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Part 3 Examination Paper 3.3 Performance Management 1 Alocin plc. (a) Total fixed costs = 31,500,000 Variable costs of producing a Cruiser Materials (2 kilograms at 60 per kilogram) Labour Variable overheads Variable cost per unit Using the formula Pq = P0 bq 500 = P0 20/25,000 (500,000) P0 = 900 Therefore the price function is Pq = 900 00008q Total Revenue = 900q 00008q2 Marginal Revenue = 900 00016q s 120 40 20 180

December 2004 Answers

Profit is maximised at the point where Marginal Revenue (MR)= Marginal Cost (MC), therefore 900 00016q = 180 from which the value of q is 450,000. To find the selling price per unit (Pq) at which a quantity of 450,000 will be demanded we use the price function as previously calculated: Pq = 900 00008q where q = 450,000 Pq = 540 The profit can be calculated as follows: Sales revenue (450,000 units x 540) Less: Variable costs (450,000 units x 180) Contribution from sales of Cruiser Less: Fixed Costs Profit from sale of Cruiser (b) 243,000,000 81,000,000 162,000,000 31,500,000 130,500,000

Breakeven point occurs where Total Revenue = Total Costs Fixed costs = 31,500,000; variable costs are 180 per unit. From (a) Total Revenue = 900q 00008q2 Therefore 900q 00008q2 180q 31,500,000 = 0
2 The formula x = b b 4ac 2a

can be used to solve the quadratic equation once it is rearranged into the form: ax2 + bx + c = 0 we have 00008q2 + 720q 31,500,000 = 0 Solving the equation x = 853,88736 or 46,112639 If x = 853,88736 then substitution into the demand function gives a value for Pq = 21689011 If x = 46,112639 then substitution into the demand function gives a value for Pq = 86310989. (c) Sales of Super Glider (990 900)/15 = 60,000 units (Note 1) Additional revenue (60,000 x 02* x 50) + (60,000 x 05 x 40) + (60,000 x 03 x 30) Material savings 60,000 x (135 90) (Note 2) Less: Additional variable costs (60,000 x 48) Incremental contribution 2,340,000 2,700,000 2,880,000 2,160,000

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Note 1: Quantity of Material CLO available to Alocin plc = 990 tonnes. Quantity of Material CLO required for manufacture of the Cruiser is 900 tonnes (450,000 x 2 kilograms). Therefore 90 tonnes are available for use in the manufacture of Super Glider units and thus (90,000/15) = 60,000 units can be manufactured. Note 2: 135 = 3 kilograms of DMP at 45 per kilogram. 90 = 15 kilograms of CLO at 60 per kilogram. (d) The use of a mathematical model to determine an optimal selling price for the Cruiser would require knowledge of cost and price functions. It is most unlikely that the board of directors will know the demand for its products with any degree of precision. This is due to the fact that the business environment is complex with many forces which influence the demand for an organisations products. In addition, the vast majority of organisations pursue a target profit as opposed to an optimal profit and therefore will not give consideration to the use of the profit maximisation model. A price and demand model shows the economic relationship that connects the variables. There are two types of variables in such a model, namely, endogenous and exogenous variables. Endogenous variables are those variables that are under the control of management. Examples include the level of output, the variable cost per unit and the amount to be spent on research and development, advertising and promotion etc. The consideration of endogenous variables is fundamental to the decision-making process. An organisation is also affected by a range of variables which originate from outside and are therefore not controllable by the management of the organisation. These are known as exogenous variables. Such variables may include long-term market trends, and government policy with regard to matters such as taxation and environmental welfare. Changes in exogenous variables cause changes in endogenous variables. The reverse is not true, however. Consideration of the impact of such variables is a prerequisite for sound decision-making. Selling price as a variable which affects demand, may be partly endogenous and partly exogenous in nature. An organisation may have some control over the price at which it chooses to sell its products, but may also have to recognise that price may be partly influenced by that of competitors and the level of competition that exists. Cost leadership Cost leadership is a generic strategy aimed at achieving overall cost leadership in an industry. In situations where companies compete in an industry in which customers are highly influenced by price, cost leadership assumes strategic importance. Thus it is vitally important that the board of directors understands their costs and cost drivers. They must also be fully cognisant of exactly what constitutes quality to their targeted customer group. The essential task is to deliver the requisite level of quality at the lowest possible cost. If Alocin plc could attain a cost level that is lower than that of each of its competitors then it could sustain times of falling prices and thus lower prosperity better than its competitors thereby ensuring long-term survival. Cost leadership might enable Alocin plc to pursue a policy based on penetration pricing. If the board of directors could estimate the total market size, then they would be able to determine what share of the market they would require in order to realise revenue and profit targets. The market for travel systems is an established market however the production innovation in terms of the reduction in weight of the Cruiser would be attractive to potential purchasers. The board of directors could opt to set a relatively low launch price for the new product. The aim of the low price is to establish a large market share quickly by encouraging customers to adopt the product. Such a tactic would be based on the premise that if a dominant market could rapidly be achieved, then competition would be deterred from entering the marketplace because of the high probability of being unable to establish a critical mass while low prices prevail. As part of the overall strategy of cost leadership the board of directors should aim to build distributor and customer loyalty which will reduce the price elasticity of demand of its products. Product differentiation Product differentiation involves the use of multiple products, each of which is branded and subject to promotion. Competitors must, out of necessity compete in many areas and strive to overcome brand loyalty through reductions in the selling price of their product offerings. Product differentiation involves the identification of those features for which customers are willing to pay. These may be related to a products image, quality, reliability, durability or post sales support in terms of the availability and quality of after sales service. Where product differentiation can be achieved it may enable the board of directors to implement a pricing strategy based on market skimming, which involves setting a relatively high price stressing the attractions of the new features such as the robustness, durability and perceived quality attaching to those with a genuine interest in the product or its associated attractions. Reaction and support is thus solicited from the top end of the particular market. If the launch is successful in this cream skimming exercise, and the decision has been taken to invest in the necessary new production resources so that larger scale production becomes possible, then the appeal of the new product can be enlarged through a shift in advertising and a reduction in price. The price reduction can be made in stages to coincide with supply side increases as new resources come into use. One of the pre-requisites for the successful operation of a pricing strategy based on market skimming is the existence of technical barriers to entry into the market. It must be difficult for competitors to come up with a similar product quickly with which they can undercut the price being charged by Alocin plc. The probability of successfully operating a pricing strategy based on market skimming is increased if the demand for the Cruiser is relatively inelastic. If Alocin plc can successfully achieve product differentiation it may also be possible to implement a pricing strategy based upon premium pricing. Such a strategy would involve pricing the Cruiser above the price of competitors products on a permanent basis. The success of such a strategy will be dependent upon potential buyers perceiving that the Cruiser is different and superior to competitors products. From the scenario it would appear that Alocin plc has a strong brand name. This coupled with the fact that the Cruiser certainly has unique properties could well combine to enable the successful operation of a pricing strategy based on premium pricing.

(e)

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Niche marketing Niche marketing targets markets in which the company can focus on cost and quality in order to meet the needs of customers who comprise a specific market. The board of directors of Alocin plc could target the Cruiser at a specific market segment comprising relatively well-off people who are willing to pay a premium for the unique feature of the Cruiser. It is quite conceivable that such a policy might be aimed at a particular geographical region in which relatively well-off people live. Alocin plc might meet the needs of such a niche segment of the market better than its competitors simply by the concentration of a specific focus on a narrower target market than those of its competitors. Cost leadership would give Alocin plc the opportunity to develop a cost-focus strategy providing niche customers with a lower priced product than the competitor offerings. Obviously such a niche would have to be sufficiently large to enable the desired levels of profitability to be attained. (f) A SWOT analysis summarises the key issues from the analysis of the business environments and the strategic capability of an organisation. The aim is to identify the extent to which the current strategy of an organisation and its more specific strengths and weaknesses are relevant to and capable of dealing with changes occurring in the business environment. SWOT stands for strengths, weaknesses, opportunities, and threats, but rather than simply listing them in terms of managerial perceptions, the intention is to undertake a more structured analysis so as to yield findings that can contribute towards the formulation of strategy. SWOT analysis is used in the rational planning model and needs to be undertaken to assist in closing the gap between predicted and desired performance of strategic planning. The provision of a simple and logically straightforward framework that can be used to appraise the organisations position is a significant benefit of SWOT analysis. Management attention is focused on what might be done to exploit strengths and opportunities and also what actions might need to be taken in order to eliminate weaknesses and nullify threats. SWOT analysis can assist in the management of risk by identifying internal weaknesses and threats from within the external business environment. A SWOT analysis could also be used by Alocin plc to assess whether there are opportunities to further exploit the unique resources, (including material CLO) and the core competences possessed by an organisation. Use of a SWOT analysis would focus the attention of management on likely reaction of competitors to the introduction of the Cruiser. This will prove an invaluable aid in the determination of the launch price of the Cruiser as management can assess the risks attaching to different pricing strategies. The directors of Alocin plc have already identified some of the strengths of the Cruiser and have realised the opportunities. However these strengths and opportunities may be short-lived if Alocin plc does not recognise the weaknesses of the Cruiser and the threats to it. Weaknesses include dependence upon the supplier of CLO and this leads to a threat that once competitors have identified that CLO is the core of the Cruisers differentiation then they will also search for supplies of CLO which may prove costly to Alocin plc. If Alocin plc strengthens its supply of CLO as a consequence of undertaking a SWOT analysis then this highlights the usefulness of such an analysis. The certain supply of CLO will strengthen Alocins pricing strategy. Management should recognise the dynamic nature of the external business environment and that the SWOT analysis is relevant to a specific point in time. Hence there is a need for a continuous focus on the potential opportunities and threats which may arise in the external business environment. SWOT analysis is nothing more than another tool available to those involved in the strategic planning processes. As with all tools it can cause problems when in the wrong hands! Thus it is vital that Alocin plc possesses the expertise in order to use SWOT analysis in a correct and beneficial manner. The board of directors of Alocin plc should pay particular attention to the composition of the team of staff responsible for undertaking the SWOT analysis, because the potential value to be derived from undertaking a SWOT analysis can be seriously undermined if those personnel undertaking the SWOT analysis lack knowledge of the entire organisation. There is always the risk that important factors may go unrecognised by those personnel involved in the strategic planning process. The external business environment is complex and dynamic and hence opportunities and threats may go undetected.

(a)

The 30,000 hours available in the finishing department are insufficient to enable Ride Ltd to manufacture the quantities of both types of bicycle that would be required to satisfy expected demand. Ride Ltd would require a minimum of 38,000 hours to be available in the finishing department in order to meet the anticipated demand for 150,000 Roadster and 70,000 Everest bicycles, as shown in the following working: Roadster Everest Required Available Shortfall 150,000/625 = 70,000/500 = Hours 24,000 14,000 38,000 30,000 8,000

Therefore finishing hours is a limiting factor or bottleneck resource.

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Calculation of net profit using marginal costing principles: Selling price (s) Variable costs Contribution Units of limiting factor (hours) Contribution per hour of limiting factor () Roadster 200 100 100 016 625 Everest 280 160 120 020 600

Ride Ltd should make Roadsters until it has satisfied total demand. It should then produce the Everest. Units 150,000 30,000 Type Roadster Everest Bottleneck resource Per unit (hours) 016 020 Bottleneck resource Consumed (hours) 24,000 6,000

Profit from manufacture and sale of this product mix would be as follows: Sales Revenue: Roadster Everest Material cost: Roadster Everest Variable production conversion costs: Roadster Everest Contribution: Roadster Everest Less: Fixed production overheads Net profit Or alternatively: Contribution: Roadster Everest 150,000 x 100 = 30,000 x 120 = 000 15,000 3,600 18,600 4,050 14,550 Units 150,000 30,000 000 Selling price per unit (s) 200 30,000 280 8,400 80 100 12,000 3,000 000

38,400

150,000 30,000

15,000

150,000 30,000

20 60

3,000 1,800 15,000 3,600

4,800

18,600

4,050

4,050 14,550

Less: fixed production overheads Net profit

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(b)

Throughput accounting ratio = return per factory hour/cost per factory hour Return per factory hour = Sales material costs/usage of bottleneck resource Sales (s) Materials/components costs (s) Return per unit Bottleneck resource (units required) Return per factory hour (s) Roadster 200 80 120 016 750 Everest 280 100 180 020 900

Cost per factory hour = Total factory costs/Bottleneck resource hours available Total factory costs amount to 8,850,000 and are comprised as follows: Variable overhead costs (fixed in short-term) Roadster (150,000 x 20) = Everest (30,000 x 60) = Fixed production overheads = Total factory costs = 3,000,000 1,800,000 4,800,000 4,050,000 8,850,000 30,000 295 Roadster 75000 29500 254 Everest 90000 29500 305

Bottleneck resource hours available = Cost per factory hour =

Return per factory hour Cost per factory hour Throughput accounting ratio

In situations where throughput accounting principles are in application, a product will be worth producing provided that the throughput return per hour of bottleneck resource is greater than the cost per factory hour. This may be measured by the throughput accounting ratio. If throughput return outweighs the cost per factory hour, the ratio will be greater than 100. Management attention should focus attention upon increasing the throughput ratio. If they can do this then higher levels of profit will be achieved.

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(c)

Since the Everest has a higher return per bottleneck hour than the Roadster, Ride Ltd should manufacture the Everest until it has satisfied the total demand for 70,000 units. The production mix of bicycles will therefore be as follows: Type Everest Roadster Units manufactured 70,000 100,000 Bicycles per hour of bottleneck resource 500 625 Total hours of bottleneck resource required 14,000 16,000

Projected Profit and Loss Account of Ride Ltd for the year ended 31 December 2005 Sales Revenue Everest Roadster Material costs Everest Roadster Throughput return Everest Roadster Less: Variable overhead costs (assumed fixed in short-term) Fixed costs Net profit Or alternatively: Throughput return: Everest 70,000 x (280 100) = Roadster 100,000 x (200 80) = Less: variable overhead costs (assumed fixed in short-term per part (a) costs) Less: fixed costs Net profit 000 12,600 12,000 24,600 4,800 4,050 Units 70,000 100,000 Units 70,000 100,000 000 Selling price per unit (s) 280 19,600 200 20,000 Material cost per unit 100 80 000

39,600

7,000 8,000 12,600 12,000 4,800 4,050

15,000

24,600

8,850 15,750

8,850 15,750

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(d)

Marginal costing and throughput accounting both determine a contribution by calculating the difference between sales revenue and variable costs. However this contribution figure will be higher under throughput accounting since only material costs are recognised as being variable costs. Under marginal costing, direct labour costs and certain overhead costs will also be deducted from sales revenues in order to calculate contribution. This is because such costs are variable in nature. Throughput accounting regards such costs as fixed and this is true insofar as they cannot be avoided in the immediate sense. When using marginal costing principles, it is essential that costs are correctly analysed and categorised as fixed or variable if correct decisions regarding product ranking are to be made. For example, in part (b) the variable production conversion cost amounting to 4,800,000 that was calculated in part (a) is described as being variable overhead cost. Thus we can conclude that all labour costs within Ride Ltd are categorised as fixed production overheads and will not affect the ranking of products within the company under either marginal costing or throughput principles. However, this is not the case with regard to variable overhead costs which are treated differently under marginal costing and throughput principles which is clearly illustrated above. In marginal costing and throughput accounting the rate of contribution generated per unit of scarce resource can be used to determine the optimum production mix. However, different rankings can occur under each method of which the decision maker must be aware.

(a)

The contingency theory of management accounting represents an attempt to identify the most appropriate accounting control system for a given set of circumstances and to identify the most important contingent variables and to assess their impact on control systems design. David Otley (1980) provided a definition of contingency theory that has become widely used: The contingency approach to management accounting is based on the premise that there is no universally appropriate accounting system applicable to all organisations in all circumstances. Rather a contingency theory attempts to identify specific aspects of an accounting system that are associated with certain defined circumstances and to demonstrate an appropriate matching. Contingency theorists have attempted to identify the specific features within the context of an organisation that impact upon the particular features of accounting system design. The major classes of contingent factors that have been identified include the environment, organisational structure and technology. Contingency theorists have suggested that those features within the external environment of an organisation that affect the design of an accounting based control system include its degree of predictability, the degree of competition faced in the market place, the number of different product-markets faced, and the degree of hostility exhibited. It has been suggested that structural features include the size of an organisation, the extent of interdependence that exists, whether it is decentralised, and the availability of resources. Technological factors include the nature of the production process, its degree of routineness, how well means-ends relationships are understood and the amount of task variety. Since the purpose of a control system is to assist an organisation to adapt its business environment then it would appear reasonable to accept that a management control system is subject to influence from the external environment in which it operates. A formal accounting control system is only one of a number of potential controls that could be adopted by an organisation. Whilst it is undeniable that the degree of sophistication of accounting controls is influenced by the intensity of competition by a firm, two other characteristics from within an organisations environment, namely dynamism and heterogeneity have been shown to affect the design of control systems. Each of these characteristics is associated with an emphasis on different aspects of accounting control. The view has also been put forward that other major influences on the design of control systems are the degree of structural complexity of an organisation and the extent to which turbulence exists in its environment. Increasing structural complexity will lead to an increase in the number of accounting tools used by an organisation, whereas environmental discontinuity may require new tools to replace those which have become obsolete. The nature of a manufacturing process determines the type of costing system that is required and the extent to which costs can be traced to products. The level of accuracy achieved in job-costing which is used in conjunction with batch production technology is higher than that which can be achieved in process costing due to the fact that greater proportion of the costs are incurred jointly by the range of final products. It follows that there is a technological constraint on the design of accounting controls due to product interdependence. One should also consider direction of causality. Is it contingent factors that cause the system to be as it is or might the system itself be a contingent factor which is a cause of change?

(b)

(i)

Business process re-engineering involves examining business processes and making substantial changes to the way in which an organisation operates. It requires the redesign of how work is done through activities. A business process is a series of activities that are linked together in order to achieve the desired objective. For example material handling might be viewed as a business process which involves the separate activities of production scheduling, storing materials, processing purchase orders, inspecting materials and paying suppliers. The aim of Business process re-engineering is to enhance organisational performance by achieving improvements in the key business processes by focusing on simplification, improved quality, enhanced customer satisfaction and cost reduction. Business process re-engineering can be applied not only to manufacturing processes but also to an extensive range of administrative activities. In the case of material handling an organisation might re-engineer the activity of processing purchase orders by collaboration with suppliers of components for their products by integration of their production planning system with that of their suppliers. This would enable purchase orders to be sent directly to their

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suppliers thereby obviating the need for any intermediate administrative activity. By the same token scheduled orders might be agreed with the supplier which would reduce the need to hold stocks of components. In circumstances where suppliers are working in close collaboration with an organisation, it may be possible to roll the quality back down the supply chain and agree quality control procedures with the supplier which would reduce the need to inspect incoming deliveries of components. Thus savings in material handling costs could be achieved via reduced storage, processing and inspection costs. Such costs do not add value to the final product and thus are of no benefit to the customer. The focus of elimination of non-value added costs and cost reduction links Business process re-engineering to Total quality management and Just-in-time philosophies. (ii) Business process re-engineering is sometimes regarded as a one-off cost-cutting exercise even though its primary focus is not the reduction of costs. The above example shows that cost reductions can result from such activities. However it should not be regarded as one-off but as a continuous activity. If the aims of Business process re-engineering are not clearly understood across the entire organisation then staff may be suspicious of managerial motives for undertaking a programme of Business process re-engineering. This may be partly attributable to the fact that Business process re-engineering was seen as being connected with the downsizing and shedding of large numbers of jobs during the early part of the last decade. A distinguishing feature of Business process re-engineering is that it involves the radical overhaul and dramatic changes in processes entailing the abandonment of existing practices and the re-design of new ones. However, Business process re-engineering is still sometimes viewed as a way of making small improvements by tinkering with existing practices. In much the same way as a Total quality programme with its focus on continuous improvement, business process re-engineering requires the long term commitment of management and staff within an organisation which is not always easily achievable.

(a)

(i)

Calculations showing an estimate of the minimum reduction in sales units required that would, on purely financial grounds, justify the withdrawal of the Super kooler from the market on 1 January 2005: If we assume that the marketing directors statement that the minimum reduction in sales volume that will occur is 10,000 units per annum for each year that the Super kooler is manufactured is correct, then the maximum sales volumes and contribution would be: Year ended 31 December 2005 2006 2007 2008 Sales units 170,000 160,000 150,000 140,000 CPU (60) 60 60 60 60 Contribution (000) 10,200 9,600 9,000 8,400

The contribution that we could expect to earn from sales of the Ultimate model amounts to 9,000,000 for each year that it is sold (100,000 units at 200 110) per unit. Using a NPV approach the evaluation of the proposed replacement of the Super Kooler model by the Ultimate model is as follows; Year Initial investment 000 (1,200) Lost Contribution Contribution Fixed from from overheads Super kooler Ultimate 000 000 000 (10,200) (9,600) (9,000) (8,400) 9,000 9,000 9,000 9,000 (150) (150) (150) (150) Net cash flow 000 (1,200) (1,350) (750) (150) 450 D.Factor at 9% p.a Present value (1,200,000) (1,237,950) (631,500) (115,800) 318,600

0 2005 2006 2007 2008

1000 0917 0842 0772 0708

Net present value = 2,866,650 A negative net present value indicates that if sales volume is expected to fall by 10,000 units per annum with effect from 1 January 2005 it would be preferable to continue manufacturing the Super kooler. (ii) The evaluation prepared (a)(i) clearly shows that a decrease of more than 10,000 in unit sales of the Super Kooler will be required in order to justify the withdrawal of the Super Kooler from the market with effect from 1 January 2005. If we assume that sales volume will decline by 20,000 units per annum then the resultant NPV can be calculated as follows: Year Initial investment 000 (1,200) Lost Contribution Contribution Fixed Net cash Discount Present from from overheads flow factor value Super kooler Ultimate at 9% p.a 000 000 000 000 (1,200) 1000 (1,200,000) (9,600) 9,000 (150) (750) 0917 (687,750) (8,400) 9,000 (150) 450 0842 378,900 (7,200) 9,000 (150) 1,650 0772 1,273,800 (6,000) 9,000 (150) 2,850 0708 2,017,800

0 2005 2006 2007 2008

Net present value = 1,782,850

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This NPV clearly shows that it would be beneficial to withdraw the Super Kooler from the market with efffect from 1 January 2005. The minimum reduction in sales volume to justify the withdrawal of the Super Kooler from the market with effect from 1 January 2005 is the decrease that causes the NPV to equal 0. This can be calculated as follows: (1 + 2,866,650/(2,866,650 + 1,782,850)) x 10,000 units = 16,165 units. (b) (i) There is nothing to prevent Woods Ltd from attempting to increase the selling price of the Ultimate since cost inflation will inevitably occur and should be taken into account. Likewise the effects of taxation should be incorporated into the financial analysis. Much will depend on the reaction of competitors with regard to changes in the forthcoming legislation and to what extent they are aware of the changing preferences of consumers. The forecast assumes an increase in the selling price upon the change of model (the Ultimate will sell for 200 whereas at present the Super kooler sells for 160). Whether this is achievable remains to be seen. The reduction in operating costs of the Ultimate may influence consumers to purchase an Ultimate model sooner than they would otherwise have done so. However, there remains the possibility that customers might not be willing to pay the increased price required for the Ultimate model and therefore retain the Super kooler models in their possession. This may cause problems with the need to hold stocks of spares etc to meet warranty claims and avoid the loss of customer goodwill. On the other hand it might be the case that the selling price of the Super kooler would need to be reduced in order to prolong its life cycle. Again, much depends on the attitudes of existing and potential customers, which will to some extent be influenced by advertising and promotional expenditure, and therefore this should be recognised in the calculations in part (a). The board of directors of Woods Ltd must be certain that the technology to be employed in the manufacture of the Ultimate is fully developed. Should this not be the case a decision to defer the change in manufacturing technology would be appropriate. We are not aware of the inventory of Super kooler parts which are held. If Woods Ltd holds significant inventory of items required in the manufacture of the Super kooler, then this should also be taken into account in the calculations in part (a). The forecast is only as good as the assumptions upon which it is based. The directors need to recognise that the degree of accuracy of the data is critical to the analysis and thus they should give careful consideration to the level of confidence they have that the forecast sales and costs will actually occur. There is inherent uncertainty in any forecast and therefore the directors should apply sensitivity analysis to the variables contained within the forecast. What if scenarios should be modelled to ascertain the effect of changes in the variables contained within the forecast. In this case, the board of directors would be primarily concerned to see the effect of changes in profitability as a consequence of different levels of sales volume of the Super kooler and the Ultimate models. It would also be necessary to consider the effect of changes in the selling price of the Ultimate. The level of risk attaching to the investment should be considered and as a consequence a cost of capital other than 9% per annum may need to be used in the financial analysis. The directors have presumably considered alternative investments that would enable the manufacture of the Ultimate to take place as well as other unrelated investment opportunities. Finally, whilst the directors are aware of the legislation which will take effect on 1 January 2009, they should consider the likelihood and impact of future government regulations on their longer-term investments. (ii) A decision by the board of directors to cease manufacture of the Super kooler with effect from 1 January 2005 would enhance the reputation of Woods Ltd as an environmentally aware manufacturer. This will raise the image of the company which may attract new customers who themselves are concerned with the preservation of the environment and thus identify with the manufacturing strategy of Woods Ltd. Indeed, if Woods Ltd is the first to substitute models such as the Super kooler with those such as the Ultimate then they may achieve a competitive advantage. However, this is unlikely to be sustainable in the future as legislation effectively forces competitors to follow suit. Nevertheless, the reputation of Woods Ltd as a leader in innovative product design may well remain a source of competitive advantage.

(a)

Responsibility accounting is based on the application of the controllability principle therefore it would seem logical to burden an area of responsibility with those costs over which the manager of the responsibility centre has significant influence. Conversely, it would be appear inappropriate to charge costs to a centre over which a manager had little or no responsibility. There are two ways in which the controllability principle can be adhered to in management accounting. Firstly, management accountants can attempt to eliminate the effects of uncontrollable items from the areas for which managers are held responsible. Thus for example a machine supervisors performance report might be confined to quantities (not costs) of direct materials, direct manufacturing labour, energy costs and related supplies. Secondly, reports can be prepared which clearly distinguish between controllable and uncontrollable items for any given area of responsibility. Unfortunately for the management accountant many areas of responsibility cannot be categorised as being controllable or uncontrollable thus the application of the controllability principle in practice is hindered by the fact that many areas of responsibility are only partially controllable. Very often events occur over which a manager has no control whatsoever such as, for example, a shortage of supply of a required resource. An obvious management response to such a problem lies in the

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substitution of an alternative resource. However, in circumstances where events are categorised as being uncontrollable managers will have far less motivation to attempt to negate their effects. It should be recognised that more often than not the effects of uncontrollable items cannot be measured precisely which further impedes management reporting. The correct categorisation of factors into controllable and uncontrollable is fundamental to the successful operation of a system of responsibility accounting. There is a distinct possibility that managers may be judged unfairly where uncontrollable factors exist. This is clearly problematic, and in extreme circumstances may render a responsibility accounting system totally ineffective. Conversely, it is also possible that managers may be protected from factors which are indeed within their control. Thus the failure to correctly distinguish between controllable and uncontrollable factors will not only seriously undermine performance evaluation but may precipitate problems associated with levels of motivation and morale within an organisation. (b) Management should attempt to deal with the distorting effects of factors recognised as being beyond the control of a manager by making appropriate adjustments before or after the period under review. There is a fundamental need to identify which potential expense items are to be regarded as controllable and uncontrollable. It is widespread practice to either show uncontrollable items in a separate section of a performance report or to exclude uncontrollable items from such reports altogether. It is clear that management need to be able to identify those factors which are uncontrollable, in order to enable sound performance measurement and reporting to take place. Kenneth Merchant has suggested that in order to distinguish between controllable and uncontrollable items the following general rule should be applied to all employees within an organisation Hold employees accountable for the performance areas that you want them to pay attention to. However, in practice controllability is difficult to pinpoint since relatively few costs are under the control of a single manager. A purchasing manager can often influence the costs of purchasing raw materials, however such costs are also dependent upon prevailing market conditions which are clearly beyond the managers control. By the same token, a manufacturing manager may influence quantities of raw materials used but quantities used may be influenced by the quality of raw materials that were purchased. Another problem lies in the fact that managers often work in teams and this largely precludes the evaluation of individual responsibility. The majority of performance reports usually have as their focus a time period of one year or less and this short term focus can mean that the current manager may have been experiencing problems and inefficiencies which were in fact a legacy from his/her predecessor. For example a manufacturing manager may be constrained by a contract for the purchase of raw materials that was negotiated by his predecessor. This gives rise to the difficulty of separating what the current incumbent actually controls from the outcomes of decisions made by others. Thus it might not be possible to answer the question What is the current manager accountable for? with the required degree of precision. Insurance policies are invariably used to minimise exposure to uncontrollable events such as fire or flood. Other insurable events include theft, accidents, damages and product and public liability insurance. After the period under review has ended management may use variance analysis to analyse the factors that cause actual results to differ from pre-determined budgeted targets. A feature of variance analysis is that it aims to distinguish between controllable and uncontrollable items and to identify which particular managers are accountable for any variances that have occurred. The use of a planning and operational approach to variance analysis might be of assistance to management. For example, any uncontrollable planning variances may be incorporated into future standards thereby improving business planning. Management may attempt to isolate the effects of uncontrollable factors by adopting the use of flexible performance standards in which targets are adjusted to reflect those uncontrollable factors arising from circumstances which were not recognised and allowed for at the time that the original targets were set. The use of flexible budgets is the most widely used flexible performance standard. Flexible budgeting aims to remove the uncontrollable effects of volume changes on cost behaviour from performance reports. Management may be able to use benchmarking to assess the performance of a responsibility centre. This method involves an evaluation of a responsibility centre relative to the performance of similar centres within the same organisation or with similar units outside the organisation. In order to prove a valid basis for comparison it is essential that the responsibility centres, which are the subject of comparison, perform similar tasks and are subject to similar environmental and business conditions. In practice, it is difficult to find units which fulfil these criteria. In circumstances where management are able to undertake relative performance evaluation the effect of uncontrollable factors is effectively eliminated since each party which is subject to the evaluation is subject to the same environmental conditions. Management may also make subjective judgements in the performance evaluation process which are based on the knowledge of the outcome measures and the circumstances faced by the managers of responsibility centres. Whilst the use of subjective judgements can help to alleviate some of the defects of measures used by accounting control systems they nonetheless lack objectivity and often fail to provide the manager being evaluated with a clear view of how performance has been evaluated. The use of subjective judgements can cause conflict with more senior managers and precipitate a decline in motivation and a loss of morale. (c) Financial targets may be derived from engineering studies of input-output relationships. Engineering targets may be used where the relationship between inputs and outputs is clearly defined and stable over time. This enables the required level of inputs to be estimated directly from product specifications. For example, in a bakery for a given output of a hand-made cake design it is possible to estimate the inputs required because a physical relationship exists between the ingredients such as, flour, butter, eggs and packaging and the number of cakes baked. A relationship between inputs and outputs can also be established for labour by closely observing the processes to determine the quantity of labour that will be required for a required

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level of output. For example, in the manufacture of hand-decorated cakes the process of decoration could be observed to determine the number of cake-decorators that would be required. In circumstances in which such clearly defined relationships between inputs and outputs do not exist management may use historical targets which are based on the results of prior periods. The major drawback in using historical targets as a basis for deriving future targets is that it is quite conceivable that poor levels of efficiency in a prior period are unwittingly incorporated into the financial target for a future period. Targets may also be derived from the results of negotiations between superiors and subordinates. The use of negotiated targets addresses the information asymmetry gap that can exist between superiors and subordinates. This gap emanates from the fact that subordinates possess much more detailed information concerning operational activities and, in particular, the relationship which subsists between inputs and outputs, whereas the higher level of management have a more holistic view of the organisation and the resource constraints within which the organisation operates. The use of negotiated targets enable the information symmetry gap to be reduced and targets that are agreed will recognise the constraints applying at both the operational level and to the organisation as a whole.

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Part 3 Examination Paper 3.3 Performance Management

December 2004 Marking Scheme Marks 2 1 1 1 1 1 1 1 2 2 1 1 1 1 Marks

(a)

Derivation of demand curve Variable costs Marginal revenue = marginal cost Correct quantity Correct selling price Profit Total revenue: total cost equation Correct use of formula Correct quantities (x) Correct selling prices Total of Superglider units Incremental sales revenue Material cost saving Incremental manufacturing costs/profit Comments (on merit): Limitations Endogenous variables Exogenous variables Comments (on merit): Cost leadership Differentiation Niche marketing Comment (on merit): Usefulness Limitations Pricing strategy Total

Maximum 6

(b)

(c)

(d)

3 3 3

Maximum 8

(e)

3 3 3

Maximum 8

(f)

3 3 3

Maximum 8 40

(a)

Ranking Correct quantities Contribution Fixed overheads/profit Return per factory hour Cost per factory hour Throughput accounting ratio Discussion Ranking Correct quantities Throughput return Overheads/Profit

2 1 2 1 1 1 1 3 1 1 1 2

(b)

Maximum 5

(c)

25

Marks (d) Comments (on merit): Treatment of labout costs Treatment of overheads Treatment of closing stock Total 2 2 2

Marks

Maximum 4 20

(a)

Comments (on merit): Explanation Factors (i) Comments (on merit): Explanation Application Limitations Total

2 8

10

(b)

3 4 3

7 3 20

(ii)

(a)

(i)

Ignore sunk cost Expected value Contribution gained/foregone Fixed costs Discounting Recognition that sales units decrease >10,000 Contribution gained/foregone NPV = 0 Interpretation

1 1 2 1 1 1 1 1 2

Maximum 5

(ii)

(b)

Comments (on merit): Limitations of forecast Comments (on merit): Enhanced reputation, image, Competitive advantage Total

(c)

3 20

(a)

Comments (on merit): Controllability Application difficulty Comments (on merit): Management responses: Controllable/uncontrollable cost classification Other actions: subjective judgements, benchmarking Comments (on merit): 3 approaches to the setting of financial targets Total

2 4

(b)

4 4

(c)

3x2

6 20

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