42 Study notes

Paper P1
Performance
By Ian Janes
CIMA course leader at Newport Business School
The concept of accounting for overheads is a good
example of how a topic introduced at C01 level
remains fundamental to your grasp of increasingly
sophisticated ideas covered in papers P1 and P2
Operations
A
s you enter your workplace or college,
it may not be instantly obvious, but
with a little thought you will realise
that overhead expenditure is all
around you. The building itself may
be rented and the organisation occu-
pying it will probably have to pay business rates of
some sort to the local authority and thats before
youve even stepped through the door.
Once inside, you may meet a receptionist at the
front desk, or a porter or caretaker, and a little fur-
ther on you may come across a coee bar or a refec-
tory. Of course, these are merely a few examples of
the many types of overheads that can be incurred
by an organisation.
Taking a wider view, its important to formally
distinguish direct costs, which can be specically
and exclusively identied with a particular cost
object, from indirect costs, which cannot be iden-
tied specically and exclusively with a given cost
object, according to Colin Drury in Management
and Cost Accounting (Cengage Learning, 2012). Cru-
cial to these denitions is the notion of a cost object,
which we often assume when answering exam ques-
tions to be a unit of a product or service, but which
can be a department or geographical area or, as Drury
observes, anything for which one wants to measure
the cost of resources used.
In your studies you will encounter this concept
rst in paper C01, Fundamentals of Management
Accounting. Part 1(e) of learning outcome B (Cost
identication and behaviour) states that candi-
dates must be able to calculate direct, variable
and full costs of products, services and activities
using overhead absorption rates to trace indirect
costs to cost units.
Lets look at a scenario that might typically
appear in a C01 exam to illustrate the fundamen-
tal principles. The following gures are given for
Dee Co, which has one department, machining:
Dee Co Machining department
Budget
Production overheads $180,000
Machine hours 45,000
Direct labour hours 7,500
Actual results
Production overheads $175,000
Machine hours 42,500
Direct labour hours 8,000
One product, the Exe, has a direct cost of $15 per
unit and the manufacture of each unit requires two
machine hours and three labour hours. So, before
production starts and perhaps before a price is set,
Dee Co wants to know the full cost of a unit of Exe.
First, we need to determine an overhead absorp-
tion rate (OAR) for the department. The general way
to do this is to divide the budgeted overhead by the
budgeted activity for the cost centre. Given that we
are talking about a machining department, its most
appropriate to use machine hours as the basis for
absorption. So the budgeted OAR = $180,000
45,000 machine hours = $4 per machine hour.
This enables Dee Co to obtain its budgeted full
cost per unit by adding the direct cost ($15) to the
overhead (2 hours x $4 per machine hour) to give
$23 per unit.
The OAR is based on budgeted gures, of course,
and the actual machine hours worked and the
actual overheads may well dier from those budg-
eted. Where this is the case, an over/under absorp-
tion of overheads will occur a common subject
of C01 exam questions. In Dee Cos case 42,500
actual machine hours x $4 per machine hour gives
an absorbed overhead of $170,000, compared with
the actual overhead of $175,000, meaning that the
overhead has been under absorbed by $5,000.
There are two reasons for this: 2,500 fewer
machine hours than expected were used, which
has caused an under absorption of 2,500 x $4 =
$10,000, but this has been oset partially by the
fact that the actual overhead turned out to be
$5,000 lower than the budgeted gure.
P1 students should be aware that fundamentals
in management accounting, such as accounting
for overheads, dont end with C01. Future papers
expect you to build what you have learned. It is
vital to see the syllabus as a whole. The knowledge
you gain in C01 and P1 will be applicable in the
Dont think
that, once you
have passed an
exam, you can
forget what has
gone before
44 Study notes
P2 paper as well. Dont think that, once you have
passed an exam, you can forget what has gone
before. Similarly, students who have been granted
an exemption from exams such as C01 should
be aware that a number of subjects including
accounting for overheads, standard costing, var-
iance analysis and budgeting may all be retested.
To paraphrase one examiner speaking recently at
a teachers conference: Having an exemption
means that the student is exempt from the exam,
not exempt from the knowledge.
Lets look at an example in the November 2010
P1 paper. Part A of question 3 illustrates the fun-
damental principle of using a blanket overhead
absorption rate, which C01 covers in detail, while
part B concerns activity-based costing. (Note that
this question demonstrates that section C ques-
tions in P1 arent always on standard costing and
investment appraisal respectively.)
The questions scenario concerns a healthcare
company, which specialises in hip, knee and
shoulder replacement operations. As well as pro-
viding these surgical procedures, it oers pre- and
post-operative care, in a fully equipped hospital,
for patients undergoing the procedures. Surgeons
are paid a xed fee for each procedure they per-
form and an additional amount for each follow-
up consultation. These are held only if there are
complications relating to the surgery. No extra fee
is charged to patients for follow-up consultations.
All other sta are paid annual salaries.
The companys costing system uses a single
overhead rate, based on revenue, to charge the
costs of support activities to the procedures. Con-
cern has been raised about the inaccuracy of the
procedure costs and the companys accountant
has started a project to implement an activity-
based costing (ABC) system.
The project team has collected the following
information on each of the surgical procedures:
The project team has also obtained the follow-
ing information about the support activities:
Part A requires us to calculate the prot per pro-
cedure for each of the three procedures, using the
current basis for charging the costs of support
activities to them ie, a single overhead rate,
based on revenue.
So the budgeted OAR = budgeted overhead
budgeted sales revenue. In this case its $9,880,000
[($8,000 x 600) + ($10,000 x 800) + ($6,000 x 400)]
= $0.65 per $1 of revenue.
So the cost of a hip replacement procedure can
be shown as follows:
Surgeons fee $1,200
Surgeons consultation fee (8% x $300) $24
Medical supplies $400
Overhead cost ($8,000 x 0.65) $5,200
$6,824
When compared against the revenue from a hip
procedure of $8,000, this gives a prot of $1,176.
Now try calculating the cost of the other two
procedures using this method and work out their
respective prots per procedure. The answers can
be found at bit.ly/P1Nov2010Answers.
Part B of the question is where we really move
into P1 territory namely, the nuts-and-bolts oper-
ation of an ABC system. The idea here, rst pro-
posed in 1998 by Robert Kaplan and Robin Cooper
in Harvard Business Review, is that traditional
blanket overhead absorption is too simple for
modern manufacturing environments, leading to
inaccurate costing. As a result, overheads need to
be broken down into pools according to how they
are driven. In other words, not all types of over-
head expenditure are driven in the same way. To
assume that they are leads to inaccurate unit costs.
But its not only manufacturing environments
that have this problem. In fact, it could be argued
that service environments eg, the healthcare
company where overheads often form a greater
proportion of total costs, need ABC even more.
Paper P1 (also relevant to C01 and P2)
Performance Operations
Procedure information Hip Knee Shoulder
Fee charged to patients per procedure $8,000 $10,000 $6,000
No of procedures a year 600 800 400
Average time per procedure 2.0 hours 1.2 hours 1.5 hours
No of procedures per theatre session 2 1 4
Inpatient days per procedure 3 2 1
Surgeons fee per procedure $1,200 $1,800 $1,500
% of procedures with complications 8% 5% 10%
Surgeons fee per consultation $300 $300 $300
Cost of medical supplies per procedure $400 $200 $300
Activity Cost driver Overheads ($)
Theatre preparation for each session No of preparations 864,000
Operating theatre usage Procedure time 1,449,000
Nursing and ancillary services Inpatient days 5,428,000
Administration Sales revenue 1,216,000
Other overheads No of procedures 923,000
9,880,000
46 Study notes
In exam questions such as this, the cost pools are
usually clear for you to see and in this case there
are ve, all driven in dierent ways.
The rst of these pools concerns theatre prepa-
ration. Note the similarity to the budgeted OAR
formula when we state that the cost driver rate for
theatre preparation = the overhead attributable
to theatre preparation the number of prepara-
tions. Bear in mind that, if there are two proce-
dures per session, 600 procedures will need only
300 preparations etc. So its $864,000 [(600 2)
+ (800 1) + (400 4)] = $720 per preparation.
This means that each hip replacement would
be charged with $360, because two procedures can
be performed per theatre session.
The second pool is operating theatre usage. The
cost driver rate for this is calculated as follows:
$1,449,000 [(600 x 2) + (800 x 1.2) + (400 x 1.5)]
= $525 per hour. Its important that you show work-
ings such as this and express the cost driver rate
in full eg, per theatre preparation or per hour.
Performing the calculations for the other three
pools gives us the following cost driver rates:
We can now use the ve cost driver rates to com-
plete our calculation of the overhead cost per hip
procedure as follows:
The direct costs of a procedure remain the same,
of course, so the full cost of a hip procedure under
ABC is as follows:
Surgeons fee $1,200
Surgeons consultation fee (8% x $300) $24
Medical supplies $400
Overhead cost $6,847
$8,471
If we compare this cost against the $8,000 fee
charged to patients, we can see that there is a loss
of $471 per hip procedure. Earlier we thought that
there was a prot on each procedure of $1,176.
Now work out the cost of the shoulder and knee
procedures using the ABC method and calculate
the revised prot (or loss) per procedure. Again,
you can check your answers against the solutions
provided at bit.ly/P1Nov2010Answers.
The sort of information provided by these cal-
culations can help managers in the running of the
business. In the example above, for instance, it
would seem that the fee charged to patients for a
hip replacement procedure would need to be
increased in order to make providing it protable
to the company.
Its also important to understand why there are
such dierences in the overhead costs of each pro-
cedure. We can see from our calculations that a
hip procedure is charged with more overhead
under ABC ($6,847) than it was under the single
overhead rate ($5,200). This contrasts with the
knee procedure, which was charged $6,500 under
the single overhead rate but is charged only $5,519
under ABC. The dierence is explained by the way
in which the respective procedures make use of
the activities. For example, the hip procedure
needs three inpatient days at $1,428 per day, com-
pared with two days for a knee procedure, which
clearly has a signicant eect. Other similar com-
parisons can be performed, but the key general
point is that the overhead is now not being driven
solely by the revenue earned from each procedure,
which meant that a knee procedure was charged
more overhead than a hip procedure. Instead, it
is being driven by each procedures use of activi-
ties, which results in the reverse eect.
What youre actually doing by performing this
sort of analysis is a form of strategic activity-based
management (ABM), which can be described as
doing the right things. By using the ABC infor-
mation, managers can decide which products to
develop and which activities to use. It can focus
on protability analysis, identifying which ser-
vices (in the case of the healthcare company) and/
or customers are the most protable and for which
sales volume should be increased.
ABM is a concept that you are more likely to
encounter in detail in P2, notably listed under part
Paper P1 (also relevant to C01 and P2)
Performance Operations
Nursing and ancillary services (per inpatient day):
$5,428,000 : [(3 days x 600) + (2 days x 800) + (1 day x 400)] = $1,428
Administration (per $1 of revenue):
$1,126,000 : [($8,000 x 600) + ($10,000 x 800) + ($6,000 x 400)] = $0.08
Other overheads (per procedure):
$923,000 : 1,800 = $513
Activity Overheads per procedure ($)
Theatre preparation $720 : 2 = 360
Operating theatre usage $525 per hour x 2 hours = 1,050
Nursing / ancillary services $1,428 per day x 3 inpatient days = 4,284
Administration $0.08 x $8,000 fee per procedure = 640
Other overheads $513 per procedure = 513
Total overhead cost per procedure 6,847
Study notes 47
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GLOBAL CONTACT DETAILS
1(f) of learning outcome B (Cost planning and
analysis for competitive advantage). This states
that candidates should be able to apply the tech-
niques of activity-based management in identify-
ing cost drivers/activities.
CIMAs ocial terminology denes strategic
ABM as actions, based on activity-based analy-
sis, that aim to change the demand for activities
so as to improve profitability. In contrast, it
denes operational ABM as actions, based on
activity driver analysis, that increase eciency,
lower costs and improve asset utilisation. So,
whereas strategic ABM is about doing the right
things, operational ABM is more a case of doing
things right.
For the purposes of the P2 exam, ABM gener-
ally acts as a collective term for a number of tech-
niques that a business can use in order to gain a
competitive advantage. These include:
l
Direct product protability, which focuses on
key products.
l
Cost reduction, which focuses on key activities.
l
Customer protability analysis, which focuses
on youve guessed it key customers.
Although ABM sounds like a new concept, you
are in fact applying principles learned earlier in
your studies in order to improve performance
management in the business. So, once again,
remember: youll need to carry the knowledge you
have gained from C01 and P1 with you into P2.
Question 3 of September 2010s P2 paper con-
tains an excellent illustration of the use of an ABM
technique, customer profitability analysis. It
concerns ST, a distribution company that buys a
product in bulk from the manufacturer, repack-
ages it into smaller packs and sells these to retail
customers. STs customers vary in size, so the scale
and frequency of their orders also vary. Some cus-
tomers order large quantities every time, whereas
others order only a few packs.
STs accounting system produces very basic
management information, which means that ST
is unaware of the costs of servicing individual cus-
tomers. But it has decided to investigate the use
of direct customer protability analysis (DCPA).
The company would like to see the results from a
small sample of customers before it decides
whether to adopt DCPA fully. The information
48
Paper P1 (also relevant to C01 and P2)
Performance Operations
Study notes
for two customers, and for the whole company,
for the previous period is as follows:
Activity costs $
Sales visits to customers 50,000
Processing orders placed by customers 70,000
Normal deliveries to customers 120,000
Urgent deliveries to customers 60,000
At C01 level, the costs above would have been
bundled into one pot of $300,000 of overhead
expenditure, absorbed on a blanket basis: OAR =
$300,000 300,000 packs sold = $1 per pack. Cus-
tomer B would therefore absorb $50,000 of the
overhead, while D would absorb $27,000.
Armed with your ABC knowledge from P1 and
applying it to the ABM concepts of P2, you can pro-
vide a dierent analysis by looking at the four over-
head types and calculating four cost driver rates:
l
Sales visits to customers = $50,000 200 visits
= $250 per visit.
l
Processing customers orders = $70,000 700
orders = $100 per order.
l
Normal deliveries to customers = $120,000 240
deliveries = $500 per delivery.
l
Urgent deliveries to customers = $60,000 30
deliveries = $2,000 per delivery.
These cost driver rates can be used to obtain a
measure of the protability of both customers:
You can see that the overhead assigned to cus-
tomer B under ABC ($46,000) is not substantially
dierent from the gure attributed under blanket
absorption ($50,000), but for customer D it is
$12,500 under ABC as opposed to $27,000. Given
that the customers are protable and there seems
to be no immediate need to stop supplying them,
this information can help managers to make better
operational decisions and improve protability.
We may wish to consider why the prot from
each customer is similar, yet customer Bs contri-
bution is almost double that of D. Of course, the
dierence is the level of overhead assigned to each
customer. ST may wish to investigate why B gen-
erates three times the number of normal deliver-
ies generated by D, but less than twice its factory
contribution. This could indicate that B places
many small orders, rather than a few large ones.
It may prompt ST to try to improve its prots by
incentivising B to make fewer, but larger, orders.
Similarly, why does B require urgent deliveries
when D doesnt? ST may wish to work out how to
improve communications with B so as to prevent
the need for urgent deliveries.
What we have here is a good case of operational
ABM i.e. doing things right. Those activities
that add value to the service can be identied and
improved. Activities that dont add value should
be reduced to cut costs without reducing customer
satisfaction. Where, for example, customers are
requesting urgent deliveries, we should nd out
why and try to limit these occurrences. Similarly,
every eort should be made to work out how to cut
the cost of activities such as normal deliveries.
So, from blanket OARs in C01 to a discussion of
both strategic and operational management issues
in P1 and P2, we can see that a sound understand-
ing of accounting for overheads is essential.
Further reading CIMA Ocial Study Text C01 Fundamentals of Management Accounting, CIMA Publishing, 2012;
CIMA Ocial Study Text P1 Performance Operations, CIMA Publishing, 2012;
CIMA Ocial Study Text P2 Performance Management, CIMA Publishing, 2012.
Customer B Customer D Company
Factory contribution $75,000 $40,500 $450,000
Number of:
Packs sold 50,000 27,000 300,000
Sales visits to customers 24 12 200
Orders placed by customers 75 20 700
Normal deliveries to customers 45 15 240
Urgent deliveries to customers 5 0 30
Customer B D
Costs $ $
Sales visits 250 x 24 = 6,000 250 x 12 = 3,000
Processing orders 100 x 75 = 7,500 100 x 20 = 2,000
Normal deliveries 500 x 45 = 22,500 500 x 15 = 7,500
Urgent deliveries 2,000 x 5 = 10,000 2,000 x 0 = 0
46,000 12,500
Contribution 75,000 40,500
Prot 29,000 28,000
IMPORTANT INFORMATION FOR
STUDENTS EXEMPT FROM ANY EXAM
Exemptions are great they recognise the value of your past
studies and get you o to a ying start. But, because the syllabus is
progressive i.e. papers often draw on knowledge covered in
previous exams you need to be condent in all topics covered by
any paper for which youve been granted an exemption.
To show how papers in any of the three pillars are related, FM
has published three articles. The rst is above. The other two oer
advice from the relevant examiners for the Financial pillar
(available at www.cimaglobal.com/nancialexemptionsarticle)
and the Enterprise pillar (www.cimaglobal.com/enterprise
exemptionsarticle). You are strongly advised to read these if you
have accepted, or are planning to accept, any exemption.