Business Analysis in Purchasing and Supply:

Free Resources
Solutions to the May 2003 examination
You can download the May 2003 examination paper from the CIPS website. The solutions below
have been prepared by Profex Publishing for the private use of individual students. They may not
be reproduced, stored in a retrieval system or transmitted, in any form or by any means, without
the prior permission of Profex Publishing. From the optional questions we have selected
Questions 16 and 18.

1 (In practice it is inconceivable that the UK government would issue a tranche of

gilts specifically to fund a particular hospital development. What the question
really means is ‘State one advantage and one disadvantage of raising funds
through the issue of gilts’.) An advantage for the government of using gilts is
that the government retains control (which they might not do if the funds came
from outside investors). A disadvantage arises if the availability of government
funds leads to slack budgetary procedures; this could in turn lead to
overspending.

2 Gross profit is sales less cost of sales, so we are looking for a factor that affects
either one of these. Answer (a) is incorrect – costs of a major refurbishment are
capital in nature and do not impact on either sales or cost of sales. Nor does the
existence of an overdraft – like the refurbishment costs, this is a balance sheet
item, not affecting the profit and loss account, so answer (b) is incorrect. Answer
(d) is incorrect because corporation tax is applied to net profit, and has no effect
earlier in the profit and loss account. By elimination we are left with answer (c) –
it appears that the hotel’s turnover and gross profit have both fallen because the
evening meals service is no longer offered.

3 Any number of costs might be given: insurance of premises, depreciation of

premises, advertising costs, costs of heat and light etc.

4 Actual costs of materials were higher than standard costs, which might be (for
example) because of unexpected wastage or an unexpected price rise from
suppliers. Actual costs of labour were lower than standard costs, which might be
(for example) because a lower wage rate was paid than was expected, or because
less overtime was worked than expected.

5 Net present value is the value (in today’s terms) of all expected cash inflows and
outflows arising from a project.

6 If the IRR is higher than the firm’s hurdle rate (ie its target rate for return on
investment projects) then the investment is worthwhile; otherwise it should be
rejected.
7 A correlation coefficient of –0.98 is very close to –1, which would indicate almost
perfect negative correlation. So if the price rises by 5% we would expect demand
to fall by exactly the same amount.

8 An obvious possibility is that demand for Component A is even throughout the

year (that would explain why mean and median are the same), whereas demand
for Component B is seasonal.

9 Possible advantages to the manufacturer include a higher level of quality, more

rapid detection of quality problems, reductions in costs, greater uniformity of
output etc.

10 Possible limitations include the historical nature of an index (so it may not
reliably predict the future) and the general nature of an index (so it may not
relate closely to the products we are really interested in).

11 An advantage of financing the property by means of a mortgage is that the

company avoids a drain on its current cash resources (which could lead to
liquidity problems). Mortgage interest is an allowable expense for tax purposes,
so the company achieves a reduction in its tax bill. Because the cost is spread
over 10 years, the regular repayments will be relatively small in amount, and will
also be predictable (which aids budgeting). Mortgage finance is relatively cheap;
interest rates are low because the lender has good security in the form of the
property being mortgaged.

However, there are also disadvantages. Default by the borrower entitles the
lender to repossess the property, with potentially disastrous consequences for
the business. The company’s gearing will increase, which may make it difficult to
raise further loan finance if any is needed. The mortgage interest is an additional
fixed cost which must be covered before any profit is available to distribute to
the owner(s) of the business.

The equipment is presumably to be acquired on a finance lease (not an operating

lease). Tax advantages available to the lessor may be passed on to OJ’s, which
could make this a cheap source of finance. As with a mortgage, the company
avoids a drain on its current cash resources and can budget for regular cash
outgoings. Depending on the terms of the lease, the lessor may be responsible for
repairs or replacement if the equipment becomes faulty, which is another
advantage for the lessee (though most finance leases make the lessee responsible
for these eventualities). Moreover OJ’s balance sheet will be strengthened,
because assets acquired under a finance lease are capitalised as fixed assets.

There are no real disadvantages to a finance lease, except that the equipment
may never become the property of OJ’s (though many finance leases have an
option to purchase). And of course the interest element included in the lease
payments will make the overall cost more expensive than outright purchase.
12 The additional staff costs are variable costs. If business is brisk and staff are
needed then there may be a high cost in hourly charges. But if business is slack,
few or no staff will be hired, and the cost will be low. The other costs
(advertising, and the finance costs associated with a mortgage or a finance lease)
are fixed: if the company decides to incur these costs, the amount to be paid will
be the same whether business is brisk or slack.

Fixed costs are more risky in the sense that if the level of business is
disappointing it may be difficult for the company to pay the costs. This is
different from the situation with variable costs: if business is poor, the company
simply declines to take on any staff and therefore incurs no staff cost.

13 The payback period indicates that the revenues generated from the new premises
and equipment will cover the cost of the initial investment after just three years.
This is a relatively short period (far shorter than the 10 years over which the
mortgage is to be repaid) and suggests that the project is not very risky, because
cashflows over a short period should be reasonably easy to predict.

The IRR is the level of return that the project is expected to generate, based on
discounting expected cashflows to present values. An IRR of 26% is an extremely
healthy level of return and again this suggests that the project is more than
viable.

14 (a) Time series analysis investigates the actual values of a variable (such as
sales demand in the present case) over a number of successive periods.
The aim is to determine the underlying trend in the variable’s movement,
as well as any seasonal and random departures from the trend. By
plotting a trend line and extrapolating it into the future the analyst can
predict the value of both trend and seasonal/random variations. Later on,
predicted values can be compared with actual values to determine how
accurate the process has been.

Regression analysis is used to determine whether there is a relationship

between two (or more) variables, and if so, the nature and strength of the
relationship. In the present case, we are considering the possibility of a
relationship between the level of advertising expenditure and the level of
sales demand. If it appears that sales increase as a result of increased
advertising spend we will be tempted to do more advertising in future;
whereas if there is no strong relationship between advertising spend and
sales demand we will be less inclined to invest in advertising. The
procedure is to ‘fit’ a straight line as closely as possible to the observed
values of the variables and then to determine the equation of the line.
Once we have done so we can estimate what level of sales demand will
arise from a given level of advertising expenditure, as well as estimating
the reliability of our forecasts.
(b) (We are told that ‘t = time period’, but not what the time period is – week,
month, quarter, year? In the solution below we assume that the time period is a
quarter. Nor are we told what units the trend line is expressed in – presumably
£, but it might equally be some other factor such as number of meals served.)

In the time series analysis, the trend line states that sales are equal to
£91,150 + 8,000t. This means that in the first quarter (t = 1) sales are
£99,150, whereas in quarter 2 (t = 2) sales are £107,150. In other words,
sales are expected to increase by £8,000 each quarter, from a base level of
£91,150. The equation of the trend line contains no factor for seasonal or
random variations, so presumably it is thought that the trend is simply
unaffected by such variations.

The mean average percentage error and the mean absolute deviation are
measures of the possible inaccuracies in the predictions. Both measures
are relatively small, meaning that the predictions are made with good
confidence.

In the regression analysis, the regression line states that sales are equal to
6a – £20,120. In other words, we believe that our sales will be equal to six
times our advertising spend, less £20,120.

The correlation coefficient is 0.55. This is a positive number, indicating a

degree of positive correlation between advertising spend and sales
demand (ie as advertising increases, sales demand also increases).
However, 0.55 is not particularly close to 1 (which would indicate perfect
correlation), so the relationship between advertising spend and sales
demand is not a strong one. This is borne out by the value of R2, namely
30.2%, which indicates that only about 30% of the variation in sales
demand is related to the level of advertising expenditure. In other words,
about 70% of the variation must be due to other factors not included in
our regression analysis.

(c) From what has been said above, it is clear that the time series analysis is
regarded as a relatively accurate tool in this case, whereas the regression
analysis is a weak predictor of likely sales demand. For this reason the
time series analysis should be preferred.
16 (Question 16 is selected because it is relatively simple bookwork – an answer can be
constructed by writing a few sentences about each of the three main probability
distributions used by buyers. The material for this can simply be lifted from pages 185ff
in your study text.)

The three main distributions used by buyers are the binomial distribution, the
Poisson distribution and the normal distribution.

 The binomial distribution applies to situations where the items under

investigation are classified as either possessing or not possessing a given
attribute. A typical example from a purchasing context might be in
quality control: an item purchased from a supplier is either defective or
non-defective. In this example the binomial distribution can be used to
estimate the likelihood of a supplier’s consignment containing a given
number of defectives. By testing a sample from the consignment and
recording the number of defectives found we can estimate the proportion
of defectives in the consignment as a whole. This might be used as a
criterion for accepting or rejecting a consignment on the basis of a sample.
Before we can use this distribution we need to know (perhaps from past
experience) the probability that a single item chosen at random is
defective.

 When the probability of a given event is very small, and the number of
‘trials’ is very large, the binomial distribution merges into the Poisson
distribution. In a purchasing context we might be interested in the
probability of a production process breaking down (because this might
affect our supplier’s ability to deliver). In this case the probability of a
breakdown is (we hope) very small, while the number of ‘trials’ is in
effect infinite (because the process is in motion continuously and in
theory could break down at any instant). This means that the conditions
of a Poisson distribution are satisfied: we are considering a rare event that
occurs at independent random times. Before we can use this distribution
we need to know (perhaps from past experience) the likelihood of a single
breakdown occurring in a given period of time.

 The normal distribution is concerned with attributes that can take

continuous (rather than discrete) values. For example, a buyer might be
interested in the output from a supplier’s production process. If, say, the
diameter of steel rods produced by the supplier has a mean value of
12mm, with a standard deviation of 1mm, what proportion of the
supplier’s output will fall within the buyer’s tolerance of 11.5–12.5mm?
This is the kind of question that a buyer can solve by means of a normal
distribution. To use this procedure we need to be satisfied that the
attribute of interest (here, the rods’ diameter) does indeed follow a
normal distribution, and we need to know the mean and standard
deviation.
18 (Question 18 is selected because it asks us, in effect, to produce a sentence or two on each
of 9 different ratios/statistics, which means that we have a readymade structure for our
solution. Moreover, there are three marks available in part (c) for fairly simple bookwork
material – see pages 51ff in your study text for a few ideas. As always with ratio
analysis, you should concentrate not so much on the bare statistics, as on the changes in
the ratios as compared with the base period.)

(a) Gross profit percentage has increased by 2.5%. Since gross profit is the
difference between sales and cost of sales we might guess that sales prices
have been increased, or production costs have been more tightly
controlled. (The examiner appears to think that the improvement could
be ‘due to the increase in stockholding’, but you should not imitate such a
schoolboy howler!) Either way, the ratio indicates that the supplier has
improved his gross margin.

However, the improved gross profit has not led to an improved bottom
line result. On the contrary, net profit is down from 8% to 5%. This
suggests that overheads have not been as closely controlled as they might
have been, or that interest costs have eaten into profits (note that the
gearing ratio has increased from 10% to 15%, suggesting a higher level of
borrowing).

In line with the net profit, return on capital employed has fallen from 12%
to 9%. If the increased borrowing has been included in the capital
employed figure this may indicate that the additional assets acquired are
not working as hard as the previous asset base.

The current ratio is very healthy: current assets are three times as great as
current liabilities. However, liquid assets are only 1.1 times as great as
current liabilities. This indicates that the company has sufficient liquid
assets – just about – to pay off its immediate debts, but suggests that stock
levels may be unduly high; that would account for the high current ratio
but much lower liquidity ratio.

This is borne out by the stock turnover period. Last year, the balance
sheet showed stocks equal to four months supplies; this year the supplier
is holding stocks equal to five months supplies, which seems higher than
is likely to be necessary.

The debtor period has fallen from 2 months to 1.6 months, meaning that
the supplier is collecting cash from its credit customers more efficiently
than last year. Perhaps boosted by this improvement in cash resources,
the company is taking less credit from its own suppliers: creditors are
being paid on average 3.1 months after invoice date (last year: 4.2
months). Even so, this seems a lengthy period, and we should investigate
whether the supplier is having difficulty in paying his debts.
 As already noted, the gearing ratio has increased from 10% to 15%. The
most likely explanation is that the supplier has raised new loan capital.
This may be a good sign if it indicates expansion by means of new asset
acquisitions. On the other hand, if the supplier has borrowed long-term
funds because he is struggling to pay off short-term liabilities this would
be a bad sign.

(b) (The above ratio analysis suggests a large number of possible questions. In the
exam it would be sensible to aim for, say, five questions, since only five marks are
available. Only if you are within the time allowance should you look for more
than this. If you can’t think of enough questions arising from the ratio analysis,
think more generally about the supplier’s set-up – quality systems, staffing, asset
base, environmental policies, current order book etc. In the solution below we
give more possibilities than you would need to achieve a pass mark.)

 Has the gearing ratio increased because of additional borrowing,

and if so what was the borrowing for?

 Was the increase in gross profit percentage a result of increased

selling prices, greater control of direct costs, or what?

 What has caused the deterioration in net profit percentage and

return on capital employed?

 Why does the supplier need to hold such high levels of stock as
the ratios indicate? Might this be buffer stock to cover
inefficiencies in production?

 Why does the company take so long to pay its credit suppliers?

 What are the supplier’s environmental policies?

 What is the state of the current order book?

 What quality systems are in place?

 Does the supplier have adequate staff with appropriate training?

(c) A cashflow forecast will indicate the current level of cash resources
enjoyed by the supplier and the extent to which this will improve or
deteriorate in the period ahead. This is vital information in assessing the
supplier’s financial stability and his ability to fulfil any contracts we enter
into.

The forecast will indicate any plans the supplier has to invest in capital
equipment. This may be important information if there are question
marks about the current asset base.
The forecast will also indicate any plans the supplier has to redeem
borrowings, which is a useful indication of the supplier’s liquidity.