01 technical

limiting factor
The assumptions, in limiting factor analysis are that a resource constraint is

problem 1 – how to determine the product mix to best utilise a limiting factor.

with the manufacturing resources available. This first article addresses
a short-term problem and that a business seeks to maximise total profit

RELEVANT to cat paper 4

The CAT Paper 4 Study Guide includes limiting Problem 1 covers 17(c) in the CAT Paper 4 Study
factor analysis within Section 17 Decision Making, Guide – ‘formulate and determine the optimal
covering situations where there is a shortage production solution when there is a single resource
of a key resource that a business uses in the constraint’. Question 4 (Section B) in the June 2008
production of its components/products. Examples CAT Paper 4 exam is an illustration of this type
of a key resource that may be in short supply of  problem.
include a particular raw material, type of labour Problem 2 covers 17(d) in the CAT Paper 4 Study
or machine capacity. The key resource in short Guide – ‘solve make/buy-in problems when there is
supply becomes the limiting factor, ie it means a single resource constraint’. Question 1 (Section
that the business is unable to produce sufficiently B) in the June 2009 CAT Paper 4 exam is an
to satisfy sales demand. illustration of this type of  problem.
When a business has a limiting factor, caused Both of the above questions were poorly
by a resource constraint, a decision needs to be answered by candidates, indicating that those
taken as to how the available resources can be studying for CAT Paper 4 generally have an
best utilised. The assumptions, in limiting factor inadequate grasp of the topic. The purpose of
analysis relevant to CAT Paper 4, are that a resource this, and a subsequent article, is to cover each of
constraint is a short-term problem and that a the two types of limiting factor decision-making
business seeks to maximise total profit with the problem described above, using the June 2008 and
manufacturing resources available. June 2009 past questions respectively to illustrate
the analysis required.
Limiting factor problems This first article addresses problem 1 – how
There are two distinct limiting factor problems, for to determine the product mix to best utilise a
a business with more than one product, in such a limiting factor.
manufacturing environment:
1 How to maximise contribution when the Question 4, June 2008
availability of a key resource is insufficient to A company manufactures three products (X, Y and
satisfy sales demand. This problem is solved by Z). All direct operatives are the same grade and are
establishing the mix of products to manufacture paid at $11 per hour. It is anticipated that there will
and sell in order to best utilise the limited be a shortage of direct operatives in the following
resource available, based on the contribution period, which will prevent the company from
each product makes per unit of the scarce achieving the following sales targets:
resource (limiting factor).
2 How to maximise contribution when the Product X 3,600 units
availability of a key resource is insufficient to Product Y 8,000 units
satisfy sales demand but the resource limitation Product Z 5,700 units
can be overcome by buying in components/
products from another manufacturer. This Selling prices and costs are shown in
problem is solved by minimising the incremental Table 1 opposite.
costs incurred in buying in, based on the
difference in costs (bought-in versus in-house)
per unit of the scarce resource (limiting factor)
required in manufacture.
 student accountant issue 01/2010
02
Studying CAT Paper 4?
www.accaglobal.com/students/cat/exams/t4

analysis: pt 1
Required: NB It can only be by prioritising the allocation of

limiting factor problems in the june 2008 and june 2009 exams
Determine the production plan that would resources to those products that make the most
maximise profit in the following period, if the contribution for every unit of the key resource
available direct operatives’ hours total 26,400. consumed that total contribution, and thus total

were poorly answered by candidates, indicating that those

profit, will be maximised.
Approach 5 Establish production priority by ranking products
As there is more than one product that uses according to the contribution per unit of the

studying for CAT Paper 4 generally have an inadequate

the scarce labour resource, the approach to scarce resource.
determining the optimal production plan is 6 Allocate the available scarce resource according
as follows: to the ranking.
1 Identify the scarce resource (limiting factor).
2 Establish the units of the scarce resource used by Solution
each product. Question 4 from the June 2008 paper will be
3 Calculate the contribution (sales less variable answered using the six stages outlined in the
costs) per unit of each product. above approach:
NB As stated earlier, it is assumed that the
allocation of available resources is a short-term
decision with the objective of maximising total
profit (also made clear in the question). As such,
fixed costs can be assumed to be unaffected
by the product mix and thus irrelevant to the
decision (also made clear in the question
scenario). The decision is based on contribution.
4 Calculate the contribution of each product per
unit of the scarce resource consumed.

table 1: product x, y and z selling prices and costs (question 4, june 2008 paper 4 exam)

Product X Product Y Product Z

$ per unit $ per unit $ per unit

grasp of the topic.

Selling prices 100.00 69.00 85.00
Variable costs:
Production* 51.60 35.00 42.40
Non-production 5.00 3.95 4.25
Fixed costs:
Production 27.20 19.80 21.00
Non-production 7.10 5.90 6.20

* includes the cost of direct operatives 24.20 16.50 17.60

The fixed costs per unit are based on achieving the sales targets. There would not be any savings
in fixed costs if production and sales are at a lower level.
03 technical

A high number of candidates simply assumed that the sales targets could

not covered in this article) based on those. These candidates, therefore,

be achieved and provided profit statements (an additional requirement

completely failed to identify and solve the limiting factor problem.

1 Limiting factor 3 Contribution per unit of product
It is already clear from the question that the Contribution is sales revenue less variable costs
shortage of direct operatives is the limiting (both production and non-production). Thus:
factor, ie the shortage will prevent the company Product X $100.00 - $56.60 (51.60 + 5.00) =
from achieving the sales targets. To prove the $43.40 per unit
fact (because such calculations may be required Product Y $69.00 - $38.95 (35.00 + 3.95) =
in answer to other such questions), and to $30.05 per unit
provide some of the figures that will be used Product Z $85.00 - $46.65 (42.40 + 4.25) =
in subsequent stages below, the total direct $38.35 per unit
operative hours required to achieve the sales
targets are: 4 Contribution per unit of scarce resource
Product X $24.20/unit ÷ $11/hr = 2.2 hrs per The contribution per unit of scarce resource can
unit × 3,600 units = 7,920 hrs be calculated either as a $ contribution per hour
Product Y $16.50/unit ÷ $11/hr = 1.5 hrs per of direct operative time or as a $ contribution per
unit × 8,000 units = 12,000 hrs $ cost of direct operatives. Thus:
Product Z $17.60/unit ÷ $11/hr = 1.6 hrs per Product X $43.40/unit ÷ 2.2 hrs/unit =
unit × 5,700 units = 9,120 hrs $19.73 per direct operative hour
29,040 hrs Product Y $30.05/unit ÷ 1.5 hrs/unit =
$20.03 per direct operative hour
Direct labour hours available are 2,640 less Product Z $38.35/unit ÷ 1.6 hrs/unit =
(26,400 - 29,040) than those required to achieve $23.97 per direct operative hour
the sales targets. or
Product X $43.40/unit ÷ $24.20/unit =
2 Units of the scarce resource used by $1.793 per $ cost of
each product direct operatives
The amount of the scarce resource (in hrs) used Product Y $30.05/unit ÷ $16.50/unit =
by each product was calculated in stage 1 above $1.821 per $ cost of
(2.2, 1.5 and 1.6 hours per unit for Products X, direct operatives
Y and Z respectively). Alternatively, the amount Product Z $38.35/unit ÷ $17.60/unit =
of the scarce resource used by each product $2.179 per $ cost of
expressed in $, which was given in the question direct operatives
(ie $24.20, $16.50 and $17.60 for Products X, Y
and Z respectively) could be used. 5 Production priority
On the basis of the contribution per unit of the
scarce resource, Product Z would be manufactured
as the first priority ($23.97/hr or $2.179/$ cost),
followed by Product Y ($20.03/hr or $1.821/$ cost)
and finally Product X ($19.73/hr or $1.793/$ cost).
The same conclusion would be reached whichever
of the calculations in stage 4 was used because the
basis is the same. The contribution per $ cost of
the direct operatives multiplied by the hourly rate of
pay will equal the contribution per direct operative
hour. For example, for Product X $1.793 per $ cost
× $11 per hour = $19.73 per hour.
 student accountant issue 01/2010
04
including the variable non-production costs, double-counting labour costs
or including all costs and thus basing the analysis on net profit per unit.
Among those candidates who made a better effort, many were unable to
calculate the contributions per unit of product correctly, at times not

It should be noted that the priority, in this Examiner’s comments on candidates’ performance
example, is quite different from that indicated by A high number of candidates simply assumed that
using (incorrectly) the contribution per unit of the sales targets could be achieved and provided
product. This would have indicated priority of profit statements (an additional requirement of
Product X ($43.40/unit), followed by Product Z the exam question not covered in this article)
($38.35/unit) and finally Product Y ($30.05/unit). based on those. These candidates, therefore,
Although Product X has the highest contribution completely failed to identify and solve the limiting
per unit, it requires disproportionately more direct factor problem.
operative hours to achieve it. Where candidates did identify the problem,
a number of them calculated the total profit of
6 Allocate the scarce resource each product on the target sales and used this to
The scarce resource of direct operative hours establish priority. Among those candidates who
needs to be allocated according to the production made a better effort, many were unable to calculate
priority established in stage 5 above. Product the contributions per unit of product correctly, at
Z has first priority and so the direct operative times not including the variable non-production
hours will be allocated up to the limit required to costs, double-counting labour costs or including
achieve the sales target of 5,700 units. This was all costs and thus basing the analysis on net profit
calculated in stage 1 to be 9,120 hours. The next per unit.
priority is Product Y. The allocation of the 26,400 Some candidates did not get beyond the
hours available can be set out as follows: calculation of a contribution/profit per unit of
Product Z 9,120 hours 5,700 units product. Many others divided the contribution/profit
Product Y 12,000 hours 8,000 units per unit of product by the labour cost per hour
21,120 hours rather than by the labour cost per unit of product
Product X 5,280 hours 2,400 units or by the labour hours per unit of product. Finally, a
(26,400 - 21,120) (5,280 hours ÷ number of candidates had difficulty establishing the
2.2 hours/unit) production priority using their own figures and/or
26,400 hours the production plan.

It can be seen that demand for Products Z and Nigel Coulthurst is examiner for CAT Paper 4
Y can be fully satisfied leaving the balance of
labour hours available to be used for Product X.
Product X is restricted to 2,400 units with the
remaining hours. This is the production plan that
would maximise total contribution and total profit
because it gives priority to those products that
generate the greatest contribution per unit of the
scarce resource.
01 technical

the
Relevant to ACCA Qualification Papers f2 and f5
between
As you are learning F5 vs F2 SYLLABUS This concept is broadened
Performance measurement and control is new and

and preparing for the Paper Syllabus Section A – specialist in Paper F5 by further looking
all the knowledge and understanding you have of

F5 exam, it is important cost and management at other techniques in addition

to know the preceding papers accounting techniques to expected values such as
only introduced in Paper F5, but is underpinned by

that have direct links with Paper F2 syllabus Section B (cost profit tables, simulation and
the paper you are studying classification, behaviour and sensitivity analysis.
since you will be expected to purpose) and Section D (cost Section F of Paper F2
have the underpinning accounting techniques) introduce introduces you to the application
knowledge. Paper F5 is directly you to costing principles and of management accounting in
underpinned by Paper F2, conventional management various decision-making areas.
Management Accounting. accounting techniques such as You will have been introduced
The aim of this article is to absorption costing. to the identification of limiting
explain the differences between Paper F5 takes these concepts factors and how to plan your
management accounting in Paper F2.

the Paper F5 syllabus and that further by exploring more modern production to maximise profit,
of Paper F2 in order to help you costing techniques such as but on the assumption that you
plan your learning and prepare activity-based costing, target have only one limiting factor
well for the exams. If you have costing etc. It is very important in the period. In Paper F5, you
been exempted from Paper for you to master Section B have to use same concept to
F2, it is vital to understand the and Section D of the Paper F2 make similar decisions, but it
relevant parts of that paper to syllabus in order to deal with will assume that you have several
plan your learning for Paper F5. this section in the Paper F5 limiting factors in the period
I will provide a link between each syllabus. For example, you cannot (multi-period limiting factors).
syllabus section in Paper F5 to understand backflush accounting In Paper F2 you will be made
the equivalent sections of the if you are not familiar with familiar with relevant costing
Paper F2 syllabus and highlight principles of process costing in and CVP in relation to decision
the major differences. I will also Paper F2. making. In Paper F5 you will
explain other differences you apply these concepts in decisions
should be aware of. Syllabus Section B – such as what price to charge for
decision‑making techniques products and whether to buy or
This section is linked to Paper F2 make the products in order to
syllabus Sections C and F. maximise profits.
Section C introduces you to
business mathematics – an Syllabus section C and D –
important tool in management budgeting and standard costing
accounting at all levels. It You will have learned about
also introduces you to the budgeting and standard costing
concept of risk and the use of principles in Paper F2 syllabus
expected values. Section E.
 student accountant issue 01/2010
02

difference
f2 and f5
Paper F2 is linked closely with Paper F5. If you have missed any
of the introductory knowledge in Paper F2, it is advisable

This area will be broadened OTHER DIFFERENCES You must also learn to
and covered in more depth in Expectation communicate clearly by
Paper F5 with the inclusion In Paper F2, you were expected structuring your answer well,
of more advanced aspects of to have the basic knowledge and showing your workings logically
budgeting and standard costing. understanding of all aspects of and discussing issues sensibly.
to go back and revise before you attempt more

For example, Paper F5 costs and costing systems. The Finally, you may need to explain
budgeting includes a discussion exam is mainly manipulation or justify any calculations you
of the different budgeting of data. In Paper F5 you are have made.
systems an organisation expected to have a full knowledge
can adopt and how budgets of Paper F2 but are expected Exam timing
affect people and the general to take a step further by not Because it is computer-based,
performance of the organisation. only manipulating the data you can take the Paper F2 exam
In standard costing, Paper F5 but also interpreting it. You when you feel you are ready.
covers advanced variances are expected to know what the For Paper F5, you have only
such as mix and yield figures you are calculating mean two days in a year to take the
variances and operational and to the organisation. This is a exam, in June and December
planning variances major difference. respectively. This means you
have to plan your study well
Syllabus section E – performance Question types so that you are ready by those
measurement and control The Paper F2 exam consists of dates – otherwise you may find
Performance measurement multiple-choice questions in which yourself going in to the exam
complex issues in Paper F5.

and control is the only area in you do not write anything. You totally unprepared.
the Paper F5 syllabus which must select the correct answer
appears to have no obvious from a choice of two, three or CONCLUSION
link with an equivalent section four options. However, apart You can see from the above that
in Paper F2. It is new and only from demonstrating knowledge Paper F2 is linked closely with
introduced in Paper F5, but is and comprehension you will Paper F5. If you have missed any
underpinned by all the knowledge need to apply your knowledge in of the introductory knowledge
and understanding you have many questions. The exam has in Paper F2 or been exempted
of management accounting in 50 questions in total. from this paper, it is advisable
Paper F2 and other parts of Paper The Paper F5 exam consists to go back and revise before you
F5. As Paper F5 students, you of scenario-based questions: attempt more complex issues in
are expected to use management five in total, each worth 20 Paper F5.
information to understand how marks. This is a major step up
an organisation is performing and from the Paper F2 exam. This Jessie Ndalama is ACCA
make appropriate decisions. means that you must prepare qualifications technical
yourself to be able to read and advisor (performance and
understand scenarios. financial management)
 01 technical

the supreme
Lords who previously sat there now sit as justices in the new Supreme Court.
On 1 October 2009, the House of Lords was replaced by a new Supreme Court

as the upper chamber of parliament, continues to exist, but now the 12 Law
as the highest court within the English legal system. The House of Lords,

RELEVANT to ACCA Qualification paper F4 (eng)

On 1 October 2009, the House ¤ The legislature is the body Courts may issue a declaration
of Lords was replaced by a new within the constitution in of incompatibility, but such a
Supreme Court as the highest which the power of making declaration does not invalidate
court within the English legal law is located. Under the legislation in question
system. The House of Lords, democratic constitutions and any action to remedy the
as the upper chamber of the body will normally be conflict must be undertaken by
parliament, continues to exist, elected. In the UK, Parliament the legislature.
but its membership has been is bicameral and is made of ¤ The executive, as its name
reduced by the 12 Law Lords the House of Commons and suggests, is the institution that
who previously sat there, and the House of Lords. It is also executes the law, ie carries
who now sit as justices in the worth stating that in countries it into effect. It is essentially
new Supreme Court. with a written constitution and the government operating
a strong separation of powers, through the instrument of
The Separation of Powers there are limits to the power the state, such as the civil
The idea of the separation of of the legislature to make law, service and other state
powers, which can be traced in that it is not permissible for functionaries. In theory, the
back to ancient Greek political laws to be made which conflict executive implements, rather
philosophy, is based on the with the rights provided under than creates, the law and is
existence of three distinct the constitution. If any such subject to the scrutiny of the
functions of government (the law is passed, it is open to legislature and the judiciary.
legislative, executive and judicial challenge in the courts, which ¤ The judiciary’s role is to decide
functions) and the conviction may strike it down as being issues in relation to the law
that these functions should be unconstitutional. However, of the state in which they are
kept apart in order to prevent the UK has no written located. A corollary of this
the centralisation of too constitution as such and description is the conclusion
much power. functions under the doctrine that it is not the function of the
of parliamentary sovereignty. judges to make law.
This effectively means that
Parliament is not just the
ultimate source of law, but
it can make such law as it
determines, which cannot be
challenged in the courts as to
its content. Even the Human
Rights Act 1998, which
introduced the European
Convention of Human Rights
and Fundamental Freedoms
into UK law, maintains the
doctrine of parliamentary
sovereignty to the extent that
the courts cannot declare
primary legislation to be
invalid on the grounds that it
conflicts with the convention.
 student accountant issue 01/2010
02

court
The fact that, before October The Court of Sessions held ¤ The 12 judges of the Supreme

Supreme Court, which was the title previously given to the High
2009, the highest court in the UK that Lord Hardie should at Court are titled Justices of
was located in, and constituted least have declared his previous the Supreme Court and will
This new Supreme Court should not be confused with the old
part of, the country’s legislative interest in the matter and that, no longer be allowed to sit
body was always considered at in the light of his failure to do as members of the House of
least somewhat anomalous. Such so, there was at least the real Lords. As a matter of fact, all
Court and Court of Appeal. In future those courts will be
a situation was clearly contrary possibility of bias, and ordered of the present members are
to any idea of the separation the case to be retried. life peers and as a result will
of powers and one that was The enormous historical be able to sit in the House of
known as the Senior Courts of England and Wales.

not lost on Lord Falconer, the change involved in remedying Lords on their retirement from
former Lord Chancellor, who the unsustainable situation their judicial office, but this
in 2005 explained the need for was brought about by the may not always be the case in
reform thus: implementation of Part 2 of the the future.
Constitutional Reform Act 2005, ¤ The immediately previously
The present position is no longer which provided for the following: serving Law Lords became the
sustainable. It is surely not ¤ The establishment of the new first Justices of the Supreme
right that those responsible for independent Supreme Court, Court, and Lord Phillips, the
interpreting the law should be able separate from the House of former Lord Chief Justice, was
to have a hand in drafting it. The Lords with its own independent appointed the first President
time has come for the UK’s highest appointments system, its own of the Supreme Court. In fact,
court to move out from under the staff and budget and its own only 11 of the previous Lords
shadow of the legislature. building: Middlesex Guildhall. of Appeal in Ordinary have
This new Supreme Court taken positions as Justices
The relevance of Lord Falconer’s should not be confused with of the Supreme Court, Lord
argument was given added the old Supreme Court, which Neuberger, instead, taking the
power by the decision of the was the title previously given position of Master of the Rolls
Scottish Court of Sessions, to the High Court and Court of in the Court of Appeal.
the equivalent of the Court of Appeal. In future those courts
Appeal, in Davidson v Scottish will be known as the Senior As has been stated above, in
Ministers (No 2) (2002). The case Courts of England and Wales. other constitutional systems,
involved a challenge to a previous both civil, as in France, or
court decision, on the grounds common law, as in the US,
of Article 6 of the ECHR, for the not only is there a clear
reason that one of the judges separation of powers between
in the earlier case, the former the judiciary, the executive and
Lord Advocate Lord Hardie, had the legislature, but there is also
spoken on the issue before the a distinct Constitutional Court
court while a member of the with the power to strike down
Scottish Assembly. legislation on the grounds of its
being unconstitutional.
03 technical

Historical constitutional change through the institution of the Supreme

Court may be, to all intents and purposes, the changes will make little
practical difference to the student of law; the previous decisions and
It has to be emphasised that It remains to be seen, Former Lord Chancellor, Lord

precedents of the former House of Lords will still be binding.

the UK Supreme Court will however, whether under the Falconer, also expressed the view
not be in the nature of these changed circumstances of the that the Supreme Court ‘will be
other supreme courts, in that contemporary constitution the bolder in vindicating both the
it will not be a constitutional Supreme Court, as the highest freedoms of individuals and,
court as such and it will not court in the land, will simply coupled with that, being willing
have the powers to strike down assume the previously limited to take on the executive’, but
legislation. Consequently, role of the House of Lords, or Lord Phillips the President of
although the proposed whether it will, with the passage the Supreme Court was more
alterations clearly increase the of time, assume new function conciliatory towards the executive
appearance of the separation and increased powers as are expressing the view that,
of powers, the doctrine of consonant with Supreme Courts although he could not predict
parliamentary sovereignty in other jurisdictions. This issue how the court would function in
remains unchallenged. arose in September 2009 when the future, he did not foresee it
the former Law Lord, Lord changing in the way suggested by
Neuberger, who gave up his Lord Neuberger.
position in the House of Lords The changes will make little
to become Master of the Rolls, practical difference to the
spoke on a BBC radio programme student of law; the previous
expressing the opinion that the decisions and precedents of
advent of the Supreme Court the former House of Lords will
was not unproblematic. As he still be binding and the previous
put it, ‘the danger is that you rules of law and procedure for
muck around with a constitution hearing appeals from lower
like the British constitution at courts will continue to operate.
your peril because you do not Consequently, the shift from
know what the consequences House of Lords to the Supreme
of any change will be’. And Court should be seamless and
that there was a real risk of unproblematic.
‘judges arrogating to themselves More information about the
greater power than they have at Supreme Court may be found at
the moment’. the court’s own very informative
website: www.supremecourt.
gov.uk/

David Kelly is examiner for

Paper F4 (ENG)
 student accountant issue 01/2010
01
For PER support and advice on answering challenge questions
www.accaglobal.com/students/acca/per/support

FOCUS ON per
PO 11: interpret financial transactions and financial statements

Professionally qualified To effectively demonstrate your ¤ How has this interpretation

conclusion, is just as necessary as simply posting transactions

accountants must be able intelligent analysis and interpretation of financial statements, competency, you might: helped your department
to do more than simply post ¤ Calculate and interpret ratios or organisation?
transactions correctly and for meaningful comparison – Provide examples
prepare accurate financial of year-on-year figures or of decisions or
with a view to reaching, presenting and explaining a valid

statements – intelligent benchmarking against relevant recommendations that

analysis and interpretation of departments of industry have arisen from your
these, with a view to reaching, competitors – for instance, to findings, made by you, your
presenting and explaining a valid evaluate profitability, efficiency colleagues or management
conclusion, is just as necessary. or investor yield – Consider the impact
Whether you’re dealing ¤ Analyse and draw conclusions of those decisions or
with company-wide financial from inventory levels, revenue recommendations –
information or data and records figures and balance sheets such as saving costs,
from specific divisions, sites or ¤ Identify trends and use your improving cash flow,
accounting periods, it’s likely knowledge of the business generating extra revenue or
that you’ll also be required to and industry sector to raise securing  investment
identify and investigate unusual issues management may ¤ What business decisions have
or alarming indicators, make want to address (eg common or could be made based on this
deductions based on how features of under-performing interpretation?
different aspects of financial or significantly over-performing – These could include new
reports interrelate, and suggest profit centres) capital purchases, piloting
reasons for certain financial ¤ Meet with external clients or new products or services,
results or trends reflected internal stakeholders to present opening new sites/branches
in the figures. End users of and discuss your findings. (or even closure of sites
financial statements – whether or lines of business) or
internal or external – need to be The next step is to answer calculation of commission
confident they can make sound, the challenge questions for payments to sales and
and accurate preparation.

informed decisions based on this objective in the trainee business development staff
the information with which they development matrix (TDM): – Also relevant would be
are presented. ¤ Outline your contribution instructions to keep a
to interpreting financial watching brief on specific
transactions or trends where you may have
financial statements: identified potential threats or
– State your individual opportunities but which need
responsibility within the observation over a longer
context of the team or period before any decisions
overall process – who uses might be taken.
the information you prepare,
and for what purpose? Performance objective 11 is
– What were you asked to do linked to Paper F3, Financial
– and how might you have Accounting, Paper F7, Financial
exceeded the demands made Reporting, and Paper P2,
on you in a positive way? Corporate Reporting.
01 technical

activity-based RELEVANT to ACCA QUAlification paper F5

Conventional costing distinguishes between The conventional approach to dealing with

resources are employed to allow high volumes to be produced.

variable and fixed costs. Typically, it is assumed fixed overhead production costs is to assume that
that variable costs vary with the number of units of the various cost types can be lumped together
output (and that these costs are proportional to the and a single overhead absorption rate derived.

of activity, often stepping up as additional manufacturing

output level) whereas fixed costs do not vary with The absorption rate is usually presented in terms
output. This is often an over-simplification of how of overhead cost per labour hour, or cost per
costs actually behave. For example, variable costs machine hour. This approach is likely to be an

Fixed costs are usually fixed only over certain ranges

per unit often increase at high levels of production over-simplification, but it has the merit of being
where overtime premiums might have to be paid relatively quick and easy.
or when material becomes scarce. Fixed costs are
usually fixed only over certain ranges of activity, EXAMPLE 1
often stepping up as additional manufacturing See Table 1 opposite.
resources are employed to allow high volumes to
be produced. The budgeted labour hours must be 112,000
Variable costs per unit can at least be measured, hours. This is derived from the budgeted outputs
and the sum of the variable costs per unit is the of 20,000 ordinary units which each take five hours
marginal cost per unit. These are the extra costs (100,000 hours) to produce, and 2,000 deluxe units
caused when one more unit is produced. However, which each take six hours (12,000 hours).
there has always been a problem dealing with fixed
production costs such as factory rent, heating, Therefore, the fixed overhead absorption rate per
supervision and so on. Making a unit does not labour hour is $224,000/112,000 = $2/hour.
cause more fixed costs, yet production cannot
take place without these costs being incurred. To The costing of the two products can be continued
say that the cost of producing a unit consists of by adding in fixed overhead costs to obtain the total
marginal costs only will understate the true cost absorption cost for each of the products.
of production and this can lead to problems. For
example, if the selling price is based on a mark‑up See Table 2 opposite.
on cost, then the company needs to make sure
that all production costs are covered by the selling For future reference, note that the total costs
price. Additionally, focusing exclusively on marginal accounted for (if production goes according to plan)
costs may cause companies to overlook important will be = 20,000 x 85 + 2,000 x 102 = $1,904,000.
savings that might result from better controlled
fixed costs. The conventional approach outlined above is
satisfactory if the following conditions apply:
1 Fixed costs are relatively immaterial compared
to material and labour costs. This is the case
in manufacturing environments which do not
rely on sophisticated and expensive facilities
and machinery.
2 Most fixed costs accrue with time.
3 There are long production runs of identical
products with little customisation.
 student accountant issue 02/2010
02
Studying Paper F5?
Performance objectives 12, 13 and 14 are linked

costing

number of units of output (and that these costs are proportional

table 1, example 1

to the output level) whereas fixed costs do not vary with output.
Conventional costing distinguishes between variable and fixed

costs. Typically, it is assumed that variable costs vary with the

Budget Ordinary units Deluxe units
Units produced 20,000 2,000

Costs per unit: $ $

Material 10 12
Labour 5 hours at $12/hour 60 6 hours at $12/hour 72
Variable overhead 5 hours at $1/hour 5 6 hours at $1/hour 6
Marginal costs 75 90

Budgeted fixed production overheads are $224,000

table 2, example 1

Budget Ordinary units Deluxe units
Units produced 20,000 2,000

$ $
Marginal costs 75 90
Fixed overheads 5 hours at $2/hour 10 6 hours at $2/hour 12
Total absorption
cost/unit 85 102

However, much modern manufacturing relies on Additionally, many companies rely on

highly automated, expensive manufacturing plants – customisation of products to differentiate
so much so that some companies do not separately themselves and to enable higher margins to be
identify the cost of labour because there is so little made. Dell, for example, a PC manufacturer, has a
used. Instead, factory labour is simply regarded website which lets customers specify their own PC
as a fixed overhead and added in to the fixed costs in terms of memory size, capacity, processor
of running the factory, its machinery, and the speed etc. That information is then fed into their
sophisticated information technology system which automated production system and the specified
coordinates production. computer is built, more or less automatically.
03 technical
to get a more accurate estimate of what each unit costs to produce we have
to examine what activities are necessary to produce each unit, because

Instead of offering customers the ability to Ordinary units are produced in long production
specify products, many companies offer an runs, with each batch consisting of 2,000 units.
extensive range of products, hoping that one
member of the range will match the requirements Deluxe units are produced in short production runs,
of a particular market segment. In Example 1, the with each batch consisting of 100 units.
activities usually have a cost attached. This is the basis of

company offers two products: ordinary and deluxe.

The company knows that demand for the deluxe Each ordinary unit consists of 20 components, each
range will be low, but hopes that the price premium deluxe unit of 30 components.
it can charge will still allow it to make a good profit,
even on a low volume item. However, the deluxe What we want to do is to get a more accurate
product could consume resources which are not estimate of what each unit costs to produce, and
properly reflected by the time it takes to make to do this we have to examine what activities are
those units. necessary to produce each unit, because activities
These developments in manufacturing and usually have a cost attached. This is the basis of
marketing mean that the conventional way of activity-based costing (ABC). The old approach
treating fixed overheads might not be good enough. of simply pretending that fixed costs are incurred
Companies need to know the causes of overheads, because of the passage of time, and that they can
and need to realise that many of their ‘fixed costs’ therefore be accounted for on the basis of labour
might not be fixed at all. They need to try to assign (or machine) time spent on each unit, is no longer
costs to products or services on the basis of the good enough. Diverse, flexible manufacturing
resources they consume. demands a more accurate approach to costing.

EXAMPLE 2 The ABC process is as follows:

An analysis of the fixed overheads of $224,000
shows that they consist of: 1 Identify a distinct ‘fixed’ overhead cost.
$ 2 Identify the activity that causes that cost. In ABC
activity-based costing (ABC).

Batch set-up costs 90,000 terminology, that activity is the ‘cost driver’, but it
Stores – material handling etc 92,000 might be better to think of it as the ‘cost causer’.
Other (rent etc) 42,000 3 Work out the cost incurred each time the
Total 224,000 activity occurs.
4 Determine how many units are made for each
incidence of the cost causer. This is likely to vary
for each type of unit.
5 Work out the cost that can be traced into each
unit produced.

See Figure 1 below.

figure 1: the abc process

Identify what Calculate the cost Trace the cost into

Identify a cost causes/drives it per causal event the units produced
The old approach of simply pretending that fixed costs are incurred because
student accountant issue 02/2010
04
of the passage of time, and that they can be accounted for on the basis of
labour (or machine) time spent on each unit, is no longer good enough.
Diverse, flexible manufacturing demands more accurate costing.

EXAMPLE 3 Material handling costs

Applying these steps to the fixed cost 1 Cost of material handling
breakdown shown in Example 2 results in the 2 Cost driver will be number of components
following analysis: handled (presumably)
3 The number of material handling events for the
Batch set-up costs year = 20 x 20,000 + 30 x 2,000 = 460,000
1 Cost of set-ups = $90,000 (from the information given above)
2 Cost driver (or cost causer) = each batch
set‑up (presumably) Cost per material handling event =
3 The number of set-ups are: $92,000/460,000 = $0.20

For ordinary units 20,000/2,000 = 10 4 Each ordinary unit takes 20 items of material
For deluxe units 2,000/100 = 20 Each deluxe unit takes 30 items of material
Total set-up occasions 30
5 Each ordinary unit will cost $0.2 x 20 = $4/unit
Cost per set-up 90,000/30 = $3,000 Each deluxe unit will cost $0.2 x 30 = $6/unit

4 Each set-up produces 2,000 ordinary units Other fixed overheads will have to be absorbed on
Each set-up produces 100 deluxe units a labour hour rate because there is no information
provided that would allow a better approach:
5 Ordinary units: $3,000/2,000 = $1.50/unit
Deluxe units: $3,000/100 = $30/unit $42,000/112,000 = $0.375/labour hour

The ABC approach to costing therefore results in the

figures shown in Table 3 below. Check: total costs
accounted for if all goes according to budget = 20,000
x 82.375 + 128.25 x 2,000 = $1,904,000, as before.

table 3, example 3

Budget Ordinary units Deluxe units
Units produced 20,000 2,000

$ $
Marginal costs
(as before) 75.00 90.00
Fixed overheads:

Set-up 1.50 30.00
Material handling 4.00 6.00
Other 5 hours at 0.375 1.875 6 hours at 0.375 2.25
Total absorption
cost/unit 82.375 128.25
05 technical

detailed information for costing purposes. But understanding the drivers of

investigating more fully what causes it to incur costs, and then to use that
ABC undoubtedly requires an organisation to spend time and effort

costs must be an essential part of good performance management.

COMPARING THE APPROACHES

Ordinary units Deluxe units

Total absorption cost/unit – conventional approach 85.000 102.00
Total absorption cost/unit – ABC approach 82.375 128.25

You will see that the ABC approach substantially Working on the principle that large cost savings
increases the cost of making a deluxe unit. This are likely to be found in large cost elements,
is primarily because the deluxe units are made in management’s attention will start to focus on how
small batches. Each batch causes an expensive this cost could be reduced.
set-up, but that cost is then spread over all the For example, is there any reason why deluxe units
units produced in that batch – whether few (deluxe) have to be produced in batches of only 100? A
or many (ordinary). It can only be right that the batch size of 200 units would dramatically reduce
effort and cost incurred in producing small batches those set-up costs.
is reflected in the cost per unit produced. There The traditional approach to fixed overhead
would, for example, be little point in producing absorption has the merit of being simple to
deluxe units at all if their higher selling price did calculate and apply. However, simplicity does not
not justify the higher costs incurred. justify the production and use of information that
In addition to estimating more accurately the might be wrong or misleading.
true cost of production, ABC will also give a better ABC undoubtedly requires an organisation
indication of where cost savings can be made. to spend time and effort investigating more
Remember, the title of Paper F5 is Performance fully what causes it to incur costs, and then
Management, implying that accountants should be to use that detailed information for costing
proactive in improving performance rather than purposes. But understanding the drivers
passively measuring costs. For example, it’s clear of costs must be an essential part of good
that a substantial part of the cost of producing performance management.
deluxe units is set-up costs (almost 25% of the
deluxe units’ total costs). Ken Garrett is a freelance writer and lecturer
 01 technical

corporation tax
candidates sitting Paper P6 (UK) in June or December 2010 and are based on tax
second will cover groups and capital gains. Both articles are relevant to

part 1:
This is the first of two articles on corporation tax and groups. The

RELEVANT to acca qualification paper p6 (UK)

legislation as it applies to the tax year 2009-10 (Finance Act 2009).

This is the first of two articles on corporation The tax rates and limits for financial year 2009,
tax and groups. The second will cover groups ending on 31 March 2010, are used throughout
and capital gains. Both articles are relevant this article.
to candidates sitting Paper P6 (UK) in either
June or December 2010 and are based on tax THE BASIC RULES
legislation as it applies to the tax year 2009–10 The structure of the H Ltd group of companies is
(Finance Act 2009). set out in Figure 1. It should be assumed, at least
Students sitting Paper P6 (UK) in 2011 will be to begin with, that all of the companies are resident
examined on the Finance Act 2010, which is the in the UK. The minority shareholders in the group
legislation as it relates to the tax year 2010–11. companies are companies with no relationship with
Accordingly, this article is not relevant to these H Ltd.
students, who should instead refer to the Finance You should be able to review the group structure
Act 2010 version which will be published on the and confidently identify the members of any group
ACCA website in 2011. relief groups and capital gains groups. Try to do
Groups of companies are an important aspect of this before you read the information in Table 1.
corporation tax in Paper P6 (UK). Having studied
the basics of this area at Paper F6 you are now FIGURE 1: THE STRUCTURE OF THE H LTD GROUP
expected to progress to more advanced aspects. OF COMPANIES
However, the basic rules continue to be of vital
importance as they are the foundation on which H Ltd
the additional rules rest. You must have a sound
knowledge of the many rules within this subject 80% 100% 60%
if you are to be able to handle an exam question 64%
involving groups. A Ltd C Ltd D Ltd
This is not an introductory article; it is relevant
80%
to students coming to the end of their studies
and finalising their preparations to sit the exam. It B Ltd
begins by briefly summarising the rules relating to
both group relief groups and capital gains groups.
It then goes on to consider a number of group relief
tax planning issues that could be introduced in an
exam question. It does not include comprehensive
explanations of the rules but assumes a
reasonable knowledge.
This article is intended to be read proactively, ie
statements made should be confirmed as true by
reference to the reader’s understanding of the rules,
or to a relevant study text. This approach will enable
future situations to be analysed from first principles
rather than by reference to a rigid set of memorised
planning points.
 student accountant issue 01/2010
02
Studying Paper P6 (UK)?
Performance objectives 19 and 20 are linked

and groups
group relief

tax in Paper P6 (UK). Having studied the basics of this area at Paper
Groups of companies are an important aspect of corporation

F6 you are now expected to progress to more advanced aspects.

TABLE 1: GROUP RELIEF AND CAPITAL GAINS GROUPS RE FIGURE 1

Group relief group Capital gains group

The groups ¤ H Ltd, A Ltd and C Ltd form a group. ¤ H Ltd, A Ltd, B Ltd and C Ltd form a
single group.
¤ A Ltd and B Ltd form a separate group.

Rationale ¤ B Ltd is not in a group with H Ltd ¤ B Ltd is in a group with H Ltd because:
because the effective interest of H Ltd – H Ltd has a direct interest in A Ltd of
in B Ltd is less than 75%. at least 75% and A Ltd has a direct
interest in B Ltd of at least 75%; and
– The effective interest of H Ltd in B
Ltd is greater than 50%.

Once a group relief group exists, the TAX PLANNING ISSUES RELATING TO GROUP RELIEF
following applies: The remainder of this article examines the tax
¤ any company in the group can surrender current planning issues relating to group relief groups.
period trading losses, non-trading deficits on Throughout this review of tax planning issues, the
loan relationships, excess property income term ‘losses’ will be used to represent any/all tax
losses, excess management expenses, and attributes that can be surrendered via group relief.
excess gift aid donations to any other company
in the group. Companies resident overseas
¤ the maximum surrender to a group company is Companies resident overseas are included within
that company’s taxable profits. For this purpose, a group relief group. However, losses can only be
a company’s taxable profits are reduced by surrendered between companies that are resident
its own trading losses for the current period in the UK or are resident overseas but have a
regardless of whether or not such a loss claim branch in the UK. If the H Ltd group were owned
is made. by H Inc, a company resident and trading outside
the UK and the European Union, rather than H
Before you study the further issues set out below, Ltd, the members of the group relief groups
consider the tax implications of making the would not change. However, losses could only be
following mutually exclusive changes to the H Ltd surrendered between A Ltd and C Ltd and between
group structure. A Ltd and B Ltd.
1 B Ltd owns 90% of W Ltd.
2 Rather than H Ltd owning A Ltd, C Ltd and D Ltd,
the owner is Mr H, a UK resident individual.

The implications are summarised at the end of

this article.
03 technical

The value of a company’s losses depends on how they are used. This value is
maximised by offsetting the losses against those profits that would
Planning the distribution of losses to members of £
the group On profits up to the lower limit
The value of a company’s losses depends on (£75,000 x 21%) 15,750
how they are used. This value is maximised by On profits between the limits
offsetting the losses against those profits that (£300,000 x 29.75%) 89,250
would otherwise be taxed at the highest rate of tax. On the remainder (£50,000 x 28%) 14,000
A company will pay tax at the full rate where its Total liability 119,000
taxable profits plus its franked investment exceed
the upper limit, at the lower, small companies A group company is to surrender losses of
rate where they are less than the lower limit and £150,000 to LC Ltd. This will reduce its profits to
at a rate in excess of the full rate where they are £275,000 and cause the company to become a
between the upper and lower limits. Accordingly, the marginal company (a good thing) saving tax partly
aim is to offset the losses against: at the full rate and partly at the marginal rate. The
¤ profits between the limits; then tax saved in respect of the £150,000 of losses is
otherwise be taxed at the highest rate of tax.

¤ profits in excess of the upper limit; then set out below.

¤ profits below the lower limit.
£
Most, if not all students are aware of this strategy On profits above the upper limit
– but many misinterpret what it means and think (£50,000 x 28%) 14,000
that it is disadvantageous for a company to have On profits between the limits
profits between the limits. In fact the opposite is (£100,000 x 29.75%) 29,750
true. Companies with profits between the limits pay Total tax saved 43,750
a rate of tax in excess of the full rate only on the
amount of profits between the limits and not on The effective rate of tax saved in respect
all of their profits. The overall effective rate of tax of the offset of the losses is 29.167%
paid by such companies must, of course, be less (£43,750/£150,000); a rate in excess of the full
than the full rate as the corporation tax liability is rate, for obvious reasons.
computed by charging tax at the full rate and then
deducting marginal relief. Associated companies
The implication of this is that it is beneficial to When determining the upper and lower limits of
use losses to cause a company that would otherwise a particular company, watch out for the length
pay tax at the full rate to become a marginal of the accounting period and make sure you are
company. This is illustrated in Example 1. confident of the definition of associated companies.
All companies in the group relief group will be
EXAMPLE 1 associates but so will other companies, including
LC Ltd has taxable profits of £425,000 and no companies where the effective ownership is less
franked investment income. Its upper limit is than 75%, companies resident overseas, and
£375,000 and its lower limit is £75,000. It will companies controlled by the same individual(s)
pay corporation tax on its profits of £119,000 even though they are not in a group with the
(£425,000 x 28%) because its profits exceed the subject company. For example, in Figure 1, all five
upper limit. When thinking about the company companies are associated with each other.
from the point of view of loss utilisation, it can
be regarded as paying corporation tax at the
following rates.
 student accountant issue 01/2010
04
group loss planning this means thinking about the possible existence of
sure you have considered all of the possible options. When dealing with
As a general rule, before starting any calculations in the exam, make

Consortia 1 Before submitting a claim to carry back losses to

As a general rule, before starting any calculations the previous year, UL Ltd should surrender losses
in the exam, make sure you have considered all of to other group companies where they will save tax
the possible options. When dealing with group loss at the full rate. UL Ltd wants to carry back losses
planning this means thinking about the possible of £160,000 and should therefore surrender
existence of a consortium. D Ltd is not a member losses of £40,000 (£200,000 – £160,000).
of the H Ltd group relief group but that does not 2 UL Ltd should then submit a claim to carry back
necessarily mean that H Ltd cannot surrender its remaining losses against the profits of the
losses to D Ltd; it depends on who owns the previous year.
remainder of D Ltd’s share capital. If companies
that each own at least 5%, together own at least The additional corporation tax saved via the
15% (such that they, together with H Ltd, own operation of this strategy, as opposed to a
at least 75%), then D Ltd will be a consortium surrender of all of the losses to group companies,
company. H Ltd would then be able to surrender is £2,800 (£160,000 x (29.75% - 28%)).
losses to D Ltd upto a maximum of 60% of
D Ltd’s profits.. Double tax relief
Any foreign tax available for offset against a
Group relief and the carry back of losses company’s corporation tax liability must be taken
Once a company has offset trading losses against into account when planning the utilisation of losses.
its total profits of the current accounting period, Sufficient overseas profits must remain subject to
it can elect to offset any remaining losses against UK corporation tax in order to avoid wasting the
its total profits of the previous 12 months. double tax relief as set out in Example 3.
Unlike group relief, the offset of losses against a
company’s own total profits is an all or nothing EXAMPLE 3
claim such that, if there are sufficient losses, KT Ltd has taxable profits of £280,000 of which
taxable profits will be reduced to zero. However, £80,000 has arisen overseas. The overseas tax on
group relief can be used to engineer the carry back the overseas profits is £16,000. There are losses in
of a particular amount of losses in order to offset the KT Ltd group relief group in excess of £280,000
losses at the highest possible rates of tax as set out and the intention is to reduce its UK corporation
in Example 2. tax liability, after the deduction of double tax relief,
to zero. All companies in the KT Ltd group pay
EXAMPLE 2 corporation tax at the full rate.
In the year ended 31 March 2010, UL Ltd has a KT Ltd will not waste any double tax relief if
trading loss of £200,000 and no other income or the UK corporation tax liability in respect of its
gains. In the previous year its taxable profits were overseas income equals the overseas tax suffered
a consortium.

£235,000. Its upper limit is £375,000 and its lower of £16,000. Accordingly, it needs to have taxable
limit is £75,000. The other members of its group overseas profits of £57,143 (£16,000/28%) and
relief group pay corporation tax at the full rate. UL to claim group relief of £222,857 (£280,000 -
Ltd has profits of £160,000 (£235,000 - £75,000) £57,143). Note that the company can choose to
taxed at the marginal rate in the year ended 31 offset the group relief against its UK profits before
March 2009. In order to relieve its losses against its overseas profits. The company’s final corporation
these profits, whilst avoiding relieving any profits tax computation is as follows:
taxed at the small companies rate, UL Ltd will need
to submit the following claims.
05 technical

the group relief aspects of the question, your first task is to identify the
possible reliefs in the loss-making company. When you come to deal with
When dealing with corporate losses, you should first think about the
£ TAX IMPLICATIONS
Taxable profits 280,000 The tax implications of making the changes to the
Less: Group relief (222,857) H Ltd group structure are:
Profits chargeable to corporation tax 57,143 1 B Ltd and W Ltd would form a separate
Corporation tax at 28% 16,000 group relief group in addition to the groups
Less: Double tax relief (16,000) already identified.
Corporation tax liability Nil W Ltd would not be in a group with A Ltd
because the effective interest of A Ltd in W Ltd
Companies joining and leaving the group would be less than 75% (80% x 90% = 72%).
You should pay close attention to any information in W Ltd would be in the H Ltd capital gains group
a question relating to the acquisition or disposal of (with A Ltd, B Ltd and C Ltd) because B Ltd
group companies because group relief is restricted would have a direct interest in W Ltd of at least
where a company is not a member of the group for 75% and the effective interest of H Ltd in W Ltd
the whole of the accounting period. For example, would be more than 50% (80% x 80% x 90%
where a company is a member of a group for = 57.6%).
eight months, only eight months of its losses will 2 A Ltd, C Ltd and D Ltd would no longer be in
be available for group relief. Similarly, only eight a corporate group. Accordingly, the only group
months of its profits can be relieved via losses from relief group would be A Ltd and B Ltd. This would
other group companies. also be the only capital gains group.
A company joins a group when it is acquired.
However, it leaves a group, for the purposes of The comments in this article do not amount to advice on
group relief, when there are arrangements in force a particular matter and should not be taken as such. No
for it to leave the group, for example, once an reliance should be placed on the content of this article
agreement for the sale of the company has been as the basis of any decision. The author and the ACCA
reached between the parties subject to a contract expressly disclaims all liability to any person in respect
being signed. This may well be some time before it of any indirect, incidental, consequential or other
is finally sold such that there may be a gap between damages relating to the use of this article.
leaving one group and joining another. Losses
arising in the gap period can only be relieved in Rory Fish is examiner for Paper P6 (UK)
the loss-making company and their use may be
members of the group.

restricted if there is a major change in the nature or

conduct of the company’s trade within three years
of the date of the change of ownership.

CONCLUSION
When dealing with corporate losses, you should first
think about the possible reliefs in the loss-making
company. When you come to deal with the group
relief aspects of the question, your first task is to
identify the members of the group. You should then
watch out for any information in the question which
introduces one or more of the above issues into
the problem.