F5 Revision Notes Final

The global body for professional accountants About us Contact us Find an accountant Technical activities Help & support
es Help & support Global 
Search...  Apply now myACCA 
Learning Professional
Home Our qualifications Employers Members Students
providers insights
Home > Students > Study resources F5 Performance Management > Technical articles
THE LEARNING RATE AND LEARNING EFFECT
RELATED LINKS
Student Accountant hub
The purpose of this article is twofold: first, it is to summarise the history of the learning curve effect and
help candidates understand why it is important. Second, it is to look at what past learning curve
questions have required of candidates and to clarify how future questions may go beyond this.
A BRIEF HISTORY OF THE LEARNING CURVE
In practice, it is often found that the resources required to make a product decrease as production
volumes increase. It costs more to produce the first unit of a product than it does to produce the one
hundredth unit. In part, this is due to economies of scale since costs usually fall when products are made
on a larger scale. This may be due to bulk quantity discounts received from suppliers, for example. The
learning curve, effect, however, is not about this; it is not about cost reduction. It is a human phenomenon
that occurs because of the fact that people get quicker at performing repetitive tasks once they have
been doing them for a while. The first time a new process is performed, the workers are unfamiliar with it
since the process is untried. As the process is repeated, however, the workers become more familiar with
it and better at performing it. This means that it takes them less time to complete it.
The first reported observation of the learning curve goes as far back as 1925 when aircraft manufacturers
observed that the number of man hours taken to assemble planes decreased as more planes were
produced. TP Wright subsequently established from his research of the aircraft industry in the 1920s and
1930s that the rate at which learning took place was not random at all and that it was actually possible to
accurately predict how much labour time would be required to build planes in the future. During World
War II, US government contractors then used the learning curve to predict cost and time for ship and
plane construction. Gradually, private sector companies also adopted it after the war.
The specific learning curve effect identified by Wright was that the cumulative average time per unit
decreased by a fixed percentage each time cumulative output doubled. While in the aircraft industry this
rate of learning was generally seen to be around 80%, in different industries other rates occur. Similarly,
depending on the industry in question, it is often more appropriate for the unit of measurement to be a
batch rather than an individual unit.
The learning process starts as soon as the first unit or batch comes off the production line. Since a
doubling of cumulative production is required in order for the cumulative average time per unit to
decrease, it is clearly the case that the effect of the learning rate on labour time will become much less
significant as production increases. Eventually, the learning effect will come to an end altogether. You can
see this in Figure 1 below. When output is low, the learning curve is really steep but the curve becomes
flatter as cumulative output increases, with the curve eventually becoming a straight line when the
learning effect ends.
Figure 1
The learning curve effect will

not always apply, of course. It
flourishes where certain
conditions are present. It is
necessary for the process to
be a repetitive one, for
example. Also, there needs to
be a continuity of workers and
they mustn’t be taking
prolonged breaks during the
production process.
THE IMPORTANCE OF THE LEARNING CURVE EFFECT
Learning curve models enable users to predict how long it will take to complete a future task.
Management accountants must therefore be sure to take into account any learning rate when they are
carrying out planning, control and decision-making. If they fail to do this, serious consequences will
result. As regards its importance in decision-making, let us look at the example of a company that is
introducing a new product onto the market. The company wants to make its price as attractive as
possible to customers but still wants to make a profit, so it prices it based on the full absorption cost plus
a small 5% mark-up for profit. The first unit of that product may take one hour to make. If the labour cost
is $15 per hour, then the price of the product will be based on the inclusion of that cost of $15 per hour.
Other costs may total $45. The product is therefore released onto the market at a price of $63.
Subsequently, it becomes apparent that the learning effect has been ignored and the correct labour time
per unit should is actually 0.5 hours. Without crunching through the numbers again, it is obvious that the
product will have been launched onto the market at a price which is far too high. This may mean that
initial sales are much lower than they otherwise would have been and the product launch may fail. Worse
still, the company may have decided not to launch it in the first place as it believed it could not offer a
competitive price.
Let us now consider its importance in planning and control. If standard costing is to be used, it is
important that standard costs provide an accurate basis for the calculation of variances. If standard costs
have been calculated without taking into account the learning effect, then all the labour usage variances
will be favourable because the standard labour hours that they are based on will be too high. This will
make their use for control purposes pointless.
Finally, it is worth noting that the use of learning curve is not restricted to the assembly industries it is
traditionally associated with. It is also used in other less traditional sectors such as professional practice,
financial services, publishing and travel. In fact, research has shown that just under half of users are in
the service sector.
HOW LEARNING CURVES HAVE BEEN EXAMINED IN THE PAST
The learning curve effect has regularly been examined in Performance Management. For example, in
December 2011, it was examined in conjunction with life cycle costing. Candidates were asked to
calculate a revised lifecycle cost per unit after taking into account the learning effect. This involved
working out the incremental labour time taken to produce the final 100th unit made before the learning
effect ended. This is a fairly common exam requirement which tests candidates’ understanding of the
difference between cumulative and incremental time taken to produce a product and the application of
the learning curve formula. It is worth mentioning at this point that you should never round learning curve
calculations to less than three decimal places. In some questions, where the learning effect is small,
over-rounding will lead to a candidate wiping out the entire learning effect and then the question
becomes pointless.
The learning curve formula, as shown below, is always given on the formula sheet in the exam:
Y = axb
Where Y = cumulative average time per unit to produce x units
a = the time taken for the first unit of output
x = the cumulative number of units produced
b = the index of learning (log LR/log2)
LR = the learning rate as a decimal
While a value for ‘b’ has usually been given in past exams there is no reason why this should always be
the case. All candidates should know how to use a scientific calculator and should be sure to take one
into the exam hall.
In June 2013, the learning effect was again examined in conjunction with lifecycle costing. Again, as has
historically been the case, the learning rate was given in the question, as was the value for ‘b’.
Back in June 2009, the learning curve effect was examined in conjunction with target costing. Once
again, the learning rate was given, and a value for ‘b’ was given, but this time, an average cost for the
first 128 units made was required. It was after this point that the learning effect ended, so the question
then went on to ask candidates to calculate the cost for the last unit made, since this was going to be the
cost of making one unit going forward in the business.
It can be seen, just from the examples given above, that learning curve questions have tended to follow a
fairly regular pattern in the past. The problem with this is that candidates don’t always actually think about
the calculations they are performing. They simply practise past papers, learn how to answer questions,
and never really think beyond this. In the workplace, when faced with calculations involving the learning
effect, candidates may not be able to tackle them. In the workplace, the learning rate will not be known in
advance for a new process and secondly, even if it has been estimated, differences may well arise
between expected learning rates and actual learning rate experienced. Therefore, it seemed only right
that future questions should examine candidates’ ability to calculate the learning rate itself. This leads us
on to the next section of the article.
CALCULATING THE LEARNING RATE
The learning effect can continue to be examined with candidates being asked to calculate the time taken
to produce an individual unit or a number of units of a product either when the learning curve is still in
effect or when it has ended. In most questions ‘b’ has usually been given, however candidates can also
be expected to calculate the learning rate itself. Here, the tabular method is the simplest way to answer
the question.
Example 1
P Co operates a standard costing system. The standard labour time per batch for its newest product was
estimated to be 200 hours, and resource allocation and cost data were prepared on this basis.
The actual number of batches produced during the first six months and the actual time taken to produce
them is shown below:
Required
(a) Calculate the monthly
learning rate that arose
during the period.
(b) Identify when the
learning period ended
and briefly discuss the
implications of this for P
Co.
Solution:
(a) Monthly rates of
learning
Learning rate:
176/200 = 88%
154.88/176 = 88%
136.29/154.88 = 88%
Therefore the monthly rate

of learning was 88%.
(b) End of learning rate and

implications
The learning period ended

at the end of September.
This meant that from
October onwards the time
taken to produce each
batch of the product was
constant. Therefore, in
future, when P Co makes decisions about allocating its resources and costing the product, it should base
these decisions on the time taken to produce the eighth batch, which was the last batch produced before
the learning period came to an end. The resource allocations and cost data prepared for the last six
months will have been inaccurate since they were based on a standard time per batch of 200 hours.
P Co could try and improve its production process so that the learning period could be extended. It may
be able to do this by increasing the level of staff training provided. Alternatively, it could try to incentivise
staff to work harder through payment of bonuses, although the quality of production would need to be
maintained.
Example 2
The first batch of a new product took six hours to make and the total time for the first 16 units was 42.8
hours, at which point the learning effect came to an end.
Required:
(a) Calculate the rate of learning.
Solution:
Again, the easiest way to solve this problem and find the actual learning rate is to use a combination of
the tabular approach plus, in this case, a little bit of maths. There is an alternative method that can be
used that would involve some more difficult maths and use of the inverse log button on the calculator, but
this can be quite tricky and candidates would not be expected to use this method. Should they choose to
do so, however, full marks would be awarded, of course.
Using algebra:
Step 1: Write out the

equation:
42.8 = 16 x (6 x r4)
Step 2: Divide each side by

16 in order to get rid of the
’16 x’ on the right hand
side of the equation:
2.675 = (6 x r4)
Step 3: Divide each side by

6 in order to get rid of the
‘6 x’ on the right hand side
of the equation:
0.4458333 = r4
Step 4: take the fourth root of each side in order to get rid of the r4 on the right hand side of the equation.
You should have a button on your calculator that says r4 or x1/y. Either of these can be used to find the
fourth root (or any root, in fact) of a number. The key is to make sure that you can use your calculator
properly before you enter the exam hall rather than trying to work it out under exam pressure. You then
get the answer:
r = 0.8171
This means that the learning rate = 81.71%.
SUMMARY
The above two examples demonstrate the type of requirements that you may find in questions where you
are asked to find the learning rate. All that we are doing is encouraging you to think a little and, in some
case, perhaps use a little bit of the maths that, as a trainee accountant, you should be more than capable
of applying.
Written by a member of the Performance Management examining team
Last updated: 1 Feb 2018

The global body for professional accountants About us Contact us Find an accountant Technical activities Help & support Global 
providers insights
DECISION TREES
RELATED LINKS
This article provides a step-by-step approach to decision trees, using a simple example to guide
you through.
There is no universal set of symbols used when drawing a decision tree but the most common ones that
we tend to come across in accountancy education are squares (□), which are used to represent
‘decisions’ and circles (○), which are used to represent ‘outcomes.’ Therefore, I shall use these symbols
in this article and in any suggested solutions for exam questions where decision trees are examined.
DECISION TREES AND MULTI-STAGE DECISION PROBLEMS
A decision tree is a diagrammatic representation of a problem and on it we show all possible courses of
action that we can take in a particular situation and all possible outcomes for each possible course of
action. It is particularly useful where there are a series of decisions to be made and/or several outcomes
arising at each stage of the decision-making process. For example, we may be deciding whether to
expand our business or not. The decision may be dependent on more than one uncertain variable.
For example, sales may be uncertain but costs may be uncertain too. The value of some variables may
also be dependent on the value of other variables too: maybe if sales are 100,000 units, costs are $4 per
unit, but if sales are 120,000 units costs fall to $3.80 per unit. Many outcomes may therefore be possible
and some outcomes may also be dependent on previous outcomes. Decision trees provide a useful
method of breaking down a complex problem into smaller, more manageable pieces.
There are two stages to making decisions using decision trees. The first stage is the construction stage,
where the decision tree is drawn and all of the probabilities and financial outcome values are put on the
tree. The principles of relevant costing are applied throughout – ie only relevant costs and revenues are
considered. The second stage is the evaluation and recommendation stage. Here, the decision is ‘rolled
back’ by calculating all the expected values at each of the outcome points and using these to make
decisions while working back across the decision tree. A course of action is then recommended for
management.
CONSTRUCTING THE TREE
A decision tree is always drawn starting on the left hand side of the page and moving across to the right.
Above, I have mentioned decisions and outcomes. Decision points represent the alternative courses of
action that are available to you. These are within your control – it is your choice. You either take one
course of action or you take another. Outcomes, on the other hand, are not within your control. They are
dependent on the external environment – for example, customers, suppliers and the economy. Both
decision points and outcome points on a decision tree are always followed by branches. If there are two
possible courses of action – for example, there will be two branches coming off the decision point; and if
there are two possible outcomes – for example, one good and one bad, there will be two branches
coming off the outcome point. It makes sense to say that, given that decision trees facilitate the
evaluation of different courses of actions, all decision trees must start with a decision, as represented by
a □.
A simple decision tree is shown below. It can be seen from the tree that there are two choices available
to the decision maker since there are two branches coming off the decision point. The outcome for one of
these choices, shown by the top branch off the decision point, is clearly known with certainty, since there
is no outcome point further along this top branch. The lower branch, however, has an outcome point on it,
showing that there are two possible outcomes if this choice is made. Then, since each of the subsidiary
branches off this outcome point also has a further outcome point on with two branches coming off it,
there are clearly two more sets of outcomes for each of these initial outcomes. It could be, for example,
that the first two outcomes were showing different income levels if some kind of investment is undertaken
and the second set of outcomes are different sets of possible variable costs for each different income
level.
Once the basic tree has

been drawn, like above, the
probabilities and expected
values must be written on it.
Remember, the probabilities
shown on the branches
coming off the outcome
points must always add up to
100%, otherwise there must
be an outcome missing or a
mistake with the numbers
being used. As well as
showing the probabilities on
the branches of the tree, the
relevant cash
inflows/outflows must also
be written on there too. This
is shown in the example later
on in the article.
Once the decision tree has been drawn, the decision must then be evaluated.
EVALUATING THE DECISION
When a decision tree is evaluated, the evaluation starts on the right-hand side of the page and moves
across to the left – ie in the opposite direction to when the tree was drawn. The steps to be followed are
as follows:
1. Label all of the decision and outcome points – ie all the squares and circles. Start with the ones closest to the right-hand
side of the page, labelling the top and then the bottom ones, and then move left again to the next closest ones.
2. Then, moving from right to left across the page, at each outcome point, calculate the expected value of the cash flows by
applying the probabilities to the cash flows. If there is room, write these expected values on the tree next to the relevant
outcome point, although be sure to show all of your workings for them clearly beneath the tree too.
Finally, the recommendation is made to management, based on the option that gives the highest
expected value.
It is worth remembering that using expected values as the basis for making decisions is not without its
limitations. Expected values give us a long run average of the outcome that would be expected if a
decision was to be repeated many times. So, if we are in fact making a one-off decision, the actual
outcome may not be very close to the expected value calculated and the technique is therefore not very
accurate. Also, estimating accurate probabilities is difficult because the exact situation that is being
considered may not well have arisen before.
The expected value criterion for decision making is useful where the attitude of the investor is risk
neutral. They are neither a risk seeker nor a risk avoider. If the decision maker’s attitude to risk is not
known, it difficult to say whether the expected value criterion is a good one to use. It may in fact be more
useful to see what the worst-case scenario and best-case scenario results would be too, in order to
assist decision making.
Let me now take you through a simple decision tree example. For the purposes of simplicity, you should
assume that all of the figures given are stated in net present value terms.
Example 1:
A company is deciding whether to develop and launch a new product. Research and development costs
are expected to be $400,000 and there is a 70% chance that the product launch will be successful, and a
30% chance that it will fail. If it is successful, the levels of expected profits and the probability of each
occurring have been estimated as follows, depending on whether the product’s popularity is high,
medium or low:
If it is a failure, there is a
0.6 probability that the
research and development
work can be sold for
$50,000 and a 0.4
probability that it will be
worth nothing at all.
The basic structure of the

decision tree must be
drawn, as shown below:
Next, the probabilities and

the profit figures must be
put on, not forgetting that
the profits from a
successful launch last for
two years, so they must be
doubled.
Now, the decision points and

outcome points must be
labelled, starting from the
right-hand side and moving
across the page to the left.
Now, calculate the expected

values at each of the
outcome points, by applying
the probabilities to the profit
figures. An expected value
will be calculated for
outcome point A and another
one will be calculated for
outcome point B. Once these
have been calculated, a third
expected value will need to
be calculated at outcome
point C. This will be done by
applying the probabilities for
the two branches off C to the
two expected values that
have already been
calculated for A and B.
EV at A = (0.2 x $1,000,000)
+ (0.5 x $800,000) + (0.3 x
$600,000) = $780,000.
EV at B = (0.6 x $50,000) +
(0.4 x $0) = $30,000.
EV at C = (0.7 x $780,000) +
(0.3 x $30,000) = $555,000
These expected values can

then be put on the tree if
there is enough room.
Once this has been done,

the decision maker can then
move left again to decision
point D. At D, the decision
maker compares the value of
the top branch of the
decision tree (which, given
there were no outcome
points, had a certain
outcome and therefore
needs no probabilities to be
applied to it) to the expected
value of the bottom branch.
Costs will then need to be
deducted. So, at decision
point D compare the EV of
not developing the product,
which is $0, with the EV of
developing the product once
the costs of $400,000 have
been taken off – ie
$155,000.
Finally, the recommendation

can be made to
management. Develop the
product because the
expected value of the profits
is $155,000.
Often, there is more than

one way that a decision tree
could be drawn. In my
example, there are actually
five outcomes if the product
is developed:
1. It will succeed and generate high
profits of $1,000,000.
2. It will succeed and generate
medium profits of $800,000.
3. It will succeed and generate low
profits of $600,000.
4. It will fail but the work will be sold generating a profit of $50,000.
5. It will fail and generate no profits at all.
Therefore, instead of decision point C having only two branches on it, and each of those branches in turn
having a further outcome point with two branches on, we could have drawn the tree as follows:
You can see that the

probabilities on the branches
of the tree coming off
outcome point A are now
new. This is because they
are joint probabilities and
they have been by
combining the probabilities
of success and failure (0.7
and 0.3) with the
probabilities of high, medium
and low profits (0.2, 0.5,
0.3). The joint probabilities
are found easily simply by
multiplying the two variables
together each time:
Success and high profits: 0.7

x 0.2 = 0.14
Success and medium profits:
0.7 x 0.5 = 0.35
Success and low profits: 0.7 x 0.3 = 0.21
Fail and sell works: 0.3 x 0.6 = 0.18
Fail and don’t sell work: 0.3 x 0.4 = 0.12
All of the joint probabilities above must, of course, add up to 1, otherwise a mistake has been made.
Whether you use my initial method, which I always think is far easier to follow, or the second method,
your outcome will always be the same.
The decision tree example above is quite a simple one but the principles to be grasped from it apply
equally to a more complex decision resulting in a tree with far more decision points, outcomes and
branches on.
Finally, I always cross off the branch or branches after a decision point that show the alternative I haven’t
chosen, in this case being the ‘do not develop product’ branch. Not everyone does it this way but I think it
makes the tree easy to follow. Remember, outcomes are not within your control, so branches off outcome
points are never crossed off. I have shown this crossing off of the branches below on my original,
preferred tree:
THE VALUE OF PERFECT AND IMPERFECT INFORMATION
Perfect information is said to be available when a 100% accurate prediction can be made about the
future. Imperfect information, on the other hand, is not 100% accurate but provides more knowledge than
no information. Imperfect information is far more difficult to calculate and you would only ever need to do
this in the exam if the numbers were extremely straightforward to start with. In this article, we are only
going to deal with perfect information in any detail. This is because the calculations involved in
calculating the value of imperfect information from my example are more complex than Performance
Management syllabus would require you to calculate.
Perfect information
The value of perfect information is the difference between the expected value of profit with perfect
information and the expected value of profit without perfect information. So, in our example, let us say
that an agency can provide information on whether the launch is going to be successful and produce
high, medium or low profits or whether it is simply going to fail. The expected value with perfect
information can be calculated using a small table. At this point, it is useful to have calculated the joint
probabilities mentioned in the second decision tree method above because the answer can then be
shown like this.
However, it could also be

done by using the
probabilities from our
original tree in the table
below and then multiplying
them by the success and
failure probabilities of 0.7
and 0.3:
EV of success with perfect

information = 0.7 x
$380,000 = $266,000
EV of failure with perfect

information = 0.3 x $0 = $0.
Therefore, total expected
value with perfect
information = $266,000.
Whichever method is used,

the value of the information
can then be calculated by
deducting the expected
value of the decision
without perfect information
from the expected value of
the decision with perfect
information – ie $266,000 –
$155,000 = $111,000. This
would represent the
absolute maximum that
should be paid to obtain
such information.
Imperfect information
In reality, information
obtained is rarely perfect
and is merely likely to give
us more information about
the likelihood of different
outcomes rather than
perfect information about
them. However, the
numbers involved in
calculating the values of
imperfect information are
rather complex and at this
level, any numerical question would need to be relatively simple. You should refer to the recommended
text for a worked example on the value of imperfect information. It is suffice here to say that the value of
imperfect information will always be less than the value of perfect information unless both are zero. This
would occur when the additional information would not change the decision. Note that the principles that
are applied for calculating the value of imperfect information are the same as those applied for
calculating the value of perfect information.

providers insights
ENVIRONMENTAL MANAGEMENT
ACCOUNTING
RELATED LINKS
A member of the Performance Management examining team provides students with an

introduction to environmental management accounting
The two requirements of the Performance Management syllabus are as follows:

discuss the issues businesses face in the management of environmental costs
describe the different methods a business may use to account for its environmental costs.
You should note that the Performance Management syllabus examines 'environmental management
accounting’ rather than ‘environmental accounting’. Environmental accounting is a broader term that
encompasses the provision of environment-related information both externally and internally. It focuses
on reports required for shareholders and other stakeholders, as well of the provision of management
information. Environmental management accounting, on the other hand, is a subset of environmental
accounting. It focuses on information required for decision making within the organisation, although much
of the information it generates could also be used for external reporting.
The aim of this article is to give a general introduction on the area of environmental management
accounting, followed by a discussion of the first of the two requirements listed above.
Many of you reading this article still won’t be entirely clear on what environmental management
accounting actually is. You will not be alone! There is no single textbook definition for it, although there
are many long-winded, jargon ridden ones available. Before we get into the unavoidable jargon, the
easiest way to approach it in the first place is to step back and ask ourselves what management
accounting itself is. Management accounts give us an analysis of the performance of a business and are
ideally prepared on a timely basis so that we get up-to-date management information. They break down
each of our different business segments (in a larger business) in a high level of detail. This information is
then used to assess how the business’ historic performance has been and, moving forward, how it can
be improved in the future.
Environmental management accounting is simply a specialised part of the management accounts that
focuses on things such as the cost of energy and water and the disposal of waste and effluent. It is
important to note at this point that the focus of environmental management accounting is not all on purely
financial costs. It includes consideration of matters such as the costs vs benefits of buying from suppliers
who are more environmentally aware, or the effect on the public image of the company from failure to
comply with environmental regulations.
Environmental management accounting uses some standard accountancy techniques to identify,

analyse, manage and hopefully reduce environmental costs in a way that provides mutual benefit to the
company and the environment, although sometimes it is only possible to provide benefit to one of these
parties.
Example:
Activity-based costing may be used to ascertain more accurately the costs of washing towels at a gym.
The energy used to power the washing machine is an environmental cost; the cost driver is ‘washing’.
Once the costs have been identified and information accumulated on how many customers are using the
gym, it may actually be established that some customers are using more than one towel on a single visit
to the gym. The gym could drive forward change by informing customers that they need to pay for a
second towel if they need one. Given that this approach will be seen as ‘environmentally-friendly’, most
customers would not argue with its introduction. Nor would most of them want to pay for the cost of a
second towel. The costs to be saved by the company from this new policy would include both the energy
savings from having to run fewer washing machines all the time and the staff costs of those people
collecting the towels and operating the machines. Presumably, since the towels are being washed less
frequently, they will need to be replaced by new ones less often as well.
In addition to these savings to the company, however, are the all-important savings to the environment
since less power and cotton (or whatever materials the towels are made from) is now being used, and
the scarce resources of our planet are therefore being conserved. Lastly, the gym is also seen as an
environmentally friendly organisation and this, in turn, may attract more customers and increase
revenues. Just a little bit of management accounting (and common sense!) can achieve all these things.
While I always like to minimise the use of jargon, in order to be fully versed on what environmental
management accounting is really seen by the profession as encompassing today, it is necessary to
consider a couple of the most widely accepted definitions of it.
In 1998, the International Federation of Accountants (IFAC) originally defined environmental

management accounting as:
‘The management of environmental and economic performance, through the development and
implementation of appropriate environment-related accounting systems and practices. While this may
include reporting and auditing in some companies, environmental management accounting typically
involves lifecycle costing, full cost accounting, benefits assessment, and strategic planning for
environmental management.’
Then, in 2001, The United Nations Division for Sustainable Development (UNDSD) emphasised their
belief that environmental management accounting systems generate information for internal decision
making rather than external decision making. This is in line with my statement at the beginning of this
article that EMA is a subset of environmental accounting as a whole.
The UNDSD make what became a widely accepted distinction between two types of information: physical
information and monetary information. Hence, they broadly defined EMA to be the identification,
collection, analysis and use of two types of information for internal decision making:
physical information on the use, flows and destinies
of energy, water and materials (including wastes)
monetary information on environment-related costs, earnings and savings.
This definition was then adopted by an international consensus group of over 30 nations and thus
eventually adopted by IFAC in its 2005 international guidance document on ‘environmental management
accounting’.
To summarise then, for the purposes of clarifying the coverage of the Performance Management
syllabus, my belief is that EMA is internally not externally focused and the Performance Management
syllabus should, therefore, focus on information for internal decision making only. It should not be
concerned with how environmental information is reported to stakeholders, although it could include
consideration of how such information could be reported internally. For example, Hansen and Mendoza
(1999) stated that environmental costs are incurred because of poor quality controls. Therefore, they
advocate the use of a periodical environmental cost report that is produced in the format of a cost of
quality report, with each category of cost being expressed as a percentage of sales revenues or
operating costs so that comparisons can be made between different periods and/or organisations. The
categories of costs would be as follows:
Environmental prevention costs: the costs of activities undertaken to prevent the production of waste.
Environmental detection costs: costs incurred to ensure that the organisation complies with regulations and voluntary
standards.
Environmental internal failure costs: costs incurred from performing activities that have produced contaminants and
waste that have not been discharged into the environment.
Environmental external failure costs: costs incurred on activities performed after discharging waste into the environment.
It is clear from the suggested format of this quality type report that Hansen and Mendoza’s definition of
‘environmental cost’ is relatively narrow.
MANAGING ENVIRONMENTAL COSTS
There are three main reasons why the management of environmental costs is becoming increasingly
important in organisations.
First, society as a whole has become more environmentally aware, with people becoming increasingly
aware about the ‘carbon footprint’ and recycling taking place now in many countries. A ‘carbon footprint’
(as defined by the Carbon Trust) measures the total greenhouse gas emissions caused directly and
indirectly by a person, organisation, event or product. Companies are finding that they can increase their
appeal to customers by portraying themselves as environmentally responsible.
Second, environmental costs are becoming huge for some companies, particularly those operating in
highly industrialised sectors such as oil production. In some cases, these costs can amount to more than
20% of operating costs. Such significant costs need to be managed.
Third, regulation is increasing worldwide at a rapid pace, with penalties for non-compliance also
increasing accordingly. In the largest ever seizure related to an environmental conviction in the UK, a
plant hire firm, John Craxford Plant Hire Ltd, had to not only pay £85,000 in costs and fines but also got
£1.2m of its assets seized. This was because it had illegally buried waste and also breached its waste
and pollution permits. And it’s not just the companies that need to worry. Officers of the company and
even junior employees could find themselves facing criminal prosecution for knowingly breaching
environmental regulations.
But the management of environmental costs can be a difficult process. This is because first, just as EMA
is difficult to define, so too are the actual costs involved. Second, having defined them, some of the costs
are difficult to separate out and identify. Third, the costs can need to be controlled but this can only be
done if they have been correctly identified in the first place. Each of these issues is dealt with in turn
below.
DEFINING ENVIRONMENTAL COSTS
Many organisations vary in their definition of environmental costs. It is neither possible nor desirable to
consider all of the great range of definitions adopted. A useful cost categorisation, however, is that
provided by the US Environmental Protection Agency in 1998. They stated that the definition of
environmental costs depended on how an organisation intended on using the information. They made a
distinction between four types of costs:
conventional costs: raw material and energy costs having environmental relevance
potentially hidden costs: costs captured by accounting systems but then losing their identity in ‘general overheads’
contingent costs: costs to be incurred at a future date – for example, clean up costs
image and relationship costs: costs that, by their nature, are intangible, for example, the costs of preparing
environmental reports.
The UNDSD, on the other hand, described environmental costs as comprising of:
costs incurred to protect the environment – for example, measures taken to prevent pollution, and
costs of wasted material, capital and labour, ie inefficiencies in the production process.
Neither of these definitions contradict each other; they just look at the costs from slightly different angles.
As a Performance Management student, you should be aware that definitions of environmental costs
vary greatly, with some being very narrow and some being far wider.
IDENTIFYING ENVIRONMENTAL COSTS
Much of the information that is needed to prepare environmental management accounts could actually be
found in a business’ general ledger. A close review of it should reveal the costs of materials, utilities and
waste disposal, at the least. The main problem is, however, that most of the costs will have to be found
within the category of ‘general overheads’ if they are to be accurately identified. Identifying them could be
a lengthy process, particularly in a large organisation. The fact that environmental costs are often
‘hidden’ in this way makes it difficult for management to identify opportunities to cut environmental costs
and yet it is crucial that they do so in a world which is becoming increasingly regulated and where scarce
resources are becoming scarcer.
It is equally important to allocate environmental costs to the processes or products which give rise to
them. Only by doing this can an organisation make well-informed business decisions. For example, a
pharmaceutical company may be deciding whether to continue with the production of one of its drugs. In
order to incorporate environmental aspects into its decision, it needs to know exactly how many products
are input into the process compared to its outputs; how much waste is created during the process; how
much labour and fuel is used in making the drug; how much packaging the drug uses and what
percentage of that is recyclable etc. Only by identifying these costs and allocating them to the product
can an informed decision be made about the environmental effects of continued production.
In 2003, the UNDSD identified four management accounting techniques for the identification and
allocation of environmental costs: input/outflow analysis, flow cost accounting, activity based costing and
lifecycle costing. These are referred to later under ‘different methods of accounting for environmental
costs’.
CONTROLLING ENVIRONMENTAL COSTS
It is only after environmental costs have been defined, identified and allocated that a business can begin
the task of trying to control them.
As we have already discussed, environmental costs will vary greatly from business to business and, to
be honest, a lot of the environmental costs that a large, highly industrialised business will incur will be
difficult for the average person to understand, since that person won’t have a detailed knowledge of the
industry concerned.
I will therefore use some basic examples of easy-to-understand environmental costs when considering
how an organisation may go about controlling such costs. Let us consider an organisation whose main
environmental costs are as follows:
waste and effluent disposal
water consumption
energy
transport and travel
consumables and raw materials.
Each of these costs is considered in turn below.
Waste
There are lots of environmental costs associated with waste. For example, the costs of unused raw
materials and disposal; taxes for landfill; fines for compliance failures such as pollution. It is possible to
identify how much material is wasted in production by using the ‘mass balance’ approach, whereby the
weight of materials bought is compared to the product yield. From this process, potential cost savings
may be identified. In addition to these monetary costs to the organisation, waste has environmental costs
in terms of lost land resources (because waste has been buried) and the generation of greenhouse
gases in the form of methane.
Water
You have probably never thought about it but businesses actually pay for water twice – first, to buy it and
second, to dispose of it. If savings are to be made in terms of reduced water bills, it is important for
organisations to identify where water is used and how consumption can be decreased.
Energy
Often, energy costs can be reduced significantly at very little cost. Environmental management accounts
may help to identify inefficiencies and wasteful practices and, therefore, opportunities for cost savings.
Transport and travel

Again, environmental management accounting can often help to identify savings in terms of business
travel and transport of goods and materials. At a simple level, a business can invest in more fuel-efficient
vehicles, for example.
Consumables and raw materials

These costs are usually easy to identify and discussions with senior managers may help to identify where
savings can be made. For example, toner cartridges for printers could be refilled rather than replaced.
This should produce a saving both in terms of the financial cost for the organisation and a waste saving
for the environment (toner cartridges are difficult to dispose of and less waste is created this way).
ACCOUNTING FOR ENVIRONMENTAL COSTS
In the context of Performance Management, when the syllabus requires you to describe the different
methods of accounting for environmental costs, it aims to cover two areas:
Internal reporting of environmental costs, which has already been discussed in the introduction.
Management accounting techniques for the identification and allocation of environmental costs: the most appropriate
ones for the Performance Management syllabus are those identified by the UNDSD, namely input/outflow analysis, flow
cost accounting, activity-based costing and lifecycle costing.
INPUT/OUTFLOW ANALYSIS
This technique records material inflows and balances this with outflows on the basis that, what comes in,
must go out. So, if 100kg of materials have been bought and only 80kg of materials have been produced,
for example, then the 20kg difference must be accounted for in some way. It may be, for example, that
10% of it has been sold as scrap and 90% of it is waste. By accounting for outputs in this way, both in
terms of physical quantities and, at the end of the process, in monetary terms too, businesses are forced
to focus on environmental costs.
FLOW COST ACCOUNTING
This technique uses not only material flows but also the organisational structure. It makes material flows
transparent by looking at the physical quantities involved, their costs and their value. It divides the
material flows into three categories: material, system and delivery and disposal. The values and costs of
each of these three flows are then calculated. The aim of flow cost accounting is to reduce the quantity of
materials which, as well as having a positive effect on the environment, should have a positive effect on a
business’ total costs in the long run.
ACTIVITY-BASED COSTING
ABC allocates internal costs to cost centres and cost drivers on the basis of the activities that give rise to
the costs. In an environmental accounting context, it distinguishes between environment-related costs,
which can be attributed to joint cost centres, and environment‑driven costs, which tend to be hidden on
general overheads.
LIFECYCLE COSTING
Within the context of environmental accounting, lifecycle costing is a technique which requires the full
environmental consequences, and, therefore, costs, arising from production of a product to be taken
account across its whole lifecycle, literally ‘from cradle to grave’.
SUMMARY
I hope you now have a clearer idea about exactly what environmental management accounting is and
why it’s important. While I have tried to give some simple, practical examples and explanations, a certain
amount of jargon is unavoidable in this subject area. Enjoy your further reading.

providers insights
BUILDING BLOCKS OF PERFORMANCE

MANAGEMENT
RELATED LINKS
Performance management—the processes that ensure organisations meet their objectives—is core to
the F5 syllabus, and understanding modern performance measurement systems is an important area
within this topic. F5 students should already be familiar with Kaplan & Norton’s Balanced Scorecard
which is a regularly examined topic and one of the foundations of modern performance measurement.
Fitzgerald and Moon’s Building Block Model is an evolution of the Balanced Scorecard, developed to
meet the needs of service organisations. It is a tool that helps management set a forward-looking
performance management framework that links an organisation’s strategy and objectives to employee
targets and motivation.
This article will review the importance of the modern approach to performance measurement, discuss the
Building Block model, and apply this model to an exam-based scenario.
MEASURING PERFORMANCE
An approach to measuring performance that we are familiar with is, ‘looking at the numbers.’ Classic
questions which are often asked about a company are, 'How much profit has it made?' 'How much have
sales grown?' 'What’s its market share compared to the competition?' However, these traditional,
financial performance metrics which are regularly calculated for accountancy exams are no longer
sufficient, according to leading thinkers on strategy and performance management.
Profit-based performance metrics measure past performance. They are also distorted by accounting
policies. Just look at the famous auto and engine maker Rolls Royce; its recently reported profits would
be £900m lower under new IFRS revenue recognition requirements. Financial metrics are also criticised
as leading to ‘managerial myopia,’ or short-termism, whereby management make decisions which
sacrifice future performance for profits today. Managers can be motivated to postpone investments and
other costs to maintain their quarterly or annual profits if their success is judged solely against financial
performance targets.
Performance management experts argue that in the increasingly competitive modern business
environment, organisations now need forward-looking performance measurement systems, linked to their
critical success factors, to achieve long-term success. The new question to ask is, 'what areas of
performance are critical to achieving our strategic objectives and how do we measure them?'
The following scenario will be used to discuss and illustrate the Building Block Model.
SCENARIO: SMARTCOURIER
SmartCourier is a package delivery company located in the developing country of Maxland. Since its
formation in 1970, SmartCourier has evolved into one of the largest and most successful shipping
companies in the country. Its mission is 'to exceed customers’ expectations in the transfer of packages by
offering the highest-quality services at competitive prices.'
SmartCourier offers a range of delivery services such as:

Standard overnight delivery
A premium add-on of guaranteed 10:30am delivery
A cheaper, three-day service for less time-critical deliveries
SmartCourier has recently launched an app that lets customers set pickup times and locations on their
smartphones which has received positive reviews in the technology press.
SmartCourier has identified the following critical success factors:

Deliver sustainable profits to shareholders
Leave customers highly satisfied at every interaction with SmartCourier
Provide a range of products which meet our clients’ evolving needs
Lead the industry with constant innovation
Managers at SmartCourier have a dynamic compensation package which includes share options, goal-
based incentives, commissions, and non-monetary public recognition. SmartCourier also allows for
flexible work schedules and is piloting an on-site child care programme at one of its locations.
SmartCourier receives positive coverage in the press about its work environment and is considered to be
an attractive employer, with motivated employees and a good reputation among job seekers.
However, SmartCourier’s profits have dropped in recent years due to increasing competition from global
transport companies who have recently entered the market in Maxland.
THE BUILDING BLOCK MODEL
The Building Block model looks at three areas of performance: dimensions, standards, and rewards.
DIMENSIONS EXPLAINED
Companies compete across a range of dimensions besides financial performance. The Building Block
model considers this and describes two categories of dimensions: ‘Results’ and ‘Determinants.’
‘Results’ are the outcome of decisions and actions taken by management in the past. These are captured
under the first two dimensions of the model, financial performance and competitiveness.
‘Determinants’ refer to the forward-looking dimensions of the model: what areas of future performance
are most important for a company to achieve positive financial and competitive results? Quality,
innovation, flexibility and resource utilization are the determinants of future success.
DIMENSIONS AT SMARTCOURIER
Results
As a listed company, the management of SmartCourier will be very interested in measuring financial
success—is it delivering the right profits and returns for its shareholders? Competitiveness is also
critical to measure as new competitors are entering the market in Maxland—is SmartCourier maintaining
or losing market share?
Determinants
SmartCourier’s managers and staff need to focus on the dimensions of performance that will determine
positive financial and competitive results. For example, on-time deliveries will lead to customer loyalty.
This falls under quality of service. The company’s varied product range should meet the needs of
different customer segments; this is an example of flexibility of service. Flexibility and quality of service
should in turn drive positive financial results, for example, higher sales revenue.
Innovation is also important to SmartCourier as it is investing in new technology and improving

processes with its smartphone app. Resource utilisation is critical to its financial success as efficient
use of delivery vehicles, staff and financial resources will reduce costs and improve profitability. In other
words, innovation and resource utilisation are driving financial success (higher profits) and
competitiveness (maintaining market share).
STANDARDS EXPLAINED
After an organisation’s dimensions are understood, standards can be set. These will be the benchmarks,
or targets, directly linked to performance metrics under headings for each dimension. There are three
aspects to consider in setting standards:
Who is responsible for achieving the standard (ownership)?
What level are the standards set at (achievability)?
Can we use the standards for a fair appraisal across the company (equity)?
These three criteria are important. If it is unclear to whom targets are assigned, managers and staff will
not have accountability and performance management will fail. If personal targets are unachievable,
people will not work harder to achieve their goals and there will be little motivation. If appraisal is not fair
and transparent, employee morale will suffer.
STANDARDS AT SMARTCOURIER
Based on the dimensions above, we can suggest standards of performance for SmartCourier:
Financial performance
Growth in sales, net profit margin, and return on investment are potential targets for regional managers.
For example, fixed targets could be set, such as 8% annual growth in sales or a target ROI of 14%. Or,
SmartCourier could use a league table approach by ranking the regions according to these standards
and then rewarding managers accordingly.
Competitiveness
With new players on the market it is important for SmartCourier to measure this area of external
performance. It can set absolute market share as a standard for measuring competitiveness by dividing
SmartCourier’s revenue by the total revenue of the industry in Maxland. A target for regional managers
could be to maintain market share as competitive rivalry is increasing in the industry.
Quality
As a service organisation, it is critical that SmartCourier delivers quality of service to retain its customer
base. It can set targets for courier agents such as 98% on-time delivery, or for call centre representatives
average time to take an order of 3 minutes. It will be important to ensure that these targets are both fair
and achievable to ensure employees are motivated (see below).
Resource utilisation
SmartCourier can measure resource utilisation by using efficiency standards such as average time per
delivery or average number of deliveries per day. However, equity should be considered here, as urban
regions could potentially out-perform rural regions as urban customers will be clustered closer together.
Flexibility of service and innovation

Flexibility of service can be measured with a targets such as 90% of orders scheduled to customers’
request and Innovation can be measured with % of customers using the smartphone app.
REWARDS EXPLAINED
The last part of the model looks at the overall reward structure of the organisation and is the link to HR
systems. Do compensation packages in the company lead people to achieve the standards of
performance which are set out above? This part of the model has three aspects:
Is the system understandable to all employees (clarity)?
Will the system drive employees to achieve their objectives (motivation)?
Do employees have control over their areas of responsibility (controllability)?
The reward system should be clearly understood by all employees: this means unambiguous
performance appraisal and bonus triggers. Rewards should be sufficiently desirable so that employees
are motived to work hard towards gaining them. Finally, if employees are assessed against factors out of
their control, they will lose interest in working towards their rewards.
REWARDS AT SMARTCOURIER
It seems like SmartCourier has an effective reward system. The compensation package covers a range
of financial and non-financial rewards and benefits, which probably contributes to the motivation of
employees by meeting their different needs. For example, new parents will be motivated by the child care
facilities, other staff may be motivated by the flexible work place arrangements. It also appears that
rewards are performance based (for example, 'goal based incentives') which will lead to increased
motivation.
It’s important for SmartCourier to ensure that rewards are controllable and clear, for example, by making
sure that targets are well defined and then agreed in appraisal meetings.
CONCLUSION
Like other modern performance measurement frameworks, the Building Block model connects an
organisation’s strategic objectives to a range of forward-looking, non-financial performance measures.
Where the Building Block Model differs, however, is that also considers reward systems and aims to
create a framework of clearly understood and communicated individual metrics that aligns individual
performance targets with organizational objectives.
Steve Willis is head tutor for Management Accounting exams at PwC Academy
References
(1) Philip Moon and Lin Fitzgerald, Performance Measurement in Service Industries, Making It Work,
Chartered Institute of Management Accountants, 1996
(2) Philip Moon and Lin Fitzgerald, Delivering the Goods at TNT: the Role of a Performance
Measurement System, Management Accounting Research 1996

Kuala Lumpur Kuala Lumpur Kuala Lumpur Kuala Lumpur Kuala Lumpur Kuala Lumpur
RM 121,000 RM 123,801 RM 91,800 RM 123,456 RM 78,000 RM 132,000
providers insights
DECENTRALISATION AND THE NEED FOR

PERFORMANCE MEASUREMENT
50
RELATED LINKS
Decentralisation is essentially the delegation of decision-making responsibility. All organisations

decentralise to some degree; some do it more than others. Decentralisation is a necessary response to
the increasing complexity of the environment that organisations face and the increasing size of most
organisations. Nowadays it would be impossible for one person to make all the decisions involved in the
operation of even a small company, hence senior managers delegate decision-making responsibility to
subordinates.
One danger of decentralisation is that managers may use their decision-making freedom to make
decisions that are not in the best interests of the overall company (so called dysfunctional decisions). To
redress this problem, senior managers generally introduce systems of performance measurement to
ensure – among other things – that decisions made by junior managers are in the best interests of the
company as a whole. Table 1 below details different degrees of decentralisation and typical financial
performance measures employed.
TABLE 1
Profit centres and

investment centres are
often referred to as
divisions. Divisionalisation
refers to the delegation of
profit-making responsibility.
WHAT MAKES A GOOD PERFORMANCE MEASURE?
A good performance measure should:

provide incentive to the divisional manager to make decisions which are in the best interests of the overall company
(goal congruence)
only include factors for which the manager (division) can be held accountable
recognise the long-term objectives as well as short-term objectives of the organisation.
TRADITIONAL PERFORMANCE INDICATORS
Cost centres
Standard costing variance analysis is commonly used in the measurement of cost centre performance. It
gives a detailed explanation of why costs may have departed from the standard. Although commonly
used, it is not without its problems. It focuses almost entirely on short-term cost minimisation which may
be at odds with other objectives, for example, quality or delivery time. Also, it is important to be clear
about who is responsible for which variance – is the production manager or the purchasing manager (or
both) responsible for raw material price variances? There is also the problem with setting standards in
the first place – variances can only be as good as the standards on which they are based.
Profit centres
Controllable profit statements are commonly used in profit centres. A pro-forma statement is given in
Table 2.
TABLE 2
The major issue with such

statements is the difficulty
in deciding what is
controllable or traceable.
When assessing the
performance of a manager
we should only consider
costs and revenues under
the control of that manager,
and hence judge the
manager on controllable
profit. In assessing the
success of the division, our
focus should be on costs
and revenues that are
traceable to the division
and hence judge the
division on traceable profit.
For example, depreciation
on divisional machinery
would not be included as a
controllable cost in a profit
centre. This is because the manager has no control over investment in fixed assets. It would, however,
be included as a traceable fixed cost in assessing the performance of the division.
Investment centres
In an investment centre, managers have the responsibilities of a profit centre plus responsibility for
capital investment. Two measures of divisional performance are commonly used:
1. Return on investment (ROI) % = controllable (traceable) profit/controllable (traceable) investment.
2. Residual income = controllable (traceable) profit – an imputed interest charge on controllable (traceable) investment.
Note: Imputed interest is calculated by multiplying the controllable (traceable) investment by the cost of
capital.
Example 1 below demonstrates their calculation and some of the drawbacks of return on investment.
Example 1:
Division X is a division of XYZ plc. Its net assets are currently $10m and it earns a profit of $2.2m per
annum. Division X's cost of capital is 10% per annum. The division is considering two proposals.
Proposal 1 involves investing a further $1m in fixed assets to earn an annual profit of $0.15m.
Proposal 2 involves the disposal of assets at their net book value of $2.3m. This would lead to a reduction in profits of
$0.3m.
Proceeds from the disposal of assets would be credited to head office not to Division X.
Required:
Calculate the current ROI and residual income for Division X and show how they would change under
each of the two proposals.
Commentary:
Under the current situation
ROI exceeds the cost of
capital and residual income
is positive. The division is
performing well.
In simple terms Proposal 1 is

acceptable to the company.
It offers a rate of return of
15% ($0.15m/$1m) which is
greater than the cost of
capital. However, divisional
ROI falls and this could lead
to the divisional manager
rejecting Proposal 1. This
would be a dysfunctional
decision. Residual income
increases if Proposal 1 is
adopted and this
performance measure
should lead to goal
congruent decisions.
In simple terms Proposal 2 is

not acceptable to the
company. The existing
assets have a rate of return
on 13% ($0.3m/$2.3m)
which is greater than the
cost of capital and hence
should not be disposed of.
However, divisional ROI
rises and this could lead to
the divisional manager
accepting Proposal 2. This
would be a dysfunctional
decision. Residual income
decreases if Proposal 2 is
adopted and once again this
performance measure
should lead to goal
congruent decisions.
RELATIVE MERITS OF ROI AND RESIDUAL INCOME
Return on investment is a relative measure and hence suffers accordingly. For example, assume you
could borrow unlimited amounts of money from the bank at a cost of 10% per annum. Would you rather
borrow £100 and invest it at a 25% rate of return or borrow $1m and invest it at a rate of return of 15%?
Although the smaller investment has the higher percentage rate of return, it would only give you an
absolute net return (residual income) of $15 per annum after borrowing costs. The bigger investment
would give a net return of $50,000. Residual income, being an absolute measure, would lead you to
select the project that maximises your wealth.
Residual income also ties in with net present value, theoretically the best way to make investment
decisions. The present value of a project's residual income equals the project's net present value. In the
long run, companies that maximise residual income will also maximise net present value and in turn
shareholder wealth. Residual income does, however, experience problems in comparing managerial
performance in divisions of different sizes. The manager of the larger division will generally show a
higher residual income because of the size of the division rather than superior managerial performance.
In addition because RI uses the cost of capital to calculate an imputed interest this cost of capital can be
adjusted to recognise the risk in different projects.
PROBLEMS COMMON TO BOTH ROI AND RESIDUAL INCOME
The following problems are common to both measures:

Identifying controllable (traceable) profits and investment can be difficult.
If used in a short-term way they can both overemphasise short-term performance at the expense of long-term
performance. Investment projects with positive net present value can show poor ROI and residual income figures in
early years leading to rejection of projects by managers (see Example 2).
If assets are valued at net book value, ROI and residual income figures generally improve as assets get older. This can
encourage managers to retain outdated plant and machinery (see Example 2).
Both techniques attempt to measure divisional performance in a single figure. Given the complex nature of modern
businesses, multi-faceted measures of performance are necessary.
Both measures require an estimate of the cost of capital, a figure which can be difficult to calculate.
Example 2:
PQR plc is considering opening a new division to manage a new investment project. Forecast cash flows
of the new project are as follows:
PQR's cost of capital is 10%

per annum. Straight line
depreciation is used.
Required:
Calculate the project's net
present value and its
projected ROI and residual
income over its five-year life.
NPV
ROI
Residual income
Commentary:
This example demonstrates
two points. Firstly, it
illustrates the potential
conflict between NPV and
the two divisional
performance measures. This
project has a positive NPV
and should increase
shareholder wealth.
However, the poor ROI and
residual income figures in
the first year could lead
managers to reject the
project. Secondly, it shows
the tendency for both ROI
and residual income to
improve over time. Despite
constant annual cash flows,
both measures improve over
time as the net book value of
assets falls. This could
encourage managers to
retain outdated assets.
NON-FINANCIAL PERFORMANCE INDICATORS (NFPIS)
In recent years, the trend in performance measurement has been towards a broader view of
performance, covering both financial and non-financial indicators. The most well-known of these
approaches is the balanced scorecard proposed by Kaplan and Norton. This approach attempts to
overcome the following weaknesses of traditional performance measures:
Single factor measures such as ROI and residual income are unlikely to give a full picture of divisional
performance.
Single factor measures are capable of distortion by unscrupulous managers (eg by undertaking Proposal 2 in Example
1).
They can often lead to confusion between measures and objectives. If ROI is used as a performance measure to
promote the maximisation of shareholder wealth some managers will see ROI (not shareholder wealth) as the objective
and dysfunctional consequences may follow.
They are of little use as a guide to action. If ROI or residual income fall they simply tell you that performance has
worsened, they do not indicate why.
The balanced scorecard approach involves measuring performance under four different perspectives, as
follows:
The term 'balanced' is used

because managerial
performance is assessed
under all four headings.
Each organisation has to
decide which performance
measures to use under
each heading. Areas to
measure should relate to
an organisation's critical
success factors.
Critical success factors

(CSFs) are performance
requirements which are
fundamental to an
organisation's success (for
example innovation in a
consumer electronics
company) and can usually be identified from an organisation's mission statement, objectives and
strategy.
Key performance indicators (KPIs) are measurements of achievement of the chosen critical success
factors. Key performance indicators should be:
specific (ie measure profitability rather than 'financial performance', a term which could mean different things to different
people)
measurable (ie be capable of having a measure placed upon it, for example, number of customer complaints rather than
the 'level of customer satisfaction')
relevant, in that they measure achievement of a critical success factor
Example 3 demonstrates a balanced scorecard approach to performance measurement in a fictitious

private sector college training ACCA students.
Example 3
The balanced scorecard

approach to performance
measurement offers
several advantages:
it measures performance in a
variety of ways, rather than
relying on one figure
managers are unlikely to be able
to distort the performance
measure as bad performance is
difficult to hide if multiple
performance measures are used
it takes a long-term perspective
of business performance
success in the four key areas
should lead to the long-term
success of the organisation
it is flexible as what is measured
can be changed over time to
reflect changing priorities
'what gets measured gets done'
– if managers know they are being appraised on various aspects of performance they will pay attention to these areas,
rather than simply paying 'lip service' to them.
The main difficulty with the balanced scorecard approach is setting standards for each of the KPIs. This
can prove difficult where the organisation has no previous experience of performance measurement.
Benchmarking with other organisations is a possible solution to this problem.
Allowing for trade-offs between KPIs can also be problematic. How should the organisation judge the
manager who has improved in every area apart from, say, financial performance? One solution to this
problem is to require managers to improve in all areas, and not allow trade-offs between the different
measures.
Back to top

providers insights
TACKLING PERFORMANCE EVALUATION

QUESTIONS
48
RELATED LINKS
Performance evaluation is a regularly examined requirement in the F5 Performance Management exam,

and is a topic that students tend to misunderstand and struggle with. Often examined as a full, 20 mark
requirement, the task of crafting a free-form answer that incorporates both supporting calculations and a
developed, written discussion is a daunting task. It’s unfamiliar territory moving up from F2, and requires
a specific set of new skills.
This article is meant to help you successfully tackle this type of question. We will work through an
approach for planning and answering this requirement, look at common mistakes and how to avoid them,
and finally take you through a completed answer that demonstrates the points in this article.
Before you go further, please download Question 31, Jungle Co, from the September 2016 exam. It will
serve as our model throughout this article.
THE REQUIREMENT
Discuss the financial and non-financial performance of Jungle Co for the year ending 31 Aug 2016.
Note: there are 7 marks available for calculations and 13 marks available for discussion. (20 marks)
As you see, this type of question can be examined as a single, 20-mark requirement – performance on
this single answer can mean the difference between a pass or a fail. In order to gain passing marks on
this requirement, it’s suggested to use and practice an approach that you can replicate under the stress
of exam day.
A recommended approach is:

Understand time management and use your time appropriately
Effectively read the requirement and plan your answer
Decide on your calculations and complete your workings
Plan your discussion
Write up your discussion using a standard approach to paragraph creation
Let’s now work through this approach step-by-step, using Jungle Co as an example.
UNDERSTAND TIME MANAGEMENT
Time management is critical skill to develop for passing ACCA exams – if you don’t grasp the concepts
we talk about here, you will struggle not only with F5 but with all your future exams.
The idea is to set a time limit for everything you do in your exam. This keeps you on track, and helps you
ensure that you cover all questions in the exam. The golden rule here is to spend 1.8 minutes per mark if
you are on the paper-based exam, and 1.7 minutes per mark if you are on the CBE. This gives you a bit
of buffer time in either case.
As question Jungle Co is 20 marks, you should spend either 34 or 36 minutes in your exam on this
question. Do not exceed this time limit: if you run out of time, move to the next question and come back
later if you manage to find extra time.
You will have a lot to do in this short window so the next step is to allocate the total time allowed to the
different tasks you’ll complete in the question. With performance evaluation questions, you are usually
given an important indication about this: the spread of marks between calculating and discussing.
For example, in question Jungle Co, it’s clearly stated that the calculations are worth a maximum of 7
marks and the discussion is worth 13 marks. This means that after reading and planning, you should
spend 1/3 of the remaining time on your calculations, and 2/3 on writing your discussion.
When time is up for the calculations you need to move to your discussion, even if you feel you haven’t
done enough. Most of the marks will come from your analysis, not your calculations. Students are often
more comfortable performing calculations than writing up an essay, so there is a real risk that you will
spend too much time on the numbers and fail to give enough attention to the discussion.
Avoid the common mistake of over-calculating and under-writing—use time management to

properly split your time between the two tasks.
EFFECTIVE READING AND PLANNING
For the scenario-based, section C questions, it’s critical that you carefully read the scenario as it will
contain important information that you need to relate to your answer. Finding this important information is
your job here. Bring a highlighter marker with you (or use the highlighter tool in the CBE) and highlight
this information as you find it.
For example, in question Jungle Co, you will find important information about the company’s product
lines, new services offered, and a big change in their approach to logistics.
Time management: you will need roughly 15-20% of your total question time to properly read and plan
your answer. Spend this time and do a good plan here to save you time later in your answer.
Avoid the common mistake of not linking your answer to the scenario. Identifying the key issues
in the scenario is the first thing you should do.
GO FOR THE ‘EASY MARKS FIRST’
This is an important concept relevant to all your ACCA exams and one that successful students follow
carefully. 'Easy marks first' means that you should always go for the easiest requirements in a question
first, saving the difficult things for later, even if it means taking things out of order. It also applies to
sections A and B of the exam: do the easiest OTs first; flag the difficult ones and come back to them later.
If you are going to run out of time, do so while attempting the difficult parts of the question that you might
not get anyway, rather than missing out on easy marks.
This is relevant to performance analysis questions. The easiest marks in this type of question (and also
the logical starting place as you can’t evaluate performance without information) come from the
calculations, so start here and get warmed up. But remember, don’t over-do it with calculations, move to
the discussion when time is up.
DECIDING WHAT TO CALCULATE
After you’ve completed your reading and planning, the next step is to do your calculations. But before
you start, you need to decide WHAT you are going to calculate. Your goal is to evaluate performance
from a broad perspective. This means you should use as wide a range of data as possible.
For example, the requirement in question Jungle Co clearly states, 'discuss the "financial" and "non-
financial" performance of the company'. Linking these two perspectives is a core aspect of the
Performance Management syllabus: it’s critical that you show, and contrast, both perspectives in your
answer.
Also, in question Jungle Co, you are practically overloaded with data as there are five separate sections,
19 rows, and two columns of data. Don’t get bogged down here; find several relevant ratios from each
section, rather than calculate everything possible from one section.
For example, after you identify that there are multiple sections of data, you could calculate some of the
following indicators, touching on as many sections as you can:
Section(s) Indicator
Profit and loss statement Change in revenue

Change in gross margin
Change in net margin
Breakdown of revenue and cost of Change in revenue by product line
sales Change cost of sales by product line
Change in gross margin by product line
Administration expenses Change in customer service costs

Change in customer service costs as a % of admin expenses
Non–financial data Change in on-time deliveries

Change in late deliveries
Change in customer complaints
Change in the % of customers who complain
Change in late Gold member deliveries
These indicators are only some examples of what you could calculate – it also might be more than you
can do in the allocated time. But don’t worry; you don’t need to calculate this full list of indicators to reach
passing marks. What’s more important is to (a) not to over-do it calculating at the expense of your
discussion (b) use data from all the sections (c) use the ratios effectively in your discussion.
Time management: when 1/3 of the time remaining after reading and planning is up, stop your
calculations and move to the discussion. It’s normal to feel that there is more that you can do, but resist
this urge; it’s time to move to the discussion part of your answer.
Avoid the common mistake of going no further than the calculations—the verb is ‘discuss,’ not
‘calculate.’ Only 7 out of 20 marks in this question are available for the numbers.
UNDERSTAND THE 'OWN FIGURE RULE' AND HOW IT WORKS IN YOUR

FAVOR
In a time-pressurised situation like your F5 exam, occasional slips of the calculator can happen. While
your section A and B answers need to be numerically correct to get marks, in section C constructed
response questions, the 'own figure rule' applies. This means that any numbers you calculate incorrectly
will be assumed correct when used later in your answer.
For example, if sales are increasing, but you accidentally show this change as decreasing, you will miss
the mark for the working. However, in your narrative, if you correctly discuss the impact of sales
decreasing, you will get full marks here even though your calculation was incorrect. But, make sure you
show your workings.
In the computer based exam, your workings will be in spreadsheet cells and markers will look at your
formulae if needed.
Avoid the common mistake of trying to get your numbers perfect in section C, scenario-based
questions. Do your calculations and quickly move to the discussion when time is up – don’t
waste valuable time double-checking everything. If there happens to be a mistake in your
numbers, but you interpret this error correctly, you will get full marks in your discussion.
MOVING ON TO THE MORE CHALLENGING PART: THE DISCUSSION
Now that you’ve completed the calculations, it’s time to move to the part that many students dread:
writing the discussion. This is the area where many students struggle. But, with the right approach to
writing and enough practice, you can develop the skills to successfully handle this component of the
requirement.
Time management: as noted above, make sure you give this part of your answer the full 2/3 of your
remaining time after reading and planning – you will need it.
HOW TO GAIN MARKS
It’s not enough to simply restate your calculation in words – for example, 'sales increased by 20 percent'.
It’s also not enough to only give short, generic statements – for example, 'this is a good sign'. You’ll get
no marks for either – you must say more.
To gain a mark, your discussion needs to add value to your calculation and be linked to business
performance. This means you need to say WHY you think something has changed and LINK this to
information in the scenario. You need to bring multiple pieces of information together to actually discuss,
or assess, performance.
Avoid the common mistakes of (a) only restating your calculations as words, and (b) only
providing short, one-phrase, generic comments. Neither of these approaches will generate any
marks.
HOW MUCH SHOULD YOU WRITE
There is no set rule for section C questions that says, ‘one mark = one point.’ Each question will have a
different marking guide. But, you need some reference to help you decide how much you should write.
Work with the general rule when the requirement is ‘discuss’ or ‘evaluate: 1 mark = 1 idea. To generate
an idea that is linked to the scenario, use roughly 3 short sentences or independent clauses.
A good method for getting your ideas down quickly when discussing calculations is to use the writing and
structuring tool, Calculate—Comment—Discuss. This approach to structuring paragraphs ensures that
you write enough, link to the scenario, and efficiently generate marks.
‘Calculate-Comment-Discuss’ works like this.
One Paragraph
Click the diagram to view

larger version
Avoid the common

mistake of creating a ‘sea
of words’—this means
pages of writing without
headings and structure.
Use short, concise
paragraphs, with
headings and
subheadings, in your
answer.
Also, make sure you stick

to the requirement, which
is ‘discuss'. Don’t drift by giving recommendations or definitions—stay focused on the requirement.
Avoid the common mistake of ‘requirement drift’. You won’t get marks for answering invented
requirements.
WHAT TO WRITE ABOUT
Use your calculations as a guide to structure your answer: focus on the areas of performance that have
changed the most and that seem to be linked to the important information in the scenario. It’s important
to focus on the RELATIVE change of an indicator as this shows the significance of what you’re writing
about.
Avoid the common mistake of producing and writing about absolute changes. Only relative
changes will be awarded marks.
For example, in question Jungle Co, late Gold member deliveries increased from 2% to 14%. What’s
important is that missed deliveries increased 700% in relative terms—this shows a major problem,
coming from the move to in-house logistics, potentially threatening continued growth of the
business. This is what you are going after in your discussion. To state the change simply as in
increase of 14 percentage points misses the point and won’t generate marks.
MAKE SURE YOUR ANSWER IS LINKED TO THE SCENARIO
In section C, it’s critical that you relate your answer to the scenario to gain marks.
For example, in question Jungle Co, you learned during reading and planning that the company took
logistics in-house instead of using international delivery companies. You then see in your calculations
that both missed deliveries and complaints have increased. It’s likely there is a cause-effect relationship
here: moving to in-house logistics caused the quality to drop, which is driving the increase in complaints.
Bring this kind of relationship out in your answer.
Avoid the common mistake of producing generic comments—link your ideas directly to the
issues in the scenario to gain marks.
INCLUDE A SUMMARY
If time permits, include an overall summary at the end of your answer, tying the financial and non-
financial perspectives together.
EXAMPLE OF A GOOD ANSWER
We’ve just looked a detailed approach to helping you construct an answer that can get you a comfortable
pass on this type of question. Here is a worked example, demonstrating the points in this article.
Workings
Click the table to view

larger version
15% increase in total

revenue
This is a good sign. It
shows that Jungle Co is
selling more units because
'prices are stable', and/or
the new cloud service is
expanding. But, we need a
breakdown of revenue to
understand this (see
below).
32.7% increase in net margin

This is excellent sign. It’s linked to the lower cost of sales from Slabak imports and the launch of cloud
computing, which is probably a higher-margin product (for example, no distribution costs for IT services).
60.5% increase in admin expenses

This is a problem because admin costs are usually fixed. This is linked to the big increase in customer
service costs, which, in turn, is probably related to the lower quality of the new supplier which is causing
more complaints (see below).
5.3% drop in household goods revenue

This is a worrying sign – it could be linked to the possible drop in quality from the Slabak imports.
28.3% change in electronic goods revenue

This is another positive signal. It shows that Jungle is outperforming the average market growth of 20%,
which means they are gaining market share.
225% increase in late deliveries

This is a major problem. It‘s linked to the move to in-house logistics. Clearly Jungle Co can’t match the
quality of the external, international suppliers. Jungle Co needs to address this as it threatens future
growth of the business.
300% increase in % of customers who complain

This is another major problem. It’s linked to both the outsourcing of production to Slabak, and the move
to in-house logistics (mentioned above). Clearly Jungle Co has serious internal process problems that
will negatively affect their reputation.
Overall
We see mostly good news from the financial indicators: sales, margins, and profits are generally
increasing. However, the non-financial information paints a different picture as we see serious problems
emerging with Jungle Co’s quality and logistics. Jungle Co needs to address these issues if they want
their financial success to continue in the long term.
SUMMARY
Common mistake How to avoid
'Over calculating' and 'under writing' Look for the time-management clue in the requirement – for example, if
the requirement says, '1/3 of the marks are available for calculations',
spend 1/3 of your time calculating and 2/3 writing
Not referencing the scenario in your Highlight the key points from the scenario as you read and then link to
discussion them in your discussion
Going no further than calculations Highlight the verb and do what the verb says. If it’s 'discuss', or
'evaluate', it’s likely at least half of the marks will come from your
writing, not your calculating
Double-checking all your calculations Calculate quickly once, and move to the discussion. 'Own figure rule'
will be in effect.
Only restating your calculation as words Use the paragraph writing tool, 'calculate-comment-discuss'
Providing only short, generic, one- Use the paragraph writing tool, 'calculate-comment-discuss'
phrase comments
'Requirement drift' – answering an Highlight the verb and only do what is asked. Nothing more.
invented requirement, rather than the
one given in the question.
Discussing change in absolute, rather Calculate changes in relative terms and discuss the impact of this. (For
than relative, terms. example, if missed deliveries go from 3% to 6%, what’s important is that
missed deliveries increased by 100%, or doubled, not that they
increased three percentage points).
Producing a 'sea of words' – this is an Use short paragraphs, with headings and sub-headings. Use 1
unstructured essay with no signposting paragraph per idea.
or breaks between ideas
Running out of time Follow the time management rule of 1.7 or 1.8 minutes per mark;
remember you won’t lose marks for spelling or grammar mistakes if you
are understood by the marker
Steve Willis is head tutor for Management Accounting exams at PwC Academy

providers insights
TRANSFER PRICING
RELATED LINKS
There is no doubt that transfer pricing is an area that candidates find difficult. It’s not surprising, then, that
when it was examined in June 2014’s Performance Management exam, answers were not always very
good.
The purpose of this article is to strip transfer pricing back to the basics and consider, first, why transfer
pricing is important; secondly, the general principles that should be applied when setting a transfer price;
and thirdly, an approach to tackle exam questions in this area, specifically the question from June 2014’s
exam. We will talk about transfer pricing here in terms of two divisions trading with each other. However,
don’t forget that these principles apply equally to two companies within the same group trading with each
other.
This article assumes that transfer prices will be negotiated between the two parties. It does not look at
alternative methods such as dual pricing, for example. This is because, in Performance Management, the
primary focus is on working out a sensible transfer price or range of transfer prices, rather than different
techniques to setting transfer prices.
WHY TRANSFER PRICING IS IMPORTANT
It is essential to understand that transfer prices are only important in so far as they encourage divisions
to trade in a way that maximises profits for the company as a whole. The fact is that the effects of inter-
divisional trading are wiped out on consolidation anyway. Hence, all that really matters is the total value
of external sales compared to the total costs of the company. So, while getting transfer prices right is
important, the actual transfer price itself doesn’t matter since the selling division’s sales (a credit in the
company accounts) will be cancelled out by the buying division’s purchases (a debit in the company
accounts) and both figures will disappear altogether. All that will be left will be the profit, which is merely
the external selling price less any cost incurred by both divisions in producing the goods, irrespective of
which division they were incurred in.
As well as transfer prices needing to be set at a level that maximises company profits, they also need to
be set in a way that is compliant with tax laws, allows for performance evaluation of both divisions and
staff/managers, and is fair and therefore motivational. A little more detail is given on each of these points
below:
If your company is based in more than one country and it has divisions in different countries that are trading with each
other, the price that one division charges the other will affect the profit that each of those divisions makes. In turn, given
that tax is based on profits, a division will pay more or less tax depending on the transfer prices that have been set.
While you don’t need to worry about the detail of this for the Performance Management exam, it’s such an important
point that it’s simply impossible not to mention it when discussing why transfer pricing is important.
From bullet point 1, you can see that the transfer price set affects the profit that a division makes. In turn, the profit that a
division makes is often a key figure used when assessing the performance of a division. This will certainly be the case if
return on investment (ROI) or residual income (RI) is used to measure performance. Consequently, a division may, for
example, be told by head office that it has to buy components from another division, even though that division charges a
higher price than an external company. This will lead to lower profits and make the buying division’s performance look
poorer than it would otherwise be. The selling division, on the other hand, will appear to be performing better. This may
lead to poor decisions being made by the company.
If this is the case, the manager and staff of that division are going to become unhappy. Often, their pay will be linked to
the performance of the division. If divisional performance is poor because of something that the manager and staff
cannot control, and they are consequently paid a smaller bonus for example, they are going to become frustrated and
lack the motivation required to do the job well. This will then have a knock-on effect to the real performance of the
division. As well as being seen not to do well because of the impact of high transfer prices on ROI and RI, the division
really will perform less well.
The impact of transfer prices could be considered further but these points are sufficient for the level of
understanding needed for the Performance Management exam. Let us now go on to consider the general
principles that you should understand about transfer pricing. Again, more detail could be given here and
these are, to some extent, oversimplified. However, this level of detail is sufficient for the Performance
Management exam.
GENERAL PRINCIPLES ABOUT TRANSFER PRICING
1. Where there is an external market for the product being transferred
Minimum transfer price

When we consider the minimum transfer price, we look at transfer pricing from the point of view of the
selling division. The question we ask is: what is the minimum selling price that the selling division would
be prepared to sell for? This will not necessarily be the same as the price that the selling division would
be happy to sell for, although, as you will see, if it does not have spare capacity, it is the same.
The minimum transfer price that should ever be set if the selling division is to be happy is: marginal cost
+ opportunity cost.
Opportunity cost is defined as the 'value of the best alternative that is foregone when a particular course
of action is undertaken'. Given that there will only be an opportunity cost if the seller does not have any
spare capacity, the first question to ask is therefore: does the seller have spare capacity?
Spare capacity
If there is spare capacity, then, for any sales that are made by using that spare capacity, the opportunity
cost is zero. This is because workers and machines are not fully utilised. So, where a selling division has
spare capacity the minimum transfer price is effectively just marginal cost. However, this minimum
transfer price is probably not going to be one that will make the managers happy as they will want to earn
additional profits. So, you would expect them to try and negotiate a higher price that incorporates an
element of profit.
No spare capacity
If the seller doesn’t have any spare capacity, or it doesn’t have enough spare capacity to meet all
external demand and internal demand, then the next question to consider is: how can the opportunity
cost be calculated? Given that opportunity cost represents contribution foregone, it will be the amount
required in order to put the selling division in the same position as they would have been in had they sold
outside of the group. Rather than specifically working an 'opportunity cost' figure out, it’s easier just to
stand back and take a logical approach rather than a rule-based one.
Logically, the buying division must be charged the same price as the external buyer would pay, less any
reduction for cost savings that result from supplying internally. These reductions might reflect, for
example, packaging and delivery costs that are not incurred if the product is supplied internally to another
division. It is not really necessary to start breaking the transfer price down into marginal cost and
opportunity cost in this situation.
It’s sufficient merely to establish:
(i) what price the product could have been sold for outside the group
(ii) establish any cost savings, and
(iii) deduct (ii) from (i) to arrive at the minimum transfer price.
At this point, we could start distinguishing between perfect and imperfect markets, but this is not
necessary in Performance Management. There will be enough information given in a question for you to
work out what the external price is without focusing on the market structure.
We have assumed here that production constraints will result in fewer sales of the same product to
external customers. This may not be the case; perhaps, instead, production would have to be moved
away from producing a different product. If this is the case the opportunity cost, being the contribution
foregone, is simply the shadow price of the scarce resource.
In situations where there is no spare capacity, the minimum transfer price is such that the selling division
would make just as much profit from selling internally as selling externally. Therefore, it reflects the price
that they would actually be happy to sell at. They shouldn’t expect to make higher profits on internal sales
than on external sales.
Maximum transfer price

When we consider the maximum transfer price, we are looking at transfer pricing from the point of view of
the buying division. The question we are asking is: what is the maximum price that the buying division
would be prepared to pay for the product? The answer to this question is very simple and the maximum
price will be one that the buying division is also happy to pay.
The maximum price that the buying division will want to pay is the market price for the product – ie
whatever they would have to pay an external supplier for it. If this is the same as the selling division sells
the product externally for, the buyer might reasonably expect a reduction to reflect costs saved by trading
internally. This would be negotiated by the divisions and is called an adjusted market price.
2. Where there is no external market for the product being transferred

Sometimes, there will be no external market at all for the product being supplied by the selling division;
perhaps it is a particular type of component being made for a specific company product. In this situation,
it is not really appropriate to adopt the approach above. In reality, in such a situation, the selling division
may well just be a cost centre, with its performance being judged on the basis of cost variances. This is
because the division cannot really be judged on its commercial performance, so it doesn’t make much
sense to make it a profit centre. Options here are to use a cost based approach to transfer pricing but
these also have their advantages and disadvantages.
Cost based approaches
Variable cost
A transfer price set equal
to the variable cost of the
transferring division
produces very good
economic decisions. If the
transfer price is $18,
Division B’s marginal costs
would be $28 (each unit
costs $18 to buy in then
incurs another $10 of
variable cost). The group’s
marginal costs are also
$28, so there will be goal congruence between Division B’s wish to maximise its profits and the group
maximising its profits. If marginal revenue exceeds marginal costs for Division B, it will also do so for the
group.
Although good economic decisions are likely to result, a transfer price equal to marginal cost has certain
drawbacks:
Division A will make a loss as its fixed costs cannot be covered. This is demotivating.
Performance measurement is also distorted. Division A is condemned to making losses while Division B
gets an easy ride as it is not charged enough to cover all costs of manufacture. This effect can also
distort investment decisions made in each division. For example, Division B will enjoy inflated cash
inflows.
There is little incentive for Division A to be efficient if all marginal costs are covered by the transfer price.
Inefficiencies in Division A will be passed up to Division B. Therefore, if marginal cost is going to be used
as a transfer price, it at least should be standard marginal cost, so that efficiencies and inefficiencies stay
within the divisions responsible for them.
Full cost/Full cost plus/Variable cost plus

A transfer price set at full cost or better, full standard cost is slightly more satisfactory for Division A as it
means that it can aim to break even. Its big drawback, however, is that it can lead to dysfunctional
decisions because Division B can make decisions that maximise its profits but which will not maximise
group profits. For example, if the final market price fell to $35, Division B would not trade because its
marginal cost would be $40 (transfer-in price of $30 plus own marginal costs of $10). However, from a
group perspective, the marginal cost is only $28 ($18 + $10) and a positive contribution would be made
even at a selling price of only $35. Head office could, of course, instruct Division B to trade but then
divisional autonomy is compromised and Division B managers will resent being instructed to make
negative contributions which will impact on their reported performance. Imagine you are Division B’s
manager, trying your best to hit profit targets, make wise decisions, and move your division forward by
carefully evaluated capital investment.
The full cost plus approach would increase the transfer price by adding a mark-up. This would now
motivate Division A, as profits can be made there and may also allow profits to be made by Division B.
However, again this can lead to dysfunctional decisions as the final selling price falls.
The difficulty with full cost, full cost plus and variable cost plus is that they all result in fixed costs and
profits being perceived as marginal costs as goods are transferred to Division B. Division B therefore has
the wrong data to enable it to make good economic decisions for the group – even if it wanted to. In fact,
once you get away from a transfer price equal to the variable cost in the transferring division, there is
always the risk of dysfunctional decisions being made unless an upper limit – equal to the net marginal
revenue in the receiving division – is also imposed.
TACKLING A TRANSFER PRICING QUESTION
Thus far, we have only talked in terms of principles and, while it is important to understand these, it is
equally as important to be able to apply them. The following question came up in June 2014’s exam. It
was actually a 20-mark question with the first 10 marks in part (a) examining divisional performance
measurement and the second 10 marks in part (b) examining transfer pricing. Parts of the question that
were only relevant to part (a) have been omitted here however the full question can be found on ACCA’s
website. The question read as follows:
Reproduction of exam question
Relevant extracts from part (a)

The Rotech group comprises two companies, W Co and C Co.
W Co is a trading company with two divisions: the design division, which designs wind turbines and
supplies the designs to customers under licences and the Gearbox division, which manufactures
gearboxes for the car industry.
C Co manufactures components for gearboxes. It sells the components globally and also supplies W Co
with components for its Gearbox manufacturing division.
The financial results for the two companies for the year ended 31 May 2014 are as follows:
(b) C Co is currently
working to full capacity.
The Rotech group’s policy
is that group companies
and divisions must always
make internal sales first
before selling outside of
the group. Similarly,
purchases must be made
from within the group
wherever possible.
However, the group
divisions and companies
are allowed to negotiate
their own transfer prices
without interference from
head office.
C Co has always charged

the same price to the
Gearbox division as it does to its external customers. However, after being offered a 5% lower price for
the similar components from an external supplier, the manager of the Gearbox division feels strongly that
the transfer price is too high and should be reduced. C Co currently satisfies 60% of the external demand
for its components. Its variable costs represent 40% of the total revenue for the internal sales of the
components.
Required:
Advise, using suitable calculations, the total transfer price or prices at which the components
should be supplied to the Gearbox division from C Co.
(10 marks)
Approach
1. As always, you should begin by reading the requirement. In this case, it is very specific as it asks you to ‘advise, using
suitable calculations…’ In a question like this, it would actually be impossible to ‘advise’ without using calculations
anyway and your answer would score very few marks. However, this wording has been added in to provide assistance.
In transfer pricing questions, you will sometimes be asked to calculate a transfer price/range of transfer prices for one
unit of a product. However, in this case, you are being asked to calculate the total transfer price for the internal sales.
You don’t have enough information to work out a price per unit.
2. Allocate your time. Given that this is a 10-mark question then, since it is a three-hour exam, the total time that should be
spent on this question is 18 minutes.
3. Work through the scenario, highlighting or underlining key points as you go through. When tackling part (a) you would
already have noted that C Co makes $7.55m of sales to the Gearbox Division (and you should have noted who the
buying division was and who the selling division was). Then, in part (b), the first sentence tells you that C Co is currently
working to full capacity. Highlight this; it’s a key point, as you should be able to tell now. Next, you are told that the two
divisions must trade with each other before trading outside the group. Again, this is a key point as it tells you that, unless
the company is considering changing this policy, C Co is going to meet all of the Gearbox division’s needs.
Next, you are told that the divisions can negotiate their own transfer prices, so you know that the price(s) you should
suggest will be based purely on negotiation.
Finally, you are given information to help you to work out maximum and minimum transfer prices. You are told that the
Gearbox division can buy the components from an external supplier for 5% cheaper than C Co sells them for. Therefore,
you can work out the maximum price that the division will want to pay for the components. Then, you are given
information about the marginal cost of making gearboxes, the level of external demand for them and the price they can
be sold for to external customers. You have to work all of these figures out but the calculations are quite basic. These
figures will enable you to calculate the minimum prices that C Co will want to sell its gearboxes for; there are two
separate prices as, when you work the figures through, it becomes clear that, if C Co sold purely to the external market,
it would still have some spare capacity to sell to the Gearbox division. So, the opportunity cost for some of the sales is
zero, but not for the other portion of them.
4. Having actively read through the scenario, you are now ready to begin writing your answer. You should work through in a
logical order. Consider the transfer from both C Co’s perspective (the minimum transfer price), then Gearbox division’s
perspective (the maximum transfer price), although it doesn’t matter which one you deal with first. Head up your
paragraphs so that your answer does not simply become a sea of words. Also, by heading up each one separately, it
helps you to remain focused on fully discussing that perspective first. Finally, consider the overall position, which in this
case is to suggest a sensible range of transfer prices for the sale. There is no single definitive answer but, as is often the
case, a range of prices that would be acceptable.
The suggested solution is shown below.
Always remember that you should only show calculations that actually have some relevance to the
answer. In this exam, many candidates actually worked out figures that were of no relevance to anything.
Such calculations did not score marks.
REPRODUCTION OF ANSWER
From C Co’s perspective:

C Co transfers components to the Gearbox division at the same price as it sells components to the
external market. However, if C Co were not making internal sales then, given that it already satisfies 60%
of external demand, it would not be able to sell all of its current production to the external market.
External sales are $8,010,000, therefore unsatisfied external demand is ([$8,010,000/0.6] – $8,010,000)
= $5,340,000.
From C Co’s perspective, of the current internal sales of $7,550,000, $5,340,000 could be sold externally
if they were not sold to the Gearbox division. Therefore, in order for C Co not to be any worse off from
selling internally, these sales should be made at the current price of $5,340,000, less any reduction in
costs that C Co saves from not having to sell outside the group (perhaps lower administrative and
distribution costs).
As regards the remaining internal sales of $2,210,000 ($7,550,000 – $5,340,000), C Co effectively has
spare capacity to meet these sales. Therefore, the minimum transfer price should be the marginal cost of
producing these goods. Given that variable costs represent 40% of revenue, this means that the marginal
cost for these sales is $884,000. This is, therefore, the minimum price which C Co should charge for
these sales.
In total, therefore, C Co will want to charge at least $6,224,000 for its sales to the Gearbox division.
From the Gearbox division’s perspective:

The Gearbox division will not want to pay more for the components than it could purchase them for
externally. Given that it can purchase them all for 95% of the current price, this means a maximum
purchase price of $7,172,500.
Overall:
Taking into account all of the above, the transfer price for the sales should be somewhere between
$6,224,000 and $7,172,500.
SUMMARY
The level of detail given in this article reflects the level of knowledge required for Performance
Management as regards transfer pricing questions of this nature. It’s important to understand why
transfer pricing both does and doesn’t matter and it is important to be able to work out a reasonable
transfer price/range of transfer prices.
The thing to remember is that transfer pricing is actually mostly about common sense. You don’t really
need to learn any of the specific principles if you understand what it is trying to achieve: the trading of
divisions with each other for the benefit of the company as a whole. If the scenario in a question was
different, you may have to consider how transfer prices should be set to optimise the profits of the group
overall. Here, it was not an issue as group policy was that the two divisions had to trade with each other,
so whether this was actually the best thing for the company was not called into question. In some
questions, however it could be, so bear in mind that this would be a slightly different requirement. Always
read the requirement carefully to see exactly what you are being asked to do.

ACCA F5 Revision Notes
COSTING PRINCIPLES
(1) Activity Based Costing
Activity Based Costing
Due to advanced manufacturing technology (AMT),
Absorption Costing Most production rely on machine/equipment

- Overhead costs increased significantly
The overheads usuall either absored based
on machine hours or direct labour hours. In the competitive environment, producing more variety of products.
Is a traditional costing method, It is no longer appropriate the share overheads either

Old days, most productions are labour intensive. based on labour hours or machine hours.
Produced narrow range of products
Overhead costs is not significant and can be Introduction of activity based costing arised, and the
simply share based on labour hours or machine hours. more overheads will be incurred if high volume of activities involved.
(Hence is be able to recognised the complexity of a product
based on the volume of activities)
* Overheads : cost per driver
Annie Tan Page 1

(2) Life Cycle Costing
Benefits
The visibility of ALL costs is increased, rather than just costs relating
to one period. This facilitates better decision-making.
Individual profitability for products is more accurate because of this.

This facilitates performance appraisal and decision-making, and means
that prices can be determined with better knowledge of the true costs.
More accurate feedback can take place when assessing whether

new products are a success or a failure, since the costs of researching,
developing and designing those products are also taken into account.
Annie Tan Page 2

(3) Target Costing
Step 6:
Step 1:
Cost gap = Estimated cost – Target cost
Determine specifications
Step 7:
Step 2: Step 5: Reduce cost gap
Determine Market Price Estimated costs (Re-engineering & use simple design, cheaper labour,
(Competitors & Consumer behaviours) (Materials, Labour, Oveheads, etc) negotiates with suppliers, alternative materials, etc)
Step 3:
Step 4: Step 8:
Target profits
Target Cost = Market price – Target profits Negotiates with customer
(Company's target ROI/profit margin)
Annie Tan Page 3

(4) Throughput Accounting
Product X Product Y
Sales $XX $XX
Less: Direct material costs ($X) ($X)
Throughput contribution $X $X
Divide: usage of bottleneck xx hour xx hour
Throughput contribution per hour $x / hour $x / hour
Divided: Conversion cost per hour $x / hour $x / hour
Throughput accounting ratio (TPAR) x.xx x.xx
If TPAR is less than 1.00, how to improve the TPAR:

1. Increase the selling price
2. Reduce material cost
3. Reduce conversion cost (labour and overhead costs)
4. Reduce the usage of bottleneck usage
Annie Tan Page 4

(5) Environmental Management Accounting
INPUT/OUTFLOW ANALYSIS
This technique records material inflows and balances this with outflows
on the basis that, what comes in, must go out.
FLOW COST ACCOUNTING

This technique uses material flows and the organisational structure.
Material flows divided into three categories: material, system and
delivery and disposal.
The values and costs of each of these three flows are then calculated.
The aim of flow cost accounting is to reduce the quantity of materials which,
as well as having a positive effect on the environment, should have a positive
effect on a business’ total costs in the long run.
ACTIVITY-BASED COSTING
ABC allocates internal costs to cost centres and cost drivers on the basis of the
activities that give rise to the costs. In an environmental accounting context,
it distinguishes between environment-related costs, which can be attributed
to joint cost centres, and environment‑ driven costs, which tend to be hidden on
general overheads.
LIFECYCLE COSTING
Within the context of environmental accounting, lifecycle costing is a technique
which requires the full environmental consequences, and, therefore, costs, arising
from production of a product to be taken account across its whole lifecycle,
literally ‘from cradle to grave’.
Annie Tan Page 5

DECISION MAKING
(1) Relevant Costing
Criterias: Irrelevant costs

Future - Committed
Incremental (opportunity cost) - Past cost / sunk cost
Cash flows - General fixed cost
Materials
(I) If regularly use, Labour
Relevant cost = replacement cost Irrelevant : Monthly salary, contracted staff
(ii) If no longer required (whichever higher) Relevant: incremental commission, sub-contracted
(1) scrap value
(2) replacement of other materials
Annie Tan Page 6

(2) BREAK EVEN ANALYSIS / COST VOLUME PROFIT ANALYSIS
BE sales quantity = Total Fixed Cost Sales required to achieved target profit
Contribution per mix Total Fixed Cost
= Sales quantity (no of mixes)
Contribution per mix
BE sales revenue = Total Fixed Cost
Weighted C/S Ratio Total Fixed Cost
= Sales revenue (Total)
Weigthed Avg C/S Ratio
Margin of safety = Target sales – BE sales (Qty & Revenue)

= Target sales – BE sales
x 100%
Target sales
Problems/Limitations:
1. Cannot assume based on constant mix
2. Not realistic to assume that most profitable product will be sold first.
Annie Tan Page 7

(3) LINEAR PROGRAMMING
Steps
1. Define variables (x & y)
2. Construct objective function (max contribution or min cost)
3. Constraints
4. Graph (x = 0, y = ? & vice versa)
5. Establish feasible area
6. Use Point Ato determine the objective function line
7. Determine optimal point
Annie Tan Page 8

(4) PRICING DECISION
Pricing policy and the market
Influences on the prices Markets Markets
Price Sensitivity Suppliers

Price perception Inflation Perfect competition Maintain existing prices (lost small market share)
Quality Newness Monopoly Non price counter attack (product change, advertising, better services)
Intermediaries Incomes Monopolistic competition Reduce prices (maintain market share)
Competitors Product range Oligopoly Raise prices with a non price counter attack (better quality service)
Ethics
Elasticity and elasticity
PED (Price elasticity of demand)

PED = 0 : Inelastic
PED = ∞ : Elastic
Massive change in quantity for small price changes
Annie Tan Page 9

Pricing Strategies
Demand Based Pricing Full cost plus pricing (traditional pricing method)
- a profit maximising price, suitable for monopoly situation, Full costs (VC + FC)
- demand can be elastic or inelastic + Profits
Selling Price
P = a – bQ
a = selling price when demand is 0 Advantages:
b = change in price / change in quantity Cover all its fixed costs
Q = quantity demanded Simple, quick and cheap method
P = selling price based on demanded quantities
Disadvantages:
To maximise profit, MR = MC Fails to recognised demand, fails to allow for competition,,
MR = a – 2bQ Ignore opportunity costs, price depnds on method of apportioning fixed costs
MC = Marginal cost / variable cost
Marginal cost plus pricing Relevant cost pricing
Variable costs
+ Profits
Selling Price
Opportunity cost approach to pricing
Advantages:
Simple and easy method, reflect demand conditions, Special orders :
Awareness of marginal costs for break even analysis, take extra work from the spare capacity
Information for variable costs is readily available.
Minimum pricing :
Disadvantages: take into consideration of incremental cots and opportunity costs
Failed to consider demand, competitors & profit maximisation
Ignore fixed costs altogether.
Annie Tan Page 10

Other pricing strategies
Penetration Pricing Skimming Pricing
Charging high prices when a product is first launched.

Charging low prices when a product is first launched. (mximise short-term profitability)
- Discourage new entrants into the market - Product is new and different
- Shorten the initial period of life cycle - High initial cash flows
- Benefits from economies of scale - Different market segments
- Demand is highly elastic - Products may have a short life cycle (cover expensive R&D)
Complementary Product Pricing Product Line Pricing
Offering for sale several related products.

Complementary products are goods that tend to be bought and used together.
- Demand of the products are likely to be inter related.
Sold separately but are connected and dependant on each other for sales. - A line can comprise related products of various sizes, types,
colours, qualities etc.
Volume Discounting Price Discrimination
Reduction in price given for larger than average purchases. By market segment
By product version
Objective: increase sales from large customers. By time
By place
Annie Tan Page 11

(5) Risks and Uncertainty
Methods of uncertainty reduction:

(1) Market research.
This can be desk-based (secondary) or field-based (primary). Desk-based is cheap but can lack focus.
Field-based research is better in that you can target your customers and your product area, but can be time consuming
and expensive. The internet is bringing down the cost and speeding up this type of research, email is being used to
gather information quickly on the promise of free gifts etc.
(2) Simulation.
Computer models can be built to simulate real life scenarios. The model will predict what range of returns
an investor could expect from a given decision without having risked any actual cash. The models use random number
tables to generate possible values for the uncertainty the business is subject to. Again, computer technology is assisting
in bringing down the cost of such risk analysis.
(3) Sensitivity analysis.

This can be used to assess the range of values that would still give the investor a positive return.
The uncertainty may still be there, but the affect that it has on the investor’s returns will be better understood. Sensitivity
calculates the % change required in individual values before a change of decision results. If only a (say) 2% change is
required in selling price before losses result an investor may think twice before proceeding. Risk is therefore better
understood.
(4) Calculation of worst and best case figures.

An investor will often be interested in range. It enables a better understanding of risk. An accountant could calculate
the worst case scenario, including poor demand and high costs whilst being sensible about it.
He could also calculate best case scenarios including good sales and minimum running costs.
This analysis can often reassure an investor. The production of a probability distribution to show an investor the
range of possible results is also useful to explain risks involved. A calculation of standard deviation is also possible
Annie Tan Page 12

Decision Rules
Risk taker:
Maximax: Willing to take risk. Optimistic. Hope for the best outcome.
Maximising the maximum return.
Maximin: Risk Averse:

Maximising the minimax regret Unwilling to accept risk. Pessimistic.
Stable return and minimise losses.
Minimax regret:
Minimising the maximum opportunity lost from choosing the wrong option.
Risk Neutral:
Expected value:
Based on average outcome.
Average outcome based on given probabilities.
Limitations of expected value:

1. Probabilities based on historical, past ≠ future!
2. Probability suitable for long term decision, not appropriate for one-off decision Decision Tree
3. Subjective judgement.
4. EV is the average outcome and it will never actually occurred.
Value of perfect information: Max cost willing to pay for market survey to obtain perfect info
Demand Best Option Profits Probability Expected Value
Weak B $x 0.4 $x
Strong A $x 0.6 $x
Expected value without perfect information $x
Expected value without perfect information (probability decision) ($x)
Value of perfect information $x
Annie Tan Page 13

BUDGETING
Incremental Budgeting Rolling Budget
‘Incremental budgeting’ is the term used to describe the process whereby a budget
is prepared using a previous period’s budget or actual performance as a base,
The rolling budget would be a budget covering a 12-month period and
with incremental amounts then being added for the new budget period.
would be updated monthly (could be quarterly or halfyearly).
Advantages: However, instead of the 12-month period remaining static, it would

– It is quick to do and a relatively simple process. always roll forward by one month.
– The information is readily available, so very limited quantitative analysis is needed.
– It is appropriate in a stable business. This means that, as soon as one month has elapsed, a budget is
prepared for the corresponding month one year later & period
Problems/Disadvantages: covered by the budget is always 12 months.
– It builds on wasteful spending.
If the actual figures for this year include overspends caused by some form of error then
the budget for the next year would potentially include this overspend again.
– It encourages organisations to spend up to the maximum allowed in the knowledge
that if they don’t do this then they will not have as much to spend in the following year’
budget.
– Assessing the amount of the increment can be difficult. Spreadsheets in Budget Preparation
– It is not appropriate in a rapidly changing business.
– Can ignore the true (activity based) drivers of a cost leading to poor budgeting.
Problems/Limitations:
Errors entering data

Rolling budgets more complex
Formulae may be wrong
Corruption of model
No audit trail
Annie Tan Page 14

Zero Based Budgeting
‘Zero-based budgeting’, on the other hand, refers to a budgeting process which ZBB : avoid the budgetary slack and wasteful spending
starts from a base of zero, with no reference being made to the prior period’s
budget or performance. Problems/Disadvantages of ZBB:
Every department function is reviewed comprehensively, with all – Departmental managers will not have the skills necessary to construct
expenditure requiring approval, rather than just the incremental decision packages.
expenditure requiring approval.
They will need training for this and training takes time and money.
– In a large organisation, the number of activities will be so large that the

Stages in zero-based budgeting amount of paperwork generated from ZBB will be unmanageable.
1. Activities are identified by managers. These activities are then described in – Ranking the packages can be difficult, since many activities cannot be
what is called a ‘decision package’. This decision package is prepared at the compared on the basis of purely quantitative measures.
base level, representing the minimum level of service or support needed to achieve
the organisation’s objectives. Further incremental packages may then be prepared Qualitative factors need to be incorporated but this is difficult.
to reflect a higher level of service or Support.
– The process of identifying decision packages, determining their purpose,
2. Management will then rank all the packages in the order of decreasing benefits costs and benefits is massively time consuming and therefore costly.
to the organisation. This will help management decide what to spend and where to spend it.
– Since decisions are made at budget time, managers may feel unable to
3. The resources are then allocated based on order of priority up to the spending level. react to changes that occur during the year. This could have a detrimental
effect on the business if it fails to react to emerging opportunities and threats.
Annie Tan Page 15

Top-down Approach / Imposed Style Budgeting Bottom-up Approach / Participative Style Budgeting
A budget allowance which is set wihtout permitting the ultimate budget

holder to have opportunity ot particpate in the budgeting process. A budgeting system in which all budget holders are given the opportunity to
(CIMA Official Terminology) participate in setting their own budgets.
(CIMA Official Terminology)
Top-down approach useful when:
1. Newly formed organisation
2. In very small businesses
Advantages:
3. During periods of economic hardship
- They are based on information from employees most familiar with the department.
4. When the operational managers lack budgeting skills
- Knowledge spread among several levels of management is pulled together
5. When the organisation's different units required preciase co-ordination
- Morale and motivation is improved
- They increase operational managers' commitment to organisational objectives
Advantages: - In general they are more realistic
- Strategic plans are likely to be incorporated into planned activities - Co-ordination between units is improved
- Enhance the co-ordination between the plans and objectives of divisions - Specific resource requirements are included.
- Use senior management's awareness of total resource availability - Senior manager's overview is mixed with operational level details
- Decrease the input from inexperienced or uninformed lower-level employees - Individual manager's aspiration levels are more likely to be taken into account.
- Decrease the period of time taken to draw up the budget
Disadvantages:
Disadvantages: - They consume more time.
- Dissatisfaction, defensiveness and low morale amongst employees. - Changes implemented by senior management may case dissatisfaction.
- The feeling of team spirit may disappear - Budgets may be unachievables if managers aren ot qualified to participate
- The acceptance of organisatiopn goals and objectives coulod be limited. - They may cause managers to introduce budgetary slack and budget bias
- Unachievable budget could result if consideration is not given to local - They can suport 'empire building' by subordinates.
operating and political environments. - An earlier start to the budgeting process could be required.
(particularly for overseas divisions) - Managers may set 'easy' budgets to ensure that they are achievable.
- The feeling of the budget as a punitive device could arise.f
Negotiated Style Budgeting
A budget in which budget allowances are set largely

on the basis of negotiations between budget holders
and those to whom they report.
(CIMA Official Terminology)
Annie Tan Page 16

STANDARD COSTING AND VARIANCE ANALYSIS
Standards Total Quality Management (TQM)
Standard costing is defines as a 'control technique that reports variances by

comparing actual ocsts to pre-set standards facilitating action through 1. Do it right the first time! (Zero defects)
managemnety by exceptions. 2. Continuous improvements
Standard is defines as a 'benchmark measurement of resource usage or

revenue or profit generation, set in defined conditions.
(CIMA Official Terminology) Cost of TQM
Spend Avoid
Ideal Standard
A standard set at an ideal level, which makes no allowance for normal losses,
waste and machine downtime Prevention Costs
- Training Internal Failure
Attainable Standard - Maintenance of machine/equipment - Rework
A standard which assumes an efficient level of operation, but which includes - Goods inward inspection
allowances for factors such as normal loss, waste and machine downtime
Basic Standard External Failure

Appraisal Costs
Standard which is kept unchanged over a period of time - Customer complaint
- Quality Control
- Warranty claim
- Finished goods inspection
Current Standard - Refund
A standard which is an adjusted basic standard based on current price levels
Uses of standard costing: VS

Standard Costing TQM
- Act as a control device by establishing standards and comparing with actual costs
1. Departmental 1. Entire organisation
- To value inventories and cost of production for cost accounting purposes.
Materials usage → production dept 2. Continuous improvement
- Assist in setting budgets and evaluating managerial performance
Material purchase → Purchasing dept 3. Qualitative focus
- Enable principle of 'management by exception'
2. Continuous cost reduction 4. No wastage allowed
- Decision Making (Prediction of future costs)
3. Quantitative focus
- Motivate staff (provision of challenging targets)
4. Consideration of wastage
- Guidance on possible ways of improving efficiency.
Annie Tan Page 17

Planning Variances
(Original vs Revised)
The changes of the variance caused by

uncontrollable factors and it is not fair
if included as part of the manager
performance.
'Planning Error'
Action:
Update the new/revised standard for the
coming budgets.
Operational Variances
A revised standard is more realistic for the use of

evaluating the manager's performance.
A fair evaluation of a manager performance by

taking into consideration of controllable factor.
Annie Tan Page 18

Variances
Sales variances Variable Overhead Cost Variance

Standard – Actual VOH Cost
(SR x SH) – (AR x AH)
Sales Price
Direct Material Cost Variance (AP – SP) Aqsold
Standard – Actual Mat Cost (AP x AQsold) – Actual total sales
(SP x SQ) – (AP x AQ)
VOH Expenditure VOH Efficiency
(SR x Ahworked) – Actual VOH cost (SH – AH worked)SR
Sales Volume Variance
Direct Material Price Direct Material Usage (AQ sold – BQ)Std Gross Profit /Std Contribution
(SP – AP) AQ (SQ – AQ) SP (AP x AQsold) – Actual total sales
(SP x AQ) – Actual Mat Cost
Sales Mix Sales Quantity

Fixed Overhead Cost Variance
(AM – SM ) SGP/SC (SM – BQ) SGP/SC
Material Yield Standard – Actual
Material Mix (SR x SH) – Actual FOH cost
(SQ – SM) SP
(SM – AM) SP (AY – SY) Std cost
FOH Expenditure Variance FOH Volume Variance

Direct Labour Cost Variance Budgeted FOH – Actual FOH cost (SR x SH) – Budgeted FOH Cost
Standard – Actual Labour Cost
(SR x SH) – (AR x AH)
Basic Formula Planning Operational
SP Ori.SP Rev.SP
Labour Rate Labour Efficiency
AP Rev.SP AP (SR – AR) AHpaid (SH – AHworked) SR FOH Efficiency Variance FOH Capacity Variance
(SR x AHpaid) – Actual Lab Cost (SH – Ahworked) SRFOH (SR X AH) – Budgeted FOH Cost
SQ Ori.SQ Rev.SQ
AQ Rev.SQ AQ
Idle Time variance (Adverse)
SR Ori.SR Rev.SR
(AHpaid – AH worked) SR
AR Rev.SR AR (idle time) SR
SH Ori.SH Rev.SH
AH Rev.SH AH
• Sales volume (operational) revised quantity is based on the changes of market size.
Annie Tan Page 19

PERFORMANCE MEASUREMENTS
Annie Tan Page 20

Annie Tan Page 21

Annie Tan Page 22

Annie Tan Page 23

F5 Revision Notes Final

Uploaded by

F5 Revision Notes Final

Uploaded by

The global body for professional accountants About us Contact us Find an accountant Technical activities Help & support

es Help & support Global 

Search...  Apply now myACCA 

THE LEARNING RATE AND LEARNING EFFECT

Student Accountant hub

A BRIEF HISTORY OF THE LEARNING CURVE

The learning curve effect will

THE IMPORTANCE OF THE LEARNING CURVE EFFECT

HOW LEARNING CURVES HAVE BEEN EXAMINED IN THE PAST

CALCULATING THE LEARNING RATE

Therefore the monthly rate

(b) End of learning rate and

The learning period ended

Step 1: Write out the

Step 2: Divide each side by

Step 3: Divide each side by

This means that the learning rate = 81.71%.

Written by a member of the Performance Management examining team

Last updated: 1 Feb 2018

Search...  Apply now myACCA 

Student Accountant hub

DECISION TREES AND MULTI-STAGE DECISION PROBLEMS

CONSTRUCTING THE TREE

Once the basic tree has

EVALUATING THE DECISION

The basic structure of the

Next, the probabilities and

Now, the decision points and

Now, calculate the expected

These expected values can

Once this has been done,

Finally, the recommendation

Often, there is more than

You can see that the

Success and high profits: 0.7

However, it could also be

EV of success with perfect

EV of failure with perfect

Whichever method is used,

Written by a member of the Performance Management examining team

Last updated: 1 Feb 2018

Search...  Apply now myACCA 

Student Accountant hub

A member of the Performance Management examining team provides students with an

The two requirements of the Performance Management syllabus are as follows:

Environmental management accounting uses some standard accountancy techniques to identify,

In 1998, the International Federation of Accountants (IFAC) originally defined environmental

MANAGING ENVIRONMENTAL COSTS

DEFINING ENVIRONMENTAL COSTS

IDENTIFYING ENVIRONMENTAL COSTS

CONTROLLING ENVIRONMENTAL COSTS

Each of these costs is considered in turn below.

Transport and travel

Consumables and raw materials

ACCOUNTING FOR ENVIRONMENTAL COSTS

FLOW COST ACCOUNTING

Written by a member of the Performance Management examining team

Last updated: 1 Feb 2018

Search...  Apply now myACCA 

BUILDING BLOCKS OF PERFORMANCE

Student Accountant hub

SmartCourier offers a range of delivery services such as:

SmartCourier has identified the following critical success factors:

THE BUILDING BLOCK MODEL

Innovation is also important to SmartCourier as it is investing in new technology and improving

Flexibility of service and innovation

Last updated: 1 Feb 2018

Search...  Apply now myACCA 

DECENTRALISATION AND THE NEED FOR

Student Accountant hub

Decentralisation is essentially the delegation of decision-making responsibility. All organisations

Profit centres and

WHAT MAKES A GOOD PERFORMANCE MEASURE?

A good performance measure should:

TRADITIONAL PERFORMANCE INDICATORS

The major issue with such