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2013ACCA F5 PerformanceManagement

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Exam Kit

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EXAM

AC

CA

Paper

F5 K I T

Performance management

PublishingPublishing






ii © Emile Woolf Publishing Limited

Sixth edition published by Emile Woolf Publishing Limited Crowthorne Enterprise Centre, Crowthorne Business Estate, Old Wokingham Road, Crowthorne, Berkshire RG45 6AW Email: [email protected] www.emilewoolfpublishing.com

© Emile Woolf Publishing Limited, January 2013

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, without the prior permission in writing of Emile Woolf Publishing Limited, or as expressly permitted by law, or under the terms agreed with the appropriate reprographics rights organisation.

You must not circulate this book in any other binding or cover and you must impose the same condition on any acquirer. Notice Emile Woolf Publishing Limited has made every effort to ensure that at the time of writing the contents of this study text are accurate, but neither Emile Woolf Publishing Limited nor its directors or employees shall be under any liability whatsoever for any inaccurate or misleading information this work could contain. British Library Cataloguing in Publications Data A catalogue record for this book is available from the British Library. ISBN: 978-1-84843-277-2 Printed and bound in Great Britain. Acknowledgements The syllabus, study guide, exam questions and answers (where indicated) are reproduced by kind permission of the Association of Chartered Certified Accountants.






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Paper F5 Performance management

c

Contents

Page

Questions and answers index v

Syllabus and exam format ix

Exam techniques xix

Formulae xxi

Section

1 Practice questions 1

Specialist cost and management accounting techniques 1

Decision‐making techniques 16

Budgeting 30

Standard costing and variance analysis 41

Performance measurement and control 56

2 Answers to practice questions 77

Specialist cost and management accounting techniques 77

Decision‐making techniques 113

Budgeting 147

Standard costing and variance analysis 173

Performance measurement and control 209

3 Mock exam questions 249

4 Answers to mock exam questions 257






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i

Questions and answers index

Question page

Answer page

Exam

Specialist cost and management accounting techniques

1 Bespoke furniture 1 77

2 Alfabeta Co 2 80

3 Target 4 82

4 Nimble Company 5 84

5 Noisy Company 6 87

6 Penna Company 7 90

7 Spring 7 91

8 Admer 8 94

9 Ride Company 9 98

10 Slip On 10 101

11 Abkaber 11 104

12 Edward Co 12 106 F5 D07

13 Jola Publishing 14 109 F5 J08

14 Yam Co 15 111 F5 J09 (Q1)

Decision making techniques

15 Light engineering 16 113 ‐

16 Tables and Benches 16 116

17 Minim Machines 17 119

18 Linear 18 121

19 Rapid Profit 19 123

20 Pricing model 20 125






Paper F5: Performance management

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Question page

Answer page

Exam

21 Ella 21 127

22 Ennerdale 22 128

23 Bravia 23 130

24 Crusty Buns 24 131

25 Albion 24 133

26 Sniff Co 25 135 F5 D07

27 Higgins Co 27 137 F5 J08

28 Shifters Haulage 27 141 F5 D08

29 Bits and Pieces (B&P) 28 143 F5 J09 (Q4)

30 Stay Clean 29 145 F5 D09 (Q5)

Budgeting

31 Flexico 30 147

32 Titfer Co 31 149

33 Storrs 33 152

34 Stem Company 34 154

35 Velo Racers 35 156

36 Experience 35 158

37 NN Company 36 160

38 Spotty 36 163

39 Henry Company 37 165 F5 D08

40 Wargrin 38 167 F5 D08

41 Northland’s LGOs 39 169 F5 J09 (Q4)

42 Big Cheese Chairs 40 170 F5 D09 (Q2)

43 The Western 40 171 F5 D09 (Q3)

Standard costing and variance analysis

44 Slug 41 173

45 Azela Co 42 175

46 StarGazer 44 179

47 Toxic Kems 45 183

48 Mermus 45 185

49 Woodeezer 46 188

50 Carat 47 192

51 Linsil 48 195

52 BRK 50 197

53 Spike Co 51 201 F5 D07

54 Chaff Co 52 203 F5 J08

55 Crumbly Cakes 54 203 F5 J09 (Q3)






Index to questions and answers

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Question page

Answer page

Exam

56 Secure Net 55 208 F5 D09 (Q1)

Performance measurement and control

57 Not for profit performance 56 209

58 West Division 56 212

59 Artiweb 57 213

60 Debito Co 58 214

61 Peseta Company 60 216

62 Two Divisions 61 218

63 INA 62 219

64 BLA 63 221

65 Talesin 64 224

66 Behaviour 66 225

67 Project X 66 228

68 Public performance 67 231

69 AV 67 233

70 Ties Only 69 236 F5 D07

71 Bridgewater Co 71 239 F5 J08

72 Pace Company 72 241 F5 D08

73 Oliver’s salon 73 244 F5 J09 (Q2)

74 Thatcher International Park 75 246 F5 D09 (Q4)







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S

Syllabus and study guide

Aim

To develop knowledge and skills in the application of management accounting techniques to quantitative and qualitative information, for planning, decision-making, performance evaluation and control.

Main capabilities

After completing this examination paper, students should be able to:

A Explain and apply cost accounting techniques

B Select and appropriately apply

Decision making techniques to facilitate business decisions and promote efficient and effective use of scarce business resources, appreciating the risks and uncertainty inherent in business and controlling those risks

C Identify and apply appropriate budgeting techniques and methods for planning and control

D Use standard costing systems to measure and control business performance and to identify remedial action

E Assess the performance of a business from both a financial and non-financial viewpoint, appreciating the problems of controlling divisionalised businesses and the importance of allowing for external aspects







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Rationale

The syllabus for Paper F5, Performance Management, builds on the knowledge gained in Paper F2, Management Accounting. It also prepares candidates for more specialist capabilities which are covered in P5 Advanced Performance Management. The syllabus begins by introducing more specialised management accounting topics. There is some knowledge assumed from Paper F2 – primarily overhead treatments. The objective here is to ensure candidates have a broader background in management accounting techniques. The syllabus then considers decision-making. Candidates need to appreciate the problems surrounding scarce resource, pricing and make-or-buy decisions, and how this relates to the assessment of performance. Risk and uncertainty are a factor of real-life decisions and candidates need to understand risk and be able to apply some basic methods to help resolve the risks inherent in decision-making. Budgeting is an important aspect of many accountants’ lives. The syllabus explores different budgeting techniques and the problems inherent in them. The behavioural aspects of budgeting are important for accountants to understand, and the syllabus includes consideration of the way individuals react to a budget. Standard costing and variances are then built on. All the variances examined in Paper F2 are examinable here. The new topics are mix and yield variances, and planning and operational variances. Again, the link is made to performance management. It is important for accountants to be able to interpret the numbers that they calculate and ask what they mean in the context of performance.

The syllabus concludes with performance measurement and control. This is a major area of the syllabus. Accountants need to understand how a business should be managed and controlled. They should appreciate the importance of both financial and non-financial performance measures in management. Accountants should also appreciate the difficulties in assessing performance in divisionalised businesses and the problems caused by failing to consider external influences on performance. This section leads directly to Paper P5. All of the subject areas covered in this syllabus could be examined in either a public sector or private sector context.

Detailed Syllabus

A Specialist cost and management accounting techniques

1 Activity based costing

2 Target costing

3 Life cycle costing

4 Throughput accounting

5 Environmental accounting

B Decision-making techniques

1 Relevant cost analysis







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2 Cost volume analysis

3 Limiting factors

4 Pricing decisions

5 Make-or-buy and other short-term decisions

6 Dealing with risk and uncertainty in decision- making

C Budgeting

1 Objectives

2 Budgetary systems

3 Types of budget

4 Quantitative analysis in budgeting

5 Behavioural aspects of budgeting

D Standard costing and variances analysis

1 Budgeting and standard costing

2 Basic variances and operating statements

3 Mix and yield variances

4 Planning and operational variances

5 Behavioural aspects of standard costing

E Performance measurement and control

1 The scope of performance measurement

2 Divisional performance and transfer pricing

3 Performance analysis in not-for-profit organisations and the public sector

4 External considerations and behavioural aspects

Approach to examining the syllabus

Paper F5, Performance Management, seeks to examine candidates’ understanding of how to manage the performance of a business.

The paper builds on the knowledge acquired in Paper F2, Management Accounting, and prepares those candidates who choose to study Paper P5, Advanced Performance Management, at the Professional level

The syllabus is assessed by a three-hour paper-based examination.

The examination will contain five compulsory 20-mark questions. There will be calculation and discursive elements to the paper with the balance being broadly in line with the pilot paper. The pilot paper contains questions from four of the five syllabus sections. Generally, the paper will seek to draw questions from as many of the syllabus sections as possible.







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Study guide

This study guide provides more detailed guidance on the syllabus. You should use this as the basis of your studies.

A Specialist cost and management accounting techniques

1 Activity based costing

(a) Identify appropriate cost drivers under ABC.

(b) Calculate costs per driver and per unit using ABC.

(c) Compare ABC and traditional methods of overhead absorption based on production units, labour hours or machine hours.(2)

2 Target costing

(a) Derive a target cost in manufacturing and service industries.

(b) Explain the difficulties of using target costing in service industries.

(c) Suggest how a target cost gap might be closed.

3 Life cycle costing

a) Identify the costs involved at different stages of the life-cycle.

b) Derive a life cycle cost in manufacturing and service industries.

c) Identify the benefits of life cycle costing.

4 Throughput accounting

a) Calculate and interpret a throughput accounting ratio (TPAR).

b) Suggest how a TPAR could be improved.

c) Apply throughput accounting to a multi-product decision-making problem.

5 Environmental accounting

a) Discuss the issues business face in the management of environmental costs.

b) Describe the different methods a business may use to account for its environmental costs.

B Decision-making techniques

1 Relevant cost analysis

a) Explain the concept of relevant costing.

b) Identify and calculate relevant costs for a specific decision situations from given data.

c) Explain and apply the concept of opportunity costs.







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2 Cost volume profit analysis

a) Explain the nature of CVP analysis.

b) Calculate and interpret break even point and margin of safety.

c) Calculate the contribution to sales ratio, in single and multi-product situations, and demonstrate an understanding of its use.

d) Calculate target profit or revenue in single and multi-product situations, and demonstrate an understanding of its use.

e) Prepare break even charts and profit volume charts and interpret the information contained within each, including multi-product situations.

f) Discuss the limitations of CVP analysis for planning and decision making.

3 Limiting factors

a) Identify limiting factors in a scarce resource situation and select an appropriate technique.

b) Determine the optimal production plan where an organisation is restricted by a single limiting factor, including within the context of “make” or “buy” decisions.

c) Formulate and solve multiple scarce resource problem both graphically and using simultaneous equations as appropriate.

d) Explain and calculate shadow prices (dual prices) and discuss their implications on decision-making and performance management.

e) Calculate slack and explain the implications of the existence of slack for decision-making and performance management. (Excluding simplex and sensitivity to changes in objective functions)

4 Pricing decisions

a) Explain the factors that influence the pricing of a product or service.

b) Explain the price elasticity of demand.

c) Derive and manipulate a straight line demand equation. Derive an equation for the total cost function (including volume-based discounts).

d) Calculate the optimum selling price and quantity for an organisation, equating marginal cost and marginal revenue.

e) Evaluate a decision to increase production and sales levels, considering incremental costs, incremental revenues and other factors.

f) Determine prices and output levels for profit maximisation using the demand based approach to pricing (both tabular and algebraic methods).

g) Explain different price strategies, including:







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i) All forms of cost-plus

ii) Skimming

iii) Penetration

iv) Complementary product

v) Product-line

vi) Volume discounting

vii) Discrimination

viii) Relevant cost

h) Calculate a price from a given strategy using cost-plus and relevant cost.

5 Make-or-buy and other short-term decisions

a) Explain the issues surrounding make vs. buy and outsourcing decisions.

b) Calculate and compare make” costs with “buy-in” costs.

c) Compare in-house costs and outsource costs of completing tasks and consider other issues surrounding this decision.

d) Apply relevant costing principles in situations involving shut down, one-off contracts and the further processing of joint products.

6 Dealing with risk and uncertainty in decision- making

a) Suggest research techniques to reduce uncertainty e.g. Focus groups, market research.

b) Explain the use of simulation, expected values and sensitivity.

c) Apply expected values and sensitivity to decision-making problems.

d) Apply the techniques of maximax, maximin, and minimax regret to decision-making problems including the production of profit tables.

e) Draw a decision tree and use it to solve a multi-stage decision problem.

f) Calculate the value of perfect information.

C Budgeting

1 Objectives

a) Outline the objectives of a budgetary control system.

b) Explain how corporate and divisional objectives may differ and can be reconciled.

c) Identify and resolve conflicting objectives and explain implications.







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2 Budgetary systems

a) Explain how budgetary systems fit within the performance hierarchy.

b) Select and explain appropriate budgetary systems for an organisation, including top-down, bottom-up, rolling, zero-base, activity- base, incremental and feed-forward control.

c) Describe the information used in budget systems and the sources of the information needed.

d) Explain the difficulties of changing a budgetary system.

e) Explain how budget systems can deal with uncertainty in the environment.

3 Types of Budget

a) Indicate the usefulness and problems with different budget types (zero-base, activity-based, incremental, master, functional and flexible).

b) Explain the difficulties of changing the type of budget used.

4 Quantitative analysis in budgeting

a) Analysis fixed and variable cost elements from total cost data using high/low and regression methods.

b) Explain the use of forecasting techniques, including time series, simple average growth models and estimates based on judgement and experience. Predict a future value from provided time series analysis data using both additive and proportional data.

c) Estimate the learning effect and apply the learning curve to a budgetary problem, including calculations on steady states

d) Discuss the reservations with the learning curve.

e) Apply expected values and explain the problems and benefits.

f) Explain the benefits and dangers inherent in using spreadsheets in budgeting.

5 Behavioural aspects of budgeting

a) Identify the factors which influence behaviour.

b) Discuss the issues surrounding setting the difficulty level for a budget.

c) Explain the benefits and difficulties of the participation of employees in the negotiation of targets.

D Standard costing and variances analysis

1 Budgeting and standard costing

a) Explain the use of standard costs.







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b) Outline the methods used to derive standard costs and discuss the different types of cost possible.

c) Explain the importance of flexing budgets in performance management.

d) Prepare budgets and standards that allow for waste and idle time.

e) Explain and apply the principle of controllability in the performance management system.

f) Prepare a flexed budget and comment on its usefulness.

2 Basic variances and operating statements

a) Calculate, identify the cause of and interpret basic variances:

i) Sales price and volume

ii) Materials total, price and usage

iii) Labour total, rate and efficiency

iv) Variable overhead total, expenditure and efficiency

v) Fixed overhead total, expenditure and, where appropriate, volume, capacity and efficiency

b) Explain the effect on labour variances where the learning curve has been used in the budget process.

c) Produce full operating statements in both a marginal cost and full absorption costing environment, reconciling actual profit to budgeted profit.

d) Calculate the effect of idle time and waste on variances including where idle time has been budgeted for.

e) Explain the possible causes of idle time and waste and suggest methods of control.

f) Calculate, using a simple situation, ABC-based variances.

g) Explain the different methods available for deciding whether or not too investigate a variance cause.

3 Material mix and yield variances

a) Calculate, identify the cause of, and explain material mix and yield variances.

b) Explain the wider issues involved in changing material mix e.g. cost, quality and performance measurement issues.

c) Identify and explain the relationship of the material price variance with the material mix and yield variances.

d) Suggest and justify alternative methods of controlling production processes.

4 Sales mix and quantity variances

a) Calculate, identify the cause of, and explain sales mix and quantity variances.







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b) Identify and explain the relationship of the sales volume variances with the sales mix and quantity variances.

5 Planning and operational variances

a) Calculate a revised budget.

b) Identify and explain those factors that could and could not be allowed to revise an original budget.

c) Calculate planning and operational variances for sales, including market size and market share, materials and labour.

d) Explain and discuss the manipulation issues involved in revising budgets.

6 Behavioural aspects of standard costing

a) Describe the dysfunctional nature of some variances in the modern environment of JIT and TQM.

b) Discuss the behavioural problems resulting from using standard costs in rapidly changing environments.

c) Discuss the effect that variances have on staff motivation and action.

E Performance measurement and control

1 The scope of performance measurement

a) Describe, calculate and interpret financial performance indicators (FPIs) for profitability, liquidity and risk in both manufacturing and service businesses. Suggest methods to improve these measures.

b) Describe, calculate and interpret non-financial performance indicators (NFPIs) and suggest method to improve the performance indicated.

c) Explain the causes and problems created by short-termism and financial manipulation of results and suggest methods to encourage a long term view.

d) Explain and interpret the Balanced Scorecard, and the Building Block model proposed by Fitzgerald and Moon.

e) Discuss the difficulties of target setting in qualitative areas.

2 Divisional performance and transfer pricing

a) Explain and illustrate the basis for setting a transfer price using variable cost, full cost and the principles behind allowing for intermediate markets.

b) Explain how transfer prices can distort the performance assessment of divisions and decisions made.

c) Explain the meaning of, and calculate, Return on Investment (ROI) and Residual Income (RI), and discuss their shortcomings.







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d) Compare divisional performance and recognise the problems of doing so.

3 Performance analysis in not for profit organisations and the public sector

a) Comment on the problems of having non-quantifiable objectives in performance management.

b) Explain how performance could be measured in this sector.

c) Comment on the problems of having multiple objectives in this sector.

d) Outline Value for Money (VFM) as a public sector objective.

4 External considerations and behavioural aspects

a) Explain the need to allow for external considerations in performance management, including stakeholders, market conditions and allowance for competitors.

b) Suggest ways in which external considerations could be allowed for in performance management.

c) Interpret performance in the light of external considerations.

d) Identify and explain the behaviour aspects of performance management






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e

Exam techniques

Five steps to exam success

1 Know your subject

It sounds obvious, but you really need to know all topics in the syllabus – ACCA can test you on any area of the syllabus so even those topics you think might ‘never come up’ could be on your next exam. Whatever the format, questions require that you have learnt definitions, know key words and their meanings and understand concepts, theories and rules.

2 Know your exam structure

Do you know how many questions you need to attempt? Do you know how long you exam is? What type of questions come up? Knowing this is essential!

The F5 exam is three hours long (plus an additional 15 minutes reading time) and has five compulsory, 25‐mark questions. Marks will be given for relevant answers but more marks will be given for answers in context. There will be a mixture of discursive and computational questions. The examiner aims to test as many of the syllabus sections as possible on each exam.







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3 Practice makes perfect

One of the best ways to prepare for your actual exam is to try lots of past questions under timed conditions. Attempt ALL of the questions in this exam kit and compare your answers with the answers to see what you need to improve on and the areas you need to go back and revise! Go back and revise and then reattempt questions if you get any wrong.

4 Time yourself

If you are sitting an exam worth 100 marks in three hours, you should aim to spend 1.8 minutes on each mark. Make sure that you have double‐checked your strategy of how you are going to allocate your time before you go into the exam and that you are comfortable answering four 25‐mark questions in three hours.

Since you don’t need to attempt the questions in order, a good strategy could be to attempt the ‘easy’ questions (such as those you either know or you don’t) at the beginning and save those that involve calculations or a bit more thought to the end.

5 Reading and planning time in the exam

You have been given an extra 15 minutes ‘reading and planning’ time in the exam. Use it wisely! You are allowed to read the questions, begin to plan your answers and use your calculator to make some preliminary numerical calculations. You’re allowed to write on your exam paper, so try going through and highlighting the key points and requirements in the questions, or jot down some ideas as to how you are going to structure your answers.






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ƒ

Formulae

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

b = the index of learning (log LR/log 2)

LR = the learning rate as a decimal

Regression analysis

y=a+bx

( )22 xxn

yxxynb

∑−∑

∑∑−∑=

nxb

ny

a∑

−∑

=

( ) ( )( )2222 yyn)xxn

yxxynr

∑−∑∑−∑

∑∑−∑=

Demand curve

P = a – bQ

quantity in changeprice in changeb =

a = price when Q = 0

MR = a – 2bQ







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1

Q&A

Practice questions


1 Bespoke furniture

A company makes hand-made furniture. It current makes three types of furniture:

Annual output

Direct labour hours

Unit price

The bookcase 1,000 100,000 $14,000

The bed 800 74,400 $12,000

The sideboard 400 60,000 $17,900 ––––––– Total 234,400

The following information on direct costs is also available:

Unit direct material cost

The bookcase $500

The bed $800

The sideboard $1,200

Direct labour costs are currently at $7.50 per hour.

Production overheads are estimated to be $24,000,000. These are absorbed using a company-wide absorption rate, based on labour hours.







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The company is considering a switch over to ABC and has prepared the following information:

Cost pool Cost $ Activity

Set-up 4,800,000 Set-ups

Purchase orders 12,000,000 Purchase orders

Retail delivery 7,108,800 Deliveries

The following information is available for the company’s products.

Product Set ups Purchase orders Deliveries

Bookcase 53 1,000 200

Bed 59 750 160

Sideboard 38 250 80

Required:

(a) Using the information available, produce a profit and loss account for each product using:

(i) Absorption costing

(ii) ABC

Comment on the costings you obtain. (18 marks)

(b) How can ABC assist in target costing? (7 marks)

(Total: 25 marks)

2 Alfabeta Co

Alfabeta Co makes two products, AB1 and AB2.

The main customer for AB1 is the government, and strict quality standards are demanded. As a consequence there is extensive inspection and quality testing for AB1, which is produced in four large production runs each year.

AB2 is made on the same machines as AB1, but inspection and testing is much less than for AB1. AB2 is also produced in long batch runs, with 12 production runs each year (once each month). Each unit of AB2 requires much more machine time than a unit of AB1.

The company has used a traditional absorption costing system to measure the costs of the two products, but the directors are aware that absorption costing is of limited value for measuring performance. They would like to know whether changing over to an activity-based costing (ABC) system would be appropriate or useful.

The following costs are available for the accounting year that has just ended, using the absorption costing system. Overheads are absorbed into product costs on a machine hour basis.






Section 1: Practice questions


Cost per unit Product AB1

Product AB2

$ $ $ $

Direct production costs

Materials

Machine costs

Production overheads

Total production cost

Selling price

Profit margin

The main overhead costs are as follows:

Overhead % of total overheads

Cost driver

General overheads 78 Machine hours

Quality control and inspection 12 Number of inspections

Production set-up costs 10 Number of production runs

If the overheads had been re-allocated using activity-based costing, the effect would have been to increase the unit cost of AB1 by about $0.50 (about 3%) and to reduce the unit cost of AB2 by about $0.60 (about 1.5%).

Required

(a) Explain why the unit costs of AB1 and AB2 have changed in the way indicated when ABC is used. (8 marks)

(b) Describe briefly the problems that are often experienced when introducing a system of activity-based costing for the first time. (4 marks)

The directors of Alfabeta Co have decided to introduce a system of activity-based costing for the next financial year. The following information is available about production costs and selling prices.

(1) Direct material costs will be $6 per unit of AB1 and $18.10 per unit of AB2.

(2) One unit of AB1 requires 12 minutes of machine time and one unit of AB2 requires 30 minutes of machine time. The machines cost $15 per hour to operate.

(3) The sales price per unit will be $20 for AB1 and $45 for AB2.

(4) Production overhead costs will be as follows:

Overhead $

General overheads 2,860,000

Quality control and inspection 400,000

Production set-up costs 380,000

Total overhead costs 3,640,000








(5) The company will produce 200,000 units of AB1 in total, in four production runs. It will also produce 15,000 units of AB2 per month, in a total of 12 production runs (one each month).

(6) Production of AB1 will be inspected and tested 20 times next year in total and production of AB2 will be inspected and tested 12 times.

Required

(c) Calculate the cost per unit and the profit margin per unit for AB1 and AB2 next year, using the traditional absorption costing system and a machine hour absorption rate for production overheads. (5 marks)

(d) Calculate the cost per unit and the profit margin per unit for AB1 and AB2 next year, using activity-based costing to allocate and absorb overhead costs. (8 marks)

(Total 25 marks)

3 Target

Pollar Co assembles and sells a range of components for motor vehicles and it is considering a proposal to add a new component to its product range. This is a component for electric motor cars, which has been given the code number NP19. The company sees an opportunity to gain market share in a market that is expected to grow considerably over time, but already competition from rival producers is strong.

Component NP19 would be produced by assembling a number of parts bought in from external suppliers, and would then be sold on to manufacturers of electric cars. Pollar Co would use its current work force of assembly workers to make the component. Production overheads are currently absorbed into production costs on an assembly hour basis.

Pollar Co is considering the use of target costing for the new component.

Required:

(a) Explain briefly how target costing might be used in the development and production of a new product. (3 marks)

(b) Explain the benefits of adopting a target costing approach at an early stage in the development of a new product. (4 marks)

(c) If a target costing approach is used and a cost gap is identified for component NP19, suggest possible measures that Pollar Co might take to reduce the gap. (5 marks)

Cost information for the new component NP19 is as follows:

(1) Part 1922: Each unit of component NP19 requires one unit of part 1922. These bought-in parts are purchased in batched of 5,000 units, and the purchase cost is $5.30 each plus delivery costs of $2,750 per batch.

(2) Part 1940: Each unit of component NP19 requires 20 cm of part 1940, which costs $2.40 per metre to purchase. However it is expected that there will be some waste due to cutting and that 5% of the purchased part will be lost in the assembly process.

(3) Other parts for component NP19 will also be bought in and will cost $7.20 per unit of the component.








(4) Assembly labour. It is estimated that each unit of component NP19 will take 25 minutes to assemble. Assembly labour, which is not in short supply, is paid $24 per hour. It is also estimated that 10% of paid labour time will be idle time.

(5) Production overheads. Analysis of recent historical costs for production overheads shows the following costs:

Total production overhead

Total assembly labour hours worked

$ Month 1 912,000 18,000 Month 2 948,000 22,000

Fixed production overheads are absorbed at a rate per assembly hour based on normal activity levels. In a normal year, Pollar Co works 750,000 assembly hours.

Pollar Co estimates that it needs to sell component NP19 at a price of no more than $56 per unit to be competitive, and it is considered that an acceptable gross profit margin on components sold by the company is 25%. Gross margin is defined as the sales price minus the full production cost of sales.

Required

(d) Calculate the expected cost per unit of component NP19 and calculate any cost gap that exists. (13 marks)

(Total 25 marks)

4 Nimble Company

Nimble Company (NC) produces, makes and sells video discs about personal health and fitness. The discs have only a short commercial life of about three years each.

The financial performance of each video disc is assessed according to the profits it makes in each of the first three years of its life. A net profit margin of 25% of sales turnover and a contribution to sales ratio of 70% are considered reasonable.

Each new video disc title is written, designed and produced in NC’s own studio and production room. Finished discs are then passed to the sales and distribution department for selling and distributing the product.

NC has developed a brand new video disc title called ‘Calorie Count’. The selling price of this product will be $20 per unit sold, with no price discounts or price reductions in any year.

Based on historical data for the production of similar products in the past, it is estimated that at a sales volume of 12,000 units in a year, total costs would be $150,000 and at a volume of 16,000 units a total cost of $170,000 is expected. If the volume exceeds 17,000 in a year, fixed costs for that year will increase by 50% above the normal level.

The budgeted sales volumes for ‘Calorie Count’ are as follows:

Year 1: 11,000 units

Year 2: 18,000 units

Year 3: 9,000 units

Marketing costs for ‘Calorie Count’, not included in the cost estimates above, will be $55,000 in Year 1 and $15,000 in Year 2. Design and development costs of $180,000 are








incurred before production and sales of the video disc begin in Year 1. These costs are written off to profit or loss as incurred (i.e. before Year 1).

Required:

(a) Explain the principles of life cycle costing and suggest why NC should consider applying these principles to the performance measurement of its products. (4 marks)

(b) Calculate the expected performance of ‘Calorie Count’ in each of the first three years of its life and comment on the expected financial performance of this product over its whole life cycle. (9 marks)

(c) Explain why incremental budgeting is a commonly used to prepare budgets and outline the main problems with using this approach to budgeting. (6 marks)

(d) Discuss the extent to which a meaningful standard cost can be set for video disc titles produced by NC, using the information and the cost classifications provided in this question (6 marks)

(Total 25 marks)

5 Noisy Company

Noisy Company (NC) makes two products, details of which are given below:

Product B Product S

$ $

Unit selling price 25 30

Direct materials 10 10

Time on process A 0.5hrs 1hrs

Time on process B 0.1 0.3

Market demand 3,000 2,000

Time available on process A 3,000 hrs

Time on process B 2,000 hrs

Total factory costs $21,000

(a) Using a throughput accounting approach, which product should be

manufactured to maximise profit? (7 marks)

(b) What is the sensitivity of the decision to changes in direct material cost and time on process A? (4 marks)

(c) NC is considering launching a new product. The market is highly competitive and is very price sensitive. They are considering the use of target costing.

Describe the use of target costing and explain how it could be of assistance to NC following a decision by the directors to manufacture the product. Your answer should include a flow diagram to illustrate a target costing cycle. (14 marks)

(Total: 25 marks)








6 Penna Company

Penna Company (PC) is trying to launch a new product into a competitive market in North America. Test marketing has revealed the following demand curve for the product:

P = 600 – 0.005Q

The estimated market for the product is 500,000 units per year. The company would like to capture 10% of this market.

The company has established a cost card based on 50,000 units of sales each year:

$

Direct materials 100

Direct labour 30

Fixed overhead 70

Total cost 200

The company wishes to achieve a target profit of $10,000,000 for sales of this product per year.

(a) What price will the company have to charge to capture its required market share and what is the target unit cost to achieve its target profit? (8 marks)

(b) What is the size of the target cost gap and how might Penna Company seek to close this gap? (10 marks)

(c) Explain the relevance of life cycle costing to target costing. (7 marks)

(Total: 25 marks)

7 Spring

At a recent board meeting of Spring Company, there was a heated discussion on the need to improve financial performance. The Production Director argued that financial performance could be improved if the company replaced its existing absorption costing approach with an activity-based costing system. He argued that this would lead to better cost control and increased profit margins.

The Managing Director agreed that better cost control could lead to increased profitability, but informed the meeting that he believed that performance needed to be monitored in both financial and non-financial terms. He pointed out that sales could be lost due to poor product quality or a lack of after-sales service just as easily as by asking too high a price for Spring’s products. He suggested that while the board should consider introducing activity-based costing, it should also consider ways in which the company could monitor and assess performance on a wide basis.

Required:

(a) Describe the key features of activity-based costing and discuss the advantages and disadvantages of adopting an activity-based approach to cost accumulation. (15 marks)

(b) Explain the need for the measurement of organisational and managerial performance, and give examples of the financial and non-financial performance measures that might be used. (11 marks)

(Total: 25 marks)








8 Admer

Admer owns several home furnishing stores. In each store, consultations, if needed, are undertaken by specialists, who also visit potential customers in their homes, using specialist software to help customers realise their design objectives. Customers visit the store to make their selections from the wide range of goods offered, after which sales staff collect payment and raise a purchase order. Customers then collect their self-assembly goods from the warehouse, using the purchase order as authority to collect. Administration staff process purchase orders and also arrange consultations.

Each store operates an absorption costing system and costs other than the cost of goods sold are apportioned on the basis of sales floor area.

Results for one of Admer’s stores for the last three months are as follows:

Department Kitchen Bathrooms Dining Rooms Total

$ $ $ $

Sales 210,000 112,500 440,000 762,500

Cost of goods sold 163,000 137,500 176,000 276,500

Other costs 130,250 181,406 113,968 325,624 ––––––– ––––––– ––––––– ––––––– Profit 116,750 (6,406) 150,032 160,376 ––––––– ––––––– ––––––– ––––––– The management accountant of Admer is concerned that the bathrooms department of the store has been showing a loss for some time, and is considering a proposal to close the bathrooms department in order to concentrate on the more profitable kitchens and dining rooms departments.

He has found that other costs for this store for the last three months are made up of:

$ Employees

Sales staff wages 1 64,800 12

Consultation staff wages 1 24,960 4

Warehouse staff wages 1 30,240 6

Administration staff wages 1 30,624 4

General overheads (light, heat, rates, etc.) 175,000 –––––––– 325,624 –––––––– He has also collected the following information for the last three months:

Department Kitchens Bathrooms Dining Rooms

Number of items sold 1,000 1,500 4,000

Purchase orders 1,000 900 2,500

Floor area (square metres) 16,000 10,000 14,000

Number of consultations 798 200 250








0The management accountant believes that he can use this information to review the store’s performance in the last three months from an activity-based costing (ABC) perspective.

Required:

(a) Discuss the management accountant’s belief that the information provided can be used in an activity-based costing analysis. (4 marks)

(b) Explain and illustrate, using supporting calculations, how an ABC profit statement might be produced from the information provided. Clearly explain the reasons behind your choice of cost drivers. (8 marks)

(c) Evaluate and discuss the proposal to close the bathrooms department. (6 marks) (d) Discuss the advantages and disadvantages that may arise for Admer from

introducing activity-based costing in its stores. (7 marks)

(Total: 25 marks)

9 Ride Company

Ride Company (RC) is engaged in the manufacturing and marketing of bicycles. Two bicycles are produced. These are the ‘Roadster’ which is designed for use on roads and the ‘Everest’ which is a bicycle designed for use in mountainous areas. The following information relates to the year ending 31 December Year 5:

(1) Unit selling price and cost data is as follows:

Roadster Everest

$ $

Selling price 200 280

Material cost 80 100

Variable production conversion costs 20 60

(2) Fixed production overheads attributable to the manufacture of the bicycles will amount to $4,050,000.

(3) Expected demand is as follows: Roadster 150,000 units

Everest 70,000 units

(4) Each bicycle is completed in the finishing department. The number of each type of bicycle that can be completed in one hour in the finishing department is as follows:

Roadster 6.25

Everest 5.00

There are a total of 30,000 hours available within the finishing department.

(5) RC operates a just in time (JIT) manufacturing system with regard to the manufacture of bicycles and aims to hold very little work-in-progress and no finished goods inventory whatsoever.








Required:

(a) Using marginal costing principles, calculate the mix (units) of each type of bicycle which will maximise net profit and state the value of that profit. (10 marks)

(b) Calculate the throughput accounting ratio for each type of bicycle and briefly discuss when it is worth producing a product where throughput accounting principles are in operation. Your answer should assume that the variable overhead cost amounting to $4,800,000 incurred as a result of the chosen product mix in part (a) is fixed in the short-term. (6 marks)

(c) Using throughput accounting principles, advise management of the quantities of each type of bicycle that should be manufactured which will maximise net profit and prepare a projection of the net profit that would be earned by Ride Company in the year ending 31 December Year 5. (5 marks)

(d) Explain two aspects in which the concept of ‘contribution’ in throughput accounting differs from its use in marginal costing. (4 marks)

(Total: 25 marks)

10 Slip On

Slip On Company (SOC) makes fashion jewellery. Details of three of its main products are given below:

Bead Plait Twist

$ $ $

Sales price 400 700 1,000

Direct materials 100 200 500

Direct labour 200 100 200

Production overhead 30 30 30 ––––– ––––– ––––– Profit 70 370 270

Market demand 10,000 5,000 4,000

Time on Machine type 1 30 minutes 60 minutes 45 minutes


Costs are based on the assumption that market demand is met in full.

The company has been growing fast and it now faces a shortage of time in its machine room. The available time on each type of machine is as follows:

Hours

Machine type 1 12,000

Machine type 2 15,000

The company adopts a throughput accounting approach to making scarce resource allocation decisions.

(a) Using throughput accounting, what is the optimum production mix and what is the profit produced? (12 marks)








(b) A newly joined management accountant disagrees with the assumptions behind throughput accounting and uses limiting factor analysis to make this kind of decision.

What production mix will she recommend and what is the resultant profit? (7 marks)

(c) Is throughput accounting more appropriate than limiting factor analysis? (6 marks)

(Total: 25 marks)

11 Abkaber

Abkaber assembles three types of motorcycle at the same factory: the 50cc Sunshine; the 250cc Roadster and the 1000cc Fireball. It sells the motorcycles throughout the world. In response to market pressures Abkaber has invested heavily in new manufacturing technology in recent years and, as a result, has significantly reduced the size of its workforce.

Historically, the company has allocated all overhead costs using total direct labour hours, but is now considering introducing Activity Based Costing (ABC). Abkaber’s accountant has produced the following analysis.

Annual output

Annual direct labour hours

Selling price

Raw materials cost

(units) ($ per unit) ($ per unit)

Sunshine 2,000 200,000 4,000 400

Roadster 1,600 220,000 6,000 600

Fireball 400 80,000 8,000 900

The three cost drivers that generate overheads are:

Deliveries to retailers – the number of deliveries of motorcycles to retail showrooms

Set-ups – the number of times the assembly line process is re-set to accommodate a production run of a different type of motorcycle

Purchase orders – the number of purchase orders.

The annual cost driver volumes relating to each activity and for each type of motorcycle are as follows:

Number of deliveries to

retailers

Number of set ups

Number of purchase

orders

Sunshine 100 35 400

Roadster 80 40 300

Fireball 70 25 100








The annual overhead costs relating to these activities are as follows:

$

Deliveries to retailers 2,400,000

Set-up costs 6,000,000

Purchase orders 3,600,000

All direct labour is paid at $5 per hour. The company holds no inventories.

At a board meeting there was some concern over the introduction of activity based costing.

The finance director argued: ‘I very much doubt whether selling the Fireball is viable but I am not convinced that activity based costing would tell us any more than the use of labour hours in assessing the viability of each product.’

The marketing director argued: ‘I am in the process of negotiating a major new contract with a motorcycle rental company for the Sunshine model. For such a big order they will not pay our normal prices but we need to at least cover our incremental costs. I am not convinced that activity based costing would achieve this as it merely averages costs for our entire production’.

The managing director argued: ‘I believe that activity based costing would be an improvement but it still has its problems. For instance if we carry out an activity many times surely we get better at it and costs fall rather than remain constant. Similarly, some costs are fixed and do not vary either with labour hours or any other cost driver.’

The chairman argued: ‘I cannot see the problem. The overall profit for the company is the same no matter which method of allocating overheads we use. It seems to make no difference to me.’

Required:

(a) Calculate the total profit on each of Abkaber’s three types of product using each of the following methods to attribute overheads:

(i) the existing method based upon labour hours, and

(ii) activity based costing. (15 marks)

(b) Comment on the implications for Abkaber of using ABC to measure performance and in so doing evaluate the issues raised by each of the directors. Refer to your calculations in requirement (a) above where appropriate. (10 marks)

(Total: 25 marks)

12 Edward Co

Edward Co assembles and sells many types of radio. It is considering extending its product range to include digital radios. These radios produce a better sound quality than traditional radios and have a large number of potential additional 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 currently absorbed 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 product development process. (4 marks)

(c) Assuming a cost gap was identified in the process, outline possible steps Edward Co could take to reduce this 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 features to Edward Co’s intended product. The board have agreed that the acceptable margin (after allowing for all production costs) 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 and additional 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 is some waste involved in the process as wire is occasionally cut to the wrong length or is damaged in the assembly process. Edward Co estimates that 2% of the purchased wire is lost in the assembly process. Wire costs $0·50 per metre 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 this type 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% of hours 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 19,000

Month 2 700,000 23,000

Fixed production overheads are absorbed on an assembly hour basis based on normal annual activity levels. In a typical 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)

(Total: 25 marks)








13 Jola Publishing

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 quality assurance 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 a year. The paper used is of relatively poor quality and is not subject to any governmental controls and consequently only 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 be of a switch to an activity based costing (ABC) approach to accounting for overheads. They currently use absorption costing, based on machine hours for all overhead calculations. They have accurately produced an analysis for the accounting year just completed as follows:

Direct production costs $per unit $per unit $per unit $per unit Paper 0·75 0·08 Printing ink 1·45 4·47 Machine costs 1·15 1·95 3·35 6·50 Overheads 2·30 3·95 Total cost 5·65 10·45 Selling price Margin 9·05 13·85 3·40 3·40 The main overheads involved are:

Overhead % of total overhead Activity driver

Property costs 75·0% Machine hours

Quality control 23·0% Number of inspections

Production 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 allocation to 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)

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

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 for each 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 of printing 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 2,160,000 Quality control 668,000 Production 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 10,000 TJs 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 the overheads. (5 marks)

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

(Total: 25 marks)

14 Yam Co

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 is first pressed then stretched and finally rolled. The processing capacity varies for each process and the factory manager has provided the following data:

Processing time per metre in hours

Product A Product B Product C

Pressing 0·50 0·50 0·40

Stretching 0·25 0·40 0·25

Rolling 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 for holidays when maintenance is carried out. On average one hour of labour is needed for each of the 225,000 hours of 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 factory costs (excluding labour and raw materials) are $18,000,000








per year. Selling prices per metre are $70 for product A, $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 is fully 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)

(Total: 20 marks)

Decision-making techniques

15 Light engineering

A light engineering company makes water tanks and water butts. Both products involve the same staff and equipment. Each product passes thorough a cutting and an assembly stage. One water tank makes a contribution of $50, and takes six hours cutting time and four hours assembly time. One water butt makes a contribution of $40, and takes three hours cutting time and eight hours assembly time. There are a maximum of 36 cutting hours each week and 48 assembly hours.

The company has to produce at least two water tanks and three water butts.

Calculate the number of water butts and water tanks that should be produced each week to maximise contribution.

You are required to:

(a) state the objective function and constraints algebraically (7 marks)

(b) draw a graph of the problem, shading the feasible region (6 marks)

(c) find the product mix that best suits company policy, and (5 marks)

(d) calculate the shadow price of one more unit of cutting time and one more unit of assembly time. (7 marks)

(Total: 25 marks)

16 Tables and benches

Flea Co makes and sells tables and benches. Both products are made from the same type of hard wood, which is in restricted supply. The company is able to obtain 10,000 kilograms of the wood in each period. The wood costs $60 per kilogram.

The tables and benches are made by highly-skilled labour. The size of the skilled work force is restricted and it would be very difficult to obtain additional labour at short








notice. The total amount of skilled labour available in each period is 4,800 hours. These employees are paid $20 per hour.

Although Flea Co makes high-quality products, it cannot raise selling prices above a level that customers find acceptable. Tables sell for $560 per unit and benches for $460 per unit. At these prices, the sales demand for tables is 1,200 units per period and the sales demand for benches is 1,500 units per period.

Data relating to the manufacture of the two products are as follows:

Tables Benches

Skilled labour time per unit 3 hours 2 hours

Wood per unit 5 kilos 5 kilos

Other variable costs per unit $10 $20

Flea Co does not hold any inventories.

Required

(a) Calculate the contribution per unit for each product. (2 marks)

(b) Assuming that Flea Co wishes to maximise the total contribution in each period, determine the optimal production and sales quantities for tables and benches. You should use the linear programming graphical method to obtain an answer, and your graph should identify clearly the feasible area and the optimal production and sales point. In addition, calculate the total contribution per period that is earned at this level of output and sales. (12 marks)

Some employees in the skilled labour work force are willing to work overtime provided that they are paid a premium of 100% for the overtime hours worked. Flea Co estimates that an additional 600 hours of labour could be made available in each period from overtime working.

Required

(c) Explain the meaning of a dual price or shadow price. Calculate the shadow price of skilled labour and the materials (wood). (5 marks)

(d) Advise Flea Co whether to accept the offer of the skilled labour workers to work overtime, discussing:

(1) the rate of pay they require

(2) the number of hours that could be made available

(3) one other factor that should be considered. (6 marks)

(Total 25 marks)

17 Minim Machines

Minim Machines (MM) is considering the acquisition of a machine on a fixed term rental to produce an item for an important customer. The customer wishes to buy quantities of a product that would be made exclusively on the machine that MM hires. The customer will buy either 240 or 390 units of the product in each period. The probability that demand per period will be 390 is 40%. No other customers will want to buy the product and the machine will have no other purpose.








The machine is available for rental in three sizes, small, medium and large. The maximum production capacity per period for each machine is 200 units of the product per period on the small machine, 300 units on the medium-size machine and 400 units per period on the large machine.

The sale price per unit of the product is $12 and the variable cost is $5 per unit for all machine sizes, except that if the machine capacity in a period exceeds sales demand, some savings in running costs will be achievable and the variable cost per unit will be 10% lower.

If the demand for products exceeds the capacity of the machine then MM will arrange for the extra units to be provided by another supplier, for which the unit cost will be $12, and the incremental administrative costs will be $100 per order. The net cost to MM on each occasion would therefore be $100.

The rental cost per period for the machine would be $400 per period for the small, $700 for the medium and $1,100 for the large machine.

The management of MM have been aggressive with their decision-making, but with the appointment of a new CEO recently a more cautious approach to decision-making has been adopted.

Required:

(a) Explain the maximax, maximin and expected value criteria that may be used for decision-making in conditions of uncertainty. (4 marks)

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

(c) Using the profit table you have prepared in answer to (b) discuss which size of machine MM should buy, allowing for the possible risk attitudes of the managers. (6 marks)

(d) In addition to the three decision-making criteria in part (a), describe THREE methods that could be used to analyse and assess the risk in a decision-making situation. (6 marks)

(Total 25 marks)

18 Linear

A company uses linear programming to establish an optimal production plan in order to maximise profit.

The company finds that for the next year materials and labour are likely to be in short supply.

Details of the company’s products are as follows:

Product A Product B $ $ Materials (at $2 per kg) 6 8 Labour (at $6.00 per hour) 30 18 Variable overheads (at $1.00 per hour) 5 3 –––– –––– Variable cost 41 29 Selling price 50 52 –––– –––– Contribution 9 3 –––– ––––








There are only 30,000 kg of material and 36,000 labour hours available. The company also has an agreement to supply 1,000 units of product A which must be met.

Required:

(a) Formulate the objective function and constraint equations for this problem. (4 marks)

(b) Plot the constraints on a suitable graph and determine the optimal production plan. (9 marks)

(c) Calculate the shadow price of materials and the shadow price of labour. (4 marks)

(d) Identify and explain four main limitations of linear programming (8 marks)

(Total: 25 marks)

19 Rapid Profit

Rapid Profit is a venture capital organisation. It currently holds shares in a number of different businesses. It offers technical support where necessary and at the moment it has been asked to advise on a number of decisions.

RDT

RDT, one of its companies, is trying to decide which machine to buy. The following information is available.

Project 1

Revenue Probability Cost Probability $ $

5,000 0.1 5,000 0.3 8,000 0.4 8,000 0.5

17,000 0.3 15,000 0.2 16,000 0.2

Project 2


25,000 0.4 15,000 0.2 40,000 0.2 20,000 0.4 60,000 0.4 40,000 0.3

Project 3


30,000 0.1 25,000 0.1 40,000 0.3 40,000 0.5 65,000 0.5 50,000 0.4 80,000 0.1








QPT

QPT runs walk in pharmacy centres on behalf of the government. It has been heavily criticised for long queuing times and is in danger of being fined by the government for failing to reach customer service quality targets. Rapid Profit has been asked to explore the use of simulation to help model queue length.

ZDR

ZDR makes a number of products, information on four of which is given below:

Rex Sheltie TriColour Texel $ $ $ $

Sales 300 500 350 600 Material cost 50 200 150 250

Labour cost 80 100 30 150 Variable overhead 20 50 40 100

Fixed overhead 30 50 30 50 Total cost 180 400 250 550

Profit 120 100 100 50 Janson Ltd has offered to supply ZDR with the products at the cost of:

Rex Sheltie TriColour Texel $ $ $ $ Sales 170 300 230 520 (a) Using the maximin decision criterion, which project would you recommend the

company to accept?

Using the maximax decision criterion, which project would you recommend the company to accept?

Using the Expected Values decision criterion, which project would you recommend the company to accept?

Briefly comment on the limitations of your analysis. (12 marks)

(b) Advise QPT on how simulation could be applied to the queuing time problem.

(5 marks)

(c) Recommend with supporting calculations which, if any products should be outsourced for ZDR. (8 marks)

(Total: 25 marks)

20 Pricing model

An essential aspect of financial and business planning is concerned with estimating costs and revenues and deciding the optimum output and price levels. A company produces a single product and operates in a market where it has to lower the sales price of all its units if it wishes to sell more units. The company’s costing and marketing departments currently use the following cost and revenue model (all output is sold in the current period):








Current model:

Total costs = 5,000 + 0.6x

Total revenue = 20x – 0.01x2

Where x = the number of units sold

The company has recently updated its cost and revenue model:

Revised model:

Total costs = 4,750 + 0.8x

Total revenue = 19x – 0.009x2

The acceptability of the current model and the proposed changes as a basis for profit planning and for monitoring performance is to be reviewed.

Required:

(a) Explain the structure of the current and the revised model. (5 marks)

(b) It has been estimated that the revised model will result in an optimal output of 1,011 units being produced and sold.

(i) Suggest two alternative ways of determining this optimal level of output. (5 marks)

(ii) Discuss the extent to which adherence to this output target is a satisfactory indicator of managerial performance. (5 marks)

(c) Name and comment on cost and revenue factors which should be considered in order to improve the validity of the model as a profit forecasting model. (10 marks)

(Total: 25 marks)

21 Ella

Ella Company recently started to manufacture and sell product DG. The variable cost of product DG is $4 per unit and the total weekly fixed costs are $18,000. The company has set the initial selling price of product DG by adding a mark up of 40% to its total unit cost. It has assumed that production and sales will be 3,000 units per week.

The company holds no stocks of product DG.

Required:

(a) Calculate for product DG:

(i) the initial selling price per unit, and

(ii) the resultant weekly profit. (3 marks)

The management accountant has established that a linear relationship between the unit selling price (P in $) and the weekly demand (Q in units) for product DG is given by:

P = 20 – 0·002Q

The marginal revenue (MR in $ per unit) is related to weekly demand (Q in units) by the equation:

MR = 20 – 0·004Q








(b) Calculate the selling price per unit for product DG that should be set in order to maximise weekly profit. (8 marks)

(c) Ella is considering introducing a new product, information on which is given below.

LG

$

Sales price 10

Variable cost 4

Unit contribution 6

Demand per period: 8,000 units. Each unit of LG has a material cost of $1.00 and each DG a material cost of $2.00.

Material costs $1 per kg.

Assuming that the company has 12,000 kg available and sells DG at the profit maximizing price, what is the optimum mix of products to sell? (10 marks)

(d) Distinguish briefly between penetration and skimming pricing policies when launching a new product. (4 marks)

(Total: 25 marks)

22 Ennerdale

Ennerdale is contemplating outsourcing some of is production. The company’s management accountant has asked for your advice on the relevant costs for the contract. The following information is available:

Materials

The contract requires 3,000 kg of material K, which is a material used regularly by the company in other production. The company has 2,000 kg of material K currently in stock which had been purchased last month for a total cost of $19,600. Since then the price per kilogram for material K has increased by 5%.

The contract also requires 200 kg of material L. There are 250 kg of material L in stock which are not required for normal production. This material originally cost a total of $3,125. If not used on this contract, the stock of material L would be sold for $11 per kg.

Labour

The contract requires 800 hours of skilled labour. Skilled labour is paid $9·50 per hour. There is a shortage of skilled labour and all the available skilled labour is fully employed in the company the manufacture of product P. The following information relates to product P:

$ per unit $ per unit Selling price 100 Less Skilled labour 38 Other variable costs 22 –––

(60) ––– 40 –––








Required:

(a) Prepare calculations showing the total relevant costs for making a decision about the contract in respect of the following cost elements:

(i) materials K and L; and

(ii) skilled labour.

(ii) the maximum price the company should pay the outsourcing company (10 marks)

(b) Explain how you would decide which overhead costs would be relevant in the financial appraisal of the contract. (3 marks)

(c) Prepare a report for senior management highlighting factors that should be taken into account when considering an outsourcing decision. (12 marks)

(Total: 25 marks)

23 Bravia

Bravia Company manufactures and sells a single product. The following data have been extracted from the current year’s budget:

Contribution per unit $8

Total weekly fixed costs $10,000

Weekly profit $22,000

Contribution to sales ratio 40%

The company’s production capacity is not being fully utilised in the current year and three possible strategies are under consideration. Each strategy involves reducing the unit selling price on all units sold with a consequential effect on the budgeted volume of sales. Details of each strategy are as follows:

Strategy Reduction in unit selling price Expected increase in

weekly sales volume over budget

% %

A 2 10

B 5 18

C 7 25

The company does not hold inventories of finished goods.

Required:

(a) Calculate for the current year:

(i) the selling price per unit for the product; and

(ii) the weekly sales (in units). (4 marks)

(b) Determine, with supporting calculations, which one of the three strategies should be adopted by the company in order to maximise weekly profits. (6 marks)

(c) Bravia has just bought out its main rival. It is now trying to determine the price to set to maximize profits.








At a price of $1,000 no units are sold. At a price of $800 200 units are sold and at price of $600 600 units are sold. Variable cost per unit are $300 and fixed costs are $300,000.

How many units should the company sell to maximize profits for the product at what price should they be sold and what is the maximum profit ? (10 marks)

(d) Discuss the circumstances under which Bravia may wish to sell its product at price that either higher of lower than the profit maximizing price? (5 marks)

(Total: 25 marks)

24 Crusty Buns

Crusty Buns are street vendors of fresh bread rolls. They pride themelves on selling only bread made the day of sale – any bread left over has to be thrown away at the end of the day.

Daily sales of bread vary greatly. Information on past sales suggest the following sales are possible:

Daily bread roll sales cents 100 0.3 300 0.2 500 0.3 700 0.2

Each bread roll costs $0.50 to make, and is sold for $0.80.

The company is trying to budget for how many rolls to make each day. Opinion is split in the company.

The production manager argues that a 100 a day should be made – this ensures that the company never has to throw away any usold bread. However, on days when demand is at 700, the company will sell out very early on in the day and will miss out on a lot of sales.

The sales manager argues that 700 rolls a day should be made to ensure high profits on days when demand is high. The production manager points out, however, that on 8 days out of 10 the company will have to throw away unsold bread.

(a) What is the amount of bread rolls the company should make to maximise its profits? (14 marks)

(b) Suggest three drawbacks of using expected values to make this kind of decsion. (6 marks)

(c) Explain the use of sensitivity in decision-making and any problems inherent in its use. (5 marks)

(Total: 25 marks)

25 Albion

The managers of Albion Company are reviewing the operations of the company with a view to making operational decisions for the next month. Details of some of the products manufactured by the company are given below.








AR2 GL3 HT4 XY5 Selling price ($/unit) 21.00 28.50 27.30 Material R2 (kg per unit 2.0 3.0 3.0 Material R3 (kg/unit) 2.0 2.2 1.6 3.0 Direct labour (hours/unit) 0.6 1.2 1.5 1.7 Variable production overheads ($/unit) 1.10 1.30 1.10 1.40 Fixed production overheads ($/unit) 1.50 1.60 1.70 1.40 Expected demand for next month (units) 950 1,000 900

Products AR2, GL3 and HT4 are sold to customers of Albion, while Product XY5 is a component that is used in the manufacture of other products. Albion manufactures a wide range of products in addition to those detailed above.

Material R2, which is not used in any other of Albion’s products, is expected to be in short supply in the next month because of industrial action at a major producer of the material. Albion has just received a delivery of 5,500 kg of Material R2 and this is expected to be the amount held in inventory at the start of the next month.

The company does not expect to be able to obtain further supplies of Material R2 unless it pays a premium price. The normal market price is $2.50 per kg. Material R3 is available at a price of $2.00 per kg and Albion does not expect any problems in securing supplies of this material. Direct labour is paid at a rate of $4.00 per hour.

Folam Company has recently approached Albion with an offer to supply a substitute for Product XY5 at a price of $10.20 per unit. Albion would need to pay an annual fee of $50,000 for the right to use this patented substitute.

Required:

(a) Determine the optimum production schedule for Products AR2, GL3 and HT4 for the next month, on the assumption that additional supplies of Material R2 are not purchased. (8 marks)

(b) If Albion decides to purchase further supplies of Material R2 to meet demand for Products AR2, GL3 andHT4, what should be the maximum price per kg that the company is prepared to pay? (3 marks)

(c) Discuss whether Albion should manufacture Product XY5 or buy the substitute offered by Folam.

Your answer must be supported by appropriate calculations. (7 marks)

(d) Discuss the limitations of marginal costing (variable costing) as a basis for making short-term decisions. (7 marks)

(Total: 25 marks)

26 Sniff Co

Sniff Co manufactures and sells its standard perfume by blending a secret formula of aromatic oils with diluted alcohol. The oils are produced by another company following a lengthy process and are very expensive. The standard perfume 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 the opposite sex. The hormone to be added will be different for the male and female perfumes. Adding hormones to perfumes is not universally








accepted as a good idea as some people have health concerns. On the other hand, market research 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 a part 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. Of this, 99% is made up of diluted alcohol which costs $20 per litre. The rest is a blend of aromatic oils costing $18,000 per 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 hormone costing $7,750 per litre will then be added. The remaining 800 litres (80%) will be for female customers and 8 litres of hormone will be added, costing $12,000 per litre. In both cases the adding of the hormone adds to the overall volume 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 hormone adding 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 700 extra hours for the female version of the hormone-added product. Labour is currently fully employed, making the standard 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 processing decision.

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 further processing 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 should consider before making such a decision. (4 marks)

(25 marks)








27 Higgins Co

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

The cues are made by skilled craftsmen (highly skilled labour) who are well known for their workmanship. The skilled craftsmen take years to train and are difficult to recruit. HC’s craftsmen are generally only able to work for 12,000 hours 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 and 12,000 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 cues Craftsmen time per cue 0·5 hours 0·75 hours Ash per cue 270 g 270 g Other 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 the contribution earned. You should use a linear programming graph (using the graph paper provided), identify the feasible region and the optimal point and accurately calculate the maximum contribution that could be earned 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 over the 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 pay requested, the quantity of hours and one other factor that HC should consider. (6 marks)

(Total: 25 marks)

28 Shifters Haulage

Shifters Haulage (SH) is considering changing some of the vans it uses to transport crates for customers. The new vans come in three sizes; small, medium and large. SH is unsure about which type to buy. The capacity is 100 crates for 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 demand figure 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 capacity of the van is greater than the demand for crates in a period then the variable cost will be lower by 10% to allow for the 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 turned away. SH estimates that in this case goodwill of $100 would be charged against profits per period to allow for lost future 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 to make 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 the possible risk attitudes of the managers. (6 marks)

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

(Total: 25 marks)

29 Bits and Pieces (B&P)

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

The sales of the business on Monday through to Saturday averages at $10,000 per day with average gross profit of 70% earned.

B&P expects that the gross profit % earned on a Sunday will be 20 percentage points lower than the average earned on the other days in the week. This is because they plan to offer substantial discounts and promotions on a Sunday to attract customers. Given the price reduction, Sunday sales revenues are expected to be 60% more than the average daily sales revenues for the other days. These Sunday sales estimates are for new customers only, with no allowance being 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 $20 per hour. In total five sales assistants will be needed for the six hours that the store will be open on a Sunday. They will also be able to take a half-day off (four hours) during the week. Staffing levels will be allowed to reduce slightly during 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 manager is 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 generated on 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 come on two hours before the store opens in the 25 ‘winter’ weeks to make sure it is warm enough for customers to come in 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 (ignore inventory movements) and on this basis reach a conclusion as to whether Sunday opening is financially justifiable. (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)

(Total: 20 marks)

30 Stay Clean

Stay Clean manufactures and sells a small range of kitchen equipment. Specifically the product range contains a dishwasher (DW), a washing machine (WM) and a tumble dryer (TD). The TD is of a rather old design and has for some time generated negative contribution. It is widely expected that in one year’s time the market for this design of TD 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 new combined 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 TD

Selling price per unit $200 $350 $80

Material cost per unit $70 $100 $50

Labour cost per unit $50 $80 $40

Contribution per unit $80 $170 –$10

Annual 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 the sales 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 force would 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 takes place now.

4. Stay Clean operates a just in time (JIT) policy and so all material cost would be saved on the TD for 12 months if TD production ceased now. Equally, the material costs relating to the lost sales on the WM and the DW would also be saved. However, the material supplier has a volume based discount scheme in place as follows:

Total annual expenditure ($) Discount

0–600,000 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 in the 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 if production 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 spending approximately 20% of his time on the TD production. He would continue to be fully employed if the TD ceases to 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 next 12 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 of one of its future products. (3 marks)

(Total: 20 marks)

Budgeting

31 Flexico

Flexico is capable of producing 5,000 units of it product (Product B) per quarter.

Sales of the product have not been impressive so production has been below capacity for the last three quarters.

Budgeted costs for each level of production are shown below:








Output 3,500 4,000 4,500 $ $ $ Direct materials 7,000 8,000 9,000 Direct labour 28,000 32,000 36,000 Production overheads 34,000 36,000 38,000 Administration, selling and distribution overheads 15,000 15,000 15,000 –––––– –––––– –––––– Total cost 84,000 91,000 98,000 –––––– –––––– ––––––

Production figures in Quarter 4 were worse than expected. Details are given below.

$ Direct materials 4,500 Direct labour 22,000 Production overheads 28,000 Administration, selling and distribution overheads 16,500 Total cost 71,000

You are required to:

(a) Prepare a flexed budget for 2,500 units. (8 marks) (b) Prepare and comment on a budgetary control statement for quarter 4. (9 marks) (c) Explain what is meant by rolling budgeting and its uses for performance

management (8 marks)

(Total: 25 marks)

32 Titfer Co

Titfer Co manufactures and sells trilby hats for men. The company is well-established and has a well-developed system of budgeting and budgetary control with variance analysis. Departmental managers are responsible for the preparation and control of their departmental budgets. Unusually, the company allows departmental managers to ask for permission to revise their budgets during the year when planning errors become apparent. When budgets are revised, variances are subsequently reported as a combination of planning and operational variances.

A newly-appointed managing director has reported to the board that in the past year or so the number of budget revisions by departmental managers has increased significantly. As a consequence, most operational variances have been favourable but there have been larger adverse planning variances. The managing director has suggested to his colleagues on the board of directors that this is reducing the value of the budgetary control information. He believes that revisions to the budget by departmental managers are permitted far too often.

Required

(a) Explain the circumstances in which budget revisions should be permitted and when they should be disallowed. (5 marks)








Two situations in which budget revisions were requested by departmental managers are as follows.

(1) Labour. Early in the current budget year the company experienced problems in its marketing and sales department. There were large numbers of customer complaints and several lost sales orders due to poor service to customers. A number of mistakes were also made in advertising and sales promotion. The manager of the sales and marketing department submitted a report to the board of directors, suggesting that the operational problems in the department were due largely to the use of largely poorly-qualified and poorly-motivated staff. He asked for board permission to begin a programme of recruitment of better-qualified but more highly paid staff into the department, to replace the existing staff over a period of about two years.

The board agreed to this request, and a programme of recruitment of experienced marketing managers and university graduates was started. A consequence in the current year staff costs in the department are much higher than budgeted, and the manager asked for permission to revise the departmental labour budget.

(2) Materials. During the year a major supplier of cloth to Titfer Co became insolvent and went out of business. The buyer responsible for purchasing cloth had the task of finding a substitute supplier at short notice. After a hurried search, the buyer found an alternative supplier about 300 miles away and a contract to buy a quantity of cloth was agreed. There was very little negotiation on price and the purchase cost of the cloth was much higher than from the previous supplier. In addition the new supplier charged delivery costs, which the previous supplier had not done.

Three months later , after more searching for a cloth supplier, the buying department found a local supplier who agreed to sell cloth at a lower price and without delivery charges. The buying department of Titfer therefore switched to the new supplier.

The head of the buying department asked for permission to revise the materials purchasing budget for the three months during which the higher-priced supplier had been used.

Required

(b) In each of the two cases described above, discuss the request for a budget revision and give your reasoned views as to whether a budget revision should be allowed. (8 marks)

The market for men’s hats has been in decline as fashions have changed. Titfer Co has produced the following data relating to the sale of trilby hats for the year to date.

Budget Sales volume 11,200 units Sales price per unit $225 Standard contribution per unit $100 Actual results for the same period Sales volume 10,900 units Average sales price per unit $200








The total market for the style of men’s hats sold by Titfer Co was estimated in the budget to be 112,000 units. The actual total market for the same period declined to just 100,000 units.

Required

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

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

(e) Comment on the sales performance of Titfer Co during this period. (4 marks)

(Total 25 marks)

33 Storrs

It is mid-June and the new managing director of Storrs Company is reviewing sales forecasts for Quarter 3 of Year 7, which begins on 1 July, and for Quarter 4. The company manufactures garden furniture and experiences seasonal variations in sales, which has made forecasting difficult in the past. Sales for the last two calendar years were as follows:

Year Quarter 1 Quarter 2 Quarter 3 Quarter 4

Year 5 $2,700,000 $3,500,000 $3,400,000 $3,000,000

Year 6 $3,100,000 $3,900,000 $3,600,000 $3,400,000

Sales in Quarter 1 of Year 7 were $3,600,000. There is two weeks to go until the end of Quarter 2 and the managing director of Storrs is confident that it will achieve sales of $4,400,000 in this quarter.

The existing sales forecasts for the two remaining quarters of the year were made by the sales director (who has been with the company for several years) during last year’s budget-setting process. These forecasts are $3,800,000 for Quarter 3 and $3,600,000 for Quarter 4.

Budgets within Storrs have traditionally been prepared and agreed by the directors of the company before being implemented by junior managers. As a basis for revising the sales forecasts for the two remaining quarters of Year 7, the management accountant of Storrs has begun to apply time series analysis in order to identify the seasonal variations in sales. He has so far calculated the following centred moving averages, using a base period of four quarters.

Year Quarter 1 Quarter 2 Quarter 3 Quarter 4

Year 5 $3,200,000 $3,300,000

Year 6 $3,375,000 $3,450,000 $3,562,500 $3,687,500

Required:

(a) Using the sales information and centred moving averages provided, and assuming an additive model, forecast the sales of Storrs for Quarter 3 and Quarter 4 of Year 7, and comment on the sales forecasts made by the sales director.

(Note that you are NOT required to use regression analysis) (8 marks)








(b) Discuss the limitations of the sales forecasting method used in part (a). (5 marks) (c) Discuss the relative merits of top-down and bottom-up approaches to budget

setting. (12 marks)

34 Stem Company

Stem Company (SC) uses skilled labour for construction work for the telecommunications business. The company has recently been asked by a major telecommunications company to construct 500 identical masts. SC has not done any contract work for this company before.

The expected costs of labour and overheads for the contract would be as follows.

Skilled labour costs. SC expects the time required to construct the first mast would be 25 labour hours. Labour costs $20 per hour. It is also expected that a 95% learning curve will apply to the first 300 masts that are constructed. After the first 300 have been constructed the time required for each subsequent mast will be the same as for the 300th mast. SC will need to use its entire skilled work force on this contract until the work is completed.

Overhead costs. SC absorbs overhead costs into the costs of construction work using a skilled labour hour absorption rate. Data about overhead costs has been obtained for the last 4 months, as follows:

Month Skilled labour hours worked

Overhead costs

$

1 10,700 102,500

2 10,400 101,600

3 10,600 101,800

4 10,900 103,600

About 120,000 skilled labour hours are worked each year.

The high-low method is used to analyse overhead costs.

The learning curve equation is y = axb, and when the learning rate is 95%, b = – 0.074.

Required

(a) List FIVE factors, other than the cost of skilled labour and overheads mentioned above, that SC should consider in calculating the price that it should charge for the contract. Explain the reasons for including each factor in your list. (10 marks)

(b) Calculate the total cost of skilled labour and overheads that SC can use as a basis for calculating a ‘cost plus’ price for the contract to construct 500 masts. (13 marks)

(c) If the first mast is expected to take 25 labour hours and the second mast is expected to take 22.5 hours to construct, show how the learning rate of 95% has been calculated. (2 marks)

(Total: 25 marks)








35 Velo Racers

Velo Racers has designed a radically new concept in racing bikes with the intention of selling them to professional racing teams. The estimated cost and selling price of the first bike to be manufactured and assembled is as follows:

$ Materials 1,000 Assembly labour (50 hours at $10 per hour) 1, 500 Fixed overheads (200% of assembly labour) 1,000 Profit (20% of total cost) 1 ,500 Selling Price 3,000

Velo Racers plans to sell all bikes at total cost plus 20% and the material cost per bike will remain constant irrespective of the number sold. Velo Racers’ management expects the assembly time to gradually improve with experience and has estimated an 80% learning curve.

A racing team has approached the company and asked for the following quotations:

1 If we were to purchase the first bike assembled, and immediately put in an order for the second, what would be the price of the second bike?

2 If we waited until you had sold two bikes to another team, and then ordered the third and fourth bikes to be assembled, what would be the average price of the third and fourth bikes?

3 If we decided to immediately equip our entire team with the new bike, what would be the price per bike if we placed an order for the first eight to be assembled?

Required:

(a) Explain learning curve theory and in particular the concept of cumulative average time. (6 marks)

(b) Provide detailed price quotations for each of the three enquiries outlined above. (9 marks)

(c) Identify the major areas within management accounting where learning curve theory is likely to have consequences and suggest potential limitations of this theory. (10 marks)

(Total: 25 marks)

36 Experience

A company works in the automotive industry. It has just started to produce a new product in one of its factories and is trying to budget for the forthcoming period.

Experience has shown the factory managers that the workforces improves its skills over time. It is estimated that an 80% learning curve applies to this factory.

The cost of making the first unit has been estimated as follows:

$ Materials 1,000 Labour (200hrs × $15 per hr) 3,000 Overhead (200hrs × $20hr) 4,000 –––––– Total 8,000 ––––––








Required:

(a) Using information in the question produce a learning curve for the company.

(4 marks)

(b) Calculate the average cost of producing 2, 8, 32 and 64 units of the product. (10 marks)

(c) Briefly comment on the implications of the learning curve for the budgeting process. (5 marks)

(d) A company is offering training to accelerate the learning to 70%. Given that the company intends to make 64 units in the first year, what is the maximum amount the company should be prepared to pay for the training? (6 marks)

(Total: 25 marks)

37 NN Company

NN Company manufactures and markets a range of electronic office equipment. The company currently has annual sales turnover of $40 million. The company has a functional structure and currently operates an incremental budgeting system. The company has a budget committee that is comprised entirely of members of the senior management team. No other personnel are involved in the budget-setting process. Each member of the senior management team has enjoyed an annual bonus of between 10% and 20% of their annual salary for each of the past five years.

The annual bonuses are calculated by comparing the actual costs attributed to a particular function with budgeted costs for that function during the twelve month period ended 31 December in each year.

A new Finance Director, who previously held a senior management position in a ‘not for profit’ health organisation, has recently been appointed. Whilst employed by the health service organisation, the new Finance Director had been the manager responsible for the implementation of a zero-based budgeting system which proved highly successful.

Required:

(a) Explain the factors that should be considered when implementing a system of zero-based budgeting within NN Company. (12 marks)

(b) Discuss the behavioural problems that the management of NN Company might encounter in implementing a system of zero-based budgeting, recommending how best to address such problems in order that they are overcome. (8 marks)

(b) Explain how the implementation of a zero-based budgeting system in NN Company may differ from the implementation of such a system in a ‘not for profit’ health organisation. (5 marks)

(Total: 25 marks)

38 Spotty

Spotty Company is seeking to establish whether there is a linear relationship between the level of advertising expenditure and the subsequent sales revenue generated.








Figures for the last eight months are as follows:

Month Advertising expenditure

Sales revenue

$000 $000 1 2.65 30.0 2 4.25 45.0 3 1.00 17.5 4 5.25 46.0 5 4.75 44.5 6 1.95 25.0 7 3.50 43.0 8 3.00 38.5 ––––– –––––

Total 26.35 289.5 ––––– –––––

Further information is available as follows:

(Advertising Expenditure × Sales Revenue) = $1,055.875

(Advertising Expenditure)2 = $101.2625

(Sales Revenue)2 = $11,283.75

All of the above are given in $ million.

Required:

(a) Using regression analysis calculate a line of best fit and predict sales for and advertising expenditure of $6,000 and comment on the reliability of your estimate

(12 marks)

(b) Discuss the impact of learning curve theory on the use of regression analysis to forecast cost (3 marks)

(c) Explain how risk and uncertainty can be incorporated into a budget. (10 marks)

(Total: 25 marks)

39 Henry Company

Henry Company (HC) provides skilled labour to the building trade. They have recently been asked by a builder to bid for a kitchen fitting contract for a new development of 600 identical apartments. HC has not worked for this builder before. 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 the time taken will be subject to a 95% learning rate. After 200 kitchens are fitted the learning rate will stop and the time taken 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 and this is shown below:

Hours worked Overhead cost $

Month 1 9,300 115,000

Month 2 9,200 113,600

Month 3 9,400 116,000








Month 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 074.02

b −==Log

LogLR

Required:

(a) Describe FIVE factors, other than the cost of labour and overheads mentioned above, that HC should take into 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 new apartment contract. (13 marks)

(c) If the second kitchen alone is expected to take 21·6 man-hours to fit demonstrate how the learning rate of 95% has been calculated. (2 marks)

(Total: 25 marks)

40 Wargrin

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 of popularity. Wargrin accepts a net profit of 35% of turnover as reasonable. A rate of contribution (sales price less variable cost) of 75% is also considered acceptable.

Wargrin has a large centralised development department which carries out all the design work before it passes the completed 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 10,000 units a total cost of $130,000 is expected. However at a volume of 14,000 units a total cost of $150,000 is expected. 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 3

Sales 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 and development costs are all incurred before the game is launched and has cost $300,000 for Stealth. These costs are written 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 consider these 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 with such an approach. (6 marks)








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

(Total: 25 marks)

41 Northland’s LGOs

Northland’s major towns and cities are maintained by local government organisations (LGO), which are funded by central 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 adjustment between 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 been agreed.

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

Weather type predicted Probability Increase in repair cost

Good 0·7 0

Poor 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 projects such 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 a contingency for road repairs might be needed. (8 marks)

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

(Total: 20 marks)

42 Big Cheese Chairs (BCC)

Big Cheese Chairs (BCC) manufactures and sells executive leather chairs. They are considering a new design of massaging 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 competitive selling 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 and assemble it ready for despatch.

Leather costs $10 per metre and two metres are needed for a complete chair although 20% of all leather is wasted in 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 the time 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 at that 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 will be 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 128th chair. (6 marks)

(Total: 20 marks)

43 The Western

The Western is a local government organisation responsible for waste collection from domestic households. The new management accountant of The Western has decided to introduce some new forecasting techniques to improve the accuracy 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 time series 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 each year. The adjustments required to the underlying trend prediction are:

Quarter Tonnes

1 –200

2 +250

3 +150

4 –100

Once T is predicted the new management accountant hopes to use the values to predict the variable operating costs and fixed operating costs that The Western will be subjected to in 2010. To this end he has provided the following operating cost data for 2009.

Volume of waste Total operating cost in 2009

(fixed + variable)

Tonnes $’000s

2,100 950

2,500 1,010

2,400 1,010

2,300 990

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 regression analysis 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. They take a previous period’s actual spend, adjust for any known changes to operations and then add a % for expected inflation in order to set the next period’s budget.

(c) Describe two advantages and two disadvantages of a local government organisation funded by taxpayer’s money using incremental budgeting as its main budgeting technique. (6 marks)

(Total: 20 marks)


44 Slug

Slug makes a product – the vegetable guard. It is the organic alternative to slug pellets and chemical sprays.








For the forthcoming period budgeted fixed costs were $6,000 and budgeted production and sales were 1,300 units.

The vegetable guard has the following standard cost:

$

Selling price 50

Materials 5kg × $4/kg 20

Labour 3hrs × $4/hr 12

Variable overheads 3hrs × $3/hr 9

Actual results for the period were as follows:

1,100 units were made and sold, earning revenue of $57,200.

6,600kg of materials were bought at a cost of $29,700 but only 6,300 kg were used

3,600 hours of labour were paid for at a cost of $14,220. The total cost for variable overheads was $11,700 and fixed costs were $4,000.

The company uses marginal costing and values all inventory at standard cost.

(a) Produce a statement reconciling actual and budgeted profit using appropriate variances. (15 marks)

(b) Assuming now that the company uses absorption costing, recalculate the fixed production overhead variances (6 marks)

(c) Discuss possible causes for the labour variances you have calculated. (4 marks)

(Total: 25 marks)

45 Azela Co

Azela Co processes and sells a type of edible nut. It buys nuts from a foreign supplier and then processes them by taking off the outer shell and packaging them for sale to customers. With the removal of the outer shell, there is a large loss of weight in the process.

The market for both buying imported nuts and re-selling the processed nuts has been stable, in terms of both price and market volume, and this stability is expected to continue in the future.

The company uses a standard marginal costing and variance analysis system to monitor performance, and the variances for month 1 of the current year were as follows:

Variance $

Material price 52,500 (Favourable)

Material usage 58,000 (Adverse)

Direct labour rate 14,000 (Adverse)

Direct labour efficiency 16,000 (Favourable)

Idle time 10,000 (Favourable)

Variable overhead expenditure 6,000 (Adverse)

Variable overhead efficiency 10,000 (Favourable)








Fixed overhead expenditure 12,500 (Favourable)

Sales price 69,000 (Adverse)

Sales volume 38,000 (Adverse)

(Note: Variable production overheads are assumed to vary with direct labour hours worked.)

The managers responsible for performance have responded to the variance reports for month 1 with the following comments.

(1) The purchasing manager has claimed that in spite of criticisms from the production manager, the buying department has saved the company tens of thousands of dollars by switching to a new and cheaper foreign supplier for the supply of edible nuts.

(2) The production manager is angry at criticism he has received for the high wages cost in his department. He was responsible for a higher-than-budgeted pay increase for production staff, which he claimed was necessary to prevent a large number of resignations from employees who had been complaining about the low wages. He believes that morale in the department is now much higher than it was before the pay increase.

(3) The engineering manager commented that the favourable fixed overhead expenditure variance was due almost entirely to his decision to delay by one month the scheduled major annual maintenance of the production department machinery.

Required

(a) Comment on the performance in month 1 of the purchasing manager, production manager and engineering manager, using the information provided above, and give your opinion (with reasons) about whether each manager has performed well. (9 marks)

Information about the standard cost per tonne of nuts produced is as follows:

1.6 tonnes of unprocessed nuts are required to produce one tonne of processed nuts for sale. Nuts have a standard cost of $220 per tonne.

It takes 2 hours to produce one tonne of processed nuts and direct labour is paid $16 per hour.

Idle time is high, and an idle time allowance of 20% of hours paid is included in the standard cost. This idle time is additional to the direct labour time above and an allowance for idle time is not included within the labour rate per hour of $16.

Variable overheads cost $10 per hour.

The standard selling price is $500 per tonne.

The standard contribution is $88 per tonne.

In month 2:

The budgeted fixed overheads for the month were $390,000.

Budgeted production output and sales volume were 7,800 tonnes.

Actual results in month 2 were as follows:

Production and sales: 7,500 tonnes








Sales revenue: $3,560,000

13,000 tonnes of edible nuts were purchased at a cost of $2,750,000

There were no opening or closing inventories.

16,500 labour hours were paid for, at a cost of $292,700.

Actual hours worked were 14,200.

Variable production overhead costs were $150,000.

Fixed costs were $375,000.

Required

(b) Calculate the variances for month 2 in as much detail as the information permits and reconcile the budgeted profit for the month with the actual profit or loss. (You are NOT required to comment on the performance of the company or its managers in month 2.) (16 marks)

(Total 25 marks)

46 StarGazer

StarGazer produces a product – the telescope. Actual results for the period were:

430 units made and sold, earning revenue of $47,300.

Materials: 1,075 kg were used.

1,200 kg of materials were purchased at a cost of $17,700

Direct labour: 1,700 hours were worked at a cost of $14,637

Fixed production overheads expenditure: $2,400.

Variable production overheads expenditure: $3,870.

The standard cost card for the product is as follows:

$ Direct material 2 kg × $15 30 Direct labour 4hrs × $8.50 34 Variable overhead 4hrs × $2.00 8 Fixed production overhead per unit 5 77

The standard unit selling price is $100. The cost card is based on production and sales of 450 units in each period.

The company values its inventories at standard cost.

(a) Produce an operating statement to reconcile budgeted and actual gross profit. (14 marks)

Half way through the period the company realises that is has forgotten to update its standard cost. It is now receiving a bulk purchase discount of 10% on its materials, based on the old standard price. It has also employed new skilled members of staff and expects efficiency to increase by 5%.

(b) Use an operational and planning approach to analyse the materials price and labour efficiency variances. (6 marks)








(c) Comment on the value of the operational and planning approach to variance analysis. (5 marks)

(Total: 25 marks)

47 Toxic Kems

A company make a product that involves three chemicals. The standard input per batch is:

Material Tonnes Cost per tonne $

A 460 200 B 345 350 C 345 450

––––– 1,150

––––– This produces 1,000 tonnes of output.

Actual results for a period were:

Material Usage Cost A 9,000 tonnes $1,935,000 B 4,000 tonnes $1,368,000 C 7,000 tonnes $3,164,000 It is now recognised that the material prices used in the standard cost card were 10% too low.

Output from the process was 17,000 tonnes.

(a) Calculate the operational and planning variances for material prices. (8 marks)

(b) Using the updated prices calculate a materials mix variance for each material and an overall yield variance. (10 marks)

(c) Briefly discuss the behavioural consequences of different types of standard cost. (7 marks)

(Total: 25 marks)

48 Mermus

Mermus is comparing budget and actual data for the last three months.

Budget Actual $ $ $ $ Sales 950,000 922,500 Cost of sales Raw materials 133,000 130,500 Direct labour 152,000 153,000 Variable production overheads 100,700 96,300 Fixed production overheads 125,400 115,300 512,100 495,100 438,900 427,400

The budget was prepared on the basis of 95,000 units of production and sales, but actual production and sales for the three-month period were 90,000 units.








Mermus uses standard costing and absorbs fixed production overheads on a machine hour basis. A total of 28,500 standard machine hours were budgeted. A total of 27,200 machine hours were actually used in the three-month period.

Required:

(a) Prepare a revised budget at the new level of activity using a flexible budgeting approach. (4 marks)

(b) Calculate the following:

(i) raw material total cost variance

(ii) direct labour total cost variance

(iii) fixed overhead efficiency variance

(iv) fixed overhead capacity variance

(v) fixed overhead expenditure variance. (8 marks)

(c) Suggest possible explanations for the following variances:

(i) raw materials total cost variance

(ii) fixed overhead efficiency variance

(iii) fixed overhead expenditure variance. (6 marks)

(d) Explain three key purposes of a budgeting system. (7 marks)

(Total: 25 marks)

49 Woodeezer

Woodeezer makes quality wooden benches for both indoor and outdoor use. Results have been disappointing in recent years and a new managing director, Peter Beech, was appointed to raise production volumes. After an initial assessment Peter Beech considered that budgets had been set at levels which made it easy for employees to achieve.

He argued that employees would be better motivated by setting budgets which challenged them more in terms of higher expected output. Other than changing the overall budgeted output, Mr Beech has not yet altered any part of the standard cost card.

Thus, the budgeted output and sales for November Year 2 was 4,000 benches and the standard cost card below was calculated on this basis:

$ Wood: 25 kg at $3·20 per kg 80.00 Labour: 4 hours at $8 per hour 32.00 Variable overheads: 4 hours at $4 per hour 16.00 Fixed overhead: 4 hours at $16 per hour 64.00 Standard cost 192.00 Selling price 220.00 Standard profit 28.00

Overheads are absorbed on the basis of labour hours and the company uses an absorption costing system. There was no opening inventory at the beginning of November Year 2.








Inventory is valued at standard cost.

Actual results for November Year 2 were as follows:

$ Wood: 80,000 kg at $3.50 280,000 Labour: 16,000 hours at $7 112,000 Variable overhead 60,000 Fixed overhead 196,000 Total production cost (3,600 benches) 648,000 Closing inventory (400 benches at $192) 76,800 Cost of sales 571,200 Sales (3,200 benches) 720,000 Actual profit 148,800

The average monthly production and sales for some years prior to November Year 2 had been 3,400 units and budgets had previously been set at this level. Very few operating variances had historically been generated by the standard costs used.

Mr Beech has made some significant changes to the operations of the company. However, the other directors are now concerned that Mr Beech has been too ambitious in raising production targets. Mr Beech had also changed suppliers of raw materials to improve quality, increased selling prices, begun to introduce less skilled labour, and significantly reduced fixed overheads.

The finance director suggested that an absorption costing system is misleading and that a marginal costing system should be considered at some stage in the future to guide decision-making.

Required:

(a) Prepare an operating statement for November Year 2. This should show all operating variances and should reconcile budgeted and actual profit for the month for Woodeezer. (14 marks)

(b) In so far as the information permits, examine the impact of the operational changes made by Mr Beech on the profitability of the company. In your answer, consider each of the following:

(i) motivation and budget setting; and

(ii) possible causes of variances. (6 marks)

(c) Re-assess the impact of your comments in part (b), using a marginal costing approach to evaluating the impact of the operational changes made by Mr Beech.

Show any relevant additional calculations to support your arguments. (5 marks)

(Total: 25 marks)

50 Carat

Carat Company, a premium food manufacturer, is reviewing operations for a three-month period of Year 3. The company operates a standard marginal costing system and manufactures one product, ZP, for which the following standard revenue and cost data per unit of product is available:








Selling price $12.00

Direct material A 2.5 kg at $1.70 per kg

Direct material B 1.5 kg at $1.20 per kg

Direct labour 0.45 hrs at $6.00 per hour

Fixed production overheads for the three-month period were expected to be $62,500.

Actual data for the three-month period was as follows:

Sales and production 48,000 units of ZP were produced and sold for $580,800

Direct material A 121,951 kg were used at a cost of $200,000

Direct material B 67,200 kg were used at a cost of $84,000

Direct labour Employees worked for 18,900 hours, but 19,200 hours were paid at a cost of $117,120

Fixed production overheads $64,000

Budgeted sales for the three-month period were 50,000 units of Product ZP.

Required:

(a) Calculate the following variances:

(i) sales volume contribution and sales price variances

(ii) price, mix and yield variances for each material

(iii) labour rate, labour efficiency and idle time variances. (8 marks)

(b) Prepare an operating statement that reconciles budgeted gross profit to actual gross profit with each variance clearly shown. (5 marks)

(c) Suggest possible explanations for the following variances:

(i) material price, mix and yield variances for material A

(ii) labour rate, labour efficiency and idle time variances. (5 marks)

(d) Critically discuss the types of standard used in standard costing and their effect on employee motivation. (7 marks)

(Total: 25 marks)

51 Linsil

Linsil has produced the following operating statement reconciling budgeted and actual gross profit for the last three months, based on actual sales of 122,000 units of its single product:

Operating statement

$ $ $

Budgeted gross profit 800,000

Budgeted fixed production overhead 352,000

Budgeted contribution 1,152,000

Sales volume contribution variance 19,200

Sales price variance (61,000)

(41,800)

Actual sales less standard variable cost of sales 1,110,200








Planning variances

Variable cost variances Favourable Adverse

Direct material price 23,570

Direct material usage 42,090

Direct labour rate 76,128

Direct labour efficiency 203,333

Total 42,090 303,031 (260,941)

Operational variances

Variable cost variances Favourable Adverse

Direct material price 31,086

Direct material usage 14,030

Direct labour rate 19,032

Direct labour efficiency 130,133

Total 144,163 50,118 94,045

Actual contribution 943,304

Budgeted fixed production overhead (352,000)

Fixed production overhead expenditure variance 27,000

Actual fixed production overhead (325,000)

Actual gross profit 618,304 The standard direct costs and selling price applied during the three-month period and the actual direct costs and selling price for the period were as follows:

Standard Actual

Selling price ($/unit) 31.50 31.00

Direct material usage (kg/unit) 3.00 2.80

Direct material price ($/kg) 2.30 2.46

Direct labour efficiency (hrs/unit) 1.25 1.30

Direct labour rate ($/hr) 12.00 12.60 After the end of the three-month period and prior to the preparation of the above operating statement, it was decided to revise the standard costs retrospectively to take account of the following:

1 A 3% increase in the direct material price per kilogram

2 A labour rate increase of 4%

3 The standard for labour efficiency had anticipated buying a new machine leading to a 10% decrease in labour hours; instead of buying a new machine, existing machines had been improved, giving an expected 5% saving in material usage.

Required:








(a) Using the information provided, demonstrate how each planning and operational variances in the operating statement has been calculated.

(11 marks)

(b) Calculate direct labour and direct material variances based on the standard cost data applied during the three-month period. (4 marks)

(c) Explain the significance of separating variances into planning and operational elements, using the operating statement above to illustrate your answer.

(5 marks)

(d) Discuss the factors to be considered in deciding whether a variance should be investigated. (5 marks)

(Total: 25 marks)

52 BRK

BRK Company operates an absorption costing system and sells three products, B, R and K which are substitutes for each other. The following standard selling price and cost data relate to these three products:

Product Selling price per unit

Direct material per unit

Direct labour per unit

B $14.00 3.00 kg at $1.80 per kg 0.5 hrs at $6.50 per hour

R $15.00 1.25 kg at $3.28 per kg 0.8 hrs at $6.50 per hour

K $18.00 1.94 kg at $2.50 per kg 0.7 hrs at $6.50 per hour

Budgeted fixed production overhead for the last period was $81,000. This was absorbed on a machine hour basis. The standard machine hours for each product and the budgeted levels of production and sales for each product for the last period are as follows:

Product B R K

Standard machine hours per unit 0.3 hrs 0.6 hrs 0.8 hrs

Budgeted production and sales (units) 10,000 13,000 9,000

Actual volumes and selling prices for the three products in the last period were as follows:

Product B R K

Actual selling price per unit $14.50 $15.50 $19.00

Actual production and sales (units) 9,500 13,500 8,500

Required:

(a) Calculate the following variances for overall sales for the last period:

(i) sales price variance

(ii) sales volume profit variance

(iii) sales mix profit variance

(iv) sales quantity profit variance

and reconcile budgeted profit for the period to actual sales less standard cost. (13 marks)








(b) Discuss the significance of the sales mix profit variance and comment on whether useful information would be obtained by calculating mix variances for each of these three products. (4 marks)

(c) Describe the essential elements of a standard costing system and explain how quantitative analysis can assist in the preparation of standard costs. (8 marks)

(Total: 25 marks)

53 Spike Co

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

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

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 miles away 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, ‘the production manager was pushing me very hard to find any solution possible!’ Two months later, another, more competitive, 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 the support 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 changed its policy so as to recruit only top graduates from good quality universities. This has had the effect of pushing up the costs 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 following the change of policy.

Required:

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








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

Budget

Sales volume 180,000 units

Sales price $17·00 per unit

Standard 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 market shrank to 1·6m units for the period under review.

Actual results for the same period

Sales volume 176,000 units

Sales 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)

54 Chaff Co

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 in the 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 wisely and saved the company thousands of dollars in purchase costs by buying the required quantity of cheaper seeds from a new supplier.

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

3. The maintenance manager feels that saving $8,000 on fixed overhead has helped the profitability of the business. He argues that the machines’ annual maintenance can wait for another month without a problem as the 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 maintenance manager using the variances and other information above and reach a conclusion as to whether or not they have each performed well. (9 marks)

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 budget profit to the actual profit using marginal costing








principles. You are not required to comment on the performance of the business or its managers for their performance in month 2. (16 marks)

(Total: 25 marks)

55 Crumbly Cakes

Crumbly Cakes make cakes, which are sold directly to the public. The new production manager (a celebrity chef) has argued that the business should use only organic ingredients in its cake production. Organic ingredients are more expensive but should produce a product with an improved flavour and give health benefits for the customers. It was hoped 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 specific individuals. 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 new production manager. No change was made at that time to the standard costs card. The variance reports for February and March are shown below (Fav = Favourable and Adv = Adverse)

Manager responsible Allocated variances February March

Variance $ Variance $

Production manager

Material price (total for all ingredients) 25 Fav 2,100 Adv

Material mix 0 600 Adv

Material yield 20 Fav 400 Fav

Sales manager

Sales price 40 Adv 7,000 Fav

Sales 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 sales manager 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 current bonus 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 kg

Eggs 0·10 0·70 per kg

Butter 0·10 1·70 per kg

Sugar 0·10 0·50 per kg








Ingredients Kg $

Total input 0·40

Normal loss (10%) (0·04)

Standard weight of a cake 0·36

Standard sales price of a cake 0·85

Standard contribution per cake after all variable costs 0·35

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

Ingredients used Kg $

Flour 5,700 $741

Eggs 6,600 $5,610

Butter 6,600 $11,880

Sugar 4,578 $2,747

Total input 23,478 $20,978

Actual loss (1,878)

Actual output of cake mixture 21,600

Actual 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 volume variances for April. You are not required to make any comment on the performance of the managers. (13 marks)

56 Secure Net (SN)

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 an allowance for waste. In November 100,000 cards were produced and sold by SN and this was well above the budgeted 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 and production issues) was asked to explain the increase. He said ‘World oil price increases pushed up plastic prices by 20% compared to our budget and I also decided to use a different supplier who promised better quality and increased reliability 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 in the figures. (4 marks)

(b) Analyse the above total variances into component parts for planning and operational variances in as much detail as the information allows. (8 marks)

(c) Assess the performance of the production manager. (8 marks)

(Total: 20 marks)


57 Not for profit performance

Required:

(a) Discuss how costing information and principles may be applied in a not-for-profit organisation in the following areas:

(i) the selection of cost units;

(ii) the use of performance measures to measure output and quality;

(iii) the comparison of planned and actual performance. (10 marks)

(b) Discuss the key features of zero-based budgeting and explain how it may be applied in a not-for-profit organisation. (8 marks)

(c) Briefly discuss how activity-based budgeting might be introduced into a manufacturing organisation and the advantages that might arise from the use of activity-based budgeting in such an organisation. (7 marks)

(Total: 25 marks)

58 West Division

Large Group has several separate divisions, each operating as an investment centre within the group. West Division makes and sells three products, A, B and C. All three products are sold under the Titan brand label, but Product A and Product B are also sold through a supermarket group as unbranded products.

Budgeted data for the year to 31 December Year 7 is as follows:

Product sales


units units units

Titan brand 160,000 120,000 50,000 Unbranded 450,000 600,000 -

Selling prices


$ per unit $ per unit $ per unit

Titan brand 2.50 3.20 5.00

Unbranded 1.50 2.00 -








Variable costs Production Packaging $ per unit $ per unit Product A: Titan brand 1.20 0.30 Unbranded 1.20 0.10 Product B: Titan brand 1.60 0.40 Unbranded 1.60 0.20 Product C: Titan brand 2.50 0.50

Budgeted marketing expenditure is $180,000 for the year, and other budgeted expenditure for other fixed costs is $375,000. The average capital employed in West Division in Year 7 is expected to be $400,000 and the division’s cost of capital is 10%.

Required

(a) Calculate the budgeted ROI for West Division for the year to 31 December Year 7. (15 marks)

(b) Calculate the budgeted residual income for West Division for the year to 31 December Year 7. (10 marks)

(Total: 25 marks)

59 Artiweb

Two retired investment bankers have recently set up a new business, Artiweb Co, which they manage themselves. They have entered into agreements with a number of artists to produce limited edition prints of their artwork, which Artiweb then sells on the internet through its web site.

The business owners believe that there is a growing demand for reasonably-priced original artwork and that limited edition prints are ideally suited to meet this demand. They also believe that through superior web site design and carefully-planned marketing initiatives, the Artiweb web site can attract large numbers of visitors and persuade a proportion of these to buy on-line.

The company has been in business for just over six months, during which time costs have been incurred in developing the web site and in marketing spending to launch the new project. It is expected that marketing costs in the future will be substantially lower than in the first six months. Costs of developing the web site are written off to profit or loss as incurred. The company has not paid any dividends but the owners are paying themselves a monthly salary which is included in administration costs.

The trading results of the company for the first two quarters (three-month periods) are as follows:

Quarter 1 Quarter 2

$ $ $ $

Sales 416,000 601,000

Cost of sales (216,000) (324,000)

Gross profit 200,000 277,000








Quarter 1 Quarter 2

$ $ $ $

Expenses:

Distribution 32,400 46,800

Administration 104,200 150,100

Web site development 100,000 75,000

Marketing 65,000 35,600

Other variable costs 50,000 72,000

Total expenses (351,600) (379,500)

Loss for the quarter (151,600) (102,500)

Required

(a) Assess the performance of the business in the first two quarters using the data in the above table. (12 marks)

(b) Consider briefly whether the losses made by the business in the first two quarters are indicative of its expected future performance. (4 marks)

The owner-managers of Artiweb Co want to analyse the performance of their business in more detail and think that a number of non-financial measures might provide useful analysis. With this purpose in mind, the following data about performance has been gathered for the first two quarters.

Quarter 1 Quarter 2

Web site ‘hits’ (see note) 34,256 42,427

Number of prints sold 1,364 1,910

Number of sales returns 5% 8%

Items despatched within 24 hours of order 85% 91%

System downtime 2.5% 4.5%

Note: A ‘web site hit’ is recorded each time that an internet user visits the home page of the Artiweb web site.

The management have obtained some data about the industry for internet art sales. The average conversion rate for web site hits to the number of items sold is 2.9%. The industry average for sales returns is about 6.5%

Required

(c) Using the non-financial information in the table above and the industry average figures where appropriate, provide a further assessment of the performance of the business in the first two quarters to supplement the analysis of financial performance in your answer to parts (a) and (b) of this question. (9 marks)

(Total 25 marks)

60 Debito Co

Debito Co is a provider of training courses in accountancy and banking. It has several regional centres where courses take place in rented accommodation. The company has








an ambitious programme for growth, and it has set targets for the managers of each regional centre. These targets are as follows:

(1) Sales revenue must increase in each quarter.

(2) The costs of trainers (lecturers) must not exceed $750 per day. Trainers are all self-employed and are paid by the day.

(3) The hire of rooms for running courses must not exceed $375 per day.

(4) Each regional training centre must meet or exceed its budget for profit in each quarter and annually.

Senior management have also announced that any regional centre manager who meets all these targets for the current year will be rewarded with a substantial bonus at the end of the year.

The manager of the North regional centre believes that the way to achieve sustainable growth is to provide training programmes of a high quality. This means getting high-quality lecturers and making sure that the lecturers are properly trained and prepared for the courses they deliver. However, he is also aware that given the current expected performance of the North centre, he will not earn a bonus this year. This worries him because he is very keen to have a bonus, which he thinks he fully deserves.

The current quarterly forecasts for the North regional centre, and the original budgeted profit for the centre, are as follows.

Q1 Q2 Q3 Q4 Total

$000 $000 $000 $000 $000

Sales 150.0 132.0 180.0 210.0 672.0

Trainers 40.0 35.2 48.0 56.0 179.2

Room hire 20.0 17.6 24.0 28.0 89.6

Staff training 5.0 5.0 5.0 5.0 20.0

Other costs 26.0 16.2 40.0 53.0 135.2

Total costs 91.0 74.0 117.0 142.0 424.0

Forecast profit 59.0 58.0 63.0 68.0 248.0

Original budgeted profit 60.0 61.0 62.0 63.0 246.0

Annual sales budget 665.0

Teaching days 50 44 60 70

Required

(a) Comment on the performance of the North regional centre and the extent to which it has or has not achieved its targets, and state whether in your view the regional centre manager will earn a bonus at the end of the year. (8 marks)

The manager of the North regional centre has been looking at a few ideas for improving the performance of the centre in the current year. He has three proposals in mind.








(1) Sales promotion. As a sales promotion, the North centre could offer individuals who attend one of the courses a discounted price of $70 for attending a second course within one month. The manager believes that if this promotion is started very soon, it will result in an extra demand for 120 places on courses at this discounted rate. These additional sales would be spread evenly over each of the four quarters of the year.

(2) New course. The North centre could introduce a new course involving the use of an interactive software system that the lecturer would demonstrate during the course. The software would be purchased in quarter 1 at a cost of $8,000. Staff training would be required during Quarter 1 and Quarter 2 at a cost of $2,000 in each quarter. The new course would be introduced in Quarter 3 and it is estimated that this would result in an increase in revenue by 10% above the forecast level in each of Quarter 3 and Quarter 4 (as measured before the extra sales from the sales promotion above). The new course would be provided at the same standards for lecturers and rooms as for all other courses. The expenditure on the software would be written off to profit or loss as incurred.

(3) Payments to lecturers. A third idea is that payments to lecturers should be delayed by one month. At the moment lecturers are paid within two weeks of submitting their invoices. The manager of North centre is inclined to delay payment by a few more weeks, and pay at the end of the month following the month of the invoice date.

Required

(b) Revise the forecasts for each quarter and for the year as a whole taking into account all three of the ideas above. (7 marks)

(c) Comment on each of the three ideas, and state your view about whether, if all three proposals were implemented, the centre manager would be likely to earn a bonus in the current year. (6 marks)

(d) Suggest two improvements that might be made to the performance management system of Debito Co that would encourage the managers of the regional centres to take a longer-term view of the business and its growth. (4 marks)

(Total: 25 marks)

61 Peseta Company

Peseta Company operates a number of sales centres which are treated as investment centres for the purpose of performance reporting. The performance of each centre is measured by return on investment (ROI), taking the net book value of the centre’s non-current assets at the beginning of the year as the measurement of ‘investment’ for this purpose. The company sets a target annual ROI for each centre of 15%, and centre managers receive a bonus of 20% of their annual salary if the centre’s ROI for the year exceeds this target.

The opening of a sales centre involves initial capital expenditure on non-current assets at the beginning of the first year, but no further capital expenditure for the next four years. Non-current assets are depreciated each year at 25% of cost and have no residual value.

Peseta Company’s stores achieve a gross profit margin on average of 60%. The business in which the company operates has been growing by about 5% each year, but is








expected to decline by about 2% per year in the future due to growing competition in the market.

The historical financial performance of one of the company’s sales centres, Centre 8 (C8), has been as follows for the past four years. (Year 4 is the most recent year.)

Year 1 Year 2 Year 3 Year 4

Sales ($000) 260 260 240 220

Gross profit ($000) 156 143 132 110

Net profit ($000) 20 21 12 7

Net assets at start of year ($000) 160 120 80 40

Required:

(a) Discuss the financial performance of Centre C8 over the past four years, using ROI and any other performance measures you consider appropriate. On the basis of these performance measures, suggest with reasons whether ROI provides a suitable measure of the centre’s performance during this period. (8 marks)

(b) Explain how the investment centre manager responsible for Centre 8 may have been able to ‘window dress’ or manipulate the financial performance of the centre so as to obtain annual bonuses more frequently. (4 marks)

Peseta Company plans to open another sales centre, Centre 25, in the near future. The following estimates have been prepared for the next four years.

Sales volume in the first year will be 16,000 units, at an average sales price of $16 per unit. Sales volume is expected to grow by 10% in Year 2 and by a further 10% in Year 3, but further volume growth will occur in year 4. To achieve these volumes of sales, the sales price will be reduced by 5% in each of Years 2, 3 and 4.

Gross profit will be 60% in Year 1. There will be no change in the unit cost of sale throughout the four-year period.

Overheads, including depreciation, will be $125,000 in each of the first two years, and will then increase by $5,000 in Year 3 and a further $5,000 in Year 4.

Centre C25 requires an investment of $200,000 in non-current assets at the start of Year 1. These assets will be depreciated by the straight-line method over four years, with no residual value at the end of this period.

Required:

(c) Calculate (in columnar form) the annual revenue, gross profit, net profit and ROI of Centre C25 for each of the years 1 – 4. (9 marks)

(d) Assuming that the estimates of sales volumes, prices and costs are reliable, calculate the minimum sales volume that Centre C25 would need to achieve in Year 4 if the centre manager is to earn any annual bonus. (4 marks)

(Total: 25 marks)

62 Two divisions

A company has two operating divisions, X and Y, that are treated as profit centres for the purpose of performance reporting.








Division X makes two products, Product A and Product B. Product A is sold to external customers for $62 per unit. Product B is a part-finished item that is sold only to Division Y.

Division Y can obtain the part-finished item from either Division X or from an external supplier. The external supplier charges a price of $55 per unit.

The production capacity of Division X is measured in total units of output, Products A and B. Each unit requires the same direct labour time. The costs of production in Division X are as follows:

Product A Product B $ $

Variable cost 46 48

Fixed cost 19 19 –––– –––– Full cost 65 67 –––– ––––

Required

You have been asked to recommend the optimal transfer price, or range of transfer prices, for Product B.

(a) What is an optimal transfer price? (5 marks)

(b) What would be the optimal transfer price for Product B if there is spare production capacity in Division X? (7 marks)

(c) What would be the optimal transfer price for Product B if Division X is operating at full capacity due to a limited availability of direct labour, and there is unsatisfied external demand for Product A? (8 marks)

(Total: 20 marks)

63 INA

INA Company manufactures and distributes generic paper-based products and currently has an annual turnover of $100 million. At present, the management of INA are uncertain whether the purchasing department is maximising its potential in terms of purchasing efficiency and effectiveness. The management are currently considering the introduction of a system of benchmarking to measure the performance of the purchasing department.

Required:

(a) Explain the term ‘benchmarking’ and briefly discuss the potential benefits that can be obtained as a result of undertaking a successful programme of benchmarking. (8 marks)

(b) Describe how a system of benchmarking could be introduced to measure the performance of the purchasing department. (10 marks)

(c) Discuss the problems that the management of INA might encounter in implementing a system of benchmarking and recommend how such problems should be successfully addressed. (7 marks)

(Total: 25 marks)








64 BLA

BLA Company is a design consultancy that provides advice to clients regarding property maintenance and improvements.

Three types of consultant are employed by BLA. These are:

(1) Architectural consultants who provide advice with regard to exterior building improvements.

(2) Interior design consultants who provide advice regarding interior design, and

(3) Landscape consultants who provide advice regarding landscaping of properties and garden design improvements.

BLA does not undertake building work on behalf of its clients and will only recommend contractors that undertake the three types of work when requested to do so by its clients. The following information is relevant:

(i) Each consultation, other than those detailed in notes (iv) and (v), is charged at a rate of $150 per consultation.

(ii) The consultants are each paid a fixed annual salary of $45,000. In addition they receive a bonus of 40% of the fee income generated in excess of budget. The bonus is shared equally among the consultants employed by BLA on 31 October in the year to which the bonus relates.

(iii) Other operating expenses (excluding the salaries of the consultants) were budgeted at $2,550,000 for the year to 31 October Year 3. The actual amount incurred in respect of the year to 31 October Year 3 was $2,805,000 which excludes payments to subcontractors per note (vii) below.

(iv) In an attempt to gain new business, consultants may undertake consultations on a ‘no-fee’ basis. Such consultations are regarded as Business Development Activity by the management of BLA

(v) Consultants will sometimes undertake remedial consultations with clients who experience problems at the time when work commences on each client’s site. Remedial consultations are also provided on a non-chargeable, i.e. ‘no fee’ basis.

(vi) In November Year 2, BLA purchased ‘state of the art’ business software for use by its consultants in simulating design improvements. The software was used throughout the year by consultants who specialise in landscape and garden design. It is now planned to introduce the use of the software by the other categories of consultant within BLA.

(vii) BLA has a policy of maintaining staff at a level of 45 consultants on an ongoing basis, irrespective of fluctuations in the level of demand. Also, BLA has retained links with retired consultants and will occasionally subcontract work to them at a cost of $150 per consultation, if current full-time consultants within a particular category are fully utilised. During the year ended 31 October Year 3 subcontractors only undertook non-chargeable client consultations.








BLA

Sundry statistics for year ended 31 October Year 3

Number of consultants by category: Budget Actual

Exterior design 18 15

Interior design 18 18

Landscape and garden design 9 12

Total client enquiries:

New business 67,500 84,000

Repeat business 32,400 28,000 Number of chargeable client consultations: New business 24,300 22,400 Repeat business 16,200 19,600 Mix of chargeable client consultations: Exterior design 16,200 13,830

Interior design 16,200 17,226 Landscape and garden design 8,100 10,944 Number of non-chargeable client consultations undertaken by BLA consultants: Number of business development consultations 1,035 1,200 Number of remedial consultations 45 405 Number of non-chargeable client consultations undertaken by subcontractors 120 Other statistics: Number of complaints 324 630

Required:

Fitzgerald and Moon have suggested that business performance should be measured in a number of ways.

Using SIX different performance indicators and the quantitative data contained above, comment on the performance of BLA. (25 marks)

65 Talesin

Talesin manufactures a range of ice-cream based confectionery products, which it sells to national supermarket chains which market the products under their own brand labels. The board of directors is committed to a policy of achieving growth. However because the company is a relatively small player within the industry the board of directors is focused solely upon internal development as opposed to growth by acquisition and has further agreed that it wishes to confine operations to the home market.

Summary financial statements for the year ended 31 May Year 5 together with prior year comparative figures are as follows:








Income statement Year 5 Year 4

$000 $000

Sales (note 1) 48,000 40,000

Cost of sales (note 2) 28,800 24,000

Gross profit 19,200 16,000

Operating expenses 10,200 8,000

Interest 1,000 0

Depreciation 4,000 4,000

Net profit 4,000 4,000

Statement of financial position 31 May

Year 5 Year 4

$000 $000

Non-current assets (net book value) 42,000 40,000

Net current assets 24,000 12,000

Total assets less current liabilities 66,000 52,000

Loan finance 10,000 –

Net assets 56,000 52,000

Capital employed:

Ordinary share capital ($1 each) 30,000 30,000

Retained earnings 26,000 22,000

Capital employed 56,000 52,000

Other information relating to Talesin is as follows:

(1) Sales information in respect of the years ended 31 May Year 5 and Year 4 is as follows:

Year 5 Year 4

Sales revenue $000 $000

1 June – 30 November 33,300 26,000

1 December – 31 May 14,700 14,000

(2) Cost of sales information:

Year 5 Year 4

$000 $000

Materials 9,360 7,800

Labour 4,620 4,200

Manufacturing overheads 14,820 12,000

Cost of sales 28,800 24,000








(3) Other Information:

Year 5 Year 4

Number of employees:

Permanent 204 200

Temporary 288 240

Number of customers 5 6

Number of new products introduced 6 5

(i) Temporary employees are hired on a full-time basis between 1 June and 30

November in each year. They were paid at the same rate as permanent employees.

(ii) Six new product lines were launched during the year ended 31 May Year 5. The manufacture of each new product line required an investment in capital equipment of $1 million.

Required:

(a) Using the above information, appraise the performance of Talesin during the year ended 31 May Year 5 and evaluate the extent to which the objective of growth has been achieved. (20 marks)

(b) Explain how the use of activity-based techniques may benefit Talesin. (5 marks)

(Total: 25 marks)

66 Behaviour

‘A competent management accounting system should endeavour to enhance the performance of a company. It should, in particular, consider the behavioural consequences of the system.’

Required:

(a) Explain why it is necessary when designing a management accounting system to consider the behavioural consequences of its application. (7 marks)

(b) Explain the potential behavioural issues that may arise in the application of performance monitoring, budgeting and transfer pricing and suggest how problems may be overcome. (18 marks)

(Total: 25 marks)

67 Project X

A large conglomerate with diverse business activities is currently considering whether it should commence Project X and has gathered the following data:

Project X Data

1 An initial investment of $54 million will be required on 1 January Year 1. The project has a three year life with a nil residual value. Depreciation is calculated on a straight line basis.








2 The project is expected to generate annual revenue flows of $80 million in Year 1, $90 million in Year 2 and $100 million in Year 3. These values may vary by ± 5%.

3 The incremental costs will be $50 million in Year 1, $60 million in Year 2 and $70 million in Year 3. These may vary by ±10%.

4 Imputed interest may be as low as 8% and as high as 13%.

Additional information:

Use the written down value of the asset at the start of each year to represent the value of the asset for the year.

Note: Ignore taxation

Required:

(a) Prepare two tables showing net profit, residual income and return on investment for each year of the project for:

(i) The BEST OUTCOME, and

(ii) The WORST OUTCOME. (10 marks)

(b) Explain the distinctive features of residual income and Return on Investment (ROI) in measuring financial performance.

Your answer should include a critique of the strengths and weaknesses of each measure. (9 marks)

(c) What broader issues are likely to be considered when deciding whether the company should proceed with a particular project? (6 marks)

(Total: 25 marks)

68 Public performance

A mixed economy operates a range of public services including Fire, Police, Education and Health. The services are provided on a regional basis but are funded from central government taxation. The government is endeavouring to improve the ‘overall performance’ of the services and is considering a range of issues surrounding this objective.

Required:

(a) Explain the term ‘overall performance’ in respect of public services and suggest a structured approach to its assessment.

Your answer should be from a generic point of view and references to particular services should be used only for illustrative purposes. (15 marks)

(b) Explain the particular problems that are likely to occur in attempting to monitor the performance of a public service that would not arise when assessing private sector activities. (10 marks)

(Total: 25 marks)

69 AV

AV is a charitable organisation, the primary objective of which is to meet the accommodation needs of persons within its locality. BW is a profit-seeking organisation which provides rented accommodation to the public. Income and








Expenditure accounts for the year ended 31 May Year 4 were as follows:

AV BW $ $

Rents received 2,386,852 2,500,000 Less: Staff and management costs 450,000 620,000 Major repairs and planned maintenance 682,400 202,200 Day-to-day repairs 478,320 127,600 Sundry operating costs 305,500 235,000 Net interest payable and other similar charges 526,222 750,000 Total costs 2,442,442 1,934,800

Operating (deficit)/surplus (55,590) 565,200

Operating information in respect of the year ended 31 May Year 4 was as follows:

(1) Property and rental information:

AV BW

Size of Property

Number of properties

Rent payable per week ($)


1 bedroom 80 40 40 2 bedrooms 160 45 80 3 bedrooms 500 50 280 4 bedrooms 160 70 Nil

AV had certain properties that were unoccupied during part of the year. The rents lost as a consequence of unoccupied properties amounted to $36,348. BW did not have any unoccupied properties at any time during the year.

(2) Staff salaries were payable as follows:

AV BW

Number of staff Salaries: $ per staff member per year Number of staff

Salaries: $ per staff member per year

2 35,000 3 50,000 2 25,000 2 35,000 3 20,000 20 20,000

18 15,000 – – (3) Planned maintenance and major repairs undertaken:

AV BW

Nature of work Number of

properties

Cost per property


Cost per property

$ $ Miscellaneous construction work 20 1,250 – – Fitted kitchen replacements (all are the same size) 90 2,610 10 5,220 Heating upgrades/replacements 15 1,500 – Replacement sets of windows and doors for 3-bedroomed properties 100 4,000 25 6,000








All expenditure on planned maintenance and major repairs may be regarded as revenue expenditure.

(4) Day-to-day repairs information:

AV BW Classification of repair

Number of repairs undertaken Total cost

Number of repairs undertaken

Emergency 960 $134,400 320 Urgent 1,880 $225,600 752 Non-urgent 1,020 $118,320 204

Each repair undertaken by BW costs the same irrespective of the classification of repair.

Required:

(a) Critically evaluate how the management of AV could measure the ‘value for money’ of its service provision during the year ended 31 May Year 4. (8 marks)

(b) (i) Identify TWO performance measures in relation to EACH of the following dimensions of performance measurement that could be used by the management of AV when comparing its operating performance for the year ended 31 May Year 4 with that of the previous year:

– Flexibility

– Service quality (4 marks)

(ii) Calculate and comment on THREE performance measures relating to ‘cost and efficiency’ that could be utilised by the management of AV when comparing its operating performance against that achieved by BW.

(6 marks)

(c) Explain why differing objectives make it difficult for the management of AV to compare its operating and financial performance with that of BW, and comment briefly on additional information that would assist in the appraisal of the operating and financial performance of BW for the year ended 31 May Year 4.

(7 marks)

(Total: 25 marks)

70 Ties Only

Ties Only is a new business, selling high quality imported men’s ties via the internet. The managers, who also own the company, are young and inexperienced but they are prepared to take risks. They are confident that importing quality ties and selling via a website will be successful and that the business will grow quickly. This is despite the well 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 administration expenses 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 server development to ensure that the server can handle the very high levels of predicted growth. All website development costs 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 new products. 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 1

Quarter 1 Quarter 2

$ $ $ $ Sales 420,000 680,000 less Cost of Sales (201,600) (340,680) –––––––– –––––––– Gross Profit 218,400 339,320 less expenses Website development 120,000 90,000 Administration 100,500 150,640 Distribution 20,763 33,320 Launch marketing 60,000 40,800 Other 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 1 above. (12 marks)

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

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

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

Table 2

Quarter 1 Quarter 2

Website hits* 690,789 863,492

Number of ties sold 27,631 38,857

On 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 return rate 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, the industry averages provided, providing your assessment of the performance of the business. (9 marks)

(Total: 25 marks)

71 Bridgewater Co

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 of Bridgewater Co have very clear objectives for the divisions and these are communicated to divisional managers on appointment and subsequently in quarterly and annual reviews. These are:

1. Each quarter, sales should grow and annual sales should exceed budget

2. Trainer (lecture staff) costs should not exceed $180 per teaching day

3. Room hire costs should not exceed $90 per teaching day

4. 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 senior management is to retire after quarter 2 of the current financial year, which has just begun. The divisional managers anticipate 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 expected performance of his division. He is a firm believer in quality and he thinks that if a business gets this right, growth and success 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 60·0 186·0 less: Trainers 8·0 7·2 10·0 12·0 37·2 Room hire 4·0 3·6 5·0 6·0 18·6 Staff training 1·0 1·0 1·0 1·0 4·0 Other 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 28·0 106·0 Annual 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 to the promotion prospects of the divisional manager (8 marks)

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 vouchers will entitle the holder to attend four training sessions on software of their choice. They can attend when they want to but are advised that one training session per quarter is sensible. The manager is confident that if the promotion took place immediately, he could sell 80 vouchers and that customers would follow the advice given to attend one session per 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 training courses. 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. Assuming similar 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 and room 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 could cause him to miss out on a well deserved promotion, the trainers owe him a favour. He intends to delay payment on 50% 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 taken together, the manager will improve his chances of promotion. (6 marks)

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

(Total: 25 marks)

72 Pace Company

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 managers get a bonus of 10% of their salary if their store’s annual ROI exceeds the target each year. Once a store is built there is 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 four years:

2005 2006 2007 2008

Sales ($’000) 200 200 180 170

Gross profit ($’000) 80 70 63 51

Net profit ($’000) 13 14 10 8

Net 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 appropriate and, 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 bonuses more 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 the gross 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 three but no further growth is expected in year 4. Sales price will start at $12 per unit for the first two years but then reduce by 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 will remain 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 four years. (9 marks)

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

(Total: 25 marks)

73 Oliver

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

A year ago, at the start of his 2009 financial year, Oliver decided to expand his operations to include the hairdressing needs of male clients. Male hairdressing prices








are lower, the work simpler (mainly hair cuts only) and so the time taken 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 services provided for female clients in the two years was the same.

The latest financial results are as follows:

2008 2009 $ $ $ $ Sales 200,000 238,500 Less cost of sales: Hairdressing staff costs 65,000 91,000 Hair products – female 29,000 27,000 Hair products – male 8,000 ––––––– ––––––– 94,000 126,000 ––––––– ––––––– Gross profit 106,000 112,500 Less expenses: Rent 10,000 10,000 Administration salaries 9,000 9,500 Electricity 7,000 8,000 Advertising 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 expecting more 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 specialist hairdressers for the female clients. She was appointed on a salary of $9,000 per annum. The second new staff member was a specialist hairdresser for the male clients. There were no increases in pay for existing staff at the start 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 2009

Number of complaints 12 46

Number of male client visits 0 3,425

Number of female client visits 8,000 6,800

Number of specialist hairdressers for female clients 4 5

Number of specialist hairdressers for male clients 0 1








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 quality and resource utilisation. (6 marks)

(Total: 20 marks)

74 Thatcher International Park (TIP)

Thatcher International Park (TIP) is a theme park and has for many years been a successful business, which has traded profitably. About three years ago the directors decided to capitalise on their success and reduced the expenditure made on new thrill rides, reduced routine maintenance where possible (deciding instead to repair equipment when it broke down) and made a commitment to regularly increase admission prices. Once an admission price 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 the directors. The last two years of financial results are shown below.

2008 2009 $ $ Sales 5,250,000 5,320,000 Less expenses: Wages 2,500,000 2,200,000 Maintenance – routine 80,000 70,000 Repairs 260,000 320,000 Directors salaries 150,000 160,000 Directors bonuses 15,000 18,000 Other 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 became concerned about the potential performance of TIP and to investigate his concerns he started to gather data to measure some non-financial measures of success. The data he has gathered is shown below:








Table 1

2008 2009 Hours lost due to breakdown of rides (see note 1) 9,000 hours 32,000 hours Average 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 data and indicate the risks it is likely to face if it continues with its current policies. (6 marks)

(Total: 20 marks)








SE

CTI

ON

2

Q&A

Answers to practicequestions


1 Bespoke furniture

Absorption costing

Company-wide absorption rate = $23,908,800 / 234,400 hrs = $102 per hour

Bookcase Bed Sideboard Total $ $ $ $ Sales 14,000 12,000 17,900 Less Direct Materials (500) (800) (1,200) Direct Labour (750) (697.50) (1,125) Overheads (10,200) (9,486) (15,300) ––––––– ––––––– ––––––– Profit 2,550 1,016.5 $275 Volume sold 1,000 800 400 Profits 2,550,000 813,200 110,000 3,473,200

Activity–based costing

The first stage in the process is to calculate the activity rate for each cost pool.

Cost Pool Cost $ Activity Cost per unit of activity

Set-up 4,800,000 150 set ups $32,000 Purchase orders 12,000,000 2,000 purchase orders $6,000 Retail Delivery 7,108,800 440 deliveries $16,156








The next step is to calculate the amount of cost that should be allocated to each product, based on the amount of activity consumed by each product.

Bookcase

Total cost Units Cost per unit

Set up costs $32,000 × 53 =$1,696,000 1,000 $1,696 Purchase orders $6,000 × 1,000 = $6,000,000 1,000 $6,000 Retail delivery $16,156 × 200 = $3,231,200 1,000 $3,231.20 Bed


Set up costs $32,000 × 59 =$1,888,000 800 $2,360 Purchase orders $6,000 × 750 = $4,500,000 800 $5,625 Retail delivery $16,156 × 160 = $2,584,960 800 $3,231.2 Sideboard


Set up costs $32,000 × 38 =$1,216,000 400 $3,040 Purchase orders $6,000 × 250 = $1,500,000 400 $3,750 Retail delivery $16,156 × 80 = $1,292,480 400 $3,231.20 This information can now be put together in the form of a profit and loss account for each product line:

Bookcase Bed Sideboard Total $ $ $ $ Sales 14,000 12,000 17,900 Less Direct materials (500) (800) (1,200) Direct labour (750) (697.50) (1,125) Set-up cost (1,696) (2,360) (3,040) Purchase orders (6,000) (5,625) (3,750) Retail delivery (3,231.20) (3,231.20) (3,231.20)

––––––––– ––––––––– ––––––––– Profit 1,822.80 (713.7) 5,553.8 Volume sold 1,000 800 400 Profits 1,822,800 (570,960) 2,221,520 3,473,360 Switching form absorption costing to ABC does not affect total company profit (the difference between the two total profit figures is due to rounding. However, it does have a dramatic effect on the profitability of individual product lines. This is summarised below.






Section 2: Answers to practice questions


Unit profit absorption costing

Unit profit ABC Change in profit

Bookcase $2,550 $1,822.80 ($727.2) Bed $1,016.5 $(713.7) ($1730.2) Sideboard $275 $5,553.8 $,5,278.8 (a) Under absorption costing sideboards have much lower profitability that the other

two products. In the event of any restructuring, the company could be tempted to discontinue their manufacture.

Under ABC sideboards have the highest unit profit by far. The principle reason for this appears to be the relatively low purchase order costs for sideboards compared to the other products. This raises some important questions for management:

Why are there such marked differences in purchase order costs per product?

Can we learn something from the production of sideboards that can be applied to the other two products?

Immediately ABC has yielded value, as it has highlighted an area for investigation and possible process improvement.

Under ABC beds are loss making so it is particularly important for management to explore the reasons that lie behind this.

Beds have high purchase order and set-up costs and both of these processes should be explored to discover possible cost savings.

(b) In target costing a company first determines its target sales volume and from this its target price to achieve this volume. At the same time it will decide the profit it requires from the product.

Given we now have profit and price information it is possible to determine the target cost to achieve this profit. Often this target cost is considerably lower than that currently being achieved i.e. there is a target cost gap.

At this point management needs to close this gap and this is where ABC can be very useful. Unlike absorption costing which arbitrarily relates everything to hours or units, successful ABC involves significant understanding of cost drivers and cost behaviour.

Managers have a better understanding of how costs are generated in a business. They are also very aware of anomalously high or low costs between products and can search both for best practice and root out inefficiency.

One of the key elements in closing a target cost gap can be redesign of a product. As a product is redesigned its consumption of activities will change. ABC is ideal to predict the change in costs that will result.

One weakness here is the inability of ABC to incorporate learning curve effects. ABC fundamentally assumes that driver rates and product consumption of activities remains constant. If a learning curve affect applies one or both of these assumptions may not apply leading or inaccurate costings and an overestimate of the target cost gap.








2 Alfabeta Co

(a) By changing from traditional absorption costing to a system of activity-based costing, it might be expected that the allocation of overhead costs will change significantly. In the case of Alfabeta Co, there is some change in unit costs, with a higher unit cost for AB1 and a lower unit cost for AB2. However the effect on unit costs is fairly small – about $0.50 or $0.60.

There are a few reasons for this.

(1) A fairly large proportion of total costs are direct costs, which are not affected by the change to ABC.

(2) Nearly 80% of overhead costs are general overheads for which the cost driver is machine hours. In the traditional absorption costing system, overheads were absorbed on a machine hour basis. The change to ABC therefore has no effect on the allocation/apportionment of these overhead costs.

(3) ABC results in a higher allocation of overhead costs to AB1 for inspection and quality control (but a lower allocation for the costs of set-up for production runs). This change in allocation explains the change in unit costs.

(b) Implementation problems with ABC

(1) It is often difficult to decide or identify the activities that should be selected for the allocation of overhead costs. Ideally a limited number of activities should be used, to prevent the ABC system from being too complex.

(2) Having selected activities as a basis for overhead cost allocation, it might be difficult to identify the most suitable cost driver for that activity.

(3) When a system of ABC is introduced, the costing system must be changed. A new system of accounting for overheads is required, based on allocating or apportioning overhead costs to the cost pools for each activity.

(4) There is often resistance to change and the introduction of new systems. Cost accountants and managers will need some training in the methods of ABC and the reasons why it produces completely different unit costs compared with the traditional costing system used in the past.

(c)

Workings: absorption rate hours

Budgeted machine hours, AB1: 200,000 × 12/60 40,000

Budgeted machine hours, AB2: 15,000 × 12 × 30/60 90,000

Total budgeted machine hours 130,000

Budgeted overhead costs $3,640,000

Absorption rate per machine hour $28








Unit costs and profit margins: traditional absorption costing

Cost per unit Product AB1 Product AB2

$ $ $ $


Materials 6.00 18.10

Machine costs (12/60) × $15 3.00 (30/60) × $15 7.50

9.00 25.60

Production overheads (12/60) × $28 5.60 (30/60) × $28 14.00

Total production cost 14.60 39.60

Selling price 20.00 45.00

Profit margin 5.40 5.40

(d)

Overhead Total cost

Units of cost

driver

Cost per unit of

cost driver

$

General overheads 2,860,000 (machine hours)

130,000 $22

Quality control and inspection 400,000 (inspections) 32 $12,500

Production set-up costs 380,000 (production runs)

16 $23,750

Total overhead costs 3,640,000

Overhead Cost per unit of cost driver

AB1 AB2

$ Number of units of cost

driver

$ Number of units of cost

driver

$

General overheads

22 40,000 880,000 90,000 1,980,000

Quality control 12,500 20 250,000 12 150,000

Set-up costs 23,750 4 95,000 12 285,000

1,225,000 2,415,000

Number of units

200,000 180,000

Overhead cost per unit $6.125 $13.416








Cost per unit Product AB1 Product AB2

$ $ $ $


Materials 6.00 18.10

Machine costs (12/60) × $15 3.00 (30/60) × $15 7.50

9.000 25.600

Production overheads 6.125 13.417

Total production cost 15.125 39.017

Selling price 20.000 45.000

Profit margin 4.875 5.983

3 Target

(a) When a company identifies a product that it wishes to make and sell, it must design the product in a way that will appeal to customers. A product design and specification must be prepared, based on a combination of technical considerations and market research.

The component will also consider the price at which the product will be sold. The price that can be obtained will often depend on the price of similar rival products in the market, or on market research into customer attitudes to price. This may be called the target price.

The company should decide on the profit margin it would like to make from the product. The desired margin is subtracted from the target price to obtain a target cost.

A cost estimate is then produced for the product if it is made to the planned design and specification and this cost estimate is compared with the target cost. If the cost estimate is higher than the target cost, the difference is called a cost gap.

When a cost gap exists, the company should re-consider the planned product design and look for ways of reducing the estimated cost to the level of the target cost – in other words, the aim should be to eliminate the cost gap before actual production of the new product item begins.

(b) Target costing should begin at an early stage in the product design and development process because the opportunity for reducing production costs is greatest at the design stage. If there is a cost gap, the product design can be amended. Because the measures to reduce costs are made at an early stage, it is easier to find ways of reducing costs that do not take away significant value for the customer. (If costs are reduced in a way that reduces value for the customer, the target sales price will probably not be achievable.)

If target costing is introduced at a later stage in the product development, for example after the material components, product design features and production methods have been finally agreed, there are fewer opportunities for cost reduction.

Early adoption of target costing also helps to create a general awareness of the need for cost control, and it increases the probability that new products will be developed at a cost that allows the company to sell them at a competitive price








whilst making an acceptable level of profit. It can therefore be argued that target costing improves the probability of commercial success (profitability) for new products.

(c) If a cost gap is identified early in the product design process, the team responsible for the product development (which should include marketing staff as well as production and R&D staff) should consider every aspect of the product design and planned production method to consider ways of reducing the costs.

The aim should be to make changes in a way that does not remove significant value for the customer. For example some aspects of the product, such as the materials or parts used, could be changed and parts that are less expensive used instead. Some features of the product design might be removed without loss of significant value.

As an alternative (or in addition to) looking for cheaper or fewer parts to the product, cost savings might be achieved by identifying suppliers who are willing to provide parts at a lower cost. Prices from suppliers might be re-negotiated, such as the fixed costs of buying part 1922 in batches.

It might be possible to change the production process in some ways to reduce the assembly time required per unit, or different assembly workers might be hired at a lower rate of pay per hour.

Finding ways of reducing overhead costs can be difficult because indirect costs cannot be identified directly with specific products. However if Pollar Co uses target costing for new products, it would be surprising if it did not also employ methods of looking for savings in overhead costs (such as total quality management and continuous improvement).

(d)

Workings: production overhead costs

Production overhead costs can be estimated using the high-low method.

Production overheads hours $

Month 1: Total cost 18,000 912,000

Month 2: Total cost 22,000 948,000

Therefore variable cost 4,000 36,000

Variable production overhead cost per hour = $36,000/4,000 = $9

Production overheads $

Month 1: Total cost of 18,00 hours 912,000

Variable cost (18,000 × $9) 162,000

Therefore fixed costs per month 750,000

Annual fixed production overhead costs = $750,000 × 12 = $9,000,000.

Fixed production overhead absorption rate = $9,000,000/250,000 = $36








Cost estimate and cost gap estimate

Cost per unit of NP19 $

Part 1922: $5.30 + ($2,750/5,000) 5.850

Part 1940: 0.20 × $2.40 × 105/100 0.504

Other parts 7.200

Assembly labour cost: 25/60 × $24 × 100/90 11.111

Variable overheads: 25/60 × $9 3.750

Fixed overheads: 25/60 × $36 15.000

Total estimated production cost 43.415

Target cost (75% of $56) 42.000

Cost gap (1.415)

4 Nimble Company

(a) Many products go through a fairly short life cycle of just a few years. Typically, sales in the early years are quite low; then they increase during the ‘mature’ phase of the life cycle; and eventually sales go into decline and production and sales of the item may be brought to an end. Expenditures follow a different pattern, with large expenditures on research and development before the product is brought to the market, and large marketing expenditures in the first year or two of the product’s life. The ‘pattern’ of revenue and costs therefore changes over each year of the product life cycle. It is therefore inappropriate to compare costs and revenues in each year, because we would not be comparing ‘like with like’ in each year. It is more appropriate to assess the financial performance of a product over its entire life cycle.

Life cycle costing may be difficult to apply to products with a long life; but the principles are applied more easily to products with a short life.

NC should consider using life cycle costing because:

Its products have a short life cycle of about three years

Sales volumes follow a typical ‘life cycle pattern’ – fairly low in Year 1, much higher in Year 2 and then much lower in Year 3

Design and development costs are incurred before sales begin in Year 1, and at the moment are written off to profit or loss as incurred, and are not included in the financial performance assessment of each product: these costs are a major element in the total life cycle costs and should be included in the assessment of performance

Marketing costs are greatest in the first year of the product, but the costs incurred in Year 1 will presumably help to generate sales in Year 2 and possibly also Year 3. It is inappropriate to measure performance by charging marketing costs to the year when the costs are incurred. It is more appropriate to consider the total marketing costs over the entire product life when assessing financial performance.








(b) Workings: Overhead costs estimate: high-low method:

$

Total cost of 16,000 units 170,000


Variable cost of 4,000 units 20,000

The variable cost is $20,000/4,000 = $5 per unit

$


Variable cost of 12,000 units (× $5) 60,000

Fixed costs each year if output is below 17,000 units 90,000

Year 1 Year 2 Year 3 Total

Sales (units) 11,000 18,000 9,000 38,000

$ $ $ $

Revenue (× $20) 220,000 360,000 180,000 760,000

Variable costs (× $5) 55,000 90,000 45,000 190,000

Contribution 165,000 270,000 135,000 570,000

Fixed costs 90,000 135,000 90,000 315,000

Profit before marketing 75,000 135,000 45,000 255,000

Marketing costs 55,000 15,000 0 70,000

Reported net profit 20,000 120,000 45,000 185,000

Development costs 180,000

Net profit over life cycle 5,000

Contribution/sales ratio 75% 75% 75% 75%

Net profit/sales ratio 9.1% 33.3% 25% 24.3%

Net profit ratio over life cycle 0.7%

Using the company’s current methods of performance measurement, the product has a contribution/sales ratio that is higher than the acceptable level of 70%, and the net profit/sales ratio exceeds the acceptable level of 25% in Year 2 and equals 25% in Year 3.

However, the poor net profit/sales ratio in Year 1, compared with Year 2 and Year 3, is due mainly to the fact that comparatively high marketing costs are charged against profit in that year (whereas there are no marketing costs at all in Year 3).

The net profit/sales ratio over the entire product life cycle is 24.3%, just below the ‘acceptable level’ of 25%, but this ignores the development costs. After deducting development costs, the entire profit over three years is only $5,000 or 0.7% of sales. It must be doubtful whether the financial return on this product is sufficient to justify its development.








(c) Incremental budgeting involves preparing a budget by taking the actual figures for the current year and adjusting them for expected changes next year, such as the expected rate of inflation in costs. It is therefore a method of budgeting by forecasting the future using actual costs in the past.

It is common in practice for several reasons:

It is simple to use. Managers with very little accounting knowledge can use incremental budgeting to prepare a budget for his or her department.

It is particularly easy to use for departmental budgets where the expenditures of the department are regarded as fixed costs. It may be sufficient simply to add a percentage to the current year’s expenditure to allow for expected inflation next year.

It is much easier to use than methods of budgeting where all items of costs have to be estimated in detail or from a zero base (such as with zero base budgeting).

Since it is easier than other budgeting methods, the budgeting process can (in principle at least) be completed much more quickly.

The main problems with incremental budgeting are as follows.

If budgets are prepared by taking costs for the current year and adding a percentage for inflation, there is a risk that ‘budget slack’ will be included in budgeted expenditures. Slack is unnecessary and wasteful spending, in excess of what the department actually needs.

Managers may even try to add in even more slack, believing that senior management will arbitrarily cut a percentage amount off budget estimates as a measure for ‘keeping costs under control’.

It encourages the view that costs will increase in the next year. Unlike zero base budgeting or Total Quality Management methods of planning for the future, incremental budgeting does not encourage a practical approach to cost reduction.

(d) A meaningful standard cost is a standard cost that can be used to measure performance in a meaningful way, which means providing information that managers can use to investigate performance and take control action where necessary.

There are various reasons why NC cannot develop meaningful standard costs, and the costs of the ‘Calorie Count’ product can be used as illustration.

(1) A large proportion of the total costs of a product are development costs. These are incurred before production and sales of the product begin, and they are costs for non-standard work. Design and development costs cannot be built into a standard cost for both these reasons.

(2) Another large proportion of total costs consist of marketing costs. These costs are also non-standard, and are incurred at the discretion of management. Marketing costs are therefore not included within any meaningful standard cost.

(3) In the case of ‘Calorie Count’, total costs over the product life cycle are $755,000, of which $505,000 are costs that may be included within a standard cost. These costs were divided into fixed and variable costs using the high-low method of cost analysis.








The variable cost is therefore an estimate of the variable cost per unit, using a method of cost estimation that may not be reliable. For a meaningful standard cost, the variable costs should be analysed in more detail (direct materials, direct labour, variable overheads), but this detail does not appear to be available. Without the detail, the only variance that can be calculated for variable costs is the total variable cost variance.

(4) Fixed costs are also estimated using the high-low method, except that total fixed costs are expected to rise by 50% if annual production exceeds 17,000 units. Since sales volumes vary from one year to the next and fixed overhead expenditure increases substantially above 17,000 units of output, it is impossible to establish a meaningful fixed cost per unit based on budgeted annual costs and normal production volume.

In summary, there is insufficient detail about costs to establish a meaningful standard variable cost per unit and fixed costs and production volumes are non-standard, making a standard fixed cost meaningless too. Variance information would therefore be meaningless.

5 Noisy Company

The first step is to determine the bottleneck factor. It is often assumed to be the machine with the lowest absolute availability of time – in this case process B. However, a bottleneck is defined as the process limiting production.

B S Total

$ $

Time on process A 0.5hrs 1hrs


Total hours needed 1,500 2,000 3,500

There is a shortfall of 500 hours on process A

B S Total

$ $

Time on process B 0.1 0.3


Total hours needed 300 600 900

There is a surplus of 1,100 hours on process B. Therefore process A is the bottleneck.

The next step is to calculate unit throughput for each product:

B S

$ $

Unit selling price 25 30

Direct materials 10 10

Throughput 15 20








The third step is to calculate the return per factory hour:

B S

Unit throughput $15 $20

Time on bottleneck 0.5hrs 1hr

Return per factory hour $30 $20

The third step is to calculate the cost per factory hour:

$21,000 / 3,000 = $7.00 per hour

The next step is to calculate the throughput accounting ratio:

B S

Return per factory hour $30 $20

Factory cost per hour $7 $7

Throughput accounting ratio 4.29 2.86

(a) Both products are viable as they each have a positive throughput accounting

ratio. However, Product B has a higher throughput accounting ratio and should be made in preference to the Product S in order to maximise profits.

(b) Tutorial note: For the decision to change the return per factor hour for Product B has to fall to the return per factor hour of Product S.

Unit though put would have to fall for this to occur. This would require materials cost to increase by $5 per unit. Material cost is budgeted at $10 so this would require a 50% increase in cost.

Product B $ Unit selling price 25 Direct materials 10 Throughput 15 Increase in materials cost 5 Revised throughput 10 Time on bottleneck 0.5 hrs Return per factory hour $20

For the return per factory to fall to $20 per hour on process A and assuming that costs do not change time on machine would have to increase from 0.5 to 0.75 hours, also an increase of 50%.

Product B $ Unit selling price 25 Direct materials 10 Throughput 15 Time on bottleneck 0.75 hrs Return per factory hour $20








These figures suggest there is no difference in sensitivity between the two products and that the decision is quite robust and is unlikely to be affected by small changes.

(c) Target costing should be an integral part of a strategic profit management system. The first step in target costing is to make an estimate of the selling price for a new product which will enable the company to capture its required share of the market. Then it is necessary to deduct the target profit from this figure to, having regard to the rate of return required on capital investment. The deduction of required profit from the proposed selling price will produce a target cost that must be met in order to ensure that the desired rate of return is obtained. Thus the main consideration with target costing is: ‘What should the product cost in order to achieve the desired level of return?’ Target costing will necessitate comparison of the current estimates of costs for the product against the target cost level. Where current cost estimates are higher than the target cost, it is necessary to find ways of making the product at a lower cost, so that this gap is closed

The management of NC should be aware that it is far easier to ‘design out’ cost during the design and development (pre-production) phase than to ‘control out’ costs after development has been completed and production and sales have begun. Thus cost reduction at this early stage of a product’s life cycle is of critical significance to business success. A number of techniques may be used to help in the achievement and maintenance of the desired level of target cost.

Attention should focus on the identification of value added and non-value added activities with the aim of the elimination of non-value added activities. These are activities that incur costs but do not provide benefits in excess of the cost (‘do not add value’). The product should be developed in an atmosphere of ‘continuous improvement’. In this regard, Total Quality techniques such as the use of Quality circles may be used to find ways of achieving reductions in costs.

It is essential that a collaborative approach is used by the management of NC and that all interested parties such as suppliers and customers are closely involved in order to create product enhancements at a reduced cost.

The target cost-setting process

Define current

cost

Define sales

volume

Define product

specification

Set target price

Define target cost

Try to close gap

Define investment requirement

Define required

profit

Calculate ‘cost gap’

Negotiate with

customer








6 Penna Company

(a) Tutorial note: The company will need to sell 50,000 units to gain 10% of the market.

The first step is to calculate the price that the item has to be sold at to achieve this market share. This can be calculated by using the demand curve:

P = 600 – 0.005Q

P = 600 – (0.005 × 50,000)

P = 600 – 250

P = $350

Since the company wishes to generate $10,000,000 profit in total, this equates to a unit profit of:

$10,000,000 / 50,000 = $200 per unit.

Once target price and target profit are available it is possible to calculate target cost:

Target price – target profit = target cost

$350 – $200 = $150 per unit

(b) The target cost gap is calculated as:

$

Target unit cost 150

Current unit cost 200

Target cost gap 50

Currently actual cost is one third higher than it should be to reach the target profit.

The company can undertake various strategies to bring costs down to target:

Product redesign

This is the most effective way of reducing costs. Once the design of a product has been finalised it is difficult to reduce significantly the majority of a product's cost. If PC has not yet finalised the design and production of the product, it would be very worthwhile them revisiting the design and production planning stags of the product lifecycle.

Outsourcing

PC could seek a deal with a third party manufacturer to make the product. Complete outsourcing would not only remove the variable cost element of production but could also lead to huge fixed cost savings. This is a course of action worth exploring by the company. Suitable controls over any patents and quality would need to be in place, together with guarantees of delivery times and the ability to be flexible with production volumes.

Cost reduction

PC has to be careful with cost cutting. If applied badly the company could damage the value of the product, leading to a fall in market price. Cost reduction, however, seeks ways of lowering cost without reducing the value of the product. PC would seek to preserve those features of the product key to its








customer value whilst seeking to reduce the cost of other areas. This, for instance, could involve cutting down on the quality of packaging.

Set up ABC costing

ABC in itself does not reduce cost. However, the act of establishing cost pools and drivers and then charging costs to products vastly improves management's understanding of what is generating cost in an organisation. It also allows management to seek out products that make very efficient use of activities. These products can then act as best practice templates that will help management to reduce the cost of other products.

(c) Target costing has a narrow timeframe as it deals with the here and now. Consider the example in the question. The company has a short-term target to meet.

What short-term price should be set?

Given the target profit what is the short-term target cost?

What is the short-term cost cut required?

In this example the extent of the short-term cost cuts are very significant and if perceived as impossible could lead to the product launch being abandoned.

Lifecycle costing, on the other hand, has a much longer timeframe as it adopts a cradle to grave approach. What is the pattern of costs to be expected through development, introduction, growth, maturity and decline?

A product in the introduction phase may have quite high unit costs. Any cost reduction to meet a target profit may seem a difficult or impossible task. However, if consideration is given to possible learning curve effects and economies of scale at higher levels of production (growth and maturity) a target return and therefore cost may appear easer to achieve.

Lifecycle costing can encourage planners to take an average cost approach to target costing i.e. what is the average cost over the life of the product? This can then be used as a baseline to consider any possible cost reduction programmes to meet target profits.

Target costing also implicitly assumes a constant price of the product. This many not be the case. In the early stages it may be possible to follow a market skimming approach to pricing and sell the product at a premium price. As a product enters late maturity and decline significant price cuts may be needed to maintain sales volumes. Clearly these changes in price have an impact on target profits and therefore target cost and should be factored into any decision.

Fundamentally, lifecycle costing encourages those undertaking target costing to broaden their time frame and to make more realistic assumptions regarding patterns of costs and revenue over time.

7 Spring

(a) Key components

Activity-based costing is based on the view that activities create costs, and products make use of activities. It is claimed that activity-based costing charges overheads to product costs in a more meaningful way than traditional absorption costing. A key feature of activity-based costing is that overhead costs are








collected in cost pools, which correspond to a particular activity or group of activities that generate costs.

An example of a cost pool is set-up costs for a production line. The cost of each set-up is included in the cost pool reflecting the recognition that costs of set-ups are incurred (‘driven’) by the number of set-ups that occur, rather than by the volume of items produced after the set-up has been completed. Set-up costs are an example of an indirect cost, and both traditional absorption costing and activity-based costing are concerned with charging indirect costs to product cost.

Traditional absorption costing assigns indirect costs or overheads to production departments and service departments and then reallocates service department overheads to production centres. Activity-based costing is likely to use, or has the potential to use, considerably more cost pools than traditional absorption costing uses production centres. In activity-based costing, the link between cost pools and product cost is called a cost driver.

A cost driver represents the extent to which a particular activity has been used by a particular product in its production. Continuing our example, an appropriate cost driver would be number of set-ups. A product which is produced in frequent short production runs would therefore incur a greater share of set-up costs than a product produced in a single production run. In traditional absorption costing, overheads are linked to product cost through overhead absorption rates such as cost per machine hour or cost per labour hour. Activity-based costing is likely to use considerably more cost drivers than traditional absorption costing uses overhead absorption rates.

Introduction of ABC

The key steps in introducing an activity-based costing system are as follows:

1 Identify the main activities that generate costs through activity analysis

2 Assign costs to cost pools

3 Select appropriate cost drivers for assigning cost pool costs to products

4 Calculate activity-based charge rates to assign the cost of activities to products

Benefits of ABC

The following benefits have been claimed for an activity-based costing:

1 Product costs are more accurate due to the more sophisticated analysis and assignment of overhead costs. Overhead costs are assigned on a cause-and-effect basis rather than on an ad hoc or subjective basis.

2 Cost behaviour is better understood due to the analysis of activities.

3 Cost control is facilitated through the identification and management of cost-generating activities. For example, in order to reduce set-up costs, production planning could be used to eliminate short production runs and hence reduce the number of set-ups.

4 Poor decisions due to inadequate cost information are less likely to occur.

Disadvantages of ABC

Identifying the main activities that generate costs in an organisation is expensive. Careful thought must be given to the ability of existing management accounting information systems to provide the detailed activity and cost information








required by an activity-based costing system: upgrading or replacement of the information system may be needed.

A further expense is the cost of training staff to use the new costing system. Once introduced, an activity-based costing system can be significantly more expensive than a traditional absorption costing system. It is possible, therefore, that in some organisations the cost of introducing and maintaining an activity-based costing system may exceed the benefits gained.

Activity-based costing may be most appropriate in an organisation where indirect costs are a significant proportion of total cost, or where a wide product range is maintained with a variety of different activity consumption patterns.

Spring should consider the significance of indirect costs to its product costs and undertake a cost-benefit analysis before making a decision to implement an activity-based costing system. Spring should also consider that further developments can flow from the introduction of an activity-based costing system, for example in budgeting (activity-based budgeting) and management philosophy (activity-based management).

(b) Managerial performance and organisational performance are inextricably linked, since managers are the key decision makers in an organisation and their decisions therefore determine organisational performance.

Managerial and organisational performance needs to be measured as part of the control process within an organisation.

The three elements of the control process are recording or measuring actual performance or output, comparing performance with planned performance or some benchmark, and taking action to correct or modify continuing performance in order to achieve planned performance. Managerial and organisational performance can be measured in a wide variety of ways, depending on which aspect of performance, financial or non-financial, is the object of interest.

A wide variety of financial (or money) performance measures can be used to assess managerial and organisational performance. Financial performance is of interest to internal and external stakeholders who are concerned to monitor the progress and risk of their investment, the security of their employment, and so on.

Examples of financial performance measures include:

Profit

Profit is usually expected to increase on an annual basis. Managers are expected to deliver increasing profits and companies are expected to produce profit increases equal to or greater than their competitors. Other measures relating to profitability include sales volume growth, gross profit margin and the ratio of net profit to sales.

Costs

A focus on managerial and organisational performance in terms of cost control or cost reduction may be especially appropriate for organisations in the public sector. Here, profitability is an inappropriate performance measure and a key objective is value for money, in terms of the drive for economy, efficiency and effectiveness.








Non-financial performance indicators

Measuring financial performance alone is not sufficient, since financial performance results from a range of organisational activities which must also therefore be monitored. Non-financial performance measures may be quantitative or qualitative.

An example of a quantitative performance measure is the number of complaints received from customers. An example of a qualitative performance measure is feedback from a sales representative to the effect that most customers are very happy with the after-sales service provided by the organisation.

An attempt is usually made to replace qualitative performance measures with a substitute measure that can be quantified. For example, the number of customer complaints can be used as a substitute measure of product quality or customer satisfaction. Similarly, the number of warranty claims can be used as a substitute measure of product reliability.

Modern organisations compete in terms of product quality, flexibility and reliability, customer satisfaction, and product dimensions such as after-sales care and customer loyalty. These features are captured by non-financial indicators such as number of customer complaints, number of warranty claims, and quality ratings (such as the star ratings of hotels or restaurants, or the position of an organisation in a league table).

A more balanced assessment of organisational and managerial performance will consider both financial and non-financial performance. For example, the Balanced Scorecard considers the customer perspective, the innovation perspective, the internal process perspective and the financial perspective, and requires the identification of quantitative and non-quantitative goals and performance measures.

8 Admer

(a)

Activity-based costing is based on identifying the activities that give rise to costs and this identification does not seem to have happened in this case. Simply collecting information on different activities is not enough. A detailed analysis of business operations is needed in order to identify relationships between costs and cost drivers. There should ideally be a one-to-one relationship between cost and cost driver. To the extent that this is not so, activity-based costing provides less useful information on product cost and for cost control.

The management accountant believes that he can use the information provided to review the store’s performance from an activity-based costing perspective, but the relationship between ‘other costs’ for the three-month period and the proposed cost drivers (number of items sold, purchase orders, etc) is unclear. If sales staff, warehouse staff, consultation staff and administration staff are on fixed salaries, their wage costs will not be linked to items sold, purchase orders or consultations.

If wage costs are apportioned on to product cost using the proposed cost drivers, it is likely that better product cost information will arise, simply because the apportionment bases being used are likely to be more appropriate to retailing than floor area. But at what point does a more sophisticated absorption costing








system become an activity-based costing system? The information provided can be used in an activity based costing analysis if wage costs do depend to some extent on the proposed cost drivers, for example if sales staff wages include a commission for each purchase order raised.

The management accountant needs to eliminate confusion by undertaking an investigation to establish and clarify the links between costs and activities if he wishes to use activity-based costing.

(b) Proposed cost drivers:

Total number of items sold (1,000 + 1,500 + 4,000) 6,500

Total number of purchase orders (1,000 + 900 + 2,5000 4,400

Total floor area (16,000 + 10,000 + 14,000) 40,000

Total number of consultations (798 + 200 + 250) 1,248

Are sales staff wages linked to items sold or to purchase orders?

(1) If sales staff wages are linked to items sold:

Sales staff wages recovery rate = $64,800/6,500 = $9.97 per item sold

(2) If sales staff wages are linked to purchase orders:

Sales staff wages recovery rate = $64,800/4,400 = $14.727 per purchase order

It seems reasonable to link consultation staff wages to the number of consultations:

Consultation staff wages recovery rate = $24,960/1,248 = $20.00 per consultation

Warehouse staff wages could be linked to either purchase orders fulfilled or to items sold

(1) If each item needs to be handled, items sold might be preferred;

Warehouse staff wages recovery rate = $30,240/6,500 = $4.652 per item sold.

(2) If warehouse staff wages are linked to purchase orders fulfilled:

Warehouse staff wages recovery rate = $30,240/4,400 = $6.873 per purchase order.

Administration staff process purchase orders and organise consultations, but no indication is given as to whether these tasks are equally weighted.

If they are, the total number of tasks = 4,400 + 1,248 = 5,648 and:

Administration staff wages recovery rate = $30,624/5,648 = $5.422 per task

General overheads appear to be related to floor space, but there will be other overheads that are not space costs; these will need to be apportioned on a different basis, or even not apportioned at all.

Using the information provided:

General overheads absorption rate = $175,000/40,000 = $4.375/square metre








Possible activity-based costing profit statement:

Department Kitchens Bathrooms Dining Rooms

Total

$ $ $ $

Sales 210,000 112,500 440,000 762,500

Cost of goods sold (63,000) (37,500) (176,000) (276,500) ––––––– ––––––– ––––––– ––––––– Variable contribution 147,000 75,000 264,000 486,000

Sales staff wages (14,727) (13,255) (36,818) (64,800)

Consultation staff wages (15,960) (4,000) (5,000) (24,960)

Warehouse staff wages (4,652) (6,978) (18,610) (30,240)

Admin staff wages (9,749) (5,964) (14,911) (30,624)

General overheads (70,000) (43,750) (61,250) (175,000) ––––––– ––––––– ––––––– ––––––– Profit 31,912 1,053 127,411 160,376 ––––––– ––––––– ––––––– –––––––

Note: Sales staff wages are apportioned using purchase orders: warehouse staff wages are apportioned using items sold; other choices are possible.

(c) Using the information from the company’s current absorption costing system, the bathrooms department appears to make a loss. When viewed from an activity-based costing perspective, however, it makes a small profit. The department makes a contribution of $75,000 towards other costs and overheads and a profit before general overheads of $44,803. Therefore financial grounds for closure do not appear to be compelling, although there may be a need to investigate the department with a view to improving profitability.

A more detailed profitability analysis of bathroom sales might lead to greater understanding of which products are relatively profitable, which products are slow-moving and which products might be removed from sale without adversely affecting sales of other products. Less drastic alternatives than closure might be suggested by such an analysis.

If the department were closed, it could be argued that general overheads would still need to be met and so overall profit would fall by about $45,000 in each three-month period. Overall profit could fall by more than this if some of the other costs allocated to the bathroom department remained after the closure. For example, the number of staff laid off would not correspond exactly to allocated wage costs. However, it is unlikely the space vacated by the bathrooms department would remain unused. The remaining departments might be expanded to fill it, or it might be used for a new venture (selling carpets, for example).

The key question is whether a better use exists for the space. If an alternative use is found, staff redundancies might be reduced or eliminated entirely. A further problem is that closure of the bathrooms department could affect sales of the other departments. The store might be seen as no longer offering an adequate range of products and potential customers might prefer other stores with a greater range of home furnishings. The potential for satisfied customers to return with further business would also be reduced if the store offered a more limited range of products.








It is also unlikely that the closure decision would be made at the level of an individual store, since it carries consequences for the company as a whole. The image of the company might suffer if it were seen to be changing its product range, or if it were seen as being unable to compete with other stores selling bathrooms.

(d) Origin of costs

Activity-based costing could help Admer understand more clearly the origin of its costs. The nature of Admer’s business means that only a small number of cost drivers is likely to exist, but even given the limited information provided, the revised profit statement is likely to be more useful than treating all overhead costs as being related to floor area.

Highlighting activities

Activity-based costing can help Admer to control costs by highlighting the activities that generate them. For example, consultation staff wages are high compared to sales staff wages in the kitchen department in this store. Perhaps sales staff could be trained to provide in-store consultations and the number of home visits reduced; this could lower administration costs and reduce the cost of consultations.

Disaggregation of costs

It is clear that general overheads are the most significant cost other than cost of sales and existing information does not suggest ways of reducing these. However, a more detailed analysis of overheads might reveal activity-based costs that are currently aggregated. Once disaggregated, they become more amenable to understanding and control.

Accurate product costs

It is argued that activity-based costing leads to more accurate product costs, and in order to achieve this Admer needs a more detailed analysis of sales revenue and cost based on the nature of the products sold. For example, the company might be able to classify kitchens as basic, intermediate and deluxe, and collect sales and cost data accordingly.

Improved decision-making

A key advantage claimed for activity-based costing is that it can provide better information to aid decision-making. In this case, it could provide more appropriate information to aid managers in reaching a decision on whether to close the bathrooms department. With better or more detailed information on product cost, managers are likely to make better decisions in key areas such as product pricing and cost control.

Potential issues

Even after introducing activity-based costing, however, Admer will still face the problem that some arbitrary apportionment of costs may still be required when pooling costs. The general overheads of light, heat and rates, for example, are likely to need to be treated in this way, along with the wages of administration staff. A related problem is that not all costs are generated by activities that can be measured in quantitative terms. The management accountant of Admer should also be aware that the costs of introducing and maintaining an activity-based costing system may exceed the benefits that such a costing system may generate. Appropriate cost drivers will need to be determined and the required








information may not be available. The existing management accounting information system may therefore need to be modified to generate the required information, and perhaps new accounting software purchased or developed.

9 Ride Company

(a) Tutorial note: You are being asked to carry out a limiting factor analysis here. The first step is to identify the limiting factor.

The 30,000 hours available in the finishing department are insufficient to enable RC to manufacture the quantities of both types of bicycle that would be required to satisfy expected demand. RC would require a minimum of 38,000 hours to be available in the finishing department in order to meet the anticipated demand for 150,000 Roadster and 70,000 Everest bicycles, as shown in the following working:

Hours

Roadster 150,000/6.25 = 24,000

Everest 70,000/5.00 = 14,000

Required 38,000

Available 30,000

Shortfall 8,000

Therefore finishing hours is a limiting factor or bottleneck resource.

Calculation of net profit using marginal costing principles:

Roadster Everest

Selling price ($) 200 280

Variable costs 100 160 ––––– ––––– Contribution 100 120 Units of limiting factor (hours) 0.16 0.20 Contribution per hour of limiting factor ($) 625 600 ––––– –––––

RC should make Roadsters until it has satisfied total demand. It should then produce the Everest.

Units Type Bottleneck resource per unit (hours)

Bottleneck resource consumed (hours)

150,000 Roadster 0.16 24,000

30,000 Everest 0.20 6,000








Profit from manufacture and sale of this product mix would be as follows:

Sales revenue Units

Selling price per unit

$ $000 $000

Roadster 150,000 200 30,000

Everest 30,000 280 8,400

38,400

Material cost

Roadster 150,000 80 12,000

Everest 30,000 100 3,000

(15,000)

Variable production conversion costs:

Roadster 150,000 20 3,000

Everest 30,000 60 1,800

(4,800)

Contribution

Roadster 15,000

Everest 3,600

18,600

Less:

Fixed production overheads (4,050)

Net profit 14,550

(b) Throughput accounting ratio = return per factory hour/cost per factory hour

Return per factory hour = Sales – material costs/usage of bottleneck resource

Roadster Everest

Sales ($) 200 280

Materials/components costs ($) 80 100

Return per unit 120 180

Bottleneck resource (units required) 0.16 0.20

Return per factory hour ($’s) 750 900

Cost per factory hour = Total factory costs/Bottleneck resource hours available








Total factory costs amount to $8,850,000 and are comprised as follows:

Variable overhead costs (fixed in short-term) $

Roadster (150,000 × $20) = 3,000,000

Everest (30,000 × $60) = 1,800,000

4,800,000

Fixed production overheads = 4,050,000

Total factory costs = 8,850,000

Bottleneck resource hours available = 30,000

Cost per factory hour = $295

Roadster Everest

$ $

Return per factory hour 750.00 900.00

Cost per factory hour 295.00 295.00

Throughput accounting ratio 2.54 3.05

In situations where throughput accounting principles are in application, a product will be worth producing provided that the throughput return per hour of bottleneck resource is greater than the cost per factory hour. This may be measured by the throughput accounting ratio. If throughput return outweighs the cost per factory hour, the ratio will be greater than 1.00. Management attention should focus attention upon increasing the throughput ratio. If they can do this then higher levels of profit will be achieved.

(c) Since the Everest has a higher return per bottleneck hour than the Roadster, RC should manufacture the Everest until it has satisfied the total demand for 70,000 units.

The production mix of bicycles will therefore be as follows:

Type Units manufactured

Bicycles per hour of bottleneck resource

Total hours of bottleneck resource required

Everest 70,000 5.00 14,000

Roadster 100,000 6.25 16,000

Projected income statement of RC for the year ended 31 December Year 5

Sales revenue Units Selling price per

unit

Total

$ $000 $000

Everest 70,000 280 19,600

Roadster 100,000 200 20,000 39,600 –––––––








Material costs Units Material cost per unit

Everest 70,000 100 7,000

Roadster 100,000 80 8,000 15,000 ––––––– Throughput return 12,600

12,000 24,600

Less: –––––––

Variable overhead costs (assumed fixed in short-term) 4,800

Fixed costs 4,050 8,850 ––––––– ––––––– 15,750 –––––––

(d) Marginal costing and throughput accounting both determine a contribution by calculating the difference between sales revenue and variable costs. However this contribution figure will be higher under throughput accounting since only material costs are recognised as being variable costs. Under marginal costing, direct labour costs and certain overhead costs will also be deducted from sales revenues in order to calculate contribution. This is because such costs are variable in nature.

Throughput accounting regards such costs as fixed and this is true insofar as they cannot be avoided in the ‘immediate’ sense. When using marginal costing principles, it is essential that costs are correctly analysed and categorised as fixed or variable if correct decisions regarding product ranking are to be made. For example, in part (b) the variable production conversion cost amounting to $4,800,000 that was calculated in part (a) is described as being ‘variable overhead cost’. Thus we can conclude that all labour costs within RC are categorised as fixed production overheads and will not affect the ranking of products within the company under either marginal costing or throughput principles.

However, this is not the case with regard to variable overhead costs which are treated differently under marginal costing and throughput principles which is clearly illustrated above. In marginal costing and throughput accounting the rate of contribution generated per unit of scarce resource can be used to determine the optimum production mix. However, different rankings can occur under each method.

10 Slip On

(a) The first step is to determine which, if any, of the two machines is the bottleneck.

Bead Plait Twist Total

Market Demand 10,000 5, 000 4,000

Time on Silver Spinning Machine

30 minutes 60 minutes 45 minutes

Time on Copper Beater 60 minutes 15 minutes 30 minutes

Total Time on Silver Spinner 5,000 hrs 5,000 hrs 3,000 hrs 13,000 hrs

Total Time on Copper Beater 10,000 hrs 1,250 hrs 2,000 hrs 13,250 hrs








Given that there are 15,000 hours on Machine type 2, the bottleneck machine is Machine type 1.

The next step is to work out throughput per unit (sales – unit direct materials cost) and then the return per factor hour:

Unit throughput / unit time on bottleneck

Return per factory hour can then be used to prioritise production.

Bead Plait Twist

$ $ $


Direct materials 100 200 500 ⎯⎯⎯ ⎯⎯⎯ ⎯⎯⎯ Unit throughput 300 500 500


Return per factory hour $600 per hr $500 per hr $667 per hr

Priority 1 3 2

Production mix

Product Demand Units made Hours used Cumulative hours used

Bead 10,000 10,000 5,000 5,000

Twist 4,000 4,000 3,000 8,000

Plait 5,000 4,000 4,000 12,000

Income statement

Bead Plait Twist Total

$ $ $ $


Direct materials 100 200 500 ⎯⎯⎯ ⎯⎯⎯ ⎯⎯⎯ Unit throughput 300 500 500

Units made 10,000 4,000 4,000

Total throughput $3,000,000 $2,000,000 $2,000,000 7,000,000

Factory cost*1 3,870,000

Profit 3,130,000 *1 Labour cost

Throughput accounting assumes labour to be a fixed cost. Total costs is based on market demand rather than production levels.

$200 × 10,000 = $

$200 × 10,000 = 2,000,000

$100 × 5,000 = 500,000

$200 × 4,000 = 800,000

3,300,000








Overhead cost $30 × 19,000 = 570,000

Total factory cost 3,870,000

(b) In limiting factor analysis, contribution per hour of limiting factor rather than throughput per hour is calculated and the assumption is made that direct labour is a variable cost.

Bead Plait Twist $ $ $ Sales price 400 700 1,000 Direct materials 100 200 500 Direct labour 200 100 200 Unit contribution 100 400 300 Time on Silver Spinner 30 minutes 60 minutes 45 minutes Contribution per hr $200 $400 $666 Priority 3 2 1

Production mix

Product Demand Units made

Hours used

Cumulative hours used

Twist 4,000 4,000 3,000 3,000 Plait 5,000 5,000 5,000 8,000 Bead 10,000 8,000 4,000 12,000

Income statement

Bead Plait Twist Total $ $ $ $ Sales price 400 700 1,000 Direct materials 100 200 500 Direct labour 200 100 200 Unit contribution 100 400 300 Units made 8,000 5,000 4,000 $800,000 $2,000,000 $1,200,000 4,000,000 Fixed costs*2 510,000 3,490,000

*2 Overhead cost

$30 × 19,000 = $570,000

(c) Throughput accounting and limiting factor analysis are very similar in a way in that they both seek to maximise return per unit of scarce resource. However, they differ in the way that costs are treated.

In throughput accounting the only variable cost is assumed to be material. All other costs are assumed to be fixed. In contrast limiting factor analysis recognised that labour and overheads can be variable costs.

In the example above the two methods led to different profits being recorded for two reasons








(1) The production priority of the products was different between the two methods.

(2) Total labour costs used in the two calculations were different. In throughput accounting the cost was assumed to be fixed and was calculated on market demand whereas in limiting factor it was assumed to be variable and total labour cost was calculated on the basis of units made.

Which of the two methods is best depends on the situation on the ground. In many manufacturing environments, production staff are no longer paid by the hour but receive salaries. In this situation throughput may prove to be the most appropriate technique. In more traditional environments, however, workers may still be paid by the hour and a limiting factor approach may be most appropriate.

11 Abkaber

(a) Motorbike costing using absorption costing

First calculate a labour hour absorption rate:

Total overhead / total labour hours

$(2.4m + $6m + $3.6m) /(0.2m + 0.22m + 0.08m) = $24 per hour.

The profit per product line is as follows

Sunshine Roadster Fireball $ $ $ Revenue*1 8,000,000 9,600,000 3,200,000 Less Direct labour*2 1,000,000 1,100,000 400,000 Materials*3 800,000 960,000 360,000 Overheads*4 4,800,000 5,280,000 1,920,000 Profit 1,400,000 2,260,000 520,000

*1 Output volume × $4,000 per Sunshine, $6,000 per Roadster, $8,000 per Fireball

*2 Labours hours × $5per hour

*3Output volume × $400 per Sunshine, $600 per Roadster and $900 per Fireball

*4 Labour hours on each product line × $24 per hour.

Motorbike costing using ABC

The first step is to calculate overhead rate per cost driver for each of the cost pools. Note that cost pools and drivers are identified in the question.

Cost Pool Value Driver Units of ‘driver’

Driver rate

Deliveries to retailers

$2,400,000 Deliveries to retailers

250 $9,600 per delivery

Set up costs $6,000,000 Number of set ups

100 $60,000 per set up

Purchase orders

$3,600,000 Number of purchase orders

800 $4,500 per purchase order








Example workings for Fireball

Deliveries: 70 × $9,600 = $672,000

Set up costs: 25 × $60,000 = 1,500,000

Purchase orders: 100 × $4,500 = $450,000

Sunshine Roadster Fireball

$ $ $

Revenue 8,000,000 9,600,000 3,200,000

Less

Direct labour 1,000,000 1,100,000 400,000

Materials 800,000 960,000 360,000

Deliveries 960,000 768,000 672,000

Set ups 2,100,000 2,400,000 1,500,000

Purchase orders 1,800,000 1,350,000 450,000

Profit/(loss) 1,340,000 3,022,000 (182,000)

(b) With absorption costing based on labour hours the quality of the information produced about costs and profit is open to question. The overhead costs (set ups, deliveries and purchase orders) may have little or no relationship to labour hours worked. As a result, overhead costs charged to each product may be ‘inaccurate’ and unreliable.

Activity-based costing is more time-consuming and complex than traditional absorption costing. However, it seeks to establish a link between overhead costs and activities, through cost drivers. In this way it may be argued that more ‘meaningful’ costs are obtained that better reflect the level of effort required to make a product.

Whilst ABC is usually seen as a superior technique its validity depends on careful choice of cost drivers and cost pools.

Finance Director

The Finance Director questions the viability of the Fireball and usefulness of information generated by ABC is assessing this issue.

With ABC, the Fireball makes a loss and it is right to question its financial viability. In order to improve its viability the company should seek to reduce costs. In the case of the Fireball deliveries are high relative to the quantity of bikes delivered. The company may also with to seek a reduction in set-ups as each of these costs $60,000.

Marketing Director

The Marketing Director is effectively calling for a relevant costing or marginal costing approach to be adopted. Fundamentally, he would like to know what is the extra cost of manufacturing one more bike and then to use this to guide his contract negotiations.

Whilst this is useful it is worth noting that marginal cost is not total cost and that if all items were priced to cover marginal cost the company would make a loss








due to its inability to cover fixed costs. If appropriate cost drivers are selected it is possible to calculate marginal costs using ABC.

It may appropriate for the company to adopt different costing systems for different purposes – marginal for short-term decision-making and ABC for on-going costing.

Managing Director

The Managing Director is correct in stating that not all overhead costs are variable. In this case it is not possible to establish causality or identify appropriate drivers.

The point about learning curves is also valid. As an organisation does this again and again it will improve and the cost of each activity will fall. To overcome this driver rates can be regularly reviewed and then adjusted to take into account this effect.

Chairman

The Chairman is technically correct in that total profit under both methods remains the same. Whilst total profit is important it is also important to examine how individual products are performing. ABC, with its focus on cause and effect, is ideally suited to the measurement of costs and profits where overhead costs are a significant part of total costs.

12 Edward Co

(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 be included 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 and the market conditions expected at the time that the product will be launched. Hence a heavy emphasis is placed on external analysis 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. An organisation 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 be closed, 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 (by calculating 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 stage considers 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 can be done to close it by the design team. Traditionally, cost control takes place at the ‘cost incurring’ stage, which is often far 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 been shown to reduce product cost by between 20% and 40% depending on product and market conditions. In traditional cost plus systems an organisation may not be fully aware of the constraints in the external environment until after the production has started. Cost reduction at this point is much more difficult as many of the costs are ‘designed in’ to the product.

– It is often argued that target costing reduces the time taken to get a product to market. Under traditional methodologies there are often lengthy delays whilst a team goes ‘back to the drawing board’. Target costing, because it has an early external 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 features

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

Team approach

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

Review the whole supplier chain

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

Components

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








Assembly workers

Productivity gains may be possible by changing working practices or by de-skilling the process. Automation is increasingly common 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.

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

Overheads

Productivity increases would also help here by spreading fixed overheads over a greater number of units. Equally Edward Limited should consider an activity based costing approach to its overhead allocation, this may reveal more favourable cost allocations 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 + units 4,000

$2,400 ) 4·70

Component 2

(98

1005.0

10025

×× ) 0·128

Material – other 8·10

Assembly labour

(90

100$12.60/hr

6030

×× ) 7·00

Variable production overhead

( $20/hr6030

× ) 10·00

Fixed production overhead

( $20/hr6030

× ) 6·00 ––––––– Total cost 35·928

Desired 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 $80,000

Extra assembly hours 4,000








Variable cost per hour $20/hr

Monthly fixed production overhead

$700,000 – (23,000 x $20/hr) $240,000

Annual fixed production overhead ($240,000 x 12) $2,880,000

FPO absorption rate =hrs 240,000

$2,880,000 $12/hr

13 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 example the CB has absorbed only $0·05 more overhead. The reason for such a small change is that the overheads are dominated by 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 difference between the relative number of machine hours for each product and the number of inspections made (the ABC driver). The CB takes less time to produce than the TJ, due to the shortness of the book. It will therefore carry a smaller amount of overhead in this regard. However, given the high degree of government regulation, the CB is subject to ‘frequent’ inspections whereas the TJ is inspected only rarely. This will mean that under ABC the CB will carry a high proportion of the quality control cost and hence change the relative cost allocations.

The production set up costs are only a small proportion of total cost and would be, therefore, unlikely to cause much of a difference in the cost allocations between the two products. However this hides the very big difference in treatment. The CB is produced in four long production runs, whereas the TJ is produced monthly in 12 production runs. The relative proportions of overhead allocated under the two overhead treatments will be very different. In this case the TJ would carry much more overhead 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 means of cost control.

– Difficulty in identifying cost drivers. In a practical context, there are frequently difficulties in identifying the appropriate drivers. 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 immediately available and therefore resistance to change is common. The setting up of new cost pools is needed which is time consuming.








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

$CB $TJ Paper (400g at $2/kg) 0.80 (100g at $1/kg) 0·10 Printing (50ml at $30/ltr) 1.50 (150ml at $30/ltr) 4·50 Machine cost (6 mins at $12/hr) 1.20 (10 mins at $12/hr) 2·00 Overheads (6 mins at $24/hr) (W1) 2.40 (10 mins at $24/hr) 4·00 –––– –––––– Total cost 5.90 10·60 Sales 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 mins

Which is 120,000 hours

Cost per hour = $24/hrhrs 120,000

$2,880,000=

Cost per unit calculations under ABC

CB $

TJ $

Paper (400g at $2/kg) 0.80 (100g at $1/kg) 0·10 Printing (50ml at $30/ltr) 1.50 (150ml at $30/ltr) 4·50 Machine cost (6 mins at $12/hr) 1.20 (10 mins at $12/hr) 2·00 Overheads (W2) 2.41 (W2) 3.88 –––– –––––– Total cost 5.91 10·48 Sales 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 3.00 Quality control 668,000 601,200 66,800 200 3340 0.6012 0.56 Production 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 3.88 –––––– –––––– –––––– –––––– Production 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 TJ Property costs Machine hours 100,000 20,000 Quality control Inspections 180 20 Production set up Set ups 4 12

A cost per driver approach is also acceptable.

14 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 this method the production capacity for all processes is as follows:


Pressing 450,000 450,000 562,500

Stretching 900,000 562,500 900,000

Rolling 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 probably be 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


Selling price 70·0 60·0 27·0

Raw materials 3·0 2·5 1·8

Throughput 67·0 57·5 25·2

Throughput per bottleneck hour* 134·0 115·0 63·0

Fixed costs per hour (W1) 90·0 90·0 90·0

TPAR 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 processing hours, 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 also increase, generating a greater rate of income for Yam if the extra production can be sold. Automation might be used or a change in the detailed processes. Investment in new machinery can also help here but the cost of that would need to be 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 business appears 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 many sources being far from a unique product. Given the industry is mature the suppliers of the raw material could be willing to negotiate on price; this could have volume or quality based conditions attached. Yam will have to be careful to protect its 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. ABC techniques can help to identify the cost drivers and with management these could be used to reduce activity levels and hence cost. Outsourcing, de-skilling or using alternative suppliers (for stationery for example) are all possible cost reduction methods.

(ii) A TPAR of less than one indicates that the rate at which product C generates throughput (sales revenue less material cost) is less than the rate at which Yam incurs fixed cost. So on a simple level, producing a product which incurs fixed cost 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 an important factor in cessation decisions

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

– 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 then product C is making a contribution that will be lost if the product ceased.








Decision-making techniques

15 Light engineering

(a) Tutorial note: The first step is to make a clear statement of what is taken to be x and what is taken to be y.

Let x = weekly production of water tanks

Let y = weekly production of water butts

Define the objective function:

The objective is to maximise contribution. Since each water tank (x) contributes $50.00 and each water butt (y) contributes $40.00, the objective function can be written as:

C = 50x + 40y

Define the constraints:

(i) Cutting time:

6x + 3y ≤ 36

(ii) Assembly time:

4x + 8y ≤ 48

(iii) Minimum constraints

The company has to produce at least two water tanks and three water butts.

x ≥ 2

y ≥ 3

(b) Constraints can be graphed by treating them as simple linear equations and working out the value of x when y = 0 and the value of y when x = 0.

(1) Cutting time constraint:

6x + 3y = 36

When x = 0, y = 12

When y = 0, x = 6

(2) Assembly time constraint:

4x + 8y = 48

When x = 0 y = 6

When y = 0 x = 12

Together with non-negativity constraints, these lines can then be plotted on a graph. The feasible region is the region within which values of x and y meet all of the stated constraints.








(c) Tutorial note: The quickest way to find the contribution maximising mix of products is to plot an iso contribution line on to the graph. Slowly move the line out from the origin – the last point inside the feasible region that it passes through is the optimum product combination.

In this example this is point P.

P is the intersection of the lines:

(1) 6x + 3y = 36

(2) 4x + 8y = 48

The intersection of these lines can be found by solving the equations simultaneously.

Step 1: Multiply equation 1 by 4 and equation 2 by 6:

(3) 24x + 12y = 144

(4) 24x + 48y = 288

Step 2: Subtract equation 3 from equation 4 to get:

36y =144

y = 4

Step 3: Inserting the value of y into equation 1 gives:

6x + 3y = 36

6x + 12 = 36

6x = 24

x = 4

Maximum contribution therefore occurs when 4 water tanks and 4 water butts are produced.

This gives a contribution of

C = 50x + 40y

C = 4 × $50 + 4 × $40 = $360

Feasible Region

12 6 2 Tanks

Butts

6

12

3

P








(d) Cutting time shadow price

The cutting time constraint is currently 6x + 3y = 36. An extra hour of cutting time changes this to 6x + 3y = 37

The profit maximising equation can now be solved as:

(1) 6x + 3y = 37

(2) 4x + 8y = 48


(3) 24x + 12y = 148

(4) 24x + 48y = 288


36y =140

y = 3.889


(1) 6x + 3y = 37

6x + 11.667 = 37

6x = 25.33

x = 4.22

Step 4: Calculate the new contribution:

C = 50x + 40y

C = 4.22 × $50 + 3.889 × $40 = $366.56

The shadow price of one extra hour of cutting time is $6.56 ($366.56 - $360)

Assembly time shadow price

The cutting time constraint is currently 4x + 8y = 48. An extra hour of cutting time changes this to 4x + 8y = 49

The profit maximising equation can now be solved as:

(1) 6x + 3y = 36

(2) 4x + 8y = 49


(3) 24x + 12y = 144

(4) 24x + 48y = 294


36y =150

y = 4.167


(1) 6x + 3y = 36

6x + 12.501 = 36

6x = 23.499

x = 3.917

Step 4: Calculate the new contribution:

C = 50x + 40y








C = 3.927 × $50 + 4.167× $40 = $363.03

The shadow price of one extra hour of cutting time is $3.03 ($363.03 - $360)

16 Tables and benches

(a)

Contribution per unit Tables Benches

$ $ $ $

Sales price 560 460

Materials 300 300

Labour 90 60

Other variable costs 10 20

Total variable costs 400 380

Contribution per unit 160 80

(b) Let x = the number of units of tables and y = the number of units of benches.

The objective function is to maximise 160x + 80y

Subject to the constraints:

(Wood): 5x + 5y ≤ 10,000

(Skilled labour) 3x + 2y ≤ 4,800

(Sales demand) x ≤ 1,200

(Sales demand) y ≤ 1,500

x and y cannot be negative.

In the graph the feasible area is 0ABCDE

The slope of the iso-contribution line is shown near the origin of the graph by 160x + 80y = 32,000.

Contribution is maximised where an iso-contribution line goes through point D. This is an iso-contribution line which is as far from the origin as possible but within the feasible area.








At point D

(1) x = 1,200

(2) 3x + 2y = 4,800

(1) × 3 = (3) 3x = 3,600

(2) – (3) 2y = 1,200

y = 600

The output and sales quantities to maximise contribution are 1,200 tables and 600 benches.

Total contribution = (1,200 × $160) + (600 × $80) = $240,000.

(c) A shadow price of a scarce resource (resource in limited supply) is the amount by which total contribution would increase if one extra unit of the resource were available at its normal variable cost. (It is also the amount by which total contribution would fall if one unit less of the resource were available).

When there is a maximum sales demand for a product, its shadow price is the amount by which total contribution would increase if the maximum sales demand were increased by 1 unit.

Shadow price of wood

This is $0, because in the optimal solution, not all the 10,000 kilos of wood are required for the contribution-maximising output. Having an extra kilo of wood would add nothing to the total contribution achievable.

0

400

2000

2400

200 1200 1600 2000

A B

C

F

D

Max demand y

Max demandx

Max contribution

contribution Wood

Skilled labour

x

y








Shadow price of skilled labour

We can calculate this by working out what the total contribution would be if 1 extra labour hour were available at its normal variable cost. The linear programming graph would be much the same as in the solution and the total contribution would be maximised where x = 1,200 and 3x + 2y = 4,801.

(1) x = 1,200 (2) 3x + 2y = 4,801 (1) × 3 = (3) 3x = 3,600 (2) – (3) 2y = 1,201 y = 600.5

The optimal solution would be to make 0.5 extra units of benches (= y). Since benches have a contribution per unit of $80, total contribution would be increased by $40.

The shadow price of skilled labour is therefore $40 per hour.

(d) Rate per hour for overtime

The skilled workers are asking for an additional $20 per hour to work overtime (a total hourly rate of $40). At this rate of pay, the additional contribution per hour worked in overtime would be the shadow price per hour less the additional variable cost per hour, which is $20 (= $40 - $20).

This means that total contribution would increase by a net amount of $20 per additional hour at this rate of pay. However, paying an overtime premium of 100% is very unusual, and Flea Co management should be advised to negotiate a lower rate of pay, say $20 plus a premium of 50% (= $30 per hour) for overtime working.

Number of hours made available

If more labour hours become available, the constraint line for skilled labour will move out to the right. Eventually, skilled labour will no longer be a scarce resource, and its shadow price will fall to $0.

This will happen at point F in the graph, where x = 1,200 and 5x + 5y = 10,000.

(1) x = 1,200 (2) 5x + 5y = 10,000 (1) × 5 = (3) 5x = 6,000 (2) – (3) 5y = 4,000 y = 800

This is 200 units more of benches than in the current optimal solution. These would require additional skilled labour time of (800 – 600 units) × 2 hours per unit = 400 extra hours.

We are told that up to 600 additional labour hours would be needed, but no more than 400 extra hours are required.








Other factor to consider

The question states that Flea Co produces high-quality products. Management will need to be satisfied that the quality of output does not fall if the employees work longer hours.

(Alternatively, your answer might comment on the reliability of the forecast for sales demand for tables. If maximum sales are higher or lower than 1,200 units, the optimal solution would change.)

17 Minim Machines

(a) Decision-making involves making a choice between two or more options, where the outcome from each option is uncertain.

Maximax decision criterion. The decision is to choose the option that offers the highest potential profit, regardless of the probability of each different possible outcome.

Maximin decision criterion. The decision is based on the worst possible outcomes for each decision option. The option selected should be the one where the outcome is best for the ‘worst possible’ outcome. Maximin therefore aims to maximise the minimum possible profit.

Expected value criterion. To use this option, there must be probability assessments for each possible outcome from each decision option. The expected value is the weighted average profit (or cost), allowing for the different possible outcomes and the probability of each. The decision should be to choose the option with the highest EV of profit (or lowest EV of cost).

(b) Workings

Contribution per unit when demand per period is more than the capacity of the machine: $12 - $5 = $7.

Contribution per unit when demand per period is less than the capacity of the machine: $12 - $4.50 = $7.50.

Size of machine

Demand per period

Contribution per period

Admin costs

Rental cost

Net profit

(capacity) units $ $ $ $

Small (200) 240 (200 × 7) 1,400 (100) (400) 900

390 (200 × 7) 1,400 (100) (400) 900

Medium (300) 240 (240 × 7.50)1,800 0 (700) 1,100

390 (300 × 7) 2,100 (100) (700) 1,300

Large (400) 240 (240 × 7.50) 1,800 0 (1,100) 700

390 (390 × 7.50) 2,925 0 (1,100) 1,825








Profit table Machine size

Small Medium Large

Demand 240 900 1,100 700

Per period 390 900 1,300 1,825

(c) The choice of size of machine will depend on the risk attitude of the management of the company.

If management take an aggressive approach to decision-making, they might apply the maximax decision criterion and select the large machine, because this offers the highest potential daily profit of $1,925.

If management takes a very cautious approach, they might apply the maximin criterion and select the medium-size machine, for which the minimum daily profit would be $1,100 – better than for the small machine ($900) or the large machine ($700).

Since there will be a number o f periods in which the customer will demand either 240 or 390 units, it may be considered appropriate to use the EV criterion. This would be a fairly cautious approach to decision making, since in the long run the actual average outcome per period should be close to the weighted average (EV). The expected value of daily profit with the small machine would be $900, for the medium machine it would be (0.6 × $1,100) + (0.4 × $1,300) = $1,180 and for the large machine it would be (0.6 × $700) + (0.4 × $1,825) = $1,150. The choice would be marginally in favour of the medium-size machine, which offers the highest EV of profit per period.

Given the more cautious approach to risk now taken by management of MM, the medium-size machine should be recommended.

(d) Three other methods of analysing and assessing risk.

(1) Minimax regret decision criterion. The option selected should by the one where the largest possible ‘regret’ is minimised. Regret is the difference between the profit that would be earned from the option selected and the profit that would have been earned if the most profitable option had been selected, given the actual outcome.

(2) Sensitivity analysis. Where the estimates of possible outcomes are uncertain, or where the probabilities of different possible outcomes are uncertain, sensitivity analysis could be used. This involves changing the value of each factor in the decision – for example reducing the sales price per unit by 5%, increasing the variable cost per unit by 10% or increasing the possible sales demand per period. The profit that is calculated using the changes to the estimates should give management some idea about the possible risk associated with each decision option.

(3) Simulation. For more complex decision problems, simulation may be used. A Monte Carlo simulation model involves estimating probabilities for all uncertain items in the situation, and using random numbers to produce a combination of values for each item and the associated profit that would occur. A large number of random number combinations and associated profit figures should be obtained, and from the results it should be possible








to create a probability distribution of the possible profit. This statistical probability distribution can then be used to analyse the risk.

Note: You may have chosen to discuss stress testing – assessing what the profit or loss would be if the ‘worst possible’ likely outcome occurred. This would be acceptable if described sufficiently to earn 2 marks.

18 Linear

(a) Let a = the number of units of A to be produced

Let b = the number of units of B to be produced

Objective function

Objective is to maximise profit:

Objective function: 9a + 23b

Constraints:

Materials: 3a + 4b ≤30,000

Labour: 5a + 3b ≤36,000

Restriction on A: a ≥1,000

Non-negativity: b ≥0

(b)

Optimal point is at the intersection of the line a = 1,000 and the materials constraint line 3a + 4b = 30,000.

Inserting the value of 1,000 into the materials constraint line:

(3 × 1,000) + 4b = 30,000

3,000 + 4b = 30,000 therefore 4b = 30,000 – 3,000, giving 4b = 27,000.

3a + 4b = 30,000

5a + 3b = 36,000

Iso-contribution line

a = 1,000

a units ‘000

b units ‘000

1 2 3 4 5 6 7 8 9 10 11 12

13

12

11

10

9

8

7

6

5

4

3

2

1

0








Therefore b = 27,000/4,000 = 6,750 units

The optimal production plan is to make 1,000 units of A and 6,750 units of B.

(c) Shadow price of labour

The shadow price of labour is $0. At present production is not constrained by labour availability but by materials supply. Labour is a slack variable. At the optimal solution there is unused labour. Adding an extra hour of labour would not increase output and therefore contribution.

Shadow price of materials

Output is currently constrained by the supply of materials. One more kilogram of materials will allow production to be increased.

At present the optimal solution is:

$ 1,000 units of A × $9 9,000 6,750 units of B × $3 20,250 Total 29,250

If one more kilogram of materials becomes available optimal point is the intersect of the a = 1,000 line and the materials constraint line 3a + 4b = 30,001.

Inserting 1,000 into the materials constraint line gives:

(3 × 1,000) + 4b = 30,001

3,000 + 4b = 30,001

4b = 27,001

b = 6,750.25

Contribution is now:

$ 1,000 units of A × $9 9,000.00 6,750.25 units of B × $3 20,250.75 Total 29,250.75

The increase in contribution of $0.75 is the shadow price of one extra kilogram of material

(d) Linear constraints

The model assumes that the rate of resource use remains constant for all units. In reality this may change as production volumes increase. Close to maximum capacity, for instance, machinery may be more prone to breakdown or tired workers make mistakes wasting time and materials.

Interconnection of products

Optimal solutions do not take into account possible interconnections between products and market preferences. Product A may only be bought after product B has been purchased and so on. Cutting down on market supply of one product may therefore reduce sales of another.

Fixed constraints

In the event of a labour shortage/machine time shortage companies will work hard to find solutions to the problem in the form of overtime working, bringing








in contract staff, outsourcing production temporarily and so on. Whilst some resources are limited many constraints can be overcome in a number of ways.

Shadow prices

Shadow prices can be misleading as they are calculated assuming that the production of fractions of a unit is possible. In reality 4 extra kgs of material are needed in this example before contribution will increase. Shadow prices are also not the same for limitless additional quantities of the scarce resource. Ultimately if enough extra of one scarce resource is made available then another scarce resource will eventually becomes critical. In the question here, if enough extra material became available, labour hours would eventually become a limiting factor.

19 Rapid Profit

(a) Maximim rule

Which project has the least worst outcome?

The worst outcome is the combination of highest costs and lowest revenues.

Project 1 $5,000 - $15,000 = ($10,000)

Project 2 $25,000 - $40,000 = ($15,000)

Project 3 $30,000 - $50,000 = ($20,000)

Project 1 has the ‘least worst’ outcome and would be selected using the maximin decision criterion.

This analysis only takes into account the size of the worst possible outcome. It does not take into account how likely it is to occur or how likely making a loss of any size is for each project.

Maximax rule

Which project has the best possible outcome?

Project 1: $16,000 – $5,000 = $11,000

Project 2: $60,000 – $15,000 = $45,000

Project 3: $80,000 – $25,000 = $55,000

Project 3 has the best possible outcome and would be chosen using the maximax rule.

As with the maximin rule no account is taken of likelihood or cumulative probability of making a loss.

Expected values

Project 1

Revenue Probability EV of revenue Cost Probability EV of cost $ $ $ $

5,000 0.1 500 5,000 0.3 1,500 8,000 0.4 3,200 8,000 0.5 4,000

17,000 0.3 5,100 15,000 0.2 3,000 16,000 0.2 3,200

12,000 8,500 Expected value: $12,000 - $8,500 = $3,500








Project 2


25,000 0.4 10,000 15,000 0.2 3,000 40,000 0.2 8,000 20,000 0.4 8,000 60,000 0.4 24,000 40,000 0.3 12,000

42,000 23,000

Expected value: $42,000 - $23,000 = $19,000

Project 3


30,000 0.1 3,000 25,000 0.1 2,500 40,000 0.3 12,000 40,000 0.5 20,000 65,000 0.5 32,500 50,000 0.4 20,000 80,000 0.1 8,000

55,500 42,500

Expected value: $55,500 - $42,500 = $13,000

The project that has the highest expected value is Project 2.

Expected values are weighted averages where the weightings are the probabilities. It is questionable whether EVs are useful for ‘one-off events’ such as these projects. The expected values may also be values that can never arise in any particular instance of a project.

(b) Simulation could be used to model queue length and waiting times. Through practical study of a shop it is possible to establish a probability distribution of inter-arrival times i.e. the time interval between people entering the shop. Again, through practical study it is possible to establish a probability distribution of time taken to service customers.

If random numbers are assigned to each service time and inter arrival times based on their probabilities the basic data are then available to model the queue.

Using random numbers it is then possible to select inter-arrival and service times for a sequence of customers. Putting these together it is possible to calculate waiting times and queue lengths.

Imagine if the first person has an inter-arrival time of 5 minutes and a service time of 3 minutes i.e. the first customer arrives 5 minutes after the shop opens and takes 3 minutes to serve. The second customer has an inter-arrival time of 1 minute and a service time of 4 minutes i.e. the second customer arrives 1 minute after the first and takes 4 minutes to serve. Remember the first customer takes 3 minutes to serve so the second customer has to wait 2 minutes (3 –1). If the third customer has an inter-arrival time of less than 2 minutes then the queue will grow to two.

Variations on a theme here include modelling the impact of opening up a second counter to see what happens to queuing times.

(c) Tutorial note:

Many students make the mistake of comparing total costs to decide which products should be outsourced. Relevant costs should be compared – in this case this means variable costs.








The correct answer to this question is very easily obtained by asking (and answering) the following question:

How much extra does it cost to buy one more unit in form outside contractors and how does this compare with the cost of making one more unit in-house?

Rex Sheltie TriColour Texel $ $ $ $ Material cost 50 200 150 250 Labour cost 80 100 30 150 Variable overhead 20 50 40 100 Total variable cost 150 350 220 500 Offer price 170 300 230 520 Saving/(cost) (20) 50 (10) (20)

Only the Sheltie should be outsourced as it the single product where the offer price from Janson is lower than the variable cost of in-house product.

20 Pricing model

(a) Cost model

The cost model is a simple linear equation of the form y = a + bx, where a represents the fixed costs and b the variable costs per unit. Hence the current cost model has fixed costs of $5,000 and a unit variable cost of $0.6. The revised cost model reduces the fixed cost element to $4,750 but the unit variable cost rises to $0.8 Therefore, the revised model generates lower cost estimates at lower output levels, but higher cost estimates at higher output levels than the current model.

Revenue model

The revenue function depicts a conventional non-linear downward sloping demand curve where the company has to lower its sale price of all of its units if it wishes to sell more. The revised coefficients in the revised model results in a lower initial price (from $20 to $19) but a slower decline in price as the units sold increase. The revision in the coefficient from 0.01 to 0.009 results in the price declining at a slower rate than previously for any given change in units sold i.e. the revised model depicts a lower price elasticity of demand. Therefore the revised model generates lower total revenue estimates at low unit sales, but greater total revenue estimates at high unit sales than the current model.

(b) Tutorial note

Two methods are asked for and the marking scheme reflects this.

(i) The optimal sales level could be determined by:

using differential calculus to determine the marginal cost (MC) and marginal revenue (MR) functions. Where MR = MC the optimal demand occurs. Solve the equation to find the optimal level.

calculating the values of total revenue and total cost at all potential unit output levels and identifying where revenues exceeded costs by the greatest absolute amount. This can be done either by using a spreadsheet or by plotting a graph.

(ii) The amended model should quantify the current efficient application of resources in the achievement of the optimum demand level. It should








therefore be a measure of current efficient managerial performance. However, managerial performance should be measured in terms of identifying, quantifying and responding to changing business variables.

The model would require to be updated in order to reflect such changes. It is unlikely that the model is sufficiently sophisticated to incorporate all the variables which reflect managerial performance.

Managerial performance is not just about reaching sales targets or controlling costs to meet budget. For example:

If the department is customer facing what about customer satisfaction?

What about quality targets?

What about staff motivation and retention?

(c) Tutorial note

Use headings to improve the clarity of your answers

Historical data

The structure of cost and revenue models frequently rely on historical information as source data but how reliable is this for forecasting? How effective is the past as a predictor for the future? Cost and revenue relationships can alter radically over time with technological and market changes – there is a need to consider the significance and impact of these issues on long-term forecasts. The solution may be to have different models for short and long-term forecasts with more detailed and stringent accuracy requirements for the shorter term estimates.

Cost behaviour

The cost models assume a constant fixed cost over all ranges of output – how realistic is this? Perhaps the cost model could incorporate a step cost function that increases as specific output levels are attained. Is the step cost necessarily an abrupt change or is it possible to incorporate a sliding step cost that results from capacity being temporarily expanded by short-term measures until the higher demand level is regarded as permanent.

The cost models assume that unit variable costs remain constant over all ranges of output – is this a reasonable assumption? What about the possibility of deriving economies or diseconomies of scale and hence resulting in a non-constant unit variable cost. E.g. Bulk purchase discounts will result in unit variable costs decreasing as output expands. These discounts may generate a downward step function in unit variable cost or even a smooth decreasing function depending on the purchase contract terms.

Impact of inflation

Are the revenue and cost forecasts based at constant prices or do we incorporate an allowance for inflation? This will probably depend upon the length of the time horizon that we are applying. What inflation factor do we use? Is RPI appropriate or do we require a more specific inflator because the industry prices change at a different rate to the general economy? Indeed in certain high tech areas the forecast may be for a general decrease in prices.

Elasticity

The forecast price elasticity of demand incorporated into the model is critical in forecasting revenues, but how accurate can this be in a changing business








environment? The model could be improved by considering the factors that determine the price elasticity of demand and incorporating the variables into the model i.e. by making the model more sensitive to the critical issues. This will increase both the potential accuracy of the model and unfortunately, the complexity of it.

Non-price factors

the revenue functions are extremely simple with price being the only factor in determining the units sold. The model concentrates on movements down the demand curve to influence the total revenue estimates and gives no consideration to ‘movements in the demand curve’, i.e. the other factors apart from price that influences the amount sold. The model would have greater validity if it were to incorporate other factors such as: tastes, customer income, competitors’ prices, population size and structure, advertising etc. How would these variables be incorporated into the model? Is there appropriate quantifiable data available that is suitable for inclusion?

21 Ella

(a) Tutorial note

This part of the question is not asking for the profit maximizing price but for the initial price based on the mark up in the question.

(i) Initial selling price = (variable + fixed cost per unit) + mark up of 40%

a = [$4 + $(18,000 ÷ 3,000)] × 1.40 = $14

(ii) Profit = 3,000 units × $4 profit per unit = $12,000

(b) Profits are maximised when:

Marginal cost (MC) = Marginal revenue (MR) MC = variable cost = 4 MR = 20 – 0.004Q So profit is maximised when: 4 = 20 – 0.004Q Q = 4,000 units P = 20 – 0.002 (4,000) = $12 = profit maximising price.

(c) Tutorial note

The company now faces a limiting factor decision problem. Which product offers the best return per unit of materials used? Production of this product should be maximised

DG ($) LG ($) Sales 12 10 Variable costs 4 4 Contribution 8 6 Kg per unit 2kg 1kg Contribution per kg $4 $6 Priority 2nd 1st








Market demand Production Material usage LG 8,000 8,000 8,000 kg DG 4,000 2,000 4,000 kg –––––– Total 12,000 ––––––

(d) Penetration pricing

In penetration prices, prices are initially set at a low level to gain market share. Products make a low unit profit but this is partly compensated for by large sales volumes. Once the product has gained market share, a company may then gradually increase prices, banking on customer loyalty to prevent huge loss of sales.

Market skimming

With market skimming, sales prices start high and the quite quickly fall. Sales volumes are initially low but margins are high. Companies set an initially high price for two reasons:

To take advantage of the eagerness of some people to own the latest product

To recover development costs as quickly as possible.

Market skimming is often used in technology-based industries where technology does not remain new for long and companies have to recoup development costs quickly. Skimming is not sustainable and quite quickly prices fall and sale volumes increase.

22 Ennerdale

(a) (i) Materials

$ K: 3,000 kg at ($19,600 ÷ 2,000) × 1.05 30,870 L: 200 kg at $11 2,200 33,070

(ii) Skilled labour

$ Labour cost 800 hours at $9·50 7,600 Opportunity cost of labour 800 hours at ($40 ÷ 4) 8,000 15,600

(iii) There is no indication of relevant fixed costs so the total relevant cost of the contract is the sum of relevant labour and materials costs:

$ Labour 15,600 Materials 33,070 Total 48,670

Given that the extra cost of completing the contract in house is $48,670 the company should not be prepared to pay more than this to outsource








(b) Any variable overhead costs associated with the contract would be relevant because they would represent additional or incremental costs caused directly by the contract.

Fixed overhead costs would only be relevant if the total fixed overhead costs of the company increased as a direct consequence of the contract being undertaken. In that case the relevant amount would be the specific increase in the total fixed overhead costs caused by the acceptance of the contract. Arbitrary apportionments of existing fixed overhead costs would not be relevant. Similarly sunk and committed costs would not be relevant.

(c)

To: Senior Management Team

From: Management Accountant

Concerning: Outsourcing

Introduction

Outsourcing can have a major impact on the structure operation of a business. If successful it can enhance quality and profitability. If it fails it can threaten the existence of the business.

Relevant costing

Outsourcing decisions based on relevant costing can be misleading. If relevant fixed costs savings are included, for instance, how certain can the company be that these savings will actually arise? The absence of such savings may lock a company into higher costs than expected rendering the outsourcing uneconomic

Reversibility

If a product or service is outsourced, how easy is it for a company to reverse this process if the relationship proves unsatisfactory or the supplier goes out of business? Loss of key personnel may the most critical factor here. If it is difficult/impossible to reverse should the company undertake the outsourcing?

Impact on remaining business

Closure of a significant part of a business due to outsourcing may have an adverse effect on staff morale, particularly if significant redundancies are involved. The impact of this needs to be quantified and included in the assessment process.

Reaction of customers

Are customers likely to react adversely to an outsourcing decision? Consider, for example, the negative reaction of UK customers to the outsourcing of bank account and broadband support to Indian call centres.

Flexibility

Is the outsourcing company able to scale its production to match our needs? If our business doubles in size in 18 months will the outsource company be able to cope. Equally, what is the financial cost of this flexibility? If we don't meet forecast levels of activity are there financial penalties?

Quality

There is a danger that by focussing on costs we forget quality. What guarantees of quality do we have. Does the supplier have a track record of high quality output/service provision?








Summary

Whilst outsourcing potentially offers the company significant benefits, a wide range of criteria need to be considered. Relevant costing is a useful tool here but a range of non-financial factors should be considered.

23 Bravia

(a) Tutorial note

Since the question provides the C/S ratio and the unit contribution it is quite easy to work back to the selling price per unit.

(i) Selling price per unit = $8 ÷ 0.40 = $20

(ii) Weekly contribution = 10,000 + 22,000 = $32,000

Weekly sales = 32,000 ÷ 8 = 4,000 units

(b)

Strategy A B C Units per week 4,400 4,720 5,000

$/unit $/unit $/unit Selling price 19.60 19.00 18.60 Less: Variable cost (12.00) (12.00) (12.00)

–––––– –––––– –––––– Contribution 7.60 7.00 6.60

–––––– –––––– –––––– $ $ $

Total contribution 33,440 33,040 33,000 ––––––– ––––––– –––––––

Contribution and therefore profit is maximised when Strategy A is adopted.

(c) Tutorial note

The heart of this question is to remember that profit maximization occurs when MC = MR.

The first step is to derive the demand curve:

P = a + bQ

a = price at which demand is zero

b = slope of demand curve

Q = demand

From the question we can write:

P = $1,000 + bQ

b = Change in price / change in quantity = $800-$600 / 200 – 600 = - 0.5

P = $1,000 – 0.5Q

Profit maximisation occurs when Marginal cost (MC) = Marginal revenue (MR)

MC =MR

Marginal cost is variable cost ($300).

P = $1,000 – 0.5Q

Therefore marginal revenue MR = $1,000 – Q

Profit is maximised where:








MC = MR

$300 = $1,000 – Q

Q = 1,300 units

The company should sell 1,300 units to maximise profits.

The price to sell this volume of units is:

P = $1,000 – 0.5Q

P = $1,000 – 0.5 × 1,300

P = $650

Profit

$ Revenue ($650 × 1,300) 845,000

Cost ($300,000 + $300 × 1,300) (690,000)

Profit 155,000

(d) Market penetration

Bravia may choose to follow a market penetration strategy to gain market share. This may be to increase share in an existing market or to become established in a new market. In the short-term the company may set low prices to boost volumes and will follow a revenue maximisation strategy. Once established prices may then return towards the profit maximising level.

Premium pricing

As part of its brand development Bravia may seek to set and maintain high prices. This is deliberately to reduce demand and creative exclusivity. Though sales volumes are low, unit profits are high. Expanding sales volume by cutting price may not be an option if it is felt that increasing market share will damage the luxury image of the product. This type of strategy is long-term and prices will remain high for the foreseeable future.

24 Crusty Buns

(a) Tutorial note: This problem is best approached by constructing a payoff table.

Workings

The cost of production for each level of output:

$ 100 × $0.5 = 50 300 × $0.5 = 150 500 × $0.5 = 250 700 × $0.5 = 350

The revenue for each level of sales:

$ 100 × $0.8 = 80 300 × $0.8 = 240 500 × $0.8 = 400 700 × $0.8 = 560








The next step is to work out the profit and loss for different combinations of production and sales demand

Tutorial Note: Remember you can only sell what you have made e.g is demand if for 500 units and only 300 have been made then only three hundred can be sold.

For example, the cost of making 700 rolls is $350 (700 × $0.5). If all 700 are sold, this will give a revenue of $560 and a profit of $210. However if sales are only 100, revenue will be $80, giving a loss of $270.

A complete set of values are presented in the payoff table below.

Expected values are then calculated by multiplying the profit for each sales demand/production combination by the probability of the demand arising.

Produce 100 Produce 300 Produce 500 Produce 700

Sales Probability Profit Expected value

Profit Expected Values

Profit Expected values

Profit Expected Values

100 0.3 30 9 (70) (21) (170) (51) (270) (81)

300 0.2 30 6 90 18 (10) (2) (110) (22)

500 0.3 30 9 90 27 150 45 50 15

700 0.2 30 6 90 18 150 30 210 42

Expected value for production level

30 42 22 (46)

From these figures, it is clear that the suggestions made by both the Production Manager and Sales Manager are wrong. In this case, the highest average daily profit will be made if the company makes 300 rolls a day.

(b) The reaction of customers to a lack of supply on high demand days is not considered. On 50% of days the store will run out of inventory. If this keeps happening customers may stop coming to the shop and will find an alternative supply leading to a fall in overall demand. The negative impact of this should be considered when making the decision about how much to make.

The analysis assumes that probabilities do not change over time – expected values are long-term average values. In the event of economic growth or decline, the probability of the sales distribution may change fundamentally. During a period of economic prosperity, for instance, the probability of low demand days may fall, with a consequent rise in high demand days.

The analysis assumes that demand will be at one of 4 discrete levels i.e. 100, 300, 500 or 700. In reality demand with vary in a continuous way between 100 and 700; for example on one day demand might be 143 and on the next 203. The simplification of the sales demand figures to just four amounts could result in a misleading financial analysis and an incorrect decision.

(c) Sensitivity analysis is used to assess the sensitivity of a decision to errors or changes in the assumptions that have been made. It can be used to calculate, for each variable with an uncertain value, by how much its value would have to change before the decision would change. It is normally expressed as a percentage of the values used in the original decision. In the context of this example:








By how much have estimates of sales volumes got to change before producing 300 buns is the wrong amount?

By how much has the probability distribution got to change before producing 300 buns is the wrong amount?

The items or ‘variables’ that are the most sensitive to change are the ones that have to be monitored most closely by management.

Sensitivity analysis has two major drawbacks.

It tends to consider changes in only one variable at a time. In reality several variables can change at the same time, which will change the nature of the analysis and the conclusions drawn from it.

Sensitivity analysis does not indicate how likely a change is to occur. All it does is indicate the size of change required to change a decision. There is an implicit assumption that smaller changes are more likely to occur though this may not always be true.

25 Albion

(a) Tutorial note

Though this question looks complex due to the volume of information, it is actually relatively straightforward. At its heart this is a limiting factor question. What production mix maximises return on material R2? Work out the contribution per unit of R2 used for each of the products – these figures are then used to prioritise production.

AR2 GL3 HT4 $ per

unit $ per

unit $ per unit

Material R2 2.5 × 2 5.00 2.5 × 3 7.50 2.5 × 3 7.50 Material R3 2 × 2 4.00 2 × 2.2 4.40 2 × 1.6 3.20 Labour 4 × 0.6 2.40 4 × 1.2 4.80 4 × 1.5 6.00 Variable overhead 1.10 1.30 1.10 Variable costs 12.50 18.00 17.80 Selling price 21.00 28.50 27.30 Contribution 8.50 10.50 9.50

R (kg per unit) 2 3 3 Contribution per kg $4.25 $3.50 $3.17 Ranking 1 2 3

Demand R2 used Production Contribution units kg units $ Product 950 1,900 950 8,075 AR2 1,000 3,000 1,000 10,500 GL3 900 600 200 1,900 HT4 5,500 20,475

The optimum production schedule is 950 units of Product AR2, 1,000 units of GL3 and 200 units of HT4, giving a total contribution of $20,475.








Tutorial note:

The fixed production overheads are ignored in this analysis because they are assumed not to vary with changes in the level of production.

(b) Further supplies of Material R2 will be used to produce additional units of Product HT4. The contribution per kg of Material R2 of Product HT4 is $3.17 and so if Albion pays 3.17 + 2.50 = $5.67 per kg for Material R2, the additional units of Product HT4 produced will make a zero contribution towards fixed costs. $5.67 is therefore the maximum price.

(c) Tutorial note

Any decision cannot just involve comparison of variable costs as there is an incremental cost of $50,000 to be accounted for.

Strong answers will also distinguish between short and long-term decision-making, together with considering non-financial criteria.

The variable cost of Product XY5:

$/unit Material R3: 3 × 2 = 6.00 Labour: 1.7 × 4 = 6.80 Variable overhead: 1.40 14.20

The substitute offered by Folam gives a saving of $4 per unit. However, Albion would also pay an annual fee of $50,000 for the right to use the substitute.

The company would need to manufacture more than $50,000/$4 = 12,500 units per year of Product XY5, or 1,042 units per month, in order for the offered substitute to be financially acceptable.

If it needed less than 12,500 units of Product XY5 per year, it would be cheaper to manufacture the product internally.

This evaluation is from a short-term perspective: in the longer term, buying in may lead to fixed cost savings and lower investment, increasing the benefits of buying in and lowering the break-even point.

Albion would also need to assure itself that the quality of the substitute was acceptable and that this quality could be maintained: the lower price offered by Folam might be associated with poorer quality than the minimum standard of quality considered necessary by Albion. Orders for the substitute product would also need to be delivered promptly in order to avoid production hold-ups.

Albion could also become dependent on Folam for supplies of the substitute product and might be vulnerable to future price increases by the supplier. Such price increases might reduce or even eliminate the cost saving of buying in.

(d) Marginal costing (variable costing) treats fixed costs as a period cost, on the assumption that fixed costs do not change in the short term. The difference between selling price and variable costs is the variable contribution made by units sold towards meeting fixed costs and generating profit.

Marginal costing has traditionally been used for short-term decisions such as whether to cease production of a product, whether to make a product or buy it from a supplier, and how to allocate scarce resources in order to maximise contribution.








A major limitation with using marginal costing as the basis for making short-term decisions is the assumption that fixed costs are irrelevant to short-term decisions. In the longer term, fixed costs will change: for example, rent is usually regarded as a fixed cost and in the longer term rent might be expected to increase due to inflation. However, a change in fixed costs may be the result of a short-term decision: for example, if a product is discontinued and as a result the work of the marketing department decreases, in the longer term marketing costs would be expected to decrease.

This points to the danger of relying on a simplistic analysis of costs into fixed costs and variable costs, and of assuming that only variable costs are relevant for decision-making purposes. It is possible for a fixed cost to be a relevant cost. It is also possible for a variable cost to be irrelevant, for example in the case where a variable cost is common to two decision alternatives. If fuel costs are incurred whether a machine is leased or bought, for example, these costs are not relevant to the decision on whether to lease or buy.

Reliance on marginal costing as a basis for making short-term decisions may therefore lead to sub-optimal decisions overall for a company, as the analysis may fail to consider all relevant costs.

26 Sniff Co

(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 revenue is clearly relevant to the decision.

– Incremental costs. A decision to further process can involve more materials and labour. Care must be taken to only include those costs that change as a result of the decision and therefore sunk costs should be ignored. Sunk costs would include, for example, fixed overheads that would already be incurred by the business before the further process decision was 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 the existing product. If the further processing changes the existing product too much there could be an impact on sales and loyalty.

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

– 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 180,000 Diluted alcohol 990 ltrs x $20/ltr 19,800 ––––––––








Material cost 199,800 Labour 2,000 hrs x $15/hr 30,000 –––––––– Total 229,800 –––––––– Cost per litre 229·80 Sales 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 96,000 Supervisor Sunk cost 0 Sunk cost 0 Labour 500 hrs x $100/hr 50,000 700 hrs x $100/hr 70,000 Fixed cost Sunk cost 0 Sunk cost 0 Market 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 $399·80 319,840 Hormone 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 take the risk of damaging the brand and the reputation of the business. To put this figure into context: the normal output generates a 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).

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








r$601.29/ltltrs 808$319,840) ($166,000

=+

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 of this 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 has a 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 change at all given the product is branded. Equally Sniff should be concerned about the health and safety of its customers since its 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 remain so 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 it removes Sniff’s reason for existence. It is more common to outsource a secondary function, like payroll processing for example.

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

27 Higgins Co

(a) Contribution per cue

Pool cue Snooker cue $ $ Selling price 41.00 69.00 Material 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 ≤ 12,000 Ash: 0·27P + 0·27S ≤ 5,400








Demand levels – Pool cues P ≤ 15,000

– Snooker cues S ≤ 12,000

Non 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 skilled labour 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) = 12,000

0·5P + 9,000 = 12,000

0·5P = 12,000 – 9,000

0·5P = 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 three month period.

The contribution earned is

C = (20 x 6,000) + (40 x 12,000)

C = 120,000 + 480,000

C = $600,000








Production schedule

E0

2

4

6

8

10

12

14

16

18

20

22

24

2 4 6 8 10 12 14 16 18 20 S

A

Ash

F

D

C

B

P

Craftsmen

Optimal point at point DFeasible region = OABCDE

contribution

Max contribution

Max S

Max P

(c) Shadow prices

A shadow price is the value assigned to changes in the quantity of a scarce resource available, normally measured in terms of contribution. If more critical scarce resource becomes available then the feasible region would tend to expand and this means that the optimal point would tend to move outward away from the origin thus earning more contribution. It is this increase 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 scarce resource. It represents the maximum they should be willing to pay for more scarce resource over and above the normal price subject 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 therefore no 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 the optimal point would move outward thus earning more contribution. Assuming that just one more hour becomes available it is 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)

Substituting S = 12,000 in equation (4)

0·5P + 0·75(12,000) = 12,001

0·5P + 9,000 = 12,001

0·5P = 3,001

P = 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 Higgins Co. 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 to negotiate on this point. Higgins takes the commercial risks in this business and would therefore be justified in keeping the majority of the rewards that come with it. Equally it is a dangerous precedent to accept the first offer and pay such a high rate for overtime, Higgins would have to ask itself what would happen next time an overtime situation arose. It is also possible that 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, changing the shape of the feasible region.








Once the craftsmen line reaches point F (see diagram) then there would be little point buying any 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) Substituting S = 12,000 in equation (6)

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

0·27P = 2,160 P = 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 constraint formula.

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

Craftsmen hours =13,000 hours

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. If more 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 full day. Tired people often produce sub-standard work. If quality is important then this could damage the reputation of the business.

Any other feasible points would be accepted

28 Shifters Haulage

(a) Maximax stands for maximising the maximum return an investor might expect. An investor that subscribes to the maximax philosophy would generally select the strategy that could give him the best possible return. He will ignore all other possible returns 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 the potential minimum returns and seek to select the strategy that will give the best worst case result. This type of investor could be 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 the return 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 repeated again 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 Van Capacity 100 150 200 Low Demand (120) 300 w1 468 w3 368 w5 High Demand (190) 300 w2 500 w4 816 w6 Workings

W1 W2 W3 W4 W5 W6 Sales 1,000 1,000 1,200 1,500 1,200 1,900 VC (400) (400) (480) (600) (480) (760) Goodwill (100) (100) (100) VC adjustment 48 48 76 Depreciation (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 suggest that 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 the worst possible result is $468, which is better than the other options. We are also told that the business managers are becoming more cautious and so a maximin criterion may be preferred by them.

Expected values could be calculated thus:

Small van $300

Medium van ($468 x 0·4) + ($500 x 0·6) = $487

Large 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-off decision – 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 would seem 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 consuming and expensive. The internet is bringing down the cost and speeding up this type of research, email is being used to gather 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 returns an investor could expect from








a given decision without having risked any actual cash. The models use random number tables to generate possible values for the uncertainty the business is subject to. Again, computer technology is assisting in 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. Sensitivity calculates the % change required in individual values before a change of decision results. If only a (say) 2% change is required in selling price before losses result an investor may think twice before proceeding. Risk is therefore better understood.

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

29 Bits and Pieces

(a) The decision to open on Sundays is to be based on incremental revenue and incremental costs:

Ref $ $ Incremental revenue W1 800,000 Incremental 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 financially justifiable.

(W1) Incremental revenue

Day Sales Gross Gross Cost of profit profit Sales

$ % $ $

Average 10,000 70%

Sunday (+60% of average) 16,000 50% 8,000 8,000

Annually (50 days) 800,000 400,000 400,000

Current results (300 days) 3,000,000 70·0% 2,100,000








New results 3,800,000 65·8% 2,500,000

(W2) Purchasing and discount on purchasing

Extra 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 costs

Staff costs on a Sunday are 5 staff x 6 hours x $20 per hour x 1·5 = $900 per day

Annual cost is $900 x 50 days = $45,000

(W4) Lighting costs

Lighting costs are 6 hours x $30 per hour x 50 days = $9,000

(W5) Heating costs

Heating cost in winter is 8 hours x $45 per hour x 25 days = $9,000

(W6) Manager’s bonus

This 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 off

This appears far from generous. The other staff are being paid time and a half and yet the manager does not appear to have this option and also is only being given time off in lieu (TOIL) at normal rates. Some managers may want their time back as TOIL so as to spend time with family or social friends; others may want the cash to spend. One would have thought some flexibility would have been sensible if the manager is to be motivated properly.

Bonus

The bonus can be calculated at $8,000 per annum (W6); on a day worked basis, this is $160 per day. This is less than that being 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 enough to keep the presumably better qualified manager happy. Indeed the bonus is dependent on the level of new sales and so there is 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 average daily 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&P has 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.








Complaints: Customers that have already bought an item on another day might complain when they see the same product on sale for much less when they come back in for something else on a Sunday. Businesses need to be strong in this regard in that they have to retain control over their pricing policy. Studies have shown that only a small proportion of people will actually complain in this situation. More might not, though, be caught out twice and hence will change the timing of purchases (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.

30 Stay Clean

(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 48,000 Lost contribution from other products Note 3 (118,500) Redundancy and recruitment costs Note 4 (3,700) Supplier payments saved Note 5 88,500 Sublet income 12,000 Supervisor 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 costs are dealt with separately below)

Note 4: If TD is ceased now, then:

Redundancy cost ($6,000) Retraining saved $3,500 Recruitment cost ($1,200) –––––––– Total cost ($3,700)

Note 5. Supplier payments:

DW ($) WM ($) TD ($) Net cost Discount Gross ($) level cost

($) Current buying cost 350,000 600,000 60,000 1,010,000 5% 1,063,158 Loss 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% 950,000 Difference 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 12,000 Lost contribution – other products Note 8 (71,000) Redundancy and recruitment Note 4 above (3,700) Lost discount Note 9 (19,000) Sublet income 12,000 Supervisor 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 gross

Current buying cost 350,000 600,000 60,000 1,010,000 5% 1,063,158

Saved cost (17,500) (30,000) (60,000)

New buying cost 332,500 (570,000) 0 902,500 5% 950,000

921,500 3% 950,000

Lost discount (19,000)

(b) Complementary pricing

Since the washing machine and the tumble dryer are products that tend to be used together, Stay Clean could link their sales with 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).

Product line pricing

All the products tend to be related to each other and used in the utility room or kitchen. Some sales will involve all three products if customers are upgrading their utility room or kitchen for example. A package price could be offered and as long as 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 the same 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 be disappointed. 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 expense of 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. Having contracted with an outsourcer this may be more difficult or involve penalties.

Budgeting

31 Flexico

(a) Tutorial note

The key to successful flexible budgeting is establishing the type of cost behaviour displayed by each cost.

Direct materials: Variable cost: unit cost ($2.00) remains the same at all levels of production

Direct labour: Variable cost: unit cost ($4.00) remains the same at all levels of production

Production overheads: Semi variable costs - Total costs increase with activity but the average cost per unit falls.

Using the high-low method

$38,000 – $34,000 / 4,500 – 3,500 = $4 per unit

Fixed cost: $34,000 – (3,500 × $4) = $20,000

Total cost = $4x + $20,000

Administration overheads: Fixed cost as total cost does not change with activity.

Using this information a flex budget for 2,500 units can be constructed.

$ Direct materials 5,000 Direct labour 20,000 Production overheads 30,000 Administration, selling and distribution overheads 15,000 Total cost 70,000

(b) Budgetary control statement 2,500 units

Flexico

Budget for 2,500 units

Actual Variance

$ $ $

Direct materials 5,000 4,500 500 (F)








Direct labour 20,000 22,000 2,000(A)

Production overheads 30,000 28,000 2,000 (F)

Administration, selling and distribution overheads 15,000 16,500 1,500 (A)

Total cost 70,000 71,000 1,000 (A)

Overall company sales are well below capacity (50% of maximum output). This is clearly a cause for concern and needs investigating.

Are market conditions generally poor?

Are we facing stiff competition?

Are our products appropriately priced?

Is our marketing effective?

Flexing the budget identifies some further areas of concern but also some areas of more positive performance.

Materials cost

Materials cost is lower per unit of product than expected. Whilst this has a positive impact on unit cost, there are concerns over quality. Are we using cheaper materials and/or using less per unit of product?

Labour costs

These are significantly higher than expected. However, given that we only have a total cost variance, it is difficult to know whether this is caused by a higher rate of pay per hour or by inefficient working (or a combination of the two). However, given the size of the variance it is certainly worth investigating further.

Production overheads

Production overheads were significantly lower than expected. This has a positive impact on costs and the cause should be investigated. The overhead figure is likely to be made up from a number of separate costs, each of which could be greater or smaller than expected.

Administration overheads

These are higher that expected and should be investigated. This is fixed cost, so it is clear that original estimates were inaccurate. This may be because administration salaries were higher than expected and/or rent and rates for offices were higher than allowed for.

(c) Rolling budgets

Rolling budgets involve preparing a new budget at regular intervals, not just once each year. Typically, a new annual budget is prepared every three months. As one quarter is completed a new quarter is added to the end of a new annual budget.

Later quarters in the budget typically have less detail than earlier periods of the budget. As the first quarter is completed this information is used to flesh out and update later quarters. In this way the budget remains up-to date and as realistic as possible.

Rolling budgets are particularly useful in dynamic and uncertain business environments. In fashion, for instance, it can be hard to forecast sales for clothing ranges with any accuracy.








Updating and rolling the budget forward can mean that budgets remain more meaningful and remain in touch with reality.

For staff it also means that performance targets are up-dated with market conditions and are therefore more achievable.

From a management perspective a rolling budget means that staff have a constant planning window which encourages staff to keep looking ahead.

It does not break up business into artificial and fixed time periods. Business is an on-going process and the imposition of fixed timescale budgets can encourage managers to lose sight of this and not plan for activities that cross budget boundaries.

Rolling budgets do, however, have a number of disadvantages:

It is time-consuming. Managers can feel that all they do is budget with less time for activities to actually reach targets.

Rolling budgets create uncertainty. Staff may feel that the 'rules of the game' keep changing and that targets are constantly changing.

Staff can feel they are the victims of their own success. If a company experiences a good quarter, future targets will be revised upwards making it harder for staff to earn performance bonuses. Staff will certainly view this as being penalised for success.

Budget revision can be used as alternative to managerial discipline. Instead of striving to reach demanding targets, managers may decide to revise a budget downwards to boost apparent performance.

32 Titfer Co

(a) The following comments are relevant to budget revisions that would produce both favourable and adverse planning variances, although in practice requests for budget revisions are more likely to occur when the planning variance will be adverse (because operational variances would be improved).

Budgeting and budgetary control provide a system for monitoring operational performance. It is therefore important that actual performance should be compared with a realistic budget. At the same time, however, revisions to the budget should not be permitted when they would disguise poor operational performance.

The general rule should be as follows.

(1) Budget revisions should be permitted when they are caused by a circumstance beyond the control of operational management, so that the original budget is no longer a fair basis for judging operational performance. All revisions to the budget, however, must be approved at senior management level, perhaps at board of director level.

(2) Budget revisions should not be permitted when they are caused by circumstances within the control of operational management

In practice, however, it might not be clear whether changes in circumstances are due to factors inside or outside the control of operational management, and each request for a budget revision should be judged on the facts of the case.

(b) Situation 1








Argument in favour of a budget revision

The board approved the request for a change in recruitment policy. It might therefore be argued that the change in policy is outside the influence of operational management in the sales and marketing department.

Arguments against a budget revision

The board approved a request from the departmental manager. The problem with the existing staff in the department was an operational matter, within the control of the departmental managers. The increase in the departmental labour costs is therefore due to operational factors for which management should be held responsible in performance reports.

If there is any improvement in the efficiency and effectiveness of the department as a result of the new recruitment policy, the departmental management will receive the credit in the departmental performance (variance) reports. It is inappropriate to allow a budget revision for one aspect of a policy change (higher staff costs) and at the same time give management credit for other aspects of the policy change (improving efficiency and/or effectiveness).

Situation 2

Argument in favour of a budget revision

The insolvency of the original cloth supplier was outside the control of the purchasing department.

The buying department could argue that they did what they could under the circumstances to maintain supplies of cloth to the company, and it is unreasonable to ‘blame’ the department for adverse price variances in the three-month period.

The department was aware that the short-term solution was not adequate for the longer term, and after further searching a cheaper source of supply was found. It may therefore be argued that the performance of the buying department should be commended and not ‘criticised’ with an adverse price variance.

Arguments against a budget revision

The management of any department need to be fully aware if the risks that they face, including the risks of insolvency of a major supplier. Contingency plans should have been in place to respond to the insolvency of the original supplier, and an alternative cheap supplier should already have been identified.

The first supplier who was found charged high prices and delivery costs, but there was little or no negotiation by the buyer of Titfer. It is the job of a buyer to negotiate on price, if possible, whatever the circumstances. In this case the buyer did not perform his task as well as he might have done.

Recommendations

There are arguments both in favour and against a budget revision in each situation. My own view is that in each case, the longer-term planning of the department was at fault in both cases. The sales and marketing department was inadequately staffed and the buying department had no contingency plans for using an alternative supplier

I would therefore recommend in each case that the request for a budget revision should be refused.

(c)








$

10,900 units should sell for (× $225) 2,452,500

They did sell for (× $200) 2,180,000

Sales price variance (× $225 - $200) 272,500 (A)

units

Budgeted sales volume 11,200

Actual sales volume 10,900

Sales volume variance in units 300 (A)

Budgeted contribution per unit $125

Sales volume (contribution) variance $37,500 (A)

(d)

units

Budgeted sales volume 11,200

Expected market share of actual market size

(10% of 100,000) 10,000

Market size variance in units 1,200 (A)


Market size variance $150,000 (A)

units

Expected market share of actual market size

(10% of 100,000) 10,000

Actual market share 10,900

Market share variance in units 900 (F)


Market share variance $112,500 (F)

(e) The analysis of the sales volume variance shows that there has been a fall in sales volume due to a fall in the total market share, and if Titfer Co had maintained its market share the decline in the size of the market would have caused a fall in contribution and profit of $150,000. This is the market size variance.

However the company was able to gain a larger share of the market than expected, which had the effect of boosting contribution and profit by $112,500, in spite of the decline in market size. This is the market share variance.

The net effect was an adverse overall sales volume variance of $37,500.








33 Storrs

(a) Tutorial note

Being provided with moving average totals speeds up the process of forecasting considerably.

In order to make the forecast the first step is to calculate seasonal variations (actual – trend). These can then be averaged to work out seasonal factors for each quarter.

The slope of the trend (moving average) line also ha to be forecast.

Using these data it is then possible to make forecasts.

Remember the question asks for the additive model (Y=T+S) not the multiplicative model Y =TxS. If you use the wrong model both working and right answer mars will be lost.

Quarter Actual sales (Y)

Centred moving average (T)

Seasonal variation (Y-T)

Year 5 $000 $000 $000

Q3 3,400 3,200 200

Q4 3,000 3,300 (300)

Year 6

Q1 3,100 3,375 (275)

Q2 3,900 3,450 450

Q3 3,600 3,562.5 37.5

Q4 3,400 3,687.5 (287.5)

To make a forecast the slope of the trend (moving average) line has to be calculated.

(3,687·5 – 3,200)/5 = $97,500 increase per quarter

The average seasonal variations and the residual error term can now be calculated.

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total

$000 $000 $000 $000 $000

Year 5 200 (300)

Year 6 (275) 450 37.5 (287.5)

Average (275) 450 118.75 (293.75) nil

Making forecasts is now a two-step process:

Predict the trend line (moving average line).

Adjust the trend line using the appropriate seasonal factor.

The sales forecast for Quarter 3 of Year 7:

Forecast centred moving average = 3,687.5 + (3 × 97.5) = $3,980,000

Forecast sales for Quarter 3 = 3,980,000 + 118,750 = $4,098,750

The sales forecast for Quarter 4 of Year 7:








Forecast centred moving average = 3,687.5 + (4 × 97.5) = $4,077,500

Forecast sales for Quarter 4 = 4,077,500 – 293,750 = $3,783,750

Both forecasts are higher than those made by the Sales Director (7.9% more for the Quarter 3 forecast and 5.1% for the Quarter 4 forecast). This may be because the Sales Director built some slack into his forecasts, or because the forecasts were made using data prior to the current year (although applying the additive model to earlier sales data does not support this).

(b) Independence of trend and seasonal factors

The additive model assumes that the trend and seasonal variations are independent of each other, and that an increasing trend is not linked to increasing seasonal variations. There is no evidence of an increasing seasonality in the sales of Storrs, and in such circumstances use of the additive model may be acceptable.

Stable trend and seasonality

The model assumes that the historical pattern of the trend and the seasonal variations will continue in the future. This may not happen for a number of reasons, for example because of the occurrence of unexpected events or because of changes in consumer preferences. The forecast sales figures should be compared with the expectations and opinions of sales staff, who may have a more detailed knowledge of likely sales and market factors.

Quantity and accuracy of data

The reliability of the forecasting method is linked to the amount and accuracy of the data analysed. Since only two years of data has been considered, the forecast is unlikely to be reliable. The reliability of the forecast will also decrease as the forecasting period increases, but the forecast period here is only six months.

(c) Top-down approach: advantages

The top-down approach to budget setting implies that budgets are imposed by senior management. This has the advantage that budgets are more likely to support the strategic objectives of the company, and the operations of different divisions are more likely to be co-ordinated. It may be an appropriate form of budget setting in small organisations, where senior managers are likely to have a detailed knowledge of all aspects of the business, or in situations where close control of planned costs is called for, such as business start up or difficult economic conditions. It also has the advantage of decreasing the amount of time taken, and the resources consumed, by budget preparation.

Top-down approach: disadvantages

There are number of difficulties with the top-down approach that make it likely that it will not regularly be used in isolation. Staff may be demotivated if they have not been involved in the formulation of budgets that produce targets they are expected to achieve, especially if their rewards and incentives are linked to their performance against budget. This reduction in motivation could result in strategic objectives and organisational goals being less than fully supported at the operational level, with company performance and profitability suffering as a result. Initiative and innovation could also be lost as staff simply ‘work to budget’, rather than making creative suggestions for improving performance that they feel are unlikely to be rewarded, or form part of future plans.








Bottom up approach: advantages

The bottom-up approach to budget setting implies that functional and other junior managers participate in the preparation of budgets. This approach is likely to lead to more realistic and more co-ordinated budgets than the top-down approach if these managers have a more detailed knowledge of the operations and markets of the organisation. It is also likely to be useful in large, established companies where the complexity of the budget-setting process calls for detailed input from lower levels of the organisation. This approach will also lead to higher levels of motivation and commitment, since managers will have contributed towards the targets against which their performance will be measured.

Bottom up approach: disadvantages

There are a number of difficulties with the bottom-up approach. For example, it can be more time-consuming than the top-down approach because of the larger number of participants in the budget-setting process. Participants may become dissatisfied if their budget proposals are subsequently amended by senior managers. Managers may introduce an element of budgetary slack into their budget estimates, giving them a ‘zone of comfort’ in reaching budget targets. Any variances between planned and actual performance are then likely to be favourable ones. The bottom-up approach also requires detailed planning and co-ordination of the budget-setting process, perhaps supported by a budget manual. The top-down and bottom-up approaches represent two extremes of the budget-setting process. In practice, a compromise or negotiated approach is likely to be used, with senior management reviewing and amending the budget proposals of junior or operational managers in the light of the organisation’s strategic plan, and junior or operational managers negotiating amendments to aspects of the budget they find unacceptable.

34 Stem Company

(a) Factors that should be considered

(1) Other costs for the contract, in addition to skilled labour costs and overhead costs. For example, there may be some materials costs, and other direct costs for the work not included in the estimates of total overheads.

(2) Since the contract would use up the available time of all the skilled labour work force, SC will be unable to do work for other customers during that time. There may consequently be opportunity costs of contribution of profit forgone, by taking on the contract and turning away other work from other customers.

(3) The bid price for the contract is likely to be a cost plus-based price. If so, SC must decide on an appropriate size of profit margin to add on to the cost.

(4) This is a new customer, who may be an important customer for the type of service that SC provides. SC may decide to offer an attractive low price for this contract in the hope of becoming a regular supplier to the customer and winning more contract work in the future.

(5) The reliability of the estimate of a 95% learning rate. The learning curve effect has a significant effect on the expected costs of labour and overheads. If this learning rate is not achieved, costs could be much higher. SC may








therefore wish to include an amount for this possibility - a ‘contingency’ – in the price that it bids.

Other factors that could be suggested are:

(6) Prices for similar work that competitors are charging. Rival bidders may put in a lower bid and win the contract.

(7) The timing of payments for the construction work. If the customer will make payments after much of the work is done, SC may wish to include an interest charge in the costs.

(b) Overhead costs estimate: high-low method:

$ per month

Total overhead cost of 10,900 hours 103,600


Variable overhead cost of 500 hours 2,000

The variable overhead cost is $2,000/500 hours = $4 per labour hour.

$ per month


Variable overhead cost of 10,900 hours (× $4) 43,600

Fixed overhead cost per month 60,000

Annual fixed overhead costs: $60,000 × 12 months = $720,000.

Fixed overhead absorption rate = $720,000/120,000 hours per year = $6 per hour.

Overhead costs will therefore be charged to the contract at the rate of $10 per hour ($4 per hour for variable overheads and $6 per hour for fixed overheads.)

Labour and overhead cost of 1st unit $

Labour (25 hours × $20) 500

Overhead (25 hours × $10) 250

Fixed overhead cost per month 750

Cumulative average labour and overhead cost of first 300 units

= $750 × 1/3000.074

= $750 × 0.65568 = $491.76

Cumulative average cost of first 299 units

= $750 × 1/2990.074

= $750 × 0.65584 = $491.88

Labour and overhead costs $

First 300 units: 300 × $491.76 147,528

First 299 units: 299 × $491.88 147,072

Labour and overhead cost of 300th unit 456








Labour and overhead costs for 500 units $

First 300 units: see table above 147,528

Next 200 units: 200 × $456 91,200

Total labour and overhead costs 238,728

(c)

hours

Total time for first 2 units (25 + 22.5) 47.50

Cumulative average time for first 2 units 23.75

Tine for first unit 25.00

Time for first 2/Time for unit 1 = 23.75/25 = 0.95

The learning rate is calculated by comparing the cumulative average time per unit with the cumulative average time when total activity has doubled. Here, the average time per unit for the first two units is 95% of the time for the first unit; therefore a 95% learning rate applies.

35 Velo Racers

(a) Learning curve theory is concerned with the idea that when a new job, process or activity commences for the first time it is likely that the workforce involved will not achieve maximum efficiency immediately.

Repetition of the task is likely to make the people more confident and knowledgeable and will eventually result in a more efficient and rapid operation. Eventually the learning process will stop after continually repeating the job.

As a consequence the time to complete a task will initially decline and then stabilise once efficient working is achieved.

The cumulative average time per unit is assumed to decrease by a constant percentage every time that output doubles. This constant percentage is known as the learning rate.

Cumulative average time refers to the average time per unit for all units produced so far, from and including the first one made.

The learning curve is thought to apply most in repetitive manufacturing environments and some of the early work on this concept was completed in the aviation industry.

(b) Tutorial note

In order to complete the different quotations the learning curve has to be applied to work out time taken and from this wages cost.








Learning curve

Number of bikes

Cumulative average time

(hours)

Total time to date (hrs)

Incremental time for

additional bike

1 50 50 50 2 (× 0.8) 40 (× 2) 80 (80 – 50) 30 4 (× 0.8) 32 (× 4) 128 (128 – 80) 48 8 (× 0.8) 25.6 (× 8) 204.8 (204.8 – 128) 76.8

Quotation 1 $ Quotation 2 $

Materials 1,000.0 Materials 2,000

Labour (30 × 10) 300.0 Labour (48 × 10) 480

Overheads 600.0 Overheads 960

Total cost 1,900.0 Total cost 3,440

Profit (20%) 380.0 Profit (20%) 688

Selling price 2,280.0 Selling price 4,128

$4,128 / 2 = $2,064 per bike

Quotation 3 $

Materials 8,000.0

Labour (204.8 × 10)

2,048.0

Overheads 4,096.0

Total cost 14,144.0

Profit (20%) 2,828.8

Selling price 16,972.8

$16,972.8/8 =$2,121.6 per bike

(c) Areas of consequence:

A standard costing system would need to set standard labour times after the learning curve had reached a plateau.

A budget will need to incorporate a learning cost factor until the plateau is reached.

A budgetary control system incorporating labour variances will have to make allowances for the anticipated time changes.

Identification of the learning curve will permit the company to better plan its marketing, work scheduling, recruitment and material acquisition activities.

The decline in labour costs will have to be considered when estimating the overhead apportionment rate.

As the employees gain experience they are more likely to reduce material wastage.








Limitations:

The stable conditions necessary for the learning curve to take place may not be present – unplanned changes in production techniques or labour turnover will cause problems and affect the learning rate.

The employees need to be motivated, agree to the plan and keep to the learning schedule – these assumptions may not hold.

Accurate and appropriate learning curve data may be difficult to estimate.

Inaccuracy in estimating the initial labour requirement for the first unit.

Inaccuracy in estimating the output required before reaching a ‘steady state’ time rate.

It assumes a constant rate learning factor.

36 Experience

(a) The learning curve can be expressed as:

y = axb

where:

y = cumulative average time to produce x units

x = cumulative number of units made

a = time taken for the first unit.

b = exponent dependent on the learning curve percentage.

b is calculated as: 2 of Log

ratetimprovemencurvelearningof Log

For a learning curve of 80% exists b would be calcuated as: 2 of Log

0.8 of Log = 0.322

The learning curve would become:

y = 200x-0.322

(b) Tutorial note

The first step here is to calculate the average number of hours for each level of production. This is important as it determines the cost of labour and the amount of overhead absorbed.

y = 200x-0.322

Cumulative units made

Calculation Average time per unit (to nearest

hour)

1 200

2 y = 200 × 2 – 0.322 160

8 y = 200 × 8 – 0.322 102

32 y = 200 × 32 – 0.322 65

64 y = 200 × 64 – 0.322 52








The next step is to use these average time figures to compute costs:

2 units 8 units 32 units 64 units $ 3 $ $ Materials 1,000 1,000 1,000 1,000 Labour (160hrs, 102hrs, 65hrs, 52hrs)

2,400 1,530 975 780

Overhead (160hrs, 102hrs, 65hrs, 52hrs)

3,200 2,040 1,300 1,040

Total 6,600 4,570 3,275 2,820

(c) The learning curve is an important concept as it can have a very marked impact on budgeted cost. This in turn feeds through into pricing and profitability. The cost estimate for the first unit given in the question was $8,000. By the time the company gets to the 64 units the learning curve effect has reduced this to $2,820.

The impact on pricing strategy is significant. If a company is confident a learning curve applies it can price early units at below cost in the knowledge that as volumes increase costs will decline leading to profit generation.

The learning curve also affects the output capacity of the business. As the time taken to make a unit declines, and assuming the absence of other limiting factors, the level of output from a business will increase.

Two important issues arise here:

What is the rate of learning?

At what point does learning stop?

The rate of learning is important as it determines how quickly costs will decline. Equally, the learning process cannot continue forever. There must come a point at which learning ceases to operate and the time taken to make a unit stabilises. Identification of this point is crucial in pricing and profitability calculations.

(d) Tutorial note

The first step is to re-calculate the learning curve and from this the average number of hours for 64 units.

For a learning curve of 80% exists b would be calcuated as:

2 of Log0.7 of Log

= 0.515

The learning curve would become:

y = 200x-0.515

Average hours for 64 units now becomes:

y = 200 × 64-0.515

y = 23.49 hrs

64 units $ Materials 1,000 Labour (23.49hrs) 235 Overhead (23.49hrs) 352 Total 1,587








Accelerating the learning curve gives a cost saving of $2,820 - $1,587 = $1,233 per unit.

Given that this is at a level of 64 units, the maximum the company should pay for the training is (64 × $1,233) = $78,912.

37 NN Company

(a) During recent years the management of NN Company has used the traditional approach of incremental budgeting. This approach involves the use of the previous year’s budget as a basis and adds or subtracts amounts to/ from that budget in order to reflect assumptions for the next (budget) year. This approach can lead to inefficiencies, because inefficiencies in the current year are rolled forward into the budget for next year.

Considerations

The implementation of a system of zero-based budgeting will require a consideration of the following:

The need for major input by management. Senior management will have to be committed – and seen to be committed – to introducing the new budgeting system

The fact that it will prove extremely time-consuming to devise and implement a ZBB system where none has existed before.

The need for a very high level of detail in data capture and processing

The fact that it might be seen as a threat by staff.

Zero-based budgeting was developed to overcome the shortcomings of incremental budgeting. The implementation of a zero-based budgeting would require each manager within NN to effectively start with a blank sheet of paper and a budget allowance of zero. The managers would be required to defend their budget levels at the beginning of each and every year. Thus, past budget decisions would as part of the process of zero-based budgeting need to be re-evaluated each year. The comprehensive resource cost-analysis process is a strong internal planning characteristic of zero-based budgeting. It follows that resource requirements are more likely to be adjusted to changing business conditions.

A zero-based budgeting decision unit is an operating division for which decision packages are to be developed and analysed. It can also be described as a cost or a budget centre. Thus the manager responsible for each cost centre within NN would be responsible for developing a description of each programme to be operated in the next budget year. In the context of zero-based budgeting such programs are referred to as decision packages, and each decision package usually will have three or more alternative ways of achieving the objectives of the decision package.

Briefly, each decision package alternative must contain, as a minimum, goals and/or objectives, activities, resources and their associated costs.

Each decision package should contain a description of how it will contribute to the attainment of the mission and goals of the organisation.

Each manager within NN will be required to review each decision package and its alternatives in order to be able to assess and justify its operation and in doing








so, several questions must be answered. In particular, each manager will need to answer the following questions:

Does this decision package support and contribute to the goals of the organisation?

What would be the result to the organisation if the decision package were to be eliminated?

Can the objectives of this decision package be accomplished more effectively and/or efficiently?

The ranking process, based upon cost/benefit analysis is used to establish a prioritised ranking of decision packages within the organisation. During the ranking process managers and their staff will analyse each of the several decision package alternatives. The analysis allows the manager to select the one alternative that has the greatest potential for achieving the objective(s) of the decision package. Ranking is a way of evaluating all decision packages in relation to each other.

The ranking process could prove to be problematic insofar as it will require our managers to make value judgements and thus subjectivity is an inherent factor in the application of zero-based budgeting. Although difficult, the ranking of decision packages is fundamental to the process of zero-based budgeting.

Following a review and analysis of all decision packages, managers will determine the level of resources to be allocated to each decision package. Once the company’s budget has been approved, managers of the decision units will put into operation all approved decision packages during the budget year.

The last major process of zero-based budgeting is monitoring and evaluation. The monitoring and evaluation process of zero-based budgeting requires a number of features are incorporated in the overall design and implementation of decision packages.

It is essential that all decision packages include measurable performance objectives and identifies the appropriate activities as means for achieving the performance objectives.

The required resources for conducting the activities, together with the planned methods for carrying out the activities should also be included.

The decision package should also include a mechanism to evaluate whether an objective is being achieved both during and after the conclusion of the program of activities for subsequent reporting to management.

(b) The implementation of zero-based budgeting will require a major planning effort. It is through the planning process that important guidelines and directions are provided for the development and ranking of the decision packages. Also, the planning process will enable managers to prepare for the uncertainty of the future. Long-range planning allows managers to consider the potential consequences of current decisions over an extended timeframe.

Zero-based budgeting addresses and supports comprehensive planning, shared decision-making, the development and application of strategies and allocation of resources as a way of achieving established goals and objectives. In addition, zero-based budgeting supports the added processes of monitoring and evaluation.








Zero-based budgeting, when properly implemented, has the potential to assist the personnel of an organisation to plan and make decisions about the most efficient and effective ways to use their available resources to achieve their defined mission, goals and objectives.

There is no doubt that the process of zero-based budgeting will consume a great deal more management time than the current system of budgeting does. This will certainly be the case in implementation of the system because managers will need to learn what is required of them. Managers may object that it is too time-consuming to introduce zero-based budgeting, however, it could be introduced on a piece-meal basis. As regards the imposition upon management time, managers may object that they simply do not have the necessary time in order to undertake an in-depth examination of every activity each year. However, if this proves to be the case then we could consider the establishment of a review cycle aimed at ensuring that each activity is reviewed on at least one occasion during every two or three years. I propose that we hold a series of training seminars for our management to help in the transition to a system of zero-based budgeting. We must also ensure that we ‘sell the benefits’ that would arise from a successful implementation.

A zero-based budgeting system would assist our managers to:

Develop and/or modify the organisation’s mission and goals.

Establish broad policies based on the mission and goals.

Efficiently identify the most desirable programs to be placed in operation.

Allocate the appropriate level of resources to each program.

Monitor and evaluate each program during and at the end of its operation and report the effectiveness of each program.

Thus, as a consequence of the adoption of zero-based budgeting our managers should be able to make decisions on the basis of an improved reporting system.

It is quite possible that zero-based budgeting would help identify and eliminate any budget bias or ‘budget slack’ that may be present. Budgetary slack is ‘a universal behavioural problem’ which involves deliberately overstating cost budgets and/or understating revenue budgets to allow some leeway in actual performance. We must acknowledge that in organisations such as ours where reward structures are based on comparisons of actual with budget results, bias can help to influence the amount paid to managers under incentive schemes. However, we should emphasise that if managers are to earn incentives as a consequence of incentive schemes that are based upon a comparison of actual outcomes with budgeted outcomes, then a zero-based budget would provide a fair yardstick for comparison.

It is important to provide reassurance to our managers that we do not intend to operate a system of zero-based budgeting against the backdrop of a blame-culture. This will help to gain their most positive acceptance of the change from a long established work practice that they may perceive afforded them a degree of ‘insurance’.

(c) The finance director is probably aware that the application of zero-based budgeting within NN might prove most fruitful in the management of discretionary costs where it is difficult to establish standards of efficiency and where such costs can increase rapidly due to the absence of such standards.








A large proportion of the total costs incurred by NN will comprise direct production and service costs where the existence of input: output relationships that can be measured render them more appropriate to traditional budgeting methods utilising standard costs. Since the predominant costs incurred by a not for profit health organisation will be of a discretionary nature, one might conclude that the application of zero-based budgeting techniques is more appropriate for service organisations such as the not for profit health organisation than for a profit-seeking manufacturer of electronic office equipment.

A further difference lies in the fact that the ranking of decision packages is likely to prove less problematic within an organisation such as NN which is only involved in the manufacture and marketing of electronic office equipment. By way of contrast, there is likely to be a much greater number of decision packages of a disparate nature, competing for an allocation of available resources within a not for profit health organisation.

38 Spotty

(a) Tutorial note

All formulae needed for the calculation of regression lines are provided in the exam.

Regression line: y – a + bx

b = 22 )x(xnyxxyn

Σ−ΣΣΣ−Σ

a = nxb

ny Σ−

Σ

In this example the advertising expenditure is the independent variable (x) and the sales revenue the dependent variable (y).

b = 7775.115675.818

35.26)2626.1018()5.28935.26()875.055,18(

2 =−×

×−×= 7.07

a = 835.2607.7

85.289

×− = 12.9

regression line: y = 12.9 + 7.07x where x and y are in $000

Forecasting sales for an advertising revenue of $6,000:

Y = 12.9 + 7.07x

Y = 12.9 + 7.07x 6 = $55.32 x 1,000 = $55,320

There are a number of concerns with this estimate:

The value of advertising expenditure lies outside the range of values used to construct the regression curve (extrapolation). This forecast therefore assumes that the relationship between advertising and expenditure remains the same. This may not be the case. At some point the market likely to become saturated and sales will cease to increase as advertising expenditure increases.

Regression analysis also implicitly assumes that any relationship remains constant over time. The data used in constructing the line were probably collected over a period of time, possibly years. It is assumed that nothing








significant has changed during this period. In reality, market conditions such as competition, could have changed, giving rise to a changing relationship between advertising expenditure and sales revenue.

The relationship also implicitly assumes that expenditure is on the same type of advertising and that it remains equally effective. The same amount could be spent in two periods but adverts are placed in different newspapers, with very different results.

(b) Learning curve theory argues that the time taken to complete units declines in a systematic way as cumulative production doubles and redoubles. Clearly this has consequences for regression analysis.

Linear regression, as the name suggests, assumes that costs behave in a linear way i.e. unit cost remains constant as activity changes. With the learning curve this is not the case and costs behave in a non-linear way. It is possible to use non-linear regression methods e.g. exponential approaches, and these may prove more accurate in forecasting costs under these circumstances.

(c) Budgeting is not a certain process as it is looking into the future. What we think is going to happen may not, of course, be what actually happens. A highly detailed budget, full of figures, can give a false impression of certainty as many of the figures used in the calculations may be little more than intelligent guesses.

Uncertainty occurs when possible future outcomes cannot easily be identified and there is no knowledge of how likely each one is to arise. In the case of risk, outcomes are identifiable and it is possible to estimate the likelihood of each outcome arising.

Uncertainty and risk can be incorporated into budgeting in a number of ways.

Expected values

If detailed probability information is available it is possible to calculated expected values for key parameters like sales volumes and unit costs. These can then be used to construct the budget. Care has to be taken however, as expected values represent long-term average values – a budget is probably a one off event. As such the expected value will probably never arise in a single budget and so it needs to be interpreted with care.

Best worst cases

In the event of uncertainty probabilities do not exist so expected values cannot be used. As an alternative it may be possible to prepare a worst case and a best case budget. If nothing else this serves to highlight the range of possible outcomes. Particular attention should be paid to the worst case scenario. If this is realised, can the business survive? If not, what can be done to make the worst case survivable?

Sensitivity analysis

Using spreadsheets it is possible to explore the impact of changes in assumptions on a budget.

By how much below budget do sales have to fall before a loss is made?

By what percentage do variable costs have to increase to cause a loss?

A rigorous sensitivity analysis can help to identify how robust the budget is, together with assessing the impact of changes

Scenario modelling








Scenario modelling is an advanced version of sensitivity analysis. The latter tends to focus on changing one variable at a time. In reality several variables change together, often in opposite directions. By building a spreadsheet model it should be possible to explore the impact of changing several variables at once.

39 Henry Company

(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 of uncertainty 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 choose between suppliers. Moreover, HC has not worked for this builder before, and so they will probably find the competition stiff and 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. In the short run it is often correctly argued that the level of fixed cost in a business may not be affected by a new contract and therefore could be ignored in bid calculation. HC needs to consider to what extent the fixed costs of its business will change if 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 be needed to assemble and fit the kitchens. It is possible that most fixings would be provided with the kitchen units, but HC should 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 for supervision of the labour force. It could, of course, be included within the overhead figures but no detail is shown.

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

Likelihood of repeat business. Some businesses consider it worthwhile to accept a low price for a new contract if it establishes a 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) $15 138,705 Variable Overhead 9,247 $ 8 (W2) 73,976 Fixed 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 200 kitchens.

For the 199 Kitchens

Using

y = axb OR y = axb

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

y = 16.22169061hours y = 243·32536

Totaltime = 16·22169061x199 Total cost = $48,421.75

Totaltime = 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 = 243.2351198

Totaltime = 16·21567465x200 Total cost = $48,647.02

Totaltime = 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 hours

For next 400 (15·01 hours x 400) 6,004.00 hours

Total 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 9,600 116,800

Lowest 9,200 113,600

Difference 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

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

Number of Time for Kitchen Cumulative time Average time Kitchens (hours) (hours) (hours) 1 24.00 24.00 24.00 2 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%








40 Wargin

(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 probably very true for Wargrin Limited. The design and development of software is a long and complicated process and it is likely that the 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 costs would have to be seen in the context of the expected trading results, therefore preventing a serious over spend at this stage or under pricing at the launch point.

(b) Budgeted results for game

Year 1 ($) Year 2 ($) Year 3 ($) Total ($) Sales 240,000 480,000 120,000 840,000 Variable cost (W1) 40,000 80,000 20,000 140,000 Fixed cost (W1) 80,000 120,000 80,000 280,000 Marketing 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 game players 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 represents 40% 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. This figure is better than the stated target.

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

However, the initial design and development costs were incurred and were significant at $300,000 and are ignored in the annual 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 performance of 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 150,000

Low 10,000 units 130,000

Difference 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 +$70,000

Fixed 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 an adjustment 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 for inflation should be a reasonable target for the spend in the next year.

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 then the 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 they will 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 each game 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 identical and 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 be valid.

Fixed production cost: The standard fixed production cost of a game will be the product of the time taken to produce the game 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 will be fairly standard.

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








41 Northland LGOs

(a) Overhead costs for the 2010 budget:

Property cost = $120,000 x 1·05 = $126,000

Central wages = ($150,000 x 1·03) + $12,000 = $166,500

Stationery = $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 roads unexpectedly 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 based on 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 weather in one year may not reflect the weather in the following year leading to wildly inaccurate estimates and hence budgeting errors.

– It is difficult to estimate the precise monetary value attaching to each of the outcomes. ‘Bad’ weather can presumably take many forms (extreme cold, heat or water); the effect of each of these could be difficult to assess. Whilst using expected values it is common to group the events together and have one probability estimate. This may prove inadequate or 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 be blamed 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 would be 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 is essential. 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 or cracks might involve repairs to the








foundations of the road. The costs could differ considerably between the different types of repairs.

(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 some standardisation within the data to allow comparison with other activities (costs, time taken and so on). A cost-benefit analysis 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 the greatest 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.

42 Big Cheese Chairs (BCC)

(a) The average cost of the first 128 chairs is as follows:

$ Frame and massage mechanism 51·00 Leather 2 metres x $10/mtr x 100/80 25·00 Labour (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 would also give the average cost of 128 chairs. Both methods are acceptable and shown here.

Tabulation:

Cumulative output Average time per Total time Average cost per (units) unit (hrs) (hrs) chair at $15 per hour 1 2 2 1·9 4 1·805 8 1·71475 16 1·6290125 32 1·54756188 64 1·47018378 128 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 better price. 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 51·00 Leather 2 metres x $10/mtr x 100/80 25·00 Labour 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 128 chairs.

Y = axb

Y = 2 x 127–0·074000581

Y = 1·39748546

Total time is 127 x 1·39748546 = 177·48 hours

Time for the 128th chair is 178·77 – 177·48 = 1·29 hours

43 The Western

(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 tonnes

Quarter 2 (Q = 6): 2,000 + 25(6) = 2,150 tonnes

Quarter 3 (Q = 7): 2,000 + 25(7) = 2,175 tonnes








Quarter 4 (Q = 8): 2,000 + 25(8) = 2,200 tonnes

Seasonal adjustments are needed thus:

Quarter 1: 2,125 – 200 = 1,925

Quarter 2: 2,150 + 250 = 2,400

Quarter 3: 2,175 + 150 = 2,325

Quarter 4: 2,200 – 100 = 2,100

Total tonnage is 1,925 + 2,400 + 2,325 + 2,100 = 8,750 tonnes for the year.

(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’s

2,100 950 1,995,000 4,410,000

2,500 1010 2,525,000 6,250,000

2,400 1010 2,424,000 5,760,000

2,300 990 2,277,000 5,290,000

Sum 9,300 3,960 9,221,000 21,710,000

Y = a +bX

Where ‘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 tonne

The 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 a budget that will take little effort.

– Budget processes can be long ones, however incremental approaches do tend to be quicker than most. Complex local government organisations can suffer from very long budget processes and incremental budgeting can alleviate this a little.

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 that next year’s budget will be as high as possible to give themselves the flexibility they need to do whatever is needed. The public 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.


44 Slug

(a) Materials price variance: based on quantities purchased since inventories are valued at standard cost

$ 6,600 kg of materials should cost (× $4) 26,400 They did cost 29,700 Material price variance 3,300 (A)

Materials usage variance kg 1,100 units produced should use (× 5kg) 5,500 They did use 6,300 Usage variance in kg 800 (A)

Standard price per kg $4 Usage variance in $ $3,200(A)

Labour rate variance $ 3,600 hours of labour should cost (× $4) 14,400 They did cost 14,220 Labour rate variance 180 (F)

Labour efficiency variance hours 1,100 units produced should take (× 3 hours) 3,300 They did take 3,600 Efficiency variance in hours 300 (A)

Standard rate per hour $4 Efficiency variance in $ $1,200(A)

Fixed overhead expenditure variance $ Budgeted fixed overhead costs 6,000 Actual fixed overhead costs 4,000 Fixed overhead expenditure variance 2,000 (F)

Variable overhead expenditure variance $ 3,600 hours should cost (× $3) 10,800 They did cost 11,700 Variable overhead expenditure variance 900 (A)

Variable overhead efficiency variance

300 hours (A) × $3 per hour = $900 (A).








Sales price variance $ 1,100 units should sell for (× $50) 55,000 They did sell for 57,200 Sales price variance 2,200 (F)

Sales volume (contribution margin) variance

Budgeted sales volume in units 1,300 Actual sales volume in units 1,100 Sales volume variance in units 200 (A)

× Standard contribution per unit $9 Sales volume variance in $contribution $1,800 (A)

Budgeted profit $ Budgeted contribution $9.00 × 1,300 units 11,700 Budgeted fixed costs (6,000) Budgeted profit 5,700

Actual profit $ $ Sales 57,200 Materials 29,700 Less closing inventory (300kg × $4.00) (1,200) 28,500 Labour 14,220 Variable overheads 11,700 Fixed costs 4,000 Total (58,420) Actual loss in the period (1,120)

Operating statement $ Budgeted profit 5,700 Sales volume variance 1,800 (A) Sales price 2,200 (F) 6,100 Cost variances F A $ $ Materials price 3,300 Materials usage 3,200 Labour rate 180 Labour efficiency 1,200 Variable overhead rate 900 Variable overhead efficiency 900 Fixed overhead expenditure 2,000 Total 2,180 9,500 Total cost variances 7,320 (A) Actual loss (1,220)








(b) Tutorial note

If the company uses absorption costing with a direct labour hour absorption rate, we can calculate an expenditure, capacity and efficiency variance for fixed production overheads.

The first step is to calculate a budgeted absorption rate per hour

Budgeted labour hours: 1,300 × 3 = 3,900 hrs

Budgeted fixed cost $6,000

Budgeted absorption rate: $6,000 /3,900 = $1.54

Fixed overhead expenditure variance Same as in (a): $2,000 (F).

Fixed overhead capacity variance

hours

Budgeted hours of work 3,900

Actual hours worked 3,600

Capacity variance in hours 300 (A)

Standard fixed overhead rate per hour $1.54

Fixed overhead capacity variance in $ $462 (A)

Fixed overhead efficiency variance

Efficiency variance in hours = 300 hours (A) – see answer to (a).

Fixed overhead efficiency variance = 300 hours (A) × $1.54 = $462 (A).

(c) Labour rate

The labour rate variance is favourable indicating a lower rate per hour was paid than expected. This is perhaps because more junior or less experienced staff were used during production. Though less likely, it is possible that staff had a pay cut imposed upon them. Finally, an incorrect or outdated standard could have been used.

Labour efficiency

This is significantly adverse, indicating staff took much longer than expected to complete the output. This may relate to the favourable labour rate variance, reflecting employment of less skilled or experienced staff. Staff demotivated by a pay cut are also less likely to work efficiently.

It may also relate to the reliability of machinery as staff may have been prevented from reaching full efficiency by unreliable equipment.

45 Azela Co

(a) Performance of the purchasing manager

The purchasing manager is claiming that his performance in month 1 was very good because he was able to purchase nuts at a cheap price from an alternative supplier. The material price variance was $52,500 favourable. However, the use








of cheaper nuts could have an adverse effect on production; and the criticism of the production manager indicates that this might be the case. In particular, actual wastage might be much higher because cheaper nuts were used. The adverse material usage variance of $58,000 might have been caused mostly or entirely by the use of the cheaper nuts. If so, the favourable price variance has been achieved at the cost of an even larger adverse usage variance, suggesting that the performance of the purchasing manager has been poor.

Performance of the production manager

For the reason explained above, it would seem that the production manager should not be held responsible for all or most of the adverse material usage variance.

The production manager has also been criticised for the adverse labour rate variance. The decision to increase wages seems to have been his responsibility. The adverse rate variance was $14,000. However if the claim of the production manager is correct that the wage increase has improved morale, much of the favourable labour and variable overhead efficiency variances and the favourable idle time variance might be attributable to more highly-motivated employees.

If this is correct, the performance of the production manager in month 1 should not be criticised, and the decision to raise wages would appear to have been a good one.

Performance of the engineering manager

The engineering manager claims that he has contributed to better performance by deferring the scheduled major annual maintenance of the production department machinery. This is wrong. Postponing the maintenance work simply defers the cost by one month, and possibly increased the risk of more machine breakdowns in month 1. He needs to take a longer-term view of performance than monthly variance and profit figures.

Sales price and sales volume

The most significant aspect of performance however is the poor sales performance, with a large adverse sales price and sales volume variance, even though the market for edible nuts is ‘stable’. If the market is stable, the company is losing market share in spite of selling its product at below the standard price. The reasons for this poor performance need to be investigated urgently. Without more information, it is not possible to identify what the cause or causes of this serious problem might be.

(b)

$ 7,500 units should sell for (× $500) 3,750,000 They did sell for 3,560,000 Sales price variance 190,000 (A)

units Budgeted sales volume 7,800 Actual sales volume 7,500 Sales volume variance in units 300 (A)








Budgeted contribution per unit $88 Sales volume (contribution) variance $26,400 (A)

$ 13,000 tonnes of materials should cost (× $220) 2,860,000 They did cost 2,750,000 Direct materials price variance 110,000 (F)

tonnes 7,500 tonnes of output should use (× 1.6) 12,000 They did use 13,000 Materials usage variance in units 1,000 (A)

Standard price per tonne of materials $220 Materials usage variance $220,000 (A)

Labour rate: $ 16,500 labour hours should cost (× $16) 264,000

They did cost 292,700

Direct labour rate variance 28,700 (A)

hours 7,500 tonnes of output should take (× 2) 15,000 They did take (excluding idle time) 14,200 Labour efficiency variance in hours 800 (F)

Standard rate per labour hour $16

Labour efficiency variance $12,800 (F)

Note: Idle time is expected to be20% of hours worked. The time to produce 1 tonne is 2 hours; therefore time paid per tonne = 2 hours × 100/80 = 2.5 hours. This gives standard idle time of 0.5 hours per tonne produced.

Idle time hours

Standard idle time: 0.5 hours × 7,500 3,750

Actual idle time (16,500 – 14,200) 2,300

Idle time variance in hours 1,450 (F)

Standard rate per labour hour $16

Idle time variance $23,200 (F)

Variable overhead expenditure $

14,200 hours should cost (× $10) 142,000


Variable overhead expenditure variance 8,000 (A)








Variable overhead efficiency variance (same in hours as labour efficiency variance)

= 800 hours (F) × $10 per hour = $8,000 (F).

Fixed overhead expenditure $

Budgeted expenditure 390,000

Actual expenditure 375,000

Fixed overhead expenditure variance 15,000 (F)

$ Budgeted profit 296,400 Budgeted fixed costs 390,000

Budgeted contribution (7,800 × $88) 686,400 Sales price variance 190,000 (A) Sales volume variance 26,400 (A) Actual sales minus standard marginal costs 470,000

Cost variances (F) (A) $ $ Direct material price 110,000 Direct material usage 220,000 Direct labour rate 28,700 Direct labour efficiency 12,800 Idle time 23,200 Variable overhead expenditure 8,000 Variable overhead efficiency 8,000 154,000 256,700 102,700 (A) Actual contribution 367,300 Budgeted fixed costs 390,000 Fixed cost expenditure variance 15,000 (F) Actual loss (7,700)

Check $ $

Revenue 3,560,000

Direct materials 2,750,000

Direct labour 292,700

Variable overhead 150,000

Fixed overhead 375,000

Total costs 3,567,700

Loss (7,700)








46 StarGazer

(a) Tutorial note

A good place to start with an operating statement is to calculate the budgeted and actual profits for the period and then from this to calculate variances.

Budgeted profit

Budgeted gross profit = ($100 – $77) × 450 = $10,350.

Actual gross profit

$ $ Sales 47,300 Materials 17,700 Less closing inventory (125 × $15) (1,875)

15,825 Labour 14,637 Variable overheads 3,870 Fixed costs 2,400 Cost of sales 36,732 Actual profit 10,568 Sales price variance

$ 430 units should sell for (× $100) 43,000 They did sell for 47,300 Sales price variance 4,300 (F)

Sales volume (profit) variance

units Budgeted sales volume 450 Actual sales volume 430 Sales volume variance in units 20 (A) Budgeted profit per unit $23 Sales volume (profit) variance $460 (A)

Materials price variance $

1,200 kg of materials should cost (× $15) 18,000


Materials price variance 300 (F)

Materials usage variance kg

430 units of output should use (× 2) 860

They did use 1,075

Materials usage variance in kg 215 (A)








Standard price per kg of materials $15

Materials usage variance $3,225 (A)

Labour rate variance $ 1,700 labour hours should cost (× $8.50) 14,450 They did cost 14,637 Labour rate variance 187 (A)

Labour efficiency variance

hours 430 units of output should take (× 4) 1,720 They did take 1,700 Labour efficiency variance in hours 20 (F)

Standard rate per labour hour $8.50 Labour efficiency variance in $ $170 (F)

Variable overheads expenditure variance

$ 1,700 hours should cost (× $2) 3,400 They did cost 3,870 Variable overhead expenditure variance 470 (A)


= 20 hours (F) × $2 per hour = $40 (F).

Fixed overheads expenditure variance

$ Budgeted fixed overhead expenditure (450 × $5) 2,250 Actual fixed overhead expenditure 2,400 Fixed overhead expenditure variance 150 (A)

Fixed overheads volume variance

units Budgeted production 450 Actual production 430 Volume variance in units 20 (A)

Standard fixed overhead cost per unit $5 Fixed overhead volume variance $100 (A)








Operating statement

$

Budgeted gross profit 10,350

Sales volume 460 (A)

9,890

Sales price 4,300 (F)

Actual sales less standard cost of sales 14,190

Cost variances F A

$ $

Materials price 300

Materials usage 3,225

Labour rate 187

Labour efficiency 170

Variable overhead expenditure 470

Variable overhead efficiency 40

Fixed overhead expenditure 150

Fixed overhead volume 100

Total 510 4,132 3,622 (A)

Actual gross profit: 10,568

(b) In the context of the question the materials price variance ($300 F) is affected by the change in the standard price for materials and can be analysed into planning and operational variances. The same is true for the labour efficiency variance ($170 (F)).

Materials price variance: planning and operational variances

$

1,200 kg of materials should cost at ex ante standard price (× $15) 18,000

They should cost at ex post standard price (× $13.50) 16,200

Materials price planning variance 1,800 (F)

$

1,200 kg of materials should cost at ex post standard price (× $13.50) 16,200


Materials price operational variance 1,500 (A)








Labour efficiency variance– planning and operational variances

hours

430 units of output should take at ex ante standard time (× 4) 1,720

They should take at ex post standard time (× 3.80) 1,634

Labour efficiency planning variance in hours 86 (F)

Standard rate per labour hour $8.50

Labour efficiency planning variance in $ $731 (F)

hours 430 units of output should take at ex post standard time (× 3.80)

1,634

They did take 1,700 Labour efficiency operational variance in hours 66 (A) Standard rate per labour hour $8.50 Labour efficiency operational variance in $ $561 (A)

(c) Operational and planning approaches to variances

Any standard costing approach is only as good as the standard costs that are used to calculate the variances.

In many circumstances there are legitimate reasons why it may be appropriate to alter a standard in retrospect. The circumstances given in the question are two such examples. However, care has to be taken to ensure that the ability to update standards in retrospect does not become a way of hiding poor managerial performance.

If applied correctly, however, the information revealed by adopting an operational and planning approach can be useful. In the case of the labour efficiency variance, the traditional variance indicates a $170 (F) variance. This suggests that the new staff have performed well.

Analysis of the operational and planning variances reveals a different story, however. Although the planning variance is a favourable, the efficiency of the new workers when compared against the new standard is unfavourable. The new workers have not achieved the 5% efficiency that was expected.

In the context of the materials price variance a similar picture appears. The purchasing department appears to have done quite well until the price discount is taken into consideration. Using the old standard price, there is a favourable material price variance. Analysing the total variance shows that of the total price variance of $1,500 (F), $1,800 was due to the expected discount, leaving an adverse operational variance of $300 for material price. Again this is useful information for management and gives a better analysis day to day business performance by the purchasing department.








47 Toxic Kems

(a) Tutorial note

Planning variances compare the old and new standards. Operational variances compare actual results are compared with the revised (ex post) standard.

Material A price planning variance $ 9,000 tonnes should cost at ex ante standard price (× $200) 1,800,000

They should cost at ex post standard price (× $220) 1,980,000 Material A price planning variance 180,000 (A) Material B price planning variance

$

4,000 tonnes should cost at ex ante standard price (× $350) 1,400,000

They should cost at ex post standard price (× $385) 1,540,000

Material B price planning variance 140,000 (A)

Material C price planning variance $ 7,000 tonnes should cost at ex ante standard price (× $450) 3,150,000

They should cost at ex post standard price (× $495) 3,465,000

Material C price planning variance 315,000 (A)

Total materials price planning variances = $(180,000 + 140,000 + 315,000) (A) = $635,000 (A).

Material A price operational variance $ 9,000 tonnes should cost at ex post standard price (× $220) 1,980,000

They did cost 1,935,000 Material A price operational variance 45,000 (F)

Material B price operational variance $

4,000 tonnes should cost at ex post standard price (× $385) 1,540,000

They did cost 1,368,000

Material B price operational variance 172,000 (F)

Material C price operational variance $

7,000 tonnes should cost at ex post standard price (× $495) 3,465,000

They did cost 3,164,000

Material C price operational variance 301,000 (F)

Total materials price operational variances = $(45,000 + 172,000 + 301,000) (F) = $518,000 (F).








(b) Tutorial note

Remember that a separate mix variance is needed for each material and that these are calculated using the revised standard costs.

The first step is to work out the proportion of each chemical in the standard mix:

Material Tonnes Percentage

A 460 40%

B 345 30%

C 345 30%

Total 1,150 100% Mix variance (operational variance)

Material

Actual mix

Standard mix

Mix variance in quantities

Standard price per

kilo

Mix variance in value

tonnes tonnes tonnes $ $

A 9,000 (40%) 8,000 1,000 (A) 220 220,000 (A)

B 4,000 (30%) 6,000 2,000 (F) 385 770,000 (F)

C 7,000 (30%) 6,000 1,000 (A) 495 495,000 (A)

20,000 20,000 0 55,000 (F)

Yield variance (operational variance)

In the standard cost, 1,150 tonnes of input produce 1,000 tonnes of output.

The weighted average standard cost of a tonne of output is calculated using the ex post standard prices as follows:

($220 × 460 tonnes + $385 × 345 tonnes + $495 × 345 tonnes) / 1,150 tonnes = $352 per tonne of input.

The total yield variance can now be calculated as:

Tonnes of input

17,000 tonnes of output should use (× 1,150/1,000) 19,550 They did use 20,000 Yield variance in tonnes of input 450 (A) Standard price per tonne of input $352 Yield variance in $ $158,400 (A)

(c) Historical standards

These are standards that were set some time ago and have not been subsequently up-dated. These are used to measure progress in the long term and they do not have a motivational impact on staff as current performance will be well in excess of the standard.








Current standards

These are standards that take into account current levels of performance e.g. staff training, efficiency, equipment levels and so on. They are the standard staff should achieve at the present time. Again they have little motivational impact on staff as they are already achieving the standard.

Attainable standards

To reach these standards staff will have to improve on current performance. However, they are set in a way that staff can reach them in the foreseeable future. This is the most motivational form of standard and can lead to significant improvement in output.

Ideal standards

These are the standards that should be reached under perfect operating conditions. Clearly perfect operating conditions are unlikely to occur. The level of improvement required to reach this type of standard is often so great that it can be demotivational. Perfect standards can be held out as long-term aspirational targets but they should not be used to reward staff in the short term.

48 Mermus

(a) Tutorial note

Remember that in a flexed budget, fixed costs do not change with the volume of activity.

The flexed budget will be based on the actual activity level of 90,000 units.

$ $ Sales: $950,000 × 90/95 = 900,000 Cost of sales Raw materials: 133,000 × 90/95 = 126,000 Direct labour: 152,000 × 90/95 = 144,000 Variable production overheads: 100,700 × 90/95 = 95,400 Fixed production overheads: 125,400 490,800 409,200

(b)

Raw materials cost variance $ 90,000 units produced: material cost should be (see above) 126,000 Actual material cost 130,500 Materials: total cost variance 4,500 (A)

Direct labour cost variance $ 90,000 units produced: material cost should be (see above) 144,000

Actual direct labour cost 153,000 Direct labour: total cost variance 9,000 (A)








Fixed overhead variances

Tutorial note

The first step here is to calculate the budgeted absorption rate.

Fixed overhead absorption rate = 125,400/28,500 budgeted machine hours = $4.40 per machine hour.

Budgeted machine hours per unit = 28,500 hours/95,000 units = 0.3 machine hours per unit.


hours 90,000 units of output should take (× 0.3) 27,000 They did take 27,200 Efficiency variance in machine hours 200 (A)

Standard fixed overhead rate per machine hour $4.40 Labour efficiency variance in $ $880 (A)

Fixed overhead capacity variance

hours Budgeted machine hours 28,500 Actual machine hours 27,200 Capacity variance in machine hours 1,300 (A) Standard fixed overhead rate per machine hour $4.40 Fixed overhead capacity variance in $ 5,720 (A)

Fixed overhead expenditure variance

$ Budgeted fixed overhead expenditure 125,400 Actual fixed overhead expenditure 115,300 Fixed overhead expenditure variance 10,100 (F)

(c) Raw materials cost variance

The budgeted raw material cost for production of 95,000 units was $1.40 per unit (133,000/95,000) but the actual raw material cost for production of 90,000 units was $1.45 per unit (130,500/90,000). The raw material cost per unit may have increased either because more raw material per unit was used than budgeted, or because the price per unit of raw material was higher than budgeted. Calculation of the raw material price and usage sub-variances would indicate where further explanation should be sought.


The fixed overhead efficiency variance measures the extent to which more or less standard hours were used for the actual production than budgeted. In this case, a total of 27,200 machine hours were actually used, when only 27,000 standard machine hours should have been used. The difference may be due to poorer production planning than expected or to machine breakdowns.








Fixed overhead expenditure variance

The fixed overhead expenditure variance measures the extent to which budgeted fixed overhead differs from actual fixed overhead. Here, actual fixed overhead is $10,100 less than budgeted. This could be due to an error in forecasting fixed production overheads such as rent and power costs, or to a decrease in fixed production overheads, such as changing to a cheaper cleaning contractor.

(d) Tutorial note

The question makes it clear that only three purposes are needed. Select three from planning, motivating, communicating, co-ordinating, evaluating, rewarding and controlling. The scope of the answer below is for illustration purposes only.

Planning

One of the key purposes of a budgeting system is to require planning to occur. Strategic planning covers several years but a budget represents a financial plan covering a shorter period, i.e. a budget is an operational plan. Planning helps an organisation to anticipate key changes in the business environment that could potentially impact on business activities and to prepare appropriate responses. Planning also ensures that the budgeted activities of the organisation will support the achievement of the organisation’s objectives.

Co-ordination

Many organisations undertake a number of activities which need to be co-ordinated if the organisation is to meet its objectives. The budgeting system facilitates this co-ordination since organisational activities and the links between them are thoroughly investigated during budget preparation, and the overall coherence between the budgeted activities is reviewed before the master budget is agreed by senior managers. Without the framework of the budgeting system, individual managers may be tempted to make decisions that are not optimal in terms of achieving organisational objectives.

Communication

The budgeting system facilitates communication within the organisation both vertically (for example between senior and junior managers) and horizontally (for example between different organisational functions). Vertical communication enables senior managers to ensure that organisational objectives are understood by employees at all levels. Communication also occurs at all stages of the budgetary control process, for example during budget preparation and during investigation of end-of-period variances.

Control

One of the most important purposes of a budgeting system is to facilitate cost control through the comparison of budgeted costs and actual costs. Variances between budgeted and actual costs can be investigated in order to determine the reason why actual performance has differed from what was planned. Corrective action can be introduced if necessary in order to ensure that organisational objectives are achieved. A budgeting system also facilitates management by exception, whereby only significant differences between planned and actual activity are investigated.

Motivation

The budgeting system can influence the behaviour of managers and employees, and may motivate them to improve their performance if the target represented








by the budget is set at an appropriate level. An inappropriate target has the potential to be demotivating, however, and a key factor here is the degree of participation in the budget-setting process. It has been shown that an appropriate degree of participation can have a positive motivational effect.

Performance evaluation

Managerial performance is often evaluated by the extent to which budgetary targets for which individual managers are responsible have been achieved. Managerial rewards such as bonuses or performance-related pay can also be linked to achievement of budgetary targets. Managers can also use the budget to evaluate their own performance and clarify how close they are to meeting agreed performance targets.

49 Woodeezer

(a) Tutorial note

An operating statement reconciles budgeted and actual profit.

Start by working out the starting figure (budgeted profit) and the ending figure (actual profit). Variances are then calculated to reconcile the two.

Budgeted profit: $28 × 4,000 = $112,000

Actual profit: (given) $148,800

Sales price variance

$ 3,200 units should sell for (× $220) 704,000 They did sell for 720,000 Sales price variance 16,000 (F)

Sales volume (profit) variance

units Budgeted sales volume 4,000 Actual sales volume 3,200 Sales volume variance in units 800 (A)

Budgeted profit per unit $28 Sales volume (profit) variance $22,400 (A)

Materials price variance

$ 80,000 kg of materials should cost (× $3.20) 256,000 They did cost 280,000 Materials price variance 24,000 (A)

Materials usage variance

kg 3,600 units of output should use (× 25) 90,000 They did use 80,000 Materials usage variance in kg 10,000 (F)








Standard price per kg of materials $3.20 Materials usage variance $32,000 (F)

Labour rate variance $ 16,000 labour hours should cost (× $8) 128,000 They did cost 112,000 Labour rate variance 16,000 (F)

Labour efficiency variance hours 3,600 units of output should take (× 4) 14,400 They did take 16,000 Labour efficiency variance in hours 1,600 (A)

Standard rate per labour hour $8 Labour efficiency variance in $ $12,800 (A)

Variable overheads expenditure variance $ 16,000 hours should cost (× $4) 64,000 They did cost 60,000 Variable overhead expenditure variance 4,000 (F)


= 1,600 hours (A) × $4 per hour = $6,400 (A).

Fixed overhead efficiency variance (same in hours as labour efficiency variance)

= 1,600 hours (A) × $16 per hour = $25,600 (A).

Fixed overhead capacity variance hours Budgeted hours (4 × 4,000) 16,000 Actual machine hours 16,000 Capacity variance in machine hours 0

Fixed overhead expenditure variance $ Budgeted fixed overhead expenditure (4 hours × $16 × 4,000)

256,000

Actual fixed overhead expenditure 196,000 Fixed overhead expenditure variance 60,000 (F)

Operating statement (absorption costing) $ Budgeted profit 112,000 Sale volume variance 22,400 (A) Standard profit for actual sales volume 89,600








Sales price variance 16,000 (F) Actual sales less standard cost of sales 105,600 Cost variances F A $ $ Materials price 24,000 Materials usage 32,000 Labour rate 16,000 Labour efficiency 12,800 Variable overhead expenditure 4,000 Variable overhead efficiency 6,400 Fixed overhead expenditure 60,000 Fixed overhead capacity 0 Fixed overhead efficiency 25,600 Totals 112,000 68,800 43,200 (F) Actual profit 148,800

(b) Motivation and budget setting

Employees failed to meet the production target of 4,000 benches by 400 units and sales were 800 units below target. However, overall profit was higher than expected, reflecting a highly favourable total cost variance. By setting an aspirational budget, he appears to have motivated staff to improve. Although they failed to meet overall targets staff improvements had an overall favourable effect on profit.

Explanations of variances

Tutorial note

Avoid stating the obvious e.g. the labour rate variance was adverse because we paid workers more per hour. To score marks you need to explain why the rate could e higher e.g. overtime/ higher quality staff. Further, try to find links between variances e.g. an adverse rate variance due to employing better quality staff might be reflected in a favourable materials usage variance as skilled staff make better use of resources and machinery.

The sales volume variance and the sales price variance may be inter-related as an increase in price is likely to reduce demand, thus an adverse SVV is consistent with a favourable SPV given the price increase.

Better quality materials are being purchased by Mr Beech and, given this was not foreseen at the time of the budget, then it may explain a higher price resulting in an adverse MPV. Conversely, however, with better materials there may be less waste and thus it may have contributed to the favourable MUV.

The lower skilled labour may account for the favourable LRV but may also account for the adverse LEV as less skilled labour may take longer to complete a given task. Also if new labour is introduced there may be an initial learning effect.

The impact of the LEV is magnified by the variable and fixed overhead efficiency variances as they are merely linear functions of the LEV. Their meaning is questionable however, as variable overheads seldom vary proportionately to








labour hours. By definition fixed overheads do not vary with labour hours and this variance merely ‘balances the books’ in an absorption costing system.

The fixed overhead expenditure variance is significant and requires further consideration. This is particularly the case if it involves discretionary expenditure which has been reduced but which may have a long-term impact on the business.

(c) Tutorial notes

In switching to marginal costing for the operating statement, a number of things change:

The statement begins with budgeted contribution

Sales volume variance is now calculated using standard unit contribution rather than standard unit gross profit.

Only one fixed overhead variance is calculated (expenditure)

Actual profit will change due to the revaluation of stock.

Standard unit contribution $ Wood: 25 kg at $3.20 per kg 80.00 Labour: 4 hours at $8 per hour 32.00 Variable overheads: 4 hours at $4 per hour 16.00 128.00 Selling price 220.00 Standard unit contribution 92.00

Budgeted contribution: 4,000 benches × $92 $368,000 Sales volume variance

units Budgeted sales volume: 4,000 Actual sales volume 3,200 Volume variance in units 800 (A)

Standard contribution per unit $92 Sales volume (contribution) variance $73,600 (A)

The revised statement will look as follows:

Operating statement (marginal costing)

$ Budgeted contribution 368,000 Sale volume variance 73,600 (A) Standard contribution for actual sales volume

294,400

Sales price variance 16,000 (F) 310,400 Cost variances F A $ $ Materials price 24,000 Materials usage 32,000 Labour rate 16,000








Labour efficiency 12,800 Variable overhead expenditure 4,000 Variable overhead efficiency 6,400 Total 52,000 43,200 8,800 (F) Actual contribution 319,200 Budgeted fixed overhead 256,000 Fixed overhead expenditure variance

60,000 (F)

Actual fixed overhead 196,000 Actual profit 123,200

44 Carat

(a)

$/unit $/unit Standard sales price 12.00 Material A = $1.70 × 2.5 = 4.25

Material B = $1.20 × 1.5 = 1.80

Labour = $6.00 × 0.45 = 2.70

8.75 Standard contribution 3.25

Sales volume (contribution) variance units Budgeted volume of sales 50,000 Actual volume of sales 48,000 Sales volume variance in units 2,000 (A) Standard contribution per unit $3.25 Sales volume variance in $ $6,500 (A)

Sales price variance $ Actual units sold should sell for ($12 × 48,000) 576,000 Actual sales revenue 580,800 Sales price variance 4,800 (F)

Direct material price variances

Material A price variance $ 121,951 kg should cost (× $1.70) 207,317 They did cost 200,000 Price variance, Material A 7,317 (F)








Material B price variance $ 67,200 kg should cost (× $1.20) 80,640 They did cost 84,000 Price variance, Material B 3,360 (A)

Material mix

Tutorial note

Before calculating mix variances, it helps to work out the proportion of each material in the standard mix:

Material A : (2.5kg / 4kg) × 100 = 62.5%

Material B:(1.5kg / 4kg) × 100 = 37.5%

Material

Actual mix

Standard mix


Standard price per

kilo

Mix variance in value

kg kg kg $ $

A 121,951 (62.5%) 118,219 3,732 (A) 1.70 6,344 (A)

B 67,200 (37.5%) 70,932 3,732 (F) 1.20 4,478 (F)

189,151 189,151 0 1,866 (A)

Materials yield variance

Standard cost per kg $ Material A: 62.5% × $1.70 = 1.0625

Material B: 37.5% × $1.20 = 0.4500

1.5125

kg 48,000 units of output should use: (2.5 + 1.5) 192,000 They did use 189,151 Materials yield variance in kg 2,849 (F)

Standard price per kg of materials $1.5125 Materials yield variance $4,309 (F)

Labour rate variance $ 19,200 labour hours should cost (× $6) 115,200 They did cost 117,120 Labour rate variance 1,920 (A)

Labour efficiency variance

hours 48,000 units of output should take (× 0.45) 21,600 They did take (excluding idle time) 18,900 Labour efficiency variance in hours 2,700 (F)








Standard rate per labour hour $6 Labour efficiency variance in $ $16,200 (F)

Idle time variance

(19,200 – 18,900) = 300 hours (A) × $6 per hour = $1,800 (A)

(b) Tutorial note

Operating statements reconcile budgeted and actual profit. The first step should be to calculate these figures:

Budgeted profit: (50,000 units × $3.25) - $62,500 = $100,000

Actual profit $580,800 – ($200,000 + $84,000 + $117,120 + $64,000) = $115,680

$ Budgeted gross profit 100,000 Sales volume contribution variance 6,500 (A) Sales price variance 4,800 (F) 98,300 Cost variances $ $ F A Materials price A 7,317 Materials price B 3,360 Material mix 1,866 Material yield 4,309 Labour rate 1,920 Labour idle time 1,800 Labour efficiency 16,200 Fixed overhead expenditure*

(62,500 – 64,000)

1,500

Total 32,304 14,924 17,380 (F) Actual profit 115,680

(c) The favourable material A price variance indicates that the actual price per kilogram was less than standard. Possible explanations include buying lower quality material, buying larger quantities of material A and thereby gaining bulk purchase discounts, a change of supplier, and using an out-of-date standard. The adverse material A mix variance indicates that more of this material was used in the actual input than indicated by the standard mix. The favourable material price variance suggests this may be due to the use of poorer quality material (hence more was needed than in the standard mix), or it might be that more material A was used because it was cheaper than expected.

The favourable material A yield variance indicates that more output was produced from the quantity of material used than expected by the standard. This increase in yield is unlikely to be due to the use of poorer quality material: it is more likely to be the result of employing more skilled labour, or introducing more efficient working practices. It is only appropriate to calculate and interpret material mix and yield variances if quantities in the standard mix can be varied. It has also been argued that calculating yield variances for each material is not useful, as yield is related to output overall rather than to particular materials in








the input mix. A further complication is that mix variances for individual materials are inter-related and so an explanation of the increased use of one material cannot be separated from an explanation of the decreased use of another.

The unfavourable labour rate variance indicates that the actual hourly rate paid was higher than standard. Possible explanations for this include hiring staff with more experience and paying them more (this is consistent with the favourable overall direct material variance), or implementing an unexpected pay increase. The favourable labour efficiency variance shows that fewer hours were worked than standard. Possible explanations include the effect of staff training, the use of better quality material (possibly on Material B rather than on Material A), employees gaining experience of the production process, and introducing more efficient production methods. The adverse idle time variance may be due to machine breakdowns; or a higher rate of production arising from more efficient working (assuming employees are paid a fixed number of hours per week).

(d) The theory of motivation suggests that having a clearly defined target results in better performance than having no target at all, that targets need to be accepted by the staff involved, and that more demanding targets increase motivation provided they remain accepted3. It is against this background that basic, ideal, current and attainable standards can be discussed.

A basic standard is one that remains unchanged for several years and is used to show trends over time. Basic standards may become increasingly easy to achieve as time passes and hence, being undemanding, may have a negative impact on motivation. Standards that are easy to achieve will give employees little to aim at. Ideal standards represent the outcome that can be achieved under perfect operating conditions, with no wastage, inefficiency or machine breakdowns.

Since perfect operating conditions are unlikely to occur for any significant period, ideal standards will be very demanding and are unlikely to be accepted as targets by the staff involved as they are unlikely to be achieved. Using ideal standards as targets is therefore likely to have a negative effect on employee motivation. Current standards are based on current operating conditions and incorporate current levels of wastage, inefficiency and machine breakdown. If used as targets, current standards will not improve performance beyond its current level and their impact on motivation will be a neutral one.

Attainable standards are those that can be achieved if operating conditions conform to the best that can be practically achieved in terms of material use, efficiency and machine performance. Attainable standards are likely to be more demanding than current standards and so will have a positive effect on employee motivation, provided that employees accept them as

51 Linsil

(a) Tutorial note

The first step is to calculate the revised standard costs. These can then be compared with the old standard to get planning variances and with actual figures to get operational variances.








Revised standard costs:

After 3% price increase, direct material price (2.30 × 1.03) $2.369 per kg

After savings of 5%, direct material usage (3.00 × 0.95) 2.85 kg per unit

Adding 4% wage increase, direct labour rate (12.00 × 1.04) $12.48 per hr

Adding back 10% decrease, direct labour hours (1.25/0.9) 1.389 hrs per unit

Planning variances

These variances compare original standard costs with revised standard costs

Variance Working Answer Direct material price variance (2.30 – 2.369) × 122,000 × 2.80 $23,570 (A) Direct material usage variance (3.00 – 2.85) × 122,000 × 2.30 $42,090 (F) Direct labour rate variance (12.00 – 12.48) × 122,000 × 1.30 $76,128 (A Direct labour efficiency variance (1.25 – (1.25/0.9)) × 122,000 × 12.00 $203,333 (A)

Operational variances

These variances compare actual cost with revised standard cost.

Variance Working Answer Direct material price variance (2.369 – 2.46) × (122,000 × 2.80) $31,086 (A) Direct material usage variance 2.30 × (2.85 – 2.80) × 122,000 $14,030 (F) Direct labour rate variance (12.48 – 12.60) × (122,000 × 1.30) $19,032 (A) Direct labour efficiency variance 12.00 × ((1.25/0.9) – 1.30) × 122,000 $130,133 (F)

(b) Tutorial note

At first glance this looks like a lot of work. It is actually very quick to complete. To get back to the traditional variances, based on the old standard simply, add up the relevant operational and planning variances for each cost.

Variance Working Answer Direct material price variance 23,570 + 31,086 $54,656 (A) Direct material usage variance 42,090 + 14,030 $56,120 (F) Direct labour rate variance 76,128 + 19,032 $95,160 (A) Direct labour efficiency variance 203,333 – 130,133 $73,200 (A)

(c) If an operating statement had been prepared which did not take into account the changes that were needed to keep the standard cost data relevant, it would have reported the direct material and direct labour variances calculated in part (b). These variances contain both controllable and uncontrollable elements.

For the variances to be more useful, these elements can be reported separately. Each variance was separated into a planning (uncontrollable) variance and an operational (controllable) variance3. Managers cannot be held responsible for variances over which they have no control and so their attention is focused on operational variances. For example, the operating statement shows that the labour efficiency variance consists of an adverse planning variance of $203,333 but a favourable operational variance of $130,133. If the controllable and








uncontrollable elements had not been separated, an adverse variance of $73,200 would have been reported.

The planning variances indicate where investigation may result in an improvement in the planning and budgeting process. For example, if it could reasonably have been expected that a wage increase would be agreed at the start of the budget period, the anticipated increase should have been incorporated. The reason for the omission of the 3% increase in direct material price should be investigated: was it a case of forgetfulness or were budget figures not checked before the budgets were sent for approval?

(d) Tutorial note

Make good use of headings here to emphasise points being made.

The following factors could be discussed.

Size

Larger cost savings are likely to arise from taking action to correct large variances and a policy could be established of investigating all variances above a given size. Size can be linked to the underlying variable in percentage terms as a test of significance: for example, a policy could be established to investigate all variances of 5% or more.

Adverse or favourable

It is natural to concentrate on adverse variances in order to bring business operations back in line with budget. However, whether a variance is adverse or favourable should not influence the decision to investigate. The reasons for favourable variances should also be sought, since they may indicate the presence of budgetary slack or suggest ways in which the budgeting process could be improved. Favourable variances may also indicate areas where the budget is easy to achieve, suggesting that the motivational effect of a budget could be improved by introducing more demanding targets.

Cost versus benefits

If the expected cost of investigating a variance is likely to exceed any benefits expected to arise from its correction, it may be decided not to investigate.

Historic pattern of variances

A variance which is unusual when compared to historic patterns of variances may be considered worthy of investigation. Statistical tests of significance may be used to highlight such variances.

Reliability and quality of data

If data is aggregated or if the quality of the measuring and recording system is not as high as would be liked, there may be uncertainty about the benefits to arise from investigation of variances.

52 BRK

(a) Tutorial note

Before sales volume variances can be calculated standard profits have to be determined.








Calculation of standard profit

Budgeted machine hours = (10,000 × 0.3) + (13,000 × 0.6) + (9,000 × 0.8) = 18,000 hours

Overhead absorption rate = 81,000/18,000 = $4.50 per machine hour.

Product B($) R($) K($) Direct material (3 × 1.80) 5.40 (1.25 × 3.28) 4.10 (1.94 × 2.50) 4.85 Direct labour (0.5 × 6.50) 3.25 (0.8 × 6.50) 5.20 (0.7 × 6.50) 4.55 Fixed overhead (0.3 × 4.50) 1.35 (0.6 × 4.50) 2.70 (0.8 × 4.50) 3.60

Standard cost 10.00 12.00 13.00 Selling price 14.00 15.00 18.00 Standard profit 4.00 3.00 5.00

Sales price variances

Product B $

9,500 units should sell for (× $14) 133,000

They did sell for (× $14.50) 137,750

Sales price variance 4,750 (F)

Product R $


They did sell for (× $15.50) 209,250


Product K $


They did sell for (× $19) 161,500


Sales price variances: summary $

Product B 4,750 (F)

Product R: 6,750 (F)

Product K: 8,500 (F)

Total sales price variances 20,000 (F)

Sale mix variance

Tutorial note

The first step is to work out the standard mix:

Total budgeted sales: 10,000 + 13,000 + 9,000 = 32,000 units








Budgeted sales mix

B: 10,000 / 32,000 × 100% = 31.25% R: 13,000 / 32,000 × 100% = 40.625% K: 9,000 / 32,000 × 100% = 28.125%

Product

Actual sales mix

Standard sales mix


Standard profit

per unit

Mix variance in profit

units units units $ $

B 9,500 (31.25%) 9,843.750 343.750 (A) 4 1,375.000 (A)

R 13,500 (40.625%) 12,796.875 703.125 (F) 3 2,109.375 (F)

K 8,500 (28.125%) 8,859.375 359.375 (A) 5 1,796.875 (A)

31,500 31,500.000 0 1,062.500 (A)

Weighted average standard profit per unit = (31.25% × $4) + (40.625% × $3) + (28.125% × $5) = $3.875 per unit

Sales quantity variance Total

Actual sales quantity in total 31,500

Budgeted sales quantity in total 32,000

Sales quantity variance in units 500 (A)

Weighted average standard profit per unit $3.875

Sales quantity variance in $ $1,937.50 (A)

Sales volume variance

Tutorial note

The sales mix and sales quantity variances are sub-variances of the sales volume variance.

$

Sales mix variance 1,062.50 (A)

Sales quantity variance 1,937.50 (A)

Sales volume variance 3,000.00 (A)

Reconciliation $ $ $

Budgeted sales at standard profit 124,000


Sales mix profit variance 1,064 (A)

Sales quantity variance 1,936 (A)

3,000 (A)

17,000 (F)

Actual sales at actual price less standard cost 141,000








(b) The sales mix profit variance explains how the change in sales mix contributed to the sales volume profit variance. It compares the actual sales quantity in the actual mix with the actual sales quantity in the standard mix, valued at the standard profit per unit.

The adverse variance calculated in part (a) was $1,062.50, indicating that the actual sales mix contained more lower-margin products and fewer higher-margin products.

A greater proportion of Product R, with the lowest standard profit of $3 per unit, was sold than was budgeted for. Lower proportions of Products B and K, with the higher standard profits per unit, were sold than budgeted for.

The sales mix variance has significance only when products are inter-related and these relationships are taken into account at the planning stage. If the products sold are not inter-related, the mix variance offers no useful information, since it incorrectly implies that a possible cause of the sales volume profit variance is a change in the mix.

(c) A standard costing system requires preparation of standard costs, comparison of standard costs with actual costs, investigation of variances and taking corrective action if needed, and review of standard costs on a regular basis. Standard costs are predetermined unit costs arising under efficient operating conditions. Standard costing can be applied to repetitive or common operations where the input to produce a required output can be clearly specified.

Preparation of standard costs

Standards are required for amount of materials, labour and services required to perform a particular operation, and cost standards are compiled from the standard costs of the individual operations needed to produce a given product. The quantities and costs needed for each standard can be derived using the engineering approach or through the analysis of historical records.

The engineering approach requires a detailed study of each operation so that the materials, labour and equipment used in the operation can be verified by observation, for example by using time and motion studies. Analysis of historical records can be carried out using quantitative analysis, including the high-low method, scatter graphs and regression analysis. Standards are set by these methods by averaging historical data and so there is a danger that past inefficiencies may be perpetuated.

Variance analysis

Variances obtained by comparing standard costs with actual costs form the basis of cost control and support the use of responsibility accounting. A wide range of variances can be calculated, depending in part on the costing system employed. The causes of individual variances can be investigated if a variance is significant, and corrective action taken where necessary. Both favourable and adverse variances should be investigated, since useful information can be derived from both.

Review of standard costs

Standard costs must be reviewed and updated if they are to retain their relevance to an organisation. The review should consider changes in the prices of inputs such as labour and materials as well as changes in working practices and production methods. The exception to this is the basic standard, which is left unchanged for long periods of time so that trends over time can be established.








However, basic standards are not commonly used. It is more usual to find ideal, current and attainable standards being used and these all need regular review.

53 Spike Co

(a) A budget forms the basis of many performance management systems. Once set, it can be compared to the actual results of an organisation to assess performance. A change to the budget can be allowed in some circumstances but these must be carefully 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 original budget inappropriate for use as a performance management tool.

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

Disallow budget revisions for operational issues. Any item that is within the operational control of an organisation should not be 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 doubtful that Spike Limited could have expected this or prevented it from happening.

– The buyer, knowing that budget revisions are common, is likely to see the liquidation as outside his control and hence expect 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 offer that 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 not have been incurred. This could be said to have been an operational error.

Conclusion

The 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’s budget 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 of an 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 needed improving. 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 the department 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 of the 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 of revenue 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, they may 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 calculation does 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 shrinking market) is 160,000 units and the business managed to beat this level comfortably by selling 176,000 units in the period.

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

Spike should be concerned that its market is shrinking.

54 Chaff Co

(a) When assessing variances it is important to consider the whole picture and the interrelationships that exist. In Chaff there appears to be doubt about the wisdom of some of the decisions that have been made. Favourable variances have been applauded 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 is not 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 material usage variance is significantly adverse, indicating much more waste than is normal has occurred in month 1. This suggests that the quality of the seed bought was poor and as a result a $52,000 excess loss has occurred. It is possible that the waste was 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 revenue and (therefore) profit. We are told that the market for sales of brown rice is stable and so it is reasonable to presume that the fall in sales price achieved is as a result of internal quality issues rather than general price falls. The purchasing manager of the 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 above together.

* ($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 efficiency variance 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 possible that 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 bought enough 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 this has saved $8,000. This will increase profits in the short term but could have disastrous consequences later. In this case only time 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 by the variance has not been made. It is also possible that the adverse variable overhead expenditure variance has been at least partly 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 risks involved.

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

$ $ Sales price 240 Less: Rice seed (1·4 Tonnes x $60/tonne) 84 Labour (2 hours x $20/hr) 40 Variable 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 adjust the 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 statement prepared.

Budget profit statement for month 2

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








$ $ Marginal costs of production 1,545,600 ––––––––Contribution 470,400 Less Fixed costs 210,000 ––––––––Budget profit 260,400 ––––––––

Actual profit for month 2.

$ $ Sales 1,800,000 Less: Rice seed 660,000 Labour 303,360 Variable overhead 480,000 –––––––– Marginal costs of production 1,443,360 ––––––––Contribution 356,640 Less Fixed costs 200,000 ––––––––Actual profit 156,640 ––––––––

Operating statement for month 2

$ $ $ Budget contribution 470,400 Variances: Adverse Favourable Sales price 120,000 Sales volume 22,400 –––––––– 142,400 –––––––– 328,000 Material price 60,000 Material usage 48,000 Labour rate 18,960 Labour efficiency 20,000 Idle time 15,600 Variable overhead efficiency 30,000 Variable overhead expenditure 30,000 –––––––– –––––––– 96,960 125,600 28,640 –––––––– Actual contribution 356,640 Budget fixed cost 210,000 Less: 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 Adv








2. Sales volume: (8,000 – 8,400)56 = 22,400 Adv

3. Material price: 60,00012,000 6012,000660,000

=⎟⎠

⎞⎜⎝

⎛ − Fav

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 Adv

6. Labour efficiency: (15,000 – 16,000)20 = 20,000 Fav

7. Idle time: (800 – 1,580*)20 = 15,600 Fav

*10% of 15,800

8. Variable overhead expenditure: 30,00015,000 3015,000480,000

=⎟⎠

⎞⎜⎝

⎛ − Adv

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 tonne

Or 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 hours

Standard idle time is 10% of 15,800 = 1,580 hours

Therefore 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.)

55 Crumbly Cakes

(a) Production manager

Assessing the performance of the two managers is difficult in this situation. In a traditional sense the production manager has seriously over spent in March following the move to organic ingredients. He has a net adverse variance against his department of $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 more expensive 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 should be better and that customers could perceive a health benefit. However, the production manager is allocated none of the favourable sales variances that result. If we assume that the improved sales are entirely as a result of the production manager’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 performing department. Indeed he will have earned a small bonus in that month.

Sales manager

A change to organic idea would need to be ‘sold’ to customers. It would presumably require a change of marketing and proper communication 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.

Bonus scheme

The problem here is that the variances have to be allocated to one individual. The good sales variances have been allocated to the sales manager when in truth the production manager’s decision to go organic appears to have been a good one and the driver of the business success. Responsibility accounting systems struggle to cope with ‘joint’ success stories, refuting in general a collective responsibility.

Under the current standards the production manager has seemingly no chance to make a bonus. The main problems appear to be the out-of-date standards and the fact that all sales variances are allocated to the sales manager, despite the root cause of the improved performance being at least in part the production manager’s decision to go organic. The system does not appear fair.

General comments

It would appear that some sharing of the total variances is appropriate. This would be an inexact science and some negotiation would be needed.

One problem seems to be that the original standards were not changed following the decision to go organic. In this sense the variances reported are not really ‘fair’. Standards should reflect achievable current targets and this is not the case here.

(b) Variance calculations

Material price variances

Ingredient Act price/kg Std price/kg Actual (AP – SP) x AQ Adv or Fav quantity kg MPV Flour 0·13 0·12 5,700 57 Adv Eggs 0·85 0·70 6,600 990 Adv Butter 1·80 1·70 6,600 660 Adv Sugar 0·60 0·50 4,578 458 Adv –––––– Total 2,165 Adv –––––– Material mix variance

Ingredient Act mix Std mix Std price Variance Adv or Fav Flour 5,700 5,870 0·12 –20 Eggs 6,600 5,870 0·70 511 Butter 6,600 5,870 1·70 1,241 Sugar 4,578 5,870 0·50 –646 ––––––– ––––––– –––––– Totals 23,478 23,478 1,086 Adv ––––––– ––––––– ––––––








Material yield variance

Actual yield 60,000 cakes

Standard yield (23,478/0·4) 58,695 cakes

Difference 1,305 cakes

Standard cost of a cake (W1) $0·302

Yield variance (1,305 * 0·302) 394 Fav

Sales price variance

Act price Std Price Act volume (AP – SP) Adv or Fav

* Act Vol

Variance

Cake 0·99 0·85 60,000 8,400 Fav

Sales volume contribution variance

Actual volume 60,000 cakes

Budget volume 50,000 cakes

Standard contribution 0·35

Variance (60,000 – 50,000) * 0·35 = $3,500 Fav

W1

Standard cost of a cake

Ingredients Kg $ Cost

Flour 0·10 $0·12 per kg 0·012 Eggs 0·10 $0·70 per kg 0·070 Butter 0·10 $1·70 per kg 0·170 Sugar 0·10 $0·50 per kg 0·050 Total input 0·40 0·302 Normal loss (10%) (0·04) ––––– Standard weight/cost of a cake 0∙36 0∙302

56 Secure Net (SN)

(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 factors outside 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 has to 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. This would 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 qualitative factors). 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 and reliability. 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 fact that the production level jumped from 60,000 to 100,000 also suggests that suppliers’ reliability was good (in that they were able 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 discount from suppliers. This should also be reflected in any performance assessment in that if this has not been secured it could be seen 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 in the period, a huge increase on budget. The ability of a production manager to react and be flexible can often form a part of a performance assessment.

In conclusion the manager could be said to have performed well.


57 Not for profit performance

(a) Tutorial note

To score highly ensure that your answer covers all three requirements. Marks will be allocated to each requirement and they are not transferable. Use of heading also emphasizes the structure of the answer and its coverage.








Not-for-profit (NFP) organisations such as charities deliver services that are usually limited by the resources available to them. It may be possible neither to express their objectives in quantifiable or measurable terms, nor to measure their output in terms of the services they deliver. The financial focus in NFP organisations is therefore placed on the control of costs.

Selection of cost units

A cost unit for a NFP organisation is a unit of service for which costs are ascertained. These cost units will be used to assess the efficiency and effectiveness of the organisation. The problem for a NFP organisation is that it may not have easily identifiable cost units, and it may not be possible to identify costs with specific outputs. Once appropriate cost units have been identified, however, they can be used to provide cost control information. Examples of costs units used by an NFP organisation are patients, wards, drug treatment programmes, bed-nights and operations, which are all used by a hospital.

The use of performance measures to measure output and quality

Where output for a NFP organisation can be quantified, targets can be set and performance against these targets can be measured. In a university, for example, targets could be set in terms of the number of students graduating with a first-class degree, the number of students in a tutorial group, and the percentage of students who complete a degree course having started it. Information could easily be gathered to enable an assessment of the University’s performance compared to agreed, budgeted or imposed targets. Measuring performance in terms of quality is not so easy. It may be possible to use a surrogate or substitute performance measure if a quality cannot be directly measured. For example, the efficiency of hospital outpatient treatment could be measured by the average length of the queue for treatment. The quality of a University course could be assessed by a composite weighting of responses to individual student questionnaires.

Comparison of planned and actual performance

It is likely that a NFP organisation will have a budget that details expected levels of income (for example from donations and investments) and expenditure (for example on staff wages, continuing programmes, fixed overheads and planned purchases). The use and application of costing principles and information here is no different than in a profit-making organisation. Planned performance can be compared to actual performance, income and cost variances calculated and investigated, and corrective action taken to remedy under-performance. Where objectives cannot be specified in terms of quantifiable targets, costing information will serve no purpose and assessment of actual performance with planned performance will need to be undertaken from a more subjective perspective.

(b) Tutorial note

Note the use of heading here to confirm to the marker than all areas of the question have been addressed.

Features of ZBB

Zero-based budgeting requires that activities be re-evaluated as part of the budget process so that each activity, and each level of activity, can justify its consumption of the economic resources available. This is in contrast to incremental budgeting, where the current budget is increased to allow for








expected future conditions. Zero-based budgeting prevents the carrying forward of past inefficiencies that can be a feature of incremental budgeting and focuses on activities rather than departments or programmes.

Each activity is treated as though it was being undertaken for the first time and is required to justify its inclusion in the budget in terms of the benefit expected to be derived from its adoption. The first step in zero-based budgeting is the formulation of decision packages. These are documents which identify and describe a given activity or group of activities in detail. The base package represents the minimum level of activity that is consistent with the achievement of organisational objectives. Incremental packages describe higher levels of activity which may be delivered if they are acceptable from a cost-benefit perspective.

Following the formulation of decision packages, they are evaluated by senior management and ranked by decreasing benefit to the budgeting organisation. Resources should then be allocated, theoretically at least, to decision packages in order of decreasing marginal utility until all resources have been allocated.

Application in the not-for-profit sector

Advantages claimed for zero-based budgeting are that it eliminates the inefficiencies that can arise with incremental budgeting, that it fosters a questioning attitude towards current activities and that it focuses attention on the need to obtain value for money from the consumption of organisational resources.

Value for money is important in not-for-profit (NFP) organisations, where the profit motive found in the private sector is replaced by the need to derive the maximum benefits from limited resources available. Providers of funds to NFP organisations expect to see their cash being used wisely, with as much as possible being devoted to the achievement of organisational aims. For this reason, NFP organisations emphasise cost control and the need for economy in the selection of resources, efficiency in the consumption of resources and effectiveness in the use of resources to achieve organisational objectives (i.e. value for money).

Zero-based budgeting can therefore be applied in a NFP organisation to analyse its activities and the services it provides into decision packages, with a view to ranking them on a cost-benefit basis relative to organisational aims and objectives. In has been noted that zero-based budgeting can be applied more effectively in service-based rather than manufacturing organisations and so it may be ideally suited to a NFP organisation such as a charity.

(c) Activity-based budgeting (ABB) would need a detailed analysis of costs and cost drivers so as to determine which cost drivers and cost pools were to be used in the activity-based costing system. However, whereas activity-based costing uses activity based recovery rates to assign costs to cost objects, ABB begins with budgeted cost-objects and works back to the resources needed to achieve the budget. Once the budgeted activity levels have been determined, the demand for resource-consuming activities is assessed from an organisational perspective. The resources needed to provide for these activities are then assessed and action taken to ensure that these resources are available when needed in the budget period.

The budgeted activity levels are determined in the same way as for conventional budgeting in that a sales budget and a production budget are drawn up. ABB








then determines the quantity of activity cost drivers (e.g. number of purchase orders, number of set-ups) needed to support the planned sales and production. Standard cost data would be compiled that included details of the activity cost drivers required to produce a product or number of products. The resources needed to support the budgeted quantity of activity cost drivers would then be determined (e.g. number of labour hours to process purchase orders, number of maintenance hours needed to complete set-ups). This resource need would then be matched against the available capacity (i.e. number of purchase clerks to process purchase orders) to see whether any capacity adjustment were needed.

One advantage suggested for ABB is that organisational resources are allocated more efficiently due to the detailed cost and activity information obtained by implementing an ABB system. Another advantage of ABB is that it avoids the pitfalls of incremental budgeting due to its detailed assessment of the activities and resources needed to support planned sales and production. In ABB the costs of support activities are not seen as fixed costs to be increased by annual increments, but as depending to a large extent on the planned level of activity.

58 West Division

Sales price

Variable cost

Contribution per unit

Sales Total contribution

$ per unit

$ per unit

$ per unit

units $

Product A: Titan brand 2.50 1.50 1.00 160,000 160,000 Unbranded 1.50 1.30 0.20 450,000 90,000 Product B: Titan brand 3.20 2.00 1.20 120,000 144,000 Unbranded 2.00 1.80 0.20 600,000 120,000 Product C: Titan brand 5.00 3.00 2.00 50,000 100,000 614,000 $ Marketing costs 180,000 Other fixed costs 375,000 555,000 59,000 Notional interest: 10% × $400,000 (40,000)

Residual income 19,000

(a) ROI = 59,000/400,000 = 14.75%.

(b) Residual income (see above) = $19,000.








59 Artiweb

(a) Sales. Artiweb appears to have achieved a very good sales performance in the first two quarters. Sales of $416,000 in the first quarter for a start-up business seem very good, and sales in Quarter 2 were over 44% higher.

Cost of sales and gross profit. In Quarter 1, the cost of sales 52% of sales, and in Quarter 2 it was about 54% of sales. From the information available in the table, it is not possible to identify the reason for the increase in the cost of sales as a percentage of sales (and fall in the gross profit margin). Either unit costs were higher in Quarter 2 or sales prices were lower. A falling gross profit margin (as a percentage) must be a cause of some concern.

Distribution costs. Distribution costs as a percentage of sales were 7.8% in both Quarter 1 and Quarter 2. This suggests that distribution costs might be a variable cost and under control (since costs as a percentage of sales revenue are not rising).

Administration costs. The increase in administration costs is also in line with the increase in sales revenue. It is unlikely that administration costs are a variable cost, since they include salaries for the two owner-managers. There is no information about whether these salaries were increased between Quarter 1 and Quarter 2. There is consequently insufficient information to assess administration costs, but these should be monitored and kept under control.

Web site development costs. These costs are written of to profit or loss as incurred. There was a significant fall in these costs in Quarter 2 and further large falls should be expected in the future.

Marketing. A large part of the marketing costs were incurred to launch the company and its business. The costs were much lower in Quarter 2 than in Quarter 1 and further cost reductions can be expected in the future, according to the information provided.

Other variable costs. These were about 12% of sales revenue in Quarter 1 and Quarter 2, suggesting that these costs remain under reasonable control.

(b) The losses made by the business are not a reflection of the likely future performance of the business. Further sales revenue growth should be expected, and if the company can keep the cost of sales under control (and prevent further falls in the gross profit margin) total gross profit will be expected to rise in future quarters. Some costs will fall, most notably web site development costs and marketing costs. If the owner-managers do not give themselves large salary increases, future rises in administration costs should be less than the rate of growth in revenue and gross profit.

If other variable costs and distribution costs remain a constant percentage of sales revenue, we can therefore expect substantial growth in gross profit and falling ‘other expenses’. Taking these together, a move from loss into profit could be expected very soon.

(c) Non-financial performance and other performance data

There was an increase of about 24% in web site hits between Quarter 1 and Quarter 2. This might seem a reasonable rate of growth, but it is essential to maintain the rate of growth in the future in order to continue growing the








business. It is possible that higher-than-expected spending will be needed for continuing web site improvements and marketing.

The ratio of units sold to web site hits was 4% in Quarter 1 and 4.5% in Quarter 2. This is an encouraging improvement, and the ratio compares well with the industry average of 4.1%. Sales returns were lower than the industry average, which also appears satisfactory.

Combining information from the two tables in the question, the average selling price per unit in Quarter 1 was $305 and in Quarter 2 it was $315. The decline in gross profit ratio would therefore appear to be caused by rising costs of sales rather than falling unit sales prices. The cost per unit sold was $158 in Quarter 1 and $170 in Quarter 2. This emphasises the point made earlier than costs of sales need to be kept under control.

The increase in the system down time to 4.5% must be another cause for concern, because when the system is down there can be no sales. Downtime might also discourage visitors to the site: having failed to get through to the site once, they might not bother to try again. Reducing the downtime should be a key target for Quarter 3.

It is not clear whether the speed of dispatch of orders is a significant statistic in this industry. However the improvement in the speed of dispatch might be an indication of greater efficiency in the distribution department.

In summary, the non-financial data helps to identify the increasing cost per unit sold and also suggests potential problems for the future with growth in web site hits and system down time. These are all issues to be managed and controlled in Quarter 3.

60 Debito Co

(a) Workings Q1 Q2 Q3 Q4 Average for

all quarters

Sales growth (%) (12.0)% 36.4% 16.7% 11.9%

Trainers: average cost per day $800 $800 $800 $800 $800

Room hire: average cost per day $400 $400 $400 $400 $400

Comment on performance against targets

(1) The North centre is not expected to increase sales revenue in each quarter, because revenue is expected to fall in Quarter 2 by 12% compared with Quarter 1. This means that the centre will fail to achieve the sales growth target, even though the average growth in revenue per quarter will be 11.9% and high rates of revenue growth are expected in each of Quarters 3 and 4.

(2) The average cost per trainer per day is expected to be $800 for each quarter. This is higher than the target maximum cost of $750 per day.

(3) The average cost of room hire per day is expected to be $400 for each quarter. This is higher than the target maximum cost of $375 per day. The North centre is therefore not expected to meet its cost targets for the year.








(4) The North centre is not expected to meet its profit targets for Quarter 1 and Quarter 2, although it is expected to exceed its profit target for the year as a whole.

From the figures available, it would appear that the North centre expects to have a successful Quarter 3 and Quarter 4 in terms of revenue growth and profitability, but it will not achieve revenue or profit targets in Quarter 1 and Quarter 2. In addition, cost targets will not be met.

It therefore seems clear that the manager of the North centre will not earn a bonus this year, in spite of the encouraging results expected in the second half of the year.

(b) Workings

Proposal 1: This will add revenue of 120/4 × $70 = $2,100 too each quarter, without apparently adding to costs at all.

Proposal 2: This will result in software costs of $8,000 in Quarter 1 and training costs of $2,000 in each of quarters 1 and 2. In quarter 3 total revenue will increase by $18,000, and in quarter 4 total revenue will increase by $21,000

Since the courses will be additional to those planned, there will be additional costs. We do not know whether ‘other costs’ will rise, but there will be some increase in costs of trainers and room hire. It is assumed that these will increase by 10%, as follows:

Q3 Q4 $000 $000 Trainer costs 4.8 5.6 Room hire costs 2.4 2.8

Proposal 3: This may have some effect on interest costs or interest income, since cash flows would be improved. There will be no other effect on profits. However, there is no data available to assess what the benefits might be. However, they will be small and so are ignored in the analysis below.

Analysis of the effect of the proposals

Q1 Q2 Q3 Q4 Total $000 $000 $000 $000 $000 Sales 152.1 134.1 200.1 233.1 719.4 Trainers 40.0 35.2 52.8 61.6 179.2 Room hire 20.0 17.6 26.4 30.8 89.6 Staff training 7.0 7.0 5.0 5.0 20.0 Software 8.0 Other costs 26.0 16.2 40.0 53.0 135.2 Total costs 101.0 76.0 124.2 150.4 424.0 Profit 51.1 58.1 75.9 82.7 267.8

(c) The combined effect of Proposals 1 and 2 would be to increase the expected profit by $19,800 in the current year.








(1) Proposal 1 would add $2,100 to profits in each quarter, so that if Proposal 2 is not implemented, the profit target for Quarter 1 would be met, but not the profit target for Quarter 2.

(2) Proposal 2 would increase profits in Quarter 3 and Quarter 4, but would reduce the expected profits in Quarters 1 and 2, because of the costs of the software and additional training.

However, taken together, Proposals 1 and 2 would not enable North regional centre to meet some of its targets:

(1) The target for ales growth in each quarter would not be met.

(2) The targets for cost control would not be met.

(3) The profit targets for Quarters 1 and 2 would not be met.

The manager of the North centre would therefore have no incentive to introduce any of the changes, because he would not earn a bonus from the improvements in the centre’s performance.

Proposal 3 should not be implemented. The benefits would be minimal and there would be a risk of annoying trainers who would have to wait longer before being paid. The potential costs of the bad will this might create are probable much greater than the small financial benefits that would be obtained.

(d) Tutorial note: Three suggestions are given here, but only 2 are required for the answer. Other suggestions might be equally acceptable.

(1) Performance should be assessed over a longer term. Assessing performance in each quarter is short term in outlook and might discourage incentives for longer-term initiatives that will improve profits in the long term but reduce them in the short term (such as Proposal 2).

(2) Performance targets for costs should not be as specific as those set by Debito Co. Managers should be allowed to spend more if the extra spending results in even more profits.

(3) The long-term success of a training company probably depends largely on the quality of the training it provides. The company should consider introducing targets for quality of courses. Quality might be measured, for example, by feedback from individuals attending courses.

61 Peseta Company

(a) Year 1 Year 2 Year 3 Year 4

$ $ $ $ Revenue 260,000 260,000 240,000 220,000 Gross profit 156,000 143,000 132,000 110,000 Net profit 20,000 21,000 12,000 7,000 Investment 160,000 120,000 80,000 40,000 ROI 12.5% 17.5% 15.0% 17.5% Sales revenue growth 0% (7.7)% (8.3)% Gross profit margin 60.0% 55.0% 55.0% 50.0% Net profit margin 7.7% 8.1% 5.0% 3.2%








ROI exceeds the target in Year 2 and Year 4, but is less than target in Year 1 and only just meets the target in Year 3. However this measure of performance fails to reflect financial performance properly, largely because the reduction in investment each year keeps ROI higher than it would otherwise be.

Sales revenue remained constant in Year 2 but fell in Years 3 and 4. This compares with a fall in sales of 2% per year in the market as a whole. The gross profit margin increased in Year 2 but fell in Years 3 and 4: this may be due to poor control over costs or to falling sales prices. Given the highly competitive nature of the market, the fall in sales revenue and gross margin may be caused by falling sales prices. The net profit margin also fell in Year 3 and Year 4, and was only 3.2% in Year 4. This was due to the fall in the gross profit margin and in spite of some reduction in other costs (from $136,000 in Year 1 to $103,000 (110,000 – 7,000) in Year 4. Taken as a whole, the performance of the centre appears to be unsatisfactory, but this is not properly shown by the ROI figures.

(b) An investment centre manager may be able to earn annual bonuses more often in several ways.

In the longer term, a manager could defer the replacement of non-current assets reaching the end of their useful life, so that the investment centre would be making profits using some non-current assets with a net book value of $0.

It may also be possible to bring forward or defer some transactions, so that revenue and gross profit is moved from one year to the next. In this way, it may be possible to manipulate annual profits so that ROI exceeds 15% in one year when it might otherwise have been less than 15%.

(c) Workings

Sales revenue in Year 1 will be 16,000 × $16 = $256,000. Gross profit is expected to be 60%; therefore the cost of sales will be 40% or $102,400. This gives a cost of sale of $6.40 per unit (= $102,400/16,000), which will remain constant in each year.

Year 1 Year 2 Year 3 Year 4

Units sold 16,000 17,600 19,360 19,360

Sales price $16 $15.20 14.44 13.718

$ $ $ $

Revenue 256,000 267,520 279,558 265,580

Cost of sales ($6.40 per unit) 102,400 112,640 123,904 123,904

Gross profit 153,600 154,880 155,654 141,676

Overheads 125,000 125,000 130,000 135,000

Net profit 28,600 29,880 25,654 6,676

Investment 200,000 150,000 100,000 50,000

ROI 14.3% 19.92% 25.65% 13.35%

Sales revenue growth 4.5% 4.5% (9.5)%








Gross profit margin 60.0% 57.9% 55.7% 53.3%

Net profit margin 11.2% 11.2% 9.2% 2.5%

(d) Net profit required to achieve ROI of 15% in Year 4 = 15% × $50,000 = $7,500.

Expected net profit in year 4 = $6,676.

Increase in net profit required to achieve ROI of 15% = $(7,500 – 6,676) = $824.

This would be achieved by increasing gross profit by the same amount, $824.

If we assume that all costs of sales are variable costs, the contribution/sales margin in Year 4 = 53.3% (see table above).

Increase in sales required to increase profit by $824 = $824/53.3% = $1,546.

This is about 0.6% of budgeted sales for the year.

An increase in sales of more than $824 or 0.6% would increase ROI to more than 15% and entitle the centre manager to a bonus.

62 Two divisions

(a) An optimal transfer price (or range of transfer prices) is a price for an internally-transferred item at which:

the selling division will want to sell units to the other profit centre, because this will add to its divisional profit

the buying division will want to buy units to the other profit centre, because this will add to its divisional profit

the internal transfer will be in the best interests of the entity as a whole, because it will help to maximise its total profit.

(b) When Division X has spare capacity, its only cost in making an selling extra units of Product B is the variable cost per unit of production, $48. Division Y can buy the product from an external supplier for $55.

It follows that a transfer that is higher than $48 but lower than $55, for additional units of production, will benefit both profit centres as well as the company as a whole. (It is in the best interests of the company to make the units in Division X at a cost of $48 than to buy them externally for $55.)

(c) When Division X is operating at full capacity and has unsatisfied external demand for Product A, it has an opportunity cost if it makes Product B for transfer to Division Y. Product A earns a contribution of $14 per unit ($62 - $46). The minimum transfer price that it would require for Product B is:

$ Variable cost of production of Product B 48 Opportunity cost: lost contribution from sale of Product A 16 Minimum transfer price to satisfy Division X management 64

Division Y can buy the product from an external supplier for $55, and will not want to buy from Division X at a price of $64. The maximum price it will want to pay is $55.

The company as a whole will benefit if Division X makes and sells Product A.

It makes a contribution of $16 from each unit of Product A.








If Division X were to make and sell Product B, the company would benefit by only $7. This is the difference in the cost of making the product in Division X ($48) and the cost of buying it externally ($55).

The same quantity of limited resources (direct labour in Division X) is needed for each product, therefore the company benefits by $9 ($16 - $7) from making units of Product A instead of units of Product B.

On the basis of this information, the transfer price for Product X should be $64 as long as there is unsatisfied demand for Product A. At this price, there will be no transfers of Product B.

63 INA

(a)

Definition

Benchmarking has been defined as ‘the establishment, through data gathering, of targets and comparators through whose use relative levels of performance (and particularly areas of underperformance) can be identified. By the adoption of identified best practices it is hoped that performance will improve.’

Forms of benchmarking

A major problem facing the management of INA lies in the accessing of information regarding the activities of a competitor firm that may be acknowledged to display best practice. Internal benchmarking i.e. using another function within the same firm as the standard can help in the avoidance of the problems of information access, but that clearly limits the scope of what can be achieved.

The most common approach is process benchmarking, where the standard of comparison is a ‘Best Practice’ firm which may be entirely unconnected with the benchmarking organisation and not even operating within the same industry. In this case the company is concerned with the processes by which its purchasing department establish and achieve targets. It is highly probable that the best yardstick for comparison would appear to be another organisation that is highly regarded for its management of such activities.

Objectives and process

The objective is to improve performance. This is best achieved by means of the sharing of information which should prove of mutual benefit to both parties to the benchmarking programme. As a result of receiving new information each party will be able to review their policies and procedures. The process of comparing respective past successes and failures can serve as a stimulus for greater innovation within each organisation.

To evaluate the operational performance of the purchasing department team the main contribution of benchmarking will be to establish a basis for targets which reflects the performance of an organisation which displays ‘Best Practice’ with regard to purchasing activities.

As a direct consequence of a comparison of existing standards with the ‘Best Practice’ organisation, managers can focus upon areas where improvements can be achieved and evaluate measures to help attain those improvements.








A principal benefit that will be derived by INA as a result of undertaking a successful programme of benchmarking will be the identification of areas where cost savings are possible.

Hence the levels of cost of sales and operating expenses can be reduced leading to increased profitability. Another benefit will be the setting of more realistic purchasing targets that will result in improved budgeting.

The improved performance of the purchasing department personnel will serve as a better platform for the introduction of initiatives such as, for example, performance related pay for the personnel within the purchasing department.

Set targets

Of fundamental importance to the programme is the need to define measurable targets and determine how those targets are going to be measured in quantitative terms. This is critical since benchmarking will be ineffective without a reliable form of measurement. Appropriate targets for use within INA might relate, for example, to the cost of sales as a percentage of turnover, costs of inventory, amount of discounts obtained, the number of stock-outs, the number of ‘emergency’ orders placed, the costs per order, the overall costs of the purchasing department.

There is a need to incur significant costs in terms of management time that needs to be invested in the benchmarking programme. However it is quite possible that considerable benefits will be realised as a result of the comparison of the activities of the purchasing department with that of an organisation that exhibits ‘Best Practice’ in terms of purchasing efficiency and effectiveness.

Identifying best practice and collaboration

With all this preparation complete, the company will then need to not only identify a ‘Best Practice’ firm against which to benchmark, but having done so it must be able to persuade that firm to collaborate in the benchmarking programme and in particular to share information. This is not an easy task to accomplish, as many organisations are reluctant to reveal confidential information to present or potential competitors.

Once the exercise is complete INA will benefit from improved levels of efficiency and effectiveness within the purchasing department, via better management information. In particular, improved visibility of costs incurred by the company will facilitate better decision-making.

(c) There are a number of potential problems inherent in undertaking a programme of benchmarking. There needs to exist a sufficient incentive for the respective parties to share information to their mutual benefit, as the success of the benchmarking programme is dependent on obtaining accurate information about the comparator organisation.

It may be very difficult to establish a co-operative agreement with a best-practice organisation. Many firms are unwilling to share sensitive performance data.

Moreover, it is essential that the business functions being benchmarked are similar enough to make the comparisons meaningful. The value of the exercise must be sufficient to justify the cost involved.

Also, it is inevitable that behavioural issues will need to be addressed in any benchmarking programme. This is especially the case if incentive schemes are in








existence and management may measure members of the purchasing department against each other.

64 BLA

Tutorial note

It is not expected that you will complete an answer of this length in the time available.

The Fitzgerald et al framework proposes six dimensions of performance which are controlled by service industries. Their propositions include that two of these, namely financial performance and competitiveness are the ‘results’ of actions previously taken and reflect the success of the chosen strategy. The remaining four dimensions of quality, flexibility, resource utilization and innovation are factors that determine competitive success now and in the future. The performance of BLA can now be analysed under this framework.

(i) Financial performance

Summary income statement for the year ended 31 October Year 3

Budget Actual

$000s $000

Fee income 6,075 6,300

Costs:

Consultants’ salaries 2,025 2,025

Bonus 90

Other operating costs 2,550 2,805

Sub-contract payments 18

4,575 4,938

Net profit 1,500 1,362

It is clear that BLA has not performed as well as expected during the year to 31 October Year 3. Whilst client income is above budget, other operating expenses reached a level which is more than 10% higher than the budget for the year, and thus it would be extremely useful to have a more detailed breakdown of other operating expenses for the year.

Consultants have earned an aggregate bonus of $90,000 (42,000 – 40,500) × $150 × 40% in respect of activity above budgeted levels.

Payments to subcontractors amounted to $18,000. Actual profit amounts to $1,362,000 against a budget of $1,500,000.

It would be extremely useful to see the results of the previous two years in order to assess whether there are any discernible trends in revenues and costs. The budget for the following year should be reviewed in the light of the actual performance of this year with particular reference to checking the footing of the assumptions upon which it has been prepared.

(ii) Competitiveness

Competitiveness may be measured in terms of market share or sales growth and the relative success in obtaining business from enquiries made by customers. The turnover of BLA for the year to 31 October Year 3 is above budget. Again it is








desirable to see the results of recent years since it might well be the case that BLA has achieved steady growth which is indicative of a high level of competitiveness in future years. BLA provided 1,200 consultations on a no-fee basis with a view to gaining new business. Also, during the year BLA consultants provided 405 non-chargeable ‘remedial’ consultations. Both of these non-chargeable activities might be viewed as initiatives to increase future levels of competitiveness.

It is useful to look at the extent to which BLA were successful in converting the enquiries received from both existing and new client enquiries into new business. The percentages are as follows:

Budget Actual

Conversion rate from enquiries

New clients 36.0% 26.7%

Repeat clients 50.0% 70.0% 70% of enquiries from the existing client base resulted in additional consultancy work for BLA. This is indicative of strong customer loyalty indicating that existing clients are satisfied with the service provided. However, the company did not perform well with regard to enquiries from potential ‘first time’ customers, only achieving a conversion ratio of 26.7%, which is approximately 74% of the intended number of ‘first time’ clients that were budgeted for. This indicates that there is probably room for improvement in the ways in which BLA deals with enquiries from prospective clients. The company should review its marketing strategies with a view to improving its conversion ratio.

As regards the nature of the chargeable activities undertaken by the consultants it can be seen that Exterior design is 14.6% below budget, whereas Interior design and Garden design are 6.4% and 35.1% above budget.

(iii) Service quality

Quality of service is the totality of features and characteristics of the service package that bear upon its ability to satisfy client needs. Flexibility and innovation in service provision may be key determinants of service quality. To some extent the increase in the number of complaints and non-chargeable consultations associated with the remedying of those complaints is indicative of a quality problem that must be addressed.

Client complaints received during the year were nearly double the budgeted level. Also the number of remedial consultations was 405 against a budgeted level of only 45, which is exactly nine times higher than budget! Perhaps BLA should review and, if necessary, limit the amount of remedial consultancy provided to any one particular client. The business development consultations can be viewed as an innovative measure with a view to gaining additional business.

It would be extremely useful to have a detailed analysis of the client complaints. In the scenario we were told that BLA only recommends contractors that undertake the three types of work when requested to do so by clients. In this regard it is important to recognise that a potential problem often exists where one party provides advice and another party is engaged to perform duties which relate to the provision of that advice.








(iv) Flexibility

Flexibility may relate to the company being able to cope with flexibility of volume, delivery speed or job specification. Hence, flexibility might be substantiated by looking at the mix of work undertaken by the consultants during the year.

The following table gives a comparison of actual and budgeted consultations by category of consultant.

Consultations by category of consultancy service

Budget % Actual % Increase/(decrease)

Exterior Design 40.0 32.9% (7.1%)

Interior Design 40.0 41.0% 1.0%

Garden Design 20.0 26.1% 6.1%

It is a deliberate policy of BLA to retain 45 consultants thereby maintaining flexibility to meet increasing demand. The delivery speed will be increased as a consequence of the retention of consultants. It would appear that a change has occurred in the mix of consultants which may well be a response to changing market requirements. Again, it would be useful to see recent years statistics in order to consider trends but notably Garden design looks to be a growth area hence the three new consultants recruited during the year. The mix of consultants should be such that BLA can cope with a range of job specifications. The fact that links have been retained with retired consultants will give an added dimension of flexibility in times of very heavy demand on its consultants.

(v) Resource utilisation

Resource utilisation measures the ratio of output achieved from those resources input. In this scenario the mean number of consultations per consultant may be used as a guide.

Average consultations per consultant Budget Actual Increase/(decrease) Exterior Design 900 922 2.4% Interior Design 900 957 6.3% Garden Design 900 912 1.3%

It is interesting to note that all categories of consultant are being utilised above budgeted levels. Consequently an aggregate bonus amounting to $90,000 was paid in respect of the year. There are potential problems if the quality of the service provision is falling. In this regard it would be useful to have more detailed analysis of the client complaints in order to ascertain whether a large proportion relate to any one category of consultancy and/or contractor.

(vi) Innovation

Innovation should be viewed in terms of its impact on financial performance, competitiveness, service-quality, flexibility and resource utilisation in the short, medium and long term. Certainly the non-chargeable activity in terms of ‘business development’ is an innovative feature within the business of BLA, as is the non-chargeable remedial consultancy provided to clients who experience








problems at the commencement of building works. The acquisition of ‘state of the art’ business software is by its very nature innovative. The result of its use is reflected in the significant increase of 35.1% above budget achieved in Garden design consultations. This has probably enabled BLA to differentiate its services from those of its competitors and enhance its reputation.

65 Talesin

(a) The overall performance of Talesin during the year ended 31 May Year 5 can be measured by its Return on Capital Employed (ROCE) as follows:

Year 5 Year 4

sliabilitie current less assets Totalinterest beforeProfit

= 000,66000,5

000,52000,4

= 7.58% 7.69%

A figure of 7.58% is not good especially when Taliesin Ltd has borrowed money at 10% in order to develop further. 7.58% is a slight fall from Year 4.

Sales have increased by 20% over the previous year. There is a considerable variation in the sales achieved by Talesin in the different halves of their accounting year. This variation in seasonal demand required the hiring of a secondary core work force for the period 1 June – 30 November during each financial year. Most of the growth in sales revenue occurred during the first half of the year ended 31 May Year 5.

Cost of sales has remained constant at 60% of sales. It is interesting to note that the composition of cost of sales has changed during the year and management should try to discover the reasons for this change. The material percentage content of cost of sales has remained constant whereas labour has decreased. Manufacturing overheads comprise the majority of cost of sales in Year 5 (51.5%). This is an increase of 1.5% over Year 4.

Year 5 Year 4

% of cost of sales:

% of cost of sales:

Materials 32.5 32.5

Labour 16.0 17.5

Overheads 51.5 50.0 ––––– ––––– 100.0 100.0 ––––– –––––

Whilst the gross profit percentage has remained constant at 40% the net profit percentage has reduced from 10% to 8.33%. In absolute terms, Talesin has earned the same profit during the year ended 31 May Year 5 as it did in the previous year.

Operating costs have risen by 27.5% over the previous year’s level. The company has also paid $1 million in interest on a loan which was taken out during the year presumably to finance the plant and equipment required in order to manufacture the six new products.








From the information provided it would appear that although sales increased by 20% over the previous year’s level, Talesin lost a customer during the year ended 31 May Year 5. It is quite conceivable that this only happened towards the end of the year and thus the income statement may not fully reflect financial consequences of the lost customer.

The loss of the customer could well be highly significant since the company had only six customers at the start of the year. It is highly probable, therefore, that each of the six customers, being supermarkets, purchased in relatively large volumes and thus significant turnover may have been lost. This will only become apparent during the next year but Talesin should attempt to find a new customer to replace the lost customer as soon as possible.

(b) The usefulness of activity-based techniques is accentuated in situations where overheads comprise a significant proportion of product costs. Manufacturing overheads comprise 30.9% of turnover during the year ended 31 May Year 5. Traditional methods of allocating overheads to products might result in product cost information which is misleading and detrimental to managerial decision-making. Calculations of product costs are more prone to error in situations where higher levels of overheads exist. The consequences can prove disastrous as, for example, in the under-pricing or over-pricing of products.

Since Talesin is going to confine its activities to its home country it must be prepared to face increased competition and this increases the need for greater visibility and more accurate product cost information. At present, Talesin offers a range of products which is increasing in number and this may lead to the need for a more detailed costing system. Traditional absorption systems might well be inadequate as the number of product variants increases.

Product development work and mixing ingredients are examples of activities which arise when new products are considered. If traditional absorption costing and budgeting are used based on machine-time in production then the effect of these activities on total product cost would be ignored. In order to gain a full appreciation of the impact of new product introduction activity-based techniques should be used to guide Talesin into the easiest way to maintain its policy of growth. For example, the application of activity-based costing can provide vital information that enables management to undertake customer profitability analysis, thereby further improving management decision-making and operating performance.

66 Behaviour

(a) The role of a management accountant is to provide information which can be used to assist and guide management in the pursuit and achievement of organisational objectives. The management information provided is read, interpreted and responded to by people within the organisation, and their responses will determine the quality of the decisions made and the extent to which corporate objectives are achieved.

Management accountants should be aware of this relationship and endeavour to ensure that the information that they supply is used in a way that benefits their organisation. The design and operation of a management accounting system should anticipate the behavioural consequences that are likely to arise as a result of its activities. A management accountant who fails to consider these








repercussions or denies responsibility for them is likely to operate a dysfunctional system.

This is most likely to manifest itself in a failure to secure goal congruence between the interested parties. The management accounting system will need to consider the particular culture of the organisation, whether it has a hierarchical or democratic structure, its attitude towards employee empowerment and the extent of delegated team decision making.

Use of ROI as a divisional performance indicator, for instance, can lead managers to delay investment to boost short-term divisional performance at the cost of longer- term results. Equally, use of top down budgeting in the wrong circumstances can lead to demotivation and the failure of staff to engage with the budget.

(b) Tutorial note

Use headings to identify each of the key areas being addressed (performance monitoring, budgeting, transfer pricing). To score highly make sure that BOTH issues and solutions are noted.

Performance monitoring:

There is a general acceptance of the idea that an organisation that monitors performance and rewards individuals for ‘good performance’ is more likely to encourage behaviour that is consistent with the objectives of the organisation. This involves the organisation ‘transmitting signals’ to its people as to what it deems desirable activities and outcomes in the workplace.

This approach has resulted in such terms and activities as performance monitoring, performance related pay, payment by results, bonus systems. The reward for the achievement of desired outcomes could be money, promotion, job security, preferred work activities, alternative work environments.

Issues

Performance monitoring and setting performance based rewards is a very complex task and problems are likely to arise in a number of areas:

It is very difficult in many work environments to measure individual performance – and if you resort to team performance, it is difficult to gauge the contribution from individual members.

It is difficult to ensure that individual targets are not inconsistent with other individuals or corporate objectives.

Current measured performance may discourage consideration of longer term issues that may have adverse repercussions.

Can a performance monitoring system comprehensively measure the key variables? For example, the desire to achieve greater volume/activity may be at the cost of quality that is more difficult to identify and appraise.

Measure fixation – concentrating on the measurement process and not on what needs to be achieved.

Misrepresentation – ‘creative’ responses that give a favourable view of activities.

Myopia – short sighted viewpoint with limited consideration to long term issues.








Solutions

The problems highlighted above can be managed if the following points are considered:

Do not underestimate the scale of the task in designing a performance monitoring system.

Consider the expectations and likely responses of all the parties concerned – take a broad view.

Ensure that the people designing and operating the system have a comprehensive understanding of the organisation’s activities and the interrelationship between all of the stakeholders.

Ensure that all parties involved believe that they will be beneficiaries of the system.

Be prepared to reappraise and modify – it is unrealistic to believe that it can be perfected at the first attempt.

Budgeting:

Issues

Adverse behavioural consequences of budgeting can arise from insufficient consideration being given to the task during the planning stage. The targets set may be perceived as:

Imposed

Complicated

Unfair

Irrelevant

Easy

Unachievable.

Solutions

This is likely to foster the ‘them and us’ syndrome and the consequential failure to achieve goal congruence. These undesirable consequences may be avoided by consulting with all interested parties, setting challenging but achievable targets, considering other people’s perception of the targets and anticipating their likely responses.

On the other hand, if budget holders are given complete autonomy or are permitted to have a significant influence on budgetary targets, they may be tempted to build in ‘slack’ to give themselves an easy life which is not in the interests of their organisation.

Further issues

Having implemented the planning stage, we need to turn our attention towards control.

Behavioural problems can arise from:

A failure to distinguish between controllable and non-controllable factors for each particular budget holder – people will feel aggrieved for being accountable for what they do not control.

A failure to account for the changing circumstances that have arisen since the budget was determined – may require budget adjustments and/or a flexible budget approach.








Failure to reward favourable variances – budget under spending that automatically results in cuts in future budget provision merely encourages spending of the entire budget, not something that should be encouraged.

Budget constrained approach – a requirement to conform to budget may stifle attempts at improvement.

Insufficient participation in budgetary control and poor communication of the reasons for change decisions may alienate staff.

Transfer pricing

Transfer pricing is primarily concerned with ensuring that semi-autonomous business units behave in a way that contributes towards the achievement of corporate and not merely divisional objectives. An effective transfer pricing system encourages divisional managers with autonomous decision making authority to pursue the interest of the corporation automatically whilst endeavouring to maximise the performance of their own business unit. Their decisions are made with self (divisional) interest as the driving factor, but coincidentally benefit the entire company. Effective transfer pricing systems consciously endeavour to harness selfish divisional behaviour to induce decisions that foster goal congruence.

Issues

Problems can arise when inappropriate prices are set that result in ‘wrong signals’ being sent and non optimal decisions being made:

Too high a price may result in unused capacity, lost contribution, reduced incentive to find external markets and

Too low a price may result in ‘excessive’ internal trading and a loss of valuable external business.

Solutions

To avoid these pitfalls the transfer pricing determination should consider:

The cost behaviour (fixed and variable) of the different divisions.

The adequacy of the information available to the divisions concerning both internal and external prices.

Both the short and long run consequences of the prices set – internal and external markets and capacity levels.

The degree of autonomy given to the divisions.

67 Project X

(a) Adopt a tabular approach as requested on the question. Ensure that figures for each year are shown.

Best outcome


$m $m $m

Revenue 84.0 94.5 105.0

Less: Direct costs 45.0 54.0 63.0

Profit before depreciation 39.0 40.5 42.0








Less depreciation 18.0 18.0 18.0

Profit 21.0 22.5 24.0

Less imputed interest (8%) 4.3 2.9 1.4

Residual income 16.7 19.6 22.6

Year 1 Year 2 Year 3 ROI 21/54 × 100 22.5/36 × 100 24/18 × 100

= 39% = 62.5% = 133%

Worst outcome


$m $m $m

Revenue 76.0 85.5 95.0

Less: Direct costs 55.0 66.0 77.0

Profit before depreciation 21.0 19.5 18.0

Less depreciation 18.0 18.0 18.0

Profit 3.0 1.5 0.0

Less imputed interest (13%) 7.0 4.7 2.3

Residual income (4.0) (3.2) (2.3)

Year 1 Year 2 Year 3 ROI 3/54 × 100 1.5/36 × 100 0/18 × 100

= 5.6% = 4.2% = 0% (b)

Residual income:

This measures net income after deducting an imputed interest charge on the capital employed. It is intended to ensure that the decision-making and performance assessment process incorporates the finance (interest) cost of securing funds for a project. It prompts the question – is this project a good use for scarce and costly funds?

Strengths

Signals to project sponsors that funding of projects involves finance costs.

Can be used to discriminate between projects that generate returns above and below the cost of capital.

Is a flexible tool as projects carrying differing risks can have separate rates of interest imputed.

Weaknesses

It does not facilitate comparison between projects that vary in size because it is an absolute measure of surplus.








Many difficulties can arise in deciding an appropriate and accurate measure of the capital employed on which to base the imputed interest charge (see further comments on ROI).

Return on investment

It gauges the efficiency of the project to generate outputs (profits) from resources input (required investment). It can be used

to assess short and long term decisions.

Strengths

It is directly related to the standard accounting process and is widely understood.

It appeals to investors who are interested in assessing the percentage return on an investment.

It permits comparison to be drawn between projects that differ in their absolute size.

It permits the performance of semi-autonomous business units to be compared with each other and with an aggregated figure.

Weaknesses

It can be difficult to identify the appropriate value of the investment – there are problems associated with the valuation of ‘assets’ in relation to their earning power. What are ‘assets’? Many ‘costs ‘are expensed, R&D for example, and do not form part of the asset base of an organisation but nevertheless make a significant contribution to the earning power of the entity. On the other hand, intangibles like brands and customer lists can be regarded as legitimate ‘assets’ in a balance sheet but are notoriously difficult to value.

Both recorded profit figures and asset values are subject to unscrupulous manipulation by senior managers in an attempt to artificially enhance the ROI performance of their companies.

It is not easy to compare the performance of investment centres if they have calculated their depreciation in different ways or have assets that vary in their age profile.

The ROI is likely to increase as assets depreciate and therefore this may deter necessary asset replacement if managers are assessed on short run ROI performance – short term ROI performance indicators may discourage long term optimal decisions being taken.

Where a conglomerate sets a common ROI target that has to be achieved for all new projects, it may present problems in assessing performance fairly where:

– the target return makes no allowance for projects with varying risk.

– where the various parts of the business operate in differing business environments.

(c) Issues to consider may include:

The anticipated project risk – is it known and can it be measured?








Does the project represent the commencement of a much larger long-term plan? An apparently poor performing project in the short term may proceed because of the long term prospects.

The relationship between different projects may need to be considered – the role of the project within the corporate plan.

The potential for an individual project to alter the overall risk of a company’s business activities e.g. a single project has the potential, if combined with certain other projects, to lower overall risk, and consequently the corporate cost of capital.

When will the project commence – now or later? Is postponement feasible?

68 Public performance

(a) Tutorial note

There are lots of different structured approaches A simple division between financial, non-financial and qualitative is one possibility as is use of Kaplan and Norton's balanced scorecard or Fitzgerald and Moons approach.

It does not matter which approach is adopted as long as the answer is structured.

‘Overall performance’ refers to a comprehensive coverage of the major issues that are generally regarded as important in assessing a public service. They could be broken down into three categories:

1 Financial indicators (assessing efficiency).

2 Non-financial quantitative indicators (assessing effectiveness).

3 Qualitative indicators that are difficult to quantify (assessing effectiveness).

Financial:

Cost per unit of activity/unit cost measurement e.g. per hospital bed per annum, annual cost per pupil, per arrest, per each call to attend a fire.

A comparison between actual and budgeted or standard cost (variance analysis) – flexible budget approach may be adopted to relate costs to activity levels.

Benchmarking costs against other regions and/or ‘best practice’.

An indicator that measures cost recovery against service delivered – e.g. fees received from dental patients who are required to contribute towards the cost of a service – may be set at a ratio to total costs incurred.

The ratio of one cost component to the total cost of the service e.g. staff costs as a percentage of the total costs. This could be supplemented by benchmarking ratios.

Non-financial (quantitative):

Units of activity delivered within a period, for example operations undertaken, number of children attending school, criminals arrested, fires attended.

Flexibility and speed of response, for example time taken for ambulances to arrive, hospital waiting lists and time elapsed between diagnosis and treatment.

Quality of service/output measures – pupils’ test marks, crime rates, life expectancy, the number of hospital deaths arising from infections, numbers of people rescued from fires.








Utilisation of resources, for example bed occupancy ratios, average class size, ratio of police vehicles currently operational.

Number of complaints received.

Accessibility, for example the distance to the nearest hospital or school.

Qualitative:

Public confidence in the service the strength of the expectation that

a criminal will be arrested.

a pupil will receive a ‘good’ education.

a patient will be ‘well looked after’ in hospital.

the fire service will respond rapidly when required.

The morale of the workforce.

The ‘attitude’ of the staff – do they appear concerned, helpful and confident when dealing with the public?

How effective are they at meeting the information needs of their ‘customers’?

Cleanliness, comfort, security – do people feel ‘comfortable’ within the premise owned by the public service (school and hospital)? It is part of ‘quality’, but it is difficult to quantify.

(b) Common problems are likely to include:

The simultaneous pursuit of multiple and sometimes conflicting objectives – the private sector frequently has a single prime objective e.g. maximisation of shareholder wealth.

Political interference – this may result in policy U-turns or long-term organisational objectives being sacrificed for short term political gains.

They are usually monopoly services therefore making it difficult to assess relative performance.

Attempts to overcome this via benchmarking with other regions can be problematical owing to geographical variations in operating environments.

It is very difficult to measure outputs that public services provide. What is the ‘output’ of the fire service? The private sector has measurable units of output whether it be goods or services – they charge for them! They also have a measure of net output – their profits.

Financial constraints, for example a private company could decide to borrow money if it thought it were in its interest, but a public body may be forbidden to undertake such action – the service may not have the freedom to act in what it regards as its own interest.

The temptation to judge outputs on the value of inputs – employing more people, spending more money on a service and building new premises is frequently taken to represent improved service provision but this is not necessarily true.








69 AV

(a) Tutorial note

Remember value for money is made up from economy, efficiency and effectiveness. Your answer should clearly discuss measurement of all three areas

The term ‘value for money’ is often used to refer to economy, efficiency and effectiveness. Value for money audits can be undertaken in order to assess whether value for money has in fact been achieved. In order for such an audit to be effective the objectives of AV would need to be clearly understood by those undertaking the audit.

The management of AV could attempt to measure the value for money of its operating activities in terms of economy, efficiency and effectiveness.

Economy

Economy is only concerned with inputs acquired by AV, and is achieved by obtaining those inputs at the lowest acceptable cost. For example, the prices at which with the replacement fitted kitchens are purchased ($2,610) could be compared with those obtainable from other vendors in order to assess whether the lowest acceptable cost is being achieved for the required level of quality. It is important that the management of AV realise that economy is measured by reference to quality of resource inputs. They need to recognise that the purchase of poor quality materials and inferior services represents false economy’.

Efficiency

Efficiency is focussed upon output, for example, maximising output for a given level of input. For example with regard to the replacement fitted kitchens, AV could use the tendering process in an attempt to maximise the number of fitted kitchens that would be installed for a given amount of money by the contractor awarded the tender. Efficiency is measured by the ratio of output to input resources. The ratio is not used in an absolute sense but in a relative sense and can be improved in four ways:

by increasing output for the same input

by increasing output by a greater proportion than the proportionate increase in input

by decreasing input for the same output, and

by decreasing input by a greater proportion than the decrease in output.

The denominator (input) is often measured in monetary terms whilst the numerator (output) can be measured in either monetary amounts or physical units, for example outputs per property.

Effectiveness

Effectiveness is focussed upon the achievement of objectives. A not-for-profit organisation will invariably have a number of objectives. For example AV may have the following objectives:

to meet housing needs

to provide quality well-managed homes

to provide the services that clients want

to provide an effective care and repair service








to support the communities within which it operates.

The three performance measures require individual consideration. For example the degree to which effectiveness is achieved gives no indication about how much was spent to achieve it (economy).

The management of AV should also recognise that these performance measures may conflict with each other. For example, during the year AV incurred expenditure amounting to $234,900 in respect of 90 replacement fitted kitchens. If AV had purchased the same replacement kitchen units as BW, then AV would only have been able to refit 45 properties ($234,900/$5,220). Hence, the efficiency ratio of inputs to outputs would have been halved. However, the purchase of replacement kitchen units at a cost of $5,220 might have resulted in a higher level of effectiveness being achieved through factors such as the longer life of the replacement kitchen units, higher quality fixtures and fittings, and enhanced aesthetic ‘appeal’ to residents.

(b) Service quality

The time required in order to undertake repairs of an emergency nature, after notification of the requirement by a tenant.

The friendliness of staff employed by AV which could be measured via the completion of questionnaires by tenants.

Flexibility

Mean waiting time for a house to become available to a tenant.

Mean waiting time to re-house a tenant in a different sized house after receipt of a request from a tenant.

The management of AV could use the following performance measures:

Cost and efficiency

AV BW

(1) The average cost, per week per house on management. $9.61 $29.81 –––––– –––––– (2) The average cost per week, per house on general

repairs. $10.22 $6.13 ––––––– –––––– (3) Percentage of rent available that was collected. 98.5% 100% –––––– ––––––

Notes/ comments:

(1) The average cost per week per house is calculated by dividing the amount of staff and management costs by the number of properties held by each of the respective organisations. Although the same number of staff (25) are employed by each organisation, staff costs incurred by BW are 37.7% higher than those of AV. This could result from different pay structures and management policies regarding remuneration that are likely to be employed within a profit-seeking organisation such as BW.

(2) AV currently pays, on average, $140 for each emergency repair, $120 for each urgent repair and $116 for each non-urgent repair. BW has benefited from the fact that each repair undertaken by BW costs the same (i.e. $100), irrespective of the classification of repair. This might be a result of a contractual arrangement with a sub-contractor that each repair undertaken is charged at the same fee in return for guaranteed business volumes for








the subcontractor. If this were the case, then AV would benefit from entering into such an arrangement for the supply of repair services.

(3) BW did not have any unoccupied properties at any time during the year. This would seemingly indicate a high level of demand for its properties. AV had potential gross rents receivable during the year of $2,423,200. Unoccupied properties resulted in lost revenues of $36,348, which amounted to 1.5% of gross rents receivable.

Tutorial note

Other ratios and relevant comments would be acceptable.

(c) The primary objective of any commercial organisation such as BW is to maximise profit. Management may take a short or long-term view regarding the ways in which they seek to achieve this objective. Management may have to choose between available options, each of which might help them to achieve this objective. However, whilst many decisions may have to be made, the objective remains clear and identifiable.

The management of BW will most probably be concerned with the provision of high quality accommodation in order to generate higher revenues and profits. The management of BW are probably trying to appeal to those who are willing to pay high rents for high quality accommodation. The fact that replacement fitted kitchens and replacement windows and doors purchased by BW cost 100% and 50% respectively, more than those purchased by AV may be an indication of this.

The objectives of not-for-profit organisations such as AV can vary significantly. AV’s primary objective is ‘to meet the accommodation needs of persons within its locality’. This might distil down to ensuring that any person, who is in need of accommodation, is in fact provided for. The absence of a profit measure makes it more difficult to measure whether objectives are in fact being achieved. It is difficult to judge whether non-quantitative objectives such as meeting accommodation needs of people have been met. This does not mean however, that such an assessment should be placed on the ‘too difficult pile’ and left unattended. A number of suitable measures need to be devised by the management accountant in order to assess the extent to which non-quantitative objectives have been met.

The management of AV would probably be better served in comparing the performance of their organisation with a similar non-profit seeking organisation that provides accommodation to meet the needs of society. Additional information that would assist in appraising the performance of BW during the year ended 31 May 2004 includes the following:

Estimates of the financial effects of changes in demand for different levels of rents charged.

Estimates of the financial effects of changes in demand for different costs/quality levels of accommodation provision.

A detailed analysis of sundry operating costs – $235,000.

Management accounts for the current and prior years.

Budget information for Year 4, Year 5 and, if available, Year 6.








70 Ties Only

(a) Financial performance of Ties Only Limited

Sales Growth

Ties Only Limited has had an excellent start to their business. From a standing start they have made $420,000 of sales and then grown that figure by over 61% to $680,000 in the following quarter. This is impressive particularly given that we know that the clothing industry is very competitive. Equally it is often the case that new businesses make slow starts, this does not look to be the case here.

Gross Profit

The gross profit for the business is 52% for quarter 1 and 50% for quarter 2. We have no comparable industry data provided so no absolute comment can be made. However, we can see the gross profit has reduced by two points in one quarter. This is 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 made, by 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 may have had to resort to sourcing extra new supplies at short notice incurring higher purchase or shipping costs. These could all reduce gross margins achieved.

Website development

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

Administration costs

These are 23·9% of sales in quarter 1 and only 22·1% of sales in quarter 2. This could be good cost control, impressive given 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 also reduce the percentage of cost against sales figure. This is an example of a business gaining critical mass. The bigger it gets the more it is able to absorb costs. Ties Only Limited may have some way to go in this regard, gaining a much greater size than at present.

Distribution costs

This 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 marketing

Another cost that although in this profit and loss account is unlikely to continue at this level. Once the ‘launch’ is complete this cost will be replaced by more general marketing of the website. Launch marketing will be more expensive than general marketing and so the profits of the business will improve over time. This








is another good sign that the results of the first two quarters are not as bad as they seem.

Other costs

Another 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. The reasons 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 without website 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 return significant 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 hits

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

Number of ties sold

The conversion rates are 4% for quarter 1 and 4·5% for quarter 2. Both these figures may seem low but are ahead of the industry average data. (Industry acquired data must be carefully applied, although in this case the data seems consistent). It appears 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

=27,631

$420,000 $15·20 per tie

Quarter 2

=38,857

$680,000 $17·50 per tie

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 profit must lie elsewhere.








On time delivery

Clearly 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 may not return. More attention will have to be placed on the delivery problem.

Sales returns

Returns are clearly common in this industry. Presumably, ties have to be seen and indeed worn before they are accepted as suitable by customers. The concern here is that the business’s return rate has jumped up in quarter 2 and is now well above the average for the industry. In other words, performance is worsening and below that of the competitors. If the business is under pressure on delivery (as shown by the lateness of delivery) it could be that errors are being made. If wrong goods are sent 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 the products could well be returned by unhappy customers.

This is clearly concerning and an investigation is needed.

System down time

System down time is to be avoided by internet based sellers as much as possible. If the system is down then customers cannot 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 a high specification) or when the site is under pressure due to peaking volumes. This second explanation is more likely in this case.

The down time percentage has risen alarmingly and this is concerning. Ideally, we would need figures for the average percentage 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 the website developers may well be warranted.

Summary

This new business is doing well. It is growing rapidly and ignoring non-recurring costs is profitable. It needs to focus on delivery 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:

%52420,000218,400

= %50680,000339,320

=

2. Website conversion rates Quarter 1: Quarter 2:

%4690,78927,631

= %5.4863,49238,857

=








3. Website hits growth

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

%2525.1

690,789863,492

==

71 Bridgewater Co

(a) The divisions of Bridgewater Co have been given very specific targets to meet it is reasonable to assume that performance will 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 growth looks better with an average growth of 14% achieved. We don’t have quarterly budget sales to compare to but the low growth in budget profit suggests that much slower sales growth than that actually achieved was expected. Overall the sales budget has 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 the promotion 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% on trainers. Given the manager’s attitude towards quality it appears he is trying to employ better trainers in the hope of more satisfied customers. This should, logically, build customer loyalty and improve local and brand reputation. This could possibly explain 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 performance measures, 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 learning environment 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 concerned is 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. His only 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 74.5 218.0 less: Trainers 8.0 7.2 12.0 14.4 41.6 Room hire 4.0 3.6 6.0 7.2 20.8 Staff training 1.5 1.5 1.0 1.0 5.0 Other costs 3.0 1.7 6.0 7.0 17.7 Software 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

Incremental effects (as a working)

Q1 Q2 Q3 Q4 Total $’000 $’000 $’000 $’000 $’000 Extra sales Voucher sales 2.5 2.5 2.5 2.5 10.0 Software sales 10.0 12.0 22.0 Extra costs Trainers 2.0 2.4 4.4 Room hire 1.0 1.2 2.2 Staff training 0.5 0.5 1.0 Software 1.8 1.8 Change 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 given that all the attendees will go on existing courses there will be no additional costs. The scheme seems to generate $10,000 of 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 already paid a higher price for a future course. However, most customers will probably not be aware of the price difference or will not bother complaining, those that do complain can be dealt with individually. It is common with promotions that the offer clearly states the terms and conditions that apply. In this way the manager can protect existing sales by excluding existing sales from the new offer.

From a promotion point of view the extra revenue and profit helps a little. If the revenue is spread evenly (as suggested) there will be $2,500 of extra revenue and profit in each of quarter 1 and 2. Unfortunately, in both cases the manager will still fall short of the target profit and the growth between quarter 1 and 2 will still be negative. He would need the take up rate of the sessions 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 argue that this development is essential. Financially the proposal looks sound. The extra courses will generate a








profit of $12,600 in this year alone, with, presumably, more courses to follow. A slower than expected take-up rate for the new course would reduce 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 until after the promotion decision is made. Integrity is an issue here. Personal promotional prospects must come second to sound business 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 flow in a positive manner. However, to delay payment without agreement can damage the relationships with the trainers, upon which 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 2 and 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 be to set targets for the quality of presentations given. Attendees could be asked to grade all trainers (or facilities) at the end of sessions. 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 quarter is too narrow and looking at the whole year is advisable. Wider issues should also be taken into consideration when making promotional decisions. Repurchase rates could be measured for client companies for example.

72 Pace Company

(a) Performance statistics

2005 2006 2007 2008

ROI 13% 17·5% 16·7% 20%

Bonus paid? No Yes Yes Yes

Sales Growth – 0% –10% –5·6%

Gross margin 40% 35% 35% 30%

Overheads $67,000 $56,000 $53,000 $43,000

Net 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 yet store W has shrunk in terms of sales over the last four years. This could be poor volumes or poor prices achieved. Given








the reducing gross margin (see below), then a reducing sales price is likely. It is possible that W is subject to higher than normal levels of competition.

Gross Margin

The gross margins have also shrunk. Reducing margins can result from sales price pressure or increases in the cost of sales levels being incurred. Suppliers might have increased prices or labour could have got more expensive. The level of margin has 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 disappointing performance.

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 the reducing asset base as the stores assets have gradually been depreciated. Net profit levels have fallen overall and yet ROI has increased.

It is hard to argue that the ROI figures properly reflect the performance of the store. The ROI will tend to increase as assets get older and this will distort the financial performance picture. In a period of falling sales and weaker margins the manager of 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 is having the information in good time to respond. The manager would have to be able to anticipate the 2005 poor result and the improvement in 2006. It is likely that such a manager would have to gamble at the end of 2005 and make an adjustment in 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 invoice before is normal, perhaps on the receipt of an order and before actual delivery. The invoice itself would not have to be sent to 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 2006 expenses instead.

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








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

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

2009 ($) 2010 ($) 2011 ($) 2012 ($)

Sales W1 216,000 237,600 248,292 235,877

Gross Profit W2 86,400 95,040 91,476 79,061

Overheads 70,000 70,000 80,000 80,000

Net Profit 16,400 25,040 11,476 (939)

Investment 100,000 75,000 50,000 25,000

ROI 16.4% 33.39% 22.95% –3.8%

W1

2009 2010 2011 2012

Sales Volume (units) 18,000 19,800a 21,780b 21,780

Sales Price ($) 12.00 12.00 11.40c 10.83d

Revenue ($)

(Volume x Price) 216,000 237,600 248,292 235,877

a: 18,000 (1·1) = 19,800

b: 19,800 (1·1) = 21,780

c: 12.00 (0·95) = 11.40

d: 11.40 (0·95) = 10.83

W2

Gross Profit

2009 40% (given). Total gross profit = $216,000 x 0·4 = $86,400

2010 40% (given). Total gross profit = $237,600 x 0·4 = $95,040

2011 (40 – 5)/100(0.95) = 36·8421052%

Total gross profit = $248,292 x 0.368421052 = $91,476

2012 (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 one and 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 = $86,400

VC per unit = $7·20

So 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.

73 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 male clients 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% in 2009 (W2).

There has been an increase in staff numbers for the female part of the business and this, combined with the fall in the volume of 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. This is probably mainly due to faster throughput, so that despite the lower average prices charged the overall margin was still quite good.

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 might encourage dissatisfaction. The addition of a junior will clearly reduce the overall average wage bill but increases costs overall whilst 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 that the launching of the new product range (males!) will have required advertising. Indeed, given the increase in sales of male hair 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 given the 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. Energy companies are often very large organisations where competition is rarely significant. Small businesses have little choice but to 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 margin and 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 he might 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 two main reasons. Firstly the switch away from a single gender salon has upset the existing customer base. It is possible that by trying to appeal to more customer types Oliver is failing to meet the needs of at least one group. It may be that the quality of hair 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). This implies that they are in training and could be of poorer quality. It is stated that they are in a supporting role but if not properly supervised 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 is concerned 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 asset utilisation.

As far as the staff usage is concerned it is a mixed scene. The female specialists are producing less per member of staff than in 2008 after the recruitment of one more staff member and a fall in volume of female clients. Each specialist served 2,000 female clients in 2008 and only 1,360 in 2009 (W9). Oliver may have been concerned with the complaints coming in and decided 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 probably not unusual; we are told that the male customer requires only a simple service. Without comparative data we cannot say whether 3,425 customers per year is good. We also cannot say that this specialist is doing ‘better’ than the others. Cutting men’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 for female 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 2009

Female $ $ Female $ Male $

Sales 200,000 170,000 68,500








Less 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 = $16,250 in 2008.

Additional staff cost $26,000 ($91,000 – $65,000) in total for two people. The junior was paid $9,000 and so the new 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% to 46/10,225 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 male clients 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.

74 Thatcher International Park (TIP)

(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. Large increases in admission prices reduce the value proposition for the customer, it is unlikely that the rate of increase is sustainable or even justifiable. Indeed with volumes falling (down by 6·7%, (W6)) it appears that some customers are being put 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 as required. This does not appear to be saving any money as the combined cost of maintenance and repair is higher in 2009 than 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 happy with the financial performance of the business and are prepared to reward the directors accordingly. Bonus levels are also well up. It may be that the directors have some form of profit related pay scheme and are being rewarded for the improved profit 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 least part of the wages cost is variable. It could also be that the directors are reducing staff levels beyond the fall in the level of customers 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 measure of performance and most would say this was a sign of good performance.

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 as ROI or return on investment. The return on assets is up considerably to 11·4% from 8% (W8). This is partly due to the significant rise in profit and partly due to the fall in asset value. We are told that TIP has cut back on new development so the fall in asset value is probably due to depreciation being charged with little being spent during the year on assets. In this regard 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 of the 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 disappointed being unable to ride. Given the fixed admission price system this is bound to irritate some customers as they have effectively paid 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. However TIP should be careful to maintain waiting times at a minimum. An increase of 10 minutes (or 50%) is likely to be noticeable by customers and is unlikely to enhance the quality of the TIP experience for them. The increase in waiting times is probably due to the high number of hours lost due to breakdown with customers being forced to queue for a fewer number of ride options.

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 compensation being paid or reputational damage








– Increased competition. The continuous raising of admission prices increases the likelihood of a new competitor entering the 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, less reliability of rides and longer queues). Regardless of the existence of competition customers could simply chose not to come, substituting another leisure activity instead

– Profit fall. In the end if customers’ numbers fall then so will profit. The shareholders, although well rewarded at the moment 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 person

2009: $5,320,000/140,000 = $38 per person

An 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 is an 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 = 180,000

2008 lost capacity is 9,000/180,000 = 0·05 or 5%

2009 lost capacity is 32,000/180,000 = 0·177 or 17·8%








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Mock exam questions This mock exam was the pilot paper for the new syllabus and is © The Association of Chartered Certified Accountants.

Answer ALL FIVE questions

1 Triple Limited

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:

Hours per unit Materials Production

Labour hours Machine hours Cost per unit ($) 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:

Number of set ups

Number of movements of

materials

Number of 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. (4 marks)

(Total: 20 marks)

2 Simply Soup Limited

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.

Table 1

F = Favourable. A = Adverse

Month 1 Month 2 Month 3

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.






Section 3: Mock exam questions


The standard cost card is as follows for the period under review

$

0.90 litres of liquidised vegetables at $0.80 per litre = 0.72

0.05 litres of melted butter at $4 per litre 0.20

1.10 litres of stock at $0.50 per litre 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)

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

Actual results for Month 4

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 $. (8 marks)

(Total: 20 marks)

3 BFG Limited

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. (10 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. (5 marks)

(Total: 20 marks)

4 Preston Financial Services

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.

Appendix 1: Financial information

Current year Previous year

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








Appendix 2: Balanced Scorecard (extract)

Internal Business Processes


Error rates in jobs done 16% 10%

Average job completion time 7 weeks 10 weeks

Customer Knowledge


Number of customers 1220 1500

Average fee levels ($) 775 600

Market Share 14% 20%

Learning and Growth


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) 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)

(Total: 20 marks)








5 Shocklat Co

Shoklat Co manufactures and sells one type of chocolate, which is sold as a very well-known branded item at a price of $14 per kilogram. This product is targeted mainly at children.

The product is made in a single process which combines a chocolate casing (material M1) with a filling (material M2). Material M1 costs $9 per kilogram and material M2 costs $7 per kilogram. They are combined in the ratio of 3 kilos of material M1 for every 4 kilos of material M2 and there is no loss in process.

The product research team, using information obtained from market research, has now developed two possible new products. By adding an extra ingredient M3 to the existing product formula Shoklat Co would be able to make a new chocolate product (CP1) that might appeal to men. Similarly by adding an extra ingredient M4 to the existing product formula it would be possible to make another new product (CP2) that might have a particular appeal to women. The market research also suggests that the appeal of the new products to the target customers would so strong that they could each be sold for a premium price. The market research cost $20,000.

Senior management of Shoklat Co are trying to decide whether to experiment with the two new products for a period of two or three months. The proposal is that about 10% of normal monthly production would be processed further and made into the two new products CP1 and CP2.

Data relating to this proposal for each month of the trial period is as follows.

(1) 35,000 kilos of the basic product will be produced and used to make the CP1 and CP2. Production of this quantity of the basic product will require 2,000 direct labour hours. Direct labour is paid $20 per hour.

(2) 800 kilos of ingredient M3 will be added to 6,000 kilos of the basic product to make 6,800 kilos of product CP1. M3 costs $19 per kilo. Additional processing will require 900 extra direct labour hours. CP1 is expected to sell for $30 per kilo.

(3) 1,200 kilos of ingredient M4 will be added to 29,000 kilos of the basic product to make 30,200 kilos of product CP2. M4 costs $80 per kilo. Additional processing will require 1,250 extra direct labour hours. CP2 is expected to sell for $20.50 per kilo.

(4) Shoklat Co has sufficient machinery to carry out the further processing. However direct labour is in short supply and the labour needed to making CP1 and CP2 would have to be taken off making the basic product. It will not be possible to hire additional labour within the next three months.

(5) The production of CP1 and CP2 would be supervised by the most experienced supervisor in the production department. His current annual salary is $80,000 which is 10% more than other supervisors in the department. It is expected that about 10% to 15% of this time would be taken up with supervision of the new work. This time will be divided 25% to CP1 and 75% to CP2.

(6) In the company’s costing system, fixed production overheads are absorbed into product costs at the rate of $40 per direct labour hour. There are no variable production overheads.








Required

(a) Explain briefly the financial and other factors that Shoklat Co should consider when deciding whether or not to make the CP1 and CP2 for a test period of three months. No calculations are required for this part of your answer. (4 marks)

(b) Prepare calculations to assess whether Shoklat Co should decide to experiment with making the two products CP1 and CP2 for a test period. Make separate recommendations about producing CP1 and CP2. (14 marks)

(c) Calculate a selling price per kilogram for CP2 that would achieve breakeven for production and sales of the product during the test period. (2 marks)

(Total: 20 marks)















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Answers to mock exam questions

1 Triple Limited

(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

Examiner’s note: 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 Production units Total hours

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

Type of overhead

Driver % Total overhea

d

Level of driver

activity

Cost/ driver

$

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

Product D Product C Product P Total

Overhead Activity $ Cost

Activity

$ Cost

Activity

$ 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 ——— ——— ———

(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






Section 4: Answers to mock exam questions


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; i.e. they involve a fair amount of `hassle`. This is explained by the following table of `activities per 1,000 units produced`.

Set-ups Materials movements Inspections

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 Simply Soup Limited

(a) (i) Meaning and controllability of the variances

Material price variance

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.

Material mix variance

This measures 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.

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


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

Cost efficiency

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.

(b) Variance calculations

Material price variance

Mixed vegetables: ⎥⎦

⎤⎢⎣

⎡−⎟

⎠

⎞⎜⎝

⎛80.0

82,000$69,700

× 82,000 = $4,100 (A)

Butter: ⎥⎦

⎤⎢⎣

⎡−⎟

⎠

⎞⎜⎝

⎛4

4,900$21,070

× 4,900 = $1,470 (A)

Stock: ⎥⎦

⎤⎢⎣

⎡−⎟

⎠

⎞⎜⎝

⎛50.0

122,000$58,560

× 122,000 = $2,440 (F)

Material mix variance

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

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

Stock: (122,000 – 112,092.7) × 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.


[112,000 – 101,902.4] × 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

208,900 05.21

= 101,902.4 litres

3 BFG Limited

(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 at $500 100,000

Second 200 at$450 90,000

Remaining 800 at$405 324,000 ———— Total 514,000 ————

(2) Direct labour

For first seven hundred batches y = axb

y = 2,500 × 700 - 0.3219

y = $303.461045

Total cost for first 700 batches = $303.461045 × 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 × 699 = $212,217








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

Total cost for the 12 months of production

$212,423 + ($206 × 500) = $315,423

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

(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 (at 80%) 500 × 0.8 = 400

Total time for two batches 2 × 400 = 800

Time for second batch 800 – 500 = 300

At 90%

Time for first batch 500

Average time for two batches (at 90%) 500 × 0.9 = 450

Total time for two batches 2 × 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 cash balances are up 5% – indicating improved liquidity. Positive cash balances are always welcome in a business.

Average debtors days (average time for receivables to pay) 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) The extra non-financial information gives much greater insight into key operational issues within the business and paints a bleaker picture for the future.

Internal business processes

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.

Customer knowledge

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.

Learning and growth

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.

5 Shocklat Co

(a) Factors to consider

When making any decision with a financial impact, the relevant costs and benefits of the decision should be considered.

(1) Incremental revenue. By further processing the basic product into CP1 and CP2, Shoklat will make incremental revenue. The additional revenue that would be earned is a relevant factor.

(2) Incremental costs. Further processing will result in incremental costs and also some opportunity costs. These are the relevant costs of further processing which must be include din the financial evaluation. (The relevant costs are the future cash flows arising as a direct consequence of the further processing decision.) However costs that have already been incurred, such as the market research costs, are not relevant.

(3) Impact on sales of the basic product. By making CP1 and CP2, production and sales quantities of the basic product will be lost. The loss of profit must be included in the relevant cost calculation. In addition the company








should consider the possible effect on customer loyalty in the longer term if supply to the market of the basic product is reduced. It might provide an opportunity for a rival producer of chocolate products to increase its share of the market for chocolate for children.

(4) Product safety. The company must be fully satisfied about the safety of the new products CP1 and CP2 before introducing them to the market. If testing has not yet been carried out, this will have an incremental cost to take into consideration.

(b) The incremental costs and benefits of further processing would be the same in each month of the trial period; therefore it is sufficient to make calculations for just one month.

Workings: opportunity cost of direct labour

Direct labour has an opportunity cost because it is in short supply and using labour to make CP1 and CP2 means that there will be a reduction in sales of the basic product.

The proposal is to further process 35,000 kilos of the basic product each month.

$ Cost of M1: 3/7 × 35,000 kilos × $9 135,000 Cost of M2: 4/7 × 35,000 kilos × $7 140,000 Material cost of the basic product 275,000 Direct labour: 2,000 hours × $20 40,000 Total variable cost 315,000 Sales value: 35,000 kilos × $14 490,000 Total contribution from these quantities 175,000 Contribution per direct labour hour $87.50 ($175,000/2,000 hours)

Incremental revenue and costs from further processing

The following costs are not relevant and should be ignored in the calculation:

(1) The market research cost is not relevant because it has already been incurred.

(2) The cost of the supervisor is not relevant because his salary will be paid anyway, and there will be no extra cash spending on supervision.

(3) The fixed overhead absorption rate is irrelevant because absorbed fixed overheads are not relevant costs. It is assumed that there will be no increase in actual cash spending on fixed overhead items as a consequence of the further processing.

Further processing to make CP1 $ $

Revenue from 6,800 kilos of CP1 (× $30) 204,000

Revenue from 6,000 kilos of basic product (× $14) 84,000

Incremental revenue from further processing 120,000

Incremental costs of further processing

800 kilos of M3 (× $19) 15,200








Direct labour: basic pay for 900 hours (× $20) 18,000

Direct labour: opportunity cost of not selling basic product (900 × $87.50) 78,750

Total incremental costs 111,950

Incremental profit from further processing to make CP1, per month 8,050

Over a three-month trial period, there would be incremental profits of $24,150 from making and selling CP1. This is a fairly small amount given the volume of processing involved, and comes to an additional profit of about $1.34 for each kilo of the basic product that is further processed.

Further processing to make CP2 $ $

Revenue from 30,200 kilos of CP2 (× $20.50) 619,100

Revenue from 29,000 kilos of basic product (× $14) 406,000

Incremental revenue from further processing 213,100

Incremental costs of further processing

1,200 kilos of M4 (× $80) 96,000

Direct labour: basic pay for 1,250 hours (× $20) 25,000

Direct labour: opportunity cost of not selling basic product (1,250 × $87.50)

109,375

Total incremental costs 230,375

Incremental loss from further processing to make CP2, per month (17,275)

Over a three-month trial period, there would be an incremental loss of $51,825 from making and selling CP2. This suggests that unless the product can be sold for a higher price or incremental costs can be produced, the company should not make and sell CP2.

(c) The breakeven selling price per kilo of CP2 would be the initial selling price of $20.50 plus $(17,275/30,200) = $20.50 + $0.572 = $21.072.













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