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Management Accounting

Level 3

Model Answers
Series 2 2005 (Code 3023)

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Management Accounting Level 3


Series 2 2005

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Management Accounting Level 3


Series 2 2005
QUESTION 1 (a) Describe activity based costing (ABC) in contrast to traditional methods of attributing production overhead costs to products. Outline two advantages of using ABC. (8 marks) (b) Explain the term investment centre and contrast investment centres with profit centres. (6 marks) (c) Define, and illustrate, the term opportunity cost. (6 marks) (Total 20 marks)

Model Answer for Question 1 (a) Activity based costing (ABC) is an approach to the attribution of overhead costs to products which involves the tracing of resource consumption directly to products. This is in contrast to the more traditional approach which initially allocates and apportions overheads to the cost centres where they are incurred. Overheads are then absorbed into the cost of products in such a way (generally a generic volume related absorption basis) that there is frequently only a tenuous link between expenses incurred and the charging of those expenses to different products. Using ABC, overhead costs are first allocated to the activities that cause them to be incurred. The key driver of each activity's costs (the key factor that causes the cost of the activity to change) needs to be identified. Any activities with a common cost driver can be pooled and then overheads are attributed to products, which create demand for the activities, based upon their relative consumption of each activity. In this way ABC recognises the range and complexity of the different products and the resulting overheads incurred. Two advantages of ABC, in contrast to traditional methods, are: (i) (ii) Greater understanding of cost behaviour and as a result better control of costs; More accurate costing and as a result better decisions.

(b) An investment centre is a responsibility centre (ie a part of a business that is the direct responsibility of a specific manager) in which the manager takes decisions regarding fixed asset investment. Managers of investment centres are thus responsible for long-term capital investment as well as the day to day revenues and costs. Investment centre long-term financial performance will be measured by relating profit to the amount invested. In contrast to an investment centre, a profit centre is a responsibility centre where the manager has responsibility for the profit generated from the use of assets, but not for the investment decisions. Managers of profit centres are thus responsible for revenues and for costs but not for fixed assets.

(c) An opportunity cost is the benefit sacrificed in favour of an alternative course of action. Every decision, which involves making a choice between two or more mutually exclusive alternatives, has an opportunity cost. For example, where a business' available resources are insufficient to meet customer demand for the business' products or services, the use of resources in a particular way will mean giving up the opportunity of using them in one or more other ways. The benefit that would have arisen from an alternative use of a resource becomes an opportunity cost of the course of action being considered.

QUESTION 2 Budgeted sales of a product in Period 1 were 6,400 units at a selling price of 89.00 per unit. Standard production costs in the period totalled 57.60 per unit. Actual revenue in Period 1 was 574,000 from the sale of 6,560 units of the product. REQUIRED (a) Calculate, for Period 1, the: (i) (ii) sales volume profit variance selling price variance. (3 marks) (3 marks)

The standard selling price and the standard costs of the product remained the same in Period 2. The budgeted gross profit for the period was 211,950. Actual sales revenue in Period 2 was 597,860 during which the following sales variances occurred: Sales volume profit Selling price REQUIRED (b) Calculate, for Period 2, the: (i) (ii) budgeted sales (units and revenue) actual sales (units) (3 marks) (3 marks) (2 marks) (6 marks) (Total 20 marks) 2,198 Adverse 3,340 Favourable

(iii) actual average selling price ( per unit). (c) Comment upon the sales performance in Periods 1 and 2.

Model Answer for Question 2 (a) Workings: Standard gross profit = 89.00 57.60 = 31.40 per unit (i) Sales volume profit variance (Period 1): = (6,560 - 6,400 units) @ 31.40/unit = 5,024 Favourable (ii) Selling price variance (Period 1): = 574,000 - (6,560 units @ 89.00/unit) = 9,840 Adverse (b) (i) Budgeted sales (Period 2): = 211,950 31.40/unit = 6,750 units 89.00/unit = 600,750 (ii) Actual sales (Period 2): = [(211,950 - 2,198) 31.40/unit] = 6,680 units (iii) Actual average selling price (Period 2): = (597,860 6,680 units) = 89.50 per unit (c) In Period 1 the favourable variance as a result of selling 2% more units than budget was more than offset by a 1.50 (1.7%) shortfall in the selling price compared with budget. The situation was somewhat reversed in Period 2 with an above budget selling price achieved, 2.00 per unit higher than in Period 1. The favourable variance effect of this was, however, offset to a significant extent by failure to achieve the budgeted sales volume (1% below). Sales volume achieved in Period 2 was, nevertheless, 1.8% higher than in Period 1. or [89.00/unit + (3,340 6,680 units)] or [(597,860 - 3,340) 89.00/unit]

QUESTION 3 The following draft summary profit budget has been prepared by a company, covering the year ahead: Sales Production cost of sales Gross profit Non-production overheads Net profit 000 650.0 410.8 239.2 195.0 44.2

The companys draft budgeted balance sheet for the end of the budget year comprises the following items: Fixed assets (NBV) Stock of raw materials Stock of finished goods Debtors Creditors Bank overdraft Share capital and reserves 000 226.7 19.7 28.6 36.2 24.0 4.2 283.0

Creditors relate to raw materials only. The production cost of sales includes 165,600 for direct materials. 60% of sales are on credit. Assume that 1 year = 365 days. REQUIRED (a) Calculate, using the above budgeted information only, the: (i) (ii) year-end working capital following ratios: (1) (2) (3) (4) finished goods stock turnover (number of times) debtor payment period (days) creditor payment period (days current ratio (3 marks) (3 marks) (3 marks) (2 marks) (2 marks)

(b) Calculate the change ( + or ) in the relevant balance sheet item (excluding bank overdraft) resulting from each of the following: (i) (ii) an increase of 30 days in the period of credit granted to customers an increase in finished goods stock to provide for a further 15 days sales (3 marks) (2 marks) (2 marks) (Total 20 marks)

(iii) a reduction of 10 days in the credit terms offered by raw material suppliers.

Model Answer for Question 3 (a) (i) Budgeted year-end working capital: = current assets - creditors or current assets - current liabilities or 84,500 - 28,200 = 56,300

= 84,500 - 24,000 = 60,500 (ii) Ratios:

(1) Finished goods stock turnover: = (410,800 28,600) = 14.4 times (2) Debtor payment period; = [36,200 (650,000 0.6)] 365 days = 34 days (3) Creditor payment period: = (24,000 165,600) 365 days = 53 days (4) Current ratio: = 84,500 : 28,200 = 3:1 (b) (i) Customer credit: Change = [(650,000 0.6) (30 365 days)] = + 32,100 debtors (ii) Finished goods stock: Change = [410,800 (15 365 days)] = + 16,900 stock (iii) Supplier credit: Change = [165,600 (10 365 days)] = 4,500 creditors

QUESTION 4 A product is manufactured in two consecutive operations. A different grade of labour is required for each operation. Details of standard times, grades and rates of pay for direct labour are: Standard direct Wage rate labour time (hours per unit of product) Operation 1 Operation 2 0.20 0.12 direct labour Grade of ( per hour)

A B

8.00 10.00

The above standard times are ideal and an 80% efficiency ratio (the attainable standard) is to be budgeted for the following four-week period (Period 6) for each operation. The basic working week is 40 hours with no overtime. 9,600 units of the product are budgeted to be manufactured in Period 6. REQUIRED (a) Using the attainable standard for Period 6, calculate the: (i) (ii) standard direct labour cost per unit of product (for each operation and in total) budgeted number of direct operatives for each operation. (5 marks) (6 marks)

In Period 5 (the previous four-week period) the ideal standard times and the standard rates of pay were the same as those set out in (a) above. Actual direct labour, in the manufacture of 8,270 units of product, in Period 5 was: Operation 1 Operation 2 REQUIRED (b) Calculate, for Period 5, the: (i) (ii) total direct labour rate variance (3 marks) Hours 2,110 1,185 16,955 12,040

efficiency ratio for each operation (to one decimal place of %) measured against the ideal standard. (6 marks) (Total 20 marks)

Model Answer for Question 4 (a) (i) Standard direct labour cost (Period 6): Operation 1 = 0.20 hours/unit 0.8 efficiency 8.00/hour = 2.00 per unit

Operation 2 = 0.12 hours/unit 0.8 efficiency 10.00/hour = 1.50 per unit 3.50 per unit (ii) Budgeted direct operatives (Period 6): Budgeted direct labour hours: Operation 1 = 0.20 hours/unit 0.8 efficiency 9,600 units = 2,400 hours Operation 2 = 0.12 hours/unit 0.8 efficiency 9,600 units = 1,440 hours Budgeted number of direct operatives: Operation 1 = 2,400 hours 40 hours/week 4 weeks = 15 operatives Operation 2 = 1,440 hours 40 hours/week 4 weeks = (b) (i) Total direct labour rate variance (Period 5): Operation 1 = 16,955 - (2,110 hours @ 8.00) = 75 Adverse 9 operatives

Operation 2 = 12,040 - (1,185 hours @ 10.00) = 190 Adverse 265 Adverse (ii) Efficiency ratios: Standard hours of actual output (at ideal standard): Operation 1 = 8,270 units 0.20 hours/unit = 1,654 standard hours Operation 2 = 8,270 units 0.12 hours/unit = Efficiency ratios: Operation 1 = (1,654 2,110 hours) 100% = 78.4% Operation 2 = (992.4 1,185 hours) 100% = 83.7% 992.4 standard hours

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QUESTION 5 Two mutually exclusive investment projects are being considered by a company. Incremental cash flows are estimated as follows: Project 1 000 (700) 190 190 190 190 190 190 Project 2 000 (700) 140 160 180 200 220 240

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

The required discount rate (cost of capital) is 12% per annum. REQUIRED (a) Without discounting the cash flows, determine which project would be preferred on financial grounds and explain why. (3 marks) (b) Calculate both the net present value (NPV) and the internal rate of return (IRR) of Project 1, using the following discount factors as appropriate: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 12% 0.893 0.797 0.712 0.636 0.567 0.507 4.112 18% 0.847 0.718 0.609 0.516 0.437 0.370 3.497 (8 marks) (c) For Project 1 calculate the annual incremental cash inflows (to the nearest 000) that are required to achieve a zero NPV when discounted at the cost of capital. (4 marks) (d) Demonstrate how the following data would have been used to determine the cost of capital: Proportion of long term capital 60% 40% Cost per annum 15% 7% (5 marks) (Total 20 marks)

Equity Debt

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Model Answer for Question 5 (a) Non-discounted net cash flows for each project total 440,000. Project 1 would be preferred because the cash inflows are expected to be received earlier (more in Years 1 to 3 offset by less in Years 4 to 6) and are thus more valuable in present value terms. (b) Project 1 - NPV at 12% (the cost of capital): = (190 4.112) - 700 = 81.3k Present value of the cash flows of Project 1 discounted at 18%: = (190 3.497) - 700 = (35.6k) Project 1 - estimated IRR: = 12% + 6%[81.3 (81.3 + 35.6)] = 16.2% (c) The present value of cash inflows of Project 1 needs to be 700k for zero NPV. Thus: 700 4.112 = 170k per annum

(d) Cost of capital: Equity Debt 15% 0.6 = 9.0 7% 0.4 = 3.0 12.0%

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QUESTION 6 The following information relates to the three products that are manufactured and sold by a company: ( per unit) Selling price Variable production costs Variable non-production costs Sales per period are: Product X Product Y Product Z 3,800 units 6,340 units 2,900 units X 8.60 4.90 1.12 Product Y 5.00 3.00 0.60 Z 11.20 5.24 1.48

Fixed costs per period are: Production Non-production REQUIRED (a) Calculate the: (i) (ii) contribution/sales ratio of each product net profit per period. (3 marks) (3 marks) 15,620 9,110

(b) Calculate, based upon the above sales mix (units) the: (i) (ii) overall contribution/sales ratio (to one decimal place of %) break-even point sales (to the nearest hundred) (4 marks) (3 marks) (3 marks)

(iii) sales (to the nearest hundred) required in a period to earn a profit of 10,000.

(c) Calculate the overall contribution/sales ratio (to one decimal place of %) based upon the following revised sales mix: Product X Product Y Product Z 30% of total sales revenue 30% of total sales revenue 40% of total sales revenue

(4 marks) (Total 20 marks)

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Model Answer for Question 6 (a) (i) Contribution/sales ratio by product: Product X Product Y Product Z (ii) (2.58/unit 8.60/unit) 100% = 30% (1.40/unit 5.00/unit) 100% = 28% (4.48/unit 11.20/unit) 100% = 40%

Net profit per period: 3,800 units @ 2.58/unit = 9,804 6,340 units @ 1.40/unit = 8,876 2,900 units @ 4.48/unit = 12,992 31,672 less Fixed costs (15,620 + 9,110) 24,730 Net profit 6,942 Contribution: Product X Product Y Product Z

(b) (i)

Overall contribution/sales ratio: Sales: Product X Product Y Product Z 3,800 units @ 8.60/unit = 32,680 6,340 units @ 5.00/unit = 31,700 2,900 units @ 11.20/unit = 32,480 96,860

Overall contribution/sales ratio: = (31,672 96,860) 100% = 32.7% (ii) Break-even point: = [24,730 (96,860 31,672)] = 75,600 (to the nearest hundred)

(iii) Required sales for 10,000 profit: = [34,730 (96,860 31,672)] = 106,200 (to the nearest hundred) (c) Revised overall contribution/sales ratio: Product X Product Y Product Z 30% 0.3 = 0.090 28% 0.3 = 0.084 40% 0.4 = 0.160 0.334 ie 33.4%

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