P 1 May 2008
P 1 May 2008
Managerial Level
Question Paper 2
Examiner’s Answers 22
The answers published here have been written by the Examiner and should provide a helpful
guide for both tutors and students.
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P1 – Performance Evaluation
Management Accounting Pillar
You are allowed 20 minutes reading time before the examination begins
during which you should read the question paper and, if you wish, highlight
and/or make notes on the question paper. However, you will not be allowed,
under any circumstances, to open the answer book and start writing or use
your calculator during the reading time.
You are strongly advised to carefully read ALL the question requirements
before attempting the question concerned (that is, all parts and/or sub-
questions). The requirements for the questions in Section C are contained in
a dotted box.
ALL answers must be written in the answer book. Answers or notes written
on the question paper will not be submitted for marking.
The list of verbs as published in the syllabus is given for reference on the
page 20.
Write your candidate number, the paper number and examination subject title
in the spaces provided on the front of the answer book. Also write your
contact ID and name in the space provided in the right hand margin and seal
to close.
Tick the appropriate boxes on the front of the answer book to indicate which
questions you have answered.
Your answers should be clearly numbered with the sub-question number then ruled
off, so that the markers know which sub-question you are answering. For multiple
choice questions, you need only write the sub-question number and the letter
of the answer option you have chosen. You do not need to start a new page for
each sub-question.
For sub-questions 1.11 to 1.17 you should show your workings as marks are
available for the method you use to answer these sub-questions.
Question One
1.1 If inventory levels have increased during the period, the profit calculated using marginal
costing when compared with that calculated using absorption costing will be
A higher.
B lower.
C equal.
D impossible to answer without further information.
(2 marks)
(2 marks)
P1 2 May 2008
The following scenario is to be used for questions 1.3 and 1.4
A company manufactures three products: W, X and Y. The products use a series of different
machines, but there is a common machine that is a bottleneck.
The standard selling price and standard cost per unit for each product for the next period are as
follows:
W X Y
£ £ £
Selling price 180 150 150
Cost:
Direct material 41 20 30
Direct labour 30 20 50
Variable production overheads 24 16 20
Fixed production overheads 36 24 30
Profit 49 70 20
Time (minutes) on bottleneck machine 7 10 7
1.3 Using a traditional limiting factor approach, the rank order (best first) of the products
would be
A W, X, Y
B W, Y, X
C X, W, Y
D Y, X, W
(2 marks)
1.4 Using a throughput accounting approach, the rank order (best first) of the products would
be
A W, X, Y
B W, Y, X
C X, W, Y
D Y, X, W
(2 marks)
May 2008 3 P1
1.5 A company’s summary budgeted operating statement is as follows:
$000
Revenue 400
Variable costs 240
Fixed costs 100
Profit 60
Assuming that the sales mix does not change, the percentage increase in sales volume that
would be needed to increase the profit to $100,000 is
A 10%
B 15%
C 25%
D 40%
(2 marks)
(i) Enterprise Resource Planning (ERP) systems are accounting oriented information
systems which aid in identifying and planning the enterprise wide resources needed
to resource, make, account for and deliver customer orders.
(ii) Flexible Manufacturing Systems (FMS) are integrated, computer-controlled
production systems, capable of producing any of a range of parts and of switching
quickly and economically between them.
(iii) Just-In-Time (JIT) is a system whose objective is to produce, or to procure,
products or components as they are required.
1.7 Flexed budgets for the cost of medical supplies in a hospital, based on a percentage of
maximum bed occupancy, are shown below:
During the period, the actual bed occupancy was 87% and the total cost of the medical
supplies was $430,000.
A $5,000 adverse
B $12,000 adverse
C $5,000 favourable
D $12,000 favourable
(2 marks)
P1 4 May 2008
1.8 A company uses a standard absorption costing system. The fixed overhead absorption
rate is based on labour hours.
Extracts from the company’s records for last year were as follows:
Budget Actual
Fixed production overhead $450,000 $475,000
Output 50,000 units 60,000 units
Labour hours 900,000 930,000
The under- or over-absorbed fixed production overheads for the year were
A $10,000 under-absorbed
B $10,000 over-absorbed
C $15,000 over-absorbed
D $65,000 over-absorbed
(2 marks)
1.10 A company will forecast its quarterly sales units for a new product by using a formula to
predict the base sales units and then adjusting the figure by a seasonal index.
The formula is BU = 4000 + 80Q
Where BU = Base sales units and Q is the quarterly period number
The seasonal index values are:
Quarter 1 105%
Quarter 2 80%
Quarter 3 95%
Quarter 4 120%
A 25%
B 80 units
C 100 units
D 1,156 units
(2 marks)
May 2008 5 P1
1.11 Product XYZ is made by mixing three materials (X, Y and Z). There is an expected loss
of 20% of the total input.
The budgeted and actual results for Period 1 are shown below. There were no opening or
closing inventories of any materials or of the finished product.
Budget Actual
Output of XYZ 800 kg 960 kg
Material
X 500 kg @ $5⋅00 per kg 600 kg @ $4⋅70 per kg
Y 300 kg @ $6⋅00 per kg 380 kg @ $6⋅50 per kg
Z 200 kg @ $7⋅00 per kg 300 kg @ $7⋅10 per kg
Total input 1,000 kg 1,280 kg
$000
Revenue 9,456
Gross profit 5,872
Operating profit 2,981
Non-current assets 17,850
Inventory 950
Cash at bank 1,750
Short-term borrowings 1,225
Trade receivables 731
Trade payables 813
P1 6 May 2008
The following data are given for sub questions 1.13, 1.14 and 1.15
Premier Cycles has two divisions: the Frame Division and the Assembly Division. The Frame
Division produces bike frames. The frames can be sold directly to external customers as “frame
only” or the frames can be transferred to the Assembly Division where they are built up into
complete bikes by adding other components, such as wheels and handlebars.
Frame Division
Budgeted details for the forthcoming year for the Frame Division are:
The Division has orders for 5,000 frames from external customers for the forthcoming year.
Assembly Division
The Manager of the Assembly Division has just signed a contract to supply 8,000 bikes to a
sporting goods retailer next year. This will mean that the Division will be operating at full
capacity. Budgeted details are as follows:
Company Policy
It has been announced that Premier Cycles will be introducing a new performance appraisal
system. The Divisional Managers’ bonuses will only be payable if they earn a minimum annual
contribution of 108% of fixed costs.
1.13 Calculate the minimum number of frames the Frame Division must sell next year in order
for the Divisional Manager to earn a bonus if frames are sold for $852 each.
(2 marks)
1.14 Calculate the maximum price per frame that the Manager of the Assembly Division could
pay and still earn a bonus next year.
(2 marks)
1.15 Ignoring Premier Cycles’ performance appraisal system, explain how the Manager of the
Frame Division should calculate the transfer price of frames it supplies to the Assembly
division in order to maximise profits for Premier Cycles.
May 2008 7 P1
1.16 State FOUR aims of a transfer-pricing system.
(2 marks)
1.17 Product GH passes through two consecutive processes: the output from Process 1 is
transferred to Process 2. Details of Process 1 for Period 3 were as follows:
There were 5,000 units of opening work-in-progress, which were valued as follows:
Materials $77,080
Labour $33,480
Production overheads $8,825
During the period, 14,000 units were added to the process and the following costs were
incurred:
Materials $230,000
Labour $101,000
Production overheads $40,000
At the end of Period 3, there were 6,000 units of closing work-in-progress. The degree of
completion for these units was:
Materials 100%
Labour 80%
Production overheads 65%
The expected normal loss is 10% of new units added to the process during the period.
These units and any other losses can be sold for $5 per unit.
11,000 units were transferred to Process 2 and there were losses of 2,000 units.
Calculate the total cost of the 11,000 units that were transferred to Process 2.
(4 marks)
Reminder
P1 8 May 2008
SECTION B – 30 MARKS
[the indicative time for answering this section is 54 minutes]
ANSWER ALL SIX SUB-QUESTIONS. EACH SUB-QUESTION IS WORTH 5
MARKS
Question Two
(a) Describe THREE key features that are present in any organisation that is successfully
focused on Total Quality Management (TQM).
(5 marks)
(b) Explain THREE behavioural consequences that may result after the introduction of
participative budgeting.
(5 marks)
May 2008 9 P1
The following data relate to sub-questions (d), (e) and (f)
A multi-national company manufactures and sells a wide range of digital equipment. The
company is structured into three Divisions: Computers, Audio-visual and Photographic. The
Divisions operate as investment centres and the performance of the Divisional Managers is
evaluated by using Return on Investment (ROI).
The Manager of the Photographic Division was concerned that the Division was falling behind its
competitors in terms of financial returns and market share, and has implemented strategies to
improve the situation. An external benchmarking exercise was undertaken to try to establish the
position of the Division in relation to its competitors in a number of key areas. It has now been
suggested that the Division should also carry out an internal benchmarking exercise.
Perspective Goal
Innovation Technology Leadership
Customer Support
(i) For the “Innovation Perspective” of the Division, recommend a performance measure and
briefly explain how the measure will reflect the achievement of the stated goal.
(3 marks)
(ii) For the “Customer Perspective” of the Division, state which data should be collected and
explain how this could be used to ensure the goal of “support’’ is met.
(2 marks)
(e) Explain THREE reasons why internal benchmarking may provide information that is more
useful to the Manager of the Photographic Division, in terms of monitoring and improving
performance, than that provided by external benchmarking.
(5 marks)
(f) Explain THREE reasons why ROI may not be a good performance measure.
(5 marks)
End of Section B
P1 10 May 2008
SECTION C – 30 MARKS
[the indicative time for answering this section is 54 minutes]
ANSWER ONE OF THE TWO QUESTIONS
Question Three
The newly-appointed Managing Director of FX has received the variance report for Month 6,
which is shown below:
Output and Sales for Month 6. Budget: 1,000 units. Actual: 1,200 units.
£ £ £
Budgeted contribution 90,000
Budgeted fixed costs 70,000
Budgeted profit 20,000
Volume variance 18,000
Expected profit on actual sales 38,000
Sales price variance 12,000
Production variances Favourable Adverse
Materials price 6,300
Materials usage 6,000
Labour rate 5,040
Labour efficiency 2,400
Variable overhead expenditure - -
Variable overhead efficiency 1,200
Fixed overhead _____ 4,000
5,040 19,900 14,860
Actual profit 11,140
The report did not include any other information. Details relating to the company and the
product that it makes are given below:
£ £
Selling price 250
Direct material (5 kg at £20) 100
Direct labour (4 hours at £10) 40
Variable overheads (4 hours at £5) 20 160
Contribution 90
Budgeted sales and production levels are 1,000 units per month.
May 2008 11 P1
Month 6
The company has just completed Month 6 of its operations. Extracts from its records show:
Required:
(a) Prepare a report for the Managing Director of FX that explains and interprets the
Month 6 variance report. The Managing Director has recently joined the company
and has very little previous financial experience.
(17 marks)
The Managing Director was concerned about the Material Price variance and its cause.
He discovered that a shortage of materials had caused the market price to rise to £23 per
kg.
Required:
(c) Discuss the advantages and disadvantages of reporting planning and operational
variances. Your answer should refer, where appropriate, to the variances you
calculated in (b) above.
(6 marks)
P1 12 May 2008
Question Four
Q, a new company, is being established to manufacture and sell an electronic tracking device:
the Trackit. The owners are excited about the future profits that the business will generate.
They have forecast that sales will grow to 2,600 Trackits per month within five months and will
be at that level for the remainder of the first year.
The owners will invest a total of $250,000 in cash on the first day of operations (that is the first
day of Month 1). They will also transfer non-current assets into the company.
Sales
The forecast sales for the first five months are:
Month Trackits
(units)
1 1,000
2 1,500
3 2,000
4 2,400
5 2,600
Sales receipts
Sales will be mainly through large retail outlets. The pattern for the receipt of payment is
expected to be as follows:
Production
The budget production volumes in units are:
$
Direct materials 60
Direct wages 10
Variable production overheads 20
Total variable cost 90
Direct materials: Payment for purchases will be made in the month following receipt. There will
be no opening inventory of materials in Month 1. It will be company policy to hold inventory at
the end of each month equal to 20% at of the following month’s production requirements. The
direct materials cost includes the cost of an essential component that will be bought in from a
specialist manufacturer.
May 2008 13 P1
Direct wages will be paid in the month in which the production occurs.
Variable production overheads: 65% will be paid in the month in which production occurs and
the remainder will be paid one month later.
Required
(a) Prepare a cash budget for each of the first three months and for that three-month
period in total.
(14 marks)
(b) There is some uncertainty about the cost of the specialist component (this is
included in the direct material cost). It is thought that the cost of the component
could range between $32 and $50 per Trackit. It is currently included in the cost
estimates at $40 per Trackit.
Calculate the budgeted total net cash flow for the three-month period in total if the
cost of the component was
(i) $32
(ii) $50
(6 marks)
(c) Prepare a report for the owners of Q that offers advice about the profitability of their
business and the situation revealed by the extracts from the business plan and
your answers to (a) and (b) above.
(10 marks)
P1 14 May 2008
May 2008 15 P1
PRESENT VALUE TABLE
P1 16 May 2008
Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n
1− (1+ r ) − n
years r
May 2008 17 P1
Formulae
PROBABILITY
A ∪ B = A or B. A ∩ B = A and B (overlap).
P(B A) = probability of B, given A.
Rules of Addition
If A and B are mutually exclusive: P(A ∪ B) = P(A) + P(B)
If A and B are not mutually exclusive: P(A ∪ B) = P(A) + P(B) – P(A ∩ B)
Rules of Multiplication
If A and B are independent: P(A ∩ B) = P(A) * P(B)
If A and B are not independent: P(A ∩ B) = P(A) * P(B | A)
Quadratic Equations
If aX2 + bX + c = 0 is the general quadratic equation, the two solutions (roots) are given
by:
− b ± b 2 − 4ac
X =
2a
DESCRIPTIVE STATISTICS
Arithmetic Mean
∑x ∑ fx
x = x= (frequency distribution)
n ∑f
Standard Deviation
∑( x − x ) 2 ∑ fx 2
SD = SD = − x 2 (frequency distribution)
n ∑f
INDEX NUMBERS
Price relative = 100 * P1/P0 Quantity relative = 100 * Q1/Q0
⎛P ⎞
∑ w ∗ ⎜⎜ 1 ⎟
⎟
⎝ Po ⎠
Price: x 100
∑w
⎛Q ⎞
∑ w ∗ ⎜⎜ 1 ⎟⎟
Quantity: ⎝ Qo ⎠ x 100
∑w
TIME SERIES
Additive Model
Series = Trend + Seasonal + Random
Multiplicative Model
Series = Trend * Seasonal * Random
P1 18 May 2008
LINEAR REGRESSION AND CORRELATION
The linear regression equation of Y on X is given by:
Y = a + bX or Y - Y = b(X – X)
where
Covariance ( XY) n ∑ XY − ( ∑ X)( ∑ Y )
b= =
Variance ( X) n ∑ X 2 − ( ∑ X) 2
and a = Y – bX
or solve
∑ Y = na + b ∑ X
∑ XY = a ∑ X + b∑X2
Coefficient of correlation
6∑d2
R(rank) = 1 -
n(n 2 − 1)
FINANCIAL MATHEMATICS
Annuity
Present value of an annuity of £1 per annum receivable or payable for n years,
commencing in one year, discounted at r% per annum:
1⎡ 1 ⎤
PV = ⎢1 − ⎥
r ⎣⎢ [1 + r ] n ⎦⎥
Perpetuity
Present value of £1 per annum, payable or receivable in perpetuity, commencing in one
year, discounted at r% per annum:
1
PV =
r
May 2008 19 P1
LIST OF VERBS USED IN THE QUESTION REQUIREMENTS
A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for
each question in this paper.
It is important that you answer the question according to the definition of the verb.
LEARNING OBJECTIVE VERBS USED DEFINITION
1 KNOWLEDGE
What you are expected to know. List Make a list of
State Express, fully or clearly, the details of/facts of
Define Give the exact meaning of
2 COMPREHENSION
What you are expected to understand. Describe Communicate the key features
Distinguish Highlight the differences between
Explain Make clear or intelligible/State the meaning of
Identify Recognise, establish or select after
consideration
Illustrate Use an example to describe or explain
something
3 APPLICATION
How you are expected to apply your knowledge. Apply To put to practical use
Calculate/compute To ascertain or reckon mathematically
Demonstrate To prove with certainty or to exhibit by
practical means
Prepare To make or get ready for use
Reconcile To make or prove consistent/compatible
Solve Find an answer to
Tabulate Arrange in a table
4 ANALYSIS
How you are expected to analyse the detail of Analyse Examine in detail the structure of
what you have learned. Categorise Place into a defined class or division
Compare and contrast Show the similarities and/or differences
between
Construct To build up or compile
Discuss To examine in detail by argument
Interpret To translate into intelligible or familiar terms
Produce To create or bring into existence
5 EVALUATION
How you are expected to use your learning to Advise To counsel, inform or notify
evaluate, make decisions or recommendations. Evaluate To appraise or assess the value of
Recommend To advise on a course of action
P1 20 May 2008
The Examiner for Management Accounting – Performance Evaluation offers to
future candidates and to tutors using this booklet for study purposes, the
following background and guidance on the questions included in this
examination paper.
(a) covers learning outcome B(iiii) - Prepare and discuss a report which reconciles budget
and actual profit using absorption and/or marginal costing principles
(b) covers learning outcome B(iv) - Calculate and explain planning and operational variances.
(c) covers learning outcome B(iv) - Calculate and explain planning and operational variances.
(a) covers learning outcome C(iii) - Calculate projected revenues and costs based on
product/service volumes, pricing strategies and cost structures.
(b) covers learning outcome C(vii) - Calculate the consequences of “what if” scenarios and
evaluate their impact on master profit and loss account and balance sheet.
(c) covers learning outcome C(iv)- Evaluate projected performance by calculating key metrics
including profitability, liquidity and asset turnover ratios.
May 2008 21 P1
Managerial Level Paper
P1 – Management Accounting –
Performance Evaluation
Examiner’s Answers
SECTION A
1.3 The traditional limiting factor approach would view contribution per unit as the selling price
minus all variable costs
W X Y
Contribution per unit £ 85 94 50
Bottleneck minutes 7 10 7
Contribution per minute 12·1 9·4 7·1
Rank 1 2 3
1.4 A throughput accounting approach assumes that materials are the only variable costs.
Consequently the contribution is different to that calculated using the traditional method.
W X Y
Contribution per unit £ 139 130 120
Bottleneck minutes 7 10 7
Contribution per minute 19·9 13 17·1
Rank 1 3 2
P1 22 May 2008
1.5 Contribution to sales ratio = 160/400 = 40%
Extra profit required = $40,000. Fixed costs are constant and therefore extra contribution
will generate extra profit.
1.7
% $
High 94 429,000
Low 82 410,000
Difference 12 19,200
87% is 5% more than 82% and therefore the total cost for the flexed budget for a bed
occupancy of 87% is $410,000 + (1,600 * 5) = $418,000
1.8 The under or over absorbed overhead is the difference between the actual overhead
spent and the overheads absorbed. Overheads are absorbed based on the standard
content of the actual output. Here we are told that the absorption rate is based on labour
hours.
The output was 60,000 units. This is 60,000 * 18 = 1,080,000 standard hours.
The actual over heads were $475,000 and therefore overheads were over absorbed by
$65,000.
May 2008 23 P1
1.11
(i) Mix variance = (actual inputs in the actual mix at standard prices) v (actual inputs in
standardised mix at standard prices)
(ii) Yield variance = (actual inputs in standardised mix at standard prices) v (standard input in
standardised mix at standard prices for the actual output).
The actual output of XYZ was 960 kg. The input required to achieve an output of 960 kg
is 1,200 kg (there is a 20% loss, therefore the input = 960/0⋅8).
1.12
1.15 The transfer price should be based on opportunity cost. If there is an external market for
the frames then the market price should be used. If there is not an external market, the
transfer price should be the marginal cost incurred.
P1 24 May 2008
1.16
1.17
Units Units
Opening W-i-P 5,000 Closing W-i-P 6,000
Input 14,000 Output 11,000
19,000 Normal loss 1,400
Abnormal loss 600
Total 19,000
The income from the sale of the normal loss (1,400 x $5) is used to reduce the cost of materials.
May 2008 25 P1
SECTION B
Three key features that can be found in any organisation that is focussed on Total Quality
Management include:
• Top priority is given to satisfying customers. The organisation will be structured in a way
to allow managers to facilitate this.
• People are considered to be the route to success. Management is visible and
accessible, and the decision making process is participative. There is only a short span
of control.
• Team working is encouraged to improve co-ordination through the organisation and the
development of skills.
• Change is embraced and the organisation is structured to allow change to happen.
• The organisation pursues continuous improvement with the aim of eliminating all
defects. Performance is measured against new benchmarks rather than against a
historic standard.
• The emphasis is on the prevention of problems rather than detection by inspection.
Three possible behavioural consequences that may result from the introduction of participative
budgeting include:
Against this:
• rolling budgets are particularly useful when the environment is uncertain. This is because
the remainder of the current budget is reviewed when a new period is added;
• there is a focus on consistently planning twelve months ahead and consequently a
constant focus on any changes to the business outlook. This necessitates a continuous
review of the organisation’s strategy and tactical operations.
• control is likely to be more effective because budgets are less likely to be out-of-date;
P1 26 May 2008
The disadvantages of rolling budgets include:
• the continuous cycle of budgeting can be time-consuming and costly:
• managers may doubt the value of preparing frequent budgets at regular intervals and
might not take the planning process seriously.
(i) A performance measure for “Technology Leadership” could be the number of patents
registered each year. This would show how inventive the team had been. In a
technology-driven market it is essential for the Division to be constantly developing new
ideas and products. Alternative measures could be: time to develop new products; time
to introduce updates to products; new technologies introduced and so on.
(ii) A successful outcome for “Support” would be that customers are satisfied with the support
that they are given. One way of measuring this would be to log the number of support
requests received and the percentage of these requests that are closed to the satisfaction
of the customer. This should be easy to administer given a web-based approach to
product/customer support.
Three reasons why internal benchmarking might provide information that is more useful than
external benchmarking, to the manager of the Photographic Division, include:
• Competitive data is not readily available for external benchmarking whereas it should be
easier to gather internal data;
• Comparisons are more relevant with internal benchmarking since they relate specifically
to the business;
• Allows the setting of acceptable targets that are already being achieved by a part of the
organisation;
• Enables continuous improvement through the sharing of best practices between
managers;
• External data does not explain how performance could be improved. More details can be
obtained about the reasons for the differences between internal business units and this
enables improvements to be made;
• An external benchmarking system can be resource intensive in terms of time and money;
• Available data for external benchmarking may be inaccurate and out of date.
May 2008 27 P1
Answer to Question Two (f)
Three reasons why Return on Investment (ROI) might not be a good performance measure
include:
• Short term v long-term conflict: ROI can encourage managers not to invest in new
projects;
• Problems of comparison: differing business profiles and risk will merit a different return;
• Reliance on a single measure: no one measure can be suitable. It is preferable to use a
portfolio of measures to reflect the organisation’s strategy;
• ROI does not reflect the “size” of the organisation/project: it is a relative measure. Some
investors and managers will prefer an absolute measure (they want to know the monetary
size);
• ROI will be determined by asset values. There are many concerns in this area: current
value of assets as opposed to historical, comparison between divisions, easier to earn a
high return from aged (and therefore depreciated) assets and so on.
• Transfer pricing systems will affect the individual profits of any divisions and therefore will
also affect their ROI.
P1 28 May 2008
SECTION C
(a)
Report
Overview
The company produced and sold 1,200 units. This was 200 units more than budgeted for and
should have resulted in additional profits of £18,000, and therefore total profits of £38,000.
However, a reduction in the selling price of £10 per unit and over-spending on materials and
fixed overheads resulted in an actual profit of £11,140.
The variance report reconciles the budget profit and the actual profit for the month by listing the
financial deviation from standard (variances). The variances are shown individually so that
specific points of concern can be seen and areas of responsibility highlighted. This report will
provide a commentary on the variances and will follow the sequence of the variance statement.
Budgeted profit
This is the profit that would have been earned if the forecast level of sales and output had been
achieved and is based on all costs and revenues being as planned.
Volume variance
Given that output and sales were higher than forecast by 200 units it is to be expected that the
profits would be different from those stated in the budget. The company uses a marginal costing
system and consequently each unit sold is deemed to earn a contribution of £90 towards fixed
costs and profit. Fixed costs are not accounted for on a unit basis; they are charged to the profit
statement as a total figure.
Given that sales were 200 units higher than budget, it would be expected that profit would be
£18,000 higher (200 x £90).
This level of sales and output (1,200 units) then provides the level of performance that other
variances should be measured against.
May 2008 29 P1
Materials price variance
The materials price variance relates to the actual quantity of materials that were purchased. We
purchased 6,300 kg for £132,300. The standard price of the materials was £20 per kg and
therefore we should have paid £126,000.
The variance is £4,000 adverse and therefore we must have spent £74,000 on fixed overheads
during Month 6.
If you require any further details please do not hesitate to contact me.
(b)
Direct Materials Variances
Planning variance = revised standard cost of output v original standard cost of output
= (5 kg @ £23 x 1,200) v £120,000
= £138,000 v £120,000
= £18,000 adverse
Operational variances (now use the revised standard price of £23 per kg)
P1 30 May 2008
Material price variance = standard cost of actual amount purchased v actual cost
= (£23 x 6,300) v £132,300
= £144,900 v £132,300
= £12,600 favourable
Material usage variance
= (standard usage for actual output v actual usage)@ £23 per kg
= ((1,200 x 5) v 6,300) @ £23
= £6,900 adverse
(c)
The revision of the standard provides a more up to date, and therefore realistic, benchmark
against which to measure performance.
For example in the scenario above, it originally looked as if the Purchasing Department had paid
far too much (£6,300) for the materials. However, it was then realised that the market price had
increased. This is an uncontrollable factor and it would be unfair to judge the performance of
the Purchasing Department against a standard that cannot be achieved. The uncontrollable
element of the total variance is separated out into a “planning variance” and then appropriate
control action can be taken based on a relevant standard. The variance that the Purchasing
Department should be held responsible for is calculated using the revised standard. This now
gives a price variance of £12,600 favourable. This gives an entirely different view of the work of
the Purchasing Department.
The operational usage variance will now be valued at £23 per kg and thus reflects the current
purchase price of the extra materials used.
A further advantage is that highlighting the planning variances helps to identify any errors in
forecasts so that the planning process can be continually refined.
The disadvantages of calculating these variances are the often subjective way of determining
the revised standard and the additional time and cost incurred.
May 2008 31 P1
Answer to Question Four
Cash budget
Month 1 Month 2 Month 3 Total
$ $ $ $
Material 106,800 104,640 211,440
Labour 14,500 16,500 21,200 52,200
Variable overheads 18,850 31,600 39,110 89,560
Fixed overheads 42,000 52,500 52,500 147,000
Total payments 75,350 207,400 217,450 500,200
Receipts 20,160 65,240 148,820 234,220
Net cash flow -55,190 -142,160 -68,630 -265,980
Opening balance 250,000 194,810 52,650 250,000
Closing balance 194,810 52,650 -15,980 -15,980
(b)
Total cash outflow for materials during the period = $211,440. This is based on a unit cost of
$60 of which $40 is for the component. Therefore, the budgeted cash paid for the component is
$140,960.
(i) If the price of the component falls to $32 the total paid for components during the period
will be $112,768 (calculated as $140,960 x 32/40).
This will result in a cash saving of $28,192 and, therefore, the total net cash flow over the
three-month period will be an outflow of $237,788.
(ii) If the price of the component rises to $50, the total cash paid for components will rise to
$176,200.
This will mean that the cash outflow will rise by $35,240 and, therefore, the total net cash
flow over the three-month period will be an outflow of $301,220.
P1 32 May 2008
(c)
Workings:
Report
To: Owners of Q
Terms of reference
This report will provide a brief review of the profitability and the prospects for the business as
revealed by your business plan.
Profitability
Based on the original estimates of a sales volume of 27,700 Trackits and $40 per component,
the forecast profit for the year is $545,000. Sales could fall by 39⋅4% before the business
started to makes losses – this is a good margin of safety. However, you have expressed
uncertainty about the price of the component.
Best: component price falls to $32. This gives a total profit of $766,600 and a margin of safety
of 47⋅7%.
Worst: component price rises to $50. This gives a total profit of $268,000 and a margin of
safety of 24⋅2%.
However, even though the business is profitable, it does not generate net cash inflows in the
short term.
Cash flow
Based on the original estimates and an opening cash balance of $250,000, the company will
need an overdraft of almost $16,000 to cover the cash deficit that will arise in Month 3.
If the component cost falls to $32 per unit, there will be sufficient funds available to cover the net
outflow for the three month period of $237,788.
However, if the component cost rises to $50 per unit, the net cash outflow rises to $301,220.
The company will need an overdraft of $51,220 to cover this, or there will be need to inject
further cash into the business.
May 2008 33 P1
Component cost
It is appreciated that any business plan is an estimate, but you have expressed uncertainty
about the cost of the outsourced component. The variability of the cost of this component has
an impact on the profitability of the business but, even at the highest forecast price, the business
is profitable.
A more critical impact of the price variability is on cash flow: you need to be aware of the
possible need to invest more cash into the business or arrange for an overdraft. However, this
will only be short-term; the business is profitable and will eventually generate net cash inflows.
The component is an essential part of the Trackit. Consequently, you should explore the
possibilities of forging a close relationship with the supplier and entering into a mutually
advantageous arrangement with them. You should try to secure a guaranteed supply at a
guaranteed price.
Note: The answer is based on using the ‘unadjusted’ contribution. If allowances are made for
the cash discount and bad debts the contribution per Trackit will be reduced by $0.84
(calculated as $140 x 15% x 4%) and $7 (calculated as $140 x 5%) respectively. The ‘what if’
analysis figures would then be:
Candidates would be rewarded for writing their report based on either of these two approaches.
P1 34 May 2008