LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 12:58 Page F5 Paper F5 Performance Management ACCA LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 12:58 Page PERFORMANCE MANAGEMENT British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by InterActive World Wide Limited Westgate House, 8-9 Holborn London EC1N 2LL www.iaww.com www.studyinteractive.org ISBN 978-1-907217-04-3 First Edition 2009 Printed in Romania © 2009 InterActive World Wide Limited London School of Business & Finance and the LSBF logo are trademarks or registered trademarks of London School of Business & Finance (UK) Limited in the UK and in other countries and are used under license All used brand names or typeface names are trademarks or registered trademarks of their respective holders All our rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of InterActive World Wide LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 12:58 Page FOREWORD Foreword Thank you for choosing to study with the London School of Business and Finance (LSBF) A dynamic, quality-oriented and innovative educational institution, the London School of Business and Finance offers specialised programmes, designed with students and employers in mind We are always at the frontline driving the latest professional developments and trends LSBF attracts the highest quality candidates from over 140 countries worldwide We work in partnership with leading accountancy firms, banks and best-practice organisations – enabling thousands of students to realise their full potential in accountancy, finance and the business world With an international perspective, LSBF has developed a rich portfolio of professional qualifications and executive education programmes To complement our face-to-face and cutting-edge online learning products, LSBF is now pleased to offer tailored study materials to support students in their preparation for exams The exam focused content in this manual will provide you with a comprehensive and up-to-date understanding of the ACCA syllabus We have an award-winning team of tutors, who are highly experienced in helping students through their professional exams and have received consistently excellent feedback I hope that you will find this manual helpful and wish you the best of luck in your studies Aaron Etingen ACCA, MSI, Founder and CEO LSB_F5 Performance Management_section 1:297mm x 210mm PERFORMANCE MANAGEMENT 28/8/09 12:58 Page LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 12:59 Page CONTENTS Contents Foreword About ACCA Paper F5 - Performance Management Contents Syllabus and Study Guide Pilot Paper Formulae Sheet 11 25 43 Chapter - Session parts and - Activity Based Costing (ABC) 47 Chapter - Session part - Life Cycle and Target Costing 71 Chapter - Session part - Backflush and Throughput Accounting Chapter - Session - Marginal Costs and Relevant Costs Chapter - Session - Linear Programming 61 81 103 Chapter - Session - Pricing Decisions 121 Chapter - Session - Budgeting 153 Chapter - Session - Decision Making Under Uncertainty 137 Chapter - Quantitive Aids to Budgeting 173 Chapter 11 - Advanced Variance Analysis 215 Feedback and Review Form 259 Chapter 10 - Basic Variance Analysis Chapter 12 - Performance Measurement 193 237 LSB_F5 Performance Management_section 1:297mm x 210mm PERFORMANCE MANAGEMENT 28/8/09 12:59 Page LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 12:59 Page F5 About ACCA Paper F5 Performance Management LSB_F5 Performance Management_section 1:297mm x 210mm PERFORMANCE MANAGEMENT 28/8/09 12:59 Page LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 12:59 Page ABOUT ACCA PAPER F5 - PERFORMANCE MANAGEMENT Aim of the Paper The aim of the paper is to introduce knowledge and understanding of management accounting.The paper develops knowledge and understanding of how to prepare and calculate costing information for use within a business Outline of the Syllabus Explain the nature of cost and management accounting Explain the purpose of cost and management accounting Identify and describe costs by classification, behaviour and purpose Explain and apply cost accounting techniques Prepare and coordinate budgets for feedback and control Use management accounting techniques to make and support decision making Format of the Exam Paper The syllabus is assessed by a two hour computer-based examination The examination consists of a mixture of mark and mark questions There will be 40 compulsory mark questions There will be 10 compulsory mark questions Getting the most from your studies Manage your time effectively If you have a busy work schedule use your study planner to catch up Do not allow yourself to fall behind Make sure that you can apply all the numbers to the formulae and can perform the calculations accurately Practice as many questions as you can You should aim to have attempted every question in the revision kit at least twice before the exam LSB_F5 Performance Management_section 1:297mm x 210mm PERFORMANCE MANAGEMENT 10 28/8/09 12:59 Page 10 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:00 Page 88 PERFORMANCE MANAGEMENT Shut Down decision As an extension of the above analysis, we can consider situations where the business may consider shutting down part of its operations It is important here to recognise the importance of relevant costing principles By closing part of the business, revenues from the products made and sold from that part of the business will be lost (foregone) However costs will also be saved (avoidable costs) Avoidable costs will include the variable costs of the part of the factory being closed It is important however to note that some fixed costs may be avoided as well The fixed costs that can be avoided are known as specific fixed costs (for example plant, machinery and salaried staff that are specifically employed in making the products in the part of the division to be closed) Fixed costs of a more general nature will not be avoided if the section of the business is closed • Decision criteria: shut down if avoidable costs > revenues foregone Worked example of shutdown decision Jones Ltd operates three divisions within a larger company The CEO has been shown the latest profit statements and is concerned that division C is losing money You are required to advise her whether or not to close down division C Division ($000s) Sales Variable costs Fixed costs Profit/(loss) A B C 100 80 40 20 10 (10) 60 20 50 20 30 20 You are also informed that 40% of the fixed cost is product specific, the remainder being allocated arbitrarily to the divisions from head office Required: Should division C be shut down? Answer Division C Revenue foregone Avoidable costs Variable Costs Specific Fixed Costs ($20,000 x 40%) Net cost of closure $’000 $’000 (40) 30 38 (2) The decision should be to retain Division C If closed, the business would lose $2,000 in overall profit In essence the contribution foregone of $10,000 ($40,000 revenue - $30,000 variable costs) exceeds the specific fixed costs saved 88 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:00 Page 89 SESSION - MARGINAL COSTS AND RELEVANT COSTS LIMITING FACTOR DECISIONS We have already seen limiting factor analysis in F2 There may (in the short-term) be a restriction on activity due to a scarce resource Typically this could be: • • • Limited availability of materials; Key staff shortages; Productive capacity etc… In the long-term, the business could rectify this by (for example) sourcing from different suppliers, recruiting new workers (or re-training existing workers), purchasing new machinery etc In the short-term, we aim to maximise contribution by choosing production combinations of products which make the ‘best use’ of the scarce resource Again we assume that fixed costs in total will not change as a result of our decision • Decision criteria: Select and produce products which maximise the contribution per unit of limiting factor The steps involved in limiting factor decision questions are: • • • • Step 1: Calculate the contribution per unit of sale (contribution of each product); Step 2: Calculate the contribution per unit of scarce resource (contribution per unit of sale ÷ limiting factor per unit of sale); Step 3: Rank production schedule in order of step – starting with the highest first; Step 4: Use up the resource in order of the ranking Worked example: Limiting Factor Analysis Neal Ltd produces two products using the same machinery The hours available on this machine are limited to 5000 Information regarding the two products is detailed below: Products (per unit data) Selling price ($) Variable cost ($) Fixed cost ($) Profit ($) Machine hours Budgeted sales (units) M 40 16 10 14 600 N 30 15 500 Required: Calculate the maximum profit that may be earned The limiting factor in this scenario is given in this question, namely machine hours In reality the business in the long-term could look to acquire a new machine, but is constrained in the short-term by the machine capacity available 89 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:00 Page 90 PERFORMANCE MANAGEMENT Step 1: Contribution/unit Product M Product N 40 30 Sales price $ Variable Costs $ (16) (15) $24 ÷8 hours = $3/machine hour $15 ÷3 hours = $5/machine hour 2nd 1st Machine hours Production schedule (1,500) Product N 500 units $7,500 (500 units x $15) Product M 437.5 units $10,500 Total Contribution (437.5 units x $24) $18,000 24 Contribution per unit (CPU) Step 2: contribution per machine hour CPU ÷ machine hours/unit Step 3: rank production Step 4: production schedule Hours available: 5,000 (500 units x machine hours) 3,500 (3,500 hours ÷ hours/unit) = 437.5 units (3,500) nil 15 Contribution In order to calculate fixed cost we MUST remember that the OAR for each product is based on budgeted levels of activity OAR = Budgeted Overhead Cost Budgeted Level of Activity Therefore in order to calculate the fixed costs in total we work ‘backwards’: Budgeted Overhead Cost = Budgeted level of activity x OAR Product M N Total Fixed Cost 90 Budgeted Activity x OAR Fixed Cost $ 500 units x $8/unit 4,000 600 units x $10/unit 6,000 $10,000 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:00 Page 91 SESSION - MARGINAL COSTS AND RELEVANT COSTS Therefore the overall profit for Neal Ltd becomes: Total Contribution Less: Fixed Costs Overall profit $ 18,000 (10,000) $8,000 Further processing decisions As an extension to our previous studies on process costing we can consider the relevant costing decision issue of whether or not it is worthwhile processing a product further through a production system For example in a petroleum refining process, crude oil is refined in a ‘joint process’ Once refined, separate products can be clearly identified such as; petrol, kerosene, lubricating oils etc These are known as ‘joint products’ and are usually identified at the split off point The business needs to decide whether it is worthwhile selling unrefined products at this ’split off’ point Alternatively the business can process/refine the product further and then sell the more refined product at a higher sales price The choice becomes: Sell at split off point or sell after further processing Sell unrefined JP1 at split-off point? Sell refined RP1 at end of final process? Joint product (JP1) Refined product (JP1) Further Process Joint Process Joint product (JP2) Sell unrefined JP2 at split-off point? Refined product (JP2) Sell refined RP2 at end of final process? The Joint Process costs can not be part of any decision that we make These costs are common to all products whether refined further or not For example, the cost of buying the crude oil is common to all refined petroleum based products that can be derived by processing that crude oil further Decision criteria: Process further (beyond the split off point) if incremental revenues generated by further processing > incremental costs of further processing 91 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:00 Page 92 PERFORMANCE MANAGEMENT A simple illustration: Unrefined Product A can be sold at the separation point for $5 per unit If it is further processed, at a cost of $8 per unit, it can then be sold in its more refined state for $16 per unit Should it be processed further? The word ‘incremental’ is important for relevant cost decisions because it identifies the extra cost, revenue or cash flow that will occur as a result of a decision Here, if Product A is processed further, incremental revenue and costs will be earned/incurred: $ Sales price if processed further (refined Product A) $ 16 Sales price if sold at split off point (unrefined Product A) Incremental revenue 11 Incremental costs of processing further (8) Extra profit by further processing We can see that further processing is worthwhile because the incremental revenue of $11 outweighs the incremental costs of $8 If we altered the example so that only $12 is earned after further processing, then the decision would change and it would no longer be worthwhile processing further and Product A should be sold at the split off point: $ Sales price if processed further (refined Product A) $ 12 Sales price if sold at split off point (unrefined Product A) Incremental revenue Incremental costs of processing further (8) (1) Extra loss by further processing Fully worked example – further processing decision Heighway Ltd operates a joint process from which four products arise The products may be sold at the separation point of the process or can be refined further and be sold at a premium Information regarding the products and the refining process can be found below: Product Selling price – at the split-off point Selling price – after further processing Costs Joint process cost per unit Refining cost per unit Specific fixed cost (total) Budgeted units E F G H 12 16 15 18 20 23 25 22 8 8 1,000 2,000 3,000 4,000 2,000 500 5,000 6,000 General Fixed Costs for the period are $20,000 if further processing is undertaken 92 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:00 Page 93 SESSION - MARGINAL COSTS AND RELEVANT COSTS Required Which products should be further processed? Answer Product E F G H Selling price – at the split-off point ($) 20 23 25 22 12 16 15 18 Less: incremental variable cost/unit of processing further (refining cost) ($) (5) (5) (5) (5) (1) 2,000 500 5,000 $6,000 $1,000 $25,000 Sell at split off point Selling price – after further processing ($) Incremental revenue/unit ($) Incremental contribution per unit (CPU) ($) x budgeted production/sales units Incremental total revenue Specific fixed cost (total) Net ‘contribution’ ($1,000) $5,000 ($2,000) ($1,000) Sell at split off point 10 ($3,000) $22,000 - - - From the table above we can see firstly that it is not worthwhile processing Product H beyond the split off point To so would earn incremental revenue of $4, but at an incremental variable cost per unit of $5 Similarly Product F creates an incremental revenue per unit of $2 and an incremental revenue overall of $1,000 This is however insufficient to cover the extra fixed overhead specifically incurred if Product F is processed beyond the split off point Finally we can compare the extra amounts earned by products E and G against the extra general fixed costs of further processing: E – net ‘contribution’ G – net ‘contribution’ General Fixed Costs Incremental profit of further processing $ $ 22,000 27,000 5,000 (20,000) 7,000 We can see that it is worthwhile processing Products E and G beyond the split off point since they not only are profitable when compared to their own specific fixed costs, they also create a profit of $7,000 after the general fixed costs have been paid off 93 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:00 Page 94 PERFORMANCE MANAGEMENT COST VOLUME PROFIT ANALYSIS (CVP) The concept of ‘break even’ analysis is familiar from previous studies The concept of CVP is based largely around contribution Again the assumption is largely that as a short-term form of decision making, fixed costs not vary with short term decisions on activity levels The true variables are sales revenues and variable costs Revision: Sales revenue – Variable costs = Contribution = Fixed Costs + Profit In order to ‘break even’ the business will be operating at a level where nil profit and nil loss is made The contribution made by the business equals its fixed costs At break even Sales – Variable Costs = Contribution – Fixed Costs = nil ∴Contribution = Fixed Costs at the break even point Importantly contribution is calculated on a per unit basis, the more units made and sold then more contribution earned by the business Fixed costs and any target profit can be expressed in total Decision criteria: Required units to sell = Target Contribution (e.g fixed costs + target profit) Contribution Per Unit (CPU) Worked example: break even analysis Freedman manufactures a product with the following budgeted data: • • • • Sales Price per unit = $10 Variable cost per unit = $4 Total Fixed Costs = $12,000 Target profit for the period = $18,000 How many units should Freedman aim to manufacture and sell to break even and to make the target profit of $8,000? Break even point (units): $12,000 = 2,000 units ($10 – $4) = $6/unit Activity to make a profit of $18,000 (units): $12,000 + $18,000 = 5,000 units ($10 – $4) = $6/unit Proof: Sales Revenue Variable costs Contribution Fixed Costs Total profit 94 Unit standards Number of units Total $ ($4) x 5,000 = (20,000) $10 $6 x 5,000 = x 5,000 = 50,000 30,000 (12,000) 18,000 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:00 Page 95 SESSION - MARGINAL COSTS AND RELEVANT COSTS RELEVANT COST ANALYSIS For any short-term decision we must consider relevant costing principles These principles build upon everything that we have seen so far! For a cost to be relevant to a decision it must have three properties: • • • It must arise in the future Anything that occurs in the past can not be relevant to decisions being made now For example, if you bought a machine three years ago for $4,500, that amount has no relevance now for a decision whether or not the machine should be replaced It is a sunk cost It must be a cash flow Cash flows have a direct link to the wealth of the owners of a business They are an objective way of measuring the success or otherwise of any decision It arises as a direct result of the decision being taken (incremental) As we have already seen, it is important to identify how cash flows in the future will differ as a result of the decision being made In summary for a cost (or revenue!) to be relevant to a decision it must be a: Future cash flow which arises as a result of the decision being taken It is important to consider the cash flows for the business as a whole and not just the decision being made in isolation, when considering relevant costs We need to explore this principle in more detail Non-relevant costs: • • • • Sunk Costs: Any cost arising as a result of a past decision can not influence a current decision For example, if the business has incurred a cost for purchasing materials, it is not going to be able to get that money back, it has been spent Committed Costs: Some businesses may have agreed to pay cash sums in the future For example the business may have agreed to pay its insurance premium in 12 monthly installments These cash outflows will have to occur whatever decisions the business takes today Non-cash flows: The most common non-cash flow is depreciation (also amortisation) Depreciation only ever affects the reported profit of a business and never affects the cash flows of a business or a decision being made Indeed the only relevant capital cash flows are the initial outlay to acquire the asset and the proceeds when the asset is sold Fixed overhead absorbed: Fixed overhead absorbed relates to an underlying fixed cost that will not vary as a result of the decision being made Overhead absorbed relates to the arbitrary re-allocation of a cost and not a true cash flow Fixed costs are not incurred on a per unit or ‘variable’ basis! Therefore fixed cost per unit can not be relevant Relevant Costs: • • • • Opportunity Costs: A business must recognise that there is often an alternative option to the decision being made by the entity Opportunity costs attempt to quantify the next best alternative for the business as a whole to the decision being made For example a business may have some inventory in its store room It is thinking of selling this material for $10 since it has no use for it A new project being considered could use that material If the decision is to go ahead with the project, the business as a whole loses the opportunity to sell that material Hence the opportunity cost of using the material in the project is $10 – reflecting the lost sales opportunity Variable Costs: Most variable costs will be incurred if the business decides to undertake a new project, but would not be incurred if the business did not go ahead with the project For example by deciding to make more units of a project, more direct costs (and hence cash outflow) will be incurred as a result Incremental costs: A decision may cause other incremental costs to be incurred For example a retailer may be considering opening a new shop By going ahead with this project, it will acquire new premises If the new shop is not opened, then the new premises will not be acquired Fixed Costs may in total change as a result of a decision For our retailer, they may incur a higher insurance premium if the new shop is opened Avoidable Costs: Costs may be avoided as a result of a decision For example by opening a new shop in a town, our retailer may no longer need to rent its existing premises 95 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:01 Page 96 PERFORMANCE MANAGEMENT RELEVANT COST OF MATERIALS Exam questions can be quite involved when using relevant cost principles The following diagram will help to identify the appropriate relevant cost to use in different circumstances YES Is the material in stock? NO Purchase price is relevant Next question YES Is the material in constant use? NO Replacement cost is relevant YES Next question Is the material scarce? Opportunity cost is relevant NO Nil value with possible disposal cost saved or sales proceeds forgone Examples – relevant cost of materials: Salako needs 10 Kg of material X to undertake a new project What is the relevant cost of material X in the following independent situations? • Material X is not in stock and is currently available at a market price of $15/Kg • Material X is regularly used by Salako It has Kg in stock which cost $13/Kg three months ago Material X is currently available at a market price of $15/Kg The relevant cash flow is the purchase cost of the material If Salako goes ahead with the project it must pay 10Kg x $15/Kg = $150 to purchase the material If the project was not undertaken, no material would be purchased By undertaking the project and using the Kg in stock, Salako will need to replace this Kg in order to undertake other projects in the future The relevant cost is again the purchase price or replacement cost of material: 10Kg x $15/Kg = $150 96 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:01 Page 97 SESSION - MARGINAL COSTS AND RELEVANT COSTS • 15 Kg of material X is in stock but is no longer available from suppliers It is used by Salako in the manufacture of the Pemberton The Pemberton has the following standard cost card: Sales Price Direct material:1Kg of material X @ $15/Kg Direct Labour: hours @ $8/hour Contribution per Unit $ 15 16 $ 40 (31) It is important to understand the concept of opportunity cost If Salako uses 10 Kg of material X on the new project, it loses the opportunity to use material X on the Pemberton This means that for each Kg of material used on making the new product, Salako will lose the chance of getting $40 revenue from a Pemberton although the direct labour cost of $16 will be saved (the historic cost of the material in Pemberton’s standard cost card is irrelevant) Therefore the opportunity cost becomes: 10 Kg x ($40 – 16) per Kg = $240 The Kg of material X remaining could be used in the manufacture of the Pemberton • 15 Kg of material X is in stock but is no longer available from suppliers It is not used by Salako in the manufacture of any other products and is about to be scrapped at a cost of $2.50/Kg By undertaking the new project, Salako will no longer need to scrap 10 Kg of material X (5Kg of material X will be disposed of whether or not the new project is undertaken) The relevant cash flow is now a saving of 10 Kg x $2.50/Kg = $25 (this is effectively a cash inflow of $25) RELEVANT COST OF LABOUR: The following diagram will help to identify the appropriate relevant cost to use in different circumstances for labour costs Examples – relevant cost of labour: 97 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:01 Page 98 PERFORMANCE MANAGEMENT YES Is the labour in permanent employment? NO Hourly rate is relevant Next question YES Is the labour fully utilised? NO Next Question Nil value YES Overtime rate is relevant Overhead possible? NO Opportunity cost is relevant Martyn needs hours of Grade A labour to undertake a new project What is the relevant cost of Grade A labour in the following independent situations? • Grade A labour is hired on a freelance basis at the rate of $12.50 per hour • Grade A labour is contracted to a 35 hour working week at a pay scale of $10.50/hour Currently the workforce is only working at 80% capacity 20% of their time is currently unutilised Grade A labour is not employed on a permanent contract basis, therefore the relevant cost is the rate paid per hour: hours x $12.50/hour = $75 Each member of the workforce could work an additional 20% x 35 hours = hours without any effect on current output and activity Therefore since the workforce is paid for 35 hours and is currently only productive for 28 of those hours, there is no relevant cost in taking up the ‘slack’ hours working on the new project Relevant cost of labour is therefore $nil • Grade A labour is contracted to a 35 hour working week at a pay scale of $10.50/hour Currently the workforce is working at 100% capacity They are willing to work overtime at a rate of normal time + a 50% premium (‘time and a half’) Whether the output of the new project is done in normal or overtime hours, the business as a whole would have to pay hours at a rate of ($10.50 + 50%) $15.75 The relevant cost of labour is therefore hours x $15.75 = $94.50 98 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:01 Page 99 SESSION - MARGINAL COSTS AND RELEVANT COSTS • Grade A labour is contracted to a 35 hour working week at a pay scale of $10.50/hour Currently the workforce is working at 100% capacity No overtime work is possible due to all machinery working to full capacity in the manufacture of the Pemberton Plus which has a standard cost card of: $ Sales Price Direct material: Kg of material X @ $15/Kg Direct Labour: hours @ $10.50/hour 15 21 Contribution per Unit $ 40 (36) If Salako undertakes the project, then it will not be able to make hours = Pemberton Plus hours per Pemberton plus The Relevant cost of undertaking the project is the $40 sales price foregone less the $15 material saved per Pemberton Plus – i.e $25 per Pemberton Plus The labour cost is incurred whatever project is undertaken The relevant cost of labour is therefore x $25 = $75 Fully worked example: relevant costs You are the management accountant of Tricks an organisation which has been asked to quote for the production of a pamphlet for an event The work could be carried out in addition to the normal work of the company Due to existing commitments, some overtime working would be required to complete the printing of the pamphlet A trainee has produced the following cost estimate based upon the resources required as specified by the operations manager: Direct materials: - paper (book value) - inks (purchase price Direct labour: - highly skilled - semi-skilled Variable overhead Printing press depreciation Fixed production costs Estimating department costs $ 4,000 2,400 250 hours @ $4.00 100 hours @ $3.50 350 hours @ $4.00 200 hours @ $2.50 350 hours @ $6.00 1,000 350 1,400 500 2,100 400 12,150 You are aware that considerable publicity could be obtained for the company if you are able to win this order and the price quoted must be very competitive The following notes are relevant to the cost estimate above: (1) The paper to be used is currently in stock at a value of $5,000 It is of an unusual specification (texture and weight) and has not been used for some time The replacement price of the paper is $9,000, whilst the scrap value of that in stock is $2,500 The stores manager does not foresee any alternative use for the paper if it is not used on the pamphlet 99 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:01 Page 100 PERFORMANCE MANAGEMENT (2) The inks required are presently not held in stock They would have to be purchased in bulk at a cost of $3,000 80% of the ink purchased would be used in producing the pamphlet There is no foreseeable alternative use for the remaining unused ink (3) Highly skilled direct labour is in short supply, and to accommodate the production of the pamphlet, 50% of the time required would be worked at weekends for which a premium of 25% above the normal hourly rate is paid The normal hourly rate is $4.00 per hour (4) Semi-skilled labour is presently under-utilised, and 200 hours per week are currently recorded as idle time If the printing work is carried out, 25 unskilled hours would have to occur during the weekend, but the employees concerned would be given two hours time off during the week in lieu of each hour worked at the weekend (5) Variable overhead represents the cost of operating the printing press and binding machines (6) When not being used by the company, the printing press is hired to outside companies for $6.00 per hour This earns a contribution of $3.00 per hour There is unlimited demand for this facility (7) Fixed production costs are those incurred by and absorbed into production, using an hourly rate based on budgeted activity (8) The cost of the estimating department represents time spent in discussions with the organisation concerning the printing of its pamphlet Required: Prepare a revised cost estimate using the opportunity cost approach, showing clearly the minimum price that the company should accept for the order Give reasons for each resource valuation in your cost estimate Answer: To address relevant cost questions of this size, it is important not to get bogged down in any one area It is also extremely important to ensure that you can explain and justify your workings For example, there are usually marks awarded in the exam for ignoring non-relevant cash flows but importantly explaining why you have ignored the cash flow In this situation we are trying to calculate the relevant costs, using an opportunity cost approach, that Tricks needs to ensure are ‘covered’ by the sales price that is charged to the client Obviously Tricks would like to charge a price higher than this minimum value However a typical exam requirement is to identify the minimum price that can be charged to a customer using a relevant/opportunity cost approach Taking each cost in turn: • • • 100 Paper: The paper required is in stock but has not alternative use It is not scarce and will be sold if not used on this contract The book value of $4,000 and the current valuation of the paper ($5,000) are non-relevant costs They are historic valuations and of no relevance to our decision and are therefore ignored Since there is no alternative use for this paper, then the next best alternative (the opportunity cost) would be to sell it for $2,500 This amount is foregone by using the paper in our contract There is no point in replacing the material at a cost of $9,000 if it is not to be used within the business o The relevant cost of the paper is $2,500 Inks: The ink has to be bought in bulk for $3,000 Unfortunately for Tricks, 20% of the ink will not be used and has to be thrown away There is no alternative use for this material o The relevant cost of the ink is $3,000 Highly skilled labour: This labour is scarce To accommodate full production of the pamphlets (50% x 250 hours) 125 hours will have to be worked in overtime at a cost of ($4.00 + 25%) $5.00 per hour The other 50% of time (125 hours) will be worked in normal working hours If we assume that the highly skilled labour is in permanent employment then there is no extra cost for these workers operating in normal hours o The relevant cost is therefore: overtime hours: 125 hours x $5.00/hour = $625 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:01 Page 101 SESSION - MARGINAL COSTS AND RELEVANT COSTS • • • • • • Semi skilled labour: This labour is currently under-utilised and has 200 hours of spare capacity We can assume that the workforce is permanently employed However, 25 hours must be undertaken at the weekend and 75 hours during the week If the workers are to work at the weekend then they will take off (2 x 25 hours) 50 hours during the week in lieu of payment This means that only 200-50 hours = 150 hours are available in the week to use up the unutilised hours However, we only need 75 of those 150 unutilised hours for this project, so no incremental cost is incurred o The relevant cost of unskilled labour is $nil Variable overhead: This cost appears to be directly variable in line with the activity levels of the business Therefore by printing these pamphlets, an incremental production cost will be incurred for the 350 hours worked by both the skilled and semi-skilled workers – i.e 350 hours x $4.00/hour = $1,400 o The relevant cost of variable overhead is $1,400 Printing press depreciation: Depreciation is of course a non-cash flow and is not relevant to the decision o The relevant cost of depreciation is $nil Printing press rental income foregone: However, the lost contribution of renting the machine out is an opportunity cost for the business By using 200 hours of printing time to make the pamphlets, the opportunity to rent out the machine is lost Although Tricks can generate $6/hour rental per hour, it also appears to incur a $3 per hour variable cost for each hour of rental Therefore the relevant cash flow is the $3/hour contribution foregone, some 200 hours x $3/hour = $600 o The relevant cost of printing press rental is $600 Fixed Production costs: The fixed production costs are absorbed into each unit using an hourly absorption rate The underlying fixed costs will not change as a result of accepting this contract They are fixed in total and therefore not relevant to the decision o The relevant cost of the fixed production costs is $nil Estimating department costs: These costs are either sunk or committed costs They have either already been incurred (sunk) or will be incurred whether or not the contract is accepted o The relevant cost of the estimating department costs is $nil Overall summary The overall relevant costs that need to be considered in establishing a minimum contract price are: Cost Materials: paper Materials: inks Labour: highly skilled Labour: semi-skilled Variable overhead Printing press depreciation Printing press rental income foregone Fixed production costs Estimating department costs Total $ 2,500 3,000 625 Nil 1,400 Nil 600 nil nil 8,125 The minimum price that is acceptable on an opportunity cost basis is $8,125 In reality Tricks would obviously wish to charge a higher price than this Indeed in the long-term all costs of the business (including fixed costs) need to be covered through sales revenues 101 LSB_F5 Performance Management_section 1:297mm x 210mm 28/8/09 13:01 Page 102 PERFORMANCE MANAGEMENT Learning Summary • • 102 Make sure you have attempted the exercises in the chapter and reviewed the solutions; Review the key learning points from the start of the chapter and ensure you now understand them ... exam LSB _F5 Performance Management_ section 1: 29 7mm x 21 0 mm PERFORMANCE MANAGEMENT 10 28 /8/09 12 :59 Page 10 LSB _F5 Performance Management_ section 1: 29 7mm x 21 0 mm 28 /8/09 12 :59 Page 11 F5 Syllabus... Guide LSB _F5 Performance Management_ section 1: 29 7mm x 21 0 mm PERFORMANCE MANAGEMENT 12 28 /8/09 12 :59 Page 12 LSB _F5 Performance Management_ section 1: 29 7mm x 21 0 mm 28 /8/09 12 :59 Page 13 SYLLABUS... Accountants ACCA LSB _F5 Performance Management_ section 1: 29 7mm x 21 0 mm PERFORMANCE MANAGEMENT 28 28 /8/09 12 :59 Page 28 LSB _F5 Performance Management_ section 1: 29 7mm x 21 0 mm 28 /8/09 12 :59 Page 29 PILOT