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ACCA
Paper F5 | PERFORMANCE MANAGEMENT
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ACCA

PAPER F5
PERFORMANCE MANAGEMENT

REVISION ESSENTIALS
JUNE 2012

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These are condensed notes focusing on key issues for those of you who lead busy, mobile
lives or for those of you who want to revise in a more focused fashion.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. (ii)


CONTENTS

CONTENTS
Page
Syllabus (v)
Core topics (vi)
Costing systems and techniques 0101
Activity based costing 0201
Developments in management accounting 0301
Relevant costing 0401
CVP analysis 0501
Limiting factor decisions 0601
Pricing 0701
Risk and uncertainty 0801
Budgeting 0901
Quantitative techniques for budgeting 1001
Basic variance analysis 1101
Advanced variance analysis 1201
Planning and operational variances 1301
Performance measurement 1401
Further aspects of performance measurement 1501

©2012 DeVry/Becker Educational Development Corp. All rights reserved. (iii)


CONTENTS

Page
Divisional performance evaluation 1601
Transfer pricing 1701
Further reading 1801
Approaching written questions 1901
Target costing and lifecycle costing 2001
Environmental management accounting 2101
Materials mix and yield variances 2201
Measuring planning variances 2301
Performance measurement 2401
Interpreting financial data 2501
Performance measurement and the balanced scorecard 2601
Transfer pricing 2701
Comprehensive analysis of past exams 2801
Examiner’s feedback 2901
Examination Technique 3001
These are condensed notes focusing on key issues and offering a limited number of examples and exercises for those of you
who lead busy, mobile lives or for those of you who want to revise in a more focused fashion.
Be Warned: These notes only offer guidance on key issues. On their own they are not enough to pass the examination.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. (iv)


SYLLABUS

INTRODUCTION E Assess the performance of a business from both a


financial and non-financial viewpoint, appreciating the
Aim
problems of controlling divisionalised businesses and
To develop knowledge and skills in the application of the importance of allowing for external aspects.
management accounting techniques to quantitative and
Position of the paper in the overall syllabus
qualitative information for planning, decision-making,
performance evaluation, and control Students must have a thorough knowledge of the material in
Paper F2 Management Accounting and a good knowledge of
Main capabilities
other knowledge papers. Performance Management is
On successful completion of this paper candidates should be further developed in paper P5 Advanced Performance
able to: Management.
A Explain, apply, and evaluate cost accounting techniques Format of the examination
B Select and appropriately apply decision-making The syllabus is assessed by a three-hour paper-based
techniques to evaluate business choices and promote examination. The exam contains five compulsory questions
efficient and effective use of scarce business resources, of 20 marks each. Generally, the paper will seek to draw
appreciating the risks and uncertainty inherent in questions from as many of the syllabus sections as possible.
business and controlling those risks
C Identify and apply appropriate budgeting techniques
and methods for planning and control
D Use standard costing systems to measure and control
business performance and to identify remedial action

©2012 DeVry/Becker Educational Development Corp. All rights reserved. (v)


CORE TOPICS CHECKLIST

CORE TOPICS Tick when completed Tick when completed

Specialist cost and management accounting techniques Budgeting

 Costing systems and techniques   Budgeting 


 Activity based costing   Quantitative techniques for budgeting 
 Developments in management accounting  Standard costing and variance analysis

Decision making techniques  Basic variance analysis 


 CVP analysis   Advanced variance analysis 
 Limiting factor decisions   Planning and operational variances 
 Pricing  Performance measurement

 Risk and uncertainty   Performance measurement 


 Further aspects of performance measurement 
 Divisional performance evaluation 
 Transfer pricing 

©2012 DeVry/Becker Educational Development Corp. All rights reserved. (vi)


COSTING SYSTEMS AND TECHNIQUES

COSTING SYSTEMS AND TECHNIQUES $/unit


Prime cost (direct materials + direct labour) x
Marginal costing
Variable production overhead x
In marginal costing (MC) inventory is valued to include only Fixed production overhead x
variable production cost: ––
Absorption costing inventory valuation x
$ per unit
––
Direct materials x
Overheads are absorbed using some pre determined overhead
Direct labour x
absorption rate. This absorption rate might be based on
__ labour hours, machine hours or even a per unit basis. If
Prime cost x labour hours are used, for example the absorption rate is
Variable production overhead x
calculated as:
––
Marginal cost inventory valuation x Budgeted fixed overheads
––
Budgeted labour hours
An important principle in management accounting is
contribution. Contribution is revenue minus variable costs. It After this, the cost per unit of each product is calculated by
shows how much the profit of an organisation increases if multiplying the labour hours used for one unit of the product
output increases by 1 unit. by this overhead absorption rate.
Absorption costing
In an absorption costing (AC) system all production costs are
included in inventory valuation. This involves using some
basis to “absorb” fixed production overheads into the cost of
making one unit of a product.

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ACTIVITY BASED COSTING

Activity Based Costing 4. Calculate the total cost that will be absorbed by each
product. (E.g. Product A used 1,000 hours of
Activity based costing is an approach to costing that attempts
maintenance. Therefore Product A will absorb 1,000
to identify the main activities that are performed, and to
hours × rate calculated in step 3 above). Each product
identify the costs associated with these activities. The costs
will include costs from several activities.
of production are then calculated based on the amount of
activity that is consumed in producing an item: 5. Calculate the cost per unit of each product by dividing
the total cost (calculated in 4) by the number of units
The steps in an activity based costing exercise can be
produced.
summarised as follows:
Advantages and disadvantages of activity based costing
1. Identify the major activities that each department
performs. (E.g. maintaining machines). Advantages
2. Determine the “driver” for each activity- that is the  Better decision making (by providing more accurate
factor that causes the cost of the activity to vary. (E.g. information of products profitability)
time taken, man hours).
 Cost can be designed out of products by eliminating
3. Calculate an absorption rate per unit of driver for each unnecessary activities.
activity- this may be based on budgeted or actual costs.
(e.g. maintenance cost per man hour =  When cost plus methods of pricing are used, prices
Total maintenance costs based on ABC are likely to reflect more accurately the
true cost of producing a product.
Total man hours

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ACTIVITY BASED COSTING

Disadvantages
 Selection of cost drivers may not be easy.
 Additional time and cost of setting up and administering
the system.
 Exclusion of non-production overheads can be difficult.
 Many judgemental decisions still required in the
construction of an ABC system.

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DEVELOPMENTS IN MANAGEMENT ACCOUNTING

DEVELOPMENTS IN MANAGEMENT  Product design takes into account those facets of a


ACCOUNTING product that customers are prepared to pay for, and
Target costing removes those that customers do not value.

Objective – to identify the required cost per unit of a product


 Cost control is considered at the design stage of a
so that an acceptable margin can be achieved even when product when it is easier to eliminate costs.
selling at a competitive price.  In practice, companies that have adopted target costing
tend to have lower costs per unit.
The following steps are used:
Lifecycle costing
 Determine the price that customers would be prepared
to pay for the product. Lifecycle costing involves budgeting and monitoring the
costs, revenues and cash flows generated by a product over
 Determine the required profit margin. Deduct this from its whole lifecycle rather than on a period-by-period basis.
the price to obtain the target cost.
Much of the costs of a product are determined at the design
 Estimate the actual cost of the product. Identify ways to stage, so it is important that at this stage future revenues are
“eliminate” the gap between actual cost and target. considered, to ensure that over the whole life, the revenues
will exceed the costs.
Target costing is more effective if used during the design of a
new product, as costs can be designed out. For existing Benefits of life cycle costing
products, costs will have to be “controlled out” which is
normally more difficult.  Management will plan the pricing strategy of a product
over its whole life rather than on a short-term basis.
Benefits of target costing
 Decision-making will be based on more relevant
 Requires organisations to focus on the external information as management have the whole picture of
environment as price is based on market rather than use the product over its life rather than the current period
of cost plus methods of pricing. only.

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DEVELOPMENTS IN MANAGEMENT ACCOUNTING

Throughput Accounting Advantages of the t.a. ratio


 Throughput accounting ratio is a performance measure.  Focuses the attention of management on eliminating
It is designed to focus the attention of management on bottlenecks. If a manager wishes to improve his or her
production bottlenecks and how to maximize the measured throughput, there are three possible ways
“throughput” that can be generated in the presence of (mathematically)
such bottlenecks.
 Increase selling price per unit or reduce material
 Throughout means revenue less cost of materials. It is cost per unit. Unlikely in a competitive
similar in principle to contribution- however, material is environment.
considered to be the only truly variable cost.  Reduce “fixed costs” per hour of bottleneck- but
 Having identified the key bottleneck, for each product, this may impact on quality
calculate the throughput generated per hour of  Eliminate the bottleneck- by investing in
bottleneck time (similar to contribution per unit of additional machinery, or redesigning processes so
limiting factor in key factor analysis.) less time is spent on the bottleneck resource.
 Calculate the fixed cost per hour of bottleneck time- Environmental management accounting
calculated by taking all other costs (including labour
and “variable overheads” which are all fixed in the Definition
short run) and dividing by the number of hours of Environmental management accounting aims to provide
bottleneck resource available during the period. internal information to management in the form of
physical information on the use of energy, water and
 Dividing the throughput generated per hour by the fixed
materials (including waste), and monetary information
cost per hour gives the throughput accounting (t.a.) ratio
on environment related costs and savings.
for each product.
 Make the products with the highest t.a. ratio first.

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DEVELOPMENTS IN MANAGEMENT ACCOUNTING

Need for environmental management accounting Environmental costs


The environment has become an important political and Various commentators have defined categories of
social issue in the past 30 years. Organisations need to be environmental related costs. Broad definitions such as that
aware of their environmental behaviour because: proposed by the US Environmental protection agency are as
follows:
 Poor environmental behaviour can harm the reputation
of the organisation, which may lead to a fall in  Conventional costs of buying inputs with environmental
revenues. relevance such as energy
 Organisations may incur fines and cost of cleaning up  Potentially hidden costs- items with environmental
in cases of poor environmental behaviour- for example relevance hidden in overheads
causing pollution.
 Contingent costs- such as cleaning up damage
 Increasing government regulation has increased the
costs of compliance with environmental laws and  Image and relationship costs.
regulations. A more narrow definition of environmental costs was given
by Hansen and Mendova:
 Organisations can save money by becoming more
efficient at their use of scarce resources- such as energy.  Environmental prevention costs- such as redesigning
Traditional management accounting does not show production processes to reduce pollution
managers the environmental impact of the  Environmental detection costs
organisation’s activities.
 Environmental internal failure costs- cost of cleaning up
pollution before it has been released into the
environment.

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DEVELOPMENTS IN MANAGEMENT ACCOUNTING

 Environmental external failure costs- cost of cleaning


up pollution after it has been released into the
environment.
Environmental management accounting techniques
 Use of environmental reports showing the costs such as
those proposed by Hansen and Mendova
 Activity based costing extended to include
environmental activities and their appropriate drivers
 Input output (mass balance) analysis- reconciles
quantities input with quantities of output (in Kilos, litres
etc.). This highlights waste.
 Flow cost accounting- a more sophisticated version of
input output analysis that produces physical and
monetary information about the inputs and outputs of
each process.
 Life cycle costing- includes environmental costs such as
packaging costs in a products life cycle.

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RELEVANT COST ANALYSIS

1 RELEVANT COSTS 2 OPPORTUNITY COST


1.1 For decision-making 2.1 Key point
 Only costs (and revenues) affected by a decision are
“relevant”.  All opportunity costs are “relevant”.
 Not all relevant costs are opportunity costs.
Relevant Non-relevant
 Future,  Historic costs, sunk 2.2 Definition
incremental, costs “The value of the benefit sacrificed . . . in favour of an
cashflows. apportioned fixed costs alternative.”
non-cash items
(depreciation, “The potential benefit foregone (from the best rejected course
profit/loss on sale). of action).”

 Avoidable costs.  Committed costs.  Clearly arise in use of scarce resources.

 Controllable.  Common costs 2.3 Potential difficulties


“management charges”.  Estimating future costs/revenues (benefit sacrificed).
 Identifying alternative uses (and best alternative
forgone).
 Ignores effect on accounting profit.
 Ignores any risk associated with each alternative.

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RELEVANT COST ANALYSIS

3 RELEVANT COST OF SPECIFIC ITEMS 3.2 Relevant costs of labour


3.1 Relevant costs of materials  If work can be done in idle time, relevant cost is zero.
 If labour is fully employed relevant cost is the
Have materials been additional payments required:
purchased?
 to hire additional labour;
No Yes  overtime payments.

Replacement Are they used  If labour is fully employed and a scarce resource
cost regularly? relevant cost amounts* to:
Yes No
 direct cost of labour (wages); plus
 lost contribution from other production.
Replacement Opportunity cost
cost (e.g. sale value) * This is equivalent to revenue foregone less costs
(other than labour) saved.
 Replacement cost = current purchase cost. 3.3 Overheads
 Deprival value applies where materials are scarce  Additional (e.g. stepped) fixed overheads or those that
(§3.4). can be saved are relevant.

 Reallocated/apportioned overheads are not relevant.

 Overhead absorption is not relevant (arbitrary).

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RELEVANT COST ANALYSIS

3.4 Deprival value


 The value of an existing asset if a business were to be
deprived of it is:

Lower of (2)

RC and Higher of (1)

NRV EV
RC = Replacement cost
NRV = Net realisable value
EV = Economic value
(i.e. PV of expected future earnings)

(1) Asset should be in use (⇒ EV) or sold (⇒ NRV)


whichever is higher.
(2) Asset should be replaced only if replacement cost is
lower than (1).

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CVP ANALYSIS

COST VOLUME PROFIT ANALYSIS (USP ×Q) ─ (UVC ×Q) ─FC = P


This is a summary of the article by Ann Irons that was Example
published in Student Accountant magazine. Ann is the
Company A makes product x. The selling price for product x
examiner for F5.
is $50 and its variable costs are $30. The contribution per
The objective of CVP analysis unit (sales price less variable costs) is $20. Fixed costs are
$200,000 per year.
CVP analysis looks primarily at the effects on differing
levels or activity on the financial results of the business. In (50Q) ─ (30Q) ─200, 000 = P.
the short-run, profitability often hinges upon volume, as sales
If we now set P to zero to find breakeven point:
price and the costs of materials and labour are usually known
with some degree of accuracy in the short run. (50Q) ─ (30Q) ─200, 000 = 0
The break-even point is where total revenues and total costs 20Q ─ 200,000 = 0
are equal. There are three methods for ascertaining the break-
20Q = 200,000
even point:
Q = 10,000 units.
1. The equation method
If company A sells exactly 10,000 units, it will break even,
Total revenues are found by multiplying unit selling price
(USP) by quantity sold (Q). Total costs are made up of total and if it sells more than 10,000 units it will make a profit.
fixed costs (FC) and variable costs (VC). Total variable costs 2. The contribution margin method
are found by multiplying unit variable cost (UVC) by total
quantity. Any excess of total revenue over total costs will The unit contribution margin (UCM) is the unit-selling price
give rise to profit (P). (USP) less the unit variable cost (UVC). Hence the formula
from our equation method can be manipulated in the
Total revenue ─total variable costs ── total fixed costs = following way:
Profit.

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CVP ANALYSIS

(USP ×Q) ─ (UVC ×Q) ─FC = P $000 Total revenue


Total costs
(USP ─UVC) ×Q = FC + P
(UCM) ×Q = FC + P 800

FC + P
Q=
UCM 600

So if P = 0 then we would simply take our fixed costs and Break even
point
divide them by out unit contribution margin.
400
Applying this to company A again: Fixed costs

UCM = 20, FC = 200,000 and P= 0


200
FC 200,000
Q= =
UCM 20
Therefore Q = 10,000 units. 10,000 20,000
Units sold
3. The graphical method
The amount of profit or loss at any different output levels is
The total costs and total revenue lines are plotted on a graph.
represented by the distance between the total cost and total
$ are shown on the y-axis, and units on the x-axis. The point
revenue line.
where the total cost and revenue lines intersect is the break-
even point. Profit-volume graphs are discussed in more detail later in the
article.

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CVP ANALYSIS

Ascertaining the sales volume required to achieve a target Finally the answer cab be read from the graph. The profit will
profit be $300,000 where the gap between the total revenue and
total cost line is $300,000 since the gap represents profit.
A business may want to know how many items it must sell in
This is not a quick enough method to use in the exam so it is
order to obtain a target profit.
not recommended.
Example (continued)
Margin of Safety
Company A wants to achieve a target profit of $300,000. If
The margin of safety indicates by how much sales can
the equation method is used, the profit of $300,000 is put into
decrease before a loss occurs, i.e. it is the excess of budgeted
the equation rather than the profit of $0.
revenues over break-even revenues. Using company A as an
(50Q) ─ (30Q) ─200, 000 = 300,000 example, let’s assume that budgeted sales are 20,000 units.
The margin of safety can be found, in units, as follows:
20Q = 500,000
Budgeted sales − break-even sales = 20,000 −10,000 =
Q = 25,000 units.
10,000 units.
Alternatively the contribution method can be used:
It may be calculated as a percentage:
UCM = 20, FC = 200,000 and P= 300,000. Budgeted sales break even sales
× 100
FC + P budgeted sales
Q=
UCM 10,000
In company A’s case it will be × 100 = 50%.
200,000 + 300,000 20,000
Q=
20 Finally it could be calculated in terms of $ revenue as
Therefore Q = 25,000. follows: Budgeted sales − break-even sales x selling price =
10,000 × $50 = $50,000.

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CVP ANALYSIS

Contribution to sales ratio The weighted C/S ratio is the total expected contribution
divided by the total expected sales:
It is often useful in single product situations, and essential in
multi product situations to ascertain how much each $ sold (20,000 × 20) + (10,000 × 15)/ (20,000 × 50) + (10,000 × 60)
actually contributes towards the fixed cost. This calculation = 34.375%.
is known as the contribution to sales or C/S ratio. It is found
in single product situations by dividing the unit contribution The C/S ratio tells us what percentage each $1 of sales
by the selling price. revenue contributes towards fixed costs.

For company A: $20/$50 = 0.4 It can also be used to calculate the break-even point in $
revenue. The break-even point in for company A can be
In multi product situations, a weighted average C/S ratio can calculated in this way:
then be used to find CVP information such as break even
point, margin of safety etc. Fixed costs $200,000
Break-even point (revenue) = = =
Example 2 C/S ratio 34.375%
$581,819 of sales revenue.
Company A also begins producing product y. The following
information is available for both products: To achieve a target profit of $300,000:
Fixed costs plus required profit
Product x Product y
C/S ratio
Sales price $50 $60
Variable cost $30 $45 $200,000 + $300,000
Contribution per unit $20 $15 = = revenue of $1,454,546.
34.375%
C/S ratios 0.4 0.25
Budgeted sales (units) 20,000 10,000 Such calculations assume that products X and Y are sold in a
constant mix of 2x to 1y. In reality this constant mix is
unlikely.

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CVP ANALYSIS

Multi product profit volume charts


The profit volume graph focuses purely on showing a profit/ The graph can then be drawn, showing cumulative sales on
loss line and does not separately show the cost and revenue the x axis and cumulative profit/ loss on the Y axis:
lines. $000
In a multi product environment it is common to show two 350
lines on the graph: one straight line, where a constant mix of
products is assumed; and one bow-shaped line, where it is
assumed that the company sells its most profitable product
200
first, and then its next most profitable product, and so on.
Most profitable first
In order to draw the graph, it is necessary to work out the C/S Sales in constant mix
ratio of each product being sold, before ranking the products
in order of profitability. In the case of company A this is
shown above, and it can be seen that since product A has a
higher C/S ratio that product B, it would be ranked (and sold) 582 1,000 1,650
first.
Sales $000
It is useful to draw a quick table (prevents mistakes in the
−200
exam hall) in order to ascertain each of the points that need to
be plotted on the graph in order to plot the profit/ loss lines:
Product ranking 1 1
Contribution Cumulative Revenue Cumulative
Profit/ loss revenue
$000 $000 $000 $000
(Fixed costs) 0 (200) 0 0
X (up to budgeted sales) 400 200 1,000,000 1,000,000
Y (up to budgeted sales) 150 350 650,000 1,650,000

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CVP ANALYSIS

Limitations of Cost volume profit analysis  Profits are calculated on a variable cost basis or, if
The limitations of CVP analysis are based on its absorption costing is used, it is assumed that
assumptions: production volumes are equal to sales volumes.
 There is a single product, or there are multiple products
sold in a fixed mix. If the product mix changes, so does
the break-even point.
 Volume is the only factor that changes. All other
variables remain constant. This may not hold true as for
example economies of scale may be achieved as volume
increases. If sales volumes are to increase price must
fall. There are many other reasons why the assumption
may not hold true.
 The total cost and total revenue functions are linear.
This is only likely to hold within a short run restricted
level of activity.
 Costs can be divided into fixed and variable. In reality
some may be semi fixed.
 Fixed costs remain constant over the “relevant range”
levels of activity in which the business has experience
and can therefore perform a degree of accurate analysis.

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LIMITING FACTOR DECISIONS

LIMITING FACTOR DECISIONS Make or buy decision


Limiting factor decisions involve maximising profits in  The steps are the same as above except that we replace
circumstances where one or more of the inputs to production contribution per unit with the saving of variable cost of
(materials, labour etc.) are scarce. Since fixed costs are manufacturing over variable cost of purchase
unaffected by the level of output in the short run, maximising
 At the end after the production plan has been
profits involves maximising contribution.
formulated as in (4) above we buy in the shortfall
Key Factor analysis
 Care over this purchase must be taken to ensure the
Where only one input is limited, and the organisation has to requisite quantity and quality of this purchase and
decide which product to manufacture, the following steps are reliability of delivery
used:
Linear Programming
1. Calculate the contribution per unit generated by each of
Where more than one input is limited, linear programming is
the products.
used to determine the mix of output that maximises
2 Identify the number of units (kilos/litres) of the limited contribution. This is best illustrated by an example.
factor used by each product.
3 Dividing (1) by (2) gives the contribution per unit of
limited factor generated by each product.
4 Produce the products that generate the highest
contribution per unit of limited factor.

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LIMITING FACTOR DECISIONS

Example Having set up the linear program, we attempt to solve it. If


there are only two variables, then the linear program can be
A company makes two products, tables and chairs. Each
solved graphically. This involves plotting the constraints on a
table generates contribution of $20, and each chair generates
diagram, to identify the “feasible” region, that is the region
contribution of $5. However, skilled labour is in short supply,
showing all the possible production possibilities which could
and only 180 labour hours are available each week. Each
be achieved given the constraints. A sample contribution line
table requires 2 hours of labour, and each chair requires 3
is then plotted. We may for example draw the line C= 1000
hours. Wood is limited to 40 square metres per week. Each
(chosen randomly). This line shows all combinations of x and
table requires 0.5 square metres, and each chair requires 0.75
y that provide contribution of 1,000. This line crosses the x-
square metres.
axis at x= 20, y= 0, and crosses the y-axis at the point where
The following steps are followed in order to set up the linear y = 5, x = 0. Having drawn the line, place a ruler over it.
program: Move the ruler away from the origin, always keeping it
parallel to the sample contribution line, and move it as far
Define the variables: Let x = output of tables and y = output
away from the origin as possible while still being in the
of chairs.
feasible region. The furthest point, where the line is still in
Define the objective function. This is the thing which we are the feasible region is the point where contribution is
trying to maximise. In this case it is contribution: C = 20 x + maximised.
5 y. (because each unit of x generates contribution of 20,
each unit of y generates contribution of 5)
Define the constraints:
Labour: 2 x + 3 y ≤ 1 80
Wood: 0.5 x + 0.75 y ≤ 40
Non negativity: x ≥ 0, y ≥ 0.

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PRICING

PRICING MR = the change in revenue from selling one more unit


2bQ = note that the marginal revenue falls at twice the rate of
Pricing policies should consider the 4 C’s of pricing:
the demand curve
 Costs – A company must cover its costs in the long run
 To maximise sales set MR = 0, solve Q and place Q in
 Competitors – It should consider the market price of the demand curve equation to gain price.
competing firms
 To maximise profits set MR = MC, solve for Q and
 Customers – A firm should take into amount how much place Q in the demand curve equation to gain price.
its customers are prepared to pay Accountant’s approaches
 Corporate objectives – The firm’s specified goal e.g. Full cost
profit maximisation should be integrated with its
pricing policy Full total absorption cost is calculated and then an allowance
for profit is added. Although costs are covered it takes no
Economist’s approach amount of customers or competition
Demand curve: Marginal cost pricing
P = a – bQ (formula given in exam) Marginal variable cost is calculated and then an allowance
P = price for contribution is added. Not all costs are covered and as
Q = quantity demanded such should only be used in short-term relevant cost
a = price at which demand would be nil decision-making.
b = slope of the demand curve (price changes over the Return on investment pricing
change in quality demanded)
Full total absorption cost is calculated and then the allowance
Marginal revenue -MR = a– 2bQ (formula given in exam) for profit is based on the required return on the investment
base. Its limitations are as for full cost pricing.

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PRICING

Strategic Approaches to pricing


Market penetration policy
In accordance with the product development life cycle
(PDLC) this involves a policy of low prices when the product
is in its growth phase to obtain market share.
Market skimming
Can be used with the PDLC and involves charging high
prices during the introductory phase usually when the
company has brought a new product to the market.
Going rate pricing
During the maturity phase of the PLDC a company may
adopt this policy of charging the market rate.

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RISK AND UNCERTAINTY

RISK AND UNCERTAINTY Example


Management accounting is concerned with the future and as If contribution could be $5,000, $30,000 or $50,000 with
such contains uncertainty and therefore risk. respective probabilities of 0.2, 0.5 and 0.3. The expected
value of the contribution
Risk preference
$5,000 × 0.2= 1,000
 A risk seeker is someone who is interested in the best
outcome no matter how small the chance of success $30,000 × 0.5= 15,000
$50,000 × 0.3 = 15,000
 A risk averse decision maker is concerned with the ––––––
most pessimistic outcome 31,000
––––––
Value of perfect information
 A decision maker is risk neutral if they are concerned
with the most likely outcome i.e. the expected value  Value of perfect information = Expected value with
perfect information – Expected value without perfect
Expected value (EV’s) information.
 The expected value of an opportunity is equal to
Example
the sum of all possible outcomes, multiplied by
their associated probability: A decision maker has to choose between 3 courses of action
on a daily basis- A, B and C. When making the decision, the
( x) = p x decision maker does not know what the state of the market
will be- it could be 1, 2 or 3. The following table shows the
possible outcomes:

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RISK AND UNCERTAINTY

Action A B C Expected value with perfect information


1 10 (25) 200
If the decision maker could commission a report that would
State of 2 200 300 (500)
accurately predict what the state of the market would be on
market 3 20 30 40
each particular day, then instead of automatically selecting
action B, the decision maker would make the following
Probability of each state of the market is as follows: decisions:
Probability Predicted state Action
1 0.3 of market chosen Outcome Prob
State of 2 0.5 1 C 200 0.3
market 3 0.2 State of 2 B 300 0.5
market 3 C 40 0.2
Expected value without perfect information
Expected value with perfect information is: (200 × 0.3) +
Expected value of each action is as follows:
(300 × 0.5) + (40 × 0.2) = $218.
A: (10 × 0.3) + (200 × 0.5) + (20 × 0.2) = $107
The expected value of perfect information therefore is: $218
B: ((25) × 0.3) + (300 × 0.5) + (30 × 0.2) = $148.5 - $148.5 = $69.5
C: (200 × 0.3) + ((500) × 0.5) + (40 × 0.2) = ($182). Other risk strategies
Without perfect information therefore, a decision maker  Maximin rule – the action with the highest minimum
using the expected value criteria would select action B, and outcome is chosen i.e. course of action A.
the expected value would therefore be $148.5.
 Maximax rule – the course of action that gives the
highest potential outcome is chosen -i.e. course of
action B.

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RISK AND UNCERTAINTY

 Minimax regret rule An economist’s concept of Decision fork (or point)


minimising the maximum regret involving the This is a point at which a decision maker has to decide
construction of another table: between two or more decisions.
Table of regrets Action a
A B C Action b
State of 1 190 225 Nil
market 2 100 Nil 800 Action c
3 20 10 Nil
Chance fork (or outcome point)
E.g. regret of A under state of market 1 is not choosing C i.e.
This occurs where there are several possible outcomes-
200 - 10 = 190.
normally for each decision taken there will be two or more
The decision rule becomes A as this option has the lowest possible outcomes.
maximum possible regret. .
Outcome B
Decision trees Probability
Where a decision involves multiple stages, and several p
outcomes are possible as a result of each decision, a decision
tree may be drawn to summarise the situation. The expected Probability
value of each path through the tree can then be calculated, to q
identify which paths have the highest expected value. Outcome A
In drawing the tree, there are two types of branches or forks:

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BUDGETING

BUDGETING  A flexed budget system involves “flexing” the original


Objectives of a system of budgeting: budget at the end of the year to reflect the actual
activity levels, based on the original budget
C – Coordination assumptions.
R – Responsibility
U – Utilisation Rolling Budgets
M – Motivation  Rather than preparing the budget once a year, the
P – Planning organisation continually updates the budget. Typically
E – Evaluation the budget will be prepared for the next twelve months.
T – Telling At the end of each month, another month’s budget is
added. Intervening months’ budgets may also be
Alternative systems of budgeting changed, if factors outside the control of the company
Fixed v Flexible v Flexed have made the original budgets inappropriate.

 A fixed budget is prepared once, and remains Activity based budgeting


unchanged when used for comparison with actual  Budgets are based on activity-based principles.
results.
Incremental v Zero Based Budgeting
 Under flexible budgeting, several budgets are prepared
using the same budget assumptions, but based on  Incremental budgeting is performed by taking the
different activity levels (sales/production units). At the previous year’s actual or budgeted figures and adding
end of the year, the budget with the activity level adjustments for inflation and other factors that have
closest to the actual is used for comparison. changed.
 Disadvantage of incremental budgeting is that it accepts
costs simply because they were there last year without
questioning whether they are really necessary.

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BUDGETING

Zero based budgeting Level of difficulty


 Managers identify the activities they wish to perform.  If budget is not achievable, it will de-motivate. If it is
(E.g. making particular products, training.) too easy, it will not challenge.
 Managers produce a decision package for each activity, Top down v Bottom up
showing costs and revenues, as well as qualitative
factors.
 Bottom up means managers prepare their own budgets.
These are then approved by a budget committee. Top
 Budget committee reviews decision packages and down means that budgets are prepared centrally, and
selects those it wishes to accept. These form the budget. imposed on managers.

 Advantage is that budget process examines each cost, Bottom up has the following advantages:
and relates it to the activities the company will perform,  Managers are more motivated to take ownership of the
rather than just accepting costs because they were in budget
previous year.
 Managers have better knowledge of situation “at the
 Disadvantage – very time consuming. coal face”
Behavioural Aspects of Budgeting Top down has the following advantages
Responsibility accounting  Non financial managers may not have the financial
knowledge to prepare budgets
 Responsibility is delegated to managers via the budget.
They are then evaluated on how they perform in  Preparing the budgets centrally may minimise problems
comparison with the budget. such as adding slack to budgets.

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BUDGETING

Controllability principle  Too much focus on profits is not consistent with the
overall goals of the organisation- to maximise the
 Managers should only be judged on things they control.
wealth of shareholders
They should not be blamed for adverse factors outside
of their control- such as increases in the price of
commodities on world markets.
Potential weaknesses of budgeting
 Budgeting takes up too much managers’ time.
 Budgets prepared 15 months before the end of the
accounting period to which they relate become out of
date.
 Managers “gaming” activities means the budget process
loses its validity. Gaming includes:
 Adding slack to budgets to make them easier to
perform
 Never beating the budget significantly
 Always spending what’s in the budget.
 In some organisations, funds are only available for
projects in the budget. This may constrain managers
who identify potential new projects after the budget
process.

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QUANTITAVE TECHNIQUES FOR BUDGETING

QUANTITATIVE TECHNIQUES FOR BUDGETING


Regression analysis When does it apply?
 Least squares technique to derive the cost function  If the product is made largely by labour effort
y = a + bx
 For identical products where the process is starting from
Where new Standards then need to be adjusted when learning
is taking place
n ∑ xy − ∑ x ∑ y
b= Example
n ∑ x 2 − (∑ x )
2
The time taken to make the first unit of a
∑ y b∑ y product is 100 minutes. A 95% learning
a= – rate applies:
n n
Cumulative Cumulative Cumulative
n = number of observations Output average time total time
b = gradient
1 100 95
You do not need to learn this formula- it is given in the exam 2 95 190
paper. 4 90.25 361
Learning curve theory 8 85.74 686
The cumulative average time per unit decreases by a constant
% every time total output doubles.

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QUANTITAVE TECHNIQUES FOR BUDGETING

Formula for the learning curve  Seasonal variation (S) – an annual cycle of variations
b
y = ax
Where  Randomly occurring variations due to non-recurring
y = cumulative average time per unit to produce x units influences
a = time taken for the first unit of output
x = number of units produced
b = the index of learning (log LR/log 2)

This formula is provided in the exam.


Technique
If asked for time of 7th unit, work out average time for 6
units and 7 units, work out total time and then take the
difference.
Trend analysis
A time series is a set of data recorded over a period of time.
It could be made up of:
 Trend (T) – the “long-term” effect when fluctuations
have been smoothed out

 Cyclical variation (C) – the “long-term” effect when


fluctuations have been smoothed out

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BASIC VARAINCE ANALYSIS

“BASIC” VARIANCE ANALYSIS


 A standard cost is a budgeted cost per unit of a Sale variances:
product. Setting standards requires assumptions to
be made about the quantity of inputs used per unit
 Sales Volume: (AQ – BQ) SMn
of a product, and the price paid for those quantities.  Sales Price: (AP – SP) AQ
 Having standards makes the budgeting process Materials variances:
much easier. The budget is effectively prepared by
multiplying the budgeted sales and production  Price: (SP – AP) AQp
quantity of each item by the standard cost and  Usage: (SQ – AQu) SP
revenue per unit.
Labour variances:
 Variance analysis is a detailed investigation into
why actual profits differ from budget, and  Rate: (SR – AR) AHp
compares the actual costs against the standards.
 Idle time: (AHw – AHp) SR
The formulas for the variances are as follows:
 Efficiency: (SH – AHw) SR
Notation:
Variable Overheads:
AQ: Actual quantity (AH = Actual Hours)
 Rate: (SR – AR) Ahw
BQ: Budgeted quantity (SH = Standard Hours)
 Efficiency (SH – AHw) SR
AP: Actual Price (AR = Actual Rate)
SP:Standard Price (SR = Standard Rate)
SMn-:Standard Margin

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BASIC VARAINCE ANALYSIS

Fixed Overheads The examiner often provides variances in the exam and
expects you to be able to provide suggestions as to the causes
Expenditure: Budgeted fixed cost – Actual fixed cost
of these. If this is the case, ensure you read the scenario
carefully as there are often clues given in the scenario as to
If absorption costing is being used, additional variances may be
the causes. Below is some guidance as to possible causes of
calculated:
variances in general terms:
 Volume: (AQ – BQ) × Standard rate per unit or (SH – BH)  Sales volume variance; measures the effect on standard
If fixed overheads are absorbed using some hourly basis, (labour margin of selling more/less units than expected.
hours, machine hours) the volume variance may be further
analysed into:
 Sales price variance; measures the effect on sales
revenues of selling at a non-standard price
 Capacity: (AH – BH) SR  Materials price variance; measures the effect on
purchases expense of paying a non-standard price for
 Efficiency: (SH – AH) SR materials
(SR means standard overhead absorption rate per hour)
 Materials usage variance measures the effect of losses,
The only differences between variance analysis using rejects, defects wastage etc. Remember to used a flexed
absorption and marginal costing are: budget for materials quantity to compare to the actual
quantity used
 Sales volume variance is valued at standard profit per unit
for absorption, and standard contribution per unit for  Labour idle time variance; measures the cost to the
marginal. company of paying workers who are not working e.g.
due to machine breakdowns, materials stock-outs.
 There is only one fixed overhead variance for marginal
costing- the expenditure overhead.  Labour rate variance; measures the effect on payroll
expense of paying workers a non-standard wage

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BASIC VARAINCE ANALYSIS

 Labour efficiency variance; measures the productivity


of workers Remember to use a flexed budget for labour
hours to compare to the actual hours worked.
 Variable overhead efficiency variance; calculated in the
same way as labour efficiency i.e. if workers have good
productivity the machinery operates for fewer hours and
incurs less variable overhead costs such as electricity.
 Variable overhead rate variance; measures the effect of
paying a non-standard rate per hour for variable
overheads such as electricity
 Fixed overhead expenditure variance; the pure spending
difference between budgeted and actual fixed costs. Do
not flex fixed costs; they should not change with the
level of activity
 Fixed overhead volume variance; only exists if using
absorption costing as it represents under or over-
absorption of fixed costs which does not occur under
marginal costing. Be careful when interpreting this
variance; it does not show a real spending difference, it
is simply a reconciling item caused by the cost
accountant’s method of charging fixed costs through the
income statement.

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ADVANCED VARIANCE ANALYSIS

ADVANCED VARIANCE ANALYSIS


Actual
Materials mix variance and yield variances Actual quantity
Where the standard cost of a product includes two or more quantity in standard
used mix Difference Variance
materials, the usage variance can be sub analysed into two
additional variances – the mix and yield variances: litres/kgs litres/kgs litres/kgs $
Total materials A B (B − A) (B −A) x Sp
Material 1
cost variance
Material 2
Material 3
___ ___ ___ ___
X X 0 $Y
Price variance Usage variance ___ ___ ___ ___

Materials yield variance


Mix Yield
variance variance The simplest way to calculate this is to compare:
Actual output – expected output for actual input. Multiply the
Materials mix variance difference by the standard cost per unit.
The best approach to the mix variance is to use a tabular
approach:

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ADVANCED VARIANCE ANALYSIS

Example Yield variance


The standard cost of a gin and tonic in a bar in London is 50 40 litres of mix should yield 114 gin and tonics.
ml gin, at a price of $5 per litre, and 300 ml tonic water, at a 40 litres did yield 100 gin and tonics
standard price of $1 per litre. Shortage: 14 gin and tonics.
Standard cost of 1 gin and tonic: ($5 × 0.05) + ($1 × 0.3) =
During one evening, 100 gin and tonics were served. 7 litres
$0.55.
of gin and 33 litres of tonic were used.
Yield variance (adverse) = 14 × $0.55 = $7.7.
Mix variance
Such variances are routinely calculated by cigarette
Actual Actual standard Variance
manufacturers who blend a mix of tobacco into the final
quantity quantity minus
product. If they use relatively more of a cheap but low
actual mix standard mix actual
quality tobacco they may find a favourable mix variance but
Litres Litres Litres
adverse yield variance.
Gin 7 5.7 (1.3) (6.5)
Tonic 33 34.3 1.3 1.3 Sales mix and quantity variances
__ __ __ __
40 40 0 (5.2)  Used to analyse the sales volume variance where the
sales budget includes a standard mix of products. This
The mix variance shows that the bar staff mixed stronger gin usually occurs in situations where similar products are
and tonics than the standard. Since Gin is more expensive sold, perhaps differentiated by brands, and each brand
than tonic, this would lead to a more expensive mix than the has very different margins.
standard. The variance is adverse.

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ADVANCED VARIANCE ANALYSIS

Total sales Product Actual Actual Diff. Std Sales


variance sales sales margin mix
actual standard variance
mix mix
(units) (units) (units) $ $
Price variance Volume variance
A 10 12 (2) 10 (20)
B 8 6 2 5 10
–– –– –– ––
Mix Quantity 18 18 0 (10)
variance variance –– –– –– ––

Sales quantity variance


Example  Takes the difference between actual sales (in the
standard mix) and budgeted sales. Again a tabular
approach works well:
Bob sells two products, A and B. He budgets to sell 8 units of
A per day and 4 units of B per day. The standard margin
Product Actual Diff. Std Sales
(contribution per unit) is $10 per unit for A and $5 per unit sales margin mix
for B. Actual sales on one particular day were 10 units of A standard Budgeted variance
and 8 units of B. mix sales
(units) (units) (units) $ $
Sales mix variance
A 12 8 4 10 40
 Similar in nature to the materials mix variance. Using a B 6 4 2 5 10
tabular approach works best: –– –– –– ––
18 12 6 50
–– –– –– ––

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ADVANCED VARIANCE ANALYSIS

Activity based costing variances Efficiency variance


Where ABC is used, the following approach is taken to Actual number of setups 2,200
calculating variances: Standard for actual output 2,420
––––––
 Expenditure variance: Actual overhead cost – Standard 220
for actual number of units of driver. Standard cost of 1 setup $400
 Efficiency: (Actual units of driver – standard units of ––––––
driver for actual output) × standard cost of one unit of Efficiency variance $88,000 (favourable)
driver.
Incorporating idle time and waste into standards
Example
Management may expect a certain amount of idle time, and
Budgeted output = 30 million units treat this as normal. If so, this “normal” idle time may be
Budgeted number of setups = 3,000 included in the standard labour cost of a product.
Standard cost per setup = $400.
Example
Actual output = 24.2 million Wage cost per hour is $12. However, management expects
Actual number of setups = 2,200 labour to be idle for 20% of the time. The standard cost of
Actual setup costs = $900,000. labour is therefore adjusted to $15 per productive hour.

Expenditure variance: Idle time variance:


Actual idle time X
Actual expenditure 900,000 Less expected X (20% of hours paid)
Standard for actual number of setups 880,000 Difference
––––––– Multiply difference by adjusted standard cost ($15) per
Expenditure variance 20,000 (adverse) productive hour to get idle time variance.

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PLANNING AND OPERATIONAL VARIANCES

Planning and operational variances Planning variances compare the standard cost of actual
output using the original standard with the standard cost of
 Variance analysis is used to provide information about output using the revised standard.
the performance of operations, by comparing actual
performance against a standard. Calculation of planning variances relating to costs (e.g.
materials or labour).
 When the standard itself is found to be inappropriate,
the standard should be revised before variance analysis Planning usage variance
is performed. $
 Standards may be revised if: Original SQ x original SP x actual output X
Revised SQ x original SP x actual output X
 Factors outside of the organisation mean that the ––
assumptions on which standards were based Planning usage variance X
become inappropriate. (For example, the ––
bankruptcy of a major supplier may mean Planning price variance
alternative suppliers had to be found.)
$
 The original standard is found to have been Revised SQ x original SP x actual output X
unrealistic. Revised SQ x revised SP x actual output X
––
 Standards should not be revised to take into account
Planning price variance X
internal inefficiencies.
––
 In practice, judgement may be required to decide if a
standard should be revised or not. Calculation of operational variances is exactly the same as
“basic variance analysis” above. The only thing that changes
is the standard itself.

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PLANNING AND OPERATIONAL VARIANCES

Planning and operational variances relating to the sales Market volume variance
volume variance
Units
Revised budgeted sales* X
Original budgeted sales X
The sales volume variance can be calculated using the
––
following format:
Difference X
Units X standard margin per unit X
Actual sales X ––
Budgeted sales X Market volume variance X
––
Difference X *Note- the revised budget quantity may have been calculated
X standard margin per unit X as the actual market size x budgeted market share.
––
Sales volume variance X Market share variance
––
Units
Actual sales X
Where the sales budget is revised at the end of the year
Revised budgeted sales X
before performing variance analysis, perhaps because the
––
actual market size was very different to what was anticipated
Difference X
when the original budget was prepared, the sales volume
X standard margin per unit X
variance can be split into two parts:
––
Market share variance X
 Market volume variance (a planning variance)
––
 Market share variance (an operational variance)

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PERFORMANCE MEASUREMENT

PERFORMANCE MEASUREMENT Liquidity


Financial performance evaluation Current assets
Current ratio = × 100
Benefits to shareholders Current liabilitie s

Main objective of an organisation, from the perspective of Gearing


the owners, is to maximise wealth. Financial performance Debt
evaluation is therefore normally performed from the Gearing ratio = × 100
Equity plus debt
perspective of the shareholders.
Ratios Conflict between Short Run and long run financial
performance
Return on capital employed (ROCE)
 Short run improvements in financial performance may
Profit before tax be at the expense of longer term, e.g. cutting back on
× 100
Equity R&D spending.

Profit before interest and tax  Performance measurement should encourage a longer-
× 100 term view, possibly by using a mix of financial and
Equity plus long term debt
non-financial performance indicators. (See below)
Profit margins
Gross profit
Gross profit margin = × 100
Revenue
Net profit
Net profit margin = × 100
Revenue

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PERFORMANCE MEASUREMENT

Non-financial performance indication (NFPIs)


Use of NFPIs in addition to financial measures has several
advantages:
 They focus on the drivers of future business
performance (e.g. quality)
 Using only financial measures may lead to short term
behaviour
 May be less easily manipulated
 May be compiled more quickly.
Key performance indicators
 Key performance indicators measure how the
organisation performs in relation to its critical success
factors.
Operational performance indicators
 Having set operational performance indicators,
managers should set performance indicators at all levels
of the business- both financial and non financial- that
are consistent with the key performance indicators.

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FURTHER ASPECTS OF PERFORMANCE MEASUREMENT

FURTHER APSECTS OF PERFORMANCE Fitzgerald and Moon


MEASUREMENT
The following characteristics that distinguish services from
Balanced scorecard approach manufacturing businesses:
This is an attempt to combine financial indicators and non-  Simultaneity – the consumption of the service takes
financial indicators to cover all relevant areas of performance place at the time of performance
such as:
 Perishability – services cannot be stored
 Financial perspective – designed to make the company
survive and prosper by reference to profitability, cash  Heterogeneity – e ach time a service is performed, it
flow, market share will be different.

 Customer perspective – designed to give responsive  Intangibility – w hat consumers value in a service can
supply and quality and is concerned with on-time be difficult to determine.
delivery, % of returns and customer satisfaction. In their building blocks model, Fitzgerald and Moon defined
 Internal business perspective – designed to give six “dimensions” through which a service industry can
manufacturing excellence and productivity and is monitor its performance:
concerned with reduced cycle times and engineering  Profitability
efficiency
 Competitiveness
 Innovation and learning perspective – designed to
reduce the time to market and improve technological  Quality
leadership by looking at the number of new product  Resource utilisation
introductions and the time to develop the next set of
products.
 Flexibility
 Innovation

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FURTHER ASPECTS OF PERFORMANCE MEASUREMENT

Non profit organisations


Performance measurement in non profit organisations is
complicated by the fact that:
 There are many stakeholders, possibly with differing
objectives. Which objectives are the priority ones?
 The organisations have limited resources within which
to try to achieve their aims.
 Performance measurement in the non profit sector
focuses on the “three ees:
 Economy (e.g. total costs per hospital bed)
 Efficiency (e.g. patients treated per doctor)
 Effectiveness – how good is the hospital (e.g. how
many patients do not return within three months.)

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DIVISIONAL PERFORMANCE EVALUATION

DIVISIONAL PERFORMANCE EVALUATION Residual income (RI)


Return on investment (ROI)  To overcome this problem, RI calculations may be
used. The calculation is profit – imputed interest
 ROI is essentially the same measure as ROCE and ARR
(capital employed multiplied by cost of capital)
 It is important only to only include costs, revenues and
 If positive the project is accepted, if negative the project
elements of the assets base controlled by the manager
is rejected and as such is an absolute measure like NPV.
when performing a managerial evaluation.
Discounted RI indeed reconciles to NPV.
Profit before interest and taxation Problems associated with both ROI and RI
× 100%
Capital employed + Long term debt  Both measures use accounting profits and are short term
 This has the benefit of providing a relative evaluation i.e. if positive RI or target ROI’s are not met in the first
for comparative purposes or period then the project may be rejected even though a
positive NPV may be observed over the whole life of
 May be used for investment appraisal where the the project. The risk of short-termism may be reduced
manager can compare an investment’s ROI with the through:
target ROI. If the division’s ROI is the same as the
company’s ROI then this will produce goal congruent  Relegating the divisional managing director to
behaviour. If not however, then dysfunctional behaviour profit centre status and make the capital
may happen (e.g. division’s ROI is 5%, company’s investment decision at group level based on NPV.
required rate 20%, project under appraisal 10%. The However this could be de-motivating.
manager would accept the project but should reject it).  Adjust the manager’s target ROI or RI downwards
in the earlier years of the project. This will not be
de-motivating.

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TRANSFER PRICING

TRANSFER PRICING An alternative way of looking at the second criteria is:


Variable cost + shadow price.
Objectives of a good transfer pricing system:
If a price exists which meets the criteria above, it will
 Autonomy automatically satisfy the objectives of a good transfer pricing
 Goal congruence system.

 Fair to both buyer and seller for performance evaluation Practical Approaches to transfer pricing
purposes. Cost plus approach
Opportunity cost approach to transfer pricing  Easy to calculate
From the perspective of the selling division, minimum  Covers all costs of selling division
transfer price is the higher of:
 Setting mark up is arbitrary
 External market price (less any savings due to internal
transfer)  Inefficiencies in selling division are passed on to buying
division.
 Variable cost + opportunity cost of supplying the goods.
From the perspective of the buying division, the maximum
 May lead to incongruent decisions.
transfer price acceptable is the lower of: Market price
 External market price  Easy to obtain
 Net revenue of the division. Net revenue means  Fair
ultimate selling price, less costs incurred in the buying
division. If the transfer price exceeds this, the buying  May lead to incongruent decisions (e.g. where selling
division will make a loss. division has spare capacity, and buying division buys
externally)

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 1701


TRANSFER PRICING

Dual Pricing
Where no transfer price can be found which is acceptable to
both parties, but the head office wants both divisions to trade
internally, dual pricing may be used. A higher price is
credited to the buying division, and a lower price debited to
the buying division- the head office absorbs the difference.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 1702


FURTHER READING

FURTHER READING  “Comparing budgeting techniques” by Ann Irons,


Relevant Articles in Student Accountant March 2010*

The ACCA website (www.accaglobal.com) includes the  “Behavioural Aspects of Budgeting” by Ken Garret,
following articles to paper F5. The articles can be March 2010*
downloaded from the following link:  “Materials mix and variance analysis” by Ann Irons,
http://www.accaglobal.com/en/student/qualification- March 2010 (summarised in this document)
resources/acca-qualification/acca-exams/f5-exams.
 “Exam analysis- Variances” by Louise Cookson, March
At this stage in your studies you may not have time to read 2010
all of these. Those marked with an asterisk are highly
recommended:  “Throughput accounting” by Ken Garrett, Feb 2010

 “Throughput accounting and the theory of constraints”  “Target costing and Lifecycle costing” by Ken Garrett,
(parts 1 and 2) by Ann Irons, October 2011 Feb 2010* (summarised in this document)

 “Environmental management accounting” by Ann  “Activity based costing” by Ken Garrett, Jan 2010
Irons, July 2010 (summarised in this document)*  “Approach to written questions- F5” by Ann Irons,
 “Performance measurement” by Ann Irons, July 2010 November 2009- (summarised in this document)*
(summarised in this document)*  Transfer Pricing by Ken Garrett, Oct 2009 (summarised
 “Cost volume profit analysis” by Ann Irons July 2010 in this document)
(summarised in this document)*  Not for profit organisations- Part 1 & 2, by Robert
 “Quantitative aspects of budgeting” by Ken Garret, Souster, Sept/Oct 2009
March 2010

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 1801


FURTHER READING

 “Measuring planning variances” by Geoff Cordwell, Other reading


April 2009 (summarised in this document) For both paper F5 and other ACCA papers it is useful to
 “The risks of uncertainty” by Michael Pogue April 2009 regularly read good quality financial press such as the
Financial Times or The Economist. Both can be viewed on-
 “Interpreting financial data” by Geoff Cordwell, May line:
2008 (summarised in this document)*
 www.ft.com
 “Linear Programming “by Geoff Cordwell, March 2008
 www.economist.com
 “Performance measurement” by Steve Jay, April 2004
(summarised in this document).

Examiner’s reports
These are available from the ACCA web site. The report for
the latest exam is summarised at the end of this document.
The full examiners reports can be downloaded from the
ACCA web site using the following link:
http://www.accaglobal.com/en/student/qualification-
resources/acca-qualification/acca-exams/f5-exams

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 1802


APPROACHING WRITTEN QUESTIONS

This is a summary of an article written by Ann Irons- the new Another reason for the poor pass rate is that candidates do
examiner for paper F5. Ann’s first exam will be the not understand the differences between F2 and F5. Where
December 2010 exam, but she has reviewed the June 2010 subjects that were in F2 are repeated in F5, the skills required
exam, and is involved in managing the marking of it. of you are over and above the knowledge required in F2. (See
the article “The difference between F2 and F5” published in
One of the reasons for the poor pass rate at paper F5 is
January 2010).
because the skills papers, of which paper F5 is one, are often
the firs time that students have had to tackle written Step by step approach to the exam on the day
questions. No longer is it sufficient to simply learn materials
Reading time
and churn out calculations.
During the 15 minutes reading time you should:
Candidates are required to write clearly and set out workings
logically and neatly. The following four skills are required:  Read all the requirements and the questions
 correctly interpret requirements  Think about the order in which you will do the
questions- best question first.
 actively read scenario based questions highlighting
what is relevant for each part of the requirement  Allocate the 180 minutes of exam time among the
questions.
 use that information to perform calculations that are
carefully structured and clearly set out, with workings When it comes to answering the question, be sure that you
shown in an easy-to-follow layout are strict with your time allocation. If you are spending too
long on one question it is either because you can’t do it
 write accurately and coherently using simple English anyway (in which case move on and come back to it later) or
rather than long rambling sentences that have no you are saying too much and going beyond what the
structure and no real content. examiner expected of you. How much an examiner expects
you to write is directly linked to the marks available and
therefore to the time available.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 1901


APPROACHING WRITTEN QUESTIONS

In the reading time you should have a chance to read the Estimate – suggests that the answer cannot be calculated with
requirements of all five questions. Remember the certainty. For example, when calculating the cost of a batch
requirement should be the first thing that you look at in a when there is an 80% learning rate, the learning rate itself
question. What is the point in reading a question if you don’t reflects what the business THINKS will happen, but it is not
know what you are looking for? When you read the certain until it has happened.
requirement, underline the ‘content’- for example target The mechanics of estimating and deriving are very similar to
costing, and the ‘instruction’- what it is telling you to do. calculating.
The instruction could be a variety of verbs such as calculate, Why do candidates perform poorly on the numerical parts of
describe, interpret, and discuss. The one thing that you can be Paper F5? In my opinion it is often because of failure to
sure of is that the verb has been carefully thought about by study the whole syllabus well enough in the first place.
the examiner. If you don’t read and understand the Anyone who thinks they can question spot is sadly mistaken.
instruction carefully then you will find that you are not Another reason why candidates score poorly on numerical
actually answering the question. If you are not answering the questions is because they approach the question in a
question you are not earning marks. Each of the common disorganised fashion, with no logical progression through the
exam instructions are dealt with below. calculations and no clear numbered workings. You should go
Answering numerical questions into the exam with a toolbox of the tools that are going to
help you answer the questions. For example, if it is a linear
Calculate - you just have to work something out. programming question, go into your toolbox and pull out
Derive – sometimes requires more than simply being able to your five-step guide for linear programming:
calculate a figure as a candidate is required to use their  define the variables
powers of deduction to derive something. For example derive  state the objective function
an equation showing the relationship between price and  state the constraints
quantity.
 draw the graph
 find the solution.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 1902


APPROACHING WRITTEN QUESTIONS

The problem with F5 is that students go into the exam with Outline this requires a fairly brief and well-organised
only a few tools in their ‘box’. If you put the work in, you overview, without the level of detail that would
will reap the rewards. be required in “describe”. For example ‘outline
the objectives of a budgetary control system’.
Answering wordy questions
Compare discuss similarities between two or more things
Candidates are not penalised for the fact that English may be
and draw conclusions. For example, compare
their second language. The real cause of the poor
product costs using activity based costing with
performance in written questions is that candidates appear
product costs using traditional costing. You
unable to grasp what to write and how much to write- i.e.
need to say why the costs are different. This
they don’t understand the instruction. Further clarification of
will involve looking in detail at the product
all the main instructions you would expect to find in an F5
costs and ascertaining the reason why the
exam is given below.
overheads absorbed into one product are higher
Describe give some sort of narrative about something. under one method than the other.
For example “describe suitable non financial
Identify this means pinpoint and list. It can be quite
performance indicators for a hospital” It would
simple, requiring knowledge rather than skill.
not be enough merely to list the items- you
Sometimes, however, candidates may have to
would have to go a step further and describe
identify points from within a question scenario,
how they might be calculated.
and this requires more skill.
Interpret explain in your own words and give your
opinion about it. For example “interpret the
balanced scorecard approach.” This is quite a
high level requirement that will usually be
reflected with higher marks.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 1903


APPROACHING WRITTEN QUESTIONS

Discuss this requires a candidate to give their own Justify you need to state why a particular answer or
thoughts on a subject, supporting it with facts position makes sense. For example, if you were
and logical reasoning. For example you could asked to justify the use of backflush accounting
be asked to discuss the effect that variances in an organisation, you would have to mention
have on staff motivation. The opinions you the relative immateriality of inventory.
give must be sound and well reasoned. It is no
Conclusion
good saying that variances are demotivational
for example without explaining why. Also you F5 is not an especially hard paper if candidates:
are expected to look at both sides of the story.
 work hard to gain knowledge of areas that they have not
Explain this means that you need to give a reason for practiced
something. This is a very common requirement.
 Underline the content and instruction of all
Evaluate you are being asked to decide on the merits of requirements at the beginning of each question and keep
something. This requirement would not be referring back to them.
expected to arise much in F5- most of the
evaluation is reserved for P5.  Keep practicing questions until your approach and
layout becomes second nature giving you the time in
Suggest this means give a suitable idea or solution, in the exam to think about the issues in the question.
situations where there may be more than one
answer to the question being asked. For
example, you may be asked to suggest how a
cost gap could be closed. There are many
possible ways to close a cost gap.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 1904


TARGET COSTING AND LIFECYCLE COSTING

TARGET COSTING AND LIFECYCLE COSTING product's life. This flaw is addressed by lifecycle
costing.
by Ken Garrett – 28 Apr 2011
TARGET COSTING
This is a summary of an article that appeared in the student
accountant magazine in April 2011. The full article can be Target costing is very much a marketing approach to costing.
downloaded from the ACCA web site. The Chartered Institute of Marketing defines marketing as:
Typically, conventional costing attempts to work out the cost Marketing says that there is no point in management,
of producing an item incorporating the costs of resources that engineers and accountants sitting in darkened rooms
are currently used or consumed. Once the total absorption dreaming up products, putting them into production, adding
cost of units has been calculated, a mark-up (or gross profit on, say 50% for mark-up then hoping those products sell. At
percentage) is used to determine the selling price and the best this is corporate arrogance; at worst it is corporate
profit per unit. The mark-up is chosen so that if the budgeted suicide.
sales are achieved, the organisation should make a profit.
Note that marketing is not a passive approach, and
There are two flaws in this approach: management cannot simply rely on customers volunteering
their ideas. Management should anticipate customer
1. The product's price is based on its cost, but no one
requirements, perhaps by developing prototypes and using
might want to buy at that price. This flaw is addressed
other market research techniques.
by target costing.
Therefore, instead of starting with the cost and working to
2. The costs incorporated are the current costs only. They
the selling price by adding on the expected margin, target
are the marginal costs plus a share of the fixed costs for
costing will start with the selling price of a particular product
the current accounting period. There may be other
and work back to the cost by removing the profit element.
important costs which are not part of these categories,
This means that the company has to find ways of not
but without which the goods could not have been made.
exceeding that cost.
Examples include the research and development costs
and any close down costs incurred at the end of the

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 2001


TARGET COSTING AND LIFECYCLE COSTING

For example, if a company normally expects a mark-up on Here are some of the decisions, made at the design stage,
cost of 50% and estimates that a new product will sell which can affect the cost of a product:
successfully at a price of $12, then the maximum cost of
production should be $8:  The features of the product

Cost + Mark-up = Selling price  How to avoid 'over design'


100% 50% 150%  The number of components needed
$8 $4 $12
 Whether the components are standard or specialised
This is a powerful discipline imposed on the company. The
main results are:  The complexity of machining and construction

 The establishment of multifunctional teams consisting  Where the product can be made
of marketing people, cost accountants, production  What to make in-house and what to sub-contract
managers, quality control professionals and others.
These teams are vital to the design and manufacturing  The quality of the product
decisions required to determine the price and feature
combinations that are most likely to appeal to potential  The batch size in which the product can be made.
buyers of products. You will see from this list that ABC can also play an
important part in target costing. By understanding the cost
 An emphasis on the planning and design stage. This
drivers (cost causers) a company can better control its costs.
becomes very important to the cost of the product
For example, costs could be driven down by increasing batch
because if something is designed such that it is
size, or reducing the number of components that have to be
needlessly expensive to make, it does not matter how
handled by stores.
efficient the production process is, it will always be a
struggle to make satisfactory profits.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 2002


TARGET COSTING AND LIFECYCLE COSTING

The concept of value engineering (or value analysis) can be LIFECYCLE COSTING
important here. Value engineering aims to reduce costs by
As mentioned above, target costing places great emphasis on
identifying those parts of a product or service which do not
controlling costs by good product design and production
add value - where “value” is made up of both:
planning, but those up-front activities also cause costs. There
 Use value (the ability of the product or service to do might be other costs incurred after a product is sold such as
what it sets out to do - its function) and warranty costs and plant decommissioning. When seeking to
make a profit on a product it is essential that the total revenue
 Esteem value (the status that ownership or use confers). arising from the product exceeds total costs, whether these
The aim of value engineering is to maximise use and esteem costs are incurred before, during or after the product is
values while reducing costs. produced. This is the concept of lifecycle costing, and it is
important to realise that target costs can be driven down by
For example, if you are selling perfume, the design of its attacking any of the costs that relate to any part of a product's
packaging is important. The perfume could be held in a plain life. The cost phases of a product can be identified as:
glass (or plastic) bottle, and although that would not damage
the use value of the product, it would damage the esteem Phase Examples of types of cost
value. The company would be unwise to try to reduce costs Design Research, development, design and tooling
by economising too much on packaging.
Manufacture Material, labour, overheads, machine set up,
Similarly, if a company is trying to reduce the costs of inventory, training, production machine
manufacturing a car, there might be many components that maintenance and depreciation
could be satisfactorily replaced by cheaper or simpler ones
without damaging either use or esteem values. However, Operation Distribution, advertising and warranty claims
there will be some components that are vital to use value End of life Environmental clean-up, disposal and
(perhaps elements of the suspension system) and others decommissioning
which endow the product with esteem value (the quality of
the paint and the upholstery).

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 2003


TARGET COSTING AND LIFECYCLE COSTING

There are four principal lessons to be learned from lifecycle example, the design specifies 10 units of a certain
costing: component, negotiating with suppliers is likely to have only a
small overall effect on costs. A bigger cost decrease would
 All costs should be taken into account when working be obtained if the design had specified only eight units of the
out the cost of a unit and its profitability. component. The design phase locks the company in to most
 Attention to all costs will help to reduce the cost per future costs and it this phase that gives the company its
unit and will help an organisation achieve its target cost. greatest opportunities to reduce those costs.

 Many costs will be linked. For example, more attention


to design can reduce manufacturing and warranty costs. Ken Garrett is a freelance lecturer and author
More attention to training can reduce machine
maintenance costs. More attention to waste disposal
during manufacturing can reduce end-of-life costs.
 Costs are committed and incurred at very different
times. A committed cost is a cost that will be incurred
in the future because of decisions that have already
been made.
 Costs are incurred only when a resource is used.
Typically, the following pattern of costs committed and costs
incurred is observed:
By the end of the design phase approximately 80% of costs
are committed. For example, the design will largely dictate
material, labour and machine costs. The company can try to
haggle with suppliers over the cost of components but if, for

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 2004


ENVIRONMENTAL MANAGEMENT ACCOUNTING

ENVIRONMENTAL MANAGEMENT ACCOUNTING environment, although sometimes it is only possible to


provide benefit to one of these parties.
This is a summary of the article that was published in Student
Accountant magazine, written by the examiner Ann Irons. Example
Introduction to environmental management accounting Activity-based costing may be used to ascertain more
accurately the costs of washing towels at a gym. The energy
Environmental management accounting (hereafter “EMA”) is
used to power the washing machine is an environmental cost;
a sub-set of management accounting. Management accounts
the cost driver is ‘washing’.
give us an analysis of the performance of the business and
are ideally prepared on a timely basis so that we get up-to- Once the costs have been identified and information
date management information. They break down each of our accumulated on how many customers are using the gym, it
difference business segments (in a larger business) in a high may actually be established that some customers are using
level of detail. This information is then used to assess how more than one towel on a single visit to the gym. The gym
the business’ historic performance has been and, moving could drive forward change by informing customers that they
forward, how it can be improved in the future. need to pay for a second towel if they need one. Given that
this approach will be seen as ‘environmentally-friendly’,
EMA focuses on things such as the cost of energy and water
most customers would not argue with its introduction. Nor
and the disposal of waste and effluent, including both
would most of them want to pay for the cost of a second
financial costs as well as cost versus benefit issues related to
towel. The costs to be saved by this new policy would
buying from suppliers who are more environmentally aware
include both the energy savings from having to run fewer
or the effect on the public image of the company from failure
washing machines all the time and the staff costs of those
to comply with environmental regulations.
people collecting the towels and operating the machines.
EMA uses some standard accountancy techniques to identify, Presumably, since the towels are being washed less
analyse, manage and hopefully reduce environmental costs in frequently, they will need to be replaced by new ones less
a way that provides mutual benefit to the company and the often as well.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 2101


ENVIRONMENTAL MANAGEMENT ACCOUNTING

Additionally, the environment can benefit as less power and by a person, organization, event or product. Second,
cotton (i.e. material for towels) is now being used, and the environmental costs are becoming huge for some companies
scarce resources of our planet are therefore being conserved. (in some cases amounting to more than 20% of operating
Lastly, the gym is also seen as an environmentally friendly costs); particularly those operating in highly industrialized
organization and this, in turn, may attract more customers sectors such as oil production. These need to be managed.
and increase revenues. Third, regulation is increasing worldwide at a rapid pace,
with penalties for non-compliance also increasing
Definition of EMA
accordingly. Its not just the companies, officers – even junior
There is no one single definition, but a widely accepted one employees – could find themselves facing criminal
that was adopted by the IFAC (International Federation of prosecution for knowingly breaching environmental
Accountants) in its 2005 international guidance document on regulations.
EMA: “EMA is the identification, collection, analysis and
The management of environmental costs is difficult, mainly
use of two types of information for internal decision making:
for the three reasons outlined below.
i) physical information on the use, flows, and destinies of
energy, water and materials (including waste), and ii) A) It is difficult to define EMA and the actual costs
monetary information on environmental-related cost, involved. Many organizations vary in their definition of
earnings and savings.” environmental costs. The US Environmental Protection
Agency stated that the definition of environmental costs
Importance of the environment to business
depended on how an organization intended on using the
There are three main reasons why the management of information. They made a distinction between four
environmental costs is becoming increasing important in types of costs: conventional costs such as raw materials
organizations. First, society as a whole has become more and energy, potentially hidden costs captured by
environmentally aware, with people becoming increasingly accounting systems but getting hidden in ‘general
aware about the ‘carbon footprint’ and recycling taking place overheads’, contingent costs such as site clean up costs,
now in many countries. A ‘carbon footprint’ measures the and image and relationship costs that by their nature are
total greenhouse gas emissions caused directly and indirectly intangible. On the other hand, the United Nations

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ENVIRONMENTAL MANAGEMENT ACCOUNTING

Division for Sustainable Development (UNDSD) scrap and 18kg discarded as waste. Flow cost
described environmental costs as comprising of two accounting uses not only material flows but also the
components: costs incurred to protect the environment organizational structure. It divides material flows into
such as measures taken to prevent pollution, and costs three categories: material, system, and, delivery and
of wasted material, capital and labour including disposal. The values and costs of each of the three are
inefficiencies. These definitions do not contradict each calculated. The aim of flow cost accounting is to reduce
other; they just look at the costs from slightly different the quantity of materials which, as well as having a
angles. As a Paper F5 student, you should be aware that positive effect on the environment, should have a
definitions of environmental costs vary greatly, with positive effect on a business’ total costs in the long run.
some being very narrow and some being far wider. Activity-based costing allocates internal costs to cost
centres and cost drivers on the basis of the activities that
B) Many of the environment costs captured by the
give rise to the costs. It distinguishes between
accounting system are difficult to separately identify as
environmental-related costs, which can be attributed to
they are found within the category of ‘general
joint cost centres, and environment-driven costs, which
overheads’. Time and effort is needed to separate them
tend to be hidden on general overheads. Life cycle
and allocate them to the product or process, which gave
costing is a technique that requires the full
rise to them. The UNDSD identified four management
environmental consequences, and, therefore, costs,
accounting techniques for the identification and
arising from production of a product to be taken
allocation of environmental costs: input/output analysis,
account across its whole lifecycle.
flow cost accounting, activity based costing and
lifecycle costing. The input/output analysis records
material inflows and balances this with material
outflows on the basis that what comes in must go out.
So, if 100 kg of materials are purchased and only 80kg
of materials have been produced then the 20kg need to
be accounted for in some way, perhaps 2kg sold as

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 2103


ENVIRONMENTAL MANAGEMENT ACCOUNTING

C) It is only after environmental costs have been defined, iii) Energy - EMA may help to identify inefficiencies
identified and allocated that a business can begin the and wasteful practices and, therefore,
task of trying to control them. Lets consider an opportunities for cost savings.
organization whose main environmental costs are: i)
iv) EMA can help to generate cost savings in
waste and effluent disposal, ii) water consumption, iii)
Transport and travel. At a basic level, a business
energy, iv) transport and travel, and v) consumables and
can invest in more fuel-efficient vehicles.
raw materials.
v) Consumables and raw materials costs are usually
i) Waste – there are lots of environmental costs
easy to identify and discussions with senior
associated with waste. For example, the costs of
managers may help to identify where savings can
unused raw materials and disposal; taxes for
be made. For example toner cartridges for printers
landfill; fines for compliance failures such as
can be refilled instead of replaced. This should
pollution. It is possible to identify how much
result in a financial saving and better for the
material is wasted in production by using the
environment as toner cartridges are difficult to
‘mass balance’ approach, whereby the weight of
dispose of.
materials bought is compared to the product yield.
From this process, potential cost savings may be
identified. In addition to these monetary cost
items, waste has environmental costs in terms of
lost land resources (because waste has been
buried) and the generation of greenhouse gases in
the form of methane.
ii) Water is actually paid for twice by businesses –
first to buy it and second to dispose of it. So the
organization needs to identify where water is used
and how consumption can be decreased.

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 2104


MATERIALS MIX AND YIELD VARIANCE ANALYSIS

MATERIALS MIX AND YIELD VARIANCE quality controls have been introduced resulting in more items
ANALYSIS being rejected.
This is a summary of the article written by Ann Irons that Further variance analysis where several materials are
was published in the Student Accountant Magazine. The used
calculations have been reworked using the approach taken in
Most products comprise of several different materials, so the
the ATC International Study system for the purpose of
more detailed mix and yield variances can be calculated. It
consistency.
may be possible to combine different levels of the component
Material usage variance materials to make the same product. This in turn may result
in differing yields. When we talk about material mix, we are
As a reminder, let’s recap on what the material usage
referring to the quantity of each material that is used to make
variance is and how it is calculated. The material usage
our product i.e. we are referring to our inputs. When we talk
variance analyses the difference between how much actual
about yield on the other hand we are talking about how much
material we have used for are production relative to how
of our product is produced- i.e. our output.
much we expected to use based on standard usage levels. So,
for example, if we had made 5,000 items using 11,000 litres Materials mix variance
of material A and out standard material usage is only 2litre
The optimum mix of materials will be the one that balances
per item, then we clearly used 1,000litre more than we
the cost of each of the materials with the yield that they
expected to. In terms of how we value the difference, it must
generate. The yield must also reach certain quality standards.
be at standard cost. Any difference between the standard and
actual cost would be dealt with by the material price For example, chemical C uses both chemicals A and B to
variance. make it. Chemical A has a standard cost of $20 per litre and
chemical B has a standard cost of $25 per litre.
There can be many reasons for an adverse material usage
variance. It may be that inferior quality materials have been Let us assume that the standard mix has been set: 8 litres of
purchased- perhaps at a lower price. It may be that changes in A and 12 litres of B will yield 19 litres of C. The standard
the production process have been made, or that increased cost for 1 litre of C is therefore $24.21 (8 × 20 + 12 × 25).

©2012 DeVry/Becker Educational Development Corp. All rights reserved. 2201


MATERIALS MIX AND YIELD VARIANCE ANALYSIS

If the cost of materials A and B changes, production As a student I was never a person to blindly learn formulae
managers may deviate from the standard mix. Managers may (for variances) and rely on these to get me through. I truly
simply fail to adhere to the standard mix for whatever reason. believe that the key to variance analysis is to understand what
This would result in a materials mix variance. is actually happening. If you understand what the materials
mix variance is trying to show, you will work out how to
Let us assume now that production of C commences. 1,850
calculate it.
litres of C is produced using a total of 900 litres of A and
1,100 litres of B (2,000 litres in total). The actual costs of A Why haven’t I considered the fact that although our materials
and B were at the standard costs of $20 and $25 per litre mix variance is $500 favourable our changed materials mix
respectively. How do we calculate the mix variance? may have produced less of C than the standard mix? Because
this of course is where the materials yield variance comes
Actual
into play.
Actual quantity
quantity in standard Materials yield variance
used mix Difference Variance
Where there is a difference between the actual and standard
litres litres litres $
level of output for a given set of inputs, a material yield
A 900 800 (100) (2,000)
variance arises. In our optimum mix, we calculated that
B 1,100 1,200 100 2,500
20litres of inputs A and B (8 litres of A and 12 litres of B)
–––––– –––––– –––––– ––––––
should produce 19litre of our output C. We are effectively
2,000 2,000 0 500 favourable
saying that there is a loss rate of 5% (1/20) in our process.
–––––– –––––– –––––– ––––––
Applying this to our example we can say that we would have
Remember it is essential that for every variance you expected our inputs of 2,000 litre to yield an output of
calculate, you state whether it is favourable or adverse. These 1,900litre (2,000 × 95%).
can be denoted by a clear ‘A’ or ‘F’ but avoid showing an
adverse variance by simply using brackets. This leads to
mistakes.

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MATERIALS MIX AND YIELD VARIANCE ANALYSIS

The yield variance is: Understanding the bigger picture


Expected output 1,900 litres Quality issues cannot be dealt with by this variance analysis.
Actual output 1,850 litres It is essential to understand the importance of producing
–––––– products that are of consistently good quality. It can be
Shortage 50 litres tempting for production managers to change the product mix
X standard cost per litre of output 24.21 in order to make savings; these savings may lead to greater
–––––– bonuses for them at the end of the year. However, if the
Yield variance (adverse) 1,210.5 quality of the product is adversely affected, this is damaging
to the reputation of the business and hence its long term
The variance is adverse because the actual yield (output) was survival prospects.
less than expected.
Unfortunately this factor cannot be incorporated into the
Making observations about variances materials yield variance. In the long run it may be deduced
from an adverse sales volume variance, as demand for the
It can be seen that there is a direct relationship between our
businesses products decreases, but it is likely to take some
materials mix variance and our materials yield variance. By
time for sales volumes to be affected. Any sales volume
using a mix of materials that was different from standard we
variance that does arise as a result of poor quality products is
have resulted in a saving of $500. However, our cheaper mix
likely to arise in a different period from the one in which the
of materials has resulted in a significantly lower yield- the
mix and yield variances arose, and the correlation will then
yield was $1,211 lower than it would have been which is
be more difficult to prove.
over double the amount that we saved by using a cheaper mix
of materials. Overall, by netting the two variances off
against each other, we have an adverse material usage
variance of $711 ($1,211 A less $500 F).

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MATERIALS MIX AND YIELD VARIANCE ANALYSIS

Similarly, poor quality materials may be more difficult to


work with. This may lead to an adverse labour efficiency
variance as the workforce takes longer than expected to
complete the work. This in turn could lead to higher
overhead costs and so on. Fortunately, consequences such as
these will occur in the same period as the mix and yield
variance and are therefore more likely to be identified and the
problem resolved.
Never underestimate the extent to which a perceived
‘improvement’ in one area (e.g. a favourable materials mix
variance) can lead to a real deterioration in another area (e.g.
decreased yield, poorer quality, higher labour costs, lower
sales volumes, and ultimately lower profitability). Always
make sure you mention such interdependencies when
discussing your variances in exam questions. The number
crunching is relatively simple once you understand the
principles; the higher skills lie in the discussion that
surrounds the numbers.

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MEASURING PLANNING VARIANCES

MEASURING PLANNING VARIANCES – In exams, the information would be given in the form of a
BY GEOFF CORDWELL scenario, rather than in a table as above. Students would be
expected to be able to interpret the information given in the
This is a summary of an article prepared by the previous
table so as to prepare their own table.
examiner for F5, Geoff Cordwell. The full article can be
downloaded from the ACCA web site. Planning variances
There are many possible ways of calculating planning The examiner believes that planning variances should be
variances. This article sets out the examiner’s preferred based on the actual level of output, rather than on the original
approach, based on the example given. budgeted level of output.
Example Material price planning variance
The following information is given regarding the standard Actual output × revised budget materials per unit
cost of artificial snow for a ski resort. After the original × revised budget price per kilo
budget had been prepared the subsequent improvements in (11,000 × 9.5 × 4.85) 506,825
technology lead to manufacturers reducing their prices to Actual output × revised budget materials per unit
$4.85 per kilo. This was considered to be a fair target, so the × original budget price per kilo
standard was revised. The standard usage was also revised. (11,000 × 9.5 × 5) 522,500
Original Revised Actual –––––––
Budget Budget spending Material planning price variance (favourable) 15,675
(Ex-ante) (Ex-post) –––––––
Material price per kilo ($) 5 4.85 4.75
Material per unit (kilos) 10 9.5
Material used (kilos) 108,900
Production (units) 10,000 10,000 11,000

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MEASURING PLANNING VARIANCES

Material usage planning variance Interpretation


Actual output × revised budgeted materials Operational variances (calculated as normal, using the
per unit (11,000 × 9.5) 104,500 revised standard instead of the original standard) are the only
Actual output × original budgeted materials variances within management control, so they alone should
per unit (11,000 × 10) 110,000 be used to assess the performance of management.
––––––– Care must be taken when revising standards- managers may
Variance (Kilos) 5,500 wish to manipulate the operational variances- for example by
Original budget price per kilo 5 not revising the standard price downward- this would result
––––––– in a more favourable operational price variance.
Variance $ (Favourable) 27,500
–––––––
Total variance: (15,675 + 27,500) 43,175

This can be proved as follows:

Original budgeted cost of 11,000 units


(11,000 × 5 × 10) 550,000
(Ex post budget flexed)
Revised budgeted cost of 11,000 units
(11,000 × 4.85 × 9.5) 506,825
–––––––
Difference 43,175

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PERFORMANCE MEASUREMENT

PERFORMANCE MEASUREMENT a country where the average rate of inflation is around 1%


per annum.
This is a summary of an article written by the examiner Ann
Irons in student accountant magazine. The full article can be Table 1: Tip’s financial results 2008 and 2009
downloaded from the ACCA web site.
2008 2009
This article will focus on a classic performance measurement $ $
question, which involves a combination of financial and non- Sales 5,250,000 5,320,000
financial analysis. I will take you through the performance Less expenses:
measurement question that appeared in the December 2009 Wages 2,500,000 2,200,000
paper, step by step, showing you how I would expect such a Maintenance – routine 80,000 70,000
question to be answered. Repairs 260,000 320,000
Directors salaries 150,000 160,000
The question read as follows:
Directors bonuses 15,000 18,000
Thatcher International Park (TIP) is a theme park and has for Other costs (including depreciation) 1,200,000 1,180,000
many years been a successful business, which has traded ––––––––– ––––––––
profitably. About three years ago the directors decided to Net profit 1,045,000 1,372,000
capitalise on their success and reduced the expenditure made ––––––––– ––––––––
on new thrill rides, reduced routine maintenance where Book value of assets at start of year 13,000,00012,000,000
possible (deciding instead to repair equipment when it broke Dividend paid 500,000 650,000
down) and made a commitment to regularly increase Number of visitors 150,000 140,000
admission prices. Once an admission price is paid customers
can use any of the facilities and rides for free. These steps
increased profits considerably, enabling good dividends to be
paid to the owners and bonuses to the directors. The last two
years of financial results are shown opposite. TIP operates in

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PERFORMANCE MEASUREMENT

One of the key areas of the paper F5 syllabus is that of Required:


performance measurement and control it is perhaps more
(b) Assess the quality of the service that TIP provides to
integral to the whole area of performance management than
its customers using Table 1 and any other relevant
any other topic examined under the syllabus.
data and indicate the risks it is likely to face if it
Required: continues with its current policies. (6 marks)
(a) Assess the financial performance of TIP using the (20 marks)
information given above. (14 marks)
Breaking down the question
During the early part of 2008 TIP employed a newly
It is clear from the way that the requirements are split that
qualified management accountant. He quickly became
Part (a) is asking about financial performance and Part (b) is
concerned about the potential performance of TIP and to
asking about non-financial performance. Broadly speaking,
investigate his concerns he started to gather data to measure
you should, therefore, keep the majority of your comments
some non-financial measures of success. The data he has
about non-financial aspects to Part (b).
gathered is shown in Table 2 below:
(a) assess the financial performance of TIP using the
Table 2: TIP’s non-financial measures of success
information given above
2008 2009
Before any kind of comment can be made about financial
Hours lost due to breakdown of rides
performance, it is important to perform some preliminary
(Note 1) 9,000 hours 32,000 hours
calculations in order to ascertain what the relative
Average waiting time per ride 20 minutes 30 minutes
movements have been from 2008 to 2009.
Note 1: TIP has 50 rides of different types. It is open 360
days of the year for 10 hours each day. You should note that it will rarely be appropriate to look at
numbers in absolute rather than relative terms. In this type of
question, it makes most sense to look at the percentage
increase or decrease in each of our figures from 2008 to

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PERFORMANCE MEASUREMENT

2009. This has been done in the section headed ‘Workings’ 2009: $5,320,000/140,000 = $38 per person
below.
An increase of $38/$35 = 8.57%
You will see that I haven’t performed a calculation for ‘other
(W3) Directors pay up by $160,000/$150,000 = 6.7%
costs’. This is because the movement in it from year to year
is so small that it is not worth mentioning. Our movement in (W4) Directors bonuses levels up from $15,000/$150,000 or
sales, on the other hand, is also relatively small but has been 10% to $18,000/$160,000 or 12.5% of turnover. This is an
mentioned. increase of 20%
The reason for this is that, first, sales in a key figure and (W5) Wages are down by ($2,500,000 –
can’t be ignored and secondly, we know enough about other $2,200,000/$2,500,000) or 12%
things going on in the business (e.g. reduction in the number
(W6) Routine maintenance down by ($80,000 -
of visitors) in order to be able to draw valid conclusions
about sales. I have set out my workings as I would like to see $70,000)/$80,000 = 12.5%
them in your exam scripts, namely, all labelled up with a (W7) Repairs up by ($320,000- 260,000)/$260,000 = 23%
working reference. While, in the real world, such analysis
would be expected to appear after any commentary as a kind (W7) Loss of customers is (150,000 – 140,000/150,000) =
of appendix, since you are not being asked for a report here it 6.7%
doesn’t really matter whether you show them at the (W9) Profits up by $1,372,000/$1,045,000 = 31.3%
beginning or end of your answer.
(W8) Return on assets:
Workings:
2008: $1,045,000/$13,000,000 = 8.03%
(W1) Sales growth is $5,320,000/$5,250,000 = 1.3%
2009: $1,372,000/$12,000,000 = 11.4%
(W2) Average admission prices were:
2008: $5,250,000/150,000 = $35 per person

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PERFORMANCE MEASUREMENT

Using the calculations you have prepared and setting out Sales
your answer
These have increased by 1.3% (W1) in the year. This is good.
It may surprise you, as indeed it surprised me, to find that a
The second answer is slightly better than the first because it
number of candidates got no further on this question than
references the percentage increase to the workings and also
performing the calculations above. These calculations, whilst
makes a comment about the increase. However, what does
essential to answering the question, would only ever be worth
‘good’ mean? How can we say whether a 1.3% increase in
a relatively small number of the marks and are merely a
sales is good or bad if we don’t refer to inflation rates (if
starting point. ‘Assessing the financial performance’ means
provided in the question, as in this case), admission prices
discussing it and commenting on in what respects it is poor
and visitor numbers? Whenever you are making a comment,
or maybe strong.
ask yourself: ‘Why do I care? Why is it important?’ This will
It is important that your answer does not become ‘a sea of help you to follow your thoughts through. A good answer for
words’, i.e. just pages of writing with no headings and no sales would read as follows:
structure. In this case, your headings could be taken from
Sales
your workings, e.g. ‘sales’, ‘directors’ pay and bonuses’ etc.
You should then start your discussion of each point by first Sales have increased by 1.3% (W1) in 2009, as compared to
referring to the calculation that you have performed in the 2008. Since inflation was 1%, the increase is barely above
relevant working. It is critical that, having referred to the the inflation rate. This means that, in real terms, sales have
percentage movement in the figure under discussion from hardly increased at all. From the financial information
year to year, you don’t just leave it like that. For example, a provided, we can see that the number of visitors in 2009 has
poor answer on sales would be this: fallen from 150,000 to 140,000. This means that the average
admission price in 2009 was $38 per person, compared to
Sales
$35 per person in 2008, an increase of 8.57% (W2). While it
These have increased by 1.3% in the year. is good that the company has been able to secure an increase
in admission price, it is not good that this has potentially
A poor, but slightly less poor answer might read:
been partly responsible for a fall in visitor numbers.

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PERFORMANCE MEASUREMENT

You can see that the good answer starts with the percentage about the effect of this on quality of service and risks in Part
increase in sales from the workings and adds to it other (a), since we would then be stepping into the requirement of
information from the question or from the workings that is Part (b), it should be mentioned in passing.
relevant to the figure being discussed (in this case, inflation
So, a poor answer to this part of the question would be this.
and admission prices). Only then is it possible to make
comments that have any kind of validity. Routine maintenance costs
To further emphasise the importance of looking at the overall These have fallen by 12.5%, which is a good reduction.
picture rather than one figure in isolation, let’s look at
‘maintenance and repairs’. Routine maintenance costs have Repair costs
fallen by 12.5%. On the face of things, this looks good. These have increased by 23%, which is substantial.
However, we cannot comment on maintenance costs without
considering how repair costs have been affected. These have A good answer, on the other hand, would read something like
increased by 23%. We also need to go further here and this:
comment on the actual amounts involved (or look at the total Routine maintenance and repair costs
costs for maintenance and repairs and comment on the total
percentage increase). While maintenance costs have In 2009, routine maintenance costs fell by 12.5% (W6), a fall
decreased by a mere $10,000, repairs have increased by of $10,000. At the same time, however, repair costs increased
$60,000. This tells us nearly everything we need to know 23% (W7), a $60,000 increase. By looking at these two
about what has happened. It is clear that, because routine figures together, and the fact that hours due to lost
maintenance has not been carried out, machines are breaking breakdown of rides increased from 9,000 hours in 2008 to a
down and repairs are, therefore, required. huge 32,000 hours in 2009, one can only conclude that the
lack of routine maintenance was a poor decision and is
This assessment is further supported by the non-financial costing the business dearly in terms of increased repair costs
information, which tells us that the hours due to breakdown and problems with the rides. The decision to reduce
of rides has increased from 9,000 hours in 2008 to 32,000 maintenance by the company needs to be reviewed urgently.
hours in 2009. Although it would be inappropriate to talk

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PERFORMANCE MEASUREMENT

By this point, it is hopefully clear that there is little point in Time spent thinking rather than writing is time well spent.
simply doing a few calculations and making meaningless
In this particular question, the examiner has basically told
comments. In questions on performance measurement, you
you what headings to use by using italics for the words
need to look at each figure as part of an overall set of data,
‘quality’ and ‘risks’. The fact that you are being asked about
bringing other data in where relevant. A figure in isolation,
qualitative aspects of the situation means that you are
such as sales, tells us little about what has really happened
obviously being asked about non-financial performance.
during the year. It is only by bringing other information in
Most of the information that is relevant to this discussion has
that any true assessment on financial performance can be
already been given to you in the question (number of visitors,
made.
hours due to breakdown of rides and average waiting time). It
This principal can equally be applied to any assessment of is also possible (although not essential) to work out lost
non-financial performance, as considered below. capacity in 2008 and 2009, i.e. percentage of hours lost out of
total hours available in order to make a year on year
Part (b) assess the quality of the service that TIP provides to
comparison. This would be done as follows:
its customers using table 1 and any other relevant data and
indicate the risks it is likely to face if it continues with its Capacity of rides in hours is 360 days × 50 rides × 10 hours
current policies. per day = 180,000
Once again, it is important that you adopt some kind of 2008 lost capacity is 9,000/180,000 = 0.05 or 5%
structure for your answer, rather than just producing a ‘sea of
2009 lost capacity is 32,000/180,000 = 0.177 or 17.8%
words’. By using the structure of headings, you make
yourself focus on what the requirement is actually asking you When discussing quality, it is important to ask yourself the
to do. This should stop you from ‘rambling’, i.e. talking question: ‘In a business like this, what affects my enjoyment
about things that are not being asked of you and not relevant. of the service?’ The answer will be – how many rides are
Whenever I used to answer exam questions, I would refer available to ride on and how long I have to queue each time.
back to the requirement many times while writing, constantly The reliability of the rides and average queuing time are
asking myself: ‘Am I answering the question?’ therefore appropriate subheadings. You could also mention

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PERFORMANCE MEASUREMENT

that the rides need to be safe as well, or you could leave this Summary
to your discussion on risks.
 Present calculations in a referenced list
Then, when discussing ‘risks’ in the second part of your
answer to Part (b), you need to think about what the potential  Don’t consider any one piece of information or number
outcomes of the current policies are. In order to answer this, in isolation
you first need to have a clear idea about the policies that have  Use headings wherever possible and avoid writing ‘a
been adopted. These are mentioned in the preamble of the sea of words’
question and include reduced expenditure on new rides, a
move from routine maintenance to reactive repairs and an  When you are writing a statement, e.g. ‘sales have
increase in prices. Where you are giving a number of points increased by 1.3%’ always ask yourself the question
in an answer, like here, it is useful to bullet point them. This ‘why do I care?’ This will help you make a meaningful
not only makes your answer easier to mark, but it makes you point and take a thought through to its logical
aware of how much you are saying. conclusion.
Regarding this last point – how much you should say in  Read all the requirements and make sure that you don’t
performance measurement questions – you should be largely start talking about, e.g. requirement (b) in requirement
guided by the marks available. Part (b) is only worth five (a), as you will then find that you have nothing to say
marks so it warrants substantially less time being spent on it when you get to requirement (b).
than Part (a). Often in these types of questions, there is far
more you could say than the time that is available. This is  Use the marks available as a guide as to how much to
particularly the case in Part (a) here. The key is to get good write. There are no set marking rules such as ‘one mark
coverage. It is pointless, for example, to spend half of your per valid point’. Marks vary from question to question.
time discussing sales in Part (a), meaning that you don’t get Ann Irons is examiner for Paper F5
enough time to cover all the other key figures. Your answers
must always be balanced.

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INTERPRETING FINANCIAL DATA

Interpreting financial data In most questions there will be some background information
– you should use it. Ties only operated in a competitive
This is a summary of an article written by the previous
environment – as stated in the question – and so a 61%
examiner and was published in the May 2008 Student
increase in one-quarter sounds pretty good in a competitive
Accountant. The full article can be downloaded from the
situation, and to say so will earn a mark. It was also the first
ACCA web site.
two quarters of the business year and so this level of growth
The purpose of this article is to point students in the right is impressive – another mark. If you then go on to say that
direction when studying the interpretation of financial data – such high growth rates are often hard to maintain, you will
which is a major topic in the Paper F5 syllabus. gain another mark. Top-scoring students should be aiming to
make these kinds of observations.
Students are advised to look at the question “Ties only” while
reading this article, as extracts from the question are used to Hypothesising as to why the growth is happening is also a
illustrate points and explain the techniques needed. source of marks. Revenue growth can be the result of extra
volume or increasing prices. In the case of Ties Only, it is
Tutors note: the question “Ties only” is included in the Study
much more likely to be increased volume; the price will
Question Bank.
surely be constrained by competition, and from the
Assessing financial performance information provided in Part (b), you can work out that prices
are falling (although that calculation was not required).
Candidates were asked to assess the financial performance of Suggesting that Ties Only has secured more customers, and
the business in its first two quarters, when sales had jumped hence increased volume of sales, scored a mark.
61% from Quarter 1 to Quarter 2. This calculation should
present no problem ((Q2/Q1)-1) expressed as a % increase). Candidates must be brave and commit themselves. You must
However, an “assessment” requires a qualitative comment or express an opinion. It is not acceptable to suggest that
two. A percentage alone will not gain a pass mark. management investigate. Although in the real world this may
well happen, in the exam hall you have to demonstrate that
you know where to look.

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PERFORMANCE MEASUREMENT AND THE BALANCED SCOREDCARD

PERFORMANCE MEASUREMENT  Typical financial performance measures for divisions,


This section is a summary of an article by Steve Jay. The depending on the type of division are as follows:
full article can be read on the ACCA web site, by  Cost centre- standard costing variances
navigating towards the technical articles relevant to
paper F5.  Profit centre- controllable profit
Decentralisation is the delegation of decision-making  Investment centre- return on investment and residual
responsibility. Nowadays, it would be impossible for one income.
person to make all the decisions, even in a small company-
Cost centres
hence senior managers delegate decision making
responsibility to subordinates. For standard costing variances, problems include:
One danger of decentralisation is that managers may make  Focuses on short term cost minimisation- this may
decisions that are not in the best interests of the overall conflict with objectives such as quality
company- so called dysfunctional decisions.
 Deciding who is responsible for the variance- for
A good performance measure should: example, is the production manager or the purchasing
 Provide an incentive for the divisional manager to make manager responsible for material purchase variances.
decisions which are in the best interests of the overall  Setting standards in the first place is difficult.
company (goal congruence)
Profit centres
 Only include factors for which the manager/ division
can be held accountable When assessing the performance of a divisional manager, we
should consider only the costs and revenues that are under
 Recognise the long-term objectives as well as the short- the control of that manager (controllable divisional profit).
term objectives of the organisation. When assessing the performance of the division, we should
look at costs and revenues traceable to the division (traceable

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PERFORMANCE MEASUREMENT AND THE BALANCED SCOREDCARD

divisional profits). For example, depreciation of machinery Division X’s cost of capital is 10%.
would be a cost that is traceable to the division, but is not
Required:
controllable by the manager, because the manager of a profit
centre does not make investment decisions. Calculate the current ROI and residual income of the
division. Show how they would change under each of the
Investment centres
proposals.
Two measures commonly used for investment centre
Solution
managers are return on investment and residual income.
Current situation
Return on investment (ROI) =
Controllable (traceable) profit 2.2million
ROI = = 22%.
controllable (traceable) investment 10million

Residual income = controllable (traceable) profit – imputed Residual income: = 2.2 million – (10 million × 10%) = $1.2
interest charge on investment. million.

Example If proposal 1 is accepted

Division X currently has net assets of $10 million and profits 2.2million + 0.15million 2.35million
ROI = = 21.4%
of $2.2 million per annum. It is considering two proposals: 10million + 1million 11million
Proposal 1- an investment in assets of $1 million to earn an Residual income = 2.35million – (11 million × 10%) = 1.25
additional profit of $0.15 million. million.
Proposal 2- selling non current assets at their net book value Comment-
of $2.3 million. This would reduce profits by 0.3 million. The
0.15million
proceeds from sale would be remitted to head office (i.e. they The return of the proposal is = 15%.
would reduce divisional investment.) 1million

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PERFORMANCE MEASUREMENT AND THE BALANCED SCOREDCARD

Since the return on the proposal is greater than the cost of Relative merits of ROI and residual income
capital of the company, from the overall company point of
view, the proposal should be accepted. If the manager of the  ROI is a relative measure. This ignores the absolute
division is judged on ROI however, the proposal may be profit- for example an investment of $100 invested at
rejected, as it would reduce the divisional ROI from the 25% would only generate $25, while an investment of
current 22% to 21.4%. Thus the use of ROI can result in $1 million invested at a rate of 15% generates
dysfunctional behaviour. The proposal generates positive $150,000. Which would you prefer?
residual income however, so would be accepted by a  Residual income is consistent with net present value
manager who is judged using this criterion. approach to investment appraisal. This is the
If proposal 2 is accepted theoretically superior way to make investment
decisions. (Net present value is not in the syllabus for
2.2million − 0.3million paper F5).
ROI = = 24.7%
10million − 2.3million
 On the other hand residual income makes it difficult to
Residual income = 1.9million – (7.7 million × 10%) = 1.13 compare the performance of divisions of different sizes.
million.
 Both methods suffer from the fact that if assets are
Comment valued at net book value, the ROI and residual income
This proposal should be rejected, as the return on the assets improve as the assets get older. This may encourage
disposed of is 13%. If ROI were used as the performance managers to retain old machinery.
measure, however, the proposal would be accepted as it
increases the divisions ROI. If residual income were used,
the proposal would be rejected.
Conclusion- in both cases, ROI has lead to dysfunctional
behaviour, while the use of residual income has lead to the
right decision being made.

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PERFORMANCE MEASUREMENT AND THE BALANCED SCOREDCARD

Non financial performance indicators Organisations should attempt to identify Key performance
indicators that can be used to measure performance under
Weaknesses of traditional financial performance indicators
each heading. Key performance indicators are based on the
include the following:
organisation’s critical success factors. Critical success factors
 Single factor measures such as ROI and residual income are performance requirements that are fundamental to an
do not give a complete picture of divisional organisation’s success-for example innovation in the
performance electronics industry.

 Single factor numbers may be distorted (for example by Key performance indicators should be:
accepting proposal 2 in the example above- thus  Specific (for example, profit is specific, financial
improving measured ROI. performance is not as it could mean different things to
 May lead to dysfunctional behaviour. different people.)

Financial performance indicators have therefore been used  Measurable


more commonly in recent years.
 Relevant- to achievement of a critical success factor.
Balanced Scorecard
The balanced scorecard approach to performance
measurement attempts to measure the performance of an
organisation under 4 headings:
 Financial success
 Customer satisfaction
 Process efficiency
 Growth

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PERFORMANCE MEASUREMENT AND THE BALANCED SCOREDCARD

Example Advantages of the balanced scorecard


A training company providing tuition for ACCA exams could  Measures performance in a variety of ways
have the following performance indicators:
 Difficult for managers to hide the true picture if
Perspective Critical success Key performance multiple measures are used
Factors indicators
 Encourages a longer term view of business performance
Financial Shareholder wealth Dividend yield %
increase in share  It is flexible- measures can be changed over time to
price reflect changing priorities
Cash flow Actual v budget Difficulties of balanced scorecard
Customer Exam success Pass rates v national  Setting standards for key performance indicators
perspective Premier college (targets)
status
 There may be trade offs- i.e. performance is good in
Process Resource utilisation % room occupancy some areas, poor in others.
efficiency
Average class size
Average tutor
teaching
Growth New products % sales from new
courses

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TRANSFER PRICING

TRANSFER PRICING 1. Performance evaluation. The success of each division


whether measured by return on investment (ROI) or
This is a summary of an article by Ken Garret, published in
residual income (RI) will be changed.
the Student Accountant Magazine. The full article can be
downloaded from the ACCA website. 2. Performance related pay – If there is a system of
performance related pay, the remuneration of
When transfer prices are needed
employees in each division will be affected as profits
Transfer prices are almost inevitably needed whenever a will change.
business is divided into more than one department or
3. Make/abandon/buy in decisions. If the transfer price is
division. Usually goods and services will flow between the
too high, it may become impossible for the receiving
divisions, and each will report its performance separately.
division to make any contribution. The division might
The accounting system will usually record goods or services
abandon the product line or buy in cheaper component
leaving one department and entering the next, as some
from outside suppliers.
monetary value must be used to record this. That monetary
value is the transfer price. 4. Motivation – if a transfer price was such than one
division found it impossible to make a profit then the
Imagine Division A makes components for a cost of $30 and
employees in that division would probably be
these are transferred to Division B for $50. Division B incurs
demotivated. In contrast the other division would have
own costs of $20 and then sells to outside customers for $90.
an easy ride as it would make profits easily, and would
As things stand, each division makes a profit of $20 per unit.
not be motivated to work more efficiently.
You will appreciate that for every $1 increase in the transfer
5. Investment appraisal. The cash inflows arising from an
price, Division A will make $1 more profit and Division B
investment are most certainly going to be affected by
will make $1 less profit. Changing the transfer price will
the transfer price, so capital investment decisions can
have knock on effects on the following areas:
depend on the transfer price.

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TRANSFER PRICING

6. Taxation and profit remittance – If the divisions are in Example


different countries the profits earned in each country
Division A Division B
will depend on transfer prices. This could affect the
$ $
overall tax burden of the group.
Transfer in price - 50
Characteristics of a good transfer price Own costs Variable 18 10
Fixed 12 10
 Preserving divisional autonomy-Divisional managers Divisional profit/ mark up 20 40
are likely to resent being told by head office which ––– –––
products they should make or sell. Transfer out/ final sale price 50 90
 Be perceived as being fair for the purposes of divisional ––– –––
performance evaluation and investment decisions.
The minimum transfer price acceptable to Division A would
 Permit each division to make a profit be $18, as this is the marginal cost of production. A transfer
price of $19 for example would not be as popular with
 Encourage divisions to make decisions that maximise Division A as would a transfer price of $50, but at least it
group profits – if the decisions that will maximise offers the prospect of contribution, eventual break even and
divisional profit also maximise group profit. This is profit.
known as goal congruence.
For the transfer in Division (Division B) the transfer in price
The economic transfer price rule plus its own marginal costs must be no greater than the
Minimum transfer price (fixed by transferring division) marginal revenue from outside sales. This allows the division
≥marginal cost of transfer out division. to make a contribution (or at least not make a negative one).
In this example, the transfer price must be no higher than $80
Maximum transfer price (fixed by receiving division) ≤ net as $80 + $10 (own variable cost) = $90 (marginal revenue).
marginal revenue of transfer in division.

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TRANSFER PRICING

The transfer price rule for Division B can be restated to say The problem with this approach is that variable costs and
that the transfer price should be no greater than the net final selling prices will change continually in the real world
marginal revenue, where net marginal revenue is marginal and this can be difficult to manage. A second problem is that
revenue less own marginal costs. Here net marginal revenues the range of transfer prices set (from $18 to $10) is large, and
= $80 ($90 −$10). therefore the respective profits of the two divisions could
vary vastly depending on where within the range they agree
So a transfer price of $50 would work, since it is ≥ $18 and ≤ the final price.
$80. Both parties will find it worth trading at that price.
Practical approaches to transfer pricing
The economic rule of transfer pricing suggested above also
leads to decisions that are in the interests of the group as a 1. Variable cost
whole. If in the example above, the final selling price (for A transfer price is set at the variable cost of the transferring
Division B) were to fall to $25, the group could not make a division produced good economic decisions, since the buying
contribution because $25 is less than the group’s total division’s marginal costs (including the transfer price) will
variable cost of $18 + $10. The transfer price that would be the same as those of the group. However, there are
make both divisions trade must be no less than $18 for drawbacks:
Division A, but no greater than $15 (net marginal revenue)
for Division B. So clearly no workable transfer price is  Division A will make a loss, as its fixed costs will not
available, and the divisions would not trade with each other. be covered.
Therefore all head office needs to do is to impose a transfer  Performance measurement is distorted – Division A
price within the appropriate range, confident that both makes a loss, while Division B is not charged enough to
divisions will act in a way that maximised group profit. cover all the costs of manufacture.
 There is little incentive for Division A to be efficient if
all the marginal costs are covered by a transfer price.

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TRANSFER PRICING

2. Full cost dysfunctional decision being made unless an upper limit –


equal to the net marginal revenue in the receiving division is
A transfer price set at full cost of $30 is more satisfactory for
also imposed.
Division A, as it will now break even. However, it can lead
to dysfunctional behaviour. If the final market price fell to 4.Variable cost plus lump sum
$35, Division B would not trade, because its marginal cost
In this approach, transfers are made at variable cost. The
would be $40, (transfer in price of $30 plus own marginal
periodically a lump sum is transferred from the buying
costs of $10). However, from a group point of view the
division to the selling division to account for fixed costs and
marginal cist is only $28 ($18 + $10) and a positive
profit. It is argued that the buying Division (Division B) has
contribution would be made even at a selling price of $35.
the correct cumulative variable cost information to make
3. Market price good decisions, yet the lump sum transfers allow the
divisions ultimately to be treated fairly with respect to
A transfer price set to the market price of the transferred
performance measurement. The size of the periodic lump
goods should give both divisions the opportunity to make
sum would be linked to the quantity or value of goods
profit if they operate at normal industry efficiencies.
transferred.
Market price provides an objective transfer price not based
5.Dual pricing
on arbitrary mark ups, and will therefore be perceived as
being fair to both divisions. In this approach, Division A transfers out at a cost plus mark
up (perhaps a market price), and Division B transfers in at
As with full cost, a market cost could also lead to
variable cost. Therefore Division A can make a motivating
dysfunctional behaviour however, as they result in fixed
profit while Division B has good economic data about
costs and profits of the selling division being variable
cumulative group variable costs. Obviously the divisional
(marginal) costs to the buying division. A similar approach,
current accounts won’t agree, and some period end
variable cost plus would have the same disadvantage. In fact,
adjustments will be needed to reconcile those and to
once you get away from a transfer price equal to the variable
eliminate fictitious inter divisional profits.
cost in the transferring division, there is always the risk of

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TRANSFER PRICING

Conclusion
Transfer prices are vitally important when motivation,
decision-making, performance measurement and investment
decisions are taken into account – and these are the factors
that so often separate successful from unsuccessful
businesses.

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COMPREHENSIVE ANALYSIS OF PAST EXAMINATIONS

Topic Dec 11 Jun 11 Dec 10 Jun 10 Dec 09 Jun 09 Dec 08 Jun 08


Traditional management and cost accounting √
Activity Based Costing √ √ √
Developments in management accounting:
Target costing √
Life cycle costing √ √
Backflush accounting
Throughput accounting √ √
Short term decision making:
Relevant costs √ √ √ √
One off contracts √
Shut down decisions
Further processing decisions
Limiting factor decisions:
One limited factor
Make or buy √
Linear programming √ √ √
Pricing √ √ √

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COMPREHENSIVE ANALYSIS OF PAST EXAMINATIONS

Topic Dec 11 Jun 11 Dec 10 Jun 10 Dec 09 Jun 09 Dec 08 Jun 08


Risk and Uncertainty √
Expected values √ √
Maximax, maximin, minimax regret √
Decision trees
Budgeting √ √ √ √ √ √
Quantitative Techniques for Budgeting
Regression/ correlation √
Time series analysis √
Learning curve theory √ √ √
Use of spreadsheets
Standard costing and variance analysis:
Basic variances √ √
Causes of variances √

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COMPREHENSIVE ANALYSIS OF PAST EXAMINATIONS

Topic Dec 11 Jun 11 Dec 10 Jun 10 Dec 09 Jun 09 Dec 08 Jun 08


Advanced variance analysis:
Materials mix and yield variances √ √
Sales mix and quantity variances √
Activity based costing variances √
Variances incorporating idle time/ learning
curve
Usefulness of variances/ behavioural impact √
Behavioural aspects of standard costing
Planning and operational variances √ √ √
Performance measurement:
Performance hierarchy
Financial performance indicators √ √
Non financial performance indicators √ √

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COMPREHENSIVE ANALYSIS OF PAST EXAMINATIONS

Topic Dec 11 Jun 11 Dec 10 Jun 10 Dec 09 Jun 09 Dec 08 Jun 08


Further aspects of performance measurement:
The Balanced Scorecard √
Performance measurement in service √
industries
Performance measurement in non profit
organisations
Benefits and problems of performance
measurement systems
Divisional performance evaluation √ √ √
Transfer Pricing √ √

Note – the current examiner’s first exam was the December 2010 exam

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EXAMINERS FEEDBACK

DECEMBER 2011 EXAM Question One


The following is a summary of the comments made by the This was a nice, straightforward relevant costing question,
examiner after the December 2011 exam. The full examiner’s which should have been well answered by most people. It
report can be downloaded from the ACCA web site. proved to be one of the most poorly answered questions on
the paper.
http://www.accaglobal.com/content/dam/acca/global/PDF-
students/2012e/F5_examreport_d11.pdf]  The biggest problem with this question was that many
candidates clearly don’t understand relevant costing.
 To their credit many candidates seemed to have taken
on board my advice to start with their best question first  Another problem was that the notes given by candidates
and then continue to answer the questions in order of didn’t explain the figures being used well enough.
their best questions. Many candidates just wrote down that a cost was
included because it was “relevant” but didn’t say why.
 Candidates also seem to be taking advice about getting
This is not an explanation and did not score marks.
the easy marks first on a question. This often meant
that, for example, candidates answered the written Question two
requirement in 4 (c) before tackling the numbers in 4 (a)
This question covered transfer pricing. Part (a) contained the
and (b).
easy marks with a simple requirement to prepare a profit
 Small improvements are being seen in the way statement.
candidates are setting out their answers, showing their
workings and tackling written requirements.
 There were many perfect answers here because the
requirement was not difficult.
 The biggest single reason for failure in the F5 exam in
December 2011 was definitely big knowledge gaps that
 Weaker candidates simply didn’t know what the words
“profit statement” meant and just produced some
many candidates seem to have.
workings showing total profit for the company.

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EXAMINERS FEEDBACK

Part (b) asked for a calculation of the maximum profit that Question four
could be earned if transfer pricing was optimised.
This question covered life cycle costing.
 The logic behind this was totally lost on the majority of
candidates.
 Part (c) was where the easy marks were, and many
candidates scored full marks for this, with a good
number of candidates tackling this part first to get the
Question three
easy marks.
Part (a) was where the bulk of the easy marks were on this
paper: a requirement to identify and explain six objectives of  Part (a) read: ‘calculate the life cycle cost per unit.’
a budgetary control system. Anyone who just calculated a cost per unit for each of
the three years totally missed the point of life cycle
 A good number of answers scored full marks. On the costing.
whole, candidates either knew the answer or didn’t.
Question five
 A small number of candidates did not know what
participative budgeting was so they scored nothing in Finally the variance question.
part (b).  A significant number of candidates scored full marks on
the materials usage, mix and quantity variance.
 Some candidates did not tackle part (b) in the best way,
which was to use the objectives of part (a) as headings  Part (c) contained a couple of easy marks on the steps
in order to give the answer some structure. involved in allocating overheads using activity based
costing. People who didn’t know the steps decided to
just tell me everything they knew about activity base
costing instead although, to be fair, this often wasn’t a
lot.

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EXAMINATION TECHNIQUE

EXAMINATION TECHNIQUE  Inability to do performance evaluation questions-


In the exams to date, the pass rate for paper F5 has not been performance evaluation is the core of paper F5, and is
high. Candidates are advised to read the examiner’s what distinguishes F5 from F2.
comments. The following is a list of the key failings  Poor interpretation of financial information. In a
demonstrated by students according to the examiner’s reports performance measurement exam, interpreting financial
to date. These comments were re inforced at the ACCA data is essential.
teachers’ conference in February 2011:
a. Say what happened
 Poor time management- with many candidates not
answering all four questions. b. Say why it may have happened
c. Offer an opinion.
 Failure to note the marks allocated to sections of
questions, with some candidates writing three pages for Examination technique
an 8-mark section of a question.
Time allocation
 Poor layout of answers- including excessive crossing
You must use the 1.8 minutes per mark rule.
out, failure to label workings, no tabulation, and use of
essay style for numerical calculations.  Spend no more than 36 minutes on a question. Never
overrun, even if you think its “going well.” A few
 Failure to answer the question asked- instead candidates
minutes spent finishing a question or tidying up are
writing everything they know about a topic in the hope
minutes wasted.
that some of it will be relevant.
 Use the 1.8 minutes rule as a guide to how long to
 Ignoring clues given in scenarios. For example, the
spend on each sub section.
examiner mentioned that the “machines had been
running well.” Many candidates still mentioned that one
possible cause of idle time was machine breakdowns.

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EXAMINATION TECHNIQUE

Written sections of questions Numerical sections


Spend a few minutes planning what you are going to write  Think about the layout of your solution. What
before diving in and writing: calculations must you do? Is there a quicker way? Is all
the information available for you to actually do the
 Note the requirement of the question carefully (and
calculations that you require?
ensure you focus on this)
 Spend a minute or two brainstorming - coming up with
 Do detailed workings below your main answer. Label
each working carefully, and reference the figures in
possible ideas that can be used. Try to use ideas from
your main answer to the appropriate workings.
the scenario rather than from your study system. Be
prepared to come up with some original thought.  Marks are given for method rather than getting the
“right answer”. If you make an arithmetical slip, don’t
 Ensure you take into account “clues” given in the
go back and correct all previous workings. Live with
scenario. The examiner gives information for a reason.
the mistake. You will only lose a mark or 2, so it’s not
 Think about the structure of your answer- taking into worth spending time correcting.
account the marking scheme. The golden rule of 1 mark
per point made is a fairly good one.
 Ensure that the marker can understand your logic- a
small amount of narrative helps markers.
When writing your answer bear in mind that the examiner
The keywords
likes well constructed short points. Two to three sentences
per mark, with a space after each point makes it easier for the Part of the secret of doing well in these exams is to actually
marker to mark. understand what the question is asking. Here are a few key
words and their meaning to help you.
Refer whenever appropriate to the information in the scenario
(but don’t simply copy this into your answer.)  “Describe” = “set out the characteristics of”. Use brief
sentences but give more depth than if the instruction
was “state” (see below).

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EXAMINATION TECHNIQUE

 “Explain” = make plain, clarify, elucidate. For example,


defining a term does not explain it, but providing an
illustration may do so.
 “State” =e express in words. Use one short sentence
(bullet point) to make each answer point.
 “Discuss” = give balanced views on and conclude
(where appropriate).
 “List” = make a list of like things.
 “Justify” = give reasoning.
 “Identify” e.g. from the scenario. This requirement is
often implied rather than expressly stated. For example,
“Describe the risks ….” requires that the risks be
identified before they can be described.
 “Comment” = make observations, appraise and/or
examine (critically).
 “Suggest” = propose or put forward.
 In addition to these words here are few extra hints to
help you refine your technique;

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Revision Essentials are not quality
assured by ACCA but their content is
substantially derived from materials which
have been quality assured by ACCA.

Revision Essentials includes:

• ACCA syllabus aim and main capabilities


• Core topics checklist
• Summary of essential facts and theory
• Further reading
• Relevant articles
• Comprehensive analysis of past examinations
• Examiners' feedback for the last exam session
• Exam technique

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