OPERATIONAL CASE STUDY February 2019 EXAM ANSWERS

OPERATIONAL CASE STUDY February 2019 EXAM ANSWERS Variant 3 SECTION 1 DIRECT LABOUR VARIANCES FOR SAFARI TOYS Rate variances The rate variances show whether the rate of pay is higher or lower than that budgeted for each grade of labour. The adverse variance for trainees has arisen because there was an increase in the national minimum wage and this increase had not been budgeted for: the actual rate of pay in the month was higher than that budgeted. Senior grade workers are paid at different rates depending on their length of service and therefore the standard rate is an average across all senior grade workers. The favourable variance for senior grade workers shows that the actual average rate of pay for the month was lower than that budgeted. This is because two of the most experienced senior grade workers left at the start of the month, and these workers would have been on higher than average rates. Mix variances The mix variances show the impact of changing the mix of labour on profit. The variances show that proportionately more of the cheaper grades of labour (trainee and junior) and proportionately less of the most expensive grade of labour (senior) was used compared to what has budgeted. Overall this change in mix had a favourable impact on profit and occurred because relatively expensive senior grade workers were replaced with relatively cheap trainees. Productivity variances The adverse productivity variances tell us that based on the original standard mix of workers, more hours were used than was originally budgeted to produce the actual output. One reason for this was that workers were paid whilst waiting for machinery to be repaired, meaning that there was idle time. Another reason could have been because two of the most experienced senior workers left and were replaced by new trainees. It s likely that the new trainees were not that productive in their first month as they will have needed training, which will have also used up the time of the trainers. It s also possible that the trainees that were promoted early were assigned new tasks appropriate to junior grade and took longer than they should have. 1

Idle time variance It would be helpful to identify the amount of idle time incurred during the month and reflect this in an idle time variance. This variance would represent the time the workers were paid but were unable to be productive. For example, the three new trainees spent two days on an induction course, which means that they were not being productive. Also, many workers were unproductive because of waiting for sewing machine repairs. Separating out idle time would mean that the mix and productivity variances would be more meaningful. For example, we would be able to see how much of the productivity variance was due to these one-off factors and how much due to inefficiency in production. 2

PRODUCTION STAFF MORALE AT SAFARI TOYS Why it is important production staff morale is maintained It is important that production staff morale is maintained so that they stay with the business. We already know that a reason for at least one experienced member of staff leaving was due to a lack of feeling valued by the business and so clearly there is a morale issue. The production staff, although not highly skilled, are skilled at what they do, and time and money is spent training them. If experienced staff leave they take this training and their experience with them, which means that another employer will benefit from the investment in training. In addition, additional cost will need to be incurred in the selection and recruitment of replacement staff. Losing experienced staff also means that the ability to train new trainees coming into the business is reduced. Safari Toys uses on-the job training for new trainees which relies on the more experienced staff. If we ve lost these staff it will end up costing more in training because we will need to engage external trainers or send new staff away onto more external courses. Also, new staff are likely to be far less efficient that experienced staff, which, as shown in last month s variances, has an impact on the productivity levels. Safari Toys is known for quality production. If production staff morale is low, they are like to be de-motivated which means that there is a higher risk that their work is not up to quality standards. This in turn could lead to higher levels of waste or sub-standard products being sold, which ultimately could damage the reputation of the business. In addition, as we have recently taken over the business, it is more important than ever that we ensure all of the Safari Toys staff feel valued in this period of transition so that morale is maintained. Low morale at this early stage could lead to inflexibility, loss of valuable experience and goodwill which in turn could lead to disruptions with customers and the perception that Safari Toys can no longer deliver quality products on-time. Measures to make sure production staff morale is maintained There are a number of measures we could take at Safari Toys to help maintain production staff morale. Firstly, we need to engage production staff as part of the decision-making process, either through quality circles or regular meetings. This is particularly important because top management is now distant from the business, being located at the Trigg Adventure site. We need to listen and act on, where appropriate, ideas that staff have on the production process or working conditions. Staff that feel part of the decision-making process or at least feel that they are being listened to, are more likely to feel motivated. We could also consider some form of formal group and personal recognition of achievements. There should be a notice board in the production area where we post achievement of targets and recognise any qualifications gained. We also need to ensure that the working environment is correct: adequate lighting, suitable chairs for the sewing machine operatives, adequate cutting equipment for the material cutting staff. We also need to ensure that they have adequate rest breaks and possibly consider a comfortable room where staff can relax on these breaks. 3

SECTION 2 MULTI-PRODUCT BREAK-EVEN The lines on the chart Line AD on the multi-product break-even chart represents all of the combinations of revenue and profit that will earned assuming that the three products are sold in the budgeted mix (that is pillows, sleeping bags and toys in the ratio 24:12:30). The start of the line on the profit axis shows that if no products are sold and therefore revenue is nil a loss of approximately F$280,000 will be incurred. This represents the fixed costs of the business. The end of the line at the right of the chart indicates that if sales are as budgeted, profit would be approximately F$115,000 after fixed costs have been deducted. Line ABCD on the chart shows the combinations of profit and revenue on the basis that we sell the most profitable product first and the least profitable last. Profitability here is measured by the c/s ratio which is a measure of the proportion of contribution per unit to sales price. In this chart the assumption will be that sleeping bags are sold first, then pillows and lastly toys as this is the ranking of the products on a c/s ratio basis. It can be noted that the steepest part of the line is at the start for sleeping bags, this is because this is the product with the highest c/s ratio. What the chart shows us about break-even and what product to focus on: The chart shows us that if we assume products are sold in the budgeted mix proportion, the revenue required to break-even is approximately F$900,000. If we assume that the three products are sold in their order of profitability, the revenue required to break-even is considerably lower at approximately F$700,000: lower because we sell the most profitable first. This shows that there is a considerable range in the relative profitability of the three different products, as evidenced in c/s ratios ranging from 12.5% to 45%. That said each product is generating a positive contribution towards fixed costs. The chart also helps us to see the margin of safety, that is, the amount by which revenue could fall before a loss is made. From a budgeted revenue of approximately F$1,350,000, assuming products are sold based on the budgeted mix, revenue can fall to F$900,000 before a loss is made. The margin of safety is even higher under the other assumption. Further, this chart shows clearly what is the most profitable product (sleeping bags) and therefore potentially the product that should be focused on the most. Interestingly sleeping bags have the lowest sales volume out of the three products and hence it will be important for management to consider whether this is because of an internal constraint in production or because customer demand is limited. If there is a limit to demand, then clearly it would make no sense to produce more of these at the expense of production of the other products. However, if the 12,000 units was an internal production constraint it would be worthwhile switching more production capacity to sleeping bags rather than toys. If there is a limit to demand, then management should also consider if this is perhaps due to the sleeping bag being over-priced (given its very high c/s ratio relative to the other products). 4

WORKING CAPITAL The working capital ratios of Safari Toys compared to Jungle Toys Inventory days are higher for Safari Toys indicating that it holds higher levels of inventory than Jungle Toys. Both companies have a similar range of products and therefore the difference in inventory levels is likely to be due to different inventory holding policies. Safari Toys is likely to have a more conservative policy where buffer levels of inventory are kept, to ensure the full satisfaction of all customer orders. Despite both companies offering customers credit terms of 30 days, Safari Toys takes longer to receive payment from its customers than Jungle Toys (54 days compared to 26 days). This shows that Safari Toys has a more relaxed approach to collecting receivables which could either be because of a deliberate policy to not chase customers or a failure to carry out appropriate credit control procedures within the Finance Department. Payable days are lower for Safari Toys than for Jungle Toys, which is another indication of a conservative approach to working capital management. Credit terms are 30 days and Safari Toys pays within this period, which will allow the business to maintain strong relationships with its suppliers. The risks associated with the approach taken by Safari Toys There are two main risks associated with Safari Toys approach to working capital management. Firstly, there is a risk that receivable balances become irrecoverable. The longer that a balance is unpaid, the greater the chance that the customer ceases to trade or simply does not pay. Safari Toys customers include small independent toys shops, and this type of customer poses the greatest risk of ceasing to trade. Secondly, there is a risk of inventory obsolescence. The longer an item is held in inventory, the greater the risk that it becomes damaged and needs to be written off. Also, there is a risk that as a result of changes in consumer preferences for different safari animals or innovations in sleeping bag or pillow design that the Safari Toys products no longer sell as well as they did. Measures we need to ensure are in place at Safari Toys to manage these risks To manage the risk of irrecoverable debts it is important that credit control procedures are robust. Credit customers should only be accepted after checking for creditworthiness and credit terms should be reviewed regularly. An aged receivables report should be generated and reviewed on a regular basis with any outstanding balances chased for payment. To manage the risk of inventory obsolescence, it is important that inventory is stored properly. Textiles need to be kept in a dry space, any damp or water damage will render the inventory unsaleable. In addition, good inventory control systems need to be in place to ensure that any slow-moving inventory is identified. For example, if lion sleeping bags stop being popular, it is important to identify that fewer are selling so that a decision can be made about whether to continue production. 5

SECTION 3: TIME SERIES Explanation of the time series information Table 1 shows us the trend in sleeping bag sales based on the last three years worth of sales. The trend represents the long-term movement in sales through the period and excludes the impact of seasonality on sales. From table 1 we can see that the trend shows significant growth during 2016 and into 2017, peaking mid-2017. After this peak the trend shows a decline in sales, albeit a relatively gradual decline. The significant growth during 2016 and 2017 fits in with the link of the sleeping bag range with a popular children s television programme, which started in early 2016. The fact that it peaked in 2017 could indicate that perhaps the programme s popularity has declined or that a saturation point had been reached in the market. Table 2 shows the seasonal variation for each quarter against the trend based on this same data and the table tells us that there is a seasonal pattern in sales. Quarter 4 shows that sales are on average 4,165 units higher than the overall trend would indicate. This is a significant variation and is due to the popularity of these sleeping bags as Christmas gifts. There is also a seasonal effect in quarter 2, although not as significant as quarter 4. This could be down to the time of year, in that sleeping bags are most useful in the summer months and hence this could be associated with getting ready for the summer. Usefulness of this time series analysis Time series analysis is useful in the sense that it uses actual data about past sales to predict what might happen in the future, which is helpful for budgeting. As noted above even, with this relatively small sample of data we can see that there is a clear trend (which seems to be a gradual decline into the future) and there are clear seasonal variations in quarter 4 and quarter 2. Knowing this can help with planning production and also perhaps when to focus on marketing. However, there are some limitations of this analysis. Firstly, past data is not necessarily an indicator of what will happen in the future, especially for a product such as this which was so successfully associated with a television programme which could cease at any time. Secondly, there are so many factors that could affect demand in the future, that are not captured in the data. For example, themed sleeping bags are a fashion trend at the moment but could go out of fashion or be replaced by a different type of product, perhaps as a result of a new children s television programme. 6

MARKETING MIX FOR SAFARI TOYS COMPARED TO TRIGG ADVENTURE Product There are certain similarities between the Safari Toys and Trigg Adventure products. Both are ultimately aimed at and used by children. In addition, both product ranges have practical applications: the climbing frames allow children to exercise, whilst the sleeping bags and pillows are designed to be used, they are not just a toy. There are also some significant differences in the products. Our domestic climbing frame is a generic product, which is not themed to appeal to a particular child s interest (such as cowboys or space). Safari Toys products, on the other hand, are heavily themed with all the products exclusively related to animals found on safari. Therefore, the range of appeal of the Safari Toys products is less, because if a child does not like safari animals, or prefers a jungle animal or a non-animal related theme such as princesses or trains, they will not want to own a Safari Toys product. The product life cycle of each range of products is also different. Trigg Adventure has been trading for over 25 years, and despite the market being stagnant, there is no expectation that the market will quickly decline. New generations of customers still want to buy climbing frames for the garden and hence the product life cycle is relatively long. Safari Toys on the other hand has only been trading since 2012 and as noted above offers themed products. Whilst at the moment Safari Toys products have a close association with a popular television series, the time series already shows that from a peak in 2017, the trend for sleeping bags is downward. This could indicate that the product has received saturation point. In any event when the television programme ends, this is likely to have a dramatic impact on the product life cycle. Price With regard to pricing we can consider this under the three categories of cost, competitors and customers. Cost is an important consideration as the objective is to make a profit, however, neither business uses a pure cost-plus pricing strategy because fluctuations in input prices such as seasoned timber and cotton material are not immediately passed onto customers because selling prices are not constantly changing. There are differences between the two businesses with regard to competitors which will have an impact of pricing. Safari Toys has a number of competitors offering very similar products, albeit, with different themes, whilst Trigg Adventure has few competitors for domestic products. This means that more attention needs to be placed on competitive pricing for Safari Toys products. Having said that, the fact that Safari Toys has a close association with a popular children s television series means that some of this competitive pressure is removed because customers will want to buy into this brand for their children. This potentially could lead to premium pricing to take advantage of this. Whilst as noted above, the customers are similar for both product ranges, one important distinction is the price points of these ranges is very different. Buying a climbing frame for the garden is for most parents a considerable investment, whilst buying a sleeping bag or pillow is less of an investment. This in turn could affect the price elasticity of demand and therefore the price that the customer is willing to pay. 7

SECTION 4 DECISION REGARDING WHICH MARKET TO TARGET Limitations of using a risk neutral approach The first limitation of this approach is that we ignore the risk associated with each market. Risk is the variability in returns and we can see from the consultant s schedule that whilst Option A has the highest expected value it also has the highest risk as shown by the standard deviation and coefficient of variation. The range of possible outcomes is greater with Option A than Option B (ranging between +F$200,000 to -F$70,000 compared to +F$100,000 to -F$10,000). Essentially, by selecting Option A there is a greater risk that we make a significant loss, although on the upside there is the chance of a higher profit as well. The second limitation of using a risk neutral approach is that the expected value is most appropriate where a decision is to be repeated a number of times. Expected value is a simple weighted average of all of the possible outcomes based on the probabilities of occurrence and is unlikely to represent what the actual outcome will be. This is acceptable where a decision is repeated numerous times because the actual outcomes over time are likely to converge to the average. This decision is a one-off decision and therefore expected value is not wholly appropriate. Finally, this approach is based on estimates of both the possible outcomes and the probabilities associated with these outcomes. There is a chance that these estimates are incorrect, although using a consultant rather than estimating ourselves, has probably enhanced reliability. Price to pay for the ABC Consulting s report ABC Consulting is offering a report which will give us perfect information about which marketing option to use. The amount we should be prepared to pay for this report will be the difference between the expected value of the decision without the report and the expected value of the decision assuming we did have perfect information. To calculate the expected value of the decision with perfect information we firstly determine the correct decision at each market condition. So, if the market is poor this would be Option B because this has the lowest loss, if the market is strong this would be Option A because of the higher profit of F$200,000 compared to F$100,000. Each of these correct decision outcomes is then multiplied by the associated probability and summed to arrive at the expected value of the decision with perfect information. The difference between this and F$89,000 will represent the maximum amount we should be prepared to pay for the report from ABC Consulting. From the tables it can be seen that perfect information would guide us to Option A in strong and medium markets but Option B in poor markets. Without perfect information we would always be in Option A. The worth of the perfect information is the reduction in the exposure to the poor market as can be seen from the tables is worth F$21,000 F$3,000. 8

QUERIES ON DRAFT FINANCIAL STATEMENTS Consolidated financial statements and goodwill We acquired 100% of the equity share capital of Safari Toys during the year. This makes Safari Toys a subsidiary of Trigg Adventure because we control all of the voting rights in the business. This in turn means that Trigg Adventure is the parent entity because it makes all of the decisions regarding Safari Toys operations. Where a parent / subsidiary relationship such as this exists, IFRS 10: Consolidated financial statements, states that the parent (Trigg Adventure) needs to present consolidated financial statements, whereby the revenues, costs, assets and liabilities of the parent and subsidiary are combined together as if they are one entity. The idea is that because Trigg Adventure has control over the operations of both businesses that in substance they should be viewed as one entity, even though legally they are separate entities. Regarding the goodwill shown in the statement of financial position, this represents the difference between what we paid for Safari Toys and the fair value of the net assets that we acquired. This is the premium over and above the value of the individual assets and liabilities in the business and represents the additional value that we placed on the business to reflect intangible assets that were not recorded, such as brand strength, the quality of the workforce and customer loyalty. Asset held for sale In accordance with IFRS 5: Non-current assets held for sale and discontinued operations, the old Safari Toys building can be shown as an asset held for sale because it is currently on the market which means that it is available for immediate sales in its current condition. The sale of the building is highly probable because management are actively seeking a buyer and there is a firm commitment to sell at its market value which is a sensible price. In addition, the sale is expected to be concluded in 2020 and hence is within the 12-month time period set down in the standard. IFRS 5 states that an asset held for sale should be valued at the lower of its carrying value and its fair value less costs to sell. The value of F$200,000 therefore represents either its accounting carrying value (cost less accumulated depreciation) or if lower, its market value less the estimated costs of selling the building (such as sales commission). 9