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No. of pages: 10

Business Level

Business Management Accounting

K B 2

JUNE 2015

Instructions to candidates

(1) Time allowed: Reading and planning – 15 minutes Writing – 3 hours (2) Total: 100 marks (3) Answer all questions. (4) This paper consists of two sections.

Section 1: 5 questions Section 2: 2 questions (5) Answers should be in the English Language, in the answer

booklet/s given to you. (6) Begin each answer on a separate page in the answer booklet. Submit

all workings.

KB2 – June 2015 Page 2 of 10

SECTION 1

All questions are compulsory.

Total marks for Section 1 is 50 marks.

Recommended time for the section is 90 minutes.

Question 01

City Agencies (CA) is the sole agent in Sri Lanka for several multinational pharmaceutical manufacturers. CA imports drugs and sells them to retail customers (pharmacies and supermarkets). CA’s customers vary in size and consequently the size and frequency of their orders also vary. The current management information system of CA, which is predominantly a financial accounting and reporting system, produces only very little management information. It hardly produces any product-wise or customer-wise decision support management information. CA is therefore unaware of the costs of servicing individual customers. The new Financial Controller, who recently joined CA, has decided to perform Customer Profitability Analysis (CPA). He has initially planned to see the results from a sample of two customers before deciding whether to fully introduce CPA. The information for these two customers, and for the whole company, for the year 2014/15 is as follows:

Customer AH LW Company Contribution (Rs. ‘000) 1,500 810 9,000 No. of packs sold (‘000) 50 27 300 No. of sales visits to customers 24 12 200 No. of orders placed by customers 75 20 700 No. of normal deliveries to customers 45 15 240 No. of urgent deliveries to customers 5 - 30

Activity Total costs for the period Rs. ‘000

Sales visits to customers 1,000 Processing orders 1,400 Normal deliveries 2,400 Urgent deliveries 1,200

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Question 02 Swinger Household (Pvt) Limited (SHL) manufactures and sells household consumer goods. The market in which it operates is highly competitive. The competition comes from other local manufacturers as well as from importers of similar items from countries such as China and Taiwan. SHL constantly designs new products in order to maintain its market share. The life cycle of products in the market is comparatively short as the competitors are also engaged in constantly introducing new products or variations of existing products. Consumers consider two main factors when buying these products: price and quality. SHL uses a market penetration pricing policy when launching its products and is always striving to improve its quality from the product design stage through to customer care. As a result it has a 25% market share, and its largest competitor has a 16% market share with around 20 other companies sharing the remainder of the market.

Required : (a) Prepare a Customer Profitability Analysis for each of the two customers.

(5 marks) (b) Demonstrate how CA could use this Customer Profitability Analysis to increase its

profits. (5 marks)

(Total: 10 marks)

Required: (a) Differentiate:

• Costs of quality conformance; and • Costs of quality non-conformance.

(3 marks)

(b) Advise how SHL should address the issues of quality conformance costs and product selling prices in the context of consumer considerations when buying the products.

(4 marks)

(c) Analyse how Kaizen principles could be used by SHL to extend the life cycle of its products.

(3 marks)

(Total: 10 marks)

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Question 03 Easyways (Pvt) Limited (EL) is a transport provider. EL is presently evaluating an offer to transport a food item packed in boxes to a customer’s sales outlet. EL needs to buy a new freezer truck for this purpose and is considering two types of trucks; Small and Large. EL is not sure about which type of truck to buy. The volume in a small truck is 200 boxes and that of a large truck is 300 boxes. Daily demand of boxes in the sales outlet varies and can be either 180 boxes (with a probability of 40%) or 270 boxes (with a probability of 60%). Transport income is Rs. 200 per box. The variable cost of transporting one consignment of boxes in a small truck is Rs. 20,000 and in a large truck is Rs. 30,000. If the demand exceeds the capacity of the truck, customer will deduct Rs. 50 per box for the shortage from the transport income of EL as a penalty to compensate the loss arising from the short-supply (delivery). Other daily overhead cost per small truck is Rs. 5,500 and per large truck is Rs. 8,500. Both types of trucks can only make one trip a day.

Required: (a) Prepare a profits table showing the outcome of all options available to EL.

(4 marks)

(b) Considering EL’s risk attitude, advise on the type of truck EL should buy if it takes the decision based on;

(i) Expected value criterion (ii) Maximax criterion (iii) Maximin criterion

(6 marks)

(Total 10 marks)

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Question 04 Electroserve (Pvt) Limited (EPL) is a divisionalised manufacturing organisation. Division B of EPL produces table lamps for which it purchases LED bulbs from outside (At Rs.125 per bulb) and Division A of EPL. The LED bulbs produced by Division A are transferred at Rs. 120 each to Division B. This price is set by adding a 20% profit mark-up to the variable cost of production. Division A operates at its full capacity. The manager of Division A is not happy with this pricing policy and claims that the price should be set at 10% profit mark-up on full cost. The following additional details are provided; The manufacture of one LED bulb consumes 2 minutes of labour at Rs. 300 per hour. Fixed production overheads are to be absorbed to the bulbs at 200% of the labour cost. Division A is not presently supplying the external market though it could supply any quantity at the present market price of Rs. 125 per bulb. However, Division A would have to spend Rs. 4 per bulb as selling and distribution costs. EPL’s ultimate objective is to maximise the profit of the whole company.

Required: (a) Calculate the proposed transfer price at 10% profit mark-up on full cost basis.

(2 marks) (b) (i) Calculate the maximum transfer price that is acceptable to Division B.

(ii) Calculate the minimum transfer price that is acceptable to Division A. (iii) Discuss the appropriateness of present and proposed transfer prices.

(5 marks)

(c) Discuss how the dual rate pricing policy could be used to overcome transfer pricing issues in EPL.

(3 marks)

(Total: 10 marks)

KB2 – June 2015 Page 6 of 10

Question 05

AB (Pvt) Limited has predicted its sales demand for each of the four quarters of 2016 as follows:

Quarter 1 2 3 4 Sales demand (units) 100,000 110,000 190,000 140,000

The company has a normal production capacity of 135,000 units per quarter without needing to utilise any overtime working. However, the capacity can be increased by up to 40% by working overtime.

It is current company policy to manufacture units using a constant level production system. This means that although the company will not hold any inventory at the beginning and end of the year (zero inventory), there are increases and decreases in the quarterly inventory levels. On this basis the selling price, variable production overhead and contribution for 2016 are expected to be as follows:

Rs. per unit Selling price 90 Direct materials 30 Direct labour 35 Variable production overhead 10 (75) Contribution 15

However, any overtime working will increase the unit direct labour cost by 20% and the unit variable production overhead cost by 10% for those units produced during overtime working. In addition, the company incurs a storage cost of Rs.4 per unit per quarter for each item that is held in inventory. These costs are not included in the production costs above.

AB is considering whether it should change the current production system to a just-in-time (JIT) production system, but is concerned that due to the fluctuating levels of its sales demand this may not be financially beneficial. If the company did change to a JIT production system, no inventory would be held while the behaviour of variable production overhead would remain unchanged.

Required: (a) Calculate the cost of holding inventory (based on average inventory levels in

each of the quarters) for each of the quarters and for the year in total, under the current production system. Assume that sales occur evenly during each quarter.

(4 marks)

(b) Evaluate on the proposal to change to a JIT production system. (6 marks)

(Total: 10 marks)

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SECTION 2

Both questions are compulsory.

Total marks for Section 2 is 50 marks.

Recommended time for the section is 90 minutes.

Question 06 Communication Networks (Pvt) Limited (CN) manufactures and sells an electronic component used in communication equipment. The company operates a standard marginal costing system and a just-in-time (JIT) purchasing and production system with no inventory of raw materials or finished goods being held. Given below is information pertaining to the budgeted and actual results for the year ended 31 March 2015. Extracts from the budget for the year ended 31 March 2015

Production and sales 10,000 units Rs. Standard selling price per unit 1,800 Standard production costs per unit: Direct material; 8 kg at Rs. 108 per kg 864 Direct labour; 1.25 hours at Rs. 180 per hour 225 Variable overheads; 1.25 hours at Rs. 60 per direct labour hour 75 Fixed production overheads 1,700,000

Extracts from the accounting records for the year ended 31 March 2015 (actual information)

Production and sales 9,000 units Selling price Rs. 1,840 per unit Direct material 74,000 kg at Rs. 112 per kg Direct labour 10,800 hours at Rs. 190 per hour Variable overheads Rs. 700,000 Fixed production overheads Rs. 1,680,000

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Required: (a) Reconcile the budgeted profit with the actual profit showing the variances in as

much detail as possible using the standard marginal costing approach. (11 marks)

(b) Explain why the variances used to reconcile profit in a standard marginal costing

system are different from those used in a standard absorption costing system. (4 marks)

(c) Calculate the variances that would be different and any additional variances that

would be required if the reconciliation statement was prepared using standard absorption costing. (Preparation of a revised statement is not required.)

(4 marks)

(d) Discuss the arguments in favour of the use of traditional absorption costing rather than marginal costing for profit reporting and inventory valuation.

(6 marks)

(Total: 25 marks)

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Question 07 Auto Sort (Pvt) Limited (ASL) is an automobile repairing company which has forecasted the following repair revenue (at present price level) for the next four years, with the existing facilities.

Repair revenue forecast (contribution equals to 60% of repair revenue)

Year Y1 Y2 Y3 Y4 Annual repair revenue (Rs. million) 10 12 15 17

The increase in annual repair revenue is due to the expected increase in the number of repairs.

The management of ASL is considering an expansion plan by investing in a repair booth.

The following information is gathered and presented at the present price levels. Investment in repair booth (based on present price levels) The purchase price of the repair booth is Rs. 10 million. In addition, an installation cost

of Rs. 2 million is payable immediately. The repair booth can be used for the next 4 years and 30% of the purchase price could be realised at the end of fourth year by sale of scraps. The ground concreting work required for the installation of the repair booth was completed two months ago for which Rs. 1 million was already paid by the company.

The maintenance cost of the repair booth is Rs. 2 million per year which will increase with the age of the repair booth by 10% annually for the third and fourth years.

If the repair booth is used, the contribution from the present operation (repair revenue less cost of materials for the repair) which is 60% of repair revenue, can be increased to 80%.

By using the repair booth, ASL could generate an additional repair revenue of Rs. 5 million per annum (for Y1 = Rs. 5 million) with 80% contribution. Due to increase in demand this revenue will increase by 10% annually for the 2nd and 3rd years and remain at that level for the 4th year.

The repair booth will allow ASL to cut down annual labour expenses by Rs. 500,000 while increasing the annual electricity cost by Rs. 200,000.

ASL is presently paying income tax at 28% during the same year in which such liabilities arise. ASL is eligible to claim a 33 1/3% depreciation allowance on the repair booth and installation cost.

All figures indicated above will inflate at a uniform rate of 5% per annum. ASL’s money (nominal) after tax cost of capital is 17.6%.

KB2 – June 2015 Page 10 of 10

Required: (a) Evaluate whether the investment in the repair booth is financially desirable to

ASL. (Use the net present value (NPV) method calculated in real terms).

(11 marks)

(b) (i) Calculate the non-discounted payback period for this investment. (ii) Explain why this method is often used by companies.

(4 marks)

(c) Assess the maximum possible cost of capital at which the project is financially desirable for the company.

(3 marks)

(d) It has now been informed by the supplier that production has been stopped at present due to an operational issue, and the repair booth price is expected to be increased in another one year’s time. As per the supplier, ASL can confirm the order for a repair booth at the present price (Rs. 10 million) by advancing full payment immediately. Otherwise, ASL can purchase it at the increased price after one year from now. Whichever option is chosen, the repair booth will be delivered to ASL after one year from now and the amounts of other operational cash flows for the 4 year period will not change.

(i) Evaluate the effect on the NPV calculated in (a) above from immediately

advancing full payment for the repair booth. (3 marks)

(ii) Calculate the maximum revised price at which it is financially advisable for

ASL to buy the repair booth instead of advancing money. (4 marks)

(Total: 25 marks)