STRATEGIC MANAGEMENT ACCOUNTING. PROFESSIONAL 1 EXAMINATION
- APRIL 2007. The Institute of Certified Public Accountants in Ireland, 9 Ely ...
STRATEGIC MANAGEMENT ACCOUNTING PROFESSIONAL 1 EXAMINATION - APRIL 2007
NOTES
Candidates should answer all three questions in Section A and two questions from Section B. All questions carry equal marks.
SMA TABLES ARE PROVIDED
TIME ALLOWED:
3.5 hours, plus 10 minutes to read the paper.
INSTRUCTIONS:
During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page.
You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted.
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The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2.
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
STRATEGIC MANAGEMENT ACCOUNTING PROFESSIONAL 1 EXAMINATION - APRIL 2007
Time Allowed: 3.5 hours, plus 10 minutes to read the paper.
Answer all three questions from Section A and any two questions from Section B.
Section A - Questions 1, 2 and 3 are all compulsory
1.
Montreal Ltd. manufactures firelighters under contract for a major supermarket chain. Under the contract Montreal receives a price of €1.70 per kilogram. The company normally produces 30,000 kilograms of firelighters for the supermarket chain each month, but it occasionally varies this quantity slightly if asked to do so. Montreal operates a standard absorption costing system. Fixed production overheads are budgeted at €9,600 per month. The standards for the direct materials required to produce a kilogram of firelighters are as follows: Direct Material Type “A”
0.6 kg.@ €0.25 per kilogram
Direct Material Type “B”
0.45 kg.@ €0.40 per kilogram
Direct Material Type “C”
0.15 kg. @ €0.80 per kilogram
Total direct materials of input per kilogram of output 1.2 kg. The only other cost is a cardboard packaging box, which Montreal purchases from a subcontractor at an agreed price of €0.05 per kilogram of firelighters sold. During January 2007 actual activity was as follows: ●
Montreal Ltd. produced 31,000 kilograms of firelighters and supplied them to the supermarket chain at the agreed price of €1.70 per kilogram.
●
Fixed overheads amounted to €11,520.
●
Direct materials purchased and used in production were: Direct Material Type “A”: Direct Material Type “B”: Direct Material Type “C”:
●
16,700 kg.@ €0.25 per kilogram 11,900 kg.@ €0.42 per kilogram 3,800 kg.@ €0.80 per kilogram
Cardboard packaging boxes were purchased at standard cost.
Page 1
REQUIRED: (a)
Calculate the standard profit per kilogram of firelighters, and the company’s total budget and actual profits for January 2007. (3 marks)
(b)
Calculate the following variances and use them to reconcile the company’s total budget and actual profits for January: ● ● ●
Direct materials price, mix and yield variances. Fixed overhead volume and spending variances. Sales volume variance. (12 marks)
(c)
The management accountant of Montreal Ltd. has stated: “In interpreting these variances, we need to bear in mind that we carried out major preventive maintenance work on our production equipment at the beginning of January, and this greatly improved its efficiency in converting direct materials into finished product”. (i)
Discuss whether the variances which you have calculated in answer to part (b) support this view. (3 marks)
(ii)
Briefly explain any changes which may be required to the company's standard costing system in consequence. (2 marks) [Total: 20 marks]
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2.
Newport Ltd. manufactures oven-ready meals which it sells in bulk to catering firms. There is a considerable amount of seasonal variation in the level of production. The following production cost data for last year is available: Production period January-February March-April May-June July-August September-October November-December
Batches of output 3,589 8,211 2,430 9,320 12,223 7,441
Total production cost €1,257,300 €2,694,100 €1,173,300 €3,097,500 €4,832,200 €2,632,000
A regression analysis was carried out on this data in an attempt to determine whether the level of production cost in any period is dependent on the number of batches of output. The regression results were as follows: Coefficient of determination (“R-squared”): Intercept: Slope: Standard error of the coefficient: Standard error of the estimate:
0.955 €16,315 €360.73 €39.29 €320,627
Management now wishes to forecast total production cost for the first production period of next year. Production will be 4,120 batches in that period.
REQUIRED: Note: The t-statistic for 4 degrees of freedom and 5% significance is 2.776. (a)
Make the forecast required by management, using the ‘high-low’ and ‘regression’ methods. (6 marks)
(b)
Calculate a 95% confidence interval for each of the following: variable costs per batch, and total costs for the first production period of next year. Then, explain clearly the significance of the confidence intervals and the regression results. (10 marks)
(c)
In your opinion, what are the two most significant advantages of using the regression method rather than the high-low method to forecast costs? Explain your answer. (4 marks) [Total: 20 marks]
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3.
Omaha Ltd. manufactures plastic components which it sells to three customers. These customers are all manufacturing firms with which Omaha has entered into long-term supply agreements. Omaha prides itself on its ability to quickly customize products to meet specific customer requirements at short notice. In some cases the entire process of customizing and manufacturing a product can be performed on a just-in-time (JIT) basis. Prices are set in accordance with a cost-based formula. Costs of direct labour and raw materials are traced to each customer, and marked up at rates of 60% and 70% respectively. Production overhead is marked up by 50% and then allocated to customers in proportion to direct labour cost. Because these markup percentages are slightly lower than those applied by its competitors, Omaha Ltd. has long believed that this pricing formula should enable it to retain the loyalty of its three customers. The Marketing Director was therefore surprised recently when he learned that one customer considered prices to be too high and was seriously considering taking his business elsewhere. Production overhead costs last month were made up of the following three elements: Activity Determining customer requirements Making design changes Machine set-up
Driver Number of liaison meetings Number of design changes Number of production batches
Cost €80,000 €60,000 €40,000 Total = €180,000
The following is a summary of the work carried out last month on behalf of the three customers:
Direct labour cost Raw material cost Number of liaison meetings Number of design changes Number of production batches
Customer A €27,000 €32,000 12 13 7
Customer B €55,000 €50,000 9 15 10
Customer C €38,000 €28,000 11 22 3
Total €120,000 €110,000 32 50 20
REQUIRED: (a)
Calculate the amount of profit which Omaha Ltd. earned from each of its three customers last month. (12 marks)
(b)
Explain which customer is most likely to be unhappy with Omaha’s pricing arrangements, and recommend what steps Omaha Ltd. should take in order to retain this customer. (4 marks)
(c)
Briefly explain how the implementation of a JIT approach to manufacturing can be a major source of competitive advantage. (4 marks) [Total: 20 marks]
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Section B - Answer any two of Question 4,5 and 6. 4.
Johannesburg Ltd. consists of a large number of autonomous business units. Each business unit provides some type of personal transport service (e.g., taxi, hackney or limousine services) but the units are operated and branded separately because they cater for different market segments. The “Western Cabs” business unit provides a hackney service in the west of Ireland, connecting airports with towns throughout the region. The main customers are students, retired people, and young immigrant workers. These customers appreciate the good value and reliability which are the acknowledged market strengths of “Western Cabs” compared to many other transport operators in the area. “Western Cabs” recently launched a new campaign advertising its services through the medium of several immigrant languages in order to consolidate this part of its customer base. The “Atlantic Limousines” business unit is based in the same geographical area, serving the same airports and towns. Its main customers are large companies who require rapid, luxurious transport for their senior managers and corporate visitors. The operating costs of the business unit are high because of the high standards of service which its customers expect, but “Atlantic Limousines” finds it worthwhile to incur these costs because of the high prices which corporate customers are willing to pay. Until recently the directors of Johannesburg Ltd. have assessed the performance of each business unit solely in terms of its monthly profit or loss. However the Financial Director has suggested that, given the very different strategies of the various business units, it may be appropriate to design a balanced scorecard for each business unit to facilitate a more comprehensive analysis of its performance.
REQUIRED: (a)
Outline the four main perspectives (sections) of a balanced scorecard, and discuss the view that the ‘financial perspective’ should be treated as being of much greater importance than the other three perspectives. (10 marks)
(b)
For each of the two business units described above, give three examples of measures which you feel should be included in the ‘customer’ perspective of that unit’s balanced scorecard. Justify the selection of each measure, and explain the assumed linkage between each measure and the business unit’s long-term financial performance. (10 marks) [Total: 20 marks]
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5.
Quango Airlines Ltd. operates an extensive network of flights throughout Europe. Most flights operate to or from the company’s hub airport in Strasbourg. The company’s top management team receives monthly reports on the profitability of each flight route, and any loss-making routes are considered for closure. The following report shows the average loss on each one-way flight between Dublin and Strasbourg (in either direction): Ticket sales (60% occupancy rate of 150-seater aircraft; ticket price = €100) OPERATING COSTS: Airport security charge Advertising costs Aviation fuel Depreciation Flight crew salaries Ground staff costs Insurance Overnight expense allowances for flight crew Total operating costs
€9,000 €450 €600 €3,600 €2,200 €1,100 €800 €2,400 €500
Loss
€11,650 €2,650
The following information is also available: (1) Airports impose a security charge in proportion to the number of seats occupied on each departing flight. (2) The figure for advertising costs relates to the cost of an ongoing press advertising campaign to maintain public awareness of Quango’s Dublin-Strasbourg route. (3) Aircraft depreciation occurs almost exclusively through obsolescence, not usage. (4) Flight crew are employed on permanent contracts. Quango has invested considerable amounts in training these crews. (5) Quango does not directly employ any ground staff. Instead, ground staff services are obtained through an agency as required. (6) The figure for insurance includes €600 which is the cost of a public liability insurance policy which specifically relates to this flight. The remaining €1,800 is an allocation of the Quango’s company-wide insurance costs. REQUIRED: (a) On the basis of the information provided, should Quango discontinue this flight? As well as calculations, your answer should include clear explanations as to why you consider particular operating costs to be relevant or irrelevant to the decision. (10 marks) (b)
Explain two other important pieces of information which, if provided, would enable you to provide a more accurate calculation of the financial implications of discontinuing this flight. (5 marks)
(c)
At present an average of 65% of the seats on Quango’s flights across its entire European network are occupied. A firm of consultants has told the Managing Director that this figure could be increased to 70% by cutting out certain flights with lower-than-average seat occupancy rates, but they warn that this would be likely to result in a reduction in the company’s total profits. Explain how this could happen. (5 marks) [Total: 20 marks] Page 6
6.
Regina Ltd. manufactures a wide range of specialized electrical products. The company is structured along divisional lines. “Division A” manufactures a specialized motor. Monthly production is 30,000 units and the marginal cost of production is €140 per unit. Half of all output is sold to external customers at a price of €200 per unit. The remaining output is sold within Regina Ltd. to “Division B”. In accordance with the company’s rules, these internal transfers are made at the same price per unit as sales to external customers (i.e €200). “Division B” uses the motor as a component in the manufacture of an industrial heater, which is sold to external customers at a price of €350 per unit. (One motor is required for each heater). “Division B” incurs a marginal cost of €100 per unit, in addition to the transfer price paid for the motor. A potential new customer (Quebec Ltd.) has offered to purchase 7,500 units per month of the industrial heater from “Division B” at a special contract price of €275 each. “Division B” has sufficient spare production capacity to produce these additional heaters.
REQUIRED: (a)
Assume that “Division A” has sufficient spare production capacity to enable it to produce the additional motors required by “Division B” to enable it to fulfill the Quebec Ltd. contract. In these circumstances, explain:
(b)
●
whether it would be in the best interests of Regina Ltd. to accept the Quebec Ltd. contract, and
●
whether the existing transfer pricing arrangements motivate the division managers to take the decisions which are in the best interests of Regina Ltd. as a whole. (7 marks)
Now assume that “Division A” has no spare production capacity. If “Division A” were to produce the additional motors required by “Division B” to enable it to fulfill the Quebec Ltd. contract, then “Division A” would reduce its sales of motors to external customers. Explain how your answer to part (a) would differ in these circumstances. (7 marks)
(c)
Critically evaluate the transfer pricing arrangements in Regina Ltd., using your answers to parts (a) and (b) to illustrate your answer. (6 marks)
[Total: 20 marks]
END OF PAPER
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SUGGESTED SOLUTIONS THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
STRATEGIC MANAGEMENT ACCOUNTING PROFESSIONAL 1 EXAMINATION - MAY 2007
Solution 1 Montreal Ltd. Part (a): ●
Standard profit per kilogram: Selling price
€1.70
Fixed overhead
€9,600 / 30,000 = €0.32
Direct Material “A”
0.6 kg. @ €0.25 = €0.15
Direct Material “B”
0.45 kg. @ €0.40 = €0.18
Direct Material “C”
0.15 kg. @ €0.80 = €0.12
Packaging
€0.05 €0.82
Standard profit
€0.88
Part (b): ●
Total budget profit = (€0.88 * 30,000) = €26,400.
●
Actual profit: Sales
31,000 @ €1.70 = €52,700
Fixed overhead
€11,520
Direct Material “A”
16,700 kg. @ €0.25 = €4,175
Direct Material “B”
11,900 kg. @ €0.42 = €4,998
Direct Material “C”
3,800 kg. @ €0.80 = €3,040
Packaging
31,000 @ €0.05 = €1,550 €25,283
Actual profit ●
€27,417
Direct materials price variance: Material
Actual Price
Standard Price
Actual Quantity
Variance
A
€0.25
€0.25
16,700
NIL
B
€0.42
€0.40
11,900
€238 U
C
€0.80
€0.80
3,800
NIL
32,400
€238 U
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●
Direct materials mix variance: Material
●
Actual Qty @
Actual Qty @
Standard
Variance
Actual Mix
Standard Mix
Price
A
16,700
16,200
€0.25
€125 U
B
11,900
12,150
€0.40
€100 F
C
3,800
4,050
€0.80
€200 F
32,400
32,400
€175 F
Direct materials yield variance: Standard DM cost
Actual Yield
Standard Yield
Variance
31,000
32,400 / 1.2
€1,800 F
per kg. of output €0.15 + €0.18 + €0.12 = €0.45 ●
= 27,000
Fixed overhead volume variance: Actual quantity
Budget quantity Standard FO absorption rate
31,000 ●
●
●
30,000
€0.32
Variance €320 F
Fixed overhead spending variance: Actual FO
Budgeted FO
Variance
€11,520
€9,600
€1,920 U
Sales volume variance: Actual quantity
Budget quantity
Standard profit per unit
Variance
31,000
30,000
€0.88
€880 F
Reconciliation: Budgeted profit
€26,400
Sales volume variance
€880 F
Flexed budget profit
€27,280
Materials price variance
€238 U
Materials yield variance
€1,800 F
Materials mix variance
€175 F
Fixed overhead volume variance
€320 F
Fixed overhead spending variance
€1,920 U
Actual profit
€27,417
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Part (c): ●
The variances seem to support this view. In particular, the MYV is significantly favourable. The standard indicates that 1.2 kilograms of input are required for each kilogram of output. The actual results show an input/output ratio of less than 1.05:1.
●
This improvement in yield seems to be due to the efficiency improvements brought about by the preventive maintenance. Improvements in yield are sometimes brought about by unfavourable MMV (using a more expensive mix of materials) but this is not the case here.
●
The significant unfavourable FOSV may well be due to the preventive maintenance expenditure. Although it far outweighs the favourable MYV in this period, the preventive maintenance will probably not need to be done every month whereas the efficiency improvement is of ongoing benefit and should result in improved yields every month.
●
The company should consider revising its standard costs to reflect the improved efficiency level of the machine. Otherwise, for example, large favourable MMV may be reported each month but these will be planning variances (i.e., due to inappropriate cost standards) rather than operational variances (i.e., due to genuinely good performance relative to a realistic expectation).
Tutorial notes: ●
Purpose of question: To test candidates’ ability to calculate certain variances, including advanced materials variances, and to assess whether a particular interpretation of a set of variances is valid. (Syllabus topic 3).
●
Links: None.
●
Options: There is potential for variation in how candidates use the variances to support the accountant’s view in part (c). Also, the point could be made that while the variances are consistent with the accountant’s view, they could be (at least partly) due to other causes.
●
Essential components: Candidates need to be able to perform the calculations required for parts (a) and (b). In part (c) candidates need to be able to make a convincing case using the evidence available from the variances (especially the MYV), and to mention the need to revise cost standards in future.
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Solution 2: Newport Ltd. Part (a): ●
High-low method: Variable cost = (€4,832,200 - €1,173,300) / (12,223 – 2,430) = €373.624/batch. Fixed cost = €4,832,200 – (12,223 * €373.624) = €265,394 per period. Cost estimate = €265,394 + (4,120 * €373.624) = €1,804,725.
●
Regression method: Cost estimate = €16,315 + (4,120 * €360.73) = €1,502,523.
Part (b): ●
95.5% of the variation in total production cost is associated with changes in the number of batches of output.
●
95% confidence interval for total costs: €1,502,523 +/- (2.776 * €320,627) = €612,462 to €2,392,584.
●
95% confidence interval for variable costs: €360.73 +/- (2.776 * €39.29) = €251.66 to €469.80.
●
The intercept and slope of the regression line represent the “best estimates” of fixed cost per period and variable costs per batch (respectively.) Specifically, they are the parameters of the linear cost function which best approximate the set of data observations provided in the table in the question. In formal mathematical terms, the regression line is the line which minimises the sum of the squared deviations of the line from the observed data points.
●
The R-squared of 0.955 indicates that 95.5% of the variation in total costs is associated with changes in the number of batches. Thus, there is quite a strong link between the number of batches of output and total cost, and this would give us reasonable confidence that the number of batches of output is a good independent variable to use in predicting future total costs.
●
Confidence intervals: It is unlikely that the true variable cost per batch or next period’s total costs will precisely match the regression estimates. The significance of a 95% confidence interval for total costs is that we can be 95% confident that the true level of total costs will fall within the upper and lower limits of the interval. Similarly, a 95% confidence interval for variable cost per batch means that we can be 95% confident that the true level of variable cost per batch will fall within the upper and lower limits of that confidence. One point specific to this case is the exceptionally wide confidence intervals. This is due to both the very small sample size and the considerable degree of variation in the data set.
Part (c): Two significant advantages of the regression method over ‘high-low’: ●
Regression provides the cost estimation function which is the best possible fit to the entire data set, whereas high-low takes account of only two data points. This is particularly important in this case where the high and low points seem to be outliers, i.e., costs are unexpectedly high at these output levels compared to cost behaviour levels of the data set as a whole.
●
Regression provides a great deal of additional data and not just a single point estimate of cost. This is important where, as in this case, the confidence intervals are very wide and management need to be aware that costs can be confidently forecast only within very wide ranges.
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Tutorial notes: ●
Purpose of question: To test candidates’ ability to apply and interpret cost estimation techniques, including simple linear regression. (Syllabus topic 2).
●
Links: None.
●
Options: Candidates can make any two valid points in their answer to (c). An example of a point which would not that the regression model gives a lower estimate of cost.
●
Essential components: Candidates need to be able to perform the calculations required for parts (a) and (b), and to provide the interpretations required in part (b). To answer (c) candidates must be able to identify and explain two significant reasons as to why the regression method is superior.
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Solution 3: Omaha Ltd. Part (a): ●
●
Prices: Customer A
Customer B
Customer C
Direct labour + 60%
€43,200
€88,000
€60,800
Raw materials + 70%
€54,400
€85,000
€47,600
Allocation of overhead marked up @ 50%
€60,750
€123,750
€85,500
Prices
€158,350
€296,750
€193,900
Customer A
Customer B
Customer C
€158,350
€296,750
€193,900
Meetings (€2,500 each)
€30,000
€22,500
€27,500
Design changes (€1,200 each)
€15,600
€18,000
€26,400
Set-ups (€2,000 batch)
€14,000
€20,000
€6,000
Direct labour
€27,000
€55,000
€38,000
Raw materials
€32,000
€50,000
€28,000
Profit
€39,750
€131,250
€68,000
Cost driver rates: Liaison meetings: €80,000 / 32 = €2,500 per meeting. Design changes: €60,000 / 50 = €1,200 per change. Set-ups: €40,000 / 20 = €2,000 per batch.
●
Profit from each customer:
Prices Traceable OH:
Part (b): ●
Customer B almost certainly was the complainant. This is not because he provided more revenue and profit to Omaha than any other customer, but rather because Omaha effectively charged him a higher percentage profit margin than other customers, as the following figures show:
Net profit as % of sales
Customer A
Customer B
Customer C
25.1%
44.2%
35.1%
●
The root cause of this ‘overcharging’ lies in the way overheads are allocated in the pricing formula. Overheads are charged purely in proportion to direct labour. However, Customer B is a ‘light user’ of the activities which drive overhead costs, relative to its use of direct labour. Customer B is cross-subsidising Customer A, who is a heavy user of these services but a light user of direct labour.
●
The most important step to retain this customer is to change the pricing formula so that prices paid by each customer reflect the underlying activities. Overheads should not be allocated to customers but should be traced using cost drivers. If activities such as design change are truly valued by customers, it is likely that they will be willing to pay prices which reflect the costs which such changes generate. Conversely, customers such as Customer B (for whom these activities are less important) are understandably unhappy about paying prices which make no allowance for their ‘light user’ status.
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Part (c): ●
Since holding stock is a costly and non-value-added activity, its elimination is a source of competitive advantage.
●
JIT manufacturing is essential for flexibility to customer requirements, especially in a case such as Omaha Ltd. require customised (not standard) products.
Tutorial notes: ●
Purpose of question: To test candidates’ to apply activity-based costing in a specific business situation. (Syllabus topic 1).
●
Links: The company manufactures on a JIT basis, and part (c) asks about a specific aspect of JIT (Syllabus topic 5).
●
Options: The issue in part (b) is fairly clear-cut, but can be explained in a variety of ways. In part (c) there are a number of valid points which could be made; the two above are examples only.
●
Essential components: The key to answering part (a) accurately is to recognise that customer profit can be measured only by comparing prices as currently calculated with activity-based costs. In part (b) candidates must be able to identify and explain the root cause of the problem and how to fix it (e.g., reductions in markup are not the answer). In part (c) candidates must be able to explain how JIT provides a major source of competitive advantage.
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Solution 4: Johannesburg Ltd. Part (a): ●
For an outline of the four perspectives of a balanced scorecard, see Drury 6th edition (pp. 999-1003) or Horngren 3rd edition.
●
Given that Johannesburg Ltd.’s ultimate concern is with the profitability of its business units, it is not surprising that its focus has tended to be on financial performance. The balanced scorecard is not about putting less emphasis on financial matters. Rather, it is about recognising that current financial measures (e.g., cash flow, gross profit) alone do not indicate the business unit’s degree of progress towards long-term financial success. For example, if attention is paid only to the ‘financial perspective’, then the firm may be tempted to reduce spending on vehicle maintenance and this may well increase gross profit margins in the short-term. However, this may have the effect of reducing ‘repeat business’ and ‘first pass yield’, which may have been identified in the ‘customer theme’ and ‘internal process theme’ respectively as being essential to the longterm profitability of the business. Thus, it is important to understand that there are enormous interdependencies between the sections of a balanced scorecard. If management try to ‘prioritise’ one theme over another, then they are neglecting to manage the business in a way which takes account of these interdependencies.
Part (b): “Western Cabs”: ●
Repeat business. If the business unit really is offering better value and reliability than its competitors, then customer who use the service once will do so again. This is important for financial performance, since it indicates that the business unit is building up a firm market share.
●
Success rate for advertising campaigns in immigrant languages. For example, if expenditure on Czechlanguage advertisements is not matched by an increase in Czech customers, then it is a waste of money. Margins are probably quite low in this business, so ineffective advertising is an unaffordable luxury.
●
Customer satisfaction ratings. Measures of customer satisfaction with “Western Cabs”, benchmarked against competitors, should be obtained regularly, perhaps by commissioning market research from an external agency. Satisfied customers translate into repeat business, and this is important for long-term market share and profitability. “Atlantic Limousines”:
●
Average ‘age’ of corporate accounts, i.e., for how long has the average corporate client been doing business with “Atlantic Limousines”. Long-lived accounts indicate that the corporate client is satisfied with the quality of service provided. This is very important for long-term profitability, since each corporate customer has a large volume of repeat business to offer.
●
Passenger satisfaction. Does the experience live up to the individual passenger’s expectations? The passenger is of course an ‘influencer’ rather than a ‘decision-maker’, since it is the corporate client which makes the ultimate decision as to which service provider to use. However, if the passenger is disappointed then this influence will be negative, leading to the closure of the corporate account.
●
Independent quality ratings. These ratings exist at the ‘top end’ of most service industries (e.g., Michelin stars for restaurants, star ratings for hotels, etc.). In many cases potential customers attach more importance to this rating than to their own subjective assessments. If, for example, “Atlantic Limousines” is consistently ranked as the best-quality provider in its sector then this will generate considerable customer loyalty from corporate clients who want to be seen to be providing important visitors with the best available service.
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Tutorial notes: ●
Purpose of question: To test candidates on their understanding of the elements of a balanced scorecard (including the importance of the linkages between the sections of a scorecard) and on their ability to identify balanced scorecard measures which are appropriate in the context of particular business strategies. (Syllabus topic 4).
●
Links: None.
●
Options: In part (b) there is very considerable scope for variation, as candidates are asked to make (and justify) their own choice of performance measures for the balanced scorecards of the two business units.
●
Essential components: In part (a) candidates need to understand the four elements of a balanced scorecard and the fact that managers need to acknowledge the links between the four elements. In part (b) the measures suggested need to be justified in the context of the particular circumstances of each business unit.
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Solution 5: Quango Airlines Ltd. Part (a): Incremental profit from closing the route: Loss of sales revenue
- €9,000
Airport security charge saved
+ €450
Advertising costs saved
+ €600
Aviation fuel costs saved
+ €3,600
Ground staff costs saved
+ €800
Insurance costs saved
+ €600
Overnight expenses allowances saved
+ €500
Loss of profit from discontinuing the flight
- €2,450
Therefore, it seems that Quango Airlines should not discontinue the flight.
Explanations of why specific costs are relevant or irrelevant: ●
Airport security charge: Completely variable in proportion to passenger numbers. Therefore, this cost will disappear if the flight is discontinued.
●
Advertising costs: If the Dublin-Strasbourg route is closed it will no longer be advertised. Therefore this cost will disappear if the route is discontinued.
●
Aviation fuel: Completely variable in proportion to the number of flights. Therefore, this cost will disappear if the flight is discontinued.
●
Depreciation: Because depreciation is caused by obsolescence, there is no saving in this regard by not making the flight. Also, depreciation reflects a past, sunk cost. Therefore this cost is not affected by, and is not relevant to, the decision.
●
Flight crew salaries: It seems unlikely that crews would be made redundant. Since they have permanent contracts, redundancy would be an expensive option for Quango to pursue. The heavy investment in training costs may be another factor in a decision to retain these staff, even though strictly speaking this is irrelevant since it is a sunk cost. In practice Quango may prefer to redeploy the crew rather than make them redundant – see part (b) below.
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Ground staff costs: Since these services are obtained through an agency as necessary, it seems likely that this cost is completely variable in proportion to the number of flights. Therefore, this cost will disappear if the flight is discontinued.
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Insurance costs: There will be a €600 saving from the cancellation of the policy which specific covers this flight. It seems unlikely that the cancellation of a single route will have any significant effect on the ‘company-wide’ insurance costs.
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Overnight expense allowances: Even if the crew are retained, they will not be paid these allowances if they are not making the flights. Hence this cost is completely variable in proportion to passenger numbers, and will disappear if the flight is discontinued.
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Part (b): ●
Alternative routes for the aircraft: Discontinuing this route will free up aircraft for use on another route which might give a higher contribution margin.
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The ‘alternative’ work to be carried out by the flight crew: The calculations in part (a) do not include any benefits the company might derive from the crew being deployed elsewhere in the company. For example, they might reduce the airline’s need to hire (and/or train) additional staff for other routes, in which case there would be a significant saving in this area as a result of closing the Dublin-Strasbourg route.
Part (c): ●
Seat occupancy currently averages 65%. Therefore, elimination of any flight whose seat occupancy is lower than 65% will have the effect of increasing average seat occupancy. One reason why this action may reduce profits is that the flights being considered for elimination may (like the Dublin-Strasbourg flight) be earning contribution margins in excess of the costs which could be avoided if the flight were eliminated. As the calculations in part (a) show, the fact that a flight is currently reporting a loss does not guarantee that the elimination of that flight will increase the company’s profits.
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Some flights with quite low occupancy rates might nevertheless be earning very healthy contribution margins for the company (e.g., a very short-haul flight might not involve any costs of overnight accommodation for flight crew because the crew could work both outward and return flights as part of a normal shift).
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Even if a flight is not profitable in itself, nevertheless it may enable passengers to connect to the airline’s more profitable flights. For example it may be worthwhile to operate even loss-making short-haul flights if they enable passengers to connect to profitable flights at the Strasbourg hub. Therefore the elimination of unprofitable flights may deprive the company of profits on other routes.
Tutorial notes: ●
Purpose of question: To test candidates on their knowledge of, and ability to apply, cost concepts for decision-making. Application of these concepts often requires some judgment in practice, and the main focus of this question is on candidates’ ability to exercise and justify such ‘judgement’. (Syllabus topic 2).
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Links: There is also an element of ‘strategic management accounting’ (as the term is used in Syllabus topic 5), since parts (b) and (c) highlight the fact that a strictly incremental approach to decision-making is often inadequate since a decision in one area of operations often has significant implications elsewhere.
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Options: The points raised above in answer to part (b) in particular are examples only. Candidates are of course free to make valid alternative points. There is also some lesser degree of scope for variation in answers to part (c).
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Essential components: In part (a), candidates need to be able to perform the calculations as required and (more importantly) to provide the explanations asked for. In part (b), any two worthwhile suggestions are acceptable, provided they are properly explained. In part (c), candidates need to make points which clearly explain why eliminating a flight with a low seat occupancy rate will not necessarily increase profits.
Page 18
Solution 6: Part (a): ●
●
●
●
Regina Ltd: Marginal cost
Marginal revenue
Decision
€140 + €100 = €240
€275
Accept (+€35)
Marginal cost
Marginal revenue
Decision
€140
€200
Accept (+€60)
Marginal cost
Marginal revenue
Decision
€200 + €100 = €300
€275
Reject (-€25)
“Division A”:
“Division B”:
Acceptance of the Quebec Ltd. order is in the best interests of Regina Ltd. However, it will not happen because “Division B” is motivated to reject the order.
Part (b): ●
●
Regina Ltd: Marginal cost + opportunity cost
Marginal revenue
Decision
€140 + (€200-€140) + €100 = €300
€275
Reject (-€25)
Marginal revenue
Decision
€200
Indifferent
Marginal cost
Marginal revenue
Decision
€200 + €100 = €300
€275
Reject (-€25)
“Division A”: Marginal cost + opportunity cost €140 + (€200-€140) = €200
●
●
“Division B”:
Rejection of the Quebec Ltd. order is in the best interests of Regina Ltd. The division managers’ decisions will be consistent with this, as the above figures show. Although “Division A” will be indifferent, “Division B” will specifically want to reject the order.
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Part (c): ●
Optimal decision-making by division managers is encouraged by transferring at the marginal cost up to the point of transfer plus the opportunity cost of making the transfer.
●
This ‘optimal price’ is the same as the external market price of the component only in the circumstances in part (b), i.e., where there is a shortage of capacity and therefore any transfers give rise to an opportunity cost from the lost contribution on the sales foregone. In part (a), where there was no spare capacity, the opportunity cost was zero. Therefore it is quite likely – as happened here, as the calculations in part (a) show – that optimal decision-making will not be motivated. Therefore market prices are not always optimal as transfer prices.
●
●
For example, in part (a), a price which is higher than €140 (the marginal cost to “Division A”) but lower than €175 (the net marginal revenue to “Division B”, i.e., €275 - €100) will motivate both managers to make the transfer, which is in the best interests of Regina Ltd.
Tutorial notes: ●
Purpose of question: To test candidates’ ability to apply their knowledge of transfer pricing, including the implications capacity constraints and goal congruence in the context of transfer pricing. (Syllabus topic 4).
●
Links: None.
●
Options: There is some scope for variation in the points made in part (c). However, candidates are expected to identify the key strengths and limitations of the transfer pricing in place.
●
Essential components: Candidates need to be able to perform the calculations required for parts (a) and (b), and to explain the issues specifically raised in those two parts. In part (c) candidates need to be able to identify why the existing transfer pricing system is goal congruent in the situation of part (b) but not of part (a).
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Marking Scheme Question 1: Montreal Ltd. Part (a):
Part (b):
Part (c):
Calculation of standard profit per kilogram Total budget profit Total actual profit Materials variances Fixed overheads variances Sales variance Reconciliation Explanation of whether variances support the accountant’s view Need for revision to cost standards
2 0.5 0.5 5 4 2 1 3 2
TOTAL:
20
Question 2: Newport Ltd. Part (a): Part (b):
Part (c):
High-low estimate Regression estimate Explanation of R-squared Calculation of confidence intervals Explanation of slope and intercept Explanation of confidence intervals Two points @ 2 marks each
5 1 2 4 1 3 4
TOTAL:
20
Question 3: Omaha Ltd. Part (a):
Part (b): Part (c):
Revenue earned from each customer ABC cost driver rates Profit earned from each customer Explanation of problem & how to fix it Explanation (TWO good points expected) TOTAL:
4 4 4 4 4 20
Question 4: Johannesburg Ltd. Part (a): Part (b):
Four perspectives: 4 * 2 marks each Why financial perspective is or is not more important “Western Cabs” business unit “Atlantic Limousines” business unit TOTAL:
8 2 5 5 20
Question 5: Quango Airlines Ltd. Part (a): Part (b): Part (c):
Calculation & explanation for each of the items of cost or revenue: (9 items @ 1 mark each) Overall recommendation Explanation (2 points @ 2.5 marks each) Explanation (TWO good points expected) TOTAL:
9 1 5 5 20
Question 6: Regina Ltd. Part (a): Part (b): Part (c):
Optimal decision – spare capacity Optimal decision – no spare capacity Evaluation of transfer pricing arrangements TOTAL: Page 21
7 7 6 20
