Performance Management · 2024

a) Product Machine hours required A B C Total Type 1 180 315 180 675 Type 2 120 175 120 415 Machine utilisation rate: Machine type 1 = 675/600 = 112.5% Machine type 2 = 415/500 = 83.0% Machine type 1 has the highest utilisation rate and the rate is above 100. Therefore, machine type 1 is the bottleneck/limiting factor. b) 67

b. a. c. Product Machine hours required A B C Total Type 1 180 315 180 675 Type 2 120 175 120 415 Machine utilisation rate: Machine type 1 = 675/600 = 112.5% Machine type 2 = 415/500 = 83.0% Machine type 1 has the highest utilisation rate and the rate is above 100. Therefore, machine type 1 is the bottleneck/limiting factor. Product A B C Contribution per unit ₦400 ₦960 ₦740 Machine type 1 hours 1.5 4.5 3.0 Contribution per hour ₦266.67 ₦213.33 ₦246.67 Ranking 1 3 2 Allocation of machine type 1 hours according to this ranking: Product A 120 units using 180 hours Product C 60 units using 180 hours 360 hours used Product B (240/4.5) 53 units using 238.5 hours 598.5 hours used A major concept underlying throughput accounting is that the majority of costs, with exception of material and component costs, are fixed. In ABC’s case it is clear that the labour cost, which is treated as a variable cost in traditional marginal costing, is indeed a fixed cost. The employees are paid for a guaranteed 800 hours (160 × 5) each month, whereas the number of labour hours required to meet the maximum demand can be calculated as 780 hours as follows. 68 d. e. Product A B C Total Labour hours per unit 0.75 6 4.5 Maximum demand (units) 120 70 60 Total hours required per month 90 420 270 780 Therefore, labour is a fixed cost that will not alter within the relevant range of activity. Throughput accounting recognises this in the calculation of throughput. Furthermore, given the perishable nature of ABC’s products, the throughput accounting approach to inventory minimisation and maximisation of throughput would be more appropriate. Product A B C ₦ per unit ₦ per unit ₦ per unit Sales revenue 910 1,740 1,400 Component cost 220 190 160 Other direct material 230 110 140 Throughput per unit 460 1,440 1,100 Machine type 1 hours 1.5 4.5 3.0 Throughput per hour ₦306.67 ₦320.00 ₦366.67 Ranking 3 2 1 Allocation of machine type 1 hours according to this ranking: Product C 60 units using 180 hours Product B 70 units using 315 hours 495 hours used Product A (105/1.5) 70 units using 105 hours 600 hours used Throughput accounting approach The conventional cost accounting approach used by ABC views inventory as an asset. In the throughput accounting approach inventory is not viewed as an asset, but rather as a result of unsynchronised manufacturing. The existence of inventory is thus viewed as a breakdown in synchronisation and a barrier to generating profits. In throughput accounting the ideal inventory level is zero, with the exception that a buffer inventory should be held prior to the bottleneck machine. 69 f. As regards the valuation of inventory, the throughput philosophy is that no value is added to inventory items and no profit is earned until the items are actually sold. Thus inventory is valued at its material cost only until it is sold. Contrast the approach The marginal costing approach currently used in TK differs from throughput accounting in the following areas: This approach to inventory valuation is in contrast to the full absorption costing system used by ABC. The latter approach encourages managers to produce output just to add to work in progress or finished goods inventory, since this helps with the absorption of overheads and boosts reported profits. This behaviour will be avoided, and managers will be more likely to be willing to minimise inventory if it is valued at material cost only. Variable and fixed costs: Marginal costing divides costs into variable costs (which vary with production volume and include materials, labour, and variable overheads) and fixed costs (which remain constant regardless of production volume). Throughput accounting considers materials cost as the only variable cost. All other costs, including labour are considered as factory cost of operating expenses and are treated as costs for the period. Contribution margin: The key metric in marginal costing is the contribution margin, which is sales revenue minus variable costs. This margin contributes to covering fixed costs and generating profit. The key metric in throughput accounting is throughput contribution, which is sales revenue minus material cost only. This margin contributes to covering the operating expenses and generating a profit. Inventory valuation: Inventory is valued based on variable costs only (as defined above). Fixed costs are treated as period costs and are expensed in the period they are incurred. In throughput, inventory is valued based on variable costs only, specifically direct material costs, avoiding complex overhead allocations. The importance of identifying scarce resources when preparing budgets

i. If an organisation produces just one product, the budget for the scarce resources is usually the starting point in the budget preparation process. ii. If an organisation produces two or more products and there is only one scarce resource, limiting factor analysis must be used to determine the most profitable use of the scarce resource. 70

iii. When there is more than one scarce resource, linear programming must be used to identify the most profitable use of resources. iv. To optimise resource allocation to competing products Prioritisation: By identifying scarce resources, companies can prioritise their allocation to the most impactful activities, ensuring that these constraints do not hinder overall production or service delivery. v. To Enhance decision-making Informed Planning: Knowing which resources are scarce allows for more informed and strategic decision-making, enabling better planning and utilisation of available resources to meet production targets and customer demand. vi. For cost efficiency Minimised Waste: Effective management of scarce resources reduces waste and inefficiencies, leading to cost savings and improved profitability. vii. To improve bottleneck management Focus on constraints: Identifying scarce resources helps in focusing efforts on managing and alleviating bottlenecks, which can significantly enhance throughput and overall system performance. viii. Risk mitigation Contingency Planning: Understanding resource limitations allows for better risk management and the development of contingency plans to mitigate potential disruptions.

ii. The use of linear programming to determine the optimum use of resources

• Linear programming is applicable when the scare resource is more than one resource.

• Decisions about what mix of product should be manufactured and sold in order to maximise profit or minimise costs are formulated and solved as linear programming problem.

• It allows optimal solution that satisfy several constraints at once.

• It is used in many industries e.g. agriculture where farmers can generate more revenue from their limited land; transportation (for cost and time efficiency) etc.

• It is used to determine the price of a scarce resources.

• It is used to determine shadow prices.

• Linear programming is a technique which determines the most profitable production mix, taking into account resources constraints and limitations. faced by an organisation. All costs are assumed to be a either fixed or variable in a relation to a single measure of activity (usually units of output). The problem is formulated in terms of an objective function and constraints are then graphed. This process highlights all possible output combinations given the resources constraints and limitations and allows for the identification of the output combination which would maximise contribution (the optimal solution). If there are more than two types of output, the graphical approach is not possible and the simplex method must be used instead. 71

Examiner’s report This is a compulsory question which tests candidates’ ability to determine a company’s machine utilisation rate for each machine and also establishes the machine that is the bottleneck and limiting factor. The second part of the question is on conventional marginal and contribution analysis to determine the profit maximising output. The third part is on throughput accounting and throughput maximising quantity while the final is on the importance of identifying scarce resources for optimality in budgeting and linear programming activities. The question being a compulsory question was well attempted. The performance of the candidates was average. The major pitfall inability of most candidates to differentiate between the use of limiting factors in conventional marginal and contribution analysis and the throughput analysis. It is hereby recommended that candidates use ICAN study manual and other Performance Management textbooks in preparing for future Institute’s examination.

Marking guide Section Description Mark Mark Total

a. Machine utilisation Rate (8 ticks @ ½ mark = 4marks) 4 b. Profit maximisation quantity using Marginal and contribution analysis. 12 ticks @ 1/3 mark = 4 marks) 4

c. Importance of throughput accounting. (3 points @ 2marks) = 6marks) 6 d. Profit maximisation quantity using throughput accounting. 15 ticks @ 1/3 mark = 5marks) 5

e. Importance of throughput in inventory (Any two points @ 1 mark = 2marks) Importance of throughput in inventory valuation. (Any two points @ 1½ marks = 3 marks) 2 3 5 72

f. Importance of identifying scarce resources in budgeting (Any 3 points @ 1 mark = 3 marks) Importance of identifying scarce resources on linear programming. (Any 2 points @ 1½ marks= 3 marks) 3 3 6 30

a. A lean information system should provide value to the users of the system. Key principles are the elimination of waste, speed of information flow, and clarity. Elimination of waste – A lean system seeks to eliminate all waste. In an information system, waste is created by errors in the information, which means that incorrect information is used and wrong decisions may be taken. Alternatively the information has to be corrected when the error is identified, and this results in a cost of correction. Correcting errors does not add value, because the error should not have occurred, and correcting errors is a wasted effort. Efficiency in the flow of information – A lean manufacturing system is one in which there is an efficient flow of items though the manufacturing process. In a lean information system, there should be an efficient flow of information. Information should be available to individuals when they need it, and there should not be unnecessary delays in providing it or making it available. While efficiency in the flow of information means that information should be available when it is needed, it should not be provided before it is needed. Information should be available ’just in time’. This is the concept of pulling items through the system rather than pushing them through. If information is provided before individuals are ready to use it, it does not have value. Clarity is also an element of lean information. Information must be clear to the people who use it and should therefore be presented in a form that they can understand and use. If information is presented in a form that is difficult to understand, it will be difficult to use. Unless it is used for its intended purposes, information has no value. Together, the elimination of waste, efficiency of information flow, and clarity of information are qualities of an information system that give value to the information that the system produces.

b. There are several reasons why KK’s current management accounting system does not fulfil the requirements of a lean information system. 73 Errors – There are many errors in the data capture from the cost accounting system. Errors represent waste in the system, by providing incorrect information about costs, or requiring correction when the errors are found. Errors also reduce the confidence of users in the information that the system provides. ’Push’ system – Monthly variance reports are provided but not until two weeks after the end of the month. There are two weaknesses in this reporting system. The first is the delay in making information available if required. The information about performance is being held by accountants and is not made available to the managers who can use it. The second problem is that the information is pushed out to management in the form of monthly variance reports, when it would be more appropriate to make the information available when management want to use if for monitoring and control purposes. The information system is dictating how and when the information should be used, whereas management should be doing this. Not encouraging lean manufacturing – more fundamentally, it can be argued that traditional cost and management accounting methods provide managers with inappropriate information that encourages the wrong sorts of management for an organisation that uses lean manufacturing methods. A key feature of lean manufacturing is the elimination of inventory, because holding inventory is wasteful. Absorption costing, however, encourages manufacturing at full capacity, even if this means manufacturing items that are not yet needed by customers, so that inventory will build up. This is because high volumes of production reduce the unit costs of manufacture by spreading overhead costs over a larger volume of output. Variance reporting of efficiency also encourages greater volumes of output, because greater efficiency means faster production. When the work force is paid a fixed wage or salary, attempts to improve efficiency will result in greater production quantities, and a build-up of inventory. The current reporting systems therefore encourage managers to control operations in a way that is inconsistent with lean manufacturing. Error reduction – To create a lean management accounting system, waste must be eliminated, and information flow improved. The causes of the data errors in data capture are not known. The problem may be the use of manual documentation for recording costs, or errors in input by inadequately trained staff. Methods of recording costs should be investigated, and the target should be to eliminate input errors entirely. Flows of information – The flow of information must be improved, so that up-to- date information is available to management when they want it. The speed of 74 entering data into the accounting system should be reviewed, and the aim should be to minimise the delay between recording data and inputting it into the accounting system. Automated methods of monitoring inventory movement or recording labour times may be considered. User access to information – The accounting system should also allow managers on-line access to information about costs, so that they can obtain and use the information they need at a time that they need it. This should apply to senior management as well as to management at the operational level. Cost allocation – The information provided by the accounting system should be reviewed, and absorption costing should be abandoned. There may be some value in using activity-based management to monitor and control overhead costs, but the most important requirement should be to value inventory at direct materials cost. This means that there will be no incentive to produce at high- capacity volumes or operate at unnecessary levels of efficiency. Favourable capacity and efficiency variances will not affect inventory costs and so will not improve management performance. Performance measures – Different items of information should be provided for performance measurement purposes. Traditional performance measurement methods for materials – price and usage variances – should be used to control materials costs. For labour, however, non-financial measures of performance may be appropriate, such as production cycle times of throughput times and the ratio of idle time to active time for the work force. The company is considering JIT purchasing for its main suppliers: if so, a suitable measure of performance may be the order-to-delivery cycle time for purchase orders. In a lean information system, information should have a practical use and support the aims of management. The management accounting system should be changed so that it provides value – a practical purpose, with no waste, rapid information flow and clarity of meaning.

Examiner’s report The question is on Lean Information System. This question is deduced from a broad management information system. It tests candidates’ knowledge of the principles and importance of adopting a lean management information system. The question was well attempted. The Performance of the candidate was average. The major pitfall observed was the inability of candidates to understand fully the meaning of Lean Information System and the differences between it and what is currently in use by KK. 75 It is recommended that candidates use the ICAN Study Text and other approved text books on Performance Management when preparing for future Institute’s examination.

Marking guide Section Description Marks Total

a. Principles of Lean information system. ( Any 3 points @ 2 marks = 6 marks) 6

b. Why the current system in KK is unable to meet the lean information requirements. (Any 2 points @ 3½ marks = 7 marks) 7

c. What changes are required to adopt the lean information system in KK., (2 points @ 3½ marks = 7 marks) 7 20

a. Redraft budget using flexible budgeting concept S/N Particulars Original Budget Flexible Budget Actuals Variances 72,000 units 75,000 units 75,000 units ₦’000 ₦’000 ₦’000 ₦’000 1 Sales 4464 4650 4650 - Less Direct material 1440 1500 1512 (12) Direct labour 720 750 738 12 Variable overhead: Production 432 450 474 (24) Administration 240 250 246 4 Total variable cost 2832 2950 2970 (20) Contribution 1632 1700 1680 (20) Less Fixed cost: Production 336 336 354 (18) Administration 288 288 300 (12) 624 624 654 (30) Net Profit 1008 1076 1026 (50) 76

Note: Variances in bracket are adverse. Computation of relevant variances: Sales related variances (Sales department): Sales Price variance = (ASP – SSP)AQ=(₦62 - ₦62 )75,000 = nil Sales Quantity variance = (BQ - AQ) SSP = (75000 - 75,000) ₦62 = nil. Direct material Variances (Purchases department): Material Price variances= AQ (AC - SC) = 75,000(₦20.16-N20.00)= ₦12,000 A Material Usage variance = (AQ - SQ) ₦20 = ₦20.00 (75,000 – ₦75,000)=Nil Direct Labour Variances (Personnel departments): Direct Labour rate variance = (AR - SR)x AH = (₦3.47949 - ₦3.50877) 212,100= ₦6210.29 F Direct labour efficiency variance = (AH - SH )SR = (212100 - 213750) ₦3.50877 =₦5789.71F Labour cost variance = ₦6210.29F + ₦5789.71F = ₦12,000F Variance production overhead variance (Production department) Expenditure variance = AH (AR - SR ) = 212,100 {(₦474,000/212100) – (₦450,000/213750)} = 212100 (₦2.23479 - ₦2.10526) = ₦27,473.31A Efficiency variance = SR ( AH - SH) = ₦2.10526 (212100 – 213750) = ₦3,473.31F Variable Production Overhead variance = N24,000 A Other variances: S/N Particulars Actual Costs Flexed costs Variances 1 Variable Administration costs ₦246,000 ₦250,000 ₦4000F 2 Fixed Production Costs ₦354,000 ₦336,000 ₦18,000A 3 Fixed Administration costs ₦300,000 ₦288,000 ₦12,000A

b. State the general behavioural problems associated with budgeting and in particular relate such issues with this situation. Such problems include:

• Use of past record to estimate is not realistic;

• Budget may contain slacks/dummies leading to over-bloated budget estimates;

• Budget may be realistic or unrealistic due to source of data and information;

• They may originate from incorrect or inaccurate records/data;

• It could be seen as a pressure device especially if prepared with sentimental Attachments;

• Personnel resistance, especially, if the budget preparation is top down driven;

• Lack of participation may introduce lack of acceptance to the budget;

• Sub optimisation where departments work for their individual goals not for Company goal;

• Budget slack or budget bias; and

• Fundamental misunderstanding about cost cutting especially where management see budget control as cost cutting. 77

c. Ways of addressing the negativities of behavioural issues in budgeting

• Introduce a realistic budgeting approach such as zero Based Budgetting approach.

• Introduce incentive schemes like bonuses.

• Train and develop management and staff members in the application of budget and budgeting control system and Total Quality Management Techniques.

• Amend the reward system.

• Set up fair unit to resolve disputes emanating from petitions, disputes, resentment and resistances.

• Ensure a change in management culture.

• Put in place a participative/negotiated approach to budgeting

Examiner’s report The question tests candidates’ ability to answer questions on flexible budgeting. The question was well attempted. The Performance was above average. The major pitfall observed was candidates’ inability to decipher the flexible nature of the budget required and interpretation of variances therefrom. It is recommended that candidates use the ICAN Study Text on Performance Management when preparing for future Institute’s examination.

Marking guide Section Description Marks Total

a. Re-drafted flexible budget (24 ticks @ ½ mark = 12marks) 12

b. What are the behaviourial issues in the budgeting system of the company. (Any 4 point @ 1mark = 4 marks) 4 c. Steps Pampam will take to address the anomalies. (Any 4 points @ 1 mark = 4 marks) 4 20 78

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 whereb = n n xy − x2 − x y x 2 anda = n y− 𝑏 n x So b = 5 × 4,442.15 5 × 330 − − (40 40 × × 40 555.1) = 6.75 50 = 0.135 a = 555.1 5 − 0.135 5 × 40 = 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 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 79 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.

Examiner’s report The question tests candidates’ ability to answer questions on forecasting. The question was well attempted since it is a popular statistical question. The Performance was above average. The major pitfall observed was the candidate’s inability to incorporate trend issues that affect different quarters of the year. It is hereby advised that candidates use the ICAN Study Text on Performance Management when preparing for future Institute’s examination. 80

Marking guide Section Description Marks Marks Total

a. Quarterly Sales forecast using 10- period observations. Statistical observation: ( 4 ticks @ 1 mark = 4 marks) Statistical variation: (4 ticks @ ½ mark = 2 marks) 4 2 6

b. Quarterly Sales Forecast using 5 – Period Observations Regression formula computation (4 ticks @ ½ mark = 2 marks) Statistical Observation: (4 ticks @ 1 mark = 4 marks) Statistical variation: ( 4 ticks @ ½ mark = 2 marks) 2 4 2 8

c. Forecasting basis using Coefficient of correlation (4 ticks @ 1½ marks = 6marks) 6 20

a. Zonal Tango (ZT) Plc Transfer price per unit for Alba Division: ₦ 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) 200,000unit Transfer price (a/b)/unit ₦4.95 Therefore the transfer price that Alba division should quote is ₦4.95/unit as computed above. 81

d. b. c. Selling price of Beta Division: ₦ 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) 2830,000 Quantity to sell (D) 200,000unit External selling price (c/d) ₦14.15 Assumptions i. Beta Division gets all inputs internally from Aba. ii. The applicable variable costs for both Alba and Beta are the same. iii. There is no transfer from Beta to Alba. The transfer price to Beta Division will be sub-optimal for the company as a whole because ₦6.80 is sold to other customers and ₦4. 95 is the price charged to the division as required to provide ₦1.85 per unit. The sub-optimal decision making also can be due to the buying division recognising the fixed cost of ₦160,000 and mark-up (Profit –residual income and imputed capital cost) as selling division variable cost of ₦4.95 when it should have been ₦4.90 regarding the transfer price. Circumstances in which a negotiated transfer price should be used instead of market based price Negotiated transfer prices are prices agreed between managers of profit centres. Negotiated transfer prices are used in situations where profit centre managers are given autonomy to agree transfer prices. This is usually in circumstances where an external intermediate market price does not exist. An advantage of this is that if the negotiations are fair and honest, the managers should be willing to trade with each other on the basis of the transfer prices agreed. A negotiated transfer price can be used instead of a market-based price in the following specific circumstances:

i. Absence of a market price: When there is no external market for the product or service being transferred, or the market is not well-established, finding a comparable market price can be difficult or impossible. In such cases, negotiation between the divisions becomes necessary; 82

ii. Custom or unique products: When the product or service being transferred is customised or unique to the company's operations, there may not be a comparable product available in the market. This uniqueness necessitates a negotiated price that reflects the specific characteristics and costs associated with the item;

iii. Internal performance measurement: When a company uses transfer prices for internal performance evaluation and management purposes. A negotiated price can be tailored to better reflect the performance of the divisions involved, aligning with the company's internal performance metrics and incentive structures;

iv. Temporary market conditions: When external market prices are volatile or influenced by temporary conditions that do not reflect the long-term value of the product or service. A negotiated transfer price can provide stability and predictability in such cases;

v. Capacity utilisation: When the supplying division has excess capacity, it may be willing to negotiate a lower transfer price to utilize its resources more effectively. Conversely, if the supplying division is at full capacity, it might negotiate a higher price to reflect opportunity costs; and

vi. Regulatory and tax considerations: When there are tax implications, especially in multinational corporations. Transfer pricing can affect the allocation of income and expenses between different tax jurisdictions. Negotiating transfer prices may help in compliance with international transfer pricing regulations and in minimizing tax liabilities.

Examiner’s report The question tests candidates’ ability to provide solutions on issues relating to divisional transfer pricing and divisional performance appraisal. The question was well attempted. The Performance was above average. The major pitfall observed was the candidates’ inability to reconcile residual income of each division to its generated revenue and net profit. It is advised that candidates use the ICAN Study Text on Performance Management when preparing for future Institute’s examination. 83

Marking guide Section Description Marks Total

a. Transfer price for ALBA (12 ticks @1/4 mark = 3 marks) 3 b. Selling price for Beta (12 ticks @ ¼ mark = 3 marks) 3

c. Sub-optimality in using transfer prices (2 points @ 2½ marks = 5 marks) 5 d. Negotiated transfer price and market based price (Any 2 points @ 2 marks = 4 marks) 4 15

Arguments in favour of using the profit measure in evaluating the performance of a business

1. Profit (however calculated) is a generally accepted measure to evaluate a business both internally and externally. Internal users of financial information identify profit-as the reward for the skills of being a successful entrepreneur. This measure is still a major determinant of the reward systems of managers of decentralised units. If they meet certain quantified performance targets they obtain the financial rewards that recognise their entrepreneurial skills.

2. External users of accounts recognise profit as a measure for identifying the success or failure of the policies of the directors who, as stewards of the assets, are entrusted with the task of increasing the wealth of shareholders. Why do an investor invest? Generally to improve their financial position over time. How do investors improve their financial position over time? Hopefully the stock market's system of intelligence identifies the important factors in the performance of a business and this is reflected in the share price. How do market analysts identify performance? Certainly the measure of 'earnings' is a major determinant in the influential commentaries that can influence investor behaviour.

3. The concept of profit is intuitive. A street trader buys inventory at ₦100 and sells it at the end of the day for ₦500. He makes a gain of ₦400 out of which he replenishes his inventory, pays his living expenses and has a surplus to demonstrate that his wealth has increased after meeting all necessary expenditure. 84

4. 'Profit' is the maximum amount that the company can distribute during the year and still expect to be as well off at the end of the year as at the beginning. Consequently profit-based measures such as return on capital employed and earnings per share recognise this all-encompassing need to measure how wealth (or capital) grows or is maintained.

5. Simplicity and Clarity: Profit is a straightforward and easily understood metric. It provides a clear and unambiguous indicator of financial success, making it accessible for a wide range of stakeholders, including investors, employees, and management.

6. Comprehensive Financial Performance: Profit encapsulates the overall financial health of a business by reflecting revenues, costs, and expenses. It shows the net effect of a company's operations and financial decisions, providing a comprehensive view of its economic performance.

7. Stakeholder Focus: For shareholders and investors, profit is a primary concern as it directly impacts dividends, stock prices, and returns on investment. Focusing on profit aligns with the interests of these key stakeholders and can drive investment and support.

8. Resource Allocation: Profitability indicates how efficiently a company is using its resources. It helps management identify which areas of the business are most productive and which may require improvement or divestment, thus guiding strategic decisions on resource allocation.

9. Incentive Alignment: Profit as a performance measure can be a powerful motivator for management and employees. Profit-linked incentives and bonuses can drive behaviors that enhance overall business performance, encouraging efficiency, innovation, and cost control.

b. Financial perspective

1. Meeting a key financial target such as Economic Value Added is regarded by some as one of the best overall measures of performance.

2. Sales growth. Insurance companies are concerned with market share and would like to see strong sales growth. Customer perspective 1. Customer retention. This is the proportion of customers who renew their policies from one year to the next. If the proportion is high, then it would imply that the insurance company is keeping its customers happy; if low, it would seem that the company is doing something wrong.

2. Number of complaints. This measure could be used for just about any organisation. A high level of complaints would indicate that the company's customers are not pleased with the service that they are receiving. 85 Learning and growth perspective or innovation and learning perspective 1. Labour turnover. Labour measures come within this perspective. A high labour turnover would indicate that the workforce is not happy, which may then lead to problems with their performance. It also means that those workers who leave will have to be replaced and that their replacements will need training, leading to extra cost and possibly initially poor performance.

2. The number of new types of policies issued each year. This would be a good indication of innovation. Internal business process perspective 1. The percentage of policies issued or claims processed with the target time. This is an indication of how well the company performs its core functions. 2. Unit cost. The cost per policy issued, or per claim processed, would be an indication of how well the business is performing its internal functions. Care must be taken that if the cost is reducing so then the service to the customer is not getting worse.

Examiner’s report The question dwells on the importance of profitability measurement vis- a-viz other non-financial measures. It also discusses the importance of the balance scorecard in an insurance company. The question was well attempted. The Performance was above average. The major pitfall observed was the candidates’ inability to mention critical examples of the 4 perspectives. It is advised that candidates use the ICAN Study Text on Performance Management when preparing for future Institute’s examination.

Marking guide Section Description Marks Marks Total

a. Importance of Profit as a performance measure (Any 2 points @ 2½ marks = 5 marks) 5 b. Explanation and examples of 4 Perspectives of Balance scored card: 4 perspectives : (Any 4 points @1½ marks = 6 marks) Explanations: (Any 4 explanations point@ 1 mark = 4 marks) 6 4 10 15 86

a. Optimal Production Plan (Optimum Quantity) for Jumbo tailor Computation of machine utilisation hours: Machine hours required: Products Workings/Calculations Machine 1 Machine 2 Hours Hours Trousers Machine 1 = 2 x 2500 5,000 Machine 2 = 3 x 2500 7,500 Jackets Machine 1 = 4 x 2600 10,400 Machine 2 = 6 x 2600 15,600 Skirts Machine 1= 6 x 4200 25,200 Machine 2= 2 x 4200 8400 Total machine hours required 40600 31500 Total Machine hours available 39200 36000 Deficit /Surplus (1400) 4500 From the above analysis, Machine 1 is the Limiting factor. Quantity Produced and Sold: Trouser = Sales /Selling Price = ₦8,250,000/₦3300 = 2,500 units Jackets = Sales /Selling Price = ₦9,880,000/ ₦3800 = 2,600 units Skirts = Sales / Selling Price = ₦12,390,000 / ₦2950 = 4200 units Contribution analysis and ranking Particulars Trousers Jacket Skirts ₦ ₦ ₦ Selling Price 3300 3800 2950 Variable costs: Direct Material Direct Labour Variable overhead 1000 500 800 2300 900 450 1600 2950 700 350 1000 2050 Contribution per unit 1000 850 900 Machine 1 hours 2 4 6 Contribution / machine 1 hours ₦500 ₦212.50 ₦150 Ranking 1st 2nd 3rd Determination of production plan Trouser = 5000 hours = 2500 units Jacket = 10400 hours = 2600 units Skirts (Balance) = 23800 hours = 23800/6 = 3967 units Total Available 39200 hours 87

b. Total profit from production plan Particulars Trousers Jackets Skirts Total Units Produced /Sales 2500 2600 3967 Unit contribution 1000 850 900 Less Product fixed Cost 250 500 400 Net Profit 750 350 500 Total Gross Profit 1,875,000 910,000 1,983,500 4,768,500 Fixed cost Block A (1,960,000) Fixed cost Block B (1,500,000) Fixed cost Block C (740,000) Total Company fixed cost (4,200,000) Total Profit ₦568,500 Note: where the attribute fixed cost is not regarded as fixed cost and therefore treated as relevant costs. ALTERNATIVELY Calculation of total profit Product Trouser Jacket Skirt Total Contribution /Unit(₦) 1000 850 900 Units Produced 2500 units 2600 units 3,967 units Total contribution (₦) ₦2500000 ₦2,210,000 ₦3,570,300 ₦8,280,300 Fixed costs: Block A ₦1,960,000 Block B ₦1,500,000 Block C ₦ 740,000 ₦4,200,000 Net Profit ₦4,080,300

Note: The attributable product fixed cost is regarded as sunk cost and not relevant in view of the fact that it can be dropped in view of current output plan is different.

Examiner’s report This question is a popular question that tests candidates’ knowledge of determination of company’s machine utilisation rate for each machine and establishing the machine that is the bottleneck and limiting factor in part (a). The part (b) of the question tests conventional marginal and contribution analysis to determine the profit maximising output and finally the computation of the total profit after considering the attributable fixed cost of each product (relevant costs) and the company fixed overheads as deduced from the three blocks housing the machines. The question was well attempted. 88 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIA

a) Kayode Limited Budgeted contribution last month Budgeted Selling price/kg = ₦368 - ₦18 = ₦350 Budgeted VC/kg = ₦19,000/95kg = ₦200 Budgeted contribution/kg ₦150 Budgeted sales quantity = 19,000kg/0.95* = 20,000kg Total budgeted contribution = 20,000 kg × ₦150 = ₦3,000,000 (* Actual sales were 95% of budget) Actual contribution last month ₦000 Actual sales = 19,000 kg × ₦368 = 6,992 Total variable cost = 4,105 Actual contribution 2,887 Materials Price Variance (MPV) Std price Actual Price Actual Qty Variance (₦000) A ₦160 ₦165 9,800 49 (A) B ₦180 ₦175 6,800 34 (F) C ₦280 ₦295 4,400 66 (A) Total MPV 81 (A) Material Mix Variance (MMV) Actual Qty in Std Mix (5:3:2) Actual Qty in actual mix Std Price/Kg ₦ Variance

(a) (b) (c) (a-b) × (c) Kg Kg ₦ ₦000 A 10,500 9,800 160 112 (F) B 6,300 6,800 180 90 (A) C 4,200 4,400 280 56 (A) Total 21,000 21,000 34 (A) Material Yield Variance (MYV) Std material cost per kg of output = ₦19,000/95 kg = ₦200 Actual Yield = 19,000kg of output Std Yield = 21,000 kg × 95/100 = 19,950kg of output MYV = (Actual Yield – Std Yield) × Std RM Cost/kg of output = (19,000 – 19,950) × ₦200 = ₦190,000 (A) 76 OR: Alternative Calculation of MYV Standard quantity in standard mix: A 19,000 × 50/95 = 10,000 kg B 19,000 × 30/95 = 6,000 kg C 19,000 × 20/95 = 4,000 kg 20,000 kg Std Q Ty In Std mix Actual Qty in Std mix Yield Variance

(a) (b) (c) (d) = (a-b) × (c) Kg Kg ₦ ₦190,000 (A) A 10,000 10,500 160 80 (A) B 6,000 6,300 180 54 (A) C 4,000 4,200 280 56 (A) Total 20,000 21,000 190 (A) Sales Price Variance (SPV) Actual Price – Budgeted Price x Actual Qty = (₦368 – 350)(19,000) = ₦342,000 (F) Market Size Variance (MZV) MZV = Budgeted contribution per unit = %)25( ⎛ │⎝000,19 %30- 000,20 %25⎞ │⎠Market Share Variance (MSV) MSV = Budgeted market share % × Actual Budgeted industry sales − industry sales in units in units × X (₦150) = 625,000 (A) Actual 𝐴𝑐𝑡𝑢𝑎𝑙 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 Budgeted Industry sales × ð‘šð‘Žð‘Ÿð‘˜ð‘’ð‘¡ − 𝑚𝑎𝑟𝑘𝑒𝑡 × contribution in units 𝑠ℎ𝑎𝑟𝑒 % 𝑠ℎ𝑎𝑟𝑒% per unit In units = 000,19 %30× %)25%30( - X ₦150 = 475,000 (F) 77 Std Price per kg Reconciliation of contribution ₦’000 ₦’000 Budgeted Contribution 3,000 Material Price Variance 81(A) Material Mix Variance 34(A) Material Yield Variance 190(A) Material Usage Variance 224 (A) Sales Price Variance 342 (F) Market Size Variance 625 (A) Market Share Variance 475 (F) Sales Volume Variance 150 (A) Actual Contribution 2,887

b) The strategy seems to have centred around trying to achieve an increased share of a declining market. The evidence for this is that market share increased significantly (from budgeted 25% to actual 30%). This helped somewhat to offset the fact that the total market shrank very significantly in by 20.83% (from 80,000 units budgeted to 63,333 units actual). How was this achieved? It seems likely that the quality of the product was deliberately improved. All of the variances in relation to raw materials are unfavourable. KL may have purchased more expensive versions of the raw materials (MPV ₦81,000 (A)), combined them in ways which made use of the more expensive types B and C (MMV ₦34,000 (A)), and been more stringent in the removal of wastage in production (MYV ₦190,000 (A)). Was this financially successful? In short, yes. The combined cost of the 3 raw materials referred to above is ₦305,000. But the benefits (in terms of an increased market share and a higher selling price) were ₦342,000 (F) + ₦475,000 (F) = ₦817,000 (F). So it could be said that there was a net gain from the strategy of (₦817,000 – ₦305,000 = ₦512,000). Why then was the actual total contribution for the month below budget? Only because of the market size variance (₦625,000 (A)) which was uncontrollable by the company. If the company had not adopted the strategy that it did, then the decrease in contribution experienced would have been far worse than it actually was. 78

Examiner’s report This is a compulsory question that tests candidates’ knowledge of how to handle advanced variance analysis and reconciliation of budgeted contribution with actual contribution. The question also tests with the analysis of Product life cycle as it relates to variance accounting. Being a compulsory question, it was attempted by most candidates. The candidates recorded average performance. The pitfall is that most candidates failed to compute material mix and material yield variances. Candidates are encouraged to study the Institute’s Study Text when preparing for future examination.

Marking guide Marks Marks Marks 1a. Budgeted Contribution Actual Contribution Reconciliation of Budgeted and Actual Contribution 22 b. Evaluation of the Product life cycle in variance analysis. 8 30

SECTION B

a.i. Labour hourly rate = N13,328,000 5,400,000 = N2.468 per labour hour a.ii Overhead attributable to each of the Product AlphamBetam Blanket rate N2.468 N2.468 Labour Hours 20 25 Overhead cost per unit N49.36 N61.70 79 b.i. Computation of cost driver absorption rate S/n Activity Cost Allocated (N) Cost driver rate (N)

1. Set up cost 2,928,000 No. of set up 72,120 40.599 2. Special handling cost Cost Driver 6,000,000 0.40

3. Customer invoicing costs 2,400,000 No. of special parts 1,160,000 No. of invoices 2900 400

4. Material handling cost 2,520,000 No. of batches 2412 1044.77

5. Other overheads 4,300,000 Labour hours 5,400,000 0.80 6. 13,328,000 Computation of total activity Product No. of setup No of spare parts Labour hours Alpham 120 1,200,000 500 12 2,400,000 Betam 72000 4,800,000 2400 2400 3,000,000 Total 72120 6,000,000 2900 2412 5,400,000 b.ii. Determination of total and unit overhead allocation to the Product: S/n Particulars Alpham Betam N N 1. Set up cost 120 x N40.599 7200 x N40.599 No. of No. of invoice Batches 4,872.00 2,923,128.00

2. Special Part handling costs: 1,200,000 x N0.40 4,800,000 x N0.40 480,000.00 1,920,000.00

3. Customer invoicing costs: 500 x N400 2400 x N400 . 200,000.00 960,000.00

4. Material handling costs: 12 x N1044.77 2400 x N1044.77 12,537.00 2,507,463.00

5. Other overhead: 2,400,000 x N0.80 3,000,000 x N0.80 1,920,000.00 2,400,000.00 Total Overhead 2,617,409.00 10,710,591.00 Units Produced 120,000.00 120,000.00 80 Total Activity(N) Unit overhead cost 21.81 89.255.00

c. Selling Price for each Product using Traditional Method Cost Particulars Alpham(N) Betam(N) Material cost 400.00 500.00 Labour cost 100.00 125.00 Overhead cost 49.36 61.70 Total costs 549.36 686.70 Profit 137.34 171.68 Selling Prices 686.70 858.38 d. Selling Prices for each product using ABC Method Cost Particulars Alpham(N) Betam (N) Material cost 400.00 500.00 Labour cost 100.00 125.00 Overhead cost 21.81 89.26 Total costs 521.81 714.26 Profit 130.45 178.57 Selling Prices 652.26 892.83

Examiner’s report This question tests candidates understanding of using ABC approach for overhead estimation. The candidates recorded an average performance. The pitfall noticed was the candidates’ failure to determine the cost driver rate of the activities. Candidates are advised to study the Institute’s Study Text when preparing for future examination.

Marking guide Marks Marks Marks 2a.i. Direct Labour hourly rate 1

ii. Unit overhead rate 2 3 bi. Cost driver rate 9 ii. Unit overhead rate using ABC approach 3 12 c. Computation of unit selling price 5 20 81

a. Calculate the Sales Price, Sales volume Profit, Sales mix profit and Sales quantity profit variances

(i) Sales price variance = AS - SS = AQS (ASP - SSP) For F = (220 - 200 ) 9,500 = N190,000 (F) For R = (260 - 250 ) 13,500 = N135,000 (F) For E = (320 - 300) 8,500 = N170,000 (F) Total sales price variance = N495,000 (F)

(ii) Sales volume variance: = (AQS in Standard Proportion - BQ) SSP F = (9,843.75 - 10,000) 200 = 31,250A R = (12,796.875 – 13,000) 250 = N50,781.25 (A) E = (8,859.375 - 9,000) 300 = N42,187.50 (A) Total N124,218.75 (A)

(iii) Sales mix variance: = (AQS - AQS in Standard Proportion) SSP Product Standard Proportion Actual Quantity Sales in Std Proportion F 10,000 = 0.3125 9,843.750 R 13,000 = 0.40625 12,796.875 E 9,000 = 0.28125 8,859.375 Total 32,000 31,500.000 F = (9,500 - 9,843.75) 200 = N68,750 (A) R = (13,500 - 12,796.875) 250 = N175,781.25 (F) E = (8,500 - 8,859.375) 300 = N107,812.50 (A) Product Sales mix variance Sales volume variance Sales Quantity variance F 68,750.00 (A) 31,250.00 (A) 100,000.00 (A) R 175,781.25 (F) 50,781.25 (A) 125,000.00 (F) E 107,812.50 (A) 42,187.50 (A) 150,000.00 (A) Total 781.25 (A) 124,218.75 (A) 125,000.00 (A) Standard Profit per unit Product F R E Direct Material 75 90 114 Direct labour 12 15 18 Variable overhead 6 7.50 9.0 Total variable cost 93 112.5 141 Fixed cost 6 12 16 Profit 101 125.5 143 Standard selling price 200 250 300 82

b. Monthly Budgeted Profit Budgeted Sales N F = 10,000 x 200 = 2,000,000 R = 13,000 x 250 = 3,250,000 E = 9,000 x 300 = 2,700,000 7,950,000 Budgeted/Standard Costs Variable Cost Material Unit Cost Labour Volt Total variable cost N F 75 12 6 = 93 x 10,000 = 930,000 R 90 15 7.5 = 112.5 x 13,000 = 1,462,500 E 114 18 9 = 141 x 9,000 = 1,269,200 3,661,500 4,288,500 Fixed Cost (4320000/12) 360,000 Budgeted Profit 3,928,500

c. Significance of Sales Mix Variance The sales mix is a calculation of the mix or proportion of each product or services sold in relation to the total sales volume and profitability. Sales mix variance is significant because:

(i) It affects profitability; (ii) It can be used in performance evaluation; and (iii) It is used for decision-making.

Examiner’s report The question tests candidates’ understanding of advanced variance analysis - Sales Price variance, Sales mix variances, Sales volume variances and sales quantity prices. It also tests candidates’ ability to determine budgeted contribution as well as the explanation of the implication of sales mix in variance accounting. The attempt on this question by candidates was very moderate. The candidates recorded average performance. The Pitfalls noticed were: The candidates’ inability to compute the standard mix /proportions on actual sales; and Deduction of annual fixed overhead when what was required is monthly fixed overhead. Candidates are advised to use the Institute’s Study Text intensively when preparing for future examination. 83

Marking guide Marks Marks Marks 3a.i. Sales price variance 2 ii. Sales volume variance 2 iii. Sales mix variance 3 iv. Sales quantity variance 3 10 b. Determination of monthly budgeted profit 6 c. Significance of sales mix variances in variance 4 20

Suggested Solutions on Relevant Costing principles:

(a) Revised Cost Estimate N Direct material Deluxe 30,000 Unique 80,000 Skilled 51,750 Direct labour Unskilled - Variable o/h 38,500 Printing press 300,000 Fixed production costs - Estimating costs - Public relation cost 10,000 510,250 Reasons for Resource valuation 1 Direct material – duluxe Current stock value of N50,000 is irrelevant as it is a sunk cost. As there is no other use for this material replacement is irrelevant. The scrap value of N30,000 is an opportunity cost and relevant. 2 Direct material – unique As paint unique is not in stock the purchase price is relevant. The entire N80,000 is chargeable though only 70% of the material will be used, as there is no foreseeable use of the remainder. 3 Direct labour – skilled As this is in short supply all labour costs are relevant. 150 hours @ N150 per hour = N22,500 150 hours @ N195 per hour = N29,250 N51,750 84 4 Direct labour - unskilled The weekend work results in 75 hours’ time off in lieu, this with the 120 (150 – 30) other hours worked totals 125 hours which is less than the 300 hours of idle time which are already being paid for, thus there is no incremental cost.

5. Variable overhead This is a future cost which will be incurred if the work is undertaken and therefore is relevant.

6. Painting Equipment The depreciation is a sunk cost and should be ignored. However, the use of the painting machine has an opportunity cost. If this work is undertaken, the machine is not available for hire. The opportunity cost is the contribution which would be earned from hiring: (300 hours x N1,000) = N300,000

7. Fixed production cost: As these costs are unaffected by the decision, they should be ignored.

8. Estimating Department cost – these costs are past and sunk

9. Public Relation costs – relevant

(b) Other non-monetary factors that should be taken into consideration are:

• Is there sufficient capacity to undertake the project?

• Is the customer credit worthy?

• Has the company the necessary skills and quality to execute the contract?

• Is the contract likely to lead to future contracts?

• Is these other lucrative contract for the company in future?

• Will project publicity translate to positive contribution to the company?

• Does the company have required expertise?

Examiner’s report This is a popular question which tests computation of revised cost estimate using relevant costing approach. The attempt by candidates was more than average. Performance on this questing remains average. The pitfall noticed was the inability of candidates to decipher relevant cost items that should be computed and added to the cost estimate. Candidates are advised to study the Institute’s Study Text when preparing for future examination. 85

Marking guide Marks Marks Marks 4 a. Preparation of revised cost estimate 15

b. Identify 4 non-monetary factors in accepting the Art Gallery contract 5 20

(a) The analyst has adopted the principles of economic value added (EVA). EVA is an estimate of a firm’s economic profit, or the value created in excess of the required return of the company. The idea is that value is created when the return on the firm’s economic capital employed exceeds the cost of that capital. This amount can be determined by making adjustments to GAAP accounting as presented by the analyst. Adjustments are made to the reported financial accounting profit and also to the statement of financial position, as follows:

i) Some of the revenue expenditure, such as research and development and advertising, provide future benefits over several years but financial accounting requirements often require such expenditure to be written off in the year in which they are incurred. This understates the value added during a particular period;

ii) The profits computed to meet financial accounting requirements do not take into account the cost of equity finance provided by the shareholders. The only cost of capital that is taken into account is interest on borrowed funds (i.e. the cost of debt finance). Profits should reflect the cost of both debt and equity finance; and

iii) A better measure of the managers’ ability to create value is to adjust the traditional financial statements for those expenses that are likely to provide benefits in future periods. The economic value added measure attempts to meet this requirement.

(b) The following comments relate to the treatment of specific adjustments: Research and development The expenditure of ₦2.1 million is added back because it represents an investment that will yield future benefits. Therefore, it should be capitalised and allocated to the future periods based on the benefits received in the particular period. The expenditure of ₦17.4 million is added back based on the assumption that the company is continuing to benefit from such expenditures that have previously been written off as depreciation based on the value that has been eroded during the period. 86 Advertising Advertising expenditure adds value by supporting future sales arising from increasing customer awareness and brand loyalty. Based on the same justification as research and development expenditure, advertising should be capitalised for the EVA calculation and added back to profits. The ₦10.5m added back in the statement of financial position reflects the costs incurred in building up future income. Some of this cost should be depreciated based on the value of future benefits eroded during the period. Interest and borrowings The aim is to ascertain whether value is being added for the shareholders in the sense of whether the funds invested in the business generate a return in excess of the opportunity cost of capital. To do this, a profit figure is calculated that initially does not include any charges for the cost of capital. Interest on borrowings is therefore added back to avoid the situation where the cost of capital on debt finance is included in the traditional profit calculation whereas the cost of equity capital is not. To ascertain the total source of funds invested in the business borrowings are added back to the capital base in the balance sheet. The required return (i.e. the opportunity cost of capital) of ₦17.5m on the resulting capital base is calculated and compared with the adjusted profit of ₦16.1m generated from the funds. This comparison captures the cost of both debt and equity and indicates that value added is a negative figure. Goodwill Goodwill refers to price paid for the business in excess of the current cost of net assets. Goodwill payments should therefore add value to the company. Hence the amount written off is added back to profits since it represents part of the intangible assets value of the business. The cumulative write off of ₦40.7m is added back in order to provide a more realistic value of the capital base from which a return should be generated. This is because it represents an element of the value of the business. The value of goodwill should be regularly reviewed and the amount eroded written off against profits.

Examiner’s report The question tests candidates’ understanding of economic value added (EVA) principle. The question was averagely attempted by candidates as it was not a popular question. The candidates recorded low performance. The pitfall noticed was candidates’ lack of understanding of the principles of EVA approach to performance measurement. Candidates are advised to study the Institute’s Study Text when preparing for future examination. 87

Marking guide Marks Marks Marks 5 a. Explanation of the Economic value Added principle (EVA) 5 b. Comment on the treatment of specific adjustments like R&D, Advertising, Interest, Borrowings and Goodwill 10 15

(i) Growth Stage Compared to the introduction stage likely changes are as follows: Unit selling prices These are likely to be reducing for a number of reasons:

• The product will become less unique as competitors use reverse engineering to introduce their versions of the product;

• PT may wish to discourage competitors from entering the market by lowering the price and hereby lowering the unit profitability; and

• The price needs to be lowered so that the product becomes attractive to customers in different market segments thus increasing demand to achieve growth in sales volume. Unit production costs These are likely to reduce for a number of reasons:

• Direct materials are being bought in larger quantities and therefore PT may be able to negotiate better prices from its suppliers thus causing unit material costs to reduce;

• Direct labour costs may be reducing if the product is labour intensive due to the effects of the learning and experience curves; and

• Fixed production costs are being shared by a greater number of units. 90

(ii) Maturity Stage Compared to the growth stage the likely changes are as follows: Unit selling prices These are unlikely to be reducing any longer as the product has become established in the market place. This is a time for consolidation and while there may be occasional offers to tempt customers to buy the product the selling price is likely to be fairly constant during this period. Unit production cost Direct material costs are likely to be fairly constant in this stage. They may even increase as the quantities required diminish compared to those required in the growth stage, with the consequential loss of negotiating power. Direct labour costs are unlikely to be reducing any longer as the effect of the learning and experience curves has ended. Indeed the workers may have started working on the next product so that their attention towards this product has diminished with the result that direct labour costs may increase. Overhead costs are likely to be similar to those of the end of the growth stage as optimum batch sizes have been established and are more likely to be used in this maturity stage of the product life cycle where demand is more easily predicted.

Examiner’s report The question tests candidates’ understanding of likely changes that will occur in unit selling price and unit cost of production in product life cycle situation especially during growth and maturity stages. Many candidates attempted the question, but performance was poor. The pitfalls noticed were: Candidates’ failure to read the questions to decipher the requirements; and Candidates’ failure to limit their discussion to the growth and maturity stages made them miss the points. Candidates are advised to pay special attention to the requirements of questions before attempting them. They should also use the Institute’s Study Text when preparing for future examination.

Marking guide Marks Marks Marks 7.i. Explain the changes in unit selling prices and unit production costs on growth stage of a product life cycle. 9 ii. Explain the changes in unit selling prices and unit production costs on maturity stage of a product life cycle. 6 15 91 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIA