ACCA

Paper F5

Performance Management

December 2011

Interim Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the interim assessment questions and submitted them for marking.

PAPER F5: PERFORMANCE MANAGEMENT

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© Kaplan Financial Limited, 2011

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1 LINEACRE CO

(a) Activity-based overhead absorption rates (OARs) are found by dividing the expected cost in each cost pool by the number of cost driver transactions expected during the coming year.

Cost Pool Cost ($) Number of Drivers ABC OAR ($) Production set-ups 105,000 300 set-ups 350.00 per set-up Product testing 300,000 1,500 tests 200.00 per test Component supply/ storage

25,000 500 component orders

50.00 per order

Customer orders/ delivery

112,500 1,000 customer orders

112.50 per order

(b) Production of product ZT3 = (100 × 60) + (60 × 50) = 9,000 units per year

Number of production runs = number of set-ups = 9,000/900 = 10 set-ups

Number of product tests = 10 × 4 = 40 tests

Number of component orders = number of production runs = 10 orders

Number of customer orders = 100 + 60 = 160 orders

General overheads absorption rate = 900,000/300,000 = $3.00 per direct labour hour

Annual direct labour hours for Product ZT3 = 9,000 × 10/60 = 1,500 hours

Activity ABC OAR Number of Drivers Annual cost ($) Setting up $350.00 per set-up 10 set-ups 3,500 Product testing $200.00 per test 40 tests 8,000 Component supply $50.00 per order 10 orders 500 Customer supply $112.50 per order 160 orders 18,000 ––––––– 30,000 General overheads = 1,500 × $3.00 per hour = 4,500 ––––––– Total annual overhead cost 34,500 ––––––– Total unit cost $ Components 1.00 Direct labour = 7.80 × 10/60 = 1.30 Overheads = 34,500/9,000 = 3.83 ––––– 6.13 Profit mark up 2.45 ––––– Selling price 8.58 –––––

(c) Traditional absorption costing allocates a proportion of fixed overheads (indirect costs) to product cost through an overhead absorption rate, usually based on labour hours, machine hours, or some other volume-related measure of activity. These overhead absorption rates may be factory-wide absorption rates (blanket rates) or, for increased accuracy in determining product cost, departmental absorption rates.

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In the traditional manufacturing environment, indirect costs constituted a relatively small proportion of total product cost compared to direct costs such as direct material cost, direct labour cost and direct expenses (collectively referred to as prime cost).

The modern manufacturing environment

In the modern manufacturing environment, indirect costs constitute a relatively high proportion of total product cost. There are several reasons for this:

Modern manufacturing is characterised by shorter and more frequent production runs rather than continuous or high volume production runs. This increases the frequency of production line set-ups and therefore the total cost arising from set-up activity.

Widespread use of computer control and automation has decreased the importance and use of direct labour. Direct labour cost as a proportion of total cost has therefore declined. This decline has been accelerated by the use of salaried employees rather than staff whose wages depend on production output, transferring labour costs from a direct cost to an indirect cost.

Increased use of just-in-time production methods and customer-led manufacture has led to quality control costs and production planning costs forming a higher proportion of total cost. These costs relate to particular production runs rather than to manufacture as a whole.

Activities and costs

Traditional absorption costing, by employing volume-related overhead absorption rates, failed to take account of the relationship between costs, activities and products. The insight at the heart of activity-based costing is that it is activities that incur costs and products that consume activities. Analysis of the way in which products consume activities allows the overhead costs incurred by those activities to be related to product cost using cost drivers derived from those activities rather than using production volume-related overhead absorption rates.

For example, set-up costs under traditional absorption costing could have been allocated to product cost using an overhead absorption rate based on machine hours. This would transfer a disproportionate amount of set-up costs to high volume products, which in fact gave rise to fewer set-ups because of their longer production runs. If set-up costs were transferred using number of set-ups as the cost driver, a fairer allocation of set-up costs would be achieved and products with longer production runs would not be penalised with a disproportionate share of their indirect costs.

Improved cost control

Activity-based costing can lead to more detailed product cost information because a larger number of ABC cost drivers are likely to be identified in a given manufacturing organisation. An average of fifteen ABC cost drivers tends to be used, compared with one or two overhead absorption rates in traditional absorption costing. This more detailed product cost information can lead to improved cost control, since managers can seek to control costs by controlling the activities that cause the costs to be incurred. Production scheduling, for example, can optimise the number of production runs in order to minimise set-up costs.

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Better information on product profitability

Since product cost information is more accurate, managers have more accurate information on the relative profitability of individual products. This can lead to better decisions on product promotion and pricing, since managers can promote higher margin products while seeking to improve margins on products where margins are lower.

Activity-based budgeting

Budget planning and formulation can use an activity-based approach to determining the required level of support activities, rather than an incremental approach based on prior year figures. With activity-based budgeting, the required level of production is used to determine the required number of cost driver transactions (e.g. number of set-ups), which in turn are used to determine the level of support activity that must be budgeted for (e.g. number of set-up engineers). In this way managers can seek to identify and eliminate any unnecessary slack in support activities, thereby improving efficiency and profitability.

Marking scheme

Marks

(a) 1 mark for each OAR 4.0

(b) 1 mark for each of the five annual overhead costs 5.0

½ mark each for component cost per unit, labour cost per unit, overhead cost per unit and total cost per unit

2.0

Calculation of selling price 1.0

––––

8.0

––––

(c) 1 mark for each point explained 8.0

––––

Total 20

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2 PSA

(a) In the rapidly changing business environment, customer requirements, economic factors and technology can all change very fast. PSA, a manufacturer of mobile phones, is in a particularly volatile business. Both life cycle costing and target costing are systems which should help the company cope with this. These systems should help PSA to compete in terms of cost and product development in the telecoms market.

Target costing

Target costing has replaced traditional cost-plus pricing in many organisations. PSA may wish to follow suit for cost reduction and control.

• PSA's environment is fast-moving. Target costing is more flexible since targets can change/reduce from month to month.

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• Cost-plus pricing focuses on internal costs while target costing takes into account the competitive market and the price customers are willing to pay. The organisation has to be outward-looking rather than inward-looking. For PSA, the final customer as well as the system supplier must be considered.

• Target costing should be used as a cost reduction technique, unlike cost-plus pricing, and should incorporate a learning effect.

• Target costing usually involves other techniques, such as value analysis and value engineering, which should simplify production methods and reduce the cost. As PSA has short product life cycles, this is very important.

• Staff can be highly motivated by target costing if used correctly. It helps to break down any artificial functional barriers as staff at all levels and in all functions are involved.

Life cycle costing

• Estimating lifecycle costs and revenues will highlight which products can generate profits quickly. As the lifecycle of PSA’s products is likely to be short because of changing technology, this is very important.

• Life cycle costing focuses on the time to market as well as money. This is often a key factor in generating profit. PSA will probably have to bring new products to market quickly and on time in order to achieve a profit.

• If costs and benefits are monitored over the lifecycle, a project can be stopped early if events have changed or not turned out as planned.

• The research and development and design costs are likely to be quite high and will need to be recovered quickly, so life cycle costing, with its emphasis on timescale, should be very beneficial.

Probably the company should adopt both life cycle costing and target costing.

(b) Backflush costing

This can be defined as: 'A method of costing, associated with a JIT production system, which applies cost to the output of a process. Costs do not mirror the flow of products through the production process, but are attached to output produced (finished goods inventory and cost of sales), on the assumption that such backflushed costs are a realistic measure of the actual costs incurred.'

Under this approach, conversion costs (labour, overheads etc) are attached to products only when they are completed. This is in direct contrast with the traditional costing system used by PSA, where costs are attached to physical cost units at every stage of their production – raw materials, work-in-progress and finished goods, analysed between different jobs or products etc.

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The benefits of the traditional approach are that:

Inventories are easily valued at any stage and time – it is particularly important for financial accounting purposes that the value of finished goods can be distinguished from that of raw materials and work-in-progress, and that a split can be derived between cost of goods sold and those finished goods remaining in inventory.

It affords a great degree of control over costs – by different type (labour, materials etc) and by cost unit (product, job etc) at all stages of the production process. Detailed variance analysis can be carried out, including planning and operational splits as illustrated above.

The traditional approach is, however, time consuming, requiring a great deal of detailed data to be entered, analysed and monitored; it is also supported by large volumes of documentation.

In the modern manufacturing environment, where the adoption of such systems as Just In Time can reduce the levels of inventory to very low levels, a great proportion of all input costs will be attributable to finished goods sold at any time. Backflush accounting was developed in response to this.

Under backflush accounting, transaction costs are recorded in relation to cost units only on their completion. It saves costs by reducing the amount of data required and the frequency of data entry. However, the conditions under which it is successfully operated as an alternative to the traditional approach include:

• low levels of inventory with little variation from one period to the next;

• highly automated and reliable production methods, removing as far as possible the potential causes of variation in efficiency/productivity rates;

• reliable suppliers who deliver on time, at fixed prices and fixed quality.

The latter two conditions would lead to insignificant cost variations within the system and so remove the need for detailed variance analysis.

PSA’s operation does not appear to meet these conditions, in that:

• there are significant inventories of raw materials

• there are significant variations in the prices of inputs

It is unlikely, therefore, that the introduction of backflush costing will be of benefit to PSA under its current operating conditions.

Marking scheme

Marks

(a) 1 mark for each advantage (or disadvantage). Both types of costing must be covered to gain maximum marks.

10.0

(b) 1 mark for each point explained. Both areas of the requirement must be covered to gain maximum marks.

10.0

––––

Total 20

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3 MOC

(a) A price-discrimination strategy is where a company sells the same products at different prices in different markets.

Three conditions are necessary for the successful operation of this pricing strategy:

• The seller must be able to determine the selling price. MOC has a monopoly and therefore this would be possible.

• It must be possible to segregate customers into different markets, e.g. using geographical location or age.

• Customers must not be able to but at the lower price in one market and sell at the higher price in another market.

(b) 1 The equation of a straight line is: y = a + bx

where y = price (P)

a = intersection of the line with the y-axis

b = gradient

x = quantity (Q)

2 Start by calculation the gradient (b):

Gradient = 700- 900 quantity in Change

$70-$55 price in Change = -0.1

3 Using the price of $55, this gradient can be substituted back into the equation:

y = a + bx

55 = a – (0.1 × 900)

55 = a – 90

a = 55 + 90

a = 145

(Alternatively: the price of $70 could be substituted back into the equation).

4 Therefore the linear relationship is P = 145 – 0.1Q

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(c) PED = price in change %

demand in change %

= 100 × (15/55)

100 × (-150/900)

= 27.27%-16.67%

= –0.611

= 0.611 (sign can be ignored)

The PED is less than 1 and as a result demand is inelastic. Therefore increasing the price from $55 to $70 will increase the revenue.

(d) To: Management Accountant

From: Student

Date: xx/xx/xx

The current pricing strategy may not be able to be applied if competition was to emerge in the market as the business would now have to be more aware of the competitors' prices.

We may be forced to use going rate pricing to match the competitors prices to compete.

However they may choose to adopt a penetration pricing strategy, which means that they will start off with a low price to try and gain some of our market share.

Competing at this price will drive down are profit margins, however we may be able to sustain low margins in the short term to try and hold onto our customer base.

As we have had such a strong monopoly of the market we should already have sufficient economies of scale to be able to withstand the lower profit margins for longer than the competitor.

We may even be able to undercut them so that they can’t gain any of market share.

Alternatively, as we are already an established name in the market we may be able to rely on brand loyalty and keep our prices high.

By keeping a high price our customer may also perceive our product to be of higher quality.

This could work particularly well because this is an executive game and presumably the customer would be more likely to choose quality over a lower price.

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Marking scheme

Marks

(a) Definition 1.0

I mark for each condition up to a maximum of 3.0

––––

4.0

––––

(b) Correct gradient 1.0

Correct intersection 1.0

Correct linear relationship 1.0

––––

3.0

––––

(c) Correct PED calculation 2.0

Correct revenue conclusion 1.0

––––

3.0

––––

(d) Report format and good presentation 1.0

1 mark for each relevant comment 9.0

––––

10.0

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Total 20

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4 NEW CONTRACT

(a) Reasons $

Paper – Book value is irrelevant because it is a sunk cost; as there is no other use, replacement would not occur so the opportunity cost or scrap sale proceeds is the relevant value.

2,500

Ink – Since this involves a future cost if the work is undertaken, the purchase price should be used. Since the remaining stock has no foreseeable use it has no value so the entire purchase cost is used.

3,000

Skilled labour – Since the weekend working is caused if the work is undertaken, the full cost is relevant:

125 hours @ $4/hr = $500

125 hours @ $5/hr = $625

1,125

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Unskilled labour – The weekend work results in 50 hours time off in lieu − this, with the 75 other hours worked, totals 125 hours, which is less than the 200 hours of idle time which are already being paid for; thus there is no incremental cost.

Nil

Variable overhead

– This is a future cost which will be incurred if the work is undertaken.

1,400

Printing press – The depreciation is a past cost and should be ignored, however the use of the press has an opportunity cost. If this work is undertaken, then the press is not available for hire. The opportunity cost is the contribution which would be earned from hiring:

200 hours @ ($6 − $3) 600

Production fixed costs

– As these costs are unaffected by the decision they should be ignored

Nil

Estimating costs – These costs are past or sunk costs and should be ignored.

Nil______

Minimum price £8,625______

(b) An opportunity cost is the value which represents the cost of the next best alternative or the benefit forgone by accepting one course of action in preference to others when allocating scarce resources.

If there is only one scarce resource, decisions can be made by ranking alternatives according to their contributions per unit of the scarce resource. However, in reality, there will be many scarce resources, and different alternatives will use alternative combinations of those scarce resources. In these situations, opportunity costs are used to identify the optimum use of those resources.

Marking scheme

Marks

(a) 2 marks per cost type with explanation 16.0

(b) Definition of opportunity costs 1.0

Scarce resources 1.0

Relevant costs 2.0

––––

3.0

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Total 20

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5 QP

(a) Throughput accounting is based on the assumption that all costs except material are fixed and throughput can be calculated as sales price less material costs. It can be seen that this is a similar measure to contribution, except that in traditional analysis labour is normally considered to be a variable cost.

Throughput accounting’s primary concern is the rate at which a business generates profits and a company will wish to maximise throughput. This is measured using the return per period ratio.

This ratio can also be used in short-term decision making to calculate an optimal production mix. A return per bottleneck resource is calculated for each product and ranked in a similar way to limiting factor analysis.

This ranking can then be used to select the product which produces the greatest throughput per unit of the bottleneck resource.

(b) QP uses throughput accounting for short-term decisions, so first calculate contribution assuming material is the only variable cost. Ingredient L is the limiting factor.

TR PN BE Sales price 340 450 270Materials 250 285 175 ––– ––– –––Throughput 90 165 95Kgs of L 7 9 4Throughput per kg of L $12.86 $18.33 $23.75Rank 3 2 1

Production plan (maximum of 7,000kg of L available):

First allocate minimum contract

50 TR × 7 350

50 PN × 9 450

50 BE × 4 200

––––– 1,000 Next produce BE to maximum demand

300 × 4 1,200

Then PN to maximum demand

350 × 9 3,150

Produce TR with the 1,650 kgs remaining

235 × 7 1,645

––––– 6,995

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The production plan to maximise the profit of QP is:

Total throughput 350 BE × $95 33,250

400 PN × $165 66,000

285 TR × $90 25,650

––––––– $124,900

(c) The objective function value of 110,714 represents the maximum throughput which can be earned given the new constraint. This represents a fall of $13,861 compared to the optimal solution calculated in (b).

The throughput is achieved by producing 500 batches of TR, 357 batches of PN and 71 batches of BE. The slack variables show the extent that this represents a shortfall on the maximum demand achievable. Thus the maximum demand of 500 batches of TR is produced (0 slack variable), a shortfall of 43 batches of PN (357 + 43 = 400) and a shortfall of 279 units of BE (71 + 279 = 350).

The shadow price L value of $3 represents the amount of extra throughput which could be earned if there was one more kg of L available. The shadow price M value represents the amount of extra throughput which could be earned if there was one more kg of M available.

Marking scheme

Marks

(a) 1 mark for each relevant point 5.0

(b) Identification of limiting factor 1.0

Calculation of throughput per unit 1.0

Calculation of throughput per kg of L 1.0

Rank 1.0

Optimum production plan 3.0

Maximum throughput 2.0

––––

9.0

––––

(c) 1 mark for each relevant point 6.0

––––

Total 20

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