Summary
Summary CIMA P2 Notes
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- Chartered Institute Of Management Accountants
- Everything you need to pass P2 - Detailed 40 pages of notes, complete with diagrams, graphs and formulae - My score: 79%
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Chartered Institute of Management Accountants Management Level P2P2 Advanced Management Accounting
Structure
A.Managing the costs of creating value (20%)
1. Activity-Based Costing and Activity-Based Management
2. The modern business environment
3. Costing techniques
B.Capital investment decision-making (35%)
4. Data required for decision-making
5. The investment decision-making process
6. Investment appraisal - further aspects
7. The pricing decision
C.Managing and controlling the performance of organisational units (30%)
8. Responsibility centres
9. Alternative measures of performance
10.Transfer pricing
D.Risk and control (15%)
11.The treatment of uncertainty and risk in decision-making
12.Risk management
Jack Gould 1 of 40
,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 (OA R ) =
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 • Cost pools: activity that consumes resources and for which
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
Jack Gould 2 of 40
,Chartered Institute of Management Accountants Management Level P2
C.Product-sustaining activities: performed to support individual products; resources consumed
independent of how many units/batches are produced, ie product design, advertising specific
product lines, updating product specification database
D.Facility-sustaining activities: cannot be related to a particular product line, ie maintenance of
buildings, facilities management, administration staff, security, business rates, property taxes
Advantages of ABC Disadvantages of ABC
Greater accuracy of product costing: particularly where non-volume related Minimal evidence that ABC improves corporate
production overheads are significant and the product line is diverse profitability
Flexible to enable analysis of costs by cost objects other than products, such as: Complex and expensive: benefits may not justify
processes, customers, managerial responsibilities cost of operation
Improves understanding of cost behaviour and reliability of cost information: May be viewed as simply a rigorous application
thus has potential to improve cost estimation of conventional costing procedures
Provides comprehensive basis for costing work Practical problems such as cost driver selection
Provides meaningful financial and non-financial measures: relevant to operational Strong general ledger required to provide reliable
level cost management and performance assessment ABC information
Provides reliable indication of long-run variable product cost: particularly ABC information is historical and internally
relevant to strategic level decision-making: orientated: historical costs are susceptible to
• Decisions concerning product pricing strategy substantial change since all production factors
• Changes to range and mix of current products are variable over longer term, therefore ABC may
• New product development lack direct relevance for future strategic decisions
Implementation of ABC (CGMA cost transformation model)
Do Don’t
• Ensure buy-in from the entire firm (Friedman & Lyne, 1999) • Avoid excessive detail and control: can obscure bigger picture or
• Use ABC for pricing and product prioritisation decisions make the firm lose sight of strategic objectives
• Management accountants to implement ABC: they are best • Avoid thinking ABC is relevant for all decisions: not all costs
placed to manage the process and ensure its benefits disappear if a product is discontinued for example
ACTIVITY-BASED MANAGEMENT (ABM)
• ABM: system of management using information derived from ABC analysis to help management
better understand costs and thus improve organisational profitability
• ABM focus management attention on key value-adding activities (Hansen & Mowen, 2014),
products and customers: to improve customer value and increase competitive advantage
• Employee empowerment: ABM takes a critical step beyond ABC by recognising the contribution
people make as the key resource in organisational success:
• All staff should be empowered to act via: training, being fairly treated, recognising success
• Nurtures good communication and team work
• Develops quality decision-making
• Leads to quality control and continuous improvement of all activities
• Management and staff must together determine which activities are critical to organisation
success, cooperating to define: cost pools, cost drivers, and key performance indicators
ABM system 5 basic information outputs:
1. Cost of activities and business processes: activities form the core of what a business does,
therefore the basic output of the ABM system must be to provide relevant cost information
2. Cost of non-value added activities: identification and elimination of non-value added/
diversionary/wasteful activities provides an invaluable focal point for management
• Strategic activity management: recognises individual activities are part of a wider process,
grouped to form a total process; strategic activity management categorises outputs of ABC as
value added or non-value added; the latter of which are unnecessary and should be eliminated
• Bellis-Jones (1992): decline from 35% to 20% of time spent on non value-added activities after
introducing ABM
3. Activity based performance measures: total activity cost is insufficient when measuring activity
performance; additional measures such as quality, time, productivity and customer service are
also required to report on improvement efforts as part of overall continuous improvement
4. Accurate product/service cost: product/services consume resources at different rates and
require different levels of support, thus costs must be accurately determined
5. Cost driver information: by identifying cost driver information for each activity, it is possible to
manage activity levels; the ABM system thus uses ABC information to assist strategic decisions:
• Whether to continue with an activity • Cost structures comparison with competitors
• Effect of cost structures on strategy • How change in activities affect suppliers and value chain
Jack Gould 3 of 40
,Chartered Institute of Management Accountants Management Level P2
DIRECT PROFIT PROFITABILITY (DPP)
• DPP: method of absorbing overheads used primarily in retail/grocery trade organisations
• DPP deducts bought-in cost and indirect costs (ie warehousing, distribution, and retailing) from
selling price to identify net profit (direct product profit), not gross profit, for each product
• Warehouse costs and store costs: includes
labour, space, and insurance costs
• Transport costs: includes labour, fuel, and
vehicles maintenance costs
• The cost attribution/apportionment process uses various measures (usually in relation to area
occupied) to reflect resource consumption of individual products. However there are exceptions:
• Insurance: may be apportioned based on value or on a risk index
• Handling costs: may vary with number of pallets handled rather than volume of good itself
• Benefits of DPP:
• Analysis of direct profitability of each product • Rationalisation of product ranges
• Better pricing decisions • Better merchandising decisions
• Better management of warehouse/store space • Provides focus for marketing initiatives
• DPP software systems: used to model costs, requiring numerous variables to carry out analysis:
• Buying and selling prices • Rate of sale • Pallet configuration • Distribution routes
• Inventory holding size • Product size • Ordering costs
Categories of indirect costs
• Overhead cost: incurred via activity not directly linked to a particular product; ie cleaning floors
• Volume-related cost: incurred in relation to space a product occupies; ie storage rental
• Product batch cost: often a time-based cost; ie unloading product deliveries onto store shelves
• Inventory financing cost: cost of tying up money in inventory; ie cost of capital tied up in goods
CUSTOMER PROFITABILITY ANALYSIS (CPA)
• CPA: analysis of revenue streams/service costs associated with different specific customer groups
• Customer profiles: different customers/customer groups make use of different activities to
varying degrees, thus differ in terms of their profitability; CPA uses ABC principles to identify the
most profitable customer profile
• Cost to serve: CPA can direct attention to attracting/retaining the most profitable customers/
customer group; conversely it can be used to review the business model currently offered to less
profitable customers, with customers charged according to cost to serve them
• Customer profitability curve: when analysing profitability of
customers a Pareto curve may exist, which serves to identify the most
significant areas for management to focus on
• Pareto curve (80/20 rule): observed phenomenon that 20% of
customers provide 80% of profit; final 50% may actually reduce total
profit, thus a team should be set up to explore ways of turning these
into profitable customers
DISTRIBUTION CHANNEL PROFITABILITY
• Distribution channels: means of transacting with customers, who seek accessibility, reciprocal
communication, products/services which satisfy their needs, prompt delivery, after sales support
• Direct channels: sales teams, telephones, shops, internet
• Indirect channels: retailers, wholesales, resellers, agents
• Channel selection: critical to business profitability, as it can account for significant proportion of
total costs; the business should always consider the ultimate needs of the customer and therefore
select the channels to ensure such needs are satisfied, considering aspects such as:
• Achieving sales • Access to customer base • Brand awareness • Speed of payment
and market targets • Customer retention rates • Competitiveness • Profitability
• Costing channels: channels will use different activities; ABC information enables costing of
distribution channels, which is important as channels differ in profitability
• Distribution channel profitability profiles: are built up to enable analysis, in order to reduce
channel distribution costs and improve profitability of products/services
Jack Gould 4 of 40
,Chartered Institute of Management Accountants Management Level P2
P2A2 Modern business environment
CHARACTERISTICS OF THE MODERN BUSINESS ENVIRONMENT
• Modern business environment: companies are now making customer satisfaction a key priority,
adopting new approaches, changing manufacturing, and investing in new technology
• Global environment is now characterised by:
Companies Customers Products
Customers and competitors are internationally based Products components are sourced globally
Companies operate
in a world economy Huge increase in demand for new, innovative products
Customers demand ever-improving levels of service
in cost, quality, reliability, flexibility, and delivery Companies have diverse product ranges, with high level
Firms must be world of customised and bespoke products/services
class to compete
Customers have greater choice than before Product life cycles have reduced
• Flexibility: move from standardised units to bespoke units means mass production techniques are
redundant; processes are now designed to accommodate flexibility, not just throughput
• Cost reduction: standard costing techniques focusing on cost control are therefore being
replaced by modern techniques which focus on cost reduction (such as ABC)
• Employee empowerment: managers must empower staff to make decisions, as this enables faster
response to customers, increased process flexibility, reduced cycle time, and improved morale
JUST-IN-TIME (JIT)
• JIT: pull system with the aim of producing items, at the required quality and quantity, at the precise
time they are required by a customer or for use, rather than for inventory
• Pull system (JIT), supplier ← production ← customer: responds to demand; problems in any
part of the system immediately halt the production line
• Push system, supplier → production → customer: inventory acts as a buffer between different
elements of the system, such as purchasing, production, and sales
• JIT approach: best described as a management philosophy, JIT encompasses a commitment to
continuous improvement and pursuit of excellence in operation of the production management
system, primarily seeking elimination of waste and elimination of inventory
• JIT inventory: there is little to no inventory, hence risk of inventory obsolescence should not exist
• JIT production (demand-based production): driven by demand for finished products, where each
component is produced only when required by the next production stage, and products only made
when the customer requests it; hence production lead time should equal processing time
• JIT purchasing (demand-based ordering): material purchases are contracted so that receipt and
usage of material coincide as much as possible
JIT production characteristics JIT purchasing characteristics
• Small batches (thus higher set-up costs), specific to customer order • A few, high quality suppliers
• Reduce set up times • Focus on quality rather than price
• Focus on quality • Frequent deliveries
• Cellular manufacturing • Geographically close suppliers
• Multi-tasking staff • Long term relationships with suppliers
Benefits of JIT Problems of JIT
Exposes problems in production, forcing managers to address Difficult to implement when an organisation operates over a large
them, rather than conceal them by holding excess inventory geographical area add far from its suppliers
Improved product quality and more diverse product range Difficult to implement when it is not easy to predict patterns of demand
Flexible manufacturing: ability to quickly respond to demands Absence of buffer inventory makes it more vulnerable to supply chain
disruption thus exposing the business to production delays, as there is
Improved supply chain relationships no safety net to protect against a breakdown in supply
Improved customer satisfaction Cost increases:
• Labour costs increase due to higher skills, training and increased
Cost savings: overtime payments, due to fluctuating demand and zero inventory
• Stock holding costs reduce: releases capital tied up in stock • Set up costs increase as more batches are produced
• Quality failure costs reduce • Material costs increase as higher quality material is used
JIT requirements
• Versatile labour force: multi-skilled labour to perform any job necessary to keep production flowing
• Cellular manufacturing: production processes grouped by product line, rather than by function: in
order to eliminate inventory movements between workstations and to speed production flow
• Simple and infallible information system; and
Jack Gould 5 of 40
,Chartered Institute of Management Accountants Management Level P2
• ‘Get it right first time’ approach and an aim of zero defects: defects cause breakdowns in the flow
of production, create expensive rework, and result in late deliveries to customers
• Strong/close relationships with major suppliers: suppliers should guarantee quality and deliver
frequently, in return for long-term commitment of business and assurances of demand
TOTAL QUALITY MANAGEMENT (TQM)
• TQM: name given to programmes - applicable to any organisation - which seek to ensure goods
are produced/services supplied of the highest quality, with 2 basic principles:
1. Continuous improvement: never be satisfied with current level of rejects; all errors provide
opportunity for improvement and managers/staff should believe in the pursuit of excellence;
2. Get it right, first time: TQM aims for zero rejects and 100% quality in the belief that costs of
prevention are less than costs of correction; therefore increase conformance costs and
decrease non-conformance costs to result in a total reduction in quality costs…
Quality costs
• Conformance costs: costs of compliance; costs to prevent quality failures
• Prevention costs: incurred in preventing mistakes and ensuring defects do not occur, ie:
• Routine preventative repairs and maintenance of equipment
• Quality training to improve skills and efficiency of staff
• Building quality into product design and manufacturing processes
• Appraisal costs: incurred in examining products mistakes and measuring conformity with
requirements, before a product is manufactured, ie:
• Cost of inspections
• Cost of operating testing equipment
• Cost of acquiring and operating the process control
• Non-conformance costs: costs of failure to comply; costs to identify quality failures
• Internal failure costs: incurred if units produced failed to reach set standards, ie
• Redesigning a new product
• Reworking costs or costs of scrap/disposal
• Costs to correct failed processes
• External failure costs: incurred if product faults are not detected until reaching the customer, ie
• Marketing costs associated with failed products and loss of customer goodwill
• Compensation for units returned by customers
• Costs of a customer service team dealing with complaints
• Repair costs and liability claims
Successful implementation of TQM (highly compatible with JIT due to focus on customer needs)
• Recognise the importance of quality: move away from acceptable quality levels (AQL) to defect
levels measured in parts per million, emphasising total cost of quality as a key strategic variable
• Total commitment to quality: drive to get things right first time applied throughout the company
• Customers: focus on customer needs/expectations and place them above needs of the business
• Employees: demand continuous improvement and ensure each operative is personally
responsible for defect free production/service; but recognise achievements
• Performance standards: agreed with each employee and customer
• Management accounting reports: various reports that evaluate efforts to improve quality
• Quality circles: team that meets voluntarily to identify and analyse work-related issues, present
solutions to management, and implement and monitor the effectiveness of such solutions
• Quality certification programmes: third party audit of control and production processes
THROUGHPUT ACCOUNTING AND THE THEORY OF CONSTRAINTS
• Aim of throughput accounting: to maximise the measure of throughput contribution; this is
achieved by determining the bottleneck constraints preventing throughput being higher
• Produce based on ranking of calculated contribution per unit of limiting factor for each product
• Bottlenecks: activities which have a lower capacity than preceding or subsequent activities,
thereby limiting throughput; bottlenecks should be removed or fully utilised at all times
• Non-bottleneck resources: should be scheduled and operated based on system constraints, and
should not be used to produce more than the bottlenecks can absorb
• Theory of constraints (TOC) (Goldratt, 1984): process of continuous improvement to clear the
throughput chain of all bottleneck constraints
1. Identify: the system’s bottleneck 2. Exploit: decide how to exploit the bottlenecks
3. Subordinate: ensure all activities are aligned with the bottleneck constraints; optimum production
of the bottleneck activity determines the production schedule of the non-bottleneck activities
4. Elevate: the system’s bottlenecks 5. Repeat: resolve the next bottleneck; return to step 1
Jack Gould 6 of 40
, Chartered Institute of Management Accountants Management Level P2
Throughout accounting measures
• The only cost deemed to relate to volume of output is direct material cost; all other costs are
deemed fixed costs, known as Total Factory Costs (TFC)
T h r o u gh p u t c o n t r i b u t i o n p e r u n i t = Re v e n u e − D i r e c t m a t e r i a l c o s t s
To t a l f a c t or y c o s t s (T FC ) = F i x e d c o s t s + Va r i a bl e l a b o u r a n d pr o d u c t i o n o v e r h e a d s
• Return per factory hour (aim to maximise): return generated by each product at the bottleneck
T h r o u gh p u t c o n t r i b u t i o n p e r u n i t
Re t u r n p e r f a c t or y h o u r =
P r o d u c t′s t i m e o n b o t t l e n e ck r es o u r c e
• Cost per factory hour (aim to minimise): cost of operating the factory
To t a l f a c t or y c o s t s
Co s t p e r f a c t or y h o u r =
To t a l t i m e o n b o t t l e n e ck r es o u r c e
• Throughput accounting ratio (TAR) (aim to maximise): measures return from product against
cost of operating the factory; typically only products with TAR > 1 should be produced
Re t u r n p e r f a c t or y h o u r
T h r o u gh p u t a c c o u n t i n g r a t i o (TA R ) =
Co s t p e r f a c t or y h o u r
BUSINESS PROCESS RE-ENGINEERING (BPR)
• Business process: collection of activities linked in a coordinated manner to achieve specific aims
• BPR: concerned with far-reaching one-off changes to improve operations; existing processes are
redesigned and technology used to find innovative ways to do business, to achieve cost savings,
improved quality, and increase ability to meet customer needs thus raising customer satisfaction
• The fundamental rethinking and radical redesign of business processes, to achieve dramatic
improvements in critical contemporary measures of performance (Hammer & Champy, 1993)
1. Process identification: identify the processes to be redesigned
2. Process rationalisation: measure existing processes, to give baseline to compare improvement to
3. Process re-design: design and built a prototype to show which changes are possible
4. Process reassembly: implement a revised system
• Value-adding activities: increase the worth of a product to the customer, must meet 3 criteria:
A.Customer is willing to pay for the output
B.Activity physically changes the output in some way
C.Activity is performed correctly at the first attempt
• Non-value adding activities: do not increase worth of a product to the customer; often possible
to minimise them but not usually possible to eliminate entirely
• Value enabling activities: may be essential for value-adding activities to take place and cannot
be eliminated altogether; they should be done simply and cost effectively
Criticisms of BPR:
• Business processes are often not redesigned but merely automated
• Often regarded as a once-for-all cost-cutting exercise; thus can be a pretext for staff reductions
• Overlooks the impact on human resources
• Excessive focus on improving existing practices rather than developing new methods of business
KAIZEN
• Kaizen (continuous improvement): Japanese term meaning to improve processes via numerous
small/incremental amounts on a regular basis rather than occasional large/far-reaching innovation;
• Link to JIT: continuous improvement or ‘Kaizen’ is integral to the JIT management philosophy
• Continuous improvement: Kaizen reduces costs by implementing continuous improvement;
there is always scope to improve on current methods as the organisation should seek perfection
• Philosophy of customer-driven improvement: Kaizen aims to create a culture of continuous
quality, cost and delivery (QCD) improvement across the value chain
• Universal responsibility: Kaizen democratises continuous improvement through the idea that the
person performing the operation is most knowledgeable about and hence best qualified to improve
it; such improvement is the aim and responsibility of every worker in every activity, at all times
• Everyone in the business: is encouraged to seek and implement opportunities to eliminate waste
in their workplace; waste includes excessive effort (muri) and excessive process (mura)
• Managers: should cultivate participation in Kaizen activities; and be seen themselves to engage
• Individuals and teams: should be rewarded and improvement results celebrated
• Cost reduction targets: Kaizen aims to achieve cost reduction targets via increased production
process efficiency; current actual costs become the baseline for new Kaizen targets, with the
emphasis on reducing variable cost of a period below the cost level in the base period
• Target reduction rate: the ratio of the target reduction amount to the cost base
Jack Gould 7 of 40

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