Management Accounting

Level 3
Series 3 2004 (Code 3023)

Model Answers
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Management Accounting Level 3

Series 3 2004

How to use this booklet Model Answers have been developed by LCCIEB to offer additional information and guidance to Centres, teachers and candidates as they prepare for LCCIEB examinations. The contents of this booklet are divided into 3 elements: (1) (2) Questions Model Answers reproduced from the printed examination paper summary of the main points that the Chief Examiner expected to see in the answers to each question in the examination paper, plus a fully worked example or sample answer (where applicable) where appropriate, additional guidance relating to individual questions or to examination technique

(3)

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Management Accounting Level 3

Series 3 2004
QUESTION 1 (a) Describe, and compare, how each of the following methods may be used to identify cost behaviour, and state the limitations of each method: (i) (ii) (b) (c) High-low Scattergraph (14 marks) Explain how the differential cost approach can be used in decision-making. (3 marks) Define the term opportunity cost. (3 marks) (Total 20 marks)

Model Answer to Question 1 (a) (i) and (ii) High-low method and scattergraph: Both methods (high-low and scattergraph) seek to establish a linear equation for costs of the form:

y = a + bx
where:

y a b x

represents total costs represents total fixed costs per period represents the variable cost per unit of activity represents the activity (in units) per period

The equation, once established in a particular situation, provides a simplistic analysis of the behaviour of costs in response to changes in the level of activity. It enables predictions to be made about what costs will be at different levels of activity. The high-low method is based upon obtaining values for the variables a and b in the linear equation by using the highest and lowest points for activity, and the associated costs, from the available data. The difference between the highest and lowest costs is divided by the difference between the highest and lowest activity in order to estimate the variable cost per unit of activity (b in the equation). The fixed cost per period (a in the equation) can then be estimated by putting the value for b (and values for x and y at either the highest or lowest points) into the equation.

CONTINUED ON NEXT PAGE

Model Answer to Question 1 continued The main limitations of the high-low method are: (i) (ii) does not take into consideration all the data, only the extremes which may not be representative. cost behaviour may be more sophisticated than the simple linear equation.

A scattergraph is produced by plotting all the cost data against activity. From the resulting scattered points on the graph an attempt can be made to identify the relationship between the variables by drawing a 'line of best fit' through the plotted points. The line is extended back to the vertical axis to reveal the estimated fixed costs per period. The slope of the line of best fit reveals the variable cost per unit of activity. The preparation of a scattergraph, and ensuing line of best fit, has the benefit (in contrast to the high-low method) of utilising all of the data to produce a different linear cost equation (ie the line of best fit is unlikely to pass through the highest and lowest points). However, like the high-low method, the scattergraph suffers from the potential limitation that it may significantly oversimplify cost behaviour. The line of best fit is also dependent upon the observer (ie it is subjective). (b) Differential costing: Business decisions involve the selection of a particular course of action from two or more alternatives. Differential costing is the process of considering all of the costs (and revenues) that would be affected (ie differ) according to which of the alternatives are selected. Ultimately, alternatives are compared, by establishing the differences between them, in order to select the one offering the greatest profit (assuming this to be the objective). (c) Opportunity cost: The term 'opportunity cost' is defined in the CIMA Official Terminology as 'the value of the benefit sacrificed when one course of action is chosen, in preference to an alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected course of action'.

QUESTION 2 A company would expect to make a profit of 60,600 per period on the sale of 30,000 units of its single product at the current selling price. Costs are as follows: Direct materials Direct labour Variable overhead Fixed overhead per unit 3.90 2.08 0.50 3.50 9.98

Fixed overhead costs per unit are based on output of 30,000 units per period. REQUIRED (a) Prepare a profit/volume (P/V) chart for units up to 40,000 per period. (7 marks) (b) Calculate the contribution/sales (C/S) ratio (expressed as a %) and the break-even point (in sales units). (7 marks) (c) Calculate the extra units that would need to be sold to maintain profit at 60,600 per period if the selling price is reduced by 10% but the unit variable costs and total fixed costs remain unchanged. (6 marks) (Total 20 marks)

Model Answer to Question 2 (a) 120 100 80 Profit (000) 60 40 20 0 20 40 Loss (000) 60 80 100 120 Workings: Fixed overheads = 105,000 per period (30,000 units @ 3.50) = loss at zero activity Profit at 30,000 units = 60,600 (extrapolate profit line to 40,000 units) (b) Profit per unit = 2.02 (60,600 30,000 units) Contribution per unit = 5.52 (3.50 + 2.02) Selling price per unit = 12.00 (9.98 + 2.02) Contribution sales ratio = 46.0% [(5.52 12.00) 100] Break-even point = 19,022 units (105,000 5.52) (c) Selling price of 10% = of 1.20 (12 0.1) in unit contribution to 4.32 per unit Sales required to maintain profit = 38,333 units [(105,000 + 60,600) 4.32] Extra sales required to maintain profit = 8,333 units (38,333 30,000) Profit/Volume Chart

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40 Sales (000 Units)

QUESTION 3 A company has set the following standards for its single product: Selling price Direct production costs: Materials Labour per unit 5.20 1.26 1.42

Budgeted production overheads per period are: Variable Fixed 7,500 23,500

Both variable and fixed production overheads are absorbed at a rate per unit of output based on budgeted production of 25,000 units per period. Budgeted sales are also 25,000 units per period. During Period 1, 25,600 units were produced and 25,200 units were sold for a total revenue of 129,024. Fixed production overheads incurred in Period 1 totalled 23,776. During Period 2, variances included: Sales volume profit Selling price Fixed production overhead volume REQUIRED (a) For Period 1, calculate the: (i) (ii) (iii) (iv) sales volume profit variance selling price variance fixed production overhead volume variance standard production cost of sales. (10 marks) (b) For Period 2, calculate the number of: (i) (ii) units produced units sold (6 marks) (c) Explain why the sales volume variance and the fixed production overhead volume variance differ. (4 marks) (Total 20 marks) 448 Adverse 1,172 Favourable 470 Adverse

Model Answer to Question 3

Workings: Selling price Costs: Direct materials Direct labour Variable production o'hd Fixed production o'hd Total Gross profit (a) Period 1: (i) Sales volume profit variance: 256 Favourable (ii) Selling price variance: 2,016 Adverse [129,024 - (25,200 units @ 5.20/unit)] [(25,200 - 25,000 units) @ 1.28/unit] per unit 5.20 1.26 1.42 0.30 0.94 3.92 1.28

(7,500 25,000 units) (23,500 25,000 units)

(iii) Fixed production overhead volume variance: 564 Favourable [(25,600 - 25,000 units) @ 0.94/unit]

(iv) Standard production cost of sales: 98,784 (b) Period 2: (i) Units produced: 24,500 units (ii) Units sold: 24,650 units [25,000 - (448 1.28/unit)] [25,000 - (470 0.94/unit)] (25,200 units @ 3.92/unit)

(c) Volume variance differences: One is based on budget versus actual sales units (sales volume variance); the other is based on budget versus actual production units (fixed production overhead volume variance) One is based on gross profit per unit (sales volume variance); the other is based on fixed production overhead per unit (fixed production overhead volume variance).

QUESTION 4 Expected sales of a company, for the financial year ending on 30 June, are 790,000. Costs for the year are expected to be: Direct: Materials Labour Overheads: Production Marketing Administration 217,600 186,080 193,700 76,200 89,100 (variable overheads are 25% of direct wages; the balance are fixed costs in the year) (variable overheads are 5% of sales revenue; the balance are fixed costs in the year) (all fixed costs in the year)

The following changes are to be allowed for in the budget for next year (in comparison with the average for the current year): (1) Increase of 3.5% in the prices of raw materials. (2) Reduction in materials wastage from 0.9% of input to 0.8% of input. (3) Increase of 4% in direct labour wage rates. (4) 5% improvement in direct labour productivity. (5) Increase of 6% in factory management salaries. In the current year, factory management salaries, which are fixed costs in the year, total 56,200. (6) Increase of 6,800 in fixed marketing expenditure. (7) Increase of 3% in selling prices. (8) Increase of 15% in the number of units produced and sold. In all other respects the current year cost behaviour patterns and relationships are expected to remain unchanged. No stocks are held. REQUIRED (a) Prepare the profit budget for next year (all calculations to the nearest ). Show (with clear workings) each element of cost as well as both gross profit and net profit. (17 marks) (b) Define the term principal budget factor and briefly explain its importance in the budgeting process. (3 marks) (Total 20 marks)

Model Answer to Question 4 (a) Profit budget: Sales Production costs: Direct materials Direct labour Overheads Total Gross profit Non-production costs: Marketing Administration Net profit (b) Principal budget factor: The principal budget factor is 'a factor which will limit the activities of an undertaking and which is often the starting-point in budget preparation'. (CIMA Official Terminology). The importance of the principal budget factor is reflected in the above definition ie it is the aspect of business which will provide the overall restriction on an organisation's activity (very often this will be the level of sales). It must, therefore, be identified at the outset of budgeting because all other budgets will be restricted by it. 90,288 89,100 179,388 82,135 258,737 211,954 203,541 674,232 261,523 (935,755 0.05) + [76,200 - (790,000 0.05) + 6,800] 935,755 (790,000 1.15 1.03) [217,600 1.15 (0.991 0.992) 1.035] (186,080 1.15 1.04 1.05) (211,954 0.25) + [193,700 (186,080 x 0.25)] + (56,200 0.06)

QUESTION 5 A company will commence trading on 1 July. Capital of 120,000 will be introduced. The following estimates have been made for the first three months: (1) Fixed assets costing 95,000 will be purchased, paid for in August. Straight-line depreciation will be charged at 10% per annum. (2) Sales: July August September 42,000 63,000 75,000

(3) 90% of sales will be on credit terms of 1 month. The remaining sales will be for cash. (4) The selling price will be cost of goods plus one third. (5) An initial stock of goods costing 30,000 will be purchased at the end of June. This month-end level of stock is planned to remain unchanged throughout the period. (6) Credit terms from the supplier of goods for resale are that payment will be made two months after purchase. (7) Rent and rates for 12 months from 1 July, of 24,000, will be paid in July. (8) Other overheads of 10,200 per month are expected, payable in the month incurred. The budgeted profit and loss account, for the three-month period July to September, has already been prepared. Budgeted net profit is 6,025. REQUIRED Prepare the following: (a) Cash budget for each month (July, August and September). (11 marks) (b) Single funds flow statement for the three month period (July to September). (9 marks) (Total 20 marks)

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Model Answer to Question 5 (a) Monthly cash budget (July, August and September): July Receipts: Capital introduced From sales: cash sales credit sales Total receipts Payments: For goods rent and rates other overheads fixed assets Total payments Net cash flow in month Opening cash balance Closing cash balance ----24,000 10,200 ----34,200 90,000 ----90,000 30,000 ----10,200 95,000 135,200 (91,100) 90,000 (1,100) 31,500 ----10,200 ----41,700 22,500 (1,100) 21,400 (42,000 0.75) 120,000 4,200 ----4,200 124,200 ----6,300 37,800 44,100 44,100 ----7,500 56,700 64,200 64,200 August September

(b) Funds flow statement () (3 months - July to September): Operating profit Add back: Depreciation Working capital: Stock Debtors Prepaid rent Creditors Net Cash outflow from operations Capital investment Capital introduced Cash generated (balance) (30,000) (67,500) (18,000) 103,500 (12,000) (3,600) (95,000) 120,000 21,400 6,025 2,375 8,400 (95,000 0.1 0.25)

(138,000 0.75)

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QUESTION 6 A company is considering the purchase of new machinery in order to achieve operating cost savings. Two alternative machines are available. Machine A would cost 300,000 with a useful life of 6 years. Machine B would cost 180,000 but would require replacement with a new machine (at the same cost) after 3 years. Operating cost savings (before charging depreciation for new machine) are forecast as follows: Year 1 2 3 4 5 6 Machine A 000 80 80 80 60 60 60 Machine B 000 70 75 80 80 80 80

The cost of capital is 12% per annum. Discount factors at 12% are: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 REQUIRED (a) Calculate for each machine: (i) (ii) the payback period the net present value. (12 marks) (b) State your recommendation as to which machine, if any, should be purchased and briefly provide reasons for your recommendation. (4 marks) (c) Determine the maximum investment amount that could be paid for Machine A to justify its purchase in preference to Machine B (assuming all other cash flow estimates to remain unchanged). (4 marks) (Total 20 marks) 0.893 0.797 0.712 0.636 0.567 0.507

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Model Answer to Question 6 (a) (i) Payback period: Year 0 1 2 3 4 5 Machine A Cum cash flow () (300,000) (220,000) (140,000) (60,000) 0 Machine B Cum cash flow () (180,000) (110,000) (35,000) (135,000) (55,000) 25,000

Payback period Machine A = 4 years Payback period Machine B = 4.7 years [4 + (55 80)] (ii) Net present value: Year 0 1 2 3 4 5 6 Discount Factor (12%) 1.000 0.893 0.797 0.712 0.636 0.567 0.507 Machine A cash flow 000 (300) 80 80 80 60 60 60 120 Machine B cash flow 000 (180) 70 75 (100) 80 80 80 105 Machine A disc cash flow 000 (300) 71.4 63.8 57.0 38.2 34.0 30.4 (5.2) Machine B disc cash flow 000 (180) 62.5 59.8 (71.2) 50.9 45.4 40.6 8.0

Net present value Machine A = (5,200) Net present value Machine B = 8,000 (b) Machine A has a negative NPV at 12% (the cost of capital) and therefore is not viable, despite the 4 year payback (undiscounted). Machine B has a positive NPV at 12% and is therefore viable, although it has a longer payback due to re-investment at end year 3. (c) The difference in NPV of the two machines, discounted at the cost of capital of 12%, is 13,200 (5,200 + 8,000). The maximum investment amount in Machine A, to justify a preference for that machine, is therefore 286,800 (300,000 - 13,200).

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