CPA Mock Evaluation Management Accounting Module (Core 2) Page 1

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1 CPA Mock Evaluation Management Accounting Module (Core 2) Page 1 Overview The Core 1 and 2 examinations are a mix of objective format and case questions. The maximum length for an individual case will be 60 minutes. The Core cases must assess the cross-competency integration, problem-solving and communication elements, which will be introduced in Core 1 and 2 (see CPA Competency Map for the competency areas being integrated). Core 1 case(s) will reflect mostly routine and low to medium complexity situations, and will provide candidates with sufficient direction to demonstrate an early level of professional skill development. By the end of Core 2, candidates should be more comfortable with cases and have further developed their critical thinking ability; Core 2 case(s) could be a bit more complex than in Core 1; Core 2 cases could also incorporate Core 1 (and any Entry level) learnings as the program builds on prior learnings. This Core 2 question tests management accounting concepts in a small business environment. Candidates are required to assume the role of a business adviser and provide an assessment of the company s profitability. Once they have assessed the company s current situation, candidates should apply basic management accounting concepts to evaluate alternative courses of action for improving profitability. The owners of the business do not have a sophisticated knowledge of accounting, so concepts have to be explained to them in an appropriate manner. The case is focused on the development of analysis skills and the ability to develop assumptions. FENCE COMPANY LTD. (Suggested time: 60 minutes) Fence Company Ltd. (FC) was incorporated in March 2015, and is owned equally by Robert and Morris Wood. The company constructs residential wood fences. FC s first year was a difficult one. It is now late March 2016, and the Wood brothers are making plans to improve FC s performance. Having decided that they needed outside advice, they asked you, CPA, to meet with them. At the meeting, you asked the brothers to describe their operations and to highlight their major concerns. The following paragraphs are your notes on the information and comments provided by Robert and Morris Wood during the meeting. The owners project that at a price of $19 a linear foot, FC will have demand to construct 60,000 linear feet of fence this year. To achieve this target, they think that one work team will be needed during the 12 weeks of April, October and November, and three teams during the 20 weeks from May through September. Their projection assumes an eight-hour day and a regular five-day week. Last year they found that an average team consisting of three people could build a 100-linear-foot fence in an eight-hour day.

2 CPA Mock Evaluation Management Accounting Module (Core 2) Page 2 The average labour cost last year was $12.50 per hour with benefits costing $2.50 per hour. Labour costs are expected to increase 10% in Last year there was little control over the amount of wood used on projects; the owners want to change this situation. The brothers recognize that fence building is not a year-round activity and are willing to cover any cash deficiency as long as there are prospects of profitability. The owners need to take out at least $50,000 each per year. In addition, they intend to hire a full-time receptionist to start on April 1 and to employ this person year-round. They expect that the salary will be about $36,000 a year (benefits included in this amount) but think that the cost will be worth it to ensure continuity and maintain the company s image. A truck will have to be rented for each work team, at $1,500 per month. Robert Wood thinks that they should keep two of the trucks from December to March for snow removal. He and Morris could do the work and lay off everyone except the receptionist. Other fixed expenses related to the truck rental, including insurance, are $4,500 per year. FC will also need to rent a machine for $600 a month to dig holes. In addition, it will cost approximately $120 to move the machine from one work site to another, unless the job sites are part of a multiple house order. The company spent $13,000 on gas and maintenance and $1,200 on telephone last year. The owners expect to hold the line on these costs this year. Morris Wood estimates that their costs last year were approximately $6 per linear foot for wood and $1 for nails and stain. The standard selling price last year was $18 per linear foot. Robert Wood thinks that they should try for $19 this year. FC s salesperson complained last year because he could not discount the price. The brothers think that it might be a good idea to allow the salesperson to go down to $18 if forced to do so in order not to lose the sale. They are considering offering the same 4% discount for any orders in April as this worked well last year. They may also offer a 10% discount on group orders for fences for four or more houses. According to the owners, a good incentive for their salesperson is crucial to increased sales. Last year, they paid the salesperson 5% of gross revenue for a basic one-house order for a fence of about 100 linear feet. For a two or three-house order they paid 7.5%. They believe that the incentive was responsible for the fact that FC had a lot of two-house orders last year. Starting in April, FC will be paying $2,500 a month to rent a warehouse for storing wood and equipment for the year. The landlord wants a security deposit of one month s rent. Draft a report to the Wood brothers that present your analysis of the issues and your preliminary recommendations.

3 CPA Mock Evaluation Management Accounting Module (Core 2) Page 3 MARKING GUIDE FENCE COMPANY LTD. This particular question draws mainly upon Core 2 and Entry level competencies, with little integration of Core 1 competencies. This question tests management accounting concepts in a small business environment. Candidates are expected to assume the role of a business advisor and provide an assessment of the company s profitability. Once they assess the current situation, they should apply management accounting concepts to identify alternative courses of action for improving profitability. The owners of the business are not sophisticated in accounting and therefore concepts need to be explained to them in an appropriate manner. This particular case also assesses candidates ability to make reasonable assumptions where necessary. Many assumptions were required on the part of the candidate. All assumptions should be clearly stated. Dear Robert and Morris Wood: I enclosed my report on Fence Company Ltd. (FC). It discusses my analysis of FC s projected operations, based on my discussions with you, and ways of improving the projected results. It is my understanding that I have been engaged as a business advisor, to provide advice on how to improve FC s profitability in the coming year. From our discussions, I have assumed that your objective is long-run profitability. Financing was not identified as a problem, so I have not done a cash flow analysis. My analysis also assumes that you are both involved full-time in the business. If any of these assumptions is wrong, please let me know as soon as possible, as I will have to adjust the analysis. My analysis of the fence business follows in two parts: Feasibility of operations. Ways to improve operations. If I can help in any other way or if you have any questions regarding the report, please feel free to contact me. Yours truly, CPA

4 CPA Mock Evaluation Management Accounting Module (Core 2) Page 4 REPORT TO WOODS BROTHERS CPA Mapping (at CORE): Evaluates cost classifications and costing methods for management of ongoing operations (Core-Level A) Evaluates and applies cost management techniques appropriate for specific costing decisions (Core- Level B) Performs sensitivity analysis (Core- Level A) Analyzes the implications of management incentive schemes and employee compensation methods (Core- Level B) Develops or evaluates financial proposals and financing plans (Core- Level B) [recommendations part] Feasibility of operations If FC is to succeed in business, then its fencing operations must be profitable. The snowremoval activities are secondary, so I have not tried to quantify the revenue that may result from them. Instead I have assumed that the revenue from snow removal will cover variable expenses only. Fixed costs, however, have been computed on the basis of a full year of expenses. (A different assumption could have been made e.g. fixed and variable would be covered.) I have used contribution-margin analysis to calculate your break-even point and have compared that to your capacity to see whether you currently have the resources you need to cover all of your costs. The contribution approach separates cost into their fixed and variable components. Fixed costs are costs that do not change regardless of how much business the company is doing. Variable cost, on the other hand, change in direct proportion to changes in levels of activity (how much business the company is doing). The difference between sales and variable cost is called the contribution margin. It is the amount available to recover fixed costs. Contribution margin is a useful tool for planning and tells you how income is affected when selling prices are changed, when different levels of output are produced, and when changes in costs are made. To use it however, assumptions have to be made regarding different selling prices, levels of output, and so on. Exhibit I shows my analysis of your variable costs for one-house, two-house and four-house orders. My assumptions are stated in the exhibit. Normal consists of any fencing sold outside of the April discount period and April is separated throughout the analysis. Exhibit II shows my calculation of your fixed costs. Please study my assumptions in this exhibit to ensure that you agree with them. Based on my assumptions, you have total annual fixed costs of $230,900.

5 CPA Mock Evaluation Management Accounting Module (Core 2) Page 5 Using these figures, we can calculate your break-even point. Break-even is the point at which the company covers all its expenses, so there is neither any profit nor any loss. Exhibit III shows a breakdown of the capacity assumptions that the breakeven analysis can be compared to. Using the information you have given me, I have calculated the maximum number of feet that you can install. The maximum footage that can be installed in 2016 is 36,000 linear feet. This is less than your anticipated level of 60,000 linear feet. This will also be useful as a basis of comparison to see if the breakeven point is even feasible. Exhibit IV shows the Break-Even analysis and the Contribution Margin per linear foot under different housing options. One problem in using break-even analysis is that an assumption has to be made about the sales mix between the different orders. I have re-calculated the breakeven footage using different housing assumptions, but keeping material and labour costs static. This analysis will provide you with insight into the impact of different policies with respect to pricing and commissions, as well as give you the amount of fencing that needs to be installed to cover all of the costs of the business. Exhibit V summarizes the operating income of the business at the various levels based on the capacity constraints of the labour force. The labour force is limited to an average of 100 linear feet per day, and therefore profitability can only be calculated based on the annual capacity of 36,000 linear feet per season. The profitability is also further broken down to show the effect of the 4% discount in April. By this analysis, it is clear to see that under no circumstance will FC be profitable given the current business model. In conclusion, my analysis shows that FC will face a severe shortage of cash in the fall and may even face bankruptcy. Clearly, the operation is not feasible based upon the proposed pricing policy and the projected costs and level of output. Ways to improve results FC can increase the contribution to fixed costs in several ways. It can increase prices, decrease its variable costs, decrease commissions and/or volume discounts, or increase its level of output. If fixed costs can be reduced then the break-even point may also be reduced. Increase prices The contribution-margin analysis reveals that FC has a serious pricing problem. FC achieves its greatest contribution margin on sales of two-house installations. The savings from doing fourhouses instead of only one (economies of scale) do not appear to justify a volume discount or higher commissions. However, the cost figures do not accurately capture the economies of scale that may be present on volume orders, such as: More efficient use of labour and less idle time. Less travel time and gas for transport of wood. Possible reduced wastage on volume orders.

6 CPA Mock Evaluation Management Accounting Module (Core 2) Page 6 More accurate cost figures would be useful. We do not know how much of FC s business will be single houses vs. bulk orders. Therefore, the previous analysis (which uses the highest contribution margin of two-house fences) is suspect at best, unless the pricing and commission structure is altered to give a uniform contribution margin. Exhibit VI shows my analysis of the price increase that would be required to break even at your current capacity of 36,000 linear feet, for each of the one-house, two-house and four-house orders. For the one-house orders the price would have to be $19.57 per foot. For the twohouse orders the price would have to be $19.44 per foot. These prices are only slightly higher than the anticipated price of $ Whether or not such a price can actually be charged will depend on the market conditions prevailing in You had forecast that you could sell 60,000 feet at $19, so it might be possible to sell 36,000 feet at the increased price. Market prices would have to be analyzed to estimate the effect of a price increase on demand. The price increase needed to sell the four-house discount seems to go beyond where the market price is reasonable, and this policy should be considered for removal. Decrease commission rate An alternative to increasing the price is to decrease the commission. Assuming that one salesperson sells all of the budgeted output of 36,000 linear feet at the lowest commission, then the salesperson will receive gross commission income of: 36,000 x $19 x.05 = $34,200. At the highest commission the salesperson would be making $54,720, more than you as owners. This is a high level of remuneration, given that it represents about six months work. The commission rate could be decreased to perhaps 3%. The salesperson would still earn about $20,520. The salesperson would be making $27,360 if given a 4% commission. The feasibility of decreasing the commission rate will depend upon negotiations with the salesperson and the arrangements made in the previous year. Possibly one of you could take on the job of selling, to save the entire commission. The rates of commission should be linked to the contribution margins obtained on the sales. An increased commission on volume sales is unnecessary, since the salesperson will try to sell in bulk wherever possible anyway. The salesperson should not be allowed to give discounts if commission is based on gross revenue. (Salespeople will generally give discounts readily rather than lose sales.) The giving of the discount costs the salesperson only a small amount in remuneration because his commission is based on gross revenue, but it costs FC a great deal as a percentage of the contribution margin. By tying the salesperson s commission to the contribution margin, the problem of harmful discounting will disappear, while the salesperson will earn the same amount overall. In short, salespersons will become more aware of profitability.

7 CPA Mock Evaluation Management Accounting Module (Core 2) Page 7 Increase capacity Assuming that the prices and commission remain the same as planned, the level of output can be increased. Exhibit VII shows my analysis of increasing capacity to be able to install 72,000 linear feet of fencing and the additional costs that will be incurred to achieve that output. The increased output will be achievable if: Sufficient sales can be made without reducing price. Work crews can be hired. Vehicles would only be required for the five summer months. Quality can be maintained without increased supervision. FC has the financial resources to cope with this higher volume of business. The warehouse capacity is sufficient. Crews run at average levels of output This increases the capacity above the anticipated demand of 60,000 linear feet, but given the expectation on increasing controls with respect to wood usage, this average of 100 linear feet per day may come down if administrative duties are added to the crews installing the fences. This excess capacity allows for you to determine the levels of control and additional administrative work in the field and still be able to achieve the level of demand that is expected. Feasibility of FC revised [Note: candidates would not be expected to do these calculations to demonstrate their competence to achieve a pass these are beyond what is achievable in the 60 minutes for most candidates. Candidates would be expected to qualitatively discuss ways of improving the results only.] Exhibit VIII provides my analysis of the overall impact of the changes suggested to increase capacity. Assuming the selling price is increased to $19.00 per linear foot, capacity is doubled, and if the four home discount is discontinued, the projected output of 60,000 feet may be possible, in which case FC will make a profit of between $114,000 and $129,000. The two of you will be able to draw a salary of $50,000 each as this is included in fixed costs. I cannot tell how likely it is that FC will be able to achieve an increased output at the assumed prices, as I have only a limited knowledge of the industry. However, FC s ability to produce at the increased level, charging a price that will not only produce a profit but will also be acceptable to customers, will determine the company s success. Thus the various options discussed above must be considered in light of realities of FC s business world.

8 CPA Mock Evaluation Management Accounting Module (Core 2) Page 8 Inventory control, purchasing, scheduling and costing A systematic way of scheduling jobs must be devised. Customers should be given firm dates and, wherever possible, transportation of wood and machinery should be kept to a minimum. Installation of fences should be done on an area-by-area basis to reduce transportation costs and supervision. FC should purchase in bulk to take advantage of discounts. The company should also try to avoid having excess wood on hand due to costs of financing this inventory and storage problems. Trade-offs may have to be made when deciding on inventory levels, but they cannot be quantified without further information. The wood allocated to each job should be accounted for by each team and given to then before the job starts. A simple job-order costing system should be developed. The team supervisor should complete a form showing the wood allocated, the wood remaining, the time spent on the job by employees, the amounts of supplies such as glue, stain, etc. being used, and any tools broken. The teams should be controlled through site inspection and analysis of the costs. Costs per foot for various jobs and teams should be reviewed and compared. Eventually, standards costs can be determined for each order on the basis of the above information. Once standard costs are known, it will be possible to use this information in planning future prices and levels of output. The standards could serve as a benchmark: actual costs incurred on a job can be compared with standards to identify any inefficiencies and ways of controlling them in the future. Incentives The teams could be given bonuses paid, say, monthly and calculated on a team basis. The bonus scheme should reward efficiency (output per time spent) and lack of spoilage. There should be disincentives for broken or lost tools, customer complaints, and recalls to fix defective work. (Enablings: Candidates would be expected to be consistent throughout their analysis. Assumptions should have been incorporated into the quantitative analysis, and clearly explained. Preliminary recommendations should have been tied to the objectives and should have flowed logically from the analysis. The role of the candidate as a business adviser and the fact that, given current forecasts, the company would be unprofitable should have led candidates to do further analysis on ways of improving profitability. Recommendations should have been practical for a small business.)

9 CPA Mock Evaluation Management Accounting Module (Core 2) Page 9 EXHIBIT I VARIABLE COSTS 1 house Variable Costs Per ft Normal April Direct Materials (Note 1) $7.00 $7.00 Direct Labour (Note 2) $3.96 $3.96 Equipment Moving (Note 3) $1.20 $1.20 Discount (Note 4) $0.00 $0.76 Commission (Note 4) $0.95 $0.95 Total $13.11 $ houses Variable Costs Per ft Normal April Direct Materials (Note 1) $7.00 $7.00 Direct Labour (Note 2) $3.96 $3.96 Equipment Moving (Note 3) $0.60 $0.60 Discount (Note 4) $0.76 Commission (Note 4) $1.43 $1.43 Total $12.99 $ houses Variable Costs Per ft Normal April Direct Materials (Note 1) $7.00 $7.00 Direct Labour (Note 2) $3.96 $3.96 Equipment Moving (Note 3) $0.30 $0.30 Discount (Note 4) $1.90 $2.66 Commission (Note 4) $1.43 $1.43 Total Note 1 Note 2 Note 3 Note 4 Wood and Nails (3 workers*8 hours)/100 * Labour Rate (base + benefits) Moving costs prorated across number of houses Selling price times discount/commission

10 CPA Mock Evaluation Management Accounting Module (Core 2) Page 10 EXHIBIT II FIXED COSTS FOR THE YEAR April 1, 2016 to March 31, 2017 No provision has been made for insurance, office supplies, advertising, idle time, heat, light, power and property taxes at the warehouse, interest expense and miscellaneous. Note- Truck: April, October, November: 1 truck x 3 months x $1,500 =$ 4,500 May, June, July, August, and September: 3 trucks x 5 months x $1,500 = $22,500 December, January, February, March: 2 trucks x 4 months x $1,500 =$12,000 Additional costs related to truck rental: $4,500 Truck rental costs total : $4,500+$22,500+$12,000+$4,500=$43,500

11 CPA Mock Evaluation Management Accounting Module (Core 2) Page 11 EXHIBIT III CAPACITY OF OPERATIONS Month Teams People per Team Weeks Days per Week Hours/Day Hours Days April May June July August September October November Total Feet per Day Capacity (Ft/year) Assumptions 1. No provision for idle time or inclement weather; average projected crew efficiency is 100 feet per crew-day. 2. Crews do not work overtime and work only a five-day week. If these assumptions are incorrect, the labour costs must be revised upwards. 3. Same number of crews is assumed as last year; otherwise, the cost of gas and repairs and of tools and truck rental must be increased. (These costs are not truly fixed costs.) EXHIBIT IV BREAK EVEN ANALYSIS Break-Even & Contribution Margin Per Foot Analysis 1 house 2 houses 4 houses Normal April Normal April Normal April Fixed Costs (prorated) $218,072 $12,828 $218,072 $12,828 $218,072 $12,828 Revenue $19.00 $19.00 $19.00 $19.00 $19.00 $19.00 Variable Costs $13.11 $13.87 $12.99 $ CM Per Foot $5.89 $5.13 $6.02 $5.26 $4.42 $ Breakeven (Feet) Fixed costs prorated based on number of days from Exhibit III

12 CPA Mock Evaluation Management Accounting Module (Core 2) Page 12 EXHIBIT V PROFITABILITY ANALYSIS Profitability Analysis (at capacity) 1 house 2 houses 4 houses Normal April Normal April Normal April Revenue 646,000 38, ,000 38, ,000 38,000 Variable Costs 445,740 27, ,490 27, ,890 30,690 Contribution Margin 200,260 10, ,510 10, ,110 7,310 Fixed Costs 218,072 12, ,072 12, ,072 12,828 Operating Income -17,812-2,568-13,562-2,318-67,962-5,518 Total -20,380-15,880-73,480

13 CPA Mock Evaluation Management Accounting Module (Core 2) Page 13 EXHIBIT VI PRICING TO BREAK EVEN AT CURRENT CAPACITY Revenue per foot $19.57 $19.44 $21.04 Profitability Analysis (at capacity) 1 house 2 houses 4 houses Normal April Normal April Normal April Revenue 665,248 39, ,998 38, ,398 42,082 Variable Costs 445,740 27, ,490 27, ,890 30,690 Contribution Margin 219,508 11, ,508 11, ,508 11,392 Fixed Costs 218,072 12, ,072 12, ,072 12,828 Operating Income 1,436-1,436 1,436-1,436 1,436-1,436 Total EXHIBIT VII COSTS INCURRED TO DOUBLE CAPACITY Costs incurred to double capacity to 72,000 feet per season Trucks (3-5 months) $22,500 Equipment Rental $7,200 Gas $13,000 Total $42,700

14 CPA Mock Evaluation Management Accounting Module (Core 2) Page 14 EXHIBIT VIII BREAK EVEN AND PROFITABILITY AT INCREASED CAPACITY Break-Even & Contribution Margin Per Foot Analysis (doubling capacity) 1 house 2 houses 4 houses Normal April Normal April Normal April Fixed Costs (prorated) $258,400 $15,200 $258,400 $15,200 $258,400 $15,200 Revenue $19.00 $19.00 $19.00 $19.00 $19.00 $19.00 Variable Costs $13.11 $13.87 $12.99 $ CM Per Foot $5.89 $5.13 $6.02 $5.26 $4.42 $ Breakeven (Feet) Profitability Analysis (at increased capacity) 1 house 2 houses Revenue Variable Costs Contribution Margin Fixed Costs Operating Income 4 houses Normal April Normal April Normal April 1,140,000 1,140,000 1,140,000 1,140,000 1,140,000 1,140, , , , , , , , , , , , , , , , , , ,600 79,800 34,200 87,300 41,700-8,700-54,300 Total 114, ,000-63,000