ACCA - P5 Study text - Emile Woolf INT

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Practice questions

8 Product B22

BB Company has received an enquiry from a customer for the supply of 500 units of

a new product, product B22. Negotiations on the final price to charge the customer

are in progress and the sales manager has asked you to supply relevant cost

information.

The following information is available:

(1) Each unit of product B22 requires the following raw materials:

Raw material type

X 4 kg

Y 6 kg

(2) The company has 5,000 kg of material X currently in stock. This was

purchased last year at a cost of $7 per kg. If not used to make product B22, this

stock of X could either be sold for $7.50 per kg or converted at a cost of $1.50

per kg, so that it could be used as a substitute for another raw material,

material Z, which the company requires for other production. The current

purchase price per kilogram for materials is $9.50 for material Z and $8.25 per

kg for material X.

(3) There are 10,000 kilograms of raw material Y in stock, valued on a FIFO basis

at a total cost of $142,750. Of this current stock, 3,000 kilograms were

purchased six months ago at a cost of $13.75 per kg. The rest of the stock was

purchased last month. Material Y is used regularly in normal production

work. Since the last purchase of material Y a month ago, the company has

been advised by the supplier that the price per kilogram has been increased by

4%.

(4) Each unit of product B22 requires the following number of labour hours in its

manufacture:

Type of labour

Skilled five hours

Unskilled three hours

Skilled labour is paid $8 per hour and unskilled labour $6 per hour.

(5) There is a shortage of skilled labour, so that if production of B22 goes ahead it

will be necessary to transfer skilled workers from other work to undertake it.

The other work on which skilled workers are engaged at present is the

manufacture of product B16. The selling price and variable cost information

for B16 are as follows:

$/unit

Selling price 100

Less: variable costs of production

Skilled labour (three hours)

Other variable costs 31

(6) The company has a surplus of unskilled workers who are paid a fixed wage

for a 37-hour week. It is estimated that there are 900 hours of unused unskilled

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labour time available during the period of the contract. The balance of the

unskilled labour requirements could be met by working overtime, which is

paid at time and a half.

(7) The company absorbs production overheads by a machine hour rate. This

absorption rate is $22.50 per hour, of which $8.75 is for variable overheads and

the balance is for fixed overheads. If production of product B22 is undertaken,

it is estimated that an extra $4,000 will be spent on fixed costs. Spare

machining capacity is available and each unit of B22 will require two hours of

machining time in its manufacture using the existing equipment. In addition,

special finishing machines will be required for two weeks to complete the B22.

These machines will be hired at a cost of $2,650 per week, and there will be no

overhead costs associated with their use.

(8) Cash spending of $3,250 has been incurred already on development work for

the production of B22. It is estimated that before production of the B22 begins,

another $1,750 will have to be spent on development, making a total

development cost of $5,000.

Required

Calculate the minimum price that the company should be prepared to accept for the

500 units of product B22. Explain briefly but clearly how each figure in the

minimum price calculation has been obtained.

(Note: the minimum price is the price equals the total relevant costs of producing

the items. Any price in excess of the minimum price will add to total profit).

9 Payoff table

A baker pays $0.10 for buns and sells them for $0.30. At the end of a day, any

pastries that have not been sold must be thrown away. On any particular day, the

probability distribution of sales demand is as follows:

Number of pastries demanded by customers 20

40 60

Probability 0.3

0.5 0.2

Required

(a) Construct a payoff matrix to show all the possible outcomes

(b) What is the maximum amount the baker should be willing to pay for perfect

information (in advance) about sales demand each day.

10 Grab Company

Grab Company engages in site clearance and site preparation work. Information

about its operations is as follows:

(1) It is Grab Company‘s policy to hire all the plant and machinery it needs,

rather than to purchase its own plant and machinery.

Practice questions

(2) Grab Company will enter into an advance hire agreement contract for the

coming year at one of three levels – high, medium or low – which correspond

to the requirements of a high, medium or low level of orders obtained.

(3) The level of orders obtained will not be known when the advance hire

agreement contract is entered into. Probabilities have been estimated by

management as to the likelihood of the orders being at a high, medium or low

level.

(4) Where the advance hire agreement entered into is lower than that required for

the level of orders actually obtained, a premium rate must be paid to obtain

the additional plant and machinery required.

(5) No refund is obtainable where the advance hire agreement for plant and

machinery is at a level in excess of that required to satisfy the site clearance

and preparation orders actually obtained.

A summary of the information relating to the above points is as follows:

Level of orders Sales revenue

Probability

Plant and machinery hire costs

Advance hire

Conversion premium

$000

High 15,000

0.25

2,300

Medium 8,500

0.45

1,500

Low 4,000

0.30

1,000

Low to medium

850

Medium to high

1,300

Low to high

2,150

Variable cost (as a percentage of turnover) 70%

Required

(a) Prepare a summary which shows the forecast net margin earned by Grab

Company for the coming year for each possible outcome.

(b) On the basis of maximising expected value, advise Grab Company whether

the advance contract for the hire of plant and machinery should be at the low,

medium or high level.

the choice of advance plant and machinery hire contract may alter the decision

reached in (b) above.

(d) Grab Company is considering employing a market research consultant who

will be able to say with certainty in advance of the placing of the plant and

machinery hire contract, which level of site clearance and preparation orders

will be obtained. On the basis of expected value, determine the maximum sum

that Grab Company should be willing to pay the consultant for this

information.

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11 Learning

A company has developed a design for a new product, the Widgette. It intends to

sell the product at full production cost plus a profit margin of 40%. The estimated

production cost and selling price for the first unit of the Widgette are as follows:

Direct materials 2,000

Direct labour (200 hours at $15 per hour)

3,000

Fixed production overhead ($20 per direct labour hour)

4,000

Full production cost 9,000

Profit margin (40%) 3,600

Selling price 12,600

The company’s management expects reductions in the time to produce subsequent

units of the Widgette, and an 80% learning curve is expected.

A customer has expressed an interest in buying units of the Widgette, and has asked

the following questions:

(1) If we bought the first Widgette for $12,600 and immediately ordered another

one, what would be the selling price for the second Widgette?

(2) If we waited until you have sold the first two Widgettes to another customer,

and then ordered the third and the fourth units that you produce, what will be

the average price for the third and fourth units?

(3) If we decided to buy eight Widgettes immediately, and asked you to quote a

single price for all eight units, what price would you charge?

Required

(a) Answer each of these questions, assuming that the policy of the company

remains to make a profit margin of 40% on every unit that it makes and sells.

(b) List three limitations of learning curve theory.

12 Greenears

Greenears is a new business producing woollen hats, which it makes in small

batches of a standard size. It estimates that the first batch of a new design of hand-

made hats will have a labour cost of $2,000. There will be an 85% learning curve

effect for subsequent batches.

In month 1 production is five batches, and in month 2 production is seven batches.

Required

Estimate the total labour cost in month 2 for making the hats.

Practice questions

13 Regression

A company has achieved the following total sales in each year for the past five

years:

Year Total sales

$ million

20X2 = Year 1

20X3 = Year 2

20X4 = Year 3

20X5 = Year 4

20X6 = Year 5

Required

(a) Use linear regression analysis to establish a formula for the trend line in sales,

and use this formula to estimate what total sales should be in 20X7 and 20X8.

(b) Calculate the correlation coefficient to decide how much reliance you can

place in your forecasts.

To produce your answer, you can make use of the following calculations:

Year Total sales

x y xy x

1 12 12

144

2 15 30

225

3 15 45

225

4 18 72

324

5 19 95

361

15 79 254

1,279

14 Replacement product

A well-established company manufactures engines. One of its current products is

Product T, for which sales will be 150,000 units in the year just ending (Year 1).

However, after four more years, at the end of Year 5, Product T will no longer be

permitted, when new government environmental regulations come into force. On or

before that time, the company needs to introduce a new product to replace Product

A replacement product has already been developed. This is Product V. A market

research report has estimated that, if Product V is introduced to the market now to

replace Product T, annual sales of Product V at a unit price of $350 would be:

Annual sales Probability

units

100,000 0.2

80,000 0.5

50,000 0.3

The current selling price of Product T is $250 per unit, and its variable cost of sales is

$180. There is no possibility of increasing the selling price.

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The annual sales demand for Product T is expected to fall each year if it is kept on

the market. The best estimate is that annual sales in Year 2 will be 10,000 units less

than in Year 1, with a further fall in sales by 10,000 units each year until Year 5.

To prepare a production facility for manufacturing Product V instead of Product T,

an initial capital outlay of $2,000,000 would be required. Annual fixed costs would

increase by $160,000. The variable cost of making and selling Product V would be

$230 per unit.

The company’s cost of capital is 8%. Ignore inflation and taxation.

Required

(a) Using DCF analysis, calculate the NPV of a proposal to replace Product T with

Product V from Year 2 onwards.

(b) Estimate the minimum annual sales for Product V that would be required to

justify the immediate replacement of Product T with Product V. Assume that

the estimates of annual sales of Product T are correct.

and in each subsequent year that would be necessary before you

recommended the immediate replacement of Product T with Product V.

Assume that the estimates of annual sales of Product V are correct.

(d) List briefly the weaknesses or limitations in the financial analysis in part (a) to

15 Probabilities

A company is considering whether or not to invest in a project where the initial cash

investment would be $6,250,000. The project would have a five-year life, and the

estimated annual cash flows are as follows:

Year Cash inflows Cash outflows

$ $

1 3,000,000

1,500,000

2 4,000,000

1,800,000

3 5,000,000

2,400,000

4 4,000,000

1,700,000

5 3,000,000

1,000,000

The cost of capital is 10%.

The estimates of cash outflows are considered fairly reliable. However, the estimates

of cash inflows are much more uncertain. Several factors could make the annual

cash flows higher or lower than expected.

 Factor 1: There is a 20% probability that government measures to control the

industry will reduce annual cash inflows by 20%.

 Factor 2: There is a 30% probability that another competitor will also enter the

market: this would reduce the estimated cash inflows by 10%.

 Factor 3: There is a 40% probability that demand will be stronger than expected.

The company would not be able to supply more products to the market, but it

Practice questions

would be able to sell at higher prices and cash inflows would be 5% higher than

estimated.

Required

Calculated the expected net present value of the project.

16 Sensitivity

A company is considering an investment in a new project to make and sell a new

product that will have a five-year life. The project will require an investment of $3

million in equipment. The residual value of this equipment after five years will be

30% of its original cost.

The estimates of net cash flows from operations in each year of the project are as

follows:

Year Net cash flow

1 400,000

2 800,000

3 800,000

4 700,000

5 400,000

These cash flows are based on estimates that the annual increase in cash spending

on fixed costs will be $200,000, and the contribution/sales ratio from transactions

will be 40%. The company’s cost of capital is 8%.

The management of the company are aware that actual cash flows could be higher

or lower than those expected, and sensitivity analysis should be carried out to

establish the extent to which costs or revenues could differ from the estimate before

the project ceased to have a positive NPV.

The investment in working capital will be minimal. Inflation and taxation should be

ignored.

Required

(a) Calculate the net present value of the project.

(b) Carry out sensitivity analysis on the following items:

(i) the cost of the equipment, assuming that the residual value will be 30%

of cost

(ii) the residual value of the equipment

(iii) sales revenue

(iv) variable costs

(v) annual fixed costs.

By how much could each of these items vary in amount before the project

ceased to have a positive NPV?

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17 The Jin Company

The directors of the Jin Company are meeting to decide about the replacement of a

machine. The existing machine has to be replaced soon, and there is a choice of two

machines that could be purchased to replace it. These are Machine A and a larger

Machine, B. The following information is available about each machine:

Machine A Machine B

Expected working life 4 years 5 years

Initial cost $600,000 $750,000

Residual value $0 $0

Working capital requirement $100,000 $200,000

The forecast pre-tax cash flows that will be earned using each machine are as

follows:

Year 1 Year 2 Year 3 Year 4 Year 5

$000 $000 $000 $000 $000

Machine A 470 520 490 450

Machine B 580 640 500 500 400

The Jin Company uses 10% as its cost of capital for capital expenditure evaluation.

Taxation at 30% is payable one year in arrears. Capital allowances are available at

the rate of 25% each year on the reducing balance method. Inflation should be

ignored.

Required

(a) Calculate the NPV with each of the machines.

(b) Calculate the payback period for each machine.

18 Growth objective

A company has an objective in its long-term business plan of achieving significant

growth in its business in the period Year 1 to Year 5. It is now the end of Year 2.

Its results for the years to 31st December Year 1 and Year 2 are summarised below.

Income statement for the year ended 31 December

Year 2 Year 1

$ $

Sales 31,200,000 26,000,000

Cost of sales 18,720,000 15,600,000

12,480,000 10,400,000

Operating expenses 6,780,000 5,200,000

Interest charges

500,000 0

Depreciation 3,000,000 3,000,000

Net profit 2,200,000 2,200,000

Practice questions

Balance sheet as at 31st December

Year 2 Year 1

$ $

Non-current assets 27,300,000 26,000,000

Net current assets 15,600,000 7,800,000

42,900,000 33,800,000

Loan 9,000,000 0

33,900,000 33,800,000

Share capital 19,500,000 19,500,000

Accumulated profit 14,400,000 14,300,000

33,900,000 33,800,000

Sales are seasonal, and are much higher in the first six months of the year than in the

second six months. The half-yearly sales figures in the past two years have been as

follows:

Sales

Year 2 Year 1

$ $

1st January

–

30th June 21,645,000 16,900,000

1st July

–

31st December 9,555,000 9,100,000

31,200,000 26,000,000

The company employs part-time workers during the first six-months of each year.

Part-time workers operate for a full working week during the weeks that they are

employed. Employee numbers have been as follows:

Employee numbers

Year 2 Year 1

Full time employees 318 260

Part time (seasonal) employees 494 310

The company introduced four new products to the market in Year 1 and another

five new products in Year 2.

Required

Explain with reasons whether the company appears to be on course for achieving its

objective of growing the business.

In particular, you should consider growth in sales, profits, investment and product

range.

19 Gap analysis

Blank Company manufactures and sells a single product. Its budget for the next

financial year is as follows:

$000

Sales (80,000 units at $600 per unit)

48,000

Production costs: materials and labour

16,000

Other production costs 8,000

Marketing and distribution costs 12,000

Administration costs 10,000

Total costs

46,000

Profit

2,000

Paper P5: Advanced performance management

Materials and labour costs in production are 100% variable, and 25% of other

production costs are variable. All administration costs are fixed costs and two-thirds

of marketing and distribution costs are also fixed.

The directors of Blank Company are dissatisfied with the budgeted profit, and

believe that annual profits should be at least double the size of the budgeted profit.

Three strategies have been proposed to improve profitability.

(1) Strategy 1. Increase sales by opening a new sales office in a neighbouring

country. It is expected that this would increase annual sales by 5,000 units, but

would add $1.2 million to annual fixed costs.

(2) Strategy 2. Re-design the product by adding several additional features that

should add value for the customer. This would have no effect on annual sales

volume in units, but the company would be able to raise the sales price to

$625. The additional costs of producing the new product design would be $1.5

million each year (all fixed costs).

(3) Strategy 3. Implement a cost reduction exercise throughout the company. It is

expected that the planned exercise would reduce all variable costs by 20%, but

would add to annual fixed costs by $3.5 million.

Required

(a) Calculate the effect of each individual strategy on annual profit, assuming that

the strategy is implemented on its own, without the other two strategies.

(b) Show whether the three strategies, if they are all introduced together, will

close the profit gap between the budgeted profit and the target profit that the

directors would like to achieve.

20 Zero based budgeting

State briefly where zero based budgeting is likely to be of the greatest value and

suggest how often ZBB should be used.

21 Marginal

The marketing director of a company selling home entertainment products has

estimated that at a sales price of $250, a new product (the Blaze) will sell 400,000

units in the next year. He also estimates that for every $10 increase or reduction in

price, annual sales will fall or increase by 20,000 units below or above this 400,000

units level.

The production engineer has estimated that the costs of making the Blaze will be a

variable cost of $210 per unit sold and annual fixed costs of $20 million.

(a) You are given the following formulae:

Price function: P

= P

– bq

Total revenue function (TR): P

q – bq

Marginal revenue function (MR): P

– 2bq

ACCA - P5 Study text - Emile Woolf INT - 2010

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