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ACCA Paper F5
Performance Management
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ExPress Notes
ACCA F5 Performance Management
Contents
About ExPress Notes 3
3. Pricing Decisions 12
6. Budgeting – an Introduction 22
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ExPress Notes
ACCA F5 Performance Management
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ACCA F5 Performance Management
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ExPress Notes
ACCA F5 Performance Management
Chapter 1
KEY KNOWLEDGE
Activity Based Costing (ABC)
ABC is a method that seeks to group overhead costs according to the activities causing
those costs. The activities giving rise to the costs are called “cost drivers”. By linking costs to
activities (cost drivers), it becomes possible to charge costs to the agents undertaking those
activities.
EXAMPLE
A factory clinic with total annual costs of $500,000 serves two Workshops A and B.
Workshop A has 200 employees and Workshop B has 300 employees.
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ExPress Notes
ACCA F5 Performance Management
An ABC approach might look at the number of visits to the clinic by the employees of A and
B.
The different levels of usage may reflect different degrees of occupational hazard present in
the two workshops.
ABC advantages: provides a more precise way to determine costs per unit of output,
especially since not all overhead costs are driven by production volumes.
Budgetary planning, pricing decisions and managing performance are all facilitated by ABC.
KEY KNOWLEDGE
Target costing
This is a market-oriented approach to costing which starts by identifying the likely price that
a product can fetch in the market, deducts the profit that the product is expected to earn,
and arrives at the maximum (target) cost of manufacturing the product.
Such a method usually requires successive iterations in order to close a “cost gap”, i.e.
where the costs are above the targeted level. Product re-design, alternative materials and
production processes are examined in order to achieve the desired level of costs.
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ACCA F5 Performance Management
KEY KNOWLEDGE
Life-cycle costing
A product normally “lives” beyond one accounting period and the costs connected to its
development/design, launch and maintenance fall unevenly across time periods. This
method takes a comprehensive view of the costs relating to the product throughout its life-
cycle.
KEY KNOWLEDGE
Back-flush Accounting
This is a simplified costing method which can be used in conditions of short operational
cycles and low inventories. Companies working on a Just-In-Time (JIT) basis may practise it,
as it avoids the detailed tracking of costs during production; instead, it records costs when
goods are completed. These costs are then “back-flushed” through the system based on
standard costs.
KEY KNOWLEDGE
Throughput accounting
This method is also consistent with a JIT environment and focuses on the bottlenecks in a
production process; by eliminating these bottlenecks, it raises the amount of output that can
flow through the process (assuming there is demand for the output – the idea is not to
produce for inventory!).
The throughput accounting approach itself considers all costs (including direct labour) as
fixed and treats only direct materials as being variable in the short term.
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ExPress Notes
ACCA F5 Performance Management
Chapter 2
KEY KNOWLEDGE
Multi-limiting factors and the use of linear
programming and shadow pricing.
When resources are scarce, or other limiting factors are present in a given situation, then
management is concerned with achieving the most efficient allocation of available resources.
Whereas planning with one limiting factor involves the use of “key factor analysis” (in which
typically one seeks to maximize the contribution per unit of the limited, or bottleneck,
resource – see Paper F2), the presence of several limiting factors requires the use of linear
programming.
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ExPress Notes
ACCA F5 Performance Management
The answer can also be graphed and Step 5 determined visually. A graph also shows the
“feasible region” of value combinations that are consistent with the constraints.
EXAMPLE
An aircraft manufacturing company producing propellers and wing ribs operates under the
following conditions:
Materials are limited to 120 kg. per week while labour must not exceed 100 hours.
4) Simultaneous solving results in: p = 8 and w = 6; the feasible corner points are p =
12.5 (when w=0) and w = 10 (when p=0)
This can also be graphed for easier visualisation of the feasible region and solution.
Slack
This represents the amount of a resource that has not been exhausted (i.e. its availability
does not act as a constraint or limiting factor in a given set of circumstances).
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ExPress Notes
ACCA F5 Performance Management
Chapter 3
Pricing Decisions
START
The Big Picture
The latter is further influenced by how much the competition is charging for the same (or
similar) product or service.
KEY KNOWLEDGE
The price elasticity of demand (PED)
This measures the sensitivity of (customer) demand to a change in prices. There is usually
an inverse relationship: when price goes up, demand goes down (and vice versa).
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ACCA F5 Performance Management
EXAMPLE
A cinema increases its ticket prices from $4 to $6; as a result, the number of cinema goers
drops from 2,000 to 1,500.
The PED = (500/2000) = 25% = 0.5 (Note:Ignore + or – signs; take the absolute value)
(2/4) 50%
In the above example, demand is considered inelastic, because the PED < 1. When PED >
1, then demand is considered elastic.
KEY KNOWLEDGE
Demand Equation
Whereas the PED is expressed in percentages, the demand equation (or function) is
portrayed as a downward sloping straight line which shows price and demand combinations
in their full values. The equation is expressed as
P = a – bQ
Where:
EXAMPLE
On an average Saturday night, a cinema (capacity: 225) attracts 150 visitors at a price of
$5. If the price of the ticket is decreased by $0.50 then 25 more people will come.
In order to fill up the cinema, the ticket price would have to be set at:
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ACCA F5 Performance Management
P = 8 – 0.02Q
At Q = 225, P = $3.50
KEY KNOWLEDGE
Total Cost Function
An equation can also be formulated to express the relationship between total costs and
variable costs:
Y = aX + b
Where:
Y = Total costs;
b = the variable cost per unit -- corresponding to the slope of the total cost line
EXAMPLE
The variable cost per unit of a bottling process is 10 cents per unit. Fixed costs amount to
$5,000. At an output level of 20,000 units, what is the total cost?
= $7,000
When working with bulk discounts and other sales volumes, it is important to make sure
that fixed costs remain unchanged over the output range covered. If they increase (as a
result of expanding the production capacity, for example) then the new (higher) level of
fixed costs need to be included in the calculation of total costs.
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ACCA F5 Performance Management
KEY KNOWLEDGE
Pricing Strategies
There are a variety of pricing strategies with which one should be familiar:
Cost plus: A mark-up is added to a given cost base (which can be variable or full production
cost).
Skimming: Enter the market at a high price to catch customers willing and able to pay the
price.
Premium pricing: Maintain a high price due to the nature of the product.
Target pricing: This method “backs into” the price by calculating the required profit and the
possible production costs first.
Perceived value pricing: Plays on perception of value and what the market is willing to pay.
Value Pricing: Increasing the value content of the product so as to defend market share (in
times of difficult economic conditions or competition).
Product-line pricing: Sell a “core” product cheaply and price high related products.
Volume-discounting pricing: The bigger the order, the lower the price per unit.
Discriminatory pricing: Pricing the same product at different levels in different markets
(geographical) or market segments (customers).
Product Bundle Pricing: Combining products into one pack and pricing it overall.
Complementary product pricing: This refers to products that are used in conjunction with
other products (e.g. printers and cartridges, razor grips and blades, staplers and staples,
automobiles and spare parts). Typically, the approach to pricing may be low for the main
product and more expensive for the “re-fills”.
Relevant cost pricing: Basing the price on a keen (accurate) understanding of the real costs
of the product or service.
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ACCA F5 Performance Management
Chapter 4
START
The Big Picture
One of management’s responsibilities involves making decisions affecting the firm in the
short-run based on relevant costs.
What is relevance?
A relevant cost is a cash cost which is uniquely incurred (or avoided) as a consequence of
taking a decision; cash, because it is the main determinant of value (unlike accounting
profit); and unique in the sense that is not common to the alternative choices that are under
consideration.
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ACCA F5 Performance Management
EXAMPLE
If, however, there is a difference in the two insurance costs, then one can speak of the
difference between the two choices as being “incremental”; this difference (referred to in
some places as the “differential”) is relevant to the decision under consideration.
Future
Relevant costs refer to the future, i.e. they can be influenced prospectively by choice. It
follows that:
Sunk costs are not relevant: They have already taken place and cannot be reversed.
Committed costs, if they cannot be avoided, are likewise not relevant, even if the timing of
their occurrence is in the future. Their “unavoidability” has already been established in the
past (making them effectively the equivalent of sunk costs).
In keeping with the above logic, relevant costs therefore involve cash, are incremental and
relate to the future.
Relevant costs need to be identified with care, as they may include opportunity costs.
EXAMPLE
A company considers building a storage facility on the site of a parking lot. If the parking lot
had been generating parking fees which will now be lost, then this foregone revenue is an
opportunity cost.
Make-Buy
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ACCA F5 Performance Management
EXAMPLE
An automotive components producer can supply itself externally with car heaters for $210
per unit. In considering whether to make these internally, the company calculates that an
equivalent unit can be made in 2 labour hours using $100 worth of materials.
Materials: 100
Contribution lost (carburettors): 80
Labour (added-back): 20
200
Superior
Revenues (m) 40
If 25% of the costs are fixed costs allocated by H.O., then it appears that closing the plant
will leave the company worse off, as 40m in revenues and only 33m in costs will disappear.
A careful examination of all costs needs to be made before arriving at a final decision.
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ACCA F5 Performance Management
Chapter 5
START
The Big Picture
Uncertainty, in contrast to risk, is not capable of being quantified. It has also been referred
to as subjective probability (or unmeasurable uncertainty).
Expected Value
Expected
Profit/(Loss) Probability Value
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ACCA F5 Performance Management
KEY KNOWLEDGE
Sensitivity
Sensitivity Analysis
This asks the following question: What happens to the NPV of a project if certain key
variables are altered. It is a one-dimensional approach as it isolates and alters each (key)
variable in turn in order to measure the impact.
Sensitivities by scenario
One can also go beyond determining project sensitivity to one variable and define scenarios,
in which several variables move simultaneously (as outlined in the previous paragraph).
Based on these scenarios, the NPV outcomes can be evaluated.
KEY KNOWLEDGE
Simulation
This is a simulation model that uses probability distribution analysis to analyze the possible
outcomes of a project. It is built on the simultaneous changes of many variables, the
relationships between these variables being defined in advance, e.g. if price is reduced, how
much demand may go up.
Each variable itself has a probability distribution and the combinations of variables are
modeled through running the model repeatedly by computer, resulting in a distribution of
simulation results.
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ACCA F5 Performance Management
KEY KNOWLEDGE
Maximax, maximin and minimax regret
In the absence of (numerical) probabilities, a decision maker may act on the basis of his
attitude toward uncertainty. Here are examples of three techniques as they relate to the
following choices regarding developing a business:
Profits Strategy
1 2 3
Outcomes:
A 25 30 20
B 50 35 55
C 60 40 45
Maximax – going for the upside: Chooses Strategy 1 (to keep the door open to a profit of
60).
Maximin – limit the downside: Choose Strategy 2 (one cannot do worse than 30).
To determine this, one needs to quantify the “regrets” under each Outcome. For example:
If the Outcome turns out to be A, then Strategy 2 (=30) would have been the best strategy.
We can modify the table above to show all the regrets (opportunity costs) under each
Outcome:
Regrets Strategy
1 2 3
Outcomes:
A (5) Best (10)
B (5) (20) Best
C Best (20) (15)
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ExPress Notes
ACCA F5 Performance Management
Chapter 6
Budgeting – an introduction
START
The Big Picture
Budgets
Budgetary control systems seek to monitor performance against the budget in a timely way
so that deviations can be identified and rectified. The system can only work as well as the
care and thought that went into defining performance targets to be measured, and the
incentives (and sanctions) that follow from achievement (or not) of those targets.
Goal congruence at all levels of the organisation – corporate, divisional and individual – must
exist for a budget, and its attendant control systems, to be effective.
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ExPress Notes
ACCA F5 Performance Management
KEY KNOWLEDGE
Budgetary Systems / Types of Budgets
Fixed
A fixed budget is not adjusted to the actual volume of output (activity level)
Flexed: This is done “after the fact” and is based on the actual level of activity
achieved.
Zero-based (ZBB)
Each year, budget owners must justify the entire budget (build it from zero)
At odds with incremental budgeting (where only changes need justification, hence
encouraging the “spend it or lose it” mentality)
A three-step approach to ZBB:
1. Define “decision packages” (i.e. activities that result in costs or revenues),
distinguishing between “mutually exclusive packages” (alternative activities to
achieve the same result) and “incremental packages” (base level of input needed
+ additional inputs)
2. Evaluate and rank packages (based on the benefit to the organisation)
3. Allocate resources across packages, considering ranking and seniority of
responsible managers
Activity-based (ABB)
No budget owners (departments, functions), but budgeted activity cost (ABC costing)
Budgeted activity cost = demand for activity * unit cost of activity
More detailed and accurate than traditional budgets, especially regarding indirect
costs
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ExPress Notes
ACCA F5 Performance Management
Incremental
Such budgets are based on what went on during the period before. Typically, this approach
results in modest changes and adjustments to the earlier budget. At worst, they retain and
perpetuate inefficiencies and old assumptions. This might be termed the “lazy man’s
budget”.
KEY KNOWLEDGE
Quantitative Analysis in Budgeting
The High-Low method and regression analysis have been covered in F2.
Learning Curves
Learning curve effects can be applied to variance analysis, as they allow standards to be
adapted to a dynamic situation, i.e. one where the time to produce units declines with the
increase in output.
EXAMPLE
A traditional labour standard would expect 4 units to be produced in 80 hrs at a labour cost
of $480.
If a 90% learning curve effect applies, then one would expect the 4 units to be completed in
less time. How long will they require?
Where:
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ExPress Notes
ACCA F5 Performance Management
Conclusion: Based on the above, 64 hrs define the standard against which the time required
to produce 4 units should be compared when calculating the labour efficiency variance.
KEY KNOWLEDGE
Behavioural Aspects of Budgeting
There are numerous inter-relationships between types of budgets, budgeting processes and
the motivation of employees:
Top-Down budgets may be necessary from a coordination point of view; however they can
be de-motivating to employees;
Bottom-Up budgets allow useful employee input, but they may create exaggerated
expectations on the part of the employee that his/her voice will be heard.
Unrealistic budgets – with unachievable targets – can be de-motivating (as can budgets
which are easily achieved, since most people stop working when they reach the targets!).
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ExPress Notes
ACCA F5 Performance Management
Chapter 7
START
The Big Picture
Standard costs are useful in that they assist the budgeting and planning process before an
activity commences, as well as the analysis of actual costs (including variance analysis) as
the activity proceeds.
KEY KNOWLEDGE
Basic Variances and Operating Statements
Variances
Variance analysis is the process by which the differences between actual and budgeted
(standard) results are quantified and examined.
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ExPress Notes
ACCA F5 Performance Management
EXAMPLE
Budget
Production: 1,100 units
Sales: 1,000 units
Sales Price: $120 / unit
Actual results
Production: 1,000 units
Sales: 950 units
Materials: 4,900 kg, $45,025
Labour: 3,100 hrs, $19,050
Variable O/Hs: $9,250
Fixed O/Hs: $17,000
Sales price: $115 / unit
Material variances
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ExPress Notes
ACCA F5 Performance Management
Labour variances
Note: Labour variances can be influenced by “learning curve” effects: as work processes are
mastered, the time required to produce a given level of output should decline.
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ExPress Notes
ACCA F5 Performance Management
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ExPress Notes
ACCA F5 Performance Management
Operating statement
A reconciliation between profit budgeted (absorption costing) and that realized follows:
26,600
Cost variances:
Materials F A
Price 925
Usage 900
Labour
Rate 450
Efficiency 600
Variable
Expenditure 50
Efficiency 300
Fixed
Expenditure 500
Volume 1,500
950 4,275 3,325 (A)
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ExPress Notes
ACCA F5 Performance Management
Marginal costing
Based on the data above, an Operating Statement based on Marginal costing follows:
40,850
Cost variances:
Materials F A
Price 925
Usage 900
Labour
Rate 450
Efficiency 600
Variable
Expenditure 50
Efficiency 300
950 2,275 1,325 (A)
Variance analysis can also be applied to the Activity-Based Costing (ABC) system.
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ExPress Notes
ACCA F5 Performance Management
Chapter 8
KEY KNOWLEDGE
Mix and Yield Variance
When materials are combined in the production process in standard proportions, with the
possibility of substituting one for the other, then the materials usage variance can be broken
down into two further measures:
Mix: This examines the (monetary) impact of altering the proportions of the two materials.
Yield: This focuses on the total amount of inputs to produce the output achieved.
The sum of the mix and yield variances is equal to the materials usage variance.
EXAMPLE
$
Material X: 5 kg @ $8 40
Material Y: 10kg @ $3 30
70
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ExPress Notes
ACCA F5 Performance Management
Mix variance:
Important!
The analysis is made on the basis of actual usage: 195 kg (50 kg of X and 145 kg of Y):
X Y
The standard mix of actual input should have been: 65 130 (X:Y = 5:10)
Interpretation: More of the cheaper material (Y) and less of the more expensive one (X)
were used, resulting in an overall favorable variance relating to the mix.
Yield variance:
Important!
The analysis is made on the basis of standard mix (X:Y = 5:10):
X Y
The yield (12 units) should have used 180 kg 60 120
Interpretation: This analysis eliminates the (distorting) influence of the differing mixes by
“normalizing” them (according to standard). It permits focus to be placed only on the impact
of having used a greater amount of materials than the standard.
The sum of the mix and yield variances (above) equal the materials usage variance: $5 (F).
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ExPress Notes
ACCA F5 Performance Management
1) The actual usage (195 kg) should, according to the standard, produce 13 units
(195/15 = 13)
2) The actual number of units produced: 12 units
3) The difference of 1 unit (13-12) is adverse and valued at standard cost: $70 (A).
KEY KNOWLEDGE
Planning and Operational Variances
Due to changing market and technical circumstances, standards may become outdated. In
such cases, it may be necessary to alter a standard, even during a budget period already in
progress.
Planning variance: Compares results based on the revised standard compared to the initial
standard. The result is usually considered to be outside the area of control of management.
Operational variance: Compares actual results with the budget based on the revised
standard. This is often considered to be within the control of management.
The distinction above between “controllable” and “uncontrollable” factors is critical insofar as
it relates to the idea of “responsibility accounting”, i.e. expecting people who have delegated
authority to take responsibility for decisions within their area of control.
KEY KNOWLEDGE
Behavioural Aspects of Standard Costing
Standard costing in the “wrong” environment can be like a duck out of water.
Manufacturing processes involve a high degree of automation with little labour input,
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ExPress Notes
ACCA F5 Performance Management
Chapter 9
KEY KNOWLEDGE
The scope of performance measurement
Balanced scorecard
Customer perspective: “To achieve our vision how should we appear to our
customers?”
Internal business processes: “To satisfy our shareholders and customers what
business processes must we excel at?”
Learning and growth: “To achieve our vision how will we sustain our ability to
change and improve?”
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ExPress Notes
ACCA F5 Performance Management
Qualitative measures
Service quality is an area that can be difficult to assess in “objective” terms. Certain actions
can be measured numerically and serve as an indication for quality; for example, measuring
the turn-around time (in days or minutes) in responding to customer requests: naturally, the
quicker (one reacts), the better. To be fully useful, however, such a measure assumes two
things: (1) that the action being measured is of value (or relevance) to the customer; and
(2) that one has a rule or a benchmark as to what constitutes a maximum acceptable turn-
around time (from the client’s point of view).
Purely qualitative factors, such as client satisfaction, can be measured by employing a scale;
e.g. a scale of 1-5, with 5 = Very satisfied, to 1 = Dissatisfied. (Note: to avoid confusion, it
may be better to use the labels without numbers, and to assign numbers when analyzing
the results.)
KEY KNOWLEDGE
Divisional Performance and Transfer Pricing
Market price
Divisional objectives may not be aligned with one another or with corporate objectives.
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ExPress Notes
ACCA F5 Performance Management
Earnings can be measured at the divisional level in relation to the financial resources they
use. The ROI measure is very similar to ROCE (return on capital employed) with the only
exception being the use of profit in the formula:
ROI as defined above is commonly used for investment appraisal and for business sector
(divisional) performance, whereas ROCE is common at the overall corporate level.
EXAMPLE
A division head with an actual ROI of 20% may be reluctant to accept a project offering a
15% ROI, especially if his bonus is based on ROI achieved.
If the corporate overall ROI target is 12%, then the division head is missing a value-creating
opportunity.
Where
A positive result adds profits to the division beyond the incremental capital cost. An
investment should be accepted if the RI is positive.
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ExPress Notes
ACCA F5 Performance Management
EXAMPLE
Cash inflows are expected to be $1.5m p.a. and the cost of capital: 10%
Year 1 2 3 4
Capital
charge(10%) -450 -337.5 -225 -112.5
From both RI and ROI points of view, the project does not look favorable to the division,
even if it would be from the corporate point of view. (Eg, at a cost of capital of 10%, the
project has a positive net present value).
Performance analysis in not for profit organisations and the public sector
Not-for-profit organizations share many similar issues with profit-making firms in terms of
careful management of costs and ensuring that organizational objectives are being fulfilled.
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ExPress Notes
ACCA F5 Performance Management
Performance management systems which are completely internal (introverted) in focus risk
losing touch with the external world. A system of external bench-marking serves to
counteract the tendency of individuals to perform only to a sufficient level rather than to a
superior level.
Organizations that figure out how to motivate and actualize the true potential in people will
win.
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