THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

STRATEGIC MANAGEMENT ACCOUNTING

PROFESSIONAL 1 EXAMINATION - APRIL 2006

Time Allowed: 3.5 hours and 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. Alexandria Ltd. manufactures high-quality pens. For many years the company manufactured only one type
of pen (namely, ballpoint pens) but last year the company also began to manufacture fountain pens. The
decision to begin manufacturing fountain pens was taken only after the companys marketing manager
confirmed that there was a significant niche market for fountain pens and the companys cost accountant
estimated that the cost of production for such pens would be much less than the selling price predicted by
the marketing manager.

When the fountain pen was introduced, sales (in terms of both quantity and price) were higher than
expected. Nevertheless the overall profits of Alexandria Ltd. have declined steadily. As a result, the cost
accountant decided that he should re-examine his estimate of the cost of producing the fountain pen, with
particular reference to overhead costs. In his original analysis, he allocated all manufacturing overhead
costs to products in proportion to direct labour cost. However, in his re-examination he decided that activity-
based costing (ABC) should be used in order to gain a more thorough understanding of the situation. The
following data is available for the most recent month:

Direct cost of production, per unit of each product:

Ballpoint pen Fountain pen

Direct materials cost 11.25 18.75
Direct labour cost 2.50 5.00

Number of units of each product produced and sold:

Ballpoint pen Fountain pen

Units produced and sold 32,000 4,000

Manufacturing overhead costs for the month:

Activity cost pool Activity measure Cost

Machine running costs Machine hours 91,000
Stores requisitions Number of requisitions 189,500
Materials movements Number of movements 67,500
Production set-ups Number of batches 102,000
Total = 450,000

Page 1
 Activity levels in relation to each product:

Activity Ballpoint pen Fountain pen Total

Machine hours 7,500 10,000 17,500
Number of requisitions 500 500 1,000
Number of movements 325 125 450
Number of batches 50 25 75

REQUIRED:

(a) Calculate the cost per unit for each of the two types of pen, if all manufacturing overheads are
allocated to products in proportion to direct labour cost.
(4 marks)

(b) Calculate the cost per unit of each of the two types of pen, if all manufacturing overheads are
allocated to products using activity-based costing.
(10 marks)

(c) Explain why the calculated cost per unit of the fountain pen is much higher in part (b) than in part (a),
and suggest what additional factors (i.e., other than those reflected in the calculations here) may
have contributed to the decline in the companys profitability since the fountain pen was introduced.
(6 marks)

[Total: 20 marks]

Page 2
2. Beirut Ltd. manufactures a chemical product called BRT. The company operates a just-in-time production
system, so no stocks of any kind are held. In December of last year, the company prepared a budget for
the first quarter of 2006. That budget assumed that sales for the quarter would be 5,000 units of BRT and
that the contribution per unit would be as follows:

Selling price per unit of BRT 70

Direct labour (2 hours @ 11 per hour) 22
Direct materials (4 kilograms @ 5 per kilogram) 20
Total variable cost per unit of BRT ---- 42
Contribution per unit of BRT 28

The actual outcome for the first quarter of 2006 differed from the budget in a number of respects:

Actual sales were 6,000 units of BRT at a price of 70 each.

The total amount of direct wages paid was 124,550. This was in respect of 10,600 direct labour
hours.

A total of 23,100 kilograms of direct materials were purchased at a price of 6.20 per kilogram.

REQUIRED:

(a) Use variance analysis to reconcile the budget and actual total contribution for the first quarter of
2006, using the data provided above.
(4 marks)

(b) Assume now that, during the first quarter of 2006, the company realised that the budget which it had
prepared in the previous December was based on erroneous assumptions in relation to direct
materials. In particular, because of foreseeable supplier price increases and certain improvements
in the efficiency of the production process, the budgeted cost of direct materials per unit of BRT
should have been 3.8 kilograms of direct materials at a cost of 6 per kilogram.

Use this additional information to prepare detailed planning and operational variances for direct
materials in the first quarter of 2006.
(12 marks)

(c) Explain the practical benefits to management of calculating detailed planning and operational
variances, using the case of Beirut Ltd. to illustrate your answer.
(4 marks)

(Total: 20 marks)

Page 3
3. Cairo Ltd. consists of several autonomous divisions, including "X-Division" and "Y-Division". Each month
"X-Division" purchases 50,000 kilograms of a chemical product ("Chemical A") from an outside supplier at
a price of 6.80 per kilogram. "X-Division" uses the chemical as a raw material in the manufacture of one
of its products.

Cairo Ltd.s managing director is aware that "Y-Division" manufactures "Chemical A" for sale to external
customers. The following is a summary of the typical monthly activities of "Y-Division":

Production and sales Selling price Marginal cost Fixed costs

to external customers (= variable cost)

200,000 kg. 8 per kg. 5 per kg. 120,000 per month

The managing director believes that it might benefit the company as a whole if "Y-Division" were to sell
some output to "X-Division", thus reducing the amount which "X-Division" would need to purchase from its
outside supplier. He has asked the two division managers to try to agree possible transfer pricing
arrangements.

REQUIRED:

N.B.: Answer each of the following three requirements separately.

(a) If the maximum monthly capacity of "Y-Division" is 200,000 kg., will the two divisions be able to agree
on a transfer price? Is this outcome in the best interests of Cairo Ltd. as a whole? Explain your
answer fully.
(6 marks)

(b) Assume now that the maximum capacity of "Y-Division" is 260,000 kg. per month but that demand
from external customers is just 200,000 kg. per month.

Discuss whether, in this situation, it will be possible for the two divisions to agree on a transfer
price.

If the two divisions can agree on a transfer price, by how much will the monthly profits of Cairo
Ltd. as a whole be increased?
(8 marks)

(c) Assume now that the maximum capacity of "Y-Division" is 220,000 kg. per month but that demand
from external customers is just 200,000 kg. per month.

In this situation, suggest a transfer pricing arrangement which would increase the profits of each of
the two divisions and would be optimal for Cairo Ltd. as a whole. Support your answer with
appropriate calculations and explanations.
(6 marks)

[Total: 20 marks]

Page 4
 Section B - Answer any two of questions four, five and six.

4. Damascus Ltd. operates three retail stores. The stores are located in close proximity to each other but are
operated separately because they deal in different types of products. The following are summary income
and expenditure accounts for the three stores for last month, produced by the companys internal
accounting system:
Hardware Interiors Gardening
Store Store Store
Sales 360,000 625,000 535,000
Less: Cost of goods sold 202,000 320,000 288,900
Gross profit 158,000 305,000 246,100
OTHER COSTS:
Salespersons salaries 36,000 45,000 42,000
Salaries of store managers & deputy managers 12,000 16,000 11,000
Depreciation of store fixtures 6,200 8,000 7,800
Store rent 40,000 65,000 50,000
Store lighting & heating 10,200 19,000 17,000
Local radio advertising costs 20,000 34,000 33,000
Share of newspaper advertising costs of
Damascus Ltd. 5,040 8,750 7,490
Share of head office salaries & expenses 20,160 35,000 29,960
Depreciation of delivery vehicles 1,400 1,400 1,400
Salaries of delivery vehicle crews 3,000 3,000 3,000
Employee fringe benefits 14,232 19,800 17,192
Net profit (loss) (10,232) 50,050 26,258

The managing director of Damascus Ltd. has suggested that the hardware store should be shut down
because it has reported losses for several successive months. However the management accountant has
warned of the need for careful analysis before any decision is made, and has assembled the following
additional information:
1. If the hardware store were closed then all salespersons, managers and deputy managers employed
in that store would be laid off. The only exception would be one manager who currently earns 7,000
per month and who would be transferred to Damascus Ltd.s head office where she would work as
an analyst and would continue to be paid her existing salary. If the hardware store were not closed
then head office would recruit a new analyst who would be paid 5,000 per month.
2. If the hardware store were closed then all of its fixtures would be transferred for use in the companys
other stores.
3. The hardware store is located in a building which the company has leased for some years. The lease
will expire shortly. The company must decide within the next three months whether or not to renew
the lease for another ten year term.
4. Because the three stores carry very different product ranges, there are separate local radio
advertising campaigns for each store. However, the company places "general purpose"
advertisements in the newspapers to publicise the company name, and the costs of such advertising
are allocated among the three stores in proportion to sales revenues.
5. Head office salaries and expenses are also allocated among the three stores in proportion to sales
revenues.
6. Because the stores are located in close proximity to each other, they share a single set of delivery
vehicles and crew. No vehicles would be disposed of if the hardware store were closed, but one crew
member (whose salary is 2,000 per month) would be laid off because of the reduced work load.
7. The reduced workload due to the closure of the hardware store would also lead to the laying off of
one administrative staff member at head office. This staff member is paid 3,500 per month.
8. The company incurs employee fringe benefits costs amounting to 20% of all salaries.

Page 5
REQUIRED:

(a) Prepare calculations to indicate the increase or decrease in the short run monthly profit of Damascus
Ltd. which would result from the closure of the hardware store. State and justify any assumptions
which you make
(11 marks)

(b) The manager of the hardware store has been summoned to make a presentation to the managing
director, in which she must justify the argument that it makes good business sense in the long run
for Damascus Ltd. to continue to operate the hardware store. She has devoted a lot of effort to
developing the business of the hardware store, and believes that it can be very profitable in the long
run, but she recognises that the managing director will not be easy to convince.

Explain three management accounting techniques which would be significantly useful to the
manager of the hardware store in making this presentation. In your answer, explain fully the
usefulness of your chosen techniques for this purpose.
(9 marks)

[Total: 20 marks]

Page 6
5. Eilat Ltd. manufactures a range of electronics products. Technical staff recently developed a design for a
new type of in-car music player which can be used to play CDs, digital downloads, and cassette tapes. The
board of the company has asked the marketing, financial, and production directors to evaluate the design
before a decision is made as to whether to begin production of the music player.

The marketing director has suggested that 90 would be a suitable selling price for the music player and
that 6,000 units per annum would be sold at this price. Variable selling costs would amount to 12 per unit
sold.

The financial director has estimated that the new capital equipment required in order to manufacture the
music player would cost 3,000,000. The company requires an annual return on investment (ROI) of 8%
on all capital investments.

The production director has not yet finalised her estimate of the cost of manufacturing the music player.
However she has commented that the design has certain features which are likely to add to the complexity
and cost of the manufacturing process without significantly enhancing the attractiveness of the product to
potential customers.

REQUIRED:

(a) Using the data provided above, calculate the target cost of manufacturing the music player, and
explain fully the significance of this figure.
(8 marks)

(b) Assume now that the production director has estimated the cost of manufacturing the music player
(using the recently-developed design) at 55 per unit and has suggested that the company should
accept a reduced ROI if necessary. Calculate the ROI if this suggestion is accepted and comment
on the production directors suggestion.
(6 marks)

(c) It is often stated that target costing is most likely to be effective when products are still at the design
stage (i.e., before any production begins) and when comprehensive information about cost driver
rates is available from the companys accounting system. Explain why this is so.
(6 marks)

[Total: 20 marks]

Page 7
6. Famagusta Ltd., which operates a number of retail stores, recently made a decision in principle to open a
new store in a retail park near the M4 motorway. Suitable store premises have been identified (which the
company can either buy or lease) and the company is confident that the new store will be a major
commercial success. For purposes of analysis it can be assumed that the store will operate for 10 years.

The cost of purchasing the premises would be 2,600,000. 1,200,000 of this amount would be payable
immediately and the balance would be payable in equal instalments at the end of each of the next 4 years.
The premises would be sold in 10 years time for an estimated 2,800,000. Repairs and maintenance costs
of the building (amounting to 80,000 per annum) would be payable at each of the next 10 years.

Alternatively Famagusta Ltd. could lease the same premises. The term of the lease would be 10 years,
with the lease payments of 150,000 per annum falling due at the beginning of each year. Famagusta Ltd.
would be required to pay a security deposit of 100,000 to the owner of the building at the beginning of
the lease, but this would be refunded in full to Famagusta Ltd. at the end of the lease. Because Famagusta
Ltd. would not be the owner of the building it would be liable for only 25% of the annual repairs and
maintenance costs.

The companys cost of capital is 8% per annum.

REQUIRED:

N.B.: Tables of present value and annuity factors are available with this paper.

(a) Should Famagusta Ltd. purchase or lease the new premises? Support your answer with appropriate
calculations using the net present value method.
(10 marks)

(b) One of the companys directors has pointed out that the figure of 2,800,000 is only a rough estimate
of the potential resale value of the premises in 10 years time. What change in the estimated resale
value would cause you to reverse your recommendation in your answer to part (a) above?
(4 marks)

(c) Despite its theoretical weaknesses, the payback method continues to be one of the most widely-
used capital budgeting techniques. Apart from its simplicity, what do you consider to be two major
reasons for its continued popularity?
(6 marks)

[Total: 20 marks]

END OF PAPER

Page 8
 Suggested Solutions

STRATEGIC MANAGEMENT ACCOUNTING

PROFESSIONAL 1 EXAMINATION - APRIL 2006

Solution 1
Alexandria Ltd.

Part (a):

Total manufacturing overhead costs = 450,000.

Total direct labour costs = (32,000 * 2.50) + (4,000 * 5) = 100,000.
Hence: overhead allocation rate = 450% of direct labour cost.
Hence: unit costs:

Ballpoint pen Fountain pen

Direct materials 11.25 18.75
Direct labour 2.50 5.00
Manufacturing overhead 450% * 2.50 = 11.25 450% * 5.00 = 22.50
Totals 25 46.25

Part (b):

Cost driver rates:

Machine running cost: 91,000 / 17,500 = 5.20 per machine hour
Stores requisitions: 189,500 / 1,000 = 189.50 per requisition
Materials movements: 67,500 / 450 = 150 per movement
Production set-ups: 102,000 / 75 = 1,360 per batch

Manufacturing overhead costs of each product:

Ballpoint pen Fountain pen

Machine running costs
Stores requisitions
Materials movements
Production set-ups
Total
7,500 * 5.20 = 39,000 10,000 * 5.20 = 52,000
500 * 189.50 = 94,750 500 * 189.50 = 94,750
325 * 150 = 48,750 125 * 150 = 18,750
50 * 1,360 = 68,000 25 * 1,360 = 34,000
250,500 199,500

Hence: ABC unit costs:

Ballpoint pen Fountain pen

Direct materials 11.25 18.75
Direct labour 2.50 5.00
Manufacturing overhead 250,500 / 32,000 = 7.83 199,500 / 4,000 = 49.875
Totals 21.58 73.625

Page 9
Part (c):

The fountain pen is much more expensive under ABC because it accounts for a much higher proportion of
cost driver activities than of total direct labour cost, as the following table shows:

Ballpoint pen Fountain pen Total

% of all machine hours 42.9% 57.1% 100%
% of all requisitions 50% 50% 100%
% of all movements 72.2% 27.8% 100%
% of all batches 66.7% 33.3% 100%
% of total direct labour cost (2.50*32,000) (5.00*4,000) 100%
/100,000 = / 100,000 =
80% 20%

Other possible reasons for the decline in profitability:

1. The increase in demand for the fountain pen may have resulted in a decrease in demand for the
ballpoint pen, so that there was no overall gain.

2. Non-manufacturing overheads have not been included in the analysis. For example, there are often
very high distribution and marketing costs for niche products such as the fountain pen.

3. There may have been across-the-board increases in costs, e.g., an increase in labour costs caused
by labour shortages or an increase in the statutory minimum wage.

Tutorial notes:

Purpose of question: To test candidates ability to implement an activity-based costing system, to illustrate
and discuss how the results differ from the situation in which a simplified costing system is used, and to
use the results of the analysis for strategic management purposes (syllabus topics 1 and 5).

Links: None.

Options: In part (c), the calculations are not essential, provided that the reasons for the difference in the
two product cost figures are explained clearly in words. As for the other possible reasons for the decline
in profitability, the points given above are examples and alternatives are acceptable.

Essential components: Candidates need to be able to perform the calculations for the two costing systems,
and to make use of the results in addressing the points raised in part (c).

Page 10
Solution 2:
Beirut Ltd.

Part (a):

Budgeted contribution = (5,000 * 28) = 140,000.

Actual contribution = (6,000 * 70) - 124,550 (23,100 * 6.20) = 152,230.

Sales Volume Variance

= (AQ BQ) * Standard Contribution = (6,000 5,000) * 28 = 28,000 F.

Direct Labour Usage Variance

= (AH SH) * Standard Wage Rate = (10,600 12,000) * 11 = 15,400 F.

Direct Labour Wage Rate Variance

= Actual Labour Cost - (AH * SWR) = 124,550 (10,600 * 11) = 7,950 U.

Direct Materials Usage Variance

= (AU SU) * Standard Price = (23,100 24,000) * 5 = 4,500 F.

Direct Materials Price Variance

= (AP SP) * AU = (6.20 5) * 23,100 = 27,720 U.

Reconciliation:

Budgeted contribution 140,000

Sales volume variance 28,000 F
Direct labour usage variance 15,400 F
Direct labour wage rate variance 7,950 U
Direct materials usage variance 4,500 F
Direct materials price variance 27,720 U
Actual contribution 152,230

Part (b):

Preliminary: Figures required for planning & operational variance calculations:

XASP: Ex ante standard price per kilogram 5

XPSP: Ex post standard price per kilogram 6
AP: Actual price per kilogram 6.20
XASQ: Ex ante standard quantity 6,000 * 4 kg. = 24,000 kg.
XPSQ: Ex post standard quantity 6,000 * 3.8 kg. = 22,800 kg.
AQ: Actual quantity 23,100

Planning Variance: Direct Materials Price

= (XPSP XASP) * XPSQ = (6 5) * 22,800 = 22,800 U.

Planning Variance: Direct Materials Usage

= (XPSQ XASQ) * XASP = (22,800 24,000) * 5 = 6,000 F.

Operational Variance: Direct Materials Price

= (AP XPSP) * AQ = (6.20 6) * 23,100 = 4,620 U.

Operational Variance: Direct Materials Usage

= (AQ XPSQ) * XPSP = (23,100 22,800) * 6 = 1,800 U.

Page 11
Part (c):

Planning variances are attributable to errors in the original budget, especially the use of inappropriate or
unrealistic assumptions. Operational variances are caused by operational inefficiencies, i.e., discrepancies
between what was actually achieved and what could realistically have been achieved.

Management can best react to planning variances by trying to improve the accuracy of the budget process
in future. By contrast, the appropriate response to operational variances is to try to pinpoint the reasons
why inefficiencies occurred, with a view to preventing their future recurrence. Since the two types of
variance require different responses from management, the ability to respond appropriately depends on
knowing which type of variance has occurred.

In the case of Beirut Ltd., the basic variance analysis in part (a) indicates only that there has been a very
large and unfavourable direct materials price variance, which was counterbalanced to a limited degree by
a much smaller favourable direct materials usage variance. However the detailed analysis in part (b)
indicates that more than 100% of the favourable direct materials usage variance was due to factors
foreseeable in December 2005, and in fact there is an unfavourable operational variance for direct
materials usage (and price). Planning errors have been a significant reason for the company not reaching
its budget contribution, but there have also been significant operational inefficiencies.

Tutorial notes:

Purpose of question: To test candidates ability to calculate (and explanation the significance of) variances,
especially planning and operational variances. (Syllabus Topic 3).

Links: None.

Options: The format of calculations may vary in parts (a) and (b), and candidates may structure the answer
to part (c) differently.

Essential components: Candidates need to be able to calculate the variances required. They also need to
be able to explain the usefulness of planning and operational variances, and to use the case of Beirut Ltd.
to illustrate this usefulness (i.e., it is not sufficient to rely on theoretical explanations without referring to the
details of the specific case).

Page 12
Solution 3:
Cairo Ltd.

Part (a):

The maximum transfer price which X-Division will be willing to pay is 6.80 per kg. (the price charged by
the external supplier).

The minimum transfer price which Y-Division will be willing to accept:

- Marginal cost of production = 5.
- Opportunity cost of transfer = 8 - 5 = 3 [because: no spare capacity].
- Minimum transfer price = 5 + 3 = 8.

The maximum price which X-Division will be willing to pay is less than the minimum transfer price which Y-
Division will be willing to accept, so the divisions will not be able to agree a transfer price.

The outcome is goal congruent. Each unit "diverted" from an external customer to X-Division would reduce
the companys revenues by 8 and would reduce costs by only 6.80. It is in the companys best interests
that no such transfers will take place.

Part (b):

The maximum transfer price which X-Division will be willing to pay is 6.80 per kg. (the price charged by
the external supplier).

The minimum transfer price which Y-Division will be willing to accept:

- Marginal cost of production = 5.
- Opportunity cost of transfer = NIL [because: all of X-Divisions needs can be manufactured using
Y-Divisions spare capacity].
- Minimum transfer price = 5 + NIL = 5.

It is likely that the two divisions will be able to agree on a price somewhere in the range between 5 and
6.80. If they can agree a price somewhere within this range then both divisions profits will increase.

It is possible that intransigence by one or both division managers might lead to a failure to agree. For
example, X-Division might refuse to offer more than 6 and Y-Division might refuse to accept less than
6.50, because each division wants to maximise its share of the increased profit at the expense of the
other division. However in the longer term both division managers are likely to recognise that failure to
agree will mean no additional profits for either division, so it is in their own best interest to reach agreement.

Increase in Cairo Ltd.s profits, if agreement is reached

= (6.80 - 5) * 50,000 kg. = 90,000.

Part (c):

The maximum transfer price which X-Division will be willing to pay is 6.80 per kg. (the price charged by
the external supplier).

The minimum transfer price which Y-Division will be willing to accept:

- Marginal cost of production = 5.
- Opportunity cost of transfer for the first 20,000 kg. of X-Divisions needs = NIL [because: these units
can be manufactured using Y-Divisions spare capacity].
- Opportunity cost of transfer for the remaining 30,000 kg. of X-Divisions needs = 8 - 5 = 3
[because: no spare capacity].
- Minimum transfer price for first 20,000 kg. = 5 + NIL = 5.
- Minimum transfer price for remaining 30,000 kg. = 5 + 3 = 8.

Page 13
 Proposed transfer pricing arrangement:
- First 20,000 kg.: 0.5 * (6.80 + 5) = 5.90. [This will be acceptable to both divisions, allowing
transfers to take place in accordance with the companys best interests, and splitting the incremental
profits equitably between the two divisions].
- Next 30,000 kg.: 8. [Any such transfers would displace sales to external customers, and should
therefore be priced at the external sales price. No transfers will take place which is optiomal].

Increase in profits, to each division and the company:

X-Division Y-Division Cairo Ltd.

(6.80 - 5.90) * 20,000 (5.90 - 5.00) * 20,000 (6.80 - 5.00) * 20,000

= 18,000 = 18,000 = 36,000

Tutorial notes:

Purpose of question: To test candidates ability to apply their knowledge of transfer pricing, including the
implications of such issues as capacity constraints, divisional autonomy, and goal congruence in the
context of transfer pricing. (Syllabus topic 4).

Links: Capacity constraints (limiting factors) also arise in syllabus topic 2.

Options: There is scope for variation in part (c) since candidates are free to outline any transfer pricing
system provided it meets the specific objectives and provided that they support their proposed scheme with
suitable explanations and calculations.

Essential components: Candidates need to be able to apply their knowledge of transfer pricing to the
specific situations outlined in the question, and not merely write down textbook knowledge of transfer
pricing. This application needs to include detailed explanations and suitable calculations where
appropriate.

Page 14
Solution 4:
Damascus Ltd.

Part (a):

Loss of sales revenue 360,000

Less: Costs saved:
Costs of goods sold 202,000
Salespersons salaries 36,000
Managerial salaries (net): 12,000 - 2,000 = 10,000
Depreciation of fixtures 0
Store rent 40,000
Store light & heat 10,200
Local radio advertising 20,000
Newspaper advertising 0
Head office salaries & expenses 3,500
Depreciation of delivery vehicles 0
Salaries of delivery vehicle crews 2,000
Employee fringe benefits:
20% * (36,000 + 10,000 + 2,000 + 3,500) = 10,300
Total costs saved 334,000
Decrease in net profits 26,000

Therefore closing the hardware store would adversely affect Damascus Ltd.s profits.

Part (b):

Examples of management accounting techniques which would be useful for this purpose:

1. Variance analysis, especially incorporating a trend element. For example it may be that the hardware store
has experienced a series of adverse variances but that these have been getting steadily smaller, indicating
progress towards achieving budgetary expectations. This would provide support for the store managers
belief in the long-term profitability of the business.

2. Net present value. The decision as to whether or not to close the store can be treated as a capital
budgeting decision, which implies that all cash flow consequences would be considered, without restriction
as to time period and including (for example) any effect on sales in the other stores as a result of them
being co-located. If the NPV of keeping the store open exceeds the NPV of closing it, then this would also
provide support for the store managers belief in the long-term profitability of the business.

3. Return on Investment or Residual Income. These are common measures of subunit performance. Of
course if profits have been negative then ROI/RI will also not be favourable (relative to the required return)
in a single period. However there may be evidence that performance, from analysis over several years, of
improvement in ROI/RI, and if so then this supports the hardware store managers case.

4. Non financial performance measures, such as those typically found in a balanced scorecard, may provide
evidence of ongoing progress that the key success factors required for long-term business success are in
place. For example if measures of customer satisfaction and repeat business are indicating strong
improvement in the customer theme, then this is good evidence that the hardware store is likely to have
the loyal customer base required for long run financial success.

Tutorial notes:

Purpose of question: To test candidates understanding of decision-making both in the short run (syllabus
topic 2) and specifically in the context of strategic management accounting (syllabus topic 5).

Page 15
 Links: Part (b) requires candidates to make the case for using three management accounting techniques
for strategic purposes. In principle these may be from any section of the syllabus, but in practice are
probably most likely to come from syllabus topics 3 and 4.

Options: Answers in part (b) are likely to be extremely varied, since candidates are required to make their
own choice of management accounting technique and justify its use in the given context.

Essential components: Candidates need to be able to perform calculations relevant to short-run decision-
making for part (a), and to state and justify assumptions if necessary. To answer part (b) well, it is essential
to make a strong case as to how the particular selected management accounting technique would be likely
to be useful for the purpose indicated in the question.

Page 16
Solution 5:
Eilat Ltd.

Part (a):

Target cost of manufacturing:

Sales: 6,000 units @ 90 540,000

Required return on investment: 8% * 3,000,000 240,000
Target cost (total) 300,000
Target cost (per unit) 300,000 / 6,000 50
Variable selling costs (per unit) 12
Target manufacturing cost per unit 50 - 12 38

The significance of this figure is that production cannot begin unless the firm is confident that the cost of
manufacturing the product (given its existing design) will be 38 per unit or less. The technical staff should
be asked to revise the design if necessary so that the cost of manufacturing the product can be reduced
to 38 or less. If this cannot be achieved then the firm cannot manufacture the product.

Part (b):

ROI in these circumstances:

Profit = (90 - 12 - 55) * 6,000 = 138,000.
ROI = 138,000 / 3,000,000 = 4.6%.

Comments:
The company cannot accept this suggestion. The company has determined that a return of 8% is required
for investments, and it must achieve this rate if the profits from the new music player are to be adequate
to cover the cost of the finance obtained in order to fund the 3,000,000 capital investment.

Instead of accepting a lower ROI or abandoning the idea of the new music player, a better idea would be
to ask the technical staff to modify the design so as to reduce the manufacturing cost per unit. The
production director herself has suggested that the design incorporates costly features which add little value
to the product, so there should be considerable scope for design change. For example, cassette tapes are
now widely considered to be an out-of-date technology, so the cassette-playing feature of the music player
could probably be removed without significantly damaging demand for the product.

Part (c):

Target costing is most effective while the product is still at the design stage because it is at this stage that
there is maximum scope for modifying the design in order to make cost savings. Once production has
commenced, the designs of the product and the manufacturing process are much more difficult to change.
It is often said that the vast majority of production costs are effectively committed by the time production
begins.

Knowledge of cost driver rates is required so that it is possible to accurately estimate the amount of cost
which will be saved if the design is changed in order to eliminate an unnecessary activity or feature. For
example if the cost driver rate for repair is known then it is possible to estimate the cost savings which will
result from decreasing the proportion of defective output. By contrast, if all overhead is allocated to
products on a labour hour basis, then this may give the completely false impression that reducing the
labour content of a product can generate significant savings in overhead costs.

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Tutorial notes:

Purpose of question: To test candidates knowledge of the theory and practice of target costing (syllabus
topic 2) and some basic use of return on investment (syllabus topic 4).

Links: Part (c) requires an appreciation of activity-based cost management (syllabus topic 5).

Options: The scope for variations from the above solution is quite limited. This is because the calculations
required in parts (a) and (b) are very clearly specified in the question, and the theoretical issues arising in
all three parts of the question are all quite fundamental to this technique. Of course, candidates may have
their own examples etc.

Essential components: Candidates need to be able to perform target costing and ROI calculations. They
need to understand how target costing is used in organisations for strategic decision-making purposes and
understand the circumstances in which target costing is most likely to be effective.

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Solution 6:
Famagusta Ltd.

Part (a):

PV of costs if the store is purchased:

Cash flow Time PV factor PV

Purchase 1,200K Y0 1 1,200,000
Purchase 350K Y1-Y4 3.312 1,159,200
Resale (2,800K) Y10 0.463 (1,296,400)
Repairs & maintenance 80K Y1-Y10 6.710 536,800
Total 1,599,600

PV of costs if the store is leased:

Cash flow Time PV factor PV

Lease payments 150K Y0-Y9 1+6.247 = 7.247 1,087,050
Security deposit 1000K Y0 1 100,000
Security deposit refund (100K) Y10 0.463 (46,300)
Repairs & maintenance 20K Y1-Y10 6.710 134,200
Total 1,274,950

The store should be leased because the costs have a lower PV.

Part (b):

Difference in PVs = (1,599,600 - 1,274,950) = 324,650.

PV factor attaching to cash flows in Year 10 = 0.463.
Hence: to reverse the decision, the resale value would have to be at least:
2,800,000 + (324,650 / 0.463 = 701,188) = 3,501,188.

Part (c):

Two major reasons for the continued popularity of the payback technique:

The payback technique is very widely used as a screening device. Projects which have very long payback
times are not even considered for detailed NPV analysis. This ensures that time and resources are not
devoted to detailed analysis of investment proposals which are very unlikely to be accepted.
Liquidity is a significant consideration for many firms in capital budgeting decisions. A rapid payback is an
advantage to such firms since it means that scarce funds are made available quickly either for the next
capital budgeting project or for paying current liabilities.

Tutorial notes:

Purpose of question: To test candidates understanding of capital budgeting (syllabus topic 3). This
includes situations where uncertainty attaches to some of the estimates, as in Part (b) of this question.
Links: Solving part (b) involves using an approach similar to a cost-volume-profit analysis calculation
(syllabus topic 2).
Options: There is a range of acceptable answers to part (c), which asks candidates to outline two major
reasons for the popularity of payback.
Essential components: Candidates need to be able to perform NPV calculations, including proper use of
the annuity present value tables. They also need to be able to identify and explain the main reasons for
the continued popularity of the payback method.

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 MARKING SCHEME

Question 1: Alexandria Ltd.

Part (a): Non-ABC based calculations 4

Part (b): Cost driver rates 3
Product costs on ABC basis 7
Part (c): Explanation why results are different 2
Other factors contributing to the decline in profitability
(TWO good points expected) 4
TOTAL: 20

Question 2: Cairo Ltd.

Part (a): Budget & actual contributions, and reconciliation 1

Sales volume variance 1
Direct labour variances 1
Direct materials variances 1
Part (b): Planning & operational variances: 4 variances @ 3 marks each 12
Part (c): Explanation of benefits of calculating planning & operational
variances, with specific reference to Beirut Ltd. 4
TOTAL: 20

Question 3: Cairo Ltd.

Part (a): Explanation as to why the divisions will not be able to agree a price 4
Explanation of why this outcome is goal congruent 2
Part (b): Explanation as to why the divisions are likely to be able to agree a price 4
Possible difficulty in agreeing a price 2
Increase in Cairo Ltd.s profits 2
Part (c): Explanation of a transfer pricing scheme which would increase the
profits of both divisions 4
Proof that the scheme is goal congruent 2
TOTAL: 20

Question 4: Damascus Ltd.

Part (a): Calculation of the likely change in company profits 11

Part (b): Justification of three management accounting techniques @ 3 marks each 9
TOTAL: 20

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Question 5: Eilat Ltd.

Part (a): Calculation of target cost of manufacturing 5

Explanation of significance of this figure 3
Part (b): Calculation of ROI 2
Response to suggestion 4
Part (c): Why products should be at the design stage 3
Why cost driver rates are needed 3
TOTAL: 20

Question 6: Famagusta Ltd.

Part (a): PV calculations 8

Recommending that the lower cost option should be chosen 2
Part (b): Calculation of change required in resale value to justify reversing
recommendation 4
Part (c): Explanation of two significant strengths of payback @ 3 marks each 6
TOTAL: 20

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