QUESTION 1

John Sibanda was recently appointed CEO of Conly Group, a divisionalised company formed
by the merger of several previously independent companies. On becoming CEO, John spent a
number of weeks on what he calls a “meet and greet” tour in which he visited each of the
company’s divisions for two days to get to know management and other staff, as well as the
business. He told you “I also wanted to get a feel for how well or badly each division is being
run and to watch for signs of “lame ducks” among the divisions that might not be paying their
way or where change might be needed”.
Subsequently John contacted you as a Master of Science in Accounting and CIMA graduate to
ask for your assistance in what he called “bringing things to the next level”. He told you that
you have two advantages which he does not possess. The first one being your professional
accounting background and the capacity for analytical rigour which it provides. The second
being your lack of any previous involvement with Conly Group, which allows you what he
calls “a detachment and an ability to be brutal where necessary which I don’t have as a hands
on CEO”.
After a long conversation with John about the impressions which he formed during his “meet
and greet” tour, you met with each divisional manager individually. These were more formal
and structured meetings than the ones John had with the managers. In your meetings divisional
managers explained their performance measurement systems to you and demonstrated them
through accompanying documentation and procedures. After conducting these meetings and
reflecting on the outcomes, you requested a follow up meeting with John so that both of you
could map the way forward.
At this follow up meeting you told John “The good news is that each of the divisions is being
fairly competently run and is generating significant shareholder value. A programme of
divestments or firing divisional managers is neither necessary nor advisable. However, in
many cases there is scope for much more rigorous approach on the part of those managers. In
quite a few cases, it seems that they are relying on intuition, experience and text book
knowledge. That approach can result in “adequate” performance at least for a while, but I
have come across instances where a more analytical approach is possible and would be
effective. For example, I have met one divisional manager who told me that “my transfer
pricing system isn’t working but I don’t know why”. This type of difficulty could lead to serious
recurring underperformance if left unchecked but in fact there is a lot that can be done to help
managers improve the quality of performance management and this will ultimately lead to
better financial results”.
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To facilitate the rollout of this revised approach John has asked you to begin by addressing
issues in the Yellow Division as outlined below.
The Yellow division consists of a number of autonomous profit centres. Some of these profit
centres manufacture various types of components while the other profit centres manufacture
finished consumer products (FCPs). In accordance with what he believes to be the best
economic practice, the division manager Ben Dube has decreed that the transfer price which
applies when components are sold to a FCP centre should be the marginal cost of the
component (up to the point of transfer) plus the opportunity cost of making the transfer. In
recent months however, Ben has received complaints from the managers of the FCP profit
centres that the managers of component profit centres have frequently refused to make any
components available to transfer, even though spare production capacity exists in the
component profit centres. Ben has said “I’m very surprised to hear of this failure to cooperation,
especially since the transfer pricing rule I have decreed is the optimal one according to the
economics textbooks”.

REQUIRED
(a) Evaluate the likely reasons for such behaviour identified above especially the refusal of
the managers of components profit centres to make any components available for
transfer even when there is spare production capacity. (4 marks)

(b) Critically assess in detail, the range of options available to Ben in order to increase the
likelihood that the components profit centre managers will behave in a goal congruent
way in relation to making the components available to transfer. (15 marks)

(c) John Sibanda believes Ben himself may sometimes engage in a behaviour which does
not promote goal congruence, and that the performance evaluation system in use may
be to blame. As an example, John states the instance where (in the last week of the most
recent financial year), Ben sold trade receivables with a book value of $500 000 to a
factoring agency at a discount of $20 000 and immediately remitted the proceeds to
Conly Group’s headquarters. John notes that there was no likelihood of the debt going
“bad” and no need for factoring and losing money in the process as the company could
have collected the full amount a month later. Ben receives a fixed annual bonus in the
year in which the Green division reaches or exceeds the target of the Residual Income.

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 Critique the likely reasons why Ben engaged in this behaviour, and recommend and
justify changes which John should consider making in terms of the way Jim’s
performance is measured and rewarded. (6 marks)

QUESTION 2
Exotic Private Company (EPC) manufactures three types of pet food. EPC has had a large and
stable market share for many years, which it attributes to the high quality of its products.
Recently, however EPC has experienced increasing competitive pressures. Although it believes
that its customers’ criteria in purchase decisions are “product quality first, price second”,
nevertheless EPC acknowledges that its increasingly strong competitors pose a growing threat
that must be addressed. The manager of EPC, Patrick Moyo has said “If our competitors offer
lower prices for the same product quality, then we have to determine how we can respond
effectively so as to preserve our market share and profits. As a starting point, I have
commissioned an activity based costing (ABC) exercise to provide a comprehensive insight
into the costs of our products and of activities that are carried out in order to manufacture and
distribute them”. The following information has been assembled for ABC purposes:
 EPC manufactures 3 products namely Pooch, Friend and Soulmate and a summary of a
typical month’s production inputs is as follows:
Pooch Friend Soulmate
Raw materials $1.80 $2.88 $3. 60
Total input (kgs) 20 000 16 000 3 500
 EPC carries out four main activities in relation to the 3 products.
1. Materials control, i.e inspection of incoming materials, to verify that they conform
to the specifications of what was ordered,
2. Process, i.e, manufacture of the various products.
3. Product control i.e quality control inspection of the finished products
4. Dispatch i.e shipment of finished products to customers
 For each of these activities, the nature of the long run cost driver relationship is that the
total cost is determined by the number of occasions the activity is carried out,
irrespective of the size or the composition of any batch. The product control activity is
carried out twice. Once for each batch of products manufactured and once for each
batch of products dispatched to the customers. For other activities, the details of the
batch sizes for each product are as follows:

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 Pooch Friend Soulmate
Materials control 2000 kg 800 kg 700 kg
Process 500 kg 400 kg 350 kg
Dispatch 500 kg 200 kg 100kg
 The total costs incurred in performing the four activities in a typical production month
are as follows:
Materials control $7 000, Process $13 500, Product control $22 600 and Dispatch
$10200
 Some of the products manufactured fail the first quality control tes (i.e at the end of the
production process) and are immediately discarded. The proportion of output loss is as
follows:
Pooch 10%, Friend 10% and soulmate 20%
REQUIRED
a) Using the ABC approach, determine the cost driver rate for each of the four activities
and the cost per kilogram of output for each of the products. (15 marks)
b) Critically appraise options as to how EPC could use the results of ABC analysis in
deciding how it can most successfully respond to the competitive pressures which it
now faces. Make reference to the results of your analysis in part a. (7 marks)
c) Suggest any other tools that can be employed by EPC in trying to improve its
competitive advantage under the circumstances and give brief explanation on their
implementation (8 marks)

QUESTION 3
A small regional airport is modernising its facilities in anticipation of significant growth in the
number of passengers using the airport. It is expected that the number of passengers will
increase by 10% per annum as a result of a “low cost” airline opening new routes to and from
the airport.

At present, the airport has only one food outlet selling sandwiches and other cold food and
drinks. To improve the facilities available to customers, the management of the airport is
considering opening a restaurant selling a range of hot food and drinks. The cost of fitting out

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the new restaurant, which will have to be fully refurbished after four years, is estimated to be
$350,000. These assets are expected to have a residual value of $30,000 at the end of four years.
A firm of consultants carried out an extensive study in relation to this project at a cost of
$30,000. The key findings from their report, regarding expected revenue and contribution from
the restaurant, are as follows:
Average revenue: $9·00 per customer
Average variable cost: $5·00 per customer
Demand in year 1: 500 customers per day
Future demand for the restaurant is expected to rise in line with passenger numbers.
The airport operates for 360 days per year. Other relevant information from the consultants’
report is listed below:

Staffing of the new restaurant:

Number of employees (Years 1 and 2): 4
Numbers employees (Years 3 and 4): 5
Average salary per employee: $20,000 per annum

Overheads
The annual budgeted fixed overhead of the airport which will be apportioned to the restaurant
is $80,000.
The annual overheads apportioned to the cold food outlet will be $30,000.

The airport’s overheads are expected to increase by the following annual amounts as a direct
result of the opening of the restaurant:

o Electricity: $40,000
o Advertising: $20,000
o Audit: $10,000

Cold food outlet

The average contribution from the sale of cold food is $2·50 per customer. If the restaurant is
not opened it is expected that the cold food outlet will sell to 1,200 customers per day in the

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coming year and in subsequent years the customer numbers will rise in line with passenger
numbers.

If the restaurant is opened, the consultants expect sales from the existing cold food outlet to
initially reduce by 40% in year 1 and then to increase in line with passenger numbers. The
airport’s Financial Director has provided the following taxation information:

 Tax depreciation: 25% reducing balance per annum.

 The first year’s tax depreciation allowance is used against the first year’s net cash
inflows.
 Taxation rate: 30% of taxable profits. Half of the tax is payable in the year in which it
arises, the balance is paid the following year.
 Any taxable losses resulting from this investment can be set against profits made by the
airport company’s other business activities since the airport company is profitable.
 The airport company uses a post-tax cost of capital of 8% per annum to evaluate
projects of this type. Ignore inflation.

REQUIRED:
(a) Calculate the net present value (NPV) of the restaurant project. (14 marks)

(b) The Managing Director of a company has been presented with the details of three
potential investment projects. He has very little experience of project appraisal and
has asked you for help.
The project details are given below:-

The project details are given below:- Project A Project B Project C

Expected NPV $150,000 $180,000 $180,000
Standard Deviation of Expected NPV $10,000 $50,000 $30,000
IRR 12% 12% 10%

The three projects will require the same level of initial investment. The projects are mutually
exclusive and therefore the Managing Director can only choose one of them.

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REQUIRED:

Interpret the information for the Managing Director (your answer should include an
explanation of the factors he should consider when deciding which project to undertake).

(6marks)

END OF EXAMINATION PAPER

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