August 2007 CPPA

8/21/2019 August 2007 CPPA

1/19

NOTESCandidates should answer all three Questions in Section A andtwo Questions from Section B.

All Questions carry equal marks.

SMA TABLES ARE PROVIDED

TIME ALLOWED:3.5 hours, plus 10 minutes to read the paper.

INSTRUCTIONS:During the reading time you may write notes on the examination paper but you may not commence

writing in your answer book.

Marks for each question are shown. The pass mark required is 50% in total over the whole paper.

Start your answer to each question on a new page.

You are reminded that candidates are expected to pay particular attention to their communication skills

and care must be taken regarding the format and literacy of the solutions. The marking system will take

into account the content of the candidates' answers and the extent to which answers are supported with

relevant legislation, case law or examples where appropriate.

List on the cover of each answer booklet, in the space provided, the number of each question(s)

attempted.

STRATEGIC MANAGEMENT ACCOUNTING

PROFESSIONAL 1 EXAMINATION - AUGUST 2007

The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2.

8/21/2019 August 2007 CPPA

2/19

THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND



Time Allowed: 3.5 hours, plus 10 minutes to read the paper. Answer all three Questions from Section A

and any two Questions from Section B.Section A - Questions 1, 2 and 3 are all compulsory

1. Cavan Ltd. manufactures two models of heavy-duty cooking rack suitable for use in restaurant kitchens andsimilar commercial environments. Both models use the same types of raw materials and direct labour. Nostocks are held. The sales budget for the first quarter of this year was as follows:

Model A Model B

Budget sales units 1,800 600

Budget selling prices 150 per unit 105 per unit

This sales budget was based on an assumption that Cavan Ltd.s total sales units would amount to a 40%share of the market in which it operates.

The company operates a standard variable costing system, and the following is a calculation of the standardvariable cost of each product:

Model A Model B

Raw materials 4 kg. @ 15 per kg. = 60 3kg. @ 15 per kg. = 45

Direct labour 2 hours @ 12 per hour = 24 1hour @ 12 per hour = 12

Variable overheads 2 direct labour hours @ 10 1 direct labour hour @ 10per hour = 20 per hour = 10

Totals: 104 67

The actual results for the quarter were as follows:

Model A Model B

Sales 1,320 units @ 150 per unit 880 units @ 105 per unit= 198,000 = 92,400

Raw materials 5,500 kg. @ 15 per kg. 2,700 kg. @ 15 per kg.= 82,500 = 40,500

Direct labour 2,600 hours @ 12.50 per hour 900 hours @12.50 per hour= 32,500 = 11,250

Variable overheads 36,000 6,350

Contribution 47,000 34,300

Published industry data indicated that, in the first quarter of this year, a total of 5,400 heavy-duty cookingracks were sold in the market in which Cavan Ltd. operates.

Page 1

8/21/2019 August 2007 CPPA

3/19

REQUIREMENT:

(a) Calculate the following variances:

Sales mix variance. Sales quantity variance. Market share variance. Market size variance.

(8 marks)

(b) Using your answer to part (a), and such additional variance calculations as you consider necessary,present a reconciliation of the budgeted and actual total company contribution. (A breakdown byproduct is not required).

(6 marks)

(c) Provide clear explanations of the significance of each of the four variances which you calculated inyour answer to part (a).

(6 marks)

[Total: 20 marks]

Page 2

8/21/2019 August 2007 CPPA

4/19

2. Down Ltd. plans to open a new factory where two products (A and B )will be manufactured using a singleset of production facilities. Engineers have estimated that the inputs required to manufacture a unit ofproduct in respect of A and B will be as follows:

Product A Product B

Direct labour hours 4 7

Machine hours 16 12

Raw materials 50 60

The factory manager estimates that, during the first month of production, the average time elapsing betweenproduction and sale of each unit of product will be 10 days in the case of Product A and 15 days in the caseof Product B. She also estimates that 40% of units of Product A and 20% of units of Product B will fail qualitycontrol tests at the end of the production process and will therefore need to be immediately repaired. Theinputs required to repair a unit of each product will be:

Product A Product B

Direct labour hours 3 5

Machine hours 6 4

Raw materials 20 25

Output in the first month will be 20,000 units of Product A and 25,000 units of Product B, and the factorysmachine capacity will be fully utilised at this level of output. The factorys energy costs are variable inproportion to the number of machine hours worked and are estimated at 550,400 per month when thefactory is operating at full capacity. Direct labour is available in any desired quantity at a wage rate of 10per hour.

Storage of products between production and sale is subcontracted to a local warehouse which chargesDown Ltd. in accordance with the quantity and duration of goods stored. Down Ltd. estimates that it willincur storage charges of 345,000 during the first month of production.

Selling prices per unit are 200 per unit for Product A and 230 per unit of Product B.

REQUIREMENT:

(a) For each of the two products, calculate the contribution per unit of output during the first month ofproduction.

(9 marks)

(b) Senior management at Down Ltd. are committed to implementing Just-In-Time production (JIT) andTotal Quality Management (TQM) insofar as possible.

To this end, the company expects that in the second month of production the average times elapsingbetween production and sale of units of each product will be only half of the corresponding times in

the first month. It is also expected that, in the second month of production, 15% of the output ofeach product will fail quality control tests at the end of the production process.

In the second month, the factory will produce at least 20,000 units of product A and 25,000 units ofproduct B (i.e. the same quantities in the previous month). However, there is substantial unfulfilleddemand for both products and any additional machine hours which become available as a result ofthe decrease in the rate of quality control failures will be used in the most profitable way possible.

Calculate the increase in total monthly contribution (i.e. between the first and second months)which will result from the implementation of these changes.

(7 marks)

(c) In the context of quality management, give two examples of appraisal costs and discuss the likelytrend in appraisal costs during the implementation of a total quality management programme.(4 marks)

[Total: 20 marks]

Page 3

8/21/2019 August 2007 CPPA

5/19

3. Donegal Ltd. manufactures a wide variety of products at its factory in Letterkenny. The company operatesan activity based costing system, and has made the following estimates of the factorys overhead costs (andrelated cost driver activities) for next month:

Cost pool Cost driver activity Total costs in pool

Production line set-up 400 set-ups 336,000

Product & equipment testing 5,000 tests 1,000,000

Customer order processing & deliveries 6,000 customer orders 1,440,000

Fixed factory overhead NONE 906,000

Because no cost driver activity can be identified for fixed factory overhead, this cost is allocated to productson a direct labour hour basis. Total direct labour hours in the factory next month are estimated at 300,000.

One of the companys products (Pro-1) is manufactured in batches of 500 units per production run. A totalof 3 tests are carried out during each production run to ensure that quality standards are achieved. It isestimated that, next month, the company will receive a total of 2,000 customer orders for Pro-1 (consisting of 800orders for 100 units per order and a further 1,200 orders for 40 units per order). Production of a unit of Pro-1requires raw materials costing 2.50 as well as one and a half hours of direct labour.

All direct labour in Donegal Ltd. is paid at a rate of 9 per hour. The selling price of each product iscalculated as the full cost of production (including all overhead allocations) plus a 25% markup.

The company operates a just-in-time system. Therefore, no stocks are held and all goods are produced inresponse to customer orders and are immediately delivered to customers.

REQUIREMENT:

(a) Calculate the unit cost of Pro-1 (in accordance with Donegal Ltd.s costing system) and the sellingprice per unit.

(10 marks)

(b) Estimate the incremental contribution which Donegal Ltd. would earn from each of the followingopportunities:

250 extra orders for 40 units of Pro-1 per order. 100 extra orders for 100 units of Pro-1 per order.

N.B.: In answering this part, take each of these two opportunities separately. Assume that the sellingprice per unit would be the same as in part (a).

(5 marks)

(c) Explain what is meant by Customer Profitability Analysis, and discuss why an activity based costingsystem is necessary in order to implement meaningful customer profitability analysis.

(5 marks)

[Total: 20 marks]

Page 4

8/21/2019 August 2007 CPPA

6/19

Section B - Answer any two Questions

4. Fermanagh Manufacturing PLC is a divisionalised company. Jack Maguire is the manager of thecompanys Textiles Division and he is considering the introduction of a new product line. This would requirean immediate investment of 1,000,000 in new fixed assets plus 500,000 in additional working capital.The fixed assets would have a useful life of four years, and the product line would be discontinued at theend of that time.

During each of the four years, 150,000 units of the product would be produced and sold at a price of 18

each. Variable costs of production would be 12 per unit and fixed costs (other than depreciation) wouldamount to 500,000 per annum. It is believed that a cash sum of 200,000 would be received when thefixed assets are sold for scrap at the end of their four year life. However, in accordance with the companysstandard accounting practices, the full purchase cost of the fixed assets would be depreciated on a straightline basis over their useful life (i.e. a zero residual value would be assumed in the calculation of the annualdepreciation charge). The working capital investment would be recovered in full at the end of the projectslife.

The performance of the Textiles Division is measured each year on the basis of Return On Investment (ROI).For this purpose, profit is defined to include any gains or losses on fixed asset disposals and the investmentbase is defined as working capital investment plus the net book value of fixed assets at the beginning of theyear.

Jack Maguire is paid a bonus each year which is linked to the extent by which his divisions actual ROIexceeds the divisions required (or target) ROI. The required rate of return for the Textiles Division is 10%per annum, and this is also the divisions cost of capital. Jacks own financial forecasts indicate that (in theabsence of the proposed investment in the new product line) the Textiles Division will earn a ROI of 15% perannum for the next five years.

Jack plans to leave his current employment within the next two to three years and set up in business as aconsultant to manufacturing companies who could benefit from his experience and advice.

REQUIREMENT:

Note: Present value and annuity tables are available with this paper.

(a) Calculate the ROI of the proposed investment in each of the next four years. Then, explain whether ornot Jack is likely to accept this proposed investment, assuming that he acts to maximise his own self-interest.

(10 marks)

(b) Calculate the net present value of the proposed investment.(4 marks)

(c) The use of ROI as a performance measure does not necessarily ensure that a division manager willtake decisions which are in shareholders best interests. Give three examples of why this so, using the

case of Fermanagh Manufacturing PLC to illustrate.(6 marks)

[Total: 20 marks]

Page 5

8/21/2019 August 2007 CPPA

7/19

5. Monaghan Ltd. manufactures advanced technical components for the computer hardware industry.

The companys Unu Division manufactures a special subcomponent at a variable cost of 70 per unit. Thisdivisions maximum monthly production capacity is 27,000 units, but its actual production each month is25,000 units. Of this actual monthly production, 15,000 units are sold to external customers (at a price of100 each) while the remaining 10,000 units are transferred to the companys Du Division at the sameprice.

The Du Divisions maximum production capacity is 13,500 units per month. However, market demand for

the divisions product is only 10,000 units and therefore production is carried out at this level. In producingone unit of its product, Du Division uses one unit of the subcomponent purchased from Unu Division andincurs additional variable costs of 90 per unit. The selling price of Du Divisions product is 200 per unit.

The Du Division recently received an enquiry from a new customer, who has offered to purchase 3,000 unitsof that divisions product each month at a price of 185 per unit.

REQUIREMENT:

(a) Prepare calculations to indicate the increase in the monthly profits of Monaghan Ltd., if the new

customers offer is accepted. (7 marks)

(b) Prepare calculations to indicate whether the existing transfer pricing arrangements would motivateeach of the two divisions to cooperate in transferring the 3,000 subcomponents needed in order tomanufacture the new customers order.

(6 marks)

(c) Identify the minimum transfer prices which would be acceptable to Unu Division and identify themaximum transfer prices which would be acceptable to Du Division. Then, suggest a transfer priceper unit for the 3,000 subcomponents which would achieve the following:

The incremental profits from doing business with the new customer are to be shared equallybetween the two divisions.

The same transfer price per unit is to apply to all units transferred.(7 marks)

[Total: 20 marks]

Page 6

8/21/2019 August 2007 CPPA

8/19

6. Tyrone Ltd. manufactures specialised engineering products. The items produced are of high quality butare fragile by nature and therefore the packaging process must be carried out with some care.

The companys product development staff recently completed design work on a new product (the TLX).Comparison with competitors products indicates that 20 per unit is a realistic selling price for the TLX. Thecompany requires a 35% margin on selling price from all products in order to ensure an adequate company-wide return on investment. Production and sales of TLX are estimated at 13,000 units per annum.

According to the design specifications, the TLX is to be produced in batches of 500 units and packaged in

batches of 25 units. Overhead costs amount to 2,000 for each batch of 500 units produced and a further125 for each batch of 25 units packaged.

The design specifications also indicate that the manufacture of each unit of TLX will require 3 units ofComponent #1 and 5 units of Component #2. Component #1 is a new item which Tyrone Ltd. will have tomanufacture at a cost of 0.20 (variable) each plus 4,000 for each batch of 10,000 units of this component.Component #2 is used regularly by the company and can be purchased in any desired quantity from areliable supplier for 0.55 each. The labour cost of fitting these components in the manufacture of TLX isestimated at 0.45 per unit of Component #1 and 0.15 per unit of Component #2.

REQUIREMENT:

(a) Prepare calculations to indicate whether Tyrone Ltd. will achieve the target cost for the TLX on thebasis of the data provided.

(8 marks)

(b) Now assume that a target costing task force has suggested the following changes in order to helpreduce the cost of the TLX:

Increase the production batch size so that each years total output of TLX would be produced injust 24 batches;

Increase the packaging batch size to 75 units of TLX; Modify the design of the TLX, such that 2 units of Component #1 would be replaced by the same

number of units of Component #2 in each TLX.

Calculate the total annual cost savings if all of these changes are implemented, and indicate whetherthe target cost would be achieved.

(8 marks)

(c) The Managing Director points out that no consideration has been given to the cost of delivering theproduct to customers. Discuss whether the company needs to give consideration to delivery costs aspart of the target costing exercise. (N.B. Calculations are not required in your answer to this part).

(4 marks)

[Total: 20 marks]

END OF PAPER

Page 7

8/21/2019 August 2007 CPPA

9/19



Solution 1: Cavan Ltd.

(a)Sales mix variance

AQ in AM AQ in SM Standard Contribution VarianceA 1,320 1,650 46 15,180 UB 880 550 38 12,540 F

2,200 2,200 2,640 U

Sales quantity variance

Weighted average contribution per unit = (75% *

46) + (25% *

38) =

44. SQV = (2,200 2,400) * 44 = 8,800 U.

Market size variance

Actual market size = 5,400 units. Budget market size = 2,400 / 40% = 6,000 units. MSZV = (5,400 6,000) * 40% * 44 = 10,560 U.

Market share variance

Actual sales = 2,200 units. Standard share of actual market = 5,400 * 40% = 2,160 units. MSHV = (2,200 2,160) * 44 = 1,760 F.

(b)Materials use variance

Actual quantity = 5,500 + 2,700 = 8,200 kg. Standard quantity = (1,320 * 4) + (880 * 3) = 7,920 kg. MUV = (8,200 7,920) * 15 = 4,200 U.

Labour efficiency variance

Actual hours = 2,600 + 900 = 3,500.

Standard hours = (1,320 * 2) + (880 * 1) = 3,520. LEV = (3,500 3,520) * 12 = 240 F.

Labour rate variance= 3,500 * (12.50 - 12) = 1,750 U.

Variable overhead efficiency variance = (3,500 LH 3,520 LH) * 10 = 200 F.

Variable overhead spending variance

Actual VO expenditure = 36,000 + 6,350 = 42,350. Standard VO expenditure for actual labour hours = (3,500 * 10) = 35,000 VOSV = 42,350 - 35,000 = 7,350 U.

Page 8

SUGGESTED SOLUTIONS

8/21/2019 August 2007 CPPA

10/19

RECONCILIATION

Budget profit: (1,800 * 46) + (600 * 38) 105,600Sales mix variance 2,640 UMarket size variance 10,560 UMarket share variance 1,760 FSales quantity variance ------------ 8,800 UMaterials use variance 4,200 ULabour efficiency variance 240 F

Labour rate variance 1,750 UVariable overhead efficiency variance 200 FVariable overhead spending variance 7,350 UActual profit: 47,000 + 34,300 81,300

(c)

The cause of the unfavourable sales mix variance is that the product with the higher contribution per unit(Model A, at 46) actually accounted for a lower proportion of sales units (60%) than budgeted (75%).Conversely, in the case of the higher-contribution product (Model B), its actual sales quantities accountedfor a higher percentage of sales units (40%) than budgeted (25%).

The unfavourable sales quantity variance shows the decrease in total contribution resulting from theincrease in total sales quantity from 2,400 to 2,200, ignoring the changing in the sales mix (i.e., holdingthe sales mix constant at its budgeted 75%:25% level).

Together, the market share and market size variances make up the sales quantity variance (1,760 F +10,560 U = 8,800 U).

The unfavourable market size variance of 10,560 is the loss of contribution which Cavan Ltd. wouldhave suffered because of the increase in the total market size from 6,000 to 5,400 units, if the companyhad achieved only a 40% market share as budgeted.

The favourable market share variance of 1,760 is the amount of additional contribution earned byCavan Ltd. as a result of increasing its market share from a budgeted 40% to an actual 44.4%.

Tutorial notes:

Purpose of question:To test candidates ability to calculate and explain advanced sales and marketingvariances, including advanced materials variances, and to identify which other variances are alsonecessary in order to complete a variance reconciliation. (Topic 3).

Links:None.

Options:Textbooks (and therefore candidates) are likely to differ somewhat in the precise methods usedto calculate variances in parts (a) and (b), although all should arrive at the same answer.

Essential components: Candidates need to be able to perform the calculations required for parts (a) and(b), and to identify which variances are required for part (b). In part (c), candidates are expected toprovide a thorough (and not merely superficial) explanation of the meanings of the variances.

Page 9

8/21/2019 August 2007 CPPA

11/19

Solution 2: Down Ltd.

(a) Energy costs per MH:

Total MH = (20,000 * 16) + (25,000 * 12) + (20,000 * 40% * 6) + (25,000 * 20% * 4) = 688,000.

Energy cost per MH = 550,400 / 688,000 = 0.80 per MH.

Storage costs per day:

Total storage days = (20,000 * 10) + (25,000 * 15) = 575,000.

Storage cost per day = 345,000 / 575,000 = 0.60 per day.

Average cost per unit:

Product A Product B

Production: labour 4 * 10 = 40 7 * 10 = 70

Production: energy 16 * 0.80 = 12.80 12 * 0.80 = 9.60

Production: materials 50 60

Storage 10 days * 0.60 = 6 15 days * 0.60 = 9

Repair: labour 40% * 3 * 10 = 12 20% * 5 * 10 = 10

Repair: energy 40% * 6 * 0.80 = 1.92 20% * 4 * 0.80 = 0.64

Repair: materials 40% * 20 = 8 20% * 25 = 5

Total cost per unit 130.72 164.24

Contribution per unit:

Product A Product B

200 - 130.72 = 69.28 230 - 164.24 = 65.76

(b) Extra MH available = (40% - 15% * 20,000 * 6) + (20% - 15% * 25,000 * 4) = 35,000 MH.

Revised costs per unit:

Product A Product B

Production: labour (as before) 40 70

Production: energy (as before) 12.80 9.60

Production: materials (as before) 50 60

Storage 5 days * 0.60 = 3 7.5 days * 0.60 = 4.50

Repair: labour 15% * 3 * 10 = 4.50 15% * 5 * 10 = 7.50

Repair: energy 15% * 6 * 0.80 = 0.72 15% * 4 * 0.80 = 0.48

Repair: materials 15% * 20 = 3 15% * 25 = 3.75

Total cost per unit 114.02 155.83

Contribution per unit of scarce resource (MH):

Product A Product B

Contribution per unit 200 - 114.02 = 85.98 230 - 155.83 = 74.17

Average MH per unit 16 + (15% * 6) = 16.9 MH 12 + (15% * 4) = 12.6 MH

Contribution per MH 5.09 5.89

Hence: Optimal use of additional hours is to increase production of B by (35.000 MH / 12.6 MH) = 2,777units.

Page 10

8/21/2019 August 2007 CPPA

12/19

Change in total contribution:

Contribution (Month 2) (20,000 * 85.98) + (27,777 * 74.17) = 3,779,820Contribution (Month 1) (20,000 * 69.28) + (25,000 * 65.76) = 3,029,600Increase in contribution 750,220

(c)

Example 1: Costs of quality control sampling at the end of the production staff (e.g., salaries paid toquality control inspectors).

Example 2: Costs of periodic testing of production equipment, to determine whether it is calibrated withsufficient accuracy.

In the earliest stages of a total quality management (TQM) programme, appraisal costs often increase asmanagement take steps to identify any defective output produced by existing production facilities andprevent if from leaving the factory. In the longer term, however, it is a fundamental tenet of TQM thatquality should be designed in and not inspected out. For example, by increasing its expenditure onpreventive maintenance and staff training, a manufacturing firm can significantly reduce the probability ofdefective output being produced. In these circumstances, appraisal becomes less necessary andtherefore appraisal costs can be expected to decrease.

Tutorial notes:

Purpose of question:To test candidates ability to identify and calculate relevant information for decision-making including the effect of a limiting factor (Topic 2), and to prepare calculations and explanations inthe context of cost of quality management (Topic 5).

Links:One effect of part (b) is to highlight the high opportunity cost (Topic 2) of low quality levels.

Options:There are many valid examples which could be given in answer to part (c). In parts (a) and (b),the precise sequence of calculations may vary somewhat although candidates should ultimately arrive at

the answers presented here.

Essential components:Candidates need to be able to identify and calculate relevant costs in parts (a)and (b), not forgetting about the significant impact of repair costs. Also, candidates must know how toidentify the optimal use of a single limiting factor in part (b). Finally, in part (c), candidates mustunderstand appraisal costs including their likely trend in the context of TQM.

Page 11

8/21/2019 August 2007 CPPA

13/19

Solution 3: Donegal Ltd.

(a) Cost driver rates:

Set-up: 336,000 / 400 = 840 per set-up.Testing: 1,000,000 / 5,000 = 200 per test.Customer order processing & delivery: 480,000 / 2,000 = 240 per order.

Fixed overhead allocation rate: 906,000 / 300,000= 3.02 per DLH.

Activity levels for Pro-1:

Total output = (800 * 100) + (1200 * 40) = 128,000 units.Number of set-ups = 128,000 / 500 = 256.Number of tests = 256 * 3 = 768.Number of customer orders = 800 + 1,200 = 2,000.

Activity-based overhead cost levels for Pro-1:

Set-up 256 * 840 = 215,040

Test 768 * 200 = 153,600

Customer order processing 2,000 * 240 = 480,000

Total 848,640

Cost and selling price per unit:

Raw materials 2.50

Direct labour 1.5 DLH * 9 = 13.50

Activity based overheads 848,640 / 128,000 = 6.63

Fixed factory overhead 1.5 DLH * 3.02 = 4.53

Total cost per unit 27.16

Selling price 27.16 plus 25% = 33.95

(b) Activity levels for Opportunity #1:

Total output = (250 * 40) = 10,000 units.Number of set-ups = 10,000 / 500 = 20.Number of tests = 20 * 3 = 60.Number of customer orders = 250.

Incremental costs & contribution for Opportunity #1:

Set-up 20 * 840 = 16,800

Test 60 * 200 = 12,000

Customer order processing 250 * 240 = 60,000

Raw materials 10,000 * 2.50 = 25,000

Direct labour 10,000 * 13.50 = 135,000

Total costs 233,680

Total sales 10,000 * 33.95 = 339,500

Total incremental contribution 90,700

Activity levels for Opportunity #2:

Total output = (100 * 100) = 10,000 units, i.e., the same as Opportunity #1. Hence, activity & incrementalcosts are the same as for Opportunity #1, except that:

- Number of customer orders = 100- Hence, cost of order processing = 100 * 240 = 24,000.

Page 12

8/21/2019 August 2007 CPPA

14/19

Hence: Incremental contribution for Opportunity #2:

Incremental contribution for Opportunity #1 90.700

Saving in customer order processing costs 60K - 24K = 36K

Incremental contribution for Opportunity #2 126,700

(c) Customer profitability analysis typically involves calculating the profit which a firm earns from its

relationships with each of its major customers. The objective is to identify the most profitable customers sothat the relationship can be carefully nurtured and maintained, and also to identify unprofitable customersso that steps can be taken to improve the profitability of such relationships.

Activity based costing is essential for meaningful customer profitability analysis. Without ABC, it wouldnot be possible to trace costs accurately to individual customers to identify their profitability. Forexample, customers can be expensive to serve because they order in small quantities (as the example inpart (b) illustrates) or require a lot of pre- or post-sales support.

Customers often differ in the mix of products which they buy. Therefore, the profit calculation for eachcustomer should include an accurate, activity-based figure for the cost of goods sold to that customer.This requires that product costs have been calculated using activity based costing insofar as possible.

Tutorial notes:

Purpose of question: To test candidates to perform and interpret activity-based costing calculations(Topic 1).

Links:Part (b) involves a relevant cost calculation (Topic 2).

Options:In part (c) there are several possible examples to explaining why ABC information is aprerequisite for customer profitability analysis.

Essential components: Part (a) requires an ability to accurately perform ABC and cost-based pricing

calculations. Part (b) requires an ability to distinguish between incremental and non-incremental costs.In part (c) candidates need to explain what customer profitability analysis is and why ABC is essential forits implementation.

Page 13

8/21/2019 August 2007 CPPA

15/19

Solution 4: Fermanagh Manufacturing PLC

(a)

Profit:

Y1, Y2, Y3 Y4

Sales: 150,000 @ 18 2,700,000 2,700,000

VC: 150,000 @ 12 1,800,000 1,800,000

FC (excl. depreciation) 500,000 500,000

Depreciation: 1,000,000 / 4 250,000 250,000

Gain on disposal 200,000

Profit 150,000 350,000

Investment base:

Y1 Y2 Y3 Y4

FA @ beginning of year 1,000,000 750,000 500,000 250,000

Working capital 500,000 500,000 500,000 500,000

Total 1,500,000 1,250,000 1,000,000 750,000

ROI:

Y1 Y2 Y3 Y410% 12% 15% 46.7%

Jack is unlikely to accept the proposed investment. His division earns 15% without it, so acceptance willreduce the average ROI during the timeframe of Jacks intended remaining employment with the company, andthus adversely affect his bonus.

(b)Cash flows:

Y) Y1, Y2, Y3 Y4

Operating cash flows (2.7M - 1.8M - 0.5M) 400,000 400,000

Purchase and sale of fixed assets (1,000,000) 200,000

Working capital (500,000) 500,000

Net cash flow (1,500,000) 400,000 1,100,000

NPV @ 10% = - 1.5M + (400K * 2.487) + (1.1M * 0.683) = 246,000.

(c)

Examples:

1. ROI includes a depreciation charge. NPV calculations do not, because depreciation is not a cash flow.

2. ROI is a year-by-year calculation, so the managers reaction to it depends on his time horizon (e.g., Jack doesnot plan to stay long enough with Fermanagh Manufacturing for the high ROI in Year 4 to be of any benefit tohim). By contrast, NPV involves evaluating a project over its whole life.

3. NPV calculations enable a project to be judged in isolation. It is possible to see whether (as in this case) the

project would increase shareholders wealth. By contrast, managers tend to react to the ROI of an individualproject in terms of how it will affect their division average ROI and this can lead to dysfunctional decisions (e.g.,Jack is unlikely to accept this project because it would reduce his existing high average ROI).

Page 14

8/21/2019 August 2007 CPPA

16/19

Tutorial notes:

Purpose of question:To test candidates ability to calculate ROI (Topic 4) and NPV (Topic 3) and theirability to identify how the performance evaluation method used is likely to affect a managers reaction to aproject (Topic 4).

Links:Part (b) requires an ability to identify incremental cash flows (Topic 2).

Options:In part (c) there is scope for variation, as candidates are free to use any three valid examples.

Essential components:In part (a) candidates need to be able to calculate ROI and assess the managerslikely reaction to the situation. Part (b) requires the ability to identify and discount incremental cash flows.To answer part (c), candidates must give examples as to why the use of ROI as a performance measuredoes not necessarily guarantee goal congruence.

Page 15

8/21/2019 August 2007 CPPA

17/19

Solution 5: Monaghan Ltd.

(a)

Spare capacity in Unu Division = (27,000 15,000 10,000) = 2,000 units.

Spare capacity in Du Division = (13,500 10,000) = 3,500 units.

Effect on profits of accepting the new order:

Price paid by customer 3,000 * 185 = 555,000

Lost external sales in Unu (3,000 2,000 = 1,000 units) * 100 = 100,000

Incremental variable costs in Unu 2,000 * 70 = 140,000

Incremental variable costs in Du 3,000 * 90 = 270,000

Incremental profit 45,000

(b)

Unu Division:

- First 2,000 units: In favour. Incremental profit on units transferred = (

100 -

70) * 2,000 =

60,000.

- Next 1,000 units: Indifferent, as internal transfer is at the same price as the displaced external sale(100).

Du Division:- Unwilling to accept the transfer. Incremental loss on units transferred = (185 - 100 - 90 = 5 per

unit) * 3,000) = 15,000.

Hence, although Unu would be willing to make the transfer, it will not take place because it is unacceptable toDu.

(c)

Minimum prices acceptable to Unu:- First 2,000 units: 70 (i.e., marginal cost).- Next 1,000 units: 100 (i.e., external market price).

Maximum prices acceptable to Du:- All units: 185 - 90 = 95 per unit.

Transfer price in accordance with criteria:- At transfer price of95 per unit, Dus profit is nil (see above).

- To give Du half of the total incremental profit, decrease this transfer price by:

Half of total profit Decrease in transfer price per unit

45,000 / 2 = 22,500 22,500 / 3,000 = 7.50

- Hence: transfer price of95 - 7.50 = 87.50 per unit.

- Dus incremental profit = 3,000 * (185 - 90 - 87.50) = 22,500.

- Unus incremental profit = (3,000 * 87.50) (1,000 * 100) (2,000 * 70) = 22,500.

Page 16

8/21/2019 August 2007 CPPA

18/19

Tutorial notes:

Purpose of question:To test candidates ability to appraise and identify transfer pricing arrangementswhich will motivate goal congruent behaviour. (Topic 4).

Links: The question asks candidates to identify goal congruent transfer pricing arrangements, and thisnecessitates (especially in part (a)) an ability to identify the relevant costs and revenue for decision-making (Topic 2) from shareholders perspective.

Options:The scope for variation in answers is limited. However, it should be noted that the solution topart (c) above is slightly longer than strictly necessary. Specifically, the question does not ask candidatesto prove that the proposed transfer pricing scheme gives equal profits (22,500) to each division.

Essential components: In all three parts, candidates need to be able to perform the calculations asrequired. Some explanations would help the flow of the answers in most parts, but is not strictlynecessary given the wording of the question.

Page 17

8/21/2019 August 2007 CPPA

19/19

Solution 6: Tyrone Ltd.

(a) Target cost = 20 less 35% = 13.

Component costs:- To buy & fit one unit of Component #1: 0.20 + (4,000 / 10,000 = 0.40) + 0.45 = 1.05.- To buy & fit one unit of Component #2: 0.55 + 0.15 = 0.70.

Expected cost per unit of TLX:

Component #1: 3 units @ 1.05 3.15

Component #2: 5 units @ 0.70 3.50

Production overheads: 2,000 / 500 units 4.00

Packaging overheads: 125 / 25 units 5.00

TOTAL 15.65

Hence, on this basis, the target cost will not be achieved.

(b)

Reduction in numbers of batches:- Production: (13,000 / 500 = 26) 24 = 2.- Packaging: (13,000 / 25 = 520) - (13,000 / 75 = 173.33) = 346.67.

Annual expected cost savings:

Production overheads: 2 * 2,000 4,000

Packaging overheads: 346.67 * 125 43,333

Substitution of components: 13,000 * 2 * (1.05 - 0.70) 9,100

TOTAL COST SAVINGS 56,433

(c) The question of whether delivery cost needs to be considered hinges on whether or not customers

expect the product price charged to include the cost of delivery.

If competitive conditions are such that customers expect the cost of delivery to be included in the productprice, then the target costing group should allow for delivery costs in their calculations as to whether ornot the target cost will be achieved. In addition, the search for cost reduction ideas should include waysof reducing delivery costs (e.g., by redesigning the product to make it lighter or otherwise easier totransport), since such cost savings directly benefit the company.

On the other hand, if competitive conditions are such that customers expect to be charged separately fordelivery, then the target costing group will pay less attention to these costs as they are not borne by the

company. Nevertheless, it should be remembered that the companys products will enjoy a competitiveadvantage if they are designed so that the cost to customers of transporting them is low.

Tutorial notes:

Purpose of question:To test candidates ability to apply their knowledge of target costing, including boththe calculation aspects and the identification of cost reduction opportunities. (Syllabus topic 2).

Links:The question also involves some very basic cost driver calculations.

Options:There is scope for variation in the sequence of calculations in parts (a) and (b), and in theprecise points made in part (c).

Essential components:Candidates need to be able to perform the calculations required for parts (a) and(b) accurately. In part (c) candidates need to address both sides of the delivery costs issue (i.e., therelevance of these costs depends on whether or not they are included in the price charged to thecustomer).

August 2007 CPPA

Documents

Transcript of August 2007 CPPA