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Performance Management
Exam Practice Kit
1|Page
Paper P2
PERFORMANCE STRATEGY
Syllabus overview
While Paper P2 continues the analytic theme of Paper P1 Performance Operations (for
example in terms of identifying relevant costs), its main focus is on the application of
information in the management processes 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.
Syllabus structure
The syllabus comprises the following topics and study weightings:
A
B
C
D
30%
30%
20%
20%
Assessment strategy
There will be a written examination paper of three hours, plus 20 minutes of preexamination question paper reading time. During the 20 minutes you can: read the
question paper and annotate or highlight the question paper. However you will not be
allowed to: open the answer book; write in the answer book; add any loose
sheets/supplements to your answer book; or use calculators. Failure to comply with these
rules will be considered as a serious breach of the exam regulations.
2|Page
Section A
50 marks
Section B
50 marks
The study time per week recommended, should be 80% question practice.
Exam strategy
Within your 20 minutes of official reading time allowed before the exam starts, read
through all requirements and information carefully. You can write on the exam paper
during this time so concentrate heavy on answer plans for the section A type questions,
look at Section B type questions only if you have time. You can write on the exam paper
during this time so produce brief outline answer plans and highlight key requirements and
scenario information.
You have 1.8 mins per mark (3 hours or 180 mins divided by 100 marks).
Allow 18 minutes per question for the five compulsory questions within section A
(total time 90 minutes).
Allow 90 minutes (the remaining time you have) to complete section B.
The examiner has said that it is unlikely section B will ever contain one compulsory
question and therefore more likely to contain two compulsory questions worth 25 marks
each.
3|Page
The section B questions are not just 45 minutes of time per question attempted; you have
to break down the 45 minutes of time allotted for each requirement before you begin.
This ensures you dont run out of time and this same principle should also be applied to
section A requirements.
Tackle all the easiest parts for numerical calculations and then attempt all the other
aspects of the requirement in the time you have. It is crucial that you manage your
time properly in the exam. Dont be afraid to stop calculating even though your answer
is not complete, otherwise over running will seriously prejudice other marks due to
inadequate time and dramatically reduce your chances of passing the exam.
Question requirements
Answer presentation
Page clearly labelled as to what part of the question you are completing
Start a fresh page for every part to a question.
Watch for write a report or memo etc.
Let the question requirement drive your headings.
Write in brief explanations 5-6 lines then a gap or white space every 5-6 lines.
Diagrams should be neat and spacious about 1/3 page in size.
Marks will be balanced according to the weighting of the syllabus.
Discussions
4|Page
Learning objectives
Learning objectives are defined at the back of every CIMA exam on exam day, a copy of
the table below will be provided on exam day. Exam requirements will BOLD these
verbs below to help you decide the correct approach to a question. The common learning
verbs include Explain, Discuss, Describe, Identify and Construct. Familiarise yourself
with these commonly used verbs.
Knowledge
Comprehension
Application
Analysis
Evaluation
List
State
Define
Make a list of
Express, fully or clearly, the details/facts of
Give the exact meaning of
Describe
Distinguish
Explain
Identify
Illustrate
Apply
Calculate/compute
Demonstrate
Prepare
Reconcile
Solve
Tabulate
Analyse
Categorise
Compare and contrast
Construct
Discuss
Interpret
Produce
Examine in detail
Place in a defined class
Show the similarities and/or differences
between
Build up or compile
Examine in detail by argument
Translate into familiar terms
Create or bring into existence
Advise
Evaluate
Recommend
5|Page
CONTENTS
Title
EXE (P2)
MNP (P2)
VBJ (P2)
QXY plc (P2)
RST (P2)
HS (P2)
Bank charges (P2)
WX
Exam year
Pilot Paper
May 2005
May 2005
Nov 2006
May 2007
Nov 2007
May 2008
May 2011
Question
page
number
13
14
15
19
19
20
21
22
Answer
page
number
103
104
105
106
108
109
112
113
Question
page
number
24
25
27
29
31
33
35
36
37
39
41
Answer
page
number
117
121
124
127
131
137
139
144
146
151
154
Title
TQ (P2)
QP plc (P2)
ZP plc (P2)
AVX plc (P2)
GHK (P2)
H (P2)
DFG (P2)
Highly skilled workers (P2)
RT
LM
Hotel
Exam year
Pilot Paper
Nov 2005
Nov 2005
May 2006
May 2006
May 2007
Nov 2007
May 2008
May 2010
Nov 2010
May 2011
6|Page
Title
SWAL (P2)
X group (P2)
ML (P2)
PK plc (P2)
Financial advisors (P2)
Compliance v conformance (P2)
AVN (P2)
W (P2)
New product (P2)
New small company (P2)
XY (P2)
Inventory levels (P2)
Workshop (P2)
Out-turn performace report
PQ
Timber products
LMN
Production manager
CAL
QW
Accountancy services
PT
TQM and JIT (P1)
Standard costing (P1)
Marginal v throughput (P1)
MRPS (P1)
JIT (P1)
Key features of TQM (P1)
Exam year
Pilot Paper
May 2005
Nov 2005
Nov 2005
May 2006
May 2006
Nov 2006
Nov 2006
May 2007
Nov 2007
May 2008
May 2008
May 2008
May 2010
May 2010
May 2010
May 2010
Nov 2010
Nov 2010
Nov 2010
Nov 2010
May 2011
Pilot Paper
May 2006
May 2006
May 2007
May 2007
May 2008
Question
page
number
44
44
45
46
46
47
47
48
49
50
51
51
52
53
54
54
55
56
57
58
58
59
60
60
60
60
60
61
Answer
page
number
157
159
160
161
163
165
167
170
171
172
174
175
177
178
180
181
182
183
185
186
187
188
189
190
191
191
192
192
7|Page
Title
Exam year
May 2005
May 2005
Nov 2006
Nov 2007
Question
page
number
62
63
64
65
Answer
page
number
194
198
202
206
8|Page
Title
Solicitors firm
DW
JYT
DVD
SFG
Feedback and feedforward (P1)
Profit centre managers (P1)
Balance scorecard (P1)
Particiaption in budgets (P1)
Beyond budgeting (P1)
J Limited (P1)
ST plc (P1)
W Limited (P1)
T plc (P1)
Product M (P1)
QBD (P1)
Budgetary planning and control (P1)
JIT systems (P1)
Feedback and forward (P1)
Nursing homes (P1)
Participative budgeting (P1)
Rolling budgets (P1)
Exam year
May 2010
Nov 2010
May 2011
May 2011
May 2011
Pilot Paper
Pilot Paper
May 2005
May 2005
May 2005
Nov 2005
Nov 2005
Nov 2005
May 2006
May 2007
Nov 2007
Nov 2007
Nov 2007
Nov 2007
Nov 2007
May 2008
May 2008
Question
page
number
69
70
70
71
72
72
72
73
73
73
74
74
74
75
75
76
77
77
77
77
78
78
Answer
page
number
210
211
212
213
215
216
217
217
219
220
221
222
223
224
225
226
227
227
228
228
230
231
9|Page
Title
M plc (P1)
RF Ltd (P1)
Trackit (P1)
X plc (P1)
Exam year
May 2006
May 2007
May 2008
Nov 2006
Question
page
number
79
80
82
85
Answer
page
number
232
236
240
244
Title
Exam year
Pilot Paper
Pilot Paper
Pilot Paper
May 2005
May 2005
May 2007
May 2008
Question
page
number
87
87
87
87
87
88
89
Answer
page
number
248
249
249
251
252
254
255
10 | P a g e
Title
Y and Z (P1)
FP (P1)
ZZ group (P1)
Computer manufacturer (P1)
Perfumes and cosmetics
SWZ
DE company
Exam year
Nov 2005
May 2006
Nov 2006
Nov 2007
May 2010
Nov 2010
May 2011
Question
page
number
90
91
93
95
96
99
100
Answer
page
number
257
262
266
269
273
276
279
11 | P a g e
Mock One
P2 Specimen (2010) exam paper
Mock Two
P2 September 2010 exam paper
Mock Three
P2 March 2011 exam paper
Mock Four
P2 September 2011 exam paper
Mock Five
P2 November 2011 exam paper
The above exam questions and solutions can be downloaded via your
mycima account which contains access to all past exam papers and
solutions, alternatively contact tufal@acornlive.com if you would like to
receive PDF copies.
12 | P a g e
Questions Section A
Part A Pricing and Product Decisions
A1 -1 EXE (CIMA P2 Pilot paper 2005)
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
1
2
50
20
3
4
200
50
350
Estimating time
100
770
154
924
Direct materials:
Steel 10m2 @ $5.00 per m2
Brass fittings
Direct labour:
Overhead
Selling price
231
1,155
Notes:
1. 1 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.
2. The brass fittings would have to be bought specifically for this job: a supplier has
quoted the price of $20 for the fittings required.
3. 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
contribution of $13.00 per hour.
4. The semi-skilled labour currently has sufficient paid idle time to be able to
complete this work.
13 | P a g e
5. 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.
6. 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.
7. 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.
(12 marks)
A1 2 MNP (CIMA P2 May 2005)
Z 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:
Common Process Account
Litres $ Litres $
Opening work in process
Materials
Conversion costs:
Variable
Fixed
Abnormal loss
1,000
5,320
100,000 250,000
100,000
180,000
5,200
101,000 535,320
Normal loss
Output M
Output N
Output P
Closing WIP
10,000
25,000
15,000
45,000
800
101,000
20,000
141,875
85,125
255,375
3,533
29,412
535,320
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:
14 | P a g e
Product
M
N
P
Further variable
processing cost
$/litre
175
095
085
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)
(b) 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)
A1 3 VBJ (CIMA P2 May 2005)
The CS group is planning its annual marketing conference for its sales executives and has
approached the VBJ Holiday company (VBJ) to obtain a quotation.
VBJ has been trying to win the business of the CS group for some time and is keen to
provide a quotation which the CS group will find acceptable in the hope that this will lead
to future contracts.
The manager of VBJ has produced the following cost estimate for the conference:
$
Coach running costs 2,000
Driver costs
3,000
Hotel costs
5,000
General overheads
2,000
Sub total
12,000
Profit (30%)
Total
3,600
15,600
You have considered this cost estimate but you believe that it would be more appropriate
to base the quotation on relevant costs. You have therefore obtained the following further
information:
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Coach running costs represent the fuel costs of $1,500 plus an apportionment of the
annual fixed costs of operating the coach. No specific fixed costs would be incurred if the
coach is used on this contract. If the contract did not go ahead, the coach would not be in
use for eight out of the ten days of the conference. For the other two days a contract has
already been accepted which contains a significant financial penalty clause. This contract
earns a contribution of $250 per day. A replacement coach could be hired for $180 per
day.
Driver costs represent the salary and related employment costs of one driver for 10 days.
If the driver is used on this contract the company will need to replace the driver so that
VBJ can complete its existing work. The replacement driver would be hired from a
recruitment agency that charges $400 per day for a suitably qualified driver.
Hotel costs are the expected costs of hiring the hotel for the conference.
General overheads are based upon the overhead absorption rate of VBJ and are set
annually when the company prepares its budgets. The only general overhead cost that can
be specifically identified with the conference is the time that has been spent in
considering the costs of the conference and preparing the quotation. This amounted to
$250.
Required:
Prepare a statement showing the total relevant cost of the contract. Explain clearly the
reasons for each of the values in your quotation and for excluding any of the costs (if
appropriate).
(10 marks)
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17 | P a g e
1,000
2,000
1,500
4,500
$
3,500
2,000
3,000
6,000
2,000
1,000
17,500
Kg
Normal loss
Outputs:
Product R
Product S
Product T
500
800
2,000
1,200
3,500
8,750
5,250
4,500 17,500
Z can sell products R, S or T after this common process or they can be individually
further processed and sold as RZ, SZ and TZ respectively. The market prices for the
products at the intermediate stage and after further processing are:
Market prices per
kg:
R
S
T
RZ
SZ
TZ
$
3.00
5.00
3.50
6.00
5.75
6.75
19 | P a g e
$000
7,000
5,688
6,334
5,446
No significant changes in cost behaviour are expected over the next twelve weeks.
20 | P a g e
Required:
(a) Calculate the optimum (profit maximising) selling price of the component for the
period.
Note: If Price = a - bq then Marginal Revenue = a - 2bq
(6 marks)
(b) Identify and explain two reasons why it may be inappropriate for HS to use this
theoretical pricing model in practice.
(4 marks)
(Total = 10 marks)
A1 7 Bank charges (CIMA P2 May 2008)
A bank is reviewing the bank account it offers to its business customers and the charges it
makes for routine transactions (for example paying into the account, writing cheques,
making electronic payments and transfers). Currently, the banks charges to its business
customers are 060 per routine transaction. The bank pays interest to the customer at
01% per year on any balance in the account.
According to the banks records, there are currently one million business customers. Each
customer makes one thousand routine transactions each year; 45% of business customers
maintain an average balance of 2,000 in their account. The accounts of the other 55% of
business customers are overdrawn with an average overdraft balance of 4,000. Interest
on overdrawn accounts is charged at 20% per year.
In addition, the bank has a number of savings account customers which, together with the
banks business customers, result in a balance of net funds that are invested by the bank
and yield an annual return by 3% per year.
The bank is concerned about a growing tendency for its competitors to provide routine
transactions free of charge to their business customers. As a result the bank is considering
twoaccount options:
Account Option One
An account that charges the business customer a fixed fee of 10 per month, with no
further charges for any routine transactions. Interest would be paid to the business
customer at 05% per year on any balances in the account. The bank expects that if it
adopts this charging structure, it will increase the number of business customers by
5%from its present level;
21 | P a g e
Direct materials
Direct labour
Overhead
100,000
160,000
200,000
$000
200
600
880
$000
320
960
1,228
$000
400
1,200
1,460
22 | P a g e
The cost behaviour patterns represented in the above forecast will apply for the whole
range of output up to 300,000 units per annum of this product.
Required:
(a)
(i) Calculate the total variable cost per unit.
(2 marks)
(ii) Calculate the selling price of the product that will maximise the companys profits.
(4 marks)
Note: If Price (P) = a - bx then Marginal Revenue = a - 2bx
(b) Explain TWO reasons why the company might decide NOT to use this optimum
selling price.
(4 marks)
(Total = 10 marks)
23 | P a g e
Questions Section B
Part A Pricing and Product Decisions
A2-1 TQ (CIMA P2 Pilot Paper 2005)
(a) TQ manufactures and retails second generation mobile (cell) phones. The following
details relate to one model of phone:
$/unit
60
25
10
Period
Budgeted production and sales (units)
1
520
2
590
3
660
$1,200 (A)
$1,900 (A)
$2,600 (A)
24 | P a g e
(b) TQ is currently developing a third generation mobile phone. It is a state of the art
new handheld device that acts as a mobile phone, personal assistant, digital camera
(pictures and video), and music player. The Board of Directors seeks your advice as to
the pricing strategy that it should adopt for such a product. The company has incurred a
significant level of development costs and recognises that the technology for these
products is advancing rapidly and that the life cycle for the product is relatively short.
Required:
Prepare a report, addressed to the Board of Directors that discusses the alternative pricing
strategies available to TQ.
(15 marks)
(Total = 25 marks)
A2 2 QP plc (CIMA P2 Nov 2005)
QP plc is a food processing company that produces pre-prepared meals for sale to
consumers through a number of different supermarkets. The company specialises in three
particular pre-prepared meals and has invested significantly in modern manufacturing
processes to ensure a high quality product. The company is very aware of the importance
of training and retaining high quality staff in all areas of the company and, in order to
ensure their production employees commitment to the company, the employees are
guaranteed a weekly salary that is equivalent to their normal working hours paid at their
normal hourly rate of 7 per hour.
The meals are produced in batches of 100 units. Costs and selling prices per batch are as
follows:
Meal
TR
/batch
PN
/batch
BE
/batch
Selling Price
340
450
270
Ingredient K (5/kg)
Ingredient L (10/kg)
Ingredient M (15/kg)
150
70
30
120
90
75
90
40
45
Labour (7/hour)
21
28
42
20
80
40
25 | P a g e
Required:
(a) State the principles of throughput accounting and the effects of using it for short-term
decision making.
(6 marks)
(b) QP plc is preparing its production plans for the next three months and has estimated
the maximum demand from its customers to be as follows:
TR 500 batches
PN 400 batches
BE 350 batches
These demand maximums are amended figures because a customer has just delayed its
request for a large order and QP has unusually got some spare capacity over the next
three months. However, these demand maximums do include a contract for the delivery
of 50 batches of each to an important customer. If this minimum contract is not satisfied
then QP plc will have to pay a substantial financial penalty for non-delivery.
The Production Director is concerned at hearing news that two of the ingredients used are
expected to be in short supply for the next three months. QP plc does not hold inventory
of these ingredients and although there are no supply problems for ingredient K, the
supplies of ingredients L and M are expected to be limited to:
Ingredient L 7,000 kilos
Ingredient M 3,000 kilos
The Production Director has researched the problem and found that ingredient V can be
used as a direct substitute for ingredient M. It also costs the same as ingredient M. There
is an unlimited supply of ingredient V.
Required:
Prepare calculations to determine the production mix that will maximise the profit of QP
plc during the next three months.
(10 marks)
(c) The World Health Organisation has now announced that ingredient V contains
dangerously high levels of a chemical that can cause life-threatening illnesses. As a
consequence it can no longer be used in the production of food.
26 | P a g e
As a result, the production director has determined the optimal solution to the
companysproduction mix problem using linear programming. This is set out below:
Objective function value
TR value
PN value
BE value
TR slack value
PN slack value
BE slack value
L value
M value
110,714
500
357
71
0
43
279
3
28
Required:
Explain the meaning of each of the values contained in the above solution.
(9 marks)
(Total = 25 marks)
A2 3 ZP plc (CIMA P2 Nov 2007)
ZP plc is a marketing consultancy that provides marketing advice and support to small
and medium sized enterprises. ZP plc employs 4 full time marketing consultants who
each expect to deliver 1,500 chargeable hours per year and each receive a salary of
60,000 per year. In addition the company employs 6 marketing support/administration
staff whose combined total salary cost is 120,000 per year.
ZP plc has estimated its other costs for the coming year as follows:
000
Office premises: rent, rates, heating
50
Advertising
Travel to clients
15
11
10
27 | P a g e
ZP plc has been attributing costs to each client (and to the projects undertaken for them)
by recording the chargeable hours spent on each client and using a single cost rate of 75
per chargeable hour. The same basis has been used to estimate the costs of a project when
preparing a quotation for new work.
ZP plc has reviewed its existing client database and determined the following three
average profiles of typical clients:
Client profile
Chargeable hours per client
D
100
E
700
F
300
50
70
100
10
The senior consultant has been reviewing the companys costing and pricing procedures.
He suggests that the use of a single cost rate should be abandoned and, where possible,
activities should be costed individually. With this is mind he has obtained the following
further information:
It is ZP plcs policy that where a visit is made to a client and the distance to the
client is more than 50 miles, the consultant will travel the day before the visit and
stay in local accommodation so that the maximum time is available for meeting
the client the following day.
The cost of travel to the client is dependent on the number of miles travelled to
visit the client.
Other costs are facility costs at present the senior consultant cannot identify an
alternative basis to that currently being used to attribute costs to each client.
Required:
(a) Prepare calculations to show the cost attributed to each client group using an
activity based system of attributing costs.
(7 marks)
(b) Discuss the differences between the costs attributed using activity based costing
and those attributed by the current system and adviser whether the senior
consultants suggestion should be adopted.
(9 marks)
28 | P a g e
Direct labour
50 hours @ 10 /hour
500
The following labour efficiency variances arose during the first six months of the
assembly of CB45:
Month
November
December
January
February
March
April
Number of batches
assembled and sold
1
1
2
4
8
16
Labour Efficiency
Variance ()
Nil
170.00 Favourable
452.20 Favourable
1,089.30 Favourable
1,711.50 Favourable
3,423.00 Favourable
An investigation has confirmed that all of the costs were as expected except that there
was a learning effect in respect of the direct labour that had not been anticipated when the
standard cost was set.
Required:
(a)
(i) Calculate the monthly rates of learning that applied during the six months;
(ii) Identify when the learning period ended and briefly discuss the implications of
your findings for AVX Plc.
(10 marks)
29 | P a g e
AVX Plc initially priced each batch of CB45 circuit boards on the basis of its standard
cost of 960 plus a mark up of 25%. Recently the company has noticed that, due to
increasing competition, it is having difficulty maintaining its sales volume at this price.
The Finance Director has agreed that the long run unit variable cost of the CB45 circuit
board is 672.72 per batch. She has suggested that the price charged should be based on
an analysis of market demand. She has discovered that at a price of 1,200 the demand is
16 batches per month, for every 20 reduction in selling price there is an increase in
demand of 1 batch of CB45 circuit boards, and for every 20 increase in selling price
there is a reduction in demand of 1 batch.
Required:
(b) Calculate the profit maximising selling price per batch using the data supplied by the
Finance Director
(8 marks)
Note: If Price (P) = a-bx then Marginal Revenue (MR) = a-2bx
The Technical Director cannot understand why there is a need to change the selling price.
He argues that this is a highly advanced technological product and that AVX Plc should
not reduce its price as this reflects badly on the company. If anything is at fault, he
argues, it is the use of Standard Costing and he has asked whether Target Costing should
be used instead.
Required:
(c)
(i) Explain the difference between standard costs and target costs;
(ii) Explain the possible reasons why AVX Plc needs to re-consider its pricing policy
now that the CB45 circuit board has been available in the market for six months.
(7 marks)
(Total = 25 marks)
30 | P a g e
G
3,000
$000
30
9
5,000
$000
50
15
H
3,000
$000
60
12
5,000
$000
100
20
J
3,000
$000
45
4.5
5,000
$000
75
7.5
K
3,000
$000
90
18
5,000
$000
150
30
10
10
13.5
22.5
36
60
10
24
40
22.5
37.5
15
13
19
11
17
11
17
Notes
1. Material A was purchased some time ago at a cost of $5 per kg. There are 5,000
kgs in inventory. The costs shown in the flexible budget are based on this
historical cost. The material is in regular use and currently has a replacement cost
of $7 per kg.
2. Material B is purchased as required ; its expected cost is $10 per kg. The costs
shown in the flexible budget are based on this expected cost.
3. Direct labour costs are based on an hourly rate of $10 per hour. Employees work
the number of hours necessary to meet production requirements.
4. Overhead costs of each product include a specific fixed cost of $1,000 per quarter
which would be avoided if the product was to be discontinued. Other fixed
overhead costs are apportioned between the products but are not affected by the
mix of products manufactured.
GHK has been advised by the only supplier of material B that the quantity of material B
that will be available during the next quarter will be limited to 5,000 kgs. Accordingly the
company is being forced to reconsider its production plan for the next quarter. GHK has
already entered into contracts to supply one of its major customers with the following :
500 units of product G
1,600 units of product H
800 units of product J
400 units of product K
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Apart from this, the demand expected from other customers is expected to be
3,600 units of product G
3,000 units of product H
3,000 units of product J
4,000 units of product K
The major customer will not accept partial delivery of the contract and if the contract
with this major customer is not completed in full, then GHK will have to pay a financial
penalty of $5,000.
Required :
(a) For each of the four products, calculate the relevant contribution per $ of material B
for the next quarter.
(6 marks)
(b) It has been determined that the optimum production plan based on the data above is
to produce 4,100 units of product G, 4600 units of product H, 800 units of product J, and
2,417 units of product K. Determine the amount of financial penalty at which GHK
would be indifferent between meeting the contract or paying the penalty.
(5 marks)
(c) Calculate the relevant contribution to sales ratios for each of the four products.
(2 marks)
(d) Assuming that the limiting factor restrictions no longer apply, prepare a sketch of a
multi product profit volume chart by ranking the products according to your contribution
to sales ratio calculations based on total market demand. Your sketch should plot the
products using the highest contribution to sales ratio first.
(6 marks)
(e) Explain briefly, stating any relevant assumptions and limitations, how the multi
product profit volume chart that you prepared in (d) above may be used by the manager
of GHK to understand the relationships between costs, volume and profit within the
business.
(6 marks)
(Total = 25 marks)
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Machinery
Two different types of machine will be required:
Machine A will print the catalogues. This is expected to take 20 hours of machine time.
The running cost of machine A is $5 per hour. There is currently 30 hours of unused time
on machine A per week that is being sold to other printers for $12 per hour.
Machine B will be used to cut and bind the catalogues. This machine is being used to full
capacity in the normal working week and this is why there is a need to work overtime.
The catalogue will require 25 machine hours and these have a running cost of $4 per
hour.
Despatch
There will be a delivery cost of $400 to transport the catalogues to the customer.
Fixed overhead costs
H uses a traditional absorption costing system to attribute fixed overhead costs to its
work. The absorption rate that it uses is $20 per direct labour hour.
Profit mark-up
H applies a 30% mark-up to its costs to determine its selling prices.
Required:
(a) In order to assist the management of H in preparing its quotation, prepare a schedule
showing the relevant costs for the production of the catalogues. State clearly your reason
for including or excluding each value that has been provided in the above scenario.
(15 marks)
(b) Explain how the use of relevant costs as the basis of setting a selling price may be
appropriate for short-term pricing decisions but may be inappropriatefor long-term
pricing decisions. Your answer should also discuss the conflict between reporting
profitability within a traditional absorption costing system and the use of relevant cost
based pricing.
(10 marks)
(Total = 25 marks)
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D /unit
115
G /unit
120
20
12
28
14
28
10
24
21
18
36
Profit
13
11
1,800kg
3,500kg
2,500 hours
6,500 machine hours
Required:
(a) Using graphical linear programming identify the weekly production schedule for
products D and G that maximises the profits of DFG during the next four weeks.
(15 marks)
(b) The optimal solution to part (a) shows that the shadow prices of Skilled labour and
Direct material A are as follows:
Skilled labour Nil
Direct material A 5.82
Explain the relevance of these values to the management of DFG.
(6 marks)
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(c) Using the graph you have drawn in part (a) explain how you would calculate by how
much the selling price of Product D could rise before the optimal solution would change.
Note: Assume that demand is not affected by the selling price. You are not required to
perform any calculations.
(4 marks)
(Total = 25 marks)
A2 8 Highly skilled workers (CIMA P2 May 2008)
An engineering company manufactures a number of products and components, using a
team of highly skilled workers and a variety of different metals.
The current supplier has announced that the amount of M1, one of the materials it
currently supplies, will be limited to 1,000 square metres in total for the next three-month
period because there will be insufficient M1 to satisfy demand.
The only items manufactured using M1 and their production costs and selling prices
(where applicable) are shown below:
Selling price
Product
P4
$/unit
125
Product
P6
$/unit
175
Component
C3
$/unit
n/a
Component
C5
$/unit
n/a
Direct materials:
M1 *
M2
Direct labour
Variable overhead
Fixed overhead **
15
10
20
10
20
10
20
30
15
30
5
15
16
8
16
10
20
10
5
10
Total cost
75
105
60
55
* Material M1 is expected to be limited in supply during the next three months. These
costs are based on M1 continuing to be available at a price of $20 per square metre.
** Fixed overhead is absorbed on the basis of direct labour cost.
Products P4 and P6 are sold externally. Components C3 and C5 are used in other
products made by the company. These other products do not require any further amounts
of material M1.
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The estimated total demand for these products and components during the next three
months is as follows:
P4
P6
C3
C5
2,000 units
1,500 units
500 units
1,000 units
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Product
130
160
3 hours
5 hours
5 kgs
4 kgs
2 litres
1 litre
3 hours
4 hours
Market research shows that the maximum demand for products R and T during June 2010
is 500 units and 800 units respectively. This does not include an order that RT has agreed
with a commercial customer for the supply of 250 units of R and 350 units of T at selling
prices of $100 and $135 per unit respectively. Although the customer will accept part of
the order, failure by RT to deliver the order in full by the end of June will cause RT to
incur a $10,000 financial penalty.
At a recent meeting of the purchasing and production managers to discuss the production
plans of RT for June, the following resource restrictions for June were identified:
Direct labour hours
Material A
Material B
Machine hours
7,500 hours
8,500 kgs
3,000 litres
7,500 hours
Required:
(a) Assuming that RT completes the order with the commercial customer, prepare
calculations to show, from a financial perspective, the optimum production plan for June
2010 and the contribution that would result from adopting this plan.
(6 marks)
(b) Prepare calculations to show, from a financial perspective, whether RT should
complete the order from the commercial customer
(3 marks)
You have now presented your optimum production plan to the purchasing and production
managers of RT. During your presentation it became clear that the predicted resource
restrictions were rather optimistic. In fact the managers agreed that the availability of all
of the resources could be as much as 10% lower than their original predictions.
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(c) Assuming that RT completes the order with the commercial customer, andusing
graphical linear programming, prepare a graph to show the optimum production plan for
RT for June 2010 on the basis that the availability of all resources is 10% lower than
originally predicted.
(11 marks)
(d) Discuss how the graph in your solution to (c) above can be used to help to determine
the optimum production plan for June 2010 if the actual resource availability lies
somewhere between the managers optimistic and pessimistic predictions.
(5 marks)
(Total = 25 marks)
A2 10 LM (CIMA P2 Nov 2010)
LM produces two products from different quantities of the same resources using a just-intime (JIT) production system. The selling price and resource requirements of each of
these two products are as follows:
Product
Unit selling price ($)
L
70
M
90
28
10
10
14
45
20
12
10
Fixed overheads are absorbed at the rate of $3 per direct labour hour.
Market research shows that the maximum demand for products L and M during
December 2010 will be 400 units and 700 units respectively.
At a recent meeting of the purchasing and production managers to discuss the companys
production plans for December 2010, the following resource availability for December
2010 was identified:
Direct labour
Direct material
Machine hours
3,500 hours
6,000 kg
2,000 hours
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Required:
(a) Prepare calculations to show, from a financial perspective, the optimum production
plan for December 2010 and the contribution that would result from adopting your plan.
(6 marks)
(b) You have now presented your optimum plan to the purchasing and production
managers of LM. During the presentation, the following additional information became
available:
(i) The company has agreed to an order for 250 units of product M for a selling price
of $90 per unit from a new overseas customer. This order is in addition to the
maximum demand that was previously predicted and must be produced and
delivered in December 2010;
(ii) The originally predicted resource restrictions were optimistic. The managers now
agree that the availability of all resources will be 20% lower than their original
predictions.
Required:
Construct the revised resource constraints and the objective function to be used to
identify, given the additional information above, the revised optimum production plan for
December 2010.
(6 marks)
(c) The resource constraints and objective function requested in part (b) above have now
been processed in a simplex linear programming model and the following solution has
been printed:
Product L
Product M
Direct labour
Direct material ($)
Machine hours
Contribution ($)
400
194
312
1.22
312
10,934.00
0
506
Required:
Analyse the meaning of each of the above eight values in the solution to the problem.
Your answer should include a proof of the five individual values highlighted in bold.
(13 marks)
(Total = 25 marks)
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For planning purposes the hotel divides the year (based on 360 days) into three seasons:
peak, mid and low.
Details of the hotel and its services and forecasts for the next year are given below.
1. Seasons, room charges, room occupancy, guests per room and room revenue
The hotel charges a price per room per night (including breakfast) irrespective of the
number of guests per room. The price charged is different in each of the seasons.
Season
Peak
Number of days
90
Price charged per room per night ($) 100.00
Hotel room occupancy %
95
Average number of guests per room 1.8
Total room revenue ($)
855,000
Mid
Low
120
80.00
75
1.5
720,000
150
55.00
50
1.2
412,500
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Season
Peak
Mid
Low
Daily demand
30% of hotel guests spend an average of $15 each
50% of hotel guests spend an average of $20 each
70% of hotel guests spend an average of $30 each
The hotel earns a 25% gross contribution from this income and employs two chefs on a
combined salary of $54,000 per year to provide this facility. All of the costs in the
restaurant and bar, except for the salaries of the chefs, are variable.
The two chefs could be made redundant with no redundancy costs.
6. General hotel costs.
These include the costs of reception staff, the heating and lighting of the common areas
and other facility related costs. The forecast costs for next year are:
Peak season
Mid season
Low season
$300,000
$400,000
$500,000
These costs could be reduced by 75% if the hotel were to close temporarily for one or
more seasons of the year.
There are also some costs that are incurred by the hotel and can only be avoided by its
permanent closure. These are estimated to $200,000 for next year.
Required:
(a) Prepare, in an appropriate format, a columnar statement that will help the managers of
the hotel to plan for next year. Your statement should show the hotels activities by
season and in total.
(18 marks)
(b)
(i) Identify, based on your statement, the actions that the managers could take to
maximise the profit of the hotel for next year.
(3 marks)
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(ii) Explain TWO factors that the managers should consider before implementing the
actions you identified in (b)(i).
(4 marks)
(Total = 25 marks)
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Questions Section A
Part B Cost Planning and Analysis for Competitive Advantage
B1 1 SWAL (CIMA P2 Pilot paper 2005)
SW is a member of the SWAL Group of companies. SW manufactures cleaning liquid
using chemicals that it buys from a number of suppliers. In the past SW has used a
periodic review stock control system with maximum, minimum and re-order levels to
control the purchase of the chemicals and the economic order quantity model to minimise
its costs.
The Managing Director of SW is considering a change by introducing a Just in Time
(JIT) system.
Required:
As Management Accountant, prepare a report to the Managing Director that explains how
a JIT system differs from the system presently being used and the extent to which its
introduction would require a review of SWs quality control procedures.
(10 marks)
B1 2 X group (CIMA P2 May 2005)
The X group is a well-established manufacturing group that operates a number of
companies using similar production and inventory holding policies. All of the companies
are in the same country though there are considerable distances between them.
The group has traditionally operated a constant production system whereby the same
volume of output is produced each week, even though the demand for the groups
products is subject to seasonal fluctuations. As a result there is always finished goods
inventory in the groups warehouses waiting for customer orders. This inventory will
include a safety inventory equal to two weeks production.
Raw material inventories are ordered from suppliers using the Economic Order Quantity
(EOQ) model in conjunction with a computerised inventory control system which
identifies the need to place an order when the re-order level is reached. The purchasing
department is centralised for the group. On receiving a notification from the
computerised inventory control system that an order is to be placed, a series of quotation
enquiries are issued to prospective suppliers so that the best price and delivery terms are
obtained for each order. This practice has resulted in there being a large number of
suppliers to the X group. Each supplier delivers directly to the company that requires the
material.
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The Managing Director of the X group has recently returned from a conference on World
Class Manufacturing and was particularly interested in the possible use of Just In Time
(JIT) within the X group.
Required:
Write a report, addressed to the Managing Director of the X group that explains how the
adoption of JIT might affect its profitability.
(10 marks)
B1 3 ML (CIMA P2 Nov 2005)
ML is an engineering company that specialises in providing engineering facilities to
businesses that cannot justify operating their own facilities in-house. ML employs a
number of engineers who are skilled in different engineering techniques that enable ML
to provide a full range of engineering facilities to its customers. Most of the work
undertaken by ML is unique to each of its customers, often requiring the manufacture of
spare parts for its customers equipment, or the building of new equipment from customer
drawings. As a result most of MLs work is short-term, with some jobs being completed
within hours while others may take a few days.
To date ML has adopted a cost plus approach to setting its prices. This is based upon an
absorption costing system that uses machine hours as the basis of absorbing overhead
costs into individual job costs. The Managing Director is concerned that over recent
months ML has been unsuccessful when quoting for work with the consequence that
there has been an increase in the level of unused capacity. It has been suggested that ML
should adopt an alternative approach to its pricing based on marginal costing since any
price that exceeds variable costs is better than no work.
Required:
With reference to the above scenario
(i) briefly explain absorption and marginal cost approaches to pricing;
(ii) discuss the validity of the comment any price that exceeds variable costs isbetter
than no work.
(10 marks)
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Required:
(a) Explain the meanings of, and the differences between, Value Analysis and Functional
Analysis.
(4 marks)
(b) Briefly explain the series of steps that you would take to implement Value Analysis
for this organisation.
(6 marks)
(Total = 10 marks)
B1 6 Compliance v conformance (CIMA P2 May 2006)
The Managing Director of a manufacturing company based in Eastern Europe has
recently returned from a conference on modern manufacturing. One of the speakers at the
conference presented a paper entitled Compliance versus Conformance the quality
control issue. The Managing Director would like you to explain to her some of the
concepts that she heard about at the conference.
Required:
Prepare a report, addressed to the Managing Director, that discusses quality costs and
theirsignificance for the company. Your report should include examples of the different
quality costs and their classification within a manufacturing environment.
(10 marks)
Note: 2 marks are available for report format
B1 7 AVN (CIMA P2 Nov 2006)
AVN designs and assembles electronic devices to allow transmission of audio / visual
communications between the original source and various other locations within the same
building. Many of these devices require a wired solution but the company is currently
developing a wireless alternative. The company produces a number of different devices
depending on the number of input sources and the number of output locations, but the
technology used within each device is identical. AVN is constantly developing new
devices which improve the quality of the audio / visual communications that are received
at the output locations.
The Managing Director recently attended a conference on world class manufacturing
entitled The extension of the value chain to include suppliers and customers and seeks
your help.
47 | P a g e
Required:
Explain
(i) the components of the extended value chain; and
(3 marks)
(ii) how each of the components may be applied by AVN.
(7 marks)
(Total = 10 marks)
B1 8 W (CIMA P2 Nov 2006)
W has recently completed the development and testing of a new product which has cost
$400,000. It has also bought a machine to produce the new product costing $150,000.
The production machine is capable of producing 1,000 units of the product per month and
is not expected to have a residual value due to its specialised nature.
The company has decided that the unit selling prices it will charge will change with the
cumulative numbers of units sold as follows:
Cumulative sales units
0 to 2,000
2,001 to 7,000
7,001 to 14,500
14,501 to 54,500
54,501 and above
Selling price
$ per unit in this band
100
80
70
60
40
Based on these selling prices, it is expected that sales demand will be as shown below:
Months
1 10
11 20
21 30
31 70
71 80
81 90
91 100
101 110
Thereafter
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$ per unit
50
40
30
25
30
W operates a Just in Time (JIT) purchasing and production system and operates its
business on a cash basis.
A columnar cash flow statement showing the cumulative cash flow of the product after its
Introduction and Growth stages has already been completed and this is set out below:
Months
Number of units produced and sold
Selling price per unit
Unit variable cost
Unit contribution
Total contribution
Cumulative cash flow
Introduction
1-10
2,000
$100
$50
$50
$100,000
($450,000)
Growth
11-30
5,000 7,500
$80 $70
$40 $40
$40 $30
$425,000
($25,000)
Required:
(a) Complete the cash flow statement for each of the remaining two stages of the
products life cycle. Do not copy the Introduction and Growth stages in your answer.
Ignore the time value of money.
(5 marks)
(b) Explain, using your answer to (a) above and the data provided, the possible reasons
for the changes in costs and selling prices during the life cycle of the product.
(5 marks)
(Total = 10 marks)
B1 9 New product (CIMA P2 May 2007)
A company is planning to launch a new product. It has already carried out market
research at a cost of $50,000 and as a result has discovered that the market price for the
product should be $50 per unit. The company estimates that 80,000 units of the product
could be sold at this price before one of the companys competitors enters the market
with a superior product. At this time any unsold units of the companys product would be
of no value.
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The company has estimated the costs of the initial batch of the product as follows:
Direct materials
Direct labour ($10 per hour)
Other direct costs
$000
200
250
100
Production was planned to occur in batches of 10,000 units and it was expected that an
80% learning curve would apply to the direct labour until the fourth batch was complete.
Thereafter the direct labour cost per batch was expected to be constant. No changes to the
direct labour rate per hour were expected.
The company introduced the product at the price stated above, with production occurring
in batches of 10,000 units. Direct labour was paid using the expected hourly rate of $10
and the company is now reviewing the profitability of the product. The following
schedule shows the actual direct labour cost recorded:
Cumulative number of batches
1
2
4
8
Required:
(i) Calculate the revised expected cumulative direct labour costs for the four levels of
output given the actual cost of $280,000 for the first batch.
(ii) Calculate the actual learning rate exhibited at each level of output.
(iii) Discuss the implications of your answers to (i) and (ii) for the managers of the
company.
(10 marks)
B1 10 New small company (CIMA P2 Nov 2007)
You are the management accountant of a new small company that has developed a new
product using a labour intensive production process. You have recently completed the
budgets for the company for next year and, before they are approved by the Board of
Directors, you have been asked to explain your calculation of the labour time required for
the budgeted output. In your calculations, you anticipated that the time taken for the first
unit would be 40 minutes and that a 75% learning curve would apply for the first 30
units.
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Required:
(a) Explain the concept of the learning curve and why it may be relevant to the above
company.
(3 marks)
(b) Calculate the expected time for the 6th unit of output.
(3 marks)
(c) Discuss the implications of the learning curve for a company adopting a penetration
pricing policy.
(4 marks)
(Total = 10 marks)
Note: The learning index for a 75% learning curve is -0.415
B1 11 XY (CIMA P2 May 2008)
You are the Management Accountant of XY, an engineering company that assembles
components into engines for sale to the automotive industry. The company is constantly
under pressure from its customers to provide more efficient engines, which are also less
damaging to the environment. The company uses value chain analysis as a tool in the
management of its activities.
The Managing Director of XY has recently been invited to a conference to give a
presentation entitled The concept of the Value Chain and the management of profits
generated throughout the chain in XY.
Required:
Prepare a report for the Managing Director explaining the points that should be covered
in the presentation.
(10 marks)
B1 12 Inventory levels (CIMA P2 May 2008)
A company experiences changing levels of demand, but produces a constant number of
units during each quarter. The company allows inventory levels to rise and fall to satisfy
the differing quarterly demand levels for its product.
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Required:
(a) Identify and explain the reasons for THREE cost changes that would result if the
company changed to a Just-In-Time production method for 2009. Assume there will be
no inventory at the start and end of the year.
(6 marks)
(b) Briefly discuss the importance of Total Quality Management to a company that
operates a Just-In-Time production method.
(4 marks)
(Total = 10 marks)
B1 13 Workshop (CIMA P2 May 2008)
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) Calculate the expected time for the eighth batch.
(3 marks)
(b) When production commenced the first batch took 45 hours. The actual learning rates
observed were as follows:
Month
1
2
3
4
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 18225 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)
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Actual
Variance
Output (batches)
60
50
10 adverse
163.53
93.65
69.88 favourable
$1,962
$1,146
$816 favourable
Further analysis has shown that, due to similarities between this product and another that
was developed last year, the rate of learning that should have been expected was 70% and
that the learning should have ceased after 30 batches. Other budget assumptions for the
new product remain valid.
Required:
(a) Prepare a revised out-turn performance report for the new product that:
(i) shows the flexed budgeted direct labour hours and direct labour cost based on the
revised learning curve data, and
(ii) shows the variances that reconcile the actual results to your flexed budget in as much
detail as possible.
(7 marks)
(b) Explain why your report is more useful to the production manager than the report
shown above.
(3 marks)
Note: The learning index values for an 80% and a 70% learning curve are -0.3219 and 0.5146 respectively.
(Total 10 marks)
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You may assume that all production costs (other than labour) are either fixed or are not
driven by labour hours worked, and that there is zero inventory at the start of month 1 and
at the end of month 6. Assume also that production and sales occur evenly during each
month at present, and that the minimum contracted hours will remain the same with the
JIT system.
Required:
(a) With the current production system:
(i) Calculate for each of the six months and the period in total, the total inventory holding
costs.
(ii) Calculate the total production cost savings made by changing to a JIT production
system.
(6 marks)
(b) Explain TWO other factors that should be considered by XY before changing to a JIT
production system.
(4 marks)
(Total = 10 marks)
B1 17 LMN (CIMA P2 May 2010)
LMN comprises three trading divisions plus a Head Office. There is a director for each
trading division and, in addition, there is a Managing Director who is based in Head
Office. Divisional directors are empowered to make decisions concerning the day to day
operations of their division and investment decisions requiring an initial investment up to
$100,000. Investment decisions involving greater initial expenditure must be authorised
by the Managing Director. Inter-divisional trading occurs between all of the trading
divisions. The transfer prices are determined by Head Office. Head Office provides
services and facilities to each of the trading divisions.
At the end of each month, the actual costs of Head Office are apportioned to the trading
divisions. Each Head Office cost is apportioned to the trading divisions using an
appropriate basis. The bases used are: number of employees; value of sales; capital
invested; and standard hours of service delivered.
The Head Office costs, together with the costs and revenues generated at divisional level,
are summarised in a divisional performance statement each month. The divisional
directors are not happy with the present performance statement and how it is used to
appraise their performance.
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Required:
(a) Explain, using examples from the scenario, three issues that LMN should consider
when designing a new divisional performance statement.
(6 marks)
LMN is thinking of introducing Activity Based Costing at its Head Office to help with
the apportionment of all its costs to the divisions.
(b) Discuss the advantages of applying Activity Based Costing to apportion all of the
Head Office costs.
(4 marks)
(Total = 10 marks)
B1 18 Production manager (CIMA P2 Nov 2010)
The following variances have been calculated in respect of a new product:
Direct labour efficiency variance $14,700 Favourable
Direct labour rate variance $ 5,250 Adverse
The variances were calculated using standard cost data which showed that each unit of
the product was expected to take 8 hours to produce at a cost of $15 per hour. Actual
output of the product was 560 units and actual time worked in the manufacture of the
product totalled 3,500 hours at a cost of $57,750.
However, the production manager now realises that the standard time of 8 hours per unit
was the time taken to produce the first unit and that a learning rate of 90% should have
been anticipated for the first 600 units.
Required:
(a) Calculate planning and operating variances following the recognition of the learning
curve effect.
(6 marks)
(b) Explain the importance of learning curves in the context of Target Costing.
(4 marks)
Note: The learning index for a 90% learning curve is -0.1520
(Total = 10 marks)
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XY is considering changing to an activity based costing system. The annual costs and the
causes of these costs have been analysed as follows:
$
580,000
30,000
15,000
60,000
40,000
1,000
4
2
4
150
250
10
8
1
600
340
6
10
2
0
18,000
250
400
250
10,000
Required:
Prepare calculations to show the effect on fees charged to each of these three clients of
changing to the new costing system.
(10 marks)
B1 22 PT (CIMA P2 May 2011)
PT manufactures and sells a number of products. All of its products have a life cycle of
six months or less. PT uses a four stage life cycle model (Introduction; Growth; Maturity;
and Decline) and measures the profits from its products at each stage of their life cycle.
PT has recently developed an innovative product. Since the product is unique it was
decided that it would be launched with a market skimming pricing policy. However PT
expects that other companies will try to enter the market very soon.
This product is generating significant unit profits during the Introduction stage of its life
cycle. However there are concerns that the unit profits will reduce during the other stages
of the products life cycle.
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Required:
For each of the
(i) Growth; and
(ii) Maturity stages of the new products life cycle
explain the likely changes that will occur in the unit selling prices AND in the unit
production costs, compared to the preceding stage.
(Total = 10 marks)
B1 23 TQM and JIT (CIMA P1 Pilot Paper 2005)
Give FOUR reasons why the adoption of Total Quality Management (TQM) is
particularly important within a Just-in-Time (JIT) production environment.
(5 marks)
B1 24 Standard costing (CIMA P1 May 2006)
Briefly discuss three reasons why standard costing may not be appropriate in a modern
business environment.
(5 Marks)
B1 25 Marginal v throughput (CIMA P1 May 2006)
Compare and contrast marginal costing and throughput accounting.
(5 Marks)
B1 26 MRPS (CIMA P1 May 2007)
Briefly explain the role of a Manufacturing Resource Planning System in supporting a
standard costing system.
(5 Marks)
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Questions Section B
Part B Cost Planning and Analysis for Competitive Advantage
B2 -1 The Q organisation (CIMA P2 May 2005)
(a) The Q organisation is a large, worldwide respected manufacturer of consumer
electrical and electronic goods. Q constantly develops new products that are in high
demand as they represent the latest technology and are must haves for those consumers
that want to own the latest consumer gadgets. Recently Q has developed a new handheld
digital DVD recorder and seeks your advice as to the price it should charge for such a
technologically advanced product.
Required:
Explain the relevance of the product life cycle to the consideration of alternative pricing
policies that might be adopted by Q.
(10 marks)
(b) Market research has discovered that the price demand relationship for the item during
the initial launch phase will be as follows:
Price ()
100
80
69
62
Demand (units)
10,000
20,000
30,000
40,000
Production of the DVD recorder would occur in batches of 10,000 units, and the
production director believes that 50% of the variable manufacturing cost would be
affected by a learning and experience curve. This would apply to each batch produced
and continue at a constant rate of learning up to a production volume of 40,000 units
when the learning would be complete. Thereafter, the unit variable manufacturing cost of
the product would be equal to the unit cost of the fourth batch. The production director
estimates that the unit variable manufacturing cost of the first batch would be 60 (30 of
which is subject to the effect of the learning and experience curve, and 30 of which is
unaffected), whereas the average unit variable manufacturing cost of all four batches
would be 52.71.
There are no non-manufacturing variable costs associated with the DVD recorder.
Required:
(i) Calculate the rate of learning that is expected by the production director.
(4 marks)
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(ii) Calculate the optimum price at which Q should sell the DVD recorder in order to
maximise its profits during the initial launch phase of the product.
(8 marks)
(iii) Q expects that after the initial launch phase the market price will be 57 per unit.
Estimated product specific fixed costs during this phase of the products life are expected
to be 15,000 per month. During this phase of the product life cycle Q wishes to achieve
a target monthly profit from the product of 30,000.
Calculate the number of units that need to be sold each month during this phase in order
that Q achieves this target monthly profit.
(3 marks)
(Total = 25 marks)
8m
8,000
000
280
220
180
200
880
Cost driver
See Note 2
Size of package see Note 3
Number of deliveries see Note 4
Number of orders
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Notes:
1. Each order will be shipped in one package and will result in one delivery to the
customer and one invoice (an order never results in more than one delivery).
2. Each invoice has a different line for each drug ordered. There are 28,000 invoice
lines each year. It is estimated that 25% of invoice processing costs are related to
the number of invoices, and 75% are related to the number of invoice lines.
3. Packing costs are 32 for a large package, and 25 for a small package.
4. The delivery vehicles are always filled to capacity for each journey. The delivery
vehicles can carry either 6 large packages or 12 small packages (or appropriate
combinations of large and small packages). It is estimated that there will be 1,000
delivery journeys each year, and the total delivery mileage that is specific to
particular customers is estimated at 350,000 miles each year. 40,000 of delivery
costs are related to loading the delivery vehicles and the remainder of these costs
are related tospecific delivery distance to customers.
The management has asked for two typical orders to be costed using next years budget
data, using the current method, and the proposed activity-based costing approach. Details
of two typical orders are shown below:
Lines on invoice
Package size
Specific delivery distance
List price of drugs supplied
Order A
2
small
8 miles
1,200
Order B
8
large
40 miles
900
Required:
(a) Calculate the charge for selling and distribution overheads for Order A and Order B
using:
(i) the current system; and
(ii) the activity-based costing approach.
(10 marks)
(b) Write a report to the management of F plc in which you
(i) assess the strengths and weaknesses of the proposed activity-based costing
approach for F plc; and
(5 marks)
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(ii) recommend actions that the management of F plc might consider in the light of
the data produced using the activity-based-costing approach.
(5 marks)
(Total = 20 marks)
B2 3 KL (CIMA P2 Nov 2006)
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)
W
15,000
X
24,000
Y
20,000
Direct materials
Direct labour ($10 per hour)
$ per unit
35
40
$ per unit
45
30
$ per unit
30
50
In addition to the above direct costs, KL incurs annual indirect production costs of
$1,044,000.
Required:
(b) Calculate the full cost per unit of each product using KLs current method of
absorption costing.
(4 marks)
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Cost driver
Number of supplier orders
Number of batches
Number of machine hours
Number of machine hours
W
5
500
4
X
8
400
3
Y
7
1,000
5
Required:
(c) Calculate the full cost per unit of each product using Activity Based Costing.
(8 marks)
(d) 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)
B2 4 Retail outlet (CIMA P2 Nov 2007)
A small retail outlet sells four main groups of products: Basic Foods (milk, bread, etc);
Newspapers & Magazines; Frozen Foods; and Canned Foods. A budgeted weekly profit
statement is shown below:
Sales revenue
Cost of sales
Gross margin
Power for freezers*
Overheads**
Net margin
Basic Foods
Newspapers
and Magazines
Frozen Foods
Canned Foods
$
800
600
200
$
1,000
700
300
$
2,400
1,200
1,200
100
100
100
200
$
1,500
550
950
100
200
650
400
800
*The freezers would be emptied and switched off as necessary during redecoration.
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**Overhead costs comprise general costs of heating and lighting, rent and rates, and other
general overhead costs. These costs are attributed to products in proportion to the floor
area occupied by each product group which is as follows:
Basic Foods
Floor area (m2)
50
Newspapers
and Magazines
50
Frozen Foods
Canned foods
100
200
For each product group, analysis has shown that the sales revenue achieved changes in
direct proportion to the floor space allocated to the product.
The owner of the retail outlet has decided that the premises need to be redecorated but is
undecided as to which of the following two options would be the most profitable.
Option 1
Close the retail outlet completely for four weeks while the redecoration takes place. The
company that is to complete the redecoration would charge $2,500 under this option. It is
expected that following the re-opening of the retail outlet there would be a loss of sales
for the next 12 weeks because customers would have had to find alternative suppliers for
their goods. The reduction in sales due to lost customers has been estimated to be 30% of
the budgeted sales during the first four weeks of reopening; 20% during the next four
weeks; and 10% during the third four weeks. In addition, in order to encourage customers
to return to the retail outlet, there would be a 10% price reduction on all Basic Foods and
Canned Foods for the entire 12 week period.
Option 2
Continue to open the retail outlet while the redecoration takes place but with a reduced
amount of floor area. The useable floor area would be reduced to 40% of that originally
available. After three weeks, the retail outlet would be closed for 05 weeks while the
goods are moved to the newly redecorated area. The retail outlet would then continue to
operate using 40% of its original floor area for a further three weeks before the work was
fully completed. The company that is to complete the redecoration would charge $3,500
under this option, and in addition there would be product movement costs of $1,000. The
owner has determined that in order to avoid losing customers there should be no
reduction in the amount of floor area given to Basic Foods and Newspapers and
Magazines throughout this period. The floor area to be used by Frozen Foods and Canned
Foods should be determined on the basis of their profitability per unit of area. However,
the Frozen Foods are presently kept in four freezers, and therefore any reductions in floor
area must be determined by complete freezer units. It may be assumed that each freezer
unit incurs equal amounts of power costs.
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Required:
(a) Advise the owner of the retail outlet which option to choose in order to minimise the
losses that will occur as a result of the decision. All workings must be shown.
(15 marks)
(b) Explain how Activity Based Costing may be used in a retail environment to improve
the decision making and profitability of the business.
(10 marks)
(Total = 25 marks)
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Questions Section A
Part C Budgeting and Management Control
C1 -1 Solicitors firm (CIMA P2 May 2010)
A firm of solicitors is using budgetary control during 2010. The senior partner estimated
the demand for the year for each of the firms four divisions: Civil, Criminal, Corporate,
and Property. A separate partner is responsible for each division.
Each divisional partner then prepared a cost budget based on the senior partners demand
estimate for the division. These budgets were then submitted to the senior partner for his
approval. He then amended them as he thought appropriate before issuing each divisional
partner with the final budget for the division. He did not discuss these amendments with
the respective divisional partners. Actual performance is then measured against the final
budgets for each month and each divisional partners performance is appraised by asking
the divisional partner to explain the reasons for any variances that occur.
The Corporate partner has been asked to explain why her staff costs exceeded the
budgeted costs for last month while the chargeable time was less than budgeted. Her
reply is below:
My own original estimate of staff costs was higher than the final budgeted costs shown
on my divisional performance report. In my own cost budget I allowed for time to be
spent developing new services for the firms corporate clients and improving the clients
access to their own case files. This would improve the quality of our services to clients
and therefore increase client satisfaction. The trouble with our present system is that it
focuses on financial performance and ignores the other performance indicators found in
modern performance management systems.
Required:
(a) Discuss the present budgeting system and its likely effect on divisional partner
motivation.
(6 marks)
(b) Explain two non-financial performance indicators (other than client satisfaction and
service quality) that could be used by the firm.
(4 marks)
(Total = 10 marks)
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DVD
Blu-ray
Sales
(players)
3,000
1,000
Selling price
(per player)
$75
$200
Standard cost
(per player)
$50
$105
The Managing Director has sent you a copy of an e-mail she received from the Sales
Manager. The content of the e-mail was as follows:
We have had an excellent month. There was an adverse sales price variance on the DVDs
of $18,000 but I compensated for that by raising the price of Blu-ray players. Unit sales
of DVD players were as expected but sales of the Blu-rays were exceptional and gave a
total sales volume profit variance of $19,000. I think I deserve a bonus!
The Managing Director has asked for your opinion on these figures. You obtained the
following information:
Actual results for April were:
DVD
Blu-ray
Sales
(players)
3,000
1,200
Selling price
(per player)
$69
$215
The total market demand for DVD players was as budgeted but as a result of distributors
reducing the price of Blu-ray discs the total market for Blu-ray players grew by 50% in
April.
The company had sufficient capacity to meet the revised market demand for 1,500 units
of its Blu-ray players and therefore maintained its market share.
Required:
(a) Calculate the following operational variances based on the revised market details:
(i) The total sales mix profit margin variance
(2 marks)
(ii) The total sales volume profit variance
(2 marks)
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(b) Explain, using the above scenario, the importance of calculating planning and
operational variances for responsibility centres.
(6 marks)
(Total = 10 marks)
C1 5 SFG (CIMA P2 May 2011)
SFG is a national hotel group that operates more than 100 hotels. The performance of the
manager of each hotel is evaluated using financial measures.
Many of the hotels managers are not happy. They believe that there can be conflict
between good performance and achieving short-term profits. They are also unhappy that
their profit reports include a share of head office costs and other costs that they cannot
control.
Required:
(a) Explain why non-financial performance measures are important in the service sector.
(2 marks)
(b) Recommend, with reasons, TWO non-financial performance measures that SFG could
use to evaluate the performance of the hotel managers.
(4 marks)
(c) Explain why, and how, non-controllable costs should be shown on the profit reports.
(4 marks)
(Total = 10 marks)
C1 6 Feedback and feedforward (CIMA P1 Pilot Paper 2005)
Briefly outline the main features of feedback control, and the feedback loopand
explain how, in practice, the procedures of feedback control can be transformed into
feed-forward control.
(5 marks)
C1 7 Profit centre managers (CIMA P1 Pilot Paper 2005)
(c) Briefly outline the advantages and disadvantages of allowing profit centre managers
to participate actively in the setting of the budget for their units.
(5 marks)
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Output of product M
Wage rate
Labour hours
Budget
600 units
30 per hour
900 hours
Actual
680 units
32 per hour
1,070 hours
It has now been established that the standard wage rate should have been 31.20 per
hour.
Required:
(i) Calculate the labour rate planning variance and calculate the operational labour
efficiency variance.
(ii) Explain the major benefit of analysing variances into planning and operational
components.
(5 marks)
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Selling price
Material FX: 1.5kg @ 6 per kg
Conversion costs (variable)
Fixed production overheads
40
9
8
15
The fixed production overhead absorption rate is based on annual production overheads
of 720,000 and budgeted annual output of 48,000 units. The fixed overheads will be
incurred evenly throughout the year.
The company also incurs fixed costs for administration of 200,000 per year.
Budgeted Sales
Quarter
1
2
3
4
Units
10,000
12,000
14,000
12,000
Inventory
It has been decided that inventory levels are to be reduced. Details are as follows:
Finished goods: 5,500 units are currently held but it has been decided that the closing
inventories for Quarters 1, 2 and 3 will be 45%, 40% and 35% of the following quarters
sales respectively.
Raw materials: 4,500 kg are currently held but it has been decided that the closing
inventories for Quarters 1 and 2 will be 25% and 20% of the followingquarters
production requirements respectively.
Required:
(a) Prepare a materials purchase budget for Quarter 1.
(5 Marks)
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Patient days
House-keeping costs
Nursing costs
Administration costs
Index
90
106
105
104
125,000
324,000
100,000
Nursing costs are semi-variable. The nursing costs for Period 2 were adjusted from the
total nursing costs of 280,000 for Period 1 by using a Patient days index of 125 and a
Nursing costs index of 108.
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Required:
Prepare the budget for Period 3.
(5 marks)
C1 21 Participative budgeting (CIMA P1 May 2008)
Explain THREE behavioural consequences that may result after the introduction of
participative budgeting.
(5 marks)
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Questions Section B
Part C Budgeting and Management Control
C2 -1 M plc (CIMA P1 May 2006)
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.
Budget Actual
6,400
7,140
$
$
51,970 58,227
224,000 205,000
23,040 24,100
62,060 112,340
361,070 399,667
Variance
$
6,257
19,000
1,060
50,280
38,597
Adverse
Favourable
Adverse
Adverse
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. 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.
2. 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.
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3. 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
5,000
$54,500
7,500
$76,500
10,000
$90,000
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Sales
The forecast sales for the first four months are as follows:
Month
Number of
components
1
1,500
2
1,750
3
2,000
4
2,100
The selling price has been set at 10 per component in the first four months.
Sales receipts
Time of payment
Month of sale
One month later
Two months later
Three months later
% of customers
20*
45
25
5
1.90
3.30
1.20
6.40
Notes:
Direct materials: 100% of the materials required for production will be purchased in the
month of production. No inventory of materials will be held. Direct materials will be paid
for in the month following purchase.
Direct wages will be paid in the month in which production occurs.
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Variable production overheads: 60% will be paid in the month in which production
occurs and the remainder will be paid one month later.
Fixed overhead costs
Fixed overhead costs are estimated at 75,000 per annum and are expected to be incurred
in
equal amounts each month. 60% of the fixed overhead costs will be paid in the month in
which they are incurred and 30% in the following month. The balance represents
depreciation of fixed assets.
Calculations are to be made to the nearest 1.
Ignore VAT and Tax.
Required:
(a) Prepare a cash budget for each of the first three months and in total.
(15 marks)
(b) There is some uncertainty about the direct material cost. It is thought that the direct
material cost per component could range between 1.50 and 2.20.
Calculate the budgeted total net cash flow for the three month period if the cost of the
direct material is:
(i) 1.50 per component; or
(ii) 2.20 per component.
(6 marks)
(c) Using your answers to part (a) and (b) above, prepare a report to the management of
RF Ltd that discusses the benefits or otherwise of performing what if analysis when
preparing cash budgets.
(9 marks)
(Total = 30 marks)
C2 3 Trackit (CIMA P1 May 2008)
Q, a new company, is being established to manufacture and sell an electronic tracking
device: the Trackit. The owners are excited about the future profits that the business will
generate. They have forecast that sales will grow to 2,600 Trackits per month within five
months and will be at that level for the remainder of the first year.
The owners will invest a total of $250,000 in cash on the first day of operations (that is
the first day of Month 1). They will also transfer non-current assets into the company.
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Trackits
(units)
1,000
1,500
2,000
2,400
2,600
% of sales value
15 *
25
40
15
Month 2
1,650
Month 3
2,120
Month 4
2,460
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Direct materials: Payment for purchases will be made in the month following receipt.
There will be no opening inventory of materials in Month 1. It will be company policy to
hold inventory at the end of each month equal to 20% at of the following months
production requirements. The direct materials cost includes the cost of an essential
component that will be bought in from a specialist manufacturer.
Direct wages will be paid in the month in which the production occurs.
Variable production overheads: 65% will be paid in the month in which production
occurs and the remainder will be paid one month later.
Fixed overhead costs
Fixed overheads are estimated at $840,000 per annum and are expected to be incurred in
equal amounts each month. 60% of the fixed overhead costs will be paid in the month in
which they are incurred and 15% in the following month. The balance represents
depreciation of non-current assets.
Ignore VAT and Tax
Required:
(a) Prepare a cash budget for each of the first three months and for that three-month
period in total.
(14 marks)
(b) There is some uncertainty about the cost of the specialist component (this is included
in the direct material cost). It is thought that the cost of the component could range
between $32 and $50 per Trackit. It is currently included in the cost estimates at $40 per
Trackit.
Calculate the budgeted total net cash flow for the three-month period in total if the cost of
the component was:
(i) $32
(ii) $50
(6 marks)
(c) Prepare a report for the owners of Q that offers advice about the profitability of their
business and the situation revealed by the extracts from the business plan and your
answers to (a) and (b) above.
(10 marks)
(Total = 30 marks)
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(b) X Plc has just been informed that Material A may be in short supply during the year
for which it is preparing budgets. Discuss the impact this will have on budget preparation
and other areas of X Plc.
(5 marks)
(c) Assuming that the budgeted production of Product W was 7,700 units and that the
following actual results were incurred for labour and overheads in the year:
Actual production
7,250 units
Actual overheads
Variable
Fixed
185,000
105,000
568,750
332,400
Prepare a flexible budget statement for X Plc showing the total variances that have
occurred for the above four costs only.
(5 marks)
(d) X Plc currently uses incremental budgeting. Explain how Zero Based Budgeting
could overcome the problems that might be faced as a result of the continued use of the
current system.
(5 marks)
(e) Explain how rolling budgets are used and why they would be suitable for X Plc.
(5 marks)
(Total = 25 marks)
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Questions Section A
Part D Control and Performance Measurement of Responsibilty Centres
D1 -1 EVA and RI (CIMA P2 Pilot paper 2005)
Explain and discuss the similarities and differences between Residual Income and
Economic Value Added as methods for assessing the performance of divisions.
(5 marks)
D1 2 Controllability principle (CIMA P1 Pilot Paper 2005)
Define the controllability principle and give arguments for and against its
implementation in determining performance measures.
(5 marks)
D1 3 Transfer pricing (CIMA P1 Pilot Paper 2005)
Discuss the problems that arise specifically when determining transfer prices where
divisions are located in different countries.
(5 marks)
D1 4 EVA (CIMA P1 May 2005)
(i) Briefly explain the main features of Economic Value Added (EVA) as it would be
used to assess the performance of divisions.
(2 marks)
(ii) Briefly explain how the use of EVA to assess divisional performance might affect
the behaviour of divisional senior executives.
(3 marks)
D1 5 WD, PD & TD (CIMA P1 May 2005)
C plc is a large company that manufactures and sells wooden garden furniture. It has
three divisions:
The Wood Division (WD) purchases logs and produces finished timber as planks or
beams. Approximately two-thirds of its output is sold to the Products Division, with the
remainder sold on the open market.
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The Products Division (PD) manufactures wooden garden furniture. The policy of C plc
is that the PD must buy all its timber from the WD and sell all its output to the Trading
Division.
The Trading Division (TD) sells wooden garden furniture to garden centres, large
supermarkets, and similar outlets. It only sells items purchased from PD.
The current position is that all three divisions are profit centres and C plc uses Return on
Investment (ROI) measures as the primary means to assess divisional performance. Each
division adopts a cost-plus pricing policy for external sales and for internal transfers
between divisions. The senior management of C plc has stated that the divisions should
consider themselves to be independent businesses as far as possible.
(i) For each division suggest, with reasons, the behavioural consequences that might arise
as a result of the current policy for the structure and performance evaluation of the
divisions.
(5 marks)
(ii) The senior management of C plc has requested a review of the cost-plus transfer
pricing policy that is currently used.
Suggest with reasons, an appropriate transfer pricing policy that could be used for
transfers from PD to TD, indicating any problems that may arise as a consequence of the
policy you suggest.
(5 marks)
D1 6 G group (CIMA P1 May 2007)
G Group consists of several autonomous divisions. Two of the divisions supply
components and services to other divisions within the group as well as to external clients.
The management of G Group is considering the introduction of a bonus scheme for
managers that will be based on the profit generated by each division.
Required:
Briefly explain the factors that should be considered by the management of G
Groupwhen designing the bonus scheme for divisional managers.
(5 marks)
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Goal
Technology Leadership
Support
Required:
(a) For the Innovation Perspective of the Division, recommend a performance measure
and briefly explain how the measure will reflect the achievement of the stated goal.
(3 marks)
(b) For the Customer Perspective of the Division, state which data should be collected
and explain how this could be used to ensure the goal of support is met.
(2 marks)
(c) Explain THREE reasons why internal benchmarking may provide information that is
more useful to the Manager of the Photographic Division, in terms of monitoring and
improving performance, than that provided by external benchmarking.
(5 marks)
(d) Explain THREE reasons why ROI may not be a good performance measure.
(5 marks)
(Total = 15 marks)
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Questions Section B
Part D Control and Performance Measurement of Responsibilty Centres
D2 -1 Y and Z (CIMA P1 Nov 2005)
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
Z
000
555
312
243
42
460
338
122
201
180
21
976m
126m
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:
(a) 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)
(b) 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)
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(c) 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 = 20 marks)
D2 2 FP (CIMA P1 May 2006)
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
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
Fixed overheads
at cost
15 per hour
10 per labour hour
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.
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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) The repairs are carried out by the Service Department and are charged at full cost
plus 40%;
(ii) The repairs are carried out by the Service department and are charged at marginal
cost;
(iii)The repairs are carried out by RS.
(8 marks)
(b)
(i) Explain, with reasons, why a full cost plus transfer pricing model may not be
appropriate for FP.
(3 marks)
(ii) Comment on other issues that the managers of FP should consider if they decide
to allow RS to carry out the repairs.
(4 marks)
(c) Briefly explain the advantages and disadvantages of structuring the departments as
profit centres.
(5 marks)
(Total = 20 marks)
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70,000
50,000
20,000
15,000
5,000
Production/Sales (units)
5,000 (3,000 of which are transferred to Division Y)
External demand (units)
3,000 (Only 2,000 of which can be currently satisfied)
Capacity (units)
5,000
External market price per unit
20
Balance sheet extract
Capital employed
60,000
Other information
Cost of capital charge
10%
Division Y
Income statement
Sales
Cost of sales
Variable costs
Contribution
Fixed costs (controllable)
Profit
Production/Sales (units)
Capacity (units)
Market price per unit
270,000
114,000
156,000
100,000
56,000
3,000
7,000
90
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Division Y
Balance sheet extract
Capital employed
110,000
Other information
Cost of capital charge
10%
Four measures are used to evaluate the performance of the Divisional Managers. Based
on the data above, the budgeted performance measures for the two divisions are as
follows:
Residual income
Return on capital employed
Operating profit margin
Asset turnover
Division X
(1,000)
833%
714%
117
Division Y
45,000
5091%
2074%
246
Current policy
It is the current policy of the group for C to be transferred to Division Y at the marginal
cost of 10 per component and that Y must buy all the components that it needs from X.
Proposed policy
ZZ Group is thinking of giving the Divisional Managers the freedom to set their own
transfer price and to buy the components from external suppliers but there are concerns
about problems that could arise by granting such autonomy.
Required:
(a) If the transfer price of the component is set by the Manager of Division X at the
current market price (20 per component), recalculate the budgeted performance
measures for each division.
(8 marks)
(b) Discuss the changes to the performance measures of the divisions that would arise
as a result of altering the transfer price to 20 per component.
(6 marks)
(c)
(i) Explain the problems that could arise for each of the Divisional Managers and for
ZZ Group as a whole as a result of giving full autonomy to the Divisional
Managers.
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(ii) Discuss how the problems you have explained could be resolved without resorting
to a policy of imposed transfer prices.
(6 marks)
(Total = 20 marks)
D2 4 Computer manufacturer (CIMA P1 Nov 2007)
A multinational computer manufacturer has a number of autonomous subsidiaries
throughout the world. Two of the groups subsidiaries are in America and Europe. The
American subsidiary assembles computers using chips that it purchases from local
companies. The European subsidiary manufactures exactly the same chips that are used
by the American subsidiary but currently only sells them to numerous external companies
throughout Europe.
Details of the two subsidiaries are given below.
America
The American subsidiary buys the chips that it needs from a local supplier. It has
negotiated a price of $90 per chip. The production budget shows that 300,000 chips will
be needed next year.
Europe
The chip production subsidiary in Europe has a capacity of 800,000 chips per year.
Details of the budget for the forthcoming year are as follows:
Sales
600,000 chips
$ per chip
Selling price
105
Variable costs
60
The fixed costs of the subsidiary at the budgeted output of 600,000 chips are $20 million
per year but they would rise to $26 million if output exceeds 625,000 chips.
Note: The maximum external demand is 600,000 chips per year and the subsidiary has no
other uses for the current spare capacity.
Group Directive
The Managing Director of the group has reviewed the budgets of the subsidiaries and has
decided that in order to improve the profitability of the group the European subsidiary
should supply chips to the American subsidiary. She is also thinking of linking the
salaries of the subsidiary managers to the performance of their subsidiaries but is unsure
which performance measure to use.
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Two measures that she is considering are profit and the return on assets consumed
(where the annual fixed costs would be used as the assets consumed).
The Manager of the European subsidiary has offered to supply the chips at a price of $95
each. He has offered this price because it would earn the same contribution per chip that
would be earned on external sales (this is after adjusting for increased distribution costs
and reduced customer servicing costs).
Required:
(a) Assume that the 300,000 chips are supplied by the European subsidiary at a transfer
price of $95 per chip. Calculate the impact of the profits on each of the subsidiaries and
the group. (5 marks)
(b) Calculate the minimum unit price at which the European subsidiary would be willing
to transfer the 300,000 chips to the American subsidiary if the performance and salary of
the Manager of the subsidiary is to be based on
(i) the profit of the subsidiary (currently $7 million)
(ii) the return on assets consumed by the subsidiary (currently 35%).
(9 marks)
(c) Write a report to the Managing Director of the group that discusses issues raised by
the directive and the introduction of performance measures. (You should use your
answers to parts (a) and (b), where appropriate, to illustrate points in your report).
(10 marks)
(d) Briefly explain how multi-national companies can use transfer pricing to reduce their
overall tax charge and the steps that national tax authorities have taken to discourage the
manipulation of transfer prices.
(6 marks)
(Total = 30 marks)
D2 5 Perfumes and cosmetics (CIMA P2 May 2010)
H manufactures perfumes and cosmetics by mixing various ingredients in different
processes, before the items are packaged and sold to wholesalers. H uses a divisional
structure with each process being regarded as a separate division with its own manager
who is set performance targets at the start of each financial year which begins on 1
January. Performance is measured using Return on Investment (ROI) based on net book
value of capital equipment at the start of the year. The company depreciates its capital
equipment at the rate of 20% per annum on a reducing balance basis.
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The annual depreciation is calculated at the start of the financial year and one-twelfth of
this annual amount is included as monthly depreciation in the fixed overhead costs of
each process. Output transferred from one process to another is valued using transfer
prices based on the total budgeted costs of the process plus a mark-up of 15%.
Process B
This is the first process. Raw materials are blended to produce three different outputs,
two of which are transferred to Processes C and D respectively. The third output is
accounted for as a by-product and sold in the external market without further processing.
The equipment used to operate this process originally cost $800,000 on 1 January 2005.
The Process B account for April 2010 was as follows:
Litres
Opening WIP NIL
Material W 10,000
Material X
5,000
Material Y
12,000
Direct labour
Overhead
Profit & Loss
Totals
27,000
$
NIL
25,000
10,000
24,000
30,000
75,000
18,800
182,800
Litres
Normal Loss 3,000
By-product 5,000
Output to C 9,000
Output to D 10,000
Closing WIP NIL
$
3,000
5,000
82,800
92,000
NIL
Totals
182,800
27,000
The material costs are variable per unit of input and direct labour costs are fixed in the
short term because employees contracts provide them with a six month notice period.
Overhead costs include a share of Head Office costs, and of the remaining overhead costs
some vary with the input volume of the process. The level of activity in April 2010 was
typical of the monthly volumes processed by the company.
Process C
This process receives input from Process B to which is added further materials to produce
a finished product that is sold in the external market at the budgeted selling price of $20
per litre. The equipment used to operate this process originally cost $500,000 on 1
January 2008.
The Process C account for April 2010 was as follows:
Litres
Opening WIP 1,000
Input from B 9,000
Material Z
3,000
Direct labour
Overhead
$
11,200
82,800
15,000
20,000
50,000
Totals
179,000
13,000
Normal Loss
Abnormal Loss
Output
Closing WIP
Litres
3,000
1,500
7,500
1,000
$
1,500
750
150,000
11,200
13,000
15,550
179,000
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The material costs are variable per unit of input and direct labour costs are fixed in the
short term because employees contracts provide them with a six month notice period.
Overhead costs include a share of Head Office costs, and of the remaining overhead costs
some vary with the input volume of the process. The level of activity that occurred in
April 2010 was typical of the monthly volumes processed by the company, and the
opening and closing work in process are identical in every respect. The process is
regarded as an investment centre and completed output and losses are valued at their
selling prices. The manager of Process C is concerned at the level of output achieved
from the input volume and is considering investing in new equipment that should
eliminate the abnormal loss. This would involve investing $1,000,000 in new processing
equipment on 1 January 2011; the existing equipment would be sold on the same date at a
price equal to its net book value.
Process D
This process receives input from Process B which is further processed to produce a
finished product that is sold in the external market at the budgeted selling price of $16 per
litre. The equipment used to operate this process originally cost $300,000 on 1 January
2000.
The Process D account for April 2010 was as follows:
Litres
Opening WIP 1,000
Input from B 10,000
Direct labour
Overhead
Totals
11,000
$
5,500
92,000
30,000
30,000
157,500
Normal Loss
Output
Closing WIP
Profit & Loss
Totals
Litres
1,000
9,000
1,000
11,000
$
3,000
144,000
5,500
5,000
157,500
Direct labour costs are fixed in the short term because employees contracts provide them
with a six month notice period. Overhead costs include a share of Head Office costs, and
of the remaining overhead costs some vary with the input volume of the process. The
level of activity in April 2010 was typical of the monthly volumes processed by the
company, and the opening and closing work in process are identical in every respect. The
process is regarded as an investment centre and completed output and losses are valued at
their selling prices. The manager of Process D believes that the transfer price from
Process B is unfair because the equivalent material could be purchased in the open
market at a cost of $7.50 per litre.
Required:
(a)
(i) Calculate the annualised Return on Investment (ROI) achieved by each of the process
divisions during April 2010.
(4 marks)
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(ii) Discuss the suitability of this performance measure in the context of the data provided
for each process division.
(4 marks)
(b)
(i) Calculate the effect on the annualised Return on Investment in 2011 of Process
Division C investing in new capital equipment.
(4 marks)
(ii) Discuss the conflict that may arise between the use of NPV and ROI in this
investment decision.
(4 marks)
(c) Discuss the transfer pricing policy being used by H from the viewpoints of the
managers of Process Division B and Process Division D.
(9 marks)
(Total = 25 marks)
D2 6 SWZ (CIMA P2 Nov 2010)
SWZ is a manufacturing company that has many trading divisions. Return on Investment
(ROI) is the main measure of each divisions performance. Each divisional managers
salary is linked only to their divisions ROI.
The following information summarises the financial performance of the S division of
SWZ over the last three years:
Year ending 31 October
Turnover
Cost of sales
Gross profit
Other operating costs
Pre-tax operating profit
2008
$000
400
240
160
120
40
2009
$000
400
240
160
104
56
2010
$000
400
240
160
98
62
400
320
256
Other operating costs include asset depreciation calculated at the rate of 20% per annum
on a reducing balance basis.
The figures shown in the above table for the capital invested as at the end of the year is
the net book value of the divisions fixed assets.
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All of the above values have been adjusted to remove the effects of inflation. There have
been no additions or disposals of fixed assets within the S division during this period.
Required:
(a) Discuss the performance of the S division over the three year period.
(9 marks)
The manager of the S division is now considering investing in a replacement machine.
The machine that would be replaced would be sold for its net book value which was
$40,000 at 31 October 2010 and the new machine would cost $100,000. The new
machine would have an expected life of five years and would be depreciated using the
same depreciation rates as the existing machinery. The new machine would reduce the
divisions cost of sales by 10%. At the end of five years it would be sold for its net book
value.
The divisional cost of capital is 8% per annum. The company has evaluated the
investment and correctly determined that it has a positive Net Present Value (NPV) of
$24,536.
Required:
(b) Prepare calculations to show why the manager of the S division is unlikely to go
ahead with the investment. Ignore taxation.
(11 marks)
(c) Prepare calculations to show how the use of Residual Income (RI) as the performance
measure would have led to a goal congruent decision by the manager of the S division in
relation to the purchase of the replacement machine. Ignore taxation.
(5 marks)
(Total = 25 marks)
D2 7 DE company (CIMA P2 May 2011)
The DE Company has two divisions. The following statement shows the performance of
each division for the year ended 30 April 2011:
Sales
Variable cost
Contribution
Fixed costs
Operating profit
D
$000
500,200
380,400
119,800
30,000
89,800
E
$000
201,600
140,000
61,600
20,000
41,600
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Division E manufactures just one type of component. It sells the components to external
customers and also to Division D. During the year to 30 April 2011, Division E operated
at its full capacity of 140,000 units. The transfer of 70,000 units to Division D satisfied
that divisions total demand for that type of component. However the external demand
was not satisfied. A further 42,000 components could have been sold to external
customers by Division E at the current price of $1,550.
The current policy of the DE Company is that internal sales should be transferred at their
opportunity cost. Consequently during the year, some components were transferred to
Division D at the market price and some were transferred at variable cost.
Required:
(a) Prepare an analysis of the sales made by Division E that shows clearly, in units and
in $, the internal and external sales made during the year.
(3 marks)
(b) Discuss the effect of possible changes in external demand on the profits of Division
E, assuming the current transfer pricing policy continues.
(6 marks)
Division E is considering investing in new equipment which would reduce its unit
variable costs by 20% and increase its capacity by 10% for each of the next five years.
The capital cost of the investment is $120m and the equipment would have no value after
five years. The DE company and its divisional managers evaluate investments using net
present value (NPV) with an 8% cost of capital.
External annual demand for the next five years will continue to be 112,000 components
at $1,550 each but the DE Company will insist that the internal annual demand for 70,000
components must be satisfied.
Required:
(c) Assuming that the current transfer pricing policy continues:
(i) Evaluate the investment from the perspective of the manager of Division E.
(6 marks)
(ii) Evaluate the investment from the perspective of the DE Company.
(4 marks)
Note: Ignore inflation and taxation.
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(d) Explain TWO factors that should be considered when designing divisional
performance measures.
(6 marks)
(Total = 25 marks)
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Solutions Section A
Part A Pricing and Product Decisions
A1 1 EXE (CIMA P2 Pilot Paper 2005)
Relevant costs
Steel
Brass fittings
Skilled labour
Semi skilled labour
Overheads
Estimating time
Administration O/H
Profit
Selling price
Workings
W1
W2
W3
W4
W5
W6
W7
W8
$
55.00
20.00
300.00
Nil
7.50
Nil
382.50
Nil
Nil
382.50
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W4 Semi-skilled labour
The cost for semi-skilled labour should be zero as we currently have surplus staff that we
can use on this job.
W5 Overheads
The overheads are fixed and therefore ignored, but the machine power costs will be
incurred as a result of this job, and so therefore we should include these costs. $0.75 x
10hrs = $7.50.
W6 Estimating time
The cost of the estimating has already been spent and so should not be included. It is a
sunk cost.
W7 Administration overheads
These costs are ignored as they are not incurred as result of this job.
W8 Profit
The profit mark up should be ignored as we are working out the lowest possible quote for
this job.
A1 2 MNP (CIMA P2 May 2005)
Part (a)
Joint products are when two or more products are produced from the same process.
Shared costs at the split-off point are called common costs.
The basis used to apportion the common costs between M, N and P is litres produced.
This can be seen by the fact that we are left with the same value per litre of $5.68 when
we divide the respective values and litres of products M, N and P.
It is fair to use this method as outputs are in litres and the results will be truly reflective
of costs apportioned.
Costs of the complete process are apportioned between the joint products only (never byproducts) for stock valuation, pricing or profitability purposes.
Part (b)
Viability means whether or not it is profitable, if it is viable it means that it is profitable
and if it is not viable it means that it is not profitable.
Sales from M, N and P
= ($6.25 x 25,000) + ($5.20 x 15,000) + ($6.80 x 45,000) = $540,250
104 | P a g e
Extra revenue
$8.40 - $6.25 = $2.15
$6.45 $5.20 = $1.25
$7.45 - $6.80 = $$0.65
Extra cost
$1.75
$0.95
$0.85
Net benefit
$0.40
$0.30
($0.20)
The optimal processing plan is to make products M and N further as they yield further
profits, but not product P as it yields a further loss. Product P should be sold just after the
common process.
A1 3 VBJ (CIMA P2 May 2005)
Relevant costs
Coach
Fuel
Driver
Hotel
Cost of quote
General overheads
Total
Workings
W1
W2
W3
W4
W5
W6
$
360
1,500
4,000 or 800
5,000
Nil
Nil
10,860 or 7,660
Workings
W1 Coach
If we were to go ahead with this contract we would need to obtain a replacement coach to
cover existing obligations. If this is ignored then we lose contribution and incur
significant penalties on existing obligations.
Replacement coach costs = $180 x 2 days = $360 or if we dont honour our current
obligations then we would lose contribution of $250 x 2 days = $500.
It is cheaper to hire replacement coach for $360.
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W2 Fuel
We need to spend $1,500 on fuel costs for this new contract.
W3 Driver
We need to hire a replacement driver for the 10 days of the new contract to cover current
obligations. Therefore $400 x 10 days = $4,000.
An alternativie way of looking at this is that the coach in any event will not be used for 8
days and so therefore ther is no need to hire a driver for 10 days as he will not be used.
Instead hire a driver for 2 days when he will be used for the coach. Therefore $400 x 2
days = $800.
W4 Hotel
This a specific cost for the new contract of $5,000.
W5 Cost of quote
The cost for preparing the quote of $250 has already been spent and so should not be
included.
W6 General overheads
These are to be ignored as they are not relevant to the quote.
A1 4 QXY plc (CIMA P2 Nov 2006)
Explanation of sales revenue line
The sales revenue line shows the amount of sales earned throughout the different level of
activities. It can be seen that between zero and somewhere between activity B and C there
is a constant rise or straight line increase in sales revenue. This means that the unit price
charged is the same and volume sold has been increasing at a constant rate.
Beyond the point between B and C sales revenue increases at much slower rate, this
indicates that selling price per unit is too high and in order to achieve previous rates of
growth there has to be a reduction in unit price.
Explanation of the fixed cost line
A fixed cost is a cost which cannot be easily identified or related to a cost per unit or
activity of any kind e.g. a cost which remains constant when the production of a good or
service within the organisation rises or falls.
Fixed cost over the long-term will normally display the characteristics of stepped cost
behaviour. That is the cost remains constant but only within a certain range of production.
Once this range of production is exceeded the fixed cost will rise.
106 | P a g e
In the diagram we can see that the fixed cost line is stepped. Between the zero activity
and up to activity level B fixed costs are constant. At zero activity fixed costs need to be
spent such as machinery and buildings in order to manufacture products.
If we were to increase our level of activity beyond level B there needs to be an increase in
fixed costs and then the costs are constant up to activity level D. There is another increase
in fixed costs at activity D when looking beyond this point and then the costs are constant
again.
These sudden stepped increases in fixed costs could be due to the factory reaching full
capacity and then extra leasehold expenses will need to be incurred in order to obtain
more buildings, if production is to increase or expand further.
Another example is supervisors salaries, they could be paid fixed salaries, but
supervision is limited to how many workers that can be supervised. Once the size of the
workforce exceeds a certain range another supervisor will need to be employed.
Explanation of total cost line
Total costs include both fixed costs and variable costs. Variable costs are costs that can
be easily identified or related to a cost per unit or activity level of some kind e.g. a
cost which rises or falls directly with the production/provision of a good or service within
an organisation. Examples could include labour piece work schemes e.g. a factory worker
that gets paid for each unit they make or the cost of material/components for the
production or assembly of a product.
All variable cost starts from the origin of the graph indicating the cost is nil if the activity
level is zero. Variable cost does not necessarily behave in a linear manner e.g. a constant
amount incurred for each unit of activity. It can behave in a curvilinear (non-linear)
manner as well, in which case the variable cost line would be curved not straight.
In the diagram it can be seen that at activity zero total cost is equal to fixed costs. At this
point there are no variable costs as there is no activity only fixed costs. Between activity
levels zero and B we can see that total cost line is increasing at constant level. The
constant increase is due to variable costs being incurred as a result of increasing activity.
Total costs increases in a stepped fashion at activity levels B and D because of the costs
behaviour of fixed costs as mentioned previously. It can be seen that variable costs are
increasing at the same constant rate within total costs up to activity level D, after this
point it can be seen that the total costs line increases more steeply. This is due to
increased variable costs per unit.
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Extra benefit
RZ
SZ
TZ
Extra variable
cost
$1.40
$0.90
1.00
Net
Nil
Nil
$600 / 1200 kg = $0.50
$1.60
($0.15)
$1.75
These recommendations are based purely on financial grounds and the company should
also look at qualitative factors as well before making their final decisions.
Part (b) (i)
Product
R
S
T
Selling price
$3
$5
$3.50
Kg
800
2,000
1,200
The common costs = $17,500. Therefore there would be a net loss of $900 if the
products R, S and T were sold to the external market. It is not financially viable.
Part (b) (ii)
If there is no external market for R, S and T then we must further process all these
products to produce RZ, SZ and TZ which can be sold.
Product
RZ
SZ
TZ
Kg
800
2,000
1,200
Total ($)
1,280
(300)
2,100
3,080
(900)
2,180
After further processing the products it now is financially viable as there is a net
benefit of $2,180.
A1 6 HS (CIMA P2 Nov 2007)
Part (a)
1. Determine the price function or demand function
The price or demand function formula is:
P = a - bq
P = Price
a = Price at which demand would be zero (i.e. the p when q=0)
b = The gradient of the demand curve
q = Quantity sold at that price (P)
109 | P a g e
P = 1,350
q = 8,000
b = 50 /100 = 0.05
a=?
In order to determine the price function we need to first find the value of a. Substitute
all known values into the price function formula to determine a.
1,350 = a 0.05 (8,000)
1,350 = a 400
1,350 + 400 = a
1,750 = a
Now we can construct the price function:
P = 1,750 0.05q
2. Determine the marginal revenue function (MR)
The MR function is the price function itself, but it will have twice the value of whatever
the b value is, within the price function.
Therefore:
MR = 1,750 2(0.05)q
MR = 1,750 0.1q
3. Determine the marginal cost function (MC)
Marginal cost is $270 being the direct material cost; however this does not include any
variable costs from labour and conversion costs. We need to use the high low method to
work this out.
High
Low
Difference
Units
9,400
7,300
2,100
$000
7,000
5,446
1,554
110 | P a g e
111 | P a g e
Option 2
The amount of business customers will increase by 1%.
Therefore the number of customers going forward = 1,000,000 x 1.10 = 1,100,000
Number of customers with a positive balance = 45% of 1,100,000 = 495,000
Interest paid to positive balance customers is nil
Number of customers with a negative balance = 55% of 1,100,000 = 605,000
Interest received from negative balance customers
= 20% of 4,000 x 605,000 = 484,000,000
Investment income is 3% of net position of customer balances
= 3% of ((605,000 x 4,000) (495,000 x 2,000)) = 40,900,000
Net income for the bank
= 484,000,000 + 40,900,000 = 524,900,000
Conclusion
The recommended course of action should be to continue with the excising bank account
structure.
A1 8 WX (CIMA P2 May 2011)
Part (a) (i)
The direct material and labour costs are completely variable. This can be determined by
dividing the combined costs of labour and material costs by the respective activity level
in the forecast, which will result in the same cost per unit at all activity levels.
For example at activity level 100,000 units material and labour costs added together are
$800,000, and therefore cost per unit = $8 per unit. This is the same rate at activity levels
160,000 and 200,000 units if you compare them with their respective combined material
and labour costs.
Overhead costs however are not completely variable and must be analysed between fixed
overheads and variable overheads.
We need to use the high-low method to find the variable overheads.
Units
200,000
100,000
100,000
114 | P a g e
115 | P a g e
It is difficult to ascertain the variable costs accurately without detailed knowledge of cost
curves this may not be available.
116 | P a g e
Solutions Section B
Part A Pricing and Product Decisions
A2 -1 TQ (CIMA P2 Pilot paper 2005)
Part (a) (i)
In order to work out the price when profits are maximised we need to construct the
demand function, from this we can derive the marginal revenue (MR) curve and equate
this to the marginal cost curve (MC) to obtain the profit max position. MR=MC.
We are given in the question that when x = 0 then P = $100 which is the maximum price.
If this is the case then we can work out a by using the demand function formula.
Therefore:
P = a bx
100 = a b(0)
100 = a 0
100 = a
We need to obtain another set of price and quantity to obtain the gradient or b value of
P = a bx, as the above set does not enable us to find it.
We are told that the selling price is $60 but not the quantity sold, but we are given fixed
overhead volume variances at this price. We can use these to obtain a quantity for this
price.
Fixed overhead volume variance
= (Actual production Budgeted production) x F/OH per unit
For each period we shall work out the actual units produced using the above formula.
This is to determine whether we have different actual units for each period and therefore
we would have a different demand function for each period as well.
Period 1
-1200 = (Actual production 520) x 10
-1,200 / 10 = Actual production 520
-120 + 520 = Actual production
400 = Actual production
117 | P a g e
Period 2
-1900 = (Actual production 590) x 10
-1900 / 10 = Actual production 590
-190 + 590 = Actual production
400 = Actual production
Period 3
-2600 = (Actual production 660) x 10
-2600 / 10 = Actual production 660
-260 + 660 = Actual production
400 = Actual production
We have the same actual units in each period of 400 and at price $60, this is quantity we
will sell.
We can now work out b.
P = a bx
60 = 100 b (400)
60 - 100 = -b (400)
-40 / 400 = -b
-0.1 = -b
0.1 = b
Therefore the demand function is P = 100 0.1x
MR = 100 2(0.1)x
MR = 100 0.2x
MC = budgeted variable costs = $25
Therefore profit max is when MR = MC
100 0.2x = 25
-0.2x = 25 100
-0.2x = -75
x = -75 / -0.2
x = 375
The quantity we would sell to maximize profits is 375 units.
The price for this quantity is P = 100 0.1 (375) = $62.50
118 | P a g e
REPORT
To:
From:
Subject:
Date:
Board of Directors of TQ
Management Accountant
Alternative pricing strategies
19th September 2003
1. Introduction
This report is designed to discuss the alternative pricing strategies available to TQ.
2. Market skimming
TQ can initially charge a high price, achieve low volume but earn a larger profit per unit
sold. This is known as market skimming. It is a strategy which exploits a price insensitive
market or an inelastic demand for a product.
TQ is selling a third generation mobile phone, it is a high technology product and as a
result there maybe an expectation by customers to pay a premium for these products.
TQs third generation phone is the first of its kind and customers will want to be the first
to enjoy it.
TQ could also use this approach as it is good for innovative high quality products where
little competition exists initially. Therefore a premium can be charged without reducing
demand for it too much.
There is always a choice of lowering the price later on when competition comes it to the
market with cheaper substitutes.
The market skimming approach also allows TQ to recover the significant levels of
development costs it had to spend on developing this phone and the fact that they have a
very short life cycle.
119 | P a g e
3. Market penetration
TQ can charge a very low price in order to capture a larger market share quicker, this is
known as market penetration.
This approach will aim to achieve a wide customer base as quickly as possible by setting
the price very low. It means that because if its affordability a lot of people will be able to
purchase it, as a result the first 2 stages are quickly achieved in the product life cycle and
also achieve economies of scale far quicker.
It will also be more difficult for other companies to enter the market as they would have
to compete on this low price and may struggle to make a profit.
4. Demand based approach
TQ could create a demand function much like that created from the second generation
phones in part (a). This would represent a straight line relationship between price charged
and quantity sold (P = a - bx) of the third generation phones, and allow us to find that
price that we can charge that would maximise profits (MR = MC).
The main problem with this is that the quality of the market research to determine the
demand function has to be very good, for it to have any real value.
It also assumes that price and quantity are the only factors in determining demand, but
TQ must be mindful of other factors which are just as important such as quality,
advertising, substitutes and brand loyalty. It is difficult to estimate the demand curve.
The demand function approach does give us a useful insight into the relationship between
price and quantity and a basis to predict what strategy to take. It makes an attempt to
incorporate demand into its calculations and is concerned with the marginal costs of
making decision ignoring irrelevant costs.
The demand function also allows us to see at what price and quantity we would maximise
profits and we can predict quantity sold given any selling price and vice versa.
I hope you have found this report useful but should you require any further assistance or
have any questions please do not hesitate to contact me.
Signed : Management Accountant.
120 | P a g e
TA ratio =
The above TA ratio can be used to assess the manager in terms of how well they have
done maximising contribution, whilst eliminating the build up of stock.
Such a technique is similar to limiting factor analysis, as managers try to improve their
TA Ratio they must concentrate on producing those products that generate the highest
contribution per bottleneck resource (or limiting factor) in order to optimise contribution
and therefore profit.
Traditionally when absorption costing was used, managers could improve results by
setting production levels higher than sales (therefore the carry forward of fixed overhead
this period to the next in the valuation of closing stock), however stock piling is not a
good thing and such stock piling will not improve performance if you use the TA Ratio.
121 | P a g e
Part (b)
We need to first identify the limiting factor and from the question it would seem it is only
ingredient L. Ingredient M may be limited but it has a substitute being V which has
unlimited supply. Having identified the limiting factor we must now work out the
contribution we earn from each of the meals, then the contribution per kg of L, and then
rank in order of production.
Selling price
Ingredient K
Ingredient L
Ingredient M
Throughput contribution
Kg of L used
Contribution per kg of L
Rank in order of production
TR
340
(150)
(70)
(30)
90
PN
450
(120)
(90)
(75)
165
BE
270
(90)
(40)
(45)
95
7kg
9kg
4kg
90/7kg = 12.86
165/9kg = 18.33
95/4kg = 23.75
Total ingredient L available is 7,000kg, however we must make a minimum order first of
50 batches for each type of meal. The ingredients used for this must be deducted before
working out the optimum production plan.
TR
PN
BE
Total
Minimum contract
50
50
50
Kg of L per batch
7
9
4
Ingredient L used
350kg
450kg
200kg
1,000kg
BE
PN
TR
L used
1,200
3,150
1,650
6,000
PN
BE
TR
Minimum contract
50
50
50
Production
350
300
236
Total
400
350
286
122 | P a g e
Part (c)
We need to interpret the linear programming solution that the computer has produced.
Objective function
This is 110,714 and is the maximum contribution that can be earned given the
constraints.
TR, PN and BE values
These are the amounts we should produce in order to maximise contribution. Therefore
we should make 500 batches of TR, 357 batches of PN and 71 batches of BE.
TR slack value
This is zero and represents the fact that we have produced up to the maximum demand of
TR, this being 500 batches. There is no shortfall in demand.
PN and BE slack values
These values represent the fact that we have not met our maximum demands for PN and
BE by 43 batches and 279 batches respectively. We are only producing 357 PNs and 71
BEs where our maximum demand is 400 and 350 batches respectively.
L and M values
These values represent shadow prices for ingredients L and M as they are both scarce
resources. Ingredient M is now also scarce because it says in the question that substitute
ingredient V is poisonous and therefore cannot be used.
The values show that for each kg of scarce resource we obtain at normal cost we can
expect to earn 3 of contribution for each kg of L and 28 contribution for each kg of M.
Ingredient K does not have a shadow price because it is not a scarce resource; we have
enough of K to produce our batches.
123 | P a g e
Consultants salary
Travel
Accommodation
Workings
W1
W2
W3
D
40,000
4,000
nil
44,000
E
140,000
7,000
8,000
155,000
F
60,000
4,000
3,000
67,000
Total
240,000
15,000
11,000
266,000
Workings
W1 - Consultants salary are direct costs for each client group, driven by chargeable
hours.
Total cost = 4 x 60,000 = 240,000
Chargeable hours = (100 x 10) + (700 x 5) + (300 x 5) = 6,000 hours
Rate per hour = 240,000 / 6,000 hours = 40 per hour
Cost for D = 40 x 100 x 10 = 40,000
Cost for E = 40 x 700 x 5 = 140,000
Cost for F = 40 x 300 x 5 = 60,000
W2 Travel cost driven by number of miles.
Number of total miles = (50 x 3 x 10) + (70 x 8 x 5) + (100 x 3 x 5) = 5,800 miles
Cost per mile = 15,000 / 5,800 miles = 2.59 per mile
Cost for D = 2.59 x 50 x 3 x 10 = 3,885
Cost for E = 2.59 x 70 x 8 x 5 = 7,252
Cost for F = 2.59 x 100 x 3 x 5 = 3,885
W3 Accommodation costs are driven by visits to clients in excess of 50 miles.
Therefore not applicable to client D as distance to their clients is less than 50 miles.
Number of qualifying visits = (8 x 5) + (3 x 5) = 55
Cost per visit = 11,000 / 55 = 200
Cost for E = 200 x 8 x 5 = 8,000
Cost for F = 200 x 3 x 5 = 3,000
124 | P a g e
Other costs
Office premises
Advertising
Telephone
Support staff
50,000
5,000
10,000
120,000
185,000
There is no obvious activity which directly drives these costs and therefore we must leave
them out of our calculations as they would not add any further benefit if they were
included.
Part (b)
Comparing the current system with the proposed ABC system
Chargeable hours
Current system (75p/hr)
ABC
Difference
D
1,000
75,000
44,000
31,000
E
3,500
263,000
155,000
108,000
F
1,500
113,000
67,000
46,000
Total
6,000
451,000
266,000
185,000
The difference is due to the unattributable costs of 185,000 as shown in part (a). We
need to obtain a cost driver for these other costs to make the above comparison more
meaningful.
We need to look at whether the same or similar figures can be arrived at by doing a rate
per chargeable hour on the total costs for ABC.
Blanket rate on chargeable hours = 266,000 / 6,000 hrs = 44.33p/hr
Chargeable hours
Blanket (44.33p/hr)
ABC
Difference
D
1,000
44,333
44,000
333
E
3,500
155,155
155,000
155
F
1,500
66,500
67,000
(500)
Total
6,000
265,988
266,000
(12)
It seems that ABC does not add much more value than the current system, as the current
system gives similar figures.
In conclusion ABC is theoretically superior, but in this case perhaps not appropriate
unless further costs drivers reveal different figures.
125 | P a g e
Part (c)
Unit level costs
These are driven by the quantity of items produced. The more produced the lower the unit
cost.
Example:
Consultants produce chargeable hours in exchange for their salary at work. We can work
out a unit cost per chargeable hour. Cost per hour = 240,000 / 6,000 hours = 40 per
hour
Batch level costs
These are costs incurred for every time a batch is processed for example administration
costs maybe incurred when a batch of mugs are made in a factory.
Examples:
The cost incurred in visiting every client once.
The cost incurred in billing every client.
The cost incurred in chasing clients for outstanding monies.
The cost incurred in negotiating the fees on a contract with a client.
Product sustaining
These are costs needed to continue the product in the future, for example client care
costs.
Examples:
The cost to employ administrative staff to organise, plan for clients service requirements.
The cost to entertain clients such as buying them lunch, evening meals and drinks or even
tickets to see sports events.
Facility sustaining
These are fixed costs spent for the use of the company as a whole, for example
warehouse or machinery costs.
Examples:
Telephone systems, fax machines, photocopiers and the canteen.
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127 | P a g e
March
8 batches were made which cost 4,000 1,711.50 = 2,288.50
Actual spend of standard cost is 2,288.50 / 4,000 x 100% = 57.21%
Actual hours taken = 57.21% x 400hrs = 228.84hrs
Average hours per batch taken to date = (50hrs + 33hrs + 54.78hrs + 91.06hrs +
228.84hrs) / 16 = 28.61hrs
Learning curve effect = 28.61hrs / 28.61hrs = 100%
April
16 batches were made which cost 8,000 3,423 = 4,577
Actual spend of standard cost is (4,577 / 8,000) x 100% = 57.21%
Actual hours taken = 57.21% x 800hrs = 457.68hrs
Average hours per batch taken to date = (50hrs + 33hrs + 54.78hrs + 91.06hrs +
228.84hrs + 457.68hrs) / 32 = 28.61hrs
Learning curve effect = 28.61hrs / 28.61hrs = 100%
The learning curve is 83% and ceases in March, when batches take 28.61 hours to make
on average. The implications are that there are no further labour efficiencies to be had
after the curve ceases and selling price and costs should be based on a batch taking 28.61
hrs.
Part (b)
Note: If Price (P) = a bx then Marginal Revenue (MR) = a 2bx
1. Determine the price function or demand function
The price or demand function formula is:
P = a - bQ
P = Price
a = Price at which demand would be zero (i.e. the p when Q=0)
b = The gradient of the demand curve
Q = Quantity sold at that price (P)
128 | P a g e
P = 1,200
b = 20
Q = 16
a=?
In order to determine the price function we need to first find the value of a. Substitute
all known values into the price function formula to determine a.
1,200 = a 20 (16)
1,200 = a 320
1,200 + 320 = a
1,520 = a
Now we can construct the price function:
P = 1,520 20Q
2. Determine the marginal revenue function (MR)
The MR function is the price function itself, but it will have twice the value of whatever
the b value itself is, within the price function.
Therefore:
MR = 1,520 2 (20) Q
MR = 1,520 - 40Q
3. Determine the marginal cost function (MC)
Marginal cost is given in the question as 672.72.
4. Equate MR = MC to obtain the units sold to maximise profits
MR = MC
1,520 40Q = 672.72
-40Q = 672.72 1,520
-40Q = -847.28
Q = 21.182
Therefore we sell 21.182 units when we maximise our profits.
5. Use the price function to determine the selling price that would maximise profits
We can substitute in 21.182 units into the price function we created before to determine
the selling price that will maximise profits.
129 | P a g e
P = 1,520 20Q
P = 1,520 20 (21.182)
P = 1,520 423.64
P = 1,096.36
The selling price that will maximise profits is 1,096.36.
Part (c) (i)
Standard costing
A standard cost is a planned or forecast unit cost for a product or service, which is
assumed to hold good given expected efficiency and cost levels within an organisation. It
represents a target cost and is useful for planning, controlling and motivating within an
organisation.
Under a standard costing system an organisation can value stock at standard cost,
incorporating this within the ledger or cost accounts of the organisation, the budget or
forecasts being a memorandum kept outside the ledger accounts.
Target costing
Market price to achieve desired market share
XX
(XX)
Desired profit
XX
Used by Nissan, Sony and Toyota and many other Japanese companies, who sought not
what a product does cost (which is what most UK companies used as the method of
pricing) but rather what it should cost.
The idea is that the product price is determined by the market place, a desired level profit
is decided upon and the balance is the costs to manufacture the products through
improved processes to be able to reduce costs to sell at the market price. Target costing
seeks to continually improve the manufacturing process by the use of JIT, TQM, cost
reduction, value analysis and benchmarking.
Standard costing develops a product, determines its cost and adds a mark up to determine
a price. This was very much an internal process ignoring competition or demand. Target
costing starts with the external market price and works backwards to deicide on levels of
cost and profit.
130 | P a g e
Relevant cost
$9,000 x 140% = $12,600
$12,000 x 140% = $16,800
$4,500 x 140% = $6,300
$18,000 x 140% = $25,200
Budgeted units
3,000
3,000
3,000
3,000
131 | P a g e
W2 Direct Material B
This is used when required and the cost of $10 per kg is used in the budgets.
Therefore on a per unit basis:
G: $6,000 / 3,000 units = $2
H: $6,000 / 3,000 units = $2
J: $13,500 / 3,000 units = $4.50
K: $36,000 / 3,000 units = $12
W3 Direct Labour
This is used when required and the cost of $10 per hour is used in the budgets.
Therefore on a per unit basis:
G: $6,000 / 3,000 units = $2
H: $24,000 / 3,000 units = $8
J: $22,500 / 3,000 units = $7.50
K: $9,000 / 3,000 units = $3
W4 Overhead
We need to look at the change in overhead costs between different levels of units. This
will be our relevant cost for overheads.
3,000 units
Product G
Product H
Product J
Product K
$6,000
$13,000
$11,000
$11,000
5,000
units
$8,000
$19,000
$17,000
$17,000
Product
Selling price
Direct Material A (W1)
Direct Material B (W2)
Direct Labour (W3)
Overhead (W4)
Contribution
Contribution per $ of Material B
Variable
overheads
$2,000
$6,000
$6,000
$6,000
G
$
10
(4.20)
(2)
(2)
(1)
0.80
0.80 / 2
= 0.40
Variable overheads
per unit
$2,000 / 2,000 units = $1
$6,000 / 2,000 units = $3
$6,000 / 2,000 units = $3
$6,000 / 2,000 units = $3
H
$
20
(5.60)
(2)
(8)
(3)
1.40
1.40 / 2
= 0.70
J
$
15
(2.10)
(4.50)
(7.50)
(3)
(2.10)
(2.10) / 4.50
= 0.47
K
$
30
(8.40)
(12)
(3)
(3)
3.60
3.60 / 12
= 0.30
132 | P a g e
Part (b)
We need to work out how much extra contribution we can make if we did not supply the
major customer.
All resources are available except material B. Lets find out how much of the scarce
resource material B will be released if the major customer was not supplied.
Product
Units in contract
G
H
J
K
500
1,600
800
400
Material B
cost per unit
$2
$2
$4.50
$12
Material B
cost per kg
$10
$10
$10
$10
Material B
per unit in kg
$2 / $10 = 0.2
$2 / $10 = 0.2
$4.50 / $10 = 0.45
$12 / $10 = 1.2
Total kg
500 x 0.2 = 100
1,600 x 0.2 = 320
800 x 0.45 = 360
400 x 1.2 = 480
Units
500
1,600
800
400
Total contribution
$400
$2,240
($1,680)
$1,440
$2,400
More contribution is earned if the contract is ignored. The extra amount of contribution
that is earned is $4,780 - $2,400 = $2,380. GHK would be indifferent meeting the
contract or paying the penalty if the penalty was $2,380.
133 | P a g e
Part (c)
Product
G
H
J
K
C/S ratio
0.80/10 = 0.08
1.40/20 = 0.07
(2.10)/15 = 0.14
3.60/30 = 0.21
Part (d)
We need to see how fixed costs are covered by the sales of each of these products first, if
we are to sketch a profit volume chart. Specific fixed costs can be avoided by not
undertaking a product but non-specific or general fixed costs are unavoidable. We need to
work out how much non-specific fixed costs we have.
Workings
Product G for 5,000 units
Overhead costs = $8,000
We know that the variable element of this is $1 per unit x 5,000 units = $5,000
We also know that product specific fixed cost is $1,000
Therefore the non-specific fixed cost = $8,000 - $5,000 - $1,000 = $2,000
Product H for 5,000 units
Overhead costs = $19,000
We know that the variable element of this is $3 per unit x 5,000 units = $15,000
We also know that product specific fixed cost is $1,000
Therefore the non-specific fixed cost = $19,000 - $15,000 - $1,000 = $3,000
Product J for 5,000 units
Overhead costs = $17,000
We know that the variable element of this is $3 per unit x 5,000 units = $15,000
We also know that product specific fixed cost is $1,000
Therefore the non-specific fixed cost = $17,000 - $15,000 - $1,000 = $1,000
Product K for 5,000 units
Overhead costs = $17,000
We know that the variable element of this is $3 per unit x 5,000 units = $15,000
We also know that product specific fixed cost is $1,000
Therefore the non-specific fixed cost = $17,000 - $15,000 - $1,000 = $1,000
134 | P a g e
Product
G
H
J
K
Specific fixed costs for all four products
Total
$
2,000
3,000
1,000
1,000
7,000
4,000
11,000
We need to now introduce each of the products and noting the cumulative profit or loss
figure. We would obviously make the product which gives the most contribution first.
Remember the requirement says that we have no longer any restrictions on resources and
make as many as we desire, and we should make up to the demand we have which would
of course include the one off contact to a major customer.
Cumulative Profit
Cumulative Sales
-$7,000
Nil
-$7,000 - $1,000
= -$8,000
-$8,000 + (4,400 x $30 x 0.12)
= $7,840
-$7,840 - $1,000
= $6,840
4,400 x $30
= $132,000
Make G
$132,000
+ (4,100 x $10)
= $173,000
$10,120 - $1,000
= $9,120
Make H
$15,560 - $1,000
= $14,560
Make J
No products sold
(only non-specific costs)
Specific fixed costs of K
Make K
Specific fixed costs of G
$173,000
+ (4,600 x $20)
=$265,000
$265,000
+ (3,800 x $15)
=$322,000
135 | P a g e
15,000
H
Profit/Loss ($000)
10,000
5,000
K
0
50
5,000
100
150
200
250
300
350
Sales ($000)
10,000
Part (e)
The chart illustrates the profit that could be earned by the 4 products. It assumes that we
will earn profits in line with contribution and assumes that the products are manufactured
in the order of highest contribution earners first.
It also shows which products are earning more contribution as the more steep the line is
the more contribution is earned, clearly here we can see that K is the most steep and earns
the most contribution then G and then H. J slopes downwards and shows that it is making
a negative contribution per unit. J should not be manufactured on these grounds.
We can also see the specific fixed costs for each product on the chart by the initial
reduction of profit by 1,000 at the start of each separate product line. The specific fixed
would not be spent if the product was not made.
136 | P a g e
Technical report
Material A
Material B
Direct labour
Supervision
Machine A
Machine B
Despatch
Fixed overhead costs
Profit mark-up
Total costs
Workings
W1
W2
W3
W4
W5
W6
W7
W8
W9
W10
$
0
15,000
2,000
500
0
240
100
400
0
0
18,240
Workings
W1 Technical report
The cost of the technical report has already been spent and so should not be included. It is
a sunk cost.
W2 Material A
It is a direct material which is regularly used and therefore we would need to use the
replacement cost to value it. 10,000 sheets x $1.50 = $15,000.
W3 Material B
We need 200 litres of ink specifically for the job but we can only buy in order sizes of
250 litres. There is also no certainty of any value for the remaining ink therefore the full
amount should be included. $8 x 250 litres = $2,000.
W4 Direct labour
The cost for direct labour is the overtime = 50hrs x $10p/h = $500.
W5 Supervision
The cost for the supervisor should be zero as currently she is able to include the
additional duties within her current hours.
W6 Machine A
Lost contribution of machine A hours = 20 hrs x $12per hr = $240.
137 | P a g e
W7 Machine B
These are the extra running costs = 25 machine hrs x $4 per hr = $100.
W8 Despatch
Delivery cost necessary for the catalogues of $400.
W9 Fixed overhead costs
These costs are ignored as they are not incurred as result of this job.
W10 Profit
The profit mark up should be ignored as we are working out the lowest possible quote for
this job.
Part (b)
In the case of short-term pricing it is appropriate to look at relevant costing. This is
because relevant costing takes into account the true costs and benefits that would occur as
a result of selling at a price today. It ignores those costs that have already been spent such
as fixed overheads as these would not be incurred now if the product was sold.
In the case of long-term pricing it is appropriate to include these fixed overheads as they
have not being occurred yet and would be as result of the manufacture of the product in
question. As a result of this the long-term price maybe higher than the short-term price,
and may mean that the price is no longer competitive.
Traditional absorption costing systems tries to include an element of fixed overhead costs
in the unit cost of products; this would be based on an activity basis that best represents
how the fixed overheads will be used. However fixed overheads do not increase or
decrease on a per unit basis they change when capacity is reached for a facility in the
organisation. This makes the inclusion of fixed overheads arbitrary and the true
profitability of the different products distorted.
Relevant costing would ignore the fixed overheads when trying to understand the
profitability of the different products because it would show the true contribution to fixed
overheads without any arbitrary distortions.
138 | P a g e
Construct the objective function this is looking at identifying the main objective that
is trying to be achieved. Here we are trying to maximise the contribution for D and G, so
we need to work this out first and then construct the objective function.
Selling price
Direct material A
Direct material B
Skilled labour
Variable overhead
Contribution
Objective function:
C = 41D + 47G
Set up the constraints these show the limits of resources available to us to try and
meet the conditions of the objective function and they are usually described as linear
equations.
D per unit
G per unit
Usage of material A
20 / 5 = 4kg
10 / 5 = 2kg
Usage of material B
12 / 3 = 4kg
24 / 3 = 8kg
Usage of skilled labour
28 / 7 = 4hrs
21 / 7 = 3hrs
Usage of machine
14 / 2 = 7hrs
18 / 2 = 9hrs
4D + 2G 1,800
4D + 8G 3,500
4D + 3G 2,500
7D + 9G 6,500
D 400, G 400
(Material A constraint)
(Material B constraint)
(Skilled labour hours constraint)
(Machine hours constraint)
(Maximum demand constraints)
139 | P a g e
Logic or non-negativity constraints these are constraints which will ensure that the
answer obtained in the solution is sensible in that only zero or positive values are in the
answer.
D 0, G 0
(Non-negativity constraints)
All constraints are plotted on to a graph and then moving away from the origin a solution
is sought where all constraint conditions are met and maximises the objective function.
Material A (4D + 2G = 1,800)
If D = 0 then:
4(0) + 2G = 1,800
2G = 1,800
G = 1,800 / 2
G = 900
If G = 0 then:
4D + 2(0) = 1,800
4D = 1,800
D = 1,800 / 4
D = 450
Material B (4D + 8G = 3,500)
If D = 0 then:
4(0) + 8G = 3,500
8G = 3,500
G = 3,500 / 8
G = 438
If G = 0 then:
4D + 8(0) = 3,500
4D = 3,500
D = 3,500 / 4
D = 875
140 | P a g e
141 | P a g e
G
900
800
Skilled labour (4D + 3G = 2,500)
700
Machine hours (7D + 9G = 6,500)
600
Max sales D = 400
500
Max sales G = 450
400
300
200
100
100
200
300
400
500
600
700
800
900
Through observing the graph the solution appears to be to make 290 units of G and 315
units of D. This however is only as accurate as the graph drawn. The solution can also be
derived through simultaneous equations which is far more accurate than using the graph
or graphical method.
We know that our solution is where material A constraint intersects with the material
B constraint.
Material A
Material B
4D + 2G = 1,800
4D + 8G = 3,500
Equation 1
Equation 2
We can use the subtraction method or substitution method to solve. We will use the
subtraction method.
Therefore subtract equation 2 from equation 1
4D + 2G = 1,800
4D + 8G = 3,500
-6G = -1,700
Equation 1
Equation 2
142 | P a g e
6G = 1,700
G = 1,700 / 6
G = 283
Substitute G =283 into equation 1
4D + 2(283) = 1,800
4D + 566 = 1,800
4D = 1,800 566
4D = 1,234
D = 1,234 / 4
D = 308.5
Therefore to maximise contribution we should make:
308 units of D and 283 units of G.
Part (b)
The shadow price is the extra contribution earned if one more unit of the scarce resource
was made available. A shadow price only exists for scarce resource. Skilled labour has a
nil shadow price because at the optimal solution it is not fully utilised as there are some
skilled labour hours left. This can be seen in the graph in that the optimal solution lies
below the skilled labour constraint indicating that there are excess skilled labour hours
available.
Direct material A is a scarce resource because at the optimal solution in the graph we are
on the constraint itself and so we have fully utilised all this resource. This is further
indicated by the value of 5.82 above. If we were to obtain another unit of direct material
A then we would earn a contribution of 5.82. Also as a result of this our optimal
solution would change.
Part (c)
If the selling price of product D increased then this would have direct impact on the
objective function or iso-contribution line. It would change how the objective function
sloped.
In order to calculate how much the selling price would have to rise before the optimal
solution would change we would have to identify the extreme points of the feasible
region and the relative unit contributions of D and G that would cause a change in choice
of optimal solution in the objective function.
143 | P a g e
P6
$
C3
$
C5
$
Selling price
or opportunity cost
125
175
75
95
Variable cost
Contribution
(55)
70
(75)
100
(44)
31
(45)
50
M1 used at
$20 per square metre
0.75
0.50
0.25
0.50
70/0.75
= $93.33
100/0.50
= $200
31/0.25
= $124
50/0.50
= $100
Contribution
per square metre
Rank in order
of production
P6
C3
C5
M1 used
750
125
125
1,000
P6
C3
C5
Make (units)
1,500
500
250
Other factors:
Exam tip: The examiner is only after three other factors, however we have given you
other factors that could be equally valid to discuss.
144 | P a g e
The fixed overheads may have a variable element varying with production; if this
is the case then contribution will change for some of the products and therefore
the optimum production plan.
The stability of the cost of material M1 as if this increases then it may not be
beneficial to make C3 and C5 but to buy them in.
The future market of the products if they are going to continue to be popular with
customers or whether they are starting to fall out of favour because of better
products coming on to the markets to replace them.
The elasticity of demand of the products and in particular how sensitive demand
would be to changes in prices.
Part (b)
If we had more material M1 available then we would make a further 750 units of C5 and
then 2,000 units of P4.
The amount of M1 needed to make 750 units of C5:
750 units x 0.50 = 375 square metres
This would save $100 per square metre of M1 and so therefore the maximum price would
be $120 including the cost of M1.
The amount of M1 needed to make 2,000 units of P4:
2,000 units x 0.75 = 1,500 square metres
This would give contribution of $93.33 per square metres of M1 and so therefore the
maximum price would be $113.33 including the cost of M1.
After satisfying these requirements there is no further need for M1 and so therefore the
maximum price to be paid for M1 is zero.
Part (c)
If we were to supply this contract and we have no more M1 then we have to stop the
production of some or all of C5, C3 and P6. We should stop the production of those
products which give us the least amount of contribution per square metre of M1 first.
500 units of P4 would need 500 x 0.75 = 375 square metres of M1.
145 | P a g e
$12,500
$15,500
$25,000
$53,000
Total demand
Direct labour (hours)
Material A (kg)
Material B (litre)
Machine hours
R
750
2,250
3,750
1,500
2,250
T
1,150
5,750
4,600
1,150
4,600
Total
8,000
8,350
2,650
6,850
Direct labour hours is the scarce resource or limiting factor as we only have available to
us 7,500 hours and we need 8,000 hours.
146 | P a g e
Product
R
$ per unit
130
(24)
(15)
(14)
(30)
47
T
$ per unit
160
(40)
(12)
(7)
(40)
61
47/3 = 15.67
61/5 = 12.20
Selling price
Direct labour ($8 per hour)
Material A ($3 per kg)
Material B ($7 per litre)
Machine hours ($10 per hour)
Contribution
Total labour hours available is 7,500 hrs, however we must fulfil a commercial customer
order first of 250 Rs and 350 Ts before working out the optimum production plan.
Commercial
contract
250
350
R
T
Total
Labour hours
used
750
1,750
2,500
R
T
Labour
hrs used
1,500
3,500
5,000
R
T
Commercial contract
250
350
Production
500
700
Total
750
1,050
R
$ per unit
100
(24)
(15)
(14)
(30)
17
T
$ per unit
135
(40)
(12)
(7)
(40)
36
147 | P a g e
R
T
Contribution
Contract
250 x $17 = $4,250
350 x $36 = $12,600
Market
500 x $47 = $23,500
700 x $61 = $42,700
$27,750
$55,300
$83,050
Part (b)
By carrying out the commercial contract it means that we fall short of meeting market
demand of T by 100 units. The lost contribution of this is 100 units x $61 per unit =
$6,100. This is less than the financial penalty of $10,000 if the commercial contract was
not met, so therefore it is better at least from a financial perspective to fulfil the
commercial contract.
Part (c)
Labour (hrs)
Material A (kg)
Material B (kg)
Machine hours
Revised resource
availability
7,500 x 0.9 = 6,750
8,500 x 0.9 = 7,650
3,000 x 0.9 = 2,700
7,500 x 0.9 = 6,750
Commercial
contract
2,500
2,650
850
2,150
Resources
remaining
4,250
5,000
1,850
4,600
5R + 4T
2R + T
3R + 4T
R 500, T 800
4,250
5,000
1,850
4,600
(Labour)
(Material A)
(Material B)
(Machine hours)
(Maximum demand)
Logic or non-negativity constraints these are constraints which will ensure that the
answer obtained in the solution is sensible in that only zero or positive values are in the
answer.
R 0, T 0
(Non-negativity or logic)
All constraints are plotted on to a graph and then moving away from the origin a solution
is sought where all constraint conditions are met and maximises the objective function.
148 | P a g e
(Labour) 3R + 5T = 4,250
If R = 0 then:
3(0) + 5T = 4,250
5T = 4,250
T = 4,250 / 5
T = 850
If T = 0 then:
3R + 5(0) = 4,250
3R = 4,250
R = 4,250 / 3
R = 1,417
(Material A) 5R + 4T = 5,000
If R = 0 then:
5(0) + 4T = 5,000
4T = 5,000
T = 5,000 / 4
T = 1,250
If T = 0 then:
5R + 4(0) = 5,000
5R = 5,000
R = 5,000 / 5
R = 1,000
(Material B) 2R + T = 1,850
If R = 0 then:
2(0) + T = 1,850
T = 1,850
If T = 0 then:
2R + 0 = 1,850
2R = 1,850
R = 1,850 / 2
R = 925
149 | P a g e
1,200
800
600
400
200
500
1,000
1,500
The optimal solution is the furthest point away from the origin within the feasible region;
therefore the optimal production plan is make 500 units of R and 550 units of T in
addition to the contract.
150 | P a g e
Part (d)
If there is an increase in optimism by mangers then the constraints would all move to the
right illustrating the availability of more resources and production would increase.
Currently the most constraining lines are labour hours and maximum demand for R.
If labour hours were increased then there would be further production of T as the labour
constraint would move to the right. This would continue up until the labour constraint
intersects with the material A constraint and maximum demand for R, it is at this point
material A also becomes a constraining resource and would need to be increased if
production were to further increase.
Clearly it can be said that in any event labour hours needs to increase if production were
to be expanded, other resources if increased would have no immediate effect as there are
resources in excess available.
A2 10 LM (CIMA P2 Nov 2010)
Part (a)
In order to find the optimum production plan we must first establish what the scarce
resource is that is restricting production to meet all demand. We will work out the total
amount of resources needed to meet maximum demand and then compare this to the
resources that we have available to us to determine any scarce resources.
Total demand
Direct labour (hours)
Direct material (kg)
Machine hours
L
400
1,600
800
400
M
700
1,400
6,300
1,400
Total
3,000
7,100
1,800
Direct material is the scarce resource or limiting factor as we only have available to us
6,000 kg and we need 7,100 kg.
Product
Selling price
Direct labour ($7 per hour)
Direct material ($5 per kg)
Machine hours ($10 per hour)
Contribution
Contribution per kg
Rank in order of production
L
$ per unit
70
(28)
(10)
(10)
22
M
$ per unit
90
(14)
(45)
(20)
11
22/2 = 11
11/9 = 1.22
2
151 | P a g e
L
M
400 units x 2 kg
6,000 kg 800 kg = 5,200 kg
Kg used
800
5,193
5,993
L
M
Production
400
577
Part (b)
The agreed order of 250 units of product M should be worked out separately for the
resources needed to complete it first as this is a requirement, then we can see what
resources are left over to formulate our new resource constraints.
250 units of product M would need:
Direct labour = 2 hrs per unit x 250 units = 500 hrs
Direct material = 9kg per unit x 250 units = 2,250 kg
Machine hours = 2 hrs per unit x 250 units = 500 hrs
Resources have also been overestimated by 20% and need to be reduced before deduction
of resource usage by the agreed order of 250 units of M, therefore:
Direct labour = (3,500 hrs x 80%) - 500 hrs = 2,300 hrs
Direct material = (6,000 kg x 80%) - 2,250 kg = 2,550 kg
Machine hours = (2,000 hrs x 80%) 500 hrs = 1,100 hrs
Revised resource constrains:
Direct labour
Direct material
Machine hours
4L + 2M 2,300
2L + 9M 2,550
1L + 2M 1,100
Objective function:
C = 22L + 11M
152 | P a g e
Part (c)
Product L 400 and product L other value 0
The value 400 represents the amount of L we should produce in order to maximise
contribution given the resource constraints. The other value 0 means that we have no
further units of L to make as we have reached the maximum market demand for L. units.
There is no shortfall in demand.
Product M 194 and product M other value 506
The value 194 represents the amount of M we should produce in order to maximise
contribution given the resource constraints. The other value 506 means that we have not
met our maximum market demand of M by 506. We are only producing 194 units of M
where as the maximum market demand is 700. There is a shortfall in demand of 700 units
194 units = 506 units.
Machine hours 312
This value represents the number of unused machine hours left at the optimal production
point where contribution is maximised given current resource constraints.
We can proof this amount of unused machine hours by comparing what has been used to
the total amount of machine hours available.
L units produced = 400 x 1 hr per unit = 400 hrs
M units produced = 194 x 2 hrs per unit = 388 hrs
Total hours used = 400 + 388 = 788 hrs
Hours available = 1,100 hrs
Hours unused = 1,100 hrs 788 hrs = 312 hrs
Direct material $1.22
This is the shadow price for direct materials as it is a scarce resource at the optimal
production point where contribution is maximised given current resource constrains. The
shadow price is maximum price you should pay above the original cost for one more
extra unit of the scarce resource, in this case being one more kg of direct material.
The proof is that if we were given 1 more kg of direct material we would use it to
increase output of product M, because still has unfulfilled demand. Each unit of M
requires 9 kg, therefore 0.11 units of M could be produced from 1 kg of material. Each
unit of M yields a contribution of $11 and therefore 0.11 units yield $1.22 contribution.
153 | P a g e
$
Room revenue
Guest related costs (W1)
Room costs (W2)
Avoidable general costs (W3)
Room / Guest contribution
Snacks
Gross contribution (W4)
Cook costs
4,617
(5,000)
12,150
(6,667)
(383)
Restaurant
Gross contribution (W5)
Staff costs
17,313.75
(13,500)
Low
$
412,500
(108,000)
(82,500)
(375,000)
(153,000)
8,150
(8,133)
5,483
33,750
(18,000)
3,813.75
380,350.75
(75,000)
305,350.75
Total contribution
Non-avoidable general costs
Net contribution
Hotel annual fixed costs
Hotel annual profit
Mid
$
720,000
(162,000)
(81,000)
(300,000)
177,000
(233)
4,867
98,313.75
(54,000)
24,750
(128,483)
(125,000)
(253,483)
Workings
W1 Guest related costs
Season
Peak
Mid
Low
Days
(D)
90
120
150
Rooms
(R)
95
75
50
Occupants
(O)
1.8
1.5
1.2
Guests
(D x R x O)
15,390
13,500
9,000
Total
$
1,987,500
(454,680)
(231,900)
(900,000)
400,920
24,867
(20,000)
47,250
(22,500)
15,750
198,233
(100,000)
98,233
44,313.75
450,100.75
(300,000)
150,100.75
(200,000)
(49,899,25)
W2 Room costs
Peak = ($5 + $3) x 90 days x 95 rooms = $68,400
Mid = ($5 + $4) x 120 days x 75 rooms = $81,000
Low = ($5 + $6) x 150 days x 50 rooms = $82,500
W3 Avoidable general costs
Peak = $300,000 x 75% = $225,000
Mid = $400,000 x 75% = $300,000
Low = $500,000 x 75% = $375,000
W4 Snacks gross contribution
Peak = 15,390 guests x 10% x $10 x 30% = $4,617
Mid = 13,500 guests x 30% x $10 x 30% = $12,150
Low = 9,000 guests x 30% x $10 x 30% = $8,100
W5 Restaurant gross contribution
Peak = 15,390 guests x 30% x $15 x 25% = $17,313.75
Mid = 13,500 guests x 50% x $20 x 25% = $33,750
Low = 9,000 guests x 70% x $30 x 25% = $47,250
Part (b) (i)
Overall from our statement it is obvious that the hotel is making losses of nearly $50,000.
Actions management could take to maximise profits:
During the low season they could shut down the hotel as it is making the main
losses in this part of the year.
Close down the snack service during the peak and the low season as it makes
losses in these seasons but makes profits during the mid season when it should
remain open.
155 | P a g e
If the hotel was closed during the low season whether or not this would still retain the
regular guests to come in the peak and mid season or whether guests will view this as
being an obvious move to focus on profits rather than customer service.
156 | P a g e
Solutions Section A
Part B Cost Planning and Analysis for Competitive Advantage
B1 1 SWAL (CIMA P2 Pilot Paper 2005)
This question had at least one mark for writing your answer in a report format!
REPORT
To:
From:
Subject:
Date:
1. Introduction
This report is designed to explain how a just-in-time (JIT) system differs from the system
presently being used and the extent to which its introduction would require a review of
SWs quality control procedures.
2. JIT purchasing and production
The JIT philosophy states that products should only be produced if there is an internal or
external customer waiting for them. Traditionally manufacturers stockpiled. JIT aims
ideally for zero stock e.g. raw materials delivered immediately at the time they are
needed, no build up of work-in-progress, finished goods only produced if there is a
customer waiting for them.
1. Closer relationships with suppliers required, fewer and more frequent items, in
return for this the supplier would get long term steady purchase orders.
2. Smaller more frequent deliveries need to be managed in order to produce.
3. Higher quality machines perhaps multi-purpose with regular maintenance.
4. Involvement and training of staff to maintain flexibility.
3. The current system compared to JIT
The current system aims to procure chemicals based on holding a minimum quantity this
is very different to JIT. JIT would aim to always hold a zero or near zero stock level as
chemicals should be bought in when there is a demand for them not to hold a minimum
level.
To secure regular small amounts of chemicals bought in under JIT, SWAL group would
have to enter into long term contracts, and therefore order costs may increase using such
as stock control system.
157 | P a g e
There is much that is needed to be changed an improved if we are to adopt a JIT approach
and should be planned carefully, and the benefits of higher quality and cheaper
production will only be seen in the long term. I would suggest many consultations with
myself and other experts in this field before embarking on such a stock control system.
158 | P a g e
I hope you have found this report useful but should you require any further assistance or
have any questions please do not hesitate to contact me.
Signed : Management Accountant.
B1 2 X group (CIMA P2 May 2005)
This question had two marks for explaining and defining JIT and the rest of the eight
marks were for profitability would be affected.
REPORT
To:
From:
Subject:
Date:
1. Introduction
This report is designed to explain how the adoption of JIT might affect X groups
profitability.
2. JIT purchasing and production
The JIT philosophy states that products should only be produced if there is an internal or
external customer waiting for them. Traditionally manufacturers stockpiled. JIT aims
ideally for zero stock e.g. raw materials delivered immediately at the time they are
needed, no build up of work-in-progress, finished goods only produced if there is a
customer waiting for them.
Closer relationships with suppliers required, fewer and more frequent items, in
return for this the supplier would get long term steady purchase orders.
Smaller more frequent deliveries need to be managed in order to produce.
Higher quality machines perhaps multi-purpose with regular maintenance.
Involvement and training of staff to maintain flexibility.
3. Increase in price of raw materials from suppliers for regular small amounts
ordered at short notice, but maybe reduced through the introduction of long-term
contracts with suppliers.
4. Additional costs incurred in improved quality control procedures put in the
production process at X group.
5. Staff training costs to ensure that they are able to carry out control procedures and
use the material efficiently.
6. Additional planning is required by management to ensure that there are no stock
outs, and therefore addition administration costs.
I hope you have found this report useful but should you require any further assistance or
have any questions please do not hesitate to contact me.
Signed : Assistant Management Accountant.
B1 3 ML (CIMA P2 Nov 2005)
Part (i)
Traditional absorption costing takes the total budgeted fixed overhead for the period and
divides by a budgeted (or normal) activity level in order to find the overhead absorption
rate
The overhead absorption rate is then used to absorb fixed overheads into the range of
products we provide. Once all costs have been allocated then a price is obtained by
adding a % mark up on the costs. The mark up would represent the profit earned on the
product.
This approach is used by companies that have a single or small range of products, fixed
overhead are a small percentage of total cost, and mass production techniques are used.
ML engineering uses an absorption costing approach based on machine hours. This is
particularly useful in this circumstance as it means that every product will always recover
a portion of the production fixed costs. However it may not be a fair method as not every
product will consume the fixed overheads based on the single activity being machine
hours. Some products may not use machine hours but still consume fixed production
overheads.
The main consequence of this is that prices charged on the various products may not be
competitive, due to the fact the cost plus approach depends on the total costs allocated
to that product. As a result of this some products make losses because fixed production
costs being unfairly allocated to it and therefore discontinued when in fact it maybe
making profit.
160 | P a g e
The alternative being a marginal cost approach would seek to ignore the fixed production
overheads. The difference between absorption costing and marginal costing organisations
is that the marginal costing organisation makes no attempt to absorb production
overhead into a cost unit.
It treats production overhead as a period cost only and does not absorb overhead, but
rather charges it entirely to the profit and loss account for each period. It is equally
important to remember that marginal costing organisations would also value stock at
variable production cost only not full production cost, as does an absorption costing
company.
This means that pricing is more competitive as costs would be lower and it means that
unused capacity in ML could be used as more contracts would be secured. The main
problem with this is that ML still may not be competitive as the mark up maybe too high.
Part (ii)
Quite clearly the Managing Director is suggesting a marginal costing approach to price
by making this comment. A marginal costing approach is very good approach in but only
in the short term, this is because fixed costs have already been spent or committed to and
by ignoring these and concentrating on those costs that do change in the short term it
means that we are covering all the costs that we would incur, but only in the short term.
Therefore any price that exceeds variable costs would be making some contribution to
fixed costs, but this may not be sustainable over the long term and fixed costs need to be
recovered at some point and enough profit needs to be made for the products to be
continued to be made.
By ignoring fixed production costs there is no attempt to understand and control them to
ensure that they are costs that should be spent and used effectively. Using a marginal
costing approach there is danger that these costs could spiral out of control over the long
term.
In addition by charging a lower price initially it maybe difficult to justify to customers
price increases especially if the market is competitive.
B1 4 PK plc (CIMA P2 Nov 2005)
REPORT
To:
From:
Subject:
Date:
1. Introduction
This report is designed to explain the changing nature of cost structures in the modern
manufacturing environment and the implications to PK plcs inventory valuation and
short term decision making.
2. Cost structures in the modern manufacturing environment
Absorption costing system used by PK plc takes the total budgeted fixed overhead for the
period and divides by a budgeted (or normal) activity level in order to find the overhead
absorption rate.
This approach is used by companies that have a single or small range of products, fixed
overhead are a small percentage of total cost, and mass production techniques are used.
It is a system that has been used for over a hundred years now and is perhaps seen as
inappropriate today because of increased competition from overseas companies,
economies of scale enjoyed by many companies, trade barriers and barriers to entry into
many markets being reduced significantly or abolished, improvements in technology and
access that customers have around the world to other manufacturers has made the global
economy into a local economy.
PK plc is in an industry producing high quality pieces of furniture and where labour skills
are very important. High quality furniture manufacture tends to have a lot of different
machines which have specific in built programs. This means there are a range of different
machines and different types of fixed production overheads not just one type these days.
Therefore we need to understand how these are driven by relating these to activities
which cause their expenditure and as a result control the costs far better.
So unlike traditional absorption costing where you have one or two costs drivers we are
now seeking several cost drivers relating to different segments of the total fixed
production costs and relating this to how products consume them. This is a modern
technique known as activity based costing (ABC).
3. Inventory valuation
We can obtain an inventory valuation using the absorption costing method which
includes a portion of fixed production costs in the valuation. Inventory valuation is
important because it is a reporting requirement but also gives you an understanding as to
how much money is being tied up in these products that are being manufactured and how
much profit is being made once the items have been sold.
Financial reporting requirements state that stock valuation should include all costs
bringing the item to its present location. This shows that stock valuation is not based on
change of activity but on a blanket absorption rate and therefore not giving a true
reflection of cost of the product and therefore profitability.
162 | P a g e
163 | P a g e
Value engineering is the activity which looks at how to achieve the same quality product
for customers at the lowest costs possible. It focuses before on costs before production
has begun whereas value analysis focuses at costs during production.
Although value analysis is another form of cost reduction it is different in that it seeks not
just to reduce costs as far as possible but takes into account what is important to
customers.
Four aspects of value:
Cost value cost of production.
Exchange value sales price.
Utility value what its functionality is.
Esteem value prestige that it is perceived hold.
Value analysis seeks to reduce cost value while maintaining the esteem value of a
product. It normally is easier reduce the cost value on items which have a utility
value as opposed to an esteem value.
Functional analysis
This looks at the functions that a product has and their perceived value to customers
versus the cost of providing these. There are nine basic steps involved in functional
analysis:
1. Choosing the object of analysis product, service or overhead area where there is
high cost, complex, low demand.
2. Select the members of the team different departments.
3. Gather information internal and external.
4. Define the functions of the object list all the functions of product (e.g. functions
of a pen?).
5. Draw a functional family tree showing relationship of function to part product
and its cost.
6. Evaluate the function arrive at a total target cost and compare to customers
expectations.
7. Suggest alternatives and compare these with the current or target (expected) cost
new methods and materials.
8. Choose the alternative operations.
9. Review the actual results.
164 | P a g e
Part (b)
Value analysis method
1. Obtain the precise requirements of the customer by considering utility, esteem and
exchange value.
2. Obtain alternative ways of manufacturing the requirements of the customers
product. For example, the newsletter that the firm produces is not read by most
clients, perhaps looking at alternative ways to convey this information to clients
such as email, meetings, free one off business advice days.
3. Authorise the suggested alternative methods in achieving the customer desires by
senior management, before production begins.
4. Produce and manufacture product.
5. Evaluate changes and response from customers. Benefits of this maybe positive
feedback from customers, improved sales and profitability, eliminate wastage,
attract more staff and better morale within the company.
B1 6 Compliance v conformance (CIMA P2 May 2006)
REPORT
To:
From:
Subject:
Date:
Managing Director
Management Accountant
Quality costs
12th February 2006
1. Introduction
This report is designed to discuss quality costs and their significance for the company,
and in particular costs of conformance and costs of non-conformance.
2. Costs of conformance
Total quality management (TQM) is the process of adopting a quality conscious
philosophy within staff culture, as well as adopting standards and procedures e.g. such as
ISO 9000 certification to monitor and control quality. Benchmarking, quality circles and
investment in training and development of employees often achieve this.
Conformance costs are those costs which are spent to try to achieve a standard or target,
such regulations or functional specifications of a product for a customer.
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Prevention costs these are spent to try and ensure the product is made to detailed
specifications and regulations. For example training staff, customer surveys,
supplier reviews and investment in machines.
Appraisal costs these are spent to understand how well a process has performed
and corrective action is taken if needed subsequently. For example measuring
equipment, inspections and tests, product quality audits.
3. Costs of non-conformance
Non-conformance costs are quality failure costs that are needed to correct products, as
they did not meet expectations or target.
There are two main types of non-conformance costs:
Internal failure costs these are quality failure costs before the products or
services have been transferred to the customer. For example re-inspection of
goods, losses or scrapping of materials and finished goods, additional
administrative costs.
External failure costs - these are quality failure costs before the products or
services have been transferred to the customer. External costs should be avoided
as they expose poor manufacturing abilities to customers. Examples are
administration of customer complaints, administration of customer services,
product liability claims, repairs and replacements, lost good will and reputation.
166 | P a g e
Although conformance costs are high costs in the short term, they would yield greater
benefits in the long term in the form of greater profitability and longevity for the
business.
Manufacturing companies could use Kaizen costing as way of improving the long-term
quality of their products. It is the process of continuous improvement by small
incremental rather than transformational changes. Its also believes strongly in
empowerment of employees to enable them to improve operations. Kaizen costing
focuses on reducing variable costs of future periods below that of prior periods. Similar
in concept to total quality management philosophy, Japanese idea and again works hand
in hand with quality circles, benchmarking or quality assurance.
Human resources are your most valued asset and they should be involved in the
search for perfection. They have superior knowledge as they are in the operation.
This is the opposite of traditional systems where the managers develop standards.
Incremental or gradual improvement.
Perfection should be sought all the time and so there is always room for
improvement.
Cost reduction targets more frequent rather than traditional annual standard costs.
Variance analysis used to help with Kaizen costing.
Investigations carried out if targets not met even if improvements have been
made.
I hope you have found this report useful but should you require any further assistance or
have any questions please do not hesitate to contact me.
Signed : Assistant Management Accountant.
B1 7 AVN (CIMA P2 Nov 2006)
Question 2
Part (i)
Porter grouped the various activities of an organisation into what he called the value
chain; he divided the organizations activities into nine types, classified as either primary
or secondary activities. These activities incur costs, but in combination with other
activities provide customer satisfaction and therefore add value.
The main components are as follows:
Technology - R & D, product design and testing, process design and testing.
Operations - Conversion of inputs (people, materials, machines etc) into the final
product or service.
The extended value chain is including external factors into the chain such as suppliers
and customers creating a value system, an example of additional components are as
below:
Supplier
value
chain
Distributor value
chains
Supplier
value
chain
Wholesaler
value chain
Supplier
value
chain
Retailer
value
chains
Part (ii)
AVN manufactures electronic devices which appear to be quite sophisticated. This is a
fast moving, volatile and competitive market and therefore AVN needs to ensure that
they are supporting each of the main components of the value chain in order to be
successful.
Each of the main components may be applied to AVN as follows:
Technology AVN must make sure that their R&D is directed towards the needs of the
customer as there is no point developing a product which consumers do not want to
purchase. Functional analysis would be a useful way of achieving this. Once the
prototype has been developed AVN must make sure that it is designed and tested to make
it easy for the consumer to operate and be durable and robust enough for its purpose.
168 | P a g e
The product must also be cost effective and so target costing should be used here to
determine the market price and profit desired and then the balancing figure being the
budget for costs, which must be realistic.
Inbound logistics The material required for this product must be sourced from
reputable and reliable suppliers. They must be checked for quality assurance and this
would reduce level of assurance needed in AVN. Re-works and customers returns are in
the long run more costly to rectify than making sure it was correct the first time it was
manufactured. Cost should also be considered to make sure that the service is delivered at
rate where AVN can make profits. Storage should also be suitable for these materials and
be secure with additional capacity if needed.
Operations Commercial production must be cost effective and efficient. There should
be coordination between inbound logistics and production determining the level of
materials required. There should also be an understanding of what types of products
should be made and the mix of labour required to achieve this. There should also be
investment in quality machinery and quality controls to prevent internal and external
failure costs.
Marketing and sales It is important that AVN informs the right target consumers of
the new product that is being launched and its main benefits over older models or other
substitutes supplied by other competitors.
Outbound logistics This is the delivery of the products to consumers. It is important
that AVN deliver these items in perfect condition, on time and the right products. AVN
must employ suitably trained sales team and distribution team to meet consumer needs,
and also consider whether this will be cost effective.
Service It is vital for AVN to receive continual feedback on their products from the
consumers to ensure that their needs are being fulfilled exactly, and if needs are changing
these are also met by creating revised models. AVN should be looking to deliver a high
quality after sales service to consumers in the way of dedicated support lines,
replacement of parts and installations if required, all of which should be cost effective.
169 | P a g e
Months
No. of units produced and sold
SP per unit
VC per unit
Contribution per unit
Total contribution
Cumulative cash flow
Maturity
Decline
31 - 70
71 - 110
20,000
20,000
20,000
$60
$60
$40
$30
$25
$30
$30
$35
$10
$600,000
$700,000 $200,000
$1,275,000
$1,475,000
Part (b)
Changes in costs
There has been a continued reduction in unit variable costs of this product from its
introduction stage to its maturity stage. It can be seen from the data given that as we
produce more of the product unit variable cost falls from $50 to $25 per unit. This can be
attributable to economies of scale being enjoyed by the company through mass
production techniques, such as below:
Stock control systems maybe more efficient as the data states the company
employs a JIT approach to stock management. This reduces stock holding costs to
nil and material is only used when and bought if there is a demand.
Discounts would have been received as the company would buy more and more
bigger batches of the raw material throughout the products life cycle.
Total quality management techniques maybe used which means that the product is
made to a very high standard reducing internal failure costs such as the inspection
and scrap material and also reduction in external failure costs such as repairs and
replacement.
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The unit variable cost has also increased at the end of the product life cycle from $25 to
$30 in its decline stage. This is expected as the demand for this product would be reduced
significantly as it would have fallen out of favour with customers, and therefore less is
being made and as a result fewer materials needed. The lower prices on raw materials
cannot be enjoyed because of the reduced quantities bought by the company and hence
the increase in unit variable costs.
Changes in selling prices
W has managed to initially charge a high price, achieve low volume but earned a larger
profit per unit sold. This is known as market skimming. It is a strategy which exploits a
price insensitive market or an inelastic demand for a product.
It would seem that Ws product has been a product that customers have been willing to
pay a premium for but this not sustainable as competitors enter the market. This can be
seen during the growth stage as competition begins to enter the market W has had to
reduce its selling price from $100 per unit to $80 and then $70 per unit. W will still
continue to increase contribution through economies of scale.
During the maturity and decline phase W has had to continue to reducing the selling price
of their product in order to stay competitive as cheaper substitutes have entered the
market produced by other manufactures.
This approach will aim to sustain its wide customer base and W should continue to
produce the product as long the selling price is greater than the marginal cost of
manufacturing the product. We can see from our answer in (a) that this is still the case for
W in the decline phase. Production should cease when this is not the case as the there
would be no extra benefit for the company, at this point the product has fallen out of
favour with customers.
B1 9 New product (CIMA P2 May 2007)
Part (i)
The company did originally estimate the labour costs for the first batch to be $250,000,
however the actual cost for the first batch was $280,000. There is a learning curve rate of
80% which we will apply to the actual cost to obtain the revised expected cumulative
labour costs.
Number of cumulative batches
1
2
4
8
Part (ii)
Number of cumulative batches
1
2
4
8
Realistic standard costs could be achieved if learning curve theory is used to judge labour
performance and would reflect anticipated learning benefits.
Budgeting for manpower needs would be far more accurate if the learning curve concept
is adopted and so therefore would safeguard against over manning the production
process.
Part (b)
Y = aXb
Y = average time for that (X) number of units or the average cost per unit
a = time for the first unit or the cost for the first unit
X = the number of units you want to calculate an average time or cost for
b = the index of learning (log r/log 2)
a = 40 mins, b = -0.415
To work out the time taken for the sixth unit of output:
Time for the first 6 units = 40 x (6 to the power of 0.415) x 6 = 114.1 mins
Time for the first 5 units = 40 x (5 to the power of 0.415) x 5 = 102.6 mins
Time for the 6th unit = 114.1 mins 102.6 mins = 11.5 mins
Part (c)
Market penetration or a penetration pricing policy is the decision to charge a very low
price in order to capture a larger market share quicker. This strategy is used when
introducing a new product into an established and competitive market.
This policy also has the following implications:
The economies of scale for the product should be achieved quicker as market
share is obtained rapidly.
Competition may be discouraged and leave the market due to the low price being
charged.
This kind of pricing policy is good for inferior products as they are cheap to
manufacture and so costs are low and therefore the price charged can be kept low.
The company should also seek to ensure that all costs are recovered in the long run or
over the life of the product. There are two ways of achieving this:
Lifecycle costing recording all costs and revenues separately and so being able
to monitor if costs are being recovered.
173 | P a g e
Experience curves show how costs decline over the life of the product because
of the learning curve effect.
REPORT
To:
From:
Subject:
Date:
Managing Director of XY
Management Accountant of XY
The concept of the Value Chain
21st May 2008
1. Introduction
This report is designed to explain the points that should be covered in the presentation on
Value Chain and the management of profits generated throughout the chain in XY.
2. The concept of Value Chain
Porter grouped the various activities of an organisation into what he called the value
chain; he divided the organizations activities into nine types, classified as either primary
or secondary activities. These activities incur costs, but in combination with other
activities provide customer satisfaction and therefore add value.
The main components are as follows:
Technology - R & D, product design and testing, process design and testing.
Operations - Conversion of inputs (people, materials, machines etc) into the final
product or service.
174 | P a g e
Value chain analysis is underpinned by the concept of quality which involves the
following:
The meaning of quality can be subjective but generally it can mean non-inferiority,
superiority or usefulness of the product or service the customer is buying. A common
interpretation of quality is "fitness for its use or purpose".
TQM is the process of embracing a quality conscious philosophy or culture, as well as
adopting quality standards and procedures within an organisation, aiming towards
perfection and continuous improvement.
Kaizen, the Japanese equivalent to TQM means continuous improvement by small
incremental steps.
I hope you have found this report useful but should you require any further assistance or
have any questions please do not hesitate to contact me.
Signed : Management Accountant.
B1 12 Inventory levels (CIMA P2 May 2008)
Part (a)
Exam tip: The examiner is only after three cost changes being explained, however we
have given you other cost changes that could be equally valid to discuss.
If Just-In-Time (JIT) were introduced the following cost changes would result:
Reduction in stock holding costs to nil as material is only used and bought if there
is a demand being the philosophy of JIT.
Reduction in stock holding costs for finished goods and work in progress as all
items will be sold to waiting customers.
175 | P a g e
Increase in price of raw materials from suppliers for regular small amounts
ordered at short notice, but maybe reduced through the introduction of long-term
exclusive contracts with suppliers.
Quality control costs will have to be put into place in the production process to
eliminate scrap, re-works and defects which would delay despatch of goods to
customers.
Staff training costs to ensure that they are able to use the new machinery
efficiently and effectively and be able to maintain them.
Part (b)
Total quality management (TQM) is important to a company that operates a JIT
production method because TQM means that the product is made to a very high standard
reducing internal failure costs such as the inspection and scrap material and also
reduction in external failure costs such as repairs and replacement.
JIT requires a TQM approach in order to operate holding zero stock levels and only
producing if there is demand, being the philosophy of JIT. This would mean whatever is
made must be to a high level of quality the first time and every time as there is no spare
material to re-make a product that is defectively made. If defective products were made
then production would have to stop while more material is sourced and the product remade, this may cause a loss of sales and customer goodwill as we would not be able to
deliver the product on time.
If the defective product were to be sold on to the customer this would cause the product
to be sent back for repairs and customer confidence and goodwill being lost.
If TQM were adopted then it would encourage a quality conscious philosophy within
staff culture, as well as adopting standards and procedures.
176 | P a g e
The learning rate has reduced between months 2 and 4 from 75% to 90%. This
maybe due to a number of reasons:
An increase in staff turnover and so new staff have to learn how to make these
products efficiently and effectively and so require more time than the experienced
staff who have left.
A gradual reduction in how much more that can be learned by the existing work
force in the manufacturing of the product.
Inferior materials being introduced and so have led to more re-works and longer
production times.
Production is no longer in its early stages and so great improvements have already
been had.
Motivation and enthusiasm of the existing staff has fallen due to lack of
incentives in perhaps skills or pay, and so therefore taking longer to produce the
items.
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Part (c)
a = 45 hrs, y = 182.25 hrs / 8 batches = 22.78 hrs on average for 8 batches
If we assume that r represents the learning rate, then:
Batches
1
2
4
8
Output (batches)
Direct labour hours
Direct labour cost ($)
Flexed budget
50
68.91 hours (W1)
$826.92 (W2)
Actual
50
93.65 hours
$1,146
Variance
24.74 hours (A)
$319.08 (A)
Direct labour efficiency variance = 24.74 hrs x $12 per labour hr = $296.88 (A)
Direct labour rate variance = $319.08 - $296.88 = $22.20 (A)
Workings
(W1) Direct labour hours
The learning curve ceases once we reach 30 batches, meaning that labour will not get any
faster in the production of any more units. Therefore we need to work out the total time
for 30 batches and compare with the total time for 29 batches to obtain the time taken to
make the 30th batch and use that as the time needed to make any further batches.
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The original budget did not take into account the revised expectations of the
learning curve for direct labour and therefore making comparisons is meaningless.
The original budget was not adjusted or flexed for the actual level of output to
obtain a fair basis of what should be expected to be used in terms of resources and
costs.
The revised out-turn performance report analyses the labour cost variance further
into the efficiency variance and labour rate variance, thus allowing improved
understanding of the real cause of the variance and then being able to assign
responsibilities to the appropriate managers.
179 | P a g e
Learning curve effects enjoyed by the workforce because the production is labour
intensive, repetitive and most of the staff is retained over the long term.
Stock control systems will be more efficient if the company employs a JIT
approach to stock management. This will reduce stock holding costs to nil and
material is only used or bought if there is a demand.
Discounts will have been received as the company would buy more and more
bigger batches of the raw material throughout the products life cycle.
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Total quality management techniques will be used which means that the product
will be made to a very high standard reducing internal failure costs such as the
inspection and scrap material and also reduction in external failure costs such as
repairs and replacement.
During the maturity phase there is unlikely to be any further significant cuts in unit
variable costs, and in the decline phase the unit production cost will begin to increase.
This is expected as the demand for this product will be reduced significantly as it will
have fallen out of favour with customers, and therefore less is being made and as a result
fewer materials needed. The lower prices on raw materials cannot be enjoyed because of
the reduced quantities bought by the company and hence the increase in unit production
costs. In addition production costs will increase due to machine breakdowns and
inefficiencies.
(iii) Selling and marketing costs
During the growth stage there will be much reduced expenditure on selling and marketing
costs as there will be wide customer awareness of the product already and a minimal
amount of expenditure will be required to reinforce the continued customer awareness of
the product.
During the maturity stage such costs will be reduced further as the product is being more
sold on reputation and word of mouth. Selling and marketing costs are not bringing any
further benefit.
During the decline stage selling and marketing costs will cease as the product will fall out
of favour with customers and will mainly become obsolete and production of which will
also cease.
B1 16 Timber products (CIMA P2 May 2010)
Part (a) (i) (ii)
Month Demand
Basic
Inc/(Dec) Closing
Ave
Std Hrs Production Inventory Inventory Inventory
Std Hrs
Std Hrs
Std Hrs
Std Hrs
1
3,100
3,780
680
680
340
2
3,700
3,780
80
760
720
3
4,000
3,780
(220)
540
650
4
3,300
3,780
480
1,020
780
5
3,600
3,780
180
1,200
1,110
6
4,980
3,780
(1,200)
0
600
Total
Inventory
Holding Costs
($6 per month)
2,040
4,320
3,900
4,680
6,660
3,600
25,200
Overtime
Costs if using JIT
($15 per hour) (W1)
3,437.55
18,750.00
22,187.55
Workings
(W1) Overtime costs
Month 3 = 220 std hours / 0.96 = 229.17 hours x $15 per hour = $3,437.55
Month 6 = 1,200 std hours / 0.96 = 1,250 hours s $15 per hour = $18,750
Part (b)
Only 2 factors are needed to be explained from the following:
1. There needs to be close relationships and contractual agreements with the
suppliers which would need to be maintained throughout, since no inventory will
be kept at XY for urgent requests such sales or defective items.
2. Smaller and more frequent deliveries will need to be planned and co-ordinated to
coincide with production needs. The supplier may not have the logistics to
support XY.
3. Higher quality machines will be needed with regular maintenance to avoid delays.
4. There will need to be involvement and training of staff to maintain flexibility of
working hours and skills.
5. Staff need to take responsibility of their quality and so they need to be encouraged
and motivated to do so.
B1 17 LMN (CIMA P2 May 2010)
Part (a)
Performance within an organisation should be focused on assessing what can be
controlled by divisions or individuals and omitting any items which are uncontrollable.
However this is clearly not the case here as there are issues the divisional directors are
responsible for but are not within their control.
Three issues are as follows:
The investment decisions that divisional directors are responsible for maybe
limited due to the $100,000 threshold. It is not clear as to the size of the divisions
and therefore it cannot be ascertained with certainty if divisional directors can
freely make meaningful independent decisions.
Head office costs are apportioned on an arbitrary basis with no consideration for
the activities or costs expended in each of the decisions; furthermore the divisions
do not have control over their own efficiency of resources that they use.
182 | P a g e
The transfer prices are enforced by head office and the divisional directors have
no input into their calculations. It is not clear whether head office is imposing on
divisions to transfer internally or whether they can decide themselves to purchase
internally or externally. There is also no information on the extent of internal
demand for goods and services.
Part (b)
Activity based costing (ABC) will look in more detail about what caused the head office
costs to be incurred and will seek to work out many cost drivers (activities). A cost
driver is any factor that causes a change in the cost activity, so it is important to identify a
causal relationship between the cost driver and the cost. So for example there maybe
head office costs which do not relate to any activities of the divisions but are
administrative expenses to support the organisation as a whole. These should be ignored
as they cannot not be affected by decisions undertaken by the divisions. LMN must only
look at costs which would occur due to the activities of the divisions, this may mean
including other costs and removing others. This would then result in a fairer way to
assess the divisions.
This would allow more efficient management of resources by understanding what drives
costs incurred by divisions. There would be better costing information for planning and
control for example and how different products, customers or distribution channels
consume different resources. Furthermore, more realistic and competitive pricing to cover
overheads and better profitability analysis because of improved accuracy over costs.
B1 18 Production manager (CIMA P2 Nov 2010)
Part (a)
Output
Direct labour hours
Direct labour cost
Flexed budget
560
4,480
$67,200
Actual output
560
3,500
$57,750
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Workings
(W1) Direct labour hours
Using the learning curve formula:
Y = aXb
Y = average time for that (X) number of units or the average cost per unit
a = time for the first unit or the cost for the first unit
X = the number of units you want to calculate an average time or cost for
b = the index of learning (log r/log 2)
a = 8 hours, b = -0.1520
Work out the average time for the first 560 units:
Y = 8 x (560 to the power of 0.5146) = 3.057 hours
Total time for 560 units = 3.057 x 560 = 1,712 hours
Part (b)
Target costing is a strategy which seeks to the selling price of a product at the market
price which consumers are willing to pay, being the price that the product should be sold
for in the market. Then deducting a desired level of benefit or profit for the organisation
in order for the manufacture to be commercially viable, and then the product be
manufactured within the value left over thereby becoming the budgeted costs or target
costs.
Market price to achieve desired market share
TARGET COST (balancing figure)
Desired profit
XX
(XX)
XX
Learning curves is an important part of a target costing strategy as it will help in reducing
costs within the business. It is only applicable to those businesses that have a labour
intensive operation where savings can be made through experience and efficiencies. In a
machine intensive operation these savings are limited as machines tend produce at the
same rate. Businesses can achieve target costs once a certain level of activity has been
achieved and so therefore for lessons can be learned and applied to standard costs once it
is known the learning capacity of the labour force.
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Prevention costs these are spent to try and ensure the product is made to detailed
specifications and regulations. For example training staff, customer surveys,
supplier reviews and investment in machines.
Appraisal costs these are spent to understand how well a process has performed
and corrective action is taken if needed subsequently. For example measuring
equipment, inspections and tests, product quality audits.
Quality non-conformance costs are quality failure costs that are needed to correct
products, as they did not meet expectations or target.
There are two main types of non-conformance costs:
Internal failure costs these are quality failure costs before the products or
services have been transferred to the customer. For example re-inspection of
goods, losses or scrapping of materials and finished goods, additional
administrative costs.
External failure costs - these are quality failure costs before the products or
services have been transferred to the customer. External costs should be avoided
as they expose poor manufacturing abilities to customers. Examples are
administration of customer complaints, administration of customer services,
product liability claims, repairs and replacements, lost goodwill and reputation.
It is clear from the scenario that CAL from a quality perspective provides middle range
quality of solar panels, as they have competitors who sell at a cheaper price but offer an
inferior range of solar panels and others who sell at a higher price but offer a high quality
range of solar panels. CAL is losing out on an increase of 25% in its market share due to
external failure costs of poor assembly skills by staff.
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This system will ensure demand is met but would lead to inefficient production and
obsolete finished goods. This is because managers would tend to produce more goods
than is necessary to meet demand. This system would also lead to other holding costs
such as damage, deterioration, administration, security and interest costs.
Part (b)
It is essential that a JIT system is underpinned by TQM. This is because under a JIT
system if an item is discovered by the customer as faulty then the company will not be in
a position to replace immediately as it does not hold any stock. It would have to
manufacture the item again and so there will be a delay to customers who may not be
happy about this. The delay may slightly less with QW as they hold 1 days worth of raw
materials but nevertheless there will be waiting time for customers.
In a constant rate production system TQM is not as important because there would be an
inventory of both raw materials and finished goods that can be used to replace the faulty
item. This system has the advantage of customers not having to wait for their replacement
item, however it has the disadvantage of greater costs for holding greater amounts of
inventory and more importantly the company moving away from a focus on quality of
product resulting in the long term loss of customer goodwill and difficulties in
convincing employees that quality is important.
B1 21 Accountancy services (CIMA P2 Nov 2010)
Cost driver rates:
Travelling to clients
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Client
Accounts preparation and advice
Requesting missing information
Issuing fee payment reminders
Holding client meetings
Travelling to clients
Total costs
A
$
32,220
480
75
960
600
34,335
B
$
8,055
1,200
300
240
2,400
12,195
C
$
10,955
720
375
480
0
12,530
40,280
10,070
13,695
41,202
48,336
(7,134)
14,634
12,084
2,550
15,036
16,434
(1,398)
Workings
(W1) Total cost on old basis
$725,000 / 18,000 hrs = $40.28 per hr
B1 22 PT (CIMA P2 May 2011)
(i) Growth stage
Unit selling prices
Due to the very short expected life cycle, during the growth stage as competition begins
to enter the market, PT will have to reduce its selling price; in order to stay competitive
as substitutes will be being produced by competitors. These substitutes would have been
created by manufacturers purchasing PTs product and reverse engineering the product.
This approach will aim to sustain demand and contribution from PQs product as long the
selling price is greater than the marginal cost of manufacturing the product. The cash
flow will be used to develop other products in development.
Unit production costs
There will be a continued reduction in unit production costs of this product during its
growth stage but unlikely to see any further reductions beyond this stage. This will be
attributable to economies of scale being enjoyed by the company through mass
production techniques, such as below:
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Learning curve effects enjoyed by the workforce because the production is labour
intensive, repetitive and most of the staff is retained over the long term.
Stock control systems will be more efficient if the company employs a JIT
approach to stock management. This will reduce stock holding costs to nil and
material is only used or bought if there is a demand.
Discounts will have been received as the company would buy more and more
bigger batches of the raw material throughout the products life cycle.
Total quality management techniques will be used which means that the product
will be made to a very high standard reducing internal failure costs such as the
inspection and scrap material and also reduction in external failure costs such as
repairs and replacement.
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Get things right first time e.g. aim for zero defects.
Eliminate waste and inefficiency.
The JIT philosophy requires that products should only be produced if there is an internal
or external customer waiting for them; it aims ideally for zero stock.
The following reasons explain why TQM is important within a JIT environment.
1. Less equipment downtime and major stoppages in production give greater
efficiency of production flow to help meet customer orders quicker.
2. Less reworks, scrap and wastage will ensure faster lead times to meet customer
demand.
3. Avoids sub-standard material from suppliers or sub-standard finished goods
holding up production.
4. More effective teamwork and training of staff will help to improve flexibility to
meet customer orders quicker.
5. Helps staff diagnose and rectify problems quicker.
6. Improved service to customers.
In conclusion within a JIT environment lead time is paramount due to the absence of
stock e.g. a chase demand strategy of meeting customer demand. TQM will help
improve response times by a more efficient and flexible organisation.
B1 24 Standard costing (CIMA P1 May 2006)
Tip: The question requires only three reasons why standard costing may not be
appropriate in a modern business environment. The solution below gives four
possible answers.
Sometimes hard to define an attainable standard especially with the complexity
and diversity of modern manufacturing. Traditionally manufacturers produced a
small range of products using mass production techniques. Nowadays products
have shorter lifecycles and different batches of many different products can be
produced, therefore standard costing is more complex as well as less useful due to
the shorter lifespan of products.
With more automation within operations and less human intervention, standards
are becoming less valuable as information. Automation produces greater
uniformity and consistency of products produced. This places less value on the
use of variances e.g. labour variances, as well as less frequency and materiality of
variances occurring.
Standard costing is an internal not external control measure. Improvement within
organisations needs to consider competition, customers and other global
environmental factors, due to greater intensity of competition. Nowadays external
benchmarking and value analysis is considered more useful to improve an
organisation and its products. Dynamic environments changing frequently do not
support the use of standard costing due to greater flexibility required.
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In order to effectively support a standard costing system there must be master files set up
containing information about the standard costs, quantities and time needed to
manufacture products. Separate master files for production, materials in stock, lead times
and labour and machine time are needed and then performance can be measured through
variance analysis.
B1 27 JIT (CIMA P1 May 2007)
The JIT philosophy requires that products should only be produced if there is an internal
or external customer waiting for them. Traditionally manufacturers stockpiled and were
not concerned whether or not there was any demand for the products. The main aim was
to have enough stock for each stage of production. This would be able to sustain any
sudden surges in demand but as a result of this there would be an excess of raw materials,
work in progress and finished goods being carried. JIT aims ideally for zero stock e.g.
raw materials delivered immediately at the time they are needed, no build up of work-inprogress, finished goods only produced if there is a customer waiting for them. It aims to
try to achieve this by doing the following:
1.
2.
3.
4.
5.
6.
7.
The company will establish senior management commitment and support for
TQM.
Processes are put in place to facilitate the adoption of standards and procedures
(such as ISO 9000 certification) to monitor and control quality. This is often
achieved by benchmarking of competition and investment in employees.
Production to achieve zero defects and eliminate waste. This would be achieved
by ensuring that adequate time is spent in manufacturing the products correctly
the first time.
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Employees are to look for continuous improvements in all the processes, resulting
in improved productivity, efficiency and less idle time from work processes
undertaken.
The company manufactures products which are more customer focussed achieved
through the use of added value activities such as continuous feedback from
customers and the reduction of customer complaints.
Stock being held by the company will be zero and there will be no work in
progress as products are being made only if there is an external or internal
demand.
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Solutions Section B
Part B Cost Planning and Analysis for Competitive Advantage
B2 -1 The Q organisation (CIMA P2 May 2005)
Part (a)
Stages in the life of a product will include:
Introduction e.g. customers unaware, high initial research and development and
marketing cost to create and market the new product
Growth e.g. awareness increases and industry size increases as more and more customers
make purchases of the product, new features to improve or differentiate the product as
more competition enters
Maturity e.g. product development, modifications and improvements to extend the
products life. Mature and a more saturated market as industry growth slows down and
demand reaches a limit, greater production efficiency/economies of scale obtained by this
stage.
Decline e.g. obsolesce of product, usually replaced by a better or newer versions or other
broader substitutes
Sales
Time
Introduction
High unit costs.
Extensive sales
promotion
Growth
Competitors
enter market.
Unit costs fall
Maturity
Profits
good.
High sales
promotion
Decline
Overcapacity
in industry.
Some players
leave market
Senility
Product possibly
retained to
enhance product
portfolio
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VC affected by
learning curve
30.00
26.10 (W1)
24.06 (W1)
22.71
VC not affected by
learning curve
30.00
30.00
30.00
30.00
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Demand units
10,000
20,000
30,000
40,000
Selling price
per unit
100
80
69
62
VC per unit
60.00
56.10
54.06
52.71
Contribution per
unit
40.00
23.90
14.94
9.29
Total
Contribution
400,000
478,000
448,200
371,600
The price that optimises contribution is 80 in the initial launch phase of 20,000 units.
Part (b) (iii)
We need to work out target contribution from the given target profit of 30,000 and then
we can work out how many units we need to sell to achieve the target contribution.
If target profit is 30,000 and fixed costs are given as 15,000 then target contribution
must be 45,000.
The initial launch phase is 20,000 units, and so we need to work out contribution per unit
after this and then we can divide this by target contribution to know how many units to
sell.
The problem is that we have a reducing variable cost due to the learning curve for every
batch we produce and so therefore we have to work out the average unit cost for every
batch.
Ave unit cost between 20,000 and 30,000 units:
(30,000 x 54.06) (20,000 x 56.10)
10,000
49.98
48.66
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132.00
99.00
Packing
Small package (given)
Large package (given)
Delivery
(40,000 1000 deliveries) 6 small packages =
(40,000 1000 deliveries) 12 small packages =
Other overheads
200,000 8000 orders =
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Order
Invoice processing
8.75 per invoice
7.50 per invoice line
7.50 x 2 =
8.75
15.00 7.50 x 8 =
8.75
60.00
Packing
small package
32.00
Delivery
small package
0.40 x 8 miles
Other overheads
25 per order
6.67
16.00
25.00
25.00
80.28
148.42
Part (b)
Tip: A good report format will make your report be well presented and provide good
structure for your answer. Part (b)(i) in short requires the advantages and
disadvantages of ABC in comparison to absorption costing, so if you know what these
are it will be the backbone to answering this part to the question. A good approach
also would be to think of good examples from the calculations in part (a) to provide
value within your report e.g. why the proposed system has led to a better or worse
understanding of how costs are driven by the different resources consumed, such as
administration or transport.
REPORT
To: Management of F Plc
From: Management Accountant
Date: DD/MM/YY
1.0 Introduction
The purpose of this report is to assess the strengths and weaknesses of the proposed
activity approach for F Plc and recommend actions that the management might consider
in the light of the new data produced using the activity based approach.
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It required less invoice processing than order B e.g. only two lines on the invoice,
meaning less resource of staff or equipment used to administrate it.
It was a small package and therefore costs less to transport per package, due to a
lorry having the ability to carry more packages per load. It also required less
distance to be transported and this was reflected also in the cost of the order.
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I would not recommend using the proposed ABC system as a way of pricing orders for
customers, as I consider it too complex, but I would recommend it perhaps internally
within F Plc when it comes to understanding how to reduce consumption of resources and
improve efficiency. I would also recommend it for customer profitability analysis when
it comes to making better management decisions about whether or not to supply a
customer e.g. is the customer losing money for F Plc? Such a system can be maintained
through a simple spreadsheet when doing so and therefore will not require significant
investment.
Signed Management Accountant
B2 3 KL (CIMA P2 Nov 2006)
Part (a)
Total or full cost plus pricing
This approach takes the variable costs involved in manufacturing the product and adding
an apportioned amount of fixed overhead using an absorption costing or activity based
costing system. This is known as the total or full cost. Then by adding a % mark up
which will represent the profit earned from selling the unit this will give us the total or
full cost plus price. This is the selling price of the unit.
Advantages
Ensures fixed overheads are recovered in the long-term as it is included in the
selling price.
Suitable if you already have an absorption costing system in place but without
such a system it would be difficult to know how much to absorb of the fixed
overheads in each of the different products.
Good for long-term profitability analysis as fixed overheads would be aimed to be
recovered fully in all products sold.
Adequate profits are made without the need to seek out a selling price that would
maximise profits as a profit mark up is included in the price.
Easy and quick to produce prices for products and therefore can be delegated to
junior staff.
Disadvantages
The selling price selected may not suit the market price and demand conditions as
it ignores competition.
The method of sharing fixed overhead over the product range is subjective as a
fixed overhead cost driver must be selected to apportion the costs. The driver may
not be representative of how fixed overheads were actually spent.
Different organisations will use different overhead absorption methods for
example an activity based costing approach versus a traditional absorption costing
approach.
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There is a far better understanding of cost as we are only looking at those costs
that change as a result of our decision that being marginal costs only.
It is useful when we only have information regarding variable costs only.
Good for short-term decision-making as it ignores historical fixed costs.
Disadvantages
Ignores fixed overhead in the long-term and therefore this would result in long
term losses. Fixed overheads need to be recovered over the long term; however
the mark up may be large enough to include this and profit.
The selling price selected may not suit the market price and demand conditions as
it ignores competition.
It maybe all you can use due to the inability to apportion fixed overhead.
Part (b)
Product
Labour hours per unit
Budgeted production
Total labour hours
W
$40 / $10 = 4
15,000
15,000 x 4 = 60,000
X
$30 / $10 = 3
24,000
24,000 x 3 = 72,000
Y
$50 / $10 = 5
20,000
20,000 x 5 = 100,000
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Material
Labour
Overhead
Total cost per unit
W
$35
$40
$4.50 x 4 = $18
$93
X
$45
$30
$4.50 x 3 = $13.50
$88.50
Y
$30
$50
$4.50 x 5 = $22.50
$102.50
Part (c)
W
15,000
Production levels
15,000/500 = 30
Number of batches
30 x 4 = 120
Supplier orders
15,000 x 5 = 75,000
Machine hours
X
24,000
24,000/400 = 60
60 x 3 = 180
24,000 x 8 = 192,000
Y
20,000
20,000/1,000 = 20
20 x 5 = 100
20,000 x 7 = 140,000
W
($550 x 120) / 15,000
= $4.40
($909 x 30) / 15,000
= $1.82
($0.98 x 75,000) / 15,000
= $4.90
($0.80 x 75,000) / 15,000
= $4
$35
$40
$90.12
X
($550 x 180) / 24,000
= $4.13
($909 x 60) / 24,000
= $2.27
($0.98 x 192,000) / 24,000
= $7.84
($0.80 x 192,000) / 24,000
= $6.40
$45
$30
$95.64
Y
($550 x 100) / 20,000
= $2.75
($909 x 20) / 20,000
= $0.91
($0.98 x 140,000) / 20,000
= $6.86
($0.80 x 140,000) / 20,000
= $5.60
$30
$50
$96.12
Part (d)
Current system
ABC
Difference
W
$
93.00
90.12
0.12
X
$
88.50
95.64
(7.14)
Y
$
102.50
96.12
6.38
It seems that for product W using Activity based costing (ABC) or the current system
produces very similar figures for unit cost, however for product Y costs are less under
ABC when compared to the current system, but this is not the case for product X where it
seems that there are more costs allocated under ABC than the current system.
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ABC looks in more detail about what causes fixed overhead to be incurred and works out
many cost drivers rather than just labour or machine hours or products produced, all
driving overheads to be incurred. It is used in order to obtain a more accurate way of
looking at how fixed overhead are driven and should give a more accurate picture when
costing products, budgeting or valuing stock.
ABC can improve profitability by:
Thereby better costing information for planning and control e.g. how different
products consume different resources or the production of flexed budgets based
upon activity based budgeting (ABB).
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Weeks 1 to 4
Weeks 5 to 8
Weeks 9 to 12
Weeks 13 to 16
Sales lost
None
30%
20%
10%
Weeks 1 to 12 there would be a 10% discount on the price of basic and canned foods.
Basic foods
Newspapers
Frozen foods
Canned foods
Lost contribution for 1 week
$
200
300
950
1,200
2,650
$
10,600
(400)
2,500
3,180
2,120
1,060
896
1,024
1,152
22,132
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Option 2
Relevant costs for option 2
Closure for a week lost contribution
($2,650 - $100) x 0.5
Redecoration costs
Product movement costs
Lost contribution on frozen foods (W1)
Lost contribution on canned foods (W1)
Total
$
1,275
3,500
1,000
2,550
6,840
15,165
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Part (b)
Traditional absorption costing takes the total budgeted fixed overhead for a period and
divides by a budgeted (or normal) activity level in order to find the overhead absorption
rate.
Activity based costing (ABC) looks in more detail about what causes fixed overhead to
be incurred and works out many cost drivers rather than just labour or machine hours or
products produced, all driving overhead to be incurred. It is used in order to obtain a
more accurate way of looking at how fixed overhead is driven and should give a more
accurate picture when costing products, budgeting or valuing stock.
ABC is a method which lends itself to a retail company environment where there are a
wide range of products being bought and sold which require different conditions in
storage and display. For example frozen foods and chilled foods require refrigeration
costs where as canned foods do not require this only storage in normal room temperature
conditions.
Main steps in ABC
Group types of fixed overhead together, if they are driven by the same type of
activity or driver. These are known as cost pools. For example quality control
supervisor and quality control rent and overhead, grouped together as both would
be driven perhaps by the number of inspections forecast for the period.
Calculate from these cost pools a fixed overhead cost per driver, for example
similar to an overhead absorption rate when compared with traditional absorption
costing.
Absorb fixed overhead by using many cost drivers rather than just one or two
cost drivers or overhead absorption rates as with traditional absorption costing
this would give management a better idea as to how different products produced
consume resources and therefore overhead.
Activity
Material procurement
Material handling
Quality control
Cost driver
No. of purchase orders
No. of movements
No. of inspections
Advantages of ABC
ABC would allow efficient management of resources by understanding what drives fixed
overhead incurred.
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There would be better costing information for planning and control for example how
different products consume different resources or the production of flexed budgets based
upon activity based budgeting (ABB).
When an organisation is formulating their long term strategic decisions, such as product
pricing, mix of products, discontinuance, launch or promotion of existing products and
the launch of new products, ABC allows for realistic pricing to cover overheads and
therefore superior profitability analysis on product ranges.
ABCs strength lies in the fact it allows accuracy over costs and drivers for products and
as a result a sensible pricing strategy is achieved. It more specifically gives a good long
term understanding of the variable costs being very relevant for decision making.
However ABC information must be put into perspective as these are historic costs and
cannot be used alone to predict future costs. They should be used as a starting point and
other internal and external information should be used to determine future costs. All costs
are variable in the long term and subject to change.
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Solutions Section A
Part C Budgeting and Management Control
C1 -1 Solicitors firm (CIMA P2 May 2010)
Part (a)
In the present budgeting system the senior partner estimates demand for the year while
the divisional manager creates the cost budgets to support demand. The cost budgets are
submitted for review by the senior partner but any amendments to the budgets are
included without consultation with the divisional partners. This illustrates that the senior
partners do not really allow divisional partners to participate in the budgeting process as
they are not consulted on budget revisions.
This can de-motivate staff leading to a decline in their productivity and efficiency as they
feel their expert opinions are not important and are simply ignored. The divisional
partners would feel that they have wasted their time in creating the budgets and would
begin to feel that they are not part of the process to improve the organisation. There is
great danger of a divide being created between the senior partner and the divisional
partners.
The current approach may also see divisional partners start to find excuses not meeting
targets just to prove to the senior partner that their budgets were correct and the changes
imposed by the senior partner were wrong. Sub-optimisation or dysfunctional behaviour
may occur for example the personal objectives of the divisional partner are not aligned
with the business objectives.
Part (b)
Only 2 are needed to be explained from the following:
Training days per staff measures the level of investment that the firm has
committed to improving staff skills to support the needs of clients.
Staff turnover measures the number of staff leaving the firm indicating that staff
are perhaps dissatisfied with the firms approach to supporting the needs of staff.
Training costs per staff measures the amount of money the firm have set aside
for staff training purposes.
Time taken between client first enquiry and first meeting measures efficiency
and flexibility of the firm to clients needs.
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Rolling budgets always provide a budget for the full period as they get updated,
unlike annual budgets which dont get updated as the periods expire. This enables
management and so enables better long term planning.
Rolling budgets are good for adaptive planning, for example there is a greater
chance that the budgets will be regularly updated to take account of changes
within the environment the organisation is operating within if used.
Part (b)
The new depot manager has two concerns that he raises about the current system:
Budgets are out of date
Annual budgets are set on annual basis and are not revisited on a regular basis. This
means that it is not possible to see if the budget is being met or even if current economic
circumstances have made the budget out of date and not applicable.
Rolling budgets would allow regular comparison to the actual outcomes more frequent
update of forecasts where necessary due to unanticipated changes in the economy. This
would keep the budgets more accurate, reliable and meaningful.
Operational and strategic decisions cannot be taken
Rolling budgets always provide a budget for the full period as they get updated and
approved my management, unlike annual budgets which dont get updated as the periods
expire. This enables depot mangers to take decisions for the early part of next year.
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Annual budgets only get updated once a year and proves difficult for depot mangers to
make decisions until the budget has been approved by management which maybe close to
the year end restricting decisions being taken by depot mangers in the early part of next
year.
Operational decisions and control must however be dealt with carefully as these entail the
day to day actions of the company and any differences in actual performance must be
noted to ensure that improvements can be made. Rolling budgets should not eliminate
these variances by revising them as it would mean that information about inefficiencies
cannot be isolated and improved.
Strategic decisions and control would benefit from rolling budgets as it help to ensure
that failing strategies are abandoned in favour of successful strategies. Rolling budgets
would allow frequent revisits to the strategy to ensure that it is being met and if not then
the original strategy being revised.
C1 3 JYT (CIMA P2 May 2011)
Target costing is a strategy which seeks the selling price of a product which consumers
are willing to pay, being the price that the product should be sold for in given market
forces. Then deducting a desired level of benefit or profit for the organisation in order for
the manufacture to be commercially viable, and then the product be manufactured within
the value left over thereby becoming the budgeted costs or target costs.
Market price to achieve desired market share
XX
(XX)
Desired profit
XX
The target cost is normally achieved over the long term using learning and experience
curve efficiencies and may take several years and so in the meantime the desired profit is
squeezed to compensate.
Target costing is not simply a cost reduction exercise but a quality improvement strategy
over the long term. It sacrifices short term profitability for long term profitability and
combines the use of JIT, TQM, cost reduction, value analysis and benchmarking to
achieve the target cost.
Kaizen costing is the process of continuous improvement through small incremental steps
rather than transformational changes. It also believes strongly in empowerment of
employees to enable them to improve operations. Kaizen costing focuses on reducing
variable costs of future periods below that of prior periods.
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Human resources are your most valued asset and they should be involved in the
search for perfection. They have superior knowledge as they are in the operation.
This is the opposite of traditional systems where the managers develop standards.
Incremental or gradual improvement.
Perfection should be sought all the time and so there is always room for
improvement.
Cost reduction targets more frequent rather than traditional annual standard costs.
Variance analysis used to help with kaizen costing.
Investigations carried out if targets not met even if improvements have been
made.
Unlike kaizen costing, target costing doesnt focus on gradual cost reduction but starting
from scratch and re-designing methods and processes to achieve large changes. Kaizen
costing relies on all employees taking part in the process because it focuses on making
small improvements by everyone.
Target costing is a strategy implemented before the launch or production of a product
unlike kaizen costing which is employed when production has commenced.
C1 4 DVD (CIMA P2 May 2011)
Part (a) (i)
The sales mix variance shows the change in the different product lines being sold and
the impact it has on profit or contribution.
DVD
Blu-ray
Actual
sales
quantity
3,000
1,200
4,200
Actual sales
at budget
mix (W1)
2,800
1,400
4,200
Difference
Profit
Variance
200 (F)
200 (A)
$25
$95
$5,000 (F)
$19,000 (A)
$14,000 (A)
The sales volume (profit) variance measures the difference between the original and
flexed budgeted profit. It measures the impact on profit, when actual sale of units is more
or less than the original budgeted sale of units. This method of calculation would be
applied when absorption costing is used by the organisation.
DVD sales volume variance = (3,000 3,000) x $25 = $0
Blu-ray sales volume variance = (1,200 1,500) x $95 = $28,500 (A)
Total sales volume variance = $28,500 (A)
Part (b)
The planning variance is beyond the operational control of management and staff for
example market size growth of Blu-ray player.
The operational variance is normally within the control of management and now more
realistic as a yardstick because calculations would include any revisions to standard, in
the case of the Blu-ray players, the revised budgeted demand due to changes in the total
market share.
An example of an operational variance is the changes in the selling prices for the DVD
and Blu-ray players resulting in variances which are controllable by management.
Planning variances will help highlight variances between those which are controllable
and those which are uncontrollable. For example the sales managers email boasts a
favourable $19,000 variance however it is not strictly entirely caused by his influences of
sales, some of it is due to the increase in total market share of Blu-ray players which is
not in the control of the sales manager. The budget for Blu-ray players should have been
1,500 units and therefore resulting in an adverse variance.
Planning variances help motivate managers and staff, for example avoids staff being
blamed for faulty planning and gives a fairer reflection of any operational variances
calculated when assessing any operational efficiencies or inefficiencies. Management and
staff would be appraised more fairly for any favourable or adverse deviations that are
within their control.
Planning variances make use of realistic standards in order to measure performance gives
better management information for control purposes.
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Part (c)
An uncontrollable cost does not mean a manager being assessed should ignore it
altogether. As an example if managers recognise there is an interest charged by head
office based upon the capital employed used within a division, then to hold them more
accountable could help improve efficiency by the minimisation of capital employed. In
the case of head office charges, lack of accountability could encourage over consumption
of these resources provided centrally. However it would be considered fairer if a manager
were not assessed on costs which are not within their own control. This is likely to
improve motivation and morale.
The way to include non-controllable costs when assessing the performance of the manger
on a fair basis is to put them into a separate section with in the report; however it is not
always clear when determining controllable and non-controllable costs. Political
arguments may ensue which are more subjective than objective when determining
controllability.
C1 6 Feedback and feedforward (CIMA P1 Pilot Paper 2005)
An example of a feedback control system is a budgetary control system. This would
gather information on past performance from the output of the system e.g. actual
financial performance, and compare this to a predetermined standard or plan (budget)
using any deviations e.g. variances, as a basis of improving future performance through
control action taken.
A feedback loop is where the output of a system is measured and fed back as input into
the system in order to obtain a desired effect, often done intentionally, in order to control
the behaviour of a system. In a double feedback loop, corrective action is not
automatically taken. The output of the system is measured, however environmental
factors will also be considered, along with internal feedback before any control action is
taken. In a single feedback loop, the output is automatically compared to a predetermined standard; any exceptions and control action will be automatically taken.
Feedback contrasted to feed-forward control is like closing the door after the horse has
already bolted, in other words there is little you can do about it now, except try and
rectify the situation to avoid it happening again. Feed-forward control is more prevention
than appraisal, controlling a system by making adjustments now to the system in advance
before any exceptions occur. It does this by trying to predict what will happen in the
future.
Feedback can be transformed into feed-forward control by being more proactive and
predictive as to what will happen in the future, rather than being reactive or backward
looking by historical reflection on the past.
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Tip: Below are many possible answers for each perspective, the question states that
you are to provide only one performance measure for each perspective and give a
reason to support each measure.
A new approach to strategic management was developed in the early 1990's by Drs.
Robert Kaplan (Harvard Business School) and David Norton. The balanced scorecard
suggests that we view the organisation from four perspectives.
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Customer perspective e.g. what must we do right for our customers and what do
they value?
Internal perspective e.g. what must we excel at or improve internally to satisfy
shareholders and customers?
Innovation and learning perspective e.g. how can we innovate and improve value?
Financial perspective e.g. how do we satisfy shareholders and create value for
them?
Customer perspective
The reason for all the above measures is that they would indicate customer satisfaction
for the quality of service customers are receiving.
Internal perspective
The reason for all of the above measures is that they would indicate failures in the
insurance companys internal processes which may impact on customer satisfaction.
High staff turnover indicates the replacement frequently of staff which can impact upon
the efficiency and effectiveness of internal activities.
Innovation and learning perspective
Training expenditure indicates the learning or staff development perspective within the
insurance company and the remaining three are good measures for innovation.
218 | P a g e
Financial perspective
All the above measures concentrate on maximising financial value for a shareholder.
C1 9 Participation in budgets (CIMA P1 May 2005)
Tip: Only three circumstances briefly explained are required. Six possible answers
are included below.
Circumstances where participation leads to poor performance
If managers are asked to participate in setting their own budgets there is the
possibility they will include slack or padding within the budget e.g. have less
sales units forecast than they could realistically achieve, given a reasonable level
of effort. This is the inevitable downside of human behaviour e.g. underestimate
to avoid blame if they were to under achieve.
Participation could create a slower process to formulate a budget because more
consultation is required. This will inevitably increase the cost and time of
formulating budgets, leading to budgets which are late or costly to produce.
The manager could be inexperienced financially. Therefore they may not be able
to contribute effectively if they were to participate. This could lead to
inaccuracies when standards or targets are developed.
In a stable environment where revenue or costs are certain there would be little
benefit in allowing a manager to participate. All this would do is add to the
complexity of formulating the budget which would be unnecessary e.g. with a
university, central government revenue could be fixed and therefore could not be
influenced by a manager.
The manager may not understand the market or industry environment very well
and therefore the targets they set could be unrealistic than if imposed centrally.
Managers could be demotivated due to going through the motions but with no
feeling of real control or influence over the budget they submit e.g. often even
with participation centralised decisions will often amend variables which are
included. If job satisfaction or morale is diminished because of this then
performance could suffer.
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The budget process is too rigid and requires conformance to it with not enough
flexibility. With the constantly changing business environment, managers need to
be having more up to date information to help them make decisions.
The budget process is often too bureaucratic, internally focussed and time
consuming.
Fixed budgets dont work today. A budget is a too static an instrument and locks
managers into the past, something they thought last year that it was right. Managers
instead need to be able to adapt constantly their priorities and put their resources where
they can create most value for customers and shareholders.
The beyond budgeting approach may include the following:
Use of rolling budgets focussing on cash forecasts and not cost control.
Budgets revised more frequently and a shorter time horizon when forecasting.
Part (ii)
The beyond budgeting approach should lead to
In the case of W Limited the environment is intensely competitive and likely that
constant change is taking place in the market for computer games e.g. frequent
innovation. W Limited by using long-term detailed budgets, may not be responding to
these changes occurring due to being too internally focussed and reflecting too much on
the past rather than what is occurring in the market at present. Planning for a three year
time horizon may add little value due to the environment changing so fast.
220 | P a g e
By the creation of more external performance measures, perhaps using the balanced
scorecard it could be monitoring more effective information, such as pricing, innovation
and customer satisfaction. By the use of rolling cash budgets it could be more in touch
with liquidity rather than too much focus on internal cost control.
I would recommend changing the current budgeting system by developing more external
measures that will help W Limited continually adapt to changes within the dynamic
environment they face. I would also recommend a shorter time horizon when planning
and more frequent revision to budgets. Greater participation by those who are more in
touch with the market environment will also help plan more effectively.
C1 11 J Limited (CIMA P1 Nov 2005)
Part (i)
Tip: The current method of budgeting used by J Ltd is incremental budgeting, this
approach updates the budget for each period, by taking the previous period as a base
and adding a certain percentage on top of this to allow for growth and inflation.
Zero based budgeting (ZBB) is a method of budgeting which requires each cost element
within a budget, to be specifically justified as though it was being under taken for the
very first time. Without approval, the budget allowance would be zero. Therefore each
cost, every period, must be justified before it can be included in the budget, with
employees encouraged to find alternative ways of accomplishing the same but for less
money, questions are asked such as;
1.
2.
3.
4.
Part (ii)
Tip: You would need three of the below problems (or others) to earn full marks.
Problems that may arise when implementing ZBB
Management may think too short-term in view when removing items from the
budget.
Entrepreneurial spirit will be needed from staff in order to add value to the
process of ZBB, this may require a change of staff culture given the existing
incremental approach being used.
Change management will need to be carefully planned for to introduce ZBB
techniques.
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Tip : A maximum of three marks are available for each requirement within part (e),
therefore you need to produce a brief response to include perhaps two issues for part
(e) (i) and three issues for part (e) (ii) or vice versa. The solutions below include
many possible answers as to what could have been discussed.
Part (i)
ERP integrates all manufacturing and related departments and functions for the entire
organisation into one single database, this enables various departments to share
information and communicate with each other in a real time environment. It is an
extension of MRP II.
The budget setting process will now be more effective because it will include an
understanding of other resource or activities rather than just production related
activities and how these relate to one another e.g. marketing, finance and HR
budgets.
The budget setting process will incorporate a more effective cash-flow forecast
for the entire organisation.
Because more enterprise wide activities are integrated, it would improve the
efficiency of the budget setting process e.g. less management time involved in
trying to link different activities together.
It should lower the cost of the budget setting process because all resources and
activities are integrated into one whole information system.
ERP should allow when planning better what if? or sensitivity analysis for the
whole organisation e.g. increasing or decreasing the volume of sales or production
activities, will give a more effective understanding of the impact this will have on
a greater number functions within the organisation.
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Part (ii)
ERP operates within a real time environment, therefore you would have
continuous exception reporting (variances) in a real time environment. This
would allow better control rather than traditional periodic review.
Less management time and expense of collecting information for comparison to
the budget or standard due to better integration of systems.
Less analysis work for management due to a greater number of exception reports
produced from one single system.
Tip: You would need to discuss both systems of setting targets from the perspective
of the senior management and finance department for 2 marks. Also around three
issues for how to alleviate this situation described. Five possible ways have been
provided for how to help alleviate the situation.
Poor performance by staff when meeting budgets can often be attributable to the method
of implementation. Ignoring the human side of participation or the introduction of a
target that is either unrealistic or unobtainable can de-motivate staff, this causing more
harm than good. Getting the balance right in terms of an achievable standard or target
is essential during the planning stage of the budgeting process. It is however a problem
in reality to actually define an attainable standard especially if the environment W Ltd
operates within is dynamic or uncertain.
It seems likely that senior management may be trying to impose a tighter budget to
improve performance by using more challenging targets, perhaps more an ideal standard
e.g. a target attained under very favourable conditions. The finance department requires a
standard that is more realistic or accurate e.g. an attainable or expected target, that can be
achieved with a reasonable level of effort from staff.
Practical action the coordinator could take to alleviate the situation described.
1. Use both challenging and realistic targets, but link higher financial reward to the
achievement of the more challenging targets and moderate incentive for the easier
targets.
2. Allow staff to participate when setting targets or budgets, this can help improve
motivation, reduce frustration and increase their job satisfaction.
3. Clear trust and communication developed between management and staff, as well
as the avoidance of being over critical by management if more challenging targets
are not achieved.
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4. Good planning to ensure whatever standards or targets that are used, they are
realistic and achievable. Periodic review of standards or targets are essential, as
well as consultation with staff during this process.
5. The use of rolling rather than periodic budgeting if a high degree of uncertainty
exists when setting targets. Rolling budgets are good for adaptive planning e.g.
more likely to be regularly updated to take account of changes within the
environment W Ltd is operating within.
C1 14 T plc (CIMA P1 May 2006)
Part (i)
Tip: Below are many possible answers for the two areas to benchmark, the question
states that you are to provide only one performance measure for each area and give a
reason.
The detection of false claims
Training expenditure (or training days) per employee to aid detection of false
claims.
Percentage false claims detected each year.
Percentage of staff suggestions for improving the method of detecting false claims
actually implemented.
Percentage of claims verified by on site inspection, police or fire reports.
Each of the above measures would indicate whether more or less false claims are being
detected each period or whether T Plc is doing enough to detect false claims.
The speed of processing claims
The reason for all of the above measures is that they would indicate the insurance
companys efficiency in processing claims. High staff turnover indicates the replacement
frequently of staff which can impact upon the efficiency of internal activities.
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Part (ii)
All performance measures and related information about detecting fraud, should be
gathered, summarised and analysed. This information then compared with relevant
industry information available, or other insurance companies which may participate as
partners in a benchmarking exercise. Such information as the rate of detection, staff
training and internal procedures should be compared externally. Internal benchmarking
could also be used to compare information between other claims departments, as well as
trend analysis of these performance measures compared over time.
For the efficiency of processing claims, once a claim is received it should be dated and
date stamped when finalised. All information should be recorded in a computerised
environment to allow automated and real time information to monitor performance
measures and analyse trends over time. Similar information for comparison should be
obtained from other insurance companies, trade journals, media an customers
complaining to ensure T Plc is doing enough in terms of the norm or industry standard for
settling claims.
For both methods standards should be implemented to be used as a yardstick to view
improvement over time. Internal groups should also be established in order to implement
improvements recommended each time benchmarking is undertaken.
C1 15 Product M (CIMA P1 May 2007)
Part (i)
Labour rate planning variance
(Actual production should take) x (old rate - revised rate)
(680units x (900hrs / 600units)) x (30.00 - 31.20)
1,020hrs x 1.20
Operational labour efficiency variance
Actual production did take
Actual production should take
50hrs x 31.20 (revised rate)
1,224 (A)
Hrs
1,070
1,020
50
1,560 (A)
Part (ii)
1. Helps highlight variances between those which are controllable and those which
are uncontrollable.
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2. Helps motivate managers and staff e.g. avoids staff being blamed for faulty
planning and gives a fairer reflection of any operational variances calculated
when assessing any operational efficiencies or inefficiencies. Management and
staff would be appraised more fairly for any favourable or adverse deviations that
are within their control.
3. Use of realistic standards in order to measure performance give better
management information for control purposes.
C1 16 QBD (CIMA P1 Nov 2007)
Opening inventory
Production (balance)
Less: Sales (given)
Closing inventory*
Qtr 1
5,500
9,900
15,400
10,000
5,400
Qtr 2
5,400
12,200
17,600
12,000
5,600
Opening inventory
Material purchases (balance)
Less material usage (W1)
Closing inventory*
Value of Purchases ()
Purchases above x 6 per Kg
W1 Material usage
Production 9,900 x 1.5 Kg =
Qtr 1
Kg
4,500
14,925
19,425
14,850
4,575
89,550
14,850 Kg
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Budgets are a constraint on doing anything different as they stifle innovation and
creativity.
Budgets are costly systems and consume large amounts of management time to
set up and analyse.
Budgets have limited use in a dynamic and fast changing environment as they
would only serve to reflect on the past and not the future, and so therefore they
would be always out of date.
Budgets are generally too internal in focus, ignoring external variables, which
more importantly should be being monitored for example the focus on sales
targets rather than customer satisfaction.
Budgets create barriers within departments due to the feeling of competition for
resources, and do not encourage fluidity between departments which is necessary
in a rapidly changing environment.
Budgets are too short-term in focus for example they may just look at a year.
In conclusion within a JIT environment lead time is paramount due to the absence of
stock e.g. a chase demand strategy of meeting customer demand. Total quality
management (TQM) will help improve response times by a more efficient and flexible
organisation.
C1 19 Feedback and forward (CIMA P1 Nov 2007)
An example of a feedback control system is a budgetary control system. This would
gather information on past performance from the output of the system e.g. actual
financial performance, and compare this to a predetermined standard or plan (budget)
using any deviations e.g. variances, as a basis of improving future performance through
control action taken.
Feed-forward control is more prevention than appraisal, controlling a system by making
adjustments now to the system in advance before any exceptions occur. It does this by
trying to predict what will happen in the future. Cash budgets would be an example
where the budget would forecast ahead and allow for planned expenditures, highlight any
cash shortages and cash surpluses. Action can be taken now to prevent problems
occurring in the future.
Feedback contrasted to feed-forward control is like closing the door after the horse has
already bolted, in other words there is little you can do about it now, except try and
rectify the situation to avoid it happening again.
C1 20 Nursing homes (CIMA P1 Nov 2007)
Administration costs for period 3
These are all fixed and we need only apply the relevant index to the cost.
Therefore:
100,000 x 104/100 = 104,000
House-keeping costs for period 3
These are all variable and so it is dependent on patient days as well house-keeping costs.
Therefore:
125,000 x 90/100 x 106/100 = 119,250
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Variable costs
Fixed costs
Variable cost
Fixed cost
800 x 125 = 100,000 200,000
Period 1
Period 2
x 125 x 108
80,000
100 100
x 108
200,000
100
280,000
x 90 x 105
108,000
100 100
x 105
216,000
100
324,000
Period 3
102,060
226,800
328,860
House-keeping
Nursing
Administration
119,250
328,860
104,000
552,110
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Tip: Only three behavioural consequences are required. Nine possible answers are
included below.
If participation is allowed then it would motivate the project team as their ideas of
budgeting would be valued and it would mean that the budget would be more
likely to be met by the team.
Team members may be aware of more relevant and up to date reactions in the
market which may be crucial in making informed decisions.
If managers are asked to participate in setting their own budgets there is the
possibility they will include slack or padding within the budget e.g. have less
sales units forecast than they could realistically achieve, given a reasonable level
of effort. This is the inevitable downside of human behaviour e.g. underestimate
to avoid blame if they were to under achieve.
The manager could be inexperienced financially. Therefore they may not be able
to contribute effectively if they were to participate. This could lead to
inaccuracies when standards or targets are developed.
In a stable environment where revenue or costs are certain there would be little
benefit in allowing a manager to participate. All this would do is add to the
complexity of formulating the budget which would be unnecessary e.g. with a
university, central government revenue could be fixed and therefore could not be
influenced by a manager.
The manager may not understand the market or industry environment very well
and therefore the targets they set could be unrealistic than if imposed centrally.
Managers could be demotivated due to going through the motions but with no
feeling of real control or influence over the budget they submit e.g. often even
with participation centralised decisions will often amend variables which are
included. If job satisfaction or morale is diminished because of this then
performance could suffer.
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Solutions Section B
Part C Budgeting and Management Control
C2 -1 M plc (CIMA P1 May 2006)
Part (a)
Tip: The budget is based upon 6,400 labour hours and is being compared to actual
expenditure based on 7,140 labour hours. This is not comparing expenditure on a like for
like basis. Budgeted expenditure needs to be flexed to represent a budget based upon
7140 labour hours and you are given information in terms of how costs behave in order to
this.
Budget
Flexed
Budget
Actual
6,400
7,140
7,140
Assembly labour
Furniture packs
Other materials
Variable overhead
Total variable cost
$
49,920
224,000
23,040
34,560
331,520
$
55,692
249,900
25,704
38,556
369,852
W1
W2
W3
W4
$
56,177 W1
205,000
24,100
76,340 W5
361,617
$
9,000 W4
27,000 W4
36,000
2,050 W1
38,050
$
9,000
27,000
36,000
2,050 W1
38,050
Fixed overhead
HQ fixed overhead
Stepped fixed cost
Managers fixed salary
Total fixed cost
Total cost
$
9,000
18,500
27,500
2,050
29,550
361,070
407,902
399,667
Variance
$
485
44,900
1,604
37,784
8,235
(A)
(F)
(F)
(A)
(F)
$
nil
nil
nil
nil
8,235 (F)
W1 Assembly labour
The original budget has removed the $2,050 managers fixed salary ($51,970 - $2,050) =
$49,920, this cost has then been prorated to reflect this cost at 7,140 rather than 6,400
hours ($49,920 x (7,140 6,400) = $55,692.
The actual cost of assembly labour $58,227 has also removed the $2,050 managers fixed
salary ($58,227 - $2,050) = $56,177. We would now have a better comparison due to
the assembly labour analysed between fixed and variable cost.
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W2 Furniture packs
Given no other information, furniture packs within the flexed budget have been prorated
on the basis of 7140 rather than 6400 hours ($224,000 x (7140 6400) = $249,900.
W3 Other materials
Given no other information, materials within the flexed budget have been prorated on the
basis of 7,140 rather than 6400 hours ($23,040 x (7,140 6,400) = $25,704.
W4 Overhead analysis between fixed and variable cost
Hours
$
10,000 90,000
7,500 76,500
2,500 13,500
Variable cost per hour
$5.40
The high low method has been used to derive the variable and fixed cost element for
overhead cost. When assembly hours exceed 7,000 hours fixed cost increases.
The above workings are based on 7,500 and 10,000 assembly hours therefore the fixed
cost included in the total cost would be the same.
Variable cost equals the change in total costs ($13,500 2,500 hours) = $5.40.
Therefore budgeted and flexed budgeted variable overhead has been calculated on the
basis of $5.40 an assembly hour.
Fixed cost is the balance of the total cost using either 7,500 or 10,000 assembly
hours above to work this out; given fixed overhead will be the same for both
activities.
$90,000 = Fixed cost + ($5.40 x 10,000 hours). Therefore fixed cost equals $36,000 at
any activity over 7,000 assembly hours.
Given the variable cost of $5.40 per assembly hour would remain constant (no other
information to assume otherwise). The fixed cost at 5,000 hours would be $54,500 =
Fixed cost + ($5.40 x 5,000 hours) $27,500 rather than as above $36,000.
The marginal or stepped fixed cost above 7,000 assembly hours would therefore be
$36,000 - $27,500 = $8,500.
The fixed overhead within the statement above has also been broken down into the fixed
$9,000 central headquarter charge and the remaining stepped fixed cost for better
analysis.
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Actual fixed costs for April were as budgeted therefore no variances for this period.
W5 Actual variable overhead
The question states that actual fixed cost is the same as budgeted fixed cost. Therefore if
actual overhead was as stated in the question $112,340 and actual fixed overhead
included within this was $36,000 (based on assembly labour hours being greater than
7000) then actual variable overhead for the period would have been $112,340 - $36,000 =
$76,340.
Part (b) (i)
The revised statement is useful for the following reasons.
1. The original format supplied by M Plc did not provide a like for like comparison
when calculating variances. This is because the original budget provided in the
scenario had not flexed the budgeted costs; to represent what costs should have
been based upon the actual assembly hours of 7140. The revised format will
allow a more accurate comparison between budgeted and actual costs for control
purposes.
2. The original format supplied by M Plc did not sub-divide costs into the
classification of either variable or fixed. By the classification of variable and
fixed cost within the revised format, it will allow management to understand cost
behaviour between costs which may rise and fall with an activity level and those
which remain constant. This will aid more effective planning, control and
decision making by central headquarters.
3. The original format supplied by M Plc did not sub-divide fixed overhead into
what was controllable by the department e.g. stepped fixed cost, and what was
uncontrollable e.g. the headquarter central overhead charged. The revised format
will allow a fairer assessment of the department, by the avoidance of criticising
the department for costs which are not within there own control.
Part (b) (ii)
Whilst assembly labour cost may very well have a strong correlation with labour hours
especially if piecework payment schemes are used, this is unlikely for the relationship
between furniture packs and other materials.
Furniture packs and other materials is more likely to be correlated with the type of
furniture being assembled not direct labour hours. For example a dining room table and
chairs maybe more complex to assemble than a wardrobe, however may require less
finished timber. This maybe evidenced by the revised flexed budget statement prepared.
234 | P a g e
It can be seen that both the furniture packs and other material variances were favourable
$44,900 and $1,604 respectively, where as the assembly labour variance was $485
adverse (which I assume if no change in the actual rate paid to staff when compared to
standard rate, this is explained by efficiency). It seems that assembly was more complex
and took longer by staff, but the furniture packs and materials used were far less. If there
were a relationship between material usage and labour efficiency, we would have seen a
greater dependency between these variances e.g. if one is favourable, so too would be the
other.
It would be a good idea for management to investigate a more effective cost driver for
furniture packs and other materials, than labour hours when preparing budgets.
Part (c)
Advantages of allowing participation
Greater motivation for the assembly department manager and his assembly
staff. Because of this targets are more likely to be met. It will also be more
interesting and more involving for the manager increasing his job satisfaction.
Participation means that targets are more likely to be accepted by the manager
and assembly staff e.g. less conflict due to setting targets themselves.
The manager or assembly staff maybe more aware of the environment they
work within e.g. how long different types of furniture take to assemble and
how much timber and material they would consume. The new manager does
seem to have many years experience working within other assembly
departments. Therefore the targets set could be more realistic than if imposed
centrally.
Disadvantages of allowing participation
If managers or assembly staff are asked to participate in setting their own targets
there is the possibility they will include slack or padding within the budget
e.g. budget longer for how long it would take to assemble different types of
furniture. This is the inevitable downside of human behaviour e.g. over estimate
to avoid blame if they were to under achieve.
Participation could create a slower process to formulate a budget because more
consultation will be required. This will inevitably increase time and cost of
formulating a budget.
The manager seems to have little experience previously of working with budgets.
Training would therefore be required in order for him to participate effectively.
I feel that the manager should be allowed to participate in budget setting, however clear
trust, communication and consultation between him and headquarters needs to be
developed. Feedback at frequent intervals, as well as the avoidance of being over critical
by headquarters will all help improve motivation and performance within the assembly
department.
235 | P a g e
Mth 2
Mth 3
Total
RECEIPTS
Sales (W1)
Capital
Total receipts
2,940
16,250
19,190
10,180
15,545
10,180
15,545
28,665
16,250
44,915
PAYMENTS
Material (W2)
Labour (W3)
Variable O/H (W4)
Fixed O/H (W5)
Total payments
0
6,105
1,332
3,750
11,187
3,515
5,940
2,184
5,625
17,264
3,420
6,666
2,318
5,625
18,029
6,935
18,711
5,834
15,000
46,480
8,003
0
8,003
(7,084)
8,003
919
(2,484)
919
(1,565)
(1,565)
0
(1,565)
Net cashflow
Bal b/f
Bal c/f
Workings
(W1) Sales
Mth 1
15,000
3,000 60
= 2,940
2,940
Mth 2
17,500
3,500 70
= 3,430
6,750
Mth 3
20,000
4,000 80
= 3,920
7,875
10,180
3,750
15,545
236 | P a g e
(W2) Material
Mth 1
Units
1,500
0
1,500
350
1,850
Mth 2
Units
1,750
(350)
1,400
400
1,800
Mth 3
Units
2,000
(400)
1,600
420
2,020
1.90 x 1,850
= 3,515
1.90 x 1,800
= 3,420
1.90 x 2,020
= 3,838
3,515
3,420
Forecast sales
Opening inventory
Closing inventory
Production
Material cost
(1.90 x units)
Material payments
Mth 4
Units
2,100
(W3) Labour
Production units
Labour cost
(3.30 x units)
Mth 1
1,850
Mth 2
1,800
Mth 3
2,020
3.30 x 1,850
= 6,105
3.30 x 1,800
= 5,940
3.30 x 2,020
= 6,666
Production units
Variable O/H cost
(1.20 x units)
Payments
60% in 1st month
40% in 2nd month
Variable O/H payments
Mth 1
1,850
Mth 2
1,800
Mth 3
2,020
1.20 x 1,850
= 2,220
1,332
1.20 x 1,800
= 2,160
1,296
888
2,184
1.20 x 2,020
= 2,424
1,454
864
2,318
1,332
Mth 1
6,250
Mth 2
6,250
Mth 3
6,250
3,750
3,750
1,875
5,625
3,750
1,875
5,625
3,750
237 | P a g e
Mth 1
1,850 x 0.40 = 740
Mth 2
1,800 x 0.40 = 720
Mth 3
2,020 x 0.40 = 808
740
720
Savings received
Total saving
1,460
New total budget cash flow = Savings received + Current total budget cash flow
1,460 + -1,565 = (105)
Part (b) (ii)
If the cost was 2.20 there would be an extra cost of 0.30 per unit.
Mth 1
1,850 x 0.30 = 555
Mth 2
1,800 x 0.30 = 540
Mth 3
2,020 x 0.30 = 606
555
540
1,095
New total budget cash flow = Extra costs to pay + Current total budget cash flow
-1,095 + -1,565 = (2,660)
Part (c)
Tip: A good report format is essential as it will present your answer well and provide
good structure. In addition there maybe up to 5 marks given for a good report format
style. Part (c) in short requires the benefits of what if when preparing cash budgets,
so if you know what these are it will be the backbone to answering this part to the
question. A good approach also would be to think of good examples from the
calculations in the previous parts which will give value within your report.
REPORT
To: Management of RF Ltd
From: Management Accountant
Subject: The benefits of what if analysis
Date: 19th May 2007
238 | P a g e
1. Introduction
The purpose of this report is to discuss the benefits or otherwise of performing what if
analysis when preparing cash budgets.
2. What if analysis
What if analysis looks at varying or changing the key variables to see how the outcome
would change. These changes would be due to revisements of estimations or probabilities
and typically might be material costs or demand. Spreadsheets are the main tool to help
create a what if analysis which allows you to manipulate key figures and giving you
instant feedback as to the impact on the outcomes. Flexible budgets are an example of
what if analysis where you have figures for different levels of demand or production,
allowing you too appreciate how profit might change as a result of these different levels.
Using our calculations from part (b) we can see that by increasing direct material cost by
16% to 2.20 per component there is a 70% fall in total budget cash flow to negative
2,660. However a 21% decrease in direct material cost to 1.50 per component will
result in a 93% increase in total budget cash flow to negative 105.
It can be seen here that direct material costs is very sensitive and a small change will
result in large change to total budget cash flow.
3. Benefits of what if analysis
What if analysis allows for better planning and can be flexed at the end of a period to
correspond and be compared to actual results achieved, giving better information for
control purposes
It gives management a better understanding of the sensitivity of costs and revenues to
small changes and therefore a better understanding of risk.
It allows management to scrutinise different scenarios such as worst case, expected case
and best case.
What if analysis lends itself to the use of spreadsheets by making calculations more
accurate, faster, easier to update changes and cuts down on the time of management to
calculate and analyse the information
The use of spreadsheets means that budgets are paperless and can be sent to and used by
multiple users.
4. Limitations of what if analysis
What if analysis does not account for qualitative information, only looking at changes
to quantitative information.
239 | P a g e
The changes that are made in what if analysis are in isolation and do not give an
understanding of what would happen to budgeted cash flow if multiple changes happened
at the same time.
What if analysis does not give management any idea of the probability of these changes
happening and therefore no true understanding of exposure to risk.
I hope you have found this report useful but should you require any further assistance or
have any questions please do not hesitate to contact me.
Signed Management Accountant
C2 3 Trackit (CIMA P1 May 2008)
Part (a)
Cash budget for Q
Months
Receipts
Sales (W1)
Total receipts
1
$
20,160
20,160
2
$
65,240
65,240
3
$
148,820
148,820
Total
$
234,220
234,220
Payments
Direct materials (W2)
Direct wages ($10 per unit)
Direct variable overheads (W3)
Fixed overheads (W4)
Total payments
0
14500
18,850
42,000
75,350
106,800
16500
31,600
52,500
207,400
104,640
21200
39,110
52,500
217,450
211,440
52,200
89,560
147,000
500,200
250,000
194,810
(55,190) (142,160)
194,810
52,650
52,650
250,000
(68,630) (265,980)
(15,980) (15,980)
240 | P a g e
Workings
(W1) Sales receipts
Selling price of tickets are $140 each
Months
1
$
140,000
2
$
210,000
3
$
280,000
20,160
30,240
40,320
35,000
52,500
20,160
65,240
56,000
148,820
1
$
87,000
2
$
99,000
3
4
$
$
127,200 147,600
Opening inventory
Purchases (balancing figure)
0
106,800
19,800
104,640
25,440
131,280
(19,800)
(25,440)
(29,520)
87,000
99,000
127,200
106,800
104,640
Variable overheads
1
$
29,000
2
$
33,000
3
$
42,400
18,850
0
18,850
21,450
10,150
31,600
27,560
11,550
39,110
Sales
Immediate payment
(15% of sales and 4% discount)
1 month later (25% of sales)
2 months later (40% of sales)
241 | P a g e
1
$
70,000
2
$
70,000
3
$
70,000
42,000
0
42,000
42,000
10,500
52,500
42,000
10,500
52,500
REPORT
To:
From:
Date:
Subject:
1.0
Owners of Q
Management Accountant
20th May 2008
Profitability of Q
Introduction
The purpose of this report is to offer advice about the profitability of your business and
the prospects revealed by your business plan.
242 | P a g e
Profitability
Annual forecast sales are 27,700 units resulting in total sales of $3,878,000 and profit of
$545,000 if the component cost is $40 per unit. This gives a net profit margin of 14%.
The break-even level of sales (the amount of units sold where all fixed costs have been
recovered and no profit or loss is made) would be 16,800 units and the margin of safety is
39% which is good as this means that sales could fall by nearly 40% before the company
started to make losses.
If the specialist component cost fell down to $32 per unit then total profit would be
$766,600 but if the component cost went up to $50 per unit then total profit would be
$268,000. The business is profitable given the best and worst case scenarios for the cost
of the specialist component.
1.2
Cash budget
The opening cash position in month 1 is $250,000 however given the expenditure over
the next three months it seems that this alone will not be enough to meet cash
consumption. An overdraft would be needed of approximately $16,000 to cover cash
requirements to Month 3.
If the unit cost of the component is now $32 then the total cost of the components will
now be $112,768. This will result in component cost savings of $28,192 decreasing total
net negative cash flow from $265,980 to $237,788.
If the unit cost of the component is now $50 then the total cost of the components will
now be $176,200. This will result in component cost increase of $35,240 increasing total
net negative cash flow from $265,980 to $301,220.
1.3
The business plan presents an optimistic projection of sales and costs and therefore it is
essential to review the assumptions for behind the plan to ensure that they are sensible
and realistic.
There is uncertainly about the cost of the specialist component and this has major impact
on profitability and cash flow. It is essential that this cost is stabilised to get a more
reliable cash budget and profit analysis.
It would appear that cash flow will be a major problem in the opening months and is vital
that additional financing such as an overdraft is arranged in the short term, because in the
long term the business will return profits.
243 | P a g e
Having a list of preferred suppliers or a single supplier will help stabilise the cost of the
component. Giving the supplier an exclusive contract of components needs should help in
agreeing a unit cost. In addition good relations with the supplier will ensure that quality
of service and material as well cost is achieved.
I hope you have found this report useful and should you have any further questions please
do not hesitate to contact me.
Management Accountant
Workings
Forecast sales for the year
= 1,000 + 1,500 + 2,000 + 2,400 + 2,600 + (7 x 2,600)
= 27,700 units
Component cost
Contribution per Trackit
Total contribution
Fixed costs
Total profit
Break-even units
Margin of safety
$32
$140 - $90 + $8
= $58
$1,606,600
$840,000
$766,600
$840,000 / $58
= 14,483
48%
$40
$140 - $90
= $50
$1,385,000
$840,000
$545,000
$840,000 / $50
= 16,800
39%
$50
$140 - $90 - $10
= $40
$1,108,000
$840,000
$268,000
$840,000 / $40
= 21,000
24%
675
2190
2865
2250
615
Qtr 2
615
1930
2545
2050
495
Qtr 3
495
1770
2265
1650
615
Qtr 4
615
1810
2425
2050
375
Qtr 5
375
1490
1865
1250
615
244 | P a g e
*Opening inventory at the start of Qtr 1 would be the closing inventory from the previous
quarter brought forward; therefore this would be 30% of Qtr 1 sales (0.3 x 2250 = 675).
Part (a)(ii)
Qtr 1
Kg
Opening inventory
Material purchases (balance)
Less material usage (W1)
Closing inventory*
Value of Purchases ()
Purchases above x 7 per Kg
W1 Material usage
Production 2190
Production 1930
Production 1770
Production 1810
2956.5
6219
9175.5
6570
2605.5
Qtr 2
Qtr 3
Qtr 4
2605.5
5574
8179.5
5790
2389.5
2389.5
5364
7753.5
5310
2443.5
2443.5
4998
7441.5
5430
2011.5
x 3 Kg =
x 3 Kg =
x 3 Kg =
x 3 Kg =
6570
5790
5310
5430
*Closing inventory for Qtr 4 would be 45% of Qtr 5 usage (production Qtr 5 1490 x
usage 3 Kg = 4470 Kg). 4470 Kg x 0.45 = 2011.5 Kg.
Part (b)
Material A has been identified as a limiting factor (or principle budget factor) e.g. a
scarce resource which is in short supply. X Plc should try firstly to identify any further
suppliers, reduce wastage levels and run down any inventory for material A it has in the
meantime. Assuming more material cannot be sourced X Plc should conduct a limiting
factor analysis on its different products sold in order to maximise contribution (and
therefore profit). X Plc will maximise contribution by allocating material A to products
that earn the highest contribution per unit of material A consumed.
Normally sales demand is the most binding constraint and therefore the sales budget is
normally produced first and the production budget second (production driven by sales).
However material A in this case would be the most binding constraint, it should be the
first operating budget prepared, then the production budget (because material A restricts
production). Once budgeted production levels have been determined, all other budgets
such as sales, other material, labour and overhead can be prepared.
245 | P a g e
Part (c)
Flexible budget statement
Original
Flexed
Budget
Budget
7700 units 7250 units
Skilled Labour (4hrs x 15) x units
Semi-skilled labour (6hrs x 9) x units
Variable overhead (10 hrs x 2.18) x units
Fixed overhead (14.55 per unit)
462,000
415,800
168,000
112,000
1,157,800
435,000
391,500
158,050
105,488
1,090,038
Actual
Results
7250 units
Total
Variance
568,750
332,400
185,000
105,000
1,191,150
-133,750
59,100
-26,950
488
-101,112
(A)
(F)
(A)
(F)
(A)
Fixed overhead
40% of overhead is fixed therefore 40% x 280,000 = budgeted fixed overhead 112,000.
Fixed overhead absorption rate per unit 112,000 7700 budgeted units = 14.55 per
unit. Within the flexed budget you could assume fixed overhead is 112,000 rather than
105,488. Because this is an absorption costing company I would assume the fixed
overhead absorbed would have been (7250 units x 14.55) 105,488 and therefore the
over absorption for the period 488.
Variable overhead
60% of overhead is variable and varies with total labour hours. 60% 280,000 =
168,000. Total labour hours forecast 7700 units x 10 hours per unit = 77000 hours.
168,000 77000 hours = 2.18 per labour hour.
Part (d)
Incremental budgeting is the process of using current and past budgets as a guide and
adding or subtracting from these budgets to arrive at income and expenditure for a future
financial period. The main problems with this system is that it can encourage wasteful
expenditure and misallocate resources. Zero based budgeting (ZBB) is a method of
budgeting which requires each cost element within a budget, to be specifically justified as
though it was being under taken for the very first time. Without approval the budget
allowance would be zero.
ZBB attempts to remove for every financial period any obsolescent or inefficient
spending, (slack or budget padding), as a process it forces management and
employees to avoid wasteful spending. Incremental budgeting normally updates
expenditure by taking the previous period as a base and adds a certain percentage
on top of these figures to allow for growth and inflation, it therefore can
compound inefficient or wasteful spending over time.
246 | P a g e
ZBB concentrates on the future and challenges past activities making staff more
flexible to environmental change. Entrepreneurship as a culture is not normally
encouraged with incremental budgeting.
ZBB can increase staff motivation due to a budgeting system that is more
interesting and more involving.
Part (e)
Rolling or continuous budgeting is when a further period is added immediately to the
budget when an earlier period has expired e.g. if Jan to Mar 2007 is the first three months
of the yearly forecast, once this has expired then Jan to Mar 2008 will be created and
added. Rolling budgets are good for adaptive planning e.g. more likely to be regularly
updated to take account of changes within the environment the organisation is operating
within.
Advantages for X Plc
Always an up to date budget available for management. This means the budget is
less likely to be out of date due to it being frequently revised or amended during
the budgeting period.
Useful for when an organisation if facing high uncertainty when forecasting e.g.
cash budgets if rolling can spot early warning signals of cash shortages much
quicker. X Plc does face major uncertainties with regard to increased levels of
competition and issues concerning the availability and cost of material and staff,
these factors will cause problems when trying to forecast accurately. Once the
budget has been established at the beginning of a period, it is then constantly
amended on account of developing circumstances.
Regular assessment and amendment keeps the forecast and standard cost
information more accurate within X Plc. This should prevent a variance arising
from external and uncontrollable circumstances, giving more meaning to the
variances which remain and the operational variances more attributable to staff
and management effort during the period.
247 | P a g e
Solutions Section A
Part D Control and Performance Measurement of Responsibilty Centres
D1 -1 EVA and RI (CIMA P2 Pilot paper 2005)
Tip: Economic value added was developed by Stern Stewart & Co.
The economic value created by a division in a given period of time
EVA =
Net cash operating profit after tax
(adjusted for accounting distortions e.g. add back depreciation)
less
Economic depreciation (a reflection of market values)
less
Amortised R&D, advertising and goodwill
less
(adjusted capital employed* x cost of capital)
* using the economic replacement cost of assets.
Tip: Residual income (RI) is calculated by taking the profit a manager earns for a
division less a notional interest charge for the investment within the division e.g. the
return generated from the division less a finance charge from the holding company or
head office using a cost of capital engaged within it.
Profit after tax
Capital employed x cost of capital
Residual income
X
(X)
X
EVA uses the replacement not historical accounting cost of assets when
calculating a finance charge by head office.
248 | P a g e
The profit calculated under both methods are different. EVA uses economic not
accounting profit, it adjusts for accounting distortions such as adding back
accounting depreciation and deducting economic depreciation instead, based upon
the replacement cost of assets. EVA would also amortise R&D, advertising or
goodwill over a useful economic life when arriving at profit.
EVA capitalises costs such as R&D, advertising or goodwill and includes these in
the replacement cost of assets to apply the finance charge. This is because EVA
considers such expenditure as long-term assets building for the future.
249 | P a g e
Exchange rates
Often the buying and selling division within a group will use different currencies and
these can fluctuate from one day to another. The difficulty in these circumstances is what
transfer price to actually set e.g. which exchange rate do you use. Another problem can
arise when settling liabilities between the two divisions e.g. exchange gains and losses
occur when payment arises.
Taxation
Different countries may set taxation rates higher or lower than other countries for profit
earned by resident companies. In cases where the buying divisions country is higher
taxation compared to the sellers, a higher transfer price can shift profit away from the
buyer to the seller, due to a higher cost incurred. This will help reduce the tax liability of
the group. Some countries also apply withholding tax on profits repatriated as dividend
by an overseas subsidiary to its parent.
Protectionism
Certain counties may restrict the flow of goods between divisions due to import quotas in
place or a tariff could be applied to the price of each good sold. In cases where tariffs are
applied, it could be important to minimise the transfer price to the buying division in the
overseas country to minimise this tax liability. Other problems could include a restriction
on foreign currency available to a buying division e.g. exchange controls, when settling
intra-group liabilities. In these cases netting off liabilities between divisions before
settlement takes place may help avoid such restrictions.
Worldwide prices of other suppliers
Due to exchange rate fluctuations a buying division may find it cheaper to buy externally
from another supplier rather than the selling division. If the marginal cost of producing
each unit for the selling division is lower than the price the buyer pays externally, this
would not maximise group profit.
250 | P a g e
Economic value added was developed by Stern Stewart & Co, a US management
consultancy firm. EVA is an absolute measure of the economic financial wealth
generated by a division or organisation over time. It deducts a finance charge using a
cost of capital, applied to the replacement cost of assets used by the division or
organisation.
EVA capitalises costs such as R&D, advertising or goodwill and includes these in the
replacement cost of assets to calculate the interest charge. This is because EVA
considers such expenditure as long-term assets building for the future.
EVA uses economic not accounting profit, it adjusts for accounting distortions such as
adding back accounting depreciation and deducting economic depreciation instead, based
upon the replacement cost of assets. EVA would also amortise R&D, advertising or
goodwill over its useful economic life when arriving at economic profit.
251 | P a g e
Part (ii)
Tip: Only three reasons briefly explained are required for how EVA might affect the
behaviour of managers. Five possible answers are included below.
EVA may affect the behaviour of divisional senior executives in the following ways.
1. They would concentrate their investment decisions on maximising shareholder
value or financial wealth of their shareholders.
2. They would concentrate on the maximisation of cash or contribution which is
more likely to maximise shareholder value e.g. EVA can not be manipulated by a
managers choice over the accounting policies they might use.
3. They would concentrate on long-term decisions as opposed to short-term
decisions e.g. with relative measures like return on investment (ROI) often new
investments deliver low profit and have high accounting book values in the early
years. This often discourages managers in the short-term from undertaking
investment due to a low ROI.
4. Because a finance charge is applied against the replacement cost of assets, it
forces managers to use and invest in assets more efficiently.
5. EVA will not discourage expenditure on long-term assets building for the future
such as marketing or research and development. This is because these items will
not be deducted entirely when arriving at economic profit, instead amortised over
the period of the expenditures useful economic life. This would lead to perhaps
greater EVA when compared to the measure of accounting profit. With
accounting profit it is more likely the entire cost would be deducted and therefore
could deter a manager if assessed on accounting measures such as residual income
or return on investment.
D1 5 WD, PD & TD (CIMA P1 May 2005)
Part (i)
WD
Two thirds of output sold by WD is to PD therefore the transfer price it sells at will
determine significantly the profits and return on investment (ROI) of WD. It is possible
that WD may not be controlling its cost due to cost-plus pricing used, which may add a
mark-up upon actual not standard cost. This would mean that WD may not be controlling
its costs, passing on any inefficiency by charging higher prices to PD.
252 | P a g e
The behavioural consequences in this case is that WD could in fact manipulate the
internal system of cost-plus pricing used by increasing its own costs in order to add a
mark-up and earn higher profit absolutely. As an example if 25% mark-up was used
100 cost + 25% mark-up would earn 25 profit per unit of timber, but if cost was
increased to 150 a 25% mark-up would earn 37.50 profit per unit of timber. This will
not improve group profit.
WD may therefore have no incentive to control cost and due to two thirds of its output
sold to PD, it may concentrate solely on supplying WD rather than external customers
due to potentially more profit. This will not improve group profit.
PD
The policy of C Plc is that PD must buy all its output from WD and sell all its output to
TD. It seems that PD is wholly reliant on both of the other two divisions, an intermediary
in the supply chain. The same consequences of behaviour as WD can apply here, that is
there would seem to be no incentive for PD to control cost, as well as any inefficiency of
WD passed on to TD in the form of higher prices.
There is also the behavioural consequences of PD and WD minimising much needed
investment in non-current assets as a way of improving return on investment. Under
investment in assets causes the net book value of assets to decrease over time. Even if
profit remains static ROI will improve, yet the managers of both divisions will have done
very little to improve financial results.
TD
Due to TD only purchasing items it sells from PD, it is highly reliant on the cost and
quality of products made by PD to earn profit. Due to the last division in the internal
supply chain it could end up paying for the inefficiencies of the other two divisions, this
effecting its ability to be competitive.
This would be incredibly frustrating for the manager of TD, especially if products can be
procured from external suppliers at far cheaper prices, as well as increasing product range
and quality if they did this. Morale and motivation in this division maybe low as a
consequence, as sales and profit earned are highly reliant on the cost, quality and range of
products sold to them by PD, they have very little control over these factors due to only
selling items purchased from PD.
253 | P a g e
Part (ii)
If the internal transfer price for items sold by PD to TD were at market price e.g. similar
to a price on the open market, many of the frustrations of TD could be avoided. At least
TD will buy at a fair market price and would not be frustrated by the fact it could procure
products from external suppliers cheaper. Also there would be greater incentive for PD
to control cost, the only way to improve profit would be to control cost and improve
efficiency, due to its prices set by the open market.
The problems of this approach is that it still may do very little to motivate PD to improve
quality, or increase or innovate its products made, due to the fact that TD according to
company policy will buy all of its products from PD anyway. It would also frustrate the
manager of division PD, if inefficiencies are still being passed on by WD due to cost-plus
pricing still applying between these two divisions. There is also the difficulty of
determining what is a definitive market price for PD products sold.
There is good argument that PD should in fact be controlled as a cost rather than profit
centre, due to the fact it does not buy or sell outside the group. If this were the case then
supply should take place at the marginal cost of production according to economic
theory. Perhaps at standard rather than actual marginal cost as an incentive for PD to
control its efficiency and cost. There is the added advantage in this case that TD could
purchase items made by PD at far less than market price, this could allow them to sell to
garden centres or similar outlets at reduced cost improving sales volume and profit,
however this also could be dangerous due to the fixed cost of PD not being considered.
If marginal costing was used there would also be little incentive for the manager of PD to
supply, as marginal cost would not cover the fixed costs of the PD division and no profit
could be earned. Perhaps instead either full cost-plus (using a standard full cost) or a
two-part tariff system should be used instead. A two-part tariff system could include an
element of profit to give PD the necessary motivation to supply, as well as control its
own cost e.g. a fixed fee to cover fixed cost and some profit, and a charge for each unit
supplied to cover the marginal cost of production.
D1 6 G group (CIMA P1 May 2007)
A transfer price must be selected by group however it must recognise the value expected
by both the buying and selling divisions. The price set should encourage internal transfer
between divisions as this would serve in the best interests of the group as a whole and not
just for themselves. The recognition of a satisfactory transfer price will also allow for a
better understanding of performance of each division by head office.
254 | P a g e
If there is an external market price for a product that could be transferred internally the
transfer price should be set at this price less any savings made by transferring internally.
This would mean that there would be an incentive by both divisions to transfer internally.
If there is a limitation on external demand then the transfer price should be set at the
marginal cost needed to manufacture the product, but a bonus incentive is needed to
manufacture and transfer.
A two-part tariff system could include an element of profit to give the necessary
motivation to supply, as well as control costs e.g. a fixed fee to cover fixed cost and some
profit, and a charge for each unit supplied to cover the marginal cost of production.
Participation of the divisions in the creation of the bonus scheme means that it would be
more likely to be accepted and there would be less conflict because they had accepted
and developed the scheme themselves.
The scheme should be clear and simple to understand by all staff and should motivate and
reward divisions on a responsibility accounting basis. This means that they should be
assessed on those costs and revenues that they can only control.
D1 7 Digital equipment (CIMA P1 May 2008)
Part (a)
To measure technology leadership we could compare the number of new products
launched each year versus the expenditure on research and development. This will tell us
how effective innovative ideas developed by the company have been by looking at
whether or not they have gone into commercial production for sale to customers.
Part (b)
The data that should be collected would include customer ratings and feedback logged
when support is sought by customers. This could be done on the phone after support has
been given or on the internet if support is web-based. This would help determine how
satisfactory support given to customers is.
Part (c)
Benefits of internal benchmarking over external benchmarking (please note just three are
needed):
Internal benchmarking information has been created by the company and not a
third party like external benchmarking information, therefore internal
benchmarking information may not be more accurate and timely than external
benchmarking information.
255 | P a g e
ROI creates an incentive not to invest in the companys long-term future and
creates short-termist behaviour by divisional managers. Under investment in
fixed assets causes the net book value of assets to decrease over time. ROI
improves over the life of an asset where little or no reinvestment takes place.
If profits remain static then ROI will improve, yet the manager may have done
very little in terms of improving results.
Managers may also be over zealous to cut back expenditure in order to improve
the profit of the division e.g. advertising or training of staff, and this can
jeopardise the longer-term profit of the business.
ROI may create political arguments over such costs as head office apportioned
overhead or interest charges by head office which have direct negative impact on
ROI.
Goal incongruent decisions maybe taken for example where an asset generates a
positive net present value but would fail on the criteria of ROI used by the
manager, and hence the project is rejected.
256 | P a g e
Solutions Section B
Part D Control and Performance Measurement of Responsibilty Centres
D2 -1 Y and Z (CIMA P1 Nov 2005)
Part (a)
Tip: Total assets less current liabilities (TALCL) or net assets is also equal to shareholders
equity + long-term liabilities. It is imperative to read the question; the operating statements are
for a single month (October) therefore profits before tax must be annualised in order for return
on investment to be calculated.
Return on investment (ROI) or Return on capital employed (ROCE)
ROI =
Division Y
15.0% =
Division Z
20.0% =
257 | P a g e
Both divisions operate in similar markets however division Z has almost the same
absolute level of variable cost as division Y, even though its sales revenue is
almost half the amount. Division Y has variable cost to sales of 38.3% (0.345m
0.9m) and division Z 56.2% (0.312m 0.555m). This indicates that
division Y looks more operationally efficient. Division Z has a much lower net
assets value than division Y which could indicate that its assets are older and
therefore more inefficient.
Division Y has a greater level of apportioned central cost (338,000 per month),
which is almost twice the amount that division Z is charged. This arbitrary
amount charged will effect the profitability of the two divisions by a great extent
e.g. for division Z an 11.7% increase in apportioned central cost would reduce
profit per month to zero (21,000 180,000).
If the uncontrollability principle is applied and central apportioned cost were to be
removed then the ROI of the two divisions would be as follows
Division Y (0.46m x 12) 9.76m = 56.6%
Division Z (0.201m x 12) 1.26m = 191.1%
More information will be needed for how central apportioned costs are allocated to each
division, as well as information on the age of the net assets used within each division, to
make a more effective comparison of financial performance between the two.
Part (b)
Tip: Residual income (RI) is calculated by taking the profit a manager earns for a division less
a notional interest charge for the investment within the division e.g. the profit generated from
the division less a finance charge from the holding company or head office using a cost of
capital. Accounting profit is calculated the same way as for return on investment (ROI).
Profit before interest and tax
Capital employed x cost of capital
Residual income
X
(X)
X
Division Y
Profit before interest and tax (0.122 million x 12 months)
Capital employed x cost of capital (9.76 million net assets x 12%)
Residual income
m
1.464
(1.171)
0.293
258 | P a g e
Division Z
Profit before interest and tax (0.021 million x 12 months)
Capital employed x cost of capital (1.26 million net assets x 12%)
Residual income
m
0.252
(0.151)
0.101
Part (c)
Tip: The biggest drawbacks of both ROI and RI are that they are accounting not cashbased measures. Such financial measures can create short-term behaviour by
divisional managers. If divisions under invest in non current assets, this causes the
net book value of net assets or capital employed to fall in value over time. If profits
remain static both ROI and RI will improve, yet the manager would have done little in
terms of improving financial results.
The choice of accounting policies used e.g. stock valuation, depreciation methods or
the way central costs are apportioned, will also distort and create different profit and
net asset levels within divisions. Managers may also be over zealous to cut back
expenditure in order to improve the profit of the division e.g. advertising, training,
research and development, and this can jeopardise the long-term profit of the division.
These methods also can frustrate managers and can cause political argument occur
over the allocation of cost centrally such as central apportioned overhead or interest
charges.
The below gives a comprehensive listing of the advantages and disadvantages of
using the two methods, however one mark, up to a maximum of 3 would have been
awarded for each brief comment you make. The level of comprehension within the
solution below would therefore not be needed.
259 | P a g e
Advantages of ROI
A relative measure so different sized divisions can be compared better than RI
when assessing financial performance.
Well understood by users of accounts.
Forces the manager to be efficient with resources (assets) used.
Disadvantages of ROI
Disincentive to invest in net assets to improve ROI. ROI improves over the life of
an asset where little or no reinvestment takes place.
Goal incongruent decisions where a new investment generates a positive net
present value, but would fail on the criteria of ROI used by the manager. This is
because new projects often will have low profit and high net book values in the
early years of investment.
An accounting not cash based measure therefore ROI can be distorted.
Advantages of RI
Consistent with profit maximisation and an absolute rather than relative measure.
Brings home the idea about cost of finance for a manager.
Unlikely when contrasted with ROI to act as a disincentive to invest e.g. as long
as profit is earned it should improve RI.
Disadvantages of RI
An accounting not cash based measure therefore RI can be distorted.
Cannot compare divisions of different sizes very well.
May discourage investment in net assets in order to lower the interest or finance
charge applied to a division.
RI improves the older net assets become e.g. a lower finance charge when applied
to the historical cost of assets within the division.
260 | P a g e
Tip: Only a few sentences about two further methods of assessment would be
required for one mark each. Possibilities could include the following.
Customer perspective
Internal perspective
Innovation and learning perspective
Financial perspective
261 | P a g e
Tip: A good approach here would be to work out a standard cost for the service
department for each repair, breaking down the standard cost into variable (marginal)
and fixed cost. This will help understand the principles of how servicing is being
charged by the service department and also make the profit calculations easier.
54.00
45.00
30.00
129.00
66.00
195.00
78.00
273.00
Repairs carried out by the service department (at full cost plus 40%)
Sales
Service
FP
Department
Department
Group
Sales
120,000 W1
136,500 W3
120,000 W5
Cost of sales
136,500 W2
97,500 W4
97,500 W6
Profit
-16,500
39,000
22,500
W1 2000 x 60
W2 500 x 273
W3 500 x 273
W4 500 x 195
W5 2000 x 60
W6 500 x 195
262 | P a g e
Sales
120,000 W1
64,500 W3
Cost of sales
64,500 W2
97,500 W4
Profit
55,500
-33,000
W1 2000 x 60
W2 500 x 129
W3 500 x 129
W4 500 x 195
W5 2000 x 60
W6 500 x 195
FP
Group
120,000 W5
97,500 W6
22,500
Sales
Cost of sales
Profit
W1 2000 x 60
W2 500 x 180
W3 500 x nil
W4 500 x 66 F/OH per unit
W5 2000 x 60
W6 (500 x 180) + 33,000 F/OH
Sales
Service
Department
Department
120,000 W1
0 W3
90,000 W2
33,000 W4
30,000
-33,000
FP
Group
120,000 W5
123,000 W6
-3,000
263 | P a g e
Another problem of full cost plus is that the price charged maybe too high, ignoring
competition in terms of how much other companies would charge for the same service.
The price charged by the service department is currently 273 per repair to the sales
department. Compared with what RS would charge this would be 180 per repair. If
these departments are to run as profit centres, the sales department may go elsewhere to
improve its own profitability.
This would actually be a goal incongruent decision because it would lower overall
profitability for the group. Fixed cost would be incurred regardless by the service
department, whether it supplied the service department or not. The actual cost to the
group in relevant costing terms would be the internal marginal cost of each repair,
currently budgeted at 129. If the sales department started to use RS the external
marginal cost to the group would be 180, therefore the group profit would fall by (500
repairs x (180 - 129) = 25,500. The group would therefore be worse off.
Part (b) (ii)
Tip: One mark will be available for each relevant issue you discuss. Six possible
solutions have been provided below.
Does RS have a solid track record for delivery e.g. references from other satisfied
customers in terms of the quality of service they provide should be sought.
The financially stability of RS should be investigated e.g. FP should obtain
previous sets of accounts and obtain credit ratings.
Does RS have the resources required to work with FP e.g. will they cope with
peak periods when demand for there services may be high.
Will RS be increasing prices above 180 per repair in the long-term?
Is any of the fixed overhead currently committed by the service department
avoidable, if there is an internal reduction in demand for there services.
Can the service department find external work to fill any spare capacity caused by
a decline in internal demand?
It will be important to have a good service level agreement (SLA) with RS that gives a
minimum level of service expected and offers rescission of the contract, should certain
conditions be broken by RS e.g. for non-performance or a low standard of service over a
period of time.
264 | P a g e
Part (c)
Tip: A profit centre is when a manager will be accountable for both creating revenue
and controlling costs. The sales and service departments will therefore be assessed on
profit earned. One mark will be available for each relevant issue you discuss. Many
possible solutions have been provided below, it is important you give both advantages
and disadvantages not just one or the other.
265 | P a g e
Division X
100,000
Division Y
270,000
(50,000)
50,000
(15,000)
35,000
(6,000)
29,000
58.33%
35.00%
1.67
(144,000)
126,000
(100,000)
26,000
(11,000)
15,000
23.64%
9.63%
2.46
Sales
Variable costs
Division X remain the same at 50,000 (10 per unit marginal cost)
Division Y 3,000 units transferred from Division X would now cost 20 per unit.
Current variable costs
Less 3,000 x 10
Add 3,000 x 20
Revised variable costs
114,000
(30,000)
(60,000)
144,000
266 | P a g e
Working 3
Finance charge
= 6,000
= 11,000
x 100%
=
=
58.33%
23.64%
=
=
35.00%
9.63%
Asset turnover
=
=
1.67
2.46
Part (b)
Performance measures
Residual income
ROCE
Operating profit margin
Asset turnover
Division X
before
(1,000)
8.33%
7.14%
1.17
Division X
after
29,000
58.33%
35.00%
1.67
Division Y
before
45,000
50.91%
20.74%
2.46
Division Y
after
15,000
23.64%
9.63%
2.46
The proposed change in policy will benefit Division X greatly and but at the expense of
Division Y.
Division Xs revenue and therefore profit increases by 30,000. This is because they are
now selling 3,000 units at 10 extra (30,000). This therefore increases their residual
income to a positive 29,000. Their return on capital has increased hugely from 8.33% to
58.33%. The operating profit margin has also increased to 35% from 7.14% and their
asset turnover is much improved.
267 | P a g e
268 | P a g e
The European subsidiary has offered price $95 to supply the chips to American
subsidiary and it would earn the same contribution (see last paragraph).
Therefore the contribution earned from this would be the same as to external sales
($105 - $60) $45.
The spare capacity will be used resulting in higher fixed costs.
Assume all the American chips are delivered (300,000) and the rest sold to
externally.
200,000 x $45
$26m - $20m
$9 million
($6 million)
$3 million
($1.5 million)
($3m - $1.5m)
1.5 million
269 | P a g e
$45
$4.5 million
$6 million
$10.5 million
$35
$50
$85
$9.1 million
$26 million
$35.1 million
$22.5 million
$12.6 million
$42
$50
$92
Part (c)
REPORT
To:
From:
Date:
Subject:
Managing Director
Accountant
November 2007
Transfer pricing and performance measures
This report will discuss issues raised by the directive and the introduction of the
performance measures.
270 | P a g e
Introduction
The American subsidiary currently sources the chips externally paying $90 per chip for
the requirement of 300,000 chips. The European subsidiary has spare capacity of
200,000 chips and here there is an opportunity to source the chips internally rather than
sourcing from external suppliers.
The groups profit increases by $1.5 million if the European supply chips to America for
the price of $95. This is a significant increase which will benefit the organisation.
Transfer Pricing
A good transfer price is one where both divisions are happy with and it doesnt impact
the group as a whole in a negative way. This usually means that divisions buy and sell
internally and do not source goods from outside the group if they can buy them internally.
The issue of supplying chips internally is what price to transfer them at. Here the needs
of the both organisations require careful consideration as not to de-motivate the
managers.
The American subsidiary is currently buying externally at $90 and this is effectively the
maximum they will pay. So the European can only really charge a maximum transfer
price of $90. The minimum price the Europeans could charge is $85 {part b(i)}, so a
range from $85 to $90 exists. However if the managers performances are going to be
measured based on returns, then the minimum price the European will want to charge is
$92 and this would clearly not be acceptable to the Americans.
From the groups perspective the transfer price is based on opportunity cost approach (or
relevant costing) to ensure goal congruence
Minimum price to a seller (the European subsidiary)
Marginal cost of each unit sold normally if seller is not at full capacity or no
intermediate market exists
Marginal cost + opportunity cost e.g. normally the external market price for the
product sold if an intermediate market exists or the division is at full capacity
Market price the buyer could obtain the product from elsewhere
Market price the buyer sells the product for, less any further costs the buyer has
before resale of the goods
271 | P a g e
What the above method will do is to set a range; so long as it is profitable to do so for the
group e.g. a range actually exists, any price within this range once set will then ensure
goal congruence e.g. seller and buyer operate in the best interests of the group as a whole.
The actual transfer price within this range would normally have to be found by politics
and compromise between the two managers.
Performance measures
Setting performance measures based on profit will encourage goal congruence. The
transfer price is $85 and this would be acceptable to both parties. This would also result
in higher profits for the group.
If the return on assets is used as a performance measure the transfer price will be too high
for the American subsidiary to accept $92 and this will result in goal incongruence. This
means chips will be sourced from outside the group resulting in lower profits.
A single performance measure is not an ideal way to measure performance of divisions as
this could result in short term decisions being taken which do not benefit in the long term.
A range of performance measures with both financial and non financial aspects is better
in the long term for the group.
Conclusion
The European subsidiary should use its spare capacity and sell chips to the American
subsidiary at $85. However the loss of external sales of 100,000 units by the European
could have a negative impact on future sales. Increasing capacity will help increase
profits.
A range of performance measures should be used to encourage goal congruence and long
term success of the group.
Part (d)
Different countries have varying tax rates. A multi-national company can set up
subsidiaries in different countries to take advantage of these tax rates through transfer
pricing to reduce their overall tax charge.
Where there are high tax rates in a country, goods can be supplied to that subsidiary at a
high transfer price to reduce profits, from a subsidiary in a low tax rate country. The idea
is to increase profits in lower tax rate country and decrease profits in a higher tax rate
country. This can be done through transfer pricing.
272 | P a g e
x 100%
ROCE is also referred to as return on investment (ROI) and return on net assets (RONA).
ROCE measures profitability and shows how well the business is utilising its capital to
generate profits.
Process
Capital employed
$
18,800
Monthly ROI
%
Annualised ROI
%
18,800 / 262,144 = 7
7 x 12 = 84
(5) x 12 = (60)
(15) x 12 = (180)
5
2
(15,550)
(5,000)
273 | P a g e
Division C and D have fixed costs occurring regardless of the volume received from
division B, therefore the managers of C and D have little control over their activity and in
addition they are highly geared and so dependent on high levels of activity in order to
cover their fixed costs.
Part (b) (i)
If investment was undertaken:
Extra income generated 1,500 litres
$30,000
from abnormal losses at $20 per litre
Abnormal sales forgone
($750)
1,500 litres x $0.50
Increase in depreciation (W1) ($11,333)
$16,666 - $5,333
Loss in 2010
($15,550)
Profit
$2,367
ROI = ($2,367 / $1,000,000) x 100% = 0.24%
Annualised ROI = 0.24% x 12 = 2.88%
If investment was not undertaken:
Fall in depreciation (W1)
$5,333 - $4,267
Loss in 2010
Loss
$1,066
($15,550)
($14,484)
NBV b/f
2008
2009
2010
2011
$
500,000
400,000
320,000
256,000
Deprecation
(20% reducing balance)
$
100,000
80,000
64,000
51,200
NBV c/f
$
400,000
320,000
256,000
274 | P a g e
275 | P a g e
Group perspective
It is important that divisions transfer material between them as far as possible otherwise
there maybe materials that the group make which are not used internally but instead the
same items are being bought externally at a high cost, leading extra unnecessary costs.
Clearly the manager of D needs to be encouraged not to make the sub-optimal decision of
purchasing material externally when it is being made by division B. Furthermore, the
material D being produced by B is part of a joint process and so in any event will be
made and so if it is not transferred to division D then it will be wasted. There would be no
change to the costs of process B and external costs spent by the group will rise.
The transfer price between division B and division D should at least match the market
price of $7.50 and so division D would be encouraged to accept the transfers from
division B. One way to do this is perhaps by reducing the costs being apportioned to the
manufacture of material B and so therefore division B can charge a lower price to
division D.
A dual pricing approach can be adopted to help in this situation, as this would mean we
give the transfer price to each of the divisions that would want in order to agree to
transfer. For example we allow division B to transfer at $9.50 but give a transfer price of
$7.50 to division D. This would encourage the transfer and the difference in the prices
can be resolved though head office re-apportioning it as charges to all divisions.
D2 6 SWZ (CIMA P2 Nov 2010)
Part (a)
x 100%
ROI
$
40 / 400 = 10%
56 / 320 = 17.5%
62 / 256 = 24.2%
276 | P a g e
There is a very good improvement of the ROI over the last 3 years from 10% up to nearly
25%. Inflation has been removed according to the question and the figures the same for
turnover and cost of sales throughout the 3 years which means there has been no increase
in products sold over the last 3 years. The gross profit has been constant at 40% and
therefore indicating no change in quantity sold and prices. Operating costs appear to be
falling over the last three years, but if depreciation is removed it shows that operation
costs have increased by $4,000 in 2009 and more significantly in 2010.
In conclusion the improvement in ROI over the last three years is largely down to the
depreciation policy rather than improved performance by the division.
Part (b)
The investment results in a positive NPV of $24,536 and so from a group company
perspective it will be accepted by head office to go ahead, however from the perspective
of the manger of S division it will depend on whether or not ROI of the division is
improved. This is because his performance is assessed on ROI. To assess this we will
look at the divisional ROI if the investment is undertaken compared to the divisional ROI
if the investment is not undertaken.
If investment was undertaken:
Sales
Cost of sales ($240,000 x 90%)
Gross profit
Other operating costs (W1)
Pre-tax operating profit
Capital invested at the end of the year (W2) = $252,800
$
400,000
216,000
184,000
(97,200)
86,800
$
400,000
240,000
160,000
(85,200)
74,800
277 | P a g e
Workings
(W1) Other operating costs
Other operating costs
Less: Depreciation ($320,000 x 20%)
Add: New depreciation (W2)
Total
$
98,000
(64,000)
63,200
97,200
(W2) New depreciation and capital invested at the end of the year
$
Current total NBV at the end of 2010
256,000
Less: NBV of machine sold
(40,000)
Add: Cost of new machine
100,000
316,000
Less: New depreciation (316,000 x 20%)
(63,200)
Revised total NBV at the end of 2011
252,800
(W3) Other operating costs
Other operating costs
Less: Old depreciation ($320,000 x 20%)
Add: New depreciation ($256,000 x 20%)
Total
$
98,000
(64,000)
51,200
85,200
Part (c)
$
86,800
(20,220)
66,580
$
74,800
(16,380)
58,420
X
(X)
X
278 | P a g e
Number
of components
Variable cost
Sales value
Internal
at variable cost
28,000
Internal
at market price
42,000
External
Total
70,000
140,000
$000
28,000
28,000
$000
42,000
65,100
$000
70,000
108,500
$000
140,000
201,600
Part (b)
External demand is very important as it determines what profits are accrued to divisions
D and E internally. Division E has sold 28,000 components at variable cost to division D.
It could have sold them externally at $1550 and could have made a profit instead of
making no profits through the internal transfer. If division D had bought externally rather
than internally then it would have had to spend $43.4m to obtain the 28,000 components
transferred to them at variable costs. This is an extra $15.4m.
Division D appears to enjoy higher profits because of the items transferred at variable
cost, which may not be fair as division E is receiving no recognition for the manufacture
of these items. There should be some benefit accrued to division E and maybe not full
market price as it cannot sell these components externally. For example if the profits
were shared equally between the divisions each division would have a profit of $7.7m.
If the market demand increased for components then the transfer price charged to
division D would increase and thereby shifting more of the profits to division E. If market
demand fell for the components then the transfer priced charged to division D would fall
and thereby shifting more of the profits to division D.
Part (c) (i)
Es capacity will increase by 10% and variable costs will fall by 20% if the new
investment is undertaken, however this benefit is reduced because of the internal transfer
policy.
279 | P a g e
Any increase in capacity for division E will have the effect of increasing external sales
but at the same time reducing the volume of forgone external sales when transferring
components to division D. Therefore there is no additional financial benefit for division
E.
Half of Es components are sold to D and 28,000 of these are transferred at variable costs.
Cost savings are therefore transferred to D because of the transfer pricing policy. E will
only enjoy cost savings on those items which are sold at market value.
Division E benefits:
VC of items sold at market value = $140m x 80% = $112m per annum
20% cost savings every year = $112m x 20% = $22.4m
PV of cost savings over 5 years at 8% cost of capital = $22.4m x 3.993 = $89.4m
The cost of the investment is $120m with no residual value and the cost saving from
investment is going to only be $89.4m, therefore it is not financially viable from division
Es perspective.
Part (c) (ii)
We need to compare the original situation to the revised situation from a group
perspective. We already know the benefits that would accrue to division E if the
investment was undertaken (see part (i) above) and therefore we now need to do the same
for division D.
Revised transfer value for division D:
42,000 components original cost of $42m x 80%
28,000 components market value of $1,550 per unit
Total
=
=
$33.6m
$43.4m
$77.0m
280 | P a g e
Part (d)
It should be fair and consider those items that can be controlled by the manager.
It should simple to understand and easy to calculate so the impact of decisions taken by
managers can be seen and measured.
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