Advanced Management Accounting Nathi Thela CIMA Paper P2
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. 1
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% 2
1 Session Activity Based Costing 3
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. 4
Session Content Method Cost Background Classification Pareto Benefits and ABC Analysis Limitations DPP ABM CPA 5
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. 6
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: 7
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. 8
Absorption Costing Service Production Product Departments Departments Lines Stage 1 Stage 2 Assigning Costs Allocating Costs Using Measures of Using a Measure of Service Usage Volume 9
Activity Based Costing Service Departments Activity Cost Product and Factory Overhead Pools Lines Stage 1 Stage 2 Assigning Costs of Allocation of Costs Individual Activities Driver Rates 10
ABC Procedure • Support activities cause costs • The products consume these activities • Cost should be charged on the basis of consumption of the activities 11
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. 12
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. 13
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. 14
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. 15
Class Example – pg. 7 • Difference between Absorption Costing and ABC 16
ABC Method Costs are driven by, and are variable with respect to, activities that occur at four levels: 17
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. 18
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. 19
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. 20
Applications of ABC DPP CPA ABM • Retail org’ns • Service org’ns • Using ABC information • Directly • Consumption for cost attributable of activities management costs 21
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. 22
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. 23
Class Example – pg. 39 • Objective Test Question 3: Direct Product Profitability 24
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 Analysi s 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. 25
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