Full List of Management Accounting for Decision Makers_17 pot

Aires plc a The SVA determination of shareholder value will be as follows: * The free cash flows will be the operating profit after tax plus the leasedepreciation charge that is, £12.0m

(28,100 × £1.96) − £51,704 = £3,372 (F)(b) The net variance on UK194 was, from the calculations in (a), £1,724 (A) (that is £5,096

− £3,372) This seems to have led directly to savings elsewhere of £4,900, giving a netcost saving of over £3,000 for the month

Unfortunately things may not be quite as simple as the numbers suggest The standard mix to make the Varnelyne might lead to a substandard product, which couldhave very wide-ranging ramifications in terms of potential loss of market goodwill.There is also the possibility that the material for which the UK194 was used as a substitute was already held in inventories If this were the case, is there any danger thatthis material may deteriorate and, ultimately, prove to be unusable?

non-Other possible adverse outcomes of the non-standard mix could also arise

The question is raised by the analysis in part (a) (and by the production manager’scomment) of why the cost standard for UK194 had not been revised to take account ofthe lower price prevailing in the market

(c) The variances, period by period and cumulatively, for each of the two materials aregiven as follows:

Without knowing the scale of these variances relative to the actual costs involved, it isnot possible to be too dogmatic about how to interpret the above information

UK500 appears to show a fairly random set of data, with the period variances ating from positive to negative and giving a net variance of zero This is what would beexpected from a situation that is basically under control

fluctu-UK800 also shows a zero cumulative figure over the six periods, but there seems to be

a more systematic train of events, particularly the four consecutive adverse variances fromperiod 3 onwards This looks as if it may be out of control and worthy of investigation

7.7

(2) Clearly the IRR lies above 10%; try 15%:

Thus the IRR lies a little above 15%, perhaps around 16%

(3) To find the payback period, the cumulative cash flows are calculated:

Thus the payback will occur after 3 years if we assume year-end cash flows

(2) Clearly the IRR lies above 10%; try 15%:

Thus the IRR lies a little above 15%; perhaps around 17%

(3) The cumulative cash flows are:

Thus the payback will occur after 3 years (assuming year-end cash flows)

(b) Presuming that Mylo Ltd is pursuing a wealth-enhancement objective, Project 1 ispreferable since it has the higher NPV The difference between the two NPVs is not significant, however

(b) Before making a final decision, the board should consider the following factors:

(1) The long-term competitiveness of the business may be affected by the sale of thepatents

(2) At present, the business is not involved in manufacturing and marketing products.Would a change in direction be desirable?

(3) The business will probably have to buy in the skills necessary to produce the uct itself This will involve costs, and problems could arise Has this been taken intoaccount?

prod-(4) How accurate are the forecasts made and how valid are the assumptions on whichthey are based?

(c) Option 2 has the highest NPV and is therefore the most attractive to shareholders.However, the accuracy of the forecasts should be checked before a final decision is made

(7,800 ) 3,300 2,100 2,100 2,100 2,900Discount factor 10% 1.000 0.909 0.826 0.751 0.683 0.621Present values (7,800) 3,000 1,735 1,577 1,434 1,801

Ground improvement option

Year 1 Year 2 Year 3 Year 4 Year 5

Ground improvements (10,000)Increased gate receipts (1,800) 4,400 4,400 4,400 4,400

(c) The ground improvement option provides the higher NPV and is therefore the preferableoption, based on the objective of shareholder wealth maximisation.

(d) A professional football club may not wish to pursue an objective of shareholder wealthenhancement It may prefer to invest in quality players in an attempt to enjoy futuresporting success If this is the case, the NPV approach will be less appropriate becausethe club is not pursuing a strict wealth-related objective

£000

Residual value of equipment (100 × 0.636) 64

520

* This is the sum of the 12 per cent discount factors over four years Where thecash flows are constant, it is a quicker procedure than working out the presentvalue of cash flows for each year and then adding them together

(b) (i) Assume the discount rate is 18% The net present value of the project would be:

£000

Residual value of equipment (100 × 0.516) 52

12 + (40/11.67) = 15.4% (This is, of course, the IRR.)This higher discount rate represents an increase of about 28% on the existingcost of capital figure

(ii) The initial outlay on equipment is already expressed in present-value terms and so,

to make the project no longer viable, the outlay will have to increase by an amountequal to the NPV of the project (that is, £40,000) – an increase of 8.3% on the statedinitial outlay

(iii) The change necessary in the annual net cash flows to make the project no longerprofitable can be calculated as follows:

Let Y = change in the annual operating cash flows Then

(Y × cumulative discount rates for a four-year period) − NPV = 0

8.7

This can be rearranged as

Y × cumulative discount factors for a four-year period = NPV

Y × 3.038 = £40,000

Y = £40,000/3.038

Y = £13,167

In percentage terms, this is a decrease of 8.8% on the estimated cash flows

(iv) The change in the residual value required to make the new product no longerprofitable can be calculated as follows:

Let V = change in the residual value:

(V × discount factor at end of four years) − NPV of product = 0This can be rearranged as follows:

V × discount factor at end of four years = NPV of product

V × 0.636 = £40,000

V= £40,000/0.636

V= £62,893This is a decrease of 63.9% in the residual value of the equipment

(c) The NPV of the product is positive and so it will increase shareholder wealth Thus, itshould be produced The sensitivity analysis suggests that the initial outlay and theannual cash flows are the most sensitive variables for managers to consider

Kernow Cleaning Services Ltd

(a) The first step is to calculate the expected annual cash flows:

The expected net present value (ENPV) can now be calculated as follows:

Period Expected cash flow Discount rate Expected PV

The probability of occurrence can be obtained by multiplying together the probability

of each of the worst outcomes above, that is 0.3 × 0.4 × 0.4 × 0.3 = 0.014

Thus, the probability of occurrence is 1.4%, which is very low

Aires plc

(a) The SVA determination of shareholder value will be as follows:

* The free cash flows will be the operating profit after tax plus the leasedepreciation charge (that is, £12.0m + £16m)

(b) The EVA®determination of shareholder value will be as follows:

Year Opening capital Capital charge Operating profit EVA®

Shareholder value and EVA ®

(a) It is difficult for these different approaches to co-exist in a highly competitive economy.The pursuit of shareholder value may be necessary in order to secure funds and for managers to secure their jobs A stakeholder approach, which is committed to satisfy-ing the needs of a broad group of constituents, may be difficult to sustain in such anenvironment

It has been suggested that other stakeholders have been seriously adversely affected bythe pursuit of shareholder value It is claimed that the application of various techniques

to improve shareholder value such as hostile takeovers, cost cutting and large ment incentive bonuses have badly damaged the interests of certain stakeholders such

manage-as employees and local communities However, a commitment to shareholder value musttake account of the needs of other stakeholders if it is to deliver long-term benefits

(b) If businesses are overcapitalised it is probably because insufficient attention is given tothe amount of capital that is required Management incentive schemes that are gearedtowards generating a particular level of profits or achieving a particular market sharewithout specifying the level of capital invested can help create such a problem EVA®can help by highlighting the cost of capital, through the capital charge

Virgo plc

There is no single correct answer to this problem The suggestions set out below are based

on experiences that some businesses have had in implementing a management bonus system based on EVA®performance

In order to get the divisional managers to think and act like the owners of the business,

it is recommended that divisional performance, as measured by EVA®, should form a significant part of their total rewards Thus, around 50 per cent of the total rewards paid tomanagers could be related to the EVA®that has been generated for a period (In the case ofvery senior managers it could be more, and for junior managers less.)

The target for managers to achieve could be a particular level of improvement in EVA®for their division over a year A target bonus can then be set for achievement of the targetlevel of improvement If this target level of improvement is achieved, 100 per cent of thebonus should be paid If the target is not achieved, an agreed percentage (below 100 percent) could be paid according to the amount of shortfall If, on the other hand, the target

is exceeded, an agreed percentage (with no upper limits) may be paid

The timing of the payment of management bonuses is important In the question it wasmentioned that Virgo plc wishes to encourage a longer-term view among its managers Oneapproach is to use a ‘bonus bank’ system whereby the bonus for a period is placed in a

‘bank’ and a certain proportion (usually one-third) can be drawn in the period in which it

is earned If the target for the following period is not met, there can be a charge against the

9.5 9.4 9.3

bonus bank so that the total amount available for withdrawal is reduced This will ensurethat the managers try to maintain improvements in EVA®consistently over the years.

In some cases, the amount of bonus is determined by three factors: the performance

of the business as a whole (as measured by EVA®), the performance of the division (as measured by EVA®) and the performance of the particular manager (using agreed indicators

of performance) The performance for the business as a whole is often given the mostweighting, and individual performance the least weighting Thus, 50 per cent of the bonusmay be for corporate performance, 30 per cent for divisional performance and 20 per centfor individual performance

Leo plc

Free cash flows

Year 1 Year 2 Year 3 Year 4 Year 5 After Year 5

†The terminal value is (9.0/0.12 × 0.567) = 42.5

Total business value will increase by £53.2m As there has been no change to the level ofborrowing, shareholder value should increase by this amount

Divisionalised organisations

(a) A divisionalised organisation is one that divides itself into operating units in order todeliver its range of products or services Divisionalisation is, in essence, an attempt todeal with the problems of size and complexity

Autonomy of action relates to the amount of discretion the managers of divisionshave been given by central management over the operations of the division Two pop-ular forms of autonomy are profit centres and investment centres Though divisional-isation usually leads to decentralisation of decision making, this need not necessarily bethe case

(b) The benefits of allowing divisional managers autonomy include:

l Better use of market information

l Increase in management motivation

l Providing opportunities for management development

l Making full use of specialist knowledge

l Giving central managers time to focus on strategic issues

l Permitting a more rapid response to changes in market conditions

10.1

Chapter 10

9.6

(c) There are certain problems with this approach which include:

l Goal conflict between divisions or between divisions and central management

l Risk avoidance on the part of divisional managers

l The growth of management ‘perks’

l Increasing costs due to inability to benefit from economies of scale

Transfers between divisions can create problems for a business Managers of the sellingdivision may wish to obtain a high price for the transfers in an attempt to achieve cer-tain profit objectives However, the managers of the purchasing division may wish tobuy as cheaply as possible in order to achieve their own profit objectives This can cre-ate conflict, and central managers may find that they are spending time arbitrating dis-putes It may be necessary for central managers to impose a solution on the divisionswhere agreement cannot be reached, which will, of course, undermine the divisions’autonomy

Financial performance measures

(a) Contribution represents the difference between the total sales revenue of the division

and the variable expenses incurred This is a useful measure for understanding the relationship between costs, output and profit However, it ignores any fixed expensesincurred and so not all aspects of operating performance are considered

The controllable profit deducts all expenses (variable and fixed) within the control of

the divisional manager when arriving at a measure of performance This is viewed bymany as the best measure of performance for divisional managers as they will be in aposition to determine the level of expenses incurred However, in practice, it may bedifficult to categorise expenses as being either controllable or non-controllable Thismeasure also ignores the investment made in assets For example, a manager maydecide to hold very high levels of inventories, which may be an inefficient use ofresources

Return on investment (ROI) is a widely used method of evaluating the profitability of

divisions The ratio is calculated in the following way:

The ratio is seen as capturing many of the dimensions of running a division

When defining divisional profit for this ratio, the purpose for which the ratio is to beused must be considered When evaluating the performance of a divisional manager,the controllable contribution is likely to be the most appropriate, whereas for evaluat-ing the performance of a division, the divisional contribution is likely to be more appro-priate Different definitions can be employed for divisional investment The net assets

or total assets figure may be used In addition, assets may be shown at original cost orsome other basis such as current replacement cost

(b) There are several non-financial measures available to evaluate a division’s performance.Examples of these measures have been cited in the chapter Further examples include:

l Plant capacity utilised

l Percentage of rejects in production runs

l Ratio of customer visits to customer orders

l Number of customers visited

If a broad range of financial and non-financial measures covering different time zons are used, there is a better chance that all of the major dimensions of managementand divisional performance will be properly assessed Focusing on a few short-termfinancial objectives incurs the danger that managers will strive to achieve these at theexpense of the longer-term objectives Clearly, ROI can be increased in the short term

hori-Division profitDivisional investment (assets employed)

10.2

by cutting back on discretionary expenditure such as staff training and research anddevelopment and by not replacing heavily depreciated assets.

We can see that the highest residual income for Division A arises when only Option X

is added to the original plan and that the lowest residual income arises when onlyOption Y is added to the original plan

(b) Division A is unlikely to find the price reduction for Division B attractive Division B,

on the other hand, will benefit by £40,000 (20,000 × £2) from the price reduction.However, overall, the total profits of the business will be unaffected as the increase inDivision B’s profits will be cancelled out by the decrease in Division A’s profit

If an outside supplier is used, the profits of the business overall will fall by theamount of the lost contribution (20,000 × (£10 − £8) = £40,000)

Another option would be to allow the outsiders to supply Division B and to use thereleased production capacity to sell outside customers 20,000 units at £11 per unit Inthis way, additional equipment costs would be avoided

Divisional profitDivisional investment (assets employed)

10.5 10.4

Required return (20% × £150,000) (30,000)Residual income (loss) (5,000)(3) The results show that the ROI is less than the required return of 20 per cent andthe residual income is negative The results must therefore be considered unsatis-factory

Increase in divisional profit 10,000Increase in cost of capital (20% × £20,000) (4,000)

(c) (1) Though the divisional profits of Goodman and Sharp will each be affected by a

change in the transfer price, the total profits of Telling Co will be unaffected Theincrease in profit occurring in one division will be cancelled out by the decrease inprofit in the other division and so the overall effect will be nil

(2) If the work goes outside, Goodman would lose £20,000 in contribution (that is,10,000 × £2) and Sharp would gain £8,000 by the reduction in the buying-in price(that is, 10,000 × (£8 − £7.20)) The net effect on the business as a whole will there-fore be a loss of £12,000 (that is, £20,000 − £8,000)

Return on investment (ROI):

Based on net profit

(b) The ROI ratios indicate that East is the better performing division However, we are told

in the question that East has older plant than West, which has recently modernised itsproduction lines This difference in the age of the plant is likely to mean that the ROI

of East is higher due, at least in part, to the fact that the plant has been substantiallywritten down Some common base is required for comparison purposes (for example,unadjusted historical cost)

10.6

We are told that ROI is used as the basis for evaluating performance We can see that,whichever measure of ROI is used, the two divisions meet the minimum returnsrequired If ROI is being used to assess managerial performance then the divisionalprofit rather than net profit figure should be used in the calculation This is because thenet profit figure is calculated after non-controllable central overheads have beendeducted.

The business should consider the use of RI as another measure of divisional formance This measure reveals the same level of performance for the current year fromeach division

per-The expenses to sales revenue ratios are revealing West has a lower direct facturing cost to sales revenue ratio but a higher indirect manufacturing cost to sales revenue ratio than East This is consistent with the introduction of modern labour-saving plant

manu-West has a higher selling expenses to sales revenue ratio than East This is probablydue to the fact that inter-business transfers are minimal whereas for East they represent

50 per cent of total sales revenue

Hercules Wholesalers Ltd

(a) The business is probably concerned about its liquidity position because:

l it has a substantial overdraft, which together with its non-current borrowings meansthat it has borrowed an amount roughly equal to its equity (according to values inthe statement of financial position);

l it has increased its investment in inventories during the past year (as shown by theincome statement); and

l it has a low current ratio (ratio of current assets to current liabilities)

(b) The operating cash cycle can be calculated as follows:

(c) The business can reduce the operating cash cycle in a number of ways The averageinventories holding period seems quite long At present, average inventories held rep-resent almost five months’ sales Reducing the level of inventories held can reduce thisperiod Similarly, the average settlement period for receivables seems long at more than four months’ sales revenue Imposing tighter credit control, offering discounts,charging interest on overdue accounts, and so on, may reduce this However, any policy

145341

Trade payables × 360Credit purchases

163452

Trade receivables × 360Credit sales revenue

decisions concerning inventories and receivables must take account of current tradingconditions Extending the period of credit taken to pay suppliers would also reduce theoperating cash cycle However, for the reasons mentioned in the chapter, this optionmust be considered carefully.

The reduction in overdraft interest as a result of the reduction in the level of investmentwill be £1,206,000 × 14% = £169,000

Cost of cash discounts offered (£20m × 60% × 2.5%) 300Additional cost of credit administration 20

320

Interest charge savings (see above) (169) (269)

These calculations show that the business would incur additional annual costs if it mented this proposal It would therefore be cheaper to stay with the existing credit policy

1,165.0 1,137.5Payables

{[£3m − (£3m × 20%)] × 2/12} (400.0){[£3.15m − (£3.15m × 20%)] × 2/12} (420.0)Accrued variable expenses

Accrued fixed expenses (15.0) (440.0) (15.0) (461.3)

11.6 11.5

(b) The expected profit for the year

(i) Current policy (ii) New policy

(c) Under the proposed policy we can see that the investment in working capital will beslightly lower than under the current policy However, profits will be substantiallylower as a result of offering discounts The increase in sales revenue resulting from thediscounts will not be sufficient to offset the additional costs of making the discounts tocustomers It seems that the business should, therefore, stick with its current policy

Delphi plc

(a) The receivables ageing schedule is:

Number of months outstanding

We can see that the receivables figure will increase substantially in the first fourmonths The retail chains will account for about 60 per cent of the total receivables out-standing by May as this group has the fastest rate of growth There is also a significantdecline in the proportion of total receivables outstanding from TV and hi-fi shops overthis period.

(b) In answering this part of the question, you should refer to the ‘five Cs of credit’ thatwere discussed in detail in the chapter

The new operating cash cycle is:

Number of days

Receivables settlement period = 86 + 20 106

254

Less Payables settlement period = 114 + 15 (129)

125

* Cost of sales is 60% of sales revenue (see Income statement)

(560 × 1.15)(2,400 × 1.10) × 0.60*

4511,450

Payables at year endPurchases

5652,400

Receivables at year endSales revenue

5601,440

Inventories at year endCost of sales

11.8