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Paper F5 Performance Management First Mock Exam June 2013 Session Answers

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Answer # 1 (a) Ease of approach. Firms may be unaware or unsure how to apply other pricing strategies. Many firms are small and do not employ staff with appropriate skills or knowledge to apply these techniques. Decision-makers may be faced with a host of uncertainties. The use of cost plus formulae enables the decision-maker to absorb some of these uncertainties and come up with a price that will be acceptable given the constraints at hand. Cost plus may be used to avoid setting the price too low and incurring losses. However, of course, it will not guarantee against loss-making. By using cost plus pricing the company's own costs will need to be calculated and thus may help the decision-maker to predict either competitors' costs or a competitive price. Information may not be available to allow an approach based on anything other than cost plus eg it may be impossible to estimate demand for products.

(b) When demand is linear the equation for the demand curve is: P = a bQ Where P = price a = the price at which demand would be nil b = the change in price/change in quantity Q = the quantity demanded b = change in price/change in quantity b = (20 15) / (50,000 45,000) = 5/5,000 b = 0.001 15 = a 0.001 x 50,000 15 = a 50 a = 65 Therefore the demand curve is P = $65 0.001Q Where Q is the quantity sold per quarter Explanation: The demand curve P = $65 0.001Q shows that at a price of $65 demand would be nil. The demand curve shows that Mango must lower its price in order to increase its sales volume. For every $5 it changes its price the volume sold will change, in the opposite direction, by 5000 units.

(c) Price elasticity of demand (PED) PED = percentage of change in demand / percentage of chance in price = {(45,000 50,000)/45,000} * 100% / {(20 15)/20} * 100% = - 0.44 Ignoring the minus sign, price elasticity is 0.44. The demand for this good would be referred to as inelastic because the price elasticity of demand is less than 1. Where demand is inelastic, the quantity demanded falls by a smaller percentage than

the percentage increase in price. In circumstances of inelastic demand, prices should be increased because revenues will increase and total costs will reduce (because quantities sold will reduce). (d) Company Mangos emphasis has always been on product innovation. As such the new generation product Uphone 3D is likely to be an innovative product that is new to the market. A market skimming strategy would be appropriate. This will enable Mango to recoup its research and development costs, make high unit profits and to cream as much profit as possible in the introductory phase of the product before competitors enter the market.

(e) & (f) Decision Tree

Answer # 2 (a) Variance analysis is only one aspect of the information required to judge performance. It does not tell management all they need to know for both financial and quality control purposes. Neither should it be used as the basis for a performance-related bonus. The reasons are as follows. Financial control The variances reported in the statement are only as reliable and accurate as the original standard cost. If the standard is inaccurate or out of date then the reported variances are not useful for control purposes. The type of standard that has been set could have an impact on the reported variances. For example, an ideal standard, which allows for inefficiencies, will nearly always result in adverse variances. In the case of the favourable price variance, this may result from a standard price that has been set at an average for the year. Assuming inflation, this will result in favourable variances at the beginning of the year (the situation that may have risen here). It may not therefore be appropriate to conclude that the favourable price variance is an indicator of efficient material procurement. This statement relates to material costs only. The variances should not be viewed in isolation and managers should consider possible inter-relationships with other cost variances. For example, a favourable variance has been achieved by changing the mix of materials. However, this mix may be more difficult to process, resulting in adverse variances on labour and machine costs. This problem is not revealed by considering material cost variances in isolation. It would not be desirable to reward the divisional manager for achieving these favourable variances without considering their possible effect on other parts of the business. Quality control The effectiveness of Bellerophon depends on the quality of the ingredients being used. However, the favourable price variance may indicate that low quality material has been purchased. Reporting price variances in this way and possibly relating them to bonus payments may encourage the purchase of lower quality materials. The correct mix of the materials is also crucial to the effectiveness of Bellerophon. However the way that the mix variance is reported could encourage the divisional manager to input more of the cheaper material and less of the more expensive material. This could have an adverse effect on quality, which the variances do not reveal. The director should consider greater use of non-financial measures to control quality, for example, the percentage of output being rejected, or the percentage of sales returned by customers. Such nonfinancial measures could be monitored continually and information could be made available to the process manager immediately, on an ad hoc basis. This would be more useful for operational decisions than a monthly cost variance statement that presents largely historical information. In summary, the variances do not tell managers all they need to know for financial and quality control purposes and they do not provide an appropriate basis for the payment of a monthly bonus. (b) Materials price variance Standard price $ per kg A B C D 104.00 49.00 186.00 72.50 Actual price $ per kg 102.90 51.20 188.00 68.16 Difference $ per kg 1.10 (F) (2.20) (A) (2.00) (A) 4.34 (F) Actual quantity kg 291.6 242.6 198.2 392.0 Variance $ 320.76 (F) 533.72 (A) 396.40 (A) 1,701.28 (F) ---------------1,091.92 (F)

Materials usage variance Standard usage for 930 units of output kg A B C D 306.9 260.4 213.9 390.6 ---------1,171.8

Actual usage kg 291.6 242.6 198.2 392.0 ---------1,124.4

Difference kg 15.3 (F) 17.8 (F) 15.7 (F) (1.4) (A) ---------47.4 (F)

Standard price $ per kg 104.00 49.00 186.00 72.50

Variance $ 1,591.2 (F) 872.2 (F) 2,920.2 (F) (101.5) (A) -------------5,282.1 (F)

Materials mix variance Standard mix Actual of actual usage mix kg kg A B C D 294.5 249.9 205.2 374.8 ---------1,124.4 291.6 242.6 198.2 392.0 ---------1,124.4 Difference kg 2.9 (F) 7.3 (F) 7.0 (F) (17.2) (A) Standard price $ per kg 104.00 49.00 186.00 72.50 Variance $ 301.60 (F) 357.70 (F) 1,302.00 (F) 1,247.00 (A) ---------------714.30 (F)

Materials yield variance Standard mix Actual of actual usage mix kg kg A B C D 306.9 260.4 213.9 390.6 ---------1,171.8 294.5 249.9 205.2 374.8 --------1,124.4 Standard price $ per kg 104.00 49.00 186.00 72.50

Difference kg 12.4 (F) 10.5 (F) 8.7 (F) 15.8 (F) ----------47.4 (F)

Variance $ 1,289.60 (F) 514.50 (F) 1,618.20 (F) 1,145.50 (F) ----------------4,567.80 (F)

(c) Try yourself

Answer # 3 (a) Detail analysis of performance of Torongo by Balanced Scorecard: Financial Analysis There are various financial observations that can be made from the data. Turnover is up 23% this is very high indicating a possibility of increasing selling price and/or number of customers. To know the real growth, the rate of inflation should be adjusted. This is encouraging and a sign of a growing business. The main weakness identified in the financial results is that the net profit margin has fallen from 21% to 9.3% suggesting that cost control may be getting worse or fee levels are being competed away. Internal business processes Number of accidents per year decreasing Number of delaying in departure decreasing Customer Knowledge Percentage of customer complain decreasing Customer acquisition increasing Learning and Growth Number of new services launched increasing Total number of buses increasing *Try to comment on your calculation on each of the three perspective Conclusion In conclusion, the financial results do not show the full picture. Though financial performance indicated profit is decreasing, but the company may invest a huge amount in 2012 to expand which may indicate a higher cost in initial stage compared to revenue.

(b) A number of difficulties arise when attempting to measure the performance of the BRTC. Multiple objectives The BRTC has multiple objectives, e.g. to provide efficient, reliable and affordable public transport to all the citizens of the country. Even if they can all be clearly identified it may be impossible to say what the overriding objective is. Measuring outputs Outputs can seldom be measured in a way that is generally agreed to be meaningful as it is difficult to judge whether non quantifiable objectives have been met. (For example, how can we measure the quality of a bus service?) Data collection can be problematic. For example, the quality of service offered to customers may be measured by the number and type of letters received either complaining or praising the company. If this measure is used it ignores the majority of customers who will not bother to write.

Lack of profit measure The BRTC is not expected to make a profit, and as there is less ticket price. Financial indicators are therefore meaningless. Nature of service provided Like many non-profit seeking organisations that provide services, the BRTC, will find it difficult to define a cost unit. This problem does exist for commercial service providers but problems of performance measurement are made simple because profit can be used. Financial constraints Although every organisation operates under financial constraints, these are more pronounced in nonprofit seeking organisations. For instance, a commercial organisation's borrowing power is effectively limited by managerial prudence and the willingness of lenders to lend, but a local authority's ability to raise finance for the BRTC (whether by borrowing or via local taxes) is subject to strict control by Central Government. Political, social and legal considerations Unlike Torongo, the BRTC is subject to strong political influences. Local authorities, for example, have to carry out central government's policies as well as their own (possibly conflicting) policies. The performance indicators of public sector organisations such as the BRTC are subject to far more onerous legal requirements than those of private sector organisations such as the Torongo. Whereas profit-seeking organisations are unlikely in the long term to continue services making a negative contribution, non-profit seeking organisations may be required to offer a range of services, even if some are uneconomic. (c) Value for Money involves providing a service in a way that is economical, efficient and effective (the 3E's). The Culture Centre can monitor the value for money being achieved by monitoring each of these criteria, bearing in mind that the achievement of one criterion might conflict with the achievement of others. In order to make such calculations meaningful they should be compared against prior year data or a similar business. Economy is the attainment of the appropriate quantity and quality of inputs at the lowest cost. For example in assessing the salaries paid to staff the aim is to obtain the desired quality at the lowest price. Effectiveness measures whether an organisations objectives have been achieved. The Culture Centre has numerous and potentially conflicting objectives. Efficiency is the relationship between inputs and outputs. In other words obtaining the greatest possible output for a given input. Economy BRTC Average cost of staff $2880,000 / 250 = $11,520 $500,000 / 5m = $0.1 Torongo $2900,000 / 175 = $16,571 $600,000 /1.2m = $0.5

Average fuel cost per passenger miles

The Torongo seems to achieve worse economy than BRTC. A comparison of staff costs shows that the CTorongo has higher average costs than BRTC. However the desired skills and experience are not likely to be the same for both organisations. A better comparison would be to compare these ratios with other organisations of same industries of the country.

The BRTC also has lower average fuel cost. However again there is a difficulty comparing these two organisations because of the differences in the nature of showing a public and a private company..

Effectiveness The BRTC attracts 1.5m customers per year. This in itself may be the measure of success or otherwise of the service (although this should be compared against a benchmark such as other similar attractions or prior year data once it exists). It should be noted, however, the average customers per carried last year was double than Torongo. Effectiveness measures success in meeting objectives such as to provide efficient, reliable and affordable public transport to all the citizens of the country . The other data given does not enable a view to be taken on other objectives such as attracting new businesses. Efficiency The BRTC could monitor the percentage of total days or hours which it was open. This would highlight the efficiency of usage of available resources and focus managers' attention on the need to meet customers needs. The data indicates that the BRTC is open far more than Torongo. This may be due to public services is expected to be available throughout all the time of the year by the stakeholders. But Average occupancy level is very much alarming compared to Torongo. It can be linked to total number of buses available for use and number of delaying of departure. The data shows timeliness is a issue BRTC has emphasized. BRTC % days open Average bus occupancy 350/365 = 96% 60% Trongo 320/365 = 88% 85%

Whilst these measures go someway towards assessing the BRTCs performance they need to be compared to a similar organisation in order to be able to draw meaningful conclusions from the data.

Answer # 4 The adoption of Zero-based budgeting within NN Ltd. (a) During recent years the management of NN Ltd has used the traditional approach of incremental budgeting. This approach entails the use of the previous years budget as a baseline and adds or subtracts amounts to/ from that budgetin order to reflect assumptions for the forthcoming budget year. The typical justification for increased expenditures, other than those related to volume changes, has been due to the increased cost of inputs to our business. This approach can lead to inefficiencies in the previous years budget being rolled forward into the next years budget purely by virtue of the fact that last years budget is the base starting point for the construction of the new budget. The implementation of a system of zero-based budgeting will require a consideration of the following: The need for major input by management; The fact that it will prove extremely time consuming; The need for a very high level of data capture and processing; The subjective judgement inherent in its application; The fact that it might be perceived as a threat by staff; Whether its adoption may encourage a greater focus upon the short-term to the detriment of longerterm planning.

Zero-based budgeting was developed to overcome the shortcomings of the technique of incremental budgeting. The implementation of a zero-based budgeting would require each manager within NN Ltd to effectively start with a blank sheet of paper and a budget allowance of zero. The managers would be required to defend their budget levels at the beginning of each and every year. Thus, past budget decisions would as part of the process of zero-based budgeting need to be re-evaluated each year. The comprehensive resource cost-analysis process is a strong internal planning characteristic of zero-based budgeting. It follows that resource requirements are more likely to be adjusted to changing business conditions. The development and implementation of the zero-based budgeting model will require managers and others in the organisation to engage in several major planning, analytical and decision-making processes. Our company has already established mission and goal statements. However, we as a management team ought to give consideration as to whether it is necessary to redefine the statements that are already in existence and/or create new ones. This redefinition of mission and goal statements will be of much value if we as a management team consider that major changes have occurred in the internal and external environment of our business. A zero-based budgeting decision unit is an operating division for which decision packages are to be developed and analysed. It can also be described as a cost or a budget centre. Thus the manager responsible for each cost centre within NN Ltd would be responsible for developing a description of each program to be operated in the next budget year. In the context of zero-based budgeting such programs are referred to as decision packages, and each decision package usually will have three or more alternative ways of achieving the decision packages objectives. Briefly, each decision package alternative must contain, as a minimum, goals and/or objectives, activities, resources and their associated costs. Each decision package should contain a description of how it will contribute to the attainment of the mission and goals of the organisation. Each manager within NN Ltd will be required to review each decision package and its alternatives in order to be able to assess and justify its operation and in doing so, several questions must be answered. In particular, each manager will need to answer the following questions: Does this decision package support and contribute to the goals of the organisation? What would be the result to the organisation if the decision package were to be eliminated? Can this decision packages objectives be accomplished more ef fectively and/or efficiently? The ranking process, based upon cost/benefit analysis is used to establish a prioritised ranking of decision packages within the organisation. During the ranking process managers and their staff will analyse each of the several decision package alternatives. The analysis allows the manager to select the one alternative that has the greatest potential for achieving the objective(s) of the decision package. Ranking is a way of evaluating all decision packages in relation to each other. Since, there are any number of ways to rank decision packages managers will no doubt employ various methods of ranking. The ranking process could prove to be problematic insofar as it will require our managers to make value judgements and thus subjectivity is an inherent factor in the application of zero-based budgeting. Although difficult, the ranking of decision packages is fundamental to the process of zero-based budgeting. Following a review and analysis of all decision packages, managers will determine the level of resources to be allocated to each decision package. Managers at different levels of responsibility in the organisation usually perform the review and analysis. Sometimes, the executive levels of management may require the managers of the decision packages to revise and resubmit their decision packages for additional review and analysis.

Our budget will be prepared following the acceptance and approval of the decision packages. Once the companys budget has been approved, managers of the decision units will put into operation all approved decision packages during the budget year. The last major process of zero-based budgeting is monitoring and evaluation. The processes of planning, analysis, selection and budgeting of decision packages will prepare our company for operation during the next year. However, what managers plan to happen during the next year may or may not occur. Adjustments may be essential during the year in order to achieve the decision package objectives. Also, there is a need to know whether or not the organization did accomplish what it set out to achieve and what level of achievement was obtained. The monitoring and evaluation process of zero-based budgeting requires a number of features are incorporated in the overall design and implementation of decision packages. It is essential that all decision packages include measurable performance objectives and identifies the appropriate activities as means for achieving the performance objectives. The required resources for conducting the activities, together with the planned methods for carrying out the activities should also be included. The decision package should also include a mechanism to evaluate whether an objective is being achieved both during and after the conclusion of the program of activities for subsequent reporting to management. (ii) The implementation of zero-based budgeting will require a major planning effort by our personnel. It is through the planning process that important guidelines and directions are provided for the development and ranking of the decision packages. Also, the planning process will enable managers to prepare for the uncertainty of the future. Long-range planning allows managers to consider the potential consequences of current decisions over an extended timeframe. Zero-based budgeting addresses and supports comprehensive planning, shared decision-making, the development and application of strategies and allocation of resources as a way of achieving established goals and objectives. In addition, zero-based budgeting supports the added processes of monitoring and evaluation. Zero-based budgeting, when properly implemented, has the potential to assist the personnel of an organisation to plan and make decisions about the most efficient and effective ways to use their available resources to achieve their defined mission, goals and objectives. There is no doubt that the process of zero-based budgeting will consume a great deal more management time than the current system of budgeting does. This will certainly be the case in implementation of the system because managers will need to learn what is required of them. Managers may object that it is too time-consuming to introduce zero-based budgeting, however, it could be introduced on a piece-meal basis. As regards the imposition upon management time, managers may object that they simply do not have the necessary time in order to undertake an in-depth examination of every activity each year. However, if this proves to be the case then we could consider the establishment of a review cycle aimed at ensuring that each activity is reviewed on at least one occasion during every two or three years. I propose that we hold a series of training seminars for our management to help in the transition to a system of zero-based budgeting. We must also ensure that we sell the benefits that would arise from a successful implementation. A zero-based budgeting system would assist our managers to: Develop and/or modify the organisations mission and goals. Establish broad policies based on the mission and goals. Efficiently identify the most desirable programs to be placed in operation. Allocate the appropriate level of resources to each program.

Monitor and evaluate each program during and at the end of its operation and report the effectiveness of each program. Thus, as a consequence of the adoption of zero-based budgeting our managers should be able to make decisions on the basis of an improved reporting system. It is quite possible that zero-based budgeting would help identify and eliminate any budget bias or budget slack that may be present. Budgetary slack is a universal behavioural problem which involves deliberately overstating cost budgets and/or understating revenue budgets to allow some leeway in actual performance. We must acknowledge that in organisations such as ours where reward structures are based on comparisons of actual with budget results, bias can help to influence the amount paid to managers under incentive schemes. However, we should emphasise that if managers are to earn incentives as a consequence of incentive schemes that are based upon a comparison of actual outcomes with budgeted outcomes, then a zero-based budget would provide a fair yardstick for comparison. It is important to provide reassurance to our managers that we do not intend to operate a system of zerobased budgeting against the backdrop of a blame-culture. This will help to gain their most positive acceptance of the change from a long established work practice that they may perceive afforded them a degree of insurance. (b) The finance director is probably aware that the application of zero-based budgeting within NN Ltd might prove most fruitful in the management of discretionary costs where it is difficult to establish standards of efficiency and where such costs can increase rapidly due to the absence of such standards. A large proportion of the total costs incurred by NN Ltd will comprise direct production and service costs where the existence of input: output relationships that can be measured render them more appropriate to traditional budgeting methods utilising standard costs. Since the predominant costs incurred by a not for profit health organisation will be of a discretionary nature, one might conclude that the application of zerobased budgeting techniques is more appropriate for service organisations such as the not for profit health organisation than for a profit-seeking manufacturer of electronic office equipment. A further difference lies in the fact that the ranking of decision packages is likely to prove less problematic within an organisation such as NN Ltd which is only involved in the manufacture and marketing of electronic office equipment. By way of contrast, there is likely to be a much greater number of decision packages of a disparate nature, competing for an allocation of available resources within a not for profit health organisation.

Answer # 5 (a) Machine hours required Type 1 Type 2 Machine utilisation rate: 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. P 180 120 Product L 315 175 R 180 120 Total 675 415

(b) Contribution per unit Machine type 1 hours Contribution per hour Ranking P $40 1.5 $26.67 1

Product L $96 4.5 $21.33 3

R $74 3.0 $24.67 2

Allocation of machine type 1 hours according to this ranking: Product P Product L 120 units using 60 units using 180 hours 180 hours ------360 hours used 238.5 hours ------598.5 hours used

Product R (240/4.5) 53 units using

(c) A major concept underlying throughput accounting is that the majority of costs, with the exception of material and component costs are fixed. In Caterpillar's case it is clear that the labour cost, which is treated as a variable cost in traditional marginal costing, is indeed a fixed cost. The employees are paid for a guaranteed 800 hours (160 5) each month, whereas the number of labour hours required to meet the maximum demand can be calculated as 780 hours as follows. Product L 6 70 420

Labour hours per unit Maximum demand (units) Total hours required per month

P 0.75 120 90

R 4.5 60 270

Total

780

Therefore labour is a fixed cost that will not alter within the relevant range of activity. Throughput accounting recognises this in the calculation of throughput.

Furthermore, given the perishable nature of Caterpillar's products, the throughput accounting approach to inventory minimisation and maximisation of throughput would be more appropriate.

(d) P $ per unit 91 22 23 46 1.5 $ 30.67 3 Product L $ per unit 174 19 11 144 4.5 $ 32.00 2 R $ per unit 140 16 14 110 3.0 $ 36.76 1

Sales revenue Component cost Other direct material Throughput per unit Machine type 1 hours

Throughput per hour Ranking

Allocation of machine type 1 hours according to this ranking: Product L Product R 60 units using 70 units using 180 hours 315 hours ------495 hours used 105 hours ------600 hours used

Product P (105/1.5)

70 units using

(e) The conventional cost accounting approach used by Caterpillar views inventory as an asset. In the throughput accounting approach inventory is not viewed as an asset, but rather as a result of unsynchronised manufacturing. The existence of inventory is thus viewed as a breakdown in synchronisation and a barrier to generating profits. In throughput accounting the ideal inventory level is zero, with the exception that a buffer inventory should be held prior to the bottleneck machine. As regards the valuation of inventory, the throughput philosophy is that no value is added to inventory items and no profit is earned until the items are actually sold. Thus inventory is valued at its material cost only until it is sold. This approach to inventory valuation is in contrast to the full absorption costing system used by Caterpillar. The latter approach encourages managers to produce output just to add to work in progress or finished goods inventory, since this helps with the absorption of overheads and boosts reported profits. This behaviour will be avoided and managers will be more likely to be willing to minimize inventory if it is valued at material cost only.