ACCA F5

PERFORMANCE MANAGEMENT
COMPLETE SUBJECT NOTES
BY VERTEX LEARNING SOLUTIONS
VALID UNTIL SEP 2025
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 TABLE OF CONTENTS

CHAPTER TOPIC PAGE NO.

1 Activity-Based Costing (ABC) 3

2 Throughput Accounting 23

3 Target Costing 33

4 Lifecycle and Environmental Costing 42

5 Cost-volume profit analysis (CVP Analysis) 61

6 Planning with Limiting Factors 83

7 Pricing Decisions 98

8 Shadow Pricing 117

9 Relevant costing 122

10 Make or Buy Decisions 132

11 Shut Down Decision 139

12 Risk and Uncertainty 145

13A Quantitative techniques 162

13B Budgeting and Standard Costing 185

14 Basic Variance Analysis 202

15 Operational and Planning Variances 214

16 Mix and Yield Variances 225

17 Performance Measurement 235

18 Financial & Non-Financial Performance Measurement 243

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Chapter 1

Activity-Based Costing (ABC)

Development of Activity-Based Costing (ABC)

Reasons for ABC Development:

1. Change in Overhead Proportion:

 Past: Overheads were small compared to direct costs (labor, materials).
 Present: Overheads (e.g., machine depreciation) are a larger portion of total costs
due to increased machine usage.
2. Increased Product Complexity:
 Past: Simple or few similar products.
 Present: Greater product diversity and complexity, necessitating more precise
overhead allocation.

Comparison of ABC and Traditional Costing:

1. Overhead Allocation:
 Traditional Costing: Uses volume-based measures (e.g., labor hours, machine
hours) for overhead allocation.

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  ABC: Establishes cost pools for support activities (e.g., material handling) and
assigns costs directly to products using cost driver rates, avoiding
reapportionment of service department costs.

2. Absorption Methods:
 Traditional Costing: Absorbs overheads based on volume measures.
 ABC: Uses multiple cost drivers (e.g., number of orders) to allocate overheads,
reflecting the actual consumption of resources.
3. Cost Drivers:
 Traditional Costing: May allocate costs in arbitrary ways, leading to less accurate
product costs.
 ABC: Identifies and uses cost drivers to trace costs more accurately to products.

Steps to Calculate Full Production Cost Using ABC:

1. Identify Major Activities: Group overheads into cost pools based on activities.
2. Identify Cost Drivers: Determine factors that drive the costs for each activity.
3. Calculate Cost Driver Rates: Compute rates by dividing activity costs by total cost driver
volumes.
4. Absorb Activity Costs: Allocate activity costs to products based on their use of each
activity.
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 5. Calculate Full Production Cost/Profit: Determine unit costs and/or total production cost
and profit or loss.

ABC provides a more accurate product costing by using multiple cost drivers and detailed activity
analysis, addressing limitations in traditional volume-based costing systems.

Example:
Saturn, a chocolate manufacturer, produces three products:

 The Sky Bar, a bar of solid milk chocolate.

 The Moon Egg, a fondant filled milk chocolate egg.
 The Sun Bar, a biscuit and nougat-based chocolate bar.

Information relating to each of the products is as follows:

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Required:

Using ABC, calculate the full production cost per unit and the profit per unit for each product.
Comment on the implications of the figures calculated.

Solution:
Step 1: Group production overheads into activities, according to how they are driven.

This has been done above. The $80,000 production overhead was split into four different
activities (cost pools).

Step 2: Identify cost drivers for each activity, i.e. what causes these activity costs to be incurred.

Activity Cost Driver

Machining costs Number of machine hours

Component costs Number of components
Set-up costs Number of set-ups
Packing costs Number of customer orders

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Step 3: Calculate an OAR for each activity

Step 4: Absorb the activity costs into the product

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Step 5: Calculate the full production cost and the profit or loss, using Activity-Based Costing.

When comparing the results of absorption costing and ABC, the Sky Bar is slightly more profitable.
The real surprise is the results for the Moon Egg and the Sun Bar. The Moon Egg is now profitable
and the Sun Bar is now loss making. This is because the production overheads have been
absorbed in a more accurate way.

For example:

 There are twenty components in a Sun Bar, compared with only six in a Moon Egg. It is
therefore fair that the Sun Bar receives more of the component cost.
 There are only four orders for the Moon Eggs but twenty-five for the Sun Bar. It is
therefore fair that the Sun Bar receives more of the packing costs.

ABC absorbs overheads more accurately and should therefore result in better decision making.
The managers at Saturn should be concerned about the Sun Bar and not the Moon Egg, as was
previously thought. They will now have to decide if it is possible to control the Sun Bar costs
and/or increase the selling price. If not, they may decide to stop selling the product.

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Advantages and Disadvantages of ABC (Activity-Based Costing)

Advantages:

 Accurate Costing: Provides a precise cost per unit, enhancing pricing, sales strategies,
performance management, and decision-making.
 Insight into Overheads: Offers a better understanding of what drives overhead costs.
 Overhead Cost Awareness: Recognizes that overhead costs aren't solely related to
production and sales volume.
 Management of Overheads: Helps in managing significant overhead costs by
understanding and controlling cost drivers.
 Complex Business Environments: Useful in deriving realistic costs in complex settings.
 Broad Application: Applicable to all overhead costs, not just production overheads.
 Versatility: Equally effective in service and product costing.

Disadvantages:

 Limited Benefit: Less useful if overhead costs are mainly volume-related or if overhead
constitutes a small portion of total costs.
 Cost Allocation Challenges: Difficult to allocate all overhead costs to specific activities.
 Choice of Drivers: Risk of inappropriate selection of activities and cost drivers.
 Complexity: More challenging to explain to stakeholders compared to traditional costing
methods.
 Cost vs. Benefit: The benefits may not always justify the costs, and ABC might not provide
significantly different insights compared to traditional absorption costing.

ABC in the Public Sector

Background:

 Pressure for Efficiency: Governments are demanding more services for less money and
greater transparency from the public sector.

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  Need for Cost Control: Public sector organizations must identify, allocate, and control
costs more effectively.

Reasons for Introducing ABC:

 Public Responsibility: Tight control of running costs is essential when government

resources are limited.
 Public Accountability: Organizations need to demonstrate wise use of taxpayer money.
 Resource Allocation: Ensures equitable distribution of resources and addresses concerns
about resource allocation fairness.
 Managerial Awareness: Helps managers understand the actual cost of services to make
informed decisions about cuts.

Resistance to ABC:

 Measurement Challenges: Requires measuring resource use, often through timesheets,

which can be challenging to implement.
 Cultural Change: Adopting ABC necessitates a cultural shift in how costs and resources
are recorded and managed in the public sector.

Throughput Accounting – Background

Modern Manufacturing Techniques

Total Quality Management (TQM)

Overview:

 TQM is a management approach aimed at producing high-quality goods and services.

 Originated in Japanese organizations and has contributed to their global success.

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Fundamental Features:

 Prevention of Errors: Focus on preventing errors before they occur.

 Total Quality Design: Emphasis on quality in the design of systems and products.
 Employee Participation: Involves real participation from all employees.
 Senior Management Commitment: Strong commitment from top management.
 Customer and Supplier Role: Recognizes the importance of customers and suppliers.
 Continual Improvement: Ongoing effort to improve quality.

Just-In-Time (JIT)

Overview:

 JIT is a production system based on responding to customer demand and producing goods
only when needed.
 Aims to eliminate large inventories of materials and finished goods.

Key Characteristics:

 High Quality: Often implemented through TQM systems.

 Speed: Ensures rapid production to meet customer needs.
 Reliability: Utilizes computer-aided manufacturing technology.
 Flexibility: Employs small batch sizes and automated techniques.
 Low Costs: Achieved through the above characteristics.

Features of JIT and TQM Environment:

 High Automation: Significant automation levels.

 High Overheads, Low Direct Labour: Elevated overheads with reduced direct labor costs.
 Customized Products: Produced in small batches.
 Low Stocks: Minimal inventory levels.
 Emphasis on Quality: Focus on high quality and continuous improvement.

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Throughput Accounting

Overview:

 Throughput accounting focuses on optimizing the use of a bottleneck resource to

maximize profitability.
 Useful in JIT environments where resource constraints are common.

Main Assumptions:

 Variable Costs: Only the purchase cost of raw materials is considered variable in the short
term.
 Direct Labour Costs: Generally fixed in the short term, often salaried or guaranteed a
minimum wage.
 Throughput = Contribution: Throughput is essentially the same as contribution margin.

Calculating Throughput:

 Formula: Throughput = Sales Revenue – Direct Material Cost.

 Objective: Maximize throughput while minimizing operating expenses and inventory.

Steps in Throughput Accounting:

1. Identify Bottlenecks:
 Find which stage of the production process limits output.
 Example: For Rad Sneakers Ltd (RS), the assembly division is the bottleneck.
2. Exploit Bottlenecks:
 Optimize the use of the bottleneck resource to maximize output.
 RS should focus on producing the most profitable products within the capacity of
the assembly division.
3. Subordinate Everything Else:
 Align all activities to support the strategy for the bottleneck.

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  Ensure that non-bottleneck activities match the production needs of the
bottleneck resource.
4. Elevate Bottlenecks:
 Take actions to eliminate the bottleneck, such as investing in additional resources.
 Example: RS could purchase an additional assembly machine to increase capacity.
5. Repeat the Process:
 After eliminating one bottleneck, identify and address the next bottleneck.
 RS should revisit the process as new constraints emerge, such as the maximum
demand.

Example:

Hard Tiles recorded a profit of $120,000 in the accounting period just ended, using marginal
costing. The contribution/sales ratio was 75%.

Material costs were 10% of sales value and there were no other variable production overhead
costs. Fixed costs in the period were $300,000.

Required:

What was the value of throughput in the period?

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The Throughput Accounting Ratio

When there is a bottleneck resource, performance can be measured in terms of throughput for
each unit of bottleneck resource consumed. There are three inter-related ratios:

Note: The total factory cost is the fixed production cost, including labour. The total factory cost
may be referred to as 'operating expenses'. These are production/factory costs only. In the exam,
watch if questions include costs not related to production (e.g. marketing), which wouldn't be
included in the ratio.

Interpretation of TPAR (Throughput Accounting Ratio)

TPAR Interpretation:

 TPAR > 1: Indicates that throughput exceeds operating costs. This suggests that the
product or process is profitable and should make a profit. Priority should be given to
products or processes with the highest TPAR ratios, as they are the most beneficial in
terms of throughput relative to operating costs.
 TPAR < 1: Indicates that throughput is insufficient to cover operating costs. This suggests
that the product or process is operating at a loss, and it would not be advisable to
prioritize or continue with such products or processes.

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Decision-Making in Throughput Accounting:

Ranking Products on the Same Production Line:

Use the return per hour figures to rank products. This approach is straightforward when
comparing products that are produced on the same line, as it directly measures the profitability
of each product in terms of throughput efficiency.

Ranking Products or Divisions Across the Company:

Use TPAR figures for comparison. TPAR is useful for reflecting differences in costs between
different factories or divisions, as it considers both throughput and operating costs, providing a
more comprehensive view of profitability across diverse operations.

Criticisms of TPAR:

Short-Term Focus:

TPAR primarily addresses short-term scenarios where resources are fixed (e.g., a bottleneck) and
operating expenses are largely fixed. This short-term focus can be limiting, as businesses often
need to consider longer-term factors and overall resource flexibility.

Long-Term Applicability:

Applying throughput accounting concepts to the long term can be challenging, especially when
all costs are variable and change with production volume or other cost drivers. TPAR might not
capture the full picture of long-term costs and benefits, making it necessary to consider other
approaches.

ABC Approach for Long-Term Performance:

In the long term, an Activity-Based Costing (ABC) approach might be more suitable for measuring
and controlling performance. ABC accounts for all overhead costs and can provide a more
detailed view of cost drivers and profitability over time.

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By understanding these aspects of TPAR and its limitations, businesses can make more informed
decisions about product profitability and resource allocation, both in the short and long term.

Example:
A business manufactures a single product that it sells for $10 per unit. The materials cost for each
unit of product sold is $3. Total operating expenses are $50,000 each month.

Labor hours are limited to 20,000 hours each month. Each unit of product takes 2 hours to
assemble.

Required:

Calculate the throughput accounting ratio (TPAR).

Solution

 Throughput per factory (assembly) hour = $(10 – 3)/2 hours = $3.50

 Cost per factory hour = $50,000/20,000 hours = $2.50

Note: The operating expenses of $50,000 are the total factory cost.

 Throughput accounting ratio = $3.50/$2.50 = 1.40

Improving the TPAR (Throughput Accounting Ratio)

Options to Increase TPAR:

1. Increase Sales Price per Unit:

 Objective: Raise the throughput per unit by increasing the sales price.
 Impact: This directly boosts throughput, as throughput is defined as sales revenue
minus direct material cost. By charging more per unit, the revenue from each sale
increases, enhancing the TPAR.
2. Reduce Material Costs per Unit:
 Objective: Lower the direct material cost per unit by finding cheaper materials or
suppliers.

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  Impact: Reducing material costs increases throughput per unit since throughput
is calculated as sales revenue minus direct material costs. Lower material costs
improve the ratio by increasing the difference between revenue and costs.
3. Reduce Total Operating Expenses:
 Objective: Lower the overall operating expenses to reduce the cost per factory
hour.
 Impact: Decreasing operating expenses reduces the denominator in the TPAR
calculation, thereby increasing the TPAR. This can be achieved through cost-saving
measures, efficiency improvements, or eliminating unnecessary overheads.
4. Improve Productivity of the Bottleneck:
 Objective: Enhance the efficiency of the bottleneck resource (e.g., assembly
workforce or machinery) to reduce the time required to produce each unit.
 Impact: By improving productivity, more units are produced per factory hour,
which increases the throughput per factory hour. This improvement can lead to a
higher TPAR by effectively using the bottleneck resource.

Example:

Suppose in the illustration above the following changes were made:

 The sales price was increased from $10 to $13.5

 The time taken to make each product fell from 2 hours to 1.75 hours
 The operating expenses fell from $50,000 to $45,000.

The following changes would take place:

Throughput per factory hour = $(13.5 – 3)/1.75 hours = $6.0

Cost per factory hour = $45,000/20,000 hours = $2.25

TPAR = $6.0/$2.25 = 2.67

The TPAR would nearly double, increasing from 1.4 to 2.67.

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