AC2097 guidance on Subject Guide activities
Activity 2.2
The absorption costing method calculates a rate based on the estimated level of activity for a period as seen in
the calculations of overhead rate in Example 2.1. Assuming that the estimated costs and estimated level of
activity are accurate, then the total overhead will be allocated to the products because all the resources
estimated have been used during the period. The product costs calculated in the examples only use part of the
available resources, so not all of the overhead is allocated to these products.
When the overhead is analysed into cost centres, the allocation to the milling cost centre shows that this
department uses a large part of the overhead cost which is allocated by machine hours, but the proportion of
the milling cost centre used by these products is quite small compared to the labour hours which were used in
the original example. The labour hour rates have also been reduced because a large amount of cost is
allocated to the milling department. Therefore the total overhead for these particular products is lower than
when using the company-wide labour hours basis.
Batch 606 uses more machine time in the milling cost centre than Batch 605. Now that the machine hours are
recognised, a cost is charged for these. Also the use of the labour hours differs because Batch 605 is using less
of the expensive spraying cost centre and more of the assembly cost centre than Batch 606.
Activity 2.3
The allocation of costs to each cost centre requires decisions to be made about how much of the common
costs should be shared by each cost centre. It is assumed that the allocated items have been accurately traced
from invoices and payroll to the cost centres that originally requested these resources. However, apportioned
costs (those not requested by a cost centre but required by the whole organisation e.g. rent, electricity etc.)
are billed by suppliers to the company as a whole, and decisions have to be made about how much of these
costs are shared across cost centres, including offices such as marketing, accounting administration etc. which
also use these resources. Only three cost centres are represented in the example, but all parts of the
organisation use power, heating and lighting etc., so decisions have to be made about how these will be
apportioned. This can involve discussions around feelings of unfairness by cost centre managers if the bases
are chosen without much care or consultation.
Part 2 of Example 2.1 provides data about use of resources by different departments, but these are only
examples of possible ways of allocation the costs. For example, heating and lighting is allocated based on floor
area, but maybe the milling cost centre has high ceilings to accommodate the machinery, so would cubic
metres be fairer? The same logic could be used for each apportioned item e.g. do all employees use the
canteen?
The calculations are further complicated by the use of budgeted costs and estimates of usage of the
department. In practice these will not be completely accurate.
Therefore, if you had enough statistics you could list different apportionment basis for each item and would
then have a different overhead rate than calculated in the example.
Activity 2.5
Feedback for this activity is provided below the activity in the subject guide.
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Activity 5.2
The information provided by the example in both chapters 2 and 4 indicate that both methods (the one
measure of activity method, and the production – department rates method) over-cost the products.
Therefore other products would be under-costed. More information is needed on the customer’s responses to
the prices which have been charged using the previous methods and the normal pricing of competing
customers. This involves some market research, as it would be inappropriate to reduce the prices if they are
acceptable to customers. The prices calculated could be regarded as long run minimum prices. It may be that a
complete overview of customer responses to previous prices of all products is needed to ascertain whether
the previous pricing approaches have led to loss of business from some customers.
Activity 6.2
If the target profit is $10,000, there are several ways this could be achieved: selling more tickets, putting up
prices, reducing variable costs, reducing the fixed venue costs, or reducing the band fee.
Would increasing the number of tickets involve some advertising? This would be an additional fixed cost.
However, if we just focus on ticket sales and fixed and variable venue fees, the following is possible:
Ticket sales of 267 and venue fee of $13 per ticket and fixed fee for venue $6,000,
or
Ticket sales of 267 and venue fee of $20.56 per ticket and fixed fee for venue of $4,000.
Total sales 267 x $75
Less variable costs 267 x $15/$22.56
267 x $15
Deal one
Deal two
20,025
20,025
4,005
267 x $22.56
6,024
Total contribution
16,020
14,001
Less fixed costs
6,000
4,000
10,020
10,001
100
77
Profit
B/E point
Contribution margin ratio
Degree of operating leverage
$60/$75
0.8
$52.44/$75
0.7
$16,000/$10,000
1.6
$14,001/$10,000
1.4
Payment to venue owner
@ 267 tickets
9,471
9,490
Activity 6.3
Weighted average contribution (£26.5 x 0.4) + (£12.7 x 0.2) + (31.3 x 0.4) = 10.6 + 2.54 + 12.52 = £25.66
Break-even £850,800 / £25.66 = 33,157.
The break-even is higher than the previous mix, which is due to the lower weighted average contribution.
Activity 7.1
Feedback for this activity is provided below the activity in the subject guide.
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Activity 7.2
Industrial engineering method
This involves time and motion studies used to identify the resource requirements of each product i.e. material,
labour time, machine time. This requires qualified engineers or time and motion study experts to be
employed. The resource requirements identified must then be costed at current or future prices depending on
the purpose of the cost. This method does not of itself determine cost behaviour, so must be used along with
another method that does; often the account analysis method can be used. This method is useful for routine
operations and can be used for work scheduling and performance standard setting. It can also be used to
analyse service activities e.g. data input as well as production operations.
Issues:
•
•
•
Must ensure that measurements are taken under normal operational circumstances.
Must investigate observations which appear to be outliers, to discover what gave rise to this unusual
cost.
Can only be used for routine, physically-measurable operations.
Quantitative methods
High-low method
Uses the two most extreme observations of past data and interpolates the behaviour of the costs between
these points.
Issues: It is a simple method, but ignores any variations of cost behaviour between the two points and assumes
that the two points are representative of behaviour within the range.
Least squares regression
Uses past data at different levels of operation to ascertain the relationship of fixed and variable costs related
to an activity by measuring the change in cost (the dependent variable) relative to the independent variable
(usually volume of output). It is more reliable than high-low method as it gives weight to all observations.
Issues: It requires good past data over a range of activity and understanding of the correct dependent variable
(cost driver). When used for future cost estimation, the user must adjust for changes in costs due to changes in
the economy.
Limitations of relying on the results of quantitative methods
•
Observations may be unrepresentative of current procedure or activities,
•
There may not be enough reliable observations,
•
There may be errors in recording costs,
•
There may not be a causal relationship between activity and cost,
•
There may be inflation effects.
Conference method
Involves the judgement of informed managers. It can be a quick way of determining cost behaviour, but must
use informed managers who are encouraged to report on the bases of the careful, detailed assessments they
produce. Rushed work may lead to poor estimates.
Account analysis method
This looks at recent past data of particular areas of cost. It may be possible to use a quantitative analysis if
there is sufficient data, but often this is not possible, so managers scrutinise the account with their knowledge
of how the costs arose. For example, power cost behaviour can be estimated from looking at the contract. The
method requires experienced managers to use judgement and care in producing their analysis.
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Activity 12.1
The analyses all seem to cover only the lifetime of the initial investment. This is quite normal but may exclude
useful projections about the future ways in which the activity may proceed. In all cases it would be useful to
know what the projects are for. Are the inflows cost savings, or net revenues from a making and selling a
product? This information will help with questions about the reliability of the estimates. Cost saving from new
technology may be easier to predict than revenues from sales of a product. If a product is involved does it have
a lifecycle? Has this been appropriately considered?
Project A
As mentioned in the activity, the inflows are growing, which implies that this may be an investment to make
and launch a product. In which case the future of that product and the need to replace the machinery to
continue the product’s profitability and customer expectations is needed.
Project B
The nature of this should be clarified, as the net inflows increase steadily in years two and three, and then
jump in year four, before falling back in year five. What is expected to happen in year four?
Project C
This is a short project and has declining net cash inflows. This could indicate a product or process which is
declining but more investment is needed for the last few years of activity. Much more information is needed
about the nature of this investment.
The investigation may change the forecasts in two ways:
o
o
If the estimates are shown to be optimistic or unrealistic, better forecasts are needed.
If the work needs to continue after the end of the asset’s life, this should be considered.
Activity 14.1
The budget is one of several methods used by management to communicate targets and boundaries and only
applies to employees who have authority to spend or generate money, which is usually supervised by the
managers of each activity (cost or revenue centre).
Although now an important part of modern management, the budget’s original and still important first role is
to determine how the organisation will meet its financial aims during the next budget period and ensure it has
sufficient finance to carry out those aims. Therefore the ability of each manager to meet their financial target
is important to the existence and continuation of the organisation.
a)
The decision on the targets for each manager should be set in discussion with the managers and
should be in line with their authority and responsibility. The budget is a financial measure rather than
a clear indication of each activity that should be performed by the manager’s department. This gives
flexibility for the manager to use his/her initiative to meet the goals set by their department in a
variety of ways, so long as they are within or better than the budgetary target. Once the budget is set
for the year it becomes a target and a boundary in terms of the financial duties of the manager.
b) As indicated above, the budget only measures the activity of managers with financial responsibility,
not everyone in the organisation. Therefore the evaluation using budgets is restricted to managers.
It is not a good tool for evaluating managers’ performance as it only measures the level of spending or
income generation of each manager and does not indicate other aspects of the manager’s role. These
must be evaluated using other measures of performance.
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Activity 16.1
A
B
C
D
ROI
35%
20%
Gearing ratio
60%
30%
1.2:1
1.2:1
supermarket
Luxury goods supplier
Debtor (receivables) days
short
long
Inventory
short
long
Creditors (payables) days
long
short
Current ratio
sector
Companies A & B
Assuming that ROI is calculated as (Net income before interest) / (Equity plus long-term debt), company A is
performing better, and return on Equity will be even better than for Company B, since interest rates are likely
to be lower than the ROI and the residual income accrues to the shareholders. However, if the ROI is actually
return on equity, then the higher gearing ratio of A will have contributed to the better return.
Companies C & D
These ratios focus on working capital. Both companies have a very low current ratio. This is understandable for
the supermarket (C), where most people pay as they buy and do not expect credit arrangements. The turnover
is fast, and in this case the company has been able to agree long creditor payment periods, perhaps because of
their buying power. The luxury goods supplier (D) may allow long payment periods for some customers, but
this may also represent a small proportion of their business. The company is likely to be holding more
inventory for more time. However, although the creditor days may be short, there may be a much higher
volume of credit.
Activity 16.2
i)
The economic viability of the division would usually be measured by “divisional segment margin”. In this
example, the allocation of corporate expenses does not seem to be in proportion with the divisional
segment margins. This could indicate that there is some variability and potential ability to avoid some
head office costs related to the continuation of a division. Perhaps these should be isolated separately.
ii)
The calculation of reward to the manager should use “divisional controllable income”.
Appraisal of reward should also consider budgeted performance and other non-financial indicators.
iii)
Guidance to the manager of net income to cover head office costs would use “divisional net income
before tax”. This target for divisional managers is important in maintaining the viability of the group and
recognises that if divisions were not part of a group they would have to meet these establishment costs
in their own right.
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Activity 18.2
Even the smallest business, e.g. selling goods at a market or on eBay, will require:
•
•
•
•
Deciding what to sell: market research
Obtaining products to sell: procurement
Obtaining a place to sell, e.g. market stall (needs a legal contract may have to pay before using), eBay
(need to open a PayPal account)
Possibly obtaining finance to pay for the above (might use personal credit card)
The above activities are the lead measures and the sale is the lag measure!
In an ongoing business all these preparations (and more) are needed to ensure that it will continue to be able
to trade after the first period. That is why forward thinking activities are important to measure in the Balanced
Scorecard.
Activity 19.1
a)
Additional prevention costs
Incoming material inspection 400 hours x $50
$20,000
Preventive maintenance 300 hours x $50
15,000
total
35,000
Less Improvements
*Reduced rework (9,600 – 200) hours x $50
$470,000
Reduced Machine repairs 1,000 hours x $50
50,000
Reduced idle time during machine repairs
83,333
Reduced external repairs 4,000 – 800 x $180
576,000
Total
1,179,333
Savings
1,144,333
*Workings:
current internal rework hours
units reworked 4,000 x 120 / 50 = 9,600 hours
The proposals would be very beneficial.
b)
There is no information on the gain in reputation if these actions are put in place, as it would take some time
for reputation to improve.
Activity 20.1
Airbnb is an online advertising facility where an individual (as opposed to a business) can let out part or all of
their home for short or longer periods of time. For example, someone with a spare room in their house could
welcome a guest or couple to use that room even though the family are also living there. Equally, if a family
planned to go away for a few weeks they could let their whole house for that time. Since the launch of Airbnb,
other people who were already in the rooms-letting business, e.g. properties let in the past specifically for
holiday makers or business guests, are now advertising on Airbnb as well as the other media they were using.
The ability to easily offer their home, or part of it, for varying periods of time has been taken up by many
people who did not do this previously. This has led to a big increase in supply of accommodation.
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The increase has led to existing suppliers having to respond, either through lowering prices or by offering
better amenities. It may also have led to some properties and letting agents going out of business.
However, on the demand side, it has also led people who use the accommodation to consider travelling more
often, or staying longer in places which are now cheaper.
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