Chartered Institute of Management Accountants Management Level P2

P2A1 Activity-Based Costing and Activity-Based Management

• Costs in financial accounting: costs must be recorded in order to calculate profit and present a
true and fair value of assets in the financial statements
• Costs in management accounting: costs must be understood in order to carry out the three main
functions of planning, control, and decision-making
CGMA COST TRANSFORMATION MODEL
• CGMA cost transformation model: designed as a framework to help organisations achieve and
maintain cost competitiveness, with 6 suggested changes to achieve this objective:
1. Engendering a cost conscious culture: everyone in the organisation should be motivated and
enabled to reduce costs in whatever way possible. Technology can play a key role
2. Managing risks of a cost conscious culture: clear processes to identify, assess and manage risks
inherent in driving cost competitiveness
3. Understanding cost drivers: investigate determine how different variables impact costs; implement
plans to reduce drivers of costs and costs themselves if unnecessary to meet customer needs
4. Connecting products with profitability: important that every product positively contributes to overall
profit; thus understand cost drivers for individual products and allocate shared costs accurately
5. Maximising value from new products: assess potential profitability of new products prior to starting
production; make products adaptable to satisfy as many customer segments as possible
6. Incorporating sustainability to optimise profits: negative environmental impact of products can add
costs (such as wastage), damage reputation and reduce sales
ACTIVITY-BASED COSTING (ABC) (Cooper & Kaplan, 1980)
• ABC: trace resource consumption to cost outputs. Resources are assigned to activities; activities
assigned to cost pools, which use cost drivers to attach overheads to outputs
1. Activities: identify organisation’s major activities
2. Cost pools: estimate costs associated with performing each activity and collect into cost pools
3. Cost drivers: identify a cost driver (factor that influences cost for each activity) for each cost pool
Act i vit y cost
4. Cost driver rate: calculate for each activity: Co s t d r i v e r r a t e =
Co s t d r i v e r i n f or m a t i o n
5. Absorb activity costs into the products: charge overheads into individual products by applying
the cost driver rate to the activity usage of the products
2. 3. 4. 5.

Traditional absorption costing Activity-based costing

Overheads charged to products using a pre-determined overhead Overheads charged to products by applying a cost driver rate
absorption rate (OAR) based on volume of production activity based on activity usage of products; overheads are allocated
to activity cost pools before being absorbed using cost drivers:
To t a l b u d ge t e d o v e r h e a d c o s t (a l l o c a t e d a n d a p p or t i o n e d )
O v e r h e a d a b s or p t i o n r a t e (O A R ) = • Cost pools: activity that consumes resources and for which
B u d ge t e d q u a n t i t y o f a b s or p t i o n b a s e
overhead costs are identified under a single heading
Calculates full unit cost: assignment of both direct and indirect costs • Cost drivers: unit of activity that consumes resources; each
(overheads) to a product, to satisfy financial accounting requirements cost pool has a cost driver that influences the level of cost

Unsuitable for decision-making; assumption that overhead Decision relevant approach using relevant/incremental cash
expenditure is proportional to production volume distorts unit cost flows, therefore more suitable for decision-making

Useful for decision-making when:

Useful to accurately measure volume-related resources consumed in
• Production overheads are high relative to direct costs
proportion to number of units produced
• There is diversity of overhead resource input to products
• Consumption of overheads is not primarily driven by volume
Traditional absorption costing tends to over-cost high-volume (enables evaluation of non-volume related support activities)
products and under-cost low-volume products; ABC remedies this
• There is diversity in the product range

ABC hierarchy (Cooper & Kaplan, 1991): costs are driven by activities that occur at 4 levels:
A.Unit-level activities: performed each time a unit is produced; resources consumed in proportion to
number of units produced, ie direct labour, direct materials, energy costs, machine maintenance
B.Batch-level activities: performed each time a batch is produced; resources consumed in
proportion to number of batches produced, ie production line set-ups, purchasing orders
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 Chartered Institute of Management Accountants Management Level P2

P2B4 Data required for decision-making

INVESTMENT DECISIONS: RELEVANT CASH FLOWS
• Investment decisions: substantial resources committed to irreversible actions, hence often the
most important decisions a company makes; such decisions should be based on relevant costs
Relevant cash flows: (A.) future, (B.) incremental (C.) cash flows
A.Future costs/revenues: only consider future cash flows that occur as a result of the decision
B.Incremental (differential) costs/revenues: only consider extra cash flows that occur as a result of
the decision; calculated as the difference in total cost between alternatives
Rel e v a n t c a sh f l o w = Ca sh f l o w i f pr o p o s a l a c c e p t e d − Ca sh f l o w i f pr o p o s a l r e je c t e d
• Avoidable costs: specific costs of an activity which would be avoided if the activity did not exist
C.Cash flows: only cash items are relevant to the decision
• Opportunity costs: relevant when aware of the next best alternative use of a resource. Defined
as the value of the benefit sacrificed when one decision is chosen in preference to an alternative;
it is represented by the foregone potential benefit from the next best rejected decision,
• ie $70 holiday + $20 lost by not working on holiday (opportunity cost) = $90 relevant cost
• Notional costs (ie notional rent): may be rent a firm foregoes by occupying the premises itself, but
is only a true opportunity cost - thus only a relevant cost - if it represents an actual identified lost
opportunity to rent the premises; if nobody is willing to pay the rent it is not an opportunity cost
Non-relevant cash flows: remain unaltered regardless of the decision
• Sunk (irrecoverable) costs: irreversibly incurred in the past, thus irrelevant to the decision
• Most fixed costs: irrelevant to the decision, unless there is an incremental fixed cost as a result
of the decision
• Committed costs: unavoidably incurred in the future as a result of past decisions that cannot be
changed; unaffected by, and thus irrelevant to, the decision
• Depreciation: an accounting adjustment rather than a cash flow, thus is irrelevant to the decision
INVESTMENT DECISIONS: QUALITATIVE FACTORS
• Qualitative factors: conventionally ignored as they are difficult to quantify in numerical terms,
qualitative factors influence - thus should be considered when making - investment decisions
Quantitative Qualitative

Cost Installation and training costs Lower staff morale if existing staff redundancies

Benefit Lower direct labour costs Improved product quality

SOURCES OF MANAGEMENT INFORMATION

• Data: numbers/letters/facts/figures in a raw and unprocessed form; unsuitable for decision-making
• Information: the result of processing of data in such a way that it is meaningful to the user; may
be used to improve the quality of decision-making
Internal External

Information • Sales ledger system • Suppliers • Employees

• Purchase leader system • Newspapers • Banks
• Payroll system • Government • Internet
• Fixed asset system • Customers
• Production
• Sales and marketing

Sources • Accounting records • Competitor information: prices and product ranges

• Personnel and payroll information • Customer information: with regards to their needs
• Production information and timesheets • Supplier information: prices, quality, delivery terms

• Quality of information: ‘ACCURATE’ acronym illustrates attributes of good quality information

• Accurate: degree of accuracy depends on the information purpose; it should be sufficiently accurate given time/cost
constraints, with managers should be aware of the degree of accuracy
• Complete: decision-making managers should have all necessary information, but not excessive information; should
be communicated to the correct person; and be aligned to overall objectives
• Cost effective: the cost of providing information should not exceed its value or benefit
• Understandable: recipients of information must understand its contents and be able to use the contents to fulfil their
needs; such as by limited - or explained - use of technical language/jargon
• Relevant: information should be relevant to its purpose; redundant information detracts from its usefulness
• Adaptable/Accessible: information should be capable of being adapted to meet the needs of the user; and
accessible through availability via the appropriate channels of communication
• Timely: information should be released quickly and provided in time to allow decision to be made, as out of date
information can result in poor decision-making
• Easy to use: information should be presented in a form recommended by industry or organisation best practice
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 Chartered Institute of Management Accountants Management Level P2

• Marginal revenue > marginal cost: worthwhile producing and selling further units as the increase
in revenue gained from sale of the next unit exceeds the cost of producing it
• Marginal revenue < marginal cost: cost of producing the next unit outweighs revenue that could
be earned from it, hence production is not worthwhile
• Marginal revenue = marginal cost (MR = MC): the business should produce units up to this point
in order to maximise profit
Algebraic approach
1. Establish the demand function between price (P) and quantity demanded (Q): P = a + b Q
• P = selling price
• Q = quantity demanded at that selling price
• a = y axis intercept; theoretical maximum price; the selling price at which demand is nil
ch a n ge i n y ch a n ge i n pr i c e (P )
b = = = gradient of curve calculated; change in selling price
• ch a n ge i n x ch a n ge i n q u a n t i t y (Q ) (P) required to change quantity demand (Q) by 1 unit
2. Double the gradient (b) to find the marginal revenue (MR): M R = a + 2b Q
3. Establish the marginal cost (MC): MC = variable cost per unit
4. To maximise profit, MR = MC; therefore substitute MR for MC into M R = a + 2b Q to establish Q
5. Substitute this value of Q into the demand function P = a + b Q to establish the optimum price
6. Use the optimum price to calculate the maximum profit:
• Re v e n u e = P r i c e × Q u a n t i t y
• Co s t = F i x e d c o s t s + Va r i a bl e c o s t s
• P r o f i t = Re v e n u e − Co s t
Algebraic approach example:
1. At price $200, company sells 1,000 units; at price $220, company sells 950 units: b = (220 - 200) / (950 - 1,000) = -0.4
∴ b = -0.4, 200 = a + (-0.4 x 1000) ∴ a = 600, ∴ P = 600 - 0.4Q
2. MR = 600 - 0.8Q
3. Variable costs are $140 and fixed costs are $36,000 ∴ MC = $140
4. 140 = 600 - 0.8Q ∴ Q = 575 units
5. P = 600 - (0.4 x 575) ∴ P = $370
6. $370 x 575 units = $212,750 revenue, cost = 36,000 + (140 x 575) = $116,500 ∴ maximum profit = $96,250
Tabular approach
• If data is given in tabular form and there is no indication of the demand function, or if there is no
simple linear relationship between output and profit, the tabular approach is best to calculate
optimum profit and establish the associated selling price
Algebraic approach graph Tabular approach table

Limitations of profit maximisation model

• Accuracy: unlikely for a business to accurately determine the demand function for a given product
• Profit: most business aim to achieve a target profit, rather than a theoretical maximum profit
• Variable cost: determining a reliable figure for marginal/variable cost is difficult, as it likely varies
depending on quantity sold; ie bulk discounts may reduce materials cost for higher output volumes
• Other factors: ie advertising level or change in customer income also affect demand, not just price
COST-BASED PRICING STRATEGIES
• Cost-plus pricing: adding a mark-up to the total cost of a product, to arrive at the selling price
• Full cost-plus pricing • Marginal cost-plus pricing
• Full cost always includes full production • Marginal cost is the same as variable cost
cost, including all absorbed overheads • When setting the selling price using this
• The more costs included in full cost, the method, a larger mark-up % is added in
lower the mark-up % order to cover both fixed costs and profit
Sel li ng pr i ce = F u l l cos t p er u n it × (1 + Ma r k − u p p er ce n t age) Sel li ng pr i ce = Ma rgi n a l cos t p er u n it × (1 + Ma r k − u p p er ce n t age)
F ull cost − plu s = Tota l bu dgeted f a ctor y costs per u nit + Mark − u p on costs Ma rgi n a l cos t − pl u s = Va r i a bl e cos t + % Con t r i bu t i on m a rgi n

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 Chartered Institute of Management Accountants Management Level P2
CONDITIONAL PROBABILITIES
• Conditional probability: probability of an event whose calculation is based on the knowledge that
some other event has occurred
• P (A and B) = P (A|B) x P (B), where P (A|B) is the probability of A occurring given that B has already occurred
• Contingency table: created by taking the given probabilities, multiplying by a convenient number,
(100 or 1000), then drawing a table to show the various combinations of factors which may exist
STANDARD DEVIATION AND NORMAL DISTRIBUTION
• Standard deviation: compares all actual outcomes with EV, to calculate how far on average
outcomes deviate from the mean
• A higher standard deviation indicates a wider spread of possible outcomes, implying a higher
degree of uncertainty, more volatile returns and more risk involved in the investment decision
σ = standard deviation
∑ (x − x̄ )2 x = each value in the data set
σ =
n x̄ = mean of all values in the data set
n = number of values in the data set

• Coefficient of variation: measures dispersion around the mean

• Enables comparison of relative size of risk for decisions with very different standard deviations;
a lower coefficient of variation indicates a less dispersed variable, thus is less risky
σ
Co e f f i c i e n t o f v a r i a t i o n =
x̄
• Normal distribution: when data is symmetrically spread out (bell curve) and peaks at the centre.
• If the mean and standard deviation are known, normal distribution can be used to calculate the
probability of a certain value occurring, as the area under the curve
Z = used with normal distribution table to find the area under the normal distribution curve
x − μ x = variable
Z =
σ μ = mean
σ = standard deviation

VALUE OF INFORMATION
• Perfect information: the forecast of the future outcome is always a correct prediction
• Imperfect information: the forecast is usually correct, but can be incorrect; not as valuable as
perfect information and can be examined in conjunction with decision trees
Value of in for m at ion = Expected prof it (outcom e) WI TH the in for m at ion − Expected prof it (outcom e) WI THOU T the in for m at ion

VALUE AT RISK (VaR) = STANDARD DEVIATION × Z STAT

• Value at risk (VaR): uses normal distribution theory to measure how the market value of an asset/
portfolio of assets is likely to decrease over the holding period, under normal market conditions
• VaR = amount of risk to be lost from an investment under usual conditions over a given holding
period, at a particular confidence level (usually set at 95% or 99%).
• For example: at 95% confidence level, the VaR will give the amount that has a 5% chance of being lost
SENSITIVITY ANALYSIS
• Sensitivity analysis: one uncertain factor/assumption/variable changed at a time to analyse the
overall impact; NPV is recalculated under different conditions
• Sensitivity margin: maximum possible change in a parameter before an opportunity is unviable
NPV
Se n s i t i v i t y m a r g i n % =
P V o f f l o w u n d er c o n s i d e r a t i o n
Benefits of sensitivity analysis Problems of sensitivity analysis

Information presented in a subjective form facilitates judgement of Assumes changes to variables can be made independently, which
the likelihood of various possible outcomes is unlikely

Identifies areas crucial to decision success, which can be carefully Only identifies how far a variable needs to change, rather than the
monitored probability of such a change

No complicated theory to understand, yet broadens perspective of Not an optimising technique: provides information on basis for
management regarding what may occur decisions to be made but it does not directly point to best decision

MONTE CARLO SIMULATION

• Monte Carlo Simulation: computerised system that extends sensitivity analysis; it uses random
numbers and probability statistics to show the effect of more than one variable changing at a time
• Method: the model identifies key variables in a decision, and assigns random numbers to each
variable in proportion to the underlying probability distribution; a powerful computer then repeats
the decision thousands of times in order to provide a view of the likely range of outcomes
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