P 2 Study Notes - Area A

Syllabus Area A - 25%Cost Analysis/TQM/Learning Curve/ABC Activity based management uses activity based cost information for a variety of purposes including cost reduction, cost modelling and customer profitability analysisABC Hierarchy of activities:Unit level - ABC adapts variances such as materials usage/material price variance to establish responsibilityBatch level activities - resources consumed in no of batches rather than units.Product Sustaining activities - product specific activities eg: stepped costs (advertising) Facility Sustaining activities - simply relate to "being in business" eg: building maintenance, securityABM includes cost reduction, product design decisions, operational control and performance evaluation (and more) - does not specifically include variane analysisKaizen Costing - used for cost reduction, not cost control. Assumes continuous improvement, targets set and applied monthlyTQM - aims to eliminate the costs of poor qualityJust in Time - Problems Makes an organisation more vulnerable to disruption in the supply chain ( out of stock could be fatal @ hospital) Wide geographical spread makes JIT difficult JIT not always suitable, may be hard to predict patterns of demand Manufacturing Cost Hierarchy Product/process level Organisation/facility level Batch level Unit level Theory of Constraints (approach to production management) - focuses of factors such as bottlenecks that act as a constraint on Material & variable costs - therefore maximise salesPricingPED (Price Elasticity of Demand) = % change in demand % change in priceLess than 1 = Inelastic (vertical demand curve) - not sensitive to price changeMore than 1 = Elastic (horizontal demand curve) - sensitive to price changePrice Function & Profit MaximisationP = a - bQP = Pricea = Price at which demand is zerob = gradient of demand curveQ = Quantity sold at the price (P)Maximum demand will occur when the price is zeroProfit is maximised when MR = MC (Marginal cost, is the cost of producing one more unit)Marginal Revenue - extra revenue received by the sale of one more unitMR = a - 2bQ Learning CurveConditions requiredProduction process should be labour intensive, with direct involvement from labour forceProduction process should be complex to allow scope for learning (long time to produce 1st batch = complex)Production process should be continuous, with no prolonged stoppage timesLow turnover of production labour - allow learning theory to develop and improveStudy NotesMoving from one single cost pool to overheads based on machine hours - ABC would highlight that " High volume products have too much overheads in them "Finance Salaries - Batch level activityThroughput Accounting RatioThroughput Contribution per hour : Conversion cost per hourLean Philosophy - would not include the Centralization of Management decision making Mixed Bank 5 NotesCost Driver = a factor which causes the costs of an activityTarget Costing focuses on costs at the development stageTarget costing - selling price is determined as a competitive market priceKaizen costing is applied during the manufacturing stage Interest costs on bank loans are a relevant cash flow in decision makingFinance costs are not included in the relevant cash flow, they will form part of the calculations for an appropriate discount rate.Syllabus Area B - 30% - Control & Performance Management of Responsibility CentresPerformance Management & Transfer PricingRelevant costing/Beyond Budgeting/Performance ManagementReturn on Capital Employed (ROCE)= PBIT * 100%Capital EmployedOrReturn on Capital Employed (ROCE)= Profit Margin * Asset TunroverCapital employed - debt & equity (share capital & reserves & long term debt from SOFP)Asset Turnover : Sales/Turnover Capital EmployedTwo Part tariff Pricing**********Relevant CostingA future incremental cash flow, arising as a direct consequence of a decision madeRelevant CostsOpportunity costProduct specific fixed costsNon - Relevant costsSunk or historicalCommittedNotionalCommonGeneral fixed costsQualitative information - cannot be easily expressed in the form of numbers, information hard to quantify - opinions, customer/supplier perceptionsQuantitative information - can be easily expressed in the form of numbers - absolute measures, relative %, ratios Management Control SystemsFeed-forward control - proactive A system that reacts in a pre-emptive way to changes in its environment React to future performance expected - make control adjustments in advance Examples, forecasting, cash budgeting, strategic planning Feedback control - reactionary part of the system output is measured and returned as input to regulate the systems further output involves gathering information on past performance and comparing it to a predetermined or standard plan Examples, comparing actual performance to standard performance, can be -ve (adverse) or +ve (favorable) - "closing the stable door after the horse has bolted" Open & Closed loop control systemsComponents: High level controller - Human Effector - either an automatic or human action to correct future undesired outcomes (exception reporting involved where adverse differences between actual and expected results are reviewed) Input - Data Process - Calculate, sort amend Sensor - detects information it is programmed to find, collects and measures data Comparator - compares actual results to standard (costs,productivity or quality) Output - Information Open loop Control (double feedback loop) System - corrective action is not automatically taken, environmental and internal feedback considered before control action is taken.Closed loop Control (single feedback loop) System - output automatically compared to a pre-determined standard, any exceptions and control action taken automatically.These systems are generally relative to People and performance (sales target systems) and Managing resources efficiently & effectively (stock control).Operating Gear - measures the effect of fixed costs on operating profit IF SALES FALL - fixed costs remain and the business may not be able to contract their fixed costs eg: 10 year lease agreement IF SALES RISE - fixed costs remain and the business will have spare capacity to meet fixed costs and therefore increase operating profit eg: 10 year lease Beyond BudgetingPRIME (main purpose of budgeting)P = PlanningR = Resource utilization or responsibility accountingI = Integration or CoordinationM = MotivationE = EvaluationGoal Congruence = making your organisation or business objectives aligned with the personal objectives of a manager or staff memberBudgetary slack/padding - the intentional over estimation of costs and/or under estimation of revenue in a budgetControl-ability Principle - assessing performance based upon measures that can be controlled only by a manager (omitting items which are uncontrollable) eg: Head office overheadsResponsibility Accounting - separating revenues and/or costs into areas of personal responsibility to assess he individual performance of a manager.Beyond Budgeting is a philosophy that traditional budgeting methods are of little use to management, ZBB and ABB are more modern methods.Modern methods of alleviating traditional budgeting: ABC Key metrics or Performance indicators - KPI's are important measures used to asses performance Balance scorecard (approach to performance assessment) Total Quality Management Value and non-value added analysis De-centralization of decisions (more empowerment) Critical Success Factors (CSFs) - operational goals that if achieved, the business will be successful. Johnson & Scholes "those components of strategy where the organisation must excel to outperform competition"Balance Scorecard - views an organisation from 4 perspectives to develop metricsCustomer - what must we do right for our customers? what do they value?Internal - what must we improve internally to satisfy shareholders and customers?Innovation & Learning - how can we innovate and improve value?Financial - how do we satisfy shareholders and create value for them?Study NotesSyllabus Area C - 30%Long Term Decision MakingPayback/ARR/NPV/IRR/Captial RationingPayback - how quickly a project takes to pay itself back(DAD - short-term, ignores time value of money)Discounted Payback - method applied to the PV of cash flows after discounting - AD in relation to paybackAccounting Rate of Return - Profit over the life of the project as a % of the initial investment(DAD - ignores time value of money, relative figure %)NPV - discounts to today's value all future cash flows of a project(AD - includes time value of money, an absolute measure, uses relevant costing)(DAD - cash flow occurs at end of year, only looks at financial costs and benefits)NPV subject to inflation - when calculating would use Discount actual (nominal) cash flows at money discount rates Discount real cash flows at real discount rates Inflation (1+M) = (1+R) * (1+I)M = money cost of capitalR = real cost of moneyI = General rate of inflationTaxation - tax on profits paid 50% in T1 and then 50% in T2Capital Allowances - when asset is bought 50% received in T1 and remaining 50% in T2IRR - cost of capital that would give a project zero NPV(AD - includes time value for money, uses relevant costing DAD - may have multiple IRR's for 1 project, confused with ARR or ROCE)An investment should be accepted if the internal rate is greater that the cost of capital. When selecting among several projects, the IRR would be calculated for each and the projects ranked by their rates of returnIRR - makes no allowance for the size of the initial investment- ignores the length of the investment period- does not necessarily reflect the impact on shareholder wealthStudy NotesDiscounted Payback involves applying a discount rate to cash flowsReplacement Theory - compares 2 products with different timescalesFor Investment Appraisal decisions the payback period = considers all cash flows received in earlier years have more valueCost of Capital DecreasesNPV - IncreasesIRR - Remains constantPayback - Remains constantROI Calculation - does not include Sales Revenue - will include margin, divisional income & earnings per shareROI shows - How effectively a company used its invested CapitalPayback Period = Net returns to recover original investment Before Depreciation but After TaxationNB: Taxation is a Cash-flow, Depreciation is not a Cash-flow.Mixed Bank 12To what does the internal rate of return equate the present value of expected future net cash receipts = Initial cost of the investment outlayNB: The internal rate of return is therefore the rate of return at which the project's NPV is zeroManagement Control & Risk - 15%RiskRisk Hedging - taking action to offset one risk by incurring a new risk in the opposite directionRisk Pooling/Diversification - the management of a portfolio of different risksInsurance = appropriate risk hedging strategy when potential cost is high, but likelihood of an adverse outcome is lowWhen the frequency is high, internal measures required to manage risk are appropriateRisk AverseA risk averse investor is an investor who prefers lower returns with known risks rather than higher returns with unknown risks.Definition: A risk averse investor is an investor who prefers lower returns with known risks rather than higher returns with unknown risks. In other words, among various investments giving the same return with different level of risks, this investor always prefers the alternative with least interest.Description: A risk averse investor avoids risks. S/he stays away from high-risk investments and prefers investments which provide a sure shot return. Such investors like to invest in government bonds, debentures and index fundsStudy NotesProduct Life CycleIntroduction Stage - Brand Awareness - Establish a Market & build demandGrowth Stage - Build Brand or Consumer preference, by stepping up advertising (marketing) - Increase salesMaturity Stage - Concentrate on differentiating from competing products - Build brand loyalty - Maintain market share & extend product life-cycle - Offer incentives to entice competitors consumers to switchDecline Stage - Promotional expenditure reduced - Reinforce brand image of remaining productsBeyond budgeting - Adaptive proceduresMarket Price/Market based Price used when: - Variable costs & market prices are constant - When a perfect external market exists Value of Perfect information - Best project in market conditions - Calculate expected net cash inflow/profit - Expected value - Deduct project with highest EV = value of Perfect informationNB - take max figure by probability, add together, subtract from EV calculatedAsset Replacement Policy - annual cash-flows are the running costs less any income from the sale of the asset @ year endTake PV of the net cash-flows to give PV of costs over replacement cycleCost of capital/Discount rate then used on a cumulative basis to determine the equivalent annual PV of the costProbability = %Expected value = Probability * AmountEvaluation of any system - 2 recurring terms are efficiency and effectiveness They are 2 key reasons for the introduction of information systems AMT = Advanced Manufacturing TechnologyFMCG = Fast Moving Consumer Goods Residual Income = Profit - Cost of CapitalDual Pricing - Buyer gets market price - Seller gets marginal cost