MODULE 2

MANAGEMENT ACCOUNTING IN DECISION SUPPORT

OUTLINES • • • • •

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Variance calculation and analysis including fixed overhead capacity and efficiency variances. Modern Management Accounting including; Activity Based Management, Total Quality Management, Balanced Scorecard. Target Costing. Relevant costs in Decision making Pricing decisions: Price/demand relationships. Cost plus pricing Market driven pricing. Limiting factors (including linear programming-with two decision variables. Application of the graphical and simultaneous equation approaches). Qualitative factors relevant to specific decisions: Internal H.R./Motivational External Competitive Activity Social and environmental considerations. Impact on stakeholder groups including: customers, employees, investors, suppliers and society.

Variance calculation and analysis including fixed overhead capacity and efficiency variances • • •

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A variance is the difference between an actual result and an expected result. Variance analysis is the process by which the total difference between standard and actual results is analysed. When actual results are better than expected results, we have a favourable variance (F). If actual results are worse than expected results, we have an adverse variance (A). The selling price variance measures the effect on expected profit of a selling price different to the standard selling price. It is calculated as the difference between what the sales revenue should have been for the actual quantity sold, and what it was. The sales volume variance measures the increase or decrease in expected profit as a result of the sales volume being higher or lower than budgeted. It is calculated as the difference between the budgeted sales volume and the actual sales volume multiplied by the standard profit per unit. The material total variance is the difference between what the output actually cost and what it should have cost, in terms of material. It can be divided into the following two sub-variances.

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The material price variance is the difference between what the material did cost and what it should have cost. The material usage variance is the difference between the standard cost of the material that should have been used and the standard cost of the material that was used. The labour total variance is the difference between what the output should have cost and what it did cost, in terms of labour. It can be divided into two sub-variances. The labour rate variance is the difference between what the labour did cost and what it should have cost. The labour efficiency variance is the difference between the standard cost of the hours that should have been worked and the standard cost of the hours that were worked. The variable production overhead total variance is the difference between what the output should have cost and what it did cost, in terms of variable production overhead. It can be divided into two sub-variances. The variable production overhead expenditure variance is the difference between the amount of variable production overhead that should have been incurred in the actual hours actively worked, and the actual amount of variable production overhead incurred. The variable production overhead efficiency variance is the difference between the standard cost of the hours that should have been worked for the number of

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units actually produced, and the standard cost of the actual number of hours worked. Fixed production overhead total variance is the difference between fixed production overhead incurred and fixed production overhead absorbed. In other words, it is the under– or overabsorbed fixed production overhead. Fixed production overhead expenditure variance is the difference between the budgeted fixed production overhead expenditure and actual fixed production overhead expenditure. Fixed production overhead volume variance is the difference between actual and budgeted production/volume multiplied by the standard absorption rate per unit. Fixed production overhead volume efficiency variance is the difference between the number of hours that actual production should have taken, and the number of hours actually taken (that is, worked) multiplied by the standard absorption rate per hour. Fixed production overhead volume capacity variance is the difference between budgeted hours of work and the actual hours worked, multiplied by the standard absorption rate per hour.

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Illustration

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Company A produces and sells one product only, the Thing, the standard cost for one unit being as follows. N Direct material A – 10 kilograms at N20 per kg 200 Direct material B – 5 litres at N6 per litre 30 Direct wages – 5 hours at N6 per hour 30 Fixed production overhead 50 Total standard cost 310 The fixed overhead included in the standard cost is based on an expected monthly output of 900 units. Fixed production overhead is absorbed on the basis of direct labour hours. During April the actual results were as follows. Production 800 units Material A 7,800 kg used, costing N159,900 Material B 4,300 litres used, costing N23,650 Direct wages 4,200 hours worked for N24,150 Fixed production overhead N47,000 Required (a) Calculate price and usage variances for each material. (b) Calculate labour rate and efficiency variances. (c) Calculate fixed production overhead expenditure and volume variances and then subdivide the volume variance.

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Solution (a) Price variance – A 7,800 kgs should have cost (N20) but did cost Price variance Usage variance – A 800 units should have used (10 kg) but did use Usage variance in kg standard cost per kilogram Usage variance in Price variance – B 4,300 litres should have cost (N6) but did cost Price variance Usage variance – B 800 units should have used (5 l) but did use Usage variance in litres standard cost per litre Usage variance in N

N 156,000 159,900 3,900 (A) 8,000 kg 7,800 kg 200 kg (F) N20 N4,000 (F) 25,800 23,650 2,150 (F)

4,000 l 4,300 l 300 (A) N6 N1,800 (A)

(b) Labour rate variance 4,200 hours should have cost (N6) but did cost Rate variance Labour efficiency variance 800 units should have taken (5 hrs) but did take Efficiency variance in hours standard rate per hour × Efficiency variance in N (c) Fixed overhead expenditure variance Budgeted expenditure (N50 x 900) Actual expenditure Expenditure variance Fixed overhead volume variance Budgeted production at standard rate (900 x N50) Actual production at standard rate (800 x N50) Volume variance

N 25,200 24,150 1,050 (F)

4,000 hrs 4,200 hrs 200 hrs (A) N6 N1,200 (A) N 45,000 47,000 2,000 (A) 45,000 40,000 5,000 (A)

Fixed overhead volume efficiency variance 800 units should have taken (5 hrs) but did take Volume efficiency variance in hours standard absorption rate per hour Volume efficiency variance Fixed overhead volume capacity variance Budgeted hours Actual hours Volume capacity variance in hours standard absorption rate per hour (N50 ÷ 5)

N 4,000 hrs 4,200 hrs 200 hrs N10 N2,000 (A) 4,500 hrs 4,200 hrs 300 hrs (A) N10 N3,000 (A)

Modern Management Accounting including; Activity Based Management, Total Quality Management, Balanced Scorecard. •

Activity Based Management Contrary to what might be imagined, many organisations do not wish to know how much it costs to make a product with precise accuracy. This is because pricing is based on what the market will bear, competitors‟ moves, etc. Others however fix their price on cost and need to be able to determine it with reasonable accuracy. The latter organisations have been greatly benefitted from the development of activity based costing (ABC), which is a modern absorption costing method, It should not be assumed that all traditional absorption costing systems are not accurate enough to give adequate information for pricing purposes or other, longrun management decision purposes. Some traditional systems treat overheads in a detailed way and relate them to service cost centres as well as production cost centres.

The service centre overheads are then spread over the production cost centres before absorption rates are calculated. The main cause of inaccuracy is in the calculation of the overhead rate itself, which is usually based on direct labour hours or machine hours. These rates assume that products that take longer to make, generate more overheads. Thus traditional cost system overcosted high volume products and undercost low volume products. Factors prompting the development of ABC system include : 1. Growing overhead costs because of increasingly automated production 2. Increasing market competition which necessitated more accurate product costs. 3. Increasing product diversity to secure economies of scope & increased market share. 4. Decreasing costs of information processing because of continual improvements and increasing application of information technology. Meaning of ABC Activity Based Costing is an accounting methodology that assign costs to activities rather than products or services. This enables resources & overhead costs to be more accurately assigned to products & services that consume them. ABC assign cost to activities based on their use of resources. It then assign cost to cost objects, such as products or customers, based on their use of activities. ABC can track the flow of activities in organization by creating a link between the activity (resource consumption) and the cost object. The flow is characterized through four core areas : • Cost object. • Cost drivers. • Resource Cost drivers. • Activity Cost drivers.

• Total Quality Management

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It is too often viewed as a technique whose usefulness is confined to manufacturing processes. However, TQM also assumes potentially greater importance as a tool for improved efficiency in service areas. By focusing on the management accounting function, we will devise a process through which quality improvement methods might be used to highlight problem areas and facilitate their solution. An initial understanding of the difference between the three major „quality‟ terms, quality control, quality assurance and quality management is essential to the short- medium- and long-term focus of business. Definitions: Quality : It is a measure of goodness to understand how a product meets its specifications. Quality Cost : Cost of performing the activities to check failure in meeting the quality specification. These activities are of four types – i) Prevention costs ii) appraisal costs iii) Internal failure costs iv) External failure costs. Quality Control (QC): It is concerned with the past, and deals with data obtained from previous production which allow action to be taken to stop the production of defective units. Quality Assurance (QA) : It deals with the present, and concerns the putting in place of systems to prevent defects from occuring. Quality Management (QM): It is concerned with the future, and manages people in a process of continuous improvement to the products and services offered by the organisation.

• Balanced Scorecard •

The Balanced Scorecard can be defined as „an approach to the provision of information to management to assist strategic policy formulation and achievement‟. It emphasizes the need to provide the user with a set of information, which addresses all relevant areas of performance in an objective and unbiased fashion. The information provided may include both financial and non financial elements, and cover areas such as profitability, customer satisfaction, internal efficiency and innovation‟. It shall be clear from the above definition that the central idea of the Balanced Scorecard is that managers should develop the measures on which they manage the business from four different perspectives: 1. customer satisfaction 2. internal business process e.g., operating cycle time. 3. kaizen approach (can we continue to improve and create value) 4. financial e.g., operating income by segments. The balanced scorecard approach emphasises the need to provide management with a set of information which covers all relevant areas of performance in an objective and unbiased fashion. The information provided may be both financial and non-financial and cover areas such as profitability, customer satisfaction, internal efficiency and innovation.

Target Costing. •

Target costing involves setting a target cost by subtracting a desired profit margin from a competitive market price. Target cost is an estimate of a product cost which is determined by subtracting a desired profit margin from a competitive market price. This target cost may be less than the planned initial product cost but it is expected to be achieved by the time the product reaches the maturity stage of the product life cycle. Definitions of Target Costing : It can be defined as “a structured approach to determining the cost at which a proposed product with specified functionality and quality must be produced, to generate a desired level of profitability at its anticipated selling price”. A critical aspect of this definition is that it emphasizes that target costing is much more than a management accounting technique. Rather, it is an important part of a comprehensive management process aimed at helping an organization to survive in an increasingly competitive environment. In this sense the term “target costing” is a misnomer: it is not a product costing system, but rather a management technique aimed at reducing a product‟s life-cycle costs.

Advantages of Target Costing 1. It reinforces top-to-bottom commitment to process and product innovation, and is aimed at identifying issues to be resolved, in order to achieve some competitive advantage. 2 It helps to create a company‟s competitive future with market-driven management for designing and manufacturing products that meet the price required for market success. 3. It uses management control systems to support and reinforce manufacturing strategies; and to identify market opportunities that can be converted into real savings to achieve the best value rather than simply the lowest cost.

Relevant costs in Decision making •

Relevant costs are future cash flows arising as a direct consequence of a decision. Features of relevant cost in decision making: Relevant costs are future costs Relevant costs are cash flows Relevant costs are incremental costs Machinery user costs Once a machine has been bought its cost is a sunk cost. Depreciation is not a relevant cost, because it is not a cash flow. However, using machinery may involve some incremental costs. These costs might be referred to as user costs and they include hire charges and any fall in resale value of owned assets, through use. Materials The relevant cost of raw materials is generally their current replacement cost, unless the materials have already been purchased and would not be replaced once used.

Labour Often the labour force will be paid irrespective of the decision made and the costs are therefore not incremental. Take care, however, if the labour force could be put to an alternative use, in which case the relevant costs are the variable costs of the labour and associated variable overheads plus the contribution forgone from not being able to put it to its alternative use.

Pricing decisions •

A pricing decision is one of the most crucial & difficult decision that a firm has to make. Such a decision affects the long term life of any profit oriented enterprise. Accounting information is often an important input to pricing decisions. Most firms needs to make decision about setting or accepting selling prices for their products or services. In some firms selling prices are derived directly from cost information by estimating future products cost & adding a suitable profit margin. In others an established market price is accepted. Fundamentally, in pricing decision the management must first decide on its pricing goal and then set the base price for goods or services. After this the firm may design its pricing strategies. Price/demand relationships According to basic microeconomic analysis, the sales price for a product in a market is determined by demand and supply. Demand is the volume of sales demand that will exist for the product at any given price. As a normal rule, sales demand will be higher when the price is lower. If the price rises, total sales demand will fall. If the price falls, sales demand will rise.

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Cost plus pricing In many business the common method of price determining is to estimate the cost of product & fix a margin of profit.. The term „cost‟ here means full cost at current output and wage levels since these are regarded as most relevant in price determination .In arriving at cost of production, it is necessary to determine the size of the unit whose products are to be costed and priced. An individual manufacturer may take his cost of production into account and arrive at a price at which the products are to be sold in the concerned region. A manufacturer having several factories all over the country may determine the weighted average cost of each of the factories and include the same in his computations so as to arrive at a uniform price for the country as a whole, e.g., if prices are to be fixed by a statutory authority, like the Tariff Commissions; weighted average price is also taken into account if large number of factories are owned by one manufacturer.

Illustration Prompt Printers Ltd., uses a scheme of pricing based on cost plus. All the overheads are charged, based on direct labour and based on the total cost arrived at, the selling price is fixed. The following figures are obtained from the Annual Budget for 1998 prepared by the company: N Sales 1,000,000 Direct material 180,000 Direct labour 320,000 Factory superintendent‟s salary 30,000 Commission paid on sales (5%) 50,000 Foreman‟s salaries 60,000 Insurance 10,000 Advertisement 20,000 Depreciation on assets 30,000 Administration expenses 90,000 Variable factory costs : Repairs and maintenance 60,000 Tools consumed 40,000 Miscellaneous supplies 10,000

The company has submitted a tender quoting N10,000 on a large order with a cost of N1,800 Direct materials and N3,200 Direct labour. The customer strikes the business at N8,900 on a „take it or leave it‟ basis. If the company accepts the order, the total sales for 1998 would be N1,008,900. The company is reluctant to accept the order as it would be against its policy of accepting an order below cost. Write a note to the Managing Director, recommending the acceptance of the order, substantiating your recommendation fully with supporting figures to explain that the price offered would not be below cost and a sizeable profit also would be made. Also comment on the pricing policy of the company.

Solution To : Managing Director From : Management Accountant Date : .................... Subject : Additional order The additional order for which the company has submitted a tender quoting N10,000/and for which the customer has offered to strike the business at N8,900/- on a „take it or leave it‟ basis and as the company is reluctant to accept the order as it would be against its policy of accepting an order below cost, the following is submitted for consideration of the Managing Director with the recommendation that the acceptance of the order will be profitable to the company as is substantiated by the following figures:

At present the company determines the sales value as follows : N N Direct material 180,000 Direct labour 320,000 Variable overheads (Repairs and Maintenance, Tools consumed Misc. supplies and sales commission) 160,000 Fixed overhead (all other expenses) 240,000 400,000 Total cost 900,000 Profit 100,000 Sales 1,000,000 While applying overhead rate, the company does not distinguish between variable and fixed overheads. Overhead, as can be seen, is charged at 125% of direct labour and profit at 1/9 of total cost. On the same basis, the quotation price has been submitted as follows: N Direct material 1,800 Direct labour 3,200

Overhead (125% of direct labour) 4,000 Total cost 9,000 Profit 1/9 of total cost 1,000 Tender price 10,000 But this is an additional activity as the total sales after the acceptance of the order would be Rs. 10,08,900. To meet this order, only the variable overheads will be incurred as fixed overheads are absorbed by normal production. Therefore, the revised figures are : N N Price offered 8,900 Direct material 1,800 Direct labour 3,200 Variable overhead excluding sales commission 1,100 ____ Sales commission @ 5% 445 6,545 Profit 2,355 It can be seen from the above that N8,900 price offered by the customer is well above the incremental cost of the additional order and the profit is above 1/3 of cost, much more than 1/9 of cost. Hence the company should accept the order. In making this recommendation, it has been assumed that the existing sales will remain unaffected by the acceptance of this order.

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Market driven pricing The price that an organisation can charge for its products will be determined to a greater or lesser degree by the market in which it operates. Perfect competition: many buyers and many sellers all dealing in an identical product. Neither producer nor user has any market power and both must accept the prevailing market price. Monopoly: one seller who dominates many buyers. The monopolist can use his market power to set a profit maximising price. Monopolistic competition: a large number of suppliers offer similar, but not identical, products. The similarities ensure elastic demand whereas the slight differences give some monopolistic power to the supplier. Oligopoly: where relatively few competitive companies dominate the market. Whilst each large firm has the ability to influence market prices, the unpredictable reaction from the other giants makes the final industry price indeterminate. Cartels are often formed.

Limiting factors (including linear programming-with two decision variables It is often assumed in budgeting that a company can produce as many units of its products (or services) as is necessary to meet the available sales demand. Sales demand is therefore normally the factor that sets a limit on the volume of production and sales in each period. Sometimes, however, there could be a shortage of a key production resource, such as an item of direct materials, or skilled labour, or machine capacity. In these circumstances, the factor setting a limit to the volume of sales and profit in a particular period is the availability of the scarce resource, because sales are restricted by the amount that the company can produce. If the company makes just one product and a production resource is in limited supply, profit is maximised by making as many units of the product as possible with the limited resources available. However, when a company makes and sells more than one different product with the same scarce resource, a budgeting problem is to decide how many of each different product to make and sell in order to maximise profits.

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Linear programming is a technique for solving problems of profit maximisation or cost minimisation and resource allocation. 'Programming' has nothing to do with computers: the word is simply used to denote a series of events.. A linear programming problem involve maximising or minimising a linear function (the objective function) subject to linear constraints. It is the process of taking various linear inequalities relating to some situation, and finding the "best" value obtainable under those conditions. Both the constraints and the “best outcome” are represented as linear relationships. What constitutes the best outcome depends on the objective. The equation constructed to represent the best outcome is known as the objective function. Typical examples would be to work out the maximum profit from making two sorts of goods when resources needed to make the goods are limited or the minimum cost for which two different projects are completed.

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Illustration Brunel manufactures plastic-covered steel fencing in two qualities, standard and heavy gauge. Both products pass through the same processes, involving steelforming and plastic bonding. Standard gauge fencing sells at N18 a roll and heavy gauge fencing at N24 a roll. Variable costs per roll are N16 and N21 respectively. There is an unlimited market for the standard gauge, but demand for the heavy gauge is limited to 1,300 rolls a year. Factory operations are limited to 2,400 hours a year in each of the two production processes. Processing hours per roll Gauge Steel-forming Plastic-bonding Standard 0.6 0.4 Heavy 0.8 1.2 What is the production mix which will maximise total contribution and what would be the total contribution?

Solution (a) Let S be the number of standard gauge rolls per year. Let H be the number of heavy gauge rolls per year. The objective is to maximise 2S + 3H (contribution) subject to the following constraints. 0.6S + 0.8H < 2,400 (steel-forming hours) 0.4S +1.2H < 2,400 (plastic-bonding hours) H < 1,300 (sales demand) S, H > 0 Note that the constraints are inequalities, and are not equations. There is no requirement to use up the total hours available in each process, nor to satisfy all the demand for heavy gauge rolls. (b) If we take the production constraint of 2,400 hours in the steel-forming process 0.6S + 0.8H < 2,400 it means that since there are only 2,400 hours available in the process, output must be limited to a maximum of: (i) 2,400 = 4,000 rolls of standard gauge; 0.6 (ii) 2,400 = 3,000 rolls of heavy gauge; or 0.8

(iii) a proportionate combination of each. This maximum output represents the boundary line of the constraint, where the inequality becomes the equation 0.6S + 0.8H = 2,400. (c) The line for this equation may be drawn on a graph by joining up two points on the line (such as S = 0, H = 3,000; H = 0, S = 4,000). (d) The other constraints may be drawn in a similar way with lines for the following equations. 0.4S + 1.2H = 2,400 (plastic-bonding) H = 1,300 (sales demand)

To satisfy all the constraints simultaneously, the values of S and H must lie on or below each constraint line. The outer limits of the feasible polygon are the lines, but all combined values of S and H within the shaded area are feasible solutions. (f) The next step is to find the optimal solution, which maximises the objective function. Since the objective is to maximise contribution, the solution to the problem must involve relatively high values (within the feasible polygon) for S, or H or a combination of both. If, as is likely, there is only one combination of S and H which provides the optimal solution, this combination will be one of the outer corners of the feasible polygon. There are four such corners, A, B, C and D. However, it is possible that any combination of values for S and H on the boundary line between two of these corners might provide solutions with the same total contribution. (g) To solve the problem we establish the slope of the iso-contribution lines, by drawing a line for any one level of contribution. In our solution, a line 2S + 3H = 6,000 has been drawn. (6,000 was chosen as a convenient multiple of 2 and 3). This line has no significance except to indicate the slope, or gradient, of every iso-contribution line for 2S + 3H. Using a ruler to judge at which corner of the feasible polygon we can draw an iso-contribution line which is as far to the right as possible, (away from the origin) but which still touches the feasible polygon.

(h) This occurs at corner B where the constraint line 0.4S + 1.2H = 2,400 crosses with the constraint line 0.6S + 0.8H = 2,400. At this point, there are simultaneous equations, from which the exact values of S and H may be calculated. 0.4S + 1.2H = 2,400 (1) 0.6S + 0.8H = 2,400 (2) 1.2S + 3.6H = 7,200 (3) ((1) x 3) 1.2S + 1.6H = 4,800 (4) ((2) x 2) 2H = 2,400 (5) ((3) – (4)) H = 1,200 (6) Substituting 1,200 for H in either equation, we can calculate that S = 2,400. The contribution is maximised where H = 1,200, and S = 2,400. Contribution Total Units per unit contribution N N Standard gauge 2,400 2 4,800 Heavy gauge 1,200 3 3,600 8,400

Application of the graphical and simultaneous equation approaches • The optimal solution can also be found using simultaneous equations. Instead of a 'sliding the contribution line out' approach simultaneous equations can be used to determine the optimal allocation of resources • A graphical solution is only possible when there are two variables in the problem. One variable is represented by the x axis and one by the y axis of the graph. Since non-negative values are not usually allowed, the graph shows only zero and positive values of x and y.

Qualitative factors relevant to specific decisions As usual the decision is not merely a matter of choosing the best financial option. Qualitative factors must once more be considered. They include: (a) (b)

What impact will a shutdown decision have on employee morale? What signal will the decision give to competitors? How will they react? (c) How will customers react? Will they lose confidence in the company's products? (d) How will suppliers be affected? If one supplier suffers disproportionately there may be a loss of goodwill and damage to future relations. Qualitative factors relevant to specific decisions include: Internal H.R./Motivational External Competitive Activity Social and environmental considerations.

Impact on stakeholder groups including: customers, employees, investors, suppliers and society. • Decision making consideration is not only based on management perspective but other stakeholders must be consider to make such decision effective, realistic, and efficient. Other stakeholders that should be put into consideration and to avoid negative impact of the stakeholders to effective decision making include: • Customers • Employees • Investors • Suppliers, and • Society.

Revision questions 1. A new product has been introduced for which an 80% learning curve is expected to apply. The standard labour information has been based on estimates of the time needed to produce the first unit which is 200 hours at N50 per hour. The first four units took 700 hours to produce at a cost of N37,500. Required (a) The original labour rate and efficiency variances. (b) The labour rate and efficiency variances which take into account the learning effect. 2. Explain pricing decisions under special circumstances • The Dervish Chemical Company operates a small plant. Operating the plant requires two raw materials, A and B, which cost N5 and N8 per litre respectively. The maximum available supply per week is 2,700 litres of A and 2,000 litres of B. The plant can operate using either of two processes, which have differing contributions and raw materials requirements, as follows.

Raw materials consumed Contribution Process (litres per processing hour) per hour A B N 1 20 10 70 2 30 20 60 The plant can run for 120 hours a week in total, but for safety reasons, process 2 cannot be operated for more than 80 hours a week. Formulate a linear programming model, and then solve it, to determine how many hours process 1 should be operated each week and how many hours process 2 should be operated each week.

REFERENCE 1. ANAN Professional Examination Study Pack. 2. ACCA professional Examination Study Pack. 3. Drury, C. (2012). “Management & Cost Accounting” 8th Edition Centage publishing. 4. Advanced Management Accounting (2011) ICAI. Vol. 1