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

Transcription

1 November 2008 Examinations Managerial Level Paper P2 Management Accounting Decision Management 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 February is a Post Examination Guide for the 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. The Chartered Institute of Management Accountants 2008

2 Management Accounting Pillar Managerial Level Paper P2 Management Accounting - Decision Management 19 November 2008 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, highlight and/or make notes 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 the 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. ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking. Answer the ONE compulsory question in Section A. This has eight subquestions and is on pages 3 to 5. Answer ALL THREE compulsory questions in Section B on pages 8 to 8. Answer TWO of the three questions in Section C on pages 9 to 14. Maths Tables and Formulae are provided on pages 15 to 17. The list of verbs as published in the syllabus is given for reference on page 18. Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the 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 2008

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. Question One 1.1 A company has an annual post tax money cost of capital of 18%. If inflation is 5% per annum the company s annual post tax real cost of capital is closest to A 12% B 13% C 23% D 24% (2 marks) 1.2 A company is considering a short-term pricing decision for a contract that would utilise some material P that it has held in inventory for some time. The company does not foresee any other use for the material. The work would require 1,000 kgs of Material P. There are 800 kgs of Material P in inventory, which were bought some time ago at a cost of $3 per kg. The material held in inventory could currently be sold for $3 50 per kg. The current purchase price of Material P is $4 50 per kg. The relevant cost of Material P for the company to use when making its pricing decision for the contract is closest to A $3,300 B $3,500 C $3,700 D $4,500 (2 marks) November P2

4 1.3 The table below summarises data that have been extracted from the cost accounting records of SV Limited. The data show the cost and the inflation index relevant to the period in which the costs were incurred. Output level Total cost Inflation index 3,000 units 9, ,000 units 11, The uninflated variable cost per unit of output to be used when predicting future costs is closest to A 2 30 B 2 59 C 2 80 D 2 97 (2 marks) 1.4 A company has only $700,000 available for investment during the coming year. It has identified the following four investment opportunities, all of which are divisible, and have the same life. Investment Capital required $ Net Present Value $ J 400, ,000 K 250, ,000 L 300, ,000 M 350, ,000 Calculate the correct rank order for these investments (best first). (2 marks) 1.5 A company is considering investing $100,000 in a new machine that will reduce its annual cash operating costs as follows: Year Operating cash costs saved $ Calculate the payback period to the nearest 0 1 years. (2 marks) Section A continues on the next page P2 4 November 2008

5 1.6 A company has recently launched a new product. The average time taken for the first 4 units was 24 minutes per unit and the average time taken for the first 32 units was 9 34 minutes per unit. Calculate the rate of learning that occurred. (3 marks) 1.7 A company manufactures three products and is planning the use of its resources for the next quarter. Details of the products and their resource requirements are as follows: Product Q R T Contribution per unit $36 $38 $44 Material A per unit (S1) 5 kgs 6 kgs 4 kgs Material B per unit (S2) 6 litres 3 litres 8 litres Labour per unit (S3) 4 hours 5 hours 6 hours All of these resources are limited in supply. The total available resources for the next quarter are: Material A (S1) 4,800 kgs Material B (S2) 5,000 litres Labour (S3) 3,500 hours Prepare the initial equations for S1, S2 and S3 to be used in solving this problem using linear programming. (3 marks) 1.8 A company is considering the price of one of its products for next year. It expects that the variable cost of making the item will be $15 per unit. It has also determined that if the selling price were to be $35 per unit then the demand would be 500 units per week. However, for every $5 increase in selling price, there would be a reduction in demand of 50 units per week; and for every $5 reduction in selling price, there would be an increase in demand of 50 units per week. Calculate the optimal selling price. Note: If Price P = a-bx then Marginal Revenue = a-2bx (4 marks) (Total for Section A = 20 marks) Reminder All answers to Section A must be written in your answer book. Answers to Section A written on the question paper will not be submitted for marking End of Section A November P2

6 SECTION B 30 MARKS [the indicative time for answering this section is 54 minutes] ANSWER ALL THREE QUESTIONS Question Two NLM uses a common process to manufacture three joint products: X, Y and Z. The costs of operating the common process total $75,400 each month. This includes $6,800 of apportioned head office costs. The remaining costs are specific to the common process and would be avoided if it were discontinued. Common costs are apportioned to the joint products on the basis of their respective output volumes. The normal monthly output from the common process is: X Y Z 4,000 litres 5,000 litres 4,500 litres There are a number of manufacturers of products that are identical to products X, Y and Z and as a result there is a competitive market in which these products can be bought and sold at the following prices: X Y Z $5 00 per litre $4 50 per litre $5 50 per litre Currently NLM uses the output from the common process as input to three separate processes where X, Y and Z are converted into SX, SY and SZ. The specific costs of these further processes (which are avoidable if the further process is discontinued) are as follows: X to SX Y to SY Z to SZ $1 25 per litre plus $1,850 per month $1 80 per litre plus $800 per month $1 55 per litre plus $2,400 per month The market selling prices of the further processed products are: SX SY SZ $6 75 per litre $7 50 per litre $7 20 per litre Required: (a) (b) Advise NLM as to which (if any) of the further processes should continue to be operated. State any relevant assumptions. (6 marks) Advise NLM whether they should continue to operate the common process. State any relevant assumptions. (4 marks) (Total for Question Two = 10 marks) P2 6 November 2008

7 Question Three (a) A manufacturing company has developed a new product. The time taken to manufacture the first unit was 24 minutes. It is expected that an 80% learning curve will apply for the first three months of production and that by the end of that period the total number of units produced will have reached 1,024. It is then expected that the time taken for each subsequent unit will be the same as the time taken for the 1,024 th unit. Required: (i) Calculate the expected time taken for the 8 th unit. (3 marks) (ii) Explain two reasons why the time taken for the 1025 th unit may be more than expected. (2 marks) Note: The value of the 80% learning index is (b) Explain the importance of considering the learning curve when deciding on the terms for a gain sharing arrangement with employees. (5 marks) (Total for Question Three = 10 marks) November P2

8 Question Four You are the Management Accountant of a small engineering company, which is a member of a large engineering group. The Managing Director has recently joined the company and has little experience of the engineering sector. He has recently returned from the group s annual management conference. The Managing Director found the seminars very useful but he is a little confused about two topics. One of the presentations discussed the use of Target Costing within the group. The Managing Director had previously thought that Target Costing would not be appropriate for an engineering group, because he thought it could only be used in an organisation that manufactured similar products. He now realises that he may be confusing Target Costing and Standard Costing. He seeks your help in explaining Target Costing and how it differs from Standard Costing. Another presentation discussed alternative investment appraisal techniques. The presenter used an example that compared three investments that were evaluated using incremental profit, accounting rate of return, payback and net present value. The presenter argued that net present value is theoretically superior to the other methods. The Managing Director seeks your help in understanding why the net present value technique is superior to the alternative investment appraisal techniques. Required: Prepare a report to the Managing Director that (a) explains Target Costing and how it differs from Standard Costing; (7 marks) (b) explains why net present value is superior to the three other investment appraisal techniques stated above. (3 marks) (Total for Question Four = 10 marks) (Total for Section B = 30 marks) End of Section B P2 8 November 2008

9 SECTION C 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS OUT OF THREE Question Five A retail company has a number of individual retail outlets in different towns. Each outlet has its own manager who can make decisions about the individual retail outlet, provided these decisions are within the parameters of the overall company policy. The performance of each individual manager is measured based on the profits of the retail outlet that he or she manages. Company policy It is company policy that each of the retail outlets should stock the following categories of items for sale to customers: Newspapers and magazines Fresh fruit and vegetables Tinned food items Frozen food items Company policy also requires that no single category should occupy more than 40% or less than 15% of the total display space available. In addition, at their own discretion, managers are permitted to use up to 10% of the total display space available for other products that meet other localised needs. The KL Retail Outlet The following weekly sales and cost data relate to the KL retail outlet; one of the outlets owned by the company: Sales $000 Purchase costs $000 Display space % Newspapers and magazines Fresh fruit and vegetables Tinned food items Frozen food items Other products The total display space available is 800 square metres. For each category of items for sale: sales revenue is directly proportional to the floor area occupied, purchase costs are directly proportional to sales revenue. In addition to the purchase costs of the items sold the retail outlet incurs other costs that total $280,000 per week. November P2

10 Required: (a) Demonstrate, using the above information and appropriate calculations, how the Manager of the KL retail outlet should allocate the space available between the different categories of items for sale to customers in order to maximise his weekly profit. (7 marks) (b) You have recently joined the retail company as its Assistant Management Accountant and, as your first project, you have been asked to compare the profitability of a number of the retail outlets. One of those within your comparison is the KL retail outlet. You have visited the KL retail outlet and have investigated the costs that are being incurred in addition to the purchase costs of the items sold. You have confirmed that typically the retail outlet incurs other costs that total $280,000 per week. Further analysis has shown that these include staff salary costs (excluding any profit-related bonus earned by the manager), staff training costs, rent, light & heat, power, equipment depreciation, point of sale software costs, stationery, telephone, inventory storage and handling costs, marketing costs and head office charges. You have discussed these other costs with the Manager of the retail outlet. The Manager of the retail outlet does not think that gross profit should be used as the basis for allocating space to items. He has suggested that some of the other costs should be attributed to the product category to which they relate rather than ignored when making the space allocation decision. Required: Prepare a report, addressed to the manager of the KL retail outlet that explains (i) the principles of Direct Product Profitability (DPP); (ii) how these principles may be applied to his retail outlet; and (iii) how their application may improve the profits of his retail outlet. (18 marks) (Total for Question Five = 25 marks) P2 10 November 2008

11 Question Six (a) A manufacturing company is considering its pricing policy for next year. It has already carried out some market research into the expected levels of demand for one of its products at different selling prices, with the following results: Selling Price Per unit Annual Demand (units) $100 50,000 $120 45,000 $130 40,000 $150 25,000 $160 10,000 $170 5,000 This product is manufactured in batches of 100 units, and analysis has shown that the total production cost depends on the number of units as well as the number of batches produced each year. This analysis has produced the following formula for total cost: Z = 70x + 80y + $240,000 Where Z represents the total production cost x represents the number of units produced; and y represents the number of batches of production. Required: (i) (ii) Prepare calculations to identify which of the above six selling prices per unit will result in the highest annual profit from this product. (7 marks) Explain why your chosen selling price might not result in the highest possible annual profit from this product. (3 marks) (Total for requirement (a) = 10 marks) (b) The company is also launching a new product to the market next year and is currently considering its pricing strategy for this new product. The product will be unlike any other product that is currently available and will considerably improve the efficiency with which garages can service motor vehicles. This unique position in the market place is expected to remain for only six months before one of the company s competitors develops a similar product. The prototype required a substantial amount of time to develop and as a result the company is keen to recover its considerable research and development costs as soon as possible. The company has now developed its manufacturing process for this product and as a result the time taken to produce each unit is much less than was required for the first few units. This time reduction is expected to continue for a short period of time once mass production has started, but from then a constant time requirement per unit is anticipated. November P2

12 Required: (i) (ii) Explain the alternative pricing strategies that may be adopted when launching a new product. (6 marks) Recommend a pricing strategy to the company for its new product and explain how the adoption of your chosen strategy would affect the sales revenue, costs and profits of this product over its life cycle. (9 marks) (Total for requirement (b) = 15 marks) (Total for Question Six = 25 marks) P2 12 November 2008

13 Question Seven A restaurant company is considering further investment in order to increase its seating capacity. The company prepares its accounts to 31 December each year and, if accepted, the proposed investment would be made on 1 January 2009 and will become operational immediately. Based on the actual results for the year to date, the latest forecast income statement for the company for the year to 31 December 2008 is as follows: Food sales 180 Drink sales Food costs 125 Drink costs 70 Staff costs 55 Other costs * Profit 35 *These other costs include rent, light & heat, power and administration overheads. 30% of these costs vary in proportion to the value of sales and the remainder are fixed costs. The proposed investment At present the restaurant is not able to exploit the growing demand from customers because it does not have sufficient seating capacity. The restaurant is considering the investment of 40,000 on 1 January It is expected that this will increase the seating capacity of the restaurant by 30% compared to the present level. The lease of the current business premises ends at the end of At that time the 40,000 investment will have no residual value. Of this total investment, 30,000 will qualify for 100% tax depreciation in 2009 and the remainder will qualify for 20% tax depreciation per year, commencing in 2009, calculated on a reducing balance basis. Any balancing tax charge will be made or allowance will be available at the end of Sales It is expected that the additional sales of food and drink will be proportional to the seating capacity increase and that the mix of food sales and drink sales will not change. Costs It is expected that apart from the effects of inflation (see below): Food costs and drink costs will continue to be the same percentages of food sales and drink sales as they are in the forecast income statement shown above. Staff costs are step costs and are expected to increase by 20% from their forecast value for 2008 if there is any capacity increase. The variable element of other costs is expected to increase in proportion to the capacity increase; the fixed cost element is expected to increase by 10,000 if there is any capacity increase. Inflation Cost inflation is predicted to be 4% per annum for each of the years 2009 to 2012 whereas selling prices are only expected to increase by 3% per annum during the same period. Taxation The company pays tax on its profits at 20%. This is payable one year after the profit is earned. Cost of capital The company s post tax money cost of capital for evaluating this investment is 8% per annum. November P2

14 Required: (a) (b) (c) Prepare calculations to show whether the investment is worthwhile assuming that the 30% increase in seating capacity is fully utilised and recommend whether the investment should proceed. (14 marks) Calculate and interpret the Internal Rate of Return (IRR) of the proposed investment. (6 marks) Calculate the sensitivity of your recommendation to changes in the percentage capacity utilisation. (5 marks) (Total for Question Seven = 25 marks) (Total for Section C = 50 marks) End of Question Paper P2 14 November 2008

15 PRESENT VALUE TABLE Present value of $1, that is payment or receipt. ( 1+ r ) n where r = interest rate; n = number of periods until 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

16 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% P2 16 November 2008

17 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 ) n X 2 ( X ) 2 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. November P2

18 LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb. LEARNING OBJECTIVE VERBS USED DEFINITION 1 KNOWLEDGE What you are expected to know. List Make a list of State Express, fully or clearly, the details of/facts of Define Give the exact meaning of 2 COMPREHENSION What you are expected to understand. Describe Communicate the key features Distinguish Highlight the differences between Explain Make clear or intelligible/state the meaning of Identify Recognise, establish or select after consideration Illustrate Use an example to describe or explain something 3 APPLICATION How you are expected to apply your knowledge. 4 ANALYSIS How you are expected to analyse the detail of what you have learned. 5 EVALUATION How you are expected to use your learning to evaluate, make decisions or recommendations. Apply Calculate/compute Demonstrate Prepare Reconcile Solve Tabulate Analyse Categorise Compare and contrast Construct Discuss Interpret Produce Advise Evaluate Recommend To put to practical use To ascertain or reckon mathematically To prove with certainty or to exhibit by practical means To make or get ready for use To make or prove consistent/compatible Find an answer to Arrange in a table Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between To build up or compile To examine in detail by argument To translate into intelligible or familiar terms To create or bring into existence To counsel, inform or notify To appraise or assess the value of To advise on a course of action P2 18 November 2008

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 This question tests candidates ability to demonstrate their understanding of relevant costs and revenues when deciding whether or not to continue operating separate processes within a joint product environment. This question addresses the learning outcome: Explain why joint costs must be allocated to final products for financial reporting purposes, but why this is unhelpful when decisions concerning process and product viability have to be taken. Question Three This question tests candidates knowledge of the learning curve and its relevance to gain sharing arrangements with employees. This question addresses the learning outcomes: Explain and apply learning and experience curves to estimate time and cost for new products and services and Discuss gain sharing arrangements whereby contractors and customers benefit if contract targets for cost, delivery etc, are beaten. Question Four This question tests candidates ability in part (a) to distinguish between Target Costing and Standard Costing. This part of the question addresses the learning outcome: Explain how target costs can be derived from target prices and describe the relationship between target costs and standard costs. In part (b) candidates were required to explain why Net Present Value is a superior technique compared to other investment appraisal techniques. This part of the question addresses the learning outcome: Compare contrast and evaluate the alternative techniques of investment appraisal. Section C answer two of three questions Question Five This question tests candidates ability to analyse the data provided to determine the optimum use of space available in a retail outlet and then to explain how the use of activity based costing might improve the information available to the manager. This question addresses the learning outcomes: Apply variable/fixed cost analysis in multiple product contexts to breakeven analysis and product mix decision making, including circumstances where there are multiple constraints and linear programming methods are needed to reach optimal solutions; and Apply activity based costing ideas to analyse direct customer profitability and extend this analysis to distribution channel profitability. Question Six This question tests candidates ability in part (a) to interpret relevant data to determine the most profitable selling price from those provided and to explain why this may not be the optimal selling price, and in part (b) to explain alternative pricing strategies for a new product and recommend the strategy to be used by the company in the scenario provided This question addresses the learning outcomes: Apply an approach to pricing based on profit maximisation in imperfect markets and evaluate the financial consequences of alternative pricing strategies. Question Seven This question tests candidates ability in part (a) to calculate the net present value of an investment proposal from the data provided and in parts (b) and (c) to calculate the Internal Rate of Return of the proposal and the sensitivity of their solution to changes in the anticipated capacity utilisation 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 November P2

20 appraisal and Apply sensitivity analysis on both short and long term decision models to identify variables that might have significant impacts on project outcomes. P2 20 November 2008

21 Managerial Level Paper P2 Management Accounting Decision Management Examiner s Answers SECTION A Answer to Question One /1 05 = Answer A 1.2 Answer C 800 kgs x resale price of $3 50 = $2, kgs x purchase price of $4 50 = $900 Total = $3,700 November P2

22 1.3 Output level Total cost Inflation index Uninflated total cost 3,000 units 9, ,900 4,000 units 11, ,200 There is a 2,300 difference in the uninflated cost for the extra 1,000 units, this equals 2 30 per unit. Answer A 1.4 Investment Capital NPV Profitability required index $ $ J 400, , K 250, , L 300, , M 350, , The rank order is K J L M 1.5 The cumulative operating costs saved are as follows: Year Operating costs saved $ Therefore payback occurs in year 3. To the nearest 0 1 years, the payback period is 2 full years plus 20/55 of the third year = 2 4 years. 1.6 Output is doubled three times from 4 units to 32 units. The average time for 32 units is % of the average time for 4 units. The third root of the learning index is thus so the learning index is 73%. P2 22 November 2008

23 1.7 Where q = number of units of Q, r = number of units of R and t = number of units of T. S1, S2 and S3 are unutilised material A, material B and labour respectively. 5q + 6r + 4t + 1S1 = 4,800 6q + 3r + 8t + 1S2 = 5,000 4q + 5r + 6t +1S3 = 3, For demand to equal zero there needs to be 10 x $5 increase in selling price, that is the price at which demand = zero is $35 + $50 = $85 Price = $85-0 1x Marginal revenue = $85-0 2x Marginal cost = $15 Equating marginal cost and marginal revenue: 15 = x 0 2x = 70 x = 350 If x = 350 then Price = $85 - (0 1 x 350) = $50 November P2

24 SECTION B Answer to Question Two (a) Incremental Contributions Incremental Incremental per litre total fixed cost profit/(loss) $ $ $ $ SX ,000 1, SY , ,200 SZ ,400 (1,725) Further process X and Y but not Z subject to the output volumes from further processing being: at least 3,700 litres of SX; at least 667 litres of SY; and no more than 16,000 litres of SZ (b) $ $ Relevant costs of the common process 68,600 Market values of common process outputs: X 4000 litres x $ ,000 Y 5000 litres x $ ,500 Z 4500 litres x $ ,750 67,250 Deficit 1,350 The common process should be discontinued, provided X, Y and Z continue to be available to buy in the market at the appropriate quality in the required quantities. P2 24 November 2008

25 Answer to Question Three (a) (i) The average time for seven units is given by the formula Y = ax b Y = 24 x Y = minutes The average time for eight units is given by the formula Y = ax b Y = 24 x Y = minutes Total time for 8 units (using average above) = minutes Total time for 7 units (using average above) = minutes Time for the eighth unit = 8 51 minutes (ii) The expected time for the 1025 th unit relies on the actual learning being the same as that expected. There are two aspects to the learning curve: the rate at which the learning occurs may be worse than expected; and the length of the learning period may be shorter than expected. These will both be affected by a number of factors which include: (b) the motivation of the employees to learn the new task; the motivation of the employees to continue to improve even after they have reached what they feel is an acceptable level of efficiency; the complexity of the task; the number of changes in the workforce during the learning period. A gain sharing arrangement is an arrangement whereby the gains of a particular activity are shared between the parties to that activity. In the context of employees being one party to the agreement, the gain would be a cost saving associated with manufacturing the item in a shorter time than that originally expected. If the learning curve were to be ignored when agreeing the target production time, then all of the benefits of learning would accrue to the employees with no benefit being received by the company. Equally, if the target is based on a post-learning position, then no credit would be given to the efforts of the employees during the learning period. It is thus important to recognise the learning effect and set target times for different phases of the learning period. In this way both the company and the employees can share the gains to be made from efficient working in a fair manner. November P2

26 Answer to Question Four REPORT To: From: Subject: Managing Director Management Accountant Target Costing, Standard Costing & Investment Appraisal Techniques Date: November 2008 Introduction This report has been produced to explain the topics that we discussed briefly when we met following your attendance at the group s annual management conference. (a) Target Costing & Standard Costing Target Costing is a system of costing that assumes that the service or product being provided to the customer has a market price that cannot be influenced by our company. Consequently, the only way for us to be profitable in relation to that product or service is for us to be able to deliver it to the customer for a target cost. The value of this target cost will be below the selling price of the item, but the actual target cost will depend on the required profit margin. Standard costing is a system of costing that compares actual costs and revenues per unit with expected costs and revenues per unit. These expected costs are referred to as standard costs and for many cost headings can be further analysed into two components: a resource quantity and the price of the resource. For example, the standard material cost would comprise the expected number of litres of material and the expected price per litre. Therefore the two terms target costing and standard costing are completely different. Some people may refer to the standard cost as being a target to be achieved, but this is not the same meaning as target costing. Investment Appraisal Techniques The techniques that you have referred to are all commonly used methods of evaluating an investment, but the difference between the net present value (NPV) technique and the others is that NPV considers the timing of the cash flow from the investment. All of the other methods (except Payback) are based on the difference between the cash inflows and outflows from the investment over its lifetime and place equal value on cash flows that occur at different times. NPV recognises the opportunity cost of money by discounting later cash flows more heavily than earlier ones to compensate for the cost of the money tied up in the investment. Conclusion I hope that this report has been useful. If you have any questions please do not hesitate to contact me. P2 26 November 2008

27 Answer to Question Five (a) Newspapers Fresh Tinned Frozen Other Magazines fruit food food Sales Purchase costs Contribution Floor space % Contribution per % Ranking 5 th 4 th 2 nd 1 st 3 rd Minimum % 15% 15% 15% 15% Balance % 15% 25% Total % 15% 15% 30% 40% 0% The manager should allocate the space available as shown in the final line of the above table in order to maximise profits. (b) REPORT To: From: Subject: Manager KL Retail Outlet Assistant Management Accountant Direct Product Profitability Date: November 2008 Introduction Further to my visit to your retail outlet I set out below an explanation of Direct Product Profitability (DPP) and how you may apply it to your retail outlet to improve future profits. The Principles of Direct Product Profitability (DPP) DPP is a costing system that recognises that it is activities that cause overhead costs to be incurred rather than the volume of activity. DPP is an extension of Activity Based Costing (ABC) which recognises that some costs are facility costs that relate to a past decision to locate the business in a particular area and that these costs are not controllable in the short term. Apart from these costs, it is important to understand the causes of activity costs so that they can be more accurately attributed to those products that use the activities that cause them. This should then provide a much more realistic product cost and thus enable decisions to be made that are based on a better understanding of the costs of a business. Applying DPP to the KL Retail Outlet Each of the overhead costs need to be separately considered to identify its cause. For some costs this will be easier than it is for others. For example the power cost associated with operating the freezers will clearly be a cost that is caused by the decision to sell frozen foods. Another example might be that some of the staff training costs were incurred specifically so that staff could advise customers on a particular type of product. This may well apply to some of the Other Goods that are currently being sold to your customers. Once the causes of these costs have been identified, it is then important to identify the extent to which each of the product categories is responsible for using the activity that causes the cost. November P2

28 This then provides the basis of attributing those overhead costs to individual product categories and the calculation of more accurate contribution values. Improving profitability More accurate calculation of the contribution of each of the product categories may well result in a change in the amount of display space that is allocated to each product category. However, this is only one of the ways in which DPP may improve the profitability of the KL Retail Outlet. Another consequence might be that, with a better understanding of the causes of costs, there may be some fundamental changes in the operation of the business. We may decide that investing in capital equipment may be worthwhile because of the cost savings that will occur by reducing the amount of movement of goods within the retail outlet. Conclusion I look forward to discussing this with you further when I next visit the KL Retail Outlet. Answer to Question Six (a) (i) Selling Total Total price Demand Revenue Cost profit (Units) $000 $000 $000 $100 50,000 5,000 3,780 1,220 $120 45,000 5,400 3,426 1,974 $130 40,000 5,200 3,072 2,128 $150 25,000 3,750 2,010 1,740 $160 10,000 1, $170 5, The maximum profit is achieved with a price of $130 per unit. (ii) (b) The solution makes an assumption concerning the slopes of the revenue and costs lines between the demand levels of 25,000 and 45,000 units. It further assumes that the profit maximising point occurs at one of the data points provided when in fact it could be slightly higher or slightly lower than the price of $130. Also the market research may not be accurate and the estimates of cost may be incorrect. When launching a new product there are two alternative strategies that may be adopted. These are known as: Market skimming; and Market penetration (i) Market skimming is the strategy of charging a very high price for the item which has the effect of only being acceptable to a small part of the market, hence the term skimming meaning taking the top layer of the market. It is only possible to use this strategy for goods and services that are unique and have a very high esteem value. Market penetration is the strategy of using a price that is low enough to gain significant market share before your competitors are able to establish themselves in the market. P2 28 November 2008

29 (ii) This company is launching a new product that is unique and, therefore, the company could adopt a market skimming strategy. If it were to adopt this approach, it would have the result of earning significant unit profits on those early sales, and these high profits might be large enough to repay most, if not all, of the company s research and development costs very quickly. It would not be long, however, before competitors were attracted towards making a similar product of their own, because of its high profitability (particularly if they can avoid the significant research and development costs by reverse engineering this company s own product). To minimise the effect of this, this company must be prepared to reduce the price of the product significantly just before its competitors enter the market. This should enable its product to reach the less wealthy members of the market place and cause it to achieve volume sales that will then allow its costs to fall, because of the effect of the learning and experience curve as the volume of production increases. This cost reduction could compensate for the lower selling prices so that unit profits will not be reduced significantly by the lower price. Answer to Question Seven (a) See attached calculations: The investment should proceed. (b) See attached calculations: The IRR is only an estimate, so it lacks some accuracy, but it shows that whilst the cost of money is less than 14%, the project is worthwhile; if the cost of money were to exceed 15% then the investment is not worthwhile. Between these values more analysis is required to establish whether the investment is worthwhile or not. However, since the current cost of capital is 8%, an increase to 14% would represent an increase of 75% of the existing level. Management needs to consider the likelihood of an increase of this size. (c) See attached calculations: November P2

30 Examiner's answer to Q7 version 2 Present Increase Cost inflation Price inflation Food sales Drink sales Total sales Food costs Drink costs Staff costs Var other costs Fixed other costs Total costs Profit % Investment -40 CAPITAL ALLOWANCES Claim C/fwd Tax saved on investment Net cashflow % Present Value NPV % Present 10% NPV IRR =10% equals 14.32% Sensitivity Capacity variables pre tax % Capacity variables post tax Discount 8% Present Value NPV Sensitivity =