THE INSTITUTE OF CERTIFIED PUBLIC

ACCOUNTANTS OF PAKISTAN (ICPAP)

Stage Professional Course Code P-502

Advanced Performance
Examination Winter-2012 Course Name
Management (Solution)

Time Allowed 03 Hours Maximum Marks 100

NOTES:

1) All questions are to be attempted.

2) Answers are expected to the precise, to the point and well written.
3) Neatness and style will be taken into account in marking the papers.
Question No 1:-

You are the management accountant of the SSA Group which manufactures
an innovative range of products to provide support for injuries to various
joints in the body. The group has adopted a divisional structure. Each division
is encouraged to maximise its reported profit.

Division A, which is based in a country called Nearland, manufactures joint-

support appliances which incorporate a ‘one size fits all people’ feature. A
different appliance is manufactured for each of knee, ankle, elbow and wrist
joints.

Budget information in respect of Division A for the year ended 31 December

2010 is as follows:

Support appliance Knee Ankle Elbow Wrist

Sales units (000’s) 20 50 20 60
Selling price per unit (Rs) 24 15 18 9
Total variable cost of sales (Rs’ 000) 200 250 160 240

Each of the four support products uses the same quantity of manufacturing
capacity. This gives Division A management the flexibility to alter the product
mix as desired. During the year to 31 December 2010 it is estimated that a
maximum of 160,000 support products could be manufactured.

The following information relates to Division B which is also part of the SSA
group and is based in Distantland:
 1. Division B purchases products from various sources, including from
other divisions in SSA group, for subsequent resale to customers.
2. The management of Division B has requested two alternative
quotations from Division A in respect of the year ended 31 December
2010 as follows:

Quotation 1 – Purchase of 10,000 ankle supports.

Quotation 2 – Purchase of 18,000 ankle supports.

The management of the SSA Group has decided that a minimum of 50,000
ankle supports must be reserved for customers in Nearland in order to ensure
that customer demand can be satisfied and the product’s competitive position
is maintained in the Nearland market.

The management of the SSA Group is willing, if necessary, to reduce the

budgeted sales quantities of other types of joint support in order to satisfy the
requirements of Division B for ankle supports. They wish, however, to
minimize the loss of contribution to the Group.

The management of Division B is aware of another joint support product,

which is produced in Distantland, that competes with the Division A version
of the ankle support and which could be purchased at a local currency price
that is equivalent to Rs9 per support. SSA Group policy is that all divisions
are allowed autonomy to set transfer prices and purchase from whatever
sources they choose. The management of Division A intends to use market
price less 30% as the basis for each of quotations 1 and 2.

Required:

(a)

i. The management of the SSA Group have asked you to advise them
regarding the appropriateness of the decision by the management of
Division A to use an adjusted market price as the basis for the
preparation of each quotation and the implications of the likely
sourcing decision by the management of Division B.

Your answer should cite relevant quantitative data and incorporate

your recommendation of the prices that should be quoted by Division
A for the ankle supports in respect of quotations 1 and 2, that will
ensure that the profitability of SSA Group as a whole is not adversely
affected by the decision of the management of Division B.
 ii. Advise the management of Divisions A and B regarding the basis of
transfer pricing which should be employed in order to ensure that the
profit of the SSA Group is maximized.

b) After considerable internal discussion concerning Quotation 2 by the

management of SSA Group, Division A is not prepared to supply
18,000 ankle supports to Division B at any price lower than 30% below
market price. All profits in Distantland are subject to taxation at a rate
of 20%. Division A pays tax in Nearland at a rate of 40% on all profits.

Advise the management of SSA Group whether the management of

Division B should be directed to purchase the ankle supports from
Division A, or to purchase a similar product from a local supplier in
Distantland. Supporting calculations should be provided.

(5+5+10=20 Marks)

Answer:-

(a) (i) As regards Quotation 1 in respect of the year ending 31 December 2010,
the management of Division B would purchase ankle supports from a local
supplier in order to increase the profitability of Division B. An internal
transfer price from Division A of Rs10.50 (Rs15 less 30%) would appear
unattractive in comparison with a locally available price of Rs9. The
management of Division B is encouraged to seek the maximization of
reported profit as its key objective.

Division A has spare production capacity of 10,000 units (Maximum available

= 160,000 units and the 2010 budget total demand is 150,000 units). Division A
could, therefore, supply 10,000 units of ankle supports at its marginal cost of
Rs7 per unit (Rs350, 000/50,000) i.e. at a total cost of Rs70, 000. However the
external supplier would charge Rs9 per unit, giving a total price of Rs90, 000
for the 10,000 units.

In order to have decisions leading to the maximization of SSA group profit,

Division A should, therefore, quote its marginal cost of Rs7 per unit for each
of the 10,000 units required by Division B.

SSA Group profit will then increase by (Rs9 – Rs7) x 10,000 = Rs20, 000.

As regards Quotation 2 in respect of the year ending 31 December 2010, the

management of Division B would again purchase from a local supplier in
order to increase the reported profitability of the division if Division A quotes
a transfer price of Rs10·50 (Rs15 less 30%).
 Division A could potentially have supplied 18,000 ankle supports by using (i)
spare capacity for 10,000 units and (ii) switching 8,000 units of production
from sales of the type of support that earns the lowest contribution per unit.

The 10,000 units of spare capacity can be supplied at marginal cost of Rs7 per
unit as in Quotation 1.

The additional 8,000 units would have to be diverted from the type of existing
support that earns the lowest contribution per unit. The situation is as
follows:

Product Knee support Ankle support Elbow support Wrist support

Selling price per unit (Rs) 24 15 18 9
Variable cost per unit (Rs) 10 7 8 4
Contribution per unit (Rs) 14 8 10 5

Division A should offer to transfer the additional 8,000 ankle supports by

diverting production from the least profitable type of support. The wrist
support earns the lowest contribution per unit (Rs5). Hence Division A should
offer to transfer the additional 8,000 ankle supports at marginal cost +
contribution foregone = Rs7 + Rs5 = Rs12.

In this case, Division B would reject the offer and would buy externally at Rs9
per unit. This would ensure that SSA Group profit is not adversely affected by
any transfer decision.

(ii) The management of the SSA Group needs to ensure that the
management of all divisions takes into consideration all internal and external
information relevant to divisional and, much more importantly, group
circumstances.

As a starting point, the basic principle which underpins transfer pricing is

that transfer prices should be set at a level which covers the marginal costs
plus any opportunity cost to the SSA Group. If the basic principle is applied
correctly then any subsequent decision made regarding whether to make
internal transfers or external sales of products or internal purchases as
opposed to external sourcing of products should lead to the most profitable
outcome from the standpoint of the group as a whole.

What is best for the SSA Group as a whole is dependent upon the capacity
utilization of its divisions. In this example everything depends on the capacity
utilization of Division A.
What is of vital importance is that the marginal revenues and marginal costs
of the SSA Group are known, understood and applied by management?

(b) (i) If Division B buys from a local supplier the financial implications for
the SSA group are as follows:

Division A sales: Rs
60,000 wrist supports at a contribution of Rs. 5 per unit 300,000
Taxation at 40% 120,000
After tax benefit of sales 180,000
Division B purchases:
18,000 ankle supports at a cost of Rs. 9 per unit 162,000
Taxation benefit at 20% 32,400
After tax cost of purchases 129,600
Net benefit to SSA Group = Rs. 180,000 – Rs 129,600 Rs. 50,400

If Division B buys internally from Division A the financial implications for

SSA group are as follows:

Division A sales: Rs
External:
50,000 wrist supports at a contribution of Rs 5 per unit 260,000
18,000 ankle supports to Division B at a contribution of (Rs
15 × 70%) – Rs 7 = Rs 3.5 per unit 63,000
323,000
Taxation at 40% 129,200
After tax benefit of sales 193,800
Division B purchases:
18,000 ankle supports at cost of Rs 10.50 per unit 189,000
Taxation benefit at 20% 37,800
After tax cost of purchases 151,200
Net benefit to SSA group Rs. 42,600

The SSA group will be Rs. 50,400 – Rs. 42,600 = Rs. 7,800 worse off if Division
B purchases the ankle supports from Division.

A, as opposed to purchasing an equivalent product from a local supplier

Question No 2:-

Franchising For You Ltd (F4U) markets a range of franchises which it makes
available to its customers, the franchisees. F4U supplies the franchisee with
information of the mode of operation, detailed operation schedules and back-
up advice (by telephone, internet) and undertakes national advertising. Each
franchisee must arrange for its own premises, equipment and undertake local
marketing.

F4U is considering the introduction of a Dance and Drama franchise which

would have an expected life of six years. From this project, the only income
F4U will receive from franchisees comes from the initial franchise fee.

The following estimates have been made relating to the cash outflows and
inflows for F4U in order that F4U can evaluate the financial viability of the
Dance and Drama franchise proposal:

1. Initial investment of Rs6m. This will include a substantial element

relating to the ‘intellectual capital’ requirement of the proposal.
2. Development/improvement costs of Rs1m per year at the end of each
of years two and three.
3. 300 franchises will be sold each year at a fee of Rs20,000 per franchisee.
4. Variable costs, payable in full on the issue of each franchise, are
estimated at Rs6,000 per franchise.
5. Directly attributable fixed costs of Rs0.6m per year in each of years one
to six. No further fixed costs will be payable by F4U after this period.
6. Corporation tax at the rate of 30%, payable in the year in which cash
flow occurs. Tax allowances are not available on the initial investment
or development/improvement costs payable by F4U.
7. All cash flows are stated in current prices and with the exception of the
initial investment will occur at the end of each year.
8. The money cost of capital is 15.44%. Annual inflation during the period
is estimated at 4%.

Required:

a) Calculate the net present value (NPV) of the Dance and Drama
franchise proposal and recommend whether it should be undertaken
by F4U.
b) Discuss the elements to be considered as ‘intellectual capital’ and
issues associated with its valuation for inclusion in the initial
investment of Rs6m.
c) Discuss ways in which reliance solely on financial performance
measures can detract from the effectiveness of the performance
management system within an organisation.

F4U has identified key variables as follows:

 1. The number of franchises taken up each year. It is estimated that a
flexible pricing policy will result in the following outcomes:

Fee per franchise Number of franchises

Rs Sold each year
22,000 270
20,000 300
18,000 355

2. The variable cost per franchise may be Rs7, 000, Rs6, 000 or Rs5, 000.

The NINE possible outcomes of a spreadsheet model used in

calculating the NPV and incorporating the variables 1 and 2 above,
have been identified as follows:

Payoff Matrix: NPV values

Fee per franchise (Rs000)

18 20 22
Variable cost 4,348,226 4,007,630 4,274,183
5
Per franchise 6 3,296,822 3,119,120 3,474,524
(Rs 000) 7 2,245,419 2,230,610 2,674,865

Required:

d) State the franchise fee pricing strategy (Rs per franchise) which will
result from the operation of each of the following decision rules:

(i) Maximax;

(ii) Maximin;

(iii) Minimax regret.

Your answer should explain the basis of operation of each of the three
decision rules.

(5+5+5+5=20 Marks)

Answer:-

a) Contribution per franchise = sales revenue – variable cost

= Rs. 20,000 – Rs. 6,000 = Rs. 14,000
 Net operating cash flow each year before taxation = (Rs14, 000 x 300) –
Rs600, 000 = Rs3, 600,000
Net operating cash flow each year after taxation = Rs3, 600,000 x 70% =
Rs2, 520,000
Net present value (NPV) at a discount rate of 11%
Net operating cash flow – initial investment – development costs
= (2,520,000 x 4.231) – (6,000,000) – (1,000,000 x 0.812) – (1,000,000 x
0.731)
= Rs3, 119,120
The positive NPV indicates that the proposal should be undertaken.
Note: A real discount rate of 11% has been used. It has been calculated
as follows:
(1 + money cost of capital)/ (1 + rate of inflation) – 1
= (1 + 0.1544)/ (1 + 0.04) – 1
= 0.11 or 11%

b) There are barriers to the creation and revision of a performance

measurement system. Key drivers are not easily measured.

This applies specifically to the issue of intellectual capital.

Intellectual capital will include assets such as employee know-how,

skills and creativity. Such assets cannot be measured using traditional
financial measures. It is necessary to identify and value a number of
alternative measures such as years of experience or service of key
employees, or the proportion of employees generating new ideas for
the development of the business.
The rise of intellectual capital statements has been driven by the
decreasing information relevance of aspects of traditional financial
statements. There is a role for accountants (in particular management
accountants) in classifying the intellectual (and intangible) assets in the
organisation.
In F4U the development of new franchises will rely heavily on the
intellectual capital input. This will require the ongoing development of
existing employee knowledge and expertise and the recruitment of
new expertise/knowledge as required by the trend in the franchise
range.
There will be specific costs incurred in the retention and development
of existing staff expertise and in the acquisition of new staff/expertise
and its development within the ethos of F4U.
c) A Performance Measurement system (PMS) must be comprehensive
for the following reasons:
- Financial is only one dimension of value – as such it is inadequate
in evaluating strategic performance of an organisation in its
entirety.
- Financial measures are traditionally backward looking – in today’s
volatile markets, a poor predictor of future performance.
- Financial measures take no account of the intangible value drivers –
especially important in knowledge intensive companies.
- Fixation with bottom line profit pushes for short-term decisions to
boost earnings streams in short term.
- Alternative perspectives are needed to satisfy demands of
providing a sustainable competitive environment.

The effectiveness of a PMS based solely on financial performance may

be reduced due to key drivers not being easily measured such as, for
example, the degree of innovation required for new franchises.

Also, there may be conflict between the PMS with the culture of an
organisation. The culture will probably focus on innovation in
franchise development. This will not be enhanced by a solely financial
based PMS. It is important that a culture is developed which recognises
and rewards the contribution of employees to achieving corporate
goals and strategy fulfillment.

It is important to focus on sustaining competitive advantage through

superior strategic management in all aspects of franchise development
and implementation. There is a need for better business intelligence
capability from both within the organisation and from external sources,
in the assessment of likely demand for new franchise areas and how
best to satisfy such demand. In this regard there is need for non-
financial performance measures in order to enhance the effectiveness of
the PMS.

d) The maximax rule looks for the largest possible outcome. In this case
F4U will choose a fee per franchise of Rs18, 000 where there is a
possibility of an NPV of Rs4, 348,226. This may be seen as risk seeking
since F4U has not been put off by the possibility of a lower NPV than if
a Rs22, 000 fee is charged and variable costs are Rs6, 000 or Rs7, 000.

The maximin rule looks for the fee per franchise which will maximise
the minimum possible NPV. Hence maximin is a risk adverse strategy.
 In this case F4U will choose a fee per franchise of Rs22, 000 where the
lowest NPV is Rs2, 674,865. This is better than the lowest figures
applying where franchise fees of Rs18, 000 or Rs20, 000 apply.

The minimax regret rule requires the choice of the fee per franchise
which will minimize the regret from making the wrong decision.
Regret in this context is the opportunity lost through making the
wrong decision. Using the calculation from the payoff matrix given in
the question, a regret matrix may be created as follows:

Regret matrix

Fee per franchise (Rs. 000)

Rs. 18 Rs. 20 Rs. 22

Variable cost 5 0 340,596 74,043
Per franchise 6 177,702 355,404 0
(Rs000) 7 429,446 444,255 0

Question No 3:-

Waseem designs, develops and sells many PC games. Games have a short
lifecycle lasting around three years only. Performance of the games is
measured by reference to the profits made in each of the expected three years
of popularity. Waseem accepts a net profit of 35% of turnover as reasonable.
A rate of contribution (sales price less variable cost) of 75% is also considered
acceptable.

Waseem has a large centralized development department which carries out

all the design work before it passes the completed game to the sales and
distribution department to market and distribute the product.

Waseem has developed a brand new game called Stealth and this has the
following budgeted performance figures.

The selling price of Stealth will be a constant Rs 30 per game. Analysis of the
costs show that at a volume of 10,000 units a total cost of Rs 130,000 is
expected. However at a volume of 14,000 units a total cost of Rs 150,000 is
expected. If volumes exceed 15,000 units the fixed costs will increase by 50%.

Stealth’s budgeted volumes are as follows:

Year 1 Year 2 Year 3

Sales Volume 8,000 unit’s 16,000 unit’s 4,000 units
In addition, marketing costs for Stealth will be Rs 60,000 in year one and Rs
40,000 in year two. Design and development costs are all incurred before the
game is launched and has cost Rs 300,000 for Stealth. These costs are written
off to the income statement as incurred (i.e. before year 1 above).

Required:

a) Explain the principles behind lifecycle costing and briefly state why
Waseem in particular should consider these lifecycle principles.
b) Produce the budgeted results for the game ‘Stealth’ and briefly assess
the game’s expected performance, taking into account the whole
lifecycle of the game.
c) Explain why incremental budgeting is a common method of budgeting
and outline the main problems with such an approach.
d) Discuss the extent to which a meaningful standard cost can be set for
games produced by Waseem. You should consider each of the cost
classifications mentioned above.
(5+5+5+5=20 Marks)

Answer:-

a) Lifecycle costing is a concept which traces all costs to a product over its
complete lifecycle, from design through to cessation. It recognises that
for many products there are significant costs to be incurred in the early
stages of its lifecycle. This is probably very true for Waseem Limited.
The design and development of software is a long and complicated
process and it is likely that the costs involved would be very
significant.
The profitability of a product can then be assessed taking all costs into
consideration.
It is also likely that adopting lifecycle costing would improve decision-
making and cost control. The early development costs would have to
be seen in the context of the expected trading results, therefore
preventing a serious over spend at this stage or underpricing at the
launch point.
b) Budgeted results for game
Year 1 (Rs) Year 2 (Rs) Year 3 (Rs) Total (Rs)
Sales 240,000 480,000 120,000 840,000
Variable cost 40,000 80,000 20,000 140,000
(WI)
Fixed cost (W 1) 80,000 120,000 80,000 280,000
Marking cost 60,000 40,000 100,000
Profit 60,000 240,000 20,000 320,000
On the face of it the game will generate profits in each of its three years
of life. Games only have a short lifecycle as the game players are likely
to become bored of the game and move on to something new.

The pattern of sales follows a classic product lifecycle with poor levels
of sales towards the end of the life of the game.

The Stealth product has generated Rs 320,000 of profit over its three
year life measured on a traditional basis. This represents 40% of
turnover – ahead of its target. Indeed it shows a positive net profit in
each of its years on existence.

The contribution level is steady at around 83% indicating reasonable

control and reliability of the production processes. This figure is better
than the stated target.

Considering traditional performance management concepts, Waseem

Limited is likely to be relatively happy with the game’s performance.

However, the initial design and development costs were incurred and
were significant at Rs 300,000 and are ignored in the annual profit
calculations. Taking these into consideration, the game only just broke
even, making a small Rs 20,000 profit.

Whether this is enough is debatable, it represents only 2·4% of sales for

example. In order to properly assess the performance of a product the
whole lifecycle needs to be considered.

Workings

W1 Split of variable and fixed cost for Stealth

Volume Cost Rs

High 14,000 units 150,000

Low 10,000 units 130,000

Difference 4,000 units 20,000

Variable cost per unit = Rs 20,000/4,000 unit = Rs 5 per unit

Total cost = fixed cost + variable cost

Rs 150,000 = fixed cost + (14,000 x Rs 5)

Rs 150,000 = fixed cost +Rs 70,000

 Fixed cost = Rs 80,000 (and Rs 120,000 if volume exceeds 15,000 units in
a year.)

c) Incremental budgeting is a process whereby this year’s budget is set by

reference to last year’s actual results after an adjustment for inflation
and other incremental factors. It is commonly used because:
- It is quick to do and a relatively simple process.
- The information is readily available, so very limited quantitative
analysis is needed.
- It is appropriate in some circumstances. For example, in a stable
business, the amount of stationery spent in one year is unlikely
to be significantly different in the next year, so taking the actual
spend in year one and adding a little for inflation should be a
reasonable target for the spend in the next year.

There are problems involved with incremental budgeting:

- It builds on wasteful spending. If the actual figures for this year

include overspends caused by some form of error then the budget for
the next year would potentially include this overspend again.
- It encourages organisations to spend up to the maximum allowed in
the knowledge that if they don’t do this then they will not have as
much to spend in the following year’s budget.
- Assessing the amount of the increment can be difficult.
- It is not appropriate in a rapidly changing business.
- Can ignore the true (activity based) drivers of a cost leading to poor
budgeting.

d) Design and development costs: Setting a standard cost for this

classification of cost would be very difficult. Presumably each game
would be different and present the program writers with different
challenges and hence take a varying amount of time.

Variable production cost: A game will be produced on a CD or DVD in

a fairly standard format. Each CD/DVD will be identical and as a
result setting a standard cost would be possible. Allowance might need
to be made for waste or faulty CDs produced. Some machine time will
be likely and again this should be the same for all items and therefore
setting a standard would be valid.

Fixed production cost: The standard fixed production cost of a game

will be the product of the time taken to produce the game and the
 imply a variability (cost per unit) that is not the case and can therefore
confuse non-accountants, causing poor decisions. The time per unit
will be fairly standard.

Marketing costs: Games may have different target audiences and

therefore require different marketing strategies. As such setting a
standard may be difficult to do. It may be possible to set standards for
each marketing media chosen. For example the rates for a page advert
in a magazine could be set as a standard. standard fixed overhead
absorption rate for the business. This brings into question whether this
is ‘meaningful’. Allocating fixed costs to products in a standard way
may not provide meaningful data. It can sometimes

Question No 4:-

Tic International Park (TIP) is a theme park and has for many years been a
successful business, which has traded profitably. About three years ago the
directors decided to capitalize on their success and reduced the expenditure
made on new thrill rides, reduced routine maintenance where possible
(deciding instead to repair equipment when it broke down) and made a
commitment to regularly increase admission prices. Once an admission price
is paid customers can use any of the facilities and rides for free.

These steps increased profits considerably, enabling good dividends to be

paid to the owners and bonuses to the directors. The last two years of
financial results are shown below.

2008 2009
Rs Rs
Sales 5,250,000 5,320,000
Less expense:
Wages 2,500,000 2,200,000
Maintenance – routine 80,000 70,000
Repairs 260,000 320.000
Directors salaries 150,000 160,000
Directors Bonuses 15,000 18,000
Other costs (including depreciation) 1,200,000 1,180,000
Net profit 1,045,000 1,372,000
Book value of assets at start of year 13,000,000 12,000,000
Dividend paid 500,000 650,000
Number of visitors 150,000 140,000
TIP operates in a country where the average rate of inflation is around 1% per
annum.

Required:

a) Assess the financial performance of TIP using the information given

above.

During the early part of 2008 TIP employed a newly qualified

management accountant. He quickly became concerned about the
potential performance of TIP and to investigate his concerns he started
to gather data to measure some non-financial measures of success. The
data he has gathered is shown below:

Table 1

2008 2009
Hours lost due to breakdown of rides (see 9,000 hours 32,000
note 1) hours
Average waiting time per ride 20 minutes 30 minutes

Note 1: TIP has 50 rides of different types. It is open 360 days of the
year for 10 hours each day

Required:

b) Assess the quality of the service that TIP provides to its customers
using Table 1 and any other relevant data and indicate the risks it is
likely to face if it continues with its current policies.
(10+10=20 Marks)

Answer:-

a) TIPs Financial performance can be assessed in a number of ways:

Sales growth

Sales are up about 1.3% (W1) which is a little above the rate of inflation
and therefore a move in the right direction. However, with average
admission prices jumping about 8.6% (W2) and numbers of visitors
falling there are clearly problems. Large increases in admission prices
reduce the value proposition for the customer; it is unlikely that the
rate of increase is sustainable or even justifiable. Indeed with volumes
falling (down by 6.7%, (W6)) it appears that some customers are being
put off and price could be one of the reasons.
Maintenance and repairs

There appears to be a continuing drift away from routine maintenance

with management preferring to repair equipment as required. This
does not appear to be saving any money as the combined cost of
maintenance and repair is higher in 2009 than in 2008 (possible risks
are dealt with in part (b)).

Directors pay

Absolute salary levels are up 6.7% (W3), well above the modest
inflation rate. It appears that the shareholders are happy with the
financial performance of the business and are prepared to reward the
directors accordingly. Bonus levels are also well up. It may be that the
directors have some form of profit related pay scheme and are being
rewarded for the improved profit performance. The directors are likely
to be very pleased with the increases to pay.

Wages

Wages are down by 12% (W5). This may partly reflect the loss of
customers (down by 6.7% (W6) if we assume that at least part of the
wages cost is variable. It could also be that the directors are reducing
staff levels beyond the fall in the level of customers to enhance short-
term profit and personal bonus. Customer service and indeed safety
could be compromised here.

Net profit

Net profit is up a huge 31.3% (W7) and most shareholders would be

pleased with that. Net profit is a very traditional measure of
performance and most would say this was a sign of good performance.

Return on assets

The profitability can be measured relative to the asset base that is being
used to generate it. This is sometimes referred to as ROI or return on
investment. The return on assets is up considerably to 11.4% from 8%
(W8). This is partly due to the significant rise in profit and partly due
to the fall in asset value. We are told that TIP has cut back on new
development so the fall in asset value is probably due to depreciation
being charged with little being spent during the year on assets. In this
regard it is inevitable that return on assets is up but it is more
questionable whether this is a good performance. A theme park (and
 thrill rides in particular) must be updated to keep customers coming
back. The directors on TIP are risking the future of the park.

b) Quality provision

Reliability of the rides

The hours lost has increased significantly. Equally the % of capacity

lost due to breakdowns is now approaching 17.8% (W9). This would
appear to be a very high number of hours lost. This would surely
increase the risk that customers are disappointed being unable to ride.
Given the fixed admission price system this is bound to irritate some
customers as they have effectively paid to ride already.

Average queuing time

Queuing will be seen by customers as dead time. They may see some
waiting as inevitable and hence acceptable. However TIP should be
careful to maintain waiting times at a minimum. An increase of 10
minutes (or 50%) is likely to be noticeable by customers and is unlikely
to enhance the quality of the TIP experience for them. The increase in
waiting times is probably due to the high number of hours lost due to
breakdown with customers being forced to queue for a fewer number
of ride options.

Safety

The clear reduction in maintenance could easily damage the safety

record of the park and is an obvious quality issue.

Risks

If TIP continues with current policies then they will expose themselves
to the following risks:

 The lack of routine maintenance could easily lead to an accident

or injury to a customer. This could lead to compensation being
paid or reputational damage
 Increased competition. The continuous raising of admission
prices increases the likelihood of a new competitor entering the
market (although there are significant barriers to entry in this
market e.g. capital cost, land and so on).
 Loss of customers. The value for money that customers see
when coming to TIP is clearly reducing (higher prices, less
reliability of rides and longer queues). Regardless of the
 existence of competition customers could simply chose not to
come, substituting another leisure activity instead
 Profit fall. In the end if customers’ numbers fall then so will
profit. The shareholders, although well rewarded at the moment
could suffer a loss of dividend. Directors’ job security could then
be threatened

Workings:

(W1) Sales growth is Rs 5,320,000/Rs 5,250,000 = 1.01333 or 1·3%

(W2) Average admission prices were:

2008: Rs 5,250,000/150,000 = Rs 35 per person

2009: Rs 5,320,000/140,000 = Rs 38 per person

An increase of Rs 38/Rs 35 = 1.0857 or 8.57%

(W3) Directors pay up by Rs 160,000/Rs 150,000 = 1·0667 or 6.7%

(W4) Directors bonuses levels up from Rs 15,000/Rs 150,000 or 10% to

Rs 18,000/Rs 160,000 or 12.5% of turnover. This is an increase of 3/15
or 20%

(W5) Wages are down by (1 – Rs 2,200,000/Rs 2,500,000) or 12%

(W6) Loss of customers is (1 – 140,000/150,000) or 6.7%

(W7) Profits up by Rs 1,372,000/Rs 1,045,000 = 1.3129 or 31.3%

(W8) Return on assets:

2008: Rs 1,045,000/Rs 13,000,000 = 1.0803 or 8.03%

2009: Rs 1,372,000/Rs 12,000,000 = 1.114 or 11.4%

(W9) Capacity of rides in hours is 360 days x 50 rides x 10 hours per

day = 180,000

2008 lost capacity is 9,000/180,000 = 0.05 or 5%

2009 lost capacity is 32,000/180,000 = 0.177 or 17.8%

Question No 5:-

Hilal Cakes make cakes, which are sold directly to the public. The new
production manager (a celebrity chef) has argued that the business should use
only organic ingredients in its cake production. Organic ingredients are more
expensive but should produce a product with an improved flavor and give
health benefits for the customers. It was hoped that this would stimulate
demand and enable an immediate price increase for the cakes.

Hilal Cakes operates a responsibility based standard costing system which

allocates variances to specific individuals. The individual managers are paid a
bonus only when net favourable variances are allocated to them.

The new organic cake production approach was adopted at the start of March
2009, following a decision by the new production manager. No change was
made at that time to the standard costs card. The variance reports for
February and March are shown below (Fav = Favourable and Adv = Adverse)

Manager Allocated variances February March

responsible variance Rs Variance Rs
Production
manager
Material price (total for all 25 Fav 2,100 Adv
ingredients)
Material mix 0 600 Adv
Material yield 20 Fav 400 Fav
Sales Manager
Sales price 40 Adv 7,000 Fav
Sales contribution volume 35 adv 3,000 Fav

The production manager is upset that he seems to have lost all hope of a
bonus under the new system. The sales manager thinks the new organic cakes
are excellent and is very pleased with the progress made.

Hilal Cakes operate a JIT stock system and holds virtually no inventory.

Required:

a) Assess the performance of the production manager and the sales

manager and indicate whether the current bonus scheme is fair to those
concerned.

In April 2009 the following data applied:

Standard cost card for one cake (not adjusted for the organic ingredient
change)

Ingredients Kg Rs
Flour 0.10 0.12 per kg
 Eggs 0.10 0.70 per kg
Butter 0.10 1.70 per kg
Sugar 0.10 0.50 per kg
Total input 0.40
Normal loss (10%) (0.04)
Standard weight of a cake 0.36
Standard sales price of a cake 0.85
Standard contribution per cake after all variable 0.35
costs

The budget for production and sales in April was 50,000 cakes. Actual
production and sales was 60,000 cakes in the month, during which the
following occurred:

Ingredients used Kg Rs
Flour 5,700 Rs 741
Eggs 6,600 Rs 5,610
Butter 6,600 Rs 11,880
Sugar 4,578 Rs 2,747
Total input 23,478 Rs 20,978
Actual loss (1,878)
Actual output of cake mixture 21,600
Actual sales price of cake Rs 0.99

All cakes produced must weigh 0.36 kg as this is what is advertised.

Required:

b) Calculate the material price, mix and yield variances and the sales
price and sales contribution volume variances for April. You are not
required to make any comment on the performance of the managers.
(8+12=20 Marks)

Answer:-

a) Production manager

Assessing the performance of the two managers is difficult in this

situation. In a traditional sense the production manager has seriously
over spent in March following the move to organic ingredients. He has
a net adverse variance against his department of Rs 2,300 in one
month. No adjustment to the standards has been made to allow for the
change to organic.
The manager has not only bought organically he has also changed the
mix, increasing the input proportion of the more expensive ingredients.
This may have contributed to the increased sales of cakes.

However, the decision to go organic has seen the sales of the business
improve. We are told that the taste of the cakes should be better and
that customers could perceive a health benefit. However, the
production manager is allocated none of the favourable sales variances
that result. If we assume that the improved sales are entirely as a result
of the production manager’s decision to change the ingredients then
the overall net favourable variance is Rs 7,700.

The production manager did appear to be operating within the original

standard in February, indicating a well performing department. Indeed
he will have earned a small bonus in that month.

Sales manager

A change to organic idea would need to be ‘sold’ to customers. It

would presumably require a change of marketing and proper
communication to customers. The sales manager would probably feel
he has done a good job in March. It is debatable, however, whether he
is entirely responsible for all of the favourable variances.

The move to organic certainly helped the sales manager as in February

he seems to have failed to meet his targets.

Bonus scheme

The problem here is that the variances have to be allocated to one

individual. The good sales variances have been allocated to the sales
manager when in truth the production manager’s decision to go
organic appears to have been a good one and the driver of the business
success. Responsibility accounting systems struggle to cope with ‘joint’
success stories, refuting in general a collective responsibility.

Under the current standards the production manager has seemingly no

chance to make a bonus. The main problems appear to be the out-of-
date standards and the fact that all sales variances are allocated to the
sales manager, despite the root cause of the improved performance
being at least in part the production manager’s decision to go organic.
The system does not appear fair.
General comments

It would appear that some sharing of the total variances is appropriate.

This would be an inexact science and some negotiation would be
needed.

One problem seems to be that the original standards were not changed
following the decision to go organic. In this sense the variances
reported are not really ‘fair