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F5 Performance Management

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The exam Five compulsory questions: 20 marks each Time allowed: 3hours plus 15 minutes reading time Balance typically 50:50 between calculations and discussion aspects

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The examiner’s key concerns Students need to be able to interpret any numbers they calculate and see the limitations of their financial analysis. In particular financial performance indicators may give a limited perspective and NFPIs are often needed to see the full picture. Questions will be practical and realistic, so will not dwell on unnecessary academic complications. Many questions will be designed so discussion aspects can be attempted even if students have struggled with calculation aspects.

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1. Advanced costing methods ABC. Target costing. Lifecycle costing. Throughput accounting. Environmental Accounting

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Activity Based Costing (ABC) Steps 1.Identify major activities. 2.Identify appropriate cost drivers (note: you may have to justify your choice here in the exam). 3.Collect costs into pools based upon the activities. 4.Charge costs to units of production based on cost driver volume.

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Activity Based Costing (ABC) Cost driver rate = total driver pool cost cost driver volume

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Advantages of ABC More realistic costs. Better insight into cost drivers, resulting in better cost control. Particularly useful where overhead costs are a significant proportion of total costs. ABC recognises that overhead costs are not all related to production and sales volume. ABC can be applied to all overhead costs, not just production overheads. ABC can be used just as easily in service costing as in product costing.

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Criticisms of ABC It is impossible to allocate all overhead costs to specific activities. The choice of both activities and cost drivers might be inappropriate. ABC can be more complex to explain to the stakeholders of the costing exercise. The benefits obtained from ABC might not justify the costs.

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Implications of ABC Pricing - more realistic costs improve cost-plus pricing. Sales strategy - more realistic margins can help focus sales strategy. Decision making – for example, research and development can be directed at products with better margins.

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Target Costing Steps 1.Estimate a market driven selling price for a new product. (E.g. to capture a required market share). 2.Reduce this figure by the firm’s required level of profit. (E.g. based on target ROI). 3.Produce a target cost figure for product designers to meet. 4.Reduce costs to provide a product that meets that target cost.

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Closing the target cost gap Value analysis Focus is on reducing cost without compromising perceived value. Can labour savings be made? Can productivity be improved? What production volume is needed to achieve economies of scale?

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Closing the target cost gap – cont. Could cost savings be made by reviewing the supply chain? Can any materials be eliminated? Can a cheaper material be substituted without affecting quality? Can part-assembled components be bought in to save on assembly time? Can the incidence of the cost drivers be reduced?

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Implications of target costing Pricing – might identify sufficient cost savings to reduce the target price. Cost control – target cost motivates managers to find new ways of saving costs.

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Lifecycle costing Is the profiling of cost over a product’s life, including the pre-production stage. Tracks and accumulates the actual costs and revenues attributable to each product from inception to abandonment. Enables a product’s true profitability to be determined at the end of its economic life.

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Implications of lifecycle costing Pricing decisions can be based on total lifecycle costs rather than simply the costs for the current period. Decision making - a timetable of life cycle costs helps show what costs need to be recovered. Control - Lifecycle costing reinforces the importance of tight control over locked-in costs, such as R&D. Performance reporting - Life cycle costing costs to products over their entire life cycles, to aid comparison with product revenues generated in later periods.

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Throughput Background Application of key factor analysis to production bottlenecks. The only totally variable costs are the purchase cost of raw materials / components Direct labour costs are not wholly variable.

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Throughput Multi-product decisions Rank products by looking at the throughput per hour of bottleneck resource time Throughput = Revenue – Raw Material Costs

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Throughput Throughput accounting ratio (TPAR) Throughput per hour of bottleneck resource Operating expenses per hour of bottleneck resource

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Throughput How to improve the TPAR Increase the sales price to increase the throughput per unit. Reduce total operating expenses, to reduce the cost per hour. Improve productivity, reducing the time required to make each unit of product.

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ACCOUNTING FOR ENVIRONMENTAL COSTS Environmental costs Internal costs directly impact on the income statement of a company. improved systems waste disposal costs product take back costs regulatory costs upfront costs backend Costs External Costs are imposed on society at large but not borne by the company that generates the cost in the first instance carbon emissions usage of energy and water forest degradation health care costs social welfare costs

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Management Accounting Techniques

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Break-even analysis The Break-even chart £ Output (units) Fixed Costs Breake ven Point Sales Revenue Total Costs Breakeven point: The point where total costs = total sales revenue and Where there is neither a profit or loss B/E Point (units) = Fixed Costs Contribution per Unit Chapter 4

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The Margin of Safety Breakeven Output Budgeted Output Margin of safety The Margin of Safety represents the level by which output can fall before the organisation makes a loss Margin of Safety = Budgeted Output – Breakeven Output Budgeted Output X 100% Chapter 4

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Contribution to Sales ratio Chapter 4 Contribution to Sales Ratio (C/S ratio) = (Contribution per unit) / Unit Sales Price Breakeven Point in Sales Value = Fixed Costs / C/S ratio Sales for a certain level of profit = Fixed Costs + Required Profit Contribution per Unit

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Basic Breakeven chart Chapter 4 0 Sales Revenue 10 20 30 Fixed Costs 40 Breakeven point Loss Profit 20 30 40506070 Number of units £’000 Total Costs

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Contribution Breakeven chart Sales Revenue 10 Total Costs Variable Costs Breakeven point Loss 20 30 40506070 Number of units £’000 Profit Fixed Costs Contribu tion Chapter 4

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The Profit-Volume Chart The profit-volume chart presents information in a way that clearly shows the change in the level of profit – using data from the previous data table: 0 +£5000 -£10000 10001500 Profit Output Page 30 Chapter 4

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Contribution = Sales Value – All Variable Costs Units010050010001500 Contribution(£)0100050001000015000 Fixed Costs(£)(10000) Profit(£)(10000)(9000)(5000)05000 Profit = (Contribution per unit x units) - Fixed Costs A product has a sales price of £20 and a variable cost of £10 per unit Contribution per unit10 Profit per unit0(90)(10)50 2. CVP Analysis

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C/S Ratio BE Point (Revenue) = Fixed Costs Required Revenue = Fixed Costs = Required profit Weighted Average C/S Ratio Multi-product breakeven analysis

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Limitations/Assumptions of CVP Costs behaviour is assumed to be linear Revenue is assumed to be linear Volume Produced = Volume Sold Ignores inflation Assumes a constant sales mix Chapter 4

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3. Planning with limited factors Key factor analysis – one resource in short supply Linear Programming – two or more scarce resources

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Key factor analysis 1.Calculate contribution per unit. 2.Calculate contribution per unit of the limiting factor. 3.Rank in order. 4.Allocate resources – make first up to max demand, then second,...

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Linear programming 1.Define variables 2.Define the objective 3.Set out constraints 4.Draw graph showing constraints and identify the feasible region 5.Identify optimal point 6.Solve for optimal solution 7.Answer the question

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Linear programming Assumptions A single quantifiable objective. Each product always uses the same quantity of the scarce resources per unit. The contribution per unit is constant. Products are independent – e.g. sell A not B. The scenario is short term.

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Linear programming Slack Slack is the amount by which a resource is under utilized. It will occur when the optimum point does not fall on the given resource line.

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Linear programming Shadow (or dual) prices The extra contribution that results from having one extra unit of a scarce resource. The max premium (i.e. over the normal cost) that the firm should be willing to pay for one extra unit of each constraint. Non-critical constraints will have zero shadow prices as slack exists already.

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Linear programming Calculating dual prices 1.Add one unit to the constraint concerned, while leaving the other critical constraint unchanged. 2.Solve the revised equations to derive a new optimal solution. 3.Calculate the revised optimal contribution. The increase is the shadow price

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Linear programming Range of applicability of dual prices The dual price only applies as long as extra resources improve the optimal solution i.e. the constraint line concerned moves out increasing the size of the feasible region and moving the optimal point. Eventually other constraints become critical.

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4. Pricing Factors to consider when pricing. Calculation aspects. Pricing approaches.

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Factors to consider when pricing Costs Competitors Corporate objectives Customers

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Calculation aspects Price elasticity of demand (PED) PED = % change in demand / % change in price. PED >1 (elastic) revenue increases if the price is cut. PED <1 (inelastic) revenue increases if the price is raised.

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Calculation aspects Equation of a straight line demand curve P = a – bQ “a” = the price at which demand would fall to zero “b” = gradient = change in price/change in demand Calculate “b” first

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Calculation aspects Equation of a cost curve C = F + vQ Volume based discounts

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Pricing approaches Cost plus pricing Price skimming Penetration pricing Linking pricing decisions for different products Volume discounts Price discrimination Relevant cost pricing

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Cost plus pricing Establish cost per unit – options include MC, TAC, prime cost Calculate price using target mark-up or margin Often used as a starting point even when using other methods

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Cost plus pricing Advantages Widely used and accepted. Simple to calculate if costs are known. Selling price decision may be delegated to junior management. Justification for price increases. May encourage price stability.

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Cost plus pricing Disadvantages Ignores link between price and demand. No attempt to establish optimum price. Which absorption method? Does not guarantee profit Which cost? Inflexibility in pricing. Circular reasoning.

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Price skimming Set a high initial price to ‘skim off’ customers who are willing to pay extra. Prices fall over time. Suitability?

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Penetration pricing Set a low initial price to gain market share If a high volume is achieved, the low price could be sustainable. Suitability?

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Linking pricing decisions for different products Basic idea: product A is cheap to attract customers who then also buy the higher margin product B. Key issue is the extent to which customer must buy the other products. Suitability?

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Volume discounts Discount for individual large order. Cumulative quantity discounts. Suitability?

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Price discrimination Have different prices in different markets for the same product. Suitability?

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Relevant cost pricing Price = net incremental cash flow. Suitability?

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5. Make v buy and other short term decisions Relevant costing principles. Make v buy decisions. Shut down decisions. Joint products – the further processing decision.

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Relevant costing principles Include –Future incremental cash flows. –Opportunity costs Exclude –Depreciation. –Sunk costs. –Unavoidable costs. –Apportioned fixed overheads. –Financing cash flows (e.g. interest).

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Make v buy Decision Look at future incremental cash flows. Watch out for opportunity costs – especially whether or not spare capacity exists and alternative uses for capacity. Practical factors?

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Shut down decisions Decision Look at future incremental cash flows. –Apportioned overheads not relevant –Closure costs – e.g. redundancies. –Alternative uses for resources? Practical factors?

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Joint products The further processing decision Look at future incremental cash flows: –sell at split off v process further and then sell. Pre-separation (“joint”) costs not relevant –only include post split-off aspects.

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6. Risk and uncertainty Basic concepts. Research techniques. Scenario planning. Simulation. Expected values. Sensitivity. Payoff tables.

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Basic concepts Risk = variability in future returns. Investors’ risk aversion Upside v downside Risk v uncertainty Risk = probability x impact

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Research techniques Desk research –Company records. –General economic intelligence. –Specific market data. Field research –Opinion v motivation v measurement –Questionnaires, experiments, observation. –Group interviews, triad testing, focus groups.

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Scenario planning 1 Identify high-impact, high-uncertainty factors. 2 Identify different possible futures. 3 Identify consistent future scenarios. 4 “Write the scenario”. 5 For each scenario identify and assess possible courses of action for the firm. 6 Monitor reality. 7 Revise scenarios and strategic options

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Simulation 1 Apply probabilities to key factors in scenario analysis. 2 Use random numbers to select a particular scenario and calculate outcome. 3 Repeat until build up a picture of possible outcomes 4 Make decision based on risk aversion.

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Expected values EV = Σ outcome × probability. Make decision based on best EV.

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Expected values Advantages Recognises that there are several possible outcomes. Enables the probability of the different outcomes to be taken into account. Leads directly to a simple optimising decision rule. Calculations are relatively simple.

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Expected values Disadvantages probabilities used are subjective. EV is the average payoff. Not useful for one-off decisions. EV gives no indication of risk Ignores the investor’s attitude to risk.

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Sensitivity Identify key variables by calculating how much an estimate can change before the decision reverses. Can only vary one estimate at a time.

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Payoff tables Prepare table of profits based on different decision choices and different possible scenarios. Four different ways of making a decision. –1 Expected values –2 Maximax –3 Maximin –4 Minimax regret

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Decision Trees A diagrammatic representation of a multi-decision problem, where all possible courses of action are represented, and every possible outcome of each course of action is shown. Decision trees should be used where a problem involves a series of decisions being made and several outcomes arise during the decision-making process. Decision trees force the decision maker to consider the logical sequence of events. A complex problem is broken down into smaller, easier to handle sections. The financial outcomes and probabilities are shown separately, and the decision tree is ‘rolled back’ by calculating expected values and making decisions.

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7. Budgeting I The purposes of budgeting. Budgets and performance management. The behavioural aspects of budgeting. Conflicting objectives.

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The purpose of budgets Forecasting Planning Control Communication Co-ordination Evaluation Motivation Authorisation and delegation

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Budgets and performance management Responsibility accounting Responsibility accounting divides the organisation into budget centres, each of which has a manager who is responsible for its performance. The budget is the target against which the performance of the budget centre or the manager is measured.

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Management by exception 1 Set up standard costs, prepare budgets and set targets. 2 Measure actual. 3 Compare actual to budget (e.g. via variances). 4 Investigate reasons for differences and take action.

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Behavioural aspects of budgeting Key issues –Dysfunctional behaviour – want goal congruence. –Budgetary slack. Management styles (Hopwood) –Budget constrained –Profit conscious –Non-accounting

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Target setting and motivation Expectations v aspirations Ideal target? Targets should be: –communicated in advance –dependent on controllable factors –based on quantifiable factors –linked to appropriate rewards –chosen to ensure goal congruence.

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Participation Advantages of participative budgets Increased motivation Should contain better information, Increases managers’ understanding and commitment Better communication Senior managers can concentrate on strategy.

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Participation Disadvantages of participative budgets Loss of control Inexperienced managers Budgets not in line with objectives Budget preparation slower and disputes can arise Budgetary slack Certain environments may preclude participation

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Conflicting objectives Company v division Division v division Short-termism Individualism

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8. Budgeting II Rolling v periodic. Incremental budgeting. Zero based budgeting (ZBB). Activity based budgeting (ABB). Feedforward control. Flexible budgeting. Selecting a budgetary system. Dealing with uncertainty. Use of spreadsheets.

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Rolling v periodic budgeting Periodic budgets The budget is prepared for typically one year at a time. No alterations once the budget has been set. Suitable for stable businesses where forecasting is easy and where tight control is not necessary.

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Rolling v periodic budgeting Rolling (continuous) budgets A budget kept continuously up to date by adding another accounting period when the earliest period has expired. Aim: to keep tight control and always have an accurate budget for the next 12 months. Suitable if accurate forecasts cannot be made, or if need tight control.

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Incremental budgeting Start with the previous period’s budget or actual results and add (or subtract) an incremental amount to cover inflation and other known changes. Suitable for stable businesses where costs are not expected to change significantly. There should be good cost control and limited discretionary costs.

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Zero based budgeting Preparing a budget from a zero base, justifying all expenditure. 1 Identify all possible services and then cost each service (decision packages) 2 Rank the decision packages 3 Identify the level of funding that will be allocated to the department. 4 Use up the funds in order of the ranking until exhausted.

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Activity based budgeting Use ABC for budgeting purposes: 1 Identify cost pools and cost drivers. 2 Calculate a budgeted cost driver rate 3 Produce a budget for each department or product by multiplying the budgeted cost driver rate by the expected usage.

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Feed forward control Feed-forward control is defined as the ‘forecasting of differences between actual and planned outcomes and the implementation of actions before the event, to avoid such differences. E.g. using a cash-flow budget to forecast a funding problem and as a result arranging a higher overdraft well in advance of the problem.

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Flexible budgeting Fixed Budgets Flexible Budgets Flexed Budgets

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Selecting a budgetary system Determinants Type of organisation. Type of industry. Type of product and product range. Culture of the organisation.

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Changing a budgetary system Factors to consider Time consuming Are suitably trained staff are available to implement the change successfully? Management time Training needs. Cost v benefits for the new system:

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Incorporating risk and uncertainty Flexible budgeting. Rolling budgets. Scenario planning. Sensitivity analysis. “What if” analysis using spreadsheets

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9. Quantitative analysis High-low. Regression and correlation. Time series analysis. Learning curves.

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High-low 1: Select the highest and lowest activity levels, and their costs. 2: Find the variable cost/unit. 3: Find the fixed cost, using either level. Fixed cost = Total cost at activity level – total variable cost.

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Regression and correlation y = a + bx r =

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Time series analysis Four components: 1 the trend 2 cyclical variations 3 seasonal variations 4 residual variations. Additive model Actual = Trend + Seasonal Variation Multiplicative model Actual = Trend x Seasonal Variation

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Learning curves As cumulative output doubles, the cumulative average time per unit falls to a fixed % (the learning rate) of the previous average. Y = ax b y = average cost per batch a = cost of first batch x = total number of batches produced b = learning factor (log LR/log 2)

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10. Standard costing and basic variances Standard costing. Recap of basic variances from F2. Labour variances with idle time. Variance investigation.

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Standard costing A pre-determination of what a product is expected to cost under specific working conditions.

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Standard costing Advantages –Annual detailed examination –Performance appraisal –Management by exception –Simplifies bookkeeping Disadvantages / problems –Standards not updated –Cost –Unrealistic standards can demotivate staff

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Types of standard Attainable Ideal Basic Current

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Sales variances

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Material variances

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Labour variances (basic)

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Variable overhead variances

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Fixed overhead variances

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Labour variances with idle time No idle time budgeted for

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Idle time budgeted for

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Variance investigation

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11. Advanced variances Materials mix and yield variances. Other targets for controlling production. Planning and operational variances. Modern manufacturing environments.

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Materials mix and yield variances Only use where materials can be substituted for each other.

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Other targets for controlling production processes Detailed timesheets, % idle time. Productivity, % yield, % waste. Quality measures e.g. reject rate. Average cost of inputs, output. Average margins. % on-time deliveries. Customer satisfaction ratings.

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Planning and operational variances

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Market size and market shares variances

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Planning and operating cost variances

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Modern manufacturing environments Total Quality Management (TQM) TQM is the continuous improvement in quality, productivity and effectiveness through a management approach focusing on both process and the product.

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Modern manufacturing environments Just-in–time (JiT) JIT is a pull-based system of planning and control. Pulling work through the system in response to customer demand. Goods are only produced when they are needed. This eliminates large inventories of materials and finished goods.

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12. Performance measurement and control Ratio analysis. NFPIs. Behavioural considerations.

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Ratio analysis Preliminaries Ratios may not be representative of the position throughout a period. Need a basis for comparison. Ratios can be manipulated Ratios indicate areas for further investigation rather than giving answers.

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Profitability ratios ROCE=Operating Profit x 100% Capital Employed Gross margin =Gross profit x 100% Sales Net margin = Net profit x 100% Sales Asset turnover=Sales / capital employed ROCE = asset turnover x net margin

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Liquidity / working capital ratios Current ratio = current assets / current liabilities Quick ratio = quick assets/ current liabilities Quick assets = current assets – inventory Receivables days = receivables / sales x 365 Payables days = payables / purchases x 365 Inventory days = inventory / cost of sales x 365

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Ratios to measure risk Financial gearing = debt/equity Financial gearing = debt / (debt + equity) Dividend cover = PAT / total dividend Interest cover = PBIT / interest Operating gearing = fixed costs / variable costs Operating gearing = contribution / PBIT

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Non-financial performance indicators Financial performance appraisal often reveals the ultimate effects of operational factors and decisions but non-financial indicators are needed to monitor causes. Critical success factors often non- financial Stakeholder objectives may also be non-financial

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The balanced scorecard (Kaplan and Norton)

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The building block model (Fitzgerald et al)

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Behavioural aspects Measures designed to assess performance should: –provide incentives to promote goal congruence. –only incorporate factors for which the manager can be held responsible. –recognise both financial and non financial aspects of performance. –recognise longer-term, as well as short term, objectives.

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Behavioural aspects Potential problems with inappropriate measures –manipulation of information provided by managers –demotivation and stress-related conflict –excessive concern for control of short term costs, possibly at the expense of longer- term profitability.

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Transfer pricing. Divisional performance measurement. 13. Transfer pricing and divisional Performance measurement

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Transfer pricing Objectives Goal congruence Performance measurement. Autonomy. Minimising global tax liability. To record the movement of goods and services. Fair split of profit between divisions.

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Transfer pricing - Exam questions Will often be given a TP and asked to comment. Look at the following. Implications for divisional performance – e.g. is a target ROI achieved? Resulting manager behaviour - does it give dysfunctional decision making – e.g. will a manager reject a new product that is acceptable to the company as a whole?

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Transfer pricing - General rule TP = marginal cost + opportunity cost In a perfectly competitive market, TP = market price. If spare capacity exists, TP = marginal cost. With production constraints, TP = marginal cost + opportunity cost of not using those resources elsewhere.

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Practical transfer pricing systems Market price Production cost + mark-up Negotiation

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Divisional performance measurement Key considerations Manager or division? Type of division. –Cost centre –Profit centre –Investment centre

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Return on Investment (ROI)

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Residual Income (RI) RI = Pre tax controllable profits – imputed charge for controllable invested capital

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14. Performance measurement in not-for-profit organisations Objectives. Performance Measurement.

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Objectives Planning for NFPs usually more complex. Multiple objectives Difficult to quantify objectives Conflicts between stakeholders Difficult to measure performance Different ways to achieve the same objective Objectives may be politically driven

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Performance measurement Value for money (VFM) Effectiveness Efficiency Economy

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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 12 Financial and Cost- Volume-Profit Models.

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