customer profitability analysis-3!3!2004 jun a

8/7/2019 Customer Profitability Analysis-3!3!2004 Jun A

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Answers


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Part 3 Examination Paper 3.3

Performance Management June 2004 Answers

1 (a) (i) NAW Group:

Statement of Budgeted Profit for the year to 31 May 2005 Division O

Product Painfree Painfree Digestisalve Digestisalve Awaysafe Total

Branded Unbranded Branded Unbranded Branded

Sales-packs (000s) 5,000 15,000 5,000 20,000 15,000 60,000

Selling price (s) 240 120 480 360 800000s 000s 000s 000s 000s 000s

Sales revenue 12,000 18,000 24,000 72,000 120,000 246,000

Cost of sales:

Material/conv.costs 4,250 12,750 9,250 37,000 42,000 105,250

Packaging costs 750 750 1,250 3,000 6,000 11,750

Total variable costs 5,000 13,500 10,500 40,000 48,000 117,000

Contribution 7,000 4,500 13,500 32,000 72,000 129,000

Fixed costs:

Fixed overheads 81,558

Advertising and promotion costs 17,400

Net profit 30,042

Net profit 30,042

Required return (10%) 12,000

Residual Income (RI) 18,042

Invested capital (000s) 120,000

Return on Investment (ROI) 2504%

(ii) During the years ended 31 May 2005 and 2006,manufacturing capacity is restricted to 780,000,000 tablets. Since

the tablets are only sold in one pack size that contains 12 tablets, enough tablets could be produced to satisfy a sales

demand of up to 65,000,000 packs during each year. Forecast demand for the year ended 31 May 2005 is

60,000,000 packs. Division O has spare capacity equivalent to 5,000,000 packs of tablets. However, forecast sales

demand for the year ended 31 May 2006 is 10% higher than that of the previous year (i.e. 60,000,000 x 110%) =

66,000,000 packs. Therefore demand is forecast to be in excess of available capacity by 1,000,000 packs, which is

likely to prove costly to the NAW group not only in terms of contribution foregone but also in terms of potential loss of

customer goodwill. It is clearly essential that management attention should be focused on the identification and removal

of the limiting factor/(s) that would otherwise prevent Division O meeting forecast demand during the year ending

31 May 2006.

Management should also give consideration to qualitative factors that may be affected by the product-mix decision. For

example, customers may be affected by the decision to manufacture one product as opposed to another. The

management of the NAW Group need to consider the extent to which their customers will be affected by any decision

which alters the availability of the finished product. For example, a decision to increase the output of Awaysafe and

reduce the output of Painfree could result in customers who previously purchased both branded and unbranded

versions of Painfree and/or Digestisalve finding an alternative supplier who is able to supply a substitute product in

both branded and unbranded (generic) variants.

Management will need to assess the market position of each product before making a decision regarding product-mix.This might involve a reduction in short-term profitability in order to gain in the longer-term.

Suppliers also require consideration since they will be affected by any changes to the product mix that necessitate

different ingredients and revisions to delivery schedules. Further negotiations will almost inevitably be required.

Management should also consider the likely response of competitors as any decision to change a production

specification, such as for example the introduction of a new tablet format, will affect competitors who will then consider

their response.

It is quite conceivable that a change in production as a result of product-mix considerations might well result in a

changed demand for individual resources, which in turn could impact upon resource availability.

(iii) The use of Residual Income helps to overcome many of the disadvantages of Return on Investment. In particular, it

reduces the temptation on the part of management to reject projects with returns greater than the hurdle rate required

by the group (10%), but acceptance of which would cause a lowering in the divisions current level of return on

investment (2504%). Thus, any project that generates a positive residual income enhances corporate performance.Consequently the use of Residual Income is more consistent than ROI with the objective of maximisation of the total

profitability of the NAW Group. Thus, RI could also be used as a basis for management incentive schemes. A further


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advantage of the RI approach lies in the fact that it is possible to apply different cost of capital percentage rates to

investments that have different levels of risk. Also, the use of the RI approach serves to provide a focus on the cost of

funds to divisional managers.

(b) (i) As regards Quotation 1 in respect of the year ending 31 May 2005, the manager of Division L would purchase from a

local supplier in order to increase the profitability of his/or her division. An internal transfer price of 560 (800 less

30%) would appear unattractive in comparison with a locally available price of 550. Since the NAW Group measures

divisional performance via the use of ROCE and RI, it follows that the manager of Division L will consider the

maximisation of profit (via lowering of purchase costs) to be of critical importance. The cost to the group will be11,500,000. This is due to the fact that Division O could potentially have supplied these 5,000,000 units at a

marginal cost of 320= 16,000,000, however an external supplier would be paid 27,500,000 for the required

5,000,000 packs of an equivalent product.

As regards Quotation 2 in respect of the year ending 31 May 2005, the manager of Division L would again purchase

from a local supplier in order to increase the profitability of his/or her division. Division O could potentially have supplied

these 9,000,000 units at a marginal cost of 320= 28,800,000 although sales of 4,000,000 packs of another

product (unbranded Painfree has the lowest contribution of 030 per pack) would need to be foregone, resulting in

an additional cost to the group of 1,200,000. Since an external supplier would be paid 49,500,000 for the required

9,000,000 packs of an equivalent product, the cost to the group would be 19,500,000 (49,500,000

28,800,000 1,200,000).

(ii) In order for the profitability of the NAW group not to suffer during the year ended 31 May 2005, the following prices

should be charged in respect of each quotation:

Quotation 1

5,000,000 packs should be offered for transfer at 320, which is the marginal cost of production. It is also the

opportunity cost to Division O, since there is enough spare capacity within Division O to meet the quotation quantity.

Thus the quoted price should be 16,000,000.

Quotation 2

Since 9,000,000 packs of Awaysafe are required, then 5,000,000 of these can be satisfied by using the spare capacity

that is available within Division O. Since management of the NAW Group have decided that 15,000,000 packs of

Awaysafe must be available for purchase within the UK, then in order to meet the requirement of Quotation 2,

management should forego sales of 4,000,000 packs of unbranded Painfree which is the product with the lowest

contribution. (030 per unit). Thus the quoted price should be 30,000,000 which is comprised as follows:

Variable costs of manufacturing 9,000,000 packs of Awaysafe at 320 per pack 28,800,000

Contribution foregone on 4,000,000 packs of unbranded Painfree at 030 1,200,000

Quoted Price 30,000,000

(iii) The ideal transfer price should reflect the opportunity cost of sale to the supplying division and the opportunity cost of

purchase to the buying division. Thus the general rule put forward is that the transfer price per unit should be the

standard variable costs of the producing division plus the opportunity cost to the company as a whole of supplying the

unit internally. The use of opportunity cost as a basis for transfer pricing would necessitate consideration of any

alternative use that could be made of the capacity within the supplying division. The supplying division would be

indifferent as whether its output was sold internally or externally. The purchasing division would choose on the basis of

whether the external purchase price was lower than the internal transfer price and this would require that full information

is available about the opportunity cost to the group of internal supply, in order to ensure that the correct purchase

decision is made from a group perspective. A significant problem lies in the fact that full information about opportunity

costs may not be easily obtainable in practice. A further consideration lies in the fact that the imposition of a transfer

price may undermine divisional authority.

(c) (i) If Division L buys from a local supplier, the financial implications for the NAW Group are as follows:

Division O sales:

15,000,000 packs of Painfree at Contribution of 030 per pack = 4,500,000

Taxation at 40% thereon 1,800,000

After tax benefit of sales 2,700,000

Division L purchases:

9 million packs of Awaysafe at Cost of 550 per pack 49,500,000

Taxation benefit at 20% thereon 9,900,000

After tax cost of purchases 39,600,000

Net cost to NAW Group 2,700,000 less 39,600,000 36,900,000

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If Division L buys internally from Division O the financial implications for the NAW Group are as follows:

Division O sales:

11 million packs of Painfree at Contribution of 030 per pack = 3,300,000

9 million packs of Awaysafe to Division L at Contribution of 240 per pack = 21,600,00024,900,000

Taxation at 40% thereon 9,960,000

After tax benefit of sales 14,940,000

Division L purchases:

9 million packs of Awaysafe at Cost of 560 per pack 50,400,000

Taxation benefit at 20% thereon 10,080,000

After tax cost of purchases 40,320,000

Net cost to NAW Group 14,940,000 less 40,320,000 25,380,000

The NAW Group will be 36,900,000 25,380,000 = 11,520,000 better off if Division L purchases product

Awaysafe from Division O, as opposed to purchasing an equivalent product from a local supplier. Notwithstanding the

fact that the wealth of the NAW Group is enhanced by the decision, there is also the fact that it makes good commercial

sense to promote the Awaysafe brand in the international arena.

(ii) When determining transfer prices the management of the NAW Group should consider the following issues:

Taxation In a large number of multinational organisations the issues relating to taxation take precedence over othertransfer pricing issues and significant amounts of management time are spent attempting to determine the transfer prices

that will minimise tax paid on a global basis. Transfer prices should be set in a way that minimises the taxation payable

by the organisation as a whole. Management should be cognisant of the fact that anti-avoidance legislation exists to

prevent companies using transfer policies to divert profits to subsidiaries/divisions based abroad.

Import duties/tariffs can prove problematic. Again, whilst it is desirable that transfer prices be kept as low as possible

in order to minimise the payment of duty in countries that impose import tariffs based on the value of incoming goods,

it should be borne in mind that governments are mindful of such practices and may invoke similar policies to that of

anti-avoidance legislation.

Currency fluctuations can also prove problematic as they give rise to exchange risk. Many international organisations

attempt to reduce their exposure to exchange risk by paying early or late to profit from the anticipated movements in

exchange. Whilst the management of NAW Group should give careful consideration regarding which currencies to

invoice in and which currencies to settle invoices etc, management should avoid the temptation to use transfer prices

as a means of moving funds from a weaker currency into a stronger currency.

Repatriation of funds must be considered when dealing with countries, which have a high inflation rate or stringent

foreign exchange regulations. It is imperative that transfer prices are only set after giving due consideration to which

countries and in what currencies cash balances should be maintained.

(d) The product life cycle (plc) depicts the movements of a product through the four phases of introduction, growth, maturity and

finally decline. The returns that the management of NAW Group will expect from each of its product will be dependent on

where that product is in its life cycle. By giving due consideration to the life cycle of the different products, the management

of NAW Group will gain a better understanding of the likely demand for its products. This will be a significant aid in the

formulation and development of a marketing plan and provide the basis for the allocation of available resources such as the

advertising and promotional budget which in the year ending 31 May 2005 is forecasted to amount to 17,400,000 (7%

of total turnover). Hence various aspects relating to how a product is managed relate to managements perception of its current

position in the life cycle. The use of the product life cycle would encourage the management of NAW Group to look beyond

the current level of returns when deciding upon investment strategy. The use of the model would enable management to

evaluate investment in products on a Whole life basis. Use of the model might not only enable management to assess

whether revenues were likely to grow or not, but might also enable them to gauge the amount of future investment needed.

The specific implications of the product life cycle for the management of the NAW Group are dependent upon the stage within

the product life cycle that a product is in, and the nature of the pricing decision being made.

In the pre-launch stage management will be concerned with the establishment of price objectives. This will necessitate the

identification and analysis of the various influences upon price such as product specifications, supply forecast levels of

demand and legal and environmental constraints.

In the introduction phase management will consider whether to employ skimming or penetration pricing policies depending

on their desired objectives and their assessment of market characteristics. At this stage the management of the NAW Group

should consider the trade discount structure that they wish to be employed and develop special offers to encourage the

adoption of the new product.

In the growth phase management should use price as a means to combat competition and attempt to maximise the benefit

to be derived from economies of scale whilst improving the perceptions of price and value of the product.

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In the maturity phase management should use price in order to protect the market position of the product. Consideration

should be given to identifying alternative distribution channels which may offer the opportunity to charge higher prices.

When a product reaches the decline phase management should use price in order to maximise potential profits, even if this

involves a diminution in market share.

Clearly it is important that the performance measures used to assess each product take account of the stage that each

respective product is at in its life cycle. Traditional performance measures such as profit and return on capital employed are

most suited to products in the mature and decline stages where management focus is upon the use of scarce resources and

the maximisation of cash flows. During the introduction and growth phases the factors that need to be controlled are those

related to the product gaining market success since these will ultimately determine its future financial value.

The management of NAW Group will be unable to forecast the precise shape or duration of a products life cycle from the

model. Hence, whilst useful as a descriptive model the plc has no predictive value. Since the management of the NAW Group

only have access to past sales data they would also find it difficult to locate the position of a product on the life cycle. For

example, if sales revenues grew during each of the past four years it would still be impossible to discern whether the product

was in the early, mid or late growth stages. Likewise a dip in sales may not signal entry into the decline stage but may be

attributable to short term economic recession.

2 (a) Statement of Budgeted Customer Profitability for the year to 31 May 2005 Division O

Large Small Supermarkets Others Total

Pharmacies Pharmacies000s 000s 000s 000s 000s

Contribution 49,350 27,050 43,350 9,250 129,000

Less:

Delivery costs 768 2,304 2,048 2,880 8,000

Changed delivery requirements 6 2 8

Purchase order costs 2 6 2 20 30

Promotion and exhibition costs 110 110

Retrospective rebates 9,180 2,280 13,950 25,410

Total other operating costs 10,066 4,590 16,002 2,900 33,558

Net profit before fixed overheads 39,284 22,460 27,348 6,350 95,442

(b) (i) Most organisations compete in increasingly competitive markets and hence it becomes vital that the management of

such organisations are able to ascertain not only the level of profitability relating to the products or services it sells, butalso the levels of profitability attaching to particular customers, markets and distribution channels to which those

products and services are sold. It has long been acknowledged that gross margin net of trade discounts is an inaccurate

measure of profitability. Product costs are generally determined from manufacturing costs, however customer costs are

often determined from the selling and distribution costs that are incurred in the period following manufacture. The

conventional accounting systems of many organisations treat these costs as period costs for both financial and

management reporting practices. Whilst this treatment might be considered appropriate for financial reporting purposes,

it is arguably a major failing of such reporting systems not to allocate such costs to customers. Since no two customers

have identical requirements it follows that profitability can vary enormously from one customer to the next. Such

variations are masked by conventional accounting systems.

Activity-based techniques may be used to assign post-manufacturing costs to customers for decision-making purposes.

The allocation of such costs should reflect the ways in which different customers consume resources. In the case of

Division O it is quite clear that each of the four customer groups is profitable. However, the allocation of customer specific

costs to customer groups shows that a significant amount of the contribution generated by the supermarkets and otherretail outlets is consumed by customer specific costs. Hence the ratio of profit before fixed overheads to sales varies

considerably from the contribution to sales ratios for those particular customer groups as shown by the following table.

Large Small Supermarkets Others

Pharmacies Pharmacies

Contribution: sales ratio (%) 5376 5932 4661 5930

Profit: sales ratio (%) 4279 4925 2941 4070

The management of Division O should utilise their management information systems in order to drill-down and

ascertain the respective rate of profitability of existing customers within each customer group. For example, the specialist

independent pharmacies and the customers who comprise the other retail outlets require a large number of deliveries

relative to the number of such deliveries required by the large pharmaceutical stores and the supermarkets. It may be

possible to re-negotiate delivery schedules so that the profitability levels of customers within these groups is improved.

The absence of accurate information relating to customer profitability might well precipitate strategic errors in the pricingof goods and/or services for particular customers. For example, if the NAW Group failed to assign costs such as those

incurred in respect of the number of deliveries made to customers, it would not be possible to price services to customers

to reflect differences in the service levels provided to different customers. Moreover, it might well be the case that such

costs may be allocated to the wrong customers!

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Many organisations do not have management information to enable managers to gain a clear understanding regarding

the profitability of their customers and/or the markets in which they operate. As services (sales, general and

administrative costs) become a more significant part of companies competitive advantage and cost structure, the

management tools must respond accordingly. In fact, for service companies, customer profitability is far more important

than product profitability because the costs of providing a service product are usually determined by customer behaviour.

(ii) The initiatives that managers should consider in order to improve customer profitability generally fall within three

categories, these are:

Process improvements Pricing decisions

Relationship management.

The management of the NAW Group should try to ensure that prior to embarking on a customer profitability exercise

that the companys overall operations are as cost-effective as possible. Many organisations attain a competitive level of

productivity by undertaking detailed reviews of technology, utilisation, performance and planning in each function. The

main limitation of such a review lies in the fact that it is function-based and fails to recognise inefficiencies that exist

within the inter-functional relationships, which are an integral part of the day-to-day operations of all organisations.

Suppliers should first look internally to see where they could improve their own processes thereby reducing the costs

incurred in supplying their customers. If most customers are migrating to smaller order sizes, companies should strive

to reduce batch-related costs, such as set-up and order handling, so that customer requirements can be satisfied at lower

cost and without raising overall prices. The use of electronic systems yields a large reduction in the cost of processing

large quantities of small orders. If customers seek variety, manufacturing companies could respond by introducing

modular designs and use information technology to enhance the linkages from design to manufacturing so that greater

variety and customisation can be offered without cost penalties.

The major opportunity for resolving conflicts between suppliers and customers, and for transforming unprofitable to

profitable relationships, arises from pricing individual orders and transactions. Any strategy focussed upon management

of customer profitability should be underpinned by customised pricing policies. By understanding the (activity-based)

cost of providing services, companies can establish prices that can precipitate more efficient behaviour of both suppliers

and customers and assist in the transformation of hitherto unprofitable relationships into profitable ones. Accurate cost

and pricing information can provide the stimulus for customers to change their ordering, shipping and distribution

patterns thereby lowering total supply chain costs to the mutual benefit of suppliers and customers.

Activity-based pricing improves the fit between suppliers and customers and has the potential to enhance the profits for

both across the supply chain. Such pricing educates customers about how their behaviour affects the costs of its

suppliers. But, often, the customer also learns about its own costs from such activity-based pricing.

Before taking any action including pricing with unprofitable customers, companies should expand the customerprofitability measurement to encompass all the relationships that each customer has with the company. While such total

profitability calculations were difficult and expensive using legacy computer systems, modern ERP and CRM systems

can identify and link all customer relationships together.

The Balanced Scorecard (BSC) provides a comprehensive framework for managing customer relationships. (R. S. Kaplan

and D. P. Norton, The Balanced Scorecard: Translating Strategy into Action (Boston: HBS Press, 1996)) The BSCs

customer perspective typically includes outcome measures for targeted (strategic) customers. Such measures include

customer acquisition, satisfaction, retention, account share, and market share. But the customer perspective should also

measure whether loyal, satisfied customers are profitable customers. Companies need to ensure that their loyal, satisfied

customers those consuming many resources are indeed a source of adequate profitability.

Many service organisations invest considerable resources in marketing campaigns to attract new customers. However,

a significant part of this investment may prove not to be worthwhile unless organisations have a clear understanding of

the characteristics of what makes a profitable customer. By knowing the characteristics of profitable customers,

companies can focus their marketing activities upon those segments that are most likely to yield profitable customers.

It is quite possible that high-quality new customers may be prove to be unprofitable in the short-term due to the fact

that there are often significant costs connected with the acquisition of new customers. Moreover, it is almost inevitable

that it may take some time to establish a relationship whereby the customer buys many products and services. In order

to improve their understanding of customer account profitability, service companies need to give separate consideration

to such newly-acquired customers and in so doing, it is vital that they should not be judged on the same criteria as

long-standing customers. Thus, in addition to recognizing cross-sectional variation of demands by customers across

multiple products and services, companies must also forecast the longitudinal variation of customers over time to arrive

at an estimate of their total life-cycle profitability.


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Workings (part a):

(i) Contribution per customer group.

Product Type Large Small Supermarkets Others Total


000s 000s 000s 000s 000s

Painfree Branded 4,200 1,400 700 700 7,000

Painfree Unbranded 1,350 3,150 4,500

Digestisalve Branded 5,400 4,050 2,700 1,350 13,500Digestisalve Unbranded 9,600 22,400 32,000

Awaysafe Branded 28,800 21,600 14,400 7,200 72,000

Total Contribution 49,350 27,050 43,350 9,250 129,000

Illustrative workings for Large Pharmacies:

Product Type Total contribution Large Large

per product Pharmacies % Pharmacies

000s of sales volume 000s

Painfree Branded 7,000 60% 4,200

Painfree Unbranded 4,500 30% 1,350

Digestisalve Branded 13,500 40% 5,400

Digestisalve Unbranded 32,000 30% 9,600Awaysafe Branded 72,000 40% 28,800

Total Contribution 49,350

(ii) Retrospective rebates.

Sales Revenues (000s)

Large Small Supermarkets Others


Painfree: 000s 000s 000s 000s

Branded 7,200 2,400 1,200 1,200

Unbranded 5,400 2,400 12,600

Digestisalve:

Branded 9,600 7,200 4,800 2,400Unbranded 21,600 2,400 50,400

Awaysafe:

NAW Brand 48,000 36,000 24,000 12,000

Total Revenue 91,800 45,600 93,000 15,600

Retrospective rebate (%) 91,010 91,015 91,015 91,010

Retrospective rebate 19,180 12,280 13,950 91,010

3 (a) In the worldwide competitive environment of today, organisations are competing in terms of product/(service quality), delivery,

reliability, post-sales service and customer satisfaction. It is only recently that management accounting systems have been

adapted to provide management with information regarding these critical variables, notwithstanding the fact that they have

represented key commercial variables for a considerable period of time. Prior to the last quarter of a century a large number

of organisations in the western world operated in the comfort of a protected competitive environment. Barriers to

communication, government support and geographical distance often protected domestic markets. This protection provided

organisations with very little stimulus to focus upon achieving improvements in efficiency and management practices, since

inefficiencies were very often passed to the customers of such organisations. In recent years such domestic markets have

been attacked by competition from overseas countries that offer low-cost, high-quality products to the domestic markets.

Overseas competitors have been able to attack domestic markets via the establishment of global networks enabling them to

acquire raw materials and distribute goods in overseas territories.

Robert Kaplan has written persuasively that much of the problem with regard to the difficulties faced by US manufacturing

organisations with regard to Japanese and European competition can be traced to management accounting techniques and

practices which do not meet the needs of todays manufacturing environment. Kaplan concluded that traditional cost

accounting systems based on an assumption of long production runs of a standard product, with unchanging characteristics

and specifications will not be relevant in this new environment.

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According to Kaplans relevance lost thesis, todays manufacturing is totally different. Instead of direct labour intensive,

standard products with long life cycles, it features sophisticated, overhead intensive, module-designed and tailor-made

product with short life cycles. Instead of utilising machinery, which had only a single purpose, there are flexible manufacturing

stations and the use of emergent CAD/CAM technologies. Instead of small groups of technical and clerical employees,

manufacturing is planned and controlled by a large number of experts in specialist technical departments and administrative

offices who manage the actual production operation. Moreover, instead of national oligopolistic and tariff-protected

competition, the world features relatively unrestricted enterprises competing around the globe, and an increasing number of

free trade arrangements.

It can therefore be argued that the metamorphosis that has taken place in manufacturing has not been followed by a

transfiguration of management accounting and control techniques. The time-honoured systems whose focus was upon

reducing and minimising product costs and emphasised short-term tactical control, have become inappropriate and frequently

misleading. Hence the assertion that management accounting systems have lost their relevance.

(b) The strategic cost management initiative proposes several ways to restore management accounting to a place of relevance

including a radical overhaul of the focus of management accounting and control systems. More specifically, the scope of

accounting and control reports should be widened to include information regarding matters such as reductions in product

throughput time, rework costs, the number of manufacturing interruptions, progress on waste management, levels of

workforce morale and indicators of quality in products. In addition, the information base available to management would be

expanded from accounting numbers to include measures and statistics relating to those variables that constitute strategic

success factors. The adoption of a more holistic focus would direct attention towards considerations that were more strategic

as opposed to operational in nature. Thus greater attention would be placed upon factors such as the ever-changing needs

of customers, long-term effectiveness, and quality measures, whilst less attention would be placed upon tactical concernssuch as achieving efficiencies and lower product costs.

A major initiative required by strategic cost management lies in the use of value-chain analysis. Value-chain analysis means

reconceiving the business as a linked set of value creating activities all the way from basic raw material sources for

component suppliers through to the end-use product delivered into the final consumers hands. The aim is to expand the

scope of management accounting to include critical external elements with a particular focus upon adding value for both

customers and suppliers.

Strategic cost management also promotes the need to revitalize management accounting by extending cost estimates over the

entire life cycle of a product, a practice that many Japanese organisations have adopted for many years. Furthermore,

Japanese organisations seek to harness the collaborative efforts of engineers, purchasing officers, component suppliers,

marketing personnel, production staff and all other involved parties in order to arrive at an estimate of the standard achievable

cost of their part of a new product. Then they establish an allowable cost which is difference between the expected selling

price and the cost needed to make the desired level of margin. Next a target cost is struck usually halfway between the

standard achievable and the allowable cost. These cost estimates are not based on current production methods and

manufacturing equipment but on potentially ideal configurations and incorporate learning-curve effects. A feature of the use

of target costing is the unceasing efforts of managers to achieve the allowable cost.

The strategic cost management initiative that has attracted the most attention is activity-based costing (ABC). Advocates of

ABC contend that many large complex organisations rely on traditional absorption cost accounting systems the use of which

gives rise to significant distortions in product cost data. Proponents of ABC argue that such distortions occur because such

systems use volume related formulae based on direct labour, direct materials, or machine utilisation in order to allocate

indirect manufacturing costs, when in fact these resources represent only a small proportion of the total cost of most products

and services. The proponents of ABC hold the view that the use of absorption based systems will result in inaccurate and

arbitrary product cost information, which, if relied upon will precipitate poor decision-making by management in areas of

critical importance such as product policy and capital investment as well as misguiding management on financial

performance and control systems that should be employed.

Strategic management accounting is an approach to management accounting that addresses issues and concerns which are

strategic in nature. It places management accounting in a much broader context in which financial information is used to

develop superior strategies in order to derive a means of achieving sustainable competitive advantage. Conventional

management accounting tends to have both, an historic focus and an inward looking perspective and be concerned with

single decisions, single periods and single entities. By way of contrast, strategic management accounting is future focussed

and consider the external business environment of an organisation and in particular the position of the organisation in relation

to its competitors in the context of sequences of decisions over multiple time periods. The future is complex and uncertain

and thus strategic management accounting can be viewed as a much-needed response to what could be viewed as major

shortcomings of conventional management accounting systems.

The use of initiatives such as value chain analysis, life cycle costing, target costing, activity-based costing and strategic

management accounting can be viewed as being the response of management accounting in its attempt to regain relevance

and maintain a focus of controls upon matters of strategic importance and long-term effectiveness.

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4 (a) (i) Memorandum

To: Board of Directors

From: Finance Director

Date: 11 June 2004

Re: The adoption of Zero-based budgeting within NN Ltd.

During recent years the management of NN Ltd has used the traditional approach of incremental budgeting. This

approach entails the use of the previous years budget as a baseline and adds or subtracts amounts to/ from that budgetin order to reflect assumptions for the forthcoming budget year. The typical justification for increased expenditures, other

than those related to volume changes, has been due to the increased cost of inputs to our business. This approach can

lead to inefficiencies in the previous years budget being rolled forward into the next years budget purely by virtue of

the fact that last years budget is the base starting point for the construction of the new budget.

The implementation of a system of zero-based budgeting will require a consideration of the following:

The need for major input by management;

The fact that it will prove extremely time consuming;

The need for a very high level of data capture and processing;

The subjective judgement inherent in its application;

The fact that it might be perceived as a threat by staff;

Whether its adoption may encourage a greater focus upon the short-term to the detriment of longer-term planning.

Zero-based budgeting was developed to overcome the shortcomings of the technique of incremental budgeting. Theimplementation of a zero-based budgeting would require each manager within NN Ltd to effectively start with a blank

sheet of paper and a budget allowance of zero. The managers would be required to defend their budget levels at the

beginning of each and every year. Thus, past budget decisions would as part of the process of zero-based budgeting

need to be re-evaluated each year. The comprehensive resource cost-analysis process is a strong internal planning

characteristic of zero-based budgeting. It follows that resource requirements are more likely to be adjusted to changing

business conditions.

The development and implementation of the zero-based budgeting model will require managers and others in the

organisation to engage in several major planning, analytical and decision-making processes. Our company has already

established mission and goal statements. However, we as a management team ought to give consideration as to whether

it is necessary to redefine the statements that are already in existence and/or create new ones. This redefinition of

mission and goal statements will be of much value if we as a management team consider that major changes have

occurred in the internal and external environment of our business.

A zero-based budgeting decision unit is an operating division for which decision packages are to be developed andanalysed. It can also be described as a cost or a budget centre. Thus the manager responsible for each cost centre within

NN Ltd would be responsible for developing a description of each program to be operated in the next budget year. In

the context of zero-based budgeting such programs are referred to as decision packages, and each decision package

usually will have three or more alternative ways of achieving the decision packages objectives. Briefly, each decision

package alternative must contain, as a minimum, goals and/or objectives, activities, resources and their associated costs.

Each decision package should contain a description of how it will contribute to the attainment of the mission and goals

of the organisation.

Each manager within NN Ltd will be required to review each decision package and its alternatives in order to be able

to assess and justify its operation and in doing so, several questions must be answered. In particular, each manager will

need to answer the following questions:

Does this decision package support and contribute to the goals of the organisation?

What would be the result to the organisation if the decision package were to be eliminated?

Can this decision packages objectives be accomplished more effectively and/or efficiently?

The ranking process, based upon cost/benefit analysis is used to establish a prioritised ranking of decision packages

within the organisation. During the ranking process managers and their staff will analyse each of the several decision

package alternatives. The analysis allows the manager to select the one alternative that has the greatest potential for

achieving the objective(s) of the decision package. Ranking is a way of evaluating all decision packages in relation to

each other. Since, there are any number of ways to rank decision packages managers will no doubt employ various

methods of ranking. The ranking process could prove to be problematic insofar as it will require our managers to make

value judgements and thus subjectivity is an inherent factor in the application of zero-based budgeting. Although

difficult, the ranking of decision packages is fundamental to the process of zero-based budgeting.

Following a review and analysis of all decision packages, managers will determine the level of resources to be allocated

to each decision package. Managers at different levels of responsibility in the organisation usually perform the review

and analysis. Sometimes, the executive levels of management may require the managers of the decision packages to

revise and resubmit their decision packages for additional review and analysis.

Our budget will be prepared following the acceptance and approval of the decision packages. Once the companys

budget has been approved, managers of the decision units will put into operation all approved decision packages during

the budget year.

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The last major process of zero-based budgeting is monitoring and evaluation. The processes of planning, analysis,

selection and budgeting of decision packages will prepare our company for operation during the next year. However,

what managers plan to happen during the next year may or may not occur. Adjustments may be essential during the

year in order to achieve the decision package objectives. Also, there is a need to know whether or not the organisation

did accomplish what it set out to achieve and what level of achievement was obtained. The monitoring and evaluation

process of zero-based budgeting requires a number of features are incorporated in the overall design and implementation

of decision packages.

It is essential that all decision packages include measurable performance objectives and identifies the appropriate

activities as means for achieving the performance objectives.

The required resources for conducting the activities, together with the planned methods for carrying out the

activities should also be included.

The decision package should also include a mechanism to evaluate whether an objective is being achieved both

during and after the conclusion of the program of activities for subsequent reporting to management.

(ii) The implementation of zero-based budgeting will require a major planning effort by our personnel. It is through the

planning process that important guidelines and directions are provided for the development and ranking of the decision

packages. Also, the planning process will enable managers to prepare for the uncertainty of the future. Long-range

planning allows managers to consider the potential consequences of current decisions over an extended timeframe.

Zero-based budgeting addresses and supports comprehensive planning, shared decision-making, the development and

application of strategies and allocation of resources as a way of achieving established goals and objectives. In addition,

zero-based budgeting supports the added processes of monitoring and evaluation.

Zero-based budgeting, when properly implemented, has the potential to assist the personnel of an organisation to plan

and make decisions about the most efficient and effective ways to use their available resources to achieve their defined

mission, goals and objectives.

There is no doubt that the process of zero-based budgeting will consume a great deal more management time than the

current system of budgeting does. This will certainly be the case in implementation of the system because managers

will need to learn what is required of them. Managers may object that it is too time-consuming to introduce zero-based

budgeting, however, it could be introduced on a piece-meal basis. As regards the imposition upon management time,

managers may object that they simply do not have the necessary time in order to undertake an

in-depth examination of every activity each year. However, if this proves to be the case then we could consider the

establishment of a review cycle aimed at ensuring that each activity is reviewed on at least one occasion during every

two or three years.

I propose that we hold a series of training seminars for our management to help in the transition to a system of

zero-based budgeting. We must also ensure that we sell the benefits that would arise from a successful implementation.A zero-based budgeting system would assist our managers to:

Develop and/or modify the organisations mission and goals.

Establish broad policies based on the mission and goals.

Efficiently identify the most desirable programs to be placed in operation.

Allocate the appropriate level of resources to each program.

Monitor and evaluate each program during and at the end of its operation and report the effectiveness of each

program.

Thus, as a consequence of the adoption of zero-based budgeting our managers should be able to make decisions on

the basis of an improved reporting system.

It is quite possible that zero-based budgeting would help identify and eliminate any budget bias or budget slack that

may be present. Budgetary slack is a universal behavioural problem which involves deliberately overstating cost budgets

and/or understating revenue budgets to allow some leeway in actual performance. We must acknowledge that inorganisations such as ours where reward structures are based on comparisons of actual with budget results, bias can

help to influence the amount paid to managers under incentive schemes. However, we should emphasise that if

managers are to earn incentives as a consequence of incentive schemes that are based upon a comparison of actual

outcomes with budgeted outcomes, then a zero-based budget would provide a fair yardstick for comparison.

It is important to provide reassurance to our managers that we do not intend to operate a system of zero-based budgeting

against the backdrop of a blame-culture. This will help to gain their most positive acceptance of the change from a long-

established work practice that they may perceive afforded them a degree of insurance.

Signed: Finance Director

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(b) The finance director is probably aware that the application of zero-based budgeting within NN Ltd might prove most fruitful

in the management of discretionary costs where it is difficult to establish standards of efficiency and where such costs can

increase rapidly due to the absence of such standards. A large proportion of the total costs incurred by NN Ltd will comprise

direct production and service costs where the existence of input: output relationships that can be measured render them more

appropriate to traditional budgeting methods utilising standard costs. Since the predominant costs incurred by a not for profit

health organisation will be of a discretionary nature, one might conclude that the application of zero-based budgeting

techniques is more appropriate for service organisations such as the not for profit health organisation than for a profit-seeking

manufacturer of electronic office equipment. A further difference lies in the fact that the ranking of decision packages is likely

to prove less problematic within an organisation such as NN Ltd which is only involved in the manufacture and marketing ofelectronic office equipment. By way of contrast, there is likely to be a much greater number of decision packages of a disparate

nature, competing for an allocation of available resources within a not for profit health organisation.

5 (a) The term value for money is often used to refer to economy, efficiency and effectiveness. Value for money audits can be

undertaken in order to assess whether value for money has in fact been achieved. In order for such an audit to be effective

the objectives of AV would need to be clearly understood by those undertaking the audit.

The management of AV could attempt to measure the value for money of its operating activities in terms of economy, efficiency

and effectiveness. Economy is only concerned with inputs acquired by AV, and is achieved by obtaining those inputs at the

lowest acceptable cost. For example, the prices at which with the replacement fitted kitchens are purchased (2,610) could

be compared with those obtainable from other vendors in order to assess whether the lowest acceptable cost is being achieved

for the required level of quality. It is important that the management of AV realise that economy is measured by reference to

quality of resource inputs. They need to recognise that the purchase of poor quality materials and inferior services representsfalse economy.

Efficiency is focussed upon output, for example, maximising output for a given level of input. For example with regard to the

replacement fitted kitchens, AV could use the tendering process in an attempt to maximise the number of fitted kitchens that

would be installed for a given amount of money by the contractor awarded the tender. Efficiency is measured by the ratio of

output to input. The ratio is not used in an absolute sense but in a relative sense and can be improved in four ways:

by increasing output for the same input;

by increasing output by a greater proportion than the proportionate increase in input;

by decreasing input for the same output; and

by decreasing input by a greater proportion than the decrease in output.

The denominator (input) is often measured in monetary terms whilst the numerator (output) can be measured in either

monetary amounts or physical units e.g. per property.

Effectiveness is focussed upon the achievement of objectives. A not for profit organisation will invariably have a number of

objectives. For example AV may have the following objectives:

To meet housing needs;

To provide quality well-managed homes;

To provide the services that clients want;

To provide an effective care and repair service;

To support the communities within which it operates.

The management of AV should be mindful that the three performance measures require individual consideration since for

example, the degree to which effectiveness is achieved gives no indication about how much was spent to achieve it.

The management of AV should also recognise that these performance measures may conflict with one another. For example,

during the year AV incurred expenditure amounting to 234,900 in respect of 90 replacement fitted kitchens. If AV had

purchased the same replacement kitchen units as BW, then AV would only have been able to refit 45 properties

(234,900/5,220). Hence, the efficiency ratio of inputs to outputs would have been halved. However, the purchase ofreplacement kitchen units at a cost of 5,220 might have resulted in a higher level of effectiveness being achieved through

factors such as the longer life of the replacement kitchen units, higher quality fixtures and fittings, and enhanced aesthetic

appeal to residents.

The management of AV should also give consideration to benchmarking against other similar charities whose primary

objective is the provision of accommodation to the communities in which they operate. Benchmarking is probably the most

significant recent development in measuring the performance of not-for-profit organisations. The management of charities

such as AV would be far more willing to share information about performance with similar organisations for their mutual

benefit, than the management of many profit-seeking organisations who often view the sharing of information as a commercial

threat. For example, the management of AV could attempt to establish whether 2,610 is the norm in respect of the cost of

a replacement fitted kitchen incurred by similar non profit-seeking organisations.

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(b) (i) Service quality.

The time required in order to undertake repairs of an emergency nature, after notification of the requirement by a tenant.

The friendliness of staff employed by AV which could be measured via the completion of questionnaires by tenants.

Flexibility.

Mean waiting time for a house to become available to a tenant.

Mean waiting time to re-house a tenant in a different sized house after receipt of a request from a tenant.

(ii) The management of AV could use the following performance measures:

Cost and efficiency.

AV BW

(1) The mean cost, per week per house on management. 961 2981

(2) The mean cost per week, per house on general repairs. 1022 613

(3) Percentage of rent available that was collected. 985% 100%

Notes/ comments:

(1) The mean cost per week per house is calculated by dividing the amount of staff and management costs by the

number of properties held by each of the respective organisations. Although the same number of staff, (25), are

employed by each organisation, staff costs incurred by BW are 377% higher than those of AV. This could result

from different pay structures and management policies regarding remuneration that are likely to be employed within

a profit-seeking organisation such as BW.(2) AV currently pays, on average, 140 for each emergency repair, 120 for each urgent repair and 116 for each

non-urgent repair. BW has benefited from the fact that each repair undertaken by BW costs the same (i.e. 100),

irrespective of the classification of repair. This might be a result of a contractual arrangement with a subcontractor

that each repair undertaken is charged at the same fee in return for guaranteed business volumes for the

subcontractor. If this were the case, then AV would benefit from entering into such an arrangement for the supply

of repair services.

(3) BW did not have any unoccupied properties at any time during the year. This would seemingly indicate a high level

of demand for its properties. AV had potential gross rents receivable during the year of 2,423,200. Unoccupied

properties resulted in lost revenues of 36,348. which amounted to 15% of gross rents receivable. Further

information is required to in order to assess whether the lost revenue is attributable to void periods i.e. properties

becoming vacant or perhaps due to tenants who have defaulted.

Note: other ratios and relevant comments would have been acceptable.

(c) The primary objective of any commercial organisation such as BW is to maximise profit. Management may take a short or

long-term view regarding the ways in which they seek to achieve this objective. Management may have to choose between

available options, each of which might help them to achieve this objective. However, whilst many decisions may have to be

made, the objective remains clear and identifiable.

The management of BW will most probably be concerned with the provision of high quality accommodation in order to

generate higher revenues and profits. The management of BW are probably trying to appeal to those who are willing to pay

high rents for high quality accommodation. The fact that replacement fitted kitchens and replacement windows and doors

purchased by BW cost 100% and 50% respectively, more than those purchased by AV may be an indication of this.

The objectives of not-for-profit organisations such as AV can vary significantly. AVs primary objective is to meet the

accommodation needs of persons within its locality. This might distil down to ensuring that any person, who is in need of

accommodation, is in fact provided for. The absence of a profit measure makes it more difficult to measure whether objectives

are in fact being achieved. It is difficult to judge whether non-quantitative objectives such as meeting accommodation needsof people have been met. This does not mean however, that such an assessment should be placed on the too difficult pile

and left unattended. A number of suitable measures need to be devised by the management accountant in order to assess

the extent to which non-quantitative objectives have been met.

The management of AV would probably be better served in comparing the performance of their organisation with a similar

non-profit seeking organisation that provides accommodation to meet the needs of society.

Additional information that would assist in appraising the performance of BW during the year ended 31 May 2004 includes

the following:

Estimates of the financial effects of changes in demand for different levels of rents charged.

Estimates of the financial effects of changes in demand for different costs/quality levels of accommodation provision.

A detailed analysis of net interest payable 750,000.

A detailed analysis of sundry operating costs 235,000.

Management accounts for the current and prior years. Budget information for 2004, 2005 and, if available, 2006.

It would also be useful to have details regarding the location of the properties held by BW. It is quite conceivable that the

houses held by BW are situated in a sought after area. Benchmarking with a best practice organisation from within the

private sector would be of much assistance in the appraisal of the operating and financial performance of BW.

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Part 3 Examination Paper 3.3

Performance Management June 2004 Answers

Marks Marks

1 (a) (i) Sales revenue 1

Cost of sales:

Materials, conversion costs 1

Packaging costs 1

Contribution 05Other operating costs 05

Advertising and promotion costs 1

Return on Investment 1

Residual Income 1

7

(ii) Comments (on merit):

Quantification of 2005 and 2006 position/remove limiting factor Up to 2

Effect on customers 1

Effect on suppliers 1

Effect on competition 1

Product-marketing strategy 1

Maximum 3

(iii) Comments (on merit):

It reduces the problem of under-investment 1

More consistent than ROI with objective of maximising the total profitability of a group 1

Basis of management incentive schemes 1

Possibility exists to use different rates of interest for different types of investment 1

Raises awareness of cost of finance 1

Maximum 3

(b) (i) Division L will purchase externally to improve its own profit 1

Performance measure based on profit 1

Sub-optimal from NAW Group viewpoint because spare capacity exists 1

Calculation of implications 2

Maximum 3

(ii) Correct Price Quotation 1 1

Correct Price Quotation 2 2

3

(iii) Comments (on merit):

Opportunity cost ideal, but 1

Supplying division would be indifferent as whether to sell internally or externally 1

The purchasing division would choose lower of external and internal transfer price 1

Use of OC would require consideration of alternative use of capacity in supplying division 1

Full information may not be available 1

Imposition of a transfer price may undermine divisional authority 1

Maximum 4

(c) (i) Purchase from local supplier:

Division O Sales 05

Division L purchases 05

Tax implications 1

Purchase internally:

Division O Sales 1

Division L purchases 1

Tax implications 1

Conclusion 1

6

(ii) Taxation minimisation 1

legal constraints 1

Exposure to currency risk 1

Import tariffs 1

Repatriation of funds 1Other relevant comments 1

Maximum 5

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Marks Marks

(d) Comments (on merit):

Linkage of expected returns to where product is in its life cycle

Appropriate performance measures required for each stage

Linkage to Product portfolio (appreciation of life cycle issues)

Limitations predictive capability? Up to 2 per comment

Maximum 6

Total 40

2 (a) Contribution 3

Delivery costs 1

Changed delivery requirements 05

Purchase order costs 1

Promotion/exhibition costs 05

Retrospective rebate 3

9

(b) (i) Comments (on merit):

Increased competition Up to 2

Failure of conventional accounting Up to 2

Strategic necessity Up to 2

Maximum 5

(ii) Comments (on merit):

Process improvements Up to 2

Activity-based pricing Up to 3

Customer relationship management Up to 2

Maximum 6

Total 20

3 (a) Comments (on merit):

Changed business environment

Fundamental need for MACS to match changed business environment

Control information out of date

Rapid feedback required

Variance analysis inappropriate

Over-emphasis upon efficiency

Inadequacy of full-cost for decision-making

Other relevant initiatives 1 mark per comment Maximum 5

(b) Comments (on merit):

General: Change of focus, scope of reports, content

Specific:

Value addedLife cycle costing

Target costing

Activity based techniques

Strategic management accounting

Other relevant initiatives 1 mark per initiative

Up to 2 marks per evaluation

(5 x 3 marks) Maximum 15

Total 20

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Marks Marks

4 (a) (i) Comments (on merit):

Factors to be considered

Effect on management

Role of management

Ranking of decision packages Up to 2

Monitoring and evaluation per comment

Maximum 10

(ii) Problems 1 mark per problem

Management actions 1 mark per action

Maximum 6

(b) Comments (on merit):

Differences

Ease of implementation Up to 2

Scope of application per comment

Other relevant comments Maximum 4

Total 20

5 (a) Comments and use of illustrative data (on merit):

Value for money Up to 1

Economy, efficiency, effectiveness Up to 5

Benchmarking Up to 2

Other relevant comments Up to 2

Maximum 7

(b) (i) Service quality measures 2 x 05

Flexibility measures 2 x 05

2

(ii) Cost and efficiency

calculation (1); comment (1) 3x 2 6

(c) Comments (on merit):

Different objectives Up to 3

Financial effects of changes in demand due to different levels of service provision

Location, age of properties, operating costs, interest, balance sheet, management

accounts, budgets

Benchmarking private sector organisation Up to 3

Maximum 5

Total 20

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customer profitability analysis-3!3!2004 jun a

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