UNIVERSITY OF LONDON

PRELIMINARY EXAM 2018

MODULE CODE : AC3097

MODULE TITLE : MANAGEMENT ACCOUNTING

DATE OF EXAM :

TIME OF EXAM :

DURATION : 3 Hours 15 min (including 15 min reading time)

TOTAL NUMBER : 10
OF PAGES
(INCLUDING
THIS PAGE)
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INSTRUCTIONS TO CANDIDATES :-

Candidates should answer FIVE of the following EIGHT questions: FOUR from
Section A and ONE from Section B. All questions carry equal marks.

Workings should be submitted for all questions requiring calculations. Any necessary
assumptions introduced in answering a question are to be stated.

8-column accounting paper is provided at the end of this question paper. If used, it
must be detached and fastened securely inside the answer book.

A calculator may be used when answering questions on this paper and it must
comply in all respects with the specification given with your Admission Notice. The
make and type of machine must be clearly stated on the front cover of the answer
book.

DO NOT TURN OVER THIS QUESTION PAPER UNTIL YOU ARE TOLD TO DO
SO.

Candidates are strongly advised to divide their time accordingly.

SECTION A Answer four questions from this section.

AC3097 Management Accounting Page 1 of 10

1. Pinewoods Hospital serves a population of 300,000 people. It is currently reviewing its
operations and preparing budgets for the year from 1st July 2018 to 30th June 2019.

It runs a modern pathology department. Part of the work of the pathology department is
performing cancer tests. Five thousand cancer tests are expected to be conducted in the year
ended 30th June 2019.

The hospital operates an internal accounting system where service departments, such as the
pathology department, ‘sell’ their services to the front-line clinical departments and are
expected to break even. The pathology department’s budget for the financial year ended 30th
June 2019 is shown below:
£000
Departmental Manager and Secretary 75
Laboratory Scientists: 10 @ £35,100 351
Laboratory Technicians: 25 @ £25,650 641
Chemical and clinical supplies 300
Electricity 125
Maintenance of equipment 150
Apportioned General hospital overheads 146
Total 1,788

Pathology Department Pricing System

Each Laboratory Scientist and each Laboratory Technician delivers 1,350 productive hours
per year. Hourly rates are £26 and £19 respectively. For charging purposes within the
hospital a 50% mark-up is applied to the hourly rates to cover the departmental overheads.
The cost of chemical and clinical supplies required for each type of test is variable so is also
charged. The variable element relating to cancer tests is £30 per test. Thus the re-charge to
clinical departments for the average cancer test will be:
£
£
Laboratory Scientist: 0.8 hours @ £26 x 150% 31.20
Laboratory Technicians: 2.7 hours @ £19 x150% 76.95
Chemical and clinical supplies 30.00
138.15

The hospital management has recently been approached by a Private Healthcare Company
who have cut the costs of the pathology laboratory by using the latest test equipment. They
are offering to provide up to 5,000 cancer tests per year at £110 each, commencing on 1st July
2018. The Pinewoods Hospital managers are considering this offer as they are always keen to
reduce costs.

Question continues on next page

AC3097 Management Accounting Page 2 of 10

1 Cont. Within the departmental budget shown above both the electricity consumption and equipment
maintenance costs are variable with activity. In the case of electricity consumption, 40% is
variable relating to the operation of the technical equipment and, of that, 25% relates
specifically to the cancer tests. For equipment maintenance 50% of the budget is variable
with usage and of this 20% relates to the cancer tests.

Investigation also reveals that most of the laboratory scientists and technicians are members
of a trade union and would be strongly resistant to any staff reductions in the department.

Required:
(a) Based on the information you have been given, and on the assumption that there are to be
no staffing reductions, show the relevant figures to decide whether or not to contract out
the testing to the private healthcare company. Give explanations as to what figures you
have or have not included, and your recommendation as to whether the offer should be
accepted. (7 marks)

(b) Show similar calculations on the assumption that appropriate staff reductions, can be
achieved by natural wastage. Show how many staff in each category can be saved. Make
recommendations as to whether, in this case, the offer should be accepted. (7 marks)

(c) Pinewoods Hospital is beginning to devote more of its work to cancer treatment.
Management have forecast that there may be demand for 1,000 additional cancer tests
during year ended 30th June 2019. These additional tests could be sub-contracted to the
Private Healthcare Company for £110 per unit.

However, Pinewoods Hospital have also investigated new ways of operating and have
discovered a more modern machine which could be leased at a cost of £30,000 per year from
1st July 2018 onwards, specifically for cancer tests. Using this machine would mean that the
time taken by laboratory technicians for each cancer test would be reduced to 1.5 hours per
cancer test and laboratory scientists’ time to 0.6 hours. Assuming that, if necessary,
laboratory staff could be reduced by natural wastage, show the financial effect of leasing the
machine, if 6000 cancer tests were performed, compared with the cost of continuing to
perform 5,000 in house using existing processes and outsource 1000 tests. Briefly comment
on your financial analysis. (6 marks)

AC3097 Management Accounting Page 3 of 10

2. Matthews Ltd, produces and sells one type of product. The company plans to sell 50,000
units per month.
Details of the sales price, standard variable cost per unit and the monthly budget for 50,000
units are shown below:
Variable cost 50,000
per unit units
£ £
Sales revenue 18.00 900,000
Costs
Material AB 3kg x £0.60 per unit 1.80 90,000
Material CD 1 kg x £2.00per unit 2.00 100,000
Labour costs - variable (0.5 hour x £7 per unit) 3.50 175,000
Production overhead - fixed 30,000
variable £1.75 per unit 1.75 87,500
Administration costs - fixed 122,500
Selling & distribution costs - fixed 12,500
variable £0.05 per unit 0.50 25,000
Total costs 9.55 642,500
Budgeted unit contribution/net income 8.45 257,500

The actual activity for the month of January turned out better than expected and 75,000 units
were produced and sold, with the following actual results:

Actual profit statement for January £

Sales revenue (75,000 units) 1,622,000
Less: Material: AB at £0.54 per kg 121,905
CD at £2.02 per kg 163,620
Labour costs ( 36,000 hours x £7.2) 259,200
Production overhead 171,250
Administration costs 187,500
Selling & distribution costs 66,500
Total costs 969,975
Net income 652,025

Required:
(a) Calculate all price, cost and quantity variances for each item of revenue and cost,
reconcile the actual net profit with the budgeted profit for 50,000 units and comment on
the variances you have calculated. (13 marks)

(b) Calculate the material mix and yield variances. (4 marks)

(c) During January, to meet the higher output, 4,000 of the 36,000 hours of labour were paid
at overtime rates of 150%. The overtime was charged to production overhead. For the
variance affected, show the amount of the variance which is due to the overtime and the
amount of the variance which still needs to be explained. (3 marks)

AC3097 Management Accounting Page 4 of 10

3. A component production department of Electronics Ltd has standards for quality control of
10% component losses in process and 3% defective components returned from customers,
replaced free of charge. Due to the just-in-time system the company does not hold inventory.

In December the company met the quality targets as shown below:

December 2017 activity report Units
Components worked in process 6400
Losses in process (10%) 640
Free replacement of defective components sold to customers
3% of components invoiced during month (5592 x 0.03) 168
Components invoiced to customers (5760/1.03) 5592

Component variable costs per unit are: £95

Quality costs for December
Internal failure costs 640 x £95 £60,800
External failure costs 168 x £95 £15,960

The company introduced more quality testing activities in January 2018 and incurred
additional expenditure during January and February as follows:

Expenditure January February

Component quality conformance checks during process £12,000 £12,000
Staff training costs £5,000 £5,000
Equipment accuracy monitoring checks 0 £3,000

The actual component production data for January and February was:

Production data January February

Units Units
Components worked in process 6,500 6,100
Losses on process ? ?
Free replacement - defective components sold to customers 180 40
Monthly output, invoiced to customers 5,700 5,600

Required:
(a) Calculate the number of components lost in process in each month separately
(i.e. in January and in February). (2 marks)

(b) For each month separately (i.e. January and February) calculate the change in units
compared to the expected standard number of units in respect of:
i) components lost in process (standard 10% of completed)
ii) defective components replaced (standard 3% of invoiced). (7 marks)

(c) Prepare a quality cost analysis for each of January and February which shows the
internal failure costs, external failure costs, appraisal cost and prevention costs and
briefly comment on the results shown by the quality cost analysis. (11 marks)

AC3097 Management Accounting Page 5 of 10

4. Jenkins Ltd produces and sells 6,000 digital cameras per year at a selling price of £500 each.
Its current production equipment was purchased on 1st July 2016 for £1,500,000 with a five-
year useful life and can process 8000 units each year. It has a disposal value of £0 after five
years and is depreciated on a straight-line basis. On 30th June 2018 the equipment will have a
disposal price of £300,000. In March 2018 due to the emergence of new technology, Jo
Strong (Jenkin’s manager) is considering either upgrading or replacing the production
equipment on 1st July 2018. Jo has identified two possibilities which would meet the same
capacity. The following table presents data for the alternatives:

Continue with Upgrade Replace

old machine
Initial equipment cost 0 £1,800,000 £2,900,000
Variable manufacturing cost per camera £280 £160 £80
Remaining useful life of equipment 3 years 3 years 3 years
Disposal value of equipment at 30.6.2021 £0 £0 £0

All equipment costs will continue to be depreciated on a straight-line basis. The annual
demand for 2018-2021 is expected to remain at 6,000 units and price and variable costs will
also remain the same. The company’s cost of capital is 12%

Required:
(a) On the assumption that the Upgrade or Replacement will be in operation from 1 st July
2018, using appropriate calculations explain whether either of the new alternatives would
be preferred financially. (6 marks)

(b) Jenkins Ltd prepares financial accounts to 30th June each year. Joe Strong receives a bonus
based on operating net income. He is planning to leave in about September 2019 and his
bonus for the year ended 30th June 2019 is his primary concern. Explain, with supporting
calculations which alternative Joe Strong would choose. (7 marks)

(c) Assuming that Jenkins Ltd has decided not to continue with the old machine. Jo Strong
wishes to know how much should be paid for upgrading the equipment which would
make the company indifferent between upgrading it and replacing it? (3 marks)

(d) Using the original information stated above, if the sales quantities were unknown, what
would be the lowest level of sales per annum for each of the three years, which the
company would need to achieve for it to be worth:

i) upgrading the equipment rather than continuing with old machine?

ii) replacing the equipment rather than continue with the old machine? (4 marks)

Discount factor 12%

Year 0 1.000
Year 1 0.893
Year 2 0.797
Year 3 0.712

AC3097 Management Accounting Page 6 of 10

5. Natural Wood Ltd has two divisions The Forest division holds land which it uses to plant and
harvest trees. The Lumber division cuts the wood into boards. Any harvested wood not sold to
“Lumber” is sold externally.

The following information relates to the year ended 31st December 2017:
Forest sold 200 million metres of timber to outside customers at £4.50 per metre and 800
million metres of timber to Lumber. Lumber uses Forest to supply all of their wood
purchases. The purchase price of wood from Forest to Lumber is Lumber’s share of Forest’s
operating expenses, calculated as Lumber’s share of the total wood harvested and sold. Due to
the nature of the business there are hardly any variable product costs in either division.

Other financial details for the two divisions are:

Forest Lumber
Total asset value £2,200 million £2,700 million
Total revenues As above £7,600 million
“Forest” operating expenses £2,000 million
“Lumber” Operating expenses other than paid to “Forest” 3,500 million
Risk adjusted weighted cost of capital 15% 20%

Required:

(a) Calculate the Residual Income (EVA®) for each division. (8 marks)

(b) In the light of your calculations in part (a) discuss the ways in which each manager’s
decision making is likely to be affected by the current transfer price system. (You should
assume that maintaining or improving EVA ® is considered as an important factor in
each manager’s performance targets). (4marks)

(c) Recommend one other method of setting the transfer price between the two divisions
and calculate the EVA® for each division using this method. Explain your reasons for
recommending this method and comment on how your method might change the
decision making of each manager. (8 marks)

AC3097 Management Accounting Page 7 of 10

6. “The Grand” is a five star hotel. It attracts business, package tours and leisure travellers.

The summary income statement for the year ended 31st December 2017 reads as follows:

£000 £000
Total Revenue 5,040
Direct Operating Material 425
Direct Operating Wages 1,170
Estate Fixed costs 2,120
General Fixed Costs 303
Total Operating costs 4,018
Annual Net Income 1,022

The revenues and direct operating costs are further analysed by the services provided:

Restaurant Leisure
Rooms Minibar Total
& bar Suite
£000 £000 £000 £000 £000
Revenues 3,350 40 1350 300 5,040
Direct Materials 35 10 350 30 425
Direct Wages 700 0 400 70 1,170

Occupancy nights
Total Room Nights Available 52,500
Occupancy Rate 70% 60% 40%

The hotel now wishes to determine the profitability of its different types of customers. These
have been identified as:

Business clients on expense accounts, who use the executive rooms and make significant use
of all facilities.
Package tour clients, tour operators bargain good prices and clients mostly explore the city
during their stay.
Individual bookings, prices of rooms vary considerably but these clients respond to discount
deals offered online.

Question continues on next page

AC3097 Management Accounting Page 8 of 10

6 cont. Analysis of revenue from clients for the year ended 31st December 2017 has revealed the
following:
Business Packages Individuals Total
Annual number of nights 10,500 20,250 6,000 36,750
Room revenue % 38 42 20 100
Minibar revenue % 70 20 10 100
Restaurant and bar revenue % 52 30 18 100
Leisure suite revenue % 60 25 15 100

Analysis of costs for the year ended 31st December 2017 has revealed that direct room costs
vary per room night. In all other departments direct costs vary with revenue.

It has been decided to allocate estate fixed costs to client groups on room occupancy, and
general fixed costs on revenues.

Required:

(a) Analyse the income and expenditure by each of the client groups in what you consider
to be an appropriate format. (10 marks)

(b) Calculate for each group of customers per room/night

 % rooms occupied
 revenues generated
 revenues less direct costs per room/night. (3 marks)

(c) Comment on the information provided by your analysis and advise the management on
pricing, withdrawal from any client groups and a strategy to fill more of the hotel’s
capacity. (5 marks)

(d) Discuss whether the method used to allocate fixed overhead is appropriate. Include in
your answer an alternative method which might give more useful figures. (You are not
required to calculate figures for your suggested answer.) (2 marks)

AC3097 Management Accounting Page 9 of 10

Section B
Answer one question from this section.

7. Explain the techniques of ‘Product Lifecycle Budgeting’ and ‘Customer Lifecycle

Budgeting’.

How do these techniques assist in strategy, pricing, income-smoothing and cash management
in a company?

8 Choose four of the terms/techniques listed below and for each one:
i) Explain the meaning of the term/technique;
ii) Drawing on your knowledge of management accounting, give two
examples of its application;
iii) Provide a discussion of some of the practical limitations of which users
should be aware with regard to the term/technique.:

(a) Absorption costing

(b) Cost centre
(c) Flexible budget
(d) Throughput contribution
(e) Value added
(f) Transfer price

AC3097 Management Accounting Page 10 of 10

 SIM Preliminary paper 2018 – Commentary

1-Pinewoods Hospital
Reading
Study Guide Chapter 8
Textbook Drury C. Management and Cost Accounting (London Cengage 2105 9th Ed [ISBN 9781408093931] (Drury)
Chapter 9

Introduction
This question relates to a hospital department which does work for other departments. All the work is recharged to the
relevant department using a pricing mechanism of charging for staff time at 150% to cover for overheads. This charged
should not be used for relevant costs calculations. The question focuses on cancer tests and the first approach assumes
that labour is a fixed cost and therefore will not be avoided if the cancer test are done by the outside agency.

Answer
a) Viability of outsourcing with no staffing reductions
Incremental cost approach
£ £
1 test 5,000 tests
Cost of outsourcing 110.00 550,000
Copland hospital in house cost saving if a cancer test outsourced
Chemical & Clinical Supplies 30.00 150,000
Electricity Consumption (£125,000 x 0.4 x 0.25) / 5,000 2.50 12,500
Equipment maintenance (£150,000x 0.5 x 0.2) /5,000 3.00 15,000
Total cost savings 35.50 177,500
Incremental loss per cancer test outsourced -74.50 372,500

Comment: Since the costs of outsourcing are greater than the in house costs the offer should be rejected.

There will be no savings in - Departmental Manager and secretary costs

Laboratory Scientists’ Salaries
Laboratory Technicians' Salaries
General Trust Overheads (7 marks)

b) Here negotiations with unions have indicated that it would be possible to reduce staff so the salaries become
variable costs.
Answer
*Staff Savings Equate to: -
Laboratory Scientists 0.8 x 5000 / 1350 = 2.96 staff (Approximately) realistically 3 staff
Laboratory Technicians 2.7 x 5000 / 1350 = 10 staff.
Viability of outsourcing with staff wastage option
Calculation of costs if staff can be made redundant £ £
1 test 5,000 tests
Cost of outsourcing 110 550,000
Copland hospital in house cost saving if a cancer test is outsourced
Chemical & Clinical Supplies 30.00 150,000
Electricity Consumption £125,000 x 0.4 x 0.25 / 5,000 2.50 12,500
Equipment maintenance £150,000x 0.5 x 0.2/5,000 3.00 15,000
Savings in staff time
Laboratory Scientists 0.8 Hours @ £26* 20.80 *104,000
Laboratory Technicians 2.7 Hours @ £19 51.30 256,500
Total cost 107.60 538,000
Incremental loss per cancer test outsourced -2.40 12,000
*3 members of staff x £35,100 = £105,300 could be used instead

Page 1 of 10
SIM Preliminary paper 2018 – Commentary

Comment: Although there is only a slight saving in cost between keeping the work in house and outsourcing, it
is still not financially worth outsourcing and valuable staff will be lost. So it is recommended to keep the work
in house. In fact it may be difficult to obtain the calculated savings in Laboratory Scientists as it may not be
possible to lose 2.96 scientists, so either 2 or 3 would not be replaced.
(7 marks)
(c) Analysis of costs with 6000 cancer tests and new equipment

Staff Savings Equate to: -

The answer assumes that part-time contracts could be used
Laboratory Scientists 0.6 x 6000 / 1350 = 2.67 staff.
Laboratory Technicians 1.5 x 6000 / 1350 = 6.67 staff. Realistically 7 staff

Calculation of costs if new machine used £ £

1 test 6,000 tests
Cost of outsourcing 110 660,000
Copland hospital in house cost saving if a cancer test is outsourced
Machine lease £30,000 per hour 5.00 30,000
Chemical & Clinical Supplies 30.00 180,000
Electricity Consumption £125,000 x 0.4 x 0.25 / 5,000 x 6000 2.50 15,000
Equipment maintenance £150,000x 0.5 x 0.2/5,000 x 6000 3.00 18,000
Savings in staff time
Laboratory Scientists 0.6 Hours @ £26 assuming some part-time contracts 15.60 93,600
Laboratory Technicians 1.5Hours @ £19 assuming some part-time contracts 28.50 171,000
Total cost 84.60 507,600
Incremental loss per cancer test outsourced 15.40 52.400

Comparison with in house for 5000 test and outsources 1,000

£
From (b) cost without outsourcing 538,000
Cost of 1,000 outsourced 110,000
648,000
Total cost of 6,000 in house 507,600
Difference 140,400

The analysis shows that it would be beneficial to hire the new machine. This is not only cheaper but
would also enable the work to be kept in house which may be more speedy and convenient.
(6 marks)

Page 2 of 10
SIM Preliminary paper 2018 – Commentary

2 - Matthews Ltd
Reading
Study Guide: Chapters 13 & 14
Textbook: Drury Chapters 16,17,18
Introduction
Part a) is a straightforward variance analysis question. A flexed budget was not asked for but helps to check that the
variances are correct.
The main mistake in calculating the variances was to assume that the standard quantity is 75,000. With use of
resources e.g. materials the standard amount of kgs. must be used and compared with the actual kgs.
The efficiency of the overhead could not be calculated as the split in actual expenditure is not provided.
Answer
Flexed budget 75,000 units Actual
Revenue - 75,000 x £18 1350,000 1,622,000
Material costs AB - 225,000 x £0.6 135,000 121,905
CD - 75,000 x £2 150,000 163,620
Unskilled labour - 37,500hrs x £7.00 262,500 259,200
Production costs - (75,000 x £1.75) +£30,000 161,250 171,250
Administration 122,500 187,500
Selling & distribution - (75,000 x £0.5) + £12,500 50,000 66,500
Total cost 881,250 969,975
Net profit 468,750 652,025

Variances
Sales volume contribution 50,000-75,000 x £8.45 contribution 211,250 F
Sales price variance (1622,000 – 1350,000) 272,000 F
Material costs AB price 225,750 x (0.60- 0.54) 13,545 F
Quantity (225,000 – 225,750) x 0.60 450 U
CD price 81,000 x (2.00-2.02) 1,620 U
Quantity (75,000 -81,000) x £2 12,000 U
Unskilled labour price 36,000 x (£7-£7.2) 7,200 U
Unskilled labour efficiency (37,500-36,000 x £7.00) 10,500 F
Production overhead 161,250 – 171,250 10,000 U
Administration 122,500 – 187,500 65,000 U
Selling & distribution 12,500 + (75000 x 0.5) - 66,500 16,500 U
Total 394,525

Sales are impressive in both quantity and price. The largest variance is the increase in sales price of £272,000
followed by sales contribution £211,250. Material AB quantity variance showed careful use of material at +£13,545.
Other material variances were deficits with CD quantity being the most worrying. Unskilled labour efficiency costs
showed good practice. But all the overheads indicated overspending which may have been caused by the nearly 50%
increase in business. (13 marks)

b) Material mix variance

Cost per kg Act usage in std Act usage in act Difference x
proportions proportions Cost per kg
AB 75% £0.60 230,062.5kg 225,750kg (4312.5 x £0.6) £2,587.2
CD 25% £2.00 76,687.5kg 81,000kg (-4312.5 x £2) £-8,625 .0
total 306,750kg 306,750kg £-6,037.8

Material Yield variance

4kg of material should produce 1 unit. 306,750/4 76,687.5
Actual production 75,000
Material yield variance -1,687.5 x (£1.8 + £2) = -6,412.5

Page 3 of 10
 SIM Preliminary paper 2018 – Commentary

Total material quantity variance

Material mix £6,037.8U
Material yield £6,412.5U
£12,450.3U

This explains the AB and CD quantity variances totalling £12,450. Mix shows that too much of CD was used. This is
the more expensive material. Yield shows that overall too much material was used.

d) The labour overtime rate was presumably based on the actual rate paid of £7.20. The overtime therefore cost 4,000
x £3.60 = £14,400. This explains £14,400 of the production overhead adverse variance, so there must be £4,400
unexplained savings elsewhere in the production overhead costs. (7 marks)

3. - Quality Electronics
Reading
Study Guide: Chapter 17
Textbook: Drury Chapter 21
Introduction
This question requires careful reading but is otherwise straight forward.
Answer
a) Units lost in process
January 6,500 – (180 + 5700) = 620units
February 6,100 – (40+ 5,600) = 460 units (2 marks)

b)
Standard Actual Benefit/cost

Losses in process - Jan 6,500 x 10% 650 620 + 30

Feb 6,100 x 10% 610 460 + 150
Free replacements - Jan 5,700 x 3% 171 180 -9
Feb 5600 x 3% 168 40 + 128
Note - (percentage changes also accepted) (7 marks)
c)
December January February
Internal failure costs 60,800 620 x £95 58,900 460 x £95 43,700
External failure costs 15,960 180 x £95 17,100 40 x £95 3,800
Appraisal costs – quality conformance -
checks 12,000 12,000
Prevention costs – staff training & - 5,000 8,000
equipment checks
Total 76,760 93,000 67,500

Comments
The benefits expected for the TQM system appear to be coming through. In January the improvement was
small and not sufficient to cover the new costs. Internal detections were improved but free replacements were
poorer than benchmark, and overall the costs were higher than December by £16,240. This may be due to the
learning curve effect as the system has only just been introduced. By February the expenditure on appraisal
and prevention costs is more than offset by the savings in external and internal failures. This is presumably
partly due to the learning curve effect of the activities introduced in January as well as the additional checks
started in February. In future months it will be important to continue to monitor results to see whether
performance improvement continues.
(11 marks)

Page 4 of 10
SIM Preliminary paper 2018 – Commentary

Question 4 – Jenkins Ltd

Reading
Study Guide: Chapter 11
Textbook: Drury Chapter 13
Introduction:
This question required students to understand that long-term decisions should be analysed using discounted cashflow
techniques but each year’s results will be reported using accrual accounting. Consequently part a) uses DCF and part
b) accrual accounting for year 2019.
Answer
a) Appraisal of the three options
Discount Existing situation Upgrade Replace
factor
Annual savings 500-280 x 6000 = £500-160 x 6000 = £500-80 x 6000 =
1,320,000 £2040,000 £2,520,000
£000 discounted discounted
Initial outlay 1.000 0 1800 (1,800) 2,900 (2,900)
Sale of old machine 1.000 0 300 300
Savings years 1-3 2.402 1320 3170.64 2040 4900.08 2,520 6053.04
NPV 3,170.64 3100.08 3,453.04

The replace option should be accepted. (6 marks)

b) Impact on profit calculation for 2019 under each alternative

Existing Upgrade Replace

Sales 3,000,000 3,000,000 3,000,000
Variable costs -1,680,000 -960,000 -480,000
Depn -300,000 -900,000 -966,667
Loss on sale -600,000
Net profit -300,000 -180,000 -366,667

Even though replace is the better option in the long-term, Joe Strong would wish to upgrade rather than replace
because of the high loss on sale of replacement, which would impact on his bonus.
(7 marks)

c) 1,800,000 – 3,453,040 + 3,100,080 = £1,447,040 (3 marks)

d) i. Upgrade – the company needs annual savings of 1,800,000/2.402 = 749,375.

number of units would be 749,375/(280-160) = 6,245 (rounded)

ii. Replacement – annual savings (2,900,000-300,000)/2.402 = 1,082,431

Units = 1,082,431/(280 -80) = 5412 units (rounded)
(4 marks)

Page 5 of 10
SIM Preliminary paper 2018 – Commentary

Question 5 - Transfer pricing - Natural Woods

Reading
Study Guide: Chapter 16
Textbook: Chapter 20
Introduction
This is a straight forward example of the co-dependency between divisions. The only difficult calculation is the transfer
price, which is cost based relating to the proportion of work done for Lumber. The transfer revenue of Forest becomes the
cost for Lumber.
Answer
a) Forest £M Lumber £M
Sales external (200 x £4.50) 900 7,600
To Lumber 80% x 2000 = 1,600* -
Total sales 2,500 7,600
Less costs
To Forest (1,600)
Operating costs (2,000) (3,500)
Profit 500 2,500
Less capital charge 15% x 2,200 330 20% x 2,700 540
EVA 170 1960
*1600/800 = £2 per unit (8 marks)

b) The manager of Forest division will be encouraged:

• to sell as much as possible to outside customers giving them preference over Lumber
• not pay much attention to cost control as the higher the costs the more reimbursement from Lumber
• not to invest in new capital equipment as this increases the asset value on which the capital charge is based.

The manager of Lumber is benefiting from the low price paid to Forest and may not be charging high enough
prices or looking into developing other value added activities because s/he is already earning good EVA.(4 marks)

c) Since there exists a market price for the wood this seems a good method to use for the transfer price because it is
the price Lumber would have to pay to other suppliers. This price would encourage co-operation between the two
divisions since Forest would be receiving as much from Lumber as from other customers.

The results (below) indicate that Lumber has been subsidized by Forest. If the market based method were adopted
it would force Lumber to develop better markets, develop higher value added products and cut operating costs.

Forest £M Lumber £M
Sales external 900 7,600
To Lumber 800 x 4.50 = 3,600 -
Total sales 4,500 7,600
Less costs
To Forest (3,600)
Operating costs (2,000) (3,500)
Profit 2,500 500
Less capital charge 15% x 2,200 330 20% x 2,700 540
EVA 2,170 (40)

This method would mean that Forest would have much higher EVA than before. The division would be happy to
sell to any customer. Cost control would be in the division’s interest.
Lumber would need to consider the prices it charges for products and possibly develop added value to its products
or services. It may consider bargaining for discounted price from Forest.
Other suggested methods correctly calculated and explained would also earn marks e.g. full cost + (8 marks)

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6. The Grand - Customer profitability analysis

Reading
Study Guide: Chapter19
Textbook: Drury Chapter 22
Introduction
The question shows that the Grand Hotel already analyses profitability by department. They now wish to identify
which clients are bringing in most business and which client groups are more profitable.

The company has already identified the percentages of client revenue relating to each department and has decided on
methods of charging the various costs to the client groups. In order to provide the right answer to the question you
must follow the ways of allocating costs as stated in the question.

The table below is one way of providing a clear format per client group. Other formats, e.g. providing the information
for each group in a separate presentation were also acceptable. “Total revenues”, “revenues less direct costs” and
“net income” should be calculated for each group as they provide important management information.
Answer
a) Client groups Business Package Individual Total
Tours bookings
Annual number of nights 10,500 20,250 6,000 36,750
Revenue £000 £000 £000 £000 £000 £000 £000
Room revenue 1273 1,407 670 3,350
Minibar revenue 28 8 4 40
restaurant and bar revenue 702 405 243 1,350
Leisure suite 180 75 45 300
total revenue generated 2,183 1,895 962 5,040
Direct costs
Rooms - material 10 19 6 35
- labour 200 386 114 700
- total 210 405 120 735
Minibar 7 2 1 10
Restaurant & bar - material 182 105 63 350
- labour 208 120 72 400
total 390 225 135 750
Leisure suite - material 18 8 4 30
- labour 42 17 11 70
total 60 25 15 100
total direct costs 667 657 271 1,595
Revenues less direct costs 1,516 1,238 691 3,445

fixed costs -estate 606 1,168 346 2,120

general 131 114 58 303
Total fixed costs 737 1,282 404 2,423
Net Income 779 -44 287 1,022
(10 marks)

b) Statistics based on per room/night

Business Package Individual Total
Tours bookings
Rooms occupied (as % of current occupancy) 28.6% 55.1% 16.3% 100%
Total revenues per room/night £207.90 £93.58 £160.33 £137.14*
Revenues less direct costs per room/night £144.38 £61.14 £115.17 £93.74*
Revenues less direct costs/total revenue % 69.4% 65.3% 71.8% 68.4%
(3 marks)

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c) Comments
The information provided by the analysis in (a) is useful in identifying the proportions of revenue, cost and net
income which relate to each client group but more information can be provided by analysing per room because of the
sizes of the different client groups. Since the hotel does not have 100% occupancy it gives some idea of how much
each extra client would bring in and how much could be spent on discounts/advertising to fill more room/nights. The
comments will focus on “Revenues less direct costs” for each client group.
At present 15,750 room/nights per year are not occupied i.e. there are 144 rooms in the hotel and on average, each
night 43 rooms are not used.

Business clients
The analysis shows that the business clients are the most profitable group bringing in 44% of “total revenues less
direct costs”. It is also individually per night the best group with highest room rates and a huge spend on minibar,
restaurant and bar and leisure. However they represent only 28.6% of current occupancy.
Individual bookings
Individuals have the next best room rate and are the next most profitable but due to smaller numbers account for
only 24% of ‘total revenues less direct costs’.
Package tours
The package tours need to be investigated as they represent 55.1% of the current capacity used but give poor
‘revenue less direct costs’ and make a loss when fixed costs are allocated. They spend very little on extras.

Pricing
Since the hotel is only 70% full, all categories of customer should be encouraged. Targeted advertising and
appropriate discounts could be worthwhile. It may be worth targeting business and individual customers more than
packages. There is some indication that packages prices need to be increased or package clients need to be
encouraged to spend more whilst in the hotel e.g. by providing a booking service for local attractions or evening
events the clients might enjoy after spending the day elsewhere.
Withdrawal of client groups
Since there is plenty of capacity, no groups should be withdrawn, although further analysis of room availability in
peak seasons might indicate that the least profitable groups should be discouraged at these times.

There may be a slight problem with the ability of the hotel to be both a package tour and a business hotel since the
two groups may have different needs. Business people may not wish to share facilities with families. This could be
met by dividing the facilities i.e. pool and leisure suite so that business customers, who are probably already in the
executive accommodation can avoid families if that is their preference. (5 marks)

d) Absorption basis
Estate fixed costs – these are presumably rent, property taxes, depreciation etc., which it seems fair to charge on a
room basis. However it might be better to charge rooms based on square metres per room as the executive rooms
are no doubt larger. Some proportion of the total overhead should be allocated to clients based on their use of other
areas i.e. restaurant, bar, gift shop and leisure facilities, since these are used in different proportions by the client
groups,

General fixed costs - Allocating general fixed costs according to revenue is not a good method as it means that the
overheads change with room revenue which does not necessarily relate to use of the overhead resource. If there are
profit centres within the hotel it means that whenever managers successfully increase sales they are automatically
charged more overhead whereas less successful managers are charged less overhead, which is unfair. A greater
breakdown of the components of the overhead should be identified and an ABC approach adopted. (2 marks)

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Section B
7.
Reading
Study Guide: Chapter 11
Textbook: Drury Chapter 21

Introduction
Clear detailed descriptions of “Product Lifecycle Budgeting” is required.
More important is the explanation of how these Budgets assist in strategy, pricing, income-smoothing and cash
management. This part of the question relates to the application of the methods not the calculation. It is useful to bear
in mind that a company which adopts these techniques will do so for all products and will be planning for several
different products to be at different stages in their lifecycle in any one year. Thus the higher cost and low profits
experienced by a product in the development, introductory and decline stages is “covered” by the good profits of
products which are in their growth or maturity stages.
Answer
Suggested issues to be incorporated into a possible answer
Product Lifecycle budgeting Life cycle is identified for each product over the whole of its life which may be short
(mobile phones) or very long (nuclear power plants). The method crosses the annual accounting periods to view the
product as a whole. It includes all costs across the value chain and revenues from development through introduction,
growth, maturity, decline and disposal.
Strategy and pricing- By looking at the whole lifecycle, management is able to explore the effect of different plans,
volumes, prices, advertising and promotion over and during the product’s life. It can consider under what
circumstances more promotion, redesign or accelerated decline may be suitable. As the lifecycle progresses these
strategic issues can be reconsidered in the light of actual performance of the product and the competitive changes
which may occur.
Income smoothing and cash management – These issues may affect the timing of the launch of each product so that it
dovetails with the maturity stage of others. This ensures that by the time the others decline, new products are into their
growth stage. The rhythm will probably fit in with customers’ expectations of when new products will be introduced.
Since stakeholders like to see steady growth in incomes, the timing of products so that income from growing and
maturing products cover the R&D of developing products is often seen. Cash management also benefits from this
approach. However it is also helped by the lifecycle budget which can not only recognise when operating cost are
going to be high and sales revenues low but can also inform the capital expenditure budget enabling companies to
raise capital at the right time to invest in new assets. (20 marks)

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8 - Choose four of the terms/techniques listed below and for each one:
i) Explain the meaning of the term/technique;
ii) Drawing on your knowledge of management accounting, give two examples of its application;
iii) Provide a discussion of some of the practical limitations of which users should be aware
with regard to the term/technique.: (Total per term 5 marks)
Reading
Study Guide: various- see contents
Textbook: Drury various – see index

(a) Absorption costing

i) Method of tracing a fair share of fixed costs to a cost object e.g. products, services or departments
ii) Examples Product costing, process costing, contract costing, departmental costs.
iii) Difficult to decide bases for allocating costs, different methods give different results. Although these are
shares of fixed costs, users may think that increases/decreases in costs production will be affected linearly
with production.
(b) Cost centre
i) A department of an organisation which, in order to perform the services required by management, needs access
to money. The duties of the department are defined and may be measured using non-financial measures to
ensure that the centre is working effectively. A cost budget is set at the level considered sufficient to carry out
the duties.
ii) Company maintenance department, Finance department.
iii) Costs need to be charged to cost centre on the basis of controllability. Often this cannot be defined clearly,
partly because there are dependencies between cost centres which impact on controllability. Cost centres may
be tempted to spend up to their budget even if savings could be made.
(c) Flexible budget
i) A process to enable actual costs to be compared with standard costs at the actual level of output. It involves
multiplying the variable standard costs and revenues by the number of units made or sold.
ii) Any budget involving variable revenues and/or costs.
iii) Requires determination of the fixed and variable parts of mixed costs.
(d) Throughput contribution
i) Throughput contribution = sales – material costs. Throughput costing which only considers material cost to
be variable are regarded by some companies as “super variable”. It is assumed that in the very short run
direct labour and variable overhead are fixed. It is used to inform production flow where bottleneck
situations may occur. The throughput contribution per minute of use of the bottleneck resources indicates
the priority of production.
ii) Highly mechanised operations, often companies which mass produce several products or components.
iii)Contribution calculations provided may not be clearly understood by all users. Only relevant in some
production situations.
(e) Value added
i) Gross value of an activity less activity costs i.e. amount of value any aspect of the organisation adds to the net
income
ii) Products or departments e.g. research & development.
iii) Often difficult to measure value added by service departments. One measure which could be used is the
opportunity cost of buying the service from an outside provider.
f) Transfer price
i) Internal price to facilitate trading between two different parts of an organisation.
ii) Divisions of a group, service departments in a company charging to other cost centres.
iii) No one method is suitable in all occasion (total 20 marks)

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