Notes ACCA Paper F5 Performance Management For exams in 2010
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ExPress Notes ACCA F5 Performance Management
Contents
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About ExPress Notes
3
1.
Specialist Cost & Management Accounting Techniques
7
2.
Decision Making – Linear Programming
10
3.
Pricing Decisions
12
4.
Make-or-buy and other short-term decisions
16
5.
Risk and Uncertainty in Decision Making
19
6.
Budgeting – an Introduction
22
7.
Budgeting and Standard Costing #1
26
8.
Budgeting and Standard Costing #2
32
9.
Performance Measurement & Control
35
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ExPress Notes ACCA F5 Performance Management
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ExPress Notes ACCA F5 Performance Management
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ExPress Notes ACCA F5 Performance Management
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ExPress Notes ACCA F5 Performance Management
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ExPress Notes ACCA F5 Performance Management
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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ExPress Notes ACCA F5 Performance Management
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 = 300,000 500,000 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 = 159,091 500,000 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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ExPress Notes ACCA F5 Performance Management
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 lifecycle.
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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ExPress Notes ACCA F5 Performance Management
Chapter 2
Decision Making – Linear Programming
KEY KNOWLEDGE Multi-limiting factors and the use of linear programming and shadow pricing. When resources are scarce, or other limiting factors are present in a given situation, then management is concerned with achieving the most efficient allocation of available resources. Whereas planning with one limiting factor involves the use of “key factor analysis” (in which typically one seeks to maximize the contribution per unit of the limited, or bottleneck, resource – see Paper F2), the presence of several limiting factors requires the use of linear programming. In such cases, linear programming is typically used to either maximise contribution or to minimize costs. The usual steps to be followed are: 1) 2) 3) 4)
Define the variables Define the “objective function” Express the constraints as equations Solve the equations simultaneously as well as feasible values corresponding to the corner points; 5) Determine the combination of specific values that satisfies the objective function.
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ExPress Notes ACCA F5 Performance Management
The answer can also be graphed and Step 5 determined visually. A graph also shows the “feasible region” of value combinations that are consistent with the constraints.
EXAMPLE An aircraft manufacturing company producing propellers and wing ribs operates under the following conditions: Materials (kg) Labour (hrs) Contribution ($)
Propellers 6 8 50
Wing ribs (set) 12 6 30
Materials are limited to 120 kg. per week while labour must not exceed 100 hours. 1) Define the variables: p = propellers w = wing ribs 2) Maximise contribution = 50p + 30w 3) Materials: 6p + 12w ≤ 120 Labour: 8p + 6w ≤ 100 4) Simultaneous solving results in: p = 8 and w = 6; the feasible corner points are p = 12.5 (when w=0) and w = 10 (when p=0) 5) Calculate the highest contribution at each of the combinations in Step 4 This can also be graphed for easier visualisation of the feasible region and solution. Shadow (dual) price A shadow price is the additional value to be obtained (usually an increase in contribution) by having available one more unit of a scarce resource. In the example above, the shadow price of 1 kg of material can be determined by re-solving the simultaneous equations with 121 (kg) substituted for 120. Similarly, the shadow price of an additional hour of labour can be expressed by re-solving the equations with labour equal to 101, and determining what the increase in contribution will be. Slack This represents the amount of a resource that has not been exhausted (i.e. its availability does not act as a constraint or limiting factor in a given set of circumstances).
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ExPress Notes ACCA F5 Performance Management
Chapter 3
Pricing Decisions
START The Big Picture The pricing of a product or service is crucially influenced by several factors: 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 =
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% change in demand % change in price
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ExPress Notes ACCA F5 Performance Management
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% = 0.5 (Note:Ignore + or – signs; take the absolute value) (2/4) 50% 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: 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:
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ExPress Notes ACCA F5 Performance Management
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; 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.
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ExPress Notes ACCA F5 Performance Management
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). 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.
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ExPress Notes ACCA F5 Performance Management
Chapter 4
Make-or-buy and other short-term decisions
START The Big Picture 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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ExPress Notes ACCA F5 Performance Management
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. Make-Buy A make-buy decision requires the determination of all relevant costs.
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ExPress Notes ACCA F5 Performance Management
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: Contribution lost (carburettors): Labour (added-back):
100 80 20 200
It is cheaper to produce internally. Shut Down decisions 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.
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ExPress Notes ACCA F5 Performance Management
Chapter 5
Risk and Uncertainty in Decision Making
START The Big Picture 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) 340 766 278 450 (230)
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Expected Probability Value 10% 20% 50% 18% 2% 100%
34.0 153.2 139.0 81.0 (4.6) 402.6
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ExPress Notes ACCA F5 Performance Management
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.
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ExPress Notes ACCA F5 Performance Management
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: Profits
1
Outcomes:
Strategy 2
A 25 30 B 50 35 C 60 40 Maximax – going for the upside: Chooses Strategy 60).
3 20 55 45 1 (to keep the door open to a profit of
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 Outcomes:
1 A B C
Maximum regrets
Strategy 2
3
(5) (5) Best
Best (20) (20)
(10) Best (15)
(5)
(20)
(15)
Conclusion: Minimizing the maximum regret leads to Strategy 1.
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ExPress Notes ACCA F5 Performance Management
Chapter 6
Budgeting – an introduction
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:
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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; They reinforce centralising tendencies in the company; There is a lack of goal congruence between corporate, divisional and individual goals
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ExPress Notes ACCA F5 Performance Management
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)
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No budget owners (departments, functions), but budgeted activity cost (ABC costing)
Budgeted activity cost = demand for activity * unit cost of activity
More detailed and accurate than traditional budgets, especially regarding indirect costs
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ExPress Notes ACCA F5 Performance Management
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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ExPress Notes ACCA F5 Performance Management
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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ExPress Notes ACCA F5 Performance Management
Chapter 7
Budgeting and Standard Costing #1
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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ExPress Notes ACCA F5 Performance Management
EXAMPLE The following is a fully-worked illustration based on the following data: Cost card (per unit) Materials (5kgs x $9 per kg) Labour (3hrs x $6 per hr) Variable O/Hs (3 hrs x $3 per hr) Fixed O/Hs (3 hrs x $5 per hr)
Budget Production: Sales: Sales Price:
1,100 units 1,000 units $120 / unit
Actual results Production: Sales: Materials: Labour: Variable O/Hs: Fixed O/Hs: Sales price:
1,000 units 950 units 4,900 kg, $45,025 3,100 hrs, $19,050 $9,250 $17,000 $115 / unit
45 18 9 15 87
Variances analysis is best performed by asking a series of parallel questions in a systematic way: Material variances (i)
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Material price variance Materials used (4,900 kg) should have cost @ $9 Materials (4,900 kg) did cost Materials price variance
44,100 45,025 $925 (A)
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ExPress Notes ACCA F5 Performance Management
(ii)
Material usage variance 1,000 units should have used @ 5 kg 1,000 units did use Materials usage variance @ standard $9 Materials total variance:
5,000 kg 4,900 kg 100 kg (F) $900 (F) $ 25 (A)
Labour variances (i)
(ii)
Labour rate variance Labour (3,100 hrs) should have cost @ $6 Labour (3,100 hrs) did cost Labour rate variance
18,600 19,050 $450 (A)
Labour efficiency variance 1,000 units should have taken @ 3 hrs 1,000 units did take Labour efficiency variance @ standard $6 Labour total variance:
3,000 hrs 3,100 hrs 100 hrs (A) $600 (A) $ 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 3,100 hrs did cost Variable O/H expenditure variance
(ii)
Variable O/H efficiency variance 1,000 units should have taken @ 3 hrs 1,000 units did take Variable O/H efficiency variance @ standard $3 Variable O/H total variance:
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9,300 9,250 50 (F)
3,000 hrs 3,100 hrs 100 hrs (A) $300 (A) $ 250 (A)
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ExPress Notes ACCA F5 Performance Management
Fixed O/H variances Fixed O/H total variance
Overhead actually incurred Overhead absorbed (1,000 units x $15) Fixed O/H total variance
$17,000 $15,000 $ 2,000 (A)
This can be broken down into two components: (i)
(ii)
Fixed O/H expenditure variance Budgeted O/H should have cost (1,100 units x $15) 16,500 Actual O/H cost 17,000 Fixed O/H expenditure variance $500 (A) Fixed O/H volume variance Budgeted production Actual production Fixed O/H volume variance @ standard $15
1,100 units 1,000 units 100 units (A) $1,500 (A)
Sales volume variance The absorption costing system calculates sales volume variances as follows:
Budgeted sales volume Actual sales volume Sales volume variance @ standard margin ($120-$87)
1,000 950 50 (A) $1,650 (A)
Sales price variance
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950 units should have sold @$120 Actual revenues (950 units x $115) Sales price variance
114,000 109,250 4,750 (A)
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ExPress Notes ACCA F5 Performance Management
Operating statement A reconciliation between profit budgeted (absorption costing) and that realized follows:
Budgeted profit
33,000
Sales volume variance Sales price variance
1,650 (A) 4,750 (A) 26,600
Cost variances: Materials Price Usage Labour
900
Rate Efficiency
Variable Expenditure Efficiency Fixed
F
Expenditure Volume
A 925
450 600 50
950
300 500 1,500 4,275
Actual profit
3,325 (A) 23,275
Note: Closing inventory is valued at standard cost
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ExPress Notes ACCA F5 Performance Management
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 Sales volume variance Sales price variance
48,000 2,400 (A) 4,750 (A) 40,850
Cost variances: Materials Price Usage
F 900
A 925
Labour Rate Efficiency Variable Expenditure Efficiency
450 600 50 950
300 2,275
Actual contribution Fixed O/Hs Budgeted Fixed O/Hs Expenditure variance
1,325 (A) 39,525
16,500 500
Actual profit
(17,000) 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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ExPress Notes ACCA F5 Performance Management
Chapter 8
Budgeting and Standard Costing #2
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 Material Y: 10kg @ $3
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$ 40 30 70
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ExPress Notes ACCA F5 Performance Management
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):
The standard mix of actual input should have been:
X 65
Y 130 (X:Y = 5:10)
The actual mix was:
50
145
Mix variances (kg): Cost ($): Variance ($):
15 (F) $8 $120(F)
Mix variance
15 (A) $3 $45(A) $75(F)
Interpretation: More of the cheaper material (Y) and less of the more expensive one (X) were used, resulting in an overall favorable variance relating to the mix. Yield variance: Important! The analysis is made on the basis of standard mix (X:Y = 5:10): The yield (12 units) should have used 180 kg
X 60
Actual input (195 kg) expressed in standard mix
65
Yield variances (kg): Cost ($): Variance ($): Yield variance
Y 120 130
5 (A) 10 (A) $8 $3 $40(A) $30(A) $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).
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ExPress Notes ACCA F5 Performance Management
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: 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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ExPress Notes ACCA F5 Performance Management
Chapter 9
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:
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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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ExPress Notes ACCA F5 Performance Management
Fitzgerald and Moon This is another model of performance management. 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 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 turnaround 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.
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ExPress Notes ACCA F5 Performance Management
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
=
Net Profit Capital Employed
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.
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ExPress Notes ACCA F5 Performance Management
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% 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
-1125
-1125
-1125
-1125
375
375
375
375
-450
-337.5
-225
-112.5
RI
-75
37.5
150
262.5
ROI
8%
11%
17%
33%
Depreciation Profit Capital charge(10%)
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.
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ExPress Notes ACCA F5 Performance Management
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)
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