Instructor Solution Manual For Management Accounting for Decision Makers 10e Atrill Chapter (1-12)

Instructor’s Manual Management Accounting for Decision Makers Tenth edition

Peter Atrill Eddie McLaney For further instructor material please visit:

go.pearson.com/uk/he/resources ISBN: 978-1-292-34949-7

© Pearson Education Limited 2021

Lecturers adopting the main text are permitted to download and photocopy the manual as required.

PEARSON EDUCATION LIMITED KAO Two KAO Park Harlow CM17 9SR United Kingdom Tel: +44 (0)1279 623623 Web: www.pearson.com/uk

-----------------------------------------Eighth edition published 2015 Ninth edition published 2019 This edition published 2021 © Pearson Education Limited 2021 The rights of Peter Atrill and Eddie McLaney to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.

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Contents Chapters

Pages

Section A: Authors’ note to tutors

4

Section B: Solutions to exercises

6

Supplementary questions

58

Progress Test 1

81

Progress Test 2

93

Tutorial/seminar questions

108

Revision questions

127

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SECTION A

Authors’ note to tutors Using the book The book is designed to provide readers with a sound introduction to management accounting. It assumes no previous knowledge of the subject and recognises that students using it may come from a wide variety of backgrounds. The book, therefore, tries to avoid technical jargon and does not assume a high level of numerical ability from students. It has been class tested by students on various courses and we have modified and refined the material to take account of their comments.

We have also taken account of the comments made by lecturers who used the first nine editions of the book and of specially commissioned reviews.

The book aims to encourage an active approach to learning by providing activities and self-assessment questions at appropriate points. This approach is designed to stimulate thought concerning particular issues and to give the readers the opportunity to test their understanding of the principles covered.

The book is supplemented by a password-controlled lecturers’ website and a student website available to all readers.

The structure of the book allows the tutor to deliver the subject in a number of ways. It can be used as recommended reading for a traditional course based on lectures and tutorials. There are critical review questions and exercises at the end of each chapter that can be used as the basis for tutorials.

It could also provide the basis for a distance learning approach for part-time or off-campus students.

For these students, the interactive nature of the book may be extremely useful where access to a tutor is restricted. The book can also be used as the basis for an open learning approach for full-time campus-based students. We have successfully used it in this way at the University of Plymouth Business School. Accounting ‘surgeries’ have also been provided to give students the opportunity for one-to-one help with any problems they face.

The book is appropriate for modules that are designed to be covered in 100 to 150 hours of study.

For full-time students, this will often be covered in one academic year.

PowerPoint slides The diagrams in the book, along with other diagrams and materials, are available as PowerPoint slides to help in delivering lectures and tutorials and these can be downloaded from the lecturers’ website.

Practice/assessment material The activities, whose solutions immediately follow them, and self-assessment questions, whose solutions are at the end of the book, form an integral part of it. In addition, there are various other

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practice/assessment materials. At the end of each chapter there are four critical review questions.

These are short, narrative questions involving recall, explanation and brief discussion. The solutions to these are given at the end of the book. At the end of all chapters, except Chapter 1 (where there are two), there are eight exercises. These are questions, many involving calculations, which are similar in nature to examination-style questions. The solutions to five of these are given at the end of the book and are, therefore, accessible to students. Solutions to the other three are in the following pages of this manual and are not accessible to students.

On the lecturers’ website, in addition to this Instructor’s Manual with solutions to selected end-ofchapter exercises there are: •

Two progress tests with solutions. These tests comprise multiple-choice questions, missingword questions and questions that are similar to the end-of-chapter exercises. One test corresponds to Chapters 1 to 5, and the other to Chapters 6 to 12.

•

Supplementary questions (10 of them) with solutions.

•

Tutorial/seminar questions with solutions.

None of this material, except the case study comments, is accessible to students.

On the student website, there are five types of material: •

Revision exercises, similar in style to the end-of-chapter exercises, with solutions.

•

Multiple-choice questions, typically 10 for each chapter. These are intended to be tackled online, where they will be automatically graded.

•

Missing-word questions, typically 10 for each chapter. These too can be attempted and graded online.

The multiple-choice questions and missing-word questions are intended to provide students with a quick assessment of their mastery of the material of each chapter.

The solutions to all of this material, except to the multiple-choice and missing-word questions, are fully annotated in order to give the necessary feedback to students.

We intend to expand the number and scope of the practice/assessment materials on a continuing basis.

We hope that you and your students will find the book both accessible and interesting. We should much appreciate any suggestions you may have on how the book and supplementary material may be improved.

Peter Atrill Eddie McLaney

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SECTION B

Solutions to exercises Exercise 2.4 Exercise 2.5 Exercise 2.8 Exercise 3.2 Exercise 3.4 Exercise 3.5 Exercise 4.2 Exercise 4.3 Exercise 4.7 Exercise 5.5 Exercise 5.6 Exercise 5.8 Exercise 6.2 Exercise 6.6 Exercise 6.8 Exercise 7.4 Exercise 7.6 Exercise 7.7 Exercise 8.2 Exercise 8.5 Exercise 8.6 Exercise 9.4 Exercise 9.6 Exercise 9.8 Exercise 10.5 Exercise 10.7 Exercise 10.8 Exercise 11.3 Exercise 11.7 Exercise 11.8 Exercise 12.1 Exercise 12.3 Exercise 12.5

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CHAPTER 2

Relevant costs and benefits for decision making Solution to Exercise 2.4 SJ Services Ltd £ The relevant cost of skilled labour as such is zero because the staff will be employed and paid irrespective of the contract. However, if the contract is undertaken, the business will lose sales in the alternative activity. The effective cost of this will be the lost sales revenue net of the ‘other costs’ that will be saved, which amounts to £32 an hour (that is, £24 + £8). So cost is 27 hours × £32 =

864

Semi-skilled staff are being paid anyway, so their wages are not relevant. The additional cost to be incurred will be the wages paid to the unskilled labour taken on to replace them. Thus: 14 hours × £14 =

196

As unskilled labour will be specifically employed for the contract, the relevant hourly wage rate is £14. Thus: 20 hours × £14 =

280

General costs

250

The rental income forgone is a relevant opportunity cost.

175

The £300 already spent on the specialised study is a sunk cost and is not relevant.

The relevant cost is the forgone opportunity to sell the results:

250

Rent would have to be paid anyway and are therefore not relevant

£2,015

Minimum price

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Solution to Exercise 2.5 Relevant cost of Product X (a) For sales of up to 1,500 tonnes Since Product A’s market seems to be limited to 500 tonnes, there can be no opportunity cost relating to Product A of producing up to 1,500 tonnes of Product X. (The business currently holds 2,000 tonnes of the raw material.) This means that the relevant cost per tonne of Product X will be: Opportunity cost of disposing of the material (£36), plus the relevant outlay cost (£80) = £116 a tonne. (b) For sales between 1,500 and 2,000 tonnes Clearly, the business would choose to produce Product A were Product X sales to be 1,500 or less, rather than sell the material for £36 a tonne. This is because, by spending £60 more (£96 in total), it can be sold as Product A for £105 a tonne. Any sales of Product X above 1,500 tonnes would be at the expense of Product A. The opportunity cost of not making Product A is £105 less £60 = £45.

Thus, the relevant cost of Product X will be: Opportunity cost of using the material (£45), plus the relevant outlay cost (£80) = £125 a tonne. (c) For sales above 2,000 tonnes To make more than 2,000 tonnes of Product X, the company will have to buy in additional inventories of the raw material at £48 a tonne.

Thus, the relevant cost of Product X will be: Outlay cost of buying the inventories (£48), plus the relevant outlay cost (£80) = £128 a tonne.

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Solution to Exercise 2.8 Internal relevant cost Material

£

‘Regular’ material

(75% × £120,000)

90,000

Special foaming chemical

(see Note 1 below)

24,000

(£80,000 − (2 × £15,000); see Note 2 below)

50,000

Labour General Managerial

30,000

Rent saving

(see Note 3 below)

15,750

Plant

(£28,000/2, see Note 4 below)

14,000

Maintenance

(see Note 5 below)

9,900 233,650

250,000

The quotation is

On the basis of this analysis, the tender from the outside supplier should be accepted in respect of the first year. This is not the case for the second year, however (see Note 1 below).

This is a difficult decision to make because it has longer-term implications that are not really capable of being assessed on the basis of the information provided. For example: •

If the container work is continued, how much will it cost to replace the plant in two years’ time?

•

If the container work ceases and the staff are transferred or declared redundant, how easily could this decision be reversed if, say, the outside supplier raised its prices for subsequent years?

Strictly, the analysis should take account of the fact that the various cash flows in the above analysis occur at different times. It is not, therefore, fair to compare them directly. How comparison should be made, where there are timing differences, is the subject of much of the discussion in Chapter 8.

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Notes: 1. As the chemical is valued at £30,000 (that is, 25% × £120,000) at cost, we can conclude that there are 40 tonnes in inventories (that is, £30,000/£750). This, according to the question, is sufficient for one year’s production of the containers. Since the alternative to using the chemical on the containers appears to be selling it at £600 a tonne, the relevant cost for the first year is £24,000 (that is, 40 tonnes @ £600 a tonne).

By the end of the first year, the existing inventories will have been exhausted, and so further supplies will have to be bought. This costs £1,050 a tonne (according to the question), increasing the annual internal cost for the second year by £18,000 (that is, (40 × £1,050) – £24,000) compared with the first.

2. It has been assumed that keeping on the two part-time employees, at £15,000 salary a year each, will not cause any salary savings to be made elsewhere.

3. The allocation of the factory rent is irrelevant since this will not be saved if the containers work is ended. The cost of the outside warehouse is, however, a saving.

4. The depreciation charge is irrelevant, since it is based on past cost. What is relevant is the £28,000 cash inflow that will result from stopping the container work, the equivalent of £14,000 for each year. This assumes that the plant could be sold for £14,000 at the end of the first year.

5. It has been assumed that the maintenance costs are specific to the container work and will be saved if this work is stopped.

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CHAPTER 3

Cost–volume–profit analysis Solution to Exercise 3.2 Lannion and Co. (a) October

November

200

300

Sales revenue (£)

5,000

7,500

Costs (balancing figure, £)

(4,000)

(5,300)

Operating profit (£)

1,000

2,200

Sales (units of the service)

The increase in output of 100 units (that is, from 200 to 300) gives rise to additional costs of £1,300 (that is, £5,300 – £4,000) or £13 a unit (that is, £1,300/100). This is the variable cost.

Since there were no price changes, the £1,300 can only have arisen from additional sales.

We do not know how much of each month’s cost figure is fixed and how much is variable, but we can work it out. For October, total variable cost = 200 × £13 = £2,600. Thus, the fixed cost must be £1,400 (that is, £4,000 – £2,600). This can be checked using the November figures: total variable cost = 300 × £13 = £3,900; fixed cost = £5,300 – £3,900 = £1,400. Fixed costs, by definition, must be the same each month.

Sales revenue per unit = £5,000/200 (or 7,500/300) = £25. Therefore: Break-even point = Fixed cost/contribution =

£14,000 £25 − £13

= 116.67, or 117 units a month (b)

Knowing the break-even point is useful because it enables management to judge how close is the planned level of activity to the point at which no profit will be made. This enables some assessment of risk to be made.

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Solution to Exercise 3.4 Alpha, Beta and Gamma (a) First, we need to deduce the total contribution for one unit of each service. This will enable us to calculate the contribution per £1 of labour and so the relative profitability of the three services, given a shortage of labour. Strictly, we should use the contribution per hour, but we do not know the number of hours involved. Since all labour is paid at the same rate, using labour cost will give us the same order of priority as using hours.

Alpha

Beta

Gamma

£000

£000

£000

Materials

(6)

(4)

(5)

Labour

(9)

(6)

(12)

Expenses

( 3)

( 2)

( 2)

Total variable cost

(18)

(12)

(19)

Sales revenue

39

29

33

Contribution

21

17

14

2.333

2.833

1.167

2nd

1st

3rd

Variable costs:

Contribution per £ of labour Order of profitability

Since 50 per cent of each budget (and, therefore, £13,500 of labour) is committed, only £6,500 (that is, £20,000 – £13,500) of labour is left uncommitted. The £6,500 should be deployed as: £ Beta

3,000

Alpha

3,500 6,500

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Total labour committed to each service and resultant profit is as follows: Alpha

Beta

Gamma

Total

£

£

£

£

50% of budget

4,500

3,000

6,000

Allocated above

3,500

3,000

–

Total

8,000

6,000

6,000

Contribution per £ of labour

2.333

2.833

1.167

Contribution per unit of service*

18,664

16,998

7,002

Labour

20,000 42,664 (33,000)

Fixed costs Maximum profit (after rounding)

9,664

*The contribution per £ of labour × total labour.

(b) The steps include:

•

Using all of the surplus labour to render the Beta service (the most efficient user of labour).

In other words, could the business sell more than £29,000 of this service? It might be worth reducing the price of the Beta, though still keeping the contribution per £1 of labour above £2.33, in an attempt to expand sales.

•

Dropping the commitment to 50 per cent of budget on each service, in favour of providing the maximum of the higher-yielding services?

•

Finding another source of labour.

•

Subcontracting the labour-intensive part of the work.

Some, possibly all, of these approaches may not be practical in the circumstances, but they seem worth considering. Other approaches may also be worth considering.

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Solution to Exercise 3.5 The hotel group (a) The variable element and, by implication, the fixed element of the hotel’s costs can be deduced by comparing any two quarters, for example: Quarter

Sales

Profit(loss)

Total cost

£000

£000

£000

1

400

(280)

680*

2

1,200

360

840*

revenue

Difference

800

160*

*This is because: Sales revenue − total costs = profit (or loss) So, Sales revenue − profit (or + loss) = total costs

Thus, the variable element of the sales price is 20 per cent (that is, (160/800) × 100). Now: The fixed costs for quarter 1

= Total costs – Variable costs = £680,000 – (20% × 400,000) = £600,000

To check that this calculation is correct and consistent for all four quarters, we can ‘predict’ the total costs for the other three quarters and then check the predicted results against those that can be deduced from the question, as follows: Quarter 2 Total cost = fixed costs + variable costs

= £600,000 + (20% × 1,200,000) = £840,000 Agrees with the question Quarter 3 Total cost = fixed costs + variable costs

= £600,000 + (20% × 1,600,000) = £920,000

Agrees with the question

Quarter 4 Total cost = fixed costs + variable costs

= £600,000 + (20% × 800,000) = £760,000

Agrees with the question

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Had the fixed and variable elements been deduced graphically, the consistency of the fixed and variable cost elements over the four quarters would have been obvious because a straight line would have emerged.

The provisional results for this year are as follows: Per guest Total

(50,000 guests)

£000

£

Sales revenue

4,000

80

Variable costs (20% of sales revenue)

(800)

(16)

Contribution

3,200

64

(2,400)

(48)

800

16

Fixed costs (that is, fixed costs a quarter × 4) Profit

(b) (1) At the same level of occupancy as for this year and incorporating the increase in variable costs of 10 per cent, the sales revenue for next year will need to be: £000 Fixed costs

2,400

Variable costs (800,000 × 110%)

880

Total costs

3,280

Target profit

1,000

Sales revenue target

4,280

Hence, the sales revenue per guest is: £4,280,000 = £85.60 50,000

(2) If the sales revenue per guest remains at the current rate, the contribution per guest will be: £80 – (£16 × 110%) = £62.40 To cover the fixed costs and the target profit, would take: £2,400,000 + 1,000,000 ≈ 54,487 visitors £62.40

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(c) The major assumptions of profit–volume analysis are that costs can be divided between those that vary with the volume of activity (and with that factor alone) and those that are totally unaffected by volume changes. Further assumptions are that both variable costs and sales revenues vary at a steady rate (straight-line relationship) with volume.

These assumptions are unlikely to be strictly valid in reality. Variable costs are unlikely to vary in a strictly straight-line manner relative to volumes. For example, at higher levels of output there may be economies of scale in purchasing (for example, bulk discounts) or the opportunity to use materials or labour more effectively. On the other hand, the opposite may be the case. At higher levels of output, cost per unit increases because a shortage may be created by the higher output level. Similarly, the business may not be able to sell more without reducing the selling price.

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CHAPTER 4

Full costing Solution to Exercise 4.2 Bodgers Ltd (a) The business predetermines the rate at which overheads are to be charged to jobs because, for full costing information to be useful, costs often need to be known either before the job is done or very soon afterwards. Two of the main reasons why businesses identify full costs are for pricing decisions and for income-measurement purposes.

For pricing, usually the customer will want to know the price in advance of placing the order.

Thus, it is not possible to wait until all of the costs have been incurred, and are known, before the price can be deduced. Even where production is not for an identified customer, the business still needs to have some idea of whether it can produce the good or service at a price that the market will bear.

In the context of income measurement, valuing finished inventories and/or work in progress is the purpose for which full costs are required. For managers to benefit as much as possible from accounting information, it must speedily follow the end of the period to which it relates. This usually means that waiting to discover actual cost is not practical. (b) Predetermining the rate at which overheads are charged to jobs requires that three judgements be made: 1

Estimating the overheads for the period concerned.

2

Deciding on the basis of charging overheads to jobs (for example, rate per direct labour hour).

3

Estimating the number of units of the basis factor (for example, number of direct labour hours) that are expected to occur during the period concerned.

Judgements 1 and 3 are difficult to make, but there will normally be some past experience to provide guidance. Judgement 2 is purely a matter of opinion. (c) The problems of using predetermined rates are really linked to the ability to estimate 1 and 3 in (b) above. The desired result is that the total of the overheads, but no more than this, become part of the cost of the various jobs worked on in the period. Only if 1 and 3 are both accurately estimated will this happen, except by lucky coincidence. There is clearly the danger that jobs will either be undercharged or overcharged with overheads, relative to the total amount of overheads incurred during the period. In fact, it is almost certain that one of these two will happen to some extent simply because perfect estimation is virtually impossible. Minor errors will not matter, but major ones could well lead to bad decisions.

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Solution to Exercise 4.3 Pieman Products Ltd Indirect costs: £ Indirect labour

25,000

Depreciation

8,000

Rent

10,000

Heating, lighting and power

5,000

Indirect materials

2,000

Other indirect costs

1,000

Total indirect costs

51,000

This list does not include the direct costs because we shall deal with the direct costs separately.

Probably a direct-labour-hour basis of charging overheads to jobs is most logical in this case (see below). The direct labour hours are given as 16,000.

Overhead recovery rate per direct labour hour: £51,000/16,000 = £3.1875 per direct labour hour Full cost of the trailer: £ Direct materials

1,150.00

Direct labour

(250 × (£320,000/16,000))

Indirect costs

(250 × £3.1875)

5,000.00 796.88 6,946.88

Total cost

that is, about £6,950.

Direct labour hours are probably the most logical basis for charging overheads to the job. Those hours may provide the only measurable thing about the job that is a reasonable assessment of the size/complexity/importance of each job relative to the others undertaken. The business’s work is probably labour intensive; it is probably difficult to introduce very much machine-controlled work into making trailers to individual specifications.

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Solution to Exercise 4.7 Athena Ltd (a) Budgeted overheads for next year Total £ 25,000 10,000 50,000 30,000 115,000

Heating and lighting Machine power Indirect labour* Depreciation

Machining Department £ 12,500 10,000 37,500 30,000 90,000

Fitting Department £ 12,500 12,500 25,000

* This is divided 300,000:100,000, that is, in proportion to direct labour.

Note that direct labour and materials are not included in this schedule because they are not indirect costs. (b) Machining Department The machine hour rate = £90,000/20,000 = £4.50 per hour Fitting Department The direct labour hour rate = £25,000/(300,000/20) = £1.67 per hour. (Note that the direct workers are paid £20 an hour, so the hours to be worked are 300,000/20.) (c) Job price £ Direct materials Direct labour:

1,200 10 hours × £20

200

20 hours × £20

400

Machining Department

50 hours × £4.50

225

Fitting Department

20 hours × £1.67

33 2,058

(to the nearest £)

20% × £2,058

412 £2,470

(to the nearest £)

Machining Department Fitting Department Overheads:

Profit loading

Thus, the price will be £2,470.

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CHAPTER 5

Costing and cost management in a competitive environment Solution to Exercise 5.5 Jerry’s Taxis Ltd The benchmarking study of operating efficiency may include the following measures:

•

profit as a percentage of total fare income

•

fuel costs as a percentage of total fare income

•

wages and salaries as a percentage of total fare income

•

average fare income per taxi

•

average running costs per taxi

•

fare income per mile

•

average fuel consumption per mile

•

total miles travelled

•

average miles travelled per taxi

•

average number of days per month a taxi is not on the road

•

average number of hours worked per driver

•

percentage of calls answered within one minute

•

percentage of abandoned calls

•

percentage of passengers picked up within 15 minutes

•

number of wheelchair accessible taxis

•

number of accidents per 1,000 miles travelled

You may have thought of others.

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Solution to Exercise 5.6 (a) People are important in a modern manufacturing environment and are increasingly recognised as such. This does not mean that direct-labour hour is a good way to deal with overheads.

Though people are important, they are increasingly ‘overheads’ themselves in that they are not engaged in working on the product, but supporting manufacturing as technicians and other experts who are maintaining and managing the machinery that carries out the work that direct labour used to do. (b) Activity-based costing (ABC) is not at all concerned with direct costs. ABC is concerned with trying to relate overheads more specifically to units of output (products or services). Direct costs, by definition, can already be identified with particular cost units and measured with respect to them. (c) It is not at all true that ABC is less applicable to the service sector. The activities that drive costs may be different in the service sector, relative to manufacturing. This does not, however, imply that the costs are any less capable of being analysed to provide more reliable cost information.

Some argue that ABC is particularly relevant to the service sector. As a result of having little or no direct materials, overheads for a typical business that is providing services form a larger element of total costs than is typical in manufacturing.

In practice, it certainly appears that ABC has successfully been applied to service-sector businesses. (d) Kaizen costing is concerned with trying to reduce costs during the production phase. Though only small cost reductions are usually obtainable, cumulatively such savings can be significant.

Typically, businesses using kaizen costing set targets for reductions in unit production costs. (e) Benchmarking is comparing one’s own business (or a section of it) with one that is regarded as one of the industry leaders; the ‘benchmark’. The objective is to improve the business and make it as good as the best in the industry by emulating the best. This comparison may be done in respect of just one aspect – for example, marketing methods – or across the board. It starts with trying to identify the businesses that are most worth emulating.

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Solution to Exercise 5.8 Lo, Mid and Hi (a) (1) Original costing method Calculation of the overhead recovery rate Total direct labour hours = (20,000 × 0.5) + (1,000 × 1) + (10,000 × 1) = 21,000 Overhead recovery rate = £4,410,000/21,000 = £210 per direct labour hour.

Unit cost and selling prices Lo

Mid

Hi

£

£

£

Material cost

25

62.5

105

Direct labour cost (£16 per hour)

8

16

16

Overheads (£210 per DLH)

105

210

210

Total cost per unit

138

288.5

331

Profit margin (20% of TC)

27.6

57.7

66.2

Selling price per unit

165.6

346.2

397.2

(2) Activity-based costing method Total cost and selling prices Lo £

Mid £

Hi £

Total £

Material cost (£/unit × budgeted production)

500,000

62,500

1,050,000

1,612,500

Direct labour cost

160,000

16,000

160,000

336,000

Overheads:

machining

1,112,000 (40%)

417,000 (15%)

1,251,000 (45%)

2,780,000

logistics

277,300 (47%)

35,400 (6%)

277,300 (47%)

590,000

establishment

436,800 (42%)

187,200 (18%)

416,000 (40%)

1,040,000

Total cost Number of units

2,486,100

718,100

3,154,300

20,000

1,000

10,000

Total cost per unit

124.3

718.1

315.4

Profit margin (20% of TC)

24.9

143.6

63.1

149.2

861.7

378.5

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6,358,500

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(b) The activity-based approach should give us a fairer basis of charging overheads to production.

On the basis of the ABC-derived figures, it is not surprising that the Lo model was overpriced relative to the market price.

At present, the Mid model looks to be priced at well below a fair estimation of cost. Its price really should be raised significantly. Hi, like the Lo model, seems overpriced at present. (c) The business should consider moving prices towards those derived from the ABC approach. At the same time, competitors’ prices should be closely examined. It may well be that the market would not bear the ABC-derived price for the Mid model. Recent volume sales of Mid have not been large, and so it may be that competition is fierce here. On the other hand, the total market may be small. It may be the case that reduced prices for Lo and Hi would expand their sales and the business’s total profit. The business should not be too eager to reduce prices if the market will bear higher ones.

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CHAPTER 6

Budgeting Solution to Exercise 6.2 (a) A budget is a business plan for a future period, usually expressed in financial terms. A forecast is an assessment/estimation of what is expected to happen in the environment. ‘Plan’ implies an intention to achieve. Thus, a budget is a plan of what is intended to be achieved during the period of the budget. Relevant forecasts may well be taken into account when budgets are being prepared, but there is a fundamental difference between budgets and forecasts.

Though a year is a popular period for detailed budgets to be drawn up, there is no strong reason in principle why they have to be of this length. (b) The layout described is generally regarded as a useful approach. Budgets are documents exclusively for the use of managers within the business. For this reason, those managers can use whatever layout best suits their purpose and tastes. In fact, there is no legal requirement that budgets should be prepared at all, let alone that they are prepared in any particular form. (c) Management by exception is based on the idea that a comparison of actual with budget performance provides a basis for control. This allows senior managers to spend most of their time dealing with those staff or activities that have failed to achieve the budget (the exceptions).

They do not have to spend too much time on those where actual performance conforms to plan.

This technique is based on a command-and-control structure insofar that activities are monitored and decisions made by senior managers. The deviations from budget are not monitored and dealt with by junior managers, as would occur in a more decentralised structure. (d) All budgeting must take account of the planned volume of activity. ABB takes an ABC approach to the identification of overheads and to trying to ensure that managers who have control over the activities that drive the costs are held accountable for those costs. Similarly, ABB seeks to ensure that managers who have no effective control over particular costs are not held accountable for them. (e) A sensible approach is to start with the budget for the area in which lies the limiting factor – that is, that factor that will, in the end, prevent the business from achieving its objectives to the extent that would have been possible were it not for that factor.

It is true that, in practice, sales demand is often the limiting factor. In those cases, the sales budget is the best place to start. The limiting factor could, however, be a shortage of suitable labour or materials. In this case, the labour or materials budget would be the sensible place to start.

The reason why the starting point is important is simply that it is easier to start with the factor that is expected to limit the other factors and for those other factors to fit in.

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Solution to Exercise 6.6 Daniel Chu Ltd (a) The finished goods inventories budget for the six months ending 30 September (in units of production) is:

Opening inventories (Note 1) Production (Note 2)

Sales (Note 3) Closing inventories

April

May

June

July

Aug

Sept

units

units

units

units

units

units

0

500

600

700

800

900

500

600

700

800

900

900

500

1,100

1,300

1,500

1,700

1,800

-

(500)

(600)

(700)

(800)

(900)

500

600

700

800

900

900

(b) The raw materials inventories budget for the six months ending 30 September (in units) is: April

May

June

July

Aug

Sept

units

units

units

units

units

units

0

600

700

800

900

900

1,100

700

800

900

900

900

1,100

1,300

1,500

1,700

1,800

1,800

Production (Note 4)

(500)

(600)

(700)

(800)

(900)

(900)

Closing inventories

600

700

800

900

900

900

Opening inventories (Note 1) Purchases (Note 2)

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The raw materials inventories budget for the six months ending 30 September (in financial terms) is: April

May

June

July

Aug

Sept

£000

£000

£000

£000

£000

£000

Opening inventories (Note 1)

–

24

28

32

36

36

Purchases (Note 2)

44

28

32

36

36

36

44

52

60

68

72

72

(20)

(24)

(28)

(32)

(36)

(36)

24

28

32

36

36

36

Production (Note 4) Closing inventories

(c) The trade payables budget for the six months ending 30 September is: April

May

June

July

Aug

Sept

£000

£000

£000

£000

£000

£000

-

44

28

32

36

36

44

28

32

36

36

36

44

72

60

68

72

72

Cash payment

-

(44)

(28)

(32)

(36)

(36)

Closing balance

44

28

32

36

36

36

Opening balance (Note 1) Purchases (Note 5)

(d) The trade receivables budget for the six months ending 30 September is: April

May

June

July

Aug

Sept

£000

£000

£000

£000

£000

£000

Opening balance (Note 1)

-

-

50

60

70

80

Sales (Note 3)

-

50

60

70

80

90

-

50

110

130

150

170

Cash received

-

-

(50)

(60)

(70)

(80)

Closing balance

-

50

60

70

80

90

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(e) The cash budget for the six months ending 30 September is: April

May

June

July

Aug

Sept

£000

£000

£000

£000

£000

£000

-

-

50

60

70

80

300

-

50

60

70

80

(Note 7)

-

44

28

32

36

36

Labour (Note 3)

10

12

14

16

18

18

17

17

17

17

17

17

(Note 8)

10

10

10

10

10

10

Non-current assets

250

Total outflows

287

83

69

75

81

81

(outflows)

13

(83)

(19)

(15)

(11)

( 1)

Closing balance

13

(70)

(89)

(104)

(115)

(116)

Inflows Share issue

300

Receipts – trade receivables (Note 6) Outflows Payments to trade payables

Overheads: Production Non-production

Net inflows

Notes: 1. The opening balance is the same as the closing balance from the previous month.

2. This is a balancing figure.

3. This figure is given in the question.

4. This figure derives from the finished inventories budget.

5. This figure derives from the raw materials inventories budget.

6. This figure derives from the trade receivables budget.

7. This figure derives from the trade payables budget.

8. This figure is the non-productive overheads less depreciation, which is not a cash expense.

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Solution to Exercise 6.8 Brown and Jeffreys (a) Sales budget Jan

Jan

Feb

Feb

Mar

Mar

Apr

Apr

May

May

June

June

Units

£

Units

£

Units

£

Units

£

Units

£

Units

£

4,000

40,000

4,000

40,000

4,500

45,000

4,500

45,000

4,500

45,000

4,500

45,000

To retailers @ £12 each

2,000

24,000

2,700

32,400

3,200

38,400

3,000

36,000

2,700

32,400

2,500

30,000

Total

6,000

64,000

6,700

72,400

7,700

83,400

7,500

81,000

7,200

77,400

7,000

75,000

To motor manufacturers @ £10 each

(b) Finished goods inventories (inventory) budget (at direct cost) [£5.80/unit] Jan

Jan

Feb

Feb

Mar

Mar

Apr

Apr

May

May

June

June

Units

£

Units

£

Units

£

Units

£

Units

£

Units

£

Opening inventories

7,000

40,600

5,850

33,930

6,150

35,670

5,450

31,610

4,950

28,710

4,750

27,550

Production

4,850

28,130

7,000

40,600

7,000

40,600

7,000

40,600

7,000

40,600

6,900

40,020

11,850

68,730

12,850

74,530

13,150

76,270

12,450

72,210

11,950

69,310

11,650

67,570

Sales

(6,000)

(34,800)

(6,700)

(38,860)

(7,700)

(44,660)

(7,500)

(43,500)

(7,200)

(41,760)

(7,000)

(40,600)

Closing inventories

5,850

33,930

6,150

35,670

5,450

31,610

4,950

28,710

4,750

27,550

4,650

26,970

‘Ideal’ inventories

4,700

5,450

5,250

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4,750

4,650

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(c) Raw materials inventories (inventory) budget (cost) Component A (£2.50/unit) Jan

Jan

Feb

Feb

Mar

Mar

Apr

Apr

May

May

June

June

Units

£

Units

£

Units

£

Units

£

Units

£

Units

£

Opening inventories

10,000

25,000

7,000

17,500

7,000

17,500

7,000

17,500

7,000

17,500

6,900

17,250

Purchases

1,850

4,625

7,000

17,500

7,000

17,500

7,000

17,500

6,900

17,250

6,800

17,000

11,850

29,625

14,000

35,000

14,000

35,000

14,000

35,000

13,900

34,750

13,700

34,250

Production

(4,850)

(12,125)

(7,000)

(17,500)

(7,000)

(17,500)

(7,000)

(17,500)

(7,000)

(17,500)

(6,900)

(17,250)

Closing inventories

7,000

17,500

7,000

17,500

7,000

17,500

7,000

17,500

6,900

17,250

6,800

17,000

Jan

Jan

Feb

Feb

Mar

Mar

Apr

Apr

May

May

June

June

Units

£

Units

£

Units

£

Units

£

Units

£

Units

£

16,500

21,450

11,650

15,145

7,000

9,100

7,000

9,100

7,000

9,100

6,900

8,970

-

-

2,350

3,055

7,000

9,100

7,000

9,100

6,900

8,970

6,800

8,840

16,500

21,450

14,000

18,200

14,000

18,200

14,000

18,200

13,900

18,070

13,700

17,810

Production

(4,850)

(6,305)

(7,000)

(9,100)

(7,000)

(9,100)

(7,000)

(9,100)

(7,000)

(9,100)

(6,900)

(8,970)

Closing inventories

11,650

15,145

7,000

9,100

7,000

9,100

7,000

9,100

6,900

8,970

6,800

8,840

Component B (£1.30/unit)

Opening inventories Purchases

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Component C (£0.80/unit) Jan Units

Jan £

Feb Units

Feb £

Mar Units

Mar £

Apr Units

Apr £

May Units

May £

June Units

June £

Opening inventories

7,200

5,760

7,000

5,600

7,000

5,600

7,000

5,600

7,000

5,600

6,900

5,520

Purchases

4,650

3,720

7,000

5,600

7,000

5,600

7,000

5,600

6,900

5,520

6,800

5,440

11,850

9,480

14,000

11,200

14,000

11,200

14,000

11,200

13,900

11,120

13,700

10,960

Production

(4,850)

(3,880)

(7,000)

(5,600)

(7,000)

(5,600)

(7,000)

(5,600)

(7,000)

(5,600)

(6,900)

(5,520)

Closing inventories

7,000

5,600

7,000

5,600

7,000

5,600

7,000

5,600

6,900

5,520

6,800

5,440

£8,345

Total purchases

£26,155

£32,200

£31,740

£32,200

£31,280

(d) Production budget Jan Units

Jan £

Feb Units

Feb £

Mar Units

Mar £

Apr Units

Apr £

May Units

May £

June Units

June £

Direct materials (sets, that is A + B + C; one of each total £4.60)

4,850

22,310

7,000

32,200

7,000

32,200

7,000

32,200

7,000

32,200

6,900

31,740

Direct labour (hours)

4,850

5,820

7,000

8,400

7,000

8,400

7,000

8,400

7,000

8,400

6,900

8,280

Total

28,130

40,600

40,600

40,600

40,600

40,020

Note: The monthly production figures are derived according the following principles: The question states that planned sales volumes must be met (the sentence preceding the bullet point list). Given the finished goods inventories position on 1 January and the limited production capacity (numbered point (4)), the only way that the business can achieve the sales targets is to ‘stockpile’ during the early months. This inevitably means that the ‘ideal’ inventories level cannot be achieved (that is, must be exceeded) during the first three months.

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(e) Trade receivables budget Jan

Feb

Mar

Apr

May

June

£ 24,000

£ 24,000

£ 32,400

£ 38,400

£ 36,000

£ 32,400

64,000

72,400

83,400

81,000

77,400

75,000

88,000

96,400

115,800

119,400

113,400

107,400

Cash receipts

(64,000)

(64,000)

(77,400)

(83,400)

(81,000)

(77,400)

Closing balance

24,000

32,400

38,400

36,000

32,400

30,000

Jan

Feb

Mar

Apr

May

June

£ 21,250

£ 8,345

£ 26,155

£ 32,200

£ 32,200

£ 31,740

8,345

26,155

32,200

32,200

31,740

31,280

29,595

34,500

58,355

64,400

63,940

63,020

Cash payments

(21,250)

(8,345)

(26,155)

(32,200)

(32,200)

(31,740)

Closing balance

8,345

26,155

32,200

32,200

31,740

31,280

Balance brought forward Sales revenue

(f) Trade payables budget

Balance brought forward Purchases

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(g) Cash budget

Receipts

Trade receivables

Jan

Feb

Mar

Apr

May

June

£

£

£

£

£

£

64,000

64,000

77,400

83,400

81,000

77,400

(21,250) (5,820) (32,000)

(8,345) (8,400) (32,000)

(26,155) (8,400) (32,000)

(32,200) (8,400) (32,000)

(32,200) (8,400) (32,000)

(31,740) (8,280) (32,000)

(59,070)

(48,745)

(66,555)

(72,600)

(72,600)

(72,020)

4,930 7,550

15,255 22,805

10,845 33,650

10,800 44,450

8,400 52,850

5,380 58,230

Payments

Trade payables Direct labour Indirect costs

Surplus for the month Closing balance

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CHAPTER 7

Accounting for control Solution to Exercise 7.4 Antonio plc Budget Original

Flexed

Actual

1,000

1,100

1,100

£

£

£

Sales revenue

31,000

34,100

34,950

Direct labour

(11,000)

(12,100)

(550 hrs)

(12,210)

(537.5 hrs)

Direct materials

(10,000)

(11,000)

(1,100 kg)

(11,630)

(1,170 kg)

Fixed overheads

(3,000)

(3,000)

(3,200)

Operating profit

7,000

8,000

7,910

Output (units) (production and sales)

Sales variances Volume £(8,000 − 7,000)

=

£1,000(F)

Price £(34,950 − 34,100) = £850(F) _________________________________________________________________ Direct labour variances Efficiency (550 − 537.5) × £22.00

=

£275(F)

Rate (537.5 × £22.00) − £12,210 = £385(A) _________________________________________________________________

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Direct materials variances Usage [(1,100 × 1) − 1,170] × £10

=

£700(A)

Price (1,170 × £10) − £11,630 = £70(F) _____________________________________________________________ Fixed overhead variances Expenditure £3,000 − 3,200

=

£200(A)

_____________________________________________________________ Reconciliation of budgeted and actual operating profit £ Budgeted operating profit Sales:

Direct labour:

Direct materials:

Fixed overheads:

£ 7,000

Volume

1,000 (F)

Price

850 (F)

Efficiency

275 (F)

Rate

(385)(A)

Usage

(700)(A)

Price

70 (F)

Expenditure

1,850

(110)

(630)

(200) 7,910

Actual operating profit Note: (F) = favourable variance; (A) = adverse variance.

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Solution to Exercise 7.6 Mowbray Ltd Budget Original

Flexed

Actual

1,200

1,000*

1,000*

£

£

£

Sales revenue

24,000

20,000

18,000

Raw materials

(9,000)

(7,500)

(3,000 kg)

(7,400)

(2,800 kg)

Labour

(2,700)

(2,250)

(125 hr)

(2,300)

(127.5 hr)

Fixed overheads

(4,320)

(4,320)

(4,100)

Operating profit

7,980

5,930

4,200

Output (units) (production and sales)

*The sales revenue of £18,000 was based on a price 10 per cent below standard price, at £18 each. Sales volume was, therefore, 1,000 units (that is, £18,000/18).

Sales variances Volume:

(7,980 − 5,930) = £2,050

(A)

Price:

(20,000 − 18,000) = £2,000

(A)

Direct material variances Usage:

[(1,000 × 3) − 2,800] × £2.50 =

£500

(F)

Price:

(2,800 × £2.50) − £7,400 =

£400

(A)

Efficiency: [(1,000 × 0.125) − 127.5] × £18 =

£45

(A)

(127.5 × £18) − £2,300 =

£5

(A)

(4,320 − 4,100) =

£220

(F)

Direct labour variances Rate: Fixed overhead variances Spending:

(The budgeted fixed overheads were £3.60 × 1,200 = £4,320.)

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= £7,980

Budgeted operating profit (1,200 × £6.65) Variances Sales: Direct materials: Direct labour: Fixed overheads:

Volume

(2,050)

(A)

Price

(2,000)

(A)

Usage

500

(F)

Price

(400)

(A)

Efficiency

(45)

(A)

Rate

( 5)

(A)

(4,050) 100 (50)

Expenditure

220 £4,200

Actual operating profit

Since the low sales demand, and the reaction to it of dropping sales prices, seems to be caused by factors outside the control of managers of Mowbray Ltd, there are strong grounds for dividing the sales volume and price variances into those that are controllable and those that are not (planning variances).

Solution to Exercise 7.7 Brive plc Budget Original

Flexed

Actual

800

850

850

£

£

£

Sales revenue

88,000

93,500

92,930

Direct materials

(33,600)

(35,700)

(2,550 kg)

(33,258)

(2,410 kg)

Direct labour

(8,400)

(8,925)

(425 hrs)

(9,665)

(445 hrs)

Fixed overheads

(21,600)

(21,600)

(21,365)

Operating profit

24,400

27,275

28,642

Output (units) (production and sales)

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Variances Sales volume = £27,275 − £24,400 =

£2,875 (F)

Sales price = £92,930 − £93,500 =

(570) (A)

Direct materials usage = (2,550 − 2,410) × £14 =

1,960 (F)

Direct materials rate = (2,410 × £14) − £33,258 =

482 (F)

Direct labour efficiency = (425 − 445) × £21.00 =

(420) (A)

Direct labour rate = (445 × £21.00) − £9,665 =

(320) (A)

Fixed overheads spending = 21,365 − £21,600 =

235 (F) £4,242 (F)

Sum of the variances = Profit reconciliation Budgeted operating profit =

£24,400 4,242

Add: Variances

£28,642

Actual operating profit

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CHAPTER 8

Making capital investment decisions Solution to Exercise 8.2 Arkwright Mills plc (a) and (b) Incremental cash flows Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

£m

£m

£m

£m

£m

£m

£m

0.40

0.50

0.50

0.50

0.50

(0.04)

(0.06)

(0.06)

(0.06)

Operating profit before depreciation Corporation tax (20%)

(0.06)

Working capital investment

(0.60)

Non-current asset investment

(1.00)

___

____

____

____

____

0.60 ___

Annual net cash flows

(1.60)

0.40

0.46

0.44

0.44

1.04

(0.06)

Discount factor 10%

1.000

0.909

0.826

0.751

0.683

0.621

0.564

Present value

(1.600)

0.372

0.380

0.330

0.301

0.646

(0.034)

NPV

0.395

On the basis of NPV, the project should be undertaken (the NPV of the project is positive).

Note: For the sake of simplicity, the question assumes that the depreciation charge will be allowable for tax calculation purposes. However, in practice, the tax authorities will normally make a separate calculation (referred to as a capital allowance calculation) to replace the depreciation charge when calculating the liability for corporation tax. (c) Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

£m

£m

£m

£m

£m

£m

£m

Annual net cash flows

(1.60)

0.40

0.46

0.44

0.44

1.04

(0.06)

Cumulative net cash flows

(1.60)

(1.20)

(0.74)

(0.30)

0.14

1.18

1.12

The payback period is the time taken for the initial investment to be recouped. In this case, the investment will pay back by the end of year 4.

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Solution to Exercise 8.5 C. George (Controls) Ltd (a) and (b) The potential variable cost savings per unit of the product is as follows: £ Labour

2.10

(that is, £3.30 − £1.20)

Materials

0.45

(that is, £3.65 − £3.20)

Variable overheads

0.18

(that is, £1.58 − £1.40)

2.73 × 50,000

= £136,500 each year Incremental cash flows Year 0

Year 1

Year 2

Year 3

Year 4

£000

£000

£000

£000

£000

136.5

136.5

136.5

136.5

Variable cost savings New equipment

(670.0)

70.0

Old equipment

150.0

(40.0)

Working capital

130.0

(130.0)

(390.0)

136.5

136.5

136.5

36.5

Discount factors

1.000

0.893

0.797

0.712

0.636

Present values

(390.0)

121.9

108.8

97.2

23.2

NPV

(38.9)

(c)

Since the NPV is negative, the project would have an adverse effect on the wealth of the shareholders of the business and should not be pursued.

(d)

Cash flow projections are used rather than profit projections since it is cash that gives command over resources. It is only when the cash is paid or received that the opportunity to deploy it elsewhere is lost or gained, respectively.

In the long run, profit and cash flows should be equal; however, the timing of the flows will be different.

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Solution to Exercise 8.6 The accountant (a) Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

£000

£000

£000

£000

£000

£000

Sales revenue

450

470

470

470

470

Working capital recovered

____

____

____

450

470

470

470

650

Materials

126

132

132

132

132

Labour

90

94

94

94

94

Overheads

30

30

30

30

30

180

Working capital

180

New equipment

500

____

____

____

____

____

680

246

256

256

256

256

(680)

204

214

214

214

394

Incremental cash flows Notes:

•

Working capital invested in this project at the start will be recovered at the end of the project’s life.

•

The relevant overheads figure is £30,000 a year additional cost that the project is expected to cause.

•

Depreciation is not a cash flow.

•

Interest on the working capital investment and, indeed on other aspects of this investment, is dealt with by discounting.

•

The development cost is not a relevant cost, since it has been incurred already and is not affected by the decision to be made.

•

The cost of the equipment to start this project is the £500,000 that must be spent. The carrying value of the old machine is not relevant since this does not represent an outlay or an opportunity cash flow.

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(b) (1) Payback period

Incremental cash flows

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

£000

£000

£000

£000

£000

£000

(680)

204

214

214

214

394

(680)

(476)

(262)

( 48)

166

560

Cumulative incremental cash flows

Thus the payback point occurs in Year 4, that is, after just over three years (assuming cash flows accrue evenly over the year).

(2) NPV

(c)

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

£000

£000

£000

£000

£000

£000

Incremental cash flows

(680)

204

214

214

214

394

Discount factor

1.000

0.893

0.797

0.712

0.636

0.567

Present values

(680)

182.2

170.6

152.4

136.1

223.4

NPV

184.7

A memo to the board might include the following points:

•

The fact that the project has a significant positive NPV, which would increase shareholder wealth.

•

The fact that the project has a relatively short payback period.

•

The figures in the analysis ignore taxation, which should be considered before a final decision is made.

•

The question of risk should be considered before a final decision is made.

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CHAPTER 9

Managing risk Solution to Exercises 9.4 (a) and (b) Plaything plc Nipper production and sales Expected net present value

Year 0 £000

Opportunity cost of equipment Contributions (see workings) Redundancy costs Additional overheads Sale of patent rights

(85.0)

(125.0)

Net differential expected cash flows 12% discount factor Expected present values Expected net present value

Year 1 £000

Year 2 £000

Year 3 £000

Year 4 £000

79.8

79.8

79.8

(15.0)

(15.0)

(15.0)

35.0 79.8 (10.0) (15.0)

(210.0)

64.8

64.8

64.8

89.8

1.00 (210.0) 3.0

0.89 57.7

0.80 51.8

0.71 46.0

0.64 57.5

The ENPV is positive and so in theory the project should be undertaken. However the ENPV is very small and not, therefore, significantly different from zero, implying that undertaking the project will have little or no effect on the business’s wealth. Given that this is a risky project with the possibility of annual sales volume only being 11,000 units it is probably not a good idea to undertake the project.

ENPV has the advantage that it summarises all of the possible outcomes in one figure, which gives a basis for making the decision. However as with all forms of summarising or averaging, information becomes hidden. For example, in the case of Plaything plc’s project, though the expected annual sales volume is 13,300 units (see workings), this is not an outcome that is capable of occurring. The actual outcome must be 11,000, 14,000 or 16,000. Only if the latter two outcomes occur will the project be successful.

Where an organisation is undertaking a range of projects, ENPV can be justified on the basis that over a range of projects the average would be expected to occur in the same way as over a fairly large number of spins of a coin the number of heads and tails will be fairly even − as would be expected.

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Workings Expected annual sales volume = (11,000 × 0.3) + (14,000 × 0.6) + (16,000 × 0.1) = 13,300 units.

Contribution per unit Sales revenue Labour cost

£ 20 (8) (6 )

Material cost

£6 Expected annual contribution = £6 × 13,300 = £79,800

Solution to Exercise 9.6 Computer Tuition Ltd (a) Assessment of the value of a direct mailing Cost of direct mailing

£140,000

2,000 additional places are worth 2,000 × (£50 − 5) = £90,000 pa Contributions from extra places

20X4

£90,000

Benefit (NPV) if undertaken at 31 December 20X3 as at that date.

20X4

90,000/(1 + 0.12)

= 80,357

20X5

(90,000)/(1 + 0.12)2 (90,000)/(1 + 0.12)3

= 71,747

20X6

= 64,060 216,164 × 0.6 = £129,698

NPV of net cost of mailing 20X3

140,000

Cost of mailing

Therefore, do not undertake the direct mailing.

Benefit (NPV) if undertaken at 31 December 20X4 (as at 31 December 20X3).

NPV of net benefits 20X5

90,000/(1 + 0.12)2

= 71,747

20X6

(90,000)/(1 + 0.12)3

= 64,060 135,807

NPV of net cost 20X4

140,000/(1 + 0.12)

125,000

Therefore, undertake direct mailing in December 20X4 should the 20X4 demand prove to be 12,000.

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(b) Schedule of expected cash flows 31 December

20X4 £

20X5 £

20X6 £

594,000 (84,000) (350,000) (100,000)

648,000

648,000

(350,000) (100,000)

(350,000) (100,000)

(250,000)

60,000

198,000

198,000

Discount factor @ 12% PV

1.000 (250,000)

0.893 53,580

0.797 157,806

0.712 140,976

NPV

£102,365

Plant Contributions (below) Direct mailing (below) Instructors

20X3 £ (250,000)

Travelling

Since the NPV is significantly positive, the project should be undertaken.

Workings Expected contributions and direct mail cost 20X4 [(0.6 × 12,000) + (0.2 × 14,000) + (0.2 × 16,000)] × (50 − 5) = £594,000 20X5 and 20X6 [(0.8 × 14,000) + (0.2 × 16,000)] × (50 − 5) = £648,000 20X4 Expected cost of direct mailing = £140,000 × 0.6 = £84,000

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Solution to Exercise 9.8 Tufty plc (a) Present value of incremental costs of buying new production equipment

New equp’t

20X2 £000 400 (1,000)

Discount factors PV NPV

(600) 1.000 (600) (352)

Sales proceeds

20X3 £000

20X4 £000

20X5 £000

20X6 £000 400 400 0.621 248

Present value of incremental cost of retaining old production equipment 20X2 £000

20X3 £000 32 (100)

20X4 £000 24 (100)

20X5 £000 18 (100)

-

(68) 0.909 (62)

(76) 0.826 (63)

(82) 0.751 (62)

20X6 £000 54 (100) (46) 0.683 (31)

20X3 £000

20X4 £000

20X5 £000

20X6 £000

600 (80) (200)

600 (80) (200)

600 (80) (200)

600 (80) (200) 60

320 0.909 291

320 0.826 264

320 0.751 240

380 0.683 259

Capital allowances Additional VC Discount factors PV NPV

(218)

Therefore, use old production equipment.

Present value of producing the new pumps 20X2 £000 NPV of using old equipment (a) Opportunity cost of disposal proceeds Sales revenue Fixed costs Basic variable costs

(218) (400)

Working capital

(60)

Discount factors PV

(678) 1.000 (678)

NPV

376

On the basis of this analysis the new pump project should go ahead.

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(b) Sensitivity analysis Assume 100% increase in fixed overhead cost 20X2 £000 Increase

20X3 £000

20X4 £000

20X5 £000

20X6 £000

80

80

80

80

Four-year annuity factor @ 10% = 3.170 NPV = 3.170 × 80 = 254 Therefore, zero NPV is where FC = 80 + (80 × 376/254) = 198.

Thus, the viability of the project is not very sensitive to misestimations of the fixed cost figure.

The actual could increase by as much as 148 per cent of the original estimate before this factor taken alone could jeopardise the project.

The problem is that it is very unlikely that only this factor will differ from the estimate on which the NPV analysis of the project was based.

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CHAPTER 10

Strategic management accounting: performance evaluation and pricing in a competitive environment Solution to Exercise 10.5 (a) This statement might be true if the market demand were to be unaffected by the price charged.

Generally, the higher the price the less will be demanded by the market. How price movements and demand changes are linked is known as ‘price elasticity’. A product or service is said to have an elastic demand where relatively small price changes tend to result in fairly large demand changes.

Only where demand is extremely inelastic would it be likely to be the case that the maximum profit would be available at the highest price. On the other hand, it may well be more profitable to sell a lesser quantity at a higher price than to sell a higher quantity at a lower price. The demand function and the cost structure will both be vital factors in the necessary analysis.

In theory, profit is maximised where marginal cost (that is, the addition to total cost caused by producing one more) equals marginal revenue (that is, the addition to total revenue caused by selling one more). (b) Elasticity of demand deals with the effect of sales price changes on the level of demand. A commodity is said to have elastic demand if demand is greatly affected by changes in price.

Such a commodity would typically be something that is not a necessity and/or has ready substitutes. Inelastic demand would tend to characterise a commodity that was both a necessity and where there are no ready substitutes. (c) This statement is wrong on two counts. First, unless the business can cover all of its costs, in the long run it will be unprofitable. Even in the short term the statement is only valid if there is clearly no other possible use for some spare capacity, like selling to another customer who will pay more. In other words, opportunity costs must be covered as well as marginal outlay costs. (d) Profit is not maximised at the point where total cost equals total revenue. This is the break-even point.

As we saw in (a) above, in theory, profit is maximised where marginal cost equals marginal revenue. At output levels below this point, increased output will yield higher total profit. Past this point, additional units of output will yield lower total profit. (e) What is described is ‘penetration pricing’, where the objective is to discourage other possible entrants to the market to stay out on the grounds that price competition is too fierce. Once the business is well established, prices can be raised.

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‘Price skimming’ is where a business charges the highest price to start with. When all that are likely to be sold at the high price have been sold, the price is lowered a little to attract other possible buyers. When the second group of buyers has bought, the price is lowered a little again and so on.

Solution to Exercise 10.7 Pisces plc Adjusted NOPAT £m Operating loss

£m (20.5)

®

EVA adjustments R&D costs [40 − (1/16 × 80)] (Note 1)

35.0

Excess allowance

6.5

41.5 21.0

Adjusted NOPAT Adjusted net assets (or capital invested) £m Net assets per statement of financial position

£m 196.5

Add R&D costs (Note 1)

70.0

Allowance for trade receivables

6.5

Restructuring costs (Note 2)

6.0

82.5 279.0

Less Marketable investments

( 9.0)

Adjusted net assets

270.0

Notes:

1. The R&D costs represent a writing back of £40 million and a writing off of 1/16 of the total cost of the R&D as the benefits are expected to last 16 years.

2. The restructuring costs are added back to the net assets as they provide benefits over an infinite period.

EVA® can be calculated as follows: EVA® = NOPAT − (R × C)

= £21m − (7% × £270m) = £2.1m Thus, the EVA® for the period is positive even though an operating loss was recorded. This means that shareholder wealth increased during the third year.

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Solution to Exercise 10.8 GB Company – the International Industries (II) enquiry (a) The minimum acceptable price of 120,000 motors to be supplied over the next four months is: £000 Direct materials

600

(120,000 × £5.00)

Direct labour

720

(120,000 × £6.00)

Variable manufacturing overheads

360

(120,000 × £3.00 (that is, £3.00 for half an hour))

Fixed manufacturing overheads

60

(4 × £15,000)

Total

1,740

The offer price is: 120,000 × £19.00 = £2, 280,000

On this basis, the price of £19 per machine could be accepted, subject to a number of factors identified in (b) below.

The minimum price that GB could accept without reducing profit would be the variable cost.

This would be the total cost above (£1,740,000) less the fixed element (£60,000), that is, £1,680,000. This would be £14 per unit (that is, £1,680,000 divided by 120,000). (b) The assumptions on which the above analysis and decision in (a) are based include the following:

•

That the contract can be accommodated within the 30 per cent spare capacity of GB. If this is not so, then there will be an opportunity cost relating to lost ‘normal’ production, which must be taken account of in the decision.

•

That sales commission and freight costs will not be affected by the contract.

•

It is unlikely that work more remunerative to GB than the contract will be available during the period of the contract.

There are also some strategic issues involved in the decision, including:

•

The possibility that the contract could lead to other and better-remunerated work from II.

A problem of selling similar products in the same market at different prices. Other customers, knowing that GB is selling at marginal prices, may make it difficult for the business to resist demand from other customers for similarly priced output.

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CHAPTER 11

Measuring divisional performance Solution to Exercise 11.3 Transfer pricing (a) The objectives of a transfer pricing system are:

•

Promoting autonomy among the divisions in order for decentralisation to work effectively.

•

Contributing to a measure of divisional performance which can be used as a basis for evaluation.

•

Ensuring the profits of the business as a whole are optimised.

•

Providing a basis for allocating resources within a division.

These objectives are considered in detail in the chapter. It is possible for there to be a conflict between the objectives stated. In particular there is often a conflict between the first and third items mentioned above. (b) Variable cost should be considered when the division is operating below capacity. However, this represents a minimum acceptable transfer price. In order for the inter-divisional sales to make a contribution towards fixed costs and profit the transfer price must be above the variable cost. Where the division is operating at full capacity, there would be an opportunity cost to the selling division of making transfers at variable cost if external customers were prepared to pay above full cost.

Full cost transfers would make no profit for the selling division. This will not be helpful in determining the allocation of resources at divisional level. It will also make the evaluation of divisional performance difficult. A full cost approach provides little incentive for divisional managers to keep control of divisional costs as these can be passed on to the buying division.

However, where the buying division has the option to buy from external customers, some pressure may be brought to bear on escalating costs. (c) Market price is, generally speaking, the best method of setting transfer prices. The market price usually represents the opportunity cost of goods and services provided. However, where there is under-capacity the use of variable costs as the basis for decisions will be more appropriate as mentioned above. By making inter-divisional sales rather than external sales there may be savings in selling and marketing costs. As a result the selling division may decide to pass on some of these savings in the form of reduced prices to the buying division.

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Solution to Exercise 11.7 The University of Devonport A good answer would probably include the following:

•

A brief outline of the benefits of divisionalisation, to put the problem in context for the VC.

•

The definition of a transfer price (TP).

•

The main objectives in setting TPs:

–

Enables the performance of each faculty to be evaluated separately.

–

Promotes faculty autonomy.

–

Encourages good decision making within the faculties to the extent that they will pursue the best interests of the University as a result of pursuing their own best interests.

•

The opportunity cost (OC) is the best TP, in theory. However, while FG’s OC is £50 FML’s is probably zero because they have spare capacity which cannot be used and probably, in the short to medium term, they would probably not shed staff.

•

FML’s proposed TP is unreasonable and may well pass on inefficiencies unnoticed.

•

It is almost certainly not in the University’s best interests to employ outsiders when they already have staff available to do the work at zero opportunity cost.

•

It is questionable whether the outsider is as high quality as the FML staff, if only because the outsider would probably not be available to students outside formal classes, nor would he/she contribute in any other way. Also potential students may be put off by the use of outsiders, which could lead to a lack of students and course fees in future.

•

It does seem unfair that if FML was encouraged, at a senior level, to staff up to teach FG students, FML cannot at least recover the additional salary cost involved.

•

A TP of £50 would probably achieve the objective of getting the faculties to follow the best interests of the University. It would encourage FG to use FML staff (same price as outsider).

For FML, they would not have much choice since the alternative is not to supply at all.

•

A solution might be to have dual TPs, that is, to have one TP applied to the FML and another to FG, in respect of the same ‘transaction’. £50 for FG and the internal hourly rate for FML might be appropriate rates for this. This would cause FG to buy from FML, yet FML not to be penalised for having recruited staff to do the FG teaching.

Note:

There is no uniquely correct answer to this question.

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Solution to Exercise 11.8 AB Ltd (a) (1) Division

A

B

£m

£m

Operating profit

4.3

14.7

Less: warehouse costs (50:50)

2.3

2.3

2.0

12.4

Assets

20

48

Warehouse assets (50:50)

4

4

24

52

2.0/24

12.4/52

= 8.3%

= 23.8%

Return on investment

(2)

(× 100)

On the basis of available evidence there are four reasonable bases for allocating the actual costs and assets of the warehouse: Division

A

B

Original

50/100

(50%)

50/100

(50%)

Space

40/100

(40%)

60/100

(60%)

Budgeted sales

50/146

(34%)

96/146

(66%)

Actual sales

30/140

(21%)

110/140

(79%)

Since we are allocating costs, Division A would prefer the lowest proportion, that is the ‘actual sales’ basis.

The manager of Division B would not react well to this basis of allocation. S/he would probably point out that Division B is being penalised for achieving the budget, while Division A is being rewarded for failing to achieve the budget. The Division B manager would also argue that space used by the two departments would provide the best and most logical basis, since this would more likely drive most of the warehouse costs.

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(b) It could be argued that the fixed costs should be allocated on an equal basis, since both divisions have equal opportunity to use the facility and that it is not the fault of Division B that it uses it more than Division A. The variable costs, however, are likely to be driven by the amount of stock stored and so the storage space occupied seems reasonable here. This would lead to allocations as follows: Division

A

B

£m

£m

Depreciation (50:50)

0.80

0.80

Other fixed costs (50:50)

0.55

0.55

Variable storage costs (40:60)

0.24

0.36

Variable handling costs (40:60)

0.52

0.78

2.11

2.49

This basis of allocation is widely open to criticism and debate.

The following points should be made here:

•

Does the space occupied by inventories reflect the costs of handling them? If not, the proposed allocation of handling cost is unfair.

•

Should the divisions be charged with warehouse costs at all when they cannot control them?

On the other hand, the divisions do influence the warehouse costs, even if they do not control them.

•

Should the divisions be charged with over-budget costs of the warehouses? Perhaps the warehouse manager should be held accountable for this amount and the divisions charged just for the budgeted figure.

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CHAPTER 12

Managing working capital Solution to Exercise 12.1 Sparkrite Ltd (a) last year

this year

Inventories turnover period 61 days

(160 + 200) / 2 × 365 1,080

73 days

(200 + 250) / 2 × 365 1,125

Average settlement period for trade receivables *

375 × 365 1,800

480 × 365 1,920

76 days

91 days

*Year-end trade receivables figures were used because opening figures were not available in both years.

(b) Ways in which the business can exercise control over inventories levels include:

•

Use of sales forecasting methods in order to assess demand for inventories

•

Use of inventories management models in order to determine the economic order quantity

•

Proper authorisation procedures for ordering inventories

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•

Establishing an accurate inventories-recording system

•

Use of the just-in-time method, improving supplier lead times and so on to minimise inventories holding

•

Regular physical checks to ensure accuracy of inventories records and to identify slowmoving and obsolete items

•

Ensuring levels of inventories monitoring and security are appropriate to the value of the inventories held.

Ways in which the business can exercise control over trade receivables’ levels include:

•

Establishing creditworthiness checks on potential customers

•

Establishing credit limits

•

Offering discounts for prompt payment

•

Charging interest on late payment

•

Calculating average settlement periods and preparing ageing schedules of trade receivables outstanding

•

Invoicing customers promptly and sending reminders and statements at appropriate points

•

Checking to see where credit limits have been breached

•

Establishing a policy for dealing with late payers.

•

Factoring (that is, allowing a finance institution to manage the trade receivables and obtaining finance on the strength of the amounts owing to the business), where appropriate.

Solution to Exercise 12.3 International Electric plc (a) The approximate equivalent annual percentage cost of allowing 2 per cent discount for receiving cash 40 days earlier is: (365/40) × 2%

=

18.25%

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(b) Value of trade receivables outstanding Old scheme

New scheme

£m

£m

0.5 × (£365m × 30/365)

15.0

15.0

0.5 × (£365m × 70/365)

35.0

Trade receivables owing

7.5

0.25 × (£365m × 30/365) 0.25 × (£365m × 70/365)

____

17.5

50.0

40.0

(c) Cost of discounts allowed = (0.75 × £365m) × 2%

= £5,475,000

(d) Net cost of the discount scheme £000 Cost of discounts

£000 5,475

Less Interest charges saved ((£50m − £40m) @ 12%)

1,200

Bad debt savings

300

1,500 3,975

Net cost

The calculations reveal that the costs of the discounts scheme heavily outweigh the benefits.

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Solution to Exercise 12.5 Delphi plc (a) The receivables ageing schedule is: Number of months outstanding 1 month

1 to 2

2 to 3

Total

or less

months

months

receivables

£000

%

TV and hi-fi

20.0

Music Retail

£000

%

£000

%

£000

%

(22.2)

20.0

(22.2)

30.0

(33.3)

30.0

(33.3)

40.0

(44.5)

40.0

(44.5)

90.0

(100.0)

90.0

(100.0)

TV and hi-fi

20.8

(12.5)

20.8

(12.5)

Music

31.8

(19.2)

30.0

(18.1)

61.8

(37.3)

Retail

43.2

(26.1)

40.0

(24.1)

83.2

(50.2)

95.8

(57.8)

70.0

(42.2)

165.8

(100.0)

TV and hi-fi

21.6

(10.0)

21.6

(10.0)

Music

33.7

(15.6)

31.8

(14.7)

65.5

(30.3)

Retail

46.7

(21.4)

43.2

(19.9)

40.0

(18.4)

129.9

(59.7)

102.0

(47.0)

75.0

(34.6)

40.0

(18.4)

217.0

(100.0)

TV and hi-fi

22.5

(9.6)

22.5

(9.6)

Music

35.7

(15.4)

33.7

(14.6)

50.4

(21.7)

46.7

(20.1)

108.6

(46.7)

80.4

(34.7)

February

March

April

____

____

____

____

May

Retail

69.4

(30.0)

43.2

(18.6)

140.3

(60.4)

43.2

(18.6)

232.2

(100.0)

We can see that the receivables figure will increase substantially in the first four months. The retail chains will account for about 60 per cent of the total receivables outstanding by May as this group has the fastest rate of growth. There is also a significant decline in the proportion of total receivables outstanding from TV and hi-fi shops over this period. (b) In answering this part of the question, you should refer to the ‘five Cs of credit’ that were discussed in detail in the chapter.

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Supplementary questions Chapter 2 Astra Controls Ltd is an electronic engineering business that specialises in the production of electronic surveillance equipment for security forces throughout the world. Recently it has received a request to produce 10 ‘Peeping Tom’ surveillance units for a foreign government. The Peeping Tom was developed some time ago by the business at a total research and development cost of £220,000. So far there has been no interest shown in the equipment and no units have been produced. The present order seems likely to represent the total sales for the Peeping Tom. The product specification for each unit is set out below: 1

Materials (a)

2

Component A

3 per unit

Component B

1 per unit

Component C

2 per unit

(b)

Component A is normally held in inventories as it is widely used throughout the business’s product range. There are 15 components currently held. These had cost £1,800 each. The sole supplier of this component has announced an immediate price rise of 5 per cent for further purchases.

(c)

Component B is no longer used for any other of the business’s products. At present there are six components in inventories costing £2,000 each. It is possible to buy additional components at a cost of £2,200 each, however the supplier insists on a minimum order quantity of six components. Any components that are not used on this contract will be disposed of at a total cost to the business of £250, irrespective of the quantity to be disposed of.

(d)

Component C is used by the business throughout its product range. At present there is none in inventories. However, an order for 20 components for use in another contract is about to be placed. The supplier normally charges £1,600 per component but for orders above 30 components a discount of 10 per cent is available on the total order price.

(e)

Additional materials costing £2,800 in total will have to be bought if the contract is undertaken.

Labour (a)

Assembly time is estimated at 10 hours for each Peeping Tom unit. The workforce required to assemble the product is paid £7.00 an hour and is in great demand. If the order is accepted the necessary labour will have to be transferred from existing work and, as a result, other orders will be lost. It is estimated that for each hour that labour is transferred to this product £50.00 of sales revenue will be lost but that savings of £15.00 an hour in materials relating to lost sales will be made.

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(b)

3

Inspection time is estimated at five hours for each Peeping Tom unit. Inspection labour can be provided by paying existing employees overtime which is paid at a 331/3 per cent premium over the standard rate of £6.00 an hour.

Overheads The business normally includes a mark-up of 30 per cent to cover overheads. This contract is not expected to give rise to any increases in overheads.

Required: Prepare an estimate of the absolute minimum price that Astra Controls Ltd could undertake the contract so as to leave the business no worse off as a result.

Your answer should clearly explain your treatment of all of the information given in the question.

Chapter 3 (a) Rennes Ltd provides a single standard service. The business’s results for the past two months are as follows: April

May

500

620

Sales revenue (£)

25,000

31,000

Operating profit (£)

10,000

14,800

Sales (units of the service)

There were no changes, of any description, in selling prices or costs over the two months.

Required: What is the break-even point for the business’s activities? (b) Required: What benefit will it be for the management of Rennes Ltd (1)

to carry out the analysis required in part (a) and

(2)

to know the business’s break-even point?

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(c) Lorient plc has three products all of which require the same production facilities. Financial data on the three products are as follows: Product

X

Y

Z

£ per unit

£ per unit

£ per unit

skilled

10

15

20

unskilled

3

6

3

Materials

9

12

15

Variable overheads

8

12

16

Share of fixed overheads

10

15

20

Labour:

All three of the products use just one raw material, which is the same material for all three products.

This material costs £12 a kilo and is scarce, such that the amount of all three products that can be produced falls well below the amounts that the market would take. All labour is a variable cost.

Product X is sold in a market where the selling price per unit is fixed at £60.

Required: Show, with workings and explanations, the price at which the business would need to sell products Y and Z such that it would be equally profitable to produce and sell any one of the three products.

Chapter 4 You have been asked to suggest a method of deducing the full cost of various production orders of Patel Ltd. This method will be used as a basis for setting prices. The production orders vary greatly in size and nature from one to the next.

The following information has been taken from the budget for the forthcoming financial year: Direct labour hours Machine hours

100,000 hours 90,000 hours £

Manufacturing costs: Power Direct materials Machine maintenance and repairs Factory heat and light Lubricants and cleaning materials Direct labour Depreciation: factory buildings machinery Indirect labour

40,000 200,000 38,000 4,000 6,000 600,000 130,000 402,000 100,000 , 1 520,000

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The business is not departmentalised for accounting purposes.

All direct labour is paid the same hourly rate.

Required: (a)

Calculate two feasible overhead rates for the year.

(b)

Prepare full costings for Order No 101 using each of the rates calculated in (a) (that is, two separate costings).

The cost sheet for Order No 101 shows the following:

(c)

Raw materials

£5,000

Direct labour hours

4,000 hours

Machine hours

1,900 hours.

State briefly which of the two bases of overheads you prefer and why.

How might you improve on the two possible costs that you derived in (b) by taking a slightly different approach?

Chapter 5 Pigeon Ltd makes two products, Robins and Wrens. Information relating to each of these products is: Robins

Wrens

Selling price per unit

£52

£91

Annual sales volume

15,000 units

18,000 units

200

800

Labour time per unit

2 hours

5 hours

Labour rate per hour

£10

£10

Material cost per unit

£25

£30

Size of each production batch

750

1,000

Bought-in parts per unit

2

1

Machine set-ups per batch

2

5

Number of sales invoices issued each year

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The Finance Director of Pigeon Ltd has recently produced the following analysis of overheads and their relevant cost drivers: Type of overhead

Cost driver

£

Bought-in parts handling costs

Number of bought-in parts

96,000

Materials handling costs

Number of production batches

38,000

Sales invoicing costs

Number of invoices issued

20,000

Machine set-up costs

Number of machine set-ups

26,000

All other overheads

Labour hours

60,000

Total overhead costs

240,000

Required: (a) Calculate the total cost per unit and profit per unit for each product using: (1) the traditional full cost method of overhead absorption ( based on labour hours) (2) the activity-based costing method. (b) Comment on your findings.

Chapter 6 Seine Products Ltd, a new manufacturing business started production on 1 January. Sales are planned to start in February and to be as follows for the rest of the year: Sales units February

400

March

500

April

600

May

700

June

800

July

900

August

800

September

800

October

700

November

600

December

500

The selling price per unit will be £100.

All sales will be made on credit. The business plans to offer a cash discount (of 2% of the amount owed) to those customers who pay by the end of the month of sale. Customers for half of all units sold 62 © Pearson Education Limited 2021

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are expected to qualify for the discount. For the remaining half of the units sold, customers for 95 per cent are expected to pay during the month following the month of the sale. The remainder is expected to be bad debts.

It is planned that sufficient finished goods inventories for each month’s sales should be available at the end of the previous month.

Raw material purchases will be such that there will be sufficient raw materials inventories available at the end of each month precisely to meet the following month’s planned production. This planned policy will operate from the end of January. Purchases of raw materials will be on two months’ credit (that is, buy in month 1, pay in month 3). The cost of raw material is £40 per unit of finished product.

The direct labour cost, which is variable with the level of production, is planned to be £20 per unit of finished production.

Production overheads are planned to be £20,000 each month, including £3,000 for depreciation.

Non-production overheads are planned to be £11,000 a month of which £1,000 will be depreciation.

Various non-current assets costing £250,000 will be bought and paid for during January.

Except where specified, assume that all payments take place in the same month as the cost is incurred.

The business will raise £300,000 in cash from a share issue in January.

Required: Draw up a cash budget for the six months from 1 January to 30 June, with a column for each month.

The budget should, among other things, show each end-of-month cash balance.

Show all workings Chapter 7 (a) The Hull factory of United Industrial Manufacturers makes just one product line. The current standard cost (of one unit) of the product is as follows: Direct labour (15 minutes) Direct materials (2 metres) Fixed overheads (based on the budgeted monthly output of 20,000 units) Selling price Profit

£ 2.30 1.50 3.30 7.10 10.50 £3.40

During last month, due to an unexpected fall in demand for the product, only 15,000 were made and sold.

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The actual results for last month were as follows: £ Sales revenue

153,900

Direct labour (4,000 hours)

(35,040)

Direct materials (32,000 metres)

(23,360)

Fixed overheads

(67,350) 125,750 £28,150

Required: (a) Prepare a statement that reconciles the budgeted actual operating profit for the Hull factory for last month, going into as much detailed analysis as the above information allows. (b) You subsequently discovered that normally (that is, when the demand is as budgeted), 20 per cent of the direct labour is worked as overtime which is paid at a 25 per cent premium. The standard direct labour cost takes this into account.

During last month no overtime was worked. However, the business followed its usual practice of employing its full direct labour force for the basic working hours throughout the month. Of the hours worked, 3,650 were devoted to manufacture of the product. The other 350 hours were spent tidying up the factory and doing some non-routine maintenance work.

Required: Show how the statement that you prepared in (a) can be revised so that it more clearly identifies how much of the profit shortfall is the responsibility of various managers. You should clearly explain your revisions to the statement and you should make suggestions as to possible reasons for individual variances.

Chapter 8 The product development department of Dolly plc is contemplating renting a factory building on a four-year lease from 1 January Year 1, investing in some new plant and using it to produce a new product, code named GS7.

Since there appears to be no possibility of the plant continuing to be economically viable beyond a four-year life, it has been decided to assess the new product over a four-year manufacturing and sales life.

Under the lease the business will pay £100,000 annually in advance on 1 January.

The plant is expected to cost £600,000. This will be bought and paid for on 1 January Year 1 and is expected to be scrapped (zero proceeds) on 31 December Year 4. The business will depreciate this asset, in its accounts, on a straight-line basis (25% each year).

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Each unit of GS7 is estimated to give rise to a variable labour cost of £200 and a variable material cost of £100. GS7 manufacture will be charged with an annual share of the business’s administrative costs, totalling £150,000 each year. Manufacture and sales of GS7s are expected to increase total administrative costs by £90,000 each year.

Manufacture and sales of GS7s are expected to be as follows: Year ending 31 December

Year

Units of GS7

1 2 3 4

400 600 500 200

These will be sold for an estimated £1,400 each.

The business will need to support the manufacture and sales of the product with working capital. This has been estimated at an amount equivalent to £100 per unit of the product sold each year. This working capital would need to be in place by the beginning of the relevant year of production and sales and reduced to zero by the end of Year 4.

The business’s accounting year-end is 31 December each year.

It has been decided, given the level of risk involved with the project, to use a discount rate of 15 per cent a year.

Required: (a)

Identify the annual net relevant cash flows and use this information to assess the project on a net present value basis at 1 January Year 1.

(b)

Estimate the internal rate of return of the project.

Chapter 10 Airies plc was recently formed and issued 80 million £0.50 shares at par (that is, for £40 million in total) and loan notes of £24 million. The business used the proceeds from the capital issues to purchase the remaining lease on some commercial properties for £64 million that are rented out to small businesses. The lease will expire in four years’ time and during that period the annual operating profits are expected to be £12m each year. At the end of the three years, the business will be wound up and the lease will have no residual value.

The required rate of return by investors is 12 per cent.

Required: Calculate the expected shareholder value generated by the business over the four years, using:

•

the SVA approach

•

the EVA® approach

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Chapter 11 Arturo plc is a manufacturing business that operates through a number of divisions. One of the divisions (the TC division) makes a standard thermostatic controller. Part of the division’s output is sold to external customers; the remainder is transferred to a second division (the HD division), which incorporates the controller into a heating device. The latter division sells these heating devices to external customers.

In the past there has not been very much divisional accountability for performance, but management is now keen to treat each division as a separate entity, for profit measurement purposes, and to link divisional managers’ bonuses and promotional prospects to divisional profits. Among other things, this has led to a need for transfer prices to be set for any products or services, produced by one division, which are transferred to another.

Required: (a)

Outline and explain the objectives of a suitable transfer price, for the thermostatic controller, in the context of Arturo plc’s circumstances.

(b)

Discuss how a suitable transfer price might be deduced taking account of factors such as: (1) the possibility of the existence of an outside supplier of the thermostatic controller, which will provide an alternative to buying them from the TC division (2) the extent to which the HD division might have spare capacity.

Chapter 12 Magpie Ltd produces a graphite tennis racquet that has been reasonably successful but sales levels have remained stable in recent years. Financial data relating to the racquet are as follows:

£ Selling price

40

Variable cost

(30)

Fixed cost apportionment

(5)

Profit

5

Magpie Ltd has recently been approached by a large supermarket that wishes to buy 30,000 racquets each year but has demanded that four months’ credit is allowed. Magpie Ltd is concerned that if the demand is accepted, its other customers, who are allowed only one month’s credit, will make similar demands. The current level of sales is 120,000 racquets each year. If the supermarket order is accepted, 10,000 extra racquets will have to be held in inventories (where the racquets are valued at total cost) and trade payables will increase by £350,000. The business expects a return of 25 per cent on it net capital invested.

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Required: Assess the acceptability of the offer made by the supermarket to Magpie Ltd on the basis that: (a)

all customers will receive a credit period of four months; and

(b)

only the supermarket will receive a four-month credit period.

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Solutions to Supplementary questions Chapter 2 Astra Controls Ltd Peeping Tom Contract £

Notes

30 @ £1,800 + 5% 6 @ £2,200

56,700 13,200

(a) (b)

C 40 @ £1,600 − 10% Less: 20 @ £1,600 Additional materials Labour 100 hours @ £35.00 per hour

25,600 2,800

(c)

3,500 400 £102,200

(d)

Component

A B

(that is, £50.00 − 15.00) Inspection labour 50 hours @ £8.00 Minimum price

Notes: (a)

Since Component A is widely used, any used on this contract will need to be replaced. What those components used on the contract originally cost is irrelevant. The business will be worse off by the replacement cost, if it is used on the contract.

(b)

The disposal cost of unwanted Component B is the same irrespective of whether this contract is undertaken. If it is not undertaken, the existing inventories must be disposed of. If the contract goes ahead, there will be surplus Components B that will also need to be disposed of.

(c)

The relevant cost of Component C for use in this contract is the additional cost that will be incurred if the contract goes ahead as compared with the cost if it does not. Thus, the relevant cost is what will be spent on the components assuming that the contract is undertaken (net of the discount) less the cost of the components that will be bought (without the benefit of the discount) if the contract does not proceed.

(d)

The actual wages of the assembly workers is not relevant here. This is because, irrespective of the contract, they will still be employed for the same number of hours. If the contract is undertaken there will be a net loss of revenue from other activities.

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Chapter 3 Rennes Ltd and Lorient Ltd (a) Sales price per unit = £25,00/500 or £31,000/620 = £50.

Total cost for April = £25,000 – 10,000 = £15,000.

Total cost for May = £31,000 – 14,800 = £16,200.

Variable cost per unit = (£16,200 − 15,000)/(620 − 500) = £10 (This is because the only reason for an increase in the costs is the increased variable costs arising from the higher volume.)

Fixed cost = Total cost – variable cost = [£15,000 − (500 × £10)] (for April) or [£16,200 − (620 × £10)] (for May) = £10,000 per month.

Break-even point = £10,000/(£50 − 10) = 250 units per month. (b) Knowledge of the relationship between FC, VC and SR will aid planning and assessment of the future.

BE will enable some risk assessment to be undertaken. (c) The products will be equally profitable where the contribution per unit of scarce resource is equal.

Contribution per-unit Product X is = £60 − (10 + 3 + 9 + 8) = £30.

Amount of scarce resource per Product X = 9/12 = 0.75kg Contribution per kg = £30/0.75 = £40 Product Y Usage of scarce resource Required contribution Required price

Product Z

12/12 = 1kg

15/12 = 1.25kg

1 × £40 = £40

1.25 × £40 = £50

40 + 15 + 6 + 12 + 12 = £85

50 + 20 + 3 + 15 + 16 = £104

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Chapter 4 Patel Ltd (a) Total cost less direct cost = overheads: Total cost Less direct cost

£1,520,000 materials

200,000

labour

600,000 800,000

Total overheads

£720,000

Direct labour hour (DLH) rate of overhead recovery = £720,000/100,000 = £7.20 Machine hour (MH) rate of overhead recovery = £720,000/90,000 = £8.00 (b) Order No 101 (using DLH basis) £ Direct cost:

materials

5,000

labour 4,000 × (£600,000/100,000)

24,000 29,000

Overheads 4,000 × £7.20

28,800 £57,800

Order No 101 (using MH basis) £ Direct cost:

materials

5,000

labour 4,000 × (£600,000/100,000)

24,000 29,000

Overheads 1,900 × £8.00

15,200 £44,200

Since the overheads are dominated by machine-related costs (power, maintenance, depreciation and so on) it could be argued that the machine hour basis gives more relevant costs.

An alternative, to choosing one basis or the other, might be to take those elements of overhead cost that are machine related (power and so on) and deal with these on a machine - hour basis and deal with those more related to people (for example, light and heat) on a direct labour hour basis.

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Time-based methods of dealing with overheads tend to be popular because most, if not all, overheads tend themselves to be time related; for example, depreciation is normally twice as much over two hours as it is over one hour.

Chapter 5 Pigeon Ltd (a) (1) Cost per unit and profit per unit using full cost method of overhead absorption Robin

Wren

£

£

Labour (2 × £10)

20.00 50.00

(5 × £10) Materials

25.00

30.00

Overheads (See below) (2 × £2)

4.00 10.00

(5 × £2) Total cost per unit

49.00

90.00

Selling price per unit

52.00

91.00

Profit per unit

3.00

1.00

Overhead cost workings £ Total overheads

240,000

Number of labour hours 120,000

[(15,000 × 2) + (18,000 × 5)] Overhead absorption rate per labour hour (£240,000/120,000)

£2.00

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(a) (2) Activity-based costing method

Overhead cost workings Overhead cost

Cost driver number of:

Total cost driver volume (a)

Cost driver volume − Robin (b)

Cost driver volume − Wren (c)

Total overhead cost

Driver rate

(d)

(e) = (d)/(a)

Total overhead cost for Robin (b) × (e)

Total overhead cost for Wren (c) × (e)

£

£

£ Bought-in parts

Parts

48,000

30,000

18,000

96,000

2

60,000

36,000

Materials handling

Batches

38

20

18

38,000

1,000

20,000

18,000

Sales invoicing

Invoices

1,000

200

800

20,000

20

4,000

16,000

Machine set-up

Set ups

130

40

90

26,000

200

8,000

18,000

Other

Labour hours

120,000

30,000

90,000

60,000

0.5

15,000

45,000

Cost per unit and profit per unit

Labour

(2 × £10)

Materials

Robin

Wren

£

£

20.00

(5 × £10)

25.00

50.00 30.00

Overheads (see above) Bought-in parts

60,000/15,000

4.00

36,000/18,000

2.00

Materials handling

20,000/15,000

1.33

18,000/18,000

1.00

Sales invoicing

4,000/15,000

0.27

16,000/18,000

0.89

Machine set-up

8,000/15,000

0.53

18,000/18,000

1.00

Other

15,000/15,000

1.00

45,000/18,000

2.50

52.13

87.39

Selling price

52.00

91,00

Profit per unit

0.13

3.61

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(b) The calculations above reveal that the differences in total cost per unit for each product do not vary greatly between the traditional full costing approach and the activity-based costing approach. Nevertheless, the profit per-unit calculations reveal that, under the full costing approach the Wren is more profitable than the Robin, whereas under the activity-based method, the situation is reversed.

The profit margin for each product is small, under both costing approaches, and so slight changes in the cost calculation can result in a change in the relative profitability of the products.

Chapter 6 Seine Products Ltd Cash budget for the six months ending 30 June Jan

Feb

Mar

Apr

May

June

£

£

£

£

£

£

zero

19,600

24,500

29,400

34,300

39,200

zero

zero

19,000

23,750

28,500

33,250

300,000

19,600

43,500

53,150

62,800

72,450

Payments to payables

zero

zero

36,000

24,000

28,000

32,000

Labour

8,000

10,000

12,000

14,000

16,000

18,000

Production

17,000

17,000

17,000

17,000

17,000

17,000

Non-production

10,000

10,000

10,000

10,000

10,000

10,000

75,000

Inflows Share issue

300,000

Receivables: current month prior month

Outflows

Overheads:

Fixed assets

250,000

Total outflows

285,000

37,000

65,000

71,000

77,000

15,000

(17,400) (31,500) (11,850)

(8,200)

(4,550)

15,000

(2,400) (33,900) (45,750) (53,950) (58,500)

Net inflows /(outflows) Balance c/fwd

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Workings Finished goods inventories budget for the six months ending 30 June (in units of production).

Jan

Feb

Mar

Apr

May

June

units

units

units

units

units

units

Opening inventories

zero

400

500

600

700

800

Production

400

500

600

700

800

900

400

900

1,100

1,300

1,500

1,700

400

500

600

700

800

500

600

700

800

900

less: Sales Closing inventories

400

Raw materials inventories budget for the six months ending 30 June (in units).

Jan

Feb

Mar

Apr

May

June

units

units

units

units

units

units

Opening inventories

zero

500

600

700

800

900

Purchases

900

600

700

800

900

800

900

1,100

1,300

1,500

1,700

1,700

less: Production

400

500

600

700

800

900

Closing inventories

500

600

700

800

900

800

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Chapter 7 United Industrial Manufacturers (a) Flexing the budget Original

Flexed

budget

budget

20,000

15,000

15,000

£

£

£

Output (units)

Actual

Direct labour

46,000

34,500 (3,750 hours)

35,040 (4,000 hours)

Direct materials

30,000

22,500 (30,000 metres)

23,360 (32,000 metres)

Fixed overheads

66,000

66,000

67,350

142,000

123,000

125,750

Selling price

210,000

157,500

153,900

Profit

68,000

34,500

28,150 F

A

£

£

Sales volume variance 68,000 − 34,500

33,500

Sales price variance 157,500 − 153,900

3,600

Direct labour efficiency variance (3,750 − 4,000) × 9.2

2,300

Direct labour rate variance (4,000 × 4 × 2.3) − 35,040

1,760

Direct materials usage variance (30,000 − 32,000) × 0.75

1,500

Direct materials price variance (32,000 × 0.5 × 1.5) − 23,360

640

Fixed overheads spending variance 66,000 − 67,350

1,350 2,400

42,250 2,400 39,850

Net variances (adverse)

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Budgeted profit 3.4 × 20,000

68,000

Net adverse variances

(39,850)

Actual profit

28,150

(b) The additional information calls into question the validity and usefulness of the two labour variances.

Direct labour efficiency variance In effect this could usefully be divided into two elements, one relating to productive time and the other to ‘idle’ (non-productive) time.

The hourly rate taking overtime premium into account was £9.20 per hour. The basic rate is therefore given by: 0.8H + (0.2H x1.25) = £9.20, where H is the basic hourly rate.

H = £8.76 Of the 4,000 hours worked, only 3,650 were involved in production.

Thus, the efficiency variance can be analysed into two elements: Productive direct labour efficiency variance [(0.25 × 15,000) – 3,650] × 8.76

£876 (F)

Idle time direct labour efficiency variance (4,000 – 3,650) × 8.76

£3,066 (A)

The original direct labour efficiency variance suggested that the labour had not been well managed.

The reassessment indicates that the labour was, in fact efficiently managed during the production time. The large adverse variance arose from the fact that not all of the labour time was productive − which was no fault of the person who manages the labour in this case.

Direct labour rate variance This could usefully be recalculated to take account of the fact that no overtime needed to be worked.

(4,000 × 8.76) − 35,040

zero

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Thus, the recalculation shows that labour was paid the standard rate and there were no savings here.

The original assessment seems to show very great savings. This was because the original was based on overtime rates, whereas (because of the low output) no overtime was actually worked.

Chapter 8 Dolly plc (a) Assessment of the GS7 project Year

0

1

2

3

4

£000

£000

£000

£000

£000

Lease

(100)

(100)

(100)

(100)

-

Plant

(600)

440

660

550

220

(90)

(90)

(90)

(90)

(40)

(20)

10

30

20

(740)

230

480

390

150

Present values

(740)

200

363

256

86

Net present value

165

Contributions (see Workings) Admin costs Working capital

Since the NPV is significantly positive, the project should be undertaken. (b) Internal rate of return – the discount rate that gives a zero NPV We know that this lies above 15 per cent (because NPV is positive at a discount rate of 15%), try 25 per cent: Year

0 £000

1 £000

2 £000

3 £000

4 £000

(740) Present values (740) Net present value (87)

230 160

480 232

390 200

150 61

So an increase in the discount rate of 10 per cent (from 15% to 25%) leads to a change in the NPV of £252,000 (from plus £165,000 to minus £87,000). This is about £25,200 for each 1 per cent (that is, £252,000/10).

So to reduce the NPV from £165,000 to zero would require an increase in the discount rate by about 6.5 per cent (that is, 165,000/25,200). Therefore, the internal rate of return is about 21.5 per cent (that is, 15 + 6.5%).

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Workings Contribution per unit = £1,400 − 100 − 200 = £1,100

Chapter 10 The SVA approach to determining shareholder value will be as follows: Year

FCF

Discount factor

Present value

£m

12%

£m

1

28.0*

0.893

25.0

2

28.0

0.797

22.3

3

28.0

0.712

19.9

4

28.0

0.636

17.8

Total business value

85.0

Less: Loan notes

24.0

Shareholder value

61.0

*The free cash flows will be the operating profit after tax plus the depreciation charge (that is, £12.0m + £16m) The EVA®approach to determining shareholder value will be as follows: Year

Opening capital invested(C)

Capital charge (12% × C)

Operating profit after tax

EVA®

Discount factor 12%

PV of EVA®

£m

£m

£m

£m

1

64.0*

7.7

12.0

4.3

0.893

3.8

2

48.0

5.8

12.0

6.2

0.797

4.9

3

32.0

3.8

12.0

8.2

0.712

5.8

4

16.0

1.9

12.0

10.1

0.636

6.4 20.9

Opening capital

64.0 84.9

Less: Loan notes

24.0

Shareholder value

60.9

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Chapter 11 (a) The objectives of transfer pricing include: 1

Encouraging divisional autonomy. By setting appropriate transfer prices it encourages the idea of departmental autonomy, which may well motivate managerial performance.

2

Promoting organisational objectives. Transfer prices should have the effect of encouraging managers, at a divisional level, to act in such a way that will be beneficial to the objectives of the organisation overall.

3

Assessing relative performance of divisions. By having appropriate transfer prices, the total profit of the organisation can fairly be ascribed to individual divisions and so their individual performances can be assessed.

These three objectives may well be in conflict. A selling price for the output of an intermediate division, which would encourage the idea of autonomy, may cause the buyer division to buy from outside the organisation, when, in fact, internal supply is cheaper from an organisational viewpoint.

The problem can be overcome by having different transfer prices for different divisions for the same product or service, in respect of the same transfer. (b) The ideal transfer price would be one which encouraged the TC division to sell to the HD division, but which at the same time encouraged both divisions to act in a manner, which is in the overall best interests of the business.

If there is an external market for the controller such that the TC division can sell all of its output to the market and the HD division can buy all of its requirements from the market, then the market price is the logical transfer price. This should be adjusted for any cost savings to the TC division resulting from low marketing and transport costs associated with internal supply. This adjustment would encourage internal transfers, because the controllers would be cheaper to HD division.

Internal transfers are more efficient because of the cost savings.

If TC division cannot sell all of its output externally, that is, it has spare capacity, the transfer price needs to be set such that use is made of the spare capacity. This means that the price should lie somewhere between the marginal cost to the TC division and the external price. At that price both divisions have a commercial advantage by internal transfers. Precisely where the transfer price is struck between these two figures is a matter of negotiation. Ultimately senior management may have to impose a transfer price on the two divisions.

Chapter 12 Magpie Ltd The contribution per unit from each additional racquet sold is £10 (that is, £40 − £30). Thus by selling an additional 30,000 racquets, the business will increase its total contribution (and total profit) by £300,000 (that is, 30,000 × £10).

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(a) In the situation where all customers will receive a credit period of four months, the extra investment that is needed will be as follows: £ 350,000

Increase in inventories held (10,000 × £35) Increase in trade receivables

1,200,000 400,000

(120,000 × £40 × 3/12) + (30,000 × £40 × /12) 4

1,950,000 Less Increase in trade payables

350,000

Increase in working capital

1,600,000

Return on investment (300,000/1,600,000)

18.75%

Given the business’s requirement of a 25 per cent return on capital invested, this would not be acceptable. (b) In the situation where only the supermarket will be granted a credit period of four months, the extra investment that is needed will be as follows: £ Increase in inventories held (10,000 × £35)

350,000

Increase in trade receivables (30,000 × £40 × 4/12)

400,000 750,000

Less Increase in trade payables

350,000

Increase in working capital

400,000

Return on investment (300,000/400,000)

75.00%

Thus, the supermarket demands are acceptable only if it is possible to grant the increased credit period to the supermarket and not to existing customers. If existing customers are also give extra time to pay, the required return on investment will not be met. Given the business’s requirement of a 25 per cent return on capital invested, this would be acceptable.

It should be said that 25 per cent seems a very high requirement for a return on capital for this contract. It seems very low risk, given that it involves a binding contract with a large business for a well-established product.

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Progress Test 1 Chapters 1 to 5 This paper is divided into three sections Answer all questions in each section Time allowed − 2½ hours

Total possible marks − 80

--------------------------------------------------------------------------------Section A – Multiple-choice questions Each question in this section is worth 2 marks (Total 20 marks) For each question select the best one of the four options available 1. The key financial objective pursued by most businesses seems to be A Maximisation of shareholders’ (owners’) wealth B Maximisation of profit after tax C Maximisation of sales revenue D Maximisation of the rate of asset growth 2. Consider the following two statements concerning the differences between financial and management accounting: 1. Management accounting reports are often prepared for a specific purpose whereas financial accounting reports usually serve a general purpose.

2. Management accounting reports place less emphasis on objective, verifiable evidence than financial accounting reports.

Which one of the following combinations (true/false) relating to the above statements is correct?

Statement

A B C D

1

2

True

True

True

False

False

True

False

False

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3. Let: S = sales revenue per unit, F = fixed cost per unit, V = variable cost per unit, TF = total fixed cost and BEP = the break-even point (in units).

What is the formula to be used when calculating the break-even point (in units) for a particular product or service?

A BEP = S/(V−F) B BEP = F/(S−V) C BEP = TF/(S − F) D BEP = TF/S−V) 4. Pelican Products plc includes a Squidget in one of its products. The Squidget takes one hour to make has the following costs per unit: Variable cost Fixed cost allocation

£ 10 5 15

If the business decides to purchase the Squidget from an outside source, it can use the spare capacity in the factory to produce Didgits that have a variable cost of £12 per unit and which can be sold for £20 per unit. The Didget takes two hours to make.

What is the maximum amount that Pelican Products should be prepared to pay a supplier for a Squidget?

A B C D

£10 £14 £18 £20

5. Consider the following two statements concerning costs.

1. Direct cost always vary directly with the level of output 2. Fixed cost always stays the same irrespective of the time period involved.

Which one of the following combinations (true/false) relating to the above statements is correct?

Statement

A B C D

1

2

True

True

True

False

False

True

False

False

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6. A business has recently purchased a tonne of PVC material at a cost of £350. The material could be sold immediately for £320 or it could be used as a substitute for another type of material that costs £310 per tonne. The PVC material is in continuous use within the business and its replacement cost is £360 per tonne.

What is the relevant cost of the material?

A B C D

£310 £320 £350 £360

7. Two businesses produce the same product. Relevant information is as follows: Hawk Ltd £20 £6 £1,000 94

Selling price per unit Variable cost per unit Fixed cost per month Planned output (units)

Osprey Ltd £20 £8 £1,000 108

Which one of the following combinations is true concerning the performance of Hawk Ltd relative to that of Osprey Ltd? Break-even point

A B C D

Margin of safety (in units)

Higher

Higher

Higher

Lower

Lower

Higher

Lower

Lower

8. Consider the following two statements concerning cost–volume–profit analysis.

1. The contribution per unit is the difference between the sales price per unit and the fixed cost per unit 2. The marginal cost per unit will usually equal the variable cost per unit.

Which one of the following combinations (true/false) relating to the above statements is correct?

Statement 1

A B C D

2

True

True

True

False

False

True

False

False

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9. To be relevant to a particular decision, a cost must satisfy the following criteria: 1.

2.

3.

4.

It must relate to the objectives of the business It must involve an outlay of cash It must differ between possible courses of action It must be based on objective, verifiable evidence

Which two of the above statements are correct?

A B C D

1 and 2 1 and 3 2 and 4 3 and 4

10. In an activity-based costing approach, a factor that causes costs is known as a A B C D

cost activator cost unit cost driver cost centre

----------------------------------------------------------------------------------------------------------

Section B – Fill in the blanks Each question in this section is worth 2 marks (Total 20 marks) For each question, select the best of the four options to fill in the blanks.

1. A(n) _______ A B C D

cost is always an irrelevant cost when making decisions.

opportunity fixed past indirect

2. An activity with a relatively high fixed cost compared with its variable cost is said to have a high _____________________________________.

A B C D

level of financial gearing level of operating gearing margin of safety contribution-to-fixed cost ratio

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3. ___________ costing is used to describe the way in which we identify the full cost per unit of output where the units of output differ.

A B C D

Batch Full Job Process

4. Activity-based costing (ABC) sees overheads as ___________________________________.

A B C D

being caused by cost units rendering a service to cost units being unrelated to cost units being impossible to control

5. Where a business seeks to make small cost savings during the production phase, the approach is known as costing.

A B C D

kaizen incremental marginal target

6. ________________ costing usually encourages workers to find ways to reduce the unit costs of a product during the production phase.

A B C D

Kaizen Target Activity-based Total life-cycle

7. Analysing a business’s activities into a sequence of value-creating activities is known as value _______________________ analysis.

A B C D

adding chain generation line

8. Under ABC, an overhead cost __________ is established for each type of cost that can be linked to a cost-driving activity.

A B C D

unit pool centre driver

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9. Indirect cost cannot be directly linked to individual cost ____________________.

A B C D

centres drivers units pools

10. When considering a break-even chart, the____________ range refers to the level of possible volumes of activity at which the business might operate.

A B C D

forecast operating planned output relevant

-------------------------------------------------------------------------------Section C Each question in this section is worth 20 marks (Total 40 marks) 1. Machine Makers Ltd (MM) makes specialist machinery to customers’ specifications. Recently, just as MM completed a particular machine for a customer, it received information that the customer had gone bankrupt with no possibility of any payment to MM being seen as likely.

The total contract price was £110,000. The contract specified that payment must be made in stages, as the machine’s manufacture progressed. MM had received £60,000 in progress payments for the machine. It is estimated that the machine could be sold, as it stands, for £80,000.

Another potential customer has been identified for the machine, but this would require alterations to it. Details of the alterations are as follows: 1

Material A. The required quantity is held in inventories. This cost £6,000 when it was bought. It would cost £6,400 to replace it. The material is hazardous and would cost the business £1,000 to scrap it. The business uses it constantly.

2

Material B. By coincidence the appropriate quantity of this material was ordered recently for another contract that was subsequently abandoned because the material was not delivered on time. MM does not normally use this material and its scrap value is £4,000.

The original cost price was agreed at £10,000. Though the contract to buy this material is binding, the supplier will accept £8,000 to compensate for the late delivery. The current market buying price is now £7,000.

3

Material C. 20 units of this material will be required. This is in general use in the business.

An order for 35 units is shortly to be placed for another job. The price for this material is £130 a unit, but the supplier allows a bulk discount of £10 a unit, for the entire order, for orders of 50 units and above.

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4

Labour. 50 hours of labour will be required for the alterations. Labour is a fixed cost to MM, because members of staff are paid in full the normal £12 an hour whether there is work for them to do or not. 20 hours, of the required 50 hours, can be provided by members of staff who currently have no work to do. Only taking staff off other work can provide the remaining 30 hours. This other work is charged out to customers at £30 an hour.

Required (a) Define the terms ‘cost’ and ‘relevant costs’ and describe the type of costs that ‘relevant costs’ may include.

(6 marks) (b) Show, with supporting explanations, the minimum price that MM could charge the customer for the altered machine, such that the shareholders would be no worse off as a result.

(14 marks) (20 marks) 2. Peterkin Ltd makes three products, the ‘Gadget’, the ‘Midget’ and the ‘Widget’. Each of the products requires the use of labour and of materials, including a special material, ‘Material X’.

Manufacturing labour is equally capable of working on all three products.

Demand for all three products has increased strongly over recent months and is expected to remain high.

Information about the products, relating to the foreseeable future, is as follows: Gadgets

Midgets

Widgets

Material X usage (metres per product)

55

25

20

Manufacturing labour (minutes per product)

40

35

50

Selling price (£ per product)

20.00

16.00

20.00

Other materials (£ per product)

1.50

1.00

1.00

Expected demand (units a week)

200

500

200

Manufacturing overheads

----------------- see below --------------

Material X costs the business £0.10 a metre and the manufacturing workers are paid £8 an hour.

The manufacturing workers are all employed on contracts that guarantee all 12 of them a 40-hour week (that is, the manufacturing workers are paid £320 a week, irrespective of the amount of work carried out). There are no other employment costs associated with the workers. It is not possible to expand the staff by employing other manufacturing workers and the existing ones are reluctant to work overtime.

Material X is in short supply and only 30,000 metres a week are expected to be available for the foreseeable future. The business holds no inventories of Material X. Supplies of it are received at the beginning of each week.

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The business incurs manufacturing overheads that are believed to be partially fixed and partially variable with manufacturing labour time. During two recent consecutive weeks, this cost totalled £2,700 in week one and £3,010 in week two.

Output for those two weeks was as follows: Gadgets

Midgets

Widgets

Week one

150

320

160

Week two

150

380

180

There have not been, nor are there expected to be in the foreseeable future, any price changes, either of sales prices or of cost elements.

Required (a) Prepare calculations that indicate whether it is the current level of staffing or the supply of Material X that will constrain the business from meeting the expected demand for the products.

(6 marks) (b) Determine, with clear workings and justification (including assumptions made), the optimal quantity of each product that the business should produce each week.

(8 marks) (c) Determine: (1) the maximum amount that the business should be prepared to pay as an overtime rate to the manufacturing workers, should any of them be prepared to work extra hours; and (2) the maximum amount that the business should be prepared to pay for any additional quantities of Material X. In each case explain how any additional resources would be deployed, if at all.

(4 marks) (d) Explain what steps the business might take to improve its profitability in the near future.

(2 marks) (20 marks)

End of question paper

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Progress Test 1 Chapters 1 to 5 Solutions

Section A 1.

A

2.

A

3.

D

4.

B

5.

D

6.

D

7.

D

8.

C

9.

B

10.

C

Section B 1.

C

2.

B

3.

C

4.

A

5.

A

6.

A

7.

B

8.

B

9.

C

10.

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Section C 1. Machine Makers Ltd (a) A cost is an amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective. Relevant costs are those that relate to the objectives of the business and that vary with the decision. Relevant costs include future outlay costs and opportunity costs. (b) Minimum price for altered machine Cost

£

Explanation

Market value of the machine

80,000

The stage payments are irrelevant. Whether they are repayable or not does not affect the current decision.

Material A

6,400

The cost to scrap and the historic cost are both irrelevant, as the material will need to be replaced.

Material B

4,000

The history of this and the final buying price are both irrelevant, because it will need to be bought irrespective of the current need.

The relevant cost is simply the scrap value.

Material C

2,050

Price for existing order = £130 × 35 = £4,550.

Price for new order = £120 × 55 = £6,600.

The relevant figure between these.

Labour (see below*)

Total

900

is

the

difference

The work done during ‘idle’ time has no relevant cost. The remainder has an opportunity cost of £30 an hour for 30 hours.

93,350

*The labour cost. It could be argued that since the business seems to have some spare capacity at present, it might be possible for the ‘other’ work to be delayed with no incremental cost. This would imply a zero relevant labour cost for the alteration work.

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2. Peterkin Ltd (a) Identification of limiting factor minutes Labour

Gadgets

200 × 40

=

8,000

Midgets

500 × 35

=

17,500

Widgets

200 × 50

=

10,000 35,500

Total minutes available = 12 × 40 × 60 = 28,800 Therefore, labour time is a limiting factor. metres Material X

Gadgets

200 × 55

=

11,000

Midgets

500 × 25

=

12,500

Widgets

200 × 20

=

4,000 27,500

Total metres available = 30,000 Therefore, Material X is not a limiting factor. (b) Manufacturing overheads Minutes worked Week

Gadgets

Midgets

Widgets

Total

1

(150 × 40 =) 6,000

(320 × 35 =) 11,200

(160 × 50 =) 8,000

25,200

2

(150 × 40 =) 6,000

(380 × 35 =) 13,300

(180 × 50 =) 9,000

28,300

Difference

3,100

Difference in the other costs = £3,010 − 2,700 = £310 Difference per minute worked = £310/3,100 = £0.10 = variable cost per minute worked

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Ranking of products

Sales revenue Material X Other materials Manufacturing overheads Contribution Minutes Contribution per minute Order of priority Therefore, produce

and

Gadgets £ 20.00 (5.50) (1.50) (4.00) 10.00 40 0.25 2

Midgets £ 16.00 (2.50) (1.00) (3.50) 9.00 35 0.257 1

Widgets £ 20.00 (2.00) (1.00) (5.00) 12.00 50 0.24 3

500 Midgets using 500 × 35 =

17,500 minutes

200 Gadgets using 200 × 40 =

8,000 minutes 25,500 minutes

66 Widgets (that is, 3,300/50)

3,300 minutes 28,800 minutes

This solution assumes:  strict linearity of variable costs and no steps in fixed costs;  the business’s objective is maximisation of short-term net cash inflows;  no other strategies that could be exploited; and  independence of production and demand for each product. (c) (1) Any additional minutes of labour that could be found would be devoted to Widgets (there is no more demand for the other products). Since Widgets generate a contribution of £0.24 a minute (£14.40 an hour), this is the maximum that should be paid as a total rate for overtime working, that is an overtime premium of £6.40 an hour.

(2) The business should not be prepared to pay anything for extra supplies of Material X since it cannot use any more of it. (d) The business might consider the following steps to improve its profitability:

•

Seek ways of making the products with less labour

•

Look for additional labour

•

Raise selling prices. This will dampen demand to a level that could be met with the existing labour, but generate higher profit.

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Progress Test 2 Chapters 6 to 12 This paper is divided into three sections Answer all questions in each section Time allowed − 3 hours

Maximum marks − 100

---------------------------------------------------------------------------------Section A – Multiple-choice questions Each question in this section is worth 2 marks (Total 20 marks) For each question select the best one of the four options available 1. Which one of the following best describes the direct material price variance?

A The difference between the actual cost of the material used and the actual quantity of material used at the standard direct material cost per unit B The difference between the actual direct material cost and direct material cost according to the flexed budget C The difference between the actual cost of the material used and the standard quantity of material used at the actual direct material cost per unit D The difference between the standard quantity of material used at the standard cost per unit and the actual quantity of material used at the standard direct material cost per unit 2. Which one of the following may account for an adverse labour efficiency variance?

A B C D

Using a higher grade of worker than was planned Change in labour-market conditions between the setting of the standard and the actual event Using higher-grade materials leading to lower wastage rates Poor supervision

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3. Which one of the following best describes the total direct labour variance?

A The difference between the actual direct labour cost and the direct labour cost according to the original budget B The difference between the actual direct labour cost and the direct labour cost according to the flexed budget C The difference between the actual cost of the labour-hours worked and the labour cost allowed (actual direct labour hours worked at the standard labour rate) D The difference between the actual cost of the labour-hours worked and standard direct labour hours worked at the actual labour rate 4. Devril plc is considering the investment in a project that has an initial cash outlay followed by a series of net cash inflows. The business applied the NPV and IRR methods to evaluate the proposal but, after the evaluation had been undertaken, it was found that the correct cost of capital figure was lower than that used in the evaluation.

What will be the effect of correcting for this error on the NPV and IRR figures?

Effect on NPV

IRR

A Decrease

Decrease

B Decrease

No change

C Increase

Increase

D Increase

No Change

5. Dune Ltd is considering a project that will require the use of a crane that cost £600,000 when it was acquired four years ago and which has a current carrying amount (statement of financial position value) of £370,000. If the project is not undertaken, the crane could be sold for £180,000 or it could be used for another project. If it is used for the other project, the business will not have to purchase another crane for £250,000. The business uses the net present value (NPV) method to appraise investment projects.

What is the relevant cost of the machine when calculating the NPV of the project?

A B C D

£600,000 £370,000 £250,000 £180,000

6. Which one of the following methods of investment appraisal uses annual profits (losses) rather than annual cash flows when evaluating investment opportunities?

A B C D

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7. The economic order quantity (EOQ) for inventories can be calculated using the following equation: EOQ = (2WX /Y )

What does Y represent?

A Cost of placing an order B Annual demand for the item of inventories C Cost of holding one unit of inventories for one year D Cost of delivering one unit of inventories to a customer 8. Consider the following two statements concerning risk analysis: 1. Sensitivity analysis provides clear decision rules concerning acceptance or rejection of an investment project.

2. The risk-adjusted discount rate adds a risk premium to the expected rate of inflation to derive a discount rate for investment projects.

Which one of the following combinations (true/false) relating to the above statements is correct?

Statement 1

2

A True

True

B True

False

C False

True

D False

False

9. Antonio plc takes 60 days to pay for goods purchased from its main supplier. To encourage more prompt payment the supplier has offered the company a 3 per cent discount if payment is made within 10 days. However, Antonio plc has refused to accept the offer.

What is the approximate annual cost of the discount foregone?

A 21.9% B 18.2% C 18.0% D 0.4%

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10. Let P = operating profit before tax, Q = operating profit after tax, R = required returns from investors, S = capital invested in the business.

What is the correct formula for calculating Economic Value Added (EVA)?

A EVA = (P/S) × R B EVA = S – (Q × R) C EVA = Q – (R × S) D EVA = P – (R × S) ----------------------------------------------------------------------------------------------------------

Section B – Fill in the blanks Each question in this section is worth 2 marks (Total 20 marks) For each question, select the best of the four options to fill in the blanks.

1. The _____________________ method of investment appraisal does not seek to measure the profitability of an investment project.

A B C D

net present value internal rate of return accounting rate of return payback

2. When evaluating investment projects using the net present value method of investment appraisal, the appropriate discount rate to use is the ___________________________________.

A B C D

required rate of return from investors in the business current rate of return from bank deposit accounts the risk-free rate of return the current return on capital employed in the business

3. The best transfer price for goods or services between divisions is one based on ____________________________.

A B C D

variable cost full cost negotiated price opportunity cost

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4. The residual income approach to measuring divisional performance measurement is closely related to the ________________________method of performance measurement.

A B C D

internal rate of return economic value added return on capital employed payback period

5. The _____________________________ system of inventories control is based on the idea of selective levels of control.

A B C D

ABC just-in-time Enterprise Resource Planning economic order quantity

6. Kaplan and Norton view the ______________ dimension as being ultimately the most important of the four dimensions identified in the balanced scorecard.

A B C D

financial learning and growth internal business process customer

7. Profit is __________________________ when marginal sales revenue equals the marginal cost of production.

A B C D

in equilibrium reduced minimised maximised

8. The accounting rate of return and ___________________________________ adopt the same approach to performance measurement.

A B C D

internal rate of return net present value method return on capital employed ratio net profit margin ratio

9. When evaluating investment projects, the assumed objective of the business is the maximisation of _____________________________________________.

A B C D

profits profitability shareholder wealth sales revenue 97 © Pearson Education Limited 2021

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10. The difference between the original and the flexed budget profit figures is called the __________________________________.

A B C D

sales price variance sales volume variance operating volume variance fixed cost variance

-------------------------------------------------------------------------------Section C Each question in this section is worth 20 marks (Total 60 marks) 1. On 31 December Year 0, Khan Ltd invested in some machinery and started to manufacture a new product the ‘Gadget’. The decision was based on the machinery being capable of producing Gadgets until the end of Year 6 and sales continuing until that time.

Actual sales of Gadgets have not been as buoyant as projected when the investment was being appraised during Year 0. As a result, the business’s management is considering abandoning the project at the end of Year 3, the earliest date at which it would be feasible to do so. You have been asked to prepare calculations and recommend whether to abandon the project at that time or to continue as originally projected until the end of Year 6.

You have discovered the following: (1) The machinery was bought on 31 December Year 0 for £420,000. Were production to be abandoned at the end of Year 3, the machinery would be disposed of for £150,000, on 31 December Year 3. Should the project continue, the machinery would be disposed of in late December Year 6, for zero proceeds.

Depreciation of this machinery has been, and if retained will continue to be, charged at the rate of £70,000 a year.

(2) It has been estimated that the most likely sales levels for the remaining three years of the project will be as follows: Year 4 Year 5 Year 6

Number of Gadgets 2,400 2,400 1,500

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(3) Gadgets are sold for £200 each. This produces a contribution of £80 a Gadget.

(4) The variable costs include £90 a Gadget for materials. The only other element of variable operating cost is labour.

(5) The business also has a longstanding product, the ‘Widget’, for which the market is very buoyant. This uses the same manufacturing labour, paid at the same rate, as the Gadgets. As a result of a shortage of this labour, sales of Widgets are lost when Gadgets are produced. A higher-than-planned output of Widgets has occurred since Year 1, due to the labour released by the Gadget sales shortfalls.

Widgets generate a contribution of £50 each, with a variable labour element of £30.

(6) It is believed that there are no other relevant cash flows associated with the decision.

(7) Given the risk of the project a cost of capital of 15 per cent per year is considered appropriate.

(8) Assume that all operating cash flows arise on the last day of the accounting year concerned.

Required Show calculations that indicate, on the basis of net present value at 31 December Year 3, whether Khan Ltd should abandon Gadget production at the end of Year 3 or continue until Year 6.

(20 marks) 2. Lee Ltd makes a range of products all of which follow a similar production process and have the same cost structure. The products are made in batches that are started at the beginning of the month and are completed and taken into finished goods inventories at the end. There is no work in progress at the end of any month. The business is considering a change in its sales prices, volumes and credit terms.

Current position Sales revenues are £0.3 million a month and produce a contribution of 40p per £1 of sales revenue. Variable raw material costs account for 20p per £1 of sales revenue. Fixed costs are £120,000 a month, of which £30,000 is depreciation. The business’s only variable costs are production costs.

Trade receivables take one month to pay, trade payables for raw materials are paid one month after purchase and the other variable costs are paid during the month of production. At the end of each month the business has sufficient raw material inventories to meet the following month’s production and enough finished inventories to meet the following month’s sales.

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Possible future position Production and sales volumes would be increased by 50 per cent. To generate the increased demand, selling prices would be reduced by 10 per cent and trade receivables would be allowed to pay two months after the sale. Neither the usage, nor the cost per product of raw materials and other variable costs would be affected by the proposed expansion. Apart from the increased trade receivables payment period, all working capital policies would remain the same as at present. The changes to sales volume, price and payment period, were they to occur, would commence with sales made from 1 December this year, but to meet the business’s working capital policies there would be effects on cash flows before that time.

The business’s balance at bank at 1 October is expected to be £70,000.

Required (a) Prepare Lee Ltd’s cash budgets for each of the months of October, November and December this year and January and February next year, on the assumption that the proposed expansion of sales goes ahead.

Note: Ignore interest

(15 marks)

(b) Discuss the effects of the expansion plans on the business’s working capital levels and profitability.

(5 marks) (20 marks) 3. Casharry Ltd is a wholesale business. Summaries of the its most recent draft income statement and balance sheet are as follows: Income statement for the year ended 31 December last year £000 Sales revenue

1,806

Cost of sales

(1,304)

Gross profit

502

Other operating expenses

(218)

Operating profit

284

Interest

(22)

Profit before taxation

262

Taxation

(76)

Profit after taxation

186

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Statement of financial position (balance sheet) as at 31 December last year £000 Non-current assets at cost Accumulated depreciation

1,428 (590) 838

Current assets Inventories

384

Trade receivables

404 788 1,626

Total assets Equity Ordinary share capital

400

Revenue reserves

492 892

Current liabilities Trade payables

520

Bank overdraft

214 734

Total equity and liabilities

1,626

Trade receivables and trade payables increased by 10 per cent by value during last year. The value of inventories stayed the same. The finance director believes that inventories levels are too high and that they should be reduced. All trade payables relate to cost of sales Assume a 365-day year.

Required (a) Calculate the average operating cash cycle (in days) during last year and explain to what use this measure could be put.

(8 marks) (b) Discuss whether there is evidence that the business has a liquidity problem.

(4 marks)

(c) Explain the types of risk and cost that might be reduced by following the finance director’s proposal to reduce inventories levels.

(8 marks) (20 marks)

End of question paper

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Progress Test 2 Chapters 6 to 12 Solutions

Section A 1.

A

2.

D

3.

B

4.

D

5.

C

6.

B

7.

C

8.

D

9.

A { [365/(60 − 10)] × 3%}

10.

C

Section B 1.

D

2.

A

3.

D

4.

B

5.

A

6.

A

7.

D

8.

C

9.

C

10.

B 102 © Pearson Education Limited 2021

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Section C 1. Khan Ltd (NPV) Differential costs of continuing 31 December

Year 3

Year 4

Year 5

Year 6

£

£

£

£

(72,000)

(72,000)

(45,000)

150,000

(72,000)

(72,000)

(45,000)

Discount factor

1.000

0.870

0.756

0.658

Present values

150,000

(62,640)

(54,432)

(29,610)

Net present value

3,318

Disposal proceeds

150,000

Contributions (see Workings)

Therefore, ‘bail out’ of the project at the end of Year 3.

Workings Labour cost per unit of Gadgets = £200 – 80 – 90 = £30. Thus for each Gadget produced, one Widget sale is lost and the net contribution for each Gadget = £80 − £50 = £30 Units

Contributions £

Year 4

2,400

× £30 =

72,000

Year 5

2,400

× £30 =

72,000

Year 6

1,500

× £30 =

45,000

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2. Lee (a) Cash budget for the five months ending 28 February next year Oct

Nov

Dec

Jan

Feb

£000

£000

£000

£000

£000

300

300

300

-

405

Trade payables (workings)

60

90

90

90

90

Other variable costs (workings)

120

180

180

180

180

Fixed costs (excl. dep’n)

90

90

90

90

90

270

360

360

360

360

Surplus/(deficit) for month

30

(60)

(60)

(360)

45

Cash balance

100

40

(20)

(380)

(335)

Receipts Trade receivables (workings) Payments

Workings Current sales revenue = £3.6m a year. = £300,000 a month.

Future sales revenue = £300,000 × 1.5 × 0.9 = £405,000 a month.

Current raw material cost = £300,000 × 0.2 = £60,000 a month.

Future raw material cost = £60,000 × 1.5 = £90,000 a month.

Current other variable cost = £300,000 × (1 – 0.4 − 0.2) = £120,000 a month.

Future other variable cost = £120,000 × 1.5 = £180,000 a month.

To have the necessary finished inventories in place for 1 December, it will be necessary to increase production during November, and to have the required raw material inventories in place for 1 November it will be necessary to increase purchases during October. (b) Current position Profit Profit per month (after depreciation) = (0.4 × £300,000) – £120,000 = zero, that is, break even Working capital RM inventories = one month’s usage = £60,000 FG inventories = one month’s usage = £60,000 + 120,000 + 120,000 = £300,000 (assuming valued at full cost) 104 © Pearson Education Limited 2021

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Trade receivables = one month’s sales revenue = £300,000 Trade payables = one month’s purchases = £60,000 Net working capital of £600,000 Possible future position Profit Profit per month = (£300,000 × 1.5 × 0.9) – (180,000 × 1.5) – 120,000 = £15,000 a month Working capital RM inventories = £60,000 × 1.5 = £90,000 FG inventories = £300,000 × 1.5 = £450,000 (assuming valued at full cost) Trade receivables = two months’ sales revenue = £405,000 × 2 = £810,000 Trade payables = £60,000 × 1.5 = £90,000 Net working capital of £1,260,000 The current position only breaks even; the increased sales should lead to a £15,000 a month or £180,000 a year profit.

There will be a large increase in working capital (£1,260,000 − £600,000 = £660,000). Without knowing how much is invested and the risk involved, it is impossible to assess how acceptable this level of profitability is.

3. Casharry Ltd (WC) (a) Operating cash cycle days Inventories holding period 384/1,304 × 365

107

Trade receivables period 404 × (105/110)/1,806 × 365

78 185

Trade payables period 520 × (105/110)/1,304 × 365

(139) 46

(Since the level of inventories was the same at both ends of the year, purchases equal cost of sales)

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(Note: Since the trade receivables and trade payables are 10 per cent higher at the end of the year than at the beginning, the average figure for last year is the start of year one × 105/110.)

Knowledge of the length of the operating cash cycle (OCC) enables the business to monitor it over time, perhaps relative to other businesses or some target. It is not possible to draw any helpful conclusion from looking at just one figure; there needs to be a basis of comparison.

A problem with using the ‘bottom line’ figure for the OCC is that values within it are not equivalent. In the case of Casharry for last year, one day’s sales are worth £4,948, whereas one day’s purchases or inventories holding are worth £3,572. So, while an extra day of trade receivables period coupled with an extra day of trade payables period would leave the OCC unchanged, it would involve an additional £1,400 or so of investment in working capital. (b) As mentioned in (a), knowledge of the number of days of the OCC tells us little without some basis of comparison.

The acid test (quick assets) ratio for this business is very low at 0.55:1 (trade receivables divided by payables plus overdraft (404/(520 + 214) = 0.55). Were the inventories fairly fast moving with a short trade receivables period, this may not be a worry, but as it stands this is a concern.

The current ratio is close to 1:1 (788/734 = 1.07), which looks low, but it is not possible to say too much without a comparison with similar businesses or this business over time.

The level of the overdraft looks worrying. It represents almost 20 per cent of the total financing of the business, according to statement of financial position (balance sheet) values. The statement of financial position may well understate the value of equity, but it still seems a lot of short-term finance that could be recalled instantly, which in practice probably means a couple of months.

A term loan may be a better arrangement than an overdraft.

The level of trade payables also seems high, compared with trade receivables. This too could be a problem. It depends on the relative market positions of Casharry and its suppliers.

Overall, the liquidity does not look strong and probably needs to be reviewed. It is not possible to be too dogmatic on this with very limited bases of comparison. (c) The types of risk and cost that might be associated with high inventories levels of a wholesaler include:

•

Financing cost. Inventories normally need to be financed. Usually buying on free trade credit covers some of this. In Casharry’s case, at present at least, trade payables are greater than the value of inventories. The credit is linked to purchases not inventories levels, so were inventories levels to be reduced, the level of payables need not be lessened.

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•

Storage costs. These are likely to be less where inventories are lower. How significant these costs are is likely to depend on the nature of the inventories. Inventories that are high value and/or need special treatment are typically more expensive to store than other inventories.

•

Insurance cost. This is likely to be subject to the same considerations as storage cost, of which it can be seen as being part.

•

Obsolescence cost. The more inventories held, the greater the risk that they will lose value either through physical deterioration or through becoming obsolete. A spare part for a machine no longer used may be in perfect condition and, in principle, as capable of being used. If the machine is no longer being used, the spare part may be worthless.

•

Physical deterioration cost. Inventories that perish, such as many foods, can lose value and the higher the level of inventories, the higher the potential cost.

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Tutorial/seminar questions Chapter 1 1. Fox and Co is pursuing the generally accepted goal of maximisation of owners’ wealth. In an attempt to achieve this, the management has decided to cut costs by reducing staff salaries.

Would this action be expected to achieve its purpose? Explain why or why not.

What general conclusion can be reached about the business’s goal and the treatment of other ‘stakeholders’ (groups involved with the business)?

2. ‘It seems sensible that a business should provide its managers and owners with financial information about itself, but why should it feel the need to supply society more generally with this information.’

Comment on this statement.

3. Broadly, all of the groups that were identified in the chapter as being users of accounting information about a business, except for the managers of the business, tend to have access to the same items of accounting information. This is typically the traditional annual accounting statements (the income statement, the statement of financial position (balance sheet) and the statement of cash flows). The managers, on the other hand, have access to all the information that they want.

Why are managers treated so much better in the provision of accounting information than the other groups?

4. A business, whose shares are listed (able to be bought and sold) on the London Stock Exchange, announces that it made more profit this year than it did last year.

Will the price of the shares go up or down? Explain your answer.

Who are the buyers and sellers of shares?

Chapter 2 1. Why is it wrong, to take account of the historic cost of an asset in making a decision about that asset’s future?

2. A business bought a machine three years ago for £12,000. The future of this machine is now under consideration.

Can £12,000 ever be the relevant cost of this machine in the context of the current decision?

3. A business has some components (code named X15) for which it paid £3.50 each when this was bought a month ago.

Is the £3.50 the ‘past’ cost, the ‘historic’ cost or the ‘sunk’ cost?

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4. The components in Question 3 (above) (X15) need to be used in a contract that is currently under consideration. This component now has a replacement cost of £3.40 each and is in constant use by the business. It could be sold for £3.00. It could be used as a substitute for another item of inventories, which will cost £3.15, needed elsewhere in the business.

What is the opportunity cost of each X15 for the contract?

Explain why.

Chapter 3 1. ‘Where a business activity has both fixed and variable costs, as volume alters the variable cost per unit of output stays the same, but the fixed cost per unit changes.’

Comment on this statement.

2. Could the marginal cost of some business activity ever be negative?

Explain your answer.

3. When there is a scarce resource, we undertake the activity that has the highest contribution per unit of the scarce resource.

Explain, with a numerical example, why this is correct and that it would be incorrect to select the activity with highest contribution per unit of output.

4. For a particular business activity, labour is a variable cost (staff are paid by the unit of output).

What factors could cause the (variable) labour cost not to be constant per unit of output?

Chapter 4 1. A business provides only one standard service.

What is the value to this business of distinguishing between direct and indirect costs? Explain your answer.

2. A business makes suitcases of various sizes.

Is the rent of the factory a direct or an indirect cost?

3. ‘Direct costs are always variable relative to the level of output, indirect costs are always fixed.’

Comment on this statement, providing examples to illustrate your points.

4. Research evidence shows that the direct-labour-hour basis of overhead absorption by cost units (products) is the most popular basis used in practice.

Is it a logical basis? Explain your answer.

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Chapter 5 1. ‘Activity-based costing follows the broad principle that the higher the level of activity, the lower the full cost per unit of output.’

Comment on this statement.

2. What principles underpin the ‘total life-cycle costing’ approach?

3. Research evidence tends to indicate that activity-based costing is not very popular in the United Kingdom.

Can you offer any possible reasons for this?

4. It is said that modern production of both goods and services tends to have a high level of indirect cost relative to direct costs.

Why should this be true? Will it necessarily be true of all types of production?

Chapter 6 1. What principles underpin activity-based budgeting (ABB)?

How does ABB differ from traditional budgeting?

2. The chapter says ‘…..the sales budget may be broken down into a number of subsidiary budgets, perhaps one for each regional sales manager. The overall sales budget will be a summary of the subsidiary ones’.

Why might a business have these subsidiary budgets?

3. Two of the identified uses of budgeting are

•

It can be used to help co-ordination between the various sections of the business.

•

It can motivate managers to better performance.

How might these two uses be in conflict with one another?

4. If you were preparing a cash budget for your personal life, what pieces of information would you find useful for it to highlight?

How would your answer differ if you were drawing up a cash budget for your business?

Chapter 7 1. It seems that traditional variance analysis has lost some popularity among UK businesses, over recent years.

Why might this be the case?

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2. Real World 7.8 suggests that a large proportion of UK businesses surveyed use standard costs to help in constructing budgets.

How would a business use standard costs in this way?

Would it be logical to do this?

3. We often hear people say such things as ‘I am on a steep learning curve’. By this they usually seem to mean that they have a lot to learn in a short time.

Is this a correct use of the expression ‘learning curve’? Explain?

4. Evidence tends to show that many UK businesses make the decision on whether to investigate a particular variance on the basis of managerial judgement, presumably on a case-by-case basis.

What are the arguments for and against such an approach?

Chapter 8 1. Real World 8.7 indicates that UK businesses tend to use one or more of the main approaches to investment appraisal.

Why might businesses use more than one method?

2. ‘The objective of discounting future cash flows in an NPV assessment is to allow for inflation.

If we could eliminate inflation, we need not discount.’

Comment on this statement.

3. In NPV we need to discount future cash flows using the opportunity cost of finance.

What is meant by the opportunity cost of finance?

4. The payback method is criticised for failing to take correct account of the time factor. Despite this, the measure is expressed in terms of years.

How can we reconcile these two points?

Chapter 9 1. ‘A sensitivity analysis of a risky project provides a set of figures that gives the decision maker clear guidance as to what decision to make.’

Is that a fair assessment of a sensitivity analysis?

2. ‘The expected value of the outcome of a project is the single value for the outcome that is most likely to occur.’

Comment on this statement.

3. ‘Subjective probabilities tend not to be helpful to the decision maker because they are only based on the opinions of various individuals, not on measurable facts.’

Is this statement true?

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4. ‘A ‟risk premium” is an amount paid annually to an insurance company to insure against some risk.’

Is this true?

Chapter 10 1. Hughes plc, a mail order retailer, is in the process of surveying customer satisfaction through questionnaires to all of its customers.

Is this a value-adding activity, in the context of value-chain analysis?

2. ‘‟Penetration pricing” is a strategy where a new product is priced high when the product is first introduced until those who will buy at that price (the least price resistant group of consumers) have been exhausted. The price is then dropped until demand from the next group of consumers has been exhausted and so on. In this way the business is able to penetrate the market by stages.’

Comment on this statement.

3. Why might a business find EVA® more useful than the unadjusted traditional financial statements?

4. ‘Customer profitability analysis is a technique for assessing the extent to which each customer could be capable of coping with the business raising its prices. It is a way of assessing the likelihood that a customer would look for alternative sources of supply, should the business increase its prices.’

Comment on this statement.

Chapter 11 1.

Marks and Spencer plc uses a standard cost of capital and, where M and S owns the branches’ premises, notional rent charges to assess the RI of its branches.

How might M and S decide on these two measures and what problems could it bring to the acceptability to branch managers of being assessed through RI?

2.

Two of the generally accepted objectives of transfer pricing are promoting departmental independence and promoting the optimisation of profits for the business.

How could achievement of one of these two objectives conflict with achieving the other?

3.

What is the ideal transfer price basis?

Can charging full cost, plus a profit loading, ever be consistent with the ideal basis?

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4.

In the chapter a point was made that a business that has operations in two countries can use its transfer pricing policy to make the bulk of its profits in the country with the lower rates of taxes on business profits.

How would a business achieve this?

What approach could the tax authorities in the higher tax rate county take to trying to deal with this?

Chapter 12 1. Why is working capital a particularly important area of concern for managers?

2. How does ‘obsolescence’ represent one of the costs of holding inventories?

3. A manufacturing business is considering the introduction of a ‘just-in-time’ approach to dealing with its raw material inventories.

What issues should the business be confident about before it goes ahead with such an approach?

4. Evidence indicates a wide range of average trade receivables /trade payables settlement periods.

What factors are likely to determine the average for these periods for an individual business?

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Outline solutions to tutorial/seminar questions Some of the questions and/or the answers to them go beyond what is contained in the chapter concerned. This was deliberate and done in an attempt to broaden out discussion.

Note that these solutions are very brief and are intended to highlight the main points. These can be filled out in discussion.

Chapter 1 1.

•

Possibly lead to lower costs (and higher profits) in the short term.

•

Almost certainly lead to dissatisfaction among workforce.

•

Likely to lead to lack of staff motivation, leading in turn to less-efficient working.

•

Also likely to lead to staff leaving, higher recruitment costs and possibly staff shortages and/or lower-quality staff.

•

Net effect lower future profitability and loss of shareholder wealth.

•

General conclusion: failure to treat all stakeholders reasonably is likely to lead to loss of owners’ wealth.

2.

•

Businesses are allowed to operate by society (that is, the population).

•

If society requires accountability from businesses, businesses must provide it or cease operations.

3.

•

Probably the other groups have accepted the traditional annual financial statements (IS, S of FP and CFS), as a result of custom and practice.

•

In most cases, the groups have no legal right to accounting information except that most UK businesses must make their annual financial statements available to the general public.

•

Managers are in a special position of having access to the information, in a way that no other group has. This is a purely practical point. Managers may or may not be seen as the most important group, but they are the only ones with direct access, in many cases.

•

It could be argued that managers have a need for more information than the other groups since it is they who have to run the business on a day-to-day basis.

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4.

•

It depends on what investors were expecting. The profit may be bigger this year than last, but it is bigger or smaller than was expected?

•

Share prices react to the laws of supply and demand. If the future of the business looks better than was expected, this will increase demand and price will tend to go up.

•

The buyers and sellers of the shares are investors; not, except rarely, the business itself.

•

Some investors are ordinary individuals who have a bit of money to invest. In the United Kingdom, however, most of them are institutional investors such as insurance businesses and pension funds.

Chapter 2 1.

•

Any decision about the future use of some asset already owned by the business can only be made in relation to options for using the asset in the future. Not having bought the asset in the first place is not such an option. It might be that the supplier would take the asset back and refund an amount equal to the historic cost (unusual in practice), but even here the relevant amount for decision making is the disposal value. It just happens to be the case that this equals the historic cost in this case. This means that the historic cost can never be a relevant cost in a decision about the asset’s future value.

2.

•

The £12,000 historic cost can never be the opportunity cost.

•

Some option for using the machine may have an opportunity cost of £12,000, but this will only be coincidence.

3.

•

The £3.50 per-unit cost is all three; the past cost, the historic cost and the sunk cost.

4.

•

The relevant cost is £3.40. If these components are used on the present contract, it will need to be replaced at this cost as it is constantly used elsewhere.

•

Since it would not be used as a substitute for the other inventories item, nor sold, the £3.15 and £3.00 values are not relevant.

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Chapter 3 1.

•

The statement is true. The variable cost of each unit is the same irrespective of level of output.

The effective fixed cost per unit reduces as the level of output expands and increases as it contracts.

•

This assumes that variable costs are strictly linear – for example, no economies of scale. It also assumes that fixed costs remain fixed over the entire range –no ‘steps’ in the fixed costs.

2.

•

Yes it could. The marginal cost is the cost of producing one more unit of the service or product.

•

For example, a major variable cost could have bulk discount that only arises after a certain level of activity. Another example is where some item of inventories can be used in production and the alternative is to scrap it with a disposal cost. This could lead to an overall negative marginal cost.

3.

•

Imagine that a business renders two services (both with very heavy demand), with the following profiles: Service A £ 100 60 40

Selling price per unit Variable costs Contribution per unit

Service B £ 70 40 30

Both services require the input of a particular type of employee who has special skills. The business employs six of these each working a 35-hour week (210 hours in total). Service A requires 30 minutes (0.5 hours) of the skilled staff and Service B 20 minutes (0.33 hours).

Contribution per hour

80 (£40/0.5)

90 (£30/0.33)

This means that the business should choose to render Service B in preference to Service A, despite the fact that the latter has the higher contribution per unit of the service provided.

To prove this point: Possible contribution per week for Service A = £40 × (210/0.5) =

£16,800

Service B = £30 × (210/0.33) =

£21,000

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This shows that Service B more effectively uses the scarce employees’ time than does Service A, despite Service A having a higher contribution per unit of service rendered.

4.

•

Labour cost per unit could increase with volume if a shortage were created. At the level of the business itself, this might be caused by a need for employees to work beyond their normal commitment, giving rise to overtime rates of pay. Major expansion could cause a more general shortage of labour in the area, again leading to higher rates of pay.

•

Labour cost per unit could decrease as a result of economies of scale being available at higher levels of output. Staff may be able to work more efficiently where higher levels of output are involved.

Chapter 4 1.

•

In these circumstances there is no benefit in distinguishing between direct and indirect costs.

•

Distinguishing between these two types of cost is only of value in deriving the full cost of cost units, where these cost units are identical to one another.

•

To derive full cost in an environment where there is a single standard product (a ‘process costing’ situation) we need simply to divide the total cost by the quantity of output to discover the full cost per unit of output, because all output is identical.

2.

•

It is impossible to answer this question. We do not know what is being costed.

•

Whether a cost is a direct or an indirect one depends on what is being costed.

•

If it is the full cost per suitcase, factory rent will be an indirect cost.

•

If the objective is to ascertain the full cost of production for a period, factory rent will be a direct cost.

3.

•

This statement is incorrect.

•

There is no link between behaviour of costs in the face of changing volumes of activity (variable and fixed) and the extent to which a cost may be unequivocally ascribed to a particular cost unit.

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•

Whether a cost is direct or indirect depends only on the thing being costed; whether costs are fixed or variable is not related to this.

•

In some activities labour is a direct cost, but it is rarely a variable cost.

•

Machine maintenance costs are indirect costs in the context of ascertaining the full cost of individual units of output, but they may well be variable (or partly variable) with the level of output.

4.

•

There is no correct basis for overhead (indirect cost) absorption by cost units.

•

A time-based measure is probably fairly logical since nearly all, if not all, overheads are time based. Rent, insurance, managerial and support staff salaries and so on are characterised by the fact that the cost for two hours is twice that for one hour.

•

The direct labour hour basis may well be logical where the overheads relate to direct labour; for example, managing and supporting direct labour. This basis has the merit that in deriving the direct costs, the direct labour hour element of each cost unit will need to be identified, so the information is available.

Chapter 5 1.

•

The statement is completely incorrect.

•

ABC is an approach to full costing where the overheads are analysed to determine which business activities caused them.

•

The overheads are then ascribed to cost units according to the extent that they caused (or drove) those overheads.

2.

•

Total life-cycle costing attempts to control costs by analysing the costs that will be incurred over the entire life of the product.

•

The life is divided into three phases: pre-production, production and post-production.

•

A particular feature of this approach is recognition of the fact that, with many products, a large proportion of the total costs are incurred or committed at the pre-production phase.

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3.

•

It is time consuming to carry out the necessary analysis.

•

Everyone may not understand the results quite as easily as the traditional approaches to dealing with overheads.

•

There is doubt as to the usefulness of full costing in decision making, so a complicated approach would tend to be regarded as unnecessary, even if it is seen as being better.

4.

•

Modern businesses tend to be mechanised and, therefore, have very high depreciation, servicing and power costs.

•

There also tends to high costs of personnel and staff welfare.

•

There tend also to be very low, or no, direct labour costs.

•

Direct material cost often remains an important element of total cost, but efficient production methods tend to lead to less waste and, therefore, to a lower total material cost.

•

In some more traditional, high labour-intensive activities (such as the services provided by solicitors, house builders and medical practitioners), there may not be the scope for capital intensity of, say, motor car manufacture, but there are still likely to be some mechanisation and staff welfare/training costs that are likely to be sizeable. There would appear to be few activities where a general trend away from direct costs towards indirect ones is entirely absent.

Chapter 6 1.

ABB follows the same logic as activity-based costing. This is that overhead costs should be carefully analysed to discover what activities are causing them. This enables the cost units (units of output) to be charged with the costs that they cause. This differs from the traditional approach where overheads are linked to cost units in a much less ‘cause and effect’ manner.

ABB sets plans for individual cost pools so that mangers can be held accountable for the costs that the activities under their control give rise to.

2.

•

The subsidiary budgets define the target for individual sales managers. It is claimed that a feature of good budgeting practice is for all managers to have their own budget.

•

In practice the overall sales budget is usually built up from the individual subsidiary areas.

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3.

•

It is generally thought that providing managers with demanding but achievable targets tends to motivate. It is possible to imagine circumstances where providing a particular manager with a demanding target will lead to a lack of co-ordination. For example, encouraging a production manager to produce a quantity of a component that is beyond the needs of the assembly department.

4.

•

Total inflow of cash, with detail of various sources, for example: from parents, from wages/salary, from student loan and so on.

•

Total outflow of cash, broken down into various areas of expenditure, for example: rent, food, entertainment, travel and so on.

(Showing detail of receipts and expenditures would enable a comparison to be made with the actual to see if plans are being met.)

•

Total receipts and expenditures would helpfully be identified for each month, or possibly, each week.

•

Monthly or weekly surplus (deficit) of receipts over payments and the running bank balance.

•

This is much the same as a business would seek to do, except that most of the precise sources and uses of cash will be different.

Chapter 7 1.

•

Variance analysis can be quite complicated and expensive to apply.

•

It cannot easily be applied to some areas of business, for example: advertising, training and so on and these areas of discretionary spending are becoming more important in the modern business.

2.

•

In effect, standards are the ‘budgeted’ or planned value for various inputs and outputs of the business’s operations.

•

It would, therefore, be entirely logical to use standards as the building blocks of the budget.

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3.

•

No it is not the correct use of the expression.

•

A learning curve is a graph of average time taken to complete a repetitive task (like handling insurance claims) against the total cumulative number of identical tasks (claims handled) by a particular individual new to the task. Experience shows that people ‘learn’ to complete the task more quickly the more times that they do it, but at a decreasing rate. This means that the time saved when handling the second task, relative to the first, is greater than that saved when handling the eleventh relative to the tenth. At some point no further ‘learning’ occurs and all tasks take the same length of time.

•

The circumstances in which the expression is often used (misused) have nothing to do with completing repetitive tasks.

4.

•

There is no theoretical rule on what should be done about variances, but managers can set out some guidelines to be regularly applied. Alternatively they can just treat each case on its merits.

•

Having a set of guidelines can lead to consistency of approach, based on careful consideration.

Failure to apply a set of pre-established guidelines could lead to particular employees feeling aggrieved and victimised if the variance for which they have responsibility is investigated, while others are left uninvestigated.

•

A problem with any set of pre-established set of guidelines is that they may not relate to a particular set of circumstances that were not envisaged when the guidelines were being established.

•

One approach might be to establish a set of guidelines, but be prepared to revise them should they appear inadequate. It might also be helpful to be prepared to bypass the guidelines if they appear inappropriate in a particular set of circumstances.

Chapter 8 1.

•

It may be felt that each method offers a different perspective on the investment project and that this can be useful.

•

Once the data relating to the project have been estimated, the effort to use it in more than one method is not great, so there is little reason for not looking at the results from more than one method, if that is felt to be useful.

•

On the other hand, for a business that is pursuing a wealth maximisation objective, only NPV is really valid and looking at the results of the other methods might confuse the issue.

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2.

•

The statement is incorrect.

•

The objective of discounting is take account of the time value of money – or, to put it another way, to take account of the cost of financing the project. The cost of capital used in the investment appraisal takes account of the prevailing interest rate, which is itself affected by the presumed rate of inflation, and an allowance for risk – a risk premium.

•

If there were no inflation predicted, the cash flows would need to be discounted by a factor that took account of an inflation-free interest rate and a risk premium.

3.

•

Opportunity cost has its usual meaning here. That is the benefit foregone by failing to take up the next best opportunity.

•

In the context of the cost of finance, the OC of F is the rate of return that could be generated from another investment of similar risk to the one under consideration.

4.

•

PP is the length of time that a project takes to repay its initial investment. To this extent time is involved.

•

The problem with PP is that it takes no account of the time value of money. It treats each £1 of cash flow (positive or negative) as being equally valuable. No distinction is made between £1 paid or received at one time and £1 paid or received at another.

•

Failing to make this distinction ignores the financing cost of the project and so ignores a major effect on the wealth of the owners of the business.

•

Since wealth enhancement is generally seen as the key financial objective, this is a major defect of PP

Chapter 9 1.

•

SA provides the decision maker with a set of figures of the value for each input that will give a zero outcome (for example, the NPV), assuming that all other inputs turn out to be as predicted.

•

SA does not provide the decision maker with clear guidance. It gives the decision maker a feel for the project, but it provides no clear decision rule. At best, it gives an impression that may well help in making the final decision.

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2.

•

The EV of a project is the average, weighted according to likelihood of occurrence, of the possible outcomes for the project. It is not the most likely outcome.

•

As an average, EV is very likely not to be equal in value to any of the possible outcomes.

3.

•

SPs are based on opinions, but they can be very helpful if they are opinions of unbiased experts.

•

Objective probabilities may seem to be more valuable because they are based on observable facts, but these are facts about the past. Such facts may or may not provide guidance about the future and so must be used with care.

4.

•

An RP is normally an addition to the basic cost of capital (finance) to take account of the riskiness of an investment project.

•

The higher the level of risk is perceived to be, the larger the RP should be. Quite how risky a project is, however, is difficult to assess, though there are statistical techniques that can be used to guide the decision maker.

Chapter 10 1.

•

This is not a value-adding activity.

•

To be a value-adding activity, the value of a particular product has to be increased, in terms of increasing its potential selling price, or moving it closer to a position where it can be sold.

•

Surveying customers’ opinions can be a very valuable activity, but in the context of value-chain analysis, it is not a value-adding activity.

2.

•

The statement is incorrect.

•

What is described in the statement is not penetration pricing, but ‘price skimming’.

•

Penetration pricing is a strategy where the product is priced cheaply until it has gained acceptance in the market/good market share.

•

This approach would dissuade other providers from entering the market.

•

The price is then increased to more profitable levels.

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3.

•

EVA® tends to be more objective and less biased that traditional profit measurement, which is usually heavily affected by the prudent nature of accounting.

•

It is more clearly focussed on the primary business objective than is the traditional income statement.

4.

•

This is not a fair description of customer profitability analysis (CPA).

•

CPA has nothing to do with how profitable the business of the customer is.

•

CPA assesses how profitable each customer is to the business, given the size and frequency of orders, delivery requirement, length of credit taken and so on by the customer.

•

Generally if a business raises its prices in a way that makes it uncompetitive with its rivals, customers will take their business to a competitor. This is irrespective of how profitable individual customers’ businesses might be.

Chapter 11 1.

•

The standard cost of capital is likely to be based on what the business has to pay for the funds that it uses. This requires an assessment of the cost of equity capital and of borrowings and averaging according to how much (in value) of each it is financed by.

•

The notional rent would be based on the rent paid at branches not owned by M and S and/or the prevailing rental charges in the location in which a particular branch operates.

•

Branch managers may call into question the validity of the finance charge on the basis that the calculation requires some judgements to be made. They could also argue that their branches are less risky operations than M and S as a whole and should, therefore, be subjected to a lower charge.

•

The value placed on the net assets at each branch could also be a matter for debate.

•

Similarly, the notional rent charge must rely on some judgements and these can be called into question.

•

It is natural that managers who are to be assessed on a measure (RI) that is calculated using some partly subjective values will query those values.

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2.

•

The problem is that a department, acting independently in its own best interests, could conflict with the overall profitability of the business.

•

For example, a department may find that the price for a service is cheaper from an outside supplier than from another internal, department. Departmental autonomy dictates that the department should buy the service from outside. This, however, may lead to the other department not being able to sell all of its capacity. This may well mean that the business, as a whole, is less well off.

3.

•

Probably the ideal TP is the market price. This requires that there is a market into which the supplying department can sell and from which the buying department can buy. This represents the opportunity cost/price. This, unfortunately, is probably relatively rare in practice.

•

Full cost, plus a profit loading, is usually a poor basis of TPs. The full cost simply passes on the inefficiencies of the selling department.

4.

•

Take for example a car manufacturer that produces the engines in its UK plant, which is a separate UK business, but wholly owned by the manufacturer. The engines are transferred to the manufacturer’s Spanish assembly plant, a wholly owned subsidiary business registered in Spain, for incorporating into the finished car. Assume that the Spanish rate of corporation tax is higher than the UK one.

•

Here the manufacturer would have a high transfer price for the engines. In this way the UK business would make a relatively large profit and be taxed on that.

•

The Spanish business would make a relatively low profit because of the high-priced engines and would be taxed on that profit.

•

The Spanish tax authorities would probably seek justification of the transfer price for the engine. They might well compare this transfer price with the prices at which Spanish-produced engines, of comparable quality, are available in the market.

•

The UK tax authorities would, presumably, be content to receive their inflated tax from the manufacturer.

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Chapter 12 1.

•

WC usually involves very significant amounts of finance, so wrong decisions can have profound effects.

•

Businesses that fail do so as a result of WC deficiencies, though there may be some other underlying problem.

•

Decisions involving WC are being made constantly by relatively junior members of staff (for example, granting credit to a customer), so rules need to be established and followed.

2.

•

Obsolescence arises where inventories lose value as a result of physical deterioration or becoming unusable because they are no longer desired.

•

Fashion items can lose significant value if they lose appeal to the target audience.

•

An engineering component can lose value if the final product that includes the component is no longer produced.

•

Broadly, the higher the inventories level, the higher the risk of loss through obsolescence.

3.

•

That it can accurately predict its requirements.

•

That the supplier can deliver at short notice in relatively small quantities.

•

That purchased inventories item is reliably of an acceptable quality.

•

That the prices charged by suppliers are not increased to a level that renders the JIT approach uneconomic.

4.

•

Relative strength in the market – a monopoly supplier can probably demand payment more quickly than one that is in a more competitive position.

•

Similarly a large customer on whom the supplier relies can often delay payment without penalty.

•

Possibly industry custom and practice may be an influence.

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Revision questions Question 1 Cost–volume–profit analysis Brendol Ltd makes a range of products, many of which require the use of components which are either bought from a sub-contractor or made by the business itself.

Three of the business’s products (‘Super’, ‘Basic’ and ‘Component 17’), whose production all require the same facilities, require the use of a raw material ‘XR5’. XR5 is not used on any other of the business’s products. The material is very difficult to work with and requires a high level of a special skill. Both the material and appropriate skilled labour are in limited supply.

All production labour is employed by the business on long-term contracts, where workers are not laid off if there are surplus labour-hours.

The budgeted per-unit cost structures of the three products for the forthcoming year are as follows:

Raw materials Direct labour Variable overheads Fixed overheads

Super

Basic

£ 24 45 2 37 108

£ 19 26 4 19 68

Component 17 £ 16 37 2 29 84

Included in the raw material cost were the following amounts for XR5, which has a budgeted cost of £4 a gram: £ Super Basic Component 17

12 5 11

Included in the direct labour cost were the following amounts for the special skilled labour (who work on the XR5), which is paid £12 an hour: £ Super

22

Basic Component 17

19 18

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The Super and Basic are completed products that are sold to external customers at budgeted unit prices of £180 and £110, respectively. Component 17 is used as a component in another of the business’s products (the Deluxe). The final selling price of each Deluxe is £200 per unit, but further variable processing costs of £110 per unit will be incurred and fixed costs of £40 per unit will be absorbed.

The budgeted demand for the forthcoming year for the three products is: units Super

600

Basic

500

Component 17

350

The demand for each product is independent of that for the other two.

The supply of XR5 during the forthcoming year is limited to 3,000 grams.

The maximum available amount of the special skilled labour during the forthcoming year is 2,600 hours.

Note that only one of these limitations will have the effect of restricting the business from satisfying the budgeted demand for the forthcoming year.

Required (a)

Show, with clear workings and justification, the optimal amount of each product that the business should produce during the forthcoming year.

(b)

State and explain the assumptions which you have made in reaching your conclusion in requirement (a).

(c)

State and explain the maximum amount that the business should pay for an additional hour of the special skilled labour and for an extra gram of XR5, should either become available at an appropriate time during the forthcoming year.

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Question 2 Full costing Marine Mouldings Ltd makes fibreglass hulls for small sailing boats. Part of the work involves the use of an automatic computer controlled moulding machine, but quite a lot of the work has to be carried out by hand. The flexibility of both the workers and the moulding machine means that the business can (and does) make hulls of a large variety of shapes and sizes.

During the accounting year just about to start, the business plans the following: Direct material

£80,000

Indirect materials

£6,000

Direct labour cost

£100,000

Direct labour time

12,500 hours

Machine time

4,000 hours

Indirect labour cost

£40,000

Depreciation of machinery

£50,000

Rent

£20,000

Heating and lighting

£5,000

Machine power

£5,000

General indirect costs

£4,000

The business has been asked to give a price estimate for a particular hull and to do so needs to identify the full cost for the job. It is estimated that the hull will require about 50 hours of direct labour, about 15 hours of machine time and about £320 worth of direct material.

Required: (a)

Determine the full cost of the hull using a logical and reasonable basis. Explain fully why you have adopted your particular basis.

(b)

Explain the logic of ‘activity-based costing’ (ABC) and discuss the extent to which ABC could be useful in determining the cost of the hull which was the subject of Requirement (a).

You are not required to do any calculations for this part of the question.

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Question 3 Variance analysis (a) Carshine Ltd provides a service to motor car owners. Using a special item of equipment and a special fluid, it treats the external paintwork of cars, which has the effect of making the paintwork seem as new. The current standard costs of treating one car are as follows: £ Direct labour (15 minutes)

2.30

Direct materials (2 litres)

1.50

Fixed overheads (based on the budgeted monthly output of 20,000 cars treated)

3.30 7.10

Selling price

10.50

Profit

£3.40

During last month, due to an unexpected fall in demand for the service, only 15,000 cars were treated.

The actual results for last month were as follows: £ Sales revenue Less: Direct labour (4,000 hours)

£ 153,900

35,040

Direct materials (32,000 litres)

23,360

Fixed overheads

67,350 125,750 £28,150

Profit

Required Prepare a statement that reconciles the budgeted actual operating profit for the business for last month, going into as much detailed analysis as the above information allows. (b)

You subsequently discovered that normally (that is, when the demand is as budgeted), 20 per cent of the direct labour is worked as overtime which is paid at a 25 per cent premium (that is, the normal rate plus 25%). The standard direct labour cost takes this into account.

During last month no overtime was worked. However, the business followed its usual practice of employing its full direct labour force for the basic working hours throughout the month. Of the hours worked 3,650 were devoted to treating cars. The other 350 hours were spent tidying up the factory and doing some non-routine maintenance work.

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Required Show how the statement, which you prepared in (a), can be revised so that it more clearly identifies how much of the profit shortfall is the responsibility of various managers. You should clearly explain your revisions to the statement and you should make suggestions as to possible reasons for individual variances.

Question 4 Investment appraisal Big Builders plc (BB), a civil engineering contractor, has been invited to tender for (give a price for) a new contract. Work on the new contract must start in January 20X8 and be completed by 31 December 20X0. The new contract price will be receivable in three equal annual instalments, on 31 December 20X8, 20X9 and 20X0. BB’s management has reason to believe that the client will probably not accept a tender price in excess of £13.5 million.

It is estimated that the new contract will require non-management labour, in each of the two years 20X8 and 20X9, paid a total of £2.5 million each year and hired for the duration of the new contract.

Staff that would be hired only for the duration of the contract would undertake management of the new contract. Employment costs of the management staff (including travel and subsistence) would be £250,000, in each of 20X8 and 20X9.

Materials for the new contract will be bought at an estimated cost of £1.3 million per annum, in each of the two years 20X8 and 20X9.

Were it to be awarded to BB, the contract would follow on from an existing contract that will be completed at the end of 20X7. The new contract requires the use of an item of plant that is being used on the existing contract and could be moved for the contract. This item of plant was bought in May 20X6 for £6 million. It had been depreciated at the rate of 20 per cent on cost per annum (straight line).

Were it not to be used in the new contract it would be sold on 31 December 20X7 for an estimated £3.0 million, payable on that date. Transporting the plant to the site of the new contract would cost an estimated £100,000, payable on 31 December 20X7. It is estimated that at the end of the new contract this plant would be disposed of for a zero net realisable value.

BB’s management regards the cost of capital for the new contract to be 15% p.a.

There are not thought to be any other incremental costs associated with the new contract.

Requirements (a)

Recommend, on the basis of the net present value as at 1 January 20X8 and with supporting calculations, whether or not the new contract would be financially advantageous to BB at a tender price of £13.5 million.

(b)

Determine, with supporting calculations, the minimum price at which BB should tender for the contract.

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(c)

Comment briefly on the conclusions of your calculations in (a) and (b).

NOTE: Assume that all cash flows occur on 31 December of the relevant year, unless another date is specified in the question.

Question 5 Working capital Bruton Ltd is a manufacturer of stylish and high-specification computer workstation furniture. The business’s products have rapidly gained market acceptance allowing it to expand rapidly from its start up four years ago. Except during the first few months, the business has never been able to produce all that the market demanded. As a result it dispatches finished products to customers as soon as they are complete.

The directors feel that the business has reached a stage where it needs to make a fairly significant investment in equipment (about £5 million) if it is to move forward in the manner that they would like. They would also like to clear the business’s overdraft.

The following is included in the business’s recent draft financial statements: Income statement for last year £m Sales revenue

£m 15.6

Raw materials and components opening inventories:

(1.1)

purchases

(5.7)

closing inventories

1.9 (4.9)

Production labour

(3.3)

Production overheads

(2.5)

(10.7) 4.9

Administration and selling costs

(1.2)

Operating profit

3.7

Interest charges

(0.1)

Profit before tax

3.6

Tax

(1.3)

Profit (all retained)

2.3

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Sales revenue and production are spread fairly evenly over the year.

Statement of financial position (balance sheet) as at the end of last year ASSETS

£m

Non-current assets Freehold land and buildings

3.2

Machinery and equipment

1.6 4.8

Current assets Inventories (all raw materials and components)

1.9

Trade receivables

4.2 6.1 10.9

Total assets EQUITY AND LIABILITIES Equity Ordinary shares

2.0

Reserves

5.7 7.7

Current Liabilities Bank overdraft

1.3

Trade payables

0.6

Taxation

1.3 3.2 10.9

Total equity and liabilities

The directors are concerned that a lot of cash seems to be tied up in working capital.

Bruton Ltd is a member of the Office Furniture Manufacturers Association, a trade association. In a recent copy of the Association’s journal, some statistics had been published of the average accounting ratios for the industry. These had been compiled from a recently conducted survey of members. Included in these were the following: settlement period for trade receivables 1.5 months settlement period for trade payables 1.5 months inventories turnover period 1.0 months

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Required (a)

Show workings which indicate the amount of cash that it will be necessary to raise for the purposes mentioned by the directors, assuming that Bruton Ltd were able to achieve industry average trade receivables, trade payables and inventories periods.

(b)

Provide some practical suggestions for managing Bruton Ltd’s working capital elements more effectively.

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Solutions to revision questions Question 1 Brendol Ltd Required resources Super

XR5 (gm)

600 × (12/4)

SSL (hours)

1,800

600 × (22/12) Basic

1,100

500 × 5/4

625

500 × 19/12 Comp 17

792

350 × 11/4

963

350 × 18/12

525 2,417 2,600

3,388 3,000

Available

Thus the supply of XR5 is a limiting factor, but not the labour.

Super

Basic

Component 17

‘Sales’ price180

110

90

VCs

26

23

18

154

87

72

Contribution

XR5 use (gm)

3

1.25

2.75

Contribution/gm

51.33

69.60

26.18

Order of priority

2

1

3

Therefore, make:

Basic

500

Super

600

Comp 17

209

using

625 gm of XR5 1,800 575 (balancing figures) 3,000

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(b) Assumptions include:

•

The business is seeking to maximise its short-/medium-term net cash inflow.

•

All labour is a fixed cost.

•

All of the variable cost is linear.

•

There are no alternative strategies which could be exploited.

•

Divisibility and independence of each product’s output.

(c) The only product that cannot be made for which there is demand is the Component 17 and it would be worth paying £30.18 (that is, £26.18 + 4.00) a gram for XR5 to meet this demand.

Assuming that any additional SS labour could not be used profitably on some other activity, it would not be worth paying anything for any additional hours.

Question 2 Marine Mouldings Ltd (a) Full cost of the hull There is no correct answer to this part of the question. Full costing, certainly in a job-costing environment, requires the use of judgement, so the best that can be done is to approach the costing in a logical and consistent manner.

In view of the fact that both automated machinery and labour are major contributors in the manufacturing process, it seems sensible to divide the overheads (indirect costs) into two parts (those that relate to machinery and those that relate to labour) and apply them to the hull concerned on the basis of machine and labour hours, respectively. Using a time-based approach to applying overheads to particular jobs is logical because most overheads are themselves time based, that is overheads tend to vary with the length of time involved.

Given the fact that direct labour time is much higher than machine time, those overheads that are not specifically related to machinery will be dealt with on a labour-hour basis. This is a convenient way to approach the problem, but it is not necessarily a correct one.

Machine-related overheads:

£

Depreciation of machinery

50,000

Machine power

5,000 55,000

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Other overheads: Indirect materials Indirect labour Rent Heating and lighting General indirect costs

£ 6,000 40,000 20,000 5,000 4,000 75,000

The direct cost is not included here because we have the precise direct material and labour cost of the particular hull that we are costing.

Overhead recovery rates Machine hour rate (relating to machine-related overheads) = £55,000/4,000 = £13.75 per machine hour.

Direct labour hour rate (relating to other overheads) = £75,000/12,000 = £6.25 per direct labour hour.

Full cost of the hull

£

Direct material

320.00

Direct labour

(£100,000/12,500) × 50

400.00

Overheads Machine related £13.75 × 15

206.25

£6.25 × 50

312.50

Other

518.75 1,238.75

It must be emphasised that there is no correct answer to this question and the £1,238.75 is only one of a large number of possible estimates. As mentioned above, dealing with all overheads, except those specifically relating to machinery, on a direct labour-hour basis is very questionable.

In a real-life case, where more is known about the business and the way in which production takes place, some better judgements might be able to be made. (b) Activity-based costing (ABC) ABC is an approach to applying overheads to units of output or production. In a job-costing environment, like the one in (a) above, it replaces the use of the traditional direct labour hour and machine hour bases.

The traditional approach that we took to estimating the cost of the hull takes the position that overheads exist and so it is necessary to apply them to units of production. ABC takes the approach that overheads are caused by activities – the so-called ‘cost drivers’. It then requires that each overhead expense is analysed carefully to see why it exists and what makes it as expensive as it is, that is, to identify the cost drivers. For example, in (a), say £10,000 of the indirect labour cost is incurred in setting up the computer-controlled moulding machine to mould a hull of a particular size and shape. It may be that it takes an equal time to set up the machine before moulding each hull 137 © Pearson Education Limited 2021

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irrespective of the size and shape of the hull to be moulded. This means that the ‘cost driver’ for this £10,000 of overheads is the number of hulls made. It seems fair that this cost is divided by the cost driver (that is, the number of hulls to be made in the period), and each hull charged with this overhead figure. Other overheads would be looked at in a similar way, so that all overhead costs are related to some cost driver or another.

ABC should lead to a more fair and useful full cost information. ABC has an obvious disadvantage in that quite a lot of time and effort is involved with analysing each overhead and identifying cost drivers. Also, as many people argue that full costs are not very useful in any case, spending more time and money deriving them may be wasted time and money.

Question 3 Carshine Ltd (a)

F

A

Sales volume variance [£10.5 − (£2.3 + £1.5)] × (20,000 − 15,000)

33,500

Sales price variance (£10.5 × 15,000) − £153,900

3,600

Direct labour efficiency variance [(0.25 × 15,000) − 4,000] × £9.20

2,300

Direct labour rate variance (4,000 × 2 × £4.60) − £35,040

1,760

Direct materials usage variance [(2 × 15,000) − 32,000] × £0.75

1,500

Direct materials price variance (32,000 × 0.5 × £1.5) − £23,360

640

Fixed overheads spending variance (£3.3 × 20,000) − £67,350

1,350 2,400

42,250 2,400 39,850

Net variances (adverse) Budgeted profit £3.4 × 20,000

68,000

Net adverse variances

(39,850)

Actual profit

28,150

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(b) The additional information calls into question the validity and usefulness of the two labour variances.

Direct labour efficiency variance In effect this could both usefully be divided into two elements.

The hourly rate taking overtime premium into account was £9.20 per hour. The basic rate is therefore given by: 0.8H + (0.2H x1.25) = £9.20, where H is the basic hourly rate.

H = £8.76 Of the 4,000 hours worked, only 3,650 were involved in production.

Thus, the efficiency variance can be analysed into two elements: Productive direct labour efficiency variance [(0.25 × 15,000) – 3,650] × £8.76

£876 (F)

Idle time direct labour efficiency variance (4,000 – 3,650) × £8.76

£3,066 (A)

The original DLEV suggested that the labour had not been well managed. The reassessment indicates that the labour was, in fact efficiently managed during the production time. The large adverse variance arose from the fact that not all of the labour time was productive which was no fault of the person who manages the labour.

Direct labour rate variance This could usefully be recalculated to take account of the fact that no overtime needed to be worked.

(4,000 × £8.76) − 35,040

zero

Thus, the recalculation shows that labour was paid the standard rate and there were no savings here. The original assessment seems to show very great savings.

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Question 4 Big Builders plc (a) Schedule of expected cash flows 31 December

20X7

20X8

20X9

20X0

£m

£m

£m

£m

-

4.50

4.50

4.50

Non-management labour

(2.50)

(2.50)

Management labour

(0.25)

(0.25)

Materials

(1.30)

(1.30)

(3.10)

0.45

0.45

4.50

Discount factors

1.000

0.870

0.756

0.658

PV

(3.10)

0.39

0.34

2.96

NPV

0.59

Contract price

Plant

(3.10)

Thus, the contract would be financially advantageous to BC at £13.5m. (b) We can see from (a) that, with annual payments of £4.50 million there is an NPV of £0.59 million.

If we can deduce what equal annual payments in 20X8, 20X9 and 20X0 will give rise to this NPV, we can adjust £4.5 million (downward) by this amount to derive the annual receipt that will give rise to a zero NPV overall.

If we call this amount A, then

0.59 = (A × 0.870) + (A × 0.756) + (A × 0.658)

so, A = £0.26 million and the annual receipt from the contract that will produce a zero NPV is £4.50m − £0.26m, that is £4.24 million.

[Note that this conclusion could be reached correctly by taking more than one different approach.] (c) Possible points include:

•

The small margin of safety, between the £4.5 million and the ‘break-even’ point, means that the success of the contract will be sensitive to the accuracy of the input data.

•

Civil engineering tends to be a fairly risky activity since outcomes are fairly difficult to predict.

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Question 5 Bruton Ltd (a) Indication of the amount of cash necessary to raise to meet its requirements Possible saving from better control of receivables, payables and inventories.

Trade receivables If sales revenue totals £15.6m and the trade receivables collection period were 1.5 months, trade receivables would be: (15.6m × 1.5)/12 =

£1.950m

Current trade receivables

4.200

Potential saving

2.250

Trade payables If purchases total £5.7m and the trade payables payment period were 1.5 months, trade payables would be: (5.7m × 1.5)/12 =

£0.713m

Current trade payables

0.600

Potential saving

0.113

Inventories If cost of sales totals £4.9m and the inventories holding period were 1.0 month, inventories would be: 4.9m/12 =

£0.408m

Current inventories

1.900

Potential saving

1.492

Total WC savings

£3.855m (say, £3.9m)

Total requirement of cash, assuming the investment in new equipment, paying off the overdraft and making the theoretical savings in the amount committed to WC = £5m + £1.3m − £3.9m = £2.4m

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(b) Practical suggestions for managing inventories, trade receivables and trade payables Inventories

•

Establish optimum order quantity for each type of inventories, using a suitable model.

•

Establish appropriate reorder levels for each type of inventories. This would be based on lead times, projected usage rates and extent to which a ‘stock out’ would be critical.

•

Budget for inventories usage.

•

Maintain reliable inventories records.

•

Use ratios to monitor inventories levels.

•

Have security and specified authority for ordering and issuing of inventories.

Trade receivables

•

Establish and maintain a clear and practical policy on granting credit.

•

Assess all credit customers carefully before advancing credit.

•

Establish sound administration of receivables, including control of goods being dispatched, invoices dispatched and existing trade receivables balances reviewed.

•

Consider offering discounts for prompt payment.

•

Use ratios to monitor trade receivables levels.

Trade payables

•

Establish a policy on trade payables, including taking discounts for prompt payment.

•

Exploit trade credit as far as is reasonable.

•

Use ratios to monitor trade payables levels.

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