ACCA F5 Revision Notes

PAper F5 

Revision Notes

TRADITIONAL ABSORPTION v ACTIVITY BASED COSTING A company manufactures two products: X and Y. Information is available as follows: (a) Product Total production X 1,000 Y 100

Labour time per unit 0.5 hours 1.0 hour



Total overhead: $16,500



Calculate the overhead content of each product using traditional absorption methods.

(b)

The total overhead has now been broken down into: Materials handling 4,800 Production scheduling 6,500 Machine-related 5,200 Product X 8 3 2

Number of purchase orders received (total) Number of production runs (total) Number of machine operations (per unit)

Product Y 4 2 6

Recalculate the overhead content of each product using an activity-based costing approach.

Answer (a)

Absorption ratio Total overheads Total labour hours X: 1,000 x 0.5 Y: 100 x 1.0

$16,500

500 100 600 hours Absorption rate = 16,500 / 600 = $27.50 per labour hour Overhead content in products X: 0.5 hours x 27.50 = Y: 1 hour x 27.50 =

$13.75 $27.50

per unit per unit

(b) Materials handling Production scheduling Machine operations

Cost driver Purchase orders Production runs Number of operation Number of units Overhead cost per unit

Total 4,800 6,500 5,200 16,500

X 3,200 3,900 4,000 11,100 1,000 $11.10

Y 1,600 2,600 1,200 5,400 100 $54

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Revision Notes

ACTIVITY BASED COSTING *

Gives fairer valuation of cost per unit •

*

Identifies cost driver for each overhead rather than absorb all at one arbitrary rate

Focuses attention on cost drivers •

Leads to better control of overheads

BUT: *

time - consuming to identify cost drivers

*

not always possible to identify a cost driver

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PAper F5 

Revision Notes

Throughput accounting A company produces 3 products, details of which are given below:

Selling price Materials Labour Variable overheads Fixed overheads Profit p.u. Machine hours p.u. Maximum demand

A 50 10 10 18 5 43 7 1 hr 500u

B 60 15 5 20 8 48 12 2 hrs 500u

C 40 8 6 4 10 28 12 2 hrs 500u

The machine time is limited to 1,800 hours. Determine the optimum production plan and calculate the maximum profit (a) using key factor analysis (b) using throughput accounting

Main assumptions of throughput accounting: *

in the short term, all costs except materials are fixed

*

inventory levels are kept to a minimum, ideally zero.

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PAper F5 

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Throughput accounting (Answer) (a) A $12 1 $12 (1)

Contribution per unit Hour per unit Contribution per hour

Production plan: A C B

500 units x 1 500 units x 2 150 units x 2

B $20 2 $10 (3)

500 1,000 300 1,800

Maximum profit A 500 units x $12 B 150 units x $20 C 500 units x $22 Maximum contribution Less: Fixed overheads A 500 units x $5 B 500 units x $8 C 500 units x $10

C $22 2 $11 (2)

(balance)

6,000 3,000 11,000 20,000 2,500 4,000 5,000 11,500 $8,500

Maximum profit

(Note: In the absence of a figure being given for fixed overheads, it is assumed that they were absorbed into product costs before knowledge of the limited time available) (b) A $40 1 $40 (1)

Throughput per unit Hour per unit Return per hour

Production plan: A B C

500 units x 1 500 units x 2 150 units x 2

Maximum profit A B C

500 units x 40 500 units x 45 150 units x 32

Less: Fixed costs A B C

500 units x 33 500 units x 33 500 units x 20 Maximum profit

B $45 2 $22.50 (2)

500 1,000 300 1,800

C $32 2 $16 (3)

(balance)

20,000 22,500 4,800 47,300 16,500 16,500 10,000 43,000 $4,300

(Note: In the absence of a figure being given for fixed overheads, it is assumed that they were absorbed into product costs before knowledge of the limited time available)

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PAper F5 

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LIFE CYCLE COSTING Consider costs and revenues over the estimated entire life of a product.

Phases of life cycle: *

Development

*

Introduction

*

Growth

*

Maturity

*

Decline

For example, might plan to have high selling price initially (high development/introduction costs, low competition), and then to have lower prices during the maturity phase (higher volume of sales, lower costs, more competition) and plan for eventual withdrawal of product (and replacement with new product) towards end of life cycle.

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PAper F5 

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TARGET COSTING 1.

Determine a realistic / competitive selling price.

2.

Determine the profit required (e.g. required profit margin)

3.

Calculate the maximum cost p.u. in order to achieve the required profit.

4.

This is the target cost

5.

Compare the estimated actual cost with the target cost. If higher, look for ways of achieving the target cost.

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PAper F5 

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PRICING Full cost plus: Take full cost (i.e. including fixed overheads) and add on a percentage Example variable cost of production $5 p.u. budgeted fixed costs $60,000 p.a. budgeted production 20,000 units p.a. mark-up of 30%

Answer fixed costs p.u. = 60,000/20,000 = $3 full cost = 5 + 3 = $8 p.u. selling price = $8 + 30% x $8 = $10.40 p.u.

Ensures that company covers fixed costs, BUT how to budget the level of Takes no account of the effect of the selling price on demand.

production?

Marginal cost plus: Take marginal (variable cost) and add on a percentage Example Variable cost of production budgeted fixed costs budgeted production

$5 p.u. $60,000 p.a. 20,000 units p.a.

mark-up of 50%

Answer marginal cost = $5 p.u. selling price = $5 + 50% x $5 = $7.50 p.u.

Avoids the problems of absorbing fixed overheads, BUT what percentage to add in order to ensure that fixed overheads are covered? Takes no account of the effect of the selling price on demand.

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Theoretical Pricing 1.

At a selling price of $80 p.u., the demand will be 50,000 units p.a.. For every $5 change in the selling price, the demand will change by 2,000 units.



Derive the price/demand equation.

Answer b = 5/2,000 = 0.0025 a = 80 + (0.0025 x 50,000) = 205 P = 205 – 0.0025Q 2.

At a selling price of $100 p.u., the demand will be 80,000 units p.a.. For every $10 change in the selling price, the demand will change by 5,000 units.



Derive the price/demand equation.

Answer b = 10/5,000 = 0.002 a = 100 + (0.002 x 80,000) = 260 P = 260 – 0.002Q 3.

At a selling price of $200, the demand will be 100,000 units p.a.. The demand will change by 10,000 units for every $30 change in the selling price. The total costs will be 60,000 + 8Q

What should be the selling price p.u. to achieve maximum profit p.a.?

Answer b = 30/10,000 = 0.003 a = 200 + (0.003 x 100,000) = 500 P = 500 – 0.003Q MR = 500 – 0.006Q MC = 8 For maximum profit MR = MC 500 – 0.006Q = 8 Q = 82,000 When Q = 82,000, P = 500 – (0.003 x 82,000)

= $254 per unit

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PAper F5 

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RELEVANT COSTING *

Suitable for one-off contracts.

*

Calculate the future, incremental (i.e. extra), cash flows which will result from doing the contract.

Sunk costs:

costs already incurred - not relevant

Opportunity costs:

lost income as a result of doing the contract - are relevant

Fixed costs:

only relevant if the total changes as a result of doing the contract

Examples: 1.

Contract requires 200 kg of material X. Company has 500 kg in stock, which originally cost $6 per kg.. Material X has no other use, and if not used in the contract will be scrapped for $2 per kg..

2.

Contract requires 300 kg of material Y. Company has 600 kg in stock, which originally cost $10 per kg.. Material Y is in regular use by the company has the current purchase price is $12 per kg..

3.

Contract requires 50 hours of skilled labour. The company pays skilled labour $5 per hour, and there is currently plenty of idle time.

4.

Contract requires 80 hours of skilled labour. Labour is paid $5 per hour. There is no spare time, and the contract would have to be done in overtime. Overtime is paid at normal rate plus 50%.

5.

Contract requires 100 hours of skilled labour. Labour is paid $5 per hour. Labour is currently fully occupied making another product which is generating a contribution of $8 p.u. Each unit of the other product requires 2 hours of skilled labour.

Answers 1) No other use, so scrap proceeds: 2) In regular use, so current purchase price: 3) Plenty of idle time, so no extra cost: 4) No spare time, so extra cost: 5) Taken from other product, so rate per hour + lost contribution per hour:

200 x $2 = $400 300 x $12 = $3,600 $NIL 80 x ($5 + 50%) = $600 100 x (5 + 8/2) = $900

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PAper F5 

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UNCERTAINTY Sales per week Sales (units) 10 20 30

Probability 0.3 0.5 0.2

$20 p.u. Selling price: Cost: $10 p.u. Any unsold units must be sold as scrap for $1 p.u. The company can contract to purchase 10, 20 or 30 units each week. How many units should they contract for? Answer Profit table (a) Contract size 10 20 30 (a)

Demand

10

20

30

100 10 (80)

100 200 110

100 200 300

Expected Values Contract size 10: 20: (0.3 x 10) + (0.7 x 200) 30: (0.3 x (80)) + (0.5 x 110) + (0.2 x 300)

Expected value 100 143 91

Contract to buy 20 units per week (b) Maximax Contract size 10: 20: 30:

Maximum 100 200 300 ⇐ Maximum

Contract to buy 30 units per week (c) Maximin Contract size 10: 20: 30:

Maximum 100 ⇐ Maximum 10 (80)

Contract to buy 10 units per week (d)

Minimax Regret Regret table Contract size 10 20 30 Contract size 10 20 30

Demand

10 0 90 180

20 100 0 90

30 200 100 0

Maximum regret 200 100 ⇐ Minimum 180

Contract to buy 20 units per week

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PAper F5 

Revision Notes

BUDGETING (1) Incremental budgeting Take last years figures and adjust for growth and inflation. Easiest and most common approach, but assumes that we continue to do things the same way. (For example, if we make our products by hand, we will budget to continue to make them by hand and ignore the fact that maybe there are now machines capable of producing them.)

Zero based budgeting Ignore what currently happens. Instead, identify different solutions available, cost them out, and budget on adopting the best solution. For example, if our product can be made by hand or made by machine, then cost out both approaches, see which is the cheaper, and budget on that basis. Although zero based is in principle a much better approach, it is time-consuming and requires expertise. A realistic way of using a zero based approach is to apply it to one area of the business each year, and budget the other areas using an incremental approach.

Activity based budgeting Use an activity based costing approach. Budget the costs for each activity and how each activity is being used, in an attempt to ensure that each activity is being used efficiently.

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PAper F5 

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BUDGETING (2)

Top-down budgeting Budget is prepared centrally and then imposed on the managers of each department Bottom-up budgeting Each manager produces his/her budget. It is the job of central management to make sure the budgets are challenged and that different departments budgets coordinate with each other.

Bottom-up budgeting is regarded as being more motivational for managers. However the budgets do need to be challenged well otherwise there is the danger of managers introducing slack into their budgets.

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PAper F5 

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BUDGETING (3)

Fixed budget

– The original budget based on the originally estimated levels of sales and production. The original budget profit remains the overall target of the company.

Flexed budget

– The budget is adjusted (or flexed) for the actual levels of sales and production. This is usually done monthly and is used for the purpose of control (compare the actual results with the flexed budget. i.e. variance analysis)

Rolling budget (continuous budgeting)

– Update the budget each month and always have a budget for the next 12 months

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PAper F5 

Revision Notes

FORECASTING HIGH LOW METHOD Month

Sales (units)

1

23100

2

24000

3

24100

4

24800

5

25000

6

26030

7

26000

8

27100

9

27200

10

27800

11

27800

12

27500 Month

Units

High

12

27500

Low

1

23100

Difference

11

4400

Change per month: 4400 / 11 = 400 Forecast for next month:

27500 + 400 = 27900 units

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PAper F5 

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LEARNING CURVES As cumulative output doubles, the cumulative average time (labour cost) per unit falls to a fixed percentage of the previous average time (labour cost) Example 1 First batch takes 100 hours to produce. There is a 75% learning effect. How long will it take to produce another 7 batches.

Answer 1 Average time per batch 100 75 56.25 x 42.1875 =

1 2 4 8

Total time

337.5hours

Time for another 7 = 337.5 – 100 = 237.5 hours Example 2 First batch takes 60 hours to produce. There is an 80% learning effect. How long will it take to produce the 7th batch?

Answer 2

b=

log0.8 log2

= −0.3219

Average time per batch if 7 produced: Average time per batch if 6 produced: Total time for 7 batches Total time for 6 batches Time for 7th



60 x 7-0.3219 = 32.07 hours 60 x 6-0.3219 = 33.70 hours

7 x 32.07 = 6 x 33.70 =

224.49 (202.20) 22.29 hours

Learning curve formula: y = axb y = average time per batch a = time for initial batch x = number of batches b = learning factor log r b= log 2

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PAper F5 

Revision Notes

Operating Statement (Absorption Costing) Original Budget Profit Sales Volume Variance units Actual sales Budgeted sales units × Standard profit p.u.

Sales Price Variance Actual sales at actual S.P. Actual sales at standard S.P

Materials Expenditure Variance Actual purchases at actual cost Actual purchases at standard cost

Materials Usage Variance kg Actual usage Standard usage for actual production kg × Standard cost

Labour Rate of Pay Variance Actual hours paid at actual cost Actual hours paid at standard cost

Labour Idle Time Variance hours Actual hours paid Actual hours worked × Standard cost

Labour Efficiency Variance hours Actual hours worked Standard hours for actual production × Standard cost

Variable Expenditure Variance Actual hours worked at actual cost Actual hours worked at standard cost

Variable Efficiency Variance hours Actual hours worked Standard hours for actual production × Standard cost

Fixed Overhead Expenditure Variance Actual total Budget Total

Fixed Overhead Volume Variance units Actual production Budget production × Standard cost per unit

Actual Profit

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PAper F5 

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Operating Statement (Marginal Costing) Original Budget Profit Sales Volume Variance units Actual sales Budget sales units × Standard contribution p.u.

Sales Price Variance Actual sales at actual S.P. Actual sales at standard S.P

Materials Expenditure Variance Actual purchases at actual cost Actual purchases at standard cost

Materials Usage Variance kg Actual usage Standard usage for actual production kg × Standard cost

Labour Rate of Pay Variance Actual hours paid at actual cost Actual hours paid at standard cost

Labour Idle Time Variance hours Actual hours paid Actual hours worked × Standard cost

Labour Efficiency Variance hours Actual hours worked Standard hours for actual production × Standard cost

Variable Expenditure Variance Actual hours worked at actual cost Actual hours worked at standard cost

Variable Efficiency Variance hours Actual hours worked Standard hours for actual production × Standard cost

Fixed Overhead Expenditure Variance Actual total Budget Total

Actual Profit

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PAper F5 

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VARIANCE ANALYSIS Budget sales and production of Product X are 600,000 units p.a. at a standard selling price of $100 p.u. The original standard costs of production were: Materials: 2 kg @ $20 per kg Labour: 1.5 hrs @ $2 per hr Variable overheads: 1.5 hrs @ $6 per hr Fixed overheads were budgeted at $10.8M for the year. Actual results for January were as follows: Sales: 53,000 units @ $95 p.u. Production costs for 55,000 units produced: Materials (110,000 kg) Labour (85,000 hrs) Variable Overheads Fixed Overheads

$2,300,000 $180,000 $502,000 $935,000

(a)

Prepare an operating statement, reconciling actual profit with budget profit.



(Note: the company’s policy is to use marginal costing)

Since preparation of the budget, the suppliers of the materials had announced a permanent price increase of 10%. As a result the manufacturing process was examined and ways were found of reducing material usage by 5% without affecting the quality of finished goods. (b) Using the additional information, analyse the total materials variance into Planning and Operational Variances.

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PAper F5 

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VARIANCE ANALYSIS (answer A) a)

Note: Budget sales are 600,000 pa, and so budget sales for January are 600,000/12 = 50,000 units Cost card Materials Labour Variable o/h Marginal cost

(2 kg x $20) (1.5 hours x $2) (1.5 hours x $6)

40 3 9 $52

Standard contribution = 100 – 52 = $48 per unit Budgeted profit: 50,000 units x $48 Less: fixed overheads

2,400,000 (900,000) $1,500,000

Operating statement Budgeted profit Sales volume variance Sales price variance

Materials Expenditure Variance Actual cost Actual purchases at standard cost

1,500,000 144,000 (F) 265,000 (A) 1,379,000

(3,000 units x $48) (53,000 x $5)

2,300,000 2,200,000

(11,000 kg x $20)

100,000 (A) Materials Usage Variance Actual usage Standard usage for actual production (55,000 x 2kg) Labour rate of pay variance Actual cost Standard hours for actual production

kg 110,000 110,000

(85,000 hrs x 2)

NIL

180,000 170,000 10,000 (A)

Labour efficiency variance Actual hours Standard hours for actual production

85,000 (55,000 hrs x 1.5) 82,500 2,500 hours x $2

Variable overheads expenditure variance Actual cost 502,000 Actual hours at standard cost (85,500 hrs x $6) 510,000 Variable overheads efficiency variance Actual hours 85,000 Standard hours for actual production (55,000 hrs x 1.5) 82,500 2,500 hours x $6 Fixed overheads expenditure variance (935,000 – 900,000)

5,000 (A)

8,000 (F)

15,000 (A)

35,000 (A) $1,222,000

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PAper F5 

Revision Notes

VARIANCE ANALYSIS (answer B) (b)

Total materials variance Actual total cost Standard cost for actual production Sales price variance Revised cost card for materials Materials (1.9 kg x $22)

2,300,000 2,200,000 100,000 (A)

(55,000 x $40)

$41.80 pu

Planning variances Expenditure Revised std purchases at revised std cost 55,000 u x 1.9 kg = 104,500 kg x $22 Revised std purchases at original std cost 104,500 kg x $20

Usage Revised std usage at actual production (55,000 units x $1.9kg) 104,500 Original std usage for actual production (55,000 x 2kg) 110,000 5,500 x$20 =

2,299,000 2,090,000 $209,000 (A)

$110,000 (F)

Operational variances Expenditure Actual purchases at actual cost Actual purchases at revised std cost

2,300,000 2,420,000 $120,000 (F)

110,000 kg x $22

Usage Actual usage Revised std usage for actual production (55,000 x 1.9kg)

kg 110,000 104,500 5,500 x$22 =

$121,000 (A)

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PAper F5 

Revision Notes

VARIANCES 1.

Always marginal costing in exam unless told otherwise, but check carefully.

2.

Always show standard cost per unit (cost card) unless given in question. (Make sure you still get the marks even if you have misread something).

3.

Examiner sometimes uses the word ‘cost variance’ to mean ‘total variance’. (e.g. ‘calculate for materials the cost, expenditure, and usage variances’. Means expenditure and usage as normal + total variance. Do not calculate total separately, it is simply the total of expenditure + usage).

4.

If more than one material, do NOT calculate mix & yield variances unless asked for. (or unless he says ‘the materials are substitutable’ but he is unlikely to use these words).

5.

Remember: for cost variances we are always comparing actual costs with standard cost for actual level of production. It is worth writing down the actual level of production if you have misread, it is then obvious what you were trying to do.

6.

Planning and Operational Variances (a)

Planning (or Revision) Variances •

(b)

This variance cannot be ‘corrected’ (or controlled) but when it is identified that it is going to occur company may decide to change plans for the future ie. feed-forward control.

Operational Variances •

Normally calculated monthly. It is too late to do anything about the period under review, but can use information to attempt to correct (or control) any problems for the future. ie. feedback control.

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PAper F5 

Revision Notes

MIX & YIELD VARIANCES Standard cost for every 8 kg of output: A B

6 kg @ $8 3 kg @ $4

Actual results: Materials input

48 12 60 A B

99,000 kg at a total cost of $800,000 36,000 kg at a total cost of $140,000

Actual production: 130,000 kg Answer Expenditure Variance Actual purchases – Actual cost kg $ A 99,000 800,000 B 36,000 140,000 $940,000

Actual purchases

– Standard cost kg $ 99,000 x $8 792,000 36,000 x $4 144,000 $936,000

Expenditure Variance = $4,000 (A) Mix variance Actual total – Actual mix – standard cost kg $ A 99,000 x $8 792,000 B 36,000 x $4 144,000 135,000 $936,000

Actual total – Actual mix – standard cost kg $ (6/9) 90,000 x $8 720,000 (3/9) 45,000 x $4 180,000 135,000 $900,000 Mix Variance = $36,000 (A)

Yield variance Actual total – Standard mix – standard cost kg $ A 90,000 x $8 720,000 B 45,000 x $4 180,000 135,000 $900,000

Standard total – standard mix – standard cost kg $ 97,500 x $8 780,000 48,750 x $4 195,000 (130,000 x 9/8) 146,250 $975,000 Yield Variance = $75,000 (F)

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PAper F5 

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COST-VOLUME-PROFIT ANALYSIS – MULTIPLE PRODUCTS A company produces and sells three products: A, B and C. The budget information for the coming year is as follows: A B Sales (units) 5,000 6,000 Selling price (p.u.) $10 $12 Variable cost (p.u.) $5 $8 Contribution (p.u.) $5 $4

C 8,000 $15 $6 $9

The total budgeted fixed overheads for the year are $50,000

(a)

Calculate the CS ratio for each product individually

(b) Calculate the average CS ratio (assuming that the budget mix of production remains unchanged) (c)

Calculate the breakeven revenue (assuming that the budget mix of production remains unchanged)

(d) Construct a PV chart (assuming that the budget mix of production remains unchanged) Assuming that the products are produced in order of their CS ratios, contruct a table showing the cumulative revenue and cumulative profits

(e) Calculate the breakeven sales revenue on this basis (f)

Add the information to the P/V chart already produced

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PAper F5 

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ENVIRONMENTAL MANAGEMENT ACCOUNTING Note: there can be no calculations on this in the exam, and there will be a maximum of 8 marks for it as one part of a question. Environmental costs comprise such things as electricity, water, and the disposal of waste. In addition there is the effect on the image of the company of not being environmentally friendly, although this is much harder to quantify. For the exam you should be able to write briefly about four techniques that may be useful:

Inflow / Outflow analysis This approach balances the quantity of resources input with the quantity that is output (either as production or as waste). Resources include not just raw materials, but also ones such as electricity. Measuring these in physical quantities and in monetary terms forces the business to focus on environmental costs.

Flow cost accounting This is really inflow / outflow analysis, but concentrates on material flows in each of three categories: the resources used in storing raw materials and in production Material: System: the resources used in storing finished goods and in quality control Delivery & disposal: the resources used in delivering to the customer and in disposing of any waste.

Life-cycle costing Ensuring that environmental costs such as the disposal of waste are included in the life-cycle costs. It may be possible to design-out these costs before the product is launched.

Environmental Activity Based Costing Environmental costs should be allocated to their own cost centres rather than simply being included in general overheads. As with ABC in general, this focuses more attention on these costs and potentially leads to greater efficiency and cost reduction.

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PAper F5 

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LIFE-CYCLE COSTING / TARGET COSTING William plc is planning to commence production of a new product – the Kate. It is expected that demand for Kate’s will last for 6 years and that they will sell 1,000 units in the first year; 3,000 units in the second year; and 6,000 units per year thereafter. The selling price will be $15 per unit, and the company wishes to achieve a mark-up of 50% on cost. The following costs have been estimated: Design and development: Variable production costs: Additional fixed production costs: End of life costs:

$40,000 $7 per unit $4,000 per year $10,000

You are required to: (a)

calculate the target cost per unit for production of Kate’s

(b) calculate the actual full production cost per unit for the first year and comment as to whether or not there is a cost gap (c)

calculate the lifecycle cost per unit and comment as to whether or not there is a cost gap

Answer (a) target cost (b)

=

15/1.50 = $10 per unit

First year production cost: Variable cost Fixed costs $4,000/1,000

7.00 4.00 $11

Cost gap = 11 –10 = $1 per unit (c)

Life cycle cost: Total costs: 4,000 + (28,000 x 7) + (6 x 4,000) + 10,000 = $270,000 Total production 1,000 + 3,000 + (4 x 6,000) = 28,000 Life cycle cost per unit = 270,000 / 28,000 = $9.64 No cost gap

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PAper F5 

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DECISION TREES Charming plc have to make a decision as to which, if either, of two machines to buy – machine A or machine B. Machine A will cost $10,000 and will last for 10 years, generating $2,000 a year if demand for the product is high, but only $1,000 a year if demand is low. If demand is low, they will be able after 5 years to scrap the machine for $1,000 or, alternatively, to invest an additional $5,000 in which case it will generate $1,500 a year for the remaining 5 years. Machine B will cost $15,000 and will also last for 10 years, generating $4,000 a year if demand is high, or $1,000 a year if demand is low. Neither machine has any scrap value at the end of 10 years. For both machines, the probability of demand being high is 0.6. Charming intend to make the decision using expected values, based on the expected net cash receipts over the life of the machines. Which (if either) of the two machines should they buy?

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PAper F5 

Revision Notes

PERFORMANCE INDICATORS RETURN ON CAPITAL

Profit before interest & tax Long term capital (ie Equity + Long Term debt)

OPERATING PROFIT MARGIN

Operating Profit Sales

CURRENT RATIO

Current Assets Current liabilities

× 100%

× 100%

Current Assets – Inventory Current liabilities

QUICK RATIO

EARNINGS PER SHARE (E.P.S.)

Profit after interest & tax Number of shares

P / E ratio

Market value per share Earnings per share

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PAper F5 

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RETURN ON INVESTMENT v RESIDUAL INCOME Division X of Y plc is currently reporting profits of $100,000 p.a. on capital employed of $800,000 A new project is being considered which will cost $100,000 and is expected to generate profits of $15,000 p.a. The target return of Y plc is 16% (a)

Should Y plc accept or reject the project?

(b) Will the manager of Division X be motivated to accept the project if his performance is measured

(i) (ii)

on Return on Investment? on Residual Income?

Answer (a) Return from project = 15,000/100,000 x 100% = 15% < target return of 16%, so reject (b)

Divisional manager (i) ROI Current ROI 100,000/800,000 x 100% = 12.5% ROI with project:

115,000/900,000 x 100% = 12.8%

Manager motivated to accept (ii)

Current RI: Profit Less: notional interest

16% x 800,000

100,000 (128,000) (28,000)

16% x 900,000

115,000 (144,000) (29,000)

RI with project Profit Less: notional interest 16% x 80,000 Manager motivated to reject

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Revision Notes

DIVISIONAL PERFORMANCE MEASUREMENT Type of responsibility centre: Cost centre: Manager has authority for decisions over costs (but not revenue)

Revenue centre: Manager has authority for decisions over revenue (but not costs)

Profit centre: Manager has authority for decisions over costs and revenues (but not capital investment decisions)

Investment centre: Manager has authority for decisions over costs, revenues, and new capital investment.

Controllable factors: The manager should only be assessed over those items over which he has control. For example, if a manager is given authority to make decisions over everything except salary increases which are dictated by central management, then it would be unfair to include salaries in his performance measurement. If (for example) it is a profit centre, then for the purposes of measuring his performance the profit of the division should be calculated ignoring salaries.

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TRANSFER PRICING OBJECTIVES: *

Goal congruence

*

Performance appraisal

*

Divisional autonomy

OVERALL: *

Must maximise group profit

PRACTICAL: *

T.P. often fixed by Head Office

*

Problem – loss of autonomy



– possibility of dysfunctional decisions

APPROACH: Allow individual managers to negotiate the transfer price

Selling division:

Minimum T.P. = Marginal cost + opportunity cost

Receiving division:

Maximum T.P. is lower of (a) external purchase price (on intermediate market) and (b) net marginal revenue (selling price less costs of receiving division)

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Revision Notes

TRANSFER PRICING [S = selling division; R= receiving division] S 15

1.

Variable production cost Final selling price $30

2.

As (1), but intermediate market exists.

R 8

S can sell intermediate market at $18; R can buy on intermediate market at $20 (a) S has unlimited production capacity and there is limited demand on the intermediate market (b) S has limited production capacity and there is unlimited demand on the intermediate market 3.

S has restricted capacity to make A and B R wants product A. A 80 100

S’s Variable production cost per unit S’s Intermediate market price per unit Answer 1) Transfer price: $15 – $22 i) Transfer price: $15 –$20 2) ii) Transfer price $18 – $20 3)

Contributions from A B A $20 p.u. B $30 p.u. Would prefer to sell B on intermediate market Minimum Transfer price for A = Marginal cost 80

+ +

Lost contribution from B 30

= $110 per unit

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B 120 150

PAper F5 

Revision Notes

Non-financial performance measures

Quality

Flexibility

Efficiency (Resource utilisation)

Innovation

Competitiveness

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Revision Notes

Variances - Differences between Marginal and absorption costing All the variances are the same in both cases, except: Sales Volume Variance: Take difference in units between budget and actual sales, and cost out at: Marginal costing:

Standard contribution per unit

Absorption costing:

Standard profit per unit

Fixed Overheads Variances

Marginal costing:

Only expenditure variance

Absorption costing:

Expenditure variance and volume variance (Volume Variance can be analysed into capacity and efficiency see separate sheet)

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Revision Notes

Original Budget Standard cost of materials: 8kg at $4 per kg = $32 per unit Budget production: 20,000 units Actual results: Production 24,000 units Materials: 190,000kg for $769,500 Since preparation of the budget, the price per kg had increased to $4.10 and the usage had been revised to 7.5 kg per unit. Calculate the planning and operational variances, and analyse each into expenditure and usage variances

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Revision Notes

Original Budget (Answer) Flexed original budget (for 24,000 units produced):

24,000 units x $32 =

$768,000 Planning $30,000 (F)

Revised budget (for 24,000 units produced):

24,000 units x $30.75 =

$738,000

Actual results (for 24,000 units produced):

Operational $31,500 (A)

$769,500 Analysis Planning variances Expenditure 24,000u x 7.5 kg =

180,000 kg x $4.10 =

738,000

180,000 kg x $4 =

720,000 $18,000

(A)

Usage: kg Revised

180,000

Flexed budget (24,000u x 8 kg

192,000 12,000 x $4 =

$48,000 (F)

Operational variances Expenditure Actual

190,000 kg

769,500

Revised

190,000 kg x $4.10 =

779,000 $9,500

(F)

Usage: kg Actual

190,000

Revised (24,000 x 7.5 kg)

180,000 10,000 x $4.10 =

$41,000 (A)

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PAper F5 

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Usage Variances Original budget: Standard cost of materials: 10 kg at 5 per kg = $50 per unit Budget production: 10,000 units Actual results: Production Materials

11,000 units 108,900kg at $4.75 per kg

Since preparation of the budget the price per kg has changed to $4.85 and the usage to 9.5kg per unit Calculate the planning and operational variances, and analyse each into expenditure and usage variances

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Revision Notes

Usage Variances (Answer) Flexed original budget (for 11,000 units produced):

11,000 units x $50 =

$550,000 Planning $43,175 (F)

Revised budget (for 11,000 units produced):

11,000 units x $46.075 = $506,825

Actual results (for 11,000 units produced):

Analysis Planning variances Expenditure 11,000u x 9.5 kg =

108,900 kg x $4.75 =

104,500 kg x $4.85 = 104,500 kg x $5 =

Operational $10,450 (A)

$517,275

506,825 522,500 $15,675

(F)

Usage: Revised Flexed budget (11,000 x 10kg)

kg 104,500 110,000 5,500 kg x $5 =

Operational variances Expenditure Actual Revised

108,900 kg x $4.75 = 108,900 kg x $4.85 =

$27,500 (F)

517,275 528,165 $10,890

(F)

Usage: Actual

kg 108,900

Revised (11,000 x 9.5 kg)

104,500 4,400 kg x $4.85 =

$21,340 (A)

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Revision Notes

Business Solutions Business Solutions is a firm of management consultants which experienced considerable business growth during the last decade. By 2000 the firm’s senior managers were beginning to experience difficulties in managing the business. During 2001 the firm was reorganised and a regional divisional structure was introduced with individual profit targets being set for each of the semi-autonomous profit centres. Although North division has its own customer base that is distinct from that of its sister division South, it does occasionally call upon the services of a South consultant to assist with its projects. North has to pay a cross charge to South per consulting day. The amount of the charge is determined by HQ. North is free to choose whether it employs a South consultant or subcontracts the project to an external consultant. The manager of North division believes that the quality of the external consultant and the one from South division are identical and on this basis will always employ the one who is prepared to work for the lower fee. The following information is also available: • North division is very busy and it charges its clients $1,200 per consulting day • North division pays its external consultant $500 per consulting day • The variable cost per internal consulting day is $100 Required: (a) Determine a possible optimal daily cross charge that should be paid by North for the services of a consultant from South in the scenarios outlined below. The charges that you select must induce both divisional managers to arrive at the same decision independently. Explain how you have determined your cross charges and state any assumptions that you think necessary. Scenario (i) South division has spare consulting capacity. Scenario (ii) South division is fully occupied earning fees of $400 per consulting day. Scenario (iii) South division is fully occupied earning fees of $700 per consulting day. 

(10 marks)

(b) Identify the possible factors that may have prompted the senior management to introduce a divisional structure in (10 marks) 2001 and suggest some potential problems that may arise.  (20 marks)

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Revision Notes

Business Solutions (Answer) (a)

Scenario (i) If North uses the external consultant, the daily contribution to the company is $1,200 – $500 = $700. If North uses a consultant from South the daily contribution to the company is $1,200 – $100 = $1,100. Therefore the cross charge rate should be set on a level where both North and South will perceive that they will benefit – above $100 and below $500 – say $300. Scenario (ii) If North uses the external consultant, the total contribution for one day’s consultancy in both North and South divisions would be: Income VC North 1,200 500 South 400 100 1,600 – 600= $1,000 If the South consultant goes to North, then the total contribution would be: $1200 – $100 = $1,100 Therefore it is best if North employs the South consultant – by setting the cross charge above $400 and below $500, say $450, both parties will benefit and agree to the transaction. Scenario (iii) If the North uses the South Consultant, the total contribution will be: $1200 – $100 = $1,100 If North employs the external consultant, the total contribution will be: Income VC North 1,200 500 South 700 100 1,900 – 600= $1,300 The lost contribution of the work in South ($600) exceeds the incremental cost ($400) of the external consultant undertaking the work. The company therefore needs to set a cross charge that discourages a consultant going North i.e. above $500 but below $700

(b)

Assumptions: • the objective of the company is to maximise contribution in the short run (not long run considerations) • the long term business consequences of rejecting work in the South (Scenario ii) can be ignored • the divisional managers’ behaviour and responses determined only by short term sectional (divisional) financial performance measurement. • access to all the decision making data that the separate divisions use. Reasons for re-organisation • the need to have local knowledge applied specifically to local decisions • a divisional company offers the opportunity to make decentralised speedy decisions – especially with a rapidly changing environment • it permits senior managers to concentrate on global strategic issues – detailed operational activities are dealt with separately by those most suitable • it permits junior managers to experience broader decision making and can be used as part of their development programme • local semi-autonomous decision making is likely to be a motivating factor for managers (less central control) • a divisional structure may reduce the complexity and cost of the communication systems within an unitary hierarchical structure Suggested problems • the senior management may have difficulty in ‘letting go’ – permitting decision to be made locally • senior management may become involved in resolving disputes between the divisions • the divisions might eventually compete against each other to the detriment of the entire company • some divisional decisions may not be in the best interests of the entire company (problems of local optimality v global optimality) – ensuring goal congruence • the potential waste from the duplication of functions

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PAper F5 

Revision Notes

HOW TO PASS ACCA EXAMS !!!! 1

Attempt every question

2 Attempt every part of every question (attempt does not mean finish – even just copying a relevant formula from the formula sheet will get a mark and could make the difference between 49 and 50) 3

Help the marker – start each new question on a new sheet of paper

4 Start each part of a question on a new sheet of paper. If you can only write one line for part (a) of a question, leave the rest of the page blank – you might think of something else later to add. 5 Help the marker – be neat! You will get marks for the correct approach even if your calculations are wrong – provided the marker can see what you have done. 6 Always write something for a written part – never write nothing! Anything sensible will almost certainly get you 1 mark, which could be the difference between passing and failing. There is no negative marking, and so even if you are wrong you will not lose marks. 7 Allocate your time – between questions and parts of questions. Spending an hour on one part of one question will certainly mean you will fail because you will not have enough time for other questions. 8 In a calculation question, no one figure can be worth more than 3 or 4 marks (if it is it will be a separate part of the question). If you find yourself spending too long on one figure then leave it – there will be plenty more marks available in the same time. 9 Help the marker – in essay parts of questions put each separate point on a new line. If you string points one after the other, there is the danger of the marker missing some of them. Do make each point into a sentence – never write one-word answers. 10 Read the requirements first – do not start worrying about the figures in the body of the question until you know what it is you are trying to do! 11 Remember the pass mark is 50%. Aim to get 50% on every part of every question as fast as you can by going for the easy bits first. Once you feel you have got half the marks then you can spend more time on the harder bits. 12

Allocate your time and attempt every part of every question.

13

Allocate your time and attempt every part of every question.

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