OPERATIONAL CASE STUDY February 2019 EXAM ANSWERS
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1 OPERATIONAL CASE STUDY February 2019 EXAM ANSWERS Variant 1 SECTION 1 COMPARISON OF THE COSTS OF IN-HOUSE AND OUT-SOURCING GROUNDWORKS The graph The graph shows us that if we do the groundworks in-house we would have substantial fixed costs, whereas if we outsourced the same work to Fallwell there would be no fixed costs. This can be seen because the Trigg Adventure line touches the y axis at F$10,000, which means that if there were no projects the fixed cost (these will probably be salary and equipment costs) would be F$10,000. The Fallwell line touches the y axis at the origin which show that if there were no FITKIDS projects there would be no cost. This is because Fallwell would charge us for each wet pour project and so each project is a variable cost to us. However, we would have a lower in-house variable cost per job than if we use Fallwell and this can be seen as the slope of our cost line is less steep than the Fallwell line. We can also see that there is a stepped fixed cost if we provide the wet pour using an in-house team as the total cost increases by F$5,000 when demand reaches 15 projects a month. As the slope of the line remains the same, we can see that our variable cost per project remains constant regardless of the demand. This means the cost of providing the groundworks with an in-house team would be more expensive than outsourcing to Fallwell when demand is lower and less expensive when demand is higher. The demand crossover point is 10 projects each month. If we have a risk neutral approach to decision making we would use expected value to make the decision. The information provided by the local government shows that the sum of the demand levels multiplied by the probabilities is Therefore, we should choose to provide the wet pour using an in-house team as at a demand level of projects this is cheaper than doing the work using Fallwell. However, the costs are very close and given that the inhouse costs are only estimates, are not reliable enough to base a decision on. It should also be noted that the outsourcing costs are more likely to be known with certainty as prices would be negotiated in advance with Fallwell as part of the contract agreement. The limitations of using expected value for this decision are as follows: The expected value is dependent on the estimate of the probabilities which are subjective. Although the local government has based the probabilities on the actual demand from other 1
2 regions it does not necessarily mean that our region will follow the same pattern. In addition, as the FITKIDS initiative is relatively young, it is unlikely that there is enough data to make the probabilities reliable. Expected value is a long run average and not useful for one off decisions like this. There is a high probability that actual demand will be less than the demand suggested by expected value and in this situation Fallwell would provide the cheaper option. POTENTIAL BENEFITS AND PROBLEMS OF IN-SOURCING GROUNDWORKS Potential benefits Performing the groundworks in-house means that any problems with communications, ambiguities with results or queries can be dealt with quickly and efficiently, rather than working through a third party. When dealing with a third party like Fallwell, managing the process becomes more bureaucratic and can lead to delays. At present Priya Patel has been managing the limited relationship between Trigg Adventure and the groundwork companies, but she does not have the time or the expertise to do justice to this role. The outsourcing relationship would be far more difficult to manage, especially when the volume of work increases. As Fallwell is a commercial company, a proportion of their charge to us is will be profit margin. If we manage the groundworks in-house we will retain that profit margin for Trigg Adventure, assuming that we can match their cost. As Sally Gomez proposes to increase the amount of commercial work in the future this promises to amount to a substantial saving in costs. Work for the new contract will need to be of the highest quality and Tony Trigg hopes that the reputation for good work that follows from this contract, will mean high sales in the future. The customer will not differentiate between the quality of the equipment and the quality of the groundworks, so groundworks can now be considered part of our core competence. We need to ensure that the groundworks are of the right quality and produced on time and this will be managed better if it is performed in house, using our own staff. As most of the work for the next few months will be taking place in schools, it will be necessary to check each employee to ensure that they comply with the legal disclosure regulations that apply when working close to children. Given the sensitivity of this, arguably it is best if Trigg Adventure controls this in-house. Potential problems Outsourcing is an incremental cost and performing the groundworks in-house has a high fixed cost element. If the commercial business does not expand as Sally Gomez hopes, we will still incur substantial costs when the FITKIDS contract is complete, whereas if we outsource we would simply engage Fallwell for less work. This makes outsourcing more flexible for Trigg Adventure, which is important, given the seasonal nature of the business and the fact that demand is likely to be unpredictable while building up the business. If we perform the groundwork in-house and we find that it does not work as well as our current arrangement, we could incur high exit barriers, such as redundancy and sale of specialist plant and equipment. Fallwell has many years experience providing companies with excellent groundwork: there are very few situations that the company has not encountered and solved. If Trigg Adventure perform the groundworks in-house, there would be a period of learning during which the company would not be as efficient or effective as the outsourcing partner. It is possible that Trigg Adventure never get the volume of demand necessary to match Fallwell s efficiency. 2
3 As this is a new function for Trigg Adventure, we will be learning the skills necessary from scratch. As we will be practicing on the new FITKIDS contract, this could ruin our reputation if we fail to deliver and future potential sales could be lost. 3
4 SECTION 2 TIME SERIES The time series information The times series table shows the actual demand for wet pour groundwork projects that has been observed by the sales team over time and contains trend and seasonal variation data. The end result of the workings in the table is to separate the seasonal variation from the trend. This is done by simply averaging four quarters at a time. So the demand for the first four quarters are added together and divided by four to get an average of and then the next four quarters, starting with Q are averaged and so on. Because these moving averages cannot be assigned against an actual data point, they are averaged again to rectify this. For example, and is averaged to and this is assigned to the data point Q The resulting centred moving average is the trend. The trend is then deducted from the actual demand to reveal the seasonal variation. The seasonal variation represents the demand above or below the trend. In Q1 the trend is 1.25 jobs below the actual, in Q above average, and so on. We can use the time series data to predict the likely demand for wet pour projects for Quarter To do this we can extrapolate the trend data into the future: in our case this is quite simple as the trend has been increasing by two projects each quarter. We would add ten projects (2 projects multiplied by five additional quarters) onto the Quarter centred moving average of We then adjust this trend forecast by the seasonal variation. In our case the predictability of the variation each quarter makes this straight forward and we would simply add 1.75 projects onto our trend figure. Limitations of using this data to determine staffing levels and other factors The major limitation of this forecasting technique is that it is using historic data to predict the future. We know that the pattern of demand for wet pour is likely to be different from what has happened in the past for two reasons: the FITKIDS contract and the tightening of health and safety laws. These changes in demand mean that our forecast using time series is unlikely to be accurate. Even if we can successfully use time series to predict the number of groundwork projects needed, it does not follow that it can then be used to accurately predict employee levels for our company. For example, customers may want their own contractors to do the groundwork and at the extreme this may mean that Trigg Adventure does not need to employ any groundwork staff. Even if we can assume that all the forecast groundwork projects are performed by Trigg Adventure it is not a good basis for predicting staffing levels. Reasons for this include: the projects are likely to be geographically dispersed and thus a proportion of employee time will be spent travelling rather than working, projects are unlikely to be the same size and will therefore have different staffing requirements and the new department is unlikely to work at optimal efficiency from the start. 4
5 PERSON SPECIFICATION FOR GROUNDWORKS SUPERVISORS A number of formats for person specifications exist but the Rodgers seven-point plan is probably the most commonly used. Using Rodgers seven-point plan, the following should be included in a person specification for groundworks supervisors: Background/ circumstances: This will include any details of previous work experience and circumstances. As this is a supervisory role we would like applicants to have experience in a similar level role. As the supervisor role will mean that they will be working in schools for the next year, they must not have a criminal record as this will prohibit them from working in close proximity to children. Attainments: This will detail any necessary qualifications and/or relevant experience. We need to employ a proportion of employees who have a recognised building qualification. Any supervisor we employ should have obtained this qualification. Disposition: This includes what it is that we would like a supervisor s goals, motivations and personality to be. As this is a new department we need supervisors who have the motivation to work hard to define the role of the department. They will also have to be the customer facing aspect of our company. We need committed and courteous supervisors. Physical make up: As groundworks is a highly physical job, involving digging and movement of equipment we will need supervisors who are physically fit. As already mentioned, this role will be customer facing so an acceptable appearance is necessary. Any successful candidate must be presentably dressed. Interests: Although not vital, any general interests or hobbies that indicate good leadership and team working skills would be a useful trait for our new supervisors. Supervisors will have to direct their team and also work closely with the installation team. Hobbies that indicate that candidates are used to directing and working within a team will be preferable. General intelligence: A supervisor in the Groundwork Department will need a good level of practical intelligence that will include problem solving and prioritisation skills. Although formal academic qualifications can indicate a general level of intelligence, it does not follow that if a candidate does not process them they do not have the correct level of intelligence. Trigg Adventure already incorporates a test in the selection process that helps to identify a candidate s practical intelligence: a similar test can be used to assess these candidates. Special attributes: As the Groundwork Department is likely to involve coordinating with the Installation Department and the customers, good communication skills and an ability to work to strict deadlines will be required. 5
6 SECTION 3 CASH FLOW AND LIQUIDITY Why Trigg Adventure cash flow has deteriorated despite booming commercial sales The shift from domestic to commercial sales has lengthened our working capital cycle. Half of our domestic customers pay up front for their goods, but most of our commercial customers do not pay until the equipment is installed. In addition, the FITKIDs contract is with a local government and they usually negotiate longer credit terms than the other commercial customers. The purchase of non-current assets needed for the wet pour groundworks means that there was an immediate cash outflow even though the benefit of the equipment, in terms of generating additional revenue and profits, will be realised over several accounting periods. The need to rectify errors in the Groundwork Department has meant that we have been busy working, but this work has involved significant cash outflow with no associated inflow. The need for additional materials has meant that we have had to forego our usual credit period, further reducing our working capital cycle. As overtime has been paid for this additional work, this also results in a cash outflow. Improvement in short term liquidity Invoice discounting could secure us a one off short-term cash boost. We could sell a proportion of our receivables to an invoice discounter, who would advance us a percentage of the receivables. The monies advanced are essentially a form of borrowing that we repay when our receivables pay us. The discounter will charge us a finance fee for this service. We could sell any spare assets that we no longer use. We probably have machinery and office equipment as well as obsolete inventory that we could sell. Although we may have to sell below carrying value, it would mean a cash inflow. We could apply strict credit control to ensure that customers pay in line with the agreed terms and conditions. At present our credit exceeds the credit terms that we grant them. By being more efficient with our credit control policies: sending out statements and reminder letters in time, chasing late payments and resolving any disputes immediately, we could reduce our working capital cycle. 6
7 DIRECT LABOUR VARIANCES FOR GROUNDWORK DEPARTMENT The total labour variance is F$5,030 Adverse This variance is the calculated by deducting total 1 from total 4 and shows that the actual labour cost in September was higher than the standard cost for actual production. The reason for this adverse variance can be explained by either paying more per hour than standard for a labour hour or for working more house than standard. Thus, this variance is explained in further detail by the rate and efficiency variances (see below). The direct labour rate variance is F$0 This variance is the calculated by deducting total 1 from total 2, where any difference would have been caused by a change in actual rate from the standard. The nil rate variance is because all employees in the Groundwork Department have been paid exactly as standard. This is to be expected as the department was established recently and pay rises are usually applied in January. The overtime worked during September was probably paid at a premium, but the premium will be charged to overhead. The direct labour efficiency variance is F$5,030 Adverse This variance is the calculated by deducting total 2 from total 4 and demonstrates that we incurred more direct labour cost in total, at standard rate, than expected to make the actual output in September. This variance can be further explained by the direct labour mix and yield variances (below), but it could also be explained by the fact that, as a new department performing tasks that are new to the business, the standards set are inaccurate. The direct labour mix variance is F$850 Adverse This variance is calculated by deducting total 2 from total 3. The mix variance shows the difference between the actual mix of total hours worked and the standard mix of total hours worked, multiplied by the standard rate. The adverse mix variance indicates that the skilled employees worked proportionately more hours than standard compared to the unskilled employees. As the skilled employees earn more per hour, this has resulted in an adverse variance. The possible reason for this is the fact that the faulty work had to be thoroughly analysed and a correct mix produced before the rework could be undertaken. The skilled workers were responsible for much of this analysis and correction work which took several days. The direct labour yield / productivity variance is F$4,180 Adverse This variance is the calculated by deducting total 3 from total 4, where the difference is caused by the standard mix of the total actual hours worked being different to the standard mix of hours needed for the actual output produced. The yield variance is adverse as we should have taken 730 hours in standard proportion to produce the number of jobs that we did but, it actually took us 950 hours in standard proportion. As it took us longer, this is an adverse variance. The major reason that we worked more hours was due to the 15% of jobs that had to be reworked during the month. Each job reworked required additional time both for analysis of the problem and then its correction. 7
8 SECTION 4 FINANCIAL STATEMENT FOR THE YEAR ENDED 31 DECEMBER 2019 Treatment of the expenditure on the digger if we decide to continue The F$120,000 purchase price of the digger can be capitalised in accordance with IAS 16: Property, plant and equipment because an asset has been created: it is probable that as a result of the digger future economic benefit will flow into the entity because groundwork is a revenue generating activity and its cost can be reliably measured. As the modification was directly attributable to bringing the asset to working condition for its intended use, the F$8,000 can also be capitalised. The digger will need to be depreciated over its useful economic life, which has to be assessed. Depreciation will commence from the date that the asset was available for use which was 1 July: hence there will be six months worth of depreciation charged to profit or loss for the year ended 31 December Treatment of the grant receipt if we decide to continue Regarding the grant receipt, the specific accounting treatment applied depends upon the purpose of the grant. In this case the grant has been received specifically for the purchase of the new digger and hence is a capital grant. As this is a capital grant, we have a choice of how to initially record it on receipt: we can either present it as deferred income or deduct the grant from the carrying value of the digger. If we use the deferred income method, we will set up a separate liability of F$50,000 in the statement of financial position. The grant will then be released to profit or loss as income on a systematic basis over the period that we expect to benefit from the grant, which in this case will be the life time of the digger. Effectively the grant income will match with the digger depreciation charge. Alternatively, we could simply net the F$50,000 from the cost of the digger and record the net amount as a non-current asset. This net amount will then be depreciated over the useful economic life of the digger. Treatment of digger if we decide not to continue with in-house groundworks If we decide to stop in-house groundworks the digger will no longer be used and it could be sold. However, this will not happen until February 2020 and therefore at the year end the digger will still be in use. It should therefore be included in the financial statements at its carrying value (cost less the appropriate depreciation (as above)). At this point it would be correct to check for any impairment of the asset, but as it is known that the market price is likely to be the carrying value, no impairment is necessary. 8
9 COST OF QUALITY REPORT Prevention The F$1,000 training courses can be categorised as a prevention cost because trained staff make less errors. The same applies to the cost of the time taken to conduct Health and Safety inductions for new staff. Errors, for example, in reading the thermometer or in safe handling of the hot mix, could lead to quality failures. Training helps to ensure good quality work and fewer mistakes by staff. Appraisal The F$2,000 spent on thermometers is an appraisal cost as these pieces of equipment check that the wet pour mix is at a correct temperature, prior to it being used. The mix that is poured is an output of the mixing process and if checks are conducted before it is passed to the next process, it will help to reduce failure costs. Therefore if we check that the mix is at the correct temperature when poured it is less likely that it will have to be done again. Internal failure Internal failure occurs when we do not meet our quality standards but before this failure has an impact on the customer. During November our supervisors spotted errors and were able to rectify them before leaving the site. The cost of digging out the mix that had been poured, the cost of the additional materials and labour needed to fill the cavity are costs that should be attributed to this category. External failure We have significant external failure costs in November and the fine that we will have to pay for failing to complete the contract on time is one of them. The two sub-standard projects completed in October also fall into this category as the customer will have been aware of the defects. The cost of liaising with the customers, returning equipment to site in addition to the direct cost of the additional labour, materials and digger hire will all be a cost of external failure. It is also possible that there is an opportunity cost as committing resource to re-working means that the resources are not available for other jobs. The fact that the local government is aware that we are late with some aspects of the contract and that we have made errors means that the quality failure is external. This means that we will have suffered a loss of reputation and there is a possibility that we will lose the contribution from potential future contracts as a result. 9
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