CIMA P2 Performance Management Study Notes by BPP

Performance Management
Management Level Paper P2 Course Notes CMP2CN10(N)
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P2 Performance Management
Step 1 Learning Phase Study Programme
Page Introduction to the paper and the course................................................................................................................. 4 Summary Skills Bank and Analysis of Verbs........................................................................................................... 9 1 2 3 4 5 6 7 8 Relevant costs and short term decisions...................................................................................................... 13 Limiting factor analysis ................................................................................................................................. 33 Linear programming: the graphical method.................................................................................................. 39 Linear programming: the simplex method .................................................................................................... 49 Additional Study Guidance and Progress Test 55 Multi-product break even analysis ................................................................................................................ 67 Pricing decisions .......................................................................................................................................... 83 Cost planning ............................................................................................................................................... 97 Cost analysis (part 1).................................................................................................................................. 115 Additional Study Guidance and Progress Test 125
Checkpoint 1
Checkpoint 2 8 9a 9b 10
Cost analysis (part 2).................................................................................................................................. 139 Cost management techniques 1 ................................................................................................................ 149 Cost management techniques 2 ................................................................................................................ 167 Budgeting ................................................................................................................................................... 185 Additional Study Guidance and Progress Test 197
Checkpoint 3 11a 11b 12 13
Performance evaluation variance analysis.............................................................................................. 211 Performance evaluation.............................................................................................................................. 227 Measuring performance in responsibility centres ....................................................................................... 245 Transfer pricing ......................................................................................................................................... 259 Additional Study Guidance and Progress Test 275
Checkpoint 4 14 15 16 17
Answers to Lecture Examples.................................................................................................................... 289 Question and Answer bank ........................................................................................................................ 325 Appendix A: Maths tables and formulae..................................................................................................... 367 Appendix B: Formulae to learn................................................................................................................... 371
INTRODUCTION
Introduction to Paper P2 Performance Management

Syllabus overview
While Paper P2 continues the analytic theme of Paper P1, its main focus is on the application of information in the management process of decision-making and control, so as to optimise performance. The first two sections deal respectively with the key contributors to operational performance revenue (decisions of what to produce, at what price) and costs (how to manage them to maximise profitability). The role of control in monitoring and improving performance then comes to the fore in the final two sections, dealing with principles and practices in the use of responsibility centres and budgeting.
The syllabus
The broad syllabus headings and their relative weightings are: Topic A B C D Pricing and product decisions Cost planning and analysis for competitive advantage Budgeting and management control Control and performance measurement of responsibility centres Study weighting 30% 30% 20% 20%
Aims
The syllabus aims to test the students ability to: Discuss concepts of cost and revenue relevant to pricing and product decisions. Analyse short-term pricing and product decisions. Discuss pricing strategies and their consequences. Evaluate techniques for analysing and managing costs for competitive advantage. Explain the principles that underlie the use of budgets in control. Evaluate performance using budgets, recognising alternative approaches and sensitivity to variable factors. Discuss the broader managerial issues arising from the use of budgets in control. Discuss the use of responsibility centres in devising organisation structure and in management control. Discuss information suitable for management decision-making in responsibility centres. Discuss the broader managerial issues arising from the division of the organisation into responsibility centres.
Links with other papers

P2 builds on Certificate level knowledge and P1 Performance Operations knowledge. Together with P1 Performance Operations it leads to P3 Risk and Control Strategy. Strong Certificate level knowledge and understanding is an essential part of preparation for P2. Once P2 is complete the numerical techniques learnt feature in all the Strategic level papers, not just P3, where students will be expected to apply their knowledge to more real-life situations.
INTRODUCTION
Learning Phase Aims

Achieving CIMA's Learning Outcomes
A Pricing and product decisions (30%)
Chapter 1 Chapter 1 Chapter 6 Chapter 1 Chapters 2, 3, 4 &5 Chapters 3 & 4 Chapter 5 Chapter 6 Chapter 6 Chapter 1
1(a) Discuss the principles of decision-making including the identification of relevant cash flows and their use alongside non-quantifiable factors in making rounded judgements. 1(b) Discuss the possible conflicts between cost accounting for profit reporting and inventory valuation and the convenient availability of information for decision-making. 1(c) Discuss the particular issues that arising in pricing decisions and the conflict between marginal cost principles and the need for full recovery of all costs incurred. 2(a) Explain the usefulness of dividing costs into variable and fixed components in the context of short-term decision-making. 2(b) Interpret variable/fixed cost analysis in multiple product contexts to break-even analysis and product mix decision-making, including circumstances where there are multiple constraints and linear programming methods are needed to identify optimal solutions. 2(c) Discuss the meaning of 'optimal' solutions and how linear programming methods can be employed for profit maximising, revenue maximising and satisfying objectives. 2(d) Analyse the impact of uncertainty and risk on decision models based on CVP analysis 3(a) Apply an approach to pricing based on profit maximisation in imperfect markets. 3(b) Discuss the financial consequences of alternative pricing strategies. 3(c) Explain why joint costs must be allocated to final products for financial reporting purposes, but why this is unhelpful when decisions concerning process and product viability have to be taken.
Cost planning and analysis for competitive advantage (30%)

Chapter 7 Chapter 9a Chapter 9a Chapter 9a Chapter 7 Chapter 8 Chapter 9a Chapter 7 Chapter 7 Chapter 9b
1(a) Compare and contrast value analysis and functional cost analysis. 1(b) Evaluate the impacts of just-in-time production, the theory of constraints and total quality management on efficiency, inventory and cost. 1(c) Explain the concepts of continuous improvement and Kaizen costing that are central to total quality management. 1(d) Prepare cost of quality reports. 1(e) Apply learning and experience curves to estimate time and cost for new products and services 1(f) Apply the techniques of activity-based management in identifying cost drivers/activities. 1(g) Explain how process re-engineering can be used to eliminate non-value adding activities and reduce activity costs 1(h) Explain how target costs can be derived from target prices and the relationship between target costs and standard costs 1(i) Discuss the concept of life cycle costing and how life cycle costs interact with marketing strategies at each stage of the life cycle 1(j) Discuss the concept of the value chain and discuss the management of contribution/profit generated throughout the chain
INTRODUCTION
1(k) Discuss gain sharing arrangements whereby contractors and customers benefit if contract targets for cost, delivery etc are beaten 1(l) Analyse direct customer profitability and extend this analysis to distribution channel profitability through the application of activity-based profitability calculations. 1(m) Apply Pareto analysis as a convenient technique for identifying key elements of data and in presenting the results of other analyses, such as activity-based profitability calculations
Chapter 9b Chapters 8 Chapter 8
Budgeting and management control (20%)

Chapter 10 Chapter 10 Chapter 10 Chapter 11b Chapter 10 Chapter 10 & 11a Chapter 10 Chapter 11b Chapter 11b Chapter 10
1(a) Explain the concepts of feedback and feedforward control and their application in the use of budgets for planning and control. 1(b) Explain the concept of responsibility accounting and its importance in the construction of functional budgets that support the overall master budget. 1(c) Identify controllable and uncontrollable costs in the context of responsibility accounting and why uncontrollable costs may or may nor be allocated to responsibility centres. 2(a) Evaluate projected performance using ratio analysis. 2(b) Evaluate the consequences of what if scenarios and their impact on the master budget 2(c) Evaluate performance using fixed and flexible budget reports 3(a) Discuss the impact of budgetary control systems and setting of standard costs on human behaviour. 3(b) Discuss the role of non-financial performance indicators. 3(c) Compare and contrast traditional approaches to budgeting with recommendations based on the 'balanced scorecard'. 3(d) Discuss the criticisms of budgeting, particularly from the advocates of beyond budgeting techniques.
Control and performance measurement of responsibility centres (20%)

Chapter 12 Chapters 10 & 12 Chapter 12
1(a) Discuss use of cost, revenue, profit and investment centres in devising organisation structure and in management control. 2(a) Discuss cost information in appropriate formats for cost centre managers, taking due account of controllable/uncontrollable costs and the importance of budget flexing. 2(b) Discuss revenue and cost information in appropriate formats for profit and investment centres managers, taking due account of cost variability, attributable costs, controllable costs and identification of appropriate measures of profit centre contribution. 2(c) Discuss alternative measures of performance for investment centres. 3(a) Discuss the likely behavioural consequences of the use of performance metrics in managing cost, profit and investment centres. 3(b) Discuss the typical consequences of a divisional structure for performance measurement as divisions compete or trade with one another. 3(c) Discuss the likely consequences of different approaches to transfer pricing for divisional decision-making, divisional and group profitability, the motivation of divisional management and the autonomy of individual divisions. 3(d) Discuss in principle the potential tax and currency management consequences of internal transfer pricing policy.
Chapter 12 Chapter 12 Chapters 12 & 13 Chapter 13
Chapter 13
INTRODUCTION
The examination paper

The examination is a three hour paper with an additional 20 minutes of reading time. Candidates are provided with a formulae sheet.
65% Numerical 40% Knowledge 35% Discussion 60% Application
Format of the Exam Section A Section B Five compulsory 10 mark questions Two compulsory questions
Marks 50 50 100
Time pressure warning

Section A Section B
INTRODUCTION
Key to icons
Question practice from the Question and Answer Bank
This is a question we recommend you attempt to reinforce your learning on a key topic.
Real-life examples
For further details see your Checkpoint Guidance
Section reference in the Study Text

You could further consolidate your knowledge in this area with additional reading from the Study Text.
Formula to learn
Formula given in exam
SUMMARY SKILLS BANK
Key skills required to pass

Our analysis of the examiners comments on past exams, together with our experience of preparing students for this type of exam, suggests that to pass Paper 2 you will need to develop a number of key skills.
5 Professional presentation of numbers and narrative answers
1 Effective use of the 20 minutes reading time at the start of the exam
4 Analysis of requirements to ensure your answer specifically addresses the requirements
3 Exam Approach to ensure that you play to your strengths and thereby maximise your marks
2 Disciplined time management to ensure that all parts of the question are answered in the time allowed
Each of these key skills is analysed on the following page.
SUMMARY SKILLS BANK
Skill 1 Effective use of reading time

Effective use of the 20 minutes of reading and planning time can make a huge difference to your performance in the exam. For each question you should: 1. 2. 3. Read the requirements, highlighting the key elements within them. Read the scenario, highlighting the pertinent info you need. Capture key words / items for inclusion in your answer.
Skill 2 Time management

It is vital that you manage your time carefully in the exam. You are allowed 1.8 minutes for every mark available, so you should manage your time accordingly. Write the amount of time you have available for each requirement on the question paper to prevent yourself over-running.
Skill 3 Exam approach

In order to maximise your marks and to avoid panicking in the exam it is important that you play to your strengths. You should therefore tackle those questions / requirements that you can do best first. You should be aware which these are from the work that you have done in the reading and planning time.
Skill 4 Analysis of requirements

You need to be familiar with the meaning of the key verbs used by the examiner if you are to maximise your marks in discussion elements. Additionally you should always try to link your answer to the particular scenario / company that the question is based upon.
Skill 5 Professional presentation

This is an area that is consistently problematic within P2. It is vital that you do not throw marks away purely because the examiner cannot follow what you have done. Calculations should be laid out clearly which cross reference to the workings that support them. Written answers should be presented as short, punchy paragraphs.
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SUMMARY SKILLS BANK
LIST OF VERBS USED IN THE QUESTION REQUIREMENTS

A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb.
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SUMMARY SKILLS BANK
12
Relevant costs and short term decisions
1
Example past paper questions May 07, Q6(a), 15 marks May 05, Q6(a), 10 marks Nov 07, Q7(a), 15 marks May 07, Q6(b), 10 marks May 09, Q6(b), 5 marks
How have the syllabus learning outcomes been examined?

Syllabus learning outcomes Discuss the principles of decisionmaking including the identification of relevant cash flows and their use alongside non-quantifiable factors in making rounded judgements. How syllabus outcomes are examined Questions usually require students to prepare a relevant cost for a particular project, detailing why costs are or are not relevant. Calculation of profitability/ loss under various scenarios and a resulting recommendation as to which course of action to take has also been required. Discussion question that has focussed on the validity of using selling price based on relevant cost in the short and long term When examined students were asked to interpret a break even chart and to explain how it illustrated issues that managers need to consider when making decisions Questions test the validity of a process and whether products should be further processed or not.
Discuss the possible conflicts between cost accounting for profit reporting and inventory valuation and information required for decision-making. Explain the usefulness of dividing costs into variable and fixed components in the context of shortterm decision-making.
Nov 06, Q4, 10 marks
Explain why joint costs must be allocated to final products for financial reporting purposes, but why this is unhelpful when decisions concerning process and product viability have to be taken.
May 07, Q4, 10 marks May 05, Q4, 10 marks Nov 08, Q2, 10 marks
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1: RELEVANT COSTS AND SHORT TERM DECISIONS
Overview
Relevant costs
Relevant costs
Non-relevant costs
Other factors
Non-financial / qualitative factors
Information for reporting and decisionmaking
Relevant costing in relation to accounting concepts
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Overview
Short-term decisions
Minimum price
Make or buy
Further processing
Accept or reject
Shutdown
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Relevant costs and revenues

The costs which should be used for decision-making are referred to as relevant costs. Relevant costs
Future
Cash
Incremental / Specific
Opportunity cost
Definition
1.1 In order for a cost to be a relevant cost it must be (i) (ii) (iii) 1.2 Future Cash flow Incremental
Relevant costs may also be: (a) Opportunity costs the value of a benefit sacrificed when one course of action is chosen in preference to an alternative. The opportunity cost is represented by the potential benefit forgone from the best rejected course of action. Opportunity costs are relevant for decision-making and are likely to arise when there are a number of possible uses of a scarce resource. (b) Avoidable costs the specific costs of an activity or sector of a business which would be avoided if that activity or sector did not exist. Avoidable costs are usually associated with shutdown decisions.
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Non-relevant costs and revenues

1.3
Non-relevant costs
Sunk costs
Committed costs
Notional costs
Fixed costs
Sunk costs costs already incurred. Not relevant in decision-making and are therefore ignored. Committed costs these have already been committed to and so are not relevant to the decision. Examples might include the cost of materials under a long-term contract. Notional costs non-cash items, or accountancy entries. Fixed costs allocated and general fixed costs are not specific to a decision. Avoidable fixed costs would be relevant.
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Relevant cost of materials

1.4
In inventory
If take from If take from inventory will be inventory wont replaced be replaced
If take from inventory cant replace it
Lecture example 1
Based on a past exam question worth 2 marks
X plc intends to print a catalogue for a one-off special promotion. The catalogue requires 120 boxes of a particular type of paper that is not regularly used by X plc although a limited amount remains in X plc's inventory from a similar job. The cost when X plc bought the paper two years ago was $17 per box and there are 50 boxes in inventory. The boxes could be sold for $14 each or could be purchased in the market for $22 each. Required Calculate the relevant cost of the paper to be used in printing the catalogue.
Solution
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Relevant cost of labour and variable overheads

1.5
Relevant cost of machinery

1.6 (a) (b) (c) Repair costs arising from use Hire charges Fall in resale value arising from use
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Lecture example 2
A plc is deciding whether to undertake a new contract.
Technique Demonstration
15 hours of labour are required for the contract. Labour is currently at full capacity producing X. Cost card for X Direct materials Direct labour Selling price Contribution Required What is the cost of using 15 hours of labour for the contract? (10 kg @ $2) (5 hrs @ $6) $/unit 20 30 50 75 25
Solution
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2
2.1
Minimum price decisions

The minimum price for a one-off decision is its total relevant costs. This is the price at which the business would breakeven.
Lecture example 3
LB Ltd has been approached by a customer to manufacture a specialised machine. This would be a one-off order which LB Ltd would undertake in addition to its normal budgeted production. The assistant accountant has prepared the following quotation: Note Direct materials: Aluminium plating (20m2 @ $10per m2) Rivets (100 @ $1 each) Direct labour: Skilled (50 hrs @ $16 per hour) Semi-skilled (20 hrs @ $10 per hour) Overheads Administration overhead @ 10% of production cost Profit 20% of total cost Selling price Notes 1 The aluminium plating is regularly used on other work within the business. It has an inventory value of $10 per m2 although the current purchase price has recently risen to $12 per m2. Rivets are currently held in inventory and cost $1 each although the company has no further use for them. They could be sold to a scrap merchant for $0.50 each. Skilled labourers are paid $16 per hour and are currently fully utilised on other work. If the job was undertaken it would be necessary to either work a maximum of 40 hours of overtime (paid at time and a half) and/or reduce the production of another product which earns contribution of $20 per hour. There is currently 100 hours of idle semi-skilled labour time available. Overheads represent an apportionment to cover factory fixed costs. It is policy to add 10% to the production cost of each job to cover the administration cost of orders accepted. Profit of 20% of total cost is added to each job as part of standard pricing policy. 1 2 3 4 5 6 7 $ 200 100 800 200 100 1,400 140 1,540 308 $1,848
2 3
4 5 6 7
Required Prepare, on a relevant cost basis, the minimum price which should be quoted for the job and suggest other factors that should also be considered prior to reaching a final decision.
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Solution
Note Aluminium plating Rivets Skilled labour Semi-skilled labour Overheads Administration overhead Total relevant cost Profit $
Minimum price Notes
Q2 Exe
3
3.1
Accept or reject
Accept or reject decisions use exactly the same principles as minimum price decisions. A project with a positive return on a relevant cost basis should be accepted, a negative return should be rejected.
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4
4.1 4.2
Make or buy
Organisations may need to decide to make components, or provide services, themselves inhouse, or alternatively, to buy them from an outside supplier. In-house production will provide greater control over the work performed but will also use capacity which will give rise to opportunity costs.
Preparation question
Lecture example 4
A plc makes a 15,000 units of component B, and a product, C $ per unit Selling price Material cost Component B (external purchase price) Direct labour Variable overhead Fixed costs ($ pa) Avoidable Non-avoidable Required (a) (b) B 8.00 4.00 2.00 14.00 15,000 20,000
C 54.00 9.50 14.50 8.00 4.00 36.00 23,400 40,000
Determine the maximum price that should be paid to an external supplier for component B. Assuming B is bought from the external supplier, how many units of C must be sold to breakeven on a relevant cost basis?
Solution
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5
5.1 5.2 5.3
Shutdown decisions
These decisions may involve the closure of divisions or products of a business that appear to be loss-making. Shutdown decisions should not be made on the basis of profitability under absorption costing as this fails to consider the relevance of fixed overheads. Shutdown decisions should focus on relevant costs (and revenues) if the closure is made.
Lecture example 5
Lewis Ltd manufactures three products, the Keir, the Lucy and the Gareth. Forecasted income statements for next year are as follows: K $'000 600 200 95 75 200 30 40 (10) L $'000 300 60 20 10 50 160 20 140 G $'000 200 30 10 5 80 75 15 60 Total $'000 1,100
Sales Cost of production Materials Labour Variable overhead Fixed overhead Gross margin Selling costs Net margin
265 75 190
The directors are considering the closure of the Keir product line, due to the losses incurred. You obtain the following information. (1) Fixed production overheads consist of an apportionment of general factory overheads, based on 80% of direct materials cost. The remaining overheads are specific to the product concerned.
(2) Selling costs are based on commission paid to sales staff. Required (a) (b) Determine if the Keir product line should be closed down. Suggest other factors that should be considered prior to a final decision.
Solution
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6
6.1
Further processing of joint products

In certain circumstances more than one product may be produced from a single process. These products may sell in their current state or may need further, separate processing before they can be sold.
Processes
Joint costs
6.2 The costs of the process will need to be apportioned between the products created by the process in order to (a) Value stock (b) Prepare financial accounts
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1: RELEVANT COSTS AND SHORT TERM DECISIONS 6.3 These costs are not relevant when deciding whether to process any product further because they are (a) Sunk (b) Arbitrarily apportioned The total joint cost may be relevant for decisions regarding the viability of the process as a whole. Joint costs can be apportioned between products based on the following. (a) (b) (c) Physical quantity Relative sales value Net realisable value
6.4 6.5
Losses
6.6 6.7 6.8 Frequently processes cause losses of volume during processing. When these losses are expected they are referred to as normal. Losses above normal level are abnormal losses. Normal losses are valued at scrap value. Abnormal losses/gains are valued at production cost. Abnormal losses may later be sold as scrap when the net loss/gain is calculated.
Calculation
6.9 The apportionment of joint costs is performed using the calculation of a cost per unit Cost per unit of output =
Input costs scrap value of normal loss Input units normal loss units
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Lecture example 6
A process produces two joint products. The following process account relates to last month's production. Process Materials Labour Variable overhead
Units 5,000 $ 25,250 14,950 7,500
Normal loss Product A Product B
Units 500 2,500 2,000
0 26,500 21,200 47,700
5,000
47,700
5,000
Each of the products can be sold immediately after the process or further processed individually before being sold.
Product Selling price after process Selling price after further processing $ /Unit 13 15 Further variable processing cost
A B Losses cannot be sold.

Required
$/Unit 10 12
$/Unit 3.75 2.75
(a) (b)
Determine the optimal processing plan for each of the two products, A and B. Evaluate the viability of the common process (i) (ii) assuming the products are both sold at split off point assuming there is no external market for the products at split off point
Solution
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Q1 Z Ltd
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7
7.1
Non-financial/qualitative factors
Assumptions in relevant costing: (a) (b) (c) (d) Cost behaviour patterns are known with certainty Costs, prices and volumes are known with certainty Objective is to maximise profit/contribution Information is complete and reliable
Chapter 1a section 8 Non quantifiable factors in decision making
Other factors to consider

7.2 7.3 Exam questions may require a discussion of other factors, aside from the financial calculation, that should be taken into account in making any decision. Factors include: (a) (b) (c) (d) (e) 7.4 Employees Customers Competitors Suppliers Flexibility
Timescale can also be relevant. Many fixed costs can be varied, but only in the long-term.
8
8.1 8.2
Information for reporting and decision-making

Information required for decision-making differs considerably from that used for profit reporting and inventory valuation. In accordance with IAS 2, absorption costing must be used for inventory valuation purposes and therefore for profit reporting. However, the inclusion of an amount for fixed overheads means it cannot be used for decision making: (a) (b) The allocation of overhead is an arbitrary apportionment and so may not reflect the actual cost of making / not making a product Fixed overheads do not change in the short term and therefore should not be considered when decision making
8.3
Absorption costing does however recognise that selling prices must cover all costs if a business is to continue to be profitable.
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9
9.1
Chapter 1a section 7 Relation to accounting concepts
Relevant costing in relation to accounting concepts

Accounts are prepared in accordance with two fundamental concepts: accruals and going concern. These concepts are not necessarily consistent with information for decision making.
Accruals
9.2 This concept looks to report transactions in the period to which they relate. However, relevant costing is concerned only with future transactions and with cashflows. Sunk costs are ignored in decision making even if they are incurred in the assessment of the particular project that is being considered.
Going concern
9.3 Financial statements are prepared on the assumption that an entity will continue in the foreseeable future. Relevant costing could be said to comply with this concept as the undertaking of decisions about future projects will only be considered if the business is still trading. However, caution needs to be exercised as if all projects are undertaken on a relevant cost basis and are priced using a minimum price then the projects will not be making enough money to cover the fixed costs of the business.
9.4
Qualitative characteristics of financial information

9.5 Financial Information must also be comparable and understandable which is achieved through relevance and reliability.
Characteristic Relevance Financial reporting Relevant costing
Assists users in evaluating past and present future events Materiality
Focuses on future events only All items associated with the decision are considered These 5 aspects can all be said to apply with regards to the particular decision being taken
Reliability
Faithful representation Substance over form Neutrality Prudence Completeness
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10 Chapter summary
Section Topic Relevant costs Summary
Relevant costs are future, incremental cash flows. Opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative. Non-relevant costs include: sunk committed notional historic
2 3 4 5 6
Minimum price Accept or Reject Make or Buy Shutdown Further processing
Minimum prices should not include an allowance for a profit mark-up. Positive returns should be accepted, negative rejected but consideration must also be given to non financial factors. Consideration should also be given to factors such as loss of control etc if items are bought in instead of being made. Some fixed costs may be saved in a shutdown scenario. Specific fixed costs will be relevant. Further processing decisions are not affected by the common cost of the process. Common costs are only relevant when considering the viability of the process. Non-quantifiable factors should also be considered before a final decision is made. These frequently involve stakeholders. Financial statements are prepared using absorption costing, due to the inclusion of overheads this is not appropriate for decision making.
Non-financial / qualitative factors Information for reporting vs decision-making
Relevant costing in Relevant costing is prepared on a future, cash basis, relation to considering all costs. The relevance is therefore at odds accounting concepts with the information prepared for financial statements, however the reliable characteristics of reporting information do also apply to relevant costing.
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END OF CHAPTER
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Limiting factor analysis
2
Example past paper questions Nov 05, Q6(b), 10 marks May 08, Q5, 25 marks Nov 08 Q5(a), 7 marks Nov 09, Q5(a), 5 marks May 10, Q6 (a&b), 9 marks

Syllabus learning outcomes Interpret variable/fixed cost analysis in multiple product contexts and product mix decision-making How syllabus outcomes are examined Limiting factor analysis to obtain an optimum solution. This has been examined in a contribution and throughput accounting environment.
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2: LIMITING FACTOR ANALYSIS
Overview
Limiting factor analysis
Principal budget factor
Single limiting factor
Shadow price
Marginal costing
Throughput accounting
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1
1.1
Principal budget factor

The production and sales plans of a business may be limited by a limiting factor / scarce resource (the 'principal budget factor'). This could be: (a) (b) (c) (d) (e) Market demand Materials Manpower (labour) Machine hours Money
The plans of the business must be built around this factor.
2
2.1
Single constraint
If a business makes more than one product, it will want to find the product mix which will maximise profit given the limiting factor. This is done by maximising contribution as follows. (a) (b) (c) Determine limiting factor by producing to maximum demand Rank products by contribution per unit of limiting factor Prepare a production plan
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Lecture example 1
Gorgo Ltd is preparing its production plan for the next week and has estimated maximum demand from its customers as follows. A B C Units 50 50 50 A $ 150 50 50 50 0 B $ 120 30 50 20 20 C $ 100 15 40 10 35
The products have the following cost cards.
Sales price Variable cost: Materials ($5/kg) Labour Fixed cost Profit
These demand figures do not include a long-term contract for the delivery of five units of each product to an important customer. If this contract is not satisfied, then Gorgo will have to pay a substantial penalty. The production director is concerned as the materials and labour used in production may be in short supply. Gorgo does not hold any inventory of raw materials but would be able to recruit temporary workers, who are equally as able as the permanent staff, as required, for a 10% premium over the usual rate. The availability of materials is expected to be restricted to 845 kg. Required Prepare calculations to determine the production mix that will maximise Gorgo's profit next week.
Solution
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2.2 Another method of decision-making involving limiting factors is throughput accounting. This will be covered in Chapter 9a.
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Shadow price
A shadow price is: (a) (b) (c) The additional contribution generated from one additional unit of limiting factor. The opportunity cost of not having the use of one extra unit of limiting factor. The maximum extra amount that should be paid for one additional unit of scarce resource.
Lecture example 2
Required
Technique demonstration
Using the information from Gorgo in Lecture example 1, determine the shadow price of material.
Solution
4
Q3 KL Retail Outlet
Chapter summary
Section 1 Topic Principal budget factor Single constraint Summary A factor which prevents the organisation producing / selling beyond a certain point. A scarce resource is a resource of limited availability. 2 Profit is maximised by maximising contribution per unit of scarce resource, assuming fixed costs are not affected by altering production decisions. Shadow prices are the increase in contribution that could be created by having one more unit of the limiting factor at the original cost. END OF CHAPTER
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Shadow price
Linear programming: The graphical method
3
Example past paper questions Nov 07, Q6(a), 15 marks Nov 09, Q5 (bi), 10 marks May 10, Q6(c), 11 marks Nov 07, Q6(b & c), 10 marks Nov 09, Q5 (bii & biii), 10 marks May 10, Q6(d), 5 marks

Syllabus learning outcomes Interpret variable/fixed cost analysis in multiple product contexts to breakeven analysis and product mix decision-making, including circumstances where there are multiple constraints and linear programming methods are needed to reach 'optimal' solutions. Discuss the meaning of 'optimal' solutions and show how linear programming methods can be employed for profit maximising, revenue maximising and satisfying objectives. How syllabus outcomes are examined Preparation of graphical linear programming and discussion of shadow prices.
Preparation of graphical linear programming and discussion of shadow prices.
39
3: LINEAR PROGRAMMING: THE GRAPHICAL METHOD
Overview
Linear Programming: The graphical method
Multiple constraints (two products)
Graphical linear programming Formulating the model Solving the problem
Shadow prices
Slack / Surplus
40
Multiple constraints
The methods discussed in Chapter 2 cannot be used when: (a) (b) (a) (b) More than one limiting factor exists Products rank differently for these resources Graphs, or Computer programs (Chapter 4)
Under these conditions linear programming is used and can be solved using:
2
2.1
Graphical linear programming

Graphical linear programming can be used when two products/services (variables) exist.
Steps
2.2 Follow these steps when you are trying to solve a problem using the graphical method. Formulating the model (a) (b) (c) Define variables Formulate objective function Formulate constraints generally in the form: amount of resource used amount available Plot constraints on a graph Identify the feasible space, ie those combinations of variables which are possible within the resource constraints Plot the slope of the objective function and slide to optimal point (away from the origin for a maximum, towards the origin for a minimum) Calculate the value of the objective function at the optimal point
Solving the problem (d) (e)

The management guide to fast food
(f) (g)
41
Lecture example 1
KG Ltd makes two products, the Purse and the Handbag. Each purse earns $5 contribution and each handbag earns $6. Inputs are as follows: Purse Handbag 2 Leather 1 m 2m2 Skilled labour 45 min 30 min There are six skilled labourers each working a 35-hour week and delivery contracts limit the amount of leather available to 600m2 each week. KG Ltd has an EU quota ruling whereby it has to produce at least as many handbags as it does purses. Leather costs $8 per m2, wages are paid at $4.20 per hour. Required Determine the optimal production plan for KG Ltd and calculation the contribution that can be achieved.
Solution
(a) Define variables
(b)
Formulate objective function
(c)
Formulate constraints (linear relationships)
42
3: LINEAR PROGRAMMING: THE GRAPHICAL METHOD (d) Plot a graph
43
3: LINEAR PROGRAMMING: THE GRAPHICAL METHOD (e) Identify feasible space
(f)
Determine optimal point
(g)
Calculate value of objective function at optimal point
44
Slack / Surplus
2.3 Slack occurs when the maximum availability of a resource is not used i.e. there is spare material. Surplus represents the production above the minimum requirement.
Lecture example 2
Calculate the value of any slack and surplus for KG.
Solution
Shadow prices
2.4
Section 3.1.3 Ranges for limiting factors
Shadow prices can be calculated from the graphical method, by relaxing or constraining one of the limiting factors at a time by a small amount (usually one unit), and recalculating the optimal solution and associated contribution.
45
Lecture example 3
Determine the maximum KG Ltd would be prepared to pay to obtain one further hour of labour.
Solution
3
3.1
Assumptions
Assumptions made in linear programming techniques include the following: (a) (b) (c) (d) (e) (f) Fixed costs are unchanged by decision Unit variable cost is constant Estimates of demand and resource requirements are known with certainty Units of output are divisible Total amount of each scarce resource is known with certainty No interdependence of demand between products
46
4
Q4 Linear programming
Chapter summary
Section 1 2 Topic Multiple constraints Graphical linear programming Summary Linear programming or computer packages will be needed to solve multiple limiting factor problems. Graphical linear programming can only be used when there are two variables (products). You should learn the steps required to produce and solve graphical linear programming problems. Slack is the amount of resource not used. Surplus is any production above the minimum requirement. Shadow prices can be calculated by resolving the problem with one extra (or one less) unit of each limiting factor in turn.
47
END OF CHAPTER
48
Linear programming: The simplex method
4
Example past paper questions Nov 05, Q6(c), 9 marks

Syllabus learning outcomes Discuss the meaning of 'optimal' solutions and show how linear programming methods can be employed for profit maximising, revenue maximising and satisfying objectives. How syllabus outcomes are examined Interpretation of a linear programming solution has been required.
49
4: LINEAR PROGRAMMING: THE SIMPLEX METHOD
Overview
Linear Programming: The simplex method
3 or more variables
Inputs Slack variables
Output
50
1
1.1
Computer-based linear programming

The computer-based method must be used when there are three or more variables. Computers use the simplex method, which is an iterative process to calculate: (a) (b) (c) (d) (e) Contribution at possible solutions Optimal combination Constraints Slack Shadow prices
1.2
The syllabus does not require you to use simplex but to: (a) (b) Prepare the input for the computer Interpret the output of the computer package.
2
2.1
Inputs
The inputs into the linear programming package will be very similar to those seen in Chapter 3, but they also include slack variables. Based on the information in Chapter 3, Lecture example 1, the inputs would be as follows: Let P Let H Let S1 Let S2 Let S3 = = = = = number of purses made and sold per week number of handbags made and sold per week slack of leather slack of labour excess of handbags made over quota
Section 4 Using linear programming
Maximise Z = 5P + 6H Subject to: (Leather) (Labour) (Quota) (Non-negativity) 2.2 1.5P + 2H + S1 = 600 0.75P + 0.5H + S2 = 210 P H + S3 = 0 P, H 0
These inputs are placed in an initial tableau. The initial tableau shows the production problem at the origin, when no output is produced. The tableau should contain: 1 row for each constraint and a solution row 1 column for each (product) variable, slack variable and 1 column for the solution
51
Lecture example 1
Required Produce the initial tableau for the production problem above.
Solution
Variable P H S1 S2 S3 Soln
3
3.1
Output
The computer output will vary according to the linear programming package used. However, all packages will incorporate similar information.
Lecture example 2
The output from two computers used to solve the problem highlighted in Lecture example 1 is as follows: Objective function value: Variable P H Constraint S1 S2 S3 Value 160.000 180.000 Slack/Surplus 0.000 0.000 20.000 1,880.000 Relative loss 0 0 Shadow price/worth 2.667 1.333 0.000
Variable P H S3 Z
P 1
H 1
S1
S2
S3
Soln 160.000 180.000
1 0 0 2.667 1.333 0
20.000 1880.000
52
4: LINEAR PROGRAMMING: THE SIMPLEX METHOD Required (a) (b) Explain the meaning of each of the values of the two linear programming packages. Should KG Ltd accept an offer from Edwards Ltd to supply them with extra leather for $10.50/m2?
Solution
53
4
Q5 Simplex
Chapter summary
Section 1 Topic Computer based linear programming Inputs Output Summary This must be used if there are three or more variables. Simplex methods of linear programming follow the same principles as graphical methods. Slack variables must be incorporated into the simplex inputs. Tableaux indicate the problem's optimal production contribution generated slack (surplus) variables shadow prices of resources (worth) opportunity costs of producing other than the optimal solution (relative loss).
2 3
END OF CHAPTER
54
CHECKPOINT 1
Checkpoint 1 Progress Review

To reinforce your learning to date you should now follow the study guidance in the following pages. On completion, your progress towards full exam preparation will be:
Take some time to reflect on the knowledge and skills you covered during Stage 1. If you feel you need further clarification on any of the key areas listed below you can use the on-line lecture for the relevant chapter. The Course Notes section for each chapter (starting overleaf) provides helpful guidance (and time commitments) on how to focus your review on the key learning points in your notes.
Key knowledge
Brought forward knowledge Some items in stage 1 you may have seen before in your studies such as single limiting factors. The P2 syllabus takes these topics further branching into multi limiting factors, slack, surplus and shadow prices. Relevant Costing Relevant costing is probably the most important technique from stage 1 to get to grips with quickly. Many of the decisions within the P2 syllabus centre around this concept. Exam questions may focus specifically on identifying the relevant cost in a given scenario but others will require application of this technique. Linear Programming Linear programming involves preparing graphs. Many students often discover that whilst they felt confident with these techniques in class, the reality of attempting these on their own is more difficult than they had envisaged so it is important to practise these techniques now. Try to memorise the steps involved in a linear programming problem and remember that the simultaneous equations prepared to discover the optimal point are for the two lines on the graph that intersect at the optimal point. (This will not necessarily be for labour and materials!)
Key skills
You should realise that you have already begun to learn some of the key skills required to do well in the P2 exam. Clear presentation is essential so that the examiner can follow and understand your answer.
55
CHECKPOINT 1
Checkpoint 1 Study Support

Chapter 1 - Relevant costs and short term decisions
Key areas - use the online lectures to selectively review these if you need to The definitions of relevant cost and opportunity cost The relevant cost of materials and labour Course Notes This is a key chapter that underpins many sections of the course. Review the relevant cost charts in sections 1.4 and 1.5 and make sure you understand them. Run through the examples once more to ensure you have got to grips of the fundamentals of relevant costing Ensure you can list the non financial factors that would be considered as part of the decision making process Question Practice Attempt Q1 from the Q&A Bank at the back of your course notes. This is a good example of how further processing is examined. If youre not completely comfortable with relevant costing attempt Q2 which looks at a minimum price scenario. There are often marks for your assumptions as well as your calculations so start to get in the habit of detailing why each item is / is not relevant. (This would take 20 mins) Additional Resources - Study Text Review section 7 (Chapter 1a) which looks at relevant costs in relation to accounting concepts. Read section 8 (Chapter 1a) to appreciate the qualitative factors involved in decision making. If your memory on joint costs is hazy read through section 9 (Chapter 1b). Joint costs / further processing has been examined several times. 5 mins 5 mins 10 mins 5 mins 15 mins 5 mins
65 mins
20 mins
Chapter 2 - Limiting factor analysis

Key areas - use the online lectures to selectively review these if you need to Single limiting factors Shadow price Course Notes Despite being brought forward knowledge, single limiting factors are often examined. If you feel unsure about any element of this chapter it is important that you revisit it and work through the appropriate examples again. Question Practice Attempt Q3. This limiting factor question will give you a flavour for how this topic which is brought forward knowledge is examined at P2.
15 mins
15 mins
56
CHECKPOINT 1
Chapter 3 - Linear programming: the graphical method

Key areas - use the online lectures to selectively review these if you need to The steps required in solving a linear programming problem. Shadow prices Course Notes Work through the examples in this chapter again to ensure you are happy with these techniques Question Practice Q4 (b) from the Question and Answer Bank in the back of the course notes will give you additional practice of using this technique and the other types of requirement that can feature in these questions. It is important to practice as many of these questions as you can, to become quicker at what can be a time consuming technique. Additional Resources Study Text Make sure you understand that a shadow price will only apply until that item ceases to be the limiting factor. See section 3.1.3.
95 mins
40 mins
45 mins
10 mins
Chapter 4 - Linear programming: the simplex method

Key areas - use the online lectures to selectively review these if you need to Addition of slack variables to produce equations Interpretation of computer output Course Notes Review the three key elements in this chapter. Formulating the model, preparing the initial tableau and interpreting the output from a linear programming package. Question Practice Q5 in the Question and Answer Bank in the back of the course notes involves formulating a model where slack variables are required. Attempt this to make sure you are comfortable with the changes to the linear programming model that slack variables require. Additional Resources Study Text Review section 4 - Using linear programming, as these theoretical aspects could come into a narrative requirement
35 mins
15 mins
10 mins
10 mins
57
CHECKPOINT 1
Checkpoint 1 Progress Test

Having completed the Study Support guidance for Checkpoint 1, you are now ready to attempt Progress Test 1. You should aim to complete the test in 1 hours. If you find it takes you significantly longer to do so then please contact your course tutor for guidance. The test starts with some multiple choice and short calculation questions. These test your understanding of the material and your ability to perform calculations required. Note that the P2 exam does not contain multiple choice questions. Three short written questions follow. These test your ability to explain and apply your knowledge. These help to prepare you for the discursive elements of the exam. It is important that you continually review your progress and revise further any areas where you feel your understanding is weak.
A
1
Multiple choice questions (10 questions approximate time 45 minutes)

Roger is considering undertaking a contract which will yield income of $15,000 over a 15-month period. To carry out the contract he will have to use 1,000 kg of material. 800 kg is already held in stock and cost $15 per kg. The current replacement cost is $20 per kg. If not used for the contract the material would be sold to Moore Ltd for $2,000 in total. Roger could utilise his old machine for the contract if conversion costs of $5,000 are undertaken. Alternatively, he could scrap his old machine and receive $3,000 and hire another one at a cost of $500 per month. Labour currently has spare capacity and variable overheads are estimated to be $1 per hour. 2,000 hours are believed to be required for the period of the contract. What is the net relevant cash flow for the contract? (Ignore the time value of money) A B C D $2,000 $2,500 $4,000 $4,500
(2 marks)
Pobble plc is in the process of preparing a quotation for a special order. The job will require 255 units of material M. 210 units, which originally cost $50 per unit, are in stock. Net realisable value per unit is $30 and replacement cost is $72 per unit. The only other use for the material is to use as a substitute for 375 units of material N which currently costs $25 per unit. What is the relevant cost of material M for the special order? (2 marks)
Top has limited factory capacity measured in labour hours and a decision must be made whether to make or buy product X. Supplies of X can be purchased for $12 per unit. If X is made each unit costs $5 in raw materials and requires 3 labour hours. Labour is paid at $1.50 per hour. Labour is currently working to capacity making product Y which earns a contribution of $2 per unit, each unit needing 5 labour hours. Which one of the following statements is true? A B C D Top should be indifferent between making or buying X since the labour will be fully utilised in any case Top should make X because it is $3.50 per unit cheaper than purchasing Top should buy X because it is $5.80 per unit cheaper than making Top should make X because it is $1.30 per unit cheaper than buying X (2 marks)
58
CHECKPOINT 1
Rhonda Bout Limited uses three components, P, Q and R, in its main product. The budget for next year indicates a requirement for 3,000 of each component. The components are all manufactured on the same machine, for which only 50,000 machine hours are available next year. The variable cost of internal manufacture of each component, together with the machine hours used, are shown in the table below. The table also shows the prices quoted by a sub-contractor for supplying the components. Component P Q R Machine hours per unit 9 5 12 Variable cost $ per unit 45 70 56 Sub-contractor price, $/unit 65 78 80
Calculate the minimum total cost at which Rhonda Bout can obtain the full requirement of components. (5 marks) 5 When deciding, purely on financial grounds, whether or not to process a joint product, the information required is: (i) (ii) (iii) (iv) (v) A B C D 6 The value of the common process costs The method of apportioning the common costs between the joint products The sales value of the joint products at the separation point The final sales value of the joint product The further processing cost of the joint product (iii), (iv) and (v) (i), (ii) and (iii) (iv) and (v) All of the above
(2 marks)
A division of a firm has three product lines X, Y and Z. Last year's results are as follows: X $'000 220 (40) (20) (30) (20) (22) (5) 83 Y $'000 150 (20) (80) (15) (50) (15) (5) (35) Z $'000 130 (60) (30) (45) (25) (13) (5) (48)
Sales Direct labour Direct materials Fixed overheads Distribution costs Selling costs Fixed admin. overhead Net profit/(loss)
(allocated on direct labour cost basis) (variable element is 50% of direct material cost) (commissions proportional to sales) (allocated equally to product lines)
No fixed overheads are directly attributable to a product line. The division's operations are independent of the rest of the firm. The overall firm's profit could be increased by closing down product line(s) A B C D Y only Z only Y and Z X, Y and Z
(2 marks)
59
CHECKPOINT 1
A company manufactures two products, S and T. Both products use the same type of resources, with the following revenue/cost data per unit: Selling price Direct materials ($4/kg) Direct labour ($6/hr) Fixed overhead ($3/hr) Profit Product S $40 (8) (18) (9) $5 Product T $30 (12) (6) (3) $9
Only 15,000 kg of material are available in the short-term, compared with 20,000 labour hours. Maximum demand for the products is 5,000 units and 2,000 units for S and T, respectively. The fixed overhead absorption rate is based upon the maximum sales demand levels; none of the fixed overheads is avoidable. Calculate the maximum amount of profit (to the nearest $'000) that the company can earn. (4 marks)
Data for questions 8 and 9

A computer package has been used to solve a linear programming problem for PD Ltd. The output is as follows: Variables X Y Constraints S1 S2 S3 S4 S5 Contribution 430 180 38,200 2.34 7.60 50 1,100 $171,900
Which of the following statements is correct with regard to this output? A B C D There is no spare capacity/surplus of the factors associated with S1, S4 and S5 There is no spare capacity/surplus of the factors associated with S2, S3 PD Ltd would be willing to purchase unlimited amounts of the factors associated with S2 and S3 (2 marks) 50 is the shadow price of the factor associated with S5 Purchase more of the factor associated with S2 from an alternative supplier at a price of $2.50. Alter the production process so that the factor associated with S1 can be used instead of that for S2 and S3. Find an alternative supplier of the factor associated with S3, and pay up to $7.60 over the original price. All options Options (i) and (iii) Options (ii) and (iii) Options (i) and (ii)
PD Ltd has a number of options available to it to alleviate or avoid its limiting factor problems. (i) (ii) (iii)
Which combination of these will increase contribution? A B C D
(2 marks)
60
CHECKPOINT 1
10
Hilliard enterprises use linear programming to establish their optimal production plan. Next year materials and labour are likely to be in short supply. Details of Hilliards products are as follows: K $ 6 30 5 41 50 9 P $ 8 18 3 29 52 23
Materials (at $2 per kg) Labour (at $6 per hour) Variable overheads (at $1 per hour) Variable cost Selling price Contribution
There are only 30,000 kg of material and 36,000 labour hours available. The company also has an agreement to supply 1,000 units of product K which must be met. Formulate the linear programming model that will maximise contribution. You are not required to attempt a solution (3 marks)
B
1 2 3
Short written questions (3 questions approximate time 25 minutes)

Explain why the financial profits may be different to the profits recorded on a relevant cost basis (5 marks) Explain what is meant by slack and surplus (4 marks) The optimal solution that has been derived for company ABC shows that the shadow price for labour is $7.33 and for material is $0. Explain the relevance of these values for ABC END OF PROGRESS TEST 1 (4 marks)
61
CHECKPOINT 1
Checkpoint 1 Progress Test Solutions

Section A
1 B Revenue Material: 200 kg $20 Scrap proceeds forgone Machine: Use old machine Scrap old machine and hire another: $3,000 (15 $500) Labour: Spare capacity Variable overheads: 2,000 $1 2 Units 255 210 45 $ $ 15,000 (4,000) (2,000) (5,000) (4,500) (4,500) (2,000) 2,500
required in stock to purchase $ 3,240 9,375 12,615 $30 210 $25 375 $6,300 $9,375 $ 5.00 4.50 1.20 10.70 12.00 1.30
Purchase cost: 45 units $72 In stock: opportunity cost (W1) (W1) Higher of 3 D NRV Material N
Relevant cost of making : Cost of making X Raw materials Labour (basic cost: 3 hrs at $1.50/hr) Lost contribution ($2 3/5) Cost of buying Additional cost of buying ie. making $1.30 cheaper than buying.
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CHECKPOINT 1
This is a make-or-buy decision involving a limiting factor. If all of the components are manufactured in-house, 78,000 machine hours will be required. Some sub-contracting will therefore be necessary, since only 50,000 machine hours are available. Costs can be kept at their lowest by minimising the extra variable costs of sub-contracting per machine hour saved. P Q R $ $ $ Variable cost of manufacture 45 70 56 78 80 Sub-contractor price 65 Extra cost of buying 20 8 24 Machine hours saved by buying 9 5 12 Extra cost of buying per hour saved $2.22 $1.60 $2.00 The priority for internal manufacture will be in the order: P, R, Q. This will minimise the extra cost of buying per hour saved. The production and purchasing plan for components should therefore be: Hours used Cost $ Manufacture 27,000 135,000 3,000 P ( 9 hrs) ( $45) 107,296 22,992 ( $56) 1,916 R ( 12 hrs) 49,992 Purchase 86,720 1,084 R (balance of requirement) ( $80) ($78) 234,000 3,000 Q Minimum cost of satisfying component requirements 563,016
5 6
A A Sales Direct costs Variable distribution Selling costs Only Y is negative ... close down. X $'000 220 (60) 160 (10) (22) 128 Y $'000 150 (100) 50 (40) (15) (5) Z $'000 130 (90) 40 (15) (13) 12
7 S 5,000 units require T 2,000 units require ... maximum demand requires: Labour 15,000 2,000 17,000 hrs and S $14 2 7 1st Units 5,000 1,666 Materials 10,000 6,000 16,000 kg T $12 3 4 2nd Kg 10,000 5,000 15,000
... materials are the limiting factor as only 15,000 kg are available. Contribution/unit Materials (kg) / unit Contribution/kg Rank Produce S T
63
CHECKPOINT 1
Profit = contribution fixed costs ... maximum profit = = = (5,000 $14) + (1,666 $12) ($45,000 + $6,000) $70,000 + $19,992 $51,000 $38,992
8 9 10
B C The shadow price of $2.34 and $7.60 indicate the extra amount to pay for the resources.
Define variables. Let k = number of units of Product K to be produced p = number of units of Product P to be produced Formulate the objective function Contributions earned from Products K and P are $9 and $23 per unit respectively. The objective function is therefore 9k + 23p Establish constraints Materials constraint Labour constraints Minimum supply Product K Non-negativity constraint Workings (1) (2) Product K requires 3kg material ($6 $2 per kg) Product P requires 4kg material ($8 $2 per kg) Product K requires 5 labour hours ($30 $6 per hour) Product P requires 3 labour hours ($18 $6 per hour) 3k + 4p 30,000 (see W1) 5k + 3p 36,000 (see W2) k 1,000 p0
Section B
1 Financial accounts are prepared under an accruals basis. In other words, income and expenditure is recorded in the period it relates to, not when cash is physically received or paid. The financial accounts are also prepared according to absorption costing where an allocation of fixed overheads is made to the cost of units. Under relevant costing principles neither of these two items occur. Any costs that have already been spent or committed to are excluded. General overheads are not included as they occur regardless of whether or not the project being assessed takes place. Depreciation is not a cashflow and so would also be ignored on a relevant cost basis. Not all variable costs will be deemed relevant. For example, if labour is not fully utilised, it can work on the project without incurring additional cost and so labour would not be charged to the project. 2 Slack occurs when maximum availability of a resource is not used. ie we have 5,000 litres available 4,000 litres are used in production, so there are 1,000 litres spare or 1,000 litres of slack. If, at the optimal solution, the resource used equals the resource available, the constraint is binding and there is no slack . Surplus is when more than the minimum requirement is made. ie there may be a requirement for minimum production to be 1,000 units. If 1,200 units are made there are 200 surplus units.
64
CHECKPOINT 1
The shadow price is the extra contribution that would be achieved if one more unit of a limiting factor were available. The shadow price for labour here is $7.33. This means that we would be prepared to pay up to an extra $7.33 ie $7.33 above the existing cost of labour/hour to obtain more of it. Labour is therefore a binding constraint, it is restricting the amount of units we can make. If we had more labour we would be able to make more units. The shadow price for material however is $0. We would not pay any more than the existing cost of the material to obtain more. This indicates that the material is not a binding constraint. We still have supplies of material that are not used in meeting our optimal production plan.
65
CHECKPOINT 1
Checkpoint 1 - Real-life Examples

The management guide to fast food
T H E
Can consumers eat a nutritious meal at McDonalds? This question fell to us as business students, not nutritionists. We used powerful statistical tools to select a series of menus promoting health, variety and consumer preference. To solve this problem, we did what all good marketing students do: analysed customer needs. To quantify nutritional requirements, we collected standards from the US Food and Drug Administration and the United Nations. These standards vary according to height, weight, age, and activity level. We also collected nutritional information on every product on McDonalds menu. But this data is only enough to select one meal how boring. Consumers can go to McDonalds seven days a week, for breakfast, lunch, and dinner. We wanted to choose a weeks worth of delicious selections. First, we identified which selections were breakfast, lunch, and/or dinner options. We also identified items as beverages, side dishes, entres, and desserts to create balanced meals and allowed consumers to express preferences (more Big Macs, the number of sugars for coffee). These decision criteria were defined mathematically and analysed using linear and goal programming. Linear programming is frequently used in business, with complex algorithms driving supply chain management software tools. Essentially, linear programming takes minimisation and maximisation conditions a little less sodium, a little more vitamin C, trade that optional dessert for your favourite French fries to select the optimal outcome meeting those conditions. If no optimum is possible, goal programming can be used to pick an alternative, and to show how close to the optimal goal the choice is. So how does McDonalds stack up? For the Editor of Career, no optimum menu was possible not enough iron, too much sodium. Still, with our added intelligence, consumers can choose a much better menu, much closer to nutritional goals than most people would expect. If only we had also designed an optimal exercise schedule. These decision criteria were defined mathematically and analysed using linear and goal programming. Linear programming is frequently used in business, with complex algorithms driving supply chain management software tools. Essentially, linear programming takes minimisation and maximisation conditions a little less sodium, a little more vitamin C, trade that optional dessert for your favourite French fries to select the optimal outcome meeting those conditions. If no optimum is possible, goal programming can be used to pick an alternative, and to show how close to the optimal goal the choice is. So how does McDonalds stack up? For the Editor of Career, no optimum menu was possible not enough iron, too much sodium. Still, with our added intelligence, consumers can choose a much better menu, much closer to nutritional goals than most people would expect. If only we had also designed an optimal exercise schedule.
66
Multi-product breakeven analysis
5
Example past paper questions May 06, Q7(c, d & e), 14 marks New to the 2010 syllabus

Syllabus learning outcomes Interpret variable/fixed cost analysis in multiple product contexts to breakeven analysis and product mix decision-making. Analyse the impact of uncertainty and risk on decision models based on CVP analysis How syllabus outcomes are examined This question required contribution to sales ratios be calculated and a multi product profit volume chart to be prepared along with a discussion of its limitations. These questions are likely to involve calculations looking at the probability of breaking even or sensitivity analysis
67
5: MULTI-PRODUCT BREAKEVEN ANALYSIS
Overview
Breakeven analysis
CVP analysis
Risk and Uncertainty
Single product
Multi-product
Normal Distribution
Sensitivity Analysis
68
1
1.1 1.2
Cost-volume-profit analysis (CVP analysis)

CVP analysis concerns the relationship between sales volume and profit. Most businesses need to at least breakeven when setting prices and output levels.
Introduction
Assumptions
1.3 Constant.. (a) (b) (c) 1.4 Selling price per unit Variable cost per unit Total fixed costs
These lead to linear relationships for volume and sales revenue. This can also be described as perfect competition.
2
2.1
Single product breakeven analysis

Breakeven point =
Fixed costs Unit contribution
Contribution/Sales ratio =
Contribution / unit Selling price / unit or Breakeven point x selling price/ unit
Fixed costs + target profit Unit contribution
Breakeven revenue =
Fixed costs C/S ratio
Output required for target profit =
Margin of safety = Budgeted sales Breakeven sales Margin of safety (%) = Budgeted sales - Breakeven sales Budgeted sales
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3
3.1
Multi-product breakeven analysis

A serious limitation of breakeven analysis is that it can only be used for single products. This analysis can be expanded for a 'single' mix of products using a weighted average contribution figure.
Introduction
Formulae
3.2 Breakeven point = Fixed costs Weighted average unit contribution
Fixed costs Weighted average C/S ratio
Breakeven revenue =
Lecture example 1
United Trading sells three products as follows. Product Selling price Variable costs Budgeted sales (units) Fixed costs are $20,000.
Required Footballs $ 7 3 2,000
Baseballs $ 6 4.50 4,000
Rugby balls $ 9 5 3,000
Assume that the sales mix is 'fixed' in these proportions.
(a) (b)
What is the breakeven sales volume? What is the breakeven sales revenue?
Solution
70
Sections 5 & 6 Target profits and margin of safety for multiple products
71
Graphs
3.3 Graphs can also be used in multi-product situations to indicate the relationships between cost, revenue and volume.
Lecture example 2
Required
Sketch a breakeven chart for Lecture example 1, indicating the profit at budgeted sales.
Solution
Workings Budget
Units 2,000 4,000 3,000
Football Baseball Rugby ball
SP $ 7 6 9
Revenue $
VC 3 4.50 5
Costs
Fixed costs
72

$000 Cost and revenues Multi-product break-even chart
70 60 50 40 30 20 10 0 2,000 4,000 6,000 8,000 10,000 Output volume (units)
73
5: MULTI-PRODUCT BREAKEVEN ANALYSIS 3.4 3.5 Multi-product P/V charts can also be produced which plot each of the products individually, so allowing their profitability to be compared. Products are plotted in the order of their contribution / sales ratio.
Lecture example 3
Required
Sketch a multi-product P/V chart for Lecture example 1.
Solution
Workings
Football Baseball Rugby ball
Revenue $ 14,000 24,000 27,000 65,000
VC $ 6,000 18,000 15,000 39,000
Contribution
C/S ratio
Cumulative revenue $ Football Rugby ball Baseball
Cumulative profit $
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5: MULTI-PRODUCT BREAKEVEN ANALYSIS Multi-product P/V chart

Profit/ Loss $ 6,000
15
30
45
60
75
Revenue $000
12,000
20,000
75
4
4.1 4.2 4.3
Impact of risk and uncertainty on CVP analysis

The assumptions in CVP about costs and revenues are all estimates and so cannot be predicted with certainty. However, if past experience enables the decision maker to predict with some accuracy the probability occurring, the decision is said to be subject to risk. Techniques such as probability and normal distributions enable risk to be accounted for. Sensitivity analysis is a tool which can help deal with uncertainty.
5
5.1
Normal distribution
The normal distribution is often described as a bell-shaped curve.
50
50
When using the normal distribution we will use the to define the mean and to define standard deviation. 5.2 The total area under the curve = 1 or 100% of the population. The normal distribution is always symmetrical around the mean. Consequently, the area either side of the mean represents 50%. Distances from the mean in the normal distribution are always measured by the number of standard deviations they represent. This is known as a Z-score - the number of standard deviations from the mean. Z= 5.4
5.3
Normal distribution tables (given in the exam) give the relationship between % of population and Z-score for any Z-score.
76
Lecture example 4
United Trading is now looking at making and selling cricket balls. The balls will be sold for $7 each and incur variable costs of $4. Fixed costs are expected to be $9,000. United Trading expect mean demand to be 3,500 units, They anticipate that sales will be normally distributed with a standard deviation of 400 units.
Required
Calculate the probability of the cricket balls at least breaking even
Solution
77
Lecture example 5
United Trading is now looking at making and selling cricket balls. The balls will be sold for $7 each and incur variable costs of $4. Fixed costs are expected to be $9,000. United Trading expect mean demand to be 3,500 units, They anticipate that sales will be normally distributed with a standard deviation of 400 units.
Required
Calculate the probability of the cricket balls making at least $2,500 profit.
Solution
78
6
6.1 6.2
Sensitivity analysis
Sensitivity analysis is a technique where decision options are tested for their vulnerability to changes in a variable. There are two approaches to sensitivity analysis are. (a) (b) Calculating the maximum percentage change in a variable before the decision would change. Assessing if the decision would change if a variable changed by x% of estimate.
6.3
Sensitivity analysis concentrates management attention on variables that are the most important for the decision under review.
Lecture example 6
Columbus makes and sells a single product the Raleigh. Financial data concerning this product is as follows: Selling price Direct materials Direct labour $ /unit 120 30 25
Fixed overheads for the month are expected to be $30,000 Anticipated sales are 750 units Some uncertainty has now arisen over the level of likely cost expected in the production of Raleigh.
Required
(a) (b)
Calculate the impact on the margin of safety if material costs increase by 5%. Calculate the maximum % increase in fixed costs possible that will still allow Columbus to break even (assuming material is $30 / unit)
Solution
79
80
Chapter summary
Section Topic CVP analysis assumptions Single product breakeven analysis Multi product breakeven analysis Summary
1 2 3
Constant selling price, variable costs and fixed costs. Breakeven point = Fixed costs contribution/unit
Multi-product breakeven analysis can only be performed if a constant product sales mix is assumed. Breakeven point = Fixed costs Weighted average contribution/unit
On a PV chart, products should be plotted individually in order of the size of their c/s ratio. 4
Impact of risk & uncertainty on CVP analysis Normal distribution
CVP calculations are forecasts and as such are subject to risk and uncertainty. Normal distribution helps account for risk by calculating the probability of breaking even. This technique can be used when the average figure for a variable or its standard deviation can be forecast. Sensitivity can be used to assess risk if one of the variables should change.
Sensitivity analysis
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Pricing decisions
6
How syllabus outcomes are examined Example past paper questions These discussion questions Nov 05, Q3, 10 marks have focussed on advantages Nov 06, Q5(a), 6 marks and disadvantages of the May 07, Q6(b), 10 marks various cost plus approaches and discussion of their value / appropriateness Optimal pricing was examined very frequently under the old syllabus for a small amount of marks. Generally the aim is to maximise profit. Discussions of various pricing strategies that may be adopted. May 06, Q5(b), 8 marks Nov 07, Q3, 10 marks Nov 08, Q6(a), 10 marks

Syllabus learning outcomes Discuss the particular issues that arise in pricing decisions and the conflict between 'marginal cost' principles and the need for full recovery of all costs incurred. Apply an approach to pricing based on profit maximisation in imperfect markets.
Discuss the financial consequences of alternative pricing strategies.
Previous syllabus Pilot Paper, Q7(b), 15 marks Nov 08, Q6(b), 15 marks
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6: PRICING DECISIONS
Overview
Pricing decisions
Price elasticity %x %P Demand function P = a bx Optimal pricing
Nature of the Product Life Cycle
Profit MR = MC
Revenue MR = 0
84
Pricing decisions Approaches and strategies
Cost plus Full cost Marginal cost Relevant cost Mark-up Margin
New products Penetration Skimming
Other Premium Discrimination Differentiation Product bundling Loss leaders Controlled pricing
85
1
1.1 1.2
Price elasticity
Economic theory states that the higher the price charged the less demand there will be for normal goods. Price elasticity of demand (PED) is a measure of the responsiveness of demand (x) to changes in price (P). Some products are more responsive than others. PED is calculated =
1.3
% change in x % change in P
When PED > 1: the product is described as having elastic demand. This means that a small change in price will cause a proportionately greater change in quantity demanded. When PED < 1: the opposite applies. Prices can be changed greatly without creating large changes in demand. 1.4 Factors determining elasticity of demand include the following. (a) (b) (c) (d) Availability of substitutes Disposable income Tastes and fashions Necessities or luxuries
Section 2 Other issues that influence pricing decisions
2
2.1 2.2 2.3
Nature of the product life cycle (PLC)

The PLC determines the volume of a good or service demanded over time. As sales volumes vary over time, it follows that profits are also likely to change.
$ Development
Introduction
Growth
Maturity
Decline
Revenue
TIME Profit
86
2.4
Stage Sales Volume
Development Introduction Growth Maturity Decline
None Very low levels Rapid increase Stable, high volume Falling demand
An understanding of the stage a product is at is important in determining the price for a product.
3
3.1
Demand function
Price will affect the quantity demanded for a product. Output considerations will alter the price to be charged. If the demand function is known, and the desired output has been calculated, the appropriate price can be determined for the product. Demand functions are usually downward sloping demand falls when price rises and vice versa due to the fact that the market is usually one of imperfect competition. ($) P
3.2
X (units)
Demand functions, in practice, may not be linear. There are two methods to solve the optimal price and quantity that can be examined:

Tabular approach Algebraic approach
For the algebraic approach it is necessary for the demand function to be in the form P = a - bx P x a b = = = = selling price quantity demanded at that price theoretical maximum price. If price is set at 'a' or above, demand will be zero change in price change in quantity Gradient of line. Represents the change in price required to change demand by 1 unit
87
4
4.1
Optimal pricing
The desired level of output can be determined graphically by plotting total cost and total revenue lines. This is another breakeven chart, as used by economists. $ MR Profit MC TR TC
Optimal output 4.2 4.3 4.4 4.5 4.6
The gradient of the total revenue line is known as the marginal revenue (MR). It is the increase in total revenue from selling one more unit. The gradient of the total cost line is known as the marginal cost (MC). It is the increase in total cost from producing one more unit. This analysis can be used to ensure the company reaches its objective. Profit is maximised where the gradients are equal, ie where marginal revenue = marginal cost. Revenue is maximised when the slope of the revenue curve is flat ie where MR = 0. $ MR TR
X Optimal output
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Optimal pricing approach

Step 1 Step 2 Step 3 Step 4 Solve the demand function. Make the MR equation given equal to the value of MC or 0 as appropriate. Substitute the values found for a and b in step 1 into the MR formulae and solve. Take the quantity found in step 3 and put this into the demand function to find the price that should be charged
Lecture example 1
A firm charges $12 per unit for its product. At this price it sells 16,000 units. Research has shown that when prices were changed by $1 per unit sales changed by 2,500 units. The product has a constant variable cost per unit of $5. The demand function is given by P = a bx. The marginal revenue will be MR = a 2bx.
Required
(a) (b) (c) (d)
Determine the demand function Determine the output level to maximise profit Determine the price to be charged to maximise profit Determine the price that should be charged to maximise revenue
Solution
89
Q6 Optimal Pricing
90
Tabular approach
4.7 One approach to determining the profit maximising production plan is to calculate the extra (marginal) costs and revenues at different combinations of output and selling price.
Lecture example 2
Output (Units) 10 Total Cost $ 10 MC $ Selling Price $ 5.00 Total Revenue $ MR $
Profit $
20 30 40 50 60
Required
25 45 70 100 135
4.50 4.00 3.50 3.00 2.50
Determine the output level and selling price that will maximise profit.
4.8 4.9
A tabular approach assumes that only discrete variables exist, ie that either 30 or 40 units can be sold, not, say, 35. The use of equations can solve this problem. Tabular approaches can be used in all circumstances. Equations will only be tested in P2 when the demand function is linear.
5
5.1
Practical pricing
Optimal pricing can be difficult to apply in practice. Demand functions are uncertain and the relationship between price and quantity may change over time. Cost functions will need to be forecasted but, being internal to the business, may be more reliable than demand/price relationships, especially if historic data is available.
91
Cost plus pricing

5.2 The price of the product is calculated by adding an appropriate profit mark-up to the product's cost. The cost used could be:

Full Cost (Absorption Cost) Full Cost (ABC) Marginal Cost Relevant Cost Standard Cost
Cost plus strategies
Strategy All Cost Plus Methods
Advantages
Easily calculated Readily determined Doesn't require or assume a linear and stable price or quantity relationship
Disadvantages
It ignores the impact that the price will have on quantity demanded and competitors It will not therefore maximise profit
Full / Absorption
Ensures each unit sold is profitable If sales meet expectations, will be profitable
May result in too high a price, meaning units will not be sold If the basis of absorbing overheads changes, price of product will change. Thus absorption costing methods require accurate overhead costing and activity level forecasting Could result in wrong decisions around price and product mix if overheads absorbed inappropriately If sales fall short of targets may make a loss
Marginal
Suitable for short term pricing, but need to ensure cover fixed costs if setting prices for the longer term Appropriate for one-offs Appropriate when have spare capacity
May not be enough to cover fixed costs and therefore could drive losses
Relevant cost
Inappropriate for use in the longer term as will not cover fixed costs Pricing of any repeat orders may be difficult. Customers will not expect prices to rise unless extra benefit is received Standards may be out of date.
Standard cost
Encourages cost control
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6
6.1 6.2
Pricing strategies for new products

A policy of low prices when the product is first launched to obtain sales volume and market share. Useful if: (a) (b) (c) the firm wants to discourage new entrants into the market the firm wishes to shorten the initial period of the product's life cycle there are significant economies of scale to be achieved
Market penetration
Market skimming
6.3
Pricing strategy leaves room for discounts later
Involves charging high prices when a product is first launched and spending heavily on advertising and sales promotion to obtain sales. As the product moves into the later stages of its life cycle (growth, maturity and decline) progressively lower prices will be charged. The aim of market skimming is to gain high unit profits early in the product's life. Useful if: (a) (b) the product is new and different, so that customers are prepared to pay high prices to be 'one up' on people who do not own it. the product has a short life cycle and needs to recover development costs and make a profit quickly.
6.4
7
7.1
Other pricing strategies

Making a product appear 'different' so as to justify a premium price. The product may be different in terms of quality, reliability, durability, after-sales service or extended warranties. Heavy advertising can establish brand loyalty which can help to sustain a premium.
Premium pricing
Price discrimination
7.2
New laws to stop British internet price rip offs
When a company can sell into two or more separate markets, it might be able to charge a different price in each market. To be successful the company must prevent the transfer of goods from the cheap market to the more expensive one.
Product differentiation
7.3 Different versions of products enable a higher price to be charged, optional extras may be one way of achieving this.
93
Product bundling
7.4 Selling a number of products or services as a package at a price lower than the aggregate of their individual prices.
Loss leaders
7.5 Particularly useful in retailing, a very low price is charged for one product, which is intended to make consumers buy additional products in the range that carry higher profit margins.
Controlled pricing
7.6 Monopolies have the potential power to charge very high prices for their goods/services as demand is inelastic. Frequently monopolies are regulated to ensure customers receive value for money.
94
Chapter summary
Section Topic Price elasticity Summary
Price elasticity of demand (PED) is calculated as % change in x . % change in P Demand is elastic when PED > 1. If prices are decreased slightly, demand will increase to a greater extent.
The product lifecycle Demand function
Demand will be based on:

the stage of the product life cycle the pricing strategy adopted.
When equations are used, the relationship between price and quantity is assumed to be linear. P = a bx Where P = price x = quantity demanded a = price at which demand is nil b = amount by which the price must fall to sell one more unit of the product
Optimal pricing
The output level to maximise profit is found when MR = MC. The output level to maximise revenue is where MR = 0. Prices at these output levels can then be determined from the demand function.
5 6 7
Cost plus pricing
Cost plus-based pricing is often used in practice as marginal cost and revenues can be difficult to identify.
Pricing strategies Market penetration and market skimming approaches are for new products suitable strategies for new product pricing. Other pricing strategies
When products can be differentiated from those of the competition, premium pricing and price discrimination become possible.
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96
Cost planning
7
How syllabus outcomes are examined Discussion question contrasting the two techniques and explanation as to how to implement Value Analysis Calculation of learning rate or the time taken to complete a certain number of units is frequently examined in both sections of the exam. Questions will often include discussion elements on areas such as reasons for the actual learning rate being different to expected. Target costing has been examined via a contrast with standard costing. Example past paper questions May 06, Q3, 10 marks Nov 07, Q2, 10 marks May 08, Q4, 10 marks May 09, Q6 (a & b), 8 marks May 10, Q1 (a), 4 marks

Syllabus learning outcomes Compare and contrast value analysis and functional cost analysis. Explain and apply learning curves to estimate time and cost for new products and services.
Explain how target costs can be derived from target prices and describe the relationship between target costs and standard costs. Discuss the concept of life cycle costing and how life cycle costs interact with marketing strategies at each stage of the life cycle.
May 06, Q5(c), 7 marks Nov 08, Q4(a), 7 marks
Candidates have been asked to prepare cost calculations for the latter two stages of the lifecycle and discuss reasons for changes in costs and prices. This area often links with pricing questions concerning which strategies should be adopted at various stages of the product life cycle.
Nov 06, Q3, 10 marks May 05 Q 7(a), 10 marks May 10, Q2, 10 marks
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7: COST PLANNING
Overview
Cost planning
Learning curves
Theory
Formula
Calculating the learning rate
Conditions
Steady state
98
7: COST PLANNING
Overview
Cost planning
Life cycle costing
Value analysis
Target costing
Functional analysis
99
7: COST PLANNING
1
1.1 1.2
Managing future costs

Calculating costs of established products and services made using established methods is relatively straightforward. Standards and budgets can be set. Costing new products and services is inherently uncertain. Modern business environments tend to:

be highly automated have short production runs involve short product life cycles hold lower levels of inventory
1.3
New costing techniques will be required.
2
2.1
Learning curve theory

When new working practices or products are introduced, the theory is that as a workforce gains experience in a task, it will come to perform that task more quickly. This means that labour costs and variable overheads (if labour hour driven) will be lower in later periods of production than initial periods.
Introduction
Conditions
2.2 The theory of learning curves will only hold if the following conditions apply: (a) (b) (c) (d) (e) (f) There is a significant manual element in the task being considered. The task must be repetitive. Production must be at an early stage so that there is room for improvement. There must be consistency in the workforce. There must not be extensive breaks in production, or workers will 'forget' the skill. Workforce is motivated.
Rule
2.3
Section 1.7 The relevance of learning curve effects in management accounting
As cumulative output doubles, the cumulative average time per unit falls to a given percentage of the previous cumulative average time per unit.
100
7: COST PLANNING 2.4 This can be shown in the form of a graph. y
Formula
2.5 Yx= aXb where Yx a X b is the cumulative average time per unit taken to produce X units is the time taken to produce the first unit is the cumulative number of units log r is the index of learning (calculated as where r is the learning rate) log 2
Steady state
2.6 Eventually, the time per unit will reach a steady state where no further improvement can be made.
Cessation of learning effect

2.7 There are practical reasons for the learning effect to cease. (a) (b) (c) When machine efficiency restricts any further improvement. The workforce reach their physical limits. There is a go-slow agreement among the workforce.
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7: COST PLANNING
Lecture example 1
A firm's workforce experiences a 75% learning rate.
Output (batches) 1 2 4 8 Required Total time (hours)
Cumulative average time (hours)
If the budgeted time for the first batch is 100 hours, calculate the time needed to produce the following. (a) (b) (c) The first eight batches in total The first ten batches in total The tenth batch only
Solution
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7: COST PLANNING
Calculating the actual learning rate

2.8 The actual learning rate achieved may not be the same as that expected. You could be asked to calculate the actual rate of learning in the exam and to comment on why this may be different to the expected learning rate.
Lecture example 2
A company has recently developed a new product.
The time taken to make the first unit was 20 minutes. The average time taken for the first 8 units was 12.5 minutes per unit. The company had anticipated achieving a learning rate of 80%
Required
(a) (b)
Calculate the rate of learning that occurred State possible reasons why the actual learning rates differed from the expected learning rates.
Solution
Q7 Learning curves 2
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7: COST PLANNING
3
3.1 3.2 3.3
Life cycle costing

Life cycle costing aims to cost a product, service, customer or project over its entire life cycle with the aim of maximising the return over the total life while minimising costs. Traditional accounting relates costs and revenues to time periods (months, years). This makes it difficult to see total profitability. Product life cycle costing considers all the costs that will be incurred from design to abandonment of a new product and compares these to the revenues that can be generated from selling this product at different target prices throughout the product's life.
Product life cycle

3.4
3.5 3.6
Products at the introduction or growth stage cannot be expected to generate cash as reinvestment will be required. In maturity and decline, profit and cash should be expected.
Characteristics of the PLC

3.7
Stage Characteristics Costs
Development No sales Introduction Initially very low levels of demand.
Research & development Very high fixed costs (eg fixed (non-current) assets, and advertising) Cost per unit falls as the products benefits from economies of scale. Some fixed costs increase (eg number of non-current assets)
Growth
Rapid increase in sales Try to establish market share Profitable stage can be the most profitable stage if you are the first company in the market
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7: COST PLANNING Stage Characteristics Costs
Maturity
Increase in demand slows and a stable level of sales achieved. Products often differentiated to prolong demand and maintain position in the market Profitable stage
Primarily variable costs
Decline
Demand starts to fall Profits still made initially but after a while losses would be made at which point the organisation should leave the market.
Primarily variable costs (now decreasing) Some fixed costs (eg decommissioning costs)
Impact of PLC in the modern environment

3.8 (a) (b) (c) Shorter product life cycles. Clearer strategic planning required. 90% of costs to be incurred throughout its life cycle will have been determined before a product reaches the market.
Maximising return over the product life cycle

3.9 There are a number of ways that return can be increased over the life cycle. (a)
Design costs out of products
Approximately 70% 90% of a product's life cycle costs are determined by decisions made early in the life cycle at the design and development stage. Thus design and production teams must work together to ensure costs are minimised. (b)
Minimise the time to market
This is the time from the conception of the product to its launch. If a company can get a product to the market place very quickly, it will give the product as long a span as possible without competitors' rival products in the market place. This should mean that market share is increased in the long-run. (c)
Minimise breakeven time
Pricing strategies will affect both contribution and volumes generated. This will thereby affect learning. (d)
Extend the length of the life cycle itself
For example, product development, finding other uses for a product or staggering the launch of the product in different markets.
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7: COST PLANNING
Advantages of LCC
3.10 (a) (b) (c) Considers external factors throughout a product's expected life. Considers all costs incurred on a product, and therefore leads to cost reduction. Very useful in the modern competitive environment, in which products often have a short life cycle and when a large portion of costs will be committed prior to commencing production.
3.11 Life cycle costing can also be used for customers. This is particularly useful in service businesses where significant costs may have been incurred to win a contract.
Implications
3.12 Given that there will be different levels of demand for a product over its expected life, it would not be appropriate to set one price for the product's entire life. 3.13 An understanding of the stages a product goes through enables you to price accordingly to either manipulate demand (low price, demand will rise and the intro stage is shortened) or to maximise profit. 3.14 All costs relating to a product including R&D are associated with the product. This enables true assessment of a products profitability. 3.15 Having looked at a products PLC it is clear that initially the product will make a loss. Viewing profitability on a periodic basis can put unnecessary pressure on management due to the visibility of the loss and could lead to wrong decisions being taken.
Life cycles and marketing

3.16 The marketing mix is made up of 4 Ps. These change over each stage of the product life cycle.
Introduction Product Price Growth Maturity Decline
Undifferentiated High market skimming or low market penetration
Higher quality Falling to stimulate demand Intensive
New features Falling price war
Reduce/rejuvenate Low to shed surplus stock High if niche market
Place
Selective
New channels Differentiate Create switching costs
Selective Reduced
Promotion Brand awareness Greater advertising Samples Trial incentives
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7: COST PLANNING
Lecture example 3
Co X are in a high tech industry and are often first to market with new technological advances. They have recently spent $500,000 designing and developing a new product. The new product is expected to have an eighteen month lifecycle. The anticipated performance of this product is as follows: Introduction Growth Sales volume (units) 4,000 9,000 Per unit ($) Selling price 599 549 Variable Cost 249 249 Overhead 100 100
Required Maturity 30,000 Decline 10,000
449 199 60
349 149 75
Calculate the profitability of the new product.
Solution
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7: COST PLANNING
4
4.1
Target costing
As product life cycles have become much shorter, the planning, development and design stage of a product is critical to an organisation's cost management process. Cost reduction must be considered at this stage of a products life cycle, rather than during the production process. Target costing involves setting a selling price for your product by reference to the market. From this your desired profit margin is deducted leaving you with a target cost.
4.2
Deriving a target cost

4.3
Traditionally: mark-up (2nd) selling price (3rd)
Cost (1st)
Target Costing: mark-up (2nd) selling price (1st)
target cost (3rd)
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7: COST PLANNING
The target setting process

4.4 Define current cost Define sales volume Define investment Define required profit Calculate cost gap
Define product specification
Set target price
Define target cost
Try to close cost gap
Implementing target costing

4.5 (a) (b) (c)
Mercedes Benz and target costing
Define product specification and estimate anticipated sales volume. Set a target selling price at which the company will be able to achieve the desired market share. Required profit is estimated based on profit margins or return on investment. Target cost is calculated as: Target selling price Less: target profit Target cost $ X (X) X
(d)
(e) (f) (g) 4.6
The estimated cost of the product is calculated based on the product specification and current cost levels. Estimated Product Cost Target Cost = Cost Gap Efforts are made to close the cost gap. Aim to design out costs before production starts and determine whether the project will go ahead.
Target costing aims to reduce the life cycle costs of new products, while ensuring quality, availability, and other consumer requirements, by examining all possible ideas for cost reduction at the product planning, research and development and the prototyping phases of production. Target costing does not cease once an item has gone into production. Costs are continually monitored to ensure the target is being achieved. If the target cost is being exceeded by a significant amount, Value Analysis will be employed. (section 5)
4.7
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7: COST PLANNING
4.8
Target costing versus standard costing Standard costing How costs are controlled Target costing
Costs must be kept within predetermined standard costs. Variances are calculated to check that this has happened. Predetermined product design
Cost
There is no cost slashing but continual pressure to ensure costs are kept to a minimum. Product design concept
Selling price
Relationship between product concept, cost and price
Price
Link with strategic plans
Profit margin Target cost The product concept and target profit margin take into account medium-term strategic plans. Continual cost reduction. Target costs are revised monthly.
None. The approach is short-term cost control through variance analysis. Standards are usually revised annually.
Time frame for cost control
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7: COST PLANNING
Lecture example 4
Sam produces rabbit hutches. He is about to launch a new top of the range hutch which he believes he can sell for $125. He demands a margin of 25% on sales. Cost information for the new hutch is as follows: Timber Good quality timber is essential the hutch needs 10m of good quality planed timber. Sam can acquire this at a cost of $48. Felt roofing material 2m2 are required. Roofing material costs $17.50 / m2 Wire 1m of wire is needed at a cost of $1.50 per metre There is some uncertainty about the amount of time needed to construct the hutch. Estimations for the labour time needed are: 1 hours 0.25 chance 2 hours 0.5 chance 2 hours 0.25 chance Labour is paid at a rate of $7 / hour Variable overhead These will be incurred at a rate of $1.50 per labour hour
Required
Calculate the target cost of the new hutch and identify any cost gap that may exist
Solution
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7: COST PLANNING
5
5.1
Value analysis
Value analysis is 'a systematic inter-disciplinary examination of factors affecting the cost of a product or service, in order to devise means of achieving the specified purpose, most economically, at the required standard of quality and reliability'. Value analysis encourages innovation and seeks to maintain the value of the product to the customer by any production method possible. Four aspects of value should be considered: (a) (b) (c) (d) Cost value Exchange value Use value Esteem value
reduce maintain or improve
5.2 5.3
Value adding and non-value adding activities

5.4 5.5 Only value adding activities should take place ie those activities which create, or enhance, the quality of saleable products. Non-value adding activities should be eliminated eg

Reworking of defective products Storage of materials Costs associated with staff turnover Movement costs (if sub-assemblies between production stages) Complex mix of components in products
5.6
To undertake value analysis the following process is adopted: (a) (b) (c) (d) (e) Understand the exact requirements of the customer Investigate whether there are alternative ways of achieving the customers requirements Select the best alternative Implement the new proposal Evaluate to establish whether the expected benefits have been gained
Functional analysis is often used as part of this process.
6
6.1 6.2 6.3
Functional analysis
Functional analysis is an analysis of the relationship between product functions, their perceived value to the customer and their cost of provision. It is concerned with improving profits by attempting to either reduce costs or by improving products by adding new features in a cost-effective way. It focuses on the specific purpose of a product or service.
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7: COST PLANNING
6.4
The steps in a functional analysis study are as follows: (a) (b) (c) (d) (e) (f) (g) (h) (i) Choose the object of analysis Select members for a functional analysis team Gather information Define the functions of the object Draw a functional family tree Evaluate the functions Suggest alternatives and compare these with the target cost Choose the alternatives for manufacturing Review actual results
Comparison of value and functional analysis

6.5
Value Analysis When used Focus on Involves Functional Analysis
During production Process to reduce cost Reducing cost without reducing value
Prior to production Customer value Adding features to improve profits
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Chapter summary
Section Topic Managing future costs Learning curve theory Summary
1 2
Costing new products is difficult so new costing techniques are required. Learning curve theory attempts to measure how the cost or time per unit of output falls for each extra unit produced. Yx= aXb is the cumulative average time per unit where Yx taken to produce X units a is the time taken to produce the first unit X is the cumulative number of units b is the index of learning (calculated as log r where r is the learning rate) log 2
Lifecycle costing
4 5 6
Target costing Value analysis Functional analysis
Life cycle costing monitors costs incurred throughout a product's life cycle, from pre-production costs up to final abandonment. Its aim is to minimise cost and maximise revenue over the life of the product. Target costing is a cost reduction system that works backwards from target selling price and mark-up to cost. Value analysis tries to maintain or improve the exchange, use and esteem values of a product while reducing its unit costs. Aims to increase margins by reducing costs or adding new features in a cost effective manner.
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Cost analysis
8
How syllabus outcomes are examined Calculation of a cost / profit per unit under absorption and ABC costing. Example past paper questions Nov 05, Q7(b - c), 18 marks Nov 06, Q5(b - d), 19 This is generally then followed by marks a discussion of the differences and May 10, Q5(b), 4 marks actions that should be taken ABC principles have been applied to groups of customers or in a retail environment (DPP). Again calculations are often requested and discussions tend to focus on how ABC information or DPP can help improve profitability or decision making. Nov 05, Q7(b c) , 18 marks May 07, Q7(e) , 10 marks Nov 08, Q5(b) , 18 marks

Syllabus learning outcomes Apply the techniques of activity-based management in identifying cost drivers/activities.
Analyse direct customer profitability and extend this analysis to distribution channel profitability through the application of activity-based costing ideas.
Apply Pareto analysis as a convenient technique for identifying key elements of data and in presenting the results of other analyses, such as activitybased profitability calculations.
This may be examined alongside This was not examined customer profitability analysis or under the old syllabus DPP to identify most / least profitable customer / product groups and suggesting appropriate actions to be taken.
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Overview
Absorption costing One OAR
Activity-based costing Cost pools Cost drivers
Cost driver analysis Unit Batch Product Facility sustaining
Cost analysis
Activity-based management
Customer profitability analysis
Distribution channel profitability
Direct product profitability
Pareto analysis
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Overview: Part 1 brought forward knowledge
Cost analysis
Absorption costing One OAR
Activity-based costing Cost pools Cost drivers
Cost driver analysis Unit Batch Product Facility sustaining
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1
1.1
Traditional absorption costing

Traditional absorption costing uses a single basis for absorbing all overheads into cost units for a particular production department cost centre. PRODUCTION SET-UP COSTS MACHINE OIL SUPERVISORS' SALARIES MACHINE REPAIRS
PRODUCTION DEPARTMENT A OAR
= One OAR
2
2.1
Activity-based costing
Production overheads are by no means all volume-related and hence a single basis for absorption, eg labour hours, would not adequately reflect the complexity of producing certain products/cost units as opposed to others. ABC is an extension of absorption costing specifically considering what causes each type of overhead category to occur, ie what the cost drivers are. Each type of overhead is absorbed using a different basis depending on the cost driver. Activities PRODUCTION SET-UP COSTS Cost drivers No. OF PRODUCTION SET-UPS MACHINE HOURS
2.2
OAR
MACHINE OIL AND MACHINE REPAIRS
OAR
Multiple OARs
SUPERVISOR'S SALARY
LABOUR HOURS
OAR
Steps in ABC
2.3 (a) (b)
Met spending 122m on paperwork
Group overheads into cost pools, according to how they are driven. Identify the cost drivers for each activity ie what causes the activity cost to be incurred. Calculate a cost per unit of cost driver. Absorb activity costs into production based on usage of cost drivers.
(c) (d)
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Lecture example 1
Recap ABC approach
Tufty Toerags is a company that makes rolls of carpets in standard widths of 4 metres which come in standard lengths of 30 metres. Over 15 years ago the machines used required a lot of manual operation and the company had established a costing system based on direct labour absorption of its fixed overhead. The company has two products, the Twist (a 50% wool/50% polypropylene mixture) and the Supertwist (an 80% wool/20% polypropylene mix). Budgeted sales (rolls) Selling price Costs: Wool (@ $6/m) Polypropylene (@ $3/m) Labour (@ $12/hr) Overheads Machining cost Stores costs Machine set-ups Despatching Drivers (total values) Number of production runs Number of orders Twist 400 15 Twist 15,000 $/m2 8.99 $/roll 360 180 3 Supertwist 20,000 $/m2 12.99 $/roll 576 72 4 $ 5,000,000 4,750,000 5,500,000 3,500,000 18,750,000 Supertwist 150 10
Tufty Toerags is considering changing from traditional absorption costing to ABC to calculate the cost of its carpets. The total unit cost under absorption costing per m2 is $8.275 for the Twist and $10.43 for the Supertwist. Required (a) (b) Assuming machine and labour hours are the same, calculate the total unit cost per m2 for each product using ABC. Calculate and comment on the profitability of each product and suggest any changes that could be made, together with any reservations you may have.
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Solution
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8: COST ANALYSIS 2.4 Uses of ABC The use of ABC provides the following opportunities. (a) (b) (c) (d) (e) (f) (g) Cost control and reduction by the efficient management of cost drivers Better costing information used to assist all decision-making Reanalysis of production and output/product mix decisions Profitability analysis (by customer, product line etc) A more realistic estimate of costs and profits which can be used in performance appraisal Better pricing Particularly suitable for long-term decisions (such as long-run pricing, capacity management and product mix decisions) as it assumes all costs are variable in relation to product choice or production level decisions.
2.5
Criticisms of ABC (a) (b) (c) (d) (e) (f) It is time consuming and expensive Will be of limited benefit if overheads are primarily volume related Reduced benefit if the company are producing similar products Cost drivers can be hard to identify Complex situations may have multiple cost drivers Some arbitrary apportionment may still exist
2.6
Favourable conditions for ABC (a) (b) (c) (d) When production overheads are high relative to prime costs (eg service sector) When there is a wide diversity of product range When there is considerable differences in the use of resources by products Where consumption of resources is not driven by volume
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3
3.1 3.2
Section 1.2 Cost analysis in the modern business environment
Cost driver analysis

Today's complex business environment means that costs are incurred because cost drivers occur at different levels. There are four key categories for activities and their related costs. Categories Unit Batch Product Facility sustaining Type of cost Direct Set ups Inspection R&D Maintenance Depreciation Rent Cost driver Units produced Batches produced Products produced None
The difference between unit costs under absorption costing and ABC depends upon the proportion of overhead in each category. If most overheads are unit level or facility sustaining the costs will be very similar. If overheads are batch or product sustaining costs, the resulting costs may be very different.
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CHECKPOINT 2

Key knowledge
Pricing Optimal pricing and the demand function are regularly examined. Students often find this difficult initially but once they have grasped the steps involved can handle these questions well. Remember: Step 1 - Solve the demand function. Then state this with the values you have discovered for a and b. Step 2 - If profit maximisation is required make the MR equation given = MC. If revenue maximisation make MR = 0. Step 3 - Substitute the values found for a & b in step 1 into this formulae and solve. Step 4 - Once MR = MC/0 is solved take the quantity found and put this into the demand function to find the price that should be charged to obtain the profit/ revenue maximising quantity. Dont forget this exam does not just include numbers but also a significant proportion of written answers. Discussion on pricing strategies for new products is also frequently examined. Make sure you understand the various pricing policies and, particularly for cost plus, can discuss the various advantages and disadvantages. Learning curves This is another topic that is examined regularly. It is important that you can use the formula to calculate the total time for production and the time taken to produce the nth unit. Make sure you practice these calculations and can list the conditions for the learning curve to exist as these may form part of a discussion piece in this area. Lifecycle and target costing These techniques can be examined via numbers but are equally if not more likely to be examined via words so ensure you can recall the principles of each.
Key skills
It is important that as well as getting to grips with the knowledge gained in stage 2 you give sufficient attention to the key skills you need in order to score well on numerical questions. You must aim to: Learn the steps involved in optimal pricing and learning curve calculations so that you can reproduce them quickly and accurately in the exam. Start to think about getting the easy marks For example in an investment appraisal put in the investment, residual value and discount rates first, then sales or costs that dont involve or have simple workings leaving the more involved items until last. As with all numerical questions, continue to lay out your answers clearly and cross-reference all your workings. This will help you to pick up additional marks in the exam the marker can reward you for correct technique even if you make some mathematical errors.
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CHECKPOINT 2

Chapter 5 - Multi-product breakeven analysis
Key areas - use the online lectures to selectively review these if you need to Calculation of multi product break even point and preparation of graph. 20 mins 15 mins Course Notes Rework lecture examples 1 & 3 to ensure you are happy with this technique. Additional Resources Study Text There are several examples in here which are useful to work through should you have the time.
35 mins
Chapter 6 - Pricing decisions

Key areas - use the online lectures to selectively review these if you need to Optimal pricing Advantages and disadvantages of cost plus Market penetration and market skimming
30 mins
Course Notes Rework the optimal pricing calculations in Lecture Example 1 as these are frequently examined. It is important that you are comfortable with the steps involved in solving these problems. Question Practice Attempt Question 6 from the Question and Answer Bank in the back of the Course Notes using your Notes to help if necessary. Optimal pricing is an area that features regularly in the P2 exam so it is important you get to grips with it as soon as you can. Additional Resources Real-life examples At the end of this checkpoint you will see two articles that look at pricing. One looks as how Sony use price skimming and the other looks at price discrimination. It is strongly recommended that you review these articles to aid your practical understanding of these techniques Study Text It is recommended that you read section 2 to add to your knowledge of issues that influence prices.
10 mins
10 mins
5 mins
5 mins
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CHECKPOINT 2
Chapter 7 Cost planning

Key areas - use the online lectures to selectively review these if you need to Learning curve theory and calculations Lifecycle and target costing Comparison of value and functional analysis
50 mins
Course Notes Lecture examples 1 & 2 should be reviewed as learning curves are frequently examined. The other aspects in this chapter tend to be examined in discussion questions. Review these techniques to ensure you fully understand them and their implications.
15 mins 10 mins
Question Practice Attempt Question 7 from the Question bank in the back of your course notes. Learning curve calculations tend to feature very regularly in the exam so its important to ensure you are comfortable with them. Additional Resources Real-life examples At the end of this checkpoint you will find an article that reviews how Mercedes-Benz uses target costing. It is strongly recommended that you read this article. Study Text Read section 1.7 which looks at the uses of the learning curve in management accounting. (5 mins)
20 mins
5 mins
Chapter 8 Cost analysis (part 1)

Key areas - use the online lectures to selectively review these if you need to The method to perform ABC Course Notes Review sections 1 - 3 to ensure you can recall the technique and uses of ABC. Ensure you can discuss the implications of ABC.
20 mins
10 mins 5 mins
Additional Resources Study Text Review section 1.2 for information on the costs of volume versus variety. Real-life examples At the end of this checkpoint you will see an article that looks at the information the metropolitan police collect using ABC. (Reading the article would take a couple of mins) 5 mins
On completion of Stages 1 & 2 (including Progress Tests) you are ready to attempt Course Exam 1
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CHECKPOINT 2

A
1

J Ltd produces and sells two products. The O sells for $12 per unit and has a total variable cost of $7.90, while H sells for $17 per unit and has a total variable cost of $11.20. For every four units of O sold, three of H are sold. J Ltd's fixed costs are $131,820 per period. Budgeted sales revenue for the next period is $398,500. What is the margin of safety (in $)? (3 marks) A company makes and sells three products A, B and C. The products are sold in the proportions A:B:C = 1:1:4. Monthly fixed costs are $55,100 and product details are as follows: Product A B C Selling price $ per unit 47 39 28 Variable cost $ per unit 25 20 11
The company wishes to earn a profit of $43,000 next month. What is the required sales value of product A in order to achieve this target profit? (3 marks) 3 A company sells three different types of training course to its customers: Weekend, Day-release and Evening. Selling prices, unit costs and monthly sales are as follows: Weekend Day-release Evening $ $ $ Selling price 120 110 95 Variable cost 55 40 50 Monthly sales 40 30 20 Calculate the average contribution to sales ratio of the company. (i) (ii) based on the sales mix stated above; and if the total number of monthly sales remains the same, but equal numbers of each course are sold. (4 marks)
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A firm has established that maximum demand for its product is 80,000 units per annum. When it reduced its prices by $20, demand rose by 1,600 units.
What is the demand function? A B C D P = 1,000 0.025Q P = 1,000 0.0125Q P = 50 0.025Q P = 500 - 0.0125Q $125 $225 $375 $500
(2 marks)
What price should be set in order to sell 50,000 units? A B C D
(2 marks)
NRC Ltd makes and sells a single product X. The selling price and marginal revenue equations for product X are as follows: Selling price = $60 - $0.001Q Marginal revenue = $60 - $0.002Q The full cost of X is $35 per unit. Fixed costs are $150,000 and it was originally budgeted to make 15,000 units. In order to maximise profit, what should be the selling price per unit? (2 marks)
Current demand for Orchards product the Russet is 5,000 units each year, its selling price is $175. For every $10 that the selling price is increased demand for the Russet falls by 500 units. Marginal cost for the Russet is $65. What price will Orchard need to set in order to maximise profits? Note: If price P = a bx then MR = a 2bx (3 marks)

The following data relate to costs, output volume and cost drivers of Heighway Rubbery Ltd for June 20X1. 1 2 Production and sales Direct production costs Direct materials Direct labour Labour hours per unit Machine hours per unit Number of production runs Number of deliveries to customers Number of production orders Number of deliveries of materials into store Production overhead costs Machining Set-up costs Materials handling (receiving) Packing costs (despatch) Engineering Product P 3,000 units $ per unit 12 3 15 2 8 3 30 17 Product Q 2,000 units $ per unit 11 6 17 1 1 2 2 5 3 Product R 1,500 units $ per unit 8 2 10 1/ 3 2 10 10 15 20 Total $70,000 $24,000 $94,000 20 15 50 40 $ 71,500 10,500 35,000 22,500 25,500 165,000
3 4 5 6 7 8 9
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Indirect production overheads that are not driven by production volume are: Item Set-up costs Materials handling Packing Engineering Cost driver Production runs Deliveries of materials Deliveries to customers Production orders
What would be the full production cost per unit of product R if overheads are absorbed on the basis of direct labour hours? A B C D $13.75 $23.75 $30.00 $51.25
(2 marks)
Calculate the full production cost per unit of product R using activity-based costing and the cost drivers described above, with overheads that are driven by production volume absorbed on a machine hour basis. (4 marks) A company has produced the first batch of a new product which took 40 hours to manufacture. With an 80% learning curve, how long would it take to make the next nine batches? (2 marks) The time taken to produce the first unit of a new product was 12 hours. By the time four units had been made, the average time per unit had dropped to 6 hours. What was the rate of learning experienced? (2 marks) KJ has recently developed a new product. It is usual for the workforce to experience an 80% learning effect as the work is repetitive. It takes 3 kg of material at $4/kg to produce each unit and variable overheads are expected to cost $2.50/hr. Labour is paid $8/hr. If the first unit took 40 minutes to produce, what will be the expected cost of the fifth unit? (4 marks)
10 11
12
B
1 2 3

Explain the term 'price elasticity'? (3 marks) Why is cost plus pricing not recommended for new products and what pricing strategies would be appropriate instead? (5 marks) What is the learning curve theory and what are the conditions for it to exist? END OF PROGRESS TEST 2 (5 marks)
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Section A
1 Contribution per unit O H $(12 7.90) $(17 11.20) = = $4.10 $5.80
Weighted average contribution ($4.10 4) + ($5.80 3) = $33.80/7 = $4.83 Break even point: Fixed costs = 131,820 W. av. Contribution/ unit 4.83 = 27,292 Mix B/E point O H
B/E Rev
4 15,595 12 187,140 3 11,697 17 198,849 7 27,292 385,989 Margin of safety Budgeted sales breakeven sales = $(398,500 385,989) = $12,511
Contribution per unit A $22 B $19 C $17 Weighted average contribution ($22 1) + ($19 1) + ($17 4) = $109/6 = 18.17 To achieve $43,000 profit: Fixed costs + target profit = 55,100 + 43,000 W. av. Contribution/ unit 18.17 = 5,399 Mix B/E point A 1 900 B 1 900 C 4 3,599 6 5,399 Required sales of A 900 $47 = $42,300 revenue Weekend $ 65 2,600 4,800 Day-release $ 70 2,100 3,300 Evening $ 45 900 1,900 Total $ 5,600 10,000
(i)
Contribution per course Total contribution ( sales volume) Total revenue Average c/s ratio =
5,600 = 56% 10,000
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(ii)
When courses are sold in equal numbers, they are sold in the ratio 1:1:1. Calculations can be performed on this ratio basis. Weekend $ 65 120 Day-release $ 70 110 Evening $ 45 95 Total $ 180 325
Contribution Sales Average c/s ratio =
180 325
= 55.4%
P = a bQ b=
20 1,600 = -0.0125
Maximum demand is 80,000 units ie when a = 0 P = 0 0.0125 x 80,000 P = 1,000 P = $1,000 0.0125Q 5 C P = $1,000 0.0125Q P = $1,000 (0.0125 x 50,000) P = $375 6 Marginal cost = = To maximise profit set MR $60 $0.002Q Q Selling price = MC = $25 = 17,500 = $60 (0.001 17,500) = $42.50 $35 $25
$150,000
15,000
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P = a bx b = 10/500 = 0.02 175 = a 0.02 5,000 175 = a 100 a = 275 P = 275 - 0.02 x Maximise profits when MR = MC 65 = a 2bx 65 = 275 0.04x 210 = 0.04x x = 5,250 P = a bx P = 275 0.02 5,250 P = 170
B Direct labour hours P Q R 3,000 2,000 1 1,500 1/3 = 1,500 = 2,000 = 500 4,000
Absorption rate for overhead
= $165,000 4,000 = $41.25 per direct labour hour.
Unit cost of R = $ (8 + 2 + 1/3 of 41.25) = $23.75 9 Overhead rates Machining Set-up costs Materials handling Packing costs Engineering Product R overhead costs Machining Set-up costs Materials handling Packing costs Engineering Cost per unit of R Direct materials Direct labour Overhead $71,500 11,000 machine hours $10,500 20 production runs $35,000 40 materials deliveries $22,500 15 deliveries to customers $25,500 50 production orders 3,000 machine hours $6.50 10 production runs $525.00 20 deliveries $875.00 10 customer deliveries $1,500.00 15 production orders $510.00 = $6.50 per machine hour = $525.00 per run = $875.00 per delivery = $1,500.00 per delivery = $510.00 per order $ 19,500 5,250 17,500 15,000 7,650 64,900 $ 8.00 2.00 43.27 53.27
($64,900 1,500 units of R)
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10
y = axb b= log 0.8 _ = 0.3219 log 2
y = 40 10-0.3219 y = 19.062 hours Time for all 10 batches 10 19.062 less: time for first batch Time for 9 batches 11 Units 1 2 4 12r2 r r r 12 y b y = = = = = = = = 6
6 12
191 (40) 151 hours
Average time (hours 12 6 r r r
0.707 70.7% axb log 0.8 _ = 0.3219 log 2 40 5-0.3219 23.825 mins 119.13
Time for 5 units = 23.825 5 = Time for 4 units = = Cost Materials Labour 40 4 -0.3219 25.6 mins 4 units Time for 5th unit =
102.40 16.73 $ 12.00
Variable overheads
Total cost of 5th unit
8 60 2.50 16.73 mins 60

16.73 mins
3 kg $4/kg
2.23
0.70 14.93
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Section B
1 Price elasticity of demand measures the responsiveness of demand to a change in price. It is calculated % change in x % change in P
If the elasticity of a product is greater than 1 it is said to be elastic. Small changes in price will drive large changes in quantity demanded. If the elasticity is less than 1 this is inelastic. Changes in price do not cause large changes in demand. 2 Cost plus pricing is not generally suitable for new products because the cost of the product is not known with certainty. Costs are likely to fall as volumes rise and as learning is experienced and so selecting a suitable cost basis is difficult. Either a strategy of market penetration or market skimming tends to be used instead. Market penetration is the policy of setting a low price in order to gain sales volumes. This enables the early stages of the product lifecycle to be shortened as volumes grow quickly. This low price also may discourage competitors entering the market. Market Skimming is where a high price is set in order to gain high unit profits. Companies which produce goods with advanced technology and therefore have high development costs tend to choose market skimming. They will tend to then lower the price as the product moves through the stages of the lifecycle. 3 Learning curve theory states that as cumulative output doubles, the cumulative average time per unit falls to a given percentage of the previous average time per unit . The conditions for it to exist are:
There must be a significant manual element to the task The task must be repetitive Production must be at an early stage The workforce should be consistent There should not be extensive breaks in production The workforce is motivated
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Pricing strategy leaves room for discounts later
F I N A N C I A L T
I M E S
Pricing strategy will be a key issue for Sony's PlayStation 3 console, which enters the European market as by far the most expensive of the new generation of games consoles - priced at 599 ($799), compared with about 250 for Nintendo's Wii and 300 for a basic version of the XBox 360. Sony justifies the price by arguing the PS3 is not just a games console but a "home entertainment hub" that can connect to the internet, display photos, play music and includes a high-definition Blu-Ray disc player, retail prices for which start at about 500 ($980). At the same time, it is clear Sony is positioning itself for price cuts later in the year. European PlayStation fans were outraged last month when Sony announced they would not be able to play many of their PlayStation 2 games on the new PS3 because the company had removed the microchip that enabled backwards compatibility. Alex Kwiatkowski, analyst at Datamonitor, said removing the chip would make it easier for Sony to cut prices before Christmas. Overall Sony is thought to be planning to halve the number of components. The PS3 prototype had 4,000 [components] but now a shift to 2,000 is in the pipeline, said Yuji Fujimori, analyst at Goldman Sachs. "Past history shows that a halving of the price results in quadrupled volumes." He expected a 100 price cut before Christmas and a further 50 before Christmas next year as a result of cutting the component numbers. He said the price cuts would result in a wider operating loss to Y70bn ($592m) from Y60bn at Sony's games unit in the fiscal year starting April 1.
New laws to stop British internet price rip-offs

S U N D A Y
Companies will be prevented from charging British consumers more than foreign residents for buying the same products or services over the telephone or internet under a proposed European law supported by Tony Blair. The measure will affect many airlines, car hire firms, travel agents and electrical goods firms that discriminate against Britons with higher prices. The European commissions proposals will be discussed by trade ministers later this month and are expected to become law next year. Currently, some companies particularly when consumers buy online or over the phone ask for a country of residence. Those living in different European Union countries are then charged different prices. Last week British Airways was charging customers in Britain twice as much as those on the Continent for the same flight. Other companies such as Hertz car rentals and Thomas Cook also charged more to British residents. Under the new measure, variable pricing will not be banned but Britons will be entitled to pay the lowest prices available to other EU residents. They may still have to pay higher postal charges and the tax charged could vary. It is hoped that, as people learn of their new rights, firms will be forced to cut prices so they are consistent throughout the EU. A spokesman for the commission said: The proposal is to break down barriers and outlaw the practice of charging different prices for the same service in the EU. Consumers will benefit and enjoy the advantages of the single market. The Department for Trade and Industry said yesterday it supported the plan and would publish its consultation paper on the scheme later this month.
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Last week British consumers booking a luxury trip to New York over the internet had to pay almost twice as much as French residents for the same flights and hotels. A business class British Airways seat costs British residents $2,353 compared with $1,071 for the French on the same flight from Paris via Heathrow. Three days basic car hire from Hertz costs Britons $129.05 but French travellers pay $108. Three nights at the Sofitel hotel in New York, booked with Thomas Cook, costs $1,074 for Britons but just $801 if you live in France. Kate Cowper, 26, from Nottingham, said she welcomed the plan after falling foul of differential pricing. She said: I booked a car on an Italian website off Hertz but when I arrived I was told that I had to pay almost twice as much because I was British. I contested the higher fee but the contract I had signed meant they just took the money from my credit card. Similar differential pricing is also used by Sony and other electronics firms. British consumers using Sonys website are charged $278 more for VGNA217M laptop computers than Spanish residents and $107 more than their counterparts in France. However, for some products Britons are offered lower prices so the proposal will also benefit other Europeans. For example, some products bought online from IKEA are cheaper. Amazon, the online bookshop, favours British residents with prices consistently lower than in France and Germany for the same products. Britain has long had a reputation as one of the most expensive countries in Europe and has been called Treasure Island by multinational firms. It had been hoped that the European single market and the internet would put pressure on prices to fall. However, studies have found British consumers are consistently charged more than those on the Continent. In countries that have adopted the euro, prices have converged, although not as quickly as was hoped. Over the past two years, studies have found that price convergence has all but stopped as companies try to maintain their profit margins. A spokesman for British Airways said: All the other airlines do it. All the airlines offer reduced fares to attract customers outside their market. A Hertz spokesman said: For decades, the market where goods and services are purchased has been a pricing factor in the travel industry. Costs and competitive conditions in individual markets are among the considerations that affect pricing. Thomas Cook said its British and French arms act independently. Sony declined to comment.
Mercedes Benz and target costing

F
I N A N C I A L
'Mercedes-Benz, has accepted that radical changes in the world car market mean that Mercedes-Benz will no longer be able to demand premium prices for its products based on an image of effortless superiority and a content of the ultimate in automotive engineering. Instead of developing the ultimate car and then charging a correspondingly sky-high price as in the past, Mercedes-Benz is taking the dramatic and radical step of moving to 'target pricing'. It will decide what the customer is willing to pay in a particular product category priced against its competitors it will add its profit margin and then the real work will begin to cost every part and component to bring in the vehicle at the target price. 'The marketing motto for the Mercedes-Benz compact C-class is that it offers customers more car for their money. It is the first practical example of the group's new pricing policy. The range embodies a principle new to Mercedes which states that before any work starts a new product will be priced according to what the market will bear and what the company considers an acceptable profit. Then each component and manufacturing process will be costed to ensure the final product is delivered at the target price.
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Under the old system of building the car, adding up the costs and then fixing a price, the C-class would have been between 15 per cent and 20 per cent dearer than the 10-year-old outgoing 190 series, Mr Vhringer said. Explaining the practical workings of the new system, he explained that project groups for each component and construction process were instructed without exception to increase productivity by between 15 and 25 per cent. And they had to reach their targets in record time. One result was that development time on the new models was cut to 40 months, about a third less than usual. But the most important effect, according to Mr Vhringer, has been to reduce the company's cost disadvantages vis--vis Japanese competitors in this class from 35 per cent to only 15 per cent.'
Met Spending $122m on paperwork

T
H E
The Metropolitan Police spent $122m in a year on writing letters and general paperwork, latest figures have shown. The cost - which does not include admin duties related to specific crimes and incidents - was up 13% on 2004-5. It easily exceeded the combined sum the country's biggest police force spent on tackling domestic burglaries ($48.75m) and sexual offences ($55.28m). The Met spokesman said the figure had risen because of improvements in collection and collation of data. Details of the force's spending were disclosed in preliminary Activity Based Costing (ABC) information due to be presented to the Metropolitan Police Authority on Thursday. The category for "non-incident Linked Paperwork" - including general correspondence not related to any specific incident took up 3.8% of the Met's total resources. Only five other activities left the force with a bigger bill. Top was "National, international and capital city policing, including anti-terrorism and Special Branch" ($505m), "visible patrols" came second at $313m and tackling "violence against the person" cost $176m.
All police forces have to collect ABC data, which assesses not only the direct cost of activities but other financial implications such as officers' time and running support departments.
A Met police spokesman said: "The Met is the largest single employer in London and this category reflects the operational feat involved in running an organisation on that scale. "It covers all the paperwork required to keep the service functioning - from ordering uniform and officer's pocket books, to leave applications, search forms and quick statements. "The MPS has a unit that is seeking to eliminate unnecessary paperwork. Part of this work is to use skilled police staff to process paperwork to free up officers to spend more time on their operational duties."
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Overview: Part 2
Cost analysis
Activity-based management
Pareto analysis
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8: COST ANALYSIS
1
1.1
Activity-based management (ABM)

Activity-based costing is a technique used to cost a product. Activity-based management uses ABC information to focus management attention on key value-adding activities, key customers and key products in order to maintain or increase competitive advantage
Sections 3.8 & 3.9 Performance Evaluation & Implementing ABM
1.2
ABM
DPP
Cost Reduction
Cost Modelling
CPA
Key products Key activities
Key customers
1.3
ABM moves away from ABC as a product costing device and uses the information generated to control or reduce cost drivers and reduce overheads, thus gaining competitive advantage.
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2
2.1 2.2

Customer profitability analysis (CPA) is 'the analysis of revenue streams and service costs associated with specific customers or customer groups'. (CIMA Official Terminology) CPA uses ABC principles to identify the most profitable customers or groups of customers so that marketing efforts can be directed towards attracting and retaining these customers.
Customer profitability statement

2.3 Revenue at list prices Less: discounts given Net revenue Less: cost of goods sold Gross margin Less: customer specific costs financing costs: credit period customer inventory Net margin from customer $'000 $'000 X (X) X (X) X
X X X (X) $X
Customer specific costs

2.4 ABC can be used to build up customer specific costs. For example: Activity Order processing Delivery After sales service Cost Driver Number of orders processed Number of miles travelled Number of visits
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3
3.1 3.2

ABC information can also be used to determine the profitability of different distribution channels. Distribution channels are the means a company transacts with its customer. They can be direct or indirect. Direct channels include, shops, sales teams, internet whereas indirect channels include retailers, wholesalers etc
Section 6 Distribution Channel Profitability
3.3
Traditionally, product costs are allocated to distribution channels based on standard costs and the product mix sold through the channel. Sales, general and administrative costs are typically allocated to distribution channels on the basis of sales volume or net revenue.
3.4 3.5
However, different channels will use some activities but not all. ABC information allows an understanding of different channel profitability by creating cost pools for activities. The channel a company chooses can be a critical driver to business profitability. Understanding the specific costs of a channel can enable a company to decide whether the goods and services they are offering may be best offered through a different channel. Decisions should not be taken purely on cost though and must also consider whether customers needs would be met if the channel was changed.
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8: COST ANALYSIS
4
4.1

Direct product profitability (DPP) is a costing system used by retail businesses. Traditionally, retailers relied on gross margins (sales revenue less purchase cost) and revenue per square metre, to indicate product profitability. These measures excluded the organisation's own costs and gave no useful information for planning and controlling the organisation's own resources.
Direct product profit

4.2 DPP is the contribution a product category makes to fixed costs and profit. It is calculated as follows: Sales price Less: purchase cost Gross margin Less: direct product costs warehouse direct costs transport direct costs store direct costs Direct product profit 4.3 $ $ X (X) X
(X) (X) (X)
(X) (X)
Any costs that are general to the organisation, but not specific to any one product, should be ignored in calculating DPP. Supermarkets analyse the direct profitability of every branded and non-branded product they sell. This helps them to decide on what ranges to present in store and also provides a focus for marketing initiatives.
143
8: COST ANALYSIS
Lecture example 2
A supermarket is considering the profitability of two different brands and types of washing detergent. SoapySuds is a compact tablet form of detergent; WhiteyWhite is conventional soap powder. The following information relates to each product: Cost price per unit Required margin on sales Shelf space occupied per product unit Average time in warehouse Average time in store Monthly unit sales per supermarket branch Normal order batch size (units) SoapySuds $3.40 15% 0.008m3 8 weeks 3 weeks 1,200 2,000 WhiteyWhite $2.40 20% 0.022m3 6 weeks 3 weeks 1,800 2,250
Cost associated with placing orders are $150 irrespective of order type or size. Goods are transferred from the warehouse to the supermarket branches in trucks with a capacity of 100m3. The average journey costs $120. Warehousing costs total $480,000 per month and the warehouse manager estimates that 60% of its capacity of 800,000m3 is utilised. Each supermarket branch has storage costs of $250,000 per month and has 200,000m3 of shelf space. General administration costs are $175,000 per month. Required Calculate the profit per item using the direct product profitability method.
Solution
144
8: COST ANALYSIS
Q8 KL
145
8: COST ANALYSIS
5
5.1
Pareto analysis
Pareto analysis is used to highlight the general principle that 80% of value is concentrated in only 20% of a population. For example 20% of inventory items may represent 80% of stock valuation 80% of company profit may be earned from 20% of customers or product range
5.2 5.3 5.4 5.5
Pareto analysis may not apply precisely. The basic principle is that a small amount of the population often accounts for a high proportion of value. The highest contributing products/ customers should be carefully controlled / monitored. Information may be presented in tables or in bar charts or graphs. This analysis may be beneficial for non-accounts staff such as sales or marketing.
Introductory example
Lecture example 3
Total customer margin $'000
The following Pareto curve has been produced for the customers of Company L. 100 80
20 Required
50
100
Number of customers
Analyse the above graph and suggest how the company could improve its position.
Solution
146
8: COST ANALYSIS
147
8: COST ANALYSIS
Chapter summary
Section 1 Topic Traditional absorption costing Activity-based costing Summary Traditional absorption costing assumes all overheads are driven by volume and as such absorbs them into the cost of a unit using one single rate. Activity-based costs are variable, not in the short-term, but in the longer-term when the level of the cost driver can be altered. ABC is said to be more appropriate for longer-term (strategic) decision-making than either marginal costing or traditional absorption costing as it focuses on the causes of cost. It does, however, have disadvantages. 3 Cost driver analysis There are 4 key categories: Unit Batch Product Facility sustaining.
The difference between unit costs under absorption costing and ABC depends upon the proportion of overhead in each category. 4 5, 6 & 7 Activity-based management Customer profitability analysis Distribution channel profitability Direct product profitability Pareto analysis ABM uses ABC information for a variety of purposes. An organisation can determine its most valuable products, customers and distribution channels using ABC-related principles. It then knows where to focus its future activities to achieve competitive advantage.
Many organisations may find that Pareto analysis applies to their customers or products in that 20% of their customer or product range provides 80% of their profit.
END OF CHAPTER
148
Cost management techniques 1
9a
Example past paper questions May 05, Q2, 10 marks May 08, Q3, 10 marks Nov 05, Q6(a b), 16 marks May 10, Q3, 10 marks

Syllabus learning outcomes Evaluate the impacts of just-in-time production, the theory of constraints and total quality management on efficiency, inventory and cost. How syllabus outcomes are examined JIT has been examined in discussion questions in relation to its impact on profitability, cost changes, quality control, and as a contrast with existing systems. The importance of TQM in a JIT environment has also been examined. Theory of constraints has been examined via a limiting factor scenario and small questions on return / hour or TA ratio. Discussion of throughput accounting being used for short term decision making has also been required. Explain the concepts of continuous improvement and Kaizen costing that are central to total quality management. Prepare cost of quality reports. A discussion of quality costs and some examples were needed. May 06 Quality costs , 10 marks
Identification of appropriate quality cost categories for various items and calculate the spend in each may be required. This is likely to be small discussion requirement.
This was not examined under the old syllabus
Explain how process re-engineering can be used to eliminate non value adding activities and reduce activity costs.
This was not examined under the old syllabus
149
9a: COST MANAGEMENT TECHNIQUES 1
Overview
World class manufacturing
Continuous Improvement
Just-in-time
Business process re-engineering
TQM
Kaizen Costing
Throughput accounting and the theory of constraints
150
1
1.1
World class manufacturing (WCM)

Focus is on: (a) (b) (c) (d) (e) (f) Quality Reliability Customisation Innovation Flexibility JIT based production
1.2
Main benefits: (a) (b) (c) (d) (e) (f) Improved quality and a reduced cost to the customer Dramatic improvements in production efficiency Improved motivation and greater loyalty from key employees Improvements in customer satisfaction and the development of genuine goodwill The achievement of competitive advantage Increase in medium to long-term profitability
2
2.1
Total quality management (TQM)

Quality management becomes TQM when it is applied to everything a business does.
Goals and aims of TQM

Small Business: Cut your coat to suit your cloth
2.2
Get it right first time The cost of preventing mistakes is less than the cost of correcting them if they occur. Continuous improvement Never be satisfied with current achievement. It is always possible to improve performance.
2.3
To gain competitive advantage via continuously improved quality To continuously reduce the cost of providing enhanced quality Innovation Eliminate waste Everybodys concern Teamwork Provide first class service to all customers
Quality management can be achieved by: (a) (b) (c) (d) Establishing standards Establishing procedures to deliver the quality standards Monitoring actual quality Taking control action when standards are not achieved
151
Design for quality

2.4 Design quality into an organisation's products and operations from the outset. (a) (b) (c) 2.5 Costs of quality Prevention costs Appraisal costs Internal failure costs External failure costs 2.6 Costs of conformance Costs of non-conformance Reduce the number of parts in a product Use components common to other products in the organisation Improve physical characteristics to meet customers needs
It is generally accepted that there is a trade off between expenditure in these two categories. The greater the spend on conformance costs, the lower the resulting non-conformance should be. Most organisations accept that some failures will occur, thus incurring non-conformance costs, but they will seek to minimise these costs by incurring quality conformance costs.
2.7
Lecture example 1
Required
Allocate the following costs into appropriate categories of quality costs and prepare a 'cost of quality' report. Comment on your findings. 20X6 $'000 40 125 35 50 85 60 395 20X7 $'000 120 60 15 20 70 20 305
Quality control training Rework costs Returns Customer complaints department Inspection of WIP Scrap
Solution
152
Performance measurement
2.8 Variance analysis is not appropriate in a TQM environment, because: (a) (b) (c) (d) 2.9 The aim is for continuous improvement Performance requires external comparators Feedback is too late, slow Non-financial measures may also be required
Alternative measures of performance, therefore, include: (a) (b) (c) (d) Measuring incoming supplies Monitoring work as it proceeds Measuring customer satisfaction Cost of quality reports
2.10 Problems with implementing TQM in an organisation: (a) (b) (c) (d) Can be demotivating because cannot achieve perfection Barriers to participation not everyone can be involved Relies heavily on the quality of suppliers Change management culture of organisation
153
Lecture example 2
Required Identify some of the possible impacts of TQM on efficiency, inventory and cost
Solution
Efficiency:
Inventory:
Cost:
Q9 Total quality Management
Kanban
2.11 Kanban control systems control the flow of goods through a manufacturing process. They are the only means of authorising production it is pulled through the system by demand. 2.12 Kanban can only work if defects are eliminated. 2.13 Kanban also permits idle time and allows labour to be used where it is most needed.
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3
3.1
Continuous improvement
In today's highly competitive environment, performance against static historical standards is no longer appropriate. Successful organisations must be open to change if they are to maintain their business advantage. Continuous improvement is an ongoing process that involves a continuous search to reduce costs, eliminate waste, and improve the quality and performance of activities that increase customer value or satisfaction.
3.2
4
4.1 4.2
Kaizen costing
Kaizen costing focuses on obtaining small, incremental cost reductions during the production stage of the product life cycle. Current costs are reduced by: Value analysis Functional analysis Analysis Functional Value Continuous improvement Kaizen costing Cost set Target Actual = base New standard set New base cost New standard cost
4.3
Stage of life cycle Design Each year of production
Constant improvement by constant reduction in standard costs is known as kaizen costing.
Standard v Kaizen
4.4 Standard Concepts Cost control Unchanged manufacturing conditions Meet standards Techniques New standards each year Variance analysis Investigate variances Employees Cause of variances Kaizen Cost reduction Continuous improvement Change to reduce costs to hit new targets New targets each month Gaps between target and estimate profit measured Investigate if rate of kaizen not met Source of solutions
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5
5.1 5.2 5.3 5.4
Just-in-time
JIT is a system whose objective is to produce or buy units as they are required rather than for inventory. It is a demand 'pull' system. JIT aims to restructure the manufacturing process to bring about more flexible, rapid and cost effective production. This will include the elimination of non-value adding activities. JIT philosophy is to investigate failures, since the failure is an opportunity to improve the process. The problem might be due to machine failure, a set-up or quality problem etc. This approach of continual trouble-shooting leads to: (a) (b) A series of small, low-cost improvements A culture of constant analysis and improvement JIT purchasing: purchase components/materials to meet production requirements JIT production: production is customer demand driven JIT Production WIP and finished goods reductions Produce to order Decreased lead and set up times Zero defects Flexible workforce Continuous improvement Quality control
5.5
There are two aspects of JIT:
JIT Purchasing Lower inventory Frequent deliveries Close relationship with fewer suppliers Long term contracts Quality assurance
156
Lecture example 3
Required Identify some of the possible impacts of JIT on efficiency, inventory and cost
Solution
Efficiency:
Inventory:
Cost:
157
Throughput accounting (TA) and theory of constraints (TOC)

The theory of constraints is a production system where the key financial concept is the maximisation of throughput while keeping conversion and investment costs to a minimum. Throughput return = Sales revenue Material cost TOC is a production system designed to (a) (b) (c) maximise throughput contribution the rate at which profit is generated minimise conversion costs all other operating costs except direct material cost minimise inventory stock, R&D and equipment and buildings
Theory of constraints (TOC)

6.1 6.2 6.3
TOC is concerned with management of bottlenecks as these act as a barrier to throughput maximisation.
Bottlenecks
6.4 Raw Materials Materials Preparation Component Preparation Final Assembly Sales
100 units per hour
50 units per hour
100 units per hour
One process will inevitably act as a bottleneck, known as a binding constraint. 6.5 Goldratts five steps for dealing with a bottleneck activity were: Step 1 Identify the binding constraint Step 2 Exploit. The highest possible output must be achieved from the binding constraint. This output must never be delayed and as such a buffer inventory should be held immediately before the constraint Step 3 Subordinate. Operations prior to the binding constraint should operate at the same speed as it so that WIP does not build up Step 4 Elevate the systems bottleneck. Steps should be taken to increase resources or improve its efficiency Step 5 Return to step 1. The removal of one bottleneck will create another elsewhere in the system
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Key resources
6.6 In practice the key resource in a factory may not be machine time or labour hours. Any constraint that reduces production flow can be used when calculating return or cost.
Lecture example 4
HYC makes three products H, Y and C.
All of the products are first moulded on machine type 1 and then finished and sealed on machine type 2. The machine hour requirements for each of the products are as follows. Product H Hours per unit 1.5 1.0 Product Y Hours per unit 4.5 2.5 Product C Hours per unit 3.0 2.0
Machine type 1 Machine type 2
The capacity of the machine type 1 is 600 hours and machine 2 is 500 hours per month. Maximum monthly demand (units) Required Calculate the machine utilisation rate for each machine each month and explain which of the machines is the bottleneck/limiting factor 120 70 60
Solution
159
Throughput accounting (TA)

6.7 TA is an accounting system based on the theory of constraints. It is very similar to marginal costing but can be used for longer-term decision making about production capacity. It is an alternative system of cost and management accounting in a JIT environment. Traditional costing Labour costs and variable overheads are treated as variable costs. Inventory levels are kept high Throughput accounting All costs other than materials are seen as fixed in the short term. Inventory levels are ideally zero (although a small buffer stock will be kept prior to the bottleneck) Idle time is accepted Inventory is valued at material cost only. Value is added when an item is sold. Profitability is determined by the rate at which money is earned.
6.8
Idle time should be eliminated where possible Inventory is valued at total production cost. Value is added when an item is produced. Product profitability can be determined by deducting a product cost from selling price.
Lecture example 5
Required
Identify some of the possible impacts of the Theory of Constraints on efficiency, inventory and cost
Solution
Efficiency:
Inventory:
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9a: COST MANAGEMENT TECHNIQUES 1 Cost:
Ratios
6.9 (a) (b) Return per factory hour = Cost per factory hour = Sales revenue material purchases Time on key resource
Total Factory Costs (all costs except materials) Total time available on key resource
(c)
TA ratio =
Return per factory hour Cost per factory hour
Ranking production
6.10 Products or divisions are ranked by TA ratio. 6.11 If two or more products are made in the same factory, they can be ranked on return per factory hour, not TA ratio, since their costs will be identical.
Target for decision making

6.12 The TA ratio should be greater than 1 if a product is to be viable in the long run. Priority must be given to products which generate the best TA ratios.
161
Lecture example 6
BR is preparing its production plan for the next three months and has estimated the maximum demand from customers as follows:
Product A B C Units 200 100 75
Each product has the following sales and cost information:

A $/unit 140 B $/unit 230 C $/unit 280
Selling price Material N ($8/kg) O ($12/kg) P ($9/kg) Labour ($8/hour) Fixed Overheads
16 12 27 28 17.50
8 27 45 57 35.62
24 24 90 32 20
BR guarantees its workers a weekly salary equivalent to their normal working hours at an hourly rate of $8/hour. BR has recently been informed by a supplier that there is a worldwide shortage of material P. As a result, the supplier will only be able to supply 1,000 kgs over the next three months.
Required
Prepare calculations to determine the profit-maximising production using: (a) (b) (c) Marginal costing contribution Throughput contribution TA ratio
and comment on the results.
Solution
162
163
7
7.1
Section 10 Business process re-engineering
Business process re-engineering (BPR)

One method to reduce non-value added costs and activities is business process reengineering. BPR is the fundamental rethinking and radical design of business processes to achieve dramatic improvements. BPR begins with no regard for a companys current operations: it asks what a company must do, and then how to do it.
7.2
Fundamental
7.3
Dramatic
7.4 BPR is not about making incremental performance improvements, these can be achieved using current techniques like TQM.
Processes
7.5 Most business are task oriented rather than process oriented, where a process is defined as a collection of activities that adds value to a customer. The shift to process-based thinking is critical.
164
Chapter summary
Section Topic World class manufacturing Summary
The traditional production environment focused on high volumes and low cost whereas the modern business environment focuses on items such as quality, reliability and flexibility.
TQM acknowledges that it is more important to get it right first time than inspect for defects. All errors provide an opportunity for continuous improvement. It is supported by cost of quality reports which separate prevention, appraisal, internal failure and external failure costs and by kaizen costing.
Total quality management
3 4
Continuous improvement Kaizen costing
A continual focus on cost reduction whilst improving quality. Kaizen costing focuses on constant small, incremental cost reductions throughout the production stage of the product lifecycle.
Just-in-time techniques acknowledge that inventory is not valuable unless demand for it exists. It has more flexible and cost effective production.
Just in time
Focuses on maximising throughput. Throughput = sales materials. Limiting factor decisions are based upon return / limiting factor. TA ratio = Return per factory hour Cost per factory hour
Business process reengineering
BPR is one method by which costs can be reduced without affecting the value of the product. It entails radical change of business processes.
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END OF CHAPTER
166
9b
Example past paper questions Nov 06, Q2, 10 marks May 08, Q2, 10 marks May 07, Q5, 7 marks Nov 08, Q3(b), 5 marks

Syllabus learning outcomes Discuss the concept of the value chain and discuss the management of contribution/profit generated throughout the chain. How syllabus outcomes are examined An explanation of the components of the extended value chain has been examined with application to the scenario given. A report requiring explanation of the value chain concept and management of profit generated throughout the chain has also been required. Discuss gain sharing arrangements whereby contractors and customers benefit if contract targets for cost, delivery etc are beaten. Questions have involved an explanation of gain sharing and some application to the scenario given and also consideration of the learning curve when drawing up a gain sharing agreement.
167
9b: COST MANAGEMENT TECHNIQUES 2
Overview
Supply chain management
Outsourcing
Value chain
Partnering Incentives Gain sharing
168
1
1.1
The value chain

Michael Porter observed that an organisation is essentially a system that converts inputs into outputs, the aim being to add value to the customer which they will find attractive and be willing to pay for and therefore make profits. A firm is profitable if: Value perceived by customers > Cost of activities that create that perception.
Example a restaurant
1.2 BUYING COOKING SERVING
A restaurant's activities can be divided into buying food, cooking it, and serving it. The ultimate value a firm creates is measured by the amount customers are willing to pay for its products or services above the cost of carrying out value activities.
Lecture example 1
Brainstorming question
What is it that customers value that enables an average spend of 2.99 at McDonalds compared with 200 in a Michelin star restaurant?
Solution
BUYING
COOKING
SERVING
169
Internal value chain

1.3 Porter analysed the various activities of an organisation into a value chain. This is a model of value and activities and the relationship between them and is particularly useful in a manufacturing environment.
SUPPORT ACTIVITIES Firm infrastructure Human resource management Technology Development Procurement Inbound logistics Operations Outbound Logistics Marketing and Sales Service
1.4
Porters value chain is a graphical representation of what a firm does to add value. It illustrates the: (a) (b) (c) direct (primary) activities; indirect (support) activities; and the linkages between these activities or processes (ie competences) that allows it to turn raw materials, fixed assets, manpower and capital into finished goods and profits
1.5
The activities in the value chain are as follows: Primary activities (a) (b) (c) (d) (e) Inbound logistics receiving, storing and handling of raw materials Operations processing raw materials into finished goods Outbound logistics storing finished goods and distributing them to customers Marketing and sales marketing and selling activities Service after or during sales service
Support activities (a) (b) (c) (d) 1.6 Infrastructure management structure, finance etc Technology department management of IT and R&D functions, designing products Human resources all functions related to staff recruitment and development Procurement purchasing function
The diagram below shows an alternative value chain in non-manufacturing environments. Strategy and administration
R&D Design Production Marketing Distribution Customer service
170
9b: COST MANAGEMENT TECHNIQUES 2 1.7 The value chain asserts that whilst excellence in manufacturing is essential for success it is not sufficient to guarantee success. All business factors should still add value and can run consecutively and concurrently. Value can also be added by the way in which these activities are linked. (a) (b) (c) (d) (e) (f) R&D new ideas for products, services or processes Design planning and engineering Production coordination and assembly of resources to produce a product Marketing teaching customers about products and persuading them to purchase Distribution delivery to customers Customer service support to customers
Extended value chain (external)/ Value system

1.8 A company's value chain is not bounded by a company's borders, its connected to what Porter describes as a value system.
1.9
As well as managing its own value chain, a firm can secure competitive advantage by managing the linkages (ie relationships) with the value chains of its suppliers and customers.
1.10 For example, our inbound logistics needs to coordinate well with the outbound logistics and operations planning of suppliers. 1.11 A firm's value chain is not always easy to identify nor are the linkages between the different elements. However, it is an important analytical tool because it helps: (a) (b) (c) (d) see the business as a whole identify potential sources of competitive advantage suggest strategies analyse competitors
171
9b: COST MANAGEMENT TECHNIQUES 2 1.12 The following example illustrates how the value chain model can be employed to analyse direct competition. Example : British Airways (or any major national airline)
Prime airports Prime slots
New seats
Aircraft layout
Quality food
Multiple booking methods
Checkin/out systems
Lost luggage return
Business passengers
Lecture example 2
Suggest appropriate ways for a 'no frills' carrier such as EasyJet to add value.
Solution
R+D
Design
Production
Marketing
Distribution
Customer service
172
Waitrose: A Case Study
A belief in quality
Our reputation has been built, above all, on the quality and freshness of our food. It is what our customers want, and it is what gives us our edge over other supermarkets: We are committed to bringing you the best quality food. Should you not enjoy one of our products, tell us and well replace and refund you. Of vital importance to us is the provenance and traceability of the food that is on our shelves. Each of our buyers is an expert in his or her own field. Much of their time is spent with the farmers, growers and suppliers, building relationships based on trust and respect. Wherever possible our buyers buy British. Increasingly, they are also sourcing local produce from small growers and suppliers close to individual Waitrose stores. Although we always seek a good deal for our customers, we also expect to offer producers a fair return and develop supportive, long-term relationships with them. This means we can help producers in poorer countries invest for the future, as well as being sure they operate to high ethical standards. Waitrose was the first supermarket to sell loose Fairtrade bananas, thanks to our partnership with a group of 100 small growers on the Windward Islands. We guarantee them a year-round fair price, and regularly send our buyers and agronomy specialists to the Islands to offer advice and help with anything from fertilisers to packaging. All bananas sold at Waitrose are now Fairtrade.
Waitrose Entertaining
Waitrose Entertaining can help you cater for any event, from home entertaining for a few friends to special occasions such as a wedding reception for hundreds. With menu ideas including oven ready dishes, canaps, celebration cakes, and fruit baskets, Waitrose Entertaining will bring something special to any occasion you may be planning.
Quick Check
Quick Check is our scan as you shop service. Using a handheld scanner, you scan each item as you take it from the shelves and pack as you go. When you have finished shopping, all that is left to do is pay at the Quick Check till, without having to unpack and re-pack your shopping. If paying using a debit, credit or account card you can save even more time by using Quick Pay. Quick Check is available in a number of branches. We will also supply special reusable bags to our partnership cardholders and Waitrose and John Lewis account card cardholders.
Home delivery
At selected branches you can choose to have your shopping delivered to your home. If you pay with your partnership card or with your Waitrose or John Lewis account card you can take advantage of our Fast track service. On completing your shopping take your goods to the Delivery Service Desk or Fast track collection point and we'll do the rest for you - there's no need for you to go through the checkout.
173
Branch extras
We can lend you wine and beer glasses, and even fish kettles, free of charge. You will only pay for any breakages.
British produce is amongst the best in the world

Waitrose always tries to source from Britain when products are in season and at the peak of freshness and flavour. All Waitrose fresh chicken, beef and pork (including that sold as sausages) venison, duck and goose is British. Most of our lamb is produced in the UK, all of our turkeys come from the UK or Ireland, and 100 per cent of our bacon is English. We are proud of our British suppliers and forge strong relationships with them founded on trust, fairness and a passion for good food. With a reputation built on the quality and freshness of our food, we are committed to letting people know about the wealth of high quality food available. Agriculture is an essential part of Britain's heritage. Waitrose believes retailers play a vital role in safeguarding the future of the countryside and the farmers who create it, and we take our responsibilities seriously. Waitrose has set up over 30 livestock producer groups - the only supermarket to do so - giving producers an assured market, clear direction, and a stable base on which to build their businesses and invest in the future.
Waitrose is the only supermarket to sell local products within a 30 mile radius of a branch.
Waitrose has a team of buyers dedicated to seeking out local and regional sources of the best quality food that often cannot be found in other supermarkets. They track down farmers, growers and suppliers, many of them small, family-run businesses, who may want to supply only a handful of Waitrose branches. A product is defined as 'local' if it is made within a 30-mile radius of the Waitrose branch where it is sold. Local products in Waitrose shops include fruit and vegetables, sausages, bacon, ice cream, wines, cheeses, sauces, and honey. At present more than 1200 local products from 450 local suppliers are available in nearby branches. Products are made largely from locally produced ingredients, free from unnecessary additives and are usually delivered straight to the branch by the supplier. Similar criteria of quality and freshness apply to 'regional' produce, but it comes from a larger area and is more widely available, for example, East Anglian potatoes. Our local and regional produce is clearly labelled so customers can easily spot the provenance.
Traceability of our foods

At Waitrose, our reputation rests on the traceability of the finest foods. This requires strong relationships throughout the food supply chain built on respect, trust and a mutual commitment to the highest standards. Having our own 4,000-acre farm means Waitrose practises what it preaches. Leckford Estate is all about innovative practices and new products, a holistic approach, choice and quality, and respect for the environment. But, above all, it's about delivering customers the very finest food from known sources.
174
9b: COST MANAGEMENT TECHNIQUES 2 Leckford Farm is a working farm producing arable crops including high quality bread-making wheat which is used to make a range of Leckford label flour. The farm also supplies milk, apples, pears, apple juice, cider, free range eggs and mushrooms as well as free range Le Poulet d'Or chickens to Waitrose branches. At Leckford, we embody the Waitrose principles of good food, good environmental practice and fair behaviour in all our transactions. At all stages we ensure responsible and sustainable agriculture and animal husbandry. We also recognise the daily challenges that farmers face in producing wholesome, affordable food as well as managing a viable farming business.
Foundation
The Waitrose Foundation is a partnership created in 2005 to help improve the lives of the farm workers who grow and pick our South African fruits. Money raised by the sale of Waitrose Foundation fruit is spent on projects that are chosen by and directly benefit the farm workers. Instead of funding through a price premium, Waitrose - in conjunction with growers, importers and exporters pass a percentage of profits into a trust to pay for educational, social and healthcare projects chosen by workers committees. So far, there are 93 projects and more than 20,000 farm workers and their families have benefitted from the work funded by the Foundation.
What's in it for Waitrose?

In order for Waitrose to continue to buy fruit from South Africa in the long term, it is vital we invest in the farm workers that grow and pick our fruit. South Africa is an important source of fruit for Waitrose; its diverse climates and landscapes, enable a wide range of produce to be grown. It's important for us to secure the future of this source as the country moves through great changes. The Waitrose Foundation is an example of how Waitrose works in partnership with its supply base to build sustainable relationships. There are two distinct stages to the foundation programme. The first stage works to address social issues and aims to ensure the transfer of essential skills and knowledge to workers, through methods such as education programmes - both basic literacy and agricultural production. The second stage will ultimately involve the ownership of land by farm workers, whereby Foundation grants will be used to buy land to be held in trust on behalf of the farm workers.
Fair trade
The Fairtrade Foundation is the only independent certifier of ethically-traded products in the UK, guaranteeing producers receive a fair price for their goods whatever the market conditions. Companies have also set up fair-trading schemes. In our coffee section, you'll see products certified by the Rainforest Alliance, which aims to provide fair wages and decent conditions for workers and encourage environmentally friendly farming practices; Good African Coffee, which shares profits fifty-fifty with growers; and Utz Kapeh, which empowers producers by teaching them professional growing and marketing techniques, treats workers fairly and meets specified environmental standards.
175
Lecture example 3
Exam standard 8 marks
The value an organisation creates is measured by the amount customers are willing to pay for its products and services less the cost of providing those products and services Required Explain how an understanding of the Value Chain and what drives value for a customer, could be used in Waitrose.
Solution
176
2
2.1
Section 2 Supply Chain Management
Supply chain management

A supply chain can be defined as the entities required to supply products to customers. Typically this will include: manufacturers, suppliers, distribution centres and retail outlets. The activities involved in the supply chain can be equated to the primary activities in Porters Value Chain. Supply chain management is the co-ordination of all supply activities of a company from it suppliers to its customers. Traditional techniques involve: (a) (b) Buying in at the lowest possible price from suppliers Selling at the highest possible price to customers
2.2 2.3
in order to maximise profit. 2.4 Supply chain management challenges this approach. It suggests that members of the supply chain should collaborate to produce something of value for the end customer. Coordinating the activities of the different businesses on the supply chain saves costs while also adding value and synergies are achieved that benefit every member in the chain.
Common Supply Chain Management practices

2.5
Lessons from 25 supply chain leaders
(a) (b) (c)
Consolidating the supplier base few suppliers with long term relationships Co-ordinating production and inventory policies Linked production schedules enable stock minimisation, just in time production and shorter lead times. Linking IT systems Data from EPOS systems is transferred immediately to manufacturers ordering systems. Goods can be delivered to the stores where they are needed without having to be stored at a warehouse first. Participation in product development Suppliers are involved in the development and design of new products. This leads to reduced design and product development time.
(d)
Advantages
2.6 (a) (b) (c) (d) (e) (f) (g) Added value in the supply chain Increased customer satisfaction Increased sales prices Reduction in waste and inefficiency between supply chain members Reduced transaction, admin & logistics costs Shorter time to market Improved responsiveness to customer requirements
177
Lecture example 4
Required
Suggest ways in which supply chain management can provide these advantages.
Solution
Lecture example 5
Required
Idea generation
Using the Waitrose Case study earlier in this chapter detail the ways in which Waitrose manages its supply chain.
Solution
178
3
3.1 3.2
Outsourcing
Outsourcing is the use of external suppliers as a source of finished products, components or services. (CIMA Official Terminology) It has been suggested that, in the next 10 to 20 years, most organisations will have outsourced every part of the value chain except the few key components that provide competitive advantage. Advantages Specialist contractors have: superior quality efficiency economy of scale capacity flexibility equipment may be underutilised inhouse supervision of outsourced activities can be lower no facilities are required in house No guarantee over quality Less control over efficiency Price rises in future Loss of in-house skill Less security of information Ethical considerations Employee opposition Difficulty in management control Disadvantages
3.3
Capital is released to reinvest:
Fixed costs are replaced by variable costs, which is useful under uncertainty. Cheaper especially if overseas locations can be accessed.
Lecture example 6
Required
What are the specific advantages and disadvantages of outsourcing customer services to developing economies?
Solution
179
4
4.1
Partnering, incentives and gain-sharing

In some situations, normal competitive pressures do not apply in relationships between customers and contractors. This might be because of the size of the project (say in the construction or civil engineering industries), because there are a limited number of contractors or because of security issues (as in defence work). In such circumstances, partnering, incentives and gain-sharing arrangements are required.
Partnering
Unlikely partners offer best of all worlds
4.2 4.3
Partnering is defined as: 'two or more organisations working together to improve performance'. Partnering is particularly suitable in the following circumstances. (a) (b) (c) (d) If significant input is required from specialist contractors or subcontractors (such as in the construction of a new airport terminal) If there is a rapid expansion of a programme of construction (say, if a supermarket chain opens lots of new branches) If time is a critical factor If there is a particular construction problem which is best solved by a team of experts (such as the construction of oil rigs)
4.4
Section 4.1 Partnering
Two key types of partnering arrangement exist. (a) (b) Strategic partnering (longer-term partnering for agreements involving more than one project) Project specific partnering.
4.5
Partnering involves: (a) Agreeing mutual objectives (b) Devising ways to resolve disputes (c) Continuous improvement (d) Measuring progress (e) Sharing gains
180
9b: COST MANAGEMENT TECHNIQUES 2 4.6 Advantages Cost savings Profit rises Reduced times Lower risk Improved quality Improved safety Higher customer satisfaction Components Trust Shared procedures Team working Open book accounting Mutual interdependence Suitability Large input needed from contractors Rapid expansion of construction Time critical Repetitive projects Expertise required
Lecture example 7
McLaren Mercedes is a well known partnership in F1 Required
Identify the benefits of the agreement to both parties and some of the potential risks.
Solution
181
Incentives
4.7 4.8 Incentives encourage partners to work together to provide benefits to the client beyond those stipulated by contract. Examples of performance that could be considered for incentives: Cost Time Quality Safety
No incentive should be provided for meeting the terms of the contract. 4.9 Negative incentives, to share extra costs, could also be employed.
Gain sharing
4.10 The concept of gain sharing is not new. Bonuses based on company profits or share options for employees have been in existence for a long while. However, gain sharing is not limited to gains within an organisation, but also incorporates contracts between separate companies. 4.11 Both parties agree to share any benefits that are achieved over and above those specified in the contract 4.12 Gain sharing arrangements could also be pain/gain sharing. All cost overruns or cost savings are shared between customer and contractor. This can be extended to the entire supply chain. 4.13 Gain sharing can cause (a) (b) (c) (d) Higher technical specification Faster delivery New sources of income to emerge Better supply chain management
These gains will need to be assessed financially through open book accounting.
182
Chapter summary
Section 1 Topic Value chain Summary The value chain is an attempt to show the activities performed by an organisation to add value, that is to make profit, and to satisfy customers. The extended value chain includes both suppliers and customers. 2 Supply chain management Outsourcing Partnering, incentives and gain sharing Members of the supply chain collaborate to provide value to the customer, sharing any savings between the partners in the chain. Non core activities are outsourced to gain access to expertise whilst making cost savings. Organisations work together to improve performance. Cost savings or overruns are shared.
3 4
183
END OF CHAPTER
184
Budgeting
10
How syllabus outcomes are examined This discussion requirement is likely to involve explanation of and examples of these techniques.
Narrative questions will require you to explain the importance of budget holders only being responsible for what they can control. You may be asked to assess a budgetary control system and comment on the treatment of controllable and uncontrollable costs This will require specific attention to how different budgeting systems will affect employees in terms of motivation and performance. Calculation of costs under various alternative possible outcomes has been required. This could be examined numerically, requiring the calculation of a flexed budget. You are likely to be given a modern scenario and asked to write about why traditional budgeting methods would be inappropriate.

Syllabus learning outcomes
Explain the concepts of feedback and feedforward control and their application in the use of budgets for planning and control. Explain the concept of responsibility accounting and its importance in the construction of functional budgets that support the overall master budget Identify controllable and uncontrollable costs in the context of responsibility accounting and why uncontrollable costs may or may not be allocated to responsibility centres Discuss the impact of budgetary control systems and setting of standard costs on human behaviour. Evaluate the consequences of what if scenarios and their impact on the master budget. Evaluate performance using fixed and flexible budget reports. Discuss the criticisms of budgeting particularly from the advocates of 'beyond budgeting' techniques.
Example past paper questions

P1 Nov 07, Q2(c), 5 marks P1 May 09, Q2(c), 5 marks P1 Nov 08, Q3(b), 12 marks
P1Nov 07, Q3(d), 10 marks
P1 May 08, Q2(b), 5 marks P1 May 06, Q3(c), 6 marks P1 May 09, Q2(a), 5 marks May 10, Q4(a), 6 marks P1 May 07, Q4(b), 6 marks
P1 Nov 06, Q2(c), 5 marks P1 May 06, Q3(a), 7 marks P1 Nov 07, Q2(d), 5 marks P1 May 05, Q2(f), 5 marks
185
10: BUDGETING
Overview
Planning and control cycle
Budgetary control
Responsibility accounting
Budgeting
Beyond budgeting
Budgets for planning Fixed Flexible Rolling
Budgets for control Flexed
Behavioural aspects of budgeting
186
10: BUDGETING
1
1.1
Introduction
A budget is a financial and/or quantitative plan of operations for a forthcoming period.
2
2.1 2.2
Planning and control

Budgeting is part of the overall process of planning and control. A budget is a plan which will assist in achieving objectives. The cycle of planning and control: Determine objectives
Control Compare actual with budget
Planning Set budget
Operate in line with objectives
3
3.1
Budgetary control
Systems theory
A system must be controlled to keep it steady or enable it to change safely. Control is required because unpredictable disturbances arise and enter the system, so that actual results/(outputs) deviate from expected results. Examples of disturbances from the environment which would impact on a business system would be as follows: Rise in the cost of raw materials Changes in demand levels Price war
A control system must ensure that the business is capable of surviving the disturbances.
187
10: BUDGETING 3.2 There are various components of a controlled system. (a) (b) (c) (d) A meaningful target or standard (eg an annual cost budget) A method of gathering and recording information from a system (sensor) (eg management accounting system) A method of comparing information to a standard (comparator) (eg a monthly variance report) The means to initiate control action (effector) (eg the purchasing manager who may source cheaper materials based on an adverse variance report)
This flow of information through a system is known as the feedback loop and is represented diagrammatically below:
Effector
Comparator
Standard
Sensor
Input
Process
Output
3.3
The feedback loop shown above is effectively a single feedback loop in that it is confined to information coming from within the organisation and refers to a fixed budget. This can be compared to a double feedback loop, in which the external environment is monitored and action maybe taken to modify the control system itself (for example, the budget may be amended to reflect an expected global increase in a material cost, or new product lines may be introduced).
Feedback control
3.4 A feedback system operates by comparing actual (historical) results against a standard or plan, and taking control action where differences between actual and plan have occurred. Events in the past (ie target deadline has been reached) are used to take corrective action for the future. Positive feedback indicates that results were better than planned. Control action may be taken to encourage the deviation from what was originally expected. Negative feedback indicates worse results than planned. Control action aims to get back to the original plan.
188
10: BUDGETING
Feedforward control
3.5 A feedforward system operates by comparing planned results against a current (revised) forecast of what results will be (unless corrective measures are taken). Control action is triggered by differences between anticipated and planned results. (ie target deadline is still in the future). Planned results $ Control
Forecast
Current date
4
4.1
Useful budgets for planning

The fixed budget is the master budget prepared before the beginning of the budget period. It is based on budgeted volumes and costs/revenues and is not adjusted regardless of the level of activity attained in the period.
Fixed budgets
Flexible budgets
4.2 The flexible budget is a budget which is designed to change as volume of activity changes. This can be done by recognising the behaviour of different costs (fixed or variable). Flexible budgets have two uses: (a) (b) At the planning stage preparing budgets at differing levels of activity. This is an example of 'what if?' analysis. Retrospectively, at the end of a control period, to compare actual results with what should have been achieved. This is essential in budgetary control.
Purpose of flexible budgets

4.3 (a) (b) (c) Designed to cope with different activity levels to keep the budget meaningful and hence preserve the relevance of variances for effective control. Useful at planning stage to show different results from possible activity levels. Necessary as control device because we can meaningfully compare actual results with relevant flexible budget, ie budgetary control.
189
10: BUDGETING
Rolling budgets
4.4 Rolling budgets are also called continuous budgets. They are particularly useful when an organisation is facing a period of uncertainty making it difficult to prepare accurate forecasts. Rolling budgets are an attempt to prepare targets and plans which are more realistic and certain, particularly with a regard to price levels, by shortening the period between preparing budgets. Instead of preparing a periodic budget annually for the full budget period, budgets would be prepared, say, every one, two or three months (four, six, or even twelve budgets each year). Each of these budgets would plan for the next twelve months so that the current budget is extended by an extra period as the current period ends: hence the name rolling budgets. Cash budgets are usually prepared on a rolling basis.
4.5
4.6
Advantages of rolling budgets

4.7 (a) (b) (c) (d) They reduce the element of uncertainty Managers have to regularly reassess the budget Planning and control will be based on a more recent plan The budget always extends for some time into the future
Disadvantages of rolling budgets

4.8 (a) (b) Effort and expense required to continuously update the budget May demotivate managers if they cannot see the benefit of regular revisions
5
5.1
Useful budgets for control

The use of flexible budgets in budgetary control can be referred to as ascertaining the budget cost allowance, or flexed budget. A flexed budget or budget cost allowance is a budget that has been prepared based on actual volumes for budgetary control purposes. It is a more meaningful performance evaluation tool as it allows a like for like comparison to be made. The flexed budget forms the basis for standard variance analysis (ie actual activity should have cost)
Flexed budgets
190
10: BUDGETING
Lecture example 1
Introductory level exam technique question
Chateau Larnaque has a bottling plant for its wine and has prepared flexible budgets: Flexible Budgets Bottles: Production costs: Materials Labour Overhead Required Calculate meaningful variances for performance evaluation purposes, if actual production was 12,350 bottles and the production costs were: Materials Labour Overhead Total 35,000 32,000 23,000 90,000 10,000 $ 30,000 27,000 20,000 12,000 $ 36,000 31,000 20,000 14,000 $ 42,000 35,000 20,000
Solution
191
10: BUDGETING
6
6.1
A controllable cost is a cost which can be influenced by the budget holder. There may well be costs which cannot be changed by the budget holder or by management within a given time period. These are uncontrollable costs.
Controllable vs uncontrollable costs
6.2 6.3 Responsibility structure Cost centre Revenue centre Profit centre Investment centre Manager's area of responsibility Decisions over costs Revenues only Decisions over costs and revenues Decisions over costs, revenues, and assets Typical financial performance measure Standard costing variances Revenues Controllable profit Return on investment and residual income Responsibility accounting is the term used to measure performance of decentralised units.
Responsibility accounting associates costs and revenues with the managers that can control them. It therefore distinguishes between controllable and uncontrollable costs.
7
7.1
Behavioural aspects of budgeting

Accountants must consider the impact of their budgeting systems on human behaviour. (a) (b) (c) (d) Budget pressure unites employees against management Pressure may lead to negative results Workers feel victimised loss of confidence and motivation results Supervisors use budgets as an expression of their position of superiority
General considerations
A good system of control must influence employees in the direction of the companys best interests.
Motivation and budget setting

7.2 The level at which standards and budgets are set will affect employee motivation and therefore their behaviour. (a) (b) Ideal standard assumes an optimum level of efficiency. Attainable standard makes an allowance for normal inefficiencies but also includes hoped-for improvements.
192
10: BUDGETING (c) (d) 7.3 7.4 7.5 Current standard based on current efficiency levels and achievements. Basic standard/historic standard not updated regularly, used to show changes over the long term.
Best performance is usually achieved when a budget is perceived as challenging but possibly achievable. (eg through the use of attainable standards.) It is vital that the goals of management are in line with the goals of the organisation as a whole. This is known as goal congruence. A manager who is assessed by his ability to meet budget may not undertake activities if they are not in the budget or be cautious about taking new business opportunities. Budgetary control should not be so rigid that it constrains the business. Management accountants should therefore try to ensure that management and employees have positive attitudes towards setting and implementing budgets, and feedback of results.
7.6
Participation in budgeting
7.7 In a top-down system, budgets are imposed on individuals by their managers. In a bottom-up system, the budget holder is invited to have input at the budget setting stage.
Advantages of top-down (imposed) budgeting systems

7.8 (a) (b) (c) (d) Likely to be quicker Avoid budgetary slack and budget bias Utilise senior management awareness of total resource availability Avoids taking local management away from day-to-day duties
Advantages of bottom-up budgeting systems

7.9 (a) (b) (c) More detailed local information used in budget setting processes Morale and motivation is improved Increased likelihood of achievement
193
10: BUDGETING
Lecture example 2
Required
Briefly outline the advantages and disadvantages of allowing profit centre managers to participate actively in the setting of the budget for their units.
Solution
8
8.1
Beyond budgeting
In recent years the following criticisms have been levelled at the traditional budgeting process that is traditional budgets: (a) (b) (c) (d) (e) Are time consuming to produce and add little value to the business Have insufficient external focus Are too rigid and prevent fast response Protect rather than reduce cost Stifle innovation
Since the late 1990s some companies have shifted their focus from the traditional budgetary cycle in favour of 'beyond budgeting'. Examples include Volvo, Ikea and Bulmers.
194
10: BUDGETING 8.2 Two concepts underlie the beyond budgeting approach: (a) (b) (a) (b) (c) (a) (b) (c) Adaptive management processes instead of rigid budgeting Decentralised management with employee empowerment Planning on a rolling basis Focus on cash forecasts not cost control KPIs referenced to external benchmarks such as competitors Managers empowered to make decisions. This speeds up response times and enables opportunities to be exploited Teams are motivated as they have responsibility. Rewards are team-based Customer-orientated teams are established
Adaptive management processes involves:
Decentralised management involves:
Lecture example 3
Orchard designs and sells mobile phones. Traditionally they have prepared detailed budgets each year. The MD is now considering changing its budgeting approach to a 'Beyond Budgeting' approach. Required Advise the management whether a beyond budgeting approach should be adopted.
Solution
195
10: BUDGETING
9
Q10 M plc
Chapter summary
Section 1 2 3 Topic Introduction to budgeting Planning and control Budgetary control Summary A budget is a financial and/or quantitative plan of operations for a forthcoming period. Budgeting is part of the planning and control process. Managers should only be assessed on those items within their control. Control can be feedback or feedforward comparison of past results or forecast results to plan. 4 Useful budgets for planning Useful budgets for control Responsibility accounting Behavioural aspects of budgeting Beyond budgeting Flexible budgets are ideal for planning. Rolling budgets are particularly helpful in times of uncertainty. Flexed budgets are the best for budget control as they allow you to compare like for like. Associates costs with the managers that can control them. The budget set and the participation in the process can have a large impact on motivation. Beyond budgeting focuses on cashflow forecasting and external KPIs. This is particularly suitable in rapidly changing business environments.
5 6 7
END OF CHAPTER
196
CHECKPOINT 3

Key knowledge
Many of the other topics covered in this stage you may have seen before either at P1 or E1 (P4 under the old syllabus). It is important not to neglect these areas though as they may well be examined in a different manner at P2 to that in the other papers. For example, throughput accounting may not be examined purely via calculation but may include a discussion of for example, its impact on stock valuation compared to traditional accounting. Activity Based Costing ABC whilst examined in a very similar manner to P1 will probably have more discussion marks and may incorporate techniques such as CPA / DPP / Pareto analysis. Cost management techniques As mentioned already, these techniques whilst having been seen before will be examined very often via a greater discussion than seen previously. The techniques in chapter 9b are normally examined via an explanation of the concept before then having to apply your knowledge to a given scenario. Budgeting You will have already seen aspects of budgeting in P1. P2 will examine different aspects of budgeting focussing on discussions around controllability and behavioural implications of budgeting as well as evaluating performance through flexed budgets.
Key skills
The exam will require concise written answers to questions on topics like budgeting. From stage 3 you should recognise that the ability to explain or discuss key techniques is an important exam skill. At Management Level, you are expected to do more than the basics as well as knowing the definitions of the key concepts you also need to be able to clearly explain these concepts, and discuss when they should be used or how they apply to various situations you may be given.
197
CHECKPOINT 3

Chapter 8 Cost analysis (part 2)
Key areas - use the online lectures to selectively review these if you need to CPA and DPP Pareto analysis 10 mins
70 mins
Course Notes Review sections 5 & 7 to ensure you understand how ABC can be applied to customers and retailers. Question Practice Attempt Question 8 from the Question and Answer Bank in the back of the course notes. Ensure that you are comfortable with the discussion required in part (d) as the interpretation of calculations is very important for P2. Additional Resources Study Text Review section 3.8 & 3.9 which looks at evaluating performance and implementing ABM. Further information on distribution channel profitability can be found in section 6. Review this if time permits.
45 mins
10 mins 5 mins
Chapter 9a Cost management techniques 1

Key areas - use the online lectures to selectively review these if you need to JIT & TQM Throughput accounting Course Notes Review these techniques to ensure that you can talk about their impacts on efficiency, inventory and cost. Work through lecture example 6 again to ensure you are comfortable with the throughput accounting ratios.
80 mins
10 mins 15 mins
Question Practice Attempt Question 9 from the Question and Answer Bank in the back of the course notes. It is important that you get into the habit of planning your answers for written questions before starting to answer these questions and that you take note of the format required ie report format. Additional Resources Brought forward knowledge EOQ this and the formulae for the holding cost of stock etc are still examinable in the P2 syllabus and could be examined via a comparison with JIT. An online lecture is available to cover this. Study Text Take brief notes on section 10 on business process re-engineering. If there are areas in this chapter that your memory is hazy on, review the relevant section in the text. (would take approx 10 mins)
20 mins
30 mins 5 mins
Real-life examples An article looking at testimonies of businesses who have used TQM is contained at the end of the checkpoint. (If you have time, take a couple of minutes to review this)
198
CHECKPOINT 3
Chapter 9b - Cost management techniques 2

Key areas - use the online lectures to selectively review these if you need to Value chain Outsourcing Gain sharing / partnering
20 mins
Course Notes Review the chapter particularly for the areas that you havent covered elsewhere in your studies to date. Additional Resources Study Text Review the additional detail in section 2 on supply chain management Review section 4 partnering, and ensure you can explain the key features of it. Review the articles at the end of this checkpoint on supply chain management and partnering to add to your understanding of how these techniques are used. (this should take 5 10 mins) Real-life examples
10 mins
5 mins 5 mins
Chapter 10 - Budgeting and budgetary control

Key areas - use the online lectures to selectively review these if you need to Budgetary control Budgets for planning and control Behavioural aspects of budgeting
75 mins
Course Notes Review this chapter and ensure you can explain the various techniques including when they are suitable, their benefits and drawbacks. Question Practice Attempt Question 10 from the Question and Answer Bank in the back of the course notes. This question involves both calculations and discussion. Practice, especially of the written elements is important preparation for the exam. Additional Resources Study Text Ensure you are familiar with section 5 which looks at using spreadsheets to build business models.
10 mins
60 mins
5 mins
199
CHECKPOINT 3

A
1

A company makes product X which passes through three production operations A, B and C. Product X sells for $8 per unit and has a direct materials cost of $3 per unit. Total labour cost for the period is $10,000 and overheads for the same period amount to $14,000. Processing times per unit and maximum processing times available for the three operations are given below: Operations A 3 mins 30,000 B 11 mins 50,000 C 6 mins 80,000
Time per unit Total capacity (mins) A B C D 2 A B C D 3 (i) (ii) (iii) (iv) (v) A B C D 0.32 0.45 0.48 0.94
Calculate the throughput accounting ratio for product X.
(2 marks)
What are the primary activities of Porter's value chain for a manufacturing company? Human resource management, information database and structure Inward movement of materials, manufacture, marketing, distribution and after sales service R&D, design, production, marketing, distribution and service Strategy, R&D, marketing and sales (2 marks) Cost centre focus High numerical accuracy Linkages between activities not shown up Focus on allocation of costs Cost reduction opportunities not identified (iii) and (v) (i), (ii) and (iv) (i), (iii) and (v) All the above
Which of the following are failures of traditional costing systems?
(2 marks)
200
CHECKPOINT 3
What are the advantages of supply chain management? (i) (ii) (iii) (iv) (v) A B C D Increased value Cheaper prices from suppliers Higher waste Collaboration of members Higher quality (i), (ii) and (iv) (ii), (iii) and (v) (iii), (iv) and (v) (i), (iv) and (v) A means of sharing cost savings between customer and supplier A means by which suppliers can cut costs and receive incentives A method to split benefits between parties to a contract in an agreed way A method of cost reduction by cutting contract levels To cope with different activity levels To reward sales rather than production To more meaningfully compare actual and budgeted costs To show different results which may occur between different activity levels (i) only (i), (ii), and (iii) (i), (iii) and (iv) (i) and (iv) A 15,000 2,500 B 25,000 5,000
(2 marks)
Gain sharing is A B C D
(2 marks)
Which of the following is/are purposes of flexible budgeting? (i) (ii) (iii) (iv) A B C D
(2 marks) C 20,000 4,000
ABC plc uses an activity based costing to allocate overheads to its products. Product Production units Batch size
Machine set up costs are driven by the number of batches of each product and have been estimated to be $300,000 for the year. Calculate the machine set up costs that would be allocate to each unit of product C. (3 marks)

Company B considers that Pareto analysis may apply to the sales and/or profits of its products. It has collated the following information: Product V W X Y Z Revenue $'000 500 700 2,500 1,600 1,800 7,100 Profit $'000 410 340 740 390 720 2,600
201
CHECKPOINT 3
8 9 10
Which products account for 80% or more of B's sales? Which products produce 80% or more of B's profits? The following graph has been prepared by K plc. Total Margin $'000 100 80 60 40 20 A 20 B 50 C Number of customers
(3 marks) (3 marks)
What possible decisions would it be useful for K plc to take for customers in groups A, B and C? (3 marks) 11 GK manufactures two products in its factory in Italy, the Romeo and the Romolo. Both products require the use of a machine in the factory, which has broken down on numerous occasions in recent months. It is currently operational for approximately 6,800 hours per annum. GKs management intends to replace the machine next year, but until then seeks advice as to which product to manufacture. Information about the products is as follows. Romeo Selling price per unit Direct material cost per unit Variable conversion costs per unit Time required on machine Maximum demand $120 $50 $35 0.65 hour 10,000 Romolo $160 $90 $25 0.75 hour 8,000
Using a throughput accounting approach, recommend which product GK should choose to manufacture first. (2 marks) 12 Flexed budgets for the cost of hotel laundry based on occupancy percentages are shown below. Occupancy Laundry cost 82% $410,000 94% $429,200
During the period, the actual occupancy was 87% and the total laundry cost was $430,000. The variance on laundry was: A B C D $5,000 adverse $12,000 adverse $5,000 favourable $12,000 favourable (2 marks)
202
CHECKPOINT 3
B
1 2 3

What are Goldratts five steps for dealing with a bottleneck? (5 marks) Explain, giving examples, how budgets can be used for feedback control and feed-forward control. (5 marks) Define budgetary slack and describe TWO negative consequences of budgetary slack for an organisation. (5 marks)
END OF PROGRESS TEST 3
203
CHECKPOINT 3

Section A
1 D Operation B is the bottleneck. Return per factory minute = = Cost per factory minute =
8-3 11
0.45/minute
24,000 50,000 0.48/minute
= Throughput ratio =
0.45 0.48 0.94
= 2 3 B D Traditional costing systems are:

location based highly accurate allocation focused linkages cost reduction
These fail in strategic decision making when:
are important 4 5 6 7 Product Production units Batch size No of batches Machine set up costs Cost driver: no of batches = 16 OAR = 300,000/16 = 18,750 per batch Machine set up costs for C = 5 x 18,750 = 93,750 Machine set up costs per unit of C = 93,750/20,000 = $4.6875 / unit
A 15,000 2,500 6 B 25,000 5,000 5 C 20,000 4,000 5 Total
D C C
There should be lower waste as quality is improved. Purchase prices might increase, but other costs will be reduced. Benefits may be financial eg cost savings but may also occur in terms of quality, timing or specification. Gain sharing encourages partnership to increase value and improve performance.
16
$300,000
204
CHECKPOINT 3
8
Product
X Z Y W V
Revenue $'000 2,500 1,800 1,600 700 500
Cumulative Revenue $'000 2,500 4,300 5,900 6,600 7,100
% 35.2 60.6 83.1 93.0 100
Three products (X, Y, Z) account for over 80% of B's sales. 9

Product Profit $'000 740 720 410 390 340 2,600 Cumulative Profit $'000 740 1,460 1,870 2,260 2,600
X Z V Y W
% 28.5 56.2 71.9 86.9 100
Four products (X, Z, V, Y) account for over 80% of B's profit. 10 Group A Group B Group C 11
Romeo Romolo
Retain, by offering incentives Attempt to increase profitability through reduced costs eg non value added Consider elimination if costs cannot be cut or prices increased
Throughput per unit

time on key resource
($(120 50)) =$70

0.65 hr
($(160 90))=$70
0.75 hr
Return per hour Ranking GK should manufacture product Romeo first. 12 B Use the high/low method:
$108 1st
$93 2nd
Occupancy Highest activity level Lowest activity level Variable cost per occupancy% = 19,200 / 12 = 1,600 Total cost for 82% Variable cost for 82% = 82 x $1,600 = Fixed cost Budget cost for 87% occupancy: Fixed cost Variable cost (87 x 1,600) 94% 82% 12% 410,000 (131,200) 278,800 278,800 139,200 418,000
Cost
429,200 410,000 19,200
205
CHECKPOINT 3
Variance:
87% bed occupancy should have cost But did cost
418,000 (430,000) 12,000 (A)
Section B
1 Goldratts five steps are: Step 1 Step 2
Identify the binding constraint Exploit the highest possible output must be achieved from the binding constraint. This output must never be delayed and as such a buffer inventory should be held immediately before the constraint Subordinate. Operations prior to the binding constraint should operate at the same speed as it so that WIP does not build up Elevate the systems bottleneck. Steps should be taken to increase resources or improve its efficiency Return to step 1. The removal of one bottleneck will create another elsewhere in the system
Step 3 Step 4 Step 5 2
Feedforward control
Feedforward control occurs when mangers forecast likely outcomes and then compare these with the desired outcomes. Action can be taken in advance to correct any adverse situations or to take full advantage of favourable situations. For example, a cash forecast may show that an organisation is likely to have a negative cash position in November and December, say. Managers can therefore take action now to avoid the situation if necessary. They could, for example, postpone capital expenditure. Feedforward control means that mangers are forewarned of any situation, whether it be good or bad, before it occurs.
Feedback control
Feedback control involves recording actual results and then comparing them with forecast or budgeted results. For example, a sales budget can act as a feedback control mechanism if the actual sales figures, are compared with the budgeted sales. Reasons for differences can be identified and efforts made to ensure that favourable differences continue to be exploited and adverse differences do not occur in the future. 3 Budgetary slack refers to the practice of overstating budgeted costs and/or understating budgeted revenues. This has negative consequences for performance in that 'good' performance is difficult to measure without a credible standard to benchmark against. For example, if budgets are set for sales at 10,000 units when the sales manager truly believes that sales can be as high as 12,000 units, then actual sales of 11,000 units would actually be disappointing, despite the fact that this level of sales is above budget. Also, budgetary slack can lead to the misallocation of resources. For example, if an activity which is deemed essential has a budgeted cost of 1.2 million for the year, yet the manager believes it can be done for 1.0 million then 200,000 which could have been allocated to other worthwhile activities, e.g. training and preventative maintenance have been misallocated.
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CHECKPOINT 3

Small Business: Cut your coat to suit your cloth
T
H E
Good news stories from the Irish manufacturing sector are thin on the ground, especially in the northeast, which has been hit by a spate of job losses in recent months. Against this background it is remarkable that one Donegal-based textiles firm claims to be enjoying one of its best years ever. Magee Weaving, a 150-year-old family firm, is taking on cut-throat competitors from low-wage economies in this notoriously difficult sector and winning. The companys success can be attributed to the type of long-term planning that separates successful SMEs (small- and medium-sized enterprises) from the also-rans. In the early 1990s Magee Weaving sensed the way the wind was blowing in the global fashion industry and decided drastic action was required. The bulging order book the company now enjoys is testament to the way that period of change was managed. As might be expected, being in a traditional industry we managed our company along traditional lines, said Sweeney. After a series of reviews of our organisation and market, we became convinced first of all of the need for change, and arising out of that of the need for us to learn how to change, he said. Sweeneys aim was to create a multiskilled and flexible organisation that was both innovative and adaptable. Employees at all levels had to learn to adapt to new technology and improved quality standards. They were introduced to industrial techniques such as world-class manufacturing and total quality management. Job profiles were more clearly defined and a greater emphasis was placed on on- and off-the-job training. We became a learning organisation, said Sweeney. The changes have given us a small, well-equipped, modern, fast- response unit. This proved to be the prerequisite for Magee Weavings fundamental change in strategy. In Europe we can never compete on price. That period of change helped us move upmarket, allowing us to introduce a very high design input. Change is now continual for us because we have to be able to recognise where the market opportunities are and the markets that can afford a European supplier.
Opinion: lessons from 25 supply chain leaders

F I N A N C I A L T I M E S D
E C
Chief executives own final accountability. Shareholders want strong profit growth and minimum volatility. Regulators and the press expect social and environmental responsibility. Customers demand someone deliver on promises made to them. Supply chain management has become the key to meeting all of these commitments. Most companies, especially in manufacturing and retail, but increasingly in the energy, entertainment, and healthcare sectors, have seen supply chain management gain strategic importance in recent years. For those wondering what good supply chain management is and how leading companies exploit it, AMR Research has published, yearly since 2004, a report titled, "The Supply Chain Top 25". This list features leading companies that have advanced supply chain from its roots in logistics, material handling, and purchasing toward the modern, demand-driven value network needed in our globalised, Internetenabled, 21st century business environment. Twentieth century business was largely built on a manufacturing economy of big assets tied up in factories and production equipment. Supply chain management in this context meant feeding the factory and shipping finished goods, acting only as a support function to the real business of making basic products for customers.
207
CHECKPOINT 3
Today's customers want goods that depend primarily on intellectual property (lifesaving molecules, entertainment electronics, creative design) and are built by companies tapping a global network of specialists to bring innovative things to people whose homes are already full of refrigerators, shoes, and shaving foam. This demand-driven value network approach is exemplified by companies such as Nike (No. 18 in 2007), which innovates with a brand and total consumer experience that supports high prices while keeping a close eye on operations across a global manufacturing and distribution network. For those who think Nike is all about marketing, consider that its supply chain has increased operating margins in each of the last four years: 2003, 10.5 per cent; 2004, 11.8 per cent; 2005, 13.5 per cent; and 2006, 14.3 per cent. The same can be said of Nokia, with the top supply chain in the world, which excels at supplier collaboration while still pushing technology and design innovation that reaches almost 1bn people worldwide. Along with Nike, Procter & Gamble (No. 3), Coca Cola (No. 13), and all the other consumer products companies on the list, Nokia's supply chain serves the chief executive's first master, shareholders, by doing more than just cutting costs. Nokia orchestrates the constant collaboration between supply, demand, and product management groups that brings profitable new products to market. Nokia's share price has doubled in the past 12 months. The principle does not only apply to companies selling to consumers. IBM (No. 4), Cisco Systems (No. 11), Johnson Controls (No. 16), and Paccar (No. 24) sell almost exclusively to corporate customers. All, however, also depend on the successful orchestration of supply (manufacturing, sourcing, logistics), demand (sales, marketing, service), and product (R&D, engineering). Each company has succeeded for shareholders by integrating processes that allow them to operate as demanddriven value networks: orchestrating players up and down the supply chain with a combination of information, visibility, cross-cutting metrics, and market discipline. Chief executives need to think of the supply chain not as a cost centre but as the orchestrator of a value network. Our Top 25 has outperformed broader stock market indices by almost 100 per cent the 12 months following release of the report each year indicating at least some link between good supply chain management and increasing shareholder value. Finally, consider accountability to the customer. Supply chains of the 20th century were inward looking, concerned primarily with factory throughput and cost control. It took a decade of leadership from the likes of Toyota (No. 5) to teach supply chains about quality. Today's best are looking for the next level to become truly demand-driven. No. 3 Procter & Gamble calls it the "moment of truth" when a consumer chooses to buy and then use a product. Everything in P&G's global value network is based on winning at this moment of truth. Supply chain management has evolved from a low impact cost centre to the essential means to drive shareholder value, global reputation, and customer satisfaction. CEOs interested in leaving a great legacy had better understand how this change is happening and what they can do about it. For a start, look to these Top 25 leaders to see how their supply chain management strategies are evolving and why they are stealing the lead from those who are still stuck in the 20th century.
Partnering: Unlikely partners offer best of all worlds

F I N A N C I A L T I M E S D E C 2 0 0 7
Just as marriage partners often undergo a long process of discovery, so corporate partnerships can be an enormous challenge. Yet scarcely a day passes without a new set of corporate banns being read. In the whirl of alliances between start-ups, software developers, systems integrators and telecommunications companies, partnering is endemic. As Alan Mac Neela and Christine Adams, analysts at research house Gartner, observe: "During the past five years, partnering has become routine in IT - so much so, it is now the cornerstone of many providers' go-tomarket strategies."
208
CHECKPOINT 3
In Amsterdam, Ron Tolido, chief technology officer for Continental Europe and Asia at consultancy and systems integrator Capgemini, "I would argue that nowadays complex clients no longer believe in the capability of a single company to deliver a single solution," he says. "From our perspective our market demands collaboration from several partners for bigger deals. The demands of the client are normally shaping the way we collaborate." In Boston, Michael O'Hara, general manager of the communications sector at Microsoft, highlights the ways he is working with US cable company Comcast to deliver $10-a-month e-mail solutions for small businesses. At the same time, a partnership with Orange, the Paris-based mobile arm of France Tlcom, puts Microsoft's advertising-funded instant messaging on Orange phones, giving a combined audience of 370m potential users. In any list of key partners provided by a systems integrator or a telco, the same names recur: Microsoft, SAP, Hewlett-Packard, IBM, and so on. Yet the depth of these partnerships varies. Mr Tolido says Capgemini creates "partnerships for a particular opportunity" according to the skills and technology required. Yet even if IBM is spurned for a particular deal, the underlying thread of collaboration must remain strong. Finding patterns in all this collaboration is not easy. Gartner's Mr Mac Neela and Ms Adams say there are multiple motivations: "Some partnerships are primarily revenue-driven - for example, to expand reach, extend the sales force, increase exposure, enable access to new, emerging or adjacent markets. Other partnerships are portfolio-centric, such as to create a more compelling or credible offering or solution, or access specialised skills or expertise." Customer pressure can create unlikely pairings. A partnership agreement in 2006 between Novell and Microsoft to make the Linux open-source operating system work better with Microsoft's Windows - and sell the two jointly where appropriate - shocked the software industry. The idea that Microsoft would work with Novell to make Linux, the historic arch-rival of Windows, interface more easily was seen as a sign that Windows' bid for world domination was dead. In practice, the accommodation recognises that the two operating systems will co-exist for many more years, and that both may profit if they work better together. A year on, Susan Heystee, general manager for global strategic alliances at Novell, says the partnership has generated revenues of $105m. Meanwhile, Novell's Linux revenues have separately grown almost two and a half times. The pair celebrated the partnership's birthday by naming 30 new clients, from car-maker BMW to the City of Los Angeles. The positive response of customers, she says, proves the tie-up answered an un-met business need. Significantly, it is demand from large corporations for simple, sustainable and low-risk relationships with a reduced number of suppliers that drives many IT industry partnerships. Orange has partnered Research in Motion, for example, the Canadian manufacturer of the BlackBerry smartphone, in a deal that enables them to roll-out and support new BlackBerry devices more quickly to a bigger market of European users. LogicaCMG, another integrator, partners BT in supplying clever, secure corporate data and e-mail. Kevin Duffy, UK sales and marketing director, at LogicaCMG, says his company can thus leverage BT's marketing strength to access its clients in a high-speed roll-out it could not have managed alone, while BT gets to offer clients superior technology. For technology start-ups, partnering provides market access, without the expense, before the solution is overtaken by other technologies. In practice, partnerships and acquisitions are not mutually exclusive. Companies may prefer acquisitions in areas where they are technically competent, but partnerships where they are not. Steve Cash, General Manager for Partnerships at BT makes the point: "We will always have M&A activity as well. The BT Group has made 17 acquisitions in the past 12 months." When it comes to big picture telco-software convergence, partnerships are the low-risk option. BT's global alliance with HP is an example. But Lucy Dimes, managing director of the BT/HP Alliance, reckons even a company the size of BT can manage only two or three of that intensity.
209
CHECKPOINT 3
Such deals require global competitors to share a vision about the future of markets and technology in areas covered by the partnership. They need a meeting of minds between chief executives - Nortel's Mike Zafirovski gets on well with Microsoft's Steve Ballmer; BT's Ben Verwaayen and HP's Mark Hurd talk the same language. The partnership vision then has to be shared down the hierarchy and built into a common business. Partnership managers list three keys to success besides commitment from the top: sufficiently different partners so that existing overlap is limited; a shared vision for the partnership; and an operating model focused on exploiting opportunities, without worrying about which partner gains most. Most reckon it takes a year or two of trust building before such partnerships really start to deliver. "It can take time before you share market data and assumptions," says Ms Dimes. "People don't always want to open the kimono with strangers, but once you get into the process, confidence grows."
210
Performance Evaluation Variance Analysis
11a
Example past paper questions May 09, Q2(f), 5 marks May 07, Q2(a), 5 marks Nov 06, Q3, 20 marks May 10, Q2(aii & b), 6 marks

Syllabus learning outcomes Evaluate performance using fixed and flexible budget reports. How syllabus outcomes are examined Calculation and interpretation of performance using variances could be required here.
211
11a: PERFORMANCE EVALUATION - VARIANCE ANALYSIS
Overview
Performance Evaluation - Variance analysis
Interpretation of variances
Traditional variance proformas
Planning & operating variances
Mix and yield variances
212
1
1.1
Interpretation of variances
One of the tools available to a business to assess how well it is performing in various areas is variance analysis. Key to evaluating performance is not just being able to calculate the variances, but to interpret and draw meaningful conclusions from the variances.
Causes of variances
1.2 Obviously the cause of the variance must be determined before appropriate action can be taken. An employee should only be judged on what they have control over.
Interdependence of variances
1.3 1.4 1.5 In order to interpret variances effectively any interdependence between variances must be identified, i.e. it is not always possible to look at individual variances in isolation. For example, a decision to purchase better quality, higher price materials may result in an adverse price variance but a favourable usage variance. The following table may help you to think about some of the operational causes of variances. Variance Material price Favourable Unforeseen discounts received Greater care in purchasing Change in material standard Material usage Material used of higher quality than standard More efficient use of material Errors in allocating material to jobs Labour rate Idle time Labour efficiency Use of workers at a rate of pay lower than standard The idle time variance is always adverse Output produced more quickly than expected because of worker motivation, better quality materials etc Errors in allocating time to jobs Adverse Price increase Careless purchasing Change in material standard Defective material Excessive waste or theft Stricter quality control Errors in allocating material to jobs Wage rate increase Machine breakdown Illness or injury to worker Lost time in excess of standard Output lower than standard set because of lack of training, substandard materials etc Errors in allocating time to jobs
213
11a: PERFORMANCE EVALUATION - VARIANCE ANALYSIS Variance Fixed overhead expenditure Fixed overhead volume Sales price Favourable Savings in costs incurred More economical use of services Production or level of activity greater than budgeted Unplanned price increase Fewer discounts given than expected Additional demand experienced Adverse Increase in cost of services used Excessive use of services Change in type of service used Production or level of activity less than budgeted Anticipated increase in selling price did not happen More discounts allowed than expected Fall in demand Lower output
Sales volume
Lecture example 1
Required
Idea Generation
Discuss instances when a favourable variance may not be good news and when adverse variances may be good for a business.
Solution
214
2
2.1
Planning and Operating Variances

We have already seen the concept of responsibility accounting and that a manager should only be assessed on those items within his control. We can apply this to variance analysis by separating the variance into the elements driven by the standard being incorrect (Planning variances), and the element that was within the control of the manager (Operational variances).
Approach to planning and operational variances

2.2
Should
Should now
Did
215
Lecture example 2
Budget Output 15,000 units of AJ Materials 4kg per unit @ $9 per kg
Exam standard for 8 marks
The following data relate to product AJ and its material content for the month of June. Actual Output 14,000 units of AJ Materials 54,000 kg @ $9.50
It has now been agreed that the standard price for the raw material purchased in June should have been $9.30 per kg and the standard kg / unit should have been 3.8 kg. Required Calculate the planning and operational material variances.
Solution
216
217
3
3.1

Where inputs can be substituted for one another, the efficiency/usage variance can be subdivided. The materials and labour variances can both be split into mix and yield (or output) components.
Materials and labour inputs
3.2 3.3
The mix variance represents the financial impact of using a different proportion of raw materials. The yield variance represents the financial impact of the input yielding a different level of output to the standard.
Lecture example 3
River Tyne Foods Co (RTF) is a manufacturer of frozen meals. It is reviewing the performance of its main product, the Rumble. RTF operates a standard absorption costing system and the following budget revenue and cost data per unit of each Rumble is as follows. Rumble ($) 3.99 0.25 1.00 0.06 0.75 0.60
Selling price Material A (sauce) Material B (meat) Material C (vegetables) Labour Fixed Overheads
125g @ $2/kg 200g @ $5/kg 75g @ $0.80/kg 0.05hrs @ $15/hr 0.05hrs @ $12/hr
218
11a: PERFORMANCE EVALUATION - VARIANCE ANALYSIS Budgeted and actual sales for Quarter 3 were 225,000 Rumbles . Actual usage of materials A Sauce B Meat C Vegetables Required Calculate the mix and yield variances for the Rumble in Quarter 3. kg 27,555 45,905 12,675 Costing ($) 58,000 239,375 10,000
Solution
219
11a: PERFORMANCE EVALUATION - VARIANCE ANALYSIS 3.4 These variances give us more insight as to what has caused the material usage variance, but as with all variances, conclusions / recommendations need to consider the impact on other affected areas for example, materials price, labour efficiency and sales volumes.
Lecture example 4
An extract from an operating statement prepared in a frozen food manufacturing facility shows the following variances for quarter 1: $
Materials prices variances Material A Material B Materials mix variance Material A Material B Materials yield variance Materials usage variance 1,568 F 815 A 641 A 1,399 F 2,320 A 1,562 A
Required: Evaluate the performance of the purchasing and production managers
Solution
220
5
Q11 Mills Ltd
Chapter summary
Section 1 Topic Interpretation of variances Summary Variance analysis is a performance evaluation tool that is often used especially as a part of cost control Interpretation of variances is as important as the calculations themselves Planning variances represent the difference between the original and revised budget. Operational variances are those items which were within a managers control. They are the difference between the revised budget and the actual. A mix variance is the result of a different mix of materials to the standard being used. A yield variance occurs when a different quantity from standard is input in order to achieve the desired output. All these variances are used in evaluating performance and as such could be examined in P2 even though they were examined in all of the earlier management accounting papers. See the additional notes section overleaf
Planning and operational variances
Traditional variances overview
221
END OF CHAPTER CHPATER

222
11a
Additional notes brought forward C1 knowledge
223
4
4.1
Traditional Variances Overview

Original budget X $ X X X X X Budgeted units standard cost or selling price per unit Flexed budget X $ X X X X X Actual units standard cost or selling price per unit Actual results X $ X X X X X Actual units actual cost or selling price per unit
Sales volume Sales revenue Cost of sales: Materials Labour Overheads Profit
Sales variance Material variance Labour variance Overhead variance
Traditional Variance Proformas

4.2 4.3 If your memory is hazy on the area of variances, please review the proformas below. Additionally, you should work through the online study resource for this area. Material variances Price Actual purchases should cost Should Actual purchases did cost Did Usage Should Did $ X (X) X Kgs X (X) X $X $ X (X) X Hrs X (X) X $X Hrs X (X) $X
Actual production should use Actual production did use Difference valued at standard cost
4.4
Labour variances Rate Should Did Efficiency Should Did Actual hours paid should cost Actual hours paid did cost
Actual production should take Actual production did take Difference valued at standard rate per hour
Idle time Should Did
Hours worked Hours paid Difference valued at standard rate per hour
224
11a: PERFORMANCE EVALUATION - VARIANCE ANALYSIS 4.5 Variable overhead variances Expenditure Should Did Efficiency Should Did $ Actual hours worked should cost Actual hours worked did cost X (X) X Hrs X (X) X $X
Actual production should take Actual production did take Difference valued at standard rate per hour
NB: This assumes variable overheads are incurred per labour hour. 4.6 Fixed overhead variances Under marginal costing, the fixed overhead variance is just the difference between budgeted and actual fixed overhead costs, ie fixed overhead expenditure variance. Under absorption costing, the fixed overhead variance can be further subdivided as follows: Total variance (over/under absorption) Expenditure variance Should Did Budget expenditure Actual expenditure $ X (X) X Volume variance Should Budgeted units Did Actual units Difference value at OAR per unit Units X (X) X $X
4.7
Sales variances Price Should Did Volume Should Did Actual units sold should sell for Actual units sold did sell for $ X (X) X Units X (X) X $X
Budgeted sales units Actual sales units
Difference valued at standard contribution/unit Under absorption costing this variance will be valued at standard profit/unit.
225
END OF CHAPTER CHPATER

226
Performance evaluation
11b
Example past paper questions P1 May 08, Q4(c), 10 marks P1 May 05, Q2(a), 5 marks

Syllabus learning outcomes Evaluate projected performance using ratio analysis. Discuss the role of non-financial performance indicators. How syllabus outcomes are examined Assessment of profitability of a business and resulting advice has been required.
Recommendation of measures for P1 Nov 08, Q2(c), 5 marks a non profit making organisation or May 10, Q4(b), 4 marks under the Balanced Scorecard have been required. Discussion of and key measures required under the Balanced Scorecard has been examined.
Compare and contrast traditional approaches to budgeting with recommendations based on the 'balanced scorecard'
227
11b: PERFORMANCE EVALUATION
Overview
Performance evaluation
Ratio Analysis Profitability Liquidity
Non-financial performance indicators
Benchmarking
Problems with financial performance indicators
Balanced scorecard
Not for profit organisations
228
1
1.1 1.2
Ratio analysis
Ratio analysis is a useful way of comparing figures in accounts. It is a commonly used technique and improves the usefulness of a report. The income statement, the balance sheet and forms of divisional income statements used by the management of business enterprises are all sources of useful information about the condition of the business. The analysis and interpretation of these statements can be done by calculating certain ratios and then using the ratios for comparison, either: (a) (b) between one year and the next for a particular business or division; or between one business or division and another.
1.3
2
2.1
Indicators of profitability
Net profit margin
Net profit 100 % Sales A high profit margin indicates that either sales prices are high or total costs are being kept well under control. 2.2
Gross profit margin
(Sales COS) Sales
100 %
A high gross profit margin indicates that either sales prices are high or production costs are being kept well under control. 2.3
Asset turnover
The ratio of sales revenue to the amount of capital employed

Sales Capital employed This shows the revenue that is generated from each $1 worth of assets employed. 2.4
Return on capital employed (ROCE)
The amount of net profit as a percentage of capital employed Net profit 100% Capital employed This shows the profit that is generated from each $1 worth of assets employed. Note that capital employed = NCA + CA CL = TALCL 2.5 Note that ROCE = Profit margin Asset turnover
229
Lecture example 1
The following figures are extracted from the accounts of Big Bond plc. Total production cost Gross profit for the year Net profit for the year before taxation Total capital employed Average number of employees in the year Number of books produced
Required 20X9 $3,269,000 $1,503,000
20X8 $2,541,000 $1,291,000
$295,000 $3,005,500 260 29,361
$287,000 $2,861,000 248 27,498
(a)
Calculate the following ratios: Gross profit margin Net profit margin ROCE Sales per employee Average number of books produced per employee Average production cost per book 35% 15% 12% 17,000 $90
(b)
20X9 data for Little Boots, a competitor of Big Bond is available and is as follows: Gross profit margin Net profit margin ROCE Sales per employee
Average number of books produced per employee 110 Average production cost per book Interpret Big Bonds performance.
Solution
230
231
3
3.1
Liquidity/working capital ratios

The current ratio can be calculated by dividing the most liquid assets in the business (receivables, inventories and cash) by the business' payables. Current ratio = Current assets Current liabilitie s
3.2
The current ratio can be amended by excluding the inventory from the current assets. This gives the quick ratio or acid test. Quick ratio = Current assets inventories Current liabilities
3.3
The operating cycle or cash conversion cycle is a measure in time of how long cash is tied up in operations (ie the period between paying for raw material inputs and receiving the cash for the ultimate sale of finished goods). It is effectively the sum of the working capital periods (receivables and inventories) less the payables period. It is calculated as follows. 1 2 Receivables period Inventory period (a) Finished goods Average finished goods Cost of sales
Average WIP Cost of production Average raw material Raw material purchases
Average receivables Credit sales
365
days
365 365 365 365
days
(b) (c)
WIP Raw material
= =
days days
Deduct payables period
Average payables Credit purchases
(days)
Net operating cycle = (cash conversion period)
By comparing the operating cycle from one period to the next, or one company to another, it should be possible to identify potential deficiencies. The period can be quantified in months by multiplying the fractions by 12.
232
Lecture example 2
KLM plc Extracts from annual accounts
The table below gives information extracted from the annual accounts of KLM plc for the past year.
20X9 ($) 96,000 103,500 75,400 623,000 715,000 743,500 875,000 243,800 75,000
Inventories: raw materials Work-in-progress Finished goods Purchases of raw materials Cost of production Cost of goods sold Sales Receivables Payables
Required
(a) (b)
Calculate the length of the operating cycle (assuming 365 days in the year). The operating cycle of a competitor of KLM is 156 days. In the light of this information what conclusions can you draw from the length of KLMs operating cycle?
Solution
233
Approaches to performance evaluation

There are three approaches to performance evaluation of which you should be aware: (a)
Horizontal analysis
ie line by line comparison of data with another (eg. accounts with prior year, budget or another company). (b) (c)
Trend analysis
This is horizontal analysis extended over several years.

Vertical analysis
This analysis involves expressing items as a % of a key item eg items in the income statement are usually expressed as a % of sales. Items in the balance sheet are expressed as a % of total assets.
5
5.1
Problems with financial performance indicators

(a) (b) (c) (d) Focus only on variables which can be expressed in monetary terms ignoring other important variables which cannot be expressed in monetary terms Focus on past
Do not convey the full picture of a company's performance in a modern business environment eg quality, customer satisfaction
Focus on the short term
234
6
6.1
Non-financial performance indicators (NFPIs)

NFPIs are measures of performance based on non-financial information which may originate in and be used by operating departments to monitor and control their activities without any accounting input. As with all performance indicators, the most effective NFPIs will be both specific and measurable.
Definition
Examples
6.2 Examples of non-financial performance indicators are summarised in the table below.
Area assessed Service quality Performance measures
Number of complaints Proportion of repeat bookings On-time deliveries Customer waiting time Set up times Number of suppliers Days inventory in hand Output per employee Materials yield percentage Production schedule adherence Output requiring reworking Manufacturing lead times Trends in market share Sales volume growth Customer visits per salesperson Client contact hours per salesperson Customer survey response information Number of complaints received Staff turnover Days lost through absenteeism Days lost through accidents/sickness Training time per employee
Production performance
Marketing effectiveness
Personnel
Different industries will place a different weighting on each area depending on those most critical to their success.
235
Value of NFPIs
6.3 (a) (b) (c) (d) (e) (f) (g) Information can be provided quickly for managers (eg per shift, daily or hourly) unlike traditional financial performance reports.
Anything can be measured/compared if it is meaningful to do so. Easy to calculate and easier for non-financial managers to understand and use effectively. Less likely to be manipulated than traditional profit related measures (counteracts short-termism).
Can be quantitative or qualitative. Provide better information about key areas such as quality, customer satisfaction, employees, and so on. Better indicator of future prospects than financial indicators which focus on the short term
Problems with NFPIs

6.4 (a) (b) (c) (d) Too many measures can lead to information overload for managers, providing information which is not truly useful. May lead managers to pursue detailed operational goals at the expense of overall corporate strategy. Need to be developed and refined over time to ensure remain relevant. Need to be linked with financial measures.
236
7
7.1
Analog Devices
Balanced scorecard
A popular approach in current management thinking to performance measurement (for service and non-service organisations) is the use of what is called a 'balanced scorecard', consisting of a variety of indicators both financial and non-financial. The balanced scorecard focuses on four different perspectives and aims to establish goals for each together with measures which can be used to evaluate whether these goals have been achieved.
The balanced scorecard
7.2
Balanced Scorecard
Customer Internal
Innovation & Learning

7.3
Perspective Customer Question
Financial
What do existing and new customers value from us? This perspective gives rise to targets that matter to customers: cost, quality and so on What processes must we excel at to achieve our financial and customer objectives? This perspective aims to improve internal processes and decision-making Can we continue to improve and create future value? This perspective considers the business's capacity to maintain its competitive position by acquiring new skills and developing new products How do we create value for our shareholders? This perspective covers traditional measures, such as growth, profitability and shareholder value, but these are set by talking to the shareholder or shareholders direct
Internal
Innovation and learning
Financial
237
11b: PERFORMANCE EVALUATION 7.4 The scorecard is 'balanced' in the sense that managers are required to think in terms of all four perspectives, to prevent improvements being made in one area at the expense of another. The method has the advantages of looking at both internal and external matters concerning the organisation, and of linking together financial and non-financial measures.
Disadvantages of this will arise from the selection and interpretation of appropriate measures, and any potential conflicts between measures (eg R&D expenditure).
7.5 7.6
Lecture example 3
Required
Recommend one performance measure for each of the four perspectives of the balanced scorecard for a restaurant. State the reason for your choice of measure.
Solution
238
8
8.1
Benchmarking
A business will attempt to seek the best available performance against which it can measure its own performance. By adopting what is regarded as best practice as a target, the business attempts to improve its own performance. In this way, the business can be as good as, or better than, the best in the world in the most important areas of operation. Benchmarking uses a realistic target for improving the operations of the business. It can benefit from the knowledge and practices of other businesses, without having to make all its own mistakes, and it can obtain a competitive advantage. Benchmarking is now widely used in not-for-profit organisations, such as the public sector.
8.2
8.3
There are several types of benchmarking: (a) (b)

Internal benchmarking: a method of comparing one operating unit or function with another within the same organisation. External or competitive benchmarking: in which information is gathered about other companies, through techniques such as
8.4 (a) (b) (c)
reverse engineering intra group (companies in same industry) inter industry (non-competing businesses with similar processes)
Internal benchmarking has some advantages over external benchmarking Data is more easily available, and therefore likely to be more up to date. Data is likely to be more relevant, since it will reflect the companys existing systems, policies and working practices. Information will be available to help the organisation understand how to make the move to best practice in one department because they will have access to what is going on behind the scenes in another department. This may not be the case with external benchmarking in which the data available is often restricted to a snapshot of outputs only.
8.5
Benchmarking usually involves the following. (a) (b) (c) (d) Establishing what makes the difference, in their customers' eyes, between an ordinary supplier and an excellent supplier Setting standards in each of those things, according to the best practice that can be found Finding out how the best companies meet those challenging standards Applying both other people's experience and in-house ideas to meet the new standards, and, if possible, to exceed them
239
11b: PERFORMANCE EVALUATION 8.6 Companies worldwide have found that there are very significant gains to be made from benchmarking including the following.* (a) (b) (c) (d) (e) (f) Better understanding of their customers and their competitors Fewer complaints and more satisfied customers Reduction in waste, quality problems and reworking Faster awareness of important innovations and how they can be applied profitably A stronger reputation within their markets And, as a result of all these, increased profits and sales revenue
* source: DTI
9
9.1
Not for profit organisations

Profit seeking organisations Primary objective:
Objectives
To maximise the wealth of the owners of the business

Secondary objectives might be:
(a) (b) (c) (d) (e)
ensure survival provide a quality product/service (customer satisfaction) be a good corporate citizen (health and safety/environment) create wealth/benefits for management/employees secure competitive advantage and grow market share
The objective of profit or wealth maximisation is thus modified to meet the needs of different interest groups (stakeholders). 9.2
Public sector organisations Primary objective might be:
Provision of a quality product/service within a value for money framework

(a) (b) (c) (d) 9.3
be a good corporate citizen (health and safety/environment) adopt an ethical social stance in decision making create wealth/benefit for management/employees earn sufficient profits to provide for future capital investment and perhaps provide a surplus for the exchequer
Not for profit organisations (NFPOs) Primary objective might be:
Provision of a social or community service for the well being of society

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11b: PERFORMANCE EVALUATION (a) (b) (c) be a good corporate citizen (health and safety/environment) adopt an ethical social stance in decision making increase wealth/benefit for management/employees
Evaluation of performance
9.4 NFPOs and public sector organisations will not have wealth maximisation as a primary objective. However, they will still have strategic objectives (albeit non-financial) and stakeholders (clients, members etc), who will wish to measure their performance. Problems of performance measurement in NFPOs (a) (b) (c) (d) Multiple objectives How to measure output Lack of financial / profit measure Difficult to define a unit
Idea Generation
9.5
Lecture example 4
Required
(a) (b)
Suggest what items might be measured for a hospital. Highlight the problems that may occur in attempting to monitor performance of the hospital using league tables of this data over time and against other hospitals.
Solution
241
Possible performance measurement methods

9.6 (a) (b) (c) (d) 9.7 The 3 Es Comparisons eg comparison of results / benchmarking between different public sector organisations Efficiency measurement ie cost / patient / day Judgement - some measurement will be subjective
The '3 Es' measures performance in value for money terms

Effectiveness success in achieving objectives Efficiency Economy
achieving better productivity (output) from resources input/consumed sourcing inputs at minimum cost while maintaining standards of quality
Idea Generation
Lecture example 5
Required
Using the 3 Es suggest a range of performance measures for a public sector higher education college.
Solution
242
10 Chapter summary
Section
Q12 Silk Imports
Topic Ratio analysis Indicators of profitability Liquidity/working capital ratios
Summary
1 2
Performance of a business can be evaluated by financial indicators. These include net profit margin, gross profit margin, asset turnover and return on capital employed. Liquidity measures include the current and quick ratios. Working capital measures look at how long a companys cash is tied up in operations. There are three general approaches horizontal analysis, trend analysis and vertical analysis. Financial indicators focus on the past and are short-term measures, so non-financial indicators often need to be used. A balance is needed between both. These are non-financial measures of performance based on internal information relating to operating departments. They should still be specific and measurable to be effective. Tools such as the balanced scorecard help to evaluate a business by looking at all key areas using a variety of financial and nonfinancial indicators. This involves the identification of best practice with a view to its adoption within a company. It can be carried out in several different ways, using both internal and external references. Performance measurement in public sector or NFP organisations can be difficult as they often have multiple objectives and these are often hard to quantify and measure. Performance is often evaluated using the 3Es Economy Effective Efficiency
Approaches to performance evaluation Problems with financial performance indicators
Non-financial performance indicators (NFPIs)
Balanced scorecard
Benchmarking
Not for Profit Organisations
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END OF CHAPTER
244
Measuring performance in responsibility centres
12
Example past paper questions
P1 May 06, Q4(c), 5 marks P1 Nov 08, Q3(b), 12 marks May 10, Q5(a), 6 marks P1 Nov 07, Q4(a), 5 marks

Syllabus learning outcomes
Discuss use of cost, revenue, profit and investment centres in devising organisation structure and management control. Discuss cost information in appropriate formats for cost centre managers, taking due account of : Controllable/uncontrollable costs and the importance of budget flexing. Cost variability, attributable costs, controllable costs and identification of appropriate measures of profit centre contribution Discuss alternative measures of performance for investment centres.
How syllabus outcomes are examined

Given a specific group you will be asked for the advantages and/or disadvantages of implementing different organisational structures.
Questions may focus on whether managers are assessed only on the basis of those costs they can control. This is often examined alongside transfer pricing and looks at the impacts on profits of various divisions if a transfer price is changed. ROI and RI calculations may be required. You may also be asked to compare and contrast ROI/RI and EVA.
P1 Nov 08, Q2(d), 5 marks P1 May 08, Q2(f), 5 marks P1 Nov 05, Q4(b), 20 marks May 10, Q7(a &b), 16 marks P1 Nov 07, Q4(c), 10 marks P1 May 07, Q2(d) , 5 marks P1 Nov 05, Q4(a), 10 marks P1 Nov 06, Q4(b), 20 marks P1 May 06, Q4(b), 7 marks
Discuss the likely behavioural consequence of the use of performance metrics in managing cost, profit and investment centres. Discuss the typical consequences of a divisional structure for performance measurement as divisions compete or trade with one another.
Narrative discussion questions are common and tested in both generic and scenario-specific cases. This outcome can bring transfer pricing back in, in terms of divisional performance measurement.
245
12: MEASURING PERFORMANCE IN RESPONSIBILITY CENTRES
Overview
Measuring performance in responsibility centres
Decentralised organisations
Investment centre performance appraisal methods
ROI
RI
EVA
246
1
1.1
Decentralised organisations
This chapter deals with decentralised organisations, ie those where managers at lower levels of an organisation have a degree of autonomy, giving them control over decisions and activities. Objectives (a) (b) (c) (d) Ensure goal congruence Increase motivation of management Reduce head office bureaucracy Provide better training for all levels of management
Section 1 Responsibility Centres
1.2
1.3
Advantages of decentralisation include: (a) (b) (c) (d) (e) Decisions taken more quickly Increase motivation of management Increase quality of decisions due to local knowledge Reduce head office bureaucracy Provide better training for all levels of management
1.4
Disadvantages of decentralisation (a) (b) (c) Potential for dysfunctional decision-making Duplication amongst divisions leading to greater cost Senior management loss of control
Appropriate performance evaluation methods are therefore needed.
Conditions for a good performance measure

1.5 A good performance measure should: (a) (b) (c) Provide incentive to the divisional manager to make decisions which are in the best interests of the overall company (goal congruence) Only include factors for which the manager (division) can be held accountable Recognise the long-term objectives as well as short-term objectives of the organisation
Division versus manager

1.6 Performance of each should be appraised separately. A manager may be in control of a particularly weak division; this does not mean the manager is underperforming. Consider potential and avoid appraising a manager on items over which he has no control.
1.7 Responsibility accounting is the term used to measure performance of decentralised units The key aspect of responsibility accounting is that a manager should only be held responsible for those items that are within his control.
247
12: MEASURING PERFORMANCE IN RESPONSIBILITY CENTRES 1.8 Responsibility structure Cost centre Revenue centre Profit centre Investment centre Manager's area of responsibility Decisions over costs Revenues only Decisions over costs and revenues Decisions over costs, revenues, and assets Typical financial performance measure Standard costing variances Revenues Controllable profit Return on investment and residual income
Transfer pricing
1.9 The transfer pricing policy (Chapter 13) will have a significant impact on responsibility accounting and performance measurement.
Lecture example 1
The following figures for the years ending 31 December 20X4 and 20X3 relate to the B and C divisions of Cordeline. The return on capital employed (ROCE) figure is the basis for awarding a 20% bonus to the manager of B division (actual ROCE/target ROCE). The below target ROCE for C division has resulted in a zero bonus award to its manager. Division 20X4 $'000 9,850 1,336 960 5,540 500 12,600 24% 20% B 20X3 $'000 7,243 1,674 919 6,000 750 12,100 28% 20% 20X4 $'000 4,543 924 1,300 7,700 6,400 9,500 12% 20% C 20X3 $'000 2,065 363 251 2,600 2,400 3,100 14% 20%
Sales Profit before interest and taxes (PBIT) Included in profit calculation: Depreciation for year Net book value (NBV) of non-current assets New investment in non-current assets Original cost of non-current assets Return on capital employed Target return on capital Required
Describe the possible counter-productive behaviour resulting from using the current ROCE calculation for performance appraisal
248
Solution
2
2.1
Performance measures for investment centres

These give a good indication of the managers ability to control costs and operations but do not relate these costs to the size of investment made in the division. In an investment centre we therefore need some alternative performance measures.
Profits and budget variances
Return on capital employed (ROCE)

2.2 In chapter 11 we looked at ROCE as one of the measures of a companys profitability. $Net profit 100% $Capital Employed ROCE shows the profit that has been earned per $ of investment.
249
12: MEASURING PERFORMANCE IN RESPONSIBILITY CENTRES If managers in a decentralised business are responsible for costs, revenues and investments calculating a divisional ROCE would be an appropriate way of assessing the performance of the divisions.
Return on investment (ROI)

2.3 ROI is a very similar measure to the ROCE figure used in corporate analysis. ROI =
Controllable Divisional Profit 100 Divisional Investment
2.4
If it is not possible to calculate controllable profit from the information given in the question, you should use profit before interest and tax (PBIT). For the divisional investment total assets less current liabilities should be used. ROI enables performance in different divisions to be compared. Similarly, new investments can also be appraised using ROI.
2.5
2.6
Decision rule Only projects which increase the existing ROI should be undertaken.
Lecture example 2
Based on previous exam questions
Brenda and Eddie have two franchises in different parts of town and want to monitor the performance of the two managers who have full control over investments. Forecast results for the year are:
Vittorios $ 90,000 500,000 Dugaldos $ 135,000 750,000
Profits Investment
Vittorio is considering investing in a labour-saving piece of equipment which will cost $8,000. This will generate an increase in net profit of $1,200 each year for 10 years, after which time the equipment is expected to have no resale value. Vittorio uses straight-line depreciation. Dugaldo has been offered a replacement oven for one of his existing ones. The existing one is written down in the books to an NBV of $2,000 but is very inefficient. Its maintenance and depreciation costs are $25,000 p.a. The replacement will cost $75,000, will have no downtime and negligible maintenance costs in its early years. Depreciation will be 20% p.a. straight-line. Each oven is estimated to generate $60,000 p.a. before these costs are considered.
Required
(a) (b)
Would profit or ROI be more equitable for comparing Vittorio's and Dugaldo's forecast performance? Show why, in each case, ROI (based on opening book values) will lead to dysfunctional decisions. Brenda and Eddies group ROCE is 12%.
250
Solution
2.7
The main reason that these dysfunctional decisions arise is that ROI is a relative measure (i.e. a ratio) and masks the absolute effect on profits.
Advantages & disadvantages of ROI

2.8
Advantages Disadvantages
% result enables easier comparison between projects / divisions
May lead to dysfunctional behaviour only projects which increase ROI will be accepted, this could be at the expense of growth in corporate profits. Distorted by the age of assets
Relates the amount of profit generated to the amount invested
Does not require a specific cost of capital Based on profit

251
Residual income
2.9 Traditionally the main alternative to ROI. It provides a hurdle figure for profit based on the companys minimum required percentage return from a division. Controllable divisional profit (usually PBIT) less: "imputed interest" (= Divisional Investment Cost of Capital) Residual income The result is an absolute figure. $ X (X) X
Lecture example 3
Required
Based on previous exam questions
Re-assess the decisions in Lecture example 2 using residual income.
Solution
Advantages and disadvantages of residual income

2.10
Avoids dysfunctional behaviour Results in maximising company wealth Different costs of capital can be used to reflect risk
Gives an absolute number so comparisons are more difficult Distorted by the age of assets Based on profit
252
3
3.1
ROI vs RI
As can be seen from the above example, residual income appears to be technically superior.
Return on investment
3.2 In practice, however, ROI is used more frequently than RI, for the following reasons. (a) (b) (c) (d) Dysfunctional behaviour is not material ROI is consistent with corporate assessment (ROCE) Percentages are more easily understood RI requires a cost of capital
Problems common to ROI and RI Calculation of 'profit'

3.3 (a) (b) (c) (d) (e) Controllable items only Treatment of transfer prices? Corporation (income) tax? Depreciation? Allocated and apportioned overheads?
Calculation of 'investment'
3.4 (a) (b) (c) (d) Historic, net book or replacement value? Include or exclude cash? Intangible assets? Service industries?
Net present Value (NPV)

3.5 NPV is superior to both these methods when assessing new investments. The difference between the maximum an investor would pay for a given set of cash flows (at his/her cost of capital) compared to the actual amount he/she is being asked to pay, the NPV, represents the change in wealth of the investor as a result of investing in the project. The appraisal is performed using relevant costing principles. Any project with a positive NPV should be accepted 3.6
Takes into account the time value of money Gives an absolute measure, allowing for comparison of projects Considers all cash flows of projects
The need to estimate a cost of capital Difficulty in obtaining all relevant costs/benefits Assumes cash flows occur at annual intervals
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4
4.1
Economic value added (EVA)

EVA is an alternative absolute performance measure, which is similar to RI in its calculation.
EVA = net operating profit after tax (NOPAT) less capital charge for the opportunity cost of capital investment.
where the capital charge = weighted average cost of capital net assets. [if net assets is not given it should be calculated as non-current assets plus working capital]. 4.2
Questions over new star
EVA is a financial performance method to calculate the true economic profit of a company, ie the residual wealth it creates. It shows the amount by which earnings exceed or fall short of the minimum rate or return that investors could get by investing elsewhere. It is based on the idea that a business must cover both its operating and capital costs: until a business returns a profit that is greater than its cost of capital it operates at a loss. Peter Drucker. In order to add to its economic value a business must make an economic profit in excess of the cost of capital that has been invested to earn that profit.
4.3 4.4
4.5
Calculation: (a) EVA is based on an 'economic profit' which is derived by making a series of adjustments to the accounting profit. Adjustments

Economic not historic cost depreciation Advertising/development costs should be charged to the periods that will benefit from them (ie capitalised and amortised) Lease charges should be capitalised Interest excluded
(b)
The notional capital charge uses replacement cost of net assets.
254
Lecture example 4
Division D operates as an investment centre. The book value of the non-current assets is $83,000 but their replacement value is estimated to be $98,000. Working capital in the division has a value of $19,000. Latest operating profits for the division were $18,500, after charging historical cost depreciation of $8,100 and the costs of a major advertising campaign which amounted to $6,000. The advertising campaign is expected to boost revenues for three years. An economic depreciation charge for the period would have been $12,300. The risk adjusted weighted cost of capital for the company is 11% per annum.
Required
Calculate the EVA for Division D. Ignore taxation.
Solution
Be careful when reading these questions.
If, as in Lecture example 4, we are given a replacement value for the non-current assets we can deduce that this relates to the assets held on our balance sheet. Some questions may be worded in such a way that implies the replacement cost of all assets may include any deferred advertising spend. If this is the case we do not need to adjust the assets again. If you are unsure, state your assumption.
255
Advantages of EVA
4.6 (a) (b) (c) (d) (e) Maximisation of EVA will create real wealth for the shareholders EVA may be less distorted by the accounting policies selected as the measure is based on figures that are closer to cash flows than accounting profits EVA is an absolute value which is easily understood by non-financial managers EVA recognises costs such as advertising and development as investments for the future and thus they do not immediately reduce the EVA in the year of expenditure EVA focuses on efficient use of capital
Disadvantages of EVA
4.7 (a) (b) (c) (d) Can encourage managers to focus on short-term performance EVA is based on historical accounts which may be of limited use as a guide to the future A large number of adjustments are required to calculate NOPAT and economic value of net assets Investment centres which are larger in size may have larger EVA figures for this reason. Allowance for relative size must be made when comparing the relative performance of investment centres
Lecture example 5
Required
Explain how using EVA might result in beneficial action being taken by management.
Solution
256
Lecture example 6
Required
Previous pilot paper question worth 5 marks
Explain and discuss the similarities and differences between Residual Income and Economic Value Added as methods for assessing the performance of divisions
Solution
Q13 Y&Z
257
Chapter summary
Section Topic Decentralised organisations Summary
Companies that decentralise enjoy several advantages but run the risk of dysfunctional behaviour through lack of control it is therefore imperative that the appropriate divisional performance measures are put in place. Managers should only be assessed on those items within their control. This is known as responsibility accounting.
Performance measures A good performance measure should be one for investment centres that drives goal congruence, measures managers only on those items that they can control and recognises long as well as short term objectives. ROI v RI
ROI is the most commonly used measure within a decentralised business but can result in dysfunctional behaviour. Using RI will increase the likelihood that decisions result in goal congruent behaviour. Both measures are based on accounting profit and can be distorted by the age of assets. They also discourage investment expenditure on items such as research and development and advertising.
EVA
EVA is an alternative to RI which measures the true economic profit of a company, or the residual wealth it creates.
END OF CHAPTER
258
Transfer pricing
13
Example past paper questions P1 May 06, Q4(b), 7 marks P1 Nov 08, Q3(b), 12 marks P1 May 09, Q4 (c & d), 16 marks P1 Nov 08, Q3 (c & d), 12 marks P1 May 06, Q4, 30 marks P1 May 05, Q2(e) and (f), 10 marks
May 10, Q7(c), 9 marks

Syllabus learning outcomes Discuss the typical consequences of a divisional structure for performance measurement as divisions compete or trade with one another. Discuss the likely consequences of different approaches to transfer pricing for divisional decisionmaking, divisional and group profitability, the motivation of divisional management and the autonomy of individual divisions. How syllabus outcomes are examined Questions tend to focus on whether the performance measures being used lead to goal congruent behaviour Calculation questions tend to require the recalculation of divisional and group profits given a specified change in the transfer pricing system. Narrative elements will require analysis of how any changes will impact likely behaviour and therefore performance measures. Discussion of implications on transfer price when a division is located overseas or how transfer pricing can be used to minimise a companys tax charge.
Discuss in principle the potential tax and currency management consequences of internal transfer pricing policy.
P1 Nov 08, Q3(d), 6 marks
259
13: TRANSFER PRICING
Overview
Transfer pricing
Aims
International aspects
Approaches
Market-based
Cost-based Actual Standard Full cost plus Variable cost plus Dual pricing Two part tariffs
Opportunity cost
260
1
1.1
Transfer pricing
Within a decentralised organisation there may be a division which makes units that are then transferred to another division. It will usually be necessary to charge the receiving division for the goods that it has received in order for performance to be measured equitably. A transfer price is the price at which goods are transferred internally.
1.2
It is vital that the transfer price is carefully selected to ensure all parties act in the best interest of the company.
Transfer pricing aims

1.3 The goals of a transfer pricing system are: (a) Goal congruence (b) Performance evaluation (c) Retain divisional autonomy (d) Motivate divisional managers (e) Optimum resource allocation External sale of intermediate product by Supply Costs incurred by Supply WHOLE COMPANY Division Supply Division Receive Revenue earned by Receive
Transfer?
Alternative suppliers to Receive
261
2
2.1 2.2
Transfer pricing in practice

If an external market exists for transferred goods (and there is unsatisfied demand externally), the transfer price can be set as the external market price.
Market-based approaches
Seller Earns the same level of profit on internal sales as external sales Happy to transfer unless at full capacity making other units that have a greater contribution.
Buyer
Happy to accept transfer (cannot buy cheaper elsewhere)
The managers of both divisions should behave in a goal congruent way. 2.3 If savings are made by selling internally then this may be reflected in the transfer price, eg by offering a discount equivalent to saved transport costs.
Cost-based approaches
2.4 The idea behind these approaches are similar to those involved in manufacturing accounts, The supplying division has its costs of manufacturing refunded and may also be given a mark up to encourage the transfer.
Actual cost vs standard cost

2.5 Use of actual costs would result in (a) (b) (c) (d) (e) all inefficiencies passed on to buying division no encouragement for cost control in selling division buying division does not know in advance what price it will be paying performance measurement is therefore difficult seller will want to transfer, buying division will not want to transfer
Using standard costs overcomes all these problems.
Full cost v variable cost

2.6 Full Cost Seller Doesnt receive any profit on transfers May not transfer unless it has spare capacity Buyer Happy to accept transfer (assuming full cost is below market price)
This approach may lead to dysfunctional behaviour.
262
13: TRANSFER PRICING 2.7 Variable cost Seller Doesnt receive any contribution towards fixed costs or profit Will not want to transfer unless it has spare capacity This approach may lead to dysfunctional behaviour. 2.8 If a transfer price is based on marginal or variable cost the supplying division does not cover its fixed costs. Two alternative approaches to overcome this problem are dual pricing and two part tariff. Buyer
Happy to accept transfer
Dual pricing
2.9 Seller Receives external market price Will want to transfer Buyer Pays variable cost Happy to accept transfer
In a dual pricing system, different prices are used by each division. The selling division is credited with a price that will allow them to earn an appropriate profit (often the external market price if one exists) and the buying division is debited with the variable or marginal cost only. The balancing figure between the two will be debited to a group account and, at the end of the year, incorporated to consolidate out the difference and arrive at the correct group profit.
Two-part tariff
2.10 Seller Buyer
Variable cost at time of transfer plus annual fixed fee Should cover fixed costs and make a profit Happy to transfer Generally happy to accept transfer
263
13: TRANSFER PRICING 2.11 Standard full cost plus percentage Seller Covers all costs and makes a contribution towards profit Will want to transfer Buyer Price may be higher than market price May not wish to accept transfer
This approach will often lead to dysfunctional behaviour. 2.12 Standard variable cost plus percentage Seller May not cover all fixed costs or make any contribution towards profit May not wish to transfer Buyer Likely to be happy to accept transfer (assuming percentage is not so large that final price exceeds market price)
This approach could potentially lead to dysfunctional behaviour .
Lecture example 1
Introductory level exam technique question
Goods are transferred from Division S to Division R at standard full cost + 10%. Division S Variable costs Fixed overhead Standard profit @ 10% Transfer price Division R, the receiving division, can buy externally @ $26. Required Discuss the likely outcome of setting the transfer price at $30.80. $ 20.00 8.00 28.00 2.80 30.80
Solution
264
Opportunity cost based approach to transfer pricing

2.13 An opportunity cost based approach is the optimum approach to setting transfer prices. Minimum transfer price Variable cost + Opportunity cost (i) (ii) Maximum transfer price Lower of: External market price or Divisional net revenue
If an external market exists for the intermediate product, opportunity cost is equal to contribution foregone If no external market, the opportunity cost is likely to be nil. Opportunity cost is likely to exist however if the company is at full capacity on another task.
2.14 Opportunity cost-based approaches should always result in goal congruent behaviour with both buyer and seller happy to transfer when it is in the group's best interest to do so.
265
Lecture example 2
Exam standard question
A profit centre produces three products, Eee, Buy and Eck. Each product has an external market, but Buy can also be transferred to Division B. After incurring extra costs of $60, Division B then sells the unit for $300. The maximum quantity that might be required for transfer is 150 units of Buy. Information on the products is as follows. External market price per unit Variable production cost per unit Labour hours required per unit Maximum external sales, in units Eee $150 $86 4 2,000 Buy $200 $95 6 1,250 Eck $140 $83 3 2,400
In the current period, labour hours in the profit centre are limited to 20,000, and this is insufficient to satisfy maximum external demand. Therefore, using limiting factor analysis, the optimal production plan has been calculated as: Contribution per unit Labour hours required Contribution per hour Ranking Optimal Production Plan Product Units Eck 2,400 Buy 1,250 Eee (balance) 1,325 Required Given that the profit centre is operating at full capacity, calculate an appropriate range of transfer prices for a unit of Buy. Hours/unit 3 6 4 Eee $64 4 $16 3rd Hours 7,200 7,500 5,300 20,000 Buy $105 6 $17.50 2nd Eck $57 3 $19 1st
Solution
266
Head office intervention

2.15 In practice, companies tend to employ a system whereby, broadly, the production plan is imposed by head office and transfers are made using cost information from within the company ie transfers are made at cost plus a profit element. 2.16 Advantage of head office imposed plan (a) No problems need arise re goal congruence
2.17 Disadvantages of head office imposed plan (a) (b) Loss of autonomous divisional decision-making power Demotivating
267
Lecture example 3
AJH plc has two divisions.
Based on a previous exam question
Division 1 manufactures a component called the Woody which it sells on the external market as well as transferring to Division 2. Division 2 then sells the Woody after further processing as the Woody Deluxe. The following information is available: Division 1 $ 110 60 150,000 5,000 900,000 Division 2 $ 230 80 150,000 3,000 850,000
Market price Woody Market price Woody Deluxe Production costs per unit Non-production overheads External demand Net assets 75% of the production cost per component is variable. Division 1 sets a transfer price of marginal cost plus 40%. AJH demands an ROI of 12% Required (a)
Calculate the profit generated by each division, profit margin and ROI
Solution
268
13: TRANSFER PRICING (b) Discuss the changes to the performance measures and their implications for the divisions as a result of changing the transfer price to full cost plus 25%.
Solution
269
Profit maximisation and transfer pricing

2.18 More complex situations may exist where both marginal cost and marginal revenue vary with output. If this is the case, a tabular approach can be used to determine a profit maximising transfer policy. As with pricing external sales, the technique is to find the output level where marginal cost of production equals the marginal revenue from sales.
Lecture example 4
No intermediate market for the output of Division S Output (units) 1 2 3 4 5 Required Determine the optimal transfer policy. Supply division (S) MCs TCs $ $ 30 70 120 180 250 TCr $ 60 125 195 270 350
Introductory question TP and profit maximisation
Receiving division (R) MCr SP/unit TR MRr $ $ $ $ 125 120 115 110 105
NMRr $
Solution
270
3
3.1
International aspects of transfer pricing

The problems encountered in setting transfer prices are compounded when a group has subsidiaries operating in different countries.
GSK settles largest tax dispute in history
Taxation
3.2 Double taxation agreements between countries mean that companies normally pay tax only once, in one country, when they transfer goods from one division to another across national borders. (A division is a wholly owned subsidiary in this instance.) If a company transfers goods from a manufacturing division in a high tax country to a marketing division in a low tax country, the company may be tempted to set a low transfer price. This would minimise the tax liability, as most of the profit would be made in the low tax country. If the manufacturing division were in a low tax country and the marketing division in a high tax country, the opposite would apply. But setting a transfer price on this basis in unwise. If a tax authority feels that a company is using an unrealistically high, or low, transfer price to reduce its liability, it can substitute an 'arms-length' price in place of the company's transfer price and tax will be paid in both countries, double taxation. Most countries now accept the Organisation for Economic Co-operations and Developments (OECD) guidelines. They provide guidance on arriving at an arms length price. However, it can still be difficult to arrive at a suitable transfer price particularly for intangible property. The onus is now on the taxpayer to demonstrate that the transfer price is reasonable, failure to do so can result in large penalties. As a result taxpayers may enter into an Advanced Pricing Agreement (APA) with the relevant tax authorities. The agreement as made in advance will avoid any disputes and therefore avoid double taxation and penalty fees.
3.3
3.4 3.5
3.6
Repatriation of funds
3.7 3.8 3.9 Exchange controls may prevent the transfer of profit overseas. Transfer prices could therefore be used to move funds between countries. If a county has high inflation, its funds will lose value, but if they can be repatriated the loss in value is prevented. If import duties exist, it would be advantageous to keep the transfer price as low as possible to avoid high duty payments
Minority shareholders
3.10 Transfer prices can also be used to reduce the amount of profit paid to minority shareholders by deliberately lowering a subsidiarys profit.
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Currency management
Section 9.3 Currency management
3.11 An additional consideration when setting transfer prices internationally is which currency the transfer should be made in. Any movements in exchange rates could result in gains or losses on exchange.
Lecture example 5
Introductory question TP and taxation
The existing results of Green Group are given below. Division S makes units to be transferred to Division R. Division R has no other sales besides the sale of transferred units. Note that Division S is located in a high tax country, and Division R is in a low tax one. $'000s Internal sales External sales Less: Internal costs External costs Divisional profit Tax Profit Division S 500 Division R 1,100 (500) (100) @ 5% 500 (25) 475
(200) 300 @ 30% (90) 210
The new tax manager of Green Group has suggested a change in the transfer pricing policy, so that the internal transfer is made at cost price of $200k. Required Evaluate the effect of this change in policy on: (a) (b) Division S Green Group
Solution
272
273
4
Q14 FP Photocopiers & Q15 PCs R Us
Chapter summary
Section 1 Topic Introduction to transfer pricing Summary Within a decentralised business, performance evaluation may be based on divisional profitability therefore it may be necessary to set transfer prices when goods are transferred between divisions. Transfer prices can be set on the basis of market price, cost or opportunity cost. Actual cost-based transfer prices are most likely to result in dysfunctional behaviour. Companies can use their transfer pricing policy in order to manipulate the overall tax that they pay.
Transfer pricing in practice
International aspects
END OF CHAPTER
274
CHECKPOINT 4

Key knowledge
Performance measurement In the modern business environment it has become evident that financial measures are insufficient on their own and need to be supplemented with a range of non-financial indicators. The balanced scorecards is a key technique which enables both financials and non-financials to be measured. Decentralised organisations Companies benefit in many ways by adopting this structure, but in so doing they expose themselves to the problems that can stem from a lack of control. It is vital that companies implement appropriate performance evaluation systems to encourage the right behaviours. Investment centres There are three main measures used to evaluate performance in investment centres: Return on Investment, Residual Income and Economic Value Added. You should be prepared to discuss the implications of these measures as well as being able to calculate them. Transfer pricing An organisation will want to know which of its many divisions are performing well and which are performing poorly. This is often done by evaluating divisional profits, and divisional profits will be directly affected by transfer prices if goods and services are provided by one division to another. You have seen several different approaches to setting transfer prices, and you need to understand when a particular approach is appropriate, and the behavioural impacts on the buyer, seller and company of each policy.
Key skills
You will have now covered the necessary knowledge of P2. Try also to remember the necessary key skills discussed so far and more importantly to start to practice these particularly as you approach your course exam. Play to your strengths so answer those questions you find easiest first Draw up any relevant proformas Ensure that when answering calculation elements you tackle the easy numbers first Carefully present your answers so that they are clear, easy to follow and workings are cross referenced to your answer. Ensure written answers explain a point concisely but in full and relate them to the scenario given wherever possible.
275
CHECKPOINT 4

Chapter 11a - Performance evaluation Variance analysis
Key areas - use the online lectures to selectively review these if you need to Planning & operating variances Mix and yield variances 10 mins 20 mins 10 mins 35 mins
175 mins
Course Notes Ensure you are can suggest possible causes for variances achieved and can explain the reason for planning and operating variances. Run through the lecture examples again to ensure you are happy with the calculations Review the additional notes section to ensure you can remember the variance pro-formas Question Practice Attempt Question 11 from the Question and Answer Bank in the back of the course notes if you feel you need further practice on this brought forward knowledge area. Additional Resources Brought forward knowledge Variance analysis variances are still examinable in the P2 syllabus and could be examined in many ways including via an assessment of performance, with flexed budgets or with learning curves. An online lecture is available to cover this.
100 mins
Chapter 11b - Performance evaluation

Key areas - use the online lectures to selectively review these if you need to Financial performance indicators (particularly profitability ratios) Non financial performance indicators Balanced scorecard
60 mins
Course Notes Ensure you are comfortable with the various ratios in this chapter. Discussions on performance measurement often focus on the use of non financial performance indicators so ensure you are comfortable with this area and can suggest suitable performance measures. Question Practice Attempt Question 12 from the Question and Answer Bank in the back of the course notes to practise discussion and interpretation of performance. Additional Resources - Real-life examples It is recommended that you read the article about the use of non financial performance indicators and the balanced scorecard contained at the end of this checkpoint.
10 mins 10 mins
35 mins
5 mins
276
CHECKPOINT 4
Chapter 12 Measuring performance in responsibility centres

Key areas - use the online lectures to selectively review these if you need to Responsibility accounting ROI v RI EVA
120mins
Course Notes Run through the examples in this chapter again to ensure you are happy with these techniques Be prepared to compare and contrast these techniques as this is often a discussion requirement. Question Practice Attempt Question 13 from the Question and Answer Bank in the back of the course notes. This question has a good mix of both calculations and discussion on this area of the syllabus. Its important to plan your answer for part (a) to ensure you can capture as many of the available marks as possible. Additional Resources Brought forward knowledge Investment appraisal techniques such as NPV and IRR are still examinable in the P2 syllabus and could be examined via a comparison with ROI. An online lecture is available to cover this. Study Text Read through section 1 which provides further information on responsibility centres. If you need further practice at EVA, work through the example in section 5. (Should take 10 mins) Real-life examples A brief article at the end of this checkpoints details how EVA is being used to decide which companies to invest in. (2 mins)
15 mins 5 mins 60 mins
35 mins 5 mins
Chapter 13 - Transfer pricing

Key areas - use the online lectures to selectively review these if you need to Transfer pricing Behavioural impacts
60 mins
Course Notes Ensure you can discuss the likely impact on both the buying and selling division of setting a transfer price at actual cost, standard cost, variable or full cost, selling price or opportunity cost. Numeric questions often focus on calculating profits within divisions when given transfer prices are in place so revisit Lecture Example 4. Implications of transfer pricing in overseas divisions is also commonly examined, so make sure you review this area.
10 mins 10 mins 5 mins
Question Practice Attempt Question 15 from the Question and Answer Bank in the back of the course notes. Understanding the implications of transfer pricing is vital for P2. Additional Resources Study Text Review of section 9.3 is strongly recommended which looks at currency management when setting a transfer price between countries with differing currencies. Real-life examples It is strongly recommended that you review the article at the end of this checkpoint which looks at the implications for GlaxoSmithKline of using a transfer price to manipulate their tax bill
20 mins
10 mins 5 mins
277
CHECKPOINT 4
On completion of this final stage (including Progress Test) you are ready to attempt Course Exam 2
278
CHECKPOINT 4
Checkpoint 4 Progress test

Having completed the Study Support guidance for Checkpoint 4, you are now ready to attempt Progress Test 4. You should aim to complete the test in 1 hours. If you find it takes you significantly longer to do so then please contact your course tutor for guidance. The test starts with some multiple choice and short calculation questions. These test your understanding of the material and your ability to perform calculations required. Note that the P2 exam does not contain multiple choice questions. Four short written questions follow. These test your ability to explain and apply your knowledge. These help to prepare you for the discursive elements of the exam. It is important that you continually review your progress and revise further any areas where you feel your understanding is weak.
A
1

Division X of Tina Pease Ltd produced the following results in the last financial year: Net profit Capital employed: 000 360 1,500 100
fixed assets net current assets
For evaluation purposes all divisional assets are valued at original cost. The division is considering a project which will increase annual net profit by 25,000 but will require average stock levels to increase by 30,000 and fixed assets to increase by 100,000. Tina Pease Ltd imposes an 18% capital charge on its divisions. Given these circumstances, will the evaluation criteria of Return on Investment (ROI) and Residual Income (RI) motivate Division X management to accept the project? ROI A B C D 2 Yes Yes No No RI Yes No Yes No 200 1,000
(2 marks)
Division W of Stoak Ltd produced the following results in the last financial year: Net profit ($000) Gross capital employed ($000)
For evaluation purposes all divisional assets are valued at original cost. A proposed project will increase the division's net profit by 22,000, but will require gross assets to increase by 100,000. Stoak Ltd imposes a 20% capital charge on its divisions. Will the evaluation criteria of Return on Investment (ROI) and Residual Income (RI) motivate division W's managers to accept the project? ROI A B C D Yes Yes No No RI Yes No Yes No (2 marks)
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CHECKPOINT 4
Which of the following definitions best describes the responsibility of an investment centre in a decentralised organisation? A B C D Responsibility for the level of sales, production costs, collection of debts and payment of suppliers Responsibility for the level of sales, production costs and treasury functions Responsibility for the level of sales, production costs and purchase of new fixed assets Responsibility for the level of production costs, treasury functions and collection of debtors and payment of suppliers (2 marks)
Data for questions 4 to 6

The following data relate to Bailey plc, a manufacturing company with several divisions. Division X produces a single product which it sells to Division Y and also to outsiders. Division X Sales to Division Y Sales revenue: Variable costs Contribution Fixed costs Profit at 25 per unit at 20 per unit at 12 per unit 100,000 (60,000) 40,000 (20,000) 20,000 External Sales 250,000 (120,000) 130,000 (50,000) 80,000
A supplier offers to supply 5,000 units at 18 each to Division Y.
If Division X does not match the lower price and cannot increase its outside sales and Division Y buys from the outside supplier, Division X total profit will be A B C D Nil 60,000 80,000 90,000 65,000 80,000 90,000 100,000
(2 marks)
If Division X reduces its price to Division Y to 18 in order to keep the business, its total profit will be A B C D
(2 marks)
If Division Y buys from the outside supplier, and Division X cannot increase its external sales, the effect on Bailey's total profit will be A B C D An increase of 10,000 A decrease of 10,000 A decrease of 30,000 A decrease of 40,000
(2 marks)
One of the main reasons for adopting a decentralised rather than a centralised organisation structure is the A B C D Improved goal congruence between divisional manager and the goals of the organisation Rapid response of management to environmental changes Availability of less subjective measures of performance Improved communication of information among the organisations managers (2 marks)
280
CHECKPOINT 4
The following data have been extracted from a companys year-end accounts: Turnover Gross profit Operating profit Non-current assets Cash at bank Short term borrowings Trade receivables Trade payables Calculate the following performance measures: (i) (ii) (iii) (iv) Operating profit margin; Return on capital employed; Trade receivable days; Current ratio. (4 marks) 7,100,000 4,850,500 3,630,000 4,500,000 2,750,000 950,000 525,000 435,000
A Division has reported a net profit of 10m for the year ended 30th April 20X9. Included in the calculation of profit are the following items: interest payable of 3m; development costs of 12m for a new product that was launched in May 20X8, and is expected to have a life of four years; advertising expenses of 1m that relate to the re-launch of a product in June 20X9. depreciation of 3m
The reported net assets invested in Division L at 30 April 20X9 were 30m. The replacement value of those assets at that date was 28m. The actual loss in value of assets during the year was 4m. The cost of capital for Division L is 5% per year. Ignore taxation. Calculate the Economic Value Added for the division for the year ended 30 April 20X9 10 State four aims of a transfer pricing system (3 marks) (2 marks)
B
1 2 3 4

Explain the benefits of operating a transfer pricing system within a divisionalised company. What are the similarities and differences between EVA and RI? Explain the advantages and weaknesses of RI compared with ROI. What are the problems associated with transfer pricing in a multinational environment? (4 marks) (4 marks) (4 marks) (5 marks)
END OF PROGRESS TEST 4
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CHECKPOINT 4

1 C Current ROI = New ROI =
360 = 22.5% 1,600
(360 + 25) 385 = = 22.25% which is lower (1,600 + 130) 1,730
Current RI in 000 = 360 - (18% of 1,600) = 72 New RI in 000 = 385 - (18% of 1,730) = 73.6, which is higher 2 A Current ROI =
200 = 20% 1000 200+22 1000+100 Profit Imputed interest (1,000 20%) = 20.18% ... Yes 200 (200) 0 222 (220) 2 ... Yes
New ROI Current RI
= =
New RI
Profit (200 + 22) Imputed interest (1,100 20%)
3 4
C B
An investment centre has responsibility for sales, production and investment in new fixed assets. Contribution from external sales Less total fixed costs (20,000 + 50,000) Profit Or: current profit Less: contribution from sales to Y 130,000 70,000 60,000 100,000 (40,000) 60,000
Lost contribution
= 5,000 2 = 10,000 No of units sold to Y
Price decrease 100,000 (10,000) 90,000
... New profit Or
= 100,000 10,000 = 90,000.
current profit reduction in value 5,000 (20 18) New profit
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CHECKPOINT 4
Effect on X's profit is decrease of Effect on Y's profit is increase of ... overall effect on Bailey plc
40,000 (as per 2) 10,000 (5,000 2) 30,000 decrease
Or: Since Bailey can manufacture the product for 12, to buy it in for 18 causes the company to loose 6. ... overall decrease = 6 5,000 = 30,000 7 B Problems associated with a decentralised structure include the following: (i) A potential lack of goal congruence. (ii) Difficulty in setting a suitable measure of performance. (iii) Difficulties in communication between divisional managers. The advantage of decentralisation is the opportunity for a speedier response to factors due to the more detailed knowledge of divisional managers.
= (3,630,000 / 7,100,000) 100% = 51.1%
Operating profit margin = (Operating profit/Turnover) 100% ROCE = (Operating profit/Capital employed) x 100% = (3,630,000 /(4,500,000 + 2,750,000 + 525,000 - 950,000 - 435,000)) 100% = 56.8% Receivable days = (Receivables/Sales) x 365 = (525,000/7,100,000) 365 = 27.0 days Current ratio = Current assets/Current liabilities = (2,750,000 + 525,000)/(950,000 + 435,000) = 2.4 times
9 Net profit Add back: Interest Advertising Depreciation Development costs Less: 1/4 development costs Economic depreciation Economic Profit Replacement value of Net Assets Development costs (12 3) Advertising EVA Economic Profit Less capital charge: 38 5% EVA 10 Just four from the following were required: Goal congruence Equitable performance evaluation Retain divisional autonomy Motivate divisional managers Optimum resource allocation 10 3 1 3 12 (3) (4) 22 28 9 1 38 22 (2) 20
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CHECKPOINT 4
Section B
1 Potential benefits of operating a transfer pricing system within a divisionalised company include the following. (a) (b) It can lead to goal congruence by motivating divisional managers to make decisions, which improve divisional profit and improve profit of the organisation as a whole. It can prevent dysfunctional decision making so that decisions taken by a divisional manager are in the best interests of his own part of the business, other divisions and the organisation as a whole. Transfer prices can be set at a level that enables divisional performance to be measured 'commercially'. A transfer pricing system should therefore report a level of divisional profit that is a reasonable measure of the managerial performance of the division. It should ensure that divisional autonomy is not undermined. A well-run transfer pricing system helps to ensure that a balance is kept between divisional autonomy to provide incentives and motivation, and centralised authority to ensure that the divisions are all working towards the same target, the benefit of the organisation as a whole.
(c)
(d)
EVA is an alternative absolute performance measure. It is similar to RI and is calculated as follows. EVA = net operating profit after tax (NOPAT) less capital charge where the capital charge = weighted average cost of capital net assets EVA and RI are similar because both result in an absolute figure which is calculated by subtracting an imputed interest charge from the profit earned by the investment centre. However there are differences as follows. (a) (b) The profit figures are calculated differently. EVA is based on an 'economic profit' which is derived by making a series of adjustments to the accounting profit. The notional capital charges use different bases for net assets. The replacement cost of net assets is usually used in the calculation of EVA.
The advantages of using RI (a) Residual income will increase when investments earning above the cost of capital are undertaken and investments earning below the cost of capital are eliminated. (b) Residual income is more flexible since a different cost of capital can be applied to investments with different risk characteristics. The weakness of RI is that it does not facilitate comparisons between investment centres nor does it relate the size of a centre's income to the size of the investment. Residual income will increase if a new investment is undertaken which earns a profit in excess of the imputed interest charge on the value of the asset acquired. Residual income will go up even if the investment only just exceeds the imputed interest charge, and this means that 'marginally profitable' investments are likely to be undertaken by the investment centre manager. In contrast, when a manager is judged by ROI, a marginally profitable investment would be less likely to be undertaken because it would reduce the average ROI earned by the centre as a whole.
284
CHECKPOINT 4
(a)
Exchange rate fluctuation
The value of a transfer of goods between profit centres in different countries could depend on fluctuations in the currency exchange rate. If taxation on profits is 20% of profits in Country A and 50% of profits in Country B, a company will presumably try to 'manipulate' profits (by means of raising or lowering transfer prices or by invoicing the subsidiary in the high-tax country for 'services' provided by the subsidiary in the low-tax country) so that profits are maximised for a subsidiary in Country A, by reducing profits for a subsidiary in Country B. Artificial attempts at reducing tax liabilities could, however, upset a country's tax officials if they discover it and may lead to some form of penalty. Many tax authorities have the power to modify transfer prices in computing tariffs or taxes on profit, although a genuine arms-length market price should be accepted.
(b)
Taxation in different countries
(c)
Import tariffs/customs duties
Suppose that Country A imposes an import tariff of 20% on the value of goods imported. A multi-national company has a subsidiary in Country A which imports goods from a subsidiary in Country B. In such a situation, the company would minimise costs by keeping the transfer price to a minimum value. If a country imposes restrictions on the transfer of profits from domestic subsidiaries to foreign multinationals, the restrictions on the transfer can be overcome if head office provides some goods or services to the subsidiary and charges exorbitantly high prices, disguising the 'profits' as sales revenue, and transferring them from one country to the other. The ethics of such an approach should, of course, be questioned. Transfer pricing can be used to enable profit centres to match or undercut local competitors. By inflating transfer prices for goods sold to subsidiaries in countries where inflation is high, the subsidiaries' profits are reduced and funds repatriated, thereby saving their value.
(d)
Exchange controls
(e) (f)
Competitive pressures Repatriation of funds
285
CHECKPOINT 4
Checkpoint 4 Real-life examples

Analog devices
F O R T U N E M A G A Z I N E F E B 1 9 9 7
Companies like Analog Devices believe that numbers alone don't tell the whole story. Analog's headquarters is in a low, sprawling red-brick building about 20 minutes outside Boston. The company's mainstay products are computer chips for use primarily in communications, military, aviation, and cellular phone applications. "In the mid-1980s we were not doing well. We simply needed to become more competitive," says Arthur M. Schneiderman, the MIT-trained engineer who developed the world's first balanced-scorecard model for Analog when he worked for it back then. "So we surveyed our customers and did benchmarking studies and found that they cared about things like delivery time and improved quality. Analog then built a model that would help its managers track and thus better manage such things. "Overall, there were about 15 non financial measures that we identified as critical to the company's performance," Schneiderman says. These were things like the rate of on-time deliveries, product development cycle times, number of new products, and so on. Analog managers can now get a history of how Analog is doing and where it is going overall. They can check on defect rates plant by plant and see how each plant's quality is improving. But Analog's model isn't just about the soft stuff. It links measurements like on-time deliveries to certain financial indicators. For example, the model now measures the percentage of sales due to new-product introductions, and gross margins on new products. Shell, by contrast, puts greater emphasis on more traditional, corporatewide indicators like revenues and return on investment. Once a quarter Analog's 12 senior managers get together for a full day to discuss, among other things, results from their scorecards. "The managers," says Goodloe Suttler, the company's corporate vice president for marketing, quality, and planning, "are then asked to explain in front of the group any variances in their results and what they are going to do about them." One manager, for instance, once had a problem with what it calls its "new-product ratios." This is a scorecard item that helps managers judge how effectively the company is spending its R&D dollars. The balanced scorecard showed that one division was lagging in new-product development. Under the old system this wouldn't have been noticed because all the conventional short-term financials looked just dandy--i.e., it was too early for the R&D slump to show up in the numbers. The division manager put more money into R&D and also began to look at new market segments while focusing a lot of attention on new-product sales and marketing strategies. "We wouldn't have done this if we were just looking at the financials," Suttler says. So what does focusing on the soft stuff do for the bottom line? Analog's revenues doubled to $1.2 billion last year, from $538 million in 1991. Operating profits have increased steadily, from a dismal 3% of sales in 1991 to a more respectable 19% last year. In April 1993, Analog's stock was selling for some $7 a share. Currently it is trading at about four times that price, hovering in the $28 range. Not bad for a company that manages itself with a model that is almost entirely devoid of traditional financial measurements.
Questions over new star

T
H E S U N D A Y T I M E S
Jamie Allsopp, manager of the New Star Hidden Value fund, is just 27 but already handles 44m of savers money, including at least 1m invested by his boss John Duffield, founder of New Star Asset Management. Hidden Value has gained 74% since Allsopp took over, compared with 44% for the FTSE All-Share index and 41% for the average fund in the UK All-Companies sector. In 2004, Hidden Value was ranked second out of 297 funds in the sector, returning 32% compared with 13% for the All-Share. As the name of Allsopps fund suggests, he seeks out promising companies that have been missed by the rest of the market. He uses a system called economic value added, or EVA, to work out if a company is creating value for shareholders and whether this is reflected in the companys share price.
286
CHECKPOINT 4
He said: EVA analysis is not widely used in the City, but it is a disciplined way of looking at a company and getting to know the business.
GSK settles largest tax dispute in history for $3.1bn

T
H E T I M E S
The largest tax dispute in history has been settled between the US Internal Revenue Service (IRS) and GlaxoSmithKline (GSK), the drugs company, which has agreed to pay the American fiscal authorities $3.1billion ($1.66 billion) in taxes and interest to end a row over transfer pricing. GSK said that the final payment fell within a $2.2 billion provision made by the company for tax liabilities. The pharmaceutical giant was exposed to a potential liability of $11.5 billion for 16 years of tax accounts between 1989 and 2005 that were disputed by the IRS. Shares in GSK reacted positively to the settlement yesterday, gaining 10p to $14.79. At the core of the dispute was a quarrel between two tax authorities, the IRS and HM Revenue and Customs in Britain, over how to divide the spoils of Zantac, the blockbuster ulcer treatment that was developed by Glaxo, GSKs predecessor. The argument between GSK and the IRS was about where the Zantac profit was earned and how much of the products value should be attributed to each jurisdiction. Developed and manufactured in the UK but widely sold in America, the US tax bill depended on the transfer price the value at which the drug was transferred to the groups US marketing subsidiaries. The zeal with which the IRS has pursued its claim reflects rising tensions between tax authorities as they seek to capture profits that can move between jurisdictions at the stroke of an accountants pen. We have consistently said that transfer pricing is one of the most significant challenges for us in corporate tax administration, Mark Everson, the IRS commissioner, said. The settlement of this case sends a strong message of our resolve to continue to deal with this issue. GSK faces further unrelated transfer-pricing litigation in the UK, Japan and Canada, mainly relating to its legacy Glaxo drugs.
287
CHECKPOINT 4
Let BPP Professional Education help you with your revision

You have now completed the very important Learning Phase of your studies. You have built core skills and have tested these using course exams and practice questions. You now need to focus on developing new skills to address the ultimate test the exam itself.
Phase 2 Practise and revision Revision courses

Our Revision Courses, available in the period running up to the exam, will focus on one objective passing the exam. Success in the exam requires more than just understanding the syllabus; you also need to apply this knowledge to the context of the exam questions. Using real exam questions written by the examiner youll learn the unique exam skills for each paper. We will teach you how to:

Pick up easy marks for that paper Write in the correct style for that particular exam Choose the best questions for you Apply simple and understandable methods to pass the most difficult technical questions Build exceptional time management skills
During a BPP Revision Course you will cover all of the issues above, maximising your chances of picking up marks. After all, those extra marks could mean the difference between a pass and a fail! We also suggest that if possible, the final step in your preparation should be a Question Day as an effective exam rehearsal that will test your technique under timed conditions. Finally, dont forget that if you wish to make use of our FREE Pass Assurance, then attending a revision course is one of the criteria you must fulfil.
Phase 3 Final exam rehearsal

Question days
A Question Day provides one final day of practice (normally 1-2 weeks before the actual exam) giving you a chance to attempt a targeted mock exam under timed conditions. Your answers will be marked and you will receive feedback during the day allowing you to practise improvements to your question technique as the day progresses. During the day your tutor will provide debriefs of the questions and helpful tuition tips. Please note that places are very limited so book early to avoid disappointment.
Note. Question Days are not a substitute for a revision course and do not count as a revision course under the Pass Assurance rules.
288
Answers to Lecture Examples
289
14: ANSWERS TO LECTURE EXAMPLES
Chapter 1
Answer to Lecture Example 1
120 boxes required In inventory 50 x resale price $14 $700 Total cost ($700 + $1,540) = $2,240 Need to purchase 70 x current market price $22 $1,540

Labour is currently working at full capacity if 15 hours are used in the contract
15 hrs 5 hrs
= 3 units of X will not be made
Cash flows under each option Undertake contract $ 90 75 165
Direct labour (15 hrs @ $6) Lost contribution 3X (3 $25) Relevant cost Alternative approach
The cash flows which will change if the contract goes ahead are: Lost revenue from X (3 $75) Saved costs from X materials (3 20) Relevant cost of 15 hrs of labour $ 225 (60) 165
290

Relevant Costing Statement
Aluminium plating Rivets Skilled labour Semi-skilled labour Overheads Administration overhead Total relevant cost Profit Minimum price
Notes
Note (1) (2) (3) (4) (5) (6) (7)
$ 240 50 1,320 1,610 1,610 1,610
(1) (2) (3)
Aluminium is in regular use therefore it needs to be replaced. Value at current purchase price Relevant cost = 20m2 $12 = 240 Rivets = opportunity cost is lost scrap proceeds 100 50p = $50 Skilled labour Cheaper to work overtime as $24/hr is less than $36/hr (16 + 20) 40 hrs @ $24 = 10 hrs @ $36 $ 960 360 1,320 (spare capacity)
(4) (5) (6) (7)
Semi skilled labour Relevant cost = nil
Overheads relevant cost is nil Incurred anyway regardless of this job. Administration costs will be incurred anyway regardless of whether or not the job is accepted therefore not relevant. Profit mark up not relevant as question asks for a minimum price. A minimum price is one which just covers the total of the relevant costs. Product interdependencies Inflation Availability of cash Time value of money Impact on supplies Potential future contracts Learning curves Repeat business Restricted output/capacity Competition Recruitment Technical feasibility Political, legal and economic considerations
Other factors
291

(a) Costs to manufacture Variable: $14 per unit 15,000 units Fixed: avoidable only $'000 210 15 225
Maximum to pay (per unit)
220 15
= $15 each
Assumption: the supplier will supply all 15,000 units required. (b) To breakeven Relevant contribution = Relevant fixed costs ($54 - $36) units = $23,400 $18 units = $23,400 Units required = 1,300

(a) If Keir were shut down the incremental costs and revenues are as follows. $'000 Lost revenue 600 Saved Materials 200 Labour 95 Variable overhead 75 Fixed overhead 40 20% $200 Selling costs 40 Profit foregone 150 Alternatively: $'000 Fixed costs still incurred 80% $200 Loss forecast (b)
Other factors
160 (10) 150
Losing over 54% of company's revenue other costs likely to change Product interdependencies Possibility of changing sales commission or reducing expenses in place of closure Capital costs of closure not considered such as asset sales/write-offs Redundancy costs
292

(a)
Sale now $ Sale after processing SP VC $ $ 13.00 3.75 15.00 2.75 NRV $ 9.25 12.25
A B
Decision
10 12
A B (b) (i)
Sell at split-off point Process further $ 25,000 24,000 (47,700) 1,300
Product A Product B Common costs Net profit
2,500 $10 2,000 12
The process is viable if the products are both sold at split off point (ii) Product A Product B 2,500 $13.00 2,000 $15.00 $ 32,500 30,000 62,500 (47,700) (9,375) (5,500) (75)
Common costs Further processing costs product A (2,500 3.75) product B (2,000 2.75) Net loss
The process is not viable if both the products are processed further before being sold.
Chapter 2
Limiting factor is materials as temporary labour can be employed.
A $ 150 50 B $ 120 30 C $ 100 15
Sales Materials Labour (10% premium) Contribution Materials (kg) Contribution/kg Ranking
55 45 10 $4.50 3
55 35 6 $5.83 2
44 41 3 $13.67 1
293
Production plan
Contract 5A 5B 5C Demand 50 C 50 B 30 A (bal)
Materials kg
50 30 15 95 150 300 300 845

If 1 more kg of material were available, it would be used towards production of A. Contribution / kg for A is $4.50. The shadow price of material is therefore $4.50
Chapter 3
(a) (b) (c) Subject to (Leather) (Skilled labour) (Quota) (Non-negativity) 1.5p + 2h 600 0.75p + 0.5h 210 ph0 p, h 0 Let p = weekly number of purses h = weekly number of handbags 5p + 6h
Objective: Maximise
294
(d)
P 400 Leather EU quota
Number of purses produced

300 280
200 Objective
100
Labour
100
200
250
300 400 h Number of handbags produced
(e) (f)
Optimal production: 160 purses 180 handbags Contribution = 5p + 6h = (5 160) + (6 180) = $1,880 per week

Surplus: KG must produce at least as many handbags as it does purses. Optimal production: 160 purses 180 handbags
Therefore there is a surplus of 20 handbags. Slack: 210 skilled labour hours are available, 600m2 of leather. The optimal solution requires: Labour: (160 0.75 hrs) + (180 0.5 hrs) = 210 hrs ... no slack labour Leather: (160 1.5 m2) + (180 2 m2) = 600 m2 ... no slack labour
295

Labour is a limiting factor so KG would be prepared to pay to obtain more of this resource. Shadow price = contribution foregone due to limiting factor = extra contribution if one more unit of limiting factor obtained at original cost. If 1.5p + 2h = 600 0.75p + 0.5h = 211 Optimal solution h = 178 p = 162.67 Contribution = 5p + 6h = $1,881.33 Original contribution = $1,880.00 Shadow price 1.33 Shadow price Usual price Maximum price $ 1.33 4.20 5.53 (leather) (labour)
Chapter 4
Variable S1 S2 S3 Solution Notes: Each row represents the coefficient of the variables in each of the initial constraints. The variables in the initial tableau are the unused production (as no products are made). The solutions indicate shadow prices. They are negative as contribution will be increased once P and H are produced. P 1.5 0.75 1 -5 H 2 0.5 -1 -6 0 0 S1 1 1 1 0 S2 S3 Soln 600 210 0

(a)
Objective function value: KG Ltd can earn $1,880 contribution. Variables: KG Ltd should make 160 purses and 180 handbags. Slack/surplus:
The slacks for constraints 1 and 2 are zero, showing that all available leather or labour will be used. The surplus for constraint 3 is 20, indicating that the EU minimum quantity of handbags has been exceeded by 20, ie. 20 more handbags than purses will be made.
Shadow price/worth:
Constraints 1 and 2 both have zero slack, and so are fully utilised. If more labour or leather could be obtained, output could be increased, and hence contribution increased.
296
An extra m2 of leather would increase contribution by $2.667, and an extra hour of labour by $1.333. Constraint 3 is non-zero, and hence a relaxation in the quota would not increase contribution.
Relative loss: The relative loss of zero for all products indicates that they are all produced in the optimal solution. If a product is not being produced at the optimal point, a relative loss would indicate the reduction in contribution if one unit of this product had to be manufactured.
(b)
The shadow price for leather is $2.667/m2, indicating that the maximum KG Ltd would be willing to pay for additional leather is $8 + $2.67 = $10.67/m2. Hence, it would accept an offer of additional leather at $10.50/m2. However, it would not want an infinite supply of leather at this price the shadow price in the computer output is only valid for a range of values.
Chapter 5
Selling price Variable costs Contribution Breakeven point = =
=
Footballs $ 7 3 4 Fixed costs Average contribution (W1)

20,000 2.889 6,923 units
Baseballs $ 6 4.50 1.50
Rugbyballs $ 9 5 4
(W1) Average contribution = =
($4 2) + ($1.50 4) + ($4 3) 2+4+3 $2.889

(a) Units (b) Revenue $ 10,766 18,462 20,772 50,000
The 6,923 units would be split as follows:

Sales mix SP $ 7 6 9
Football Baseball Rugbyball
2 4 3 9
1,538 3,077 2,308 6,923
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Budgets Costs Revenues
Footballs Baseballs Rugbyballs Fixed costs Total costs
(2,000 $3) (4,000 $4.50) (3,000 $5)
$ 6,000 18,000 15,000 39,000 20,000 59,000
(2,000 $7) (4,000 $6) (3,000 $9)
$ 14,000 24,000 27,000 65,000
Multi-product breakeven chart $'000 Costs and revenues Revenue 65 $6,000 profit 59 50 20 Total costs
6,923
9,000
Output volume (units)

Footballs Baseballs Rugby balls Plot in order of C/S ratio
Product Footballs Rugby balls Baseballs Cumulative sales $ 14,000 41,000 65,000 Cumulative profit $ (12,000) 0,000 6,000 Contribution $ 8,000 6,000 12,000 Sales $ 14,000 24,000 27,000 C/S ratio
57.1% 25.0% 44.4%
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Multi-product P/V chart

Profit/ loss 6,000 X
0 14,000
X 41,000
X 50,000
65,000 Revenue
12,000
20,000 X

The break even point is:
$9,000 ( 7 4)
= 3,000 units
Since sales are normally distributed, they can be shown on the following curve:
3,000 3,500
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The Z value for the shaded area is: Z= Z=
x
3,000 3,500 400
Z = -1.25 This is a probability of 0.3944 (from the tables). We will also break even at sales above 3,500 which has a probability of 0.5 Probability of breaking even is therefore 0.3944 + 0.5 = 0.8944 or 89.44%

The number of units to drive a profit of $2,500 is: = 3,834 units ( 7 4) Since sales are normally distributed, they can be shown on the following curve:
$9,000 + $2,500
3,500 3,834 The Z value for the shaded area is: Z= Z=
3,834 - 3,500 400 Z = 0.84 This is a probability of 0.2995 (from the tables). Probability of making at least $2,500 profit is therefore 0.5 0.2995 = 0.2005 or 20.05%

(a) Current breakeven point =
$30,000 (120 30 25) = 462 units
Current Margin of safety = 750 462 = 288 units Materials increase by 5% = $31.5 Revised breakeven point =
$30 ,000 (120 31.5 25)
= 473 units
Revised Margin of safety = 750 473 = 277 units ... change in margin of safety = drop of 11 units. A fall of 3.8%
300
(b)
Contribution from 750 units @ $65 each = $48,750 Current fixed costs are $30,00 so they could rise to $48,750 a rise of $18,750.
18,750 30,000
= 62.5% rise
Chapter 6
(a) P = a bX b= $1 2,500 = 0.0004
12 = a (0.0004 16,000) a = 18.4 P = 18.4 0.0004X (b) MC = MR 5 = 18.4 0.0008X Therefore, X = 16,750 units (c) (d) P = 18.4 (0.0004 16,750) = $11.70 per unit MR = 18.4 0.0008X MR = 0 at maximum revenue 18.4 0.0008X = 0 X = 23,000 units P = $9.20 per unit

Output (units) 10 20 30 40 50 60 Total Cost $ 10 25 45 70 100 135 MC $ 10 15 20 25 30 35 Selling Price $ 5.00 4.50 4.00 3.50 3.00 2.50 Total Revenue $ 50 90 120 140 150 150 MR $ 50 40 30 20 10 0 Profit $ 40 65 75 70 50 15
Output level of 30 units. Selling price of $4 per unit.
301
Chapter 7
(a)
Output Total time (hrs) Cumulative average time (hrs)
1 2 4 8 (b)
100 150 225 337.5
100 75% 75 75% 56.25 75% 42.19
Y = aXb a = 100 X = 10 b = log 0.75/log 2 = 0.125/0.301 = 0.415 Y = 100 10 0.415 = 38.459 hrs
Total time taken to produce 10 batches: 10 38.459 = 384.59 hrs (c) Y = aXb a = 100 X=9 b = 0.415 Y = 100 9-0415 = 40.1781 hrs
Total time to produce 9 batches = 9 x 40.1781 = 361.60 hrs Time to produce 10th batch = 384.59 361.60 = 22.99 hrs
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(a)
Unit Total Time per unit Cumulative Average Time per unit
1 2 4 8 Let r = learning rate 20r3 = 12.5 r =3 12.5 20
20
20
r r r
12.5
r = 0.855 or 86% (b) Expected learning rate was 80%. The actual learning rate was therefore slower than expected. This could be many reasons for this such as: Changes in the workforce Demotivated workforce Break in production between first and the rest of the units Less skilled staff than anticipated Too optimistic when setting targets

Development Sales volume (units) $000s Revenue Variable Cost Overhead Development cost 500 (500) 2,396 996 400 0 1,000 4,941 2,241 900 0 1,800 13,470 5,970 1,800 0 5,700 3,490 1,490 750 0 1,250 24,297 10,697 3,850 500 9,250 Introduction 4,000 Growth 9,000 Maturity 30,000 Decline 10,000 Total
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$ Selling price margin (25%) Target cost Expected cost Timber Roofing material (2 17.50) Wire Labour (W) (2 7) Variable overhead (2 1.50) Cost gap (w) Expected time for labour X 1 hours 2 hours 2 hours px p 0.25 0.5 0.25 px 0.375 1.0 0.625 2.000 125.00 31.25 93.75 $ 48.00 35.00 1.50 14.00 3.00 101.50 $7.75
Chapter 8
(a) Prime cost Overheads (W3)
Workings Activity Cost pool Driver Cost driver ratio Cost driver units Twist ($/m2) 4.53 5.41 9.94 Supertwist ($/m2) 5.43 3.76 9.19
Machining Stores Set-ups Despatching
$ 5,000,000 4,750,000 5,500,000 3,500,000
Machine Hours (W1) Value of Materials (W2) Runs Customers
3,750 : 6,667 8,100 : 12,960 400 : 150 15 : 10
10,417 21,060 550 25

Supertwist 20,000 4/12 6,667
(W1) Total machine hours, as labour Total labour hours

Twist 15,000 3/`12 3,750
304
(W2) Total value of materials = ((360 + 180) 15,000) + ((576 + 72) 20,000) = 8,100,000 + 12,960,000 = $21,060,000
Total overheads Twist $ 1,800,000 Supertwist $ 3,200,000
Machining Stores Set ups Despatching Total overheads total m2 O/H per m2 (b) AC SP Cost Profit SP Cost Profit/(loss)
1,830,600 4,000,000 2,100,000 9,730,600 15,000 120 = 1,800,000 $5.41
2,928,960 1,500,000 1,400,000 9,028,960 20,000 120 = 2,400,000 $3.76

Twist 8.99 8.28 0.71 Supertwist 12.99 10.43 2.56
ABC
8.99 9.94 (0.95)
12.99 9.19 3.80
ABC is a more accurate reflection of the costs incurred in production. Twist is more expensive than believed and, at a selling price of $8.99, is loss making. Its price may need to be increased. Supertwist shows the opposite result. Supertwist currently sells in higher volumes, so the company should attempt to increase its sales. This analysis does not permit decisions over closure of Twist production.
Reservations
Could Twist costs be cut? Are the products substitutes or complements? Are these products sold to the same customers? How long would it take to reduce overheads if Twist production was reduced? Twist does generate positive contribution.
305

Selling price (100%) Bought-in-price Contribution (15%/20%) Less
Ordering SoapySuds $ 4.00 3.40 0.60 WhiteyWhite $ 3.00 2.40 0.60
$150 per order 2,000 2,250

Delivery
0.075 0.067
120 100m3
= $1.20/m3 0.0096 0.0264
0.008m3 0.022m3
Warehousing
480,000m3
480,000
= $1/m3/month 0.016 0.033
0.008m3 2 months 0.022m3 1.5 months

Stores
200,000m3
250,000
= $1.25/m3/month 0.0075 0.0206 0.4919 0.453
0.008m3 0.75 month 0.022m3 0.75 month DPP General costs are not product specific so are ignored.

Pareto's rule applies. 20 of the 100 customers generate 80% of the margin. 50 of the customers generate 100% of the margin with the other 50 customers making losses. The company would benefit if customers contributed more evenly to profit. Suggestions could include:

analysis of non-value added activities to cease charging for value added items removal of customers
Customer profitability analysis and ABC would be helpful.
306
Chapter 9a
20X6 Prevention costs Quality control Appraisal costs Inspection of WIP Internal failure costs Rework Scrap External failure costs Returns Complaints 20X7
$'000 40 85 125 60 35 50 395
% 10.1 21.6
$'000 120 70 60 20 15 20 305
% 39.3 23.0
46.8
26.2
21.5 100
11.5 100
Total costs of quality are falling. Also more is being spent on improving conformance. Failure is falling. However reduced appraisal costs could cause future failures to increase. A longer period of assessment would be helpful.

Efficiency Zero defects. Wastage eliminated. Inventory Buffer stocks not required if quality is present throughout the purchasing and production process Cost Continuous improvement aims to drive down cost. Pay more per item for guaranteed level of quality

Efficiency Cellular working workers more flexible. Can operate more processes therefore quicker, more efficient process. Wastage eliminated. Machines maintained regularly eliminating breakdowns and slows in production. Inventory Lower inventory of raw materials Lower inventory of finished goods Cost Fewer holding costs Less cost of obsolescence Higher delivery costs Higher price paid to guarantee quality & reliability Potentially higher labour cost as overtime maybe worked to meet demand rather than production occurring evenly throughout the year.
307

Product Y 315 175
Machine hours required Type 1 Type 2 Machine utilisation rate:
H 180 120
C 180 120
Total 675 415
Machine type 1 = 675/600 = 112.5% Machine type 2 = 415/500 = 83.0% Machine type 1 has the highest utilisation rate and the rate is above 100 per cent. Therefore machine type 1 is the bottleneck/limiting factor.

Efficiency Technique looks at making most efficient use of production capacity. Operation runs at pace of bottleneck. Inventory Only inventory is small buffer stock immediately before bottleneck Cost Lower inventory costs. Less capital tied up in inventory. Prevents surplus stock being bought.

(a) Contribution/unit of scarce resource Sales Materials N O P Labour Contribution Kg P Contribution/kg Rank Production plan 200 A 80 B Less: fixed costs Profit
P Kg 600 400 1,000 Contribution $ 11,400 7,440 18,840 A $ 140 16 12 27 28 57 3 19 B $ 230 8 27 45 57 93 5 18.6 C $ 280 24 24 90 32 110 10 11
(200 $17.50) + (100 $35.62) + (75 $20)
8,562 10,278
NB: This treats labour as a variable cost but the reality is labour is fixed and will be paid regardless of whether demand for all units can be fulfilled.
308
(b)
Throughput Sales Materials N O P Throughput Bottleneck resource (Kg P) Return/KgP Rank Production plan
A $ 140 16 12 27 85 3 28.3
B $ 230 8 27 45 150 5 30
C $ 280 24 24 90 142 10 14.2
1
Throughput $ 15,000 14,110 29,110
P Kg 100 B 500 166 A 500 1,000 Less: total factory costs (200*(28 + 17.50)) + (100*(57 + 35.62)) + (75 *(32 + 20)) Profit
22,262 6,848 $ 22,262 1,000 $22.26
(c)
Cost/kg P Total factory costs Total Kg P Cost/Kg P TA ratio TA ratio Rank

A 28.3 B 30
C 14.2
22.26 1.27 2
22.26 1.35 1
22.26 0.64 Not viable
BR has, effectively, created labour as a fixed cost by guaranteeing a minimum weekly wage. Throughput accounting regards labour as fixed, in the short-term, and is a better method for making decisions. Decisions should now be taken to: increase C's TA ratio further increase A and B's TA ratios without increasing inventory
309
Chapter 9b
COOKING SERVING
BUYING
Cheap
Fast Standardised
Fast/ immediate
Fresh Provenance
Unique Presentation special
Product Knowledge Make customer feel special
Cheap airports
New low maintenance aircraft
Seat layouts
One class only
Internet booking
No tickets No seat allocations
Leisure passengers

Waitrose customers value quality, freshness and service.
SUPPORT ACTIVITIES Firm infrastructure Human resource management Technology Development Procurement
Local suppliers (within 30 miles) High quality Fresh produce Traceable provenance Fairtrade Wine experts Carry to car service Home delivery Quick Check Price commitment quality food at VFM Adverts in quality magazines No quibble replacements Entertaining Free glass hire
By understanding what its customers value Waitrose can maximise the margin they generate. Focus on quality, freshness, local, British produce, farming standards and sustainability assures its discerning customers that the produce they are buying is top quality whilst ethically produced.
310
Having instore experts such as wine experts assures the consumer that they will be offered tailored advice based on their particular requirements. An appreciation that for many of their customers time is sparse and they dont want to be queuing at supermarket tills led to developments such as quick check. Add on services such as Waitrose entertaining enables busy customers to order high quality food for special occasions.

Removal of inspection of both goods inwards and outwards if quality can be assured and level of desired quality known a non-value adding activity. Economy of scale through co-operation in ordering. Better knowledge of end customer's interest communicated down the chain. Internet makes this more feasible. Power balancing between organisations. Faster response times. Reduced transport costs and times through location management. Reduced inventory levels.

Has its own farm so can control quality of milk, apples, pears, eggs, mushrooms, free range chicken etc Has relationships built upon trust and fairness Only supermarket to have livestock producer groups Local sourcing within 30 miles enables lower transportation and storage costs Waitrose Foundation secure long term supply via investment in poorer, volatile countries

Good knowledge of English Cheaper labour market Longer working day supported by time differences Lower IT/infrastructure costs Tax
Bad press Foreign exchange risk Political red tape Lack of local knowledge Culture

Mercedes design, develop and produce the F1 engines for McLaren
Benefits for McLaren:
Access to Mercedes expertise McLaren receive the engines free of charge Due to the naming McLaren Mercedes, McLaren can still sell all the advertising space on the car
311
Mercedes want to be associated with a winning team so they will put a lot of effort into the development of a high performance engine Mercedes name is part of team name. Lots of media coverage PR Associated with a winning team Helps their own engine development which they can use in their road cars.
Benefits for Mercedes Benz:
Mercedes engineers will be part of the McLaren team so this requires team working and trust. Mercedes also supply engines to other teams for a fee, and will often have an engineer with those teams. McLaren therefore need to trust that Mercedes will not share confidential information about McLaren.
Chapter 10
Workings: Materials: Variable cost = $3/unit Overhead: Fixed cost = $20,000 Labour: (High-low method) ... VC/unit = $2 By substitution into high output: Total VC Total FC = $28,000 = $35,000 $28,000 = $7,000 Flexed budget Units Materials (12,350 3) Labour (7,000 + 2 12,350) Overhead 12,350 $ 37,050 31,700 20,000 88,750 Actual 12,350 $ 35,000 32,000 23,000 90,000 Variance 2,050 F (300) A (3,000) A (1,250) A
Output 14,000 10,000 4,000 Cost 35,000 27,000 8,000

Main advantages of participation are as follows :
If profit centre managers participate in setting the targets they are more likely to accept these and show more commitment towards achieving them. Narrowing the knowledge and information gap
312
The detailed knowledge of day to day operations that profit managers have will enable more effective and relevant targets to be set. This process of information sharing will lead to the setting of optimal targets, taking into account both organisational and operational constraints and opportunities and making variance analysis more meaningful. Motivation and improved performance Research findings confirm that participation increases job satisfaction, improves work related attitudes and leads to better performance. The process of participation may be more time consuming in some circumstances participation may lead to less difficult targets or the introduction of budget slack. Research has shown certain people to react better to an imposed budget
Potential disadvantages of participation

Orchard is in a very competitive industry, where technological advances mean that the products have very short lifecycles and change rapidly. Traditional budgeting means planning a long way in advance and so does not lend itself easily to this type of business. It may well therefore be appropriate to move to a 'beyond budgeting' approach and have a set of KPI's instead. These would include some key financial and non-financial indicators, eg YOY sales growth, market share, product innovations and so on.
Chapter 11a
Some examples would include:
Price / rate variance
Favourable this may indicate buying a material / employing labour too cheaply which may have quality implications. Adverse a decision to purchase better quality materials may be the right thing to do and lead to better efficiency.
Usage / efficiency variances
Favourable this may indicate that too little material or time is being used which may result in poor quality goods.
Sales price variance
Favourable it may be that price has been raised too high so that volume and overall revenue is down. Adverse this may have been reduced in order to drive more sales.
313
Planning Should 14,000 units should cost @ 4kg @ $9 Should now 14,000 units @ revised cost @ 3.8kg @ $9.30 Operational Should now 14,000 units @ revised cost @ 3.8kg @ $9.30 Did Did cost 54,000 @ $9.50
$ 504,000 (494,760) 9,240 (F) $ 494,760 513,000 (18,240) (A)
Planning Price Should 14,000 units @ revised std kg should cost @ 3.8kg @ $9 Should now 14,000 units @ revised std kg should now cost @ 3.8kg @ $9.30 Usage Should 14,000 units @ orig std kg 4kg Should now 14,000 units @ revised std kg 3.8kg
@ original standard cost $9 Total Planning variance $25,200 F - $15,960 A = $9,240 (F)
Operating Price Should now 54,000 kg should cost @ $9.30 Did 54,000 kg did cost Usage Should now 14,000 units @ revised std kg 3.8kg Did 14,000 units did use
$ 478,800 (494,760) 15,960 (A) $ 56,000 (53,200) 2,800 (F) $25,200 (F)
@ revised standard cost $9.3 Total Operating variance $10,800 A + $7,440 A = $18,240 (A)
$ 502,200 (513,000) 10,800 (A) $ 53,200 (54,000) 800 (A) $7,440 (A)

Mix variance Std mix Act qty 26,917 (W) 43,068 16,150 86,135 Act mix Act qty 27,555 45,905 12,675 86,135 Variance Cost/kg 2 5 0.80 Variance 1,276 (A) 14,185 (A) 2,780 (F) 12,681 (A)
A B C (W)
(638) A (2,837) A 3,475 F -
125/400 86,135 = 26,917 200/400 86,135 = 43,068 75/400 86,135 = 16,150
314
Yield variance Std mix Std qty 28,125(W) 45,000 16,875 90,000 Std mix Act qty 26,917 43,068 16,150 86,135 Variance Cost/kg 2 5 0.80 Variance 2,416(F) 9,660 (F) 580 (F) 12,656 (F)
A B C (W)
1,208 F 1,932 F 725 F 3,865 F
225,000 Rumbles should use: A B C @ 125g = @ 200g = @ 75g = 28,125 45,000 16,875 Units 215,337.5 225,000 9,662.5 (F) $12,658 (F)
Alternative Yield variance calculation
Actual input should yield (86,135 / 0.4) Actual input did yield @ Std cost / unit $1.31

The purchasing manager is responsible for the price variance. On the face of it, it would appear that he has done a good job as the overall price variance is favourable. It suggests that he has achieved a good price or discounts from suppliers. However the usage variance is adverse and this could be caused by the quality of the material purchased. If the material was of a lower quality than normal (which could be the case with material A) then this could have been the cause of the adverse yield variance. The production manager is in control of the usage variances in other words both the mix and yield variances. As these are adverse overall it can be said that he has performed poorly. The mix variance shows that more of material A has been used than B this may be due to the fact that the material was cheaper and so the production manager chose to use more of this item. However whilst this has driven a favourable mix variance this is outweighed by the adverse yield variance. This yield variance is likely to be a consequence of the change of mix in material. It suggests that the use of material A has caused the process to be less efficient and more input has been required to achieve the production. This could be the fault of the production manager as he has altered the mix however, this could be to compensate for the increase in price of material B. If material A is of a lower quality then the decision to purchase at this quality could be said to have a detrimental effect on the whole production and so the purchasing manager has not purchased as wisely as he thought.
315
Chapter 11b
(a) Gross profit margin = gross profit 100% sales
20X9 $ 3,269,000 1,503,000 4,772,000 20X8 $ 2,541,000 1,291,000 3,832,000
1,291,000 3,832,000 33.7%
Total production cost Gross profit Sales Gross profit margin = = net profit Net profit margin = 100% sales Net profit margin
1,503,000 4,772,000 31.5%
= =
295,000 4,772,000 6.2%
287,000 3,832,000 7.5%
net profit ROCE = 100% capital employed ROCE
= = = =
Sales per employee
295,000 3,005,000 9.8% 4,772,000 260 $18,354

29,361 260 113 3,269,000 29,361 111
287,000 2,861,000 10.0% 3,832,000 248 $15,452
Average number of books produced per employee = = Average production cost per book = =
27,498 248 111

2,541,000 27,498 92
(b) Big Bonds gross profit has fallen over the period. This implies that either his selling price has fallen, or his direct costs have risen. An increase in costs is probably the most likely cause. His gross profit is lower than that of Little Boots. Net profit has also fallen over the period, this could be a direct flow through from the gross profit, again this is lower than the competitor. It is however much lower in comparison with Little Boots than the gross margin is. This would suggest that Little Boots has much better cost control than Big Bond, not only at a production cost level but also for the non production costs. As expected given the profitability measures above, ROCE has fallen slightly and is lower than Little Boots. Sales per employee has actually risen over the period and is better than Little Boots. Much of the rise is due to the increase in selling price but not all.
316
Similarly the average number of books produced per employees has increased and is higher than Little Boots. This implies that Big Bond is being efficient here, getting more from its labour force than the previous year and its competitor. The average production cost per book has risen making it more expensive to make than for Little Boots. Their costs were similar in the previous year. It would seem that it is the direct material cost that is driving this increase in costs and rendering Big Bond less profitable than Little Boots. Perhaps Big Bonds suppliers have raised their prices and it would be appropriate to switch to another supplier. Big Bonds labour force appear to be very efficient, but Big Bond needs to focus on its direct material cost control to compete more effectively with Little Boots.

(a) Days taken can be computed Receivables 243,800 x365 = x 365 Sales 875,000 Raw materials 96,000 x 365 x 365 = Purchases 623,000 Work - in - progress 103,500 x 365 = x 365 Cost of production 715,000 Finished goods 75,400 x 365 x 365 = Cost of sales 743,500 Trade payables 75,000 x 365 = x 365 Purchases 623,000 Total length of cycle
days 101.7
56.2
52.8 37.0
(43.9) 203.8
(b) The competitors cycle is only 156 days. This means that they are managing their operating cycle much better than KLM and their money is not tied up for as long a period. KLMs cash is tied up in working capital for nearly 48 days more than their competitors. This could well be an unhealthy operating cycle. KLM are paying the amounts they owe in just over 40 days but its taking them just over 100 days to collect their debts. This could result in cash flow problems for them and certainly is costing them more to fund than their competitors will be paying.

Balanced scorecard some examples. You may have thought of others. Make sure your answer includes justifications of your choice of measure. Customer no. of complaints no. of returning customers customer satisfaction scores staff turnover time taken to deliver meal to guest
Internal
Innovation and learning no. days staff training per yr no. new dishes on menu Financial spend per guest food margin % drink margin %
317

(a) Incidents of MRSA Waiting times Number of compensations/complaints Under/over spends against budget Deaths Overtime costs Re-admissions Costs per bed/night Number of bed blockers Length of stay Common problems are likely to include: Concentration on one factor at detriment of others. How can it be made directly comparable (poor areas of country v affluent areas). Creative accounting/Fraud. Self fulfilling prophecy (downward spiral).
(b)

Effectiveness Efficiency Achieving target pass rates of grades Proportion of graduates employed within a year. Cost of books per student Staff hours per student Teaching cost per student Total cost of producing a graduate. (Objective) (Input to output ratio)
Economy
Value for money in sourcing lecture staff of appropriate quality Competitive tendering for computers security cleaning
(Cost of inputs)
Chapter 12
Possible counter-productive behaviour resulting from using the current ROCE calculation for performance appraisal (1) As managers are judged on the basis of the ROCE that their divisions earn each year, they are likely to be motivated into taking decisions which increase the division's short-term ROCE and rejecting projects which reduce the short-term ROCE even if the project is in excess of the company's target ROCE and hence is desirable from the company's point of view. This is an example of sub-optimality and a lack of goal congruence in decision making. A similar misguided decision would occur if the manager of C division, say, was worried about the low ROCE of his division and decided to reduce his investment by scrapping some assets not currently being used. The reduction in both depreciation charge and assets would immediately improve the ROCE. When the assets were eventually required, however, the manager would then be obliged to buy new equipment. The current method bases the calculation of ROCE on the net book value of assets. If a division maintains the same annual profits and keeps the same asset without a policy of regular replacement of non-current assets, its ROCE will increase year by year as the assets get older.
(2)
(3)
318
Simply by allowing its assets to depreciate a divisional manager is able to give a false impression of improving performance over time. The level of new investment in non-current assets by C division was over three times that of B division in 20X3 and nearly 13 times that of B division in 20X4. B division is using old assets that have been depreciated to a much greater extent than those of C division and hence the basis of the ROCE calculation is much lower. Consequently it is able to report a much higher ROCE. (4) (5) The method used to calculate ROCE therefore also provides a disincentive to divisional mangers to reinvest in new or replacement assets because the division's ROCE would probably fall. A further disadvantage of measuring ROCE as profit divided by the net book value of assets is that it is not easy to compare fairly the performance of one division with another. Two divisions might have the same amount of working capital, the same value of non-current assets at cost and the same profit. But if one division's assets have been depreciated by a much bigger amount, perhaps because they are older, that division's ROCE will be bigger. In some respects this is the case with B and C divisions. Both the profit and the original asset cost of C division are about the same proportion of B division's profit and original asset cost but the ROCE of B division is twice that of C division.

(a) (b) ROI as it is a relative measure, and takes into account size of investment.
Vittorio:
90,000 = 18% 500,000
Current ROI =
ROI of equipment =
1,200 = 15% 8,000
ie less than current (18%) so would turn down. However 15% is better than company requirement (12%) so should have been accepted.
Dugaldo: ROI of current =
60,00020,0005,000 2 ,000
= 1750%
ROI of replacement =
60,00015,000 = 60% 75,000
Replacement is not as good as current so Dugaldo rejects. 60% > 12% so company would accept replacement.

Vittorio:
Cost saving (profit) of proposal Imputed interest = 12% 8,000 Residual income
Dugaldo:
= =
1,200 (960) 240 (Positive so accept)
Profit from proposal = (60,000 15,000) Existing profit = (60,000 5,000 20,000) Incremental profit Imputed interest = 12% 75,000 Incremental RI
= =
45,000 35,000 10,000 (9,000) $1,000 (Positive so accept)
319

Operating profit Add back historical cost depreciation Less economic depreciation Add back advertising costs Less amortisation of advertising costs for current year ($6,000/3yr) NOPAT (ignoring taxation) Replacement value of non-current assets Working capital Add back investment in advertising to benefit in next 2 years ($2,000x2) Economic value of net assets NOPAT Capital charge (11% $121,000) EVA $ 18,500 8,100 (12,300) 6,000 (2,000) 18,300 98,000 19,000 4,000 121,000 18,300 13,310 4,990

Adjustment to operating profit removes the differences that accounting policies may create no gain from manipulating profit. Prevents short-term decisions being taken as expenditure (ie advertising) spread over the period that benefits from it. EVA focuses on maximising shareholder wealth incentivising achievement of EVA will drive shareholder value.

Residual income (RI) is a way of measuring the performance of an investment centre.
RI = net profit - imputed interest cost.
where the imputed interest = weighted average cost of capital net assets The calculation of EVA is very similar to the calculation of RI.
EVA = net operating profit after tax (NOPAT) less capital charge
where the capital charge = weighted average cost of capital net assets EVA and RI are similar because both result in an absolute figure which is calculated by subtracting an imputed interest charge from the profit earned by the investment centre. However there are differences as follows. (a) The profit figures are calculated differently. EVA is based on an 'economic profit' which is derived by making a series of adjustments to the accounting profit. (i) Costs which would normally be treated as expenses, but which are considered within an EVA calculation as investments building for the future, are added back to NOPAT to derive a figure for 'economic profit'. These costs are included instead as assets in the figure for net assets employed, ie as investments for the future. Costs treated in this way include items such as goodwill, research and development expenditure and advertising costs. Accounting depreciation is added back to the profit figures, and economic depreciation is subtracted instead to arrive at NOPAT. Economic depreciation is a charge for the fall in asset value due to wear and tear or obsolescence.
(ii)
320
(iii) (b)
Any lease charges are excluded from NOPAT and added in as a part of capital employed.
The notional capital charges use different bases for net assets. The replacement cost of net assets is usually used in the calculation of EVA.
Chapter 13
There is no incentive for the receiving division to buy internally. If they can they will buy externally at $26. This may be sub optimal from the groups perspective.

Optimal production Plan: Product Eck Buy Eee (balance)
Units 2,400 1,250 1,325 hours 7,200 7,500 5,300 20,000
If labour is diverted for the transfer, hours will come from product Eee which is earning contribution of $16 per hour. Minimum transfer price should be: Variable unit cost Opportunity cost 6 hrs x $16 Therefore minimum transfer price is Maximum transfer price would be: Lower of : external market price : divisional net revenue Therefore max transfer price is The transfer price should be between $191 and $200 $ 95 96 191 $ 200 240 $200
321

(a) External sales (5,000 x 110) Internal sales (3,000 x 63 (W1)) Less: production costs (8,000 x 60) Non-production costs Profit Profit margin (109,000 / 739,000) ROI (109,000 / 900,000)
Division 1 $ 550,000 189,000 739,000 (480,000) (150,000) 109,000
14.7% 12.1%
Division 2 $ 690,000 (240,000) (189,000) (150,000) 111,000
External sales (3,000 230) Less: Production costs (3,000 80) Internal costs (3,000 63) Non-production costs Profit Profit margin (111,000 / 690,000) ROI (111,000 / 850,000) (W1) Transfer price $60 75% 40% mark-up (b) External sales (5,000 110) Internal sales (3,000 75 (W1)) Less: production costs (8,000 60) Non-production costs Profit Profit margin (145,000 / 775,000) ROI (145,000 / 900,000)
16.1% 13.1% $ 45 18 63
Division 1 $ 550,000 225,000 775,000 (480,000) (150,000) 145,000
18.7% 16.1%
Division 2 $ 690,000 (240,000) (225,000) (150,000) 75,000
External sales (3,000 230) Less: Production costs (3,000 80) Internal costs (3,000 75) Non-production costs Profit Profit margin (75,000 / 690,000) ROI (75,000 / 850,000)
10.9% 8.8%
322
(W1) Transfer price $60 1.25 Div1 Current New transfer transfer price price 109,000 145,000 19.8% 26.4% 12.1% 16.1% Current transfer price 111,000 16.1% 13.1% $ 75 Div2 New transfer price 75,000 10.9% 8.8%
Profit Profit Margin ROI
Changing the transfer price takes the transfer price from $63 to $75 per unit. For all the performance measures this improves the performance shown by division 1 but division 2s measures deteriorate. Division 1 would therefore be very happy with the new level of transfer price. With the current transfer price the groups desired ROI is achieved by both divisions. Changing the transfer price to $75 means that division 2 no longer meets the groups target ROI. Division 2 are therefore likely to be demotivated if the transfer price was changed. As a result Division 2 are unlikely to accept $75 as a transfer price. They may look to source an alternative for the Woody from suppliers outside AJH.

Supply Output TCs MCs TCr 1 30 30 60 2 70 40 125 3 120 50 195 4 180 60 270 5 250 70 350 Units should be transferred whilst MCS NMRR: Receiving MCr 60 65 70 75 80 TR 125 240 345 440 525 MRr 125 115 105 95 85 NMRr 65 50 35 20 5
Transfer 1 2 3 4 5
MCs 30 40 50 60 70
NMRr 65 50 35 20 5
MCs NMRr if 2 units are transferred. The transfer price should be between $40 and $50.

(a) (b) Division S profit will be reduced to zero, so the manager of division S will be demotivated (assuming performance evaluation is based on profit). Original group P.A.T. = $685k Revised profits: Profit before tax Less tax PAT Group P.A.T. has improved. It is unlikely that the tax authorities would accept such a policy as an 'arms length' transaction. S R 800 (40) 760 (1,100 300) (5% 800)
323
END OF ANSWERS TO LECTURE EXAMPLES
324
Question and Answer bank
325
Index to Question and Answer bank

Page Questions 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Answers Z Ltd ............................................................................................................................................. 327.......................341 Exe ............................................................................................................................................... 328.......................342 KL Retail Outlet ............................................................................................................................ 329.......................342 Linear Programming..................................................................................................................... 330.......................343 Simplex......................................................................................................................................... 331.......................345 Optimal Pricing ............................................................................................................................. 331.......................345 Learning Curves 2 ........................................................................................................................ 332 ......................346 KL ................................................................................................................................................. 332 ......................347 Total Quality Management ........................................................................................................... 333.......................351 M plc............................................................................................................................................. 334 ......................352 Mills Ltd ........................................................................................................................................ 335 ......................356 Silk Imports................................................................................................................................... 336 ......................358 Y and Z plc ................................................................................................................................... 337 ......................359 FP Photocopiers........................................................................................................................... 338.......................362 PCs R Us...................................................................................................................................... 340.......................364
326
QUESTION AND ANSWER BANK
1 Z Ltd
Z Ltd manufactures three joint products (M, N and P) from the same common process. The following process account relates to the common process last month and is typical of the monthly results of operating this process: Litres 1,000 100,000 COMMON PROCESS ACCOUNT $ 5,320 Normal loss 250,000 Output M Output N 100,000 Output P 180,000 Closing work in process Abnormal loss 101,000 535,320 Litres 10,000 25,000 15,000 45,000 800 5,200 101,000 $ 20,000 141,875 85,125 255,375 3,533 29,412 535,320
Opening work in process Materials Conversion costs: Variable Fixed
Each one of the products can be sold immediately after the common process, but each one of them can be further processed individually before being sold. The following further processing costs and selling prices per litre are expected: Selling price after Selling price after Further variable Product common process further processing processing cost $/litre $/litre $/litre M 6.25 8.40 1.75 N 5.20 6.45 0.95 P 6.80 7.45 0.85 Required (a) State the method used to apportion the common costs between the products M, N and P and comment on its acceptability. Explain why it is necessary to apportion the common costs between each of the products. (5 marks) Evaluate the viability of the common process, and determine the optimal processing plan for each of the three products, showing appropriate calculations. (5 marks) (Total = 10 marks)
(b)
327
2 Exe
You have received a request from EXE to provide a quotation for the manufacture of a specialised piece of equipment. This would be a one-off order, in excess of normal budgeted production. The following cost estimate has already been prepared: Note Direct materials: Steel Brass fittings Direct labour: Skilled Semi-skilled Overhead Estimating time 10m2 @ $5.00 per m2 25 hours @ $8.00 per hour 10 hours @ $5.00 per hour 35 hours @ $10.00 per hour 1 2 3 4 5 6 7 8 $ 50 20 200 50 350 100 770 154 924 231 1,155
Administration overhead @ 20% of production cost Profit @ 25% of total cost Selling price Notes 1
2 3
4 5
6 7 8
The steel is regularly used, and has a current stock value of $5.00 per square metre. There are currently 100 square metres in stock. The steel is readily available at a price of $5.50 per square metre. The brass fittings would have to be bought specifically for this job: a supplier has quoted the price of $20 for the fittings required. The skilled labour is currently employed by your company and paid at a rate of $8.00 per hour. If this job were undertaken it would be necessary either to work 25 hours' overtime, which would be paid at time plus one half, OR in order to carry out the work in normal time, reduce production of another product that earns a contribution of $13.00 per hour. The semi-skilled labour currently has sufficient paid idle time to be able to complete this work. The overhead absorption rate includes power costs which are directly related to machine usage. If this job were undertaken, it is estimated that the machine time required would be ten hours. The machines incur power costs of $0.75 per hour. There are no other overhead costs that can be specifically identified with this job. The cost of the estimating time is that attributed to the four hours taken by the engineers to analyse the drawings and determine the cost estimate given above. It is company policy to add 20% to the production cost as an allowance for administration costs associated with the jobs accepted. This is the standard profit added by your company as part of its pricing policy.
Required Prepare on a relevant cost basis, the lowest cost estimate that could be used as the basis for a quotation. Explain briefly your reasons for using each of the values in your estimate. (10 marks)
328
3 KL Retail Outlet
A retail company has a number of individual retail outlets in different towns. Each outlet has its own manager who can make decisions about the individual retail outlet, provided these decisions are within the parameters of the overall company policy. The performance of each individual manager is measured based on the profits of the retail outlet that he or she manages. Company policy It is company policy that each of the retail outlets should stock the following categories of items for sale to customers: Newspapers and magazines Fresh fruit and vegetables Tinned food items Frozen food items
Company policy also requires that no single category should occupy more than 40% or less than 15% of the total display space available. In addition, at their own discretion, managers are permitted to use up to 10% of the total display space available for other products that meet other localised needs. The KL Retail Outlet The following weekly sales and cost data relate to the KL retail outlet, one of the outlets owned by the company: Sales Purchase costs Display space $'000 $'000 % Newspapers and magazines 150 105 25 Fresh fruit and vegetables 130 75 20 Tinned food items 400 240 30 Frozen food items 200 90 15 Other products 150 100 10 The total display space available is 800 square metres. For each category of items for sale: sales revenue is directly proportional to the floor area occupied purchase costs are directly proportional to sales revenue
In addition to the purchase costs of the items sold the retail outlet incurs other costs that total $280,000 per week. Required Demonstrate, using the above information and appropriate calculations, how the manager of the KL retail outlet should allocate the space available between the different categories of items for sale to customers in order to maximise his weekly profit. (7 marks)
329
4 Linear Programming
Company C manufactures two products. The budgeted selling price and cost per unit are as follows: Product Selling price Direct labour ($8 per hour) Direct material A ($3 per kg) Direct material B ($4 per kg) Other variable costs Fixed overhead absorbed Profit X $/unit 86 16 12 12 20 12 14 Y $/unit 74 12 15 8 15 12 12
Demand for the products is seasonal. In order to ensure that the production facilities are not idle at various times during the year the company has signed a contract with company D to supply them with the products as own label goods. Company D Contract The company is to supply Company D with 500 units of product X and 300 units of product Y in each of November and December 2009 for $73 and $62 per unit respectively. If Company C fails to honour this contract in full in each of these months then there is a significant financial penalty for each month of their failure. November 2009 The total number of direct labour hours available to produce products X and Y in November 2009 is limited to 4,000 hours, but all of the other production resources are readily available in November 2009. In addition to the contract with Company D, the demand for products X and Y in November 2009 is 1,000 units and 800 units respectively. December 2009 In December there will be 5,450 direct labour hours available to produce products X and Y and the supply of materials will also be limited. Only 11,000 kgs of material A and 6,100 kgs of material B will be available. In addition to the contract with Company D, the demand for products X and Y in December 2009 is 1,300 units and 1,400 units respectively. Inventory Company C does not hold inventories of materials or finished goods. Required: (a) (b) Prepare calculations to determine the production plan that will maximise the profits of Company C in November 2009. (5 marks) For December 2009 only: (i) (ii) Use graphical linear programming to calculate the optimal production plan for the month. (10 marks) Calculate the value of the monthly financial penalty at which the company would be indifferent between supplying products X and Y under the Company D contract or selling them in the general market. (5 marks) Calculate the maximum price per kg that should be paid to an alternative supplier to obtain additional material B. (5 marks) (Total = 25 marks)
(iii)
330
5 Simplex
A company manufactures three products and is planning the use of its resources for the next quarter. Details of the products and their resource requirements are as follows: Product Contribution per unit Material A per unit (S1) Material B per unit (S2) Labour per unit (S3) Q $36 5 kgs 6 litres 4 hours R $38 6 kgs 3 litres 5 hours T $44 4 kgs 8 litres 6 hours
All of these resources are limited in supply. The total available resources for the next quarter are: Material A (S1) Material B (S2) Labour (S3) Required Prepare the initial equations for S1, S2 and S3 to be used in solving this problem using linear programming (3 marks) 4,800 kgs 5,000 litres 3,500 hours
6 Optimal Pricing
A company is considering the price of one of its products for next year. It expects that the variable cost of making the item will be $15 per unit. It has also determined that if the selling price were to be $35 per unit then the demand would be 500 units per week. However, for every $5 increase in selling price, there would be a reduction in demand of 50 units per week; and for every $5 reduction in selling price, there would be an increase in demand of 50 units per week. Required Calculate the optimal selling price. Note: If Price P = a-bx then Marginal Revenue = a-2bx (4 marks)
331
7 Learning Curves 2
A company has developed a new product that it will manufacture in its workshop. The product is highly specialised and initially will be produced to order only. The product will be manufactured in batches. The estimated labour time required for the first batch is 40 hours, but due to the nature of the product and the manufacturing method to be used, it is expected that an 80% learning curve will apply. Required (a) (b) Calculate the expected time for the eighth batch. (3 marks)
When production commenced the first batch took 45 hours. The actual learning rates observed were as follows. Total batches produced Month to date Actual learning rate 1 1 2 2 75% 3 4 75% 4 8 90% For each of months 2 and 4, state possible reasons why the actual learning rates differed from the expected rates. (3 marks)
(c)
The total time taken to produce the first eight batches was 182.25 hours. Calculate the cumulative learning rate up to the end of Month 4. (Remember that the first batch took 45 hours.) (4 marks) (Total = 10 marks)
8 KL
KL manufactures three products, W, X and Y. Each product uses the same materials and the same type of direct labour but in different quantities. The company currently uses a cost plus basis to determine the selling price of its products. This is based on full cost using an overhead absorption rate per direct labour hour. However, the managing director is concerned that the company may be losing sales because of its approach to setting prices. He thinks that a marginal costing approach may be more appropriate, particularly since the workforce is guaranteed a minimum weekly wage and has a three month notice period. Required (a) Given the managing directors concern about KLs approach to setting selling prices, discuss the advantages and disadvantages of marginal cost plus pricing AND total cost plus pricing. (6 marks) The direct costs of the three products are shown below: Product Budgeted annual production (units) Direct materials Direct labour ($10 per hour) W 15,000 $ per unit 35 40 X 24,000 $ per unit 45 30 Y 20,000 $ per unit 30 50
In addition to the above direct costs, KL incurs annual indirect production costs of $1,044,000.
332
Required (b) Calculate the full cost per unit of each product using KLs current method of absorption costing. (4 marks) An analysis of the companys indirect production costs shows the following: Material ordering costs Machine setup costs Machine running costs General facility costs $ 220,000 100,000 400,000 324,000 Cost driver Number of supplier orders Number of batches Number of machine hours Number of machine hours
The following additional data relate to each product: Product Machine hours per unit Batch size (units) Supplier orders per batch Required (c) (d) Calculate the full cost per unit of each product using activity based costing (8 marks) W 5 500 4 X 8 400 3 Y 7 1,000 5
Explain how activity based costing could provide information that would be relevant to the management team when it is making decisions about how to improve KLs profitability. (7 marks) (Total = 25 marks)
9 Total Quality Management

You have recently been appointed as a companys Assistant Management Accountant. The company has recently begun operating a just-in-time production system but is having problems in meeting the demands of its customers because of quality failures within its production function. Previously, the company used to hold sufficient levels of finished goods inventory so that quality problems did not lead to lost sales. However, it was costly to hold high inventories and, as a result, the company decided to adopt the just-intime approach. The Production Director believes that higher expenditure on Compliance costs is necessary to avoid the costs of Non-compliance, but he is having difficulty convincing the Managing Director and seeks your help. Required: Prepare a report addressed to the Managing Director that
explains briefly the principles of Total Quality Management, explains the four categories of quality costs and explains the relationship between Compliance and Non-compliance costs in the context of Total Quality Management. (10 marks)
333
10 M plc
M plc designs, manufactures and assembles furniture. The furniture is for home use and therefore varies considerably in size, complexity and value. One of the departments in the company is the assembly department. This department is labour intensive; the workers travel to various locations to assemble and fit the furniture using the packs of finished timbers that have been sent to them. Budgets are set centrally and they are then given to the managers of the various departments who then have the responsibility of achieving their respective targets. Actual costs are compared against the budgets and the managers are then asked to comment on the budgetary control statement. The statement for April for the assembly Department is shown below. Assembly labour hours Assembly labour Furniture packs Other materials Overheads Total Budget 6,400 $ 51,970 224,000 23,040 62,060 361,070 Actual 7,140 $ 58,227 205,000 24,100 112,340 399,667 Variance $ 6,257 Adverse 19,000 Favourable 1,060 Adverse 50,280 Adverse 38,597 Adverse
Note. The costs shown are for assembling and fitting the furniture (they do not include time spent travelling to jobs and the related costs). The hours worked by the manager are not included in the figure given for the assembly labour hours. The manager of the assembly department is new to the job and has very little previous experience of working with budgets but he does have many years experience as a supervisor in assembly departments. Based on that experience he was sure that the department had performed well. He has asked for your help in replying to a memo he has just received asking him to 'explain the serious overspending in his department'. He has sent you some additional information about the budget: (1) (2) (3) The budgeted and actual assembly labour costs include the fixed salary of $2,050 for the manager of the assembly department. All of the other labour is paid for the hours they work. The cost of furniture packs and other materials is assumed by the central finance office of M plc to vary in proportion to the number of assembly labour hours worked. The budgeted overhead costs are made up of three elements: a fixed cost of $9,000 for services from central headquarters, a stepped fixed cost which changes when the assembly hours exceed 7,000 hours, and some variable overheads. The variable overheads are assumed to vary in proportion to the number of assembly labour hours. Working papers for the budget showed the impact on the overhead costs of differing amounts of assembly labour hours: Assembly labour hours Overhead costs The actual fixed costs for April were as budgeted. Required (a) (b) (c) (d) Prepare, using the additional information that the manager of the assembly department has given you, a budgetary control statement that would be more helpful to him. (9 marks) Discuss the differences between the format of the statement that you have produced and that supplied by M plc. (3 marks) Discuss whether M plc should change to a system of participative budgeting. (8 marks) Outline the difference between budgets for planning and budgets for control, citing an example of each. (5 marks) (Total = 25 marks) 5,000 $54,500 7,500 $76,500 10,000 $90,000
334
11
Mills Ltd
Mills Ltd make units, which are sold directly to the public. The new production manager has argued that the business should use a higher quality material.. The materials are more expensive but should produce an improved product. It was hoped that this would stimulate demand and enable an immediate price increase for the units. Mills Ltd operates a responsibility based standard costing system which allocates variances to specific individuals. The individual managers are paid a bonus only when net favourable variances are allocated to them. The new higher quality production approach was adopted at the start of March 20X9, following a decision by the new production manager. No change was made at that time to the standard costs card. The variance reports for February and March are shown below (Fav = Favourable and Adv = Adverse) Manager responsible Allocated variances February Variance $ 25 Fav 0 20 Fav 40 Adv 35 Adv March Variance $ 2,100 Adv 600 Adv 400 Fav 7,000 Fav 3,000 Fav
Production manager
Material price (total for all materials) Material mix Material yield Sales price Sales contribution volume
Sales manager
The production manager is upset that he seems to have lost all hope of a bonus under the new system. The sales manager thinks the new high quality units are excellent and is very pleased with the progress made. Mills Ltd operate a JIT stock system and holds virtually no inventory. Required (a) Assess the performance of the production manager and the sales manager and indicate whether the current bonus scheme is fair to those concerned. (7 marks)
In April 20X9 the following data applied: Standard cost card for one units (not adjusted for the higher quality material change) Ingredients A1 B2 C3 D4 Total input Standard sales price of a units Standard contribution per units after all variable costs Kg $
010
010 010 010 040
012 per kg
070 per kg 170 per kg 050 per kg 085 035
335
The budget for production and sales in April was 50,000 units. Actual production and sales was 60,000 units in the month, during which the following occurred: Materials used A1 B2 C3 D4 Total input Actual loss Actual output of units mixture Actual sales price of a units Kg $
5,700
6,600 6,600 4,578 23,478 (1,878) 21,600
$741
$5,610 $11,880 $2,747 $20,978
$099
Required (b) Calculate the material price, mix and yield variances and the sales price and sales contribution volume variances for April. You are not required to make any comment on the performance of the managers. (13 marks) (Total = 20 marks)
12
Silk Imports
Silk imports is a new business, selling high quality imported women's scarves via the internet. The managers, who also own the company, are young and inexperienced but they are prepared to take risks. They are confident that importing quality scarves and selling via a website will be successful and that the business will grow quickly. This is despite the well recognised fact that selling clothing is a very competitive business. They were prepared for a loss-making start and decided to pay themselves modest salaries (included in administration expenses in Table 1 below) and pay no dividends for the foreseeable future. The owners are so convinced that growth will quickly follow that they have invested enough money in website server development to ensure that the server can handle the very high levels of predicted growth. All website development costs were written off as incurred in the internal management accounts that are shown below in Table 1. Significant expenditure on marketing was incurred in the first two quarters to launch both the website and new products. It is not expected that marketing expenditure will continue to be as high in the future. Customers can buy a variety of styles, patterns and colours of scarves at different prices.
336
The business's trading results for the first two quarters of trade are shown below in Table 1. Table 1 $ Sales less Cost of Sales Gross Profit less expenses Website development Administration Distribution Launch marketing Other variable expenses Total expenses Loss for quarter Required (a) Assess the financial performance of the business during its first two quarters using only the data in Table 1 above. (12 marks) Quarter 1 $ 420,000 (201,600) 218,400 $ Quarter 2 $ 680,000 (340,680) 339,320
120,000 100,500 20,763 60,000 50,000 (351,263) (132,863)
90,000 150,640 33,320 40,800 80,000 (394,760) (55,440)
The owners are well aware of the importance of non-financial indicators of success and therefore have identified a small number of measures to focus on. These are measured monthly and then combined to produce a quarterly management report. The data for the first two quarters management reports is shown below: Table 2 Number of scarves sold On time delivery Sales returns System downtime The industry average for sales returns was 13%. Required (b) Comment on each of the non-financial data in Table 2 above taking into account, where appropriate, the industry averages provided, providing your assessment of the performance of the business. (8 marks) (Total = 20 marks) Quarter 1 27,631 95% 12% 2% Quarter 2 38,857 89% 18% 4%
13 Y and Z plc
(a) A large organisation, with a well-developed cost centre system, is considering the introduction of profit centres and/or investment centres throughout the organisation, where appropriate. As management accountant, you will be providing technical advice and assistance for the proposed scheme. Required Explain what conditions are necessary for the successful introduction of profit centres and investment centres.
(5 marks)
337
(b)
Y and Z are two divisions of a large company that operate in similar markets. The divisions are treated as investment centres and every month they each prepare an operating statement to be submitted to the parent company. Operating statements for these two divisions for October are shown below: Operating statements for October Sales revenue Less variable costs Contribution Less controllable fixed costs (includes depreciation on divisional assets) Controllable income Less apportioned central costs Net income before tax Total divisional net assets Y '000 900 345 555 95 460 338 122 9.76m Z '000 555 312 243 42 201 180 21 1.26m
The company currently has a target return on capital of 12% per annum. However, the company believes its cost of capital is likely to rise and is considering increasing the target return on capital. At present the performance of each division and the divisional management are assessed primarily on the basis of return on investment (ROI). Required (i) Calculate the annualised return on investment (ROI) for divisions Y and Z, and discuss the relative performance of the two divisions using the ROI data and other information given above. (9 marks) Calculate the annualised residual income (RI) for divisions Y and Z, and explain the implications of this information for the evaluation of the divisions' performance. (6 marks) Briefly discuss the strengths and weaknesses of ROI and RI as methods of assessing the performance of divisions. Explain two further methods of assessment of divisional performance that could be used in addition to ROI or RI. (5 marks) (Total = 25 marks)
(ii) (iii)
14 FP Photocopiers
FP sells and repairs photocopiers. The company has operated for many years with two departments, the Sales Department and the Service Department, but the departments had no autonomy. The company is now thinking of restructuring so that the two departments will become profit centres. The Sales Department This department sells new photocopiers. The department sells 2,000 copiers per year. Included in the selling price is 60 for a one year guarantee. All customers pay this fee. This means that during the first year of ownership if the photocopier needs to be repaired then the repair costs are not charged to the customer. On average 500 photocopiers per year need to be repaired under the guarantee. The repair work is carried out by the Service Department who, under the proposed changes, would charge the Sales Department for doing the repairs. It is estimated that on average the repairs will take 3 hours each and that the charge by the Service Department will be 136,500 for the 500 repairs. The Service Department Adverse This department has two sources of work: the work needed to satisfy the guarantees for the Sales Department and repair work for external customers. Customers are charged at full cost plus 40%. The details of the budget for the next year for the Service Department revealed standard costs of: Parts Labour Variable overheads at cost 15 per hour 10 per labour hour
338
Fixed overheads
22 per labour hour
The calculation of these standards is based on the estimated maximum market demand and includes the expected 500 repairs for the Sales Department. The average cost of the parts needed for a repair is 54. This means that the charge to the Sales Department for the repair work, including the 40% mark-up, will be 136,500. Proposed Change It has now been suggested that FP should be structured so that the two departments become profit centres and that the managers of the Departments are given autonomy. The individual salaries of the managers would be linked to the profits of their respective departments. Budgets have been produced for each department on the assumption that the Service Department will repair 500 photocopiers for the Sales Department and that the transfer price for this work will be calculated in the same way as the price charged to external customers. However the manager of the Sales Department has now stated that he intends to have the repairs done by another company, RS, because they have offered to carry out the work for a fixed fee of 180 per repair and this is less than the price that the Sales Department would charge. Required (a) Calculate the individual profits of the Sales Department and the Service Department, and of FP as a whole from the guarantee scheme if: (i) (ii) (iii) (b) (i) The repairs are carried out by the Service Department and are charged at full cost plus 40%; The repairs are carried out by the Service department and are charged at marginal cost; The repairs are carried out by RS. (7 marks) Explain, with reasons, why a full cost plus transfer pricing model may not be appropriate for FP. (2 marks) Comment on other issues that the managers of FP should consider if they decide to allow RS to carry out the repairs. (3 marks)
(ii) (c) (d)
Briefly explain the advantages and disadvantages of structuring the departments as profit centres. (4 marks) SW Limited and AL Limited are members of the same group. SW Limited supplies its output to AL Limited, as well as selling to its external market. SW Limited has capacity to produce up to 500,000 litres a week. The external market demand is 350,000 litres per week, and previously AL Limited demanded 100,000 litres per week. AL Limited has now advised SW Limited that it will require 250,000 litres per week from January 20X2. SWAL group policy Evaluate the performance of group companies on the basis of their individual profits Set transfer prices that will encourage the maximisation of group profits
Required Prepare a report to the group management team outlining how an appropriate transfer pricing policy would provide a satisfactory basis for appraising the performance of individual companies. Comment on the implications of this policy for the maximisation of group profits. (9 marks) (Total = 25 marks)
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15
PCs R Us
PCs R Us is a company that manufactures and sells PCs. It has two divisions. Division P makes the components that go into each PC. Division C assembles the PCs to each individual customers requirements and ships them to the customer. The components Division P makes are only transferred to C. Division C only uses components that P has produced but also incurs additional costs in assembling and distributing orders to customers. Currently profit is used to assess each divisions performance. The transfers that take place do so at full cost plus. Required (a) (b) Discuss the possible behavioural consequences that may arise as a result of the current performance evaluation methods. Suggest with reasons an appropriate transfer pricing policy for PCs R Us. (5 marks) (5 marks) (Total = 10 marks)
END OF QUESTION BANK
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1 Z Ltd
(a) Product M N P Value at end of process (i) $ 141,875 85,125 255,375 482,375 Litres (ii) 25,000 15,000 45,000 85,000 Value per litre from process ((i)/(ii)) $ 5.675 5.675 5.675
As $482,375/85,000 = $5.675 the method used to apportion common costs between the joint products is litres produced. This method is only suitable when products remain in the same state that is dont separate into liquid and gas products. It also doesn't take into account the relative income earning potential of each product. However, it does allow values to be put on the products for stock and financial reporting purposes. It is necessary to apportion the common costs between each product to put a value on stock for financial reporting and so sales can be matched with the cost the of sales. (b) (i) Viability of the common process Product M N P Selling price after common process $/litre 6.25 5.20 6.80 Litres 25,000 15,000 45,000 Total revenue $ 156,250 78,000 306,000 540,250 (482,375) 57,875
Less costs at end of common process (per (a) above) Net revenue at the end of the common process Therefore the common process is viable as net revenue is positive. (ii) Optimal processing plan for each product Selling price now $ 6.25 5.20 6.80 Selling price after $ 8.40 6.45 7.45 Extra variable costs $ 1.75 0.95 0.85
M N P
Contribution $ 6.65 5.50 6.60
Products M and N should be processed further as the contribution per unit of each of these products is greater than the selling price before extra processing takes place (net revenue is positive). Product P should not be processed further as Z Ltd would be worse off by ($6.80 $6.60) = $0.20 per unit.
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2 Exe
Notes Direct materials Steel Brass fittings Direct labour Skilled Semi-skilled Overhead Estimating time Administration overhead Profit Selling price Lowest cost estimate = 382.50 Notes 1 2 10m2 $5.50 (the replacement cost) Overtime option 25 hrs $8 1.5 = 300 Reduction in production of another product option = 25 $(8 + 13) = 525 It is cheaper to work overtime and hence this will be the relevant cost. There is no incremental cost involved since the employees are currently being paid to be idle. General fixed costs will be incurred regardless of whether or not the order is accepted and so are not relevant. The relevant cost therefore relates to the machine usage and is 10 hrs $0.75. This is a sunk cost and is therefore not relevant. Administration costs will be incurred regardless of whether or not the order is accepted and so are not relevant. We are asked to produce a lowest cost estimate which is one which just covers incremental costs and makes no profit. The profit mark up is therefore not relevant. 1 2 3 4 5 6 7 $ 55.00 20.00 300.00 7.50 382.50 382.50
3 4 5 6 7
3 KL Retail Outlet
Limiting factor is display space available therefore space should be allocated according to contribution per square metre of display space (subject to company policy constraints). Total Category Newspapers/magazines Fresh fruit and vegetables Tinned food items Frozen food items Other products Display space m2 200 160 240 120 80 Contribution $'000 45 55 160 110 50 $ 225 344 667 917 625 5 4 2 1 3 Contribution per m2 Ranking
Company policy requires each of the four main categories to be allocated at least 15% of floor space. This leaves up to 40% of floor space free to be allocated according to the rankings above. Floor area allocated to frozen food items should be maximised (that is, 40% of total area). After minimum floor space (15%) has been allocated to the other three main categories, this leaves 15% to be
342
allocated to the tinned food items which were ranked second (therefore this category will receive 30% of the total floor area). The final allocation will be Category Newspapers/magazines Fresh fruit and vegetables Tinned food items Frozen food items Floor space m2 120 120 240 320 800 Less: Other costs Total profit $000 27.00 41.28 160.08 293.44 521.80 (280.00) 241.80 ($225 120) ($344 120) ($667 240) ($917 320)
4 Linear Programming
(a) X $/unit 26 2 13 2 500 units 1,000 hours 675 units 1,350 hours 1,175 units Y $/unit 24 15 16 1 300 units 450 hours 800 units 1,200 hours 1,100 units
Contribution Direct labour hours/unit Contribution per direct labour hour Rank Minimum Uses Balance Total production (b)
1,450 hours 2,550 hours
Firstly, the resources available after meeting the minimum contract must be calculated. Then inequalities / equations can be calculated and plotted to determine the optimal use of the remaining resources: Resource DL A B Used by contract X Y Total 1,000 450 1,450 2,000 1,500 3,500 1,500 600 2,100 Unused 4,000 7,500 4,000 Equation 2x + 1.5y = 4,000 4x + 5y = 7,500 3x + 2y = 4,000 Data points x y 2,000 2,667 1,875 1,500 1,333 2,000
In addition to the above resource constraints, there are two demand constraints: x = 1,300 y = 1,400 and an iso-contribution line: Z = 26x + 24y (using $20,000 as a target contribution) give data points of x = 769 and y = 833
343
344
(i) (ii)
The optimal production plan is 725 units of X and 925 units of Y plus fulfilment of the contract. If the contract were not to be performed then the resources used by the contract would be used to make additional units of X and Y for sale in the external market. The graph shows that the two material resources are more binding than the direct labour constraint so the optimal use of the resources released can be calculated: 4x + 5y = 3,500 becomes 12x + 15y = 10,500 3x + 2y = 2,100 becomes 12x + 8y = 8,400 Therefore 7y = 2100 so y = 300 and by substitution x = (3,500 (5 x 300))/4 = 500. This is the same as the resource utilisation for the contract, so revenues can be compared. All of the production capacity can be sold in the open market at the full selling prices, so if the penalty value were equal to the loss of sales revenue, the company would be indifferent between the contract and market sales. This amounts to: 500 Units of X at $13 per unit plus 300 units of Y at $12 per unit = $10,100
(iii)
Both material constraints are binding. If material B were less scarce then the output would change: Existing position 4x + 5y = 7,500 becomes 12x + 15y = 22,500 3x + 2y = 4,000 becomes 12x + 8y = 16,000 Therefore 7y = 6,500 so y = 92857 and by substitution x = (7,500 (5 x 92857))/4 = 71429 Revised position 4x + 5y = 7,500 becomes 12x + 15y = 22,500 3x + 2y = 4,001 becomes 12x + 8y = 16,004 Therefore 7y = 6,496 so y = 928 and by substitution x = (7,500 (5 x 928))/4 = 715 Thus There is a reduction in y by 057 units losing $1368 contribution There is an increase in x by 071 units gaining $1846 contribution The net effect therefore is an increase in contribution of $478 so the maximum price that should be paid per kg is $878 (the original cost per kg plus the contribution value).
5 Simplex
q = number of units of Q, r = number of units of R and t = number of units of T. S1 is slack material A, S2 is slack material B, S3 is slack labour 5q + 6r + 4t + S1 = 4,800 6q + 3r + 8t + S2 = 5,000 4q + 5r + 6t +S3 = 3,500
6 Optimal Pricing
Demand function = P = a bx b = 5/50 = 0.1 35 = a (500 x 0.1) 35 = a 50 a = 85 Demand function is therefore: P = 85 0.1x Maximise profit when MR = MC
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The marginal revenue (MR) function is MR 15 70 x = a 2bx = 85 (2 0.1x) = 0.2x = 350 units
Substituting x = 350 in the demand function P = 85 (0.1 350) P = 50 The profit-maximising level of sales is 350 units at a price of $50 per unit.
7 Learning Curves 2
(a) Expected time for the eighth batch Yx Y8 = aXb = 40 8-0.32193 = 40 0.512 = 20.48 hours (average time per batch) = 40 7-0.32193 = 40 0.534 = 21.36 hours (average time per batch) Cumulative batches 8 7 Cumulative average time Per batch (hours) 20.48 21.36 Total time (hours) 163.84 149.52 14.32
Y7
The expected time for the eighth batch is therefore 14.32 hours (b) Possible reasons why actual learning rates differed from expected rules The learning rates for months 2 and 3 are better than expected. This may be due to management underestimating the ability of the workforce to master the new techniques. The workforce may also have been initially enthusiastic about learning new skills. The learning rate in month 4 deteriorated. Possible reasons for this could be changes in the workforce, lack of motivation or potential long periods between production of batches (as batches are only produced to order). (c) Cumulative learning rate up to the end of month 4 Use the learning curve formula in reverse. Average time taken per unit to date =
182.25 8
= 22.78 hours
22.78 45
= 0.506
r3 = 0.506 r=
3
0.506
r = 0.79686 or 79.7% (approximately 80%)
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8 KL
(a) Problems with and advantages of full cost-plus pricing There are several problems with relying on a full cost approach to pricing. (i) (ii) (iii) (iv) It fails to recognise that since demand may be determining price, there will be a profitmaximising combination of price and demand. There may be a need to adjust prices to market and demand conditions. Budgeted output volume needs to be established. Output volume is a key factor in the overhead absorption rate. A suitable basis for overhead absorption must be selected, especially where a business produces more than one product.
However, it is a quick, simple and cheap method of pricing which can be delegated to junior managers (which is particularly important with jobbing work where many prices must be decided and quoted each day) and, since the size of the profit margin can be varied, a decision based on a price in excess of full cost should ensure that a company working at normal capacity will cover all of its fixed costs and make a profit. The advantages and disadvantages of a marginal cost-plus approach to pricing Here are the advantages. (i) (ii) (iii) It is a simple and easy method to use. The mark-up percentage can be varied, and so mark-up pricing can be adjusted to reflect demand conditions.
It draws management attention to contribution, and the effects of higher or lower sales volumes on profit. In this way, it helps to create a better awareness of the concepts and implications of marginal costing and cost-volume-profit analysis. For example, if a product costs $10 per unit and a mark-up of 150% is added to reach a price of $25 per unit, management should be clearly aware that every additional $1 of sales revenue would add 60 pence to contribution and profit. There are, of course, drawbacks to marginal cost-plus pricing. Although the size of the mark-up can be varied in accordance with demand conditions, it does not ensure that sufficient attention is paid to demand conditions, competitors' prices and profit maximisation. It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently high to ensure that a profit is made after covering fixed costs.
(i)
(ii) (b)
Calculate the full cost per unit of each product using absorption costing The full cost of each product will include indirect costs allocated to each product using a predetermined overhead absorption rate. In the case of KL, this is based on direct labour hours.
W $ Variable cost/unit Direct materials Direct labour Production overhead (W) Full cost/unit X $ Y $
35.00 40.00 18.00 93.00
45.00 30.00 13.50 88.50
30.00 50.00 22.50 102.50
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Working
Total overheads = $1,044,000.

W Total labour hours Hrs per unit Budgeted annual production Total annual direct labour hrs X Y Total
4 15,000 60,000
3 24,000 72,000
5 20,000 100,000
232,000
Overhead absorption rate (OAR) = $1,044,000/232,000 OAR per direct labour hour = $4.50/hr per direct labour hour Hrs per unit Production overhead absorbed per unit (c) 4 18.00 3 13.50 5 22.50
Calculate the full cost per unit of each product using ABC We have listed the steps taken to calculate the unit costs using an ABC system of costing. The references to workings are to the workings below.
Step 1
Work out the annual activity for each cost driver.

Working Annual activity Batches Batch size (units) Annual units Annual number of batches Supplier orders Per batch Annual number of batches W X Y Total
500 15,000 30 4 30 120 5 15,000 75,000
400 24,000 60 3 60 180 8 24,000 192,000
1,000 20,000 20 5 20 100 7 20,000 140,000
110
Annual supplier orders

Machine hours Per unit Annual units Annual machine hours
400
407,000
Step 2
Use this information to calculate the activity cost driver rates in working below. You should also be able to use information provided in the table in the question.
Working Cost driver rates
Material ordering costs Machine setup costs Machine running costs General facility costs
$220,000 400 supplier orders = $ 550 per supplier order $100,000 110 batches = $ 909 per batch $400,000 407,000 machine hours = $ 0.98 per machine hour $324,000 407,000 machine hours = $ 0.80 per machine hour
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Step 3
Apply these cost driver rates to the supplier orders, batch sizes and machine hours for each product. This will give you the unit cost for each product for each cost pool. See workings 1, 2,3 and 4. Workings
Supplier orders per batch Batch size Cost driver (supplier orders) per unit Activity cost driver rate (per order) $ Unit cost $ Batch size in units Activity cost driver rate (per batch) $ Unit cost $
Machine hours per unit Activity cost driver rate $ (per machine hour) Unit cost $
W 4 500 = 4/500 550 4.40
X 3 400 = 3/400 550 4.125
Y 5 1,000 = 5/1,000 550 2.75
W 500 909 1.82

W 5
X 400 909 2.27

X 8
Y 1,000 909 0.91

Y 7
0.98 4.90
W 5 0.80 4.00
0.98 7.84
X 8 0.80 6.40
0.98 6.86
Y 7 0.80 5.60
4
Machine hours per unit Activity cost driver rate $ (W5) Unit cost $
Step 4
You should now be able to calculate the full unit cost using the information you have already calculated slotted into a table as below. Using activity based costing, unit costs for the three products would be as follows.
W $/unit 35.00 40.00 4.40 1.82 4.90 4.00 90.12 X $/unit 45.00 30.00 4.13 2.27 7.84 6.40 95.64 Y $/unit 30.00 50.00 2.75 0.91 6.86 5.60 96.12
Direct material Direct labour Material ordering costs (W1) Machine set-up costs (W2) Machine running costs (W3) General facility costs (W4)
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Alternative solution The alternative way to approach this problem, given that we have information on all the products that the costs have to be shared between, is to use ratios rather than cost drivers.
Step 1 Step 2
Work out the annual activity for each cost driver (same calculation as in Step 1 above).
Allocate costs proportionately according to each product's activity in relation to the total.
W X Y
Material ordering costs
x 220,000 400 = 66,000 30 x 100,000
120
x 220,000 400 = 99,000 60 x 100,000
180
x 220,000 400 = 55,000 x 100,000 110 = 18,182

x 400,000 407 = 137,592 x 324,000 407 = 111,450 $322,224 140 140
100
Machine set-up costs
20
110 = 27,273
110 = 54,545
192
Machine running costs
75 x 400,000 407 = 73,710
x 400,000 407 = 188,698 192 x 324,000
General facility costs
75
407 = 59,705 Total indirect costs
x 324,000
407 = 152,845 $495,088
$226,688
Step 3
Calculate indirect cost per unit and full cost per unit
W X Y
Total indirect cost Budgeted annual production (units) Indirect cost per unit Direct costs per unit Material Labour Full cost per unit
226,688 15,000 $15.12 35.00 40.00 $90.12
495,088 24,000 $20.64 45.00 30.00 $95.64
322,224 20,000 $16.12 30.00 50.00 $96.12
(d)
How ABC could provide information relevant to decisions regarding profitability The management team of KL will need to look at price and cost when it considers profitability. ABC can be useful to business in both areas of decision making The unit costs calculated using ABC differ to those calculated under full cost. These are summarised in the table below.
W $ 93.00 90.12 2.88 X $ 88.50 95.64 (7.14) Y $ 102.50 96.12 6.38
Full cost per unit ABC cost per unit Difference
350
Costing ABC helps with cost reduction because it provides an insight into causal activities and allows organisations to consider the possibility of outsourcing particular activities, or even of moving to different areas in the industry value chain, eg reduce numbers of orders and increase size of batches. Many costs are driven by customers (delivery costs, discounts, after-sales service and so on), but traditional cost accounting does not account for this. Companies may be trading with certain customers at a loss but may not realise it because costs are not analysed in a way that would reveal the true situation. ABC can be used in conjunction with customer profitability analysis (CPA) to determine more accurately the profit earned by serving particular customers. Pricing
ABC establishes a long-run product cost and because it provides data which can be used to evaluate different business possibilities and opportunities it is particularly suited for decisions such as pricing. Pricing has long-term strategic implications and average cost is probably more important than marginal cost in many circumstances. An ABC cost is an average cost, but it is not always a true cost because some costs such as depreciation are usually arbitrarily allocated to products. An ABC cost is therefore not a relevant cost for all decisions.
Profit The differences in unit costs between full cost, and ABC cost shown in the table show that management need to consider a few actions from the results of ABC costing. Should they increase the price of X which has a higher ABC cost than full cost? On the other hand should management reduce the price of Y which has a lower ABC cost than full cost?
9 Total Quality Management

Report To: From: Date: Subject:
Managing Director Assistant Management Accountant May 20X9 Total Quality Management
This report gives a brief overview of the principles of Total Quality Management (TQM), the costs involved and the relationship between compliance and non-compliance costs (also known as conformance and nonconformance costs). Principles of TQM The key principle of TQM is get it right first time the belief that the costs of preventing mistakes in the first place are less than the costs of correcting these mistakes once they occur. Another basic principle is dissatisfaction with the status quo the belief that it is always possible to improve (get it right next time). This is known as continuous improvement. In order for TQM to work properly, everyone within the organisation must be committed to its principles and the ultimate objective of producing good quality goods or services. In order to encourage this commitment, everyone should be encouraged to make suggestions that might improve quality and given responsibility for achieving quality results.
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Quality costs There are four categories of costs that are related to TQM. (a) Prevention costs Prevention costs are incurred prior to or during production in order to prevent sub-standard or defective goods being produced. Examples include quality engineering and training staff in aspects of quality control. (b) Appraisal costs These costs are incurred once the goods or services have been produced to ensure that outputs meet quality standards. Examples include inspection costs and acceptance testing. (c) Internal failure costs These are the costs arising from inadequate quality of goods or services that are identified before the customer takes ownership. One example is the loss from failure of purchased items goods may have to be produced again to fulfil an order due to sub-standard production that is discovered prior to delivery. (d) External failure costs These costs arise from inadequate quality of goods or services that is discovered after the customer has taken ownership. Such costs include administration of the customer complaints section and repair costs of goods returned by customers. Compliance and non-compliance costs The four cost categories mentioned above can be divided into costs of compliance (conformance) with quality standards prevention and appraisal costs and costs of non-compliance (non-conformance) with these standards (internal and external failure costs). There is a trade-off between compliance and non-compliance costs. To achieve low levels of defects, costs of compliance must be necessarily high. As a greater level of defects becomes acceptable, compliance costs fall, but the costs of non-compliance increase. Whilst in theory TQM has zero tolerance of defects, in reality there will normally be an acceptable level of defects at which total costs (compliance plus non-compliance) are minimised. Conclusion I hope the above information is of assistance ahead of our meeting next week.
10 M plc
(a) Assembly labour hours
Variable costs Assembly labour (W1, W2, W3) Furniture packs (W4) Other materials (W5) Variable overheads (W6) Fixed costs Manager Stepped-fixed cost (W6) Total departmental fixed costs Central costs Original budgeted 1 6,400 $ Flexed budgeted 2 7,140 $ Actual costs 3 7,140 $ Variance (3 2)
$ 485 (A) 44,900 (F) 1,604 (F) 37,784 (A) 8,235 8,235 (F)
49,920 224,000 23,040 34,560 331,520 2,050 18,500 20,550 9,000 361,070
55,692 249,900 25,704 38,556 369,852 2,050 27,000 29,050 9,000 407,902
56,177 205,000 24,100 76,340 361,617 2,050 27,000 29,050 9,000 399,667
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Workings
Both budgeted and actual assembly labour costs given include manager's fixed salary of $2,050 which has to be deducted $51,970 $2,050 = $49,920
Budgeted assembly labour costs are flexed to reflect actual labour hours by multiplying the cost by
actual hours budgeted hours

$49,920 3
7,140 hrs = $55,692 6,400 hrs
We need to deduct the assembly manager's fixed salary of $2,050 from the actual costs of $58,227 $58,227 $2,050 = $56,177
We need to flex the original budget for the cost of furniture packs to reflect the actual labour hours worked. $224,000
7,140 hrs = $249,900 6,400 hrs
We need to flex the original budget for other materials to reflect the actual labour hours worked $23,040
7,140 hrs = $25,704 6,400 hrs
The budgeted overheads include a fixed cost of $9,000 and a stepped-fixed cost which we need to work out using the high-low method. The stepped fixed cost changes when the assembly hours exceed 7,000 hours. In order to identify these stepped fixed costs we compare the overhead costs for the two different levels of labour hours at 7,500 and 10,000 hours respectively. At 7,500 assembly labour hours we have a + 7,500 b = $76,500 At 10,000 assembly labour hours we have a + 10,000 b = $90,000 Where, a is defined below as: a = Stepped fixed cost + $9,000 a + 10,000 b = $90,000 (1) a + 7,500 b = $76,500 (2) Subtracting (2) from (1) we get 2,500 b = $13,500 b=
$13, 500 = 5.4 2, 500
Substituting the value of b in (1) a + 5.4 10,000 = 90,000 a = 90,000 54,000 = 36,000 a = stepped fixed costs at 7,000 hours + $9,000 = $36,000 Stepped fixed costs at 7,000 hours = $36,000 $9,000 = $27,000
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To find the stepped fixed cost component at 5,000 hours, we substitute the value of b = 5.4 in the following equation a1 + 5,000 b = $54,500 where a1 is the stepped fixed cost at 5,000 units (including the central fixed cost of $9,000) a1 + 5,000 5.4 = $54,500 a1 = $27,500 Deducting the central fixed cost of $9,000, the stepped fixed cost for 5,000 units is $27,500 less $9,000 = $18,500. (b)

The revised format of the statement is more helpful as it has been flexed to the actual level of activity and therefore compares like with like. The revised format separates costs into variable (and hence controllable) costs and fixed costs or central costs (and therefore uncontrollable). This will facilitate analysis, performance measurement and responsibility accounting. The format originally submitted has some inconsistencies which make comparison very difficult. In addition to the fact that the format was not comparing like with like, the manager's fixed salary was included in overheads when labour assembly hours related only to the variable labour input.
(c)
Top tips. Whereas bullet points provide a clear way of presentation, the examiner stressed that these should be supplemented by adequate explanatory narrative. Make sure you relate the discussion to the specific entity in question.
Advantages of participative budgets

They are based on information from employees most familiar with the department Knowledge spread among several levels of management is pulled together Morale and motivation is improved They increase operational managers' commitment to organisational objectives In general they are more realistic Co-ordination between units is improved Specific resource requirements are included Senior managers' overview is mixed with operational level details Individual managers' aspiration levels are more likely to be taken into account
The allocation of overheads in M plc is likely to vary considerably depending on the size, complexity and value of the furniture being assembled. It is, therefore, important to involve employees with detailed knowledge of the process. This will not only draw on useful experience but also increase motivation and commitment. Disadvantages of M plc moving to a system of participative budgeting

They consume more time An earlier start to the budgeting process may therefore be required They may cause managers to introduce budgetary slack and budget bias Managers may, therefore, set 'easy' budgets to ensure that they are achievable They can support 'empire building' by subordinates
In considering the advantages of introducing participative budgeting M plc needs to be aware of the potential disadvantages. The most important potential problem, apart from participative budgets requiring more resource and taking longer to prepare, is the possible introduction of slack. Negotiated style of budgeting A negotiated budget is a 'budget in which budget allowances are set largely on the basis of negotiations between budget holders and those to whom they report.'
354
At the two extremes, budgets can be dictated from above or simply emerge from below but, in practice, different levels of management often agree budgets by a process of negotiation. In the imposed budget approach, operational managers will try to negotiate with senior managers the budget targets which they consider to be unreasonable or unrealistic. Likewise senior management usually review and revise budgets presented to them under a participative approach through a process of negotiation with lower level managers. Final budgets are therefore most likely to lie between what top management would really like and what junior managers believe is feasible. The budgeting process is hence a bargaining process and it is this bargaining which is of vital importance, determining whether the budget is an effective management tool or simply a clerical device. (d) Budgets for planning and budgets for control Budgets for planning An organisation planning process can be divided into two sections, long-term strategic planning (also known as corporate planning) and short-term planning. (1) Long-term planning This involves selecting appropriate strategies so as to prepare a long-term plan to attain the organisation's objectives. This long-term corporate plan serves as the long-term framework for the organisation as a whole but for operational purposes it is necessary to convert the corporate plan into a series of short-term plans (or budgets), usually covering one year, which relate to sections, functions or departments. (2) Short-term planning The annual process of short-term planning (or budgeting) should be seen as steps in the progressive fulfilment of the corporate plan as each short-term plan steers the organisation towards its long-term objectives. The short-term budgets for the various functions of the organisation are coordinated and consolidated by the budget committee into the master budget, which is a summary of organisation-wide plans for the coming period. The master budget is what is known as a fixed budget. This does not mean that the budget is kept unchanged. Revisions will be made to it if the situation so demands. It simply means that the budget is prepared on the basis of an estimated volume of production and sales, but no plans are made for the event that actual volumes differ from budgeted volumes. Budgets for control Having set the master budget, control processes need to be established. The basic control model involves comparing actual results achieved with what results should have been under the circumstances. Every business is dynamic, however, and actual volumes of output cannot be expected to conform exactly to the fixed master budget. Comparing actual results directly with the fixed master budget results is meaningless. For useful control information, it is necessary to compare actual results at the actual level of activity achieved with the results that should have been expected at this level of activity, which is shown by a flexible budget.
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11
Mills Ltd
(a)
Production manager
The production manager instigated the new higher quality production approach and this has fundamentally changed the nature of the business. Before the new system started, there were favourable material variances for price and yield and the production manager would have received a bonus as a result. The higher quality ingredients are more expensive and this results in adverse material price and mix variances in March. The material yield variance is favourable but not by enough to compensate for the adverse variances. This means that the production manager would not receive a bonus under the current scheme.
Sales of the units have improved significantly so customers presumably appreciate the improved quality and mix of materials. The production manager does not receive any credit for the favourable sales variances and that does not seem fair. Sales manager
In contrast, the sales variances that the sales manager is responsible for have moved from adverse in February to favourable in March. The new approach has therefore been a success with customers. The sales manager will have had to sell the improved units to customers and is therefore partly responsible for the improvement, but the original impetus came from the production manager.
Bonus scheme
The bonus scheme does not seem to be fair as it will not reward the two managers fairly for their efforts. They are both responsible for the improved sales but it is very difficult to fairly allocate responsibility in this situation. Some form of sharing of responsibility and reward is required. The standards that the variances are based on need to be changed to reflect the new approach that the business is taking. For example, the standard price of the materials needs to be increased. (b)
Variance calculations Material price variances $ 684 741 57 (A) $ 4,620 5,610 990 (A) $ 11,220 11,880 660 (A)
5,700 kg of A1 should have cost ( $0.12) but did cost Material price variance
6,600 kg of B2 should have cost ( $0.70) but did cost Material price variance
6,600 kg of C3 should have cost ( $1.70) but did cost Material price variance
4,578 kg of D4 should have cost ( $0.50) but did cost Material price variance
$ 2,289 2,747 458 (A)

$ 2,165 (A)
Total material price variance
356
Material mix variances
Total quantity used = 5,700 + 6,600 + 6,600 + 4,578 = 23,478 kg Standard mix of actual use of each ingredient is in equal proportions = 23,478/4 = 5,869.5 kg
Actual quantity Actual mix Kg 5,700 6,600 6,600 4,578 23,478 Actual quantity Standard mix Kg 5869.5 5869.5 5869.5 5869.5 23,478 Standard cost per kg $ 0.12 0.70 1.70 0.50
A1 B2 C3 D4
Variance Kg 169.5 730.5 730.5 1,291.5
Variance $ 20.34 (F) 511.35 (A) 1,241.85 (A) 645.75 (F) 1,087.11 (A)
Material yield variance Standard cost of a unit
A1 B2 C3 D4
0.1 0.1 0.1 0.1
kg kg kg kg
$0.12 $0.70 $1.70 $0.50
$ 0.012 0.070 0.170 0.050 0.302
The actual quantity of inputs are expected to yield (23,478/0.4) Actual output Yield variance in units standard cost per unit ($0.302)
Alternative method Standard quantity Standard mix Kg 6,000 6,000 6,000 6,000 24,000 Actual quantity Standard mix Kg Variance Kg 130.5 130.5 130.5 130.5
Units 58,695 60,000 1,305 (F) $394.11 (F)
Standard cost per kg $ 0.12 0.70 1.70 0.50 Variance $ 15.66 91.35 221.85 65.25 394.11 (A)
A1 B2 C3 D4
5869.5 5869.5 5869.5 5869.5 23,478
Sales price variance
60,000 $(0.99 0.85) = $8,400 (F)

Sales contribution volume variance
Actual sales of units Budgeted sales of units Variance in units standard contribution per units
60,000 50,000 10,000 $0.35 $3,500 (F)
357
12
Silk Imports
(a)
Financial performance Sales growth
Silk Imports appear to have made an excellent start with initial sales of $420,000 growing by 62% ((680,000 420,000)/420,000 100%) to Quarter 2. This is particularly impressive given the acknowledged competitiveness of this business sector.
Gross profit
The gross profit margin in Quarter 1 was 52% (218,400/420,000 100%) and 50% (339,320/680,000 100%) in Quarter 2. The level of margin may be as expected for this business sector but we would need industry average data for comparison. However, a fall in margin needs to be investigated. It could be that Silk Imports were initially able to source cheaper scarves but the rapid growth meant that alternative, more expensive suppliers had to be found. Alternatively, competitors quickly responded to this new entrant and lowered their prices in response. This pressure could have forced Silk Imports to lower their prices.
Website Development
All website development costs are being written off as incurred so we would expect costs to be higher in the initial quarters. The website costs are over a third of total expenses, so the initial loss is mostly explained by this write-off and does not therefore give any major cause for concern.
Administration costs
Although administration costs have risen in absolute terms, as a percentage of sales they have fallen from 23.9% (100,500/420,000 100%) to 22.2% (150,640/680,000 100%). Administration costs are the second biggest expense so very important to control. This could indicate that administration costs are being effectively controlled which is good news. It could also be because fixed overheads are being spread over a larger volume and this will continue to improve as the business grows.
Distribution costs
These costs form the smallest proportion of total expenses (about 6%) and the proportion of distribution costs to sales has remained constant at 4.9% (20,763/420,000 100%). These costs will be subject to external influences such as a general rise in postage costs.
Launch marketing
This is similar to the website costs as it is expected to fall once the business is established. Silk Imports will need to continue to market their website but this is likely to be cheaper than the initial big launch marketing campaign. The negative impact on profitability will therefore reduce over time.
Other variable expenses
These have again increased in line with the sales volume and are 11.9% of sales (50,000/420,000 100%). (b)
Non-financial performance indicators Average price of scarves
Quarter 1: $420,000/27,631 = $15.20 Quarter 2: $680,000/38,857 = $17.50 In part (a) it was suggested that the fall in gross profit margin might be due to a price reduction. This data provides evidence that this is not the case. There must therefore be an alternative explanation.
358
On time delivery
This has dropped significantly from 95% to 89% and this is worrying. The service provided to customers is a key differentiator, especially if the company is competing on quality not price. Customers will go elsewhere if their expectations are not met. Action will need to be taken to remedy this problem.
Sales returns
This is again a key indicator of quality and whether customers' expectations are being met. Returns have risen from 12% to 18% and are now above the industry average of 13%. Returns are to be expected on Internet sales where the product may look different in reality, but a higher than average rate means that the internet is not adequately describing and illustrating the products. Again, quality may be less than customers expect. Alternatively, the pressure to dispatch orders may be resulting in errors or packaging problems. Either of these reasons does not bode well for the business and action must be taken to remedy the problem.
System downtime
Customers who use shopping websites are usually time pressured individuals who will not react well to delays in loading pages. It is all too easy to immediately switch to a competitor's website so it is essential that system downtime is kept to an absolute minimum to avoid lost sales. It would be useful to compare the figures with an industry average but the important point is that system downtime has doubled. This could be due to pressure on the website as a result of the volume of demand. As the website development has been such a costly and important part of the business set-up, the owners of Silk Imports should have an urgent discussion with the website developers to come up with a solution.
Conclusion
Silk Imports are doing well in terms of sales growth and potential profitability for a brand new business. However the owners need to focus their attention on the accuracy of order delivery, website reliability and the quality of the product. Further investigation needs to be made of the fall in gross profit margin.
13 Y and Z
(a) The following conditions are necessary for the successful introduction of such centres.
The centres must have a measurable output. This does not mean that the output must necessarily be sold on the external market. It may be transferred internally for use in another part of the organisation. In this case the 'revenue' generated is determined by the use of a transfer price. It must be possible for the centre manager to exercise control over the level of output. For an investment centre, it must be possible for the centre manager to exercise control over the level of investment in the centre, and for the level of investment to be measured objectively. A reporting system must be established which provides rapid and accurate feedback to keep centre managers informed about their performance.
Centre managers must accept the change and must be willing to accept the extra responsibility associated with their new role. Provision must be made for adequate education and training in the operation of the new responsibility accounting system. Central management must also fully understand and accept the new system, particularly if they are required to delegate authority for decisions which they are accustomed to making themselves.
359
(b)
Top tips. The question gives the operating statement for one month and requires the calculation of the annualised ROI. This should not throw you, all you need to do is multiply the net income before tax by 12.
This is actually a fairly straightforward question providing plenty of scope for meaningful and relevant discussion. Where you are asked to comment on performance (as you often are in this paper) be prepared to pose questions and identify further information that may be required. Although you are asked to calculate the ROI, your discussion may supplemented with the secondary performance ratios of profit margin and asset turnover. (i) Annualised return on investment (ROI) Annualised net income before tax
Y 122,000 12 = 1,464,000 Z 21,000 12 = 252,000
ROI
1,464,000 = 15% 9,760,000
252,000 = 20% 1,260,000
The two divisions Y and Z operate in similar markets. Of the two, Z is the smaller one in terms of both sales and divisional net assets. Z also has the higher ROI of the two, being 20% compared to Y's 15%. However, what is surprising is the different proportion of variable costs in relation to sales for the two divisions. Variable costs constitute 38 percent of sales for Y and 56 percent of sales for Z. We need further information to explain the higher variable costs of Z. Could these be related to the lower divisional assets? There is a range of possible explanations here and further investigation will be necessary. It is possible that division Z's assets are old and lead to inefficiency in production. Although Z's overall ROI is higher, this may be because its assets are old and do not reflect the current replacement cost. The results highlight the fundamental problem with using ROI as a single measurement of performance. ROI can lead to sub-optimal decisions where a manager is unwilling to undertake further investment which, although giving a positive return, may reduce the current ROI. This may be the case with division Z. There is no indication that division Z is outsourcing part of its production process, which may have been a possible explanation for higher variable costs and lower divisional assets. Further investigation is required. Looking at the secondary performance ratios of profit margin and asset turnover below, it is easy to see that division Y has the higher profit margin and lower asset turnover.
Secondary performance ratios For division Y
ROI =
Divisional profit Divisional sales
Divisional sales Divisional capital employed Asset turnover 900,00012

9,760,000 1.1% = 15% 555,00012 1,260,000 5.286% = 20%
ROI =
Profit margins 122,00012 900,00012

13.56% 21,00012 555,00012 3.78%
=
For division Z
ROI = =
360
We need to look at the relative ages of the assets and their relationship to replacement cost to be able to assess further the divisional performance. We also need further information on the basis for apportioning central costs. If only controllable income is assessed as a proportion of divisional net assets, the returns are even more strikingly different (56.56% for Y and 191% for Z). (ii) Annualised Residual Income (RI) Residual income = Accounting profit Notional interest on capital. For Y For Z RI = RI = (122,000 12) (12% 9760,000) = 1,464,000 1,171,200 = 292,800 (21,000 12) (12% 1,260,000) = 252,000 151,200 = 100,800
The absolute score RI is positive for both divisions. This means that sufficient residual income is left for the shareholders after an imputed interest charge on divisional assets is deducted from net profit. Whereas the relative measure ROI is higher for division Z, the absolute measure RI is higher for division Y. RI is a superior measure technically but no single measure alone is sufficient for a meaningful performance evaluation. As the cost of capital rises, RI will fall. The imputed interest charge should be calculated on the replacement cost of assets. It would appear that here we have assets at historic cost. (iii) ROI Advantages ROI is a relative measure expressed in percentage terms. As such it is easy to understand and can be readily compared against a required benchmark rate. Disadvantages ROI can lead to sub-optimal decisions. As the case of divisions Y and Z illustrates, it is not certain whether it is better to have a return of 20% on a 1.2 million investment or a 15% on a 9.8 million investment. Shareholders may prefer the former in that less of their funds are tied in the business. However, the use of ROI may tend to limit growth as a manager assessed on ROI alone will be unwilling to undertake further investment providing a return lower than the current one he is earning. Residual Income Advantages Residual income (RI) requires that a capital charge is imputed on each division's profit. RI does not suffer from the potential problems of ROI as any investment providing a return in excess of the required rate is likely to be accepted. Disadvantages The imputed capital charge is based on assets at historic cost. Divisions with older assets may appear to be doing better in the short term. Other methods Other methods of performance assessment are Economic Value Added (EVA) and profitability measures such as net profit margin and gross profit margin. EVA is similar to RI in that it is an absolute measure. However, EVA is considered an improved variant of RI in that it is based on economic and not accounting profit. Moreover, the capital charge is based on the replacement cost of assets. Net profit margin is measured as a percentage of net profit to turnover. Gross profit is measured as a percentage of gross profit to turnover.
361
14 FP Photocopiers
(a) Parts Labour (3 hrs 15 per hour) Variable overheads ( 3 hrs 10 per labour hour) Marginal cost Fixed overheads (3 hrs 22 per labour hour) Total cost Mark-up (40% of total cost) Selling price Transfers at 40% mark up
Sales department 120,000 ((136,500) (16,500) Sales department 120,000 64,500 55,500 Sales department 120,000 90,000 Service department 136,500 (97,500) 39,000 Service department 64,500 97,500 (33,000) Service department 33,000 (33,000) FP 120,000 (97,500) 22,500 Per repair 54 45 30 129 66 195 78 273 For 500 repairs
64,500 33,000 97,500 39,000 136,500
Sales Costs Profits Transfers at marginal cost
Sales Costs Profits Repairs carried out by RS
FP 120,000 97,500 22,500
Sales Repair costs (180 per repair 500) Fixed overheads Profit/(loss) (b) (i) Full cost may not be appropriate because:

30,000
FP 120,000 (90,000) 33,000 (3,000)
It is likely to build the inefficiencies of the Service Department. It may lead to implied poor performance by the Sales Department. The performance measures and reward system would lead to sub-optimal decisions by the manager of the Sales Department.
(ii)
Other issues to consider include:

Why is the quote by RS lower than the cost of the Services Department? Are fixed costs committed? What is the standard quality of the repairs by RS?
362
Other possible suggestions

Is the offer by RS a short-term offer? Is the price likely to remain stable or rise in the long term? Why are the costs of the Service Department higher than the price charged by RS? Are the fixed costs avoidable? Can the Services Department find other work to take up the capacity released if RS do the guaranteed repairs?
(c)
Advantages and disadvantages of structuring the departments as profit centres Advantages

By structuring the departments as profit centres the organisation benefits from the local knowledge of decentralised units and improved, faster decision making. Profit centres are also likely to increase motivation of local managers and by reducing bureaucracy, lead to high efficiency.
Other advantages you have thought of include

The time of senior management would be released to focus on strategic issues. The increased autonomy of local managers provides good training ground for the company.
Disadvantages

Possible loss of control by senior management Possible dysfunctional decision making Possible duplication of tasks and functions and costs
(d)
REPORT
To: From: Date: Subject:
Group management team Management accountant 23 October 20X1 Transfer pricing policy
Introduction This report outlines an appropriate transfer pricing policy for transfers between SW Limited and AL Limited.
Overall group policy The group transfer pricing policy should ensure the maximisation of group profits. This is achieved by the inclusion in the transfer price of any opportunity costs associated with internal transfer.
Policy up to January 20X2 In the period up to January 20X2, SW Limited will have spare capacity: 500,000 litres per week can be produced and so production of 100,000 litres for internal transfer will have no effect on our ability to produce 350,000 litres for external customers. There is therefore no opportunity cost associated with the internal transfers as they do not cause a reduction in contribution from external sales. The transfer price should therefore be set at variable cost.
Internal transfers are often cheaper than external sales, however (due to savings in selling, administration, delivery costs and so on), and so it would seem reasonable for AL Limited to expect a discount on variable cost.
The transfer price might therefore be set at slightly less than variable cost so that the two divisions can share the cost savings from internal transfers compared with external sales.
363
Note that standard variable cost should be used because actual costs vary with volume, seasonal and other factors and because, if used as a basis for transfer prices, any inefficiency in SW Limited could be passed on to AL Limited in the form of an increased transfer price. Given that SW Limited earns no contribution on transfers at variable cost, it will be indifferent between making the transfers and producing no output. Head office intervention may therefore be required to ensure that transfers take place. 4 Policy from January 20X2 From January 20X2, SW Limited will have insufficient capacity to meet both internal and external demand. If SW Limited were to supply AL Limited with 250,000 litres per week, it would be unable to meet 100,000 litres of external demand and would lose the contribution on these sales. The transfer price must therefore take the opportunity cost of this lost contribution into account. A two-tier transfer pricing system is required. 150,000 litres should have a transfer price of (adjusted) variable cost (as above) as there is no external demand for this output. 100,000 litres should have a transfer price of external selling price, adjusted for any savings on internal transfers as necessary.
5
I hope this information has proved useful. If you wish to discuss the points raised please do not hesitate to contact me.
Signed: Management accountant
15
PCs R Us
(a) Division P is only making components that are transferred to division C. The transfer price is currently set at full cost plus. Division P is recovering all the costs that it incurs and making a guaranteed mark up on every transaction. Division P is therefore likely to be very happy with this transfer price. As the price is at full cost not standard full cost, there is no incentive at all for P division to control its costs. Whatever it spends, division C will effectively pay for and it will still make a guaranteed mark up. Division C will pay whatever the components cost to make. As this is on an actual basis, that cost can vary and it will make it very hard for division C to plan their expenditure. Additionally, division C will effectively be penalised if division P overspends. Any increase in the costs of the components will directly reduce division Cs profit. As profit is the performance measure used, division C will be very unhappy with this transfer price. They may even consider going externally to source the components as they will be able to negotiate a more competitive price that the current full cost plus that they are being charged. This cost will be agreed upon up front and will not change. This transfer price is clearly not in the best interest of PCs R US. It is encouraging inefficient spending and does not encourage cost control. This may even lead to components being bought in from external suppliers which may reduce PCs R US overall level of profit. (b) Division P is essentially a cost centre, yet it is being assessed on the basis of profit and is not measured on its ability to control its costs. A better transfer price would be to use standard cost plus. In this way both divisions could still be measured consistently ie by both using profit.
364
Division Ps profitability would therefore be determined by how well it has controlled its costs. If it spends more than the standard it will reduce its profitability. This will result in a lower cost basis for the company. Division C would be much happier with a transfer price of standard cost plus as it knows in advance exactly what it will pay. Additionally, it is only paying the agreed amount, The only items which can therefore affect the rate of its profitability are items that are internal to its division, i.e. how well it controls its own costs and the selling prices that it agrees with the customers.
365
END OF QUESTION AND ANSWER BANK
366
Appendix A Maths tables and formulae
367
368
APPENDIX A: MATHS TABLES AND FORMULAE
Tables
Area under the normal curve
This table gives the area under the normal curve between the mean and the point Z standard deviations above the mean. The corresponding area for deviations below the mean can be found by symmetry.
Z=
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3.0 3.1 3.2 3.3 3.4 3.5
(x )
0.00 .0000 .0398 .0793 .1179 .1554 .1915 .2257 .2580 .2881 .3159 .3413 .3643 .3849 .4032 .4192 .4332 .4452 .4554 .4641 .4713 .4772 .4821 .4861 .4893 .4918 .4938 .4953 .4965 .4974 .4981 .49865 .49903 .49931 .49952 .49966 .49977
0.01 .0040 .0438 .0832 .1217 .1591 .1950 .2291 .2611 .2910 .3186 .3438 .3665 .3869 .4049 .4207 .4345 .4463 .4564 .4649 .4719 .4778 .4826 .4864 .4896 .4920 .4940 .4955 .4966 .4975 .4982 .4987 .4991 .4993 .4995 .4997
0.02 .0080 .0478 .0871 .1255 .1628 .1985 .2324 .2642 .2939 .3212 .3461 .3686 .3888 .4066 .4222 .4357 .4474 .4573 .4656 .4726 .4783 .4830 .4868 .4898 .4922 .4941 .4956 .4967 .4976 .4982 .4987 .4991 .4994 .4995 .4997
0.03 .0120 .0517 .0910 .1293 .1664 .2019 .2357 .2673 .2967 .3238 .3485 .3708 .3907 .4082 .4236 .4370 .4484 .4582 .4664 .4732 .4788 .4834 .4871 .4901 .4925 .4943 .4957 .4968 .4977 .4983 .4988 .4991 .4994 .4996 .4997
0.04 .0160 .0557 .0948 .1331 .1700 .2054 .2389 .2704 .2995 .3264 .3508 .3729 .3925 .4099 .4251 .4382 .4495 .4591 .4671 .4738 .4793 .4838 .4875 .4904 .4927 .4945 .4959 .4969 .4977 .4984 .4988 .4992 .4994 .4996 .4997
0.05 .0199 .0596 .0987 .1368 .1736 .2088 .2422 .2734 .3023 .3289 .3531 .3749 .3944 .4115 .4265 .4394 .4505 .4599 .4678 .4744 .4798 .4842 .4878 .4906 .4929 .4946 .4960 .4970 .4978 .4984 .4989 .4992 .4994 .4996 .4997
0.06 .0239 .0636 .1026 .1406 .1772 .2123 .2454 .2764 .3051 .3315 .3554 .3770 .3962 .4131 .4279 .4406 .4515 .4608 .4686 .4750 .4803 .4846 .4881 .4909 .4931 .4948 .4961 .4971 .4979 .4985 .4989 .4992 .4994 .4996 .4997
0.07 .0279 .0675 .1064 .1443 .1808 .2157 .2486 .2794 .3078 .3340 .3577 .3790 .3980 .4147 .4292 .4418 .4525 .4616 .4693 .4756 .4808 .4850 .4884 .4911 .4932 .4949 .4962 .4972 .4979 .4985 .4989 .4992 .4995 .4996 .4997
0.08 .0319 .0714 .1103 .1480 .1844 .2190 .2517 .2823 .3106 .3365 .3599 .3810 .3997 .4162 .4306 .4429 .4535 .4625 .4699 .4761 .4812 .4854 .4887 .4913 .4934 .4951 .4963 .4973 .4980 .4986 .4990 .4993 .4995 .4996 .4997
0.09 .0359 .0753 .1141 .1517 .1879 .2224 .2549 .2852 .3133 .3389 .3621 .3830 .4015 .4177 .4319 .4441 .4545 .4633 .4706 .4767 .4817 .4857 .4890 .4916 .4936 .4952 .4964 .4974 .4981 .4986 .4990 .4993 .4995 .4997 .4998
369
APPENDIX A: MATHS TABLES AND FORMULAE
END OF APPENDIX A
370
Appendix B Formulae to learn
371
372
APPENDIX B: FORMULAE TO LEARN
Formulae to learn
Cost accounting concepts and techniques:
Overhead Absorption rate OAR = Budgeted overhead Budgeted activity
Contribution = Sales all variable costs
Multi product break even analysis:

Single product formulae: Breakeven point = Fixed costs Unit contribution
Breakeven revenue =
Fixed costs or Breakeven point x SP C/S ratio
Output required for target profit = Multi product formulae:
Fixed costs + target profit Unit contribution
Breakeven point =
Fixed costs Weighted average unit contribution Fixed costs Weighted average C/S ratio or Breakeven units x each SP
Breakeven revenue =
Pricing decisions:
PED =
%x %P
% change in x % change in P
Demand function = P = a - bx
P x a b
= = = =
selling price quantity demanded at that price theoretical maximum price change in price change in quantity
Maximise profit where MR = MC Maximise revenue where MR = 0
373
Cost planning:
Target Cost = Selling price desired profit margin Cost gap = Target cost estimated cost
Cost analysis:
OAR
Cost pool ($) Cost driver
Cost management techniques:

Return / hour =
Sales material purchases Time on key resource
Cost / hour
Total factory costs Total Time on key resource Return / hour Cost / hour
(total factory costs = all costs excluding materials)
TPAR
Performance evaluation:
Profitability ratios
ROCE =
PBIT Capital employed 100 %
Net profit margin Gross profit margin Asset turnover
= = =
Net profit Sales Sales
100 % 100 %
Gross profit
Sales Capital employed
Liquidity/working capital ratios

Current ratio Quick ratio Receivables period = = = Current assets Current liabilities
Current assets - inventories Current liabilities
Average receivables Credit sales
365
374
Inventory periods:
Finished Goods WIP
= =
Average finished goods 365 Cost of sales

Average WIP Cost of production
365 365
Raw Material
Average raw material Raw material purchases
Payables period Working capital cycle
= =
Average payables Credit purchases
365
Receivable period + Inventory period payable period
Measuring performance in responsibility centres:

ROI
Divisional Profit Divisional Investment Divisional profit
100
Residual income =
X (X) X
Less: imputed interest (investment x cost of capital) Residual Income

EVA
Economic profit (NOPAT) Less: capital charge (net assets x cost of capital) EVA
X (X) X
375
END OF APPENDIX B
BPP House, Aldine Place, London W12 8AA Tel: 0845 0751 100 (for orders within the UK) Tel: +44 (0)20 8740 2211 Fax: +44 (0)20 8740 1184
376 www.bpp.com/learningmedia

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Performance Management

Management Level Paper P2 Course Notes CMP2CN10(N)

Improving study material and removing errors

Checkpoint 3 11a 11b 12 13

Introduction to Paper P2 Performance Management

Links with other papers

Learning Phase Aims

Cost planning and analysis for competitive advantage (30%)

Chapter 9b Chapters 8 Chapter 8

Budgeting and management control (20%)

Control and performance measurement of responsibility centres (20%)

Chapter 12 Chapter 12 Chapters 12 & 13 Chapter 13

The examination paper

Time pressure warning

Section reference in the Study Text

Formula given in exam

SUMMARY SKILLS BANK

Key skills required to pass

5 Professional presentation of numbers and narrative answers

4 Analysis of requirements to ensure your answer specifically addresses the requirements

Each of these key skills is analysed on the following page.

SUMMARY SKILLS BANK

Skill 1 Effective use of reading time

Skill 2 Time management

Skill 3 Exam approach

Skill 4 Analysis of requirements

Skill 5 Professional presentation

SUMMARY SKILLS BANK

LIST OF VERBS USED IN THE QUESTION REQUIREMENTS

SUMMARY SKILLS BANK

Relevant costs and short term decisions

How have the syllabus learning outcomes been examined?

Nov 06, Q4, 10 marks

1: RELEVANT COSTS AND SHORT TERM DECISIONS

Non-financial / qualitative factors

Information for reporting and decisionmaking

Relevant costing in relation to accounting concepts

1: RELEVANT COSTS AND SHORT TERM DECISIONS

1: RELEVANT COSTS AND SHORT TERM DECISIONS

Relevant costs and revenues

1: RELEVANT COSTS AND SHORT TERM DECISIONS

Non-relevant costs and revenues

1: RELEVANT COSTS AND SHORT TERM DECISIONS

Relevant cost of materials

If take from inventory cant replace it

Based on a past exam question worth 2 marks

1: RELEVANT COSTS AND SHORT TERM DECISIONS

Relevant cost of labour and variable overheads

Relevant cost of machinery

1: RELEVANT COSTS AND SHORT TERM DECISIONS

1: RELEVANT COSTS AND SHORT TERM DECISIONS

Minimum price decisions

1: RELEVANT COSTS AND SHORT TERM DECISIONS

Minimum price Notes

1: RELEVANT COSTS AND SHORT TERM DECISIONS

C 54.00 9.50 14.50 8.00 4.00 36.00 23,400 40,000

1: RELEVANT COSTS AND SHORT TERM DECISIONS

1: RELEVANT COSTS AND SHORT TERM DECISIONS

Further processing of joint products

1: RELEVANT COSTS AND SHORT TERM DECISIONS

Based on a past exam question worth 10 marks

Normal loss Product A Product B

Units 500 2,500 2,000

0 26,500 21,200 47,700