Test 1

CAT

Paper 7

Planning, Control and Performance

Management
June 2007

Test 1 4Success – Answers

To gain maximum benefit, do not refer to these

answers until you have completed the test
questions and submitted them for marking.

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CAT Paper 7 Planning, Control and Performance Management

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 Test 1

ANSWER 1
(a) The four stages of a typical product life cycle are:

Introductory – This is the stage when the product is first introduced in the market.
There is little competition. Sales tend to be slow during the period as many are
unaware of the product.

Growth – During this stage the product gains recognition. Sales increase rapidly and
competitors start to enter the market.

Maturity – This is the stage where sales start to stabilize. There is strong competition
in the market. It is the time when suppliers must emphasise on product differentiation.
Prices may also start to fall.

Decline – Customers are losing interest in the product. The product is becoming
obsolete. Suppliers may have to consider withdrawing the product and replace it with
a more profitable one.

(b) Analysis

Shirts Shorts
Contribution per unit £11 £12
Labour hour per unit 0.5 0.25
Contribution per hour £22 £48
Ranking (2) (1)

Let the number of units of shorts to produce = x, total hours required = 0.25x.

So number of units of shirts to produce = 0.25x, total hours required = 0.125x.

0.25x + 0.125x = 6,000 (maximum number of hours)

x = 16,000

So, make 16,000 units of shorts and 4,000 units of shirts.

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CAT Paper 7 Planning, Control and Performance Management

(c) Budgets

April May Jun

Shirts Shorts Shirts Shorts Shirts Shorts
Sales volume 15,000 20,000 15,300 20,400 15,606 20,808
Selling price £30 £22 £30 £22 £30 £22
Sales (£) 450,000 440,000 459,000 448,800 468,180 457,776

April May Jun

Shirts Shorts Shirts Shorts Shirts Shorts
Sales volume 15,000 20,000 15,300 20,400 15,606 20,808
+ Closing stock 6,120 8,160 6,242 8,323 6,367 8,490
– Opening stock 0 0 (6,120) (8,160) (6,242) (8,323)
Prod volume 21,120 28,160 15,422 20,563 15,731 20,975

Fabric for April May Jun July*

Shirts (1 sq m per unit) 21,120 15,422 15,731 16,046
Shorts (0.5 sq m per unit) 14,080 10,282 10,488 10,697
Total required (sq m) 35,200 25,704 26,219 26,743
+ Closing stock 25,704 26,219 26,743
– Opening stock 0 (25,704) (26,219)
Purchase requirement 60,904 26,219 26,743

* You need to work out July sales and production volumes.

(d) (i) Trend is the general direction that the sales is heading. Seasonal variation
how the sales data repeats itself in each quarter across the years.

(ii) For third quarter of 20X6, x = 11

So y = 2,000 + 40 × 11 = 2,440

Adjust for seasonal variation expected sales = 2,440 + 60 = 2,500 units.

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 Test 1

ANSWER 2
(a) Revised operating statement

Level of actual sales: 720,000 units

Comment Budget Actual Variance

reference
£000 £000 £000
Sales 1 1,152 1,071 (81)
Cost of sales
Materials 2 189 144 45
Labour
Variable 3 270 288 (18)
Fixed 4 100 94 6
Overheads 36 36 Nil
595 562 33
Gross profit 557 509 (48)
Other overheads
Selling and distribution
Fixed 5 72 83 (11)
Variable 6 162 153 9
Administration
Fixed 7 184 176 8
Variable 54 54 Nil
472 466 6
Net profit 85 43 (42)

Comments

1 Sales variance: £81,000 (A)

(i) The sales volume variance would- appear to be £49,000 (F) (the
difference between budgeted profit for 640,000 units and the flexed
budgeted profit for 720,000 units, ie £36,000 and £85,000). (This
figure can be verified by adding the variances stated above (£42,000
(A)) to the volume variance (£49,000 (F)) which equals £7,000 (F),
which is the difference between the budgeted and actual profits,
£43,000 - 36,000.)

(ii) The adverse sales variance of £81,000 is therefore due to sales price
which could have resulted from reducing prices as a deliberate policy
or else offering bulk discounts to customers.

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CAT Paper 7 Planning, Control and Performance Management

2 Materials cost variance: £45, 000 (F)

(i) Buying in bulk and attracting quantity discounts. (The firm will need to
consider current stock levels and their implication on working capital
investment.)

(ii) Buying lower quality materials.

(iii) Taking advantage of unexpected purchase opportunities in the

supply market.

(iv) Using material more efficiently and reducing wastage below normal
expectations.

3 Variable labour cost variance: £18, 000 (A)

(i) Inefficient work systems.

(ii) Extra time taken by working on lower quality material.

(iii) Labour mix problems, eg using high paid grades to perform the work
of low graded workers (due to absenteeism, holidays, etc).

(iv) Unplanned overtime payments.

4 Fixed labour cost variance: £6,000 (F)

(i) Possibly caused by a member of staff, classified as fixed such as a

shop-floor supervisor, leaving the company and not replaced
(approximately £24,000 a year, a single salary level).

5 Fixed selling and distribution costs variance: £11,000 (A)

(i) Advertising and fixed sales promotion expenditure exceeding budget.

(ii) Employment of an additional sales person on a fixed salary.

6 Variable selling and distribution costs variance: £9, 000 (F)

(i) Efficient sales calling patterns (reducing salespeople expenses).

(ii) Better utilisation of sales and distribution vehicles (reducing petrol, oil
and maintenance costs).

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 Test 1

7 Fixed administration cost variance: £8,000 (F)

(i) This variance is probably the result of another case of a member of

staff leaving and not being replaced in the short term.

(b) Ineffectiveness of original operating statement

When budget and actual figures are compared for the purpose of extracting and
analysing variances it is important that 'like is compared with like', ie that the
budgeted volume of activity is the same as the actual volume of activity. The
statement provided compares sales revenue and costs for 640,000 units with an
actual volume of 720,000 units. In the absence of flexing the budget the variance give
misleading signals to management.

(c) Problems of forecasting figures used in flexible budgeting

Any budget is a forecast based on assumptions, which use ex-ante data (the data
available at that time). The problems associated with forecasting figures which are to
be used in flexible budgeting are:

(i) Flexible budgeting relies on being able to establish cost behaviour and
separate costs into their fixed and variable elements. This is not always an
easy task. What is required is an accurate basis for flexing variable overhead
which can be difficult to establish. Consider the case of an accounts office
when month by month total costs are different (implying variable costs). What
basis would be used to flex the variable costs? The correlation between cost
and volume is not always easy to determine.

(ii) Forecasts are often produced by extrapolation, which assumes that past
results are a function of the future, and thus form a basis for projection.
However what happened in the past does not always hold true for the future,
eg there can be a distortion to the past material price trend due to an
unexpected environmental event, such as an unexpected fall in the value of
sterling.

(iii) Forecasting techniques used for flexible budgeting tend to assume a linear
cost/volume/profit relationship and therefore the projection only holds true in
what is called the relevant range. Large volume changes call for more
sophisticated forecasting techniques.

(iv) Developing the last point further, the computation of step-fixed costs also
needs to be considered. Fixed costs can increase or decrease as sale/
production volumes increase or decrease, eg space, plant and equipment,
certain grades of labour.

(v) Another problem is caused by the turbulent and sometimes erratic changes in
a firm's business environment, which may have a significant impact on
budget results. Examples are, the rate of inflation, constraints imposed by
limiting factors, the level of sales, actions of competitors.

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CAT Paper 7 Planning, Control and Performance Management

ANSWER 3
(a) (i) Total labour cost variance

Standard cost of output:

£
Component X: 0.40 hours at £5 = £2.00 × 35,000 units 70,000
Component Y: 0.56 hours at £8 = £2.80 × 25,000 units 70,000
_______
140,000
Actual labour cost 138,500
_______
Total labour cost variance 1,500 (F)
_______

(ii) Labour rate variance

£
13 weeks × 40 hours × 53 workers should have cost
(× £5) 137,800
Actual cost 138,500
_______
Labour rate variance 700 (A)
_______

(iii) Labour efficiency variance

£
35,000 units of Component X should have taken
(× 0.40 hours) 14,000 hrs
25,000 units of Component Y should have taken
(× 0.56 hours) 14,000 hrs
_______
Total standard hours for output 28,000 hrs
Actual hours taken (13 × 40 × 53) 27,560 hrs
_______
Difference 440 hrs (F)
× Standard rate per hour × £5
_______
Labour efficiency variance 2,200 (F)
_______

Summary

Labour rate variance £700 (A)

Labour efficiency variance _______ (F)
£2,200

Total labour cost variance £1,500 (F)

_______

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 Test 1

(b) (i) Standard purchase price for Material A per kilo

£
47,000 kg did cost 85,110
Price variance (given) 430 (F)
_______
Standard cost of the 47,000 kg 85,540

Hence:

Standard cost per kg of Material A = £85,540/47,000

£1.82 per kg

(ii) Standard usage of Material A per unit of production of Component X

Let k = Standard kg per unit of Component X.

Formula

(Standard kg for output − Actual kg used) × Standard price per kg =

Usage variance

Thus:

((35,000 × k) − 33,426) × 1.82 = -320.32

63,700k − 60,8535.32 = -320.32
63,700k = 60,515
k = 0.95 kg

Conclusion

The standard cost of Material A for one unit of Component X is:

0.95 kg of Material A at £1.82 per kg = £1.729

(c) The stages in the establishment of the material purchase quantity budget for Material
A for a period are as follows.

(i) Obtain separate functional estimates.

(ii) Establish the limiting factor (the principal budgeting factor) and budget to
optimise it.

(iii) Based on the limiting factor establish a sales budget for components X and Y.

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CAT Paper 7 Planning, Control and Performance Management

(iv) Set the production budget on the basis of the sales budget (assuming that the
production capacity is not the limiting factor, in which case the production
budget would have been used as the basis for deciding the sales budget).
The production budget would be set taking account of any planned changes
in stocks of finished components. A planned increase in finished components
stock would necessitate the production budget being greater than the sales
budget and vise versa.

(v) Establish the material usage budget (in kilos) by multiplying the standard
usage of Material A per component by the budgeted production quantity of
each component.

(vi) Draw up the material purchase quantity (kilos) by adjusting the material
usage quantity budget for any planned increase or decrease in. stock of
Material A.

(Note: in certain circumstances, for example where there are material import quotas,
the raw material may be the limiting factor (or principal budgeting factor) in which
case the maximum available material would be budgeted first with the other budgets,
production and sales, etc emanating from the-raw material budget.)

ANSWER 4
(a) Traditional costing systems were designed some time ago when a narrow range of
products existed and overhead costs were a relatively small proportion of total costs.
The business and competitive environment faced by firms has substantially due to the
globalisation of markets and technological innovation. This has meant that companies
now have to variety, flexibility and quality. This resulted in a re-examination of the
traditional way of costing products and services.

Activity-based costing (ABC) claimed to be different from traditional approaches to

costing. It moves away from a tendency to allocate costs or services through the
departmental divisions of an organisation. Instead ABC recognises that costs may be
usefully analysed by the activities performed. These activities are not necessarily
defined by departmental boundaries. Data is collected on the activities performed in
order to calculate the costs of products or services benefiting from the activities. The
concept is based on the idea that ‘activities cause costs' and 'products consume
activities'. This is therefore the logical way to carry out the costing of a product. A
further disadvantage of the traditional approach to costing is that it has tended to
penalise products or services that are produced and delivered m high volumes. This
is because the traditional bases of applying costs were often volume-based, for
example machine hours, labour hours or a constant percentage overhead. Labour
hours have traditionally been a popular basis for absorbing overhead costs despite
the fact that these costs now form only a small proportion of the total costs of a
business. Furthermore some activities carried out in organisations are not necessarily
associated with the volume of product or service produced. For example. the
administration cost of dealing with a customer enquiry is not related to the volume of
the transaction. In a similar way the cost to set-up a machine is not related to the
length of time for the production run.

The nature of some overhead costs have also changed, for example, focusing on the
customer or on quality, as indicated above. These costs are no longer really
manufacturing costs but rather are now more organisational support costs. ABC is
claimed to be more appropriate to the needs of modern organisations where there is
a growing burden of these different overheads and fewer volume-based costs.
However, some observers argue that ABC is simply a more refined version of
traditional absorption costing.

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 Test 1

(b) (i) The process of installing an ABC system involves an analysis of

organisational activities and the extent of their occurrence. These activities
are then related to products and services and their cost. Once a company
has undertaken this exercise the database thus produced can become the
basis for forward planning and budgeting. For example, once the planned
scale of production has been established it is possible to translate this into
the number of times activities are required to be performed. This will help to
define required departmental capacities for machines and for staffing levels.
The financial budget for each activity centre can then be established by
extending these activities by the cost per activity. This activity based estimate
can provide an input to budget discussions, though it may not necessarily
establish the budget figure. The activity analysis/ABC cost information
therefore becomes the basis for the company modelling alternative scenarios
before incorporating an agreed position into the master budget statement.

Unfortunately much of this activity information will be historical therefore as

systems change or product volumes differ its accuracy may be invalidated.
Likewise, the cost per activity could be an historical rate and will need
adjustment for any anticipated cost/inflation changes.

(ii) By managing the activities underlying costs it is then possible to control the
level of costs. This is the basis of the concept that 'products consume
activities' and 'activities cause costs'. As overheads have grown, the
feedback reporting methods that have been traditionally used often have
proved to be insufficient. By preparing regular reports on activity volume
some attempt can be made to predict and manage the costs involved. Such
reports may provide the opportunity to pose questions regarding different
ways of carrying out processes in order to reduce the activities and hence the
costs incurred. Thus ABC may persuade management to find methods to
proactively manage costs through managing the activities.

Additionally, activities reflect the work rate of departments and other

organisational sub units. The activities are therefore additional measures of
performance of the department. Thus ABC provides additional opportunities
to manage departmental performance. The following diagram illustrates this
particular point:

Cost assignment view

Resources

Process view

Activities
Cost drivers Activities Performance measures
Activities
Activities

Cost objects

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CAT Paper 7 Planning, Control and Performance Management

If costs are to be controlled it is not enough for there to be cost reporting.

What is also needed is managerial intervention regarding a spending
decision. If a reduced activity volume is achieved in a particular department in
itself this may not reduce the cost. For example staff may need to be re-
deployed or machines disposed of before costs are actually reduced. This
highlights the fact that ABC is a resource consumption model not a spending
model. There is no direct link between managing the activities and automatic
control or management of the cost.

(iii) Decision making involves the identification of relevant costs for the various
decision alternatives. As each decision is unique so the appropriate
identification of costs and revenues are unique also. In decision making the
relevant costs to a decision are more commonly the marginal costs whereas
ABC costs are ultimately average costs. Although such costs may be
accurate than traditional cost, an ABC based cost cannot be assumed to be a
relevant cost for a decision, such as deleting a product or closing a
department.

When considering deleting a product some of the costs identified to that

product, through ABC, will be removed but not all costs. It may still be simpler
to analyse costs into variable and fixed components in order to make the
decision.

One solution to this problem is the suggestion that a hierarchy of cost

classification is created. This hierarchy involves identifying activity costs at a
number of different hierarchical levels:

1 The unit (individual item) level.

2 The batch level (changing when the number of batches change, eg

set-up).

3 The product level (which are common to all products within the
product line).

4 The facility sustaining level (this relate to the whole plant where
various product lines are produced).

Adopting this approach will help to focus manager’s minds on which part of
the hierarchy is likely to be removed in a decision to remove a particular
product. It has been suggested that ABC costs represent long-run average
costs of a product. These costs are not designed therefore to be used directly
for decision making. It is important that users are aware of this before making
profitability decisions based on ABC costs.

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