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					Performance Management
PART 3 FRIDAY 6 JUNE 2003

QUESTION PAPER Time allowed 3 hours This paper is divided into two sections Section A BOTH questions are compulsory and MUST be answered TWO questions ONLY to be answered

Section B

Present Value and Annuity Tables are on pages 7 and 8

Paper 3.3

Section A – BOTH questions are compulsory and MUST be attempted 1 A motor car manufacturer has been specialising in the production and sale of one model of car. The model is somewhat dated, and the current sales forecast indicates that the sales will decline from the current level (2003) of 170,000 cars per annum to 150,000 in 2004, 130,000 in 2005 and 110,000 in 2006. The company supplies to order and no stocks are held. Carbon monoxide emission regulations will prevent the model being manufactured and sold after December 2006. The company’s current estimates of the selling price and costs in 2004 are as follows: Per car £ 9,500 3,600 4,000

Selling Price Production costs: Material and labour (vary with production volume) Assembly*

*75% of the assembly costs are fixed and the remainder vary with production volume. In addition, the company estimates that it will incur the following non-production costs: Marketing costs of £60 million. 50% of these vary with sales volume Delivery costs of £75 million. 20% of these vary with sales volume. The Administration costs of £10 million are fixed. The selling price, variable costs per car and total fixed costs are expected to remain constant throughout the period from 2004 to 2006. The company’s Managing Director is unhappy with the current annual profit forecasts for 2004–2006 based upon the information above and believes that the company has the potential to increase the profit to £280m in each of the years 2004 to 2006. The Managing Director has undertaken a strategic review and developed the following strategies: Strategy 1 A marketing proposal will enable the company to enter a new overseas market with the result that the total (including the overseas market) sales level will be stabilised at 160,000 cars per annum from 2004 to 2006. The market entry costs will be £30 million for each of the three years. Strategy 2 A re-design of the car will enhance its sales appeal and will permit the company to increase its selling price to £10,000. The re-design costs are £30 million and are to be amortised over three years on a straight line basis. Strategy 3 A radical cost reduction programme will improve efficiency and lower all variable costs by 20%. This will add £70 million to the annual fixed overheads each year from 2004 to 2006.

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Required: (a) Prepare a financial analysis showing the current annual forecast of costs, revenues and profits for each of the years 2004 to 2006 and briefly comment on the figures. Ignore inflation. (6 marks) (b) Estimate the profit in 2004 if: (i) Strategy 1 was implemented; (2 marks) (2 marks) (2 marks) (4 marks)

(ii) Strategy 2 was implemented; (iii) Strategy 3 was implemented. (c) Estimate the profit in 2004 if all three strategies were implemented.

(d) Explain why the total of the increase in profit arising from the three strategies implemented separately in (b) is different from the total profit calculated in (c). Illustrate your answer with a numerical reconciliation of the differences in the two profit figures. (5 marks) (e) Explain how ‘Gap Analysis’ can be used to assist a company to plan the achievement of its strategic profit objective. Illustrate your answer with a diagram which quantifies the effect of your calculations in (a), (b), (c) and (d) above. (7 marks) (f) (i) Explain how sensitivity analysis could be used in conjunction with the profit estimates that you have made for the company and illustrate your answer with reference to each of the strategies;

(ii) Calculate and comment on the percentage change in the key variable in each of strategies 1, 2 and 3 from its original forecast level in order that the desired profit level of £280m for 2004 will be achieved in each case. (8 marks) (g) What major external environmental factors need to be considered in assessing the success of the three strategies? (4 marks) (40 marks)

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A large conglomerate with diverse business activities is currently considering whether it should commence Project X and has gathered the following data: Project X Data 1. An initial investment of £54 million will be required on 1 January year 1. The project has a three year life with a nil residual value. Depreciation is calculated on a straight line basis. 2. The project is expected to generate annual revenue flows of £80m in year 1, £90m in year 2 and £100m in year 3. These values may vary by ±5%. 3. The incremental costs will be £50m in year 1, £60m in year 2 and £70m in year 3. These may vary by ±10%. 4. The most likely cost of capital is 10%.This may vary from 8% to 13% for the life of the project. Additional information: Assume that all cash flows other than the initial investment take place at the end of each year. Use the written down value of the asset at the start of each year to represent the value of the asset for the year. Note: Ignore taxation Required: (a) Prepare two tables showing net profit, residual income and return on investment for each year of the project and also net present value (NPV) for: (i) The BEST OUTCOME; (8 marks)

(ii) The WORST OUTCOME.

(b) Explain the distinctive features of Residual Income, Return on Investment and Net Present Value in measuring financial performance. Your answer should include a critique of the strengths and weaknesses of each measure. (8 marks)

(c) What broader issues are likely to be considered when deciding whether the company should proceed with a particular project? (4 marks) (20 marks)

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Section B – TWO questions ONLY to be attempted 3 Velo Racers has designed a radically new concept in racing bikes with the intention of selling them to professional racing teams. The estimated cost and selling price of the first bike to be manufactured and assembled is as follows: Materials Assembly Labour (50 hours at £10 per hour) Fixed Overheads (200% of Assembly labour) Profit (20% of total cost) Selling Price £ 1,000 1,500 1,000 1,500 ––––– 3,000 –––––

Velo Racers plans to sell all bikes at total cost plus 20% and the material cost per bike will remain constant irrespective of the number sold. Velo Racers’ management expects the assembly time to gradually improve with experience and has estimated an 80% learning curve. A racing team has approached the company and asked for the following quotations: 1. 2. 3. If we were to purchase the first bike assembled, and immediately put in an order for the second, what would be the price of the second bike? If we waited until you had sold two bikes to another team, and then ordered the third and fourth bikes to be assembled, what would be the average price of the third and fourth bikes? If we decided to immediately equip our entire team with the new bike, what would be the price per bike if we placed an order for the first eight to be assembled?

Required: (a) Explain Learning Curve Theory and in particular the concept of cumulative average time. (b) Provide detailed price quotations for each of the three enquiries outlined above. (4 marks) (6 marks)

(c) Identify the major areas within management accounting where learning curve theory is likely to have consequences and suggest potential limitations of this theory. (10 marks) (20 marks)

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A mixed economy operates a range of public services including Fire, Police, Education and Health. The services are provided on a regional basis but are funded from central government taxation. The government is endeavouring to improve the ‘overall performance’ of the services and is considering a range of issues surrounding this objective. Required: (a) Explain the term ‘overall performance’ in respect of public services and suggest a structured approach to its assessment. Your answer should be from a generic point of view and references to particular services should be used only for illustrative purposes. (10 marks) (b) Explain the particular problems that are likely to occur in attempting to monitor the performance of a public service that would not arise when assessing private sector activities. (6 marks) (c) Suggest ways in which the problems that you have highlighted in answering section (b) may be managed or overcome. (4 marks) (20 marks)

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‘A competent management accounting system should endeavour to enhance the performance of a company. It should, in particular, consider the behavioural consequences of the system.’ Required: (a) Explain why it is necessary when designing a management accounting system to consider the behavioural consequences of its application. (5 marks) (b) Explain the potential behavioural issues that may arise in the application of performance monitoring, budgeting and transfer pricing and suggest how problems may be overcome. (15 marks) (20 marks)

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End of Question Paper

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