Paper F5 Performance Management Final Mock Exam June 2013 Session Answers

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Answers # 1 (a) Logistics Managers proposal Effect on 20X9 ROI It will have been assumed in arriving at the 31/12/X9 net assets that the debt will have been paid. Reversing this assumption has the effect of increasing liabilities and has no effect on assets, as cash is excluded. Thus net assets will be reduced by $90,000 (to $5,410,000). Whether the $2,000 late payment penalty is accounted for in 20X9 or 20Y0 will depend to some extent on the companys accounting policy. The accruals concept would, however, lean towards it being accounted for in 20X9. Thus operating profits would be reduced by $2,000 (to $814,750). The new ROI would thus be 814,750 5,410,000 100 = 15.06% Thus the target will have been achieved and bonuses paid. This is, of course, no indication of improved performance, but simply an arithmetical anomaly arising as a result of one side of the transaction being ignored in the calculation. In fact, the finance cost of the late payment is extremely high. Longer term effects There would be no quantifiable longterm effects, although relationships with the supplier may be adversely affected by the late payment. Production managers proposal Effect on 20X5 ROI Assuming no depreciation charge in 20X9, net assets would be increased by the cost of the new assets, $300,000 (to $5,800,000), and operating profits would be unaffected. The new ROI would thus be 816,750 5,800,000 100 = 14.08% This represents a reduction of ROI in the short term. Longer term effects In 20Y0 and beyond, the full impact of the cost savings and depreciation charge would be felt operating profits would be decreased by a net $(30,000 29,000) = $1,000. Net assets value will be increased, but the increase will be smaller each year as the asset is depreciated. In 20Y0, the ROI would be 816,750 (5,800,000 30,000) 100 = 14.15% This will still not help the division to achieve its target of 15%, although it does exceed the companys cost of capital and thus may be desirable overall. But this illustrates one of the major problems with using book values for assets in performance measures as the assets get older, they appear to give better performance. This can have the effect of deterring managers from replacing assets even though this may be of benefit in the long term through cost savings (as above), increased productivity etc.

Divisional Accountants proposal Residual income (RI) is an absolute measure of performance, and is arrived at by deducting a notional interest charge at the companys cost of capital on the net assets. Appraising the two divisions performance forecasts under this method would have the following results: 20X9 operating profit $ 816,750 203,500 Interest charge (10% net assets) $ 550,000 92,500 Residual income $ 266,750 111,000

Division Aye Division Bee

In summary, RI has advantages and disadvantages over ROI as a performance measure, and both suffer from common valuation problems. One of these can be used as part of a package of performance indicators market share, productivity, employee satisfaction, technological advancement, etc but neither is perfect in isolation. The performance rankings of the two divisions are now apparently reversed. However, the RIs of the two divisions are not directly comparable whilst Division Aye has produced nearly twice the level of RI than that of Division Bee, the net asset base required to do this is over six times as large. RI cannot be meaningfully used to compare investments of differing sizes, as ROI can. One could also question the use of the companys average cost of money in computing the notional interest charge. The two divisions have been set a target well above this may be because they are considered riskier than average. If 15% had been used in the computation, Division Aye would have negative RI, whilst Division Bee has positive RI reflecting the same information as the ROI, that Aye is not achieving its target return. The RI uses the same principles for establishing profit and asset values as the ROI, and thus shares the same problems. As assets get older and their WDV falls, the imputed interest falls and RI rises. However, RI can be of greater benefit than ROI in management decision making. Management may only feel inclined to undertake new investment if doing so improves their performance measure. For example, Division Bee currently enjoys a ROI of 22% and its manager may only consider new projects that give a return at least as good as this (although this may depend upon the particular structure of the bonus scheme a fixed bonus provided the target of 15% is reached may not provoke such an attitude). However, the RI measure will improve with new investment, i.e. increase, provided the investments returns are at least covering the rate used in computing the notional interest (12% or 15%). This will ensure that projects that are worthwhile from the companys point of view will also be seen as such by the divisional manager (goal congruence).

(c) Financial measures taken in isolation are unlikely to tell the whole story of a divisions or companys performance. They must be put into context, taking account of the circumstances in which they were achieved new products being introduced, market changes, technological changes, competitors moves, availability of resources, etc. For example, one might question why the two divisions in Scotswood are apparently performing at such different levels. Whilst quality of management may well be a contributory factor, it is unlikely to explain a difference of over five percentage points in ROI.

The age profile of assets used should be considered, as discussed above. Division Aye may have recently invested in new machinery, possibly in response to technological advances. Not to do so would put them at a disadvantage over their competitors, and thus is for longterm benefit. The industry of the much smaller Division Bee may be more static, requiring less asset changes. Performance relative to the market and competitors should be considered (market share, product leadership, etc) and the degree of innovation achieved. Level of complaints received may also be monitored. Consider the performance of a manager labour turnover, staff morale, managers relationships with both subordinates and superiors. The level of job satisfaction felt by employees at all levels is an important consideration in the plan for achievement of company objectives. Answer # 2 (a) Room A Contribution per seminar = $832,000 / (8 cities x 52 weeks) = $2,000 Room cost = delegate fees contribution = (100 delegates x $80) $2,000 = $6,000 Room B Contribution per seminar = 2,163,200 / 8 x 52 = $5,200 Room cost = (200 delegates x $80) $5,200 = $10,800 Room C Contribution per seminar = $3,993,600 / (8 x 52) = $9,600 Room cost = (300 delegates x $80) $9,600 = $14,400 Room D Contribution per seminar = $6,656,000 / (8 x 52) = $16,000 Room cost = (400 delegates x $80) $16,000 = $16,000 (b) (i) Expected Contribution if 100 places available = $832,000 Expected Contribution if 200 places available = 1,497,000 Expected Contribution if 300 places available = 998,000 Expected Contribution if 400 places available =1,331,200 This analysis shows that Faith Co. should contract for Room B with 200 capacity as it has the highest expected value at $1,497,600. (ii) Limitations of the expected value approach Expected values indicate what an outcome is likely to be in the long term with repetition. The main limitation is that the expected value may never actually occur. Expected values are used to support a risk-neutral attitude and ignore any variability in the range of possible outcomes. The variables involved can only be estimated so great care should be taken to avoid relying too heavily on educated guesses.

(c) The minimum contribution for each decision is as follows. Room A Room B Room C Room D $832,000 ($1,164,000) ($2,662,400) ($3,328,000)

Applying a maximin approach (maximising the minimum contribution) , Faith should choose RoomA. The minimax regret rule aims to minimise the regret from making the wrong decision . The regret matrix is shown below. The regret is calculated by taking the maximum expected contribution from each demand level (as shown in the table for (a) and deducting the contribution that would result from the room size that was contracted for. For example, if 200 places were demanded but only 100 places were contracted for, that would mean that the regret is $2,163,200 $832,000 = $1,331,200. Regret Table: Room size Demand 100 200 400 Maximum regret 100 0 1,331,200 5,824,000 5,824,000 200 1,996,800 0 4,492,800 4,492,800 300 3,494,400 1,497,600 2,662,400 3,494,400 400 4,160,000 2,163,200 0 4,160,000

To minimise the maximum regret, Room C with 300 places needs to be contracted for.

(d) The information systems that may be introduced to reduce uncertainty in Faith Co: A retail web site - this site should be interactive enabling customers to correspond with the customer relationship officer to evaluate their choices and purchases. This can be backed up with the reservation of the room online. Customer accounts - may be established by the company to establish the number of returning customers to the site and company. Web site monitoring - the company may scan web sites of their main competitors to identify changes in their sales items and press releases relating to their performance. This monitoring will reduce the actual data collection which will be required by the staff working at Faith and enable them to evaluate their performance in relation to others. lf the industry standard increases and Faith are unaware of the change they could find that their pcsition ls eroded, as competitors are abie to improve their margins. Management Information System - both of the above systems will require a management information system to report on the purchases made by the customers. They will then be able to analyse the number of customers who return to buy the albums etc. and the ability to report and summarise information from the sales transaction will enable the organisation to obtain greater marketing information with the result of targeting specific customers. The organisation will need to create a number of reporting systems relating to the individual sales in different cities. This will enable the company to identify the profit margins on individual lines to determine their profitability and their overall contribution to the performance of the business.

Executive information system (ElS) - this is a high-level information system that may be used by the strategic managers within Faith to compare the performance of the companies in a summary format. The information gathered by the MIS and other lower level information systems can be filtered into this system to provide important information relating to the overall costs and sales.

Answer # 3 Define the variables Let S represent the number of Scottie services to be provided Let L represent the number of Labrador services to be provided Let C represent contribution Formulate the objective function C = 7.5S + 15L Formulate the constraints Specialised cleaning materials 0.1S + 0.15L 60 Labour time 0.5S +L 300 Machine time 0.5S + 0.25L 150 Minimum number of Scotties S 25 Minimum number of Labradors L 50 Plot constraints Specialised cleaning products 0.1S + 0.15 L = 60 If S=0 0.15L = 60 L = 400 If L = 0 0.1S = 60 S = 600 Labour time 0.5S +L = 300 If S=0 L = 300 If L=0 0.5S = 300 S = 600 Machine time 0.5S + 0.25L = 150 If S=0 0.25L = 150 L = 600 If L=0 0.5S = 150 S = 300 Plot objective function C = 7.5S + 15L Try C being 3,000 If S=0 15L = 3,000 L = 200 If L=0 7.5S = 3,000 S = 400 Plot the graph - NEEDS A GRAPH INSERTING TO SHOW SOLUTION

Solve The optimal solution is where machine hours and labour cross. Solving using simultaneous equations: 0.5S + 0.25L = 150 equation1 0.5S + L = 300 equation 2 Equation 2 Equation 1 0.75L = 150 L = 200 Substitute back into equation 2 0.5S + 200 = 300 0.5S = 100 S = 200 In order to maximize contribution, Puppycare should provide 200 Scotties and 200 Labradors.

(b) Contribution maximized where 200 Scotties and 200 Labradors are provided given a contribution of: (200 x 7.50) + (200 x 15) = 4,500. Shadow price for machine hours: 0.5S + 0.25L = 151 equation1 0.5S + L = 300 equation 2 Equation 2 Equation 1 0.75L = 149 L = 198.67 Substitute back into equation 2 0.5S + 198.67 = 300 0.5S = 101.33 S = 202.67 Optimal solution = 202.67S + 198.67L Giving contribution of = (202.67 x 7.50) + (198.67 x 15) = 4,500.075 Shadow price = 4,500.075 - 4,500 = 7.5p Shadow price for specialized cleaning material: Specialised cleaning material is a non-critical constrains for Puppycare. Hence the shadow price is nill. (c) Performance measurement in service businesses has sometimes been perceived as difficult because of the different characteristics of service from product. But the modern view is that if something is difficult to measure this is because it has not been clearly enough defined. Fitzgerald & Moon provide building blocks for standards, rewards and dimensions for performance measurement systems in service businesses.

Standards These are ownership, achievability and equity. Ownership - To ensure that employees take ownership of standards, they need to participate in the budget and standard-setting processes. They are then more likely to accept the standards, feel more motivated as they perceive the standards to be achievable and morale is improved. The disadvantage to participation is that it offers the opportunity for the introduction of budgetary slack. Achievability - Standards need to be set high enough to ensure that there is some sense of achievement in attaining them, but not so high that there is a demotivating effect because they are unachievable. It is management's task to find a balance between what the organisation perceives as achievable and what employees perceive as achievable. Equity - It is vital that equity is seen to occur when applying standards for performance measurement purposes. The performance of different business units should not be measured against the same standards if some units have an inherent advantage unconnected with their own efforts. For example, divisions operating in different countries should not be assessed against the same standards. Rewards The reward structure of the performance measurement system should guide individuals to work towards standards. Three issues need to be considered if the performance measurement system is to operate successfully: clarity, motivation and controllability. Clarity - The organisation's objectives need to be clearly understood by those whose performance is being appraised ie they need to know what goals they are working towards. Motivation - Individuals should be motivated to work in pursuit of the organisation's strategic objectives. Goal clarity and participation have been shown to contribute to higher levels of motivation to achieve targets, providing managers accept those targets. Bonuses can be used to motivate. Controllability - Managers should have a certain level of controllability for their areas of responsibility. For example they should not be held responsible for costs over which they have no control. Dimensions Competitive performance, focusing on factors such as sales growth and market share. Financial performance, concentrating on profitability, capital structure and so on. Quality of service looks at matters like reliability, courtesy and competence. Flexibility is an apt heading for assessing the organisation's ability to deliver at the right speed, to respond to precise customer specifications, and to cope with fluctuations in demand. Resource utilisation, not unsurprisingly, considers how efficiently resources are being utilised. This can be problematic because of the complexity of the inputs to a service and the outputs from it and because some of the inputs are supplied by the customer (he or she brings their own hair, for example). Many measures are possible, however, for example 'number of customers per hairdresser'. Performance measures can be devised easily if it is known what activities are involved in the service. Innovation is assessed in terms of both the innovation process and the success of individual innovations. These dimensions can be divided into two sets. The results (measured by financial performance and competitiveness) The determinants (the remainder)

Answer # 4 Sales Volume profit variance Budgeted sales Actual sales Sales volume variance in units Standard profit margin per unit Sales volume variance in $ TV 800 units 560 units 240 units (A) $5 $1,200 (A) DVD 600 units 1,260 units 660 units (F) $3 $1,980 (F) AC 300 units 250 units 50 units (A) $4 $200 (A)

Total sales volume variance = $580 (F) Sales Mix profit variance Total quantity sold (560 + 1,260 + 250) = 2,070 Budgeted total quantity (800 + 600 + 300) = 1,700 Standard Mix on actual sales TV DVD AC Total Sales Quantity profit variance Budgeted sales TV DVD AC Total 800 600 300 Standard Mix on actual sales (800/1700) x 2070 (600/1700) x 2070 (300/1700) x 2070 Profit per unit 5 3 4 (800/1700) x 2070 (600/1700) x 2070 (300/1700) x 2070 Actual sales 560 1260 250 Profit per unit 5 3 4

$ 2071 (A) 1588 (F) 461 (A) 944 (A)

$ 871 (F) 392 (F) 261 (F) 1524 (F)

If an organisation uses standard marginal costing instead of standard absorption costing then standard contribution rather than standard profit margin is used in the calculations.

(b) The favourable sales volume variance indicates that a potential increase in profit was achieved as a result of the change in sales volume compared with the budgeted volume. The sales mix variance is adverse due to the fact that more of the less profitable product was sold than budgeted. Profit would have been $944 higher if the 2,070 units had been sold in the budgeted mix of TV 8: DVD 6: AC 3.

The favourable sales quantity variance of $1,524 is the difference in profit because sales volumes of products were higher than budgeted, possibly due to effective marketing campaigns.

(c) Maximising profits Selling price Demand Sales Revenue Variable cost (in house) Subcontractor cost Fixed cost Profit 12 6,000 72,000 37,200 11,200 _____ 23,600 11 7,200 79,200 43,400 1,550 11,200 _____ 23,050 10 11,200 112,000 43,400 32,550 11,200 _____ 24,850 9 13,400 120,600 43,400 44,800 11,200 _____ 21,200

The price of $10 and sales of 11,200 units would maximise the profit, as illustrated above at $24,850 provided the estimates prove to be correct.

(d) Environmental Management Accounting Try yourself

Answer # 5 (a) Learning curve theory can be used in budgeting to: - Calculate the marginal (incremental) cost of making extra units of a product. - Quote selling prices for a contract, where prices are calculated at cost plus a percentage mark-up for profit. An awareness of the learning curve can make all the difference between winning contracts and losing them, or between making profits and selling at a loss-making price. - Prepare realistic production budgets and more efficient production schedules. - Prepare realistic standard costs for cost control purposes. (b) $ Direct material cost (W1) Direct labour cost (W2) (35435.94 x 10) Variable overhead (35435.94 x 3) Fixed cost (11000 x 18) Total Cost Profit Mark-up 25% Selling Price Selling Price per unit 631,200

354,359.4

106,307.8 198,000 ------------1,289,867.2 322,466.8 1,612,334 1,151.67

Workings (W1) Direct material cost = (300 x 600) + (300 x 600 x 80%) + (800 x 600 x 80% x 80%) (W2) Direct labour hour Cumulative average time per unit to produce 900 units = 500 x 900
-0.4150

= 29.7139 hour

Cumulative total labour hour to produce 900 units = 900 x 29.7139 = 26742.4919 hour Cumulative average time per unit to produce 899 units = 500 x 899
-0.4150

= 29.7276 hour

Cumulative total labour hour to produce 899 units = 899 x 29.7276 = 26725.1052 hour Time to produce 900 unit = 26742.4919 - 26725.1052 = 17.3869 hour Total time to produce 1400 units = 26742.4919 + 500 x 17.3869 = 35435.94 hour
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(c) Limitations of using learning curve in modern manufacturing environment Try yourself

(d) Life cycle costing tracks and accumulates costs and revenues attributable to each product over the entire product life cycle. Every product goes through a life cycle in Metallica Ltd. Development - The product has a research and development stage where costs are incurred but no revenue is generated. Introduction - The product is introduced to the market. Potential customers will be unaware of the product or service, and the organisation may have to spend further on advertising to bring the product or service to the attention of the market. Growth - The product gains a bigger market as demand builds up. Sales revenues increase and the product begins to make a profit. Maturity - Eventually, the growth in demand for the product will slow down and it will enter a period of relative maturity. It will continue to be profitable. The product may be modified or improved, as a means of sustaining its demand. Decline - At some stage, the market will have bought enough of the product and it will therefore reach 'saturation point'. Demand will start to fall. Eventually it will become a loss-maker and this is the time when the organisation should decide to stop selling the product or service. The level of sales and profits earned over a life cycle can be illustrated diagrammatically.