f5 kaplan practice questions

KAPLAN PU BL ISHING 1

QUESTIONS

PAPER F5 : PERFORMANCE MANAGEMENT

2 KAPLAN PU BL ISH ING

SPECIALIST COST AND MANAGEMENT ACCOUNTING TECHNIQUES

MANAGEMENT ACCOUNTING

‘In the broadest sense, all accounting is management accounting. All financial and cost information generated by accountants is of some interest to management. But, in practice, where management accounting differs from financial accounting ...’ (from An Insight into Management Accounting by John Sizer)

Required: (a) Give a brief definition of management accounting. (6 marks)

(b) Give a discussion of the major differences between management and financial accounting. (20 marks)

(Total: 25 marks)

LECTURER RESOURCE PACK – QUESTIO NS


A COLLEGE

A college offers a range of degree courses. The college organisation structure consists of three faculties, each with a number of teaching departments. In addition, there is an administrative/management function and a central services function.

The following cost information is available for the year ended 30 June 20X7:

(1) Occupancy costs

Total £1,500,000. Such costs are apportioned on the basis of area used which is: Square feet Faculties 7,500 Teaching departments 20,000 Administration/management 7,000 Central services 3,000

(2) Administration/management costs

Direct costs: £1,775,000.

Indirect costs: an apportionment of occupancy costs.

Direct and indirect costs are charged to degree courses on a percentage basis.

(3) Faculty costs

Direct costs: £700,000.

Indirect costs: an apportionment of occupancy costs and central service costs.

Direct and indirect costs are charged to teaching departments.

(4) Teaching departments


Indirect costs: an apportionment of occupancy costs and central service costs plus all faculty costs.

Direct and indirect costs are charged to degree courses on a percentage basis.

(5) Central services


Indirect costs: an apportionment of occupancy costs.

Direct and indirect costs of central services have in previous years been charged to users on a percentage basis. A study has now been completed which has estimated what user areas would have paid external suppliers for the same services on an individual basis. For the year ended 30 June 20X7, the apportionment of the central services cost is to be recalculated in a manner which recognises the cost savings achieved by using the central services facilities instead of using external service companies. This is to be done by apportioning the overall savings to user areas in proportion to their share of the estimated external costs.



The estimated external costs of service provision are as follows: £000 Faculties 240 Teaching departments 800 Degree courses: Business studies 32 Mechanical engineering 48 Catering studies 32 All other degrees 448 ____

1,600 ____

(6) Additional data relating to the degree courses are as follows: Degree course Business

Studies Mechanical Engineering

Catering Studies

Number of graduates 80 50 120 Apportioned costs (as % of totals) Teaching departments 3% 2.5% 7% Administration/management 2.5% 5% 4%

Central services are to be apportioned as detailed in (5) above.

The total number of graduates from the college in the year to 30 June 20X7 was 2,500.

Required:

(a) Prepare a flow diagram which shows the apportionment of costs to user areas. No values need be shown. (5 marks)

(b) Calculate the average cost per graduate, for the year ended 30 June 20X7, for the college and for each of the degrees in business studies, mechanical engineering and catering studies, showing all relevant cost analysis. (15 marks)

(c) Suggest reasons for any differences in the average cost per graduate from one degree to another, and discuss briefly the relevance of such information to the college management. (5 marks)

(Total: 25 marks)



ADMER

Admer owns several home furnishing stores. In each store, consultations, if needed, are undertaken by specialists, who also visit potential customers in their homes, using specialist software to help customers realise their design objectives. Customers visit the store to make their selections from the wide range of goods offered, after which sales staff collect payment and raise a purchase order. Customers then collect their self-assembly goods from the warehouse, using the purchase order as authority to collect. Administration staff process purchase orders and also arrange consultations. Each store operates an absorption costing system and costs other than the cost of goods sold are apportioned on the basis of sales floor area. Results for one of Admer’s stores for the last three months are as follows:

Department Kitchens Bathrooms Dining Rooms

Total

$ $ $ $

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

Cost of goods sold

63,000 137,500 176,000 276,500

Other costs 130,250 _______ 81,406 _______ 113,968 _______ 325,624 _______

Profit/(loss) 16,750 _______ (6,406) _______ 150,032 _______ 160,376 _______ The management accountant of Admer is concerned that the bathrooms department of the store has been showing a loss for some time, and is considering a proposal to close the bathrooms department in order to concentrate on the more profitable kitchens and dining rooms departments. He has found that other costs for this store for the last three months are made up of:

$ Employees

Sales staff wages 164,800 12

Consultation staff wages 124,960 4

Warehouse staff wages 130,240 6

Administration staff wages 130,624 4

General overheads (light, heat, rates, etc.)

175,000 _______

325,624 _______



He has also collected the following information for the last three months:

Department Kitchens Bathrooms Dining

Rooms

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

Purchase orders 1,000 900 2,500

Floor area (square metres)

16,000 10,000 14,000

Number of consultations

798 200 250

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

Required:

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

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

(c) Evaluate and discuss the proposal to close the bathrooms department. (6 marks)

(d) Discuss the advantages and disadvantages that may arise for Admer from introducing activity-based costing in its stores. (7 marks)

(Total: 25 marks)



QP PLC QP plc is a food processing company that produces pre-prepared meals for sale to consumers through a number of different supermarkets. The company specialises in three particular pre-prepared meals and has invested significantly in modern manufacturing processes to ensure a high quality product. The company is very aware of the importance of training and retaining high quality staff in all areas of the company and, in order to ensure their production employees’ commitment to the company, the employees are guaranteed a weekly salary that is equivalent to their normal working hours paid at their normal hourly rate of £7 per hour.

The meals are produced in batches of 100 units. Costs and selling prices per batch are as follows: Meal TR PN BE £/batch £/batch £/batch Selling price 340 450 270 Ingredient K (£5/kg) 150 120 90 Ingredient L (£10/kg) 70 90 40 Ingredient M (£15/kg) 30 75 45 Labour (£7/hour) 21 28 42 Factory costs absorbed 20 80 40

QP plc has adopted throughput accounting for its short-term decisions.

Required: (a) State the principles of throughput accounting and the effects of using it for short-term

decision making. (6 marks)

(b) QP plc is preparing its production plans for the next three months and has estimated the maximum demand from its customers to be as follows:

TR 500 batches PN 400 batches BE 350 batches

These demand maximums are amended figures because a customer has just delayed its request for a large order and QP has unusually got some spare capacity over the next three months. However, these demand maximums do include a contract for the delivery of 50 batches of each to an important customer. If this minimum contract is not satisfied, then QP plc will have to pay a substantial financial penalty for non-delivery.

The Production Director is concerned at hearing news that two of the ingredients used are expected to be in short supply for the next three months. QP plc does not hold inventory of these ingredients and, although there are no supply problems for ingredient K, the supplies of ingredients L and M are expected to be limited to:

Ingredient L 7,000 kilos Ingredient M 3,000 kilos

The Production Director has researched the problem and found that ingredient V can be used as a direct substitute for ingredient M. It also costs the same as ingredient M. There is an unlimited supply of ingredient V.

Required: Prepare calculations to determine the production mix that will maximise the profit of

QP plc during the next three months. (10 marks)



(c) The World Health Organization has now announced that ingredient V contains dangerously high levels of a chemical that can cause life-threatening illnesses. As a consequence it can no longer be used in the production of food.

As a result, the production director has determined the optimal solution to the company’s production mix problem using linear programming. This is set out below:

Objective function value 110,714 TR value 500 PN value 357 BE value 71 TR slack value 0 PN slack value 43 BE slack value 279 L shadow price value 3 M shadow price value 28

Required: Explain the meaning of each of the values contained in the above solution. (9 marks)

(Total: 25 marks)



MN LTD

MN Ltd manufactures automated industrial trolleys, known as TRLs. Each TRL sells for £2,000 and the material cost per unit is £600. Labour and variable overhead are £5,500 and £8,000 per week respectively. Fixed production costs are £450,000 per annum and marketing and administrative costs are £265,000 per annum.

The trolleys are made on three different machines. Machine X makes the four frame panels required for each TRL. Its maximum output is 180 frame panels per week. Machine X is old and unreliable and it breaks down from time to time. It is estimated that, on average, between 15 and 20 hours of production are lost per month. Machine Y can manufacture parts for 52 TRLs per week and Machine Z, which is old but reasonably reliable, can process and assemble 30 TRLs per week.

The company has recently introduced a just-in-time (JIT) system and it is company policy to hold little work-in-progress and no finished goods stock from week to week. The company operates a 40-hour week, 48 weeks a year (12 months × 4 weeks) but cannot meet demand. The demand for the next year is predicted to be as follows. This is expected to be typical of the demand for the next four years:

Units per week Units per week

January 30 July 48

February 30 August 45

March 33 September 42

April 36 October 40

May 39 November 33

June 44 December 30

The production manager has suggested that the company replaces Machine Z with either Machine F or Machine G. Machine F can process 36 TRLs per week and costs £330,000. It is expected that labour costs would increase by £2,500 per week if Machine F were installed. Machine G can process 45 TRLs per week and costs £550,000. It is estimated that the variable overhead cost per week will increase by £4,500 if TRLs are made on Machine G. The maintenance manager is keen to spend £100,000 on a major overhaul of machine X – he says this will make it 100% reliable.

The management of MN Ltd is wondering whether it should now install a full standard costing and variance analysis system. At present, standard costs are calculated only as part of the annual budgeting process. Management is concerned about implementing so many changes in a short space of time, but feels the system could be very useful.

The company’s cost of capital is 10% per annum. It evaluates projects over four years and depreciates its assets over five years.

Required: Using the case of MN Ltd in the scenario above:

(a) Explain the concept of throughput accounting. (6 marks)

(b) To what uses do advocates of throughput accounting suggest that the throughput ratio be put? (6 marks)

(c) Explain how the concept of contribution in throughput accounting differs from that in marginal costing. (7 marks)



(d) If MN Ltd has decided to purchase Machine G and spend £100,000 on a major overhaul of Machine X, the management accountant and the production manager should collaborate to ensure a new focus for monitoring and reporting production activities. What is the new focus? Explain what should be monitored and reported. 6 marks)

(Total: 25 marks)



BML

BML has three product lines: P1, P2 and P3. Since its creation the company has been using a single direct labour cost percentage to assign overhead costs to products.

Despite P3, a relatively new line, attracting additional business, increasing overhead costs and a loss of market share, particularly for P2, a major product, have convinced the management that the costing system is in need of some development. A team, led by the management accountant was established to develop an improved system of costing based on activities. The team spent several weeks collecting data (see tables below) for the different activities and products. For the accounting period in question, given in the tables below is data on BML’s three product lines and overhead costs: P1 P2 P3 Production volume 7,500 units 12,500 units 4,000 units Direct labour cost per unit £4 £8 £6.40 Material cost per unit £18 £25 £16 Selling price per unit £47 £80 £68 Materials movements (in total) 4 25 50 Machine hours per unit 0.5 0.5 0.2 Set-ups (in total) 1 5 10 Proportion of engineering work 30% 20% 50% Orders packed (in total) 1 7 22

Activities Overhead cost

£ Material receiving and handling 150,000 Machine maintenance and depreciation 390,000 Set-up labour 18,688 Engineering 100,000 Packing 60,000 ___________

Total 718,688 ___________

Required: (a) Calculate the overhead rate and the product unit costs under the existing costing

system. (5 marks)

(b) Identify for each overhead activity, an appropriate cost driver from the information supplied, and then calculate the product unit costs using a system that assigns overheads on the basis of the use of activities. (11 marks)

(c) Comment on the results of the two costing systems in (a) and (b) above. (9 marks)

(Total: 25 marks)



ABC PLC

ABC plc, a group operating retail stores, is compiling its budget statements for 20X8. In this exercise revenues and costs at each store A, B and C are predicted. Additionally, all central costs of warehousing and a head office are allocated across the three stores in order to arrive at a total cost and net profit of each store operation.

In earlier years the central costs were allocated in total based on the total sales value of each store. But as a result of dissatisfaction expressed by some store managers alternative methods are to be evaluated.

The predicted results before any re-allocation of central costs are as follows: A B C £000 £000 £000 Sales 5,000 4,000 3,000 Costs of sales 2,800 2,300 1,900 ____ ____ ____ Gross margin 2,200 1,700 1,100 Local operating expenses Variable 660 730 310 Fixed 700 600 500 ___ ___ ___ Operating profit 840 370 290 ___ ___ ___ The central costs which are to be allocated are: £000 Warehouse costs: Depreciation 100 Storage 80 Operating and despatch 120 Delivery 300 Head office: Salaries 200 Advertising 80 Establishment 120 ________ Total 1,000 ________

The management accountant has carried out discussions with staff at all locations in order to identify more suitable ‘cost drivers’ of some of the central costs. So far the following has been revealed: A B C Number of despatches 550 450 520Total delivery distances (thousand miles) 70 50 90Storage space occupied (%) 40 30 30

1 An analysis of senior management time revealed that 10% of their time was devoted to warehouse issues with the remainder shared equally between the three stores.

2 It was agreed that the only basis on which to allocate the advertising costs was sales revenue.

3 Establishment costs were mainly occupancy costs of senior management.

This analysis has been carried out against a background of developments in the company, for example, automated warehousing and greater integration with suppliers.



Required: As the management accountant prepare a report for the management of the group

which:

(i) computes the budgeted net profit of each store based on the sales value allocation base originally adopted and explains ‘cost driver’, ‘volume’ and ‘complexity’ issues in relation to cost allocation commenting on the possible implications of the dissatisfaction expressed; (7 marks)

(ii) computes the budgeted net profit of each store using the additional information provided, discusses the extent to which an improvement has been achieved in the information on the costs and profitability of running the stores and comments on the results. (14 marks)

(b) Explain briefly how regression analysis and coefficient of determination (r2) could be used in confirming the delivery mileage allocation method used in (a) above. (4 marks)

(Total: 25 marks)



KEY FACTORS AND THROUGHPUT ACCOUNTING Sunglow Estates Company (SEL) has acquired a 600-hectare site comprising the following:

Land groups

(1) Agricultural land in current use 280 hectares

(2) Derelict land formerly occupied by factories 250 hectares

(3) Contaminated land formerly used for chemical storage 70 hectares

It is possible for SEL to develop this site with a combination of houses, apartments and shops. The associated development costs per hectare are as follows:

Houses Apartments Shops

Land group

$000 $000 $000

(1) 370 715 790

(2) 340 640 698

(3) − − 820.52

It is not possible to use land group (3) for houses or apartments, but this land can be used for the development of shops without first decontaminating it.

Income per hectare generated by the three types of development are:

Sale of leases

Annual ground rent

$000 $000

Houses 230 40

Apartments 480 70

Shops − 200

SEL’s planning consent for the development specifies that no more than 40 hectares of the development should be occupied by shops and no less than 200 hectares should be occupied by houses. Land developed for houses in excess of the minimum specified by the planning consent will qualify for a government subsidy in the form of an interest-free loan of $200,000 per hectare developed, repayable in four annual instalments of $50,000.

It is possible to decontaminate all or part of land group (3) at a cost of $80,000 per hectare. Such decontaminated land is, for development purposes, the same as agricultural land.

SEL appraises investments using DCF evaluation, a 10% cost of money for low-risk investments (including development of houses and apartments), a 15% cost of money for high-risk investments (including the development of shops) and an eight-year time horizon.

‘I remember being told about the useful decision-making technique of limiting factor analysis (also known as ‘contribution per unit of the key factor’). If an organisation is prepared to believe that, in the short run, all costs other than direct materials are fixed costs, is this not the same thing that throughput accounting is talking about? Why rename limiting factor analysis as throughput accounting?’



Required: (a) Explain what a limiting (or ‘key’) factor is and what sort of things can become limiting factors

in a business situation. Which of the factors in the scenario could become a limiting factor? (8 marks)

(b) Explain the techniques that have been developed to assist in business decision-making when single or multiple limiting factors are encountered. (7 marks)

(c) Explain the management idea known as throughput accounting. State and justify your opinion on whether or not throughput accounting and limiting factor analysis are the same thing. Briefly comment on whether throughput accounting is likely to be of relevance to SEL. (10 marks)

(Total: 25 marks)



DECISION MAKING TECHNIQUES

JB LTD

JB Ltd is a small specialist manufacturer of electronic components and much of its output is used by the makers of aircraft for both civil and military purposes. One of the few aircraft manufacturers has offered a contract to JB Ltd for the supply, over the next 12 months, of 400 identical components.

The data relating to the production of each component is as follows:

(1) Material requirements

3 kg material M1 – see note (i) below

2 kg material P2 – see note (ii) below

1 part no. 678 – see note (iii) below

Notes:

(i) Material M1 is in continuous use by the company. 1,000 kg are currently held in stock at a book value of £4.70/kg but it is known that future purchases will cost £5.50/kg.

(ii) 1,200 kg of material P2 are held in stock. The original cost of this material was £4.30/kg but, as the material has not been required for the last two years, it has been written down to £1.50/kg scrap value. The only foreseeable alternative use is as a substitute for material P4 (in current use) but this would involve further processing costs of £1.60/kg. The current cost of material P4 is £3.60/kg.

(iii) It is estimated that the part no. 678 could be bought for £50 each.

(2) Labour requirements

Each component would require five hours of skilled labour and five hours of semi-skilled. An employee possessing the necessary skills is available and is currently paid £5/hour. A replacement would, however, have to be obtained at a rate of £4/hour for the work which would otherwise be done by the skilled employee. The current rate for semi-skilled work is £3/hour and an additional employee could be appointed for this work.

(3) Overhead

JB Ltd absorbs overhead by a machine hour rate, currently £20/hour, of which £7 is for variable overhead and £13 for fixed overhead. If this contract is undertaken, it is estimated that fixed costs will increase for the duration of the contract by £3,200. Spare machine capacity is available and each component would require four machine hours.

A price of £145 per component has been suggested by the large company which makes aircraft.

Required: (a) State whether or not the contract should be accepted and support your conclusion with

appropriate figures for presentation to management; (16 marks)

(b) Comment briefly on three factors which management ought to consider and which may influence their decision. (9 marks)

(Total: 25 marks)



EXE AND WYE

A firm manufactures two products, EXE and WYE, in departments dedicated exclusively to them. There are also three service departments, stores, maintenance and administration. No stocks are held as the products deteriorate rapidly.

Direct costs of the products, which are variable in the context of the whole business, are identified to each department. The step-wise apportionment of service department costs to the manufacturing departments is based on estimates of the usage of the service provided. These are expressed as percentages and assumed to be reliable over the current capacity range. The general factory overheads of £3.6m, which are fixed, are apportioned based on floor space occupied. The company establishes product costs based on budgeted volume and marks up these costs by 25% in order to set target selling prices.

Extracts from the budgets for 20X8 are provided below: Annual volume (units) EXE WYE Maximum capacity 200,000 100,000Budget 150,000 70,000

EXE WYE Stores Maintenance Admin Costs (£m) Material costs 1.8 0.7 0.1 0.1 – Other variable costs 0.8 0.5 0.1 0.2 0.2 Departmental usage (%) Maintenance 50 25 25 Administration 40 30 20 10 Stores 60 40 Floor space (sq m) 640 480 240 80 160

Required: Workings may be £000 with unit prices to the nearest penny.

(a) Calculate the budgeted selling price of one unit of EXE and WYE based on the usual mark up. (6 marks)

(b) Discuss how the company may respond to each of the following independent events, which represent additional business opportunities:

(i) an enquiry from an overseas customer for 3,000 units only of WYE where a price of £35 per unit is offered

(ii) an enquiry for 50,000 units of WYE to be supplied in full at regular intervals during 20X8 at a price which is equivalent to full cost plus 10%.

In both cases support your discussion with calculations and comment on any assumptions or matters on which you would seek clarification. (13 marks)

(c) Explain the implications of preparing product full costs based on maximum capacity rather than annual budget volume. (6 marks)

(Total: 25 marks)



PLASTIC TOOLS

A small company is engaged in the production of plastic tools for the garden.

Sub-totals on the spreadsheet of budgeted overheads for a year reveal the following:

General Moulding Finishing factory department department overhead Variable overhead £000s 1,600 500 1,050 Fixed overhead £000s 2,500 850 1,750 Budgeted activity Machine hours (000s) 0,800 600 Practical capacity Machine hours (000s) 1,200 800

For the purposes of reallocation of general factory overhead it is agreed that the variable overheads accrue in line with the machine hours worked in each department. General factory fixed overhead is to be reallocated on the basis of the practical machine hour capacity of the two departments.

It has been a long-standing company practice to establish selling prices by applying a mark-up on full manufacturing cost of between 25% and 35%.

A possible price is sought for one new product which is in a final development stage. The total market for this product is estimated at 200,000 units per annum. Market research indicates that the company could expect to obtain and hold about 10% of the market. It is hoped the product will offer some improvement over competitors’ products, which are currently marketed at between £90 and £100 each.

The product development department have determined that the direct material content is £9 per unit. Each unit of the product will take two labour hours (four machine hours) in the moulding department and three labour hours (three machine hours) in finishing. Hourly labour rates are £5.00 and £5.50 respectively.

Management estimate that the annual fixed costs which would be specifically incurred in relation to the product are: supervision £20,000, depreciation of a recently acquired machine £120,000 and advertising £27,000. It may be assumed that these costs are included in the budget given above. Given the state of development of this new product, management do not consider it necessary to make revisions, to the budgeted activity levels given above, for any possible extra machine hours involved in its manufacture.

Required: (a) Briefly explain the role of costs in pricing. (8 marks)

(b) Prepare full cost and marginal cost information which may help with the pricing decision. (10 marks)

(c) Comment on the cost information and suggest a price range which should be considered. 7 marks)

(Total: 25 marks)



BIL MOTOR COMPONENTS PLC

(a) In an attempt to win over key customers in the motor industry and to increase its market share, BIL Motor Components plc have decided to charge a price lower than their normal price for component TD463 when selling to the key customers who are being targeted. Details of component TD463’s standard costs are as follows:

Standard cost data Component TD463

Batch size 200 units

Machine Machine Machine Group 1 Group 7 Group 29 Assembly

£ £ £ £

Materials (per unit) 26.00 17.00 − 3.00 Labour (per unit) 2.00 1.60 0.75 1.20 Variable overheads (per unit) 0.65 0.72 0.80 0.36 Fixed overheads (per unit) 3.00 2.50 1.50 0.84 _____ _____ ____ ____ 31.65 21.82 3.05 5.40 _____ _____ ____ ____

Setting-up costs per batch of 200 units £10 £6 £4 −

Required:

Compute the lowest selling price at which one batch of 200 units could be offered, and critically evaluate the adoption of such a pricing policy. (9 marks)

(b) The company is also considering the launch of a new product, component TDX489, and have provided you with the following information.

Product TDX489 Standard cost per box £

Variable cost 6.20 Fixed cost 1.60 ____

7.80 ____

Market research − forecast of demand Selling price (£) 13 12 11 10 9 Demand (boxes) 5,000 6,000 7,200 11,200 13,400 The company only has enough production capacity to make 7,000 boxes. However, it would be possible to purchase product TDX489 from a sub-contractor at £7.75 per box for orders up to 5,000 boxes, and £7 per box if the orders exceed 5,000 boxes.

Required: Prepare and present a computation which illustrates which price should be selected in order to maximise profits. (10 marks)

(c) Where production capacity is the limiting factor, explain briefly the ways in which management can increase it without having to acquire more plant and machinery. (6 marks)

(Total: 25 marks)



MOV COMPANY

MOV Company produces custom-built sensors. Each sensor has a standard circuit board (SCB) in it. The current average contribution from a sensor is £400. MOV Company’s business is steadily expanding and in the year just ending (2001/2002), the company will have produced 55,000 sensors. The demand for MOV Company’s sensors is predicted to grow over the next three years:

Year Units

2008/09 58,000

2009/10 62,000

2010/11 65,000

The production of sensors is limited by the number of SCBs the company can produce. The present production level of 55,000 SCBs is the maximum that can be produced without overtime working. Overtime could increase annual output to 60,500, allowing production of sensors to also increase to 60,500. However, the variable cost of SCBs produced in overtime would increase by £75 per unit.

Because of the pressure on capacity, the company is considering having the SCBs manufactured by another company, CIR Company. This company is very reliable and produces products of good quality. CIR Company has quoted a price of £116 per SCB, for orders greater than 50,000 units a year. MOV Company’s own costs per SCB are predicted to be:

£ Direct material 28 Direct labour 40 Variable overhead 20 (based on labour cost) Fixed overhead 24 (based on labour cost and output of 55,000 units) Total cost 112

The fixed overheads directly attributable to SCBs are £250,000 a year; these costs will be avoided if SCBs are not produced. If more than 59,000 units are produced, SCBs’ fixed overheads will increase by £130,000.

In addition to the above overheads, MOV Company’s fixed overheads are predicted to be:

Sensor production in units: 54,001 to 59,000 59,001 to 64,000 64,001 to 70,000

Fixed overhead: £2,600,000 £2,900,000 £3,100,000

MOV Company currently holds a stock of 3,500 SCBs but the production manager feels that a stock of 8,000 should be held if they are bought-in; this would increase stockholding costs by £10,000 a year. A purchasing officer, who is paid £20,000 a year, spends 50% of her time on SCB duties. If the SCBs are bought-in, a liaison officer will have to be employed at a salary of £30,000 in order to liaise with CIR Company and monitor the quality and supply of SCBs. At present, 88 staff are involved in the production of SCBs at an average salary of £25,000 a year: if the SCBs were purchased, 72 of these staff would be made redundant at an average cost of £4,000 per employee.

The SCB department, which occupies an area of 240 × 120 square metres at the far end of the factory, could be rented out, at a rent of £45 per square metre a year. However, if the SCBs were to be bought-in, for the first year only MOV Company would need the space to store the increased stock caused by outsourcing, until the main stockroom had been reorganised and refurbished. From 2009/10, the space could be rented out; this would limit the annual production of sensors to 60,500 units. Alternatively, the space could be used for the production of sensors, allowing annual output to increase to 70,000 units if required.



Required: (a) Critically discuss the validity of the following statement. It was produced by Jim

Elliott, the company’s accountant, to show the gain for the coming year (2008/2009) if the SCBs were to be bought-in. Saving in £ Manufacturing staff – salaries saved: 72 staff × £25,000 1,800,000 Purchasing officer – time saved 10,000 Placing orders for SCB materials: 1,000 orders × £20 per order 20,000 Transport costs for raw materials for SCBs 45,000 ____________

Cost saved 1,875,000 Additional cost per SCB: (£116 – £112) × 58,000 units 232,000 ____________

Net gain if SCBs purchased 1,643,000 ____________

(10 marks)

(b) (i) Produce detailed calculations that show which course of action is the best financial option for the three years under consideration. (Ignore the time value of money.) (12 marks)

(ii) Advise the company of the long-term advantages and disadvantages of

buying-in SCBs. (3 marks)

(Total: 25 marks)



PRIVATE HOSPITAL A private hospital is reviewing its requirements for nursing care. It wishes to maintain its high quality service at the lowest cost, consistent with a variety of constraints. Two categories of nurse are employed – ‘qualified’ and ‘student’. Past experience has shown that at least 100 qualified nurses, or equivalent, are required. Because of knowledge, experience and training, the work of one qualified nurse is deemed equivalent to that of two student nurses. On average, a qualified nurse costs the hospital $13,000 a year and a student nurse $6,000 (inclusive of pay, food, accommodation, etc). The student nurses’ hall can accommodate 50 student nurses. For successful working practices there must be at least as many qualified nurses as student nurses. To meet the requirements of a local charity that donates substantial sums to the hospital, at least 30 student nurses must be under training. The hospital personnel manager’s assessment of the current job market is that a maximum of 140 trained nurses could be recruited.

Required:

(a) State mathematically the hospital’s objective function and its constraints. (7 marks)

(b) Draw a graph for this problem, shading the feasible region. (10 marks)

(c) Recommend the optimum combination of nurses to employ. (5 marks)

(d) Comment briefly on your recommendation. (3 marks)

(Total: 25 marks)



BUDGETING

ACCOUNTING TYPE CONTROL INFORMATION FOR MANAGEMENT

The effective use of the control information provided by an organisation’s accounting department might be reduced by the behaviour of its operating managers.

Required: Explain the main motivation or attitudes of operating managers that would tend to result in less effective use of the control information and to suggest actions that the accounting department might take to improve the situation.

(Total: 25 marks)



SYCHWEDD PLC

Sychwedd plc manufacture and sell three products R, S, and T which make use of two machine groups, 1 and 2. The budget for period 1, the first quarter of their next accounting year, includes the following information:

Machine Group Fixed overhead absorption rates: 1 2 Rate per machine hour £10.00 £11.20 ____ ____

Product R Product S Product T Sales (kilos) 12,000 25,000 40,000 £ £ £ Sales 120,000 250,000 360,000 ______ ______ ______ Variable costs 73,560 164,250 284,400 Fixed overheads 19,752 38,300 42,400 ______ ______ ______ Budgeted net profit 26,688 47,450 33,200 ______ ______ ______ For the second quarter (period 2), it is estimated that the budgeted machine hours and direct labour hours needed to produce 1,000 kilos of each of the products are: Machine Group Machine hours 1 2 Product R 75 80 S 30 110 T 50 50 Direct labour hours Product R 30 40 S 10 50 T 20 20 Budgeted fixed overheads (to be absorbed using a machine hour rate) £40,800 £68,365 Budgeted variable labour and overheads, (rate per direct labour hour)

£7.50 £8.50

Product R Product S Product T Budgeted material costs per 1,000 kilos £4,508 £5,096 £6,125 Expected sales (kilos) 10,000 25,000 50,000 Planned price changes: Compared with period 1 10% increase No change No change A sales commission of 4% of the sales value will be paid.

There are no budgeted opening or closing stocks i.e., all production is expected to be sold.

Required: (a) Compute the machine hour rate for each machine group for period 2. (4 marks)

(b) Calculate the budgeted contribution and net profit for each of the three products for period 2. (12 marks)

(c) Assuming that the sales trend shown over the two periods is forecast to continue, comment briefly on the figures and advise management accordingly. (9 marks)

(Total: 25 marks)



BUDGET COMPILATION

A product manager has responsibility for a single product and is in the process of submitting data to be compiled into budgets for 20X9. The manager has performance targets set in relation to sales volume, profitability levels and a target cash surplus from the product.

Shown below are the agreed budgeted sales for the product for December 20X8 to May 20X9. Dec Jan Feb Mar April May Units 14,000 16,000 22,000 17,000 20,000 24,000 The company policy is that, at each month end, the closing stock of finished goods should be 25% of the following month’s forecast sales and the stock of raw material should be sufficient for 10% of the following month’s production. Stock levels currently conform to this policy. One unit of raw material makes one unit of finished stock, there is no wastage.

Raw material purchases are paid for during the month following the month of purchase. All other expenses are paid for as incurred. All sales are made on credit and the company expects cash receipts for 50% of sales in the month of sale and 50% in the following month.

The company operates an absorption costing system which is computed on a monthly basis. That is, in addition to direct costs it recovers each month’s fixed and variable manufacturing overhead expenses in product costs using the budgeted production and budgeted expenditure in the month to establish an absorption rate. This cost is used to place a value on the stock holding. Opening stock is valued at the unit cost which was established in the previous month. At 1 January 20X9 finished stock should be assumed at £40 per unit. A flow of cost based on FIFO is assumed.

Sales are made at a price of £58 per unit.

Estimated costs to be used in the budget preparation for the product are: Manufacturing costs: Material £10.00 per unit produced Variable overhead and labour £16.00 per unit produced Fixed overhead costs £210,000 per month (including depreciation of £54,000 per month) Selling costs: Variable £7.00 per unit sold Fixed £164,000 per month

Required:

(a) Compute the monthly budgeted production and material purchases for January to March 20X9. (6 marks)

(b) Prepare a budgeted profit and loss account and a statement of cash receipts and payments for January 20X9. (10 marks)

(c) Explain briefly the implications of the company’s treatment of fixed manufacturing overheads compared to a predetermined overhead rate prepared annually. (4 marks)

(d) The preparation of budget data may be assisted by the use of a time series. Explain what a time series is and the various components which comprise one. (5 marks)

(Total: 25 marks)



ACRED LIMITED

Acred Ltd manufactures a single product. It is preparing monthly budgets for the six months from July to December 20X4. The following standard revenue and cost data is available: Selling price £12.00 per unit Materials 2 kg per unit at £2.40 per kg Labour £1.80 per unit Direct expenses £1.20 per unit • Sales in June 20X4 and July 20X4 are forecast to be 10,000 units in each month. As a

direct result of marketing expenditure of £95,000 in August 20X4, sales are expected to be 11,000 units in August 20X4 and to increase by 1,000 units in each month from September to December. Sales after December 20X4 are expected to remain at the December 20X4 level.

• 25% of sales are paid for when they occur and 75% of sales are paid for in the month following sale. Stocks of finished goods at the end of each month are required to be 20% of the expected sales for the following month. Stocks of materials at the end of each month are required to be 50% of the materials required for the following month’s production.

• Materials are paid for in the month following purchase. Labour and direct expenses are paid for in the month in which they occur. Overheads for production, administration and distribution will be £34,000 per month, including depreciation of £12,000 per month. These overheads are payable in the month in which they occur. Acred Ltd has a £750,000 bank loan at 8% per annum on which it pays interest twice per year, in March and September.

• The cash balance at the end of June 20X4 is expected to be £50,000.

Required: (a) Prepare the following budgets for Acred Ltd on a month by month basis for the six

month period from July to December 20X4:

(i) production budget (units)

(ii) cash budget. (13 marks)

(b) Critically discuss the relative merits of periodic budgeting and continuous budgeting. (7 marks)

(c) Discuss the consequences of budget bias (budgetary slack) for cost control. (5 marks)

(Total: 25 marks)

(Note: It is unlikely that you will be asked to produce a full month-by-month budget in the F5 exam. However, this question gives excellent practice of key calculations and will help you appreciate the bigger picture.)



ACCOUNTING SYSTEMS

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

Required: (a) Explain why it is necessary when designing a management accounting system to

consider the behavioural consequences of its application. (7 marks)

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

(Total: 25 marks)



BUDGETARY PLANNING

FRD Ltd is a manufacturer of industrial control systems. It has designed a new system called the X7 and expects to produce the X7 in a continuous operation over an 18 month period. During this period, it is expected that a total of sixteen X7s will be produced and sold. The production of the X7 is a labour intensive operation and units are produced one after another.

The costs of producing the first X7 are as follows:

Skilled Labour – 1,200 hours at a rate of £20 per hour

Unskilled Labour – 1,800 hours at a rate of £15 per hour

Materials – £20,000

Overheads – £10 per labour hour worked (total of Skilled and Unskilled)

It is known that in producing any product, Skilled Labour usage experiences an 80% learning curve effect and Unskilled Labour usage experiences a 90% learning curve effect.

FRD has decided to set the selling price per unit of the X7 as the average production cost per unit (for the full sixteen unit production run) plus a 25% addition thereon for profit.

Note: When appraising the impact of the learning curve, you should use the cumulative average time model, where doubling output reduces the cumulative average hours per unit by a factor of 80% or 90% (whichever is applicable).

Required: (a) Calculate the selling price per unit of the X7. (10 marks)

(b) Calculate the forecast total production cost of the third and fourth X7 produced (that is, the cost of the third and fourth units together). Calculate the profit or loss arising from the sale of the third and fourth units using the unit selling price you have calculated in answer to (a). (10 marks)

(c) Explain the logic, uses and limitations of the learning curve model. (5 marks)

(Total: 25 marks)



STANDARD COSTING AND VARIANCES

Q LTD

(a) Q Ltd operates a system of standard costing and in respect of one of its products which is manufactured within a single cost centre, the following information is given.

For one unit of product the standard material input is 16 litres at a standard price of £2.50 per litre. The standard wage rate is £5 per hour and 6 hours are allowed in which to produce one unit. Fixed production overhead is absorbed at the rate of 120% of direct wages cost.

During the last four-week accounting period:

The material price variance was extracted on purchase and the actual price paid was £2.45 per litre.

Total direct wages cost was £121,500.

Fixed production overhead incurred was £150,000.

Variances Favourable Adverse £ £

Direct material price 8,000 Direct material usage 6,000 Direct labour rate 4,500 Direct labour efficiency 3,600 Fixed production overhead expenditure 6,000

You are required to calculate for the four-week period:

(i) budgeted output in units;

(ii) number of litres purchased;

(iii) number of litres used above standard allowed;

(iv) actual units produced;

(v) actual hours worked;

(vi) average actual wage rate per hour.

(18 marks)

(b) ‘Physical measures of output and technical measures of production efficiency are often more useful than financial measures, particularly at the lower levels of an organisation.’

You are required, in the context of variance analysis, to discuss and expand on the above statement. (7 marks)

(Total: 25 marks)



HAIRDRESSING

A company operates a number of hairdressing establishments, which are managed on a franchise arrangement. The franchisor offers support using a PC package, which deals with profit budgeting and control information.

Budget extracts of one franchisee for November 20X7 are shown below analysed by male and female clients. For the purposes of budget projections average revenue rates are used. At the month end these are compared with the average monthly rates actually achieved using variance analysis. Sales price, sales quantity, sales mix and cost variances are routinely produced in order to compare the budget and actual results.

Staff working in this business are paid on a commission basis in order to act as an incentive to attract and retain clients. The labour rate variance is based on commission payments, any basic pay is part of the monthly fixed cost.

Budget Male Female Clients 4,000 1,000 £ £ Average revenue (per client) 7.5 18.0 Average commission (per client) 3.0 10.0 Total monthly fixed cost £20,000 Actual results Male Female Clients 2,000 2,000 £ £ Average revenue (per client) 8.0 20.0 Average commission (per client) 3.5 11.0 Total monthly fixed cost £24,000

Required: (a) Reconcile the budgeted and actual profit for November by calculating appropriate

price, quantity, mix and cost variances, presenting the information in good form. You should adopt a contribution style, with mix variances based on units (i.e. clients). (13 marks)

(b) Write a short memorandum to the manager of the business commenting on the result in (a) above (5 marks)

(c) Comment on the limitations associated with generating sales variances as in (a) above. (7 marks)

(Total: 25 marks)



FOOD MANUFACTURER A food manufacturer specialises in the production of frozen cakes and sweet products, selling mainly to supermarkets. The following monthly budget applies to one of its products. Original budget £000 £000 Sales 1,000 Costs: Ingredients 400 Labour and energy 100 Fixed overheads 300 ___ 800 ___ Profit 200 ___ For the ingredients, a standard quantity of 5 kg per pack is required; a standard price of 40p per kg applies in the original budget.

Considerable attention has been given to increasing the market share of this product whilst attempting to maintain its profitability. Consequently, since the preparation of the budget the management team implemented some changes to the manufacture and sale of this product. These changes were as follows:

(i) The product was budgeted to sell for £5.00 per pack but, to promote sales, a price reduction on all sales to £4.50 per pack was made.

(ii) The supplier of ingredients was changed and this secured a price reduction to 37.5p per kg on all ingredient supplies in return for a long-term contract.

(iii) The method of working was changed in order to reduce the direct labour and energy costs which are regarded as variable.

All of the above changes applied for the whole of the month just ended and are reflected in the actual results shown below. The management intend, however, to use the original budget, for both cost and volume, as a reference point until the effect of the changes has been evaluated.

The following actual results have just been reported for the month: Actual results £000 £000 Sales 1,080 Costs: Ingredients 520 Labour and energy 110 Fixed overheads 340 ___ 970 ___ Profit 110 ___ Required: (a) Prepare a flexible budget (for the actual quantity sold in the month just ended) based

on the original budgeted unit costs and selling price. (5 marks)

(b) Using variances, reconcile the original budget profit with the actual profit. You should use a contribution approach to variance analysis. (10 marks)

(c) Provide a commentary on the variances you have produced. Within this commentary refer to possible interrelationships between the variances and how the level of fixed overheads may be reduced. (10 marks)

(Total: 25 marks)



MERMUS PLC

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

Budget Actual £ £ £ £ Sales 950,000 922,500Cost of sales Raw materials 133,000 130,500 Direct labour 152,000 153,000 Variable production overheads 100,700 96,300 Fixed production overheads 125,400 115,300 __________ __________ 511,100 495,100 __________ __________

438,900 427,400 __________ __________

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

Mermus uses standard costing and absorbs fixed production overheads on a machine hour basis.

A total of 28,500 standard machine hours were budgeted. A total of 27,200 machine hours were actually used in the three-month period.

Required: (a) Prepare a revised budget at the new level of activity using a flexible budgeting

approach. (4 marks)

(b) Calculate the following:

(i) raw material total cost variance;

(ii) direct labour total cost variance;

(iii) fixed overhead efficiency variance;

(iv) fixed overhead capacity variance;

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

(c) Suggest possible explanations for the following variances:

(i) raw materials total cost variance;

(ii) fixed overhead efficiency variance;

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

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

(Total: 25 marks)



ASH PLC Ash plc recorded the following actual results for Product RS8 for the last month:

Product RS8 2,100 units produced and sold for $14.50 per unit Direct material M3 1,050 kg costing $1,680 Direct material M7 1,470 kg costing $2,793 Direct labour 525 hours costing $3,675 Variable production overhead $1,260 Fixed production overhead $4,725

Standard selling price and cost data for one unit of Product RS8 is as follows.

Selling price $15.00 Direct material M3 0.6 kg at $1.55 per kg Direct material M7 0.68 kg at $1.75 per kg Direct labour 14 minutes at $7.20 per direct labour hour Variable production overhead $2.10 per direct labour hour Fixed production overhead $9.00 per direct labour hour

At the start of the last month, 497 standard labour hours were budgeted for production of Product RS8. No inventories of raw materials are held. All production of Product RS8 is sold immediately to a single customer under a just-in-time agreement.

Required:

(a) Prepare an operating statement that reconciles budgeted profit with actual profit for Product RS8 for the last month. You should calculate variances in as much detail as allowed by the information provided. (17 marks)

(b) Discuss how the operating statement you have produced can assist managers in:

(i) controlling variable costs;

(ii) controlling fixed production overhead costs. (8 marks) (Total: 25 marks)



LINSIL

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

Operating statement $ $ $ Budgeted gross profit 80

0,000

Budgeted fixed production overhead 352,000 –––––––– Budgeted contribution 1,152,000 Sales volume contribution variance 19,200 Sales price variance (61,000) ––––––– (41,800) –––––––– Actual sales less standard variable cost of sales 1,110,200 Planning variances Variable cost variances Favourable Adverse Direct material price 23,

991

Direct material usage 42,090 Direct labour rate 81,333 Direct labour efficiency 203,350 ––––––– ––––––– 42,090 308,674 (266,584) ––––––– ––––––– Operational variances Variable cost variances Favourable Adverse Direct material price 31,086 Direct material usage 14,451 Direct labour rate 19,032 Direct labour efficiency 135,355 –––––––– ––––––– 149,806 50,118 99,688 –––––––– ––––––– –––––––– Actual contribution 943,304 Budgeted fixed production overhead (352,000) Fixed production overhead expenditure variance 27,000 ––––––– Actual fixed production overhead (325,000) –––––––– Actual gross profit 618,304 ––––––––



The standard direct costs and selling price applied during the three-month period and the actual direct costs and selling price for the period were as follows:

Standard Actual

Selling price ($/unit) 31.50 31.00

Direct material usage (kg/unit) 3.00 2.80

Direct material price ($/kg) 2.30 2.46

Direct labour efficiency (hrs/unit) 1.25 1.30

Direct labour rate ($/hr) 12.00 12.60

After the end of the three-month period and prior to the preparation of the above operating statement, it was decided to revise the standard costs retrospectively to take account of the following:

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

2 A labour rate increase of 4%.

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

Required: (a) Using the information provided, demonstrate how each planning and operational variance in

the operating statement has been calculated. (11 marks)

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

(c) Explain the significance of separating variances into planning and operational elements, using the operating statement above to illustrate your answer. (5 marks)

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

(Total: 25 marks)



PERFORMANCE MEASUREMENT

CARR LTD

(a) Planning is expressed by the budgets which are prepared, but, prior to this, it is necessary to go through a forecasting exercise.

Required Discuss briefly five problems that are likely to arise when forecasting for a business.

(10 marks)

(b) C Ltd employs 300 people and has sales of £9 million. It has five producing departments, two service departments and manufactures one product.

No effective planning or financial control system has been established but after one of the directors had attended a course on ‘Finance for Non-Financial Managers’ he decided to introduce a budget system and performance reports related to responsibilities. Other directors and management had some reservations about the introduction of this system but they were persuaded to allow its introduction.

After the end of April, which was the first month of the current financial year, departmental performance reports were issued to all departmental supervisors. These took the form of that illustrated below for Production Department ‘D’ which was produced by the office manager – the senior person on the administrative staff. (A separate report was issued relating to direct material and direct labour.)

Monthly report: Department ‘D’ – April 20X0 Actual Planning Variance budget

Units produced 1,100 1,000 100

£ £ £ Salaries and wages 10,000 10,500 500 Indirect labour 8,000 7,000 1,000* Maintenance 3,500 2,750 750* Overhead allocated 3,000 2,750 250* Consumable stores 1,600 1,500 100* Depreciation 2,500 2,500 0 Insurance 1,100 1,000 100* Sundries 1,000 500 500* ______ ______ _____

30,700 28,500 2,200 ______ ______ _____

*Note: Considerable inefficiency; action should be taken to improve cost control in this department.

J, the supervisor for Department D, was not pleased on receiving her report and declared she did not have time to bother with such paperwork and, in any case, the report was inaccurate and unfair. Her comment was typical of others who had received similar reports.

Required: (i) State what changes ought to be made to the report and why; (10 marks)

(ii) Assess the situation as it now stands in May and indicate what should be done in respect of the budget system and the departmental performance reports. (5 marks)

(Total: 25 marks)



SPRING PLC

At a recent board meeting of Spring plc, there was a heated discussion on the need to improve financial performance. The Production Director argued that financial performance could be improved if the company replaced its existing absorption costing approach with an activity-based costing system. He argued that this would lead to better cost control and increased profit margins. The Managing Director agreed that better cost control could lead to increased profitability, but informed the meeting that he believed that performance needed to be monitored in both financial and non-financial terms. He pointed out that sales could be lost due to poor product quality or a lack of after-sales service just as easily as by asking too high a price for Spring plc’s products. He suggested that while the board should consider introducing activity-based costing, it should also consider ways in which the company could monitor and assess performance on a wide basis.

Required: (a) Describe the key features of activity-based costing and discuss the advantages and

disadvantages of adopting an activity-based approach to cost accumulation. (14 marks)

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

(Total: 25 marks)



DIVISIONS A AND B

An organisation has two divisions A and B which make sole use of the output of a service division which provides printing and stationery services. Estimated information for the divisions for the year ending 31 December 20X1 is as follows:

(1) Division A Division B Service Division £m £m £m Capital employed 40 25 14 Profit (before service division costs)

10 8

Total costs: 7 (2) Each division has a 15% target return on capital employed.

(3) An activity based costing study has revealed the following additional analysis for the service division: Service provided to: Cost driver Division Service cost A B £m Sales No. of customers 10,000 5,000 1.8 Advertising No. of product types 8 12 2.4 Production No. of batches 60,000 60,000 0.8 Administration No. of employees 800 200 2.0

(4) Management at each division has determined independently that the stationery and print service could be obtained from external suppliers for a fee per annum of £2m and £4.5m for division A and division B respectively.

Required: (a) Prepare a summary which shows the return on capital employed reported at each of

divisions A, B and the service division for EACH of the following transfer price bases from the service division:

(i) Total cost on 50/50 basis

(ii) Total cost on 50/50 basis plus profit mark-up of 30%

(iii) Total cost using an activity based cost approach

(iv) External supplier prices. (16 marks)

(b) Discuss the acceptability of each of the charge bases in (a) to the management at each division and to the organisation as a whole. (9 marks)

(Total: 25 marks)



NOT-FOR-PROFIT SECTOR

During the last 20 years, successive British governments have sought to promote efficiency and effectiveness in all areas of the public sector. Actions taken to promote these ends have included the development and use of appropriate performance indicators. However, both the nature and use of these indicators has been subject to widespread criticism.

Required: (a) Explain the concepts of efficiency and effectiveness within the context of the public

sector and distinguish between the two. (8 marks)

(b) Explain the use of performance indicators in the public sector with particular reference to benchmarking and the balanced scorecard. (9 marks)

(c) Explain the problems that may be encountered in the use of performance indicators in the public sector. (8 marks)

(Total: 25 marks)



PERFORMANCE MANAGEMENT

(a) Discuss ways in which benchmarking may be used by an organisation as part of a performance measurement and improvement focus. (6 marks)

(b) ‘The measurement of performance in a not-for-profit organisation may have value for money as its focus.’

Expand on this statement incorporating comment on economy, efficiency and effectiveness into your answer.

Note: You should select a not-for-profit situation of your own choosing as the basis of your discussion. (9 marks)

(c) Discuss the advantages which may be claimed for Kaplan and Norton’s balanced scorecard as a basis for performance measurement over traditional management accounting views of performance measurement. Your answer should include specific examples of quantitative measures for each aspect of the balanced scorecard. (10 marks)

(Total: 25 marks)



WINDERMERE Windermere operates a divisional organisation structure. The performance of each division is assessed on the basis of the Return on Capital Employed (ROCE) that it generates.

For this purpose the ROCE of a division is calculated by dividing its ‘trading profit’ for the year by the ‘book value of net assets’ that it is using at the end of the year. Trading profit is the profit earned excluding non-recurring items. Book value of net assets excludes any cash, bank account balance or overdraft because Windermere plc uses a common bank account (under the control of its head office) for all divisions.

At the start of every year each division is given a target ROCE. If the target is achieved or exceeded than the divisional executives are given a large salary bonus at the end of the year.

In 20X1, Windermere plc’s division A was given a target ROCE of 15%. On 15 December 20X1 A’s divisional manager receives a forecast that trading profit for 20X1 would be $120,000 and net assets employed at the end of 20X1 would be $820,000. This would give an ROCE of 14.6% which is slightly below A’s target.

The divisional manager immediately circulates a memorandum to his fellow executives inviting proposals to deal with the problem. By the end of the day he has received the following proposals from those executives (all of whom will lose their salary bonus if the ROCE target is not achieved):

(1) from the Works Manager: that $100,000 should be invested in new equipment resulting in cost savings of $18,000 per year over the next fifteen years;

(2) from the Chief Accountant: that payment of a $42,000 trade debt owed to a supplier due on 16 December 20X1 be deferred until 1 January 20X2. This would result in a $1,000 default penalty becoming immediately due;

(3) from the Sales Manager: that $1,500 additional production expenses be incurred and paid in order to bring completion of an order forward to 29 December 20X1 from its previous scheduled date of 3 January 20X2. This would allow the customer to be invoiced in December, thereby boosting 20X1 profits by $6,000, but would not accelerate customer payment due on 1 February 20X2.

(4) From the Head of Internal Audit: That a regional plant producing a particular product be closed allowing immediate sale for $120,000 of premises having a book value of $90,000. This would result in $50,000 immediate redundancy payments and a reduction in profit of $12,600 per year over the next fifteen years.

Required: (a) Assess each of the above four proposals having regard to:

(i) their effect on divisional performance in 20X1 and 20X2 as measured by Windermere plc’s existing criteria,

(ii) their intrinsic commercial merits,

(iii) any ethical matters that you consider relevant.

You should ignore taxation and inflation. (20 marks)

(b) Discuss what action Windermere plc’s Finance Director should take when the situation at division A and the above four proposals are brought to his attention. (5 marks)

(Total: 25 marks)


ANSWERS



SPECIALIST COST AND MANAGEMENT ACCOUNT TECHNIQUES

MANAGEMENT ACCOUNTING

(a) The quotation from Sizer continues:

‘...where management accounting differs from financial accounting, cost accounting, budgetary control and financial planning, is in emphasis upon purpose rather than techniques. Management accounting may be defined as the application of accounting techniques to the provision of information designed to assist all levels in planning and controlling the activities of the firm.’

(b) In general, the difference between financial accounts and management accounts is that statute requires the former to be kept, whereas the latter are kept because of their usefulness. More specifically:

(i) Financial records must be kept by law, whereas there is no legal requirement to prepare management accounts. The Companies Acts, FRSs, SSAPs, EDs, etc, regulate the production and form of financial accounts, in order to ensure that shareholders are kept adequately informed of their company’s performance. Management accounts, on the other hand, are produced for internal use by the company, and therefore there is no need for any form of statutory backing for their production, distribution, presentation and format.

(ii) The expense of keeping financial records cannot be avoided, whereas the cost of keeping management records must be offset by resultant savings eg, by highlighting unnecessary wastage of raw materials, idle time etc, which can subsequently be corrected.

(iii) The main reason for keeping financial records is to comply with legal requirements, in particular, reporting results to the shareholders and filing the accounts with Companies House. Management accounts are kept for planning and control purposes.

(iv) Financial records are mainly concerned with profits; management accounts on the other hand consider all aspects of management.

(v) The financial statements that have to be produced are closely defined but the form, content and format of management accounts can be decided by management according to the type of business and its information needs.

(v) Financial accounts are historical; management accounts are predictive and historical. Thus, financial accounts are based on the past performance of the company, whereas management accounts will be required to plan for the future eg, should material X be brought in from outside suppliers or should it be made in-house?

(vi) Financial records are subject to the concept of prudence; management accounts must be as accurate as possible. Thus, while the financial accounts will show a provision for all known liabilities, whether realised or unrealised, revenue and profits will not be anticipated, but will be included in the accounts only when realised. On the other hand there is no reason why management accounts should not anticipate both losses and profits; management will be more interested in the actual position than in exercising caution.

LECTURER RESOURCE PACK – ANSWER S


A COLLEGE

Key answer tips The flow diagram for part (a) should not be difficult, but the time allowance for 5 marks does present problems. However, time spent on ensuring that you draw a correct picture of the cost apportionments will not only gain these marks but help a great deal in answering part (b). Part (b) is basically an arithmetic exercise. Good use of the flow diagram will help in breaking this down into a series of apportionments. The model answer uses a ‘step’ approach. Students should adopt this approach; any attempt to apportion all the costs in a single table is likely to fail. There is no one answer for part (c). Use your common sense and make brief general statements.

(a) Flow diagram

Occupancy

Administration/ management

Central services

Degree courses

Faculty

Teaching departments

(b) Average cost per graduate

Step 1

Apportion occupancy costs: ⎟⎟⎠

⎞⎜⎜⎝

⎛= ft sqper 40£

ft sq 500,37000,500,1£

Square feet 000

£000

Administration/Management 7.0 280 Central services 3.0 120 Faculty 7.5 300 Teaching departments 20.0 800 ____ ____ 37.5 1,500 ____ ____



Step 2

Apportion central services costs:

⎟⎟⎠

⎞⎜⎜⎝

⎛ +£1,600,000 Costs External

000,120£000,000,1£

= 70 pence per £1 of external cost. External cost Apportionment of central

services cost £000 £000 Faculty 240 168 Teaching departments 800 560 Degree courses 560 392 ____ 1,120 ____

Step 3

Apportion Teaching Department costs (includes 100% of Faculty costs) and Administration/Management costs to degree courses.

Teaching department: £000 £000 Direct costs 5,525 Occupancy 800 Central services 560 –––– 6,885 Faculty costs Direct costs 700 Occupancy 300 Central services 168 –––– 1,168 –––– 8,053 ––––

Administration/management: £000 Direct costs 1,775Occupancy 280 –––– 2,055

Total degree courses costs: £000 Teaching 8,053Administration 2,055Central services 392 ––––– 10,500

Average college cost per student = £ , ,,

£ ,10 500 0002 500

4 200 students

=



Step 4

Analyse £10,500,000 by degree course (in round £000s). Total Business

Studies Mechanical Engineering

Catering Studies

£000 £000 £000 £000 Teaching department

8,053

(3%) 242

(2.5%) 201

(7%) 564

Administration/ management

2,055

(2.5%) 51

(5%) 103

(4%) 82

Central services (based on external costs)

392

22

34

22

________ ________ ________ ________

10,500 315 338 668 ________ ________ ________ ________

Average cost per graduate

£3,938

£6,760 £5,567

________ ________ ________

Tutorial note:

Central services. Apportion the £392,000 of costs on the basis of the external costs of £560,000 (in £000, 32 + 48 + 32 + 448). This gives an apportionment of £0.70 per £1 of external cost. So business Studies is charged 0.70 × £32,000 = £22,400, and so on.

(c) Discussion

The average cost per graduate will differ from one degree course to another for several reasons, the most obvious of which is the very different nature of the courses. The engineering and catering courses will require much greater use of expensive machinery and equipment, which in turn will need more room. In addition these courses will probably require much greater lecturer input than on the business studies courses. The much lower staff/student ratio will push up the teaching costs per student.

Another factor to be considered is the variability in the student numbers. This variable is unlikely to have an impact on many of the costs, which are mainly fixed in nature. For example, if in the following year intake is up to sixty on the mechanical engineering degree, with a similar level of costs, the average cost per student would fall to nearly that being reported for a catering studies student.

These average cost figures must be interpreted with great care by the management. They give a ‘rough’ guide to the relative cost of degree courses but the arbitrary apportionments render them very nearly useless for decision-making. For decision-making, incremental costs are required.



ADMER

Key answer tips

Part (a) of the question might seem straightforward, but you must beware of writing an over-simplified answer. Activity-based costing should be based on a close analysis of activities, the costs of activities and the drivers of those costs. The question does not provide this depth of analysis, and part (a) of the question expects you to recognise this. If your answer explains how useful ABC can be for management, you have missed much of the point of the question, because it is very doubtful whether ABC can be applied here usefully with the information available. The risk is that ABC becomes nothing more than an alternative approach to absorption costing, which would be of little information value to management.

Part (b) of the question asks for an ABC analysis, but leaves it to you to decide what the cost drivers might be. This is not necessarily clear, and your answer should state the assumptions that you make. Part (c) requires you to compare the original profit figures with ABC profit figures, and to discuss a possible decision to close the bathrooms department. It is essential to remember that for decision-making purposes, relevant costs and benefits should be considered – not absorption costing information. In part (c), you should also consider the many other factors that will influence a decision about whether to shut the department or not. There are a lot of points that can be made!

Part (d) of the question is challenging because it takes the basic issue of the usefulness of activity-based costing, and asks you to apply it to a specific case study – here, a chain of home furnishing stores. Your answer should refer specifically to the case study.

(a) Activity-based costing is based on identifying the activities that give rise to costs. This identification process does not seem to have been undertaken in this case. Simply collecting information on different activities is not enough. A detailed analysis of business operations is needed in order to identify relationships between costs and cost drivers. There should ideally be a one-to-one relationship between cost and cost driver. To the extent that this is not so, activity-based costing provides less useful information on product costs and for the purpose of cost control.

review the store’s performance from an activity-based costing perspective. However, the relationship between ‘other costs’ for the three-month period and the proposed cost drivers (number of items sold, purchase orders, etc) is unclear.

If sales staff, warehouse staff, consultation staff and administration staff are on fixed salaries, their wage costs will not be linked to items sold, purchase orders or consultations. If wage costs are apportioned to product costs using the proposed cost drivers, it is likely that better product cost information will arise, simply because the apportionment bases being used are likely to be more appropriate to retailing than floor area. However at what point does a more sophisticated absorption costing system become an activity-based costing system?

The information provided can be used in an activity-based costing analysis if wage costs do depend to some extent on the proposed cost drivers, for example if sales staff wages include a commission for each purchase order raised. The management accountant needs to eliminate confusion by undertaking an investigation to establish and clarify the links between costs and activities if he wishes to use activity-based costing.



(b) Proposed cost drivers:

Total number of items sold = 1,000 + 1,500 + 4,000 = 6,500

Total number of purchase orders = 1,000 + 900 + 2,500 = 4,400

Total floor area = 16,000 + 10,000 + 14,000 = 40,000

Total number of consultations = 798 + 200 + 250 = 1,248

Sales staff wages

Are sales staff wages linked to items sold or to purchase orders?

(1) If sales staff wages are linked to items sold:

Sales staff wages recovery rate = $64,800/6,500 = $9.97/item sold

(2) If sales staff wages are linked to purchase orders:

Sales staff wages recovery rate = $64,800/4,400 = $14.727/purchase order

Consultation staff wages

It seems reasonable to link consultation staff wages to the number of consultations: Consultation staff wages recovery rate = $24,960/1,248 = $20.00/consultation

Warehouse staff wages

Warehouse staff wages could be linked to either purchase orders fulfilled or to items sold:

(1) If each item needs to be handled, items sold might be preferred;

Warehouse staff wages recovery rate = $30,240/6,500 = $4.652/ item sold

(2) If warehouse staff wages are linked to purchase orders fulfilled:

Warehouse staff wages recovery rate = $30,240/4,400 = $6.873/purchase order

Administration staff wages

Administration staff process purchase orders and organise consultations, but no indication is given as to whether these tasks are equally weighted. If they are, the total number of tasks = 4,400 + 1,248 = 5,648 and:

Administration staff wages recovery rate = $30,624/5,648 = $5.422/task

General overheads

General overheads appear to be related to floor space, but there will be other overheads that are not space costs; these will need to be apportioned on a different basis, or even not apportioned at all. Using the information provided:

General overheads absorption rate = $175,000/40,000 = $4.375/square metre



Possible activity-based costing profit statement: Department Kitchens Bathrooms Dining Total

$ $ $ $

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

Cost of goods sold (63,000) _______

(37,500) _______

(176,000)

_______

(276,500) _______

Variable contribution 147,000 75,000 264,000 486,000

Sales staff wages (14,727) (13,255) (36,818) (64,800)

Consultation staff wages (15,960) (4,000) (5,000) (24,960)

Warehouse staff wages (4,652) (6,978) (18,610) (30,240)

Admin staff wages (9,749) (5,964) (14,911) (30,624)

General overheads (70,000) _______

(43,750) _______

(61,250) _______

(175,000) _______

Profit 31,912 _______

1,053 _______

127,411 _______

160,376 _______

Notes:

1 Sales staff wages are apportioned using purchase orders.

2 Warehouse staff wages are apportioned using items sold.

Other choices are possible.

(c) The absorption costing system currently used by the company indicates that the bathrooms department makes a loss.

From an activity-based costing perspective, however, the bathrooms department might make a small profit. The department makes a contribution towards other costs and overheads of $75,000 and a profit before general overheads of $44,803. Therefore financial grounds for closure do not appear to be compelling, although there may be a need to investigate the department with a view to improving profitability.

A more detailed profitability analysis of bathroom sales might lead to a greater understanding of which products were relatively profitable, which products were slow-moving and which products might be removed from sale without adversely affecting sales of other lines. Less drastic alternatives than closure might be suggested by such an analysis.

If the department were closed, it could be argued that general overheads would still need to be met and so overall profit would fall by about $45,000 in each three-month period. Overall profit could fall by more than this if some of the other costs allocated to the bathroom department remained after the closure. For example, the number of staff laid off would not correspond exactly to allocated wage costs.

However, it is unlikely the space vacated by the bathrooms department would remain unused. The remaining departments might be expanded to fill it, or it might be used for a new venture (selling carpets, for example). The key question is whether a better use exists for the space. If an alternative use is found, staff redundancies might be reduced or eliminated entirely.

A further problem is that closure of the bathrooms department could affect sales of the other departments. The store might be seen as no longer offering an adequate range of products and potential customers might prefer other stores with a greater range of home furnishings. The potential for satisfied customers to return with further business would also be reduced if the store offered a more limited range of products.

It is also unlikely that the closure decision would be made at the level of an individual store, since it carries consequences for the company as a whole. The image of the



company might suffer if it were seen to be changing its product range, or if it were seen as being unable to compete with other stores selling bathrooms.

(d) Activity-based costing could help Admer understand more clearly the factors that ‘drive’ its costs. The nature of Admer’s business means that only a small number of cost drivers is likely to exist, but even given the limited information provided, the revised profit statement is likely to be more useful than treating all overhead costs as being related to floor area.

Activity-based costing can help Admer to control costs by highlighting the activities that generate them. For example, consultation staff wages are high compared to sales staff wages in the kitchen department in this store. Perhaps sales staff could be trained to provide in-store consultations and the number of home visits reduced; this could lower administration costs and reduce the cost of consultations.

It is clear that general overheads are the most significant cost other than cost of sales and existing information does not suggest ways of reducing these. However, a more detailed analysis of overheads might reveal activity-based costs that are currently aggregated. Once disaggregated, they become more amenable to understanding and control.

It is argued that activity-based costing leads to more accurate product costs, and in order to achieve this Admer needs a more detailed analysis of sales revenue and cost, based on the nature of the products sold. For example, the company might be able to classify kitchens as basic, intermediate and deluxe, and collect sales and cost data accordingly.

A key advantage claimed for activity-based costing is that it can provide better information to aid decision-making. In this case, it could provide more appropriate information to aid managers in reaching a decision on whether to close the bathrooms department. With better or more detailed information on product cost, managers are likely to make better decisions in key areas such as product pricing and cost control.

Even after introducing activity-based costing, however, Admer will still face the problem that some arbitrary apportionment of costs may still be required when pooling costs. The general overheads of light, heat and rates, for example, are likely to need to be treated in this way, along with the wages of administration staff. A related problem is that not all costs are generated by activities that can be measured in quantitative terms.

The management accountant of Admer should also be aware that the costs of introducing and maintaining an activity-based costing system may exceed the benefits that such a costing system may provide. Appropriate cost drivers will need to be determined and the required information may not be available. The existing management accounting information system may therefore need to be modified to generate the required information, and perhaps new accounting software purchased or developed.



QP PLC

Key answer tips: Part (a) asks you to focus on throughput accounting, particularly with reference to short-term decision making. There are only 6 marks available and these can be earned by explaining the principles involved and how TA is used to identify the production mix which maximises short-term contribution. In part (b) the first task is to identify the limiting factors. At first it appears that there is a shortage of two ingredients and linear programming would have to be used. One ingredient can be replaced by another which has unlimited supply so this becomes a problem which can be solved by calculating contribution (or in this case, throughout) per limiting factor. Part (c) asks you to explain the solution of a linear programming model. There are a lot of marks available here for very little effort and you should attempt to include as much detail as possible.

(a) Throughput accounting is based on the assumption that all costs except material are fixed and throughput can be calculated as sales price less material costs. It can be seen that this is a similar measure to contribution, except that in traditional analysis labour is normally considered to be a variable cost.

Throughput accounting’s primary concern is the rate at which a business generates profits and a company will wish to maximise throughput. This is measured using the return per period ratio. This ratio can also be used in short-term decision making to calculate an optimal production mix. A return per bottleneck resource is calculated for each product and ranked in a similar way to limiting factor analysis. This ranking can then be used to select the product which produces the greatest throughput per unit of the bottleneck resource.

(b) QP plc uses throughput accounting for short-term decisions, so first calculate contribution assuming material is the only variable cost. Ingredient L is the limiting factor. TR PN BE Sales price 340 450 270 Materials 250 285 175 ––– ––– –––Throughput 90 165 95 Kgs of L 7 9 4 Throughput per kg of L £12.86 £18.33 £23.75 Rank 3 2 1

Production plan (maximum of 7,000kg of L available)

First allocate minimum contract 50 TR × 7 350 50 PN × 9 450 50 BE × 4 200 ––––– 1,000 Next produce BE to maximum demand 300 × 4 1,200 Then PN to maximum demand 350 × 9 3,150 ––––– 5,350 Produce TR with the 1,650 kgs remaining 235 × 7 1,645 ––––– 6,995



(Not enough L left to produce another full batch of TR.)

The production plan to maximise the profit of QP plc is: Total throughput 350 BE × £90 31,500 400 PN × £165 66,000 285 TR × £95 27,075 ––––––– £124,575

(c) The objective function value of 110,714 represents the maximum throughput which can be earned given the new constraint. This represents a fall of £13,861 compared to the optimal solution calculated in (b).

The throughput is achieved by producing 500 batches of TR, 357 batches of PN and 71 batches of BE. The slack variables show the extent that this represents a shortfall on the maximum demand achievable. Thus the maximum demand of 500 batches of TR is produced (0 slack variable), a shortfall of 43 batches of PN (357 + 43 = 400) and a shortfall of 279 units of BE (71 + 279 = 350).

The shadow price L value of £3 represents the amount of extra throughput which could be earned if there was one more kg of L available. The shadow price M value represents the amount of extra throughput which could be earned if there was one more kg of M available



MN LTD

(a) The basic concept of throughput accounting is the notion of throughput itself. This can be defined as:

‘The rate of production of a defined process over a stated period of time’

or, to quote Galloway and Waldron:

‘… throughput is the contribution remaining after material costs … At the product level, throughput is equivalent to the rate at which money is earned. It is calculated as sales revenue minus material cost.’

Management Accounting (Jan 1989), p33

Underpinning this basic concept are three further concepts, which can be stated as follows:

(1) In the short term all manufacturing costs, with the exception of material costs, are largely pre-determined and can, therefore, be regarded as fixed.

(2) Holding and producing inventory is not regarded as a value-added activity. Profitability is seen as being inversely proportional to the time taken for production to respond to demand, i.e. throughput time. Since holding inventory lengthens throughput time, profitability can be seen as being inversely proportional to the level of inventory in the system. This supports the advocacy of a ‘Just-in-Time’ system of inventory management.

(3) Overall product profitability is determined by two factors:

(i) the rate at which it contributes money – this is a measure of the product’s relative profitability; and

(ii) the rate at which the factory spends money.

Comparing the rate at which a product contributes money to the rate at which the factory spends it determines absolute profitability.

The objective is to maximise the ‘throughput’ in any given time period and this automatically focuses attention on any bottleneck resource(s). If profit is to be maximised (in the short term), then the optimal utilisation of any bottleneck resources needs to be determined and, if possible, the bottleneck removed.

(b) The throughput accounting ratio, as defined, measures the rate at which the business generates money compared with the rate at which the business spends money. This ratio needs to exceed one if the business is to maintain itself as a going concern. The definition of throughput, explained in part (a), is similar to the existing concept of ‘value added’.

In effect, MN Ltd needs to add value to the business at a greater rate than it is expending conversion costs to add that value. The ratio implies that only products with a throughput accounting ratio greater than one should be produced and that these products can be ranked in terms of profitability by their throughput accounting ratio. To maximise this throughput in the short term, the product(s) with the highest throughput accounting ratio should be produced.

However, this short-term approach may conflict with longer term measures of profitability. For instance, MN Ltd is proposing to replace machine Z with either machine F or machine G and possibly overhaul machine X. This proposal generates a positive NPV but, in the short term, the throughput accounting ratio for the TRLs may decline.

(c) Whilst throughput accounting and marginal costing have many similarities, the main difference arises from the definition of contribution or, more specifically, what can be



regarded as a variable cost. The traditional marginal costing approach assumes that direct labour is a variable cost. Whilst this may have been true 30 or 40 years ago when labour was typically paid at piece rate, this is no longer the case – in the short term, throughput accounting treats labour as a fixed cost. Marginal costing also tends to emphasise cost behaviour, especially overheads, and usually attempts to separate these into fixed and variable components. As with labour costs, throughput accounting treats all production overhead costs as fixed in the short term and aggregates these with labour into what is referred to as ‘total factory cost’. Consequently, in throughput accounting the only cost that is treated as variable in the short term is the direct material cost.

Furthermore, marginal costing does not provide a direct disincentive to produce for, or carry stock. Throughput accounting discourages this by using the total cost of direct materials purchased in the period in the calculation of throughput, rather than the cost of material actually used, as is the case with marginal costing.

(d) If Machine G is purchased and Machine X is overhauled, then the capacity of each machine will be as follows:

Machine X = 45 TRLs per week

Machine G = 45 TRLs per week

Machine Y = 52 TRLs per week

This means that both Machine X and Machine G will become potential bottleneck resources. However, demand is not forecast to exceed 45 TRLs per month until July so the emphasis, initially, will be on ensuring that the new machine is installed and Machine X is overhauled by the end of June at the latest, and preferably by the end of May. Once these machines are fully operational they will both need to be monitored to ensure they are fully utilised, especially in periods where demand exceeds maximum available capacity. Calculation of the return per factory hour for each machine and the associated throughput accounting ratio will assist this process, as will monitoring the level of reworks and rejects that use the bottleneck resources.



BML

(a) Existing costing system:

Calculation of overhead recovery rate:

Labour cost = (£4 × 7,500) + (£8 × 12,500) + (£6.40 × 4,000)

= £155,600

Overhead rate = costLabour cost Overhead × 100%

600,155£688,718£= × 100%

= 462% of labour cost. P1 P2 P3 £ £ £ Direct materials 18.00 25.00 16.00 Direct labour cost 4.00 8.00 6.40 Overhead cost (462% of labour) 18.48 36.96 29.57 ______ ______ ______ Unit cost 40.48 69.96 51.97 ______ ______ ______

(b) Activity-based costing

ABC workings:

Receiving and handling materials cost

Total cost = £150,000

Cost driver = Number of materials movements

Number of materials movements = 4 + 25 + 50 = 79 movements

Cost per material movement = £150,000/79 = £l,898.73.

Cost per unit of P1 = (£1,898.73 × 4)/7,500 = £1.01 per product unit

Cost per unit of P2 = (£1,898.73 × 25)/12,500 = £3.80 per product unit

Cost per unit of P3 = (£1,898.73 × 50)/4,000 = £23.73 per product unit.

Maintenance and depreciation cost


Cost driver = Number of machine hours

Number of machine hours = (0.5 × 7,500) + (0.5 × 12,500) + (0.2 × 4.000) = 10,800

Cost per machine hour = £390,000/10,800 = £36.11 per machine hour

Cost per unit of P1 = £36.11 × 0.5 = £18.06 per product unit

Cost per unit of P2 = £36.11 × 0.5 = £18.06 per product unit

Cost per unit of P3 = £36.11 × 0.2 = £7.22 per product unit.

Set-up labour cost


Cost driver = Number of set-ups



Number of set-ups 1 + 5 + 10 = 16

Cost per set-up = 18,688/16= £1,168 per set-up

Cost per unit of P1 = (£1,168 × 1)/7,500 = £0.16 per product unit


Cost per unit of P3 = £(1,168 × 10)/4,000 = £2.92 per product unit.

Engineering cost


Cost driver: Based on proportion of engineering work.

Cost per unit of P1 = (£100,000 × 30%)/7,500 = £4.00 per product unit

Cost per unit of P2 = (£100,000 × 20%)/12,500 = £1.60 per product unit

Cost per unit of P3 = (£100,000 × 50%)/4,000 = £12.50 per product unit.

Packing cost


Cost driver = Number of orders packed

Number of orders packed = 1 + 7 + 22 = 30

Cost per order = £60,000/30 = £2,000



Cost per unit of P3 = £(2,000 × 22)/4,000 = £11.00 per product unit Unit costs P1 P2 P3 £ £ £ Direct materials 18.00 25.00 16.00 Direct labour 4.00 8.00 6.40 _______ _______ _______ 22.00 33.00 22.40 _______ _______ _______ Overhead costs: Receiving/materials handling 1.01 3.80 23.73 Maintenance and depreciation 18.06 18.06 7.22 Set-up labour 0.16 0.47 2.92 Engineering 4.00 1.60 12.50 Packing 0.27 1.12 11.00 _______ _______ _______ Sub total overhead costs 23.50 25.05 57.37 _______ _______ _______ Total unit cost 45.50 58.05 79.77 _______ _______ _______

Examiner's note An alternative approach to the ABC calculations would be to allocate the total overhead costs to each product line using the cost drivers identified above, finally dividing by the number of units to arrive at the unit cost, as follows:



Total P1 P2 P3 £ £ £ £ Receiving and handling 150,000 7,595 47,468 94,937 Maintenance/depreciation 390,000 135,417 225,694 28,889 Set-up labour 18,688 1,168 5,840 11,680 Engineering 100,000 30,000 20,000 50,000 Packing 60,000 2,000 14,000 44,000 __________ __________ __________ __________ Sub-total overhead costs 718,688 176,180 313,002 229,506 __________ __________ __________ __________ Number of units 7,500 12,500 4,000 Unit overhead cost (£) £23.49 £25.04 £57.38

Any difference between the figures for unit overhead costs derived by the two methods is due to rounding differences.

(c) P1 is shown to have lower unit costs under the original ('traditional') absorption costing system than on the ABC basis. This is caused by its relatively higher machine hour usage and smaller proportion of labour cost, compared to the other products, and the effect this has on the overhead cost allocation. Using ABC, P1 has a very small profit margin. This must therefore raise questions about its viability at its current selling price of £47.

It is a relatively simple product to make. For example, it seems to consist of just one production run and one packing order for the whole output, which means it does not use much of these supporting resources. However it does use a considerable proportion of machine hours, which is what gives rise to much of its allocated overhead cost.

In comparison to P1, Product P3 seems to be a complex product to administer, made in small batches with small orders. In the original system, P3 was being under-costed, being subsidised by P2. It appears to offer a good margin based on its original cost, but the ABC analysis shows that at a selling price of £68, it does not manage to cover all of the direct and overhead costs assigned to it.

There is therefore little surprise that this new product line is attracting additional business, because it is priced below the cost of making it if all of the activities the company undertakes are needed. The company cannot afford to continue business at this price and needs to find some way of managing up the price of this product to make it viable in the future. An alternative may be to re-examine the way it is manufactured, and the ABC system may offer some help in this by assisting with an analysis of what is involved in its manufacture. Presently, it is the high proportion of overhead costs for material movement, engineering and packing which make it expensive. If it is seen to have a future, BML may need to re-engineer their manufacturing methods in relation to this product which makes quite modest use of machining resources.

P2 has the highest volume of the three products, though we are told it is suffering a loss of market share. It is the most labour intensive product and this resulted in serious over-costing under the original system, because overhead was apportioned on a labour cost basis. To put it another way, the ABC cost is lower because the product makes less use of engineering machine hours etc, than the other products. It would seem competitors discovered that they could manufacture this and sell it for a lower price and still make a profit. BML should realise that its major cost is in the use of machinery, and for the volume produced it makes little use of other support costs. It is therefore quite economical to make, though the original system does not reveal this. BML still make a good volume of this product and although we do not know much about the market for it a lower price might stimulate demand, and offer higher sales volumes recovering some of the market share.



Examiner's note The above comments are based on the information as presented in the question. We know nothing about any other overhead costs relating, for example, to administration and selling. No information about the market for the three products is supplied, e.g. market shares or competitors’ prices. Such information as this would place the company in a better position to judge the adequacy of the results of its costing system.



ABC PLC

Key answer tips For Part (a), (i) the computations will only account for 1-2 marks, so don’t waste time by repeating detail from the question - start with the operating profit figures given, and deduct the allocated overhead costs as a total figure for each store. Explanation of the term ‘cost driver’ should be reasonably straightforward from a rudimentary knowledge of ABC; for what is required for ‘volume’ and ‘complexity’ in both explanation and comment, you must focus on the area of cost allocation and think how these issues can affect it. Part (a), (ii) the apportionment of individual overhead costs between cost centres on different bases is a procedure that should be familiar to you. The relevant bases are fairly obvious from the cost driver information given in the question, with the exception of warehouse costs (depreciation and part of HO costs). Don’t waste time worrying about the ‘right’ basis to use, make a rational decision, jot it down, and carry on. Again, the computations account for a minority of the allocated marks - ensure you allow enough time to consider what the figures show. Try not to be too categorical – ‘this method now produces the correct allocation of costs and shows that store C is unprofitable and must be closed’ - as any method of allocating true central shared costs between units will have some arbitrary element and needs to be used with care in decision making. Remember fixed costs are fixed whatever fancy methods are used to split them. In the computations, time could be saved by working in £000s and using a total column. In part (b), do not waste any of the few marks allocated to this part by explaining the mechanics of the techniques themselves; think how they can be applied in this particular context. Discuss both regression and correlation

(a) (i) Report

To: Group management

From: Accountant

Date: xx/xx/xx

Subject: Reporting store’s profits

This report presents the budgeted profits for 20X8 of stores A, B and C based on the method of sharing central costs that was originally employed by the group - sales value. As a result of discussions with management at various levels, alternative ‘drivers’ of these costs have been revealed. This is explained and then applied to the results budgeted for 20X8, finally drawing some conclusions.

A B C £ £ £ Operating profit 840,000 370,000 290,000 Central costs (apportion 5:4:3) 416,667 333,333 250,000 –––––––– –––––––– ––––––––

Net profit 423,333 36,667 40,000 –––––––– ––––––––

––––––––

Cost drivers are events or activities which result in costs being incurred. They are commonly used to allocate costs to cost objectives, or reported and ‘managed’ in order to ‘manage’ the costs they influence. It is argued that in many traditional costing systems, the cost drivers or allocation bases which were used have ‘volume’ implications, for example the number of units produced or sold, the machine hours worked or, in our case, sales value. It is clear that there are many other factors which give rise to costs being incurred or resources consumed. It is not only the volume of business but the way that business is done which causes costs. Dealing with a small volume of business



in a complex product or for a difficult customer is sometimes more costly than a large volume in a familiar situation. It is important that cost reports reveal this issue of complexity, so that management can take steps to deal with any business issues which arise. In the original allocation it is implied that store A, which makes the most sales, consumes the greatest proportion of the central resources. This need not be the case, because it depends on what and how it sells and how it is served by the central resource.

Our company has used sales value to allocate all central costs. It is unlikely that this accurately reflects the way central resources have been consumed by the three stores. The basis seems to be one which is conveniently available and one which is related more to what each store can ‘bear’ of the central costs, rather than any cost causality. It has a tendency to penalise a store if its sales are high, and this can be seen in the case of store A. It is therefore a discouragement to a better-performing store. Additionally, it may influence the accuracy of the budgets, in that stores might deliberately under-state their budgets in order to attract a lower overhead charge.

(ii) A revised profit for each store is shown below which uses the information obtained from recent discussions with staff at all locations.

Total Warehouse operations

Store A Store B Store C

Head office £ £ £ £ £Salaries 200,000 20,000 60,000 60,000 60,000Advertising (5:4:3) 80,000 – 33,333 26,667 20,000Establishment (10:30:30:30) 120,000 12,000 36,000 36,000 36,000 __________ 32,000 Warehouse Depreciation (40:30:30) (note 1) 100,000 40,000 30,000 30,000Storage (40:30:30) (note 1) 80,000 32,000 24,000 24,000Operating and despatch 120,000 + (note 2) 55,000 45,000 52,000Delivery (note 3) 300,000 100,000 71,429 128,571 __________ __________ __________

Store costs 356,333 293,096 350,571Operating profit 840,000 370,000 290,000 __________ __________ __________

Net profit/(loss) 483,667 76,904 (60,571 __________ __________ __________

Notes:

1 Apportion on the basis of storage space occupied.

2 Apportion on the basis of the number of despatches (550:450:520).

3 Apportion on the basis of delivery distances (70:50:90).

The revised calculations show that the costs identified with store C exceed the current level of operating profit, and an overall loss is disclosed. Stores A and B show improved results based on these allocations. The bases selected are believed to bear a closer relationship to how the resources are consumed in providing service to the three stores. The allocation reflects the benefit they receive rather than their ‘ability to bear’ the cost. There are, however, still some costs which will always prove difficult to identify, and these inevitably result in an arbitrary allocation (if management requires them to be allocated). Advertising costs are one such example. It is useful for management to be aware of this analysis, though they should use it with care, since it does not directly make decisions for them. It does not give any information about the



efficiency with which store C is managed, nor does it indicate that the company would make more profit by closing store C.

It would be useful to see a trend of this information over a period of years. It would also be important to know the extent of competition in the area and the market being served.

In the current situation, it may be uneconomic to service store C at its present volume. Having made this point, store C has the smallest gross margin percentage (37%), compared with store A (44%). It has a different sales mix or different pricing structure. From the further statistics, it is also a difficult store to support. It requires proportionately more despatches and greater delivery distances to be travelled. This information suggests there is scope to rationalise delivery to reduce costs, consider direct delivery from some suppliers, examine vehicle routing schedules, and so on.

Further investigation and discussion is required before taking any firm decisions but the information presented above has highlighted issues which would not have been disclosed by the allocation method previously adopted.

(b) Regression analysis and the use of r2 would demonstrate the association between some of the central costs and allocation bases proposed. In the case of delivery miles, it would be necessary to accumulate cost of delivery for a number of periods, say quarterly for three years, and set these against the miles travelled. The value would require adjusting for accruals and inflation over the three year periods. A regression equation would identify the variable and fixed elements of the cost. The coefficient of determination (r2) would express the degree of association between the variable cost and the delivery miles. A close association between these would produce a value for r2 of close to 1.



KEY FACTORS AND THROUGHPUT ACCOUNTING

(a) Once a business has decided its strategy for the next five years, in terms of, for example, market share, revenue and profit growths, diversification into new areas, development of new products etc, it then has to set about planning the achievement of the strategy. At this point, it will need to recognise any ‘key factors’ that may limit the extent to which targets can be achieved, at least in the short term. Such limiting factors may come from lack of sufficient:

• demand

• production facilities

• advertising/marketing personnel/expertise

• labour of the right levels of skill

• capital for investment.

Whilst most of these can be overcome in the longer term, by training, investment, borrowing etc, the short term budgets must start from the current levels available and maximise returns from those, by using one of the techniques described in (b) to determine an optimum production plan (e.g. that giving maximum profit, or minimum cost).

Whilst availability of construction labour will probably not be a problem to SEL, and extra plant and machinery can generally be hired, they may experience limitations in:

• funding, particularly for the longer term developments;

• availability of suitable sites;

• sales and marketing expertise, that may leave properties unlet.

(b) The technique used to tackle a limiting factor problem depends upon the number of limiting factors present.

Single limiting factor

If there is one main key factor, then the approach is one of ranking the various options available according to the benefit they yield per unit of the limiting factor (or scarce resource) used.

For example, SEL has acquired a 600 hectare site – this is therefore the limiting factor. If it was all, for example, land group (1), and there was no loan benefit available, the three types of development would be ranked on the basis of NPV per hectare, resulting in the order of preference of shops, apartments and houses.

Thus the land should first be developed for shops, up to the maximum allowed or thought to be saleable, then allocated to apartments up to any relevant maximum, with the balance, if any, allocated to houses.

Minimum requirements can be catered for by taking the amount of resource needed to meet these out of the total available before allocating the balance as above.

Multiple limiting factors

Where more than one limiting factor needs to be taken into account, the linear programming approach is needed.

Where there are two products, or options, the optimum allocation of the scarce resources between the products can be solved graphically. Each limiting factor is represented by a constraint line, and these together determine the ‘feasible region’ – all the production plans that are possible under the constraints. The best (e.g. profit maximising) plan is given by one of the vertices of this area, which can be found by trial and error, or by



bringing in the objective line. This can all be done manually, or with the help of a computer with the appropriate software and graphic facilities.

For more than two products or options, where a graphical approach is not possible, the simplex iteration process can be applied to the linear programming problem. This will normally be done by a computer.

(c) Throughput accounting is a performance measurement system that relates production and other costs to ‘throughput’, defined as (sales revenue – material costs). The assumption is that a manager has a given set of resources available (buildings, equipment, workforce) with fixed costs over a particular period. These resources are used to process purchased materials and components in order to generate sales revenue.

The aim of throughput accounting is to maximise the value of throughput in the period, which thus focuses management on four aspects, argued to be the main variables in a modern manufacturing environment – sales price, sales volume, speedy and efficient use of materials and cost of materials.

One of the constraints on throughput may be lack of capacity in one or more stages of the process, which are termed ‘bottlenecks’, caused by scarce resources. The optimum allocation of these resources to products passing through the bottleneck can be determined either by the limiting factor approach described above (where the aim is to maximise contribution) or by throughput analysis (where the aim is to maximise throughput). The difference is essentially the extent to which costs are viewed to be variable.

For example, suppose a business produces products X and Y with the following standard costs: X Y $/unit $/unit Direct material 3 9 Direct labour 21 4 Variable overheads 6 8 Fixed overheads 6 __ 3 __ 36 __ 24 __ Selling price 64 __ 50 __

The maximum capacities for each of these products in the machining process are 40 and 50 per hour respectively.

If there was an increase in capacity in the machining department, to which product should it be allocated? X Y $/unit $/unit Sales revenue 64 50 Less: materials 3 __ 9 __ Throughput 61 41 Less: other variable costs 27 __ 12 __ Contribution 34 __ 29 __ Units per hour 40 50 Throughput per hour 2,440 2,050 Contribution per hour 1,360 1,450

Thus under the throughput approach, product X would be chosen, whereas under the limiting factor method, Y would be considered the better user of the resource.



This example illustrates that throughput is just a simpler version of the contribution to limiting factor approach, although it can give different conclusions. Which is the most relevant to a particular business depends upon the true variability of the costs involved, at least over the period for which the decision is being taken. Does increased capacity in the machining process really result in extra labour and variable overhead costs, or are they essentially fixed (e.g. are we making use of idle time)?

Throughput is unlikely to be of relevance to SEL, as there are unlikely to be constraints on construction speed through lack of materials, labour, machines etc. As mentioned before, constraints are more likely to be in the form of finance or land. Tutorial note: The examiner has stated that a numerical example was not mandatory. However, it is probably the clearest way to illustrate the similarities and differences between the two approaches.



DECISION MAKING TECHNIQUES

JB LTD

Tutorial notes:

(1) The question is basically about relevant costs, with reference to a specific decision – whether or not to accept a special order.

(2) The brief details concerning the companies in the opening paragraphs are important when considering what the relevant costs are, and especially for part (b) concerning other factors.

(3) It is important to consider each element of cost one at a time and build up the total relevant cost. Also the arguments for recognition (or not) as a relevant cost should be made on an item-by-item basis. The decision should be made, with the relevant ‘benefit’ statement, after the supporting arguments have been detailed.

(4) A question of this type requires some careful thought if good marks are to be achieved.

(a) Cost/benefit statement £ £

Materials: M1 (W1) 6,600 P2 (W2) 1,600 Part no. 678 (W3) 20,000 ______ 28,200 Labour: Skilled (W4) 8,000 Semi-skilled (W5) 6,000 ______ 14,000 Overheads: Variable (W6) 11,200 Fixed (W7) 3,200 ______ 14,400 ______

Total relevant costs 56,600 Contract price (400 units × £145) 58,000 ______

Benefit of contract 1,400 ______

Therefore, recommend contract is accepted.

(b) Tutorial note: Answering part (b) is not much more than relating common sense ideas to possible alternatives to the contract. Remember to comment briefly, not merely state.

(i) Will the company receive other, perhaps more beneficial, orders during the period of this contract? There may be unforeseen opportunity costs of accepting this order by having to refuse these alternatives.

(ii) Will accepting this order result in future orders, which may result in substantial ‘profits’? This may be very important to JB Ltd. because it works in a specialised, restricted industry.



(iii) Is the supply of M1 sufficient to meet all the company’s needs, including the new contract? If not, the benefit of this contract may be more than reversed with lost production elsewhere.

Workings

(W1) M1: In continuous use, therefore any usage will need replacement. Book value of £4.70/kg is an irrelevant sunk cost. Relevant cost = Replacement cost = 3 kg × 400 units × £5.50 = £6,600.

(W2) P2: Both original and revised book values are irrelevant. Not likely to be used as P2, therefore no replacement cost. Relevant cost is the possible net saving in P4 purchases = 2 kg × 400 units × (£3.60 – £1.60) = £1,600.

(W3) Part no. 678: Future purchase cost of £50 × 400 units = £20,000, is the relevant cost.

(W4) Skilled: Additional cost incurred is the £4/hour; the £5/hour will be the same whether the contract is accepted or not. Therefore, relevant cost = 5 hours × 400 units × £4 = £8,000.

(W5) Semi–skilled: Additional employee costs = Relevant costs = 5 hours × 400 units × £3 = £6,000.

(W6) Variable: Assuming that variable overheads would continue to increase at £7/machine hour, relevant cost = 4 hours × 400 units × £7 = £11,200.

(W7) Fixed: The absolute increase of £3,200 is the relevant cost.

Tutorial note: Calculations based on fixed costs per unit should be avoided.



EXE AND WYE

Key answer tips Part (a) is a standard apportionment and re-apportionment exercise, using the step-wise method - take care to choose the correct order in which to clear service departments. This part only attracts 6 marks (11 minutes’ worth) so don’t spend hours on presentation, explanations etc. In part (b), when advising on the acceptability of accepting additional orders, the main question to ask is – can it be completed using solely spare capacity, or will it necessitate the curtailment of existing business? If the former, then the basic principle is that the order is acceptable provided the price covers the variable cost of manufacture. If the latter, then the opportunity cost of lost contribution from existing business needs to be brought into the equation. In either case, it is variable unit cost that is relevant here, and any apportioned fixed costs should be ignored. So your first task is to compute the variable cost per unit of WYE, including its share of the service departments’ variable costs. Now use this information to determine the decision in (a) on financial grounds, then comment on other less quantifiable aspects that may need to be brought into the decision. For (ii) you need to recognise that some of the new business would be met from spare capacity, and some by giving up existing business, and an overall gain/loss must be computed (again in contribution terms). Then, stand back from the numbers to make some practical comments on other impacts of accepting this order. The main consequence here is the inevitable under-absorption of overheads resulting in adverse volume variances. Try to think of some positive aspects too, and bring in numbers (from the previous parts) if you have time and they add to your argument.

(a) EXE WYE Stores Maintenance Admin £m £m £m £m £m Material costs 1.800 0.700 0.100 0.100 – Other variable costs 0.800 0.500 0.100 0.200 0.200 General factory 1.440 1.080 0.540 0.180 0.360 _______

0.560 Admin (40:30:20:10) 0.224 0.168 0.112 0.056 (0.560) _______ _______

0.536 Maintenance (50:25:25)

0.268

0.134

0.134

(0.536)

_______ _______ 0.986 Stores (60:40) 0.592 0.394 (0.986) _______ _______ _______ Total costs (£m) 5.124 2.976 _________ ________

Volume (budget units) 150,000 70,000 _________ ________

£ £ Full cost/unit 34.16 42.51 Mark-up (25%) 8.54 10.63 _________ ________ Price 42.70 53.14 _________ ________

The prices of EXE and WYE based on the target mark-up are £42.70 and £53.14 respectively.



(b) (i) The full cost and the cost plus price both include an allocation of fixed overheads. As the company has some spare capacity they should be aware also of the product variable cost to help with this sort of decision. It can be shown that by focusing on the variable cost only, an extra unit of WYE costs £20.97.

EXE WYE Stores Maintenance Admin £m £m £m £m £m Material costs 1.800 0.700 0.100 0.100 – Other variable costs 0.800 0.500 0.100 0.200 0.200 Admin (40:30:20:10) 0.080 0.060 0.040 0.020 (0.200) _______ _______

0.320 Maintenance (50:25:25)

0.160

0.080

0.080

(0.320)

_______ _______ 0.320 Stores (60:40) 0.192 0.128 (0.320) _______ _______ _______ Variable costs (£m) 3.032 1.468 _______ _______

Volume (budget units) 150,000 70,000 _________ ________

Variable cost/unit £20.21 £20.97 The price offered makes some contribution to the fixed costs and profit of the

company, though not as much as the normal business.

For 3,000 units, the reported profit will increase by 3,000 × (£35 – £20.97) = £42,090. The company should not replace normal business but if this sale transaction is additional, it appears worthwhile. The company should check that it will not affect its relationship with existing customers or the prices it can command in the market, i.e. the markets are segregated. As a loss leader in this market it may create further business opportunities, though sales should not all be at this sort of price level. Even allowing for the approximation involved in some of the budgeted costs and the arbitrariness of some allocations of costs it appears that the extra revenue exceeds the extra cost and for this volume there is a minimal risk.

(ii) Enquiry price £42.51 + 10% = £46.76

Normal price (from (a)) = £53.14

Unlike the scenario in (i) above, the volume of this potential order is significant. The price indicated is above the full cost but below the normal selling price. Some extra volume would be attractive, but to meet this order the company would have to operate at full capacity and turn away existing business. A financial evaluation can be made by comparing the contribution from the volume that is the subject of the enquiry at the offer price with the contribution from the volume of business that would have to be sacrificed at normal price levels. £ Gain from new business 50,000 × (£46.76 – £20.97) = 1,289,500Existing trade lost 20,000 × (£53.14 – £20.97) = 643,400 ____________

Net gain 646,100 ____________



There could be major goodwill implications for the company if it refuses some of its existing business for this product, if that is the decision it makes. This loss of goodwill might also extend to products other than the one in question here, for which we have no detail. The price being suggested of cost plus 10% is a steep change from the normal price of this product, and if it applies to a significant volume, it may well alter the market position of the product. We are not, however, in a position to assess this with any calculation.

If the company takes the order, it will become reliant on the business of one customer, and so will need to consider the chance of repeat orders from this source.

The analysis assumes that the company is comfortable operating at the 100,000 capacity indicated and that the current cost levels will apply, i.e. unit variable costs will be unchanged and there will be no change in the total fixed costs. Although the increase in contribution/profit for the order looks attractive, the company would be advised to look beyond the current year to a longer-term negotiation on both price and volume. It might be inappropriate to turn away existing business which may have a long-term future for the one-off enquiry which has just a one-year life. If a longer term contract with price terms which may be attractive to both parties could be established, this may encourage the company to invest in order to expand capacity and not lose any business.

(c) In general, using maximum capacity as the volume base for overhead recovery, rather than budget volume, will result in lower overhead recovery rates per unit. This is because the fixed overheads are spread over a greater volume, and this will inevitably lead to a lower full product cost.

The cost would not be representative of the average actual product cost being achieved in the current year, unless current volumes are the same as the maximum capacity level. The company must expect an adverse volume variance to be reported if such a costing approach is adopted.

This approach will, however, reveal a target product cost which can be achieved if high levels of business volume are achieved. In this way, it can be a motivation to management to go out, be more competitive and attract new business. It will show just how low overhead rates and product costs can get.

The revised product cost can be computed by adjusting the fixed overhead component of the product cost for WYE. £ per unit Original full cost 42.51 Variable cost 20.97 _______

Original fixed cost 21.54 _______

Revised fixed cost 115.08* Add back variable cost 20.97 _______

Revised product cost 36.05 _______

*This is achieved by adjusting the original fixed cost by the proportion 70:100, which is the ratio of budgeted volume to maximum volume for WYE. An alternative would be to re-examine the overhead apportionment, though it would come to the same conclusion.

Management should be aware that full product costs, including as they do arbitrary overhead allocation and volume levels, are approximations. Pricing and other decisions are usefully informed by a range of values which include variable costs and full costs based on alternative approaches. The accountant must ensure however that management are fully aware of the assumptions contained in the cost calculations which he/she presents.



PLASTIC TOOLS

(a) Cost-based approaches to pricing involve use of either full cost or marginal cost, or a combination of the two. To the cost, a desired profit margin may be added, hence cost-plus basis of pricing. It may seem that a full-cost plus basis is safe because it ensures that a profit will be earned. This is only true however if the volume that was used to estimate the product cost is actually achieved. If the sales demand falls below the volume used to predict the product cost the total sales revenue may be insufficient to cover all costs including the total fixed costs. One situation where the cost-plus approach may be the only feasible method is in the production of one-off special products. Where management have to quote for the production of a unique item it is logical to seek to recover all applicable costs in the price.

If a firm is faced with spare capacity, in the short run, then any price above the marginal cost will increase profit, provided normal business is not affected. Marginal costs may also be employed in situations where a firm is seeking to identify a minimum short-run price to obtain business which has some long-run profit potential. The existence of fixed costs, which must be covered in the long-run, must not be lost sight of. There is a case therefore for being aware of the full-cost in addition to the marginal cost of a product or service.

A major objection to cost-plus pricing is that, in its basic form, it tends to ignore what the customer is prepared to pay or what the level of demand is likely to be at various prices. There is, therefore, a strong theoretical argument to support the economic model. This model suggests a price/demand schedule should be established and this should be compared with costs, both fixed and variable, at different volume levels to locate the maximum profit point. The practical problem with this approach is the complexity of obtaining this demand / price / cost information for the many products or services which a typical firm offers.

(b) Calculation of overhead rates Variable overhead Moulding Finishing General

factory £000 £000 £000 Sub total 1,600 500 1,050 Re-allocation 600 450 (1,050) _______ _______ 2,200 950 _______ _______ Machine hours 800 600 Rate per hour £2.750 £1.583

Fixed overhead Moulding Finishing General

factory £000 £000 £000 Sub total 2,500 850 1,750 Re-allocation 1,050 700 (1,750) _______ _______ 3,550 1,550 _______ _______ Machine hours 800 600 Rate per hour £4.4375 £2.583



Product costing Moulding Finishing General

factory £000 £000 £000 Direct material 9.00 Direct labour 2 × £5 10.00 3 × £5.50 16.50 _______

26.50 Variable overhead 4 ×£2.750 11.00 3 × £1.583 4.75 _______ 15.75 _______ Variable manufacturing cost 51.25 Fixed overheads 4 × £4.4375 17.75 3 × £2.583 7.75 _______ 25.50 _______ Full manufacturing cost 76.75 _______

Price based on full manufacturing cost: Mark up % 25% 30% 35% £ £ £ Mark up 19.19 23.03 026.86 Proposed price 95.94 99.78 103.61

Price based on variable cost and incremental fixed costs: £ Variable manufacturing cost (as above) 51.25 Incremental fixed costs £167,000/20,000 units 08.35 _______ 59.60 _______

(c) The full cost approach using the existing allocation methods and mark-up practices suggests prices in the range of £96 to £104. At the top of this range it is a little above the current market price but the product is suggested to offer some improvements over competitors. The management may find, additionally, that as they go into full production, that they are able to increase their efficiency and lower their costs. The fact that the full cost price is broadly similar to the prevailing market price is an indicator that the company is not too far out of line with the cost of manufacture of this product.

The product variable cost is £51.25. In the very short term this could be taken to be a minimum price but which offers no contribution to overheads or profit. Management may see it as appropriate to cover at least the incremental fixed costs specific to this product. Working on an assumption of 20,000 unit sales per annum raises the minimum price to £60, though this value is dependent on the accuracy of the volume base used to apply the specific fixed overheads.

In the present situation the management should be guided more by the prevailing market price and full cost recovery than a marginal approach. The price should not be pitched too low because they may want to reinforce the impression that the product offers improvement.



BIL MOTOR COMPONENTS PLC

Key Answer Tip In part (a) when you are asked for ‘the lowest selling price’ at which a product should be offered, you should generally be thinking along marginal/relevant costing lines. Provided it is not the business’s only, or main, product, one may assume that non-incremental fixed costs are being covered elsewhere in the business, and thus can be ignored. In this case, the information indicates this scenario (note, it is a price that is only going to be charged to some key customers) and the marginal cost approach was expected. However, the examiner has said that marks were still awarded to those who justified taking a marginal approach. Once you have tackled the computations, don’t forget the critical evaluation. This should be both from the company’s point of view, and that of their customers/market. In part (b) first note that the manufacturing variable cost is less than the buying-in price, so the company will generally want to manufacture up to full capacity before buying in (although you should note the assumptions here). Thus for each demand level given, you need to decide the split between manufacture and buying in, compute the total variable costs and compare with the revenue (using the appropriate price) to get contribution. The level with the highest contribution is then chosen. In part (c), for 4 marks, you are expected to produce at least four suggestions. Make sure you explain each suggestion sufficiently to show how it helps to increase capacity.

(a) ← Machine group → Per unit 1 7 29 Assembly Total

£ £ £ £ £

Total cost 31.65 21.82 3.05 5.40 Less: Fixed overheads 3.00 2.50 1.50 0.84 _____ _____ ____ ____

28.65 19.32 1.55 4.56 Setting-up costs 0.05 0.03 0.02 − _____ _____ ____ ____

Variable cost 28.70 19.35 1.57 4.56 54.18 _____ _____ ____ ____ _____

The lowest possible price could be (200 × 54.18) = £10,836 per batch of 200 which would cover the whole of the variable cost.

However, the above-mentioned price would not be making any contribution towards the recovery of the fixed overheads. If the company is to make a profit, it has to recover its fixed overheads.

Even in this case, the selling price cannot really be set simply by reference to the variable costs. The prices at which competitors are offering the same product, plus engaging in market research should also be considered. Of particular importance are the likely reactions of competitors e.g. if the strategy starts a price war the company could lose more than it gains.

In addition, the company needs to think about what the likely outcome will be if other customers of the product concerned find out about the ‘special price’!

Finally, the company must realise that this kind of strategy cannot work overnight, it does take time. It could, in fact, be a number of years before the company can charge the customer the full price.



(b) For outputs up to 7,000 units/Sales up to 7,000 units

£ £ £ £ £

Selling price 13.00 12.00 11.00 10.00 9.00 Less: Variable cost 6.20 6.20 6.20 6.20 6.20 _____ _____ _____ _____ _____

6.80 5.80 4.80 3.80 2.80 _____ _____ _____ _____ _____

For outputs and sales over 7,000 units £ £ £

Selling price 11.00 10.00 9.00 Less: Bought-out finished price 7.75 7.75 7.00 _____ _____ _____

3.25 2.25 2.00 _____ _____ _____

Selling price Volume Contribution Total units per unit contribution £ £ £

13 5,000 6.80 34,000 _____

12 6,000 5.80 34,800 _____

11 7,000 4.80 33,600 200 3.25 650 _____

34,250 _____

10 7,000 3.80 26,600 4,200 2.25 9,450 _____

36,050 _____

9 7,000 2.80 19,600 6,400 2.00 12,800 _____

32,400 _____

The price of £10, and sales of 11,200 units would maximise the profit, as illustrated above at £36,050 provided the estimates prove to be correct.



(c) Management can increase their company’s production capacity by:

• improving product design so that the production process can be simplified and take up less time;

• improving plant lay-out, production methods and production scheduling, to reduce idle time and avoid bottlenecks;

• introducing the working of overtime and/or ‘shift working’, if this has not already been done, to make more production time available;

• introducing or improving an existing incentive scheme which makes use of the standard costing system, to enhance productivity;

• buying certain components from outside suppliers rather than manufacturing them, which frees machines and equipment for other purposes;

• employing sub-contracting manufacturers to produce completed products which also frees production facilities.



MOV COMPANY

Key answer tips: Again there is a lot of information here. Probably the easiest trap to fall into would be that to do with the stepped fixed costs and the effect of increasing production. Set out the available options and any assumptions you are making very clearly. In fact, part (a) is probably the most difficult part of this question as the statement you are required to ‘discuss critically’ is rather a mess. You need to marshall your thoughts and try to be clear in your criticisms.

(a) The statement produced by the company accountant is invalid in the following respects:

• His approach is very incomplete, in that he has listed out relevant costs that are saved (even though these are not complete and anyway they are not all ‘saved’) by outsourcing and then deducts the ‘additional costs’ that will be incurred by outsourcing.

• It is not a competent assessment of whether the outsourcing route should be taken since it only covers costs for one year ahead. These are exceptional since they include redundancy costs (or rather, they should include these – Jim has omitted them), and of course they do not reflect the increased costs that will be incurred as sales increase.

• Revenues are expected to increase over time as a result of the increased capacity offered by outsourcing, and the effect of this has been totally ignored.

• He is assuming that only 72 of the staff are made redundant but states nothing about what is happening with the costs of the (88 – 72) 16 staff who remain. It is probable that their costs can also be treated as ‘saved’ since they will be doing other jobs in the factory which would otherwise have to be paid for separately.

• He takes no account of the redundancy costs of £4,000 per staff member, that is £288,000.

• The figure for the purchasing officer will not be ‘saved’ since, although he will not be doing the existing job, he will be doing another one for which he will be paid

• The cost of the liaison officer should be treated as a negative saving – it has been omitted.

• We have no detail on how Jim has arrived at the figures for placing 1,000 orders at £20 each. It can be assumed that this includes the purchasing officer’s costs which have therefore been double-counted here.

• Jim has included transport costs for SCBs raw materials as being saved, but again these are double-counted as they would be included in the direct materials part of the variable cost of SCBs dealt with below.

• The additional cost of SCBs is stated as the bought-in price less current fully absorbed total costs. Instead, it should be as follows:



£ £ Bought in price 116 Less: marginal cost (28 + 40 + 20) (88) _____ 28 × 58,000 1,624,000 _____ Less: Directly attributable fixed overheads saved (250,000) ____________ Additional costs (£23.69 per unit) 1,374,000 ____________ (b) (i)

A Expand production with overtime Year to

date 2008/2009 2009/2010 2010/2011 Total

Units produced 55,000 58,000 60,500 60,500 Additional units per year 3,000 5,500 5,500 £000 £000 £000 £000 £000 Additional contribution

£400 × 3,000 or 5,500

1,200.0 2,200.0 2,200.0

Variable costs

£75 × 3,000 or 5,500

(225.0) (412.5) (412.5)

Additional fixed costs – SCBs (130.0) (130.0) – Sensors (300.0) (300.0) ––––– –––––– –––––– –––––– 975.0 1,357.5 1,357.5 3,690.0B Expand production with CIF Company

Year to date

2008/2009 2009/2010 2010/2011 Total

Units produced 55,000 58,000 62,000 65,000 Additional units per year 3,000 7,000 10,000 £000 £000 £000 £000 £000 Additional contribution

£400 × 3,000 or 7,000 or 10,000

1,200 2,800 4,000

Variable costs difference

£28 × 58,000 or 62,000 or 65,000

(1,624) (1,736) (1,820)

Redundancy (288) Stock holding (10) (10) (10) Liaison officer (30) (30) (30) Fixed costs – SCBs saved 250 250 250 – Sensors (300) (500) –––––– ––––– ––––– ––––– (502) 974 1,890 2,362



C Rent out SCB area Year

to date 2008/2009 2009/2010 2010/2011 Total

Units produced 55,000 58,000 60,500 60,500 Additional units per year 3,000 5,500 5,500 £000 £000 £000 £000 £000 Rental income

240 × 120= 28,800 x £45

0 1,296 1,296

Additional contribution

£400 × 3,000 or 5,500

1,200 2,200 2,200

Variable costs difference

£28 × 58,000 or 60,500

(1,624) (1,694) (1,694)

Redundancy (288) Stock holding (10) (10) (10) Liaison officer (30) (30) (30) Fixed costs – SCBs saved 250 250 250 – Sensors (300) (300) –––– ––––– –––– –––– (502) 1,712 1,712 2,922 –––– ––––– –––– ––––

Outsourcing to CIF without renting out the space (B) is the least favourable approach, and the best approach would be to work the overtime over the next three years (A). This will generate a £768,000 greater return than buying in and renting out (C).

(ii) Outsourcing the production of SCBs may seem expensive in the short term (B and C) but in the long term it could be beneficial to the company:

Capacity is thereby expanded to be a closer fit to projected demand. This may suit the company best as it may be bad for business to be turning down work due to lack of capacity, a lack that not even long-term overtime can address.

Overtime working to full capacity as a vital part of any company’s plans is rather risky – quality can be affected and the company is very vulnerable to the effects of factory downtime, strikes and problems with supply.

If demand rises above 65,000 units in the long term then the company will be glad that it took the decision to outsource at this point. In 2010/11 we can see that sales of 65,000 in B generate a return that is (£1,890.0 – £1,357.5) £532.5 higher than the same period under A. If, under B, demand increased by another 3,000 units then the effect would be as follows:



Year to

date 2008/2009 2009/2010 2010/2011 2011/2012

Units produced 55,000 58,000 62,000 65,000 68,000 Additional units per year 3,000 7,000 10,000 13,000 £000 Additional contribution

£400 × 13,000 5,200

Variable £28 × 68,000 costs difference

(1,904)

Redundancy Stock holding (10) Liaison officer (30) Fixed costs – SCBs saved 250 – Sensors (500) 3,006

This represents an increase of (£3,006.0 – £1,357.5) £1,648.5 over the overtime option in the fourth year, and suggests that outsourcing now to take advantage of sales rises in the future may be a good idea.

However, there is a serious disadvantage on top of the short-term extra cost, namely that outsourcing removes some of the control and opportunity for innovation from the company where the product was designed. There might also be a loss of skills among the workers, which means that it would be difficult to reverse the outsourcing decision in the future. This may be a particular disadvantage if demand does not in fact continue to grow and the company wishes to downsize, but not cease, its production of sensors.

To some extent, the issue for MOV Company is two-fold – how secure does it feel about future demand for sensors and hence its future need for SCBs? This is a point that it should examine separately from the issue of whether or not to buy in components. In addition, MOV Company could simply look at increasing its capacity, say by moving premises or investing in more sophisticated machinery and better training for staff.



PRIVATE HOSPITAL

Key answer tips: This question is an application of the graphical linear programming technique to a cost minimisation problem. As with all these problems, you must take care to (i) define your variables appropriately, including a timescale, (ii) set out and label your objective and constraints clearly, (iii) draw as neat a graph as possible (note there are 10 marks for this in this question), with a title, labelled axes and constraint lines and a clearly identified feasibility region. There are various ways to determine the optimum solution. Here, we try each of the corners of the feasibility region; an alternative would be to plot a sample objective line on the graph and move it inwards (for minimisation) to find the last corner it passes through before leaving the feasibility region entirely. Whichever method you choose, give a brief explanation of how you arrived at your solution. The requirement in (d) to comment carries only 3 marks, so any sensible point made will get the marks. The sensitivity of your solution to changes (a rough assessment) is always a good bet.

(a) Let q = number of qualified nurses employed per year and s = number of student nurses employed per year.

Objective function: minimise annual costs ∴ minimise 13,000q + 6,000s Subject to: q + ½s ≥ 100 (at least 100 qualified or equivalent are required) s ≤ 50 (accommodation) q ≥ s or q − s ≥ 0 (working practice) s ≥ 30 (charity) q ≤ 140 (job market)

(b) Graph showing feasible region



(c) Co-ordinates of the vertices of the feasible region:

A: intersection between s = 50 and q + ½s = 100 (75, 50)

B: intersection between s = 30 and q + ½s = 100 (85, 30)

C: (140, 30)

D: (140, 50)

Vertex (q, s) 13,000q + 6,000s = costs

A: (75, 50) 13,000 × 75 + 6,000 × 50 = 1,275,000

B: (85, 30) 13,000 × 85 + 6,000 × 30 = 1,285,000

C: (140, 30) 13,000 × 140 + 6,000 × 30 = 2,000,000

D: (140, 50) 13,000 × 140 + 6,000 × 50 = 2,120,000

The cost will be minimised when employing 75 qualified nurses and 50 student nurses.

(d) There is little difference in the total cost of employing either 75 qualified nurses and 50 student nurses or 85 qualified nurses and 30 student nurses. The hospital could therefore employ any combination of student and qualified nurses along the line q + ½s = 100 between points A and B, to give them greater flexibility.



BUDGETING

ACCOUNTING TYPE CONTROL INFORMATION FOR MANAGEMENT

In providing control information for operating managers, the accounting department is providing a service which must be seen by line management to be meeting its needs in terms of enabling the managers to carry out their responsibilities efficiently and effectively.

The cost control information generated by the management accounting system is only one source of information to an operating manager. There are other systems covering such areas as work study and labour productivity where the information is not necessarily expressed in monetary values. A manager may regard cost control information as having a lower priority than meeting delivery dates or maintaining good communications with his workforce to minimise industrial relations problems. His view on priorities might be influenced by the attitude of his immediate manager too.

An operation manager may indicate a lack of interest in accounting information. This may be because the information he receives is not what he needs, or at least not what he thinks he needs. He may just not understand the information he receives because he has not been trained or educated to do so.

Some managers may show an attitude or resentment to the accounting control information because they consider that it is not provided to help them so much as to provide a basis for their superiors to gauge managerial performance. This may be very common in organisations where budgets and standards are imposed on managers by more senior managers. An operating manager may feel that the reporting of control information creates a situation potentially dangerous to his self-image and which he will try to have nothing to do with. This could occur when more senior management use these reports in such a way as to impose pressure from above on operating managers.

The effectiveness of accounting reports to operating managers tends to be affected by the organisation structure. In a large decentralised or divisionalised structure a state of inaction or inertia can sometimes develop and be reflected in attitudes and actions.

The esteem of the accounting department and the information service it provides to operating managers can often be influenced by the way that the senior managers regard the system. The way that senior management use accounting control information and stress the importance of it can influence attitudes and motivations of operating managers at levels lower down in the organisation structure.

In terms of providing an accounting service to internal management, there is no right to existence of such a service. It should only exist as long as it is providing the appropriate service to meet the needs of management. Therefore, a flexible approach to meeting the ever-changing needs is suggested. The management accountant should be approachable by operating managers so that he is aware of their problems and possible anxieties about the system. Training courses can be arranged to ensure managers at least understand the basis of the systems and what the information generated by them means and how it can and should be used.

Like computer services management, accountants are often criticised for using specific terms, specialised terms or jargon when they communicate. This should be avoided unless the recipients do fully understand such terminology.

Participation in the setting of standards or budgets is vital if managers are to be motivated to understand and use the control data they receive.

It is important that in providing control information the accountants understand and apply the objectives behind the ‘management by exception’ concept. Management’s attention should be drawn to the deviations that are occurring (variances from budget or standard) rather than on



the masses of detail where everything is going according to plan. It should not be the aim to inundate an operating manager with reports full of figures which may demotivate him so that he takes no notice of any of the figures.

Accountants should aim at providing information on the key areas of each manager’s area of responsibility.

It is important to educate operating managers to realise that the provision of the specialist accounting and other services is to give them information which they can use in controlling their own areas of responsibility. The information provided should be communicated to operating managers as soon as possible after the event to which it relates if it is to have the most benefit to them.

Overall the accounting department management should be aware that it is providing just one source of control information to operating managers, albeit a very important all-embracing one. It is a specialist service that is offered which needs to be understood by operating management, and at the same time there is communication in the other direction which keeps the accounting department aware of the changing needs of operating managers. A sympathetic relationship with operating management needs to be developed.



SYCHWEDD PLC

Key answer tips In part (a) a machine hour rate needs total budgeted overheads for the period (given in the question) and total machine hours budgeted to be worked. The latter is determined from budgeted product activity levels (here, production = sales) and machine hours by products (here given in terms of hours per 1,000 kg). In part (b) the computations required are not complex, but there are a lot of numbers to work through. You need to make sure you set out your answer in such a way that the examiner can award marks for method even if you make the odd slip here and there. Set up a proforma statement first, ensuring you can identify the contribution line as well as profit, then use separate workings where necessary to compute the figures. These should be referenced in to your statement. In part (c) it is a temptation to think that by the time you have worked your way through the data for the first two parts, you’re virtually there, and it needs only a quick note or two for this part. When there are this many marks involved, this is a dangerous strategy. At the very least, as the question specifically refers to the sales trend, you can assess what is happening to each product in this respect. Consider both the sales volumes and the resulting contributions, as you have this information for both periods. On the whole, you should be ignoring fixed costs in your analysis as they are absorbed on a relatively arbitrary basis. Then look for any other points worthy of mention – e.g. high proportion of material costs.

(a) Period 2 Machine

group 1 Machine

group 2 Product R (10,000 × 75 machine hours per 1,000) 750 (10 × 80) 800S (25,000 × 30 machine hours per 1,000) 750 (25 × 110) 2,750T (50,000 × 50 machine hours per 1,000) 2,500 (50 × 50) 2,500 ________ ________

Budgeted machine hours 4,000 6,050 ________ ________

Overheads (given) £40,800 £68,365Machine hour rate £10.20 £11.30 __________ __________

(b) Period 2 Product profitability analysis Product R Product S Product TKilos of sale 10,000 25,000 50,000 Sale price per kg £10 × 1.10

= £11£10 £9

£ £ £ Sales 110,000 250,000 450,000 __________ __________ __________

Direct materials (W1) 45,080 127,400 306,250 Variable labour and overheads (see W2) 5,650 12,500 16,000 Sales commission at 4% 4,400 10,000 18,000 __________ __________ __________

Variable cost 55,130 149,900 340,250 __________ __________ __________

Contribution 54,870 100,100 109,750 Fixed overheads (see W3) 16,690 38,725 53,750 __________ __________ __________

Budgeted net profit 38,180 61,375 56,000 __________ __________ __________



Workings

(W1) Materials

Product R: £4,508 × (10,000/1,000) = £45,080

Product S: £5,096 × (25,000/1,000) = £127,400

Product T: £6,125 × (50,000/1,000) = £306,250.

(W2) Variable labour and overheads Direct labour

hours: Products

R S T R S T Machine group

Labour and overhead

rate per hour

£ £ £

1 30 : 10 : 20 £7.50 225 75 150 2 40 : 50 : 20 £8.50 340 425 170 _____ _____ _____

Cost per 1,000 kg 565 500 320 _____ _____ _____

Number of batches (sales/1,000) 10 25 50 Variable labour and overheads £5,650 £12,500 £16,000

(W3) Fixed overheads Machine group

Machine hours Machine hour rate (see (a))

Products

R S T R S T £ £ £ 1 75 : 30 : 50 £10.20 765 306 510 2 80 : 110 : 50 £11.30 904 1,243 565 _______ _______ _______ Fixed overhead cost per 1,000 kg 1,669 1,549 1,075 _______ _______ _______ Number of batches (see above) 10 25 50 Fixed overheads £16,690 £38,725 £53,750

The net profit figures have been calculated using absorption costing, i.e.absorbing fixed overheads into the product costs. This method uses arbitrary bases for apportionment, such as floor area, number of employees etc.

The fixed overhead recovery rate uses machine hours (i.e. it is an output-based measure) when in fact a lot of the fixed overheads tend to vary more with time than output. Absorption costing is an attempt to ensure that costs are recovered. It does not attempt to provide accurate and realistic product costs. The marginal costing contribution approach only includes those costs which vary with output, i.e. the variable costs. By indicating the amount that each product contributes towards the recovery of the fixed overheads and profit, marginal cost is considered to be a more appropriate costing method for decision-making purposes.



(c) At the outset, it should be noted that the budgets are only estimates and that the assumptions on which they were based could change. They provide targets against which the actual performance can be compared as and when the information becomes available.

For decision-making purposes, management need to use a contribution approach and also assess where the product is in its life cycle.

The sales of product R are expected to fall. If this continues in the future, the product will be in the decline stage of its life cycle and a time could come when its contribution would not cover the fixed overheads assigned to it, meaning that they would have to be recovered out of the contributions generated by the other products.

Product S, if it continues to remain static in terms of the sales demand would appear to have reached its peak. However, there should be a significant increase in period two in its contribution, possibly resulting from increased efficiency, improved productivity and cost reductions.

Product T could well be into its growth stage, with an anticipated 25% increase in volume planned for period two. Here also the selling price is expected to remain unchanged and increases in efficiency should help to increase the contribution per kilo from £1.89 to around £2.20.

The management need to consider what action they can take to reverse the trends in products S and T and search for new products.

Management also needs to be made aware of the very high proportion of material costs. The material cost for all products as a percentage of the total cost is over 73%. This high level of investment in materials should make inventory management a very high priority. In order to reduce material costs and expensive holding costs, management will need to monitor and review the situation at frequent intervals. They could consider actions which would reduce waste (for example, better design/production methods) or reduce the cost (for example, by using substitutes).



BUDGET COMPILATION

Key answer tips In part (a) the key is to remember the flow of the budgets - starting with the sales units given, add closing stock (finished goods) and subtract opening stock to get to production. This will determine materials usage, which then needs to be adjusted for opening and closing stock of raw materials in the same way to arrive at materials purchases. In part (b) we are looking at one month only, and the main working required is that of closing stock value, incorporating the overhead absorption rate appropriate to that month’s production. In part (c), having used the company’s ‘monthly’ system of overhead absorption in (b), you are now asked to assess its implications. You should start by stating the obvious - that stock value will fluctuate with production levels, even though budgeted overhead for the month is constant - then think how this might affect the information conveyed by the management accounts. Part (d) is a straightforward textbook explanation of a time series and its components, and should give easy marks.

(a) Production budget (units) Dec Jan Feb Mar Apr Sales 14,000 16,000 22,000 17,000 20,000 Closing stock 4,000 5,500 4,250 5,000 6,000 _____ _____ _____ _____ _____ 18,000 21,500 26,250 22,000 26,000 Opening stock 3,500 4,000 5,500 4,250 5,000 _____ _____ _____ _____ _____ Production 14,500 17,500 20,750 17,750 21,000 _____ _____ _____ _____ _____

Purchases budget (units) Dec Jan Feb Mar Production 14,500 17,500 20,750 17,750 Closing stock 1,750 2,075 1,775 2,100 _____ _____ _____ _____ 16,250 19,575 22,525 19,850 Opening stock 1,450 1,750 2,075 1,775 _____ _____ _____ _____ Purchases 14,800 17,825 20,450 18,075 _____ _____ _____ _____

Examiner's note Columns for January to March only are required in an answer to (a) though you will find that you will need some data from December for the cash budget, as well as the production for April for the purchases budget.

(b) Working: Product unit manufacturing cost for January £ Material 10 Variable overhead and labour 16 Fixed overhead 12 ____

38 ____

Note: The fixed overhead rate for January is calculated using the budgeted monthly overhead and production: £210,000/17,500 = £12/unit.



Budgeted profit and loss account January 20X9 (FIFO stock valuation) £000 £000Sales 16,000 × £58 928Raw material usage 17,500 × £10 175 Variable overhead and lab. 17,500 × £16 280 Fixed overhead 17,500 × £12 210 _____

Manufacturing cost 17,500 × £38 665 Closing stock (5,500 × £38) (209) _____

12,000 × £38 456 Opening stock 4,000 × £40 (cost given) 160 Cost of sales 616 _____

Gross profit 312

_____

Selling costs Variable 16,000 units of sale × £7 112 Fixed 164 _____

276 _____

Net profit 36 _____

Cash receipts and payments January 20X9 £000 £000 Receipts From December sales 50% × 14,000 × £58 406 From January sales 50% × 16,000 × £58 464 _____ Total receipts 870 Payments: Materials (December purchases) (14,800 × £10) 148 Variable overhead and labour (17,500 × £16) 280 Fixed overhead (210,000 – 54,000 dep'n) 156 Variable selling (16,000 × £7) 112 Fixed selling 164 _____

Total payments 860 _____ Receipts less payments in January 10 _____

(c) Under a system of absorption costing, an overhead rate is used to apply overheads to each unit produced. At present the company applies each month’s overhead to products based on the budgeted production levels and the budgeted expenditure in each month, which are used to establish a separate predetermined rate for each month. As a result, unit overhead costs fluctuate if production levels fluctuate because the fixed overheads are spread over fluctuating volumes.

It can be disconcerting and misleading for production and sales staff to be dealing with product costs which fluctuate on a monthly basis. This is especially so when the fluctuation has not been caused by changes in production efficiency, and it bears no relation to changes in the general market price.



One way to overcome this is to compute an overhead rate which is based on a longer time period, for example quarterly, or a predetermined annual rate as mentioned in the question. This enables large fluctuations in, and extreme values of, product costs to be avoided. This would mean that management would be able to monitor the business volume and overhead costs on which the calculations were based to ensure that over the longer-term the average product costs which were predicted were in fact achieved.

(d) A time series is the name given to a set of observations taken at equal intervals of time in order to obtain an overall picture of what is taking place. For example, monthly sales covering a period of, say, five years. A time series consists of various components, such as trend, cyclical, seasonal and residual components.

To develop this explanation a little further, the trend component is the way in which the series appears to be moving over a long interval, after other fluctuations have been smoothed out. The cyclical component is the wave-like appearance which occurs in the series when taken over a fairly long period, a number of years. Generally it is caused by the booms and slumps in an industry or trade cycle.

A seasonal component is the regular rise and fall of values over specified intervals of time, within say one year. Though the term seasonal is used it does not have to align with seasons, but any regular variations over short time periods. Residual components are any other variations which cannot be ascribed to any of those mentioned above, essentially random factors and due to unpredictable causes.



ACRED LIMITED

Key answer points Part (a) of the question calls for a lot of calculations and a clear presentation of the budgeted figures. You need to be well-organised to complete the solution within the time available. Note that part (a) of the question is worth just 13 marks, only one half of the total marks for the question. You should therefore beware of spending too much time getting the figures right in part (a) leaving yourself insufficient time to answer part (b) – which should be reasonably straightforward to answer.

(a) (i) Acred Ltd: Production budget for 6 months to end of December 20X4 July Aug Sept Oct Nov Dec units units units units units units

Sales 10,000 11,000 12,000 13,000 14,000 15,000Stock increase 200 200 200 200 200 0 ––––– ––––– ––––– ––––– ––––– –––––Production 10,200 11,200 12,200 13,200 14,200 15,000

––––– ––––– ––––– ––––– ––––– –––––(ii) Acred Ltd: Cash budget for 6 months to end of December 20X4

July Aug Sept Oct Nov Dec £ £ £ £ £ £

Receipts (W2) Cash sales 30,000 33,000 36,000 39,000 42,000 45,000Credit sales 90,000 90,000 99,000 108,000 117,000 126,000 –––––– –––––– –––––– –––––– –––––– –––––– 120,000 123,000 135,000 147,000 159,000 171,000 –––––– –––––– –––––– –––––– –––––– ––––––Payments Materials (W3) 48,480 51,360 56,160 60,960 65,760 70,080Labour (W4) 18,360 20,160 21,960 23,760 25,560 27,000Direct expenses (W5)

12,240 13,440 14,640 15,840 17,040 18,000

Fixed o'hds (W6) 22,000 22,000 22,000 22,000 22,000 22,000Advertising – 95,000 – – – –Interest – – 30,000 – – – –––––– –––––– –––––– –––––– –––––– –––––– 101,080 201,960 144,760 122,560 130,360 137,080 –––––– –––––– –––––– –––––– –––––– ––––––Receipts less payments

18,920 (78,960) (9,760) 24,440 28,640 33,920

Opening cash 50,000 68,920 (10,040) (19,800) 4,640 33,280 –––––– –––––– –––––– –––––– –––––– ––––––Closing cash 68,920 (10,040) (19,800) 4,640 33,280 67,200

–––––– –––––– –––––– –––––– –––––– ––––––Workings

(W1) Sales budget for 6 months to end of December 20X4 June July Aug Sept Oct Nov Dec Sales (units) 10,000 10,000 11,000 12,000 13,000 14,000 15,000Sales price £12 £12 £12 £12 £12 £12 £12Revenue (£) 120,000 120,000 132,000 144,000 156,000 168,000 180,000



(W2) Sales receipts June July Aug Sept Oct Nov Dec Sales revenue 120,000 120,000 132,000 144,000 156,000 168,000 180,000Cash sales (25%) 30,000 30,000 33,000 36,000 39,000 42,000 45,000Credit sales (75%) 90,000 90,000 99,000 108,000 117,000 126,000 135,000

(W3) Material purchases June July Aug Sept Oct Nov Dec Production (units) 10,000 10,200 11,200 12,200 13,200 14,200 15,000Materials for production

(kg) 20,000 20,400 22,400 24,400 26,400 28,400 30,000

£ £ £ £ £ £ £ Materials for production 48,000 48,960 53,760 58,560 63,360 68,160 72,000 Half delivered in month 24,000 24,480 26,880 29,280 31,680 34,080 Closing stock delivered 24,480 26,880 29,280 31,680 34,080 36,000 ––––– ––––– ––––– ––––– ––––– ––––– Total purchases in month 48,480 51,360 56,160 60,960 65,760 70,080 ––––– ––––– ––––– ––––– ––––– ––––– Payable in July Aug Sept Oct Nov Dec

(W4) Payments for labour

Calculation of labour cost: production units × £1·80 per unit

(W5) Payments for direct expenses

Calculation of direct expenses: production units × £1·20 per unit

(W6) Payments for fixed overheads

Calculation of cash fixed overheads: £34,000 – £12,000 = £22,000 per month

Depreciation is excluded as a non-cash item.

(b) A periodic budget is one that is drawn up for a full budget period, such as one year. A new budget will not be introduced until the start of the next budget period, although the existing budget may be revised if circumstances deviate markedly from those assumed during the budget preparation period.

A continuous or rolling budget is one that is revised at regular intervals by adding a new budget period to the full budget as each budget period expires. A budget for one year, for example, could have a new quarter added to it as each quarter expires. In this way, the budget will continue to look one year forward. Cash budgets are often prepared on a continuous basis.

The advantages of periodic budgeting are that it involves less time, money and effort than continuous budgeting. For example, frequent revisions of standards could be avoided and the budget-setting process would require managerial attention only on an annual basis.

A major advantage of continuous budgeting is that the budget remains both relevant and up to date. As it takes account of significant changes in economic activity and other key elements of the organisation’s environment, it will be a realistic budget and hence is likely to be more motivating to responsible staff. Another major advantage is that there will always be a budget available that shows the expected financial performance for several future budget periods.

It has been suggested that if a periodic budget is updated whenever significant change is expected, a continuous budget would not be necessary. Continuous budgeting could be used where regular change is expected, or where forward planning and control are essential, such as in a cash budget.



(c) Budget bias (budgetary slack) occurs when managers aim to give themselves easier budget targets by understating budgeted sales revenue or overstating budgeted costs.

Cost control using budgets is achieved by comparing actual costs for a budget period with budgeted or planned costs. Significant differences between planned and actual costs can then be investigated and corrective action taken where appropriate.

Budget bias will lead to more favourable results when actual and budgeted costs are compared. Corrective action may not be taken in cases where costs could have been reduced and in consequence inefficiency will be perpetuated and overall profitability reduced.

Managers may incur unnecessary expenditure in order to protect existing budget bias with the aim of making their jobs easier in future periods, since if the bias were detected and removed, future budget targets would be more difficult to achieve. Unnecessary costs will reduce the effectiveness of cost control in supporting the achievement of financial objectives such as value for money or profitability.

Where budget bias exists, managers will be less motivated to look for ways of reducing costs and inefficiency in those parts of the organisation for which they bear responsibility. The organisation’s costs will consequently be higher than necessary for the level of performance being budgeted for.



ACCOUNTING SYSTEMS

(a) The role of a management accountant is to provide information which can be used to assist and guide management in the pursuit and achievement of organisational objectives. The management information provided is read, interpreted and responded to by people within the organisation, and their responses will determine the quality of the decisions made and the extent to which corporate objectives are achieved. Management accountants should be aware of this relationship and endeavour to ensure that the information that they supply is used in a way that benefits their organisation. The design and operation of a management accounting system should anticipate the behavioural consequences that are likely to arise as a result of its activities. A management accountant who fails to consider these repercussions or denies responsibility for them is likely to operate a dysfunctional system. This is most likely to manifest itself in a failure to secure goal congruence between the interested parties. The management accounting system will need to consider the particular culture of the organisation, adjust to whether it has a hierarchical or democratic structure, its attitude towards employee empowerment and the extent of delegated team decision making.

(b) Performance monitoring:

There is a general acceptance of the idea that an organisation that monitors performance and rewards individuals for ‘good performance’ is more likely to encourage behaviour that is consistent with the objectives of the organisation. This involves the organisation ‘transmitting signals’ to its people as to what it deems desirable activities and outcomes in the workplace. This approach has resulted in such terms and activities as, performance monitoring, performance related pay, payment by results, bonus systems – the reward for the achievement of desired outcomes could be money, promotion, job security, preferred work activities, alternative work environments. Unfortunately this is a very complex task and problems are likely to arise in a number of areas:

• It is very difficult in many work environments to measure individual performance – and if you resort to team performance, it is difficult to gauge the contribution from individual members.

• It is difficult to ensure that individual targets are not inconsistent with other individuals or corporate objectives.

• Current measured performance may discourage consideration of longer term issues that may have adverse repercussions.

• Can a performance monitoring system comprehensively measure the key variables e.g. 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 the planning 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 undesirable consequences may be avoided by consulting with all interested parties, setting challenging but achievable targets, considering other people’s perception of the targets and anticipating their likely responses. On the other hand, if budget holders are given complete autonomy or are permitted to have a significant influence on budgetary targets, they may be tempted to build in ‘slack’ to give themselves an easy life which is not in the interests of their organisation.

Having implemented the planning stage, we need to turn our attention towards control. Behavioural problems can arise from:

• A failure to distinguish between controllable and non-controllable factors for each particular budget holder – people will feel aggrieved for being accountable for what they do not control.

• A failure to account for the changing circumstances that have arisen since the budget was determined – may require budget adjustments and/or a flexible budget approach.

• Failure to reward favourable variances – budget under spending that automatically results in cuts in future budget provision merely encourages spending of the entire budget, not something that should be encouraged.

• Budget constrained approach – a requirement to conform to budget may stifle attempts at improvement.



• Insufficient participation in budgetary control and poor communication of the reasons for change decisions may alienate staff.

Transfer Pricing

Transfer pricing is primarily concerned with ensuring that semi-autonomous business units behave in a way that contributes towards the achievement of corporate and not merely divisional objectives. An effective transfer pricing system encourages divisional managers with autonomous decision making authority to automatically pursue the interest of the corporation whilst endeavouring to maximise the performance of their own business unit. Their decisions are made with self (divisional) interest as the driving factor, but coincidentally benefit the entire company. Effective transfer pricing systems consciously endeavour to harness selfish divisional behaviour to induce decisions that foster goal congruence. Problems can arise when inappropriate prices are set that result in ‘wrong signals’ being sent and non-optimal decisions being made:

• Too high a price may result in unused capacity, lost contribution, reduced incentive to find external markets and unnecessary 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.



BUDGETARY PLANNING

(a) 16 units Average skilled hours per unit (see below) 491.52 Average unskilled hours per unit (see below) 1180.98

Average cost per unit (16 units) Skilled hours 491.52 x £20 9,830.40 Unskilled hours 1,181.98 x £15 17,714.70 Materials 20,000.00 Overheads 16,725.00 ____________

Average cost 64,270.10 Mark-up 16,067.53 ____________

Selling price 80,337.63 ____________

Tutorial note: use the note in the question re doubling output reducing cumulative average hours per unit to arrive at the averages as shown in the table below.

Units Cumulative average unit time (skilled)

Cumulative average unit time (unskilled)

1 1,200 x 0.8 1,800 x 0.9 2 960 1,620 4 768 1,458 8 614.4 1,312.2 16 491.52 1,180.98

(b) 2 units 4 units

Average skilled hours per unit 960 768 Average unskilled hours per unit 1620 1458

Average cost per unit (16 units) Skilled hours 19,200.00 15,360.00 Unskilled hours 24,300.00 21,870.00 Materials 20,000.00 20,000.00 Overheads 25,800.00 22,260.00 ______________ ______________ Average cost 89,300.00 79,490.00

Total cost 178,600.00 317,960.00

Cost 3rd & 4th unit 139,360.00 Sales revenue 3rd & 4th unit 160,675.25 ______________ Profit 3rd & 4th unit 21,315.25 ______________

(c) The logic behind the learning curve model is that labour efficiency increases with the level of output and that this increase is amenable to a simple form of mathematical modelling. The model used assumes that the increase in efficiency follows a curvilinear pattern with the increase in efficiency tending to become less pronounced as progressively higher levels of output are considered.



The model can be used in all areas of budgeting, business planning, standard costing and business decision making. The limitations of the model fall under two headings. Firstly, it only applies where labour skill is a critical element in the production process and output is relatively low. Secondly, like all models, the learning curve is a simple representation of a complex reality.



STANDARD COSTING AND VARIANCES

Q LTD

(a) (i) Budget overhead cost = £150,000 − £6,000 = £144,000

Budget cost/unit = 120% (6 hrs × £5) = £36

Budgeted units = 36£

000,144£ = 4,000

(ii) Material price variance = £8,000 (F) Price variance/litre = £0.05 (F)

Quantity purchased = 05.0£

000,8£ = 160,000 litres

(iii) Usage variance = £6,000 (A) Standard price = £2.50/litre

Excess usage = 50.2£

000,6£ = 2,400 litres

(iv) Actual wage cost = £121,500 Total wage variance = £900 (A) _______ Standard cost = £120,600

Standard cost/unit = 6 hours @ £5 = £30

Actual output = 30£

600,120£ = 4,020 units

(v) Labour efficiency variance = £3,600 (F) Standard rate/hour = £5

Saving in hours = 5£600,3£

= (720) hours

Standard hours = 6 hours × 4,020 units = 24,120 Actual hours 23,400 (vi) Wages cost = £121,500

Actual rate/hr = 400,23500,121£

= £5.19

(b) Physical and technical measures are those taken and used as the basis of variance analysis prior to their valuation by applying standard prices. Examples include numbers of hours, units of production, quantities of materials.

These measures avoid the use of financial jargon and money values which are often alien to lower levels of management. As a result managers are able to identify with the differences reported and be able to apply their knowledge to eliminating such differences in future.

The valuation of such physical differences may be unreliable because of the use of standard prices. These are estimates which may be shown to be invalid due to inflation and other effects. Physical measures do not suffer from this valuation effect.



Employees are more conscious of physical measures – they use kilograms of material and expend hours of labour. How those amounts are valued is, to some extent, irrelevant. Employees will be trained not to use excess physical quantities and will be expected to reach a certain proficiency in their use of time and machinery and it is those measures and targets that they are likely to concentrate on.



HAIRDRESSING

Key answer tips In part (a) in order to be able to reconcile them you need to first determine what the budgeted and actual profit figures are. Now move onto the variance analysis, treating clients like product units and commissions like variable labour costs. Using a marginal costing approach, as required, results in sales mix and quantity variances being valued at standard contribution (revenue - commission) and there being no fixed overhead volume variance. In part (b) you’ve computed the numbers in (a) - now use them to tell a story. State what the figures are showing (not ‘adverse cost variance’ but ‘costs higher than expected’), then try to suggest a cause. Since the examiner specifically asked for the mix variance, it is important that you comment on it here. Look for links between variances wherever possible. In part (c) some of the comments that may be made relate to all variances, not just sales - inappropriateness of standards, outdated standards etc. But you must quickly focus on the sales aspects, and the relevance of the mix/quantity analysis for possibly unrelated products is an important point to raise. As usual, try to gear your answer to the particular business concerned whenever possible.

(a) Budget Contribution per

sale Total budgeted

contribution £ £ 4,000 sales to Men (7.5 – 3.0) = 4.5 18,000 1,000 sales to Women (18.0 – 10.0) = 8.0 8,000 ________

5,000 total sales 26,000 ________

Budgeted average contribution per sale = £26,000/5,000 = £5.20.

Budgeted profit = £26,000 – fixed costs £20,000 = £6,000. Actual Contribution per

sale Total budgeted

contribution £ £ 2,000 sales to Men (8.0 – 3.5) = 4.5 9,000 2,000 sales to Women (20.0 – 11.0) = 9.0 18,000 ________

4,000 total sales 27,000 ________

Actual profit = £27,000 – fixed costs £24,000 = £3,000.

Profit variance = Budgeted profit – Actual profit = £6,000 – £3,000 = £3,000 (A).

Sales mix variance Actual

sales mix

Total sales in standard mix

Mix var. Stand.cont’n

Mix var.

Units Units Units £ £ Men 2,000 (80%) 3,200 1,200 A 4.50 5,400 A Women 2,000 (20%) 800 1,200 F 8.00 9,600 F _______ _______ _______ 4,000 4,000 4,200 F _______ _______ _______



Sales quantity variance UnitsBudgeted total sales units (4,000 + 1,000) 5,000Actual total sales units (2,000 + 2,000) 4,000 _______

Quantity variance 1,000 AStandard average contribution per unit £5.20Quantity variance in £ £5,200 A

Reconciliation statement £ £ Budgeted profit 6,000 Price variances: Male 2,000 × (8.0 – 7.5) 1,000 F Female 2,000 × (20.0 – 18.0) 4,000 F Mixture variance (see workings) 4,200 F Quantity variance (see workings) 5,200 A Fixed overhead expenditure variance: (20,000 – 24,000)

4,000 A

Labour rate variance: Male 2,000 × (3.0 – 3.5) 1,000 A Female 2,000 × (10.0 – 11.0) 2,000 A _______ Total variances 3,000 A _______ Actual profit 3,000 _______

(b) Memorandum

To: Manager

Date xx/xx/xx

The overall result is below the budget expectations, the variance analysis will help to explore the reasons for this. It appears that it has been possible to put prices up beyond the level that was envisaged, or clients have been requiring different treatments which has lifted the overall price. This applies to both male and female clients, as the price variances are both favourable.

The level of business was significantly less than planned. Only 80% of the planned number of clients were attracted to the business, 4,000 compared with the budget of 5,000. However, there was a significantly favourable move concerning the mix of clients. Far more female clients attended and they provide a higher level of contribution than male clients, resulting in a favourable mix variance. In overall terms the effect of the sales side on the profitability of the business was favourable compared to the original budget.

The adverse profit implications came from higher than planned commission rates paid to staff. Perhaps this was likely given the higher than average selling prices achieved. The other negative impact reported was the variance on fixed overhead expenditure and further detail is required here before any corrective action can be anticipated. It may be difficult to change fixed overheads and, depending on further analysis, it may be necessary to amend the budget figure.

(c) When interpreting the disaggregation of the profit variance with particular reference to sales variances, various limitations can be suggested. In the particular business environment envisaged, it may be difficult to set ‘standard’ selling prices, so any variances need to be interpreted with care. It may not be possible, for example, to apply the same rigour as in manufacturing situations, however these approximate targets may prove useful.



It should be noted that the actual sales performance is being compared to a budget which may have been set some time ago. In this regard, the extent to which it may have become out of date must be considered. A more recently revised forecast could be used as an alternative.

The splitting of price and volume implications in these variances, whilst common in both theory and practice, needs care in interpretation. There is little doubt that in many market situations, sales prices and quantities are interrelated, and they cannot be looked at without also considering the other. In the example in part (a), it might be possible to suggest that the situation with regard to male customers represents a move along the demand curve, and actual demand was less than the budget because a higher price was charged.

Finally, the attempt to report mix and quantity variances might be questionable. A mix variance implies some ability for the business to control the mix of sales to men and women. To provide management with a mix variance where no such control exists would be misleading.



FOOD MANUFACTURER

Key answer tips You are given an original budget, followed by some post-budget planning changes, and then actual figures. This should lead you into thinking along the lines of planning and operational variances. However, four things point towards these being required as part of the discussion in (c) rather than as an explicit part of the variance analysis in (b): – the question states that the original budget is to be used as a reference point – there is no detail about the changes to the methods of working – there is no mention of planning and operational variances in requirement (b) – the budget prepared in (a) is based upon the original figures. So parts (a) and (b) are standard budget/variance analysis computations. Whilst the examiner has incorporated some of his workings in the discussion in (c), you are best advised to set these out clearly following your answer to (b). It is in part (c) that you should make use of the information regarding post-budget planning changes. Start with an overall summary of the picture painted by the analysis in (b), then look at individual variances, tying them in to the changes where possible. You must also address the specific areas required by the question, interrelationships and overheads.

(a) Actual sales were £1,080,000, but the sale price was (× 4.50/5.00) of the budgeted price. The actual sales at the budgeted price were therefore £1,080,000 × (5.00/4.50) = £1,200,000. Flexed budget Actual VarianceUnits 240,000 240,000 £000 £000 £000 £000 £000 Sales 1,200 1,080 120 AIngredients (40%) 480 520 40 ALabour and energy (10%) 120 110 10 F _____ _____ 600 630 _____ _____ Contribution 600 450 Fixed overheads 300 340 40 A _____ _____ Profit 300 110 190 A _____ _____

Note: The answer only specifically required the flexible budget (flexed budget).

(b) Workings Budgeted ingredients cost £400,000 Price per kg £0.40 Budgeted kg (400,000/0.40) 1,000,000 Kg of ingredients in each pack 5 Budgeted number of packs (1,000,000/5) 200,000 Actual sales by volume Sales = £1,080,000a £4.50/pack

= 240,000 packs



Actual ingredients used: £520,000/£0.375 per kg = 1,386,667 kg. kg 240,000 packs should use (× 5) 1,200,000 but did use 1,386,667 ____________

Usage variance 186,667 kg (A) ____________

Standard price per kg £0.40 Usage variance in £ £74,667 (A) ____________

£ 1,386,667 kg should cost (× £0.40) 554,667 but did cost 520,000 __________ Ingredient price variance 34,667 F __________

An overall reconciliation of profit is as follows: £000 £000 Budget profit 200.0 Sales volume contribution variance 100.0 F _______ Budget profit for actual sales 300.0 Sales price variance 120.0 A Ingredient usage variance 74.7 A Ingredient price variance 34.7 F Labour and energy variance 10.0 F Overhead expenditure variance 40.0 A _______ 190.0 A _______ Actual profit 110.0 _______

(c) Commentary

The budgeted sales volume was 200,000 packs, whereas 240,000 packs were actually sold, a volume increase of 20%. The material, labour and energy costs are dealt with as totally variable costs. This results in the contribution margin (using the original budget) being £2.50 per pack (£1,000,000 – £400,000 – £100,000)/200,000. It can be seen that the increased volume earned £100,000 extra standard contribution (40,000 × £2.50) compared to the original budget. The price reduction of 50p per pack, however, resulted in lower sales revenue – and lower profits by £120,000. It would be useful to examine the sales price and volume variances together because of the interrelationship between them. The price reduction will have had an impact on the volume sold and this, which was probably anticipated, should be noted by the management. This marketing tactic of trading off price and volume (moving along the demand curve) does not appear to have been entirely successful, but we have no information about the experiences of other manufacturers of similar products. There could have been an unexpected downturn of the whole market. For example, the position could have been worse if the company had not decided to reduce the price. To investigate further they should, perhaps, look outside the organisation for more market intelligence.



The actual total cost of material exceeded that which was planned by £40,000. It is possible to analyse this difference further from the information supplied. The price reduction obtained was worth £34,667, a favourable variance. A substantial adverse usage variance of £74,667 occurred. The purchasing department would appear to have succeeded in making purchases of ingredients at favourable prices. If, however, after further investigation the ingredient usage variance is found to be due to waste caused by poorer quality purchases, this has been a false economy. This is a further example of possible interrelationships among variances and should be noted to inform future decisions on ingredient sourcing. It is not appropriate from current information to jump to conclusions about poor quality ingredients; theft or an error in the figures collected could be the cause. If, however, the ingredients are of a poorer quality then there may also be long-term repercussions in subsequent sales of these or other products, another example of interrelationships between the variances which should be borne in mind.

The labour and energy costs show a small favourable variance so the changed method of working has made a difference, providing these are completely variable costs. The actual costs incurred were more than the original budget, but less than the budget when it is flexed for the increased volume. From the information given, it is not possible to isolate labour and energy variances separately. Nor is it possible to identify rate and efficiency variances for these variable costs.

The actual fixed overheads were greater than the budget by £40,000. The detailed expenses should be consulted to identify any reasons for cost differences, to judge whether the costs are controllable and what action is needed, or whether the budget should be revised. Reduction of fixed overheads in the short-term may be particularly problematic. Scope to ‘manage’ the fixed costs (see expenditure variance) may occur when there is some potential to renegotiate prices or use resources more efficiently, perhaps resulting in some resources being disposed of (including staffing economies). However, some of the fixed costs may be uncontrollable in the short-term, for example, the rates applied to premises cannot change unless some premises are vacated. Such changes cannot be made immediately, and there may therefore be a lag in any economies in this area. The company is attempting to increase market share through increased sales, and although this should result in a greater total contribution to overall costs, this in itself does not reduce costs.



MERMUS PLC

(a) The flexed budget will be based on the actual activity level of 90,000 units. £ £ Sales: £950,000 × 90/95 = 900,000 Cost of sales Raw materials: 133,000 × 90/95 = 126,000 Direct labour: 152,000 × 90/95 = 144,000 Variable production overheads: 100,700 × 90/95 95,400 Fixed production overheads 125,400 __________ 490,800 __________ 409,200 __________

(b) Raw materials cost total variance = 126,000 – 130,500 = £4,500 (Adverse)

Direct labour cost total variance = 144,000 – 153,000 = £9,000 (Adverse)

Fixed overhead absorption rate = 125,400/28,500 = £4.40 per machine hour

Standard machine hours for actual production = 28,500 × 90/95 = 27,000 hrs

Standard fixed overhead (actual production) = 27,000 × 4.4 = £118,800

Fixed overhead absorbed on actual hours = 27,200 × 4.4 = £119,680

Fixed overhead efficiency variance = 118,800 – 119,680 = 880 (Adverse)

Fixed overhead absorbed on actual hours = 27,200 × 4.4 = £119,680

Fixed overhead absorbed on budgeted hours = 28,500 × 4.4 = £125,400

Fixed overhead capacity variance = 119,680 – 125,400 = £5,720 (Adverse)

Budgeted overhead expenditure = £125,400

Actual overhead expenditure = £115,300

Fixed overhead expenditure variance = 125,400 – 115,300 = £10,100 (Favourable)

(c) Raw materials cost variance

The budgeted raw material cost for production of 95,000 units was £1.40 per unit (133,000/95,000) but the actual raw material cost for production of 90,000 units was £1.45 per unit (130,500/90,000). The raw material cost per unit may have increased either because more raw material per unit was used than budgeted, or because the price per unit of raw material was higher than budgeted. Calculation of the raw material price and usage sub-variances would indicate where further explanation should be sought.

Fixed overhead efficiency variance

The fixed overhead efficiency variance measures the extent to which more or less standard hours were used for the actual production than budgeted. In this case, a total of 27,200 machine hours were actually used, when only 27,000 standard machine hours should have been used. The difference may be due to poorer production planning than expected or to machine breakdowns.



Fixed overhead expenditure variance

The fixed overhead expenditure variance measures the extent to which budgeted fixed overhead differs from actual fixed overhead. Here, actual fixed overhead is £10,100 less than budgeted. This could be due to an error in forecasting fixed production overheads such as rent and power costs, or to a decrease in fixed production overheads, such as changing to a cheaper cleaning contractor.

(d) Key purposes of a budgeting system that could be discussed include planning, co-ordination, communication, control, motivation and performance evaluation. Students were required only to discuss three key purposes.

Planning

One of the key purposes of a budgeting system is to require planning to occur. Strategic planning covers several years but a budget represents a financial plan covering a shorter period, i.e. a budget is an operational plan. Planning helps an organisation to anticipate key changes in the business environment that could potentially impact on business activities and to prepare appropriate responses. Planning also ensures that the budgeted activities of the organisation will support the achievement of the organisation’s objectives.

Co-ordination

Many organisations undertake a number of activities which need to be co-ordinated if the organisation is to meet its objectives. The budgeting system facilitates this co-ordination since organisational activities and the links between them are thoroughly investigated during budget preparation, and the overall coherence between the budgeted activities is reviewed before the master budget is agreed by senior managers. Without the framework of the budgeting system, individual managers may be tempted to make decisions that are not optimal in terms of achieving organisational objectives.

Communication

The budgeting system facilitates communication within the organisation both vertically (for example between senior and junior managers) and horizontally (for example between different organisational functions). Vertical communication enables senior managers to ensure that organisational objectives are understood by employees at all levels. Communication also occurs at all stages of the budgetary control process, for example during budget preparation and during investigation of end-of-period variances.

Control

One of the most important purposes of a budgeting system is to facilitate cost control through the comparison of budgeted costs and actual costs. Variances between budgeted and actual costs can be investigated in order to determine the reason why actual performance has differed from what was planned. Corrective action can be introduced if necessary in order to ensure that organisational objectives are achieved. A budgeting system also facilitates management by exception, whereby only significant differences between planned and actual activity are investigated.

Motivation

The budgeting system can influence the behaviour of managers and employees, and may motivate them to improve their performance if the target represented by the budget is set at an appropriate level. An inappropriate target has the potential to be demotivating, however, and a key factor here is the degree of participation in the budget-setting process. It has been shown that an appropriate degree of participation can have a positive motivational effect.



Performance evaluation

Managerial performance is often evaluated by the extent to which budgetary targets for which individual managers are responsible have been achieved. Managerial rewards such as bonuses or performance-related pay can also be linked to achievement of budgetary targets. Managers can also use the budget to evaluate their own performance and clarify how close they are to meeting agreed performance targets.



ASH PLC

Key answer tips

For part (a) the question gives no indication whether materials M3 and M7 are substitutes, so it is unclear whether separate usage or mix and yield variances should be calculated. The key here is to state your assumption and keep going.

In part (b) after describing the control process (especially management by exception), try to comment on specific variances and likely action. You could have developed this aspect of your answer more:

e.g. material M3 – the adverse price variance should direct managers to investigate why prices are higher than expected. This could involve reviewing whether it is the result of market conditions (uncontrollable) or poor purchasing (controllable).

(a) Operating statement for Product RS8 for the last month

$ Budgeted gross profit (W1) 18,339.3 Sales volume profit variance (W2) 258.3 ________ (A)

Actual sales at standard profit 18,081.0 Sales price variance (W3) 1,050.0 ________ (A)

Actual sales less standard cost 17,031.0

Cost variances $ $ Favourable Adverse Direct material M3 Price variance (W4) 52.5 Usage variance (W5) 325.5 Direct material M7 Price variance (W6) 220.5 Usage variance (W7) 73.5 Direct labour Rate variance (W8) 105.0 Efficiency variance (W9) 252.0 Variable production overhead Expenditure variance (W10) 157.5 Efficiency variance (W11) 73.5 Fixed production overhead Expenditure variance (W12) 252.0 Volume variance (W13) _____ 63.0 ______

430.5 _____ 1,144.5 ______ 714.0 _______ (A)

Actual gross profit (W14) 16,317.0 _______



Workings Number of units of RS8 budgeted to be produced in period = 497 × 60/14 = 2,130 units Calculation of standard profit per unit: $ Direct material M3 = 0.6 × 1.55 = 0.93 Direct material M7 = 0.68 × 1.75 = 1.19 Direct labour = 7.20 × 14/60 = 1.68 Variable production overhead = 2.10 × 14/60 = 0.49 Fixed production overhead = 9.00 × 14/60 = 2.10 _____ Total cost 6.39 Selling price 15.00 _____ Standard gross profit per unit 8.61 _____

(W1) Budgeted gross profit = 2,130 × 8.61 = $18,339.3

(W2) Sales volume profit variance = (2,130 – 2,100) × 8.61 = $258.3 (A)

(W3) Sales price variance = (15.0 – 14.5) × 2,100 = $1,050.0 (A)

(W4) Material M3 price variance = (1.55 × 1,050) – 1,680 = $52.5 (A)

(W5) Material M3 usage variance = ((2,100 × 0.6) – 1,050) × 1.55 = $325.5 (F)

(W6) Material M7 price variance = (1.75 × 1,470) – 2,793 = $220.5 (A)

(W7) Material M7 usage variance = ((2,100 × 0.68) – 1,470) × 1.75 = $73.5 (A)

Mix and yield variances may be offered instead of usage variances:

Actual quantity in actual proportions = (1,050 × 1.55) + (1,470 × 1.75) = $4,200.00

Actual quantity in standard mix = (1,181.25 × 1.55) + (1,338.75 × 1.75) = $4,173.75

Standard mix for actual yield = (1,260 × 1.55) + (1,428 × 1.75) = $4,452

Direct material mix variance = $4,173.75 – 4,200 = $26.25 (A)

Direct material yield variance = 4,452 – 4,173.75 = $278.25 (F)

The sum of the mix and yield variances is the same as the sum of the usage variances:

(W8) Direct labour rate variance = (7.2 × 525) – 3,675 = $105.0 (F)

(W9) Direct labour efficiency variance = ((2,100 ×14/60) – 525) × 7.2 = $252.0 (A)

(W10) Variable overhead expenditure variance = (2.1 × 525) – 1,260 = $157.5 (A)

(W11) Variable overhead efficiency variance = ((2,100 × 14/60) – 525) × 2.1 =

$73.5 (A)

Budgeted fixed production overhead = 497 × 9 = $4,473 Fixed production overhead expenditure variance = 4,473 – 4,725 =

$252.0 (A)

Standard hours for actual production = 2,100 × 14/60 = 490 hours (W13) Fixed production overhead volume variance = (490 – 497) × 9 = $63.0 (A)



Fixed production overhead efficiency and capacity variances may be offered: Budgeted standard labour hours = 497 hours Actual labour hours = 525 hours Standard labour hours for Actual production = 2,100 × 14/60 = 490 hours Fixed production overhead efficiency variance = (490 – 525) × 9 = $315 (A) Fixed production overhead capacity variance = (497 – 525) × 9 = $252 (F) The efficiency and capacity variances sum to the fixed production overhead volume variance. (W14) Actual gross profit calculation $ Direct material M3 1,680 Direct material M7 2,793 Direct labour 3,675 Variable production overhead 1,260 Fixed production overhead 4,725 ______ 14,133 Sales revenue = 2,100 × 14.50 = 30,450 ______ 16,317 ______

(b) Controlling variable costs The first step in the process of controlling costs is to measure actual costs. The second step is to calculate variances that show the difference between actual costs and budgeted or standard costs. These variances then need to be reported to those managers who have responsibility for them. These managers can then decide whether action needs to be taken to bring actual costs back into line with budgeted or standard costs. The operating statement therefore has a role to play in reporting information to management in a way that assists in the decision-making process. The operating statement quantifies the effect of the volume difference between budgeted and actual sales so that the actual cost of the actual output can be compared with the standard (or budgeted) cost of the actual output. The statement clearly differentiates between adverse and favourable variances so that managers can identify areas where there is a significant difference between actual results and planned performance. This supports management by exception, since managers can focus their efforts on these significant areas in order to obtain the most impact in terms of getting actual operations back in line with planned activity. In control terms, variable costs can be affected in the short term and so an operating statement for the last month showing variable cost variances will highlight those areas where management action may be effective. In the short term, for example, managers may be able to improve labour efficiency through training, or through reducing or eliminating staff actions which do not assist the production process. In this way the adverse direct labour efficiency variance of $252, which is 7.3% of the standard direct labour cost of the actual output, could be reduced. Controlling fixed production overhead costs In the short term, it is unlikely that fixed production overhead costs can be controlled. An operating statement from last month showing fixed production overhead variances may not therefore assist in controlling fixed costs. Managers will not be able to take any action to correct the adverse fixed production overhead expenditure variance, for example, which may in fact simply show the need for improvement in the area of budget planning. Investigation of the component parts of fixed production overhead will show, however, whether any of these are controllable. In general, this is not the case. Absorption costing gives rise to a fixed production overhead volume variance, which shows the effect of actual production being different from planned production. Since



fixed production overheads are a sunk cost, the volume variance shows little more than that the standard hours for actual production were different from budgeted standard hours. Similarly, the fixed production overhead efficiency variance offers little more in information terms than the direct labour efficiency variance. While fixed production overhead variances assist in reconciling budgeted profit with actual profit, therefore, their reporting in an operating statement is unlikely to assist in controlling fixed costs.



LINSIL

Key answer tips

It is easy to get confused by part (a) of this question. Planning variances should compare the original standard cost (the ‘ex ante’ standard) with the revised standard cost (the ‘ex post’ standard). Operational variances should compare actual costs with the revised standard cost. The key is to recognise that both the original and revised cost budgets need to be flexed to actual output levels.

If you can work out the solution to part (a), the rest of the question is more straightforward. Part (b) asks for traditional variance calculations, part (c) asks about the reasons for separating planning and operational variances, and part (d) asks about the factors to consider in deciding whether or not to investigate a variance – all basic study text topics.

Planning and operating variances

Revised standard costs

After 3% price increase: direct material price 2.30 × 1.03 = $2.369/kg After savings of 5%: direct material usage 3.00 × 0.95 = 2.85 kg/unit Adding 4% wage increase: direct labour rate 12.00 × 1.04 = $12.48/hour Adding back 10% decrease: direct labour hours 1.25/0.90 = 1.3889 hrs/unit

Basic approach

Actual costs } Operating variances Flexed revised budget } Planning variances Flexed original budget Both the original and revised budgets are flexed to be based on actual output of 122,000 units.

Materials

Operating variances AQ × AP = 122,000×2.80×2.46 = 840,336 31,086 (A) Materials price AQ × RSP = 122,000×2.80×2.369 = 809,250 14,451 (F) Materials usage RSQ × RSP = 122,000×2.85×2.369 = 823,701

Planning variances RSQ × RSP = 122,000×2.85×2.369 = 823,701 23,991 (A) Materials price RSQ × OSP = 122,000×2.85×2.30 = 799,710 42,090 (F) Materials usage OSQ × OSP = 122,000×3×2.30 = 841,800



PERFORMANCE MEASUREMENT

CARR LTD

(a) Forecasting difficulties (only five required).

(i) It can be difficult to establish the relationships which exist between the activities of a business and the level of its costs, this is especially true of complex international organisation structures.

(ii) Government legislation may impose changes to the operations of the business and thereby alter the cost structures and sales volumes.

(iii) Changes in international legislation as a result of the EU may alter the marketability of the organisation’s products and require a reorganisation of product ranges and cost structures.

(iv) There is a trend towards shorter product life cycles because of the increasing competitiveness of the market place. However, development cycles are increasing because of the complexity of the products, this leads to difficulties in planning the launch of new products.

(v) Legislation is causing the majority of costs to become fixed with the consequent raising of the volume of sales needed to breakeven. This makes planning for new products more risky than before and reduces the incentive to make new products.

(vi) Economic up-turns/down-turns, including interest rate movements can be difficult to predict.

(vii) Exchange rate movements can be difficult to predict.

(viii) International (global) competition is becoming more common and it is more difficult to predict competitor action and technical innovation.

(b) (i) The report does not make any allowance for changes in the level of costs as a result of producing more units than budgeted. It would be reasonable to assume that at least some of the costs are variable and these should be adjusted so that a meaningful comparison can be made with the adjusted cost target which is usually referred to as a flexible budget. For example, consumable stores costs are likely to be proportional to output. Actual output is 10% higher than budgeted and this would imply that consumable stores costs should therefore be 1,500 x 1.1 = 1,650. This implies a favourable effect as the actual costs were only 1,600. This is a very different conclusion to that suggested by the office manager using figures that were not flexed.

In addition there does not appear to be any consideration of whether the costs are controllable by the recipient of the report, the controllable variances should be highlighted and emphasis should be placed on these so that management action can be taken as appropriate. For example, insurance is probably centrally arranged and not within the control of the supervisor of the department.

Also the report only shows one period. Whilst it is common to show the results of each period separately it is to be expected that fluctuations will occur from one period to the next, these fluctuations will be smoothed out over time and for this reason the results for the year to date should also be reported with percentages being used to show the trend of the variance. This trend is the most significant aspect of variance reporting.



(ii) The system should be modified to take account of the behavioural nature of the costs and both the original and flexed budget should be shown on the report together with the actual costs. The report should also show the year to date values using the same format together with trend percentages for the variances. Finally either only the controllable variances should be shown, or if all variances are to be shown, then those which are controllable should be emphasised.



SPRING PLC

(a) Activity-based costing is based on the insight that activities create costs, while products consume activities. It is claimed that activity-based costing attaches overheads to product cost in a more meaningful way than traditional absorption costing.

A key feature of activity-based costing is that overhead costs are collected in cost pools, which correspond to a particular activity or group of activities that generate costs. A classic example of a cost pool is set-up costs for a production line. The cost of each set-up is included in the cost pool reflecting the recognition that it is set-ups that incur costs, rather than the volume of production on the production line. Set-up costs are an example of an indirect cost, and both traditional absorption costing and activity-based costing are concerned with the allocation of indirect costs onto product cost. Traditional absorption costing assigns indirect costs or overheads to production departments and service departments and then reallocates service department overheads to production centres. Activity-based costing is likely to use, or has the potential to use, considerably more cost pools than traditional absorption costing uses production centres. In activity-based costing, the link between cost pools and product cost is called a cost driver. A cost driver represents the extent to which a particular activity has been used by a particular product in its production. Continuing our example, an appropriate cost driver would be number of set-ups. A product which is produced in frequent short production runs would therefore incur a greater share of set-up costs than a product produced in a single production run. In traditional absorption costing, overheads are linked to product cost through overhead absorption rates such as cost per machine hour or cost per labour hour. Activity-based costing is likely to use considerably more cost drivers than traditional absorption costing uses overhead absorption rates.

The key steps in introducing an activity-based costing system are as follows:

1 Identify the main activities that generate costs through activity analysis.

2 Assign costs to cost pools.

3 Select appropriate cost drivers for assigning cost pool costs to products.

4 Calculate activity-based charge rates to assign the cost of activities to products.

The following benefits have been claimed for an activity-based costing:

1 Product costs are more accurate due to the more sophisticated analysis and assignment of overhead costs. Overhead costs are assigned on a cause-and-effect basis rather than on an ad hoc or subjective basis.

2 Cost behaviour is better understood due to the analysis of activities.

3 Cost control is facilitated through the identification and management of cost-generating activities. For example, in order to reduce set-up costs, production planning could be used to eliminate short production runs and hence reduce the number of set-ups.

4 Poor decisions due to inadequate cost information are less likely to occur.

As for disadvantages, identifying the main activities that generate costs in an organisation is expensive. Careful thought must also be given to the ability of existing management accounting information systems to provide the detailed activity and cost information required by an activity-based costing system: upgrading or replacement may be needed. A further expense is the cost of training staff to use the new costing system. Once introduced, an activity-based costing system can be significantly more expensive than a traditional absorption costing system. It is possible, therefore, that in



some organisations the cost of introducing and maintaining an activity-based costing system may exceed the benefits gained.

Activity-based costing may be most appropriate in an organisation where indirect costs are a significant proportion of total cost, or where a wide product range is maintained with a variety of different activity consumption patterns. Spring plc should consider the significance of indirect costs to its product costs and undertake a cost-benefit analysis before making a decision to implement an activity-based costing system. Spring plc should also consider that further developments can flow from the introduction of an activity-based costing system, for example in budgeting (activity-based budgeting) and management philosophy (activity-based management).

(b) Managerial performance and organisational performance are inextricably linked, since managers are the key decision makers in an organisation and their decisions therefore determine organisational performance.

Managerial and organisational performance needs to be measured as part of the control process within an organisation. The three elements of the control process are recording or measuring actual performance or output, comparing performance with planned performance or some benchmark, and taking action to correct or modify continuing performance in order to achieve planned performance. Managerial and organisational performance can be measured in a wide variety of ways, depending on which aspect of performance, financial or non-financial, is the object of interest.

A wide variety of financial (or money) performance measures can be used to assess managerial and organisational performance. Financial performance is of interest to internal and external stakeholders who are concerned to monitor the progress and risk of their investment, the security of their employment, and so on. Examples of financial performance measures include:

Profit

Profit before interest and tax or profit after tax are usually expected to increase on an annual basis and the financial media often refer to profit when discussing managerial and organisational performance. Managers are expected to deliver increasing profits and organisations are expected to produce profit increases equal to or greater than their competitors.

Earnings per share

Earnings per share is a profit measure of interest to shareholders and the financial market, since it represents the maximum dividend per share that a company could pay. Managerial rewards could be linked in part to meeting performance targets based on earnings per share.

Cash flow

Because profit may be affected by arbitrary adjustments linked to accounting policies and because profit does not measure directly the ability to generate returns for investors, many shareholders and providers of debt finance prefer to concentrate on changes in cash flow as a means of assessing managerial and organisational performance.

Costs

A focus on managerial and organisational performance in terms of cost control or cost reduction may be especially appropriate for organisations in the public sector. Here, profitability is an inappropriate performance measure and a key objective is value for money, in terms of the drive for economy, efficiency and effectiveness.



Share price

Since one of the ways in which shareholders receive a return from their investment in a company is through capital growth, they will be interested in assessing managerial and organisational performance in terms of share price growth. If managers invest in projects with a positive net present value then, theoretically, the share price should increase to reflect the rise in corporate net present value. Conversely, organisations in which managers are believed to be poor performers will experience a share price decrease.

Net present value of future cash flows

In theory, it is the net present value of future cash inflows which explain the share price, though share prices can be subject to influences which are nothing to do with performance of the business. If businesses are managed to maximise shareholder value, managers should be interested in maximising the present value of future cash flows.

Measuring financial performance alone is not sufficient, since financial performance results from a range of organisational activities which must also therefore be monitored. Non-financial performance measures may be quantitative or qualitative. An example of a quantitative performance measure is the number of complaints received from customers. An example of a qualitative performance measure is feedback from a sales representative to the effect that most customers are very happy with the after-sales service provided by the organisation.

An attempt is usually made to replace qualitative performance measures with a substitute measure that can be quantified. For example, the number of customer complaints can be used as a substitute measure of product quality or customer satisfaction. Similarly, the number of warranty claims can be used as a substitute measure of product reliability.

Modern organisations compete in terms of product quality, flexibility and reliability, customer satisfaction, and product dimensions such as after-sales care and customer loyalty. These features are captured by non-financial indicators such as number of customer complaints, number of warranty claims, and quality ratings (such as the star ratings of hotels or restaurants, or the position of an organisation in a league table).

A more balanced assessment of organisational and managerial performance will consider both financial and non-financial performance. For example, Kaplan and Norton’s Balanced Scorecard considers the customer perspective, the innovation perspective, the internal process perspective and the financial perspective, and requires the identification of quantitative and non-quantitative goals and performance measures.



DIVISIONS A AND B

(a) Division service Division A Division B £m £m £m Capital employed 40 25 14 _____ _____ _____

(i) Total cost on 50/50 basis: Profit (before service

charges) 10.0 8.0

Service division charge 3.5 3.5 ______ ______ Net profit 6.5 4.5 nil ______ ______ Return on capital employed 16.3% 18.0% nil (ii) Total cost on 50/50 basis

plus 30% profit:

Profit (before service charges)

10.00 8.00

Service division charge 4.55 4.55 ______ ______ Net profit 5.45 3.45 2.1 ______ ______ Return on capital employed 13.6% 13.8% 15.0% (iii) Total cost on ABC basis: Profit (before service

charges) 10.00 8.00

Service division charge 4.16 2.84 ______ ______ Net profit 5.84 5.16 nil ______ ______ Return on capital employed 14.6% 20.6% nil (iv) External supplier prices: Profit (before service

charges) 10.00 8.00

Service division charge 2.00 4.50 ______ ______ Net profit 8.00 3.50 –0.5 ______ ______ Return on capital employed 20.0% 14.0% –3.6% Workings:

(W1) Where the service division charges out total cost plus 30% profit mark-up we have: £m Total cost 7.0 Profit mark-up 2.1 _____

Charge out 9.1 _____

Hence charge to each division is £9.1/2 = £4.55.



(W2) Where activity based costs are used when charging out the service division costs we have: Service type Cost driver Service Division A

costs Division B

costs £m £m £m Sales Customers 1.8 1.20 0.60 Advertising Product types 2.4 0.96 1.44 Production Batches 0.8 0.40 0.40 Administration Employees 2.0 1.60 0.40 _____ _____ Total 4.16 2.84 _____ _____

(W3) Total external sales value of the service is £6.5m. Where this is used as the charge-out from the service division, it will report a net loss of £0.5m.

(b) The required return on capital employed for each division is 15%. Division A will achieve this return where a 50/50 cost basis or an external supplier price basis is used. It will not find the 50/50 cost plus profit mark-up or the ABC bases acceptable. Division B will achieve the required 15% return where the 50/50 cost basis or the ABC basis is used. It will not find the 50/50 cost plus profit mark-up or the external supplier price acceptable.

The service division will only find the 50/50 cost plus profit mark-up basis acceptable. This enables it to record a return of 15%. It will be unhappy with the cost based approaches which result in it reporting a nil return on capital employed. It is unlikely to find the external price basis acceptable since this results in it recording a negative return on capital employed of 3.6%

The organisation requires the charge basis to provide a stimulus for improvement in performance at each division.

Division A is likely to seek to reduce its requirement for the stationery and print service where an ABC cost basis is used for transfers. This will make this approach appealing to the organisation. Division B, however, records its highest return (20.6%) where the ABC approach is used and is unlikely to attempt to economise on its use of the service.

The external supplier price basis provides the organisation with an external benchmark. This shows that the service division must attempt to reduce its costs below the current £7m. It also suggests a problem with the structure of the service division in that its ABC costs to divisions A and B are radically different from the corresponding external quotes. We have:

Division A Division B £ £Internal (ABC) costs 4.16 2.84External price quotations 2.00 4.50 _____ _____

Net internal (cost)/benefit (2.16) 1.76 _____ _____

This may stimulate action to re-appraise the methods used by the service division.

The organisation is unlikely to find the 50/50 cost based methods acceptable. The arbitrary nature of the cost apportionment and of the mark-up to the service division will not provide any stimulus for change at each division.



NOT-FOR-PROFIT SECTOR

(a) Efficiency turns around making the maximum possible use of a given set of resources. That is, it involves a straight comparison of output and input.

Many UK local authorities in the 1970s were judged to be making an inefficient use of the resources available to them. They undertook most of their activities (e.g. council house maintenance, road repairs, maintenance of parks and gardens etc) using large numbers of direct council employees. It was often found that the use of obsolete equipment and inefficient working practices (strict job demarcation was widespread) resulted in the operation involving excessive costs.

Measures taken in the 1980s to improve efficiency in the public sector included the ‘introduction’ of obligatory competitive tendering whereby public works departments were forced to compete with outside contractors for the provision of services of all kinds. Experience over the last twenty years suggests that this process has considerably improved efficiency in local authorities. This means that the public obtain greater ‘value for money’.

Effectiveness relates to an organisation’s objectives. It does not matter how efficiently operations are carried out, if those operations are not contributing to the organisation’s objectives then they cannot be effective. This concept is a little more difficult to handle than efficiency. An NFP organisation will normally have a number of stated objectives. For example, a local authority may have ‘maintaining an acceptable quality of life for elderly residents’ as one of its objectives. It has several means by which it may achieve this objective, including:

• providing ‘meals on wheels’ (Social Services Department)

• providing a mobile library (Libraries Department)

• maintaining access to and facilities in local parks (Parks Department)

• providing police support to the elderly at home (Police Department)

• providing nursing homes (Housing Department).

All of these departmental activities contribute to achievement of the objective and the effectiveness of the organisation. The problem is to find the optimum combination of spending for each of the Departments.

Many elderly people continue to live in their own homes, but are just on the threshold of requiring accommodation in a nursing home. One may find that a small cut back in spending in one area (eg the withdrawal of a mobile library) may push a lot of elderly people over that threshold. There is then an enormous demand for extra spending by the Housing Department. Nursing home accommodation is an expensive last resort in caring for the elderly.

It works the other way. An occasional visit by a care worker or a police officer may enable many elderly people to stay in their own homes for much longer than would otherwise be the case. The key is to effectiveness is in finding an optimum pattern of spending to achieve a given objective.

Effectiveness is, by its very nature, rather more difficult to measure than efficiency. However it should be appreciated that performance in an NFP organisation is a function of both efficiency and effectiveness. Performance measurement has to take account of this.



(b) Performance measures are an essential element in the methodology of control. Such measures should focus on both inputs to and outputs from the process. In this way, one can obtain an impression of both efficiency and effectiveness.

If one is measuring the performance of a road maintenance operation then performance indicators might include the following:

• average hourly rate paid to labour force

• average price paid per kg of tarmacadam used

• average price paid to resurface 10m2 of road

• average annual operating cost per vehicle used

• average length of road closed for maintenance through year

• average number of unrepaired pot holes per km of road

• resident complaints per year/residents concerning road quality

• number of car crashes per year attributed to road surface faults

• average time taken to repair reported road surface fault

Using all of these measures provides a ‘broad based’ impression of performance which considers many aspects of the operation. For example, if cheap, poor-quality tarmacadam is used then this will impact favourably on one performance measure (price per kg) but adversely on others because repairs will be sub-standard. There are alternative possible approaches to road maintenance – eg a focus on repairing faults as they occur or a focus on preventative maintenance by resurfacing all roads on a ‘rolling programme’. A full range of performance measures will report on the relative effectiveness of these alternatives.

Performance measures are most meaningful when they allow comparison with some standard or benchmark. Performance measures for several different local authorities may be collected and published to allow ‘benchmarking’. A balanced scorecard approach involves appraising the objectives of an operation to determine what the most appropriate performance indicators are.

(c) Many problems have been experienced in the use of performance indicators in the public sector. These tend to fall under two headings.

The first heading is the difficulty of being sure that one is comparing like with like. For example, the performance of one road maintenance department may seem generally inferior to that of another. But the two operations may be subtly different. The roads of one authority may be more heavily used by HGVs than another. The residents in one authority area may be more eager to report faults and complain than in another. The driving and parking habits of residents in neighbouring local authorities may differ. All these things mean that a straight evaluation of performance through comparison of indicators (no matter how broad based) requires some care.

The second heading is the danger of adopting a range of performance indicators that is too narrow. The case most recently publicised is the use of ‘waiting list numbers’ as a means of measuring performance in the NHS. Reliance on this one measure tends to distort the pattern of healthcare provision. Hospital managers are induced to concentrate on patients with illnesses that are simple and easy to treat – at the expense of patients with chronic or critical conditions. The former category can be removed from the waiting lists quickly and easily whereas the latter group can be more problematic even if their condition is more urgent.

Police services have always been willing to offer leniency to criminals who make a full confession of all their previous crimes when arrested. This is reasonable since a



criminal should be rewarded for co-operating with the police and given an opportunity to ‘wipe the slate clean’. However, when the performance of a police service is measured on the basis of 'crime clear up rates' then arrested criminals may be induced to confess to crimes they did not commit.

In order to be effective, performance measurement in NFPs has to be broad based and applied in a sensitive manner. If these criteria are not applied then performance measurement can end up doing more harm than good.



PERFORMANCE MANAGEMENT

(a) Benchmarking enables organisations to learn about their own business practices and the best practice of others. It will help an organisation to identify areas in which it is not implementing best practice and to determine improvement programmes which will lead to the achievement of and improvement upon current best practice.

Benchmarking should focus on areas which are of significant strategic importance to the organisation. It will also be useful to target areas where it is envisaged significant improvement can be made. This will maximise the benefit in the short term from available resources for improvement. This is likely to create a positive motivational influence on staff and improve their commitment to the benchmarking ethos.

Benchmarking may have one or more areas of focus. It may, for example, be internal in nature where one internal unit (or division) learns from another. Alternatively it may be external in focus. It may focus on best practice by competitors where this information can be obtained. Again it may focus on customers by comparing current performance with the expectations of the customer such as the percentage of faulty goods amongst those reaching the customer.

(Alternative relevant discussion would be accepted.)

(b) The absence of the profit measure requires an alternative focus in a not-for-profit organisation. The principle of value-for-money implies that efforts must be made to ensure that the available funds are spent in the provision of services in a way which maximises the benefit to the users of the services. The value for money principle should be considered in conjunction with economy, efficiency and effectiveness.

• Economy implies the principle of frugality. What is the least cost method of providing a requirement?

• Efficiency implies the maximising of the output:input ratio.

• Effectiveness focuses on the achievement of the desired objectives through the spending of the available funds.

The three measures may be in conflict with each other and may sometimes complement each other. For example, purchasing a cheap version of an item (economy) may help maximise the number of units which may be obtained for a given sum of money (efficiency). This may be at variance with the desired objective of a high standard of performance from each of the units (effectiveness).

An example from a housing department viewpoint could be the desire to improve the quality of housing to occupants through a policy of installing double glazed windows.

The purchase of cheap window units (economy) may help increase the number of houses which can be converted (efficiency). This could possibly lead to dissatisfaction through poor performance of the units e.g. high condensation and poor sound proofing and hence the non-achievement of improved quality of living (effectiveness).

(c) Robert Kaplan and David Norton carried out studies in several companies in the early 1990’s. The studies aimed at investigating the need to balance short-term financial performance with the drivers of long-term growth opportunities. A number of advantages of the balanced scorecard over the traditional major focus on financial performance may be suggested. These include:

• Traditional measures tend to be dominated by financial accounting requirements. For example the need for stock valuation, including WIP for balance sheet purposes. Also the focus on short-term profit and ROI in order to ensure that short-term financial reporting was favourably received by stakeholders. The balanced scorecard is more broadly based. It argues that



no single measure can provide a clear performance target or focus attention on critical areas of the business.

• Traditional measures are mainly inward looking. The balanced scorecard is more broadly based. It is more outward looking and focuses on comparisons with competitors in order to establish best practice and ensure that change is implemented in order to achieve it. It requires a balanced presentation of both financial and non-financial measures and goals.

• The balanced scorecard focuses to a greater extent than traditional measures on strategic planning for the longer term. It attempts to identify the needs and concerns of customers and the identification of new products and markets.

• The balanced scorecard attempts to overcome the over-emphasis of traditional measures on the quantifiable aspects of the internal operations of a company expressed in financial terms. It also considers a range of non-financial and qualitative measures.

The balanced scorecard views the business from four different perspectives which are internal business, innovation and learning, customer and financial perspectives. The questions asked in relation to these perspectives are:

• What processes must we excel at to achieve our customer and financial objectives?

• Can we continue to improve and create value?

• What do existing and new customers value from us?

• How do we create value for shareholders?

The balanced scorecard establishes goals for each of the four perspectives and provides measures that should assist in movement towards these goals. Its focus is both internal and external. Examples of measures that could be used are:

• Internal business perspective: cycle time, unit cost analysis including cost trends and VA/NVA analysis, engineering efficiency.

• Innovation and learning perspective: Time to market for new products; number of new products introduced.

• Customer perspective: % sales from new products, % on time deliveries, % orders from enquiries, customer survey analysis.

• Financial perspective: overall measures such as profit, sales growth, ROI; liquidity measures such as cash flow analysis; evaluation of new investment opportunities.



WINDERMERE

Key answer tips

This is a standard type of divisional assessment question: ROCE used as the performance measure, bonuses for meeting target ROCE, schemes to improve ROCE – some actually profitable but showing poor results, some short term manipulation to improve reported results but not in the long term interests of the company. There is one useful note in the question – there is central control of cash – it is always useful to assume this otherwise an investment will have no effect on a division’s net assets (non-current asssets rise, bank balance falls). You will need to make an assumption about what is meant by ‘cost savings’ in (i), pre or post depreciation, but state your assumption. The requirement of (a) provides you with a useful structure for your answer, although some initial general comments on the use of ROCE might help. Don’t anticipate (b) in your answer to (a).

(a) Assessment of four year-end proposals

Two general comments are of relevance to all four proposals:

• With ROCE based on NBV of assets employed, there is an incentive to under-invest, to improve ROCE by ‘reducing the bottom line’ rather than ‘increasing the top line’ in the ratio.

• When ROCE-based assessment is linked to a bonus scheme, there is a greater incentive to make ROCE appear satisfactory irrespective of the true commercial merit of an operation of project.

(i) The works manager – new equipment

An investment at the end of the year will increase capital employed without providing the opportunity to earn any of the savings forecast. ROCE is likely to fall from 14.6% to:

%0.13100000,100$000,820$

000,120$ =×+

Without knowing the depreciation policy, it is not possible to state the effect of this proposal on 19X2 ROCE.

The project itself may well be viable. If 15% can be taken as the division’s cost of capital and net annual cash inflows amount to $18,000, the NPV is:

$18,000 × 5.847 − $100,000 = $5,246.

The project has a positive NPV and should be accepted.

Under the same assumptions and assuming straight line depreciation of $6,667 p.a., the ROCE at the end of the first year would be:

%1.12100667,6$000,100$

667,6$000,18 =×−

−

This is less than the target, but that is a failure of the ROCE method and the method of depreciation used. (The ROCE would increase each year as the NBV reduces and in the final year the project’s ROCE would be $11,333 ÷ $0 = infinity).

There are no ethical issues at stake, but a number of management issues as introduced above and discussed in (b).



(ii) The chief accountant – delay payments to payables

The effect of non-payment of payables at the year end is to decrease assets by $42,000 (the creditor appears in the division’s books, but cash does not) and reduce profit by $1,000. ROCE will move from 14.6% to:

%3.15100000,42$000,820$

000,1$000,120$ =×−−

The required target has been achieved.

This proposal will have no effect on 20X2 ROCE.

The longer term effect is that the company has lost $1,000 and kept $42,000 cash for another month. The cost of this proposal is therefore 1/42 = 0.024 per month, or:

[(1.024)12

− 1] × 100 = 32.6% per year.

This makes the scheme appear rather costly.

The company does not want to get a reputation for being a poor payer, as suppliers may withhold goods and it may become difficult to obtain further credit.

The ethics of deferring payment of debt, which is commercially non-viable, in order to earn a bonus, needs to be questioned.

(iii) The sales manager – bring forward completion of order

The effect of this transaction would be to increase profit by $6,000. As work in progress changes to receivables in the accounting records, capital employed would increase by $6,000 (since receivables includes profit, but work in progress includes cost only). ROCE would change from 14.6% to:

($120,000 + $6,000)/($820,000 + $6,000)

= $126,000/$826,000

= 0.153 or 15.3%.

This proposal achieves the desired ROCE.

This proposal will reduce 20X2 profit by $6,000, because it has the effect of bringing profit forward from 20X2 to 20X1.

Looking at the transaction without regard to year-end performance, $1,500 has been spent with no benefit to total cash inflows, although the balance sheet will look more impressive.

This is another example of dysfunctional decisions based on a form of assessment and related remuneration scheme that encourages manipulation of year end accounts.

As with the previous proposal, the ethics of taking a commercially unsound decision, in order to secure a bonus, should be challenged.

(iv) The head of internal audit – closing a regional plant

This proposal would have a dramatic effect on capital employed, immediately reducing it by $90,000. The effect on profit would be a fall of $50,000 through redundancy and a rise of $30,000 profit on sale of assets. However, none of these would be included in trading profit (since they are presumably non-recurring) and so ROCE would increase to:

%4.16100000,90£000,820$

000,120$ =×−



This easily achieves the required standard.

Without knowing the depreciation policy, or the life of the assets, the effect of this proposal on 20X2 ROCE cannot be determined.

The loss of $12,600 p.a. for 15 years comes from a net disinvestment of $120,000 − $50,000 = $70,000. The PV of the lost profit (ignoring the possibility of ‘profit’ of $12,600 being increased by depreciation of $90,000 ÷ 15 = $6,000 to $18,600) for 15 years at 15% is:

$12,600 × 5.847 = $73,672.

This suggests that the plant should be retained in order to earn these profits. (ROCE appraisal has been ignored.)

Sacking people to improve ROCE despite the move being against the long-term benefit of the business is unethical. The analysis has also excluded any possible loss of business in other parts of the division from customers inconvenienced by this particular closure.

(b) Remedial action by company finance director

Many of the problems above come from the use of return on capital employed (ROCE) based on year end figures which encourages under-investment and manipulation.

Possible solutions include:

• Change to Residual Income (RI) so that divisions will be rewarded for making wise long-term investment decisions

• Use DCF methods for assessing capital projects. This overcomes the short-term view taken by using ROCE. Performance can then be assessed by seeing whether the cash flow projections used to assess a project are achieved in reality

• If there is an insistence on the use of ROCE, it can be improved by:

– using average capital employed figures rather than year-end ones;

– using gross book values rather than net-book values;

– changing depreciation methods to ensure that ROCE does not improve just by retaining assets whose book value steadily falls

• Ensure central approval of investment (and disinvestment) budgets and controls to check that commitments are met

• Central control of payments to payables and collection of receivables

• If the above is too ‘interventionist’ lay down guidelines for payments and collection periods

• The Divisional Manager deserves a reprimand for ‘window dressing’ although he is trying to make his accounts look better in a way that will not only boost his bonus but will also appeal to outside analysts

• The importance of ethical considerations in decision-making should be emphasised to Divisional management

• Change the bonus scheme and pay each manager a fair day’s salary for doing a fair day’s work without the troublesome complication of a bonus scheme.

f5 kaplan practice questions

Documents