Strategic Performance Management Professional 2 Examination Pilot Paper

Strategic Performance Management Professional 2 Examination Pilot Paper Notes: Answer all questions. Time Allowed 3.5 hours plus 10 minutes to read the paper Examination Format This is an open book examination. Hard copy material may be consulted during this examination subject to the limitations advised on the Institute s website. Reading Time During the reading time you may write notes on the examination paper but you may not commence writing in your answer booklet. Marks Marks for each question are shown. A mark of 50 or more is required to achieve a pass in this paper. Answers Start your answer to each question on a new page. You are reminded that candidates are expected to pay particular attention to their communication skills. Care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates answers and the extent to which the answers are supported with relevant legislation, case law or examples where appropriate. Answer Booklets List on the cover of each answer booklet, in the space provided the number of each question attempted. Additional instructions are shown on the front cover of each answer booklet. The Institute of Certified Public Accountants in Ireland

STRATEGIC PERFORMANCE MANAGEMENT PROFESSIONAL 2 EXAMINATION - PILOT PAPER TIME ALLOWED: 3.5 Hours and 10 minutes to read the paper. Answer ALL questions Hilda Smith was appointed CEO of General Industries Ltd. just under three years ago. The company is a manufacturer of computer peripherals and accessories (including USB sticks, printer cartridges, and many other items). In the months following her appointment, Hilda found that the company s strategy and its strategic performance management (SPM) system were well embedded and that there was little appetite for change among the company s directors. The main reason for the directors attitude seemed to be that the company had experienced steady (if unspectacular) growth in sales and profitability for several years. However, in most (although not all) divisions this steady growth levelled off in recent months, and Hilda seized the opportunity to obtain the directors approval to hire you as a consultant to advise on the SPM system and related matters. Hilda arranged a preliminary meeting with you to explain how she felt about the company and about her relationship with the directors. I m uneasy at their attitude of it ain t broken, so don t fix it. This company s strategy, its SPM system, and even its organizational structure were never really planned. Of course, I m not denying that the company has had a lot of success in the past, and I m not proposing that we should scrap everything and start again. But we do need to reexamine at least some things which we have just taken as given. Otherwise, we may find ourselves overwhelmed by competitive pressures which we are unable to respond to effectively. General Industries Ltd. sells most of its output to cost-conscious retailers including ebay shops, computer superstores, and discount stores. The company s strategy involves being very cost-conscious, and a cost-plus approach to product pricing is used extensively in the company. For this purpose, costs are traced to products using activity-based costing, and moderate profit markups are applied. The directors believe that this approach has helped to sustain strong sales volumes. Target costing is used prior to the introduction of new products. The company consists of several divisions, with each division being responsible for manufacturing and selling a particular product range. Nominally, each division manager has a lot of decision-making autonomy, says Hilda, but my conversations with these managers leaves me with the impression that they feel quite stressed by the way they and their divisions are managed from above. Of course, if you can t cope with a bit of stress then you shouldn t be a division manager, but I have tried to summarize their main concerns so that we can at least reflect on whether or not they have just cause for complaint. There has been noticeably high turnover of division managers in recent months, in spite of the competitive remuneration, so we have to at least consider whether there might be some things which we need to change.

Hilda explains that the division managers biggest grievance is with the system used to evaluate their performance. In principle, it s simple enough, says Hilda. At the start of each year, a division manager is assigned targets for divisional return on investment (ROI), activity-based profit margin on each major product, first pass yield, and sales volumes. In each case, the level of the target is handed down by the CEO (that s currently me!) At the end of the year, a division manager who has achieved all four targets is automatically awarded maximum bonus. As for those division managers who have achieved some but not all of the four targets well, the directors hold a meeting at which they decide subjectively how much bonus (if any) each such division manager should get. The division managers complain that this process is a bit too subjective. In particular, they complain that the decisions are sometimes mutually inconsistent or unfair, and that the directors may have gotten into the habit of using this decision process to signal to certain division managers that their future prospects in the company aren t bright. A second grievance on the part of division managers is that they often see opportunities which would (in the managers opinions) be good for the company, but they have to forego them either because of some aspect of the company s rules or because of a direct intervention by the CEO. For example, one division manager stated that he often has spare production capacity which he is unable to use because the company s rules preclude him from applying marginal cost pricing to the additional output. On the other hand, the manager of another division experiences frequent production bottlenecks and would like to have the authority to make unilateral decisions about investing in additional production capacity to alleviate such bottlenecks. Under the company s current capital budgeting procedures, a division manager only has authority to decide on capital investments of 50,000 or less. Any larger investments must be submitted to the board of directors for approval, and the division manager s application must include a demonstration that the proposed investment s ROI is likely to exceed the division s cost of capital in each year of the investment s useful life. Question 1 (a) Hilda Smith has drafted the following mission statement for General Industries Ltd., which she believes is an accurate encapsulation of the company s existing strategy: Our mission is to achieve cost leadership in the manufacture and supply of computer accessories and peripherals, through rigorous cost management and a strategic approach to pricing, thus securing the ability to forge sustainable business relationships with cost-conscious retailers. Explain the main ways in which this mission statement differentiates General Industries Ltd. from its competitors. (6 marks) (b) Suggest one non-financial performance measure (other than first pass yield) which should be used to assess the performance of each of the production

(c) managers in each of the company s factories. Justify your answer by reference to the company s strategy and mission. (4 marks) Which one competitor accounting technique would be most useful to General Industries Ltd.? Justify your choice by reference to the company s strategy and mission. (5 marks) (Total for Question 1: 15 marks) Question 2 Identify and evaluate the significant possible problems caused by the methods used to determine division managers bonuses in General Industries Ltd. (Total for Question 2: 20 marks) Question 3 Using the following example, prepare calculations to indicate the benefit to the company s shareholders of giving division managers full authority to make unilateral decisions about investing in additional production capacity to alleviate production bottlenecks: The company s Carlow Division manufactures two types of external hard drive ( Drive Y and Drive Z ). Production of each external hard drive requires a sequence of three manufacturing operations (identified here as Processes 1, 2 and 3, which must be carried out in that order). The total available capacity of each process (per annum) is as follows: Process 1 Process 2 Process 3 27,500 hours 15,000 hours 15,000 hours All production costs are fixed, apart from direct materials. No stocks of finished goods or work-in-progress are held. Summary of resource requirements and market data for each product: Drive Y Drive Z Process times, per unit of each hard drive: - Process 1 4 minutes 5 minutes - Process 2 1 minute 4 minutes

- Process 3 3 minutes 4 minutes Cost of raw materials, per drive: - in Process 1 7 10 - in Process 2 8 12 - in Process 3 9 13 Selling prices: 45 60 Maximum demand, per annum: 180,000 units 150,000 units An immediate investment of 2,500,000 would be required in order to purchase additional production equipment which would eliminate the bottleneck. Assume that this additional equipment would have a 4-year life and that it would increase fixed overheads (excluding depreciation) by 600,000 during each year of its life. The cost of capital is 10% per annum (present value tables are available with this paper). (Total for Question 3: 20 marks) Question 4 One of the few divisions which earned a higher-than-budgeted profit in the last financial year (i.e., 2007) was the Empire Division. This division manufactures specialised computer components which are useful in protecting wireless networks against unauthorised access. The Empire Division sells both standard and enhanced versions of the component, and the following data is taken from the division s budget for 2007: Standard Version Enhanced Version Sales quantities 108,000 units 162,000 units Selling price per unit 18 20 Variable cost per unit 10 13 The budget also included fixed overhead costs of 900,000, which were not expected to vary irrespective of the quantity or mix of products sold. It was noted that the company s combined sales of components (in units) amounted to 48% of the estimated total market for such components in the country of sale. Early in 2007, Hilda Smith became concerned about the possibility that the Empire Division s high market share might attract unwelcome attention from government regulators. Accordingly, she instructed the division manager that the division should

not pursue any further market share growth, but should instead to try to improve profitability by changing the sales mix. The actual total market in 2007 for this type of component amounted to 650,000 units, including sales by the Empire Division of 125,580 units of its standard version and 173,420 units of its enhanced version. The Empire Division s selling prices, fixed costs, and per-unit variable costs were exactly as budgeted. Hilda Smith s comment on the actual results for 2007 was as follows: on the one hand, I am glad that the division achieved a higher profit that budgeted on the other hand, the fact that sales of both versions of the product were higher than budgeted seems to suggest that the division manager failed to comply with my instructions as to how improved profitability should be achieved. Required (a) Calculate the Empire Division s budget and actual profit for 2007. Then, prepare variance analysis calculations in as much detail as is possible from the information provided. (14 marks) (b) Respond to Hilda Smith s statement that the division manager failed to comply with her instructions as to how improved profitability should be achieved. Also, comment on whether Hilda s instructions were appropriate in this case. Support your answer to this part by reference to the results of your calculations in part (a). (6 marks) (Total for Question 4: 20 marks) Question 5 From your conversations with Hilda Smith, you have ascertained that she encourages divisions to use target costing as one means of ensuring adequate profitability. By way of illustration, she has provided you the following information which relates to the Wexford Division of General Industries Ltd., which produces computer keyboards and mice. The research and development (R & D) staff of the Wexford Division recently developed a range of three potential new types of cordless computer keyboard, and (following consultation with production and marketing staff) the following estimates of machine hours (MH) and monthly output were arrived at: Keyboard A Keyboard B Keyboard C Production and sales, per month 8,000 units 10,000 units 4,000 units MH, per unit of output 3 MH 2 MH 1 MH

Having received the above data, the Wexford Division s management accountant consulted widely in the division, and on this basis developed the following estimates of the activity levels and overhead costs associated with the production of the potential new keyboards: Production set-up: There would be a total of 500 production set-ups per month, at a total cost of 300,000. Materials movements: There would be a total of 12,500 materials movements per month, at a total cost of 250,000. Machine running costs: These would amount to 1 per MH worked. A target costing team (chaired by the divisional management accountant, and including representatives from all functional management areas in the division) determined that none of the three keyboards was likely to be adequately profitable given the expected market conditions and the above cost information. Subsequently, at the request of the target costing team, the R & D staff made some changes to the designs of the three keyboards which would have the effect of simplifying the production processes without adversely affecting the attractiveness and functionality of the finished products to customers. The following is a summary of the reductions in activity levels associated with each product as a result of the design simplifications: Reduction in number of production set-ups Reduction in number of materials movements Reduction in number of MH per unit of output Keyboard A Keyboard B Keyboard C No reduction 8 per month 12 per month No reduction 900 per month 300 per month 1 MH per unit of output No reduction No reduction Required: (a) Assuming that the proposed design changes are implemented, calculate the reduction in the unit cost of each of the three keyboards in each of the following circumstances: If all overheads are traced to products using activity-based costing. If all overheads are allocated to products on the basis of the number of units of output. (12 marks) (b) Explain why it is essential for the divisions of General Industries Ltd. to use activity-based costing information in order to achieve strategic advantage from the

implementation of target costing. Use the example of the Wexford Division to illustrate your answer. (6 marks) (c) A member of the accounting staff in the Wexford Division (who recently joined General Industries Ltd. from another company which also manufactures computer keyboards) has commented on the cost driver rate for production set-up in the proposed manufacture of cordless keyboards. His comment is that the rate seems rather high and that benchmarking offers one means for the Wexford Division to address the problem. Respond to this suggestion. (7 marks) (Total for Question 5: 25 marks) END OF PAPER

THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND STRATEGIC PERFORMANCE MANAGEMENT PROFESSIONAL 2 EXAMINATION PILOT PAPER SUGGESTED SOLUTIONS

Solution 1: Part (a): The mission statement provided by Hilda Smith distinguishes General Industries Ltd. from its competitors in several ways. First, an emphasis on rigorous cost management (e.g., through minimizing non-value-adding costs of manufacturing or marketing) is fundamental to the goal of price leadership. Second, it is clear that the company has a strategic (as opposed to opportunistic) approach to pricing, since costs are traced to products using activity-based costing and a profit markup (albeit a moderate one) is required from each product. Finally, it is this combination of low cost and strategic pricing which enables General Industries Ltd. to make use of particular types of outbound supply chain (namely, cost-conscious retail outlets such as ebay shops) which would be unavailable to less price-competitive manufacturers. Part (b): One appropriate measure would be the manufacturing cycle time, which is the length of time which elapses between when production commences and when the customer receives the goods ordered. Manufacturing cycle time consists of the time for four separate activities, but only one of these (processing) adds any value. The other three activities (inspection of products; movement of work-in-progress; and queuing of work for processing facilities to become available) are not. Thus, reduction of the manufacturing cycle time by reduction of the time taken for these activities has two benefits, namely, (i) elimination of unnecessary costs and (ii) reduction in the time taken to fill customer orders. This is highly consistent with the company s strategy of cost leadership and with forging long-term business relationships with customers who will be pleased by the improved speed with which orders are fulfilled. Part (c): The achievement of cost leadership over competitors is a fundamental plank of General Industries Ltd. s strategy. Therefore, competitor cost assessment is almost certainly the competitor accounting technique which would be most useful for this company. Given its strategy and mission, General Industries Ltd. needs to engage in competitor cost assessment to guard against the possibility that a competitor will develop a cost advantage which will allow it to (for example) begin to steal market share from attack (which involves regularly estimating General Industries Ltd). A specific example of competitor cost assessment would be monitoring changes in the location of competitor s production capacity (e.g., relocation of production overseas) and assessing the impact of such changes on the competitor s cost levels. Solution 2: The following problems arise: 1. Targets are apparently set on a wholly top-down basis by the CEO. If managers perceive some or all of their division s targets as unrealistically difficult, then at the end of the year they may perceive that they have been unjustly deprived of bonuses which their effort and skill levels entitle them to.

2. There are effectively upper bounds in place on each of the four performance measures, e.g., a division manager who precisely achieves his or her target on all four measures receives the same bonus as a manager who significantly exceeds all four targets. Of course, there can be good reasons for this approach (e.g., it is often argued that it encourages managers to pursue steady and sustainable growth strategies rather than exceptional one-off performance). The danger, however, is that upper bounds can dilute the incentive effect of a performance target (e.g., if the target is set at too low a level so that the division manager can achieve the target without significant effort). 3. It is unclear how the upper bounds operate in cases where a manager achieves some (but not all) of his or her performance targets, and this may be the basis for the perceived inconsistency or unfairness referred to in the case. For example, if a manager exceeds two of his targets but falls short on the other two, should he expect the directors assessment as to how much bonus (if any) he will receive to depend on the extent to which he exceeded or fell short? If division managers were provided with a proper understanding of how the directors make their judgments (including the answers to questions such as these), the perception that the process was too subjective might well change. 4. There appears to be considerable inconsistency of corporate governance in the functioning of this part of the strategic performance management (SPM) system. For example, the CEO sets targets for each of the four performance measures; bonuses are automatic in some cases; and bonuses are at the discretion of the board of directors in other cases. The operation and design of a management control system is a difficult task which involves ongoing changes; there is never an easy optimal model which can be used. This makes it all the more important that someone should have ownership of the process. The present structure does not seem to provide this. For example, it is not even clear who (if anyone) has the authority to suggest changes to the set of measures used for the annual divisional performance evaluation. 5. If it is true that (as the division managers perceive) the board of directors uses the process of deciding on bonuses as a means to signal to certain division managers that their future prospects in the company are poor, then this is neither ethical nor sensible. It is unethical because it means that individual managers are being deprived of bonuses to which the board believes the individuals are entitled. It is also ineffective since an unwanted manager might achieve all four of his or her targets and thus the board would not be able to prevent him or her from qualifying automatically for maximum bonus. If the board no longer wants to retain the services of a particular division manager, then it would be better if the board were to offer him or her a redundancy package rather than to try to engineer the manager s resignation. Solution 3 continued on next page

Solution 3: Step 1: Identify the bottleneck, given existing process capacities: Process 1 Process time needed, to supply maximum demand Drive Y Drive Z Total process time required (hours) 180,000 * 4 min = 12,000 hours Capacity (hours) 150,000 * 5 min = 12,500 hours 24,500 27,500 Utilisation rates 24.5 / 27.5 = 89% Process 2 180,000 * 1 min = 3,000 hours 150,000 * 4 min = 10,000 hours 13,000 15,000 13 / 15 = 87% Process 3 180,000 * 3 min = 9,000 hours 150,000 * 4 min = 10,000 hours 19,000 15,000 19 / 15 = 127% Bottleneck resource = Process 3. Step 2: Identify the optimal production plan: Optimal use of the bottleneck (Process 3): Drive Y Drive Z Selling price 45 60 Raw materials 7+ 8+ 9 = 24 10+ 12+ 13= 35 Contribution 21 25 Time (per unit) on the bottleneck process 3 minutes 4 minutes Return per minute on the bottleneck process 21 / 3 min = 7 25 / 4 min = 6.25

Hence: Optimal product mix: Units of product Process 3 hours used Process 3 hours remaining Drive Y 180,000 drives 180,000 drives * 3 minutes = 9,000 hours 15,000 9,000 =6,000 hours Drive Z 6,000 hours / 4 minutes = 90,000 drives 6,000 hours NIL Step 3: Identify unfulfilled demand, due to bottleneck resource: Units of product Maximum demand Unfulfilled demand (optimal product mix) Drive Y 180,000 180,000 NIL Drive Z 90,000 150,000 60,000 units Hence, the effect of elevating the bottleneck would be to increase sales of Drive Z by 60,000 units per annum. Step 4: Financial effect of elevating the bottleneck: t 0 t 1 t 4 Cost of upgrade - 2,500,0000 Extra contribution = [60,000 * 25] + 1,500,000 Fixed Costs - 600,000 Totals - 2,500,000 + 900,000 NPV @ 10% = - 2,500,000 + ( 900,000 * 3.170) = + 353,000

Solution 4: Part (a): Contributions per litre (budget and actual): o Standard: 18-10 = 8. o Enhanced: 20-13 = 7. Profit: Standard Enhanced Standard: contribution 8 * 108,000 = 864,000 8 * 125,580 = 1,004,640 Enhanced: contribution 7 * 162,000 = 1,134,000 7 * 173,420 = 1,213,940 Fixed costs 900,000 900,000 Profit 1,098,000 1,492,000 Total sales units: Standard Enhanced 108,000 + 162,000 = 270,000 125,580 + 173,420 = 299,000 Budgeted sales mix: o Standard: 108,000 / 270,000 = 40%. o Enhanced: 162,000 / 270,000 = 60%. Budgeted weighted average contribution per unit = (40% * 8) + (60% * 7) = 7.40. SQV = (AQ BQ ) * Weighted ave budget contribution per unit = (299,000 270,000) * 7.40 = 214,600F

Sales mix variance (SMV): AQ, in actual mix AQ, in standard mix Standard contribution per unit Variance Standard: 125,580 119,600 8 47,840 F Enhanced: 173,420 179,400 7 41,860 U 299,000 299,000 Total SMV = 5,980 F Market size variance: o Actual market size = 650,000. o Budget market size = 270,000 / 0.48 = 562,500 o Budget market share percentage = 270,000 / 562,500 = 48%. o Variance = (650,000 562,500) * 48% * 7.40 = 310,800 F. Market share variance: o Actual quantity = 299,000. o Standard share of actual market = 48% * 650,000 = 312,000 units. o Variance = (299,000 312,000) * 7.40 = 96,200 U. Part (b): Sales mix: There has been a change in sales mix in accordance with Hilda s instructions, resulting in a favourable sales mix variance of 5,980. Although this seems like a fairly small variance, two points must be made: o The two products do not differ greatly in their contributions per unit ( 8 vs. 7) so it is difficult to achieve a very significant mix effect. o In accordance with Hilda s instructions, the more profitable product (i.e., Enhanced ) has increased its share of total sales volume by two percentage points: Budget Actual Standard: 40% 42% Enhanced: 60% 58%

Market share: Although total sales units have increased in absolute terms (resulting in a very significant sales quantity variance), nevertheless the division s percentage market share is less than budgeted. The variance analysis shows that there was a favourable sales quantity variance of 214,600, but this would have been even higher (to the extent of 96,200) if the division had retained its budgeted 48% market share. The division s actual market share was 299,000 / 650,000 = 46%, i.e., two percentage points lower than budget. In summary: The division manager seems to have complied with both aspects of the managing director s instructions. Hilda should note that, despite the increase in profits in 2007, the strategy appears to be a costly one. The opportunity cost of allowing the market share to decrease was offset only to a very slight extent by the change in sales mix. Solution 5: Part (a): Cost driver rates: Set-up: 300,000 / 500 = 600 per set-up. Movement: 250,000 / 12,500 = 20 per movement. Machining: = 1 per MH. Cost savings as a result of the design changes to Keyboard A: = (1 MH * 1 per MH) = 1 per unit of Product A. Cost savings as a result of the design changes to Keyboard B: Set-up: (8 * 600) = 4,800 per month. Movement: (900 * 20) = 18,000 per month. Cost savings as a result of the design changes to Keyboard C: Set-up: (12 * 600) = 7,200 per month. Movement: (300 * 20) = 6,000 per month. Effect of using ABC cost savings due to design changes will be traced directly to the product concerned. Hence, the cost reductions per unit will be: Keyboard A: 1. Keyboard B: [( 4,800 + 18,000) = 22,800] / 10,000 = 2.28. Keyboard C: [( 7,200 + 6,000) = 13,200] / 4,000 = 3.30. Effect of allocating overheads on a units of outputs basis

Total cost savings = (8,000 * 1) + 22,800 + 13,200 = 44,000. Total output (units) = 8,000 + 10,000 + 4,000 = 22,000. Cost saving = 44.000 / 22,000 = 2 per unit of any product. Part (b): When the anticipated cost of manufacturing a keyboard is so high that the keyboard would not provide the division with its required profit margin, a target for cost reductions must be set and achieved if the keyboard is to be manufactured. These cost reductions can be brought about by design changes to the keyboard. An ABC system is essential in order to ensure that any cost savings made as a result of changing the design of any keyboard are fully reflected in the reported cost of that keyboard, instead of being unfairly spread over several keyboards. In part (a), we see that if overheads are allocated to all units on the basis of units of output, then it appears that the design changes have resulted in the costs of a unit of each keyboard (A, B or C) having been reduced by 2. ABC analysis is required in order to show that the cost savings resulting from the design changes differ substantially as between the three keyboards. The impact of the design changes on the cost of keyboard A is more modest than suggested by the non-abc data, because all that has happened is a 1-hour reduction in machine time giving rise to a 1 reduction in machining costs. Similarly, the ABC data is necessary to reveal the full impact of the activity reductions on the unit cost of keyboards B and C (whose costs are reduced by substantially more than the 2 indicated by the non-abc analysis). Example: Suppose that management had decided that, given the need to compete successfully with rival firms products and prices, a 2 unit cost reduction was necessary before any of the new cordless keyboards should be introduced to the marketplace. The ABC analysis shows that this target has been achieved for keyboards B and C (but not A), and therefore only B and C are economically worthwhile. If management had relied on the non-abc data, it would have drawn the precisely opposite (and wrong) conclusion. Part (c): Benchmarking may have some potential for the purpose suggested. The specific goal would be to learn (by comparison with another division or company) how to carry out the set-up activity more efficiently but without without creating adverse side effects. For example, one reason for the lower set-up cost in the other company may have been that the operation was performed less carefully, and this behaviour would not be worth emulating because it would be likely to increase costs during the production run (e.g., from frequent machine breakdown).

However, the potential of benchmarking should not be overlooked, It is possible that the other company has developed an efficient and high-quality set-up routine which is worth emulating. Of course, one consideration is that this excellence may have come at a cost e.g., the other company may have made a very large capital investment in manufacturing technology in order to reduce costs, and General Industries Ltd. may not have the funds to follow suit. However, given the importance of cost leadership to its competitive strategy, the company cannot afford to ignore the other keyboard manufacturer s cost advantage in relation to production set-up. Another problem is that the competitor will likely be unwilling to share information with General Industries Ltd. as to how its cost advantage in relation to production set-up. Of course, the accounting staff member who previously worked in that company may have some insights which he can share with the Wexford Division. Furthermore, the Wexford Division may find that it can learn how to reduce set-up costs by studying other divisions of General Industries Ltd. (or perhaps even the manufacturing operations of other manufacturers which are highly efficient but which do not compete directly with General Industries Ltd).