Performance Management · 2021

a. Concept of linear programming and usefulness Linear programming is a mathematical method for determining a way to achieve the best outcome (such as maximum profit or lowest cost) subject to a number of limiting factors (constraints). A linear programming problem involves maximising or minimising a linear function (the objective function) subject to linear constraints. Both the constraints and the “best outcome” are represented as linear relationships. What constitutes the best outcome depends on the objective. The equation constructed to represent the best outcome is known as the objective function. Uses of linear programming (LP)

• Budgeting: In preparing budget, one of the first steps is the identification of the key (limiting) factor. When there is more than one limiting factor, LP can be used to identify the most profitable use of resources.

• Capital budgeting: When we have multi-period capital rationing, LP can be used to optimally allocate the available funds among the competing projects.

• Transfer pricing: In a divisionalised organisation, LP can be used to compute optimal transfer price between divisions when the supplying division does not have sufficient capacity to met all the demands placed upon it.

• Calculating relevant costs: The relevant cost of a scarce resource is calculated as acquisition cost of the resource plus opportunity cost. When more than one scarce resource exist, LP can be used to establish the opportunity cost (Shadow price).

• Maximum payment for the supply of additional scarce resources: If labour is an effective limiting factor, for example, the maximum overtime premium to pay per additional hour is the shadow price which can be determined using LP.

• Control: LP is also useful in the analysis of variances. For example, adverse material usage variances can be indication of material wastage. Such variances 68 should be valued at the standard cost of the material plus the opportunity cost of the loss of one scarce unit of material. LP can be used to determine the opportunity cost.

b. Computation of unit selling price and associated unit profit of the two products. Biggis N Smallis N Material 250 150 Labour costs: Machine time 60 30 Processing 40 50 Overhead cost 30 40 Total costs 380 270 Profit per unit 76 54 Selling price per unit 456 324

c. ADVICE ON THE OUTPUT TO BE PRODUCED TO MAXIMISE TOTAL PROFIT STEP 1 –DETERMINATION OF LIMITING FACTOR Materials needed to produce 200,000 units of Biggis & 100,000 units of Smallis BIGGIS 5kg x 200,000 1,000,000 SMALLIS 3kg x 100,000 300,000 Total Required 1,300,000 Available Material 1,800,000 Conclusion: Materials are not limiting factor since available resources exceed resources needed to meet production levels. Machine time needed to produce 200,000 units of Biggis and 100,000 units of Smallis. 69 BIGGIS 4hrs x 200,000 800,000 SMALLIS 2hrs x 100,000 200,000 Total Required 1,000,000 Available Hours 800,000 Conclusion: Machine time is a limiting factor since hours available are less than the hours needed to meet production levels. Other processing time needed to produce 200,00 units of Biggs and 100,000 units of smallis: BIGGIS 4hrs x 200,000 800,000 SMALLIS 5hrs x 100,000 500,000 Total Required 1,300,000 0 Available Hours 1,400,000 Conclusion: Other processing time is not a limiting factor since hours available exceeds hours needed to meet production levels. STEP 2 – DETERMINATION OF PRIORITY OF PRODUCTION PLAN Biggis Smallis N N Selling price 456 324 Total variable costs (350) (230) Contribution per unit 106 94 Machine time per unit 4 2 Contribution per machine time 26.5 47 Ranking 2nd 1st PRODUCT UNITS HOURS USED HOURS LEFT SMALLIS 100,000 200,000 600,000 BIGGIS 150,000 600,000 - 70 Comment Hence, the optimal production plan for NTAMS Manufacturing Company Ltd is to produce 100,000 units of Smallis and 150,000 units of Biggis.

(d) SHADOW PRICE MEANING The shadow cost of a binding constraint is the amount by which the objective function decreases (or increases) as a result of availability of one unit less or more of the scarce resource. The solutions to the dual problem of the primal problem give the shadow costs (prices), hence the alternative term dual costs (prices). USEFULNESS OF SHADOW PRICES

• Can be used to determine the relevant cost of a scarce resource

• Useful in setting transfer price

• Useful in setting transfer price

• It assists in determining opportunity cost

• Can be used in allocating funds to projects when there is multi-period capital rationing. The major limitation of shadow price is that it is valid for a limited range of output. For example, if labour hour is the limiting factor, the shadow price will tend to zero as more labour hours are supplied. 71 CALCULATION OF SHADOW PRICE OF THE CONSTRAINTS Shadow price only exists for binding resources – hence shadow price will only exist for machine time. If one (1) additional machine time is available, total machine time will be 800,001 Total units of Biggis to be produced wil l be 150,000.25 units (600,001/4) New Total contribution will be (100,000 x 94) + (150,000.25 x 106) = 25,300,026.50 Previous total contribution was (100,000 x 94) + (150,000 x 106) = 25,300,000 Increase in contribution = 25,300,026.50 – 25,300,000 = 26.50 Alternative solution Candidates may reduce the available machine time by 1 hour. If one machine hour is reduced Total units of Biggis =149,999.75 units N New contribution (100,000 x 94 + 149,999.75 x 106) = 25, 299,973.5 Old contribution 25,300,000 Shadow price (reduction in contribution) (26.50) Shadow price = N26.50k

ei) NPV (Discount Factor 15%) = 2.283 Total contribution = 25,300,000 (2.283) = 57,759,900 Total Outflow = 45,000,000 = 45,000.000 NPV = N12,759,000 Yes, the project’s NPV is positive and therefore worthwhile.

ii) If a discount factor = 35% Total contribution = 25.300,000 x 1.696 = N42,908,800 Total Outflow = N 45,000,000 NPV at 35% = (N2,091,200) IRR = a + ( BA

- A) (b – a) 72 a = Positive NPV discount rate A = Positive NPV b = Negative NPV discount rate B = Negative NPV = 15% + ( 200,091,2000,759,12 000,759,12 \+ ) (35% – 15%) = 15% + ( 000,759,12 100,851,14 ) (20%) = 15% + 17.18% = 32.18%

Examiner’s report The question tests students’ understanding of resource allocation using contribution per limiting factor. It was attempted by the majority of the candidates being a compulsory question. The performance was below average. The major pitfall was the lack of understanding in the subject area and the conditions that must be satisfied before the linear programming is applied. Candidates are advised to read the ICAN study text when preparing for future examination of the Institute.

Marking guide Mark Total a. Definition of linear programming 1 Explanation of linear programming 1 Usefulness (3 points at 1 mark per point) 3 5 b. Selling Price (20 ticks at ¼ mark per tick) 5 c. Advice on the optimal output 10 d. Shadow Price/usefulness/limitation 5 Shadow price computations 7 12 e. Investment analysis - NPV 4 Calculation of IRR 4 8 40 73

SECTION B

(a) Materials supply is a limiting factor for forecast 1, but not for forecast 2. Forecast 1 Product A Product B Product C ₦ ₦ ₦ Sales price per unit 10.00 20.00 30.00 Variable cost per unit 6.50 11.00 18.10 Contribution 3.50 9.00 11.90 Contribution per kg of material 0.88 1.29 0.85 Ranking 2nd 1st 3rd Optimal production plan for forecast 1 Units Contribution kg of material ₦ Product B 800 5,600 7,200 Product A 500 2,000 1,750 Product C 1,030 14,420 12,257 Total contribution 22,020 21,207 Optimal Production Plan for forecast 2 Product A Product B Product C Total ₦per unit ₦ per unit ₦ per unit Sales price 15.00 25.00 40.00 Variable-cost 6.50 11.00 18.10 Contribution 8.50 14.00 21.90 Sales volume (units) 350 700 1,000 Total contribution ₦2,975 ₦9,800 ₦21,900 ₦34,675 74 Recommendation: Forecast 2 should be adopted for the budget period. It produces a contribution of ₦34,675 which is ₦13,468 higher than the contribution for forecast 1.

(b) REPORT To: The Managing Director From: The Finance Manager Subject: Budget Preparation Process Date: 5 May 2021

1. INTRODUCTION In line with the request of the management of our company, PQR Plc (“PQR” or “the Company”) kindly see below the detailed discussion on some of the key issues in the budget preparation process.

2. PRINCIPAL BUDGET FACTOR The principal budget factor or limiting factor or key budget factor is a factor, which at any time is an overriding planning limitation on the activities of the organisation. Examples of principal budget factors include: staffing limitations, scarcity of materials and other logistics, limited financial resources, low sales demand, limited storage facilities, etc.

3. BUDGET MANUAL The budget manual sets out the budget guidelines which are budgeting instructions, that the Budget Committee gives to guide departmental heads involved in the preparation of the budget so that they follow a particular goal, objective, technique, trend or method of estimating the income and expenditure variables.

4. ROLE OF THE BUDGET COMMITTEE The Budget Committee is made up of members of senior management that oversees all budgetary matters. A typical budget committee includes the chief executive officer, heads of strategic business units and the chief finance officer. The committee sets or approves the overall budget goals for the organisation, and its major business units, 75 directs and coordinates budget preparation, approves the final budget, monitors operations as the year unfolds, and reviews the operating results at the end of the period. The budget committee also approves major revisions of the budget during the period. This committee usually consists of sectional or departmental managers and is usually serviced by the Budget Officer who normally is the finance officer. Apart from the above, the functions of the committee may include the following: ➢ Determine budget policy guidelines and selecting budget policies compatible with organisational goals and objectives; ➢ Establishing the budget timetable; ➢ Review budget estimates submitted by sectional heads; ➢ Facilitate the co-ordination of the budgets; ➢ Suggest amendments to budgets and revising budget estimates when necessary; ➢ Approve budgets after amendments; ➢ Facilitate the generation of budgetary control reports; ➢ Analysing budget reports and recommending changes; ➢ Examine variances, recommend investigation of variances and recommend solutions to remedy off-standard performance; and ➢ Advise top management on all matters concerning the budget.

Examiner’s report The question examines candidates on optimal mix of production and some concepts associated with the budgeting process. Majority of the candidates attempted the question, the performance was average. The main pitfall is inability of the students to identify the quantity of the limiting factor. Candidates are encouraged to read the Institute’s study text when preparing for the examination of the Institute.

Marking guide Mark Total a. Forecast to be Adopted/Computation 11 b. i) Principal budget factor 3 ii) Budget manual 3 iii) Role of budget committee 3 9 20 76

a) Year Quarter Trend point Sales trend (cartons) x y = a + bx 2019 3 13 10,472.33 + (82.67 × 13) = 11,547 2019 4 14 10,472.33 + (82.67 × 14) = 11,630 2020 1 15 10,472.33 + (82.67 × 15) = 11,712 2020 2 16 10,472.33 + (82.67 × 16) = 11,795 The seasonally adjusted forecasts are therefore as follows: Year Quarter Seasonally adjusted forecast sales (cartons) 2019 3 11,547 × 1.06 = 12,240 2019 4 11,630 × 0.91 = 10,583 2020 1 11,712 × 1.05 = 12,298 2020 2 11,795 × 0.98 = 11,559

b) We need to calculate the regression line of the last five periods' observations. This line is y = a + bx where b = n xy− x y n x2− x 2 and a = yn − 𝑏 x n So b = 5 × 4,442.15 − (40 × 555.1) 5 × 330 − 40 × 40 = 6.75 50 = 0.135 a = 555.1 5 − 0.135 × 40 5 = 111.02 − 1.08 = 109.94 We need to multiply the a and b values back up by 100 to compensate for the fact that the y values were scaled down by 100 before the sigma calculations were carried out. So the regression line is y = 10,994 + 13.5x 77 Year Quarter Trend point Sales trend (cartons) x y = a + bx 2019 3 13 10,994 + (13.5 × 13) = 11,169.5 2019 4 14 10,994 + (13.5 × 14) = 11,183.0 2020 1 15 10,994 +(13.5 × 15) = 11,196.5 2020 2 16 10,994 + (13.5 × 16) = 11,210.0 The seasonally adjusted forecasts are therefore as follows: Year Quarter Seasonally adjusted forecast sales (cartons) 2019 3 11,169.5 × 1.06 = 11,840 2019 4 11,183.0 × 0.91 = 10,177 2020 1 11,196.5 × 1.05 = 11,756 2020 2 11,210.0 × 0.98 = 10,986

c) One common method of deciding on which forecasting basis produces the better result is to compare the coefficients of determination. With ten periods' observations we are told that r2 = 0.535. With five periods' observations we have to calculate the coefficient of determination from the equation given in the tables provided. r2 = n xy − x y 2 n x2 − x 2 n 𝑦2 − ( 𝑦)2 = 5 × 4,442.15 − 40 × 555.1 2 5 × 330 − 40 × 40 5 × 61,627.4 − (555.1 × 555.1) = 6.752 50 × 0.99 = 0.92 Prima facie the forecasting method, using five periods' observations is much better than the other using ten periods, since the coefficient of determination of the former is 0.92 compared with 0.535 for the latter. We can explain 92% of the variations in sales by the passage of time using the former method, but can explain only 53.5% of the variations in sales using the latter method. 78

Examiner’s report The question tests candidates’ knowledge of regression analysis in forecasting. Few candidates attempted the question, the performance was average. The major pitfall of the candidates was inability to apply seasonal variation of the trend to the forecast. Candidates are encouraged to read the Institute’s study text when preparing for future examination of the Institute.

Marking guide Mark Total a. Forecast of 4 Quarters using 10-period observation 8 b. Forecast of 4 Quarters using 5-period observation 8 c. Commenting of better of forecast:

- Coefficient of determination formulae 1 - Substituting of figures into the formulae 1 - Comparation of two forecast figures 1 - Decision 1 4 20

ADRAC COMMUNITY SCHOOL

a. REDRAFTING THE BUDGET FOR THE YEAR ENDED 30 JUNE 2020 BUDGETED INCOME N’000 Pupils Rate/Pupil N Pupils registered at the beginning of school year 720 21,000 15, 120 Average Expected Number of New Joiners 51 18,000 918 16,038 79 BUDGETED EXPENDITURE Actual cost for the year Ended 30-June-2019 Budget Cost for the year Ended 30-June-2020 N’000 N’000 Repairs and Maintenance Note 1 600 3% 618 Salary Note 2 11,880 2% 12,019 Improvement of canteen Note 3 1,300 1,255 13,892 Budgeted Surplus/(Deficit) 2,146

Note 1: Repairs & maintenance 600,000 (1.03) = 618,000

Note 2: Salaries (12,400,000 – 520,000) (1 + 0.02 x 7/12) = 12,019,000

Note 3: Improvement of canteen Estimated cost Pro Expected cost 1,450,000 0.7 1,015,000 800,000 0.3 240,000 1,255,000

(b) Advantages of Incremental Budgeting – Incremental budgeting is very easy to prepare. This makes it possible for a person without any accounting training to build a budget. – Incremental budgeting is also very quick to comprehend compared to other budgeting methods. – The information required to complete it is also usually readily available Disadvantages of Incremental Budgeting – There is no incentive to eliminate wasteful or unnecessary spending from the budget; – It encourages more waste (or budget slack) because managers will try to spend up to their budget limit so that budget for next financial year will not reduce. – It increases allocated cost irrespective of performance. 80 Inflationary Adjustment

(c) STEPS IN PREPARING ZERO-BASED BUDGET Zero-based Budget is prepared as follows:

(i) A decision must be taken to provide for a minimum level of operation. This means deciding for each basic operation whether or not to perform the operation. (ii) Having decided on a basic level of operations, a basic expenditure budget can be prepared. (iii) The next step is to consider each incremental decision package and decide whether additional operation is justified. An incremental decision package is justified if the expected benefits exceed the estimated costs.

(d) EXTENT TO WHICH ZERO-BASED BUDGET CAN BE USED BY ADRAC TO IMPROVE BUDGETING PROCESS

i. It can be used to help lower costs by avoiding blanket increases or decreases to a prior period's budget. ii. It can be used to help in efficient allocation of resources (department-wise) as it does not look at the historical numbers but looks at the actual numbers iii. It leads to the identification of opportunities and more cost- effective ways of doing things by removing all the unproductive or redundant activities. iv. Since every line item is to be justified, zero-based budget overcomes the weakness of incremental budgeting of budget inflation. v. It also improves coordination and communication within the department and motivates employees by involving them in decision- making.

Examiner’s report The question tests candidates’ understanding of Incremental Budget and Zero Based Budget. Majority of the candidates attempted the question. Candidates performance was above average. The candidates are advised to read the Institute’s study text when preparing for the Institute’s examination in future. 81

Marking guide Mark Total a. Redrafted budget 6 b. i) Advantages (Any 2 at 1 mark) 2

ii) Disadvantages (Any 2 at 1 mark) 2 4 c. 3 steps at 2 marks 6 d. Extent of use of ZBB by Adrac (Any 2 points at 2 marks each) 4 20

a) Unit contribution ₦13,000 – (8,000 + 500) = ₦4,500 Unit loss when surplus sold ₦8,500 – 5,000 = ₦3,500 Unit penalty when demand not satisfied ₦2,000 per outfit not sold Probability of sales levels Sales Probability 1,100 0.3 1,200 0.4 1,300 0.2 1,400 0.1 Contribution calculations (1,100 units purchased) Demand contribution ₦ 1,100 1,100 × ₦4,500 = 4,950,000 1,200 1,100 × ₦4,500 – 100 × ₦2,000 = 4,750,000 1,300 1,100 × ₦4,500 – 200 × ₦2,000 = 4,550,000 1,400 1,100 × ₦4,500 – 300 × ₦2,000 = 4,350,000 (1,200 units purchased) Demand Contribution ₦ 1,100 1,100 × ₦4,500 – 100 × ₦3,500 = 4,600,000 1,200 1,200 × ₦4,500 = 5,400,000 1,300 1,200 × ₦4,500 – 100 × ₦2,000 = 5,200,000 1,400 1,200 × ₦4,500 – 200 × ₦2,000 = 5,000,000 82 (1,300 units purchased) Demand Contribution ₦ 1,100 1,100 × ₦4,500 – 200 × ₦3,500 = 4,250,000 1,200 1,200 × ₦4,500 – 100 × ₦3,500 = 5,050,000 1,300 1,300 × ₦4,500 = 5,850,000 1,400 1,300 × ₦4,500 – 100 × ₦2,000 = 5,650,000 (1,400 units purchased) Demand Contribution ₦ 1,100 1,100 × ₦4,500 – 300 × ₦3,500 = 3,900,000 1,200 1,200 × ₦4,500 – 200 × ₦3,500 = 4,700,000 1,300 1,300 × ₦4,500 – 100 × ₦3,500 = 5,500,000 1,400 1,400 × ₦4,500 = 6,300,000 Summary of outcomes Probability Order quantity Demand 1,100 1,200 1,300 1,400 0.3 0.4 0.2 0.1 Application of probability on the Pay off Matrix State of Nature (Sales) Decision 0.3 0.4 0.2 0.1 Alternatives 1,100 1,200 1,300 1,400 Max 1100 1,485,000 1,900,000 910,000 435,000 1,900,000 1200 1,380,000 2,160,000 1,040,000 500,000 2,160,000 1300 1,275,000 2,020,000 1,170,000 565,000 2,020,000 1400 1,170,000 1,880,000 1,100,000 630,000 1,880,000 :. On the basis of the expected contribution the number of outfits to order is 1,200 units.

Note: The order/receipt costs of ₦80,000 are constant throughout and therefore have been ignored. Expected contribution ₦000 1,100 4,950,000 4,750,000 4,550,000 4,350,000 4,730 1,200 4,600,000 5,400,000 5,200,000 5,000,000 5,080 1,300 4,250,000 5,050,000 5,850,000 5,650,000 5,030 1,400 3,900,000 4,700,000 5,500,000 6,300,000 4,780 83

b) The basic EOQ model assumes a known demand per period e.g., per year and the aim is then to find how often, and therefore how much, to order at a time so as to minimise total costs, each order arriving when the stock level is zero so that there are no ’lost sales’ and no surplus stock. (It has to be said that the basic EOQ model is rarely, if ever applicable in this simple form in a real-life case, although refinements such as variable demand can be built into the model). By contrast, in the model calculated, demand is not known with certainty but is assumed to conform to the probability distribution given. Since the whole of the season’s stock has to be ordered in a single batch at the start of the season, both overstocking and under stocking are possible, with resultant loss of profit contribution.

Examiner’s report The question tests the candidates’ understanding of decision making under uncertainty. Few students attempted the question and performance was below average. The major pitfall was lack of understanding in identifying possible scenarios for decision making. Candidates are advised to study the Institute’s text for future Institute’s study examination.

Marking guide Mark Total a. i) Number of outfits to maximise profits (32 ticks at ½ mark) 16 ii) Decision 1 17 b. Compare models 1½ Contrast models 1½ 3 20

CHUKWUKAH NIGERIA LIMITED

(a) Full budgeted production cost per unit using absorption costing Product Jel Jet Jal Total Budgeted annual production (units) 25,000 20,000 27,600 Labour hours per unit 2·5 3 2 Total labour hours 62,500 60,000 55,200 177,700 Overhead absorption rate = N6,887,000/177,700 = N38·76 per hour. 84 Product Jel Jet Jal N per unit N per unit N per unit Direct materials 250.00 280.00 220.00 Direct labour 300.00 360.00 240.00 Overhead (N38·76 x 2·5/3/2) 96.90 116.28 77.52 Full cost per unit 646.90 756.28 537.52

(b) Full budgeted production cost per unit using activity based costing Product Jel Jet Jal Total Budgeted annual production (units) 25,000 20,000 27,600 Batch size 500 800 400 Number of batches (i.e. set ups) 50 25 69 144 Number of purchase orders per batch 4 5 4 Total number of orders 200 125 276 601 Machine hours per unit 1·5 1·25 1·4 Total machine hours 37,500 25,000 38,640 101,140 Cost driver rates: Cost per machine set up N1,400,000/144 = N9,722.22 Cost per order N1,580,000/601 = N2,628.95 Machine running cost = ₦21,000,000/101140 = ₦20.76 General facility cost = 1,807,000/101140 = ₦17.87 Allocation of overheads to each product: Product Jel Jet Jal Total N N N N Machine set up costs 486,111 243,055 670,833 1,400,000 Material ordering costs 525,790 328,619 725,591 1,580,000 Machine running cost 778,624 519,082 802,294 2,100,000 General facility cost 669,987 446,658 690,355 1,807,000 Total 2,460,512 1,537,414 2,889,073 6,887,000 85 Quantity Produced 25,000 20,000 27,600 Overhead cost per unit N98.42 N76.87 N104.68 Allocation of overheads to each product Total cost per unit: N per unit N per unit N per unit Direct materials 250.00 280.00 220.00 Direct labour 300.00 360.00 240.00 Overhead 98.42 76.87 104.68 ABC cost per unit 648.42 716.87 564.68

c. The company prices product on the basis of cost plus pricing model. The application of ABC model will impact the selling price and sales volume of the products as follows: Jel: The demand is elastic. As a result of ABC model, cost will increase from N646.90 to N648.42 meaning increase in selling price and reduction in sales volume Jet: The demand is elastic. As a result pf ABC method, cost will decrease from N756.28 to N716.87 meaning that there will be a decrease in selling price and increase in sales volume. JAL: The demand is inelastic meaning change in price will not affect the quantity demanded. Hence, even though the cost increased from N537.52 to N564.68, selling price will increase but will not affect the sales volume.

Examiner’s report The question tests the candidates’ understanding of overhead apportionment using Traditional and Activity Based Costing Method. Majority attempted the question and the performance was average. The major pitfall was the determination of the number of batches involved. Candidates are encouraged to make use of the Institute’s text for future Institute’s examination. 86

Marking guide Mark Total a. Budgeted full cost per unit (12 ticks at ½ mark each tick) 6 b. Budgeted ABC full production cost per unit Cost driver rate (4 ticks at ½ mark each) 2 Production cost per unit (12 ticks at ½ mark each) 6 8 c. Impact of ABC on selling price/sales volume 6 20 87 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIA

a) The availability of materials may be a constraint when formulating the budget.

i) There may be a shortage of supply of materials e.g. where they are Imported and it is known that a bad harvest or political unrest will limit the total quantity available. ii) The company may have a limited quantity of specialist storage space available. For example raw material may require specially humidified storage or special storage container space where it is toxic or dangerous in nature. Such constraints may limit the overall amount of material which can be made available during the budget period. iii) The level of material losses in stores and in the production process may be unacceptably high. This will increase the total input materials required and could lead to a shortfall arising. iv) Seasonal material input v) Surge in demand vi) Storage facility and capacity vii) Transport system to move material viii) Price of related input material for substitute and complementary goods The steps: The company may attempt to minimise the effect of potential shortages by placing forward orders for materials. It may also consider possible substitute materials which are more readily available. Where storage space is a problem, the company may consider the renting of extra storage facilities. It may also wish to negotiate a ’just-in-time’ agreement whereby deliveries of material are guaranteed by suppliers to coincide with the forward production plan. In order to reduce the level of material losses, stores layout and control procedures should be reviewed. In the production process additional focus on the efficiency of machinery and the level of training of the work force should help reduce the level of material losses and hence the total material input required. 69

b) Computation of Production that maximises profit Product K T F N N N Selling Price 1,800 2,520 3,000 Less Variable cost: Direct labour (280) (560) (700) Material A (300) (240) (420) Material B (480) (720) (600) Variable overhead (160) (320) (400) Contribution/Unit 580 680 880 Ranking the products using contribution/kg of material B Kg of material B 4 6 5 Contribution/kg N145 N113.33 N176 Ranking 2nd 3rd 1st Use of material B 3,600kg 3,900kg 10,000kg Optimal Production 900 650 2,000

c) Producing with no special emphasis on special order K T F Contr./Unit N580 N680 N880 Normal Production 500 800 1,600 Unit of material B 4 6 5 2,000 4,800 8,000 = 14,800 Ranking 2nd 3rd 1st Bal. to be used for special Order 700kg 0 2,000kg = 2,700 Units to be produced under special order 175 units 400 units Normal contribution 580 x 500 =290,000 800 x 680 544,000 1,600 x 880 = 1,408,000 = N2,242,000 Special Order 175 x 380 = 66,500 - 400 x 680 = 272,000 N338,500 N356,500 N544,000 N1,680,000 = N2,580,500 70 Producing with Emphasis on Special order Optimal Production (units) 900 650 2,000 N Contribution/unit N580 N680 N880 Total Contribution N522,000 N442,000 N1,760,000 2,724,000 Less Discount N80,000 N80,000 N80,000 (240,000) N442,000 N362,000 N1,680,000 = 2,484,000 Financial Penalty N2,580,500 – N2,484,000 = N 96,500

d) Advantages of outsourcing:

i. It allows each party to focus on core competences. This should lead to improved quality of the final products produced by Alice. In addition, this should lead to improved efficiency in that part of the overall operations. ii. It should lead to improved services provided to customers, leading to an increase in customer satisfaction. This will assist in retaining existing customers and achieving repeat sales. iii. Outsourcing will mean that the amount of capital expenditure is reduced, as the company will no longer be required to invest in the plant and equipment needed to carry out the outsourced activity. iv. It should lead to less incidence of under-utilisation of assets. This will lead to greater efficiency, and will impact positively on a number of important performance measures (e.g. ROA, asset turnover, ROE, etc). v. It is possible, but by no means certain, that an activity can be provided by an outsourcer at lower cost than is possible in-house, as a result of the outsourcer’s ability to specialise. Disadvantages of outsourcing: i. Staff resistance: Members of staff, particularly those currently working in the activity to be outsourced, may be resistant, as they will fear that their jobs will be lost. ii. Loss of critical skill: In the medium to long term, the skills associated with the outsourced activity will be lost to the company. It is probable that replacing such skills could prove to be costly. If an inappropriate activity is outsourced, or the outsourcing initiative is unsuccessful, this could prove to be very costly. Once such skills have been lost, the supplier may seek to increase prices. In such circumstances there would be little option to accept the increased cost, unless an alternative supplier can be identified. 71

iii. Quality of the supplier: The success of an outsourcing initiative will be heavily influenced by the quality of the supplier. It may be difficult to identify a supplier who can provide the correct skills and meet the required specification. iv. Loss of confidential data: When an activity is outsourced, there is a danger that it allows competitors to obtain access to data which otherwise would remain in-house. This may lead to a commercial disadvantage. This is most likely to occur in the case of a product, and competitors may now be able to carry out a tear-down analysis more easily. v. Reputational problems: The most significant potential problem is the damage to reputation which may result if the supplier does not meet the required specification. vi. Outsourcing firm may turn to a competitor vii. Loss of managerial control viii. Failure to meet delivery targets

ix. Selection of vendors may take time and effort

Examiner’s report This is a compulsory question that tests candidates’ knowledge on how to handle limiting factor. Being a compulsory question, it was attempted by almost all the candidates. The candidates recorded an average performance. The pitfall is that most candidates failed to compute the financial penalty that will be expected when Kikelomo Ltd fails to supply the special order in full as well as failure to treat the discount as an attributable variable costs that only applies to the special order. Candidates are encouraged to study the Institute’s study manual when preparing for ICAN examinations. 72

Marking guide Marks a 3 factors that cause material input constraint 3 3 Steps to overcome them 3 6 b - Contribution per unit 1 ½ - Contribution per kg of material B 1 ½ - Ranking 1 ½ - Optimal Production 4 ½ 9 c Computation of lowest value of financial penalty (36 ticks at 16 mark) 6 d Advantages of outsourcing (2 points at 21/2 marks) 5 Disadvantage of outsourcing (2 points at 2 marks) 4 9 30

a) Outsourcing Cost Year Particular CF DCF@12% PV N N 1-5 Outsourcing Cost (100,000) 3.605 (360,500) 0 Sales of machine 30,000 1.000 30,000 1 Engineering cost (8,000) 0.893 (7143) 1-5 Rent 2,000 3.605 7,210 330,433 Internal Production Cost Year Particular CF DCF@12% PV N N 1-5 Direct material (44,000) 3.605 (158,620) 1-5 Direct Labour (22,000) 3.605 (79,310) 1-5 Variable O/H (14,000) 3.605 (50,470) 1-5 Engineering cost (8,000) 3.605 (28,840) 317,240 Decision: Produce internally The company should continue to produce “Part 2011”. 73 Alternative Approach

a) There are two options to evaluate

- Outsource......................A - Produce .......................B In the solution that follows, we use incremental approach Cash flows (N) Items Yr A B A-B PVF@12% PV Sales of machine 0 30,000 0 30,000 1 30,000 Outsourcing costs 1-5 (100,000) 0 (100,000) 3.605 (360,500) Direct materials 1-5 0 (44,000) 44,000 3.605 158,200 Direct labour 1-5 0 (22,000 22,000 3.605 79,310 Variable overhead 1-5 0 (14,000) 14,000 3.605 50,470 Product, etc engineering 1 (8,000) (8,000) 0 0.893 0 2-5 0 (8,000) 8,000 2.712 21,696 Rent 1-5 0 (2,000) 2,000 3.606 7,210 NPV if outsourcing N(13,614) The company should continue to produce part 2011.

b) NPV =N330,433 – N317,240= N13,193 Sensitivity of the quoted price = NPV PV of outsourcing cost x 100 = N13,139 N360,500 x 100 = 3.66% This means that the unit price should not reduce more than N100 - (N100 x 3.66%) = N100 - N3.66 = N96.34 Alternative Solution: 3.605 x 1000 units x Price =N360,500 – NPV = 3,605 P = N360,500 – N13,193 3,605P = N347,307 P = N347,307 3,605 P = N96.34 74

c) The following are the non-financial factors that would favour internal production:

i) Labour Union: If outsourcing leads to laying off operatives who are currently producing the components, labour union may react adversely, if not properly handled.

ii) Quality: To maintain high level of quality of the component, it might be better to produce rather than to outsource.

iii) Ability to meet delivery scheduling: Internal production should ensure that the components are delivered as and when needed.

iv) Continuity of supply: This component will be needed for the next five years. Strategic reasons will demand that the company should keep the supply under its control. Thus, for harmonious labour relationship, desired level of quality, ability to meet delivery scheduling and continuity of supply, it better to produce rather than outsourcing.

Examiner’s report This is one of the open-ended questions that tests candidates’ understanding of relevant cost. The attempt on this question by candidates was very low. The candidates recorded below average performance. The pitfall noticed is candidates’ failure to apply the discounting aspect of the question. Candidates are encouraged to study the Institute’s study manual when preparing for ICAN future examinations.

Marking guide Marks A DG to outsource or not (20 ticks at ½ mark) 10 B Maximum price to be quoted by KK Ltd 5 C Non-financial factors that affect internal production (Any 2 points at 2½ marks) 5 20 75

a. Using marginal costing principles to calculate the profit maximising output and profit: Products X Y Sales volume 16,000 units 24,000 units N N Sales Price 44 54 Less variable costs: Direct material 20 18 Direct labour 6 11 Variable overheads 6 11 Total variable costs 32 40 Contribution per unit 12 14 Machine hours per product 1.50 hours 2 hours Contribution per machine hours N8 N7 Ranking 1st 2nd Hours Required: Product X = 16,000 x 1.50 = 24,000hours Product Y = 24,000 x 2 = 48,000 hours Total hours machine required = 72,000 hours Available hours: 64,000 hours Production Mix = Product X = 16,000 units x 1.50 hours = 24,000 hours Product Y = 40,000 /2 = 20,000 units = 40,000 Hours Therefore, profit maximising output = Product X = 16,000 units Product Y = 20,000 units Associated Profit Product X Y Total N Unit contribution 12 14 Total contribution N192,000 N280,000 472,000 Less Attributable fixed cost N(10,000) N(10,000) (20,000) Less General Fixed costs (100,000) Net Profit N182,000 N270,000 352,000 76

b. The advantages of throughput accounting over marginal costing method in profit maximising decisions include:

(i) It helps to identify the factors that limit the organisation from realising its goal. (ii) It helps management to solve organisational crisis and improve business processes to ensure a competitive edge. (iii) It identifies method which the organisation can use to improve its financial management.

c. Calculation of the throughput accounting ratio for Products X and Y Computing throughput return per bottleneck X Y Sales volume 16,000 units 24,000 units Sales Price N44 N54 Less: Throughput costs: Direct material N20 N18 Throughput return N24 N36 Machine hours per unit 1.50 hours 2 hours Throughput returns per machione hours N16 N18 Ranking 2nd 1st Factory operating cost per bottleneck Particulars X Y Total N Units of production 16,000 24,000 Direct labour N96,000 N264,000 360,000 Variable overhead N96,000 N264,000 360,000 Attributable fixed costs N10,000 N10,000 20,000 Other fixed costs 100,000 Tot Throughput accounting ratio = Throughput return per bottleneck Factory cost per bottle neck Product X Y Throughput returns per machione hours N16 N18 Factory operating cost per machine hour N13.125 13.125 Throughput Accounting ratio = 16 18 = 13.125 13.125 = 1.22 1.37 Ranking to manufacture 2nd 1st

d. Product X Y Total N Total machine hours 16000 hours 48,000 hours Machine hours/Unit 1.5 hours 2 hours Profit maximising output 10,667 units 24,000 units Throughput return/hour N16 N18 Total Return N256,000 N864,000 1,120,000 Total operating cost 840,000 Total operating costs 280,000

Examiner’s report The question tests candidates’ understanding of throughput accounting and marginal costing analysis. The attempt on this question by candidates was very high. The candidates recorded above average performance. The pitfall noticed is inability of the candidates to compute throughput accounting ratio. Candidates are advised to use ICAN study manual intensively when preparing for ICAN future examinations. 78

Marking guide Marks a Computation of profit maximising output and profit (20 ticks at 1/5 mark) 4 b Advantages of throughput accounting over marginal costing. (2 points at 2 marks) 4 c Computation of Throughput accounting ratio. (40 ticks at 1/5 mark) 8 d Computation of profit maximising output and profit using throughput Accounting. (16 ticks ¼ mark) 4 20

a) HENRY LIMITED Quarter 1 Quarter 2 Quarter 3 Quarter 4 (i) units units units units Actual sales volumes 420,000 450,000 475,000 475,000 Seasonal variation + 25,000 + 15,000 0 40,000 Deasonalised sales volumes 395,000 435,000 475,000 515,000 Quarter 1 Quarter 2 Quarter 3 Quarter 4 (ii) units units units units Trend projection 555,000 595,000 635,000 675,000 Seasonal variation +25,000 +15,000 - 40,000 Forecast sales volume 580,000 610,000 635,000 635,000

b) Seasonal variations Seasonal variations are short term variations in data that occur due to the time or season of the year. These variations could be due to hourly, daily, weekly, monthly or yearly changes in sales patterns. Due to these variations, forecast data do not always follow the historical trend and hence, the figures have to be adjusted to account for these variations. Deseasonalised or seasonally adjusted data: Actual data recorded already include seasonal variations. In order to get a clear picture of the trend (i.e. the underlying pattern), the effect of seasonal variations have to be adjusted - a process referred to as deaseasonalising the data. 79 Observation of the actual data suggests that the rate of increase in sales is declining. Uses Provided that the observed trend in deseasonalised data continues, the deseasonalised data can be used to project the trend in future sales. The trend values are adjusted by seasonal variations in each quarter to predict actual sales.

c) Argument for manager’s participation

i) Managers have experience of the day-to-day running of the business. Their knowledge can help ensure that budget targets are on the one hand: realistic, and on the other hand, a reflection of the full capabilities of the business. ii) Through manager participation the budgeting process can also become an opportunity for senior management to communicate organisational strategy, policies and expectations. This should encourage subordinate managers to concentrate on corporate goals rather than their own personal goals and will therefore help to achieve goal congruence. iii) Participation tends to increase motivation since managers feel they are valued. In addition, input to target setting encourages greater commitment to budgets as the budgets are then perceived to be fair. This again leads to improved goal congruence. iv) Grooming of managers for top posts: The consultation processes involved can be used to access manager potential and help provide training in the skills needed for higher-level management. Challenges arising from manager participation

i) Since managers are required to implement budgets, they may attempt to set easily achievable targets, over-estimating resource requirements for instance. This can be a particular problem if bonuses depend on achieving such targets. Occasionally, the reverse problem can arise: managers might be over optimistic, thinking an ambitious target will improve their status.

ii) Managers may have different degress of skill in determining an appropriate level of difficulty for budget targets, particularly in a changing business environment. Lack of confidence may also make a manager reluctant to participate.

iii) Although participation is usually perceived to improve motivation, if managers’ ideas are rejected, they may feel slighted and have less motivation and commitment to the budget than if it had been imposed from above. 80

Examiner’s report This is an unpopular question which dwells on trend analysis, seasonal variation and de-seasonalised adjusted data as tools for forecasting and budgeting. The (a) aspect tests candidates ability to compute trend figures using trend and seasonal variation information while the (b) and (c) parts dwelt on theories of seasonal variation, deseasonalised variations and participative budgetary process.

Marking guide Marks Marks Marks a (i) Adjusting for personal variation (20 ticks at ¼ mark) 5 (ii) Forecasts for sales volumes (16 ticks at ¼ mark) 4 9 b - Explanation of seasonal valuation 1½

- Explanation of deseasonalised adjusted data 1½ - Uses of time series/Forecast 2 5 - c Advantages of participative budgeting (2 points at 1 ½ marks) 3 Disadvantages of participative budgeting (2 points at 1½ marks) 3 6 20

GASKIYA NIG LTD a. Calculation of the expected net present value of the two Projects Computation of joint Probability distribution S/N Factor 1 Factor 2 Factor 3 Workings Joint Probability 1 YES YES YES 0.2 X 0.3 X 0.4 0.024 2 YES YES NO 0.2 X 0.3 X. 0.6 0.036 3 YES NO NO 0.2 X 0.7 X 0.6 0.084 4 NO NO NO 0.8 X 0.7 X 0.6 0.336 5 NO NO YES 0.8 X 0. 7 X 0.4 0.224 6 NO YES YES 0.8 X 0.3 X0.4 0.096 7 YES NO YES 0.2 X 0.7 X 0.4 0.056 8 NO YES NO 0.8 X 0.3 X. 0.6 0.144 Total 1.000 81 Impact on inflow S/N Joint Probability Inflow impact Result Final expected value 1 0.024 1 - 0.25 -0.10 + 0.05 0.70 0.0168 2 0.036 1 -0.25 – 0.10 0.65 0.0234 3 0.084 1 – 0.25 0.75 0.0630 4 0.336 1-0.0 1.00 0.3360 5 0.224 1 +0.05 1.05 0.2352 6 0.096 1 -0.10+ 0.05 0.95 0.0912 7 0.056 1 – 0.25 + 0.05 0.80 0.0448 8 0.144 1 – 0.10 0.90 0.1296 1.000 0.9400 Thus the EV of considering the 3 factors is 0.94. Therefore the NPV of Project A and B are: Project A Year Cash inflow EV of Cash flow PV of cash flow N’000 N’000 N’000 N’000 N’000 N’000 0 - (13,000) (13,000) 1.000 (13,000) 1 6,000 x 0.94 Cash Net Cash Discount outflow flow rate 10% 5,640 (3,000) 2,640 0.909 2,399.76 2 8,000 x 0.94 7,520 (4,000) 3,520 0.826 2,907.52 3 10,000 x 0.94 9,400 (4,000) 5,400 0.751 4,055.40 4 9,000 x 0.94 8,460 (3,000) 5,460 0.683 3,729.18 5 6,000 x 0.94 5,640 (3,000) 2,640 0.621 1,639.44 NPV +1,731.30 82 Project B Year Cash inflow EV of Cash flow Cash outflow PV of cash flow N’000 N’000 N’000 N’000 N’000 0 - (14,000) (14,000) 1.000 (14,000) 1 10,000 x 0.94 9,400 (5,000) 4,400 0.909 3,999.60 2 9,000 x 0.94 8,460 (4,000) 4,460 0.826 3,683.96 3 8,000 x 0.94 7,520 (3,000) 4,520 0.751 3,394.52 4 8,000 x 0.94 7,520 (3,000) 4,520 0.683 3,087.16 5 4,000 x 0.94 3,760 (2,000) 1,760 0.621 1,092.96 NPV +1,258.20

b. Project A will be more profitable with a higher NPV of N1,731.30

Examiner’s report The question tests candidates’ understanding of investment appraisal under situations of uncertainty with sensitivity of variables that affected the investment . The question was highly attempted by candidates as it was a popular capital investment appraisal question. The candidates recorded average performance. The pitfall noticed is the inability of the candidates to decipher the several other factors that affect the annual cash inflows and reflect their effect on the present values of net cash flow. Candidates are encouraged to study the Institute’s study pack when preparing for ICAN future examinations.

Marking guide

- Marks Marks Marks - Company Name ½ - Computation of joint probability - (9 ticks at ¼ mark) 2¼ - Computation of expected value ( 9 ticks at ¼ mark) 2¼ - Expected Net Present value of project A (24 ticks at 1/6 mark) 4 - Expected Net Present value of Project B (24 ticks at 1/6 mark) 4 13 - Most profitable project 2 15 83 Net Cash flow Discount rate 10%

Mr. Alade could use any of the following three approaches to deal with uncertainty:

(i) Maximin Decision Rule: The decision maker will look at the options and choose the one that has the highest minimum return. This type of decision maker is a pessimist and will look at the worst outcome for each of the options and seeks to get the best of the worst.

(ii) Maximax Decision Rule: The decision maker will look at the options and choose the one that has the highest return. This type of decision maker is an optimist.

(iii) Minimax Decision Rule (Regret): The decision maker will analyse the options and choose an option so that if it is the wrong choice, the regret will not be as much as if the others had been chosen and they were wrong. This type of decision maker seeks to minimise the post-event regret of having made a wrong decision.

(iv) If probabilities can be assigned to the outcomes then “uncertainty” will become “risk”. It will then be possible to calculate “expected values”. The decision will choose the outcome that has the highest expected value. This assumes that the decision maker is risk neutral. METHOD OF DEALING WITH RISK The expected value of an option does not give any indication of the risk associated with the option. The risk, or spread, of the possible outcomes of each option can be measured by calculating the standard deviation. A risk minimiser would choose the option with the lowest standard deviation. The trade off between risk and return can be evaluated by calculating the coefficient of variation (standard deviation over the expected value).

(v) Decision tree is a flowchart to represent possible solution based on certain conditions

(vi) Simulation method forecasts the outcome of an event using probabilities associated with the events.

(vii) Sensitivity analysis is a method that determines the effect of risk on the expected outcome of a key variable or factor. 84 Attitude of Decision Makers: (i) Risk averse: This avoids risk without adequate compensation for the risk (ii) Risk neutral: This is indifferent about risk taking and hence, ignores it (iii) Risk seeking: This takes risk without compensation for the risk.

Examiner’s report This question tests candidates theoretical appreciation of decision making under situations of uncertainty and risk. Many candidates attempted the question. The candidates recorded average performance. The major pitfall noticed is the inability of candidates to work in accordance with the examiners’ requirements that no computations are required. Candidates are advised to pay special attention to the requirements of questions as well as use the Institute’s study manual when preparing for ICAN future examinations.

Marking guide Marks Marks - 3 Methods of uncertainty in decisions making. (Any 3 points and explanations) 9 - 1 Method of risk appraisal in decision making. (Any 1 point and explanation) 3 - 3 Attitudes associated with decision making under risk/uncertainty. (Any 3 points and explanations) 3 15 85

a) Garki Plc Transfer price per unit for Alba Division: N Residual income 700,000 Notional interest (12% x 4,000,000) 480,000 Net profit 1,180,000 Divisional fixed cost 160,000 Contribution 1,340,000 Variable cost (900,000 x 4.90) 4,410,000 Total revenue 5,750,000 Less: External revenue (700,000 x 6.80) (4,760,000) Internal revenue (A) 990,000 Excess/idle capacity (900,000 – 700,000) (B) 200,000 units Transfer price (A/B)/unit N4.95 b) Selling price of Beta Division N Residual income 500,000 Notional interest (10% x 3,000,000) 300,000 Net profit 800,000 Divisional fixed cost 140,000 Contribution 940,000 Plus Variable cost further of processing cost (200,000 x 4.50) 900,000 Plus Transfer price (200,000 x 4.95) - input cost 990,000 Total revenue (c) 2,830,000 Quantity to sell (D) 200,000 External selling price (C/D) N14.15 Assumption: External offer price from intermediate market from Beta Division is equal to or greater than N4.95 transfer price.

c) The transfer price to Beta Division will be sub-optimal to the company as a whole since N6.80 is the price to external customers while N4.95 is price to the division necessitating a loss of N1.85 per unit. The sub- optimal decision making also can be due to the buying division recognising the fixed costs of N160,000 and mark-up (Profit – residual income and imputed capital cost) of selling divisions as variable costs of N4.95 when it should have been N4.90 in setting the transfer price. 86

d) Negotiated transfer Price Versus Market based Price A negotiated transfer price is a price that is a product of agreements between the managers of the profit centres. Here, managers are given the autonomy to agree on transfer price. Negotiated transfer prices are appropriate when there is an imperfect market for the goods and services that are bought and sold between divisions. Market-based transfer pricing is based on the existence of external market. Market-based transfer pricing is perhaps the easiest form of transfer pricing when it comes to determining the price that will be paid between divisions of the same company. It uses the normal market rate that would be paid if the goods were bought on the open market.

Examiner’s report The question is a transfer pricing question that is computed using expected divisional profit and residual income information. Many candidates attempted the question. The candidates recorded average performance. The pitfall noticed is candidates computation of transfer price based on variable costs and opportunity cost without taking into consideration divisional returns expectation in the areas of divisional profit and residual income which are the basis of sub-optimality. Candidates are advised to pay special attention to the requirements of questions as well as use the Institute’s study manual when preparing for ICAN future examinations.

Marking guide Marks Marks a Transfer price from Alba divison (12 ticks at ¼ mark) 3 b Selling price by Beta division (12 ticks at ¼ mark) 3 c Transfer price as sub-optimal decision (2 reasons at 2 ½ marks) 5 d - Explanation of Negotiated Transfer price 2

- Explanation of market based Transfer Price’ 2 4 Total 15 87 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIA