ACCOUNTING FOR MANAGER INTERPRETING ACCOUNTING INFORMATION FOR DECISION MAKING 4TH EDITION BY PAUL M

TEST BANK

ACCOUNTING FOR MANAGER INTERPRETING ACCOUNTING INFORMATION FOR DECISION MAKING 4TH EDITION BY PAUL M COLLIER SOLUTION MANUAL Chapter 1

Solutions

1.1

Explain the difference between accounting, an account, and accountability.

Accounting is a collection of systems and processes used to record, report and interpret business transactions. An account is an explanation or report in financial terms about those transactions. Accountability arises from the stewardship function, that managers have to provide an account to other stakeholders in the business.

1.2

Summarise the main activities of management accountants.

The main activities of management accountants includes participation in planning, primarily through budgets; generating, analysing, presenting and interpreting information to support decision-making, and monitoring and controlling performance.

1.3

Explain how the role of management accounting has changed over the last 100 years.

The origin of management accounting was cost accounting in factories, where accountants were close to the business and advised non-financial managers.

Management accountants have advised on economies of scale as well as of scope as businesses grew and diversified as divisionalization, conglomerates and multinational organizations increased the demand for accounting information. Non-financial performance information has come to challenge management accounting information. Although new techniques have been developed, new manufacturing technologies and the growth of service industries has not been matched by the changing role of management accountants. Management accounting is increasingly decentred in organizations, with IT carrying out the bulk of routine transaction processing.

Organizations are increasingly looking for management accountants to use their financial expertise to contribute to strategy formulation and implementation.

Chapter 2

Solutions

2.1

Explain the idea of value-based management and how shareholder value relates to the interaction between product and capital markets.

Value-based management uses a variety of techniques to measure increases in shareholder value, which is assumed to be the primary goal of all business organizations. Shareholder value refers to the economic value of an investment by discounting future cash flows to their present value using the cost of capital for the business. To achieve shareholder value, a business must generate profits in their markets for goods and services (product markets) that exceed the cost of capital (the weighted average cost of equity and borrowings) in the capital market.

2.2

Explain the key issues in corporate governance as they relate to accounting.

The responsibilities of the Board include setting the company’s strategic goals, providing leadership to senior management, monitoring business performance and reporting to shareholders. The last two of these explicitly relate to accounting, and the first two implicitly do so. In the UK the Combined Code and in the US the Sarbanes-Oxley Act include important responsibilities of the Board in relation to financial statements and performance management. The role of a Board is to provide leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed.

These controls include many accounting controls including budgets, capital expenditure evaluations, etc. The financial reports of a company are the responsibility of the Board which must ensure that the company keeps proper accounting records which disclose with reasonable accuracy the financial position of the company at any time and ensure that financial reports comply with the Companies Act. The Board is also responsible for safeguarding the company’s assets and for taking reasonable steps to prevent and detect fraud.

Chapter 3 3.1

Solutions

An accounting system comprises accounts that can be grouped into: c) assets, liabilities, income and expenses

3.2

A transaction to record the sale of goods on credit would involve a double entry for the sales value to the following accounts: d) increase debtors and increase sales Note there also is an associated entry for the cost of goods sold: increase cost of sales and reduce inventory

3.3

A retail business has sales of £100,000 cost of goods sold of £35,000 salaries of £15,000 rental of £4,000 and advertising of £8,000. All of the income and expenses have been paid out of the owner’s initial capital of £25,000. In addition, the business paid cash of £30,000 for stock (which remains unsold) and purchased equipment on credit for £20,000. The financial statements of the business would show: b) Profit of £38,000 cash of £33,000 and capital of £63,000 Profit

Sales Cost of sales Salaries Rent Advertising

100,000 -35,000 -15,000 - 4,000 - 8,000 £38,000

Cash

Capital£25,000 Plus profit 38,000 - Inventory -30,000 £33,000

Capital

Initial Plus profit

£25,000 38,000 £63,000

Assets Cash 33,000 + Equipment 20,000 + Inventory 30,000 = 83,000 Liabilities Creditors (Equipment) 20,000 + Capital 63,000 = 83,000 3.4

A Balance Sheet shows liabilities of £125,000 and assets of £240,000. The Income Statement shows income of £80,000 and expenses of £35,000.

Capital is: b) £115,000

Capital = assets – liabilities = 240,000 – 125,000 = 115,000 3.5

A transaction to record the purchase of fixed assets on credit would involve: c) increasing creditors and increasing fixed assets

3.6

For each of the following transactions, identify whether there is an increase or decrease in profit, cash flow, assets or liabilities: Transaction

Profit Income Expenses

Cash Flow

Issues shares to public Borrows money over 5 years

Increases

Pays cash for equipment Buys inventory on credit

Decreases

Increases (Selling price less cost price)

Pays cash for salaries, rent, etc.

Pays cash to suppliers

Decreases (Expenses)

Increases (Fixed asset) Increases (Current asset: stock)

Decreases

Increases

Decreases (Depreciation expense)

Increases (Current liability: creditors)

1. Increases (Current asset: debtors @ selling price) 2. Decreases (Current asset: stock @ cost price)

Decreases

Receives cash from customers

Liabilities

Increases (Equity) Increases (Long term debt)

Increases

Sells goods on credit

Depreciates equipment

Assets (excluding cash)

Decreases (Current liability: Creditor) Decreases (Current asset: debtors Decreases (Fixed assets)

3.7

The following balances are shown in alphabetical order in a professional service firm’s ledger at the end of a financial year: Advertising Bank Capital Creditors Debtors Fixed assets Income Rent Salaries

15,000 5,000 71,000 11,000 12,000 100,000 135,000 10,000 75,000

Calculate a. the profit for the year b. the capital at the end of the year

Profit

Balance Sheet

Income Advertising Rent Salaries Profit

135,000 15,000 10,000 75,000

Fixed assets Debtors Bank Creditors Capital Opening capital Plus profit

100,000 35,000 100,000 12,000 5,000 117,000 11,000 106,000 71,000 35,000 106,000

Chapter 6

Solutions

6.1

Explain (with reasons) whether managers are included as users of financial statements.

Users of financial statements are defined by the Framework for the Preparation and Presentation of Financial Statements as investors, employees, lenders, suppliers and trade creditors, customers, government and the public. Management is not defined as a user because management has the ability to determine the form and content of the information it needs. The reporting of information to meet the needs of management is beyond the scope of the Framework.

6.2

The cost of sales is: d) All of the above

6.3

Operating profit is the same as: d) All of the above

6.4

Inventory is an example of: b) a current asset

6.5

If a business has fixed assets of £750,000 working capital of £150,000 and long term debt of £300,000 its shareholders’ funds can be calculated as: d) £600,000 Assets 750,000 + 150,000 = 900,000 less debt of 300,000 = 600,000

6.6

A business has agreed to undertake an advertising campaign that will cost £240,000 to be carried out equally over the financial year beginning 1st January. Half of the annual cost is to be paid six-monthly in advance on the first days of January and July. At 31st March the financial statements would show: b) an expense of £60,000 and a prepayment of £60,000 The monthly cost of advertising is £20,000 (£240,000/12). At 31st March £120,000 has been paid in advance (a prepayment on 1st January) but this has been reduced by 3 months expenditure of £20,000 a total of £60,000. The balance of £60,000 paid in advance for the period April to June remains a prepayment.

6.7

Virko PLC buys a new computer system for £180,000 on 1st January. It expects the system to last for four years. If the company’s financial year is from 1st January to 31st December, the value of the computer system in Virko’s Balance Sheet at 31st December of the same year will be: b) £135,000 Depreciation of £180,000 over 4 years is £45,000 per annum. At the end of the year the asset will be valued at £180,000 - £45,000 = £135,000.

6.8

Thomas Investments has an operating profit for the year of £185,000. An examination of the Income Statement and Balance Sheet shows that depreciation was £65,000 taxation was £40,000 new capital investment was £100,000 and repayment of borrowings was £65,000. The change in cash over the period was: a) an increase of £45,000 Operating profit + Depreciation

Less

Taxation Capital Borrowings Increase in cash

185,000 65,000 A non-cash expense previously deducted from profit 250,000 40,000 100,000 65,000

205,000 45,000

6.9

The amounts shown as taxation and dividends in the Income Statement and cash Flow Statement: d) are different because of the timings of cash outflows

6.10

A company pays its insurance policy for the calendar year of £78,000 on 1st January. On 31st March, what is the impact on the Income Statement, Balance Sheet and Cash Flow? £78,000 / 12 = £6,500 per month At 31st March, expense of £6,500 x 3 = £19,500 Prepayment (Current asset) is £6,500 x 9 = £58,500 Cash has reduced by £78,000

6.11

A company incurs gas costs for heating of £12,000 per year, although three-quarters of the annual cost is incurred between January and June.

Bills are received quarterly at the end of March, June, September & December and paid two weeks later. What is the accrual at the end of June and where does this appear in the financial statements?

Average cost is £12,000 / 12 = £1,000 per month BUT effect of timing!

January – June ¾ of £12,000 = £9,000 / 6 = £1,500 per month Accrual is £1,500 x 3 = £4,500 – expense and accrual (current liability)

6.12

A company has bought a new computer system for cash at the beginning of its financial year at a cost of £30,000. It is expected to last 4 years with no value at the end of that period. What is the impact on the Income Statement, Balance Sheet and Cash Flow at the end of the year?

Depreciation is £30,000 / 4 = £7,500 per annum – expense in Income Statement Cash flow is £30,000 Balance Sheet shows asset cost of £30,000 less depreciation of £7,500 = £22,500 net (book value or written down value).

6.13

Regal Farms Ltd has sales of £2.5 million, a gross profit of £1.7 million and expenses of £800,000. Regal has paid interest of £72,000 and has to provide for Corporations Tax of £310,000 and dividends of £300,000.

Calculate the EBIT, profit after tax and retained profits for the year.

Sales Gross profit Expenses EBIT Interest Profit before tax Income tax Profit after tax Dividends Retained profits

6.14

A professional services firm has income of £1,750,000. It incurs salaries of £1.6 million of which 60% is allocated as a cost of sales and the balance as selling and administration. The only other cost charged to cost of sales is travelling of £50,000. Other administration costs are £80,000. Calculate the gross profit and net profit.

Sales Cost of sales 60% of 1,600,000 Travel Gross profit Salaries 40% of 1,600,000 Other administration costs Net profit

6.15

2,500,000 1,700,000 800,000 900,000 72,000 828,000 310,000 518,000 300,000 218,000

1,750,000 960,000 50,000 1,010,000 740,000 640,000 80,000 720,000 20,000

On 1st January, QRS Ltd is formed with capital of £250,000, all of which is held in the company’s bank account. On the same day, QRS purchases an existing business from Taylor plc for £400,000. An independent valuer has valued the assets as follows: Plant & Equipment £100,000 Trade receivables £ 50,000 Inventory £ 75,000 QRS funds the acquisition by a long-term borrowing of £150,000 and using its available cash. a. Show the Balance Sheet of QRS after these transactions have taken place.

Fixed assets Goodwill Plant & Equipment Current assets Bank Debtors Inventory Total assets Long term debt Equity

175,000 100,000 275,000 50,000 75,000 125,000 400,000 150,000250,000

b. If QRS wishes to amortise its goodwill over 10 years, how will goodwill appear in the Balance Sheet at the end of the first year?

Amortise £175,000 / 10 = £17,500 p.a.

At end of year 1, Balance Sheet shows: Goodwill Less provision for amortization

175,000 17,500 157,500

Chapter 7 7.1

Solutions

XYZ Ltd’s Income Statement shows the following: 2006 Sales 1,250,000 Cost of sales 787,000 Selling & Admin. Expenses 324,000

2005 1,175,000 715,000 323,000

Based on these figures, which of the following statements is true: d) Although the operating profit has increased, the operating margin has decreased as a result of a reduction in the gross margin and higher expenses, despite sales growth Although the operating profit has increased (from £137,000 to £139,000), the operating margin has decreased (from 11.6% to 11.1%) as a result of a reduction in the gross margin (from 39% to 37%) and higher expenses (from £323,000 to £324,000), despite sales growth (of 6.4%).

2008 2007 Sales 1,250,000 1,175,000 Sales growth 6.4% Cost of sales 787,000 715,000 Gross profit 463,000 460,000 Gross margin 37% 39% Selling & Admin. Expenses 324,000 323,000 Operating profit 139,000 137,000 Operating margin 11.1% 11.6%

7.2

Using the above information for Monitor Services PLC, the Return on Capital Employed: a) has improved from 40.3% to 56.4%

ROCE is PBIT/ Total capital employed Total capital employed = shareholders’ funds plus long term debt PBIT Shareholders funds + Long term debt 2008

2007

54,094 = 56.4% 95,871

38,507 = 40.3% 95,450

7.3

In reviewing liquidity and gearing ratios for Monitor Services PLC, we can say that: b) long term debt has reduced as a proportion of total capital employed, and liquidity has declined due to the increase in current liabilities

Liquidity is current assets/current liabilities (i.e. creditors) 2008 2007 Liquidity 134,950 = 1.06 111,817 = 1.18 127,799 94,301 Gearing is long term debt shareholders funds plus long term debt Gearing 2,088 = 2.2% 12,264 = 12.8% 95,871 95,450 Therefore, long term debt has reduced as a proportion of total capital employed, and liquidity has declined due to the increase in current liabilities (relative to the increase in current assets).

7.4

Tubular Steel has 1 million shares issued that have a market price of £5.00 each. After tax profits are £350,000 and the dividend paid is 25p per share. d) All of the above Dividend paid is 25p x 1 million = £250,000 Dividend payout ratio = dividend paid/after tax profits = 250,000/350,000 = 71.4% Earnings per share = after tax profits/number of shares = 350,000/1 million = 35 pence P/E ratio = market value/EPS = 5.00/.35 = 14.3

7.5

When considering the working capital ratio for a company with inventory, the acid test ratio will: b) always be worse As current assets will be reduced by the value of inventory

7.6

If ROCE declines from 12% to 10% from one year to the next and shareholders’ funds have remained constant, it is most likely because: c) PBIT is lower and/or long-term debt is higher Although b and d are also possible

7.7

Sales have increased since the previous year and the gross profit to sales ratio has increased but the operating profit to sales ratio has fallen. This is most likely because: a) expenses have increased

7.8

Risk is highest when: d) gearing ratio is higher and the interest cover ratio is lower

7.9

The asset turnover ratio represents: b) the efficiency of use of assets to generate sales

7.10

Brigand Ltd has 2 million shares issued with a market price of £2.50 each.

The company wants to pay a dividend of 60% of its after-tax profits of £1,750,000. The dividend yield would be: d) 21%

1,750,000 x 60% = dividend of £1,050,000/2,000,000 shares = 52.5 pence per share Dividend yield = .525/2.50 = 21% 7.11

Calculate the following ratios: o Return on investment (ROI) o Return on capital employed (ROCE) o Operating margin o Gross margin o Sales growth

o Working capital to sales o Gearing o Asset turnover 2008

2007

Return on (shareholders’) investment/equity (ROI/ROE) net profit after tax

13.8

shareholders’ funds

131.5

=

10.5%

16.3

=

12.9%

=

10.8%

126.6

Return on capital employed (ROCE) profit before interest & tax

27.2

=

11.9%

S’h funds + long term debt

131.5+96.7=228.2

29.5

126.6+146.1=272.7

Operating margin (profit/sales) profit before interest & tax

27.2

sales

141.1

=

19.3%

29.5

=

21.3%

=

60.3%

138.4

Gross margin Gross profit

82.2

Sales

141.1

=

58.2%

83.5 138.4

Sales growth Sales year 2 – Sales year 1

141.1-138.4=2.7

Sales year 1

138.4

=

+1.95%

Working capital/sales Working capital

-38.5 =

sales

141.1

-27.3%

7.4

=

5.3%

146.1 =

53.6%

138.4

Gearing ratio long term debt

96.7

=

42.4%

s’h funds + long term debt

131.5+96.7=228.2

126.6+146.1=272.7

sales

141.1 =

138.4 =

total assets

266.7+28.3=295

Asset turnover

7.12

47.8%

46.1%

265.3+35=300.3

Calculate the days’ sales outstanding, stock turn, days’ stock held and days’ purchases outstanding.

Average daily sales is 9,000,000/250 = £36,000 Days’ sales outstanding = 1,200,000/36,000 = 33.33 days Cost of sales is 40% of 9,000,000 = £3,600,000 Stock turn is Cost of sales/ stock = 3,600,000/450,000 = 8 Days’ stock held is 250/8 = 31.25 days Average daily purchases is 3,600,000/250 = 14,400 Days’ purchases outstanding = 1,400,000/14,400 = 97.2 days

7.13

Calculate sufficient ratios for both 2008 and 2007 to demonstrate the changes in profitability, liquidity, efficiency, gearing and shareholder return of Tamalan plc and comment on the most important changes between 2008 and 2007.

Ratios: 2008 2007

Sales growth

20.5%

Gross profit/sales Expenses growth Operating profit/sales ROCE ROI Interest cover

16.3% 64.6% 11.6% 58.5% 40.0% N/A

16.2%

Dividend per share Dividend payout ratio Dividend yield

0.0750 38.4% 5.0%

0.0660 39.5% 4.7%

12.7% 71.8% 45.3% N/A

Asset turnover

254.7%

253.6%

Stock turn DSO

6.3 N/A

6.7 N/A

Working capital Acid test Days purchases

1.09 0.24 68.2

0.96 0.26 76.9

Gearing

6.4%

7.6%

P/E Ratio

7.0

7.6

Main comments:  High sales growth with margin retained but large expense increase and reduced rate of operating profit  Significantly lower ROCE and ROI due largely to increase in shareholders’ funds (retained profits)  Virtually no borrowings so very low gearing and insignificant interest cover  Dividend ratios show slight improvement  Very high asset turnover (typical for retail)  Slightly reduced stock turn, as retail DSO not applicable  Working capital finely balanced, acid test demonstrates need to sell stock to pay creditors which are quite high, although slight improvement – pressure from creditors?  P/E over 7 years.

7.14 a. Explain how ratio analysis can be used to interpret business performance, with an emphasis on the different types of ratios that can be used The main points here are to identify ratios as requiring either trends or benchmarks for interpretation. Also, the need to use a mix of profitability, liquidity, gearing, activity/efficiency and shareholder return ratios. b. Use the above ratios to explain the strengths and weaknesses of the financial performance of Corollary plc over the last four years.

Ratio Comment Sales growth Increasing sales growth Return on shareholders' investment (ROI) Return on capital employed (ROCE) Operating profit/sales Gross profit/sales

Increasing, due to dependence on LT debt Reduced (therefore more LT debt) Increased GP but higher overheads Increasing GP (prices or CoS)

Working capital Acid test (quick ratio)

Reducing, close to 100% Reducing, reliance on stock

Gearing Interest cover

Increasing debt Lower coverage

Asset turnover Days' sales outstanding Stock turn Days' purchases outstanding

Stronger level of sales for asset base Poor credit control Higher stock turnover Taking longer to pay creditors

Dividend per share Dividend payout ratio Dividend yield Price/earnings ratio

Paying higher ppn of profit to maintain constant DPS Constant DPS so falling share price Declining operating profit; share price may be declining

Overall, sales are increasing but profits are declining, mainly due to expense increases despite increases in GP. There is more LT debt and working capital is tight with the company facing risk in paying its debts and covering its interest charges. Although stock turn has improved, there seems to be poor management of debtors contributing to this. Dividends are being maintained by paying out a higher proportion of profits but the share price may be falling in recognition of risk and declining profitability.

Question 8 8.1

Solutions

National Retail Stores has identified the following data from its accounting records for the year ended 31st December: sales £1,100,000; purchases £650,000; expenses £275,000. It had an opening stock of £150,000 and a closing stock of £200,000. Based on this information, the gross profit and operating profit/loss is: b) a gross profit of £500,000 and an operating profit of £225,000

Sales Less cost of sales Opening stock Purchases

1,100,000 150,000 650,000 800,000 200,000

- Closing stock Cost of sales Gross profit - Expenses Operating profit

8.2

600,000 500,000 275,000 225,000

Opening stock is £350,000. Closing stock is £325,000. Purchases are £650,000.

Sales are £1,000,000. The cost of sales is: d) £675,000

Sales Op stock Purchases Cl stock Cost of sales GP

1,000,000 350,000 650,000 1,000,000 325,000 675,000 325,000

8.3

In a retail organization, sales: d) decrease inventory and increase cost of sales

8.4

Using the information provided above, calculate the cost of sales and inventory value using the weighted average method.

Units

Unit price Total cost 2500 £ 12.00 1500 £ 11.50 1000 £ 11.00 5000 £

Weighted average cost 58,250/5,000 Cost of sales Inventory

8.5

Units

30000 17250 11000 58,250

£

11.65

3000 £ 2000 £

34,950 23,300

Using the information provided above, calculate the cost of sales and inventory value using the FIFO method.

Unit price Total cost 2500 £ 12.00 1500 £ 11.50 1000 £ 11.00

FIFO Cost of sales 2500 £ 500 £ 3000

12.00 11.50

Inventory (FIFO) 1000 £ 1000 £ 2000

11.50 11.00

30000 17250 11000

£

30000 5750 35,750

£

11500 11000 22,500

8.6

Calculate:  The total job cost and the cost per table  The cost of sales  The value of inventory  The gross profit for the tables that were sold Units Unit cost Total cost Plastic 100 12 1200 Timber 70 20 1400 Metal 15 35 525 3125 Labour 20 40 800 Overhead 20 30 600 Total job 4525 cost Cost per table 20 226.25 Cost of sales Inventory

5

3393.75 1131.25

Sales Cost of sales Gross profit

15

450

6750.00 3393.75 3356.25

8.7 a. Calculate the cost per equivalent unit for the month of April using the weighted average method of process costing. b. Calculate the value of work in progress and the value of completed stock transferred to finished goods during the month

Opening WIP Units commenced Closing WIP Completed

Units 25,000 35,000 60,000 15,000 33.3% complete as to conversion 45,000

Cost per unit: Openin Cost Total £ Complete WIP Total Cost per g WIP £ for d units Equivalen equivalen equivalen month t units t units t unit £ £ Material 18,500 300,00 318,500 45,000 15,000 60,000 £5.31 0 Conversio 36,750 230,00 266,750 45,000 5,000 50,000 £5.34 n 0 Total £55,250 530,00 £585,25 £10.65 0 0 Work in progress: Materials 15,000 @ £5.31 £79,650 Conversion 5,000 @ £5.34 £26,700 £106,350 Finished goods: 45,000 units @ £10.65 Total costs 8.8

£479,250 £585,600 Rounding differences ignored

The Gargantuan Company has the following transactions during December.

Prepare a combined cost of goods sold and Income Statement showing all these transactions and identify the value of inventory to be included in the Balance Sheet at the end of December.

Sales 435,000 Opening stock 120,000 Purchases 300,000 420,000 Closing stock 150,000 270,000 Gross profit 165,000 Rental 30,000 Salaries & wages 45,000 Depreciation 12,000 Marketing expenses 15,000 102,000 Net profit 63,000

Inventory in Balance Sheet = 150,000

Note: 1. Cost of sales calculated as 435,000 - 165,000 = 270,000 2. Purchases calculated as 270,000 + 150,000 - 120,000 = 300,000

Chapter 10 10.1

Solutions

Godfrey’s target selling price per hour is: c) £50.88

Direct labour costs Variable costs Fixed costs £250,000/20,000 Target return (750,000 x 25%)/20,000 Price 10.2

25.00 4.00 12.50 9.38 50.88

Assuming that both activity levels are within the relevant range, the semivariable costs for December are: c) £25,000 Variable costs are £2 per unit (£10,000/5,000) for December 10,000 @ £2 = £20,000 Fixed costs do not change with activity, for December £30,000 As total costs are £75,000 semi-variable costs for December are £25,000 (£75,000 - £20,000 - £30,000)

10.3

A business sells a single product and incurs fixed costs of £60,000. The average selling price is £45 and variable costs are £20. The total sales revenue to achieve a profit of £20,000 is closes to: b) £144,000 Using CVP analysis 60,000 + 20,000 = 80,000 = 3,200 (45-20) 25 3,200 @ £45 is £144,000 or unit contribution as a% of sales is 45-20 = 45 60,000 + 20,000 = £144,144 0.5555

10.4

0.5555

Within its relevant range, MaxiVent sells its highest volume of 150,000 units at a total cost of £85,000. Selling its lowest volume of 100,000 units incurs total costs of £75,000. Variable costs per unit are: b) £0.20 Hi Lo

150,000 100,000 50,000

£85,000 £75,000 £10,000

VC = £10,000/50,000 = £0.20 Proof: 100,000 @ .20 = £20,000 – 75,000 therefore FC = £55,000 150,000 @ .20 = £30,000 – 85,000 therefore FC = £55,000

10.5

A business has fixed costs of £100,000, an average selling price of £15 and a unit contribution of 40% of sales. The number of units that need to be sold to breakeven is: d) 16,667 Contribution = £6 (40% of £15) B/Even = 100,000/6 = 16,667 units

10.6

Budgeted sales are 100,000 units and the breakeven level of sales are 80,000. The selling price is £18 per unit. The margin of safety is: c) 20% 100,000 – 80,000 = 20,000/100,000 = 20%

10.7

The effect on Travesty’s operating profit of deleting the Porcelain product line will be to: d) make it worse by £500

Sales Variable costs Avoidable product-related fixed costs Contribution to corporate fixed overhead

Allocated corporate fixed costs Operating profit

10.8

Cutlery 30,000 15,000 5,000

Glassware 35,000 20,000 7,500

Porcelain 10,000 7,000 2,500

Total 75,000 42,000 15,000

10,000

7,500

18,000

5,000

5,833

500 if product discontinued will lose this contribution 1,667

5,000

1,667

-1,167

5,500

12,500

The level of sales (in units) that will maximise profits is: c) 30,000 Units

25,000 30,000 35,000 40,000

Price per unit £10 £9 £8 £7

Revenue 250,000 270,000 280,000 280,000

Costs 150,000 160,000 175,000 190,000

Contribution 100,000 110,000 MAX. 105,000 90,000

10.9

a. Calculate the possible price/quantity combinations within the relevant range of production and the permissible pricing range and determine the optimum level of sales that will maximise profitability. b. What will be Webster’s net profit for that optimum price/quantity combination?

c. What is the number of units that must be sold, at the optimum selling price to achieve Webster’s target profit of £3.5 million? a. & b.

Price per unit

250 300 350 400 450 500 550

600

Quantity

Revenue (£’000) Price x Qty

Variable costs (£’000)

Contribution

@ £85

33750 30500 27250 24000 20750 17500 14250

O/SIDE RELEV RANGE 9537.5 9600.0 9337.5 8750.0 7837.5

2316.25 2040.00 1763.75 1487.50 1211.25

7221.25 7560.00 7573.75 7262.50 6626.25

** MAX

O/SIDE RELEV RANGE

11000

b. As fixed costs are the same at each level of activity they can be ignored in the above Table as the maximum contribution is also the maximum profit. Optimum sales are at price of £450, selling 20,750 units for a maximum contribution of £7,573,750 less fixed costs of £4,500,000 is a profit of £3,073,750 c. The contribution per unit at the optimum sales level is £365 (£450 - £85). The breakeven sales units to generate a profit of £3.5 million is 4,500,000 + 3,500,000 = 21,918 units 365

10.10

a. By how much does the average cost change between processing 10,000 and 20,000 documents? Why? b. Does the marginal cost change in the same way?

Volume 10,000 20,000

Variable 70,000 140,000

Fixed 100,000 100,000

Total 170,000 240,000

Avg cost/unit £17 £12

a. The average cost reduces by £5 from £17 to £12. This is because the fixed costs of £100,000 are spread over 20,000 documents (£5 per document) rather than 10,000 documents (£10 per document). b. The marginal cost is £7, i.e. the variable cost. It does not change per unit irrespective of volume within the relevant range.

10.11 Terrier Financial Services has fixed costs of £12,500,000. Shareholders expect a profit return before interest and taxes of £5,000,000. Terrier achieves an average margin of 1.5% on the volume of client money handled. What is the volume of money that has to be handled to achieve the profit target?

Contribution is 1.5% (0.015) Fixed costs + Target profit = 12,500,000 + 5,000,000 Unit contribution as a % of sales .015 (i.e. £1.167 billion or £1,167 million)

= £1,166,666,667

10.12 The national Hospital Purchasing Authority is negotiating with Clinical Services to reduce its selling price by 20% although a volume of at least 1,200 kits per month has been promised. Should Clinical Services accept this offer? If so, why? If not, what would be your suggestion in order for Clinical Services to maintain its current level of profitability?

If selling price reduces by 20% to £120 Sales 1,200 @ £120 £144,000 Cost of sales 1,200 @ £85 102,000 Gross profit 42,000 Fixed costs 50,000 Net loss 8,000 Clinical Services should not accept this offer. However, if it loses the contract, the company will need to look for a replacement customer to cover its fixed costs.

To maintain the current level of profitability: The new margin is £35 per kit (£120 - £85). To cover fixed costs of £50,000 and the current profits of £25,000, Clinical Services would need to sell £75,000 = 2,143 kits £35/unit Clinical Services should therefore negotiate over the minimum number of kits to be sold to hospitals.

10.13 What is the profitability of Unfocused Books’ three departments and what recommendations would you make to the owners?

Sales Cost of sales Gross profit Departmental costs Contribution to shared fixed costs Shared fixed costs Net profit

Fiction 250,000 45% 112,500 137,500 50,000

Non-Fiction 100,000 50% 50,000 50,000 35,000

Children’s 75,000 55% 41,250 33,750 35,000

Total 425,000

87,500

15,000

-1,250

101,250

30,000

30,000

30,000

90,000

57,500

-15,000

-31,250

11,250

203,750 221,250 120,000

Unfocused Books makes substantial profits from fiction books and at least makes a positive contribution toward shared fixed costs from non-fiction sales. However it is losing money on Children’s books. Unless sales can be increased (breakeven for children’s books before contributing to shared fixed costs is £77,778 (£35,000/0.45)) the children’s department should be closed, to improve profits by £1,250. If the shared fixed costs cannot be reduced, they will need to be covered from the remaining two departments. As fiction books have the highest sales value and lowest cost of sales, it may be that sales can be increased by using the Children’s department space to sell more fiction books.

10.14

a. If the average selling price is £21, calculate the breakeven point in quantity and money terms and draw a rough sketch of a cost-volumeprofit (CVP) graph that shows the relationships between the elements of CVP.

Breakeven FC/CMpu = 150,000/(21-7) = 10,714 services 10714 @ £21 = £224,995 (£225,000)

Revenue

Total costs

VC £7pu

Breakeven £225,000

FC £150K

Breakeven 10714

b. Ignoring any market demand or capacity limitations, calculate the optimum selling price for Greentown Industries and identify which customer group is most profitable Quantity Revenue Contribution Ranking Selling Variable price costs @ £7 MNC £19 13,000 247,000 91,000 156,000 5 CORP £20 12,500 250,000 87,500 162,500 3 SM BUS 12,000 252,000 84,000 168,000 ** 1 £21 GOV £22 11,000 242,000 77,000 165,000 2 PVT £23 10,000 230,000 70,000 160,000 4

Optimum selling price is Small Business £21 c. Based on the calculation of optimum selling prices in (b) above but with the capacity and demand assumptions taken into consideration, calculate the maximum profits that Greentown can earn and the customer mix and quantity by which that profit can be achieved.

Ranking as above 1. 20,000 Small Business @ £21 = £420K - £140K = £280K 2. 20,000 Govt @ £22 = £440K - £140K = £300K 3. 20,000 Corporate @ £20 = £400K - £140K = £260K Total contribution = £840K – FC £150K = PBIT £690K max profits 10.15

a. Present the financial information in a more meaningful form, showing the contribution each division makes to total profitability (in £’000) I.T. Finance Strategy M&A Total Income 1,200 1,700 900 1,500 5,300 % of total 22.6% 32.1% 17% 28.3% 100% Variable staff costs 600 900 350 600 2,450 Contribution 600 800 550 900 2,850 margin Margin % 50% 47% 61% 60% 53.8% 200 500 600 150 1,450 Fixed staff costs identifiable with segment 400 300 (50) 750 1,400 Contribution to business-wide costs Business-wide 271 385 204 340 1,200 costs (allocated as % of income) 129 (85) (254) 410 200 Operating profit/(loss) b. Ignoring any redundancy payments, advise the senior partners as to i. which, if any, divisions should be closed, and ii. the likely profit, assuming constant sales, if those divisions were closed As the unavoidable fixed costs for Strategy division exceed the contribution, this division should be closed, increasing profits by £50K. As Finance makes a positive contribution to business-wide costs, it should be retained.

c. By re-presenting the financial information, explain the consequences to remaining divisional profitability if any division is closed (in £’000) I.T. Finance M&A Total Income 1,200 1,700 1,500 4,400 % of total 27.3% 38.6% 34.1% 100% Variable staff costs 600 900 600 2,100 600 800 900 2,300 Contribution margin Margin % 50% 47% 60% 53.8% 200 500 150 850 Fixed staff costs identifiable with segment 400 300 750 1,450 + 50 Contribution to business-wide costs Business-wide 328 463 409 1,200 costs (allocated as % of income) 72 (163) 341 250 + 50 Operating profit/(loss) Note effect on divisional profits is to reduce each, due to allocation of overhead previously charged to Strategy division.

Chapter 11 11.1

Solutions

Hilltop Solutions has a planned level of activity of 150,000 units, fixed costs are £300,000 and variable costs are £7 per unit. The actual production volume is 140,000 units.

The standard cost per unit and actual average cost per unit is: c) 9.00 & 9.14 Volume 150,000 140,000

Variable 1,050 980

Fixed Total Standard 300 1,350 9.00 300 1,280

Average 9.14

The standard cost per unit is £9.00 at the budgeted level of activity The actual average cost per unit is £9.14 at the actual production volume 11.2

Prado Products produces 20,000 units for a total cost of £250,000 but when 30,000 units are produced the total cost is £300,000. The fixed costs for Prado are: c) £150,000 Units 20,000 30,000 10,000

Total cost £ 250,000 300,000 50,000

Cost of additional 10,000 units is £50,000

Therefore variable cost is £5 per unit For 20,000 units variable costs are 20,000 @ £5 = £100,000 Fixed costs are £250,000 - £100,000 = £150,000 11.3

The preferred use of the limited labour hours is: d) prioritise selling to business because the contribution per labour hour is higher Applying contribution margin per labour hour or throughput accounting (because the ‘bottleneck’ capacity limitation is labour) achieves the same result in this case.

Business Households Price 120 200 Less materials -40 -110 Less labour -50 -70 Contribution 30 20 Labour hours 5 7 Contribution Per labour hour £6 £2.86 Ranking 1 2 or Price 120 200 Less materials -40 -110 Throughput contribution 80 90

Labour hours Throughput contribution Per labour hour Ranking

11.4

5

7

£16 1

£12.86 2

A consultancy business has budgeted for sales of 15,000 hours per year, for which its total costs are £750,000 (comprising £600,000 fixed costs and variable costs of £10 per hour. In fact, it sells only 12,500 hours in the year. The standard cost per hour is: c) £50 Fixed cost

15,000 hours 12,500

600,000 600,000

Variable cost Total cost @ £10/hr 150,000 750,000 125,000 725,000

Average cost per hour £50 - standard £58 - actual

11.5

For a particular decision, the relevant costs will include: b) material costs where material is in stock that has only a scrap value

11.6

A call centre can process 100,000 calls per month for a cost of £250,000.

During one month, the number of calls processed was 85,000. During that month, the cost of unused capacity was: b) £37,500 £250,000/100,000 = £2.50 per call 15,000 calls @ £2.50 = £37,500

11.7

A full-time student pays £10,000 for tuition, incurs £6,000 for accommodation and meals, £1,000 for text books and is forced to give up work which earned her £8,000. Calculate the cost of the student’s education and explain your answer.

The total cost of education is £25,000. The ‘cash cost’ is £17,000 comprising tuition, accommodation & meals, and text books. The income foregone is an opportunity cost of £8,000 so the true cost of education is £25,000. However, accountants would only recognise the cash cost of £17,000 in accounting records and reports. Nevertheless the full cost of £25,000 is more relevant for decision making.

11.8

The goal of the theory of constraints and throughput accounting is to maximise production capacity in bottlenecks by a ranking of products that have: d) the highest throughput contribution (of sales less cost of materials) per hour of bottleneck capacity

11.9 a.

Produce a financial justification that will support NewIdea’s proposal, assuming that NewIdea’s products will reduce the downtime and waste to the target levels.

HiTek’s capacity is 25,000 units p.a. If downtime and waste are each 5%, then production capacity is 25,000 x 90% or 22,500 units. However, HiTek is only achieving 25,000 x 85% or 21,250 units, a shortfall of 1,250 units (25,000 x 5% being 2.5% for each of downtime and waste).

The 1250 units lost to production due to excess downtime and waste can be valued at £30 each (selling price of £100 x 30% contribution), a total of £37,500.

For an additional cost of £10,000 to buy NewIdea’s product (£30,000 £20,000), HiTek will recover an additional £37,500 in contribution, improving profits by £27,500 per annum. b. If you received such a proposal from NewIdea, what would you want to be sure of before accepting their proposal.

Before accepting NewIdea’s proposals, you would need to assure yourself as to how their product would reduce downtime and waste. In doing this, you would need to determine the causes of downtime and waste to determine whether there is a connection with the consumables used.

11.10 The General Manager has asked for your advice in relation to this disagreement within the management team.

People do what they are rewarded for, hence it is not surprising that the Sales Manager prefers the Advanced service. The Accountant is also correct in preferring sales of the highest contribution per unit. However, subject to any limitations of customer demand, the Operations Manager is correct in identifying the need to use his limited production capacity to greatest effect.

The contribution per labour hour is:

Contribution per labour hour

Standard £30 (£3,000/100)

Modified £25.83 (£3100/120)

Advanced £25 (£4000/160)

This shows that the standard service makes the largest contribution per labour hour (the limited capacity). If more standard services could be sold, utilising the capacity for those services will yield the highest profit. However, to achieve this, the reward structure for sales people will need to be altered.

11.11 What are the relevant costs involved in this decision? Should Cowboy sub-contract its delivery requirements to Select? What considerations are there in making this decision?

The relevant cost of each alternative is the future incremental cash flows: Relevant cost to retain inRelevant cost to house delivery subcontract delivery Salary & oncosts of driver 16,000 3,500 Replacement casual labour for builder Road tax, insurance & 1,000 servicing (Depreciation is not a future incremental cash flow) Fuel costs 3,000 Sale proceeds of vehicle -2,000 Subcontract cost 12 @ 24,000 £2,000 Relevant costs £23,500 £22,000 As can be seen, the subcontract option is the lower cost option, however, this is only because the subcontract cost is offset by the resale value of the vehicle, which will only happen once. In future years, the in-house cost continues as £23,500 compared to a subcontract cost of £24,000. The relevant costs are therefore different in the first and second years. A further consideration is that the vehicle will need to be replaced at some time in the future and the relevant costs will then alter once again. There is little financial incentive beyond the first year and a judgement needs to be made about the likely life of the existing vehicle and the non-financial consequences of an outsourcing decision.

11.12 Chassis – sunk cost irrelevant and no future incremental cash flow Engine - future incremental cash flow to purchase Less future incremental cash flow from sale of old engine Net relevant cost Or Buy additional parts The best choice of the two options would be to buy a reconditioned engine and sell the old one, so this becomes the relevant cost (note that the cost of the old engine is a sunk cost and hence irrelevant to the decision) Purchase of tyres Paint – at replacement price Relevant cost of materials

Nil £375 £225 £150 £250

150 180 70 £400

11.13 a. If Maximus Company has excess machine capacity and can add more labour as needed (i.e. neither machine capacity nor labour is a constraint), which product is the most attractive to produce? Provide calculations and reasons to support your answer.

Plain model Regular model Super model Selling price £30.00 £32.50 £40.00 Direct material £9.00 £10.00 £9.50 Direct labour £5.00 £7.50 £10.00 Variable overhead £4.00 £6.00 £8.00 Total variable cost £18.00 £23.50 £27.50 Contribution margin £12.00 £9.00 £12.50 When there is no limit on production capacity the super model should be manufactured since it has the highest contribution margin per unit. b. If Maximus Company has excess machine capacity but a limited amount of labour time available, to which product or products should the excess production capacity be devoted? Provide calculations and reasons to support your answer Plain Regular Super model model model Contribution margin per unit £12.00 £9.00 £12.50 Direct labour hours required (=DL cost/£5 per hour) 1 1.5 2 Contribution margin per direct labour hour £12.00 £6.00 £6.25 When labour is in short supply the plain model should be manufactured, since it has the highest contribution margin per direct labour hour.

Chapter 12 12.1

Solutions

A consultant is paid a salary of £40,000 per annum and her employer pays national insurance of 12% and pension contributions of 6%.

Assuming the consultants works 230 days per year and is productive for 75% of that time, her daily cost rate is closest to: b) £154 £40,000 + 18% = £47,200 £47,200/230 days = £205 per day @ 75% productivity = £154 per day

12.2

A company has 5 employees who have a cost of £100 per day each but currently have no work to do and this situation is expected to last for the next two weeks. The company is considering accepting a special order that will take 5 employees one week each, commencing immediately. The work will require supervision, equivalent to 10% of the direct labour time, but all supervisors are very busy. Supervision costs are normally £200 per day but additional supervision will involve overtime at the rate of £300 per day. The relevant cost for the order is: a) £750 5 employees x 5 days = 25 days @ £100 per day = £2,500 - Not a relevant cost as labour is surplus and there is no future incremental cash flow Supervision is 10% of 25 days = 2.5 days @ £300 = £750 – the overtime, not the normal cost, is the future incremental cash flow.

Relevant cost is therefore £750.

12.3

A call centre department incurs costs of £100,000 per annum which provides the staff to make 25,000 sales calls each year. At the end of the year, management reports disclose that the actual number of calls made is 23,000. The cost of spare capacity can be calculated as: b) £8,000 £100,000/25,000 calls is a standard cost of £4 per call.

The unused capacity is 2,000 calls (25,000 – 23,000) The cost of spare capacity is 2,000 @ £4 = £8,000

12.4

The unavoidable cost for each “Special Delivery Service” is: d) £5 Labour can be made redundant and vehicles sold, so the only remaining unavoidable cost is for administrative support

12.5

Ace Training Company employs 10 trainers with a total salary of £300,000 and oncosts of 15%. Each trainer has six weeks per year leave and averages 3 days out of each working week delivering training courses.

The standard cost per training day is: a) £250

10 trainers x 46 weeks (52-6) x 3 days = 1,380 training days £300,000 + 15% = £345,000 345,000/1,380 = £250 12.6

a. Calculate the cost for the market research project based on absorption costing principles b. Calculate the relevant cost of the market research project c. What are the standard costs identified in this case? What are the marginal or variable costs identified in this case? Explain why there is a difference between the costs calculated in a) and b) above a&b Project cost based on Relevant cost (future incremental cash absorption costing flows only) principles 100 hours staff @ £22 2,200 Nil Temp staff 100 @ £15 1,500 1,500 Library research data 2,500 Nil Update to library research 500 500 data Printing & postage 1,000 1,000 2,000 Nil In-house computer processing Specialist software 2,250 2,250 package and training (1750 + 500) 10,500 3,500 Manager’s time (7000 + 3500) Partner’s time 1,500 Nil Total 23,950 8,750 Of the project costs, £15,200 incurs no future, incremental cash flow and so these are not relevant costs. c.

MSC’s standard costs identified in the case are: Staff costs of £22 per hour In-house computer processing of £2,000 per survey Management time at £500 per day MSC’s variable costs in this case are: Staffing (Both in-house and temporary) Update to library research data Printing and postage Specialist software package and training Manager’s time Partner’s time The library research data and computer processing time are fixed as, even though they incur charges, this contract does not influence the total cost incurred.

12.7

Provide some explanations for the profit shortfall.

The difference between budget and actual profit is £750,000.

The revenue budget was 16,000 @ £186 plus 60,000 @ £66 = £6,936,000 Actual revenue was 14,000 @ £186 plus 52,000 @ £66 = £6,036,000 The revenue shortfall is the cost of spare capacity: 2,000 partner hours (16,000 – 14,000) @ £186 = 8,000 associate hours (60,000 – 52,000) @ £66 = Lost revenue

£372,000 £528,000 £900,000

The lost revenue of £900,000 has only been offset by reduced costs of £150,000 (£100,000 on salaries and £50,000 on other fixed costs) resulting in the profit shortfall of £750,000.

The 3 vacancies would have contributed 6,000 chargeable hours (3/30ths x 60,000) @ £66 or £396,000. There are however a further 2,000 hours not charged out by partners and 2,000 not charged out by associates (8,000 – 6,000).

The charge out rate is three times the labour cost so if labour is not charged out the effect on profits is proportional to that ratio.

12.8

How does a business process and activity-based approach help to understand the difficulties facing the Recruitment department? What steps could the department take to overcome its difficulties?

The 7 recruiters have available a total of 8,330 hours (7 x 170 x 7) for recruitment. The total time required for recruitment activity is 9,720 (18 x 45 x 12). There is therefore a shortfall of 1,390 hours. If recruitment activity continues in the same pattern, the requirement for recruiters is 8.17 (9,720/7/170) compared with the current staffing of 7.

The shortfall is a little over one recruiter (1,390/7/170) and this is the likely reason why the department is exceeding its budget for overtime, and possibly making hurried decisions and taking longer than needed to recruit staff. A further likely reason for these problems is the seasonality of demand for recruitment activity which will cause additional costs in peak times but an inability to carry forward spare capacity during periods of reduced recruitment activity.

There are several steps open to the Recruitment department. First, the department should present its figures to management to demonstrate why cost, quality and time overruns are occurring and to seek either an increase in resources, changes to recruitment practices or attention to the causes of the turnover of staff.

Staff turnover may be the result, for example, of morale, lack of opportunities, poor salaries, location or poor recruitment decisions. Recruitment activity may also be the result of new positions as a result of business growth. If the drivers of recruitment are better understood, efforts can be made to reduce the causes of unnecessary recruitment activity and hence the resources allocated to Recruitment.

Second, the Recruitment department should look internally to identify what processes are undertaken by the administrators to see if any savings could be made or if multi-skilling could enable administrators to be trained as recruiters for peak times, with temporary staff being employed for the administrative support. The department should also consider what non-recruitment activities the recruiters are carrying out that reduces their recruitment activity to 170 days per year.

12.9

a. Calculate both the product cost (using standard accounting practices) and the relevant cost for this custom job Relevant cost Product cost 0 750 Direct labour 25 hours @ £30 200 200 Delivery/Installation labour bought in 4 hours @ £50 Supervision 150 20% of direct labour Timber – at replacement 1,100 1,000 price/cost 500 750 Metal frame – at opportunity cost/cost Indirect materials 100 100 Overhead 250 Quality inspection fee 175 175 Total 2,075 3,375 b. What is the lowest price at which the tender should be submitted assuming we want to make a profit of £200? What will be the impact of such a price on profits reported in the management profits report? What are the opportunity costs of not undertaking this job?

The lowest price for the tender is £2,075 plus a profit of £200, a total of £2,275.

The impact of this on reported profits will be to show a loss of £1,100 (£3,375 - £2,275), as standard accounting practices will charge costs of £3,375 to the job.

The opportunity costs of not doing the job are: 25 hours of direct labour not worked Supervision costs not recovered Overhead not recovered

c. Compare and contrast historical accounting information for the calculation of product costs with the notion of relevant costs. What are the limitations of both methods?

Historical costs are needed for stock valuation and financial reporting. They are based on direct costs (labour and materials and other outgoings) plus an allocation of overhead to cover the predominantly fixed costs of the business.

They are required under SSAP9 for financial reporting and must include both direct costs and production overhead. Kaplan & Cooper have criticised the use of costs calculated for stock valuation for management decision making purposes.

Relevant costs are the future, incremental cash flows for a particular decision at a particular time. They ignore sunk costs like overhead but consider opportunity costs. For example, relevant costs ignore the cost of surplus labour where that cost is unavoidable, but take into account the replacement cost of materials used in production. A weakness of relevant costs is that its use can lower profits by accepting lower than necessary selling prices in the short-term that can lead to losses where fixed costs are not recovered.

Chapter 13

Solutions

13.1

The business-wide overhead recovery rate and the cost-centre overhead recovery rate for Division 1 are, respectively: a) £55.55 and £62.50 1 2 3 Total Division Overheads 50% 30% 20% 250,000 150,000 100,000 500,000 Hours 4,000 2,000 3,000 9,000 Hourly rate £62.50 £75 £33.33 £55.55

13.2

The main proposal made by Cooper & Kaplan in their article “How cost accounting distorts product costs” is that: b) nearly all product costs are variable and cost systems need to reflect the variability of these costs in terms of the number of transactions.

13.3

Fixed production costs must be included in the valuation of inventory because: c) it is a requirement of SSAP9 While the other answers may be correct, only SSAP9 is a mandatory requirement.

13.4

If set-up costs are driven by the number of production runs, what is the set-up cost per unit traced to product A? a) £7.92

66,000 12 + 5 + 8

13.5

=

2640 x 12 = 31,680 4,000

= 7.92

Use the following costs per unit to identify the prime cost, total production cost and total cost for a product: c) 36, 72 & 85

Direct materials Direct labour Prime cost Indirect materials Indirect labour 8 Variable production overhead10 Fixed production overhead 12 Total production cost Variable selling & admin expense Fixed selling & admin expense Total cost

£ per unit 12 24 36 6

22 72 5 8 85

13.6

The business-wide overhead absorption rate is: c) £4.55

Labour hours Budgeted overhead Overhead per labour hour 13.7

Dept B 7,000 £45,000 £6.43

Dept C 10,000 £30,000 £3

Total 22,000 £100,000 £4.55

A customer has ordered a custom-made product that will require 5 purchase orders, 6 material issues, 2 production orders and 4 deliveries.

The overhead to be allocated to the product is: b) £760

Purchasing Material issues Scheduling Delivery

13.8

Dept A 5,000 £25,000 £5

Cost pool

Cost driver

300,000 400,000

5,000 10,000

Cost per driver £60 £40

300,000 200,000 1,200,000

10,000 5,000

£30 £40

Number for order 5 6

Cost for order £300 £240

2 4

£60 £160 £760

The method of determining overhead allocation using absorption costing and that under activity-based costing differs because: c) Activity-based costing allocates costs to cost pools and traces costs to products based on cost drivers whereas absorption costing allocates costs to cost centres and then to products based on a measure of activity such as direct labour hours.

13.9

a. Calculate the total budget b. Calculate cost driver rates c. Estimate the cost for a job requiring 15 days of design and 150 screens, records and reports a. Total budgeted costs are: No. Design 6 Programming 4 Testing 2 Direct labour cost Manager 1 Accommodation Computer lease costs Travel Total budget

£ per annum £180,000 £100,000 £ 40,000 £320,000 £ 45,000 £100,000 £ 25,000 £ 10,000 £500,000

b. As the drivers for programming and testing are the same, these can be grouped into a single cost pool. Overheads can then be allocated to each cost pool.

Design Direct costs Allocate manager’s costs equally Accommodation and computer lease costs Travel costs Total costs Cost drivers Cost per cost driver c.

Programming & Testing 140,000 30,000

180,000 15,000

125,000

10,000 205,000 1,000 days £205 per day

295,000 10,000 records £29.50 per record

Total 320,000 45,000 125,000

10,000 500,000

Job cost estimate: 15 days’ design @ £205 = £3,075 150 screens etc. @ £29.50 = £4,425 Total cost of job = £7,500

13.10

a. Calculate the amount of overhead allocated to small and large advertising campaigns under existing methods b. Apply activity-based costing to calculate the cost per cost driver for each of the cost pools c. Use the costs per cost driver to calculate the activity-based overhead applicable to small and large campaigns d. Calculate the percentage to be added to direct advertising costs to recover overhead costs under activity-based costing a. Current allocation of costs over small/large ‘won’ campaigns Campaign mix

Small Large Total

Direct advertising costs per campaign 4,000 28,000

Number of campaigns

Overhead costs allocated to each campaign

325 25

1,300,000 700,000 2,000,000

b. Overheads cost pools and drivers under ABC Cost pool Creative Production

Budget costs

Share of Total cost Cost Cost per rental etc. pool driver driver 500,000 150,000 650,000 800 £812 750,000 150,000 900,000 350 £2,571

300,000

Admin & support Total costs

150,000

450,000

400

£1,125

2,000,000

c. i. ABC allocation of creative costs over creative ‘bids’ Campaign mix

No. bids

Small Large

400 400 800

ABC costs per bid 812 812

Total costs 324,800 rounded to 325,000 324,800 rounded to 325,000 649,600 rounded to 650,000

c. ii.ABC allocation of production costs over production ‘wins’ Campaign mix

No. campaigns

Small Large

325 25 350

ABC costs per campaign 2,571 2,571

Total costs 835,575 rounded to 835,000 64,275 rounded to 65,000 899,850 rounded to 900,000

c. iii ABC allocation of admin & support costs over number of customers Campaign mix

No. customers

Small Large

300 100 400

ABC costs per customer 1,125 1,125

Total costs 337,500 112,500 450,000

c. iv ABC costing of campaign mix Campaign mix

Creative costs

Small Large

325,000 325,000 650,000

Production costs

Admin & support costs 835,000 337,500 65,000 112,500 900,000 450,000

Total costs

Cost per Number campaign of campaigns 1,497,500 325 £4,607 502,500 25 £20,100 2,000,000 350

d. Current allocation of costs over small/large ‘won’ campaigns Campaign mix

Small Large

Direct advertising costs per campaign

ABC costs per campaign

4,000 28,000

4,607 20,100

Overhead allocation as a % of direct advertising costs 115% 71.8%

13.11

a.

Calculate the overhead rate for each of departments A, B and C and calculate the product cost for HiVol and LoVol. b. Calculate the activity-based overhead rate for each cost pool and calculate the product cost for HiVol and LoVol. c. Compare the product costs using activity-based costing with the product cost that allocates overhead on the basis of direct labour hours. Why is there a difference? a. Overhead hourly rate per department: Departmental overhead costs Total Overhead Planned labour hours Overhead rate per labour hour

A

B

C

Total

150,000 50,000

250,000 40,000

200,000 20,000

£3

£6.25

£10

600,000 110,000

HiVol: A Labour hours in each department Overhead cost based on labour hours Direct materials Direct labour Total product cost

B

C

Total

8

7

3

£24

£43.75

£30

£97.75

£300.00 £180.00 £577.75

LoVol: A Labour hours in each department Overhead cost based on labour hours Direct materials Direct labour Total product cost

B

C

Total

10

5

5

£30

£31.25

£50

£111.25

£150.00 £200.00 £461.25

b. Activity-based overhead per cost driver Business Process Total costs Cost driver

Purchasing 100,000 20,000 purchase orders

Scheduling 125,000 5,000 production

Materials handling 375,000 25,000 material issues

Total 600,000

£5

orders £25

Purchasing

Scheduling

Activity-based cost per cost driver

£15

HiVol:

Number of cost drivers for each process Overhead cost based on cost drivers No. of products produced Activity-based overhead per unit of product Direct materials Direct labour Total product cost

10,000

1,500

Materials handling 18,000

£50,000

£37,500

£270,000

Total

357,500 5,000 £71.50 £300.00 £180.00 £551.50

LoVol: Purchasing Number of cost drivers for each process Overhead cost based on cost drivers No. of products produced Activity-based overhead per unit of product Direct materials Direct labour Total product cost

Scheduling

10,000

3,500

Materials handling 7,000

£50,000

£87,500

£105,000

Total

242,500 1,000 £242.50 £150.00 £200.00 £592.50

c. Comparison of two methods: Total product cost Allocating overhead against direct labour hours Allocating overhead based on activity-based costing

HiVol

LoVol £577.75

£461.25

£551.50

£592.50

HiVol and LoVol have similar labour costs per unit but because there is a higher quantity of HiVol produced, HiVol incurs a disproportionate amount of overhead when it is a result of the allocation of overheads by direct labour hours.

Under activity-based costing, LoVol incurs high overheads, evidenced by the disproportionate number of cost drivers for each business process (given the relatively small volume). This overhead is spread over the low number of units produced which increases the cost per unit.

HiVol has been subsidising the cost of LoVol under the absorption costing method.

The activity-based method more accurately traces the overhead costs incurred to the products based on the cost drivers – the causes of activity that consumes overhead.

13.12

a.

Calculate the total cost of each Product H using: i. Absorption costing using a business-wide overhead recovery rate ii. Absorption costing using departmental overhead rates iii. Activity-based costing

b. Explain the principles underlying the basis of calculation of each of the three above-mentioned methods and the most likely reasons for any similarity or difference between the results in applying the three methods in this case. c. Explain the overhead allocation problem, particularly with regard to the issues raised by Cooper and Kaplan in their article “How cost accounting distorts product costs” i. Absorption costing Production Overheads 432,000 12,000 Direct labour hours £36 Ohead cost per lab hr Product H 8 Ohead alloc £288 Total

Assembly 220,000 10,000

Despatch 140,000 7,000

Total 792,000 29,000

£22

£20

£27.31

12 £264

4 £80 £632

24 £655.44

A (i). Absorption costing based on business-wide overhead costs is £740 + £655 = £1,395 A (ii). Absorption costing plus departmental overhead rates is £740 + £632 = £1,372 iii. Activity-based costing Cost pool

Cost driver

Order processing

100,000

Purchasing

200,000

Operations

450,000

25,000 customer orders 10,000 Purchase orders 60,000 direct labour hours

Distribution

42,000

5,000 deliveries

Cost per driver £4

Cost for Product H 1,000 @ £4 £4,000

£20

700 @ £20 £14,000

£7.50

29,000 @ £7.50 £217,500 2,000 @ £8.40 £16,800

£8.40

792,000

£252,300 400 £630.75

Number of products Overhead per product H Costing based on ABC is £740 + £631 = £1,371

b. Need to differentiate departmental costs from cost pools and drivers and the difference between an arbitrary use of labour hours and a cause-effect relationship used in ABC. In this case, similarity of results may lie in direct labour being a good proxy for overheads and an even spread of use of resource usage over the three departments. c. Overhead allocation problem Given a range of product/services and/or different production processes and the increase in overhead as a component of business costs, the underlying assumptions as to how overheads are allocated over product/services and the impact on profitability of that decision, and whether this is done at all (variable costing), on the basis of hours (absorption costing) or cost drivers (ABC).

Cooper & Kaplan: labour-based method is arbitrary method, and does not reflect demands on resources, bias costs of individual products, subsidisation problem, cost of unused capacity not identified, subservient to the needs of external financial reporting, costs treated as fixed do vary with batches, number of products, etc.

13.13

a. Calculate the overhead per direct labour hour using a departmental rate. b. Calculate the total overhead cost allocated to each of the four product groups using the departmental rate c. Calculate the costs per cost driver under activity-based costing d. Calculate the total overhead cost allocated to each of the four product groups using activity-based costing e. Comment on the approaches to costing and the differences between your answer to (b) and (d) above. (a) Overhead per DLH

Overhead costs (£) Direct labour hours Overhead per DLH

Design

Machining

150,000

Total

250,000

Assembly & Distribution 200,000

600,000

10,000

12,500

20,000

42,500

£15

£20

£10

(b) Overhead allocated to product groups using departmental rate

Liggles

Widgets

Zonnets

Carusos

Total

Design

Machining

2,000 @ £15 30,000 3,000 @ £15 45,000 3,000 @ £15 45,000 2,000 @ £15 30,000 £150,000

1,500 @ £20 30,000 1,000 @ £20 20,000 7,000 @ £20 140,000 3,000 @ £20 60,000 £250,000

(c) Calculation of costs per cost driver Cost pool £ Cost driver Order entry Production Delivery Total

100,000 Customer orders 350,000 Production orders 150,000 Delivery orders £600,000

(d) Overhead allocated to products under ABC No drivers Cost per driver Liggles 1500 @ £20 500 @ £175 1000 @ £30 Widgets 500 @ £20 1000 @ £175 1000 @ £30 Zonnets 1000 @ £20 250 @ £175 1000 @ £30 Carusos 2000 @ £20 250 @ £175 2000 @ £30 Total

Assembly & Distribution 10,000 @ £10 100,000 5,000 @ £10 50,000 2,000 @ £10 20,000 3,000 @ £10 30,000 £200,000

No. of drivers 5,000 2,000 5,000

Subtotal 30,000 87,500 30,000 10,000 175,000 30,000 20,000 43,750 30,000 40,000 43,750 60,000

Total

160,000

115,000

205,000

120,000 £600,000

Cost per driver £20 £175 £30

Total cost

147,500

215,000

93,750

143,750 £600,000

(e) The limitations of applying the departmental overhead rate is that overheads are allocated to departments using often simplistic assumptions such as floor area, number of employees, etc. and the assumption is that DLH is representative of how overheads are consumed by different products, i.e. the more DLH, the more overhead is allocated. While this may be true for some overheads, it is unlikely to be true for all overheads.

The ABC method, by tracing overheads more accurately to products shows that Widgets are undercosted using the departmental DLH rate whilst Zonnets are overcosted. A similar but less significant situation is evident with Carusos and Liggles. This cross-subsidisation of products is a common feature of DLH-based overhead allocations and leads to skewed pricing and sales. This kind of problem is frequently identified by the introduction of ABC systems. However, ABC is expensive to implement due to the need for specialist accounting software and the time involved in ascertaining cost pools, cost drivers and activity volumes for each cost driver.

Liggles Widgets Zonnets Carusos Total

DLH-based overhead 160,000 115,000 205,000 120,000 £600,000

ABC-based overhead 147,500 215,000 93,750 143,750 £600,000

% difference -7.8% +87% -54.3% +19.8%

13.14 Dept A 32000 10000 7895

Dept B 16000 10000 3158

Dept C 24000 10000 3947

Depreciation

12500 62395

1250 30408

10000 47947

Alloc mtce Total overhead

10132 72526

4053 34461

5066 53013

Labour hours Overhead per DLH

5000 $14.51

2000 $17.23

2500 $21.21

9500 $16.84

Cost centre 5,500 Total 300 180 144 624 6,124

Blanket 5,500

a.

Rent Supervision Electricity

b.

Direct material Direct labour A B C Direct labour Prime cost Overhead A

Hours 12 6 8 26

Rate $25 $30 $18

12

$14.51

Mtce 8000 10000 0

Total 80,000 40000 15000

1250 19250 19250 0

25000 160000

174

Basis 100 equally 9500 % alloc

9500 160000

624 6,124

Dept A 40

Dept B 20

Dept C 30

5000

2000

2500

50%

5%

40%

5000

2000

2500

Mtce 10

5%

sqmtrs equally(/4) lab hrs % alloc

lab hrs

B C Overhead Total product cost

6 $17.23 8 $21.21 26

103 170 447 $6,571

438 $6,562

c. There is almost no difference between the product cost and overhead cost attributed under the blanket or cost centre rates. This is because there is no apparent difference between the cost structure or utilisation in each cost centre or in the extent to which the product uses the resources of different cost centres. d.

Direct material Direct labour Prime cost

Overhead Total product cost

ABC 5,500 624 6,124

735 $6,859

Cost pool Customer orders Production orders Deliver orders Materials handling

Cost per driver

Product No. drivers

ABC cost

$45

4

180

$75 $30

3 7

225 210

$60

2

120 735

e. The product causes overhead costs to be incurred over and above that which is allocated using the DLH rate. The cost drivers show the overhead consumption to produce the product.

Using DLH for overhead allocation results in under pricing of the product.

Chapter 14 14.1

Solutions

The payback period for each project is (in years): b) A = 2.5, B = 3, C = 2

End of year

1

2

3

Project A

100

300

B

40

140

400 2.5 years 350 3 years

C

200

150 2 years

14.2

4

5

Assuming the initial investment is depreciated over the life of the project, the accounting rate of return for the project is: d) 48% avg investment 350/2 = 175 Income 40 + 100 + 210 + 260 + 160 = 770 Depreciation expense = 350 avg profits 770 – 350 = 420/5 = 84 84/175 = 48%

14.3

The cash value added (or profitability index) for each project suggests that the preferred project is: a) Project A A 450/350 = 1.29 B 400/350 = 1.14 C 375/350 = 1.07

14.4

The net present value of the investment, assuming a 7% cost of capital is: d) -£49,000 130 @ .9346 200 @.8734 300 @ .8163 200 @ .7629 150 @.7130 PV of cash inflows - Initial investment NPV

121 175 245 153 107 801 850 -49

14.5

The Board of Grudgework Holdings has received a presentation supporting a £600,000 capital investment. The calculations for accounting rate of return, payback and discounted cash flows are shown below. What issues would you draw to the attention of the Board in considering these figures?

Overall, the figures appear to be healthy, however it is always a good question to ask how future cash flows, that are notoriously difficult to predict, have been estimated.

The average ROI is 16.7% but there are substantial variations from year to year. The first year shows only a 6.3% return while the last year shows an accounting loss. The second, third and fourth years show good returns. This may be an issue if different managers are accountable for performance over the five year period.

The payback is three years and the only question, as for ROI, is whether this meets any Board criteria for capital investment.

The net present value using an 8% cost of capital (it needs to be verified that this is the actual cost of capital) shows an NPV of £90,303 which can be expressed as a cash value added or profitability index of 15% (90,303/600,000). The internal rate of return can also be calculated using the spreadsheet function as 14%.

The only other issue to be considered is the riskiness of the investment in terms of market demand, competition, technological change and future cash flows that may be lower than predicted.

14.6

Which of the three investment proposals would you prefer and why

Project A Cash flows

Year 0

Cash inflows Net present value at 12% Profitability Index IRR

-150,000 39,592 26.4% 23.8%

Project B Cash flows

Year 0

Cash inflows Net present value at 12% Profitability Index IRR

-200,000 27,801 13.9% 18.5%

Project C Cash flows

Year 0

Year 1 50,000

Year 1 75,000

Year 1

Year 2 75,000

Year 2 75,000

Year 2

Year 3 75,000

Year 3 75,000

Year 3

Year 4 50,000

Year 4 75,000

Year 4

Cash inflows Net present value at 12% Profitability Index IRR

-300,000 -5,319 -1.8% 11.2%

50,000

100,000

150,000

100,000

Project A has the highest IRR at 23.8% and the highest profitability index. Project B has an acceptable IRR and profitability index but this is lower than for Project A and is based on a larger capital investment. Project C has a negative net present value as the IRR of 11.2% does not cover the cost of capital of 12%.

14.7 a. For each of the investment alternatives, calculate the i. Net present value ii. Payback iii. Accounting rate of return (on an average basis, not per year), and iv. Recommend, with reasons, which of the investment proposals should be approved. b. Compare and contrast net present value, payback and accounting rate of return as methods of capital investment appraisal. What are the strengths and limitations of each method?

Investment proposal Year 1

Year 2

Year 3

Year 4

Year 5

Inflows Outflows Net cash inflows -2,300,000 PV of cash flows (@12%) 2,356,760 NPV 56,760 IRR 13.0%

800,000 300,000 500,000

1,000,000 250,000 750,000

1,200,000 300,000 900,000

1,100,000 400,000 700,000

900,000 500,000 400,000

Cumulative cash flow Payback

500,000

1,250,000

2,150,000

Year 1

Year 2

Year 3

Year 4

Year 5

700,000

900,000

1,100,000

1,000,000

800,000

Capital investment

ARR (Average) Cash flows Depreciation Profit Average profit Average investment Average ROI

Year 0 -2,300,000

2,850,000 3,250,000 3yrs 2.5 mths

3,250,000 -2,300,000 950,000 190,000 1,150,000 16.5%

Alternative investment Capital investment Inflows

Year 0 -2,000,000

Outflows Net cash inflows -2,000,000 PV of cash flows (@12%) 1,996,282 NPV -3,718 IRR 11.9%

300,000 400,000

250,000 650,000

Cumulative cash flow Payback

400,000

1,050,000

ARR (Average) Cash flows Depreciation Profit Average profit Average investment Average ROI Comparison Initial Alternative

300,000 800,000

400,000 600,000

500,000 300,000

1,850,000 2,450,000 3 yrs 3 mths

2,750,000

2,750,000 -2,000,000 750,000 150,000 1,000,000 15.0% NPV Payback 56,760 3yrs 2.5 mths -3,718 3 yrs 3 mths

ARR 16.5% 15.0%

b. For example: Difference between accounting profit and cash flow. Taking account of time value of money and cost of capital. Ignoring cash flows after payback period. Ignoring timing of profits under ARR. All methods: difficulty of predicting cash flows accurately.

Chapter 15

Solutions

15.1

A responsibility centre for which a manager is held accountable for the return on investment is usually regarded as a: c) investment centre

15.2

The investment in a division of £400,000 returns a profit before interest of £25,000. However, Head Office charges a notional 5% cost of capital. The Return on Investment (%) and Residual income (£) are: b) 6.25% and £5,000 ROI 25,000/400,000 = 6.25% £400,000 @ 5% = 20,000 RI = 25,000 – 20,000 = 5,000

15.3

The division of a multinational corporation shows sales of £2.1 million, variable cost of sales of £1.3 million and divisional overheads of £600,000 – 60% of which is deemed controllable by the division and the other 40% is a head office allocation. The profit on which the divisional manager should be evaluated is: b) £440,000 Sales Cost of sales Contribution margin Controllable overhead 60% of £600K Controllable profit Non controllable overhead 40% of £600K Operating profit

15.4

2,100 1,300 800 360 440 240 200

Golf Holdings has two divisions: Alpha and Bravo. Alpha has a variable cost of sales of £11 per unit which is its transfer price to Bravo. However, Alpha can sell its product on the open market for a variable selling cost of £7 per unit. It is unable to do so however, as Bravo takes the entire product that Alpha can produce. Bravo uses the product it buys from Alpha as a raw material and adds its own cost of sales of £12. Bravo’s market selling price is £45 although it incurs variable selling expenses of £10 per unit. How does the transfer price influence the performance evaluation of Alpha and Bravo? What changes would you suggest?

Alpha can generate a contribution of £7 per unit on the open market (£25 - £11 - £7) however when it transfers its product to Bravo it breaks even (the transfer price of £11 is equal to the cost of sales). There is no incentive for Alpha, as the profit contribution is passed over to Bravo.

Bravo sells its product for £45 and has cost of sales of £23 (£11 + £12) and selling expenses of £10, thereby making a contribution of £12 per unit. All of

Golf’s profit is shown as being earned by Bravo, as the following summary shows: Alpha Selling price Transfer price Variable cost of sales Contribution margin Variable selling expense Contribution per unit sold

11 11 0

Bravo 45 11 12 22 10 12

Golf Total 45 23 22 10 12

For Golf Holdings, Bravo’s contribution of £12 is higher than Alpha’s open market contribution of £7 per unit, so there is a corporate benefit in continuing with the transfer of Alpha’s product.

However, to avoid the detriment to Alpha, a transfer price of £18 would be more appropriate, equal to Alpha’s cost of sales plus its lost contribution of £7 per unit. This would be more equitable to both divisions, as the following summary shows: Alpha Selling price Transfer price Variable cost of sales Contribution margin Variable selling expense Contribution per unit sold

15.5

18 11 7 7

Bravo 45 18 12 15 10 5

Golf Total 45 23 22 10 12

Enrod’s cost of capital is 16%. Compare the performance of the two divisions under both ROI and Residual income measures. In which division should Enrod invest more capital?

Enrod PLC has two divisions: Old and New. Its summary results are: Old New Total Investment 2,000,000 5,000,000 7,000,000 Net profit 400,000 900,000 1,300,000 ROI 20% 18% 18.6% Cost of capital @ 16% 320,000 800,000 1,120,000 Residual income 80,000 100,000 180,000 The ROI of Old division is higher than New. However, the RI of New is higher than that of Old, although this is only because it has a larger capital investment, and not because it is more profitable (in ROI terms). Enrod should invest more in Old division because the difference between the ROI (20%) and the cost of capital (16%) is greater. This of course assumes that additional investment will generate the same rate of return as the existing investment.

15.6

The Clarity Division of Mega Glass PLC has an investment of £1,500,000 and currently generates a net profit of £112,500 per year. Clarity has proposed an additional investment of £1,000,000 which is expected to return an annual profit of £90,000. Mega Glass is concerned that Clarity is not recovering the group’s cost of capital of 8%. Use ROI and RI techniques to advise Mega Glass.

Current investment Current net profit ROI

1,500,000 112,500 7.5%

Cost of capital (%) Cost of capital (£) Residual income

8% 120,000 -7,500

Additional investment Additional net profit ROI Cost of capital Residual income New total investment New profit New ROI Cost of capital Residual income

1,000,000 90,000 9.0% 80,000 10,000 2,500,000 202,500 8.1% 200,000 2,500

Clarity’s ROI is 7.5%, less than the cost of capital, hence the residual income is negative. The division’s proposal however is for an investment that returns 9%, in excess of the cost of capital which will lead to a higher average ROI (8.1%) and a positive residual income. Clarity is currently eroding shareholder value. If the division is to be retained, the additional investment will be motivational to management. However, Mega Glass needs to consider if it can make an alternative investment that will generate a greater return than that in Clarity.

15.7

What would be the effect of these two alternatives on Quicker’s reported profits and what might be the likely motivational effects? What suggestions would you make?

Alternative 1: If prices were increased by 20%: Sales 1,200,000 Cost of sales 850,000 Gross profit (29.2%) 350,000 (mark-up of 41.1%) Overhead costs 120,000 Corporate costs recharged from parent 80,000 Net profit 150,000

This would change the mark-up on cost of sales from the current 17.6% to a more realistic (from Quicker’s point of view) 41.1%. This would provide an incentive for Quicker but would provide little advantage to Paramount, who may wish to work more on the open market.

Alternative 2: If prices reflected direct costs of £850,000 and total overheads of £200,000: Sales 1,050,000 Cost of sales 850,000 Gross profit (29.2%) 200,000 (mark-up of 23.5%) Overhead costs 120,000 Corporate costs recharged from parent 80,000 Net profit 0 Paramount’s suggestion would lead to a break-even position for Quicker. This would result in a mark-up on direct costs of 23.5% and would motivate Quicker towards efficiency and cost control in order to generate a profit.

However, it may be that a negotiated transfer price to provide a small profit to Quicker would be a better incentive. As this would be lower than the competitive market price, this would also be an incentive to Paramount.

15.8

Compare the functional and divisional structure for business organizations and how the accounting function is located within each type of structure.

The functional business structure assigns functional responsibilities (e.g. sales, operations, accounting) to departments. Accounting is centralised and provides a staff function to line managers. This structure is suitable for smaller organizations, with a narrow geographic spread and/or a limited product range.

Larger and more diversified organizations will typically adopt a divisionalized structure based on geography or products, with each division having responsibility for all activities, including many of the staff functions such as accounting. The divisions will be supported by a head office or corporate centre with specialists (including for example, a Director of Finance). Whilst planning is centralized, implementation is decentralized to those who have a better understanding of how to satisfy their product markets.

Chapter 16

Solutions

16.1

Zero based budgeting is a technique where a department: a) is required to make a case for its budget as if its activities were new

16.2

The process whereby annual budgets are spread over a number of accounting periods is called: c) phasing or profiling

16.3

A company’s annual sales budget is for 120,000 units, spread equally through the year. It needs to have one and a half months stock at the end of each month. If opening stock is 12,000 units, the number of units to be produced in the first month of the budget year is: c) 13,000 Sales + Closing stock - Opening stock Production

16.4

10,000 (120,000/12) 15,000 (10,000 + 5,000) 25,000 12,000 13,000

The standard costs for a manufacturing business are £12 per unit for direct materials, £8 per unit for direct labour and £5 per unit for manufacturing overhead. The sales projection is for 5,000 units, 3,500 units need to be in stock at the end of the period and 1,500 units are in stock at the beginning of the period. The production budget will show costs for that period of: a) £175,000 Standard production costs £25 per unit (£12 + £8 + £5) Production is for 7,000 units (5,000 + 3,500 – 1,500) 7,000 @ £25 = £175,000

16.5

Debtors increase by £15,000 and creditors increase by £11,000. The effect on cash flow of the change in working capital is an: c) decrease of £4,000 Increase in debtors increases working capital and consumes cash Increase in creditors reduces working capital and improves cash flow Therefore a net decrease in cash of £4000 (£15,000 - £11,000)

16.6 a. Produce a budget that shows the contribution for each of the three services. Rank the three services as to the greatest contributions to profitability. What are the constraints? b. The marketing manager has asked your advice as to whether to accept EITHER 200 people attending a conference and staying for dinner in two sittings but with no hotel accommodation (which will make it very difficult to sell hotel rooms) OR to refuse the conference booking but to

maintain the average 60% hotel occupancy, of which half use the dining room. a. Jaguar Hotel’s budget: Hotel Capacity Selling price/unit Revenue Material costs/unit Material costs Throughput contribution Throughput contribution per unit of limited capacity Other variable costs/unit Variable costs Maximum contribution Contribution per unit Ranking

100 rooms £75

Dining Room 100 seats £35

Conference Centre 200 seats £40

Total

7,500 3,500 8,000 £5 laundry £15 food £5 refreshments 500 1,500 1,000 7,000 2,000 7,000 £70

£20

£35

£5 cleaning

£10 labour

£1 light & heat

500 6,500

1,000 1,000

200 6,800

£65

£10

£34

1

3

2

19,000

3,000 16,000

1,700 14,300

Both the contribution per unit and the throughput contribution identify the appropriate ranking as hotel rooms, conference centre and dining. The optimum product mix is to sell the conference facility with as many attendees staying overnight and using the dining facility. However, the dining facility and hotel capacity (100) may be a limiting factor if all (200) conference attendees want to use those facilities. b. If 200 people attend a conference and stay for dinner in 2 sittings, the maximum contribution is: Conference £6,800 Dining 2 @ £1,000 £2,000 Total £8,800 If there is no conference but 60% occupancy is achieved on hotel rooms, half of whom have dinner in dining room, the maximum contribution is: Hotel 60 @ £65 £3,900 Dining 30 @ £10 £3,000 Total £6,900 The best option is the conference, by a large margin.

16.7

Jethro Turnbull Ltd is a privately owned business. It has budgeted for profits (after deducting depreciation of £35,000) of £125,000. Debtors are expected to increase by £20,000, inventory is planned to increase by £5,000 and creditors should increase by £8,000. Capital expenditure is planned of £50,000, income tax of £35,000 has to be paid and loan repayments are due totalling £25,000. What is the forecast cash position of Jethro Turnbull at the end of the budget year, assuming a current bank overdraft of £15,000?

Operating profit + Depreciation

16.8

125,000 35,000 160,000

- Working capital increase: Debtors increase 20,000 Inventory increase 5,000 Creditors increase (8,000)

-17,000

- Capital expenditure - Income tax - Loan repayments Net increase in cash Opening bank overdraft Forecast cash at end of year

-50,000 -35,000 -25,000 33,000 -15,000 18,000

Bridgeport PLC has produced the following summary profit budget and cash forecast for the next six months. What assumptions can you make about the business based on these figures? What questions would you want to ask in relation to the figures?

Bridgeport has produced a very simple set of figures. Certain assumptions are implied by these figures: 1. That sales are seasonal as they double in the second quarter.

2. That cost of sales is a constant 40% throughout the period, i.e. that there is no change in the relationship between costs and prices during the period.

3. That overheads are constant throughout the period.

It is unusual that all costs remain constant, especially when volume doubles, especially so suddenly. It is not apparent whether the business sells goods or services. If goods, we would expect a build up in stock to be reflected in the cash forecast. If services, we would expect the cost of sales or overheads to change in the second quarter to reflect additional overhead costs.

The business is presumably a cash business as the cash flow shows no change in debtors, as would be expected when sales suddenly increase. Similarly, all costs appear to be on a cash basis as no change in creditors is shown.

Although there is capital expenditure planned in the cash forecast, there is no depreciation adjustment to the profit in the cash forecast. This may be an error or the business may not previously have had any depreciable assets. As the cash forecast shows a loan repayment it would be interesting to know what the loan was used for as there seems to be no fixed or current assets at all.

16.9 a. Produce a i.

Profit budget for each of the five years, showing both gross profit and operating profit; ii.

Cash flow for each of the five years, and iii. Apply a discounted cash flow technique and use this to recommend whether the new division and capital investment should proceed. b. What does theory tell us about the strengths and limitations of budgeting and the discounted cash flow technique? a.

Investment 10,000,000 Year 1 2 3 4 Sales revenue 4,000,000 6,000,000 8,000,000 6,000,000 Cost of sales 30% 1,200,000 1,800,000 2,400,000 1,800,000 Gross profit 2,800,000 4,200,000 5,600,000 4,200,000 Rent & office expenses 300,000 300,000 300,000 300,000 Selling & admin salaries 400,000 420,000 441,000 463,050 (+5%) 100,000 100,000 200,000 200,000 Repairs & maintenance Depreciation 25% 2,500,000 2,500,000 2,500,000 2,500,000 Operating profit (a) -500,000 880,000 2,159,000 736,950 Add back depreciation 2,500,000 2,500,000 2,500,000 2,500,000 Cash flow(b) 2,000,000 3,380,000 4,659,000 3,236,950 .8929 .7972 .7118 .6355 1,785,800 2,694,536 3,316,276 2,057,081 PV 10,826,010 Less initial investment 10,000,000 NPV at 12% © 826,010 Proceed as NPV is positive. b. Strengths and limitations of budgeting and the discounted cash flow: Strengths: Link to strategy. Method of resource allocation decisions. Co-ordination/ communication. Motivation (with incentives). Control mechanism. Evaluate performance (SBU & manager). Time value of money (in capital expenditure). Link to shareholder value.

Limitations: Difficulty of predicting (esp. for capital expenditure). Change in competition, new technologies, demand etc. Bias. Aggregation. Risk (content v. process). Beyond Budgeting movement. High hurdle rates for capital expenditure, and. Shank’s broader strategic cost management approach.

5 4,000,000 1,200,000 2,800,000 300,000 486,203 300,000 0 1,713,798 0 1,713,798 .5674 972,409

Chapter 17 17.1

Solutions

Given an original budget of 2,000 units at a variable cost of £3 per unit and actual performance of 1,800 units at an actual cost of £3.20 per unit, the variance based on a flexible budget will be: a) £360 unfavourable Budget

Flex

Actual

Units At

2000 £3

1800 £3

1800 £3.20

Cost Variance

£6000

£5400

£5760 £360 - unfav (i.e 1800 @ 0.20)

17.2

The method of adjusting the budget to reflect the actual volume of sales is called: b) flexible budgeting

17.3

A company has budgeted for materials of £170,000 but the actual costs are £164,000. The company has also budgeted for labour of £130,000 with actual costs being £133,000. The expense variance is: b) £3,000 favourable

Materials Labour Total

Budget for Actual for Variance the year to the year to date date 170,000 164,000 6,000 Fav 130,000 133,000 3,000 Adv 300,000 297,000 3,000 Fav

17.4

Higher prices from material suppliers will be reflected in the: a) material price variance

17.5

Poor quality materials that require greater skill to work will be reflected in the: d) labour efficiency variance

17.6

Management has asked you to prepare a variance report and reconcile the budget and actual result. Management believes that a flexible budget may be helpful in understanding the variances.

The first step in constructing a meaningful variance analysis is to prepare a flexed budget:

Units Selling price per unit Revenue Variable costs Contribution margin Fixed expenses Operating profit

Budget 25,000 £4

Flexed Budget 23,000 £4

Actual

100,000 @ £2.50/unit 62,500 37,500

92,000 @ £2.50/unit 57,500 34,500

94,300 @ £2.35/unit 54,050 40,250

30,000 7,500

30,000 4,500

31,500 8,750

23,000 £4.10

The variances between the flexed budget and actual results are: Sales price variance 23,000 units @ (£4.10 - £4.00) 2,300 Fav Variable cost price variance 23,000 units @ (£2.50 - £2.35) 3,450 Fav (NB There is no information to calculate a variable cost efficiency variance) Fixed cost variance (£30,000 - £31,500) 1,500 Adv Net 4,250 Fav This is equal to the difference between the profit in the flexed budget (£4,500) and the actual result (£8,750) The variance between the original budget (£7,500) and the flexed budget (£4,500 is the sales quantity variance at the standard margin per unit 25,000 – 23,000 = shortfall of 2,000 units standard margin is £4 - £2.50 = £1.50 2,000 @ £1.50 = Total variance This is equal to the difference between the profit in the Original budget (£7,500) and the actual result (£8,750) 17.7

 

3,000 Adv 1,250 Fav

What does the report tell the reader? What is its limitation?

Construct a flexible budget and determine the variances. How does that provide more information to users?

This report shows that revenue was behind budget by £21,000 which was offset by some costs being contained below budget. The biggest problem with this report is that it compares the budget revenue, costs and profit of selling 1200 hours with the actual revenue, costs and profit of selling 1100 hours.

Producing a flexed budget reveals more information as follows: Flex Budget Variance report

Budget

Flexed

Actual

Hours sold @ average price/hour Revenue

Budget 1200 1100 £100 £100 120,000 110,000

1100 £90 99,000

-11,000

Direct labour hours @ average salary cost Direct labour cost

1200 £40 48,000

1100 £40 44,000

1150 £38.50 44,275

-275

Variable overheads Travel @ 5% of revenue

6,000

5,500

5,200

300

Fixed overheads

35,000

35,000

36,500

-1,500

Total costs

89,000

84,500

85,975

-1,475

Operating profit

31,000

25,500

13,025

12,475

Variance Flex Actual

Plus loss of margin on 100 hours not sold @ £100/hour Less direct labour 100 @ £40 less variable overheads 100 @ £100 @ 5% Lost margin

10,000

Total variance

17,975

-4,000 -500 5,500

By comparing budget and actual revenue, costs and profits for the actual volume of sales (1100 hours) we see that the revenue variance was £11,000 (£110,000 - £99,000 or 1100 hours at a price reduction of £10 per hour, i.e. £100 - £90).

Rather than direct labour costs being £3,725 below budget as the first report showed, the flexed budget reveals that spending was £275 over budget. This is a combination of: 50 hours extra being worked @ £40 £2,000 adverse - efficiency less saving of 1150 hours at £1.50 per hour £1,725 favourable – price Net adverse variance £ 325 Similarly, variable overheads are only £300 below budget (compared with £800 in the first report) as less revenue was earned.

There is no difference in reported fixed overhead overspend as this is independent of volume.

The flexible budget report shows that in like-for-like terms, the profit was £12,475 below budget expectation, due to the sales price variation of £11,000 and the net

additional costs of £1,475. Although the most significant element is the fixed costs, the direct labour variance should not be ignored as a future increase in the labour rate may no longer offset the inefficiency of the direct labour (4.5% additional hours worked over those sold, i.e. 50/1100).

The flexed budget report also shows the effect of the 100 hours not sold, i.e. the lost margin of £5,500 which brings the total variance back to the originally reported figure of £17,975.

17.8 a. Produce a report that compares the original budget with actual costs for materials and labour in July. b. Produce a budget versus actual variance report using a flexible budget and calculate the variances on that basis. c. Calculate both usage and price variances for each of materials and labour. d. Explain why variance analysis using a flexible budget may be helpful for management control. a. Budget v Actual Materials Labour Total costs

Budget 93,750 84,000 177,750

Actual Variance 99,450 -5,700 81,315 2,685 180,765 -3,015

b. Flexible budget

Materials Labour Total costs

Flex budget Actual Variance 84,375 99,450 -15,075 75,600 81,315 -5,715 159,975 180,765 -20,790

c. Variance analysis SQ x SP

AQ x SP Usage

Materials

£84,375

£95,625 -£11,250

Material variance Labour

£99,450 -£3,825

-£15,075 £75,600

£81,900 Usage -£6,300

Labour variance

AQ x AP Price

£81,315 Price £585

-£5,715

d. Variance analysis based on a flexed budget is helpful because it provides feedback to managers to investigate the causes. Separating usage and price variances is important because the causes may be quite different and different managers may be responsible e.g. purchasing for material prices; human resources for labour rates; and production for usage variances. Variances may be a result of factors such as stockouts causing higher cost purchases, quality problems with materials, overtime or

inexperienced labour, etc. These causes need to be identified to prevent recurrence and standard costs may need to be updated if they are no longer relevant.

Chapter 18

Solutions

18.1

A concern with recognising all the costs of a product or service from the design stage through to its abandonment can be described as a process of: d) life cycle costing

18.2

Tranmere PLC estimates that a new product will sell in sufficient quantities to justify its manufacture at a selling price of £175. The company needs to invest £5 million to produce a quantity of 10,000 of these new products per year and requires a return on that investment of 12% per annum. The current prediction is that the product will cost £140 to manufacture. To achieve the target selling price and target rate of return, the product needs to be re-engineered to reduce its cost of manufacture by: b) £25 Target return £5M @ 12% = £600,000/10,000 = £60 per unit Target cost = selling price £175 – target profit £60 = target cost £115 Need to re-engineer product cost reduction of £25 (£140-£115)

18.3

Carry out a customer profitability analysis and make recommendations in relation to any future strategies DeepNDark should take in relation to its Top 5 customers.

Sales Gross margin % Gross profit Selling expenses 5% Distribution expenses Contribution Fixed costs Customer proftability

A 250,000 30% 75,000 12,500 30,000 32,500 30,000 2,500

B 250,000 25% 62,500 12,500 14,000 36,000 25,000 11,000 -

C 200,000 15% 30,000 10,000 25,000 5,000 15,000 20,000

D 150,000 35% 52,500 7,500 12,000 33,000 15,000 18,000

E 100,000 40% 40,000 5,000 5,000 30,000 10,000 20,000

Customers D & E are the most profitable, even though sales are lower than Customers A & B. Customer B is profitable but Customer A is making a very small profit. All customers except Customer C are making a contribution towards fixed costs but Customer C is making a negative contribution. Unless Customer C’s prices can be increased or costs reduced, it should be abandoned. Pricing or cost control also needs to be addressed for Customer A. The company should also consider increasing sales to Customers D & E in particular.

Total 950,000 260,000 47,500 86,000 126,500 95,000 31,500

18.4

Calculate the product’s profitability each year and over the lifecycle and draw appropriate conclusions.

Sales Gross margin Gross profit Expenses Net profit Cumulative

-

2003 100,000 25% 25,000 45,000 20,000 20,000 -

2004 120,000 30% 36,000 65,000 29,000 49,000 -

2005 175,000 35% 61,250 30,000 31,250 17,750

2006 325,000 25% 81,250 25,000 56,250 38,500

2007 300,000 20% 60,000 30,000 30,000 68,500

2008 Total 150,000 1,170,000 15% 22,500 286,000 30,000 225,000 7,500 61,000 61,000

The annual profits show that in the first two years the product made a loss and only returned a profit (after deducting past losses) in 2006, the product’s best year.

Performance deteriorated in 2007 and a loss was made before the product was abandoned in 2008. Sales grew slowly before they peaked in 2006 & 2007 and margins increased but then fell substantially in 2006, presumably as the company tried to build sales by reducing prices, a feature that continued over the next two years. Whilst the product was profitable over its lifecycle this was only a result of higher sales in 2006 and 2007 achieved at the expense of lower margins.