Paper P2 Management Accounting Decision Making. Examiner s Brief Guide to the Paper 19

Transcription

1 November 2006 Examinations Managerial Level Paper P2 Management Accounting Decision Making Question Paper 2 Examiner s Brief Guide to the Paper 19 Examiner s Answers 20 The answers published here have been written by the Examiner and should provide a helpful guide for both tutors and students. Published separately on the CIMA website ( from mid- February 2007 is a Post Examination Guide for this paper, which provides much valuable and complementary material including indicative mark information The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recorded or otherwise, without the written permission of the publisher.

2 Management Accounting Pillar Managerial Level Paper P2 Management Accounting - Decision Management 22 November 2006 Wednesday Morning Session Instructions to candidates You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper, and if you wish, make annotations on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or subquestions). The requirements for the questions in Sections B and C are contained in a dotted box. Answer the ONE compulsory question in Section A. This has eight subquestions and is on pages 2 to 5. Answer ALL THREE compulsory questions in Section B on pages 6 to 10. Answer TWO of the three questions in Section C on pages 11 to 14. Maths Tables and Formulae are provided on pages 15 to 17. Write your full examination number, paper number and the examination subject title in the spaces provided on the front of the examination answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered. P2 Decision Management P2 2 November 2006

3 SECTION A 20 MARKS [the indicative time for answering this section is 36 minutes] ANSWER ALL EIGHT SUB-QUESTIONS Instructions for answering Section A: The answers to the eight sub-questions in Section A should ALL be written in your answer book. Your answers should be clearly numbered with the sub-question number and then ruled off, so that the markers know which sub-question you are answering. For multiple choice questions, you need only write the sub-question number and the letter of the answer option you have chosen. You do not need to start a new page for each sub-question. For sub-questions 1.6, 1.7, and 1.8 you should show your workings as marks are available for the method you use to answer these sub-questions. Question One 1.1 A processing company operates a common process from which three different products emerge. Each of the three products can then either be sold in a market that has many buyers and sellers or further processed independently of each other in three other processes. After further processing each of the products can be sold in the same market for a higher unit selling price. Which of the following is required to determine whether or not any of the products should be further processed? (i) (ii) (iii) (iv) (v) (vi) (vii) Total cost of the common process The basis of sharing the common process cost between the three products The total cost of each of the three additional processes The unit selling price of each product after further processing The unit selling price of each product before further processing The percentage normal loss of each further process The actual units of output of each product from the common process. A B C D (iii), (iv), (vi) and (vii) only (i), (ii), (iii), (iv), (vi) and (vii) only (i), (ii), (v) and (vii) only (iii), (iv), (v), (vi) and (vii) only (2 marks) November P2

4 1.2 Z plc is preparing a quotation for a one off contract to manufacture an item for a potential customer. The item is to be made of steel and the contract would require 300 kgs of steel. The steel is in regular use by Z plc and, as a consequence, the company maintains an inventory of this steel and currently has 200 kgs in inventory. The company operates a LIFO basis of inventory valuation and its most recent purchases were as follows: 20 November kgs costing November kgs costing 1,100 The steel is easily available in the market where its current purchase price is 4 25 per kg. If the steel currently held in inventory was to be sold it could be sold for 3 50 per kg. The relevant cost of the steel to be included in the cost estimate is A 1,050 B 1,260 C 1,275 D 1,300 (2 marks) 1.3 X is considering the following five investments: Investment J K L M N $000 $000 $000 $000 $000 Initial investment Net Present Value Investments J and L are mutually exclusive, all of the investments are divisible and none of them may be invested in more than once. The optimum investment plan for X assuming that the funding available is limited to $1m is A $400,000 in J plus $600,000 in N. B $400,000 in M plus $600,000 in N. C $500,000 in M plus $500,000 in N. D $350,000 in K plus $600,000 in N plus $50,000 in M. (2 marks) P2 4 November 2006

5 1.4 A hospital is considering investing $80,000 in a new computer system that will reduce the amount of time taken to process a patient s records when making an appointment. It is estimated that the cash benefit of the time saved will be $20,000 in the first year, $30,000 in the second year and $50,000 in each of the next three years. At the end of five years the computer system will be obsolete and will need to be replaced. It is not expected to have any residual value. Calculate the payback period to one decimal place of one year. (2 marks) 1.5 An investment company is considering the purchase of a commercial building at a cost of 0 85m. The property would be rented immediately to tenants at an annual rent of 80,000 payable in arrears in perpetuity. Calculate the net present value of the investment assuming that the investment company s cost of capital is 8% per annum. Ignore taxation and inflation. (2 marks) 1.6 A bakery produces three different sized fruit pies for sale in its shops. The pies all use the same basic ingredients. Details of the selling prices and unit costs of each pie are as follows: Small Medium Large $ per pie $ per pie $ per pie Selling price Ingredients Direct labour Variable overhead Weekly demand (pies) Fruit (kgs per pie) The fruit used in making the pies is imported and the bakery has been told that the amount of fruit that they will be able to buy for next week is limited to 300 kgs. The bakery has established its good name by baking its pies daily using fresh fruit, so it is not possible to buy the fruit in advance. Determine the mix of pies to be made and sold in order to maximise the bakery s contribution for next week. (3 marks) November P2

6 1.7 H is launching a new product which it expects to incur a variable cost of $14 per unit. The company has completed some market research to try to determine the optimum selling price with the following results. If the price charged was to be $25 per unit then the demand would be 1,000 units each period. For every $1 increase in the selling price, demand would reduce by 100 units each period. For every $1 reduction in the selling price, the demand would increase by 100 units each period. Calculate the optimum selling price. Note: If Price (P) = a bx; then Marginal Revenue = a 2bx (3 marks) 1.8 A company sells three different levels of TV maintenance contract to its customers: Basic, Standard and Advanced. Selling prices, unit costs and monthly sales are as follows: Basic Standard Advanced Selling price Variable cost Monthly contracts sold Calculate the average contribution to sales ratio of the company (i) (ii) based on the sales mix stated above; and if the total number of monthly contracts sold remains the same, but equal numbers of each contract are sold. (4 marks) (Total for Section A = 20 marks) End of Section A Section B starts on page 6 P2 6 November 2006

7 SECTION B 30 MARKS [the indicative time for answering this section is 54 minutes] ANSWER ALL THREE QUESTIONS Question Two AVN designs and assembles electronic devices to allow transmission of audio / visual communications between the original source and various other locations within the same building. Many of these devices require a wired solution but the company is currently developing a wireless alternative. The company produces a number of different devices depending on the number of input sources and the number of output locations, but the technology used within each device is identical. AVN is constantly developing new devices which improve the quality of the audio / visual communications that are received at the output locations. The Managing Director recently attended a conference on world class manufacturing entitled The extension of the value chain to include suppliers and customers and seeks your help. Required: Explain (i) (ii) the components of the extended value chain; and how each of the components may be applied by AVN. (3 marks) (7 marks) (Total for Question Two = 10 marks) November P2

8 Question Three W has recently completed the development and testing of a new product which has cost $400,000. It has also bought a machine to produce the new product costing $150,000. The production machine is capable of producing 1,000 units of the product per month and is not expected to have a residual value due to its specialised nature. The company has decided that the unit selling prices it will charge will change with the cumulative numbers of units sold as follows: Cumulative sales units Selling price $ per unit in this band 0 to 2, ,001 to 7, ,001 to 14, ,501 to 54, ,501 and above 40 Based on these selling prices, it is expected that sales demand will be as shown below: Months Sales demand per month (units) , Thereafter NIL Unit variable costs are expected to be as follows: $ per unit First 2,000 units 50 Next 12,500 units 40 Next 20,000 units 30 Next 20,000 units 25 Thereafter 30 W operates a Just in Time (JIT) purchasing and production system and operates its business on a cash basis. A columnar cash flow statement showing the cumulative cash flow of the product after its Introduction and Growth stages has already been completed and this is set out below: Introduction Growth Months Number of units produced and sold 2,000 5,000 7,500 Selling price per unit $100 $80 $70 Unit variable cost $50 $40 $40 Unit contribution $50 $40 $30 Total contribution $100,000 $425,000 Cumulative cash flow ($450,000) ($25,000) P2 8 November 2006

9 Required: (a) (b) Complete the cash flow statement for each of the remaining two stages of the product s life cycle. Do not copy the Introduction and Growth stages in your answer. Ignore the time value of money. (5 marks) Explain, using your answer to (a) above and the data provided, the possible reasons for the changes in costs and selling prices during the life cycle of the product. (5 marks) (Total for Question Three = 10 marks) November P2

10 Question Four You are the Assistant Management Accountant of QXY plc, a food manufacturer. The Board of Directors is concerned that its operational managers may not be fully aware of the importance of understanding the costs incurred by the business and the effect that this has on their operational decision making. In addition, the operational managers need to be aware of the implications of their pricing policy when trying to increase the volume of sales. You are scheduled to make a presentation to the operational managers tomorrow to explain to them the different costs that are incurred by the business, the results of some research that has been conducted into the implications for pricing and the importance of understanding these issues for their decision making. The diagram on the opposite page has already been prepared for the presentation. Required: You are required to interpret the diagram and explain how it illustrates issues that the operational managers should consider when making decisions. (Note: your answer must include explanations of the Sales Revenue, Total Cost and Fixed Cost lines, and the significance of each of the activity levels labelled A, B, C, D). (10 marks) (Total for Section B = 30 marks) The diagram for Question Four is on the next page Section C starts on page 12 P2 10 November 2006

11 Diagram for Question Four - Costs and Revenues over a range of activity levels $ Sales Revenue Total Cost Fixed Cost A B C D Activity November P2

12 SECTION C 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS OUT OF THREE Question Five KL manufactures three products, W, X and Y. Each product uses the same materials and the same type of direct labour but in different quantities. The company currently uses a cost plus basis to determine the selling price of its products. This is based on full cost using an overhead absorption rate per direct labour hour. However, the Managing Director is concerned that the company may be losing sales because of its approach to setting prices. He thinks that a marginal costing approach may be more appropriate, particularly since the workforce is guaranteed a minimum weekly wage and has a three month notice period. Required: (a) Given the Managing Director s concern about KL s approach to setting selling prices, discuss the advantages and disadvantages of marginal cost plus pricing AND total cost plus pricing. (6 marks) The direct costs of the three products are shown below: Product W X Y Budgeted annual production (units) 15,000 24,000 20,000 $ per unit $ per unit $ per unit Direct materials Direct labour ($10 per hour) In addition to the above direct costs, KL incurs annual indirect production costs of $1,044,000. Required: (b) Calculate the full cost per unit of each product using KL s current method of absorption costing. (4 marks) P2 12 November 2006

13 An analysis of the company s indirect production costs shows the following: $ Cost driver Material ordering costs 220,000 Number of supplier orders Machine setup costs 100,000 Number of batches Machine running costs 400,000 Number of machine hours General facility costs 324,000 Number of machine hours The following additional data relate to each product: Product W X Y Machine hours per unit Batch size (units) ,000 Supplier orders per batch Required: (c) Calculate the full cost per unit of each product using Activity Based Costing. (8 marks) (d) Explain how Activity Based Costing could provide information that would be relevant to the management team when it is making decisions about how to improve KL s profitability. (7 marks) (Total for Question Five = 25 marks) November P2

14 Question Six A theatre has a seating capacity of 500 people and is considering engaging MS and her orchestra for a concert for one night only. The fee that would be charged by MS would be $10,000. If the theatre engages MS, then this sum is payable regardless of the size of the theatre audience. Based on past experience of events of this type, the price of the theatre ticket would be $25 per person. The size of the audience for this event is uncertain, but based on past experience it is expected to be as follows: Probability 300 people 50% 400 people 30% 500 people 20% In addition to the sale of the theatre tickets, it can be expected that members of the audience will also purchase confectionery both prior to the performance and during the interval. The contribution that this would yield to the theatre is unclear, but has been estimated as follows: Contribution from confectionery sales Probability Contribution of $3 per person 30% Contribution of $5 per person 50% Contribution of $10 per person 20% Required: (a) Using expected values as the basis of your decision, advise the theatre management whether it is financially worthwhile to engage MS for the concert. (5 marks) (b) Prepare a two-way data table to show the profit values that could occur from deciding to engage MS for the concert. (5 marks) (c) Explain, using the probabilities provided and your answer to (b) above, how the two-way data table can be used by the theatre management to evaluate the financial risks of the concert, including the probability of making a profit. (9 marks) (d) Calculate the maximum price that the theatre management should agree to pay for perfect information relating to the size of the audience and the level of contribution from confectionery sales. (6 marks) (Total for Question Six = 25 marks) P2 14 November 2006

15 Question Seven JK plc prepares its accounts to 31 December each year. It is considering investing in a new computer controlled production facility on 1 January 2007 at a cost of 50m. This will enable JK plc to produce a new product which it expects to be able to sell for four years. At the end of this time it has been agreed to sell the new production facility for 1m cash. Sales of the product during the year ended 31 December 2007 and the next three years are expected to be as follows: Year ended 31 December Sales units (000) Selling price, unit variable cost and fixed overhead costs (excluding depreciation) are expected to be as follows during the year ended 31 December 2007: Selling price per unit 1,200 Variable production cost per unit 750 Variable selling and distribution cost per unit 100 Fixed production cost for the year 4,000,000 Fixed selling and distribution cost for the year 2,000,000 Fixed administration cost for the year 1,000,000 The following rates of annual inflation are expected for each of the years : % Selling prices 5 Production costs 8 Selling and distribution costs 6 Administration costs 5 The company pays taxation on its profits at the rate of 30%, with half of this being payable in the year in which the profit is earned and the remainder being payable in the following year. Investments of this type qualify for tax depreciation at the rate of 25% per annum on a reducing balance basis. The Board of Directors of JK plc has agreed to use a 12% post-tax discount rate to evaluate this investment. Required: (a) (b) Advise JK plc whether the investment is financially worthwhile. Calculate the Internal Rate of Return of the investment. (17 marks) (3 marks) (c) Define and contrast (i) the real rate of return and (ii) the money rate of return, and explain how they would be used when calculating the net present value of a project s cash flows. (5 marks) (Total for Question Seven = 25 marks) (Total for Section C = 50 marks) November P2

16 PRESENT VALUE TABLE Present value of $1, that is ( 1+ r ) n where r = interest rate; n = number of periods until payment or receipt. Periods Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% P2 16 November 2006

17 Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years n 1 (1+ r ) r Periods Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% November P2

18 FORMULAE Time series Additive model: Series = Trend + Seasonal + Random Multiplicative model: Series = Trend*Seasonal*Random Regression analysis The linear regression equation of Y on X is given by: where: and or solve Exponential Geometric Y = a + bx or Y Y = b(x X ), Covariance ( XY ) b = Variance ( X ) a = Y b X Y = na + b X XY = a X + b X 2 Y = ab x Y = ax b n XY ( X )( Y ) = 2 2 n X ( X ) Learning curve Y x = ax b where: Y x = the cumulative average time per unit to produce X units; a = the time required to produce the first unit of output; X = the cumulative number of units; b = the index of learning. The exponent b is defined as the log of the learning curve improvement rate divided by log 2. P2 18 November 2006

19 The Examiner for Management Accounting Decision Management offers to future candidates and to tutors using this booklet for study purposes, the following background and guidance on the questions included in this examination paper. Section A Question One Compulsory Question One comprises eight sub questions in objective testing format. Some of the questions provide a choice of answers of which only one is correct while others require solution by the candidate. This question covers a number of syllabus areas and learning outcomes and is designed to complement the syllabus coverage of the remaining questions on the paper. Section B Questions Two, Three and Four Compulsory Question Two requires candidates to explain the extended Value Chain and how it may be applied by the company in the scenario. The question addresses the learning outcome explain the concept of the value chain and discuss the management of contribution/profit generated throughout the chain. Question Three requires candidates to complete a cash flow statement based upon the data provided for the life-cycle of a product. Candidates are then required to explain the possible reasons for the changes in costs and selling prices. This question addresses the learning outcome explain the concept of life cycle costing and how life cycle costs interact with marketing strategies at each stage of the life cycle. Question Four requires candidates to interpret a breakeven chart and explain how it illustrates issues that operational managers should consider when making decisions. This question addresses the learning outcome discuss the usefulness of dividing costs into variable and fixed components in the context of short-term decision making. Section C answer two of three questions Question Five requires candidates to discuss the advantages and disadvantages of marginal cost plus pricing and total cost plus pricing in part (a). In the remainder of the question candidates were required to calculate the unit cost of the company s products using traditional absorption costing and activity based costing and to explain how the use of activity based costing could provide information that would be relevant to the company s management team when they are making decisions to improve the company s profitability. This question addresses the learning outcomes explain the particular issues that arise in pricing decisions and the conflict between marginal cost principles and the need for full recovery of all costs incurred and apply the techniques of activity based management in identifying cost drivers/activities and explain how process re-engineering can be used to eliminate non-value adding activities and reduce activity costs. Question Six requires candidates to prepare calculations by applying probabilities to the data provided. They are required to interpret the results to advise a theatre as to the financial risks associated with a proposed concert and to determine the maximum price that should be paid by the theatre company for perfect information relating to the event. This question addresses the learning outcomes analyse risk and uncertainty by calculating expected values and standard deviations together with probability tables and histograms and prepare expected value tables and ascertain the value of information. Question Seven requires candidates to apply the net present value technique to the data provided to determine the financial viability of a proposed investment. Then in part (b) candidates are required to determine the Internal Rate of Return of the investment and in part (c) to define and contrast the real and money rates of return and explain how they would be used when calculating the net present value of the cash flows from a project. This question addresses the learning outcomes calculate project cash flows, accounting for tax and inflation, and apply perpetuities to derive end of project value where appropriate and evaluate project proposals using the techniques of investment appraisal. November P2

20 Managerial Level Paper P2 Management Accounting Decision Management Examiner s Answers SECTION A Answer to Question One 1.1 Statements (iii), (iv), (v), (vi) and (vii) are correct. The correct answer is D = 1,275. The correct answer is C. 1.3 Calculate the profitability index values of each of the investments and rank them: Investment Profitability Index Rank J rd K th L th M st N nd Invest in: M $500,000 yielding $160,000 N $500,000 yielding $158,333 Total $1,000,000 yielding $318,333 The correct answer is C. P2 20 November 2006

21 1.4 After 2 years the total inflows = $50,000 After 3 years the total inflows = $100,000 Therefore payback occurs after 2 6 years ,000 x 1/0 08 = 1m therefore NPV = 0 15m 1.6 Small Medium Large Contribution/pie $0 50 $1 60 $3 00 Contribution/kg $2 50 $5 33 $5 00 Ranking 3 rd 1 st 2 nd Make (pies) NIL Uses (kgs) NIL Marginal cost (MC) = $14 Price (P) = $ q Marginal Revenue (MR) = $ q So if MC = MR then: 14 = q 0 02q = 21 q = 1,050 Price = $35 (0 01 x 1,050) = $ Basic Standard Advanced Total Previous ratio: Sales Contribution C/S ratio = 47 6% New ratio: Sales Contribution C/S ratio = 49 1% November P2

22 SECTION B Answer to Question Two (a) The Extended Value Chain includes both internal and external factors, whereas the Value Chain includes only the internal factors. The value chain is the sequence of business factors that add value to the organisation s products and services and comprises the following: R&D Design Production Marketing Distribution Customer Service The Extended Value Chain adds Suppliers to the left hand side and Customers to the right hand side and recognises the importance of the relationships that the organisation has with these external parties in the overall process of adding value. (b) AVN is operating in a market that is constantly changing as a result of new technology being developed. As a consequence AVN needs to ensure that their organisation is as efficient and flexible as possible. By building a relationship with a small number of suppliers, AVN can benefit by being assured of receiving quality components without the need for excessive inspection of deliveries. This relationship also benefits the supplier as they are guaranteed continuity of demand and can plan to meet AVN s production schedules. Each of the internal factors can be applied to AVN as follows: R & D The generation of, and experimentation with, ideas for new devices and processes; Design The detailed planning and engineering of devices and processes; Production The coordination and assembly of resources to produce a product; Distribution The mechanism by which AVN s products are delivered to their customers; Customer Services The support activities provided to customers before and after the devices are installed. Customers are the other important external factor within the extended value chain. AVN must meet the demands of customers both present and future. In a highly competitive market such as that found today, it is essential that AVN understands the needs of its customers and seeks to organise itself to meet those needs in the most efficient and effective way possible if it is to survive. P2 22 November 2006

23 Answer to Question Three (a) Introduction* Growth* Maturity Decline Weeks Number of units produced and sold 2,000 5,000 7,500 20,000 20,000 20,000 Selling price per unit $100 $80 $70 $60 $60 $40 Unit variable cost $50 $40 $40 $30 $25 $30 Unit contribution $50 $40 $30 $30 $35 $10 Total contribution $100,000 $425,000 $1,300,000 $200,000 Cumulative cash flow ($450,000) ($25,000) $1,275,000 $1,475,000 *Note: The Introduction and Growth stages are shown here for completeness. Candidates were not required to include these in their answer. (b) Economies of scale are likely to explain the reduction in unit costs over time. More specifically this could include the impact of the learning curve and the benefits of bulk purchase discounts. It is noted though that the unit variable cost rises in the decline stage and this is consistent with the diseconomy of scale, say in material purchase price, caused by the reduced volumes. Other costs also start to increase, possibly as a consequence of the reducing efficiency of the equipment being used, The reduction in selling prices over time is typical of the product life cycle. Market skimming in the introduction stage reflects high unit prices paid by a select few customers. The company s competitors enter the market in the growth phase and selling prices reduce (a) to stimulate demand, (b) to compete with new market entrants, and (c) to reflect the effect of economies of scale on costs. At the maturity stage, selling prices stabilise at $60 per unit. This reflects what may be an established oligopolistic market price. In the decline stage prices fall to attract what demand is still available as newer, better products emerge. November P2

24 Answer to Question Four Notes for meeting with Operational Managers: The implications of understanding costs and revenues for decision making The diagram shows the monetary values of costs and revenues over a range of activity levels. Fixed costs are costs which are not expected to change in total when there is a change in activity level within the relevant range. The diagram shows that these costs are incurred when there is a zero level of activity. This is usually as a result of making a decision to commence activity and incurring costs such as rent and rates on a business premises. In this case it can be seen that the level of fixed costs changes at certain levels of activity which have been identified as points B and D. This is an example of a stepped fixed cost. Clearly there is a significant increase in the level of costs as soon as these activity levels are reached. This means that for decision making a manager must be aware of these key activity points because otherwise they might accept an order which causes a significant increase in cost for a small amount of additional revenue. Total costs are the sum of the fixed costs referred to above and the variable costs. Variable costs are incurred in proportion to the level of activity and are most likely to be the ingredients and packing materials used in the food manufacturing process. The diagram shows that the variable costs are constant per unit of activity up to activity level B as the gradient of the line is constant throughout this activity range. Between activity levels B and D the variable costs are constant per unit, but the unit cost is lower than that up to point B possibly due to economies of scale and learning effects. However, above activity level D it can be seen that the gradient of the line increases. This represents a higher unit cost for these units. Sales revenue increases as the level of activity increases and the rate of increase is constant from the activity level of zero up to activity point C. This implies that the selling price per unit is constant up to this point. However, above point C while the total sales revenue continues to increase, it does so at a decreasing rate. This shows that the market research indicates that in order to sell a volume higher than activity level C the price per unit must be reduced. The diagram can also be used to identify the level of activity at which profits are maximised. This lies at the activity level where the vertical distance between the sales revenue and total cost lines is greatest. Activity level A represents the level of activity at which the total revenue and total costs are equal and thus there is neither a profit nor a loss. This is commonly referred to as the breakeven point. This means that at activity levels lower than point A the company makes a loss, but that beyond activity point A profits start to be earned. Activity level B has already been explained as the point at which the fixed costs and total costs increase due to the step effect. It can be seen that this has a significant effect on the profit being earned. Activity level C shows the point at which reductions in selling price are required in order to increase the volume of sales being achieved. Beyond this point the slopes of the total cost and sales revenue lines show that total costs are rising faster than total revenues and thus profits are falling. Activity level D shows the impact of the next step in the fixed costs which has a similar effect on profit as that indicated in relation to activity point B above. P2 24 November 2006

25 SECTION C Answer to Question Five (a) Absorption costing is a costing system that attributes all production costs to individual cost units. As a consequence its use as part of a cost plus pricing system should ensure that the company is profitable providing the volume of sales provides a mark up that is sufficient to cover the non production costs that are incurred. Marginal costing is a costing system that only attributes variable production costs to the cost unit. Thus the percentage mark-up that is added as part of a cost plus pricing system must be sufficient to cover the fixed production overhead costs as well as the non production overhead costs before any profit results. Both systems are used in an environment where market based pricing is either difficult or inappropriate, often because of the uniqueness of the product or service being provided. Thus cost plus pricing enables senior managers to delegate the price setting decision to operational managers. Both systems have their own problems. The use of absorption cost means that the price is dependent at least in part on the method used to absorb the costs into each cost unit. Furthermore it suggests that this is the cost of the individual item whereas in fact it includes costs that would continue to be incurred if the item were not produced. Thus a manager may reject a sale because the customer is only prepared to pay a price which is less than the absorption cost, but in fact that price would be better than no sale because it exceeds the variable cost and thus makes a contribution to the fixed costs that would be incurred anyway. The use of marginal costing identifies the variable cost of the item produced and thus provides a clear indication of the minimum price that should be charged so as to avoid a negative contribution. However this approach may mean that managers are persuaded to sell items at too low a price, so that the contribution earned is insufficient to cover the fixed costs of the business. Also it is very difficult to increase the price for a subsequent sale of the same item to the same customer, so the company may find it difficult to break out of the low price arena once they have entered it. (b) Hours Direct labour hours: W 15,000 x 4 60,000 X 24,000 x 3 72,000 Y 20,000 x 5 100, ,000 Absorption rate $1,044,000 / 232,000 $4 50 per direct labour hour Product W X Y $/unit $/unit $/unit Direct material Direct labour Overhead Total November P2

26 (c) Cost driver rates: W X Y Number of batches Number of supplier orders Number of machine hours (000) Material ordering cost $220,000 / 400 = $550 per supplier order Machine setup cost $100,000 / 110 = $909 per batch Machine running cost $400,000 / 407,000 = $ per machine hour General facility cost $324,000 / 407,000 = $ per machine hour Note: The values shown in the table below are calculated using these cost driver rates. This causes minor differences compared to the total overhead cost because of roundings. Product W X Y Total /unit Total /unit Total /unit $ $ $ $ $ $ Direct materials Direct labour Material ordering 66,000 99,000 55,000 Machine setups 27,270 54,540 18,180 Machine running 73, , ,592 General facility 59, , , , , , Total cost (d) The above calculations show that the unit cost of product W is similar under both the current absorption and activity based costing methods. However there are significant differences in the unit costs of product X and product Y. This may provide an opportunity to change the selling prices of these products to reflect their true cost. As a result, profitability may be improved. Activity Based Costing recognises the causes of costs and attributes the costs to products depending on their utilisation of the activities that cause costs to be incurred. As a consequence it is argued that the attribution of costs is less arbitrary than traditional absorption costing and leads to more accurate unit costs. The management of KL can use the information provided by the Activity Based Costing approach to identify potential cost savings by changing the method of operation within the company; for example by increasing the size of each batch or standardising on the material suppliers.that are used to reduce the number of supplier orders. It may also be appropriate to consider investing in new machines to reduce the number of machine hours. The effect of Activity Based Costing is often to identify costs as being more controllable because their cause has now been identified. While some facility costs will remain and are truly fixed as they are not driven by any particular future activity, many of the other costs will now become variable depending on the number of times an activity is performed and therefore more controllable. P2 26 November 2006

27 Answer to Question Six (a) The expected size of the audience is: (300 x 0 5) + (400 x 0 3) + (500 x 0 2) = 370 people The expected value of contribution from non-ticket sales is: ($3 x 0 3) + ($5 x 0 5) + ($10 x 0 2) = $5 40 Ticket price = $25 00 Expected income ($ $5.40) x 370 $11,248 Less MS fee $10,000 Expected gain $1,248 Thus MS should be engaged for the concert. (b) Size of audience Contribution from confectionery sales $3 (1,600) 1,200 4,000 $5 (1,000) 2,000 5,000 $ ,000 7,500 All values shown in the cells of the above table are in $ (c) The probabilities can be combined to show the probability of each of the nine possible outcomes occurring. These are shown in the following table: Size of audience Contribution from confectionery sales $3 15% 9% 6% $5 25% 15% 10% $10 10% 6% 4% By combining the values that have been summarised in these two tables it can be seen that there is a 40% chance of the concert making a loss (and hence a 60% chance of it having a profit). Furthermore it can be seen that the solution found in part (a) is an average value and that the range of possible results is from a loss of $1,600 to a profit of $7,500. The probabilities can also be used to demonstrate that the distribution of possible values is skewed, because the probability of the profit being above the average (expected) value of $1,248 is 41%. The theatre management can use this information to evaluate their decision more thoroughly. Instead of relying on a single possible value these tables show the range of values that could occur and the likelihood of each of them occurring. The information therefore allows the theatre management to consider the risks associated with their decision. November P2

28 (d) The maximum price that should be paid for the information is the difference between the expected value that would result from actions taken with the information compared to the expected value calculated without the information (as already calculated above $1,248). There are two aspects to the information: the size of the audience and the level of contribution from confectionery sales. The possible combinations/decisions and their probabilities and expected values are as follows: Audience Confectionery Contribution ($) Outcome ($) Decision Probability Expected Value ($) Yes (1,000) No (1,600) No ,000 Yes ,000 Yes ,200 Yes ,500 Yes ,000 Yes ,000 Yes Total 1,738 The value of the information and therefore the maximum price that should be paid for it is $1,738 less $1,248 = $490. P2 28 November 2006

29 Answer to Question Seven (a) m m m m m m Sales Variable cost: Production Sales Fixed cost: Production Sales Administration Total cost Pre-tax operating cash flow Tax Post-tax operating cash flow (1 0) Capital cash flow (50 0) 1 0 Total cash flow (50 0) (1 0) DF@12% PV (50 0) (0 6) NPV = 22 1m The investment has a positive NPV and therefore is financially worthwhile. Workings: Capital allowances Operating profit Taxable profit Tax Payable current year Payable next year m m m m m m 2007 Cost 50 WDA WDA WDA Disposal 1 0 Balancing allowance November P2

30 Note: The tax liability has been rounded so that the tax payments are stated to the nearest 0 1m (b) The IRR is found by comparing the NPV at two different discount rates. Since the investment has a positive NPV at 12% then a higher discount rate should be chosen. Using a 20% discount rate results in the following: Total cash flow ( m) (50 0) (1 0) DF@20% PV ( m) (50 0) (0 4) NPV = 11.5m Thus an 8% increase in the discount factor caused NPV to reduce by 10 6m. The internal rate of return is found when the NPV equals zero so it can be estimated to be approximately: 20% + (11 5 / 10 6 x 8%) = 29% (c) The difference between the real rate of return and the money rate of return is the annual rate of inflation. The money rate of return includes an allowance for annual inflation whereas the real rate of return does not. Thus the two rates are connected by the formula: (1 + real rate of return) x (1 + inflation rate) = (1 + money rate of return) so that for example if the real rate of return required from a project is 6% per annum and annual inflation is expected to be 4% per annum, the money rate of return required is given by: 1 06 x 1 04 = The required money rate of return would thus be 10 24%. This is slightly more than the result of simply adding together the 6% and 4% together because of the compounding effect. This can be applied to investment decisions because such decisions usually occur within a real world environment in which inflation exists, so to ignore the effects of inflation is a simplification that may not be appropriate. Most managers when asked to predict future costs and revenues will think in terms of today s price levels and then estimate the inflation that is expected to occur in future periods. This means that the predicted cash flows are stated in terms of future price levels and thus the viability of the investment must be measured using an inflation inclusive cost of capital. However, the exercise of inflating each of the future cash flows can be time consuming. If the rate of inflation to be applied to EVERY element of the investment is the same then the same result can be determined by not inflating ANY of the investment cash flows and discounting instead using the real cost of capital. P2 30 November 2006