THE UNIVERSITY OF MANCHESTER MANCHESTER BUSINESS SCHOOL WORLDWIDE DEGREE EXAMINATIONS November 2010 MASTER OF BUSINESS ADMINISTRATION COURSE

Accounting (Financial and Management) TIME ALLOWED: 3 HOURS plus 10 Minutes Reading Time* NOTE TO INVIGILATORS THIS IS A CLOSED BOOK EXAMINATION *During the 10 minute reading time you may write on this paper but not on the answer book. Instructions to students 1. Sections A and B are on financial accounting, and Sections C and D are on management accounting. Answer ONE question from each section. Please note section A contains one COMPULSORY question. Each question is worth equal marks. For questions with several parts, the weights appear at the end of each part. Marks will be deducted for answers of an illegible nature. Do not staple any foreign materials into the answer books. Please ensure that you write your 4 digit exam I.D number and paper reference number on the front of your answer book. Failure to do so may result in nonmarking of your script. Ensure that your answer is well structured. State and defend any assumptions clearly. The examiner is looking for a robustly defended answer. You may use electronic calculators, provided they do not store text. In answering these questions, write down any formulae you use, show all your calculations and explain your answers, including any assumptions you make.

2. 3. 4.

5. 6. 7.

SECTION A Question A1 is COMPULSORY Question A1 Below are extracts from the financial statements of a listed company which operates a chain of bakery and sandwich retail outlets in the United Kingdom.

Income statements 2009 000 Revenue Cost of sales Gross profit Distribution costs Administrative expenses Other income Operating profit Interest receivable and similar income Profit before taxation Taxation Profit for the year 658,186 (252,284) 405,902 (321,686) (35,783) 48,433 346 48,779 (14,405) 34,374 2008 000 628,198 (241,939) 386,259 (309,735) (35,944) 8,033 48,613 857 49,470 (15,375) 34,095

Balance sheets 2009 000 Non-current assets Intangible assets Property, plant and equipment Current assets Inventories Trade and other receivables Cash and cash equivalents Current liabilities Trade and other payables Current tax liabilities Provisions for liabilities and charges Net current liabilities Non-current liabilities Other payables Provisions for liabilities and charges (30,460) (3,296) (26,108) (2,428) (71,738) (8,857) (857) (13,741) (62,761) (8,337) (2,843) (34,658) 11,886 21,206 34,619 12,152 22,698 4,433 579 211,155 686 210,455 2008 000

Net assets Capital and reserves Share capital Share premium account Other reserves Retained earnings Total equity

164,237 2,080 13,533 359 148,265 164,237

147,947 2,080 13,533 359 131,975 147,947

Cash flow statements

2009 000 Cash flows from operating activities Cash generated from operations Tax paid Net cash generated from operating activities Cash flows from investing activities Purchase of property, plant and equipment Purchase of intangible assets Proceeds from sale of property, plant and equipment Interest received Net cash used in investing activities Cash flows from financing activities Sale of own shares Shares purchased and cancelled Dividends paid Other financing cash flows Net cash used in financing activities Net increase/(decrease) in cash and cash equivalents 1,182 (15,339) 1,087 (13,070) 32,561 (30,296) 2,368 346 (27,582) 87,944 (14,731) 73,213

2008 000 59,163 (14,807) 44,356 (40,758) (686) 2,200 857 (38,387) 698 (9,738) (14,535) 8,083 (15,492) (9,523)

Notes: The market value of the companys shares at the year end was 4.37 (2008: 3.50). Share capital consists of 104 million shares with a nominal value of 2p per share.

Requirements: a) Prepare a report describing how the liquidity of the company has changed between 2008 and 2009. Comment on why these changes may have occurred. What possible changes in the businesss activities and /or efficiency may have had an effect on the changes in liquidity? You should use appropriate ratios in your analysis. (10 marks)

b)

Imagine you are a prospective investor in this companys shares. Calculate 3 investor ratios for 2009 and 2008 which would help you to decide whether to invest, and briefly explain the meaning of each one. (10 marks)

c)

Explain why financial statements include an accounting policies note. Give examples of how users of financial statements would find such a note useful, illustrating your answer with respect to the financial statements in this question. (5 marks) Total: 25 marks

Requirement: a) Prepare a report describing how the liquidity of the company has changed between 2008 and 2009. Comment on why these changes may have occurred. What possible changes in the businesss activities and /or efficiency may have had an effect on the changes in liquidity? You should use appropriate ratios in your analysis. (10 marks) Students should calculate appropriate ratios and draw on aspects of liquidity from both the balance sheet and the cash flow statement Appropriate ratios would include current ratio quick ratio Students may link this to working capital management such as: debtor days creditor days stock days Students may also include some cash ratios such as: cash from operations to current liabilities

The ratio calculations and workings are shown on the next page of the solutions. Students should discuss changes in the ratios and relate them to each other. Students should also discuss the absolute numbers such as the cash balance and change in cash balance, whether there have been cash inflows or outflows from operations, investing and financing. Students should comment on the implications of these cash inflows or outflows and relate them to other aspects of the financial statements where appropriate. Suggested points: Improvement in liquidity from 2008 to 2009 as evidenced by the large increase in cash generated from operating activities and improvement in current and quick ratios (driven in part by increase in cash) Receivables days and inventory days pretty consistent (suggesting tight control given the increase in revenue from 2008 to 2009) but payables days have lengthened by 9 days - if there has been a deliberate policy to pay suppliers later this may backfire if it damages supplier relationships, but is a cheap source of short-term financing, especially as the company has no borrowings/overdraft so there are limited other sources of finance for them in the short term

Ratio Current ratio current assets/current liabilities Quick ratio current assets excl inventory/current liabilities Receivables days receivables/revenue x 365 Payables days payables/cost of sales x 365 Inventory days 11,886 / 252,284 x 365 inventory/cost of sales x 365 Inventory turnover 252,284 / 11,886 cost of sales / inventory x 365 Asset turnover revenue/equity + oncurrent liabilities Cash generated from operations to current liabilities cash generated from operations/current liabilities 658186 / (164237+30460+3296) (21,206+34,619) (71,738+8,857+857) (11,886+21,206+34,619 ) (71,738+8,857+857)

2009 0.83:1 (12,152+22,698+443 3) (62,761+8,337+2,843 ) (22698+4433) (62761+8337+2843)

2008 0.53:1

0.69:1

0.37:1

21,206 x 365 658,186 71,738 252,284 x 365

12 days

22,698 x 365 628,198 62761 x 365 241939 12,152 / 241,939 x 365 241,939 / 12,152

13 days

104 days

95 days

17 days

18 days

21 times

20 times 3.6 times

3.3 times

628198 / (147947+26108+242 8) 59163 / (62761+8337+2843)

87944 / (71738+8857+857)

1.1 times

0.8 times

b)

Imagine you are a prospective investor in this companys shares. Calculate 3 investor ratios for 2009 and 2008 which would help you to decide whether to invest, and briefly explain the meaning of each one. (10 marks)

Ratio EPS P/E Dividend per share Dividend cover Dividend yield Cash generated from operations per share Return on equity

2009 34,374 / 104,000 437 / 33.1 15,339 / 104,000 34,374 / 15,339 14.7 / 437 87,944 / 104,000 34,374 / 164,237 33.1p 13.2 times 14.7p 2.24 times 3.40% 84.6p 20.90%

2008 34,095 / 104,000 350 / 32.8 14,535 / 104,000 34,095 / 14,535 13.9 / 350 59,163 / 104,000 34,095 / 147,947 32.8p 10.7 times 13.9p 2.35 times 4.00% 56.9p 23.00%

c)

Explain why financial statements include an accounting policies note. Give examples of how users of financial statements would find such a note useful, illustrating your answer with respect to the financial statements in this question. (5 marks)

Students should identify that businesses have choices available to them when preparing accounts in which accounting policies they select. The accounting policies note details which choices have been made. The choices affect the figures in the balance sheet and income statement so it is important that users are told what choices have been made. Suggestions may include: Inventory valuation policy this is a significant balance and the valuation method is likely to have a material effect on position and performance. The stock has a short shelf-life so policies about write-down or write-off of inventory would also be important for this business Classification of revenue vs other income what did the 8m other income relate to in prior year? Accounting policies relating to PPE largest figure on the balance sheet. It doesnt appear that they revalue their properties (no revaluation reserve) but depreciation methods, useful lives, impairment would all be significant issues (large property estate of stores), also do they lease any properties and how do they go about classifying the leases as finance or operating leases, as this will affect their liabilities and the nature and size of expenses in the income statement. Basis for estimation of provision liabilities and how they are split between current and non-current

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Section B Answer one question in Section B Question B2 The income statements for the years to 30 September 2010 and 2009 and the balance sheets as at 30 September 2010 and 2009 of Rugby Ltd are detailed below:

Sales Cost of sales Gross profit Expenses Operating profit Net interest expense Profit before tax Corporation tax Profit after tax Retained profit

2010 000 1,850 -1,125 725 -375 350 -30 320 -110 210 210

2009 000 1,295 -750 545 -265 280 -25 255 -75 180 180

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2010 000 Property, Plant and Equipment Cost Depreciation Current Assets Inventory Trade Receivables Cash Current liabilities Trade payables Bank Overdraft Taxation Net current assets Total assets less current liabilities Long term loan Net assets Capital and Reserves 1 ordinary shares Retained profit 1,575 -395

000

2009 000 1,325 -340

000

1,180 85 95 50 230 83 15 12 110 120 1,300 -375 925 75 50 15 140 80 20 10 110

985

30 1,015 -300 715

265 660 925

265 450 715

Notes: The interest expense is shown net of receipts. In the year to 30 September 2010, the interest received in cash amounted to 10,000 and is equal to the interest income for the year. There was no outstanding interest due at 30 September 2010 or 30 September 2009. During the year to 30 September 2010, a piece of equipment was sold for 15,000. The item had an original cost of 40,000 and Rugby Ltd made a loss on disposal of 11,000.

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Required: a) Prepare a cash flow statement for the year to 30 September 2010 ensuring that the structure of your statement is in accordance with IAS7 (17 marks) 000 378 -40 -108 230 000

Cash flow from operating activities Interest paid Income tax paid Net cash from / (used in) operating activities Interest received Purchase of PPE Proceeds from sale of PPE Net cash from / (used in) investing activities Proceeds from issue of long term loan Net cash from / (used in) financing activities Net decrease in cash and cash equivalents Cash and cash equivalents at the beginning of the period* Cash and cash equivalents at the end of the period*

10 -290 15 -265

75 75

40

-5 35

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Net profit before tax Add: interest expense Operating profit before working capital changes Add: depreciation Less: inc in receivables Less: inc in inventory Less: dec in payables Add: loss on disposal Cash from operations

000 320 30

000

350

69 -45 -10 3 -52 11 378

Opening depreciation Disposals Depreciation charge* Closing depreciation

340 -14 69 395

b) Discuss the idea that cash flow statements are more useful to users of financial statements than income statements and balance sheets because they are more objective and therefore more difficult to manipulate. (8 marks) Points may include the following: o Profit based on accruals concept o Includes accounting choice, judgement and subjectivity o Usefulness of cash flow statement given how important cash is to a business o Cash flow only reports cash in and out which is objective o Breaks down cash flows into different activities so can see sources and uses of cash o Doesnt show all round picture o All used in conjunction together to give full picture of business performance and position Total 25 marks

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Question B3 On 1 March 2010, Murphy plc entered into an agreement to lease a piece of machinery for 4 years. The machine would have cost 104,605 to purchase and has an expected useful life of approximately 4 years. Murphy plc will pay 4 annual instalments of 33,000; the first payment is to be made on 28 February 2011. The interest rate implicit in the agreement is 10%. Required: a) State whether you would consider the above lease agreement to be a finance lease or an operating lease. Give reasons for your answer. (4 marks) b) Assume the lease is a finance lease; calculate the interest expense and the depreciation expense for each of the 4 years of the lease agreement. Assume that depreciation is charged on a straight line basis. (6 marks) c) Assume the lease is a finance lease; calculate the amounts that would be shown in the balance sheet at the end of each year of the agreement. (6 marks) d) In March 2009, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) issued a joint discussion paper proposing possible changes to the current accounting treatment for leases. The boards propose that lease accounting should be based on the principle that all leases give rise to liabilities for future rental payments and assets that should be recognised in an entitys statement of financial position. Bob Herz, the chairman of the Financial Accounting Standards Board in the US commented that The proposals are intended to improve the transparency, credibility and usefulness of lease accounting. Explain whether or not you think that these proposals will improve the transparency, credibility and usefulness of lease accounting and whether or not you agree that these proposals would better reflect the rights and obligations arising from leasing contracts on the balance sheets of lessees. (9 marks) Total 25 marks

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Murphy plc: answer (a) State whether you would consider the above lease agreement to be a finance lease (b) or an operating lease. Give reasons for your answer. (4 marks) This is a finance lease. Reasons: the present value of minimum lease payments amounts to substantially the fair value of the asset the lease term is for the majority of the life of the assets substantially all of the risks and rewards of ownership have been transferred to the lessee

(c) Assume the lease is a finance lease; calculate the interest expense and the depreciation expense for each of the 4 years of the lease agreement. Assume that depreciation is charged on a straight line basis. (6 marks) b/f interest payment c/f 104,605 10,461 33,000 82,066 82,066 8,207 33,000 57,273 57,273 5,727 33,000 30,000 30,000 3,000 33,000 0 Depreciation 26,15 104,605 1 26,15 78,454 1 26,15 52,303 1 26,15 26,152 1 nbv 78,454 52,303 26,152 1

(d) Assume the lease is a finance lease; calculate the amounts that would be shown in the balance sheet at the end of each year of the agreement. (6 marks) Liability interes b/f t payment c/f 104,605 10,461 33,000 82,066 82,066 8,207 33,000 57,273 57,273 5,727 33,000 30,000 30,000 3,000 33,000 0

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Depreciation 26,15 104,605 1 26,15 78,454 1 26,15 52,303 1 26,15 26,152 1

nbv 78,454 52,303 26,152 1

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(e) In March 2009, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) issued a joint discussion paper proposing possible changes to the current accounting treatment for leases. The boards propose that lease accounting should be based on the principle that all leases give rise to liabilities for future rental payments and assets that should be recognised in an entitys statement of financial position. Bob Herz, the chairman of the Financial Accounting Standards Board in the US commented that The proposals are intended to improve the transparency, credibility and usefulness of lease accounting. Explain whether or not you think that these proposals will improve the transparency, credibility and usefulness of lease accounting and whether or not you agree that these proposals would better reflect the rights and obligations arising from leasing contracts on the balance sheets of lessees. (9 marks) Points may include the following: Leased assets will have to be brought on the balance sheet as both an asset and the corresponding liability The liability will increase the gearing ratio of these companies as well as the interest cover This may make the businesses look more risky previously this financing would not have been found on the balance sheet. If both types of leases are treated in the same manner, it will stop management being incentivised to structure lease schemes in such a way that enables them to keep the long term obligations off the balance sheet this should bring more information to the users on the face of the balance sheet, giving it equal importance to that of finance leases. This may make it more useful to users. Including these obligations on the balance sheet rather than the notes may also make them more prominent and therefore more transparent for users.

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Section C Answer one question in Section C Question C4 Explain the costing system that Wilkerson (the case study that you studied) currently use, and evaluate how far it is adequate to support management decisions. Suggest an alternative costing system that you consider might generate more decision-relevant information, and assess which system is likely to be most appropriate for Wilkersons business. Total 25 marks Question C5 Explain why the management of Borealis (the case study that you studied) were dissatisfied with their budgeting system. Explain the alternative approach to planning and control that they introduced in its place, and evaluate the results that this new approach produced. Total 25 marks

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Section D Answer one question in Section D Question D6 Trimake makes three main product-lines, using broadly the same production methods and equipment for each. At present they use a conventional full absorption costing system, and have selected machine hours as the basis on which all production overhead costs are to be absorbed into products1. Details of the products for a typical month are:Hours per unit of output (i.e. per product) Labour hours Machine hours Materials per unit Volumes Units of output produced 750 1,250 7,000

Product:X Y Z

1 1

1 1 3

20 12 25

Direct labour costs 6 per hour. Total production overheads are 654,500 per month, and in a typical month 23,375 machine hours are operated, split between the three product-lines:Machine hours per product Product:X Y Z 1 1 3 Volumes Total machine hours required per product-line 1,125 1,250 21,000 -------23,375 ======

750 1,250 7,000

The absorption rate is therefore 654,500 / 23,375 machine-hours = 28 per machinehour (a) you are required to calculate the cost per unit for each product using conventional methods (4 marks)
1

i.e. they are using a single blanket overhead rate, or plant-wide rate, rather than a specific rate for each of the separate cost centres (i.e. departments) which are involved in the production process.

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Trimake Ltd. Question, page 2 of 2 The company carries out an activity analysis and determines that there are four main broad types of activity which are responsible for requiring the consumption of the resources which are represented by the total of 654,500, divided as follows:Costs relating to set-ups Costs relating to machinery Costs relating to materials handling Costs relating to inspection Total production overhead % 35 20 15 30 ---100% ===

These proportions can therefore be applied to divide the total of 654,500 into four cost pools, for each of which an appropriate cost driver needs to be defined and measured. The activity analysis has also determined that the total number of activities which are related to each product-line in a typical month are as follows:Number of setups Product X Product Y Product Z 75 115 480 ----670 === Number of movements of materials 12 21 87 ----120 === Number of inspections 150 180 670 ----1,000 ==== Number of machine-hours ) ) ) as above ) )

You are required:(b) to calculate the cost per unit for each product using ABC principles (15 marks) (c) to comment on the reasons for any differences in the product costs you have calculated in your answers to (a) and (b) respectively (6 marks)

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Trimake Ltd. suggested answer

a. Production cost per unit - traditional method Product X () 3 20 42 (1.5 hours) ----------65 ----------Product Y () 9 12 28 (1 hour) ----------49 ----------Product Z () 6 25 84 (3 hours) ----------115 -----------

Direct labour @ 6 per hour Direct materials Production O/H @ 28 per machine hour

b. Production cost per unit - ABC method

The total production overhead is derived from the overheads allocated to the product in part (a): Product A Product B Product C Overhead costs traced to cost pools:Set-up cost Machining Materials handling Inspection Cost driver rates: Cost per set-up 341.903 Cost per machine-hour 5.60 Cost per material movement 818.125 Cost per inspection 196.35 ( = 229,075 / 670) ( = 130,900 / 23,375 [see note below]) ( = 98,175 / 120) ( = 196,350 / 1,000) 229,075 130,900 98,175 196,350 654,500 (35%) (20%) (15%) (30%) 31,500 35,000 588,000 654,500 (= 750 x 42) (= 1,250 x 28) (= 7,000 x 84)

Note: machine hours = (750 x 1.5) + (1,250 x 1) + (7,000 x 3)

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Trimake Ltd. suggested answer Overhead cost assigned to each product:Product X Set-up costs @ 341.903 Machining @ 5.60 per machine hour Materials handling @ 818.125 per materials movement Inspection @ 196.35 per inspection Overhead cost per product-line Number of products Overhead cost per product 25,643 6,300 (1,125) 9,817 29,453 (150) -------71,213 -------750 95 (75) Product Y 39,319 (115) 7,000 (1,250) 17,181 (21) 35,343 (180) -------98,843 -------1,250 79 Product Z 164,113 (480) 117,600 (21,000) 71,177

(12)

(87)

131,554 (670) --------484,444 --------7,000 69

Production cost per product, following ABC principles:Product X Direct labour @ 6 per hour Direct materials Production O/H 3 20 95 ----------118 ----------+82% Product Y 9 12 79 ----------100 ----------+104% Product Z 6 25 69 ----------100 -----------13%

Change, compared with traditional method

c. Comment:-

The traditional method allocates overheads in proportion to machine hours to products (4.8% to X, 5.3% to Y, and 89.9% to Z). However, when overheads are assigned on the basis of the numbers of set-ups, movements of materials and inspections, the proportions of overheads assigned to product Z are 72% (480/670) for set-up costs, 72% (87/120) for materials handling costs, and 67% (670/1,000) for inspection costs. In contrast, the traditional method allocates approximately 90% of all costs to product Z, so the unit cost for product Z is higher with this method. The opposite position applies with products X and Y and as a result, their unit costs are lower with the traditional method. Advocates of the ABC approach would argue that this means that under the traditional method product Z (the high-volume and relatively less complex product) is effectively cross-subsidising products X and Y and that this is not

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transparent from the traditional system, so that management decisions on pricing, promotions, etc. could be distorted.

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Question D7 Alpha Manufacturing Ltd produces a single product, the sigma. The product requires a single production process, and the standard cost for this is presented in the following standard cost card:-

Direct material:Direct labour Overheads:2 kg of material A @ 1 per kg 1 kg of material B @ 3 per kg 3 hours @ 3 per hour variable: 3 hours @ 2 per direct labour hour fixed: hour Total standard cost Standard profit margin (25% on cost) Standard selling price 3 hours @ 4 per direct labour 6.00 12.00

2.00 3.00 9.00

18.00 32.00 8.00 40.00 ==== Alpha Ltd plans to produce 10,000 units of sigma in the month of April, and the budgeted costs based on the information contained in the standard cost card above are as follows:-

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Budget based on the above standard costs and an output of 10,000 units per month: Sales Direct materials 10,000 units of sigma @ 40 per unit A: 20,000 kg @ 1 per kg B: 10,000 kg @ 3 per kg Direct labour Variable overheads 30,000 hours @ 3 per hour 30,000 hours @ 2 per direct labour hour 20,000 30,000 50,000 90,000 60,000 120,000 320,000 Profit 80,000 ====== NB: budgeted fixed overheads are 120,000 per month and are charged on the basis of direct labour hours, giving a fixed overhead rate of 4 per direct labour hour (120,000 / 30,000 direct labour hours). 400,000

Fixed overheads (see note below)

The actual results for April are:-

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 Sales Direct materials 9,000 units of sigma @ 42 each A: 19,000 kg @ 1.10 per kg B: 10,100 kg @ 2.80 per kg Direct labour Variable overheads Fixed overheads Profit 28,500 hours @ 3.20 per hour 20,900 28,280

378,000

49,180 91,200 52,000 116,000 308,380 69,620 ======

Manufacturing overheads are charged to production on the basis of direct labour hours. Actual production and sales for the period were 9,000 units. Required (a) Produce a variance statement which explain the reasons for the overall difference of 10,380 between the budgeted profit of 80,000 and the actual profit of 69,620 in terms of the variances that can be calculated from the data above. 15 Marks On the basis of your analysis of the variances, explain to Alphas Chief Executive what has happened during the month and the main factors which appear to have affected its performance. 5 Marks Evaluate the advantages and disadvantages as a method of management control of this approach, in which a businesss results are analysed in detail into a number of different variances. 5 marks Total 25 marks END OF EXAMINATION

(b)

(c)

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Alpha Manufacturing suggested answer NB: the following analysis takes a holistic approach and sets out the table below as the first stage in the workings. This is an optional part of the workings and is done here to help to provide an overview of the analysis as a whole, but it does not necessarily have to be used every time with practice, it can be possible to calculate the variances directly without first going through this step. Std cost p.u. Original budget (10,000 products) Material A: 2 kg @ 1 2.00 20,000 [20,000 kg @ 1] Material B: 1 kg @ 3 3.00 30,000 [10,000 kg @ 3] Dir. labour: 3 hrs @ 2 9.00 90,000 [30,000 hrs @ 3] Var. O/H: 3 hrs @ 2 Total Variable Cost Fixed O/H Sales 6.00 --------20.00 12.00 --------32.00 40.00 --------8.00 --------60,000 --------200,000 120,000 --------320,000 400,000 (10,000 @ 40) --------80,000 --------Flexed budget (9,000 products) 18,000 [18,000 kg @ 1] 27,000 [9,000 kg @ 3] 81,000 [27,000 hrs @ 3] 54,000 --------180,000 120,000 --------300,000 360,000 (9,000 @ 40) --------60,000 --------Actual (9,000 products) 20,900 [19,000 kg @ 1.10] 28,280 [10,100 kg @ 2.80] 91,200 [28,500 hrs @ 3.20] 52,000 --------192,380 116,000 --------308,380 378,000 (9,000 @ 42) --------69,620 --------2,000 F --------12,380 A 4,000 F --------8,380 A 18,000 F (9,000 @ 2) --------9,620 F --------10,200 A 1,280 A 2,900 A Overall variance per line

Profit

The total profit variance is the profit which Alpha actually realised in the month of 69,620 (column 4), minus the profit that they originally budgeted of 80,000 (col. 2). In any particular situation this could be either positive or negative; here it is negative, i.e. an adverse (or unfavourable) total profit variance of 69,620 - 80,000 = 10,380, since actual profits were 10,380 less than planned. The purpose of variance analysis is to take this total profit variance and analyse it into its constituent elements to identify where in the organisation any deviations from plan occurred and who is responsible, in order to

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determine the reasons and take whatever actions are needed (this approach is termed responsibility accounting). Here, the main reason is that sales volume was 10% down (only 9,000 products instead of the 10,000 planned). This alone is responsible for a fall in profit of 1,000 products x the expected contribution of 20 on each product (40 sales price minus 20 total variable cost per unit) = 20,000. This is equal to the difference between the profit figures stated in the original budget (col. 2) and the flexed budget (col. 3) respectively. In any question that you are asked to do, the data which you will need to complete columns 1, 2 and 4 will be given in the question. Column 3 (the flexed budget) is calculated by taking column 2 (the original budget) and adjusting it as follows:- for each variable cost, multiply the amount in column 2 x (actual volume the volume on which the original budget was based: here, 9000/10000). - for each fixed cost, the amount in column 3 should be the same as in column 2 (since by definition an increase in volume would not justify any increase in the amount to be spent on a cost which is expected to stay fixed). Since the flexed budget (column 3) is simply the original budget (column 2) adjusted only for any difference in the volume of final output, it must follow that any remaining differences between the flexed budget (col. 3) and the actual results (col. 4), which will be shown in column 5, must be due to either or both:a difference in the rate at which inputs have been converted into outputs: i.e. the kilos of raw materials (or whatever) which have been needed to produce each product - the efficiency or quantity element;

- a difference in the prices paid for inputs, compared with what was originally expected - the price element. The amounts in column 4 must therefore be analysed between their quantity and price elements. Taking Material A as an example:Quantity: the flexed budget allows for 18,000 kilos to be used (1 kilo for each product); however actual usage was 19,000 kilos, so there has been excess usage of 1,000 kilos. This will reduce profits, so the variance will be adverse). To calculate the amount by which profits have been reduced due to this single cause, this must be multiplied by the standard price per unit of raw materials, i.e. 1 per kilo. The calculation is therefore:(19,000 kg - (9,000 units x 2 kg per unit)) x 1 per kg = 1,000 A (adverse) Price: the original budget planned for each kilo to cost 1; however in the event 1.10 per kilo has been paid, i.e. an overspend of 10 pence per kilo (therefore another adverse variance). In order to calculate the amount by which profits have been reduced due to this single cause, this must be multiplied by the actual quantity used in the period, i.e. 19,000 kilos. The calculation is therefore:(1 - 1.10) x 19,000 kilos = 1,900 A

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Note that the further analysis of the total variance is similar for materials and labour (and also for sales), i.e. it is analysed between quantity and price; but it differs for each of variable and fixed overheads (in different ways). The purpose of variance analysis is to produce a report which provides management with the basis to investigate the causes for any deviations from plan and if possible correct them. It is an example of management by exception: i.e. there is no need to be concerned in areas where things are going according to plan, but where there are variances then this may indicate that attention is required. Given that management time is limited, this should concentrate on only those variances which are (1) material in amount, and (2) where the causes are likely to be controllable.

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Variance Report for the month Budgeted profit Sales volume Sales price Material A usage Material A price Material B usage Material B price Labour efficiency Labour rate VO efficiency * VO expenditure * Fixed overheads (10,000 9,000 = 1,000 products) (42 - 40 = 2 per product) x 9,000 products (19,000 kg - (9,000 products x 2 kg)) x 1 per kg (1 - 1.10) x 19,000 kilos (10,100 9,000) @ 3 (3.00 - 2.80 = 20 pence per kg) x 10,100 kg (27,000 28,500 = 1,500 hours) @ 3 (3.20 - 3.00 = 20 pence per hr) x 28,500 hrs (28,500 27,000 = 1,500 hours) @ 2 per hour (28,500 hours @ 2) - 52,000 120,000 - 116,000 20,000 A 18,000 F 1,000 A 1,900 A 3,300 A 2,020 F 4,500 A 5,700 A 3,000 A 5,000 F 4,000 F ------10,380 A --------Total profit 69,620 ====== 80,000

* these are the equivalent of usage and price variances. The VO efficiency variance measures how much extra was spent on variable overheads due to the inefficiency in production, e.g. how much extra energy was used in production because more hours were worked than were justified by the number of products actually produced. The VO expenditure variance (5,000 F, here) indicates that although more energy, etc. was consumed than should have been, it was also purchased more cheaply than expected. In practice, total variable overheads will probably include several different items, each in different units and at different prices, and probably also the responsibility of a number

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of different managers, so these variances at an aggregate level are probably only of limited help. ** as stated above, the total impact of the fall in volume of 1,000 products was 20,000 (adverse). However, most costing systems in practice are based on full costs, and would therefore distinguish between the fixed overheads recovered per unit (12 per unit here) and the profit margin of 8 per unit (remember that profit means after all costs, both variable and fixed; contribution means after only the variable costs). Most variance analysis systems would therefore report this (perhaps confusingly) as 2 separate amounts, i.e.:fixed overhead volume variance: 1,000 units @ 12 = 12,000 A sales margin quantity variance: 1,000 units @ 8 = 8,000 A If wanted, and if the data is available, each of these volume-related variances can be further analysed to reflect the causes of the loss in volume: was it due to a loss in capacity (e.g. the factory suffered downtime due to a strike or machine breakdown) or to lowerthan-expected efficiency? Note: variance analysis can be taken down into further detail if wanted, if this would generate useful information. E.g. a company with more than one product in its range (unlike Alpha) might want to break down the sales price variance between the part that is due to actual changes in the prices charged to customers, and the part which is due to differences in the sales mix. I.e. the company may not have changed its prices, but customers may have bought more low-margin products and less high-margin products than expected (or vice versa), and this will have affected profit.

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