213540695-ACCA-F5-All-Past-Papers.pdf

Performance Management

Time allowed Reading and planning: 15 minutesWriting: 3 hours

ALL FOUR questions are compulsory and MUST be attempted.

Do NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor.

This question paper must not be removed from the examination hall.

Fundamentals Pilot Paper – Skills module

Pape

r F5

The Association of Chartered Certified Accountants

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Answer ALL FOUR questions

1 Triple Limited makes three types of gold watch – the Diva (D), the Classic (C) and the Poser (P). A traditional product costing system is used at present; although an activity based costing (ABC) system is being considered. Details of the three products for a typical period are:

Hoursperunit Materials Production Labourhours Machinehours Costperunit($) Units Product D ½ 1½ 20 1,750 Product C 1½ 1 12 1,250 Product P 1 3 25 7,000

Direct labour costs $6 per hour and production overheads are absorbed on a machine hour basis. The overhead absorption rate for the period is $28 per machine hour.

Required:

(a) Calculate the cost per unit for each product using traditional methods, absorbing overheads on the basis of machine hours. (3 marks)

Total production overheads are $654,500 and further analysis shows that the total production overheads can be divided as follows:

% Costs relating to set-ups 35 Costs relating to machinery 20 Costs relating to materials handling 15 Costs relating to inspection 30 Total production overhead 100

The following total activity volumes are associated with each product line for the period as a whole:

Numberof Numberofmovements Numberof Setups ofmaterials inspections Product D 175 112 1,150 Product C 115 121 1,180 Product P 480 187 1,670 670 120 1,000 Required:

(b) Calculate the cost per unit for each product using ABC principles (work to two decimal places). (12 marks)

(c) Explain why costs per unit calculated under ABC are often very different to costs per unit calculated under more traditional methods. Use the information from Triple Limited to illustrate. (4 marks)

(d) Discuss the implications of a switch to ABC on pricing and profitability. (6 marks)

(25 marks)

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2 Simply Soup Limited manufactures and sells soups in a JIT environment. Soup is made in a manufacturing process by mixing liquidised vegetables, melted butter and stock (stock in this context is a liquid used in making soups). They operate a standard costing and variances system to control its manufacturing processes. At the beginning of the current financial year they employed a new production manager to oversee the manufacturing process and to work alongside the purchasing manager. The production manager will be rewarded by a salary and a bonus based on the directly attributable variances involved in the manufacturing process

After three months of work there is doubt about the performance of the new production manager. On the one hand, the cost variances look on the whole favourable, but the sales director has indicated that sales are significantly down and the overall profitability is decreasing.

The table below shows the variance analysis results for the first three months of the manager’s work.

Table1

F = Favourable. A = Adverse Month1 Month2 Month3 Material Price Variance $300 (F) $900 (A) $2,200 (A) Material Mix Variance $1,800 (F) $2,253 (F) $2,800 (F) Material Yield Variance $2,126 (F) $5,844 (F) $9,752 (F) Total Variance $4,226 (F) $7,197 (F) $10,352 (F)

The actual level of activity was broadly the same in each month and the standard monthly material total cost was approximately $145,000.

The standard cost card is as follows for the period under review $ 0.90 litres of liquidised vegetables @ $0.80/ltr = 0.72 0.05 litres of melted butter @$4/ltr 0.20 1.10 litres of stock @ $0.50/ltr 0.55

Total cost to produce 1 litre of soup 1.47

Required:

(a) Using the information in table 1:

(i) Explain the meaning of each type of variances above (price, mix and yield but excluding the total variance) and briefly discuss to what extent each type of variance is controllable by the production manager.

(6 marks)

(ii) Evaluate the performance of the production manager considering both the cost variance results above and the sales director’s comments. (6 marks)

(iii) Outline two suggestions how the performance management system might be changed to better reflect the performance of the production manager. (4 marks)

(b) The board has asked that the variances be calculated for Month 4. In Month 4 the production department data is as follows:

ActualresultsforMonth4 Liquidised vegetables: Bought 82,000 litres costing $69,700 Melted butter: Bought 4,900 litres costing $21,070 Stock: Bought 122,000 litres costing $58,560

Actual production was 112,000 litres of soup

Required:

Calculate the material price, mix and yield variances for Month 4. You are not required to comment on the performance that the calculations imply. Round variances to the nearest $. (9 marks)

(25 marks)

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3 BFG Limited is investigating the financial viability of a new product the S-pro. The S-pro is a short-life product for which a market has been identified at an agreed design specification. The product will only have a life of 12 months.

The following estimated information is available in respect of S-pro:

1. Sales should be 120,000 in the year in batches of 100 units. An average selling price of $1,050 per batch of 100 units is expected. All sales are for cash.

2. An 80% learning curve will apply for the first 700 batches after which a steady state production time will apply, with the labour time per batch after the first 700 batches being equal to the time for the 700th batch. The cost of the first batch was measured at $2,500. This was for 500 hours at $5 per hour.

3. Variable overhead is estimated at $2 per labour hour.

4. Direct material will be $500 per batch of S-pro for the first 200 batches produced. The second 200 batches will cost 90% of the cost per batch of the first 200 batches. All batches from then on will cost 90% of the batch cost for each of the second 200 batches. All purchases are made for cash

5. S-pro will require additional space to be rented. These directly attributable fixed costs will be $15,000 per month.

A target net cash flow of $130,000 is required in order for this project to be acceptable.

Note: The learning curve formula is given on the formulae sheet. At the learning rate of 0.8 (80%), the learning factor (b) is equal to -0.3219.

Required:

(a) Prepare detailed calculations to show whether product S-pro will provide the target net cash flow. (12 marks)

(b) Calculate what length of time then second batch will take if the actual rate of learning is: (i) 80%; (ii) 90%.

Explain which rate shows the faster learning. (5 marks)

(c) Suggest specific actions that BFG could take to improve the net cash flow calculated above. (8 marks)

(25 marks)

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4 The following information relates to Preston Financial Services, an accounting practice. The business specialises in providing accounting and taxation work for dentists and doctors. In the main the clients are wealthy, self-employed and have an average age of 52.

The business was founded by and is wholly owned by Richard Preston, a dominant and aggressive sole practitioner. He feels that promotion of new products to his clients would be likely to upset the conservative nature of his dentists and doctors and, as a result, the business has been managed with similar products year on year.

You have been provided with financial information relating to the practice in appendix 1. In appendix 2, you have been provided with non-financial information which is based on the balanced scorecard format.

Appendix1:Financialinformation Currentyear Previousyear Turnover ($’000) 945 900 Net profit ($’000) 187 180 Average cash balances ($’000) 21 20 Average debtor / trade receivables days (industry average 30 days) 18 days 22 days Inflation rate (%) 3 3

Appendix2:BalancedScorecard(extract) InternalBusinessProcesses Currentyear Previousyear Error rates in jobs done 16% 10% Average job completion time 7 weeks 10 weeks

CustomerKnowledge Currentyear Previousyear Number of customers 1220 1500 Average fee levels ($) 775 600 Market Share 14% 20%

LearningandGrowth Currentyear Previousyear Percentage of revenue from non-core work 4% 5% Industry average of the proportion of revenue from non-core work in accounting practices 30% 25% Employee retention rate. 60% 80%

Notes

1. Error rates measure the number of jobs with mistakes made by staff as a proportion of the number of clients serviced

2. Core work is defined as being accountancy and taxation. Non-core work is defined primarily as pension advice and business consultancy. Non core work is traditionally high margin work

Required:

(a) Using the information in appendix 1 only, comment on the financial performance of the business (briefly consider growth, profitability, liquidity and credit management). (8 marks)

(b) Explain why non financial information, such as the type shown in appendix 2, is likely to give a better indication of the likely future success of the business than the financial information given in appendix 1. (5 marks)

(c) Using the data given in appendix 2 comment on the performance of the business. Include comments on internal business processes, customer knowledge and learning/growth, separately, and provide a concluding comment on the overall performance of the business. (12 marks)

(25 marks)

End of Question paper

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Formulae Sheet

Learning curve

Y = axb

Where y = average cost per batch a = cost of first batch x = total number of batches produced b = learning factor (log LR/log 2) LR = the learning rate as a decimal

Regression analysis

Demand curve

P = a – bQ b = change in price change in quantity

a = price when Q = 0

y=a+bx

b=n∑xy-∑x∑yn∑x -(∑x)

a=∑yn

-b∑xn

r=n∑xy

2 2

--∑x∑y

n∑x -(∑x) )(n∑y -(∑y) )2 2 2 2

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Answers

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Pilot Paper F5 AnswersPerformance Management

1 TRIPLELimited

(a) Traditional cost per unit D C P $ $ $ Material 20 12 25 Labour ($6/hour) 3 9 6 Direct costs 23 21 31 Production overhead ($28/machine hour) 42 28 84 Total production cost /unit 65 49 115

(b) ABC cost per unit

Examinersnote: Each step required has been given its own sub-heading to make the procedure clear. The basic principle is to find an overhead cost per unit of activity for each element of overhead cost. In some cases it might then be possible to find an overhead cost per unit directly; here it is probably easier to split overheads between each product type first and then find a cost per unit as shown.

(i) Total overheads

These were given at $654,500

(ii) Total machine hours (needed as the driver for machining overhead)

Product Hours/unit Productionunits Totalhours D 1½ 1,750 21,125 C 1 1,250 21,250 P 3 7,000 21,000 Total machine hours 23,375 (iii) Analysis of total overheads and cost per unit of activity

Typeofoverhead Driver % Totaloverhead Levelof Cost/driver $ driveractivity Set-ups Number of set ups 35 229,075 670 341.90 Machining Machine hours 20 130,900 23,375 5.60 Materials handling Material movements 15 98,175 120 818.13 Inspection Number of inspections 30 196,350 1,000 196.35 100 654,500

(iv) Total overheads by product and per unit

ProductD ProductC ProductP Total Overhead Activity $CostActivity $CostActivity $Cost Activity $Cost Set-ups 75 25,643 115 39,319 480 164,113 670 229,075 Machining 1,125 6,300 1,250 7,000 21,000 117,600 23,375 130,900 Material Handling 12 9,817 21 17,181 87 71,177 120 98,175 Inspection 150 29,453 180 35,343 670 131,554 1,000 196,350 Total overhead cost 77,213 98,843 484,444 654,500

Units produced 750 1,250 7,000 Costs per unit $94.95 $79.07 $69.21

(v) Cost per unit D C P $ $ $ Direct costs (from (a)) 23.00 21.00 31.00 Overheads (from (iv)) 94.95 79.07 69.21 117.95 100.07 100.21

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(c) Comment

The overhead costs per unit are summarised below together with volume of production.

Product D C P Volume 750 1,250 7,000 Conventional overheads $42 $28 $84 ABC overheads $95 $79 $69

The result of the change to Activity Based Costing is clear, the overhead cost of D and C have risen whilst that of P has fallen.

This is in line with the comments of many who feel that ABC provides a fairer unit cost better reflecting the effort required to make different products. This is illustrated here with product P which may take longer to make than D or C, but once production has started the process is simple to administer. This may be due to having much longer production lines.

Products D and C are relatively minor volume products but still require a fair amount of administrative time by the production department; ie they involve a fair amount of `hassle`. This is explained by the following table of `activities per 1,000 units produced`.

Set-ups Materials Inspections movements D 100 16 200 C 92 17 144 P 69 12 96

This table highlights the problem. – Product P has fewer set-ups, material movements and inspections per 1,000 units than or C– As a consequence product P’s overhead cost per unit for these three elements has fallen– The machining overhead cost per unit for P is still two or three times greater than for products D or C, but because this

overhead only accounts for 20% of the total overhead this has a small effect on total cost.– The overall result is P’s fall in production overhead cost per unit and the rise in those figures for D and C

(d) Pricing and Profitability

Switching to ABC can, as in this case, substantially change the costs per unit calculations. Consequently if an organisation’s selling prices are determined by a version of cost-plus pricing then the selling prices would alter.

In this case the selling price of D and C would rise significantly, and the selling price of P would fall. This, at first glance may be appealing however:

– Will the markets for D and C tolerate a price rise? There could be competition to consider. Will customers be willing to pay more for a product simply because Triple Ltd has changed its cost allocation methods?

– Product P is a high volume product. Reducing its selling price will have a dramatic effect on revenue and contribution. One would have to question whether such a reduction would be compensated for by increased volumes.

Alternatively, one could take the view that prices are determined by the market and therefore if Triple Ltd switches to ABC, it is not the price that would change but the profit or margin per unit that would change.

This can change attitudes within the business. Previously high margin products (under a traditional overhead absorption system) would be shown as less profitable. Salesmen (possibly profit motivated) can begin to push the sales of different products seeking higher personal rewards. (Assuming commission based on profits per unit sold)

It must always be remembered that if overheads are essentially fixed then they should be ignored in business decision making. Switching to ABC can change reported profits per unit but it is contribution per unit that is perhaps more important.

2 (a) SIMPLY SOUP Limited

(i) Meaning and Controllability of the variances

MaterialPriceVariance

Indicates whether Simply Soup has paid more (adverse) or less (favourable) for its input materials than the standard prices set for the period. For example, if a new supplier had to be found and the price paid was more than the standard price then Simply Soup would incur an extra cost. This extra cost is the price variance.

Price variances are controllable to the extent that Simply Soup can choose its suppliers. On the other hand, vegetables are a seasonal and weather dependent crop and therefore factors outside Simply Soups control can influence prices in the market. The key issue is that the production manager will not control the price paid that is the job of the Purchasing Manager.

MaterialMixVariance

Considers the cost of a change in the mix of the ingredients to make soup. For example adding less butter (which is expensive) and more stock (which is cheaper) will be a cheaper mix than the standard mix. A cheaper mix will result in a favourable variance.

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$69,70082,000

$21,0704,900

$58,560122,000

The recipe determines the mix. The recipe is entirely under the control of the production manager.

MaterialYieldVariance

This shows the productivity of the manufacturing process. If the process produces more soup than expected then the yield will be good (favourable). At the moment 2.05 litres of input produces 1 litre of soup, if 2.05 litres of input produces more than 1 litre of soup then the yield is favourable. Greater yield than expected can be a result of operational efficiency or a change in mix.

The production manager controls the operational process so should be able to control the yield. Poor quality ingredients can damage yield but the production manager should be in control of quality and reject dubious ingredients. The production manager is also responsible for things like spillage. Higher spillage can also reduce yield.

(ii) Production manager’s performance

CostEfficiency

The production manager has produced significant favourable cost variances. The total favourable variance has risen from $4,226 to $10,352 in the first three months. This last figure represents approximately 7.1% of the standard monthly spend.

The prices for materials have been rising but are probably outside the control of the production manager. The rising prices may have put pressure on the production manager to cheapen the mix.

The mix has become cheaper. This could be seen as a cost efficient step. However, Simply Soup must question the quality implications of this (see later).

The yield results are the most significant. The manager is getting far more out of the process than is usual. The new mix is clearly far more productive than before. This could easily be seen as an indicator of good performance as long as the quality is maintained.

Quality

The concern is that the production manager has sacrificed quality for lower cost and greater quantity. The sales director has indicated that sales are falling, perhaps an indication that the customers are unhappy with the product when compared to competitor offers. The greater yield and cheaper mix may well have produced a tasteless soup.

Overall

Overall there has to be concern about the production manager’s performance. Cost control and efficiency are important but not at the expense of customer satisfaction and quality. We do not have figures for the extent to which sales have been damaged and small reductions may be acceptable.

(iii) Changes to the performance management system

The performance management system needs to take account of the quality of the soup being produced and the overall impact a decision has on the business.

Quality targets need to be agreed with the manager. These are difficult to quantify but not impossible. For example soup consistency (thickness) is measurable. Regular tasting will indicate a fall in quality; tasters could give the soup a mark out of 10 on taste, colour, smell etc.

The production manager should not be rewarded for producing lots of cheap soup that cannot be sold. The performance management system should reflect the overall effect that decisions have. If the production manager’s actions have reduced sales then sales volume variances should be allocated to the production manager as part of the performance assessment.

(b) Variance calculations

MaterialPriceVariance

Mixed Vegetables: – 0.80 x 82,000 = $4,100 (A)

Butter: – 4 x 4,900 = $1,470 (A)

Stock: – 0.50 x 122,000 = $2,440 (F)

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MaterialMixVariance

Mixed Vegetables: (82,000 – 91,712.2*) x 0.80 = $7,770 (F)

Butter: (4,900 – 5,095.1) x 4 = $780 (F)

Stock: (122,000 – 112,092.7) x 0.50 = $4,954 (A)

Total Mix Variance = $3,596 (F)

Note: it is only the total mix variance that is a valid variance here Total input volume = (82,000 + 4,900 + 122,000) = 208,900

* Standard mix for mixed vegetables is = $91,712.2

Note: alternate approaches are acceptable.

MaterialYieldVariance [112,000 – 101,902.4] x 1.47 = $14,843(F)

The standard inputs add up to 2.05 units (0.9+0.5+1.1). This produces 1ltr of soup. The actual inputs were 208,900 litres and therefore the standard expected output should be

1 208,900 = 101,902.4 litres 2.05

3 BFGLimited

(a) Sales 120,000 units Sales Revenue $1,260,000 Costs: Direct materials (W1) $514,000 Direct Labour (W2) $315,423 Variable overhead $126,169 Rent $180,000 Net cash flow $124,408 Target cash flow $130,000

The target cash flow will not be achieved

Workings:

(1) Direct material: Batches $ First 200 @ $500 100,000 Second 200 @$450 90,000 Remaining 800 @$405 324,000 Total 514,000

(2) Direct labour

For first seven hundred batches y = axb

y = 2,500 x 700 –0.3219

y = $303.461045

Total cost for first 700 batches = $303.461045 x 700 = $212,423

All batches after the first 700 will have the same cost as the 700th batch. To calculate the cost of the 700th batch we need to take the cost of 699 batches from the cost of 700 batches.

For 699 batches y = a x b y = 2,500 x 699 –0.3219

y = $303.600726 Total cost for first 699 batches = $303.600726 x 699 = $212,217

Cost of 700th batch is $212,423 - $212,217 = $206

Total cost for the 12 months of production

$212,423 + ($206 x 500) = $315,423

(3) Variable overhead is $2 per hour or 40% of direct labour

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(b) To calculate the learning factor BFG will have had to measure the time taken to make the first batch (500 hours) and then the time taken to make the second batch. The learning rate measures the relationship between the average time taken between two points as production doubles. The easiest way to measure the learning rate is when the production doubles between the first and second batches.

At 80%

Time for first batch 500 Average time for two batches @80% 500 x 0.8 = 400 Total time for two batches 2 x 400 = 800 Time for second batch 800 – 500 = 300

At 90%

Time for first batch 500 Average time for two batches @90% 500 x 0.9 = 450 Total time for two batches 2 x 450 = 900 Time for second batch 900 – 500 = 400

The 80% learning rate reduces the time taken for the two successive batches above by a greater amount (or faster). Hence the 80% learning rate is the faster learning.

(c) Possible actions to improve the net cash flows are:

– Increase the price charged. The question states that an agreed specification has been reached, however further research may reveal that a higher price could be tolerated by the market. Equally a form of price skimming may be possible to improve short term net cash flow.

– Reduce the labour cost per batch by removing unnecessary operations or processes. It may be possible to simplify the design without damaging the ability to achieve the price stated.

– Improve the learning rate. This may involve improving the training or the quality of people involved in the production process. This does takes time and costs money in the short run.

– Consider substitute materials (without damaging the product specification). Also look for new suppliers to reduce the input cost.

– Consider ways to reduce the level of variable overhead incurred by the product.

– Investigate whether the production of product X could take place in existing space and hence avoid the extra rent charge. Re-negotiate the rent charge with the landlord.

4 Preston Financial Services

(a) Financial analysis

There are various financial observations that can be made from the data.

– Turnover is up 5% – this is not very high but is at least higher than the rate of inflation indicating real growth. This is encouraging and a sign of a growing business.

– The main weakness identified in the financial results is that the net profit margin has fallen from 20% to 19.8% suggesting that cost control may be getting worse or fee levels are being competed away.

– Profit is up 3.9%. In absolute terms profits are impressive given that Richard Preston is the sole partner owning 100% of the business.

– Average cashbalances are up 5% – indicating improved liquidity. Positive cash balances are always welcome in a business.

– Average debtorsdays are down by 3 days – indicating improved efficiency in chasing up outstanding debts. It is noticeable that Preston’s days are lower than the industry average indicating strong working capital management. The only possible concern may be that Richard is being particularly aggressive in chasing up outstanding debts.

Overall, with a possible concern about margins and low growth, the business looks in good shape and would appear to have a healthy future.

(b) Financial performance indicators will generally only give a measure of the past success of a business. There is no guarantee that a good past financial performance will lead to a good future financial performance. Clients may leave and costs may escalate turning past profits to losses in what can be a very short time period.

Non financial measures are often termed “indicators of future performance”. Good results in these measures can lead to a good financial performance. For example if a business delivers good quality to its customers then this could lead to more custom at higher prices in the future.

Specifically the information is appendix 2 relates to the non financial measures within the balanced scorecard.

Internal business processes are a measure of internal efficiency. Interestingly these measures can indicate current cost efficiency as much as any future result

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Customer knowledge measure how well the business is dealing with its external customers. A good performance here is very likely to lead to more custom in the future.

Innovation and learning measures that way the business develops. New products would be reflected here along with indicators of staff retention. Again this is much more focused on the future than the present.

Measuring performance by way of non-financial means is much more likely to give an indication of the future success of a business.

(c) The extra non-financial information gives much greater insight into key operational issues within the business and paints a bleaker picture for the future.

Internalbusinessprocesses

Error rates Error rates for jobs done are up from 10% to 16%, probably a result of reducing turnaround times to improve delivery on time

percentages. This is critical as users expect the accounts to be correct. Errors could lead to problems for clients with the Inland Revenue, bankers, etc. What is worse, Richard could be sued if clients lose out because of such errors. One could say that errors are unlikely to be revealed to clients. Businesses rarely advertise mistakes that have been made. They should of course put mistakes right immediately.

CustomerKnowledge

Client retention The number of clients has fallen dramatically – this is alarming and indicates a high level of customer dissatisfaction. In an

accountancy practice one would normally expect a high level of repeat work – for example, tax computations will need to be done every year. Clearly existing clients are not happy with the service provided.

Average fees It would appear that the increase in revenue is thus due to a large increase in average fees rather than extra clients – average

fee is up from $600 to $775, an increase of 29%! This could explain the loss of clients in itself, however there could be other reasons.

Market share The result of the above two factors is a fall in market share from 20% to 14%. Looking at revenue figures one can estimate

the size of the market as having grown from $4.5m to $6.75m, an increase of 50%. Compared to this, Preston’s figures are particularly worrying. The firm should be doing much better and looks to being left behind by competitors.

LearningandGrowth

Non-core services The main weakness of the firm seems to be is its lack of non-core services offered. The industry average revenue from non-core

work has increased from 25% to 30% but Richard’s figures have dropped from 5% to 4%. It would appear that most clients are looking for their accountants to provide a wider range of products but Richard is ignoring this trend.

Employee retention Employee turnover is up indicating that the staff are dissatisfied. Continuity of staff at a client is important to ensure a quality

product. Conservative clients may resent revealing personal financial details to a variety of different people each year. Staff turnover is possibly a result of extra pressure to complete jobs more quickly without the satisfaction of a job well done. Also staff may realise that the lack of range of services offered by the firm will limit their own experience and career paths

Conclusion In conclusion, the financial results do not show the full picture. The firm has fundamental weaknesses that need to be

addressed if it is to grow into the future. At present it is being left behind by a changing industry and changing competition. It is vital that Richard reassesses his attitude and ensures that the firm has a better fit with its business environment.

In particular he should seek to develop complementary services and reduce errors on existing work.

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Pilot Paper F5 Marking SchemePerformance Management

1 (a) For each product 1 mark Total 3 marks

(b) Total machine hours 2 marks Cost per driver calculation 3 marks Overheads split by product table 4 marks Cost per unit calculation 3 marks Total 12 marks

(c) Explanation 4 marks

(d) Comment on pricing, markets, customers and profitability 6 marks Total 25marks

2 (a) For each variance Explanation of meaning of variance 1 mark Brief discussion of controllability 1 mark 6 marks

(b) Comment on cost variance Price: Outside Production Managers Control 1 mark Rising prices pressures 1 mark

Mix Cheaper mix and comment 1 mark

Yield High yield results and comment 1 mark

Quality Comment on quality implications 1 mark

Overall summary 1 mark 6 marks

(c) Improvements to performance measurement system For each sensible suggestion 2 marks 4 marks

(d) Variance calculations Price: 1 mark for each ingredient 3 marks Mix: 3 marks Yield: 3 marks Method marks should be awarded as appropriate 9 marks Total 25marks

3 (a) Sales 1 marks Direct material 2 marks Direct labour first seven months 3 marks last five months 3 marks Variable overhead 1 marks Rent 1 marks Decision 1 marks Total for part (a) 12 marks

(b) Second batch times 80% 2 marks 90% 2 marks Comment on faster learning 1 marks Total for part (b) 5 marks

(c) Actions to improve net cash flow (2 marks per explained idea) 8 marks Total for part (c) Total 25marks

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4 (a) Financial commentary Turnover growth 2 marks Profitability 2 marks Cash position 2 marks Debtor management 2 marks Total 8 marks

(b) Future performance General explanation with example 2 marks Comment on each area 3 marks Total 5 marks

(c) Assessment of future prospects. Internal business processes Error rates 3 marks Not revealed to clients 1 marks Customer Knowledge Retention 1 marks Fee levels 2 marks Market share/size 1 marks Learning and growth Lack of product range 2 marks Employee retention 2 marks Total 12 marks Total 25marks

Fundamentals Level – Skills Module

Time allowedReading and planning: 15 minutesWriting: 3 hours


Formulae Sheet is on page 9


During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet untilinstructed by the supervisor.


Pape

r F5Performance

Management

Monday 10 December 2007


This is a blank page.The question paper begins on page 3.

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ALL FOUR questions are compulsory and MUST be attempted

1 Edward Co assembles and sells many types of radio. It is considering extending its product range to include digitalradios. These radios produce a better sound quality than traditional radios and have a large number of potentialadditional features not possible with the previous technologies (station scanning, more choice, one touch tuning,station identification text and song identification text etc).

A radio is produced by assembly workers assembling a variety of components. Production overheads are currentlyabsorbed into product costs on an assembly labour hour basis.

Edward Co is considering a target costing approach for its new digital radio product.

Required:

(a) Briefly describe the target costing process that Edward Co should undertake. (3 marks)

(b) Explain the benefits to Edward Co of adopting a target costing approach at such an early stage in the productdevelopment process. (4 marks)

(c) Assuming a cost gap was identified in the process, outline possible steps Edward Co could take to reducethis gap. (5 marks)

A selling price of $44 has been set in order to compete with a similar radio on the market that has comparable featuresto Edward Co’s intended product. The board have agreed that the acceptable margin (after allowing for all productioncosts) should be 20%.

Cost information for the new radio is as follows:

Component 1 (Circuit board) – these are bought in and cost $4·10 each. They are bought in batches of 4,000 andadditional delivery costs are $2,400 per batch.

Component 2 (Wiring) – in an ideal situation 25 cm of wiring is needed for each completed radio. However, there issome waste involved in the process as wire is occasionally cut to the wrong length or is damaged in the assemblyprocess. Edward Co estimates that 2% of the purchased wire is lost in the assembly process. Wire costs $0·50 permetre to buy.

Other material – other materials cost $8·10 per radio.

Assembly labour – these are skilled people who are difficult to recruit and retain. Edward Co has more staff of thistype than needed but is prepared to carry this extra cost in return for the security it gives the business. It takes 30 minutes to assemble a radio and the assembly workers are paid $12·60 per hour. It is estimated that 10% ofhours paid to the assembly workers is for idle time.

Production Overheads – recent historic cost analysis has revealed the following production overhead data:

Total production overhead Total assembly labour hours$

Month 1 620,000 19,000Month 2 700,000 23,000

Fixed production overheads are absorbed on an assembly hour basis based on normal annual activity levels. In atypical year 240,000 assembly hours will be worked by Edward Co.

Required:

(d) Calculate the expected cost per unit for the radio and identify any cost gap that might exist. (13 marks)

(25 marks)

3 [P.T.O.

2 Ties Only is a new business, selling high quality imported men’s ties via the internet. The managers, who also ownthe company, are young and inexperienced but they are prepared to take risks. They are confident that importingquality ties and selling via a website will be successful and that the business will grow quickly. This is despite thewell recognised fact that selling clothing is a very competitive business.

They were prepared for a loss-making start and decided to pay themselves modest salaries (included in administrationexpenses in table 1 below) and pay no dividends for the foreseeable future.

The owners are so convinced that growth will quickly follow that they have invested enough money in website serverdevelopment to ensure that the server can handle the very high levels of predicted growth. All website developmentcosts were written off as incurred in the internal management accounts that are shown below in table 1.

Significant expenditure on marketing was incurred in the first two quarters to launch both the website and newproducts. It is not expected that marketing expenditure will continue to be as high in the future.

Customers can buy a variety of styles, patterns and colours of ties at different prices.

The business’s trading results for the first two quarters of trade are shown below in table 1

Table 1Quarter 1 Quarter 2

$ $ $ $Sales 420,000 680,000less Cost of Sales (201,600) (340,680)

–––––––– ––––––––Gross Profit 218,400 339,320less expensesWebsite development 120,000 90,000Administration 100,500 150,640Distribution 20,763 33,320Launch marketing 60,000 40,800Other variable expenses 50,000 80,000

–––––––– ––––––––Total expenses (351,263) (394,760)

–––––––– ––––––––Loss for quarter (132,863) (55,440)

–––––––– ––––––––

Required:

(a) Assess the financial performance of the business during its first two quarters using only the data in table 1above. (12 marks)

(b) Briefly consider whether the losses made by the business in the first two quarters are a true reflection of thecurrent and likely future performance of the business. (4 marks)

4

The owners are well aware of the importance of non-financial indicators of success and therefore have identified asmall number of measures to focus on. These are measured monthly and then combined to produce a quarterlymanagement report.

The data for the first two quarters management reports is shown below:

Table 2Quarter 1 Quarter 2

Website hits* 690,789 863,492Number of ties sold 27,631 38,857On time delivery 95% 89%Sales returns 12% 18%System downtime 2% 4%* A website hit is automatically counted each time a visitor to the website opens the home page of Ties Only.

The industry average conversion rate for website hits to number of ties sold is 3·2%. The industry average sales returnrate for internet-based clothing sales is 13%.

Required:

(c) Comment on each of the non-financial data in table 2 above taking into account, where appropriate, theindustry averages provided, providing your assessment of the performance of the business.

(9 marks)

(25 marks)

5 [P.T.O.

3 Spike Co manufactures and sells good quality leather bound diaries. Each year it budgets for its profits, includingdetailed budgets for sales, materials and labour. If appropriate, the departmental managers are allowed to revise theirbudgets for planning errors.

In recent months, the managing director has become concerned about the frequency of budget revisions. At a recentboard meeting he said ‘There seems little point budgeting any more. Every time we have a problem the budgets arerevised to leave me looking at a favourable operational variance report and at the same time a lot less profit thanpromised.’

Required:

(a) Describe the circumstances when a budget revision should be allowed and when it should be refused.(5 marks)

Two specific situations have recently arisen, for which budget revisions were sought:

Materials

A local material supplier was forced into liquidation. Spike Co’s buyer managed to find another supplier, 150 milesaway at short notice. This second supplier charged more for the material and a supplementary delivery charge on top.The buyer agreed to both the price and the delivery charge without negotiation. ‘I had no choice’, the buyer said, ‘theproduction manager was pushing me very hard to find any solution possible!’ Two months later, another, morecompetitive, local supplier was found.

A budget revision is being sought for the two months where higher prices had to be paid.

Labour

During the early part of the year, problems had been experienced with the quality of work being produced by thesupport staff in the labour force. The departmental manager had complained in his board report that his team were‘unreliable, inflexible and just not up to the job’.

It was therefore decided, after discussion of the board report, that something had to be done. The company changedits policy so as to recruit only top graduates from good quality universities. This has had the effect of pushing up thecosts involved but increasing productivity in relation to that element of the labour force.

The support staff departmental manager has requested a budget revision to cover the extra costs involved followingthe change of policy.

Required:

(b) Discuss each request for a budget revision, putting what you see as both sides of the argument and reach aconclusion as to whether a budget revision should be allowed. (8 marks)

6

The market for leather bound diaries has been shrinking as the electronic versions become more widely available andeasier to use. Spike Co has produced the following data relating to leather bound diary sales for the year to date:

BudgetSales volume 180,000 unitsSales price $17·00 per unitStandard contribution $7·00 per unit

The total market for diaries in this period was estimated in the budget to be 1·8m units. In fact, the actual total marketshrank to 1·6m units for the period under review.

Actual results for the same periodSales volume 176,000 unitsSales price $16·40 per unit

Required:

(c) Calculate the total sales price and total sales volume variance. (4 marks)

(d) Analyse the total sales volume variance into components for market size and market share. (4 marks)

(e) Comment on the sales performance of the business. (4 marks)

(25 marks)

7 [P.T.O.

4 Sniff Co manufactures and sells its standard perfume by blending a secret formula of aromatic oils with dilutedalcohol. The oils are produced by another company following a lengthy process and are very expensive. The standardperfume is highly branded and successfully sold at a price of $39·98 per 100 millilitres (ml).

Sniff Co is considering processing some of the perfume further by adding a hormone to appeal to members of theopposite sex. The hormone to be added will be different for the male and female perfumes. Adding hormones toperfumes is not universally accepted as a good idea as some people have health concerns. On the other hand, marketresearch carried out suggests that a premium could be charged for perfume that can ‘promise’ the attraction of a suitor.The market research has cost $3,000.

Data has been prepared for the costs and revenues expected for the following month (a test month) assuming that apart of the company’s output will be further processed by adding the hormones.

The output selected for further processing is 1,000 litres, about a tenth of the company’s normal monthly output. Ofthis, 99% is made up of diluted alcohol which costs $20 per litre. The rest is a blend of aromatic oils costing $18,000per litre. The labour required to produce 1,000 litres of the basic perfume before any further processing is 2,000 hours at a cost of $15 per hour.

Of the output selected for further processing, 200 litres (20%) will be for male customers and 2 litres of hormonecosting $7,750 per litre will then be added. The remaining 800 litres (80%) will be for female customers and 8 litresof hormone will be added, costing $12,000 per litre. In both cases the adding of the hormone adds to the overallvolume of the product as there is no resulting processing loss.

Sniff Co has sufficient existing machinery to carry out the test processing.

The new processes will be supervised by one of the more experienced supervisors currently employed by Sniff Co.His current annual salary is $35,000 and it is expected that he will spend 10% of his time working on the hormoneadding process during the test month. This will be split evenly between the male and female versions of the product.

Extra labour will be required to further process the perfume, with an extra 500 hours for the male version and 700extra hours for the female version of the hormone-added product. Labour is currently fully employed, making thestandard product. New labour with the required skills will not be available at short notice.

Sniff Co allocates fixed overhead at the rate of $25 per labour hour to all products for the purposes of reporting profits.

The sales prices that could be achieved as a one-off monthly promotion are:– Male version: $75·00 per 100 ml – Female version: $59·50 per 100 ml

Required:

(a) Outline the financial and other factors that Sniff Co should consider when making a further processingdecision.

Note: no calculations are required. (4 marks)

(b) Evaluate whether Sniff Co should experiment with the hormone adding process using the data provided.Provide a separate assessment and conclusion for the male and the female versions of the product.

(15 marks)

(c) Calculate the selling price per 100 ml for the female version of the product that would ensure furtherprocessing would break even in the test month. (2 marks)

(d) Sniff Co is considering outsourcing the production of the standard perfume. Outline the main factors it shouldconsider before making such a decision. (4 marks)

(25 marks)

8

9

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

x) )(n y) )2 2 2 2

End of Question Paper

Answers

Fundamentals Level – Skills Module, Paper F5Performance Management December 2007 Answers

1 Edward Limited

(a) Target costing process

Target costing begins by specifying a product an organisation wishes to sell. This will involve extensive customer analysis,considering which features customers value and which they do not. Ideally only those features valued by customers will beincluded in the product design.

The price at which the product can be sold at is then considered. This will take in to account the competitor products andthe market conditions expected at the time that the product will be launched. Hence a heavy emphasis is placed on externalanalysis before any consideration is made of the internal cost of the product.

From the above price a desired margin is deducted. This can be a gross or a net margin. This leaves the cost target. Anorganisation will need to meet this target if their desired margin is to be met.

Costs for the product are then calculated and compared to the cost target mentioned above.

If it appears that this cost cannot be achieved then the difference (shortfall) is called a cost gap. This gap would have to beclosed, by some form of cost reduction, if the desired margin is to be achieved.

(b) Benefits of adopting target costing

– The organisation will have an early external focus to its product development. Businesses have to compete with others(competitors) and an early consideration of this will tend to make them more successful. Traditional approaches (bycalculating the cost and then adding a margin to get a selling price) are often far too internally driven.

– Only those features that are of value to customers will be included in the product design. Target costing at an early stageconsiders carefully the product that is intended. Features that are unlikely to be valued by the customer will be excluded.This is often insufficiently considered in cost plus methodologies.

– Cost control will begin much earlier in the process. If it is clear at the design stage that a cost gap exists then more canbe done to close it by the design team. Traditionally, cost control takes place at the ‘cost incurring’ stage, which is oftenfar too late to make a significant impact on a product that is too expensive to make.

– Costs per unit are often lower under a target costing environment. This enhances profitability. Target costing has beenshown to reduce product cost by between 20% and 40% depending on product and market conditions. In traditionalcost plus systems an organisation may not be fully aware of the constraints in the external environment until after theproduction has started. Cost reduction at this point is much more difficult as many of the costs are ‘designed in’ to theproduct.

– It is often argued that target costing reduces the time taken to get a product to market. Under traditional methodologiesthere are often lengthy delays whilst a team goes ‘back to the drawing board’. Target costing, because it has an earlyexternal focus, tends to help get things right first time and this reduces the time to market.

(c) Steps to reduce a cost gap

Review radio featuresRemove features from the radio that add to cost but do not significantly add value to the product when viewed by thecustomer. This should reduce cost but not the achievable selling price. This can be referred to as value engineering or valueanalysis.

Team approachCost reduction works best when a team approach is adopted. Edward Limited should bring together members of themarketing, design, assembly and distribution teams to allow discussion of methods to reduce costs. Open discussion andbrainstorming are useful approaches here.

Review the whole supplier chainEach step in the supply chain should be reviewed, possibly with the aid of staff questionnaires, to identify areas of likely costsavings. Areas which are identified by staff as being likely cost saving areas can then be focussed on by the team. Forexample, the questionnaire might ask ‘are there more than five potential suppliers for this component?’ Clearly a ‘yes’ responseto this question will mean that there is the potential for tendering or price competition.

ComponentsEdward Limited should look at the significant costs involved in components. New suppliers could be sought or differentmaterials could be used. Care would be needed not to damage the perceived value of the product. Efficiency improvementsshould also be possible by reducing waste or idle time that might exist. Avoid, where possible, non-standard parts in thedesign.

Assembly workersProductivity gains may be possible by changing working practices or by de-skilling the process. Automation is increasinglycommon in assembly and manufacturing and Edward Limited should investigate what is possible here to reduce the costs.The learning curve may ultimately help to close the cost gap by reducing labour costs per unit.

11

Clearly reducing the percentage of idle time will reduce product costs. Better management, smoother work flow and staffincentives could all help here. Focusing on continuous improvement in production processes may help.

OverheadsProductivity increases would also help here by spreading fixed overheads over a greater number of units. Equally EdwardLimited should consider an activity based costing approach to its overhead allocation, this may reveal more favourable costallocations for the digital radio or ideas for reducing costs in the business.

(d) Cost per unit and cost gap calculation

Component 1 $ per unit

(4·10 +$2,400

) 4·70––––––––––4,000 units

Component 2

(25

x 0·5 x100

) 0·128––– –––100 98

Material – other 8·10Assembly labour

(30

x $12·60/hr x100

) 7·00–– –––60 90

Variable production overhead

(30

x $20/hr) 10·00––60

Fixed production overhead

(30

x $12/hr) 6·00––60

–––––––Total cost 35·928Desired cost($44 x 0·8) 35·20

–––––––Cost gap 0·728

–––––––

Working

1. Production overhead cost

Using a high low method

Extra overhead cost between month 1 and 2 $80,000Extra assembly hours 4,000Variable cost per hour $20/hr

Monthly fixed production overhead$700,000 – (23,000 x $20/hr) $240,000Annual fixed production overhead ($240,000 x 12) $2,880,000

FPO absorption rate$2,880,000

= $12/hr–––––––––––240,000 hrs

2 Ties Only Limited

(a) Financial performance of Ties Only Limited

Sales GrowthTies Only Limited has had an excellent start to their business. From a standing start they have made $420,000 of sales andthen grown that figure by over 61% to $680,000 in the following quarter. This is impressive particularly given that we knowthat the clothing industry is very competitive. Equally it is often the case that new businesses make slow starts, this does notlook to be the case here.

Gross ProfitThe gross profit for the business is 52% for quarter 1 and 50% for quarter 2. We have no comparable industry data providedso no absolute comment can be made. However, we can see the gross profit has reduced by two points in one quarter. Thisis potentially serious and should not be allowed to continue.

The cause of this fall is unclear, price pressure from competitors is possible, who may be responding to the good start madeby the business. If Ties Only Limited is reducing its prices, this would reflect on the gross profit margin produced. ,It could also be that the supply side cost figures are rising disproportionately. As the business has grown so quickly, it mayhave had to resort to sourcing extra new supplies at short notice incurring higher purchase or shipping costs. These could allreduce gross margins achieved.

12

Website developmentWebsite costs are being written off as incurred to the management accounting profit and loss account. They should be seenas an investment in the future and unlikely to continue in the long term. Website development has been made with the futurein mind; we can assume that the future website costs will be lower than at present. Taking this into consideration the lossmade by the business does not look as serious as it first appears.

Administration costsThese are 23·9% of sales in quarter 1 and only 22·1% of sales in quarter 2. This could be good cost control, impressivegiven the youth and inexperience of the management team.

Also any fixed costs included in the cost (directors’ salaries are included) will be spread over greater volume. This would alsoreduce the percentage of cost against sales figure. This is an example of a business gaining critical mass. The bigger it getsthe more it is able to absorb costs. Ties Only Limited may have some way to go in this regard, gaining a much greater sizethan at present.

Distribution costsThis is a relatively minor cost that again appears under control. Distribution costs are likely to be mainly variable (postage)and indeed the proportion of this cost to sales is constant at 4·9%.

Launch marketingAnother cost that although in this profit and loss account is unlikely to continue at this level. Once the ‘launch’ is completethis cost will be replaced by more general marketing of the website. Launch marketing will be more expensive than generalmarketing and so the profits of the business will improve over time. This is another good sign that the results of the first twoquarters are not as bad as they seem.

Other costsAnother cost that appears under control in that it seems to have simply varied with volume.

(b) Although the business has lost over $188,000 in the first two quarters of its life, this is not as disastrous as it looks. Thereasons for this view are:

– New businesses rarely breakeven within six months of launch– The profits are after charging the whole of the website development costs, these costs will not be incurred in the future– Launch marketing is also deducted from the profits. This cost will not continue at such a high level in the future

The major threat concerns the fall in gross profit percentage which should be investigated.

The owners should be relatively pleased with the start that they have made. They are moving in the right direction and withoutwebsite development and launch marketing they made a profit of $47,137 in quarter 1 and $75,360 in quarter 2.

If sales continue to grow at the rate seen thus far, then the business (given its ability to control costs) is well placed to returnsignificant profits in the future.

The current profit (or loss) of a business does not always indicate a business’s future performance.

(c) Non-financial indicators of success

Website hitsThis is a very impressive start. A new business can often find it difficult to make an impression in the market. Growth in hitsis 25% between the two quarters. If this continued over a year the final quarter hits would be over 1·3m hits. The internetenables new businesses to impact the market quickly.

Number of ties soldThe conversion rates are 4% for quarter 1 and 4·5% for quarter 2. Both these figures may seem low but are ahead of theindustry average data. (Industry acquired data must be carefully applied, although in this case the data seems consistent). Itappears that the business has a product that the market is interested in. Ties Only Limited are indeed looking competitive.

We can use this statistic to calculate average price achieved for the ties

Quarter 1$420,000

= $15·20 per tie–––––––––27,631

Quarter 2$680,000

= $17·50 per tie–––––––––38,857

This suggests that the fall in gross profit has little to do with the sales price for the ties. The problem of the falling gross profitmust lie elsewhere.

On time deliveryClearly the business is beginning to struggle with delivery. As it expands, its systems and resources will become stretched.Customers’ expectations will be governed by the terms on the website, but if expectations are not met then customers maynot return. More attention will have to be placed on the delivery problem.

13

Sales returnsReturns are clearly common in this industry. Presumably, ties have to be seen and indeed worn before they are accepted assuitable by customers. The concern here is that the business’s return rate has jumped up in quarter 2 and is now well abovethe average for the industry. In other words, performance is worsening and below that of the competitors. If the business isunder pressure on delivery (as shown by the lateness of delivery) it could be that errors are being made. If wrong goods aresent out then they will be returned by disappointed customers.

The alternative view is that the quality of the product is not what is suggested by the website. If the quality is poor then theproducts could well be returned by unhappy customers.

This is clearly concerning and an investigation is needed.

System down timeSystem down time is to be avoided by internet based sellers as much as possible. If the system is down then customerscannot access the site. This could easily lead to lost sales at that time and cause customers not to try again at later dates.Downtime could be caused by insufficient investment at the development stage (we are told that the server was built to ahigh specification) or when the site is under pressure due to peaking volumes. This second explanation is more likely in thiscase.

The down time percentage has risen alarmingly and this is concerning. Ideally, we would need figures for the averagepercentage down time achieved by comparable systems to be able to comment further.

The owners are likely to be disappointed given the level of initial investment they have already made. A discussion with thewebsite developers may well be warranted.

SummaryThis new business is doing well. It is growing rapidly and ignoring non-recurring costs is profitable. It needs to focus ondelivery accuracy, speed and quality of product. It also needs to focus on a remedy for the falling gross profit margin.

Workings

1. Gross profit

Quarter 1: Quarter 2:218,400

= 52%339,320

= 50%–––––––– ––––––––420,000 680,000

2. Website conversion rates

Quarter 1: Quarter 2:27,631

= 4%38,857

= 4·5%–––––––– ––––––––690,789 863,492

3. Website hits growth

Between quarter 1 and quarter 2 the growth in website hits has been:

863,492= 1·25 = 25%––––––––

690,789

3 Spike Limited

(a) A budget forms the basis of many performance management systems. Once set, it can be compared to the actual results ofan organisation to assess performance. A change to the budget can be allowed in some circumstances but these must becarefully controlled if abuse is to be prevented.

Allow budget revisions when something has happened that is beyond the control of the organisation which renders the originalbudget inappropriate for use as a performance management tool.

These adjustments should be approved by senior management who should attempt to take an objective and independentview.

Disallow budget revisions for operational issues. Any item that is within the operational control of an organisation should notbe adjusted.

This type of decision is often complicated and each case should be viewed on its merits.

The direction of any variance (adverse or favourable) is not relevant in this decision.

(b) Materials

Arguments in favour of allowing a revision

– The nature of the problem is outside the control of the organisation. The supplier went in to liquidation; it is doubtfulthat Spike Limited could have expected this or prevented it from happening.

14

– The buyer, knowing that budget revisions are common, is likely to see the liquidation as outside his control and henceexpect a revision to be allowed. He may see it as unjust if this is not the case and this can be demoralising.

Arguments against allowing a budget revision

– There is evidence that the buyer panicked a little in response to the liquidation. He may have accepted the first offerthat became available (without negotiation) and therefore incurred more cost than was necessary.

– A cheaper, more local supplier may well have been available, so it could be argued that the extra delivery cost need nothave been incurred. This could be said to have been an operational error.

ConclusionThe cause of this problem (liquidation) is outside the control of the organisation and this is the prime cause of the overspend.Urgent problems need urgent solutions and a buyer should not be penalised in this case. A budget revision should be allowed.

Labour

Arguments in favour of allowing a revision

– The board made this decision, not the departmental manager. It could be argued that the extra cost on the department’sbudget is outside their control.

Arguments against allowing a budget revision

– This decision is entirely within the control of the organisation as a whole. As such, it would fall under the definition ofan operational decision. It is not usual to allow a revision in these circumstances.

– It is stated in the question that the departmental manager complained in his board report that the staff level neededimproving. It appears that he got his wish and the board could be said to have merely approved the change.

– The department will have benefited from the productivity increases that may have resulted in the change of policy. If thedepartment takes the benefit then perhaps they should take the increased costs as well.

Conclusion

This is primarily an operational decision that the departmental manager agreed with and indeed suggested in his board report.No budget revision should be allowed.

An alternative view is that the board made the final decision and as such the policy change was outside the direct control ofthe departmental manager. In this case a budget revision would be allowed.

(c) Total sales variances

Sales price variance = (Actual SP – Std SP) x Act sales volume= (16·40 – 17·00) x 176,000= $105,600 (Adverse)

Sales volume variance = (Actual sales volume – Budget sales volume) x Std contribution= (176,000 – 180,000) x 7= $28,000 (Adverse)

(d) Market size and share variances

Market size variance = (Revised sales volume – budget sales volume) x Std contribution= (160,000 – 180,000) x 7= $140,000 (Adverse)

Market share variance = (Actual sales volume – revised sales volume) x Std contribution= (176,000 – 160,000) x 7= $112,000 (Favourable)

(e) Comment on sales performance

Sales Price

The biggest issue seems to be the decision to reduce the sales price from $17·00 down to $16·40. This ‘lost’ $105,600 ofrevenue on sales made compared to the standard price.

It seems likely that the business is under pressure on sales due to the increased popularity of electronic diaries. As such, theymay have felt that they had to reduce prices to sustain sales at even the level they achieved.

Volume

The analysis of sales volume into market size and share shows the usefulness of planning and operational variances. Overall,the sales level of the business is down by 4,000 units, losing the business $28,000 of contribution or profit. This calculationdoes not in itself explain how the sales department of the business has performed.

In the face of a shrinking market they seem to have performed well. The revised level of sales (allowing for the shrinkingmarket) is 160,000 units and the business managed to beat this level comfortably by selling 176,000 units in the period.

15

As mentioned above, the reducing price could have contributed to the maintenance of the sales level. Additionally, theimproved quality of support staff may have helped maintain the sales level. Equally the actions of competitors are relevant tohow the business has performed. If competitors have been active then merely maintaining sales could be seen as anachievement.

Spike should be concerned that its market is shrinking.

4 (a) Sniff should consider the following factors when making a further processing decision.

– Incremental revenue. The new perfume, once further processed, should generate a higher price and the extra revenueis clearly relevant to the decision.

– Incremental costs. A decision to further process can involve more materials and labour. Care must be taken to onlyinclude those costs that change as a result of the decision and therefore sunk costs should be ignored. Sunk costs wouldinclude, for example, fixed overheads that would already be incurred by the business before the further process decisionwas taken. The shortage of labour means that its ‘true’ cost will be higher and need to be included.

– Impact on sales volumes. Sniff is selling a ‘highly branded’ product. Existing customers may well be happy with theexisting product. If the further processing changes the existing product too much there could be an impact on sales andloyalty.

– Impact on reputation. As is mentioned in the question, adding hormones to a product is not universally popular. Manygroups exist around the world that protest against the use of hormones in products. Sniff could be damaged by thisassociation.

– Potential legal cases being brought regarding allergic reactions to hormones.

(b) Production costs for 1,000 litres of the standard perfume

$Aromatic oils 10 ltrs x $18,000/ltr 180,000Diluted alcohol 990 ltrs x $20/ltr 19,800

––––––––Material cost 199,800Labour 2,000 hrs x $15/hr 30,000

––––––––Total 229,800

––––––––Cost per litre 229·80Sales price per litre 399·80

Lost contribution per hour of labour used on new products

($399,800 – $199,800) ÷ 2,000 hrs = $100/hr

Incremental costs

Male version Female version$ $

Hormone 2 ltr x $7,750/ltr 15,500 8 ltr x $12,000/ltr 96,000Supervisor Sunk cost 0 Sunk cost 0Labour 500 hrs x $100/hr 50,000 700 hrs x $100/hr 70,000Fixed cost Sunk cost 0 Sunk cost 0Market research Sunk cost 0 Sunk cost 0

––––––– –––––––––Total 65,500 166,000

––––––– –––––––––

Incremental revenues

Male version Female version$ $

Standard 200 ltr x $399·80/ltr 79,960 800 ltr x $399·80 319,840Hormone added 202 ltr x $750/ltr 151,500 808 ltr x $595/ltr 480,760

–––––––– ––––––––Incremental revenue 71,540 160,920

–––––––– ––––––––Net benefit/(cost) 6,040 (5,080)

–––––––– ––––––––

The Male version of the product is worth further processing in that the extra revenue exceeds the extra cost by $6,040.

The Female version of the product is not worth further processing in that the extra cost exceeds the extra revenue by $5,080.

In both cases the numbers appear small. Indeed, the benefit of $6,040 may not be enough to persuade management to takethe risk of damaging the brand and the reputation of the business. To put this figure into context: the normal output generatesa contribution of $170 per litre and on normal output of about 10,000 litres this represents a monthly contribution of around$1·7m (after allowing for labour costs).

16

Future production decisions are a different matter. If the product proves popular, however, Sniff might expect a significantincrease in overall volumes. If Sniff could exploit this and resolve its current shortage of labour then more contribution couldbe created. It is worth noting that resolving its labour shortage would substantially reduce the labour cost allocated to thehormone added project. Equally, the prices charged for a one off experimental promotion might be different to the prices thatcan be secured in the long run.

(c) The selling price charged would have to cover the incremental costs of $166,000. For 808 litres that would mean the pricewould have to be

($166,000 + $319,840)= $601·29/ltr––––––––––––––––––––––

808 ltrs

or about $60·13 per 100 ml.

This represents an increase of only 1·05% on the price given and so clearly there may be scope for further consideration ofthis proposal.

(d) Outsourcing involves consideration of many factors, the main ones being:

– Cost. Outsourcing often involves a reduction in the costs of a business. Cost savings can be made if the outsourcer hasa lower cost base than, in this case, Sniff. Labour savings are common when outsourcing takes place.

– Quality. Sniff would need to be sure that the quality of the perfume would not reduce. The fragrance must not changeat all given the product is branded. Equally Sniff should be concerned about the health and safety of its customers sinceits perfume is ‘worn’ by its customers

– Confidentiality. We are told that the blend of aromatic oils used in the production process is ‘secret. This may not remainso if an outsourcer is employed. Strict confidentiality should be maintained and be made a contractual obligation.

– Reliability of supply. Sniff should consider the implications of late delivery on its customers.

– Primary Function. Sniff is apparently considering outsourcing its primary function. This is not always advisable as itremoves Sniff’s reason for existence. It is more common to outsource a secondary function, like payroll processing forexample.

– Access to expertise. Sniff may find the outsourcer has considerable skills in fragrance manufacturing and hence couldbenefit from that.

17

Fundamentals Level – Skills Module, Paper F5Performance Management December 2007 Marking Scheme

Marks1 (a) Process description

Product specification 1Selling price 1Cost calculation 1

–––3

–––

(b) Benefits of target costingPer benefit 1

–––4

–––

(c) Methods to reduce the cost gapPer idea 1

–––5

–––

(d) Cost calculationComponent 1 2Component 2 2Material other 1Assembly labour 2Variable production overhead 1High low calculation 2Fixed production OAR calculation 1Fixed production overhead 1Cost gap identified 1

–––13–––25–––

2 (a) Sales 2Gross profit 3Website development 2Administration 2Distribution 1Launch marketing 2Overall comment 2

–––Max 12

–––

(b) Future profits comment 4–––

(c) Website hits 2Number of tie sales 1Tie price calculation 2On time delivery 2Returns 2System down time 1Summary comment 1

–––Max 11

–––25–––

19

Marks3 (a) When adjustment allowed 21/2

When adjustment not allowed 21/2–––5

–––

(b) Materials discussion 3Conclusion 1Labour discussion 3Conclusion 1

–––8

–––

(c) Sales price variance 2Sales volume variance 2

–––4

–––

(d) Market size variance 2Market share variance 2

–––4

–––

(e) Comment on sales price 2Comment on sales volume 2

–––4

–––25–––

4 (a) Per factor outlined 1–––

4–––

(b) Hormone costs 2Supervisor excluded 1Direct labour 3Fixed cost allocation excluded 1Market research 1Incremental revenue 3Net benefit 2Concluding comment 2

–––15–––

(c) Breakeven calculation 2–––

2–––

(d) Per factor outlined 1–––

4–––25–––

20







Pape

r F5Performance

Management

Monday 9 June 2008



1 Chaff Co processes and sells brown rice. It buys unprocessed rice seeds and then, using a relatively simple process,removes the outer husk of the rice to produce the brown rice. This means that there is substantial loss of weight inthe process. The market for the purchase of seeds and the sales of brown rice has been, and is expected to be, stable.Chaff Co uses a variance analysis system to monitor its performance.

There has been some concern about the interpretation of the variances that have been calculated in month 1.

1. The purchasing manager is adamant, despite criticism from the production director, that he has purchased wiselyand saved the company thousands of dollars in purchase costs by buying the required quantity of cheaper seedsfrom a new supplier.

2. The production director is upset at being criticised for increasing the wage rates for month 1; he feels the decisionwas the right one, considering all the implications of the increase. Morale was poor and he felt he had to dosomething about it.

3. The maintenance manager feels that saving $8,000 on fixed overhead has helped the profitability of thebusiness. He argues that the machines’ annual maintenance can wait for another month without a problem asthe machines have been running well.

The variances for month 1 are as follows:

$Material price 48,000 (Fav)Material usage 52,000 (Adv)Labour rate 15,000 (Adv)Labour efficiency 18,000 (Fav)Labour idle time 12,000 (Fav)Variable overhead expenditure 18,000 (Adv)Variable overhead efficiency 30,000 (Fav)Fixed overhead expenditure 8,000 (Fav)Sales price 85,000 (Adv)Sales volume 21,000 (Adv)

Fav = Favourable, Adv = Adverse

Chaff Co uses labour hours to absorb the variable overhead.

Required:

(a) Comment on the performance of the purchasing manager, the production director and the maintenancemanager using the variances and other information above and reach a conclusion as to whether or not theyhave each performed well. (9 marks)

2

In month 2 the following data applies:

Standard costs for 1 tonne of brown rice

– 1·4 tonnes of rice seeds are needed at a cost of $60 per tonne– It takes 2 labour hours of work to produce 1 tonne of brown rice and labour is normally paid $18 per hour. Idle

time is expected to be 10% of hours paid; this is not reflected in the rate of $18 above.– 2 hours of variable overhead at a cost of $30 per hour– The standard selling price is $240 per tonne– The standard contribution per tonne is $56 per tonne

Budget information for month 2 is

– Fixed costs were budgeted at $210,000 for the month– Budgeted production and sales were 8,400 tonnes

The actual results for month 2 were as follows:

Actual production and sales were 8,000 tonnes

– 12,000 tonnes of rice seeds were bought and used, costing $660,000– 15,800 labour hours were paid for, costing $303,360– 15,000 labour hours were worked– Variable production overhead cost $480,000– Fixed costs were $200,000– Sales revenue achieved was $1,800,000

Required:

(b) Calculate the variances for month 2 in as much detail as the information allows and reconcile the budgetprofit to the actual profit using marginal costing principles. You are not required to comment on theperformance of the business or its managers for their performance in month 2. (16 marks)

(25 marks)

3 [P.T.O.

2 Higgins Co (HC) manufactures and sells pool cues and snooker cues. The cues both use the same type of good qualitywood (ash) which can be difficult to source in sufficient quantity. The supply of ash is restricted to 5,400 kg perperiod. Ash costs $40 per kg.

The cues are made by skilled craftsmen (highly skilled labour) who are well known for their workmanship. The skilledcraftsmen take years to train and are difficult to recruit. HC’s craftsmen are generally only able to work for 12,000hours in a period. The craftsmen are paid $18 per hour.

HC sells the cues to a large market. Demand for the cues is strong, and in any period, up to 15,000 pool cues and12,000 snooker cues could be sold. The selling price for pool cues is $41 and the selling price for snooker cues is$69.

Manufacturing details for the two products are as follows:

Pool cues Snooker cuesCraftsmen time per cue 0·5 hours 0·75 hoursAsh per cue 270 g 270 gOther variable costs per cue $1·20 $4·70

HC does not keep inventory.

Required:

(a) Calculate the contribution earned from each cue. (2 marks)

(b) Determine the optimal production plan for a typical period assuming that HC is seeking to maximise thecontribution earned. You should use a linear programming graph (using the graph paper provided), identifythe feasible region and the optimal point and accurately calculate the maximum contribution that could beearned using whichever equations you need. (12 marks)

Some of the craftsmen have offered to work overtime, provided that they are paid double time for the extra hours overthe contracted 12,000 hours. HC has estimated that up to 1,200 hours per period could be gained in this way.

Required:

(c) Explain the meaning of a shadow price (dual price) and calculate the shadow price of both the labour(craftsmen) and the materials (ash). (5 marks)

(d) Advise HC whether to accept the craftsmens’ initial offer of working overtime, discussing the rate of payrequested, the quantity of hours and one other factor that HC should consider. (6 marks)

(25 marks)

4

This is a blank page.Question 3 begins on page 6.

5 [P.T.O.

3 Bridgewater Co provides training courses for many of the mainstream software packages on the market.

The business has many divisions within Waterland, the one country in which it operates. The senior managers ofBridgewater Co have very clear objectives for the divisions and these are communicated to divisional managers onappointment and subsequently in quarterly and annual reviews. These are:

1. Each quarter, sales should grow and annual sales should exceed budget2. Trainer (lecture staff) costs should not exceed $180 per teaching day3. Room hire costs should not exceed $90 per teaching day4. Each division should meet its budget for profit per quarter and annually

It is known that managers will be promoted based on their ability to meet these targets. A member of the seniormanagement is to retire after quarter 2 of the current financial year, which has just begun. The divisional managersanticipate that one of them may be promoted at the beginning of quarter 3 if their performance is good enough.

The manager of the Northwest division is concerned that his chances of promotion could be damaged by the expectedperformance of his division. He is a firm believer in quality and he thinks that if a business gets this right, growth andsuccess will eventually follow.

The current quarterly forecasts, along with the original budgeted profit for the Northwest division, are as follows:

Q1 Q2 Q3 Q4 Total$’000 $’000 $’000 $’000 $’000

Sales 40·0 36·0 50·0 60·0 186·0less:Trainers 8·0 7·2 10·0 12·0 37·2Room hire 4·0 3·6 5·0 6·0 18·6Staff training 1·0 1·0 1·0 1·0 4·0Other costs 3·0 1·7 6·0 7·0 17·7

––––– ––––– ––––– ––––– ––––––Forecast net profit 24·0 22·5 28·0 34·0 108·5

––––– ––––– ––––– ––––– ––––––Original budgeted profit 25·0 26·0 27·0 28·0 106·0Annual sales budget 180·0

––––– ––––– ––––– ––––– ––––––Teaching days 40 36 50 60

Required:

(a) Assess the financial performance of the Northwest division against its targets and reach a conclusion as tothe promotion prospects of the divisional manager (8 marks)

6

The manager of the Northwest division has been considering a few steps to improve the performance of his division.

Voucher scheme

As a sales promotion, vouchers will be sold for $125 each, a substantial discount on normal prices. These voucherswill entitle the holder to attend four training sessions on software of their choice. They can attend when they want tobut are advised that one training session per quarter is sensible. The manager is confident that if the promotion tookplace immediately, he could sell 80 vouchers and that customers would follow the advice given to attend one sessionper quarter. All voucher holders would attend planned existing courses and all will be new customers.

Software upgrade

A new important software programme has recently been launched for which there could be a market for trainingcourses. Demonstration programs can be bought for $1,800 in quarter 1. Staff training would be needed, costing$500 in each of quarters 1 and 2 but in quarters 3 and 4 extra courses could be offered selling this training. Assumingsimilar class sizes and the usual sales prices, extra sales revenue amounting to 20% of normal sales are expected(measured before the voucher promotion above). The manager is keen to run these courses at the same tutorial androom standards as he normally provides. Software expenditure is written off in the income statement as incurred.

Delaying payments to trainers

The manager is considering delaying payment to the trainers. He thinks that, since his commitment to quality couldcause him to miss out on a well deserved promotion, the trainers owe him a favour. He intends to delay payment on50% of all invoices received from the trainers in the first two quarters, paying them one month later than is usual.

Required:

(b) Revise the forecasts to take account of all three of the proposed changes. (7 marks)

(c) Comment on each of the proposed steps and reach a conclusion as to whether, if all the proposals were takentogether, the manager will improve his chances of promotion. (6 marks)

(d) Suggest two improvements to the performance measurement system used by Bridgewater Co that wouldencourage a longer term view being taken by its managers. (4 marks)

(25 marks)

7 [P.T.O.

4 Jola Publishing Co publishes two forms of book.

The company publishes a children’s book (CB), which is sold in large quantities to government controlled schools.The book is produced in only four large production runs but goes through frequent government inspections and qualityassurance checks.

The paper used is strong, designed to resist the damage that can be caused by the young children it is produced for.The book has only a few words and relies on pictures to convey meaning.

The second book is a comprehensive technical journal (TJ). It is produced in monthly production runs, 12 times ayear. The paper used is of relatively poor quality and is not subject to any governmental controls and consequentlyonly a small number of inspections are carried out. The TJ uses far more machine hours than the CB in its production.

The directors are concerned about the performance of the two books and are wondering what the impact would beof a switch to an activity based costing (ABC) approach to accounting for overheads. They currently use absorptioncosting, based on machine hours for all overhead calculations. They have accurately produced an analysis for theaccounting year just completed as follows:

CB TJ$per unit $per unit $per unit $per unit

Direct production costsPaper 0·75 0·08Printing ink 1·45 4·47Machine costs 1·15 1·95

3·35 6·50Overheads 2·30 3·95Total cost 5·65 10·45Selling price 9·05 13·85Margin 3·40 3·40

The main overheads involved are:

Overhead % of total overhead Activity driverProperty costs 75·0% Machine hoursQuality control 23·0% Number of inspectionsProduction set up costs 2·0% Number of set ups

If the overheads above were re-allocated under ABC principles then the results would be that the overhead allocationto CB would be $0·05 higher and the overhead allocated to TJ would be $0·30 lower than previously.

Required:

(a) Explain why the overhead allocations have changed in the way indicated above. (8 marks)

(b) Briefly explain the implementation problems often experienced when ABC is first introduced. (4 marks)

8

The directors are keen to introduce ABC for the coming year and have provided the following cost and selling pricedata:

1. The paper used costs $2 per kg for a CB but the TJ paper costs only $1 per kg. The CB uses 400g of paper foreach book, four times as much as the TJ uses.

2. Printing ink costs $30 per litre. The CB uses one third of the printing ink of the larger TJ. The TJ uses 150ml ofprinting ink per book.

3. The CB needs six minutes of machine time to produce each book, whereas the TJ needs 10 minutes per book.The machines cost $12 per hour to run.

4. The sales prices are to be $9·30 for the CB and $14·00 for the TJ

As mentioned above there are three main overheads, the data for these are:

Overhead Annual cost for the coming year$

Property costs 2,160,000Quality control 668,000Production set up costs 52,000

––––––––––Total 2,880,000

––––––––––

The CB will be inspected on 180 occasions next year, whereas the TJ will be inspected just 20 times.

Jola Publishing will produce its annual output of 1,000,000 CBs in four production runs and approximately 10,000TJs per month in each of 12 production runs.

Required:

(c) Calculate the cost per unit and the margin for the CB and the TJ using machine hours to absorb theoverheads. (5 marks)

(d) Calculate the cost per unit and the margin for the CB and the TJ using activity based costing principles toabsorb the overheads. (8 marks)

(25 marks)


9

10

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx


a=∑yn

-b∑xn

r=n∑xy

2 2

--∑x∑y

n∑x -(∑x) )(n∑y -(∑y) )2 2 2 2

Answers

Fundamentals Level – Skills Module, Paper F5Performance Management June 2008 Answers

1 Chaff Co

(a) When assessing variances it is important to consider the whole picture and the interrelationships that exist. In Chaff thereappears to be doubt about the wisdom of some of the decisions that have been made. Favourable variances have beenapplauded and adverse variances criticised and the managers in charge dispute the challenge to their actions.

Purchasing manager. The purchasing manager has clearly bought a cheaper product, saving $48,000. The cause of this isnot specified and it could be due to good buying or negotiation, reductions in quality or changes in overall market conditions.We are told the market for buying seeds is stable, so there is more likely to be an internal reason for the problem. The materialusage variance is significantly adverse, indicating much more waste than is normal has occurred in month 1. This suggeststhat the quality of the seed bought was poor and as a result a $52,000 excess loss has occurred. It is possible that the wastewas caused by the labour force working poorly or too quickly and this has to be considered.

The sales price achieved is also well down on standard with the sales price variance showing an $85,000 loss of revenueand (therefore) profit. We are told that the market for sales of brown rice is stable and so it is reasonable to presume that thefall in sales price achieved is as a result of internal quality issues rather than general price falls. The purchasing manager ofthe only ingredient may well be responsible for this fall in quality. This may have also led to a fall in the volume of sales,another $21,000 of adverse variance.

In conclusion the purchasing manager appears mainly responsible for a loss of $110,000* taking the four variances abovetogether.

* ($85,000 + $52,000 + $21,000 – $48,000)

Production director. The production director has increased wage rates and this has cost an extra $15,000 in month 1.However one could argue that this wage increase has had a motivational effect on the labour force. The labour efficiencyvariance is $18,000 favourable; and so it is possible that a wage rise has encouraged the labour force to work harder.Academic evidence suggests that this effect might only be temporary as workers get used to the new level of wages.

Equally the amount of idle time has reduced considerably, with a favourable variance of $12,000 resulting. Again it is possiblethat the better motivated labour force has been more willing to work than before. Idle time can have many causes, including,material shortages or machine breakdowns. However, we are told the machines are running well and the buyer has boughtenough rice seeds.

In conclusion the increase in the wage rate did cost more money but it may have improved morale and enhanced productivity.The total of the three variances above is $15,000* Fav. *($18,000 + $12,000 – $15,000)

Maintenance manager. The maintenance manager has decided to delay the annual maintenance of the machines and thishas saved $8,000. This will increase profits in the short term but could have disastrous consequences later. In this case onlytime will tell. If the machines breakdown before the next maintenance then lost production and sales could result.

The maintenance manager has only delayed the spend and not prevented it altogether. A saving of $8,000 as suggested bythe variance has not been made. It is also possible that the adverse variable overhead expenditure variance has been at leastpartly caused by poor machine maintenance.

The variance calculated is not the saving made as it represents a timing difference only. The calculation also ignores the risksinvolved.

(b) The standard contribution is given, but could be calculated as follows (not required by the question but shown as a proof):

$ $Sales price 240Less:Rice seed (1·4 Tonnes x $60/tonne) 84Labour (2 hours x $20/hr) 40Variable overhead (2 hours x $30/hr) 60

––––Marginal costs of production 184

––––Standard contribution 56

––––

The standard labour charge needs to be adjusted to reflect the cost to the business of the idle time. It is possible to adjustthe time spent per unit or the rate per hour. In both cases the adjustment would be to multiply by 10/9 – a 10% adjustment.In the case above the rate per hour has been adjusted to $18 x 10/9 = $20/hr. (Both approaches would gain full marks.)

In order to reconcile the budget profit to the actual profit, both these profits need to be calculated and an operating statementprepared.

13

Budget profit statement for month 2

$ $Sales (8400u x $240/u) 2,016,000Less:Rice seed (1·4 tonnes x $60/tonne x 8,400 tonnes) 705,600Labour (2 hours x $20/hr x 8,400 tonnes) 336,000Variable overhead (2 hours x $30/hr x 8,400 tonnes) 504,000

––––––––Marginal costs of production 1,545,600

––––––––––Contribution 470,400Less Fixed costs 210,000

––––––––––Budget profit 260,400

––––––––––

Actual profit for month 2.

$ $Sales 1,800,000Less:Rice seed 660,000Labour 303,360Variable overhead 480,000

––––––––Marginal costs of production 1,443,360

––––––––––Contribution 356,640Less Fixed costs 200,000

––––––––––Actual profit 156,640

––––––––––

Operating statement for month 2

$ $ $Budget contribution 470,400Variances: Adverse Favourable

Sales price 120,000Sales volume 22,400

––––––––142,400––––––––328,000

Material price 60,000Material usage 48,000Labour rate 18,960Labour efficiency 20,000Idle time 15,600Variable overhead efficiency 30,000Variable overhead expenditure 30,000

–––––––– ––––––––96,960 125,600 28,640

––––––––Actual contribution 356,640Budget fixed cost 210,000Less: Fixed cost expenditure variance 10,000

––––––––Actual fixed cost 200,000

––––––––Actual profit 156,640

––––––––

Workings for the variances in month 2

1. Sales price: (225 – 240)8,000 = 120,000 Adv2. Sales volume: (8,000 – 8,400)56 = 22,400 Adv

3. Material price:

4. Material usage: (12,000 – 11,200*)60 = 48,000 Adv*(8,000 x 1·4 = 11,200)

5. Labour rate: (19·20 – 18)15,800 = 18,960 Adv6. Labour efficiency: (15,000 – 16,000)20 = 20,000 Fav7. Idle time: (800 – 1,580*)20 = 15,600 Fav

*10% of 15,800

14

660 00012 000

60 12 000 60 000,,

– , ,⎛⎝⎜

⎞⎠⎟

= Fav

8. Variable overhead expenditure:

9. Variable overhead efficiency variance: (15,000 – 16,000)30 = 30,000 Fav

Alternative calculations if standard hours adjusted for expected idle time and not the rate.

Standard cost (2 hours x 10/9) x $18 = $40 per tonneOr 2·222 hours x $18 = $40 per tonne

Rate variance as above = 18,960 Adv

Idle time: (800 – 1,580)18 = 14,040 Fav

Efficiency variance: (15,000 – 16,197·77777*)18 = 21,560 Fav* (standard time allowed less standard idle time)Standard time is 8,000 tonnes x 2·222 hours = 17,777·777 hoursStandard idle time is 10% of 15,800 = 1,580 hoursTherefore expected working hours is 17,777·777 – 1,580 = 16,197·777 hours(Note – there are many alternative methods of dealing with this issue, any reasonable attempt was accepted.)

2 Higgins Co

(a) Contribution per cuePool cue Snooker cue

$ $Selling price 41·00 69·00Material cost at $40/kg (10·80) (10·80)Craftsmen cost at $18/hr (9·00) (13·50)Other Variable cost (1·20) (4·70)

–––––– –––––––Contribution per cue 20·00 40·00

–––––– –––––––

(b) Formulation of the linear programming problem

Variables

Let P and S be the number of pool and snooker cues made and sold in any three month period.

Let C represent the contribution earned in any three month period

Constraints:

Craftsmen: 0·5P + 0·75S ≤ 12,000Ash: 0·27P + 0·27S ≤ 5,400Demand levels – Pool cues P ≤ 15,000

– Snooker cues S ≤ 12,000Non negativity: P, S ≥ 0

Objective: Higgins seeks to maximise contribution in a three month period, subject to:20P + 40S = C

See diagram on next page

The feasible region is identified as the area inside OABCDE.

The contribution line is identified as the dotted line. Pushing the contribution line outward increases the contribution gained(theory of iso-contribution). The contribution line last leaves the feasible region at point D which is the intersect of the skilledlabour line and the maximum demand line for S.

Solving at point D:

Maximum demand S = 12,000 (1)Craftsmen 0·5P + 0·75S = 12,000 (2)

Substituting S = 12,000 in equation (2)

0·5P + (0·75 x 12,000) = 12,0000·5P + 9,000 = 12,000

0·5P = 12,000 – 9,0000·5P = 3,000

P = 6,000

Therefore the maximum contribution is earned when 6,000 pool cues and 12,000 snooker cues are made and sold in a threemonth period.

The contribution earned is

C = (20 x 6,000) + (40 x 12,000)C = 120,000 + 480,000C = $600,000

15

480 00015 000

30 15 000 30 000,,

– , ,⎛⎝⎜

⎞⎠⎟

= Adv

Production schedule

16

E

0

2

4

6

8

10

12

14

16

18

20

22

24

2 4 6 8 10 12 14 16 18 20S

contribution

A

Ash

Craftsmen

Max S

Max P

Max contribution

F

D

C

B

P

Feasible region = OABCDEOptimal point at point D

(c) Shadow prices

A shadow price is the value assigned to changes in the quantity of a scarce resource available, normally measured in termsof contribution. If more critical scarce resource becomes available then the feasible region would tend to expand and thismeans that the optimal point would tend to move outward away from the origin thus earning more contribution. It is thisincrease in the contribution that is the shadow price measured on a per unit of scarce resource basis.

Management can use the shadow price as a measure of how much they would be willing to pay to gain more of a scarceresource. It represents the maximum they should be willing to pay for more scarce resource over and above the normal pricesubject to any non-financial issues that may be present.

If the availability of a non-critical scarce resource increased then the feasible region would not tend to expand and thereforeno more contribution could be earned. In this case extra non-critical scarce resource has no value and a nil shadow price.

Calculation of shadow prices:

Ash: This is a non-critical scarce resource and as such it has a shadow price of nil. Put simply we have slack (spare material)of ash and therefore have no desire to pay more to get more of it.

Craftsmen: This is a critical scarce resource and if more became available then the feasible region would expand and theoptimal point would move outward thus earning more contribution. Assuming that just one more hour becomes available itis necessary to find the new optimal point and measure the increase in contribution earned.

At point D, we re-solve based on the available craftsmen hours being one more than previously.

S = 12,000 (3)0·5P + 0·75S = 12,001 (4)


0·5P + 0·75(12,000) = 12,0010·5P + 9,000 = 12,001

0·5P = 3,001P = 6,002

The new optimal solution would be where 12,000 snooker cues and 6,002 pool cues are made. This would earn an extra$40 (2 x $20) in contribution.

The shadow price is therefore $40 per extra hour of craftsmen time.

(d) Acceptability of the craftmens’ offer.

Rate of pay

The rate of pay requested (double time) is on the face of it less than the shadow price and is therefore affordable by HigginsCo. The business would be better off by accepting the offer.

However, it is common for overtime to be paid at time and a half ($27 per hour) and Higgins would be well advised tonegotiate on this point. Higgins takes the commercial risks in this business and would therefore be justified in keeping themajority of the rewards that come with it. Equally it is a dangerous precedent to accept the first offer and pay such a highrate for overtime, Higgins would have to ask itself what would happen next time an overtime situation arose. It is also possiblethat double time, being so generous, encourages slow working in normal time so as to gain the offer of overtime.

How many hours to buy?

The problem here is that as Higgins buys more craftsmen time, the craftsmen constraint line will move outward, changingthe shape of the feasible region. Once the craftsmen line reaches point F (see diagram) then there would be little point buyingany more hours since Higgins would then not have the materials (ash) to make more cues.

We need therefore to calculate the number of hours needed at point F.

At F

Maximum demand for S S = 12,000 (5)Ash 0·27P + 0·27S = 5,400 (6)


0·27P + 0·27(12,000) = 5,4000·27P + 3,240 = 5,400

0·27P = 2,160P = 8,000

Point F falls where S = 12,000 and P = 8,000

The craftsmen hours needed at this point would be given by putting the above P and S values in the craftsmen constraintformula.

Craftsmen hours = (0·5 x 8,000) + (0·75 x 12,000)Craftsmen hours =13,000 hours

17

Therefore Higgins should only buy 1,000 hours (13,000 – 12,000).

In general terms Higgins need only buy the number of hours that the business can use to make and sell more product. Ifmore ash can also be bought then more labour hours may be desirable.

Quality of work

Higgins should consider the quality of work. Overtime hours can force tiredness on craftsmen that have already worked a fullday. Tired people often produce sub-standard work. If quality is important then this could damage the reputation of thebusiness.

Any other feasible points would be accepted

3 Bridgewater Co

(a) The divisions of Bridgewater Co have been given very specific targets to meet it is reasonable to assume that performancewill be assessed relative to them.

Sales Growth

The northwest division suffers from a slow start to the year, with falls in sales from quarter 1 to quarter 2. Overall sales growthlooks better with an average growth of 14% achieved. We don’t have quarterly budget sales to compare to but the low growthin budget profit suggests that much slower sales growth than that actually achieved was expected. Overall the sales budgethas been exceeded, with big increases in sales in the last two quarters

The manager’s promotion could be damaged by the slow start. The ‘good news’ of better sales growth comes after thepromotion decision is taken.

Cost control – trainer costs

The division spends slightly more (as a % of sales) than budgeted on trainers. It is spending 20% as opposed to 18% ontrainers. Given the manager’s attitude towards quality it appears he is trying to employ better trainers in the hope of moresatisfied customers. This should, logically, build customer loyalty and improve local and brand reputation. This could possiblyexplain the better growth in the later quarters.

Again the problem for the promotion seeking manager, investing in the future in this way damages short term performancemeasures, in this case cost targets.

Cost control – room hire costs

The divisional manager is also spending more on room hire. He is spending 10% as opposed to the budgeted 9% of sales.He could be buying poorly, hence wasting money. Alternatively he could be hiring better quality rooms to improve the learningenvironment and enhance the training experience.

Again his focus on quality may be undermining his short term promotional prospects.

Profit

Annually, the divisional manager is beating the targets laid down for profit. His problem as far as his promotion is concernedis the profit targets laid down for the first two quarters are not met.

The promotion decision comes too early for his employers to see the benefit of a quality focus made earlier in the year.

Overall, promotional prospects do not look good. The manager has not met any of his targets in the first two quarters. Hisonly hope is that his bosses look at future forecasts and take them in to consideration when making the decision.

(b) Revised forecasts

Q1 Q2 Q3 Q4 Total$’000 $’000 $’000 $’000 $’000

Sales 42·5 38·5 62·5 74·5 218·0less:Trainers 8·0 7·2 12·0 14·4 41·6Room hire 4·0 3·6 6·0 7·2 20·8Staff training 1·5 1·5 1·0 1·0 5·0Other costs 3·0 1·7 6·0 7·0 17·7Software 1·8 1·8

––––– ––––– ––––– ––––– –––––Forecast Net profit 24·2 24·5 37·5 44·9 131·1

––––– ––––– ––––– ––––– –––––Original Budget profit 25·0 26·0 27·0 28·0 106·0

18

Incremental effects (as a working)

Q1 Q2 Q3 Q4 Total$’000 $’000 $’000 $’000 $’000

Extra salesVoucher sales 2·5 2·5 2·5 2·5 10·0Software sales 10·0 12·0 22·0Extra costsTrainers 2·0 2·4 4·4Room hire 1·0 1·2 2·2Staff training 0·5 0·5 1·0Software 1·8 1·8Change in forecast Net profit +0·2 +2·0 +9·5 +10·9 +22·6

(c) Voucher scheme

At first glance of it the voucher scheme looks a good one. The manager is confident of a reasonable volume of sales and giventhat all the attendees will go on existing courses there will be no additional costs. The scheme seems to generate $10,000of extra sales revenue in the year. One should question the assumption that no extra costs are incurred.

One potential concern would be that existing customers may object to the price reduction, particularly if they have alreadypaid a higher price for a future course. However, most customers will probably not be aware of the price difference or will notbother complaining, those that do complain can be dealt with individually. It is common with promotions that the offer clearlystates the terms and conditions that apply. In this way the manager can protect existing sales by excluding existing sales fromthe new offer.

From a promotion point of view the extra revenue and profit helps a little. If the revenue is spread evenly (as suggested) therewill be $2,500 of extra revenue and profit in each of quarter 1 and 2. Unfortunately, in both cases the manager will still fallshort of the target profit and the growth between quarter 1 and 2 will still be negative. He would need the take up rate of thesessions to be quicker to help his promotion prospects. Manipulation of the accounting figures should be resisted

Software upgrade

A software training company must stay in touch with modern software developments. From that point of view you could arguethat this development is essential. Financially the proposal looks sound. The extra courses will generate a profit of $12,600in this year alone, with, presumably, more courses to follow. A slower than expected take-up rate for the new course wouldreduce this year’s effect.

The promotional aspects are not as good. The extra costs occur in quarter 1 and 2 but the revenue does not come in untilafter the promotion decision is made. Integrity is an issue here. Personal promotional prospects must come second to soundbusiness decisions. The manager should show the revised forecasts to his bosses and hope this sways the decision.

Delayed payment to trainers

This is a poor idea. This will not affect profit, costs or any of the performance measures in question. It will affect cash flowin a positive manner. However, to delay payment without agreement can damage the relationships with the trainers, uponwhich he depends on for the quality of their presentations.

Overall the three proposals do improve the performance of the division. However most of the benefits accrue after quarter 2and might therefore come too late for the promotion decision.

(d) To encourage a longer term view more emphasis should be placed on non-financial measures of performance.

This business is dependent amongst other things on the quality of its course provision. As a result an improvement could beto set targets for the quality of presentations given. Attendees could be asked to grade all trainers (or facilities) at the end ofsessions. This would prevent cheap but weak presenters (and poor quality rooms) being employed by managers.

Equally, the senior managers have to take account of longer periods when assessing performance. Viewing a single quarteris too narrow and looking at the whole year is advisable. Wider issues should also be taken into consideration when makingpromotional decisions. Repurchase rates could be measured for client companies for example.

4 Jola Publishing

(a) The first thing to point out is that the overhead allocations to the two products have not changed by that much. For examplethe CB has absorbed only $0·05 more overhead. The reason for such a small change is that the overheads are dominatedby property costs (75% of total overhead) and the ‘driver’ for these remains machine hours once the switch to ABC is made.Thus no difference will result from the switch to ABC in this regard.

The major effect on the cost will be for quality control. It is a major overhead (23% of total) and there is a big differencebetween the relative number of machine hours for each product and the number of inspections made (the ABC driver). TheCB takes less time to produce than the TJ, due to the shortness of the book. It will therefore carry a smaller amount ofoverhead in this regard. However, given the high degree of government regulation, the CB is subject to ‘frequent’ inspectionswhereas the TJ is inspected only rarely. This will mean that under ABC the CB will carry a high proportion of the qualitycontrol cost and hence change the relative cost allocations.

19

The production set up costs are only a small proportion of total cost and would be, therefore, unlikely to cause much of adifference in the cost allocations between the two products. However this hides the very big difference in treatment. The CBis produced in four long production runs, whereas the TJ is produced monthly in 12 production runs. The relative proportionsof overhead allocated under the two overhead treatments will be very different. In this case the TJ would carry much moreoverhead under ABC than under a machine hours basis of overhead absorption.

(b) There are many problems with ABC, which, despite its academic superiority, cause issues on its introduction.

– Lack of understanding. ABC is not fully understood by many managers and therefore is not fully accepted as a meansof cost control.

– Difficulty in identifying cost drivers. In a practical context, there are frequently difficulties in identifying the appropriatedrivers. For example, property costs are often significant and yet a single driver is difficult to find.

– Lack of appropriate accounting records. ABC needs a new set of accounting records, this is often not immediatelyavailable and therefore resistance to change is common. The setting up of new cost pools is needed which is timeconsuming.

(c) Cost per unit calculation using machine hours for overhead absorption

$CB $TJPaper (400g at $2/kg) 0·80 (100g at $1/kg) 0·10Printing (50ml at $30/ltr) 1·50 (150ml at $30/ltr) 4·50Machine cost (6 mins at $12/hr) 1·20 (10 mins at $12/hr) 2·00Overheads (6 mins at $24/hr) (W1) 2·40 (10 mins at $24/hr) 4·00

–––– ––––––Total cost 5·90 10·60Sales price 9·30 14·00

–––– ––––––Margin 3·40 3·40

–––– ––––––

(W1) Workings for overheads:

Total overhead $2,880,000

Total machine hours(1,000,000 x 6 mins) + (120,000 x 10 mins) = 7,200,000 minsWhich is 120,000 hours

Cost per hour =$2,880,000

= $24/hr–––––––––––––120,000 hrs

Cost per unit calculations under ABC

CB TJ$ $

Paper (400g at $2/kg) 0·80 (100g at $1/kg) 0·10Printing (50ml at $30/ltr) 1·50 (150ml at $30/ltr) 4·50Machine cost (6 mins at $12/hr) 1·20 (10 mins at $12/hr) 2·00Overheads (W2) 2·41 (W2) 3·88

–––– ––––––Total cost 5·91 10·48Sales price 9·30 14·00

–––– ––––––Margin 3·39 3·52

–––– ––––––

(W2) Working for ABC overheads alternative:

Total CB TJ No of drivers Cost/driver CB TJ$ $ $

Property costs 2,160,000 1,800,000 360,000 120,000 18/hr 1·80 3·00Quality control 668,000 601,200 66,800 200 3340 0·6012 0·56Production set up 52,000 13,000 39,000 16 3250 0·013 0·325

–––––––––– –––––––––– –––––––– ––––––– ––––––Total 2,880,000 2,414,200 465,800 Cost per unit 2·41 3·88Production level 1,000,000 120,000 ––––––– ––––––

Cost per unit 2·41 3·88––––––– ––––––

The above overheads have been split on the basis of the following activity levels

Driver CB TJProperty costs Machine hours 100,000 20,000Quality control Inspections 180 20Production set up Set ups 4 12

A cost per driver approach is also acceptable.

20

Fundamentals Level – Skills Module, Paper F5Performance Management June 2008 Marking Scheme

Marks1 (a) Assessment of each person 3

Buyer (poor quality, usage, sales issue)Production director (motivation, efficiency and idle time issue)Administration manager (short-termism, timing only)Allow flexibility here in interpetation

–––9

–––

(b) Budget profit calculationLabour 1Sales 1/2Rice seed 1/2Variable overhead 1/2Fixed cost 1/2Sales price variance 1Sales volume variance 1Material price variance 1Material usage variance 1Labour rate variance 1Labour efficiency variance 2Idle time variance 2Variable overhead expenditure variance 1Variable overhead efficiency variance 1Fixed overhead expenditure variance 1Format 1

–––16–––25–––

21

Marks2 (a) Selling prices 1/2

Ash costs 1/2Craftsmen costs 1/2Contribution identified 1/2–––

2–––

(b) Assigning letters for variables 1/2Defining ash constraint 1Defining craftsmen constraint 1Demand constraint – pool 1/2Demand constraint – snooker 1/2Non-negativity constraint 1/2Correctly drawn diagram

Labels 1/2Title 1/2Ash constraint line 1/2Craftsmen constraint line 1/2Pool demand line 1/2Snooker demand line 1/2Identified feasible region 1/2Contribution line 1Identified optimal point 1/2

Solve at optimal 2Calculation of contribution 1

–––12–––

(c) Explanation of a shadow price 2Ash shadow price 1Craftsmen shadow price 2

–––5

–––

(d) Rate of pay discussion 2Quantity of hours discussion 1Quantity of hours calculation 1Quality (or other) 2

–––6

–––25–––

22

Marks3 (a) Per target discussed 2

–––8

–––

(b) Revised forecastsVoucher sales affect 1Vista sales affect 2Extra trainer cost 1Extra room hire cost 1Staff training increase 1/2Software cost 1/2Overall revised profit calculation 1

–––7

–––

(c) Per idea commented on 2–––

6–––

(d) For each suggestion 2–––

4–––25–––

4 (a) Comment on rent and rates 2Comment on quality control 2Comment on production set up cost 2Comment on overall effect 2

–––8

–––

(b) For each explanation 2–––

4–––

(c) Paper cost CB 1/2Paper cost TJ 1/2Printing ink cost CB 1/2Printing ink cost TJ 1/2Machine cost CB 1/2Machine cost TJ 1/2Overhead OAR 1Overhead cost CB 1/2Overhead cost TJ 1/2Margins 1

–––6 max 5

–––

(d) Split of rent and rates 11/2Split of quality control 11/2Split of production set up cost 11/2Overhead cost per unit CB 11/2Overhead cost per unit TJ 11/2Direct cost as above 1

–––Maximum 8

–––25–––

23




The formulae are on page 6.




Pape

r F5Performance

Management




1 Pace Company (PC) runs a large number of wholesale stores and is increasing the number of these stores all the time.It measures the performance of each store on the basis of a target return on investment (ROI) of 15%. Store managersget a bonus of 10% of their salary if their store’s annual ROI exceeds the target each year. Once a store is built thereis very little further capital expenditure until a full four years have passed.

PC has a store (store W) in the west of the country. Store W has historic financial data as follows over the past fouryears:

2005 2006 2007 2008Sales ($’000) 200 200 180 170Gross profit ($’000) 80 70 63 51Net profit ($’000) 13 14 10 8Net assets at start of year ($’000) 100 80 60 40

The market in which PC operates has been growing steadily. Typically, PC’s stores generate a 40% gross profit margin.

Required:

(a) Discuss the past financial performance of store W using ROI and any other measure you feel appropriateand, using your findings, discuss whether the ROI correctly reflects Store W’s actual performance.

(8 marks)

(b) Explain how a manager in store W might have been able to manipulate the results so as to gain bonusesmore frequently. (4 marks)

PC has another store (store S) about to open in the south of the country. It has asked you for help in calculating thegross profit, net profit and ROI it can expect over each of the next four years. The following information is provided:

Sales volume in the first year will be 18,000 units. Sales volume will grow at the rate of 10% for years two and threebut no further growth is expected in year 4. Sales price will start at $12 per unit for the first two years but then reduceby 5% per annum for each of the next two years.

Gross profit will start at 40% but will reduce as the sales price reduces. All purchase prices on goods for resale willremain constant for the four years.

Overheads, including depreciation, will be $70,000 for the first two years rising to $80,000 in years three and four.

Store S requires an investment of $100,000 at the start of its first year of trading.

PC depreciates non-current assets at the rate of 25% of cost. No residual value is expected on these assets.

Required:

(c) Calculate (in columnar form) the revenue, gross profit, net profit and ROI of store S over each of its first fouryears. (9 marks)

(d) Calculate the minimum sales volume required in year 4 (assuming all other variables remain unchanged) toearn the manager of S a bonus in that year. (4 marks)

(25 marks)

2

2 Shifters Haulage (SH) is considering changing some of the vans it uses to transport crates for customers. The newvans come in three sizes; small, medium and large. SH is unsure about which type to buy. The capacity is 100 cratesfor the small van, 150 for the medium van and 200 for the large van.

Demand for crates varies and can be either 120 or 190 crates per period, with the probability of the higher demandfigure being 0·6.

The sale price per crate is $10 and the variable cost $4 per crate for all van sizes subject to the fact that if the capacityof the van is greater than the demand for crates in a period then the variable cost will be lower by 10% to allow forthe fact that the vans will be partly empty when transporting crates.

SH is concerned that if the demand for crates exceeds the capacity of the vans then customers will have to be turnedaway. SH estimates that in this case goodwill of $100 would be charged against profits per period to allow for lostfuture sales regardless of the number of customers that are turned away.

Depreciation charged would be $200 per period for the small, $300 for the medium and $400 for the large van.

SH has in the past been very aggressive in its decision-making, pressing ahead with rapid growth strategies. However,its managers have recently grown more cautious as the business has become more competitive.

Required:

(a) Explain the principles behind the maximax, maximin and expected value criteria that are sometimes used tomake decisions in uncertain situations. (4 marks)

(b) Prepare a profits table showing the SIX possible profit figures per period. (9 marks)

(c) Using your profit table from (b) above discuss which type of van SH should buy taking into consideration thepossible risk attitudes of the managers. (6 marks)

(d) Describe THREE methods other than those mentioned in (a) above, which businesses can use to analyse andassess the risk that exists in its decision-making. (6 marks)

(25 marks)

3 [P.T.O.

3 Henry Company (HC) provides skilled labour to the building trade. They have recently been asked by a builder to bidfor a kitchen fitting contract for a new development of 600 identical apartments. HC has not worked for this builderbefore. Cost information for the new contract is as follows:

Labour for the contract is available. HC expects that the first kitchen will take 24 man-hours to fit but thereafter thetime taken will be subject to a 95% learning rate. After 200 kitchens are fitted the learning rate will stop and the timetaken for the 200th kitchen will be the time taken for all the remaining kitchens. Labour costs $15 per hour.

Overheads are absorbed on a labour hour basis. HC has collected overhead information for the last four months andthis is shown below:

Hours worked Overhead cost $Month 1 9,300 115,000Month 2 9,200 113,600Month 3 9,400 116,000Month 4 9,600 116,800

HC normally works around 120,000 labour hours in a year.

HC uses the high low method to analyse overheads.

The learning curve equation is y = axb, where

Required:

(a) Describe FIVE factors, other than the cost of labour and overheads mentioned above, that HC should takeinto consideration in calculating its bid. (10 marks)

(b) Calculate the total cost including all overheads for HC that it can use as a basis of the bid for the newapartment contract. (13 marks)

(c) If the second kitchen alone is expected to take 21·6 man-hours to fit demonstrate how the learning rate of95% has been calculated. (2 marks)

(25 marks)

4

b LogLRLog

= =2

0 074– .

4 Wargrin designs, develops and sells many PC games. Games have a short lifecycle lasting around three years only.Performance of the games is measured by reference to the profits made in each of the expected three years ofpopularity. Wargrin accepts a net profit of 35% of turnover as reasonable. A rate of contribution (sales price lessvariable cost) of 75% is also considered acceptable.

Wargrin has a large centralised development department which carries out all the design work before it passes thecompleted game to the sales and distribution department to market and distribute the product.

Wargrin has developed a brand new game called Stealth and this has the following budgeted performance figures.

The selling price of Stealth will be a constant $30 per game. Analysis of the costs show that at a volume of 10,000units a total cost of $130,000 is expected. However at a volume of 14,000 units a total cost of $150,000 isexpected. If volumes exceed 15,000 units the fixed costs will increase by 50%.

Stealth’s budgeted volumes are as follows:

Year 1 Year 2 Year 3Sales volume 8,000 units 16,000 units 4,000 units

In addition, marketing costs for Stealth will be $60,000 in year one and $40,000 in year two. Design anddevelopment costs are all incurred before the game is launched and has cost $300,000 for Stealth. These costs arewritten off to the income statement as incurred (i.e. before year 1 above).

Required:

(a) Explain the principles behind lifecycle costing and briefly state why Wargrin in particular should considerthese lifecycle principles. (4 marks)

(b) Produce the budgeted results for the game ‘Stealth’ and briefly assess the game’s expected performance,taking into account the whole lifecycle of the game. (9 marks)

(c) Explain why incremental budgeting is a common method of budgeting and outline the main problems withsuch an approach. (6 marks)

(d) Discuss the extent to which a meaningful standard cost can be set for games produced by Wargrin. Youshould consider each of the cost classifications mentioned above. (6 marks)

(25 marks)

5 [P.T.O.


6

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve

P = a – bQ

b = change in price change in quantity


y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

x) )(n y) )2 2 2 2

Answers


1 (a) Performance statistics

2005 2006 2007 2008ROI 13% 17·5% 16·7% 20%Bonus paid? No Yes Yes YesSales Growth – 0% –10% –5·6%Gross margin 40% 35% 35% 30%Overheads $67,000 $56,000 $53,000 $43,000Net profit % on Sales 6·5% 7% 5·6% 4·7%

The performance of store W can be assessed in various ways:

Sales Growth

Sales revenue growth is most unimpressive. We are told that the market in which PC operates is steadily growing and yetstore W has shrunk in terms of sales over the last four years. This could be poor volumes or poor prices achieved. Given thereducing gross margin (see below), then a reducing sales price is likely. It is possible that W is subject to higher than normallevels of competition.

Gross Margin

The gross margins have also shrunk. Reducing margins can result from sales price pressure or increases in the cost of saleslevels being incurred. Suppliers might have increased prices or labour could have got more expensive. The level of marginhas only reached the normal level once in the last four years. Clearly W is under performing.

Overhead Control

The one area that is impressive is the apparent ability of the business to reduce overheads as sales and margin have shrunk.This is often difficult to do. It is possible that reducing these overheads could have contributed to the poor sales performance,if (for example) quality has been affected, or one could say it reflects flexible management.

Net Margin

The net margin has also fallen, primarily due to falling gross margins as overheads have reduced. Clearly a disappointingperformance.

ROI

The ROI has improved in most years and has exceeded the 15% target in all but one year (year 1). This is simply due to thereducing asset base as the stores assets have gradually been depreciated. Net profit levels have fallen overall and yet ROI hasincreased.

It is hard to argue that the ROI figures properly reflect the performance of the store. The ROI will tend to increase as assetsget older and this will distort the financial performance picture. In a period of falling sales and weaker margins the managerof W has been awarded bonuses in three out of four years. This is hard to justify.

(b) The unethical manager would have needed to move profits out of 2006 and in to 2005. One immediate problem here ishaving the information in good time to respond. The manager would have to be able to anticipate the 2005 poor result andthe improvement in 2006. It is likely that such a manager would have to gamble at the end of 2005 and make an adjustmentin the hope of a better year in 2006.

The manager need only move $2,000 of profit from 2006 to 2005 to achieve a 15% return in both years.

Possible methods of adjustment include:

Accelerate revenue: Sales made early in 2006 could be wrongly included in 2005. He could, for example, raise an invoicebefore is normal, perhaps on the receipt of an order and before actual delivery. The invoice itself would not have to be sentto the customer, merely filed until the second year had begun and delivery made.

Delay the recording of 2005 cost: A supplier’s invoice could be left unrecorded at the end of 2005, including it in 2006expenses instead.

Understate a provision or accrual in 2005: This has the effect of moving cost from 2005 to 2006 (assuming that by theend of 2006 the provision is correctly stated).

Manipulate accounting policy: Inventory values (for example) are easy targets for the unethical manager. If inventory in 2005could be overstated this would have the effect of increasing 2005 profits at the expense 2006 profits.

9

(c) The forecast for store S is as follows:

2009 ($) 2010 ($) 2011 ($) 2012 ($)Sales W1 216,000 237,600 248,292 235,877Gross Profit W2 86,400 95,040 91,476 79,061Overheads 70,000 70,000 80,000 80,000Net Profit 16,400 25,040 11,476 (939)Investment 100,000 75,000 50,000 25,000ROI 16·4% 33·39% 22·95% –3·8%

W1

2009 2010 2011 2012Sales Volume (units) 18,000 19,800a 21,780b 21,780Sales Price ($) 12·00 12·00 11·40c 10·83d

Revenue ($)(Volume x Price) 216,000 237,600 248,292 235,877a: 18,000 (1·1) = 19,800b: 19,800 (1·1) = 21,780c: 12.00 (0·95) = 11.40d: 11.40 (0·95) = 10.83

W2

Gross Profit

2009 40% (given). Total gross profit = $216,000 x 0·4 = $86,4002010 40% (given). Total gross profit = $237,600 x 0·4 = $95,0402011 (40 – 5)/100(0·95) = 36·8421052%

Total gross profit = $248,292 x 0·368421052 = $91,4762012 (40 – 5 – 4·75)/(100(0·95)(0·95)) = 33·5180055%

Total gross profit = $235,877 x 0·335180055 = $79,061

Alternatively, given that variable costs are said to be constant over the four years, could calculate the variable cost in year oneand hold for the four years. Gross profit is then simply sales revenue less variable costs.

Variable costs in 2005:

$216,000 – 18,000 x VC = $86,400VC per unit = $7·20So year two gross profit will be:

$237,600 – 19,800 x 7·2 = $95,040

(d) In order for a bonus to be paid in 2012 an ROI of 15% is needed. This implies a net profit of $25,000 x 15% = $3,750.

Adding overheads of $80,000 to this net profit means that $83,750 of gross profit is needed. At a gross profit % of 33·518%this implies sales of $249,866.

At a price of $10·83 this suggests sales volume of 23,072 units.

2 (a) Maximax stands for maximising the maximum return an investor might expect. An investor that subscribes to the maximaxphilosophy would generally select the strategy that could give him the best possible return. He will ignore all other possiblereturns and only focus on the biggest, hence this type of investor is often accused of being an optimist or a risk-taker.

Maximin stands for maximising the minimum return an investor might expect. This type of investor will focus only on thepotential minimum returns and seek to select the strategy that will give the best worst case result. This type of investor couldbe said to be being cautious or pessimistic in his outlook and a risk-avoider.

Expected value averages all possible returns in a weighted average calculation.

For example if an investor could expect $100 with a 0·3 probability and $300 with a 0·7 probability then on average thereturn would be:

(0·3 x $100) + (0·7 x $300) = $240

This figure would then be used as a basis of the investment decision. The principle here is that if this decision was repeatedagain and again, then the investor would get the EV as a return. Its use is more questionable for use on one-off decisions.(Note: you were not asked for a critique of this method.)

(b) Profit calculations

Small Van Medium Van Large VanCapacity 100 150 200Low Demand (120) 300 w1 468 w3 368 w5

High Demand (190) 300 w2 500 w4 816 w6

10

Workings

W1 W2 W3 W4 W5 W6Sales 1,000 1,000 1,200 1,500 1,200 1,900VC (400) (400) (480) (600) (480) (760)Goodwill (100) (100) (100)VC adjustment 48 48 76Depreciation (200) (200) (300) (300) (400) (400)Profit 300 300 468 500 368 816

(c) Which type of van to buy?

This depends on the risk attitude of the investor. If they are optimistic about the future then the maximax criteria would suggestthat they choose the large van as this has the potentially greatest profit.

If they are more pessimistic, then they would focus on the minimum expected returns and choose the medium van as theworst possible result is $468, which is better than the other options. We are also told that the business managers arebecoming more cautious and so a maximin criterion may be preferred by them.

Expected values could be calculated thus:

Small van $300Medium van ($468 x 0·4) + ($500 x 0·6) = $487Large van ($368 x 0·4) + ($816 x 0·6) = $637

Given SH is considering replacing a number of vans you could argue that an EV approach has merit (not being a one-offdecision – assuming individual booking sizes are independent of each other).

The final decision lies with the managers, but, given what we know about their cautiousness, a medium sized van wouldseem the logical choice. The small van could never be the correct choice.

(d) Methods of uncertainty reduction:

– Market research. This can be desk-based (secondary) or field-based (primary). Desk-based is cheap but can lack focus.Field-based research is better in that you can target your customers and your product area, but can be time consumingand expensive. The internet is bringing down the cost and speeding up this type of research, email is being used togather information quickly on the promise of free gifts etc.

– Simulation. Computer models can be built to simulate real life scenarios. The model will predict what range of returnsan investor could expect from a given decision without having risked any actual cash. The models use random numbertables to generate possible values for the uncertainty the business is subject to. Again, computer technology is assistingin bringing down the cost of such risk analysis.

– Sensitivity analysis. This can be used to assess the range of values that would still give the investor a positive return.The uncertainty may still be there, but the affect that it has on the investor’s returns will be better understood. Sensitivitycalculates the % change required in individual values before a change of decision results. If only a (say) 2% change isrequired in selling price before losses result an investor may think twice before proceeding. Risk is therefore betterunderstood.

– Calculation of worst and best case figures. An investor will often be interested in range. It enables a betterunderstanding of risk. An accountant could calculate the worst case scenario, including poor demand and high costswhilst being sensible about it. He could also calculate best case scenarios including good sales and minimum runningcosts. This analysis can often reassure an investor. The production of a probability distribution to show an investor therange of possible results is also useful to explain risks involved. A calculation of standard deviation is also possible.

3 (a) There are various issues that HC should consider in making the bid. (Only five are required for two marks each.)

Contingency allowance. HC should consider the extent to which its estimates are accurate and hence the degree ofuncertainty it is subjected to. It may be sensible to allow for these uncertainties by adding a contingency to the bid.

Competition. HC must consider which other businesses are likely to bid and recognise that the builder may be able to choosebetween suppliers. Moreover, HC has not worked for this builder before, and so they will probably find the competition stiffand the lack of reputation a problem.

Inclusion of fixed overhead. In the long run fixed overhead must be covered by sales revenue in order to make a profit. Inthe short run it is often correctly argued that the level of fixed cost in a business may not be affected by a new contract andtherefore could be ignored in bid calculation. HC needs to consider to what extent the fixed costs of its business will changeif it wins this new contract. It is these incremental fixed costs that are relevant to a bid calculation.

Materials and loose tools. No allowance has been made for the use of tools and the various fixings (screws etc) that will beneeded to assemble and fit the kitchens. It is possible that most fixings would be provided with the kitchen units, but HCshould at least consider this.

Supervision of labour. The time given in the question is 24 hours to ‘fit’ the first kitchen. There seems no allowance forsupervision of the labour force. It could, of course, be included within the overhead figures but no detail is shown.

11

Idle time. It is common for building works to be delayed by lack of materials for example. The labour time figure needs toreflect this.

Likelihood of repeat business. Some businesses consider it worthwhile to accept a low price for a new contract if it establishesa reputation with a new buyer. HC could offer to do this work cheaper in the hope of more profitable work later on.

The risk of non-payment. HC may decide not to bid at all if it feels that the builder may struggle to pay.

Opportunity costs of alternate work.

Possibility of working in overtime.

(b) Bid calculations for HC to use as a basis for the apartment contract.

Cost Hours Rate per hour Total$

Labour 9,247 (W1) $15 138,705Variable Overhead 9,247 $ 8 (W2) 73,976Fixed Overhead 9,247 $ 4 (W2) 36,988

––––––––Total Cost 249,669

––––––––

(W1)

Need to calculate the time for the 200th kitchen by taking the total time for the 199 kitchens from the total time for 200kitchens.

For the 199 Kitchens

Usingy = axb OR y = axb

y = 24x199–0.074 y = (24 x 15) x 199–0.074

y = 16·22169061hours y = 243·32536Totaltime = 16·22169061x199 Total cost = $48,421·75Totaltime = 3,228·12hours

For the 200 Kitchens

y = axb OR y = axb

y = 24x200–0.074 y = (24 x 15) x 200–0.074

y = 16·21567465hours y = 243·2351198Totaltime = 16·21567465x200 Total cost = $48,647·02Totaltime = 3,243·13hours 200th cost = $225·27

The 200th Kitchen took 3,243·13 – 3,228·12 = 15·01 hours

Total time is therefore:

For first 200 3,243·13 hoursFor next 400 (15·01 hours x 400) 6,004·00 hoursTotal 9,247·13 hours (9,247 hours)

(W2)

The overheads need to be analysed between variable and fixed cost elements.

Taking the highest and lowest figures from the information given:

Hours Cost $Highest 9,600 116,800Lowest 9,200 113,600Difference 400 3,200

Variable cost per hours is $3,200/400hours = $8 per hour

Total cost = variable cost + fixed cost

116,800 = 9,600 x 8 + fixed cost

Fixed cost = $40,000 per month

Annual fixed cost = $40,000 x 12 = $480,000

Fixed absorption rate is $480,000/120,000 hours = $4 per hour

12

(c) A table is useful to show how the learning rate has been calculated.

Number of Time for Kitchen Cumulative time Average timeKitchens (hours) (hours) (hours)1 24·00 24·00 24·002 21·60 45·60 22·80

The learning rate is calculated by measuring the reduction in the average time per kitchen as cumulative production doubles(in this case from 1 to 2).

The learning rate is therefore 22·80/24·00 or 95%

4 (a) Lifecycle costing is a concept which traces all costs to a product over its complete lifecycle, from design through to cessation.It recognises that for many products there are significant costs to be incurred in the early stages of its lifecycle. This is probablyvery true for Wargrin Limited. The design and development of software is a long and complicated process and it is likely thatthe costs involved would be very significant.

The profitability of a product can then be assessed taking all costs into consideration.

It is also likely that adopting lifecycle costing would improve decision-making and cost control. The early development costswould have to be seen in the context of the expected trading results, therefore preventing a serious over spend at this stageor under pricing at the launch point.

(b) Budgeted results for game

Year 1 ($) Year 2 ($) Year 3 ($) Total ($)Sales 240,000 480,000 120,000 840,000Variable cost (W1) 40,000 80,000 20,000 140,000Fixed cost (W1) 80,000 120,000 80,000 280,000Marketing cost 60,000 40,000 100,000

––––––– –––––––– ––––––– ––––––––Profit 60,000 240,000 20,000 320,000

––––––– –––––––– ––––––– ––––––––

On the face of it the game will generate profits in each of its three years of life. Games only have a short lifecycle as the gameplayers are likely to become bored of the game and move on to something new.

The pattern of sales follows a classic product lifecycle with poor levels of sales towards the end of the life of the game.

The Stealth product has generated $320,000 of profit over its three year life measured on a traditional basis. This represents40% of turnover – ahead of its target. Indeed it shows a positive net profit in each of its years on existence.

The contribution level is steady at around 83% indicating reasonable control and reliability of the production processes. Thisfigure is better than the stated target.

Considering traditional performance management concepts, Wargrin Limited is likely to be relatively happy with the game’sperformance.

However, the initial design and development costs were incurred and were significant at $300,000 and are ignored in theannual profit calculations. Taking these into consideration, the game only just broke even, making a small $20,000 profit.Whether this is enough is debatable, it represents only 2·4% of sales for example. In order to properly assess the performanceof a product the whole lifecycle needs to be considered.

Workings

W1 Split of variable and fixed cost for Stealth

Volume Cost $High 14,000 units 150,000Low 10,000 units 130,000Difference 4,000 units 20,000

Variable cost per unit = $20,000/4,000 unit = $5 per unit

Total cost = fixed cost + variable cost$150,000 = fixed cost + (14,000 x $5)$150,000 = fixed cost +$70,000Fixed cost = $80,000 (and $120,000 if volume exceeds 15,000 units in a year.)

(c) Incremental budgeting is a process whereby this year’s budget is set by reference to last year’s actual results after anadjustment for inflation and other incremental factors. It is commonly used because:

– It is quick to do and a relatively simple process.– The information is readily available, so very limited quantitative analysis is needed.– It is appropriate in some circumstances. For example, in a stable business, the amount of stationery spent in one year

is unlikely to be significantly different in the next year, so taking the actual spend in year one and adding a little forinflation should be a reasonable target for the spend in the next year.

13

There are problems involved with incremental budgeting:

– It builds on wasteful spending. If the actual figures for this year include overspends caused by some form of error thenthe budget for the next year would potentially include this overspend again.

– It encourages organisations to spend up to the maximum allowed in the knowledge that if they don’t do this then theywill not have as much to spend in the following year’s budget.

– Assessing the amount of the increment can be difficult. – It is not appropriate in a rapidly changing business.– Can ignore the true (activity based) drivers of a cost leading to poor budgeting.

(d) Design and development costs: Setting a standard cost for this classification of cost would be very difficult. Presumably eachgame would be different and present the program writers with different challenges and hence take a varying amount of time.

Variable production cost: A game will be produced on a CD or DVD in a fairly standard format. Each CD/DVD will be identicaland as a result setting a standard cost would be possible. Allowance might need to be made for waste or faulty CDs produced.Some machine time will be likely and again this should be the same for all items and therefore setting a standard would bevalid.

Fixed production cost: The standard fixed production cost of a game will be the product of the time taken to produce thegame and the standard fixed overhead absorption rate for the business. This brings into question whether this is ‘meaningful’.Allocating fixed costs to products in a standard way may not provide meaningful data. It can sometimes imply a variability(cost per unit) that is not the case and can therefore confuse non-accountants, causing poor decisions. The time per unit willbe fairly standard.

Marketing costs: Games may have different target audiences and therefore require different marketing strategies. As suchsetting a standard may be difficult to do. It may be possible to set standards for each marketing media chosen. For examplethe rates for a page advert in a magazine could be set as a standard.

14


Marks1 (a) Calculations of performance statistics (1/2 each max 21/2) 21/2

Sales comment 1Gross margin comment 1Overheads comment 1Net margin comment 1ROI discussion 3

–––Max 8

(b) Timing of decision problem 1Revenue acceleration 1Delay of cost 1Manipulation of accounting policy 1

–––4

(c) Sales volume 11/2Sales price 11/2Gross profit year 1 1/2Gross profit year 2 1/2Gross profit year 3 1/2Gross profit year 4 1/2Overhead included 1Investment values 2ROI calculations 1

–––9

(d) Target net profit 1Target gross profit 1Target sales 1Target volume 1

–––4

–––Total 25

–––

15

Marks2 (a) Maximax explanation 1

Maximin explanation 1Expected value explanation 2

–––4

(b) Profit calculationsSmall van sales 1/2Small van VC 1/2Small van goodwill or VC adjustment 1Small van depreciation 1Medium van – as above for small van 3Large van as above for small van 3

–––9

(c) Optimist view 2Pessimist view 2Expected value calculation 1Expected value discussion 1

–––6

(d) Market Research 11/2Simulation 11/2Sensitivity 11/2Range 11/2–––

6–––

Total 25–––

3 (a) For each description 2–––

10

(b) Average time for 199th kitchen 1Total time for 199 kitchens 1Average time for 200th kitchen 1Total time for 200 kitchens 1200th kitchen time 1Cost for first 200 1Cost for next 400 1Variable cost per hour 2Fixed cost per month 1Fixed cost per hour 1Cost for variable overhead 1Cost for fixed overhead 1

–––13

(c) Average time per unit 1Explanation 1

–––2

–––Total 25

–––

16

Marks4 (a) Lifecycle costing principles:

Performance assessment over whole life 1Improved decision making/cost control 1Relate to Wargrin 2

–––4

(b) Sales 1Variable cost 1Fixed cost 2Marketing cost 1Comments on profit performance (against stated targets) 2Consideration of all lifecycle costs 2

–––9

(c) Why incremental budgeting common – per idea (max 3) 1Problems of incremental budgets – per idea (max 3) 1

–––6

(d) Discussion of each component 11/2–––Max 6

–––Total 25

–––

17



ALL FIVE questions are compulsory and MUST be attempted.





Pape

r F5Performance

Management

Monday 8 June 2009



2

ALL FIVE questions are compulsory and MUST be attempted

1 Yam Co is involved in the processing of sheet metal into products A, B and C using three processes, pressing,stretching and rolling. Like many businesses Yam faces tough price competition in what is a mature world market.

The factory has 50 production lines each of which contain the three processes: Raw material for the sheet metal isfirst pressed then stretched and finally rolled. The processing capacity varies for each process and the factory managerhas provided the following data:

Processing time per metre in hoursProduct A Product B Product C

Pressing 0·50 0·50 0·40Stretching 0·25 0·40 0·25Rolling 0·40 0·25 0·25

The factory operates for 18 hours each day for five days per week. It is closed for only two weeks of the year forholidays when maintenance is carried out. On average one hour of labour is needed for each of the 225,000 hoursof factory time. Labour is paid $10 per hour.

The raw materials cost per metre is $3·00 for product A, $2·50 for product B and $1·80 for product C. Other factorycosts (excluding labour and raw materials) are $18,000,000 per year. Selling prices per metre are $70 for productA, $60 for product B and $27 for product C.

Yam carries very little inventory.

Required:

(a) Identify the bottleneck process and briefly explain why this process is described as a ‘bottleneck’.(3 marks)

(b) Calculate the throughput accounting ratio (TPAR) for each product assuming that the bottleneck process isfully utilised. (8 marks)

(c) Assuming that the TPAR of product C is less than 1:

(i) Explain how Yam could improve the TPAR of product C. (4 marks)(ii) Briefly discuss whether this supports the suggestion to cease the production of product C and briefly

outline three other factors that Yam should consider before a cessation decision is taken. (5 marks)

(20 marks)

3 [P.T.O.

2 Oliver is the owner and manager of Oliver’s Salon which is a quality hairdresser that experiences high levels ofcompetition. The salon traditionally provided a range of hair services to female clients only, including cuts, colouringand straightening

A year ago, at the start of his 2009 financial year, Oliver decided to expand his operations to include the hairdressingneeds of male clients. Male hairdressing prices are lower, the work simpler (mainly hair cuts only) and so the timetaken per male client is much less.

The prices for the female clients were not increased during the whole of 2008 and 2009 and the mix of servicesprovided for female clients in the two years was the same.

The latest financial results are as follows:

2008 2009$ $ $ $

Sales 200,000 238,500Less cost of sales:Hairdressing staff costs 65,000 91,000Hair products – female 29,000 27,000Hair products – male 8,000

––––––– –––––––94,000 126,000

–––––––– ––––––––Gross profit 106,000 112,500Less expenses:Rent 10,000 10,000Administration salaries 9,000 9,500Electricity 7,000 8,000Advertising 2,000 5,000

––––––– –––––––Total expenses 28,000 32,500

–––––––– ––––––––Profit 78,000 80,000

–––––––– ––––––––

Oliver is disappointed with his financial results. He thinks the salon is much busier than a year ago and was expectingmore profit. He has noted the following extra information:

1. Some female clients complained about the change in atmosphere following the introduction of male services,which created tension in the salon.

2. Two new staff were recruited at the start of 2009. The first was a junior hairdresser to support the specialisthairdressers for the female clients. She was appointed on a salary of $9,000 per annum. The second new staffmember was a specialist hairdresser for the male clients. There were no increases in pay for existing staff at thestart of 2009 after a big rise at the start of 2008 which was designed to cover two years’ worth of increases.

Oliver introduced some non-financial measures of success two years ago.

2008 2009Number of complaints 12 46Number of male client visits 0 3,425Number of female client visits 8,000 6,800Number of specialist hairdressers for female clients 4 5Number of specialist hairdressers for male clients 0 1

4

Required:

(a) Calculate the average price for hair services per male and female client for each of the years 2008 and 2009.(3 marks)

(b) Assess the financial performance of the Salon using the data above. (11 marks)

(c) Analyse and comment on the non-financial performance of Oliver’s business, under the headings of qualityand resource utilisation. (6 marks)

(20 marks)

5 [P.T.O.

3 Crumbly Cakes make cakes, which are sold directly to the public. The new production manager (a celebrity chef) hasargued that the business should use only organic ingredients in its cake production. Organic ingredients are moreexpensive but should produce a product with an improved flavour and give health benefits for the customers. It washoped that this would stimulate demand and enable an immediate price increase for the cakes.

Crumbly Cakes operates a responsibility based standard costing system which allocates variances to specificindividuals. The individual managers are paid a bonus only when net favourable variances are allocated to them.

The new organic cake production approach was adopted at the start of March 2009, following a decision by the newproduction manager. No change was made at that time to the standard costs card. The variance reports for Februaryand March are shown below (Fav = Favourable and Adv = Adverse)

Manager responsible Allocated variances February MarchVariance $ Variance $

Production managerMaterial price (total for all ingredients) 25 Fav 2,100 AdvMaterial mix 0 600 AdvMaterial yield 20 Fav 400 Fav

Sales managerSales price 40 Adv 7,000 FavSales contribution volume 35 Adv 3,000 Fav

The production manager is upset that he seems to have lost all hope of a bonus under the new system. The salesmanager thinks the new organic cakes are excellent and is very pleased with the progress made.

Crumbly Cakes operate a JIT stock system and holds virtually no inventory.

Required:

(a) Assess the performance of the production manager and the sales manager and indicate whether the currentbonus scheme is fair to those concerned. (7 marks)

In April 2009 the following data applied:

Standard cost card for one cake (not adjusted for the organic ingredient change)

Ingredients Kg $Flour 0·10 0·12 per kgEggs 0·10 0·70 per kgButter 0·10 1·70 per kgSugar 0·10 0·50 per kgTotal input 0·40Normal loss (10%) (0·04)Standard weight of a cake 0·36Standard sales price of a cake 0·85Standard contribution per cake after all variable costs 0·35

6

The budget for production and sales in April was 50,000 cakes. Actual production and sales was 60,000 cakes inthe month, during which the following occurred:

Ingredients used Kg $Flour 5,700 $741Eggs 6,600 $5,610Butter 6,600 $11,880Sugar 4,578 $2,747Total input 23,478 $20,978Actual loss (1,878)Actual output of cake mixture 21,600Actual sales price of a cake $0·99

All cakes produced must weigh 0·36 kg as this is what is advertised.

Required:

(b) Calculate the material price, mix and yield variances and the sales price and sales contribution volumevariances for April. You are not required to make any comment on the performance of the managers.

(13 marks)

(20 marks)

7 [P.T.O.

4 Bits and Pieces (B&P) operates a retail store selling spares and accessories for the car market. The store has previouslyonly opened for six days per week for the 50 working weeks in the year, but B&P is now considering also opening onSundays.

The sales of the business on Monday through to Saturday averages at $10,000 per day with average gross profit of70% earned.

B&P expects that the gross profit % earned on a Sunday will be 20 percentage points lower than the average earnedon the other days in the week. This is because they plan to offer substantial discounts and promotions on a Sundayto attract customers. Given the price reduction, Sunday sales revenues are expected to be 60% more than the averagedaily sales revenues for the other days. These Sunday sales estimates are for new customers only, with no allowancebeing made for those customers that may transfer from other days.

B&P buys all its goods from one supplier. This supplier gives a 5% discount on all purchases if annual spend exceeds$1,000,000.

It has been agreed to pay time and a half to sales assistants that work on Sundays. The normal hourly rate is $20per hour. In total five sales assistants will be needed for the six hours that the store will be open on a Sunday. Theywill also be able to take a half-day off (four hours) during the week. Staffing levels will be allowed to reduce slightlyduring the week to avoid extra costs being incurred.

The staff will have to be supervised by a manager, currently employed by the company and paid an annual salary of$80,000. If he works on a Sunday he will take the equivalent time off during the week when the assistant manageris available to cover for him at no extra cost to B&P. He will also be paid a bonus of 1% of the extra sales generatedon the Sunday project.

The store will have to be lit at a cost of $30 per hour and heated at a cost of $45 per hour. The heating will comeon two hours before the store opens in the 25 ‘winter’ weeks to make sure it is warm enough for customers to comein at opening time. The store is not heated in the other weeks

The rent of the store amounts to $420,000 per annum.

Required:

(a) Calculate whether the Sunday opening incremental revenue exceeds the incremental costs over a year (ignoreinventory movements) and on this basis reach a conclusion as to whether Sunday opening is financiallyjustifiable. (12 marks)

(b) Discuss whether the manager’s pay deal (time off and bonus) is likely to motivate him. (4 marks)

(c) Briefly discuss whether offering substantial price discounts and promotions on Sunday is a good suggestion.(4 marks)

(20 marks)

8

5 Northland’s major towns and cities are maintained by local government organisations (LGO), which are funded bycentral government. The LGOs submit a budget each year which forms the basis of the funds received.

You are provided with the following information as part of the 2010 budget preparation.

Overheads

Overhead costs are budgeted on an incremental basis, taking the previous year’s actual expenditure and adding a set% to allow for inflation. Adjustments are also made for known changes. The details for these are:

Overhead cost category 2009 cost ($) Known changes Inflation adjustmentbetween 2009 and 2010

Property cost 120,000 None +5%Central wages 150,000 Note 1 below +3%Stationery 25,000 Note 2 below 0%

Note 1: One new staff member will be added to the overhead team; this will cost $12,000 in 2010

Note 2: A move towards the paperless office is expected to reduce stationery costs by 40% on the 2009 spend

Road repairs

In 2010 it is expected that 2,000 metres of road will need repairing but a contingency of an extra 10% has beenagreed.

In 2009 the average cost of a road repair was $15,000 per metre repaired, but this excluded any cost effects ofextreme weather conditions. The following probability estimates have been made in respect of 2010:

Weather type predicted Probability Increase in repair costGood 0·7 0Poor 0·1 +10%Bad 0·2 +25%

Inflation on road repairing costs is expected to be 5% between 2009 and 2010.

New roads

New roads are budgeted on a zero base basis and will have to compete for funds along with other capital projectssuch as hospitals and schools.

Required:

(a) Calculate the overheads budget for 2010. (3 marks)

(b) Calculate the budgets for road repairs for 2010. (6 marks)

(c) Explain the problems associated with using expected values in budgeting by an LGO and explain why acontingency for road repairs might be needed. (8 marks)

(d) Explain the process involved for zero based budgeting. (3 marks)

(20 marks)

9 [P.T.O.

10

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

x) )(n y) )2 2 2 2


Answers


1 Yam Co

(a) The output capacity for each process is as follows:

The total processing hours of the factory is given but can be proven as follows:18 hours x 5 days x 50 weeks x 50 production lines = 225,000 hours.

Given this, the production capacity for pressing must be 225,000 hours/0·5 hours per metre = 450,000 metres. Using thismethod the production capacity for all processes is as follows:

Product A Product B Product CPressing 450,000 450,000 562,500Stretching 900,000 562,500 900,000Rolling 562,500 900,000 900,000

The bottleneck is clearly the pressing process which has a lower capacity for each product. The other processes will probablybe slowed to ensure smooth processing.

Clearly an alternative approach is simply to look at the original table for processing speed and pick out the slowest process.This is pressing. (full marks available for that explained observation)

(b) TPAR for each product

Product A Product B Product CSelling price 70·0 60·0 27·0Raw materials 3·0 2·5 1·8Throughput 67·0 57·5 25·2Throughput per bottleneck hour* 134·0 115·0 63·0Fixed costs per hour (W1) 90·0 90·0 90·0TPAR 1·49 1·28 0·7

Working* 67/0·5 = 134 57·5/0·5 = 115 25·2/0·4 = 63

W1 The fixed cost per bottleneck hour can be calculated as follows:Total fixed costs are $18,000,000 plus the labour cost. Labour costs $10 per hour for each of the 225,000 processinghours, a cost of $2,250,000.

Total fixed cost is therefore $18,000,000 + $2,250,000 = $20,250,000

Fixed cost per bottleneck hours is $20,250,000/225,000 = $90 per hour

(c) (i) Yam could improve the TPAR of product C in various ways:

Speed up the bottleneck process. By increasing the speed of the bottleneck process the rate of throughput will alsoincrease, generating a greater rate of income for Yam if the extra production can be sold. Automation might be used ora change in the detailed processes. Investment in new machinery can also help here but the cost of that would need tobe taken into account.

Increase the selling prices. It can be difficult to increase selling prices in what we are told is a competitive market.Volume of sales could be lost leaving Yam with unsold stock or idle equipment. On the other hand, given the businessappears to be selling all it can produce, then a price increase may be possible.

Reduce the material prices. Reducing material prices will increase the net throughput rate. Metal is available from manysources being far from a unique product. Given the industry is mature the suppliers of the raw material could be willingto negotiate on price; this could have volume or quality based conditions attached. Yam will have to be careful to protectits quality levels. Bulk buying increases stock levels and the cost of that would need to be considered.

Reduce the level of fixed costs. The fixed costs should be listed and targets for cost reduction be selected. ABCtechniques can help to identify the cost drivers and with management these could be used to reduce activity levels andhence cost. Outsourcing, de-skilling or using alternative suppliers (for stationery for example) are all possible costreduction methods.

(ii) A TPAR of less than one indicates that the rate at which product C generates throughput (sales revenue less materialcost) is less than the rate at which Yam incurs fixed cost. So on a simple level, producing a product which incurs fixedcost faster than it generates throughput does not seem to make commercial sense. Clearly the TPAR could be improved(using the methods above) before cessation is considered any further.

However, cessation decisions involve consideration of many wider issues (only three required).

– Long-term expected net cash flows from the product allowing for the timing of those cash flows (NPV) are animportant factor in cessation decisions

– Customer perception could be negative in that they will see a reduction in choice

13

– Lost related sales: if product C is lost will Yam lose customers that bought it along with another product?– What use could be made of the excess capacity that is created– Throughput assumes that all costs except raw materials are fixed; this may not necessarily be the case and only

avoidable fixed costs need to be taken into account for a cessation decision. If few fixed costs can be avoided thenproduct C is making a contribution that will be lost if the product ceased.

2 Oliver’s Salon

(a) The average price for hairdressing per client is as follows:

2008: Female clients paid $200,000 for 8,000 visits. This is an average price per visit of $200,000/8,000 = $25.

In 2009 the female hairdressing prices did not increase and the mix of sales did not change so of the total revenue $170,000(6,800 x $25) was from female clients. This means that the balance of $68,500 ($238,500 – $170,000) was from maleclients at an average price of $20 per visit ($68,500/3,425).

(b) Financial performance assessment

Hairdressing sales growth: Oliver’s Salon has grown significantly during the two years, with an increase of 19·25% (W1).This is impressive in a mature industry like hairdressing.

The increase has come from the launch of the new male hairdressing with a significant contraction in the core female business– down 15% (W1).

Hairdressing gross margin: Oliver’s hairdressing overall gross margin has reduced significantly, down from 53% to 47·2% in2009 (W2).

There has been an increase in staff numbers for the female part of the business and this, combined with the fall in the volumeof sales from female clients, has significantly damaged margins from that customer type, with a fall from 53% to 40·5%(W2).

The margins from male clients in 2009 are 63·5% which is better than that achieved in 2008 from the female clients. Thisis probably mainly due to faster throughput, so that despite the lower average prices charged the overall margin was still quitegood.

Staff costs: The staffing levels have had to increase to accommodate the new male market and the extra levels of business.The new hairdresser for the male clients is being paid slightly more than the previously employed staff (W3). This mightencourage dissatisfaction. The addition of a junior will clearly reduce the overall average wage bill but increases costs overallwhilst the volume of female clients is shrinking.

Advertising spend: This has increased by 150% in the year (W4). This is probably nothing to worry about as it is likely thatthe launching of the new product range (males!) will have required advertising. Indeed, given the increase in sales of malehair services it is fair to say that the money was well spent.

Rent is clearly a fixed cost and administrative expenses have gone up a mere 5·5%; these costs appear under control giventhe overall volume of clients is well up on 2008.

Electricity costs have jumped 14·3% which seems a lot but is probably a cost which Oliver would find hard to control. Energycompanies are often very large organisations where competition is rarely significant. Small businesses have little choice butto pay the going rate for energy.

Net Profit: Overall net profit has worsened to 33·5% from 39% (W8). This is primarily due to the weakening gross marginand extra costs incurred for advertising. The advertising cost may not recur and so the net margin might improve next year.

Overall it is understandable that Oliver is disappointed with the financial results. With a 19·25% increase in overall sales hemight have expected more net profit.

(c) Non-financial performance

Quality: The number of complaints is up by 283% (W5) and is proportionately more frequent. This seems to be due to twomain reasons. Firstly the switch away from a single gender salon has upset the existing customer base. It is possible that bytrying to appeal to more customer types Oliver is failing to meet the needs of at least one group. It may be that the quality ofhair services has not worsened but that the complaints are regarding the change towards a multi-gender business.

Secondly the wage rates paid to the new junior staff seem to be well below the wage rates of the existing staff (W3). Thisimplies that they are in training and could be of poorer quality. It is stated that they are in a supporting role but if not properlysupervised then mistakes could easily occur. This can easily lead to complaints from dissatisfied customers.

Resource utilisation: The main resources that Oliver has are the staff and the rented property. As far as the property isconcerned the asset is being used to a much higher degree with 27·8% more clients being serviced in the year (W6).However, as the overall margins are lower one might argue that just focusing solely on volume misses the point on assetutilisation.

14

As far as the staff usage is concerned it is a mixed scene. The female specialists are producing less per member of staff thanin 2008 after the recruitment of one more staff member and a fall in volume of female clients. Each specialist served 2,000female clients in 2008 and only 1,360 in 2009 (W9). Oliver may have been concerned with the complaints coming in anddecided to do something about service levels by increasing resources for the female clients.

The specialist dealing with male clients has produced far more treatments than those serving the females. This is probablynot unusual; we are told that the male customer requires only a simple service. Without comparative data we cannot saywhether 3,425 customers per year is good. We also cannot say that this specialist is doing ‘better’ than the others. Cuttingmen’s hair is quicker to do, so more output is inevitable.

Workings:

(W1) Sales growth overall is $238,500/$200,000 or +19·25%. The female hairdressing sales has though fallen by 15%($200,000 – $170,000)/$200,000. This is entirely reflected in volume as there was no price increase in 2009 forfemale clients.

(W2) Gross margin overall is $106,000/$200,000 or 53% in 2008 and $112,500/238,500 or 47·2% in 2009.

This can be analysed between the female and male clients:

2008 2009Female $ $ Female $ Male $

Sales 200,000 170,000 68,500Less cost of sales:Hairdressing staff costs (W3) (65,000) (74,000) (17,000)Hair products – female (29,000) (27,000)Hair products – male (8,000)

–––––––– ––––––– –––––––Gross profit 106,000 69,000 43,500

–––––––– ––––––– –––––––GP% 53% 40·5% 63·5%

(W3) Staff cost growth is $91,000/$65,000 or +40%. In absolute terms average staff costs were $65,000/4 = $16,250in 2008.

Additional staff cost $26,000 ($91,000 – $65,000) in total for two people. The junior was paid $9,000 and so thenew specialist for the male customers must have been paid $17,000

(W4) Advertising increased by $5,000/$2,000 or 150%

(W5) Number of complaints up by 46/12 or 283%. Complaints per customer visit up from 12/8,000 or 0·15% to46/10,225 or 0·44%

(W6) Client growth is 10,225/8,000 or 27·8%

(W7) Number of female clients per specialist is 8,000/4 or 2,000 in 2008 and 6,800/5 or 1,360 in 2009. Number of maleclients per specialist is 3,425 in 2009.

(W8) Net profit is $78,000/200,000 or 39% in 2008 and $80,000/238,500 or 33·5% in 2009.

3 Crumbly Cakes

(a) Production managerAssessing the performance of the two managers is difficult in this situation. In a traditional sense the production manager hasseriously over spent in March following the move to organic ingredients. He has a net adverse variance against his departmentof $2,300 in one month. No adjustment to the standards has been made to allow for the change to organic.

The manager has not only bought organically he has also changed the mix, increasing the input proportion of the moreexpensive ingredients. This may have contributed to the increased sales of cakes.

However, the decision to go organic has seen the sales of the business improve. We are told that the taste of the cakes shouldbe better and that customers could perceive a health benefit. However, the production manager is allocated none of thefavourable sales variances that result. If we assume that the improved sales are entirely as a result of the productionmanager’s decision to change the ingredients then the overall net favourable variance is $7,700.

The production manager did appear to be operating within the original standard in February, indicating a well performingdepartment. Indeed he will have earned a small bonus in that month.

Sales managerA change to organic idea would need to be ‘sold’ to customers. It would presumably require a change of marketing and propercommunication to customers. The sales manager would probably feel he has done a good job in March. It is debatable,however, whether he is entirely responsible for all of the favourable variances.

The move to organic certainly helped the sales manager as in February he seems to have failed to meet his targets.

15

Bonus schemeThe problem here is that the variances have to be allocated to one individual. The good sales variances have been allocatedto the sales manager when in truth the production manager’s decision to go organic appears to have been a good one andthe driver of the business success. Responsibility accounting systems struggle to cope with ‘joint’ success stories, refuting ingeneral a collective responsibility.

Under the current standards the production manager has seemingly no chance to make a bonus. The main problems appearto be the out-of-date standards and the fact that all sales variances are allocated to the sales manager, despite the root causeof the improved performance being at least in part the production manager’s decision to go organic. The system does notappear fair.

General commentsIt would appear that some sharing of the total variances is appropriate. This would be an inexact science and some negotiationwould be needed.

One problem seems to be that the original standards were not changed following the decision to go organic. In this sense thevariances reported are not really ‘fair’. Standards should reflect achievable current targets and this is not the case here.

(b) Variance calculations

Material price variancesIngredient Act price/kg Std price/kg Actual (AP – SP) x AQ Adv or Fav

quantity kg MPVFlour 0·13 0·12 5,700 57 AdvEggs 0·85 0·70 6,600 990 AdvButter 1·80 1·70 6,600 660 AdvSugar 0·60 0·50 4,578 458 Adv

––––––Total 2,165 Adv

––––––

Material mix varianceIngredient Act mix Std mix Std price Variance Adv or FavFlour 5,700 5,870 0·12 –20Eggs 6,600 5,870 0·70 511Butter 6,600 5,870 1·70 1,241Sugar 4,578 5,870 0·50 –646

––––––– ––––––– ––––––Totals 23,478 23,478 1,086 Adv

––––––– ––––––– ––––––

Material yield varianceActual yield 60,000 cakesStandard yield (23,478/0·4) 58,695 cakesDifference 1,305 cakesStandard cost of a cake (W1) $0·302Yield variance (1,305 * 0·302) 394 Fav

Sales price varianceAct price Std Price Act volume (AP – SP) Adv or Fav

* Act VolVariance

Cake 0·99 0·85 60,000 8,400 Fav

Sales volume contribution varianceActual volume 60,000 cakesBudget volume 50,000 cakesStandard contribution 0·35Variance (60,000 – 50,000) * 0·35 = $3,500 Fav

W1Standard cost of a cakeIngredients Kg $ CostFlour 0·10 $0·12 per kg 0·012Eggs 0·10 $0·70 per kg 0·070Butter 0·10 $1·70 per kg 0·170Sugar 0·10 $0·50 per kg 0·050Total input 0·40 0·302Normal loss (10%) (0·04)

–––––Standard weight/cost of a cake 0·36 0·302

16

4 Bits and Pieces

(a) The decision to open on Sundays is to be based on incremental revenue and incremental costs:

Ref $ $Incremental revenue W1 800,000Incremental costs– Cost of sales W2 335,000– Staff W3 45,000– Lighting W4 9,000– Heating W5 9,000– Manager’s bonus W6 8,000– Total 406,000

––––––––Net incremental revenue 394,000

––––––––

Conclusion

On the basis of the above it is clear that the incremental revenue exceeds the incremental costs and therefore it is financiallyjustifiable.

(W1) Incremental revenue

Day Sales Gross profit Gross profit Cost of Sales$ % $ $

Average 10,000 70%Sunday (+60% of average) 16,000 50% 8,000 8,000Annually (50 days) 800,000 400,000 400,000Current results (300 days) 3,000,000 70·0% 2,100,000New results 3,800,000 65·8% 2,500,000

(W2) Purchasing and discount on purchasingExtra purchasing from Sunday trading is $800,000 – $400,000 = $400,000

Current annual purchasing is $18,000 x 50 =$900,000

New annual purchasing is ($900,000 + $400,000) x 0·95 = $1,235,000

Incremental cost is $1,235,000 – $900,000 = $335,000 (a $65,000 discount)

(W3) Staff costsStaff costs on a Sunday are 5 staff x 6 hours x $20 per hour x 1·5 = $900 per dayAnnual cost is $900 x 50 days = $45,000

(W4) Lighting costsLighting costs are 6 hours x $30 per hour x 50 days = $9,000

(W5) Heating costsHeating cost in winter is 8 hours x $45 per hour x 25 days = $9,000

(W6) Manager’s bonusThis is based on the incremental revenue $800,000 x 1% = $8,000 (or $160 per day)

(b) The manager’s rewards can be summarised as follows:

Time offThis appears far from generous. The other staff are being paid time and a half and yet the manager does not appear to havethis option and also is only being given time off in lieu (TOIL) at normal rates. Some managers may want their time back asTOIL so as to spend time with family or social friends; others may want the cash to spend. One would have thought someflexibility would have been sensible if the manager is to be motivated properly.

BonusThe bonus can be calculated at $8,000 per annum (W6); on a day worked basis, this is $160 per day. This is less than thatbeing paid to normal staff; at time and a half they earn 6 hours x $20 x 1·5 = $180 per day. It is very unlikely to be enoughto keep the presumably better qualified manager happy. Indeed the bonus is dependent on the level of new sales and so thereis an element of risk involved for the manager. Generally speaking higher risk for lower returns is far from motivating.

The level of sales could of course be much bigger than is currently predicted. However, given the uplift on normal averagedaily sales is already +60%, this is unlikely to be significant.

(c) Discounts and promotion

When new products or in this case opening times are launched then some form of market stimulant is often necessary. B&Phas chosen to offer substantial discounts and promotions. There are various issues here:

Changing buying patterns: It is possible that customers might delay a purchase a day or two in order to buy on a Sunday.This would cost the business since the margin earned on Sunday is predicted to be 20% points lower than on other days.

17

Complaints: Customers that have already bought an item on another day might complain when they see the same producton sale for much less when they come back in for something else on a Sunday. Businesses need to be strong in this regardin that they have to retain control over their pricing policy. Studies have shown that only a small proportion of people willactually complain in this situation. More might not, though, be caught out twice and hence will change the timing ofpurchases (as above).

Quality: The price of an item can say something about its quality. Low prices tend to suggest poor quality and vice versa.B&P should be careful so as not to suggest that lower prices do not damage the reputation of the business as regards quality.

5 Northland

(a) Overhead costs for the 2010 budget:

Property cost = $120,000 x 1·05 = $126,000Central wages = ($150,000 x 1·03) + $12,000 = $166,500Stationery = $25,000 x 0·6 = $15,000

(b) The road repair budget will be based on 2,200 metres of road repairs; it is common to include a contingency in case roadsunexpectedly need repair (see part (c)).

The weather conditions could add an extra cost to the budget if poor or bad conditions exist. The adjustment needed is basedon an expected value calculation:

(0·7 x 0%) + (0·1 x 10%) + (0·2 x 25%) = 6%

Hence the budget (after allowing for a 5% inflation adjustment) will be:

2,200 x $15,000 x 1·06 x 1·05 = $36,729,000

This could be shown as:

(2,200 x 15,000 x 1·0 x 0·7) + (2,200 x 15,000 x 1·1 x 0·1) + (2,200 x 15,000 x 1·25 x 0·2) = $34,980,000

The $34,980,000 could then be adjusted for inflation at 5% to give $36,729,000 as above.

(c) An expected value calculation used in budgeting has the following problems associated with it:

– It is often difficult to estimate the probabilities associated with different (in this case) weather conditions. The weatherin one year may not reflect the weather in the following year leading to wildly inaccurate estimates and hence budgetingerrors.

– It is difficult to estimate the precise monetary value attaching to each of the outcomes. ‘Bad’ weather can presumablytake many forms (extreme cold, heat or water); the effect of each of these could be difficult to assess. Whilst usingexpected values it is common to group the events together and have one probability estimate. This may prove inadequateor inaccurate.

– The expected value that is calculated might not reflect the true cost leading to over or under spends on budget.– The managers will have an easy fallback position should the budgets turn out to be incorrect. It would probably be

accepted that the weather (and hence the probability of it) is outside their control and over spends could not then beblamed on them.

A contingency is often added to a budget in the event that there is uncertainty on the likely spend. In this case there wouldbe much uncertainty over the level and indeed type of road repairs required. Roads could be damaged by weather conditions(extreme cold or heat) or unexpected land movements (earthquakes). Public safety could be at risk meaning that a repair isessential. This could result in a higher spend.

Equally the type of repair needed would vary and be unpredictable. Small holes might be simply filled in but larger holes orcracks might involve repairs to the foundations of the road. The costs could differ considerably between the different types ofrepairs.

(d) Zero based budgeting involves three main steps:

– Define decision packages. These are detailed descriptions of the activities to be carried out. There will be somestandardisation within the data to allow comparison with other activities (costs, time taken and so on). A cost-benefitanalysis is often carried out at this stage to ensure the most cost effective and beneficial approach to the activity is taken.

– Evaluation and ranking of activities. Each activity is assessed; those that are perhaps part of a legal obligation become‘must do’ activities; others may be viewed as discretionary. The LGO will have to decide which of the activities offer thegreatest value for money (VFM) or the greatest benefit for the lowest cost.

– Allocation of resource. The budget will then be created for the accepted activities.

18


Marks Marks1 (a) Identification of bottleneck 1

Explanation 2–––

3

(b) Sales prices (per product) 0·5Raw material cost (per product) 0·5Throughput per bottleneck hour (per product) 0·5Fixed costs 1·5Fixed cost per hour 0·5TPAR (per product) 0·5

–––8

(c) (i) Increase speed of bottleneck 1Increase selling prices – difficult to do 1Reduce material prices 1Reduce level of fixed costs 1

–––4

(ii) Explain a TPAR 2Long-term cash flows 1Lost related sales 1Use of spare capacity 1Fixed costs 1Any other reasonable factor e.g. lost contribution 1

–––Maximum 5

–––Total 20

–––

2 (a) Average price for female customers 1Average price for male customers 2

–––3

(b) Sales growth 2Gross margin 2Rent 1Advertising spend 2Staff costs 2Electricity 1Overall comment 1

–––11

(c) Quality – single gender 1·5Quality – wage levels 1·5Quality – other 1·5Resource utilisation – property 1Resource utilisation – staff 2Resource utilisation – other 1·5

–––Maximum 6

–––Total 20

–––

19

Marks Marks3 (a) Production manager assessment 2

Sales manager assessment 2Bonus scheme comment 3

–––7

(b) Price variance 3Mix variance 3Yield variance 3Sales price variance 2Sales volume variance 2

–––13

–––Total 20

–––

4 (a) Existing total sales 1New sales 1Incremental sales 1Existing purchasing 1Discount allowed for 1Incremental Sunday purchasing costs 1Staff cost 1Lighting cost 1Heating cost 1Manager’s bonus 1

–––Maximum 12

(b) Time off at normal rate not time and a half 1Lack of flexibility 1Bonus per day worked calculation and comment 1Risk 1

–––4

(c) Changing customer buying pattern 2Complaints risk 2Quality link 2

–––Maximum 4

–––Total 20

–––

20

Marks Marks5 (a) Property cost 1

Central wages 1Stationery 1

–––3

(b) Basic budget 2Contingency included 2Expected value adjustment 2

–––6

(c) Probability estimates difficult 1Monetary values uncertain 1EV not an actual value 1Easy fall back for managers 1ContingencyUncertainty issue 1Weather 1Other outside influences 1Type of repairs variable 1

–––8

(d) Explanation of ZBB process 3–––

3–––

Total 20–––

21








Pape

r F5Performance

Management




1 Secure Net (SN) manufacture security cards that restrict access to government owned buildings around the world.

The standard cost for the plastic that goes into making a card is $4 per kg and each card uses 40g of plastic after anallowance for waste. In November 100,000 cards were produced and sold by SN and this was well above thebudgeted sales of 60,000 cards.

The actual cost of the plastic was $5·25 per kg and the production manager (who is responsible for all buying andproduction issues) was asked to explain the increase. He said ‘World oil price increases pushed up plastic prices by20% compared to our budget and I also decided to use a different supplier who promised better quality and increasedreliability for a slightly higher price. I know we have overspent but not all the increase in plastic prices is my fault’

The actual usage of plastic per card was 35g per card and again the production manager had an explanation. He said‘The world-wide standard size for security cards increased by 5% due to a change in the card reader technology,however, our new supplier provided much better quality of plastic and this helped to cut down on the waste.’

SN operates a just in time (JIT) system and hence carries very little inventory.

Required:

(a) Calculate the total material price and total material usage variances ignoring any possible planning error inthe figures. (4 marks)

(b) Analyse the above total variances into component parts for planning and operational variances in as muchdetail as the information allows. (8 marks)

(c) Assess the performance of the production manager. (8 marks)

(20 marks)

2

2 Big Cheese Chairs (BCC) manufactures and sells executive leather chairs. They are considering a new design ofmassaging chair to launch into the competitive market in which they operate.

They have carried out an investigation in the market and using a target costing system have targeted a competitiveselling price of $120 for the chair. BCC wants a margin on selling price of 20% (ignoring any overheads).

The frame and massage mechanism will be bought in for $51 per chair and BCC will upholster it in leather andassemble it ready for despatch.

Leather costs $10 per metre and two metres are needed for a complete chair although 20% of all leather is wastedin the upholstery process.

The upholstery and assembly process will be subject to a learning effect as the workers get used to the new design.BCC estimates that the first chair will take two hours to prepare but this will be subject to a learning rate (LR) of 95%.The learning improvement will stop once 128 chairs have been made and the time for the 128th chair will be thetime for all subsequent chairs. The cost of labour is $15 per hour.

The learning formula is shown on the formula sheet and at the 95% learning rate the value of b is –0·074000581.

Required:

(a) Calculate the average cost for the first 128 chairs made and identify any cost gap that may be present atthat stage. (8 marks)

(b) Assuming that a cost gap for the chair exists suggest four ways in which it could be closed. (6 marks)

The production manager denies any claims that a cost gap exists and has stated that the cost of the 128th chair willbe low enough to yield the required margin.

(c) Calculate the cost of the 128th chair made and state whether the target cost is being achieved on the 128thchair. (6 marks)

(20 marks)

3 [P.T.O.

3 The Western is a local government organisation responsible for waste collection from domestic households. The newmanagement accountant of The Western has decided to introduce some new forecasting techniques to improve theaccuracy of the budgeting. The next budget to be produced is for the year ended 31 December 2010.

Waste is collected by the tonne (T). The number of tonnes collected each year has been rising and by using timeseries analysis the new management accountant has produced the following relationship between the tonnes collected(T) and the time period in question Q (where Q is a quarter number. So Q = 1 represents quarter 1 in 2009 and Q = 2 represents quarter 2 in 2009 and so on)

T = 2,000 + 25Q

Each quarter is subject to some seasonal variation with more waste being collected in the middle quarters of eachyear. The adjustments required to the underlying trend prediction are:

Quarter Tonnes1 –2002 +2503 +1504 –100

Once T is predicted the new management accountant hopes to use the values to predict the variable operating costsand fixed operating costs that The Western will be subjected to in 2010. To this end he has provided the followingoperating cost data for 2009.

Volume of waste Total operating cost in 2009(fixed + variable)

Tonnes $’000s2,100 9502,500 1,0102,400 1,0102,300 990

Inflation on the operating cost is expected to be 5% between 2009 and 2010.

The regression formula is shown on the formula sheet.

Required:

(a) Calculate the tonnes of waste to be expected in the calendar year 2010. (4 marks)

(b) Calculate the variable operating cost and fixed operating cost to be expected in 2010 using regressionanalysis on the 2009 data and allowing for inflation as appropriate. (10 marks)

Many local government organisations operate incremental budgeting as one of their main budgeting techniques. Theytake a previous period’s actual spend, adjust for any known changes to operations and then add a % for expectedinflation in order to set the next period’s budget.

(c) Describe two advantages and two disadvantages of a local government organisation funded by taxpayer’smoney using incremental budgeting as its main budgeting technique. (6 marks)

(20 marks)

4

4 Thatcher International Park (TIP) is a theme park and has for many years been a successful business, which hastraded profitably. About three years ago the directors decided to capitalise on their success and reduced theexpenditure made on new thrill rides, reduced routine maintenance where possible (deciding instead to repairequipment when it broke down) and made a commitment to regularly increase admission prices. Once an admissionprice is paid customers can use any of the facilities and rides for free.

These steps increased profits considerably, enabling good dividends to be paid to the owners and bonuses to thedirectors. The last two years of financial results are shown below.

2008 2009$ $

Sales 5,250,000 5,320,000Less expenses:Wages 2,500,000 2,200,000Maintenance – routine 80,000 70,000Repairs 260,000 320,000Directors salaries 150,000 160,000Directors bonuses 15,000 18,000Other costs (including depreciation) 1,200,000 1,180,000

–––––––––– ––––––––––Net profit 1,045,000 1,372,000

–––––––––– ––––––––––

Book value of assets at start of year 13,000,000 12,000,000

Dividend paid 500,000 650,000

Number of visitors 150,000 140,000

TIP operates in a country where the average rate of inflation is around 1% per annum.

Required:

(a) Assess the financial performance of TIP using the information given above. (14 marks)

During the early part of 2008 TIP employed a newly qualified management accountant. He quickly becameconcerned about the potential performance of TIP and to investigate his concerns he started to gather data to measuresome non-financial measures of success. The data he has gathered is shown below:

Table 1

2008 2009Hours lost due to breakdown of rides (see note 1) 9,000 hours 32,000 hoursAverage waiting time per ride 20 minutes 30 minutes

Note 1: TIP has 50 rides of different types. It is open 360 days of the year for 10 hours each day

Required:

(b) Assess the quality of the service that TIP provides to its customers using Table 1 and any other relevant dataand indicate the risks it is likely to face if it continues with its current policies. (6 marks)

(20 marks)

5 [P.T.O.

5 Stay Clean manufactures and sells a small range of kitchen equipment. Specifically the product range contains adishwasher (DW), a washing machine (WM) and a tumble dryer (TD). The TD is of a rather old design and has forsome time generated negative contribution. It is widely expected that in one year’s time the market for this design ofTD will cease, as people switch to a washing machine that can also dry clothes after the washing cycle has completed.

Stay Clean is trying to decide whether or not to cease the production of TD now or in 12 months’ time when the newcombined washing machine/drier will be ready. To help with this decision the following information has been provided:

1. The normal selling prices, annual sales volumes and total variable costs for the three products are as follows:

DW WM TDSelling price per unit $200 $350 $80Material cost per unit $70 $100 $50Labour cost per unit $50 $80 $40Contribution per unit $80 $170 –$10Annual sales 5,000 units 6,000 units 1,200 units

2. It is thought that some of the customers that buy a TD also buy a DW and a WM. It is estimated that 5% of thesales of WM and DW will be lost if the TD ceases to be produced.

3. All the direct labour force currently working on the TD will be made redundant immediately if TD is ceased now.This would cost $6,000 in redundancy payments. If Stay Clean waited for 12 months the existing labour forcewould be retained and retrained at a cost of $3,500 to enable them to produce the new washing/drying product.Recruitment and training costs of labour in 12 months’ time would be $1,200 in the event that redundancy takesplace now.

4. Stay Clean operates a just in time (JIT) policy and so all material cost would be saved on the TD for 12 monthsif TD production ceased now. Equally, the material costs relating to the lost sales on the WM and the DW wouldalso be saved. However, the material supplier has a volume based discount scheme in place as follows:

Total annual expenditure ($) Discount0–600,000 0%

600,001–800,000 1%800,001–900,000 2%900,001–960,000 3%960,001 and above 5%

Stay Clean uses this supplier for all its materials for all the products it manufactures. The figures given above inthe cost per unit table for material cost per unit are net of any discount Stay Clean already qualifies for.

5. The space in the factory currently used for the TD will be sublet for 12 months on a short-term lease contract ifproduction of TD stops now. The income from that contract will be $12,000.

6. The supervisor (currently classed as an overhead) supervises the production of all three products spendingapproximately 20% of his time on the TD production. He would continue to be fully employed if the TD ceasesto be produced now.

Required:

(a) Calculate whether or not it is worthwhile ceasing to produce the TD now rather than waiting 12 months(ignore any adjustment to allow for the time value of money). (13 marks)

(b) Explain two pricing strategies that could be used to improve the financial position of the business in the next12 months assuming that the TD continues to be made in that period. (4 marks)

(c) Briefly describe three issues that Stay Clean should consider if it decides to outsource the manufacture ofone of its future products. (3 marks)

(20 marks)

6

7

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

x) )(n y) )2 2 2 2


Answers

Fundamentals Level – Skills Module, Paper F5 Performance Management December 2009 Answers

1 (a) The total variances are as follows:

Total price variance = ($5.25 – $4)3,500kg = $4,375 Adverse

Total usage variance = (3,500 – 4,000)4 = $2,000 Favourable

This makes a total of $2,375 Adverse

(b) The planning variances are calculated by comparing the original budget and the revised standards after adjustment for factorsoutside the control of the organisation.

On this basis the revised standards would be a price of $4·80 per kg with revised usage at 42g per card.

Planning price variance = ($4·80 – $4)4,200 = $3,360 Adverse

Planning Usage variance = (4,200 – 4,000)$4 = $800 Adverse

The total planning error (variance) is $4,160 Adverse

The operational variances compare the actual spend with the revised budget figures.

Operational price variance = ($5·25 – $4·80)3,500kg = $1,575 Adverse

Operational usage variance = (3,500 – 4,200)$4·80 = $3,360 Favourable

The total operational variance is $1,785 Favourable

The method above is in line with the article previously written by the examiner and published in the ACCA student newsletter.Other methods applied consistently would score full marks.

(c) The production manager is subject to external pressures which appear beyond his control. The size of the security card hasto fit the reader of that card and if the industry specification changes there is nothing that he can do about that. This is, then,a ‘planning’ error and should not form part of any assessment of his performance.

Equally if world-wide oil prices increase (and hence plastic prices) then the production manager cannot control that. Thiswould be allocated as a planning error and ignored in an assessment of his performance.

The performance of the production manager should be based on the operational variances (and any relevant qualitativefactors). The decision to use a new supplier ‘cost’ an extra $1,575 in price terms. On the face of it this is, at least potentially,a poor performance. However, the manager seems to have agreed to the higher price on the promise of better quality andreliability. If this promise was delivered then this could be seen as a good decision (and performance). The savings in waste(partly represented by the usage variance) amount to $3,360 favourable. This would seem to suggest better quality. The factthat the production level jumped from 60,000 to 100,000 also suggests that suppliers’ reliability was good (in that they wereable to deliver so much). The net variance position is relevant at a saving of $1,785.

It is also possible that such a large increase in volume of sales and production should have yielded a volume based discountfrom suppliers. This should also be reflected in any performance assessment in that if this has not been secured it could beseen as a poor performance.

This is backed up by the lack of obvious quality problems since we are told that 100,000 cards were produced and sold inthe period, a huge increase on budget. The ability of a production manager to react and be flexible can often form a part ofa performance assessment.

In conclusion the manager could be said to have performed well.

2 (a) The average cost of the first 128 chairs is as follows:

$Frame and massage mechanism 51·00Leather 2 metres x $10/mtr x 100/80 25·00Labour (W1) 20·95

––––––Total 96·95

––––––

Target selling price is $120.

Target cost of the chair is therefore $120 x 80% = $96

The cost gap is $96·95 – $96·00 = $0·95 per chair

(W1)

The cost of the labour can be calculated using learning curve principles. The formula can be used or a tabular approach wouldalso give the average cost of 128 chairs. Both methods are acceptable and shown here.

11

Tabulation:

Cumulative output Average time per Total time (hrs) Average cost per (units) unit (hrs) chair at $15 per hour 1 22 1·94 1·8058 1·7147516 1·629012532 1·5475618864 1·47018378128 1·39667459 178·77 20·95

Formula:

Y = axb

Y = 2 x 128–0·074000581

Y = 1·396674592

The average cost per chair is 1·396674592 x $15 = $20·95

(b) To reduce the cost gap various methods are possible (only four are needed for full marks)

– Re-design the chair to remove unnecessary features and hence cost– Negotiate with the frame supplier for a better cost. This may be easier as the volume of sales improve as suppliers often

are willing to give discounts for bulk buying. Alternatively a different frame supplier could be found that offers a betterprice. Care would be needed here to maintain the required quality

– Leather can be bought from different suppliers or at a better price also. Reducing the level of waste would save on cost.Even a small reduction in waste rates would remove much of the cost gap that exists

– Improve the rate of learning by better training and supervision– Employ cheaper labour by reducing the skill level expected. Care would also be needed here not to sacrifice quality or

push up waste rates.

(c) The cost of the 128th chair will be:

$Frame and massage mechanism 51·00Leather 2 metres x $10/mtr x 100/80 25·00Labour 1·29 hours x $15 per hour (W2) 19·35

––––––Total 95·35

––––––

Against a target cost of $96 the production manager is correct in his assertion that the required return is now being achieved.

(W2)

Using the formula, we need to calculate the cost of the first 127 chairs and deduct that cost from the cost of the first 128chairs.

Y = axb

Y = 2 x 127–0·074000581

Y = 1·39748546Total time is 127 x 1·39748546 = 177·48 hoursTime for the 128th chair is 178·77 – 177·48 = 1·29 hours

3 (a) In 2010 the four quarters will be numbers 5–8, consequently the trend figures for waste to be collected will be:

Quarter 1 (Q = 5): 2,000 + 25(5) = 2,125 tonnesQuarter 2 (Q = 6): 2,000 + 25(6) = 2,150 tonnesQuarter 3 (Q = 7): 2,000 + 25(7) = 2,175 tonnesQuarter 4 (Q = 8): 2,000 + 25(8) = 2,200 tonnes

Seasonal adjustments are needed thus:

Quarter 1: 2,125 – 200 = 1,925Quarter 2: 2,150 + 250 = 2,400Quarter 3: 2,175 + 150 = 2,325Quarter 4: 2,200 – 100 = 2,100

Total tonnage is 1,925 + 2,400 + 2,325 + 2,100 = 8,750 tonnes for the year.

12

(b) Regression analysis can be used to calculate the variable operating and fixed operating costs in 2009.

Tonnes (X) Total Cost (Y) XY X2

$000’s2,100 950 1,995,000 4,410,0002,500 1010 2,525,000 6,250,0002,400 1010 2,424,000 5,760,0002,300 990 2,277,000 5,290,000

Sum 9,300 3,960 9,221,000 21,710,000

Y = a +bXWhere ‘a’ is fixed operating cost and ‘b’ is variable operating cost in this context.

Using the formula given:

b = (4 x 9,221,000 – 9,300 x 3,960)/(4 x 21,710,000 – (9,300)2)

b = 0·16 or $160 per tonne as the original data is in $000’s. This was the variable operating cost per tonne for 2009.

a = (3,960/4) – (0·16 x 9,300/4)

a = 618 or $618,000 as the original data is in $000’s. This was the fixed operating cost in 2009.

Allowing for inflation:The variable operating cost in 2010 will be $160 x 1·05 = $168 per tonneThe fixed operating cost in 2010 will be $618,000 x 1·05 = $648,900

(c) Advantages of an incremental budgeting approach:

– Local government organisations are often complex and incremental budgeting will be seen as a simple approach to abudget that will take little effort.

– Budget processes can be long ones, however incremental approaches do tend to be quicker than most. Complex localgovernment organisations can suffer from very long budget processes and incremental budgeting can alleviate this alittle.

Disadvantages of incremental budgeting:

– Public bodies, such as local governments, will be encouraged to use up all of this year’s budget in order to ensure thatnext year’s budget will be as high as possible to give themselves the flexibility they need to do whatever is needed. Thepublic services required can be unpredictable and so local government organisations prefer to be able to be flexible.

– Overspends made in this year will be budgeted for again next year, this is hardly giving taxpayers value for money.

4 (a) TIPs Financial performance can be assessed in a number of ways:

Sales growth

Sales are up about 1·3% (W1) which is a little above the rate of inflation and therefore a move in the right direction. However,with average admission prices jumping about 8·6% (W2) and numbers of visitors falling there are clearly problems. Largeincreases in admission prices reduce the value proposition for the customer, it is unlikely that the rate of increase issustainable or even justifiable. Indeed with volumes falling (down by 6·7%, (W6)) it appears that some customers are beingput off and price could be one of the reasons.

Maintenance and repairs

There appears to be a continuing drift away from routine maintenance with management preferring to repair equipment asrequired. This does not appear to be saving any money as the combined cost of maintenance and repair is higher in 2009than in 2008 (possible risks are dealt with in part (b)).

Directors pay

Absolute salary levels are up 6·7% (W3), well above the modest inflation rate. It appears that the shareholders are happywith the financial performance of the business and are prepared to reward the directors accordingly. Bonus levels are alsowell up. It may be that the directors have some form of profit related pay scheme and are being rewarded for the improvedprofit performance. The directors are likely to be very pleased with the increases to pay.

Wages

Wages are down by 12% (W5). This may partly reflect the loss of customers (down by 6·7% (W6) if we assume that at leastpart of the wages cost is variable. It could also be that the directors are reducing staff levels beyond the fall in the level ofcustomers to enhance short-term profit and personal bonus. Customer service and indeed safety could be compromised here.

Net profit

Net profit is up a huge 31·3% (W7) and most shareholders would be pleased with that. Net profit is a very traditional measureof performance and most would say this was a sign of good performance.

13

Return on assets

The profitability can be measured relative to the asset base that is being used to generate it. This is sometimes referred to asROI or return on investment. The return on assets is up considerably to 11·4% from 8% (W8). This is partly due to thesignificant rise in profit and partly due to the fall in asset value. We are told that TIP has cut back on new development sothe fall in asset value is probably due to depreciation being charged with little being spent during the year on assets. In thisregard it is inevitable that return on assets is up but it is more questionable whether this is a good performance. A theme park(and thrill rides in particular) must be updated to keep customers coming back. The directors on TIP are risking the future ofthe park.

(b) Quality provision

Reliability of the rides

The hours lost has increased significantly. Equally the % of capacity lost due to breakdowns is now approaching 17·8% (W9).This would appear to be a very high number of hours lost. This would surely increase the risk that customers are disappointedbeing unable to ride. Given the fixed admission price system this is bound to irritate some customers as they have effectivelypaid to ride already.

Average queuing time

Queuing will be seen by customers as dead time. They may see some waiting as inevitable and hence acceptable. HoweverTIP should be careful to maintain waiting times at a minimum. An increase of 10 minutes (or 50%) is likely to be noticeableby customers and is unlikely to enhance the quality of the TIP experience for them. The increase in waiting times is probablydue to the high number of hours lost due to breakdown with customers being forced to queue for a fewer number of rideoptions.

Safety

The clear reduction in maintenance could easily damage the safety record of the park and is an obvious quality issue.

Risks

If TIP continues with current policies then they will expose themselves to the following risks:

– The lack of routine maintenance could easily lead to an accident or injury to a customer. This could lead to compensationbeing paid or reputational damage

– Increased competition. The continuous raising of admission prices increases the likelihood of a new competitor enteringthe market (although there are significant barriers to entry in this market e.g. capital cost, land and so on).

– Loss of customers. The value for money that customers see when coming to TIP is clearly reducing (higher prices, lessreliability of rides and longer queues). Regardless of the existence of competition customers could simply chose not tocome, substituting another leisure activity instead

– Profit fall. In the end if customers’ numbers fall then so will profit. The shareholders, although well rewarded at themoment could suffer a loss of dividend. Directors’ job security could then be threatened

Workings:

(W1) Sales growth is $5,320,000/$5,250,000 = 1·01333 or 1·3%

(W2) Average admission prices were:2008: $5,250,000/150,000 = $35 per person2009: $5,320,000/140,000 = $38 per personAn increase of $38/$35 = 1·0857 or 8·57%

(W3) Directors pay up by $160,000/$150,000 = 1·0667 or 6·7%

(W4) Directors bonuses levels up from $15,000/$150,000 or 10% to $18,000/$160,000 or 12·5% of turnover. This isan increase of 3/15 or 20%

(W5) Wages are down by (1 – $2,200,000/$2,500,000) or 12%

(W6) Loss of customers is (1 – 140,000/150,000) or 6·7%

(W7) Profits up by $1,372,000/$1,045,000 = 1·3129 or 31·3%

(W8) Return on assets:2008: $1,045,000/$13,000,000 = 1·0803 or 8·03%2009: $1,372,000/$12,000,000 = 1·114 or 11·4%

(W9) Capacity of rides in hours is 360 days x 50 rides x 10 hours per day = 180,0002008 lost capacity is 9,000/180,000 = 0·05 or 5%2009 lost capacity is 32,000/180,000 = 0·177 or 17·8%

14

5 (a) The relevant costs of the decision to cease the manufacture of the TD are needed:

Cost or Revenue Working reference Amount ($)Lost revenue Note 1 (96,000)Saved labour cost Note 2 48,000Lost contribution from other products Note 3 (118,500)Redundancy and recruitment costs Note 4 (3,700)Supplier payments saved Note 5 88,500Sublet income 12,000Supervisor Note 6 0

––––––––Net cash flow (69,700)

––––––––

Conclusion: It is not worthwhile ceasing to produce the TD now.

Note 1: All sales of the TD will be lost for the next 12 months, this will lose revenue of 1,200 units x $80 = $96,000

Note 2: All normal labour costs will be saved at 1,200 units x $40 = $48,000

Note 3: Related product sales will be lost. This will cost the business 5% x ((5,000u x $150) + (6,000u x $270)) = $118,500 in contribution (material costsare dealt with separately below)

Note 4: If TD is ceased now, then:

Redundancy cost ($6,000)Retraining saved $3,500Recruitment cost ($1,200)

––––––––Total cost ($3,700)

Note 5. Supplier payments:

DW ($) WM ($) TD ($) Net cost Discount Gross cost($) level ($)

Current buying cost 350,000 600,000 60,000 1,010,000 5% 1,063,158Loss of TD (60,000) (60,000) 5% (63,158)Loss of related sales at cost (17,500) (30,000) (47,500) 5% (50,000)New buying cost 921,500 3% 950,000Difference in net cost 88,500

Note 6: There will be no saving or cost here as the supervisor will continue to be fully employed.

An alternative approach is possible to the above problem:

Cash flow Ref Amount ($)Lost contribution – TD Note 7 12,000Lost contribution – other products Note 8 (71,000)Redundancy and recruitment Note 4 above (3,700)Lost discount Note 9 (19,000)Sublet income 12,000Supervisor Note 6 above 0

––––––––Net cash flow (69,700)

––––––––

Note 7: There will be a saving on the contribution lost on the TD of 1,200 units x $10 per unit = –$12,000

Note 8: The loss of sales of other products will cost a lost contribution of 5% ((5,000 x $80) + (6,000 x $170)) = $71,000

Note 9

DW WM TD Total (net) Discount Total grossCurrent buying cost 350,000 600,000 60,000 1,010,000 5% 1,063,158Saved cost (17,500 (30,000) (60,000)New buying cost 332,500 (570,000) 0 902,500 5% 950,000

921,500 3% 950,000Lost discount (19,000)

(b) Complementary pricingSince the washing machine and the tumble dryer are products that tend to be used together, Stay Clean could link their saleswith a complementary price. For example they could offer customers a discount on the second product bought, so if they buy(say) a TD for $80 then they can get a WM for (say) $320. Overall then Stay Clean make a positive contribution of $130(320 + 80 – 180 – 90).

15

Product line pricingAll the products tend to be related to each other and used in the utility room or kitchen. Some sales will involve all threeproducts if customers are upgrading their utility room or kitchen for example. A package price could be offered and as longas Stay Clean make a contribution on the overall deal then they will be better off.

(c) Outsourcing requires consideration of a number of issues (only 3 required):

– The cost of manufacture should be compared to cost of buying in from the outsourcer. If the outsourcer can provide thesame products cheaper then it is perhaps preferable

– The reliability of the outsourcer should be assessed. If products are delivered late then the ultimate customer could bedisappointed. This could damage the goodwill or brand of the business.

– The quality of work that the outsourcer produces needs to be considered. Cheaper products can often be at the expenseof poor quality of materials or assembly.

– The loss of control over the manufacturing process can reduce the flexibility that Stay Clean has over current production.If Stay Clean wanted, say, to change the colour of a product then at present it should be able to do that. Havingcontracted with an outsourcer this may be more difficult or involve penalties.

16

Fundamentals Level – Skills Module, Paper F5 Performance Management December 2009 Marking Scheme

Marks1 (a) Price variance 2

Usage variance 2–––

4

(b) Planning price variance 2Planning usage variance 2Operational price variance 2Operational usage variance 2

–––8

(c) Explanation of external problems beyond control of manager 4Assessment of factors within the control of the manager 4Conclusion 1

–––Maximum 8

–––Total 20

–––

2 (a) Frame cost 1Leather cost 2Labour average time for 128 units 1Labour total time for 128 units 1Average cost per chair 1Target cost 1Cost gap 1

–––8

(b) Per suggestion 1·5–––

6

(c) Frame 0·5Leather 0·5Average time per unit 2Total time 1Time for 128th chair 1Conclusion 1

–––6

–––Total 20

–––

3 (a) Calculation of trend figures 1Adjustment for seasonal variation 2Total tonnage for budget 1

–––4

(b) Completion of table with X, Y, XY and X2 4Calculation of (b) 2Calculation of (a) 2Allowance for inflation 2

–––10

(c) Per advantage/disadvantage 1·5–––

6–––

Total 20–––

17

Marks4 (a) Sales growth 3

Maintenance 3Directors pay 2Wages 2Net profit 2Return on assets 2

–––14

(b) Reliability of rides 2Average queuing time 2Each risk 1

–––Maximum 6

–––Total 20

–––

5 (a) Lost revenue 2Saved labour cost 2Lost contribution from other products 2Redundancy and recruitment cost 2Supplier payments 3Sublet income 1Supervisor 1

–––Maximum 13

(b) Complementary pricing 2Product line pricing 2Other valid suggestions 2

–––Maximum 4

(c) Per issue 1–––

3–––

Total 20–––

18


The Association of Chartered Certifi ed Accountants

Performance Management

Monday 14 June 2010

Time allowed

Reading and planning: 15 minutesWriting: 3 hours


Formulae Sheet is on page 8.


During reading and planning time only the question paper may

be annotated. You must NOT write in your answer booklet until

instructed by the supervisor.


Pape

r F5

2


1 Brick by Brick (BBB) is a building business that provides a range of building services to the public. Recently they have been asked to quote for garage conversions (GC) and extensions to properties (EX) and have found that they are winning fewer GC contracts than expected.

BBB has a policy to price all jobs at budgeted total cost plus 50%. Overheads are currently absorbed on a labour hour basis. BBB thinks that a switch to activity based costing (ABC) to absorb overheads would reduce the cost associated to GC and hence make them more competitive.

You are provided with the following data:

Overhead Annual Activity driver Total number category overheads $ of activities per year Supervisors 90,000 Site visits 500 Planners 70,000 Planning documents 250 Property related 240,000 Labour hours 40,000 –––––––– Total 400,000 ––––––––

A typical GC costs $3,500 in materials and takes 300 labour hours to complete. A GC requires only one site visit by a supervisor and needs only one planning document to be raised. The typical EX costs $8,000 in materials and takes 500 hours to complete. An EX requires six site visits and fi ve planning documents. In all cases labour is paid $15 per hour.

Required:

(a) Calculate the cost and quoted price of a GC and of an EX using labour hours to absorb the overheads.

(5 marks)

(b) Calculate the cost and the quoted price of a GC and of an EX using ABC to absorb the overheads.

(5 marks)

(c) Assuming that the cost of a GC falls by nearly 7% and the price of an EX rises by about 2% as a result of

the change to ABC, suggest possible pricing strategies for the two products that BBB sells and suggest two

reasons other than high prices for the current poor sales of the GC. (6 marks)

(d) One BBB manager has suggested that only marginal cost should be included in budget cost calculations as

this would avoid the need for arbitrary overhead allocations to products. Briefl y discuss this point of view and

comment on the implication for the amount of mark-up that would be applied to budget costs when producing

quotes for jobs. (4 marks)

(20 marks)

3 [P.T.O.

2 Sticky Wicket (SW) manufactures cricket bats using high quality wood and skilled labour using mainly traditional manual techniques. The manufacturing department is a cost centre within the business and operates a standard costing system based on marginal costs.

At the beginning of April 2010 the production director attempted to reduce the cost of the bats by sourcing wood from a new supplier and de-skilling the process a little by using lower grade staff on parts of the production process. The standards were not adjusted to refl ect these changes.

The variance report for April 2010 is shown below (extract).

Adverse Favourable Variances $ $ Material price 5,100 Material usage 7,500 Labour rate 43,600 Labour effi ciency 48,800 Labour idle time 5,400

The production director pointed out in his April 2010 board report that the new grade of labour required signifi cant training in April and this meant that productive time was lower than usual. He accepted that the workers were a little slow at the moment but expected that an improvement would be seen in May 2010. He also mentioned that the new wood being used was proving diffi cult to cut cleanly resulting in increased waste levels.

Sales for April 2010 were down 10% on budget and returns of faulty bats were up 20% on the previous month. The sales director resigned after the board meeting stating that SW had always produced quality products but the new strategy was bound to upset customers and damage the brand of the business.

Required

(a) Assess the performance of the production director using all the information above taking into account both the

decision to use a new supplier and the decision to de-skill the process. (7 marks)

In May 2010 the budgeted sales were 19,000 bats and the standard cost card is as follows:

Std cost Std cost $ $ Materials (2kg at $5/kg) 10 Labour (3hrs at $12/hr) 36 Marginal cost 46 Selling price 68 Contribution 22

In May 2010 the following results were achieved:

40,000kg of wood were bought at a cost of $196,000, this produced 19,200 cricket bats. No inventory of raw materials is held. The labour was paid for 62,000 hours and the total cost was $694,000. Labour worked for 61,500 hours.

The sales price was reduced to protect the sales levels. However, only 18,000 cricket bats were sold at an average price of $65.

Required:

(b) Calculate the materials, labour and sales variances for May 2010 in as much detail as the information allows.

You are not required to comment on the performance of the business. (13 marks)

(20 marks)

4

3 Cut and Stitch (CS) make two types of suits using skilled tailors (labour) and a delicate and unique fabric (material). Both the tailors and the fabric are in short supply and so the accountant at CS has correctly produced a linear programming model to help decide the optimal production mix.

The model is as follows:

Variables: Let W = the number of work suits produced Let L = the number of lounge suits produced

Constraints Tailors’ time: 7W + 5L ≤ 3,500 (hours) – this is line T on the diagram Fabric: 2W + 2L ≤ 1,200 (metres) – this is line F on the diagram Production of work suits: W ≤ 400 – this is line P on the diagram

Objective is to maximise contribution subject to:

C = 48W + 40L

On the diagram provided the accountant has correctly identifi ed OABCD as the feasible region and point B as the optimal point.

Required:

(a) Find by appropriate calculation the optimal production mix and related maximum contribution that could be

earned by CS. (4 marks)

(b) Calculate the shadow prices of the fabric per metre and the tailor time per hour. (6 marks)

0200 400 600 800

200240

400

600

800

L

W

B

E

C

DCont

A

T F

P

CS – Production Plan

Feasible region OABCDOptimal point B

5 [P.T.O.

The tailors have offered to work an extra 500 hours provided that they are paid three times their normal rate of $1·50 per hour at $4·50 per hour.

Required:

(c) Briefl y discuss whether CS should accept the offer of overtime at three times the normal rate. (6 marks)

(d) Calculate the new optimum production plan if maximum demand for W falls to 200 units. (4 marks)

(20 marks)

6

4 Hammer is a large garden equipment supplier with retail stores throughout Toolland. Many of the products it sells are bought in from outside suppliers but some are currently manufactured by Hammer’s own manufacturing division ‘Nail’.

The prices (a transfer price) that Nail charges to the retail stores are set by head offi ce and have been the subject of some discussion. The current policy is for Nail to calculate the total variable cost of production and delivery and add 30% for profi t. Nail argues that all costs should be taken into consideration, offering to reduce the mark-up on costs to 10% in this case. The retail stores are unhappy with the current pricing policy arguing that it results in prices that are often higher than comparable products available on the market.

Nail has provided the following information to enable a price comparison to be made of the two possible pricing policies for one of its products.

Garden shears Steel: the shears have 0·4kg of high quality steel in the fi nal product. The manufacturing process loses 5% of all steel

put in. Steel costs $4,000 per tonne (1 tonne = 1,000kg)

Other materials: Other materials are bought in and have a list price of $3 per kg although Hammer secures a 10% volume discount on all purchases. The shears require 0·1kg of these materials.

The labour time to produce shears is 0·25 hours per unit and labour costs $10 per hour.

Variable overheads are absorbed at the rate of 150% of labour rates and fi xed overheads are 80% of the variable overheads.

Delivery is made by an outsourced distributor that charges Nail $0·50 per garden shear for delivery.

Required:

(a) Calculate the price that Nail would charge for the garden shears under the existing policy of variable cost plus

30%. (6 marks)

(b) Calculate the increase or decrease in price if the pricing policy switched to total cost plus 10%. (4 marks)

(c) Discuss whether or not including fi xed costs in a transfer price is a sensible policy. (4 marks)

(d) Discuss whether the retail stores should be allowed to buy in from outside suppliers if the prices are cheaper

than those charged by Nail. (6 marks)

(20 marks)

7 [P.T.O.

5 Jump has a network of sports clubs which is managed by local managers reporting to the main board. The local managers have a lot of autonomy and are able to vary employment contracts with staff and offer discounts for membership fees and personal training sessions. They also control their own maintenance budget but do not have control over large amounts of capital expenditure.

A local manager’s performance and bonus is assessed relative to three targets. For every one of these three targets that is reached in an individual quarter, $400 is added to the manager’s bonus, which is paid at the end of the year. The maximum bonus per year is therefore based on 12 targets (three targets in each of the four quarters of the year). Accordingly the maximum bonus that could be earned is 12 x $400 = $4,800, which represents 40% of the basic salary of a local manager. Jump has a 31 March year end.

The performance data for one of the sports clubs for the last four quarters is as follows

Qtr to Qtr to Qtr to Qtr to 30 June 2009 30 September 2009 31 December 2009 31 March 2010 Number of members 3,000 3,200 3,300 3,400 Member visits 20,000 24,000 26,000 24,000 Personal training sessions booked 310 325 310 339 Staff days 450 480 470 480 Staff lateness days 20 28 28 20 Days in quarter 90 90 90 90

Agreed targets are:

1. Staff must be on time over 95% of the time (no penalty is made when staff are absent from work) 2. On average 60% of members must use the clubs’ facilities regularly by visiting at least 12 times per quarter 3. On average 10% of members must book a personal training session each quarter

Required:

(a) Calculate the amount of bonus that the manager should expect to be paid for the latest fi nancial year.

(6 marks)

(b) Discuss to what extent the targets set are controllable by the local manager (you are required to make a case

for both sides of the argument). (9 marks)

(c) Describe two methods as to how a manager with access to the accounting and other records could unethically

manipulate the situation so as to gain a greater bonus. (5 marks)

(20 marks)

8

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx


a=∑yn

-b∑xn

r=n∑xy

2 2

--∑x∑y

n∑x -(∑x) )(n∑y -(∑y) )2 2 2 2


Answers

11

Fundamentals Level – Skills Module, Paper F5

Performance Management June 2010 Answers

1 (a) Costs and quoted prices for the GC and the EX using labour hours to absorb overheads:

GC $ EX $ Materials 3,500 8,000 Labour 300hrs x $15/hr 4,500 500hrs x $15/hr 7,500 Overheads 300hrs x $10/hr (W1) 3,000 500hrs x $10/hr 5,000 ––––––– ––––––– Total cost 11,000 20,500 ––––––– ––––––– Quoted price 16,500 30,750 ––––––– –––––––

(W1). Overhead absorption rate is calculated as $400,000/40,000hrs = $10/hr

(b) Costs and quoted prices for the GC and the EX using ABC to absorb overheads:

GC $ EX $ Materials 3,500 8,000 Labour 300hrs x $15/hr 4,500 500hrs x $15/hr 7,500 Overheads – Supervisor (W2)/(W3) 180 1,080 – Planners (W2)/(W3) 280 1,400 – Property (W2)/(W3) 1,800 3,000 ––––––– ––––––– Total cost 10,260 20,980 ––––––– ––––––– Quoted price 15,390 31,470 ––––––– –––––––

(W2)

Costs Number of drivers Cost per driver Supervisor 90,000 500 180 Planners 70,000 250 280 Property 240,000 40,000 6

(W3)

Supervisor Planner Property Cost per driver (W2) $180 $280 $6 GC 180 x 1 = 180 280 x 1 = 280 6 x 300 = 1,800 EX 180 x 6 = 1,080 280 x 5 = 1,400 6 x 500 = 3,000

(c) The pricing policy is a matter for BBB to decide. They could elect to maintain the current 50% mark-up on cost and if they did the price of the GC would fall by around 7% in line with the costs. This should make them more competitive in the market.

They could also reduce the prices by a little less than 7% (say 5%) in order to increase internal margins a little.

It is possible that the issue lies elsewhere. If the quality of the work or the reputation and reliability of the builder is questionable then reducing prices is unlikely to improve sales. It is conceivable that BBB has a good reputation for EX but not for GC, but more likely that a poor reputation would affect all products. Equally poor service levels or lack of fl exibility in meeting customer needs may be causing the poor sales performance. These too will not be ‘corrected’ by merely reducing prices.

It is also possible that the way salesmen discuss or sell their products for the GC is not adequate so that in some way customers are being put off placing the work with BBB.

BBB is in competition and it perhaps needs to refl ect this in its pricing more (by ‘going rate pricing’) and not seek to merely add a mark-up to its costs.

BBB could try to penetrate the market by pricing some jobs cheaply to gain a foothold. Once this has been done the completed EX or GC could be used to market the business to new customers.

The price of the EX would also need consideration. There is no indication of problems in the selling of the EX and so BBB could consider pushing up their prices by around 2% in line with the cost increase. On the fi gures in my answer the price goes up for a typical extension to $31,470 from $30,750 a rise of $720. This does not seem that signifi cant and so might not lose a signifi cant number of sales.

The reliability and reputation of a builder is probably more important than the price that they charge for a job and so it is possible that the success rate on job quotes may not be that price sensitive.

12

(d) Marginal costs are those costs that are incurred as a consequence of the job being undertaken. In this case they would include only the materials and the labour. If overheads are included then this is known as total absorption costing.

Overheads are for many businesses fi xed by nature and hence do not vary as the number of jobs changes. In a traditional sense any attempt to allocate costs to products (by way of labour hours for example) would be arbitrary with little true meaning being added to the end result. The overhead absorption rate (OAR) is merely an average of these costs (over labour hours) and is essentially meaningless. This switch (to marginal costing) would also avoid the problem of the uncertainty of budget volume. Budget volume is needed in order to calculate the fi xed cost absorption rate.

The marginal cost (MC) is more understandable by managers and indeed customers and a switch away from total absorption cost (TAC) could have benefi ts in this way. Clearly if overheads are going to be excluded for the cost allocations then they would still have to be covered by way of a bigger margin added to the costs. In the end all costs have to be paid for and covered by the sales in order to show a profi t.

A more modern viewpoint is that activity causes costs to exist. For example, it is the existence of the need for site visits that gives rise to the need for a supervisor and therefore, for his costs. If the activities that drive costs are identifi ed, more costs can then be directly traced to products, hence eradicating the need for arbitrary apportionment of many overhead costs. This has the benefi t of all costs being covered, rather than the potential shortfall that can arise if marginal cost plus pricing is used.

In the long run businesses have to cover all costs including fi xed overheads in order to make a profi t, whichever pricing strategy is adopted.

2 (a) The performance of the production director could be looked at considering each decision in turn.

The new wood supplier: The wood was certainly cheaper than the standard saving $5,100 on the standard the concern though might be poor quality. The usage variance shows that the waste levels of wood are worse than standard. It is possible that the lower grade labour could have contributed to the waste level but since both decisions rest with the same person the performance consequences are the same. The overall effect of this is an adverse variance of $2,400, so taking the two variances together it looks like a poor decision. As the new labour is trained it could be that the wood usage improves and so we will have to wait to be sure.

The impact that the new wood might have had on sales cannot be ignored. No one department within a business can be viewed in isolation to another. Sales are down and returns are up. This could easily be due to poor quality wood inputs. If SW operates at the high quality end of the market then sourcing cheaper wood is risky if the quality reduces as a result.

The lower grade of labour used: SW uses traditional manual techniques and this would normally require skilled labour. The labour was certainly paid less, saving the company $43,600 in wages. However, with adverse effi ciency and idle time of a total of $54,200 they actually cost the business money overall in the fi rst month. The effi ciency variance tells us that it took longer to produce the bats than expected. The new labour was being trained in April 2010 and so it is possible that the situation will improve next month. The learning curve principle would probably apply here and so we could expect the average time per bat to be less in May 2010 than it was in April 2010.

(b) Variance for May 2010:

Material price variance ($196,000/40,000 – 5) x 40,000 = $4,000 Fav

Material usage variance (40,000 – (19,200 x 2)) x $5/kg = $8,000 Adv

Labour rate variance ($694,000/62,000 – 12) x 62,000 = 50,000 Fav

Labour effi ciency variance (61,500 – 57,600) x 12 = 46,800 Adv

Labour idle time variance 500 x 12 = 6,000 Adv

Sales price variance (68 – 65) x 18,000 = 54,000 Adv

Sales volume contribution variance (18,000 – 19,000) x 22 = 22,000 Adv

3 (a) The optimal production mix can be found by solving the two equations given for F and T.

7W + 5L = 3,500 2W + 2L = 1,200

Multiplying the second equation by 2·5 produces:

7W + 5L = 3,500 5W + 5L = 3,000

2W = 500 W = 250

Substituting W = 250 in the fabric equation produces:

2 x 250 + 2L = 1,200 2L = 700 L = 350

13

The optimal solution is when 250 work suits are produced and 350 lounge suits are produced. The contribution gained is $26,000:

C = 48W + 40L C = (48 x 250) + (40 x 350) C = 26,000

(b) The shadow prices can be found by adding one unit to each constraint in turn.

Shadow price of T

7W + 5L = 3,501 2W + 2L = 1,200

Again multiplying the second equation by 2·5 produces:

7W + 5L = 3,501 5W + 5L = 3,000 2W = 501 W = 250·5

Substituting W = 250·5 in the fabric equation produces:

(2 x 250·5) + 2L = 1,200 2L = 1,200 – 501 L = 349·5

Contribution earned at this point would be = (48 x 250·5) + (40 x 349·5) = 26,004 which is an increase of $4.

Hence the shadow price of T is $4 per hour.

Shadow price of F

7W + 5L = 3,500 2W + 2L = 1,201

Again multiplying the second equation by 2·5 produces:

7W + 5L = 3,500·0 5W + 5L = 3,002·5 2W = 497·5 W = 248·75

Substituting W = 248·75 in the fabric equation produces:

(2 x 248·75) +2L = 1,201 2L = 1,201 – 497·5 L = 351·75

Contribution earned at this point would be = (48 x 248·75) + (40 x 351·75) = 26,010, which is an increase of $10.

Hence the shadow price of F is $10 per metre.

(c) The shadow price represents the maximum premium above the normal rate a business should be willing to pay for more of a scarce resource. It is equal to the increased contribution that can be gained from gaining that extra resource.

The shadow price of labour here is $4 per hour. The tailors have offered to work for $4·50 – a premium of $3·00 per hour. At fi rst glance the offer seems to be acceptable.

However, many businesses pay overtime at the rate of time and a half and some negotiation should be possible to create a win/win situation. Equally some consideration should be given to the quality aspect here. If excessive extra hours are worked then tiredness can reduce the quality of the work produced.

(d) If maximum demand for W falls to 200 units, the constraint for W will move left to 200 on the x axis of the graph. The new optimum point will then be at the intersection of:

W = 200 and 2W + 2L = 1,200

Solving these equations simultaneously, if: W = 200, then (2 x 200) + 2L = 1,200 Therefore L = 400.

So, the new production plan will be to make 400L and 200W

14

4 (a) Price under existing policy

$ Steel (0·4/0·95 x $4·00) 1·68 Other materials ($3·00 x 0·9 x 0·1) 0·27 Labour (0·25 x $10) 2·50 Variable overhead (0·25 x $15) 3·75 Delivery 0·50 –––––– Total variable cost 8·70 Mark-up 30% 2·61 –––––– Transfer price 11·31 ––––––

(b) The only difference would be to add the fi xed costs and adjust the mark-up %.

$ Existing total variable cost 8·70 Extra fi xed cost (0·25 x $15 x 0·8) 3·00 –––––– Total cost 11·70 Mark-up 10% 1·17 –––––– Transfer price 12·87 ––––––

The price difference is therefore 12·87 – 11·31 = $1·56 per unit

(c) As far as the manufacturer is concerned, including fi xed costs in the transfer price will have the advantage of covering all the costs incurred. In theory this should guarantee a profi t for the division (assuming the fi xed overhead absorption calculations are accurate). In essence the manufacturer is reducing the risk in his division.

The accounting for fi xed costs is notoriously diffi cult with many approaches possible. Including fi xed costs in the transfer price invites manipulation of overhead treatment.

One of the main problems with this strategy is that a fi xed cost of the business is being turned into a variable cost in the hands of the seller (in our case the stores). This can lead to poor decision-making for the group since, although fi xed costs would normally be ignored in a decision (as unavoidable), they would be relevant to the seller because they are part of their variable buy in price.

(d) Degree of autonomy allowed to the stores in buying policy.

If the stores are allowed too much freedom in buying policy Hammer could lose control of its business. Brand could be damaged if each store bought a different supplier’s shears (or other products). On the other hand, fl exibility is increased and profi ts could be made for the business by entrepreneurial store managers exploiting locally found bargains. However, the current market price for shears may only be temporary (sale or special offer) and therefore not really representative of their true market ‘value’. If this is the case, then any long-term decision to allow retail stores to buy shears from external suppliers (rather than from Nail) would be wrong.

The question of comparability is also important. Products are rarely ‘identical’ and consequently, price differences are to be expected. The stores could buy a slightly inferior product (claiming it is comparable) in the hope of a better margin. This could seriously damage Hammer’s brand.

Motivation is also a factor here, however. Individual managers like a little freedom within which to operate. If they are forced to buy what they see as an inferior product (internally) at high prices it is likely to de-motivate. Also with greater autonomy, the performance of the stores will be easier to assess as the store managers will have control over greater elements of their business.

15

5 (a) Bonus calculation:

Qtr to Qtr to Qtr to Qtr to Bonus; hits’ 30 June 2009 30 September 2009 31 December 2009 31 March 2010 Staff on time? On-time % 430/450 = 452/480 = 442/470 = 460/480 = 95·5% 94·2% 94·0% 95·8% 2 Bonus earned? Yes No No Yes

Members visits Target visits 60% x 3,000 x 60% x 3,200 x 60% x 3,300 x 60% x 3,400 x 12 = 21,600 12 = 23,040 12 = 23,760 12 = 24,480 Actual visits 20,000 24,000 26,000 24,000 Bonus earned? No Yes Yes No 2

Qtr to Qtr to Qtr to Qtr to Bonus; hits’ 30 June 2009 30 September 2009 31 December 2009 31 March 2010 Personal training Target 10% x 3,000 10% x 3,200 10% x 3,300 10% x 3,400 = 300 = 320 = 330 = 340 Actual sessions 310 325 310 339 Bonus earned Yes Yes No No 2

Total 6

The bonus earned by the manager would be 6 x $400 = $2,400, which is 50% of the total bonus available.

(b) An important principle of any target based bonus system is that the targets must be based on controllable aspects of the manager’s role.

Staff on time The way in which a manager manages staff can have a big bearing on whether or not an individual staff member is keen to

work and arrive on time. We are told that the local manager has the power to vary employment contracts so he should be able to agree acceptable shift patterns with staff and reward them for compliance. In this respect the lateness of staff is controllable by the manager.

On the other hand an individual staff member may be subject to home pressures or problems with public or other transport meaning that even they cannot control the time of arrival at work on some days. The manager cannot control these events either. If this problem became regular for a member of staff then the local manager could vary the contract of employment accordingly.

Overall, lateness to work is controllable by the local manager.

Member use of facilities The local manager controls the staff and hence the level of customer service. Good quality customer services would probably

encourage members to use the facilities more often. Equally, by maintaining the club to a high standard then the local manager can remove another potential reason for a member not to use the facilities regularly.

On the other hand customers are infl uenced by many factors outside of the club. Their state of health or their own work pressures can prevent members being able to come to the club.

Overall, the local manager can only partly control the number of member visits.

Personal training sessions Again, the local manager controls the level of customer service and the standard of maintenance in the personal training

department. He also has control over prices so, if the bookings fall, he is able to reduce price or make special offers to encourage use of the facilities.

On the other hand, personal training sessions may be seen as a luxury by customers and in times of fi nancial diffi culty they are expendable by them. Personal training sessions are often available from other sources and competition can force down the sales of the club. The manager can respond to that by improving services. He cannot, however, make signifi cant investment in improving the facilities without board approval.

Overall, the local manager can only partly control the number of personal training sessions booked.

(c) There are a variety of methods that the performance data can be manipulated:

Cut off The unethical manager could record visits in a different period than was actually the case. For example in quarter three the

target for personal training sessions was not met by 20 sessions. This was probably obvious to the manager in the last few days of that quarter. He could have therefore recorded some sessions as having taken place in the next quarter. Indeed, only one session would have to be moved in this way in order for the manager to meet the target in the fi nal quarter and gain another $400 of bonus.

16

Reduce prices to below economic levels to encourage use The targets that the manager is subject to are mainly volume driven. A reduction in prices would harm profi tability but would

not damage the manager’s bonus potential. More sessions are bound to follow if the price is set low enough.

(Other ideas would be acceptable including advising staff to take the day off if they were going to be late. This would damage service levels admittedly, but would potentially gain a bonus for lateness.)

17

Fundamentals Level – Skills Module, Paper F5

Performance Management June 2010 Marking Scheme

Marks Marks1 (a) Materials 1 Labour 1 OAR 1 Overhead costs per unit 1 Price 1 Total 5

(b) Materials 0·5 Labour 0·5 Overheads per unit per category (3 categories) – 1 mark each 3 Price 1 Total 5

(c) GC reduce price by 7% 1 GC reduce by < 7% 1 Quality, reputation, reliability, sales documentation quality 2 EX increase price by 2% 1 EX hold price 1 Total 6

(d) MC and TAC defi nitions 1 FC explanation of issue 2 Margin increase needed 1 Total 4 –––– Total 20 ––––

2 (a) Assessment of wood decision 2·5 Assessment of labour decision 2·5 Sales consequences 2 Total 7

(b) MPV 2 MUV 2 LRV 2 LEV 2 LIT 1 SPV 2 SVCV 2 13 –––– Total 20 ––––

3 (a) Optimal point calculation 3 Contribution 1 4

(b) For each shadow price 3 6

(c) Rate discussion 3 Other factors e.g. tiredness, negotiation 3 6

(d) Find optimum point 1 Solve 2 equations 2 Conclusion 1 4 –––– Total 20 ––––

18

Marks Marks4 (a) Steel 1 Other material 1 Labour 1 Variable overhead 1 Delivery 1 Mark-up 1 Total 6

(b) Fixed cost 2 Mark-up 2 Total 4

(c) Covers all cost 1 Risk 1 Fixed cost accounting 1 Converts a FC to VC 2 Total (max) 4

(d) Market price may be temporary 1 Brand 1 Profi tability 1 Flexibility 1 Control 1 Motivation 1 Performance assessment 1 Comparability 1 Total (max) 6 –––– Total 20 ––––

5 (a) Per target 2 Total 6

(b) For each target – supporting controllability 1·5 For each target – denying controllability 1·5 Target 9

(c) For each idea of manipulation up to 2·5 5 –––– Total 20 ––––








Pape

r F5Performance

Management




2


1 Carad Co is an electronics company which makes two types of televisions – plasma screen TVs and LCD TVs. Itoperates within a highly competitive market and is constantly under pressure to reduce prices. Carad Co operates astandard costing system and performs a detailed variance analysis of both products on a monthly basis. Extracts fromthe management information for the month of November are shown below:

NoteTotal number of units made and sold 1,400 1Material price variance $28,000 A 2Total labour variance $6,050 A 3

Notes

(1) The budgeted total sales volume for TVs was 1,180 units, consisting of an equal mix of plasma screen TVs andLCD screen TVs. Actual sales volume was 750 plasma TVs and 650 LCD TVs. Standard sales prices are $350per unit for the plasma TVs and $300 per unit for the LCD TVs. The actual sales prices achieved duringNovember were $330 per unit for plasma TVs and $290 per unit for LCD TVs. The standard contributions forplasma TVs and LCD TVs are $190 and $180 per unit respectively.

(2) The sole reason for this variance was an increase in the purchase price of one of its key components, X. Eachplasma TV made and each LCD TV made requires one unit of component X, for which Carad Co’s standard costis $60 per unit. Due to a shortage of components in the market place, the market price for November went upto $85 per unit for X. Carad Co actually paid $80 per unit for it.

(3) Each plasma TV uses 2 standard hours of labour and each LCD TV uses 1·5 standard hours of labour. Thestandard cost for labour is $14 per hour and this also reflects the actual cost per labour hour for the company’spermanent staff in November. However, because of the increase in sales and production volumes in November,the company also had to use additional temporary labour at the higher cost of $18 per hour. The total capacityof Carad’s permanent workforce is 2,200 hours production per month, assuming full efficiency. In the month ofNovember, the permanent workforce were wholly efficient, taking exactly 2 hours to complete each plasma TVand exactly 1·5 hours to produce each LCD TV. The total labour variance therefore relates solely to the temporaryworkers, who took twice as long as the permanent workers to complete their production.

Required:

(a) Calculate the following for the month of November, showing all workings clearly:

(i) The sales price variance and sales volume contribution variance; (6 marks)

(ii) The material price planning variance and material price operational variance; (2 marks)

(iii) The labour rate variance and the labour efficiency variance. (7 marks)

(b) Explain the reasons why Carad Co would be interested in the material price planning variance and thematerial price operational variance. (5 marks)

(20 marks)

3 [P.T.O.

2 The Accountancy Teaching Co (AT Co) is a company specialising in the provision of accountancy tuition courses inthe private sector. It makes up its accounts to 30 November each year. In the year ending 30 November 2009, itheld 60% of market share. However, over the last twelve months, the accountancy tuition market in general has faceda 20% decline in demand for accountancy training leading to smaller class sizes on courses. In 2009 and before, ATCo suffered from an ongoing problem with staff retention, which had a knock-on effect on the quality of serviceprovided to students. Following the completion of developments that have been ongoing for some time, in 2010 thecompany was able to offer a far-improved service to students. The developments included:

– A new dedicated 24 hour student helpline– An interactive website providing instant support to students– A new training programme for staff– An electronic student enrolment system – An electronic marking system for the marking of students’ progress tests. The costs of marking electronically were

expected to be $4 million less in 2010 than marking on paper. Marking expenditure is always included in costof sales

Extracts from the management accounts for 2009 and 2010 are shown below:

2009 2010$’000 $’000 $’000 $’000

Turnover 72,025 66,028Cost of sales (52,078) (42,056)

–––––––– –––––––Gross profit 19,947 23,972Indirect expenses:Marketing 3,291 4,678Property 6,702 6,690Staff training 1,287 3,396Interactive website running costs – 3,270Student helpline running costs – 2,872Enrolment costs 5,032 960

–––––– ––––––Total indirect expenses (16,312) (21,866)

–––––––– –––––––Net operating profit 3,635 2,106

–––––––– –––––––

On 1 December 2009, management asked all ‘freelance lecturers’ to reduce their fees by at least 10% with immediateeffect (‘freelance lecturers’ are not employees of the company but are used to teach students when there are notenough of AT Co’s own lecturers to meet tuition needs). All employees were also told that they would not receive apay rise for at least one year. Total lecture staff costs (including freelance lecturers) were $41·663 million in 2009and were included in cost of sales, as is always the case. Freelance lecturer costs represented 35% of these totallecture staff costs. In 2010 freelance lecture costs were $12·394 million. No reduction was made to course prices inthe year and the mix of trainees studying for the different qualifications remained the same. The same type andnumber of courses were run in both 2009 and 2010 and the percentage of these courses that was run by freelancelecturers as opposed to employed staff also remained the same.

Due to the nature of the business, non-financial performance indicators are also used to assess performance, asdetailed below.

2009 2010Percentage of students transferring to AT Co fromanother training provider 8% 20%Number of late enrolments due to staff error 297 106Percentage of students passing exams first time 48% 66%Labour turnover 32% 10%Number of student complaints 315 84Average no. of employees 1,080 1,081

4

Required:

Assess the performance of the business in 2010 using both financial performance indicators calculated from theabove information AND the non-financial performance indicators provided.

NOTE: Clearly state any assumptions and show all workings clearly. Your answer should be structured around thefollowing main headings: turnover; cost of sales; gross profit; indirect expenses; net operating profit. However, indiscussing each of these areas you should also refer to the non-financial performance indicators, where relevant.

(20 marks)

5 [P.T.O.

3 The Cosmetic Co is a company producing a variety of cosmetic creams and lotions. The creams and lotions are soldto a variety of retailers at a price of $23·20 for each jar of face cream and $16·80 for each bottle of body lotion. Eachof the products has a variety of ingredients, with the key ones being silk powder, silk amino acids and aloe vera. Sixmonths ago, silk worms were attacked by disease causing a huge reduction in the availability of silk powder and silkamino acids. The Cosmetic Co had to dramatically reduce production and make part of its workforce, which it hadtrained over a number of years, redundant.

The company now wants to increase production again by ensuring that it uses the limited ingredients available tomaximise profits by selling the optimum mix of creams and lotions. Due to the redundancies made earlier in the year,supply of skilled labour is now limited in the short-term to 160 hours (9,600 minutes) per week, although unskilledlabour is unlimited. The purchasing manager is confident that they can obtain 5,000 grams of silk powder and 1,600 grams of silk amino acids per week. All other ingredients are unlimited. The following information is availablefor the two products:

Cream LotionMaterials required: silk powder (at $2·20 per gram) 3 grams 2 grams– silk amino acids (at $0·80 per gram) 1 gram 0·5 grams– aloe vera (at $1·40 per gram) 4 grams 2 gramsLabour required: skilled ($12 per hour) 4 minutes 5 minutes– unskilled (at $8 per hour) 3 minutes 1·5 minutes

Each jar of cream sold generates a contribution of $9 per unit, whilst each bottle of lotion generates a contribution of$8 per unit. The maximum demand for lotions is 2,000 bottles per week, although demand for creams is unlimited.Fixed costs total $1,800 per week. The company does not keep inventory although if a product is partially completeat the end of one week, its production will be completed in the following week.

Required:

(a) On the graph paper provided, use linear programming to calculate the optimum number of each product thatthe Cosmetic Co should make per week, assuming that it wishes to maximise contribution. Calculate the totalcontribution per week for the new production plan. All workings MUST be rounded to 2 decimal places.

(14 marks)

(b) Calculate the shadow price for silk powder and the slack for silk amino acids. All workings MUST be roundedto 2 decimal places. (6 marks)

(20 marks)

6

4 The Gadget Co produces three products, A, B and C, all made from the same material. Until now, it has usedtraditional absorption costing to allocate overheads to its products. The company is now considering an activity basedcosting system in the hope that it will improve profitability. Information for the three products for the last year is asfollows:

A B CProduction and sales volumes (units) 15,000 12,000 18,000Selling price per unit $7.50 $12 $13Raw material usage (kg) per unit 2 3 4Direct labour hours per unit 0·1 0·15 0·2Machine hours per unit 0·5 0·7 0·9Number of production runs per annum 16 12 8Number of purchase orders per annum 24 28 42Number of deliveries to retailers per annum 48 30 62

The price for raw materials remained constant throughout the year at $1·20 per kg. Similarly, the direct labour costfor the whole workforce was $14·80 per hour. The annual overhead costs were as follows:

$Machine set up costs 26,550Machine running costs 66,400Procurement costs 48,000Delivery costs 54,320

Required:

(a) Calculate the full cost per unit for products A, B and C under traditional absorption costing, using directlabour hours as the basis for apportionment. (5 marks)

(b) Calculate the full cost per unit of each product using activity based costing. (9 marks)

(c) Using your calculation from (a) and (b) above, explain how activity based costing may help The Gadget Coimprove the profitability of each product. (6 marks)

(20 marks)

5 Some commentators argue that: ‘With continuing pressure to control costs and maintain efficiency, the time has comefor all public sector organisations to embrace zero-based budgeting. There is no longer a place for incrementalbudgeting in any organisation, particularly public sector ones, where zero-based budgeting is far more suitableanyway.’

Required:

(a) Discuss the particular difficulties encountered when budgeting in public sector organisations compared withbudgeting in private sector organisations, drawing comparisons between the two types of organisations.

(5 marks)

(b) Explain the terms ‘incremental budgeting’ and ‘zero-based budgeting’. (4 marks)

(c) State the main stages involved in preparing zero-based budgets. (3 marks)

(d) Discuss the view that ‘there is no longer a place for incremental budgeting in any organisation, particularlypublic sector ones,’ highlighting any drawbacks of zero-based budgeting that need to be considered.

(8 marks)

(20 marks)

7 [P.T.O.

8

Formulae Sheet

Learning curve

Y = axb

Where y = cumulative average time per unit to produce x units a = the time taken for the first unit of output x = the cumulative number of units produced b = the index of learning (log LR/log2) LR = the learning rate as a decimal

Regression analysis

Demand curve



y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

( x) )(n y) )2 2 2 2


Answers


1 (a) (i) Sales price variance and sales volume variance

Sales price variance = (actual price – standard price) x actual volume

Actual Standard Difference Actual Salesprice price volume price

Variance$ $ $ $

Plasma TVs 330 350 –20 750 15,000 ALCD TVs 290 300 –10 650 6,500 A

–––––––21,500 A–––––––

Sales volume contribution variance = (actual sales volume – budgeted sales volume) x standard margin

Actual Budgeted Difference Standard Sales sales sales margin volume

volume volume variance$ $

Plasma TVs 750 590 160 190 30,400 FLCD TVs 650 590 60 180 10,800 F

–––––– –––––– –––––––1,400 1,180 41,200 F

–––––– –––––– –––––––

(ii) Material price planning and purchasing operational variances

Material planning variance = (original target price – general market price at time of purchase) x quantity purchased

($60 – $85) x 1,400 = $35,000 A.

Material price operational variance = (general market price at time of purchase – actual price paid) x quantity purchased.

($85 – $80) x 1,400 = $7,000 F.

(iii) Labour rate and labour efficiency variances

Labour rate variance = (standard labour rate per hour – actual labour rate per hour) x actual hours worked.

Actual hours worked by temporary workers:Total hours needed if staff were fully efficient = (750 x 2) + (650 x 1·5) = 2,475.Permanent staff provide 2,200 hours therefore excess = 2,475 – 2,200 = 275.However, temporary workers take twice as long, therefore hours worked = 275 x 2 = 550

Labour rate variance relates solely to temporary workers, therefore ignore permanent staff in the calculation.

Labour rate variance = ($14 – $18) x 550 = $2,200 A.

Labour efficiency variance = (standard labour hours for actual production – actual labour hours worked) x standard rate.

(275 – 550) x $14 = $3,850 A.

(b) Explanation of planning and operational variances

Before the material price planning and operational variances were calculated, the only information available as regardsmaterial purchasing was that there was an adverse material price variance of $28,000. The purchasing department will beassessed on the basis of this variance, yet, on its own, it is not a reliable indicator of the purchasing department’s efficiency.The reason it is not a reliable indicator is because market conditions can change, leading to an increase in price, and thischange in market conditions is not within the control of the purchasing department.

By analysing the materials price variance further and breaking it down into its two components – planning and operational –the variance actually becomes a more useful assessment tool. The planning variance represents the uncontrollable elementand the operational variance represents the controllable element.

The planning variance is a really useful for providing feedback on just how skilled management are in estimating future prices.This can be very easy in some businesses and very difficult in others.

The operational variance is more meaningful in that it measures the purchasing department’s efficiency given the marketconditions that prevailed at the time. It therefore ignores factors that the purchasing department cannot control, which in turn,stops staff from becoming demotivated.

11

2 TurnoverTurnover has decreased from $72·025 million in 2009 to $66·028 million in 2010, a fall of 8·3%. However, this must beassessed by taking into account the change in market conditions, since there has been a 20% decline in demand for accountancytraining. Given this 20% decline in the market place, AT Co’s turnover would have been expected to fall to $57·62m if it had keptin line with market conditions. Comparing AT Co’s actual turnover to this, it’s actual turnover is 14·6% higher than expected. Assuch, AT Co has performed fairly well, given market conditions.

It can also be seen from the non-financial performance indicators that 20% of students in 2010 are students who have transferredover from alternative training providers. It is likely that they have transferred over because they have heard about the improvedservice that AT Co is providing. Hence, they are most likely the reason for the increased market share that AT Co has managed tosecure in 2010.

Cost of salesCost of sales has decreased by 19·2% in 2010. This must be considered in relation to the decrease in turnover as well. In 2009,cost of sales represented 72·3% of turnover and in 2010 this figure was 63·7%. This is quite a substantial decrease. The reasonsfor it can be ascertained by, firstly, looking at the freelance staff costs.

In 2009, the freelance costs were $14·582m. Given that a minimum 10% reduction in fees had been requested to freelancelecturers and the number of courses run by them was the same year on year, the expected cost for freelance lecturers in 2010 was$13·124m. The actual costs were $12·394m. These show that a fee reduction of 15% was actually achieved. This can be seenas a successful reduction in costs.

The expected cost of sales for 2010 before any cost cuts, was $47·738m assuming a consistent ratio of cost of sales to turnover.The actual cost of sales was only $42·056m, $5·682m lower. Since freelance lecturer costs fell by $2·188m, this means thatother costs of sale fell by the remaining $3·494m. Staff costs are a substantial amount of this balance but since there was a payfreeze and the average number of employees hardly changed from year to year, the decreased costs are unlikely to be related tostaff costs. The decrease is therefore most probably attributable to the introduction of online marking. AT Co expected the onlinemarking system to cut costs by $4m, but it is probable that the online marking did not save as much as possible, hence the$3·494m fall. Alternatively, the saved marking costs may have been partially counteracted by an increase in some other costincluded in cost of sales.

Gross profitAs a result of the above, the gross profit margin has increased in 2010 from 27·7% to 36·3%. This is a big increase and reflectsvery well on management.

Indirect expenses– Marketing costs: These have increased by 42·1% in 2010. Although this is quite significant, given all the improvements that

AT Co has made to the service it is providing, it is very important that potential students are made aware of exactly what thecompany now offers. The increase in marketing costs has been rewarded with higher student numbers relative to thecompetition in 2010 and these will hopefully continue increasing next year, since many of the benefits of marketing won’t befelt until the next year anyway. The increase should therefore be viewed as essential expenditure rather than a cost that needsto be reduced.

– Property costs: These have largely stayed the same in both years.

– Staff training: These costs have increased dramatically by over $2 million, a 163·9% increase. However, AT Co had identifiedthat it had a problem with staff retention, which was leading to a lower quality service being provided to students. Also, dueto the introduction of the interactive website, the electronic enrolment system and the online marking system, staff wouldhave needed training on these areas. If AT Co had not spent this money on essential training, the quality of service wouldhave deteriorated further and more staff would have left as they became increasingly dissatisfied with their jobs. Again,therefore, this should be seen as essential expenditure.

Given that the number of student complaints has fallen dramatically in 2010 to 84 from 315, the staff training appears tohave improved the quality of service being provided to students.

– Interactive website and the student helpline: These costs are all new this year and result from an attempt to improve thequality of service being provided and, presumably, improve pass rates. Therefore, given the increase in the pass rate for firsttime passes from 48% to 66% it can be said that these developments have probably contributed to this. Also, they haveprobably played a part in attracting new students, hence improving turnover.

– Enrolment costs have fallen dramatically by 80·9%. This huge reduction is a result of the new electronic system beingintroduced. This system can certainly be seen as a success, as not only has it dramatically reduced costs but it has alsoreduced the number of late enrolments from 297 to 106.

Net operating profitThis has fallen from $3·635m to $2·106m. On the face of it, this looks disappointing but it has to be remembered that AT Co hasbeen operating in a difficult market in 2010. It could easily have been looking at a large loss. Going forward, staff training costswill hopefully decrease. Also, market share may increase further as word of mouth spreads about improved results and service atAT Co. This may, in turn, lead to a need for less advertising and therefore lower marketing costs.

12

It is also apparent that AT Co has provided the student website free of charge when really, it should have been charging a fee forthis. The costs of running it are too high for the service to be provided free of charge and this has had a negative impact on netoperating profit.

Note: Students would not have been expected to write all this in the time available.

Workings (Note: All workings are in $'000)

1. TurnoverDecrease in turnover = $72,025 – $66,028/$72,025 = 8·3%Expected 2010 turnover given 20% decline in market = $72,025 x 80% = $57,620Actual 2010 turnover CF expected = $66,028 – $57,620/$57,620 = 14·6% higher

2. Cost of salesDecrease in cost of sales = $42,056 – $52,078/$52,078 = 19·2%Cost of sales as percentage of turnover: 2009 = $52,078/$72,025 = 72·3%2010 = $42,056/$66,028 = 63·7%

Freelance staff costs: in 2009 = $41,663 x 35% = $14,582Expected cost for 2010 = $14,582 x 90% = $13,124Actual 2010 cost = $12,394$12,394 – $14,582 = $2,188 decrease$2,188/$14,582 = 15% decrease in freelancer costs

Expected cost of sales for 2010, before costs cuts, = $66,028 x 72·3% = $47,738.Actual cost of sales = $42,056.Difference = $5,682, of which $2,188 relates to freelancer savings and $3,494 relates to other savings.

3. Gross profit margin2009: $19,947/$72,025 = 27·7%2010: $23,972/$66,028 = 36·3%

4. Increase in marketing costs = $4,678 – $3,291/$3,291 = 42·1%

5. Increase in staff training costs = $3,396 – $1,287/$1,287 = 163·9%

6. Decrease in enrolment costs = $960 – 5,032/5,032 = 80·9%

7. Net operating profitDecreased from $3,635 to $2,106. This is fall of 1,529/3,635 = 42·1%

3 (a) Optimum production plan

Define the variablesLet x = no. of jars of face cream to be producedLet y = no. of bottles of body lotion to be producedLet C = contribution

State the objective functionThe objective is to maximise contribution, CC = 9x + 8y

State the constraintsSilk powder 3x + 2y ≤ 5,000Silk amino acids 1x + 0·5y ≤ 1,600Skilled labour 4x + 5y ≤ 9,600

Non-negativity constraints:x, y ≥ 0

Sales constraint:y ≤ 2,000

Draw the graphSilk powder 3x + 2y = 5,000If x = 0, then 2y = 5,000, therefore y = 2,500If y = 0, then 3x = 5,000, therefore x = 1,666·7

Silk amino acids 1x +0·5y = 1,600If x = 0, then 0·5y = 1,600, therefore y = 3,200If y = 0, then x = 1,600

Skilled labour 4x + 5y = 9,600If x = 0, then 5y = 9,600, therefore y = 1,920If y = 0, then 4x = 9,600, therefore x = 2,400

13

Solve using iso-contribution lineIf y =800 and x = 0, then if C = 9x + 8yC = (8 x 800) = 6,400Therefore, if y = 0, 9x = 6,400Therefore x = 711·11

Using the iso-contribution line, the furthest vertex from the origin is point c, the intersection of the constraints for skilled labourand silk powder.

Solving the simultaneous equations for these constraints:4x + 5y = 9,600 x 33x + 2y = 5,000 x 4

12x + 15y = 28,80012x + 8y = 20,000

Subtract the second one from the first one7y = 8,800, therefore y = 1,257·14.

If y = 1,257·14 and:4x + 5y = 9,600

Then 5 x 1,257·14 + 4x = 9,600Therefore x= 828·58

If C = 9x + 8yC = $7,457·22 + $10,057·12 = $17,514·34

14

3,500

3,000

2,500

2,000

1,500

1,000

500

00 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500

Jars of face cream

Bot

tles

of b

ody

lotio

n y = 2,000

b

c

d

ea

c = 9x +

8y

1x + 0·5y=

1,600

3x + 2y=

5,000

4x + 5y = 9,600

Silk powder Silk amino acids Skilled labour

Iso-contribution lineMaximum sales of lotionFeasible region

(b) Shadow prices and slack

The shadow price for silk powder can be found by solving the two simultaneous equations intersecting at point c, whilstadding one more hour to the equation for silk powder.

4x +5y = 9,600 x 33x + 2y = 5,001 x 4

12x + 15y = 28,80012x + 8y = 20,004

Subtract the second one from the first one

7y = 8,796, therefore y = 1,256·57

3x + (2 x 1,256·57) = 5,001.Therefore x = 829·29

C = (9 x 829·29) + (8 x 1,256·57) = $17,516·17Original contribution = $17,514·34Therefore shadow price for silk powder is $1·83 per gram.

The slack for amino acids can be calculated as follows:

(828·58 x 1) + (0·5 x 1,257·14) = 1,457·15 grams used.Available = 1,600 grams.Therefore slack = 142·85 grams.

4 (a) Cost per unit under full absorption costing

Total annual overhead costs: $Machine set up costs 26,550Machine running costs 66,400Procurement costs 48,000Delivery costs 54,320

––––––––195,270––––––––

Overhead absorption rate:

A B C TotalProduction volumes 15,000 12,000 18,000Labour hours per unit 0·1 0·15 0·2Total labour hours 1,500 1,800 3,600 6,900

Therefore, overhead absorption rate = $195,270/6,900 = $28·30 per hour

Cost per unit:

A B C$ $ $

Raw materials ($1·20 x 2/3/4kg) 2·4 3·6 4·8Direct labour ($14·80 x 0·1/0·15/0·2hrs) 1·48 2·22 2·96Overhead ($28·30 x 0·1/0·15/0·2 hrs) 2·83 4·25 5·66

––––– ––––– –––––Full cost per unit 6·71 10·07 13·42

––––– ––––– –––––

(b) Cost per unit using full absorption costing

Cost drivers:Cost pools $ Cost driverMachine set up costs 26,550 36 production runs (16 + 12 + 8)Machine running costs 66,400 32,100 machine hours (7,500 + 8,400 + 16,200)Procurement costs 48,000 94 purchase orders (24 + 28 + 42)Delivery costs 54,320 140 deliveries (48 + 30 + 62)

––––––––195,270––––––––

Cost per machine set up $26,550/36 = $737·50Cost per machine hour $66,400/32,100 = $2·0685Cost per order $48,000/94 = $510·6383Cost per delivery $54,320/140 = $388

15

Allocation of overheads to each product:

A B C Total$ $ $ $

Machine set up costs 11,800 8,850 5,900 26,550Machine running costs 15,514 17,375 33,510 66,400Procurement costs 12,255 14,298 21,447 48,000Delivery costs 18,624 11,640 24,056 54,320

––––––– ––––––– ––––––– ––––––––58,193 52,163 84,913 195,270––––––– ––––––– ––––––– ––––––––

Number of units produced 15,000 12,000 18,000

$ $ $Overhead cost per unit 3·88 4·35 4·72

Total cost per unit A B C$ $ $

Materials 2·4 3·6 4·8Labour 1·48 2·22 2·96Overheads 3·88 4·35 4·72

––––– –––––– ––––––7·76 10·17 12·48

––––– –––––– ––––––

(c) Using activity-based costing

When comparing the full unit costs for each of the products under absorption costing as compared to ABC, the followingobservations can be made:

Product AThe unit cost for product A is 16% higher under ABC as opposed to traditional absorption costing. Under ABC, it is $7·76per unit compared to $6·71 under traditional costing. This is particularly significant given that the selling price for product Ais $7·50 per unit. This means that when the activities that give rise to the overhead costs for product A are taken into account,product A is actually making a loss. If the company wants to improve profitability it should look to either increase the sellingprice of product A or somehow reduce the costs. Delivery costs are also high, with 48 deliveries a year being made for productA. Maybe the company could seek further efficiencies here. Also, machine set up costs are higher for product A than for anyof the other products, due to the larger number of production runs. The reason for this needs to be identified and, if possible,the number of production runs needs to be reduced.

Product BThe difference between the activity based cost for B as opposed to the traditional cost is quite small, being only $0·10. Sincethe selling price for B is $12, product B is clearly profitable whichever method of overhead allocation is used. ABC does notreally identify any areas for concern here.

Product CThe unit cost for C is 7% lower under ABC when compared to traditional costing. More importantly, while C looks like it ismaking a loss under traditional costing, ABS tells a different story. The selling price for C is $13 per unit and, under ABC, itcosts $12·48 per unit. Under traditional absorption costing, C is making a loss of $0·42 per unit. Identifying the reason forthe differences in C, it is apparent that the number of production runs required to produce C is relatively low compared to thevolumes produced. This leads to a lower apportionment of the machine set up costs to C than would be given under traditionalabsorption costing. Similarly, the number of product tests carried out on C is low relative to its volume.

ABC is therefore very useful in identifying that C is actually more profitable than A, because of the reasons identified above.The company needs to look at the efficiency that seems to be achieved with C (low number of production runs less testing)and see whether any changes can be made to A, to bring it more in line with C. Of course, this may not be possible, in whichcase the company may consider whether it wishes to continue to produce A and whether it could sell higher volumes of C.

5 (a) Difficulties in the public sector

In the public sector, the objectives of the organisation are more difficult to define in a quantifiable way than the objectives ofa private company. For example, a private company’s objectives may be to maximise profit. The meeting of this objective canthen be set out in the budget by aiming for a percentage increase in sales and perhaps the cutting of various costs. If, on theother hand, the public sector organisation is a hospital, for example, then the objectives may be largely qualitative, such asensuring that all outpatients are given an appointment within eight weeks of being referred to the hospital. This is difficult todefine in a quantifiable way, and how it is actually achieved is even more difficult to define.

This leads onto the next reason why budgeting is so difficult in public sector organisations. Just as objectives are difficult todefine quantifiably, so too are the organisation’s outputs. In a private company the output can be measured in terms of salesrevenue. There is a direct relationship between the expenditure that needs to be incurred i.e. needs to be input in order toachieve the desired level of output. In a hospital, on the other hand, it is difficult to define a quantifiable relationship betweeninputs and outputs. What is more easy to compare is the relationship between how much cash is available for a particular

16

area and how much cash is actually needed. Therefore, budgeting naturally focuses on inputs alone, rather than therelationship between inputs and outputs.

Finally, public sector organisations are always under pressure to show that they are offering good value for money, i.e.providing a service that is economical, efficient and effective. Therefore, they must achieve the desired results with theminimum use of resources. This, in itself, makes the budgeting process more difficult.

(b) Incremental and zero-based budgeting

‘Incremental budgeting’ is the term used to describe the process whereby a budget is prepared using a previous period’sbudget or actual performance as a base, with incremental amounts then being added for the new budget period.

‘Zero-based budgeting’, on the other hand, refers to a budgeting process which starts from a base of zero, with no referencebeing made to the prior period’s budget or performance. Every department function is reviewed comprehensively, with allexpenditure requiring approval, rather than just the incremental expenditure requiring approval.

(c) Stages in zero-based budgeting

Zero-based budgeting involves three main stages:

1. Activities are identified by managers. These activities are then described in what is called a ‘decision package’. Thisdecision package is prepared at the base level, representing the minimum level of service or support needed to achievethe organisation’s objectives. Further incremental packages may then be prepared to reflect a higher level of service orsupport.

2. Management will then rank all the packages in the order of decreasing benefits to the organisation. This will helpmanagement decide what to spend and where to spend it.

3. The resources are then allocated based on order of priority up to the spending level.

(d) No longer a place for incremental budgeting

The view that there is no longer a place for incremental budgeting in any organisation is a rather extreme view. It is knownfor encouraging slack and wasteful spending, hence the comment that it is particularly unsuitable for public sectororganisations, where cash cutbacks are being made. However, to say that there is no place for it at all is to ignore thedrawbacks of zero-based budgeting. These should not be ignored as they can make ZBB implausible in some organisationsor departments. They are as follows:

– Departmental managers will not have the skills necessary to construct decision packages. They will need training forthis and training takes time and money.

– In a large organisation, the number of activities will be so large that the amount of paperwork generated from ZBB willbe unmanageable.

– Ranking the packages can be difficult, since many activities cannot be compared on the basis of purely quantitativemeasures. Qualitative factors need to be incorporated but this is difficult.

– The process of identifying decision packages, determining their purpose, costs and benefits is massively time consumingand therefore costly.

– Since decisions are made at budget time, managers may feel unable to react to changes that occur during the year. Thiscould have a detrimental effect on the business if it fails to react to emerging opportunities and threats.

It could be argued that ZBB is more suitable for public sector than for private sector organisations. This is because, firstly, itis far easier to put activities into decision packages in organisations which undertake set definable activities. Localgovernment, for example, have set activities including the provision of housing, schools and local transport. Secondly, it is farmore suited to costs that are discretionary in nature or for support activities. Such costs can be found mostly in not for profitorganisations or the public sector, or in the service department of commercial operations.

Since ZBB requires all costs to be justified, it would seem inappropriate to use it for the entire budgeting process in acommercial organisation. Why take so much time and resources justifying costs that must be incurred in order to meet basicproduction needs? It makes no sense to use such a long-winded process for costs where no discretion can be exercisedanyway. Incremental budgeting is, by its nature, quick and easy to do and easily understood. These factors should not beignored.

In conclusion, whilst ZBB is more suited to public sector organisations, and is more likely to make cost savings in hard timessuch as these, its drawbacks should not be overlooked.

17


Marks1 (a) (i) Sales price variance 3

Sales volume variance 3–––

6–––

(ii) Purchasing planning variance 1Purchasing efficiency variance 1

–––2

–––

(iii) Actual hours worked 3Labour rate variance 2Labour efficiency variance 2

–––7

–––

(b) Each valid reason 1–––

5–––20–––

19

Marks2 Turnover

8·3% decrease 0.5Actual t/o 14·6% higher 0.5Performed well CF market conditions 1Transfer of students 1

–––Max. turnover 3

–––

Cost of sales19·2% decrease 0.563·7% of turnover 0.515% fee reduction from freelance staff 2Other costs of sale fell by $3·555m 2Online marking did not save as much as planned 1

–––Max. COS 5

–––

Gross profit – numbers and comment 1

Indirect expenses:Marketing costs42·1% increase 0.5Increase necessary to reap benefits of developments 1Benefits may take more than one year to be felt 0.5

Property costs – stayed the same 0.5

Staff training163·9% increase 0.5Necessary for staff retention 1Necessary to train staff on new website etc 1Without training, staff would have left 1Less student complaints 1

Interactive website and student helplineAttracted new students 1Increase in pass rate 1

Enrolment costsFall of 80·9% 0.5Result of electronic system being introduced 1Reduced number of late enrolments 1

–––Max. Indirect expenses 9

–––

Net operating profitFallen to $2·106 0.5Difficult market 1Staff training costs should decrease in future 1Future increase in market share 1Lower advertising cost in future 1Charge for website 1

–––Max. net operating profit 3

–––20–––

20

Marks3 (a) Optimum production plan

Assigning letters for variables 0.5Defining constraint for silk powder 0.5Defining constraint for amino acids 0.5Defining constraint for labour 0.5Non-negativity constraint 0.5Sales constraint: x 0.5Sales constraint: y 0.5Iso-contribution line worked out 1The graph:Labels 0.5Silk powder 0.5Amino acids 0.5Labour line 0.5Demand for x line 0.5Demand for y line 0.5Iso-contribution line 0.5Vertices a–e identified 0.5Feasible region shaded 0.5Optimum point identified 1Equations solved at optimum point 3Total contribution 1

–––14

–––

(b) Shadow prices and slackShadow price 4Slack 2

–––6

–––20–––

4 (a) Contribution per unitOverhead absorption rate 2Cost for A 1Cost for B 1Cost for C 1

–––5

–––

(b) Cost under ABCCorrect cost driver rates 5Correct overhead unit cost for A 1Correct overhead unit cost for B 1Correct overhead unit cost for C 1Correct cost per unit under ABC 1

–––9

–––

(c) Using ABC to improve profitabilityOne mark per point about the Gadget Co 1

–––6

–––20–––

21

Marks5 (a) Explanation

Difficulty setting objectives quantifiably 2Difficulty in saying how to achieve them 1Outputs difficult to measure 2No relationship between inputs and outputs 2Value for money issue 2

–––Maximum 5

–––

(b) Incremental and zero-based budgetingExplaining ‘incremental budgeting’ 2Explaining ‘zero-based budgeting’ 2

–––4

–––

(c) Stages involved in zero-based budgetingEach stage 1

–––3

–––

(d) DiscussionAny disadvantage of inc. that supports statement (max. 3) 1Incremental budgeting is quick and easy 1Any disadvantage of ZBB that refutes statement (max. 3) 1Easier to define decision packages in public sector 2more appropriate for discretionary costs 2Conclusion 1

–––Maximum 8

–––20–––

22








Pape

r F5Performance

Management

Monday 13 June 2011



1 Cement Co is a company specialising in the manufacture of cement, a product used in the building industry. Thecompany has found that when weather conditions are good, the demand for cement increases since more buildingwork is able to take place. Last year, the weather was so good, and the demand for cement was so great, that CementCo was unable to meet demand. Cement Co is now trying to work out the level of cement production for the comingyear in order to maximise profits. The company doesn’t want to miss out on the opportunity to earn large profits byrunning out of cement again. However, it doesn’t want to be left with large quantities of the product unsold at the endof the year, since it deteriorates quickly and then has to be disposed of. The company has received the followingestimates about the probable weather conditions and corresponding demand levels for the coming year:

Weather Probability DemandGood 25% 350,000 bagsAverage 45% 280,000 bagsPoor 30% 200,000 bags

Each bag of cement sells for $9 and costs $4 to make. If cement is unsold at the end of the year, it has to be disposedof at a cost of $0·50 per bag.

Cement Co has decided to produce at one of the three levels of production to match forecast demand. It now has todecide which level of cement production to select.

Required:

(a) Construct a pay off table to show all the possible profit outcomes. (8 marks)

(b) Decide the level of cement production the company should choose, based on the following decision rules:

(i) Maximin (1 mark)

(ii) Maximax (1 mark)

(iii) Expected value (4 marks)

You must justify your decision under each rule, showing all necessary calculations.

(c) Describe the ‘maximin’ and ‘expected value’ decision rules, explaining when they might be used and theattitudes of the decision makers who might use them. (6 marks)

(20 marks)

2

2 Heat Co specialises in the production of a range of air conditioning appliances for industrial premises. It is about tolaunch a new product, the ‘Energy Buster’, a unique air conditioning unit which is capable of providing unprecedentedlevels of air conditioning using a minimal amount of electricity. The technology used in the Energy Buster is uniqueso Heat Co has patented it so that no competitors can enter the market for two years. The company’s developmentcosts have been high and it is expected that the product will only have a five-year life cycle.

Heat Co is now trying to ascertain the best pricing policy that they should adopt for the Energy Buster’s launch ontothe market. Demand is very responsive to price changes and research has established that, for every $15 increase inprice, demand would be expected to fall by 1,000 units. If the company set the price at $735, only 1,000 unitswould be demanded.

The costs of producing each air conditioning unit are as follows:

$Direct materials 42Labour 12 (1·5 hours at $8 per hour. See note below)Fixed overheads 6 (based on producing 50,000 units per annum)

–––Total cost 60

–––

Note

The first air conditioning unit took 1·5 hours to make and labour cost $8 per hour. A 95% learning curve exists, inrelation to production of the unit, although the learning curve is expected to finish after making 100 units. Heat Co’smanagement have said that any pricing decisions about the Energy Buster should be based on the time it takes tomake the 100th unit of the product. You have been told that the learning co-efficient, b = –0·0740005.

All other costs are expected to remain the same up to the maximum demand levels.

Required:

(a) (i) Establish the demand function (equation) for air conditioning units; (3 marks)

(ii) Calculate the marginal cost for each air conditioning unit after adjusting the labour cost as required bythe note above; (6 marks)

(iii) Equate marginal cost and marginal revenue in order to calculate the optimum price and quantity.(3 marks)

(b) Explain what is meant by a ‘penetration pricing’ strategy and a ‘market skimming’ strategy and discusswhether either strategy might be suitable for Heat Co when launching the Energy Buster. (8 marks)

(20 marks)

3 [P.T.O.

3 Noble is a restaurant that is only open in the evenings, on SIX days of the week. It has eight restaurant and kitchenstaff, each paid a wage of $8 per hour on the basis of hours actually worked. It also has a restaurant manager and ahead chef, each of whom is paid a monthly salary of $4,300. Noble’s budget and actual figures for the month of Maywas as follows:

Budget ActualNumber of meals 1,200 1,560

$ $ $ $Revenue: Food 48,000 60,840

Drinks 12,000 11,700––––––– ––––––––

60,000 72,540Variable costs:

Staff wages (9,216) (13,248)Food costs (6,000) (7,180)Drink costs (2,400) (5,280)Energy costs (3,387) (3,500)

(21,003) (29,208)––––––– ––––––––

Contribution 38,997 43,332Fixed costs:Manager’s and chef’s pay (8,600) (8,600)Rent, rates and depreciation (4,500) (13,100) (4,500) (13,100)

––––––– –––––––– ––––––– ––––––––Operating profit 25,897 30,232

––––––– ––––––––

The budget above is based on the following assumptions:

1 The restaurant is only open six days a week and there are four weeks in a month. The average number of orderseach day is 50 and demand is evenly spread across all the days in the month.

2 The restaurant offers two meals: Meal A, which costs $35 per meal and Meal B, which costs $45 per meal. Inaddition to this, irrespective of which meal the customer orders, the average customer consumes four drinks eachat $2·50 per drink. Therefore, the average spend per customer is either $45 or $55 including drinks, dependingon the type of meal selected. The May budget is based on 50% of customers ordering Meal A and 50% ofcustomers ordering Meal B.

3 Food costs represent 12·5% of revenue from food sales.

4 Drink costs represent 20% of revenue from drinks sales.

5 When the number of orders per day does not exceed 50, each member of hourly paid staff is required to workexactly six hours per day. For every incremental increase of five in the average number of orders per day, eachmember of staff has to work 0·5 hours of overtime for which they are paid at the increased rate of $12 per hour.You should assume that all costs for hourly paid staff are treated wholly as variable costs.

6 Energy costs are deemed to be related to the total number of hours worked by each of the hourly paid staff, andare absorbed at the rate of $2·94 per hour worked by each of the eight staff.

Required:

(a) Prepare a flexed budget for the month of May, assuming that the standard mix of customers remains thesame as budgeted. (12 marks)

4

(b) After preparation of the flexed budget, you are informed that the following variances have arisen in relation tototal food and drink sales:

Sales mix contribution variance $1,014 AdverseSales quantity contribution variance $11,700 Favourable

Required:

BRIEFLY describe the sales mix contribution variance and the sales quantity contribution variance. Identifywhy each of them has arisen in Noble’s case. (4 marks)

(c) Noble’s owner told the restaurant manager to run a half-price drinks promotion at Noble for the month of Mayon all drinks. Actual results showed that customers ordered an average of six drinks each instead of the usualfour but, because of the promotion, they only paid half of the usual cost for each drink. You have calculated thesales margin price variance for drink sales alone and found it to be a worrying $11,700 adverse. The restaurantmanager is worried and concerned that this makes his performance for drink sales look very bad.

Required:

Briefly discuss TWO other variances that could be calculated for drinks sales or food sales in order to ensurethat the assessment of the restaurant manager’s performance is fair. These should be variances that COULDbe calculated from the information provided above although no further calculations are required here.

(4 marks)

(20 marks)

4 (a) Brace Co is an electronics company specialising in the manufacture of home audio equipment. Historically, thecompany has used solely financial performance measures to assess the performance of the company as a whole.The company’s Managing Director has recently heard of the ‘balanced scorecard approach’ and is keen to learnmore.

Required:

Describe the balanced scorecard approach to performance measurement. (10 marks)

(b) Brace Co is split into two divisions, A and B, each with their own cost and revenue streams. Each of the divisionsis managed by a divisional manager who has the power to make all investment decisions within the division.The cost of capital for both divisions is 12%. Historically, investment decisions have been made by calculatingthe return on investment (ROI) of any opportunities and at present, the return on investment of each division is16%.

A new manager who has recently been appointed in division A has argued that using residual income (RI) tomake investment decisions would result in ‘better goal congruence’ throughout the company.

Each division is currently considering the following separate investments:

Project for Division A Project for Division BCapital required for investment $82·8 million $40·6 millionSales generated by investment $44·6 million $21·8 millionNet profit margin 28% 33%

The company is seeking to maximise shareholder wealth.

Required:

Calculate both the return on investment and residual income of the new investment for each of the twodivisions. Comment on these results, taking into consideration the manager’s views about residual income.

(10 marks)

(20 marks)

5 [P.T.O.

5 Thin Co is a private hospital offering three types of surgical procedures known as A, B and C. Each of them uses apre-operative injection given by a nurse before the surgery. Thin Co currently rent an operating theatre from aneighbouring government hospital. Thin Co does have an operating theatre on its premises, but it has never been putinto use since it would cost $750,000 to equip. The Managing Director of Thin Co is keen to maximise profits andhas heard of something called ‘throughput accounting’, which may help him to do this. The following information isavailable:

1 All patients go through a five step process, irrespective of which procedure they are having:

– step 1: consultation with the advisor;– step 2: pre-operative injection given by the nurse;– step 3: anaesthetic given by anaesthetist;– step 4: procedure performed in theatre by the surgeon;– step 5: recovery with the recovery specialist.

2 The price of each of procedures A, B and C is $2,700, $3,500 and $4,250 respectively.

3 The only materials’ costs relating to the procedures are for the pre-operative injections given by the nurse, theanaesthetic and the dressings. These are as follows:

Procedure A Procedure B Procedure C$ per procedure $ per procedure $ per procedure

Pre-operative nurse’s injections 700 800 1,000Anaesthetic 35 40 45Dressings 5·60 5·60 5·60

4 There are five members of staff employed by Thin Co. Each works a standard 40-hour week for 47 weeks of theyear, a total of 1,880 hours each per annum. Their salaries are as follows:

– Advisor: $45,000 per annum;– Nurse: $38,000 per annum;– Anaesthetist: $75,000 per annum;– Surgeon: $90,000 per annum;– Recovery specialist: $50,000 per annum.

The only other hospital costs (comparable to ‘factory costs’ in a traditional manufacturing environment) aregeneral overheads, which include the theatre rental costs, and amount to $250,000 per annum.

5 Maximum annual demand for A, B and C is 600, 800 and 1,200 procedures respectively. Time spent by eachof the five different staff members on each procedure is as follows:

Procedure A Procedure B Procedure CHours Hours Hours

per procedure per procedure per procedureAdvisor 0·24 0·24 0·24Nurse 0·27 0·28 0·30Anaesthetist 0·25 0·28 0·33Surgeon 0·75 1 1·25Recovery specialist 0·60 0·70 0·74

Part hours are shown as decimals e.g. 0·24 hours = 14·4 minutes (0·24 x 60).

Surgeon’s hours have been correctly identified as the bottleneck resource.

6

Required:

(a) Calculate the throughput accounting ratio for procedure C.

Note: It is recommended that you work in hours as provided in the table rather than minutes. (6 marks)

(b) The return per factory hour for products A and B has been calculated and is $2,612·53 and $2,654·40respectively. The throughput accounting ratio for A and B has also been calculated and is 8·96 and 9·11respectively.

Calculate the optimum product mix and the maximum profit per annum. (7 marks)

(c) Assume that your calculations in part (b) showed that, if the optimum product mix is adhered to, there will beexcess demand for procedure C of 696 procedures per annum. In order to satisfy this excess demand, thecompany is considering equipping and using its own theatre, as well as continuing to rent the existing theatre.The company cannot rent any more theatre time at either the existing theatre or any other theatres in the area,so equipping its own theatre is the only option. An additional surgeon would be employed to work in the newlyequipped theatre.

Required:

Discuss whether the overall profit of the company could be improved by equipping and using the extratheatre.

Note: Some basic calculations may help your discussion. (7 marks)

(20 marks)

7 [P.T.O.

8

Formulae Sheet

Learning curve

Y = axb

Where Y = cumulative average time per unit to produce x units a = the time taken for the first unit of output x = the cumulative number of units produced b = the index of learning (log LR/log2) LR = the learning rate as a decimal

Regression analysis

Demand curve



y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

( x) )(n y) )2 2 2 2

P = a – bQ

MR = a – 2bQ


Answers

11


1 Cement Co

(a) Pay off table

SUPPLY (no. of bags)Prob.* 350,000 280,000 200,000

Weather $’000 $’000 $’000Good $’000 0·25 1,750 (1) 1,400 1,000

DEMAND Average $’000 0·45 1,085 (2) 1,400 1,000Poor $’000 0·3 325 640 1,000

* The probability column is only shown so as to help in part (b) (iii)’s calculations.

Profit per bag sold in coming year = $9 – $4 = $5Loss per bag disposed of = $4 + $0·50 = $4·50

(1) 350,000 x $5 = $1,750,000

(2) [280,000 x $5] – [70,000 x $(4·50)] = $1,085,000 etc

(b) (i) Maximin – identify the worst outcome for each level of supply and choose the highest of these worst outcomes.

SUPPLY (no. of bags)350,000 280,000 200,000

$’000 $’000 $’000Worst 325 640 1000

The highest of these is $1,000,000 therefore choose to supply only 200,000 bags to meet poor conditions.

(ii) Maximax – identify the best outcome for each level of supply and choose the highest of these best outcomes.SUPPLY (no. of bags)

350,000 280,000 200,000$’000 $’000 $’000

Best 1,750 1,400 1,000

The highest of these is $1,750,000 therefore choose to supply 350,000 bags to meet good conditions.

(iii) Expected value – use the probabilities provided in order to calculate the expected value of each of the supply levels.

Good (0·25 x $1,750,000) + (0·45 x $1,085,000) + (0·30 x $325,000) = $1,023,250Average (0·7 x $1,400,000) + (0·3 x $640,000) = $1,172,000Poor 1 x $1,000,000 = $1,000,000

The expected value of producing 280,000 bags when conditions are average is the highest at $1,172,000, thereforethis supply level should be chosen.

(c) Maximin and expected value decision rules

The ‘maximin’ decision rule looks at the worst possible outcome at each supply level and then selects the highest one of these.It is used when the outcome cannot be assessed with any level of certainty. The decision maker therefore chooses theoutcome which is guaranteed to minimise his losses. In the process, he loses out on the opportunity of making big profits. Itis often seen as the pessimistic approach to decision-making (assuming that the worst outcome will occur) and is used bydecision makers who are risk averse. It can be used for one-off or repeated decisions.

The ‘expected value’ rule calculates the average return that will be made if a decision is repeated again and again. It doesthis by weighting each of the possible outcomes with their relative probability of occurring. It is the weighted arithmetic meanof the possible outcomes.

Since the expected value shows the long run average outcome of a decision which is repeated time and time again, it is auseful decision rule for a risk neutral decision maker. This is because a risk neutral person neither seeks risk or avoids it; theyare happy to accept an average outcome. The problem often is, however, that this rule is often used for decisions that onlyoccur once. In this situation, the actual outcome is unlikely to be close to the long run average. For example, with CementCo, the closest actual outcome to the expected value of $1,172,000 is the outcome of $1,085,000. This is not too far awayfrom the expected value but many of the others are really different.

2 The Energy Buster

(a) Profit

In order to ascertain the optimum price, you must use the formula P = a – bQ

Where P = price; Q = quantity; a = intersection (price at which quantity demanded will be nil); b = gradient of the demandcurve.

The approach is as follows:

(i) Establish the demand function

b = change in price/change in quantity = $15/1,000 = 0·015.

We know that if price = $735, quantity = 1,000 units.

Establish ‘a’ by substituting these values for P, Q and b into our demand function:

735 = a – 0·015Q15 + 735 = aTherefore a = 750.

Demand function is therefore P = 750 – 0·015Q

(ii) Establish marginal cost

The labour cost of the 100th unit needs to be calculated as follows:

Formula = y = axb.a = 1·5

Therefore, if x = 100 and b= –·0740005, then y = 1·5 x 100–0·0740005 = 1·0668178Therefore cost per unit = 1·0668178 x $8 = $8·5345Total cost for 100 units = $853·45.

If x = 99, y = 1·5 x 99–0·0740005 = 1·0676115Therefore cost per unit = $8·5408Total cost for 99 = $845·55Therefore cost of 100th unit = $853·45 – $845·55 = $7·90.

Therefore total marginal cost = $42 + $7·90 = $49·90.Fixed overheads have been ignored as they are not part of the marginal cost.

(iii) Find profit

(1) Establish the marginal revenue function

MR = a – 2bQ MR = 750 – 0·03Q

(2) Equate MC and MR

49·90 = 750 – 0·03Q0·03Q = 700·1Q = 23,337

(3) Find optimum price

P = 750 – (0·015 x 23,337)= $399·95

(b) (i) Penetration pricingWith penetration pricing, a low price would initially be charged for the Energy Buster. The idea behind this is that theprice will make the product accessible to a larger number of buyers and therefore the high sales volumes will compensatefor the lower prices being charged. A large market share would be gained and possibly, the Energy Buster might becomeaccepted as the only industrial air conditioning unit worth buying.

The circumstances that would favour a penetration pricing policy are:

– highly elastic demand for the Energy Buster i.e. the lower the price, the higher the demand. The preliminaryresearch does suggest that demand is elastic.

– if significant economies of scale could be achieved by Heat Co, then higher sales volumes would result in sizeablereductions in costs. This is not the case here, since learning ceases at 100 units.

– if Heat Co was actively trying to discourage new entrants into the market. In this case, new entrants cannot enterthe market anyway, because of the patent.

12

– if Heat Co wished to shorten the initial period of the Energy Buster’s life cycle so as to enter the growth and maturitystages quickly. We have no evidence that this is the case for Heat Co, although it could be.

From the above, it can be seen that this could be a suitable strategy in some respects but it is not necessarily the bestone.

(ii) Market skimmingWith market skimming, high prices would initially be charged for the Energy Buster rather than low prices. This wouldenable Heat Co to take advantage of the unique nature of the product, thus maximising sales from those customers wholike to have the latest technology as early as possible. The most suitable conditions for this strategy are:

– the product is new and different. This is indeed the case with the Energy Buster.

– the product has a short life cycle and high development costs that need to be recovered quickly. The life cycle isfairly short and high development costs have been incurred.

– since high prices attract competitors, there needs to be barriers to entry in order to deter competitors. In Heat Co’scase, there is a barrier, since it has obtained a patent for the Energy Buster.

– the strength and sensitivity of demand are unknown. Again, this is not the case here.

Once again, the Energy Buster meets only some of the conditions which would suggest that although this strategy maybe suitable the answer is not clear cut. The fact that high development costs have been incurred and the life cycle isfairly short are fairly good reasons to adopt this strategy. Whilst we have demand curve data, we do not really know justhow reliable this data really is, in which case a skimming strategy may be a safer option.

3 Noble restaurant

(a) Flexed budget

Number of meals 1,560$ $

Food sales (1) 62,400Drink sales (1) 15,600

–––––––Total revenue 78,000Variable costs:Staff wages (2) (12,672)Food costs (3) (7,800)Drink costs (4) (3,120)Energy costs (5) (4,234)

–––––––(27,826)–––––––

Contribution 50,174Fixed costs:Manager’s and chef’s pay (8,600)Rent, rates and depreciation (4,500)

–––––––(13,100)–––––––

Operating profit 37,074––––––––––––––

(1) Food revenueFood revenue = 1,560 x $40 = $62,400Drinks revenue = 1,560 x ($2·50 x 4) = $15,600.

(2) Staff wagesAverage number of orders per day = 1,560/(6 days x 4 weeks) = 65 per day.Therefore extra orders = 15 per day.8 staff x 1·5 hours x 6 days x 4 weeks = 288 extra hours.At $12 per hour = $3,456 extra wages.Total flexed wages = $9,216 + $3,456 = $12,672.

(3) Food costsFood costs = 12·5% x $62,400 = $7,800.

(4) Drink costsDrinks costs = $15,600 x 20% = $3,120.

(5) Energy costs Standard total hours worked = (8 x 6) x 6 days x 4 weeks = 1,152 hours.Extra hours worked = 288 (working 2).Total hours = 1,152 + 288 = 1,440.At $2·94 per hour = $4,234.

13

(b) The sales mix contribution variance measures the effect on profit of changing the mix of actual sales from the standard mix.The sales quantity contribution variance measures the effect on profit of selling a different total quantity from the budgetedtotal quantity.

The mix variance is adverse here. Since meal B generates a higher contribution than meal A, the adverse variance shows thatmore of meal A must have been sold, relative to B, than budgeted. Since the quantity variance is favourable, this means thatthe total quantity of meals sold (in the standard mix) was higher than expected, as evidenced by the number of meals soldbeing 1,560 rather than the budgeted 1,200.

(c) Two other variances

Drink salesAs well as the price variance for drinks sales, the sales margin volume variance could be calculated. This will examine thedifference between the standard volume of sales that would ordinarily be expected for this number of customers (1,560 x 4 drinks) compared to the actual volume of drinks sold because of the drinks promotion (1,560 x 6 drinks). Since the varianceis calculated by applying the increase in volume to the standard margin, this variance will be favourable.

In addition, the total sales margin price variance for drinks sales could be split into an operational and a planning variance.The manager is only responsible for any operational variance and any part of the sales margin variance that relates to aplanning error (i.e. the last minute decision by the owner to run the drinks promotion) should be separated out. This way, themanager will not be held accountable for matters outside of his control.

Food salesBy running the half price drinks offer promotion, more customers have been attracted to the restaurant. Drinks have beentreated as a ‘loss leader’ i.e. sold at a low price in order to entice customers. It would therefore be relevant to calculate somevariances in relation to food sales in order to show how the drinks promotion has increased food sales. The most obvious oneto calculate would be the sales margin volume variance for food sales.

NOTE: Candidates only needed to mention two variances.

4 Brace Co

(a) Balanced scorecard

The balanced scorecard is a strategic management technique for communicating and evaluating the achievement of thestrategy and mission of an organisation. It comprises an integrated framework of financial and non-financial performancemeasures that aim to clarify, communicate and manage strategy implementation. It translates an organisation’s strategy intoobjectives and performance measurements for the following four perspectives:

Financial perspectiveThe financial perspective considers how the organisation appears to shareholders. How can it create value for itsshareholders? Kaplan and Norton, who developed the balanced scorecard, identified three core financial themes that will drivethe business strategy: revenue growth and mix, cost reduction and asset utilisation.

Customer perspectiveThe customer perspective considers how the organisation appears to customers. The organisation should ask itself: ‘to achieveour vision, how should we appear to our customers?’.

The customer perspective should identify the customer and market segments in which the business units will compete. Thereis a strong link between the customer perspective and the revenue objectives in the financial perspective. If customerobjectives are achieved, revenue objectives should be too.

Internal perspectiveThe internal perspective requires the organisation to ask itself the question – ‘what must we excel at to achieve our financialand customer objectives?’. It must identify the internal business processes that are critical to the implementation of theorganisation’s strategy. Kaplan and Norton identify a generic process value chain consisting of three processes: the innovationprocess, the operations process and the post-sales process.

Learning and growth perspectiveThe learning and growth perspective requires the organisation to ask itself whether it can continue to improve and createvalue.

If an organisation is to continue having loyal, satisfied customers and make good use of its resources, it must keep learningand developing. It is critical that an organisation continues to invest in its infrastructure – i.e. people, systems andorganisational procedures – in order to provide the capabilities that will help the other three perspectives to be accomplished.

14

(b) Divisional performance

ROI:Division ANet profit = $44·6m x 28% = $12·488mROI = $12·488m/$82·8m = 15·08%

Division BNet profit = $21·8m x 33% = $7·194mROI = $7·194m/$40·6m = $17·72%

Residual income:Division ADivisional profit = $12·488mCapital employed = $82·8mImputed interest charge = $82·8m x 12% = 9·936mResidual income = $12·488m – $9·936m = $2·552m.

Division BDivisional profit = $7·194mCapital employed = $40·6mImputed interest charge = $40·6m x 12% = $4·872mResidual income = $7·194 – $4·872 = $2·322m.

CommentsIf a decision about whether to proceed with the investments is made based on ROI, it is possible that the manager of Division A will reject the proposal whereas the manager of Division B will accept the proposal. This is because each divisioncurrently has a ROI of 16% and since the Division A investment only has a ROI of 15·08%, it would bring the division’soverall ROI down to less than it’s current level. On the other hand, since the Division B investment is higher than its current16%, the investment would bring the division’s overall ROI up.

When you consider what would actually be best for the company as a whole, you come to the conclusion that, since bothinvestments have a healthy return, they should both be accepted. Hence, the fact that ROI had been used as a decision-making tool has led to a lack of goal congruence between Division A and the company as whole. This backs up whatthe new manager of Division A is saying. If they used residual income in order to aid the decision-making process, bothproposals would be accepted by the divisions since both have a healthy RI. In this case, RI helps the divisions to makedecisions that are in line with the best interests of the company. Once again, this backs up the new manager’s viewpoint.

It is important to note, however, that each of the methods has numerous advantages and disadvantages that have not beenconsidered here.

5 (a) Throughput accounting ratio (TAR)

TAR is traditionally defined as: return per factory hour/cost per factory hour. In this context, we are dealing with a hospital,so it will be: return per hospital hour/cost per hospital hour.

Since, in throughput accounting, all costs except material costs are treated as fixed costs, total hospital costs will be all thesalaries plus the general overheads:

$45,000 + $38,000 + $75,000 + $90,000 + $50,000 + $250,000 = $548,000.

Total hours of bottleneck resource, the surgeon’s time, = 40hrs x 47 weeks = 1,880 hours.

Therefore cost per hospital hour = $548,000/1,880 = $291·49.

Return per hospital hour now needs to be calculated.

$Selling price per unit 4,250Materials cost:– injection (1,000)– anaesthetic (45)– dressings (5·6)

–––––––––Throughput per unit 3,199·40

–––––––––

Time on BNR in hours 1·25

Return per hour ($) 2,559·52

TAR $2,559·52/$291·49= 8·78

15

16

(b) Optimum production plan

Limiting factor analysis can be used to determine the optimum production plan. Each procedure first needs to be rankedaccording to its TAR, then as many of each procedure should be performed as possible, starting with the most profitableprocedure first.

A B C$ $ $

TAR 8·96 9·11 8·78Ranking 2 1 3

Name Number Hrs each Total hours T/P per hour Total T/PB 800 1 800 2,654·40 2,123,520A 600 0·75 450 2,612·53 1,175,638·5C 504 1·25 630 2,559·52 1,612,497·6

–––––– ––––––––––––1,880 4,911,656·1

–––––– –––––––––––––––––– ––––––––––––

The optimum production plan is therefore to perform the maximum number of procedures A and B (600 and 800respectively) and perform only 504 of procedure C.

Total profit will be:

$Throughput 4,911,656·1Less total costs (548,000)

––––––––––––Profit 4,363,656·1

––––––––––––––––––––––––

(c) Profitability increase

At present, if the company adheres to the optimum production plan above, it will be satisfying customer demand forprocedures A and B but not for procedure C. The most obvious way to try and increase profit would be to try and exploitdemand for procedure C. There are two main factors that would need to be overcome in order for this demand to be exploited.Firstly, another surgeon would need to be employed. Most other members of staff clearly have excess time available, becausethe surgeon’s required time is at least double their required time. The recovery specialist, however, is currently used for1,292·96 hours [(600 x 0·6) + (800 x 0·7) + (504 x 0·74)]. This staff member therefore has 587·04 spare hours available(1,880 – 1,292·96). This is enough to carry out the additional 696 procedures of C, gvien that each one uses 0·74 hoursof the recovery specialist’s time (0·74 x 696 = 515·04).

If another surgeon was employed he would be able to meet all of the excess demand for procedure C, which would be 696procedures (1,200 – 504).

Secondly, the other theatre would need to be equipped with the necessary equipment so that the second surgeon couldoperate in it. A quick calculation will show that this cost will be more than covered even in the first year (and the theatre costis capital anyway, and will be benefitted from over many years).

$T/P from additional 696 procedures (696 x 1·25 x $2,559·52) = 2,226,782Cost of equipment (750,000)Surgeon’s fee (90,000)

––––––––––1,386,782––––––––––

Without even taking into account future years, on the basis of one year’s throughput alone, it is worth equipping the secondtheatre provided that a suitably qualified second surgeon can be found.

17


Marks1 (a) Pay off table

Calculation of profit 1Calculation of loss 1‘Demand’ label 0·5‘Supply’ label 0·5Weather column 0·5Supply column – 350,000 1·5Supply column – 280,000 1·5Supply column – 200,000 1·5

–––8

–––

(b) Decision criterion

(i) MaximinSelecting highest of the low 1

–––

(ii) MaximaxSelecting highest of the high 1

–––

(iii) Expected valueCalculating EV when good 1Calculating EV average 1Calculating EV when poor 1Selecting highest 1

–––4

–––

(c) Maximin and EVDescribe maximin 1Used when outcome cannot be assessed with any certainty 1Risk averse/pessimistic 1One-off/repeated decisions 1Describe EV 2Risk neutral 1Repeated decisions 1

–––Maximum marks 6

–––Total marks 20

––––––

18

Marks2 (a) Profit using demand-based approach

(i) Establish demand function:Find b 1Find a 1Write out demand function 1

–––3

–––

(ii) Find MC:Average cost of 100 1Total cost of 100 1Average cost of 99 1Total cost of 99 1Difference 1Correct total MC excluding fixed cost 1

–––6

–––

(iii) Establish MR function 1Equate MC and MR to find Q 1Find optimum price 1

–––3

–––

(b) Market based strategiesPenetration pricingEach valid point 1

–––Max 4

–––

Market skimmingEach valid point 1

–––Max 4


––––––

19

Marks3 (a) Flexed budget

Food sales 1Drink sales 1Total revenue 1Staff wages 1·5Food costs 1Drinks costs 1Energy costs 1·5Variable costs total 1Contribution 1Manager’s and chef’s pay 0·5Rent & Rates 0·5Operating profit 1

–––12

–––

(b) Explanation of variances 2Suggestions of reason for variances 2

–––4

–––

(c) Variance discussionsEach variance 2

–––Maximum 4


––––––

4 (a) Balanced scorecard approachStating what it is 2Financial perspective 2Customer perspective 2Internal perspective 2Learning and growth perspective 2

–––Maximum 10

–––

(b) ROI/RIROI for A 1ROI for B 1RI for A 2RI for B 2

–––Maximum for ROI/RI 6

–––

CommentsA rejects, B accepts under ROI 1Both accept under RI 1ROI produces wrong decision for company 1RI produces right decision 1Manager right 1Other factors to consider 1

–––Maximum for comments 6

–––10


––––––

Marks5 (a) TAR

Cost per hour 3Return per hour – C 2Ratio – C 1

–––6

–––

(b) Optimum production planRanking 1Optimum number of A 1·5Optimum number of B 1·5Optimum number of C 1·5Total throughput 0·5Less cost 0·5Profit 0·5

–––7

–––

(c) DiscussionDemand satisfied for A & B 1Unsatisfied demand for C 1Calculation re recovery specialist 2Would need another surgeon 1Other staff have lots of idle time 1Need extra theatre time 1Profit calculation 1Financially feasible 1Each other valid point 1Conclusion 1

–––Maximum 7


––––––

20








Pape

r F5Performance

Management




1 The Telephone Co (T Co) is a company specialising in the provision of telephone systems for commercial clients. Thereare two parts to the business:

– installing telephone systems in businesses, either first time installations or replacement installations;– supporting the telephone systems with annually renewable maintenance contracts.

T Co has been approached by a potential customer, Push Co, who wants to install a telephone system in new officesit is opening. Whilst the job is not a particularly large one, T Co is hopeful of future business in the form of replacementsystems and support contracts for Push Co. T Co is therefore keen to quote a competitive price for the job. Thefollowing information should be considered:

1. One of the company’s salesmen has already been to visit Push Co, to give them a demonstration of the newsystem, together with a complimentary lunch, the costs of which totalled $400.

2. The installation is expected to take one week to complete and would require three engineers, each of whom ispaid a monthly salary of $4,000. The engineers have just had their annually renewable contract renewed withT Co. One of the three engineers has spare capacity to complete the work, but the other two would have to bemoved from contract X in order to complete this one. Contract X generates a contribution of $5 per engineer hour.There are no other engineers available to continue with Contract X if these two engineers are taken off the job.It would mean that T Co would miss its contractual completion deadline on Contract X by one week. As a result,T Co would have to pay a one-off penalty of $500. Since there is no other work scheduled for their engineers inone week’s time, it will not be a problem for them to complete Contract X at this point.

3. T Co’s technical advisor would also need to dedicate eight hours of his time to the job. He is working at fullcapacity, so he would have to work overtime in order to do this. He is paid an hourly rate of $40 and is paid forall overtime at a premium of 50% above his usual hourly rate.

4. Two visits would need to be made by the site inspector to approve the completed work. He is an independentcontractor who is not employed by T Co, and charges Push Co directly for the work. His cost is $200 for eachvisit made.

5. T Co’s system trainer would need to spend one day at Push Co delivering training. He is paid a monthly salaryof $1,500 but also receives commission of $125 for each day spent delivering training at a client’s site.

6. 120 telephone handsets would need to be supplied to Push Co. The current cost of these is $18·20 each,although T Co already has 80 handsets in inventory. These were bought at a price of $16·80 each. The handsetsare the most popular model on the market and frequently requested by T Co’s customers.

7. Push Co would also need a computerised control system called ‘Swipe 2’. The current market price of Swipe 2is $10,800, although T Co has an older version of the system, ‘Swipe 1’, in inventory, which could be modifiedat a cost of $4,600. T Co paid $5,400 for Swipe 1 when it ordered it in error two months ago and has no otheruse for it. The current market price of Swipe 1 is $5,450, although if T Co tried to sell the one they have, it wouldbe deemed to be ‘used’ and therefore only worth $3,000.

8. 1,000 metres of cable would be required to wire up the system. The cable is used frequently by T Co and it has200 metres in inventory, which cost $1·20 per metre. The current market price for the cable is $1·30 per metre.

9. You should assume that there are four weeks in each month and that the standard working week is 40 hourslong.

Required:

(a) Prepare a cost statement, using relevant costing principles, showing the minimum cost that T Co shouldcharge for the contract. Make DETAILED notes showing how each cost has been arrived at and EXPLAININGwhy each of the costs above has been included or excluded from your cost statement. (14 marks)

(b) Explain the relevant costing principles used in part (a) and explain the implications of the minimum pricethat has been calculated in relation to the final price agreed with Push Co. (6 marks)

(20 marks)

2

2 Bath Co is a company specialising in the manufacture and sale of baths. Each bath consists of a main unit plus a setof bath fittings. The company is split into two divisions, A and B. Division A manufactures the bath and Division Bmanufactures sets of bath fittings. Currently, all of Division A’s sales are made externally. Division B, however, sells toDivision A as well as to external customers. Both of the divisions are profit centres.

The following data is available for both divisions:

Division A

Current selling price for each bath $450Costs per bath:

Fittings from Division B $75Other materials from external suppliers $200Labour costs $45

Annual fixed overheads $7,440,000Annual production and sales of baths (units) 80,000Maximum annual market demand for baths (units) 80,000

Division B

Current external selling price per set of fittings $80Current price for sales to Division A $75Costs per set of fittings:

Materials $5Labour costs $15

Annual fixed overheads $4,400,000Maximum annual production and sales of sets of fittings (units) 200,000(including internal and external sales)Maximum annual external demand for sets of fittings (units) 180,000Maximum annual internal demand for sets of fittings (units) 80,000

The transfer price charged by Division B to Division A was negotiated some years ago between the previous divisionalmanagers, who have now both been replaced by new managers. Head Office only allows Division A to purchase itsfittings from Division B, although the new manager of Division A believes that he could obtain fittings of the samequality and appearance for $65 per set, if he was given the autonomy to purchase from outside the company. DivisionB makes no cost savings from supplying internally to Division A rather than selling externally.

Required:

(a) Under the current transfer pricing system, prepare a profit statement showing the profit for each of thedivisions and for Bath Co as a whole. Your sales and costs figures should be split into external sales and inter-divisional transfers, where appropriate. (6 marks)

(b) Head Office is considering changing the transfer pricing policy to ensure maximisation of company profits withoutdemotivating either of the divisional managers. Division A will be given autonomy to buy from external suppliersand Division B to supply external customers in priority to supplying to Division A.

Calculate the maximum profit that could be earned by Bath Co if transfer pricing is optimised. (8 marks)

(c) Discuss the issues of encouraging divisional managers to take decisions in the interests of the company as awhole, where transfer pricing is used. Provide a reasoned recommendation of a policy Bath Co should adopt.

(6 marks)

(20 marks)

3 [P.T.O.

3 You have recently been appointed as an assistant management accountant in a large company, PC Co. When youmeet the production manager, you overhear him speaking to one of his staff, saying:

‘Budgeting is a waste of time. I don’t see the point of it. It tells us what we can’t afford but it doesn’t keep us frombuying it. It simply makes us invent new ways of manipulating figures. If all levels of management aren’t involved inthe setting of the budget, they might as well not bother preparing one.’

Required:

(a) Identify and explain SIX objectives of a budgetary control system. (9 marks)

(b) Discuss the concept of a participative style of budgeting in terms of the six objectives identified in part (a).(11 marks)

(20 marks)

4 Fit Co specialises in the manufacture of a small range of hi-tech products for the fitness market. They are currentlyconsidering the development of a new type of fitness monitor, which would be the first of its kind in the market. Itwould take one year to develop, with sales then commencing at the beginning of the second year. The product isexpected to have a life cycle of two years, before it is replaced with a technologically superior product. The followingcost estimates have been made.

Year 1 Year 2 Year 3Units manufactured and sold 100,000 200,000Research and development costs $160,000Product design costs $800,000Marketing costs $1,200,000 $1,000,000 $1,750,000Manufacturing costs:

Variable cost per unit $40 $42Fixed production costs $650,000 $1,290,000

Distribution costs:Variable cost per unit $4 $4·50Fixed distribution costs $120,000 $120,000

Selling costs:Variable cost per unit $3 $3·20Fixed selling costs $180,000 $180,000

Administration costs $200,000 $900,000 $1,500,000

Note: You should ignore the time value of money.

Required:

(a) Calculate the life cycle cost per unit. (6 marks)

(b) After preparing the cost estimates above, the company realises that it has not taken into account the effect of thelearning curve on the production process. The variable manufacturing cost per unit above, of $40 in year 2 and$42 in year 3, includes a cost for 0·5 hours of labour. The remainder of the variable manufacturing cost is notdriven by labour hours. The year 2 cost per hour for labour is $24 and the year 3 cost is $26 per hour.Subsequently, it has now been estimated that, although the first unit is expected to take 0·5 hours, a learningcurve of 95% is expected to occur until the 100th unit has been completed.

Calculate the revised life cycle cost per unit, taking into account the effect of the learning curve.

Note: the value of the learning co-efficient, b, is –0·0740005. (10 marks)

(c) Discuss the benefits of life cycle costing. (4 marks)

(20 marks)

4

5 Choc Co is a company which manufactures and sells three types of biscuits in packets. One of them is called ‘Ooze’and contains three types of sweeteners: honey, sugar and syrup. The standard materials usage and cost for one unitof ‘Ooze’ (one packet) is as follows:

$Honey 20 grams at $0·02 per gram 0·40Sugar 15 grams at $0·03 per gram 0·45Syrup 10 grams at $0·025 per gram 0·25

–––––1·10

–––––

In the three months ended 30 November 2011, Choc Co produced 101,000 units of ‘Ooze’ using 2,200 kg of honey,1,400 kg of sugar and 1,050 kg of syrup. Note: there are 1,000 grams in a kilogram (kg).

Choc Co has used activity-based costing to allocate its overheads for a number of years. One of its main overheads ismachine set-up costs. In the three months ended 30 November 2011, the following information was available inrelation to set-up costs:

BudgetTotal number of units produced 264,000Total number of set ups 330Total set-up costs $52,800

ActualTotal number of units produced 320,000Total number of set ups 360Total set-up costs $60,000

Required:

(a) Calculate the following variances for materials in Ooze:

(i) Total materials usage variance; (4 marks)

(ii) Total materials mix variance; (4 marks)

(iii) Total materials quantity (yield) variance. (4 marks)

(b) Calculate the following activity-based variances in relation to the set-up cost of the machines:

(i) The expenditure variance; (3 marks)

(ii) The efficiency variance. (3 marks)

(c) Briefly outline the steps involved in allocating overheads using activity based costing. (2 marks)

(20 marks)

5 [P.T.O.

6

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

( x) )(n y) )2 2 2 2

P = a – bQ

MR = a – 2bQ


Answers


1 T Co

(a) Cost statement

$ NoteLunch 0 1Engineers’ costs 500 2Technical advisor 480 3Site visits 0 4Training costs 125 5Handsets 2,184 6Control system 7,600 7Cable 1,300 8

–––––––Total cost 12,189

–––––––

Notes

Note 1: LunchThis past cost is a ‘sunk cost’ and should therefore be excluded from the cost statement. It has already arisen and is thereforenot incremental.

Note 2: Engineers’ costsSince one of the engineers has spare capacity, the relevant cost of his hours is Nil. This is because relevant costs must ariseas a future consequence of the decision, and since his wage will be paid regardless of whether he now works on the contractfor Push Co, it is not an incremental cost.

The situation for the other two engineers is slightly different. Their time is currently fully utilised and earning a contributionof $5 per hour each. This is after deducting their hourly cost which, given a salary of $4,000 per month each, is $25 perhour ($4,000/4 x 40). However, in one week’s time – when they would otherwise be idle – they can complete Contract Xand earn the contribution anyway. Therefore, the only relevant cost is the penalty of $500 that will be payable for the delayon Contract X.

Note 3: Technical advisorSince the advisor would have to work overtime on this contract, the relevant cost is the overtime rate of $60 ($40 x 1·5) perhour. This would total $480 for the whole job.

Note 4: Site visitsThis is a cost paid directly by Push Co to a third party. Since it is not a relevant cost for T Co, it has been excluded.

Note 5: Training costsSince the trainer is paid a monthly salary irrespective of what work he does, this element of his cost is not relevant to thecontract, since it is not incremental. However, the commission of $125 will arise directly as a consequence of the decisionand must therefore be included.

Note 6: HandsetsAlthough T Co has 80 of the 120 handsets required already in inventory, they are clearly in regular use in the business.Therefore, if the 80 are used on this contract, they will simply need to be replaced again. Consequently, the relevant cost forboth the 40 that need to be bought and the 80 already in inventory is the current purchase price of $18·20 each. 120 x$18·20 = $2,184.

Note 7: Control systemThe historic cost of Swipe 1, $5,400, is a ‘sunk’ cost and not relevant to this decision. However, since the company couldsell it for $3,000 if it did not use it for this contract, the $3,000 is an opportunity cost here. The current market price for Swipe 1 of $5,450 is totally irrelevant to the decision as T Co has no intention of replacing Swipe 1, since it was bought inerror. In addition to the $3,000, there is a modification cost of $4,600, bringing the total cost of converting Swipe 1 to$7,600. This is still a cheaper option than buying Swipe 2 for $10,800, therefore the company would choose to do themodification to Swipe 1. The cost of $10,800 of a new Swipe 2 system is therefore irrelevant now.

Note 8: CableThe cable is in regular use by T Co, therefore all 1,000 metres should be valued at the current market price of $1·30 permetre. The $1·20 per metre is a sunk cost and not relevant.

(b) Relevant costing principles

Relevant costs are those costs that change as a result of making a particular decision. In simple terms, a relevant cost is afuture cash flow arising as a direct consequence of a decision. In order for a cost to be relevant to a decision, it must thereforemeet all three of these criteria:

Future – any costs which have already been incurred are regarded as ‘sunk’ costs and will prevent a cost from beingconsidered relevant.

9

Cash flow – the cost must be a cash flow and not just an accounting adjustment, such as a provision for a debt ordepreciation. Also, cash flows that are the same for all alternatives are not relevant.

Direct consequence – this criteria means that the cash flow must be incremental. For example, if a cost has already beencommitted to, then it will arise irrespective of whether the decision goes ahead. It will not therefore meet the ‘directconsequence’ criteria.

Opportunity cost – this is the value of the best alternative that is foregone as a result of making a decision. In the case of thetelephone system that Push Co needs for the contract, the foregone sales proceeds of $3,000 are an example of anopportunity cost since, by using the system for this contract, Push Co foregoes these sales proceeds.

Note: candidates would not be required to write all of this for the available marks.

Significance of minimum price calculated

The cost calculated in part (a) is a starting point only, showing the minimum cost that could be charged to the customer. IfT Co charged this price, it would be no better or worse off than if it did not carry out the work, i.e. it would make no profitor loss. This means that T Co would not be rewarded for the risk that it takes in completing the work, unless some kind of amark-up is also incorporated.

Also, other costs – such as the lunch of $400 – whilst not incremental to the decision now, have been incurred. Ideally,therefore, T Co should seek to recover them.

It could also be that, for example, in one week’s time, when the engineers are busy completing the delayed contract X, anotheropportunity comes up that the company has to reject because the engineers are busy on Contract X. Therefore, with hindsight,it would be seen that there was an opportunity cost associated with using the engineers on this work and delaying contractX.

Furthermore, none of the business’s overheads have been considered in the cost statement and, in the long term, these wouldneed to be covered.

It is clear, therefore, that the relevant cost calculated in part (a) is only a starting point for T Co to use when deciding how toprice the contract. The purpose of accepting contracts is to make profit and increase shareholder wealth. This will only bedone if a price higher than the relevant cost of the contract is charged. In setting this price, however, T Co also needs to giveconsideration to the fact that it hopes to attract future work from Push Co. The price needs to be attractive enough for thecustomer to return in the future.

2 Bath Co

(a) Profit statement

Division A Division B Company$’000 $’000 $’000

Sales revenue:External (1) 36,000 9,600 45,600Inter-divisional transfers 0 6,000

––––––– ––––––– –––––––Total 36,000 15,600 45,600

––––––– ––––––– –––––––Variable costs: External material costs (2) (16,000) (1,000) (17,000)Inter-divisional transfers (3) (6,000) 0Labour costs (4) (3,600) (3,000) (6,600)

––––––– ––––––– –––––––Total (25,600) (4,000) (23,600)

––––––– ––––––– –––––––Fixed costs (7,440) (4,400) (11,840)

––––––– ––––––– –––––––Profit 2,960 7,200 10,160

––––––– ––––––– –––––––

Workings ($’000)

(1) External salesDiv A: 80,000 x $450 = $36,000Div B: 120,000 x $80 = $9,600Div B: 80,000 x $75 = $6,000

(2) External material costsDiv A: 80,000 x $200 = $16,000Div B: 200,000 x $5 = $1,000

(3) Inter-divisional transfersDiv A: 80,000 x $75 = $6,000

10

(4) Labour costsDiv A: 80,000 x $45 = $3,600Div B: 200,000 x $15 = $3,000

(b) Bath Co’s profit if transfer pricing is optimised

Division A Division B Company$’000 $’000 $’000

Sales revenue:External (1) 36,000 14,400 50,400Internal sales (2) 1,300

––––––– ––––––– –––––––Total 36,000 15,700 50,400

––––––– ––––––– –––––––Variable costs:External material costs (3) (19,900) (1,000) (20,900)Inter-divisional transfers (2) (1,300)Labour costs (3,600) (3,000) (6,600)

––––––– ––––––– –––––––Total (24,800) (4,000) (27,500)

––––––– ––––––– –––––––Fixed costs (7,440) (4,400) (11,840)

––––––– ––––––– –––––––Profit 3,760 7,300 11,060

––––––– ––––––– –––––––

Note: A transfer price of $65 has been used on the assumption that the company will introduce the policy discussed in (c).Provided that the transfer price is set between the minimum of $20 (Division B’s marginal cost) and $65 (the cost to DivisionA of buying from outside the group), the actual transfer price is irrelevant in this calculation. The overall profit of the companywill be the same.

Workings ($’000)

(1) External salesDiv A: 80,000 x $450 = $36,000Div B: 180,000 x $80 = $14,400

(2) Internal sales/inter-divisional transfers20,000 x $65 = $1,300

(3) Material costsDiv A: 60,000 x $265 + (20,000 x $200) = $19,900Div B: 200,000 x $5 = $1,000

(c) Issues and suitable transfer price

Divisional managers’ performance is assessed using a metric as decided by the company. This may simply be the profit forthe period, or, depending on the type of responsibility centre being used, a metric such as residual income or return on capitalemployed. Whatever the metric being used, the division’s profit figure is going to affect it and divisional managers are thereforegoing to be keen to maximise their individual profits. By focusing on individual decisions, divisional managers are often notaware of the impact of their decisions on the company as a whole. This would particularly be the case where a decision whichis in the best interests of the company actually makes an individual division’s performance look worse.

The transfer pricing system in place needs to take into account the behavioural impact of the prices being charged.Sometimes, this can mean that a ‘dual transfer pricing system’ needs to be introduced in order to ensure that divisionalmanagers act in the interests of the company as a whole.

It can be seen from part (b) that the best decision for the company is that:

– Division A buys 60,000 sets of fittings from an outside supplier and buys the remaining 20,000 sets of fittings fromDivision B in order to ensure that Division B is working to full capacity.

– Division B sells as many sets of fittings as possible externally, at $80 per set. Since the maximum external demand is180,000 units, Division B sells the remaining 20,000 sets of fittings to Division A. The minimum transfer price thatwould be acceptable to Division B is its marginal cost of $20 per unit, since it has spare capacity. However, if thistransfer price is used, Division B becomes worse off than before the autonomy was given, and Division B’s manager willnot like this. As far as Division A is concerned, it will not want to pay more than the $65 that it can buy from outsidethe group.

Bath Co’s policy therefore needs to ensure that, firstly, Division A’s manager is prepared to buy 20,000 sets of fittings fromDivision B and secondly, Division B is prepared to sell them at $65 per set. Since it is in Division B’s best interest to work tofull capacity and the manager of Division B knows that Division A can obtain fittings for $65 per set, it should not be difficultfor B to agree to sell to A at this price. A policy of negotiated transfer prices would achieve this fairly quickly. However, thecompany also needs to have a policy that divisions buy internally first, where this would be in the best interests of the overallprofitability of the company. This would ensure that Division A buys the 20,000 sets of fittings from Division B. This way, theoverall profit of the company is maximised whilst also ensuring that divisional managers do not become demotivated.

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3 (a) Objectives of a budgetary control system

– To compel planningBudgeting makes sure that managers plan for the future, producing detailed plans in order to ensure the implementationof the company’s long term plan. Budgeting makes managers look at the year ahead and consider the changes inconditions that might take place and how to respond to those changes in conditions.

– To co-ordinate activitiesBudgeting is a method of bringing together the activities of all the different departments into a common plan. If anadvertising campaign is due to take place in a company in three months’ time, for example, it is important that theproduction department know about the expected increase in sales so that they can scale up production accordingly. Eachdifferent department may have its own ideas about what is good for the organisation. For example, the purchasingdepartment may want to order in bulk in order to obtain bulk quantity discounts, but the accounts department may wantto order in smaller quantities so as to preserve cash flow.

– To communicate activitiesThrough the budget, top management communicates its expectations to lower level management. Each department hasa part to play in achieving the desired results of the company, and the annual budget is the means of formalising theseexpectations. The whole process of budget setting, whereby information is shared between departments, facilitates thiscommunication process.

– To motivate managers to perform wellThe budget provides a basis for assessing how well managers and employees are performing. In this sense, it can bemotivational. However, if the budget is imposed from the top, with little or no participation from lower level managementand employees, it can have a seriously demotivational effect. This is discussed further in part (b).

– To establish a system of controlExpenditure within any organisation needs to be controlled and the budget facilitates this. Actual results are comparedto expected results, and the reasons for any significant, unexpected differences are investigated. Sometimes the reasonsare within the control of the departmental manager and he/she must be held accountable; at other times, they are not.

– To evaluate performanceOften, managers and employees will be awarded bonuses based on achieving budgeted results. This makes more sensethan evaluating performance by simply comparing the current year to the previous year. The future may be expected tobe very different than the past as economic conditions change. Also, events happen that may not be expected to reoccur.For example, if weather conditions are particularly wet one year, a company making and selling umbrellas would beexpected to make higher than usual sales. It would not be fair to assess managers against these historical sales levelsin future years, where weather conditions are more normal.

(Other possible objectives include:

– To delegate authority to budget holdersA formal budget permits budget holders to make financial decisions within the specified limits agreed, i.e. to incurexpenditure on behalf of the organisation.

– To ensure achievement of the management’s objectivesObjectives are set not only for the organisation as a whole but also for individual targets. The budget helps to work outhow these objectives can be achieved.)

(b) Participative budgeting

‘Participative budgeting’ refers to a budgeting process where there is some level of involvement from subordinates within theorganisation, rather than budgets just being set by the top level of management.

There are various views about whether participative budgeting is more effective than other styles. Each of the objectives frompart (a) is dealt with below, considering the extent to which participative budgeting helps to achieve this.

– To compel planningParticipative budgeting will compel planning. Although participation can take many forms, often it will take the form ofbottom-up budgeting, whereby the participation starts at the lowest level of management and goes all the way up to thetop. If this is the case, then planning is taking place at many levels, and should be more accurate than if it simply takesplace at a high level, by individuals who are not familiar with the day to day needs of the business.

– To co-ordinate activitiesCo-ordination of activities may become more time consuming if a participative style of budgeting is used. This isbecause, not only does there need to be co-ordination between departments but there also has to be co-ordinationbetween the different levels of management within each department. The process should be cumbersome but alsoeffective, with everyone knowing exactly what the plan is.

– To communicate activitiesCommunication will be particularly effective with participative budgeting, although how effective depends on the extentof the participation. If all levels of management are involved, from the bottom up, then all levels of management knowwhat the plan is. However, the plan may change as different departments’ budgets are reviewed together and the overall

12

budgeted profit compared to the top level management’s expectations. Hence, it may be the case that those peopleinvolved in the initial budgets, i.e. lower level management, have to deal with their budgets being changed.

– To motivate managers to perform wellIf managers play a part in setting the budget, they are more likely to think that the figures included in them are realistic.Therefore, they are more likely to try their best to achieve them. However, it may be that managers have built budgetaryslack into their budgets, in an attempt to make themselves look good. Therefore, managers could end up performingless well than they would do had tougher targets been set by their superiors.

– To establish a system of controlIn terms of establishing a system of control, it is largely irrelevant whether the budget setting process is a participativeone or not. What is important is that actual results are compared to expected, and differences are investigated. Thisshould happen irrespective of the budget setting process. Having said that, control is only really effective if the budgetedfigures are sound. As stated above, whilst they are more likely to be realistic if a participative style of budgeting is used,the system is open to abuse in the form of budgetary slack.

– To evaluate performanceManagers will be appraised by comparing the results that they have achieved to the budgeted results. A participativebudget will be an effective tool for this provided that participation is real rather than pseudo and provided that themanagers have not built slack into their figures, which has gone uncorrected.

Note: candidates would not be required to write all of this for the available marks.

4 (a) Life cycle cost per unit

$R & D costs 160,000Product design costs 800,000Marketing costs 3,950,000Fixed production costs 1,940,000Fixed distribution costs 240,000Fixed selling costs 360,000Administration costs 2,600,000Variable manufacturing costs 12,400,000(100,000 x $40 + 200,000 x $42)Variable distribution costs 1,300,000(100,000 x $4 + 200,000 x $4·50)Variable selling costs 940,000(100,000 x $3 + 200,000 x $3·20)

–––––––––––Total costs 24,690,000

–––––––––––

Therefore cost per unit = $24,690,000/300,000 = $82·30

(b) New life cycle cost

Total labour time for first 100 units:y = axb

b = –0·0740005

If x = 100, then y = 0·5 x 100–0·0740005

= 0·3556 hours per unit.Therefore total hours for 100 units = 35·56 hours

Time for 99th unit y = 0·5 x 99–·0740005

= 0·3559 hours per unit.Therefore total hours for 99 units = 35·23 hours.

Therefore, time for 100th unit = 35·56 hours – 35·23 hours = 0·33 hours

Total labour cost over life of product:

Year 2100 units at 0·3556 per unit 36 hours99,900 at 0·33 hours per unit 32,967 hours

–––––––––33,003 hours

–––––––––at $24 per hour $792,072

–––––––––

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Year 3200,000 at 0·33 per unit 66,000 hours

–––––––––at $26 per hour $1,716,000

–––––––––

Total revised life cycle cost

$Therefore total labour cost 2,508,072Other life cycle costs from (a) 24,690,000Less labour cost included in (a) (3,800,000)(100,000 x 0·5 x $24) + (200,000 x 0·5 x $26)

–––––––––––Total revised life cycle costs 23,398,072

–––––––––––

Therefore cost per unit = $23,398,072/300,000 = $77·99

(c) Benefits of life cycle costing

– The visibility of ALL costs is increased, rather than just costs relating to one period. This facilitates better decision-making.

– Individual profitability for products is more accurate because of this. This facilitates performance appraisal and decision-making, and means that prices can be determined with better knowledge of the true costs.

– More accurate feedback can take place when assessing whether new products are a success or a failure, since the costsof researching, developing and designing those products are also taken into account.

Note: Other valid benefits would also be awarded marks.

5 (a) (i) Usage variance

Std usage for Actual Variance Std cost Varianceactual output usage per kg

kgs kgs kgs $ $Honey 2,020 2,200 (180) 20 (3,600)Sugar 1,515 1,400 115 30 3,450Syrup 1,010 1,050 (40) 25 (1,000)

––––––(1,150) A––––––

(ii) Mix variance

Actual qnty Actual qnty Variance Std cost Variancestd mix actual mix per kg

kgs kgs kgs $ $Honey 2,066·67 2,200 (133·33) 20 (2,666·60)Sugar 1,550 1,400 150 30 4,500Syrup 1,033·33 1,050 (16·67) 25 (416·75)

–––––––––1,416·65 F

–––––––––

(iii) Yield variance

Std quantity Actual qnty Variance Std cost Variancestd mix std mix per kg

kgs kgs kgs $ $Honey 2,020 2,066·67 (46·67) 20 (933·40)Sugar 1,515 1,550 (35) 30 (1,050)Syrup 1,010 1,033·33 (23·33) 25 (583·25)

–––––––––(2,566·65) A–––––––––

The method used above is a more simple method for calculating the mix and yield variances than the one shown below.However, in the method shown below, the individual variances for each material are also meaningful, whereas they are notin the method shown above. Since the question only asks for the total variances, students will be given credit for eithermethod.

14

(ii) Mix variance

Actual qnty Actual qnty Variance budgeted Std cost Difference Variancestd mix actual mix WAC per kg per kg

kgs kgs kgs $ $Honey 2,066·67 2,200 (133·33) 24·44 20 (4·44) 592·59Sugar 1,550 1,400 150 24·44 30 5·56 833·33Syrup 1,033·33 1,050 (16·67) 24·44 25 0·56 (9·26)

–––––––––1,416·66 F

–––––––––

(iii) Yield variance

Std usage for Actual qnty Variance Varianceactual output actual mix

kgs kgs kgs $Honey 2,020 2,200 (180) 24·44 (4,400·00)Sugar 1,515 1,400 115 24·44 2,811·11Syrup 1,010 1,050 (40) 24·44 (977·78)

–––––––––(2,566·67) A–––––––––

Budgeted weighted average cost

Honey 2,066·67 20 41,333·4Sugar 1,550 30 46,500Syrup 1,033·33 25 25,833·25

–––––––––––4,650 113,666·65 24·44

–––––––––––

WAC = $113,666·65/4,650 kg = $24·44

(b) (i) Expenditure variance

Cost driver rate = $52,800/330 = $160Expected cost therefore = 360 x $160 $57,600Actual cost $60,000

––––––––Variance $2,400 A

––––––––

(ii) Efficiency variance

Expected no. of units per set up264,000/330 = 800

Therefore expected no. of set ups for320,000 = 320,000/800 = 400Actual number of set ups 360

–––––––Difference 40 F

–––––––x standard rate per set up $160

–––––––Variance $6,400 F

–––––––

(c) Steps involved in activity based costing

– Identify the organisation’s major activities.– Collect the costs associated with each activity into cost pools.– Identify the cost drivers i.e. those factors which give rise to the costs.– Charge the costs to the products on the basis of the cost driver.

15

17


Marks1 (a) Costing statement

Lunch 1Engineer costs 3Technical advisor 1Site visits 1Training costs 2Handsets 2Control system 3Cable 1

–––14

–––

(b) ExplanationRelevant costingFuture cost/sunk cost 1Cash flow not accounting adjustment 1Incremental 1Committed cost 1Opportunity cost 1

–––Maximum 4

–––Price to be chargedDoesn’t incorporate profit 1Doesn’t cover all costs 1Ignores fixed costs 1Contract X – engineer’s time 1Starting point only 1Need to make a profit 1Need to attract future work 1

–––Maximum for price 4

–––Maximum for (b) overall 6


––––––

Marks2 (a) Profit statement

Sales revenue:External 1Inter-divisional transfers 0·5External material costs 1Inter-divisional transfers 0·5Labour costs 1Fixed costs 1Profit 1

–––6

–––

(b) Revised profitExternal sales 1Inter-divisional transfers 1Material costs 2Internal transfers (materials) 1Labour costs 1Fixed costs 1Profit 1

–––8

–––

(c) Transfer price difficulties and policyEach well-explained point on difficulties 1

–––Maximum 4

–––Well reasoned recommendation 4

–––Maximum for (c) overall 6


––––––

3 (a) ObjectivesEach objective 1·5

–––Maximum 9

–––

(b) Participative style of budgetingExplaining participative budgeting 2Each objective discussed in relation to it 1·5

–––Maximum 11


––––––

18

Marks4 (a) Life cycle cost

R & D costs 0·5Product design costs 0·5Marketing costs 0·5Fixed production costs 0·5Fixed distribution costs 0·5Fixed selling costs 0·5Administration costs 0·5Variable manufacturing costs 0·5Variable distribution costs 0·5Variable selling costs 0·5Total costs 0·5Cost per unit (correct figure) 0·5

–––6

–––

(b) Revised life cycle costTime per unit for 100 units 1Total time of 100 units 1Time per unit for 99 units 1Total time of 99 units 1Time for 100th unit 1Total labour cost year 2 1Total labour cost year 3 1Carry forward life cycle costs from (a) 1Deduct original labour cost in (a) 1Revised cost per unit 1

–––10

–––

(c) Benefits of life cycle costingPer valid point made 1·5

–––Maximum 4


––––––

5 (a) Material variances

(i) Usage variance 4

(ii) Mix variance 4

(iii) Yield variance 4–––12

–––

(b) Overhead variances

(i) Expenditure variance 3

(ii) Efficiency variance 3–––

6–––

(c) ABCEach step 0·5

–––Maximum 2


––––––

19








Pape

r F5Performance

Management

Monday 11 June 2012



1 Robber Co manufactures control panels for burglar alarms, a very profitable product. Every product comes with a oneyear warranty offering free repairs if any faults arise in this period.

It currently produces and sells 80,000 units per annum, with production of them being restricted by the short supplyof labour. Each control panel includes two main components – one key pad and one display screen. At present,Robber Co manufactures both of these components in-house. However, the company is currently consideringoutsourcing the production of keypads and/or display screens. A newly established company based in Burgistan iskeen to secure a place in the market, and has offered to supply the keypads for the equivalent of $4·10 per unit andthe display screens for the equivalent of $4·30 per unit. This price has been guaranteed for two years.

The current total annual costs of producing the keypads and the display screens are:

Keypads Display screensProduction 80,000 units 80,000 units

$’000 $’000Direct materials 160 116Direct labour 40 60Heat and power costs 64 88Machine costs 26 30Depreciation and insurance costs 84 96Total annual production costs 374 390

Notes:1. Materials costs for keypads are expected to increase by 5% in six months’ time; materials costs for display screens

are only expected to increase by 2%, but with immediate effect.2. Direct labour costs are purely variable and not expected to change over the next year.3. Heat and power costs include an apportionment of the general factory overhead for heat and power as well as

the costs of heat and power directly used for the production of keypads and display screens. The generalapportionment included is calculated using 50% of the direct labour cost for each component and would beincurred irrespective of whether the components are manufactured in-house or not.

4. Machine costs are semi-variable; the variable element relates to set up costs, which are based upon the numberof batches made. The keypads’ machine has fixed costs of $4,000 per annum and the display screens’ machinehas fixed costs of $6,000 per annum. Whilst both components are currently made in batches of 500, this wouldneed to change, with immediate effect, to batches of 400.

5. 60% of depreciation and insurance costs relate to an apportionment of the general factory depreciation andinsurance costs; the remaining 40% is specific to the manufacture of keypads and display screens.

Required:

(a) Advise Robber Co whether it should continue to manufacture the keypads and display screens in-house orwhether it should outsource their manufacture to the supplier in Burgistan, assuming it continues to adopta policy to limit manufacture and sales to 80,000 control panels in the coming year. (8 marks)

(b) Robber Co takes 0·5 labour hours to produce a keypad and 0·75 labour hours to produce a display screen.Labour hours are restricted to 100,000 hours and labour is paid at $1 per hour. Robber Co wishes to increaseits supply to 100,000 control panels (i.e. 100,000 each of keypads and display screens).

Advise Robber Co as to how many units of keypads and display panels they should either manufacture and/oroutsource in order to minimise their costs. (7 marks)

(c) Discuss the non-financial factors that Robber Co should consider when making a decision about outsourcingthe manufacture of keypads and display screens. (5 marks)

(20 marks)

2

2 The Universal Health System (UHS) provides the entire healthcare service to residents in Illopia. The UHS is fundedcentrally through revenues from taxpayers. However, the government is not involved in the day-to-day running of theUHS, which is largely managed regionally by a number of self-governing trusts, such as the Sickham UHS Trust.

The Sickham UHS Trust runs one hospital in Sickham and, like other trusts in Illopia, receives 70% of its incomelargely from the UHS’ ‘payments by results’ scheme, which was established two years ago. Under this scheme, thetrust receives a pre-set tariff (fee income) for each service it provides. If the Trust manages to provide any of its servicesat a lower cost than the pre-set tariff, it is allowed to use the surplus as it wishes. Similarly, it has to bear the cost ofany deficits itself. Currently, the Trust knows that a number of its services simply cannot be provided at the tariff paidand accepts that these always lead to a deficit. Similarly, other services always seem to create a surplus. This is partlybecause different trusts define their services and account for overheads differently. Also, it is partly due to regionaldifferences in costs, which are not taken into account by the scheme, which operates on the basis that ‘one tariff fitsall’.

The remaining 30% of the Trust’s income comes from transplant and heart operations. Since these are not coveredby the scheme, the payment the Trust receives is based on the actual costs it incurs in providing the operations.However, the Trust is not allowed to exceed the total budget provided for these operations in any one year.

Over recent years, the Trust’s board of directors has become increasingly dissatisfied with the financial performanceof the Trust and has blamed it on poor costing systems, leading to an inability to control costs. As a result, the financedirector and his second in command – the financial controller – have now been replaced. The board of directors hastaken this decision after complaining that ‘the Trust simply cannot sustain the big deficit between income andspending’. The new financial controller comes from a manufacturing background and is a great advocate of targetcosting, believing that the introduction of a target costing system at the Sickham UHS Trust is the answer to all of itsproblems. The new financial director is unconvinced, believing target costing to be only really suitable inmanufacturing companies.

Required:

(a) Explain the main steps involved in developing a target price and target cost for a product in a typicalmanufacturing company. (6 marks)

(b) Explain four key characteristics that distinguish services from manufacturing. (4 marks)

(c) Describe how the Sickham UHS Trust is likely, in the current circumstances, to try to derive:

(i) a target cost for the services that it provides under the ‘payment by results’ scheme; and (2 marks)

(ii) a target cost for transplants and heart operations. (2 marks)

(d) Discuss THREE of the particular difficulties that the Sickham UHS Trust may find in using target costing inits service provision. (6 marks)

(20 marks)

3 [P.T.O.

3 Sauce Co manufactures and sells cartons of cooking sauces, which deteriorate over time and must be used withinthree months. Over the last two years, Sauce Co has experienced all kinds of problems. The financial and salesdirectors believe these to be a result of persistently unrealistic sales targets imposed by the managing director, whomakes forecasts based on his own subjective and overly optimistic views about future sales. Whilst an incentivescheme is in place for employees, the company has not hit its targets for the last three years, so no bonuses havebeen paid out. The financial director has asked you to forecast the sales for the last two quarters of 2012, hoping topresent these figures to the managing director in an attempt to persuade him that the basis of forecasting needs to bechanged. Production volumes are also currently based on anticipated sales rather than actual orders.

The following sales figures are available for the last two years. All of the figures represent actual sales except forquarter 2 of 2012, which is an estimate. The financial director is satisfied that this estimate can be relied upon.

Year Quarter One Quarter Two Quarter Three Quarter Four’000 units ’000 units ’000 units ’000 units

2010 900 1,1002011 1,200 1,000 1,050 1,3002012 1,400 1,150

The following centred moving averages have been calculated, using a base period of four quarters:

Year Quarter One Quarter Two Quarter Three Quarter Four’000 units ’000 units ’000 units ’000 units

2011 1,068·75 1,112·5 1,162·5 1,206·252012 1,243·75 1,287·5

The average seasonal variations for 2010 have already been made available to you and are 0·908 for quarter 3 and1·082 for quarter 4. The random component is negligible and can therefore be ignored.

Required:

(a) Using the information provided above, and assuming a proportional (multiplicative) model, forecast the salesof Sauce Co for the last two quarters of 2012. Calculate your seasonal adjustments to four decimal places.

(10 marks)

(b) Discuss the likely impact that the budgeting style and inaccurate sales forecasts have had on the staff andbusiness of Sauce Co. (10 marks)

(20 marks)

4

4 Lock Co makes a single product – a lock – and uses marginal costing. The standard cost card for one unit is as follows:

Standard cost card $Selling price 80

–––Direct materials (4 kg at $3 per kg) 12Direct labour (2 hours at $10 per hour) 20Variable overhead (2 hours at $2 per hour) 4

–––Marginal cost 36

–––

A junior member of the accounts team produced the following variance statement for the month of May.

Budget Actual Variances(1,000 units) (960 units)

$ $ $Sales 80,000 76,800 3,200 AdvLess: Marginal costDirect materials (12,000) (11,126) 874 FavDirect labour (20,000) (18,240) 1,760 FavVariable overheads (4,000) (3,283) 717 Fav

––––––– ––––––– ––––Contribution 44,000 44,151 151 Fav

––––––– ––––––– ––––––––––– ––––––– ––––

Lock Co used 3,648 kg of materials in the period and the labour force worked – and was paid for – 1,824 hours.Until now, Lock Co has had a market share of 25%. In the month of May, however, the market faced an unexpected10% decline in the demand for locks.

Required:

(a) Prepare a statement which reconciles budgeted contribution to actual contribution in as much detail aspossible. Do not calculate the sales price and the labour rate variances, since both of these have a value ofnil. Clearly show all other workings. (12 marks)

(b) The production director at Lock Co believes that the way to persistently increase market share in the long termis to focus on quality, and is hoping to introduce a ‘Total Quality Management’ (TQM) approach. The financedirector also shares this view and has said that ‘standard costing will no longer have a place within theorganisation if TQM is introduced.’

Discuss the view that there is no longer a place for standard costing if TQM is introduced at Lock Co.(8 marks)

(20 marks)

5 [P.T.O.

5 The Biscuits division (Division B) and the Cakes division (Division C) are two divisions of a large, manufacturingcompany. Whilst both divisions operate in almost identical markets, each division operates separately as aninvestment centre. Each month, operating statements must be prepared by each division and these are used as abasis for performance measurement for the divisions.

Last month, senior management decided to recharge head office costs to the divisions. Consequently, each divisionis now going to be required to deduct a share of head office costs in its operating statement before arriving at ‘netprofit’, which is then used to calculate return on investment (ROI). Prior to this, ROI has been calculated usingcontrollable profit only. The company’s target ROI, however, remains unchanged at 20% per annum. For each of thelast three months, Divisions B and C have maintained ROIs of 22% per annum and 23% per annum respectively,resulting in healthy bonuses being awarded to staff. The company has a cost of capital of 10%.

The budgeted operating statement for the month of July is shown below:

B C$’000 $’000

Sales revenue 1,300 1,500Less variable costs (700) (800)

–––––– ––––––Contribution 600 700Less controllable fixed costs (134) (228)

–––––– ––––––Controllable profit 466 472Less apportionment of head office costs (155) (180)

–––––– ––––––Net profit 311 292

–––––– ––––––Divisional net assets $23·2m $22·6m

Required

(a) Calculate the expected annualised Return on Investment (ROI) using the new method as preferred by seniormanagement, based on the above budgeted operating statements, for each of the divisions. (2 marks)

(b) The divisional managing directors are unhappy about the results produced by your calculations in (a) and haveheard that a performance measure called ‘residual income’ may provide more information.

Calculate the annualised residual income (RI) for each of the divisions, based on the net profit figures for themonth of July. (3 marks)

(c) Discuss the expected performance of each of the two divisions, using both ROI and RI, and making anyadditional calculations deemed necessary. Conclude as to whether, in your opinion, the two divisions haveperformed well. (6 marks)

(d) Division B has now been offered an immediate opportunity to invest in new machinery at a cost of $2·12 million.The machinery is expected to have a useful economic life of four years, after which it could be sold for $200,000.Division B’s policy is to depreciate all of its machinery on a straight-line basis over the life of the asset. Themachinery would be expected to expand Division B’s production capacity, resulting in an 8·5% increase incontribution per month.

Recalculate Division B’s expected annualised ROI and annualised RI, based on July’s budgeted operatingstatement after adjusting for the investment. State whether the managing director will be making a decisionthat is in the best interests of the company as a whole if ROI is used as the basis of the decision.

(5 marks)

(e) Explain any behavioural problems that will result if the company’s senior management insist on using solelyROI, based on net profit rather than controllable profit, to assess divisional performance and reward staff.

(4 marks)

(20 marks)

6

7

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

( x) )(n y) )2 2 2 2

P = a – bQ

MR = a – 2bQ


Answers


1 (a) Keypads Display screensVariable costs $ $Materials ($160k x 6/12) + ($160k x 1·05 x 6/12) 164,000($116k x 1·02) 118,320Direct labour 40,000 60,000Machine set-up costs($26k – $4k) x 500/400 27,500($30k – $6k) x 500/400 30,000

–––––––– ––––––––231,500 208,320

Attributable fixed costsHeat and power ($64k – $20k)/($88k – $30k) 44,000 58,000Fixed machine costs 4,000 6,000Depreciation and insurance ($84/$96k x 40%) 33,600 38,400

–––––––– ––––––––81,600 102,400

–––––––– ––––––––Total incremental costs of making in-house 313,100 310,720

–––––––– –––––––––––––––– ––––––––Cost of buying (80,000 x $4·10/$4·30) 328,000 344,000

–––––––– ––––––––Total saving from making 14,900 33,280

–––––––– ––––––––

Robber Co should therefore make all of the keypads and display screens in-house

(Note: It has been assumed that the fixed set-up costs only arise if production takes place.)

(Alternative method)Relevant costs Keypads Display screens

$ $Direct materials($160,000/2) + $160,000/2 x 1·05 164,000$116,000 x 1·02 118,320Direct labour 40,000 60,000Heat and power $64,000 – (50% x $40,000) 44,000$88,000 – (50% x $60,000) 58,000Machine set up costs:Avoidable fixed costs 4,000 6,000Activity related costs (w1) 27,500 30,000Avoidable depreciation and insurance costs: 40% x $84,000/$96,000 33,600 38,400

–––––––– ––––––––Total relevant manufacturing costs 313,100 310,720

–––––––– ––––––––Relevant cost per unit: 3·91375 3·884Cost per unit of buying in 4·1 4·3

–––––––– ––––––––Incremental cost of buying in 0·18625 0·416

–––––––– ––––––––

As each of the components is cheaper to make in-house than to buy in, the company should continue to manufacture keypadsand display screens in-house.

Working 1Current no. of batches produced = 80,000/500 = 160.New no. of batches produced = 80,000/400 = 200.Current cost per batch for keypads = ($26,000 – $4,000)/160 = $137·5.Therefore new activity related batch cost = 200 x $137·5 = $27,500.Current cost per batch for display screens = ($30,000 – $6,000)/160 = $150.Therefore new activity related batch cost = 200 x $150 = $30,000.

(b) The attributable fixed costs remain unaltered irrespective of the level of production of keypads and display screens, becauseas soon as one unit of either is made, the costs rise. We know that we will make at least one unit of each component as bothare cheaper to make than buy. Therefore they are an irrelevant common cost.

11

Keypads Display screens$ $

Buy 4·1 4·3Variable cost of making ($231,500/80,000) 2·89($208,320/80,000) 2·6

––––– ––––Saving from making per unit 1·21 1·7

––––– ––––Labour hour per unit 0·5 0·75

––––– ––––Saving from making per unit of limiting factor 2·42 2·27

––––– ––––––––– ––––Priority of making 1 2

Total labour hours available = 100,000.Make maximum keypads, i.e. 100,000, using 50,000 labour hours (100,000 x 0·5 hours)Make 50,000/0·75 display screens, i.e. 66,666 display screens.Therefore buy in 33,334 display screens (100,000 – 66,666).

Note 1: It is equally as acceptable to have treated the heat and power costs as variable and include them in the above. Itwill not have changed the outcome and is an entirely acceptable interpretation of the scenario.

Note 2: If a production run cannot be stopped part way through, then the company would only be able to make 66,400and would have to buy 33,600, since production takes place in batches of 400 units.

(c) Non-financial factors

– The company offering to supply the keypads and display screens is a new company. This would make it extremely riskyto rely on it for continuity of supplies. Many new businesses go out of business within the first year of being in businessand, without these two crucial components, Robber Co would be unable to meet demand for sales of control panels.Robber Co would need to consider whether there are any other potential suppliers of the components. This would beuseful as both a price comparison now and also to establish the level of dependency that would be committed to if thisnew supplier is used. If the supplier goes out of business, will any other company be able to step in? If so, at what cost?

– The supplier has only agreed to these prices for the first two years. After this, it could put up its prices dramatically. Bythis stage, Robber Co would probably be unable to begin easily making its components in house again, as it wouldprobably have sold off its machinery and committed to larger sales of control panels.

– The quality of the components could not be guaranteed. If they turn out to be poor quality, this will give rise to problemsin the control panels, leading to future loss of sales and high repair costs under warranties for Robber Co. The fact thatthe supplier is based overseas increases the risk of quality and continuity of supply, since it has even less control ofthese than it would if it was a UK supplier.

– Robber Co would need to establish how reliable the supplier is with meeting promises for delivery times. This kind ofinformation may be difficult to establish because of the fact that the supplier is a new company. Late delivery could havea serious impact on Robber Co’s production and delivery schedule.

2 (a) Deriving a target price and cost in a manufacturing company

Step 1: A product is developed that is perceived to be needed by customers and therefore will attract adequate sales volumes.

Step 2: A target price is then set based on the customers’ perceived value of the product. This will therefore be a marketbased price.

Step 3: The required target operating profit per unit is then calculated. This may be based on either return on sales or returnon investment.

Step 4: The target cost is derived by subtracting the target profit from the target price.

Step 5: If there is a cost gap, attempts will be made to close the gap. Techniques such as value engineering may beperformed, which looks at every aspect of the value chain business functions, with an objective of reducing costs whilesatisfying customer needs.

Step 6: Negotiation with customers may take place before deciding whether to go ahead with the project.

(b) Four characteristics of services

– Spontaneity: unlike goods, a service is consumed at the exact same time as it is made available. No service exists untilit is being experienced by the consumer.

– Heterogeneity/variability: services involve people and, because people are all different, the service received may varydepending on which person performs it. Standardisation is expected by the customer but it is difficult to maintain.

– Intangibility: unlike goods, services cannot be physically touched.

12

– Perishability: unused capacity cannot be stored for future use.

(Also acceptable characteristics are that ‘No transfer of ownership takes place when a service is provided’ and ‘serviceindustries rely heavily on their staff, who often have face-to-face contact with the customer, and represent the organisation’sbrand’.)

(c) Deriving target costs

(i) For services under the ‘payment by results’ scheme

The obvious target price is the pre-set tariff that is paid to the trust for each service. This is known with certainty andsince the trust is a not for profit organisation, there may not be any need to deduct any profit margin from the tariff.Problems may arise because of the fact that it is already known that costs sometimes exceed the pre-set tariff. Theseissues are discussed in (d).

(ii) For transplant and heart operations

For these operations, the trust is paid on the basis of its actual costs incurred. However, since the trust only has arestricted budget for such services, it is still important that it keeps costs under control. The target cost could be basedon the average cost of these services when performed in the past, or the minimum cost that it has managed to providesuch services on before, in order to encourage cost savings. It is important that quality is not affected, however.

Note: All reasonable suggestions would be acceptable.

(d) Difficulties for the Sickham UHS Trust in using target costing

The main difficulties for the trust are as follows:

It is difficult to find a precise definition for some of the servicesIn order for target costing to be useful, it is necessary to define the service being provided. Whilst the introduction of the pre-set tariff will make this more easy for some services, as this definition can be used, for other services not covered by thetariff, definition could be difficult.

It is difficult to decide on the correct target cost for servicesFor the pre-set tariff services, the obvious target cost would be the pre-set tariff. However, bearing in mind that the Trust knowsthat some services can be provided at less than this and some services cannot be provided at this price at all, one has toquestion whether it is right to use this as the target cost. A target cost which is unachievable could be demotivational for staffand one which is easily met will not provide an incentive to keep costs down.

As regards the other operations, the target can be set at a level which is both achievable but feasible, so this should result inless of an issue.

It would be difficult to use target costing for new servicesThe private sector initially developed the use of target costing in the service sector with the intention that it should only beused for new services rather than existing ones. Considering the work that a hospital performs particularly, it would be difficultto establish target costs when there is no comparative data available, unless other hospitals have already provided servicesand the information can be obtained from them.

The costing systems at the Sickham UHS Trust are poorIf costs are to be analysed in depth, the analysis must be based on accurate and timely costing systems, which do not appearto currently exist at the Sickham UHS Trust. A large part of the hospitals’ costs for services are going to be overhead costsand these need to be allocated to services on a consistent basis. This is not currently happening.

Note: Only three difficulties were required.

3 (a) Quarter Actual volume Centred moving Seasonal percentageof sales average

’000 units ’000 units2010Q3 900Q4 1,1002011Q1 1,200 1068·75 1·1228Q2 1,000 1112·50 0·8989Q3 1,050 1162·50 0·9032Q4 1,300 1206·25 1·07772012Q1 1,400 1243·75 1·1256Q2 1,150 1287·50 0·8932

The average seasonal variations can now be calculated to see whether any adjustment to the percentages is required, sincethey must be 4·0 in total.

13

Since the averages total 4·0057, each one needs to be reduced by 0·0014

Q1 Q2 Q3 Q42010 0·9080 1·08202011 1·1228 0·8989 0·9032 1·07772012 1·1256 0·8932Total 2·2484 1·7921 1·8112 2·1597

––––––– ––––––– ––––––– –––––––Average 1·1242 0·8960 0·9056 1·0799 4·0057

––––––– ––––––– ––––––– –––––––Rounded 1·1228 0·8946 0·9042 1·0785 4·0001

The difference of 0·0001 is due to rounding and can be ignored.The average trend of the centred moving averages is (1,287·5 – 1,068·75)/5 = 43,750 units.Therefore forecast centred moving average for Q3 in 2012 = 1,287,500 + 43,750 = 1,331,250.Adjusted for seasonal variation: 1,331,250 x 0·9042 = 1,203,716·25 units.

Forecast centred moving average for Q4 of 2012 = 1,287,500 + (2 x 43,750) = 1,375,000.Adjusted for seasonal variation = 1,375,000 x 1·0785 = 1,482,937·5 units.

Note: Other methods are equally as acceptable to answer 3(a). Candidates could have worked back from the centred movingaverages provided in the question for 2012 quarters 3 or 4 and they could also have used linear regression.

(b) Likely impact on the staff and business

Staff– Since the budgeting style has been an imposed one rather than a participative one, morale amongst staff is likely to be

low, since they have not been involved in the process at all.

– Additionally, since sales targets appear to be unachievable and staff have not received performance related bonuses,staff are not motivated to try and achieve targets since they feel like they are impossible to achieve. Team spirit will below and an atmosphere of ‘doing the bare minimum’ is likely to exist.

– Since budgets are imposed from the top down, the culture will not be one in which operational management generateideas, as they will feel like they are not appreciated and that their views are not taken into account.

Business– Since sales levels are overestimated, production volumes must also be too high. As well as this leading to high inventory

costs because actual sales are then lower than expected, since the product is also perishable, waste levels have probablybeen high. These will be significant costs to the company.

– Also, when customers do receive their goods, it is likely that they will be close to their expiry date, since they will havebeen taken from inventory that has been held for some time. This will be frustrating for customers because productsmay then perish before the end customer gets to use them. Also, it is likely that a sauce that is two months old doesnot taste as good as a sauce that is only a few days old. Both of these factors may be causing damage to the company’sreputation.

– Too many staff are probably being employed in the business, bearing in mind that the staffing levels will be related toforecast production volumes. One can only assume that whilst initially, production volumes relate to the forecast, as itbecomes apparent that sales are not as high as anticipated and inventory levels increase, production slows down. Staffare probably sitting idle for some of the time, which is demotivating for them and costly to the company.

4 (a) Variance calculations

Sales market share:Revised budgeted sales 900 unitsActual sales 960 units

–––––––60 units

at std contribution per unit of $44 $2,640 F

Sales market sizeOriginal budgeted sales 1,000 unitsRevised budgeted sales 900 units

–––––––100 units

at std contribution per unit of $44 $4,400 A

14

$44 ($80 – $36)Material price (SP – AP) x AQ= ($3 – $3·05) x 3,648 $182 AMaterial usage (SQAP – AQ) x SP(3,840 – 3,648) x $3 $576 FLabour efficiency (SHAP – AH) x SR(1,920 – 1,824) x $10 $960 FVariable overhead efficiency (SHAP – AH) x SR(1,920 – 1,824) x $2 $192 FVariable overhead expenditure(AHSR – actual cost) = $3,648 – $3,283 $365 F

–––––Total $151 F

–––––

Reconciliation Statement $ $Budgeted sales revenue 80,000Budgeted standard variable cost (36,000)

––––––––Budgeted contribution 44,000Sales contribution variances– market share 2,640– market size (4,400) (1,760)

–––––––– ––––––––42,240

Variable cost variancesMaterials– price (182)– usage 576 394

––––––––Labour efficiency 960Variable overhead– efficiency 192– expenditure 365 557

–––––––– ––––––––Actual contribution 44,151

––––––––––––––––

(b) TQM and standard costing

– TQM relies on a culture of continuous improvement within an organisation. For this to succeed, the focus must be onquality, not quantity. The cost of failing to achieve the desired level of quality must be measured in terms of internal andexternal failure costs.

– Traditional variance analysis focuses on quantity rather than quality. This could mean that, for example, lower gradelabour is used in an attempt to reduce costs. This would be totally at odds with a TQM culture, which is the basis ofthe problem of the two systems running side by side.

– A traditional standard system allocates responsibility for variances to the different departmental managers. When a TQMsystem is adopted, all employees’ roles in ensuring quality are highlighted and everyone is seen as equally important inthe quality assurance process. This difference would make it difficult for the two systems to co-exist.

– Traditional standard costing systems usually make allowances for waste. This would be totally contrary to the TQMphilosophy, which aims to eliminate all waste.

– Continuous improvement makes the standard cost system less relevant due to regular small changes to the process.

It would seem to be the case that the two systems would struggle to co-exist at Lock Co.

5 (a) ROI

Return on investment

= net profit/net assets

Division B$311,000 x 12/$23,200,000 = 16·09%

Division C$292,000 x 12/$22,600,000 = 15·5%

15

(b) Residual income

B C$’000 $’000

Net profit 3,732 3,504Less: imputed interest charge$22·6 x 10% (2,260)$23·2m x 10% (2,320)

–––––– ––––––Residual income 1,412 1,244

–––––– ––––––

(c) Performance of the two divisions

ROIDivisions B and C have ROIs of 16·09% and 15·5% respectively, compared to the target of 20%. This suggests that thedivisions have not performed well, but the reason for this is that now, uncontrollable head office costs are being taken intoeffect before calculating the ROI. The target ROI has not been reduced to reflect the change in the method being used tocalculate it. Using the old method, ROI would have been as follows:

B: ($311,000 + $155,000) x 12/$23·2m = 24·1%C: ($292,000 + $180,000) x 12/$22·6m = 25·06%

From this it can be seen that both divisions have actually improved their performance, rather than it having become worse.

RIFrom the residual income figures, it can clearly be seen that both Division B and C have performed well, with healthy RIfigures of $1·4m and $1·2m respectively, even when using net profit rather than controllable profit as bases for thecalculations. The cost of capital of the company is significantly lower than the target return on investment that the companyseeks, making the residual income figure show a more positive position.

(d) Division B’s ROI with investment

Depreciation = 2,120,000 – 200,000/48 months = $40,000 per month.Net profit for July = 311k + ($600k x 8·5%) – $40k = $322kAnnualised net profit: $322k x 12 = $3,864k.Opening net assets after investment = $23,200k + $2,120 = $25,320k.ROI = $3,864k/25,320k = 15·26%

Therefore, Division B will not proceed with the investment, since it will cause a decrease in its ROI.

If RI is calculated with the investment, the result is as follows:

B$’0003,864

Less: imputed interest charge$25·32m at 10% (2,532)

––––––Residual income 1,332

––––––

This calculation shows that, if the investment is undertaken, RI is actually lower than without the investment. So, if eitherROI or RI is considered by Division B’s manager when deciding whether to undertake the investment, the investment will notbe undertaken. This decision will be in the best interests of the company as a whole, since the RI of the investment alone isactually negative ($132k – $212k = $(80k)).

(e) Behavioural issues

The staff in both divisions have been used to meeting targets and getting rewarded appropriately. Suddenly, they will find thateven though in reality divisional performance has improved, neither division is meeting its ROI target. This will purely be asa result of the inclusion of the head office costs. The whole basis of being assessed on uncontrollable apportioned costs isquestionable in the first place. However, if it is going to be done this way, at the least the target ROI must be revised.

Staff are likely to become frustrated with a new system which is inherently unfair. This could give rise to staff organisingthemselves together in order to oppose the system. At the least, they are likely to become quickly demotivated, working slowerthan possible and perhaps withdrawing things like voluntary overtime. The cost to the company as a whole is likely to behigh and the situation needs to be resolved as quickly as possible.

16


Marks1 (a) Incremental cost of buying in

Direct materials 1Direct labour 0·5Heat and power 1Set-up costs 3Depreciation and insurance 1Total cost of making/cost per unit of making 0·5Conclusion 1

–––8

–––

(Method 2)Direct materials 1Direct labour 0·5Heat and power 1Avoidable fixed costs 1Activity related costs (w1) 2Avoidable depreciation and insurance 1Total relevant cost of manufacturing/cost per unit 0·5Conclusion 1

–––8

–––

(b) If 100,000 control panels madeVariable cost of making per unit 1Saving from making 1Saving per labour hour 1Ranking 1Make 100,000 keypads 1Make 66,666 display screens 1Buy 33,334 display screens 1

–––7

–––

(c) Non-financial factorsPer factor 1 or 2

–––Maximum 5


––––––

17

Marks2 (a) Steps

Develop product 1Set target price 1Set profit margin 1Set target cost 1Close gap 1Value engineering 1Negotiate 1

–––Maximum 6

–––

(b) CharacteristicsSpontaneity 1Heterogeneity 1Intangibility 1Perishability 1Other 1


–––

(c) Deriving target costs

(i) Scheme target costs 2–––

(ii) Other services’ target costs 2–––

(d) DifficultiesEach difficulty explained 2

–––6


––––––

3 (a) Predicting sales volumesSeasonal percentages 3Average seasonal variations 2Average trend of centred moving average 1Forecast moving average for Q3 1Adjusted for seasonal variation 1Forecast moving average for Q4 1Adjusted for seasonal variation 1

–––10

–––

(b) Likely impactPer point discussed 2

–––10


––––––

18

Marks4 (a) Reconciliation statement

Variance calculationsMarket share 1·5Market size 1·5Material price 1Material usage 1Labour efficiency 1Variable overhead efficiency 1Variable overhead expenditure 1Reconciliation statement 4

–––12

–––

(b) TQM and standard costingPer valid discussion point 2Conclusion 1



––––––

5 (a) ROIROI for B 1ROI for C 1

–––2

–––

(b) RI calculationsRI for B 1·5RI for C 1·5

–––3

–––

(c) DiscussionROI discussion 2RI discussion 2Extra ROI calculation under old method 1Valid conclusion drawn 1


–––

(d) ROI/RI after investmentROI calculation 2RI calculation 1Comments and conclusion 2

–––5

–––

(e) Behavioural issuesROI of investmentPer valid point 1

–––4


––––––

19








Pape

r F5Performance

Management




1 Hair Co manufactures three types of electrical goods for hair: curlers (C), straightening irons (S) and dryers (D.) Thebudgeted sales prices and volumes for the next year are as follows:

C S DSelling price $110 $160 $120Units 20,000 22,000 26,000

Each product is made using a different mix of the same materials and labour. Product S also uses new revolutionarytechnology for which the company obtained a ten-year patent two years ago. The budgeted sales volumes for all theproducts have been calculated by adding 10% to last year’s sales.

The standard cost card for each product is shown below.

C S D$ $ $

Material 1 12 28 16Material 2 8 22 26Skilled labour 16 34 22Unskilled labour 14 20 28

Both skilled and unskilled labour costs are variable.

The general fixed overheads are expected to be $640,000 for the next year.

Required:

(a) Calculate the weighted average contribution to sales ratio for Hair Co.

Note: round all workings to 2 decimal places. (6 marks)

(b) Calculate the total break-even sales revenue for the next year for Hair Co.


(c) Using the graph paper provided, draw a multi-product profit-volume (PV) chart showing clearly the profit/losslines assuming:

(i) you are able to sell the products in order of the ones with the highest ranking contribution to sales ratiosfirst; and

(ii) you sell the products in a constant mix.

Note: only one graph is required. (9 marks)

(d) Briefly comment on your findings in (c). (3 marks)

(20 marks)

2

2 Truffle Co makes high quality, hand-made chocolate truffles which it sells to a local retailer. All chocolates are madein batches of 16, to fit the standard boxes supplied by the retailer. The standard cost of labour for each batch is $6·00and the standard labour time for each batch is half an hour. In November, Truffle Co had budgeted production of24,000 batches; actual production was only 20,500 batches. 12,000 labour hours were used to complete the workand there was no idle time. All workers were paid for their actual hours worked. The actual total labour cost forNovember was $136,800. The production manager at Truffle Co has no input into the budgeting process.

At the end of October, the managing director decided to hold a meeting and offer staff the choice of either acceptinga 5% pay cut or facing a certain number of redundancies. All staff subsequently agreed to accept the 5% pay cutwith immediate effect.

At the same time, the retailer requested that the truffles be made slightly softer. This change was implementedimmediately and made the chocolates more difficult to shape. When recipe changes such as these are made, it takestime before the workers become used to working with the new ingredient mix, making the process 20% slower for atleast the first month of the new operation.

The standard costing system is only updated once a year in June and no changes are ever made to the system outsideof this.

Required:

(a) Calculate the total labour rate and total labour efficiency variances for November, based on the standard costprovided above. (4 marks)

(b) Analyse the total labour rate and total labour efficiency variances into component parts for planning andoperational variances in as much detail as the information allows. (8 marks)

(c) Assess the performance of the production manager for the month of November. (8 marks)

(20 marks)

3 [P.T.O.

3 Web Co is an online retailer of fashion goods and uses a range of performance indicators to measure the performanceof the business. The company’s management have been increasingly concerned about the lack of sales growth overthe last year and, in an attempt to resolve this, made the following changes right at the start of quarter 2:

Advertising: Web Co placed an advert on the webpage of a well-known online fashion magazine at a cost of$200,000. This had a direct link from the magazine’s website to Web Co’s online store.

Search engine: Web Co also engaged the services of a website consultant to ensure that, when certain key words areinput by potential customers onto key search engines, such as Google and Yahoo, Web Co’s website is listed on thefirst page of results. This makes it more likely that a customer will visit a company’s website. The consultant’s fee was$20,000.

Website availability: During quarter 1, there were a few problems with Web Co’s website, meaning that it was notavailable to customers some of the time. Web Co was concerned that this was losing them sales and the ITdepartment therefore made some changes to the website in an attempt to correct the problem.

The following incentives were also offered to customers:

Incentive 1: A free ‘Fast Track’ delivery service, guaranteeing delivery within two working days, for all continuingcustomers who subscribe to Web Co’s online subscription newsletter. Subscribers are thought by Web Co to becomecustomers who place further orders.

Incentive 2: A $10 discount to all customers spending $100 or more at any one time.

The results for the last two quarters are shown below, quarter 2 being the most recent one. The results for quarter 1reflect the period before the changes and incentives detailed above took place and are similar to the results of otherquarters in the preceding year.

Quarter 1 Quarter 2Total sales revenue $2,200,000 $2,750,000Net profit margin 25% 16·7%Total number of orders from customers 40,636 49,600Total number of visits to website 101,589 141,714Conversion rate – visitor to purchaser 40% 35%The percentage of total visitors accessing website through magazine link 0 19·9%Website availability 95% 95%Number of customers spending more than $100 per visit 4,650 6,390Number of subscribers to online newsletter 4,600 11,900

Required:

Assess the performance of the business in Quarter 2 in relation to the changes and incentives that the companyintroduced at the beginning of this quarter. State clearly where any further information might be necessary,concluding as to whether the changes and incentives have been effective.

(20 marks)

4

4 Designit is a small company providing design consultancy to a limited number of large clients. The business is matureand fairly stable year on year. It has 30 employees and is privately owned by its founder. Designit prepares an annualfixed budget. The company’s accounts department consists of one part-qualified accountant who has a heavyworkload. He prepares the budget using spreadsheets. The company has a November year end.

Designit pays each of its three sales managers an annual salary of $150,000, plus an individual bonus based onsales targets set at the beginning of the year. There are always two levels of bonus that can be earned, based on alower and an upper level of fee income. For the year ended 30 November 2012, for example, each of the salesmanagers was given a lower target of securing $1·5m of fee income each, to be rewarded by an individual bonusequating to 20% of salary. If any of the managers secured a further $1·5m of fee income, their bonus would increaseby 5% to the upper target of 25%. None of the managers achieved the upper target but all of them achieved the lowerone.

This is the same every year and Designit finds that often the managers secure work from several major clients earlyin the year and reach the $1·5m target well before the year has ended. They then make little effort to secure extrafees for the company, knowing that it would be almost impossible to hit the second target. This, together with a fewother problems that have arisen, has made the company consider whether its current budgeting process could beimproved and whether the bonus scheme should also be changed.

Designit is now considering replacing the fixed budget with a monthly rolling budget, which Designit believes willmake the budgeting process more relevant and timely and encourage managers to focus on the future rather than thepast. It would also prevent the problem of targets being met too early on in the year by the sales managers becausethe targets would be set for monthly performance rather than annual performance. For example, a manager could begiven a target of securing $200,000 fee income in the first month for a reward of 2% of salary. Then, depending onwhat is happening both within the business and in the economy as a whole, at the end of the first month, a differenttarget fee income could be set for the second month.

Required:

(a) Explain what a monthly rolling budget is and how it would operate at Designit. (4 marks)

(b) Discuss the problems that may be encountered if Designit decides to introduce monthly rolling budgetstogether with a new bonus scheme, such as the one outlined above. (6 marks)

(c) Discuss the problems with the current bonus scheme and, assuming that the company decides againstintroducing rolling budgets, describe and justify an alternative, more effective bonus scheme that could beintroduced. (6 marks)

(d) Discuss the risk of using the company accountant’s own spreadsheets for budgeting. (4 marks)

(20 marks)

5 [P.T.O.

5 Wash Co assembles and sells two types of washing machines – the Spin (S) and the Rinse (R). The company hastwo divisions: the assembly division, and the retail division.

The company’s policy is to transfer the machines from the assembly division to the retail division at full cost plus10%. This has resulted in internal transfer prices, when S and R are being transferred to the retail division, of$220·17 and $241·69 respectively. The retail division currently sells S to the general public for $320 per machineand R for $260 per machine. Assume it incurs no other costs except for the transfer price.

The retail division’s manager is convinced that, if he could obtain R at a lower cost and therefore reduce the externalselling price from $260 to $230 per unit, he could significantly increase sales of R, which would be beneficial to bothdivisions. He has questioned the fact that the overhead costs are allocated to the products on the basis of labourhours; he thinks it should be done using machine hours or even activity based costing.

You have obtained the following information for the last month from the assembly division:

Product S Product RProduction and sales (units) 3,200 5,450Materials cost $117 $95Labour cost (at $12 per hour) $6 $9Machine hours (per unit) 2 1Total no. of production runs 30 12Total no. of purchase orders 82 64Total no. of deliveries to retail division 64 80

Overhead costs: $Machine set-up costs 306,435Machine maintenance costs 415,105Ordering costs 11,680Delivery costs 144,400

––––––––Total 877,620

––––––––

Required:

(a) Using traditional absorption costing, calculate new transfer prices for S and R if machine hours are used asa basis for absorption rather than labour hours.


(b) Using activity based costing to allocate the overheads, recalculate the transfer prices for S and R.


(c) (i) Calculate last month’s profit for each division, showing it both for each product and in total, if activitybased costing is used. (3 marks)

6

(ii) You have calculated the profits that both divisions made last month using traditional absorption costing andfound them to be as follows:

Using labour hours to allocate overhead Product S Product R Total *$ $ $

Assembly’s division profit 64,064 119,737 183,801Retail division’s profit 319,456 99,790 419,246

––––––––603,047*––––––––

Using machine hours to allocate overheadsAssembly division’s profit 86,720 97,065 183,785Retail division’s profit 69,760 349,563 419,323

––––––––603,108*––––––––

* Note: small differences arise in figures because of rounding.

Required:

Given these two sets of figures and your calculations in (c) (i), discuss whether activity based costingshould be implemented. Consider the decision from the view of each of the divisional managers.

(6 marks)

(20 marks)

7 [P.T.O.

8

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

( x) )(n y) )2 2 2 2

P = a – bQ

MR = a – 2bQ


Answers


1 Hair Co

(a) Weighted average contribution to sales ratio (WA C/S ratio) = total contribution/total sales revenue.

Per unit: C S D$ $ $

Selling price 110 160 120Material 1 (12) (28) (16)Material 2 (8) (22) (26)Skilled labour (16) (34) (22)Unskilled labour (14) (20) (28)

––– ––– –––Contribution 60 56 28

––– ––– –––

Sales units 20,000 22,000 26,000

Total sales revenue $2,200,000 $3,520,000 $3,120,000

Total contribution $1,200,000 $1,232,000 $728,000

WA C/S ratio = $1,200,000 + $1,232,000 + $728,000/$2,200,000 + $3,520,000 + $3,120,000= $3,160,000/$8,840,000 = 35·75%

(b) Break-even sales revenue = fixed costs/C/S ratio

Therefore break-even sales revenue = $640,000/35·75% = $1,790,209·70.

(c) PV chart

Calculate the individual C/S ratio for each product then rank them according to the highest one first.

Per unit: C S D$ $ $

Contribution 60 56 28Selling price 110 160 120C/S ratio 0·55 0·35 0·23Ranking 1 2 3

Product Revenue Cumulative Revenue Profit Cumulative Profit(x axis co-ordinate) (y axis co-ordinate)

$ $ $ $0 0 0 (640,000) (640,000)Make C 2,200,000 2,200,000 1,200,000 560,000Make S 3,520,000 5,720,000 1,232,000 1,792,000Make D 3,120,000 8,840,000 728,000 2,520,000

11

(d) From the chart above it can be seen that, if the products are sold in order of the highest ranking first, break even will takeplace at a point just under $1,200,000 of sales revenue. The exact figure can be worked out by taking the fixed costs of$640,000 and dividing them by Product C’s C/S ratio of 0·55, i.e. the exact BEP is $1,163,636. This is substantially earlierthan the break-even point which occurs if the products are all sold in a constant mix, which is $1,790,209, as calculated in(b) above.

The reason for this is obviously because the more profitable product, C, contributes more per unit to fixed costs when beingsold on its own, than when a mix of products C, S and D are sold. The weighted average C/S ratio of all three products isonly 35·75%, compared to C’s C/S ratio of 55%. Obviously, then, break even will occur earlier if C is sold in priority.

In reality, however, the mix of sales will vary throughout the year and Hair Co can neither assume that the products are soldin a constant mix, nor that the most profitable can be sold first.

2 Truffle Co

(a) Basic variances

Standard cost of labour per hour = $6/0·5 = $12 per hour.

Labour rate variance = (actual hours paid x actual rate) – (actual hours paid x std rate)Actual hours paid x std rate = $136,800/·95 = $144,000. Therefore rate variance = $144,000 – $136,800 = $7,200 F

Labour efficiency variance = (actual production in std hours – actual hours worked) x std rate[(20,500 x 0·5) – 12,000] x $12 = $21,000 A.

(b) Planning and operational variances

Labour rate planning variance(Revised rate – std rate) x actual hours paid = [$12 – ($12 x 0·95)] x 12,000 = $7,200 F.

Labour rate operational varianceThere is no labour rate operational variance.(Revised rate – actual rate) x actual hours paid = $11·40 – $11·40 x 12,000 = 0

12

Most profitable first

Constant mix

2,0000 4,000 6,000 8,000 10,000

–1,000

–500

0

500

1,000

1,500

2,000

2,500

3,000

Sales revenue $’000

Prof

it $’0

00

C

S

D

Labour efficiency planning variance(Standard hours for actual production – revised hours for actual production) x std rate[10,250 – (20,500 x 0·5 x 1·2)] x $12 = $24,600 A.

Labour efficiency operational variance(Revised hours for actual production – actual hours for actual production) x std rate(12,300 – 12,000) x $12 = $3,600 F.

(c) Discussion

When looking at the total variances alone, it looks like the production manager has been extremely poor at controlling hisstaff’s efficiency, since the labour efficiency variance is $21,000 adverse. It also looks, at a glance, like he has managed tosecure labour at a lower rate.

In order to assess the production manager’s performance fairly, however, only the operational variances should be taken intoaccount. This is because planning variances reflect differences that arise because of factors that are outside the control of theproduction manager. The operational variance for the labour rate was $0, which means that the labour force were paid exactlywhat was agreed at the end of October: their reduced rate of $11·40 per hour. The manager clearly did not have to payanyone for overtime, for example, which would have been expected to push this rate up. The rate reduction was secured bythe company and was not within the control of the production manager, so he cannot take credit for the favourable rateplanning variance of $7,200. The company is the source of this improvement.

As regards labour efficiency, the planning and operational variances give us more information about the total efficiencyvariance of $21,000A. When this is broken down into its two parts, it becomes clear that the operational variance, for whichthe manager does have control, is actually $3,600 favourable. This is because, when the recipe is changed as it has beenin November, the chocolates usually take 20% longer to make in the first month whilst the workers are getting used tohandling the new ingredient mix. When this is taken into account, it can therefore be seen that workers took less than the20% extra time that they were expected to take, hence the positive operational variance. The planning variance, on the otherhand, is $24,600 adverse. This is because the standard labour time per batch was not updated in November to reflect thefact that it would take longer to produce the truffles. The manager cannot be held responsible for this.

Overall, then, the manager has performed well, given the change in the recipe.

3 Web Co

Web Co has made three changes and introduced two incentives in an attempt to increase sales. Using the performance indicatorsgiven in the question, it is possible to assess whether these attempts have been successful.

Total sales revenueThis has increased from $2·2 million to $2·75m, an increase of 25% (W1). This is a substantial increase, especially consideringthe fact that a $10 discount has been given to all customers spending $100 or more at any one time. However, because a numberof changes and incentives have been introduced, it is not possible to assess how effective each of the individual changes/incentiveshas been in increasing sales revenue without considering the other performance indicators.

Net profit margin (NPM)This has decreased from 25% to 16·7%. In $ terms this means that net profit was $550,000 in quarter 1 and $459,250 inquarter 2 (W2). If the 25% NPM had been maintained in quarter 2, the net profit would have been $687,500 for quarter 2. It istherefore $228,250 lower than it would have been. This is mainly because of the $200,000 paid out for advertising and the$20,000 paid to the consultant for the search engine work. The remaining $8,250 difference could be a result of the cost of the$10 discounts given to customers who spent more than $100, depending on how these are accounted for. Alternatively, it couldbe due to the costs of providing the Fast Track service. More information would be required on how the discounts are accountedfor (whether they are netted off sales revenue or instead included in cost of sales) and also on the cost of providing the Fast Trackservice.

Whilst it is not clear how long the advert is going to run for in the fashion magazine, $200,000 does seem to be a very large cost.This expense is largely responsible for the fall in NPM. This is discussed further under ‘number of visits to website’.

Number of visits to websiteThese have increased dramatically from 101,589 to 141,714, an increase of 40,125 visits (39·5% W3). The reason for this isa combination of visitors coming through the fashion magazine’s website (28,201 visitors W5), with the remainder of the increasemost probably being due to the search engine consultants’ work. Both of these changes can therefore be said to have been effectivein improving the number of people who at least visit Web Co’s online store. However, given that the search engine consultant onlycharged a fee of $20,000 compared to the $200,000 paid for magazine advertising, in relative terms, the consultant’s workprovided value for money. Web Co’s sales are not really high enough to withstand a hit of $200,000 against profit, hence the fallin NPM.

Number of orders/customers spending more than $100The number of orders received from customers has increased from 40,636 to 49,600, an increase of 22% (W4). This shows that,whilst most of the 25% sales revenue increase is due to a higher number of orders, 3% of it is due to orders being of a higherpurchase value. This is also reflected in the fact that the number of customers spending more than $100 per visit has increased

13

from 4,650 to 6,390, an increase of 1,740 orders. So, for example, If each of these 1,740 customers spent exactly $100 ratherthan the $50 they might normally spend, it would easily explain the 3% increase in sales that is not due to increased ordernumbers. It depends partly on how the sales discounts of $10 each are accounted for. As stated above, further information isrequired on these.

An increase in the number of orders would also be expected, given that the number of visitors to the site has increased substantially.This leads on to the next point.

Conversion rate – visitor to purchaserThe conversion rate of visitors to purchasers has gone down from 40% to 35%. This is not surprising, given the advertising on thefashion magazine’s website. Readers of the magazine may well have clicked on the link out of curiosity and may come back andpurchase something at a later date. It may be useful to have a breakdown of the visitor to purchaser rate, showing one statistic forvisitors who have come from the online magazine and one for those who have not. This would help clarify the position.

Website availabilityRather than improving after the work completed by Web Co’s IT department, the website’s availability has stayed the same. Thismeans that the IT department’s changes to the website have not corrected the problem. Lack of availability is not good for business,although its exact impact is difficult to ascertain. It may be that visitors have been part of the way through making a purchase onlyto find that the website then becomes unavailable. More information would need to be available about aborted purchases, forexample, before any further conclusions could be drawn.

Subscribers to online newsletterThese have increased by a massive 159%. It is not clear what impact this has had on the business as we do not know whetherthe level of repeat customers has increased. This information is needed. Surprisingly, it seems that there has not been an increasedcost associated with providing Fast Track delivery, as the whole fall in net profit has been accounted for, so one can only assumethat Web Co managed to offer this service without incurring any additional cost itself.

ConclusionWith the exception of the work carried out to make the system more available, all of the other measures seem to have increasedsales or, in the case of Incentive 1, increased subscribers. More information is needed in relation to a couple of areas, as notedabove. The business has therefore been responsive to changes made and incentives implemented but the cost of the advertisingwas so high that, overall, profits have declined substantially. This expenditure seems too high in relation to the correspondingincrease in sales volumes.

Workings1. Increase in sales revenue $2·75m – $2·2m/$2·2m = 25% increase.2. NPM: 25% x $2·2m = $550,000 profit in quarter 1. 16·7% x $2·75m = $459,250 profit in quarter 2. 3. No. of visits to website: increase = 141,714 – 101,589/101,589 = 39·5%.4. Increase in orders = 49,600 – 40,636/40,636 = 22%.5. Customers accessing website through magazine line = 141,714 x 19·9% = 28,201.6. Increase in subscribers to newsletter = 11,900 – 4,600/4,600 = 159%.

4 Designit

(a) ExplanationThe rolling budget outlined for Designit would be a budget covering a 12-month period and would be updated monthly.However, instead of the 12-month period remaining static, it would always roll forward by one month. This means that, assoon as one month has elapsed, a budget is prepared for the corresponding month one year later. For example, Designit wouldbegin by preparing a budget for the 12 months from 1 December 2012 to 30 November 2013, to correspond with its yearend. Then, at the end of December 2012, a budget would be prepared for the month December 2013, so that the unexpiredperiod covered by the budget is always 12 months.

When the budget is initially prepared for the year ending 30 November 2013, the first month is prepared in detail, with muchless detail being given to later months, where there is a greater uncertainty about the future. Then, when this first month haselapsed and the budget for the month of December 2013 is prepared, it is also necessary to revisit and revise the budget forJanuary 2013, which will now be done in more detail.

Note: This answer gives more level of detail than would be required to gain full marks.

(b) ProblemsDesignit only has one part-qualified accountant. He is already overworked and probably has neither the time nor theexperience to prepare rolling budgets every month. One would only expect to see monthly rolling budgets of this nature inbusinesses which face rapid change. There is no evidence that this is the case for Designit. If it did decide to introduce rollingbudgets, it would probably be sufficient if they were updated on a quarterly rather than a monthly basis. If this monthly rollingbudget is going to be introduced, it is going to require a lot of input from many of the staff, meaning that they will have lesstime to dedicate to other things.

The sales managers may react badly to the new budgeting and incentive system. They are used to having been set targetsthat are easily achievable. With the new system, they will have to work hard all year round. They are also likely to becomefrustrated with the fact that they do not know the target for the whole year in advance. Once they have hit their target for the

14

month, they may then also be tempted to hold back further work and let it run into the next month, so that they increase thechances of meeting next month’s target. This would not be good for the business.

(c) Alternative incentive schemeThe issue with the current bonus scheme is that the reward system is stepped, rather than being a percentage of sales. Thefirst $1·5 million fee income target is too easy to reach and the second $1·5 million target is too hard to reach. Therefore,managers are not motivated to earn additional fees once the initial $1·5 million target has been reached.

A series of constantly rising bonus rates ranging over a narrower rate of sales could be used. For example, every $500,000of fee income could be rewarded with an additional bonus equivalent to 5% of salary. Alternatively, the bonus could bereplaced by commission, giving the managers a reward as a percentage of the fee income rather than a percentage of salary.Currently, the company is paying out $30,000 in bonus to each of its managers each year. This is 2% of $1·5 million.Therefore, the bonus could be that each manager earns 2% commission on all sales.

(d) Using spreadsheetsIf spreadsheets are used for budgeting, the part-qualified accountant could be rekeying large amounts of data taken from thecompany’s systems. It would be very easy for him to make a mistake when he is entering his data, especially withoutsomeone else to check his work.

Similarly, if there is any error in any of the formulae, all the numbers in the budget will be wrong. Whilst this risk alreadyexists because fixed budgets are being prepared on spreadsheets, the rolling budgets will be far more complex, whichincreases the risk of error in the design of the model or any of the formulae.

A model can become easily corrupted simply by putting a number in the wrong cell. The accountant is unlikely to spot thisdue to his lack of experience and the time pressure on him.

When spreadsheets are used, there is no audit trail that can be followed in order to check the numbers.

5 Wash Co

(a) Transfer price using machine hours

Total overhead costs = $877,620Total machine hours = (3,200 x 2) + (5,450) x 1 = 11,850Overhead absorption rate = $877,620/11,850 = $74·06Overhead cost for S = 2 x $74·06 = $148·12 and for R = 1 x $74·06 = $74·06.

Product S Product R$ $

Materials cost 117 95Labour cost (at $12 per hour) 6 9Overhead costs 148·12 74·06

–––––– ––––––Total cost 271·12 178·0610% mark-up 27·11 17·81

–––––– ––––––Transfer price using machine hours 298·23 195·87

–––––– ––––––

(b) Transfer price using ABC

Machine set up costs: driver = number of production runs.30 + 12 = 42.Therefore cost per set up = $306,435/42 = $7,296·07

Machine maintenance costs: driver = machine hours: 11,850 (S= 6,400; R=5,450)$415,105/11,850 = $35·03

Ordering costs: driver = number of purchase orders82 + 64 = 146.Therefore cost per order = $11,680/146 = $80Delivery costs: driver = number of deliveries.64 + 80 = 144.Therefore cost per delivery = $144,400/144 = $1,002·78

15

Allocation of overheads to each product:

Product S Product R Total$ $ $

Machine set-up costs 218,882 87,553 306,435Machine maintenance costs 224,192 190,913 415,106Ordering costs 6,560 5,120 11,680Delivery costs 64,178 80,222 144,400

–––––––– –––––––– ––––––––Total overheads allocated 513,812 363,808 877,620

–––––––– –––––––– ––––––––Number of units produced 3,200 5,450 8,650

$ $Overhead cost per unit 160·57 66·75

Transfer price per unit:Materials cost 117 95Labour cost 6 9Overhead costs 160·57 66·75

––––––– –––––––Total cost 283·57 170·75Add 10% mark up 28·36 17·08

––––––– –––––––Transfer price under ABC 311·93 187·83

––––––– –––––––

(c) (i) ABC monthly profit

Using ABC transfer price from part (b):

Assembly division Product S Product R TotalProduction and sales 3,200 5,450

$ $10% mark up 28·36 17·08

–––––––––– ––––––––––Profit 90,752 93,086 183,838

–––––––––– –––––––––– ––––––––

Retail division Product S Product R TotalProduction and sales 3,200 5,450

$ $Selling price 320 260Cost price (311·93) (187·83)

–––––––––– –––––––––––Profit per unit 8·07 72·17

–––––––––– –––––––––––Total profit 25,824 393,327 419,151

–––––––––– ––––––––––– ––––––––

(ii) Discussion

From the various profit figures for the three bases of allocating overheads, various observations can be made.

– There is obviously very little difference between the TOTAL profits of each division whichever method is used,except for differences arising from rounding. In each case, the total profit made by the assembly division isapproximately $183,000 and $419,000 for the retail division. It is the reallocation of profits from R to S or S toR that is the important factor in this situation, given that the retail division wants to reduce prices but increase salesvolumes for R.

– As regards the assembly division, when labour hours are used to allocate overheads, there is a big differencebetween the profits that each of the two products makes. When machine hours or ABC are used, this differencebecomes much smaller.

– As regards the retail division, when labour hours are used, product S generates 76% of the profit. When thismethod of allocation is then changed so that either machine hours are used or ABC is used, the main share of theprofit then moves to product R. In the case of ABC, the profit moves so much to R that S only generates a profitper unit of $8·07 for the retail division, which is very low for a selling price of $320.

– From the assembly division manager’s point of view, any change that results in increased sales of either R or S tothe retail division would be a good thing for the assembly division, given that both products are profitable. However,the assembly division’s manager would probably oppose the implementation of ABC to achieve this end resultbecause firstly, it is complex and secondly, it is unnecessary here. The aim of this exercise is to set more accuratetransfer prices for R and S, which should mean a reduction in R’s transfer price and an increase in S’s, accordingto the information given. This would then have the effect of enabling the retail division to lower its price for R andincrease sales volumes. This goal is achieved simply by changing the basis of overhead absorption from labourhours to machine hours, without the need for activity based costing.

16

– The retail manager’s view is likely to be exactly the same. If the basis of absorption is changed so that a lowertransfer price is charged, the retail division could potentially reduce their selling price for R, provided that theincreased sales volumes more than make up for the reduced margin. There is no need to get into the complexitiesof ABC when the results it produces are not that different.

17

Fundamentals Level – Skills Module, Paper F5Performance Management December 2012

Marks1 Hair Co

(a) Weighted average C/S ratioIndividual contributions 3Total sales revenue 1Total contribution 1Ratio 1

–––6

–––

(b) Break-even revenue 2–––

(c) PV chartIndividual CS ratios 1·5Ranking 1Workings for chart 2Chart:Labelling 0·5Plotting each of six points 4

–––9

–––

(d) DiscussionGeneral comments re assumptions of CVP (max. 2 marks) 1Each valid point re BEP 1

–––3

–––Total 20

––––––

2 Truffle Co

(a) Rate and efficiency variancesRate variance 2Efficiency variance 2

–––4

–––

(b) Planning and operational variancesLabour rate planning variance 2Labour rate operational variance 2Labour efficiency planning variance 2Labour efficiency operational variance 2

–––8

–––

(c) DiscussionOnly operational variances controllable 1No labour rate operating variance 1Planning variance down to company, not manager 2Labour efficiency total variance looks bad 2Manager has performed well as regards efficiency 2Standard for labour time was to blame 2Conclusion 2


–––Total 20

––––––

19

Marks3 Web Co

Calculations 4Missing info 3Discussion and further analysis (2–3 marks per point) 18Conclusion 2

–––Total 20

––––––

4 Designit

(a) ExplanationUpdated after one month elapsed 1Always 12 months 1Example given 1First month in detail 1Later month less detail 1Need to revisit earlier months 1

–––Maximum 4

–––

(b) ProblemsMore time 1Lack of experience 1Too regular 2Managers’ resistance 2Work harder 1Holding back work 2

–––Maximum 6

–––

(c) Simpler incentive schemeCurrent target too easy 1Second target too hard 1Other valid point re current scheme 1New scheme outlined 3

–––6

–––

(d) Using spreadsheetsErrors entering data 1Rolling budgets more complex 1Formulae may be wrong 1Corruption of model 1No audit trail 1

–––Maximum 4

–––Total 20

––––––

20

Marks5 Wash Co

(a) Transfer price using machine hoursCalculating OAR 1New TP for S 1New TP for R 1

–––3

–––

(b) Transfer price using ABCIdentify cost drivers 1Cost driver rates 2Total overheads allocated 2Overhead cost per unit 1Total cost per unit 1Transfer price per unit 1

–––8

–––

(c) ABC profit and discussion

(i) Profit calculation 3–––

(ii) Each valid comment 2–––

Maximum marks 6–––

Total 20––––––

21








Pape

r F5Performance

Management

Monday 3 June 2013



1 Gym Bunnies (GB) is a health club. It currently has 6,000 members, with each member paying a subscription fee of$720 per annum. The club is comprised of a gym, a swimming pool and a small exercise studio.

A competitor company is opening a new gym in GB’s local area, and this is expected to cause a fall in GB’smembership numbers, unless GB can improve its own facilities. Consequently, GB is considering whether or not toexpand its exercise studio in a hope to improve its membership numbers. Any improvements are expected to last forthree years.

Option 1No expansion. In this case, membership numbers would be expected to fall to 5,250 per annum for the next threeyears. Operational costs would stay at their current level of $80 per member per annum.

Option 2Expand the exercise studio. The capital cost of this would be $360,000.The expected effect on membership numbersfor the next three years is as follows:

Probability Effect on membership numbers0·4 Remain at their current level of 6,000 members per annum0·6 Increase to 6,500 members per annum

The effect on operational costs for the next three years is expected to be:

Probability Effect on operational costs0·5 Increase to $120 per member per annum0·5 Increase to $180 per member per annum

Required:

(a) Using the criterion of expected value, prepare and fully label a decision tree that shows the two optionsavailable to GB. Recommend the decision that GB should make.

Note: Ignore time value of money. (12 marks)

(b) Calculate the maximum price that GB should pay for perfect information about the expansion’s exact effecton MEMBERSHIP NUMBERS. (6 marks)

(c) Briefly discuss the problems of using expected values for decisions of this nature. (2 marks)

(20 marks)

2

2 Squarize is a large company which, for many years, operated solely as a pay-tv broadcaster. However, five years ago,it started product bundling, offering broadband and telephone services to its pay-tv customers. Customers taking upthe offer were then known in the business as ‘bundle customers’ and they had to take up both the broadband andtelephone services together with the pay-tv service. Other customers were still able to subscribe to pay-tv alone butnot to broadband and telephone services without the pay-tv service.

All contracts to customers of Squarize are for a minimum three-month period. The pay-tv box is sold to the customerat the beginning of the contract; however, the broadband and telephone equipment is only rented to them.

In the first few years after product bundling was introduced, the company saw a steady increase in profits. Then,Squarize saw its revenues and operating profits fall. Consequently, staff bonuses were not paid, and staff becamedissatisfied. Several reasons were identified for the deterioration of results:

1. In the economy as a whole, discretionary spending had been severely hit by rising unemployment and inflation.In a bid to save cash, many pay-tv customers were cancelling their contracts after the minimum three-monthperiod as they were then able to still keep the pay-tv box. The box comes with a number of free channels, whichthe customer can still continue to receive free of charge, even after the cancellation of their contract.

2. The company’s customer service call centre, which is situated in another country, had been the cause of lots ofcomplaints from customers about poor service, and, in particular, the number of calls it sometimes took to resolvean issue.

3. Some bundle customers found that the broadband service that they had subscribed to did not work. As a result,they were immediately cancelling their contracts for all services within the 14 day cancellation period permittedunder the contracts.

In a response to the above problems and in an attempt to increase revenues and profits, Squarize made the followingchanges to the business:

1. It made a strategic decision to withdraw the pay-tv–broadband–telephone package from the market and, instead,offer each service as a standalone product.

2. It guaranteed not to increase prices for a 12-month period for each of its three services. 3. It transferred its call centre back to its home country and increased the level of staff training given for call centre

workers.4. It investigated and resolved the problem with customers’ broadband service.

It is now one year since the changes were made and the finance director wants to use a balanced scorecard to assessthe extent to which the changes have been successful in improving the performance of the business.

Required:

(a) For each perspective of the balanced scorecard, identify two goals (objectives) together with a correspondingperformance measure for each goal which could be used by the company to assess whether the changeshave been successful. Justify the use of each of the performance measures that you choose. (16 marks)

(b) Discuss how the company could reduce the problem of customers terminating their pay-tv service after onlythree months. (4 marks)

(20 marks)

3 [P.T.O.

3 Cam Co manufactures webcams, devices which can provide live video and audio streams via personal computers. Ithas recently been suffering from liquidity problems and hopes that these will be eased by the launch of its newwebcam, which has revolutionary audio sound and visual quality. The webcam is expected to have a product life cycleof two years. Market research has already been carried out to establish a target selling price and projected lifetimesales volumes for the product. Cost estimates have also been prepared, based on the current proposed productspecification. Cam Co uses life cycle costing to work out the target costs for its products, believing it to be moreaccurate to use an average cost across the whole lifetime of a product, rather than potentially different costs fordifferent years. You are provided with the following relevant information for the webcam:

Projected lifetime sales volume 50,000 unitsTarget selling price per unit $200Target profit margin (35% selling price) $70Target cost per unit $130Estimated lifetime cost per unit (see note below for detailed breakdown) $160

Note: Estimated lifetime cost per unit:$ $

Manufacturing costsDirect material (bought in parts) 40Direct labour 26Machine costs 21Quality control costs 10Rework costs 3

–––100

Non-manufacturing costsProduct development costs 25Marketing costs 35

–––60

––––Estimated lifetime cost per unit 160

––––

The average market price for a webcam is currently $150.

The company needs to close the cost gap of $30 between the target cost and the estimated lifetime cost. The followinginformation has been identified as relevant:

1. Direct material cost: all of the parts currently proposed for the webcam are bespoke parts. However, most of thesecan actually be replaced with standard parts costing 55% less. However, three of the bespoke parts, whichcurrently account for 20% of the estimated direct material cost, cannot be replaced, although an alternativesupplier charging 10% less has been sourced for these parts.

2. Direct labour cost: the webcam uses 45 minutes of direct labour, which costs $34·67 per hour. The use of morestandard parts, however, will mean that whilst the first unit would still be expected to take 45 minutes, there willnow be an expected rate of learning of 90% (where ‘b’ = –0·152). This will end after the first 100 units havebeen completed.

3. Rework cost: this is the average rework cost per webcam and is based on an estimate of 15% of webcamsrequiring rework at a cost of $20 per rework. With the use of more standard parts, the rate of reworks will fall to10% and the cost of each rework will fall to $18.

Required:

(a) Recalculate the estimated lifetime cost per unit for the webcam after taking into account points 1 to 3 above.(12 marks)

(b) Explain the ‘market skimming’ (also known as ‘price skimming’) pricing strategy and discuss, as far as theinformation allows, whether this strategy may be more appropriate for Cam Co than charging one pricethroughout the webcam’s entire life. (8 marks)

(20 marks)

4

4 Block Co operates an absorption costing system and sells three types of product – Commodity 1, Commodity 2 andCommodity 3. Like other competitors operating in the same market, Block Co is struggling to maintain revenues andprofits in face of the economic recession which has engulfed the country over the last two years. Sales prices fluctuatein the market in which Block Co operates. Consequently, at the beginning of each quarter, a market specialist, whoworks on a consultancy basis for Block Co, sets a budgeted sales price for each product for the quarter, based on hisexpectations of the market. This then becomes the ‘standard selling price’ for the quarter. The sales department itselfis run by the company’s sales manager, who negotiates the actual sales prices with customers. The following budgetedfigures are available for the quarter ended 31 May 2013.

Product Budgeted production Standard selling price Standard variableand sales units per unit production costs per unit

Commodity 1 30,000 $30 $18Commodity 2 28,000 $35 $28·40Commodity 3 26,000 $41·60 $26·40

Block Co uses absorption costing. Fixed production overheads are absorbed on the basis of direct machine hours andthe budgeted cost of these for the quarter ended 31 May 2013 was $174,400. Commodity 1, 2 and 3 use 0·2 hours, 0·6 hours and 0·8 hours of machine time respectively.

The following data shows the actual sales prices and volumes achieved for each product by Block Co for the quarterended 31 May 2013 and the average market prices per unit.

Product Actual production and Actual selling price Average market pricesales units per unit per unit

Commodity 1 29,800 $31 $32·20Commodity 2 30,400 $34 $33·15Commodity 3 25,600 $40·40 $39·10

The following variances have already been correctly calculated for Commodities 1 and 2:

Sales price operational variancesCommodity 1: $35,760 AdverseCommodity 2: $25,840 Favourable

Sales price planning variancesCommodity 1: $65,560 FavourableCommodity 2: $56,240 Adverse

Required:

(a) Calculate, for Commodity 3 only, the sales price operational variance and the sales price planning variance.(4 marks)

(b) Using the data provided for Commodities 1, 2 and 3, calculate the total sales mix variance and the total salesquantity variance. (11 marks)

(c) Briefly discuss the performance of the business and, in particular, that of the sales manager for the quarterended 31 May 2013. (5 marks)

(20 marks)

5 [P.T.O.

5 Newtown School’s head teacher has prepared the budget for the year ending 31 May 2014. The government paysthe school $1,050 for each child registered at the beginning of the school year, which is June 1, and $900 for anychild joining the school part-way through the year. The school does not have to refund the money to the governmentif a child leaves the school part-way through the year. The number of pupils registered at the school on 1 June 2013is 690, which is 10% lower than the previous year. Based on past experience, the probabilities for the number ofpupils starting the school part-way through the year are as follows:

Probability No. of pupils joining late0·2 500·3 200·5 26

The head teacher admits to being ‘poor with numbers’ and does not understand probabilities so, when calculatingbudgeted revenue, he just calculates a simple average for the number of pupils expected to join late. His budgetedrevenue for the year ending 31 May 2014 is therefore as follows:

Pupils Rate per pupil Total incomePupils registered at beginning of school year 690 $1,050 $724,500Average expected number of new joiners 32 $900 $28,800

–––––––––$753,300–––––––––

The head teacher uses incremental budgeting to budget for his expenditure, taking actual expenditure for the previousyear as a starting point and simply adjusting it for inflation, as shown below.

Note Actual cost Inflationary Budgeted cost forfor y/e 31 May 2013 adjustment y/e 31 May 2014

$ $Repairs and maintenance 1 44,000 +3% 45,320Salaries 2 620,000 +2% 632,400Capital expenditure 3 65,000 +6% 68,900

––––––––Total budgeted expenditure 746,620

––––––––Budget surplus 6,680

––––––––

Notes1. $30,000 of the costs for the year ended 31 May 2013 related to standard maintenance checks and repairs that

have to be carried out by the school every year in order to comply with government health and safety standards.These are expected to increase by 3% in the coming year. In the year ended 31 May 2013, $14,000 was alsospent on redecorating some of the classrooms. No redecorating is planned for the coming year.

2. One teacher earning a salary of $26,000 left the school on 31 May 2013 and there are no plans to replace her.However, a 2% pay rise will be given to all staff with effect from 1 December 2013.

3. The full $65,000 actual costs for the year ended 31 May 2013 related to improvements made to the schoolgym. This year, the canteen is going to be substantially improved, although the extent of the improvements andlevel of service to be offered to pupils is still under discussion. There is a 0·7 probability that the cost will be$145,000 and a 0·3 probability that it will be $80,000. These costs must be paid in full before the end of theyear ending 31 May 2014.

The school’s board of governors, who review the budget, are concerned that the budget surplus has been calculatedincorrectly. They believe that it should have been calculated using expected income, based on the probabilitiesprovided, and using expected expenditure, based on the information provided in notes 1 to 3. They believe thatincremental budgeting is not proving a reliable tool for budget setting in the school since, for the last three years, therehave been shortfalls of cash despite a budget surplus being predicted. Since the school has no other source of fundingavailable to it, these shortfalls have had serious consequences, such as the closure of the school kitchen for aconsiderable period in the last school year, meaning that no hot meals were available to pupils. This is thought tohave been the cause of the 10% fall in the number of pupils registered at the school on 1 June 2013.

6

Required:

(a) Considering the views of the board of governors, recalculate the budget surplus/deficit for the year ending 31 May 2014. (6 marks)

(b) Discuss the advantages and disadvantages of using incremental budgeting. (4 marks)

(c) Briefly outline the three main steps involved in preparing a zero-based budget. (6 marks)

(d) Discuss the extent to which zero-based budgeting could be used by Newtown School to improve thebudgeting process. (4 marks)

(20 marks)

7 [P.T.O.

8

Formulae Sheet

Learning curve

Y = axb

Demand curve

Where Y = cumulative average time per unit to produce x units

a = the time taken for the first unit of output

x = the cumulative number of units produced

b = the index of learning (log LR/log2)

LR = the learning rate as a decimal

P = a – bQ

b =change in price

change in quantity


MR = a – 2bQ


Answers


11

1(a)

Decision tree

DA

C

B

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Workings

Option 1Net income = $720 – $80 = $640 per annum.

Option 2If costs $120 per annum, net income = $720 – $120 = $600 per annum.If costs $180 per annum, net income = $720 – $180 = $540 per annum.

Expected value and decision:

EV at A = (0·5 x $3·6m) + (0·5 x $3·24m) = $3·42mEV at B = (0·5 x $(3·9m) + (0·5 x $3·51m) = $3·705mEV at C = (0·4 x $3·42m) + (0·6 x $3·705m) = $3·591m per annum

At D, compare EV of:Option 1: (3 x $3·36m) = $10·08mOption 2: ($3 x $3·591m) – $360k = $10·413m

Therefore choose option 2 – expand exercise studio.

(b) With perfect information:

If membership numbers were 6,000:EV = $3·42m x 3 = $10·26mLess costs of $360k = $9.9m

Therefore, with these membership numbers, GB would choose option 1 instead.

If membership numbers were 6,500:EV = $3·705 x 3 = $11·115mLess costs of $360k = $10·755m

In this instance, GB would choose option 2.

So, if membership numbers are 6,000, of which there is a 0·4 probability, EV will be $10·08m (option 1) and if membershipnumbers are 6,500, of which there is a 0·6 probability, then EV will be $10·755m (option 2).

Therefore EV with perfect information = (0·4 x $10·08m) + (0·6 x $10·755) = $10·485m.

Without perfect information the EV is $10·413m, therefore the value of it is $72k ($10·485m – $10·413m). This representsthe maximum price that GB should be prepared to pay for the information.

(c) The expansion decision is a one-off decision, rather than a decision that will be repeated many times. Expected values, onthe other hand, give us a long run average of the outcome that would be expected if a decision was to be repeated manytimes. The actual outcome may not be very close to the expected value calculated and the technique is therefore not reallyvery useful here.

Also, estimating accurate probabilities is difficult because this exact situation has not arisen before.

The expected value criterion for decision-making is useful where the attitude of the investor is risk neutral. We do not knowwhat the management of Gym Bunnies’ attitude to risk is, which makes it difficult to say whether this criterion is a good oneto use. In a decision such as this one, it would be useful to see what the worst case scenario and best case scenario resultswould be too, in order to assist decision-making.

12

2 (a) Goals and measures

(Other reasonable suggestions will be equally acceptable)

(b) Pay-tv customers currently own the boxes, meaning that a certain number of customers appear to cancel their contract afterthe first three months and just keep the set-top box with its free channels. Squarize may want to consider loaning the boxesrather than selling them to the customers at the beginning of the contract.

The company only has a minimum contract period of three months. This seems very short and perhaps the company couldconsider increasing it to 12 months. Unnecessary administration costs must be arising because it takes time, and thereforemoney, to set up new customers. If these customers then leave three months later, the company has not had muchopportunity to earn profits from the customers generating these costs.

13

Goals Performance Measures Reason

Financial perspectiveIncrease revenue Percentage increase in total revenue The changes have been implemented

partly in an attempt to increase revenues,so it is sensible to measure the extent towhich revenues have actually increased.

Increase operating profit margin Percentage increase in operating profit The changes have been implementedpartly in an attempt to increase operatingprofit, so it is sensible to measure theextent to which operating profit has actuallyincreased.

Customer perspectiveIncrease customer acquisition Total sales to new customers The fourth change (to standalone products)

was made in an attempt to attract newcustomers. This measure will help toassess whether the change has beensuccessful.

Reduce loss of customers Customer churn rate The first three of the four changes madewere made in an attempt to retaincustomers. This performance measure willhelp to assess whether the changes havebeen successful.

Internal business perspectiveReduce number of broadbandcontracts cancelled

Number of broadband contractscancelled

This performance measure will enableSquarize to assess whether the improvedbroadband service has resulted in areduction of the number of contractscancelled.

Increase after sales servicequality

Percentage of customer requests thatare handled with a single call

Squarize transferred its call centre back toits home country. This measure will assesswhether that has improved the servicequality to customers as a result.

Learning and growth perspectiveIncrease call centre workers’ skilllevels

Number of training hours peremployee

This measure will improve the likelihood ofcustomers receiving an improved service. Abetter public image should result, leadingto increased revenues as new customersare attracted to the business.

Increase employees’ satisfaction Percentage decrease in staff turnover This measure will also help to improvecustomer service, thereby improvingcompany image, attracting new customersand increasing revenues in the long term.

3 (a) Revised target cost

$ $Manufacturing costDirect material (working 1) 21·60Direct labour (working 2) 10·96Machine costs 21Quality control costs 10Rework costs (working 3) 1·80

–––––65·36

Product development cost 25Marketing cost 35

–––––Non-manufacturing costs 60

–––––––Total cost 125·36

––––––––––––––

Working 1: Direct material costParts to be replaced by standard parts = $40 x 0·8 = $32.New cost of those at 45% (100% – 55%) = $14·40.Unique irreplaceable parts: original cost = $40 x 20% = $8.New cost $7·20Revised direct material cost = $14·40 + $7·20 = $21·60

Working 2: Direct labourDirect labour – cost per unit for first one hundred units:Y = axb

45 x 100–0·152 = 22·346654 minutesTotal time for 100 units = 2,234·6654 minutes.

Time for the 100th unit:Time for 99 units = 45 x 99–0·152

= 22·380818 minutes.For 99 units = 2,215·701 minutes.Therefore, time for 100th unit = 2,234·6654 – 2,215·701 = 18·9644 minutes.

Time for remaining 49,900 units = 946,323·56 minutes.Total labour time for 50,000 units = 948,558·23 minutes.Therefore total labour cost = 948,558·23/60 x $34·67 = $548,108·56.Therefore average labour cost per unit = $548,108·56/50,000 = $10·96.

Note: Some rounding is acceptable and marks would still be given.

Working 3: Rework costTotal cost = 50,000 x 10% x $18 = $90,000.Cost per average unit = $90,000/50,000 = $1·80.

(b) Market skimming

Market skimming is a strategy that attempts to exploit those areas of the market which are relatively insensitive to pricechanges. Initially, high prices for the webcam would be charged in order to take advantage of those buyers who want to buyit as soon as possible, and are prepared to pay high prices in order to do so.

The existence of certain conditions is likely to make the strategy a suitable one for Cam Co. These are as follows:

– Where a product is new and different, so that customers are prepared to pay high prices in order to gain the perceivedstatus of owning the product early. The webcam has superior audio sound and visual quality, which does make itdifferent from other webcams on the market.

– Where products have a short life cycle this strategy is more likely to be used, because of the need to recover developmentcosts and make a profit quickly. The webcam does only have a two year life cycle, which does make it rather short.

– Where high prices in the early stages of a product’s life cycle are expected to generate high initial cash inflows. If thiswere to be the case for the webcam, it would be particularly useful for Cam Co because of the current liquidity problemsthe company is suffering. Similarly, skimming is useful to cover high initial development costs, which have been incurredby Cam Co.

– Where barriers to entry exist, which deter other competitors from entering the market; as otherwise, they will be enticedby the high prices being charged. These might include prohibitively high investment costs, patent protection or unusuallystrong brand loyalty. It is not clear from the information whether this is the case for Cam Co.

– Where demand and sensitivity of demand to price are unknown. In Cam Co’s case, market research has been carriedout to establish a price based on the customers’ perceived value of the product. The suggestion therefore is that someinformation is available about price and demand, although it is not clear how much information is available.

14

It is not possible to say for definite whether this pricing strategy would be suitable for Cam Co, because of the limitedinformation available. However, it does seem unusual that a high-tech, cutting edge product like this should be sold at thesame price over its entire, short life cycle. Therefore, price skimming should be investigated further, presuming that this hasnot already been done by Cam Co.

4 (a) Sales price operational variance: (actual price – market price) x actual quantity

Commodity 3: ($40·40 – $39·10) x 25,600 = $33,280F

Sales price planning variance: (standard price – market price) x actual quantity

Commodity 3: ($41·60 – $39·10) x 25,600 = $(64,000)A

An alternative approach to the variance calculations for Commodity 3 would be as follows:

Sales price operational variance

Commodity 3Should now $39·10Did $40·40

–––––––Difference $1·30FActual sales quantity 25,600Variance $33,280F

Sales price planning variance

Commodity 3Should now $39·10Should $41·60

–––––––Difference $2·50AActual sales quantity 25,600Variance $64,000A

(b) Sales mix variance:

(Actual sales quantity in actual mix at standard margin) – (actual sales quantity in standard mix at standard margin) =$768,640 (w.1 & 2) – $782,006 (w.3) = $13,366 adverse.

Working 1: Standard margins per unit:Budgeted machine hours = (30,000 x 0·2) + (28,000 x 0·6) + (26,000 x 0·8) = 43,600.Overhead absorption rate = $174,400/43,600 = $4 per hour.

Product Commodity 1 Commodity 2 Commodity 3$ $ $

Standard selling price 30 35 41·60Variable production costs (18) (28·40) (26·40)Fixed production overheads (0·8) (2·4) (3·2)

–––––– ––––– –––––Standard profit margin 11·20 4·20 12

–––––– ––––– –––––

Working 2: Actual sales quantity in actual mix at standard profit margin:

Product Actual quantity Standard profit $in actual mix

Commodity 1 29,800 $11·20 333,760Commodity 2 30,400 $4·20 127,680Commodity 3 25,600 $12 307,200

––––––– ––––––––85,800 768,640––––––– ––––––––

Working 3 Actual sales quantity in standard mix at standard profit margin:

Product Actual quantity in standard mix Standard profit $Commodity 1 85,800 x 30/84 = 30,643 $11·20 343,202Commodity 2 85,800 x 28/84 = 28,600 $4·20 120,120Commodity 3 85,800 x 26/84 = 26,557 $12 318,684

––––––– ––––––––85,800 782,006––––––– ––––––––

The sales quantity variance = (actual sales quantity in standard mix at standard margin) – (budgeted sales quantity instandard mix at standard profit margin) = $782,006 (w.3 above) – $765,600 (w.4) = $16,406 favourable.

15

Working 4: Budgeted sales quantity in standard mix at standard profit margin:

Product Quantity Standard profit $Commodity 1 30,000 $11·20 336,000Commodity 2 28,000 $4·20 117,600Commodity 3 26,000 $12 312,000

––––––– ––––––––84,000 765,600––––––– ––––––––

(c) The calculations above have shown that, as regards the sales price, there is a $23,360 favourable operational variance anda $54,680 adverse planning variance. In total, these net off to a sales price variance of $31,320 adverse. The sales managercan only be responsible for a variance to the extent that he controls it. Since the standard selling prices are set by a consultant,rather than the sales manager, the sales manager can only be held responsible for the operational variance. Given that thiswas a favourable variance of $23,360, it appears that he has performed well, achieving sales prices which, on average, werehigher than the market prices at the time. The consultant’s predictions, however, were rather inaccurate, and it is these thathave caused an adverse variance to occur overall in relation to sales price.

As regards sales volumes, the mix variance is $13,366 adverse and the quantity variance is $16,406 favourable, meaningthat the total volume variance is $3,040 favourable. This is because total sales volumes were higher than expected, althoughit is apparent that the increased sales related to the lower margin Commodity 2, with sales of Commodity 1 and Commodity 3 actually being lower than budget.

The total variance relating to sales is $28,280 adverse. This looks poor but, as identified above, it is due to the inaccuracyof the sales price forecasts made by the consultant. We know that Block Co is facing tough market conditions because of theeconomic recession and therefore it is not that surprising that market prices were actually a bit lower than originallyanticipated. This could be due to the recession hitting even harder in this quarter than in previous ones.

5 (a) Budget deficit/surplus

Budgeted income:Income from pupils registered on 1 June 2013: $724,500 (given in question)Expected number of new joiners: (0·2 x 50) + (0·3 x 20) + (0·5 x 26) = 29Expected income from new joiners at $900 each = $26,100Total expected income = $750,600.

Budgeted expenditure:Repairs and maintenance: $30,000 x 1·03 = $30,900.Salaries: [($620,000 – $26,000)/2] + [($620,000 – $26,000 x 1·02)/2]= $297,000 + $302,940 = $599,940.Expected capital expenditure = (0·7 x $145,000) + (0·3 x $80,000) = $125,500.Total expected expenditure = $756,340.

Budget deficit = $5,740.

(b) Discussion of estimates

Advantages

– Incremental budgeting is very easy to perform. This makes it possible for a person without any accounting training tobuild a budget.

– Incremental budgeting is also very quick compared to other budgeting methods.– The information required to complete it is also usually readily available.

Disadvantages

– On the other hand, incremental budgeting encourages inefficiency because it does not question the preceding year’sfigures on which it is based. No-one asks how those figures could be reduced.

– Similarly, in some organisations, it encourages slack because departmental managers may attempt to use their entirebudget up for one year, even if they do not need to, just to ensure that that cash is available again the next year.

– Errors from one year are carried to the next, since the previous year’s figures are not questioned.

(c) Zero-based budgeting (ZBB)

The three main steps involved in preparing a zero-based budget are as follows:

1. Activities are identified by managers. Managers are then forced to consider different ways of performing the activities.These activities are then described in what is called a ‘decision package’, which:

– analyses the cost of the activity;– states its purpose;– identifies alternative methods of achieving the same purpose;

16

– establishes performance measures for the activity;– assesses the consequence of not performing the activity at all or of performing it at different levels.

As regards this last point, the decision package may be prepared at the base level, representing the minimum level ofservice or support needed to achieve the organisation’s objectives. Further incremental packages may then be preparedto reflect a higher level of service or support.

2. Management will then rank all the packages in the order of decreasing benefits to the organisation. This will helpmanagement decide what to spend and where to spend it. This ranking of the decision packages happens at numerouslevels of the organisation.

3. The resources are then allocated, based on order of priority up to the spending level.

(d) Use of ZBB at Newtown School

There is definitely a place for ZBB at Newtown School. At the moment, incremental budgeting is responsible for recurringunexpected cash shortages, which is deterring new pupils from joining the school. Had a deficit been predicted for the yearended 31 May 2013, perhaps $65,000 would not have been spent on improving the school gym, and then it would nothave been necessary to close the school kitchen. ZBB would be good to establish the way cash is spent on those activitiesthat are, to a certain extent, discretionary.

For example, although there is a need for pupils to have somewhere to eat lunch, it is not essential for children to have acooked meal every day. It is essential that children do have somewhere to eat though and, as a bare minimum, they wouldneed an area where they could eat their sandwiches and have access to fresh water. ZBB could be used to put togetherdecision packages which reflect the different levels of service available to the children. For example, the most basic level ofservice could be the provision of an area for the children to eat a lunch brought from home. The next level would be theprovision of some cold and maybe hot food for the children, but on a self-service basis. Finally, the highest level of servicewould be a restaurant for the children where they get served hot meals at tables. At Newtown School the catering managercould prepare the decision packages and they would then be decided upon by the head teacher, who would rank themaccordingly.

Similarly, although some level of sports education is needed, the extent of the different activities offered is discretionary. ZBBcould be used to create decision packages for each of these services in order to prioritise them better than they are currentlybeing prioritised.

ZBB takes a long time to implement and would not be appropriate to all categories of expenditure at the school. Much of thebudgeting is very straight forward. Incremental budgeting could still be used as a starting point for essential expenditure suchas salary costs, provided that changes in staff numbers are also taken into account. There is an element of essential, recurringexpenditure in relation to repairs and maintenance too, since the costs of the checks and repairs needed to comply with healthand safety standards seem to largely stay the same each year, with an inflationary increase.

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Marks1 (a) Decision tree diagram

Start with decision point 0·5Option 1 format 0·5Option 2 format 5Expected value and decisionEV at A 1EV at B 1EV at C 2Compare EVs at D 1Recommendation that follows 1

–––12–––

(b) Price of perfect informationEV with 6,000 members 2EV with 6,500 members 2Price 2

–––6

–––

(c) Discussion 2–––

Total marks 20––––––

2 (a) Balanced scorecardIdentifying the four perspectives 2Each goal 0·5Each performance measure 0·5Each reason 1


–––

(b) Customer retention issueEach point discussed – 2 marks 4



––––––

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Marks3 (a) Revised lifetime cost

Direct material cost 2·5Direct skilled labour cost:Cumulative average time per unit for 100 units 1Cumulative total time for 100 units 0·5Cumulative average time per unit for 99 units 1Cumulative total time for 99 units 0·5Incremental time for 100th unit 1Total time for 49,900 units 0·5Total time for 50,000 units 0·5Total labour cost for 50,000 units 0·5Average labour cost per unit 0·5Machine costs 0·5Quality control costs 0·5Rework cost 1Non-manufacturing cost 1Total cost 0·5

–––12–––

(b) Market skimmingExplanation – maximum 2Discussion of each condition – maximum 2Conclusion 1



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4 (a) Planning and operational variancesOperational variance 2Planning variance 2

–––4

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(b) Mix and quantity variancesStandard profit per unit 4Mix variance 4Quantity variance 3

–––11–––

(c) DiscussionEach valid comment 1

–––5


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Marks5 (a) Budgeted income 2

Repairs and maintenance 1Teachers’ salaries 1·5Capital expenditure 1Deficit 0·5

–––6

–––

(b) Advantages and DisadvantagesTwo advantages 2Two disadvantages 2

–––4

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(c) Zero-based budgetingStep 1 2Step 2 2Step 3 2

–––6

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(d) Use of ZBB to Newtown SchoolEach point made 1

–––Maximum 4


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213540695-ACCA-F5-All-Past-Papers.pdf

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