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Summary CIMA P1 Notes
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Chartered Institute of Management Accountants Operational Level P1P1 Management Accounting
Structure
A. Cost accounting for decision and control (30%)
1. Rationales for costing
2. Traditional costing
3. Activity-based costing
4. Other costing techniques
5. Variance analysis
6. Further variance analysis
B. Budgeting and budgetary control (25%)
7. Preparing budgets
8. Forecasting techniques
9. Budgetary control
C. Short-term commercial decision making (30%)
10. Relevant cost and decision making
11. Break-even analysis
12. Linear programming
D. Risk and uncertainty in the short-term (15%)
13. Risk and uncertainty in the short-term
Jack Gould 1 of 53
, Chartered Institute of Management Accountants Operational Level P1
P1A1: Rationales for costing
Decision making levels
• Operational: lower level management focus on short term routine or day-to-day issues.
• Such as: resource management inventory levels, production capacity, staff utilisation
• Tactical: middle level management form a link between strategic and operational levels, often
implementing medium term decisions made at strategic level to an area/division of a business.
• Such as: how to operate in a chosen market, staff recruitment, changing suppliers, customer
service, purchasing new machines
• Strategic: top level management making long term decisions that impact the entire organisation.
• Such as: assessing the economic situation, expanding into new markets, whether to launch a
new product, or acquiring other businesses.
MANAGEMENT AND COST ACCOUNTING
• Accountancy involves the measurement, analysis and reporting of (non-)financial information to
help managers, shareholders and other interested parties make decisions about organisations.
Financial accounting Management accounting Cost accounting
De nition “Classification and recording of the monetary “The application of the principles of accounting Sub-set of management
transactions of an entity in accordance with and financial management to create, protect, accounting: “the gathering of cost
established concepts, principles, accounting preserve and increase value for the information and its attachment to cost
standards and legal requirements and their stakeholders of for-profit and not-for-profit objects, the establishment of
presentation, by means of statements of profit enterprises in the public and private sectors.” budgets, standard costs and actual
or loss, statements of financial position and costs of operations, processes,
cash flow statements, during and at the end of activities or products; and the
an accounting period.” analysis of variances, profitability or
the social use of funds”
Law A legal requirement of organisations is to No legal requirement; it is carried out at the
produce financial statements which show a discretion of management
true and fair view of their financial position
Rules Governed by many regulations; information Not governed by rules or regulations;
must be presented in prescribed formats information may be provided in any format
Information Uses historical financial information Uses both historical and future information,
in all forms (financial or non-financial)
Role Role is more clearly and narrowly defined; Role is more loosely defined; main purposes
their purpose is the production of statutory are planning, controlling and decision making;
financial statements/accounts for an the provision of any information required
organisation/entity by management to aid decision making
Users Provide information available for external use Provide information for internal use; focusing
such as the public or anyone interested; on the needs of management
focusing on the needs of external stakeholders
Decisions Strategic decisions: management accounting Operational and tactical decisions:
takes a broader view of the organisation and as a sub-set of management
take decisions that include a more strategic accounting, cost accounting focuses
basis with a longer-term view more on calculating costs of a
product/service and extending this to
potentially controlling and managing
costs. It is thus typically more useful
for operational and tactical decisions
due to a focus on often short-term
improvements and decisions.
Data Quantitative and qualitative data: more Quantitative data: mainly focuses
expansive scope difficult to quantify, such as on data that can be measured
customer satisfaction or employee motivation
THE PURPOSE OF MANAGEMENT ACCOUNTING
1. Planning (for the future of the business):
• Planning involves establishing the objectives and goals of an organisation, and formulating
relevant strategies that can be used to achieve such objectives and goals.
• Budgets: management accountants will create financial plans of what will occur based on different
assumptions by preparing budgets, which explain potential impacts of different courses of action
2. Control (the performance of the business):
• Control involves monitoring, measuring, evaluating and correcting actual performance to ensure
the organisation’s plans are being achieved.
• Variances: information relating to actual results must be compared to the budgeted targets, with
differences - known as variances - calculated and reported to management, facilitating the control
of operations with corrective action if necessary
3. Decision making (that adds value to the business):
• Decision making involves considering information that has been provided and using it to make
informed decisions.
• Managers require reliable information to compare different courses of action available, to thus
understand the consequences of each action might be, and to hence make informed decisions.
Jack Gould 2 of 53
fi
,Chartered Institute of Management Accountants Operational Level P1
THE MANAGEMENT ACCOUNTANT
• Traditionally, management accountants were largely involved in reporting performance of the
business to management, working in isolation as a separate business function.
• Today however, management accountants are regarded as value-adding business partners;
expected to not only forecast the future of the business, but to assist in delivering this future by
identifying opportunities for enhancing performance of the organisation.
• Management accountants are therefore an integral part of any business: they work alongside
business managers as mentors, advisors and drivers of performance, as well as translating
results into a variety of information to management for planning, control and decision making.
CIMA definition of the role of management accountant:
• Chartered management accountants help organisations establish viable strategies and convert
them to profit (commercial) or into value for money (not-for-profit). To achieve this they carry out:
• Formulation of policy and set corporate aims • Provision of information and analysis on which
• Formulation of strategic plans derived from decisions are based
corporate aims • Monitoring outcomes against plans and
• Formulation of shorter term operational plans initiating action for performance improvement
• Acquisition and use of finance • Derivation of performance measures and
• Design and management of information benchmarks for monitoring and control: both
systems, recording of events and transactions non-financial and financial; both qualitative
• Generation, communication and interpretation and quantitative
of financial and operating information for • Improving business systems and processes
management and other stakeholders through risk management and internal audit
• Through these forward-looking roles and application of skills, management accountants improve
organisation’s performance, security, growth and competitiveness; their work, experience and
responsibilities are highly varied and change to reflect changing needs of stakeholders.
THE IMPORTANCE OF UNDERSTANDING COSTS
• ‘Cost’ can be used in two contexts:
• As a noun: ie the cost of an item • Or as a verb: ie attempting to cost an activity
• In financial accounting: all costs must be recorded so that profit can be calculated, and the true
and fair financial position can be presented in the financial statements
• In management accounting: an understanding of costs is required in order to carry out the three
main functions of planning, control and decision making. By understanding and calculating cost,
information can be produced and used for:
• Recording in financial statements: by determining cost to manufacture products/provide services
• Inventory valuation: through use of cost per units
• Pricing decisions: cost information can inform decisions on selling price to charge for a product
• Supply decisions: understanding profitability can help determine products/services to supply
• Benchmark for future performance: cost can act as a benchmark for future performance, with
differences from the expected (standard) cost calculated (known as variances) and evaluated
CGMA cost transformation model
• Cost management is thus a key component of the management accountant’s role
• To survive in the modern global business environment, firms must continually seek opportunities
to improve cost structures while generating value for customers.
• Hence, the cost transformation model was developed to provide a framework to help companies
achieve and maintain cost-competitiveness, with 6 suggested changes to achieve this:
• Creating 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.
• Understanding cost drivers: investigating cost and how different variables impact on costs; with
plans to reduce the drivers of costs and perhaps the costs themselves if unnecessary in meeting
customer needs. This may involve critical evaluations of current systems and processes.
• Managing risks of a cost conscious culture: clear process to identify, assess and manage risks
inherent in driving cost competitiveness
• Ensuring products and services are profitable: important that every product/service positively
contributes to overall organisational profits; thus understand cost drivers for each products
• Maximising value from new products: potential profitability of new products should be assessed
before production begins; and the product/service be made adaptable to satisfy as many
customer segments as possible
• Environmental impact of products: negative impacts can add costs (such as wastage), damage
reputation and reduce sales; incorporate sustainability to optimise profits
Jack Gould 3 of 53
,Chartered Institute of Management Accountants Operational Level P1
COST TERMS
Cost units
• Cost unit: “a unit of product or service in relation to which costs are ascertained.”
• A cost unit is therefore anything measurable and for which it is possible to ascertain the cost, both
tangible (can be seen or touched) and intangible (cannot be seen or touched but is measurable).
• Examples of industry/activity - cost unit:
• Electricity - Megawatt-hour (MwH) • Professional service - chargeable hour
• Education - enrolled student • Selling - customer call
Cost centres
• Cost centre: “a production department or service location, a function, an activity, or an item
of equipment for which costs are accumulated.”
• A cost centre is used as a collecting place for costs. Examples:
• Production location - factory machine • Function - sales representative
workshop • Activity - quality control
• Service location - stores, canteen • Item of equipment - packing machine
• The cost of operating the cost centre is determined for the period, and then this total cost is
related to the cost units which have passed through the cost centre
Cost objects
• Cost object: “for example a product, service, [cost] centre, activity, customer or distribution
channel in relation to which costs are ascertained.”
• A cost object is anything for which costs can be ascertained; it is an umbrella term, meaning that
all cost units and cost centres are thus types of cost object.
CLASSIFICATION OF COSTS
• Costs can be classified in many ways, but it is necessary to be able to classify all costs; to arrange
them in logical groups, in order to devise an efficient system to collect and analyse the costs
Classification of costs according to their ELEMENT
• Material costs: components bought in by the company which are used in manufacturing the
product, including the cost of carriage inwards.
• Labour costs: costs of the people working for the organisation, including wages and salaries
together with other employment related costs such as bonuses and overtime.
• Expense costs: regularly incurred costs of running the business, such as rent, business rates,
utility costs, postage, insurance, telephones, and so on.
• Subdivision of cost classifications
• Within most classifications there may be subdivisions (and further sub divisions), for example (a
non-exhaustive list of) materials might include:
• Raw materials (of which further subdivisions may be…)
• Steel, Plastic, Glass, etc
• Components (complete parts)
• Consumables (such as cleaning materials)
• Maintenance materials (such as spare parts, lubricating oils, etc)
Classification of costs according to their NATURE
• Direct costs: can be specifically attributed to a particular cost object. For example making a table:
• Direct materials: timber, screws and drawer handles
• Direct labour: wages paid to the machine operator, assembler and finisher
• Direct expenses: royalty payments to the designer of the table
• PRIME COST (total of all direct costs) = direct material cost + direct labour cost + direct expenses
• Indirect costs (also known as OVERHEADS): cannot be directly attributed to a particular cost
object. For example making a table:
• Indirect materials: lubricating oils and cleaning materials (not part of the finished product)
• Indirect labour: salaries of factory supervisors (not directly associated with production)
• Indirect expenses: factory rent and electricity (shared out across all batches produced)
Jack Gould 4 of 53
,Chartered Institute of Management Accountants Operational Level P1
• Product costs: costs which are only incurred if production takes place. Includes direct material,
direct labour, and absorbed production overheads
• Product costs are charged to the individual product and matched against the sales revenue they
generate
• Period costs: costs which are incurred due to the passage of time. Includes costs such as rent,
insurance, directors’ salaries and deprecation; these still accrue regardless of production
• Period costs are charged in full to the statement of profit or loss in the period in which they are
incurred
Classification of costs according to their FUNCTION
• Production costs: incurred in the manufacture of the product
• Non-production costs: albeit not directly involved in the manufacture of the product, are required
to support the overall activity of the firm, such as sales, distribution and administration.
Classification of costs according to their BEHAVIOUR
• Cost behaviour refers to the way in which costs are affected by fluctuations in the level of activity;
the behaviour of cost in relation to change in activity levels.
• Understanding how costs behave in relation to activity is essential for planning, control and
decision making, as it is not otherwise possible for managers to forecast and control costs.
Fixed cost
• Fixed cost: “a cost incurred for an accounting period that, within certain output or turnover limits,
tends to be unaffected by fluctuations in the levels of activity (output or turnover).”
• Examples: insurance; manager salaries; rental of premises
• Relevant range: fixed costs are - within certain activity limits (the relevant range) - unaffected
by changes in activity levels.
• Period cost: a fixed cost is also a period cost, highlighting that it is incurred according to time
elapsed rather than level of activity; it is a constant within the relevant range.
• Fixed cost per unit: within the relevant range, total fixed cost is constant, however fixed cost per
unit reduces as activity level increases, because the same amount of fixed cost is spread over an
increasing number of units.
Fixed cost Fixed cost per unit Stepped fixed cost
• Stepped fixed cost: describes where a total cost remains constant for a relevant range of activity,
but increases to the next step when a critical level of activity is reached.
• Critical point: as fixed costs are only truly fixed for the relevant range of activity; within the
relevant range activity can be expanded without requiring extra premises for example, meaning
rent is unchanged. However if activity expands to the critical point beyond the relevant range, for
example where further premises are required, then rent (and cost) increases to a higher level.
Variable cost
• (Linear) Variable cost: “a cost that varies with a measure of activity.” Variable costs change in
direct proportion to changes in the activity level; and are assumed to be linear, meaning the cost is
nil at zero activity level.
• Examples: direct material, direct labour, variable overheads.
• Variable cost per unit: for a linear variable cost, variable cost per unit will remain constant as
activity level is increased, within the relevant range.
Linear variable cost Variable cost per unit
Jack Gould 5 of 53
,Chartered Institute of Management Accountants Operational Level P1
• Non-linear or curvilinear variable cost:
• Cost B becomes less steep as activity level increase, indicating each successive unit of activity
is adding less to the total variable cost than the previous unit (economies of scale)
• Cost A becomes steeper as activity level increase, indicating each successive unit of activity is
adding more to the total variable cost than the previous unit (diseconomies of scale)
Non-linear / Curvilinear variable cost
Semi-variable cost
• Semi-variable cost: “a cost containing both fixed and variable components and thus partly
affected by a change in the level of activity.” Semi-variable costs are also referred to as a semi-
fixed, hybrid, or mixed cost.
• Examples: gas, electricity, telecommunications
• With a semi-variable cost there is a fixed amount payable for the period regardless of the level
of activity, with a further variable amount which is related to the level of activity (left).
• Alternatively semi-variable cost may remain constant up to a certain level of activity, before
increasing as the variable cost element is incurred (right).
Semi-variable cost Alternative semi-variable cost
Jack Gould 6 of 53
, Chartered Institute of Management Accountants Operational Level P1
P1A2: Traditional costing
ABSORPTION COSTING
• The aim of traditional absorption costing is to determine the full production cost per unit
Production costs summarised into a cost card:
• Note 1: when using absorption costing to determine the cost per unit, focus only on production
overhead costs, which must be absorbed into units of production using a suitable basis.
• Whereas cost per unit for direct materials and direct labour is straightforward; production
overheads, as an indirect cost, must be attributed to each unit by nature
• Absorption costing is therefore a costing method that denotes how the ‘sharing out’ of production
overheads to individual cost units is accomplished, through a three step process:
1. Allocation of fixed production overheads, treated as a product cost, to cost centres
• Indirect production costs are initially allocated to cost centres; allocation is the process of
charging a cost directly and in full to the source of the expenditure
2. Apportionment (and reapportionment) of the overheads collected in cost centres (from step 1)
other than direct production cost centres, to direct production cost centres
• The production overhead costs that have been allocated to cost centres other than direct
production cost centres must be reapportioned to direct production cost centres; apportionment
is the process of sharing on a fair basis
• At the end of the apportionment process, all the production overheads have been allocated or
apportioned to the direct production cost centres
3. Absorption of the overheads from production cost centres into cost units using an overhead
absorption rate (OAR)
• An absorption rate is calculated for each production cost centre; this is the rate at which
production overheads will be added to the cost of production going through that cost centre
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
• Absorption base: Each production cost centre will measure production differently; the objective
is to use a measure which reflects the nature of the work. Common measures include:
• Physical units produced: OAR is rate per unit. Only valid when all cost units produced in the
period are identical, meaning this method is not very practical.
• Direct labour hours worked: OAR is direct labour hour rate. Favoured method as it is time
based, but most appropriate in labour-intensive cost centres which are becoming rarer.
• Direct machine hours operated: OAR is direct machine hour rate. The most widely used as
a result of increasing automation, but most appropriate in machine dominated cost centres
and for absorbing overheads relating to machine activity.
O v e r h e a d a b s or b e d = OA R × A c t u a l a b s or p t i o n b a s e
• Predetermined absorption rates: while possible to calculate overhead absorption rates (OAR)
using actual overhead costs and actual production volume, OARs are usually predetermined using
budgeted figures or expected costs and activity levels, because:
• It is inconvenient to wait for the end of the accounting period to work out the absorption rates
• A predetermined rate is required to enable a selling price to be estimated
• Overhead costs may vary throughout the year; overhead absorption rate smooths variations in
overheads by applying an average overhead cost to each unit of product throughout the year
• A budgeted overhead expenditure and budgeted production volume are therefore used to absorb
production overhead costs at a predetermined absorption rate.
• The problem with using predetermined overhead absorption is that actual figures for overheads
incurred are likely to be different to the budgeted figures used to calculate the predetermined
overhead absorption rate, thus leading to an (under-)/over-absorption of overheads:
(Un d e r −) / O v e r − a b s or p t i o n = (B u d ge t e d OA R × A c t u a l u n i t s) − A c t u a l o v e r h e a d s i n c u r r e d
• Over-absorption: if the amount absorbed exceeds actual cost incurred; added to SOPL profit
• Under-absorption: if the amount absorbed is less than actual cost incurred; subtracted from profit
Jack Gould 7 of 53
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