The Examiner's Answers Specimen Paper. Performance Management

Transcription

1 The Examiner's Answers Specimen Paper P2 - SECTION A Answer to Question One The Value Chain is the concept that there is a sequence of business factors by which value is added to an organisation s products and services. Modern businesses cannot survive merely by having efficient production facilities, they must also have a thorough understanding of the importance of the relationship between all of the elements in the value chain. These include: research & development, design, manufacturing, marketing, distribution and customer service. The DT group currently has an internal manufacturing facility, this makes communications between different parts of that manufacturing process relatively straight-forward, however, if part of this process is to be outsourced this will place as added burden on the production management to ensure that all parts of the production process operate smoothly. Aside from communication difficulties, there may be different work ethics to contend with, and delays in receiving items and quality issues may disrupt the flow of goods to customers. This will lead to difficulties in identifying where profits / contributions are being earned (and lost) within the value chain. Gain sharing arrangements are based on the concept of sharing profits, however, if they are to be successful both parties must be willing to share the information necessary to determine the extent of any gain (or loss) that has arisen. The DT group may seek to enter a gain sharing arrangement with the suppliers of the components that they have outsourced. This would require both organisations to establish some clear targets which could include quality specifications and delivery schedules. The gain from lower levels of rejects and earlier delivery of components can then be determined and shared between DT and the external supplier. 1

2 Answer to Question Two Number of batches completed Average time per batch 1 1,000 hours hours hours hours hours hours hours It seems that the average time equals 5 3 hours per unit (i.e. 530 hours per batch after 64 batches had been completed. 4 batches were produced so the average time per batch should have been 810 hours (as shown in the answer to (a) above. Therefore the total time should have been 4 x 810 hours = Actual hours taken were Operating efficiency difference 3,240 hours. 2,500 hours 740 hours Favourable By comparing the standard with the revised target time, the planning variance can be identified: Original standard (5 3 hours x 400 units) Time allowed per learning curve Planning efficiency difference 2,120 hours 3,240 hours 1,120 hours Adverse Each of these differences in hours is valued using the standard hourly rate of $10 per hour, so the revised efficiency variances are: Planning variance Operating variance $11,200 Adverse $7,400 Favourable The rate variance remains unchanged at $ 1,000 Adverse Requirement (c) The analysis of the efficiency variance into planning and operational effects provides more meaningful information because it shows the true efficiency of the operations as opposed to an invalid application of the original target. As production has only reached four batches by the end of August and the learning period seems to continue to around 64 batches it is clear that the learning has not yet been completed and therefore it is unfair to measure performance against the post learning standard. These revised calculations show that the actual learning is better than was expected whereas the original variance calculation showed that the time taken was more than it should have been. Rather than acusing the workforce of being inefficient they should be congratulated on their efficiency. 2

3 Answer to Question Three Feedback control is the comparison of actual performance with an agreed target such as the budget set by the Managing partner. An example would be a comparison of the fees earned by each partner compared to those budgeted to be earned. Feed-forward control is the comparison of a draft version of a target with a rule or objective. An example would be the comparison of the draft cash budget with the target cash balances and the overdraft facility. As a result of this comparison it may be necessary to defer some expenditure until a later period or reduce it so as to stay within the firm s existing cash balances / overdraft facility. This will lead to a second draft of the cash budget being prepared. One beneficial consequence of involving the other partners in the preparation of the firm s budgets is that they will accept ownership of their budget and accept responsibility for achieving their target. However, one adverse consequence is that since they will effectively be setting their own targets they may be tempted to set a target that is more easily achieved than that which would have been set by the Managing partner. This is known as the inclusion of budgetary slack. Answer to Question Four Calculation of cost driver rates: Machine maintenance $100,000 / ((1,500 x 3) + (2,500 x 2) + (4,000 x 3)) = $4 65 per machine hour Machine setups $70,000 / [{(1,500/50) x 2} + {(2,500/100) x 3} + {(4,000/500) x 1}] = $ per setup Purchasing $90,000 / [{(1,500/50) x 4} + {(2,500/100) x 4} + {(4,000/500) x 6}] = $ per order Material Handling $60,000 / [{(1,500/50) x 10} + {(2,500/100) x 5} + {(4,000/500) x 4}] = $ per movement Other Costs $80,000 / ((1,500 x 2) + (2,500 x 4) + (4,000 x 3)) = $3 20 per labour hour Product X Y Z Batch costs: Machine setup 979 1, Purchasing 1,343 1,343 2,015 Material handling 1, ,635 3,468 3,029 5 Batch size Unitised batch costs Machine maintenance Other costs Product overhead costs

4 Pareto Analysis is also known as the 80:20 rule. In this context it means that 80% of the production overhead costs are caused by 20% of the total number of causes. W has identified the causes of 80% of its overhead costs (i.e. $320,000 out of the total of $400,000) and linked these with just four cost drivers. The remaining $80,000 is said to be caused by a number of factors. By focusing attention on controlling these four cost causes in the future, and minimising the costs of cost control, W will be controlling 80% of its production overhead costs. Answer to Question Five Standard costs are the estimated costs of providing one unit of goods or service. They are determined by identifying the resources expected to be required for the completion of the unit and the price expected to be paid for each unit of those resources. Target costs are determined by taking the market price of a product or service and deducting the required profit margin to determine the cost at which the product or service must be provided in order to meet the required profit margin. HJ is diversifying into a well established market place where it is likely to be a price taker rather than a price maker. HJ will therefore be able to determine the selling price of its range of plastic moulded items. HJ must then determine the profit that it wishes to achieve to make a reasonable return on its investment in the new machinery. By deducting the profit required from the selling price HJ will determine the target cost for its plastic moulded products. HJ will then have to consider its production methods and the impact of any learning and experience efficiencies that may arise to determine whether it is capable of producing the items for their target cost. Short term marginal cost based pricing is often necessary to enter into a new market that is already well established and mature. However, this form of pricing is unlikely to be financially viable in the longer term because of the need to recover the fixed costs of the business and deliver a suitable return for the business owners. The difficulty lies in making the switch from one pricing model to the other without losing the customer base that has been built up using the marginal cost based prices. It will therefore be necessary for HJ to develop new items which have the perception of adding value to the original product range so that they can be sufficiently differentiated to allow the new prices to be introduced. 4

5 SECTION B Answer to Question Six 1. The cost of the engineering specification is based on the time spent (i.e. 3 days) multiplied by the salary and related employment costs of $500 per day. However, this is not a relevant value because the time has already been spent and is therefore a sunk cost. The relevant value is $NIL. 2. The cost of Direct Material A is based on 10,000 square metres valued using the weighted average basis. This can be shown to be calculated by: 10,000 square metres x $6 = $60,000 5,000 square metres x $630 = $31,500 15,000 square metres total = $91,500 = an average of $6 10 per square metre This is not the correct valuation because the material is in regular use by PQR. Consequently its relevant cost is its cost of replacement which is $7 per square metre which is therefore $70,000 in total. 3. The cost of Direct Material B is based on 250 metre lengths being bought at a price of $10 per metre length. This is not the correct valuation because the sole supplier has a minimum order size of 300 metre lengths and the remainder has no foreseeable use or net sales revenue. Therefore the relevant cost is the cost of the minimum order of 300 lengths, i.e. 300 x $10 = $3, The cost of the components is based on the normal transfer pricing policy of $8 plus a 50% mark-up = $12 per component. 500 components x $12 = $6,000. However, this is not the relevant cost to the M group. The relevant cost to the M group is the variable cost of manufacturing the components plus any lost contribution from the reduction in external sales by HK. Thus: 350 components x variable cost only = 350 x $8 = $2, components x variable cost + lost contribution = 150 x ($8 + $3) = $1,650 Total relevant cost of the components = $2,800 + $1,650 = $4,450 The external market price of $14 is not relevant because it is cheaper to manufacture them internally, even if there is lost contribution caused by reduced external sales. 5. The cost of direct labour is the cost of the existing employees; 1000 hours x $12 50 per hour. This is not the relevant cost. The relevant cost is the lower of: a) Recruiting engineers to do the work at $15 per hour; and b) Transferring the existing employees and recruiting replacements to do their work at $14 per hour. The second of these is the lower cost option so the relevant cost is 1000 hours x $14 per hour = $14, The cost of the supervisor is based on a monthly salary of $3,500 (annual salary of $42,000 / 12 months) multiplied by 10% as the the project time estimate = $350. This is not the relevant cost. The supervisor is already employed and will continue to be employed whether the project goes ahead or not. If the supervisor cannot complete this 5

6 work within his normal hours he will work overtime but he is not paid for this so there is no incremental cash flow. The relevant cost is $NIL. 7. The machine hire cost is based on 5 days multiplied by a hire charge of $500 per day. However, this is not the relevant cost because there is a lower cost option available. If the machine is hired for an entire month at a cost of $5,000 and then sub hired for $150 per day for 20 days (total $3,000) the net cost of this option is $2,000. Therefore the relevant cost is $2, The overhead cost value is based on the latest annual forecast of overhead costs and capacity levels as follows: $220,000 / 80% of 50,000 hours = $5.50 per hour 1,000 hours of skilled labour x $5.50 per hour = $5,500. However, this is not a relevant cost. There is no indication that these overhead costs are incurred as a result of undertaking the project, indeed being based on an absorption rate implies that they are not project specific and will be incurred whether the project goes ahead or not. The relevant cost is therefore $NIL. Note $ Engineering specification 1 NIL Direct material a 2 70,000 Direct material B 3 3,000 Components 4 4,450 Direct Labour 5 14,000 Supervision 6 NIL Machine hire 7 2,000 Overhead costs 8 NIL Total 93,450 The difference between the reported profit and that which would be expected based on the relevant cost schedule is caused by the differing nature of the accounting techniques used for decision making compared to those used for profit reporting and inventory valuation. For example: (i) The usage of material A on the project will be valued using its average cost of $6.10 per square metre rather than the replacement cost of $7 per square metre. (ii) The accounting system will attribute overhead costs to the project using an absorption rate that would normally be based on the budgeted costs and activity levels. This is relevant for profit reporting and is required by external reporting rules, but is not appropriate for short term decision making as these costs are not affected by the decision. Requirement (c) There are a number of non-financial factors that need to be considered, these include: (i) (ii) Will there be any long term impact on the external market of HK as a result of them choosing to make an internal supply in preference to their external customers. Does this mean that their external customers will find a permanent alternative supplier? Will there be any conflicts between the temporary replacement workers being paid $14 per hour to do the work of employees who are currently being paid $12.50 per hour? 6

7 Answer to Question Seven The performance statement does not show the actual return on capital employed achieved by each division which is: D: 2.5% E: 10% F: 12% It can thus be seen that only Division E achieved the target that had been set for it by Head Office. However, there are a number of other factors that need to be considered in relation to the performance report. 1. The management charges from Head Office are presumed to be non-controllable at divisional level, it is therefore inappropriate to include them in any measure of divisional performance. 2. The basis of valuing the Capital Employed by each division is not stated. It is assumed to be based on the original cost of the assets less accumulated depreciation. As a consequence older assets will have lower original costs (due to price inflation) and lower book values (due to more years depreciation charges). As a result comparisons between divisions may not be a fair comparison. This may also explain the different cost structure that seems to exist in Division F where fixed production costs are approximately 25% of total production costs whereas in divisions D and E the fixed production costs are around 50% of total production costs. This may imply that the equipment used in Divisions D and E is newer and more automated. The problem with negotiated transfer prices is that the results of the negotiations is as much affected by the personalities of the managers of each division as it is by the circumstances surrounding the transaction. If one manager has a stronger personality than another, or is a better negotiator then this will act to the detriment of the weaker division and may not be in the best interests of the company as a whole. The inter-divisional trading affects the performance of all of the divisions. Assuming that the goods sold between the divisions were similar to those that the supplying division sold into the external market, then the following analysis can be made. 1. Goods sold by Division D. The external sales of Division D were $130,000 during the year for which the variable cost was $32,000, a mark-up of just over 300%. If the same mark up were applied to the internal sale then Division D s profits would have increased by $52,000 to $62,000 and the profits of Division E would reduce by $52, Goods sold by Division F The external sales of Division F were $385,000 during the year for which the variable cost was $221,000, a mark-up of 75%. The mark-up added to the internal sale was 67% so there is not a significant impact on the profit reported by the divisions as a result of these internal transactions. 7

8 Requirement (c) Division D E F $000 $000 $000 Net sales - External Sales - Internal Total sales Variable production costs - External Internal ** 27 - Internal mark-up** 60 Fixed production costs Divisional administration costs Divisional profit Non-controllable Head Office management charge Profit Capital employed Return on Capital Employed (based on profit) 15 5% 0 5% 12 0% Return on Capital Employed (based on divisional profit) 18% 2% 15 7% * Internal sales have been valued at their equivalent external prices by applying the mark-up calculated earlier. ** These values show the variable cost to the company of these internal transactions and the mark-up that would normally apply to these transactions. Requirement (d) A system of dual prices would mean that the selling price recorded by the selling division would not be the same as the buying price recorded by the buying division. Typically, the buyer would include the company variable cost as their cost and the seller would include a value closer to market value as their sales. If this were done here, then the Internal mark-up shown under Variable Production cost would not appear and as a result the divisional profit of division E would have increased by $60,000 to $71,000 which would give the division a Return on Capital. The Chartered Institute of Management Accountants