acca f5 performance management solved past papers 0208

Performance Management

Time allowed Reading and planning: 15 minutesWriting: 3 hours

ALL FOUR questions are compulsory and MUST be attempted.

Do NOT open this paper until instructed by the supervisor.

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

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

Fundamentals Pilot Paper – Skills module

Pape

r F5

The Association of Chartered Certified Accountants

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Answer ALL FOUR questions

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

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 Number of movements Number of Set ups of materials inspections Product D 175 112 1,150 Product C 115 121 1,180 Product P 480 187 1,670 670 120 1,000 Required:

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

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

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

(25 marks)



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

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

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

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.

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

Total cost to produce 1 litre of soup 1.47

Required:

(a) Using the information in table 1:

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

(6 marks)

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

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

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

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 $. (9 marks)

(25 marks)



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

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

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

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

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

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

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

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

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

Required:

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

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

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

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

(25 marks)



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

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

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

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 Current year Previous year Error rates in jobs done 16% 10% Average job completion time 7 weeks 10 weeks

Customer Knowledge Current year Previous year Number of customers 1220 1500 Average fee levels ($) 775 600 Market Share 14% 20%

Learning and Growth Current year Previous year Percentage of revenue from non-core work 4% 5% Industry average of the proportion of revenue from non-core work in accounting practices 30% 25% Employee retention rate. 60% 80%

Notes

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

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

Required:

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

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

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

(25 marks)

End of Question paper



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Formulae Sheet

Learning curve

Y = axb

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

Regression analysis

Demand curve

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

a = price when Q = 0

y=a+bx

b=n∑xy-∑x∑yn∑x -(∑x)

a=∑yn

-b∑xn

r=n∑xy

2 2

--∑x∑y

n∑x -(∑x) )(n∑y -(∑y) )2 2 2 2



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Answers



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Pilot Paper F5 AnswersPerformance Management

1 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

Examiners 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 overhead Level of Cost/driver $ driver activity 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



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(c) Comment

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

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

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

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

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

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

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

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

(d) Pricing and Profitability

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

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

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

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

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

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

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

2 (a) SIMPLY SOUP Limited

(i) Meaning and Controllability of the variances

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

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



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$69,70082,000

$21,0704,900

$58,560122,000

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

Material Yield Variance

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.

(iii) Changes to the performance management system

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

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

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

(b) Variance calculations

Material Price Variance

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

Butter: – 4 x 4,900 = $1,470 (A)

Stock: – 0.50 x 122,000 = $2,440 (F)



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Material Mix Variance

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

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

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

Total Mix Variance = $3,596 (F)

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

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

Note: alternate approaches are acceptable.

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

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

1 208,900 = 101,902.4 litres 2.05

3 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 @ $500 100,000 Second 200 @$450 90,000 Remaining 800 @$405 324,000 Total 514,000

(2) Direct labour

For first seven hundred batches y = axb

y = 2,500 x 700 –0.3219

y = $303.461045

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

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

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

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

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

Total cost for the 12 months of production

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

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



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

At 80%

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

At 90%

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

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

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

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

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

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

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

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

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

4 Preston Financial Services

(a) Financial analysis

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

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

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

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

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

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

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

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

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

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

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



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

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

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

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

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.



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Pilot Paper F5 Marking SchemePerformance Management

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

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

(c) Explanation 4 marks

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

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

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

Mix Cheaper mix and comment 1 mark

Yield High yield results and comment 1 mark

Quality Comment on quality implications 1 mark

Overall summary 1 mark 6 marks

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

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

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

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

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



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

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

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



PerformanceManagement

PART 3

FRIDAY 6 DECEMBER 2002

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A BOTH questions are compulsory and MUST beanswered

Section B TWO questions ONLY to be answered

Pape

r 3.3



Section A – BOTH questions are compulsory and MUST be attempted

1 Privmed is a privately owned profit seeking hospital that specialises in operations to replace hip and knee joints.Privmed traditionally determines its prices by adding a 10% mark-up to the budgeted full cost of an operation. Thefixed overheads are absorbed on the basis of operating hours using a predetermined rate.

Privmed Operating and Financial Data for 2001Hip Knee Total

Total operating capacity (hours) 10,800Theatre utilisation ratio 70%Average duration of operation 3·0 hours 3·6 hoursNumber of operations taken * 1270Total Costs £15,036,780Fixed overheads £12,000,000

* not given

The variable costs per operation are as budgeted.

Privmed Budgeted Data for 2001Hip Knee Total

Fixed overhead £12,000,000Annual operating hours 8,000Variable cost per operation £1,450 *

* not given

Required:

(a) Calculate the number of hip operations undertaken during the year and the variable cost of performing a kneeoperation. (4 marks)

(b) Calculate the prices that Privmed would have charged in 2001 for:

(i) A hip operation;

(ii) A knee operation. (4 marks)

(c) An activity based costing study recently discovered that the fixed overheads are determined by non operating timerelated activities. The study revealed the following data:

Activity Cost Driver Hip Knee Fixed 0verheadsConsultations with potential patients Number of consultations 3,000 2,000 £8,980,000X-rays Number of X-rays 6,200 6,200 £1,800,000Post-operative care Days of care 7,860 23,580 £1,220,000

Required:

Re-calculate the prices that would have been charged in 2001 for each knee and hip operation by using anactivity based costing approach. (5 marks)

(d) Compare the results of your calculated prices in (b) and (c) and suggest with reasons what pricing decisionsyou would recommend to the hospital. (5 marks)

(e) The Regional Public Health Authority is under pressure to reduce the length of its patients’ waiting lists for kneeand hip operations. In an effort to improve the situation the area manager has approached Privmed and askedthem to consider whether they would undertake some operations on a fee-paying basis. The approach iswelcome, as the hospital’s Theatre Manager would like to improve the utilisation of the facilities. Indeed, thehospital recently employed a consultant for a fee of £70,000 to assess the financial viability of undertaking publichealth authority operations at differing levels. The consultant concluded that contracting to undertake publichealth authority operations would also add to the administrative workload currently undertaken by the hospitale.g. billing and quality monitoring activities. It would be necessary to employ an additional clerk for £15,000 paand additional variable administrative cost per operation would be £150 for a knee operation and £100 for a hipoperation. If the hospital were to take on this work, it must also consider an additional requirement to keep 2·5%of its total operating capacity spare to meet the immediate needs of its ‘special’ clients i.e. it cannot plan to usethis proportion of its total capacity.

2For free ACCA resources visit http://kaka-pakistani.blogspot.com


The public health authority has approached the hospital and has proposed two alternative one-year contracts:

Contract (1)The hospital would be required to perform an equal number of hip and knee operations during the next year thatwould utilise their remaining available spare capacity. The public health authority has agreed that the contractprice should be composed of all the relevant incremental costs of the contract plus an 80% mark up.

Contract (2)The hospital would be required to perform 1,500 knee operations. The public health authority will refund all theadditional administrative costs resulting from the contract. The 1,500 additional knee operations would requirethe hospital to install a temporary operating theatre for a total cost of £500,000 with a two-year life. Oncompletion of the contract, the hospital estimates that it could lease the temporary theatre during its second yearwith the following revenue estimates:

30% probability of earning £200,00040% probability of earning £100,00030% probability of earning £80,000

The public health authority is only prepared to pay £3,500,000 in addition to the refund of administrative costsfor this one-year contract.

Required:

(i) Calculate the contract price and estimated financial benefit of Contract 1; (7 marks)

(ii) Calculate the estimated financial benefit of Contract 2. (3 marks)

Note: The data/calculations in this section are at 2001 price levels.

(f) If either of the contracts were to be taken on, it would result in no capacity being available to meet an unexpectedincrease in demand from its private patients.

Required:

Explain the potential revenue consequences of such an event occurring and compile a list of information/datathat you require to assess the financial consequences of the private patient demand unexpectedly rising to80% of the total capacity during the contract year. (7 marks)

(g) Suggest three broad areas of non-financial performance that the public health authority is likely to have tomonitor as part of a contract involving knee and hip operations. Your answer should include specific variablesthat are to be monitored. (5 marks)

(40 marks)

3 [P.T.O.For free ACCA resources visit http://kaka-pakistani.blogspot.com


2 Mack-King, a long established UK fast food chain expanded its operations abroad for the first time in 1999 in Coja.Although the UK business is much larger than the new operation in Coja, they both operate as semi-autonomousbusiness divisions with their own performance targets. Compared with the UK, the Coja business environment ischaracterised by significant political uncertainty and limited general awareness of Mack-King products and outletlocations.

Financial Data (£000) for Mack-King2000 ACTUALS 2001 ACTUALS

UK COJA TOTAL UK COJA TOTALTURNOVER 780 70 850 845 106 951Less:Labour 200 10 210 216 12 228Materials 150 20 170 165 24 189Other Operating Costs 80 5 85 85 5 90

–––– ––– –––– –––– ––– ––––430 35 465 466 41 507–––– ––– –––– –––– ––– ––––

Marketing 60 30 90 70 70 140Interest (Group) – – 14 – – 41Depreciation and amortisation 100 8 108 100 16 116

–––– ––– –––– –––– ––– ––––160 38 212 170 86 297–––– ––– –––– –––– ––– ––––

Total Costs 590 73 677 636 127 804Profit 190 (3) 173 209 (21) 147

NBV of Fixed Assets (year end) 520 40 560 520 90 610(includes capital expenditurein the year)Capital expenditure in year 90 30 120 100 66 166Long-Term Debt (Group) – – 140 – – 340Capital and Reserve 600 744

Required:

(a) Provide an assessment of the total corporate financial performance of Mack-King and of the contributionmade towards it by each of the two divisions between 2000 and 2001. (8 marks)

(b) Identify and explain the purpose of any additional information that would be required to provide a morecomplete assessment of Mack-King’s financial performance. (4 marks)

(c) Explain the problems that may arise in endeavouring to assess the comparative financial performance of themanagement in the two divisions. Suggest any allowances/adjustments that could be made to improve thevalidity of any comparisons between managers operating in different countries. (4 marks)

(d) Suggest two separate measures of performance that would be appropriate for a fast food chain, for each ofthe following areas:

Service Quality;Marketing Effectiveness;Personnel;Food Preparation. (4 marks)

(20 marks)



Section B – TWO questions ONLY to be attempted

3 You are responsible for managing the preparation of all revenue and cost budgets for a motor componentmanufacturer. You are aware that the external environment has a significant impact on the business activity andfinancial performance of your company and that the current information systems are underdeveloped and ineffectivein this respect.

Required:

(a) Identify which aspects of the external environment you are likely to consider and give reasons for your choice.(10 marks)

(b) Identify where you might find the relevant sources of information. (5 marks)

(c) Suggest how an external environment information system could be introduced into your company.(5 marks)

(20 marks)

4 (a) Explain the role and content of a Mission Statement. (5 marks)

(b) Explain how a Mission Statement could contribute towards the planning and performance measurementprocess. (9 marks)

(c) Identify the potential problems arising from using a Mission Statement to manage performance. (6 marks)

(20 marks)

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

Current Model:Total Costs = 5,000 + 0·6xTotal 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 + 0·8xTotal Revenue = 19x – 0·009x2

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

Required:

(a) Explain the structure of the current and the revised model. (4 marks)

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

(i) Suggest two alternative ways of determining this optimal level of output. (3 marks)

(ii) Discuss the extent to which adherence to this output target is a satisfactory indicator of managerialperformance. (3 marks)

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

(20 marks)

End of Question Paper



Answers



9

Part 3 Examination – Paper 3.3Performance Management December 2002 Answers

1 (a) Current utilisation = 0·7 x 10,800 = 7,560Hours spent on knee operations = 1,270 x 3·6 = 4,572Hours spent on hip operations = 7,560 – 4,572 = 2,988

No of hip operations =2,988

= 996–––––3

Total variable costs = £15,036,780 – £12,000,000 =£3,036,780Less variable costs of hip operationOn private patients (996 x £1,450) £1,444,200

–––––––––––= Variable cost of knee operations £1,592,580

–––––––––––

Therefore the variable cost of one knee operation on a private patient:

=£1,592,580

= £1,254–––––––––––1,270

(b) (i) and (ii)Hip Knee£ £

Variable costs 1,450 1,254Absorbed Fxed Overhead+ 4,500 5,400

––––– ––––––5,950 6,654

+10% mark-up 595 ,665·4––––– ––––––

Price 6,545 7,319·4––––– ––––––

+ workings£12,000,000

= £1,500 hourly overhead absorption rate––––––––––––8,000 hours

Hip = 3 hours x 1,500 = £4,500Knee = 3·6 hours x 1,500 = £5,400

(c) Hip Knee TotalConsulting (3:2) 5,388,000 3,592,000 = 8,980,000x-ray (1:1) 900,000 900,000 1,800,000Post operative care (1:3) 305,000 915,000 1,220,000

–––––––––– –––––––––– –––––––––––6,593,000 5,407,000 12,000,000–––––––––– –––––––––– –––––––––––

÷ no of operations 996 1,270––––––––––– –––––––––––

= Overhead per operation 6,619·5 4,257·5––––––––––– –––––––––––

Variable cost 1,450 1,254Fixed Overhead 6,619·5 4,257·5

––––––––––– –––––––––––Total cost per operation 8,069·5 5,511·5+10% mark-up 807 551.1

––––––––––– –––––––––––Price 8,876·5 6,062·6

––––––––––– –––––––––––

(d) The traditional pricing method based on operating hours does not consider the activities that drive costs. The activity basedinformation identifies the causes or ‘drivers’ of costs. The costs arising from the performance of hip operations exceed thecurrent prices being charged for them – each hip operation makes a loss. On the other hand, the price charged for a kneeoperation is far in excess of the costs arising from the operation. Indeed, the hospital may be losing some knee patientbusiness because their prices are far above their costs and may possibly be set at an uncompetitive level. The hospital wouldneed to consider the general market environment before making a final decision, but on the information currently available,they should lower the price of their knee operations and increase the price of the hip operations.



10

(e) (i) Contract 1

Available capacityHours

Total 10,80070% used (7,560)2·5% (kept spare) (270)

––––––Available for contract 2,970

––––––

The number of knee and hip operations possible can be solved by formulating simultaneous equations and then solvingthem.

2,970 = 3h + 3·6k h= hip k= kneek = h

2,970 = 3h + 3·k0 = 3h – 3k

––––––––––––––––2,970 = 6.6k

2,970 = k = 450–––––

6·6

HoursCheck: 450 x 3·6 = 1,620

450 x 3·0 = 1,350–––––

Total hours 2,970–––––

Therefore 450 knee and 450 hip operations are possible

£Hip 450 x (1,450 + 100) = 697,500Knee 450 x (1,254 + 150) = 631,800

––––––––––Total Variable Costs = 1,329,300+ Clerk’s salary 15,000

––––––––––Total attributable cost = 1,344,300

The mark up is 80% of the net attributable cost =Contract Price = 1,344,300 x 1·8 = £2,419,740Net benefit = 1,075,440

N.B. The £70,000 consultancy fee should be ignored in the calculation – it is a sunk cost and is not attributable to thiscontract.

(ii)£

Variable cost of 1,500 knee operations x £1,254 1,881,000Property 500,000Revenue in year 2·3 x 200,000 = 60,000·4 x 100,000 = 40,000·3 x 80,000 = 24,000 (124,000)

––––––––376,000 376,000–––––––– ––––––––––

Net attributable cost 2,257,000––––––––––

Contract price 3,500,000Att. costs 2,257,000

––––––––––Net financial benefit 1,243,000



11

(f) Potential revenue consequences:

– loss of alternative revenues from private patients who cannot be treated within the contract period

– turning away private patients during the contract period may have adverse long-term consequences – loss of goodwilland they go elsewhere in future

– a satisfactory service to the public health authority may result in a contract extension, providing long-term guaranteedrevenues

– the increase in demand that cannot be met may provide the opportunity to raise/re-negotiate future prices and hencerevenues with the public health authority

The financial consequences are essentially concerned with identifying the opportunity costs of not being able to meet theincrease in private patient demand when it rises from 70% to 80% of capacity.

Information/data is required to provide estimates :

– lost patient numbers

– type of operations not carried out

– lost revenues

– the associated costs that have been avoided

– the long-term consequences of lost goodwill arising from turning away patients

– will any switching take place between public health and private patients – how significant? Revenue and costconsequences?

– what it is the probability of the 80% utilisation ratio being maintained permanent?

– what are the operational and financial consequences of expanding capacity in both the short and the long term?

(g) Non-financial Performance Indicators:

– they will be concerned with ensuring that the operations are being carried out according to an agreed schedule of activity.This may be undertaken by comparing the cumulative running totals of scheduled operations with actual numbers

– Surgical Quality – the health authority will wish to monitor the ‘quality’ of the surgery. This may involve monitoring postoperative treatments, the health of the patients before and after the operation, and the number of fatalities

– Non-Medical Service Quality – this could involve monitoring any non-medical areas of service provision, e.g. patients’attitudes towards the quality of food supplied, the manner in which they were received at the reception or the informationprovided to concerned relatives.

Some candidates assumed that fixed overheads would increase as a consequence of the additional number of operations tobe performed with regard to question 1(e)(i) and 1(e)(ii). Where this assumption was made, it would result in a contract priceof £11,230,110 and estimated financial benefit amounting to £4,991,160 re part 1(e)(i). The same assumption would resultin an estimated financial benefit/(cost) of £(5,143,250) re part 1(e)(ii).

These solutions would be acceptable alternatives to those contained above.

2 (a) The candidates may choose other acceptable indicators to those identified in the suggested answer.

– Sales revenue growth

– Sales margin = operating profit before interest/Sales

– ROCE =Profit before interest–––––––––––––––––

Equity + debt

– EBITDA = Earnings before deducting interest, tax, depreciation and amortisation

– Financial Structure =Debt/Equity

– Fixed Asset Turnover =Turnover

–––––––––––Fixed Assets

2000 ACTUALS 2001 ACTUALSUK COJA TOTAL UK COJA TOTAL

Actual Sales revenue growth + 8·3% + 51% + 11·9%2001 Actuals comparedwith 2001 Budget + 1·8% + 6% + 2·3%Sales Margin (before int) 24·4 (4·2) 22·0 24·7 (19·8) 19·8ROCE % 25·3 17·3EBITDA 295,000 304,000Fixed Asset Turnover 1·5 1·8 1·52 1·6 1·2 1·6Debt

·23 ·46–––––Equity



12

Comments:Sales Revenue– the business is expanding particularly rapidly in Coja (actual revenue growth of 51%) – much faster then the overall

company.

ProfitsUnfortunately the rapid sales growth has been accompanied by increasing losses in Coja. The unprofitable activity in Coja,especially during 2001 mainly arises from the rapid growth in marketing costs. In contrast, the operating costs have growncomparatively slowly. The overall profit of the company has declined. The non-operating costs (interest and marketing) haveincreased from 104 in 2000 to 181 in 2001, a 74% increase.

The impact of the rising interest charges is highlighted when we compare the decline in profits from £173,000 in 2000 to£147,000 in 2001, with the rise in EBITDA from £295,000 to £304,000 during the same period (EBITDA excludes interestamongst other things)

The Coja operation appears to have relatively lower labour costs than the UK. This can be identified with two percentages:

2000 2001UK COJA UK COJA

Labour costs–––––––––––––––––––Total Operational costs

47% 29% 46% 29%

Labour–––––––Turnover

26% 14% 26% 11%

Fixed Asset UtilisationThe corporate wide asset turnover has remained steady although the drive for expansion in Coja has witnessed a declinebetween 2000 and 2001. This may be a consequence of a delay in sales growth following the investment programme in thenew market.

The Significance of Capital Expenditure in CojaIf we assume that the depreciation and amortisation arises only from FA depreciation, then the capital expenditure programmein Coja would have resulted in the NBV of FA increasing by 400% within two years (see table below). If as is more likely, theamortisation included some element of the writing down of intangibles (e.g. licence), then the growth of FA would have beeneven faster. This is in contrast with the UK where the NBV of FA remained constant for the same period.

COJA Fixed Assets UK Fixed Assets2000 2001 2000 2001

O/B 18 40 530 520ADD 30 66 90 115 DEP (8) (16) (100) (105)C/B 40 90 520 530

Financial StructureThe additional long-term borrowing resulted in the debt/equity rate doubling from ·23 to ·46, which exceeded the budgetestimates.

(b) – additional historic data – how is the current performance doing in comparison with the long term – what significantfactors have changed?

– competitor information – how are they performing in the current business environment in comparison with Mack-King?Are they doing better or worse? In what respects? Can Mack-King adopt some of the best practices and use them asbenchmarks?

– market development – has the fast-food market been changing? What are the likely changes in customer buying patternsduring the next few years? Is the company preparing for the future or merely dealing with the present?

– do the shareholders approve of the expansion into Coja – how has the share price been moving recently?

– the company is increasing its long-term borrowing, but what is the short run liquidity situation?

– Coja as long term – what are the long-term market and profit projections for Coja? Have they been modified in the lightof recent figures?

(c) This is concerned with the difficulty of differentiating the performance of the business unit from the performance of themanager of the unit. Coja is making a loss, but how well is the Coja manager performing? How is he coping with theenvironment within which he operates? Would another manager do better or worse than the current manager?

The UK manager’s unit earns considerable profit – this does not mean that he is necessarily a better manager. There is a needto compare on a ‘level playing field’ – but this never exists.



13

The measurement of managers’ performance needs to be clearly understood, objective and fair.

A ‘level playing field’ may be approached but probably never reached by

– taking both a long as well as a short-term view

– allow for differences in market environments e.g. setting different per capita customer spend targets according to localper capita income

– allowing for differing population density

– allowing for differing degrees of competition in the two divisions

– allowing for differing wage rates and local manpower skills availability

– differences in culture concerning the purchase of fast food – acceptable spending trends, frequency of purchase, the rateof take-aways to be eaten on premises

– allow for differing supplier chains and service provisions

– allow for foreign exchange rate fluctuations.

(d) Candidates are permitted to select any two relevant measures, so long as they are classified under the correct group.

Service Quality

– customer waiting time

– number of complaints

– proportion of regular customers

Marketing Effectiveness

– sales revenue growth

– sales revenue per employee

– market share

Personnel

– staff turnover

– absenteeism records

– training days per employee

Food Preparation

– food poisoning reports

– adherence to recommended food preparation methods

– material usage per product

3 (a) Information areas

Customers – What are their needs and expectations? Are the needs changing? What is the potential for products and markets?

Competitors – Who are they? What are they doing? Can their ideas/products be copied? Size? Pricing policy? Profitability?Market share?

Legal Framework – compliance requirements to meet statutory standards e.g. safety, labelling and working conditions.

Suppliers – Information is required concerning:

– quality of supplier

– prices

– potential of new suppliers

– financial viability of suppliers

Political and Environmental Framework The motor vehicle industry business will be influenced by government transport policy, vehicle emission standards and thehealth and safety laws concerned with production methods.

Financial and Economic EnvironmentBusiness activity is influenced by general level of economic activity. Inflation rates, interest rates, foreign exchange rates andthe levels of imports and exports all impact upon business.



14

All of the above issues are likely to have consequences for the company in terms of future

– business activity levels

– financial performance

– production method

– costs

– business viability

– market trends

and therefore need to be considered in the preparation of budgets – they will influence the future revenues, costs and growthof the company.

(b) Sources

Market research – commissioned or generally available from secondary sources.

Trade reports – magazines and conferences

Suppliers – price lists and brochures

Government reports – general reports and the occasional specific report on industrial sectors

Government statistics – economic indicators, industrial output, consumer spending, inflation rates.

Newspaper and other media reports – a great deal of this information is now available on the Internet – more accessible.

(c) Implementation

– data capture systems need to be developed with assigned responsibility for obtaining the information.

– monitoring systems are required to ensure that new information and new information sources are identified and utilised.

– ensure that the appropriate people receive the information that they require – avoid sending everyone all the data – mayresult in it being dismissed.

– dissemination of the information via

company magazine

e-mail/Internet

occasional meetings to discuss the impact of significant issues

– may need to categorise the information as being relevant for strategic or operational decisions – that this categorisationmay influence the frequency and detail required.

– do the people preparing the budgets have the competence to interpret and incorporate the information provided into theirestimates?

– is the information distributed in its raw form or is it modified to meet the internal users specific needs?

4 (a) A Mission Statement describes the organisation’s basic function in society. What is it trying to accomplish? The elements ofa Mission Statement might include:

Purpose: Why does it exist? A company exists primarily to create wealth for its shareholders whereas a hospital exists to carefor the sick.

Strategy: It may specify the business that the organisation is in, the product and service areas it is going to operate and thenecessary competences that need to be present.

Values and Culture: It may state the beliefs, ethical standpoints and principles under which activity is to be carried out.

The statement can range from short snappy sentences (‘Absolutely, Positively, Overnight’ for a parcel courier service) to a pagelong description of business intentions (for, example, for public sector organisations). Whatever the length, it should guide allemployees at all levels to work collectively towards the achievement of the corporate mission – ‘a guiding light’.

It may attempt to incorporate several of the stakeholders (for example, shareholders, customers, employees), and increasingly,the environment.



15

(b) The Mission Statement can play an important part in the planning process by providing:

– a framework within which the plans must be developed

– a focus on strategies

– a screening device for unacceptable projects, practices and activities

– a communication device to establish a common acceptable corporate culture.

This framework should impact upon both high level strategic plans e.g. what areas of business are acceptable, and onoperational planning decisions such as sources of supply and the way customers are dealt with by staff.

In terms of the owners, the statement may incorporate:

(i) a broad intention to enhance shareholder wealth

(ii) this then needs to be converted into specific goals such as to provide a return on investment and/or increase share value

(iii) then measurable targets will be developed, e.g. 20% return on investment annually and/or a share price increase of 5%in excess of the industry average

(iv) and to achieve the required 20% return on investment may necessitate the profit margin on sales to be 43%.

The mission statement will therefore result in the cascading down of increasingly more detailed plans and targets. Thesetargets will be set for the corporate entity, business sub-units and individuals. They will provide the basis of the performancemeasurement when they are compared with the outcomes.

Good performance might be concerned with the extent that we are achieving the mission, the organisation never gets there,it is more of a journey that should be pursued. Performance is concerned with assessing the extent that a desire, goal,objective or target has been achieved – a comparative judgement. To what extent have we achieved what was set out to bedone?

(c) Potential problem areas:

– the wording of the statement may be rather vague and abstract and therefore provide limited assistance in developingstrategies

– the content of the statement may provide the management with non-congruent goals. For example, maximisingshareholder wealth may conflict with any ethical statements made in the mission. Trade-offs between quantifiablefinancial targets and non-quantifiable goals complicate the assessment of managerial performance

– the potential for inconsistent goal setting can occur between departments, differing managerial levels and over time

– the Mission Statement is occasionally regarded by employees as ‘political window dressing’ and does not in their viewreflect actual company strategy and the actions of management – this may result in adverse behavioural consequences

– the statement does not normally stipulate a time horizon for the achievement of the mission – problems arise inassessing how well the organisation is doing.

5 (a) The cost model is a simple linear equation of the form y = a + bx, where a represents the fixed costs and b the variable costsper unit. Hence the current cost model has fixed costs of £5,000 and a unit variable cost of £0·6. The revised cost modelreduces the fixed cost element to £4,750 but the unit variable cost rises to £0·8 Therefore, the revised model generates lowercost estimates at lower output levels, but higher cost estimates at higher output levels than the current model.

The revenue function depicts a conventional non-linear downward sloping demand curve where the company has to lowerits sale price of all of its units if it wishes to sell more. The revised coefficients in the revised model results in a lower initialprice (from £20 to £19) but a slower decline in price as the units sold increase. The revision in the coefficient from 0·01 to0·009 results in the price declining at a slower rate than previously for any given change in units sold ie the revised modeldepicts a lower price elasticity of demand. Therefore the revised model generates lower total revenue estimates at low unitsales, but greater total revenue estimates at high unit sales than the current model.

(b) (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 = MCthe optimal demand occurs. Solve the equation to find the optimal level.

– by calculating the values of total revenue and total cost at all potential unit output levels and identifying where revenuesexceeded costs by the greatest absolute amount.

(ii) The amended model should quantify the current efficient application of resources in the achievement of the optimumdemand level. It should therefore be a measure of current efficient managerial performance. However, managerialperformance 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 sufficientlysophisticated to incorporate all the variables which reflect managerial performance.



(c) – the structure of cost and revenue models frequently rely on historical information as source data – but how reliable isthis for forecasting? How effective is the past as a predictor for the future? Cost and revenue relationships can alterradically over time with technological and market changes – there is a need to consider the significance and impact ofthese issues on long-term forecasts. The solution may be to have different models for short and long-term forecasts withmore detailed and stringent accuracy requirements for the shorter term estimates.

– The cost models assume a constant fixed cost over all ranges of output – how realistic is this? Perhaps the cost modelcould incorporate a step cost function that increases as specific output levels are attained. Is the step cost necessarilyan abrupt change or is it possible to incorporate a sliding step cost that results from capacity being temporarily expandedby 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 reasonableassumption? 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 functiondepending on the purchase contract terms.

– are the revenue and cost forecasts based at constant prices or do we incorporate an allowance for inflation? This willprobably depend upon the length of the time horizon that we are applying. What inflation factor do we use? Is RPIappropriate or do we require a more specific inflator because the industry prices change at a different rate to the generaleconomy? Indeed in certain high tech areas the forecast may be for a general decrease in prices.

– The forecast price elasticity of demand incorporated into the model is critical in forecasting revenues, but how accuratecan this be in a changing business environment? The model could be improved by considering the factors that determinethe price elasticity of demand and incorporating the variables into the model i.e. by making the model more sensitive tothe critical issues. This will increase both the potential accuracy of the model and unfortunately, the complexity of it.

– the revenue functions are extremely simple with price being the only factor in determining the units sold. The modelconcentrates on movements down the demand curve to influence the total revenue estimates and gives no considerationto movements in the demand curve i.e. the other factors apart from price that influences the amount sold. The modelwould 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 thereappropriate quantifiable data available that is suitable for inclusion?



17

Part 3 Examination – Paper 3.3Performance Management December 2002 Marking Scheme

Marks1 (a) Number of operations 1

Variable cost of hip 1Variable cost of knee 2____

4

(b) (i) Price of hip 2Price of knee 2____

4

(c) Overhead apportionment for knee 2Overhead apportionment for hip 2Price of hip and knee 1____

5

(d) Explanation of (a),(b),(c) 2Consequences of costing method on prices 3____

5

(e) (i) Available capacity 1Simultaneous solutions 3Total attributable cost 2Contract price 1

(ii) Revenues 1Attributable cost 1Net financial benefit 1____

10

(f) Potential revenue consequences 3Information required 4____

7

(g) Schedule activity 1Surgical quality 2Non medical 2____

5____

40____

2 (a) Relevant calculations 4Comments 4____

8

(b) 1 x each point identified (maximum 4) 4

(c) Problems 2Allowances – 0·5 each point made 2____

4

(d) Service 1Marketing effectiveness 1Personnel 1Food Preparation 1____

4____

20____



18

Marks

3 (a) 2 marks for each information area identified and briefly explained 5 × 2 10

(b) 1 mark for each source identified 5 × 1 5

(c) 1 mark for each method of introduction 5 × 1 5____

20____

4 (a) The role 2The elements 3____

5

(b) What the statement provides 3Cascading objectives and targets 4Relating statement to performance 2____

9

(c) Problems identified (1·5 each) (maximum 6 marks) 6____

20____

5 (a) Explanation of cost equation 2Explanation of revenue equation 2____

4

(b) (i) 1·5 marks per alternative 3(ii) Discussion 3____

6

(c) 2 marks per issue x 5 (maximum) 10____

20____

____

Maximum Total 100____




PART 3

FRIDAY 6 JUNE 2003

QUESTION PAPER





Present Value and Annuity Tables are on pages 7 and 8

Pape

r 3.3



2


1 A motor car manufacturer has been specialising in the production and sale of one model of car. The model issomewhat dated, and the current sales forecast indicates that the sales will decline from the current level (2003) of170,000 cars per annum to 150,000 in 2004, 130,000 in 2005 and 110,000 in 2006. The company suppliesto order and no stocks are held. Carbon monoxide emission regulations will prevent the model being manufacturedand sold after December 2006.

The company’s current estimates of the selling price and costs in 2004 are as follows:

Per car £

Selling Price 9,500Production costs:

Material and labour (vary with production volume) 3,600Assembly* 4,000

*75% of the assembly costs are fixed and the remainder vary with production volume.

In addition, the company estimates that it will incur the following non-production costs:

Marketing costs of £60 million. 50% of these vary with sales volumeDelivery costs of £75 million. 20% of these vary with sales volume.The Administration costs of £10 million are fixed.

The selling price, variable costs per car and total fixed costs are expected to remain constant throughout the periodfrom 2004 to 2006.

The company’s Managing Director is unhappy with the current annual profit forecasts for 2004–2006 based uponthe information above and believes that the company has the potential to increase the profit to £280m in each of theyears 2004 to 2006. The Managing Director has undertaken a strategic review and developed the following strategies:

Strategy 1A marketing proposal will enable the company to enter a new overseas market with the result that the total (includingthe overseas market) sales level will be stabilised at 160,000 cars per annum from 2004 to 2006. The market entrycosts will be £30 million for each of the three years.

Strategy 2A re-design of the car will enhance its sales appeal and will permit the company to increase its selling price to£10,000. The re-design costs are £30 million and are to be amortised over three years on a straight line basis.

Strategy 3A radical cost reduction programme will improve efficiency and lower all variable costs by 20%. This will add £70million to the annual fixed overheads each year from 2004 to 2006.



3 [P.T.O.

Required:

(a) Prepare a financial analysis showing the current annual forecast of costs, revenues and profits for each ofthe years 2004 to 2006 and briefly comment on the figures. Ignore inflation. (6 marks)

(b) Estimate the profit in 2004 if:

(i) Strategy 1 was implemented; (2 marks)

(ii) Strategy 2 was implemented; (2 marks)

(iii) Strategy 3 was implemented. (2 marks)

(c) Estimate the profit in 2004 if all three strategies were implemented. (4 marks)

(d) Explain why the total of the increase in profit arising from the three strategies implemented separately in (b)is different from the total profit calculated in (c). Illustrate your answer with a numerical reconciliation of thedifferences in the two profit figures. (5 marks)

(e) Explain how ‘Gap Analysis’ can be used to assist a company to plan the achievement of its strategic profitobjective. Illustrate your answer with a diagram which quantifies the effect of your calculations in (a), (b),(c) and (d) above. (7 marks)

(f) (i) Explain how sensitivity analysis could be used in conjunction with the profit estimates that you havemade for the company and illustrate your answer with reference to each of the strategies;

(ii) Calculate and comment on the percentage change in the key variable in each of strategies 1, 2 and 3from its original forecast level in order that the desired profit level of £280m for 2004 will be achievedin each case. (8 marks)

(g) What major external environmental factors need to be considered in assessing the success of the threestrategies? (4 marks)

(40 marks)



4

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

Project X Data1. 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 £80m in year 1, £90m in year 2 and £100m in

year 3. These values may vary by ±5%.3. The incremental costs will be £50m in year 1, £60m in year 2 and £70m in year 3. These may vary by ±10%.4. The most likely cost of capital is 10%.This may vary from 8% to 13% for the life of the project.

Additional information:Assume that all cash flows other than the initial investment take place at the end of each year. 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 projectand also net present value (NPV) for:

(i) The BEST OUTCOME;

(ii) The WORST OUTCOME. (8 marks)

(b) Explain the distinctive features of Residual Income, Return on Investment and Net Present Value inmeasuring financial performance.

Your answer should include a critique of the strengths and weaknesses of each measure. (8 marks)

(c) What broader issues are likely to be considered when deciding whether the company should proceed with aparticular project? (4 marks)

(20 marks)



5 [P.T.O.


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

£Materials 1,000Assembly Labour (50 hours at £10 per hour) 1,500Fixed Overheads (200% of Assembly labour) 1,000Profit (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 constantirrespective 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 bethe 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 beassembled, 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 weplaced an order for the first eight to be assembled?

Required:

(a) Explain Learning Curve Theory and in particular the concept of cumulative average time. (4 marks)

(b) Provide detailed price quotations for each of the three enquiries outlined above. (6 marks)

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

(20 marks)

4 A mixed economy operates a range of public services including Fire, Police, Education and Health. The services areprovided on a regional basis but are funded from central government taxation. The government is endeavouring toimprove 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 itsassessment.

Your answer should be from a generic point of view and references to particular services should be used only forillustrative purposes. (10 marks)

(b) Explain the particular problems that are likely to occur in attempting to monitor the performance of a publicservice that would not arise when assessing private sector activities. (6 marks)

(c) Suggest ways in which the problems that you have highlighted in answering section (b) may be managed orovercome. (4 marks)

(20 marks)



5 ‘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 behaviouralconsequences of its application. (5 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. (15 marks)

(20 marks)



7 [P.T.O.

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Answers



11

Part 3 Examination – Paper 3.3Performance Management June 2003 Answers

1 (a) 2004 2005 2006Sales units 150,000 130,000 110,000

£m £m £mRevenues 1,425 1,235 1,045Less Variable Costs– Materials and Labour 540 468 396– Assembly (variable) 150 130 110– Marketing 30 26 22– Delivery 15 13 11

––––– ––––– –––––Total 735 637 539

Contribution 690 598 506Less Fixed Costs

Assembly 450 450 450Marketing 30 30 30Delivery 60 60 60Administration 10 10 10

––––– ––––– –––––550 550 550

Profit = 140 48 (44)

The drop in sales volume will result in a decrease in the total annual contribution. The profit performance will decline and aloss will be sustained by 2006.

(b) Original Strategy 1 Strategy 2 Strategy 3Forecast

Volume 150,000 160,000 150,000 150,000Selling Price £9,500 £9,500 £10,000 £9,500

£m £m £m £mRevenues 1,425 1,520 1,500 1,425Less Variable Costs– Materials and Labour 540 576 540 432– Assembly 150 160 150 120– Marketing 30 32 30 24– Delivery 15 16 15 12

––––– ––––– ––––– –––––Total 735 784 735 588

Contribution 690 736 765 837Less Fixed Overheads– Assembly 450– Marketing 30 550 550 550– Delivery 60– Administration 10– Strategy 1 30– Strategy 2 10– Strategy 3 70

––––– ––––– ––––– –––––550 580 560 620

––––– ––––– ––––– –––––Profit 140 156 205 217

––––– ––––– ––––– –––––



12

(c) All three strategies together:2004

Selling Price 10,000Volume 160,000

£mRevenue 1,600Less Variable Costs:– Materials and Labour 460·8– Assembly 128·0– Marketing 25·6– Delivery 12·8

627·2Contribution 972·8Less Fixed Overheads– Assembly 450– Marketing 30– Delivery 60– Administration 10– Strategy 1 30– Strategy 2 10– Strategy 3 70

––––––660

––––––Profit 312·8

––––––

(d) Increase in profit from separate strategies:

£mStrategy 1 16Strategy 2 65Strategy 3 77

–––

Total increase in profit £158m––––––

The increase in profit from the implementation of 3 strategies simultaneously –

312·8 – 140 = £172·8m

A net increase of £14·8m when they are combined together.

There is a synergy between the three strategies that provides a contribution greater than the sum of their parts.

£mStrategies 1 and 2:Additional units (10,000) x additional contribution (£500) = 5·0

Strategies 1 and 3:Additional units (10,000) x saving in variable costs (£980) = 9·8

––––14·8––––

OR additional units (10,000) x additional contribution (1,480) = £14·8m––––––––––––––

(e) Gap Analysis is concerned with the gap between the forecast position from continuing with current activities and the positionthat the organisation desires. It is not the gap between the current position and the forecast position. The Managing Directoris unhappy with the current profit/(loss) forecast of £140m in 2004, £48m in 2005 and £(44)m in 2006. The strategiesoutlined will enable a profit of £312·8m to be achieved in 2004.

Each strategy contributes towards filling the gap

£312·8m – £140m = £172·8m



13

The desired position for 2004 is to achieve more than double the current profit estimate of £140m i.e. in excess of £280m.Gap analysis can be illustrated with the following diagram.

(f) (i) Sensitivity Analysis is a technique that permits options to be tested as to their sensitivity/responsiveness to changes inspecified key variables such as units sold, price and material costs. The strategies outlined above generate otherpredicted outcomes from specified changes in particular variables. For example:

Strategy 3 Strategy 3 offers a 20% reduction in variable costs as a result of a £70m cost reduction programme. Whatif the £70m cost reduction programme only reduced costs by 15% – is it still worthwhile? How sensitive isthe success of the strategy on the original estimates?

Strategy 1 What additional profits result from strategy 1 if the sales only rose to 155,000 or 156,000?Strategy 2 What if a re-design permitted the price to rise to £9,700 or £10,200 and not 10,000?

Sensitivity Analysis can be used to assess the robustness of a strategy – will it continue to deliver its major benefits inspite of some changes in key variables.

It provides management with more information than a single point estimate of an outcome. It provides a range ofpredicted outcomes depending upon the behaviour of key variables. It considers risk and uncertainty by offeringalternative scenarios – increasing realism and complexity.

(ii) Percentage changes/sensitivity data:

Strategy 1 – % change in volumeContribution required = £580m + £280m = £860m Original forecast contribution = £690mTherefore, units increase required = (£860m – £690m) /£690m = 24·6%

Strategy 2 – % increase in selling price from re- designExtra profit required = £280m – £205m = £75mTherefore the revenue required = £1,500m + £75m = £1,575m This requires a selling price of £1,575m/150,000 = £10,500 per carTherefore the % increase in selling price = (£10,500 – £9,500)/£9,500 = 10·5%

Strategy 3 – % reduction in variable cost from cost reduction programmeAdditional profit required = £280m – £217m = £63mThe variable costs required = £588m – £63m = £525m Therefore the % reduction in variable costs required = (£735m – £525m)/£735m = 28·6%

This indicates that a much greater percentage change from the current forecast is required in the key variable(s) forstrategies 1 and 3 if the desired outcome is to be achieved as compared to the percentage change required for strategy 2.

(g) The financial performance of the company will be influenced by the economic, financial, legal and social environment withinwhich it operates. There is a range of non-controllable factors that will have a significant impact upon the performance thatthe company achieves. Therefore an assessment of the success of the strategies will require these factors to be considered.

– The general level of economic activity – is it a period of growth or contraction?

– The presence of local economic factors that make the situation particularly favourable or difficult e.g. the availability ofskilled labour.

– Interest rate movements and the debt structure of the company. A heavily indebted company during times of risinginterest rates will be operating in a particularly difficult financial environment.

312·8

£m Profit

2003 2004

298

}}}

} Desiredoutcome£280m

Synergy gain£14·8m

Str 3extra £77m

Str 2extra £65m

Str 1extra £16m

Currentforecast£140m

Year



14

– Strategy 1 depends upon the success in entering a new overseas market. The condition of the overseas economy andexchange rate movements will be particularly vital to the success of this strategy.

– Government policy towards car ownership can have a significant influence on the performance of the company –taxation, safety and environmental legislation, policy towards traffic congestion – all these have the potential to impacton car sales.

– Competitors – they are unlikely to be passive and will take counter measures to maintain their market share in responseto the strategies.

This list is illustrative and is obviously not exhaustive and alternative approaches are acceptable e.g. candidates may refer toPEST analysis.

2 (a) (i) BEST OUTCOMEYear 1 2 3

£m £m £mRevenues 84·0 94·5 105Less direct costs 45·0 54·0 63

––––– –––––– ––––––= net cash flow 39·0 40·5 42Less depreciation 18·0 18·0 18

––––– –––––– ––––––= Profit 21·0 22·5 24Less imputed interest (8%) 4·32 2·88 1·44

––––– –––––– ––––––= Residual Income 16·68 19·62 22·56

––––– –––––– ––––––

NBV 54 36 18

ROI 21 x 100 = 39%

22·5 x 100 = 62·5%

24 x 100 = 133%–– –––– ––

54 36 18

Year Cash flow Discount factor (8%) DCF0 (54) 1 (54)1 39·0 0·926 36·12 40·5 0·857 34·73 42·0 0·794 33·3

NPV = 50·1

(ii) WORST OUTCOMEYear 1 2 3

£m £m £mRevenues 76·0 85·5 95Less direct costs 55·0 66·0 77

––––– –––––– ––––––= net cash flow 21·0 19·5 18Less depreciation 18·0 18·0 18

––––– –––––– ––––––= Profit 3·0 1·5 0Less imputed interest (13%) 7·02 4·68 2·34

––––– –––––– ––––––= Residual Income (4·02) (3·18) (2·34)

––––– –––––– ––––––

NBV 54 36 18

ROI 3 x 100 = 5·6%

1·5 x 100 = 4·2%

0 x 100 = 0%–– ––– ––

54 36 18

Year Cash flow Discount factor (13%) DCF0 (54) 1 (54)1 21·0 0·885 18·62 19·5 0·783 15·33 18·0 0·693 12·5

NPV = (7·6)

(b) Residual Income:This measures net income after deducting an imputed interest charge on the capital employed. It is intended to ensure thatthe decision making and performance assessment process incorporates the finance (interest) cost of securing funds for aproject. 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.



15

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 usedto 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 notform part of the asset base of an organisation but nevertheless make a significant contribution to the earning power ofthe entity. On the other hand, intangibles like brands and customer lists can be regarded as legitimate ‘assets’ in abalance sheet but are notoriously difficult to value.

– Both recorded profit figures and asset values are subject to unscrupulous manipulation by senior managers in an attemptto artificially enhance the ROI performance of their organisations – candidates should be given credit for referring torecent (2002) scandals within large US companies.

– It is not easy to compare the performance of investment centres if they have calculated their depreciation in differentways 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 managersare assessed on short run ROI performance – short term ROI performance indicators may discourage long term optimaldecisions being taken.

– Where a conglomerate sets a common ROI target that has to be achieved for all new projects, it may present problemsin 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.

Net Present Value:Unlike the other two indicators NPV considers the time value of money – it is concerned with not only how much, but alsowhen. Therefore it is particularly suitable for decisions whose consequences have a long time horizon, e.g. capital projects.

Strengths– The emphasis on cash flows is particularly appealing to shareholders who are seeking short and long term cash returns. – The use of cash flows is subject to less manipulation and fewer subjective decisions than the use of profits based on

accruals accounting (see above comments on ROI).– It considers the opportunity cost of not holding money.– Risk can be allowed for by adjusting the cost of capital.

WeaknessesNPV estimates require a number of assumptions concerning decision critical variables such as:– the duration of the cash flows.– the timing of the cash flows within the life of the project – it is very difficult to profile cash flows accurately over long

time periods.– determining the appropriate cost of capital to apply to the project and whether this should remain constant over the life

of the project. This is especially difficult when the organisation is not able or is unwilling to arrange long term fixedinterest funding.

– the heavy reliance on estimates and subjective decision making permits and encourages project sponsors and otherinterested parties to submit optimistic projections that cannot be easily refuted.

(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 and longer term plan? An apparently poor performing

project in the short term may proceed because of the long term prospects.– The synergy and 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? Is this project an integral element of a broader

plan?



16

3 (a) Learning Curve Theory is concerned with the idea that when a new job, process or activity commences for the first time it islikely that the workforce involved will not achieve maximum efficiency immediately. Repetition of the task is likely to makethe people more confident and knowledgeable and will eventually result in a more efficient and rapid operation. Eventuallythe learning process will stop after continually repeating the job. As a consequence the time to complete a task will initiallydecline 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.Cumulative average time refers to the average time per unit for all units produced so far, from and including the first onemade.

(b) No of Cumulative Total Time Incremental TimeBikes Average Time To Date for Additional Bikes

(hours) (hours) (hours)1 50 502 (x 0·8) 40 (x 2) 80 (80 – 50) 304 (x 0·8) 32 (x 4) 128 (128 – 80) 488 (x 0·8) 25·6 (x 8) 204·8 (204·8 – 128) 76·8

Quotation 1 £ Quotation 2 £Materials 1,000 Materials 2,000Labour (30 x10) 300 Labour (48 x 10) 480Overheads 600 Overheads 960

–––––– ––––––Total cost 1,900 Total cost 3,440Profit (20%) 380 Profit (20%) 688

–––––– ––––––Selling Price 2,280 Selling Price 4,128

–––––– ––––––

4,128/2 = £2,064 Per Bike

Quotation 3 £Materials 8,000Labour (204·8 x 10) 2,048Overheads 4,096

––––––––Total cost 14,144Profit (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.

4 (a) NB – A structured approach could take many alternative forms. This suggested answer represents one approach – candidatesare likely to offer many variations. The request for a ‘structured’ approach is to avoid candidates merely listing a series ofrandom indicators without consideration to the relationship between them and their contribution towards overall performanceassessment.‘Overall performance’ refers to a comprehensive coverage of the major issues that are generally regarded as important inassessing 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).



17

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 e.g. operations undertaken, number of children attending school, criminals

arrested, fires attended.– Flexibility and speed of response e.g. 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 e.g. – bed occupancy ratios, average class size, ratio of police vehicles currently operational.– Number of complaints received.– Accessibility – e.g. distance to 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 singleprime objective e.g. maximisation of shareholder wealth.

– Political interference – this may result in policy U-turns or long term organisational objectives being sacrificed for shortterm political gains.

– They are usually monopoly services therefore making it difficult to assess relative performance. Attempts to overcomethis via benchmarking with other regions can be problematical owing to geographical variations in operatingenvironments.

– It is very difficult to measure outputs that public services provide. What is the ‘output’ of the fire service? The privatesector has measurable units of output whether it be goods or services – they charge for them! They also have a measureof net output – their profits.

– Financial constraints e.g. a private company could decide to borrow money if it thought it were in its interest, but apublic body may be forbidden to undertake such action – the service may not have the freedom to act in what it regardsas its own interest.

– The temptation to judge outputs on the value of inputs – employing more people, spending more money on a serviceand building new premises is frequently taken to represent improved service provision but this is not necessarily true.

(c) – Change in the governance to restrict political interference.– Facilitate regional benchmarking by introducing adjustment factors to compensate for known regional disparities e.g.

permit higher rates of pay in high wage locations and allowing for variations in the socio-economic composition of thepopulation.

– Undertake cost-benefit analysis of projects in an effort to place a monetary value on the service provision.– Accept that it is difficult to monitor their performance in a quantifiable and objective way, and therefore appoint and trust

independent agencies staffed by experts who will make subjective decisions based upon their experience and theinformation presented to them.



5 (a) The role of a management accountant is to provide information which can be used to assist and guide management in thepursuit and achievement of organisational objectives. The management information provided is read, interpreted andresponded to by people within the organisation, and their responses will determine the quality of the decisions made and theextent to which corporate objectives are achieved. Management accountants should be aware of this relationship andendeavour to ensure that the information that they supply is used in a way that benefits their organisation. The design andoperation of a management accounting system should anticipate the behavioural consequences that are likely to arise as aresult of its activities. A management accountant who fails to consider these repercussions or denies responsibility for themis likely to operate a dysfunctional system. This is most likely to manifest itself in a failure to secure goal congruence betweenthe 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 delegatedteam decision making.

(b) Performance Monitoring:There is a general acceptance of the idea that an organisation that monitors performance and rewards individuals for ‘goodperformance’ is more likely to encourage behaviour that is consistent with the objectives of the organisation. This involves theorganisation ‘transmitting signals’ to its people as to what it deems desirable activities and outcomes in the workplace. Thisapproach 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 workactivities, alternative work environments. Unfortunately this is a very complex task and problems are likely to arise in anumber of areas:

– It is very difficult in many work environments to measure individual performance – and if you resort to teamperformance, 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.

Candidates should be given credit for illustrating these issues with specific references to a work environment.

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:Adverse behavioural consequences of budgeting can arise from insufficient consideration being given to the task during theplanning stage. The targets set may be perceived as:

– Imposed – Complicated– Unfair– Irrelevant– Easy – Unachievable.

This is likely to foster the ‘them and us’ syndrome and the consequential failure to achieve goal congruence. These undesirableconsequences may be avoided by consulting with all interested parties, setting challenging but achievable targets, consideringother people’s perception of the targets and anticipating their likely responses. On the other hand, if budget holders are givencomplete 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.

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 willfeel 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 requirebudget adjustments and/or a flexible budget approach.

– Failure to reward favourable variances – budget under spending that automatically results in cuts in future budgetprovision 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.

18



19

Transfer Pricing:Transfer pricing is primarily concerned with ensuring that semi-autonomous business units behave in a way that contributestowards the achievement of corporate and not merely divisional objectives. An effective transfer pricing system encouragesdivisional managers with autonomous decision making authority to pursue the interest of the corporation automatically whilstendeavouring to maximise the performance of their own business unit. Their decisions are made with self (divisional) interestas the driving factor, but coincidentally benefit the entire company. Effective transfer pricing systems consciously endeavourto harness selfish divisional behaviour to induce decisions that foster goal congruence. Problems can arise when inappropriateprices 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 andunnecessary external sourcing from the buying division.

– Too low a price may result in ‘excessive’ internal trading and a loss of valuable external business.

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.



Part 3 Examination – Paper 3.3Performance Management June 2003 Marking Scheme

1 (a) Calculation of:Revenues 1Costs 3Profits 1Comment 1 6

–––

(b) Strategy 1 profit 2Strategy 2 profit 2Strategy 3 profit 2 6

–––

(c) Contribution 2Profit 2 4

–––

(d) Increase in profit 1Comment 1Reconciliation 3 5

–––

(e) Comment 2Graph 5 7

–––

(f) (i) General comment 4

(ii) Calculation (3 x 1) 3Summary comment 1 8

–––

(g) 4 x 1 (per point) 4–––40–––

2 (a) (i) Residual income 2ROI 1NPV 2 5

–––

(ii) Residual income 1ROI 1NPV 1 3

––– –––8

(b) Comments on residual income 3Comments on ROI 3Comments on NPV 3 max 8

–––

(c) Issues listed (2 x 2) 4–––20–––

3 (a) General explanation 2Explanation of cumulative Average time 2 4

–––

(b) Quotation estimates (3 x 2) 6 6–––

(c) Areas of impact (5 x 1) 5Potential problems (5 x 1) 5 10

––– –––20–––

21



4 (a) Explanation of overall performance 4Financial issues 2Non-financial issues 2Qualitative issues 2 6

–––

(b) Problems (1 x 6) 6

(c) Suggestions to overcome (4 x 1) 4–––20–––

5 (a) General role of management accountant 2Behavioural responses 2Consequences of ignoring issue 1 5

–––

(b) Performance Monitoring:potential problems 3methods of overcoming 2

Transfer pricing:potential problems 3methods of overcoming 2

Budgeting:potential problems 3methods of overcoming 2 15

––– –––20–––

22




PART 3


QUESTION PAPER



Section A BOTH questions are compulsory and MUST be answered



Pape

r 3.3



2


1 The NW Entertainments Company (NWEC) is a privately owned organisation which operates an amusement park ina rural area within the North West region of a country which has a good climate all year round. The amusement parkcomprises a large fairground with high-quality rides and numerous attractions designed to appeal to people of all ages.The park is open for 365 days in the year.

Each day spent by a guest at the park is classed as a ‘Visitor Day’. During the year ended 30 November 2003 a totalof 2,090,400 visitor days were paid for and were made up as follows:

Visitor category % of total visitor daysAdults 4014–18 years of age and Senior Citizens 20Under 14 years of age 40

Two types of admission pass are available for purchase, these are:

The ‘One-day Visitor’s pass’ and the ‘Two-day Visitor’s pass’, which entitles the holder of the pass to admission to theamusement park on any two days within the year commencing 1 December.

The pricing structure was as follows:

(i) The cost of a One-day pass for an adult was £40. Visitors aged 14–18 years and Senior Citizens receive a 25%discount against the cost of adult passes. Visitors aged below 14 years receive a 50% discount against the costof adult passes.

(ii) The purchase of a Two-day Visitor’s pass gave the purchaser a 25% saving against the cost of two One-dayVisitor’s passes.

(iii) 25% of the total visitor days were paid for by the purchase of One-day passes. The remainder were paid for bythe purchase of Two-day passes.

Total operating costs of the park during the year amounted to £37,600,000.

NWEC receives income from traders who provide catering and other facilities to visitors to the amusement park. Thereare 30 such traders from whom payments are received. The amount of the payment made by each trader is dependentupon the size of the premises that they occupy in the amusement park as shown in the following summary:

Size of premises No of Annual PaymentTraders per Trader

£Large 8 54,000Medium 12 36,000Small 10 18,000

The income from each trader is received under 3 year contracts which became effective on 1 December 2003. Theincome is fixed for the duration of each contract.

All operating costs of the park incurred during the year ending 30 November 2004 are expected to increase by 4%.This has led to a decision by management to increase the selling price of all categories of admission passes by 4%with effect from 1 December 2003. Management expect the number of visitor days, visitor mix and the mix ofadmission passes purchased to be the same as in the previous year.

NWEC also own a 400 bedroom hotel with leisure facilities, which is located 20 kilometres from the amusement park.During the year ended 30 November 2003, the charge per room on an all-inclusive basis was £100 per room, pernight. The total operating costs of the hotel amounted to £7,950,000. Average occupancy during the year was 240rooms per night. The hotel is open for 365 days in the year.

It is anticipated that the operating costs of the hotel will increase by 4% in the year ending 30 November 2004.Management have decided to increase the charge per room, per night by 4% with effect from 1 December 2003 andexpect average occupancy will remain at the same level during the year ending 30 November 2004.

The revenue of the hotel is independent of the number of visitors to the amusement park.



3 [P.T.O.

Required:

(a) Prepare a statement showing the budgeted net profit or loss for the year to 30 November 2004. (7 marks)

(b) The management accountant of NWEC has prepared the two-way data table shown in Appendix 1. Discusshow the directors could make use of such a table. (4 marks)

(c) (i) Another organisation has announced its intention to open an amusement park and hotel. The managementof NWEC are uncertain of the impact that this will have on the number of visitors to its park and hotel duringthe year to 30 November 2004. Current estimates of the number of visitors to the amusement park and theaverage percentage occupancy of the hotel are as follows:

Amusement Park Hotel

Admission Receipts Probability Occupancy % ProbabilityIncrease/(decrease)Increase by 10% 0·20 75% 0·10No change 0·60 60% 0·60Decrease by 15% 0·20 45% 0·30

Using Appendix 1 on page 4, prepare a summary which shows the range of possible net profit or lossoutcomes, and the combined probability of each outcome. The table should also show the expectedvalue of net profit or loss for the year. (6 marks)

(ii) Comment briefly on the use of expected values by management. (3 marks)

(d) Discuss SIX performance measurement criteria that management could utilise in order to assess the qualityof service provided by the hotel. Indicate what would be measured and state the mechanisms which wouldenable measurement of the chosen criteria. (6 marks)

(e) Name and comment on the actions that could be taken by management in the short-term, in an attempt toensure that the profitability of NWEC is not affected by the opening of an amusement park by anotherorganisation. (6 marks)

(f) Explain the term ‘strategic management accounting’ and discuss the benefits that might accrue to NWEC asa result of its introduction by management. (8 marks)

(40 marks)



4

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68



This is a blank page.Question 2 begins on page 6.



6

2 BLA Ltd is a design consultancy that provides advice to clients regarding property maintenance and improvements.Three types of consultant are employed by BLA Ltd. 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 Ltd does not undertake building work on behalf of its clients and will only recommend contractors that undertakethe 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 thefee income generated in excess of budget. The bonus is shared equally among the consultants employed by BLA Ltd 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 yearto 31 October 2003. The actual amount incurred in respect of the year to 31 October 2003 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. Suchconsultations are regarded as Business Development Activity by the management of BLA Ltd.

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

(vi) In November 2002, BLA Ltd purchased ‘state of the art’ business software for use by its consultants in simulatingdesign improvements. The software was used throughout the year by consultants who specialise in landscapeand garden design. It is now planned to introduce the use of the software by the other categories of consultantwithin BLA Ltd.

(vii) BLA Ltd has a policy of maintaining staff at a level of 45 consultants on an ongoing basis, irrespective offluctuations in the level of demand. Also, BLA Ltd has retained links with retired consultants and will occasionallysubcontract work to them at a cost of £150 per consultation, if current full-time consultants within a particularcategory are fully utilised. During the year ended 31 October 2003 subcontractors only undertook non-chargeable client consultations.

BLA LtdSundry statistics for year ended 31 October 2003

Budget ActualNumber of consultants by category:Exterior design 18 15Interior design 18 18Landscape & garden design 9 12Total client enquiries:New business 67,500 84,000Repeat business 32,400 28,000Number of chargeable client consultations: New business 24,300 22,400Repeat business 16,200 19,600Mix of chargeable client consultations:Exterior design 16,200 13,830Interior design 16,200 17,226Landscape and garden design 8,100 10,944



Budget ActualNumber of non-chargeable client consultationsundertaken by BLA consultants:

Number of business development consultations 1,035 1,200Number of remedial consultations 45 405

Number of non-chargeable client consultationsundertaken by subcontractors: 120

Other statistics:Number of complaints 324 630

Required:

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

Using FIVE different performance indicators and the quantitative data contained above, comment on theperformance of BLA Ltd. (15 marks)

(b) Briefly discuss THREE factors that should be considered in the determination of expected standards in aperformance measurement system. (5 marks)

(20 marks)




3 ‘The continued use of management accounting techniques may be viewed in the context of changing perceptions ofthe most appropriate method by which to measure performance.’

Required:

Discuss this statement in the context of cost analysis and cost comparison using standard costing and qualityimprovement programmes.

(20 marks)

4 INA Ltd manufactures and distributes generic paper-based products and currently has an annual turnover of £100 million.

At present, the management of INA Ltd are uncertain whether the purchasing department is maximising its potentialin terms of purchasing efficiency and effectiveness.

The management are currently considering the introduction of a system of benchmarking to measure the performanceof the purchasing department.

Required:

(a) Explain the term ‘benchmarking’ and briefly discuss the potential benefits that can be obtained as a resultof undertaking a successful programme of benchmarking. (6 marks)

(b) Describe how a system of benchmarking could be introduced to measure the performance of the purchasingdepartment. (8 marks)

(c) Discuss the problems that the management of INA Ltd might encounter in implementing a system ofbenchmarking and recommend how such problems should be successfully addressed. (6 marks)

(20 marks)



5 The directors of Bennett plc are evaluating a proposal to enter the market for a single product which has an estimatedlife cycle of four years. The company has recently paid £200,000 to a market research consultancy for work done inrespect of the proposal.

The market researchers estimated that the total market size would be as follows:

Year Units1 1,000,0002 1,600,0003 1,200,0004 500,000

The Marketing Director has estimated that sales volume amounting to 5% of the total market size can be achieved inyear 1 if a selling price of £80 per unit is maintained throughout the year. The board of directors are in agreementthat they wish to maintain a 5% share by volume, of the total market size in each of years 2–4.

The Finance Director has gathered relevant information and prepared the following evaluation relating to the proposedmanufacture and sale of the new product:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 NPV IRRSales units 50,000 80,000 60,000 25,000Selling price per unit (£’s) 80 74 78 85

£’000 £’000 £’000 £’000 £’000 £’000 £’000 %Cost/residual value –2,700 750Working capital –800 800Advertising costs –1,200 –800 –400 –200Sales revenue 4,000 5,920 4,680 2,125Variable costs (£35/unit) –1,750 –2,800 –2,100 –875Attributable fixed costs –700 –700 –700 –700Net cash flow –4,700 750 2,020 1,680 1,350 750Discount factor at 14% 1·000 0·877 0·769 0·675 0·592 0·519Discounted cash flow –4,700·00 657·75 1,553·38 1,134·00 799·20 389·25NPV at 14% –166·42Discount factor at 12% 1·000 0·893 0·797 0·712 0·636 0·567Discounted cash flow –4,700·00 669·75 1,609·94 1,196·16 858·6 425·25NPV at 12% 59·70IRR = 12·53

The Finance Director uses a cost of capital of 14% to evaluate all such proposals.

Required:

(a) Using the above information, critically assess the evaluation prepared by the Finance Director. (10 marks)

(b) Describe the use of target costing and explain how it could be of assistance to Bennett plc following adecision by the directors to manufacture the product. Your answer should include a flow diagram to illustratea target costing cycle. (10 marks)

(20 marks)



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Answers



15


1 (a) NWEC Ltd

Budgeted Profit and Loss Statement for year to 30 November 2004Amusement Park – admission receipts:

One-day pass £ £Adults: 8,696,06414–18 years, senior citizens 3,261,024Under 14 years 4,348,032

Two-day passAdults: 19,566,14414–18 years, senior citizens 7,337,304Under 14 years 9,783,072

––––––––––52,991,640

Other revenue Income from traders 1,044,000–––––––––––

Total revenue – park 54,035,640Operating costs 39,104,000

–––––––––––Budgeted profit of park 14,931,640Hotel income 9,110,400Hotel operating costs 8,268,000

––––––––––Budgeted profit of hotel 842,400

–––––––––––Total budgeted profit 15,774,040

–––––––––––

Workings:No. of Visitor days for year to 30 November 2004 = 2,090,400One-day passes = 2,090,400 x 25% = 522,600Two-day passes (2,090,400 x 75%)/2 = 783,900

Admission fees applicable from 1 December 2003.(increased by 4% per annum).Category of visitor:

One-day pass (£) Two-day pass (£)Adults 41·60 62·4014–18 years; senior citizens 31·20 46·80Under 14’s 20·80 31·20

(b) A two-way data table shows the results of combinations of different values of two key variables. In this case, the table enablesthe management of NWEC to view the net profit or loss for each of a range of combinations of levels of admission to the parkand hotel occupancy. A spreadsheet data table tabulates the results of sensitivity analysis – i.e. the outcome values when oneor two values are changed. The use of a data table enables the management of NWEC to quickly assess the impact onprofitability of changes in the number of visitor days to its amusement park and/or in the level of hotel occupancy. This tableindicates to management that for a net loss of £510,670 to occur within the year to 30 November 2004, not only would thenumber of visitor days sold have to decrease by 25% but also hotel occupancy would have to fall to 40% (by 331/3% of theprevious year’s level). The best possible outcome is a profit of £28,649,968 which would arise if visitor days to the parkincreased by 20% and the hotel occupancy rate also increased to 75% from 60%. Most decisions are quite complex,involving a range of different input values. The management of NWEC can perform ‘what-if’ analysis, which will improve thequality of decision-making within the organisation.



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(c) (i) The range of possible outcomes using the probability estimates given in the question and the values contained withinAppendix 1 are shown in the following table together with the expected value of net profit.

% Change in Probability Hotel Probability Combined Net Profit Expected ValueVisitor days Occupancy Probability of net profit

£ £+10% 0·20 75% 0·10 0·020 23,350,804 467,016

60% 0·60 0·120 21,073,204 2,528,78445% 0·30 0·060 18,795,604 1,127,736

0% 0·60 75% 0·10 0·060 18,051,640 1,083,09860% 0·60 0·360 15,774,040 5,678,65445% 0·30 0·180 13,496,440 2,429,359

–15% 0·20 75% 0·10 0·020 10,102,894 202,05860% 0·60 0·120 7,825,294 939,03545% 0·30 0·060 5,547,694 332,862

–––––– –––––––––––1·000 14,788,602

–––––– –––––––––––

(ii) The use of expected values takes into account the relative likelihood of each of the possible outcomes occurring. Theexpected value of £14,788,602 is not one of the potential outcomes in the table, but is the weighted average of thoseoutcomes. The use of expected values by the management of NWEC implies that they have a risk-neutral attitude. A riskneutral decision-maker will ignore the variability in the range of potential outcomes and will be concerned only with theexpected value of outcomes.

(d) The management of NWEC could choose from the following list of criteria relating to service quality. As required by thequestion, a measure and mechanism for measurement is also provided.

– Appearance – the appearance of staff reflects the image of the hotel.

– Responsiveness – staff responsiveness assumes critical significance in the hotel industry. The time taken to deal withqueries by reception staff.

– Comfort – room facilities such as air-conditioning, tea/coffee-making and cold drinks facilities.

– Availability – the in-room availability of office facilities such as e-mail, facsimile and access to photocopying.

– Cleanliness – the cleanliness of all facilities within the hotel.

– Safety measures – the frequency of inspections made regarding safety equipment within the hotel and compliance withlegislation.

Customer surveys would be an appropriate mechanism for measurement of each of the foregoing measures with the exceptionof safety which management should measure by inspection of internal records.

(e) Management could consider taking some of the following actions in order to maintain and improve the profitability of theamusement park:

– The current structure regarding admissions is limited to the sale of either one-day or two-day passes. Perhaps, a widerchoice of tickets available for purchase by visitors might encourage more frequent visits by individual visitors. Forexample, many visitors might welcome the opportunity to purchase season tickets which would allow them to visit thepark at any time during the year. Consideration could also be given to discounted family tickets and ‘twilight’ tickets forafternoon/evening visitors. The latter would also help maintain the number of visitors throughout any given day sincethe late arrival of such visitors would offset those who left after spending the morning and afternoon at the park.

– The amusement park is situated in a rural area which may deter potential visitors to the park who are either unable todrive or do not have their own means of transport. Management should consider the provision of a transport servicefrom the nearest towns/cities to the amusement park. This might also lead to a reduction in the number of vehicles atthe amusement park leading to improved access and improved levels of safety.

– The company is expected to incur total operating costs amounting to £47,372,000 during the year to 30 November2004. Management should give consideration to instituting a formal programme of cost reduction. The focus of such aprogramme is upon the need to reduce costs below the previously accepted norm whilst simultaneously avoiding areduction in either quality or effectiveness. If NWEC has a ‘loose culture’ regarding cost-consciousness, there may wellbe scope for significant savings to be achieved.

– It is noticeable that the company does not have any revenues from advertising. By the very nature of its business, NWECis well positioned to raise such revenues from those organisations wishing to advertise their goods and services to thecustomers that visit the amusement park.



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(f) The distinguishing feature of Strategic Management Accounting (SMA) is that it considers the relationship of the organisationwith its external business environment. It focuses attention on suppliers, customers and competitive rivals. Information maybe quantitative or qualitative in nature, and some information will be of a non-financial nature. For a long time there havebeen criticisms of the information provided by management accountants as having an inward-looking perspective.

The development of a strategic management accounting system could provide extremely valuable additional information foruse by the management of NWEC. This value lies in the fact that the information is forward-looking and should focus on theorganisation and its external business environment. Such information will therefore focus on potential issues of importanceto the stakeholders of the organisation, in particular, its suppliers, customers and competitive rivals.

When management implement a chosen strategy they are seeking to derive a sustainable competitive advantage, and thisprocess will be aided by the information gathered within a strategic management accounting system. Virtually all organisationsare subject to environmental change and in this respect NWEC is no exception. Thus it is critical that all aspects of a businessare monitored so that a holistic approach is taken when strategic plans are being developed. The strategic managementaccounting system should be capable of coping with changes that can and will inevitably occur in a dynamic businessenvironment. Hence it is crucial that changes such as the emergence of a new competitor, are detected and reflected withinstrategic plans at the earliest opportunity.

If implemented, it is vital that a strategic management accounting system provides information that is relevant and reliabletherefore enabling the management of NWEC to make correct decisions. This is critical to any business given that decisionsof a strategic nature affect the entire organisation and are generally irreversible in the short-term, and quite often long term.Thus managers throughout NWEC should receive information that will enable them to take the right options thereby improvingthe overall position of the organisation. In this regard it is essential the managers be provided with information, which relatesto every aspect of NWEC and looks at its position relative to the entire industry in which it operates. This will enable dueconsideration to be given not only to the strengths and weaknesses of the NWEC but also to the opportunities and threatsfacing it.

There is no doubt that a strategic management accounting system, by providing information that facilitates better planning,control and decision making would make a major contribution to the longer term development of NWEC.

2 (a) The Fitzgerald et al framework proposes six dimensions of performance which are controlled by service industries. Theirpropositions include that two of these, namely financial performance and competitiveness are the ‘results’ of actions previouslytaken and reflect the success of the chosen strategy. The remaining four dimensions of quality, flexibility, resource utilisationand innovation are factors that determine competitive success now and in the future. The performance of BLA Ltd can nowbe analysed under this framework.

(i) Financial performance

Summary Profit and Loss Account for the year ended 31 October 2003

Budget Actual£’000s £’000s

Fee income 6,075 6,300Costs:Consultants’ salaries 2,025 2,025Bonus 90Other operating costs 2,550 2,805Subcontract 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 2003. Whilst client income isabove 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) x £150 x 40% in respect of activity abovebudgeted levels. Payments to subcontractors amounted to £18,000. Actual profit amounts to £1,362,000 against abudget of £1,500,000. It would be extremely useful to see the results of the previous two years in order to assesswhether there are any discernible trends in revenues and costs. The budget for the following year should be reviewedin the light of the actual performance of this year with particular reference to checking the footing of the assumptionsupon which it has been prepared.

(ii) Competitiveness

Competitiveness may be measured in terms of market share or sales growth and the relative success in obtainingbusiness from enquiries made by customers. The turnover of BLA Ltd for the year to 31 October 2003 is above budget.Again it is desirable to see the results of recent years since it might well be the case that BLA Ltd has achieved steadygrowth 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 levelsof competitiveness.



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It is useful to look at the extent to which BLA Ltd were successful in converting the enquiries received from both existingand new client enquiries into new business. The percentages are as follows:

Budget ActualConversion rate from enquiriesNew 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 Ltd. This is indicative ofstrong customer loyalty indicating that existing clients are satisfied with the service provided. However, the company wasunable to fare as well with regard to enquiries from potential ‘first time’ customers, only achieving a conversion ratio of26·7%, which is approximately 74% of the intended number of ‘first time’ clients that were budgeted for. This indicatesthat there is probably room for improvement in the ways in which BLA Ltd deals with enquiries from prospective clients.The company should review its marketing strategies with a view to improving its conversion ratio.

In absolute terms new business was approximately 7·8% below budget whereas repeat business was 21·0% abovebudget.

As regards the nature of the chargeable activities undertaken by the consultants it can be seen that Exterior design is14·6% 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 satisfyclient needs. Flexibility and innovation in service provision may be key determinants of service quality. To some extentthe increase in the number of complaints and non-chargeable consultations associated with the remedying of thosecomplaints is indicative of a quality problem that must be addressed. This problem needs to be investigated. BLA Ltdonly provides advice to clients and only recommends contractors when asked to do so by clients. It would be interestingto see how many of the complaints related to recommendations made by BLA Ltd. Assuming consultants could haveotherwise undertaken chargeable work, the revenue foregone as a consequence of the remedial consultations was£60,750. Client complaints received during the year were nearly double the budgeted level. Also the number of remedialconsultations was 405 against a budgeted level of only 45, which is exactly nine times higher than budget! PerhapsBLA Ltd 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 additionalbusiness. It is noticeable that during the year ended 31st October 2003 retired consultants working on a subcontractbasis undertook 120 consultations, each of which was of a non-chargeable nature. It is highly unlikely that the workundertaken by the retired consultants was in nature of Business Development Activity as such work would invariably beundertaken by the consultants employed on a full-time basis by BLA Ltd. Moreover, given that the actual number ofcomplaints during the year totalled 630 and that BLA consultants themselves undertook 405 remedial consultations, itwould be reasonable to assume that the retired consultants undertook further remedial consultations and/or work thatrelated to complaints from clients.

It would be extremely useful to have a detailed analysis of the client complaints. In the scenario we were told that BLAonly recommends contractors that undertake the three types of work when requested to do so by clients. In this regardit is important to recognise that a potential problem often exists where one party provides advice and another party isengaged 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 serviceBudget % 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 Ltd 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 changehas occurred in the mix of consultants which may well be a response to changing market requirements. Again, it wouldbe useful to see recent years statistics in order to consider trends but notably garden design looks to be a growth areahence the three new consultants recruited during the year. The mix of consultants should be such that BLA Ltd can copewith a range of job specifications. The fact that links have been retained with retired consultants will give an addeddimension of flexibility in times of very heavy demand upon its consultants.

(v) Resource utilisation

Resource utilisation measures the ratio of output achieved from those resources input. In this scenario the mean numberof consultations per consultant may be used as a guide.



19

Average consultations per consultantBudget 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 anaggregate bonus amounting to £90,000 was paid in respect of the year ended 31 October 2003. There are potentialproblems if the quality of the service provision is falling. In this regard it would be useful to have more detailed analysisof the client complaints in order to ascertain whether a large proportion relate to any one category of consultancy and/orcontractor. BLA Ltd has adopted an innovative approach that requires consultants to undertake non-chargeable businessdevelopment consultations which have at their heart the intention of generating new business. Hence in the immediatesense there is a trade-off between resource utilisation and innovation.

(vi) Innovation

Innovation should be viewed in terms of its impact on financial performance, competitiveness, service-quality, flexibilityand resource utilisation in the short, medium and long term. Certainly the non-chargeable activity in terms of ‘businessdevelopment’ is an innovative feature within the business of BLA Ltd, as is the non-chargeable remedial consultancyprovided to clients who experience problems at the commencement of building works. The acquisition of ‘state of theart’ business software is by its very nature innovative. The result of its use is reflected in the significant increase of35·1% above budget achieved in garden design consultations. This has probably enabled BLA Ltd to differentiate itsservices from those of its competitors and enhance its reputation. Certainly the management of BLA Ltd will be hopingfor a similar increase in business as a consequence of the use of the software by its external and interior designconsultants. The management should ensure the introduction of the software has not caused the increase in the numberof complaints received.

(b) In establishing targets, the importance of individuals taking ownership of the standards has long been established: this isoften facilitated by the adoption of a budgetary system based on employee participation. This is also considered to bebeneficial to the organisation since it alleviates, or at the very least reduces, many of the dysfunctional consequencesassociated with particular control models. In particular, managers who participate in the standard-setting process are morelikely to accept the standards set, feel less job-related tension and have better relationships with their superiors andcolleagues. Participation does, however, provide opportunities for the introduction of budgetary slack in order that anysubsequent monitoring of activities presents a favourable outcome.

Budgets need to be realistic enough to encourage employees to perform, but not set at levels so high that they aredemotivated. The challenge to management lies in finding the balance between what the company views as achievable andwhat the employee views as achievable as this often proves to be a source of organisational conflict.

It is important that the standards of performance measurement chosen by management facilitate a fair comparison across allsimilar business units and that equity is seen to prevail in measuring the performance of those units. There may becircumstances where some business units have an inherent advantage unconnected with their own deliberate initiatives. Forexample, some business units will be subject to higher levels of environmental uncertainty than others. In situations wherehigher levels of uncertainty exist, there will be a need for greater reliance to be placed on subjective judgment in appraisingperformance, with consequently less reliance being placed on objective, financial data. It would be inappropriate andinequitable to measure the performance of two completely different business contexts in an identical manner.

3 With changes in business in recent years the information needs of management have expanded significantly both in terms of scopeand variety. Criticism of management accounting made by some commentators has arisen from the view that managers arerequired to make decisions in an increasingly complex business environment, and yet they are supplied with information by theirorganisation’s internal management information systems which is inadequate for that purpose.

Standard costing was developed to meet the requirements of a traditional manufacturing environment. If standard costing is toprovide an effective means of cost control then it is critical that attainable standards are set in terms of agreed levels of price andperformance. Standard costs are compared with actual costs for the purpose of ascertaining variances. Such variances are theninvariably broken down into their respective price and quantity components. It should be recognised that the ascertainment ofvariances is only the first stage in assessing performance. Variances must be analysed in depth, in order to establish whether theyare significant, whether they are controllable, and if so where the responsibility for the variance lies. The analysis of variancesfacilitates the validation of the current standards and also improvements in methods for establishing standards in the future.

Improvements in performance management may be obtained via the adoption of a planning and operational approach to varianceanalysis, particularly in situations where the product mix is relatively stable.

During recent years many commentators including Kaplan and Johnson have put forward the view that standard costing varianceanalysis should no longer be used as a basis for either cost-control or the evaluation of performance in the modern manufacturingenvironment. Such writers have expressed the view that the use of standard costing variance analysis may lead to behaviour, whichis incompatible with those strategic manufacturing objectives that must be achieved by companies, in order that they flourish intoday’s intensely competitive international business arena. There is a growing consensus that if organisations wish to competeeffectively in such a competitive climate, they should adopt strategies which are primarily aimed at satisfying their customers. Thisrequires a concentrated focus upon quality, time and innovation. There is a widespread view that such critical success factors canbest be achieved by the adoption of a Total Quality Management programme.



20

The characteristics of a total quality programme should include the following:

– The establishment of corporate values that focus the attention of the entire organisation on the need for the total satisfactionof all customers.

– All members of the organisation are actively involved in continually improving the processes and systems under their controland each person takes ownership of the responsibility for his or her own quality assurance.

– Participation of all employees within the organisation is actively sought and encouraged.

– Significant investments may be made in the training and education of staff to aid the realisation of their potential.

– Quality circles are established to help ensure that their work is defect free.

– Both suppliers and customers are actively involved in the process of improvement.

– Process redesign is used to simplify processes, systems, procedures and the organisation itself.

When a product is designed, its specification should consider those factors which will minimise future rectification costs. Theproduction methods used should be as straightforward as possible and utilise the skills and resources possessed by theorganisation. It is highly significant that in the modern manufacturing environment it is often observed that approximately 90% ofthe production costs of a product are determined in its design phase. Thus effective performance management requires themonitoring of costs and revenues over the whole life cycle of the product. Traditional standard costing and variance analysis mayonly focus upon production costs over a period of one month, and hence this is viewed by many commentators as being of littlerelevance and rather myopic. Ensuring that quality factors have been correctly engineered into the design of products may thereforeonly be apparent when costs are reported on a life-cycle basis.

An information system is needed to enable management to measure the success of those procedures adopted to ensure quality. Itis vital that such systems should measure both monetary and non-monetary factors. Quality can be measured in terms of its impactupon profit via costs incurred and revenues generated. An example of a monetary measure would be the costs of rework whereasnon-monetary measures would include defect rates, customer complaints and yield statistics. Over time, the pre-eminence offinancial measures may diminish as non-financial measures to account for strategically important factors are developed. Duerecognition should be given to the fact that variance analysis resulting from the use of traditional standard costing systems caninhibit quality. For example, favourable material price and labour rate variances can arise as a consequence of the use of lowerquality resources. However the use of poorer quality inputs to any process will often precipitate a reduction in the quality of output.In the same vein, the use of efficiency and usage variances concentrate on the quantity of output from a given level of input, notthe quality. Thus standard costing concentrates upon quantity and ignores other strategically important factors such as quality,which contribute to effectiveness.

By way of contrast, the measurement and reporting of quality is central to the operation of a TQM philosophy. Quality costs areclassified as prevention costs, appraisal costs, internal failure costs and external failure costs.

Prevention costs are the costs incurred to reduce appraisal costs to a minimum. Examples of prevention costs include the use ofquality circles aimed at achieving process improvements and the cost of regular staff training programmes.

Appraisal costs are the costs incurred for activities such as inspecting and testing, in initially ascertaining and ensuringconformance of the product to quality requirements. Examples of appraisal costs include the cost of quality control staff carryingout inspection checks on the receipt of materials and the cost of test equipment.

Internal failure costs are the costs arising from inadequate quality before the transfer of ownership from supplier to purchaser.Examples of an internal failure costs would be the cost of scrapped production and the costs of rework.

External failure costs are the costs arising from inadequate quality discovered after the transfer of ownership from supplier topurchaser. Examples include costs associated with recalled products, free replacement of goods and the delivery costs relating toreplacements.

There are a number of reasons which support the view that there is little benefit in running both a total quality programme and astandard costing system simultaneously. These include the following:

– Predetermined standards conflict with the philosophy of continual improvement which is at the heart of a total qualitymanagement programme. There is a danger that the use of such standards will create an organisational mind-set focusedupon the attainment of the standards as opposed to continual improvement.

– Standard costing is best suited to a stable, standardised and repetitive environment. However it is probable that continualimprovements will alter work methods and processes thus creating a constantly changing environment in which the use ofstandard costing might be inappropriate.

– The use of attainable standards, which contain an allowance for inefficiency, is diametrically opposed to the elimination ofwaste which is a major component of any total quality management programme.

– Under a standard costing control system, managers are made responsible for the variances relating to that part of anorganisation’s activities which is under their control. Standard costing variance measurement is primarily focused upon costcontrol which could prove detrimental to the level of quality achieved throughout the organisation. One of the objectives of atotal quality management programme is to make all personnel aware of and take ownership of the responsibility for thedelivery of quality products to the customer.



21

– A continuous improvement environment requires a constant effort to do things better as opposed to attempting to achieve anarbitrary standard based upon the assumption that prevailing conditions will remain static for a period of time.

– With regard to largely automated production systems it can be argued that use of statistical quality control can make theproduction processes extremely consistent and reliable such that variances no longer arise. If this view is held then it followsthat the focus of attention should be switched to the design phase of the product, as this is where the vast majority of costsare effectively committed.

In spite of the apparent persuasiveness of these criticisms, it can be argued that the basic principle of standard costing varianceanalysis remains sound and that it can remain valuable in a Total Quality Environment. Reasons supporting the continuedusefulness of standard costing include the following:

– Standard costing can still be a valuable aid to planning in a TQM environment where budgets will still require quantification.For example, standards can be set for the planned level of quality costs to be incurred during the forthcoming period.

– Whilst work teams need real-time quantitative feedback, the provision of periodic financial information via the standardcosting system is valuable in that informs them of the financial consequences of their actions.

– Whilst it is undeniable that the emphasis of standard costing is upon cost control and that management need to measureperformance via a range of appropriate performance indicators, cost control nevertheless remains an important consideration,albeit one of many.

– There is no reason why existing standards should not be used as the basis in the construction of a cost for a new product.

– In relation to the pricing of products, target costs can be compared with current standard costs. Inevitably there will be a ‘costgap’ which management can then take the necessary steps to reduce or even eliminate using techniques such as valueengineering.

– In manufacturing industries in many different countries, overhead costs are volume-related. Thus it remains possible thatstandard costing variance analysis still has a significant role to play in cost management.

In conclusion, it would appear reasonable to suggest that the fundamental principle of accounting control incorporated in standardcosting systems remains sound. Many organisations wish to retain the atmosphere of cost-consciousness that is arguably the mostimportant benefit derived from the use of a standard costing system. However, such organisations need to recognise that they facethe challenge of adapting their systems in order to meet the changing requirements of modern manufacturing industry.

4 (a) Benchmarking has been defined as ‘the establishment, through data gathering, of targets and comparators through whoseuse relative levels of performance (and particularly areas of underperformance) can be identified. By the adoption of identifiedbest practices it is hoped that performance will improve.’

A major problem facing the management of INA Ltd lies in the accessing of information regarding the activities of a competitorfirm that may be acknowledged to display best practice. Internal benchmarking i.e. using another function within the samefirm as the standard can help in the avoidance of the problems of information access, but that clearly limits the scope of whatcan 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 sameindustry.

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 regardedfor its management of such activities.

The objective is to improve performance. This is best achieved by means of the sharing of information which should prove ofmutual benefit to both parties to the benchmarking programme. As a result of receiving new information each party will beable to review their policies and procedures. The very process of comparing respective past successes and failures can serveas a stimulus for greater innovation within each organisation.

To evaluate the operational performance of the purchasing department team the main contribution of benchmarking will beto establish a basis for targets which reflects the performance of an organisation which displays ‘Best Practice’ with regard topurchasing 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 thoseimprovements.

A principal benefit that will be derived by INA Ltd as a result of undertaking a successful programme of benchmarking willbe the identification of areas where cost savings are possible. Hence the levels of cost of sales and operating expenses canbe reduced leading to increased profitability. Another benefit will be the setting of more realistic purchasing targets that willresult in improved budgeting. The improved performance of the purchasing department personnel will serve as a betterplatform for the introduction of initiatives such as, for example, performance related pay for the personnel within thepurchasing department.



(b) It is critical that detailed planning of the work to be undertaken takes place if the programme of benchmarking is to besuccessful. In order to collectively benchmark the purchasing department as a whole, the company must first review andassess current practices. Of fundamental importance to the programme is the need to define measurable targets anddetermine how those targets are going to be measured in quantitative terms. This is critical since benchmarking will beineffective without a reliable form of measurement. Appropriate targets for use within INA Ltd might relate, for example, tothe cost of sales as a percentage of turnover, costs of inventory, amount of discounts obtained, the number of stock-outs, thenumber of ‘emergency’ orders placed, the costs per order, the overall costs of the purchasing department.

At the outset it should be acknowledged that there is a need to incur significant costs in terms of management time that needsto be invested in the benchmarking programme. However it is quite possible that considerable benefits will be realised as aresult 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. During the preliminary stages of the programme, the company will needto give detailed consideration as to how the benchmarking exercise is to be conducted. The fundamental aim of theprogramme will be to obtain comparative information in order that performance indicators may be developed. In turn, thesewill be used to identify areas in which improvements can be obtained with resultant cost savings.

With all this preparation complete, the company will then need to not only identify a ‘Best Practice’ firm against which tobenchmark, but having done so it must be able to persuade that firm to collaborate in the benchmarking programme and inparticular to share information. This is not an easy task to accomplish, as many organisations are reluctant to revealconfidential information to present or potential competitors.

Once the exercise is complete INA Ltd will benefit from improved levels of efficiency and effectiveness within the purchasingdepartment, via better management information. In particular, improved visibility of costs incurred by the company willfacilitate better decision-making.

(c) There are a number of potential problems inherent in undertaking a programme of benchmarking. There needs to exist asufficient incentive for the respective parties to share information to their mutual benefit, as the success of the benchmarkingprogramme is dependent upon obtaining accurate information about the comparator organisation. Moreover, it is essentialthat the business functions being benchmarked are similar enough to facilitate meaningful comparisons. The value of theexercise must be sufficient to justify the cost involved. Also, it is inevitable that behavioural issues will need to be addressedin any benchmarking programme. This is especially the case if incentive schemes are in existence and management maymeasure members of the purchasing department against each other. Tactful management of the introduction of abenchmarking programme is essential. Management should give priority to the need to communicate the reasons forundertaking a programme of benchmarking in order to gain the full co-operation of the personnel within the purchasingdepartment whilst reducing the potential level of resistance to change. Management need to handle the ethical implicationsrelating to the introduction of benchmarking in a sensitive manner and should endeavour, insofar as is possible, to providereassurance to the members of the purchasing department that their status, remuneration and working conditions will notsuffer as a consequence of the benchmarking programme.

5 (a) In order to evaluate the investment, numerous issues require consideration by the management of Bennett plc. Firstly, therewas a need to incur expenditure of £200,000 on market research relating to the proposal. This expenditure constitutes a‘sunk cost’ and therefore has been excluded from the evaluation by the finance director. It must be acknowledged that thereis no guarantee as to the precision of the estimate of market size arrived at by the market research consultancy. It is clear thatthe management of Bennett plc are placing a high degree of reliance upon the consultants’ assessment. As the new projectrequires a sizeable capital investment, the estimate of sales assumes critical significance.



23

It is noticeable that the intended selling price of the product varies in each of years 1–4. This reflects the desired intention ofthe board of directors to maintain a 5% share of the total market in each of the four years of the estimated life of the product.The changes in selling price are intended to help procure this desired level of market share. There is a linear relationshipbetween selling price per unit and sales units. The finance director has used a price/demand relationship of P = 90 –0·0002Q to estimate the selling price to be charged in order to achieve the required sales quantities of the product in eachyear.

Quotations will almost certainly have been obtained to substantiate the capital outlay that would be required in order to enablemanufacture of the product to commence. It is highly probable therefore that the Year 0 outlay is accurate. The residual valueis more uncertain estimate which the finance director has chosen to recognise during year 5, which reflects the fact that, inpractice, such capitial items cannot be sold immediately upon cessation of such a project due to amount of time required forde-commissioning/dismantling etc.

The requirement for the injection of working capital should also be free from material error. Any error regarding the timing ofthe release of working capital will be due to the inaccuracy of the estimated life cycle of the product.

The marketing director’s estimates in respect of the intended advertising campaign total £2·6 million in undiscounted terms.The estimates and the phasing of this amount should be subjected to a detailed examination. If it were possible to defer someof the expenditure, then the NPV and IRR arrived at in the forecast, and hence the projects desirability, would be improved.

An estimated variable cost of £35 per unit has been assumed to remain constant for the expected four-year life of the product.This may be an unrealistic assumption and ignores any efficiency gains and/or benefits from ‘learning’ and ‘experience’ thatcould arise.

The estimated fixed costs should be reviewed to ensure that they are truly attributable to the investment. These costs areforecast to remain ‘fixed’ for the four-year life of the project and this may also be too simplistic an assumption.

In the scenario we are told that the finance director uses a cost of capital of 14% as a hurdle rate with which to evaluate allsuch proposals. However, whether this is an appropriate cost of capital to use for this project is questionable. In theory, themarginal cost of capital (MCC) should be used for any such project although one should acknowledge that the MCC of a givenproject might itself might be difficult to ascertain. Nevertheless, given that no two projects are identical it is reasonable toquestion the use of a single hurdle rate in the appraisal of all projects within Bennett plc.

The finance director chose to use two performance measures, Net Present Value (NPV) and Internal Rate of Return (IRR), inappraising the investment. Each of these measures is based on the use of discounted cash flow analysis. When evaluatinginvestments with a simple cash flow profile i.e. those involving a one-off investment outlay followed by a stream of cashinflows, both the NPV and IRR methods produce the same ‘accept’ or ‘reject’ decisions.

The finance director might well appreciate that an advantage which accrues from the use of the NPV method, lies in thesimplicity with which results are stated. NPV is an absolute measure of performance which produces a result expressed in£’s which directly reflects the changed wealth position expected as a consequence of undertaking an investment. However,because NPV is an absolute measure of performance it does not easily allow two investments of very different scales to becompared. By way of contrast, the Internal rate of return produces a result which is shown as a percentage, and this resulthas to be compared with a required rate of return before a decision regarding whether to invest or not can be made. SinceIRR is a relative measure, it could be used by the finance director to compare returns on investment projects which differsignificantly in scale.

However, because internal rate of return (IRR) ignores the relative size of investments, it should not be used to select betweenmutually exclusive projects since the project with the highest IRR might have the lowest absolute return.

The evaluation prepared by the finance director also ignores the effects of both inflation and taxation which could provesignificant given the timescales and level of investment involved.

In view of the number of variables contained in the forecast, the management of Bennett plc should apply sensitivity analysisto the forecasted cash flows, in order to gain a more comprehensive appreciation of the financial implications of the project.

(b) Target costing should be viewed as an integral part of a strategic profit management system. The initial consideration in targetcosting is the determination of an estimate of the selling price for a new product which will enable a firm to capture its requiredshare of the market. Then it is necessary to reduce this figure to reflect the firm’s desired level of profit, having regard to therate of return required on new capital investment and working capital requirements. The deduction of required profit from theproposed selling price will produce a target price that must be met in order to ensure that the desired rate of return is obtained.Thus the main theme that underpins target costing can be seen to be ‘what should a product cost in order to achieve thedesired level of return’.

Target costing will necessitate comparison of current estimated cost levels against the target level which must be achieved ifthe desired levels of profitability, and hence return on investment, are to be achieved. Thus where a gap exists between thecurrent estimated cost levels and the target cost, it is essential that this gap be closed.

In the case of Bennett plc it is apparent that if the market research findings regarding market share has been accuratelyforecast at appropriate selling prices for the four-year life of the project, then costs must be reduced from the currentlyestimated level if the proposal is to be acceptable at a ‘hurdle rate’ of 14%.



The management of Bennett plc should be cognisant of the fact that it is far easier to ‘design out’ cost during the pre-production phase than to ‘control out’ cost during the production phase. Thus cost reduction at this stage of a product’slife cycle is of critical significance to business success. A number of techniques may be employed in order to help in theachievement and maintenance of the desired level of target cost. Attention should be focused upon the identification of valueadded and non-value added activities with the aim of the elimination of the latter. The product should be developed in anatmosphere of ‘continuous improvement’. In this regard, Total Quality techniques such as the use of Quality circles may beused in attempting to find ways of achieving reductions in product cost.

Value engineering techniques can be used to evaluate necessary product features such as the quality of materials used. It isessential that a collaborative approach is used by the management of Bennett plc and that all interested parties such assuppliers and customers are closely involved in order to engineer product enhancements at reduced cost.

The target cost-setting process

Source: Sakurai,H, Journal of Cost Management for the Manufacturing Industries, ‘Target Costing and how to use it,’ iii No 2, (1989)

24

Defineproductspecification

Definesalesvolume

Settargetprice

Defineinvestmentrequirement

Definerequiredprofit

Definecurrentcost

Definetargetcost

Try toclosegap

Calculate‘cost gap’

Negotiatewithcustomer




Marks Marks1 (a) Admission revenue:

Use of correct prices 3Correct ‘passes’ 1Other income (correct figure) 1Operating costs 1Hotel income 1

––– 7

(b) Comments on data table (on merit)––– 4

(c) (i) Combined probability schedule 2Profit and loss schedule 2Expected value (correct answer) 2

––– 6

(ii) Likelihood of occurrence 1Risk neutrality 1Other relevant comments 1

––– 3

(d) Comments re selected criteria 3measures/mechanisms 3

––– 6

(e) Comments on actions:Admission passes (variants)Cost reductionImprove accessibilityAdvertising revenuesOther relevant comments

Up to 2 marks per comment ––– 6

(f) Explanation of strategic management accounting Up to 3Benefits Up to 5

––– 8–––

Total 40–––

2 (a) Comments (on merit) re:Financial performance Up to 3Competitiveness Up to 3Service quality Up to 3Flexibility Up to 3Resource utilisation Up to 3Innovation Up to 3

––– Maximum 15

(b) Ownership Up to 2Achievability Up to 2Equity Up to 2

––– Maximum 5–––

Total 20–––



Marks Marks3 Standard costing:

Appropriateness re Performance measurement Up to 4Inappropriateness re Performance measurement Up to 4Need for change Up to 4Quality improvement programmes:Characteristics/features Up to 4Quality costs Up to 4Other relevant discussion (on merit) Up to 4


Total 20–––

4 (a) Definition Up to 2Potential benefits Up to 4

––– Maximum 6

(b) Need for initial review of current practices 1Need for measurable targets Up to 3Need for comparative information to facilitate the developmentof appropriate performance indicators Up to 3Need for management resource/time 1Need for collaboration with excellent performer 1Need for consideration of other relevant factors: such as suppliersdealt with, annual spend, frequency and no of orders, order value. Up to 2Other relevant discussion (on merit) Up to 2

––– Maximum 8

(c) Problems Up to 3Recommendations Up to 3


Total 20–––



Marks Marks5 (a) Market research – a prediction; expenditure exclusion 1

Capital cost/residual value 0·5Residual value in year 5 1Working capital introduction/ release 0·5Recognition of price and demand relationship 1Estimation of function 2Variable costs 1Fixed costs – attributable 1Advertising 1NPV is an absolute measure; simplicity of result; problem of comparability 1IRR is a relative measure; ignores the relative size of investments 1Other relevant discussion (on merit) including:Challenge cost of capitalTaxation ignoredInflation ignored Up to 3


(b) Explain target costing Up to 2Diagram Up to 5Return <14% 1Application of target costing principles to scenario: Focus on design stageComments on appropriate techniques. e.g. Value engineering,Focus on Value added,Collaborative approach,Total quality initiatives,Other relevant discussion (on merit) Up to 5


Total 20–––

27




PART 3

FRIDAY 11 JUNE 2004

QUESTION PAPER





Pape

r 3.3





1 The NAW Group manufactures healthcare products which it markets both under its own brand and in unbrandedpacks. The group has adopted a divisional structure. Division O, which is based in a country called Homeland,manufactures three pharmaceutical products for sale in the domestic market. Budgeted information in respect ofDivision O for the year ending 31 May 2005 is as follows:

Sales information:Product ‘Painfree’ ‘Digestisalve’ ‘Awaysafe’Sales packs (000’s) NAW Brand 5,000 5,000 15,000

Unbranded 15,000 20,000 –

Selling price per pack (£) NAW Brand 2·40 4·80 8·00Unbranded 1·20 3·60 –

Cost of sales information:Variable manufacturing Material and Packagingcosts per pack: conversion costs

costs£ £

‘Painfree’NAW Brand 0·85 0·15Unbranded 0·85 0·05

‘Digestisalve’NAW Brand 1·85 0·25Unbranded 1·85 0·15

‘Awaysafe’NAW Brand 2·80 0·40

Other relevant information is as follows:

(1) Each of the three products is only sold in tablet form in a single pack-size which contains 12 tablets. During theyear to 31 May 2005 it is estimated that a maximum of 780 million tablets could be manufactured. All threeproducts are manufactured by the same process therefore management have the flexibility to alter the product-mix. Management expect that sales volume will increase by 10% in the year ending 31 May 2006.

(2) Advertising expenditure has been committed to under a fixed term contract with a leading consultancy and istherefore regarded as a fixed cost by management. Advertising expenditure in respect of the turnover of brandedproducts in the year ending 31 May 2005 is apportioned as follows:

Product: Advertising expenditureas a % of turnover

Painfree 5%Digestisalve 10%Awaysafe 12%

(3) The average capital employed in the year to 31 May 2005 is estimated to be £120 million. The company’s costof capital is 10%.

(4) The management of the NAW Group use both Return on Investment (ROI) and Residual Income (RI) to assessdivisional performance.

(5) Budgeted fixed overheads (excluding advertising) for Division O during the year ended 31 May 2005 amount to£81,558,000.

(6) There is no planned change in manufacturing capacity between the years ended 31 May 2005 and 31 May 2006.

(7) Ignore taxation for all calculations other than those in part (c).



Required:

(a) (i) Prepare a statement of budgeted profit in respect of Division O for the year ending 31 May 2005.

Your answer should show the annual budgeted contribution of each branded and unbranded product.Calculate BOTH the residual income (RI) and Return on Investment (ROI) for Division O. (7 marks)

(ii) Name and comment on THREE factors, other than profit maximisation, that the management of theNAW Group ought to consider when deciding upon the product mix strategy for the year ending 31 May2006. (3 marks)

(iii) Suggest THREE reasons why the management of the NAW Group may have chosen to use ResidualIncome (RI) in addition to Return on Investment (ROI) in order to assess divisional performance.

(3 marks)

Division L of the NAW Group is based in Farland. The management of Division L purchases products from varioussources, including other divisions of the group, for subsequent resale. The manager of Division L has requested twoalternative quotations from Division O in respect of the year ended 31 May 2005:1. Quotation 1 – Purchasing five million packs of ‘Awaysafe’. 2. Quotation 2 – Purchasing nine million packs of ‘Awaysafe’.

The management of the NAW Group has made a decision that a minimum of 15 million packs of ‘Awaysafe’ must bereserved for Homeland customers in order to ensure that customer demand can be satisfied and the product’scompetitive position is further established in the Homeland market.

The management of the NAW Group is willing, if necessary, to reduce the budgeted sales quantities of other productsin order to satisfy the requirements of Division L. They wish, however, to minimise the loss of contribution to thegroup.

The management of Division L is aware of the availability of another product that competes with ‘Awaysafe’ whichcould be purchased at a local currency price that is equivalent to £5·50 per pack. The NAW Group’s policy is that alldivisions are allowed the autonomy to set transfer prices and purchase from whatever sources they choose. Themanagement of Division O intend to use market price less 30% as the basis for each of the quotations.

(b) (i) From the viewpoint of the NAW Group, comment on the appropriateness of the decision by themanagement of Division O to use an adjusted market price as a basis for the preparation of Quotations1 and 2, and the implications of the likely decision by the management of Division L. (3 marks)

(ii) Recommend the prices that should be quoted by Division O for ‘Awaysafe’, in respect of Quotations 1and 2, which will ensure that the profitability of the NAW Group as a whole is not adversely affected bythe decision of the management of Division L. (3 marks)

(iii) Discuss the proposition that transfer prices should be based on opportunity costs. (4 marks)

(c) (i) After much internal discussion concerning Quotation 2 by the management of the NAW Group, Division Ois not prepared to supply nine million packs of ‘Awaysafe’ to Division L at a price lower than market priceless 30%. All profits earned in Farland are subject to taxation at a rate of 20%. Division O pays tax inHomeland at a rate of 40% on all profits.

Advise the management of the NAW Group whether the management of Division L should be directedto purchase ‘Awaysafe’ from Division O, or purchase a similar product from a local supplier. Supportingcalculations should be provided. (6 marks)

(ii) Identify and comment on the major issues that can arise with regard to transfer pricing in a multinationalorganisation. (5 marks)

(d) Evaluate the extent to which the management of the NAW Group could make use of the product life cyclemodel in the determination of its product pricing strategy. (6 marks)

(40 marks)



2 Candidates are advised that information contained in Question 1 is also relevant to this question.

The management of the NAW Group has divided the customers of Division O into four customer groups: largepharmaceutical stores, independent specialist pharmacies, supermarkets and other retail outlets (such as petrolstations, newsagents, etc). The management accountant of the NAW Group has reviewed internal records relating tocustomer ordering, shipping and distribution patterns and also extracted information from the budget file for the yearended 31 May 2005.

Budgeted sales statistics (% of sales volume)Customer group Large Independent Supermarkets Other retail

Pharmaceutical Specialist outletsstores pharmacies

Product‘Painfree’NAW Brand 60 20 10 10Unbranded 30 – 70 –

‘Digestisalve’NAW Brand 40 30 20 10Unbranded 30 – 70 –

‘Awaysafe’NAW Brand 40 30 20 10

Other budgeted statisticsCustomer group Large Independent Supermarkets Other retail

Pharmaceutical Specialist outletsstores pharmacies

No. of deliveries 400 2,400 800 3,000No. of purchase orders 100 300 100 1,000Promotion and exhibition events 4 – – –Average kilometres per delivery 300 150 400 150No. of times delivery requirements 30 – 10 –were changed

The following information is available:

(1) The review of internal records undertaken by the management accountant has revealed new information. It hasbeen established that £33,558,000 of the total of £81,558,000 costs which were categorised as fixedoverheads in Question 1, do in fact vary with activities.

N.B. Candidates need only consider this new information with regard to their answers to Question 2.

(2) The budgeted overheads of £33,558,000 for the year ending 31 May 2005 may be charged to the four customergroups using the following costs per unit of activity:

Activity CostDelivery £6·40 per kilometreChanged delivery requirements £200·00 per changeOrder processing £20·00 per orderPromotion and exhibition £27,500 per event

(3) NAW Group pays a retrospective rebate based on annual sales revenue to each customer group as follows:

Customer group: % rebate basedon sales value

Large pharmaceutical stores 10Independent specialist pharmacies 5Supermarkets 15Other retail outlets –



Required:

(a) Prepare a statement of budgeted customer profitability for the year ending 31 May 2005 which shows theprofit before fixed overheads for each of the four customer groups. Your answer should be based on theoriginal budgeted sales volumes i.e. excluding Quotations 1 and 2. (9 marks)

(b) (i) Discuss the proposition that ‘customer profitability is as critical as product profitability.’ (5 marks)

(ii) Discuss the initiatives that managers should consider in order to improve customer profitability.(6 marks)

(20 marks)




3 Required:

(a) Identify and discuss the circumstances that have brought about the proposition that traditional managementaccounting control systems have lost their ‘relevance’ to today’s manufacturing and organisationalenvironment. (5 marks)

(b) Evaluate strategic cost management initiatives which may be used in order to restore the ‘relevance’ ofmanagement accounting control systems in today’s manufacturing and organisational environment.

(15 marks)

(20 marks)

4 NN Ltd manufactures and markets a range of electronic office equipment. The company currently has a turnover of£40 million per annum. The company has a functional structure and currently operates an incremental budgetingsystem. 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 theirannual salary for each of the past five years. The annual bonuses are calculated by comparing the actual costsattributed 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 beenthe manager responsible for the implementation of a zero-based budgeting system which proved highly successful.

Required:

(a) As the new Finance Director, prepare a memorandum to the senior management team of NN Ltd whichidentifies and discusses:

(i) factors to be considered when implementing a system of zero-based budgeting within NN Ltd;(10 marks)

(ii) the behavioural problems that the management of NN Ltd might encounter in implementing a system ofzero-based budgeting, recommending how best to address such problems in order that they areovercome. (6 marks)

(b) Explain how the implementation of a zero-based budgeting system in NN Ltd may differ from theimplementation of such a system in a ‘not for profit’ health organisation. (4 marks)

(20 marks)



5 AV is a charitable organisation, the primary objective of which, is to meet the accommodation needs of persons withinits locality.

BW is a profit-seeking organisation which provides rented accommodation to the public.

Income and Expenditure accounts for the year ended 31 May 2004 were as follows:

AV BW £’s £’s

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

––––––––– –––––––––Total costs 2,442,442 1,934,800Operating (deficit)/surplus (55,590) 565,200

Operating information in respect of the year ended 31 May 2004 was as follows:

(1) Property and rental information:

AV BW–––––––––––––––––––––––––––––––––––––––––––––––––––––––– ––––––––––Size of Property Number of Rent payable Number of

properties per week (£’s) properties1 bedroom 80 40 402 bedrooms 160 45 803 bedrooms 500 50 2804 bedrooms 160 70 nil

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

(2) Staff salaries were payable as follows:

AV BW––––––––––––––––––––––––––––––––––––– –––––––––––––––––––––––––––––Number of staff Salary (£’s) per Number of staff Salary (£’s) per

staff member staff memberper annum per annum

2 35,000 3 50,0002 25,000 2 35,0003 20,000 20 20,000

18 15,000 – –

(3) Planned maintenance and major repairs undertaken:

AV BW––––––––––––––––––– ––––––––––––––––––

Nature of work Number of Cost per Number of Cost perproperties property properties property

£ £Miscellaneous construction work 20 1,250 – –Fitted kitchen replacements (all are the same size) 90 2,610 10 5,220Heating upgrades/replacements 15 1,500 – –Replacement sets of windows and doors for 100 4,000 25 6,0003-bedroomed properties

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



(4) Day-to-day repairs information:

AV BW–––––––––––––––––––––––––––– ––––––––––––––––

Classification Number of repairs Total cost Number of repairs of repair undertaken undertakenEmergency 960 £134,400 320Urgent 1,880 £225,600 752Non-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 provisionduring the year ended 31 May 2004. (7 marks)

(b) (i) Identify TWO performance measures in relation to EACH of the following dimensions of performancemeasurement that could be used by the management of AV when comparing its operating performancefor the year ended 31 May 2004 with that of the previous year:

– Flexibility – Service quality. (2 marks)

(ii) Calculate and comment on THREE performance measures relating to ‘cost and efficiency’ that could beutilised by the management of AV when comparing its operating performance against that achieved byBW. (6 marks)

(c) Explain why differing objectives make it difficult for the management of AV to compare its operating andfinancial performance with that of BW, and comment briefly on additional information that would assist inthe appraisal of the operating and financial performance of BW for the year ended 31 May 2004.

(5 marks)

(20 marks)




Answers



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1 (a) (i) NAW Group:Statement of Budgeted Profit for the year to 31 May 2005 – Division OProduct Painfree Painfree Digestisalve Digestisalve Awaysafe Total

Branded Unbranded Branded Unbranded BrandedSales-packs (000’s) 5,000 15,000 5,000 20,000 15,000 60,000Selling price (£’s) 2·40 1·20 4·80 3·60 8·00

£’000’s £’000’s £’000’s £’000’s £’000’s £’000’sSales revenue 12,000 18,000 24,000 72,000 120,000 246,000

––––––– ––––––– ––––––– ––––––– –––––––– ––––––––Cost of sales:Material/conv.costs 4,250 12,750 9,250 37,000 42,000 105,250Packaging costs 750 750 1,250 3,000 6,000 11,750

––––––– ––––––– ––––––– ––––––– –––––––– ––––––––Total variable costs 5,000 13,500 10,500 40,000 48,000 117,000

––––––– ––––––– ––––––– ––––––– –––––––– ––––––––Contribution 7,000 4,500 13,500 32,000 72,000 129,000Fixed costs:Fixed overheads 81,558Advertising and promotion costs 17,400

––––––––Net profit 30,042

––––––––

Net profit 30,042Required return (10%) 12,000

––––––––Residual Income (RI) 18,042

––––––––

Invested capital (£000’s) 120,000

Return on Investment (ROI) 25·04%

(ii) During the years ended 31 May 2005 and 2006,manufacturing capacity is restricted to 780,000,000 tablets. Sincethe tablets are only sold in one pack size that contains 12 tablets, enough tablets could be produced to satisfy a salesdemand of up to 65,000,000 packs during each year. Forecast demand for the year ended 31 May 2005 is60,000,000 packs. Division O has spare capacity equivalent to 5,000,000 packs of tablets. However, forecast salesdemand for the year ended 31 May 2006 is 10% higher than that of the previous year (i.e. 60,000,000 x 110%) =66,000,000 packs. Therefore demand is forecast to be in excess of available capacity by 1,000,000 packs, which islikely to prove costly to the NAW group not only in terms of contribution foregone but also in terms of potential loss ofcustomer goodwill. It is clearly essential that management attention should be focused on the identification and removalof the limiting factor/(s) that would otherwise prevent Division O meeting forecast demand during the year ending 31 May 2006.

Management should also give consideration to qualitative factors that may be affected by the product-mix decision. Forexample, customers may be affected by the decision to manufacture one product as opposed to another. Themanagement of the NAW Group need to consider the extent to which their customers will be affected by any decisionwhich alters the availability of the finished product. For example, a decision to increase the output of ‘Awaysafe’ andreduce the output of ‘Painfree’ could result in customers who previously purchased both branded and unbrandedversions of ‘Painfree’ and/or ‘Digestisalve’ finding an alternative supplier who is able to supply a substitute product inboth branded and unbranded (generic) variants.

Management will need to assess the market position of each product before making a decision regarding product-mix.This might involve a reduction in short-term profitability in order to gain in the longer-term.

Suppliers also require consideration since they will be affected by any changes to the product mix that necessitatedifferent ingredients and revisions to delivery schedules. Further negotiations will almost inevitably be required.

Management should also consider the likely response of competitors as any decision to change a productionspecification, such as for example the introduction of a new tablet format, will affect competitors who will then considertheir response.

It is quite conceivable that a change in production as a result of product-mix considerations might well result in achanged demand for individual resources, which in turn could impact upon resource availability.

(iii) The use of Residual Income helps to overcome many of the disadvantages of Return on Investment. In particular, itreduces the temptation on the part of management to reject projects with returns greater than the hurdle rate requiredby the group (10%), but acceptance of which would cause a lowering in the division’s current level of return oninvestment (25·04%). Thus, any project that generates a positive residual income enhances corporate performance.Consequently the use of Residual Income is more consistent than ROI with the objective of maximisation of the totalprofitability of the NAW Group. Thus, RI could also be used as a basis for management incentive schemes. A further



advantage of the RI approach lies in the fact that it is possible to apply different cost of capital percentage rates toinvestments that have different levels of risk. Also, the use of the RI approach serves to provide a focus on the cost offunds to divisional managers.

(b) (i) As regards Quotation 1 in respect of the year ending 31 May 2005, the manager of Division L would purchase from alocal supplier in order to increase the profitability of his/or her division. An internal transfer price of £5·60 (£8·00 less30%) would appear unattractive in comparison with a locally available price of £5·50. Since the NAW Group measuresdivisional performance via the use of ROCE and RI, it follows that the manager of Division L will consider themaximisation of profit (via lowering of purchase costs) to be of critical importance. The cost to the group will be£11,500,000. This is due to the fact that Division O could potentially have supplied these 5,000,000 units at amarginal cost of £3·20= £16,000,000, however an external supplier would be paid £27,500,000 for the required5,000,000 packs of an equivalent product.

As regards Quotation 2 in respect of the year ending 31 May 2005, the manager of Division L would again purchasefrom a local supplier in order to increase the profitability of his/or her division. Division O could potentially have suppliedthese 9,000,000 units at a marginal cost of £3·20= £28,800,000 although sales of 4,000,000 packs of anotherproduct (unbranded ‘Painfree’ has the lowest contribution of £0·30 per pack) would need to be foregone, resulting inan additional cost to the group of £1,200,000. Since an external supplier would be paid £49,500,000 for the required9,000,000 packs of an equivalent product, the cost to the group would be £19,500,000 (£49,500,000 –£28,800,000 – £1,200,000).

(ii) In order for the profitability of the NAW group not to suffer during the year ended 31 May 2005, the following pricesshould be charged in respect of each quotation:

Quotation 1

5,000,000 packs should be offered for transfer at £3·20, which is the marginal cost of production. It is also theopportunity cost to Division O, since there is enough spare capacity within Division O to meet the quotation quantity.Thus the quoted price should be £16,000,000.

Quotation 2

Since 9,000,000 packs of ‘Awaysafe’ are required, then 5,000,000 of these can be satisfied by using the spare capacitythat is available within Division O. Since management of the NAW Group have decided that 15,000,000 packs of‘Awaysafe’ must be available for purchase within the UK, then in order to meet the requirement of Quotation 2,management should forego sales of 4,000,000 packs of unbranded ‘Painfree’ which is the product with the lowestcontribution. (£0·30 per unit). Thus the quoted price should be £30,000,000 which is comprised as follows:

Variable costs of manufacturing 9,000,000 packs of ‘Awaysafe’ at £3·20 per pack £28,800,000Contribution foregone on 4,000,000 packs of unbranded ‘Painfree’ at £0·30 £1,200,000

––––––––––––Quoted Price £30,000,000

(iii) The ‘ideal’ transfer price should reflect the opportunity cost of sale to the supplying division and the opportunity cost ofpurchase to the buying division. Thus the general rule put forward is that the transfer price per unit should be thestandard variable costs of the producing division plus the opportunity cost to the company as a whole of supplying theunit internally. The use of opportunity cost as a basis for transfer pricing would necessitate consideration of anyalternative use that could be made of the capacity within the supplying division. The supplying division would beindifferent as whether its output was sold internally or externally. The purchasing division would choose on the basis ofwhether the external purchase price was lower than the internal transfer price and this would require that full informationis available about the opportunity cost to the group of internal supply, in order to ensure that the correct purchasedecision is made from a group perspective. A significant problem lies in the fact that full information about opportunitycosts may not be easily obtainable in practice. A further consideration lies in the fact that the imposition of a transferprice may undermine divisional authority.

(c) (i) If Division L buys from a local supplier, the financial implications for the NAW Group are as follows:

Division O sales:15,000,000 packs of ‘Painfree’ at Contribution of £0·30 per pack = £4,500,000

Taxation at 40% thereon £1,800,000–––––––––––

After tax benefit of sales £2,700,000

Division L purchases:9 million packs of “Awaysafe” at Cost of £5·50 per pack £49,500,000Taxation benefit at 20% thereon £9,900,000

––––––––––––After tax cost of purchases £39,600,000

Net cost to NAW Group £2,700,000 less £39,600,000 £36,900,000––––––––––––

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If Division L buys internally from Division O the financial implications for the NAW Group are as follows:

Division O sales:11 million packs of ‘Painfree’ at Contribution of £0·30 per pack = £3,300,0009 million packs of ‘Awaysafe’ to Division L at Contribution of £2·40 per pack = £21,600,000

––––––––––––£24,900,000

Taxation at 40% thereon £9,960,000––––––––––––

After tax benefit of sales £14,940,000

Division L purchases:9 million packs of ‘Awaysafe’ at Cost of £5·60 per pack £50,400,000Taxation benefit at 20% thereon £10,080,000

––––––––––––After tax cost of purchases £40,320,000

Net cost to NAW Group £14,940,000 less £40,320,000 £25,380,000––––––––––––

The NAW Group will be £36,900,000 – £25,380,000 = £11,520,000 better off if Division L purchases product‘Awaysafe’ from Division O, as opposed to purchasing an equivalent product from a local supplier. Notwithstanding thefact that the wealth of the NAW Group is enhanced by the decision, there is also the fact that it makes good commercialsense to promote the ‘Awaysafe’ brand in the international arena.

(ii) When determining transfer prices the management of the NAW Group should consider the following issues:

Taxation – In a large number of multinational organisations the issues relating to taxation take precedence over othertransfer pricing issues and significant amounts of management time are spent attempting to determine the transfer pricesthat will minimise tax paid on a global basis. Transfer prices should be set in a way that minimises the taxation payableby the organisation as a whole. Management should be cognisant of the fact that anti-avoidance legislation exists toprevent companies using transfer policies to divert profits to subsidiaries/divisions based abroad.

Import duties/tariffs – can prove problematic. Again, whilst it is desirable that transfer prices be kept as low as possiblein order to minimise the payment of duty in countries that impose import tariffs based on the ‘value’ of incoming goods,it should be borne in mind that governments are mindful of such practices and may invoke similar policies to that ofanti-avoidance legislation.

Currency fluctuations – can also prove problematic as they give rise to exchange risk. Many international organisationsattempt to reduce their exposure to exchange risk by paying early or late to ‘profit’ from the anticipated movements inexchange. Whilst the management of NAW Group should give careful consideration regarding which currencies toinvoice in and which currencies to settle invoices etc, management should avoid the temptation to use transfer pricesas a means of moving funds from a weaker currency into a stronger currency.

Repatriation of funds – must be considered when dealing with countries, which have a high inflation rate or stringentforeign exchange regulations. It is imperative that transfer prices are only set after giving due consideration to whichcountries and in what currencies cash balances should be maintained.

(d) The product life cycle (plc) depicts the movements of a product through the four phases of introduction, growth, maturity andfinally decline. The returns that the management of NAW Group will expect from each of its product will be dependent onwhere that product is in its life cycle. By giving due consideration to the life cycle of the different products, the managementof NAW Group will gain a better understanding of the likely demand for its products. This will be a significant aid in theformulation and development of a marketing plan and provide the basis for the allocation of available resources such as theadvertising and promotional budget which in the year ending 31 May 2005 is forecasted to amount to £17,400,000 (7%of total turnover). Hence various aspects relating to how a product is managed relate to management’s perception of its currentposition in the life cycle. The use of the product life cycle would encourage the management of NAW Group to look beyondthe current level of returns when deciding upon investment strategy. The use of the model would enable management toevaluate investment in products on a ‘Whole life basis’. Use of the model might not only enable management to assesswhether revenues were likely to grow or not, but might also enable them to gauge the amount of future investment needed.

The specific implications of the product life cycle for the management of the NAW Group are dependent upon the stage withinthe product life cycle that a product is in, and the nature of the pricing decision being made.

In the pre-launch stage management will be concerned with the establishment of price objectives. This will necessitate theidentification and analysis of the various influences upon price such as product specifications, supply forecast levels ofdemand and legal and environmental constraints.

In the introduction phase management will consider whether to employ skimming or penetration pricing policies dependingon their desired objectives and their assessment of market characteristics. At this stage the management of the NAW Groupshould consider the trade discount structure that they wish to be employed and develop special offers to encourage theadoption of the new product.

In the growth phase management should use price as a means to combat competition and attempt to maximise the benefitto be derived from economies of scale whilst improving the perceptions of price and value of the product.

15



In the maturity phase management should use price in order to protect the market position of the product. Considerationshould be given to identifying alternative distribution channels which may offer the opportunity to charge higher prices.

When a product reaches the decline phase management should use price in order to maximise potential profits, even if thisinvolves a diminution in market share.

Clearly it is important that the performance measures used to assess each product take account of the stage that eachrespective product is at in its life cycle. Traditional performance measures such as profit and return on capital employed aremost suited to products in the mature and decline stages where management focus is upon the use of scarce resources andthe maximisation of cash flows. During the introduction and growth phases the factors that need to be controlled are thoserelated to the product gaining market success since these will ultimately determine its future financial value.

The management of NAW Group will be unable to forecast the precise shape or duration of a product’s life cycle from themodel. Hence, whilst useful as a descriptive model the plc has no predictive value. Since the management of the NAW Grouponly have access to past sales data they would also find it difficult to locate the position of a product on the life cycle. Forexample, if sales revenues grew during each of the past four years it would still be impossible to discern whether the productwas in the early, mid or late growth stages. Likewise a dip in sales may not signal entry into the decline stage but may beattributable to short term economic recession.

2 (a) Statement of Budgeted Customer Profitability for the year to 31 May 2005 – Division O

Large Small Supermarkets Others TotalPharmacies Pharmacies

£’000’s £’000’s £’000’s £’000’s £’000’sContribution 49,350 27,050 43,350 9,250 129,000Less:Delivery costs 768 2,304 2,048 2,880 8,000Changed delivery requirements 6 – 2 – 8Purchase order costs 2 6 2 20 30Promotion and exhibition costs 110 – – – 110Retrospective rebates 9,180 2,280 13,950 – 25,410

––––––– ––––––– ––––––– –––––– ––––––––Total – other operating costs 10,066 4,590 16,002 2,900 33,558Net profit before fixed overheads 39,284 22,460 27,348 6,350 95,442

(b) (i) Most organisations compete in increasingly competitive markets and hence it becomes vital that the management ofsuch organisations are able to ascertain not only the level of profitability relating to the products or services it sells, butalso the levels of profitability attaching to particular customers, markets and distribution channels to which thoseproducts and services are sold. It has long been acknowledged that gross margin net of trade discounts is an inaccuratemeasure of profitability. Product costs are generally determined from manufacturing costs, however customer costs areoften determined from the selling and distribution costs that are incurred in the period following manufacture. Theconventional accounting systems of many organisations treat these costs as period costs for both financial andmanagement reporting practices. Whilst this treatment might be considered appropriate for financial reporting purposes,it is arguably a major failing of such reporting systems not to allocate such costs to customers. Since no two customershave identical requirements it follows that profitability can vary enormously from one customer to the next. Suchvariations are masked by conventional accounting systems.

Activity-based techniques may be used to assign post-manufacturing costs to customers for decision-making purposes.The allocation of such costs should reflect the ways in which different customers consume resources. In the case ofDivision O it is quite clear that each of the four customer groups is profitable. However, the allocation of customer specificcosts to customer groups shows that a significant amount of the contribution generated by the supermarkets and otherretail outlets is consumed by customer specific costs. Hence the ratio of profit before fixed overheads to sales variesconsiderably from the contribution to sales ratios for those particular customer groups as shown by the following table.

Large Small Supermarkets OthersPharmacies Pharmacies

Contribution: sales ratio (%) 53·76 59·32 46·61 59·30Profit: sales ratio (%) 42·79 49·25 29·41 40·70

The management of Division O should utilise their management information systems in order to ‘drill-down’ andascertain the respective rate of profitability of existing customers within each customer group. For example, the specialistindependent pharmacies and the customers who comprise the ‘other retail outlets’ require a large number of deliveriesrelative to the number of such deliveries required by the large pharmaceutical stores and the supermarkets. It may bepossible to re-negotiate delivery schedules so that the profitability levels of customers within these groups is improved.

The absence of accurate information relating to customer profitability might well precipitate strategic errors in the pricingof goods and/or services for particular customers. For example, if the NAW Group failed to assign costs such as thoseincurred in respect of the number of deliveries made to customers, it would not be possible to price services to customersto reflect differences in the service levels provided to different customers. Moreover, it might well be the case that suchcosts may be allocated to the wrong customers!

16



17

Many organisations do not have management information to enable managers to gain a clear understanding regardingthe profitability of their customers and/or the markets in which they operate. As services (sales, general andadministrative costs) become a more significant part of companies’ competitive advantage and cost structure, themanagement tools must respond accordingly. In fact, for service companies, customer profitability is far more importantthan product profitability because the costs of providing a service product are usually determined by customer behaviour.

(ii) The initiatives that managers should consider in order to improve customer profitability generally fall within threecategories, these are:

– Process improvements– Pricing decisions– Relationship management.

The management of the NAW Group should try to ensure that prior to embarking on a customer profitability exercisethat the company’s overall operations are as cost-effective as possible. Many organisations attain a competitive level ofproductivity by undertaking detailed reviews of technology, utilisation, performance and planning in each function. Themain limitation of such a review lies in the fact that it is function-based and fails to recognise inefficiencies that existwithin the inter-functional relationships, which are an integral part of the day-to-day operations of all organisations.

Suppliers should first look internally to see where they could improve their own processes thereby reducing the costsincurred in supplying their customers. If most customers are migrating to smaller order sizes, companies should striveto reduce batch-related costs, such as set-up and order handling, so that customer requirements can be satisfied at lowercost and without raising overall prices. The use of electronic systems yields a large reduction in the cost of processinglarge quantities of small orders. If customers seek variety, manufacturing companies could respond by introducingmodular designs and use information technology to enhance the linkages from design to manufacturing so that greatervariety and customisation can be offered without cost penalties.

The major opportunity for resolving conflicts between suppliers and customers, and for transforming unprofitable toprofitable relationships, arises from pricing individual orders and transactions. Any strategy focussed upon managementof customer profitability should be underpinned by customised pricing policies. By understanding the (activity-based)cost of providing services, companies can establish prices that can precipitate more efficient behaviour of both suppliersand customers and assist in the transformation of hitherto unprofitable relationships into profitable ones. Accurate costand pricing information can provide the stimulus for customers to change their ordering, shipping and distributionpatterns thereby lowering total supply chain costs to the mutual benefit of suppliers and customers.

Activity-based pricing improves the fit between suppliers and customers and has the potential to enhance the profits forboth across the supply chain. Such pricing educates customers about how their behaviour affects the costs of itssuppliers. But, often, the customer also learns about its own costs from such activity-based pricing.

Before taking any action – including pricing – with unprofitable customers, companies should expand the customerprofitability measurement to encompass all the relationships that each customer has with the company. While such totalprofitability calculations were difficult and expensive using legacy computer systems, modern ERP and CRM systemscan identify and link all customer relationships together.

The Balanced Scorecard (BSC) provides a comprehensive framework for managing customer relationships. (R. S. Kaplanand D. P. Norton, The Balanced Scorecard: Translating Strategy into Action (Boston: HBS Press, 1996)) The BSC’scustomer perspective typically includes outcome measures for targeted (strategic) customers. Such measures includecustomer acquisition, satisfaction, retention, account share, and market share. But the customer perspective should alsomeasure whether loyal, satisfied customers are profitable customers. Companies need to ensure that their loyal, satisfiedcustomers – those consuming many resources are indeed a source of adequate profitability.

Many service organisations invest considerable resources in marketing campaigns to attract new customers. However,a significant part of this investment may prove not to be worthwhile unless organisations have a clear understanding ofthe characteristics of what makes a profitable customer. By knowing the characteristics of profitable customers,companies can focus their marketing activities upon those segments that are most likely to yield profitable customers.

It is quite possible that high-quality new customers may be prove to be unprofitable in the short-term due to the factthat there are often significant costs connected with the acquisition of new customers. Moreover, it is almost inevitablethat it may take some time to establish a relationship whereby the customer buys many products and services. In orderto improve their understanding of customer account profitability, service companies need to give separate considerationto such newly-acquired customers and in so doing, it is vital that they should not be ‘judged’ on the same criteria aslong-standing customers. Thus, in addition to recognizing cross-sectional variation of demands by customers – acrossmultiple products and services, companies must also forecast the longitudinal variation of customers over time to arriveat an estimate of their total life-cycle profitability.



Workings (part a):

(i) Contribution per customer group.Product Type Large Small Supermarkets Others Total

Pharmacies Pharmacies£’000’s £’000’s £’000’s £’000’s £’000’s

Painfree Branded 4,200 1,400 700 700 7,000Painfree Unbranded 1,350 – 3,150 – 4,500

Digestisalve Branded 5,400 4,050 2,700 1,350 13,500Digestisalve Unbranded 9,600 – 22,400 32,000

Awaysafe Branded 28,800 21,600 14,400 7,200 72,000––––––– ––––––– ––––––– –––––– ––––––––

Total Contribution 49,350 27,050 43,350 9,250 129,000

Illustrative workings for Large Pharmacies:

Product Type Total contribution Large Large per product Pharmacies % Pharmacies

£’000’s of sales volume £’000’sPainfree Branded 7,000 60% 4,200Painfree Unbranded 4,500 30% 1,350

Digestisalve Branded 13,500 40% 5,400Digestisalve Unbranded 32,000 30% 9,600

Awaysafe Branded 72,000 40% 28,800–––––––

Total Contribution 49,350

(ii) Retrospective rebates.

Sales Revenues (000’s)Large Small Supermarkets Others

Pharmacies PharmaciesPainfree: £’000’s £’000’s £’000’s £’000’sBranded 7,200 2,400 1,200 1,200Unbranded 5,400 2,400 12,600

Digestisalve:Branded 9,600 7,200 4,800 2,400Unbranded 21,600 2,400 50,400

Awaysafe:NAW Brand 48,000 36,000 24,000 12,000

––––––– ––––––– ––––––– ––––––Total Revenue 91,800 45,600 93,000 15,600

Retrospective rebate (%) 91,010 91,015 91,015 91,010––––––– ––––––– ––––––– ––––––

Retrospective rebate 19,180 12,280 13,950 91,010––––––– ––––––– ––––––– ––––––––––––– ––––––– ––––––– ––––––

3 (a) In the worldwide competitive environment of today, organisations are competing in terms of product/(service quality), delivery,reliability, post-sales service and customer satisfaction. It is only recently that management accounting systems have beenadapted to provide management with information regarding these critical variables, notwithstanding the fact that they haverepresented key commercial variables for a considerable period of time. Prior to the last quarter of a century a large numberof organisations in the western world operated in the comfort of a protected competitive environment. Barriers tocommunication, government support and geographical distance often protected domestic markets. This protection providedorganisations with very little stimulus to focus upon achieving improvements in efficiency and management practices, sinceinefficiencies were very often passed to the customers of such organisations. In recent years such domestic markets havebeen attacked by competition from overseas countries that offer low-cost, high-quality products to the domestic markets.Overseas competitors have been able to attack domestic markets via the establishment of global networks enabling them toacquire raw materials and distribute goods in overseas territories.

Robert Kaplan has written persuasively that much of the problem with regard to the difficulties faced by US manufacturingorganisations with regard to Japanese and European competition can be traced to management accounting techniques andpractices which do not meet the needs of today’s manufacturing environment. Kaplan concluded that ‘traditional costaccounting systems based on an assumption of long production runs of a standard product, with unchanging characteristicsand specifications will not be relevant in this new environment’.

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According to Kaplan’s relevance lost thesis, today’s manufacturing is totally different. Instead of direct labour intensive,standard products with long life cycles, it features sophisticated, overhead intensive, module-designed and tailor-madeproduct with short life cycles. Instead of utilising machinery, which had only a single purpose, there are flexible manufacturingstations and the use of emergent CAD/CAM technologies. Instead of small groups of technical and clerical employees,manufacturing is planned and controlled by a large number of experts in specialist technical departments and administrativeoffices who manage the actual production operation. Moreover, instead of national oligopolistic and tariff-protectedcompetition, the world features relatively unrestricted enterprises competing around the globe, and an increasing number offree trade arrangements.

It can therefore be argued that the metamorphosis that has taken place in manufacturing has not been followed by atransfiguration of management accounting and control techniques. The time-honoured systems whose focus was uponreducing and minimising product costs and emphasised short-term tactical control, have become inappropriate and frequentlymisleading. Hence the assertion that management accounting systems have lost their relevance.

(b) The strategic cost management initiative proposes several ways to restore management accounting to a place of relevanceincluding a radical overhaul of the focus of management accounting and control systems. More specifically, the scope ofaccounting and control reports should be widened to include information regarding matters such as reductions in productthroughput time, rework costs, the number of manufacturing interruptions, progress on waste management, levels ofworkforce morale and indicators of quality in products. In addition, the information base available to management would beexpanded from accounting numbers to include measures and statistics relating to those variables that constitute strategicsuccess factors. The adoption of a more holistic focus would direct attention towards considerations that were more strategicas opposed to operational in nature. Thus greater attention would be placed upon factors such as the ever-changing needsof customers, long-term effectiveness, and quality measures, whilst less attention would be placed upon tactical concernssuch as achieving efficiencies and lower product costs.

A major initiative required by strategic cost management lies in the use of value-chain analysis. Value-chain analysis meansreconceiving the business as a ‘linked set of value creating activities all the way from basic raw material sources forcomponent suppliers through to the end-use product delivered into the final consumers hands.’ The aim is to expand thescope of management accounting to include critical external elements with a particular focus upon adding value for bothcustomers and suppliers.

Strategic cost management also promotes the need to revitalize management accounting by extending cost estimates over theentire life cycle of a product, a practice that many Japanese organisations have adopted for many years. Furthermore,Japanese organisations seek to harness the collaborative efforts of engineers, purchasing officers, component suppliers,marketing personnel, production staff and all other involved parties in order to arrive at an estimate of the standard achievablecost of their part of a new product. Then they establish an allowable cost which is difference between the expected sellingprice and the cost needed to make the desired level of margin. Next a target cost is struck usually halfway between thestandard achievable and the allowable cost. These cost estimates are not based on current production methods andmanufacturing equipment but on potentially ideal configurations and incorporate learning-curve effects. A feature of the useof target costing is the unceasing efforts of managers to achieve the allowable cost.

The strategic cost management initiative that has attracted the most attention is activity-based costing (ABC). Advocates ofABC contend that many large complex organisations rely on traditional absorption cost accounting systems the use of whichgives rise to significant distortions in product cost data. Proponents of ABC argue that such distortions occur because suchsystems use volume related formulae based on direct labour, direct materials, or machine utilisation in order to allocateindirect manufacturing costs, when in fact these resources represent only a small proportion of the total cost of most productsand services. The proponents of ABC hold the view that the use of absorption based systems will result in inaccurate andarbitrary product cost information, which, if relied upon will precipitate poor decision-making by management in areas ofcritical importance such as product policy and capital investment as well as misguiding management on financialperformance and control systems that should be employed.

Strategic management accounting is an approach to management accounting that addresses issues and concerns which arestrategic in nature. It places management accounting in a much broader context in which financial information is used todevelop superior strategies in order to derive a means of achieving sustainable competitive advantage. Conventionalmanagement accounting tends to have both, an historic focus and an inward looking perspective and be concerned withsingle decisions, single periods and single entities. By way of contrast, strategic management accounting is future focussedand consider the external business environment of an organisation and in particular the position of the organisation in relationto its competitors in the context of sequences of decisions over multiple time periods. The future is complex and uncertainand thus strategic management accounting can be viewed as a much-needed response to what could be viewed as majorshortcomings of conventional management accounting systems.

The use of initiatives such as value chain analysis, life cycle costing, target costing, activity-based costing and strategicmanagement accounting can be viewed as being the response of management accounting in its attempt to regain relevanceand maintain a focus of controls upon matters of strategic importance and long-term effectiveness.

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4 (a) (i) Memorandum

To: Board of DirectorsFrom: Finance Director

Date: 11 June 2004

Re: The adoption of Zero-based budgeting within NN Ltd.

During recent years the management of NN Ltd has used the traditional approach of incremental budgeting. Thisapproach entails the use of the previous year’s budget as a baseline and adds or subtracts amounts to/ from that budgetin order to reflect assumptions for the forthcoming budget year. The typical justification for increased expenditures, otherthan those related to volume changes, has been due to the increased cost of inputs to our business. This approach canlead to inefficiencies in the previous year’s budget being rolled forward into the next year’s budget purely by virtue ofthe fact that last year’s budget is the base starting point for the construction of the new budget.

The implementation of a system of zero-based budgeting will require a consideration of the following:

– The need for major input by management;– The fact that it will prove extremely time consuming;– The need for a very high level of data capture and processing;– The subjective judgement inherent in its application;– The fact that it might be perceived as a threat by staff;– Whether its adoption may encourage a greater focus upon the short-term to the detriment of longer-term planning.

Zero-based budgeting was developed to overcome the shortcomings of the technique of incremental budgeting. Theimplementation of a zero-based budgeting would require each manager within NN Ltd to effectively start with a blanksheet of paper and a budget allowance of zero. The managers would be required to defend their budget levels at thebeginning of each and every year. Thus, past budget decisions would as part of the process of zero-based budgetingneed to be re-evaluated each year. The comprehensive resource cost-analysis process is a strong internal planningcharacteristic of zero-based budgeting. It follows that resource requirements are more likely to be adjusted to changingbusiness conditions.

The development and implementation of the zero-based budgeting model will require managers and others in theorganisation to engage in several major planning, analytical and decision-making processes. Our company has alreadyestablished mission and goal statements. However, we as a management team ought to give consideration as to whetherit is necessary to redefine the statements that are already in existence and/or create new ones. This redefinition ofmission and goal statements will be of much value if we as a management team consider that major changes haveoccurred in the internal and external environment of our business.

A zero-based budgeting decision unit is an operating division for which decision packages are to be developed andanalysed. It can also be described as a cost or a budget centre. Thus the manager responsible for each cost centre withinNN Ltd would be responsible for developing a description of each program to be operated in the next budget year. Inthe context of zero-based budgeting such programs are referred to as decision packages, and each decision packageusually will have three or more alternative ways of achieving the decision package’s objectives. Briefly, each decisionpackage 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 goalsof the organisation.

Each manager within NN Ltd will be required to review each decision package and its alternatives in order to be ableto assess and justify its operation and in doing so, several questions must be answered. In particular, each manager willneed 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 this decision package’s objectives be accomplished more effectively and/or efficiently?

The ranking process, based upon cost/benefit analysis is used to establish a prioritised ranking of decision packageswithin the organisation. During the ranking process managers and their staff will analyse each of the several decisionpackage alternatives. The analysis allows the manager to select the one alternative that has the greatest potential forachieving the objective(s) of the decision package. Ranking is a way of evaluating all decision packages in relation toeach other. Since, there are any number of ways to rank decision packages managers will no doubt employ variousmethods of ranking. The ranking process could prove to be problematic insofar as it will require our managers to makevalue judgements and thus subjectivity is an inherent factor in the application of zero-based budgeting. Althoughdifficult, 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 allocatedto each decision package. Managers at different levels of responsibility in the organisation usually perform the reviewand analysis. Sometimes, the executive levels of management may require the managers of the decision packages torevise and resubmit their decision packages for additional review and analysis.

Our budget will be prepared following the acceptance and approval of the decision packages. Once the company’sbudget has been approved, managers of the decision units will put into operation all approved decision packages duringthe budget year.

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The last major process of zero-based budgeting is monitoring and evaluation. The processes of planning, analysis,selection and budgeting of decision packages will prepare our company for operation during the next year. However,what managers plan to happen during the next year may or may not occur. Adjustments may be essential during theyear in order to achieve the decision package objectives. Also, there is a need to know whether or not the organisationdid accomplish what it set out to achieve and what level of achievement was obtained. The monitoring and evaluationprocess of zero-based budgeting requires a number of features are incorporated in the overall design and implementationof decision packages.

– It is essential that all decision packages include measurable performance objectives and identifies the appropriateactivities as means for achieving the performance objectives.

– The required resources for conducting the activities, together with the planned methods for carrying out theactivities should also be included.

– The decision package should also include a mechanism to evaluate whether an objective is being achieved bothduring and after the conclusion of the program of activities for subsequent reporting to management.

(ii) The implementation of zero-based budgeting will require a major planning effort by our personnel. It is through theplanning process that important guidelines and directions are provided for the development and ranking of the decisionpackages. Also, the planning process will enable managers to prepare for the uncertainty of the future. Long-rangeplanning 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 andapplication 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 planand make decisions about the most efficient and effective ways to use their available resources to achieve their definedmission, goals and objectives.

There is no doubt that the process of zero-based budgeting will consume a great deal more management time than thecurrent system of budgeting does. This will certainly be the case in implementation of the system because managerswill need to learn what is required of them. Managers may object that it is too time-consuming to introduce zero-basedbudgeting, 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 theestablishment of a review cycle aimed at ensuring that each activity is reviewed on at least one occasion during everytwo 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 onthe 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’ thatmay be present. Budgetary slack is ‘a universal behavioural problem’ which involves deliberately overstating cost budgetsand/or understating revenue budgets to allow some leeway in actual performance. We must acknowledge that inorganisations such as ours where reward structures are based on comparisons of actual with budget results, bias canhelp to influence the amount paid to managers under incentive schemes. However, we should emphasise that ifmanagers are to earn incentives as a consequence of incentive schemes that are based upon a comparison of actualoutcomes 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 budgetingagainst 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’.

Signed: Finance Director

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(b) The finance director is probably aware that the application of zero-based budgeting within NN Ltd might prove most fruitfulin the management of discretionary costs where it is difficult to establish standards of efficiency and where such costs canincrease rapidly due to the absence of such standards. A large proportion of the total costs incurred by NN Ltd will comprisedirect production and service costs where the existence of input: output relationships that can be measured render them moreappropriate to traditional budgeting methods utilising standard costs. Since the predominant costs incurred by a not for profithealth organisation will be of a discretionary nature, one might conclude that the application of zero-based budgetingtechniques is more appropriate for service organisations such as the not for profit health organisation than for a profit-seekingmanufacturer of electronic office equipment. A further difference lies in the fact that the ranking of decision packages is likelyto prove less problematic within an organisation such as NN Ltd which is only involved in the manufacture and marketing ofelectronic office equipment. By way of contrast, there is likely to be a much greater number of decision packages of a disparatenature, competing for an allocation of available resources within a not for profit health organisation.

5 (a) The term ‘value for money’ is often used to refer to economy, efficiency and effectiveness. Value for money audits can beundertaken in order to assess whether value for money has in fact been achieved. In order for such an audit to be effectivethe 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, efficiencyand effectiveness. Economy is only concerned with inputs acquired by AV, and is achieved by obtaining those inputs at thelowest acceptable cost. For example, the prices at which with the replacement fitted kitchens are purchased (£2,610) couldbe compared with those obtainable from other vendors in order to assess whether the lowest acceptable cost is being achievedfor the required level of quality. It is important that the management of AV realise that economy is measured by reference toquality of resource inputs. They need to recognise that the purchase of poor quality materials and inferior services represents‘false economy’.

Efficiency is focussed upon output, for example, maximising output for a given level of input. For example with regard to thereplacement fitted kitchens, AV could use the tendering process in an attempt to maximise the number of fitted kitchens thatwould be installed for a given amount of money by the contractor awarded the tender. Efficiency is measured by the ratio ofoutput to input. 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 eithermonetary amounts or physical units e.g. per property.

Effectiveness is focussed upon the achievement of objectives. A not for profit organisation will invariably have a number ofobjectives. 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 management of AV should be mindful that the three performance measures require individual consideration since forexample, the degree to which effectiveness is achieved gives no indication about how much was spent to achieve it.

The management of AV should also recognise that these performance measures may conflict with one another. For example,during the year AV incurred expenditure amounting to £234,900 in respect of 90 replacement fitted kitchens. If AV hadpurchased 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 ofreplacement kitchen units at a cost of £5,220 might have resulted in a higher level of effectiveness being achieved throughfactors such as the longer life of the replacement kitchen units, higher quality fixtures and fittings, and enhanced aesthetic‘appeal’ to residents.

The management of AV should also give consideration to benchmarking against other similar charities whose primaryobjective is the provision of accommodation to the communities in which they operate. Benchmarking is probably the mostsignificant recent development in measuring the performance of not-for-profit organisations. The management of charitiessuch as AV would be far more willing to share information about performance with similar organisations for their mutualbenefit, than the management of many profit-seeking organisations who often view the sharing of information as a commercialthreat. For example, the management of AV could attempt to establish whether £2,610 is the ‘norm’ in respect of the cost ofa replacement fitted kitchen incurred by similar non profit-seeking organisations.

22



(b) (i) 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.

(ii) The management of AV could use the following performance measures:

Cost and efficiency.AV BW

(1) The mean cost, per week per house on management. £9·61 £29·81–––––– ––––––

(2) The mean 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 mean 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), areemployed by each organisation, staff costs incurred by BW are 37·7% higher than those of AV. This could resultfrom different pay structures and management policies regarding remuneration that are likely to be employed withina 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 eachnon-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 subcontractorthat each repair undertaken is charged at the same fee in return for guaranteed business volumes for thesubcontractor. If this were the case, then AV would benefit from entering into such an arrangement for the supplyof repair services.

(3) BW did not have any unoccupied properties at any time during the year. This would seemingly indicate a high levelof demand for its properties. AV had potential gross rents receivable during the year of £2,423,200. Unoccupiedproperties resulted in lost revenues of £36,348. which amounted to 1·5% of gross rents receivable. Furtherinformation is required to in order to assess whether the lost revenue is attributable to ‘void periods’ i.e. propertiesbecoming vacant or perhaps due to tenants who have defaulted.

Note: other ratios and relevant comments would have been acceptable.

(c) The primary objective of any commercial organisation such as BW is to maximise profit. Management may take a short orlong-term view regarding the ways in which they seek to achieve this objective. Management may have to choose betweenavailable options, each of which might help them to achieve this objective. However, whilst many decisions may have to bemade, the objective remains clear and identifiable.

The management of BW will most probably be concerned with the provision of high quality accommodation in order togenerate higher revenues and profits. The management of BW are probably trying to appeal to those who are willing to payhigh rents for high quality accommodation. The fact that replacement fitted kitchens and replacement windows and doorspurchased 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 theaccommodation needs of persons within its locality’. This might distil down to ensuring that any person, who is in need ofaccommodation, is in fact provided for. The absence of a profit measure makes it more difficult to measure whether objectivesare in fact being achieved. It is difficult to judge whether non-quantitative objectives such as meeting accommodation needsof 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 assessthe 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 similarnon-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 includesthe 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 net interest payable – £750,000.– A detailed analysis of sundry operating costs – £235,000.– Management accounts for the current and prior years.– Budget information for 2004, 2005 and, if available, 2006.

It would also be useful to have details regarding the location of the properties held by BW. It is quite conceivable that thehouses held by BW are situated in a sought after area. Benchmarking with a ‘best practice’ organisation from within theprivate sector would be of much assistance in the appraisal of the operating and financial performance of BW.

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Marks Marks1 (a) (i) Sales revenue 1

Cost of sales:Materials, conversion costs 1Packaging costs 1Contribution 0·5Other operating costs 0·5Advertising and promotion costs 1Return on Investment 1Residual Income 1

–––– 7

(ii) Comments (on merit):Quantification of 2005 and 2006 position/remove limiting factor Up to 2Effect on customers 1Effect on suppliers 1Effect on competition 1Product-marketing strategy 1

–––– Maximum 3

(iii) Comments (on merit):It reduces the problem of under-investment 1More consistent than ROI with objective of maximising the total profitability of a group 1Basis of management incentive schemes 1Possibility exists to use different rates of interest for different types of investment 1Raises awareness of cost of finance 1

––– Maximum 3

(b) (i) Division L will purchase externally to improve its own profit 1Performance measure based on profit 1Sub-optimal from NAW Group viewpoint because spare capacity exists 1Calculation of implications 2


(ii) Correct Price – Quotation 1 1Correct Price – Quotation 2 2

–––– 3

(iii) Comments (on merit):Opportunity cost – ideal, but 1Supplying division would be indifferent as whether to sell internally or externally 1The purchasing division would choose lower of external and internal transfer price 1Use of OC would require consideration of alternative use of capacity in supplying division 1Full information may not be available 1Imposition of a transfer price may undermine divisional authority 1


(c) (i) Purchase from local supplier:Division O Sales 0·5Division L purchases 0·5Tax implications 1Purchase internally:Division O Sales 1Division L purchases 1Tax implications 1Conclusion 1

–––– 6

(ii) Taxation – minimisation 1– legal constraints 1

Exposure to currency risk 1Import tariffs 1Repatriation of funds 1Other relevant comments 1


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Marks Marks(d) Comments (on merit):

Linkage of expected returns to where product is in its life cycleAppropriate performance measures required for each stage Linkage to Product portfolio (appreciation of life cycle issues)Limitations – predictive capability? Up to 2 per comment

–––– Maximum 6–––

Total 40–––

2 (a) Contribution 3Delivery costs 1Changed delivery requirements 0·5Purchase order costs 1Promotion/exhibition costs 0·5Retrospective rebate 3

–––– 9

(b) (i) Comments (on merit):Increased competition Up to 2Failure of conventional accounting Up to 2Strategic necessity Up to 2


(ii) Comments (on merit):Process improvements Up to 2Activity-based pricing Up to 3Customer relationship management Up to 2


Total 20–––

3 (a) Comments (on merit):Changed business environmentFundamental need for MACS to match changed business environmentControl information ‘out of date’Rapid feedback requiredVariance analysis inappropriateOver-emphasis upon efficiencyInadequacy of full-cost for decision-makingOther relevant initiatives 1 mark per comment Maximum 5

(b) Comments (on merit):General: Change of focus, scope of reports, contentSpecific:Value addedLife cycle costingTarget costingActivity based techniquesStrategic management accountingOther relevant initiatives 1 mark per initiative

Up to 2 marks per evaluation(5 x 3 marks) Maximum 15

–––Total 20

–––

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Marks Marks4 (a) (i) Comments (on merit):

Factors to be consideredEffect on managementRole of managementRanking of decision packages Up to 2Monitoring and evaluation per comment


(ii) Problems 1 mark per problemManagement actions 1 mark per action


(b) Comments (on merit):DifferencesEase of implementation Up to 2Scope of application per commentOther relevant comments –––– Maximum 4

–––Total 20

–––

5 (a) Comments and use of illustrative data (on merit):Value for money Up to 1Economy, efficiency, effectiveness Up to 5Benchmarking Up to 2Other relevant comments Up to 2


(b) (i) Service quality – measures 2 x 0·5Flexibility – measures 2 x 0·5

–––– 2

(ii) Cost and efficiencycalculation (1); comment (1) 3x 2

–––– 6

(c) Comments (on merit):Different objectives Up to 3Financial effects of changes in demand due to different levels of service provisionLocation, age of properties, operating costs, interest, balance sheet, managementaccounts, budgetsBenchmarking – private sector organisation Up to 3


Total 20–––

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PART 3


QUESTION PAPER






Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examinationhall


Pape

r 3.3




1 Alocin plc is a well-established manufacturer of high quality consumer durables. The company has recently developeda state of the art ‘travel system’ i.e. baby carriage for infant children. The travel system, named the ‘Cruiser’ ismanufactured from a rare substance (CLO), which gives it superior strength to any other travel system that is currentlyon the market. The marketing director believes that the fact the ‘Cruiser’ weighs less than half of the weight of allcurrently available travel systems will give the company a considerable competitive advantage. Alocin plc alsomanufactures another travel system called the ‘Glider’ which is manufactured from material DMP.

The following information is available in respect of the year ending 31 December 2005:

(1) Each Cruiser requires 2 kilograms of CLO.

(2) Alocin plc has access to a maximum of 990 tonnes of CLO during the year. Each kilogram of CLO costs £60.NB 1 tonne = 1,000 kilograms.

(3) The labour cost of manufacturing a ‘Cruiser’ is estimated at £40 per unit.

(4) Variable overheads are estimated to be £20 per unit.

(5) Incremental fixed costs relating to the ‘Cruiser’ are estimated to be £31·5 million.

(6) The nature of CLO means that it cannot be stored for future use. The only alternative use for any surplus CLOduring the period is in the manufacture of an alternative version of the ‘Glider’.

(7) (i) The marketing director has estimated that at a selling price of £500 per Cruiser, an annual sales volume of500,000 would be achieved. He has further estimated that an increase/decrease in price of £20 will causequantity demanded to decrease/increase by 25,000 units. He has provided you with the following formulae:

Price function: Pq = P0 – bqTotal revenue (TR) function: = P0q – bq2

Marginal revenue (MR) function: = P0 – 2bq

Where P0 = Price at zero units of demandPq = Price at q units of demand b = price:demand relationshipq = Units of demand.

(ii) Where the relevant matching of total revenue and total cost functions is expressed as the quadratic equation ax2 + bx + c = 0, the break-even point(s) in units may be calculated using the formula:

N.B. This formula is independent of those formulae stated in (i) above.

Required:

(a) Calculate the profit maximising output level for sales of the ‘Cruiser’ and the profit that would arise fromthose sales during the period ending 31 December 2005. (6 marks)

(b) Calculate the output level(s) of ‘Cruisers’ and associated selling prices at which Alocin plc will breakeven.(6 marks)

The alternative version of the ‘Glider’ is called the ‘Super Glider’. Each ‘Super Glider’ unit would require 1·5 kilogramsof CLO which would be substituted for three kilograms of Material DMP, which costs £45 per kilogram.

Three models of the ‘Super Glider’ could be manufactured. These are the ‘Gold’, ‘Silver’ and ‘Bronze’ models. Themarketing director is confident that all units manufactured would be sold during the year.

2

x –b b ac

2a= ± 2 4–



Revenue and quantity information relating to the ‘Super Glider’ is as follows:

Model Incremental revenue % of total per unit (£’s) sales units

Gold 50 20Silver 40 50Bronze 30 30

Each ‘Super Glider’ unit has labour and variable overhead costs of £30 and £18 respectively.

(c) Calculate the incremental contribution arising from the sale of the ‘Super Glider’. (4 marks)

(d) Explain why the board of directors of Alocin plc may choose not to use the profit maximising model (per (a))in order to derive a selling price for the ‘Cruiser’. You should include reference to demand being a functionof a range of endogenous and exogenous variables as part of your answer. (8 marks)

(e) Explain ways in which each of the following may affect the pricing strategies that the management of Alocin plc might adopt for the ‘Cruiser’:

(i) Cost leadership(ii) Product differentiation(iii) Niche marketing. (8 marks)

(f) Explain the benefits and potential limitations of the use of SWOT analysis by the management of Alocin plc. Your answer should include a brief comment with respect to the formulation of a pricing strategyfor the ‘Cruiser’. (8 marks)

(40 marks)



2 Ride Ltd 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 mountainousareas. The following information relates to the year ending 31 December 2005:

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

Roadster Everest£ £

Selling price 200 280Material cost 80 100Variable 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 unitsEverest 70,000 units

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

Roadster 6·25Everest 5·00

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

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

Required:

(a) Using marginal costing principles, calculate the mix (units) of each type of bicycle which will maximise netprofit and state the value of that profit. (6 marks)

(b) Calculate the throughput accounting ratio for each type of bicycle and briefly discuss when it is worthproducing a product where throughput accounting principles are in operation. Your answer should assumethat the variable overhead cost amounting to £4,800,000 incurred as a result of the chosen product mix inpart (a) is fixed in the short-term. (5 marks)

(c) Using throughput accounting principles, advise management of the quantities of each type of bicycle thatshould be manufactured which will maximise net profit and prepare a projection of the net profit that wouldbe earned by Ride Ltd in the year ending 31 December 2005. (5 marks)

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

(20 marks)




3 (a) Explain the contingency theory of management accounting and expand on ways in which its componentshighlight and allow explanations of differences in management accounting control systems. (10 marks)

(b) (i) Explain the term ‘Business process re-engineering’ and how its application might enable overall businessperformance to be improved. (7 marks)

(ii) Briefly discuss potential problems which may be encountered in the implementation of a business re-engineering programme. (3 marks)

(20 marks)



4 Woods Ltd is a well-established company which manufactures and markets domestic kitchen appliances. One of itscurrent products is a refrigerator called the ‘Super kooler’. A sales volume of 180,000 units will be achieved duringthe year ending 31 December 2004.

The board of directors is aware that the government recently announced that the disposal and manufacture of largekitchen appliances such as refrigerators would be the subject of future legislation that will take effect from 1 January2009. The legislation will require that a percentage of all new products such as refrigerators will be manufacturedfrom recycled products.

The board of directors had anticipated this change but had not been aware of the date that the new legislation wouldtake effect. The new product development team within Woods Ltd has designed a new refrigerator called the ‘Ultimate’which will comply with all aspects of the forthcoming legislation.

The board of directors recently engaged Prospero, a market research consultancy to undertake a study of the likelydemand for the ‘Ultimate’, for which a fee of £50,000 was paid. Their findings revealed that consumer tastes havechanged insofar as they now seek more energy-efficient kitchen appliances. The consultants produced the followingestimate of annual sales volumes that may be achieved at the intended launch price of £200 per unit together withtheir associated probabilities:

Sales units per annum Probability125,000 0·30100,000 0·40

75,000 0·30

The board of directors has decided that expected value of sales units should be applied in all calculations.

The board of directors are considering when to replace the ‘Super kooler’ with the ‘Ultimate’ model and have askedyou to advise them accordingly. The following information is available to you:

(1) The current selling price per unit of the ‘Super kooler’ is £160. It will not be possible to achieve any furtherincreases in selling price during the remainder of the product’s life. The variable cost of manufacturing the ‘Superkooler’ is £100 per unit.

(2) The manufacture of the ‘Ultimate’ requires a change in manufacturing technology that will require an immediatecapital outlay of £1,200,000. The capital outlay will ensure that Woods Ltd has sufficient manufacturing capacityto cope with whatever level of demand should arise.

(3) It will not be possible to manufacture both models as only one type of manufacturing technology can be housedin the factory of Woods Ltd at any one time.

(4) The variable cost of manufacturing the ‘Ultimate’ is expected to be £110 per unit.

(5) The introduction of the ‘Ultimate’ model will increase fixed costs by £150,000 per annum.

(6) The board of directors uses a cost of capital of 9% per annum to evaluate new investments.

(7) The board of directors expects a decline in sales volume to occur during each year that they continue to marketthe ‘Super kooler’. However, the board is uncertain as to the rate of decline in sales volume that will occur. Themarketing director has stated that the minimum reduction in sales volume that will occur in the year ending 31 December 2005 is 10,000 units and that for each additional year that manufacture takes place a furtherminimum reduction of 10,000 units will occur.



Required:

(a) (i) Prepare an evaluation of the proposed replacement of the ‘Super kooler’ by the ‘Ultimate’ on 1 January2005 on purely financial grounds (using a NPV approach). (5 marks)

(ii) Calculate the minimum reduction in sales volume of the ‘Super kooler’ which will apply in the yearending 31 December 2005 and for each additional year thereafter (i.e. which will replace the 10,000units stated in note 7 above), in order to justify the withdrawal of the ‘Super kooler’ from the marketwith effect from 1 January 2005. (5 marks)

(b) (i) Explain the limitations of the analysis performed in part (a) and suggest how the board of directors couldaddress those limitations before making a decision regarding when to cease manufacture of the ‘Superkooler’. (7 marks)

(ii) Explain the potential benefits that may arise as a consequence of a decision by the board of directors tocease the manufacture of the ‘Super kooler’ with immediate effect, irrespective of the financialconsequences of such a decision. (3 marks)

Assume that all cash flows other than where stated will take place at the end of each year.

(20 marks)

5 ‘Responsibility accounting is based on the application of the controllability principle.’

Required:

(a) Explain the ‘controllability’ principle and why its application is difficult in practice. (6 marks)

(b) Explain how the management of an organisation can attempt to overcome the difficulties inherent in thepractical application of the controllability principle. (8 marks)

(c) Explain the following approaches that can be used to set financial targets within an organisation:

(i) Engineered approach(ii) Historical approach(iii) Negotiated approach. (6 marks)

(20 marks)



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Answers




1 Alocin plc.

(a) Total fixed costs = £31,500,000

Variable costs of producing a ‘Cruiser’

£’sMaterials (2 kilograms at £60 per kilogram) 120Labour 40Variable overheads 20

––––Variable cost per unit 180

––––

Using the formula Pq = P0 – bq

500 = P0 –20/25,000 (500,000)P0 = 900

Therefore the price function is Pq = 900 – 0·0008qTotal Revenue = 900q – 0·0008q2

Marginal Revenue = 900 – 0·0016q

Profit is maximised at the point where Marginal Revenue (MR)= Marginal Cost (MC), therefore 900 – 0·0016q = 180 fromwhich the value of q is 450,000.

To find the selling price per unit (Pq) at which a quantity of 450,000 will be demanded we use the price function as previouslycalculated:

Pq = 900 – 0·0008q where q = 450,000Pq = £540

The profit can be calculated as follows:

£Sales revenue (450,000 units x £540) 243,000,000Less:Variable costs (450,000 units x £180) 81,000,000

––––––––––––Contribution from sales of ‘Cruiser’ 162,000,000Less:Fixed Costs 31,500,000

––––––––––––Profit from sale of ‘Cruiser’ 130,500,000

––––––––––––

(b) Breakeven point occurs where Total Revenue = Total Costs

Fixed costs = £31,500,000; variable costs are £180 per unit.

From (a) Total Revenue = 900q – 0·0008q2

Therefore 900q – 0·0008q2 – 180q – 31,500,000 = 0

The formula

can be used to solve the quadratic equation once it is rearranged into the form:

ax2 + bx + c = 0

we have –0·0008q2 + 720q – 31,500,000 = 0

Solving the equation x = 853,887·36 or 46,112·639

If x = 853,887·36 then substitution into the demand function gives a value for Pq = £216·89011

If x = 46,112·639 then substitution into the demand function gives a value for Pq = £863·10989.

(c) Sales of ‘Super Glider’ (990 – 900)/1·5 = 60,000 units (Note 1)£

Additional revenue (60,000 x 0·2* x £50) + (60,000 x 0·5 x £40) + (60,000 x 0·3 x £30) 2,340,000Material savings 60,000 x (£135 – £90) (Note 2) 2,700,000Less:Additional variable costs (60,000 x £48) 2,880,000

––––––––––Incremental contribution 2,160,000

––––––––––

13

x b b ac2a

= ±– – 2 4



Note 1: Quantity of Material CLO available to Alocin plc = 990 tonnes.Quantity of Material CLO required for manufacture of the ‘Cruiser’ is 900 tonnes (450,000 x 2 kilograms).Therefore 90 tonnes are available for use in the manufacture of ‘Super Glider’ units and thus (90,000/1·5) =60,000 units can be manufactured.

Note 2: £135 = 3 kilograms of DMP at £45 per kilogram.£90 = 1·5 kilograms of CLO at £60 per kilogram.

(d) The use of a mathematical model to determine an optimal selling price for the ‘Cruiser’ would require knowledge of cost andprice functions. It is most unlikely that the board of directors will know the demand for its products with any degree ofprecision. This is due to the fact that the business environment is complex with many forces which influence the demand foran organisation’s products. In addition, the vast majority of organisations pursue a target profit as opposed to an optimal profitand therefore will not give consideration to the use of the profit maximisation model. A price and demand model shows theeconomic relationship that connects the variables. There are two types of variables in such a model, namely, endogenous andexogenous variables. Endogenous variables are those variables that are under the control of management. Examples includethe level of output, the variable cost per unit and the amount to be spent on research and development, advertising andpromotion etc. The consideration of endogenous variables is fundamental to the decision-making process. An organisation isalso affected by a range of variables which originate from outside and are therefore not controllable by the management ofthe organisation. These are known as exogenous variables. Such variables may include long-term market trends, andgovernment policy with regard to matters such as taxation and environmental welfare. Changes in exogenous variables causechanges in endogenous variables. The reverse is not true, however. Consideration of the impact of such variables is a pre-requisite for sound decision-making. Selling price as a variable which affects demand, may be partly endogenous and partlyexogenous in nature. An organisation may have some control over the price at which it chooses to sell its products, but mayalso have to recognise that price may be partly influenced by that of competitors and the level of competition that exists.

(e) Cost leadershipCost leadership is a generic strategy aimed at achieving overall cost leadership in an industry. In situations where companiescompete in an industry in which customers are highly influenced by price, cost leadership assumes strategic importance.Thus it is vitally important that the board of directors understands their costs and cost drivers. They must also be fullycognisant of exactly what constitutes quality to their targeted customer group. The essential task is to deliver the requisitelevel of quality at the lowest possible cost. If Alocin plc could attain a cost level that is lower than that of each of its competitorsthen it could sustain times of falling prices and thus lower prosperity better than its competitors thereby ensuring long-termsurvival. Cost leadership might enable Alocin plc to pursue a policy based on penetration pricing. If the board of directorscould estimate the total market size, then they would be able to determine what share of the market they would require inorder to realise revenue and profit targets. The market for travel systems is an established market however the productioninnovation in terms of the reduction in weight of the ‘Cruiser’ would be attractive to potential purchasers. The board ofdirectors could opt to set a relatively low launch price for the new product. The aim of the low price is to establish a largemarket share quickly by encouraging customers to adopt the product. Such a tactic would be based on the premise that if adominant market could rapidly be achieved, then competition would be deterred from entering the marketplace because ofthe high probability of being unable to establish a critical mass while low prices prevail. As part of the overall strategy of costleadership the board of directors should aim to build distributor and customer loyalty which will reduce the price elasticity ofdemand of its products.

Product differentiationProduct differentiation involves the use of multiple products, each of which is branded and subject to promotion. Competitorsmust, out of necessity compete in many areas and strive to overcome brand loyalty through reductions in the selling price oftheir product offerings. Product differentiation involves the identification of those features for which customers are willing topay. These may be related to a product’s image, quality, reliability, durability or post sales support in terms of the availabilityand quality of after sales service. Where product differentiation can be achieved it may enable the board of directors toimplement a pricing strategy based on market skimming, which involves setting a relatively high price stressing the attractionsof the new features such as the robustness, durability and perceived quality attaching to those with a genuine interest in theproduct or its associated attractions. Reaction and support is thus solicited from the ‘top end’ of the particular market. If thelaunch is successful in this ‘cream skimming’ exercise, and the decision has been taken to invest in the necessary newproduction resources so that larger scale production becomes possible, then the appeal of the new product can be enlargedthrough a shift in advertising and a reduction in price. The price reduction can be made in stages to coincide with supplyside increases as new resources come into use. One of the pre-requisites for the successful operation of a pricing strategybased on market skimming is the existence of technical barriers to entry into the market. It must be difficult for competitorsto come up with a similar product quickly with which they can undercut the price being charged by Alocin plc. The probabilityof successfully operating a pricing strategy based on market skimming is increased if the demand for the ‘Cruiser’ is relativelyinelastic.

If Alocin plc can successfully achieve product differentiation it may also be possible to implement a pricing strategy basedupon premium pricing. Such a strategy would involve pricing the ‘Cruiser’ above the price of competitors’ products on apermanent basis. The success of such a strategy will be dependent upon potential buyers perceiving that the ‘Cruiser’ isdifferent and superior to competitors’ products. From the scenario it would appear that Alocin plc has a strong brand name.This coupled with the fact that the ‘Cruiser’ certainly has unique properties could well combine to enable the successfuloperation of a pricing strategy based on premium pricing.



Niche marketingNiche marketing targets markets in which the company can focus on cost and quality in order to meet the needs of customerswho comprise a specific market. The board of directors of Alocin plc could target the ‘Cruiser’ at a specific market segmentcomprising relatively well-off people who are willing to pay a premium for the unique feature of the ‘Cruiser’. It is quiteconceivable that such a policy might be aimed at a particular geographical region in which relatively well-off people live.Alocin plc might meet the needs of such a niche segment of the market better than its competitors simply by the concentrationof a specific focus on a narrower target market than those of its competitors. Cost leadership would give Alocin plc theopportunity to develop a cost-focus strategy providing niche customers with a lower priced product than the competitorofferings. Obviously such a niche would have to be sufficiently large to enable the desired levels of profitability to be attained.

(f) A SWOT analysis summarises the key issues from the analysis of the business environments and the strategic capability ofan organisation. The aim is to identify the extent to which the current strategy of an organisation and its more specificstrengths and weaknesses are relevant to and capable of dealing with changes occurring in the business environment. SWOTstands for strengths, weaknesses, opportunities, and threats, but rather than simply listing them in terms of managerialperceptions, the intention is to undertake a more structured analysis so as to yield findings that can contribute towards theformulation of strategy. SWOT analysis is used in the rational planning model and needs to be undertaken to assist in closingthe gap between predicted and desired performance of strategic planning. The provision of a simple and logicallystraightforward framework that can be used to appraise the organisation’s position is a significant benefit of SWOT analysis.Management attention is focused on what might be done to exploit strengths and opportunities and also what actions mightneed to be taken in order to eliminate weaknesses and nullify threats. SWOT analysis can assist in the management of riskby identifying internal weaknesses and threats from within the external business environment. A SWOT analysis could alsobe used by Alocin plc to assess whether there are opportunities to further exploit the unique resources, (including materialCLO) and the core competences possessed by an organisation. Use of a SWOT analysis would focus the attention ofmanagement on likely reaction of competitors to the introduction of the ‘Cruiser’. This will prove an invaluable aid in thedetermination of the launch price of the ‘Cruiser’ as management can assess the risks attaching to different pricing strategies.The directors of Alocin plc have already identified some of the strengths of the ‘Cruiser’ and have realised the opportunities.However these strengths and opportunities may be short-lived if Alocin plc does not recognise the weaknesses of the ‘Cruiser’and the threats to it.

Weaknesses include dependence upon the supplier of CLO and this leads to a threat that once competitors have identifiedthat CLO is the core of the ‘Cruiser’s’ differentiation then they will also search for supplies of CLO which may prove costly toAlocin plc. If Alocin plc strengthens its supply of CLO as a consequence of undertaking a SWOT analysis then this highlightsthe usefulness of such an analysis. The certain supply of CLO will strengthen Alocin’s pricing strategy.

Management should recognise the dynamic nature of the external business environment and that the SWOT analysis isrelevant to a specific point in time. Hence there is a need for a continuous focus on the potential opportunities and threatswhich may arise in the external business environment.

SWOT analysis is nothing more than another tool available to those involved in the strategic planning processes. As with alltools it can cause problems when in the wrong hands! Thus it is vital that Alocin plc possesses the expertise in order to useSWOT analysis in a correct and beneficial manner. The board of directors of Alocin plc should pay particular attention to thecomposition of the team of staff responsible for undertaking the SWOT analysis, because the potential value to be derivedfrom undertaking a SWOT analysis can be seriously undermined if those personnel undertaking the SWOT analysis lackknowledge of the entire organisation. There is always the risk that important factors may go unrecognised by those personnelinvolved in the strategic planning process. The external business environment is complex and dynamic and henceopportunities and threats may go undetected.

2 (a) The 30,000 hours available in the finishing department are insufficient to enable Ride Ltd to manufacture the quantities ofboth types of bicycle that would be required to satisfy expected demand. Ride Ltd would require a minimum of 38,000 hoursto be available in the finishing department in order to meet the anticipated demand for 150,000 Roadster and 70,000 Everestbicycles, as shown in the following working:

HoursRoadster 150,000/6·25 = 24,000Everest 70,000/5·00 = 14,000

–––––––Required 38,000Available 30,000

–––––––Shortfall 8,000

–––––––

Therefore finishing hours is a limiting factor or bottleneck resource.



Calculation of net profit using marginal costing principles:

Roadster EverestSelling price (£’s) 200 280Variable costs 100 160Contribution 100 120

Units of limiting factor (hours) 0·16 0·20Contribution per hour of limiting factor (£) 625 600

Ride Ltd should make Roadsters until it has satisfied total demand. It should then produce the Everest.

Units Type Bottleneck resource Bottleneck resourcePer unit (hours) Consumed (hours)

150,000 Roadster 0·16 24,00030,000 Everest 0·20 6,000

Profit from manufacture and sale of this product mix would be as follows:

£’000 £’000Sales Revenue: Units Selling price per

unit (£’s)Roadster 150,000 200 30,000Everest 30,000 280 8,400 38,400

––––––

Material cost:Roadster 150,000 80 12,000Everest 30,000 100 3,000 15,000

––––––Variableproductionconversioncosts:Roadster 150,000 20 3,000Everest 30,000 60 1,800 4,800

––––––Contribution:Roadster 15,000Everest 3,600 18,600

––––––Less:Fixed productionoverheads 4,050 4,050

–––––– –––––––Net profit 14,550

–––––––

Or alternatively:

£’000Contribution: Roadster 150,000 x £100 = 15,000

Everest 30,000 x £120 = 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 EverestSales (£’s) 200 280Materials/components costs (£’s) 80 100Return per unit 120 180

Bottleneck resource (units required) 0·16 0·20Return 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 x £20) = 3,000,000Everest (30,000 x £60) = 1,800,000

––––––––––4,800,000

Fixed production overheads = 4,050,000––––––––––

Total factory costs = 8,850,000––––––––––

Bottleneck resource hours available = 30,000Cost per factory hour = £295

Roadster Everest£ £

Return per factory hour 750·00 900·00Cost per factory hour 295·00 295·00Throughput accounting ratio 2·54 3·05

In situations where throughput accounting principles are in application, a product will be worth producing provided that thethroughput return per hour of bottleneck resource is greater than the cost per factory hour. This may be measured by thethroughput 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 ofprofit will be achieved.



(c) Since the Everest has a higher return per bottleneck hour than the Roadster, Ride Ltd should manufacture the Everest until ithas 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 Total hours of bottleneckbottleneck resource resource required

Everest 70,000 5·00 14,000Roadster 100,000 6·25 16,000

Projected Profit and Loss Account of Ride Ltd for the year ended 31 December 2005

£’000 £’000Sales Revenue Units Selling price per

unit (£’s)Everest 70,000 280 19,600Roadster 100,000 200 20,000 39,600

–––––––

Material costs Units Material cost perunit

Everest 70,000 100 7,000Roadster 100,000 80 8,000 15,000

–––––––Throughput returnEverest 12,600Roadster 12,000 24,600

–––––––

Less:Variable overhead costs (assumed fixed in short-term) 4,800Fixed costs 4,050 8,850

––––––– –––––––Net profit 15,750

–––––––

Or alternatively:

£’000Throughput return: Everest 70,000 x £(280 – 100) = 12,600

Roadster 100,000 x £(200 – 80) = 12,000–––––––24,600

Less: variable overhead costs(assumed fixed in short-term per part (a) costs) 4,800Less: fixed costs 4,050 8,850

––––––– –––––––Net profit 15,750

–––––––



(d) Marginal costing and throughput accounting both determine a contribution by calculating the difference between salesrevenue and variable costs. However this contribution figure will be higher under throughput accounting since only materialcosts are recognised as being variable costs. Under marginal costing, direct labour costs and certain overhead costs will alsobe 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 ifcorrect decisions regarding product ranking are to be made. For example, in part (b) the variable production conversion costamounting to £4,800,000 that was calculated in part (a) is described as being ‘variable overhead cost’. Thus we canconclude that all labour costs within Ride Ltd are categorised as fixed production overheads and will not affect the ranking ofproducts within the company under either marginal costing or throughput principles. However, this is not the case with regardto variable overhead costs which are treated differently under marginal costing and throughput principles which is clearlyillustrated above.

In marginal costing and throughput accounting the rate of contribution generated per unit of scarce resource can be used todetermine the optimum production mix. However, different rankings can occur under each method of which the decisionmaker must be aware.

3 (a) The contingency theory of management accounting represents an attempt to identify the most appropriate accounting controlsystem for a given set of circumstances and to identify the most important contingent variables and to assess their impact oncontrol systems design.

David Otley (1980) provided a definition of contingency theory that has become widely used: ‘The contingency approach tomanagement accounting is based on the premise that there is no universally appropriate accounting system applicable to allorganisations in all circumstances. Rather a contingency theory attempts to identify specific aspects of an accounting systemthat are associated with certain defined circumstances and to demonstrate an appropriate matching.’

Contingency theorists have attempted to identify the specific features within the context of an organisation that impact uponthe particular features of accounting system design. The major classes of contingent factors that have been identified includethe environment, organisational structure and technology. Contingency theorists have suggested that those features within theexternal environment of an organisation that affect the design of an accounting based control system include its degree ofpredictability, the degree of competition faced in the market place, the number of different product-markets faced, and thedegree of hostility exhibited. It has been suggested that structural features include the size of an organisation, the extent ofinterdependence that exists, whether it is decentralised, and the availability of resources. Technological factors include thenature of the production process, its degree of ‘routineness’, how well means-ends relationships are understood and theamount of task variety.

Since the purpose of a control system is to assist an organisation to adapt its business environment then it would appearreasonable to accept that a management control system is subject to influence from the external environment in which itoperates. A formal accounting control system is only one of a number of potential controls that could be adopted by anorganisation. Whilst it is undeniable that the degree of sophistication of accounting controls is influenced by the intensity ofcompetition by a firm, two other characteristics from within an organisation’s environment, namely dynamism andheterogeneity have been shown to affect the design of control systems. Each of these characteristics is associated with anemphasis on different aspects of accounting control. The view has also been put forward that other major influences on thedesign of control systems are the degree of structural complexity of an organisation and the extent to which ‘turbulence’ existsin its environment. Increasing structural complexity will lead to an increase in the number of accounting tools used by anorganisation, whereas environmental discontinuity may require new tools to replace those which have become obsolete.

The nature of a manufacturing process determines the type of costing system that is required and the extent to which costscan be traced to products. The level of accuracy achieved in job-costing which is used in conjunction with batch productiontechnology is higher than that which can be achieved in process costing due to the fact that greater proportion of the costsare incurred jointly by the range of final products. It follows that there is a technological constraint on the design of accountingcontrols due to product interdependence.

One should also consider direction of causality. Is it contingent factors that cause the system to be as it is or might the systemitself be a contingent factor which is a cause of change?

(b) (i) Business process re-engineering involves examining business processes and making substantial changes to the way inwhich an organisation operates. It requires the redesign of how work is done through activities. A business process is aseries of activities that are linked together in order to achieve the desired objective. For example material handling mightbe viewed as a business process which involves the separate activities of production scheduling, storing materials,processing purchase orders, inspecting materials and paying suppliers.

The aim of Business process re-engineering is to enhance organisational performance by achieving improvements in thekey business processes by focusing on simplification, improved quality, enhanced customer satisfaction and costreduction. Business process re-engineering can be applied not only to manufacturing processes but also to an extensiverange of administrative activities. In the case of material handling an organisation might re-engineer the activity ofprocessing purchase orders by collaboration with suppliers of components for their products by integration of theirproduction planning system with that of their suppliers. This would enable purchase orders to be sent directly to their



suppliers thereby obviating the need for any intermediate administrative activity. By the same token scheduled ordersmight be agreed with the supplier which would reduce the need to hold stocks of components. In circumstances wheresuppliers are working in close collaboration with an organisation, it may be possible to roll the quality back down thesupply chain and agree quality control procedures with the supplier which would reduce the need to inspect incomingdeliveries of components. Thus savings in material handling costs could be achieved via reduced storage, processingand inspection costs. Such costs do not add value to the final product and thus are of no benefit to the customer. Thefocus of elimination of non-value added costs and cost reduction links Business process re-engineering to Total qualitymanagement and Just-in-time philosophies.

(ii) Business process re-engineering is sometimes regarded as a ‘one-off’ cost-cutting exercise even though its primary focusis not the reduction of costs. The above example shows that cost reductions can result from such activities. However itshould not be regarded as ‘one-off’ but as a continuous activity. If the aims of Business process re-engineering are notclearly understood across the entire organisation then staff may be suspicious of managerial motives for undertaking aprogramme of Business process re-engineering. This may be partly attributable to the fact that Business process re-engineering was seen as being connected with the downsizing and shedding of large numbers of jobs during the earlypart of the last decade. A distinguishing feature of Business process re-engineering is that it involves the radical overhauland dramatic changes in processes entailing the abandonment of existing practices and the re-design of new ones.However, Business process re-engineering is still sometimes viewed as a way of making small improvements by‘tinkering’ with existing practices.

In much the same way as a Total quality programme with its focus on continuous improvement, business process re-engineering requires the long term commitment of management and staff within an organisation which is not alwayseasily achievable.

4 (a) (i) Calculations showing an estimate of the minimum reduction in sales units required that would, on purely financialgrounds, justify the withdrawal of the ‘Super kooler’ from the market on 1 January 2005:

If we assume that the marketing director’s statement that the minimum reduction in sales volume that will occur is10,000 units per annum for each year that the ‘Super kooler’ is manufactured is correct, then the maximum salesvolumes and contribution would be:

Year ended Sales units CPU Contribution31 December (£60) (£’000)2005 170,000 £60 10,2002006 160,000 £60 9,6002007 150,000 £60 9,0002008 140,000 £60 8,400

The contribution that we could expect to earn from sales of the ‘Ultimate’ model amounts to £9,000,000 for each yearthat it is sold (100,000 units at £200 – £110) per unit. Using a NPV approach the evaluation of the proposedreplacement of the ‘Super Kooler’ model by the ‘Ultimate’ model is as follows;

Year Initial Lost Contribution Contribution Fixed Net D.Factor Presentinvestment from from overheads cash at 9% p.a value

‘Super kooler’ ‘Ultimate’ flow£’000 £’000 £’000 £’000 £’000 £

0 (1,200) (1,200) 1·000 (1,200,000)2005 (10,200) 9,000 (150) (1,350) 0·917 (1,237,950)2006 (9,600) 9,000 (150) (750) 0·842 (631,500)2007 (9,000) 9,000 (150) (150) 0·772 (115,800)2008 (8,400) 9,000 (150) 450 0·708 318,600

Net present value = £–2,866,650

A negative net present value indicates that if sales volume is expected to fall by 10,000 units per annum with effectfrom 1 January 2005 it would be preferable to continue manufacturing the ‘Super kooler’.

(ii) The evaluation prepared (a)(i) clearly shows that a decrease of more than 10,000 in unit sales of the ‘Super Kooler’ willbe required in order to justify the withdrawal of the ‘Super Kooler’ from the market with effect from 1 January 2005. Ifwe assume that sales volume will decline by 20,000 units per annum then the resultant NPV can be calculated asfollows:

Year Initial Lost Contribution Contribution Fixed Net cash Discount Presentinvestment from from overheads flow factor value

‘Super kooler’ ‘Ultimate’ at 9% p.a£’000 £’000 £’000 £’000 £’000 £

0 (1,200) (1,200) 1·000 (1,200,000)2005 (9,600) 9,000 (150) (750) 0·917 (687,750)2006 (8,400) 9,000 (150) 450 0·842 378,9002007 (7,200) 9,000 (150) 1,650 0·772 1,273,8002008 (6,000) 9,000 (150) 2,850 0·708 2,017,800

Net present value = £1,782,850



This NPV clearly shows that it would be beneficial to withdraw the ‘Super Kooler’ from the market with efffect from 1 January 2005.

The minimum reduction in sales volume to justify the withdrawal of the ‘Super Kooler’ from the market with effect from1 January 2005 is the decrease that causes the NPV to equal £0. This can be calculated as follows:

(1 + 2,866,650/(2,866,650 + 1,782,850)) x 10,000 units = 16,165 units.

(b) (i) There is nothing to prevent Woods Ltd from attempting to increase the selling price of the ‘Ultimate’ since cost inflationwill inevitably occur and should be taken into account. Likewise the effects of taxation should be incorporated into thefinancial analysis.

Much will depend on the reaction of competitors with regard to changes in the forthcoming legislation and to what extentthey are aware of the changing preferences of consumers. The forecast assumes an increase in the selling price uponthe change of model (the ‘Ultimate’ will sell for £200 whereas at present the ‘Super kooler’ sells for £160). Whetherthis is achievable remains to be seen. The reduction in operating costs of the ‘Ultimate’ may influence consumers topurchase an ‘Ultimate’ model sooner than they would otherwise have done so. However, there remains the possibilitythat customers might not be willing to pay the increased price required for the ‘Ultimate’ model and therefore retain the‘Super kooler’ models in their possession. This may cause problems with the need to hold stocks of spares etc to meetwarranty claims and avoid the loss of customer goodwill.

On the other hand it might be the case that the selling price of the ‘Super kooler’ would need to be reduced in order toprolong its life cycle. Again, much depends on the attitudes of existing and potential customers, which will to someextent be influenced by advertising and promotional expenditure, and therefore this should be recognised in thecalculations in part (a).

The board of directors of Woods Ltd must be certain that the technology to be employed in the manufacture of the‘Ultimate’ is fully developed. Should this not be the case a decision to defer the change in manufacturing technologywould be appropriate.

We are not aware of the inventory of ‘Super kooler’ parts which are held. If Woods Ltd holds significant inventory ofitems required in the manufacture of the ‘Super kooler’, then this should also be taken into account in the calculationsin part (a).

The forecast is only as good as the assumptions upon which it is based. The directors need to recognise that the degreeof accuracy of the data is critical to the analysis and thus they should give careful consideration to the level of confidencethey have that the forecast sales and costs will actually occur. There is inherent uncertainty in any forecast and thereforethe directors should apply sensitivity analysis to the variables contained within the forecast. ‘What if’ scenarios shouldbe modelled to ascertain the effect of changes in the variables contained within the forecast. In this case, the board ofdirectors would be primarily concerned to see the effect of changes in profitability as a consequence of different levelsof sales volume of the ‘Super kooler’ and the ‘Ultimate’ models. It would also be necessary to consider the effect ofchanges in the selling price of the ‘Ultimate’.

The level of risk attaching to the investment should be considered and as a consequence a cost of capital other than9% per annum may need to be used in the financial analysis.

The directors have presumably considered alternative investments that would enable the manufacture of the ‘Ultimate’to take place as well as other unrelated investment opportunities.

Finally, whilst the directors are aware of the legislation which will take effect on 1 January 2009, they should considerthe likelihood and impact of future government regulations on their longer-term investments.

(ii) A decision by the board of directors to cease manufacture of the ‘Super kooler’ with effect from 1 January 2005 wouldenhance the reputation of Woods Ltd as an environmentally aware manufacturer. This will raise the image of thecompany which may attract new customers who themselves are concerned with the preservation of the environmentand thus identify with the manufacturing strategy of Woods Ltd. Indeed, if Woods Ltd is the first to substitute modelssuch as the ‘Super kooler’ with those such as the ‘Ultimate’ then they may achieve a competitive advantage. However,this is unlikely to be sustainable in the future as legislation effectively forces competitors to follow suit. Nevertheless, thereputation of Woods Ltd as a leader in innovative product design may well remain a source of competitive advantage.

5 (a) Responsibility accounting is based on the application of the ‘controllability’ principle therefore it would seem logical to burdenan area of responsibility with those costs over which the manager of the responsibility centre has significant influence.Conversely, it would be appear inappropriate to charge costs to a centre over which a manager had little or no responsibility.There are two ways in which the controllability principle can be adhered to in management accounting. Firstly, managementaccountants can attempt to eliminate the effects of uncontrollable items from the areas for which managers are heldresponsible. Thus for example a machine supervisor’s performance report might be confined to quantities (not costs) of directmaterials, direct manufacturing labour, energy costs and related supplies. Secondly, reports can be prepared which clearlydistinguish between controllable and uncontrollable items for any given area of responsibility.

Unfortunately for the management accountant many areas of responsibility cannot be categorised as being controllable oruncontrollable thus the application of the controllability principle in practice is hindered by the fact that many areas ofresponsibility are only partially controllable. Very often events occur over which a manager has no control whatsoever suchas, for example, a shortage of supply of a required resource. An obvious management response to such a problem lies in the



substitution of an alternative resource. However, in circumstances where events are categorised as being uncontrollablemanagers will have far less motivation to attempt to negate their effects. It should be recognised that more often than not theeffects of uncontrollable items cannot be measured precisely which further impedes management reporting.

The correct categorisation of factors into ‘controllable’ and ‘uncontrollable’ is fundamental to the successful operation of asystem of responsibility accounting. There is a distinct possibility that managers may be judged unfairly where uncontrollablefactors exist. This is clearly problematic, and in extreme circumstances may render a responsibility accounting system totallyineffective. Conversely, it is also possible that managers may be protected from factors which are indeed within their control.Thus the failure to correctly distinguish between controllable and uncontrollable factors will not only seriously undermineperformance evaluation but may precipitate problems associated with levels of motivation and morale within an organisation.

(b) Management should attempt to deal with the distorting effects of factors recognised as being beyond the control of a managerby making appropriate adjustments before or after the period under review. There is a fundamental need to identify whichpotential expense items are to be regarded as controllable and uncontrollable. It is widespread practice to either showuncontrollable items in a separate section of a performance report or to exclude uncontrollable items from such reportsaltogether. It is clear that management need to be able to identify those factors which are uncontrollable, in order to enablesound performance measurement and reporting to take place. Kenneth Merchant has suggested that in order to distinguishbetween controllable and uncontrollable items the following general rule should be applied to all employees within anorganisation – ‘Hold employees accountable for the performance areas that you want them to pay attention to.’ However, inpractice controllability is difficult to pinpoint since relatively few costs are under the control of a single manager. A purchasingmanager can often influence the costs of purchasing raw materials, however such costs are also dependent upon prevailingmarket conditions which are clearly beyond the manager’s control. By the same token, a manufacturing manager mayinfluence quantities of raw materials used but quantities used may be influenced by the quality of raw materials that werepurchased. Another problem lies in the fact that managers often work in teams and this largely precludes the evaluation ofindividual responsibility.

The majority of performance reports usually have as their focus a time period of one year or less and this short term focuscan mean that the current manager may have been experiencing problems and inefficiencies which were in fact a legacy fromhis/her predecessor. For example a manufacturing manager may be constrained by a contract for the purchase of rawmaterials that was negotiated by his predecessor. This gives rise to the difficulty of separating what the current incumbentactually controls from the outcomes of decisions made by others. Thus it might not be possible to answer the question ‘Whatis the current manager accountable for?’ with the required degree of precision.

Insurance policies are invariably used to minimise exposure to uncontrollable events such as fire or flood. Other insurableevents include theft, accidents, damages and product and public liability insurance.

After the period under review has ended management may use variance analysis to analyse the factors that cause actualresults to differ from pre-determined budgeted targets. A feature of variance analysis is that it aims to distinguish betweencontrollable and uncontrollable items and to identify which particular managers are accountable for any variances that haveoccurred. The use of a planning and operational approach to variance analysis might be of assistance to management. Forexample, any uncontrollable planning variances may be incorporated into future standards thereby improving businessplanning.

Management may attempt to isolate the effects of uncontrollable factors by adopting the use of flexible performance standardsin which targets are adjusted to reflect those uncontrollable factors arising from circumstances which were not recognised andallowed for at the time that the original targets were set. The use of flexible budgets is the most widely used flexibleperformance standard. Flexible budgeting aims to remove the uncontrollable effects of volume changes on cost behaviour fromperformance reports.

Management may be able to use benchmarking to assess the performance of a responsibility centre. This method involvesan evaluation of a responsibility centre relative to the performance of similar centres within the same organisation or withsimilar units outside the organisation. In order to prove a valid basis for comparison it is essential that the responsibilitycentres, which are the subject of comparison, perform similar tasks and are subject to similar environmental and businessconditions. In practice, it is difficult to find units which fulfil these criteria. In circumstances where management are able toundertake relative performance evaluation the effect of uncontrollable factors is effectively eliminated since each party whichis subject to the evaluation is subject to the same environmental conditions.

Management may also make subjective judgements in the performance evaluation process which are based on the knowledgeof the outcome measures and the circumstances faced by the managers of responsibility centres. Whilst the use of subjectivejudgements can help to alleviate some of the defects of measures used by accounting control systems they nonetheless lackobjectivity and often fail to provide the manager being evaluated with a clear view of how performance has been evaluated.The use of subjective judgements can cause conflict with more senior managers and precipitate a decline in motivation anda loss of morale.

(c) Financial targets may be derived from engineering studies of input-output relationships. Engineering targets may be usedwhere the relationship between inputs and outputs is clearly defined and stable over time. This enables the required level ofinputs to be estimated directly from product specifications. For example, in a bakery for a given output of a hand-made cakedesign it is possible to estimate the inputs required because a physical relationship exists between the ingredients such as,flour, butter, eggs and packaging and the number of cakes baked. A relationship between inputs and outputs can also beestablished for labour by closely observing the processes to determine the quantity of labour that will be required for a required



level of output. For example, in the manufacture of hand-decorated cakes the process of decoration could be observed todetermine the number of cake-decorators that would be required.

In circumstances in which such clearly defined relationships between inputs and outputs do not exist management may usehistorical targets which are based on the results of prior periods. The major drawback in using historical targets as a basis forderiving future targets is that it is quite conceivable that poor levels of efficiency in a prior period are unwittingly incorporatedinto the financial target for a future period.

Targets may also be derived from the results of negotiations between superiors and subordinates. The use of negotiated targetsaddresses the information asymmetry gap that can exist between superiors and subordinates. This gap emanates from thefact that subordinates possess much more detailed information concerning operational activities and, in particular, therelationship which subsists between inputs and outputs, whereas the higher level of management have a more holistic viewof the organisation and the resource constraints within which the organisation operates. The use of negotiated targets enablethe information symmetry gap to be reduced and targets that are agreed will recognise the constraints applying at both theoperational level and to the organisation as a whole.




Marks Marks1 (a) Derivation of demand curve 2

Variable costs 1Marginal revenue = marginal cost 1Correct quantity 1Correct selling price 1Profit 1

––– Maximum 6

(b) Total revenue: total cost equation 1Correct use of formula 1Correct quantities (x) 2Correct selling prices 2

––– 6

(c) Total of ‘Superglider’ units 1Incremental sales revenue 1Material cost saving 1Incremental manufacturing costs/profit 1

––– 4

(d) Comments (on merit):Limitations 3Endogenous variables 3Exogenous variables 3

––– Maximum 8

(e) Comments (on merit):Cost leadership 3Differentiation 3Niche marketing 3

––– Maximum 8

(f) Comment (on merit):Usefulness 3Limitations 3Pricing strategy 3


Total 40–––

2 (a) Ranking 2Correct quantities 1Contribution 2Fixed overheads/profit 1

––– 6

(b) Return per factory hour 1Cost per factory hour 1Throughput accounting ratio 1Discussion 3

––– Maximum 5

(c) Ranking 1Correct quantities 1Throughput return 1Overheads/Profit 2

––– 5



Marks Marks(d) Comments (on merit):

Treatment of labout costs 2Treatment of overheads 2Treatment of closing stock 2

Maximum 4–––

Total 20–––

3 (a) Comments (on merit):Explanation 2Factors 8

––– 10

(b) (i) Comments (on merit):Explanation 3Application 4

––– 7

(ii) Limitations 3––– 3

–––Total 20

–––

4 (a) (i) Ignore sunk cost 1Expected value 1Contribution gained/foregone 2Fixed costs 1Discounting 1

––– Maximum 5

(ii) Recognition that sales units decrease >10,000 1Contribution gained/foregone 1NPV = 0 1Interpretation 2

––– 5

(b) Comments (on merit):Limitations of forecast 7

––– 7

(c) Comments (on merit):Enhanced reputation, image, Competitive advantage 3

––– 3–––

Total 20–––

5 (a) Comments (on merit):Controllability 2Application – difficulty 4

––– 6

(b) Comments (on merit):Management responses: Controllable/uncontrollable cost classification 4 Other actions: subjective judgements, benchmarking 4

––– 8

(c) Comments (on merit):3 approaches to the setting of financial targets 3 x 2

––– 6–––

Total 20–––




PART 3

FRIDAY 10 JUNE 2005

QUESTION PAPER









Pape

r 3.3




1 NB Candidates are advised to read all of the information including that contained in tables 1, 2 and 3 beforeattempting this question.

Quicklink Ltd operates in the distribution and haulage industry and has achieved significant growth since its formationin 1997. Its main activities comprise the door-to-door delivery of mail, parcels and industrial machinery.

The information contained in notes (i–vii) below relates to Quicklink Ltd in respect of the year ended 31 May2005 and changes planned in the year ending 31 May 2006.

(i) Contracted clients were charged at the following rates during the year ended 31 May 2005: Mail £6 per delivery,Parcels £10 per delivery and Machinery £200 per delivery.

(ii) Rates for non-contract clients during each of the years ended 31 May 2005 and year ending 31 May 2006,were/are based upon the contracted client rates per delivery plus an additional percentage fee per deliverycharged to non-contract clients as follows:Activity Additional FeeMail 40%Parcel 20%Machinery 50%

(iii) On 1 June 2003, Quicklink Ltd entered into a fixed price contract for the provision of fuel for its delivery vehiclesfor the three-year period ending 31 May 2006. For the year ending 31 May 2006 fuel costs will be as follows: (a) £0·10 per kilometre in respect of the delivery of mail and parcels(b) £0·50 per kilometre in respect of the delivery of industrial machinery.Each vehicle owned by Quicklink Ltd is in use for 340 days per annum.

(iv) Employee salaries were paid throughout the year ended 31 May 2005 at a rate of £26,400 per employee, perannum.

(v) Sundry operating costs (excluding fuel and salaries) of Quicklink Ltd amounted to £3,000,000 during the yearended 31 May 2005.

(vi) The board of directors expect that for the year ending 31 May 2006 the following will apply:(a) contract rates of Quicklink Ltd business will increase by 5%(b) sales volumes are expected to remain at the same level as in the year ended 31 May 2005(c) salaries and other operating expenses will increase by 4%.

(vii) The board of directors agreed to purchase Celer Transport, an unincorporated business, which was founded inDecember 2001. The purchase took effect on 1 June 2005. Celer Transport has main activities comprising thedelivery of mail, parcels and processed food. The managing director of Quicklink Ltd has expressed his view that‘the acquisition of the Celer Transport business would constitute a good strategic move even though it is expectedto make a loss of £50,000 during the year ending 31 May 2006’.

The information contained in notes (viii–xii) below relates to the business of Celer Transport in respect of the yearending 31 May 2006:

(viii) A distinctive competence of the Celer Transport business relates to its success in winning contracts with majorfood producers. Each contract is for a fixed term of three years and all contracts were renewed on 1 June 2005.Contract values per annum are as follows:Number of contracts Value per contract (£)

4 225,0006 150,0009 100,000

(ix) (1) The sales volume of mail and parcel deliveries to Celer Transport clients is expected to increase by 10% perannum with effect from 1 June 2005. It is intended to use the client billing rates of Quicklink Ltd that werein application during the year ended 31 May 2005 as the basis of charging for mail and parcel deliveries toCeler Transport clients during the year ending 31 May 2006. This is due to the fact that Quicklink Ltd hadhigher client billing rates than Celer Transport and the board of directors recognised that it would have beendifficult to adopt company-wide billing rates with effect from 1 June 2005.

(2) During the year ended 31 May 2005 the billing rates of Celer Transport in respect of contract and non-contract mail and parcel deliveries were 90% of the level of the rates charged by Quicklink Ltd.



(x) Fuel requirements for the Celer Transport business activities are forecast to cost £0·12 per kilometre for mail andparcel deliveries and £0·60 per kilometre for deliveries of processed food. The fuel required for Celer Transportbusiness during the year ending 31 May 2006 cannot be provided under the current agreement entered into byQuicklink Ltd as detailed in note (iii). Each Celer Transport vehicle is in use for 340 days per annum.

(xi) All Celer Transport employees will be paid on the same basis as Quicklink Ltd employees.

(xii) Sundry operating costs (excluding fuel and salaries) of the Celer Transport business will amount to £1,990,340.

Other information:(xiii) During the year ended 31 May 2005 the number of employees was as follows:

Quicklink Ltd Celer TransportActivity type Mail and parcels Machinery Mail and parcels Processed foodNumber of Employees 50 20 20 20

The number of employees is forecast to remain unchanged during the year ending 31 May 2006.

(xiv) Quicklink Ltd implemented a new call management system for customer enquiries/orders which became fullyoperational with effect from 1 June 2004.

(xv) The Managing Director of Quicklink Ltd recently attended a seminar on Total Quality Management (TQM) and isfirmly of the opinion that the adoption of a TQM philosophy would benefit the company.

Other actual operating statistics for the year ended 31 May 2005 are contained in tables 1, 2 and 3 below. Targetstatistics are shown in bold type.

Table 1Quicklink Ltd Celer Transport

Mail Parcels Machinery Mail Parcels Processed foodNumber of deliveries 468,000 234,000 35,700 120,000 75,000 32,500Contract deliveries (%) 468,060 468,060 46,090 468,030 468,30 111,100Number of on-time deliveries 465,660 232,830 35,700 099,900 60,000 31,525Mix of business deliveries:Same day delivery 193,600 146,800 35,700 090,000 56,250 32,500Next day delivery 374,400 187,200 468,0– 030,000 18,750 –On-time delivery target (%) 468,099 187,299 468,99 468,095 468,95 31,100Number of lost items – – – 000,120 468,25 11,1, –


Vehicle type Mail and Machinery Mail and Processed foodparcels parcels

Average kilometres per vehicle per day 300 400 300 300Number of vehicles 55 21 22 22

NB The statistics in table 2 are expected to remain unchanged during the year ending 31 May 2006.


Target time period for answering telephone calls 20 seconds 30 secondsNumber of telephone calls received 1,650,000 600,000Number of telephone calls answered within target time period 1,633,500 540,000Number of abandoned telephone calls – 112,000



Required:

(a) Prepare, in columnar format, the budgeted profit and loss accounts for the year ending 31 May 2006 of:

(i) Quicklink Ltd;(ii) Celer Transport; and(iii) The combined entity. (16 marks)

(b) Comment (with relevant calculations) on the performance of the business of Quicklink Ltd and CelerTransport during the year ended 31 May 2005 and, insofar as the information permits, its projectedperformance for the year ending 31 May 2006. Your answer should specifically consider:

(i) Revenue generation per vehicle(ii) Vehicle utilisation and delivery mix(iii) Service quality. (14 marks)

(c) Comment on four reasons why the Managing Director of Quicklink Ltd might consider the acquisition of theCeler Transport business to be a ‘good strategic move’ insofar as may be determined from the informationprovided. (5 marks)

(d) Discuss the main benefits that might accrue from the successful implementation of a Total QualityManagement programme by the management of the combined entity. (5 marks)

(40 marks)



2 NCL plc, which has a divisionalised structure, undertakes civil engineering and mining activities. All applications bydivisional management teams for funds with which to undertake capital projects require the authorisation of the boardof directors of NCL plc. Once authorisation has been granted to a capital application, divisional management teamsare allowed to choose the project for investment.

Under the terms of the management incentive plan, which is currently in operation, the managers of each divisionare eligible to receive annual bonus payments which are calculated by reference to the return on investment (ROI)earned during each of the first two years by new investments. ROI is calculated using the average capital employedduring the year. NCL plc depreciates its investments on a straight-line basis.

One of the most profitable divisions during recent years has been the IOA Division, which is engaged in the miningof precious metals. The management of the IOA Division is currently evaluating three projects relating to the extractionof substance ‘xxx’ from different areas in its country of operation. The management of the IOA Division has been givenapproval by the board of directors of NCL plc to spend £24 million on one of the three proposals it is considering (i.e.North, East and South projects).

The following net present value (NPV) calculations have been prepared by the management accountant of the IOADivision.

North Project East Project South ProjectNet cash Present Net cash Present Net cash Presentinflow/ value inflow/ value inflow/ value

(outflow) at 12% (outflow) at 12% (outflow) at 12%£’000 £’000 £’000 £’000 £’000 £’000

Year 0 (24,000·0) (24,000·0) (24,000·0) (24,000·0) (24,000·0) (24,000·0)Year 1 6,000·0 5,358·0 11,500·0 10,269·5 12,000·0 10,716·0Year 2 8,000·0 6,376·0 11,500·0 9,165·5 10,000·0 7,970·0Year 3 13,500·0 9,612·0 11,500·0 8,188·0 9,000·0 6,408·0Year 4 10,500·0 6,678·0 – – 3,000·0 1,908·0

–––––––– –––––––– ––––––––NPV 4,024·0 3,623·0 3,002·0

–––––––– –––––––– ––––––––

The following additional information concerning the three projects is available:

(1) Each of the above projects has a nil residual value.

(2) The life of the East project is three years. The North and South projects are expected to have a life of four years.

(3) The three projects have a similar level of risk.

(4) Ignore taxation.

Required:

(a) Explain (with relevant calculations) why the interests of the management of the I0A Division might conflictwith those of the board of directors of NCL plc. (10 marks)

(b) Explain how the adoption of residual income (RI) using the annuity method of depreciation might prove tobe a superior basis for the management incentive plan operated by NCL plc.(N.B. No illustrative calculations should be incorporated into your explanation). (4 marks)

The IOA Division is also considering whether to undertake an investment in the West of the country (the West Project).An initial cash outlay investment of £12 million will be required and a net cash inflow amounting to £5 million isexpected to arise in each of the four years of the life of the project.

The activities involved in the West project will cause the local river to become polluted and discoloured due to thedischarge of waste substances from mining operations.

It is estimated that at the end of year four a cash outlay of £2 million would be required to restore the river to itsoriginal colour. This would also clear 90% of the pollution caused as a result of the mining activities of the IOADivision.

The remaining 10% of the pollution caused as a result of the mining activities of the IOA Division could be clearedup by a further cash outlay of £2 million.



(c) Evaluate the West project and, stating your reasons, comment on whether the board of directors of NCL plcshould spend the further £2 million in order to eliminate the remaining 10% of pollution. (6 marks)

(Ignore Taxation).

(20 marks)




3 Better budgeting in recent years may have been seen as a movement from ‘incremental budgeting’ to alternativebudgeting approaches.

However, academic studies (e.g. Beyond Budgeting – Hope & Fraser) argue that the annual budget model may beseen as (i) having a number of inherent weaknesses and (ii) acting as a barrier to the effective implementation ofalternative models for use in the accomplishment of strategic change.

Required:

(a) Identify and comment on FIVE inherent weaknesses of the annual budget model irrespective of the budgetingapproach that is applied. (8 marks)

(b) Discuss ways in which the traditional budgeting process may be seen as a barrier to the achievement of theaims of EACH of the following models for the implementation of strategic change:

(i) benchmarking;(ii) balanced scorecard; and(iii) activity-based models. (12 marks)

(20 marks)



4 The Dental Health Partnership was established in 1992 and provides dentistry and other related services to thepopulation of Blaintopia, a country in which the public health service is partially funded by the Government.

Additional information relating to the Dental Health Partnership for the year ended 31 May 2005 is as follows:

(1) The partnership was open for five days per week during 48 weeks of the year.

(2) Each dentist treated 20 patients per day. The maximum number of patients that could have been treated by adentist on any working day was 24 patients.

(3) (i) The partnership received a payment from the government each time any patient was consulted as shown inthe following table:

Category of treatment Payments fromGovernment (£’s)

No treatment required 12Minor treatment 50Major treatment 100

(ii) In addition, adult patients paid a fee for each consultation which was equal to the amount of the paymentshown per category of treatment in the above table. Children and Senior Citizens were not required to paya fee for any dental consultations.

(4) The partnership received an annual fee of £20,800 from a well-known manufacturer of dental products under afixed-term contract of three years’ duration. The contract commenced on 1 June 2004 and relates to thepromotion of the products of the manufacturer.

(5) The total of material and consumable costs (which are 100% variable) during the year ended 31 May 2005amounted to £446,400.

(6) Staff costs were paid as follows:

Category of Salary per annum,Employee per employee (£’s)Dentist 60,000Dental Assistant 20,000Administrator 16,000

Note: A fixed bonus payment amounting to 4% of their basic salary was paid to each Dental Assistant andAdministrator.

(7) Establishment costs and other operating costs amounted to £85,000 and £75,775 respectively for the yearended 31 May 2005.

(8) All costs other than materials and consumables costs incurred by the Dental Health Partnership are subject tocontracts and are therefore to be treated as fixed costs.

(9) A table of non-financial information relating to the Dental Health Partnership for the year ended 31 May 2005is as follows:

Number of Dentists: 6Dental Assistants 7Administrators 2Patient ‘Mix’:Adults 50%Children 40%Senior Citizens 10%Mix of patient appointments (%):No treatment required 70%Minor treatment 20%Major treatment 10%



Required:

(a) Prepare a summary Profit and Loss Account of the Dental Health Partnership for the year ended 31 May 2005 and calculate the percentage of maximum capacity that was required to be utilised in orderto break even in the year ended 31 May 2005. (12 marks)

(b) Discuss FOUR factors that distinguish service from manufacturing organisations and explain how each ofthese factors relates to the services provided by the Dental Health Partnership. (5 marks)

(c) Excluding the number of complaints by patients, identify and briefly explain THREE quantitative non-financial performance measures that could be used to assess the ‘quality of service’ provided by theDental Health Partnership. (3 marks)

(20 marks)



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

Summary financial statements for the year ended 31 May 2005 together with prior year comparative figures are asfollows:

Profit and Loss Account2005 2004£’000 £’000

Sales (note 1) 48,000 40,000Cost of sales (note 2) 28,800 24,000

––––––– –––––––Gross Profit 19,200 16,000Operating expenses 10,200 8,000Interest 1,000 0Depreciation 4,000 4,000

––––––– –––––––Net Profit 4,000 4,000

––––––– –––––––

Balance Sheet2005 2004£’000 £’000

Fixed Assets (net book value) 42,000 40,000Net Current Assets 24,000 12,000

––––––– –––––––Total Assets less Current Liabilities 66,000 52,000Loan Finance 10,000 –

––––––– –––––––Net Assets 56,000 52,000

––––––– –––––––

Capital Employed:Ordinary Share Capital (£1 each) 30,000 30,000Retained Earnings 26,000 22,000

––––––– –––––––Capital Employed 56,000 52,000

––––––– –––––––

Other information relating to Taliesin Ltd is as follows:

(1) Sales information in respect of the years ended 31 May 2005 and 2004 is as follows:

2005 2004Sales revenue £000 £0001 June–30 November 33,300 26,0001 December–31 May 14,700 14,000

(2) Cost of sales information:2005 2004£’000 £’000

Materials 9,360 7,800Labour 4,620 4,200Manufacturing overheads 14,820 12,000

––––––– –––––––Cost of sales 28,800 24,000



(3) Other Information:

2005 2004Number of employees:Permanent 204 200Temporary 288 240Number of customers 5 6Number 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. Theywere paid at the same rate as permanent employees.

(ii) Six new product lines were launched during the year ended 31 May 2005. The manufacture of each newproduct line required an investment in capital equipment of £1 million.

Required:

(a) Using the above information, appraise the performance of Taliesin Ltd during the year ended 31 May 2005and evaluate the extent to which the objective of growth has been achieved. (11 marks)

(b) Explain the major benefits of pursuing a policy of internal development. (4 marks)

(c) Explain how the use of activity-based techniques may benefit Taliesin Ltd. (5 marks)

(20 marks)



14

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Answers



19


1 (a) Quicklink LtdBudgeted Profit and Loss Account for the year ending 31 May 2006

Quicklink Ltd Celer Transport Combined£ £ £

Revenue:Contract clients:Mail 1,769,040 237,600 2,006,640Parcels 1,474,200 247,500 1,721,700Machinery/processed food 6,747,300 2,700,000 9,447,300

–––––––––– –––––––––– –––––––––––9,990,540 3,185,100 13,175,640

Non-contract clients:Mail 1,651,104 776,160 2,427,264Parcels 1,179,360 693,000 1,872,360Machinery/processed food 1,124,550 – 1,124,550

–––––––––– –––––––––– –––––––––––3,955,014 1,469,160 5,424,174

Total revenue 13,945,554 4,654,260 18,599,814

Operating costs:Fuel 1,989,000 1,615,680 3,604,680Salaries 1,921,920 1,098,240 3,020,160Sundry operating costs 3,120,000 1,990,340 5,110,340

–––––––––– –––––––––– –––––––––––Total operating costs 7,030,920 4,704,260 11,735,180

–––––––––– –––––––––– –––––––––––Net profit 6,914,634 (50,000) 6,864,634

–––––––––– –––––––––– –––––––––––

Workings

(1) Sales Revenue:

Quicklink LtdContract Total number Contract Number of Fee per Total (£)clients: of deliveries deliveries contract delivery

(%) deliveriesMail 468,000 60 280,800 £6·30 1,769,040

(£6 x 1·05)Parcels 234,000 60 140,400 £8·40 1,474,200

(£10 x 1·05)Machinery 35,700 90 32,130 £210 6,747,300

(£200 x 1·05)

Non-contract Total number Non-contract Number of Fee per Total (£)clients: of deliveries deliveries non-contract delivery

(%) deliveriesMail 468,000 40 187,200 £8·82 1,651,104

(£6 x 1·05 x 140%)Parcels 234,000 40 93,600 £12·60 1,179,360

(£10 x 1·05 x 120%)Machinery 35,700 10 3,570 £315 1,124,500

(£200 x 1·05 x 150%)

Celer TransportContract Total number Contract Number of Fee per Total (£)clients: of deliveries deliveries contract delivery

(%) deliveriesMail 132,000 30 39,600 £6 237,600

(120,000 x 110%)Parcels 82,500 30 24,750 £10 247,500

(75,000 x 110%)Processed food 32,500 100 32,500 2,700,000



20

Non-contract Total number Non-contract Number of Fee per Total (£)clients: of deliveries deliveries non-contract delivery

(%) deliveriesMail 132,000 70 92,400 £8·40 776,160

(120,000 x 110%) (£6 x 140%)Parcels 82,500 70 57,750 £12·00 693,000

(75,000 x 110%) (£10 x 120%)

(2) Fuel costs:

Quicklink Ltd Number of vehicles Days in use Average Cost per Cost (£)kilometres per kilometrevehicle per day

Mail and parcels 55 340 300 £0·10 561,000Machinery 21 340 400 £0·50 1,428,000

––––––––––1,989,000––––––––––

Celer Transport Number of vehicles Days in use Average Cost per Cost (£)kilometres per kilometrevehicle per day

Mail and parcels 22 340 300 £0·12 269,280Processed food 22 340 300 £0·60 1,346,400

––––––––––1,615,680––––––––––

(3) Salaries:Number of employees Salary per annum Cost (£)

Quicklink Ltd 70 £27,456 (£26,400 x 104%) 1,921,920Celer Transport 40 £27,456 (£26,400 x 104%) 1,098,240

(4) Sundry operating costsCost (£)

Quicklink Ltd (£3,000,000 x 104%) 3,120,000Celer Transport Per question 1,990,340

(b) The businesses of Quicklink Ltd and Celer Transport are engaged in the same industry and are therefore broadly comparable.Each business has its own ‘distinctive competence’ which in the case of Quicklink Ltd is the delivery of industrial machinerywhilst Celer Transport has developed a specialism in the delivery of processed food.

Relevant operating statistics are as follows:

Quicklink Ltd Quicklink Ltd Celer Transport Celer Transport2005 2006 2005 2006

Revenue per vehicle (per annum) Actual Budget Actual BudgetMail and parcels £105,172 £110,431 £72,679 £88,830Machinery/processed food £357,000 £374,850 £122,727 £122,727

Vehicle in-use % 93 93 93 93Deliveries per vehicle (per annum):Mail and parcels 12,764 12,764 8,864 9,750Machinery/processed food 1,700 1,700 1,477 1,477

2005 2005Actual Target Actual Target

Delivery mix (mail/parcels):Same day 20% 75%Next day 80% 25%

On-time deliveries (%):Mail and parcels 99·5% 99% 82% 95%Machinery/processed food 100·0% 99% 97% 100%

No. of lost items 145

% of telephone calls answered within target time 99% 90%

% of telephone calls abandoned 0% 2·00%

The number of mail and parcel deliveries per vehicle, per annum, made by Quicklink Ltd during the year ended 31 May 2005was 44% higher than those made by Celer Transport which explains the higher budgeted revenues per Quicklink vehicleengaged in the delivery of mail and parcels for the year ending 31 May 2006. The revenue generation per vehicle shows thatthe budgeted average revenue generated vehicle used in the delivery of mail and parcels in respect of the year ending 31 May2006 amounts to £110,431 and £88,830 in respect of Quicklink Ltd and Celer Transport respectively. However, this



difference will reduce in the year ending 31 May 2006 due to the projected growth in sales volumes of the Celer Transportbusiness. The average mail/parcels delivery of mail/parcels per vehicle of the Quicklink Ltd part of the business is budgetedat 12,764 which is still 30·91% higher than that of the Celer Transport business.

As far as specialist activities are concerned, Quicklink Ltd is budgeted to generate average revenues per vehicle amounting to£374,850 whilst Celer Transport is budgeted to earn an average of £122,727 from each of the vehicles engaged in deliveryof processed food. It is noticeable that all contracts with major food producers were renewed on 1 June 2005 and it wouldappear that there were no increases in the annual value of the contracts with major food producers. This might have beenthe result of a strategic decision by the management of the combined entity in order to secure the future of this part of thebusiness which had been built up previously by the management of Celer Transport.

Each vehicle owned by Quicklink Ltd and Celer Transport is in use for 340 days during each year, which based on a 365 day year would give an in use % of 93%. This appears acceptable given the need for routine maintenance and repairsdue to wear and tear.

During the year ended 31 May 2005 the number of on-time deliveries of mail and parcel and industrial machinery deliverieswere 99·5% and 100% respectively. This compares with ratios of 82% and 97% in respect of mail and parcel and processedfood deliveries made by Celer Transport. In this critical area it is worth noting that Quicklink Ltd achieved their higher on-timedelivery target of 99% in respect of each activity whereas Celer Transport were unable to do so. Moreover, it is worth notingthat Celer Transport missed their target time for delivery of food products on 975 occasions throughout the year 31 May 2005and this might well cause a high level of customer dissatisfaction and even result in lost business.

It is interesting to note that whilst the businesses operate in the same industry they have a rather different delivery mix interms of same day/next day demands by clients. Same day deliveries only comprise 20% of the business of Quicklink Ltdwhereas they comprise 75% of the business of Celer Transport. This may explain why the delivery performance of CelerTransport with regard to mail and parcel deliveries was not as good as that of Quicklink Ltd.

The fact that 120 items of mail and 25 parcels were lost by the Celer Transport business is most disturbing and could provedamaging as the safe delivery of such items is the very substance of the business and would almost certainly have resultedin a loss of customer goodwill. This is an issue which must be addressed as a matter of urgency.

The introduction of the call management system by Quicklink Ltd on 1 June 2004 is now proving its worth with 99% of callsanswered within the target time of 20 seconds. This compares favourably with the Celer Transport business in which only90% of a much smaller volume of calls were answered within a longer target time of 30 seconds. Future performance in thisarea will improve if the call management system is applied to the Celer Transport business. In particular, it is likely that thenumber of abandoned calls will be reduced and enhance the ‘image’ of the Celer Transport business.

WorkingsRevenue generation per vehicle:

Quicklink Ltd 2006 2005Mail and parcels: £ £Contract mail 1,769,040Contract parcels 1,474,200Non-contract mail 1,651,104Non-contract parcels 1,179,360

––––––––––Total 6,073,704

Number of vehicles 55Revenue per vehicle £110,431 = £105,172 (110,431/1·05)

Machinery: £ £Contract 6,747,300Non-contract 1,124,550

––––––––––Total 7,871,850

Number of vehicles 21Revenue per vehicle £374,850 = £357,000 (374,850/1·05)

Celer Transport 2006 2005Mail and parcels: £ £Contract mail 237,600Contract parcels 247,500Non-contract mail 776,160Non-contract parcels 693,000

––––––––––Total 1,954,260

Number of vehicles 22Revenue per vehicle £88,830 = £72,679 (88,830/1·10 x 90%)

Processed food: 2,700,000 2,700,000Number of vehicles 22Revenue per vehicle £122,757 £122,757 (no change in contract values)

21



Deliveries per vehicle:Quicklink Ltd Celer Transport

2005 2006 2005 2006Actual Budget Actual Budget

Mail and parcel deliveries:Number of deliveries 702,000 702,000 195,000 214,500

(468,000 + 234,000) (195,000 x 110%)Number of vehicles 55 55 22 22Deliveries per vehicle 12,764 12,764 8,864 9,750

Machinery/processed food deliveries:Number of deliveries 35,700 35,700 32,500 32,500Number of vehicles 21 21 22 22Deliveries per vehicle 1,700 1,700 1,477 1,477

(c) The managing director of Quicklink Ltd might consider ‘the acquisition of the Celer Transport business to be a good strategicmove’ for the following reasons:

– The acquisition of the Celer Transport business would enable a rapid expansion of the business, whereas to groworganically in a competitive industry requires a much longer timescale and be more difficult to achieve.

– Since the business operates both mail/parcel deliveries there is the potential for synergies to be taken advantage of interms of route scheduling as well as the opportunities to take advantage of the complementary mix of same day/nextday business that are distinctive features of the separate businesses.

– The fact that each of the Quicklink Ltd and Celer Transport businesses has a distinctive competence in terms of thedelivery of machinery and food products respectively helps to reduce the threat to future income streams.

– The combination of the Quicklink Ltd and Celer Transport business might well present opportunities to take advantageof economies of scale. There would undoubtedly be scope for savings in establishment costs, staff costs, communicationcosts etc.

– It is quite possible that the fuel costs per kilometre of the Celer Transport business during the year ending 31 May 2006,which are budgeted to be 20% higher than those of Quicklink Ltd, may reduce profitability by up to £269,280. Hencethe Celer Transport business would have been budgeted to make a profit of £219,280 as opposed to a loss of £50,000(note 1), had its fuel been provided under the terms of the contract with the supplier of fuel to Quicklink Ltd.

Note (1):£ £

Loss per part 1(a) (50,000)Potential saving in fuel costs:Actual expenditure by Celer Transport business:340 x 300 x 22 x (£0·12 + £0·60)= 1,615,680Expenditure at contract rates:340 x 300 x 22 x (£0·10 + £0·50) = 1,346,400

––––––––––Potential saving in fuel costs 269,280

–––––––––Potential net profit 219,280

–––––––––

NB: The above calculation assumes that the cost per kilometre of a vehicle used in the delivery of processed food would bethe same as that of a vehicle used in the delivery of industrial machinery.

(d) The benefits that might accrue from the successful implementation of a Total quality management programme by themanagement of the combined entity include the following:

– There will be an increased awareness of all personnel within Quicklink Ltd of the need to establish a ‘quality culture’within the company which will provide a basis of improved performance throughout the organisation.

– The successful adoption of a TQM philosophy would ensure that there is a real commitment to ‘continuous improvement’in all processes.

– It would place a greater focus on customer satisfaction since at the heart of any TQM programme is a deep-seatedcommitment to the satisfaction of every customer.

– There would be a greater emphasis upon teamwork which would be used in a number of forms e.g. quality circles whichcould be established with a view to improving performance within every area of the business. The fostering of team spiritwill also improve communication within Quicklink Ltd.

– A major characteristic of a TQM programme is process-redesign which is used to simplify processes, systems,procedures and the organisation itself. In this respect the adoption of a TQM philosophy will be invaluable since theintegration of the Quicklink Ltd and Celer Transport businesses will require, of necessity, a detailed review of thoseprocesses currently employed.

22



– The adoption of a TQM philosophy will necessitate the monitoring of quality costs in order to measure whether theobjective of continuous improvement is being achieved. In this respect the aim will be to eliminate internal failure costssuch as late deliveries and lost items which are clearly detrimental to a business which operates in the transport andhaulage industry.

2 (a) Project North East SouthYear 1 Cashflow 6,000·0 11,500·0 12,000·0

Depreciation (6,000·0) (8,000·0) (6,000·0)––––––––– ––––––––– –––––––––

Profit/(loss) nil 3,500·0 6,000·0Average invested capital 21,000·0 20,000·0 21,000·0Return on Investment (ROI) nil 17·50% 28·57%

Year 2 Cashflow 8,000·0 11,500·0 10,000·0Depreciation (6,000·0) (8,000·0) (6,000·0)

––––––––– ––––––––– –––––––––Profit 2,000·0 3,500·0 4,000·0Average invested capital 15,000·0 12,000·0 15,000·0Return on Investment (ROI) 13·33% 29·17% 26·67%

The management of the IOA Division is likely to prefer to invest in the South project as the projected return on investment ismuch higher than the projected returns from the North and East projects. Their choice of project would be influenced by thefact that under the terms of the management incentive plan they are eligible to receive annual bonus payments which arecalculated by reference to the overall year 1 and 2 return on investment (ROI). Thus the management incentive plan iscausing divisional management to adopt a short-term focus which is detrimental to the organisation as a whole. Theinappropriate performance-rewards linkage can therefore be said to be precipitating dysfunctional behaviour on the part ofthe management of the IOA Division. It would be interesting to know for how long ROI had formed the basis of payment underthe management incentive plan. We know that in recent years the IOA Division has been one of the more profitable divisionswithin NCL plc, however, one must question to what extent the fortunes of NCL plc have been adversely affected by thedysfunctional behaviour of not only the management of the IOA Division, but also all the other divisional management teams.

On the other hand, the board of directors of NCL plc could adopt a much longer-term view and also have as an objective themaximisation of shareholders’ wealth. They are likely to assess the three projects on a whole-life basis and consequently willchoose the project which yields the largest discounted cash flow. In this case that is the North project. Much will of coursedepend upon the attitude to risk of the board of NCL. The fact that the life of the East investment is only three years mightwell mean that there is less uncertainty in the estimate of future cashflows than there is in the estimates of the North andSouth projects which are forecasted to have a life of four years.

(b) The use of residual income as a basis for the management incentive plan operated by NCL plc would have the followingadvantages:

Divisional management would be more willing to accept a project with a positive residual income and this would contributeto the improved performance of NCL plc. Also, the disincentive to accept a project with a positive residual income but a returnon investment regarded by divisional management as not being in their best interests would be removed, because divisionalmanagement would be rewarded.

The use of annuity depreciation may improve performance appraisal by removing the effect of straight-line depreciation whichtends to distort project returns especially in the early years of a project’s life when invested capital remains relatively high dueto the constant depreciation charge. The residual income approach using annuity depreciation will only match the NPV if theannual cashflows of a project are constant. Hence the method when applied to the North or South projects would producean NPV which does not exactly match that previously calculated. By way of contrast it is forecast that the East project willhave constant cashflows and in this instance the NPV and residual income based approach when discounted, will producethe same result.

(c) The net present value of the West project is dependent upon the level of environmental expenditure that will be incurred byDivision IOA at the conclusion of the project. The potential NPV of the West project can be calculated using a discount rateof 12% per annum which assumes that the West project has similar characteristics to the North, East and South projects.

Net cash inflows for each of years 1–4 = £5 million

Cumulative discount factor at 12% per annum = 3·037

Therefore the present value of cashflows is £5 million x 3·037 = £15,185 million and the net cash flow after the initialoutlay of £12 million is £3,185,000.

There is now the strategic consideration regarding whether to spend £2 million which will restore the river to its original colourand also clear 90% of the pollution caused as a result of the mining activities of the IOA Division, or to incur expenditure ofa further £2 million which will completely redress any damage done to the environment by the activities of the IOA Division.

23



24

The net present value of the potential outcomes is as follows:

Environmental expenditure £2 Million £4 million£000 £000

Net cash flow before environmental expenditure £3,185 £3,185Year 4 expenditure (discounted at 12%)£2m * 0·636 (1,272)£4m * 0·636 (2,544)

–––––– ––––––Net present value 1,913 641

–––––– ––––––

If only £2 million of expenditure was incurred in respect of making good the local environment, the NPV of the West projectwould be nearly three times greater than it would be if £4 million were to be spent. However, much will depend upon theextent of that the board of directors of NCL plc is socially responsible, which in turn is dependent upon their concern for theenvironment in which they operate. The board of directors should acknowledge that the activities it undertakes will invariablybe of concern to those communities in which it operates. With regard to the West project the board of directors of NCL plcshould be mindful that the fact that the river would be polluted for up to four years constitutes a significant reputational riskbecause a polluted river will inevitably precipitate much negative public opinion.

Moreover the board of directors of NCL plc need to be aware of the fact that whilst profits and cashflows may be reduced asa consequence of pursuing socially responsible policies their image as a socially responsible organisation will be enhancedand this may well create goodwill from which longer-term benefits may arise.

3 (a) The weaknesses of traditional budgeting processes include the following:

– many commentators, including Hope and Fraser, contend that budgets prepared under traditional processes add littlevalue and require far too much valuable management time which would be better spent elsewhere.

– too heavy a reliance on the ‘agreed’ budget has an adverse impact on management behaviour which can becomedysfunctional having regard to the objectives of the organisation as a whole.

– the use of budgeting as base for communicating corporate goals, setting objectives, continuous improvement, etc is seenas contrary to the original purpose of budgeting as a financial control mechanism.

– most budgets are not based on a rational causal model of resource consumption but are often the result of protractedinternal bargaining processes.

– conformance to budget is not seen as compatible with a drive towards continuous improvement.

– budgeting has an insufficient external focus.

(b) BenchmarkingBenchmarks enable goals to be set that may be based on either external measures of ‘best practice’ organisations or internalcross-functional comparisons which exhibit ‘best practice’. A primary aim of the traditional budgeting process is the setting ofrealistic targets that can be achieved within the budget period. The setting of realistic targets means that the extent ofunderperformance against ‘best practice’ standards loses visibility, and thus short-term financial targets remain thepredominant focus of the traditional budgeting process. It is arguable that because the budgetary reporting system purportsto give managers ‘control’, there is very little real incentive to seek out benchmarks which may be used to raise budgetedperformance targets. Much depends upon the prevailing organisational culture since benchmarking may be viewed as anattempt by top management to impose impossible targets upon operational managers. The situation is further exacerbatedwhere organisations do not measure their success relative to their competition.

Balanced scorecardThe Balanced scorecard is often misunderstood as a consequence of the failure by top management to ensure that it isimplemented effectively within the organisation. Thus it may be viewed as the addition of a few non-financial measures tothe conventional budget. In an attempt to overcome this misperception many management teams now establish aperformance-rewards linkage based upon the achievement of Scorecard targets for the forthcoming budget period.Unfortunately this can precipitate dysfunctional behaviour at every level within the organisation.

Even in situations where the Scorecard has been well-designed and well-implemented it is difficult for it to gain widespreadacceptance. This is because all too often there exists a culture which places a very high value upon the achievement of thefixed annual targets in order to avoid the loss of status, recognition and rewards.

A well-constructed Scorecard contains a mix of long-term and short-term measures and therefore drives the company in thedirection of medium-term strategic goals which are supported by cross-functional initiatives. On the other hand, the budgetingprocess focuses the organisation on the achievement of short-term financial goals supported by the initiatives of individualdepartments. Budgets can also act as an impediment to the acceptance of responsibility by local managers for theachievement of the Scorecard targets. This is often the case in situations where a continued emphasis exists on meeting short-term e.g. quarterly targets.

Activity-based modelsTraditional budgets show the costs of functions and departments (e.g. staff costs and establishment costs) instead of the costsof those activities that are performed by people (e.g. receipt of goods inwards, processing and dispatch of orders etc). Thus



25

managers have no visibility of the real ‘cost drivers’ of their business. In addition, it is probable that a traditional budgetcontains a significant amount of non-value-added costs that are not visible to the managers. The annual budget also tendsto fix capacity for the forthcoming budget period thereby undermining the potential of Activity-based management (ABM)analysis to determine required capacity from a customer demand perspective. Those experienced in the use of ABMtechniques are used to dealing with such problems, however their tasks would be much easier to perform and their resultsmade more reliable if these problems were removed.

4 (a) Dental Health Partnership

Summary Profit and Loss Account for the year ended 31 May 2005£

Fees received 1,226,880 (Note 1)Other Operating Income 20,800

––––––––––Total Income 1,247,680Less: variable costsMaterial and consumables 446,400Less: fixed costsSalaries 538,880Establishment costs 85,000Other operating costs 75,775

––––––––––Total costs 1,146,055

––––––––––Net profit for the period 101,625

––––––––––

Calculation of % of total capacity required to break-even during the year ended 31 May 2005.

Fees received £1,226,880Less: variable costs £446,400

–––––––––––Contribution £780,480

–––––––––––

Total number of consultations 28,800

Weighted average contribution per patient visit = £780,480/28,800= £27·10

Total fixed costs: £Salaries 538,880Establishment costs 85,000Other operating costs 75,775

––––––––699,655

Less: fixed income 20,800––––––––

Total fixed costs less fixed income 678,855––––––––

Divide by weighted average contribution per patient visit £678,855/£27·10 = 25,050 consultations.Total capacity for patient visits= 28,800/0·8333 = 34,560 per annum

Therefore percentage of maximum capacity required in order to break-even is 25,050/34,560 = 72·5%

Note 1. Fees received:

Adult fees = Payment plus Government refundChildren/Senior Citizens = Government refund

Adjusted patient mix is as follows:

Adults 50% x 2 = 100%Children 40%Senior Citizens 10%

––––––Total 150%

––––––

The weighted average fee per patient is as follows:

Type of patient treatment: £None 0·70 x £12 = 8·40Minor 0·20 x £50 = 10·00Major 0·10 x £100 = 10·00

––––––Total 28·40

––––––

Therefore fees received during the year ended 31 May 2005 = 28,800 x 1·5 x £28·40 = £1,226,880.



Note 2. Capacity:

Each dentist had a maximum of 24 patients per day but on average treated 20 patients per day which equates to 83·333%of maximum capacity.

(b) The major characteristics of services which distinguish services from manufacturing are as follows:

– Intangibility.

When a dentist provides a service to a client there are many intangible factors involved such as for example theappearance of the surgery, the personality of the dentist, the manner and efficiency of the dental assistant. The outputof the service is ‘performance’ by the dentist as opposed to tangible goods.

– Simultaneity.

The service provided by the dentist to the patient is created by the dentist at the same time as the patient consumed itthus preventing any advance verification of quality.

– Heterogeneity.

Many service organisations face the problem of achieving consistency in the quality of its output. Whilst each of thedentists within the Dental Health Partnership will have similar professional qualifications there will be differences in themanner they provide services to clients.

– Perishability.

Many services are perishable. The services of a dentist are purchased only for the duration of an appointment.

(c) In order to assess the quality of patient care provided by the Dental Health Partnership the following performance measuresmight be used:

– The percentage of ‘on time’ treatment of those patients who arrived prior to their appointment time would provide anindication regarding the effectiveness of the scheduling of appointments by the Dental Health Partnership.

– the percentage of patient appointments which were re-arranged at the request of the Dental Health Partnership.Rearranged appointments represent the provision of a lower level of service provision to clients who may, as a result,switch to an alternative dental practice.

– the percentage of patients who return for treatment after their first appointment would provide an indication that theywere satisfied with the service they received.

– the percentage of patients who were able to gain an appointment at their preferred date and time is an indication of theavailability of the service to clients.

Note: Candidates were only required to discuss three measures.

5 (a) The overall performance of Taliesin Ltd during the year ended 31 May 2005 can be measured by its Return on CapitalEmployed (ROCE) as follows:

2005 2004Profit Before Interest = 5,000 4,000––––––––––––––––––––––––––––– ––––––– –––––––Total Assets less Current Liabilities 66,000 52,000

= 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 2004. Since this information was available at the start of the 2005 financial year the directors shouldhave reconsidered their objective of growth.

Sales have increased by 20% over the previous year. There is a considerable variation in the sales achieved by Taliesin Ltdin the different halves of their accounting year. This variation in seasonal demand required the hiring of a secondary core workforce for the period 1 June – 30 November during each financial year. Most of the growth in sales revenue occurred duringthe first half of the year ended 31 May 2005.

Cost of sales has remained constant at 60% of sales. It is interesting to note that the composition of cost of sales has changedduring the year and management attention should be focussed on this in order to ascertain the reasons for this change. Thematerial percentage content of cost of sales has remained constant whereas labour has decreased. Manufacturing overheadscomprise the majority of cost of sales in 2005 (51·5%). This is an increase of 1·5% over 2004.

2005 2004% of cost of sales: % of cost of sales:

Materials 32·5 32·5Labour 16·0 17·5Overheads 51·5 50·0

–––––– ––––––100·0 100·0

–––––– ––––––

26



Whilst the gross profit percentage has remained constant at 40% the net profit percentage has reduced from 10% to 8·33%.In absolute terms, Taliesin Ltd has earned the same profit during the year ended 31 May 2005 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 aloan which was taken out during the year presumably to finance the plant and equipment required in order to manufacturethe six new products.

Details of the composition of net current assets are required in order to ascertain the liquidity position of Taliesin plc andthereby gain a fuller picture of the financial position of Taliesin Ltd.

From the information provided it would appear that although sales increased by 20% over the previous year’s level, TaliesinLtd has lost a customer during the year ended 31 May 2005. It is quite conceivable that this only happened towards the endof the year and thus the profit and loss account might not fully reflect financial consequences of the lost customer. The lossof the customer could well be highly significant since the company had only six customers at the start of the year. It is highlyprobable, therefore, that each of the six customers, being supermarkets, purchased in relatively large volumes and thussignificant turnover may have been lost. This will only become apparent during the next year but Taliesin Ltd should attemptto find a new customer to replace the lost customer as soon as possible.

Growth may only have been achieved by introducing new products. There may be a limit to the number of times that thiscan be done effectively. It has already been noted that the six new products have led to a loan, the cost of which exceeds thereturn generated by Taliesin Ltd.

(b) The major benefits of pursuing a policy of internal development that may accrue to Taliesin Ltd are as follows:

– By confining their activities to its internal environment the company avoids the need to manage the integration ofbusinesses which is necessitated by an acquisition. Management teams, when considering the acquisition of anotherorganisation, very often underestimate the costs of integration.

– There is no need for the board of directors of Taliesin Ltd to familiarise itself with different organisational and nationalcultures, values etc, thereby avoiding many potential problems.

– The board of directors of Taliesin Ltd is better able to control the activities of the business and the need for more complexsupply chains and strategic alliances with foreign organisations is rendered unnecessary.

– All investments are made at market price whereas if the board of directors was to attempt to grow the businessacquisition then significant outlays would probably be made in respect of purchased goodwill.

– As the organisation develops and expands, staff are provided with development and learning activities that mayprecipitate an increase in the level of their commitment to the organisation.

(c) The usefulness of activity-based techniques is accentuated in situations where overheads comprise a significant proportion ofproduct costs. Manufacturing overheads comprise 30·9% of turnover during the year ended 31 May 2005. Traditionalmethods of allocating overheads to products might result in product cost information which is misleading and detrimental tomanagerial decision-making. Calculations of product costs are more prone to error in situations where higher levels ofoverhead exist. The consequences can prove disastrous as, for example, in the under-pricing or over-pricing of products.

Since Taliesin Ltd is going to confine its activities to its home country it must be prepared to face increased competition andthis increases the need for greater visibility and more accurate product cost information.

At present, Taliesin Ltd offers a range of products which is increasing in number and this may lead to the need for a moredetailed costing system. Traditional absorption systems might well be inadequate as the number of product variants increases.

One would expect that each new product developed is more complex than its predecessors. The company would probablystart with simple Vanilla, then a few basic flavours but as Taliesin Ltd has expanded one would expect it to take longer tooriginate and test new products until they are ready to be introduced. It will probably take longer to mix the ingredients for arun of each product.

These two, development 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 activitieswould be ignored.

In order to gain a full appreciation of the impact of new product introduction activity-based techniques should be used toguide Taliesin Ltd into the easiest way to maintain its policy of growth. It may be a better decision to expand abroad or intonew markets at home with the existing products than pursue growth by introducing new products to a dwindling number ofcustomers.

We are not told of the composition of the customer base of Taliesin Ltd. However, one thing we do know is that the scope ofactivity-based techniques extends beyond products and services. For example, the application of activity-based costing canprovide vital information that enables management to undertake customer profitability analysis, thereby further improvingmanagement decision-making and operating performance.

27




Marks Marks1 (a) Sales revenue 11

Fuel 4Salaries 1Sundry operating costs 1Presentation (including profit/loss) 2


(b) Revenue generation per vehicle 8Vehicle utilisation and delivery mix 6·5Service quality 6


(c) Comments (on merit) – four required up to 1·5 marks each Maximum 5

(d) Link to: Improved performance 1Continuous improvement 1Customer satisfaction 1Team spirit 1

Process-redesign 1Quality costs 1Other relevant comments 2


Total 40–––

2 (a) Relevant calculations 6Comments (on merit) 4 10

–––

(b) Comments (on merit)Residual income 2Annuity depreciation 3

––– Maximum 4

(c) Revenue 1Expenditure 1Net cash flow 1Comments (on merit) 3 6

––– –––Total 20

–––

3 (a) Comments (on merit):Inherent disadvantages (five required) Up to 2 marks each Maximum 8

(b) Benchmarking 4Balanced scorecard 4Activity-based models 4 12

––– –––Total 20

–––

29



Marks Marks4 (a) Fee income 4

Materials and consumables 0·5Salaries 1Establishment and other operating costs 0·5Other operating income/profit 1Calculation of break even capacity utilisation 5

––– 12

(b) Comments (on merit):Intangibility Up to 1·5Simultaneity eachHeterogeneityPerishability

––– Maximum 5

(c) One mark per performance measure 3 3–––

Total 20–––

5 (a) Comments (on merit):Return on Capital Employed (ROCE) 2Sales revenue 2Cost of sales 2Operating costs 1Interest payable 1Net profit 1New product introduction 1Lost customer 2Net current assets 1Other relevant comments 2


(b) Comments (on merit):Avoidance of problems re:Integration of different businessesDifferent culturesControlPurchased goodwillOther relevant comments Maximum 4

(c) Comments (on merit):High overhead contentMore accurate product cost informationExtension to customer profitability analysisOther relevant comments Maximum 5

–––Total 20

–––

30




PART 3


QUESTION PAPER








Pape

r 3.3




1 KCB is a business services group which owns a software house that develops and markets application software tomeet the manufacturing, distribution and accounting requirements of its clients. Kickstart Ltd is a subsidiary companywithin KCB, whose consultants provide the following three services:

Project management Implementation support Product education and training.

The following information is relevant for the year ending 31 December 2006.

(1) The government will pay a grant (as per note 2) to Kickstart Ltd based on the number of clients serviced duringthe year. This is budgeted as follows:

Service: Number of clientsProject management 200Implementation support 400Product education and training 720

(2) Cost and revenue data are as follows:

Department Project Implementation Productmanagement support education

andtraining

£ £ £Salaries 2,500,000 960,000 1,200,000Variable costs per client consultation 4,000 400 150Fee per client consultation 25,000 2,000 1,000Government grant per client 5,000 600 300

Other fixed costs are budgeted to be £2,827,500 and general administration costs are budgeted to be£390,000.

(3) An activity-based costing study recently undertaken on behalf of the management of Kickstart Ltd concluded that80% of other fixed costs as per note (2) (excluding general administration costs), are determined by time spenton activities as per the following table:

Activity Cost driver Project Implementation Product Othermanagement support education fixed

and coststraining (£000)

Pre-contract meetings Number of 4 2 1 956meetings(per consultation)

Assessment of client needs Time taken 2·25 0·5 0·25 650(days perconsultation)

Post-implementation monitoring Time taken 3 0·5 0·25 656and support (days per

consultation)



The budgeted number of consultations is as follows:

Service: Number of consultationsProject management 300Implementation support 1,500Product education and training 1,800

The remaining 20% of other fixed costs (excluding general administration costs) are attributable to the three typesof service as follows:

£Project management 325,500Implementation support 145,000Product education and training 95,000

(4) Prior to 1 January 2006, the management of Kickstart Ltd allocated the total (100%) of ‘Other fixed costs’(excluding general administration costs) between the three types of service, based on the budgeted number ofconsultations.

Required:

(a) (i) Using the findings of the activity-based costing study and based on the budgeted number ofconsultations, prepare a budgeted Profit and Loss statement for the year ending 31 December 2006which shows the profit/(loss) attributable to each of the three services undertaken by Kickstart Ltd.

(10 marks)

(ii) Using the previous overhead allocation basis (as per note 4), calculate the budgeted profit/(loss)attributable to each type of service for the year ending 31 December 2006 and comment on the resultsobtained using the previous and revised methods of overhead allocation. (5 marks)

(b) Envico Ltd, another subsidiary of the KCB Group, is well established and provides seminars on various aspectsof current and recently announced changes in employment legislation. Envico Ltd has decided to enter into aone-year renewable contract with Mieras Business Associates, which owns large premises that are suitable forholding educational seminars in each of eight cities. Envico Ltd has had similar dealings with Mieras BusinessAssociates during recent years.

Mieras Business Associates has offered a choice of four different contracts, each of which relates to seminarrooms of differing sizes. These are known as room types A, B, C and D, which are capable of accommodating100, 200, 300 and 400 delegates respectively.

Envico Ltd will charge an all-inclusive fee of £80 per delegate at every seminar throughout the year. The costincurred by Envico Ltd varies according to room type, as shown in the following table:

Room type No of attendees Cost per seminar (£)A 100 6,000B 200 10,800C 300 14,400D 400 16,000

Envico must decide in advance of the forthcoming year which size of conference room to contract for. It is notpossible to contract for a different size conference room in different cities, i.e. only one size of room can be thesubject of the contract with Mieras Business Associates.

Due to the rapid growth in interest regarding environmental issues and corporate social responsibility, and thelarge amount of forthcoming legislative changes, Envico Ltd has decided to hold one seminar in every week ofthe year in each city. Sometimes a regional government representative will attend and speak at such seminars.On other occasions a national government representative will attend and speak at such seminars. The rest of thetime the speakers at seminars are representatives from within Envico Ltd.

Envico has estimated the following frequency regarding seminars to be held during the forthcoming year:

Category of speaker: %Envico representative 20Regional government representative 50National government representative 30



Market research has indicated that where a national government representative is in attendance, Envico Ltd canbe reasonably assured of selling 400 seminar places and where a regional government representative is inattendance 200 seminar places can be sold. Envico Ltd expects to sell only 100 seminar places when there isno attendance by a government representative.

Required:

(i) Advise Envico Ltd on the size of seminar room that should be contracted from Mieras BusinessAssociates, using the criterion of expected value. Your answer should show the expected annualcontribution from each decision option. (9 marks)

(ii) Determine whether your decision in (b)(i) would change if you were to use the Maximin and Minimaxregret decision criteria. Your answer should be supported by relevant workings. (6 marks)

Required:

(iii) A firm of consultants has offered to undertake a study on behalf of Envico Ltd which will provide perfectinformation regarding seminar attendance during the forthcoming year.

Advise the management of Envico Ltd with regard to the maximum amount that they should pay toconsultants for perfect information regarding seminar attendance and comment briefly on the use ofperfect information in such decisions. (5 marks)

(c) At a recent meeting of the board of directors, the managing director of Envico Ltd said that he considered itessential to be able to assess the ‘value for money’ of each seminar. He suggested that the quality of the speakersand the comfort of the seminar rooms were two assessment criteria that should be used in order to assess the‘value for money’ of each seminar.

Required:

Discuss SIX separate and distinct assessment criteria (including those suggested by the managing director),that would enable the management of Envico Ltd to assess the ‘value for money’ of each seminar.

(6 marks)

(d) Explain the term ‘environmental management accounting’ and the benefits that may accrue to organisationswhich adopt it. (4 marks)

(45 marks)



2 (a) Explain the term ‘backflush accounting’ and the circumstances in which its use would be appropriate.(6 marks)

(b) CSIX Ltd manufactures fuel pumps using a just-in-time manufacturing system which is supported by a backflushaccounting system. The backflush accounting system has two trigger points for the creation of journal entries.These trigger points are:

the purchase of raw materialsthe manufacture of finished goods.

The transactions during the month of November 2005 were as follows:

Purchase of raw materials £5,575,000Conversion costs incurred:Labour £1,735,000Overheads £3,148,000Finished goods completed (units) 210,000Sales for the month (units) 206,000

There were no opening inventories of raw materials, work-in-progress or finished goods at 1 November. Thestandard cost per unit of output is £48. This is made up of £26 for materials and £22 for conversion costs (ofwhich labour comprises £8·20).

Required:

(i) Prepare ledger accounts to record the above transactions for November 2005. (6 marks)

(ii) Briefly explain whether the just-in-time system operated by CSIX Ltd can be regarded as ‘perfect’.(3 marks)

(15 marks)



This is a blank page.Question 3 starts on page 7.




3 Moffat Ltd, which commenced trading on 1 December 2002, supplies and fits tyres and exhaust pipes and servicesmotor vehicles at thirty locations. The directors and middle management are based at the Head Office of Moffat Ltd.Each location has a manager who is responsible for day-to-day operations and is supported by an administrativeassistant. All other staff at each location are involved in fitting and servicing operations.

The directors of Moffat Ltd are currently preparing a financial evaluation of an investment of £2 million in a new ITsystem for submission to its bank. They are concerned that sub-optimal decisions are being made because the currentsystem does not provide appropriate information throughout the organisation. They are also aware that not all of thebenefits from the proposed investment will be quantitative in nature.

Required:

(a) Explain the characteristics of THREE types of information required to assist in decision-making at differentlevels of management and on differing timescales within Moffat Ltd, providing TWO examples of informationthat would be appropriate to each level. (10 marks)

(b) Identify and explain THREE approaches that the directors of Moffat Ltd might apply in assessing theQUALITATIVE benefits of the proposed investment in a new IT system. (6 marks)

(c) Identify TWO QUALITATIVE benefits that might arise as a consequence of the investment in a new IT systemand explain how you would attempt to assess them. (4 marks)

(20 marks)



4 Diverse Holdings Plc has five wholly-owned subsidiary companies. These are:

(i) Organic Foods Ltd (OFL) which is involved in the production and sale of organically grown fruit and vegetables.OFL has built up a very good reputation as a supplier of quality produce.

(ii) Haul-Trans Ltd (HTL) which was acquired on 1 December 2005 and is involved in transporting a range ofproducts on behalf of third parties.

(iii) Kitchen Appliances Ltd (KAL) which is involved in the manufacture and sale of small, manually-operated kitchenappliances. KAL has recently suffered from squeezed margins as a consequence of competition from low costimports.

(iv) Paper Supplies Ltd (PSL) which manufactures and sells a narrow range of stationery products to two distributors.(v) Office Products Ltd (OPL) which manufactures and sells computer workstations with unique design features

which are highly regarded by health and safety experts.

The management accountant of Diverse Holdings Plc has gathered the following actual and forecast informationrelating to the five subsidiaries:

Year ending 30 November2003 2004 2005 2006 2007Actual Actual Actual Forecast Forecast

(OFL)Market size (£m) 100·0 120·0 150·0 180·0 225·0Turnover (£m) 5·0 8·0 10·0 13·5 18·0Operating Profit (£m) 1·0 1·8 2·5 3·0 3·6

(HTL)Market size (£m) Unknown Unknown Unknown Unknown UnknownTurnover (£m) 40·0 40·0 41·0 42·0 42·0Operating Profit (£m) 4·0 4·0 4·0 5·0 5·6

(KAL)Market size (£m) 252·0 250·0 245·0 242·0 240·0Turnover (£m) 37·5 37·5 35·5 32·0 29·0Operating Profit/(loss) (£m) 1·5 1·1 0·7 0·3 (0·2)

(PSL)Market size (£m) 60·0 65·0 70·0 77·0 84·0Turnover (£m) 2·0 2·0 2·0 2·0 2·1Operating Profit (£m) 0·6 0·6 0·6 0·5 0·5

(OPL)Market size (£m) 200·0 220·0 240·0 260·0 280·0Turnover (£m) 15·0 16·0 16·5 17·0 17·5Operating Profit (£m) 1·50 1·60 1·65 1·70 1·75

The management accountant has also collated the following information relating to the market share held at 30 November 2005 by the market leader in those markets in which each subsidiary operates:

Subsidiary Market Market share (%) held by market leader

Organic Foods Ltd Food production 6·66Haul-Trans Ltd Transport UnknownKitchen Appliances Ltd Kitchen appliances 16Paper Supplies Ltd Stationery 35Office Products Ltd Workstations 25

The management has decided not to undertake any further acquisitions during the next two years due to a shortageof funds.



Required:

(a) Identify and comment on FOUR advantages that may be gained as a result of the adoption of a formal systemof strategic planning. (4 marks)

(b) Explain how the use of SWOT analysis may be of assistance to the management of Diverse Holdings Plc. (3 marks)

(c) (i) Using ONLY the above information, assess the competitive position of Diverse Holdings Plc.(7 marks)

(ii) Explain THREE strategies that might be adopted in order to improve the future prospects of DiverseHoldings Plc. (6 marks)

(20 marks)



5 Astrodome Sports Ltd was formed in December 2000 by seven engineers who comprise the board of directors of thecompany. The seven engineers previously worked together for ‘Telstar’, a satellite navigation company.

In conjunction with one of the three largest construction companies within their country they constructed the ‘365Sports Complex’ which has a roof that opens and uses revolutionary satellite technology to maintain grass surfaceswithin the complex. The complex facilities, which are available for use on each day of the year, include two tenniscourts, a cricket pitch, an equestrian centre and six bowling greens. The tennis courts and cricket pitch are suitablefor use as venues for national competitions. The equestrian centre offers horse-riding lessons to the general public andis also a suitable venue for show-jumping competitions. The equestrian centre and bowling greens have increased inpopularity as a consequence of regular television coverage of equestrian and bowling events.

In spite of the high standard of the grass surfaces within the sports complex, the directors are concerned by reducedprofit levels as a consequence of both falling revenues and increasing costs. The area in which the ‘365 SportsComplex’ is located has high unemployment but is served by all public transport services.

The directors of Astrodome Sports Ltd have different views about the course of action that should be taken to providea strategy for the future improvement in the performance of the complex. Each director’s view is based on his/herindividual perception as to the interpretation of the information contained in the performance measurement system ofthe complex. These are as follows:

Director(a) ‘There is no point whatsoever in encouraging staff to focus on interaction with customers in efforts to create a

‘user friendly’ environment. What we need is to maintain the quality of our grass surfaces at all costs since thatis the distinguishing feature of our business.’

(b) ‘Buy more equipment which can be hired out to users of our facilities. This will improve our utilisation ratioswhich will lead to increased profits.’

(c) ‘We should focus our attention on maximising the opening hours of our facilities. Everything else will take careof itself.’

(d) ‘Recent analysis of customer feedback forms indicates that most of our customers are satisfied with the facilities.In fact, the only complaints are from three customers – the LCA University which uses the cricket pitch formatches, the National Youth Training Academy which held training sessions on the tennis courts, and a localbowling team.’

(e) ‘We should reduce the buildings maintenance budget by 25% and spend the money on increased advertising ofour facilities which will surely attract more customers.’

(f) ‘We should hold back on our efforts to overcome the shortage of bowling equipment for hire. Recent rumours arethat the National Bowling Association is likely to offer large financial grants next year to sports complexes whocan show they have a demand for the sport but have deficiencies in availability of equipment.’

(g) ‘Why change our performance management system? Our current areas of focus provide us with all theinformation we need to ensure that we remain a profitable and effective business.’

As management accountant of Astrodome Sports Ltd you have recently read an article which discussed the followingperformance measurement problems:

(i) Tunnel vision(ii) Sub-optimisation(iii) Misinterpretation(iv) Myopia(v) Measure fixation(vi) Misrepresentation(vii) Gaming(viii) Ossification.



Required:

(a) Explain FOUR of the above-mentioned performance measurement problems (i-viii) and discuss which of theviews of the directors (a-g) illustrate its application in each case. (12 marks)

(b) Discuss the relevance of each of the following actions as steps in trying to remedy performance measurementproblems relating to the ‘365 Sports Complex’ and suggest examples of specific problem classifications thatmay be reduced or eliminated by each action:

(i) Focusing on and improving the measurement of customer satisfaction(ii) Involving staff at all levels in the development and implementation of performance measures(iii) Being flexible in the extent to which formal performance measures are relied on(iv) Giving consideration to the auditing of the performance measurement system. (8 marks)

(20 marks)




Answers




N.B. (i) These answers are more detailed than would be expected of a ‘good pass’ candidate under examination conditions.(ii) Alternative explanations would be acceptable where appropriate.

1 (a) (i) Kickstart Ltd

Budgeted Profit and Loss Statement for the year ending 31 December 2006.

Project Implementation Product education Totalmanagement support & training

£ £ £ £Fees receivable 7,500,000 3,000,000 1,800,000 12,300,000Government grants receivable 1,000,000 240,000 216,000 1,456,000

–––––––––– –––––––––– –––––––––– –––––––––––Total revenue 8,500,000 3,240,000 2,016,000 13,756,000

–––––––––– –––––––––– –––––––––– –––––––––––Less:Salaries 2,500,000 960,000 1,200,000 4,660,000Variable costs 1,200,000 600,000 270,000 2,070,000Other fixed costs:ABC related 706,343 972,286 583,371 2,262,000Attributable 325,500 145,000 95,000 565,500

–––––––––– –––––––––– –––––––––– –––––––––––4,731,843 2,677,286 2,148,371 9,557,500–––––––––– –––––––––– –––––––––– –––––––––––

Profit/(loss) before general administration costs 3,768,157 562,714 (132,371) 4,198,500General administration costs (390,000)

–––––––––––Net profit 3,808,500

–––––––––––

Note 1:

Calculation of ABC related costs:

Activity: Pre-contract meetings:

Cost Driver Project Implementation Product Total Cost (£)management support education and pre-

training contractmeetings

Number of consultations: 300 1,500 1,800Number of meetings 4 2 1(per consultation)Total pre-contract 1,200 3,000 1,800 6,000 956,000meetings per activityCost: (1,200/6,000) (3,000/6,000) (1,800/6,000)

* £956,000 = * £956,000 = * £956,000 =£191,200 £478,000 £286,800

Activity: Assessment of client needs:

Cost Driver Project Implementation Product Total days Cost (£)management support education and spent on

training assessmentof clientneeds

Number of consultations: 300 1,500 1,800Days (per consultation) 2·25 0·5 0·25Total days per activity 675 750 450 1,875 650,000Cost: (675/1,875) (750/1,875) (1,800/6,000)

* £650,000 = * £650,000 = * £650,000 =£234,000 £260,000 £156,000



Activity: Post-implementation monitoring and support:

Cost Driver Project Implementation Product Total days Cost (£)management support education spent on post-

and training implementationmonitoring and

supportNumber of consultations: 300 1,500 1,800Days (per consultation) 3 0·5 0·25Total days per activity 900 750 450 2,100 656,000Cost: (900/2,100) (750/2,100) (450/2,100)

* £656,000 = * £656,000 = * £656,000 =£281,143 £234,286 £140,571

Summary of activity-based costs:

Activity: £ £ £Pre-contract meetings 191,200 478,000 286,800Assessment of client needs 234,000 260,000 156,000Post-implementation, monitoring and support 281,143 234,286 140,571

–––––––– –––––––– ––––––––Total 706,343 972,286 583,371

–––––––– –––––––– ––––––––

(ii) The profit/(loss) using the previous method of allocating fixed overheads is shown in the following table:£ £ £ £

Profit/(loss) before general administration costs using an activity-based approach 3,768,157 562,714 (132,371) 4,198,500Add:Other fixed costs (per a (i)) ABC related and attributable 1,031,843 1,117,286 678,371 2,827,500Less:Other fixed costs (based on consultations) (235,625) (1,178,125) (1,413,750) (2,827,500)

–––––––––– –––––––––– –––––––––– ––––––––––Profit/(loss) before general administration costs 4,564,375 501,875 (867,750) 4,198,500General administration costs (390,000)

––––––––––Net profit 3,808,500

––––––––––

The proposed treatment of other fixed costs uses an activity-based approach which will give the management of the KCBGroup a more accurate picture of the income streams arising from each of the three types of consultation undertakenby Kickstart Ltd. Under the previous method overheads were allocated on the basis of the total number of budgetedconsultations. However, this method would have masked the true position since it pre-supposes that each consultationundertaken incurs an equal amount of fixed overhead whereas this is not the case as the results of the activity-basedcosting study clearly shows.

Note 2:Calculation of ‘Other fixed costs’ on the basis used prior to 1 January 2006.

Cost Driver Project Implementation Product Total Cost (£)management support education and consultations

trainingNumber of consultations: 300 1,500 1,800 3,600 2,827,500Cost: (300/3,600) (1,500/3,600) (1,800/3,600)

* £2,827,500 = * £2,827,500 = * £2,827,500 =£235,625 £1,178,125 £1,413,750

(b) (i) Pay-off tablePurchaseoptions

Demand Prob 100 200 300 400Contribution Expected Contribution Expected Contribution Expected Contribution Expected

value value value value£ £ £ £ £ £ £ £

100 0·20 832,000 166,400 (1,164,800) ,,(232,960) (2,662,400) (532,480) (3,328,000) (665,600)200 0·50 832,000 416,000 2,163,200 1,081,600 665,600 332,800 0 0400 0·30 832,000 249,600 2,163,200 648,960 3,993,600 1,198,080 6,656,000 1,996,800

–––––––– –––––––––– ––––––––– ––––––––––832,000 1,497,600 998,400 1,331,200–––––––– –––––––––– ––––––––– ––––––––––

On the basis of expected values Envico Ltd should contract for room B which has a capacity of 200 attendees and wouldgive an expected value of £1,497,600.



Note 3:Example of workings for the Pay-off table re (b)(i):

If we assume that room size C was contracted for and subsequent demand was for 100 delegate places, then theresultant contribution would be calculated as follows:

(100 x £80) – £14,400 = –£6,400 x 8 x 52 = (£2,662,400).

(ii) The minimum contribution for each possible decision is as follows:

Room Type Minimum contribution (£)A 832,000B (1,164,800)C (2,662,400)D (3,328,000)

Applying a Maximin approach to this decision would result in room type A, which can accommodate up to 100attendees being contracted for, since it is the only room size that, if contracted for, would not result in a negativecontribution.

Applying a Minimax regret approach then the regret matrix would appear as follows:

Purchase100 200 300 400

Demand100 0 1,996,800 3,494,400 4,160,000200 1,331,200 0 1,497,600 2,163,200400 5,824,000 4,492,800 2,662,400 0Maximum regret 5,824,400 4,492,800 3,494,000 4,160,000

Therefore in order to minimise the maximum regret room type C, with a capacity to accommodate up to 300 attendeesshould be contracted for.

(iii) If attendance = 100 then management would opt for room size A which would produce a contribution of £832,000 x0·2 = £166,400.

If attendance = 200 then management would opt for room size B which would produce a contribution of £2,163,200x 0·5 = £1,081,600.

If attendance = 400 then management would opt for room size D which would produce a contribution of £6,656,000x 0·3 = £1,996,800.

Therefore the expected value of perfect information would be the sum of the expected values of the three possibleoutcomes which amounts to £3,244,800. Thus, if the information is correct then management should be willing to payup to £3,244,800 – £1,497,600 = £1,747,200 for the information. In practice, it is unlikely that perfect informationis obtainable. The management of Envico Ltd are really buying an information system that will provide them with a signalwhich may prove to be correct or incorrect! For example, the consultants may predict that demand will be for 300seminar places, however there still remains the fact that there is a likelihood of actual demand being for either 100,200 or 400 seminar places. One should be mindful that imperfect information which may be, say only 75% reliable,might still be worth obtaining. Other than when the value of imperfect and perfect information are equal to zero, thevalue of perfect information will always be greater than the value of imperfect information.

(c) The following are six separate and distinct assessment criteria (including those suggested by the managing director), thatwould enable the management of Envico Ltd to assess the ‘value for money’ of each seminar. The assessment criteria arepresented as questions that would comprise the contents of a questionnaire but other presentations would have been equallyacceptable.

(1) Did the course meet your objectives?

‘Value for money’ may, in part, be assessed by reference to the ‘effectiveness’ of the service provision. Effectiveness maybe viewed in this context as meeting the objectives of attendees. All attendees have similar but varying objectives andhence it is vital that Envico Ltd meets the objectives of all attendees if seminars are to constitute ‘value for money’.

(2) How would you rate the quality of the speakers?

A primary resource of Envico Ltd is its speakers and thus it is important to gauge how they were perceived to performby the attendees.

(3) How would you rate comfort, cleanliness and facilities of the seminar rooms?

Again, a principal resource, which is consumed when providing the service, is the seminar room and the facilitiescontained within it. Attendees will find a clean and ergonomically designed room more conducive for education andtraining activities.



(4) How would you assess the quality of the course materials?

Since Envico Ltd undertakes the provision of educational and training seminars then the quality of course materialsprovided assumes critical significance as they represent the ‘raison d’être’ of Envico Ltd. If they are perceived to be ofhigh quality they may act as a good advertisement for the company. Conversely, poor quality course materials will causeEnvico Ltd to be perceived poorly.

(5) How strongly would you recommend Envico courses to friends and colleagues?

This is a very important consideration since ‘word of mouth’ may represent the best means of advertising the servicesprovided by Envico Ltd and is indicative of whether attendees consider that they have received ‘value for money’ fromEnvico Ltd.

(6) Do you consider that you could have achieved your objectives in attending the course in a more expedient manner? Ifso, please detail below.

This question acknowledges that the time of attendees is a scarce resource and hence there may well be an opportunitycost in attending seminars in addition to the explicit costs such as course fees, travel and subsistence costs etc. It isessential that Envico Ltd is flexible in its approach to meeting the needs of clients where attendance at seminars is eitherimpracticable or undesirable. Perhaps a series of interactive CDs and/or video tuition may be more appropriate in certaininstances.

(d) Environmental management accounting (EMA) involves the generation and analysis of both financial and non-financialinformation in order to support internal environmental management processes. It is complementary to the conventionalmanagement accounting approach, with the aim to develop appropriate mechanisms that assist the management oforganisations in the identification and allocation of environmentally related costs.

Organisations that alter their management accounting practices to incorporate environmental concerns will have greaterawareness of the impact of environment-related activities on their profit and loss accounts and balance sheets. This is becauseconventional management accounting systems tend to attribute many environmental costs to general overhead accounts withthe result that they are ‘hidden’ from management. It follows that organisations which adopt EMA are more likely to identifyand take advantage of cost reduction and other improvement opportunities. A concern with environmental costs will alsoreduce the chances of employing incorrect pricing of products and services and taking the wrong options in terms of mix anddevelopment decisions. This in turn may lead to enhanced customer value whilst reducing the risk profile attaching toinvestments and other decisions which have long term consequences.

Reputational risk will also be reduced as a consequence of adopting (EMA) since management will be seen to be acting inan environmentally responsible manner. Organisations can learn from the Shell Oil Company whose experience in the muchpublicised Brent Spar incident cost the firm millions in terms of lost revenues as a result of a consumer boycott.

2 (a) Backflush accounting focuses upon output of an organisation and then works backwards when allocating costs between costof goods sold and inventories. It can be argued that backflush accounting simplifies costing since it ignores both labourvariances and work-in-progress. Whilst in a perfect just-in-time environment there would be no work-in-progress at all, therewill in practice be a small amount of work-in-progress in the system at any point in time. This amount, however, is likely tobe negligible in quantity and therefore not significant in terms of value. Thus, a backflush accounting system simplifies theaccounting records by avoiding the need to follow the movement of materials and work-in-progress through the manufacturingprocess within the organisation.

The backflush accounting system is likely to involve the maintenance of a raw materials and work-in–progress accounttogether with a finished goods account. The use of standard costs and variances is likely to be incorporated into theaccounting entries. Transfers from raw materials and work-in-progress account to finished goods (or cost of sales) will probablybe made at standard cost. The difference between the actual inputs and the standard charges from the raw materials andwork-in-progress account will be recorded as a residual variance, which will be recorded in the profit and loss account. Thus,it is essential that standard costs are a good surrogate for actual costs if large variances are to be avoided. Backflushaccounting is ideally suited to a just-in-time philosophy and is employed where the overall cycle time is relatively short andinventory levels are low. Naturally, management will still be eager to ascertain the cause of any variances that arise from theinefficient usage of materials, labour and overhead. However investigations are far more likely to be undertaken using non-financial performance indicators as opposed to detailed cost variances.



(b) Dr Cr£ £

1. Raw materials inventory a/c 5,575,000Creditors 5,575,000

2. Conversion costs 4,883,000Bank 1,735,000Creditors 3,148,000

3. Finished goods inventory 10,080,000Raw materials inventory a/c 5,460,000Conversion costs: – labour 1,722,000

– overheads 2,898,000

4. Cost of sales (206,000 x £48) 9,888,000Finished goods inventory 9,888,000

The ledger accounts in respect of the above transactions would be as follows:

Raw materials inventory

1. Creditors £5,575,000 3. Finished goods £5,460,000Balance c/fwd £115,000

––––––––––– –––––––––––£5,575,000 £5,575,000––––––––––– –––––––––––

Finished goods inventory

3. Raw materials £5,460,000 4. Cost of sales £9,888,000Conversion costs £4,620,000 Balance c/fwd £192,000

–––––––––––– ––––––––––––£10,080,000 £10,080,000–––––––––––– ––––––––––––

Conversion costs

2. Bank £1,735,000 3. Finished goods £4,620,000Creditors £3,148,000 Balance c/fwd £263,000

––––––––––– –––––––––––£4,883,000 £4,883,000––––––––––– –––––––––––

Cost of sales

4. Finished goods £9,888,000 To Profit and Loss a/c £9,888,000––––––––––– –––––––––––£9,888,000 £9,888,000––––––––––– –––––––––––

The inventory balances as at 30 November 2005 are:£

Raw materials account 115,000Finished goods account 192,000

––––––––307,000––––––––

The balance of £263,000 on the conversion costs account would be debited to the profit and loss account.

(c) In a ‘perfect’ just-in-time manufacturing system there would not have been any inventories of raw materials or finished goodsat the end of November 2005. The quantity of fuel pumps manufactured during November 2005 would have been 206,000which would be equal to the quantity sold during the period. The debit entry to the finished goods account in respect ofNovember 2005 would have been £9,888,000 and would match the cost of sales for the period. Since a lower volume offinished goods would be manufactured in a perfect just-in-time system one would expect that reductions would also occur inthe amount of raw materials purchased and conversion costs consumed.

3 (a) The management of an organisation need to exercise control at different levels within an organisation. These levels are oftencategorised as being strategic, tactical and operational. The information required by management at these levels varies innature and content.

Strategic informationStrategic information is required by the management of an organisation in order to enable management to take a longer termview of the business and assess how the business may perform during that period. The length of this longer term view willvary from one organisation to another, being very much dependent upon the nature of the business and the ability of thoseresponsible for strategic direction to be able to scan the planning horizon. Strategic information tends to be holistic and



summary in nature and would be used by management when, for example, undertaking SWOT analysis. In Moffat Ltdstrategic information might relate to the development of new services such as the provision of a home-based vehicle recoveryservice or the provision of twenty-four hour servicing. Other examples would relate to the threats posed by Moffat Ltd’scompetitors or assessing the potential acquisition of a tyre manufacturer in order to enhance customer value via improvedefficiency and lower costs.

Tactical informationTactical information is required in order to facilitate management planning and control for shorter time periods than strategicinformation. Such information relates to the tactics that management adopt in order to achieve a specific course of action. InMoffat Ltd this might involve the consideration of whether to open an additional outlet in another part of the country orwhether to employ additional supervisors at each outlet in order to improve the quality of service provision to its customers.

Operational informationOperational information relates to a very short time scale and is often used to determine immediate actions by thoseresponsible for day-to-day management. In Moffat Ltd, the manager at each location within Moffat Ltd would requireinformation relating to the level of customer sales, the number of vehicles serviced and the number of complaints receivedduring a week. Operational information might be used within Moffat Ltd in order to determine whether staff are required towork overtime due to an unanticipated increase in demand, or whether operatives require further training due to excessivetime being spent on servicing certain types of vehicle.

(b) One approach that the directors of Moffat Ltd could adopt would be to ignore the qualitative benefits that may arise on thebasis that there is too much subjectivity involved in their assessment. The problem that this causes is that the investment willprobably look unattractive since all costs will be included in the evaluation whereas significant benefits and savings will havebeen ignored. Hence such an approach is lacking in substance and is not recommended.

An alternative approach would involve attempting to attribute values to each of the identified benefits that are qualitative innature. Such an approach will necessitate the use of management estimates in order to derive the cash flows to beincorporated in a cost benefit analysis. The problems inherent in this approach include gaining consensus among interestedparties regarding the footing of the assumptions from which estimated cash flows have been derived. Furthermore, if theproposed investment does take place then it may well be impossible to prove that the claimed benefits of the new systemhave actually been realised.

Perhaps the preferred approach is to acknowledge the existence of qualitative benefits and attempt to assess them in areasonable manner acceptable to all parties including the company’s bank. The financial evaluation would then not onlyincorporate ‘hard’ facts relating to costs and benefits that are quantitative in nature, but also would include details ofqualitative benefits which management consider exist but have not attempted to assess in financial terms. Such benefits mightinclude, for example, the average time saved by location managers in analysing information during each operating period.

Alternatively the management of Moffat Ltd could attempt to express qualitative benefits in specific terms linked to a hierarchyof organisational requirements. For example, qualitative benefits could be categorised as being:

(1) Essential to the business(2) Very useful attributes(3) Desirable, but not essential(4) Possible, if funding is available(5) Doubtful and difficult to justify.

(c) One of the main qualitative benefits that may arise from an investment in a new IT system by Moffat Ltd is the improved levelof service to its customers in the form of reduced waiting times which may arise as a consequence of better scheduling ofappointments, inventory management etc. This could be assessed via the introduction of a questionnaire requiring customersto rate the service that they have received from their recent visit to a location within Moffat Ltd according to specific criteriasuch as adherence to appointment times, time taken to service the vehicle, cleanliness of the vehicle, attitude of staff etc.Alternatively a follow-up telephone call from a centralised customer services department may be made by Moffat Ltdpersonnel in order to gather such information.

Another qualitative benefit of the proposed investment may arise in the form of competitive advantage. Improvements incustomer specific information and service levels may give Moffat Ltd a competitive advantage. Likewise, improved inventorymanagement may enable costs to be reduced thereby enabling a ‘win-win’ relationship to be enjoyed with its customers.

4 (a) The following are some of the advantages that may be gained as a consequence of the adoption of a formal system of strategicplanning:

(1) Managers are forced to consider the future. Strategic planning can assist management to form a ‘vision’ of the futureand, in so doing, encourages creativity and the use of initiative on the part of those involved in the strategic planningprocess.

(2) The identification of risks which may have gone unnoticed in the absence of formal planning systems.

(3) A strategic plan focuses management attention on the need to give due consideration to an ever-changing environmentin which organisations can get left behind. A strategic plan highlights the need to anticipate change and assists inhelping an organisation to become more ‘adaptive’ thereby increasing its chances of longer term prosperity.



(4) Greater consistency will be achieved between long term, medium term and short term objectives, plans and controls.The plans should identify whether the business objectives are leading an organisation in the right direction or whetherorganisational objectives require re-assessment. It is vital that strategic and operational considerations are reflected insystems of performance measuremnent and budgetary control.

(5) Strategic planning should help to identify the opportunities for investment and the need for long term finance well inadvance of requirements.

(6) All markets have a cycle. Strategic planning should help to identify the need for and timing of the launching of newproducts.

(7) Strategic planning will entail the review of management resources. Management does not remain unaltered for decades.The strategic plan may identify the need for new or additional management expertise.

N.B. Only four reasons were required.

(b) The use of SWOT analysis will focus management attention on current strengths and weaknesses of each subsidiary companywhich will be of assistance in the formulating of the business strategy of Diverse Holdings Plc. It will also enable managementto monitor trends and developments in the constantly changing environments of their subsidiaries. Each trend or developmentmay be classified as an opportunity or a threat that will provide a stimulus for an appropriate management response.Management can make an assessment of the feasibility of required actions in order that the company may capitalise uponopportunities whilst considering how best to negate or minimise the effect of any threats.

A SWOT analysis should assist the management of Diverse Holdings Plc as they must identify their strengths, weaknesses,opportunities and threats. These may be classified as follows:

Strengths which appear to include both OFL and HTL.

Weaknesses which must include PSL and its limited outlets, which generate little growth and could collapse overnight. KALis also a weakness due to its declining profitability.

Opportunities where OFT, HTL and OPL are operating in growth markets.

Threats from which KAL is suffering.

If these four categories are identified and analysed then the group should be strengthened.

(c) (i) Organic Foods Ltd (OFL) with a market share of 6·66% is the market leader at 30 November 2005 and is forecast tohave a market share of 8% by 30 November 2007. Operating profits appear to be healthy and therefore it seemsreasonable to regard OFL as a current ‘strength’ of Diverse Holdings Plc. This is supported by the fact that OFL has builtup a very good reputation as a supplier of quality produce.

Haul Trans Ltd was acquired on 1 December 2005 and has a demonstrable record of recent profitability. It is noticeablethat the profitability of HTL is forecast to increase by 40% (excluding inflation) during its first two years of ownership.No one organisation appears to dominate the market. Forecast profits are expected to grow significantly from an almoststatic turnover and thus more information is required regarding how this increase in profitability is to be achieved.Management may have identified opportunities for achieving significant cost savings and/or forming businessrelationships with new and more profitable customers, while ceasing to service those customers who are less profitable.

Kitchen Appliances Ltd (KAL) has been identified as both a weakness and threat. KAL’s market is slowly contracting,but its share is falling more quickly. It was almost the market leader at 30 November 2005. Judging by its fall in thelevel of operating profit KAL is carrying heavy fixed costs which must make it more difficult to compete. Indeed, it isforecast to make a loss during the year ending 30 November 2007. KAL has suffered from squeezed margins as aconsequence of competition from low cost imports. The situation may be further exacerbated as competition from abroadintensifies.

Paper Supplies Ltd (PSL) has stood still in a growing market, one which is dominated by a single supplier. PSL appearsto be struggling to achieve any growth in turnover, profits and therefore cash flow. PSL cannot really compete with anarrow range of products and only two customers.

Office Products Ltd (OPL) is growing but appears unable to increase its operating profit in % terms. It appears to beoperating in a high-growth market but unable to achieve a reasonable market share in spite of the fact that its productsare highly regarded by health and safety experts.

(ii) The forecast situation of Diverse Holdings Plc is not without its problems. KAL and OPL require the immediate attentionof management. The position of KAL is precarious to say the least. There is a choice of strategies for it:

(i) Outsource the manufacture of appliances(ii) Set up a manufacturing operation overseas(ii) Withdraw from the market.

Each alternative must be assessed. Whatever decision is taken it is unlikely to affect the other four subsidiaries.

PSL is also independent of the other subsidiaries. A strategic decision to widen its range of products and outlets mustsurely help. Hence management should endeavour to find new markets for its products, which are separate and distinctfrom those markets served by its appointed distributors.



In order to improve the prospects of OPL management need to adopt appropriate strategies since at the present time thecompany appears to be in a high growth market but is unable to capture a reasonable market share. Perhaps the answerlies in increased or more effective advertising of the endorsement of the product range by health and safety experts.

Management should endeavour to develop a strategy to integrate further its subsidiaries so that they can benefit fromeach other and also derive as much synergy as possible from the acquisition of HTL.

It is of paramount importance that management ensure that sufficient funds are channelled into growing OFL and HTL,which are both showing a rising trend in profitability. The group has depleted cash reserves which must to some extentbe attributable to the purchase of HTL. It is possible that the divestment of KAL would provide some much neededfunding.

5 (a) Candidates may choose FOUR problems with performance measures from those listed below:

Tunnel vision may be seen as undue focus on performance measures to the detriment of other areas. For example ‘There isno point whatsoever in encouraging staff to focus on interaction with customers in efforts to create a ‘user friendly’environment. What we need is to maintain the quality of our grass surfaces at all costs since that is the distinguishing featureof our business.’

Sub-optimisation may occur where undue focus on some objectives will leave others not achieved. For example, ‘We shouldfocus our attention upon maximising the opening hours of our facilities. Everything else will take care of itself.’ This strategyignores the importance of a number of other issues, such as the possible need to increase the availability of horse-riding andbowling equipment for hire.

Misinterpretation involves failure to recognise the complexity of the environment in which the organisation operates.Management views have focused on a number of performance measures such as ‘spend the money on increased advertisingof our facilities which will surely attract more customers.’ This fails to recognise the more complex problems that exist. Thetown is suffering from high unemployment which may cause population drift and economic decline. This will negate manyof the initiatives that are being suggested by management. This may to some extent be offset by the good transport links tothe ‘365 sports complex’.

Myopia refers to short-sightedness leading to the neglect of longer-term objectives. An example would be ‘We should reducethe buildings maintenance budget by 25% and spend the money on increased advertising of our facilities which will surelyattract more customers.’

Measure fixation implies behaviour and activities in order to achieve specific performance indicators which may not beeffective. For example, ‘Buy more equipment which can be hired out to users of our facilities. This will improve our utilisationratios which will lead to increased profits.’ Problems of unemployment and lack of complaints from customers may mean thatmore equipment will not improve profit levels.

Misrepresentation refers to the tendency to indulge in ‘creative’ reporting in order to suggest that a performance measureresult is acceptable. For example ‘Recent analysis of customer feedback forms indicate that most of our customers are satisfiedwith the facilities. In fact, the only complaints are from three customers – the LCA University who use the cricket pitch formatches, the National Youth Training Academy who hold training sessions on the tennis courts, and a local bowling team.’This ignores the likely size of capacity share occupied by these three customers. In this regard it should be acknowledgedthat complaints represent a significant threat to the business since ‘bad news often travels fast’ and other customers may then‘vote with their feet’.

Gaming is where there is a deliberate distortion of the measure in order to secure some strategic advantage. This may involvedeliberately under performing in order to achieve some objective. For example, ‘We should hold back on our efforts toovercome the shortage of bowling equipment for hire. Recent rumours are that the National Bowling Association are likely tooffer large financial grants next year to sports complexes who can show they have a demand for the sport but have deficienciesin availability of equipment.’

Ossification which by definition means ‘a hardening’ refers to an unwillingness to change the performance measure schemeonce it has been set up. An example could be ‘Why change our performance management system? Our current areas of focusprovide us with all the information that we need to ensure that we remain a profitable and effective business.’ This ignoresissues/problems raised in the other comments provided in the question.

(b) Trying to focus on and improve the measurement of customer satisfaction.This is a vital goal. Without monitoring and improvement of levels of customer satisfaction, an organisation will tend tounderachieve and is likely to have problems with its future effectiveness. Positive signals from performance measures madeearlier in the value chain are only relevant if they contribute to the ultimate requirement of customer satisfaction. Tunnel visionand sub-optimisation are examples of measurement problems that may be reduced through recognition of the need for amanagement focus on customer satisfaction. For example undue focus on the importance of maximising opening hours maylead to lack of focus on other quality issues seen as important by customers.

Involving staff at all levels in the development and implementation of performance measures.People are involved in the achievement of performance measures at all levels and in all aspects of an organisation. It isimportant that all staff are willing to accept and work towards any performance measures that are developed to monitor theirpart in the operation of the organisation and in the achievement of its objectives. This should help, for example, to reduce



gaming. At the sports complex an example of gaming might be, a deliberate attempt to understate the potential benefits ofmaintaining the buildings in order to ensure that funds would be used for other purposes such as an increased advertisingbudget. The directors of Astrodome Sports Ltd must recognise that leisure facilities that appear dated and in a poor state ofrepair will cause customers to look for more aesthetically appealing alternatives.

Being flexible in the extent to which formal performance measures are relied on.It is best to acknowledge that measures should not be relied on exclusively for control. A performance measure may give ashort-term signal that does not relate directly to actions that are taking place to improve the level of performance in the longerterm. To some extent, improved performance may be achieved through the informal interaction between individuals andgroups. This flexibility should help to reduce measure fixation and misrepresentation. For example the percentage increase inthe quantity of bowling equipment purchased is seen as necessarily implying increased demand for use of the bowling greens.

Giving consideration to the audit of the performance measurement system.Actions that may be taken may include:– Seeking expert interpretation of the performance measures in place. It is important that any audit is ‘free from bias’ and

conducted independently on an ‘arm’s length’ basis. Thus it is essential that such audits should be ‘free from theinfluence’ of those personnel involved in the operation of the system.

– Maintaining a careful audit of the data used. Any assessment scheme is only as good as the data on which it is foundedand how this data is analysed and interpreted.

The above actions should help, in particular, to reduce the incidence and impact of measure fixation, misinterpretation andgaming.For example, an audit may show that the directors of Astrodome Sports Ltd are fixated on equipment availability andmisinterpret this as being the key to customer volume and high profitability. The audit may also provide evidence of gamingsuch as a deliberate attempt to underplay the benefits of one course of action in order to release funds for use on somealternative.




Marks Marks1 (a) (i) Fees 1

Subsidies 1Salaries 0·5Variable costs 0·5Other fixed costs (ABC related) 6Attributable 0·5Profit/(loss) 0·5 10

(ii) Profit/(loss) 2Comments (on merit) 3 5

(b) (i) Contribution 3Expected values 3Pay-off table 2Recommendation 1 9

(ii) Maximin – principle 1Recommendation 1Minimax – regret table 3Recommendation 1 6

(iii) Calculation 3Comments (on merit) 2 5

(c) Criteria 6 x 1 6

(d) Explanation 2Benefits 2 4

–––Total 45

2 (a) Explanation 3Circumstances 3 x 1 6

(b) T accounts Ledger accounts 4Inventory values 1Conversion costs balance w/off 1 6

(c) Manufacturing and sales quantities differ 1Zero inventories 1Accounting entries 1 3

–––Total 15

3 (a) Strategic 4Tactical 3Operational 3 10

(b) Comments (on merit) 3 x 2 6

(c) Qualitative benefits 2 x 2 4–––

Total 20

4 (a) Advantages 4 x 1 4

(b) Usefulness 3 x 1 3

(c) (i) Comments (on merit) 7 x 1 7

(ii) Strategies 3 x 2 6–––

Total 20



Marks Marks5 (a) Problem explanation and illustrative comment 4 x 3 12

(b) Comments (on merit) 4 x 2 8–––

Total 20–––




PART 3

FRIDAY 9 JUNE 2006

QUESTION PAPER









Pape

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1 The Great Western Cake Company (GWCC) is a well-established manufacturer of specialist flour confectioneryproducts, including cakes. GWCC sells its products to national supermarket chains. The company’s success duringrecent years is largely attributable to its ability to develop innovative products which appeal to the food selectors withinnational supermarket chains.

The marketing department of Superstores plc, a national supermarket chain has asked GWCC to manufacture a cakeknown as the ‘Mighty Ben’. Mighty Ben is a character who has recently appeared in a film which was broadcastaround the world. The cake is expected to have a minimum market life of one year although the marketing departmentconsider that this might extend to eighteen months.

The management accountant of GWCC has collated the following estimated information in respect of the Mighty Bencake:

(1) Superstores plc has decided on a launch price of £20·25 for the Mighty Ben cake and it is expected that thisprice will be maintained for the duration of the product’s life. Superstores plc will apply a 35% mark-up on thepurchase price of each cake from GWCC.

(2) Sales of the Mighty Ben cake are expected to be 100,000 units per month during the first twelve months.Thereafter sales of the Mighty Ben cake are expected to decrease by 10,000 units in each subsequent month.

(3) Due to the relatively short shelf-life of the Mighty Ben cake, management has decided to manufacture the cakeson a ‘just-in-time’ basis for delivery in accordance with agreed schedules. The cakes will be manufactured inbatches of 1,000. Direct materials input into the baking process will cost £7,000 per batch for each of the firstthree months’ production. The material cost of the next three months’ production is expected to be 95% of thecost of the first three months’ production. All batches manufactured thereafter will cost 90% of the cost of thesecond three months’ production.

(4) Packaging costs will amount to £0·75 per cake. The original costs of the artwork and design of the packagingwill amount to £24,000. Superstores plc will reimburse GWCC £8,000 in the event that the product iswithdrawn from sale after twelve months.

(5) The design of the Mighty Ben cake is such that it is required to be hand-finished. A 75% learning curve willapply to the total labour time requirement until the end of month five. Thereafter a steady state will apply withlabour time required per batch stabilising at that of the final batch in month five. The labour requirement for thefirst batch of Mighty Ben cakes to be manufactured is expected to be 6,000 hours at £10 per hour.

(6) A royalty of 5% of sales revenue (subject to a maximum royalty of £1·1 million) will be payable by GWCC to theowners of the Mighty Ben copyright.

(7) Variable overheads are estimated at £3·50 per direct labour hour.

(8) The manufacture of the Mighty Ben cake will increase fixed overheads by £75,000 per month.

(9) In order to provide a production facility dedicated to the Mighty Ben cake, an investment of £1,900,000 will berequired and this will be fully depreciated over twelve months.

(10)The directors of GWCC require an average annual return of 35% on their investment over 12 months and 18 months.

(11) Ignore taxation and the present value of cash flows.

Note: Learning curve formula:y = axb

where y = average cost per batcha = the cost of the initial batchx = the total number of batchesb = learning index (= –0·415 for 75% learning rate)

2



Required:

(a) Prepare detailed calculations to show whether the manufacture of Mighty Ben cakes will provide the requiredrate of return for GWCC over periods of twelve months and eighteen months. (20 marks)

(b) (i) Advise the directors of GWCC on specific actions which may be considered in order to improve theestimated return on their investment of £1,900,000. (8 marks)

(ii) Briefly discuss TWO factors which could reduce the rate of return earned by the investment as per theresults in part (a). (4 marks)

(c) Explain the term ‘target costing’ and how it may be applied by GWCC. Briefly discuss any potentiallimitations in its application. (8 marks)

(40 marks)

3 [P.T.O.



2 (a) The following diagram illustrates a ‘Performance Pyramid’ view of performance management.

‘The Performance Pyramid’

Required:

Explain the proposition that business may be viewed as a ‘performance pyramid’. (5 marks)

(b) ‘EAJ’, which commenced trading on 1 June 2003, is a business services group whose consultants implementthree types of application software packages designed to meet the accounting, distribution and manufacturingrequirements of its clients. Each consultant specialises in the implementation of one type of application softwarei.e. accounting, distribution or manufacturing. EAJ does not sell application software packages. EAJ implementsapplication software packages but clients are responsible for purchasing the packages.

The following information relates to the year ended 31 May 2006.

(1) Each consultation, other than those detailed in notes (4) and (5), is charged at a rate of £700 per day fornew clients and £550 per day for existing clients. Consultants are budgeted to work for 240 days per year.

(2) The consultants are each paid a fixed annual salary of £50,000. In addition they receive a bonus of 40%of the net value of the fee income generated in excess of budget minus the revenue foregone as aconsequence of undertaking remedial consultations (per notes 5 and 8) based on a ‘notional’ rate of £700per consultant day. The bonus is shared equally among the consultants employed by EAJ on 31 May in theyear to which the bonus relates.

(3) Other operating expenses (excluding the salaries of the consultants) were budgeted at £3,600,000. Theactual amount incurred was £4,500,000.

(4) In an attempt to gain new business, consultants may undertake consultations on a ‘no-fee’ basis. Suchconsultations are regarded as business development activity by the management of EAJ. Each of theseconsultations is budgeted to take one consultant day.

(5) Consultants will sometimes undertake remedial consultations with new clients who experience problemswith regard to implementation. Remedial consultations are also provided on a non-chargeable, i.e. ‘no fee’basis. Each of these consultations requires two consultant days.

(6) Since its formation EAJ has had a policy of maintaining staff at a level of 100 consultants on an ongoingbasis, irrespective of fluctuations in the level of demand.

4

The Vision

Market satisfaction Financial measures

Customer satisfaction Flexibility Productivity

Quality Delivery Process time Waste

Operations

External effectiveness Internal effectiveness



(7) EAJ has a help desk which provides support to its client base.

(8) Sundry statistics for the year ended 31 May 2006 together with other statistics for the previous two yearsare as follows:

Budget ActualNumber of consultants by category:Accounting 40 40Distribution 30 25Manufacturing 30 35

Total client enquiries (in days):New clients 12,000 15,000Existing clients 25,200 24,500

Number of chargeable client days: New clients 4,200 4,500Existing clients 12,600 14,700

Mix of chargeable client days:Accounting 6,720 8,480Distribution 5,040 4,000Manufacturing 5,040 6,720

Other statistics (all stated on an ACTUAL basis) relating to the years ended 31 May 2004–2006 are asfollows:

2004 2005 2006Number of clients 320 500 700Number of client complaints: 160 225 280Number of on-time implementations (%) 92% 96% 99%Implementation time per application (days) 3·0·5 2·5·5 2·0·0Number of accounts in dispute 20 15 10% of support desk calls resolved 85% 95% 99%Chargeable client days 16,800 18,000 19,200Number of business development consultations 100 200 300Number of remedial consultations (New clients) 310 380 450Turnover (£000) 4,000 7,500 ?Net profit (£000) 600 900 ?

Required:

Using the above information, analyse and discuss the performance of EAJ for the year ended 31 May 2006under the following headings:

(i) Financial performance and competitiveness;

(ii) External effectiveness;

(iii) Internal efficiency. (15 marks)

(20 marks)

5 [P.T.O.



Section B – TWO question ONLY to be attempted

3 The Specialist Clothing Company Ltd (SCC Ltd) is a manufacturer of a wide range of clothing. Its operations areorganised into five divisions which are as follows:

(i) Fashion (ii) Industrial (iii) Leisure(iv) Children(v) Footwear

The Fashion division manufactures a narrow range of high quality clothing which is sold to a leading retail store whichhas branches in every major city in its country of operation. The products have very short life cycles.

The Industrial division manufactures a wide range of clothing which has been designed for use in industrialenvironments. In an attempt to increase sales volumes, SCC Ltd introduced the sale of these products via mail orderwith effect from 1 June 2005.

The Leisure division manufactures a narrow range of clothing designed for outdoor pursuits such as mountaineeringand sky diving, which it markets under its own, well-established ‘Elite’ brand label.

The Children division manufactures a range of school and casual wear which is sold to leading retail stores.

The Footwear division manufactures a narrow range of footwear.

The management accountant of SCC Ltd has gathered the following actual and forecast information relating to the fivedivisions:

Year ending 31 May 2004 2005 2006 2007 2008Actual Actual Actual Forecast Forecast

FashionMarket size (£m) 200·0 240·0 280·0 305·0 350·0Turnover (£m) 110·0 114·4 122·4 130·5 135·0

IndustrialMarket size (£m) 150·0 158·0 166·0 174·0 182·0Turnover (£m) 115·0 115·1 115·2 115·3 115·4

LeisureMarket size (£m) 120·0 120·5 121·0 121·5 121·8Turnover (£m) 113·6 114·2 114·7 115·0 115·2

ChildrenMarket size (£m) 160·0 170·0 180·0 190·0 100·0Turnover (£m) 112·0 112·1 112·2 112·3 112·4

FootwearMarket size (£m) 120·0 120·2 120·4 120·6 121·0Turnover (£m) 1110·50 1110·52 1110·54 1110·52 1110·50

The management accountant has also collated the following information relating to the market share held at 31 May 2006 by the market leader or nearest competitor in the markets in which each division operates:

Division (%) Market share held by market leader/nearest competitor

Fashion 18Industrial 15Leisure 70Children 28Footwear 33

6



Required:

(a) Use the Boston Consulting Group matrix in order to assess the competitive position of SCC Ltd. (10 marks)

(b) Advise the management of SCC Ltd of THREE strategies that should be considered in order to improve thefuture performance of SCC Ltd. (6 marks)

(c) Discuss TWO limitations of the Boston Consulting Group matrix as a strategic planning tool. (4 marks)

(20 marks)

4 Stay Cool Ltd provides refrigerated storage facilities for major food producers. The directors are currently evaluatingtwo quotations from alternative suppliers in respect of the replacement of the refrigeration system at one of theirdepots. The following information is available in respect of each quotation:

(1) Refrigeration system: Supplier NN Ltd KK LtdSystem ‘Steadychill’ ‘Technofreeze’Anticipated working life (years) 4 6Initial investment (£) 440,000 690,000Residual value (£) 0 0Working capital requirement (£) 120,000 120,000

(2) The forecast pre-tax net cash inflows (excluding maintenance costs) associated with each refrigeration system areas follows:

Years ahead1 2 3 4 5 6

£000 £000 £000 £000 £000 £000‘Steadychill’ 440 500 460 420‘Technofreeze’ 500 540 600 600 450 350

(3) Maintenance costs for the ‘Steadychill’ system are estimated at £50,000 for each year of the system’s lifewhereas maintenance costs for the ‘Technofreeze’ system are estimated to be £50,000 in year 1 and thereafterto increase by £10,000 in each subsequent year of its life.

(4) KK Ltd has recently entered the market for the storage of refrigerated foods and has received favourable publicityfrom trade journals regarding their technically complex refrigeration systems, of which the ‘Technofreeze’ systemis a ‘prototype’. Due to the fact that KK Ltd has relatively untried refrigeration systems, the finance director of StayCool Ltd has suggested that an appropriate discount rate for the ‘Technofreeze’ system is 12% per annum, whichis 2% higher than his estimate of the appropriate discount rate for the “Steadychill” system.

(5) Taxation at 30% is payable one year in arrears, and capital allowances are available at a rate of 25% on areducing balance basis.

(6) Ignore inflation.

Required:

(a) (i) Calculate the net present value and payback period for each of the refrigeration systems. (12 marks)

(ii) Recommend which of the refrigeration systems should be purchased. You should state your reasonswhich must be supported by relevant calculations. (3 marks)

(b) (i) State FOUR reasons why payback period is widely used by organisations in the capital investmentappraisal process. (2 marks)

(ii) Briefly explain the extent to which the application of sensitivity analysis might be useful in decidingwhich refrigeration system to purchase and discuss the limitations inherent in its use. (3 marks)

(20 marks)

7 [P.T.O.



5 You are the Senior Management Accountant of Better Gardens Ltd (BGL), a well-established manufacturer of a rangeof conservatories, summerhouses and large garden ornaments. The company’s turnover and after-tax profits for theyear ending 31 May 2007 are forecast to be £100 million and £20 million respectively. The company has 350employees in total who are comprised as follows:

Function/level: Number of employeesDirectors/ Senior managers 20Sales staff 40Assembly staff 250Administrative & support staff 40

BGL’s products are sold to specialist ‘Garden Centres’ by its sales staff, each of whom is home-based. The forty salesstaff work from home and are supported by administrative and support staff who also undertake telephone-basedselling activities.

The manufacture of conservatories and summer-houses is undertaken by 210 assembly staff, some of whom work inteams and others who work on an individual basis.

The large garden ornaments, each of which is hand-finished, are produced by 40 assembly staff who are responsiblefor their individual output.

The directors of BGL are considering whether to implement a reward scheme for all employees within the organisation.They have approached you for advice with regard to this matter. The production director recently stated ‘if weimplement a reward scheme then it is bound to be beneficial for BGL’.

Required:

(a) As Senior Management Accountant, prepare a memorandum to the directors of BGL which explains:

(i) the potential benefits to be gained from the implementation of a reward scheme; (6 marks)

(ii) the factors that should be considered in the design of a reward scheme for BGL; (7 marks)

(iii) whether you agree or not with the statement of the production director. (3 marks)

(b) Briefly discuss how stakeholder groups (other than management and employees) may be rewarded for ‘good’performance. (4 marks)

(20 marks)

8



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13

Part 3 Examination – Paper 3.3 June 2006 AnswersPerformance Management

1 (a) 12 months 18 monthsSales units (Working 1) 1,200,000 1,590,000

£ £Sales revenue (Working 1) 18,000,000 23,850,000

––––––––––– –––––––––––Costs:Direct Materials (Working 2) 7,686,000 10,020,150Packaging (Working 3) 916,000 1,216,500Direct Labour (Working 4) 4,140,155 5,179,115Royalties (Working 5) 900,000 1,100,000Variable overheads (Working 6) 1,449,054 1,812,690Fixed overheads 900,000 1,350,000

––––––––––– –––––––––––Total costs 15,991,209 20,678,455

––––––––––– –––––––––––Profit 2,008,791 3,171,545Less:Cost of investment 1,900,000 1,900,000Projected return: 108,791 1,271,545Average annual projected return 108,791 847,697

(2/3)Average annual rate of return 5·73% 44·62%

Required average annual rate of return: 35% 35%

The required average annual rate of return (35%) will be achieved over an eighteen month period (projected = 44·62%) butwill not be achieved in the event that the product is withdrawn from the market after a period of twelve months (projected =5·73%).

Workings:(1) Sales units are 100,000 units per month for months 1–12 inclusive. Thereafter sales units fall by 10,000 each month.

Thus sales units in months 13–18 are as follows:Month No. Sales (units) 12 months 18 months

13 90,00014 80,00015 70,00016 60,00017 50,00018 40,000

––––––––Total months (13–18) 390,000 1,200,000 1,590,000

––––––––Selling price per cake =

£20·25 x (100/135) £15 £15–––– ––––

Sales revenue= £18,000,000 £23,850,000

(2) Direct materials:Months Batches £’s1–3 300 x 7,000 2,100,0004–6 300 x 6,650 1,995,0007–12 600 x 5,985 3,591,000

––––––––––Cost for 12 months 7,686,00013–18 390 x 5,985 2,334,150

–––––––––––Cost for 18 months 10,020,150

–––––––––––



14

(3) Packaging costs:Months 1–12

£Unit costs = £0·75 x 1,200,000 = 900,000Design and artwork costs: £24,000 less refund of £8,000 = 16,000

–––––––––916,000

––––––––– Months 1–18

£Unit costs = £0·75 x 1,590,000 = 1,192,500Design and artwork costs = 24,000

–––––––––– 1,216,500––––––––––

(4) Direct Labour:For months (1–5 inclusive) y = axb

y = 60,000 x 500–0·415

y = £4,550·71Therefore the total cost = £4,550·71 x 500 =£2,275,355

All batches after the first 500 batches will have the labour cost of the 500th batch.For 499 batches y = axb

y = 60,000 x 499–0·415

y = £4,554·49Therefore the total cost =£4,554·49 x 499 = £2,272,691

The cost of the 500th batch is £2,275,355 – £2,272,691 = £2,664

The total cost for 12 months is £2,275,355 + (700 x £2,664) = £4,140,155The total cost for 18 months is £4,140,155 + (390 x £2,664) = £5,179,115

(5) RoyaltiesMonths 1–12: 5% x £18,000,000 = £900,000Months 1–18: 5% x £23,850,000 = £1,192,500 (subject to a maximum of £1,100,000).

(6) Variable overheads amount to £3·50 per hour i.e. 35% of direct labour.

(b) (i) The directors of GWCC might consider any of the following specific actions in order to improve the return on theinvestment:– Attempt to raise the selling price of the Mighty Ben cake to Superstores plc. Much will depend on the nature of the

relationship in terms of mutuality of trust and co-operation between the parties. If Superstores plc are insistent ona launch price of £20·25 and a mark-up of 35% on its purchase price from GWCC then this is likely to beunsuccessful.

– Attempt to reduce the material losses in the first 600 batches of production via improved process control.– Attempt to negotiate a retrospective rebate based on volumes of packaging purchased.– Improve the rate of learning of the hand-skilled cake decorators via a more intensive training programme and/or

altering the flow of production.– Undertake a thorough review of all variable overheads which have been absorbed on the basis of direct labour

hours. It might well be the case that labour is not the only ‘cost driver’ in which case variable overheads might beoverstated.

– Undertake a thorough review of all fixed overheads to ensure that they are specific to the production of the MightyBen cake.

– Adopt a ‘value engineering’ approach in order to identify ‘non value added’ features/aspects of the product orprocesses used to produce it. This would have to be done in conjunction with Superstores plc, but might end in a‘win-win’ scenario.

– Ensure that all overhead expenditure will be incurred in the most ‘economic’ manner.

(ii) Two factors which might reduce the return earned by the investment are as follows:

(i) Poor product qualityThe very nature of the product requires that it is of the highest quality i.e. the cakes are made for humanconsumption. Bad publicity via a ‘product recall’ could potentially have a catastrophic effect on the total sales toSuperstores plc over the eighteen month period.

(ii) The popularity of the Mighty Ben characterThere is always the risk that the popularity of the character upon which the product is based will diminish with aresultant impact on sales volumes achieved. In this regard it would be advisable to attempt to negotiate withSuperstores plc in order to minimise potential future losses.



15

(c) Target costing should be viewed as an integral part of a strategic profit management system. The initial consideration in targetcosting is the determination of an estimate of the selling price for a new product which will enable a firm to capture its requiredshare of the market. In this particular example, Superstores plc, which on the face of it looks a powerful commercialorganisation, wishes to apply a 35% mark-up on the purchase price of each cake from GWCC. Since Superstores plc hasalready decided on a launch price of £20·25 then it follows that the maximum selling price that can be charged by GWCCis (100/135) x £20·25 which is £15·00.

This is clearly a situation which lends itself to the application of target costing/pricing techniques as in essence GWCC cansee the extent to which they fall short of the required level of return with regard to a contract with Superstores plc which endsafter twelve months. Thus it is necessary to reduce the total costs by £556,029 to this figure in order to achieve the desiredlevel of profit, having regard to the rate of return required on new capital investment. The deduction of required profit fromthe proposed selling price will produce a target price that must be met in order to ensure that the desired rate of return isobtained. Thus the main theme that underpins target costing can be seen to be ‘what should a product cost in order to achievethe desired level of return’.

Target costing will necessitate comparison of current estimated cost levels against the target level which must be achieved ifthe desired levels of profitability, and hence return on investment, are to be achieved. Thus where a gap exists between thecurrent estimated cost levels and the target cost, it is essential that this gap be closed.

The Directors of GWCC plc should be aware of the fact that it is far easier to ‘design out’ cost during the pre-production phasethan to ‘control out’ cost during the production phase. Thus cost reduction at this stage of a product’s life cycle is of criticalsignificance to business success.

A number of techniques may be employed in order to help in the achievement and maintenance of the desired level of targetcost. Attention should be focussed upon the identification of value added and non-value added activities with the aim of theelimination of the latter. The product should be developed in an atmosphere of ‘continuous improvement’. In this regard, totalquality techniques such as the use of Quality circles may be used in attempting to find ways of achieving reductions in productcost.

Value engineering techniques can be used to evaluate necessary product features such as the quality of materials used. It isessential that a collaborative approach is taken by the management of GWCC and that all interested parties such as suppliersand customers are closely involved in order to engineer product enhancements at reduced cost.

The degree of success that will be achieved by GWCC via the application of target costing principles will be very muchdependent on the extent of ‘flexibility’ in variable costs. Also the accuracy of information gathered by GWCC will assumecritical importance because the use of inaccurate information will produce calculated ‘cost gaps’ which are meaningless andrender the application of target costing principles of little value.

2 (a) Many writers including Lynch and Cross suggest a number of measures that go beyond traditional financial measures suchas profitability, cash flow and return on capital employed. The measures that they propose relate to business operatingsystems, and they address the driving forces that guide the strategic objectives of the organisation. Lynch and Cross suggestthat customer satisfaction, flexibility and productivity are the driving forces upon which company objectives are based. Theysuggest that the status of these driving forces can be monitored by various indicators which can be derived from lower level(departmental) measures of waste, delivery, quality and cycle time. The Performance Pyramid derives from the idea that anorganisation operates at different levels each of which has a different focus. However, it is vital that these different levelssupport each other. Thus the pyramid links the business strategy with day to day operations.

The Performance Pyramid – ‘Measure up – the essential guide to measuring business performance’,Lynch and Cross (1991).

The Vision

Market satisfaction Financial measures

Customer satisfaction Flexibility Productivity

Quality Delivery Process time Waste

Operations

External effectiveness Internal effectiveness

Business operating system

Departments

SBU’s

Corporate vision

9 dimensionsof pyramid



(b) (i)EAJ

Financial performance and Competitiveness

Summary Profit and Loss Account for the year ended 31 May 2006

Budget Actual£’000s £’000s

Fee income:New 2,940 3,150Existing 6,930 8,085

––––––– –––––––9,870 11,235

Costs:Consultants salaries 5,000 5,000Bonus 294Other operating costs 3,600 4,500

––––––– –––––––Total costs 8,600 9,794

––––––– –––––––Net profit 1,270 1,441

––––––– –––––––

It is clear that EAJ performed well during the year ended 31 May 2006. Fee income was 13·8% above budget, in spiteof the fact that other operating costs were 25% higher than budget. The management of EAJ should investigate whatcaused this significant overspend and therefore it would be extremely useful to have a more detailed breakdown of otheroperating costs. Consultants earned an aggregate bonus of ((£11,235,000 – £9,870,000) – (450 x 2 x £700)) x 40%= £294,000 in respect of activity above budgeted levels. Actual net profit was £1,441,000 against a budgeted netprofit of £1,270,000. In spite of the overspend on other operating costs EAJ is achieving rapid growth in levels of netprofit. In 2005 (its second year of trading) net profit was 50% higher than in its first year. In 2006 net profit hasincreased by 60·1% over 2005 net profit.

EAJ could measure its competitiveness in terms of sales growth and the relative success in obtaining business fromenquiries made by customers. In assessing sales growth it needs to be borne in mind that this is the ‘start-up’ phase ofEAJ. However, EAJ increased sales revenue from £4,000,000 in its first year to £11,235,000 in its third year ofoperation, which is very impressive. EAJ’s success in obtaining business from enquiries made by customers for the yearended 31 May 2006 is shown in the following table.

Conversion rate from enquiries: Budget ActualNew clients 35·0% 30·0%Repeat clients 50·0% 60·0%

60% of enquiries from existing clients resulted in additional chargeable consultancy days for EAJ. This may well indicatethat EAJ is starting to build customer loyalty despite the fact that the organisation has only been in existence for threeyears. With regard to enquiries from potential ‘first time’ clients, EAJ achieved a conversion ratio of 30·0%, against abudgeted conversion ratio of 35% that was budgeted. However, in absolute terms new business was approximately7·1% above budget whilst existing business was 16·7% above budget.

As regards the nature of the chargeable activities undertaken by the consultants it can be seen that Distribution softwareimplementation was 20·6% below budget, whereas Accounting and Manufacturing implementations were 26·2% and33·3% respectively above budget.

EAJ provided 300 consultations on a no-fee basis with a view to gaining new business. Also, during the year EAJconsultants provided non-chargeable ‘remedial’ consultations. Both of these non-chargeable activities might be viewedas initiatives aimed at increasing future levels of competitiveness. However, each remedial consultation could be viewedas inefficiency.

16



(ii) External effectivenessIn order to achieve ‘external effectiveness’ EAJ has to satisfy its customers. Customer satisfaction may be defined asmeeting customer expectations. The quality of service provision and delivery are operational criteria that can be used tomonitor levels of customer satisfaction. To some extent the increase in the number of complaints and non-chargeableconsultations associated with the remedying of those complaints is indicative of a quality problem that must beaddressed. This problem needs to be investigated. In particular the number of chargeable days for implementation ofdistribution applications is significantly below budget and it might well be the case that poor service ‘delivery’ is givingrise to the need for remedial consultations.

Assuming consultants could otherwise have undertaken chargeable work at a rate of £700 per day, revenue amountingto £630,000 was lost as a consequence of having to undertake remedial consultations. It would appear that EAJ doesnot budget for complaints. A summary of client complaints received by EAJ is shown in the following table:

Year ended 31 May 2004 2005 2006Number of complaints 160 225 280Number of clients 320 500 700Complaint: client ratio (%) 50% 45% 40%

Whilst it can be seen that the complaint:client ratio is improving, it should be recognised that this may be due to thefact that the size of the client base is increasing very rapidly. Such a trend might be expected during the first few yearsof operation, especially in a business such as EAJ.

The harsh fact is that the number of complaints is increasing in absolute terms. In order to be able to better assesscustomer satisfaction, complaints need to be analysed since the nature of complaints may well be of far more relevancethan the number of complaints!

The number of customer support desk queries resolved is improving; i.e. 2004 (85%); 2005 (95%) and 2006 (99%).This will further enhance the level of customer satisfaction. The fact that the number of accounts in dispute is fallingwhilst the number of clients is increasing significantly on a year-on-year basis may also be an indication of improvedcustomer satisfaction. The increase in the number of new customers and the increased revenues generated per customerare probably indicators of increasing levels of customer satisfaction.

(iii) Internal efficiencyInternal efficiency may be assessed by reference to flexibility and productivity. Flexibility relates to the business operatingsystem as a whole whilst productivity relates to the management of resources such as, in the case of EAJ, consultantstime.

Flexibility might be substantiated by looking at the mix of work undertaken by the consultants during the year. Thefollowing table gives a comparison of actual and budgeted consultations by category of consultant.

Consultations by category of consultant:Budget % Actual % Increase/(decrease)

Accounting 40·0 44·2 4·2%Distribution 30·0 20·8 (9·2%)Manufacturing 30·0 35·0 5·0%

It is a deliberate policy of EAJ to retain 100 Consultants thereby maintaining flexibility to meet increasing demand. Thedelivery speed will be increased as a consequence of the retention of consultants. It would appear that a change hasoccurred in the mix of consultants which may well be a response to changing market requirements. Again, it would beuseful to see recent year’s statistics in order to consider trends.

Productivity can be measured by the ratio of output achieved from those resources input. In this scenario the averagenumber of chargeable days per consultant may be used as a guide.

Average number of chargeable days per consultantBudget Actual Increase/(decrease)

Accounting 168 212 26·2%Distribution 168 160 (4·8%)Manufacturing 168 192 14·3%

The implementation of distribution application software was more than 20% below budget. Chargeable distributionconsultancy days based on the original budget of 168 days per consultant would produce a total of 4,200 chargeabledays which is 200 more than the actual levels. Again this might be indicative of a quality problem. ‘Cycle time’ wouldappear to be improving as evidenced by the increasing number of on-time implementations as well as the reduction inthe implementation time of each application. In this respect EAJ needs to be certain that the reduction in implementationtime has not caused a diminution in the quality of service delivery. Consequently an aggregate bonus amounting to£294,000 was paid in respect of the year ended 31 May 2006. EAJ needs to ensure that the incentive provided by thebonus is not causing a loss of ‘internal efficiency’.

With regard to the bonus paid to consultants then it is questionable whether the bonus should be shared equally byconsultants since chargeable activity levels clearly vary between categories of consultant.

17



18

3 (a) The management of The Specialist Clothing Company Ltd (SCC) could use the Boston Consulting growth share matrix in orderto assess its divisions’ companies in terms of their rate of market growth and relative market share. The model is based onthe premise that the market position of a strategic business unit (SBU) i.e. division, can be assessed by reference to its growthrate and that its relative market share best indicates the strength of an organisation. The model uses four categories, theseare:

StarsA star product has a relatively high market share in a high growth market. The fashion division is experiencing strong growthin a rapidly growing market. It is forecast to have a market share of 10% by the end of 2007 and therefore it seems reasonableto categorise the Fashion division as a star.

Problem children (sometimes called question marks)The distinguishing feature of a problem child is that they have a relatively low market share in a high-growth market. TheChildren’s division would appear to fall into this category. The market leader enjoys 33% of the market whilst SCC Ltd appearsto be struggling to achieve any growth in turnover and hence profits and therefore cash flow remain relatively static. Similarly,the Industrial division would appear to be a problem child since it operates in a relatively high-growth market but appearsunable to achieve a reasonable market share. It would appear that the introduction of sales of industrial clothing via mail-order has not been successful.

Cash cowsA cash cow is characterised by a relatively high market share in a low growth market and should generate significant cashflows. The Leisure division appears to be a cash cow since it has a very high market share (70%) in what can be regardedas a low-growth market.

DogsA dog is characterised by a relatively low market share in a low growth market and might well be loss making and thereforehave negative cash flow.

The Footwear division would appear to fall into this category since it’s market share is relatively low and forecast to fall duringeach of the next two years in what is a low-growth market.

The forecast situation of SCC Ltd is far from ideal. It has a dog (the Footwear division) and two problem children (Industrialand Children’s divisions) that require the immediate attention of management. The dog classification of the Footwear divisionis precarious to say the least. Competitors within low growth markets will invariably offer high levels of resistance to anyattempts to reduce their share of a low-growth or declining market. As far as the problem children are concerned,management need to devise appropriate strategies to convert them into stars since at the present time they appear to be inhigh growth markets but are unable to capture a reasonable market share. The cash generated by the Leisure division shouldbe applied to ensure the continued upward trend of the only current star (the Fashion division) and then applied to assist inthe development of the problem children.

(b) The four quadrants of the Boston-growth share matrix summarise expected profits and resultant cash flows and recommendsan outline strategy to follow which rather simplistically may be summarised as invest in stars, scrutinise the problem children,milk the cows and divest the dogs.

Value Chain AnalysisIt is vital that the management of SCC Ltd undertake a value chain analysis of each of its divisions in order to identify andeliminate all non-value added activities, thereby improving profitability and cash flow without necessarily increasing turnoveror market share.

Divestment of the Footwear divisionSerious consideration should be given to the divestment of the Footwear division. This will enable resources to be redirectedto divisions categorised as problem children i.e. the Industrial and Children’s divisions.

Support the StarsAs far as the Fashion division is concerned, it is obviously in a growth market and currently performing well. It is vital, giventhe forecast performance of the other subsidiaries that the management of SCC Ltd do not concentrate on the poor performersto the detriment of its only star.

(c) There are numerous criticisms that have been made regarding the BCG growth share matrix. Two such criticisms are asfollows:

– It is a model and the weakness of any model is inherent in its assumptions. For example many strategists are of theopinion that the axes of the model are much too simplistic. The model implies that competitive strength is indicated byrelative market share. However other factors such as strength of brands, perceived product/service quality and costsstructures also contribute to competitive strength.Likewise the model implies that the attractiveness of the marketplace is indicated by the growth rate of the market. Thisis not necessarily the case as organisations that lack the necessary capital resources may find low-growth markets anattractive proposition especially as they tend to have a lower risk profile than high-growth markets.

– There are problems with defining the market. The model requires management to define the marketplace within whicha business is trading in order that its rate of growth and relative market share can be calculated. This can proveproblematic in comparing competitors since if they supply different products and services then the absence of aconsistent basis for comparison impairs the usefulness of the model.



19

Other valid criticisms include the following:

The application of the BCG matrix may prove costly and time-consuming since it necessitates the collection of a largeamount of data. The use of the model may also lead to unfortunate consequences, such as:

– Moving into areas where there is little experience– Over-milking of cash cows– Abandonment of potentially healthy businesses labelled as problem children– Neglect of interrelationships among businesses, and– Too many problem children within the business portfolio largely as a consequence of incorrect focus of

management attention.

4 (a) (i) The taxation liability calculations are as follows: ‘Steadychill’Year 1 2 3 4

£ £ £ £Operating cash flows (excluding 440,000 500,000 460,000 420,000maintenance)Maintenance (50,000) (50,000) (50,000) (50,000)Capital allowances (110,000) (82,500) (61,875) (185,625)Profits liable to corporation tax 280,000 367,500 348,125 184,375Taxation at 30% 84,000 110,250 104,438 55,313

‘Technofreeze’Year 1 2 3 4 5 6

£ £ £ £ £ £Operating cash 500,000 540,000 600,000 600,000 450,000 350,000flows (excluding maintenance)Maintenance (50,000) (60,000) (70,000) (80,000) (90,000) (100,000)Capital allowances (172,500) (129,375) (97,031) (72,773) (54,580) (163,740)Profits liable to 277,500 350,625 432,969 447,227 305,420 86,260corporation taxTaxation at 30% 83,250 105,188 129,891 134,168 91,626 25,878

The net present value calculations are as follows:

‘Steadychill’Year 0 1 2 3 4 5

£ £ £ £Initial investment (440,000)Working capital (120,000) 120,000Net operating cash flows 390,000 450,000 410,000 370,000Taxation (84,000) (110,250) (104,438) (55,313)Net cash flow (560,000) 390,000 366,000 299,750 385,562 (55,313)Discount factor (10%) 1·000 0·909 0·826 0·751 0·683 0·621Present values (560,000) 354,510 302,316 255,112 263,339 (34,349)

The net present value = £550,928.

The payback period is 1 year +170,000

= 1·464 years–––––––––366,000

‘Technofreeze’Year 0 1 2 3 4 5 6 7

£ £ £ £ £ £ £ £Initial investment (690,000)Working capital (120,000) 120,000Net operating cash flows 450,000 480,000 530,00 520,000 360,000 250,000Taxation (83,250) (105,188) (129,891) (134,168) (91,626) (25,878)Net cash flow (810,000) 450,000 396,750 424,812 390,109 225,832 278,374 (25,878)Discount factor (12%) 1·000 0·893 0·797 0·712 0·636 0·567 0·507 0·452Present values (810,000) 410,850 316,210 302,467 248,110 128,047 141,136 (11,697)

The net present value = £716,123.

The payback period is 1 year +360,000

= 1·907 years–––––––––396,750



20

(ii) The ‘Technofreeze’ refrigeration system has the larger NPV however consideration needs to be given to the fact that weare comparing two refrigeration systems which have unequal lives. In order to do this we can convert the cash flowsinto an equivalent annual cash flow with NPV’s of £550,928 for the ‘Steadychill’ and £716,123 for the ‘Technofreeze’refrigeration systems. The equivalent annual cash flow can be calculated using the following formula:

Net present valueAnnuity factor for n years at r%

Where r = the cost of capital.

‘Steadychill’ ‘Technofreeze’Net present value £550,928 £716,123Annuity factor (from tables) 3·170 4·111Equivalent annual cash flow = £173,794 £174,197

On the basis of equivalent annual cash flows then the directors of Stay Cool Ltd should be advised to purchase the‘Technofreeze’ refrigeration system, although the difference is so small that other factors would undoubtedly influencetheir decision.

(b) (i) Payback period is widely used by organisations in the capital investment appraisal process due to the following reasons:– It is easy to calculate and understand– There is a lack of understanding of more sophisticated techniques which take into consideration the time value of

money– Payback may be expedient for organisations who need to recover their capital outlay quickly due to the fact that

they are experiencing liquidity problems– Payback is appropriate for smaller investments which do not warrant the use of more sophisticated techniques– Payback reduces uncertainty by focusing on nearer and therefore more certain cash flows.

(ii) Sensitivity analysis could be used to assess how responsive the NPV calculated in part (a) in respect of each decisionoption change is to changes in the variables used to calculate it. The application of sensitivity analysis requires that thenet present values are calculated under alternative assumptions in order to determine how sensitive they are to changingconditions. In this particular example then a relatively small change in the forecast cash flows might lead to a changein the investment decision. The application of sensitivity analysis can indicate those variables to which the NPV is mostsensitive and the extent to which these variables may change before an investment results in a negative NPV. Thus theapplication of sensitivity analysis may provide management with an indication of why a particular project might fail. Thedirectors of Stay Cool Ltd should give consideration to the potential variations in the independent variables which featurein the decision-making process such as:

– estimated revenues– estimated operating costs– estimated working lives– estimated repair costs– the estimated discount rate i.e. cost of capital of each alternative investment.

Sensitivity analysis has some serious limitations. The use of the method requires changes in each variable underconsideration are isolated. However management may be focused on what happens if changes occur in two or morecritical variables. Another problem relating to the use of sensitivity analysis to forecast outcomes lies in the fact that itprovides no indication of the likelihood of the occurrence of changes in critical variables.



5 (a) Memorandum

To: The board of directorsFrom: Senior management accountantDate: 9 June 2006

Subject: Factors to be considered in the design of a reward scheme.

Further to your recent request concerning the above please find detailed below factors for your consideration:

(i) The potential benefits to be gained from the implementation of a reward scheme.

– Rewards and incentives can make a positive contribution to strategy implementation by shaping the behaviour ofindividuals and groups. A well designed reward scheme will be consistent with organisational objectives andstructure.

– There is evidence which suggests that the existence of a reward scheme provides an incentive to achieve a goodlevel of performance. Moreover, the existence of effective schemes also helps not only to attract but to retainemployees who make positive contributions to the running of an organisation.

– Key values can be emphasised by incorporating key performance indicators in the performance-rewardsmechanisms which underpin the scheme. This helps to create an ‘understood environment’ in which it is clear toall employees what performance aspects precipitate organisational success.

– An effective reward scheme will create an environment in which all employees are focused upon ‘continuousimprovement’.

– Schemes which incorporate equity share ownership for managers and employees alike can encourage behaviourwhich is in the longer-term interests of the organisation by focusing on actions aimed at increasing the market valueof the organisation.

(ii) The factors that should be considered in the design of a reward scheme for BGL.

– Whether performance targets should be set with regard to results or effort. It is more difficult to set targets foradministrative and support staff since in many instances the results of their efforts are not easily quantifiable. Forexample, sales administrators will improve levels of customer satisfaction but quantifying this is extremely difficult.

– Whether rewards should be monetary or non-monetary. Money means different things to different people. In manyinstances people will prefer increased job security which results from improved organisational performance andadopt a longer term-perspective. Thus the attractiveness of employee share option schemes will appeal to suchindividuals. Well designed schemes will correlate the prosperity of the organisation with that of the individuals itemploys.

– Whether the reward promise should be implicit or explicit. Explicit reward promises are easy to understand but inmany respects management will have their hands tied. Implicit reward promises such as the ‘promise’ of promotionfor good performance is also problematic since not all organisations are large enough to offer a structured careerprogression. Thus in situations where not everyone can be promoted there needs to be a range of alternative rewardsystems in place to acknowledge good performance and encourage commitment from the workforce.

– The size and time span of the reward. This can be difficult to determine especially in businesses such as BGLwhich are subject to seasonal variations. i.e. summerhouses will invariably be purchased prior to the summerseason! Hence activity levels may vary and there remains the potential problem of assessing performance whenan organisation operates with surplus capacity.

– Whether the reward should be individual or group based. This is potentially problematic for BGL since the assemblyoperatives comprise some individuals who are responsible for their own output and others who work in groups.Similarly with regard to the sales force then the setting of individual performance targets is problematic since salesterritories will vary in terms of geographical spread and customer concentration.

– Whether the reward scheme should involve equity participation? Such schemes invariably appeal to directors andsenior managers but should arguably be open to all individuals if ‘perceptions of inequity’ are to be avoided.

– Tax considerations need to be taken into account when designing a reward scheme.

(iii) ‘If we implement a reward scheme then it is bound to be beneficial for BGL’.The statement of the manufacturing director is not necessarily correct. Indeed there is much evidence to support theproposition that the existence of performance-related reward schemes can encourage dysfunctional behaviour. This oftenmanifests itself in the form of ‘budgetary slack’ which is incorporated into budgets in anticipation of subsequent cuts byhigher levels of management or to make subsequent performance look better.

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(b) Good performance should result in improved profitability and therefore other stakeholder groups may be rewarded for ‘goodperformance’ as follows:– Shareholders may receive increased returns on equity in the form of increased dividends and /or capital growth.– Customers may benefit from improved quality of products and services, and possibly lower prices. – Suppliers may benefit from increased volumes of purchases.– Government will benefit from increased amounts of taxation.

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Part 3 Examination – Paper 3.3 June 2006 Marking SchemePerformance Management

Marks Marks1 (a) Sales: – first 12 months 0·5

Sales– next 6 months 1·5Direct materials 2 x 1 2Packaging 2 x 1 2Direct labour: – first 12 months 6Direct labour: – next 6 months 3Royalties 2 x 0·5 1Variable overheads 2 x 0·5 1Fixed overheads 2 x 0·5 1Returns 2 x 0·5 1Conclusion 1 20

–––(b) (i) Recommended actions 8 8

–––(ii) Factors 2 x 2 4 4

–––(c) Target costing – explanation 2

Target costing – application 5Target costing – limitations 3 Maximum 8

––– –––40–––

2 (a) Explanation of link between strategy and operations 2Explanation of the Pyramid 3 5

–––(b) Financial performance & competitiveness 6

External effectiveness 6Internal efficiency 6 Maximum 15

––– –––20–––

3 (a) Assessment of subsidiaries 5 x 2 10

(b) Appropriate strategies 3 x 2 6

(c) Criticisms 2 x 2 4–––20–––

4 (a) (i) NPV calculations 10Payback 2

(ii) Equivalent annual cash flow – calculations 2Recommendation 2 x 1 1 15

–––(b) (i) Reasons 4 x 0·5 2 2

–––(ii) Use 1

Limitations 2 3––– –––

20–––

5 (a) (i) Benefits 6(ii) Factors to be considered 7(iii) Discussion of production director’s statement 3 16

––– –––(b) Explanation 4 x 1 4 4

––– –––20–––

23




PART 3


QUESTION PAPER








Pape

r 3.3




1 Wonderland plc, which is based in Robynland, owns Cinola Island which is located off the coast of Robynland. OnCinola Island, Wonderland plc operates a circus and zoological gardens (zoo) both of which are open for 365 daysper annum. The circus, which is widely regarded as the best in the world, can accommodate a maximum of 14,000visitors per day. The zoological gardens, which opened on 1 December 1999, can accommodate a maximum of20,000 visitors per day. Visitors travel to and from Cinola Island using petrol-driven ferries owned by Wonderland plc.There is no other mode of transport to and from Cinola Island.

The following information is available in respect of the year ended 30 November 2006 and the year ending 30 November 2007.

(1) The zoo and circus were open on each day of the year. The circus performed once per day and was alwaysoperated at maximum capacity.

(2) Three types of ticket were sold as follows:

Ticket type Admission to:Z ZooC CircusZC Zoo and Circus

The total of admissions to the zoo was 6,570,000. The total of admissions to the circus was 5,110,000. Thesetotals include 4,380,000 type ‘ZC’ tickets.

(3) Admission fees per visitor were as follows:

Category Zoo only Circus only£ £

Adults 40 40Children and Senior citizens 20 20

Visitors who purchased ticket type ‘ZC’ received a discount of 25% on the cost of separately purchasing a type‘Z’ and a type ‘C’ ticket. Each ticket type was valid for one day only.

(4) The visitor ‘mix’ for all ticket types was as follows:

Adults 40%Children and senior citizens 60%

(5) In addition to any admission fees payable, visitors paid a transport fee for the return journey to and from CinolaIsland. The total transport fees received amounted to £25,550,000 of which £15,330,000 was attributable tothe zoo, the remainder being attributable to the circus.

(6) The management of Wonderland plc categorises all operating costs, including those relating to the operation ofits petrol-driven ferries, as fixed costs. These were as follows:

Zoo Circus£130m £100m

Note: The petrol-driven ferries were fully depreciated as at 1 December 2006.

(7) Wonderland plc received an annual fee of £10 million from an International media group under a fixed-termcontract of three years’ duration. The contract commenced on 1 December 2005 and relates to the rights totelevise programmes which were filmed in the zoo and therefore the fee should be regarded as relating to thezoo.

(8) Admission fees to the zoo and circus will be increased by 5% with effect from 1 December 2006. Transport feeswill remain unchanged.

(9) It is anticipated that all operating costs will increase by 4% per annum due to the impact of inflation during theyear ending 30 November 2007.

(10)The management of Wonderland plc expect that the number of visitors, visitor mix and ticket mix will remainunchanged during the year ending 30 November 2007.

(11) Ignore taxation.

2



Required:

(a) Prepare the budgeted profit and loss account for Wonderland plc for the year ending 30 November 2007.(9 marks)

(b) Calculate the percentage of maximum capacity at which the zoo will break even during the year ending 30 November 2007. You should assume that 50% of the revenue from sales of ticket type ZC is attributableto the zoo. (7 marks)

(c) The management of Wonderland plc are concerned regarding the extent to which fluctuations in zoo revenueswill impact upon the total profitability of Wonderland plc during the year ending 30 November 2007. They arenot concerned about fluctuations in circus revenues and are confident that it will remain at maximum capacitythroughout the year. However, because Robynland has experienced considerable fluctuations in the rate ofinflation during recent years, the management of Wonderland plc are also concerned regarding the impact uponprofitability of any variation in the rate of inflation from the 4% allowed for, as per Note (9).

The management of Wonderland plc have obtained the following forecasts regarding zoo revenues and thepossible rates of inflation in respect of the year ending 30 November 2007.

Zoo revenues Probability Inflation ProbabilityIncrease by 10% 0·25 2% 0·30No change 0·50 4% 0·40Decrease by 10% 0·25 8% 0·30

Note: Transport revenues relating to the zoo would increase or decrease by the same percentage as zoo revenues.

Required:

(i) Using the above information, prepare a summary in an appropriate format which shows:

(1) the range of possible company net profit or loss outcomes(2) the combined probability of each potential outcome(3) the expected value of net profit for the year. (10 marks)

(ii) Calculate the probability of the net profit being less than £75 million. (2 marks)

(d) The management of Wonderland plc have become concerned about the increased level of operating costsassociated with its petrol-driven ferries and have made a strategic decision to dispose of these. They are nowconsidering entering into a contract with the Newman Steamship Company (NSC), a shipping organisation basedin Robynland. The contract would entail NSC providing transport to and from Cinola Island for all visitors to thezoo and circus.

As a result of negotiations with NSC, the directors of Wonderland plc are considering two options whereby NSCwill become responsible for the transportation of visitors to and from Cinola Island with effect from 1 December2007 or 1 December 2008.

Additional information is available as follows:

(1) NSC would require Wonderland plc to pay for the necessary modifications to their steamships in order thatthey would satisfy marine regulations with regard to passenger transportation. The only firm which couldundertake this work is currently working to full capacity and would require a payment of £2,450,000 inorder to undertake the work necessary so that the ferries could be in operation by 1 December 2007. Thesame firm would require a payment of £1,725,000 in order to make the necessary modifications so thatthe ferries could be in operation by 1 December 2008. The government of Robynland would be willing topay a grant of 8% towards the cost of getting the ferries into operation by 1 December 2007, but would notbe willing to pay a grant in respect of any later date.

(2) On 1 December 2002 Wonderland plc paid £500,000 to the Port Licencing Authority of Robynland. Thispayment was for a licence which entitles Wonderland plc to use all harbour facilities in Robynland duringthe five-year period ending 30 November 2007. The licence could be renewed on 1 December 2007 at acost of £150,000 per annum.

3 [P.T.O.



(3) Redundancy payments would need to be paid in respect of loss of employment. These would amount to£1,200,000 if the contract with NSC commenced on 1 December 2007. This amount would reduce to£750,000 if the contract commenced on 1 December 2008.

(4) Wonderland plc has a contract for the provision of petrol for its ferries which is due to expire on 30 November2008. Early termination of the contract would incur a penalty charge of £76,000. An emergency reservestock of petrol held by Wonderland plc, which cannot be used after 30 November 2007 due to marineregulations regarding the age of fuel, could be sold for £55,000 on 1 December 2007 but not on any datethereafter.

(5) The ferries could be sold for £3,300,000 on 1 December 2007. If retained after 1 December 2007 theferries would require servicing during the year ending 30 November 2008 which would incur costsamounting to £150,000. The resale value of the ferries on 1 December 2008 would be £2,900,000.

(6) Stock of consumable items which originally cost £150,000 could be sold on 1 December 2007 for£110,000 and on 1 December 2008 for £50,000.

Required:

(i) On purely financial grounds, advise whether the management of Wonderland plc should enter into acontract with NSC with effect from 1 December 2007 or 1 December 2008. You may ignore the timevalue of money. (9 marks)

(ii) Briefly discuss FOUR non-financial factors which might influence the above decision. (4 marks)

(e) Briefly discuss FOUR initiatives that management might consider in order to further enhance profitability.(4 marks)

(45 marks)

4



2 The Information Technology division (IT) of the RJ Business Consulting Group provides consulting services to itsclients as well as to other divisions within the group. Consultants always work in teams of two on every consultingday. Each consulting day is charged to external clients at £750 which represents cost plus 150% profit mark up. Thetotal cost per consulting day has been estimated as being 80% variable and 20% fixed.

The director of the Human Resources (HR) division of RJ Business Consulting Group has requested the services oftwo teams of consultants from the IT division on five days per week for a period of 48 weeks, and has suggested thatshe meets with the director of the IT division in order to negotiate a transfer price. The director of the IT division hasresponded by stating that he is aware of the limitations of using negotiated transfer prices and intends to charge theHR division £750 per consulting day.

The IT division always uses ‘state of the art’ video-conferencing equipment on all internal consultations which wouldreduce the variable costs by £50 per consulting day. Note: this equipment can only be used when providing internalconsultations.

Required:

(a) Calculate and discuss the transfer prices per consulting day at which the IT division should provideconsulting services to the HR division in order to ensure that the profit of the RJ Business Consulting Groupis maximised in each of the following situations:

(i) Every pair of consultants in the IT division is 100% utilised during the required 48-week period inproviding consulting services to external clients, i.e. there is no spare capacity.

(ii) There is one team of consultants who, being free from other commitments, would be available toundertake the provision of services to the HR division during the required 48-week period. All otherteams of consultants would be 100% utilised in providing consulting services to external clients.

(iii) A major client has offered to pay the IT division £264,000 for the services of two teams of consultantsduring the required 48-week period.

(12 marks)

(b) Briefly explain THREE limitations of negotiated transfer prices. (3 marks)

(15 marks)

5 [P.T.O.




3 Vision plc is a reputable manufacturer of a specialist range of optical and photographic equipment. At present,marketing activities are confined to its home market in Blinkland. The directors wish to achieve a net profit per annumof £150 million by the year ending 30 November 2009.

The following information is available:

Note 1:The most recent forecast covering the three year period ending 30 November 2009, based on sales of products whichwere in existence at 1 December 2006 to existing customers, is as follows:

Year ending 30 November: 2007 2008 2009£m £m £m

Turnover 100·0 105·0 110·0Net Profit 40·0 42·0 44·0

Note 2:Vision plc manufactures a range of products within its three divisions, as follows:

DivisionAstronomy This division manufactures telescopic equipment which is sold via mail order to private individuals.Medical This division manufactures microscopes and associated equipment which are sold to hospitals and

schools in Blinkland.Outdoor pursuits This division manufactures a range of cameras and binoculars which are sold via mail order to

private individuals.

Note 3:The following became effective on 1 December 2006:

(i) The company created a new division called the Oceanic division which manufactures cameras suitable forunderwater use. These are sold to clubs and societies that engage in scuba diving activities. Sales revenue isforecast to be £5 million in the first year of operation with an anticipated doubling of sales volume during eachof the next two years of operation. Variable costs are forecast at 40% of sales revenue in the first year of operationand are expected to reduce to 35% and 30% during each of the next two years respectively. Fixed overheads areforecast at £1 million in the first year of operation and are expected to increase by 10% per annum during eachof the next two years.

(ii) The company purchased the ‘Sound and vision’ chain of camera shops comprising a total of 30 retail outletswithin Blinkland. Each of the 20 ‘out of town’ outlets is forecast to make a profit of £750,000 and each of the10 city outlets is forecast to make a profit of £1 million during the year ending 30 November 2007. It isanticipated that profits of ‘out of town’ and city outlets will increase by 8% and 4% per annum respectively duringeach of the next two years.

(iii) The company purchased Racquets Ltd, a well-established manufacturer of tennis, badminton and squashracquets. Racquets Ltd made a profit of £15 million during the year ended 30 November 2006 and profit isexpected to increase by £1 million per annum during each of the next three years.

(iv) A new camera known as the ‘Birdcam-V’ was launched. This camera will allow bird-watching activities to takeplace during the night, irrespective of prevailing noise and weather conditions. The Birdcam-V is the only cameraon the market which has special ‘noise and weather’ filtering capabilities and has an expected life of three years.

The marketing director has estimated that at a selling price of £600 per unit, a total of 85,000 units per annumwould be sold during the year ending 30 November 2007 and that each increase or decrease in the selling priceof £10 will cause quantity demanded to decrease or increase by 1,000 units. The variable cost per unit isexpected to remain constant at £180. Development costs amounting to £45,967,500 are to be written off evenlyover the expected life of the Birdcam-V. The directors of Vision plc have agreed to adopt the combination of sellingprice and output that will maximise profit earned from sales of the Birdcam–V.

6



Required:

(a) Calculate the ‘profit gap’ that is forecast to exist at 30 November 2009. (10 marks)

(b) (i) Explain how the use of Ansoff’s product-market matrix might assist the management of Vision plc toreduce the profit-gap that is forecast to exist at 30 November 2009. (3 marks)

(ii) Explain how the existing product range and the actions per Note (3) would feature in Ansoff’s product-market matrix. (7 marks)

(20 marks)

7 [P.T.O.



4 Our Timbers Ltd is a market leader in the supply of timber-based products to the construction industry. The companyhas two divisions, namely the RP division which manufactures products used in the construction of residentialproperties and the IP division which manufactures products used in construction of industrial properties.

The following information is available in respect of the three year period ended 30 November 2006:

(1) (i) Net Assets as at 30 November were as follows:

2006 2005 2004£000 £000 £000

Fixed Assets (net book value) 75,600 64,800 54,000Net Current Assets 64,400 55,200 56,000

–––––––– –––––––– ––––––––Net Assets 140,000 120,000 110,000

–––––––– –––––––– ––––––––Fixed Assets acquired during year 19,200 18,000

Note: No disposals of fixed assets took place during the above periods.

(ii) The total capital employed of Our Timbers Ltd was invested in the divisions during each year as follows:

Division % of total capital employedRP 40IP 60

(iii) Depreciation is charged at 10% per annum on a reducing balance basis.

(2) Operating cash flows were as follows:

Division 2006 2005£m £m

RP 14·4 13·1IP 20·0 18·0

(3) Each division has a target rate of return of 22·5% on average capital employed throughout each year. Divisionalmanagers are eligible to receive an annual bonus amounting to 10% of annual salary if the target rate of returnis achieved.

Required:

(a) (i) Calculate the return on the average capital employed by each of the divisions during the years ended 30 November 2005 and 30 November 2006. (6 marks)

(ii) Comment briefly on how divisional managers might respond to the results achieved and ONE potentialproblem that might be experienced by Our Timbers Ltd. (2 marks)

(b) Until 30 November 2006 the company outsourced its entire sales administration and would have incurredservice costs amounting to £3,855,000 and £4,895,000 in respect of divisions RP and IP during the yearending 30 November 2007. However, a strategic decision was taken to establish an in-house division known asthe ‘Sales division’ which would be dedicated to servicing the needs of divisions RP and IP and therefore wouldnot provide any service whatsoever to any other party. The sales division became operational on 1 December2006.

(1) Budgeted information in respect of the year ending 30 November 2007 is as follows:

Division RP IP Sales£m £m £m

Average capital employed 52 78 9Profit before service costs 12 16

8



(2) The management accountant has prepared a detailed analysis of the budget of the sales division for the yearending 30 November 2007 which is as follows:

Total Quotation Order Invoice Customer Managementpreparation processing generation visits costs

£000 £000 £000 £000 £000 £000Salaries 4,100 1,400 1,500 250 200 750Consumable items 900 50 350 250 200 50IT costs 1,000 200 400 50 50 300Sundry operating costs 1,000 150 150 50 350 300

–––––– –––––– –––––– ––––– –––– ––––––Total 7,000 1,800 2,400 600 800 1,400

–––––– –––––– –––––– ––––– –––– ––––––

Cost driver Quotations Sales Invoices Visitsorders

Activity volume 1,022,000 817,600 511,000 2,500

(3) The estimated usage of the Sales division by the RP and IP divisions is as follows:

Division RP IPNumber of quotations prepared 255,500 766,500Number of sales orders processed 204,400 613,200Number of invoices generated 102,200 408,800Number of customer visits 2,000 500

(4) The company owns tree plantations from which it satisfies 100% of its requirement for timber during eachyear.

The managing director of Our Timbers Ltd has proposed that all services provided by the Sales division to the RPand IP divisions during the year ending 30 November 2007 should be invoiced on the basis of cost plus 30%with all costs, other than management costs, split according to the estimated usage data detailed in note (3)above. Management costs would be shared equally between divisions RP and IP.

Required:

(i) Evaluate the proposal of the managing director and comment on its likely acceptance by the managersof the three divisions. (9 marks)

(ii) Comment briefly on the use of its own tree plantations as a source of raw materials by Our Timbers Ltd.(3 marks)

(20 marks)

9 [P.T.O.



5 A management accounting focus for performance management in an organisation may incorporate the following:

(1) the determination and quantification of objectives and strategies(2) the measurement of the results of the strategies implemented and of the achievement of the results through a

number of determinants(3) the application of business change techniques, in the improvement of those determinants.

Required:

(a) Discuss the meaning and inter-relationship of the terms (shown in bold type) in the above statement. Youranswer should incorporate examples that may be used to illustrate each term in BOTH profit-seekingorganisations and not-for-profit organisations in order to highlight any differences between the two types oforganisation. (14 marks)

(b) Provide an example that illustrates a structured application of the terms contained in the above statement inrespect of a profit-seeking organisation OR a not-for-profit organisation of your own choice. (6 marks)

(20 marks)


10



Answers




Tutorial note: These model answers are considerably longer and more detailed than would be expected from any candidate in theexamination. They should be used as a guide to the form, style and technical standard (but not in length) of answer that candidatesshould aim to achieve. However, these answers may not include all valid points mentioned by a candidate – credit will be given tocandidates mentioning such points.

1 (a) Wonderland plc – Budgeted Profit and Loss Account for the year ending 30 November 2007£000 £000

Admission revenue: (W1)Zoo only: Adults 36,792

Children & Senior citizens 27,594 64,386––––––––

Circus only: Adults 12,264Children & Senior citizens 9,198 21,462

––––––––Zoo and circus: Adults 110,376

Children & Senior citizens 82,782 193,158–––––––– ––––––––

Total admission revenue 279,006Transport revenue 25,550Other revenue 10,000

––––––––Total revenue 314,556Operating costs (W2) 239,200

––––––––Profit 75,356

––––––––

Workings:

(W1) Admission revenue:Total of admissions to zoo = 6,570,000Admissions to zoo via Type ZC ticket =4,380,000Therefore admissions to zoo via Type Z ticket = 2,190,000

Total of admissions to circus = 5,110,000Admissions of circus via Type ZC ticket = 4,380,000Therefore admissions to circus via Type C ticket = 730,000

Ticket type Number Category % Number Ticket Admissionsold sold price revenue

(000) (000) (£) (£000)Zoo only:Z 2,190 Adults 40 876 42·00 36,792Z 2,190 Children & Senior citizens 60 1,314 21·00 27,594

––––––––64,386

––––––––Circus only:C 730 Adults 40 292 42·00 12,264C 730 Children & Senior citizens 60 438 21·00 9,198

––––––––21,462

––––––––Zoo and circus:ZC 4,380 Adults 40 1,752 63·00 110,376ZC 4,380 Children & Senior citizens 60 2,628 31·50 82,782

––––––––193,158––––––––

Total admission revenue = 279,006––––––––

(W2) Operating costs:Zoo 130,000Circus 100,000

––––––––230,000 x 1·04 = £239,200

13



(b) £Zoo admission revenue (W3) 160,965,000Travel revenue 15,330,000

––––––––––––Revenue 176,295,000

––––––––––––

No of visitors 6,570,000Revenue per visitor = £176,295,000/6,570,000 £26·8333

£Fixed costs 135,200,000Less:Fixed income 10,000,000

––––––––––––Fixed costs less fixed income 125,200,000

––––––––––––

Divide by weighted average contribution per visit = £125,200,000/£26·8333 = 4,665,844 visitorsTotal capacity for visitors to the zoo = 20,000 x 365 = 7,300,000Therefore the percentage of maximum capacity required in order to break even is 4,665,844/7,300,000 = 63·92%

W3Zoo admission revenue:

Ticket type AdmissionRevenue

(£s)Z 64,386,000 (W1)ZC 96,579,000 (50% of £193,158,000)

––––––––––––Total 160,965,000

––––––––––––

(c) (i) % Probability Inflation Probability Combined Total Total costs Possible Expectedchange (%) probability revenue (W6) net profit value ofin zoo (W4) net profitrevenues £ £ £ £+10% 0·25 2 0·30 0·075 332,185,500 234,600,000 97,585,500 7,318,913

4 0·40 0·100 332,185,500 239,200,000 92,985,500 9,298,5508 0·30 0·075 332,185,500 248,400,000 83,785,500 6,283,913

0% 0·50 2 0·30 0·150 314,556,000 234,600,000 79,956,000 11,993,4004 0·40 0·200 314,556,000 239,200,000 75,356,000 15,071,2008 0·30 0·150 314,556,000 248,400,000 66,156,000 9,923,400

–10% 0·25 2 0·30 0·075 296,926,500 234,600,000 62,326,500 4,674,4884 0·40 0·100 296,926,500 239,200,000 57,726,500 5,772,6508 0·30 0·075 296,926,500 248,400,000 48,526,500 3,639,488

–––––– –––––––––––1·000 Expected profit 73,976,002–––––– –––––––––––

(ii) There are four potential outcomes which would result in a profit of less than £75 million. The sum of the combinedprobabilities of these outcomes is (0·15 + 0·075 + 0·10 + 0·075) = 0·40. Thus there is a 40% chance that theprofit earned during the year ending 30 November 2007 will be less than £75 million.

W4Total revenue:

Admission fees Travel fees (W5) Other revenue Total revenue£ £ £ £

+10% 295,102,500 27,083,000 10,000,000 332,185,500No Change 279,006,000 25,550,000 10,000,000 314,556,000–10% 262,909,500 24,017,000 10,000,000 296,926,500

Note: Admission fees:No change = £279,006,000 (160,965 + 118,041)+10% = £295,102,500 ((160,965 x 1·1) + 118,041)–10% = £262,909,500 ((160,965 x 0·9) + 118,041)

W5Travel fees:

Zoo Circus Total£ £ £

No change 15,330,000 10,220,000 25,550,000+10% 16,863,000 10,220,000 27,083,000–10% 13,797,000 10,220,000 24,017,000

N.B. The circus always operated at maximum capacity and therefore travel fees attributable to it would remainunchanged.

14



W6Calculation of Total costs:

Zoo Circus Total costs Inflation Total costsbefore inflation rate

£000 £000 £000 £000130,000 100,000 230,000 2% 234,600130,000 100,000 230,000 4% 239,200130,000 100,000 230,000 8% 248,400

(d) (i) Relevant cash flows of the two decision alternatives are as follows:Cessation at Cessation at

1 December 2007 1 December 2008£000 £000

Modification costs 2,254 1,725Licence fee 150Redundancy payments 1,200 750Petrol: penalty 76Disposal proceeds –3,300 –2,900Repairs and maintenance 150Consumables –110 –50

–––––– ––––––Net cash outflow/(inflow) 120 (175)

–––––– ––––––

On the basis of relevant cash flows the management of Wonderland plc should be advised to cease using its petrol-driven ferries with effect from 1 December 2008 as this will result in a saving of £120,000 – (£175,000) = £295,000.

(ii) Four factors that could be considered are as follows:

(i) The quality of the service provided by NSC as evidenced by, for example, the comfort of the ferries, on-boardfacilities, friendliness and responsiveness of staff.

(ii) The health and safety track record of NSC – passenger safety is a ‘must’ in such operations.(iii) The reliability, timeliness and dependability of NSC as a service provider.(iv) The potential loss of image due to redundancies within Wonderland plc.

(e) In order to enhance profitability management might take the following actions:

(i) Increase the maximum capacity of the circus.(ii) Undertake a detailed review of operating costs which are budgeted at £239,200,000. Such a review might identify non-

value added costs which may be eliminated thereby increasing profitability.(iii) Enter into a strategic arrangement with large hotels and travel agencies to offer travel and accommodation inclusive

arrangements for visitors to Cinola Island. This might help to increase the number of visitors to the zoo thereby increasingprofits.

(iv) Change the price structure and entitlement of tickets so that purchasers might visit Cinola Island on two separate daysin order to attend the zoo and circus. Additional revenues would arise as a consequence of the increased number ofvisitors to the zoo, thereby increasing profitability.

(v) Hold prize draws for free tickets to the zoo for families on an ‘all-inclusive basis’, including restaurants, photographs,souvenirs etc.

N.B. Only four initiatives were required to be discussed.

2 (a) (i) The transfer price of £750 proposed by the IT division is based on cost plus 150% from which it can be deduced thatthe total cost of a consulting day is (100/250) x £750 = £300. This comprises £240 (80%) variable cost and £60(20%) fixed cost. In this instance the transfer price should be set at marginal costs plus opportunity cost. It is assumedin this situation that transferring internally would result in the IT division having a lost contribution of £750 – £240 =£510 per consulting day. The marginal cost of the transfer of services to the HR division is £190 (£240 external variablecosts less £50 saving due to use of internal video-conferencing equipment). Adding the opportunity cost of £510 givesa transfer price of £700 per consulting day. This is equivalent to using market price as a basis for transfer pricing wherethe transfer price is set at the external market price (£750) less any costs avoided (£50) by transferring internally.

(ii) There is in effect no external market available for one of the required pairs of consultants within the IT division andtherefore opportunity cost will not apply and transfers should be made at the variable cost per consulting day of £190.The other pair of consultants, who would otherwise be 100% utilised in providing consulting services to external clients,should be charged at a rate of £700 per day which represents marginal cost plus opportunity cost.

(iii) The lost contribution from the major client amounts to £264,000/(2 x 240) = £550 less variable costs of £240 =£310 per consulting day. Thus, in this instance the transfer price should be the contribution foregone of £310 plusinternal variable costs of £190 making a total of £500 per consulting day.

15



(b) Negotiated transfer prices suffer from the following limitations:

– The transfer price which is the final outcome of negotiations may not be close to the transfer price that would be optimalfor the organisation as a whole since it can be dependent on the negotiating skills and bargaining powers of individualmanagers.

– They can lead to conflict between divisions which may necessitate the intervention of top management to mediate.

– The measure of divisional profitability can be dependent on the negotiating skills of managers who may have unequalbargaining power.

– They can be time-consuming for the managers involved, particularly where large numbers of transactions are involved.

3 (a) Year ending 30 November 2007 2008 2009£000 £000 £000

Existing portfolio 40,000 42,000 44,000Oceanic division 2,000 5,400 12,790Shops 25,000 26,600 28,312Racquets 16,000 17,000 18,000Birdcam-V 25,000 25,000 25,000

–––––––– –––––––– ––––––––Forecast profit 108,000 116,000 128,102Target profit 150,000

––––––––Shortfall i.e. Profit-gap 21,898

––––––––

Working 1Birdcam-V

Using the demand function P = a – bq where:

P = selling price at which q units are demandeda = price at which zero units will be demandedb = change in unit price/change in quantity demandedq = quantity demanded

b = 10/1,000 = 0·01

600 = a – 0·01(85,000)600 = a – 850∴ a = £1,450

Demand function is P = 1,450 – 0·01qTotal revenue function = Pq = 1,450q – 0·01q2

Marginal revenue function = 1,450 – 0·02qMarginal revenue = marginal cost ∴ 1,450 – 0·02q = 180∴ 0·02q = 1,270 and q = 63,500

Using the demand function P = 1,450 – 0·01q thenP = 1,450 – 0·01(63,500)P = 1,450 – 635 = £815

Therefore profit per annum can be calculated as follows:

£Revenue 63,500 x £815 51,752,500Variable costs 63,500 x £180 11,430,000

–––––––––––Contribution 40,322,500Fixed overheads £45,967,500/3 15,322,500

–––––––––––Profit per annum 25,000,000

–––––––––––

16



(b) (i) Igor Ansoff’s product-market matrix is as follows:

The design of the matrix will focus the attention of the management of Vision plc on strategic responses in order topromote growth in profits. Use of the matrix will enable management to evaluate and select alternative strategic optionsin order to reduce or eliminate the ‘profit-gap’. Management will be able to use information relating to the past inassessing the potential future benefits that may derive from the adoption of alternative strategies. The model, like manyother models, has little predictive capability. However, in using the model, management will be able to take into accountthe level of risk attaching to each of their strategic options. For example, the adoption of a strategy of market penetrationentails the lowest risk whereas a diversification strategy has the highest risk especially when the entry strategy is notbased upon the core competencies of Vision plc.

(ii) Market Penetration

With regard to existing products it would appear that a strategy of market penetration is being followed, whereby attemptsare made to sell existing products into existing markets. This is a low risk strategy which is most unlikely to lead to highrates of growth, reflected in the forecast increase of 2% per annum in the years ending 30 November 2008 and 2009.Management seeks here to increase its market share with the current product range. In pursuing a penetration strategythe management of Vision plc may to some extent be able to exploit opportunities including the following:

– Encouraging existing customers to buy more of their brand– Encouraging customers who are buying a competitor’s brand to switch to their brand– Encouraging non-users within the segment to buy their brand

‘Strengths’ within the current portfolio will need to be consolidated and any areas of weakness addressed with remedialaction.

Market Development

The purchase of the retail outlets will enable management to sell existing products via new channels of distribution. Theproducts of both the Astronomy and Outdoor Pursuits divisions could be sold via the retail outlets. Very often newmarkets can be established in geographical terms. Management could, for example, look to promote the sale ofmicroscopes and associated equipment to overseas hospitals.

Product Development

The launch of the Birdcam-V is an example of a product development strategy whereby new products are targeted atexisting markets. Very often, existing products can be improved, or if an organisation possesses adequate resources,completely new products can be developed to meet existing market needs. Some of the main risks here lie in the ‘timeto market’ and product development costs which frequently go well beyond initial estimates.

Diversification

The purchase of Racquets Ltd is an example of diversification on the part of Vision plc since the products and marketsof Racquets Ltd bear no relationship to the existing products and markets of the company. In this regard thediversification is said to be unrelated.

The establishment of the Oceanic division could be regarded as a related diversification since existing technology will beused to develop new products for new markets. The success of this strategy will very much depend on the strength ofthe Vision brand.

17

Market ProductPenetration DevelopmentStrategy Strategy

MarketDevelopment

Diversification

StrategyStrategy

New

Mar

kets

Exis

ting

Existing Products New



4 (a) (i) 2006 2005Division RP IP RP IP

£000 £000 £000 £0002006 2006 2005 2005

Cash flow 14,400 20,000 13,100 18,000Depreciation (W1) 3,360 5,040 2,880 4,320

––––––– ––––––– ––––––– –––––––Profit 11,040 14,960 10,220 13,680

Average invested capital 52,000 78,000 46,000 69,000Return on capital employed (ROCE) % 21·23 19·18 22·22 19·83

(ii) It is noticeable that neither division has achieved the target rate of return on capital employed of 22·5% per annumduring either year. Hence managers would not have received a bonus payment. This might lead to dysfunctionalbehaviour by divisional managers who might be tempted to avoid investing capital in their respective divisions in orderto reduce the average capital employed in order to achieve a level of ROCE which will earn them a bonus payment. Incircumstances where such disincentives to invest exist then it is probably going to be the case that the actions ofdivisonal managers will not be in the best interests of the company as a whole.

Workings:(W1) Depreciation:

Year 2005 2006£000 £000

1 December 54,000 64,800Add: additions 18,000 19,200

––––––– –––––––Subtotal 72,000 84,00030 November 64,800 75,600

––––––– –––––––∴ Depreciation = 7,200 8,400

––––––– –––––––Charged as follows:Division RP (40%) 2,880 3,360Division IP (60%) 4,320 5,040

(b) (i) DivisionActivity Activity Total RP IP Sales

cost split cost£000 £000 £000 £000

Quotation preparation 1:3 1,800 450 1,350Sales order processing 1:3 2,400 600 1,800Invoice generation 1:4 600 120 480Customer visits 4:1 800 640 160Management costs 1:1 1,400 700 700

–––––– ––––––– –––––––7,000 2,510 4,490

Add: mark up 30% 753 1,347 2,100––––––– –––––––

3,263 5,837Profit after service costs 12,000 16,000Less: service costs of sales division (3,263) (5,837)

––––––– –––––––Profit 8,737 10,163

Average capital employed (£000) 52,000 78,000 9,000ROCE (%) 16·80 13·03 23·33

Our Timbers Ltd is obviously anticipating a substantial fall in profits compared to the 2006 profit levels. From a personalpoint of view, neither the managers of the RP or IP divisions would be pleased with the forecast results due to the fallin projected ROCE statistics. On the other hand, the manager of the sales division would welcome the proposal of themanaging director since the ROCE earned by the sales division in the year ending 30 November 2007 would be 23·33%which is above the company target rate of 22·5%. The budget of Our Timbers Ltd for the year ending 30 November2007 illustrates that a static ROCE target fails to take into account fluctuations in trading circumstances.

Notwithstanding the fact that there is an anticipated fall in profits, from a divisional point of view the manager of the RPdivision would welcome the decision to cease the outsourcing arrangement because divisional reported profit wouldincrease by £3,855,000 – £3,263,000 = £592,000.

Conversely, the manager of the IP division from a divisional point of view would not welcome the decision to cease theoutsourcing arrangement because its reported profit will decrease by £5,837,000 – £4,895,000 = £942,000.

However, much depends on the attitude of the managers of each division with regard to Our Timbers Ltd as a whole.The costs of outsourcing amounts to £8·75m whereas the costs of in-sourcing the sales division amount to £7m, which

18



clearly indicates that Our Timbers Ltd would increase overall profitability by £1·75m as a direct consequence ofestablishing the sales division during the year ending 30 November 2007. It is important that the managers of each ofthe three divisions act in the best interests of Our Timbers Ltd as a whole.

The managing director of Our Timbers Ltd should be mindful of the fact that the mark-up of 30% that would be chargedby the sales division is the result of an internal decision which might have been ‘arbitary’, to say the least, and that amark-up of 28% would have resulted in the manager of the sales division being dissatisfied in reporting an ROCE belowthe company target of 22·5%.

(ii) The use of its own tree plantations as a source of raw materials not only ensures available supplies of timber but mayalso demonstrate that the directors of Our Timbers Ltd are mindful of the need for careful planning in the consumptionof natural resources. This concern with the need to protect the environment will enhance the reputation of Our TimbersLtd as an environmentally-conscious organisation which in turn may translate into a source of competitive advantagesince contemporary thought is very much focused on the environmental responsibilities of organisations with particularregard to the use of natural resources such as timber.

5 (a) Objectives may be viewed as profit and market share in a profit-oriented organisation or the achievement of ‘value for money’in a not-for-profit organisation (NFP). The overall objective of an organisation may be expressed in the wording of its missionstatement.

In order to achieve the objectives, long-term strategies will be required. In a profit-oriented organisation, this may incorporatethe evaluation of strategies that might include price reductions, product design changes, advertising campaign, product mixchange and methods changes, embracing change techniques such as BPR, JIT, TQM and ABM. In NFP situations, strategiesmight address the need to achieve ‘economy’ through reduction in average cost per unit; ‘efficiency’ through maximisation ofthe input:output ratio, whilst checking on ‘effectiveness’ through monitoring whether the objectives are achieved.

The annual budget will quantify the short-term results anticipated of the strategies. These results may be seen as the level offinancial performance and competitiveness achieved. This quantification may be compared with previous years and withactual performance on an ongoing basis. Financial performance may be measured in terms of profit, liquidity, capital structureand a range of ratios. Competitiveness may be measured by sales growth, market share and the number of new customers.In a not-for-profit organisation, the results may be monitored by checking on the effectiveness of actions aimed at theachievement of the objectives. For instance, the effectiveness of a University may be measured by the number of degreesawarded and the grades achieved. The level of student ‘drop-outs’ each year may also be seen as a measure of ineffectiveness.

The determinants of results may consist of a number of measures. These may include the level of quality, customersatisfaction, resource utilisation, innovation and flexibility that are achieved. Such determinants may focus on a range of non-financial measures that may be monitored on an ongoing basis, as part of the feedback information in conjunction withfinancial data.

A range of business change techniques may be used to enhance performance management.

Techniques may include:Business process re-engineering (BPR) which involves the examination of business processes with a view to improving theway in which each is implemented. A major focus may be on the production cycle, but it will also be applicable in areas suchas the accounting department.

Just-in-time (JIT) which requires commitment to the pursuit of ‘excellence’ in all aspects of an organisation.

Total quality management (TQM) which aims for continuous quality improvement in all aspects of the operation of anorganisation.

Activity based management systems (ABM) which focus on activities that are required in an organisation and the cost driversfor such activities, with a view to identifying and improving activities that add value and eliminating those activities that donot add value.

Long-term performance management is likely to embrace elements of BPR, JIT, TQM and ABM. All of these will be reflectedin the annual budget on an ongoing basis.

(b) An illustration of the features detailed above, framed in the context of a University as an organisation in the not-for-profit sectormight be as follows:

The Overall objective might well be stated in the mission statement of a University. An example of such a mission statementmight be as follows:

‘To provide a quality educational environment in a range of undergraduate and post-graduate disciplines and a qualityeducational focus for students and the business community.’

More specifically, objectives may be seen as the achievement of ‘value for money’ thereby ensuring effectiveness in areas suchas:– The provision of high added value to students;– The establishment of a reputation for recognised expertise in specific areas of research work within the wider community;

and– The provision of a high quality service to industry and commerce.

19



Strategies may focus on aspects such as:– The recruitment and retention of high quality academic staff;– The development of IT equipment and skills within the institution;– The mentoring of students in order to ensure high added value and low drop-out rates in intermediate years of study;

and– The close liaison with employers as to qualities in graduate/post-graduate employees that they will value highly.

The determinants used to measure the results of strategies might include:– Competitiveness – cost per graduate compared to other institutions; growth in student numbers; number of staff holding

a PhD qualification;– Financial performance – average cost per graduate; income generation from consultancy work;– Quality – range of awards (percentages of 1st class degrees); employer responses; measures of quality of delivery of

education, advice to students, etc;– Flexibility – variable entry and exit points to courses; modular structure; the variety of full-time, part-time and distance

learning modes;– Resource Utilisation – staff:student ratios; quotas met by each course; accommodation filled;– Innovation – latest IT provision in linking lecture theatres to information databases; increased provision of flexi-

learning/mixed mode course provision.

The application of business change techniques might include the following:BPR with a focus on IT developments, flexible-learning or mixed mode course provision.JIT with a focus on moves towards student-centred uptake of educational opportunities e.g. via intranet availability of lectureand tutorial material linked to more flexible access to staff rather than a ‘push’ system of pre-structured times oflectures/tutorials.TQM with a focus on moves to improve quality in all aspects of the learning environment including delivery of lectures, accessto staff and pastoral care issues.ABM with a focus on activities on a per student basis (both planned and actual) with a view to eliminating activities that donot add value e.g. cost per lecture per student.

20




Marks Marks1 (a) Admission revenue 6

Transport revenue 0·5Other revenue 0·5Operating costs 1Presentation 1 9

(b) Revenue 3No of visitors 1Weighted average contribution per visit 1Fixed costs less fixed revenue 1% of maximum capacity 1 7

(c) (i) Combined probability schedule 2Revenue 3Costs 3Expected values 2 10

(ii) Principle 1Calculation 1 2

(d) (i) Modifications 2Licence fee 1Redundancy payments 1Petrol penalty 1Disposal proceeds 1Repairs and maintenance 1Consumables 1Recommendation 1 9

(ii) Non-financial factors 4 x 1 4

(e) Initiatives 4 x 1 4–––45

–––

2 (a) (i) Transfer price and comment 4

(ii) Transfer price and comment 4

(iii) Transfer price and comment 4 12

(b) Reasons (1 per comment) 3 3–––15

–––

3 (a) Existing portfolio 1Oceanic division 2Retail outlets 2Racquets Ltd 1Birdcam-V 5‘Profit gap’ 1 Maximum 10

(b) (i) Focus attention on different strategies 1Description 2Risk 1 Maximum 3

(ii) Comments (on merit)Existing portfolio 1Retail outlets – market development 1·5Birdcam-V 1·5Racquets Ltd – unrelated diversification 1·5Oceanic division – related diversification 1·5 7

–––20

–––

21



Marks Marks4 (a) (i) Depreciation 3

Average capital employed 2ROCE 1

(ii) Comments (on merit):Required ROCE not achieved 1Dysfunctional behaviour 2 Maximum 8

(b) (i) Activity cost split 3Mark up 0·5Revised profit 0·5Comments (on merit) 5 9

(ii) Availability of supplies of raw materials 1Issue re timber is a natural resource 1Environmentally responsible organisation 1Competitive advantage 1 Maximum 3

–––20

–––

5 (a) Explanation of terms 5 x 3 Maximum 14

(b) Explanation of terms 4 x 2 Maximum 6–––20

–––

22




PART 3

FRIDAY 8 JUNE 2007

QUESTION PAPER









Pape

r 3.3




1 The Harding Law Partnership (HLP) provides legal services to commercial clients in the country of Strifeland. Thepartnership commenced trading on 1 June 2001. Each of the advisors employed by HLP is a specialist in theprovision of legal services in respect of ONLY one of the following categories of work:

Property;Commercial; orLitigation.

Appendices 1.1 and 1.2 below show statistics (both budget and actual) for the twelve month period ended 31 May2007 for HLP and also for a competitor, Merlin Advisory Services (MAS).

Additional information relating to HLP for the year ended 31 May 2007 is as follows:

(1) Fees charged per consultation (including subcontracted consultations)

Type of work Fee per consultation (£)Property 75Commercial 150Litigation 250

(2) HLP offered an ‘Advisory Protection Scheme’ under which member clients paid a fixed annual fee which entitledthem to priority service and a number of consultations without further charge during the year.

The number of non-chargeable consultations and fees payable under the Advisory Protection Scheme were asfollows:

Type of Number of consultations Annual fee (£)work without further charge per clientProperty 20 1,500Commercial 40 6,000

Note: The scheme did not apply to litigation work and you may assume that no client for property and commercialaffairs required more than the number of consultations allowed without further charge to which each client isentitled under the ‘Advisory Protection Scheme’.

(3) Each advisor was paid a salary of £50,000 per annum.

(4) HLP used the services of subcontractors when its own staff were unable to undertake commercial or litigationwork due to a lack of expertise. Payments to subcontractors were as follows:

Type of work Payment (£) per consultationCommercial 450Litigation 500

(5) Actual other operating expenses (excluding salaries of advisors and subcontract costs as per notes (3) and (4)above) amounted to £2,850,000, including an amount of £250,000 paid in respect of professional indemnityinsurance premiums. Budgeted other operating expenses (excluding salaries of advisors and subcontract costs asper notes (3) and (4) above) were £3,250,000, including an amount of £250,000 in respect of professionalindemnity insurance premiums.

Information for competitor MAS for the year ended 31 May 2007 is as follows:

(1) Fees charged per consultation (including subcontracted consultations)

Type of work Fee per consultation (£)Property 60Commercial 150Litigation 200

(2) Cost information£000

Salaries 1,560Professional indemnity insurance costs 100Other operating costs 2,032

2



(3) MAS operated a similar ‘Advisory Protection Scheme’ to that of HLP. The annual fees charged were £1,200 and£5,000 in respect of property and commercial work agreements respectively.

(4) MAS also used the services of subcontract advisors for specialist work at a cost of £350 per consultation.

Appendix 1.1Statistics for the year ended 31 May 2007

HLP MASBudget Actual Actual

Number of advisors employed throughout the year:Property 12 12 10Commercial 10 10 10Litigation 4 6 6Number of chargeable consultations (by work category),undertaken by own advisors:Property 17,080 20,200 12,500Commercial 12,000 13,200 10,200Litigation 1,920 2,400 2,125Number of chargeable consultations undertaken by subcontractors:Commercial – 320 20Litigation – 600 20‘Advisory Protection Scheme’ consultation uptake (property) 9,000 9,900 9,000‘Advisory Protection Scheme’ consultation uptake (commercial) 4,000 7,200 6,000Number of non-chargeable remedial consultations (all in respectof commercial work) – 180 135

––––––– ––––––– –––––––Total consultations undertaken 44,000 54,000 40,000

––––––– ––––––– –––––––Number of Advisory Protection Scheme clients – Property 600 600 900Number of Advisory Protection Scheme clients – Commercial 200 200 300

Appendix 1.2 Other statistics for the year ended 31 May 2007:

HLP MASBudget Actual Actual

Number of enquiries received from potential new clients 22,000 25,000 28,000Number of new client consultations 11,000 10,000 18,200Number of on-time consultations 44,000 51,000 39,600Number of times consultations were re-scheduled – 1,620 200Number of successful consultations 44,000 45,900 38,000Number of client complaints received – 670 135Number of successful claims for negligent advice – 3 –

3 [P.T.O.



Required:

(a) Using the information contained in Appendix 1.1, prepare budgeted and actual profit and loss statements forHLP and also a profit and loss statement on an actual basis for MAS for the year ended 31 May 2007.

(14 marks)

(b) Using the information contained in Appendix 1.1, discuss the financial performance of HLP and MAS,incorporating details of the following in your discussion:

(i) Overall client fees (total and per consultation) (ii) Advisory protection scheme consultation ‘utilisation levels’ for both property and commercial clients(iii) Cost/expense levels. (10 marks)

(c) Using the information contained in Appendix 1.2, compare the performance of HLP and MAS incorporatingrelevant percentage and ratio statistics under the following headings:

(i) Competitiveness; (5 marks)

(ii) Service quality; and (7 marks)

(iii) Flexibility. (3 marks)

(d) The managing partner of HLP stated at a recent partners’ meeting that ‘every advisor should aim to ensure that95% of all hours he/she works are billed to clients. This will ensure that we remain both profitable andcompetitive’.

Required:

Discuss the statement of the managing partner, drawing attention to any concerns that you may haveregarding the statement. (6 marks)

(45 marks)

4



2 Ice-Time Ltd (ITL) manufactures a range of sports equipment used in a variety of winter-sports in Snowland.Development engineers within ITL have recently developed a prototype of a small engine-propelled bobsleigh namedthe ‘Snowballer’, which has been designed for use by young children. The directors of ITL recently spent £200,000on market research, the findings of which led them to believe that a market exists for the Snowballer.

The marketing director has suggested that ITL should use the ‘Olympic’ brand in order to market the Snowballer.

The finance director of ITL has gathered relevant information and prepared the following evaluation relating to theproposed manufacture and sale of the Snowballer.

(1) Sales are expected to be 3,200 units per annum at a selling price of £2,500 per unit.

(2) Variable material, labour, and overhead costs are estimated at £1,490 per unit.

(3) In addition, a royalty of £150 per unit would be payable to Olympic plc, for the use of their brand name.

(4) Fixed overheads are estimated at £900,000 per annum. These overheads cannot be avoided until the end of theyear in which the Snowballer is withdrawn from the market.

(5) An initial investment of £5 million would be required. A government grant equal to 50% of the initial investmentwould be received on the date the investment is made. However, because the Snowballer would be classified asa luxury good, no tax allowances would be available on this initial investment. The estimated life cycle of theSnowballer is six years.

(6) Corporation tax at the rate of 30% per annum is payable in the year in which profit occurs.

(7) All cash flows are stated in current prices and, with the exception of the initial investment and the governmentgrant, will occur at the end of each year.

(8) The nominal cost of capital is 15·44%. Annual inflation during the period is expected to amount to 4%.

Required:

(a) Calculate the net present value (NPV) of the Snowballer proposal and recommend whether it should beundertaken by the directors of ITL. (4 marks)

(b) Using sensitivity analysis, estimate by what percentage each of the under-mentioned items, taken separately,would need to change before the recommendation in (a) above is varied:

(i) Initial outlay;(ii) Annual contribution. (4 marks)

(c) Using sensitivity analysis, estimate by what percentage the life cycle of the Snowballer would need to changebefore the recommendation in (a) above is varied. (4 marks)

(d) Comment on THREE factors other than NPV that the directors of ITL should consider when deciding whetherto manufacture the Snowballer. (3 marks)

(15 marks)

5 [P.T.O.




3 The Chemical Services Group plc (CSG), which operates a divisionalised structure, provides services to industrial anddomestic customers in Swingland, a country whose economic climate is subject to significant variations. There havebeen a number of recent changes at board level within CSG and therefore the managing director called a meeting ofthe board of directors at which each of four recently appointed directors put forward their view as to what their primaryfocus should be. These were as follows:

The research and development director stated that ‘my primary focus is upon ensuring that we continue to developthe products and services that satisfy the requirements of our existing and potential customers’.

The finance director stated that ‘my primary focus is upon keeping our investors satisfied’.

The human resources director stated that ‘my primary focus is upon ensuring that we take all the steps necessary toestablish and maintain our reputation as a responsible employer’.

The corporate affairs director stated that ‘my primary focus is upon the need to ensure that we are recognised as asocially responsible organisation’.

Required:

(a) Discuss the criteria that should be considered in deciding upon suitable performance measures in respect ofthe primary focus of each of the FOUR directors of CSG providing THREE appropriate quantitative measuresfor each primary focus.

Note: your answer may include financial or non-financial quantitative measures. (12 marks)

(b) Explain how growth may be assessed, and critically discuss the advantages and issues that might arise as aresult of a decision by the directors of CSG to pursue the objective of growth. (8 marks)

Note: your answer should refer to financial and non-financial factors.(20 marks)

6



4 Healthfoods Ltd (HFL) is a well-established company which markets fruit and vegetables under their ‘Good Health’brand name at each of its 6 outlets in the country of Ateland. During recent years HFL has marketed organically grownfruit and vegetables. The directors are now planning to market organic mushrooms which have a unique eating qualityand will be the most nutritious mushrooms available on the market.

The finance director has collated the following information regarding the proposed introduction and sale of organicmushrooms within Ateland:

(1) HFL will purchase the organic mushrooms from Orgmush Ltd (OML) and sell them at each of its 6 outlets withinAteland. Sales volumes of organic mushrooms are expected to be at the same level at each outlet.

(2) OML, which is the only grower of this particular type of organic mushroom within Ateland, has offered HFL achoice of four different contracts in respect of the forthcoming year. OML has the capacity to produce 360,000kilograms of organic mushrooms for each of the 6 outlets.

The cost incurred by HFL in respect of organic mushrooms will vary according to contract size, as shown in thefollowing table:

Contract Number of kilograms Cost per kilogram (£)A 160,000 4·45B 240,000 3·70C 280,000 3·55D 360,000 3·35

Note: The same contract type must be chosen in respect of each outlet.

(3) HFL will charge £5·50 per kilogram for all sales of organic mushrooms.

(4) Any unsold produce will be sold to the Animal Farm Group for £0·25 per kilogram.

(5) HFL must decide in advance of the forthcoming year which size of contract to enter.

(6) HFL uses acclaimed dieticians, international athletes or international film stars to promote its products viatelevision advertisements and has estimated the following probability distribution of advertisements to be heldduring the forthcoming year:

Category of advertisement: %Acclaimed dietician 20International athlete 40International film star 40

Market research has indicated that where an acclaimed dietician appears in an advertisement, HFL can be reasonablyassured of selling 160,000 kilograms of mushrooms per outlet and where an international athlete appears in anadvertisement then 234,000 kilograms of mushrooms per outlet will be sold. HFL expects to sell 360,000 kilogramsof mushrooms per outlet when an international film star appears in an advertisement.

Required:

(a) Using expected values, advise HFL regarding which contract should be entered into with OML.

Your answer should show the expected annual contribution from each contract. (12 marks)

(b) Determine whether your decision in (a) would change if you were to use each of the Maximin and Minimaxregret decision criteria.

Your answer should be supported by relevant workings. (6 marks)

(c) Briefly discuss why the directors of HFL might choose contract D irrespective of whether or not contract Dwould have been selected using expected values as per part (a). (2 marks)

(20 marks)

7 [P.T.O.



5 GE Railways plc (GER) operates a passenger train service in Holtland. The directors have always focused solely onthe use of traditional financial measures in order to assess the performance of GER since it commenced operationsin 1992. The Managing Director of GER has asked you, as a management accountant, for assistance with regard tothe adoption of a balanced scorecard approach to performance measurement within GER.

Required:

(a) Prepare a memorandum explaining the potential benefits and limitations that may arise from the adoption ofa balanced scorecard approach to performance measurement within GER. (8 marks)

(b) The following information is available in respect of GER for the years ended 31 May 2007 and 2006:

(1) Summary financial statements

Profit and Loss Account2007 2006£000 £000

Sales 33,000 30,525Cost of sales (14,850) (14,652)

––––––– –––––––Gross Profit 18,150 15,873Operating expenses (8,250) (7,293)Depreciation (3,300) (3,300)

––––––– –––––––Net Profit 6,600 5,280

––––––– –––––––

Balance Sheet2007 2006£000 £000

Fixed Assets (net book value) 33,160 29,500Net Current Assets 9,360 6,420

––––––– –––––––Net Assets 42,520 35,920

––––––– –––––––Financed by:Ordinary Share Capital (£1 each) 22,500 22,500Retained Earnings 20,020 13,420

––––––– –––––––Capital Employed 42,520 35,920

––––––– –––––––

8



(2) Other information relating to GER

Sales revenue (£000) 2007 2006Existing routes 25,080 24,420New routes 7,920 6,105Current Assets and Current Liabilities (£000)Stocks 6,610 4,950Debtors 2,560 3,550Creditors 3,960 3,300Other statistics:Number of new routes (planned) 4 6Number of new routes (actual) 6 4Number of customer ticket enquiries received 1,375,000 1,271,875Number of customer tickets sold 1,100,000 1,017,500Number of routes in operation 36 30Number of routes producing 80% of total revenue 20 24Number of trains in operation 15 15Average number of days in use 320 335Number of passenger miles 66,000,000 61,000,000Average train occupancy 80% 78%Number of times trains were 100% occupied 120 39Number of train journeys 4,000 3,900Number of train station ‘stops’ 10,000 9,500Number of late arrivals at train station ‘stops’ 200 285Number of employees 254 250Number of hours of employee training 2,159 2,000

(3) Each new route introduced required a cash investment in capital equipment of £660,000.

Required:

(i) Using only the above information, prepare a statement (in columnar format) which shows goals,measures (one of which must be cash flow) and statistics for each of the four perspectives of thebalanced scorecard in respect of GER. Your answer should include TWO goals, measures and statisticsrelating to each perspective of the balanced scorecard.

Insofar as possible you should show statistics for 2006 and 2007. (9 marks)

(ii) Suggest THREE other performance measures (not applied in (i)) which might be used to assess thecustomer perspective of the balanced scorecard of GER. (3 marks)

(20 marks)

9 [P.T.O.



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Answers




1 (a) Profit and Loss Accounts for the year ended 31 May 2007

HLP MASBudget Actual Actual£000 £000 £000

Revenue:Annual fee customers:Property 900 900 1,080Commercial 1,200 1,200 1,500Consultations:Property 1,281 1,515 750Commercial 1,800 2,028 1,533Litigation 480 750 429

–––––– –––––– ––––––Total revenue 5,661 6,393 5,292Cost of sales:Salaries 1,300 1,400 1,560Indemnity insurance 250 250 100Subcontract costs:Commercial 144 7Litigation 300 7Other operating expenses 3,000 2,600 2,032

–––––– –––––– ––––––Total costs 4,550 4,694 3,706

–––––– –––––– ––––––Net profit 1,111 1,699 1,586Net profit/sales (%) 19·6 26·6 30·0

(b) (i) Overall client consultation revenues are higher than budget in all three activities undertaken by the business as shownin the following table:

HLP HLP MAS HLP HLP MASRevenue Revenue Revenue Fee per Fee per Fee per

consultation (£) consultation (£) consultation (£)Consultation type: (budget) (actual) (actual) (budget) (actual) (actual)

£000 £000 £000Property 2181 2,415 1,830 75 75 60Commercial 3,000 3,228 3,033 150 150 150Litigation 480 750 429 250 250 200

HLP revenues from consultations relating to property, commercial and litigation work were 10·7%, 7·6% and 56·6%above budget, respectively. HLP charges 25% more than MAS for property and litigation consultations. HLP and MAScharge the same fee (£150) in respect of each commercial consultation.

The figures in (a) show that HLP has obtained a budgeted net profit: sales percentage of 19·6%. Its actual netprofit/sales percentage is 26·6% which is 3·4% below the net profit/sales percentage (%) achieved by its competitorMAS.

HLP has improved its revenue position via a number of factors:

(i) Annual fee clients in respect of both Property and Commercial work were as per budget. Property clients werecharged £1,200 whilst commercial clients were charged £6,000. Competitor MAS charged fees of £1,200 and£5,000 respectively.

(ii) The percentage uptake of consultations under the ‘Advisory Protection Scheme’ had an impact on profit levels forthe year ended 31 May 2007. The following table shows the relative figures for HLP and competitor MAS:

HLP HLP MAS(budget) (actual) (actual)

Property work:Total consultations per agreement (clients x 20) 12,000 12,000 18,000Actual consultations taken up (per appendix 1.1) 9,000 9,900 9,000Percentage take-up 75·0% 82·5 % 50·0%Commercial work:Total consultations per agreement (clients x 40) 8,000 8,000 12,000Actual consultations taken up (per appendix 1.1) 4,000 7,200 6,000Percentage take-up 50 % 90 % 50 %

15



(ii) As far as annual agreements relating to property work are concerned, HLP had a take up rate of 82·5% whereas MAShad a take up rate of only 50%. Therefore, HLP has ‘lost out’ to competitor MAS in relative financial terms as regardsthe ‘take-up’ of consultations relating to property work. This is because both HLP and MAS received an annual fee fromeach property client irrespective of the number of consultations given. MAS should therefore have had a better profitmargin from this area of business than HLP. However, the extent to which HLP has ‘lost out’ cannot be quantified sincewe would need to know the variable costs per consultation and this detail is not available. What we do know is thatHLP earned actual revenue per effective consultation amounting to £90·90 whereas the budgeted revenue perconsultation amounted to £100. MAS earned £120 per effective consultation.

The same picture emerges from annual agreements relating to commercial work. HLP had a budgeted take up rate of50%, however the actual take up rate during the period was 90%. MAS had an actual take up rate of 50%. The actualrevenue per effective consultation earned by HLP amounted to £167 whereas the budgeted revenue per consultationamounted to £300. MAS earned £250 per effective consultation.

There could possibly be an upside to this situation for HLP in that it might be the case that the uptake of 90% ofconsultations without further charge by clients holding annual agreements in respect of commercial work might beindicative of a high level of customer satisfaction. It could on the other hand be indicative of a mindset which says ‘Ihave already paid for these consultations therefore I am going to request them’.

(iii) Budgeted and actual salaries in HLP were £50,000 per annum, per advisor. Two additional advisors were employedduring the year in order to provide consultations in respect of commercial work. MAS paid a salary of £60,000 to eachadvisor which is 20% higher than the salary of £50,000 paid to each advisor by HLP. Perhaps this is indicative thatthe advisors employed by MAS are more experienced and/or better qualified than those employed by HLP.

HLP paid indemnity insurance of £250,000 which is £150,000 (150%) more than the amount of £100,000 paid byMAS. This excess cost may well have arisen as a consequence of successful claims against HLP for negligence inundertaking commercial work. It would be interesting to know whether HLP had been the subject of any successfulclaims for negligent work during recent years as premiums invariably reflect the claims history of a business. Ratherworrying is the fact that HLP was subject to three such claims during the year ended 31 May 2007.

Significant subcontract costs were incurred by HLP during the year probably in an attempt to satisfy demand and retainthe goodwill of its clients. HLP incurred subcontract costs in respect of commercial properties which totalled £144,000.These consultations earned revenue amounting to (320 x £150) = £48,000, hence a loss of £96,000 was incurredin this area of the business.

HLP also paid £300,000 for 600 subcontract consultations in respect of litigation work. These consultations earnedrevenue amounting to (600 x £250) = £150,000, hence a loss of £150,000 was incurred in this area of the business.In contrast, MAS paid £7,000 for 20 subcontract consultations in respect of commercial work and an identical amountfor 20 subcontract consultations in respect of litigation work. These consultations earned revenue amounting to20 x (£150 + £200) =£7,000. Therefore, a loss of only £7,000 was incurred in respect of subcontract consultationsby MAS.

Other operating expenses were budgeted at 53·0% of sales revenue. The actual level incurred was 40·7% of salesrevenue. The fixed/variable split of such costs is not given but it may well be the case that the fall in this percentage isdue to good cost control by HLP. However, it might simply be the case that the original budget was flawed. CompetitorMAS would appear to have a slightly superior cost structure to that of HLP since its other operating expenses amountedto 38·4% of sales revenue. Further information is required in order to draw firmer conclusions regarding cost controlwithin both businesses.

(c) (i) Competitiveness may be measured in terms of market share or sales growth. HLP has shown growth in all areas of itsbusiness as shown in the following table:

HLP HLPConsultation type: Number of Number of Gain Gain over

consultations consultations over budget(budget) (actual) budget (%)

Property 26,080 30,100 4,020 15·4Commercial 16,000 20,720 4,720 29·5Litigation 1,920 3,000 1,080 56·3

The figures in the above table might well be indicative of increased market share. However, competitiveness may alsobe measured in terms of relative success/failure in obtaining new business. The split between existing and new businesscan be calculated from the information contained in appendix 1.1. HLP budgeted to convert (11,000/22,000) = 50%of its enquiries from new clients into chargeable consultations. However, HLP actually converted (10,000/25,000) =40% of new clients enquiries into chargeable consultations. MAS performed better than HLP with (18,200/28,000) =65% of enquiries from new clients being converted into chargeable consultations.

(ii) Quality of service is the totality of features and characteristics of the service package that bear upon its ability to satisfyclient needs. To some extent the number of complaints and the need to provide non-chargeable consultations associatedwith the remedying of those complaints is indicative of a service quality problem that must be addressed. Hence thisproblem needs to be investigated at the earliest opportunity. Assuming consultants could have otherwise undertaken

16



chargeable work, the revenue foregone as a consequence of the remedial consultations relating to commercial workamounted to (180 x £1500) = £27,000. Client complaints received by HLP during the year amounted to 1·24% ofconsultations undertaken by commercial advisors whereas none were budgeted. In contrast, competitor MAS received135 complaints which coincided with the number of non-chargeable consultations undertaken by them. This mayindicate that MAS operate a policy of a remedial consultation in respect of all complaints received from clients.

With regard to the number of on-time consultations, HLP only achieved an on-time consultation percentage of 94·4%which is far inferior to that of 99% achieved by competitor MAS. Also, HLP re-scheduled the appointment times of1,620 (3%) of its total consultations whereas competitor MAS only re-scheduled 0·5% of its consultation times. Thepercentage number of successful consultations provided by HLP and MAS was 85% and 95% respectively whichindicates that competitor MAS possesses a superior skills-base to that of HLP.

The most alarming statistic lies in the fact that HLP was subject to three successful legal actions for negligence. Thismay not only account for the 150% increase in the cost of professional indemnity insurance premiums but may alsoresult in a loss of client confidence and precipitate a considerable fall in future levels of business should the claimsbecome much publicised.

(iii) Flexibility may relate to the company being able to cope with flexibility of volume, delivery speed or job specification. Inthis particular context, flexibility appears to have been problematic for HLP as evidenced by the fact that 320consultations relating to commercial were subcontracted during the year. This could be due to the lack of the ability ofHLP advisors to be able to provide consultations to a potentially wide-range of commercial clients, i.e. the variability inthe ‘job specification’ requires greater flexibility than HLP can deliver. Furthermore, a total of 600 consultations relatingto litigation work were also subcontracted throughout the year. These subcontract consultations might be due to theinability of HLP to deal with fluctuations in demand.

(d) In one respect the managing partner is quite correct since turnover and net profit have reached levels of £6,393,000 and£1,699,000 respectively in just six years. However, there are visible signs that all is not well. All businesses have limitedresources and in this respect it is visible that the advisors are ‘stretched’, as evidenced by the following statistics regardingresource utilisation. Resource utilisation measures the ratio of output achieved from those resources input. In this scenariothe mean number of consultations per advisor may be used as a guide.

Average consultations per advisor:Budget Actual Increase/(decrease) Increase/(decrease) %

Property 2,173 2,508 335 15·4Commercial 1,600 2,058 458 28·6Litigation 480 400 (80) (16·7)

It is interesting to note that property and commercial advisors are being utilised above budgeted levels. There are potentialproblems if the quality of the service provision is falling. The number of commercial consultations was 29·5% higher thanbudget. It may be the case that the advisors are ‘stretched’ to the point where service quality is being adversely affected. Themanaging partner’s statement illustrates ‘tunnel vision’ on his/her part in that an undue focus is being placed on achievinggrowth to the detriment of other areas.

Matters such as the amount of time spent travelling to/from clients’ premises, updating client records, together with the timespent updating one’s knowledge in light of new or forthcoming legislative changes will render a target of 95% unachievablein such businesses as that of HLP.

2 (a) Calculation of expected net present value (£000)

Sales volume = 3,200 units.

£Sales revenue per unit 2,500Variable costs per unit 1,640

––––––Contribution per unit 860

––––––

Total contribution = (3,200 x £860) = £2,752,000 – fixed overheads £900,000 = £1,852,000 less taxation (at 30%)£555,600 = £1,296,400.

Net present value at a discount rate of 11% per annum = (£1,296,400 x 4·231) – (£5,000,000 x 50%) = £2,985,068.The project should be undertaken by the directors of ITL.

Notes:(i) Variable cost per unit = £1,490 + Royalty £150 = £1,640.(ii) £200,000 already spent on market research is a sunk cost and therefore not included in the calculation of the expected

net present value of the Snowballer proposal.(iii) A real discount rate of 11% has been used. It has been calculated as follows: ((1 + nominal cost of capital)/(1 + rate

of inflation)) – 1 = 1·1544/(1 + 0·04) = 1·11 – 1 = 0·11 or 11%.

17



(b) (i) The NPV of the proposal is £2,985,068. The initial outlay(net) could be varied by the NPV of £2,985,068 to be£5,485,068 giving a total outlay of £10,970,136 before the NPV would become negative. This is due to the 50%government grant that is available on the initial investment. This represents a percentage increase of 119·4%(10,970,136 – 5,000,000).–––––––––––––––––––––––

5,000,000

(ii) The level of annual contribution at which NPV will be equal to zero can be calculated using the formula (1 – t)4·231 x – initial investment – fixed overheads (1 – t) = 0, where t is the rate of corporation tax and x = annualcontribution. This gives:

(1 – 0.30) 4·231x – £2,500,000 – (900,000 (1 – 0·30) 4·231) = 0∴ 2·9617 x = £2,500,000 + 2,665,530∴ x = £1,744,110.

This shows that annual contribution can decline from the existing level of £2,752,000 to £1,744,110. This representsa percentage decrease of 36·62% (1,007,890/2,752,000) x 100%. The 4·231 in the above formula represents thecumulative discount factor for six years at a rate of 11% per annum. £2,500,000 represents the investment outlay netof the government grant.

(c) The life cycle of the Snowballer: £

NPV of year 1 net cash flow = £1,296,400 x 0·901 = 1,168,056NPV of year 2 net cash flow = £1,296,400 x 0·812 = 1,052,677

––––––––––Total for year 1 and year 2 2,220,733Investment outlay (net) 2,500,000

––––––––––NPV required in year 3 in order to achieve a zero NPV 279,267

However, if fixed overheads are incurred in year 3 irrespective of the sales life of the Snowballer then discounted fixed costsamounting to £460,530 (£900,000 x 0·7 x 0·731) would be incurred.

Hence discounted contribution required in order to achieve a zero NPV would amount to £279,267 + £460,530 =£739,797.

The total discounted contribution for the whole of year 3 amounts to £2,752,000 x 70% x 0·731 = £1,408,198.

Hence the reduction in year 3 life allowable in year 3 = (1,408,198 – 739,797)/1,408,198 = 47·46% (say 47%approximately). So the life cycle required during year 3 = 53% or (0·53 of the year). This means that 2 + 0·53 = 2·53years are required to produce an overall NPV = 0.

Hence the fall in the life cycle of the project (for an overall NPV = 0) = 6 – 2·53 = 3·47 years or 3·47/6 = 57·8% (whichis the sensitivity measure).

(d) Factors that should be considered by the directors of ITL include:

(i) The cash flows are estimated. How accurate they are requires detailed consideration. (ii) The cost of capital used by the finance director might be inappropriate. For example if the Snowballer proposal is less

risky than other projects undertaken by ITL then a lower cost of capital should be used.(iii) The rate of inflation may vary from the anticipated rate of 4% per annum.(iv) How strong is the Olympic brand name? The directors are proposing to pay royalties equivalent to 6% of sales revenue

during the six years of the anticipated life of the project. Should they market the Snowballer themselves?(v) Would competitors enter the market and what would be the likely effect on sales volumes and selling prices?

N.B: Only three factors were required.

3 (a) The primary focus of the research and development directorThere is a need to measure the ability of CSG to offer up to date services that are sought after by existing and potentialcustomers. In this regard it would be relatively easy to determine the number of new products/services introduced in previousperiods. The performance of individual innovations should also be assessed. Also the aggregate expenditure on thedevelopment of new services may indicate how CSG has performed with regard to offering up to date, customer focusedservices.

The primary focus of the finance directorCSG could use return on capital employed (ROCE), economic value added (EVA) or residual income (RI) as measures offinancial performance. EVA and RI are both superior to return on capital employed (ROCE) in that each method is more likelyto develop goal congruence in terms of acquisition and disposal decisions. It is vital that any performance measure chosenis consistent with the NPV rule. The use of RI could prove problematic when managers adopt a short term outlook and useshort term performance measures as decisions may not be consistent with the NPV rule. EVA attempts to avoid the problemsassociated with understated asset values that arise in the use of ROCE and RI. Current values should be used as opposed tohistorical costs.

18



The primary focus of the human resources director CSG could use measures such as the rate of staff turnover, the level of absenteeism, training costs per employee and thenumber of applications received for each job vacancy. These measures may provide an indication of the extent to which CSGcan be regarded as a socially responsible employer.

These measures should be compared with those of prior periods and targets. Employee attitude surveys may also beundertaken on a systematic basis in order to assess matters such as the degree of satisfaction with the payment systems thatare in operation, management style and working conditions.

The primary focus of the corporate affairs directorCSG could use measures such as the amounts spent on the disposal of waste chemicals, the number of complaints receivedfrom clients and members of the public and the total of contributions made to organisations which seek to meet socialobjectives, e.g. charities, schools and hospitals.

(b) Growth may be measured in a number of ways which are as follows:

Cash flowThis is a very important measure of growth as it ultimately determines the amount of funds available for re-investment by anybusiness.

Sales revenueGrowth in sales revenues generated is only of real value to investors if it precipitates growth in profits.

ProfitabilityThere are many measures relating to profit which include sales margin, earnings before interest, taxation, depreciation andamortisation (EBITDA) and earnings per share. More sophisticated measures such as return on capital employed and residualincome consider the size of the investment relative to the level of profits earned. In general terms, measures of profitabilityare only meaningful if they are used as a basis for comparisons over time or in conjunction with other measures ofperformance. Growth rate in profitability are useful when compared with other companies and also with other industries.

Return on investmentA growing return upon invested capital suggests that capital is being used more and more productively. Indicators of a growingreturn would be measured by reference to dividend payment and capital growth.

Market shareGrowth in market share is generally seen as positive as it can generate economies of scale.

Number of products/service offeringsGrowth is only regarded as useful if products and services are profitable.

Number of employeesMeasures of productivity such as value added per employee and profit per employee are often used by shareholders inassessing growth. Very often an increased headcount is a measure of success in circumstances where more people areneeded in order to deliver a service to a required standard. However it is incumbent on management to ensure that allemployees are utilised in an effective manner.

It is a widely held belief that growth requires profits and that growth produces profits. Profits are essential in order to preventa company which has achieved growth from becoming a target for a take-over or in a worse case scenario goes intoliquidation. Hence it is fundamental that a business is profitable throughout its existence. Growth accompanied by growth inprofits is also likely to aid the long-term survival of an organisation. CSG operates in Swingland which experiences fluctuationsin its economic climate and in this respect the exploitation of profitable growth opportunities will help CSG to survive at theexpense of its competitors who do not exploit such opportunities.

Note: Alternative relevant discussion and examples would be accepted.

4 (a) Pay-off table

Purchase optionsDemand Prob Contract A Contract B Contract C Contract DKilograms Contribution Expected Contribution Expected Contribution Expected Contribution Expected

value value value value£ £ £ £ £ £ £ £

160,000 0·20 1,008,000 201,600 72,000 14,400 (504,000) (100,800) (1,656,000) (331,200)234,000 0·40 1,008,000 403,200 2,403,000 961,200 1,827,000 730,800 675,000 270,000360,000 0·40 1,008,000 403,200 2,592,000 1,036,800 3,276,000 1,310,400 4,644,000 1,857,600

–––––––––– –––––––––– –––––––––– ––––––––––1,008,000 2,012,400 1,940,400 1,796,400–––––––––– –––––––––– –––––––––– ––––––––––

On the basis of expected values HFL should select Contract B under which 240,000 kilograms will be supplied during theforthcoming year which would give an annual expected value of £2,012,400.

19



Note 1:Example of workings for the Pay-off table in part (a): If we assume that Contract B was selected and subsequent demand was for 160,000 kilograms then the resultantcontribution would be calculated as follows:(160,000 x £·50) – (240,000 x £3·70) = (£8,000) + (80,000 x £0·25) = £12,000 x 6 =£72,000.

(b) The minimum contribution for each possible decision is as follows:

Contract Minimum contribution (£)A 1,008,000B 72,000C (504,000)D (1,656,000)

Applying a Maximin approach to this decision would result in the selection of Contract A under which 160,000 kilograms oforganic mushrooms would be supplied to HFL.

Applying a minimax regret approach, the regret matrix would appear as follows:

Contract type A B C DDemand per outlet 160,000 240,000 280,000 360,000

£ £ £ £160,000 0 936,000 1,512,000 2,664,000234,000 1,395,000 0 576,000 1,728,000360,000 3,636,000 2,052,000 1,368,000 0

–––––––––– –––––––––– –––––––––– ––––––––––Maximum regret 3,636,000 2,052,000 1,512,000 2,664,000

Therefore in order to minimise the maximum regret, Contract C, under which 280,000 kilograms of organic mushroomswould be supplied to HFL, would be chosen.

(c) The directors might select Contract D under which 360,000 kilograms of organic mushrooms would be supplied to HFL foreach outlet. This is the entire capacity of HFL which would ensure that competitors would not be able to supply the sameproduct and hence the competitive advantage held by HFL might be preserved.

5 (a) To: Board of directorsFrom: Management AccountantDate: 8 June 2007

The potential benefits of the adoption of a balanced scorecard approach to performance measurement within GER are asfollows:

A broader business perspectiveFinancial measures invariably have an inward-looking perspective. The balanced scorecard is wider in its scope andapplication. It has an external focus and looks at comparisons with competitors in order to establish what constitutes bestpractice and ensures that required changes are made in order to achieve it. The use of the balanced scorecard requires abalance of both financial and non-financial measures and goals.

A greater strategic focusThe use of the balanced scorecard focuses to a much greater extent on the longer term. There is a far greater emphasis onstrategic considerations. It attempts to identify the needs and wants of customers and the new products and markets. Henceit requires a balance between short term and long term performance measures.

A greater focus on qualitative aspectsThe use of the balanced scorecard attempts to overcome the over-emphasis of traditional measures on the quantifiable aspectsof the internal operations of an organisation expressed in purely financial terms. Its use requires a balance betweenquantitative and qualitative performance measures. For example, customer satisfaction is a qualitative performance measurewhich is given prominence under the balanced scorecard approach.

A greater focus on longer term performanceThe use of traditional financial measures is often dominated by financial accounting requirements, for example, the need toshow fixed assets at their historic cost. Also, they are primarily focused on short-term profitability and return on capitalemployed in order to gain stakeholder approval of short term financial reports, the longer term or whole life cycle often beingignored.

The limitations of a balanced scorecard approach to performance measurement may be viewed as follows:

The balanced scorecard attempts to identify the chain of cause and effect relationships which will provide the stimulus forthe future success of an organisation.

20



Advocates of a balanced scorecard approach to performance measurement suggest that it can constitute a vital componentof the strategic management process.

However, Robert Kaplan and David Norton, the authors of the balanced scorecard concept concede that it may not be suitablefor all firms. Norton suggests that it is most suitable for firms which have a long lead time between management action andfinancial benefit and that it will be less suitable for firms with a short-term focus. However, other flaws can be detected inthe balanced scorecard.

The balanced scorecard promises to outline the theory of the firm by clearly linking the driver/outcome measures in a causeand effect chain, but this will be difficult if not impossible to achieve.

The precise cause and effect relationships between measures for each of the perspectives on the balanced scorecard will becomplex because the driver and outcome measures for the various perspectives are interlinked. For example, customersatisfaction may be seen to be a function of several drivers, such as employee satisfaction, manufacturing cycle time andquality. However, employee satisfaction may in turn be partially driven by customer satisfaction and employee satisfactionmay partially drive manufacturing cycle time. A consequence of this non-linearity of the cause and effect chain (i.e., there isnon-linear relationship between an individual driver and a single outcome measure), is that there must be a question markas to the accuracy of any calculated correlations between driver and outcome measures. Allied to this point, any calculatedcorrelations will be historic. This implies that it will only be possible to determine the accuracy of cause and effect linkagesafter the event, which could make the use of the balanced scorecard in dynamic industries questionable. If the market isundergoing rapid evolution, for example, how meaningful are current measures of customer satisfaction or market share?

These criticisms do not necessarily undermine the usefulness of the balanced scorecard in presenting a more comprehensivepicture of organisational performance but they do raise doubts concerning claims that a balanced scorecard can beconstructed which will outline a clear cause and effect chain between driver and outcome measures and the firm’s financialobjectives.

(b) (i) The statistics in respect of GER are as follows:

2007 2006Financial perspectiveGoals: Measures:Success Profit 6,600 5,280Survival Cash flow 2,930 (W1) unknownProsperity Return on capital employed 15·5% 14·7%Customer perspectiveGoals: Measures:New products % sales from new routes 24 20Competitiveness % ticket sales from enquiries 80 80Responsive supply % of on-time stops 98 97Internal business perspectiveGoals: Measures:Service excellence Cost per route (£000) 413 488Service provision efficiency Cost per passenger mile (excluding depreciation) (£) 0·35 0·36New route introduction Introduction schedule, actual v plan 150% 66%Innovation and learning perspectiveGoals: Measures:Product focus Number of routes producing 80% of sales 20 24Employee skill level Training hours per employee 8·5 8·0

W(1)Cash flow (2007) £000Net profit 6,600Depreciation 3,300

––––––Profit on ordinary activities 9,900Adjustments for movements in working capital:Stocks (1,660)Debtors 990Creditors 660

––––––Cash generated from operations 9,890Acquisition of fixed assets (6,960)

––––––Net cash flow 2,930

––––––

Note: Alternative relevant discussion and examples would be accepted.

21



(ii) Performance measures that may be used to assess the customer perspective of the balanced scorecard of GER includethe following:

Lost or damaged luggage per 1,000 passengersTrain cancellation rateDenied boarding rateNumber of passenger complaints.

Note: Only three measures were required.

22




Marks Marks1 (a) Revenue calculations:

Advisory Protection Scheme 3Consultations 4Costs:Salaries 1Indemnity insurance 1Subcontract costs 2Other operating expenses 2Presentation 1 14

–––

(b) Net profit: sales (%) 1Consultation fees structure 1Advisory Protection Schemes:Fee structure 1Utilisation rates 3Cost structure 4 10

–––

(c) Competitiveness 5Service quality 7Flexibility 3 15

–––

(d) Statement is wrong 2Concerns 4 6

––– –––45

–––

2 (a) Contribution 1Fixed overheads 0·5Grant receivable 0·5Corporation tax 0·5NPV 1·5Sunk cost 1 Maximum 4

–––

(b) (i) Calculation 2(ii) Calculation 2 4

–––

(c) Calculation 4 4

(d) Factors 3 x 1 3–––15

–––

3 (a) Comments (on merit):Directors statements 4 x 3 12

(b) Comments (on merit):Assessment 4Advantages/issues 4 8

––– –––20

–––

23



Marks Marks4 (a) Pay-off table 11

Recommendation 1 12–––

(b) Maximin – number 1Explanation 1

Minimax regret – regret table 3explanation 1 6

–––

(c) Comments on merit 2 2–––20

–––

5 (a) Memorandum format 1Comments (on merit) 7 8

–––

(b) (i) Goals 3Cash flow 4Performance measures 4 Maximum 9

–––

(ii) Performance measures 3 x 1 3–––20

–––

24



Fundamentals Level – Skills Module

Time allowedReading and planning: 15 minutesWriting: 3 hours


Formulae Sheet is on page 9


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


Pape

r F5Performance

Management

Monday 10 December 2007




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

2



ALL FOUR questions are compulsory and MUST be attempted

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

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

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

Required:

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

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

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

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

Cost information for the new radio is as follows:

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

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

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

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

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

Total production overhead Total assembly labour hours$

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

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

Required:

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

(25 marks)

3 [P.T.O.



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

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

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

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

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

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

Table 1Quarter 1 Quarter 2

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

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

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

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

–––––––– ––––––––

Required:

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

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

4



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

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

Table 2Quarter 1 Quarter 2

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

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

Required:

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

(9 marks)

(25 marks)

5 [P.T.O.



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

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

Required:

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

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

Materials

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

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

Labour

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

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

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

Required:

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

6



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

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

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

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

Required:

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

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

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

(25 marks)

7 [P.T.O.



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

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

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

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

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

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

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

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

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

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

Required:

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

Note: no calculations are required. (4 marks)

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

(15 marks)

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

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

(25 marks)

8



9

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

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




Answers



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

1 Edward Limited

(a) Target costing process

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

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

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

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

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

(b) Benefits of adopting target costing

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

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

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

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

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

(c) Steps to reduce a cost gap

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

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

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

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

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

11



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

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

(d) Cost per unit and cost gap calculation

Component 1 $ per unit

(4·10 +$2,400

) 4·70––––––––––4,000 units

Component 2

(25

x 0·5 x100

) 0·128––– –––100 98

Material – other 8·10Assembly labour

(30

x $12·60/hr x100

) 7·00–– –––60 90

Variable production overhead

(30

x $20/hr) 10·00––60

Fixed production overhead

(30

x $12/hr) 6·00––60

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

–––––––Cost gap 0·728

–––––––

Working

1. Production overhead cost

Using a high low method

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

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

FPO absorption rate$2,880,000

= $12/hr–––––––––––240,000 hrs

2 Ties Only Limited

(a) Financial performance of Ties Only Limited

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

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

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

12



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

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

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

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

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

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

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

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

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

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

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

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

(c) Non-financial indicators of success

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

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

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

Quarter 1$420,000

= $15·20 per tie–––––––––27,631

Quarter 2$680,000

= $17·50 per tie–––––––––38,857

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

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

13



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

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

This is clearly concerning and an investigation is needed.

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

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

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

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

Workings

1. Gross profit

Quarter 1: Quarter 2:218,400

= 52%339,320

= 50%–––––––– ––––––––420,000 680,000

2. Website conversion rates

Quarter 1: Quarter 2:27,631

= 4%38,857

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

3. Website hits growth

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

863,492= 1·25 = 25%––––––––

690,789

3 Spike Limited

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

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

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

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

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

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

(b) Materials

Arguments in favour of allowing a revision

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

14



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

Arguments against allowing a budget revision

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

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

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

Labour

Arguments in favour of allowing a revision

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

Arguments against allowing a budget revision

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

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

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

Conclusion

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

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

(c) Total sales variances

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

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

(d) Market size and share variances

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

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

(e) Comment on sales performance

Sales Price

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

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

Volume

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

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

15



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

Spike should be concerned that its market is shrinking.

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

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

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

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

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

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

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

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

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

––––––––Total 229,800

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

Lost contribution per hour of labour used on new products

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

Incremental costs

Male version Female version$ $

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

––––––– –––––––––Total 65,500 166,000

––––––– –––––––––

Incremental revenues

Male version Female version$ $

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

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

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

–––––––– ––––––––

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

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

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

16



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

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

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

808 ltrs

or about $60·13 per 100 ml.

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

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

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

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

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

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

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

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

17



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

Marks1 (a) Process description

Product specification 1Selling price 1Cost calculation 1

–––3

–––

(b) Benefits of target costingPer benefit 1

–––4

–––

(c) Methods to reduce the cost gapPer idea 1

–––5

–––

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

–––13–––25–––

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

–––Max 12

–––

(b) Future profits comment 4–––

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

–––Max 11

–––25–––

19



Marks3 (a) When adjustment allowed 21/2

When adjustment not allowed 21/2–––5

–––

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

–––8

–––

(c) Sales price variance 2Sales volume variance 2

–––4

–––

(d) Market size variance 2Market share variance 2

–––4

–––

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

–––4

–––25–––

4 (a) Per factor outlined 1–––

4–––

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

–––15–––

(c) Breakeven calculation 2–––

2–––

(d) Per factor outlined 1–––

4–––25–––

20









Pape

r F5Performance

Management

Monday 9 June 2008





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

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

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

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

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

The variances for month 1 are as follows:

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

Fav = Favourable, Adv = Adverse

Chaff Co uses labour hours to absorb the variable overhead.

Required:

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

2



In month 2 the following data applies:

Standard costs for 1 tonne of brown rice

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

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

Budget information for month 2 is

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

The actual results for month 2 were as follows:

Actual production and sales were 8,000 tonnes

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

Required:

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

(25 marks)

3 [P.T.O.



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

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

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

Manufacturing details for the two products are as follows:

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

HC does not keep inventory.

Required:

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

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

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

Required:

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

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

(25 marks)

4




5 [P.T.O.



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

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

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

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

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

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

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

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

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

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

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

Required:

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

6



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

Voucher scheme

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

Software upgrade

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

Delaying payments to trainers

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

Required:

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

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

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

(25 marks)

7 [P.T.O.



4 Jola Publishing Co publishes two forms of book.

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

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

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

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

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

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

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

The main overheads involved are:

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

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

Required:

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

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

8



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

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

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

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

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

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

Overhead Annual cost for the coming year$

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

––––––––––Total 2,880,000

––––––––––

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

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

Required:

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

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

(25 marks)


9



10

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve



y=a+bx

b=n∑xy-∑x∑yn∑x -(∑x)

a=∑yn

-b∑xn

r=n∑xy

2 2

--∑x∑y

n∑x -(∑x) )(n∑y -(∑y) )2 2 2 2



Answers



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

1 Chaff Co

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

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

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

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

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

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

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

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

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

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

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

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

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

––––Marginal costs of production 184

––––Standard contribution 56

––––

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

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

13



Budget profit statement for month 2

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

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

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

––––––––––Budget profit 260,400

––––––––––

Actual profit for month 2.

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

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

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

––––––––––Actual profit 156,640

––––––––––

Operating statement for month 2

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

Sales price 120,000Sales volume 22,400

––––––––142,400––––––––328,000

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

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

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

––––––––Actual fixed cost 200,000

––––––––Actual profit 156,640

––––––––

Workings for the variances in month 2

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

3. Material price:

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

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

*10% of 15,800

14

660 00012 000

60 12 000 60 000,,

– , ,⎛⎝⎜

⎞⎠⎟

= Fav



8. Variable overhead expenditure:

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

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

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

Rate variance as above = 18,960 Adv

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

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

2 Higgins Co

(a) Contribution per cuePool cue Snooker cue

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

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

–––––– –––––––

(b) Formulation of the linear programming problem

Variables

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

Let C represent the contribution earned in any three month period

Constraints:

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

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

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

See diagram on next page

The feasible region is identified as the area inside OABCDE.

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

Solving at point D:

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

Substituting S = 12,000 in equation (2)

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

0·5P = 12,000 – 9,0000·5P = 3,000

P = 6,000

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

The contribution earned is

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

15

480 00015 000

30 15 000 30 000,,

– , ,⎛⎝⎜

⎞⎠⎟

= Adv



Production schedule

16

E

0

2

4

6

8

10

12

14

16

18

20

22

24

2 4 6 8 10 12 14 16 18 20S

contribution

A

Ash

Craftsmen

Max S

Max P

Max contribution

F

D

C

B

P

Feasible region = OABCDEOptimal point at point D



(c) Shadow prices

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

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

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

Calculation of shadow prices:

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

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

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

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


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

0·5P = 3,001P = 6,002

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

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

(d) Acceptability of the craftmens’ offer.

Rate of pay

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

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

How many hours to buy?

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

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

At F

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


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

0·27P = 2,160P = 8,000

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

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

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

17



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

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

Quality of work

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

Any other feasible points would be accepted

3 Bridgewater Co

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

Sales Growth

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

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

Cost control – trainer costs

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

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

Cost control – room hire costs

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

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

Profit

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

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

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

(b) Revised forecasts

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

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

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

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

18



Incremental effects (as a working)

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

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

(c) Voucher scheme

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

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

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

Software upgrade

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

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

Delayed payment to trainers

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

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

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

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

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

4 Jola Publishing

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

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

19



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

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

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

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

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

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

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

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

–––– ––––––Margin 3·40 3·40

–––– ––––––

(W1) Workings for overheads:

Total overhead $2,880,000

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

Cost per hour =$2,880,000

= $24/hr–––––––––––––120,000 hrs

Cost per unit calculations under ABC

CB TJ$ $

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

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

–––– ––––––Margin 3·39 3·52

–––– ––––––

(W2) Working for ABC overheads alternative:

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

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

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

Cost per unit 2·41 3·88––––––– ––––––

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

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

A cost per driver approach is also acceptable.

20



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

Marks1 (a) Assessment of each person 3

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

–––9

–––

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

–––16–––25–––

21



Marks2 (a) Selling prices 1/2

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

2–––

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

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

Solve at optimal 2Calculation of contribution 1

–––12–––

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

–––5

–––

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

–––6

–––25–––

22



Marks3 (a) Per target discussed 2

–––8

–––

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

–––7

–––

(c) Per idea commented on 2–––

6–––

(d) For each suggestion 2–––

4–––25–––

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

–––8

–––

(b) For each explanation 2–––

4–––

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

–––6 max 5

–––

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

–––Maximum 8

–––25–––

23






The formulae are on page 6.




Pape

r F5Performance

Management

Monday 8 December 2008





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

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

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

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

Required:

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

(8 marks)

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

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

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

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

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

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

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

Required:

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

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

(25 marks)

2



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

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

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

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

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

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

Required:

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

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

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

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

(25 marks)

3 [P.T.O.



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

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

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

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

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

HC uses the high low method to analyse overheads.

The learning curve equation is y = axb, where

Required:

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

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

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

(25 marks)

4

b LogLRLog

= =2

0 074– .



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

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

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

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

Stealth’s budgeted volumes are as follows:

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

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

Required:

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

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

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

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

(25 marks)

5 [P.T.O.




6

Formulae Sheet

Learning curve

Y = axb


Regression analysis

Demand curve

P = a – bQ

b = change in price change in quantity


y=a+bx

b=y

x)

a=n

-x

n

r=

2 2

- y

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



Answers



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

1 (a) Performance statistics

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

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

Sales Growth

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

Gross Margin

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

Overhead Control

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

Net Margin

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

ROI

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

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

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

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

Possible methods of adjustment include:

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

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

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

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

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

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

W1

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

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

W2

Gross Profit

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

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

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

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

Variable costs in 2005:

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

$237,600 – 19,800 x 7·2 = $95,040

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

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

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

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

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

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

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

(0·3 x $100) + (0·7 x $300) = $240

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

(b) Profit calculations

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

High Demand (190) 300 w2 500 w4 816 w6

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Workings

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

(c) Which type of van to buy?

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

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

Expected values could be calculated thus:

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

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

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

(d) Methods of uncertainty reduction:

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

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

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

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

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

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

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

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

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

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

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

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

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

Opportunity costs of alternate work.

Possibility of working in overtime.

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

Cost Hours Rate per hour Total$

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

––––––––Total Cost 249,669

––––––––

(W1)

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

For the 199 Kitchens

Usingy = axb OR y = axb

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

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

For the 200 Kitchens

y = axb OR y = axb

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

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

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

Total time is therefore:

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

(W2)

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

Taking the highest and lowest figures from the information given:

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

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

Total cost = variable cost + fixed cost

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

Fixed cost = $40,000 per month

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

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

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

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

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

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

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

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

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

(b) Budgeted results for game

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

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

––––––– –––––––– ––––––– ––––––––

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

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

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

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

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

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

Workings

W1 Split of variable and fixed cost for Stealth

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

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

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

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

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

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

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There are problems involved with incremental budgeting:

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

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

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

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

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

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

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

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

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

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

–––Max 8

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

–––4

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

–––9

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

–––4

–––Total 25

–––

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Marks2 (a) Maximax explanation 1

Maximin explanation 1Expected value explanation 2

–––4

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

–––9

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

–––6

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

6–––

Total 25–––

3 (a) For each description 2–––

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

–––13

(c) Average time per unit 1Explanation 1

–––2

–––Total 25

–––

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Marks4 (a) Lifecycle costing principles:

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

–––4

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

–––9

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

–––6

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

–––Total 25

–––

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acca f5 performance management solved past papers 0208

Documents

product p

product line

units product d

new production manager

cost variances

basis of machine hours

direct labour costs

costing abc system