Performance Management · November 2021

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