P2 November 2010 Solutions - · PDF fileP2 November 2010 Exam Solutions - 3 - Quality...

P2 November 2010 Exam Solutions

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SECTION A – 50 MARKS Question One (a) Calculate planning and operating variances following the recognition of the learning curve effect. (6 marks)

Flexed budget Actual output Revised flexed budget Output 560 560 560 Direct labour hours 4,480 3,500 1,712 (W1) Direct labour cost $67,200 $57,750 $25,680

Planning variance = flexed budget – revised flexed budget Planning variance = $67,200 - $25,680 = $41,520 (F) Labour efficiency variance = (actual hours – revised flexed hours) x std cost per hr Labour efficiency variance = (3,500 -1,712) x $15 = $26,820 (A) Labour rate variance = actual hours at std rate – actual cost Labour rate variance = (3,500 x $15) - $57,750 = $5,250 (A) Workings (W1) – Direct labour hours Using the learning curve formula: Y = aXb Y = average time for that (X) number of units or the average cost per unit a = time for the first unit or the cost for the first unit X = the number of units you want to calculate an average time or cost for b = the index of learning (log r/log 2) a = 8 hours, b = -0.1520 Work out the average time for the first 560 units: Y = 8 x (560 to the power of –0.5146) = 3.057 hours Total time for 560 units = 3.057 x 560 = 1,712 hours


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(b) Explain the importance of learning curves in the context of Target Costing. (4 marks) Target costing is a strategy which seeks to the selling price of a product at the market price which consumers are willing to pay, being the price that the product should be sold for in the market. Then deducting a desired level of benefit or profit for the organisation in order for the manufacture to be commercially viable, and then the product be manufactured within the value left over thereby becoming the budgeted costs or target costs.

Market price to achieve desired market share XX

TARGET COST (balancing figure) (XX)

Desired profit XX

Learning curves is an important part of a target costing strategy as it will help in reducing costs within the business. It is only applicable to those businesses that have a labour intensive operation where savings can be made through experience and efficiencies. In a machine intensive operation these savings are limited as machines tend produce at the same rate. Businesses can achieve target costs once a certain level of activity has been achieved and so therefore for lessons can be learned and applied to standard costs once it is known the learning capacity of the labour force. Question Two Explain, with reference to CAL, quality conformance costs and quality non-conformance costs and the relationship between them. (4 marks) Quality conformance costs are those costs which are spent to try to achieve a standard or target, such regulations or functional specifications of a product for a customer. There are two main types of quality conformance costs:

• Prevention costs – these are spent to try and ensure the product is made to detailed specifications and regulations. For example training staff, customer surveys, supplier reviews and investment in machines.

• Appraisal costs – these are spent to understand how well a process has

performed and corrective action is taken if needed subsequently. For example measuring equipment, inspections and tests, product quality audits.


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Quality non-conformance costs are quality failure costs that are needed to correct products, as they did not meet expectations or target. There are two main types of non-conformance costs:

• Internal failure costs – these are quality failure costs before the products or services have been transferred to the customer. For example re-inspection of goods, losses or scrapping of materials and finished goods, additional administrative costs.

• External failure costs - these are quality failure costs before the products or

services have been transferred to the customer. External costs should be avoided as they expose poor manufacturing abilities to customers. Examples are administration of customer complaints, administration of customer services, product liability claims, repairs and replacements, lost goodwill and reputation.

It is clear from the scenario that CAL from a quality perspective provides middle range quality of solar panels, as they have competitors who sell at a cheaper price but offer an inferior range of solar panels and others who sell at a higher price but offer a high quality range of solar panels. CAL is losing out on an increase of 25% in its market share due to external failure costs of poor assembly skills by staff. (b) Assuming that CAL continues with its present systems and that the percentage of quality failings is as stated above:

(i) Calculate, based on the budgeted figures and sales returns rate, the total relevant costs of quality for the coming year. (4 marks)

(ii) Calculate the maximum saving that could be made by implementing

an inspection process for the solar panels, immediately before the goods are delivered. (2 marks)

(i) Non-conformance cost calculations Cost of replacing faulty goods for free is that we would have to supply not 20,000 items but a further 2% in addition to this demand. Therefore, supply 20,000 x 100/98 = 20,408. 408 items represent the free replacement which would cost CAL $45 per unit, therefore a total of $18,360.


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Other non-conformance costs include the lost increase of market share by 25%. This would result in 20,000 x 25% = 5,000 extra lost sales. This would give a lost contribution of 5,000 x $15 per unit = $75,000. Total non-conformance costs = $18,360 + $75,000 = $93,360 (ii) If through an inspection it was found that some solar panels were faulty and not fit for customer consumption then the lost sale could be avoided as well as the delivery charge. The item would still be faulty and the only cost incurred would be internal failure costs. The maximum savings will therefore be $93,360 less the internal costs before delivery being 408 units x $40 per unit = $16,320, giving a net saving of $77,040. Question Three (a) Compare and contrast QW’s present production and inventory policy and practices with a traditional production system that uses constant production levels and holds inventory to meet peaks of demand. (5 marks) QW currently employs a form of just-in-time (JIT) whereby products should only be produced if there is an internal or external customer waiting for them. QW manufacture to specific customer order and so there is no finished goods stockpiled in the company but they do however hold 1 day’s stock of raw materials to meet demand if suppliers are not able to deliver. The system also encourages efficient work of staff as delays may result in lost sales. The proposed system aims to procure items to meet constant rates of production. This would mean holding minimum levels of raw materials as well as finished goods to meet fluctuations in demand. This is very different to the current system being JIT which aims to always hold a zero or near zero stock level. This system will ensure demand is met but would lead to inefficient production and obsolete finished goods. This is because managers would tend to produce more goods than is necessary to meet demand. This system would also lead to other holding costs such as damage, deterioration, administration, security and interest costs.


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(b) Discuss the importance of a Total Quality Management (TQM) system in a just-in-time (JIT) environment. Use QW to illustrate your discussion. (5 marks) It is essential that a JIT system is underpinned by TQM. This is because under a JIT system if an item is discovered by the customer as faulty then the company will not be in a position to replace immediately as it does not hold any stock. It would have to manufacture the item again and so there will be a delay to customers who may not be happy about this. The delay may slightly less with QW as they hold 1 day’s worth of raw materials but nevertheless there will be waiting time for customers. In a constant rate production system TQM is not as important because there would be an inventory of both raw materials and finished goods that can be used to replace the faulty item. This system has the advantage of customers not having to wait for their replacement item, however it has the disadvantage of greater costs for holding greater amounts of inventory and more importantly the company moving away from a focus on quality of product resulting in the long term loss of customer goodwill and difficulties in convincing employees that quality is important. Question Four (a) Explain the differences between the above annual budgeting system and a rolling budget. (4 marks) An annual budgeting system is the process of using existing budgets as a guide to prepare the budget for the next 12 months which normally coincide with financial year end of the company. Rolling or continuous budgeting is when the budget is updated on a regular and frequent basis. The method is to add a further period immediately to the budget when an earlier period has expired, for example if Jan to Mar 2005 is the first three months of the yearly forecast, once this has expired then Jan to Mar 2006 will be created and added. Two of the key differences between these two systems are:

• Rolling budgets always provide a budget for the full period as they get updated, unlike annual budgets which don’t get updated as the periods expire. This enables management and so enables better long term planning.

• Rolling budgets are good for adaptive planning, for example there is a

greater chance that the budgets will be regularly updated to take account of changes within the environment the organisation is operating within if used.


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(b) Discuss how the Southern region depot manager could use a rolling budget system to address his concerns. (6 marks) The new depot manager has two concerns that he raises about the current system: Budgets are out of date Annual budgets are set on annual basis and are not revisited on a regular basis. This means that it is not possible to see if the budget is being met or even if current economic circumstances have made the budget out of date and not applicable. Rolling budgets would allow regular comparison to the actual outcomes more frequent update of forecasts where necessary due to unanticipated changes in the economy. This would keep the budgets more accurate, reliable and meaningful. Operational and strategic decisions cannot be taken Rolling budgets always provide a budget for the full period as they get updated and approved my management, unlike annual budgets which don’t get updated as the periods expire. This enables depot mangers to take decisions for the early part of next year. Annual budgets only get updated once a year and proves difficult for depot mangers to make decisions until the budget has been approved by management which maybe close to the year end restricting decisions being taken by depot mangers in the early part of next year. Operational decisions and control must however be dealt with carefully as these entail the day to day actions of the company and any differences in actual performance must be noted to ensure that improvements can be made. Rolling budgets should not eliminate these variances by revising them as it would mean that information about inefficiencies cannot be isolated and improved. Strategic decisions and control would benefit from rolling budgets as it help to ensure that failing strategies are abandoned in favour of successful strategies. Rolling budgets would allow frequent revisits to the strategy to ensure that it is being met and if not then the original strategy being revised.


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Question Five (a) Prepare calculations to show the effect on fees charged to each of these three clients of changing to the new costing system. (10 marks) Cost driver rates:

Accounts preparation and advice

$580,000 / 18,000 hrs = $32.22 per hr

Requesting missing information $30,000 / 250 times = $120 per request

Issuing fee payment reminders $15,000 / 400 times = $37.50 per reminder

Holding client meetings $60,000 / 250 meetings = $240 per meeting

Travelling to clients $40,000 / 10,000 miles = $4 per mile

Client A B C $ $ $ Accounts preparation and advice 32,222 8,055 10,955 Requesting missing information 480 1,200 720 Issuing fee payment reminders 75 300 375 Holding client meetings 960 240 480 Travelling to clients 600 2,400 0 Total costs 34,337 12,195 12,530 Total costs on old basis (W1) 40,280 10,070 13,695 Client fees – new basis 41,204 14,634 15,036 Client fees – old basis 48,336 12,084 16,434 Difference (7,132) 2,550 (1,398)

Workings (W1) – Total cost on old basis $725,000 / 18,000 hrs = $40.28 per hr


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SECTION B – 50 MARKS Question Six (a) Prepare calculations to show, from a financial perspective, the optimum production plan for December 2010 and the contribution that would result from adopting your plan. (6 marks) In order to find the optimum production plan we must first establish what the scarce resource is that is restricting production to meet all demand. We will work out the total amount of resources needed to meet maximum demand and then compare this to the resources that we have available to us to determine any scarce resources.

L M Total Total demand 400 700 Direct labour (hours) 1,600 1,400 3,000 Direct material (kg) 800 6,300 7,100 Machine hours 400 1,400 1,800

Direct material is the scarce resource or limiting factor as we only have available to us 6,000 kg and we need 7,100 kg.

Product L M $ per unit $ per unit Selling price 70 90 Direct labour ($7 per hour) (28) (14) Direct material ($5 per kg) (10) (45) Machine hours ($10 per hour) (10) (20) Contribution 22 11 Contribution per kg 22/2 = 11 11/9 = 1.22 Rank in order of production 1 2

Amount of material available is 6,000 kg.

Kg used L 400 units x 3 kg 800 M 6,000 kg – 800 kg = 5,200 kg 5,200 kg / 9 kg = 577 units 5,193 5,993

Optimum production plan

Production L 400 M 577


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Contribution from production plan

L 400 x $22 = $8,800 M 577 x $11 = $6,347

Contribution $15,147 (b) Construct the revised resource constraints and the objective function to be used to identify, given the additional information above, the revised optimum production plan for December 2010. (6 marks) The agreed order of 250 units of product M should be worked out separately for the resources needed to complete it first as this is a requirement, then we can see what resources are left over to formulate our new resource constraints. 250 units of product M would need: Direct labour = 2 hrs per unit x 250 units = 500 hrs Direct material = 9kg per unit x 250 units = 2,250 kg Machine hours = 2 hrs per unit x 250 units = 500 hrs Resources have also been overestimated by 20% and need to be reduced before deduction of resource usage by the agreed order of 250 units of M, therefore: Direct labour = (3,000 hrs x 80%) - 500 hrs = 2,300 hrs Direct material = (6,000 kg x 80%) - 2,250 kg = 2,550 kg Machine hours = (2,000 hrs x 80%) – 500 hrs = 1,100 hrs Revised resource constrains: Direct labour 4L + 2M ≤ 2,300 Direct material 2L + 9M ≤ 2,550 Machine hours 1L + 2M ≤ 1,100 Objective function: C = 22L + 11M (c) Analyse the meaning of each of the above eight values in the solution to the problem. Your answer should include a proof of the five individual values highlighted in bold. (13 marks) Product L 400 and product L other value 0 The value 400 represents the amount of L we should produce in order to maximise contribution given the resource constraints. The other value 0 means that we have no further units of L to make as we have reached the maximum market demand for L. units. There is no shortfall in demand.


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Product M 194 and product M other value 506 The value 194 represents the amount of M we should produce in order to maximise contribution given the resource constraints. The other value 506 means that we have not met our maximum market demand of M by 506. We are only producing 194 units of M where as the maximum market demand is 700. There is a shortfall in demand of 700 units – 194 units = 506 units. Machine hours 312 This value represents the number of unused machine hours left at the optimal production point where contribution is maximised given current resource constraints. We can proof this amount of unused machine hours by comparing what has been used to the total amount of machine hours available. L units produced = 400 x 1 hr per unit = 400 hrs M units produced = 194 x 2 hrs per unit = 388 hrs Total hours used = 400 + 388 = 788 hrs Hours available = 1,100 hrs Hours unused = 1,100 hrs – 788 hrs = 312 hrs Direct material $1.22 This is the shadow price for direct materials as it is a scarce resource at the optimal production point where contribution is maximised given current resource constrains. The shadow price is maximum price you should pay above the original cost for one more extra unit of the scarce resource, in this case being one more kg of direct material. The proof is that if we were given 1 more kg of direct material we would use it to increase output of product M, because still has unfulfilled demand. Each unit of M requires 9 kg, therefore 0.11 units of M could be produced from 1 kg of material. Each unit of M yields a contribution of $11 and therefore 0.11 units yield $1.22 contribution. Labour hours 312 This value represents the number of unused labour hours left at the optimal production point where contribution is maximised given current resource constraints.


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Contribution $10,934 This is the maximum contribution that can be earned given the constraints at the optimal production point. Proof: Contribution from L units = 400 x $22 = $8,800 Contribution from M units = 194 x $11 = $2,134 Total contribution = $8,800 + $2,134 = $10,934


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Question Seven (a) Discuss the performance of the S division over the three year period. (9 marks)

Return on capital employed (ROCE)

= Profit before interest and tax (PBIT) x 100% Capital employed

The ROI for the three years:

Year ROI $

2008 40 / 400 = 10% 2009 56 / 320 = 17.5% 2010 62 / 256 = 24.2%

There is a very good improvement of the ROI over the last 3 years from 10% up to nearly 25%. Inflation has been removed according to the question and the figures the same for turnover and cost of sales throughout the 3 years which means there has been no increase in products sold over the last 3 years. The gross profit has been constant at 40% and therefore indicating no change in quantity sold and prices. Operating costs appear to be falling over the last three years, but if depreciation is removed it shows that operation costs have increased by $4,000 in 2009 and more significantly in 2010. In conclusion the improvement in ROI over the last three years is largely down to the depreciation policy rather than improved performance by the division. (b) Prepare calculations to show why the manager of the S division is unlikely to go ahead with the investment. Ignore taxation. (11 marks) The investment results in a positive NPV of $24,536 and so from a group company perspective it will be accepted by head office to go ahead, however from the perspective of the manger of S division it will depend on whether or not ROI of the division is improved. This is because his performance is assessed on ROI. To assess this we will look at the divisional ROI if the investment is undertaken compared to the divisional ROI if the investment is not undertaken.


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If investment was undertaken: $ Sales 400,000 Cost of sales ($240,000 x 90%) 216,000 Gross profit 184,000 Other operating costs (W1) (97,200) Pre-tax operating profit 86,800

Capital invested at the end of the year (W2) = $252,800 ROI = ($86,800 / $252,800) x 100% = 34.3%

If investment was not undertaken: $ Sales 400,000 Cost of sales 240,000 Gross profit 160,000 Other operating costs (W3) (85,200) Pre-tax operating profit 74,800

Capital invested at the end of the year ($256,000 - $51,200) = $204,800 ROI = ($74,800 / $204,800) x 100% = 36.5% Workings (W1) – Other operating costs $ Other operating costs 98,000 Less: Depreciation ($320,000 x 20%) (64,000) Add: New depreciation (W2) 63,200 Total 97,200 (W2) – New depreciation and capital invested at the end of the year $ Current total NBV at the end of 2011 256,000 Less: NBV of machine sold (40,000) Add: Cost of new machine 100,000 316,000 Less: New depreciation (316,000 x 20%) (63,200) Revised total NBV at the end of 2011 252,800 (W3) – Other operating costs $ Other operating costs 98,000 Less: Old depreciation ($320,000 x 20%) (64,000) Add: New depreciation ($256,000 x 20%) 51,200 Total 85,200


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(c) Prepare calculations to show how the use of Residual Income (RI) as the performance measure would have led to a goal congruent decision by the manager of the S division in relation to the purchase of the replacement machine. Ignore taxation. (5 marks)

Profit before interest and tax (PBIT) X Capital employed x head office % interest charge (X) Residual Income X

If investment was undertaken: $ Pre-tax operating profits 86,800 Notional capital charge ($252,800 x 8%) (20,220) Residual Income 66,580

If investment was not undertaken: $ Pre-tax operating profits 74,800 Notional capital charge ($204,800 x 8%) (16,380) Residual Income 58,420

Difference is an increase of Residual Income if investment undertaken of $8,160

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