THE UNIVERSITY OF MANCHESTER

MANCHESTER BUSINESS SCHOOL WORLDWIDE

DEGREE EXAMINATIONS November 2010

MASTER OF BUSINESS ADMINISTRATION

COURSE – Accounting (Financial and Management)

TIME ALLOWED: 3 HOURS plus 10 Minutes Reading Time*

NOTE TO INVIGILATORS

THIS IS A CLOSED BOOK EXAMINATION

*During the 10 minute reading time you may write on this paper but not on the answer book.

Instructions to students

1. Sections A and B are on financial accounting, and Sections C and D are on management accounting. Answer ONE question from each section. Please note section A contains one COMPULSORY question. Each question is worth equal marks. For questions with several parts, the weights appear at the end of each part.

2. Marks will be deducted for answers of an illegible nature.

3. Do not staple any foreign materials into the answer books.

4. Please ensure that you write your 4 digit exam I.D number and paper reference number on the front of your answer book. Failure to do so may result in non-marking of your script.

5. Ensure that your answer is well structured. State and defend any assumptions clearly. The examiner is looking for a robustly defended answer.

6. You may use electronic calculators, provided they do not store text.

7. In answering these questions, write down any formulae you use, show all your calculations and explain your answers, including any assumptions you make.

1

SECTION AQuestion A1 is COMPULSORY

Question A1

Below are extracts from the financial statements of a listed company which operates a chain of bakery and sandwich retail outlets in the United Kingdom.

Income statements

2009£’000

2008 £’000

Revenue 658,186 628,198

Cost of sales (252,284) (241,939)

Gross profit 405,902 386,259

Distribution costs (321,686) (309,735)

Administrative expenses (35,783) (35,944)

Other income - 8,033

Operating profit 48,433 48,613

Interest receivable and similar income 346 857

Profit before taxation 48,779 49,470

Taxation (14,405) (15,375)

Profit for the year 34,374 34,095

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Balance sheets

2009£’000

2008 £’000

Non-current assets

Intangible assets 579 686

Property, plant and equipment 211,155 210,455

Current assets

Inventories 11,886 12,152

Trade and other receivables 21,206 22,698

Cash and cash equivalents 34,619 4,433

Current liabilities

Trade and other payables (71,738) (62,761)

Current tax liabilities (8,857) (8,337)

Provisions for liabilities and charges (857) (2,843)

Net current liabilities (13,741) (34,658)

Non-current liabilities

Other payables (30,460) (26,108)

Provisions for liabilities and charges (3,296) (2,428)

Net assets 164,237 147,947

Capital and reserves

Share capital 2,080 2,080

Share premium account 13,533 13,533

Other reserves 359 359

Retained earnings 148,265 131,975

Total equity 164,237 147,947

3

Cash flow statements

2009£’000

2008 £’000

Cash flows from operating activities

Cash generated from operations 87,944 59,163

Tax paid (14,731) (14,807)

Net cash generated from operating activities 73,213 44,356

Cash flows from investing activities

Purchase of property, plant and equipment (30,296) (40,758)

Purchase of intangible assets - (686)

Proceeds from sale of property, plant and equipment 2,368 2,200

Interest received 346 857

Net cash used in investing activities (27,582) (38,387)

Cash flows from financing activities

Sale of own shares 1,182 698

Shares purchased and cancelled - (9,738)

Dividends paid (15,339) (14,535)

Other financing cash flows 1,087 8,083

Net cash used in financing activities (13,070) (15,492)

Net increase/(decrease) in cash and cash equivalents 32,561 (9,523)

Notes:

The market value of the company’s shares at the year end was £4.37 (2008: £3.50).

Share capital consists of 104 million shares with a nominal value of 2p per share.

4

Requirements:

a) Prepare a report describing how the liquidity of the company has changed between 2008 and 2009. Comment on why these changes may have occurred. What possible changes in the business’s activities and /or efficiency may have had an effect on the changes in liquidity? You should use appropriate ratios in your analysis.

(10 marks)

b) Imagine you are a prospective investor in this company’s shares. Calculate 3 investor ratios for 2009 and 2008 which would help you to decide whether to invest, and briefly explain the meaning of each one.

(10 marks)

c) Explain why financial statements include an accounting policies note. Give examples of how users of financial statements would find such a note useful, illustrating your answer with respect to the financial statements in this question.

(5 marks)

Total: 25 marks

5

Requirement:

a) Prepare a report describing how the liquidity of the company has changed between 2008 and 2009. Comment on why these changes may have occurred. What possible changes in the business’s activities and /or efficiency may have had an effect on the changes in liquidity? You should use appropriate ratios in your analysis.

(10 marks)

Students should calculate appropriate ratios and draw on aspects of liquidity from both the balance sheet and the cash flow statement

Appropriate ratios would include current ratio quick ratio

Students may link this to working capital management such as: debtor days creditor days stock days

Students may also include some cash ratios such as: cash from operations to current liabilities

The ratio calculations and workings are shown on the next page of the solutions.

Students should discuss changes in the ratios and relate them to each other.

Students should also discuss the absolute numbers such as the cash balance and change in cash balance, whether there have been cash inflows or outflows from operations, investing and financing. Students should comment on the implications of these cash inflows or outflows and relate them to other aspects of the financial statements where appropriate.

Suggested points: Improvement in liquidity from 2008 to 2009 as evidenced by the large increase

in cash generated from operating activities and improvement in current and quick ratios (driven in part by increase in cash)

Receivables days and inventory days pretty consistent (suggesting tight control given the increase in revenue from 2008 to 2009) but payables days have lengthened by 9 days - if there has been a deliberate policy to pay suppliers later this may backfire if it damages supplier relationships, but is a cheap source of short-term financing, especially as the company has no borrowings/overdraft so there are limited other sources of finance for them in the short term

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Ratio 2009 2008

Current ratio

current assets/current liabilities

(11,886+21,206+34,619)

(71,738+8,857+857)

0.83:1 (12,152+22,698+4433)

(62,761+8,337+2,843)

0.53:1

Quick ratio

current assets excl inventory/current liabilities

(21,206+34,619)(71,738+8,857+857)

0.69:1 (22698+4433)(62761+8337+2843)

0.37:1

Receivables days

receivables/revenue x 365

21,206 x 365658,186

12 days 22,698 x 365628,198

13 days

Payables days

payables/cost of sales x 365

71,738252,284 x 365 104 days 62761 x 365

241939 95 days

Inventory days

inventory/cost of sales x 365

11,886 / 252,284 x 365 17 days 12,152 / 241,939 x 365

18 days

Inventory turnover

cost of sales / inventory x 365

252,284 / 11,886 21 times 241,939 / 12,152 20 times

Asset turnover

revenue/equity + on-current liabilities

658186 /(164237+30460+3296)

3.3 times 628198 /(147947+26108+242

8)

3.6 times

Cash generated from operations to current liabilities

cash generated from operations/current liabilities

87944 / (71738+8857+857)

1.1 times 59163 /(62761+8337+2843)

0.8 times

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b) Imagine you are a prospective investor in this company’s shares. Calculate 3 investor ratios for 2009 and 2008 which would help you to decide whether to invest, and briefly explain the meaning of each one.

(10 marks)

Ratio 2009 2008

EPS 34,374 / 104,000 33.1p 34,095 / 104,000 32.8p

P/E 437 / 33.1 13.2 times 350 / 32.8 10.7 times

Dividend per share 15,339 / 104,000 14.7p 14,535 / 104,000 13.9p

Dividend cover 34,374 / 15,339 2.24 times 34,095 / 14,535 2.35 times

Dividend yield 14.7 / 437 3.40% 13.9 / 350 4.00%

Cash generated from operations per share

87,944 / 104,000 84.6p 59,163 / 104,000 56.9p

Return on equity 34,374 / 164,237 20.90% 34,095 / 147,947 23.00%

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c) Explain why financial statements include an accounting policies note. Give examples of how users of financial statements would find such a note useful, illustrating your answer with respect to the financial statements in this question.

(5 marks)

Students should identify that businesses have choices available to them when preparing accounts in which accounting policies they select. The accounting policies note details which choices have been made. The choices affect the figures in the balance sheet and income statement so it is important that users are told what choices have been made.

Suggestions may include: Inventory valuation policy – this is a significant balance and the valuation

method is likely to have a material effect on position and performance. The stock has a short shelf-life so policies about write-down or write-off of inventory would also be important for this business

Classification of revenue vs other income – what did the £8m other income relate to in prior year?

Accounting policies relating to PPE – largest figure on the balance sheet. It doesn’t appear that they revalue their properties (no revaluation reserve) but depreciation methods, useful lives, impairment would all be significant issues (large property estate of stores), also do they lease any properties and how do they go about classifying the leases as finance or operating leases, as this will affect their liabilities and the nature and size of expenses in the income statement.

Basis for estimation of provision liabilities and how they are split between current and non-current

9

Section BAnswer one question in Section B

Question B2

The income statements for the years to 30 September 2010 and 2009 and the balance sheets as at 30 September 2010 and 2009 of Rugby Ltd are detailed below:

  2010 2009  £’000 £’000Sales 1,850 1,295Cost of sales -1,125 -750Gross profit 725 545Expenses -375 -265Operating profit 350 280Net interest expense -30 -25Profit before tax 320 255Corporation tax -110 -75Profit after tax 210 180     Retained profit 210 180

10

2010 2009£’000 £’000 £’000 £’000

Property, Plant and EquipmentCost 1,575 1,325Depreciation -395 -340

1,180 985Current AssetsInventory 85 75Trade Receivables 95 50Cash 50 15

230 140Current liabilitiesTrade payables 83 80Bank Overdraft 15 20Taxation 12 10

110 110Net current assets 120 30Total assets less current liabilities

1,300 1,015

Long term loan -375 -300Net assets 925 715

Capital and Reserves£1 ordinary shares 265 265Retained profit 660 450

925 715

Notes:

The interest expense is shown net of receipts. In the year to 30 September 2010, the interest received in cash amounted to £10,000 and is equal to the interest income for the year. There was no outstanding interest due at 30 September 2010 or 30 September 2009.

During the year to 30 September 2010, a piece of equipment was sold for £15,000. The item had an original cost of £40,000 and Rugby Ltd made a loss on disposal of £11,000.

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Required:

a) Prepare a cash flow statement for the year to 30 September 2010 ensuring that the structure of your statement is in accordance with IAS7

(17 marks)

  £’000 £’000Cash flow from operating activities

378  

Interest paid -40  Income tax paid -108  Net cash from / (used in) operating activities

  230

     Interest received 10  Purchase of PPE -290  Proceeds from sale of PPE 15  Net cash from / (used in) investing activities

  -265

     Proceeds from issue of long term loan

75  

Net cash from / (used in) financing activities

  75

     Net decrease in cash and cash equivalents

  40

     Cash and cash equivalents at the beginning of the period*

  -5

Cash and cash equivalents at the end of the period*

  35

12

  £’000 £’000Net profit before tax 320  Add: interest expense 30  Operating profit before working capital changes

  350

     Add: depreciation   69Less: inc in receivables -45  Less: inc in inventory -10  Less: dec in payables 3      -52Add: loss on disposal   11Cash from operations   378

 Opening depreciation 340Disposals -14Depreciation charge* 69Closing depreciation 395

b) Discuss the idea that cash flow statements are more useful to users of financial statements than income statements and balance sheets because they are more objective and therefore more difficult to manipulate.

(8 marks)Points may include the following:

o Profit based on accruals concept o Includes accounting choice, judgement and subjectivityo Usefulness of cash flow statement given how important cash is to a

businesso Cash flow only reports cash in and out which is objectiveo Breaks down cash flows into different activities so can see sources and

uses of casho Doesn’t show all round pictureo All used in conjunction together to give full picture of business

performance and positionTotal 25 marks

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Question B3

On 1 March 2010, Murphy plc entered into an agreement to lease a piece of machinery for 4 years. The machine would have cost £104,605 to purchase and has an expected useful life of approximately 4 years.

Murphy plc will pay 4 annual instalments of £33,000; the first payment is to be made on 28 February 2011. The interest rate implicit in the agreement is 10%.

Required:

a) State whether you would consider the above lease agreement to be a finance lease or an operating lease. Give reasons for your answer.

(4 marks)

b) Assume the lease is a finance lease; calculate the interest expense and the depreciation expense for each of the 4 years of the lease agreement. Assume that depreciation is charged on a straight line basis.

(6 marks)

c) Assume the lease is a finance lease; calculate the amounts that would be shown in the balance sheet at the end of each year of the agreement.

(6 marks)

d) In March 2009, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) issued a joint discussion paper proposing possible changes to the current accounting treatment for leases. The boards propose that lease accounting should be based on the principle that all leases give rise to liabilities for future rental payments and assets that should be recognised in an entity’s statement of financial position. Bob Herz, the chairman of the Financial Accounting Standards Board in the US commented that “The proposals … are intended to improve the transparency, credibility and usefulness of lease accounting”. Explain whether or not you think that these proposals will improve the transparency, credibility and usefulness of lease accounting and whether or not you agree that these proposals would better reflect the rights and obligations arising from leasing contracts on the balance sheets of lessees.

(9 marks)

Total 25 marks

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Murphy plc: answer

(a) State whether you would consider the above lease agreement to be a finance lease

(b) or an operating lease. Give reasons for your answer.(4 marks)

This is a finance lease. Reasons:

the present value of minimum lease payments amounts to substantially the fair value of the asset

the lease term is for the majority of the life of the assets substantially all of the risks and rewards of ownership have been transferred

to the lessee

(c) Assume the lease is a finance lease; calculate the interest expense and the depreciation expense for each of the 4 years of the lease agreement. Assume that depreciation is charged on a straight line basis.

(6 marks)

b/f interest payment c/f104,605 10,461 33,000 82,06682,066 8,207 33,000 57,27357,273 5,727 33,000 30,00030,000 3,000 33,000 0

Depreciation nbv104,605 26,151 78,45478,454 26,151 52,30352,303 26,151 26,15226,152 26,151 1

(d) Assume the lease is a finance lease; calculate the amounts that would be shown in the balance sheet at the end of each year of the agreement.

(6 marks)Liability

b/f interest payment c/f104,605 10,461 33,000 82,06682,066 8,207 33,000 57,27357,273 5,727 33,000 30,00030,000 3,000 33,000 0

Depreciation nbv104,605 26,151 78,45478,454 26,151 52,30352,303 26,151 26,152

15

26,152 26,151 1

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(e) In March 2009, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) issued a joint discussion paper proposing possible changes to the current accounting treatment for leases. The boards propose that lease accounting should be based on the principle that all leases give rise to liabilities for future rental payments and assets that should be recognised in an entity’s statement of financial position. Bob Herz, the chairman of the Financial Accounting Standards Board in the US commented that “The proposals … are intended to improve the transparency, credibility and usefulness of lease accounting”. Explain whether or not you think that these proposals will improve the transparency, credibility and usefulness of lease accounting and whether or not you agree that these proposals would better reflect the rights and obligations arising from leasing contracts on the balance sheets of lessees.

(9 marks)

Points may include the following: Leased assets will have to be brought on the balance sheet as both an asset

and the corresponding liability The liability will increase the gearing ratio of these companies as well as the

interest cover This may make the businesses look more risky – previously this financing

would not have been found on the balance sheet. If both types of leases are treated in the same manner, it will stop management

being incentivised to structure lease schemes in such a way that enables them to keep the long term obligations off the balance sheet – this should bring more information to the users on the face of the balance sheet, giving it equal importance to that of finance leases. This may make it more useful to users.

Including these obligations on the balance sheet rather than the notes may also make them more prominent and therefore more transparent for users.

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Section C

Answer one question in Section C

Question C4

Explain the costing system that Wilkerson (the case study that you studied) currently use, and evaluate how far it is adequate to support management decisions. Suggest an alternative costing system that you consider might generate more decision-relevant information, and assess which system is likely to be most appropriate for Wilkerson’s business.

Total 25 marks

Question C5

Explain why the management of Borealis (the case study that you studied) were dissatisfied with their budgeting system. Explain the alternative approach to planning and control that they introduced in its place, and evaluate the results that this new approach produced.

Total 25 marks

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Section D

Answer one question in Section D

Question D6

Trimake makes three main product-lines, using broadly the same production methods and equipment for each. At present they use a conventional full absorption costing system, and have selected machine hours as the basis on which all production overhead costs are to be absorbed into products1. Details of the products for a typical month are:-

Hours per unit of output (i.e. per product)

Materials per unit

Volumes

Labour hours Machine hours

£ Units of output

produced

Product:-X ½ 1½ 20 750Y 1½ 1 12 1,250Z 1 3 25 7,000

Direct labour costs £6 per hour.

Total production overheads are £654,500 per month, and in a typical month 23,375 machine hours are operated, split between the three product-lines:-

Machine hours per product

Volumes Total machine hours required per product-line

Product:-X 1½ 750 1,125Y 1 1,250 1,250Z 3 7,000 21,000

--------23,375

====== The absorption rate is therefore £654,500 / 23,375 machine-hours = £28 per machine-hour

(a) you are required to calculate the cost per unit for each product using conventional methods

1 i.e. they are using a single ‘blanket overhead rate’, or ‘plant-wide rate’, rather than a specific rate for each of the separate cost centres (i.e. departments) which are involved in the production process.

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(4 marks)

20

Trimake Ltd. – Question, page 2 of 2

The company carries out an activity analysis and determines that there are four main broad types of activity which are responsible for requiring the consumption of the resources which are represented by the total of £654,500, divided as follows:-

%Costs relating to set-ups 35Costs relating to machinery 20Costs relating to materials handling 15Costs relating to inspection 30

----Total production overhead 100%

===

These proportions can therefore be applied to divide the total of £654,500 into four cost pools, for each of which an appropriate cost driver needs to be defined and measured.

The activity analysis has also determined that the total number of activities which are related to each product-line in a typical month are as follows:-

Number of set-ups

Number of movements of

materials

Number of inspections

Number of machine-hours

Product X 75 12 150 ))) as above))

Product Y 115 21 180Product Z 480 87 670

----- ----- -----670 120 1,000=== === ====

You are required:-

(b) to calculate the cost per unit for each product using ABC principles(15 marks)

(c) to comment on the reasons for any differences in the product costs you have calculated in your answers to (a) and (b) respectively

(6 marks)

21

Trimake Ltd. – suggested answer

a. Production cost per unit - traditional method

Product X Product Y Product Z(£) (£) (£)

Direct labour @ £6 per hour 3 9 6Direct materials 20 12 25Production O/H @ £28 per machine hour

42(1.5 hours)

28(1 hour)

84(3 hours)

----------- ----------- -----------65 49 115

----------- ----------- -----------

b. Production cost per unit - ABC method

The total production overhead is derived from the overheads allocated to the product in part (a):

£Product A 31,500 (= 750 x £42)Product B 35,000 (= 1,250 x £28)Product C 588,000 (= 7,000 x £84)

654,500

Overhead costs traced to cost pools:- £

Set-up cost 229,075 (35%)Machining 130,900 (20%)Materials handling 98,175 (15%)Inspection 196,350 (30%)

654,500

Cost driver rates:- £

Cost per set-up 341.903 ( = £229,075 / 670)Cost per machine-hour 5.60 ( = £130,900 / 23,375 [see note

below])Cost per material movement 818.125 ( = £98,175 / 120)Cost per inspection 196.35 ( = £196,350 / 1,000)

Note: machine hours = (750 x 1.5) + (1,250 x 1) + (7,000 x 3)

22

Trimake Ltd. – suggested answer

Overhead cost assigned to each product:-

Product X Product Y Product Z

Set-up costs @ £341.903 25,643 (75) 39,319 (115)

164,113 (480)

Machining @ £5.60 per machine hour

6,300 (1,125)

7,000 (1,250)

117,600 (21,000)

Materials handling @ £818.125 per materials movement

9,817 (12) 17,181 (21)

71,177 (87)

Inspection @ £196.35 per inspection

29,453 (150)

35,343 (180)

131,554 (670)

-------- -------- ---------Overhead cost per product-line 71,213 98,843 484,444

-------- -------- ---------Number of products 750 1,250 7,000Overhead cost per product £95 £79 £69

Production cost per product, following ABC principles:-

Product X Product Y Product Z

Direct labour @ £6 per hour 3 9 6Direct materials 20 12 25Production O/H 95 79 69

----------- ----------- -----------118 100 100

----------- ----------- -----------Change, compared with traditional method +82% +104% -13%

c. Comment:-

The traditional method allocates overheads in proportion to machine hours to products (4.8% to X, 5.3% to Y, and 89.9% to Z). However, when overheads are assigned on the basis of the numbers of set-ups, movements of materials and inspections, the proportions of overheads assigned to product Z are 72% (480/670) for set-up costs, 72% (87/120) for materials handling costs, and 67% (670/1,000) for inspection costs.

In contrast, the traditional method allocates approximately 90% of all costs to product Z, so the unit cost for product Z is higher with this method. The opposite position applies with products X and Y and as a result, their unit costs are lower with the traditional method. Advocates of the ABC approach would argue that this means that under the traditional method product Z (the high-volume and relatively less complex product) is effectively cross-subsidising products X and Y and that this is not

23

transparent from the traditional system, so that management decisions on pricing, promotions, etc. could be distorted.

24

Question D7

Alpha Manufacturing Ltd produces a single product, the sigma. The product requires a single production process, and the standard cost for this is presented in the following standard cost card:-

£ £

Direct material:-

2 kg of material A @ £1 per kg 2.00

1 kg of material B @ £3 per kg 3.00

Direct labour

3 hours @ £3 per hour 9.00

Overheads:- variable: 3 hours @ £2 per direct labour hour

6.00

fixed: 3 hours @ £4 per direct labour hour

12.00

18.00

Total standard cost 32.00

Standard profit margin (25% on cost) 8.00

Standard selling price 40.00

====

Alpha Ltd plans to produce 10,000 units of sigma in the month of April, and the budgeted costs based on the information contained in the standard cost card above are as follows:-

25

Budget based on the above standard costs and an output of 10,000 units per month:-

£ £ £

Sales 10,000 units of sigma @ £40 per unit 400,000

Direct materials

A: 20,000 kg @ £1 per kg

20,000

B: 10,000 kg @ £3 per kg

30,000

50,000

Direct labour 30,000 hours @ £3 per hour

90,000

Variable overheads

30,000 hours @ £2 per direct labour hour

60,000

Fixed overheads (see note below) 120,000

320,000

Profit 80,000

======

NB: budgeted fixed overheads are £120,000 per month and are charged on the basis of direct labour hours, giving a fixed overhead rate of £4 per direct labour hour (£120,000 / 30,000 direct labour hours).

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The actual results for April are:-

£ £ £

Sales 9,000 units of sigma @ £42 each

378,000

Direct materials

A: 19,000 kg @ £1.10 per kg

20,900

B: 10,100 kg @ £2.80 per kg

28,280

49,180

Direct labour 28,500 hours @ £3.20 per hour

91,200

Variable overheads

52,000

Fixed overheads

116,000

308,380

Profit 69,620

======

Manufacturing overheads are charged to production on the basis of direct labour hours. Actual production and sales for the period were 9,000 units.

Required

(a) Produce a variance statement which explain the reasons for the overall difference of £10,380 between the budgeted profit of £80,000 and the actual profit of £69,620 in terms of the variances that can be calculated from the data above.

15 Marks

(b) On the basis of your analysis of the variances, explain to Alpha’s Chief Executive what has happened during the month and the main factors which appear to have affected its performance.

5 Marks

(c) Evaluate the advantages and disadvantages as a method of management control of this approach, in which a business’s results are analysed in detail into a number of different variances.

5 marks

Total 25 marksEND OF EXAMINATION

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Alpha Manufacturing – suggested answer

NB: the following analysis takes a holistic approach and sets out the table below as the first stage in the workings. This is an optional part of the workings and is done here to help to provide an overview of the analysis as a whole, but it does not necessarily have to be used every time – with practice, it can be possible to calculate the variances directly without first going through this step.

Std cost p.u.

Original budget

Flexed budget

Actual Overall variance per line

(10,000 products)

(9,000 products)

(9,000 products)

Material A: 2 kg @ £1

£2.00 20,000 18,000 20,900 2,900 A

[20,000 kg @ £1]

[18,000 kg @ £1]

[19,000 kg @ £1.10]

Material B: 1 kg @ £3

£3.00 30,000 27,000 28,280 1,280 A

[10,000 kg @ £3]

[9,000 kg @ £3]

[10,100 kg @ £2.80]

Dir. labour: 3 hrs @ £2

£9.00 90,000 81,000 91,200 10,200 A

[30,000 hrs @ £3]

[27,000 hrs @ £3]

[28,500 hrs @ £3.20]

Var. O/H: 3 hrs @ £2

£6.00 60,000 54,000 52,000 2,000 F

---------

--------- --------- --------- ---------

Total Variable Cost £20.00 200,000 180,000 192,380 12,380 AFixed O/H £12.00 120,000 120,000 116,000 4,000 F

---------

--------- --------- --------- ---------

£32.00 320,000 300,000 308,380 8,380 ASales £40.00 400,000 360,000 378,000 18,000 F

(10,000 @ £40)

(9,000 @ £40) (9,000 @ £42) (9,000 @ £2)

---------

--------- --------- --------- ---------

Profit £8.00 80,000 60,000 69,620 9,620 F--------

---------- --------- --------- ---------

The total profit variance is the profit which Alpha actually realised in the month of £69,620 (column 4), minus the profit that they originally budgeted of £80,000 (col. 2). In any particular situation this could be either positive or negative; here it is negative, i.e.

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an adverse (or unfavourable) total profit variance of £69,620 - £80,000 = £10,380, since actual profits were £10,380 less than planned. The purpose of variance analysis is to take this total profit variance and analyse it into its constituent elements to identify where in the organisation any deviations from plan occurred and who is responsible, in order to determine the reasons and take whatever actions are needed (this approach is termed ‘responsibility accounting’).

Here, the main reason is that sales volume was 10% down (only 9,000 products instead of the 10,000 planned). This alone is responsible for a fall in profit of 1,000 products x the expected contribution of £20 on each product (£40 sales price minus £20 total variable cost per unit) = £20,000. This is equal to the difference between the profit figures stated in the original budget (col. 2) and the flexed budget (col. 3) respectively.

In any question that you are asked to do, the data which you will need to complete columns 1, 2 and 4 will be given in the question. Column 3 (the flexed budget) is calculated by taking column 2 (the original budget) and adjusting it as follows:-

- for each variable cost, multiply the amount in column 2 x (actual volume ÷ the volume on which the original budget was based: here, 9000/10000).

- for each fixed cost, the amount in column 3 should be the same as in column 2 (since by definition an increase in volume would not justify any increase in the amount to be spent on a cost which is expected to stay fixed).

Since the flexed budget (column 3) is simply the original budget (column 2) adjusted only for any difference in the volume of final output, it must follow that any remaining differences between the flexed budget (col. 3) and the actual results (col. 4), which will be shown in column 5, must be due to either or both:-

- a difference in the rate at which inputs have been converted into outputs: i.e. the kilos of raw materials (or whatever) which have been needed to produce each product - the efficiency or quantity element;

- a difference in the prices paid for inputs, compared with what was originally expected - the price element.

The amounts in column 4 must therefore be analysed between their quantity and price elements. Taking Material A as an example:-

Quantity: the flexed budget allows for 18,000 kilos to be used (1 kilo for each product); however actual usage was 19,000 kilos, so there has been excess usage of 1,000 kilos. This will reduce profits, so the variance will be adverse). To calculate the amount by which profits have been reduced due to this single cause, this must be multiplied by the standard price per unit of raw materials, i.e. £1 per kilo. The calculation is therefore:-

(19,000 kg - (9,000 units x 2 kg per unit)) x £1 per kg = £1,000 A (adverse)

Price: the original budget planned for each kilo to cost £1; however in the event £1.10 per kilo has been paid, i.e. an overspend of 10 pence per kilo (therefore another adverse

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variance). In order to calculate the amount by which profits have been reduced due to this single cause, this must be multiplied by the actual quantity used in the period, i.e. 19,000 kilos. The calculation is therefore:-

(£1 - £1.10) x 19,000 kilos = £1,900 A

Note that the further analysis of the total variance is similar for materials and labour (and also for sales), i.e. it is analysed between quantity and price; but it differs for each of variable and fixed overheads (in different ways).

The purpose of variance analysis is to produce a report which provides management with the basis to investigate the causes for any deviations from plan and if possible correct them. It is an example of management by exception: i.e. there is no need to be concerned in areas where things are going according to plan, but where there are variances then this may indicate that attention is required. Given that management time is limited, this should concentrate on only those variances which are (1) material in amount, and (2) where the causes are likely to be controllable.

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Variance Report for the month

Budgeted profit

80,000

Sales volume (10,000 – 9,000 = £1,000 products) 20,000 A

Sales price (£42 - £40 = £2 per product) x 9,000 products

18,000 F

Material A usage

(19,000 kg - (9,000 products x 2 kg)) x £1 per kg

1,000 A

Material A price

(£1 - £1.10) x 19,000 kilos 1,900 A

Material B usage

(10,100 – 9,000) @ £3 3,300 A

Material B price

(£3.00 - £2.80 = 20 pence per kg) x 10,100 kg

2,020 F

Labour efficiency

(27,000 – 28,500 = 1,500 hours) @ £3 4,500 A

Labour rate (£3.20 - £3.00 = 20 pence per hr) x 28,500 hrs

5,700 A

VO efficiency *

(28,500 – 27,000 = 1,500 hours) @ £2 per hour

3,000 A

VO expenditure *

(28,500 hours @ £2) - £52,000 5,000 F

Fixed overheads

£120,000 - £116,000 4,000 F

------- 10,380 A

---------

Total profit 69,620

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* these are the equivalent of usage and price variances. The VO efficiency variance measures how much extra was spent on variable overheads due to the inefficiency in production, e.g. how much extra energy was used in production because more hours were worked than were justified by the number of products actually produced. The VO expenditure variance (£5,000 F, here) indicates that although more energy, etc. was consumed than should have been, it was also purchased more cheaply than expected. In practice, total variable overheads will probably include several different items, each in different units and at different prices, and probably also the responsibility of a number

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of different managers, so these variances at an aggregate level are probably only of limited help.

** as stated above, the total impact of the fall in volume of 1,000 products was £20,000 (adverse). However, most costing systems in practice are based on full costs, and would therefore distinguish between the fixed overheads recovered per unit (£12 per unit here) and the profit margin of £8 per unit (remember that profit means after all costs, both variable and fixed; contribution means after only the variable costs). Most variance analysis systems would therefore report this (perhaps confusingly) as 2 separate amounts, i.e.:-

fixed overhead volume variance: 1,000 units @ £12 = £12,000 Asales margin quantity variance: 1,000 units @ £8 = £8,000 A

If wanted, and if the data is available, each of these volume-related variances can be further analysed to reflect the causes of the loss in volume: was it due to a loss in capacity (e.g. the factory suffered downtime due to a strike or machine breakdown) or to lower-than-expected efficiency?

Note: variance analysis can be taken down into further detail if wanted, if this would generate useful information. E.g. a company with more than one product in its range (unlike Alpha) might want to break down the sales price variance between the part that is due to actual changes in the prices charged to customers, and the part which is due to differences in the sales mix. I.e. the company may not have changed its prices, but customers may have bought more low-margin products and less high-margin products than expected (or vice versa), and this will have affected profit.

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