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## F5 Performance Management

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**The exam**Five compulsory questions: 20 marks each Time allowed: 3hours plus 15 minutes reading time Balance typically 50:50 between calculations and discussion aspects**The examiner’s key concerns**• Students need to be able to interpret any numbers they calculate and see the limitations of their financial analysis. • In particular financial performance indicators may give a limited perspective and NFPIs are often needed to see the full picture. • Questions will be practical and realistic, so will not dwell on unnecessary academic complications. • Many questions will be designed so discussion aspects can be attempted even if students have struggled with calculation aspects.**1. Advanced costing methods**ABC. Target costing. Lifecycle costing. Throughput accounting. Environmental Accounting**Activity Based Costing (ABC)**Steps Identify major activities. Identify appropriate cost drivers (note: you may have to justify your choice here in the exam). Collect costs into pools based upon the activities. Charge costs to units of production based on cost driver volume.**Activity Based Costing (ABC)**Cost driver rate = total driver pool cost cost driver volume**Advantages of ABC**• More realistic costs. • Better insight into cost drivers, resulting in better cost control. • Particularly useful where overhead costs are a significant proportion of total costs. • ABC recognises that overhead costs are not all related to production and sales volume. • ABC can be applied to all overhead costs, not just production overheads. • ABC can be used just as easily in service costing as in product costing.**Criticisms of ABC**It is impossible to allocate all overhead costs to specific activities. The choice of both activities and cost drivers might be inappropriate. ABC can be more complex to explain to the stakeholders of the costing exercise. The benefits obtained from ABC might not justify the costs.**Implications of ABC**Pricing - more realistic costs improve cost-plus pricing. Sales strategy - more realistic margins can help focus sales strategy. Decision making – for example, research and development can be directed at products with better margins.**Target Costing**Steps Estimate a market driven selling price for a new product. (E.g. to capture a required market share). Reduce this figure by the firm’s required level of profit. (E.g. based on target ROI). Produce a target cost figure for product designers to meet. Reduce costs to provide a product that meets that target cost.**Closing the target cost gap**Value analysis Focus is on reducing cost without compromising perceived value. Can labour savings be made? Can productivity be improved? What production volume is needed to achieve economies of scale?**Closing the target cost gap – cont.**Could cost savings be made by reviewing the supply chain? Can any materials be eliminated? Can a cheaper material be substituted without affecting quality? Can part-assembled components be bought in to save on assembly time? Can the incidence of the cost drivers be reduced?**Implications of target costing**Pricing – might identify sufficient cost savings to reduce the target price. Cost control – target cost motivates managers to find new ways of saving costs.**Lifecycle costing**Life cycle costing • Is the profiling of cost over a product’s life, including the pre-production stage. • Tracks and accumulates the actual costs and revenues attributable to each product from inception to abandonment. • Enables a product’s true profitability to be determined at the end of its economic life.**Implications of lifecycle costing**• Pricing decisions can be based on total lifecycle costs rather than simply the costs for the current period. • Decision making - a timetable of life cycle costs helps show what costs need to be recovered. • Control - Lifecycle costing reinforces the importance of tight control over locked-in costs, such as R&D. • Performance reporting - Life cycle costing costs to products over their entire life cycles, to aid comparison with product revenues generated in later periods.**Throughput**Background • Application of key factor analysis to production bottlenecks. • The only totally variable costs are the purchase cost of raw materials / components • Direct labour costs are not wholly variable.**Throughput**Multi-product decisions • Rank products by looking at the throughput per hour of bottleneck resource time • Throughput = Revenue – Raw Material Costs**Throughput**Throughput accounting ratio (TPAR) Throughput per hour of bottleneck resource Operating expenses per hour of bottleneck resource**Throughput**How to improve the TPAR • Increase the sales price to increase the throughput per unit. • Reduce total operating expenses, to reduce the cost per hour. • Improve productivity, reducing the time required to make each unit of product.**Break-even analysis**The Break-even chart Breakeven point: The point where total costs = total sales revenue and Where there is neither a profit or loss Breakeven Point Sales Revenue Total Costs £ Fixed Costs Output (units) B/E Point (units) = Fixed Costs Contribution per Unit Chapter 4**The Margin of Safety**The Margin of Safety represents the level by which output can fall before the organisation makes a loss Margin of safety Breakeven Output Budgeted Output Margin of Safety = Budgeted Output – Breakeven Output X 100% Budgeted Output Chapter 4**Contribution to Sales ratio**Contribution to Sales Ratio (C/S ratio) = (Contribution per unit) / Unit Sales Price Breakeven Point in Sales Value = Fixed Costs / C/S ratio Sales for a certain level of profit = Fixed Costs + Required Profit Contribution per Unit Chapter 4**Basic Breakeven chart**Sales Revenue Profit £’000 Breakeven point Total Costs 40 30 Loss Fixed Costs 20 0 10 20 40 50 60 70 30 Number of units Chapter 4**Contribution Breakeven chart**Sales Revenue Profit £’000 Breakeven point Contribution Total Costs Fixed Costs Loss Variable Costs 10 20 40 50 60 70 30 Number of units Chapter 4**TheProfit-Volume Chart**The profit-volume chart presents information in a way that clearly shows the change in the level of profit – using data from the previous data table: +£5000 Profit 0 Output 1000 1500 -£10000 Chapter 4 Page 30**2. CVP Analysis**Profit = (Contribution per unit x units) - Fixed Costs Contribution = Sales Value – All Variable Costs A product has a sales price of £20 and a variable cost of £10 per unit**Multi-product breakeven analysis**Fixed Costs BE Point (Revenue) = C/S Ratio Weighted Average C/S Ratio Fixed Costs = Required profit Required Revenue = Weighted Average C/S Ratio**Limitations/Assumptions of CVP**• Costs behaviour is assumed to be linear • Revenue is assumed to be linear • Volume Produced = Volume Sold • Ignores inflation • Assumes a constant sales mix Chapter 4**3.Planning with limited factors**Key factor analysis – one resource in short supply Linear Programming – two or more scarce resources**Key factor analysis**Calculate contribution per unit. Calculate contribution per unit of the limiting factor. Rank in order. Allocate resources – make first up to max demand, then second,...**Linear programming**Define variables Define the objective Set out constraints Draw graph showing constraints and identify the feasible region Identify optimal point Solve for optimal solution Answer the question**Linear programming**Assumptions • A single quantifiable objective. • Each product always uses the same quantity of the scarce resources per unit. • The contribution per unit is constant. • Products are independent – e.g. sell A not B. • The scenario is short term.**Linear programming**Slack • Slack is the amount by which a resource is under utilized. It will occur when the optimum point does not fall on the given resource line.**Linear programming**Shadow (or dual) prices • The extra contribution that results from having one extra unit of a scarce resource. • The max premium (i.e. over the normal cost) that the firm should be willing to pay for one extra unit of each constraint. • Non-critical constraints will have zero shadow prices as slack exists already.**Linear programming**Calculating dual prices Add one unit to the constraint concerned, while leaving the other critical constraint unchanged. Solve the revised equations to derive a new optimal solution. Calculate the revised optimal contribution. The increase is the shadow price**Linear programming**Range of applicability of dual prices • The dual price only applies as long as extra resources improve the optimal solution • i.e. the constraint line concerned moves out increasing the size of the feasible region and moving the optimal point. • Eventually other constraints become critical.**4. Pricing**Factors to consider when pricing. Calculation aspects. Pricing approaches.**Factors to consider when pricing**Costs Competitors Corporate objectives Customers**Calculation aspects**Price elasticity of demand (PED) • PED = % change in demand / % change in price. • PED >1 (elastic) revenue increases if the price is cut. • PED <1 (inelastic) revenue increases if the price is raised.**Calculation aspects**Equation of a straight line demand curve • P = a – bQ • “a” = the price at which demand would fall to zero • “b” = gradient = change in price/change in demand • Calculate “b” first**Calculation aspects**Equation of a cost curve • C = F + vQ • Volume based discounts**Pricing approaches**Cost plus pricing Price skimming Penetration pricing Linking pricing decisions for different products Volume discounts Price discrimination Relevant cost pricing**Cost plus pricing**Establish cost per unit – options include MC, TAC, prime cost Calculate price using target mark-up or margin Often used as a starting point even when using other methods**Cost plus pricing**Advantages • Widely used and accepted. • Simple to calculate if costs are known. • Selling price decision may be delegated to junior management. • Justification for price increases. • May encourage price stability.**Cost plus pricing**Disadvantages • Ignores link between price and demand. • No attempt to establish optimum price. • Which absorption method? • Does not guarantee profit • Which cost? • Inflexibility in pricing. • Circular reasoning.**Price skimming**Set a high initial price to ‘skim off’ customers who are willing to pay extra. Prices fall over time. Suitability?**Penetration pricing**Set a low initial price to gain market share If a high volume is achieved, the low price could be sustainable. Suitability?**Linking pricing decisions for different products**Basic idea: product A is cheap to attract customers who then also buy the higher margin product B. Key issue is the extent to which customer must buy the other products. Suitability?