OPERATIONAL CASE STUDY February 2019 EXAM ANSWERS

Variant 2

SECTION 1

DECISION CRITERIA UNDER CONDITIONS OF UNCERTAINTY

The three decision criteria used under conditions of uncertainty are known as maximax,
maximin and minimax regret.

Maximax criterion

A decision maker that uses the maximax criterion is an optimist. Using this approach, the
option chosen will be the one that offers the maximum monthly return. The maximum return
here for each product range are: F$218,400 for the climbing wall, F$174,000 for the playhouse
and F$256,800 for the adventure platform.

Therefore, under this criterion we will choose the adventure platform as this gives us the
highest possible return.

Maximin criterion

A decision maker that uses the maximin criterion is a pessimist. Using this approach, the range
that maximises the minimum return achievable will be selected. The minimum returns for each
of the three ranges are: F$40,800 for the climbing wall, F$108,000 for the playhouse and
F$32,400 for the adventure platform.

Therefore, under this criterion we will choose the playhouse as this is the highest of the three
lowest returns.

Minimax regret criterion

A decision maker that uses the minimax regret criterion is often referred to as a “bad loser”.
The decision is made by firstly identifying the product range that maximises the return at each
of the three market conditions. The differential between the highest return and the other two
at each of the market conditions represents the regret of having made a bad choice.

If the market demand is low the playhouse has the best return and so the regret of choosing
the playhouse is F$0. The climbing wall has a regret of F$67,200 (= F$108,000-F$40,800)
and the adventure platform has a regret of F$75,600 (= F$108,000-F$32,400).

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Once we have completed the regret table we then choose the product range that minimises
the maximum regret, or to put it another way, we select the best of the worst. So, the maximum
regrets for each product range are: F$67,200 for the climbing wall, F$82,800 for the playhouse
and F$75,600 for the adventure platform.

Therefore, under this criterion we will choose the climbing wall as this has the minimum of the
maximum regrets of the three product ranges.

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DEVELOPMENT PROJECT EXPENDITURE

How the criteria in IAS 38: Intangible assets apply to the development project

The project to develop the new product ranges has been underway for approximately two
months. Under IAS 38 we can capitalise the costs incurred for a development project from the
date that six criteria have been met. These six criteria are as follows:

• The intangible asset must be technically feasible. As the working prototypes were
completed on 31 January we can assume that this is the date that this was achieved.
• There must be an intention to complete the intangible asset and use or sell it. As the
senior management authorised Grace to start work on the project on 1 January and
set a deadline for 28 February, this criterion has been satisfied.
• Resources to complete the development must be available. The finance and staff
resources were made available to complete this project on 1 January.
• The intangible asset will generate probable future economic benefit. The market
research consultancy firm confirmed that the market was viable on 14 January. In
addition, the demand estimates that the consultancy supplied show a positive return
even at the markets lowest demand level. Therefore, this criterion was met on 14
January.
• The costs to be capitalised can be reliably measured. The schedule of expenditure
identified for the project are proof that this criterion has been met.
• There is an ability to use or sell the intangible asset. As we have developed these
product ranges internally with the express intention to sell them in the commercial
market, this criterion was met on 1 January.

Therefore, all these criteria had been met on 31 January and this is the date that we should
consider that the intangible asset was created.

Treatment in the financial statements for the year ending 31 December 2019

As 31 January is the point at which the intangible asset was created, we can capitalise relevant
expenditure incurred from that date until 28 February, which is the date that the project was
completed. Relevant expenditure includes any expenditure which is directly attributable to
creation of the intangible asset and includes salaries and raw materials and consumables.
The advertising costs are specifically excluded under IAS 38 as this expenditure is not incurred
to generate the intangible asset.

Although the new cutting machine can be capitalised it is not an intangible asset and therefore
will not be covered under IAS 38. Instead this will be part of property, plant and equipment
and depreciated in accordance with IAS 16: Property, plant and equipment.

The intangible asset will be shown in the statement of financial position and will be amortised
once production begins. Given the project is to develop three new products and only one will
be launched on 1 May, then one third of the asset can be amortised from 1 May (the rest will
start to be amortised once the other two products are launched). Therefore, in the statement
of profit or loss there will be an eight-month charge for the year. The amortisation period should
reflect the useful economic life of the asset, which will be the anticipated life of the new product
range.

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SECTION 2

SALES FORECASTING

How the information has been used to forecast sales demand for our climbing walls

The trend formula has been assumed to apply to our climbing walls because it has been taken
from actual sales of similar products. The trend is the long-term direction or underlying
movement in values in a set of data. The trend formula, Y = 188 + 12 M is the formula for a
straight line and shows an upward demand. We can expect to sell (188+12) 200 climbing walls
in the first month following launch and 12 more for every month after this: this is the basis on
which the trend for sales of our new climbing wall has been calculated.

Once we had the forecast trend figures for each month’s sales for the first year, we adjusted
the trend for seasonal variations. Seasonal variations are short–term, predictable variations in
the trend. For example, sales of climbing walls may increase during periods when demand for
our customers’ services is low. These periods would be the most practical time for customers
to renew equipment. Our domestic outdoor play equipment is also subject to seasonal
variations as we experience higher demand during the summer than we do in the winter.

As the seasonal variation for climbing walls is based on the multiplicative model, this means
that the seasonal variation for each month is a proportion of the trend. For example, in January
the forecast sales will be 50% below the trend forecast, while in October the seasonal variation
will be 50% higher than the trend forecast. We can adjust all the monthly trend figures by the
relevant month’s seasonal variation and aggregate them to arrive at a demand forecast for the
first year’s sales.

How the sales forecast has then been used to set the raw material purchase budget

Sales demand is our principal budget factor. This means that sales demand is the element
which limits output and therefore our performance and profits in this new sector. Therefore, all
our functional budgets flow from the principal budget factor, which is why budget preparation
starts with the sales forecast. To calculate our raw material purchase budget, we must follow
the budget setting process in a set, logical order.

Once we know how many climbing walls we are forecast to sell each month, we can produce
the sales budget. The sales budget will detail the number of climbing walls and the revenue
that we expect to achieve from them. Following this we calculate how many climbing walls we
need to produce to satisfy the sales budget: this is the production budget. The production
budget will differ from the sales budget because, in the early months of production, when sales
are below the trend we will be producing climbing walls and placing them in inventory. This
inventory will reduce once sales demand increases from October onwards. From the
production budget we calculate the material usage, that it the amount of raw materials that we
will use in order to satisfy the production budget. We have standard cost cards that detail all
the material requirements and we can use these to calculate how much of each of the different
categories of raw materials we will need. At this point we can adjust for any fluctuations in raw
material inventory levels and any normal loss to ascertain how much raw material we need to
purchase.

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THE DECISION-MAKING UNIT (DMU)

A DMU is a term used to describe all the individuals that play a part in their businesses’ buying
decision-making process. These are:

Users: These are the members of an organisation that will use our climbing walls, in the case
of the nurseries and play centres these will be the children and the carers or supervisors of
the children. It is important that the sales team understands the needs of the users in order to
match the correct product from the range with the organisation.

Influencers: These are the people that can steer the buying decision in a particular direction.
For example, the local government will have a Health and Safety Officer and this person could
decide that climbing walls are too high a risk for children in the play centre. Although
influencers are often formal and internal to the organisation they can also be informal and
external. For example, we sent prototypes to specialist children’s magazines for review and
when the results are published, they may influence the buying decision.

Gatekeepers: These are the people who control the flow of information to others. Even if we
produce the best product in Fawland we will not be able to sell it unless we are known by the
key roles in the buying decision. A good example of gatekeepers are the receptionists who
prevent the members of the sales team from accessing the people in these key buying roles.

Buyers: The buyer is the professional purchasing role. This person will have a criteria for
selecting the products and will be responsible for sourcing goods and negotiating the terms.
In most cases this is the person that members of our team need to persuade that our products
are the most fitting for their organisation’s needs.

Decider: This is the person that will make the final decision about placing an order, usually a
senior manager. For example, most organisations will operate within budgetary constraints
and even if our products are the most suitable for the users, the Finance Director could still
veto the deal.

Initiator: The initiator is the person that recognises that there is a need to be satisfied. This
role could be as simple as replacing a worn out version of the product. In the case of the
climbing walls this is unlikely to be a direct replacement as the climbing walls are novel and
innovative. The fact that the Government has warned that children in Fawland are not fit
enough may mean that organisations recognise the need for play equipment that means more
physical exertion.

It is important to understand that the six roles in a DMU are not mutually exclusive. For
example the carers of the children in the play centres or nurseries could also take the role of
influencer. If a carer viewed the equipment as too advanced or dangerous for the children, as
experts, they could influence the buyer not to buy.

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SECTION 3

BONUS SCHEME CRITERIA

Motivational

A good bonus scheme should encourage the sales team to be effective and productive. They
should want to work harder as a result of the scheme. The climbing wall bonus scheme does
achieve this as more walls have been sold in total than budgeted.

Consistent and fair

A good bonus scheme should be applied equally to all sales and be within the control of the
sales team. This bonus scheme is fair as it rewards employees for sales, which should be
within their control. It is also consistent in as much as each climbing wall sold earns the
employee F$10. However, this is not consistent with the bonus paid for the other products sold
by Trigg Adventure.

Reward good performance

Good performance for the sales team must be defined in terms of the amount of sales made.
The bonus scheme awards F$10 for each unit sold and so would appear to meet this criterion
in terms of sales volume. However, to achieve this sales volume, it appears that the sales
team have discounted the selling price of the entire range to the maximum limit. Therefore,
the bonus scheme is rewarding actual units sold regardless of the price and does not achieve
this criterion.

In line with organisational goals

A good bonus scheme should encourage goal congruence; it should align personal and
organisational goals. The bonus scheme does not meet this criterion as although it motivates
the team to sell more units in total the sales are skewed towards selling the small climbing
wall. The target was to sell 30 large climbing walls, but the sales team only sold five. This has
implications for the contribution earned during June (see below): in effect the bonus scheme
is encouraging the sales team to act in self-interest at the expense of Trigg Adventure.

Affordability

Clearly any bonus scheme that Trigg Adventure adopts must be affordable. All bonus schemes
have a dual aspect, an inherent conflict, as the higher the bonus earned by the sales team,
the higher the cost to Trigg Adventure. There is no evidence to suggest that Trigg Adventure
cannot afford this new bonus scheme, but it is more expensive than the scheme it replaces
and has contributed to a lower contribution than budgeted.

Suggestions for improving the bonus scheme

A better bonus scheme would need to ensure goal congruence and reward good performance.
The scheme could be set as a percentage of sales revenue rather than a flat rate.

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SALES VARIANCES

Sales price variance F$11,850 adverse

This variance shows that the actual selling price achieved was less than the budgeted selling
price for all three products in the range. The sales team were given the discretion to offer
customers a discount in order to secure a sale and the difference between the actual and
budgeted selling price indicates that this discount was offered freely. The motivation for the
sales staff offering the discount is probably due to the fact that their bonus was based on units
sold and not on achieving the budgeted selling price.

Sales mix variance F$14,000 adverse

The sales mix variance indicates the increase or decrease in profit due to the actual total
volume of products being sold in a different proportion to the budgeted mix. We must have
sold proportionately more of the lower contribution products and less of the higher contribution
products to achieve this adverse variance.

As can be seen from the data we have sold significantly more of the small climbing walls than
the actual quantity in the budgeted mix and these products have the lowest standard
contribution of all the items sold. Similarly, we can see that we sold significantly less than the
actual quantity in budgeted mix of the large climbing walls and these items are the items with
the highest standard contribution. It is probable that these differences in product sales have
been influenced by the bonus scheme. As the bonus is paid at a flat rate per item, regardless
of the type of item, it is likely that the sales team have focused on selling the smaller climbing
walls because they are easier to sell. This could be because they are less of a financial outlay.

Sales quantity variance F$6,000 favourable

The sales quantity variance quantifies the effect on our contribution of selling a higher quantity
in standard mix than budgeted. We sold 105 climbing walls which is more than the 90 budgeted
and when this difference is multiplied by the standard contribution it indicates that we have
earned F$6,000 more contribution than budgeted.

The reasons for this variance are not altogether clear. However, as the sales team are paid a
bonus for each item sold, it is possible that the bonus has motivated them. Another reason for
the variance could be because this is the first month of sales of the climbing walls and that the
forecasts could have been inaccurate, so it follows that our sales budgets are inaccurate.

Sales volume contribution variance F$8,000 adverse

The sales volume variance is the sum of the sales mix and sales quantity variances. It
quantifies the effect on our contribution due to selling 105 units rather than the budgeted 90
units. This variance is adverse overall because the positive effect on contribution gained from
the quantity does not overcome the negative effect on contribution caused by the sales mix
variance.

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SECTION 4

PRODUCTION SCHEDULE

The optimal production decision

The production schedule should be prioritised according to the products that maximise total
contribution. As we have enough hangers in inventory to meet the maximum demand for all
sizes of climbing wall, these specialist components are not a production constraint. However,
we only have 5,000 pegs in inventory and need 7,560 to satisfy the maximum demand for all
products. This means that we are over 2,500 pegs short of meeting maximum demand and
are only just able to cover our contractual obligation and meet the minimum demand.
Therefore, pegs are a production constraint.

As we have identified a single production constraint we should prioritise production in order to

maximise contribution per unit of limiting factor. This will maximise overall contribution and
therefore profit.

Before we prioritise the order that we make the climbing we must meet our contractual
obligations and make the minimum demand of each size. The 5,000 pegs that we hold in
inventory will allow us to satisfy this minimum demand. The remaining pegs (5,000-4,600)
would then be allocated to the product earning the largest contribution per peg. This would be
the small climbing wall. This is because we want to earn the largest contribution and a peg will
generate F$10.00 contribution when we make a small climbing wall, F$8.70 when we make a
medium climbing wall and F$8.57 when we make a large climbing wall.

Should we pay F$2,500 for 1,000 additional pegs?

If we had 1,000 additional pegs, we would continue to make the products in the order
suggested above to maximise contribution. We would buy the 1,000 additional pegs if the
contribution earned from them exceeded the cost of buying them. As the additional 1,000 pegs
will still leave us short of the 7,560 needed to meet maximum demand, the minimum
contribution we can earn from a peg is F$8.57. As the additional cost is F$2.50 a peg, it will
be worthwhile to place the special order for the 1,000 pegs.

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EOQ

The purpose of the EOQ and the nature of holding and ordering costs

The EOQ model works on the principle that the optimal order size for inventory is the order
quantity which minimises the total of inventory holding costs and ordering costs. Therefore, its
purpose is to establish an optimal order level for each component of inventory.

Holding costs consist of the incremental cost of holding inventory. The holding costs at Trigg
Adventure are the incremental cost of insurance (our premiums are charged on the value of
the inventory), the opportunity cost of the capital that is invested in the inventory (money used
to finance inventory holding cannot be used to expand our product range further), the
incremental warehouse costs (if we extend our product lines further we may have to increase
the number of stores staff or increase the space needed), and so on. It is assumed that the
relevant holding cost will increase as the quantity of inventory held increases.

Ordering costs are the fixed cost of placing an order. These costs are usually the clerical costs
of preparing the purchase order, receiving deliveries and paying invoices. This includes
Richard Herrick’s salary for the time taken to complete the order form, postage costs,
transportation costs, and so on. These costs are assumed to remain constant regardless of
the number of components ordered therefore the fewer orders, the lower the cost.

Assumptions that mean that it is inappropriate for purchase of the climbing wall
components

The EOQ is a useful model but it is based on a number of assumptions that may not apply to
our new products.

One assumption is that the holding cost per unit will remain constant. As most of our raw
material inventory is bulky in nature, this may not always be the case as costs of storage are
likely to be stepped (more store room labour or space will be needed as inventory levels
increase).

Another assumption made when calculating the total holding cost is that the average holding
is half of the order quantity. This would be the case where demand for the product is evenly
distributed throughout the year. However, we have a business that is seasonal and therefore
demand varies throughout the year for all our products. In addition, the demand for our
climbing walls is currently expanding in an unpredictable pattern which is not conducive to
using the EOQ.

A further assumption is that the lead time is known with certainty. The lead time is the time
taken from placing the order to receiving the goods. When this is known with certainty the
EOQ can be used to determine at what point the order should be raised to obtain additional
inventory. However, our peg and hanger supplier has not been consistent as they have taken
between two and four weeks to deliver a standard order.

The EOQ ignores shortage costs which may be quite significant, given our current shortage
problems with the pegs and hangers. If we are short of these components we lose sales and
customer goodwill.

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