F5 – Performance Management

ACCA
PAPER F5
PERFORMANCE MANAGEMENT
JUNE 2011 REVISION CLASS

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 AMG
PROFESSIONALS

Prepared by
Gbenga Okubadejo

F5 - Management accounting 2
 F5 – Performance Management

Presentation Objective

To provide a revision tool to students writing paper F5

To provide exam focus study that saves time

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Outline

F2 revision

Modern management accounting

Cost volume profit (CVP) analysis

The Concept of limiting factor analysis

Pricing decisions

Short-term decisions

Risk and uncertainty

Budget and budgetary control

Quantitative analysis in budgeting

Standard costing and variance analysis

Performance measurement 4
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1 F2 – Management accounting revision

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Introduction to Management accounting

F2 – Management Accounting gave the background to paper f5. It is better

you’re confident with the concepts and techniques learnt at the lower level.

Costing is the process of determining the cost of products, services or activities. Methods
include absorption costing and process costing.
Direct cost = D.M + D.L + D. EXP
All direct production costs are referred to as PRIME COSTS.
Addition of all indirect costs = Overheads.
Direct + indirect = Total factor cost.
Absorption costing is a method of sharing out overheads incurred amongst units produced. It
follows three processes:
Allocation
Apportionment
Absorption: may lead to under/over absorbed overhead

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F2 revision
1 For absorption

When sales fluctuate
because of seasonality in
sales demand but
production is held
constant, absorption
costing avoids large
fluctuations in profit.

Prices based on
marginal cost (minimum
prices) does not
guarantee profit.

Absorption recognises
that all costs are variable
in the long run.

It is the method allowed
by accounting standards.
F5 – Performance Management
For marginal costing
2

It shows how an
organisation's cash flows and
profits are affected by
changes in sales volumes
since contribution varies in
direct proportion to units sold.

By using absorption costing
and setting a production level
greater than sales demand,
profits can be manipulated.

Total costs need separation
for decision making

For short-run decisions in
which fixed costs do not
change, fixed costs are
irrelevant.
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2 Modern management accounting techniques

Activity based costing (ABC)

Target costing

Life cycle costing

Throughput accounting

Environmental accounting
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Activity based costing (ABC)

Steps to follow in ABC

1Identify major activities.
2 Identify cost drivers (factors which determine the
size of an activity/cause the costs of an activity).
3 Collect costs associated with each activity into
cost pools.
4 Charge costs to products on the basis of the Why ACT is not enough
number of an activity’s cost driver they generate. One basis of absorption – volume
Companies now produce variety
Cost drivers of Products
•Volume related (eg labour hrs) for costs that vary May hide inefficiency.
with production volume in the short term (eg power Allocate more ohds to
costs) volume-based product
• Transactions in support departments for other costs
(eg No of visit for site supervisor costs)

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Target costing

Involves setting a target cost by subtracting a
desired profit margin from a competitive market
price

The target cost may be less that the initial
product cost but it is expected to be achieved
by the time the product reaches maturity

There is a focus on price-led costing, customer
requirements and design
Steps in target costiing
1. Do market research to obtain a competitive price
2. Determine the required magin
3. Cal. target cost = estimated SP – req’d margin
4. Compare the estimated costs with the target
5. Cost gap exists if estimated > target.
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Life cycle costing
This method tracks and accumulates costs
and revenues over a product’s entire life. This cycle include
1. Development 2. Introduction 3. Growth 4.Maturity 5. Decline

Maximising returns over the product life cycle

1. Design costs out of products

2. Minimise the time to market
3. Minimise breakeven time
4. Maximise the length of the life span
5. Minimise product proliferation
6. Manage the product’s cashflows

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Life cycle costing

Sales
Volume

Sales

Profit

Time

Introduction Growth Maturity Decline

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Throughput accounting
Basic concept of throughput
 In the short run, all costs except materials are fixed
 In a JIT environment, the ideal inventory level is zero. So unavoidable, idle
capacity in some operations must be accepted
 The factory spends money when goods are produced and a product makes money
when it sold. Overall profitability is determined by how fast the product makes money
compare to how the factory spends.

Throughput accounting ratio

= Return per factory hour
Total conversion cost per factory hour
TPAR > 1 = Continue Product
TPAR < 1 = Cease Product
Before cessation, consider other qualitative factors. Or consider working on the
product for TPAR to > 1.

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Environmental management accounting (EMA)

Definition

The generation and analysis of both financial and

non-financial information in order to support
environmental management processes.

Typical environmental costs

Importance Consumables and raw materials
Identifying environmental costs associated Transport and travel
with individual products and services can Waste and effluent disposal
assist with pricing decisions Water consumption
 Ensuring compliance with regulatory Energy
standards
 Potential for cost savings

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Cost volume profit (CVP analysis)
How to calculate a multi-product breakeven point
1. Calculate the contribution per unit.
2. Calculate the contribution per mix.
3. Calculate the breakeven point in number of mixes.
4. Calculate the breakeven point in units and revenue.

How to calculate a multi-product C/S (or profit volume or P/V) ratio

Calculation of breakeven sales:
1. Calculate the revenue per mix.
2. Calculate the contribution per mix.
3. Calculate the average C/S ratio.
It is vital to remember that for
multi-product Breakeven analysis,
4. Calculate the total breakeven point. a constant product sales mix
5. Calculate the revenue ratio per mix. must be assumed.
6. Calculate the breakeven sales.

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Cost volume profit (CVP analysis)

Target profits
1. Calculate the contribution per mix.
2. Calculate the required number of mixes.
3. Calculate the required number of units and
4. sales revenue of each product.

Limitations of CVP analysis

It is assumed that fixed costs are the same in total and variable costs
are the same per unit at all levels of output

It is assumed that sales prices will be constant at all levels of activity

Production and sales are assumed to be the same

Uncertainty in estimates of fixed costs and unit variable costs is
often ignored

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Decision making time

“Decision making is an
important aspect of the
Paper F5 syllabus, and
questions on this topic will
be common…….but this
article will focus on only
“…….The first step in any linear
one: linear programming.”
programming problem is to produce
the equations for constraints and the
contribution function. This should
not be difficult at this level.”

Excerpts from technical article by Geoff

Cordwell former examiner for Paper F5.
 F5 – Performance Management
Linear programming
Formulating the problem

Steps in linear programming

1. Define variable
2. Construct objective function
3. Establish constraints
4. Graph
5. Find the optimal solution
There are two methods of finding the optimal
solution:
1. Graphical method
2. Using equations

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Linear Programming
Slack Surplus

Occurs when maximum availability of a
Occurs when more than a minimum

resource is not used. requirement is used.

The resource is not binding at the
Surplus is associated with ≥ constraints
optimal solution. Slack is associated with eg a minimum production requirement
≤ constraints.

Shadow price

It is the increase in contribution created by the availability of an

extra unit of a limited resource at its original cost.

It is the maximum premium an organisation should be willing
to pay for an extra unit of a resource.

It provides a measure of the sensitivity of the result.

It is only valid for a small range before the constraint becomes
non-binding or different resources become critical.

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Pricing decisions
Influence on price
1. Cost Price elasticity of demand (η)
A measure of the extent of change in market
2. Demand
demand for a good, in response to a change in
3. Income level its price
4. Competition = change in quantity demanded, as a % of
demand ÷ change in price, as a % of price
5. Quality perception
6. Market structure Inelastic demand
7. Product life cycle η<1
 Demand falls by a smaller % than % rise in price
8. E.c.t.  Pricing decision: increase prices
Elastic demand
η>1
 Demand falls by a larger % than % rise in price
 Pricing decision: decide whether change in cost
will be less than change in revenue.

NB: For pricing strategy to be adopted, make

reference to PED.
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Profit Maximisation
Determining the profit-maximising
selling price/output level
Profits are maximised when
MC = MR.
Other Pricing strategy
Penetrating pricing
Skimming pricing
Product-line pricing
Complimentary pricing
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Pricing strategy
Full cost plus
Advantages
Quick, simple, cheap method
Ensures company covers
fixed costs.
Disadvantages
Doesn’t recognise profit
maximising price and output
Budgeted output needs to be
established
Suitable basis for overhead
absorption needed

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Short-term decisions

Relevant costs are Make or Buy

 Future e.g sunk not relevant
Compare internal
 Incremental e.g the amount by differential production
which fixed cost steps up costs with supplier’s
 Cash flows e.g provisions, quotation.
notional costs, absorbed
Consider other
overheads not relevant.
qualitative factors
N.B: before sub-contracting
1. Useful for one-off contract or outsourcing
2. Minimum pricing
3. The key note is “I don’t want to
be worse off”. if I can’t make
money then I don’t wanna loose
any!

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Short-term decision
Further processing decision

Determine the contribution earned on
the current operation.

Calculate incremental costs and
revenue

Compare the results and act Shut down decision
accordingly.

Bear in mind that some fixed costs may Any short-term decision
no longer be incurred if the decision is to must consider qualitative
shut down and they are therefore relevant factors related to the impact
on employees, customers,
to the decision.
competitors and suppliers

Consider the size of the incremental
contribution that would be earn.

Lastly, consider other qualitative factors
e.g current brand loyalty, legal implication,
social effect, accuracy of data available.

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Risk and uncertainty
The technique that a decision maker will use in dealing
with risk and uncertainty will be dependent on his risk
attitude.
Attitude to risk

Risk seeker A decision maker interested in the best
outcomes no matter how small the chance that they may
occur

Risk neutral A decision maker concerned with what will
be the most likely outcome

Risk averse A decision maker who acts on the
assumption that the worst outcome might occur

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Methods of dealing with risk and uncertainty

Methods of dealing with risk and uncertainty

Market research: Primary & secondary

Expected values (EV) - indicate what an outcome is likely to
be in the long term with repetition. The expected value will
never actually occur. EV = PR * OUTCOME

Decision rule: This involves calculation of
1. Maximax
2. Maximin
3. Minimax regret rule

Sensitivity analysis

Simulation

Brainstorming or scenario building

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Budgeting and budgetary control
Objectives of a budgetary planning
and control system

Ensure the organisation’s
objectives are achieved

Compel planning

Communicate ideas and plans

Co-ordinate activities

Provide a framework for
responsibility accounting

Establish a system of control

Motivate employees to improve
their performance
F5 – Performance Management
Negative effects of budgets
include
At the planning stage
– Managers may fail to co-ordinate
plans with those of other budget
centres.
– They may build slack into expenditure
estimates.
When putting plans into action
– Minimal co-operation and
communication between managers.
– Managers might try to achieve targets
but not beat them.
Using control information
– Resentment, managers seeing the
information as part of a system of trying
to find fault with their work.
– Scepticism of the value of information
if it is inaccurate, too late or not
understood.
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Budgetary systems
Traditional budgetary systems
Incremental budgeting
This involves adding a certain percentage to last
year’s budget to allow for growth and inflation. It
encourages slack and wasteful spending to creep
into budgets.
Fixed budget
These are prepared on the basis of an estimated
volume of production and an estimated volume of
sales. No changes are made to the budgets and
are not adjusted (in retrospect) to
reflect actual activity levels.
F5 – Performance Management
Flexible budget

These are budgets which, by
recognising different cost
behaviour patterns, change as
activity levels change.

At the planning stage, flexible
budgets can be drawn up to show
the effect of the actual volumes of
output and sales differing from
budgeted volumes.

At the end of a period, actual
results can be compared to a
flexed budget (what results should
have been at actual output and
sales volumes) as a control
procedure.
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Zero-based budgeting

Zero-based budgeting
This approach treats the
Merit
preparation of the budget for
each period as an independent
Identifies and
planning exercise: the initial removes inefficient
budget is zero and every item of and/or obsolete
expenditure has to be justified in operations
its entirety to be included. It is
Provides a
usually developed as a package. psychological impetus
to employees to
Steps in ZBB
avoid wasteful
1. Define decision packages expenditure
2. Evaluate and rank packages on
Leads to a more
the basis of their benefit to the efficient allocation of
organisation. resources

3. Allocate resources according to

the funds available and the
ranking of packages.

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Standard costing
Uses of standard costing

To act as a control device
(variance analysis)

To value inventories and cost
production

To assist in setting budgets and
evaluating managerial
performance

To enable the principle of
‘management by exception’ to
be practiced

To provide a prediction of future
costs for use in decision-making
situations

To motivate staff and
management by providing
challenging targets

To provide guidance on
possible ways of improving
efficiency
F5 – Performance Management
Types of standard
Ideal
Perfect operating conditions
Unfavourable motivational impact
Attainable
Allowances made for inefficiencies and
wastage
Incentive to work harder (realistic but
challenging)
Current
Based on current working conditions
No motivational impact
Basic
Unaltered over a long period of time
Unfavourable impact on performance
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Variance analysis
A standard cost card will look as follows:
$/unit
Direct material (20kg@$5/kg) 100
Direct labour (10hrs@$5/hr) 50
Prime costs 150
Variable Overheads(10hrs@$10/hr) 100
Total variable cost 250
Fixed cost (10hrs@$12/hr) 120
Total factory cost 370
Profit (25% mark-up) 92.50
Selling price 462.50

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Reasons for variances
Material price (F) – unforeseen discounts received
(A) – price increase, careless purchasing
Material usage (F) – material used higher quality than
standard
(A) – defective material, waste, theft
Labour rate (F) – use of less skilled (lower paid) workers
(A) – rate increase
Idle time (always (A)) – machine breakdown, illness
Labour efficiency (F) – better quality materials
(A) – lack of training
Overhead expenditure (F) – cost savings
(A) – excessive use of services
Overhead volume - production greater or less than budgeted

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Planning and operation
Planning variances
Arise because of inaccurate
planning/faulty standards and so
not controllable by operational
managers but by senior
management
Calculated by comparing an
original standard with a revised
standard
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Operational variances

Caused by adverse/favourable
operational performance

Calculated by comparing actual
results with a realistic, revised
standard/budget
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Performance measurement
Financial performance Non-financial performance
indicators (FPI) indicators (NFPI)
Profitability ratio
Look at a wider range of

ROCE variables

Provide information on

Profit margin quality and customer

Sales growth satisfaction

Better indicator of future

Asset turnover prospects

Liquidity ratios
Can be provided quickly
 Inventory days and tailored to circumstances

 Receivable days
 etc

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Balanced Scorecard
Perspective Question Explanation

Customer What do existing and new customers Gives rise to targets that matter to
value from us? customers: cost,
quality, delivery, inspection, handling
and so on.

Internal What processes must we excel at to Aims to improve internal processes

achieve our financial and customer and decision
objectives? making.

Innovation and Can we continue to improve and Considers the business's capacity to
learning create maintain its competitive position
future value? through the acquisition of new skills
and the development of new
products.
Financial How do we create value for our Covers traditional measures such as
shareholders? growth, profitability and shareholder
value but set through talking to the
shareholder or shareholders direct.

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Not-for-profit organisations
Problem with performance
measurement
 Multiple objectives
 Measuring outputs
 Lack of profit measure
 Nature of service provided
 Financial constraints
 Political, social and legal
considerations
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Suggested way out
Judge performance in terms
of inputs
 Use experts’ subjective
judgment
 Use benchmarking
 Use unit cost quantitative
measures
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Value for money
3 E’S

Efficiency: Relationship between inputs and outputs

(getting out as much as possible for what goes in)
Effectiveness: Relationship between outputs and
objectives (getting done what was supposed to be done)
Economy: Obtaining the right quality and quantity of
inputs at lowest cost (being frugal)

For further reading: BPP revision kits

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