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Answers Fundamentals Level C Skills Module, Paper F5 Performance Management June

2008 Answers

1 Chaff Co (a) When assessing variances it is important to consider the whole picture and the interrelationships that exist.

In Chaff there appears to be doubt about the wisdom of some of the decisions that have been made. Favourable variances have been applauded and adverse variances criticised and the managers in charge dispute the challenge to their actions. Purchasing manager. The purchasing manager has clearly bought a cheaper product, saving $48,000. The cause of this is not specified and it could be due to good buying or negotiation, reductions in quality or changes in overall market conditions. We are told the market for buying seeds is stable, so there is more likely to be an internal reason for the problem. The material usage variance is significantly adverse, indicating much more waste than is normal has occurred in month 1. This suggests that the quality of the seed bought was poor and as a result a $52,000 excess loss has occurred. It is possible that the waste was caused by the labour force working poorly or too quickly and this has to be considered. The sales price achieved is also well down on standard with the sales price variance showing an $85,000 loss of revenue and (therefore) profit. We are told that the market for sales of brown rice is stable and so it is reasonable to presume that the fall in sales price achieved is as a result of internal quality issues rather than general price falls. The purchasing manager of the only ingredient may well be responsible for this fall in quality. This may have also led to a fall in the volume of sales, another $21,000 of adverse variance. In conclusion the purchasing manager appears mainly responsible for a loss of $110,000* taking the four variances above together. * ($85,000 + $52,000 + $21,000 C $48,000) Production director. The production director has increased wage rates and this has cost an extra $15,000 in month 1. However one could argue that this wage increase has had a motivational effect on the labour force. The labour efficiency variance is $18,000 favourable;

and so it is possible that a wage rise has encouraged the labour force to work harder. Academic evidence suggests that this effect might only be temporary as workers get used to the new level of wages. Equally the amount of idle time has reduced considerably, with a favourable variance of $12,000 resulting. Again it is possible that the better motivated labour force has been more willing to work than before. Idle time can have many causes, including, material shortages or machine breakdowns. However, we are told the machines are running well and the buyer has bought enough rice seeds. In conclusion the increase in the wage rate did cost more money but it may have improved morale and enhanced productivity. The total of the three variances above is $15,000* Fav. *($18,000 + $12,000 C $15,000) Maintenance manager. The maintenance manager has decided to delay the annual maintenance of the machines and this has saved $8,000. This will increase profits in the short term but could have disastrous consequences later. In this case only time will tell. If the machines breakdown before the next maintenance then lost production and sales could result. The maintenance manager has only delayed the spend and not prevented it altogether. A saving of $8,000 as suggested by the variance has not been made. It is also possible that the adverse variable overhead expenditure variance has been at least partly caused by poor machine maintenance. The variance calculated is not the saving made as it represents a timing difference only. The calculation also ignores the risks involved. (b) The standard contribution is given, but could be calculated as follows (not required by the question but shown as a proof): $ $ Sales price

240 Less: Rice seed (1・4 Tonnes x $60/tonne)

84 Labour (2 hours x $20/hr)

40 Variable overhead (2 hours x $30/hr)

60 CCCC Marginal costs of production

184 CCCC Standard contribution

56 CCCC The standard labour charge needs to be adjusted to reflect the cost to the business of the idle time. It is possible to adjust the time spent per unit or the rate per hour. In both cases the adjustment would be to multiply by 10/9 C a 10% adjustment. In the case above the rate per hour has been adjusted to $18 x 10/9 = $20/hr. (Both approaches would gain full marks.) In order to reconcile the budget profit to the actual profit, both these profits need to be calculated and an operating statement prepared.

13 Budget profit statement for month

2 $ $ Sales (8400u x $240/u) 2,016,000 Less: Rice seed (1・4 tonnes x $60/tonne x 8,400 tonnes) 705,600 Labour (2 hours x $20/hr x 8,400 tonnes) 336,000 Variable overhead (2 hours x $30/hr x 8,400 tonnes) 504,000 CCCCCCCC Marginal costs of production 1,545,600 Contribution 470,400 Less Fixed costs 210,000 Budget profit 260,400 Actual profit for month 2. $ $ Sales 1,800,000 Less: Rice seed 660,000 Labour 303,360 Variable overhead 480,000 CCCCCCCC Marginal costs of production 1,443,360 Contribution 356,640 Less Fixed costs 200,000 Actual profit 156,640 Operating statement for month

2 $ $ $ Budget contribution 470,400 Variances: Adverse Favourable Sales price 120,000 Sales volume 22,400 CCCCCCCC 142,400 CCCCCCCC 328,000 Material price 60,000 Material usage 48,000 Labour rate 18,960 Labour efficiency 20,000 Idle time 15,600 Variable overhead efficiency 30,000 Variable overhead expenditure 30,000 96,960 125,600 28,640 CCCCCCCC Actual contribution 356,640 Budget fixed cost 210,000 Less: Fixed cost expenditure variance 10,000 CCCCCCCC Actual fixed cost 200,000 CCCCCCCC Actual profit 156,640 CCCCCCCC Workings for the variances in month

2 1. Sales price: (225 C 240)8,000 = 120,000 Adv 2. Sales volume: (8,000 C 8,400)56 = 22,400 Adv 3. Material price: 4. Material usage: (12,000 C 11,200*)60 = 48,000 Adv *(8,000 x 1・4 = 11,200) 5. Labour rate: (19・20 C 18)15,800 = 18,960 Adv 6. Labour efficiency: (15,000 C 16,000)20 = 20,000 Fav 7. Idle time: (800 C 1,580*)20 = 15,600 Fav *10% of 15,800

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000 60

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60 000 , , C , , ? ? ? ? ? ? = Fav 8. Variable overhead expenditure: 9. Variable overhead efficiency variance: (15,000 C 16,000)30 = 30,000 Fav Alternative calculations if standard hours adjusted for expected idle time and not the rate. Standard cost (2 hours x 10/9) x $18 = $40 per tonne Or 2・222 hours x $18 = $40 per tonne Rate variance as above = 18,960 Adv Idle time: (800 C 1,580)18 = 14,040 Fav Efficiency variance: (15,000 C 16,197・77777*)18 = 21,560 Fav * (standard time allowed less standard idle time) Standard time is 8,000 tonnes x 2・222 hours = 17,777・777 hours Standard idle time is 10% of 15,800 = 1,580 hours Therefore expected working hours is 17,777・777 C 1,580 = 16,197・777 hours (Note C there are many alternative methods of dealing with this issue, any reasonable attempt was accepted.)

2 Higgins Co (a) Contribution per cue Pool cue Snooker cue $ $ Selling price 41・00 69・00 Material cost at $40/kg (10・80) (10・80) Craftsmen cost at $18/hr (9・00) (13・50) Other Variable cost (1・20) (4・70) Contribution per cue 20・00 40・00 (b) Formulation of the linear programming problem Variables Let P and S be the number of pool and snooker cues made and sold in any three month period. Let C represent the contribution earned in any three month period Constraints: Craftsmen: 0・5P + 0・75S ≤ 12,000 Ash: 0・27P + 0・27S ≤ 5,400 Demand levels C Pool cues P ≤ 15,000 C Snooker cues S ≤ 12,000 Non negativity: P, S ≥

0 Objective: Higgins seeks to maximise contribution in a three month period, subject to: 20P + 40S = C See diagram on next page The feasible region is identified as the area inside OABCDE. The contribution line is identified as the dotted line. Pushing the contribution line outward increases the contribution gained (theory of iso-contribution). The contribution line last leaves the feasible region at point D which is the intersect of the skilled labour line and the maximum demand line for S. Solving at point D: Maximum demand S = 12,000 (1) Craftsmen 0・5P + 0・75S = 12,000 (2) Substituting S = 12,000 in equation (2) 0・5P + (0・75 x 12,000) = 12,000 0・5P + 9,000 = 12,000 0・5P = 12,000 C 9,000 0・5P = 3,000 P = 6,000 Therefore the maximum contribution is earned when 6,000 pool cues and 12,000 snooker cues are made and sold in a three month period. The contribution earned is C = (20 x 6,000) + (40 x 12,000) C = 120,000 + 480,000 C = $600,000

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15 000

30 000 , , C , , ? ? ? ? ? ? = Adv Production schedule

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20 S contribution A Ash Craftsmen Max S Max P Max contribution F D C B P Feasible region = OABCDE Optimal point at point D (c) Shadow prices A shadow price is the value assigned to changes in the quantity of a scarce resource available, normally measured in terms of contribution. If more critical scarce resource becomes available then the feasible region would tend to expand and this means that the optimal point would tend to move outward away from the origin thus earning more contribution. It is this increase in the contribution that is the shadow price measured on a per unit of scarce resource basis. Management can use the shadow price as a measure of how much they would be willing to pay to gain more of a scarce resource. It represents the maximum they should be willing to pay for more scarce resource over and above the normal price subject to any non-financial issues that may be present. If the availability of a non-critical scarce resource increased then the feasible region would not tend to expand and therefore no more contribution could be earned. In this case extra non-critical scarce resource has no value and a nil shadow price. Calculation of shadow prices: Ash: This is a non-critical scarce resource and as such it has a shadow price of nil. Put simply we have slack (spare material) of ash and therefore have no desire to pay more to get more of it. Craftsmen: This is a critical scarce resource and if more became available then the feasible region would expand and the optimal point would move outward thus earning more contribution. Assuming that just one more hour becomes available it is necessary to find the new optimal point and measure the increase in contribution earned. At point D, we re-solve based on the available craftsmen hours being one more than previously. S = 12,000 (3) 0・5P + 0・75S = 12,001 (4) Substituting S = 12,000 in equation (4) 0・5P + 0・75(12,000) = 12,001 0・5P + 9,000 = 12,001 0・5P = 3,001 P = 6,002 The new optimal solution would be where 12,000 snooker cues and 6,002 pool cues are made. This would earn an extra $40 (2 x $20) in contribution. The shadow price is therefore $40 per extra hour of craftsmen time. (d) Acceptability of the craftmens'

offer. Rate of pay The rate of pay requested (double time) is on the face of it less than the shadow price and is therefore affordable by Higgins Co. The business would be better off by accepting the offer. However, it is common for overtime to be paid at time and a half ($27 per hour) and Higgins would be well advised to negotiate on this point. Higgins takes the commercial risks in this business and would therefore be justified in keeping the majority of the rewards that come with it. Equally it is a dangerous precedent to accept the first offer and pay such a high rate for overtime, Higgins would have to ask itself what would happen next time an overtime situation arose. It is also possible that doubl........