P2 Exam Revision Kit

CIMA REVISION CARDS

Management Accounting –Decision ManagementJo Avis

Managerial Level Paper P2

AMSTERDAM l BOSTON l HEIDELBERG l LONDON l NEW YORK l OXFORDPARIS l SAN DIEGO l SAN FRANCISCO l SINGAPORE l SYDNEY l TOKYO

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First published 2005

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Welcome to CIMA’s Official Revision Cards. These cards have been designed to:

. Save you time by summarising the syllabus content in a concise form

. Jog your memory through the use of diagrams and bullet points

. Follow the structure of the CIMA Official Study Systems

. Refer to relevant questions found within the Preparing for the Examination section of the study system

. Provide you with plenty of exam tips and hints

Ensure exam success by revising with the only revision cards endorsed by CIMA.

TABLE OF CONTENTS

1. Revision of basics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. Absorption, activity-based and marginal costing .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73. Break-even analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154. Relevant costs and short-term decisions .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215. Linear programming .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256. Pricing .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337. Risk and uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418. Investment appraisal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479. The value chain – TQM ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6510. Activity-based approaches .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6911. Learning and experience curves .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7512. Costing systems.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Revision of Basics

Basic aspects, classifications and approaches to cost accounting

Topics

. Cost units

. Cost centres

. Classification of costs

. Cost behaviour

. Analysing the elements of cost

Key Revision Questions

Q2

1

Cost units

Definitions

Cost – the amount of expenditure incurred on, orattributable to, a specified thing or activity

Cost unit – a unit of product or service in relationto which costs are ascertained, e.g. chargeablehour (professional services), account maintained(credit control)

Cost centre – a production or service location,function, activity, or item of equipment, for whichcosts are accumulated, e.g. stores, quality control

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —2

Revision of Basics

Classification of costs

To collect and analyse costs efficiently, a way to classify all costs is needed. Can be classified by nature or by purpose(why incurred), e.g.

Direct and indirect – whether directly attributable to the cost unit

Fixed and variable – whether cost alters as activity level changes

Production, selling and administration – functional analysis

Controllable and uncontrollable – whether within management control

Normal and abnormal – whether expected

Relevant and non-relevant – whether relevant to the decision

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —3

––––––––––––––––––––––––––––––––––––––––––––Revision of Basics

Cost behaviour

K Fixed costs – does not change regardless of thelevel of activity, e.g. factory rent

K Fixed costs – stepped. Fixed for a range ofactivity, then increase in a step, e.g. need to rentadditional warehousing

K Variable costs – vary with the level of activity

K Semi-variable costs – contain both fixed andvariable components – thus partly affected byactivity level, e.g. electricity

£

Q

£

Q

£

Q

£

Q

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —4

Revision of Basics

Analysing semi-variable costs

Three main methods are used:

(a) High–low method

(b) Scattergraph method

(c) Least squares method of regression analysis(you should have covered this in earlier studies)

High–low method

Units £

Highest activity level 2450 41,150

Lowest activity level 1750 36,250

Increase 700 4,900

Variable cost¼ £4,900/700¼ £7 per unit

At total cost¼ £41,150

Variable cost¼ 2450� £7¼ £17,150

; Fixed cost¼ £41,150� £17,150¼ £24,000

Scattergraph method

K Data plotted onto scattergraph

K Line of best fit drawn by eye

K Intercept of line gives fixed cost

K Gradient of line gives variable cost

£

x

x

x

x

x

Q

fixedcost }

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —5

––––––––––––––––––––––––––––––––––––––––––––Revision of Basics

This Page Intentionally Left Blank

Absorption,Activity-Based andMarginal Costing

The alternative cost accounting techniques of absorption costing,activity-based costing and marginal costing. The alternative uses of cost

accounting information and the appropriateness of each technique tothose uses

Topics

. Overhead allocation and apportionment

. Overhead absorption

. Under or over absorption

. Activity-based costing

. Marginal costing

. Preparing profit statements

. Reconciling marginal and absorption costing


Q6a and bQ18a and b

7

Overhead allocation and apportionment

Once suitable cost centres have been selected,overheads must be analysed

Method1. Cost allocation – where costs can be specifically

attributed to a particular cost centre

2. Cost apportionment – non-specific costs are sharedbetween cost centres on the basis of benefits received

3. Absorption rates – once overhead costs are establishedfor each cost centre, they can be absorbed by theindividual cost units

Absorption rates would include

Rate per unit produced – easy but units must be identicalDirect labour hour rate – few businesses are labour

intensiveMachine hour ratePercentage of direct wages cost – inequitable where wage

rates differPercentage of direct materials costPercentage of prime cost

Criteria for choice

K Must result in most realistic charge

K Major factor will be the practical applicability of therate

K Time based rates should be used whereverpossible

Criticisms of the technique

K Based on labour hours when most of theproduction is mechanised

K Low information content – Activity BasedCosting devised as a solution

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —8

Absorption, Activity-Based and Marginal Costing

Under or over absorption of overheads

K Occurs when estimated figures used inpredetermined rates don’t match the actualfigures

K If actual overhead is higher than the amountabsorbed, overhead is under-absorbed

K If actual overhead is lower than the amountabsorbed, overhead is over-absorbed.E.g.

Estimated results Actual results

Overhead £340,000 £360,000

Labour hours 170,000 150,000

Overhead absorption rate¼ £340,000/170,000¼ £2

Overhead absorbed¼ 150,000� £2¼ £300,000

Under-absorption¼ £360,000� £300,000¼ £60,000

Accounting for under or overabsorption

K It is not necessary to adjust stock values

K Cost of units sold will have been under/overstated. Adjustment is therefore charged/credited to the profit and loss account for theperiod

Should be minimised by regular reviews of expenditureand consideration of adjustments to absorption rate

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —9

––––––––––––––––––––––––––––Absorption, Activity-Based and Marginal Costing

Activity based costing

Analyses all activities to identify what drives the cost,e.g. Quality Control

Cost driver – number of production runs

Absorption rate for quality control – number of productionruns set up for that product

Method

(1) Collect costs(2) Pool costs on the basis of activities which consume

resources(3) Allocate overheads to products on the basis of

appropriate cost drivers

E.g. quality control overhead for the period is£120,000. The cost driver is the number of productionruns inspected in the period. A total of 600 runs weredone in the year

Absorption rate for quality control¼ 120,000/600¼ £200/inspection

Z product, taking 75 runs a year, would thereforeabsorb 75� £200¼ £15,000.

Assuming that 2400 units of Z were made, the qualitycontrol element of the overhead charge for a unit ofproduct Z¼ £15,000/2,400¼ £6.25

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —10


Marginal costing – differences from absorption costing

Absorption costing

K All stock items valued at full production cost,including fixed production overhead

Marginal costing

K Values all the stock items at variable or marginalcost only

K Fixed costs are treated as period costs andwritten-off in full against profits

K Variable costs are matched against sales value toidentify contribution

K Contribution contributes to fixed overhead andprofit

Sales value� Variable costs¼Contribution

Contribution� Fixed costs¼ Profit

Profit statements

Can be prepared using either marginal or absorptioncosting

When using absorption costing, overheads are absorbedon the basis of expected usage. Therefore, differentmethods give different profit figures, if stock levels differ

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —11


Profit statements

Pro-forma profit statement –marginal costing

Sales revenue xLess variable cost of salesOpening stock (at variable cost) xVariable production cost xClosing stock (at variable cost) (x)

xLess variable selling costs (x)

Variable cost of sales (x)Contribution xLess fixed overheadsFixed production xFixed selling and administration x

(x)Profit x

Pro-forma profit statement –absorption costing

Sales revenue xLess full production cost of salesOpening stock (at full cost) xFull production cost xClosing stock (at full cost) (x)

xFull production cost of sales (x)Gross profit xLess selling and administration costVariable selling and administration (x)Fixed selling and administration (x)

xOver/under absorption x/(x)Net profit x

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —12


Profit statements

K Profit differences are caused by differences in closing stock valuations

K In absorption costing, some fixed production overhead is carried forward in stock. If stock levels increase,absorption costing profit is higher, if they decrease, the absorption costing profit is lower

Reconciliation

Marginal cost profit xStock increase/decrease� fixed cost per unit x/(x)Absorption cost profit x

K The profit differences occur in the short term when stocks fluctuate, but, in the long term, the total profit will bethe same, whichever method is used. All costs are eventually charged to profits, it is simply a timing difference

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —13



Break-even Analysis

Applying the principles of marginal costing and contribution analysis tobreak-even analysis and simple activity related short-tem decisions

Topics

. Calculating break-even point

. Drawing break-even charts

. Multi-product CVP analysis

. Using costs for decision making


Q1.10Q5.1

15

Calculating break-even point

Definition

The study of the effects on future profit of changesin fixed cost, variable cost, sales price, quantityand mix

Definition

A high CS ratio means contribution grows morequickly as sales increase

Break-even point occurs at the sales level wherecontribution¼ fixed costs

Break-even point in units ¼ Fixed costs

Contribution per unit

Definition

Margin of safety is the difference betweenexpected sales levels and break even sales

Margin of safety¼ Expected sales level� Break-even point in units

Contribution sales ratio ¼ Contribution per unit

Sales price per unit

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —16

Break-even Analysis

Drawing break-even charts

A basic break-even chart

1. Select appropriate scales for axes and draw and labelthem

2. Draw the fixed cost line and label it3. Draw the total cost line and label it4. Draw the revenue line and label it5. Mark any required information on the chart and read

off solutions as required6. Check the accuracy of your readings using

arithmetic

Breakeven point

Fixed cost

Margin of safety

Budgetdemand

No. of units

Sales reve

nue

PROFIT

Total cost

Loss

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —17

–––––––––––––––––––––––––––––––––––––––––––Break-even Analysis


Contribution break-even chart

K Contribution break-even chart shows a variablecost line instead of a fixed cost line

K Can then read off contribution for any level ofactivity

Profit volume chart

An alternative break-even chart, also called profit orcontribution volume graph, which plots a single line

depicting the profit or loss for each level of activity.Shows effect on profit and break-even point of anychanges in the variables

K Vertical axis shows profits and losses

K Horizontal axis drawn at zero profit and loss

K Break-even point is where the line cuts thehorizontal axis

Breakeven point

Variable cost

Fixedcost

Contribution

No. of units

Sales revenue

PROFIT

Total cost

Loss

£

Breakeven point

No. of units

LOSS

PROFIT

£

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —18

Break-even Analysis


Limitations of break-even (CVP) analysis

CVP makes a number of simplifying assumptions

K Costs are linear

K Sales revenues are constant

K No changes in the stock levels

K Activity level is the only factor affecting costs

K Assumes a single product or a constant sales mix

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —19

–––––––––––––––––––––––––––––––––––––––––––Break-even Analysis

Multi-product CVP analysis

The basic break-even model can be used only in a business operation with one product. With several products, themodel can be used but needs adaptation

Using costs for decision making

K Most decisions involve changing one of the variables in order to maximise profits

K Only costs that change as a result of the decision should be considered

K Such costs are known as relevant costs

K Often, fixed costs are not relevant – marginal costing is, therefore, better for decision making

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —20

Break-even Analysis

Relevant Costs andShort-term Decisions

How to solve short-term decision-making problems using relevant costsand revenues

Topics

. Identifying relevant costs

. Limiting factor decision-making


Q1.5, 1.6Q3.4Q9

21

Identifying relevant costs

Definition

Those costs that will be affected by the decisionbeing taken. They will be the incremental futurecash flows associated with the decision

All relevant costs should be considered inmanagement decision-making. All non-relevantcosts should be ignored.

Study tip

Watch out for the following non-relevant costs

K Sunk or past costs

K Absorbed fixed overheads

K Committed costs

K Depreciation

K Notional costs

Opportunity costs – a special typeof relevant cost

Value of a benefit sacrificed when one course ofaction is chosen in preference to an alternative

A project will use material in stock. If not used inthe project, it could have been:

K sold at £5 per tonne

K used in another project, saving the purchaseof material at £5.50 per tonne

Before the contract, the best alternative wouldhave been to use it and save £5.50. This is,therefore, the opportunity cost of the material

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —22

Relevant Costs and Short-term Decisions

Limiting factor decision-making

Limiting factor – any factor in short supply stopping theorganisation from expanding its activities. Examplesinclude: raw materials, labour hours and machine time

A firm will need to devise an optimal production plan thatmaximises contribution from the use of the scarceresource

Decision rule:

Maximise the contribution per limiting factor

Example: A firm has 3 products, as given in thetable opposite. Material supplies are restricted to3700 kg.

A B CContribution per unit £12 £16 £8Usage of material 4 kg 8 kg 2 kgMonthly demand in units 400 200 300

The contribution per limiting factor can be calculated

A B CContribution per kg ofmaterial £3/kg £2/kg £4/kgRanking 2 3 1

The production plan can then be worked out, as follows

kg available3700

Make 300C, 300� 2 kg (600) 3100Make 200B, 200� 8 kg (1600) 1500Make 375A, 375� 4 kg (1500) –

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —23

––––––––––––––––––––––––––––––––Relevant Costs and Short-term Decisions


Linear Programming

Solving decision-making problems where there is more than one scarceresource and how to interpret the solutions

Topics

. Basic linear programming

. Graphical method

. Slack and surplus

. Shadow prices

. Simplex


Q4a–cQ6Q45

25

Basic technique

Definition

A technique for allocating scarce resourcesbetween products to maximise the benefit fromthem when there is more than one limiting factor

Study tip

For two products, find the solution graphicallyFor more than two products, use the Simplexmodel

1. Determine the variables

The objective variable – the quantity that is to beoptimised – i.e. maximised or minimised, e.g.

Let z¼ total £ contribution earned

The decision variables, e.g.

Let x1¼ no. of units of product A made

Let x2¼ no. of units of product B made

2. Construct the objective function, e.g.

Maximise z¼ 50x1þ 70x2

Where A has a contribution of £50 and B of £70

3. Specify the constraints, e.g.

Machine hours 3x1þ 10x2� 330

Where a unit of A takes 3 hrs to machine, a unit of Btakes 10 hrs and the total hours available are 330

4. Write out the non-negativity conditions, e.g.

Product A x1� 0

The answer to the number of A to producecannot be less than zero

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Linear Programming

Graphical technique

1. Draw 2 axes2. Plot all the constraints as straight lines3. Identify and mark the feasible region4. Determine the values of the decision variables at

the extreme points of the feasible region and, foreach, the corresponding value for the objectivevariable

5. Choose the largest answer (maximisation) or thesmallest (minimisation)

Study tip

Be careful with unusual constraints, e.g.

K Total combined output of products A and Bmust be at least 20 units

x1þ x2� 20

K The number of units of B produced must bedouble the number of units of A

x2� 2x1

K Products A and B must be manufactured inthe ratio 2 : 7

7x1¼ 2x2

x1

x2

100

80

60

40

20

20E D

A

A,B,C,D,E - extreme points

Constraints

Feasible region

B

C

40 60 80 100

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —27

–––––––––––––––––––––––––––––––––––––––––––Linear Programming

Slack and surplus

The optimal solution can be used to determine which ofthe constraints are binding. Insert the amounts to beproduced of each unit into each constraint

Example

Optimal solution is 10u of x, and 28u of x2

For constraint 3x1þ 10x2� 330, insert the solution:

3(10)þ 10(28)¼ 310

Slack/surplus can then be calculated 330� 310¼ 20slack

Slack is concerned with ‘less than orequal to’ constraints

Usage < Amount available) slack available

Surplus is concerned with ‘greater thanor equal to’ constraints

Production > Minimum required) surplus created

Where a constraint is binding, obtaining more of it wouldincrease contribution

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —28

Linear Programming

Shadow prices and opportunity costs

Definition

Shadow price is the increase in value that oneextra unit of a limiting resource would create. It isthe opportunity cost of not having the unitavailable

To find the shadow price of aconstraint

K Restate the relevant constraint, assuming 1 moreunit of scarce resource

K Find the new optimum solution

K The difference between the original solution andthe new solution will be the shadow price of theconstraint

Simplex

Definition

A computer modelling technique to find theoptimal solution where there are more than 2products

Study tip

You will not be examined on the method itself,but should be able to interpret the final solutioncalculated

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —29


Simplex

Interpreting the optimal solution

A linear programming problem may be constructed asfollows:

Let z¼ total contribution earned

Let x1, x2, x3, x4¼ number of A, B, C and D tables tobe produced

Maximise: z¼ 60x1þ 123x2þ 135x3þ 90x4

Subject to:

Cutting: 2x1þ 2x2þ 1x3þ 6x4� 3000

Assembly: 5x1þ 4x2þ 3x3þ 2x4� 9000

Finishing: 1x1þ 4x2þ 5x3þ 3x4� 4950

Max production: x1þ x2þ x3þ x4� 1800

Min. A tables: x1� 800

x2, x3, x4� 0

The solution would therefore be shown as:

Objective function variable (z): 168,780.0000

Variable Value Relative loss

x1 950.0000 0.0000

x2 250.0000 0.0000

x3 600.0000 0.0000

x4 0.0000 48.0000

Constraint Slack/surplus Worth

1 0.0000 9.0000

2 1,450.0000 0.0000

3 0.0000 21.0000

4 150.0000 21.0000

5 0.0000 0.0000

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —30

Linear Programming

Simplex

The solution should be interpreted as follows:

K Optimal plan is to make 950 A, 250 B, 600 C andno D tables

K Total contribution earned would then be £168,750

K Constraints 1 (cutting) and 3 (finishing) arebinding

K Constraint 2 (assembly) will have 1450 sparehours

K Constraint 4 (max number) has been met exactly

K Constraint 5 (min number) has been exceeded by150 units

Relative loss

K Optimal production plan specifies no ornatetables. To make one would reduce contributionby £48

Worth

K Constraints 1 and 3 are binding. £9 and £21 aretheir respective shadow prices

K Constraint 4 – if maximum production could beincreased by one table, contribution wouldincrease by £21

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —31



Pricing

Covers the alternative pricing strategies that an organisation may adoptin the pricing of its products and services

Topics

. Price elasticity of demand

. Product life cycle

. Profit maximisation

. Cost based pricing

. Other strategies


Q12Q13

33

Price elasticity of demand

A major consideration in pricing decisions is the effect achange in price will have on the quantity sold

Elasticity of demand

¼ �% change in quantity demanded

% change in price

Formula measures the impact of a movement from aparticular point on the demand curve

Point elasticity > 1: demand is elastic, i.e. anincrease in price will cause a proportionallygreater drop in volume. Example: luxury goodssuch as holidays

Point elasticity < 1: demand is inelastic, i.e. anincrease in price will cause a proportionallysmaller drop in volume. Example: necessities andhabit-forming goods, such as cigarettes

PED will be affected by

K Scope of the market

K Information within the market

K Availability of substitutes

K Complementary products

K Disposable income

K Necessities

K Habit

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —34

Pricing

The product life cycle

All products and services have a life cycle K Different pricing strategies will be appropriate atdifferent stages in the life cycle

Introductory

K Penetration pricing

K Price skimming

Growth

K Low price to increase market share

Maturity

K Focus on minimising elasticity

Decline

K Price wars can occur

Introduction

£'000

Growth Maturity Decline

TimeProfit

Sales revenue

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —35

––––––––––––––––––––––––––––––––––––––––––––––––––Pricing

The profit-maximisation model

Definition

A mathematical model that can be used todetermine an optimum selling price

Based on the theory that profit is maximisedwhere marginal cost is equal to marginal revenue

Study tip

Use of the full model is outside the syllabus, butsimple questions may be set

Example

K Maximum demand for a company’s product is150,000 units p.a.

K Demand will reduce by 50 units for every £1increase in the selling price

K The company has calculated that profit ismaximised at a sales volume of 54,000 unitsper annum

K Required: Determine the profit maximisingselling price for the product

SolutionEquation of demand given by p¼ a� bq

b¼ 1/50¼ 0.02

at p¼ 0, q¼ 150,000

0¼ a� 0.02� 150,000

a¼ 3000

; pV 3000R 0.02q

at x¼ 54000 units,p¼ 3000� 0.02� 54000¼ £1920

i.e. profit is maximised at a selling price of £1920

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —36

Pricing

The profit-maximisation model

Limitations with the model

K Difficult to determine the demand function with accuracy

K Most firms aim for target not optimum profit

K Hard to obtain accurate marginal costs

K Marginal cost may not be constant – e.g. bulk discounts

K Factors other than price affect demand

Cost-plus pricing involves adding a mark-up to thecost of the product in order to arrive at a selling price

The mark-up can be added to full product cost ormarginal cost only.

Consideration must be given to the mark-up used

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––––––––––––––––––––––––––––––––––––––––––––––––––Pricing

Pricing strategies based on cost

Full cost plus

Calculated as

1:Total budgeted factory cost*þ mark-up on cost

Budgeted volume

* fixed and variable production costs

Total budgeted factory costþ other costs*

2:þmark up on costs

Budgeted volume

* all selling, distribution and administration costs

Advantages of full cost plus

K Required profit achieved if budget sales achieved

K Useful in contracting industries

K Quick and cheap if cost structures known

K Useful to justify price increases

Disadvantages of full cost plus

K Can result in uncommercial prices

K Problematic if budget sales volumes not achieved

K Ignores factors such as competitor activity

K Ignores price elasticity of demand

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —38

Pricing

Pricing strategies based on cost

Marginal cost plus

Calculated as

Unit price¼ variable cost þ% contribution margin

Advantages of marginal cost plus

K As accurate as full cost – simply uses largermark-up

K Awareness of marginal cost facilitates pricingbelow full cost to fill capacity

K Good for pricing specific contracts – recognisesrelevant costs

K Facilitates decision making when resources arescarce

Disadvantages of marginal cost plus

K Fixed costs may not be recovered in the longterm

K May encourage price wars

K Difficult to raise prices where mark-ups are low

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––––––––––––––––––––––––––––––––––––––––––––––––––Pricing

Other pricing strategies

K Premium pricing

K Market skimming

K Penetration pricing

K Price differentiation

K Loss leader pricing

K Product bundling

K Pricing with additional features

K Discount prices

K Controlled prices

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —40

Pricing

Risk and Uncertainty

Recognising the uncertainty that exists when costs andrevenues are estimated and assessing how the risk associated with such an

uncertainty can be evaluated

Topics

. Probability

. Expected values

. Attitudes to risk

. Decision trees

. Value of perfect information


Q11Q33

41

Probability

Definitions

Uncertainty – where no information is available topredict the outcome

Risk – where several potential outcomes and theprobability of each occurring can be identified

Expected values

K The most common method for accounting forprobabilities is the use of expected values (EV)

K The EV is calculated by weighting the possibleoutcomes by their probabilities and summing upthe result

Example

A company is considering launching a new product. Theselling price is to be set at £15. A number of probabilitiesfor different revenue levels are predicted. The project hasa required expected value of £1,200

Units sold Revenue Probability Pay off£ £

70 1050 0.2 210100 1500 0.45 675130 1950 0.35 682.5

1.00 EV 1567.5

The project exceeds the EV and will be accepted

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Attitudes to risk

K Risk neutral – assumed by EV – ignores variations in outcome. Concerned only with the most likely outcome

K Risk seeker – concerned only with the best possible outcome, no matter how unlikely it is

K Risk averse – prefer the alternative with the least variation

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––––––––––––––––––––––––––––––––––––––––––Risk and Uncertainty

Decision trees

Simple, visual way of presenting probabilistic informationto management

Example

A company has a choice of two strategies for itsproduct launch. Results will depend on the level ofdemand, which may be high (60% chance) or low.Strategy A will earn £45,000 (high demand) or£20,000 (low demand). Strategy B will earn£75,000 or £5,000. The problem can be shown ona decision tree.

Strategy B has the highest EV and should beadopted.

0.6

Cash flow

£45,000

£20,000

£75,000 £45,000

£5,000 £2,000

£8,000

EV £35,000

£27,000

Pay-off

0.4

0.6

0.4

Strategy B

Strategy A

EV £47,000

The point at which a decision is made

The point at which a chance event occurs

Branches represent the different possibleoutcomes

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Decision trees

Other factors to consider

1. Time Value of Money – Can be incorporated to refine the model2. Assumes risk neutrality – In the above example Project A had a lower EV, but less variability in the potential

outcomes and a higher ‘low’ outcome. Attitude to risk would affect the investor’s choice3. Sensitivity – The probabilities used are subjective estimates and changes in them may impact the decision made4. Oversimplification – In reality, it is unlikely that any project will have only a few discrete outcomes

Value of perfect information

K Obtaining better quality estimates should improvethe decision-making process

K The value of that perfect information is theincrease in the expected value of the project,once the information is made available

Example

If, in the previous example, a market research companycould be employed to predict whether demand for theproducts would be high or low. The maximum value ofthe research can be calculated as follows:

If told demand will be high, Strategy B will be adopted.If told demand is low, Strategy A will be adopted.

EV¼ (0.6� 75,000)þ (0.4� 20,000)¼ 53,000

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––––––––––––––––––––––––––––––––––––––––––Risk and Uncertainty

Value of perfect information

So, the improvement in EV which can be obtained bypaying for the research is £53,000� £47,000¼ £6,000.This amount represents the maximum to be paid for theresearch – i.e. it is the value of the perfect information

Other methods for dealing withuncertainty

K Sensitivity analysis

K Adjusting the discount rate

K Adjusting the payback period

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Investment Appraisal

How the principles of decision-making and the effects of risk anduncertainty are applied to long-term decision-making

Topics

. NPV, Payback, IRR, ARR

. Annuities

. Unequal lives

. Replacement

. Capital rationing

. Estimates – sensitivity

. Estimates – risk

. NPV and inflation

. NPV and tax

. Post-project appraisal

. Project abandonment

Key revision questions

Q22Q23Q24Q25Q26Q34Q40Q41Q43Q44

47

NPV – Net Present Value

Definition

The sum of the present value of all of the inflowsfrom a project, less the present value of anyoutflows. If the net inflows exceed the netoutflows, the NPV will be positive and the projectshould be accepted

Formula for discounting PV¼ sum� 1/(1þ r)n, wherer¼ discount rate and n¼ no. of years the sum is to bediscounted

Study tip

A formula sheet containing most of the discountrates needed will be provided in the exam

Example

A project has the following cash flows:

Year 0 1 2 3 4£(1000) £640 £640 £20 £20

The discount rate for the project is 5%

The NPV of the project can be found as follows:

Year 0 1 2 3 4DF @5% 1 0.952 0.907 0.864 0.823PV (1000) 609 580 17 16 NPV¼ £222

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NPV – Net Present Value

NPV – advantages

K Takes account of the time value of money

K Represents the increase in shareholderwealth – theoretically superior

K Uses cash flows rather than subjective profits

NPV – disadvantages

K Speed of repayment not clear

K Based on estimates

K Complex

Definition

The time taken for cash inflows from a project tomatch the outflows and repay the initialinvestment

Cumulative cash flows are calculated year on yearuntil they total the initial investment. Projects areaccepted if they pay back within target period.

ExampleThe payback period for the above project would be:

Year 0 1 2 3 4C/f £(1,000) £640 £640 £20 £20Cum c/f £640 £1280 £1300 £1320

Payback is, therefore, after 2 years, or if cash flows occurevenly throughout the year, after 1 yearþ (1000� 640)/640¼ 1.6 years

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––––––––––––––––––––––––––––––––––––––––––Investment Appraisal

Payback

Payback – advantages

K Simple

K Favours liquidity

K Minimises risk

Payback – disadvantages

K Ignores time value of money

K Ignores cash flows after the cut-off point

Payback can be adapted to take account of the timevalue of money. The cash flows are first discounted at anappropriate discount rate. The cumulative cash flows ofthe above project then become:

Year 1 2 3 4609 1189 1206 1222

Payback is now said to be after 2 years, or if cash flowsoccur evenly, after 1 yearþ (1000� 609)/580¼ 1.67 years

These figures can be used to calculate two furthermeasures

Discounted Payback Index

DPBI ¼ Present value of net cash inflows

Initial cash outlay

¼ 1222

1000¼ 1:22

Measures how many times a project recovers its fundsand is, therefore, useful when funds are scarce

Can also be calculated as a Profitability Index:

PI ¼ NPV of a project

Initial cash outlay

¼ 222

1000¼ 0:22

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —50


IRR – Internal Rate of Return

Variation of the NPV method

Definition

IRR is the discount rate at which the NPV is zeroProjects with an IRR greater than the company’scost of capital should be accepted

IRR is determined by trial and error using the formula

IRR ¼ DR1 þ NPV1ðNPV1 � NPV2Þ � ðDR2 � DR1Þ

� �

For the above project, the NPV was calculated at twodiscount rates:

At 5% the NPV¼ £222

At 25% the NPV¼�£60

Thus, the IRR can be calculated as

IRR¼ 5þ [222/(222þ 60)� (25�5)]¼ 20.74%

The project therefore breaks even at a discount rate ofabout 20%.

IRR – advantages

K Managers familiar with percentages

K No need to predict discount rates

K Requires exercise of judgement

IRR – disadvantages

K Cannot be used to choose between projects(see below)

K May have multiple IRRs (see below)K Assumes cash flows reinvested at the IRR

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —51


IRR – Internal Rate of Return

IRR – the conflict with NPVThe IRR rule will sometimes conflict with the NPV rule:

Project A has the higher IRR, yet, at the company’s costof capital, Project B has the higher NPV

Study tip

IRR cannot be used to choose between two viableprojects – always choose the project with thehigher NPV

Multiple IRRs

K Not all projects have single IRRs

K When cash flow signs change between positiveand negative a number of times over the years,a number of IRRs may exist

Study tip

When multiple IRRs occur, take care to identifywhether the NPV is positive or negative betweenthe IRRs

800

0

A

5 10 15 20

B Cost of capital = 5%

Discountrate(200)

NPV

DR

IRR1 IRR2

£

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ARR – Accounting Rate of Return

Definition

The ARR is the project’s return on investment orROI. A project is accepted when the ARR is higherthan the target rate set by management

It is calculated, using accounting profits, as follows:

ARR¼ (Av. annual profit / Av. investment)� 100%

For the above example and making the followingassumptions:

K Year 0 flow is the purchase of a fixed asset

K Depreciation is the only difference between cashflow and profit

K Asset will be depreciated to zero over the life ofthe project

The ARR will be

Accounting profit¼ £1320� £1000¼ £320

Av. Annual profit¼ £320/4 years¼ £80

Av. Investment¼ £1000/2¼ £500

ARR¼ (£80/£500)� 100%¼ 16%

ARR – advantages

K Availability of profit data

K Focus on balance sheet

K ROI used for performance appraisal

ARR – disadvantagesK Profit is more subjective than cash flows

K May conflict with NPV

K Requires the setting of a target rate

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NPV and annuities

Where a project has equal annual cash flows, the PV canbe found by multiplying the cash flow by the appropriateannuity factor

This can be calculated using the formula

1

i1þ 1

ð1þ iÞn� �

Where i¼ discount rate and n¼ the number of yearsover which the annuity is received

Study tip

A formula sheet, containing most of the annuityfactors you may need in the exam, will beprovided. However, make sure that you practiseusing the formula, in case you do need it

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Unequal lives

Where two mutually exclusive projects have different life spans, this must be adjusted for before NPV can be usedto choose between them

Method:

Calculate annualised equivalents (AE) for each NPV

Formula AE¼NPV/Annuity factor of project’s life

Replacement

Annualised equivalents can be used to determine the optimum replacement cycle for an assetMethod:

1. Calculate the NPV of each replacement cycle2. Convert each NPV into an annualised equivalent3. Choose the optimum cycle, based on the best AE

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Capital rationing

Occurs when a company has limited investment fundsand not all positive NPV projects can be adopted.

Method:

1. Calculate the Profitability Index of each project.

PI ¼ NPV of project

Cash outlay in then rationed period

2. Rank projects by PI3. Do projects in order of PI until all scarce funds are

utilised

Assumptions

K Projects are divisible

K Project returns are proportional to the percentageof funds invested

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Estimates – sensitivity analysis

Definition

A modelling and risk assessment procedure, inwhich changes are made to significant variables,in order to determine the effect of these changeson the planned outcome

Method:

1. Calculate the NPV of the project2. Convert the NPV into an annualised equivalent3. Each cash flow can alter by the AE before the

decision to take on the project alters

Advantages

K Simple process, using computer spreadsheets

K Easy to apply

K Directs attention to key variables

N.B. In the real world, a number of variables may alter atthe same time. Probabilities may be used to predict thelikelihood of various outcomes occurring

Estimates – risk

Methods that can be used to account for risk within aproject appraisal include:

K Sensitivity analysisK Probability distributions

K Adjustments to the discount rate

K Adjustment to the required payback period

K More conservative estimates

K Decision tree analysis

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —57


Inflation and the cost of capital

K Increasing prices will reduce the purchasingpower of money

K The rate of inflation is expressed as a percentage(IR)

Cost of capital can be expressed as

K A monetary rate (MR) – includes an element forinflation, or

K A real rate (RR) – the underlying return requiredbefore inflation adjustment

K The relationship between them is expressed as

RR¼ [(1þMR)/(1þ IR)�1]

Methods for dealing with inflation

There are two methods for dealing with inflation

1. Real approach

K Cash flows expressed in today’s terms

K Discount cash flows using the real rate

2. Monetary approach

K Cash flows expressed at inflated value

K Discount cash flows using the monetary rate

Illustration of the methods

Company is considering a project

Initial investment: £150,000

Cash flows in years 1–3: £55,000 pa

Monetary cost of capital: 10%

Inflation: 6% over the project life

Required:

1. Calculate the NPV using the real method2. Calculate the NPV using the monetary method


— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —58


Answer 1

K Calculate the real cost of capital

RR¼ (1.10/1.06)� 1¼ 3.8%

K Calculate the required discount rates

Year DF 3.8%1 1� 1/(1þ 0.038) 0.9632 0.963� 1/1.038 0.9283 0.928� 1/1.038 0.894

K Calculate the NPV

Year Cash flow DF PV0 (150,000) 1.000 (150,000)1 55,000 0.963 52,9652 55,000 0.928 51,0403 55,000 0.894 49,170

NPV ¼ 3,175

Answer 2

K Inflate the cash flows to create money flowsYear Inflated cash flow

1 55,000� 1.06¼ 58,3002 58,300� 1.06¼ 61,7983 61,798� 1.06¼ 65,506

K Calculate the NPV using the money cost ofcapital and the inflated flows

Year Cash flow DF PV0 (150,000) 1.000 (150,000)1 58,300 0.909 52,9952 61,798 0.826 51,0453 65,506 0.751 49,195

NPV ¼ 3,235


— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —59


NPV – Incorporating the effectof taxation

Taxation can have a major impact on project viability.Tax is paid on profits at a rate of 50% in the year theprofits are earned and 50% in the following year.

K Tax charged on net cash flows will reduce the NPV

K Tax relief given on assets purchased – in the formof Writing Down Allowances (WDAs) – willimprove the NPV

Writing Down Allowances

K Are expressed as a percentage – usually 25%

K Are applied to the asset cost on a reducingbalance basis

K Are given in full for every year that the companyowns the asset (even when owned for only oneday of the accounting period)

K Are not given in year of sale – instead, abalancing allowance or charge is given – thisensures total allowances equal total fall in value

K The allowance is set against company profits toreduce liability to corporation tax.

Illustration

A company buys an asset for £10,000 at the end of itsaccounting period. The cash flows from the 2-yearproject are £7000. The asset has a scrap value of£6000 when disposed of at the end of year 2. WDAare given at 25% reducing balance and Corporationtax is charged at 30%.

1. Calculate the net cash flows for the project2. Recalculate the net cash flows if the asset were

bought a day later at the start of an accountingperiod.


— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —60


Answer 1

1. Calculate the WDAThe first WDA will be given for the year ended T0, as theasset was owned for part of the year

£ Tax @ 30%T0 Investment 10,000T0 WDA @ 25% (2500) 750

7500

T1 WDA @ 25% (1875) 5635625

T2 Proceeds (6000)Balancing charge (375) (113)

2. Calculate the net cash flows

T0 T1 T2 T3Income 7000 7000Tax 30% (1050) (1050)

(1050) (1050)Asset (10,000)Scrap 6000WDA relief 375 375

282 281(56) (57)

Net cf (9625) 6607 11125 (1107)


— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —61


Answer 2

1. Calculate the WDAThe first WDA will be given for the year ended T1, as it isthe first year in which the asset is owned

£ Tax @ 30%To Investment 10,000T1 WDA @ 25% (2500) 750

7500

T2 Proceeds (6000) 450Balancing allowance 1500

2. Calculate the net cash flowsTo T1 T2 T3

Income 7000 7000Tax 30% (1050) (1050)

(1050) (1050)Asset (10,000)Scrap 6000WDA relief 375 375

225 225Net cf (10,000) 6325 11,500 (825)

Study tip

When setting up NPV calculations with tax in,remember to put in one extra column, to takeaccount of the lag in the second part of the taxpayment


— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —62

Post-project appraisal

Definition

A mechanism whereby experience from the pastprojects can be fed into the organisation’sdecision-making process to aid future decisions onthe future projects

Benefits include

K Benefits relating to the performance of the currentproject – speedy modification or termination ofunder-performing projects

K Benefits which relate to the selection and theperformance of the future projects – better qualitydecisions and greater realism in expectations

K Benefit to the investment appraisal systemitself – formal highlighting of the weaknesses canimprove control mechanisms

Project abandonment

A decision to terminate a project should be based onlyon the future cash flows

If future incremental cash in-flows will not exceed thefuture out-flows, the project should be terminated


— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —63


The Value Chain – TQM

The impact of the modern environment on working practices andmanagement accounting systems

Topics

. Value chain

. JIT

. TQM


Q39

65

The value chain – TQM

The principle

Excellence in manufacturing is necessary forsuccess, but it will not work alone. A firm mustappreciate the relationship between all the factorsin the value chain – the sequence of businessfactors by which value is added to theorganisation’s products and services

The main consideration for business is the smoothcoordination of the functions within theorganisation

World-class manufacturing

The philosophy of continuous improvement andfirst class performance that underpins thoseorganisations that ‘get the value chain right’

Just-in-time concept

A system where the objective is to produceproducts as required for use or by a customer,rather than for stock. It is a ‘pull’ system,responsive to demand

Strategy and administration

Internal External

R & D Design Production Marketing Distribution Customerservice

Customers

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —66


The value chain – TQM

Just-in-time concept(JIT) – a philosophy

K Commitment to continuous improvement and thepursuit of excellence

K Aims to eliminate all non-value added costs

K Manufacturing lead time should equal theprocessing time

Features of a JIT system

K Exposes problems

K Reduces stockholdings as one of the outcomes

K Manufactures similar products together

K Works on a ‘pull’ principle

K Relies on multi-skilling

K Can substantially reduce defects

Total quality management – TQM

Quality is best viewed from the customer’sperspective – is the product ‘fit for purpose’? Failure tomeet the customer’s requirements will put a firm out ofbusiness

Costs of failing to deliver quality

Internal costs

K Internal failure, e.g. costs of scrap

K Appraisal costs – the costs of measuringconformity with requirements, e.g. set-upinspections

K Prevention costs – costs of ensuring that defectsdo not occur in the first place

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —67

–––––––––––––––––––––––––––––––––––––––––The Value Chain – TQM

Total quality management – TQM

Features of TQM

K Focus on continuous production

K Workforce training

K Focus on product design and life cycle

K High quality information feedback systems

K Re-appraisal of performance measures

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —68


Activity-basedApproaches

A comparison of activity-based costing (ABC) with absorption costingand how the use of ABC can improve management’s decision-making

Topics

. The overhead problem

. Absorption costing

. Direct Product Profitability

. Activity-based costing

. Activity-based management

. Customer Profitability Analysis

. Pareto analysis


Q20Q21Q37

69

The overhead problem

Absorption costing was originally designed for productioncompanies to deal with production costs. It is lesssuitable for service and retail organisations

Overheads were then only a small part of the overallcosts and inaccuracies in absorption were small andinsignificant. It was never intended for use in short-termdecision-making, and a number of modern activity-basedapproaches have subsequently been developed

Direct Product Profitability (DPP)A modern way of absorbing overheads in retailorganisations

Traditionally, bought-in cost was deducted from sellingprice to give gross margin. This was of little use for costcontrol and decision-making

DPP deducts

Buy-in price and

Indirect costs – based on the way the goods usedor created them

A typical DPP calculation would appear as follows:

£ £Selling price 1.50Less: bought in price (0.80)Gross margin 0.70Less: Direct product costs

Warehouse costs 0.16Transport costs 0.18Store costs 0.22

(0.56)Direct product profit 0.14

Advantages of DPP

K Facilitates betterK Cost analysis

K Pricing decisions

K Management of space

K Rationalisation of product range

K Merchandising decisions

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —70

Activity-based Approaches

Activity-based costing (ABC)

Traditional costing systems have a number ofdisadvantages

K Product costings are not accurate enough forpricing decisions

K They tend to use labour or machine hours – anoutdated approach, as most overheads do notvary directly with hours

K Provide limited information

Terminology

Traditional costing

Costs are gathered together, based on where theyare incurred, i.e. cost centres and the cost objectsare costed based on absorption rates

ABC costing

Costs are gathered together, based on resourcecost drivers into cost pools or cost activities, andthe cost objects are costed, based on activity costdrivers

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —71

––––––––––––––––––––––––––––––––––––––––Activity-based Approaches

Activity-based costing (ABC)

Absorbing overheads using ABC

1. Identify and collect overhead costs2. Pool costs based in activities which have consumed

resources (e.g. handling, set-ups, quality control)3. Allocate overheads to products based on cost dri-

vers (e.g. quality control overhead may be allocatedon the basis of the no. of inspections)

Example

Machine overhaul overhead amounts to £180,000 inone year. The cost driver has been identified as thenumber of set-ups, and 450 were carried out in theyear.

Charge out rate for set-ups would be£180,000/450¼ £400 per set-up

A product range requiring 75 set-ups would thereforebe allocated 75� £400¼ £30,000 of the set-up costfor the year.

If 2,500 units of that product were produced, then theoverhead per unit in respect of the set-up costs wouldbe £30,000/2,500¼ £12

Usefulness of ABC

ABC is particularly useful for product costing where:

K Production overheads are high in relation to directcosts

K Product range is diverseK Products use differing amounts of the overhead

resources

K Consumption of overhead resource is notprimarily driven by volume

— — — — — — —— — — — — — — — — —— — — — — — — — — —— — — — — — — — — —— — — —72


Activity-based management

Definition

A system of management which usesactivity-based cost information for a variety ofpurposes, including cost reduction, cost modellingand customer profitability analysis. The aim is to usethe information to ensure that the customer needsare met using a minimum of resources.

Advantages

K Identifies where activities are duplicated, causingwaste

K Used to monitor activities and thereby control costs

K Flags up changes in activity or resource consumption– empowers managers to view fixed costs aspotentially variable

K Helps identify a non-value-added expenditure

Customer profitability analysis

K Different customers and customer groups willmake use of different activities and to varyingdegrees

K ABC permits the creation of customer profiles andthe analysis of customer profitability

K Information can be used to target profitablecustomers and review the business modelcurrently offered to less profitable ones

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––––––––––––––––––––––––––––––––––––––––Activity-based Approaches

Pareto analysis

Based on the observed phenomenon that 80% ofpopulation’s wealth is owned by 20% of the people

Approximation of the principle holds true in manybusiness situations, e.g. relationship between

K Contribution and revenue

K Customers and profit

K Stock items and stock value

Typical Pareto graph

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Learning andExperience Curves

An explanation of learning and experience curves and an analysis of theirapplication to decision-making

Topics

. Learning curves

. Experience curves

Key questions

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Learning curves

Learning curve

The resources required to produce the givenamounts of a product tend to decline as outputaccumulates

One significant cause of the decline is the learningcurve – workers become more adept at a task themore they perform it

This improvement can be measuredmathematically

The cumulative average time per unit/batchdecreases by a fixed percentage each timethe cumulative production doubles

A Learning Rate is expressed in terms of the % fall intime, so a 90% learning rate indicates that the averagetime per unit in each cumulative batch will fall to 90% ofthe previous average

Learning curve – graphicalrepresentation

Example

A firm with a Learning Rate of 80% takes 50 hoursto make its first unit. It has now made a total of 16units. How long will the next 16 units take?

Cum. av. timeper batch (hrs)

Steady state

a

X

Yx

0

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Learning and Experience Curves

Learning curves

Cumulativeproduction

Average timeper unit

Total timetaken – hours

1 50 50

2 50� 0.8¼ 40 40� 2¼ 80

4 40� 0.8¼ 32 32� 4¼ 128

8 32� 0.8¼ 25.6 25.6� 8¼ 204.8

16 25.6� 0.8¼ 20.48 20.48� 16¼ 327.68

32 20.48� 0.8¼ 16.38 16.38� 32¼ 524.16

The time for the next 16 units is therefore524.16� 327.68¼ 196.48 mins.

Formula approach

The above technique will only work when cumulativeproduction doubles. However, the learning curve formulacan be applied to any multiple

Formula

YV axb

where

Y¼ cumulative average time per unit

a¼ time taken for the first unit

x¼ total number of units

b¼ index of learning

The index of learning is calculated as

b¼ log of the learning rate/log 2

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–––––––––––––––––––––––––––––––––––––Learning and Experience Curves

Learning curves

Example

1. Derive the formula for the 80% learning rateand apply it to confirm the cumulativeaverage time per unit for 16 batches in theprevious illustration

2. Using the same formula, calculate thecumulative average time per unit for 20 batches

The formula is calculated as follows:

b¼ log 0.8/log 2¼� 0.322

y¼ ax�0.322

At 16 batches,Average time taken per batch¼ 50� 16�0.322

¼ 20.48At 20 batches,Average time taken per batch¼ 50� 20�0.322

¼ 19.06

Formula approach

Uses of the learning curve

K Price setting

K Budget setting

K Production scheduling

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Learning and Experience Curves

Experience curves

Experience curves are very similar to learning curves;however, they deal with the reduction of all costs asproduction volumes increase

Uses of the experience curve

When a new product is to be introduced tomarket, large volumes of sales may be needed tomake good profits. Knowledge of the experiencecurve will allow the company to price the initialunits below their production costs. The low pricewill ensure the high volume of sales needed forthe experience curve to operate and a profit will bemade for the period

Formula

As for the learning curve, except a now representsthe cost of the first unit, i.e.

Y¼ axb where

Y¼ cumulative average cost per unit

a¼ cost of the first unit

x¼ total number of units

b¼ index of experience

The index of experience is calculated as

b¼ log of the experience rate/log 2

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Costing Systems

The management accounting profession has introduced new costingsystems to provide management with the information they need to operate

in today’s business environment. Modern challenges include increasingflexibility and customer focus whilst also improving efficiency and

incorporating new technology

Topics

. Modern manufacturing philosophy

. Just-in-time (JIT)

. Backflush accounting

. The theory of constraints (TOC)

. Throughput accounting (TA)

. Target costing

. Life cycle costing


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Modern manufacturing philosophy

Traditional thinking, focused on large production volumesto reduce the cost per unit and minimising variety toreduce set-up costs

By contrast, modern thinking emphasises:

K Smooth steady production flow – throughput

K Parts working together as effectively as possible

K Flexibility and attention to customer needs

K Offering a wide range of products on demand

This is to be achieved through:

Minimising the movement of components and products

K Organising manufacturing layout by productfamily

K Simplifying production scheduling

K Reducing waiting times

Just-in-time (JIT) systems

Operates on a pull system:

1. Customer requests a product2. Start to make the product using small amount of

WIP held3. Demand for components triggers component

production4. Component production triggers the need for raw

materials5. Buy the raw material as needed

Requirements for JIT systems

K Versatile workforceK Production processes grouped by product

line, rather than function

K Simple, reliable information system

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Costing Systems

Backflush accounting

K Traditional cost accounting systems track rawmaterials and components through the productionsystems – ‘sequential tracking’

K However, the absence of levels of stock and WIPin JIT require a new accounting system

K ‘Backflush accounting’ delays recording costs untilafter events have occurred, using the standardcosts to ‘flush out’ the manufacturing costs

Two events can trigger the recording process:

1. Purchase of raw materials (unless a full JIT system– where no stocks of raw materials held – whenonly the second trigger operates)

2. Transfer of goods to finished goods stock (or in trueJIT system – on the sale of goods)

Example 1 – small raw materialstock, no finished goods stock

Company buys £3200 of raw materials andspends £3000 on labour and overheads to convertto the finished goods

All goods are sold – worth £6000 at standardcost

Materials – £2900, Conversion – £3100

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Solution 1Raw material purchase

Stock control Dr 3200

Creditors control Cr 3200

Conversion costs incurred

Conversion cost control Dr 3000

Individual a/cs Cr 3000

Goods sold

Cost of goods sold Dr 6000

Stock control Cr 2900

Conversion costs allocated Cr 3100

Under / over allocation of conversion costs

Conversion costs allocated Dr 3100

Costs of goods sold Cr 100

Conversion costs control Cr 3000

Example 2 – no raw material stock,some finished goods stock held

The facts are as in the previous example, except

Transfer to finished goods is £6,000

Cost of goods sold is £5,900

Finished goods stock is therefore £100

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Costing Systems


Solution 2Raw material purchase – no entry

Conversion costs incurred

Conversion cost control Dr 3000

Individual a/cs Cr 3000

Finished goods produced

Finished goods control Dr 6000

Creditors control Cr 2900

Conversion costs allocated Cr 3100

Finished goods sold

Cost of goods sold Dr 5900

Finished goods control Cr 5900

Under / over allocation of conversion costs

Conversion costs allocated Dr 3100

Costs of goods sold Cr 100

Conversion costs control Cr 3000

Backflush accounting – features

K Only used with JIT systems

K Saves accounting time – less recording

K Eliminates direct labour as a cost category

K Ignores WIP as immaterial

Criticisms

K Does not conform to the UK FR rules

K Provides limited information

K If used where stock balances exist, regular stocktakes required

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–––––––––––––––––––––––––––––––––––––––––––––Costing Systems

The theory of constraints (TOC)

The theory

Focuses attention on the bottlenecks within theorganisation, which hinder speedy productionMain aim is to maximise the rate of manufacturingoutput (throughput) of the organisationProduction rate of the entire factory is set at the paceof the bottleneck – the constraining resource

Definitions

Throughput contribution¼ Sales revenue� completely variable costs¼ Sales revenue� direct material cost

Conversion costs¼ All production costs, excluding completelyvariable costs

Investments¼ All stocks, R & D costs, equipmentand buildings

Throughput accounting (TA)

K Developed from the Theory of Constraints

K Measures performance in terms of the rate atwhich the business can generate return through abottleneck

K Key measure:

Throughput contribution / Time period

i.e.

(Sales revenue – Material cost) / Time period

K Focuses attention on the removal of bottlenecks

K Products are ranked according to the time theyspend using the bottleneck resource:

Product return per hour

¼ Throughput contribution p=u

Hours used on the bottleneck resource p=u

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Costing Systems

The theory of constraints (TOC)

To ensure that improvements are not gained only byincreasing costs, the cost per factory minute is alsocalculated:

Total conversion cost

Bottleneck resource hours available

The throughput accounting ratio can therefore becalculated as:

Return per factory hour

Cost per factory hour

Example

A plc sells a product for £40 per unit. Directmaterial costs are £25 per unit. Other factory costsare £5000 per week. A bottleneck has beenidentified in the polishing department. Only 1000hours are available per week and each unit takes3/4 hour to polish

Solution

Throughput accounting ratio is calculated asfollows:

Return per factory hour: (£40� £25)/0.75¼ £20

Cost per factory hour: £5000/1000¼ £5

TA ratio¼ £20/£4¼ 5

The higher the TA ratio, the more efficient the firmwould be

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Target costing

Definition

A profit planning system to control costs andmanage profit over a product’s life cycle

In the traditional cost-plus pricing, production costs areseen as unalterable and a mark-up is then added to givea price that is considered commercial

Target costing works in the other direction

1. Product design concept developed2. Selling price determined3. Profit requirement set – based on strategic profit

planning4. Target cost developed5. Product design worked on until the target cost is

achieved

Implications for the businessTarget costing cannot operate in isolation – needssupport systems for

K Sales pricing

K Target profit computation

K Research and development

K Infusing target costs into products

K Human motivation and support

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Costing Systems

Life cycle costing

Aims to maximise the revenues and minimise the costsover the entire life span of the product

Product life cycle costing

To maximise the return from a product over its lifecycle, the following factors must be managed

K Maximise the length of the life cycle

K Design costs out of the product

K Minimise the time to market

K Manage the product’s cash flows

Customer life cycle costing

K Expensive to attract and register newcustomers

K The longer a customer is retained, the moreprofitable they become. This profitabilityincreases, until a plateau is reached

K Aim is to attract and retain the most profitabletypes of customer

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Documents

P2 Exam Revision Kit