Club Atlantic – suggested solution (20 marks)

Part a)

Club Atlantic Restaurant Performance Statement Month to 31 October

Flexed Variance
Actual
Budget (over)/under
Number of guest days 11 160 11 160 Nil
R R R
Controllable expenses
Food (W1) 205 000 234 360 29 360
Cleaning materials (W2) 22 320 22 320 -
Heat, light and power (W3) 20 500 27 900 7 400
Catering wages (W4) 84 000 83 700 (300)
331 820 368 280 36 460
Non-controllable expenses
Rent, rates, insurance and depreciation (W5) 18 600 18 600 -

Workings for flexed budget figures:

W1: R201 600 x 11 160/9 600
W2: R19 200 x 11 160/9 600
W3: R24 000 x 11 160/9 600
W4: 11 160/40 x R300
W5: R18 000/30 x 31 [original budget incorrectly based on 30 days but October has 31 days]
Part b)
Letter format, with letter addressing the following:
[Note: aspects of the solution below are adapted from Management and Cost Accounting by Drury]
a) Do budgets motivate managers to achieve objectives?

Budgets can be useful tools to influence managerial behaviour and motivate managers to
perform in line with the company’s objectives. A budget provides a standard that, under the
right circumstances, a manager will be motivated to strive to achieve. However, budgets
can also encourage inefficiency and conflict between managers. If managers have actively
participated in preparing the budget, and it is used as a tool to assist managers in managing
their divisions, it can act as a strong motivational device by providing a challenge which
encourages improved performance. However, if a budget is dictated from above, and
imposes a threat rather than a challenge, it may be resisted and do more harm than good.

There is substantial evidence from research that a defined, quantitative goal or target is
more likely to motivate higher levels of performance than when no such target is stated.
People perform better when they have a clearly defined goal to aim for and are aware of
the standards that will be used to evaluate their performance. The fact that a financial
target represents a specific quantitative goal gives it a strong motivational potential, but the
targets set must be accepted if managers are to be motivated to achieve higher levels of
performance.

Unfortunately, it is not possible to specify exactly the optimal degree of difficulty for
financial targets, since task uncertainty and cultural, organisational and personality factors
all affect an individual manager's reaction to a financial target. However, it is
understandable that there is a point beyond which a budget/target is perceived as
impossible to achieve and a manager’s level of aspiration level and performance declines
dramatically. In contrast, a budget that is set based on what is expected to be achieved
motivates a lower level of performance due to complacency. To motivate the highest level
of actual performance, demanding budgets should be set, and small adverse variances
should be regarded as a healthy sign and not as something to be avoided. If budgets are
always achieved with no adverse variances, this indicates that the standards are too loose
to motivate the best possible results. It appears therefore that it may be best to establish
tight budgets to motivate maximum performance, although this may mean that the budget
has a high probability of not being achieved.

However, budgets are not used purely as a motivational tool to maximise performance.
They are also used for other purposes such as planning purposes and it is very unlikely that
tight budgets will be suitable for planning purposes. Tight budgets that have a high
 probability of not being achieved are also very unsuitable for cash budgeting and for
bringing together company plans in the form of a master budget. Most companies do
however use the same budgets for planning and motivational purposes. If this is done and
only one set of budgets is used, then it is very unlikely that one can, at the same time,
perfectly meet both planning and motivational requirements.

Budgets with a high probability of being achieved are actually widely used in practice. They
provide managers with a sense of achievement and self-esteem that can be beneficial to
the company in terms of increased levels of commitment and aspirations. Rewards such as
bonuses, promotions and job security are normally linked to budget achievement in which
case the “costs to employees” of failing to meet budget targets can be high.

Another important consideration is the fact that the greater the probability of the failure to
meet budget targets the greater is the probability that managers will be motivated to
distort their performance by engaging in behaviour that will result in the harmful side-
effects of controls [as outlined in the lesson activities].

b) Does motivating managers lead to improved performance?

Motivating managers should result in improved performance as outlined in (a) above. Apart
from motivating managers to improve performance, there are many other factors on which
improved performance also depends, which include: education, skills, training, conducive
work environment etc.

Motivating managers is therefore not guaranteed to result in improved performance, and

could very well result in a lack of goal congruence, amongst other harmful side-effects of
controls such distorting performance to achieve budget/targets.

c) Does the current method of reporting performance motivate Susan Green and Brian Hilton
to be more efficient?

Using a fixed budget is unlikely to encourage managers to become more efficient when
budgeted expenses are variable with activity. In the original performance report actual
expenditure for 11 160 guest days is compared with budgeted expenditure for 9 600 days. It
is misleading to compare actual costs at one level of activity with budgeted costs at another
level of activity. In such instances, where the actual level of activity is above the budgeted
level, adverse variances will then be reported for variable cost items. Managers will
therefore be motivated to reduce activity so that favourable variances will be reported.

Therefore it is not surprising that Susan Green has expressed concern that the performance
statement does not reflect a valid reflection of her performance. In contrast, most of Brian
Hilton's expenses are fixed and costs will not increase when volume increases. A failure to
flex the budget will therefore not distort Brian’s performance.

To motivate managers, challenging budgets should be set and small adverse variances
should normally be regarded as a healthy sign and not something to be avoided. If budgets
are always achieved with no adverse variances this may indicate that undemanding budgets
may have been set which are unlikely to motivate best possible performance. This situation
could apply to Brian who always appears to report favourable variances.
 A2Z – suggested solution (40 marks)

Part a)
See Excel file for workings.
[A] [B] [B - A]
GIVEN GIVEN GIVEN [Meaningful] Divisional Group
Strat plan Budget Flexed Estimate Variance GM's MD's
Aug-19 Oct-19 budget Apr-20 analysis view view
Market size 150,000 150,000 165,000 165,000 165,000 165,000
Sales volume 35,000 36,000 39,600 35,800 (3,800) 38,500 38,500
Market share 23.3% 24.0% 24.0% 21.7% -2.3% 23.3% 23.3%
R'000 R'000 R'000 R'000 R'000 R'000 R'000
Sales revenue 28,000 28,800 31,680 28,100 (3,580) 29,834 30,800
Marginal cost (14,350) (15,300) (16,830) (14,900) 1,930 (16,024) (15,785)
Contribution 13,650 13,500 14,850 13,200 (1,650) 13,811 15,015
Fixed cost (6,500) (6,800) (6,800) (7,200) (400) (7,200) (6,500)
Product development (2,000) (2,000) (2,200) (1,400) 800 (1,400) (2,240)
Marketing (3,500) (3,200) (3,520) (2,600) 920 (3,800) (3,920)
Profit 1,650 1,500 2,330 2,000 (330) 1,411 2,355
(2,050)
Commentary:
When evaluating Division X’s results it is critical for the original budget to be flexed, based on
the changed market size and an unchanged market share which is to be maintained (as done
above in column referenced [A]), in light of the information given and the comments of the
Divisional GM and the Group MD.
At a high-level the meaningful variance analysis clearly indicates dismal performance and
attempted manipulation of results, based on the following:
- Lost market share of 2.3% resulting in significant lost contribution of R1.65 million.
- Overspending on fixed costs of R400 000.
- Underspending on important discretionary expenses (product development and marketing)
to try make up for the otherwise poor performance. Although the net negative variance is
only R330 000, it would have been -R2.05 million when ignoring the “gain” from
underspending on the discretionary expenses!
However, without flexing the budget as outlined above, the projected profit is R500 000 in excess of
budget and the estimated bonus of the Divisional GM is 46.7% (20% + [(100% - 20%) x R0.5m/R1.5m])
which is ludicrous as further outlined below:
- Projected product development costs have declined by approximately one-third and this
suggests that the manager is seeking to improve short-term profits by actions that will reduce
long-term profits.
- Projected marketing costs have also declined by approximately 20% and this may have
contributed to the decline in market share and the failure to achieve the budgeted sales based
 on the flexed budget or the Group MD's view. The reduced marketing expenditure may also have
a detrimental long-term impact beyond the current year.
- The Divisional GM's proposal to reduce selling prices and not maintain marketing expenditure
specified in the strategic plan has resulted in a reduced profit when compared with the Group
MD's view.
- Fixed costs have increased significantly over budget and strategic plan whereas average unit
variable cost is less than budget but above strategic plan.
- Further investigation is required to ascertain the reasons for these changes as it seems that the
Divisional GM has attempted to obtain the bonus by making short-term savings that may result
in significant reductions in long-term profit.

Part b)
The existing bonus scheme focuses entirely on profit as the single performance measure. The main
advantage of the current bonus scheme is that it is easy to understand and encourages managers to
focus on the same measure that is used by external financial markets to evaluate the performance of
the company as a whole.
The current system encourages the Divisional GM to try to negotiate a budget that understates
potential profit by overstating costs and understating sales. This may have a detrimental impact on
group planning.
The profit calculation includes a large proportion of discretionary expenses. The current scheme
encourages managers to spend less than budget on those items that are unlikely to have a short-term
impact, e.g. product development expenditure. However, the short-term reduction in costs may
result in a much higher reduction in long-term profits.
The bonus scheme gives no bonus for a failure to meet budgeted profit by only a small amount
whereas a 20% bonus is given if the budget is just achieved. Also, if profit is greater than the
maximum there is no incentive to increase profits any further.
There is also no attempt to distinguish between controllable and non-controllable profit or provide an
incentive to achieve other important goals, e.g. quality, market share, flexibility, innovation etc.

Part c)
The revised bonus scheme should be based on controllable profit defined as follows:
Contribution
Less: Controllable fixed costs
Planned product development costs
Planned advertising costs
The use of planned discretionary costs will reduce the incentive for the manager to undertake
unnecessary cost cutting. Using planned discretionary spending motivates Divisional GMs to spend
the amount agreed in the strategic plan.
Ideally, additional qualitative and non-financial performance measures should be included in the
bonus scheme. However, this would involve some form of weighting system to determine the
contribution of each measure to the overall bonus. Without additional information it is difficult to
make specific recommendations and there is always the danger that the proposed solution will be too
complex. Alternatively, the bonus might be reduced by specific amounts because of a failure to
achieve other important group goals.
Attention should be given to removing the fixed bonus of 20% and the maximum of 100%. If the
bonus continues to be based on profits then it would be preferable to fix it at a specific percentage of
the amounts by which they exceed the targets.
Considering the fact that an incentive bonus should always ensure that as far as possible
management's actions will align with what shareholders require, the incentive should be linked to
value creation e.g. a share based compensation scheme. In this regard, another improvement to the
bonus system could include a link to positive cashflow generated as opposed to profits, as the latter
usually leads to attempts by managers to manipulate profits (i.e. window dressing of accounting
results based on the bending of accounting rules or choice of accounting policies that help managers
obtain bonuses).
Lastly, a ‘bonus bank’ could also be used which ensures that an incentive bonus is not fully paid in a
given good year with some of it banked against which future poor performance can be offset, if
necessary.

Part d)
Extending the bonus scheme throughout the company should increase the motivation of managers.
However, bonuses based on total company profits are less suited to lower management levels
because individuals are likely to consider that they cannot significantly influence total company
profits.
A further disadvantage is that those who contribute little are awarded the same bonus as those that
contribute a great deal, from a value-adding work effort perspective.
A possible solution is to introduce differential bonuses but these schemes are more complex and may
cause conflict as some individuals will be perceived as receiving more favourable treatment than
others.
Bushworks – suggested solution (35 marks)

Part a)
See Excel file for workings.
As indicated below, either a “total” approach which first separately analyses the existing
situation (Old below) and the amended situation (New below) could have been adopted OR an
“incremental” approach could have been followed which looks at the expected change (which
below is defined as the decision is taken to “implement the new quality management
programme”).
Old New Incremental
Stores losses 6,871.10 - (6,871.10)
Specification check (140,000.00) - 140,000.00
Purchase of synthetic slabs (10,993,800.00) (9,198,864.40) 1,794,935.60
Curing process (5,359,478.00) (4,181,302.00) 1,178,176.00
Scrap sales 133,987.00 10,453.50 (123,533.50)
Finishing process conversion cost (5,064,706.50) (3,478,154.40) 1,586,552.10
Scrap sales 361,765.00 51,744.00 (310,021.00)
Stock holding costs (6,750.00) (225.00) 6,525.00
Cost of quality programme - (2,500,000.00) (2,500,000.00)
Profit (21,062,111.40) (19,296,348.30) 1,765,763.10

Net difference between New and Old = 1,765,763.10

Part b)
Prevention costs are quality costs incurred in preventing the production of products that do not
conform to specification. E.g.

 The cost incurred to for the supplier to deliver slabs of guaranteed design specification in
terms of the new system i.e. R40 extra that is paid per hundred units.
 The R2.5mil cost of the new quality management programme.

Appraisal costs are quality costs incurred to ensure that materials and products meet quality
conformance standards. E.g.

 On receipt into stock with the current system, the synthetic slabs are checked to ensure that
the slabs received conform to specification (R140 000 per annum).
Internal failure costs are quality costs associated with materials and products that fail to meet quality
standards and include costs incurred before the product is dispatched to the customer. E.g.

 Store losses of synthetic slabs with the existing situation.

 Losses in the curing and finishing processes under both systems.

External failure costs are quality costs incurred when products or services fail to meet customer
needs or requirements after they have been delivered. These costs are generally the most significant
as they have a dramatic impact on future sales. E.g.

 Customer returns of faulty finished components that have been sold, under both systems.