Management Accounting – Performance Evaluation

CIMA’s Official

Study System

Managerial Level

Management

Accounting –

Performance

Evaluation

Bob Scarlett

AMSTERDAM BOSTON HEIDELBERG LONDON NEW YORK OXFORD

PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO

CIMA Publishing

An imprint of Elsevier

Linacre House, Jordan Hill, Oxford OX2 8DP

30 Corporate Drive, Burlington, MA 01803

First published 2005

Copyright © 2005 Elsevier Ltd. All rights reserved

No part of this publication may be reproduced in any material form (including

photocopying or storing in any medium by electronic means and whether

or not transiently or incidentally to some other use of this publication) without

the written permission of the copyright holder except in accordance with the

provisions of the Copyright, Designs and Patents Act 1988 or under the terms

of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road,

London, England W1T 4LP. Applications for the copyright holder’s written

permission to reproduce any part of this publication should be addressed

to the publisher

Permissions may be sought directly from Elsevier’s Science and

Technology Rights Department in Oxford, UK: phone: (44) (0) 1865 843830;

fax: (44) (0) 1865 853333; e-mail: [email protected]. You may also

complete your request on-line via the Elsevier homepage

(http://www.elsevier.com), by selecting ‘Customer Support’ and then

‘Obtaining Permissions’

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

ISBN 0 7506 67117

Typeset by Newgen Imaging Systems (P) Ltd, Chennai, India

Printed in Great Britain

For information on all CIMA publications

visit our website at www.cimapublishing.com

Important Note

A new edition of the CIMA Official Terminology is due to be published in

September 2005. As this is past the publication date of this Study System the

page reference numbers for ‘Management Accounting Official Terminology’

contained in this Study System are for the 2000 edition. You should ensure that

you are familiar with the 2005 CIMA Official Terminology (ISBN 0 7506 6827 X)

once published, available from www.cimapublishing.com

iii 2005.1

The CIMA Study System xiii

Acknowledgements xiii

How to use your CIMA Study System xiii

Study technique xv

The Performance Evaluation syllabus xvi

Transitional arrangements xxi

1 Cost Accounting Systems 1

Learning Outcomes 1

1.1 Introduction 1

1.2 The difference between marginal costing

and absorption costing 1

1.3 Preparing profit statements using each method 2

1.3.1 Profit statements using marginal costing 3

1.3.2 Profit statements using absorption costing 3

1.4 Reconciling the profit figures 4

1.4.1 Reconciling the profits given by the different methods 4

1.4.2 Reconciling the profits for different periods 5

1.4.3 Profit differences in the long term 5

1.5 Marginal costing or absorption costing? 6

1.6 Specific order costing 6

1.7 Job costing 7

1.7.1 Job cost cards and databases 7

1.7.2 Collecting the direct costs of each job 7

1.7.3 Attributing overhead costs to jobs 8

1.7.4 A worked example 8

1.7.5 Other applications for job costing 10

1.8 Batch costing 10

1.9 Process costing 10

1.9.1 Previous process costs 12

1.9.2 Opening work in progress 12

1.9.3 Solution to Example 1 using the FIFO method 14

1.9.4 Discussion of Example 1 15

1.9.5 Choice of methods and standard costing 16

1.9.6 Process costing with opening work in progress 17

1.9.7 Solution to Example 2 using the FIFO method 18

1.9.8 Process losses 20

Contents

1.10 Joint products and by-products 21

1.10.1 Joint product costing 22

1.10.2 Apportioning common costs to joint products 22

1.10.3 Using notional or proxy sales values for common

cost apportionment 23

1.10.4 The final sales value method of

common cost apportionment 24

1.10.5 Using joint product costs for decision-making 25

1.10.6 Joint products and the further processing decision: an example 25

1.10.7 Costing by-products 26

1.10.8 Joint and by-products: an example 27

1.11 Summary 28

Reading 29

Revision Questions 31

Solutions to Revision Questions 37

2 The Theory and Practice of Standard Costing 43

Learning Outcomes 43

2.1 Introduction 43

2.2 The theory and practice of standard costing 43

2.3 What is a standard cost? 44

2.4 Performance levels 45

2.4.1 A standard 45

2.4.2 Ideal standard 45

2.4.3 Attainable standard 45

2.4.4 Basic standard 45

2.5 Setting standard costs 46

2.5.1 Standard material price 46

2.5.2 Standard material usage 46

2.5.3 Standard labour rate 46

2.5.4 Standard labour times 46

2.5.5 Production overhead costs 46

2.6 Updating standards 47

2.7 Standard costing in the modern industrial environment 47

2.8 What is variance analysis? 47

2.9 Variable cost variances 48

2.9.1 Direct material cost variances 48

2.9.2 The direct material price variance and

stock valuation 49

2.9.3 Direct labour cost variances 50

2.9.4 Variable overhead cost variances 51

2.10 Fixed production overhead variances 52

2.10.1 The reasons for under- or over-absorption of overhead 52

2.10.2 The fixed production overhead total variance 53

2.10.3 The fixed production overhead expenditure variance 53

2.10.4 The fixed production overhead volume variance 53

iv MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION P1 CONTENTS

2005.1

MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION P1 vCONTENTS

2005.1

2.10.5 Analysing the fixed production overhead volume variance 54

2.10.6 Fixed production overhead capacity variance 54

2.10.7 Fixed production overhead efficiency variance 54

2.11 Sales variances 55

2.11.1 The selling price variance 55

2.11.2 The sales volume variance 56

2.11.3 The sales volume profit variance 56

2.12 Reconciling the actual and budget profit 56

2.13 Standard marginal costing 59

2.13.1 The fixed overhead volume variance 59

2.13.2 The fixed overhead expenditure variance 59

2.13.3 The sales volume contribution variance 59

2.13.4 Reconciling the actual and budget profit 60

2.14 Idle time variances 61

2.14.1 Expected idle time 62

2.15 Calculating actual data from standard cost details and variances 63

2.16 Example: Preparing a reconciliation statement 64

2.16.1 Reconciliation of budgeted and actual profit 66

2.16.2 Calculation of cost variances shown in reconciliation above 67

2.17 Some miscellaneous ideas 68

2.18 Summary 69

Readings 71

Revision Questions 89

Solutions to Revision Questions 97

3 Standard Costing and Performance Evaluation 107

Learning Outcomes 107

3.1 Introduction 107

3.2 Material mix and yield variances 107

3.3 Labour mix and yield variances 110

3.4 Sales variances 112

3.5 Planning and operational variances 114

3.6 Capacity ratios 118

3.6.1 Standard hour 118

3.6.2 Calculating the capacity ratios 119

3.7 Investigation and interpretation of variances 120

3.7.1 Percentage variance charts 121

3.7.2 The reasons for variances 122

3.7.3 Investigation models 123

3.7.4 Interrelationship of variances 124

3.8 Behavioural considerations 126

3.8.1 Organisational goals 126

3.8.2 Target levels for standards and budgets 126

3.8.3 Performance measures and evaluation 127

3.8.4 Participation in setting standards and budgets 128

3.8.5 Budget bias 128

3.9 Standard costing in the modern business environment 129

3.9.1 Criticisms of standard costing 129

3.9.2 Addressing the criticisms 129

3.9.3 Standards and variances: a cautionary note 130

3.10 Benchmarking 130

3.11 Developments and current thinking in the application

of standard costing 131

3.11.1 McDonaldization – Another angle on things 131

3.11.2 Diagnostic reference groups 131

3.12 Summary 132

Readings 133

Revision Questions 139

Solutions to Revision Questions 145

4 Basic Aspects of Management Accounting 153

Learning Outcomes 153

4.1 Introduction 153

4.2 Cost behaviour 153

4.2.1 Fixed cost 154

4.2.2 Variable cost 155

4.2.3 Semi-variable cost 157

4.2.4 Analysing semi-variable costs 158

4.2.5 Using historical data 160

4.3 Costs and activity based techniques (ABTs) 160

4.4 Breakeven or cost–volume–profit analysis 161

4.4.1 Calculating the breakeven point 161

4.5 The margin of safety 161

4.6 The contribution to sales (C/S) ratio 162

4.7 Drawing a basic breakeven chart 163

4.8 The contribution breakeven chart 165

4.9 The PV chart 165

4.9.1 The advantage of the PV chart 166

4.10 The limitations of breakeven (or CVP) analysis 167

4.11 The economist’s breakeven chart 168

4.12 Using costs for decision-making 168

4.12.1 Short-term decision-making 169

4.13 Evaluating proposals 169

4.14 Relevant costs 171

4.14.1 Non-relevant costs 171

4.15 Opportunity costs 173

4.15.1 Examples of opportunity costs 173

4.15.2 Notional costs and opportunity costs 173

4.16 Avoidable, differential and incremental costs 174

4.16.1 Avoidable costs 174

4.16.2 Differential/incremental costs 174

4.16.3 Using incremental costs 174

4.16.4 Incremental revenues 174

vi MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION P1 CONTENTS

2005.1

4.17 Limiting factor decision-making 175

4.17.1 Decisions involving a single limiting factor 176

4.18 Summary 178

Readings 179

Revision Questions 183

Solutions to Revision Questions 189

5 The Theory and Practice of Budgeting 195

Learning Outcomes 195

5.1 Introduction 195

5.2 The purposes of budgeting 195

5.2.1 Budgetary planning and control 196

5.2.2 What is a budget? 196

5.2.3 The budget period 197

5.2.4 Strategic planning, budgetary planning and

operational planning 197

5.3 The preparation of budgets 198

5.3.1 Co-ordination: the budget committee 198

5.3.2 Participative budgeting 198

5.3.3 Information: the budget manual 198

5.3.4 Early identification of the principal

budget factor 199

5.3.5 The interrelationship of budgets 199

5.3.6 Using spreadsheets in budget preparation 200

5.3.7 The master budget 200

5.4 Preparation of operational budgets 200

5.4.1 Using stock control formulae in budget preparation 201

5.4.2 Budget interrelationships 202

5.5 The cash budget 202

5.5.1 Preparing cash budgets 202

5.5.2 Interpretation of the cash budget 204

5.5.3 Cash budget: second example 204

5.6 Rolling budgets 207

5.7 Forecasting and planning 208

5.8 Time series 210

5.8.1 The concept 210

5.8.2 Factors that cause variations 211

5.8.3 Time series modelling 211

5.9 Sensitivity analysis 214

5.10 Zero-based budgeting 215

5.10.1 Advantages of ZBB 217

5.10.2 Disadvantages of ZBB 217

5.10.3 ZBB in practice 218

5.11 Programme-planning budgeting systems 218

5.12 Activity-based budgeting 221

5.13 Summary 222

MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION P1 vii CONTENTS

2005.1

Readings 223

Revision Questions 235

Solutions to Revision Questions 245

6 Budgetary Control 255

Learning Outcomes 255

6.1 Introduction 255

6.2 The Theory of Systems 256

6.3 System design 256

6.3.1 The characteristics and components of a system 256

6.3.2 Control systems 256

6.4 Feedback control loops and system operation 257

6.5 Budgetary control information 258

6.5.1 Budget centres 258

6.5.2 Budgetary control reports 259

6.6 Fixed and flexible budgets 261

6.6.1 Preparing a flexible budget 261

6.6.2 Using flexible budgets for planning 263

6.6.3 Flexible budgets 263

6.6.4 Extrapolating outside the relevant range 265

6.7 Behavioural aspects of budgetary control 265

6.7.1 Motivation and co-operation 266

6.7.2 Failure of goal congruence 266

6.7.3 The budget as a pot of cash 267

6.7.4 Budget negotiation 267

6.7.5 Influence on accounting policies 268

6.7.6 Budget constrained management styles 268

6.7.7 Budgets and motivation 268

6.8 Modern developments in control systems 269

6.8.1 The problem of discretionary costs 269

6.8.2 Developments from financial modelling and

budgeting packages 270

6.8.3 Rethinking the purpose of the monthly report and

decision support systems 270

6.8.4 Beyond budgeting 271

Readings 273

Revision Questions 283

Solutions to Revision Questions 289

7 Budgeting and Performance Evaluation 301

Learning Outcomes 301

7.1 Introduction 301

7.2 Performance evaluation 302

7.2.1 The profit and loss account 302

7.2.2 Return on capital employed 303

viii MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION P1 CONTENTS

2005.1

7.2.3 Asset turnover 303

7.2.4 Liquidity 304

7.3 Exercise 304

7.4 Understanding the business 306

7.5 Reporting a performance evaluation 306

7.6 Non-financial performance indicators 307

7.7 Benchmarking 310

7.8 The balanced scorecard 312

7.9 Performance evaluation in

the not-for-profit sector 313

7.10 Summary 315

Reading 317

Revision Questions 323

Solutions to Revision Questions 325

8 Developments in Management Accounting 331

Learning Outcomes 331

8.1 Introduction 331

8.2 The modern economic environment 331

8.2.1 Traditional production processes 331

8.2.2 The background to change 332

8.3 The new manufacturing 333

8.3.1 Computer-aided design 333

8.3.2 Computer-aided manufacturing 333

8.3.3 Computer-integrated manufacturing 334

8.3.4 Flexible manufacturing systems 334

8.4 The value chain 335

8.5 Production operations systems and management strategies 335

8.5.1 Material requirements planning 335

8.5.2 Manufacturing resources planning 336

8.5.3 Optimised production technology (OPT) 337

8.5.4 ERP, CRM and SCM 338

8.5.5 Just-in-time concept 339

8.6 Total quality management (TQM) 341

8.7 Synchronous manufacturing 343

8.8 The emphasis on continuous improvement 344

8.9 Activity-based costing 344

8.9.1 Traditional versus activity-based cost 344

8.10 Transaction analysis and cost drivers 346

8.11 Favourable conditions for ABC 348

8.12 Establishing an activity-based product cost 348

8.12.1 Comparison with traditional costing 348

8.12.2 Analysis of activities 349

8.12.3 Cost management and ABC 352

8.12.4 A comprehensive example of ABC 353

8.12.5 Variance analysis and ABC 362

MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION P1 ixCONTENTS

2005.1

8.13 Throughput accounting 363

8.13.1 The theory of constraints 363

8.13.2 Throughput accounting 364

8.13.3 Throughput cost control and effectiveness measures 367

8.13.4 Summary of throughput accounting 368

8.14 Backflush accounting 369

8.15 Summary 372

Readings 373

Revision Questions 387

Solutions to Revision Questions 393

9 Responsibility Centres and Transfer Pricing 409

Learning Outcomes 409

9.1 Introduction 409

9.2 Cost, Revenue, Profit and Investment Centres 410

9.2.1 Cost centres 410

9.2.2 Profit centres 411

9.2.3 Revenue centres and investment centres 411

9.2.4 Reporting responsibility centre results 412

9.3 Transfer pricing 412

9.3.1 Aims and features 413

9.3.2 General rules 413

9.3.3 Cost-based prices 414

9.3.4 Market-based prices 416

9.3.5 Marginal cost 419

9.3.6 Dual pricing 420

9.3.7 Profit-maximising transfer prices 420

9.3.8 Negotiated transfer prices 421

9.3.9 Other behavioural considerations 422

9.4 Taxation and other financial aspects of transfer pricing 423

9.4.1 Taxation 423

9.4.2 Repatriation of funds 426

9.4.3 Minority shareholders 427

9.5 Using subsidies to spread risk 427

9.6 Investment centres and performance measures 429

9.6.1 Investment centres/strategic business units 429

9.6.2 Return on investment 431

9.6.3 The problems with ROI 432

9.6.4 Residual income (RI) 434

9.6.5 Current thinking about performance metrics 435

9.7 Summary 437

Reading 439

Revision Questions 443

Solutions to Revision Questions 449

x MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION P1 CONTENTS

2005.1

Preparing for the Examination 461

Revision Questions 463

Solutions to Revision Questions 503

Index 557

May 2005 Exam

MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION P1 xi CONTENTS

2005.1

This Page Intentionally Left Blank

xiii 2005.1

The CIMA

Study System

Acknowledgements

Every effort has been made to contact the holders of copyright material, but if any here

have been inadvertently overlooked the publishers will be pleased to make the necessary

arrangements at the first opportunity.

How to use your CIMA Study System

This Performance Evaluation Study System has been devised as a resource for students attempt￾ing to pass their CIMA exams and provides:

a detailed explanation of all syllabus areas;

extensive ‘practical’ materials, including readings from relevant journals;

generous question practice, together with full solutions;

an exam preparation section, complete with exam standard questions and solutions.

This Study System has been designed with the needs of home-study and distance-learning

candidates in mind. Such students require very full coverage of the syllabus topics, and also

the facility to undertake extensive question practice. However, the Study System is also ideal

for fully taught courses.

The main body of the text is divided into a number of chapters, each of which is organ￾ised on the following pattern:

Detailed learning outcomes expected after your studies of the chapter are complete. You

should assimilate these before beginning detailed work on the chapter, so that you can

appreciate where your studies are leading.

Step-by-step topic coverage. This is the heart of each chapter, containing detailed explanatory

text supported where appropriate by worked examples and exercises. You should work

carefully through this section, ensuring that you understand the material being explained

and can tackle the examples and exercises successfully. Remember that in many cases

knowledge is cumulative: if you fail to digest earlier material thoroughly, you may strug￾gle to understand later chapters.

Readings and activities. Most chapters are illustrated by more practical elements, such as rel￾evant journal articles or other readings, together with comments and questions designed

to stimulate discussion.

Question practice. The test of how well you have learned the material is your ability to tackle

exam-standard questions. Make a serious attempt at producing your own answers, but at

this stage do not be too concerned about attempting the questions in exam conditions.

In particular, it is more important to absorb the material thoroughly by completing a full

solution than to observe the time limits that would apply in the actual exam.

Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an illusion to

think that this provides the same benefits as you would gain from a serious attempt of

your own. However, if you are struggling to get started on a question you should read the

introductory guidance provided at the beginning of the solution, and then make your

own attempt before referring back to the full solution.

Having worked through the chapters you are ready to begin your final preparations for

the examination. The final section of this CIMA Study System provides you with the guid￾ance you need. It includes the following features:

A brief guide to revision technique.

A note on the format of the examination. You should know what to expect when you

tackle the real exam, and in particular the number of questions to attempt, which ques￾tions are compulsory and which optional, and so on.

Guidance on how to tackle the examination itself.

A table mapping revision questions to the syllabus learning outcomes allowing you to

quickly identify questions by subject area.

Revision questions. These are of exam standard and should be tackled in exam condi￾tions, especially as regards the time allocation.

Solutions to the revision questions. As before, these indicate the length and the quality of

solution that would be expected of a well-prepared candidate.

If you work conscientiously through this CIMA Study System according to the guide￾lines above you will be giving yourself an excellent chance of exam success. Good luck with

your studies!

Guide to the Icons used within this Text

Key term or definition

Equation to learn

Exam tip to topic likely to appear in the exam

Exercise

Question

Solution

Comment or Note

xiv MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION P1 THE CIMA STUDY SYSTEM

2005.1