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IMPORTANT!!! PLEASE READ CAREFULLY

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Contents
1. Traditional Costing Methods 3

2. Activity Based Costing 7

3. Limiting Factor Analysis 11


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4. Environmental Management Accounting 15

5. Modern Manufacturing Environment 19

6. Linear Programming 25

7. Standard Costing and Basic Variance Analysis 27

8. Advanced Variances 33

9. Budgeting 39

10. Forecasting Techniques 47

11. Risk and Uncertainty 55

12. Relevant Costing 61

13. Cost Volume Profit Analysis 67

Answers to Examples 73

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Chapter 1
TRADITIONAL COSTING METHODS
1. Introduction
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The collective term traditional costing methods refers to:

๏ Absorption Costing

๏ Marginal costing

These costing methods will be familiar to you from previous studies.

You will need to understand traditional costing methods in order to compare and contrast
their differences. From here you will be able to consider their strengths or weaknesses
against modern alternatives such as ABC costing.

Important to this section is the concept of marginal costing contribution which links to many
other parts of CIMA P1 syllabus for example, limited factor analysis, variance reconciliations
and cost volume profit (CVP) techniques. (see later chapters)

2. The purpose of calculating a cost per unit.

Exercise 1
Why do we need to obtain a cost per unit?

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3. Features of Absorption costing


Includes a share of production overheads in the product cost.

Acceptable method of inventory valuation as per IAS 2.

Results in a FULL product cost per unit.

Overheads are allocated apportioned then absorbed across all units using a single cost driver
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(usually machine or labour hours).

Suitable costing system for mass produced, homogeneous products - where overheads are
largely volume driven.

4. Strengths and weaknesses of Absorption Costing

5. Features of Marginal Costing


Useful for internal, short term decision making.

Only variable costs are included in product cost.

Overheads are classed as period costs.

Focus is on CONTRIBUTION earned (which is not distorted by overhead costs) and can be
used to evaluate decisions relating to incremental units.

Contribution = Selling Price less Variable cost.

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6. Strengths and weaknesses of Marginal costing


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7. Reconciliation of profits, Absorption Vs Marginal Costing


Absorption and Marginal costing result in different reported profits in the short term. This is
because inventory includes or does not include a charge for fixed overheads.

When production in the period is not equal to sales (inventory decreases or increases) there
will be a different profit figure reported under each costing system.

The reconciliation required is below:


๏ ABSORPTION PROFIT $X

Change in inventory levels in period x OAR (X / (X))

๏ Marginal Costing Profit $X

To determine the direction of the adjustment - a useful mnemonic is SIAM

When Stocks Increase Absorption (profit) is More

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Exercise 2
Sales in period 12000 units.
Production volume 13500 units
Selling price $150
Variable costs $65 per unit
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Fixed production costs per unit $30


The company above uses a marginal costing system.
Calculate the difference in reported profit under absorption costing?

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Chapter 2
ACTIVITY BASED COSTING
1. Introduction
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Traditional absorption costing systems share overheads across all products based on a single
cost driver (usually machine or labour hours).

It is argued that a modern manufacturing environment requires a more sophisticated and


intelligent costing system.

Under ABC costing, overhead costs are given greater attention and visibility because they are
assigned to different products based on the extent to which each product ‘drives’ or causes
that cost.

This costing system can be relatively time-consuming and costly to implement but can be
useful, if manufacturing overhead expenditure is significant and a diverse product range
exists. ABC can also be applied to costing within service industries.

2. The steps to be followed are as follows:


๏ Identify the major ‘activities’ that give rise to overheads (e.g. quality testing, ordering
costs etc)
๏ Determine what causes the cost of each activity – the cost driver (e.g. number of
inspections, number of orders)
๏ Calculate the total costs for each activity – the cost pools.
๏ Calculate a cost per cost driver.
๏ Allocate the overhead costs to products based on their usage of cost driving activities.
๏ Calculate the overhead cost per unit for each item of output.

NOTE on CIMA new objective test exams.


It is unlikely that objective tests questions will require you to complete all steps from
beginning to end. However, it is important to be familiar with the entire process before you
can answer questions on isolated areas of the sequence.

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Exercise 1
Una manufactures three products: A, B, and C.
Data for the period just ended is as follows:

A B C
Production (units) 20,000 25,000 2,000
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Sales price ( per unit) $20 $20 $20


Material cost (per unit) $5 $10 $10
Labour hours (per unit) 2 hours 1 hour 1 hour
(Labour is paid at the rate of $5 per hour)
Overheads for the period were as follows:
Set-up costs 90,000
Receiving 30,000
Despatch 15,000
Machining 55,000
$190,000
Cost driver data:
A B C
Machine hours per unit 2 2 2
Number of set-ups 10 13 2
Number of deliveries received 10 10 2
Number of orders despatched 20 20 20
(a) Calculate the cost (and hence profit) per unit, absorbing all the overheads on the basis
of labour hours.
(b) Calculate the cost (and hence profit) per unit absorbing the overheads using an Activity
Based Costing approach.

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3. ABC Cost Hierarchy


ABC costing classifies costs into the following categories.

๏ Unit level cost – are incurred with each unit of output -e.g. power is used by factory
machines each time a unit is produced.
๏ Batch level costs –increase with each ‘batch’ of output -e.g. equipment set-up costs are
incurred each time a new batch is processed.
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๏ Product Sustaining costs – this type of cost does not increase in relation to batches or
units produced but are necessary costs to support particular product types – e.g. design
costs.
๏ Facility level costs – General manufacturing overheads these can not easily be traced
to production activity e.g. admin staff salaries.

4. Strengths / Weaknesses of ABC Costing

Exercise 2
Explain the benefits, which can be gained from changing to a more effective costing system?

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Chapter 3
LIMITING FACTOR ANALYSIS
1. Introduction
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Limited Factor analysis can be used to determine optimum production levels when faced
with scarcity of a single resource (a limiting factor).

The limiting factors, in exam questions will often take the form of a shortage of a particular
raw material or an insufficient number of labour hours being available.

Management are faced with a decision of what quantities and mix of products to
manufacture in order to maximise profits given this constraint.

In a marginal costing environment, the concept of contribution can be used to plan


production in a manner which will maximise profits.

Following this, we find solutions to limiting factor scenarios in a throughput costing


environment.

2. Traditional Limiting Factor Analysis


When faced with a shortage in production resources, management can use a contribution-
focussed approach to help them identify an optimum production plan.

The marginal costing model provides information on the contribution level of all products. In
the short term, fixed costs do not change – so profits can be maximised through following a
production plan that maximises contribution.

In a situation where there is a scarcity of a particular resource, the products competing for use
of that resource can be ranked in terms of their contribution earned per unit of limited
resource. For example, a shortage of labour hours will require products to be prioritised
based on those which earn the most contribution per each scarce labour hour used.

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Exercise 1
Pi plc manufactures 2 products, A and B.
The cost cards are as follows:

A B
Selling price 25 28
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Materials 8 20
Labour 5 2
Other variable costs 7 2
Fixed costs 3 2
23 26
Profit $2 $2
Machine hours p.u. 2 hrs 1 hr
Maximum demand 20,000 units 10,000 units
The total hours available are 48,000.
Calculate the optimum production plan and the maximum profit using conventional limiting
factor analysis.

3. Theory of Constraints and Throughput


Goldratt’s Theory of Constraints is an important management methodology which can be
applied to systems that are unable to meet their goals (usually maximising profit) due to a
constraint. Management should ensure that efforts are focussed on making the best possible
use of this limitation. Ideally the constraint will need to be eliminated in the longer term,
meanwhile Goldratt recommended reorganising all other system activities around the
constraint to ensure its use is optimised. The constraint in manufacturing is referred to as a
bottleneck.

Goldratt refers to Throughput as a key performance measure. The main concepts of


throughput accounting are given below.

๏ Throughput is the rate at which the system generates money. It is measured in


monetary terms and links directly to profitability therefore the objective is to maximise
throughput values or throughput flow.

Throughtput ($) = Sales Revenue less Direct Material Costs

๏ In the short run, ALL costs (except direct materials) are viewed as being fixed. This
includes LABOUR as Fixed cost. The sum of all these production costs including labour is
called TOTAL FACTORY COSTS.
๏ The constraint on production is referred to a Bottleneck.
๏ Throughput accounting can be used in a Just-in-time environment.

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4. Key formulae:

Throughput ($) = Sales revenue – Direct Material costs

Total factory costs = ALL production costs (except materials)

Throughput per Unit $


1 Return per factory hour =
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Time per unit in bottleneck resource (hrs)

Total factory cost (inc labour +overheads)


2 Cost per factory hour =
Total time available in Bottleneck (ALL hrs)

Return per factory hour (1)


3 Throughput accounting ratio (TPAR)=
Cost per factory hour (2)

4.1. Interpretation of TPAR ratios:

The TPAR ratio should be greater than 1 for the product to be classed as financially viable.
Priority should be given to the products which generate the highest TA ratios.

Products with a TPAR ratio less than one should be discontinued.

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Exercise 2
Pi plc manufactures 2 products, A and B.
The cost cards are as follows:

A B
Selling price 25 28
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Materials 8 20
Labour 5 2
Other variable costs 7 2
Fixed costs 3 2
23 26
Profit $2 $2
Machine hours p.u. 2 hrs 1 hr
Maximum demand 20,000 units 10,000 units
The total hours available are 48,000.
(a) Calculate the optimum production plan and the maximum profit, on the assumption
that in the short-term only material costs are variable i.e. using a throughput
accounting approach
(b) Calculate and Interpret the Throughput Accounting ratios (TPAR ratios)
(c) Suggest some business strategic reasons why management might decide NOT to
withdraw an unprofitable product from sale.

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Chapter 4
ENVIRONMENTAL MANAGEMENT
ACCOUNTING
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1. Introduction
Environmental management accounting (EMA) seeks to ensure that companies are fully
accounting for the environmental costs of their actions. Greater awareness of environmental
costs will equip management to make more informed decisions – ultimately the aim being to
improve corporate environmental performance.

Modern businesses can no longer ignore environmental risks and the potentially negative
consequences that poor environmental behaviour can have on their long term success. These
costs have traditionally been underrepresented or ignored by conventional accounting
practices.

Globally, the pressure relating to environmental impact has intensified and companies are
facing pressure from governments, pressure groups and consumers to demonstrate
commitment to responsible environmental practice.

In this chapter we will discuss the types of environmentally related costs faced by businesses,
and describe the different methods a business may use to account for these costs.

2. The impact of environmental behaviour on financial


performance.
Businesses who pay insufficient attention to their environmental behaviour may find this will
adversely affect their financial performance:

๏ Direct costs may increase as a result of wasteful resource utilisation and additional
clean-up costs.
๏ Revenue may suffer through reputational damage. Lost sales and potential customer
boycotts will have a negative impact on sales income.
๏ Financial stability can be threatened as brand values deteriorate, lending is curbed
and insurance cover may be withdrawn.
๏ Further failure costs can take the form of fines, penalties and potentially limitless law
suit costs.

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3. Identifying Environmental Costs


Environmental costs will include expenditure on recycling, energy and the costs of dealing
with waste.

However, when accounting for total corporate environmental costs this definition needs to
be widened to include other non-conventional or hidden/intangible environmental costs
that management should be made aware of.
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Environmental accounting seeks to include and increase visibility of all relevant


environmentally related costs and costs savings so they can be fully accounted for within
management decision making.

For example:

Delivery and transport costs. By emphasising these costs, a business may seek to reduce
this type of expenditure and lower their impact on the environment. Distribution methods
could be redesigned and new policies enforced relating to staff travel.

Product design costs should be considered in an effort to reduce or avoid the future
environmental costs - e.g. through reducing the overall size/weight of the finished product
there should be a positive impact on packaging and distribution expenditure.

Staff training in matters such as correct handling and disposal of waste.

Research and Development expenditure relating to environmental matters.

Other costs such as the measuring, controlling and reporting of environmental data such as
pollution levels.

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4. Categorisation of Environmental Costs


Environmental costs can be seen to fall into the following categories:

Environmental Prevention Costs – This relates to expenditure paid to prevent or limit the
effects of adverse environmental impact from occurring.

Environmental Appraisal Costs –relate to expenditure needed to determine whether an


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environmental policy is meeting its planned objectives.

Internal Failure Costs are those which are borne exclusively by the business to manage and
limit the impact of hazardous waste which has been produced.

External Failure Costs are costs which have been caused by company through actions such
as hazardous waste production but which were not managed or contained and so the costs
have also been borne by the wider society.

Environmental Costs here are categorised using the quality costing framework as seen
elsewhere in the syllabus.

Similar to quality expenditure, if sufficient investment is made in the areas of prevention


and appraisal – this can reduce the potentially limitless costs that can be associated with
internal and external environmental failure.

Successful environmental management is now seen as an integral part of Total Quality


Management (TQM) with global companies striving for continuous improvement and
benchmarking of best environmental practices.

Exercise 1
Suggest some key performance indicators (kpis) that could be used to measure the
environmental performance of a large supermarket chain.

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5. Different methods of accounting for environmental costs


There are four methods that have been suggested as ways of accounting for environmental
costs.

(a) Input / Output analysis


This approach balances the quantity of resources that are input with the quantity that is
output either as production or waste. Reconciling inputs with their physical output
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quantities in terms of volume and also in monetary terms, forces the business to
account for all wastage and full environment impact of their product.

(b) Flow cost accounting


This is really inflow/outflow analysis (as described above) but instead of applying simply
to the business as a whole, it takes into account the organisational structure. Resources
input into the business are divided into three categories:
• Material: the resources used in production and storing of raw materials.
• System: the resources used in (for example) in systems such as production and
quality control
• Delivery and disposal: resources used in delivering to the customer and in
disposing of any waste.
As with input/output the ultimate aim in recording these movements is to reduce the
amount of materials consumed by each flow.This will reduce the environmenal impact
of the product in addition to decreasing total costs overall.

(c) Lifecycle costing


This type of costing aims to account for the total cost of a product during its whole life
span. This includes costs incurred at the research and development stage up until the
period after product is withdrawn from sale. The relevance to EMA is that some of these
costs will be environmentally related. These can be particularly significant at the end of
a product’s life when expenditure such as site clearance and disposal of unwanted
inventory may be incurred.

(d) Environmental Activity Based Costing


Activity Based Costing has been discussed in an earlier chapter. It can be applied to
environmental costs and therefore environmental cost drivers can be identified. Once
established –these costs can be better assigned to the activities which cause them.
Then the process of cost reduction and better control can begin.

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Chapter 5
MODERN MANUFACTURING
ENVIRONMENT
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1. Introduction
Some of the techniques we cover in P1 relate to traditional systems for example, marginal
and absorption costing – whereas others such as Throughput and ABC are designed for more
modern environments.

This chapter introduces some terms and concepts that relate to modern manufacturing.
These considerations should underpin any decisions you make as a management accountant.

2. Modern Manufacturing
The following aspects should help you to compare the modern manufacturing
environment to traditional manufacturing.

๏ Level of competition

๏ Distribution networks

๏ Impact of technology

๏ Consumer power.

๏ Globalisation

๏ Product Lifecycle

๏ Product diversity

๏ Quality requirements

๏ Impact of the worldwide web.

๏ Legislation and Regulation.

๏ Perception & involvement of employees

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3. Just In Time ( JIT)


You should be familiar with the principles of Just in time (JIT) systems from previous studies.

Exercise 1
Can you recall the features of JIT, in terms of the following areas:
(a) Level of inventory holding
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(b) Supplier relationships


(c) Maintenance of machinery
(d) Empowerment of workers.
(e) Pull production flow.
(f) Quality

Exercise 2
Note down the benefits and problems of JIT.
Benefits

Drawbacks

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4. Quality.
Quality may mean different things to different people. – a dictionary definition, for example,
suggests the term ‘excellence’. However, a new way at looking at quality is to focus on the
user.

In this respect, ‘user satisfaction’ and ‘fitness for use’ have become modern definitions for
quality.
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4.1. Quality and costs


Quality may cost businesses more initially however the gains are longer term in the form of
savings and additional profits stemming from customer loyalty and brand value. The idea is
by spending more on prevention and detection costs – known as conformance costs – a
business can save potentially much more by avoiding the costs of failure (non-conformance
costs).

4.2. Conformance Costs


๏ Prevention Costs – Cost of preventing defects before they occur – example is training
procurement staff on purchasing quality materials.
๏ Appraisal Costs – this is the cost of inspecting and testing. For example, quality
inspections of components before they are used.

4.3. Non- conformance Costs


๏ Internal Failure Costs – Costs of quality failures incurred by the firm before the product
reaches the customer – eg cost of reworking or scrapping items.
๏ External Failure costs – refer to costs of poor quality that occur after the product /
service has reached the customer. This may include cost of returned items, loss of
goodwill or reputation.

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5. Total Quality Management (TQM)


Total Quality Management (TQM) is a modern management approach that is aims to
increase competitive advantage through focus on the customer and a commitment to
quality.

TQM requires an organisational wide commitment to meeting customer expectations and


improving existing results whilst embedding quality throughout.
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Full dedication from senior management is crucial for this approach to be successful - this
attitude needs to filter down and be embraced by everybody working in or with the
company.

5.1. The basic principles are:


๏ Customer Focus – the customer is deemed the most important asset of the company.
The organisation needs to design its products and processes from a customer point of
view.
๏ Get it right, first time. Focus on prevention rather than detection of errors. Taking
action to avoid the cost of rework or faulty items.
๏ Continuous improvement – through constant process of performance measurement
and a willingness to change current processes. It embraces innovation and change. Also
eliminating waste is a part of this.
๏ Employee Participation Employees are ‘internal customers’ who should be given
responsibility, trust and empowerment. Rewards and recognition are crucial, as is
regular communication. Training in TQM and other skills is positively encouraged. It is
believed that this treatment will result in a talented, motivated and committed
workforce.

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6. Standard costing & TQM


Some critics argue that Standard Costing systems are incompatible with the principles of
TQM. Some of the reasons are discussed below:

๏ Standard costing focuses on traditional financial costs (material, labour etc)


whereas TQM recognises importance of quality costs
๏ In Standard costing systems performance is appraised in terms of output and the
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quantity produced. TQM recognises that its not always important how many are
produced but how well these are produced. TQM focuses on quality not quantity.
๏ Standard costs are historic backward looking. For example, variances are
calculated after they have happened. TQM suits a changing environment with a culture
that strives to move forward & adapt. Standards can soon become out of date so critics
argue that benchmarking is a more forward-thinking performance measurement tool.
๏ Performance analysis is done periodically. A key principle of TQM is ‘continuous
improvement’. This involves looking forward and constantly evaluating- not just at set
periods throughout the year.
๏ Standard costing incorporates responsibility accounting, e.g., variances are
assigned to the department managers who are seen as accountable. In contrast –
TQM believes everyone is responsible. There is a shared understanding, a high level of
employee involvement and a less formal organisational structure.
๏ Standard costing & Variance analysis can be seen as assigning blame on individual
managers or departments. TQM focus is more positive, e.g., what can we do better – not
who did what wrong…

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Exercise 3
It has been argued that some of the standard costing performance measures are irrelevant in a
TQM environment.
Explain why each variance below may not be relevant in a TQM environment.
(a) Labour efficiency variance
(b) Labour price variances…
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(c) Material price variance


(d) Idle time variances

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Chapter 6
LINEAR PROGRAMMING
1. Introduction
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Previously we dealt with scenarios, which had ONE scarce resource –we approached these
using either limiting factor analysis or throughput accounting.

Linear programming is the method for use when there are TWO or more limiting factors.

2. Linear Programming
2.1. The steps are as follows:
(1) Define the variables
(2) Formulate an equation for the objective function
(3) Formulate equations for the constraints
(4) Graph the constraints, shade the feasible region and label its vertices
(5) Plot the iso contribution line and use it to find the optimum solution.
(6) Confirm solution with simultaneous equations.

CIMA – EXAM FOCUS


It is unlikely that you will be required to follow the whole process in an objective test
question.
However, any part of the process could be examined and this method is best understood
in its entirety before you can attempt questions based on isolated parts.

Exercise 1
Peter makes two types of chair – the ‘Executive’ and the ‘Standard’.
The data relating to each as follows:

Standard Executive
Materials 2 kg 4 kg
Labour 5 hours 6 hours
Contribution $6 $9
There is a maximum of 80 kg of material available each week and 180 labour hours per week.
Demand for ‘Standard’ chairs is unlimited, but maximum weekly demand for ‘Executive’ chairs is 10.
Find the optimal production plan, which will maximise contribution and state the
contribution value that will be generated.

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3. Spare capacity: Slack


Linear programming scenarios are likely to involve various resource shortages.

Despite this, you may find that the optimum solution does not fully utilise all of the resources
available.

If the optimum solution results in using less than the maximum available of a particular
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resource, then we have spare capacity of that resource known as slack.

Exercise 2
Using the information from example 1, calculate the slack for each of the constraints i.e. for
materials, for labour, and for demand for ‘Executive’ chairs.

4. Shadow prices
In business, resource shortages can often be overcome through paying a premium to obtain
additional units of scarce resource.

For example – a shortage of labour hours can usually be resolved if overtime payments are
offered.

The shadow price (also known as the dual price) of a limited resource is the additional that we
would be prepared to pay, over-and-above the current resource price per unit.

This value is equal to the extra profit that would result if one extra unit of the limited resource
was available.

NB) If there is slack in the resource, then shadow price is Nil – we would not pay any
additional amount for an extra unit – because we have spare capacity already.

Exercise 3
Using the information from example 1, calculate the shadow price of each of the constraints
i.e. for materials, for labour, and for demand for ‘Executive’ chairs.

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Chapter 7
STANDARD COSTING AND BASIC
VARIANCE ANALYSIS
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1. Introduction
In an earlier chapter we identified that budgeting as a means of controlling the organisation.
Through comparison of budgeted figures and actuals areas can be identified that may need
corrective action. Problems can be addressed in an attempt to control future outcomes.

In this chapter we will look at the setting of standard costs, which form the basis of budget
figures. This section also requires basic variance calculations and interpretations.

Please Note:
All basic variances (calculations and interpretations) are examinable under CIMA P1
syllabus. The formulae relating to these are not included in this chapter but you should
be familiar with these from previous studies.
Advanced variances are an extension of this topic and are dealt with in the next chapter.

2. Standard costs
A Standard cost is an estimated unit cost.

The standard cost for a product (or service) is determined in advance based on expected
resource usage using expected resource prices.

Standard costing systems use these predetermined values to estimate income and
expenditure under standard conditions.

It was developed primarily for manufacturing (but can be applied to services), and was
designed for environments where there is mass production of homogenous products

The standard costs form the basis of budget totals, which can then be compared to actuals as
part of the performance management process.

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The standard cost card below shows the standard costs/ prices and usage / efficiency
rates that are expected to produce one unit of product X. Any deviations from these
expected rates will result in variances (adverse or favourable)

Illustration 1
Standard cost card for Product X
$ per unit
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Sales price 100


Materials (2 kg @ $20/kg ) 40
Labour (1.5 hrs @ $2/hr ) 3
Variable o/h (1.5 hrs @ $6/hr) 9
Fixed o/h (1.5 hrs @ $10/hr) 15
Standard cost of production 67
Standard profit per unit 33

2.1. Uses of standard costing


๏ Inventory valuation (for internal and/or external use)
๏ As a basis for pricing decisions
๏ For budget preparation
๏ For budgetary control
๏ For performance measurement
๏ For motivating staff using standards as targets

2.2. Limitations of standard costing


๏ Obtaining appropriate standards can be difficult
๏ Standards may be different depending on their purpose (see next section)
๏ Less useful when environment does not involve mass production of homogenous
items.
๏ Standard costing can lead to an over-emphasis on quantitative measures of
performance at the expense of qualitative measures (e.g. customer satisfaction; quality
and employee morale)
๏ Traditional standards are based on company’s own costs – a more modern approach is
benchmarking, which considers best practice of other organisations.
Please also see chapter on Modern manufacturing environment with regard to the
relevance of standard costing

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2.3. McDonaldisation

McDonaldisation is a term to describe the increasing level of standardisation in society. It


is based on the fast food giant’s approach to mass delivery of standardised products.

Through use of predetermined products and methods on a global scale - the restaurant chain
is described as achieving efficiency, calculability, predictability and control.
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However, critics argue this occurs at the expense of individuality and that cost reduction
takes priority over other important factors such as employee motivation and consumer
choice

2.4. Types of standards


๏ Ideal standard
100% efficient 100% of the time.
Calculated assuming perfect operating conditions.
Could form the basis for long-term aims, but not useful for variance analysis or
budgeting because unrealistic.

๏ Basic standard
This is a long-term standards which remain unchanged over many years. Often they are
determined at the inception of a product.
It is only really of use to show trends or improvements over time.
They are not useful measures of current performance.

๏ Expected / Attainable standard


This is a standard expected to apply to a specific budget period and is based on normal
efficient operating conditions. It can incorporate allowance for wastage and idle time.
This is usually the basis for variance analysis. However, standards may be too ‘easy’ to
be used as targets.

๏ Current standard
This is the current attainable standard which reflects conditions actually applying in the
period under review.
They are useful when operating under abnormal conditions – eg a period of hyper
inflation.
They may reduce the drive for improvement because the standards reflect up-to-date
cost environment.

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3. Variance analysis
In the chapter on budgeting, we looked at the comparison between the actual results for a
period and the flexed budget. The differences between the two are referred to as
variances.

* Basic variance formulae should be knowledge brought forward from previous studies.
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In this section we will repeat the exercise, and then analyse them into their different
components. If we are to investigate variances properly and use them for control, then it is
important that we are able to consider the reasons for their occurrence.

3.1. Total variances

Exercise 1
A company has prepared the following standard cost card:

$ per unit
Materials (4 kg at $4.50 per kg) 18
Labour (5 hrs at $5 per hr) 25
Variable overheads (5 hrs at $2 per hr) 10
$53

Budgeted selling price $75 per unit, and the budgeted fixed overheads are $130,500

Budgeted production 8,700 units


Budgeted sales 8,000 units
There is no opening inventory
The actual results are as follows:
Sales: 8,400 units for $613,200
Production: 8,900 units with the following costs:

Materials (35,464 kg) 163,455


Labour (45,400 hrs paid, 44,100 hrs worked) 224,515
Variable overheads 87,348
Fixed overheads 134,074
Prepare a flexed budget and calculate the total variances
Note: the company currently uses marginal costing

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3.2. Analysis of variances

The total variance that we have calculated for materials indicates that the actual expenditure
on materials was not $18 per unit. However, this could be either because we used the wrong
amount of materials (which should have been 4 kg per unit) or that we paid the wrong price
(which should have been $4.50 per kg). More likely of course, it would be a combination of
the two.
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We will therefore analyse this and the other variances in as much detail as possible.

Exercise 2
Using the data from example 1, analyse the variances and use them to produce on Operating
Statement reconciling the budgeted profit with the actual profit.

3.3. Absorption costing


In the previous example, the company had been using absorption costing. They could
alternatively have used marginal costing. The variances will be calculated in very much the
same way, but when using marginal costing the focus is on contribution (rather than profit)
and the fact that we will not be absorbing fixed overheads means that any fixed overhead
volume variance is not relevant.

Exercise 3
Using data from example 1
(a) prepare the original fixed budgets using absorption costing
(b) prepare an Operating Statement using a absorption costing approach

3.4. Interpretation of variances

Exercise 4
In the previous example there was a materials price variance.
Suggest possible reasons for its occurrence.

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Chapter 8
ADVANCED VARIANCES
1. Introduction
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In this chapter we will look at variances in further detail. This builds on the techniques and
principles of basic variances (previous chapter).

Planning and Operational variances allow management to concentrate on controllable


issues only by removing the effect of an incorrect or outdated standard, which is beyond the
entity’s control.

Mix and Yield variances look at the effect of altering proportions of a standard mix. In this
chapter, we will apply the techniques to material mixes – however, you should be prepared to
apply this to other scenarios such as sales mix or labour mix.

Also we look at ABC variances.

2. Planning and Operational variances


Variance analysis assists management in exercising control by identifying areas where there
may be operational problems.

Amongst the possible reasons for a variance – it may be that the factor driving it is
uncontrollable and/or external to the organisation.

For example, adverse material price variances would usually be seen as the responsibility of
the procurement department.

However, imagine that the increase in material costs, in this case, had been caused by a
global price rise due to scarcity. This factor is not in the control of the procurement manager.

With hindsight the original budget should’ve allowed for a higher material cost. As it stands,
the original budget is based on an incorrect/ outdated material standard cost.

By calculating planning variances, we are able to remove the effect of this incorrect
standard so we can focus on operational performance only.

It makes more sense to compare actual results with a revised budget, when the original
budget value is not valid.

The first step in these situations is to create a revised budget (sometimes called Ex post)
which will be based on the ‘revised or updated’ prices or efficiency rates.

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2.1. Planning variance

Calculated by comparing the:

Original budget (or ex ante)

to

Revised budget – (ex post)


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2.2. Operational variance

Calculated by comparing the:

Revised budget – (ex post)

To

Actual results.

Operational variances are of interest to management because they represent performance of


the business and factors influencing them should be controllable.

Exercise 1
Original budget:
Standard labour cost per unit of product is $7.
Each unit takes 0.5hours to produce at a labour rate of $14 per hour.
Budgeted production for January was 20,000 units

Actual results:
Production: 22,000 units
Actual labour worked were 11,400 hours at $15.50 per hour.
Since preparation of the budget the prevailing external labour rate has increased to $17.50
Calculate the labour rate planning variance and the labour rate operational variance.

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Exercise 2
Original budget:
Budget production: 21,000 units
Standard Material cost per unit 3kg @$4 per kg
Actual results:
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Production: 10,000 units


Materials: 33,000 kg for $4.20
A global shortage meant that the external price for this material was higher than budgeted and
should have been $5.20
Calculate the planning and operational material price variances.

3. Mix and Yield variances


3.1. It is quite common in practice for one product to use several different
materials.
For example, a desk may use wood for the top and metal for the legs.

For each of the materials we can calculate price and usage variances in the normal way, and
usually this is sufficient for our purpose.

However, suppose we were manufacturing a mixed fruit juice that contained a mixture of
strawberry juice and banana juice. To calculate usage variances for each material separately
would be of little use – if we used less strawberry juice than budgeted, we would
automatically use more banana juice. We would therefore end up with one variance
favourable and one adverse, and yet the overall effect on costs could be either favourable or
adverse depending on which juice was the most expensive.

In this situation, when the materials may be substituted for each other (or are substitutable)
then we look at all the materials together and analyse the usage variance into the following
variances:

๏ Mix variance
this shows the effect on cost of changing the proportions of the mix of materials input
into the process

๏ Yield variance
This shows the difference between the actual and expected output or yield from the
process

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Exercise 3
The standard material cost per unit of a product is as follows:

$
Material X 2 kg @ $3 per kg 6
Material Y 1 kg @ $2 per kg 2
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8
The actual production during the period was 5,000 units and the materials used were:
Material X 9,900 kg costing $27,000
Material Y 5,300 kg costing $11,000
Calculate the total materials cost variance; the materials price variance; the materials usage
variance; the mix variance; and the yield variance.

3.2. Other mix variances (Sales mix)


Although the calculation of mix variances most commonly relates to materials, exactly the
same sort of situation could be relevant for labour if there were more than one grade (paid at
different rates) that were substitutable.

The approach would be exactly the same as for materials.

Slightly less obvious (although essentially the same approach) is the situation where sales are
‘substitutable’.

For example, suppose a company sold two types of desk which although similar had different
profit margins. Clearly the company would hope for higher sales, but they would also be
interested in the mix of sales – it would be better if customers bought more of the desks
giving higher profit p.u., even if it were to mean selling fewer of the desks that gave lower
profit p.u..

Again, in this situation, the approach used for materials may be useful.

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Exercise 4
Olga plc sells three products – A, B and C.
The following table shows the budget and actual results for these products:

A B C
Budget:
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Sales (units) 200 100 100


Price (p.u.) $20 $25 $30
Cost (p.u.) $17 $21 $24

Actual:
Sales (units) 180 150 170
Price (p.u.) $22 $22 $26
Cost (p.u.) $16 $18 $25
Calculate the total sales margin variance, and analyse into the sales price variance; the sales
mix variance; and the sales quantity variance.

4. Activity Based Costing Variances


You will remember from an earlier chapter that ABC is a way of allocating overheads to
products using cost drivers.

The main reason for doing this was not just to encourage cutting the total cost of the
overhead, but also to encourage more efficient use of the overhead.

For example, we may have had an overhead cost for despatch of $100,000 and a total of 5,000
despatches. This would mean that it was costing $20 per despatch. We could reduce the cost
per despatch by either cutting the total cost (an expenditure variance) or by increasing the
number of despatches (an efficiency variance).

Exercise 5
The following information is available for a period:

Budget Actual
Production 48,000 units 50,400 units
Activity level 2,000 dispatches 2,200 dispatches
Total overhead cost of dispatching $120,000 $126,720
Calculate the total overhead variance for despatching, and analyse into the expenditure and
efficiency variances.

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Chapter 9
BUDGETING
1. Introduction
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Budgeting is core to management accountancy and represents a method with which to plan,
control and evaluate performance of an organisation. This syllabus area links to standard
costing, variance analysis and forecasting.

Students need to be able to explain the purposes of budgeting and discuss the different
budgeting methods and their suitability to a particular scenario. Calculations of key budget
figures are expected- as is knowledge of the usefulness of budgets as a control mechanism.

2. Budgeting Objectives
๏ Planning
๏ Communication
๏ Coordination
๏ Motivation
๏ Authorisation / Delegation
๏ Control
๏ Evaluation of performance

Exercise 1
Consider budgets you may have experienced in your workplace or elsewhere. How successful were
they at fulfilling the objectives above?
(a) Suggest how a budget might be used as a motivational tool.
(b) To what extend does a budget enable the communication of business objectives and
future plans to others in the company?

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3. Principal budget factor


The principal budget factor is the factor that limits the activity for the budget period.
Normally this is the level of sales demand and therefore the sales budget is usually the first
budget to be prepared and this leads to the others.

However, it could be (for example) a limit on the availability of raw materials that limits
activity. In this case Raw Materials would be the principal budget factor, and this would the
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first budget to be prepared.

4. The preparation of budgets

Sales Budget

Production Budget

Raw materials Labour Factory overheads

Cost of goods sold


budget

Selling and distribution General and


expenses administrative expenses

Budgeted Income
Statement

Capital expenditure
Cash Budget
budget

Budgeted Statement of
Financial Position

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Exercise 2
The XYZ company produces three products, X, Y, and Z. For the coming accounting period budgets
are to be prepared using the following information:
Budgeted sales
Product X 2000 units at $100 each
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Product Y 4000 units at $130 each


Product Z 3000 units at $150 each

Standard usage of raw material


Wood Varnish
(kg per unit) (litres per unit)
Product X 5 2
Product Y 3 2
Product Z 2 1
Standard cost of raw material $8 $4

Inventories of finished goods


X Y Z
Opening 500u 800u 700u
Closing 600u 1000u 800u

Inventories of raw materials


Wood Varnish
Opening 21,000 10,000
Closing 18,000 9,000

Labour
X Y Z
Standard hours per unit 4 6 8
Labour is paid at the rate of $3 per hour

Using the information provided above-


Prepare the following budgets:
(a) Sales budget (quantity and value)
(b) Production budget (units)
(c) Material usage budget (quantities)
(d) Material purchases budget (quantities and value)
(e) Labour budget (hours and value)

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5. Key Terms (Revision)


The terms below should be familiar to you from earlier studies.

๏ Fixed Budget

๏ Flexed Budget

๏ Rolling Budget
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๏ Feed forward Control

๏ Feedback Control

Explain how the above could be used in the planning, control and performance evaluation of
an organisation?

Exercise 3
A company has prepared the following fixed budget for the coming year.
Sales 10,000 units
Production 10,000 units

$
Direct materials 50,000
Direct labour 25,000
Variable overheads 12,500
Fixed overheads 10,000
$97,500

Budgeted selling price $10 per unit.


At the end of the year, the following costs had been incurred for the actual production of 12,000
units.

$
Direct materials 60,000
Direct labour 28,500
Variable overheads 15,000
Fixed overheads 11,000
$114,500

The actual sales were 12,000 units for $122,000


(a) Prepare a flexed budget for the actual activity for the year
(b) Calculate the variances between actual and flexed budget, and summarise in a form
suitable for management. (Use a marginal costing approach)

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6. Budget Styles
๏ Top – Down (Non-participatory) – This type of budget is created and executive by
senior management. The targets set are communicated to various department
managers and imposed onto the organisation.
๏ Bottom Up (participatory) – In contrast to the above, Bottom up/ participatory
budgeting shares the decision making and control across the organisation. Middle
managers and other key staff are invited to discuss and plan targets before they are set.
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This consultation process can result in more realistic budgets as well as improving the
morale of the staff involved.

Exercise 4
How are department managers likely to feel when budget figures are imposed rather than
agreed with them?
Can you suggest any arguments in favour of Top- Down Budgeting (or any problems that may arise
with Bottom Up Budget approach)?
Using your answers for part (b) -suggest circumstances when a Top-Down approach might be the
best method to follow?

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7. Methods of budgeting
๏ Incremental budgeting
This approach uses prior period figures and adjusts them by an amount to cover
inflation and any other known changes.
It is the most common approach, it is reasonably quick and for stable companies it
tends to be fairly accurate.
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However, one potential problem is that it can encourage errors and past inefficiencies
to be carried forward.
Incremental planning does not encourage the company to consider new ways of
operating the business. Wasteful expenditure is not questioned each year because the
budgeting process incorporates and carries this forward to next period.
For example, if we require a wages budget, we will probably ask the wages department
to produce it and they (using an incremental approach) will assume that our workers
will continue to operate as before. They will therefore simply adjust by any expected
wage increases.
As a result, the ‘plan’ for our workers stays the same as before. Nobody has been
encouraged to consider different ways of operating that may be more efficient.

๏ Zero-based budgeting (ZBB)


With zero-based budgeting we do not build upon the prior period values. Instead, we
consider each activity on its own merits and draw up the costs and benefits of the
different methods of achieving it (and indeed whether or not the activity should
continue). The management then decide on the most effective way of performing each
activity.
ZBB is bottom up by nature and aims to cut wasteful expenditure.
Although this approach is in principle a much better approach to budgeting, it is time-
consuming and also requires high level of management expertise. For this reason, it is
sometimes restricted to just to a few activities each year in order that training and help
may be given to the people involved. The remaining activities may then be budgeted
using the incremental approach.

๏ Activity Based Budgeting (ABB)


The activity-based approach uses the principles and costing information obtained by an
ABC costing system.
ABB budgets will use a number of different cost drivers e.g. number of orders , number
of machine-set-ups, number of inspections etc – to calculate the budgeted overhead
figures.
Activity Based measures recognise that certain costs are are a result of a demand for
activities rather than output driven (which is the assumption in our traditional
budgeting model).
The process will begin with the key budget factor (usually sales) in order to first
determine the volume driven costs and revenues – from here the various other
overhead costs will be calculated according to the expected level of support activities,
which drive them.

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7.1. Strengths/ Weaknesses of Budget Methods?

Incremental ( strengths / weaknesses)

ZBB (strengths / weaknesses)


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ABB ( strengths/ weaknesses)

7.2. Suitability

Based on your assessment of budget methods above– Comment on their suitability for
different scenarios.

Factors you might consider – Size of business, management expertise, culture, skills and
attitudes, time available, business objectives, economic climate, the type of business
(manufacturing, service industry, not for profit) etc.

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Chapter 10
FORECASTING TECHNIQUES
1. Introduction
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This chapter demonstrates some of the key mathematical techniques, which can be used to
prepare financial forecasts.

These are:

๏ High low method


๏ Regression Analysis
๏ Time Series.

You are expected to be able to calculate and interpret results for all methods.

2. Semi Variable costs


From your previous studies, you will be aware of different types of cost and the typical cost
behaviour of variable and fixed costs.

Many costs are ‘semi-variable’ and have a fixed AND a variable element.

A typical example of a semi variable cost would be a telephone bill where the customer’s total
bill comprises of a fixed monthly line rental and the cost of telephone calls on top.

The line rental is fixed and does not change throughout the period. It is known in advance
and does not change regardless of how many telephone calls are made.

The cost relating to telephone calls is classed as variable because it is determined by the
usage in the period. (i.e. it is volume driven and increases in a linear fashion)

2.1. Importance of accurate costing information

As a management accountant, you will need to obtain accurate cost information to provide a
reliable basis for budgets and forecasts.

In addition to statutory and reporting requirements- better costing information supports


better planning as well as better decision making in areas such as product pricing.

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2.2. Historic Data.

Historic cost data can be obtained from system records.

A graph of total costs, in relation to output could look something like this:
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Individually, the costs are unlikely to be useful in determining which element is fixed and
which variable.

However, our techniques of High-low and Regression analysis enable us to use this data as a
basis for estimating costs and identifying their variable and fixed elements.

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3. High-low method
The high-low method is a very quick and simple approach to identifying the variable and
fixed elements of semi variable cost.

This approach assumes a linear relationship and uses the highest and lowest data points
taken from a normal range of business activity.
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Once identified – the highest and lowest activity levels and the associated total cost for each,
can be input into the following formula to obtain variable cost per unit.

Total Cost at highest activity – Total Cost at lowest activity


VC =
Total Units at high activity level – Total units at low activity
level

Substituting total variable cost back into the total cost figures can then identify the fixed cost
element.

Total Cost = Fixed Cost + Total Variable Cost

NB) Total Variable Cost = Variable cost per unit x Number of Units

Exercise 1
The following table shows the total costs recorded at different activity levels during the year
Output Total Cost
(units) ($)
100 40,000
400 65,000
200 45,000
700 85,000
600 70,000
500 70,000
300 50,000

Use the High-low technique to estimate variable cost per unit and fixed cost per month.

NB) It is important that data selected is representative of normal business activity. Any
anomalies or one-off occurrences that could distort the results should be removed.

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4. Regression Analysis
Also known as ‘least squares’ method, this technique is also appropriate for use when costs
are believed to follow a linear relationship.

Similar to High-low method, regression analysis can be used to separate semi-variable costs
into their fixed and variable elements.
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However, instead of using just two extreme points, highest and lowest, as our method
previously, this superior technique allows you to incorporate all of the data sets into your
computation and thus provides an estimate of variable and fixed costs that is based on a
greater amount of historic information.

Effectively, this recreates a line of best fit through the scattered data points.

The equation of a line and the formula needed to find ‘a’ and ‘b’ are given below:

y = a + bx

n∑ xy − ∑ x ∑ y
∑ y − b∑ x 2
n n n∑ x 2 − (∑ x )

Applied to our costing scenarios,

a will be the fixed cost (y intercept)

b will be the variable cost per unit (the gradient)

y will be total cost (independent variable)

x will be the activity level ( dependent variable)

n is the number of data sets

The method is far simpler than the formula appears and involves a logical process (see
lecture).

* CIMA have confirmed that this formulae is examinable and will not be provided in the
objective test examinations.

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Exercise 2
The following table shows the number of units produced each month and the total cost incurred:

Output Total Cost


(units) ($)
100 40,000
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400 65,000
200 45,000
700 85,000
600 70,000
500 70,000
300 50,000
Calculate the regression line, y = a + bx

Note – this will give you a slightly different answer to the high-low technique. This is because
both provide approximations only.

4.1. Using the equation as a forecasting tool

Once a linear expression for the data has been obtained – we are able to use this to estimate
or predict total costs ‘y’ for any given activity level x.

However, forecasting beyond the data range or applying to scenarios, which are based on
different circumstances, should be avoided.

Exercise 3
Calculate the estimated total cost for the above scenario if the forecast output level is
expected to be 650 units.

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4.2. Correlation Coefficient

You are NOT required calculate or remember the formula for Pearson’s correlation coefficient
for CIMA P1 however you must be able to show an understanding of the results.

For information only

n∑ xy − ∑ x ∑ y
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Correlation Coefficient r =
( n ∑ x − ( ∑ x ) )( n ∑ y − ( ∑ y ) )
2
2
2
2

The formula is applied to the historic data as before and can be used to determine how linear
the relationship between variables is.

The result should fall within the range of -1 to + 1 and can be interpreted as follows:

r=1 the data variables X and Y display a perfect positive linear correlation (ie costs Y
are increasing directly with output X.)

r = -1 the variables display a perfect negative linear correlation (in this case Y will
decrease for each increase in X)

r=0 The variables do not appear to exhibit linear correlation.

Eg. If correlation coefficient r = 0.91 (close to +1) then this tells us that the two variables ( for
example, cost and output, appear to have a very strong positive linear correlation – based on
the data observations selected.

Exercise 4
Our techniques can be applied to scenarios outside management accounting.
State what type of correlation you would expect to find in examples below: i.e. positive,
negative or no correlation.
(a) Number of hours spent studying and likely exam score.
(b) Number of pages printed and ink levels in a printer.
(c) Shoe size and level of disposable income .

4.3. Problems with regression analysis?

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5. Time series analysis


Management accountants can use historic data to identify trends and patterns, which can be
used to better inform their forecasts.

As before – these patterns may not be exhibited by each individual value within the data but
instead become apparent when looking a general movements across a period of time.
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5.1. Key Definitions


Time series: A data set of observations recorded in equal intervals over a period of time –
e.g. monthly.

Histogram is a graph of time series data. Where X axis displays time period –e.g. years,
quarters, months.

5.2. Time series components


๏ Trend within data is the ‘underlying’ general movement over time.
๏ Seasonal fluctuations in data, -this is a regular variation within the data that is
calendar or seasonally related. Any predictable change or pattern that recurs or repeats
within one year can be described as seasonal.
๏ Cyclical variations repeat in cycles over period that is more than one year, eg often
these are fluctuations relating to economic cycles of boom and bust.
๏ Random (residual) fluctuations are unpredictable and irregular and are not therefore
useful for forecasting.

You will not be required to calculate the cyclical or random components in


CIMA P1 exam questions

๏ Additive model - assumes that all components are independent of each other.

TS = T + SV + C + R

๏ Multiplicative model is better for use when components are moving in line with trend
(eg seasonal variations appear to be increasing as level of trend rises).

TS = T x SV x C x R

Regression analysis can be used to estimate a trend line for a time series. The X variables in
the regression formulae will be represented by time – with period one being the first data
observed. This line can then be used as a forecasting tool.

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5.3. Obtaining the Trend - Moving averages

In order to distinguish the trend from the seasonal variations, we use the method of moving
averages. This is a smoothing technique intended to reveal underlying data trends and cancel
the effect of random fluctuations.

Exercise 5
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Set out below are the sales per quarter (in 000’s of units) of a company over the last 3 years.
Quarter
1 2 3 4
2000 80 87 82 90
2001 90 95 93 102
2002 105 112 103 116
Identify the trend and calculate the average seasonal variation.

5.4. The multiplicative model

In the previous example we calculated the seasonal variations using the additive model.

However, if the trend is increasing it would perhaps be more sensible to accept an increasing
seasonal variation.

The multiplicative model deals with this by measuring the seasonal variation as actual as a
percentage of trend.

Exercise 6
Using the data from example 5 together with the trend already calculated, calculate the
average seasonal variation using the multiplicative model.

6. Forecasting Considerations

Exercise 7
Discuss below the limitations of using past data as a prediction of future results.

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Chapter 11
RISK AND UNCERTAINTY
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This topic represents 15% of the 2015 CIMA P1 syllabus.

It lends itself well to objective type questions and will provide the basis for further
techniques introduced in CIMA P2 and P3.

1. Introduction
Business decision-making often requires choices to be made now about future outcomes,
which are unlikely to be known with certainty.

Key decisions such as new product launches, capital investments and other opportunities are
usually made without guarantee of future results.

Risk exists where the actual outcomes of a decision may not be in line with the forecasted or
expected outcomes. This will mean that results will be different than planned or hoped for.

2. Risk vs Uncertainty
The terms risk and uncertainty are often used interchangeably but there is a technical
difference:

Risk differs from uncertainty in that risk can be quantified. For example – we do not know
what the result will be from a roll of a dice – but we do know it can only be one of six possible
outcomes.

Uncertainty exists when there are no such ‘well defined’ possible outcomes. The outcomes
are not known or quantifiable in the same way as risk. This means probabilities cannot be
used as a basis for predictions.

3. Risk profiles
The approach taken to decision- making may be influenced by the decision-makers attitude
to risk.

A risk seeker will be interested in the best possible outcome, no matter how small the
chance that they may occur. This is described as an optimistic attitude, which may be
considered reckless if likelihood of outcomes are ignored.

Someone who is risk neutral will be concerned with the most likely or ‘average’ outcome.

A risk averse decision maker is pessimistic and selects options on the basis of the worst
outcomes occurring.

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4. Decision Making Techniques (Risk and Uncertainty)


For the examination you are expected to be aware of, and to apply, several different
approaches when dealing with risk and uncertainty within the decision making process.

๏ Expected values
๏ Decision Rules (Maximax, maximin, minimax regret)

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Decision Trees
๏ Sensitivity Analysis
๏ Standard deviation

5. Expected Values
Expected Values can be obtained when in situations which have various possible outcomes
for which the probabilities of each are known.

The expected value represents a long run average result that the decision maker could expect
if the event were repeated numerous times.

EV = Σpx

Exercise 1
The outcome of a new venture has been forecast below.
Probability of $50,000 profit = 0.3
Probability of ($20,000) loss = 0.7
What is the expected value of this project?
Should the decision maker go ahead with the venture?

5.1. Limitations of Expected Value Method.

Expected value method is often the approach of a risk neutral decision maker. However there
are some serious limitations of this method.

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6. Decision Rules
Given a range of possible outcomes (usually profits or payoffs) examination questions may
ask you to identify the decision that would be chosen by the decision making criterion below.

๏ Maximax – represents the choice of an optimist who will prefer the


option that results in the best possible returns regardless of
likelihood.
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๏ Maximin – this pessimistic decision maker considers the worst result of


all available options and seeks to minimise this. Therefore
maximin option will choose the option that gives the best
of the worst outcomes.
๏ Minimax Regret – this represents the choice of a ‘sore loser’. They seek to
minimise the maximum possible ‘regret’ from all the
options available.

Exercise 2
John has a factory capacity of 1,200 units per month.
Units cost him $6 each to make and his normal selling price is $11 each. However, the demand per
month is uncertain and is as follows:
Demand Probability
400 0.2
500 0.3
700 0.4
900 0.1
He has been approached by a customer who is prepared to contract to a fixed quantity per month
at a price of $9 per unit. The customer is prepared to sign a contract to purchase 300, 500, 700 or
800 units per month.
The company can vary production levels during the month up to the maximum capacity, but
cannot carry forward any unsold units in inventory.
(a) Calculate all possible profits that could result from the various demand levels.
(b) Determine for what quantity John should sign the contract, under each of the following
criteria:
i) expected value
ii) maximin
iii) maximax
iv) minimax regret
(c) What is the most that John would be prepared to pay in order to obtain perfect
knowledge as to the level of demand?

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7. Decision Trees
A decision tree is a diagrammatical representation of the various alternatives and outcomes. It
is relevant when using an expected value approach and where there are several decisions to
be made – it makes the options more understandable.

Exercise 3
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Combi plc are having problems with one of their offices and have decided that there are three
courses of action available to them:
(a) shut down the office, raising proceeds of $5 million
(b) have an expensive refurbishment of the office costing $4,000,000
(c) have a cheaper refurbishment of the office at a cost of $2,000,000
If they do the expensive refurbishment, then a good result will yield a return of $13,500,000
whereas a poor result will yield a return of only $6,500,000.
If they alternatively decide to do the cheaper refurbishment, then a good result will yield a return of
$8,500,000 whereas a poor result will yield $4,000,000.
In either case, the probability of the refurbishment achieving a good result has been estimated to
be 2/3.
An independent company has offered to undertake market research for them in order to identify in
advance whether the result of refurbishment is likely to be good or poor. The research will cost
$200,000 and there is a 68% probability that it will indicate a good result.
Unfortunately, the research cannot be guaranteed to be accurate. However, if the research
indicates a good result, then the probability of the actual result being good is 91%.
If the survey indicates a poor result, then the probability of the actual result being good is 13%.
Combi have already decided that if they do have market research, and if the research indicates a
poor result, then they will only be prepared to consider the cheaper refurbishment.
Use a decision tree to recommend what actions should be taken.

Note: In this example, the market research is not guaranteed to be accurate. This is likely
to be the case in real life and is an example of imperfect knowledge

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8. Sensitivity Analysis
Sensitivity analysis can be useful to appraise a decision, where the outcome is dependent on
a number of uncertain input variables.

For example, a decision to launch a new product is likely to be based on estimated demand
levels, estimated selling price, estimated variable costs etc.
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Sensitivity analyses the effect of changes made to each variable, in order to determine their
effect on the decision.

By considering the sensitivity of each input variable we can ascertain which variables are the
most critical and therefore perhaps need more work confirming our estimates.

Exercise 4
Harry is about to considering a new business opportunity.
Based on his current estimations – the opportunity looks profitable.
His forecasted sales revenue is $30,000 per year – based on 1000 units sold.
His accountant has helped him to estimate fixed costs of 15,000 p.a.
The variable costs per unit are likely to be $10 per unit.
(a) Confirm, on the basis of the above figures, that the new opportunity is worthwhile
(b) Calculate the sensitivity to change of:
i. Sales Revenue (selling price)
ii. Sales volume
iii. Total variable costs
iv. Fixed costs
(c) Comment on the results

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9. Standard Deviation.
When dealing with average outcomes – such as expected values – it can be useful to have an
indication of ‘dispersion’. That being the difference between individual values within a
sample from their ‘mean’ average.

The higher the standard deviation – the more spread out the individual values will be from
their mean. High standard deviation therefore represents high risk.
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For example – project A and project B both have an expected value of $40,000.

Project A has a standard deviation of $2000

Project B has a standard deviation of $6500

This means that project A’s profits are within ±$2000 of $40,000. Whereas Project B profits
have a difference of ±$6500 from $40,000.

The formula for standard deviation is below:

2
SD= ∑(X–X) p

When calculating standard deviation where expected value is X – the method follows a
columnar format.

Exercise 5
The following are likely returns from project Z.
Return Probability
10% 0.2
15% 0.5
20% 0.3
Calculate the expected value and the standard deviation for project Z.
What is the co-efficient of variation in this case?

Standard Deviation
NB) Coefficient of variation =
MEAN

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Chapter 12
RELEVANT COSTING
1. Introduction
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A key part of business is decision making. This involves selecting a course of action NOW that
will affect the future.

Relevant costing is a method that is used for long term and short term decisions.

Short-term decisions concern how to make the best use of resources in the short term- they
are operational or tactical in nature. Short-term decisions are usually concern relatively low
values, are likely to be repeatable/ reversible and individually are not expected to have much
impact on the business long term.

For short term decisions we can ignore the time value of money.

Typical examples involve make-or-buy, contract pricing, acceptance of one-off orders and
shut down decisions.

2. Relevant Costing
Relevant costs refer to costs which are directly incurred (or saved) by the decision being
made.

As a rule they should be Future, Incremental and cash based.

An exception to this is Opportunity costs which is the value of the next best alternative, that
must be sacrificed in order to pursue the current course of action.

Opportunity costs can only apply to limited or finite resources- otherwise no sacrifice results
from using them.

Example:

The cost of contribution lost from transferring key workers to focus on a new project would
be a relevant cost for the new project.

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3. Non –relevant costs


Non-relevant costs are those that will not change as a result of the decision.

Always read the particulars of the question – but in general the following costs are not
relevant for decision making.

Sunk costs – These are costs, which have already been paid. Therefore they will not change
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as a result of a decision and therefore are not relevant when evaluating the costs of a
decision. An example may be costs of research relating to a new product – these should not
be allowed to influence the decision to go ahead with the product because those costs have
been already paid and not change

Committed Costs – these type of costs must be paid regardless of the decision. They are
usually ongoing commitments – possibly lease or rental agreements that must be honoured
by the business in the short term.

Book Values or historic costs these costs are usually irrelevant to a decision because they
are out of date and are not a consequence of a decision being taken now.

Non- monetary costs – these are accounting valuations and estimates such as depreciation
and amortisation – these are not cash flows, so are seen as irrelevant for decision making.

Exercise 1
Identify the relevant costs from scenarios below:
(1) Your research team have spent $50,000 researching project Q during 2X14? ( Relevant / Non-
relevant)
(2) The production manager currently earns a salary of $20,000p.a. Your new project will incur
approximately $5000 p.a of overtime from him which means his salary is expected to be
$25,000 for the duration of the project. (Which is relevant cost for project here? $20,000 or
$5000 or $25,000)
(3) A decision to manufacture a new product is expected to increase fixed costs by $3000 per
month. ( Relevant / Non-relevant)

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4. Relevant costing – further practice


This sort of question is really testing that you can determine what information in the question
is relevant to the decision, and what information (for example, sunk costs) is irrelevant.

This is not a topic for which you can really learn rules. The main thing is to understand the
thought process involved and then to read questions very carefully and to state the
assumptions you have made where relevant.
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Exercise 2
The managing director of Parser Ltd, a small business, is considering undertaking a one-off contract
and has asked her inexperienced accountant to advise on what costs are likely to be incurred so
that she can price at a profit. The following schedule has been prepared:
Costs for special order:

Notes $
Direct wages 1 28,500
Supervisor costs 2 11,500
General overheads 3 4,000
Machine depreciation 4 2,300
Machine overheads 5 18,000
Materials 6 34,000
98,300
Notes:
(1) Direct wages comprise the wages of two employees, particularly skilled in the labour process
for this job, who could be transferred from another department to undertake work on the
special order. They are fully occupied in their usual department and sub-contracting staff
would have to be bought-in to undertake the work left behind. Subcontracting costs would
be $32,000 for the period of the work. Different subcontractors who are skilled in the special
order techniques are available to work on the special order and their costs would amount to
$31,300.
(2) A supervisor would have to work on the special order. The cost of $11,500 is comprised of
$8,000 normal payments plus $3,500 additional bonus for working on the special order.
Normal payments refer to the fixed salary of the supervisor. In addition, the supervisor would
lose incentive payments in his normal work amounting to $2,500. It is not anticipated that
any replacement costs relating to the supervisor’s work on other jobs would arise.
(3) General overheads comprise an apportionment of $3,000 plus an estimate of $1,000
incremental overheads.
(4) Machine depreciation represents the normal period cost based on the duration of the
contract. It is anticipated that $500 will be incurred in additional machine maintenance costs.
(5) Machine overheads (for running costs such as electricity) are charged at $3 per hour. It is
estimated that 6000 hours will be needed for the special order. The machine has 4000 hours
available capacity. The further 2000 hours required will mean an existing job is taken off the
machine resulting in a lost contribution of $2 per hour.

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(6) Materials represent the purchase costs of 7,500 kg bought some time ago. The materials are
no longer used and are unlikely to be wanted in the future except on the special order. The
complete inventory of materials (amounting to 10,000 kg), or part thereof, could be sold for
$4.20 per kg. The replacement cost of material used would be $33,375.
Because the business does not have adequate funds to finance the special order, a bank overdraft
amounting to $20,000 would be required for the project duration of three months. The overdraft
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would be repaid at the end of the period. The bank’s overdraft rate is 18%.
The managing director has heard that, for special orders such as this, relevant costing should be
used that also incorporates opportunity costs. She has approached you to create a revised costing
schedule based on relevant costing principles.
Adjust the schedule prepared by the accountant to a relevant cost basis, incorporating
appropriate opportunity costs.

5. Shutdown problems
This sort of question is asking for a decision as to whether or not to close part of the business.

Exercise 3
(a) A company manufactures three products, Pawns, Rooks and Bishops. The present net annual
income from these is as follows:

Pawns Rooks Bishops Total


$ $ $ $
Sales 50,000 40,000 60,000 150,000
Less variable costs 30,000 25,000 35,000 90,000
Contribution 20,000 15,000 25,000 60,000
Less fixed costs 17,000 18,000 20,000 55,000
Profit/loss 3,000 (3,000) 5,000 5,000

The company is considering whether or not to cease selling Rooks. It is felt that selling prices
cannot be raised or lowered without adversely affecting net income. $5,000 of the fixed costs
of Rooks are direct fixed costs which would be saved if production ceased. All other fixed
costs would remain the same.
(b) Suppose, however, that it were possible to use the resources released by stopping production
of Rooks to produce a new item, Crowners, which would sell for $50,000 and incur variable
costs of $30,000 and extra direct fixed costs of $6,000.
Consider whether the company should cease production and sale of Rooks under each of the
scenarios in (a) and (b) above.

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6. Make or Buy decisions


In order to overcome problems of limited resources, a firm may buy in a product instead of
making it itself.

Where incremental costs of manufacture are less than those of buying in, the firm should
make – assuming that there are not limited resources.
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Where resources are limited, the firm should concentrate on making those products which
give the greatest saving (over buying in) per unit of the scarce resource.

To decide which products should be made and which should be bought, we calculate the
saving per unit of scarce resource from making the product rather than buying it in.

Exercise 4
The availability of Material B is limited to 8,000 kg

Product X Y Z
Demand (units) 2,000 2,500 4,000
Variable cost to make ($ per unit) 10 12 14
Buy-in price ($ per unit) 13 17 16
Kg of B required per unit 3 2 1
(included in variable cost)
Which products should the company make and which should it buy?

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Chapter 13
COST VOLUME PROFIT ANALYSIS
1. Introduction
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You are likely to be familiar with elements of CVP analysis from your previous studies. CIMA
P1 syllabus advances this knowledge by requiring application of breakeven techniques to
more complex decision making scenarios. You will need to become familiar with Profit
Volume (P/V) analysis – and the calculation of breakeven point in a multi-product
environment.

Cost-volume-profit analysis considers the relationship between costs (fixed and variable),
sales volume and levels of profit.

The techniques of CVP analysis are used in breakeven calculations, contribution/ sales
ratio analysis and can be applied to indicate the level of sales necessary to make a desired
profit (target profit) or the amount by which sales can fall before the product is loss making
(margin of safety).

2. Breakeven
Breakeven point represents the minimum level of sales (revenue or volume) needed to cover
total costs (fixed and variable). At breakeven point, profit is equal to zero because our total
sales income is equal to total expenditure.

The formula is for breakeven volume is below:

Total Fixed Costs


Breakeven point (in UNITS) =
Contribution per unit

3. Contribution to sales ratio (C/S Ratio)


The contribution sales ratio is an important concept – it indicates the level of contribution
that is included in sales revenue or selling price.

Contribution per unit


C/S ratio = x 100
Selling price

It can be used in the calculation of Breakeven point ($s)

Total Fixed Costs


Breakeven point (in REVENUE) =
C/S ratio

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Exercise 1
Product X has variable costs of $2 per unit, and selling price of $6 per unit.
The fixed costs are $1,000 per year
(a) Use the above information to calculate budgeted sales revenue and budgeted costs
when planned production is 300 units per year. What is budgeted profit (or loss) at this
level?
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(b) What is the breakeven point (in units)?


(c) What is C/S ratio of this product – explain the meaning?
(d) What is the breakeven revenue ($) ?

4. Margin of safety
The Margin of Safety measures the difference between budgeted sales and breakeven sales.

It can be expressed as percentage and shows the fall in budgeted sales that can be tolerated
before breakeven point is reached. This is a key measure of risk because management know
that any fall beyond breakeven point means the product will become loss making.

Margin of Safety ($) = Budgeted Sales less Breakeven sales

Budgeted Sales less Breakeven sales


Margin of Safety as % = x 100
Budgeted Sales

Exercise 2
Calculate the margin of safety % for example 1

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5. Target Profit
Breakeven calculations will often ask for level of sales that is necessary to earn a target profit
figure.

Fixed Costs + Target Profit


Target Profit (Sales units) =
Contribution per unit
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Fixed Costs + Target Profit


Target Profit (Sales revenue) =
C/S Ratio

Exercise 3
Using example 1, calculate the sales revenue needed to generate a target profit of $320?

6. Breakeven chart
Breakeven point can be displayed and solved graphically.

Exercise 4
Draw a breakeven chart for example 1
Cost and
revenue
($)

Output (units)

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7. Profit-volume chart
The profit volume chart shows the profit or loss at any level of activity. Intuitively, the greatest
loss will occur when no sales are made (sales = zero). This loss will be equal to the fixed costs.
The point will be the vertical intercept and is the starting point when creating this graph.

Exercise 5
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Draw a profit-volume chart for example 1


Profit ($)

Sales units)

Loss ($)

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8. Multi-product CVP analysis


Breakeven analysis so far has assumed that just one product is being sold –in reality a
company is likely to make several products, a range - each with a different CS ratio.

Management are still likely to be interested in the break-even sales revenue (in order to cover
the fixed overheads), but the existence of several products makes it less certain and this is
approach through an assumption that products will be sold in a predetermined ‘budgeted’
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sales mix.

The mix may be obtained from scenario’s forecast sales volumes or from indicated ratios or
percentages.

A weighted average c/s ratio is the quickest way to find the breakeven sales values for a
multiproduct scenario.

Total Contribution (standard proportions)


Weighted Average C/S Ratio =
Total Sales Revenue (standard proportions)

Fixed Costs
Breakeven Sales Revenue =
Weighted average C/S ratio

Exercise 6
A company produces and sells three products: C, V and P.
The budget information for the coming year is as follows:

C V P
Sales (units) 4,800 4,800 12,000
Selling price (p.u.) $5 $6 $7
Variable cost (p.u.) $3.75 $5.25 $4.35
Contribution (p.u.) $1.25 $0.75 $2.65
The total budgeted fixed overheads for the year are $8,000
(a) Calculate the CS ratio for each product individually
(b) Calculate the weighted average CS ratio (assuming that the budgeted product mix
remains unchanged)
(c) Calculate the breakeven revenue (assuming that the budgeted product mix remains
unchanged)
(d) Construct a PV chart (assuming that the budgeted product mix remains unchanged)
(e) Assume that the products are sold in order of their CS ratios, construct a table showing
the cumulative revenue and cumulative profits associated with this selling order.
(f) Add the information to the P/V chart already produced for Exercise 6 and calculate the
breakeven sales revenue on this basis

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9. Limitations of CVP analysis


CVP analysis is sometimes described as a crude, oversimplified model of cost, behaviour. The
following assumptions are its weaknesses.

๏ The selling price per unit is assumed to remain constant at all levels of activity
๏ The variable cost per unit is assumed to remain constant at all levels of activity.

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It is assumed that the total fixed costs do not change across all levels of production.
๏ It is assumed that the production volume is equal to sales volume in the period (i.e.
there are no changes in the levels of inventory)
๏ It requires the budgeted product mix proportions to be known in advance and remain
unchanged.

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ANSWERS TO EXAMPLES

Chapter 1
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Exercise 1
Reasons why a cost per unit is required:
๏ To value inventory (SFP)
๏ To calculate cost of sales for income statement.
๏ To determine a selling price.
๏ To plan and make decisions (budgeting, forecasting)
๏ To determine the impact of management decisions on costs i.e. evaluation of a cost savings
or change in cost due to a new supplier etc.
๏ To measure performance- eg using key ratios and variance analysis.

Exercise 2
Production units > Sales units (inventory has increased).

SIAM helps us to remember when stocks increase absorption costing profit will be higher.

The adjustment required is:


Change in units x OAR
(13500-12000) x $30 = $45,000

Absorption costing profit will be $45,000 higher than the marginal costing profit reported for that
period.
NB) The inclusion of selling price, variable cost etc are distracters and not needed to solve this
problem.
Fixed production cost per unit is another name for Overhead Absorption Rate (OAR).

Chapter 2

Exercise 1

(a) Total overheads $190,000


Total labour hours
A 20,000 × 2 = 40,000
B 25,000 × 1 = 25,000
C 2,000 × 1 = 2,000
67,000hours
190,000
O.A.R. = = $2.836 per hour
67,000

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Cost cards:
A B C
Materials 5 10 10
Labour 10 5 5
Overheads (at $2.84 per hr) 5.68 2.84 2.84
20.68 17.84 17.84
Selling price 20 20 20
Profit / Loss $(0.68) $2.16 $2.16
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(b) Total A B C
Set-up costs
(Cost per set up = ) 90,000 36,000 46,800 7,200

Receiving
(Cost per delivery = ) 30,000 13,636 13,636 2,728

Despatch
(Cost per order = ) 15,000 5,000 5,000 5.000

Machining
(Cost per machine hour: ) 55,000 23,404 29,256 2,340
190,00
0 78,040 94,692 17,268
Number of units 20,000 25,000 2,000
Overheads p.u. $3.90 $3.79 $8.63

Costings:
A B C
Materials 5 10 10
Labour 10 5 5
Overheads 3.90 3.79 8.63
18.90 18.79 23.63
Selling price 20 20 20
Profit / Loss $1.10 $1.21 $(3.63)

Exercise 2
Better costing information can be used to reduce and control costs more effectively.

Better pricing decisions

More accurate basis for forecasting and budgeting

Supports other areas of decision-making – such as identification and discontinuation of


unprofitable product lines.

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Chapter 3

Exercise 1
A B
Selling price 25 28
Materials 8 20
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Other variable 12 4
20 24
Contribution p.u. 5 4
Machine hrs p.u. 2 1

Contribution per hour $2.50 $4

Production

units hours
B: 10,000 × 1 hr = 10,000
A: 19,000 × 2hrs = 38,000
48,000hours

Profit
$
A: 19,000 × $5 95,000
B: 10,000 × $4 40,000
135,000
less Fixed costs:
[A: 20,000 × $3
B: 10,000 × $2] 80,000
Profit $55,000

Exercise 2
(a) A B
Selling price 25 28
Materials 8 20
Throughput p.u. $17 $8
Machine hrs p.u. 2 1

Contribution per hour $8.50 $8


(2) (1)

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Production Plan

units hours
A: 20,000 × 2hrs = 40,000
B: 8,000 × 1hr = 8,000
48,000 hours
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Profit

$
A: 20,000 × $17 340,000
B: 8,000 × $8 64,000
404,000
less “fixed” costs:
[A: 20,000 × $15
B: 10,000 × $6] 360,000
Profit $44,000

360,000
Cost per factory hour = = $7.50
$48,000

(b) Throughput accounting ratios:

8.50
A: = 1.13
7.50

8
B: = 1.07
7.50

Interpretation: Both products have a TPAR greater than 1 which means they are both financially
viable products (they return more per hour than the factory cost per hour) However, Product A is
more profitable than product B – which is why the production plan we created prioritised resources to
producing all of product A first.

(c) Management should always consider other business strategic factors before withdrawing a
product from sale. For example, product may be a vital part of the range that customers value.
Alternatively, sale price may be deliberately low due to pricing strategies such as introductory
pricing, loss leadership or a price penetration policy.

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Chapter 4

Exercise 1
Suitable KPIs for a supermarket aiming to monitor their environmental performance could be as
follows:

Kg of waste disposed of per week


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Number of tonnes of plastic carrier bags recycled per quarter.


Number of certified eco-products/ organic produce on sale per store.
Value of Dollars invested into environmental research for future green policies.
% of customers rating the store’s environmental policies as Good or Excellent
No. of litres of fuel used per £1million customer deliveries.
No. of fuel-efficient delivery lorries used per regional area.

Chapter 5

Exercise 1
(1) Level of inventory holding - Ideally inventory holding will be nil for Just in time systems.
Parts arrive just in time to be included in the production item so that many of the risks of
holding inventory (tied up cash, storage space and obsolescence) can be avoided.
(2) Supplier relationships – Suppliers become strategic partners – they need to be reliable and
able to consistently deliver small quantities exactly when required. The supplies need to
arrive quickly and be defect free - there is no allowance in JIT time frame for rejects and
reworks.
(3) Maintenance of machinery - The tight schedule of JIT production can not allow time to be
wasted through faulty machines or mechanical breakdown – therefore a proactive system of
preventative maintenance will be in place
(4) Empowerment of workers – workers are treated with full respect and trust - their ideas are
listened to and anyone on the production line has the ability to stop production if required.
They are often multi-skilled and can work cross functions
(5) Pull production flow. Factory layout is designed to minimise flow time between processes.
Because it is a Pull system – the customers orders act like a signal for production to begin.
(6) Quality There is a commitment to quality in JIT manufacturing - this links with TQM – there is
no time available for reworks or faulty products. The belief is in continuous improvement – a
company who is striving to get better.
Other features of JIT include zero waste, lean production methods, visual control systems,
standardisation of parts, high flexibility, fast throughput and short set-up times.

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Exercise 2
Benefits
๏ Lower inventory holding costs.
๏ Less risk of obsolescence
๏ Lower storage costs.
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๏ Greater flexibility
๏ Improved worker motivation.
๏ Better quality product.

Disadvantages
๏ Risk that supply chain failure will cause consequences in the JIT company.
๏ Relies on flexible workforce – this may not be possible
๏ Not suitable for businesses that are located in low populated areas or who are geographically
wide spread.
๏ Difficulty in switching suppliers can mean that best quotes are not always obtained on a
regular basis

Exercise 3
It has been argued that some of the standard costing performance measures are irrelevant in a
TQM environment.
๏ Labour efficiency variance –

(TQM aim to have motivated staff and empowered to work best they can at all times)

๏ Labour Price variances –

to get positive variances here –management could be encouraged to use lower cost labour –
that's against the TQM principles.

๏ Material price variance –

less relevant due to good relationships with suppliers so materials less variable or susceptible
to shortages.

๏ Idle time variances –

waste built into the system – not compatible with TQM

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Chapter 6

Exercise 1
Let S = number of standard chairs produced per week
E = number of executive chairs produced per week
Constraints:
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Materials: 2S + 4E ≤ 80
Labour: 5S + 6E ≤ 180
Demand: E ≤ 10
Non-negativity: S ≥ 0; E ≥ 0
Objective:
Maximise C = 6S + 9E
S

40
Feasible area:
A, B, C, D, 0
A

30
B

20 C

10

D
0 10 20 30 40 E

Maximum contribution occurs at point B (using the objective function).


At B, 2S + 4E = 80 (1)
5S + 6E = 180 (2)
(1) × 2.5: 5S + 10E = 200 (3)
(3) – (2): 4E = 20
E=5
In (1): 2S + 20 = 80
2S = 60
S = 30
C = 6S + 9E
= 180 + 45
= $225
Produce 5 Executive chairs and 30 standard chairs per week.
Maximum contribution is $225 per week.

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Exercise 2
There is no spare material or labour
The spare demand for executive chairs is 5 chairs (10 – 5)

Exercise 3
(a) If there was 1 more kg of material available, then the material constraint becomes:
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2S + 4E ≤ 81
Point B will still be the optimum solution, and therefore this will be when:
2S + 4E = 81 (1)
5S + 6E = 180 (2)
(1) × 2.5 5S + 10E = 202.5 (3)
(3) – (2) 4E = 22.5
E = 5.625
in (1) 2S + 22.5 = 81
2S = 58.5
C = 6S +9E
= 175.5 + 50.625
= 226.125
Shadow price of material = extra contribution
= 226.125 – 225
= $1.125 per kg
(b) If there was 1 more hour of labour available, then the labour constraint becomes: 5S + 6E ≤
181
Point B will still be the optimum solution, and therefore this will be when:
2S + 4E = 80 (1)
5S + 6E = 181 (2)
(1) × 2.5 5S + 10E = 200 (3)
(3) – (2) 4E = 19
E = 4.75
in (1) 2S + 19 = 80
2S = 61
S = 30.5
C = 6S +9E
= 183 + 42.75
= 225.75
Shadow price of labour = 225.75 – 225
= $0.75 per hour
The shadow price of demand for executive chairs is $0, because there is already spare
demand.

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Chapter 7

Exercise 1

Original Flexed Variances


Actual
Fixed Budget Budget
Sales (units) 8,000 8,400 8,400
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Production (units) 8,700 8,900 8,900

$ $ $
Sales 600,000 630,000 613,200 16,800 (A)
Materials 156,600 160,200 163,455 3,255 (A)
Labour 217,500 222,500 224,515 2,015 (A)
Variable o/h 87,000 89,000 87,348 1,652 (F)
461,100 471700 475318
Less: Inventory (37,100) (26,500) (26,500)
424,000 445,200 448,818
Contribution 176,000 184,800 (164,382)
Less: Fixed o/h (130,500) (130,500) (134,074) 3,574 (A)
Profit $45,500 $54,300 $30,308 23,992 (A)

Exercise 2
Materials
Expense variance
Actual purchases at actual cost 163,455
35,464kg
at standard cost
($4.50) 159,588
$3,867 (A)
Usage variance
kg
Actual usage 35,464
Standard usage for actual production
(8,900 u × 4kg) 35,600
136 kg
at a standard cost ($4.50) = $612 (F)

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Labour
Rate of Pay variance

Actual hours paid at actual cost 224,515


45,400 hours at standard cost ($5) 227,000
$2,485 (F)
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Idle Time Variance


Actual hours paid 45,400
Actual hours worked 44,100
1,300 hrs
at a standard cost ($5) = $6,500 (A)
Efficiency variance
Actual hours worked 44,100
Standard hours for actual production
(8,900 u × 5hrs) 44,500
400 hrs
at a standard cost ($5) = $2,000 (F)
Variable overheads
Expenditure variance
Actual hours worked at actual cost 87,348
44,100 at standard cost 88,200
$852 (F)
Efficiency variance
Actual hours worked 44,100
Standard hours for actual production
(8,900u × 5hrs) 44,500
400 hrs
at a standard cost ($2) = $800 (F)
Fixed overheads
Expenditure variance

Actual total 134,074


Original budget total 130,500
$3,574 (A)
at a standard cost ($3) = $1,200 (F)

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Operating Statement
$
Original budget profit 45,500
Sales – volume variance 8,800 (F)
54,300
Sales – price variance (16,800) (A)
Materials – expense variance (3,867) (A)
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– usage variance 612 (F)


Labour – rate of pay variance 2,485 (F)
– idle time variance (6,500) (A)
– efficiency variance 2,000 (F)
Variable o/hs – expense variance 852 (F)
– efficiency variance 800 (F)
Fixed o/hs – expense variance (3,574) (A)
Actual profit $30,308

Exercise 3
Original Flexed
Actual Variances
Fixed Budget Budget
Sales (units) 8,000 8,400 8,400
Production (units) 8,700 8,900 8,900

$ $ $
Sales 600,000 630,000 613,200 16,800 (A)
Materials 156,600 160,200 163,455 3,255 (A)
Labour 217,500 222,500 224,515 2,015 (A)
Variable o/h 87,000 89,000 87,348 1,652 (F)
Fixed o/h 130,500 133,500 134,074 574 (A)
591,600 605,200 609,392
Closing inventory (47,600) (34,000) (34,000)
544,000 571,200 575,392
Profit $56,000 $58,800 $37,808 20,992 (A)

Fixed overheads
Expenditure variance

Actual total 134,074


Original budget total 130,500
$3,574 (A)
Capacity variance
Actual hours worked 44,100
Budget hours (8,700u × 5hrs) 43,500
600 hrs
at a standard cost ($3) = $1,800 (F)

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Efficiency variance
Actual hours worked 44,100
Standard hours for actual production
(8,900u × 5hrs) 44,500
400 hrs
at a standard cost ($3) = $1,200 (F)
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Operating Statement
$
Original budget profit 56,000
Sales – volume variance 2,800 (F)
58,800
Sales – price variance (16,800) (A)
Materials – expense variance (3,867) (A)
– usage variance 612 (F)
Labour – rate of pay variance 2,485 (F)
– idle time variance (6,500) (A)
– efficiency variance 2,000 (F)
Variable o/hs – expense variance 852 (F)
– efficiency variance 800 (F)
Fixed o/hs – expense variance (3,574) (A)
– capacity variance 1,800 (F)
– efficiency variance 1,200 (F)
Actual profit $37,808

Exercise 4
No Answer

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Chapter 8

There are different ways to calculate planning variances – however,


this method is CIMA’s preferred method – as per examiner’s article

Exercise 1
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Labour rate planning variance


Actual output x revised std hours x original labour rate
22000 x 0.5 x $14 = 154000
= $38,500 ADV
Actual output x revised std hours x revised labour rate
22000 x 0.5 x $17.50 = 192500

Labour rate Operational variance


Actual output x actual std hours x revised labour rate
22000 x 0.518* x 17.50 = 199500
=22800 Fav
Actual output x ctual hours x actual labour rate
22000 x 0.518* x 15.50 = 176700

*11,400/22,000 =0.511h per unit

Exercise 2
Planning material price variance
Actual output x revised std kg x original cost per kg
10,000 x 3kg x $4 = 120,000
= 36000 ADVERSE
Actual output x revised std kg x revised cost per kg
10,000 x 3kg x $5.20 = 156,000

Operational material price variance


Actual output x actual kg x revised cost per kg
10,000 x 3.3kg x 5.20 =171600
=33,000 FAV
Actual output x actual kg x actual cost per kg
10,000 x 3.3kg x 4.20 =138600

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Exercise 3
Total materials cost variance
Actual total cost (27,000 + 11,000) 38,000
Standard total cost (5,000 × $8) 40,000
Total cost variance $2,000 (F)
Materials price variance
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Actual Actual Actual Standard


purchases cost purchases cost
kg $ kg $
X 9,900 27,000 9,900 29,700
Y 5,300 11,000 5,300 10,600
38,000 40,300
Price variable = 38,000 – 40,300 = $2,300 (F)
Mix variance
Actual Standard Standard Standard
purchases cost mix cost
kg $ kg $
X 9,900 29,700 (⅔) 10,133 30,399
Y 5,300 10,600 (⅓) 5,067 10,134
15,200kg 40,300 15,200 kg 40,533
Mix variance = 40,300 – 40,533 = 233 (F)
Yield variance
Standard mix Standard Standard Standard
(actual total) cost mix cost
kg $ kg $
X 10,133 30,399 10,000 30,000
Y 5,067 10,134 5,000 10,000
15,200 kg 40,533 15,000 kg 40,000
Yield variance = 40,533 – 40,000 = 533 (A)
(Usage variance = Yield variance + Mix variance = 533 (A) + 233 (F) = 300 (A))

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Exercise 4
Note: throughout this answer we use standard costs because cost variances are calculated
separately in the usual way
Total sales margin variance
Budget profit:
A 200u × (20 – 17) 600
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B 100u × (25 – 21) = 400


C 100u × (30 – 24) = 600
1,600

Actual profit (using standard costs):

A 180u × (22 – 17) 900


B 150u × (22 – 21) = 150
C 107u × (26 – 24) = 340
1,390
Total variance = 1,390 – 1,600 = $210 (A)

Sales price variance


Actual selling Standard
Actual sales Actual sales
price selling price
units $ units $
A 180 × 22 = 3,960 180 × 20 = 3,600
B 150 × 22 = 3,300 150 × 25 = 3,750
C 170 × 26 = 4,420 170 × 30 = 5,100
$11,680 $12,450
Sales price variance = 11,680 – 12,450 = $770 (A)

Sales mix variance


Actual total Actual selling Actual total Standard
sales price sales profit p.u.
units $ units $
A 180 × $3 = 540 (2/4) 250 × $3 = 750
B 150 × $4 = 600 (1/4) 125 × $4 = 500
C 170 × $6 = 1,020 (1/4) 125 × $6 = 750
500 $2,160 500 $2,000
Mix variance = 2,160 – 2,000 = $160 (F)

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Sales quantity variance


Actual total
Standard Standard
sales standard Budget sales
Profit profit
mix
units $ units $
A 250 × $3 = 750 200 × $3 = 600
B 125 × $4 = 500 100 × $4 = 400
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C 125 × $6 = 750 100 × $6 = 600


500 $2,000 400 $1,600
Quantity variance = 20,000 – 1,600 = $400 (F)

Exercise 5
Total variance:
$
Actual total expenditure 126,720
Standard cost for actual production 126,000
(50,400 × 120,000/48,000)
720 (A)
Expenditure variance:
$
Actual total expenditure 126,720
Standard cost for actual despatches 132,000
(2,200 × 120,000/2,000)
5,280 (F)
Efficiency variance:
Despatches
Actual number of despatches 2,200
Standard number of despatches for actual production 2,100
(50,400 × 2,000/48,000)
100
Variance = 100 despatches × standard cost per despatch
= 100 × 120,000/2,000 = $6,000 (A)

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Chapter 9

Exercise 1
Budget Objectives Discussion
Depending on your own experiences, you may find the budgets that you have dealt with so far
were or were not effective in their purpose of planning, coordination, communication and other
goals.
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If you found the budgets you have experienced were particularly poor in any of the aspects –
consider why this was the case. How might the results or the reaction of those involved be
different, if the budget process had been approached a different way?
A budget is a key internal document and underpins the foundations of the next period’s activities.
Therefore, as a management accountant the choice of budget and how successful it is
implemented will depend on your ability to consider different methods and the suitability of each,
for the organisation where you work.
(a) Budgets can be motivating if targets are challenging but achievable. Motivation can be
enhanced further by involving staff in their own target setting. Rewards such as salary
bonuses can also be linked to achievement of budgeted figures. However, when dealing
with individuals and incentivising courses of action, care must be taken to ensure that the
results are goal congruent with the aims of the company.
(b) Budgets can be used to communicate strategic aims of the owners and senior managers to
all levels of the company. The budget executes these plans by translating them into smaller
objectives. Messages on strategic direction of the company, will be transferred across the
organisation. For example, a drive for growth, quality or cost-cutting should be apparent in
the targets set. This communication should be consistent with other messages that are
conveyed across the company and elsewhere.

Exercise 2
(a) Sales budget
$
X 2,000u × $100 = 200,000
Y 4,000u × $130 = 520,000
Z 3,000u × $150 = 450,000
$1,170,000
(b) Production budget
X Y Z
Sales 2,000 4,000 3,000
Opening inventory (500) (800) (700)
Closing inventory 600 1,000 800
Production 2,100 u 4,200u 3,100u

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(c) Material usage budget


Wood Varnish
X 2,100u ×5= 10,500 ×2 4,200
Y 4,200u ×3= 12,600 ×2 8,400
Z 3,100u ×2= 6,200 ×1 3,100
29,300 kg 15,700 litres
(d) Materials purchases budget
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Wood Varnish
Usage 29,300 15,700
Opening inventory (21,000) (10,000)
Closing inventory 18,000 9,000
26,300 kg 14,700 litres
× $8 × $4
$210,400 $58,800
(e) Labour budget

hours
X 2,100u × 4 = 8,400
Y 4,200u × 6 = 25,200
Z 3,100u × 8 = 24,800
58,400 hours
×$3
$175,200

Exercise 3
Flexed Actual Variances
Sales 12,000u 12,000 u
Production 12,000u 12,000 u

Sales 120,000 122,000 2,000 (F)


Materials 60,000 60,000 –
Labour 30,000 28,500 1,500 (F)
Variable o/h 15,000 15,000 –
105,000 103,500
Contribution 15,000 18,500
Fixed o/h 10,000 11,000 1,000 (A)
Profit $5,000 $7,500 $2,500 (F)

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Statement
$
Original budget contribution (10,000u × $1.25) 12,500
Sales volume variance (2,000 × $1.25) 2,500 (F)
15,000
Sales price variance 2,000 (F)
Labour variance 1,500 (F)
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Actual contribution 18,500


Fixed overheads
Budget 10,000
Variance 1,000 (A) 11,000
Actual profit $7,500

Exercise 4
(a) In a Top-down budgeting system, middle managers and other employees are likely to feel
demotivated and possibly resentful of targets which are imposed from above.
Targets may be too challenging and therefore unrealistic. Targets which are too easy may
cause complacency amongst staff. NB) Targets will be discussed further in our standard
costing chapter.
There may be changes in circumstances at operational level e.g. new staff members that will
need training or individual supplier issues. These may not have been considered in the Top
Down budget.
As a consequence, department managers may view the budget as irrelevant and feel further
demotivated by the lack of senior management understanding.
(b) Despite the drawbacks in terms of employee morale, top down budgeting is much quicker.
The consultation process for participatory budgeting is likely to be time consuming. Further
problems may arise if department managers have little budget setting experience and can
not appreciate company wide factors. The occurrence of conflicts between management
regarding targets will make the budgeting process even longer and more difficult to
manage.
(c) Participatory Budgeting is usually the preferred method for a modern business
environment. It is particularly suitable to Just in time environments which encourage staff
participation and knowledge sharing as part of the employee culture. However, there may
be occasions when Top Down imposed budget style is suitable.
For example, when a budget must be planned and implemented very quickly- in a take-over/
acquisition situation, the top down approach may be more suitable.
If the company is very large or geographically widespread – full consultation may not be
possible – alternatively a very small company may not have department heads or middle
management with which to consult – so the budget targets are better communicated from
top-down.
Top down budgeting may be used when departmental resistance is expected but no
negotiation or compromise is possible. For example – extreme cost cutting measures are not
going to be popular and so may have to be enforced to ensure business survival.

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Chapter 10

Exercise 1
u $
High 700 85,000
Low 100 40,000
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600u $45,000

45,000
Variable cost = = $75
600

For high:

Total cost = 85,000


Variable cost (700u @ $75) 52,500
Fixed cost $32,500

Exercise 2
x y xy x2 y2
1 40 40 1 1,600
4 65 260 16 4,225
2 45 90 4 2,025
7 85 595 49 7,225
6 70 420 36 4,900
5 70 350 25 4,900
3 50 150 9 2,500
28 425 1,905 140 27,375
Σx Σy Σxy Σx2 Σy2

n∑ xy−∑ x ∑ y
b=
n∑ x 2 −(∑ x )
2

7×1,905−28×425
=
7×140−282
1, 435
= = 7.321
196

a=
∑ y − b∑ x
n n
425 7.321×28
= − = 31.430
7 7
y = 31.430 + 73.21x

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Exercise 3
y =31,430 + 73.21(650)

y = $79,016

Exercise 4
Number of hours spent studying and Exam results [positive correlation expected]
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Number of pages printed and ink levels in a printer. [Negatively correlated]


Shoe size and level of disposable income [No correlation]

Exercise 5
Moving Trend Seasonal % variation
Average Variation
2000 1 80
2 87 84.75
3 82 87.25 86 -4 95.3
4 90 89.25 88.25 + 1.75 102.0
2001 1 90 92 90.62 - 0.62 99.3
2 95 95 93.5 +1.5 101.6
3 93 98.75 96.87 - 3.87 96.0
4 102 103 100.87 +1.13 101.1
2002 1 105 105.5 104.25 +0.75 100.7
2 112 109 107.25 +4.75 104.4
3 103
4 116

1 2 3 4
2000 - - -4 + 1.75
2001 - 0.62 + 1.5 - 3.87 + 1.13
2002 + 0.95 + 4.75 - -
Total + 0.13 + 6.25 - 7.87 + 2.88
Averages + 0.06 + 3.12 - 3.93 + 1.44

Exercise 6

1 2 3 4
2000 - - 95.3 102.0
2001 99.3 101.6 96.0 101.1
2002 100.7 104.4 - -
Total 200 206 191.3 203.1
Averages 100% 103% 95.6% 101.5%

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Exercise 7
Discussion could include:

Correlation does not necessarily imply causation.

Too few data observations reduces the reliability of using data as a forecast.
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The past is not necessarily an indication to the future.

Take care when predicting outside the range of normal activity.

Take care when predicting too far in the future.

Consider other factors that may influence future results (PEST factors).

Conclusion
As a management accountant techniques, which can analyse past data and use them to forecast
future results, can be very useful.

However, these methods should always be applied carefully – considering the points discussed
above – in addition to application of good judgment and management expertise.

Chapter 11

Exercise 1
(a) The expected value will be ( 0.3*50,000) + (0.7 * -20,000) = $1000.

In the long run they should end up with an average profit of $1000.

(b) On the basis of EV alone - the decision maker can accept the project.

However, the actual result of the venture may be loss making. The principle of expected
values is designed for experiments that are due to be repeated multiple times – therefore
using this technique to appraise a one-off venture may not be appropriate.

Exercise 2
Demand
(a) Contract size 400u 500u 700u 900u
300u 2,900 3,400 4,400 5,400
500u 3,500 4,000 5,000 5,000
700u 4,100 4,600 4,600 4,600
800u 4,400 4,400 4,400 4,400

(b) (i) Expected value if contract size =


300 units = (0.2 ×2,900) + (0.3 × 3,400) + (0.4 × 4,400) + (0.1 × 5,400) = $3,900
500 units = (0.2 × 3,500) + (0.3 × 4,000) + (0.5 × 5,000) = $4,400
700 units = (0.2 × 4,100) + (0.8 × 4,600) = $4,500
900 units = $4,400

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Sign contract for 700 units


(ii) maximin
Worst outcome from:
300 units = $2,900
500 units = $3,500
700 units = $4,100
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800 units = $4,400


Sign contract for 800 units
(iii) Best outcome from
300 units = $5,400
500 units = $5,000
700 units = $4,600
800 units = $4,400
Sign contract for 300 units
(iv) Regret table:

Demand 400u 500u 700u 900u


Contract size
300u 1,500 1,200 600 0
500u 900 600 0 400
700u 300 0 400 800
800u 0 200 600 1,000

Worst regret for


300 units = $1,500
500 units = $900
700 units = $800
800 units = $1,000
Sign contract for 700 units
(c) With perfect knowledge of the level of demand, the payoffs would be as follows:
Result of Decision Payoff
perf. know. Contract $
400 800u 4,400
500 700u 4,600
700 500u 5,000
900 300u 5,400

The expected return with perfect knowledge =

(0.2 × 4,400) + (0.3 × 4,600) + (0.4 × 5,000) + (0.1 × 5,400) = $4,800

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The expected return without perfect knowledge (from (b)(i) is $4,500

So the most to pay for perfect knowledge

= 4,800 – 4,500

= $300
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Exercise 3
13.5M
5M
2/3
od
Go

A
)
t

(4M
shu

ive
ens
exp Bad
⅓ 6.5M

1
(2M 8.5M
)
che
ap 2/3 13.5M
d
Goo .91
0
B od
Go
C
Bad
Market ⅓ 4M
)
research e (4M Bad
(0.2M) e nsiv 0.0
exp 9
6.5M
Good result
2
F 0.68 (2M 8.5M
che
)
d 0.91
Ba ap Goo
0.3 d re D
shut

2 sul
t
Bad
0.0
9
3 5M 4M

ch
eap
(2M
) .13 8.5M
d0
shu

G o o
E
t

5M Ba
d0
.87
4M

Expected values:

at A (2/3 × 13.5M) + (1/3 ×6.5M) = 11.17M


B (2/3 ×8.5M) + (1/3 × 4M) = 7M
C (0.91 × 13.5M) + (0.09 × 6.5M) = 12.87M

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D (0.91 × 8.5M) + (0.09 × 4M) = 8.095M


E (0.13 × 8.5M) + (0.87 × 4M) = 4.585M
Decisions
at 2: choose expensive, 8.87M (12.87 – 4)
at 3: choose shut, 5M
Expected value at F, (0.68 × 8.87M) + (0.32 × 5M) = 7.63M
Decision at 1: choose market research, 7.43M (7.63 – 0.2)
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Exercise 4

Sensitivity Analysis

Current Assumptions – based on 1000 units sold:


$
Sales Revenue 30,000
Variable costs (10,000)
Contribution 20,000
Fixed Costs (15000)
Profit 5,000 <Based on these estimates – this project will be
profitable

Sensitivity Analysis

Sales revenue
5000
x 16.6%
30,000

Sales Volume ( this is like sensitivity of contribution)


5,000
x 100 = 25%
20,000

Total Variable costs


5,000
x 100 = 50%
10,000

Fixed costs
5,000
x 100 = 33.3%
15,000

Interpretation.

Each element can be interpreted in similar way as below:


If total sales revenue was to fall by more than 16.6% (of its current estimated value) then the project
will be loss making.

If the total variable costs were to rise by more than 50% of the current estimated figure then the
project will become loss making.

Critical variable: Sales Revenue


In sensitivity analysis – the smallest % of the results identifies the most critical variable.

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In this case - sales revenue (based on the estimated selling price) is the lowest percentage of the
project. This means management should recognise that this variable needs to be carefully
estimated and based on thorough market research. The analysis tells them that a drop in selling
price of more than 16.6% will make the project non-viable.

All sensitivity calculations assume the other variables of the project are held constant.

Exercise 5
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Standard Deviation with Expected Value


x p px x–x p (x – x)2
10 0.2 2 – 5.5% 6.05
15 0.5 7.5 – 0.5% 0.125
20 0.3 6 + 4.5% 6.075
15.5% 12.25
x
Standard deviation = 12.25 = 3.5%
The expected value of return = 15.5%
The standard deviation is 3.5% (expressed in same units as the data given).

The coefficient of variation is 3.5/15.5 = 0.2258 which is 22.6% ( This % gives an indication of
relative magnitude of variation in the data).

Chapter 12

Exercise 1
(1) Your research team have spent $50,000 researching project Q during 2X14? (Non-relevant)
(2) The production manager currently earns a salary of $20,000p.a. Your new project will incur
approximately $5000 p.a of overtime from him which means his salary is expected to be
$25,000 for the duration of the project. (Which is relevant cost for project here? $5000 )
(3) A decision to manufacture a new product is expected to increase fixed costs by $3000 per
month. ( Relevant )

Exercise 2
Revised costs for special order:
Notes $
Subcontractor costs 1 31,300
Supervisor costs 2 1,000
General overheads 3 1,000
Machine maintenance 4 500
Machine overheads 5 22,000
Materials 6 31,500
Interest costs 7 900
88,200
Notes:

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1. The choice lies between the two subcontractor costs that have to be employed because of
the shortage of existing labour. The minimum cost is to have subcontractors employed who
are skilled in the special process.
2. Only the difference between the bonus and the incentive payment represents an additional
cost that arises due to the special order. Fixed salary costs do not change.
3. Only incremental costs are relevant.
4. Depreciation is a period cost and is not related to the special order. Additional maintenance
costs are relevant.
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5. The relevant costs are the variable overheads ($3 × 6000 hours) that will be incurred, plus the
displacement costs of $2 × 2000 hours making a total of $22,000.
6. Since the materials are no longer used the replacement cost is irrelevant. The historic cost of
$34,000 is a sunk cost. The relevant cost is the lost sale value of the inventory used in the
special order which is: 7,500 kg × $4.20 per kg = $31,500.
7. Full opportunity costing will also allow for imputed interest costs on the incremental loan.
The correct interest rate is the overdraft rate since this represents the incremental cost the
company will pay. Simple interest charges for three months are therefore: (3/12) × $20,000 ×
18% = $900.

Exercise 3
(a) Lost contribution from Rooks (15,000)
Save fixed overheads 5,000
Net loss from ceasing Rooks 10,000

Therefore, should continue production of Rooks.

(b) Lost contribution from Rooks (15,000)


Save fixed overheads 5,000
Extra contribution from Crowners 20,000
Extra fixed costs of Crowthers (6,000)
Net gain from ceasing Rooks 4,000

Therefore, should cease production of Rooks and produce Crowners instead.

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Exercise 3
X Y Z
Buy-in price 13 17 16
Cost to make 10 12 14
Saving (p.u.) $3 $5 $2
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Kg of B 3 2 1

Saving per kg $1 $2.50 $2


RANKING 3 1 2
Material B
Units
(kg)
Y MAKE 2,500 5,000
Z MAKE 3,000 3,000
8,000 kg

Z BUY 1,000
X BUY 2,000

Chapter 13

Exercise 1
$
Selling price 6
Variable costs 2
Contribution 4

(a) $
Total contribution (300u × $4) 1,200
Fixed costs (1,000)
Profit $200

Fixed costs 1,000


(b) Breakeven = = = 250 units
Contribution p.u 4
(c) C/S Ratio is 4/6 = 0.66 (This tells us that 66% of selling price is contribution)
(d) Breakeven revenue = 250 u × $6p.u. = $1,500

1,000
If used formula with C/ S ratio – result is approx the same as above = 1,515
0.66

Approx $1500

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Exercise 2
Margin of safety

Budgeted sales = 300 units


Breakeven = 250 units

300 – 250
Margin of safety = × 100 = 16.67%
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300

Exercise 3
Contribution 4
C/S ratio = = = 0.67
Sales 6

$
Target profit 320
Fixed overheads 1,000
Target contribution $1,320

Sales revenue required = Target contribution ÷ C/S ratio = 1320 ÷ 4/6 = $1,980

Exercise 4
Cost & revenue
($)

3,000 Total
revenue

2,000 Total cost

1,000
} variable
cost

0 250 500
} fixed cost

output
(units)
breakeven

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Exercise 5
Profit
($)

1,000
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0 500 Sales (units)

breakeven
(250 units)

1,000

Exercise 6
(a) CS ratios:

C = 1.25 / 5.00 = 0.25 (or 25%)

V = 0.75 / 6.00 = 0.125 (or 12.5%)

P = 2.65 / 6.00 = 0.379 (or 37.9%)

(b) Average CS ratio:

Based on budget sales,

Total revenue = (4800 x 5) + (4800 x 6) + (12000 x 7)

= $136,800

Total contribution = (4800 x 1.25) + (4800 x 0.75) + (12000 x 2.65)

= $41,400

Average CS ratio = 41400/136800 = 0.303 (or 30.3%)

(Alternatively, the average CS ratio may be calculated by taking the weighted average of the
individual CS ratios, weighting by the budgeted sales revenues.)

(c) Breakeven sales revenue = fixed overheads / CS ratio

= 8000/0.303

= $26,400

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(d) See graph below

Profit ($)
+ 40,000

V
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+ 30,000

+ 20,000

+ 10,000 P

0 50,000 100,000 150,000 Sales ($)

– 10,000

(e) P has the highest CS ratio, followed by C, followed by V.

Cumulative Cumulative
Sales Profit
P (12,000 × 7 =) 84,000 ((12,000 × 2.65) – 8000) 23,800
C (4,800 × 5 = 24,000) 108,000 (4,800 × 1.25 = 6000) 29,800
V (4,800 × 6 = 28,800) 136,800 (4,800 × 0.75 = 3600) 33,400

(f) If selling products in the order of highest contribution (P then C then V) Product P’s sales
alone will achieve breakeven. This means breakeven point from this selling strategy will be =
8000/0.379 = $21,108 of product P.

See dotted lines on P/V chart above

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