Advanced Management Accounting

Nathi Thela

CIMA Paper P2

1

Format of the Paper

Fundamentals of Objective Tests

The Objective Tests are 90-minute assessments

comprising 60 compulsory questions, with one or more

parts. There will be no choice and all questions should be

attempted.

2

Core Areas of Syllabus

A. Cost planning and analysis 30%

for competitive advantage

B. Control and Performance Management

of Responsibility Centres 20%

C. Long-term decision making 30%

D. Management control and risk 20%

3

1SessionActivity Based

Costing

4

ABC Learning Outcome

Lead A: Evaluate techniques for analysing and managing costs

for competitive advantage

Component A1a): Evaluate activity-based management

• Activity-based costing to derive 'long-run' costs appropriate for use in decision-

making.

• Activity-based management and its uses in improving the efficiency of repetitive

overhead activities.

• Direct and activity-based cost methods in tracing costs to 'cost objects' such as

customers or distribution channels, and the comparison of such costs with

appropriate revenues to establish 'tiered' contribution levels, as in the activity-based

cost hierarchy.

• Direct customer profitability and distribution channel profitability.

5

Session Content

ABC

Background

Pareto

Analysis

ABMCPA

Benefits and

Limitations

DPP

Cost

Classification

Method

6

Activity Based Costing (ABC)

Problems of Traditional Costing Methods

• the largest cost of production is indirect overheads but these are categorised together in one

figure that lacks detail and is not useful to management

• because management does not know what the components are of the largest production

cost (indirect overheads) they cannot implement proper cost control

• the costs are often allocated between products on the basis of direct labour hours – despite

the fact that direct labour is becoming a smaller proportion of product costs and does not fairly

reflect the relationship between the products and the indirect overheads

• because costs are inappropriately or inaccurately shared between products it means that

the total production cost can be wrong which can lead to poor pricing and production decisions

• Activity based costing (ABC) has been developed to solve the problems that

traditional costing methods create in these modern environments.

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Activity Based Costing (ABC)

Modern Production Environment

• Modern producers have changed the way that they produce so that they

have:

- much more machinery and computerised manufacturing systems

- smaller batch sizes

- less use of 'direct' labour

• This has had the following impact on production costs:

- more indirect overheads (for example, insurance and depreciation of the

machines and computers

- less direct labour costs

• This means that the traditional methods of costing (marginal and

absorption) produce standard cost cards that are less useful due to

inaccurate product costs:

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Activity Based Costing (ABC)

• Absorption costing- Charges overheads to products based on a hourly absorption rate

• ABC- Is an alternative approach to product costing. It is a form of absorption

costing, does not absorb overhead on the basis of volume but it

breaks down overheads into cost pools before absorbing them using

cost drivers.

- A cost pool is an activity that consumes resources and for which

overhead costs are identified and allocated. For each cost pool, there

should be a cost driver.

- A cost driver is a unit of activity that consumes resources. An

alternative definition of a cost driver is a factor influencing the level of

cost.

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Absorption Costing

Service

Departments

Production

Departments

Product

Lines

Stage 1 Stage 2

Assigning Costs

Using Measures of

Service Usage

Allocating Costs

Using a Measure of

Volume

10

Activity Based Costing

Service Departments

and Factory Overhead

Activity Cost

Pools

Assigning Costs of

Individual Activities

Allocation of Costs

Driver Rates

Stage 1 Stage 2

Product

Lines

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ABC Procedure

• Support activities cause costs

• The products consume these activities

• Cost should be charged on the basis of consumption of

the activities

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Favourable Conditions For ABC

When is relevant?

- Production overheads are high relative to direct

costs.

- Diversity in the product range.

- Diversity of overhead resource input to products.

- Consumption of overhead resources is not driven

primarily by volume.

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Benefits of ABC

- More accurate product line costs.

- More flexible the approach can analyse costs by processes,

areas of managerial responsibility and customers.

- ABC avoids the problem of cost absorption on an

inappropriate basis.

- Provides a reliable indication of long-run variable product

cost.

- Provides meaningful financial (periodic cost driver rates)

and non-financial (periodic cost driver volumes) measures.

- Improves cost estimation by accurate identification and

understanding of cost behaviour.

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Limitations

- ABC information is historic and internally orientated and

therefore lacks direct relevance for future strategic decisions.

- Practical problems such as cost driver selection.

- More expensive than traditional absorption costing as it

requires more detailed information and analysis.

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Calculating the full production cost per unit using ABC

• Step 1: Group production overheads into activities,

according to how they are driven.

• Step 2: Identify cost drivers for each activity, i.e. what

causes these activity costs to be incurred.

• Step 3: Calculate a cost driver rate for each activity.

• Step 4: Absorb the activity costs into the product.

• Step 5:Calculate the full production cost and/ or the profit or

loss.

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Class Example – pg. 7

• Difference between Absorption Costing and ABC

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ABC Method

Costs are driven by, and are variable with respect to,

activities that occur at four levels:

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ABC and Decision Making

ABC systems are primarily designed to furnish management with cost

information relating to an organisation's products.

ABC information is useful beyond what its been traditionally used for.

its values lies in greater accuracy attaching to product costing, which

in turn increases the degree of reliability of cost information used for

the above purposes.

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ABM

• CIMA definition:

‘System of management which uses activity-based cost information for a

variety of purposes including cost reduction, cost modelling and customer

profitability analysis.’

ABM is simply using the information derived from an ABC analysis for cost

management. ABM seeks to classify each activity within a process as a

value-added or non-value-added activity. Non-value-added activities are

unnecessary and represent waste. The aim should be to eliminate them.

For example, time spent dealing with customer complaints is wasted time,

but cannot be reduced until the customers have nothing to complain

about!

ABM will not reduce costs, it will only help the manager understand costs

better.

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ABM

• Outputs from the ABM Information System

ABM can be used in assessing strategic decisions such as:

• whether to continue with a particular activity

• how cost structures measure up to those of competitors

• how changes in activities and components affect the suppliers and value chain.

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Applications of ABC

DPP CPA

• Retail org’ns

• Directly

attributable

costs

• Service org’ns

• Consumption

of activities

ABM

• Using ABC

information

for cost

management

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Direct Product Profitability

Direct Product Profitability is defined in CIMA's Official Terminology as

'used primarily within the retail sector...DPP involves the attribution of

both the purchase price and other indirect costs (for example distribution,

warehousing and retailing to each product line. Thus a net profit, as

opposed to a gross profit, can be identified for each product. The cost

attribution process utilises a variety of measures (for example

warehousing space and transport time) to reflect the resource

consumption of individual products').

In the Retail industry, Gross Margin was relied upon. Why is it meaningless?

• none of the costs generated by the retail organisation itself are included in its

calculation i.e. storage costs of the different goods and these costs vary

considerably from one good to another

• A method was needed which related the indirect costs to the goods according

to the way the goods used or created these costs.

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Direct Product Profitability

The Benefits of DPP, are summarized as follows:

• Better cost analysis;

• Better pricing decisions;

• Better management of store and warehouse space;

• The rationalisation of product ranges;

• Better merchandising decisions.

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Class Example – pg. 39

• Objective Test Question 3: Direct Product Profitability

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Customer Profitability Analysis

In many organisations, it is just as important to cost customers as it is to

cost products. Different customers or groups of customers differ in their

profitability.

Customers use some activities but not all, and different groups of customers have

different ‘activity profiles’.

Customer Profitability Analysis defined in CIMA's Official Terminology as 'the

analysis of revenue streams and service costs associated with specific customers

or customer groups').

Service organisations such as a bank or a hotel in particular need to cost

customers.

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Customer Profitability Analysis

A bank’s activities for a customer will include the following types of

activities:

• Withdrawal of cash;

• Unauthorised overdraft;

• Request for a statement;

• Stopping a cheque;

• Returning a cheque because of insufficient funds.

Different customers or categories of customers will each use different amounts of

these activities and so customer profitability profiles can be built up, and

customers can be charged according to the cost to serve them.

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Problems with Implementing ABC/ABM

Why is still not widely used?• they do not agree on its usefulness or cost effectiveness in terms of costs and

benefits

• It requires considerable time and effort.

PARETO Analysis

Pareto analysis is based on the 80:20 rule that was a phenomenon first observed

by Vilfredo Pareto, a nineteenth century Italian economist. He noticed that 80 per

cent of the wealth of Milan was owned by 20 per cent of its citizens:

• The management accountant can use it in a number of different circumstances

to help direct management’s attention to the key control mechanisms or

planning aspects.

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PARETO Analysis

Procedure

(1) Rank the data in descending order.

(2) Find each figure as a percentage of the total.

(3) Turn this into a cumulative percentage.

(4) It is possible to draw a diagram to illustrate the principle, e.g. a

component bar chart or a cumulative frequency graph.

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Class Example – pg. 33 & 34

• Pareto Analysis and Charts

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Activity based budgeting (ABB)

Activity based budgeting• A method of budgeting which uses cost driver information to analyse data

• May involve preparing an activity matrix

• General overhead are not activity-driven

Example

• The cost driver for each activity is identified. A forecast is made of the number of units of the cost driver that will occur in the budget period.

• Given the estimate of the activity level for the cost driver, the activity cost is estimated. Where appropriate, a cost per unit of activity is calculated.