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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

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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(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

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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(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

## 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

## 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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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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## 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)

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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)

(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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