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F5 Performance Management



Prepared by Gbenga Okubadejo

F5 - Management accounting

F5 Performance Management

Presentation Objective

To provide a revision tool to students writing paper F5 To provide exam focus study that saves time

F5 Performance Management

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

F5 Performance Management

F2 Management accounting revision

F5 Performance Management

Introduction to Management accounting

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

F5 Performance Management

F2 revision

For absorption

For marginal costing

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.

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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Modern management accounting techniques

Activity based costing (ABC) Target costing Life cycle costing Throughput accounting Environmental accounting

Activity based costing (ABC)

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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 One basis of absorption volume number of an activitys cost driver they generate. Companies now produce variety of Products Cost drivers May hide inefficiency. Volume related (eg labour hrs) for costs that vary with production volume in the short term (eg power Allocate more ohds to volume-based product costs) Transactions in support departments for other costs (eg No of visit for site supervisor costs)

Target costing

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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 reqd margin 4. Compare the estimated costs with the target 5. Cost gap exists if estimated > target.

Life cycle costing

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This method tracks and accumulates costs and revenues over a products entire life. This cycle include 1. Development 2. Introduction 3. Growth 4.Maturity 5. Decline

Maximising returns over the product life cycle

1. 2. 3. 4. 5. 6.

Design costs out of products Minimise the time to market Minimise breakeven time Maximise the length of the life span Minimise product proliferation Manage the products cashflows

Life cycle costing

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Sales Volume


Time Introduction Growth Maturity Decline


Throughput accounting
Basic concept of throughput

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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)


The generation and analysis of both financial and non-financial information in order to support environmental management processes.

Typical environmental costs

Identifying environmental costs associated with individual products and services can assist with pricing decisions Ensuring compliance with regulatory standards Potential for cost savings

Consumables and raw materials Transport and travel Waste and effluent disposal Water consumption Energy


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.

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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. 4. Calculate the total breakeven point. 5. Calculate the revenue ratio per mix. 6. Calculate the breakeven sales.

It is vital to remember that for multi-product Breakeven analysis, a constant product sales mix must be assumed.


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

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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


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 one: linear programming.

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.The first step in any linear 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.

Linear programming
Formulating the problem

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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


Linear Programming
Occurs when maximum availability of a resource is not used. The resource is not binding at the optimal solution. Slack is associated with constraints.

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Occurs when more than a minimum requirement is used. Surplus is associated with constraints eg a minimum production requirement

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.


Pricing decisions
Influence on price 1. Cost 2. Demand 3. Income level 4. Competition 5. Quality perception 6. Market structure 7. Product life cycle 8. E.c.t.

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Price elasticity of demand ()

A measure of the extent of change in market demand for a good, in response to a change in its price = change in quantity demanded, as a % of demand change in price, as a % of price
Inelastic demand <1 Demand falls by a smaller % than % rise in price Pricing decision: increase prices Elastic demand >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.

Profit Maximisation
Determining the profit-maximising selling price/output level

F5 Performance Management

Pricing strategy
Full cost plus Advantages Quick, simple, cheap method Ensures company covers fixed costs. Disadvantages Doesnt recognise profit maximising price and output Budgeted output needs to be established Suitable basis for overhead absorption needed

Profits are maximised when MC = MR. Other Pricing strategy

Penetrating pricing Skimming pricing Product-line pricing Complimentary pricing


Short-term decisions Relevant costs are

Future e.g sunk not relevant Incremental e.g the amount by which fixed cost steps up Cash flows e.g provisions, notional costs, absorbed overheads not relevant. N.B: 1. Useful for one-off contract 2. Minimum pricing 3. The key note is I dont want to be worse off. if I cant make money then I dont wanna loose any!

F5 Performance Management

Make or Buy Compare internal differential production costs with suppliers quotation. Consider other qualitative factors before sub-contracting or outsourcing


Short-term decision Further processing decision

Determine the contribution earned on the current operation. Calculate incremental costs and revenue Compare the results and act accordingly. Bear in mind that some fixed costs may no longer be incurred if the decision is to shut down and they are therefore relevant to the decision. 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.

F5 Performance Management

Shut down decision

Any short-term decision must consider qualitative factors related to the impact on employees, customers, competitors and suppliers


Risk and uncertainty

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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


Methods of dealing with risk and uncertainty

F5 Performance Management

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


Budgeting and budgetary control

Objectives of a budgetary planning and control system Ensure the organisations 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

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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.

Budgetary systems

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Traditional budgetary systems

Incremental budgeting This involves adding a certain percentage to last years 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. 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.

Zero-based budgeting

F5 Performance Management

Zero-based budgeting
This approach treats the preparation of the budget for each period as an independent planning exercise: the initial budget is zero and every item of expenditure has to be justified in its entirety to be included. It is usually developed as a package. Steps in ZBB 1. Define decision packages 2. Evaluate and rank packages on the basis of their benefit to the organisation. 3. Allocate resources according to the funds available and the ranking of packages.

Identifies and removes inefficient and/or obsolete operations Provides a psychological impetus to employees to avoid wasteful expenditure Leads to a more efficient allocation of resources

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

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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


Variance analysis
A standard cost card will look as follows:

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$/unit Direct material (20kg@$5/kg) Direct labour Prime costs Variable Overheads(10hrs@$10/hr) Total variable cost Fixed cost (10hrs@$12/hr) Total factory cost Profit (25% mark-up) Selling price (10hrs@$5/hr) 100 50 150 100 250 120 370 92.50 462.50


Reasons for variances

Material price Material usage

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(F) unforeseen discounts received (A) price increase, careless purchasing (F) material used higher quality than standard (A) defective material, waste, theft (F) use of less skilled (lower paid) workers (A) rate increase (always (A)) machine breakdown, illness (F) better quality materials (A) lack of training

Labour rate Idle time

Labour efficiency

Overhead expenditure (F) cost savings (A) excessive use of services Overhead volume - production greater or less than budgeted

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


Performance measurement Financial performance indicators (FPI) Profitability ratio ROCE Profit margin Sales growth Asset turnover Liquidity ratios Inventory days Receivable days etc

F5 Performance Management

Non-financial performance indicators (NFPI) Look at a wider range of variables Provide information on quality and customer satisfaction Better indicator of future prospects Can be provided quickly and tailored to circumstances


Balanced Scorecard
Perspective Question

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What do existing and new customers value from us?

Gives rise to targets that matter to customers: cost, quality, delivery, inspection, handling and so on.


What processes must we excel at to achieve our financial and customer objectives?

Aims to improve internal processes and decision making.

Innovation and learning

Can we continue to improve and create future value?

Considers the business's capacity to maintain its competitive position through the acquisition of new skills and the development of new products. Covers traditional measures such as growth, profitability and shareholder value but set through talking to the shareholder or shareholders direct.


How do we create value for our shareholders?


Not-for-profit organisations Problem with performance measurement

F5 Performance Management

Suggested way out Multiple objectives Measuring outputs Lack of profit measure Nature of service provided Financial constraints Political, social and legal considerations
Judge performance in terms of inputs Use experts subjective judgment Use benchmarking Use unit cost quantitative measures


Value for money 3 ES

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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


F5 Performance Management