P1 Course notes

Syllabus A: Cost Accounting For Decision And Control .....................2

Syllabus A1. Different Rationales For Costing .........................................................................2

Syllabus A2. Costing Concepts .............................................................................................14

Syllabus A3. Costing Methods ..............................................................................................33

Syllabus A3. Standard Costing ..............................................................................................60

Syllabus B. BUDGETING .............................................................87

Syllabus B1. Different Rationales For Budgeting ..................................................................87

Syllabus B2. Prepare Budgets ...............................................................................................96

Syllabus B2. Preparing Forecasts .......................................................................................116

Syllabus B3. Budgetary Control ..........................................................................................139

Syllabus C. SHORT-TERM DECISION MAKING ............................149

Syllabus C1. Product Mix Decisions ...................................................................................149

Syllabus C1. Cost plus pricing ............................................................................................160

Syllabus C2. Relevant Costing ............................................................................................163

Syllabus C3. Short-term Decision Making ..........................................................................170

Syllabus C3. Break-even analysis .......................................................................................181

Syllabus D. DEALING WITH RISK AND UNCERTAINTY .................193

Syllabus D1a. Risk And Uncertainty ....................................................................................193

Syllabus D1b. Decision Models ...........................................................................................204

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 Syllabus A: Cost Accounting For Decision And Control
Syllabus A1. Different Rationales For Costing

Purpose and role of cost and management accounting

The purpose of cost and management accounting is

to provide information to managers that will help them to:

1. plan the activities (e.g.) plan number of units to produce this year

2. make decisions regarding activities (e.g.) purchase materials required for

production

3. control the activities (e.g.) control amount of materials being used for production

4. evaluate the activities (e.g.) evaluate whether more/less materials were used per
unit in comparison to the original plan

The information is used by managers, employees and decision makers internal to

the organisation.

Management information is generally supplied in the form of reports.

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Reports may be:

• routine (monthly management accounts) or

• prepared for a specific purpose (e.g. one-off decisions)

Cost accounting and Management accounting

Cost accounting and management accounting are terms which are often used
interchangeably. 

It is not correct to do so. 

Cost accounting is a part of management accounting.

Cost accounting is mainly concerned with:

• Preparing statements (e.g. budgets, costing)

• Cost data collection

• Applying costs to inventory, products and services

Therefore, management accounting goes beyond cost accounting.

In general, cost accounting information is unsuitable for decision-making.

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 Financial accounting vs Management accounting

Learn this well …

Management accounting Financial accounting

1. Users and decision-makers Internal use - External use -

Management and employees Shareholders, banks, government

2. Purpose of information To aid in planning, decision- To record the financial performance

making and control and position of the business

3. Legal requirements None Limited companies must produce

financial statements

4. Formats Management decide the best According to company law

way to present information.

5. Nature of information Most monetary; but also non- Monetary information

monetary information

6. Time period Historical and forward-looking Mainly historical

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 Strategic Planning

Senior management formulate long-term (e.g. 5 to 10 years) objectives and plans for an
organisation.

Such plans include overall profitability, the profitability of different segments of the
business, capital equipment needs and so on.

It can also include qualitative information, for example, plans to enter into a new market,
or create a new product.

Tactical Planning

Senior management make medium-term, more detailed plans for the next year

e.g. decide how the resources of the business should be employed, and to monitor how
they are being and have been employed.

Operational Planning

All managers are involved in making day-to-day decisions.

'Front-line' managers such as foremen or senior clerks have to ensure that specific
tasks are planned and carried out properly within a factory or office.

Operational information is derived almost entirely from internal sources.

It is prepared frequently and is highly detailed.

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 Cost Transformation And Management

‘The CGMA Cost Transformation Model is designed to help businesses to achieve and
maintain cost competitiveness.

It serves as a practical and logical planning and control framework for transforming and
managing a business’ cost-competitiveness.’ (CGMA, 2016)

Framework

‘Engendering A Cost-Conscious Culture’

• Continuous process of cost consciousness

• Employees should be motivated to consider costs in daily duties

‘Managing The Risks Inherent In Driving Cost-Competitiveness’

• Understand and manage risks that could prevent a business achieving its cost
transformation and management objectives

‘Connecting Products With Profitability’

• Understand how their products and services create value for customers to avoid
losing customers, or having to accept a lower price

• Understanding product value means the product portfolio can be tailored

‘Generating Maximum Value Through New Products'

• Design products for flexibility. so that features can be added or eliminated as

appropriate to appeal to new markets

• Extra value should translate to a ‘willingness to pay’

• 80% of a product's cost is determined before production commences management

accountants should be involved in the design process to drive down costs and drive
up customer value

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 ‘Incorporating Sustainability To Optimise Profits'

• Avoiding unnecessary costs will increase profit, for example, reducing machining
steps could reduce material waste, power consumption and tool wear

• Include the cost of sustainability initiatives in product costs

‘Understanding Cost Drivers: Cost Accounting Systems And Processes’

• Reducing costs whilst simultaneously preserving or enhancing customer value

requires the right information

• Regularly review cost systems to ensure the output supports the needs of decision
makers

This model helps cost reduction exercises by providing a framework as a useful starting
place

However, it may be too rigid for some organisations which means that time will be spent
considering things that are not necessary.


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 Area of Responsibility

Each manager must have a well-defined area of responsibility and the authority to make
decisions within that area.

An area of responsibility may be structured as

Cost centre

A cost centre is a production or service location, function, activity or item of equipment

whose costs are identified and recorded

e.g. manufacturing department, purchasing department and paint shop.

A cost centre manager is responsible for, and has control over, the costs incurred in the
cost centre.

The manager has no responsibility for earning revenue.

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 A performance report for a cost centre:

Important points about the performance report:

• - it should distinguish between controllable costs and uncontrollable costs

• - the actual costs are compared with a budget that has been flexed to the actual
activity level achieved.


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 Revenue centre

A revenue centre is accountable for revenues only.

Revenue centre managers should normally have control over how revenues are raised

e.g. retail outlet, sales department and airline reservation department.

Profit centre

A profit centre is a part of the business for which both costs and revenues are identified

e.g. product division

The budget for the sales revenue and variable cost of sales will be flexed according to
the activity level achieved

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 A profit centre performance report:

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 Investment centre

An investment centre is a profit centre with additional responsibilities for capital

investment and possibly for financing, and whose performance is measured by its return
on capital employed (ROCE), RI and ROI.

e.g. subsidiary company

Managers of subsidary companies will often be treated as investment centre manager

and will be accountable for profits and capital employed.

The amount of capital employed in an investment centre should consist only of directly
attributable non-current assets and working capital (net current assets)

Cost centres, revenue centres, profit centres and investment centres are also known as
responsibility centres.


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 Big Data

is an emerging technology that has implications across all business departments.

It involves the collection and analysis of a large amount of data to find trends,
understand customer needs and help organisations to focus resources more
effectively.

Benefits:

1. Easy to convert to useful information

2. Gaining competitive advantage

3. Driving innovation

The 3 V's

Big data has a role to play in information management

Gartner’s 3Vs definition of "Big Data":

Volume

The quantity of data now being produced is being driven by social media and
transactional-based data sets recorded by large organisations.

For example, data captured from in-store loyalty cards.


Velocity

Velocity refers to the speed at which 'real time' data is being streamed  into the
organisation.

To make data meaningful it needs to be processed in a reasonable time frame.


Variety

Modern data takes many different forms.

Structured data may take the form of numerical data whereas unstructured data
may be in the format of email or video

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 Syllabus A2. Costing Concepts

Production Cost Classification

Video link: https://www.acowtancy.com/textbook/cima-p1/costing-concepts-1/cost-classification/notes

Prime Cost

is made up of...

1. Direct Materials +

2. Direct labour +

3. Direct expenses

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Video link: https://www.acowtancy.com/textbook/cima-p1/costing-concepts-1/cost-classification/notes

Overheads

are

1. Indirect Material +

2. Indirect Labour +

3. Indirect Expenses

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 Types of Cost Behaviour

Costs can be classified according to the way that they behave within different levels
of activity.

Cost behaviour tends to classify costs as:

Variable cost

Fixed cost

Stepped fixed cost

Semi-variable cost

Variable Cost
A variable cost varies directly with output. (The more you make the more the cost - IN
TOTAL)

However, the variable cost PER UNIT remains constant.

Direct costs are variable costs (Eg Raw materials, Labour and direct Overheads)

Graph 1: Total variable costs

Variable costs in total change in direct proportion to the level of activity.

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Graph 2: Variable cost per unit

The cost per unit of variable costs remains constant.

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Fixed Costs
A Fixed cost (within certain activity levels) remains constant (In total)

However that also means the more the output - the Fixed Cost PER UNIT will fall

Eg Salaries, Rent, Straight line depreciation

Graph 3: Total Fixed Costs

Total fixed costs remain constant over a given level of activity.

Graph 4: Fixed Cost per unit

The fixed cost per unit falls as the level of activity increases but never reaches zero.

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Stepped Fixed Costs

A stepped fixed cost is only fixed within certain levels of activity.

The depreciation of a machine may be fixed if production remains below 1,000 units per
month. If production exceeds 1,000 units, a second machine may be required, and the cost
of depreciation (on two machines) would go up a step.

Other stepped fixed costs include rent of warehouse (more space required if activity
increases) and supervisors’ wages (more supervisors required if number of employees
increase).

Graph 5: Stepped Fixed Costs

Fixed costs increase in steps as activity level increases beyond a certain limit.

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Semi-variable Costs (semi-fixed/mixed)

Semi-variable costs contain both fixed and variable components and are therefore partly
affected by changes in the level of activity.

Examples of semi-variable costs includes

Electricity and gas bills

Fixed cost = standing charge

Variable cost = electricity / gas used

Salesman's salary

Fixed cost = basic salary

Variable cost = commission on sales made

Costs of running a car

Fixed cost = road tax, insurance

Variable costs = petrol, oil, repairs

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Graph 6: Total semi-variable costs

Graph 7: Semi-variable costs per unit

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Graph 8: Other cost behaviour patterns
This graph represents a cost which is variable with output, subject to a minimum (fixed)
charge.

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 Production costs and Non-Production costs

Cost accounting is used for:

1. Preparing statements (e.g. budgets, costing)

2. Cost data collection

3. Applying costs to inventory, products and services

For the preparation of financial statements, costs are often classified as:

1. Production

2. non-production costs

Production costs
are costs identified with goods produced for resale.

Production costs are all the costs involved in the manufacture of goods, i.e.:
• direct material

• direct labour

• direct expenses

• variable production overheads

• fixed production overheads

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Non-production costs
are not directly associated with production of manufactured goods.

They are taken directly to the income statement as expenses in the period in which
they are incurred.

Such costs consist of:

• administrative costs

• selling and distribution expenses

• finance costs

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 Different elements of production cost

Costs can be classified by element:

1. materials

2. labour

3. overheads (expenses)

Materials
This includes all costs of materials purchased for production or non-production
activities

e.g. raw materials and components.

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Labour
This includes all staff costs relating to employees.

Overheads
Overheads include all other costs which are not materials or labour.

These include rent, telephone, and depreciation of equipment.

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 Different elements of non production costs

Administrative costs
These include all the costs involved in running the general administration
department of an organisation.

Examples of administrative costs include:

• Depreciation of office buildings and equipment.

• Office salaries, including salaries of directors, secretaries and accountants.

• Rent, rates, insurance, lighting, cleaning, telephone charges and others.

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Selling costs
Selling costs include all costs incurred in promoting sales and retaining customers.

Examples of selling costs are:

• Salaries and commission of salesmen and sales department staff.

• Advertising and sales promotion, market research.

• Rent, rates and insurance of sales offices and showroom.

Distribution costs
Distribution costs include all costs incurred in making the packed product ready for
dispatch and delivering it to the customer.

Examples of distribution overhead are:

• Delivery costs

• Wages of packers, drivers and despatch clerks.

• Insurance charges, rent, rates and depreciation of warehouse.

Finance costs

Finance costs include all the costs that are incurred in order to finance an
organisation, for e.g. loan interest.

Non-production costs are taken directly to the income statement as expenses in the
period in which they are incurred.

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 Costing in Different Organisations

Costing in Manufacturing and Service Organisations

Video link: https://www.acowtancy.com/textbook/cima-p1/costing-concepts-1/costing-in-different-

organisations/notes

Job Costing
This is used when each item output of product is unique / customised

Eg Construction projects

Process Costing
Multiple items are produced simultaneously

Eg Oil refining or brewing

Instead of costing all the products individually, an average cost per unit is used.

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Video link: https://www.acowtancy.com/textbook/cima-p1/costing-concepts-1/costing-in-different-

organisations/notes


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 Costing Digital Products

Features of digital costing

• It is vital to have the most up-to-date pricing information available and therefore
links to supplier IT systems are crucial.

• Information is gathered in real time

• Large volumes of data are processed

Costing Digital Products

Particular Issues Include:

1. High Fixed Costs

Digital products often need huge research and development.

With no guarantee of success and things moving so quickly these often have to
be written off

2. Low Variable Costs

The cost of a new student accessing acowtancy is v small

The cost of a new listener to a song online is v v v small

The cost of a new reader to an e-book is v v v small

3. Ongoing Development Costs are high

New software updates and competition mean development costs are continually
high - either that or face obsolescence!

4. Security/Compliance costs are high

Hackers are a continual problem as are viruses

There is also the issue of data protection regulations

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5. Evolving Revenue Streams
Buy access to the software for a period of time

Buy access to the software monthly or annually

Buy access as a one-off (until a new version requires a new purchase)

The big issue is accounting for these digital costs correctly - when and where in the
accounts

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 Syllabus A3. Costing Methods

Absorption Costing

Under absorption costing, fixed overheads are dealt with by calculating

a budgeted overhead absorption rate (OAR).

The Overhead Absorption Rate (OAR)

OAR = Budgeted overheads / Budgeted level of activity

The following can be used as the basis to absorb overheads:

1. number of units

2. labour hours

3. machine hours

Illustration 1
The Company produces product A only.

Product A takes 100 machine hours to produce.

Budgeted overheads are $100,000.

Required:
Calculate the OAR.

Solution:
Budgeted overheads are $100,000.

Budgeted machine hours for the period were 100.

OAR = $100,000 / 100 machine hours

OAR = $1,000 per machine hour

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Illustration 2
The Company produces product A and B.

Product A takes 60 machine hours to produce.

Product B takes 40 machine hours to produce.

Budgeted overheads are $100,000.

Required:
Calculate the OAR.

Solution:
Budgeted overheads are $100,000.

Budgeted machine hours for the period were 60 + 40 = 100.

OAR = $100,000 / 100 machine hours

OAR = $1,000 per machine hour

Therefore, Product A will absorb $1,000 x 60 = $60,000

Product B will absorb $1,000 x 40 = $40,000

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 Absorption and Marginal Costings

The effect of absorption and marginal costing on inventory valuation and profit

1. Marginal costing
values inventory at the total variable production cost of a product.

E.g. direct labour, direct material, direct expenses and the variable part of
overheads

NO FIXED o/h costs included

2. Absorption costing
values inventory at the full production cost (including fixed production
overheads) of a product.

3. Inventory values using absorption costing are therefore greater than those
calculated using marginal costing.

4. Since inventory values are different, profits reported in the Income statement (I/
S) will also be different.

Illustration
The cost of Product A:

Direct materials $10

Direct labour $5

Direct expenses $2

Variable production overhead $6

Fixed production overhead $8

What will the inventory valuations be according to marginal and absorption costing?

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Solution

• Marginal costing:
Direct materials $10

Direct labour $5

Direct expenses $2

Variable production overhead $6

Value of 1 unit of Product A = 10 + 5 + 2 + 6 = $23

• Absorption costing
Direct materials $10

Direct labour $5

Direct expenses $2

Variable production overhead $6

Fixed production overhead $8

Value of 1 unit of product A = 10 + 5 + 2 + 6 + 8 = $31

Pricing decisions: Marginal & absorption costing

Marginal costing

- is appropriate for short-term pricing decisions.

- when used for pricing decisions includes the 'marginal (variable) cost' of the
product.

- is more appropriate than absorption costing for use in one-off pricing decisions.

Absorption costing

- is appropriate for long-term pricing decisions.

- when used for pricing decisions includes the 'total-cost' of the product.

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 The concept of contribution

Marginal Costing
Marginal costing is an alternative method of costing to absorption costing.

In marginal costing, only variable costs are charged as a cost of sale.

Therefore, the cost of a unit =

Direct materials + direct labour + variable production overheads

Fixed costs are treated as a period cost, and are charged in full to the income
statement of the accounting period in which they are incurred.

Contribution
How do we calculate contribution?

Contribution = Sales price – variable costs

Contribution is of fundamental importance in marginal costing, and the term
'contribution' is really short for 'contribution towards covering fixed overheads and
making a profit'.

Total contribution = contribution per unit x sales volume

Profit = Total contribution – Fixed overheads

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Illustration
Calculate the Total Contribution, using Marginal Costing.

$per unit

Sales price 40

Direct materials 20

Direct labour 10

Variable production overheads 3

Fixed overheads 2

Sales volume 100 unit

Solution

Contribution $40-$20-$10-$3 = $7/unit

Total contribution = $7 x 100 units = $700


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 Profit or loss

Profit or loss under absorption and marginal costing

• In marginal costing, fixed production costs:

- are not included in the COS

- are treated as period costs (are written off as they are incurred)

• In absorption costing, fixed production costs

- are absorbed into the cost of units

- are included in the COS

• In the long run, total profit for a company will be the same whether marginal
costing or absorption costing is used

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 Marginal costing income statement $ $

Sales x

less Variable cost of sales

Opening inventory x

Production costs x

Variable Production Overhead costs x

---

less Closing inventory (x)

---

(x)

---

less Variable selling, dist, admin costs (x)

---

Contribution x

less Fixed costs (actual incurred)

Production x

Selling and distribution x

Administration x

---

(x)

---

Net profit x

==

Note that inventories are valued at variable production costs only.

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Illustration 1

A company produced 1,000 units of Product A.

The opening and closing inventory was 100 units and 500 units respectively.

The selling price and production costs for Product A were as follows:

Selling price    $30 per unit

Direct costs   $10 per unit

Variable production overhead costs $6 per unit

Total Fixed production overhead  costs  4,000

What is the Gross profit for Product A, using marginal costing?

Solution

Number of units sold = (OP + Produced - CL) = (100 + 1,000 - 500) = 600 units

Contribution per unit = 30 - 10 - 6 = $14 per unit

Contribution = 600u x Contribution $14= $8,400

Gross Profit = $8,400 - Fixed OH $4,000 = $4,400

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Profit under Absorption costing

Absorption costing income statement $ $

Sales x

less Cost of sales

Opening inventory x

Production costs x

Variable production overhead costs x

Fixed overhead absorbed x

---

less Closing inventory (x) (x)

--- ---

Fixed overhead (under)/over absorbed x/(x)

-----

Gross profit x

less Selling, admin etc costs

(non production) (x)

----

Net profit x

===

Note that inventories are valued at full production cost

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Illustration 2
A company produced 1,000 units of Product A.

The opening and closing inventory was 100 units and 500 units respectively.

There was no under or over absorption of fixed overheads.

The selling price and production costs for Product A were as follows:

$ per unit 

Selling price    30

Direct costs   10

Variable production overhead costs 6

Fixed production overhead  costs (OAR)  4

Gross profit 10

What is the Gross profit for Product A, using absorption costing?

Number of units sold = (OP + Produced - CL) =  (100 + 1,000 - 500) = 600 units

Gross Profit =  600u x Gross profit $10 = $6,000

Marginal costing Absorption costing

Closing inventories are valued at Closing inventories are valued at full

Marginal production cost Production cost

Fixed costs are period costs Fixed costs are absorbed into unit costs

Cost of sales does not include a share Cost of sales does include a share of fixed
Of fixed overheads overheads

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 Reconcile the profits or losses

Remember!

Profit ($) = Sales ($) - Cost Of Sales (COS) ($)

Sales ($) = Sales in units x Selling price ($)

COS ($) = Sales in units x Inventory value ($)

Sales in units = Opening inventory + Purchases (Production) - Closing Inventory

If production (units) is equal to sales (units)

there will be no difference in profits

If inventory levels increase

between the beginning and end of a period, absorption costing will report the
higher profit.

This is because some of the fixed production OH will be carried forward in closing
inventory (which reduces cost of sales and therefore reduces Expenses and
therefore increases the Profit).

LESS expenses you have .... MORE Profit you get

If inventory levels decrease

absorption costing will report the lower profit because as well as the fixed OH
incurred, fixed production overhead which had been carried forward in opening
inventory is released and is also included in cost of sales.

MORE expenses you have .... LESS Profit you get

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Therefore:
1. If inventory levels increase, absorption costing gives the higher profit

2. If inventory levels decrease, marginal costing gives the higher profit

3. If inventory levels are constant, both methods give the same profit

Profits generated using absorption & marginal costing can also be reconciled as
follows:

Difference in the profit = change in inventory in units x OAR per unit

Illustration 1 - If inventory levels increase

Production was 500 units and Sales 200 units.

No opening inventory.

OAR = $2 per unit

Calculate the difference in the Profit.

Step 1: Calculate Closing Inventory (CL)

CL = Production - Sales = 500 - 200 = 300 units

Step 2: Change in Inventory

OP = 0 units

CL = 300 units

Change in Inventory = Closing - Opening = 300 - 0 = 300 units (Increase)

Increase in Inventory means AC > MC

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Step 3: Difference in Profit

= change in inventory in units x OAR per unit

300 units x $2 per unit = $600

AC Profit > MC Profit by $600

Illustration 2 - If inventory levels decrease

Production was 500 units and Sales 800 units.

The opening inventory was 400 units.

OAR = $2 per unit

Calculate the difference in the Profit.

Step 1: Calculate Closing Inventory

Sales = OP + Production - CL

800 = 400 + 500 - CL

CL = 900 - 800

CL = 100 units

Step 2: Change in Inventory

OP = 400 units

CL = 100 units

Change in Inventory = Closing - Opening = 100 - 400 = - 300 units decrease

OP 400 > CL 100, therefore, there was a decrease in the inventory level

Decrease in Inventory means MC > AC

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Step 3: Difference in Profit

= change in inventory in units x OAR per unit

= 300 units x $2 per unit = $600

MC Profit > AC Profit by $600

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 Calculating and Interpreting a TPAR

What is throughput?

Throughput is the rate of converting raw materials and purchased components into
products sold to customers.

In money terms, it is the extra money that is made for an organisation from selling
its products.

Throughput = Revenue – Raw material cost

What is throughput accounting?

Throughput accounting (TA) is an approach to accounting which is largely in

sympathy with the JIT philosophy.

The following are the main concepts in throughput accounting

1. In the short run, most costs in the factory (with the exception of materials costs)
are fixed.

These fixed costs include direct labour.

These fixed costs are called Total Factory Costs (TFC) (operating expenses).

2. In a JIT environment, the ideal inventory level is zero.

Products should not be made unless a customer has ordered them.

Work in progress should be valued at material cost only until the output is
eventually sold, so that no value will be added and no profit earned until the sale
takes place.

3. Profitability is determined by the rate at which sales are made and, in a JIT
environment, this depends on how quickly goods can be produced to satisfy
customer orders.

Since the goal of a profit-orientated organisation is to make money, inventory

must be sold for that goal to be achieved.

Traditional Cost Accounting versus Throughput Accounting Ratio

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Traditional Cost Accounting versus Throughput Accounting Ratio

Conventional cost accounting Throughput accounting

Inventory is not an asset. it is a result of

1. Inventory is an asset unsynchronised manufacturing and is a barrier to
making profit.

2. Costs can be classified either

Such classifications are no longer useful.
as direct or indirect

3. Product profitability can be

Profitability is determined by the rate at which money is
determined by deducting a
earned.
product cost from selling price.

4. Profit can be inceased by Profit is a function of material cost, total factory cost
reducing cost elements. and throughput.

Marginal costing and throughput accounting both determine a contribution by

calculating the difference between sales revenue and variable costs.

However this contribution figure will be higher under throughput accounting since
only material costs are recognised as being variable costs.

Under marginal costing, direct labour costs and certain overhead costs will also be
deducted from sales revenues in order to calculate contribution.

Throughput accounting regards such costs as fixed and this is true insofar as they
cannot be avoided in the ‘immediate’ sense.

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Illustration 1

x y

sales revenue 25 30

material cost 5 8

labour cost (@ $3/hr) 3 6

variable overheads 2 2

fixed overheads 1 4

max demand 10,000 15,000

How do we calculate contribution under Marginal costing?

x x y y

$ $ $ $

sales revenue 25 30

less variable costs

material 5 8

labour 3 6

variable cost 2 10 2 16

---- ---- ---- ----

contribution / unit 15 14

How do we calculate Throughput?

x y

$ $

sales revenue 25 30

less material 5 8

---- ----
return / unit 20 22

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Throughput accounting and the theory of constraints
The theory of constraints is applied within an organisation by following ‘the five
focusing steps’ – a tool which was developed to help organisations deal with
constraints.

1. Identify the system’s bottlenecks

2. Decide how to exploit the system’s bottlenecks

This involves making sure that the bottleneck resource is actively being used as
much as possible and is producing as many units as possible.

3. Subordinate everything else to the decisions made in Step 2

The production capacity of the bottleneck resource should determine the

production schedule for the organisation as a whole.

Idle time is unavoidable and needs to be accepted if the theory of constraints is

to be successfully applied.

4. Elevate the system’s bottlenecks

This will normally require capital expenditure.

5. If a new constraints is broken in Step 4, go back to Step 1

The likely constraint in the system is likely to be market demand.

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The Throughput Accounting Ratio (TPAR)

Where there is a bottleneck resource (limiting factor), performance can be measured

in terms of throughput for each unit of bottleneck resource consumed.

Three important ratios

• Throughput (return) per factory hour

Throughput per unit

------------------------------------------------

Product’s time on the bottleneck resource

• Cost per factory hour

Total Factory Cost

-------------------------------------------------

Total time available on bottleneck resource

The cost per factory hour is across the whole factory and therefore only needs to
be calculated once (not for each product).

• Throughput accounting Ratio

Return per factory hour

---------------------------

Cost per factory hour

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TPAR more than 1 would suggest that throughput exceeds operating costs so the
product should make a profit.

Priority should be given to the products generating the best ratios.

TPAR less than 1 would suggest that throughput is insufficient to cover operating
costs, resulting in a loss.

Criticisms of TPAR

1. It concentrates on the short-term

2. It is more difficult to apply throughput accounting concepts to the longer term

when all costs are variable

3. In the long run, ABC might be more appropriate for measuring and controlling
performance

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 Activity based costing (ABC)

Absorption Costing vs. ABC

In absorption costing, we allocate overheads to production and service

departments, using the overhead absorption rate based on volume of hours or units
normally

However, in many modern operations, overheads are not primarily influenced by

volume.

So ABC absorbs overheads instead using cost drivers such as:

Ordering costs – no. of orders

Set-up costs – no. of set-ups

Packing costs – no. of packing orders

Steps when applying ABC

Step 1: Identify activities (Cost pool) that incur overhead costs

Step 2: Determine the cost driver and Cost driver volume

Step 3: Calculate a cost per cost driver

Step 4: Calculate the overhead cost of products

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Illustration 1

A company uses an activity based costing system.

The company produces different types of products.

Purchasing = $ 100,000

Number of Purchase orders of all products = 100 orders

Product A's details:

Annual production of Product A = 10,000 units

Number of Purchase orders of product A = 25 orders

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Required:
Calculate The Purchase cost per unit of Product A

Solution

Step 1: Identify activities (Cost pools) that incur overhead costs

Activity = Purchasing

Cost pool = $ 100,000

Step 2: Determine the cost driver and Cost driver volume

Purchase orders = Cost driver

Number of Purchase orders = 100 orders

Step 3: Calculate a cost per cost driver

$100,000 /100 orders = $1,000 per purchase order

Step 4: Calculate absorbed overheads to the Product A

Total purchasing cost for A = $1,000 per purchase order x 25 orders = $25,000

Purchasing cost per unit for A = $25,000 / 10,000 units = $2.5 per unit

Video link: https://www.acowtancy.com/textbook/cima-p1/costing-methods/alternative-cost-

management-techniques/notes

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Advantages of ABC
• More accurate cost information is obtained.

It identifies ways of reducing overhead costs in the longer-term.

This will enable managers to make better decisions, particularly in respect of

pricing and marketing activities.

• It provides much better insights into what drives overhead costs.

ABC recognises that overhead costs are not all related to volume. It also
identifies activities and costs that do not add value.

• ABC can be applied to all overhead costs, not just production overheads.

Disadvantages of ABC
ABC may not be universally beneficial.

There are four major issues to be considered:

• Cost vs benefit
The need to analyse costs on a radically different basis will require resources,
which will lead to additional costs.

Clearly the benefits which will be obtained must exceed these costs.

In general terms, an organisation which has little competition, a stable and

standardised product range and for which overheads represent a small
proportion of total cost, will not benefit from the introduction of ABC.

• Need for informed application

While ABC is likely to provide better information for decision makers, it must still
be applied with care.

ABC is not fully understood by many managers and therefore is not fully
accepted as a means of cost control.

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• Difficulty in identifying cost drivers
In a practical context, there are frequently difficulties in identifying the
appropriate drivers.

ABC costs are based on assumptions and simplifications.

The choice of both activities and cost drivers might be inappropriate.

• Lack of appropriate accounting records

ABC needs a new set of accounting records, this is often not immediately
available and therefore resistance to change is common.

The setting up of new cost pools is needed which is time-consuming.

Worked out example

The following example looks at the different activities within a company, their cost
and their cost driver.

The cost per driver is found by dividing the total cost of the activity by the quantity
of the cost drivers.

Overhead costs are then charged to products or services on the basis of activities
used for each product or service.

Cost pool Cost driver volume Cost/driver

Activity
$ $

Process set up 37500 100 set ups 375 / set up

Material 180 / purchurase

9000 50 purchase orders
procurement order

10 standard 1000/ maintenance

Maintenance 22500
maintenance plans plan

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 2000 material
 11.25 / material
Material handling 22500
movement movement

Quality control 20500 250 inspections 82 / inspection

Order processing 13000 300 customers 43.33 / customer

---------
$112500
======

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 Syllabus A3. Standard Costing

Standard Costs

A standard cost is a predetermined estimated unit cost of a product or service.

Therefore, a standard cost represents a target cost.

Standard costing has a variety of uses

• It is useful for planning, control and motivation.

• It is used to value inventories and cost production for cost accounting purposes.

• It acts as a control device by establishing standards (planned costs), highlighting

activities that are not conforming to plan and thus alerting management to areas
which may be out of control and in need of corrective action.

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 Methods used to derive Standard costs

Cost Card

A standard cost is based on technical specifications for the materials, labour time
and other resources required and the prices and rates for the materials and labour.

A standard cost card shows full details of the standard cost of each product.

Standard cost card - product A

Direct material x kgs / ltrs x

Direct labour x hrs@$x x

Direct expenses x

--

Standard direct cost (prime cost) x

Variable production overheads x

--

Standard variable cost of x (marginal costing)

production

Fixed production overhead x

--

Standard full production cost x (absorption costing)

Administration & marketing x

overhead

--

Standard cost of sale x

Standard profit x

--

Standard sales price x

==

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Four main types of cost standards

1. Basic standards

– these are long-term standards which remain unchanged over a period of years.

They are used to show trends over time.

Basic standards may become increasingly easy to achieve as time passes and
hence, being undemanding, may have a negative impact on motivation.

2. Ideal standards

– these standards are based upon perfect operating conditions.

Therefore, they include no wastage, no scrap, no breakdowns, no stoppages, no

idle time.

Since perfect operating conditions are unlikely to occur for any significant
period, ideal standards will be very demanding and are unlikely to be accepted
as targets by the staff involved as they are unlikely to be achieved.

Using ideal standards as targets is therefore likely to have a negative effect on

employee motivation.

3. Attainable standards

– these standards are based upon efficient but not perfect operating
conditions.  

These standards include allowances for the fatigue, machine breakdown and
normal material losses.

Attainable standards motivate performance as they can be achieved can be

used for product costing, cost control, inventory valuation, estimating and as a
basis for budgeting.

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4. Current standards

– these standards are based on current level of efficiency and incorporate

current levels of wastage, inefficiency and machine breakdown.

They do not provide any incentive to improve on the current level of

performance.

Their impact on motivation will be a neutral one.

Current standards are useful during periods of high inflation.

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 Materials total, price and usage variances

The direct material total variance can be subdivided into the direct material price
variance and the direct material usage variance.

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 Direct material total variance = actual units should have cost $x

actual units did cost $x

--------

direct material total variance $x (f/a)

=====

Direct material price variance = actual kgs should have cost $x

actual kgs did cost $x

--------

direct material price variance $x (f/a)

=====

Direct material usage variance = actual units should have used x kgs

actual units did use x kgs

---------

usage variance in kgs x kgs (f/a)

x standard cost per kg $x

---------

usage variance in $ $x (f/a)

======

The direct material total variance

is the difference between what the output actually cost and what it should have
cost, in terms of material.

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The direct material price variance

calculates the difference between the standard cost and the actual cost for the
actual quantity of material used or purchased.

In other words, it is the difference between what the material did cost and what it
should have cost.

The direct material usage variance

is the difference between the standard quantity of materials that should have been
used for the number of units actually produced, and the actual quantity of materials
used, valued at the standard cost per unit of material.

In other words, it is the difference between how much material should have been
used and how much material was used, valued at standard cost.

Variance Favourable Adverse

unforeseen discounts received price increase

Material price more care taken in purchasing careless purchasing
change in material standard change in material standard

material used of higher quality than defective material excessive

Material standard more effective use made of waste theft stricter quality
usage material errors in allocating material to control errors in allocating
jobs material to jobs

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 Labour total, rate and efficiency variance

The total labour variance can be subdivided between labour rate

variance and labour efficiency variance.

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Direct labour total variance = actual units should have cost $x

actual units did cost $x

-------

direct labour total variance $x (f/a)

=====

Direct labour rate variance = actual hrs should have cost $x

actual hrs did cost $x

-------

direct labour rate variance $x (f/a)

=====

Direct labour efficiency variance = actual units should have taken x hrs

actual units did take x hrs

---------

efficiency variance in hrs x hrs (f/a)

x standard rate per hr $x

---------

efficiency variance in $ $x (f/a)

======

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The direct labour total variance is the difference between what the output should
have cost and what it did cost, in terms of labour.

The direct labour rate variance is the difference between the standard cost and the
actual cost for the actual number of hours paid for.

In other words, it is the difference between what the labour did cost and what it
should have cost.

The direct labour efficiency variance is the difference between the hours that should
have been worked for the number of units actually produced, and the actual number
of hours worked, valued at the standard rate per hour.

In other words, it is the difference between how many hours should have been
worked and how many hours were worked, valued at the standard rate per hour.

Variance Favourable Adverse

use of apprentices or other
Labour rate wage rate increase use of
workers at a rate of pay lower
higher grade labour
than standard

Idle time the idle time variance is always machine breakdown

adverse non-availability of material
illness or injury to worker

output produced more quickly lost time in excess of

Labour
than expected because of work standard allowed.
efficiency
motivation better quality of output lower than standard
equipment or materials, or better set because of deliberate
methods. errors in allocating restrictions, lack of training or
time to jobs sub-standard material used.
errors in allocating time to
jobs

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 Variable overhead total, expenditure and efficiency
variance

Variable Overhead Variances

The variable production overhead total variance can be subdivided into the variable
production overhead expenditure variance and the variable production overhead
efficiency variance (based on actual hours).

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Variable overhead total variance = actual units should have cost $x

actual units did cot $x

---------

var overhead total variance $x (f/a)

---------

Variable overhead expenditure variance = actual hrs should cost $x

actual hrs did cost $x

---------

var overhead exp variance $x (f/a)

--------

Variable overhead efficiency variance = actual units shd have taken x hrs

actual units did take x hrs

--------

efficiency variances in hrs x hrs (f/a)

x standard rate per hr $x

---------

efficiency variance in $ $x (f/a)

======

The variable production overhead expenditure variance is the difference between

the amount of variable production overhead that should have been incurred in the
actual hours actively worked, and the actual amount of variable production
overhead incurred.

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The variable production overhead efficiency variance is exactly the same in hours as
the direct labour efficiency variance, but priced at the variable production overhead
rate per hour.

Variance Favourable Adverse

variable increase in cost of overheads

savings in costs incurred
overhead used excessive use of
more economical use of
expenditure overheads change in type of
overheads
overheads

variable labour force working more

labour force working less
overhead efficiently (favourable labour
efficiently (adverse labour
efficiency efficiency) better supervision or
efficiency) lack of supervision
staff training

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 Fixed overhead total, expenditure, volume, capacity
and efficiency variance

The fixed production overhead total variance can be subdivided as

follows:

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Fixed overhead total variance = overhead incurred $x

overhead absorbed $x

--------

fix overhead total variance $x (f/a)

=====

Fixed overhead expenditure variance budgeted overhead

$x
= expenditure

actual overhead expenditure $x

-------

fix overhead expenditure

$x (f/a)
variance

=====

Fixed overhead volume variance = actual units produced x units

budgeted units produced x units

----------

x units (f/
volume variance in units
a)

x standard rate per unit $x

-----------

volume variance in $ $x (f/a)

=======

The volume efficiency variance is calculated in the same way as the labour
efficiency variance.

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Fixed overhead vol efficiency variance = actual units shd have taken x hrs

actual units did take x hrs

-----------

vol efficiency variance in hrs x hrs (f/a)

x standard oar rate per hr $x

----------

vol efficiency variance in $ $x (f/a)

=======

The volume capacity variance is the difference between the budgeted hours of work
and the actual active hours of work (excluding any idle time).

Fixed overhead vol capacity variance = budgeted hours of work x hrs

actual hours of work x hrs

-----------

vol capacity variance in

x hrs (f/a)
hrs
x standard oar rate per
$x
hr

----------

vol capacity variance in $ $x (f/a)

=======

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Fixed overhead total variance is the difference between fixed overhead incurred and
fixed overhead absorbed. In other words, it is the under– or over-absorbed fixed
overhead.

Fixed overhead expenditure variance is the difference between the budgeted fixed
overhead expenditure and actual fixed overhead expenditure.

Fixed overhead volume variance is the difference between actual and budgeted
(planned) volume multiplied by the standard absorption rate per unit.

Fixed overhead efficiency variance is the difference between the number of hours
that actual production should have taken, and the number of hours actually taken
(that is, worked) multiplied by the standard absorption rate per hour.

Fixed overhead capacity variance is the difference between budgeted (planned)

hours of work and the actual hours worked, multiplied by the standard absorption
rate per hour.

Variance Favourable Adverse

increase in cost of services

fixed savings in costs incurred
used
overheadexpenditure changes in prices relating to
excessive use of services
fixed
change in type of services
overhead expenditure
used

labour force working less

fixed overhead volume labour force working more efficiently
efficiency efficiently lost production through
strike

machine breakdown,
fixed overhead volume labour force working
strikes, labour
capacity overtime
shortage

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 Sales price and volume variance

Sales Variances

The sales price variance shows the effect on profit of selling at a different price from
that expected.

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Sales price variance = actual units should have sold $x

actual units did sell $x

----

sales price variance $x (f/a)

===

Sales volume variance = budgeted sales volume x units

(absorption costing) actual sales volume x units

--------

sales volume variance in units x units (f/a)

x standard profit per unit $x

-------

sales volume variance in $ $x (f/a)

=====

Sales volume variance = budgeted sales volume x units

(marginal costing) actual sales volume x units

------------

sales volume variance in units x units (f/a)

x standard contribution per unit $x

------------

sales volume variance in$ $x (f/a)

========

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The sale price variance is a measure of the effect on expected profit of a different
selling price to standard selling price. It is calculated as the difference between what
the sales revenue should have been for the actual quantity sold, and what it was.

The sales volume profit variance is the difference between the actual units sold and
the budgeted (planned) quantity, valued at the standard profit (under absorption
costing) or at the standard contribution (under marginal costing) per unit.

In other words, it measures the increase or decrease in standard profit as a result of

the sales volume being higher or lower than budgeted (planned).

Possible causes of sales variances

• unplanned price increases

• unplanned price reduction to attract additional business

• unexpected fall in demand due to recession

• increased demand due to reduced price

• failure to satisfy demand due to production difficulties

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 Sales Mix and Quantity Variances

Sales Variances

Where a company sells several different products that have different profit margins,

the sales volume variance can be divided into a sales quantity (sometimes called a

sales yield variance) and sales mix variance.

The quantity variance measures the effect of changes in physical volume on total

profits.

The mix variance measures the impact arising from the actual sales mix being

different from the budgeted sales mix.

The variances can be measured either in terms of contribution margins or profit

margins.

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 Planning and Operational Variances for sales

Planning and operational Variances

We can divide the total variance into:

1. Planning variances (or revision variances)

Are variances which have arisen because of inaccurate planning or faulty

standards

A planning variance compares an original standard with a revised standard that

should or would have been used if planners had known in advance what was
going to happen.

A planning variance is deemed not controllable by management.

i.e. management may not be held responsible.

2. Operational variances (or operating variance)

Are variances which have been caused by adverse or favourable operational

performance, compared with a standard which has been revised in hindsight.

An operational variance compares an actual result with the revised standard.

It is deemed controllable by management.

Hence, management is held responsible for operational variances.

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Planning and operational variances for sales

For sales, two variances have to be calculated

Planning – market volume/size variance

Operational – market share variance

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 Planning and Operational Variances for material &
labour

Planning and operational variances for materials and labour

For materials and labour, planning and operational variances can be calculated by
comparing original and revised budgets (planning) and revised budgets with actual
results (operational).

A material price planning variance is really useful to provide feedback on just how
skilled managers are in estimating future prices.

The operational variance is more meaningful as it measures the purchasing

department’s efficiency given the market conditions that prevailed at that time. It
ignores factors which cannot be controlled by purchasing department.

Illustration 1
Budgeted Material price per kg is $5

Budgeted Material per unit = 4kg

Actual Output is 10,000 units

The standard price for the raw material purchased should have been $6 per kg.

The material price planning variance is:

Solution
Standard price $6 - Budgeted price $5 = $1

$1 x 4kg x 10,000 units = $40,000 (A) – adverse

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 Backwards Variances

Sometimes you will be asked to work backwards from a variance to actual or

budgeted data.

The most effective technique here is to:

1. Write out the variance proforma

2. Fill in the pro forma as much as you can (with figures given in the question)

3. Work backwards, by filling in the blanks, until you get to your answer

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variances/notes

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 Investigating variances

When should variances be investigated?

When deciding which variances to investigate, the following factors should be

considered:

1. Reliability and accuracy of the figures.

Mistakes in calculating budget figures, or in recording actual costs and revenues,

could lead to a variance being reported where no problem actually exists (the
process is actually ‘in control’).

2. Materiality.

The size of the variance may indicate the scale of the problem and the potential
benefits arising from its correction.

3. Possible interdependencies of variances.

Sometimes a variance in one area is related to a variance in another.

For example, a favourable raw material price variance resulting from the purchase of
a lower grade of material, may cause an adverse labour efficiency variance because
the lower grade material is harder to work with.

These two variances would need to be considered jointly before making an

investigation decision.

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4. The inherent variability of the cost or revenue. Some costs, by nature, are quite
volatile (oil prices, for example) and variances would therefore not be surprising.

Other costs, such as labour rates, are far more stable and even a small variance
may indicate a problem.

5. Costs and benefits of correction.

If the cost of correcting the problem is likely to be higher than the benefit, then there
is little point in investigating further.

6. Trends in variances.

One adverse variance may be caused by a random event.

A series of adverse variances usually indicates that a process is out of control.

7. Controllability/probability of correction.

If a cost or revenue is outside the manager’s control (such as the world market price
of a raw material) then there is little point in investigating its cause.


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 Syllabus B. BUDGETING
Syllabus B1. Different Rationales For Budgeting

Why organisations use budgeting

A budget is a quantified plan of action for a forthcoming accounting

period

A budget
is a plan of what the organisation is aiming to achieve and what it has set as a
target.

A forecast is an estimate of what is likely to occur in the future.

The budget is 'a quantitative statement for a defined period of time, which may
include planned revenues, expenses, assets, liabilities and cash flows.

The objectives of a budgetary planning and control system are:

• To ensure the achievement of the organisation's objectives

• To compel planning in line with the objectives of the organization

• To communicate ideas and plans to individual managers

• To coordinate the different activities so that managers are working towards the
same common goal

• To evaluate the performance of management

• To establish a system of controlling costs by comparing actual results with the

budget

• To motivate employees to improve their performance and beat targets

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 Planning and control cycle

A budget is a quantified plan of action for a forthcoming accounting

period

• Stage 1: Set Mission

This involves establishing the broad overall aims and goals of the organisation –
its mission may be both economic and social.

Most organisations now prepare and publish their mission in a mission

statement.

Mission statements often include the following information:

• Purpose and aim(s) of the organisation

• The organisation's primary stakeholders: clients/customers, shareholders,

congregation, etc.

• How the organisation provides value to these stakeholders, for example by

offering specific types of products and/or services

• Stage 2: Identify Objectives

This requires the company to specify objectives towards which it is working.

The objectives chosen must be quantified and have a timescale attached to

them.

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Objectives should be SMART:
• Specific

• Measurable

• Achievable

• Relevant

• Time limited

• Stage 3: Search for possible courses of action

A series of specific strategies should be developed.

Strategy is the course of action, including the specification of resources

required, that the company will adopt to achieve its specific objective.

To formulate its strategies, the firm will consider the products it makes and the
markets it serves. E.g. of strategies are

• Developing new markets for existing products

• Developing new products for existing markets

• Developing new products for new markets

• Stage 4: Gathering data about alternatives and measuring pay-offs

• Stage 5: Select course of action

Having made decisions, long-term plans based on those decisions are created.

• Stage 6: Implementation of short-term (operating) plans

This stage shows the move from long-term planning to short-term plans – the
annual budget.

The budget provides the link between the strategic plans and their
implementation in management decisions.

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• Stage 7: Monitor actual outcomes
Detailed financial and other records of actual performance are compared with
budget targets (variance analysis)

• Stage 8: Respond to divergences from plan

This is the control process in budgeting, responding to divergences from plan
either through budget modifications or through identifying new courses of action

The overall is summarised in the diagram below

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 Stages in the budgeting process

Stages in the Budgetary Process

• Stage 1: Communicating policy guidelines to preparers of budgets

The long-term plan forms the framework within which the budget is prepared.

It is therefore necessary to communicate the implications of that plan to the

people who actually prepare the budget.

• Stage 2: Determining the factor that restricts output – Principal Budget

Factor

Generally there will be one factor which restricts performance for a given period.

Usually this will be sales, but it could be production capacity, or some special
labour skills.

• Stage 3: Preparation of a budget using the principal budgetary factor

On the assumption that sales is the principal budget factor, the next stage is to
prepare the sales budget.

This budget is very much dependent on forecast sales revenue.

• Stage 4: Initial preparation of budgets

Ideally budgets should be prepared by managers responsible for achieving the

targets contained therein.

This is referred to as participative budgeting.

• Stage 5: Co-ordination and review of budgets

At this stage the various budgets are integrated into the complete budget
system.

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 Any anomalies between the budgets must be resolved and the complete budget
package subject to review.

At this stage the budget income statement, balance sheet and cash flow must
be prepared to ensure that the package produces an acceptable result.

• Stage 6: Final acceptance of budgets

All of the budgets are summarised into a master budget, which is presented to
top management for final acceptance.

• Stage 7: Budget review

The budget process involves regular comparison of budget with actual, and
identifying causes for variances.

This may result in modifications to the budget as the period progresses

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 Motivation in performance management

The purpose of a budgetary control system is to assist management in planning and

controlling the resources of their organisation by providing appropriate control

information.

The information will only be valuable, however, if it is interpreted correctly and used

purposefully by managers and employees.

The correct use of control information therefore depends not only on the content of

the information itself, but also on the behaviour of its recipients.

A number of behavioural problems can arise:

1. The managers who set the budget or standards are often not the managers who

are then made responsible for achieving budget targets.

2. The goals of the organisation as a whole, as expressed in a budget, may not

coincide with the personal aspirations of individual managers.

This is known as dysfunctional behaviour.

3. When setting the budget, there may be budgetary slack (or bias).

Budget slack is a deliberate over-estimation of expenditure and/or under-

estimation of revenues in the budgeting process.

This results in a budget that is poor for control purposes and meaningless

variances.

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The importance of motivation in performance management

Motivation is the drive or urge to achieve an end result.

Hence, if employees and managers are not motivated, they will lack the drive or
urge to improve their performance and to help the organization to achieve its goals
and move forward.

The management accountant should therefore try to ensure that employees have
positive attitudes towards setting budgets, implementing budgets and feedback of
results.

Factors such as financial and non financial rewards, prestige and esteem, job
security and job satisfaction may all play a part to motivate management and
employees.

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 Impact of External Factors on Budgeting

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external-factors-on-budgeting/videos

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 Syllabus B2. Prepare Budgets

Types of Budgetary Systems

Rolling Budget

A rolling budget is sometimes called a continuous budget.

Here, a portion of the budget period is replaced on a regular basis so that the
overall budget period remains unchanged.

For example, with a budget period of one year, at the end of each quarter a new
quarter could be added to the end of the budget period and the elapsed quarter
could be deleted, so that the budget will always be looking one year ahead.

A cash budget is often a rolling budget because of the need to keep tight control of
this area of financial management.

A rolling budget is also supported by the availability of cheap and powerful

information processing via personal computers and computer networks.

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Advantages of rolling budgets

1. They reduce the element of uncertainty in budgeting because they concentrate

detailed planning and control on short-term prospects where the degree of

uncertainty is much smaller.

2. They force managers to reassess the budget regularly, and to produce budgets

which are up to date in the light of current events and expectations.

3. Planning and control will be based on a recent plan which is likely to be far more

realistic than a fixed annual budget made many months ago.

4. Realistic budgets are likely to have a better motivational influence on managers.

5. There is always a budget which extends for several months ahead.

For example, if rolling budgets are prepared quarterly there will always be a

budget extending for the next 9 to 12 months.

This is not the case when fixed annual budgets are used.

Disadvantages of rolling budgets

1. They involve more time, effort and money in budget preparation.

2. Frequent budgeting might have an off-putting effect on managers who doubt the

value of preparing one budget after another at regular intervals.

3. Revisions to the budget might involve revisions to standard costs too, which in

turn would involve revisions to stock valuations.

This could replace a large administrative effort from the accounts department

every time a rolling budget is prepared.


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Incremental Budget

Incremental budgeting is a process whereby this year’s budget is set by reference to

last year’s actual results after an adjustment for inflation and other incremental
factors.

It is commonly used because:

1. It is quick to do and a relatively simple process.

This makes it possible for a person without any accounting training to build a
budget.

2. The information is readily available, so very limited quantitative analysis is

needed.

3. It is appropriate in some circumstances.

For example, in a stable business, the amount of stationery spent in one year is
unlikely to be significantly different in the next year, so taking the actual spend in
year one and adding a little for inflation should be a reasonable target for the
spend in the next year.

There are problems involved with incremental budgeting:

1. It builds on wasteful spending (inefficiencies).

If the actual figures for this year include overspends caused by some form of
error then the budget for the next year would potentially include this overspend
again.

2. It encourages organisations to spend up to the maximum allowed (encourages

slack) in the knowledge that if they don’t do this then they will not have as much
to spend in the following year’s budget.

3. Assessing the amount of the increment can be difficult.

4. It is not appropriate in a rapidly changing business.

5. Can ignore the true (activity based) drivers of a cost leading to poor budgeting


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Activity-Based Budget

Activity-based budgeting (ABB) would need a detailed analysis of costs and cost
drivers so as to determine which cost drivers and cost pools were to be used in the
activity-based costing system.

However, whereas activity-based costing uses activity-based recovery rates to

assign costs to cost objects, ABB begins with budgeted cost-objects and works
back to the resources needed to achieve the budget.

The budgeted activity levels are determined in the same way as for conventional
budgeting in that a sales budget and a production budget are drawn up.

ABB then determines the quantity of activity cost drivers (e.g. number of purchase
orders, number of set-ups) needed to support the planned sales and production.

Standard cost data would be compiled that include details of the activity cost
drivers required to produce a product or number of products.

The resources needed to support the budgeted quantity of activity cost drivers
would then be determined (e.g. number of labour hours to process purchase orders,
number of maintenance hours needed to complete set-ups).

This resource need would then be matched against the available capacity (i.e.
number of purchase clerks to process purchase orders) to see whether any capacity
adjustment were needed.

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Advantages of ABB

1. Organisational resources are allocated more efficiently due to the detailed cost
and activity information obtained by implementing an ABB system.

2. It avoids slack that is often linked to incremental budgeting due to its detailed
assessment of the activities and resources needed to support planned sales and
production.

3. In ABB the costs of support activities are not seen as fixed costs to be increased
by annual increments, but as depending to a large extent on the planned level of
activity.

4. It provides a useful basis for monitoring and controlling overhead costs, by

drawing management attention to the actual costs of activities and comparing
actual costs with what the activities were expected to cost.

Disadvantages of ABB

1. A considerable amount of time and effort might be needed to establish an ABB

system, for example to identify the key activities and their cost drivers.

2. ABB might not be appropriate for the organisation and its activities and cost
structures.

3. A budget should be prepared on the basis of responsibility centres, with

identifiable budget holders made responsible for the performance of their budget
centre.

A problem with ABB could be to identify clear individual responsibilities for

activities.

4. It could be argued that in the short term many overhead costs are not
controllable and do not vary directly with changes in the volume of activity for
the cost driver.

The only cost variances to report would be fixed overhead expenditure variances
for each activity.

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Feed-Forward Control

Feed-forward control is defined as the ‘forecasting of differences between actual

and planned outcomes and the implementation of actions before the event, to avoid
such differences’.

Whereas feedback is based on a comparison of historical actual results with the

budget for the period to date, feed-forward compares:

* the target or objectives for the period, and

* the actual results forecast.

Advantages of Feed-Forward Control

1. It informs managers of what is likely to happen unless control action is taken.

2. It encourages managers to be proactive and deal with problems before they

occur.

3. Reforecasting on a monthly or continuous basis can save time when it comes to

completing a quarterly or annual budget.

Disadvantages of Feed-Forward Control

1. It may be time consuming as control reports must be produced regularly.

2. It may require a sophisticated forecasting system, which might be expensive.

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Zero-Based Budgeting

Zero-based budgeting requires that activities be re-evaluated as part of the budget

process so that each activity, and each level of activity, can justify its consumption
of the economic resources available.

This is in contrast to incremental budgeting, where the current budget is increased

to allow for expected future conditions. Zero-based budgeting prevents the carrying
forward of past inefficiencies that can be a feature of incremental budgeting and
focuses on activities rather than departments or programmes.

Each activity is treated as though it was being undertaken for the first time and is
required to justify its inclusion in the budget in terms of the benefit expected to be
derived from its adoption.

Steps in zero-based budgeting

Zero-based budgeting involves three main stages

1. Activities are identified by managers. These activities are then described in what
is called a ‘decision package’.

This decision package

a. Analyses the cost of the activity

b. States its purpose

c. Identifies alternative methods of achieving the same purpose

d. Establishes performances measures for the activity

e. Assesses the consequence of not performing the activity at all or of

performing it at different levels.

This decision package is prepared at the base level, representing the minimum
level of service or support needed to achieve the organisation’s objectives.
Further incremental packages may then be prepared to reflect a higher level of
service or support

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2. Management will then rank all the packages in the order of decreasing benefits
to the organisation.

This will help management decide what to spend and where to spend it.

3. The resources are then allocated based on order of priority up to the spending
level

Advantages claimed for zero-based budgeting

1. It eliminates the inefficiencies that can arise with incremental budgeting.

2. It fosters a questioning attitude towards current activities.

3. It focuses attention on the need to obtain value for money from the consumption
of organisational resources.

Disadvantages claimed for zero-based budgeting

1. Departmental managers will not have the skills necessary to construct decision
packages. They will need training for this and training takes time and money.

2. In a large organisation, the number of activities will be so large that the amount
of paperwork generated from ZBB will be unmanageable.

3. Ranking the packages can be difficult, since many activities cannot be

compared on the basis of purely quantitative measures. Qualitative factors need
to be incorporated but this is difficult.

4. The process of identifying decision packages, determining their purpose, costs

and benefits is massively time consuming and therefore costly.

5. Since decisions are made at budget time, managers may feel unable to react to
changes that occur during the year. This could have a detrimental effect on the
business if it fails to react to emerging opportunities and threats.

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It could be argued that ZBB is more suitable for public sector than for private sector
organisations. This is because, firstly, it is far easier to put activities into decision
packages in organisations which undertake set definable activities. Local
government, for example, has set activities including the provision of housing,
schools and local transport.

Secondly, it is far more suited to costs that are discretionary in nature or for support
activities. Such costs can be found mostly in not for profit organisations or the
public sector, or in the service department of commercial operations.

Since ZBB requires all costs to be justified, it would seem inappropriate to use it for
the entire budgeting process in a commercial organisation. Why take so much time
and resources justifying costs that must be incurred in order to meet basic
production needs?

It makes no sense to use such a long-winded process for costs where no discretion
can be exercised anyway. Incremental budgeting is, by its nature, quick and easy to
do and easily understood. These factors should not be ignored.

Master Budget

The master budget is a summary of all of the budgets which generally comprises a
budgeted income statement, a budgeted statement of financial position and a
budgeted cash flow statement.

Assuming that the level of demand is the principal budget factor, the various
functional, departmental and master budgets will be drawn up in the following order.

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Functional Budget

Functional budgets are prepared and consolidated to produce the master budget.
These would include raw materials budget, raw material usage and purchases
budgets, sales budget and production budget.

Fixed Budget

A fixed budget is one prepared in advance of the relevant budget period which is
not changed or amended as the budget period progresses.

This budget represents a periodic approach to budgeting, since a new budget is

prepared towards the end of the budget period for the subsequent budget period.
In this way, an organisation may set a new budget on an annual basis.

A fixed budget is likely to be useful in circumstances where the organisational

environment is relatively stable and can be predicted with a reasonable degree of
certainty.

Flexible Budget

A flexible budget is a budget which, by recognising different cost behaviour

patterns, is designed to change as volumes of output change.

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Beyond Budgeting

Various commentators have identified the drawbacks of traditional budgets that

they:

1. rarely focus on strategy and are often contradictory

2. are time consuming and costly to put together

3. constrain responsiveness and flexibility

4. often deter change

5. add little value, especially given the time taken to prepare them

6. focus on cost reduction rather than value creation

7. strengthen vertical command and control .

Beyond Budgeting is based on 6 principles

• front line teams to take decisions

• a high performance climate based on performance reviews, internal competition

and a sense of customer ownership

• front line teams with the freedom to take decisions in line with the company’s
governance principles and strategic goals

• teams given responsibility for value creating systems

• teams focused on customer outcomes

• open and ethical information systems which generates more reliable information,
greater transparency and more ethical reporting

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 Principal budget factor

The importance of principal budget factor in constructing the budget

Limiting factor

In every organisation, there is some factor that restricts performance for a given
period. This factor is known as the principal budget factor or limiting factor.

In the majority of organisations, this factor is sales demand but it can also be
shortage of materials or inadequate plant capacity.

Decisions must be taken at an early stage to minimise the impact of any principal
budget factor.

Once this factor has been identified, this budget must be set first and then the other
individual functional budgets are set after, this will ensure that coordination of
functions takes place.

Therefore, if the principal budgeting factor is sales demand, then this budget would
be set first, followed by the production budget and then the purchases budget.

Or, if the principal budget factor is plant capacity, the functional budget for plant
capacity should be set first, followed by other functional budgets, it would not make
sense to set a sales budget first with a sales volume in excess of exiting plant
capacity, unless decisions were made on improving capacity, subcontracting work
or cutting back on the sales budget.


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 Sales & Functional budgets

Budgets

A Functional budget

is a budget of income and/or expenditure which applies to a particular function.

The main functional budgets are:

• Sales budget

• Production budget

• Raw material usage budget

• Raw material purchases budget

• Labour budget

• Overheads budget

Sales Budget

A sales budget can be prepared both in units and in value

Production Budget

Budgeted production levels can be calculated as follows:

Budgeted production =

Forecast sales + closing inventory of finished goods – opening inventory of finished

goods

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Illustration

Finished goods inventory equal to 20% of the next month’s budgeted sales.

Sales for the current month are 2,000 units and are budgeted to be 2,400 units next
month.

How many units will be produced in the current month?

Solution

Sales 2,000

Cl Inventory 480 (20% x 2,400)

Op Inventory (400) (20% x 2000)

2,080 units will be produced this month.

Material Budget

How many kg/litres do you need to produce a certain amount of units.

• Material usage budget

Material usage =

Budgeted production x Quantity required to produce one unit

• Material purchases budget

Material purchases budget =

Material usage budget + closing inventory (of material kg/l) – opening inventory
(of material kg/l)

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Illustration

A company produces product X.

Expected production is 3,000 units.

Each unit uses 5kg of raw materials.

What is the materials usage budget?

Solution

Materials usage = Production * Quantity/unit

= 3,000 x 5

= 15,000 kg

Labour Budget

Labour budget = no. of hours x labour rate per hour

Overhead Budget

The overhead budget will be made up of variable costs and fixed costs

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 Master budgets

Prepare Master Budgets

When all the functional budgets have been prepared, they are summarised and
consolidated into a master budget which consists of

1. Budgeted income statement

2. Budgeted statement of financial position

3. Cash budget

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 Cash budgets

Cash Budgets

Cash budgets are vital to the management of cash.

They show the expected inflows and outflows of cash through the company.

They help to show cash surpluses and cash shortages.

It is especially important to maintain a cash balance necessary to meet ongoing

obligations.

However, holding cash carries with it a cost – the opportunity cost of the profits

which could be made if the cash was either used in the company or invested

elsewhere.

Cash management is therefore concerned with optimising the amount of cash

available to the company and maximising the interest on any spare funds not

required immediately by the company.

Management can therefore use cash budgets to plan ahead to meet those

eventualities – arranging borrowing when a deficit is forecast, or buying short-term

securities during times of excess cash.

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Illustration 1

The accounts receivables at the beginning of next year are expected to be $200.

The budgeted sales for the next year are $1,000.

All budgeted sales will be in cash.

Credit customers pay in the month following sale.

What are the budgeted total cash receipts from customers next year?

Solution

Opening $200

Sales $1,000

Closing ($0)

Note:

No closing balance since all sales were in cash.

The budgeted total cash receipts from customers will be $1,200 (200 + 1,000).

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Illustration 2

The accounts receivables at the beginning of next year are expected to be $200.

The budgeted sales for the next year are $1,000.

60% of the budgeted sales will be on credit and the remainder will be cash sales.

Credit customers pay in the month following sale.

What are the budgeted total cash receipts from customers next year?

Solution

Opening $200

Sales $1,000

Closing (w1) ($50)

Working 1:

60% x $1,000 x 1/12 = $50

The budgeted total cash receipts from customers will be $1,150 (200 + 1,000 - 50).


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 Syllabus B2. Preparing Forecasts

Time series - Components

Time Series

A time series

is a series of figures or values recorded over time.

e.g. monthly sales over the last 3 years.

The data often conforms to a certain pattern over time.

This pattern can be extrapolated into the future and hence forecasts are possible.

Time periods may be any measure of time including days, weeks, months and
quarters.

A graph of a time series is called a Histogram

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A time series has 4 components:

1. Trend

a trend is the underlying long-term movement over time in values of data recorded

2. Seasonal variations or fluctuations

are short-term fluctuations in recorded values, due to different circumstances

e.g. sales of ice creams will tend to be highest in the summer months

3. Cycles or cyclical variations

are medium-term changes in results caused by circumstances which repeat in

cycles

e.g. booms and slumps in the economy.

4. Residual variantions

no-recurring, random variations.

These may be caused by unforseen circumstances such as a change in

government, a war, technological change or a fire.

Hence these are non-repetitive and non-predictable variations.

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The actual time series is:

Y = T + S + C + R

Where:

Y = the actual time series

T = the trend series

S = the seasonal component

C = the cyclical component

R = the random component

In the exam, it is unlikely that you will be expected to carry out any calculation of
‘C’.

Therefore, ‘C’ will be ignored.

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 Methods of finding the trend

These are Methods of finding the Trend:

1. Moving averages

2. A line of best fit

this can be drawn by eye on a graph

3. Linear regression analysis

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 Moving Averages

It is common for a moving average to be measured over an even number of time

periods

By analysing the four-quarter moving average of sales, seasonal variations will be

smoothed out and it will be possible to identify the Trend = the long-term
movement over time.

For example, the four-quarter moving average of 4 quarters of sales is shown

below:

This average relates to the mid-point of the period ie between summer and autumn.

However, the moving average needs to relate to a particular quarter, otherwise

seasonal variations cannot be calculated.

The illustration below shows how to deal with this:

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Illustration: Moving averages

Calculate a four-quarter moving average trend of the following results.

Sales in $'000

Spring Summer Autumn Winter

20X0 100 150 180 90

20X1 120 160 190 110

To align these moving averages to a specific quarter, we need to average the moving
averages to create a 'Centred moving average':

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The centred moving average now relates to a specific quarter

eg 132.5 relates to Autumn 20X0

This is the TREND, ie the long-term movement over time.

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 Additive And Multiplicative Models

Trend and Seasonal Variations

Seasonal variations arise in the short-term

It is very important to distinguish between trend and seasonal variation.

Seasonal variations must be taken out, to leave a figure which is indicating the
Trend.

Methods of calculating Seasonal variation:

1. Additive model

2. Proportional (multiplicative) model

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 Additive model

This is based upon the idea that each actual result is made up of two influences.

Time series = Trend (T) + Seasonal Variation (SV)

Additive model - Steps

Step 1

Identify the trend

using Centred moving averages

Step 2

Deduct the Trend from the time series data to obtain the Seasonal variation

the logic here is that if Time series = Trend + Seasonal variation then re-arranging
this gives:

Seasonal variation = Time series (Y) - Trend (T)

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Illustration

Calculate the average seasonal variations from the following data.

Sales in $'000

Actual data Spring Summer Autumn Winter

20X0 100 150 180 90

20X1 120 160 190 110

Trend data

20X0 132.5 136.25

20X1 138.75 142.5

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 The multiplicative model

The additive model assumes that seasonal variation does not increase over time.

This is unlikely — for example, companies that are growing rapidly will have
increasing sales figures and therefore higher seasonal variations too.

This drawback of the additive model is picked up by the Multiplicative model.

The multiplicative model is generally considered to be better as it assumes forecast

seasonal components are a constant proportion of sales.

Time series = Trend x Seasonal Variation (SV)

Multiplicative model - Steps

Step 1
Identify the trend

using centred moving averages

Step 2
Divide the time series by the trend data to obtain the seasonal variation

the logic here is that if time series = trend x seasonal variation then re-arranging this
gives:

Seasonal variation = Time series (Y) / Trend (T)

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Illustration - Multiplicative model

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Forecasting

Illustration - Additive model

The trend for train passengers at Paddington station is given by the relationship:

y = 5.2 + 0.24x

y = number of passengers per annum

x = time period (2010 = 1)

What is the trend in 2019?

Solution
If x = time period (2010 = 1), then 2019 will be 9.

y = 5.2 + 0.24 x 9 = 7.36

Illustration - Multiplicative model

A company uses a multiplicative time series model.

Trend = 500 + 30T

T1 = First quarter of 2010.

Average seasonal variation:

1st Q = -20

2nd Q = +7

3rd Q = +16

4th Q = -1

What is the sales forecast of the 3rd Q of 2012?

Solution
If T1 = First quarter of 2010, then 3rd Quarter of 2012 will be 11.

T = (500 + (30 x 11)) x 116% = 963


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 Time Series Analysis Advantages

Advantages & Disadvantages

Advantages of Time Series Analysis

• it is useful when forecasting data which has a regular seasonal pattern as may be
the case with sales of certain products

• it is a rather simplistic approach

Disadvantages of Time Series Analysis

• it assumes that past trends will continue indefinitely and that extrapolating data
based on historic information will give valid conclusions.

• In reality, the sales of products may be influenced by the actions of competitors,

particularly in relation to new products becoming available on the market.

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 Linear Regression

This model says how dependent one variable is on another.

For example cost (X) and volume (Y).

These variables are called the dependent and independent variables.

The Dependent variable’ value depends on the value of the other variable.

E.g. Sales may be dependent on marketing spend

You would then need to determine the strength of the relationship between these
two variables in order to forecast sales.

For example, if the marketing budget increases by 1%, how much will your sales
increase?

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Regression Equation

This helps us predict the variable we require. 


The formula for a simple linear regression is as follows:

Y = a + bx

where:

Y is the value we are trying to forecast (dependent)

“b” is the slope of the regression,

“x” is the value of our independent value, and

“a” represents the y-intercept. (the value we are trying to

forecast when the independent value is 0)

A simpler way to picture this might be thinking of variable costs and fixed costs.

We are trying to forecast TOTAL COSTS

So

Y = Total costs

b = Variable cost per unit

a = Fixed Costs

x = Amount of units produced

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In this graph, the dots represent the actual date.

Linear regression attempts to estimate a line that best fits the data, and the
equation of that line results in the regression equation

Once a linear relationship is identified and quantified using linear regression

analysis, values for (a) and (b) are obtained and these can be used to make a
forecast for the budget such as a sales budget or cost estimate for the budgeted
level of activity


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 ‘What if’ analysis

Ask questions using “what if …”.

For example:

What if the Sales decrease by 20%

What if the Cost of sales increase by 10%

Steps of What-If analysis:

1. Defining areas of interest (e.g. Profit)

2. Generating questions (if) - e.g. what if cost of sales increase by 1%

3. Generating answers (e.g. profit will decrease by 1%)

Illustration

Revenues 100%

Variable costs (50%)

Fixed costs (20%)

Profit 30%

What If the sales volume turns to be only 70%?

Solution
Revenues 70%

Variable costs 50 x 0.70 = (35%)

Fixed costs (20%)

Profit 70 - 35 - 20 = 15%


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 High/low analysis

High-low method

This method analyses semi-variable costs into their fixed and variable elements.

Always select the period with the highest activity level and the period with the
lowest activity level.

Step 1: Find the variable cost per unit (VC/unit)

Total cost at high activity level - Total cost at low activity level

-----------------------------------------------------------------------

Units at high activity level - Units at low activity level

Step 2: Find the fixed cost (FC)

TC at high activity level – (Units at high activity level × VC/unit)

Step 3: Find the Total cost (TC)

TC = FC + VC/unit x Activity level

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Illustration 1

Activity (Units) Total Cost

July 4,360 $26,810

August 6,400 $31,400

What is the Total cost of 3,000 units?

Solution

Step 1: Variable cost per unit

VC per unit = ($31,400 - $26,810) / (6,400 - 4,360) = $2.25

Step 2: Fixed cost

TC = FC + VC

$26,810 = FC + ($2.25/unit x 4,360 units)

FC = $17,000

Step 3: Total cost of 3,000 units

TC = $17,000 + (3,000 units x $2.25/unit)

TC = 23,750

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 High-low method with Step up

Step 1: Remove the step up from the Total Cost (TC)

Step 2: Find the variable cost per unit (VC/unit)

Total cost at high activity level - Total cost at low activity level

--------------------------------------------------------------------

Total units at high activity level - Total units at low activity level

Step 3: Find the fixed cost (FC)

Total cost at high activity level – (Total units at high activity level × Variable
cost per unit)

Step 4: Find the Total cost (TC)

TC = FC + VC/unit x Activity level

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Illustration 2

Note: If there is a step up of fixed cost between the activity levels given, first remove
the step up and then find the variable and fixed costs with the high low method.

Activity (Units) Production Cost

July 32,000 $270,000

August 44,000 $340,000

There is a step up of $5,000 in fixed costs when activity crosses 35,000 units.

What is the Production cost of 37,500 units?

Solution:

Step 1: Remove the step up from the TC

$340,000 - $5,000 = $335,000

Step 2: Variable cost per unit

VC per unit = ($335,000 - $270,000) / (44,000 - 32,000) = 5.42

Step 3: Fixed cost (Use the activity with the step up because our desired
activity level also includes the step up)

TC = FC + VC

$340,000 = FC + ($5.42/unit x 44,000 units)

FC = $101,520

Step 4: Total cost of 37,500 units

TC = $101,520 + ($5.42/unit x 37,500 units)

TC = $304,770

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Advantages of the High-Low Method

1. Easy to use

2. Easy to understand

3. Quick method

Limitations of the High-Low Method

1. It relies on historical cost data – predictions of future costs may not be reliable

2. It assumes that the activity level is the only factor affecting costs

3. It uses only two values to predict costs – all data falling between the highest and
lowest values are ignored

4. Bulk discounts may be available at large quantities

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 Syllabus B3. Budgetary Control

Fixed Budgets

The master budget

prepared normally prior to the start of an accounting period is called the fixed
budget

It is not changed in response to changes in activity or costs/revenues.

It is produced for a single level of activity, i.e. based on estimated production.

Comparison of a fixed budget with the actual results for a different level of activity is
of little use for budgetary control purposes.

This is because we will not really be comparing like with like.

The purpose of a fixed budget

lies in its use at the planning stage.

It is useful for controlling any fixed cost, and particularly non-production fixed costs

such as advertising, because such costs should be unaffected by changes in

activity level.

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 Flexible budgets in control

Budgetary Control

Budgetary control involves controlling costs by comparing the budget with the
actual results and investigating any significant differences between the two.

Any differences (variances) are made the responsibility of key individuals who can
either exercise control action or revise the original budgets.

If this control process is to be valid and effective, it is important that the variances
are calculated in a meaningful way.

One of the major concerns is to ensure that the budgeted and actual figures reflect
the same activity level.

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Flexible Budgets

A flexible budget is a budget that adjusts or flexes for changes in the volume of
activity.

The flexible budget is more sophisticated and useful than a fixed budget, which
remains at one amount regardless of the volume of activity.

For example, a firm may have prepared a fixed budget at a sales level of $100,000.

Flexible budgets may be prepared at different activity levels

e.g. anticipated activity 100% and also 90%, 95%, 105% and 110% activity.

Flexible budgets can be useful but time and effort is needed to prepare them.

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 Flexed Budgets

A flexed budget

is a budget prepared to show the revenues, costs and profits that should have been
expected from the actual level of production and sales.

If the flexed budget is compared with the actual results for a period, variances will
be much more meaningful.

The high-low method may have to be used in order to determine the fixed and
variable elements of semi-variable costs.

However, please note that fixed costs remain unchanged regardless of the level of
activity and should not be flexed.

How to flex a budget?

Consider this - you plan to make 10 products.

Each product should use 2Kg each.

Therefore the budgeted number of Kg is 20Kg

Actually 14 products were made and 25Kg used.

If the budget wasn't flexed you would compare 25Kg to the budgeted 20Kg and get
an ADVERSE variance of 5Kg.

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But this is not taking into account the fact that 4 more products were made than
budgeted

So we need to flex this budget..

Actual Quantity of 14 should take 2kg each = 28kg

Actual Kg used 25kg

Therefore, the usage variance is actually 3 kg FAVOURABLE

Illustration

The budget was for 100 items at a labour cost of $200

The actual amount produced was 120 items at a labour cost of $250

Flex the budget and compare actual to budgeted

$200 / 100 x 120 = $240 (Flexed Budget)

Compare to actual = $250

$10 over budget

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 The concepts of feedback

Feedback

is the process of reporting back control information to management

In a business organisation, it is information produced from within the organisation

(management control reports) with the purpose of helping management and other
employees with control decisions.

• Single loop feedback, normally expressed as feedback.

is the feedback relatively small variations between actual and plan.

This implies that the existing plans will not change.

• Double loop feedback, also known as higher level feedback

ensures that plans, budgets, organisational structures and the control systems
themselves are revised to meet changes in conditions.

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The elements in the control cycle

1. Plans and targets are set for the future

These could be long-, medium- or short-term plans.

Examples include budgets, profit targets and standard costs.

2. Plans are put into operation

As a consequence, materials and labour are used, and other expenses are
incurred.

3. Actual results are recorded and analysed

4. Information about actual results is fed back to the management concerned,

often in the form of accounting reports.

This reported information is feedback

5. The feedback is used by management to compare actual results with the plan or
targets (what should be or should have been achieved).

6. By comparing actual and planned results, management can then do one of three
things, depending on how they see the situation.

Feedforward Control

Is the comparison of forecast results with planned outcomes

• Basically, we will carry out a forecast to correct unfavourable results before they
actually happen.

• e.g. We may carry out a forecast for the end of the year based on the first 3
months of operation, and discover material costs are outside the budgeted
amount.

Therefore, we can take action to reduce costs and ensure the budgeted targets
are achieved.

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 Responsibility accounting

The concept of responsibility accounting and its significance in control

Budgetary control and responsibility accounting are seen to be inseparable

Each manager must have a well-defined area of responsibility and the authority to
make decisions within that area.

This is known as a responsibility accounting unit.

An area of responsibility may be structured as

1. A cost centre

– the manager is responsible for cost control only

2. A revenue centre

– the manager is responsible for revenues only

3. Profit centre

– the manager has control over costs and revenues

4. Investment centre

– the manager is empowered to take decisions about capital investment for his
department.

A common problem is that the responsibility for a particular cost or item is shared
between two (or more) managers.

For e.g. the responsibility for material costs will be shared between production and
purchasing managers.

It is important that the reporting system should be designed so that the

responsibility for performance achievements is identified as that of a single
manager.

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 Controllable and uncontrollable costs

Measuring Performance

The main problem with measuring performance is in deciding which costs are
controllable and which costs are traceable.

The performance of a manager is indicated by the controllable profit and the

success of the division as a whole is judged on the traceable profit.

Controllable costs and revenues are those costs and revenues which result from
decisions within the authority of a particular manager within the organisation.

These should be used to assess the performance of the managers.

For example, depreciation on machinery in Division A is a traceable fixed cost

because profit centre managers do not have control over the investment in non-
current assets.

Most variable costs are controllable in the short term because managers can
influence the efficiency with which resources are used.

Some costs are non-controllable, such as increases in expenditure items due to

inflation.

Other costs are controllable in the long term rather than the short term.

For example, production costs might be lower by the introduction of new

machinery.

However, its results will be seen in the long term.


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 Ethical Implications of Budgeting

Competitive Market

• Pressure to be profitable leading to using unsustainable inputs; not paying a fair

price to suppliers

• Employees suffer only receiving the minimum wage; no training or development

opportunities

Government Agency

• Budgets set for political gain

• Decisions based on cost rather than effectiveness. eg. Cheaper, lower quality,
drugs may be preferred by the public sector

Subsidiary

• Internal politics may mean budgets for some subsidiaries are more challenging
than others.

• Tax rates may make it more desirable to make profits in certain subsidiaries

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 Syllabus C. SHORT-TERM DECISION MAKING

Syllabus C1. Product Mix Decisions

Limiting Factor

- is the factor (aspect of business/resource) that limits an organisation’s activities.

For many businesses, this may frequently be the level of sales that can be achieved
but at other times a business may be limited by a shortage of a resource which
prevents the business from achieving its sales potential.

Other examples of limiting factors would include:

1. supply of skilled labour;

2. supply of materials;

3. factory space;

4. finance;

5. plant capacity; and

6. market demand.

A business may face a single constraint situation however, others may face a multi
constraint scenario.

Limiting factor analysis

looks at product mix decisions from a financial perspective only.

The main objective in limiting factor analysis is:

Profit Maximisation


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 Optimal Production Plan - ranking

Planning with one limiting factor

When there is only one scarce resource, key factor analysis can be used to solve

the problem.

Options must be ranked using contribution earned per unit of the scarce resource.

Three steps in key factor analysis

1. Step 1: - First determine the limiting factor (bottleneck resource)

2. Step 2: - Rank the options using the contribution earned per unit of the scarce

resource

3. Step 3: - Allocate resources

Product A Product B

SP / Unit 100 120

VC / Unit 80 75

FC / Unit 10 12

Skilled Labour / Unit 0.5 hr 0.75 hr

Demand (units) 5,000 4,000

How many labour hours are required?

Required: Product A (0.5 x 5000) 2,500

Required Product B (0.75 x 4000) 3,000

5,500

Available 4,000

Shortfall 1,500

∴Labour hours are a limiting factor

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 Product A Product B

SP / Unit 100 120

VC / Unit 80 75

Cont / Unit 20 45

Lab hrs / Unit 0.5 0.75

Cont / Lab hr 40 60

Ranking 2 1

Prod Plan

Product Units Lab Hrs / Unit Total Lab Hrs

Available = 4,000

Product B 4,000 0.75 (3,000)

Available 1,000

Product A 1,000/0.5 = 2,000 0.5 (1,000)

Available 0

Therefore, produce 2000 units of Product A and 4000 units of Product B

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Assumptions

1. A single quantifiable objective. In reality, there may be multiple objectives.

2. Each product always uses the same quantity of the scarce resource per unit.

3. The contribution per unit is constant. However, the selling price may have to be
lowered to sell more; discounts may be available as the quantity of materials
needed increases.

4. Products are independent. It may not be possible to prioritise product A at the

expense of product B.

5. We focus on the short term, therefore ignoring fixed costs.

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 Linear programming

When there are two or more resources in short supply, linear programming is
required to find the solution.

Linear programming is used to:

1. maximise contribution and/or

2. minimise costs

Steps involved in linear programming

1. Define the variables

2. Define and formulate the objective

3. Formulate the constraints

4. Draw a graph identifying the feasible region. The constraints are represented as
straight lines on the graph.

The feasible region shows those combinations of variables which are possible
given the resource constraints.

5. Solve for the optimal production plan. An iso-contribution line (an objective
function for a particular value) must be drawn. All points on this line represent an
equal contribution.

This line must move to and from the origin in parallel. The objective is to get the
highest contribution or the minimum cost within the binding constraints.

A linear programming situation can be solved using simultaneous equations.

However, this technique should be used after one has determined graphically the
constraints and the feasible region.

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Linear programming assumptions

1. a single quantifiable objective

2. each product always uses the same quantity of the scarce resource per unit.

3. the contribution (or cost) per unit is constant for each product, regardless of the
level of activity. Therefore, the objective function is a straight line.

4. products are independent

5. the focus is short-term

6. all costs either vary with a single volume-related cost driver or they are fixed for
the period under consideration.

Illustration

A company manufactures two types of boxes, Box A and Box B.

Contribution / box A = $20 Contribution / box B = $45

Two materials, X and Y are used in the manufacturing of each box.

Each material is in short supply.

Material X = 3,000 kg available Material Y = 2,700 kg available

Each box A uses 20 kg of Material X and 15 kg of Material Y

Each box B uses 30 kg of Material X and 50 kg of Material Y

The objective of this company is to maximize profits.

Variables

Let A be the number of boxes of A produced and sold

Let B be the number of boxes of B produced and sold

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Objective function

Max C = 20A + 45B

Constraints

Mat X = 20A + 30B ≤ 3,000

Mat Y = 15A + 50B ≤ 2,700

Non-negativity = A,B ≥ 0

Material X

20A + 30B = 3,000

When A is 0, B = 100

When B is 0, A = 150

Material Y

15A + 50B = 2700

When A = 0, B = 54

When B = 0, A = 180

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 Shadow price

Any scarce resource that is fully utilised in the optimal solution will have a shadow
price.

It would be worth paying more than the ‘normal’ price to obtain more of the scarce
resource because of the contribution foregone by not being able to satisfy the sales
demand.

Therefore, if more critical (scarce) resource becomes available, then the feasible
region would tend to expand and this means that the optimal point would tend to
move outward away from the origin, thus earning more contribution.

Hence the shadow price of a binding constraint is the amount by which the total
contribution would increase if one more unit of the scarce resource became
available.

Management can use the shadow price as a measure of how much they would be
willing to pay to gain more of a scarce resource over and above the normal price
subject to any non-financial issues that may be present.

If the availability of a non-critical scarce resource increased then the feasible region
would not tend to expand and therefore no more contribution could be earned. In
this case, extra non-critical scarce resource has no value and a nil shadow price.

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Calculating shadow prices

1. add one unit to the constraint concerned while leaving the other critical
constraint unchanged

2. solve the revised simultaneous equations to derive a new optimal solution

3. calculate the revised optimal contribution and compare to the old contribution.

The increase in contribution is the shadow price for the constraint under
consideration.

Illustration

Following from the previous illustration, find the shadow price of Material X.

20A + 30B = 3001 (add 1 kg to Material X)

15A + 50B = 2700

20A + 30B = 3001 ….. x5

15A + 50B = 2700 ….. x3

100A + 150B = 15005

minus 45A + 150B = 8100

Totals 55A / = 6905

A = 125.55

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100 A + 150B = 15005

100(125.55) + 150B = 15005

B = 16.33

Therefore New Contribution =

20 (125.55) + 45 (16.33)

= 2511+ 734.85

= 3245.85

Old Contribution = 3245.20

Shadow price = 0.65

Extra contribution / kg of Material X

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 Slack

Slack occurs when the maximum availability of a resource is not used.

Therefore, slack is the amount by which a resource is under-utilised. It will occur

when the optimum point does not fall on the given resource line.

If, at the optimal solution, the resource used equals the resource available, the
constraint is binding and there is no slack.

Hence, a shadow price has to be calculated.

What happens if the objective is to minimise costs?

1. Same steps as above

2. Check the constraints :- are they less than or greater than?

3. If they are ‘greater than’, the region which you should consider is above the
constraint.

4. The optimal point will be the first point you reach on the feasible region when
you shift out the iso-cost function.

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 Syllabus C1. Cost plus pricing

Cost plus selling price

Step 1: Calculate Return required (Profit per unit)

= Investment x %

And then you need to divide it by number of units

Step 2: Calculate Total Costs per unit

Step 3: Calculate the Selling price

= Profit + Total Cost

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Illustration

Cow Co manufactures a product X. It incurs a total cost of $100 per unit.

Cow Co manufactures 10,000 units each year and the directors wish to achieve a

return of 20% on the total capital of $1,000,000 invested in the company.

The cost-plus selling price of one unit of product X should be:

Solution:

Step 1:

20% return on $1m = $200,000 required profit

Per unit = $200,000 / 10,000 = $20

Step 2:

Total cost = $100 per unit.

Step 3:

Total cost plus profit = selling price

$100 + $20 = $120

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 Margins & Mark up

Cost plus pricing

- means that a desired profit margin is added to total costs to arrive at the selling
price.

Mark-up profit

is calculated as a percentage of the total costs of the job

e.g. 20% mark-up, for example 20% of the total cost of $100 is $20 is the mark up
profit

selling price 120

total cost (100)

-------------------------

profit 20

Margin profit

is calculated as a percentage of the selling price of the job

e.g. 20% margin, for example 20% of the selling price of $100 is $20 margin profit

selling price 100

total cost (80)

-------------------------

profit 20

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 Syllabus C2. Relevant Costing

Relevant cost of Materials

Any short term decisions should be approached using relevant costing

principles

Companies and government bodies have increasingly tended to concentrate on

their core competences – what they are really good at – and turn other functions
over to specialist contractors.

This is known as outsourcing or sub-contracting.

Relevant costs and revenues are:

In the FUTURE

CASH only

INCREMENTAL only

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Decision making should be based on relevant costs and revenues.

1. Relevant costs are FUTURE costs.

A decision is about the future and it cannot alter what has been done already.

Costs that have been incurred in the past are totally irrelevant to any decision
that is being made 'now'.

Such costs are called past costs or sunk costs and are irrelevant.

2. Relevant costs are CASHFLOWS.

Only cash flow information is required.

This means that costs or charges which do not reflect additional cash spending
(such as depreciation and notional costs) should be ignored for the purpose of
decision making.

3. Relevant costs are INCREMENTAL costs and it is the increase in costs and
revenues that occurs as a direct result of a decision taken that is relevant.

Common costs can be ignored for the purpose of decision making.

4. Relevant costs are AVOIDABLE costs

These are costs which would not be incurred if the activity to which they relate
did not exist.

Therefore, they are relevant to a decision.

Committed costs are future costs that cannot be avoided because of decisions that
have already been made.

These are non-relevant costs

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Opportunity Costs

Opportunity costs only arise when resources are scarce and have alternative uses.

When an alternative course of action is given up, the financial benefits lost are
known as opportunity costs.

So they are the lost contribution from the best use of the alternative forgone.

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 Relevant cost of Materials

If used & replaced regularly this is their current replacement cost

But what if we have already have them in stock and won't use them regularly?

Well then we can either sell them or use them on another project

So, here the relevant cost of using them is the higher of: -

• Their current resale value

• Their alternative use value

So also if the materials have no resale value and no other possible use, then the
relevant cost is nil

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 Original Current Current
Qty needed Qty currently
Material cost of qty purchase resale
for contract in inventory
in inv price price

A 400 kg 200 kg $10/kg $15/kg $12/kg

B 200 kg 100 kg $20/kg $22/kg $15/kg

Material A is used regularly in the business.

Material B is no longer used and has no alternative use in the business.

The relevant cost of material is:

Material A – regularly used – replace

400 kg x $15 = $6000

Material B – 100 kgs in stock could have been sold if not used in the contract

opportunity cost = 100 kg x $15 = $1500

The other 10 0kg have to be purchased at $22

100 kg x $22 = $2200

Therefore $1500+$2200 = $3700

Please note that the original cost is a sunk cost, therefore irrelevant.

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 Relevant cost of Labour

The key question here is: Is there spare capacity?

Different Scenarios...

• Spare capacity

So, additional work can be undertaken at no extra cost :)

Relevant cost of labour is a big, fat 0

• Full capacity - so hire more workers

Relevant cost is current pay rates

• Full capacity - takes workers from another project

So this project can't be finished :( - so we lose its contribution but we still have
to pay the workers on our project

Relevant cost is Lost contribution + labour cost

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 Syllabus C3. Short-term Decision Making

The further processing decision

occurs when there is a choice between selling part-finished output or

processing it further.

An Example:

A Company manufactures two joint products, A and B.

Output per batch is 10 units of A and 15 units of B.

The sales value of A at split-off point is $80 per unit.

An opportunity exists to process product A further, at an extra cost of $500 per

batch, to produce product C.

One unit of joint product A is sufficient to make one unit of C which has a sales
value of $150 per unit.

Solution

Sales value of C (10 units x $150) = 1,500

Sales value of A (10 units x $80) = 800

Incremental revenue from further processing = 1,500 - 800 = 700

Further processing cost = $500

Benefit from further processing in order to sell C = 700 - 500 = $200 per batch

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 Make or Buy Decisions

A key consideration here is spare capacity

If Spare production capacity is available

So here we have spare room to MAKE more products, therefore...

• Production resources may be idle (if the component is purchased from outside)

• Fixed costs are irrelevant (because we won't need any extra fixed costs)

• So just consider the variable costs of MAKING compared to the purchase cost

of BUYING

Decision
1. Buy

If buying price < the variable costs of making

2. Make

If buying price > variable costs of making

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No spare capacity available?
So we need to buy more space or stop making something to create space

Stopping making something to create capacity causes lost contribution

So compare the contribution lost + extra costs of MAKING to the purchase price of
BUYING

Decision
1. Buy

if relevant costs of making > Purchase price

2. Make

if relevant costs of making < Purchase price

Illustration
Craft Ltd makes four components A, B, C, and D and the associated annual costs
are as follows:

A B C D
Production volume (units) 1,500 3,000 5,000 7,000

Unit variable costs $ $ $ $

Direct Materials 4 4 5 5
Direct Labour 8 8 6 6
Variable production overheads 2 1 4 5
Total 14 13 15 16

Fixed costs directly attributable are: 3,000 6,000 10,000 7,000

The unit prices of an external supplier are: 12 16 20 24

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Determine whether any of the components should be bought in from the external
supplier.

SOLUTION

  A B C D
Costs if Made 14 13 15 16
Costs if Bought (12) (16) (20) (24)
Savings per unit Bought  2 (3) (5) (8)
Number of units 1,500 3,000 5,000 7,000
         
Total Savings if Bought 3,000 (9,000) (25,000) (56,000)
Plus Direct Fixed Costs Saved 3,000 6,000 10,000 7,000
         
Total Saving 6,000 (3,000) (15,000) (49,000)

Therefore only buy in component A as this is the only one which makes a saving if
bought in


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 Accept or Decline contracts

A business should identify the incremental cash flows associated with a new one-off
contract/project.

Illustration
The managing director of Q Limited is considering undertaking a one-off contract.

She 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

Direct wages $28,500
General overheads $4,000
Machine depreciation $2,300
Materials $34,000

Total $68,800

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Notes
Direct wages comprise the wages of two employees, particularly skilled in the
labour process for this job.

They could be transferred from another department to undertake the work on the
special order.

They are fully occupied in their usual department and sub-contracting staff would
have to be brought in to undertake the work left behind. 


Sub-contracting costs would be $32,000 for the period of the work.

Other sub-contractors who are skilled in the special order techniques are also
available to work on the special order.

The costs associated with this would amount to $31,300.

General overheads comprise an apportionment of $3,000 plus an estimate of

$1,000 incremental overheads.

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.

Materials represent the purchase costs of 7,500kg bought some time ago.

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The materials are no longer used and are unlikely to be wanted in the future except
for the special order.

The complete stock of materials (amounting to 10,000kg), or part thereof, could be

sold for $4.20 per kg.

The replacement cost of material used would be $33,375.

Required: 

Produce a revised costing schedule for the special project based on relevant
costing principles. Fully explain and justify each of the costs included in the costing
schedule.

• Direct Wages

1. Option 1:

Take the workers from their usual departments at a cost of $32,000 to

replace them there

2. Option 2:

Hire sub-contractors at a cost of $31,300

Therefore choose sub contractors

• General Overheads

General fixed overheads will have to paid anyway

We are only interested in 'extra' fixed costs which here are $1,000

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• Machine Depreciation

We are only interested in the relevant cashflows - depreciation is not a cashflow

There are extra maintenance costs though with the new contract of $500

• Materials

The amount already in stock is a past sunk cost.

We are only interested in future incremental costs

The replacement cost is not a future cost either (as we have the stock already
and is not to be used elsewhere)

The only relevant future cost is the fact we cannot sell it in the future (as we
would as we are not using it)

This cost is 7,500 x $4.20 = $31,500

• Overdraft Interest

This is a future incremental cost if the contract is taken

$20,000 x 3/12 x 18% = $900

Item Cost
Direct wages 31,300
Overheads 1,000
Maintenance 500
Materials 31,500
Interest 900

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 Close or Continue

Closure or continuation decisions

Here you need to look at:

The loss in revenue from closing down the operation, and


The saving in costs from closing down (= avoidable costs).

This basically means look at its contribution - so make sure all the costs are direct -
otherwise they wont be saved

Illustration

The management of Oh no It's all going wrong!

Co is considering the closure of one of its operations (department 2) and the

financial accountant has submitted the following report.

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Department 1 2 3 Total
Sales (units) 10,000 5,000 15,000 30,000
Sales ($) 150,000 92,000 158,000 400,000
Direct material 75,000 75,000 50,000 200,000
Direct labour 25,000 25,000 10,000 60,000
Production overhead 5,000 2,500 7,500 15,000

Gross profit 45,000 -10,500 90,500 125,000

Expenses -15,000 -9,200 -15,800 -40,000

Net profit ($) 30,000 -19,700 74,700 85,000

In addition to the information supplied above, you are told that:

Production overheads of $15,000 have been apportioned to the three departments

on the basis of unit sales volume

Expenses are head office overhead, apportioned to departments on sales value.

As management accountant, you further ascertain that, on a cost driver basis:

Half of the so-called direct labour is fixed and cannot be readily allocated.

Prepare a report for management including a restatement of the financial position in

terms of contribution made by each department and making a clear

recommendation.

179 aCOWtancy.com
  1 2 3 Total

Sales 150,000 92,000 158,000 400,000

Direct Materials (75,000) (75,000) (50,000) (200,000)

Direct Labour (12,500) (12,500) (5,000) (30,000)

Production Overheads (5,000) (2,500) (7,500) (15,000)

         

Contribution 57,500 2,000 95,500 155,000

As Department 2 makes a positive contribution it should not be closed down

Shut down decisions

• Loss of contribution from the segment

• Savings in specific fixed costs from closure

• Penalties resulting from the closure, e.g. redundancy, compensation to

customers

• Alternative use for resources released

• Knock-on impact, e.g. loss leaders cancelled - products that got customers into
the store

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 Syllabus C3. Break-even analysis

Break even?

One of the most important decisions that needs to be made before any business
even starts is ‘how much do we need to sell in order to break-even?’

By ‘break-even’ we mean simply covering all our costs without making a profit.

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 Break-Even Point and Margin of Safety

Break-Even (Units)

Every Sale makes a CONTRIBUTION towards FIXED costs.

Once the fixed costs are paid for by these sales then you break even:

So the break even point in units is Fixed Costs / Contribution (per unit)

Video link: https://www.acowtancy.com/textbook/cima-p1/break-even-analysis/break-

even-point-and-margin-of-safety/notes

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Break-Even (Revenue)
Very similar to Break-even (units) except instead of contribution in units it's contribution to
sales ratio

So the break even point in units is Fixed Costs / Contribution to sales ratio

Video link: https://www.acowtancy.com/textbook/cima-p1/break-even-analysis/break-even-point-and-

margin-of-safety/notes

Margin of Safety

The Margin of Safety is simply how many we predict to sell ABOVE the breakeven
level

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Video link: https://www.acowtancy.com/textbook/cima-p1/break-even-analysis/break-even-point-and-
margin-of-safety/notes

Achieving A Required Profit

Video link: https://www.acowtancy.com/textbook/cima-p1/break-even-analysis/break-even-point-and-

margin-of-safety/notes

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 Multi-Product Situations

Multi - Product: Break Even (Units & Revenue)

Because there's one more than one product then we need the Weighted Average
Contribution per unit or to sales ratio

Break Even Units

Fixed Costs

-------------

Weighted Average Contribution (per unit)

Break Even Revenue

Fixed Costs

-------------

Weighted Average Contribution : Sales Ratio

Video link: https://www.acowtancy.com/textbook/cima-p1/break-even-analysis/multi-

product-situations/notes

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Target Profit - Multi Product Illustration

Video link: https://www.acowtancy.com/textbook/cima-p1/break-even-analysis/multi-

product-situations/notes

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 Limitations and Technology

Limitations of Breakeven Analysis

Video link: https://www.acowtancy.com/textbook/cima-p1/break-even-analysis/limitations-

and-technology/notes

Data and Technology

Video link: https://www.acowtancy.com/textbook/cima-p1/break-even-analysis/limitations-

and-technology/notes


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 Break-Even Charts and Profit Volume

Basic Break-Even Chart

A basic breakeven chart records:

- costs and revenues on the vertical axis (y)

- units sold on the horizontal axis (x).

Lines are drawn on the chart to represent costs and sales revenue.

The breakeven point is where the Total revenues line meets the Total costs line

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The contribution breakeven chart

One of the problems with the basic breakeven chart is that it is not possible to read
contribution.

A contribution breakeven chart is based on the same principles, but it shows the
variable cost line instead of the fixed cost line.

The same lines for total cost and sales revenue are shown so the breakeven point,
and profit can be read off in the same way as with a basic B/E chart.

However, it is also possible also to read the contribution for any level of activity.

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Profit-volume chart

The profit-volume graph focuses purely on showing a profit/ loss line and doesn’t
separately show the cost and revenue lines.

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Multi-product

In a multi-product environment, it is common to actually show two lines on the

graph:

one straight line, where a constant mix between the products is assumed; and

one bow-shaped line, where it is assumed that the company sells its most profitable
product first and then its next most profitable product, and so on.

In order to draw the graph, it is therefore necessary to work out the C/S ratio of
each product being sold before ranking the products in order of profitability.

It can be observed from the graph that, when the company sells its most profitable
product first (x) it breaks even earlier than when it sells products in a constant mix.

The break-even point is the point where each line cuts the x axis.


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 Syllabus D. DEALING WITH RISK AND UNCERTAINTY

Syllabus D1a. Risk And Uncertainty

Risk & Uncertainty

Risk

This is present when future events occur with measurable probability

Risk can be quantified by applying probabilities to the various possible outcomes

Uncertainty

This is present when the likelihood of future events is incalculable

Uncertainty is an inability to predict the outcome of an activity due to a lack of

information


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 Expected Values (EV)

The ‘expected value’ rule calculates the average return that will be made if a
decision is repeated again and again.

It does this by weighting each of the possible outcomes with their relative
probability of occurring.

It is the weighted arithmetic mean of the possible outcomes.

The likelihood that an event will occur is known as its probability.

This is normally expressed in decimal form with a value between 0 and 1.

A value of 0 denotes a nil likelihood of occurrence whereas a value of 1 signifies

absolute certainty.

A probability of 0.4 means that the event is expected to occur four times out of ten.

The total of the probabilities for events that can possibly occur must sum up to 1.0.

An expected value is computed by multiplying the value of each possible outcome

by the probability of that outcome, and summing the results.

EV = ∑px

Where:

p = probability of the outcome

x= the possible outcome

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A risk neutral investor will generally make his decisions based on maximising EV.

Video link: https://www.acowtancy.com/textbook/cima-p1/risk-and-uncertainty/expected-

values/notes

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 The Value of Perfect and Imperfect Information

Uncertainty means we might consider getting more info

Perfect information is available when a 100% accurate prediction can be made

about the future.

Imperfect information The concept of perfect information is somewhat artificial

since, in the real world, such perfect certainty rarely, if ever, exists.

The approach to calculate the value of perfect and imperfect information is the
same:

Expected value of the decision with (im)perfect information - Expected value

without it

Video link: https://www.acowtancy.com/textbook/cima-p1/risk-and-uncertainty/the-value-of-perfect-and-

imperfect-information/notes

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 Standard Deviations

Using Standard Deviation To Measure Risk

Video link: https://www.acowtancy.com/textbook/cima-p1/risk-and-uncertainty/standard-deviations/notes

Co-Efficient of Variation

Standard deviation / expected value (mean)

Illustration 1

Alpha Co is considering investing in one of the following projects:

Project Expected value $000 Standard deviation $000

A 950 600

B 1,400 580

C 250 300

D 760 740

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Required

If Alpha Co wishes to select the project with the lowest risk factor (coefficient of variation) it
will select project:

SOLUTION

Coefficient of variation = Standard deviation / expected value (mean)

A = 600 / 950 = 0.63

B = 580 / 1,400 = 0.41

C = 300 / 250 = 1.2

D = 740 / 760 = 0.97

Lowest risk factor (coefficient of variation) = project B

Illustration 2

Beta Co is considering investing in one of two mutually exclusive projects.

Information about the projects is shown below:

Project A Project B

Expected value of profit $165,000 $199,000

Standard deviation $51,533 $133,389

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Required

If the management of Beta Co are risk averse, which project would they be most likely to
invest in?

SOLUTION

On the basis of EVs alone, project B is marginally preferable to project A, by $34,000.

($199,000-$165,000 = $34,000).

However, if the management are risk averse, they would be more likely to choose project A
because, although it has a smaller EV, the possible profits are subject to less variation.

This is demonstrated through a smaller standard deviation.

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 Normal Distribution

- is probability (%) of something happening (eg. achieving a profit) based on

standard deviation and average (mean).

This formula is given in the exam:

Z = (x - µ) / Ϭ

where:

Z is a Z-score = probability % - from the mean to variable X (you have to calculate

"Z" using Probability tables);

μ is the mean (average) = the Most popular figure

σ is the standard deviation = how far away from the average you are

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Normal Distribution Table

This is given in the exam

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Illustration 1

Average profit is $100

Std deviation $10

What is the probability of profit more than $105?

Solution:

Step 1. Calculate Z-score


Z = (x - µ) / Ϭ

Z = (105 - 100) / 10

Z = 5 / 10 = 0.5

Step 2. Find the % in the Table


Find Z value of 0.5 in the first column = 0.1915 or 19.15%

Step 3. Calculate the probability of profit being more than $105.


Less than $105 = 50% + 19.15% = 69.15%

Greater than $105 = 50% - 19.15% = 30.85%

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Illustration 2

Average (Expected value) profit from a project is $200,000

Standard deviation is  $100,000. 

If the project loses more than $50,000 the company will be in financial difficulties.

What is the probability of the project losing more than $50,000?

Step 1. Calculate Z-score


Z = (x - µ) / Ϭ

Z = (-50,000 - 200,000) / 100,000 

Z = 2.5

Step 2. Find the % in the Table


Find Z value of 2.5 in the first column = 0.4938 or 49.38%

Step 3. Calculate the probability of the project losing MORE than $50,000 is:

So less than $50,000 = 50% + 49.38% = 99.38%

So greater than $50,000  = 100% - 99.38% = 0.62%

So we have a 99.38% confidence that losses won't fall lower than 50k

Another way of saying this is the value at risk is 50,000 when we have a 99.38%
confidence level


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 Syllabus D1b. Decision Models

Maximax, Maximin and Minimax Regret

Video link: https://www.acowtancy.com/textbook/cima-p1/decision-models/maximax-maximin-and-minimax-

regret/notes

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 Attitudes to risk by individuals

Here we look at the decision-maker’s attitude to risk.

There are 3 possible attitudes:

1. Risk Averse - avoid risk

Risk-averse are willing to accept a lower level of return.

A risk averse investor would want to consider standard deviations as it tells them more
about the risk they are taking on in the decision they are making and can help them avoid
high risk choices

- They would choose the maximin decision

2. Risk Seeking - seek risk

Those that are risk-seeking favour higher risks and higher returns

They would choose the maximax decision

3. Risk Neutral - ignore risk

They may choose the highest expected value.

Normal distributions give information about probabilities but not about risk so would be
useful to risk neutral investors

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 Payoff tables

A profit table (payoff table) is useful for scenario where there is a range of possible
outcomes and a variety of possible responses.

A payoff table simply illustrates all possible profits/losses.

Illustration

Mr. Luck runs a small shop with milk products.

He buys his products for $10 and sell them for $15.

The product is not possible to store, any unsold item is scrapped at the end of day
at scrap value of $2 per product.

Supplies of product to the shop is made before the number of sales is known,
however Mr. Luck has records about last 150 days sales.

Based on the records the sales were:

50 days of 150 days - 150 products sold

70 days of 150 days - 200 products sold

30 days of 150 days - 100 products sold

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1. STEP 1: Calculate probabilities of outcomes:
150 products will be sold with probability of 50 days/150 days, which is 0.33

200 products will be sold with probability of 70 days/150 days, which is 0.47

100 products will be sold with probability of 30/150 days, which is 0.2

2. STEP 2: Calculate all possible outcomes:

E.g. if supply is 150 and sales are also 150, the profit is 150*(15-10)=$750;

however if supply is 150 and sales are only 100, the profit will be
100*(15-10)+50*(2-10)=$100

STEP 3: Fill the outcomes to the payoff table.

3. STEP 3: Fill the outcomes to the payoff table.

Daily demand (in qty) Probability Daily supply

150 200 100

150 0.33 750 350 500

200 0.47 750 1000 500

100 0.2 100 -300 500

4. STEP 4: Make a decision:

a. Maximax (risk seeker) - choose the best - order a supply of 200 products

b. Maximin (risk averse) - choose the outcome with the highest expected return
under the worst possible conditions - order a supply of 100 products

c.Using expected values (EV - risk neutral approach) - calculate EV of each

choice using probabilities - e.g. EV of outcome 150 ordered, 150 sold is
$750*0,33. See following table:

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Daily demand (in qty) Probability Daily supply

150 200 100

150 0.33 750*0.33=250 350*0.33=117 500*0.33=167

200 0.47 750*0.47=350 1000*0.47=467 500*0.47=233

100 0.2 100*0.2=20 -300*0.2=-60 500*0.2=100

TOTAL EXPECTED
620 524 500
VALUES

Using EV we should choose order of 150 products.

d. Minimax regret - outcome with the lowest possible regret (opportunity costs) -
regret is calculated as a difference between the best outcome profit and other
choices, see the table:

Daily demand (in qty) Probability Daily supply

150 200 100

750-350=40 750-500=25
150 0.33 750-750=0
0 0

1000-1000= 1000-500=5
200 0.47 1000-750=250
0 00

500-
100 0.2 500-100=400 500-500=0
(-300)=800

Max opportunity costs of the

400 800 500
choice

So based on minimax regret regret decision rule we should choose order of 150
products.

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 Decision Trees

A Decision Tree is a diagram that looks at alternative courses of action

and their possible outcomes

There are 2 stages to using Decision Trees:

1. Draw the Decision Tree (including all probabilities and outcomes)

2. Use expected values at all outcome points to make decisions.

Drawing the Decision Tree

• Draw the tree from left to right

• A square represents a Decision

• A circle represents an Outcome

• At a Decision Square - a branch from it represents a potential event - with a

probability of it happening attached

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Figure 1:

There are two branches coming off the initial decision point - the top branch has a
certain outcome

The lower branch has two possible outcomes, and a further 2 possible outcomes
for each of these

The next step would be to label the tree and put the cash inflows/outflows and
probabilities in

Evaluation of the Tree

Evaluate the tree from right to left

• Calculate an Expected Value at each Outcome circle

• Choose the best option at each Decision square

• Finally, recommend the option with the highest expected value

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Video link: https://www.acowtancy.com/textbook/cima-p1/decision-models/decision-trees/notes

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 Sensitivity

Sensitivity Analysis

This calculates the maximum percentage change in a variable before a decision

would change

The lower % variables that are therefore the most important for the decision under
review.

Video link: https://www.acowtancy.com/textbook/cima-p1/decision-models/sensitivity/notes

Advantages of Sensitivity Analysis

1. Easy to understand

2. Highlights key variables

Disadvantages of Sensitivity Analysis

1. Looks at variable only one at a time

2. It does not assess the probability of any change occurring

3. Does not offer a clear decision rule; management judgement is still required

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