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ACCA F5

Performance Management
Tutor: Tena Sheil (ACCA, BBS)
ACCA F5 Performance Management

ACCA F5 Performance Management - Overview

Pass Mark: 50% Exam: Mar, Jun, Sept, Dec.

Format: All Compulsory

Section A:
20 x 2 mark Multiple Choice Questions from across the Syllabus

Section B:
3 x 10 mark questions and 2 x 15 mark questions

Formula sheet showing Learning Curve and Demand Curve provided

Timing: 3 hours (180 minutes) & 15 minutes reading and planning time

Be ruthless. Allow 1.8 minutes per mark

The two most important things in the exam:


1.) Answering all of the questions to give you every chance at those 100 marks!!!
2.) Laying out your answer clearly so that the examiner can give you all the marks.

So you must:
PRACTICE QUESTIONS!!! PRACTICE YOUR TIMING!!!

Aim of this Syllabus


To develop knowledge and skills in the application of management accounting techniques to
quantitative and qualitative information for planning, decision-making, performance evaluation,
and control.

Your Syllabus

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ACCA F5 Performance Management

Section A Cost and Management Accounting Techniques


Absorption Costing

A Direct Cost can be defined as a cost which can be accurately traced to a cost object with little
effort. Total direct costs usually increase in line with activity/production levels.
For example if you were making a chair, Materials and Labour would be direct costs increasing
with every chair you produced.

An Indirect Cost (Overhead) can be defined as a cost which cannot be accurately traced to a cost
object and often benefits many products or services that you provide. These costs are less or not
related to activity/production levels.
For example if you were making a chair, Insurance and electricity would be indirect costs.

Total costs = Direct Costs plus Indirect Costs

Cost Card Under Absorption Costing $/unit


Direct Material 5
Direct Labour 10
Prime Cost 15
Variable Overheads 6
Fixed Overheads 2
Full Product Cost 23
(A cost card shows the cost of making one unit)

The objective of absorption costing is to include in the total cost of a product “an appropriate
share of the organisation’s total overhead”. An appropriate share is generally taken to mean an
amount which reflects the amount of time and effort that has gone into producing a unit or
completing a job. Absorption costing is therefore a method for sharing overheads between
products / services on a fair basis.

The main reasons for using absorption costing are; inventory valuations, pricing decisions and
establishing the profitability of different products. It is also worth noting that financial
accounting standards and in particular “IAS 2 Inventories” recommend using absorption costing
to value inventory.

The three stages of absorption costing are:


 Allocation
 Apportionment
 Absorption

Allocation is the process by which whole cost items are charged direct to a cost centre.
A cost centre is generally a department. So if we have a supervisor for department A, and a
supervisor for department B, the wages of these supervisors will simply be “allocated” to the
relevant department. A problem arises when one supervisor may be responsible for two
departments or cost centres and here we have to apportion the wages.

Apportionment is used where the overhead cost is shared over several cost centres when
allocation is not feasible or possible. E.g. the salary of a supervisor who is responsible for a
number of cost centres. The first stage of overhead apportionment is to identify all overheads

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ACCA F5 Performance Management

such as light and heat, rent, canteen etc. It is considered important that overhead costs should be
shared out on a fair basis. The basis for apportionment in most cases would be:
 Rent, rates, light and heat, repairs and depreciation of buildings → floor area occupied by
each cost centre
 Depreciation, insurance of equipment → Cost or book value of equipment
 HR, canteen, welfare, first aid etc. → Number of employees or number of labour hours
worked in each cost centre

Absorption is the process whereby overhead costs allocated and apportioned to cost centres are
added to unit, job or batch costs.
Overheads are usually added to cost units using a predetermined overhead absorption rate,
which is calculated from the budget using a 4-step process:

1. Estimate the overhead likely to be incurred during the coming period.


2. Estimate the activity level for the period. This could be total hours, units or direct costs or
whatever we wish to base the overhead absorption rates upon.
3. Divide the estimated overhead by the budgeted activity level. This produces the overhead
absorption rate.
4. Absorb the overhead into the cost unit by applying the calculated absorption rate.

Blanket Absorption Rates:


A blanket absorption rate is an absorption rate used throughout a factory and for all jobs and
units of output irrespective of the department in which they were produced.
Blanket overhead absorption rates are not appropriate where:
- There is more than one department
- Jobs do not spend an equal amount of time in each department

Over and under absorption of overheads:


Over and under absorption occurs because the predetermined overhead absorption rates are
based on estimates. It is quite likely that either one or both estimates will not agree with what
actually occurs.
Over absorption means that the overheads charged to the cost of sales are greater than the
overheads actually incurred.
Under absorption means that insufficient overheads have been included in the cost of sales.

Simple P&L under Absorption Costing


Sales (Units * Sales Price) xxx

Cost of Sales
Opening Stock xxx
Cost of Units Produced (Variable and Fixed) xxx
Less Closing Stock (xxx)
xxx
Over/under absorbed (+/-) xxx (xxx)

Gross Profit xxx

Less non production Costs xxx


xxx
xxx
xxx (xxx)
Net Profit xxx

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ACCA F5 Performance Management

Marginal Costing

Marginal cost is the variable cost of one unit of product or service.

Marginal costing is an alternative method of costing to absorption costing. In marginal costing,


only variable costs are charged as a cost of sale and a contribution is calculated (sales – variable
costs). Closing inventories of work in progress or finished goods are valued at marginal cost.
Fixed costs are treated as a period cost, and are charged in full to the profit and loss account of
the accounting period in which they are incurred (as opposed to each unit or job in absorption
costing).

The marginal production cost per unit of item therefore usually consists of the following:
- Direct Materials
- Direct Labour – Even if staff are on a fixed wage unless specifically told differently
- Variable production overheads
Contribution is an important measure in marginal costing and is calculated as the difference
between sales and marginal (variable) cost of sales. The term contribution is really short for
“contribution towards covering fixed overheads and making a profit”.

Cost Card Under Marginal Costing $/unit


Direct Material 5
Direct Labour 10
Prime Cost 15
Variable Overheads 6
Marginal Product Cost 23

Sales – Marginal Costs = Contribution


Contribution – Fixed Costs = Profit

The principles of marginal costing are:


- Fixed costs are the same for any volume of sales or production. Therefore by selling
an extra item of product or service the following will happen:
- Revenue will increase by the sales value of the item sold
- Costs will increase by the variable cost per unit
- Profit will increase by the amount of contribution earned from the extra item

Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution
earned from the extra item. Profit measurement should therefore be based on an analysis of
total contribution.

Marginal costing suggests that since fixed costs relate to a period of time, and do not change
with increases or decreases in sales volume; it is misleading to charge units of sale with a share of
fixed costs. Absorption costing is therefore misleading, and it is more appropriate to deduct fixed
costs from total contribution for the period to derive a profit figure.

When a unit of product is made, the extra costs incurred in its manufacture are the variable costs.
Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased. It is
therefore argued that the valuation of closing inventories should be at variable production cost
(direct materials, direct labour, any direct expenses and variable production overhead) because
these are the only costs properly attributable to the product.

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ACCA F5 Performance Management

Marginal Cost and Absorption Costing Compared


- In marginal costing, fixed production costs are treated as period costs and are written
off as they are incurred.
- In absorption costing, fixed production costs are absorbed into the cost of units and
carried forward in inventory to be charged against sales for the next period.
Inventory values using absorption costing are therefore greater than those calculated
using marginal costing.
- In marginal costing it is necessary to identify variable costs, contribution and fixed
costs.
- In absorption costing it is not necessary to distinguish variable from fixed costs.

Arguments in favour of absorption costing:


- It is fair to share fixed production costs between units of production as such costs are
incurred to make output
- Closing inventories valued in accordance with IAS2 principles
- It is easier to determine the profitability of several products by charging a share of fixed
overheads to them rather than working out if the total contribution from several
products will cover fixed costs
- Where building up inventory is necessary (e.g. fireworks) fixed costs should be included
in inventory valuations in order to prevent a series of losses from occurring (e.g. long
before the period in which Halloween falls).

Arguments in favour of marginal costing:


- Simple to operate
- No apportionment of fixed costs
- Closing inventory realistically valued at variable production cost per unit
- Size of contribution provides management with useful information about expected
profits
- Absorption costing encourages management to produce goods in order to absorb
allocated overheads instead of meeting market demands
- Under/over absorption of overheads is avoided
- It is a great aid to decision making

Reconciling Profits:
Reported profit figures using marginal costing or absorption costing will differ if there is any
change in the level of inventories in the period. If production is equal to sales there will be no
difference in calculated profits using the costing methods. The difference in profits reported
under the two costing systems is due to the different inventory valuation methods used.

Reconciling Profits:
A quick way to establish the difference in profits is to use the following formula:
Difference in Profits = change in inventory level x overhead absorption rate per unit

Triple A Rule;
A - Absorption Costing
A - Additional Stock (i.e. and increase)
A - Additional Profit
Under absorption costing if there is an increase in stock during the period you will see additional
profit when compared to Marginal costing.

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ACCA F5 Performance Management

Simple P&L under Marginal Costing


Sales (Units * Sales Price) xxx

Cost of Sales
Opening Stock xxx
Variable Cost of Units Produced xxx
Less Closing Stock (xxx) (xxx)
xxx
Less other Variable Cost (xxx)

Contribution xxx

Less Fixed Costs xxx


xxx
xxx
xxx (xxx)
Net Profit xxx

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ACCA F5 Performance Management

Example of Absorption Costing and Marginal Costing

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ACCA F5 Performance Management

Activity Based Costing (ABC)

Activity based costing is an alternative to absorption costing. It involves the identification of the
factors which cause the costs of an organisation’s major activities. These are known as cost
drivers. Support overheads are then charged to products based on their usage of these activities.

The absorption costing approach was developed in a time when most organisations produced
only a narrow range of products and when overhead costs were only a small fraction of total
costs. Direct labour and direct materials would have been the largest proportion of total costs.

Nowadays, however, the situation is different. With the advent of advanced manufacturing
technology, overheads are likely to be far more important, for reasons including:
- Direct labour may account for as little as 5% of a product’s cost
- The accessibility of information technology now allows for more sophisticated overhead
methods than in the past.

In today’s business environment it is difficult to justify the use of direct labour or direct materials
as the basis for allocating overheads. It is against this background that Activity Based Costing
(ABC) has emerged.

Many resources are used in non-volume related support activities, which have increased due to
advanced manufacturing technology, such as setting-up, production scheduling, inspection and
data processing. These support activities assist the efficient manufacture of a wide range of
products and are not, in general, affected by changes in production volume. They tend to vary in
the long term according to the range and complexity of the products manufactured rather than
the volume of output. The wider the range and the more complex the products, the more
support services will be required.

Consider for example, factory X which produces 10,000 units of one product the Alpha and
factory Y which produces 1,000 units each of 10 slightly different versions of the Alpha.

Support activity costs in factory Y are likely to be a lot higher than support activity costs in
factory X but the factories produce an identical number of units.
Take setting up for example. Factory X will only need to set up once, while factory Y will have to
set up the production run at least ten times for ten different products. Factory Y will therefore
incur more set-up costs.

The major ideas behind activity based costing include:


- Activities cause costs. Activities include ordering, materials handling, machining,
assembly, production scheduling and despatching.
- Producing products creates demand for the activities
- Costs are assigned to a product on the basis of the products consumption of activities

Activity based costing involves the identification of the factors which cause the costs of an
organisation’s major activities. Support overheads are then charged to products on the basis of
their usage of the factor causing the overheads.

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ACCA F5 Performance Management

Calculating product costs using ABC


An ABC system operates as follows:
Step 1 - Identify an organisation’s major activities
Step 2 - Identify the cost drivers. A cost driver is a factor which causes the cost of an activity.
Example:
Activity Cost Driver:
Ordering No of Orders
Materials Handling No of Production Runs
Production Scheduling No of Production Runs
Despatching No of Despatches
Step 3 - Collect the costs of each activity into cost pools.
Step 4 - Charge support overheads to products on the basis of their usage of the activity.

Advantages of ABC:
1.) ABC focuses on the nature of cost behaviour and attempts to provide meaningful
product costs.
2.) ABC recognises that many overhead costs arise out of the diversity and complexity of
operations and does not assume that overhead costs are related to volume of activity
only and just use a meaningless direct labour hour recovery rate or machine hour
recovery rate.
3.) The complexity of manufacturing has increased, with wider product ranges, shorter
product lifecycles, a greater importance being attached to quality and more complex
production processes. ABC recognises this complexity with its multiple cost drivers.
4.) In a more competitive environment, companies must be able to assess product
profitability realistically. ABC facilitates good understanding of what drives overhead
costs.
5.) In a modern manufacturing environment, overhead functions include a lot of non-factory-
floor activities such as product design, quality control, production planning, sales order
planning and customer service. ABC is concerned with all overhead costs, including the
costs of these functions, and so it takes management accounting beyond its “traditional”
factory floor boundaries.

Criticisms of ABC
1.) Some measure of arbitrary cost apportionment may still be required at the cost pooling
stage for items like rent, rates and building depreciation. If an ABC system has many cost
pools the amount of apportionment needed may be even greater.
2.) The ability of a single cost driver to explain fully the cost behaviour of all items in its
associated pool is questionable.
3.) To have a usable cost driver, a cost must be caused by an activity that is measurable in
quantitative terms and which can be related to production output. But not all costs can
be treated in this way. For example, what drives the cost of the annual external audit?
4.) ABC is sometimes introduced because it is fashionable, not because it will be used by
management to provide meaningful product costs or extra information. If management
is not going to use ABC information, a traditional absorption costing system may be
simpler to operate.
5.) There can be difficulties in gathering all of the data required for an ABC system.
6.) It can be costly and time-consuming to implement and operate
7.) There can be resistance to change by staff and lack of top management support.

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ACCA F5 Performance Management

Simple example of ABC versus Absorption

Cooper Ltd manufactures four products, W, X, Y and Z. Output and cost data for the period just
ended are as follows:

Output Units No of Material Cost Direct Labour Machine hours


production per unit hours per unit per unit
runs
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14

Direct labour cost is €5 per hour.

Overhead costs are as follows:


Short-run variable costs 3,080
Set-up costs 10,920
Production and scheduling costs 9,100
Materials Handling costs 7,700
30,800

Required:
Calculate product costs using the following approaches:
a.) Absorption Costing
b.) ABC

Solution:

a.) Absorption Costing

Total Hours = 10+30+100+300 = 440


AOR = €30,800 / 440 hours = €70 per labour hour

W X Y Z Total
Direct Materials 200 800 2,000 8,000 11,000
Direct Labour 50 150 500 1,500 2,200
Overheads 700 2,100 7,000 21,000 30,800
Total Cost 950 3,050 9,500 30,500 44,000
Units produced 10 10 100 100
Cost per unit 95 305 95 305

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ACCA F5 Performance Management

b.) Activity Based Costing


Cost / Cost-driver = Cost per activity
Sort-run variable costs 3,080 / 440 machine hours = €7 per machine hr.
Set-up costs 10,920 / 14 prod. runs = €780 per run
Production and scheduling costs 9,100 / 14 prod. runs = €650 per run
Materials Handling costs 7,700 / 14 prod. runs = €550 per run

W X Y Z Total
Direct Materials 200 800 2,000 8,000 11,000
Direct Labour 50 150 500 1,500 2,200
Short-run Variable O/H's 70 210 700 2,100 3,080
Set-up Costs 1,560 1,560 3,900 3,900 10,920
Prod & Sched Costs 1,300 1,300 3,250 3,250 9,100
Materials Handling Costs 1,100 1,100 2,750 2,750 7,700
4,280 5,120 13,100 21,500 44,000
Units Produced 10 10 100 100
Cost per unit 428 512 131 215

If we compare the two sets of figures they suggest the traditional volume-based absorption
costing system is flawed.
Product Absorption costing ABC unit cost Difference
unit cost
W 95 428 333
X 305 512 207
Y 95 131 36
Z 305 215 -90

Absorption costing under allocates overhead costs to low-volume products (here W and X with
ten units of output) and over allocates to higher-volume products (here Z in particular).
Absorption costing also under allocates overhead costs to less complex products (here W and Y
with just one hour of work needed) and over allocates overheads to more complex products
(here X and particularly Z).

Advantages of ABC:
1.) ABC focuses on the nature of cost behaviour and attempts to provide meaningful
product costs.
2.) ABC recognises that many overhead costs arise out of the diversity and complexity of
operations and does not assume that overhead costs are related to volume of activity
only and just use a meaningless direct labour hour recovery rate or machine hour
recovery rate.
3.) The complexity of manufacturing has increased, with wider product ranges, shorter
product lifecycles, a greater importance being attached to quality and more complex
production processes. ABC recognises this complexity with its multiple cost drivers.
4.) In a more competitive environment, companies must be able to assess product
profitability realistically. ABC facilitates good understanding of what drives overhead
costs.
5.) In a modern manufacturing environment, overhead functions include a lot of non-factory-
floor activities such as product design, quality control, production planning, sales order
planning and customer service. ABC is concerned with all overhead costs, including the

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ACCA F5 Performance Management

costs of these functions, and so it takes management accounting beyond its “traditional”
factory floor boundaries.

Criticisms of ABC
1.) Some measure of arbitrary cost apportionment may still be required at the cost pooling
stage for items like rent, rates and building depreciation. If an ABC system has many cost
pools the amount of apportionment needed may be even greater.
2.) The ability of a single cost driver to explain fully the cost behaviour of all items in its
associated pool is questionable.
3.) To have a usable cost driver, a cost must be caused by an activity that is measurable in
quantitative terms and which can be related to production output. But not all costs can
be treated in this way. For example, what drives the cost of the annual external audit?
4.) ABC is sometimes introduced because it is fashionable, not because it will be used by
management to provide meaningful product costs or extra information. If management
is not going to use ABC information, a traditional absorption costing system may be
simpler to operate.
5.) There can be difficulties in gathering all of the data required for an ABC system.
6.) It can be costly and time-consuming to implement and operate
7.) There can be resistance to change by staff and lack of top management support.

ABC versus traditional absorption costing


Traditional absorption costing allocates overheads to production departments (cost centres)
whereas ABC systems assign overheads to each major activity (cost pools). In absorption costing
this can lead to many reapportionments of service department costs to ensure that all overheads
are allocated to production departments. ABC establishes separate cost pools for support
activities such as despatching and materials handling and as the costs of these activities are
assigned to products through cost drivers, reapportionment of service department costs is
avoided.
The principle idea of ABC is to focus attention on what causes costs to increase, the cost drivers.
Just as there are no rules for what to use as the basis for absorbing costs in traditional absorption
costing, there are also difficulties in choosing cost drivers.
Focusing attention on what actually causes overheads and tracing overheads to products on the
basis of the usage of cost drivers ensures that a greater proportion of overheads are product
related, whereas traditional costing systems allow overheads to be related to products in rather
more arbitrary ways. It is this feature of ABC which produces, it is claimed, greater accuracy.

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ACCA F5 Performance Management

Target Costing

Target costing involves setting a target cost for a product having identified a target selling price
and a required profit margin. The target cost is the target sales price less the required profit.

This costing method is most effective for new products and products in the design stage because
at this stage it is easier and cheaper to introduce changes needed to reduce costs. It is used in the
context of continual improvement, increasing effectiveness, continuous cost reduction and
product enhancement.

Examples of decisions which reduce costs:


 Use of standard components
 Use of cheaper materials
 Exclusion of design features
Steps for target costing:
 Research the market to estimate an acceptable (Target) sales price and anticipated
demand
 Estimate required profit (Using company’s required return or Return on Investment)
 Calculate the target cost = Target selling price – required profit
 Estimate the cost based on current/intended design and production processes
 Calculate the Target Cost Gap = Estimated cost – target cost
 Make efforts to close the gap - If the gap cannot be closed the product might be
redesigned or scrapped.

Methods used to close the Target Cost Gap:


 Use a cheaper labour source or train staff to be more efficient
 Use standard components
 Improve technological efficiency
 Reduce components or use different materials
 Cut out activities that do not add value
You need to be able to discuss methods of closing the Target Cost Gap suggested by a given
scenario in the exam.

Example:
I have researched an acceptable market price for my product of €120. I require a profit margin of
10%. What is my target cost?

Solution:
Profit Margin = 120 x 10% = 12
Target cost = 120 – 12 = €108

Characteristics of sevices;
 Intangibility
 Inseparability
 Variability
 Perishability
 No transfer of ownership
These characteristics make target costing difficult for services because services are far more
difficult to tie down in exact detail to a specification.

See June 2012 Q2 which was a full theory question on Target Costing.

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ACCA F5 Performance Management

Life Cycle Costing

Life cycle costing (LCC) takes into account that the costs and revenues of a product are different
at different stages of its life cycle. For example during development of a product costs may be
high but revenue might be low or non-existent. This costing method attributes costs and
revenues to the product over its entire life.

The product life cycle has five stages:


 Development
 Introduction
 Growth
 Maturity
 Decline

Costs incurred during the product life cycle:


 Research & development costs: design, testing, production process, equipment
 Training costs
 Production costs
 Distribution & Transportation
 Marketing costs
• Customer service
• Field maintenance
• Brand promotion
 Inventory costs
 Retirement and disposal costs.

A traditional cost accumulation system looks at costs in a particular (for example) 12 month
period to match an accounting year. So they only look at profitability in given periods not over
the entire product life. LCC tracks and accumulates costs and revenues attributable to a product
over the entire product life cycle. This allows a decision to be made as to whether a product
should be considered for commercial development by examining if they will still be profitable
even after design and development costs as well as disposal or clean-up costs are taken into
account. LCC can be used in both manufacturing and service industries to assess products,
services and customers.

There are a number of benefits associated with life cycle costing.


(a) The life cycle concept results in earlier actions to generate revenue or to lower costs than
otherwise might be considered.
(b) Better decisions should follow from a more accurate and realistic assessment of revenues and
costs, at least within a particular life cycle stage.
(c) Life cycle thinking can promote long-term rewarding in contrast to short-term profitability
rewarding.
(d) The life cycle concept helps managers to understand acquisition costs vs. operating and
support costs. It encourages businesses to find a correct balance between investment costs and
operating expenses.

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ACCA F5 Performance Management

Maximisation of return:
 At the design and development stage, careful planning can reduce the design, production
and processing costs for the entire life of the product.
 Reduce Time to Market
 Minimise the time to Breakeven
 Maximise lifespan

Sample question
Solaris specialises in the manufacture of solar panels. It is planning to introduce a new slimline
solar panel specially designed for small houses. Development of the new panel is to begin shortly
and Solaris is in the process of determining the price of the panel. It expects the new product to
have the following costs.
Y1 Y2 Y3 Y4
Units manufactured and 2,000 15,000 20,000 5,000
sold
R&D 1,900,000 100,000 - -
Marketing 100,000 75,000 50,000 10,000
Production/Unit 500 450 400 450
Customer Service Costs /Unit 50 40 40 40
Disposal of Specialist 300,000
Equipment

The Marketing Director believes that customers will be prepared to pay $500 for a solar panel but
the Financial Director believes this will not cover all of the costs throughout the lifecycle.
Required
Calculate the cost per unit looking at the whole life cycle and comment on the suggested price.

Y1 Y2 Y3 Y4 Total
Units manufactured and 2,000 15,000 20,000 5,000 42,000
sold
R&D 1,900,000 100,000 - - 2,000,000
Marketing 100,000 75,000 50,000 10,000 235,000
Production/Unit 500 x 2000 450 x 15,000 400 x 20,000 450 x 5,000 18,000,000
Customer Service Costs 50 x 2000 40 x 15,000 40 x 20,000 40 x 5,000 1,700,000
/Unit
Disposal of Specialist 300,000 300,000
Equipment
Total LCC for 42,000 units 22,235,000
Total LCC for one unit 529.40

Don’t forget to Comment!!

Discuss the following:


Price is too low to cover total LCC.
a) Increase price
b) Look for cost savings

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ACCA F5 Performance Management

Life Cycle Calculation


Q4 Dec 2011

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ACCA F5 Performance Management

Throughput Accounting

Throughput accounting is a product management system which aims to maximise throughput,


and therefore cash generation from sales, rather than profit. A just in time (JIT) environment is
operated, with buffer inventory kept only when there is a bottleneck resource.

Throughput is the money (not profit) that a system generates through the sales it makes.
Sales – Material Costs = Throughput
All other costs including direct labour are viewed in throughput accounting as fixed costs.

Concept 1 In the short term all factory costs are fixed costs including direct labour.
Concept 2 Inventory is a bad thing (JIT environment)
Concept 3 Profitability is determined by the rate at which money comes through the door.
To maximise profit we need to eliminate inventory and bottleneck to maximise
throughput.

A bottleneck resource or binding constraint is an activity which has a lower capacity than
preceding or subsequent activities, thereby limiting throughput.

The Theory of Constraints (TOC) is an approach to production management which aims to


maximise sales revenue less material and variable overhead cost. It focuses on factors such as
bottlenecks which act as constraints to this maximisation.

The bottleneck factor


For some organisations the bottleneck factor is sales; they simple cannot sell the amount they
can produce. More often though the bottleneck factor is a resource used within the system. For
example lack of a certain product, available time on a machine or certain skilled labour. There will
only be one bottleneck factor at a time.

Once the bottleneck is identified, attempts should be made to remove it. If this is not possible we
should ensure that we are only using other resources up to the point that the bottleneck
dictates. Production should be limited to the fully utilised capacity of the bottleneck. We should
hold a small buffer inventory immediately prior to the bottleneck to ensure that the bottleneck is
never further delayed.

The focus in the Theory of Constraints is to increase the capacity of the bottleneck constraint,
known as Elevating the Bottleneck. For example if the constraint is time on a particular machine
we could buy a new machine, increase working days from five to six or seven, increase the length
of daily shifts and ensure that maintenance is done during non-shift hours. If the constraint is
elevated enough it will no longer be the bottleneck and another resource will become the
bottleneck and the process begins again.

Goldratt’s 5 step plan: (Summary of Theory of Constraints)


1. Identify the constraint
2. Exploit the contstraint to maximise output
3. Subordinate/synchronise everything else to the constraint
4. Elevate the performance of the constraint
5. Assess whether the constraint has shifted and if so revert to step 1

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ACCA F5 Performance Management

Performance Measures and Throughput Accounting

Throughput is maximised by ranking products in order for production and sale according to the
throughput that they earn per unit of bottleneck resource they earn. This is an important aspect
for F5.

Throughput return per factory hour

𝑆𝑎𝑙𝑒𝑠 – 𝑑𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 𝑐𝑜𝑠𝑡


𝑈𝑠𝑎𝑔𝑒 𝑜𝑓 𝐵𝑜𝑡𝑡𝑙𝑒𝑛𝑒𝑐𝑘 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒 𝑖𝑛 𝐻𝑜𝑢𝑟𝑠 (𝐹𝑎𝑐𝑡𝑜𝑟𝑦 ℎ𝑜𝑢𝑟𝑠)

Throughput Accounting (TA) Ratio


This is the ratio of the throughput per unit of bottleneck resource to the factory cost of a unit of
bottleneck resource. Should definitely be more than ‘1’ because at a ratio of 1 is only covering
factory costs. You may be asked to rank products by TA ratio.

𝑇ℎ𝑟𝑜𝑢𝑔ℎ𝑝𝑢𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝐵𝑜𝑡𝑡𝑙𝑒𝑛𝑒𝑐𝑘 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒


Throughput Accounting Ratio = 𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝐵𝑜𝑡𝑡𝑙𝑒𝑛𝑒𝑐𝑘 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒
(May also express ‘unit of Bottleneck Resource’ as ‘per factory hour’)

Example
Corrie produces three products, X, Y and Z. The capacity of Corrie's plant is restricted by process
alpha. Process alpha is expected to be operational for eight hours per day and can produce 1,200
units of X per hour, 1,500 units of Y per hour, and 600 units of Z per hour.

Selling prices and material costs for each product are as follows.
Product Selling price Material cost Throughput contribution
X 150 80 70
Y 130 40 90
Z 300 100 200
Operating costs are $720,000 per day.

(a) Calculate the profit per day if daily output achieved is 6,000 units of X, 4,500 units of Y and
1,200 units of Z.
(b) Calculate the TA ratio for each product.
(c) In the absence of demand restrictions for the three products, advise Corrie's management on
the optimal production plan.

Solution
(a) Profit per day = throughput contribution – conversion cost
= [($70 × 6,000) + ($90 × 4,500) + ($200 × 1,200)] – $720,000
= $345,000

(b) TA ratio = throughput contribution per factory hour/operating cost per factory hour
Operating cost per factory hour = $720,000/8 = $90,000
Product Throughput contribution Cost per factory hour TA ratio
per factory hour
X $70 x 1200 = 84,000 $90,000 0.93
Y $90 x 1500 = 135,000 $90,000 1.50
Z $200 x 600 = 120,000 $90,000 1.33

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ACCA F5 Performance Management

(c)
First attempt to increase factory hours.

If this is impossible prioritise Product Y because its TA ratio is highest. Since there is no demand
restriction we should look at producing only Product Y. (There may be qualitative reasons why
we would not want to do this.)
Throughput would then be:
1500 (units of Y per hour) x 8 (Hours per day) x 90 (throughput per unit) = 1,080,000
Profit would be:
1,080,000 – 720,000 = 360,000 which is a 60,000 improvement on the current situation.

Consider dropping Product X because of its low TA ratio.

Final note so don’t forget: Throughput and contribution are not the same.

Throughput = Sales – Direct Materials


Contribution = Sales – All marginal (variable) Costs

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ACCA F5 Performance Management

Throughput Accounting Calculation


Dec 2013 Q2

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ACCA F5 Performance Management

Environmental Accounting
Environmental management accounting (EMA) is the generation and analysis of both financial
and nonfinancial information in order to support internal environmental management processes.

This is important with regard to compliance, inclusion of environmental costs in the pricing
decision and identification of cost saving measures.

In Martin Bennett and Peter James’s article 'The green bottom line: management accounting for
environmental improvement and business benefit', Management Accounting, November 1998,
they identified a number of important aspects to the environmental subject:
 Waste minimisation, management and processing
 Cost of capital increased by perceived investor risk where there is poor environmental
management
 Energy costs and environmental taxes
 Pressure groups
 Legislation forcing an end to the lifecycle of some products and beginning of others

They suggested that businesses could achieve environmental benefits through:


(a) Integrating the environment into capital expenditure decisions
(b) Understanding and managing environmental costs which are often hidden.
(c) Introducing waste minimisation schemes
(d) Understanding and managing life cycle costs. Particularly around being made responsible for
upstream and downstream costs
(e) Measuring environmental performance for statutory compliance and consumer satisfaction
(f) Involving management accountants in a strategic approach to environment-related
management accounting and performance evaluation. Including current and proactive evaluation
of (i) Government policies, such as on transport
(ii) Legislation and regulation
(iii) Supply conditions, such as fewer landfill sites
(iv) Market conditions, such as changing customer views
(v) Social attitudes, such as to factory farming
(vi) Competitor strategies
Such analysis and action should help organisations to better understand present and future
environmental costs and benefits.

Defining environmental costs


Internal v external
Internal costs are those which are caused by the organisation and bourne by them
External costs are those which are caused by an organisation and borne by others. e.g. clean up
operations after a river has been polluted by an unidentified source.

The EPA in the USA makes the following categorisation:


Conventional costs – e.g. energy costs which impact on the environment
Potentially hidden costs – relevant costs that are captured with business accounts but might be
hidden within overheads
Contingent costs – costs which will be incurred at a later date e.g. costs of restoring land to its
original state after quarrying
Image and relationship costs – costs incurred to preserve environmental reputation or ensure
compliance with regulations.
Environmental costs should be defined, identified and appropriately allocated with an
organisation.

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ACCA F5 Performance Management

Accounting for environmental costs (Sample answer Dec 2013)


Input/outflow analysis
This technique records material inflows and balances this with outflows on the basis that what
comes in, must go out. So, if 100 kg of materials have been bought and only 80 kg of materials
have been produced, for example, then the 20 kg difference must be accounted for in some way.
It may be, for example, that 10% of it has been sold as scrap and 10% of it is waste. By accounting
for outputs in this way, both in terms of physical quantities and, at the end of the process, in
monetary terms too, businesses are forced to focus on environmental costs.
Flow cost accounting
This technique uses not only material flows but also the organisational structure. It makes
material flows transparent by looking at the physical quantities involved, their costs and their
value. It divides the material flows into three categories: material, system and delivery, and
disposal. The values and costs of each of these three flows are then calculated. The aim of flow
cost accounting is to reduce the quantity of materials which, as well as having a positive effect on
the environment, should have a positive effect on a business’s total costs in the long run.
Activity-based costing
ABC allocates internal costs to cost centres and cost drivers on the basis of the activities which
give rise to the costs. In an environmental accounting context, it distinguishes between
environment-related costs, which can be attributed to joint cost centres, and environment-driven
costs, which tend to be hidden in general overheads.
Life cycle costing
Within the context of environmental accounting, life cycle costing is a technique which requires
the full environmental consequences, and therefore costs, arising from production of a product
to be taken account of across its whole life cycle, ‘from cradle to grave’.

ISO 14001 is a management standard that provides a framework for environmental management
systems which it says should include;
• An environmental policy statement
• An assessment of environmental aspects and legal and voluntary obligations
• A management system
• Internal audits and reports to senior management
• A public declaration that ISO 14001 is being complied with
Critics feel that these standards focus too much on management and not enough on
performance, verification and reporting. Your discussion of a management system should
recommend review, policy & procedures, life cycle assessment, compliance, waste and pollution
management, development and investment in better environmental technology and processes
and a reporting framework.

Please read the technical article from August 2015 which is in your Part A Resources folder.

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