P 2 Study Notes - Area A

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Syllabus Area A - 25%

Cost Analysis/TQM/Learning Curve/ABC

Activity based management uses activity based cost information for a variety of purposes including cost reduction, cost modelling and customer profitability analysis

ABC Hierarchy of activities:

Unit level - ABC adapts variances such as materials usage/material price variance to establish responsibility

Batch level activities - resources consumed in no of batches rather than units.

Product Sustaining activities - product specific activities eg: stepped costs (advertising)

Facility Sustaining activities - simply relate to "being in business" eg: building maintenance, security

ABM includes cost reduction, product design decisions, operational control and performance evaluation (and more) - does not specifically include variane analysis

Kaizen Costing - used for cost reduction, not cost control. Assumes continuous improvement, targets set and applied monthly

TQM - aims to eliminate the costs of poor quality

Just in Time - Problems

Makes an organisation more vulnerable to disruption in the supply chain ( out of stock could be fatal @ hospital)

Wide geographical spread makes JIT difficult

JIT not always suitable, may be hard to predict patterns of demand

Manufacturing Cost Hierarchy

Product/process level

Organisation/facility level

Batch level

Unit level

Theory of Constraints (approach to production management) - focuses of factors such as bottlenecks that act as a constraint on Material & variable costs - therefore maximise sales

Pricing

PED (Price Elasticity of Demand) = % change in demand % change in price

Less than 1 = Inelastic (vertical demand curve) - not sensitive to price change

More than 1 = Elastic (horizontal demand curve) - sensitive to price change

Price Function & Profit Maximisation

P = a - bQ

P = Price

a = Price at which demand is zero

b = gradient of demand curve

Q = Quantity sold at the price (P)

Maximum demand will occur when the price is zero

Profit is maximised when MR = MC (Marginal cost, is the cost of producing one more unit)

Marginal Revenue - extra revenue received by the sale of one more unit

MR = a - 2bQ

Learning Curve

Conditions required

Production process should be labour intensive, with direct involvement from labour force

Production process should be complex to allow scope for learning (long time to produce 1st batch = complex)

Production process should be continuous, with no prolonged stoppage times

Low turnover of production labour - allow learning theory to develop and improve

Study Notes

Moving from one single cost pool to overheads based on machine hours - ABC would highlight that " High volume products have too much overheads in them "

Finance Salaries - Batch level activity

Throughput Accounting Ratio

Throughput Contribution per hour : Conversion cost per hour

Lean Philosophy - would not include the Centralization of Management decision making

Mixed Bank 5 Notes

Cost Driver = a factor which causes the costs of an activity

Target Costing focuses on costs at the development stage

Target costing - selling price is determined as a competitive market price

Kaizen costing is applied during the manufacturing stage

Interest costs on bank loans are a relevant cash flow in decision making

Finance costs are not included in the relevant cash flow, they will form part of the calculations for an appropriate discount rate.

Syllabus Area B - 30% - Control & Performance Management of Responsibility Centres

Performance Management & Transfer Pricing

Relevant costing/Beyond Budgeting/Performance Management

Return on Capital Employed (ROCE)

= PBIT * 100%

Capital Employed

Or

Return on Capital Employed (ROCE)

= Profit Margin * Asset Tunrover

Capital employed - debt & equity (share capital & reserves & long term debt from SOFP)

Asset Turnover : Sales/Turnover

Capital Employed

Two Part tariff Pricing

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Relevant Costing

A future incremental cash flow, arising as a direct consequence of a decision made

Relevant Costs

Opportunity cost

Product specific fixed costs

Non - Relevant costs

Sunk or historical

Committed

Notional

Common

General fixed costs

Qualitative information - cannot be easily expressed in the form of numbers, information hard to quantify - opinions, customer/supplier perceptions

Quantitative information - can be easily expressed in the form of numbers - absolute measures, relative %, ratios

Management Control Systems

Feed-forward control - proactive

A system that reacts in a pre-emptive way to changes in its environment

React to future performance expected - make control adjustments in advance

Examples, forecasting, cash budgeting, strategic planning

Feedback control - reactionary

part of the system output is measured and returned as input to regulate the systems further output

involves gathering information on past performance and comparing it to a predetermined or standard plan

Examples, comparing actual performance to standard performance, can be -ve (adverse) or +ve (favorable) - "closing the stable door after the horse has bolted"

Open & Closed loop control systems

Components:

High level controller - Human

Effector - either an automatic or human action to correct future undesired outcomes (exception reporting involved where adverse differences between actual and expected results are reviewed)

Input - Data

Process - Calculate, sort amend

Sensor - detects information it is programmed to find, collects and measures data

Comparator - compares actual results to standard (costs,productivity or quality)

Output - Information

Open loop Control (double feedback loop) System - corrective action is not automatically taken, environmental and internal feedback considered before control action is taken.

Closed loop Control (single feedback loop) System - output automatically compared to a pre-determined standard, any exceptions and control action taken automatically.

These systems are generally relative to People and performance (sales target systems) and Managing resources efficiently & effectively (stock control).

Operating Gear - measures the effect of fixed costs on operating profit

IF SALES FALL - fixed costs remain and the business may not be able to contract their fixed costs eg: 10 year lease agreement

IF SALES RISE - fixed costs remain and the business will have spare capacity to meet fixed costs and therefore increase operating profit eg: 10 year lease

Beyond Budgeting

PRIME (main purpose of budgeting)

P = Planning

R = Resource utilization or responsibility accounting

I = Integration or Coordination

M = Motivation

E = Evaluation

Goal Congruence = making your organisation or business objectives aligned with the personal objectives of a manager or staff member

Budgetary slack/padding - the intentional over estimation of costs and/or under estimation of revenue in a budget

Control-ability Principle - assessing performance based upon measures that can be controlled only by a manager (omitting items which are uncontrollable) eg: Head office overheads

Responsibility Accounting - separating revenues and/or costs into areas of personal responsibility to assess he individual performance of a manager.

Beyond Budgeting is a philosophy that traditional budgeting methods are of little use to management, ZBB and ABB are more modern methods.

Modern methods of alleviating traditional budgeting:

ABC

Key metrics or Performance indicators - KPI's are important measures used to asses performance

Balance scorecard (approach to performance assessment)

Total Quality Management

Value and non-value added analysis

De-centralization of decisions (more empowerment)

Critical Success Factors (CSFs) - operational goals that if achieved, the business will be successful. Johnson & Scholes "those components of strategy where the organisation must excel to outperform competition"

Balance Scorecard - views an organisation from 4 perspectives to develop metrics

Customer - what must we do right for our customers? what do they value?

Internal - what must we improve internally to satisfy shareholders and customers?

Innovation & Learning - how can we innovate and improve value?

Financial - how do we satisfy shareholders and create value for them?

Study Notes

Syllabus Area C - 30%

Long Term Decision Making

Payback/ARR/NPV/IRR/Captial Rationing

Payback - how quickly a project takes to pay itself back

(DAD - short-term, ignores time value of money)

Discounted Payback - method applied to the PV of cash flows after discounting - AD in relation to payback

Accounting Rate of Return - Profit over the life of the project as a % of the initial investment

(DAD - ignores time value of money, relative figure %)

NPV - discounts to today's value all future cash flows of a project

(AD - includes time value of money, an absolute measure, uses relevant costing)

(DAD - cash flow occurs at end of year, only looks at financial costs and benefits)

NPV subject to inflation - when calculating would use

Discount actual (nominal) cash flows at money discount rates

Discount real cash flows at real discount rates

Inflation

(1+M) = (1+R) * (1+I)

M = money cost of capital

R = real cost of money

I = General rate of inflation

Taxation - tax on profits paid 50% in T1 and then 50% in T2

Capital Allowances - when asset is bought 50% received in T1 and remaining 50% in T2

IRR - cost of capital that would give a project zero NPV

(AD - includes time value for money, uses relevant costing DAD - may have multiple IRR's for 1 project, confused with ARR or ROCE)

An investment should be accepted if the internal rate is greater that the cost of capital. When selecting among several projects, the IRR would be calculated for each and the projects ranked by their rates of return

IRR

- makes no allowance for the size of the initial investment

- ignores the length of the investment period

- does not necessarily reflect the impact on shareholder wealth

Study Notes

Discounted Payback involves applying a discount rate to cash flows

Replacement Theory - compares 2 products with different timescales

For Investment Appraisal decisions the payback period = considers all cash flows received in earlier years have more value

Cost of Capital Decreases

NPV - Increases

IRR - Remains constant

Payback - Remains constant

ROI Calculation - does not include Sales Revenue - will include margin, divisional income & earnings per share

ROI shows - How effectively a company used its invested Capital

Payback Period = Net returns to recover original investment Before Depreciation but After Taxation

NB: Taxation is a Cash-flow, Depreciation is not a Cash-flow.

Mixed Bank 12

To what does the internal rate of return equate the present value of expected future net cash receipts = Initial cost of the investment outlay

NB: The internal rate of return is therefore the rate of return at which the project's NPV is zero

Management Control & Risk - 15%

Risk

Risk Hedging - taking action to offset one risk by incurring a new risk in the opposite direction

Risk Pooling/Diversification - the management of a portfolio of different risks

Insurance = appropriate risk hedging strategy when potential cost is high, but likelihood of an adverse outcome is low

When the frequency is high, internal measures required to manage risk are appropriate

Risk Averse

A risk averse investor is an investor who prefers lower returns with known risks rather than higher returns with unknown risks.

Definition: A risk averse investor is an investor who prefers lower returns with known risks rather than higher returns with unknown risks. In other words, among various investments giving the same return with different level of risks, this investor always prefers the alternative with least interest.

Description: A risk averse investor avoids risks. S/he stays away from high-risk investments and prefers investments which provide a sure shot return. Such investors like to invest in government bonds, debentures and index funds

Study Notes

Product Life Cycle

Introduction Stage - Brand Awareness

- Establish a Market & build demand

Growth Stage - Build Brand or Consumer preference, by stepping up advertising (marketing)

- Increase sales

Maturity Stage - Concentrate on differentiating from competing products

- Build brand loyalty

- Maintain market share & extend product life-cycle

- Offer incentives to entice competitors consumers to switch

Decline Stage - Promotional expenditure reduced

- Reinforce brand image of remaining products

Beyond budgeting - Adaptive procedures

Market Price/Market based Price used when:

- Variable costs & market prices are constant

- When a perfect external market exists

Value of Perfect information

- Best project in market conditions

- Calculate expected net cash inflow/profit

- Expected value

- Deduct project with highest EV = value of Perfect information

NB - take max figure by probability, add together, subtract from EV calculated

Asset Replacement Policy - annual cash-flows are the running costs less any income from the sale of the asset @ year end

Take PV of the net cash-flows to give PV of costs over replacement cycle

Cost of capital/Discount rate then used on a cumulative basis to determine the equivalent annual PV of the cost

Probability = %

Expected value = Probability * Amount

Evaluation of any system -

2 recurring terms are efficiency and effectiveness

They are 2 key reasons for the introduction of information systems

AMT = Advanced Manufacturing Technology

FMCG = Fast Moving Consumer Goods

Residual Income = Profit - Cost of Capital

Dual Pricing

- Buyer gets market price

- Seller gets marginal cost