Fundamentals Level – Skills Module, Paper F5 Performance Management m u n n a r e p m 6 3 · 3 $ e m o c n i t e N
June 2013 Answers
m u n n a r e p
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Workings Option 1 Net income = $720 – $80 = $640 per annum. Option 2 If costs $120 per annum, net income = $720 – $120 = $600 per annum. If costs $180 per annum, net income = $720 – $180 = $540 per annum. Expected value and decision:
EV at A = (0·5 x $3·6m) + (0·5 x $3·24m) = $3·42m EV at B = (0·5 x $(3·9m) + (0·5 x $3·51m) = $3·705m EV at C = (0·4 x $3·42m) + (0·6 x $3·705m) = $3·591m per annum At D, compare EV of: Option 1: (3 x $3·36m) = $10·08m Option 2: ($3 x $3·591m) – $360k = $10·413m Therefore choose option 2 – expand exercise studio. (b)
With perfect information: If membership numbers were 6,000: EV = $3·42m x 3 = $10·26m Less costs of $360k = $9.9m
Therefore, with these membership numbers, GB would choose option 1 instead. If membership numbers were 6,500: EV = $3·705 x 3 = $11·115m Less costs of $360k = $10·755m
In this instance, GB would choose option 2. So, if membership numbers are 6,000, of which there is a 0·4 probability, EV will be $10·08m (option 1) and if membership numbers are 6,500, of which there is a 0·6 probability, then EV will be $10·755m (option 2). Therefore EV with perfect information = (0·4 x $10·08m) + (0·6 x $10·755) = $10·485m. Without perfect information the EV is $10·413m, therefore the value of it is $72k ($10·485m – $10·413m). This represents the maximum price that GB should be prepared to pay for the information. (c)
The expansion decision is a one-off decision, rather than a decision that will be repeated many times. Expected values, on the other hand, give us a long run average of the outcome that would be expected if a decision was to be repeated many times. The actual outcome may not be very close to the expected value calculated and the technique is therefore not really very useful here. Also, estimating accurate probabilities is difficult because this exact situation has not arisen before. The expected value criterion for decision-making is useful where the attitude of the investor is risk neutral. We do not know what the management of Gym Bunnies’ attitude to risk is, which makes it difficult to say whether this criterion is a good one to use. In a decision such as this one, it would be useful to see what the worst case scenario and best case scenario results would be too, in order to assist decision-making.
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2
(a)
Goals and measures Goals
Performance Measures
Reason
Financial perspective Increase revenue
Percentage increase in total revenue
The changes have been implemented partly in an attempt to increase revenues, so it is sensible to measure the extent to which revenues have actually increased.
Increase operating profit margin
Percentage increase in operating profit
The changes have been implemented partly in an attempt to increase operating profit, so it is sensible to measure the extent to which operating profit has actually increased.
Customer perspective Increase customer acquisition
Total sales to new customers
The fourth change (to standalone products) was made in an attempt to attract new customers. This measure will help to assess whether the change has been successful.
Reduce loss of customers
Customer churn rate
The first three of the four changes made were made in an attempt to retain customers. This performance measure will help to assess whether the changes have been successful.
Internal business perspective Reduce number of broadband contracts cancelled
Number of broadband contracts cancelled
This performance measure will enable Squarize to assess whether the improved broadband service has resulted in a reduction of the number of contracts cancelled.
Increase after sales service quality
Percentage of customer requests that are handled with a single call
Squarize transferred its call centre back to its home country. This measure will assess whether that has improved the service quality to customers as a result.
Learning and growth perspective Increase call centre workers’ skill levels
Number of training hours per employee
This measure will improve the likelihood of customers receiving an improved service. A better public image should result, leading to increased revenues as new customers are attracted to the business.
Increase employees’ satisfaction
Percentage decrease in staff turnover
This measure will also help to improve customer service, thereby improving company image, attracting new customers and increasing revenues in the long term.
(Other reasonable suggestions will be equally acceptable) (b)
Pay-tv customers currently own the boxes, meaning that a certain number of customers appear to cancel their contract after the first three months and just keep the set-top box with its free channels. Squarize may want to consider loaning the boxes rather than selling them to the customers at the beginning of the contract. The company only has a minimum contract period of three months. This seems very short and perhaps the company could consider increasing it to 12 months. Unnecessary administration costs must be arising because it takes time, and therefore money, to set up new customers. If these customers then leave three months later, the company has not had much opportunity to earn profits from the customers generating these costs.
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3
(a)
Revised target cost $
Manufacturing cost Direct material (working 1) Direct labour (working 2) Machine costs Quality control costs Rework costs (working 3) Product development cost Marketing cost Non-manufacturing costs
$
21·60 10·96 21 10 1·80 ––––– 25 35 –––––
Total cost
65·36
60 ––––––– 125·36 ––––––– –––––––
Working 1: Direct material cost Parts to be replaced by standard parts = $40 x 0·8 = $32. New cost of those at 45% (100% – 55%) = $14·40. Unique irreplaceable parts: original cost = $40 x 20% = $8. New cost $7·20 Revised direct material cost = $14·40 + $7·20 = $21·60 Working 2: Direct labour Direct labour – cost per unit for first one hundred units: Y = axb 45 x 100–0·152 = 22·346654 minutes Total time for 100 units = 2,234·6654 minutes.
Time for the 100th unit: Time for 99 units = 45 x 99–0·152 = 22·380818 minutes. For 99 units = 2,215·701 minutes. Therefore, time for 100th unit = 2,234·6654 – 2,215·701 = 18·9644 minutes. Time for remaining 49,900 units = 946,323·56 minutes. Total labour time for 50,000 units = 948,558·23 minutes. Therefore total labour cost = 948,558·23/60 x $34·67 = $548,108·56. Therefore average labour cost per unit = $548,108·56/50,000 = $10·96. Note: Some rounding is acceptable and marks would still be given. Working 3: Rework cost Total cost = 50,000 x 10% x $18 = $90,000. Cost per average unit = $90,000/50,000 = $1·80. (b)
Market skimming
Market skimming is a strategy that attempts to exploit those areas of the market which are relatively insensitive to price changes. Initially, high prices for the webcam would be charged in order to take advantage of those buyers who want to buy it as soon as possible, and are prepared to pay high prices in order to do so. The existence of certain conditions is likely to make the strategy a suitable one for Cam Co. These are as follows: –
Where a product is new and different, so that customers are prepared to pay high prices in order to gain the perceived status of owning the product early. The webcam has superior audio sound and visual quality, which does make it different from other webcams on the market.
–
Where products have a short life cycle this strategy is more likely to be used, because of the need to recover development costs and make a profit quickly. The webcam does only have a two year life cycle, which does make it rather short.
–
Where high prices in the early stages of a product’s life cycle are expected to generate high initial cash inflows. If this were to be the case for the webcam, it would be par ticularly useful for Cam Co because of the current liquidity problems the company is suffering. Similarly, skimming is useful to cover high initial development costs, which have been incurred by Cam Co.
–
Where barriers to entry exist, which deter other competitors from entering the market; as otherwise, they will be enticed by the high prices being charged. These might include prohibitively high investment costs, patent protection or unusually strong brand loyalty. It is not clear from the information whether this is the case for Cam Co.
–
Where demand and sensitivity of demand to price are unknown. In Cam Co’s case, market research has been carried out to establish a price based on the customers’ perceived value of the product. The suggestion therefore is that some information is available about price and demand, although it is not clear how much information is available.
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It is not possible to say for definite whether this pricing strategy would be suitable for Cam Co, because of the limited information available. However, it does seem unusual that a high-tech, cutting edge product like this should be sold at the same price over its entire, short life cycle. Therefore, price skimming should be investigated further, presuming that this has not already been done by Cam Co.
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(a)
Sales price operational variance: (actual price – market price) x actual quantity Commodity 3: ($40·40 – $39·10) x 25,600 = $33,280F Sales price planning variance: (standard price – market price) x actual quantity Commodity 3: ($41·60 – $39·10) x 25,600 = $(64,000)A
An alternative approach to the variance calculations for Commodity 3 would be as follows: Sales price operational variance Commodity 3 $39·10 $40·40 ––––––– $1·30F 25,600 $33,280F
Should now Did Difference Actual sales quantity Variance Sales price planning variance
Commodity 3 $39·10 $41·60 ––––––– $2·50A 25,600 $64,000A
Should now Should Difference Actual sales quantity Variance (b)
Sales mix variance:
(Actual sales quantity in actual mix at standard margin) – (actual sales quantity in standard mix at standard margin) = $768,640 (w.1 & 2) – $782,006 (w.3) = $13,366 adverse. Working 1: Standard margins per unit: Budgeted machine hours = (30,000 x 0·2) + (28,000 x 0·6) + (26,000 x 0·8) = 43,600. Overhead absorption rate = $174,400/43,600 = $4 per hour. Product
Standard selling price Variable production costs Fixed production overheads Standard profit margin
Commodity 1 $ 30 (18) (0·8) –––––– 11·20 ––––––
Commodity 2 $ 35 (28·40) (2·4) ––––– 4·20 –––––
Commodity 3 $ 41·60 (26·40) (3·2) ––––– 12 –––––
Working 2: Actual sales quantity in actual mix at standard profit margin: Product
Commodity 1 Commodity 2 Commodity 3
Actual quantity in actual mix 29,800 30,400 25,600 ––––––– 85,800 –––––––
Standard profit
$
$11·20 $4·20 $12
333,760 127,680 307,200 –––––––– 768,640 ––––––––
Working 3 Actual sales quantity in standard mix at standard profit margin: Product Commodity 1 Commodity 2 Commodity 3
Actual quantity in standard mix 85,800 x 30/84 = 30,643 85,800 x 28/84 = 28,600 85,800 x 26/84 = 26,557 ––––––– 85,800 –––––––
Standard profit $11·20 $4·20 $12
$ 343,202 120,120 318,684 –––––––– 782,006 ––––––––
The sales quantity variance = (actual sales quantity in standard mix at standard margin) – (budgeted sales quantity in standard mix at standard profit margin) = $782,006 (w.3 above) – $765,600 (w.4) = $16,406 favourable.
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Working 4: Budgeted sales quantity in standard mix at standard profit margin: Product Commodity 1 Commodity 2 Commodity 3
(c)
Quantity 30,000 28,000 26,000 ––––––– 84,000 –––––––
Standard profit $11·20 $4·20 $12
$ 336,000 117,600 312,000 –––––––– 765,600 ––––––––
The calculations above have shown that, as regards the sales price, there is a $23,360 favourable operational variance and a $54,680 adverse planning variance. In total, these net off to a sales price variance of $31,320 adverse. The sales manager can only be responsible for a variance to the extent that he controls it. Since the standard selling prices are set by a consultant, rather than the sales manager, the sales manager can only be held responsible for the operational variance. Given that this was a favourable variance of $23,360, it appears that he has performed well, achieving sales prices which, on average, were higher than the market prices at the time. The consultant’s predictions, however, were rather inaccurate, and it is these that have caused an adverse variance to occur overall in relation to sales price. As regards sales volumes, the mix variance is $13,366 adverse and the quantity variance is $16,406 favourable, meaning that the total volume variance is $3,040 favourable. This is because total sales volumes were higher than expected, although it is apparent that the increased sales related to the lower margin Commodity 2, with sales of Commodity 1 and Commodity 3 actually being lower than budget. The total variance relating to sales is $28,280 adverse. This looks poor but, as identified above, it is due to the inaccuracy of the sales price forecasts made by the consultant. We know that Block Co is facing tough market conditions because of the economic recession and therefore it is not that surprising that market prices were actually a bit lower than originally anticipated. This could be due to the recession hitting even harder in this quarter than in previous ones.
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(a)
Budget deficit/surplus Budgeted income: Income from pupils registered on 1 June 2013: $724,500 (given in question) Expected number of new joiners: (0·2 x 50) + (0·3 x 20) + (0·5 x 26) = 29 Expected income from new joiners at $900 each = $26,100 Total expected income = $750,600. Budgeted expenditure: Repairs and maintenance: $30,000 x 1·03 = $30,900. Salaries: [($620,000 – $26,000)/2] + [($620,000 – $26,000 x 1·02)/2] = $297,000 + $302,940 = $599,940. Expected capital expenditure = (0·7 x $145,000) + (0·3 x $80,000) = $125,500. Total expected expenditure = $756,340.
Budget deficit = $5,740. (b)
Discussion of estimates Advantages
– – –
Incremental budgeting is very easy to perform. This makes it possible for a person without any accounting training to build a budget. Incremental budgeting is also very quick compared to other budgeting methods. The information required to complete it is also usually readily available.
Disadvantages
– – – (c)
On the other hand, incremental budgeting encourages inefficiency because it does not question the preceding year’s figures on which it is based. No-one asks how those figures could be reduced. Similarly, in some organisations, it encourages slack because departmental managers may attempt to use their entire budget up for one year, even if they do not need to, just to ensure that that cash is available again the next year. Errors from one year are carried to the next, since the previous year’s figures are not questioned.
Zero-based budgeting (ZBB)
The three main steps involved in preparing a zero-based budget are as follows: 1.
Activities are identified by managers. Managers are then forced to consider different ways of performing the activities. These activities are then described in what is called a ‘decision package’, which: – – –
analyses the cost of the activity; states its purpose; identifies alternative methods of achieving the same purpose;
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– –
establishes performance measures for the activity; assesses the consequence of not performing the activity at all or of performing it at different levels.
As regards this last point, the decision package may be prepared at the base level, representing the minimum level of service or support needed to achieve the organisation’s objectives. Further incremental packages may then be prepared to reflect a higher level of service or support.
(d)
2.
Management will then rank all the packages in the order of decreasing benefits to the organisation. This will help management decide what to spend and where to spend it. This ranking of the decision packages happens at numerous levels of the organisation.
3.
The resources are then allocated, based on order of priority up to the spending level.
Use of ZBB at Newtown School
There is definitely a place for ZBB at Newtown School. At the moment, incremental budgeting is responsible for recurring unexpected cash shortages, which is deterring new pupils from joining the school. Had a deficit been predicted for the year ended 31 May 2013, perhaps $65,000 would not have been spent on improving the school gym, and then it would not have been necessary to close the school kitchen. ZBB would be good to establish the way cash is spent on those activities that are, to a certain extent, discretionary. For example, although there is a need for pupils to have somewhere to eat lunch, it is not essential for children to have a cooked meal every day. It is essential that children do have somewhere to eat though and, as a bare minimum, they would need an area where they could eat their sandwiches and have access to fresh water. ZBB could be used to put together decision packages which reflect the different levels of service available to the children. For example, the most basic level of service could be the provision of an area for the children to eat a lunch brought from home. The next level would be the provision of some cold and maybe hot food for the children, but on a self-service basis. Finally, the highest level of service would be a restaurant for the children where they get served hot meals at tables. At Newtown School the catering manager could prepare the decision packages and they would then be decided upon by the head teacher, who would rank them accordingly. Similarly, although some level of sports education is needed, the extent of the different activities offered is discretionary. ZBB could be used to create decision packages for each of these services in order to prioritise them better than they are currently being prioritised. ZBB takes a long time to implement and would not be appropriate to all categories of expenditure at the school. Much of the budgeting is very straight for ward. Incremental budgeting could still be used as a starting point for essential expenditure such as salary costs, provided that changes in staff numbers are also taken into account. There is an element of essential, recurring expenditure in relation to repairs and maintenance too, since the costs of the checks and repairs needed to comply with health and safety standards seem to largely stay the same each year, with an inflationary increase.
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Fundamentals Level – Skills Module, Paper F5 Performance Management 1
December 2012 Answers
Hair Co (a)
Weighted average contribution to sales ratio (WA C/S ratio) = total contribution/total sales revenue. Per unit:
C $ 110 (12) (8) (16) (14) ––– 60 –––
Selling price Material 1 Material 2 Skilled labour Unskilled labour Contribution Sales units
S $ 160 (28) (22) (34) (20) ––– 56 –––
D $ 120 (16) (26) (22) (28) ––– 28 –––
20,000
22,000
26,000
Total sales revenue
$2,200,000
$3,520,000
$3,120,000
Total contribution
$1,200,000
$1,232,000
$728,000
WA C/S ratio = $1,200,000 + $1,232,000 + $728,000/$2,200,000 + $3,520,000 + $3,120,000 = $3,160,000/$8,840,000 = 35·75% (b)
Break-even sales revenue = fixed costs/C/S ratio Therefore break-even sales revenue = $640,000/35·75% = $1,790,209·70.
(c)
PV chart
Calculate the individual C/S ratio for each product then rank them according to the highest one first. Per unit:
C $ 60 110 0·55 1
Contribution Selling price C/S ratio Ranking Product
Revenue $
0 Make C Make S Make D
0 2,200,000 3,520,000 3,120,000
S $ 56 160 0·35 2
Cumulative Revenue (x axis co-ordinate) $ 0 2,200,000 5,720,000 8,840,000
Profit $ (640,000) 1,200,000 1,232,000 728,000
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D $ 28 120 0·23 3 Cumulative Profit (y axis co-ordinate) $ (640,000) 560,000 1,792,000 2,520,000
3,000
D
2,500
2,000 S 1,500
1,000
Most profitable first Constant mix C
500 0 0 0 ’ $ t i f o r P
0 0
2,000
4,000
6,000
8,000
10,000
Sales revenue $’000
–500
–1,000 (d)
From the chart above it can be seen that, if the products are sold in order of the highest ranking first, break even will take place at a point just under $1,200,000 of sales revenue. The exact figure can be worked out by taking the fixed costs of $640,000 and dividing them by Product C’s C/S ratio of 0·55, i.e. the exact BEP is $1,163,636. This is substantially earlier than the break-even point which occurs if the products are all sold in a constant mix, which is $1,790,209, as calculated in (b) above. The reason for this is obviously because the more profitable product, C, contributes more per unit to fixed costs when being sold on its own, than when a mix of products C, S and D are sold. The weighted average C/S ratio of all three products is only 35·75%, compared to C’s C/S ratio of 55%. Obviously, then, break even will occur earlier if C is sold in priority. In reality, however, the mix of sales will vary throughout the year and Hair Co can neither assume that the products are sold in a constant mix, nor that the most profitable can be sold first.
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Truffle Co (a)
Basic variances
Standard cost of labour per hour = $6/0·5 = $12 per hour. Labour rate variance = (actual hours paid x actual rate) – (actual hours paid x std rate) Actual hours paid x std rate = $136,800/·95 = $144,000. Therefore rate variance = $144,000 – $136,800 = $7,200 F Labour efficiency variance = (actual production in std hours – actual hours worked) x std rate [(20,500 x 0·5) – 12,000] x $12 = $21,000 A. (b)
Planning and operational variances Labour rate planning variance (Revised rate – std rate) x actual hours paid = [$12 – ($12 x 0·95)] x 12,000 = $7,200 F. Labour rate operational variance There is no labour rate operational variance. (Revised rate – actual rate) x actual hours paid = $11·40 – $11·40 x 12,000 = 0
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Labour efficiency planning variance (Standard hours for actual production – revised hours for actual production) x std rate [10,250 – (20,500 x 0·5 x 1·2)] x $12 = $24,600 A. Labour efficiency operational variance (Revised hours for actual production – actual hours for actual production) x std rate (12,300 – 12,000) x $12 = $3,600 F. (c)
Discussion
When looking at the total variances alone, it looks like the production manager has been extremely poor at controlling his staff’s efficiency, since the labour efficiency variance is $21,000 adverse. It also looks, at a glance, like he has managed to secure labour at a lower rate. In order to assess the production manager’s performance fairly, however, only the operational v ariances should be taken into account. This is because planning variances reflect differences that arise because of factors that are outside the control of the production manager. The operational variance for the labour rate was $0, which means that the labour force were paid exactly what was agreed at the end of October: their reduced rate of $11·40 per hour. The manager clearly did not have to pay anyone for overtime, for example, which would have been expected to push this rate up. The rate reduction was secured by the company and was not within the control of the production manager, so he cannot take credit for the favourable rate planning variance of $7,200. The company is the source of this improvement. As regards labour efficiency, the planning and operational variances give us more information about the total efficiency variance of $21,000A. When this is broken down into its two parts, it becomes clear that the operational variance, for which the manager does have control, is actually $3,600 favourable. This is because, when the recipe is changed as it has been in November, the chocolates usually take 20% longer to make in the first month whilst the workers are getting used to handling the new ingredient mix. When this is taken into account, it can therefore be seen that workers took less than the 20% extra time that they were expected to take, hence the positive operational variance. The planning variance, on the other hand, is $24,600 adverse. This is because the standard labour time per batch was not updated in November to reflect the fact that it would take longer to produce the truffles. The manager cannot be held responsible for this. Overall, then, the manager has performed well, given the change in the recipe.
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Web Co
Web Co has made three changes and introduced two incentives in an attempt to increase sales. Using the performance indicators given in the question, it is possible to assess whether these attempts have been successful. Total sales revenue This has increased from $2·2 million to $2·75m, an increase of 25% (W1). This is a substantial increase, especially considering the fact that a $10 discount has been given to all customers spending $100 or more at any one time. However, because a number of changes and incentives have been introduced, it is not possible to assess how effective each of the individual changes/incentives has been in increasing sales revenue without considering the other performance indicators. Net profit margin (NPM) This has decreased from 25% to 16·7%. In $ terms this means that net profit was $550,000 in quarter 1 and $459,250 in quarter 2 (W2). If the 25% NPM had been maintained in quarter 2, the net profit would have been $687,500 for quarter 2. It is therefore $228,250 lower than it would have been. This is mainly because of the $200,000 paid out for advertising and the $20,000 paid to the consultant for the search engine work. The remaining $8,250 difference could be a result of the cost of the $10 discounts given to customers who spent more than $100, depending on how these are accounted for. Alternatively, it could be due to the costs of providing the Fast Track service. More information would be required on how the discounts are accounted for (whether they are netted off sales revenue or instead included in cost of sales) and also on the cost of providing the Fast Track service.
Whilst it is not clear how long the advert is going to run for in the fashion magazine, $200,000 does seem to be a very large c ost. This expense is largely responsible for the fall in NPM. This is discussed further under ‘number of visits to website’. Number of visits to website These have increased dramatically from 101,589 to 141,714, an increase of 40,125 visits (39·5% W3). The reason for this is a combination of visitors coming through the fashion magazine’s website (28,201 visitors W5), with the remainder of the increase most probably being due to the search engine consultants’ work. Both of these changes can therefore be said to have been effective in improving the number of people who at least v isit Web Co’s online store. However, given that the search engine consultant only charged a fee of $20,000 compared to the $200,000 paid for magazine advertising, in relative terms, the consultant’s work provided value for money. Web Co’s sales are not really high enough to withstand a hit of $200,000 against profit, hence the fall in NPM. Number of orders/customers spending more than $100 The number of orders received from customers has increased from 40,636 to 49,600, an increase of 22% (W4). This shows that, whilst most of the 25% sales revenue increase is due to a higher number of orders, 3% of it is due to orders being of a higher purchase value. This is also reflected in the fact that the number of customers spending more than $100 per visit has increased
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from 4,650 to 6,390, an increase of 1,740 orders. So, for example, If each of these 1,740 customers spent exactly $100 rather than the $50 they might normally spend, it would easily explain the 3% increase in sales that is not due to increased order numbers. It depends partly on how the sales discounts of $10 each are accounted for. As stated above, further information is required on these. An increase in the number of orders would also be expected, given that the number of visitors to the site has increased substantially. This leads on to the next point. Conversion rate – visitor to purchaser
The conversion rate of visitors to purchasers has gone down from 40% to 35%. This is not surprising, given the adver tising on the fashion magazine’s website. Readers of the magazine may well have clicked on the link out of curiosity and may come back and purchase something at a later date. It may be useful to have a breakdown of the visitor to purchaser rate, showing one statistic for visitors who have come from the online magazine and one for those who have not. This would help clarify the position. Website availability
Rather than improving after the work completed by Web Co’s IT department, the website’s availability has stayed the same. This means that the IT department’s changes to the website have not corrected the problem. Lack of availability is not good for business, although its exact impact is difficult to ascertain. It may be that visitors have been part of the way through making a purchase only to find that the website then becomes unavailable. More information would need to be available about aborted purchases, for example, before any further conclusions could be drawn. Subscribers to online newsletter
These have increased by a massive 159%. It is not clear what impact this has had on the business as we do not know whether the level of repeat customers has increased. This information is needed. Surprisingly, it seems that there has not been an increased cost associated with providing Fast Track delivery, as the whole fall in net profit has been accounted for, so one can only assume that Web Co managed to offer this service without incurring any additional cost itself. Conclusion
With the exception of the work carried out to make the system more available, all of the other measures seem to have increased sales or, in the case of Incentive 1, increased subscribers. More information is needed in relation to a couple of areas, as noted above. The business has therefore been responsive to changes made and incentives implemented but the cost of the advertising was so high that, overall, profits have declined substantially. This expenditure seems too high in relation to the corresponding increase in sales volumes. Workings
1. 2. 3. 4. 5. 6.
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Increase in sales revenue $2·75m – $2·2m/$2·2m = 25% increase. NPM: 25% x $2·2m = $550,000 profit in quarter 1. 16·7% x $2·75m = $459,250 profit in quarter 2. No. of visits to website: increase = 141,714 – 101,589/101,589 = 39·5%. Increase in orders = 49,600 – 40,636/40,636 = 22%. Customers accessing website through magazine line = 141,714 x 19·9% = 28,201. Increase in subscribers to newsletter = 11,900 – 4,600/4,600 = 159%.
Designit (a)
Explanation
The rolling budget outlined for Designit would be a budget covering a 12-month period and would be updated monthly. However, instead of the 12-month period remaining static, it would always roll forward by one month. This means that, as soon as one month has elapsed, a budget is prepared for the corresponding month one year later. For example, Designit would begin by preparing a budget for the 12 months from 1 December 2012 to 30 November 2013, to correspond with its year end. Then, at the end of December 2012, a budget would be prepared for the month December 2013, so that the unexpired period covered by the budget is always 12 months. When the budget is initially prepared for the year ending 30 November 2013, the first month is prepared in detail, with much less detail being given to later months, where there is a greater uncertainty about the future. Then, when this first month has elapsed and the budget for the month of December 2013 is prepared, it is also necessary to revisit and revise the budget for January 2013, which will now be done in more detail. Note: This answer gives more level of detail than would be required to gain full marks. (b)
Problems
Designit only has one part-qualified accountant. He is already overworked and probably has neither the time nor the experience to prepare rolling budgets every month. One would only expect to see monthly rolling budgets of this nature in businesses which face rapid change. There is no evidence that this is the case for Designit. If it did decide to introduce rolling budgets, it would probably be sufficient if they were updated on a quarterly rather than a monthly basis. If this monthly rolling budget is going to be introduced, it is going to require a lot of input from many of the staff, meaning that they will have less time to dedicate to other things. The sales managers may react badly to the new budgeting and incentive system. They are used to having been set targets that are easily achievable. With the new system, they will have to work hard all year round. They are also likely to become frustrated with the fact that they do not know the target for the whole year in advance. Once they have hit their target for the
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month, they may then also be tempted to hold back fu rther work and let it run into the next month, so that they increase the chances of meeting next month’s target. This would not be good for the business. (c)
Alternative incentive scheme The issue with the current bonus scheme is that the reward system is stepped, rather than being a percentage of sales. The first $1·5 million fee income target is too easy to reach and the second $1·5 million target is too hard to reach. Therefore, managers are not motivated to earn additional fees once the initial $1·5 million target has been reached.
A series of constantly rising bonus rates ranging over a narrower rate of sales could be used. For example, every $500,000 of fee income could be rewarded with an additional bonus equivalent to 5% of salary. Alternatively, the bonus could be replaced by commission, giving the managers a reward as a percentage of the fee income rather than a percentage of salar y. Currently, the company is paying out $30,000 in bonus to each of its managers each year. This is 2% of $1·5 million. Therefore, the bonus could be that each manager earns 2% commission on all sales. (d)
Using spreadsheets If spreadsheets are used for budgeting, the part-qualified accountant could be rekeying large amounts of data taken from the company’s systems. It would be very easy for him to make a mistake when he is entering his data, especially without someone else to check his work.
Similarly, if there is any error in any of the formulae, all the numbers in the budget will be wrong. Whilst this risk already exists because fixed budgets are being prepared on spreadsheets, the rolling budgets will be far more complex, which increases the risk of error in the design of the model or any of the formulae. A model can become easily corrupted simply by putting a number in the wrong cell. The accountant is unlikely to spot this due to his lack of experience and the time pressure on him. When spreadsheets are used, there is no audit trail that can be followed in order to check the numbers.
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Wash Co (a)
Transfer price using machine hours
Total overhead costs = $877,620 Total machine hours = (3,200 x 2) + (5,450) x 1 = 11,850 Overhead absorption rate = $877,620/11,850 = $74·06 Overhead cost for S = 2 x $74·06 = $148·12 and for R = 1 x $74·06 = $74·06.
Materials cost Labour cost (at $12 per hour) Overhead costs Total cost 10% mark-up Transfer price using machine hours (b)
Product S $ 117 6 148·12 –––––– 271·12 27·11 –––––– 298·23 ––––––
Product R $ 95 9 74·06 –––––– 178·06 17·81 –––––– 195·87 ––––––
Transfer price using ABC Machine set up costs: driver = number of production runs. 30 + 12 = 42. Therefore cost per set up = $306,435/42 = $7,296·07 Machine maintenance costs: driver = machine hours: 11,850 (S= 6,400; R=5,450) $415,105/11,850 = $35·03 Ordering costs: driver = number of purchase orders 82 + 64 = 146. Therefore cost per order = $11,680/146 = $80 Delivery costs: driver = number of deliveries. 64 + 80 = 144. Therefore cost per delivery = $144,400/144 = $1,002·78
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Allocation of overheads to each product:
Machine set-up costs Machine maintenance costs Ordering costs Delivery costs Total overheads allocated Number of units produced Overhead cost per unit Transfer price per unit: Materials cost Labour cost Overhead costs Total cost 10% mark up
Add
Transfer price under ABC (c)
(i)
Product S $ 218,882 224,192 6,560 64,178 –––––––– 513,812 –––––––– 3,200
Product R $ 87,553 190,913 5,120 80,222 –––––––– 363,808 –––––––– 5,450
$ 160·57
$ 66·75
117 6 160·57 ––––––– 283·57 28·36 ––––––– 311·93 –––––––
95 9 66·75 ––––––– 170·75 17·08 ––––––– 187·83 –––––––
Product S 3,200 $ 28·36 –––––––––– 90,752 ––––––––––
Product R 5,450 $ 17·08 –––––––––– 93,086 ––––––––––
Product S 3,200 $ 320 (311·93) –––––––––– 8·07 –––––––––– 25,824 ––––––––––
Product R 5,450 $ 260 (187·83) ––––––––––– 72·17 ––––––––––– 393,327 –––––––––––
Total $ 306,435 415,106 11,680 144,400 –––––––– 877,620 –––––––– 8,650
ABC monthly profit
Using ABC transfer price from part (b): Assembly division Production and sales
10% mark up Profit Retail division Production and sales
Selling price Cost price Profit per unit Total profit (ii)
Total
183,838 –––––––– Total
419,151 ––––––––
Discussion
From the various profit figures for the three bases of allocating overheads, various observations can be made. –
There is obviously very little difference between the TOTAL profits of each division whichever method is used, except for differences arising from rounding. In each case, the total profit made by the assembly division is approximately $183,000 and $419,000 for the retail division. It is the reallocation of profits from R to S or S to R that is the important factor in this situation, given that the retail division wants to reduce prices but increase sales volumes for R.
–
As regards the assembly division, when labour hours are used to allocate overheads, there is a big difference between the profits that each of the two products makes. When machine hours or ABC are used, this difference becomes much smaller.
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As regards the retail division, when labour hours are used, product S generates 76% of the profit. When this method of allocation is then changed so that either machine hours are used or AB C is used, the main share of the profit then moves to product R. In the case of ABC, the profit moves so much to R that S only generates a profit per unit of $8·07 for the retail division, which is very low for a selling price of $320.
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From the assembly division manager’s point of view, any change that results in increased sales of either R or S to the retail division would be a good thing for the assembly division, given that both products are profitable. However, the assembly division’s manager would probably oppose the implementation of ABC to achieve this end result because firstly, it is complex and secondly, it is unnecessary here. The aim of this exercise is to set more accurate transfer prices for R and S, which should mean a reduction in R’s transfer price and an increase in S’s, according to the information given. This would then have the effect of enabling the retail division to lower its price for R and increase sales volumes. This goal is achieved simply by changing the basis of overhead absorption from labour hours to machine hours, without the need for activity based costing.
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3,000
D
2,500
2,000 S 1,500
1,000
Most profitable first Constant mix C
500 0 0 0 ’ $ t i f o r P
0 0
2,000
4,000
6,000
8,000
10,000
Sales revenue $’000
–500
–1,000 (d)
From the chart above it can be seen that, if the products are sold in order of the highest ranking first, break even will take place at a point just under $1,200,000 of sales revenue. The exact figure can be worked out by taking the fixed costs of $640,000 and dividing them by Product C’s C/S ratio of 0·55, i.e. the exact BEP is $1,163,636. This is substantially earlier than the break-even point which occurs if the products are all sold in a constant mix, which is $1,790,209, as calculated in (b) above. The reason for this is obviously because the more profitable product, C, contributes more per unit to fixed costs when being sold on its own, than when a mix of products C, S and D are sold. The weighted average C/S ratio of all three products is only 35·75%, compared to C’s C/S ratio of 55%. Obviously, then, break even will occur earlier if C is sold in priority. In reality, however, the mix of sales will vary throughout the year and Hair Co can neither assume that the products are sold in a constant mix, nor that the most profitable can be sold first.
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Truffle Co (a)
Basic variances
Standard cost of labour per hour = $6/0·5 = $12 per hour. Labour rate variance = (actual hours paid x actual rate) – (actual hours paid x std rate) Actual hours paid x std rate = $136,800/·95 = $144,000. Therefore rate variance = $144,000 – $136,800 = $7,200 F Labour efficiency variance = (actual production in std hours – actual hours worked) x std rate [(20,500 x 0·5) – 12,000] x $12 = $21,000 A. (b)
Planning and operational variances Labour rate planning variance (Revised rate – std rate) x actual hours paid = [$12 – ($12 x 0·95)] x 12,000 = $7,200 F. Labour rate operational variance There is no labour rate operational variance. (Revised rate – actual rate) x actual hours paid = $11·40 – $11·40 x 12,000 = 0
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Labour efficiency planning variance (Standard hours for actual production – revised hours for actual production) x std rate [10,250 – (20,500 x 0·5 x 1·2)] x $12 = $24,600 A. Labour efficiency operational variance (Revised hours for actual production – actual hours for actual production) x std rate (12,300 – 12,000) x $12 = $3,600 F. (c)
Discussion
When looking at the total variances alone, it looks like the production manager has been extremely poor at controlling his staff’s efficiency, since the labour efficiency variance is $21,000 adverse. It also looks, at a glance, like he has managed to secure labour at a lower rate. In order to assess the production manager’s performance fairly, however, only the operational v ariances should be taken into account. This is because planning variances reflect differences that arise because of factors that are outside the control of the production manager. The operational variance for the labour rate was $0, which means that the labour force were paid exactly what was agreed at the end of October: their reduced rate of $11·40 per hour. The manager clearly did not have to pay anyone for overtime, for example, which would have been expected to push this rate up. The rate reduction was secured by the company and was not within the control of the production manager, so he cannot take credit for the favourable rate planning variance of $7,200. The company is the source of this improvement. As regards labour efficiency, the planning and operational variances give us more information about the total efficiency variance of $21,000A. When this is broken down into its two parts, it becomes clear that the operational variance, for which the manager does have control, is actually $3,600 favourable. This is because, when the recipe is changed as it has been in November, the chocolates usually take 20% longer to make in the first month whilst the workers are getting used to handling the new ingredient mix. When this is taken into account, it can therefore be seen that workers took less than the 20% extra time that they were expected to take, hence the positive operational variance. The planning variance, on the other hand, is $24,600 adverse. This is because the standard labour time per batch was not updated in November to reflect the fact that it would take longer to produce the truffles. The manager cannot be held responsible for this. Overall, then, the manager has performed well, given the change in the recipe.
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Web Co
Web Co has made three changes and introduced two incentives in an attempt to increase sales. Using the performance indicators given in the question, it is possible to assess whether these attempts have been successful. Total sales revenue This has increased from $2·2 million to $2·75m, an increase of 25% (W1). This is a substantial increase, especially considering the fact that a $10 discount has been given to all customers spending $100 or more at any one time. However, because a number of changes and incentives have been introduced, it is not possible to assess how effective each of the individual changes/incentives has been in increasing sales revenue without considering the other performance indicators. Net profit margin (NPM) This has decreased from 25% to 16·7%. In $ terms this means that net profit was $550,000 in quarter 1 and $459,250 in quarter 2 (W2). If the 25% NPM had been maintained in quarter 2, the net profit would have been $687,500 for quarter 2. It is therefore $228,250 lower than it would have been. This is mainly because of the $200,000 paid out for advertising and the $20,000 paid to the consultant for the search engine work. The remaining $8,250 difference could be a result of the cost of the $10 discounts given to customers who spent more than $100, depending on how these are accounted for. Alternatively, it could be due to the costs of providing the Fast Track service. More information would be required on how the discounts are accounted for (whether they are netted off sales revenue or instead included in cost of sales) and also on the cost of providing the Fast Track service.
Whilst it is not clear how long the advert is going to run for in the fashion magazine, $200,000 does seem to be a very large c ost. This expense is largely responsible for the fall in NPM. This is discussed further under ‘number of visits to website’. Number of visits to website These have increased dramatically from 101,589 to 141,714, an increase of 40,125 visits (39·5% W3). The reason for this is a combination of visitors coming through the fashion magazine’s website (28,201 visitors W5), with the remainder of the increase most probably being due to the search engine consultants’ work. Both of these changes can therefore be said to have been effective in improving the number of people who at least v isit Web Co’s online store. However, given that the search engine consultant only charged a fee of $20,000 compared to the $200,000 paid for magazine advertising, in relative terms, the consultant’s work provided value for money. Web Co’s sales are not really high enough to withstand a hit of $200,000 against profit, hence the fall in NPM. Number of orders/customers spending more than $100 The number of orders received from customers has increased from 40,636 to 49,600, an increase of 22% (W4). This shows that, whilst most of the 25% sales revenue increase is due to a higher number of orders, 3% of it is due to orders being of a higher purchase value. This is also reflected in the fact that the number of customers spending more than $100 per visit has increased
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from 4,650 to 6,390, an increase of 1,740 orders. So, for example, If each of these 1,740 customers spent exactly $100 rather than the $50 they might normally spend, it would easily explain the 3% increase in sales that is not due to increased order numbers. It depends partly on how the sales discounts of $10 each are accounted for. As stated above, further information is required on these. An increase in the number of orders would also be expected, given that the number of visitors to the site has increased substantially. This leads on to the next point. Conversion rate – visitor to purchaser
The conversion rate of visitors to purchasers has gone down from 40% to 35%. This is not surprising, given the adver tising on the fashion magazine’s website. Readers of the magazine may well have clicked on the link out of curiosity and may come back and purchase something at a later date. It may be useful to have a breakdown of the visitor to purchaser rate, showing one statistic for visitors who have come from the online magazine and one for those who have not. This would help clarify the position. Website availability
Rather than improving after the work completed by Web Co’s IT department, the website’s availability has stayed the same. This means that the IT department’s changes to the website have not corrected the problem. Lack of availability is not good for business, although its exact impact is difficult to ascertain. It may be that visitors have been part of the way through making a purchase only to find that the website then becomes unavailable. More information would need to be available about aborted purchases, for example, before any further conclusions could be drawn. Subscribers to online newsletter
These have increased by a massive 159%. It is not clear what impact this has had on the business as we do not know whether the level of repeat customers has increased. This information is needed. Surprisingly, it seems that there has not been an increased cost associated with providing Fast Track delivery, as the whole fall in net profit has been accounted for, so one can only assume that Web Co managed to offer this service without incurring any additional cost itself. Conclusion
With the exception of the work carried out to make the system more available, all of the other measures seem to have increased sales or, in the case of Incentive 1, increased subscribers. More information is needed in relation to a couple of areas, as noted above. The business has therefore been responsive to changes made and incentives implemented but the cost of the advertising was so high that, overall, profits have declined substantially. This expenditure seems too high in relation to the corresponding increase in sales volumes. Workings
1. 2. 3. 4. 5. 6.
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Increase in sales revenue $2·75m – $2·2m/$2·2m = 25% increase. NPM: 25% x $2·2m = $550,000 profit in quarter 1. 16·7% x $2·75m = $459,250 profit in quarter 2. No. of visits to website: increase = 141,714 – 101,589/101,589 = 39·5%. Increase in orders = 49,600 – 40,636/40,636 = 22%. Customers accessing website through magazine line = 141,714 x 19·9% = 28,201. Increase in subscribers to newsletter = 11,900 – 4,600/4,600 = 159%.
Designit (a)
Explanation
The rolling budget outlined for Designit would be a budget covering a 12-month period and would be updated monthly. However, instead of the 12-month period remaining static, it would always roll forward by one month. This means that, as soon as one month has elapsed, a budget is prepared for the corresponding month one year later. For example, Designit would begin by preparing a budget for the 12 months from 1 December 2012 to 30 November 2013, to correspond with its year end. Then, at the end of December 2012, a budget would be prepared for the month December 2013, so that the unexpired period covered by the budget is always 12 months. When the budget is initially prepared for the year ending 30 November 2013, the first month is prepared in detail, with much less detail being given to later months, where there is a greater uncertainty about the future. Then, when this first month has elapsed and the budget for the month of December 2013 is prepared, it is also necessary to revisit and revise the budget for January 2013, which will now be done in more detail. Note: This answer gives more level of detail than would be required to gain full marks. (b)
Problems
Designit only has one part-qualified accountant. He is already overworked and probably has neither the time nor the experience to prepare rolling budgets every month. One would only expect to see monthly rolling budgets of this nature in businesses which face rapid change. There is no evidence that this is the case for Designit. If it did decide to introduce rolling budgets, it would probably be sufficient if they were updated on a quarterly rather than a monthly basis. If this monthly rolling budget is going to be introduced, it is going to require a lot of input from many of the staff, meaning that they will have less time to dedicate to other things. The sales managers may react badly to the new budgeting and incentive system. They are used to having been set targets that are easily achievable. With the new system, they will have to work hard all year round. They are also likely to become frustrated with the fact that they do not know the target for the whole year in advance. Once they have hit their target for the
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