CMA

PART ONE

Financial Planning,

Performance and

Control

Units 15 & 16

Performance Management

(20% - Levels A, B, and C)

Control (management-by-exception approach) in U.15 and Management

Control (management-by-objectives approach) in U.16 Factors to be analyzed
for control and performance evaluation include revenues, costs, profits, and
investment in assets. Variance analysis based on flexible budgets and standard
costs is heavily tested, as is responsibility accounting for revenue, cost,
contribution, and profit centers. The balanced scorecard is included in this
coverage, as are quality considerations.

Presentation and answering the CMA MCQs are an integrated part of these
materials.
DIRECT MATERIAL VARIANCE

Direct material Price variance =

(Actual price - Standard price) *Actual quantity

(AP-SP) *AQ

Note:

- Actual quantity purchased.

- It is usually the responsibility of purchasing manager.

Direct material Quantity, Efficiency, Usage variance =

(Actual quantity - Standard quantity)* Standard price

(AQ-SQ) * SP

Notes:

- Actual quantity used in production.

- It is the responsibility of production, industrial engineering and

sometimes purchasing manager.

- For internal cost accounting the unfavorable variance recorded as

a debit and the favorable recorded in the entries to provide
information for use in controlling the cost.

- Direct material quantity (usage) variance is sometimes

supplemented by two variances:

Direct material mix variance, and Direct material yield variance.

Those variances calculated only when the production process
involves combining several materials in varying proportion.

Direct material mix variance =

(Weighted average unit of standard price for actual mix – Weighted

average unit of standard price for standard mix) * Actual quantity

(W.A. of SP for AQ - W.A. of SP for SQ) *AQ

Direct material yield variance =

(Actual total quantity - Standard total quantity)* Weighted average

unit of standard price for standard mix

(AQ - SQ)* W.A. of SP for SQ

Total Direct material variance =

(Actual price*Actual quantity) - (Standard price*Standard quantity)

(AP*AQ) - (SP*SQ)

DIRECT LABOR VARIANCE

Direct labor Rate variance =

(Actual rate - Standard rate) *Actual hours

(AR-SR) * AH

Direct labor Efficiency variance =

(Actual hours - Standard hours)* Standard rate

(AH-SH) * SR

Notes:

- Direct labor efficiency variance can divided into two variances:

Direct labor mix variance, and direct labor yield variance.

Direct labor mix variance =

(Weighted average unit of standard rate for actual hours mix –

Weighted average unit standard rate of standard hours mix)* Actual
hours

(W.A. of SR for AH - W.A. of SR for SH) *AH

Direct labor yield variance =

(Actual hours - Standard hours)* Weighted average unit of standard

rate for standard mix

(AH - SH)* W.A. of SP for SH

Total Direct labor variance =

(Actual rate*Actual hours) - (Standard rate*Standard hours)

(AR*AH) - (SR*SH)

FACTORY OVERHEAD VARIANCE

1. Variable Factory Overhead (OH) variance

Total Variable Factory Overhead (OH) variance =

Actual Variable OH – standard input (hours) allowed for actual

output X standard VOH rate

Actual input (hours) x actual VOH rate

(AR*AH) - (SH*SR)

Spending Variable factory overhead variance =

Actual variable overhead – Actual input (hours) x standard VOH rate

Actual input (hours) x actual VOH rate

AH * AR - AH * SR

(AR-SR) * AH

Efficiency Variable factory overhead variance =

Actual input (hours) x standard VOH rate - standard input (hours)

allowed for actual output X standard VOH rate

AH * SR - SH * SR

(AH-SH) * SR

Notes:

- The efficiency variance is related to the labor efficiency variance

when OH is applied to production on the basis of direct labor hours,
For example, if the labor efficiency variance is unfavorable, the
efficiency variance will also be unfavorable, since both would be
based on the same number of input hours.

- If the base of the application rate is the unit (output), Efficiency

variance equal to zero because the rate is applied on the base of
output not the inputs.

- The overtime premium if:-

1- planned (expected) as a requirement of specific job or order is a

direct cost .

2- Unplanned (unexpected) as arising from heavy overall volume of

the work it is an indirect cost (OH).
2. Fixed factory overhead (OH) variance

Total Fixed factory overhead variance =

Actual Fixed OH – standard input (hours) allowed for actual output X

standard FOH rate

Actual Fixed OH - (Actual units * SH * SR)

Spending (Budgeted) Fixed factory overhead variance =

Actual Fixed OH – Budgeted Fixed OH

Actual Fixed OH - (Standard units * SH * SR)

Production Volume Fixed factory overhead variance =

Budgeted Fixed OH - standard input allowed for actual output X

standard FOH rate

(Standard units * SH * SR) - (Actual units * SH * SR)

Notes:

- For the fixed OH, the flexible and the static budget are the same
because the fixed costs are by their nature unchanging within the
relevant rang.

- No efficiency variance in fixed OH. Production (volume variance).

- Is the idle capacity variance because it is just a measure of the use

of capacity.

- Is the denominator – level variance (it measure the deviation from

the denominator)
- Is the difference between the budgeted fixed OH and the fixed
overhead applied so it is the reason for under applied or over applied
of fixed OH.

- Due to the difference between the planned level and the actual
level achieved.

- Least significant and its responsibility rest with top management

not the production manager because it may result from labor strike ,
economic downturns ,bad weather or a change in planned production.

- When compared with spending variance is least useful in detecting

short term problems in cost controlling.

- Fixed FOH used with the absorption method.

OH Variances Analysis:

- Variance analysis for OH consists of a two-way, or three-way or

four-way method of computation, depending on the significance of
the variance amounts compared to the cost of analysis.

- Whether the two-way or three-way or four-way analysis of OH is

used, the total overhead variance must equal the under or over-
applied overhead.

- If the sum of all variances is a net unfavorable variance (debit

balance), the factory overhead is under applied and vice versa.

- Four-Way overhead variance analysis:

Includes all four component variances

Four-Way analysis

Spending variance for Variable OH

Spending variance for Fixed OH

Efficiency variance

Volume variance

- Three-Way overhead variance analysis:

Combines the variable spending and fixed budget variances into a

single spending variance and reports the other two variances
separately.

Three-Way analysis

Spending variance

Efficiency variance

Volume variance

Total OH

- Two-Way overhead variance analysis:

Combines the spending and efficiency variances into a single flexible

variance and reports the volume variance separately.

Two-Way analysis

Flexible Budget variance(controllable )

Volume variance

Total OH

SALES VARIANCES

Sales variance analysis is not only tool of the manufacturing division

but also a method used to judge the effectiveness of the selling
departments, if a firm’s sales differ from the amount budget the
deference could be attributable to either the sale price variance

or the sales volume variance.

Sales price variance =

(Actual selling price - Budgeted selling price) x Actual units sold

(AP – SP ) * AQ

AQ: Flexible budget

Sales volume variance (Contribution margin volume variance) =

(Actual units sold – Budgeted units) x Budgeted standard

contribution margin per unit.

(AQ - SQ) * Budgeted U.C.M.

SQ: Master budget

- Sales volume variance can be divided into Sales Quantity

variance, and Sales Mix variance.

Sales quantity variance =

(Total Actual units sold – Total Budgeted units to be sold) x WA of

budgeted Unit contribution margin for planned mix.

(AQ - SQ) * W.A of Budgeted U.C.M for planned mix.

Sales Mix variance =

(Weighted average of budgeted Unit contribution margin for actual

mix - Weighted average of budgeted Unit contribution margin for
planned mix) x Total Actual units sold.
(W.A of Budgeted U.C.M for actual mix - W.A of Budgeted U.C.M for
planned mix) * AQ.

Market Size Variance =

(Actual market size in units - Budgeted market size in Units) x

Budgeted market share percentage x Weighted average of budgeted
Unit contribution margin for planned mix.

Market Share Variance =

(Actual market share percentage - Budgeted market share

percentage) x Actual market size in units x

Weighted average of budgeted Unit contribution margin for planned

mix.

U 16: RESPONSIBILITY ACCOUNTING AND PERFORMANCE

MEASURES

Responsibility Accounting is a method of defining segments or

subunits in an organization as types of responsibility centers based
on their level of autonomy and the responsibilities of their managers,
Responsibility centers are classified by their primary effect on the
company as a whole.

- A company must determine the parties within an organization that

are responsible for performance and establish a means for evaluating
their performance.
- Each manager is in-charge of a responsibility centre and is
accountable for a specified set of activities within an organization.

The basic objective of responsibility accounting is to motivate

management to perform in a manner consistent with overall
company, And also to reduce defective units, to increase

efficiency in the manufacturing process, and to reduce costs.

To establish a responsibility accounting the company must do:

- Establish a proper system of delegating authority and

responsibility.

- Divide a company into cost, revenue, profit, investment, and

service centers.

Types of responsibility Centers:

-Cost center:

A manager for a cost center is responsible for controlling costs in a

department that generates little or no revenue. Therefore, the
manager is rewarded whenever he can minimize costs while
maintaining an expected level of quality, Finance, administration,
human resources, accounting, customer service, and help desks are
all examples of cost centers, If the cafeteria is not expected to make
a profit, it is also a cost center, Even plants and manufacturing
facilities are sometimes considered a cost center.

Cost centers are the least complex type of responsibility centers

because it has no responsibility for revenues and investments.

Variance analysis is the best technique for evaluating performance of

cost centers.
Revenue center:

Responsible for sales but not for the manufacturing costs of the
sales, A revenue center obtains products from either a cost center or
a profit center, Revenue centers are evaluated on their ability to
provide a contribution (sales less the direct revenue center costs),

Profit centers:

Responsible for both costs and revenues. Profit centers are often
separate reporting segments, Managers of profit centers would be
evaluated based on actual profits versus expected profits, A manager
has the responsibility to make decisions concerning markets and
sources of supply.

Investment centers:

Managers for investment centers are responsible for investments,

costs, and revenues in their department.

Service Centers: It Services centers exist primarily to provide

specialized support to other organization segments (subunits), e.g., a
maintenance department; they are usually operated as cost center.

Advantage of responsibility accounting

- Costs can be traced to either:

- The individual who has the best knowledge about the reasons for
cost increase.

- The activity that caused the cost to increase.

Disadvantage of responsibility accounting

- Its behavioral implication on managers whose performance is to be

evaluated.

CONTRIBUTION AND SEGMENT REPORTING

Managing the performance of the various responsibility centers

depends on an analysis of their costs and revenue contributions to
the organization.

Contribution margin approach is emphasized in responsibility

accounting because it focuses on levels of controllability, fixed costs
are much less controllable than variable costs, and

therefore, the contribution margin may be fairer basis for evaluation

than the gross margin to reporting on an income statement is useful
for internal decision making.

The segment margin is the segment's contribution margin less all

traceable fixed costs for the segment.

The segment margin is a useful indication of a segment's

profitability, if it is not positive, the segment may need to be
discontinued unless it adds value to other segments.

TRANSFER PRICES

- Allocating costs to a responsibility center or segment involves

assigning pricing for the goods and services that pass between
segments, Company strategy is greatly affected by choice of transfer
prices.

- Transfer prices are used by profit and investment centers.

- Transfer prices facilitating performance evaluation of the various
segments, Motivating segment manager.

- Goal congruence is the agreement regarding the goals of the

organization or the segment by both supervisors and subordinates.

- Motivation is the desire of managers to attain a specific goal (goal

congruence) and the commitment to accomplish the goal (managerial
effort).

Types of transfer prices

1-Market Price Model

It is used in decentralized system in which each responsibility centre

may be a completely separate entity.

The reason for decentralization is to motivate managers to achieve

the best result.

2-Differential Outlay (Cash) Cost plus opportunity Cost

Takes only the cash cost plus the opportunity cost (the benefit
forgone by not selling to an outsider) ignoring non cash cost (ex.
deprecation).

Example

Assume product costing $10, of which $4 non cash cost, can be sold
for $16.

The outlay cost is $6 ($10-$4) and the opportunity cost is $6 ($16-

$10), therefore, the selling segment will charge $12 for each unit to
the purchasing segment.

3-Full Absorption Cost

The full cost (absorption) model starts with the seller's variable cost
for the item and then allocates fixed costs to the price.

Adding fixed costs is relatively straightforward and fair.

Full-cost price includes materials, labor, and manufacturing

overhead applied.

4-Cost plus (a Lump Sum or a Mark-up percentage)

Cost may be either the standard or the actual cost, the standard cost
has the advantage of isolating variances, and Actual costs give the
selling division little incentive to control costs. This method ignores
market prices and may not promote long-term efficiencies.

5-Negotiable Price

The negotiated price model sets the transfer price through

negotiation between the buyer and the seller, when different
business units experience conflicts, negotiation or even arbitration
may be needed to keep the company as a whole functioning
efficiently.

A negotiated price may result when organizational segments are free

to determine the prices at which they buy and sell internally.

- It is the best bargain between organization segments.

- It ignores market and cost prices.

6-Dual Pricing

- It is rarely used because the incentive to control costs is reduced.

- Uses two transfer-pricing methods, the seller would record the
transfer to another segment at the market price, and the buyer would
record a purchase at the variable cost of production, therefore, the
total profit of a company will be less than the sum of the profits of
the individual segments.

- It improves segments' performance and reduces problems of goal

congruence.

- The seller is assured of high price, and the buyer is assured of an

artificially low price.

Notes:

- There is no best method in determining transfer prices.

- Ideally the chosen method should help segments managers to make

optimal decisions for the organization as a whole.

- If the selling segment is a profit or investment centre transfer

pricing is most likely to cause conflicts.

- If the selling segment is a cost centre it has less or no incentive to

maximize revenues and therefore, there will be no conflict.

Multinational Company Performance Measurement

The non financial differences among countries-in economy, laws,

customs, and politics-should play a part in evaluating a foreign
division's results.

Multinational companies must account for additional concerns such

as how tariffs, exchange rates, and the availability and relative cost
of materials and skills could affect performance evaluations.

- Financial measures include:

Contribution approach

Return on investment (ROI)

Residual income (RI)

Return on sales

- Non financial measures include:

Market share

Product throughput time

Quality ratings

Machine setup time

Return on Investment (ROI) approach

- It is known as "Accounting Rate of Return".

- ROI is the key performance measure of an investment centre.

- The disadvantages of ROI:

1) It can motivate managers to reject a project, which is profitable

from the entire company point of view.

2) It subject to manipulation by managers of investment centers.

3) When average age of assets differs across segments, the ROI will
not be appropriate for performance evaluation.

Residual Income (RI) approach

- Residual income (RI) is a dollar amount of income less a chosen

required rate of return for an investment
Residual Income in $ = Division’s net income – Cost of capital x
division assets

- The imputed cost of an investment (asset) is the required rate of

return multiplied by the investment (asset), a measure of the
opportunity cost of not being able to invest the funds elsewhere.

- Imputed costs attempt to add up the costs of an investment (asset)

that are not always recognized under accrual accounting.

- Imputed interest Rate may be defined as:

o The target return on investment set by management, or

o The current, not historical weighted average cost of capital.

Return on Sales (RoS) approach

- It is used to measure performance in trading and service

companies because they have low level of investments in property,
plant, and equipment (fixed assets).

Return on Sales = Operating Income / Sales or Revenue

Investment Base Issues

Using ROI and RI as performance measurement tools may present

challenges when attempting to compare competing companies or
various internal business units, This is due to the fact that
organizations may use different approaches to measure their
financial performance, Among the differences that may make these
types of comparisons less useful are:

- Differing revenue and expense recognition policies.

- Differing inventory measurement policies.

- Possession of joint or shared assets between business units

- Differing choices on what to consider an asset and how to value

those assets.

THE BALANCED SCORECARD

- Effective management control requires performance measurement

and feedback

- The success of a performance measurement and control system is

determined by its effectiveness in getting people to modify their
performance.

- Feedback regarding managerial performance may take the form of

financial and non financial measures that may be internally or
externally generated, Moreover; different measures have a long-
term or short-term.

- Organizational mechanisms for performance feedback should

satisfy the behavioral criteria of goal congruence and managerial
effort.

- Senior Management should be aware of the limitations of accrual

accounting measures, For example, cash - based and accrual based
measures may yield different results

- Human reactions to feedback should be considered in setting

performance standards and designing control systems.

- Critical Success Factor (CSFs) determined in a strategic analysis

to measurement of its performance.
- CSFs are financial and non financial measures of the elements of
the firm performance that vital to competitive advantage.

Critical Success Factor (CSF) Measurement :

Financial

- Increase shareholder value

-Increase in common stock price

- Increase customer satisfaction

-greater market share.

- Higher customer retention rate.

- Positive response

Internal business process

-Improve product quality

-Improve internal process

-Achieved of zero defect

-Reduction in delivery cycle time

- smaller cost variance

Learning and growth

- Increase employee Confidence.

- increase employee competence

- Number of suggestions to improve process

- Positive response to surveys.

- attendance at internal, and external training seminars

- Implementing the Balanced Scorecard

- Once the firm has identified its CSFs, it must establish specific
measures for each CSF that is both relevant to the success and
reliably stated.

- By providing measures that are non financial as well as financial,

long-term as well as short-term, internal as well as external.

- The development and implementation of a comprehensive balanced

scorecard requires support and participation by senior management.

Problems in implementation of the balanced scorecard approach:

- Using too many measures.

- Failing to evaluate personnel on non financial as well as financial

measures.