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ACCA Professional Level Paper P5 Advanced Performance Management Course Examination 2

Question Paper Time allowed Reading and Planning Writing Section A TWO compulsory questions to be attempted Section B TWO out of THREE questions to be attempted During reading and planning time only the question paper may be annotated 15 minutes 3 hours

Instructions:
Please attempt this exam under test conditions and attach the frontsheet complete with your name and address to your script. The completed package should be sent to BPP Professional Education. Take a few moments to review the notes on the inside of this page titled, Get into good exam habits now! before attempting this exam.

DO NOT OPEN THIS PAPER UNTIL YOU ARE READY TO START UNDER EXAMINATION CONDITIONS
ACP5CE12(J) Exam 2 Questions

Get into good exam habits now!


Take a moment to focus on the right approach for this exam.

Effective time management


Watch the clock, allocate 1.8 minutes to each mark and move on if you get behind. Take a few moments to think what the requirements are asking for and how you are going to answer them. Remember one mark is usually allocated for each valid point you give in a discursive question.

Effective planning
This paper is in exactly the same format as the real exam. You should read through the paper and plan the order in which you will tackle the questions. Always start with the one you feel most confident about. Read the requirements carefully: focus on mark allocation, question words (see below) and potential overlap between requirements. Identify and make sure you pick up the easy marks available in each question.

Effective layout
Present your numerical solutions using the standard layouts you have seen. Show and reference your workings clearly. With written elements try and make a number of distinct points using headings and short paragraphs. You should aim to make a separate point for each mark. Ensure that you explain the points you are making ie why is the point a strength, criticism or opportunity? Give yourself plenty of space to add extra lines as necessary, It will also make it easier for the examiner to mark.

Common terminology
Advise Analyse Calculate/compute Compare and contrast Define Describe Discuss Distinguish Evaluate Explain Identify Interpret Justify List Prepare Recommend Summarise To counsel, inform or notify Examine in detail the structure of To ascertain or reckon mathematically Show the similarities and/or differences Give the exact meaning of Communicate the key features of To examine in detail by argument Highlight the differences between To appraise or assess the value of Make clear or intelligible/state the meaning of Recognise, establish or select after consideration Process information to explain its meaning To produce reasons in support of State short pieces of information on separate lines To make or get ready for use To advise on a course of action To express the most important facts of

ACP5CE12(J) Exam 2 Questions

SECTION A BOTH questions are compulsory 1 Transfer Pricing


(a) The ECB Group manufactures a range of products within its many divisions. Division Black and Division Brown, two of the divisions of ECB, both require products Alpha and Beta which are available from two other divisions of ECB, Division A and Division B respectively. Divisions Black and Brown convert Alpha and Beta into products Blackalls and Brownalls respectively. The market demand for Blackalls and Brownalls considerably exceeds the production possible because of the limited availability of Alpha and Beta. There is no external market for Alpha and Beta so no alternative supplier of the intermediate products is available to Divisions Black and Brown in place of Alpha and Beta. Information in respect of the divisions of ECB for the year ended 30th March 20X8 is as follows. Blackalls Selling price per unit ($) Processing cost per unit ($) Intermediate products required per unit: Alpha: Beta Division A Variable cost per Alpha / Beta Machine hours required (hrs per unit) Maximum capacity 1,200 units $6 Division B $4 5 8,000 hours 45 12 3 units 2 units Brownalls 54 14 2 units 4 units

In order to solve the problem of how best to use the limited capacity, the management accountant of ECB employed linear programming which indicated that the scarcity value (shadow price) of Alpha was $0.50 and of Beta $2.75 per unit. The solution indicated that Alpha and Beta should be transferred such that 200 units of Blackalls and 300 units of Brownalls could be produced and sold. ECB sets transfer prices on the basis of variable cost plus shadow price. Required (a) Calculate the contribution earned by the group for the year ended 30th March 20X8. if the sales pattern indicated by the linear programming model is implemented. Your answer should indicate BOTH the contribution per unit of intermediate product earned by Divisions A and B and the contribution per unit of final product earned by Divisions Black and Brown. (7 marks) Comment on the results derived in (a) and on the possible attitude of management of the various divisions to the transfer pricing and product deployment policy. (6 marks)

(b)

ACP5CE12(J) Exam 2 Questions

(c)

In the following year the capacities of divisions A and B have each doubled and the following changes have taken place. Alpha: There is still no external market for this product, but Division A has a large demand for other products which could use the capacity and earn a contribution of 5% over costs. Variable cost per unit for the other products would be the same as for Alpha and such products would use the capacity at the same rate as Alpha. Beta: An intermediate market for this product now exists and Beta can be bought and sold in unlimited amounts at $7.50 per unit. External sales of Beta would incur additional transport costs of 50c per unit which are not incurred in inter-divisional transfers. The market demand for Blackalls and Brownalls is still expected to exceed the production availability of Alpha and Beta. (i) Calculate the transfer prices at which Alpha and Beta should now be offered to Black and Brown divisions in order that the transfer policy implemented will lead to the maximisation of group profit. Determine the production and sales pattern for Alpha, Beta, Blackalls and Brownalls which will now maximise group contribution and calculate the group contribution that this will achieve, assuming that divisions will make decisions consistent with maximisation of profits. (9 marks)

(ii)

(d)

Discuss the advantages and disadvantages of each of the following transfer pricing bases at which component Alpha might be offered by Division A to Divisions Black or Brown: (i) (ii) (iii) External selling price and adjusted selling price; Marginal cost and marginal costs plus an annual lump sum; and Dual pricing

Your answer should incorporate illustrative values ($) for each transfer price using the data provided above and any additional data of your choice. (13 marks) (Total = 35 marks)

2 Performance measurement
Performance measurement in companies has traditionally been based on feedback on the budget, expressed in financial terms. There is now much discussion about alternative methods of performance measurement to ensure that a company achieves its overall goals. Required (a) (b) (c) (d) Briefly outline three reasons why performance measures for many organisations are still mainly expressed in terms of money. (3 marks) Comment on the effectiveness of the use of return on investment (ROI) and residual income (RI) as performance indicators, showing under what circumstances a company may use these. (7 marks) Briefly outline what you understand by the balanced scorecard as a performance measure. (10 marks) Explain the problems of using a broad range of non-financial measures for the short and long-term control of a business. (5 marks) (Total = 25 marks)

ACP5CE12(J) Exam 2 Questions

SECTION B TWO questions only to be attempted 3 ROCE


A recently formed group of companies is proposing to use a single return on capital employed (ROCE) rate as an index of the performance of its operating companies. These companies differ considerably from one another in size and type of activities. Senior management are particularly concerned that the evaluations made from the use of this rate should be valid in terms of measurement of performance. Required (a) Discuss four considerations in calculating the ROCE rate to which the group will need to attend, to ensure that its intentions are achieved. For each consideration give an example of the type of problem that can arise. (8 marks) Discuss three types of circumstance in which a single ROCE rate might not be an adequate measure of performance and, for each, explain what should be done to supplement the interpretation of the results of the single ROCE rate. (12 marks) (Total = 20 marks)

(b)

4 Quality and NFPOs


(a) A manufacturers inspection procedures indicate that one faulty item out of every 1,000 good items produced is sent to a customer. The management regards this as acceptable as a replacement will be issued free of charge. Unit sales are 10 million per year with a unit cost of $20 and a profit of $5. Marketing costs are $10 per new customer per year. It is assumed that every customer who buys a faulty product will return it and thereafter go elsewhere for their purchases. The average sales are two units per customer per year. (i) (ii) (iii) Estimate the net cost of this policy per year and comment on your findings Identify how these costs relate to the classifications of costs of quality and comment on these for this business Recommend a more suitable policy that would alter the costs of quality for this manufacturer and explain how a TQM approach would differ. (12 marks)

(b)

In discussing not-for-profit organisations, Bowman and Asch state ... even if the goals are clear but achievement of them is not measurable, then assessing the performance of the organisation becomes extremely difficult.' Bowman and Asch, Strategic Management Required Explain how the performance of a not-for-profit organisation could be assessed. (8 marks) (Total = 20 marks)

ACP5CE12(J) Exam 2 Questions

5 JIT
'Japanese companies that have used just-in-time (JIT) for five or more years are reporting close to a 30% increase in labour productivity, a 60% reduction in inventories, a 90% reduction in quality rejection rates, and a 15% reduction in necessary plant space. However, implementing a just-in-time system does not occur overnight. It took Toyota over twenty years to develop its system and realise significant benefits from it.' Sumer C Aggrawal, Harvard Business Review Required (a) (b) Explain how the benefits claimed for JIT in the above quotation are achieved and why it takes so long to achieve those benefits. (12 marks) Evaluate the usefulness of traditional management accounting systems and suggest how these should be developed or replaced in order to facilitate and make best use of JIT. (8 marks) (Total = 20 marks)

ACP5CE12(J) Exam 2 Questions

Maths tables

ACP5CE12(J) Exam 2 Questions

ACP5CE12(J) Exam 2 Questions

Student self assessment


Having completed this paper take a few minutes to consider what you did well and what you found difficult. Use this as a basis to focus your future study on effectively improving your performance.

Common problems
Timing and planning
Did you finish too early? Did you overrun?

Future emphasis if you answer Yes

Y/N Y/N

Focus your planning time on generating more ideas. Use models to help develop width to your thinking. Focus on allocating your time better. Practise questions under strict timed conditions. If you get behind leave space and move on. Focus your planning time on developing a logical structure to your answer.

Did you waffle?

Y/N

Layout
Was your answer difficult to follow? Y/N Use headings and subheadings. Use numbering sequences when identifying points. Leave space between each point. Show why the point identified answers the question set. Give yourself time and space to make the markers job easy.

Did you fail to explain each point clearly? Y/N Did you fail to show any workings or were your workings unclear? Y/N

Content
Did you struggle with: Interpreting the questions? Y/N Learn the meaning of question words (inside front cover). Learn subject jargon (study text glossary). Read questions carefully noting all the parts. Practise as many questions as possible. Review your notes/text. Work through easier examples first. Contact ACCA queries for help. Quiz yourself constantly as you study. You need to develop your memory as well as your understanding of a subject.

Understanding the subject?

Y/N

Remembering the notes/text?

Y/N

ACP5CE12(J) Exam 2 Questions

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ACP5CE12(J) Exam 2 Questions

ACCA Professional Level Paper P5 Advanced Performance Management Course Examination 2

Guidance, Marking scheme and Suggested solutions

ACP5CE12 (J) Exam 2 Solutions

AC112 P5(2)

Guidance
This exam contains two sections. Section A has two compulsory questions, which are worth sixty marks in total. The examiner has discretion to award up to seventy marks in Section A. Section B has a choice of two out of three questions each worth twenty marks.

Guidance on improving performance on the exam paper.


Which questions to do first? It is important for you to decide which order to attempt the questions. Section A The P5 examiner tells us that candidates who leave question one until last in the exam are less likely to pass the exam. so we suggest that you start with the compulsory questions in Section A. Section B Then carry on and attempt the optional question that you are more confident about first. This means you will build up marks early on giving you a solid base to tackle the harder question later. However do not spend too long on the question you are confident about as you need to spend an equal amount of time on each. You cannot pass the exam answering two or three questions well and the rest poorly. An alternative strategy is to answer all questions in strict order. You could use the time saved choosing the order by starting to plan your answers. You may prefer to use this method if you find yourself spending too long on your favourite questions as it forces you to spend an equal time on each before moving on. Strategy Make sure your answers are focused and specific to the organisation in each scenario. Show clear workings for your calculations and write full sentences in your explanations. Most importantly, apply your skills in a practical context. Dont get bogged down with long explanations of models and techniques. You need to know and understand them but your application is what earns you good marks in the exam. Time management Use the reading and planning phase to make sure that you get as many of the marks as possible. Write a short plan for each question containing bullet points per mark and use it to write your answer when the writing time begins. Never overrun on any question and once the time is up move on to the next.

ACP5CE12(J) Exam 2 Solutions

1 Transfer Pricing
Marking scheme
(a) Contribution for the group based on linear programming model Contribution per unit of all four products (1 mark each) Commentary. 1 mark per division on attitude plus 2 marks max for consequences Calculation of transfer prices for transfer of Alpha and Beta Sales and production pattern for all four products Group contribution Comments on merit: External selling price and adjusted selling price Cost based transfer prices Dual price 3 4 2 3 4 Marks 7 6

(b) (c)

99 9

(d)

5 5 5 max

13 35

Suggested solution
Top tips. In (a) start with the total annual contribution which you can calculate easily from data in the question. The remainder of the calculations in this part are variants on this initial calculation so use the same format and slot in the shadow or opportunity cost as required. Make sure that you are clear about what the question wants you to do. Distinguish between a shadow price and an opportunity cost. The contributions earned on internal transfers of Betas and Alphas should be excluded, as they are internal to the group. In part (b) you need to take the figures you calculated and discuss the transfer pricing implications for all four divisions and their likely response to transfer prices based on shadow pricing. In part (c) you should have continued with a columnar format for your answer and added workings where necessary. You should have noticed that the requirement to maximise group profits meant that you needed to use an opportunity cost basis for your transfer prices. Part (d) asks you to consider the advantages and disadvantages of the transfer prices mentioned in the question, but it is important that your comments relate to ECB and its divisions. For example, you should have spotted that there is no external market for Alpha so no selling price exists. As a result, many of the usual advantages of basing transfer prices on market prices cannot apply. Easy marks. The calculation of contribution in (a) is simple enough. Setting out a proforma grid to slot in your calculations throughout as most of the figures dont change.

ACP5CE12(J) Exam 2 Solutions

(a)

Total annual contribution for ECB $/unit 12 18 8 Blackalls $/unit 45 $/unit Brownalls 14 (2 6) (4 4) 12 16 $/unit 54

Selling price Processing cost Cost of Intermediate products: Alpha (3 6) Beta (2 4) Contribution per unit Units produced and sold Contribution Total contribution earned Contributions per unit Divisions A and B Transfer price (W1) Variable cost Contribution per unit (= shadow price) W1 Alpha transfer price Beta transfer price Divisions Black and Brown Selling price Processing cost Intermediate products @transfer price Alpha (3 6.50) Beta (2 6.75) Contribution per unit (b)

38 7 200 1,400

42 12 300 3,600

$5,000

Division A $/unit 6.50 6.00 0.50 Variable cost $6 $4 Black $/unit $/unit 45 12.00 19.50 13.50 Shadow price $0.50 2.75

Division B $/unit 6.75 4.00 2.75 Transfer price $6.50 $6.75

Brown $/unit 14 (2 6.50) (4 6.75) 13 27

$/unit 54

45 nil

54 nil

When shadow prices are used to set transfer prices, all of the contribution is deemed to be earned in the divisions, which produce the scarce resource. The result is that no contribution is attributed to Black and Brown divisions. The management of Black and Brown divisions are likely to be demotivated by the proposed transfer pricing policy, as the pricing system implies that their divisions earn no contribution. Such a situation is obviously absurd. There is no external market for Alphas and Betas, and it is the sales of Blackalls and Brownalls produced by Black and Brown, which generate revenue. As a result the managers of these two divisions may act in a dysfunctional manner and may fail to produce either Black or Brown for sale in the open market, thus eliminating ECB group profits. Moreover, the zero contribution earned will not allow any fixed costs of production to be recovered by these divisions. The management of divisions A and B are more likely to have a positive attitude towards the transfer pricing policy because they can earn a contribution toward their fixed costs. However the manager of division A may feel that the 8.3% mark-up of 50c on a cost of $6.50 is too low when compared with that for B which earns $2.75 mark-up (68%) on a cost of $4.

ACP5CE12(J) Exam 2 Solutions

The product deployment policy determined by the management accountant results in a larger volume of work for Division Black than for Division Brown in respect of these products. This may cause behavioural problems if the manager of the Division Brown perceives the allocation of resources to be unfair. There is limited capacity in both Division A and B. The ECB group will want to encourage these limits to be raised to increase output, but the current transfer pricing systems do not encourage the managers to Division A and Division B to do this as shadow prices will fall as capacity increases. As here is no external market for Alpha and Beta and so no alternative suppliers, ECB may well have competitive advantage in production of Black and Brown on which it should attempt to capitalise. (c) (i) To maximise group profits, transfer prices should be based on marginal cost plus lost opportunity. The shadow prices given earlier no longer apply as the capacity of Division A and B has doubled, so the lost opportunity needs to be calculated. Marginal cost $6 $4 Opportunity cost $0.30 $3.00 Transfer price $6.30 $7.00

Alpha transfer price Beta transfer price Workings

(W1) The opportunity cost for Alpha is the contribution which could be earned if the capacity was used for other products = $6 5% = $0.30. The opportunity cost for Beta is the contribution, which could be earned from external sales. $/unit Selling price 7.50 Transport costs (0.50) Variable costs (4.00) Contribution 3.00 (ii) 2,400 Alphas will be made for the use of the Black division. 3,200 Betas will be made, of which 1,600 will be transferred to the Division Black and 1,600 sold externally. ECB will discontinue production of Brownalls, but will make 800 Blackalls each year. Group contribution Beta 1,600 x $3 Blackalls 800 x $7 Workings 1 Selling price Processing cost Intermediate products @ transfer price: Alpha (3 6.30) Beta (2 7.00) Contribution Blackalls $/unit $/unit 45.00 12.00 18.90 14.00 (2 6.30) (4 7.00) Brownalls $/unit $/unit 54.00 14.00 12.60 28.00 4,800 5,600 10,400

44.90 0.10

54.60 (0.60)

If divisions will make decisions consistent with maximisation of profit, then the manager of Division Brown will be willing to cease production of Brownalls as they no longer create profit for the division. ACP5CE12(J) Exam 2 Solutions 5

Division Black will therefore be able to take all available output of Alpha and Beta to make Blackalls. 2 Maximum production capacity has been doubled to 2,400 Alphas and 3,200 Betas (8,000 hours x 2/ 5 hours/unit). Blackalls require more Alphas than Betas so availability of Alpha is the limiting factor. Maximum achievable production = 2,400/3 = 800 Blackalls. 800 Blackalls require 1,600 Betas. The remaining Betas (1,600 units) will be sold externally. (d) (i) External selling price and adjusted selling price. Product Alpha has no external market and it is only sold by division A to other divisions of ECB so no indicative price can be obtained. Basing transfer price bases on external selling price is designed to: (1) Simulate the characteristics of the open market and ensure that both Division A and Divisions Black and Brown behave as if the transaction is at arm's length. This should lead to optimal decision making. Ensure the market price should be seen to be fair to all parties make sure the profit sharing achieved under such a system can be considered to be objective since it is based on external factors and is not distorted by subjective or internal considerations.

(2) (3)

But these advantages do not apply in this case as there is no such selling price in the external market Thus any transfer price deemed to be based on an external market price would: (1) (2) Be arbitrary. Act as a disincentive to use up any spare capacity in the Divisions Black and Brown. Setting a price based on incremental cost, in contrast, might provide an incentive to use up the spare resources in order to provide a marginal contribution to profit.

Adjusted selling prices are used to determine transfer prices when divisions have different cost structures depending on whether goods are sold externally or transferred to other divisions, such as packaging and transport costs, as Division B has for Beta which incurs additional transport costs of 50c per unit on external sales. It would seem reasonable that these were taken into account if a market for Alpha existed so that Division A would make the same level of profit on transfers as it would on external sales. (ii) Marginal cost and marginal cost plus an annual lump sum. In the absence of an external market, the optimum transfer price is likely to be one based on cost plus. Marginal costs should be preferred to full cost and standard cost should be preferred to actual cost so that there are no distortions to decision making caused by changes in capacity or efficiency. If Division A has some spare capacity for which no other use is available, it might offer Alpha at marginal cost. This is $6 per unit. However Alpha has a shadow price and Division A should work at full capacity for the benefit of ECB. Management at Divisions Black and Brown could make a decision about transfers from Division A on a basis that would lead to group profit maximising decisions. It may be decided as part of Group policy to allow transfers to be made on the basis of marginal cost plus a lump sum to allow for a share of the fixed costs of Division A. The size of this fixed sum would have to be agreed between management at Division A and Divisions Black and Brown.

ACP5CE12(J) Exam 2 Solutions

The advantages of cost based transfer prices include: (1) (2) (3) The transfer price can be fixed and agreed in advance without being subject to external fluctuations. The price should motivate divisional managers to increase output and reduce expenditure levels. The transfer price can be set in such a way as to ensure a fair division of profit between divisions.

The disadvantages of a cost based transfer pricing system are as follows. (1) Reaching agreement between divisions as to an appropriate mark-up can be difficult especially as division A has an opportunity cost of production which depends on the level of capacity and varied between $0.50 and $0.30 (see earlier solution). Such a system is dependent on cost behaviour and can only be used for ranges of production over which costs vary linearly with output. The use of a cost based transfer price may encourage dysfunctional behaviour if one division feels that the price is wrong.

(2) (3) (iii)

Dual Pricing A dual pricing system may be used as part of ECBs Group accounting policy. In this case, Division A may be allowed to use one price for its profit reporting but, offer to transfer at a different price. For example the transfer could be based on marginal cost ($6.00) if spare capacity existed, or marginal cost plus lost opportunity ($6.30 - $6.50) whilst Division As profits could be based on a higher price (say $8). The advantages of dual pricing include: (1) (2) Division A will make profits which will be motivating and enable performance assessment in line with other divisions of ECB. Divisions Black and Brown would be motivated to buy from Division A thus increasing group profits

The disadvantages of dual pricing include: (1) (2) A group profit adjustment would be made on consolidation of profits at the year-end. There may be confusion over the price of an Alpha which may upset decision making.

ACP5CE12(J) Exam 2 Solutions

2 Performance measurement
Marking scheme
(a) (b) (c) (d) Reasons why performance measures still mainly in monetary terms 1 mark per advantage or disadvantage Introduction, four perspectives (Max 2 marks each) 1 mark per valid comment Marks 3 7 10 5 25

Suggested solution
Top tips. (a) is only worth three marks so dont go into a lot of detail. In (b) you need to cover both advantages and disadvantages. In part (d) you need to draw on your knowledge rather than application so you should really put down at least five to six points to earn good marks. Easy marks. Describing the balanced scorecard in (c) is pure book knowledge as you just need to list the four perspectives. (a) Reasons why performance measures for many organisations are still mainly expressed in monetary terms (i) Companies are required by law to report their financial performance. It is therefore easy and saves time to base performance measures on the monetary information prepared for financial accounting purposes. Money is easy to measure. Non-financial factors such as customer satisfaction are often more difficult to quantify. Most commonly-used accounting ratios are expressed in monetary terms. Monetary measures are easy to understand and interpret. Non-financial indicators such as 'absenteeism per type of customer' are more difficult to analyse. Money provides a standard unit for comparison purposes. Non financial factors (such as a defect, a complaint or production set-up time) are more difficult to define and are likely to vary in different organisations or even in different divisions of the same organisation.

(ii) (iii) (iv) (v)

(b)

The return on investment (ROI) (also known as return on capital employed (ROCE)) is a division's profit expressed as a percentage of the investment in the division. As such it is compatible with accounting reports. The residual income (RI) for a division is calculated by deducting an imputed interest charge, based on investment in the division, from its profit. ROI therefore tends to be easier to understand. Both measures use the same basic figure for profit and investment, but residual income produces an absolute measure whereas the return on investment is expressed as a percentage. A number of disadvantages are associated with both methods. (i) Both methods suffer from disadvantages in measuring profit and investment. The investment can be based on net assets (most usually), gross assets or replacement cost, but none of these bases is ideal. Moreover, divisions might use different bases to value inventory and to calculate depreciation, and any charges made for the use of head office services or allocation of head office assets to divisions are likely to be arbitrary.

ACP5CE12(J) Exam 2 Solutions

(ii) (iii)

It is questionable whether a single measure is appropriate for measuring the complexity of divisional performance. The biggest problem in divisional performance measurement is that if a division maintains the same annual profit, keeps the same assets without a policy of regular non-current asset replacement and values assets at net book value, its ROI or RI will increase year by year as the assets get older, even though profits may be static. This can give a false impression of improving performance over time and acts to discourage managers from undertaking new investments.

In addition, ROI suffers from the following disadvantages. (i) Rigid adherence to the need to maintain ROI in the short term can discourage managers from investing in new assets (since the average ROI of a division tends to fall in the early stages of a new investment) even if the new investment is beneficial for the group as a whole (because the investment's ROI is greater than the group's target rate of return). This focuses attention on short-run performance whereas investment decisions should be evaluated over their full life (which will normally be over a long term). RI can help to overcome this problem of suboptimality and a lack of goal congruence by highlighting projects which return more than the cost of capital (as an increase in RI must be beneficial for the organisation as a whole). It can be difficult to compare percentage ROI results of divisions if their activities are very different. RI can overcome this problem through the use of different interest rates for different divisions.

(ii)

There are also a number of disadvantages associated with RI: it does not facilitate comparisons between divisions; neither does it relate the size of a division's income to the size of the investment. In these respects ROI is a better measure. The disadvantages of the two methods have a number of behavioural implications. During the time of their employment, managers like to ensure that their performance and the results of their decisions appear in the most favourable light. It is probable that they will have no regard for the later life of their division's projects or for the overall performance of the group. They will therefore favour proposals that produce excellent results in the short term but are possibly unacceptable in the longer term and they will disregard proposals that are in the best interests of the group as a whole. ROI and RI can therefore produce dysfunctional decision making. Managers may consider their own performance and not the longer-term interests of the division or the interests of the group. (c) Traditional financial accounting measures such as return on investment and earnings per share have been criticised as giving misleading signals for continuous improvement and innovation activities which today's competitive environment demands. The balanced scorecard is a way of measuring performance which integrates traditional financial measures with operational, customer and staff issues which are vital to the long-term competitiveness of an organisation. The balanced scorecard allows managers to look at their business from four important perspectives. (i) Customer perspective. This section of the balanced scorecard requires customers themselves to identify a specific set of goals and performance measures relating to what actually matters to them, be it time, quality, performance of the product or service. In order to view the organisation's performance through customers' eyes, market researchers are hired to assess how the organisation is performing. Internal business perspective. Measures from the customer's perspective need to be translated into the actions the organisation must take to meet these expectations. The internal business perspective of the balanced scorecard identifies the business processes that have the greatest impact on customer satisfaction, such as quality and employee skills.

(ii)

ACP5CE12(J) Exam 2 Solutions

(iii)

Innovation and learning perspective. Whilst the customer and internal process perspectives identify the current parameters for competitive success, the organisation needs to learn, innovate and improve to satisfy future needs. It must produce new products, reduce costs and add value. Performance measures must emphasise continuous improvement in meeting customer needs. Examples of measures might be the length of time it takes to create new products or the percentage of revenue which comes from new products. Financial perspective. This includes traditional measures such as profitability and growth but the measures are set through talking to shareholders direct. The financial perspective looks at whether the other three perspectives will result in financial improvement.

(iv)

The success of the balanced scorecard approach lies in viewing all of the measure as a whole. Once those factors that are important to the organisation's success have been established, performance measures and targets for improvement are set. The measures and targets must be clearly communicated to all levels of management and employees so that they understand how their efforts can impact upon the targets set. The balanced scorecard can then become the most important monthly management report. (d) Many companies are discovering the usefulness of non-financial performance indicators (NFPIs) such as quality measures, numbers of complaints, non-productive hours, system down time and so on. However there are a number of problems associated with such measures. (i) (ii) (iii) (iv) Too many measures could be reported, overloading managers with information that is not truly useful (or comes to be regarded as not useful) or that sends conflicting signals. It is difficult to judge which non-financial measures are the most important. The ultimate goal of commercial organisations remains the maximisation of profit. An overconcentration on non-financial measures may lead to the neglect of this criterion. Some non-financial aspects of performance are very difficult to measure objectively. For example a measure of customer complaints does not indicate that all customers who did not complain were entirely satisfied. Measures may conflict with each other: achieving measure X can be at the expense of achieving measure Y (such as productivity and quality). If NFPIs are used as the basis of managerial performance evaluation, the areas not covered by the measures used may be ignored.

(v) (vi)

10

ACP5CE12(J) Exam 2 Solutions

3 ROCE
Marking scheme
(a) (b) Fully discussed considerations (2 marks each, max 8) Illustration of circumstances (2 marks each) Suggested alternatives (2 marks each) 6 6 Marks 8 12 20

Suggested solution
Top tips. In (a) you need to think critically about the use of ROCE as a measure. There is plenty of material in the Study text covering the potential drawbacks of this measure and in using financial measures overall. Using little examples to illustrate points can be helpful if you have time as we have done in our answer. (b) needs you to think a bit more about what you wrote in (a) and apply this to specific circumstances. You must be prepared to think of examples and applications at this level so practise lots of questions and read a good financial newspaper. Easy marks. You could earn a few marks in (a) just listing the drawbacks but better marks are available for explanations. (a) Considerations to which the group will need to attend in calculating ROCE (i) How is 'capital employed' to be defined? Should the group use gross assets, non-current assets plus net current assets or some other figure? Should the group use year-end values or average values over the year? The difficulty lies in ensuring that comparisons over time are meaningful. For example, if mean assets values are used, consider the return on a non-current asset costing $100,000 and being written off over four years, which yields a profit of $10,000 pa. Although the profit in dollars is constant, the ROCE increases as the asset ages, which might tend to discourage replacement. Year 1 2 3 4 (ii) Mean capital employed $ 87,500 62,500 37,500 12,500 ROCE % 11.4 16.0 26.7 80.0

Should assets be valued at historical cost or at replacement cost? Replacement cost will overcome some of the difficulty identified in (i) by providing a more comparable asset valuation, but there are problems in ascertaining replacement cost, particularly for older assets which may no longer be available. As well as deciding how the denominator, capital employed, is to be defined, the group will have to consider how the numerator, 'return' is to be defined. Should it be profit before or after tax? Here there may be a conflict between the views of the holding company and those of the subsidiaries. The subsidiaries may see pre-tax profit as a more appropriate measure of their operational effectiveness, but the holding company may be more interested in the overall return as measured by profit after tax. Problems will arise if companies within the group operate in different countries with different rates of tax, or if one company is a small company for corporation tax purposes and another is not.

(iii)

ACP5CE12(J) Exam 2 Solutions

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(iv)

Similar accounting methods must be adopted by all group companies, to ensure comparability. Problems could arise over such items as depreciation, research and development expenditure and inventory valuation, where different accounting methods are permitted.

(b)

The inadequacy of ROCE as a measure of performance (i) If ROCE is used as the sole measure of performance, it could lead to poor investment decisions. For instance, suppose companies A and B each have the opportunity to invest $100,000 yielding a 20% return on capital. A currently has a 15% return on capital employed of $500,000 and B a return of 21% on capital employed of $2,000,000. If ROCE is the criterion, A will accept the project but B will reject it because of the effect on their respective ROCEs. If the company's cost of capital is only 12%, it may well be that B should undertake the project, which would be beneficial for the group as a whole and less risky for B than for A due to their relative size. The remedy is not to rely on ROCE in these circumstances but to employ DCF methods of investment appraisal and to use residual income rather than ROCE as a measure of individual companies' performance. (ii) ROCE may depend on the type of business within which a particular company operates. For instance, it is likely to be higher for a retail company than for a manufacturing company. ROCE information for the companies within the group should be supplemented by further comparisons with companies in the same industry. (iii) ROCE may not be an adequate measure if there is heavy inter-company trading, particularly if it is holding company policy to force companies to trade with one another in circumstances which may not be beneficial to all parties. The remedy is to use market-based transfer prices as a basis for calculating each company's profit for ROCE purposes.

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ACP5CE12(J) Exam 2 Solutions

4 Quality and NFPO


Marking scheme
(a) (i) Net cost of current policy (ii) Costs of quality for the business - identify and comment upon (per cost) (iii) Recommended policy and how TQM approach would differ Explanation of difficulties (1 mark per relevant point) Explanation of how (1 mark per relevant point) 2 4 6 3 5 8 20 Marks

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(b)

Suggested solution
Top tips. Part (a) (i) is based on the information given in the question so it is a simple calculation as you will see. Think about the consequences of losing customers and having to replace them. In part (a) (ii), you need to mention all four types of quality costs and explain them. Remember to apply them to the scenario given as you are asked to comment on them for this business. Then in part (a) (iii) you need to make recommendations based on your findings in part (a) (ii). For instance, would you recommend an approach based on compensating customers for a small number faulty goods or would you strive to eliminate all faults before the goods go out the door? Then comment on how a TQM approach to quality costs would differ. Then in (b), you need to make clear points about VFM and qualitative and quantitative measures being appropriate. This is explained in Chapter 15 of the Study text. Easy marks. Mentioning VFM and the three Es in (b) should get you some marks straight away. (a) (i) Assumed number of bad units delivered each year = 10m/1,000 = 10,000 Cost of manufacturing replacements for faulty units 10,000 x $20 Marketing costs for new replacement customers 10,000 x $10 Cost of poor quality Less profit from original sale 10,000 x $5 Net cost of poor quality $000 200 100 300 50 250

Although the cost of the original defective item is recovered, the company still suffers the cost of replacing the item and losing the original customer which means having to market to a new customer. There is also an ongoing loss of reputation which cannot be quantified here. (ii) External failure costs are costs arising from inadequate quality discovered after the transfer of ownership from supplier to purchaser. The manufacturer is happy to incur some level of external failure costs as they have a replacement policy. In this example the cost of replacements, of defects and of new marketing are external failure costs as these are incurred because of inadequate quality which is not discovered until after transfer of ownership. Internal failure costs arise as a result of inadequate quality but before the transfer of ownership to purchaser. Examples of each include reinspection costs and the cost of repair of faulty goods discovered during the manufacturing process.

ACP5CE12(J) Exam 2 Solutions

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A traditional view of quality costs identifies these as costs of non-conformance which rise in proportion to the percentage of defects identified. Other quality costs are known as costs of conformance. These consist of prevention costs and appraisal costs. These are costs incurred prior to or during production to prevent defects arising, and costs incurred in order to ensure that the output meets required quality standards. This manufacturer does incur appraisal costs as goods are inspected prior to dispatch. The costs of conformance fall as the percentage of defects increases. A traditional view of the costs of quality holds that there is an optimal level of quality effort at which the total costs of quality are at a minimum. (iii) As stated above, it appears that the manufacturer already incurs appraisal costs since the goods are inspected prior to dispatch. A recommended policy would be to establish the reasons for the faults (an internal failure cost) and the extent of the problem be more precisely ascertained (appraisal cost) as it is not known that all dissatisfied customers return their goods though it is almost certain that their business is lost. Once this has been done it will be possible to decide whether, by spending more on prevention, the overall cost of quality can be reduced. TQM differs to the approach already discussed in that it believes that there should not be an optimal level of quality at which some failures occur. The target should be zero defects. Quality costs are difficult to measure and failure costs in particular. The real costs of failure also include management time sorting out problems and the loss of confidence both inside the organisation and in the market place. So TQM is based on the view that: 1. It is better to spend money on prevention before failure occurs than on inspection to detect failures after they arise. Prevention and appraisal costs are subject to management control. Extra effort on prevention will reduce internal failure costs and therefore external failure costs as well. These costs reduce as a consequence of the efforts spent on prevention and appraisal.

2.

(b)

Performance measurement in not-for-profit organisations is difficult because of the problem of identifying a measure of performance that is objective, relevant, easily determined and understood by all the interested parties. In 'profit-seeking' firms, profit and profitability provide a useful method of assessing the level of success against the objectives of the firm. The absence of financial objectives makes it much more difficult to assess performance in a not-for-profit organisation, however. It is therefore important that the management of such an organisation focuses attention on the areas of economy, efficiency and effectiveness. By developing appropriate performance measures, it will be possible to monitor the amount of resources used, the relationship between the input and outputs of the operation and the extent to which the objectives of the organisation are achieved. Bowman and Asch highlight the difficulty in measuring performance. In developing a system to measure performance, the management accountant should select the performance indicators at the planning stage of the process. It is often necessary for a considerable amount of ingenuity and creativity to be used in developing useful non-financial indicators. Performance indicators should cover all aspects of the performance of the organisation and this can result in conflicts between the different measures. While it is possible for the goals and objectives of a not-for-profit firm to be very clear, considerable difficulty may be experienced in assessing the success in reaching the goals. This is because of the difficulties in measuring performance. Both quantitative and qualitative performance indicators will need to be chosen to provide a basis of judging the extent to which the goals of the organisation are achieved. 14 ACP5CE12(J) Exam 2 Solutions

5 JIT
Marking scheme
(a) Discussion of four benefits (i) reduction in inventories (ii) increase in labour productivity (iii) reduction in plant space (iv) reduction in quality rejection rates Explanation of timing needed (b) Developments needed (2 marks each. Max 8 marks) Marks max 3 max 3 max 3 max 3 max

10 2 112 8 20

Suggested solution
Top tips. In (a) start your answer with an introduction to JIT and explain that there are two aspects being purchasing and production. Ensure you refer to the four improvements mentioned in the quotation in your answer. Then in (b) think about the features of JIT such as a reduction in inventory which mean certain aspects of traditional management accounting reporting are now redundant. Then ask if other measures, such as quality, become more important. Easy marks. You can score a couple of marks in (a) by just stating what JIT is and mentioning the two aspects. (a) Just-in-time (JIT) has emerged from criticisms of traditional responses to the problems of improving manufacturing capacity and reducing unit costs of production. The JIT approach involves a continuous commitment to the pursuit of excellence in all phases of manufacturing systems and design. The aims of JIT are to produce the required items, at the required quality and in the required quantities, at the precise time they are required. In particular, JIT aims to achieve the following. (i) (ii) (iii) (iv) (v) (vi) The elimination of non-value-added activities Zero inventory Zero defects Batch sizes of one Zero breakdowns A 100% on-time delivery service

There are two aspects to JIT systems, JIT purchasing and JIT production, both of which assist in the benefits highlighted by Aggrawal. (i) Reduction in inventories JIT purchasing seeks to match the usage of materials with the delivery of materials from external suppliers. This means that material inventories can be kept at near-zero levels. For JIT purchasing to be successful this requires the organisation to have confidence that the supplier will deliver on time and that the supplier will deliver materials of 100% quality, that there will be no rejects, returns and hence no consequent production delays. The reliability of suppliers is of utmost importance and hence the company must build up close relationships with their suppliers. This can be achieved by doing more business with fewer suppliers and ACP5CE12(J) Exam 2 Solutions 15

placing long-term orders so that the supplier is assured of sales and can produce to meet the required demand. Such factors will enable inventory levels to be kept as near to zero as possible and help to produce Aggrawal's claimed benefit. (ii) Increase in labour productivity In a JIT production environment, production processes must be shortened and simplified. Each product family is made in a work cell based on flowline principles. The variety and complexity of work carried out in these work cells is increased (compared with more traditional processes), necessitating a group of dissimilar machines working within each work cell. Workers must therefore be more flexible and adaptable, the cellular approach enabling each operative to operate several machines. Operatives are trained to operate all machines on the line and undertake routine preventative maintenance. It is factors such as these that result in an increase in labour productivity in a JIT environment. (iii) Reduction of necessary plant space With JIT production, factory layouts must change to reduce movement of workers and products. Traditionally machines were grouped by function. All the drilling machines were together, all the grinding machines were together and so on. A part therefore had to travel long distances, moving from one part of the factory to the other, often stopping along the way in a storage area. All these are non-value-added activities which have to be reduced or eliminated. Material movements between operations are therefore minimised by eliminating space between work stations and grouping dissimilar machines into manufacturing cells on the basis of product groups. Storage space is reduced due to the reasons set out in (i) above. Plant space is therefore kept to a minimum. (iv) Reduction in quality rejection rates Production management within a JIT environment seeks to both eliminate scrap and defective units during production and avoid the need for reworking of units. Defects stop the production line, thus creating rework and possibly resulting in a failure to meet delivery dates. Quality, on the other hand, reduces costs. This level of quality is assured by designing products and processes, introducing quality awareness programmes and statistical checks on output quality, providing continual worker training and implementing vendor quality assurance programmes to ensure that the correct product is made to the appropriate quality level on the first pass through production. Some of the changes necessary to produce such benefits are quite radical and cannot be implemented overnight. The co-operation of workers is vital and they must be trained and will need many hours of practice. Close relationships with suppliers cannot be established straight away. They must be built up over time as trust between the two parties develops. It is therefore obvious that the benefits cannot be expected to appear within 24 hours but must be developed gradually to allow the full benefits of JIT to materialise. (b) Necessary developments in an organisation's management accounting system due to implementation of JIT include: (i) There will be no need for an elaborate cost accounting system of stores requisitions; materials transfer notes and so on, since inventories will be very low or non-existent. Many material purchases should be capable of being traced direct to cost units. Since production only occurs when demand arises, the output will not be held in inventory and accounting entries can be made as the goods are sold. A backflush accounting system could be used instead, whereby accounts for inventory are not kept and the purchase of materials is recorded only when the sale is made.

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ACP5CE12(J) Exam 2 Solutions

(ii)

A system of economic batch quantities for inventory control will no longer be valid since products will be manufactured as they are needed and not manufactured for inventory. Inventory will be ordered and produced as needed to satisfy demand. instead, The system will need to be able to provide information for non-financial performance measures such as the percentage of quality control rejects, the ratio of machine downtime to productive time and the delivery by suppliers against quality or timing standards. Delivery and waste will become more important than economic batches. Traditional variance analysis as a control technique is not compatible with a JIT environment. In traditional management accounting environments, adverse efficiency variances should be avoided, which means that managers should try to prevent idle time. This could result in the manufacture of unwanted products that must be held in store and might eventually be scrapped. Hence efficiency variances could, in a JIT environment, focus management attention on the wrong problems. In a JIT environment, the critical issues with materials purchasing are supplier reliability, materials quality and delivery in small order quantities. Purchasing managers should not be shopping around every month looking for the cheapest price. Many JIT systems depend on long-term contractual links with suppliers, which means that material price variances are not relevant for management control purposes. Standard costing will still be required but principally as the building blocks for the financial accounts. Actual rather than standard cost will be stressed. To control and reduce costs Kaizen costing should be adopted to focus on small, incremental cost reductions over the products life cycle. Activity based costing would be a more suitable method of calculating product costs than absorption costing. JIT causes changes to the production process and leads to more overheads such as quality assurance, software development and fewer traditional cost drivers such as direct labour and machine hours. The management accounting system must therefore be capable of collecting information to allow the smooth running of an ABC system, for example information on cost drivers such as the number of orders and the collection of total costs into cost pools.

(iii)

(iv)

(v)

ACP5CE12(J) Exam 2 Solutions

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ACP5CE12(J) Exam 2 Solutions

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