Notes

Notes
ACCA Paper F2
(FIA Paper FMA)
Management Accounting
For exams in 2015
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ACCA F2 Management Accounting
Contents
Page | 2
About ExPress Notes
1.
The Nature, Source and Purpose of

Management Information
2.
Cost Accounting Techniques
12
3.
Budgeting
21
4.
Standard Costing
31
5.
Performance Measurement
40
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Chapter 1
The Nature, Source and Purpose of

Management Information
The Characteristics of Good Information

The qualities of good information can be summarized in the word ACCURATE:
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Accurate,
Complete,
Cost-beneficial,
User-targeted,
Relevant,
Authoritative,
Timely and
Easy to use
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KEY KNOWLEDGE
Management Accounting
The process of identification, measurement, accumulation, analysis, preparation,

interpretation and reporting of information used by management to set targets, plan
resource allocation, evaluate investment choices and monitor/control the operating
performance and the orderly conduct of the business.
Differences in purpose and scope, compared to Financial Accounting
Aimed at internal users (as opposed to financial accounting, which is aimed at

external stakeholders)
Focused on present and future performance (as opposed to financial accounting,

which reports past performance)
Not required by law and not regulated by accounting frameworks (as opposed to
financial accounting, which is a legal requirement and is regulated by accounting
frameworks)
Focused on specific areas or activities (as opposed to financial accounting, which

provides a holistic view of companys performance)
Employs non-financial indicators as well financial, while financial accounting uses

only financial measures.
Managerial Processes
The key processes which face management can be divided into:
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Planning: Defining objectives and appropriate strategies for attaining them;
Decision-making: Making choices, not only with regard to the selection of strategies,
but also along the way as implementation proceeds;
Control: Monitoring of performance during the course of business and taking

remedial action steps as necessary
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Planning
Planning occurs at different levels of the organisation:
Strategic
Strategic: covers the big view of the organisation. It

answers the question What business or businesses should
we be in and what are our objectives?
Tactical
Tactical: this embraces the short-term (budgetary periods);
Operational
Functional (or operational) strategy: this refers to day-to-day

target-setting
Responsibility centers
Related to the above is the notion of responsibility that attaches to each level of an
organisation:
Responsibility centres
Cost Centres
Revenue Centres
Profit Centres
Investment Centres
Cost centres: Responsible for current expenses only

Revenue centres: Responsible for revenues, but not current expenses other than marketing
expenses
Profit centres: Responsible for revenues and current expenses
Investment centres: Responsible for revenues, current expenses and capital expenditure
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KEY KNOWLEDGE
Sources of data
The sources of data are almost infinite, and they must be selected and evaluated carefully
based on reliability and relevance.
KEY KNOWLEDGE
Classifications of cost
In financial accounting, it is a convention to break down costs into:
KEY KNOWLEDGE
Production vs. Non-Production costs
Production costs: These are costs (both direct and indirect, also variable and fixed) which
relate to the production of goods; this is also referred to as manufacturing or factory cost. It
is these costs, accumulated, which provide the value at which goods are placed in inventory
(prior to sale) and form the cost of goods value when sold.
Non-production costs: These are expenses that are incurred independent of production and
include administrative, selling, distribution and finance costs. These costs can have the
character of period costs, as they relate to the period of time in which they occur.
KEY KNOWLEDGE
Direct vs. Indirect costs
Direct costs: are costs that can be directly attributable to a product.

Indirect costs: these are costs that cannot be directly attributable to a product.
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KEY KNOWLEDGE
Fixed vs. Variable costs
Fixed costs: are costs that remain constant regardless of the volume of production. A variety
of indirect costs are fixed.
Variable costs: vary in proportion with the volume produced. Direct costs are by their nature
variable in behaviour.
Although a variable cost increases with the level of activity, the variable cost per unit
remains fixed, while a fixed cost per unit falls with a rise in the level of activity.
Other types of costs:
Mixed costs: these are costs that contain a fixed and a variable element.
Step costs: costs that remain fixed within a defined range of production, but at a certain
level of output increase in a significant way to a new (fixed) level.
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Chapter 2
Cost Accounting Techniques
Materials
The ordering, receiving and issuing of materials from inventory must be controlled according
to procedures and documented at all stages with forms appropriate to the purpose.
The controls and procedures are designed to monitor inventory movements so as to
minimise discrepancies and losses and theft.
Economic Order Quantity
This is a method which seeks to minimize the costs associated with holding inventory.
To determine the total costs, the following data is required:
Q = order quantity
D = quantity of product demanded annually
P = purchase cost for one unit
C = fixed cost per order (not incl. the purchase price)
H = cost of holding one unit for one year
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The total cost function is as follows:

Total cost = Purchase cost + Ordering cost + Holding cost
which can be expressed algebraically as follows:
TC
= PxD
+ C x D/Q
+ H x Q/2
It is this total cost function which must be minimized.

Recognizing that:
PD does not vary;
Ordering costs rise the more frequently one places (during the year); and
Holding costs rise the fewer times one places orders (due to larger quantities being
ordered each time),
It follows that there is a trade-off between the Ordering and the Holding costs.
The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each
other, i.e.
C x D/Q = H x Q/2
Rearranging the above and solving for Q results in
Labour
Direct labour refers to work which is directly involved in the manufacture of a product.
Indirect labour (e.g. the supervisors salary or that of a security guard) forms part of
overhead costs.
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Absorption Costing
This is one method which seeks to make the link between overheads and (product) cost
units. The diagram below provides a useful roadmap.
Total Production Costs
Direct Costs
Indirect costs (overheads)
2. Allocate/Apportion to Cost Centers
Production A
Production B
Service C
1. Allocate
3. Reapportion from
Service to Production
Production A
Production B
4. Absorb
Cost Unit
The focus (above) is production. Overhead costs that are not incurred at the time of
production do not find their way into inventory.
It is useful to think of production costs as being those that end up as part of the inventory
(valuation) while other (non-production) costs are incurred outside, and normally after the
product leaves inventory.
Contribution
Contribution is defined as the difference between Sales revenue and the marginal cost of
sales, or
Contribution = Sales Variable costs (both production and non-production)
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Marginal costing
A marginal approach to costing focuses on the variable (marginal) costs generated in a
business and considers fixed costs as period costs. This allows the company to be able to
quantify the amount by which its costs rise, if it produces/sells an additional unit of output.
Example
Below is data on a manufacturing company.
Selling price (per unit):
120
Cost card (per unit):

Direct materials
Direct labour
Variable production O/Hs
Total variable costs
45
18
9
72
There is a variable selling cost of $2 per unit

Year 1
(units)
Year 2
(units)
Budget (normal) production
1,100
1,100
Actual Production
Actual Sales
1,000
950
1,100
1,150
$16,500
$ 7,000
$16,500
$ 7,000
Actual fixed production O/Hs

Actual SGA costs
Based on the above data, a profit and loss statement for the Years 1 and 2 is shown on the
next page.
Assume that the beginning inventory is zero.
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Profit/Loss (Marginal costing)

Year 1
$
Sales (950/1,150 units)
Year 2
$
114,000
138,000
Less: Variable cost of sales

Opening inventory
3,600
Production costs:
o
Variable
(1,000 x $72)
(1,100 X $72)
Less: closing inventory

(50 x $72)
72,000
79,200
(3,600)
Less: Variable selling costs

(950 x $2)
(1,150 x $2)
0
(68,400)
(82,800)
(1,900)
(2,300)
Contribution
43,700
52,900
Less: Fixed production O/Hs

Less: SGA costs
(16,500)
(7,000)
(16,500)
(7,000)
Profit
20,200
29,400
Inventory is valued at variable production costs.
Absorption Costing
This method argues that focusing on marginal costs is potentially misleading in the longer
run because fixed production costs have also to be covered. Accounting conventions require
that fixed production costs be reflected in each unit produced.
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Revised cost card (Absorption costing)

Direct materials
Direct labour
Fixed production O/Hs
Total production costs
45
18
9
15
87
Profit/Loss (Absorption costing)

Year 1
$
Sales (950/1,150 units)
Year 2
$
114,000
138,000
Less: Variable cost of sales

Opening inventory
4,350
Production costs:
o
Variable
(1,000 x $72)
(1,100 X $72)
72,000
Fixed
(1,000 x $15)
(1,100 X $15)
15,000
79,200
16,500
Less: closing inventory

(50 x $87)
(4,350)
Over/(under) absorption
1,500
Gross Profit
Less: Variable selling costs
(950 x $2)
(1,150 x $2)
1,900
Less: SGA costs
7,000
0
0
(84,150)
29,850
(100,050)
37,950
2,300
Profit
(8,900)
7,000
20,950
(9,300)
28,650
Inventory is valued at the full production costs.
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Summary of Absorption costing and Marginal costing formats
Absorption Costing
Marginal Costing
Variable/Fixed
production costs
Variable production/
non-production costs
Revenue
Less: Cost of Sales
Gross profit
Contribution
Less: Expenses
Variable/Fixed
Fixed production/
Net Profit
Job costing / Batch costing

This refers to the calculation of costs associated with a specific job or customer order. This
is appropriate in situations where each product or service is distinct, and possibly unique, in
its delivery.
Batch costing is similar to job costing; the distinction lies in the identification of costs with
specific batches, which are numbered (separately identified) for this purpose.
Process Costing
Process costing is a technique that applies to the mass production of a large number of
identical products, moving through a series of processing stages. The accumulated costs of
production can be averaged over the number of items produced.
The average cost is determined by the following formula:
Average cost per unit =
Total cost of inputs Scrap value of rejected units

No. of units of input Normal loss
The total cost of inputs refers to labour, materials and overhead costs of production. If
losses occur along the way that necessitate the scrapping of defective units, then to the
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extent that these items fetch a scrap value, then that (scrap) value will reduce the total
costs.
Similarly, an accounting is made of the number of units introduced into a process with the
expectation that a normal loss will be incurred. The number of good units emerging from a
process will therefore be the number of units entering it, minus the expected number lost in
processing.
Abnormal gains and losses are accounted for as an adjustment to the accounts using the
same value as the good output (deducted in the case of loss and added in the case of
gains).
Equivalent units (EU)
This refers to the way in which partially-completed output (work-in-progress or WIP) is
expressed. If an unfinished unit of product contains 35% of the labour and materials costs
of a complete unit, then the unit has a degree of completion of 35% in terms of value. It is
therefore considered to have an EU of 35%, which is normally expressed in monetary terms.
Weighted average method
The weighted average method makes no distinction between units that were started (but
not finished) in a previous process and those started in the current process. Since all the
units, when completed, are visually identical, processing costs are averaged over all the
units.
First-In-First-Out (FIFO) method
The FIFO method does make a distinction between units that were started in a previous
process and those begun in a current process. FIFO costing separates the costs that were
incurred in the previous period from costs of the current period.
Joint products / By-products

Joint products are two or more products that share a common processing path until the
point of separation. Until they go their own (separate) ways, the costs of production during
the joint processing cannot be physically distinguished.
There are different methods used to apportion common costs to such products at the point
of separation:
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Market value (based on expected sales price)
Number of units (litres, tons, or some other objective physical measurement)
Net realizable value = Final sales value Incremental processing costs
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By-products are goods which are incidental to the production process and which generate
cash from sales, though the amount is modest in comparison to the overall revenues of the
firm. The cash received for by-products can be viewed as a bonus that reduces production
costs.
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Chapter 3
Budgeting
Budgeting: definition and purpose
Quantitative plan for the future, used to:
a) Communicate
Objectives
b) Motivate
Employees
b) Control
Activities
b) Evaluate
Performance
The master budget process
Annual frequency, preferably revised on a regular basis (rolling budget)

Based on organizations objectives, expressed in financial, quantitative and
qualitative measures
The operating budget sequence
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Sales budget
Production budget
Ending inventory budget
Direct materials budget, Direct labour budget, Factory overhead budget
Cost of Sales budget
R&D budget, Marketing budget, Distribution budget, Customer service budget, Admin
budget
Pro-forma income statement
The financial budget sequence
Capital budget
Cash budget
Pro-forma balance-sheet and pro-forma statement of cash-flows
Operating budgets
These are budgets that quantify the revenues and costs relating to a companys activities at
a disaggregated level, meaning that there is direct input from department and functional
levels. They require both volume (e.g. units of output, quantities, hours, etc.) and price
specifications. Operating budgets are modelled on what will emerge as the companys
income statement. Examples include:
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Sales budget
Production budget
Direct material usage
Direct material purchases
Direct labour budget
Factory overhead budget
Selling & distribution budget
Administrative expenses budget
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The disaggregation of budgets referred to above allows the practice of responsibility

accounting.
Expected Value
This is the average of possible outcomes weighted by the probability of each outcome.
Profit/(Loss)
340
766
278
450
-230
Expected
Probability Value
10%
20%
50%
18%
2%
100%
34.0
153.2
139.0
81.0
-4.6
402.6
Regression analysis
This is a statistical tool used to describe the relationship between two sets of variables.
The correlation coefficient denoted by r -- measures the strength of the linear association
between the variables. The range for r is: -1 < r < +1
The coefficient of determination measures the degree to which the variation in the
dependent variable can be explained by the independent variable (x). It is denoted as r2 and
its range is: 0 < r2 < 1
The use of spreadsheets is a basic skill that all accountants should possess.
Discounted cash flow (DCF) techniques

The preeminence of cash
Cash, both its receipt and possession, lies at the basis of economic value. Cash is used to
pay the bills and bonuses. It is a better indicator of wealth when compared with measures
defined by accounting conventions, such as accounting profit.
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Timing and value

Tracking and measuring cash flows on a time-adjusted basis is critical: cash received quickly
can be used to repay debt (avoiding interest costs) or invested (earning interest). Cash paid
with a delay can reduce costs (as long as penalties are not incurred).
It follows that the longer one waits for a receipt of cash, the less that cash is worth in
todays terms. Among other factors, its purchasing value may diminish due to the effects of
inflation.
Instead of receiving USD 100 today, assume it will be received after one year. To
compensate for the delay, what should the value be after one year?
Present Value (PV)

100
Future Value (FV)

100 x (1+r)
Interpreting r:
As opportunity cost: what we sacrifice by not having it now.
As risk-adjusted rate: representing the riskiness of not getting the money back.
As cost of capital rate: representing the return that capital providers expect
From a companys point of view, this is the rate of return that the business must generate
for its capital providers (shareholders and lenders). If a company has to raise the necessary
cash for its activities, then this is the rate it must pay.
It reflects the opportunity cost to the investors (what investment alternatives they have) on
a risk-adjusted basis.
Discounting
The above relationship between PV and FV:
PV x (1+r) = FV
can be re-arranged to:
PV = FV
(1+r)
with r representing the discount rate.
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The above refers to one-period discounting, with r corresponding to the period.

If discounting is done over more than one period, then the discounting effect will be:
PV = FV
(1+r)n
where n refers to the number of periods.
Thus, 100 received after two years, discounted at 10% p.a. will be
PV = 100 = 82.6
(1.10)2
This reflects that the uncertainty of getting money back increases with time.
This allows one to discount future values into present values and can be applied to a series
of cash flows:
Year:
Future Values:
100
100
125
105
140
If discounted at r = 10%, then the above cash flows can be restated at their present values:
FV discounted:
100
1.10
100
(1.10)2
125
(1.10)3
105
(1.10)4
140
(1.10)5
PV:
90.9
82.6
93.9
71.7
86.9
Added together results in total PV = 426.

Reducing future cash flows of different timings and amounts to one PV is a powerful
tool.
Note: If all the cash flows had been equal say 100 then the PV calculation would have
been simplified:
FV discounted:
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100
1.10
100
(1.10)2
100
(1.10)3
100
(1.10)4
100
(1.10)5
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PV:
90.9
82.6
75.1
68.3
62.1
The addition of the above is = 379

Net Present Value (NPV)
To add meaning to the future cash flows, we can include the amount invested (which gives
rise to the FVs):
Year:
100
100
125
105
140
Investment: (200)
FV:
PV:
(200)
90.9
82.6
93.9
71.7
86.9
Year 0 amounts denote the present and are automatically = PV.

The NPV of the above cash flows is therefore = 226.
Discounted Payback
We can apply the concept of discounting to the Payback method in order to capture the time
value of money element.
Year:
100
100
125
105
140
Investment: (200)
FV:
PV:
(200)
90.9
82.6
93.9
71.7
86.9
In the table above, the (simple) payback period is in Year 2.

The Discounted Payback period is longer (Year 3).
Relevant Cash Flows
When evaluating projects, cash flow projections must meet the criteria of relevance.
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ExPress Notes
Relevance refers to cash flows that are relevant to the decision whether to accept a project
or not. Cash flows that are created (or discontinued) as a result of taking the decision (to
undertake the project) are relevant; these are also called incremental cash flows.
Included in relevant cash flows would be any investments in equipment and working capital
required by the project. More subtle, but no less important, are any opportunity costs
incurred as a result of accepting the project.
Cash flows which occur whether the project goes ahead or not are not relevant. Also not
relevant are:
Sunk costs;
Committed costs;
Allocated (overhead) costs;
Non-cash expenses
Depreciation is an example of a non-cash expense. One may need to work with

depreciation, however, if they are related to a calculation of taxes due. Any change in the
amount of taxes paid is a very relevant cash flow!
Internal rate of Return (IRR)
The internal rate of return (IRR) is defined as the discount rate (r) at which the net present
value (NPV) of a stream of cash flows will be equal to zero. In other words,
If, at a discount rate r, NPV = 0, then IRR = r
The IRR includes among its assumptions the following: any cash flows generated in the
course of a project being evaluated are calculated as being reinvested at the IRR rate.
Comparison of NPV and IRR methods

The following decision rules apply to appraisal methods:
NPV: Positive NPV projects are acceptable; the higher the better.
IRR: An IRR in excess of a hurdle rate (set by the company) indicates acceptability; the
higher (the IRR) the better.
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ExPress Notes
EXAMPLE
Year
-5,000
6,000
-7,500
8,850
IRR
NPV:
10%
14%
16%
20%
454
263
172
18%
545
263
129
Intuitively, IRR should be preferable, as it relates return to amount invested.

Equal investment amounts do not necessarily remove the ambiguity.
EXAMPLE
Year
IRR
-500
-500
NPV (9%)
100
600
20%
97
500
155
25%
89
Principal budget factor

When a budget is prepared, management must identify any factors that will prevent the
company from surpassing a certain level of activity.
A bank, for example, may be constrained from developing an extensive branch network
owing to the scarcity of suitably-skilled professional staff; or production may be constrained
by the built capacity of the plant or by the level of demand for a companys products. In
each of these cases, there is a limiting factor at work.
Fixed vs. flexible budgets

Traditional budgets tended to be rigid, i.e. they were not subject to modification during the
period to which they referred.
Example
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ExPress Notes
A producer of office equipment has a budget for the coming year:

Output: 1,000
Costs:
Materials
Labour
Fixed O/Hs
Total
units
75,000
200,000
100,000
375,000
After 3 months, the company observes that sales are running ca. 20% higher than originally
projected and it has therefore increased its production by a similar amount. In order to look
back at what its budget would have been had the actual (higher) level of activity been
anticipated, management can prepare a flexed budget; this is effectively a re-calibration of
the original budget. It allows management to re-focus their efforts without losing time
tracking artificial spending excesses according to the original budget.
Output: 1,200
Costs:
Materials
Labour
Fixed O/Hs
Total
units
90,000
225,000
100,000
415,000
Prepare a flexed budget for an output level of 1,075 units.

Based on the data (below), the
variable cost of labour is $125 per unit, and the

fixed cost of labour is $75,000
Output:
1000
1200
Mats
75,000
90,000
Labour
200,000
225,000
Fix
100,000
100,000
Total
375,000
415,000
Therefore the cost of labour at output of 1,075 units is $209,375.
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ExPress Notes
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
Chapter 4
Standard Costing
Absorption Costing
This method argues that focusing on marginal costs is potentially misleading in the longer
run because fixed production costs have also to be covered. Accounting conventions require
that fixed production costs be reflected in each unit produced.
Fixed Overhead Absorption Rate (FOAR) =
Budgeted production O/H

Budgeted level of production
Budget (normal) production
Year 1
(units)
1,100
Year 2
(units)
1,100
Actual fixed production O/Hs
$16,500
$16,500
Fixed Overhead Absorption Rate (FOAR) = $15 ($16,500/1,100)
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ExPress Notes
Cost card (Absorption costing)

Direct materials
Direct labour
Fixed production O/Hs
Total production costs
45
18
9
15
87
Having established the OAR, we now have a basis on which the production department can
keep track of the fixed overheads being generated as the manufacturing process proceeds.
Actual output (units) x OAR = Fixed O/H absorbed
Basic variance analysis
The following data is from a manufacturing company

Budget
Production:
Sales:
Sales Price:
1,100 units
1,000 units
$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
Cost card (per unit)
Materials (5kgs x $9 per kg)
Labour (3hrs x $6 per hr)
Variable O/Hs (3 hrs x $3 per hr)
Fixed O/Hs (3 hrs x $5 per hr)
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45
18
9
15
87
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ExPress Notes
Variance calculations
Sales volume variance (Absorption costing)
Budgeted sales volume
Actual sales volume

Sales volume variance
@ standard margin ($120-$87)
1,000
950
50 (A)
$1,650 (A)
Sales volume variance (Marginal costing)
Budgeted sales volume
Actual sales volume
1,000
950

50 (A)
@ standard contribution ($120-$72) $2,400 (A)
Sales price variance
950 units should have sold @$120
114,000
Actual revenues (950 units x $115)
109,250
4,750 (A)
Material variances
(i)
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Material price variance
Materials used (4,900 kg) should have cost @ $9
44,100
Materials (4,900 kg) did cost
45,025
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ExPress Notes
Materials price variance

(ii)
$925 (A)
Material usage variance
1,000 units should have used @ 5 kg
5,000 kg
1,000 units did use
4,900 kg
Materials usage variance

@ standard $9
Materials total variance:
100 kg (F)
$900 (F)
$ 25 (A)
Labour variances
(i)
Labour rate variance
Labour (3,100 hrs) should have cost @ $6
18,600
Labour (3,100 hrs) did cost
19,050
Labour rate variance

(ii)
$450 (A)
Labour efficiency variance
1,000 units should have taken @ 3 hrs
3,000 hrs
1,000 units did take
3,100 hrs
Labour efficiency variance

@ standard $6
Labor total variance:
100 hrs (A)

$600 (A)
$ 1,050 (A)
Variable O/H variances

(i)
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Variable O/H expenditure variance
3,100 hrs should have cost @ $3
9,300
3,100 hrs did cost
9,250
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ExPress Notes
Variable O/H expenditure variance

(ii)
50 (F)
Variable O/H efficiency variance
1,000 units should have taken @ 3 hrs
3,000 hrs
1,000 units did take
3,100 hrs
Variable O/H efficiency variance

@ standard $3
Variable O/H total variance:
100 hrs (A)

$300 (A)
$ 250 (A)
Fixed O/H total variance (Absorption costing)
Overhead actually incurred
$17,000
Overhead absorbed (1,000 units x $15)
$15,000
Fixed O/H total variance
$ 2,000 (A)
This can be broken down into two components:

(i)
Fixed O/H expenditure variance
Budgeted O/H should have cost (1,100 units x $15) 16,500
Actual O/H cost

Fixed O/H expenditure variance
(ii)
$500 (A)
Fixed O/H volume variance (Absorption Costing)
Budgeted production
1,100 units
Actual production
1,000 units
Fixed O/H volume variance

@ standard $15
Page | 35
17,000
100 units (A)

$1,500 (A)
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ExPress Notes
Interpreting variances
Material price
Favourable:
Unanticipated discounts received, better purchasing/negotiation,

cheaper (substandard) materials
Adverse:
Price inflation, poor purchasing, better quality materials
Material usage
Favourable:
Better quality materials, more efficient processing
Adverse:
Substandard material, waste, poor quality control, theft
Labour rate
Favourable:
Low pay rates, cheap workers
Adverse:
Wage inflation
Labour efficiency
Favourable:
More efficient production, motivated/better trained workers, better

materials and/or equipment
Adverse:
Poorly trained workers, deficient work organization, materials or

equipment
Overhead expenditure
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Favourable:
Cost savings, more efficient use of ancillary services
Adverse:
Poor cost disciplines, complexity and bureaucracy
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ExPress Notes
Overhead volume
Favourable:
Using production capacities beyond the level budgeted
Adverse:
Under-utilization of production capacities
Inter-connections among variances

As can be seen above, a factor causing a favourable variance may at the same time be the
cause of an adverse variance in another part of the companys operations.
It is managements responsibility to understand these relationships and to be able to
anticipate, and if possible quantify, the impact of their actions on overall performance.
At the same time, management needs to review standards for their relevance and
usefulness, as well as apply common sense to the materiality and controllability of specific
variances.
Reconciliation of budgeted profit and actual profit

Operating statement
Prepare a reconciliation between the profit budgeted and that realized.
Budgeted profit (Absorption costing)
33,000
1,650 (A)
4,750 (A)
26,600
Cost variances:
Materials
Price
Usage
A
925
900
Labour
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ExPress Notes
Rate
450
Efficiency
600
Variable
Expenditure
50
Efficiency
300
Expenditure
500
Fixed
Volume
950
1,500
4,275
Actual profit
3,325 (A)
23,275
Note: Closing inventory is valued at standard cost

Operating Statement based on Marginal costing
Budgeted contribution (Marginal costing)
2,400 (A)
4,750 (A)
48,000
40,850
Cost variances:
Materials
Price
Usage
A
925
900
Labour
Rate
450
Efficiency
600
Variable
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ExPress Notes
Expenditure
Efficiency
50
950
300
2,275
Actual contribution
Fixed O/Hs Budgeted
Fixed O/Hs Expenditure variance
Actual profit
Page | 39
1,325 (A)
39,525
16,500
500
(17,000)
22,525
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ExPress Notes
Chapter 5
Performance Measurement
Mission Statement
It sets the broad purpose of the organisation

It is articulated in a mission statement, which is an open-ended statement outlining the
core values of the business, defining the industry the firm competes in, and describing
the general way of doing business.
KEY KNOWLEDGE
Financial Performance measures
Included in financial performance measures is a range of ratios:
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Efficiency ratios (e.g. asset turnover, debtor days and creditor days);
Gearing ratios (e.g. debt equity ratio);
Liquidity ratios (e.g. current ratio and quick ratio);
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ExPress Notes
Profitability ratios (e.g. gross margin, operating margin and ROCE);

Interest ratios (e.g. interest coverage).
Value for Money

A useful way to judge performance in a not-for-profit organization is to apply the Value-forMoney method can be useful. It incorporates three elements, referred to as the 3 Es:
Economy: Getting the best deal on inputs
Efficiency: Converting inputs into the maximum number of outputs
Effectiveness: Ensuring that organizational objectives are being met
KEY KNOWLEDGE
The scope of performance measurement
Balanced scorecard
The balance scorecard addresses a number of parameters (or perspectives) in monitoring
business performance by asking the following questions:
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Financial perspective: To succeed financially how should we appear to our

shareholders?
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
Return on Investment (ROI) at the Divisional Level

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
Net Profit
Capital Employed
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.
Residual Income (RI)
Convert results into monetary magnitudes:
Residual Income
Divisional EBIT (minus) Imputed interest
Where
Imputed interest
= Capital Employed X Capital charge (or cost of capital)
A positive result adds profits to the division beyond the incremental capital cost. An
investment should be accepted if the RI is positive.
Non-financial performance indicators

NFPIs are important because:
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ExPress Notes
They broaden managements view of what needs to be mastered and measured in

the organization; if financial measures alone were used, there is the risk of focusing
only on improving financial results in the short-term while neglecting the long-term
viability of the business;
Employees, especially at the operational level, can relatemore easily to NFPIs (no. of
tons of steel processed; length of time it takes to cook a cheeseburger);
Companies increasingly resort to NFPIs since operational measures may provide a

leading (or early) indicator of what becomes visible only later in the financial results;
in other words, management can react more quickly to problems (e.g. customer
surveys that indicate a significant drop in customer loyalty, which can endanger the
medium/long-term health of a business)
(end of ExPress Notes)
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The Nature, Source and Purpose of

The Characteristics of Good Information

The process of identification, measurement, accumulation, analysis, preparation,

Aimed at internal users (as opposed to financial accounting, which is aimed at

Focused on present and future performance (as opposed to financial accounting,

Focused on specific areas or activities (as opposed to financial accounting, which

Employs non-financial indicators as well financial, while financial accounting uses

Planning: Defining objectives and appropriate strategies for attaining them;

Control: Monitoring of performance during the course of business and taking

Strategic: covers the big view of the organisation. It

Tactical: this embraces the short-term (budgetary periods);

Functional (or operational) strategy: this refers to day-to-day

Cost centres: Responsible for current expenses only

In financial accounting, it is a convention to break down costs into:

Direct costs: are costs that can be directly attributable to a product.

Cost Accounting Techniques

The total cost function is as follows:

It is this total cost function which must be minimized.

PD does not vary;

Indirect costs (overheads)

2. Allocate/Apportion to Cost Centers

Cost card (per unit):

There is a variable selling cost of $2 per unit

Budget (normal) production

Actual fixed production O/Hs

Profit/Loss (Marginal costing)

Less: Variable cost of sales

Less: closing inventory

Less: Variable selling costs

Less: Fixed production O/Hs

Inventory is valued at variable production costs.

Revised cost card (Absorption costing)

Profit/Loss (Absorption costing)

Less: Variable cost of sales

Less: closing inventory

Less: SGA costs

Inventory is valued at the full production costs.

Summary of Absorption costing and Marginal costing formats

Job costing / Batch costing

Total cost of inputs Scrap value of rejected units

Joint products / By-products

Market value (based on expected sales price)

Number of units (litres, tons, or some other objective physical measurement)

Net realizable value = Final sales value Incremental processing costs

Budgeting: definition and purpose

Quantitative plan for the future, used to:

The master budget process

Annual frequency, preferably revised on a regular basis (rolling budget)