(a) The performance of the production director could be looked at considering each decision in turn.
The new wood supplier: The wood was certainly cheaper than the standard saving $5,100 on the standard the concern though might be poor quality. The usage variance shows that the waste levels of wood are worse than standard. It is possible that the lower grade labour could have contributed to the waste level but since both decisions rest with the same person the performance consequences are the same. The overall effect of this is an adverse variance of $2,400, so taking the two variances together it looks like a poor
decision. As the new labour is trained it could be that the wood usage improves and so we will have to wait to be sure.
The impact that the new wood might have had on sales cannot be ignored. No one
department within a business can be viewed in isolation to another. Sales are down and returns are up. This could easily be due to poor quality wood inputs. If SW operates at the high quality end of the market then sourcing cheaper wood is risky if the quality reduces as a result.
The lower grade of labour used: SW uses traditional manual techniques and this would normally require skilled labour. The labour was certainly paid less, saving the company $43,600 in wages. However, with adverse efficiency and idle time of a total of $54,200 they actually cost the business money overall in the first month. The efficiency variance tells us that it took longer to produce the bats than expected. The new labour was being trained in April 2010 and so it is possible that the situation will improve next month. The learning curve principle would probably apply here and so we could expect the average time per bat to be less in May 2010 than it was in April 2010. (b) Variance for May 2010:
Material price variance ($196,000/40,000 – 5) x 40,000 = $4,000 Fav Material usage variance (40,000 – (19,200 x 2)) x $5/kg = $8,000 Adv Labour rate variance ($694,000/62,000 – 12) x 62,000 = 50,000 Fav Labour effi ciency variance (61,500 – 57,600) x 12 = 46,800 Adv Labour idle time variance 500 x 12 = 6,000 Adv
Sales price variance (68 – 65) x 18,000 = 54,000 Adv
Sales volume contribution variance (18,000 – 19,000) x 22 = 22,000 Adv
(c) As far as the manufacturer is concerned, including fi xed costs in the transfer price will have the advantage of covering all the costs incurred. In theory this should guarantee a profi t for the division (assuming the fi xed overhead absorption calculations are accurate). In essence the manufacturer is reducing the risk in his division.
The accounting for fi xed costs is notoriously diffi cult with many approaches possible. Including fi xed costs in the transfer price invites manipulation of overhead treatment. One of the main problems with this strategy is that a fi xed cost of the business is being turned into a variable cost in the hands of the seller (in our case the stores). This can lead to poor decision-making for the group since, although fi xed costs would normally be ignored in a decision (as unavoidable), they would be relevant to the seller because they are part of their variable buy in price.
(d) Degree of autonomy allowed to the stores in buying policy.
If the stores are allowed too much freedom in buying policy Hammer could lose control of its business. Brand could be damaged if each store bought a different supplier’s shears (or other products). On the other hand, fl exibility is increased and profits could be made for the business by entrepreneurial store managers exploiting locally found bargains.
However, the current market price for shears may only be temporary (sale or special offer) and therefore not really representative of their true market ‘value’. If this is the case, then any long-term decision to allow retail stores to buy shears from external suppliers (rather than from Nail) would be wrong.
The question of comparability is also important. Products are rarely ‘identical’ and
consequently, price differences are to be expected. The stores could buy a slightly inferior
product (claiming it is comparable) in the hope of a better margin. This could seriously damage Hammer’s brand.
Motivation is also a factor here, however. Individual managers like a little freedom within which to operate. If they are forced to buy what they see as an inferior product (internally) at high prices it is likely to de-motivate. Also with greater autonomy, the performance of the stores will be easier to assess as the store managers will have control over greater elements of their business.
Web Co has made three changes and introduced two incentives in an attempt to increase sales. Using the performance indicators given in the question, it is possible to assess whether these attempts have been successful. Total sales revenue
This has increased from $2·2 million to $2·75m, an increase of 25% (W1). This is a
substantial increase, especially considering the fact that a $10 discount has been given to all customers spending $100 or more at any one time. However, because a number of changes and incentives have been introduced, it is not possible to assess how effective each of the individual changes/incentives has been in increasing sales revenue without considering the other performance indicators. Net profit margin (NPM)
This has decreased from 25% to 16·7%. In $ terms this means that net profit was $550,000 in quarter 1 and $459,250 in quarter 2 (W2). If the 25% NPM had been maintained in quarter 2, the net profit would have been $687,500 for quarter 2. It is
therefore $228,250 lower than it would have been. This is mainly because of the $200,000 paid out for advertising and the $20,000 paid to the consultant for the search engine work. The remaining $8,250 difference could be a result of the cost of the $10 discounts given to customers who spent more than $100, depending on how these are accounted for. Alternatively, it could be due to the costs of providing the Fast Track service. More
information would be required on how the discounts are accounted for (whether they are netted off sales revenue or instead included in cost of sales) and also on the cost of providing the Fast Track service.
Whilst it is not clear how long the advert is going to run for in the fashion magazine, $200,000 does seem to be a very large cost.
This expense is largely responsible for the fall in NPM. This is discussed further under ‘number of visits to website’. Number of visits to website
These have increased dramatically from 101,589 to 141,714, an increase of 40,125 visits (39·5% W3). The reason for this is a combination of visitors coming through the fashion magazine’s website (28,201 visitors W5), with the remainder of the increase most
probably being due to the search engine consultants’ work. Both of these changes can therefore be said to have been effective in improving the number of people who at least visit Web Co’s online store. However, given that the search engine consultant only charged a fee of $20,000 compared to the $200,000 paid for magazine advertising, in relative terms, the consultant’s work provided value for money. Web Co’s sales are not really high enough to withstand a hit of $200,000 against profit, hence the fall in NPM. Number of orders/customers spending more than $100.The number of orders received from customers has increased from 40,636 to 49,600, an increase of 22% (W4). This shows that, whilst most of the 25% sales revenue increase is due to a higher number of orders, 3% of it is due to orders being of a higher purchase value. This is also reflected in the fact that the number of customers spending more than $100 per visit has increased from 4,650 to 6,390, an increase of 1,740 orders. So, for example, If each of these 1,740 customers spent exactly $100 rather than the $50 they might normally spend, it would
easily explain the 3% increase in sales that is not due to increased order numbers. It depends partly on how the sales discounts of $10 each are accounted for. As stated
above, further information is required on these. An increase in the number of orders would also be expected, given that the number of visitors to the site has increased substantially. This leads on to the next point.
Conversion rate – visitor to purchaser
The conversion rate of visitors to purchasers has gone down from 40% to 35%. This is not surprising, given the advertising on the fashion magazine’s website. Readers of the magazine may well have clicked on the link out of curiosity and may come back and
purchase something at a later date. It may be useful to have a breakdown of the visitor to purchaser rate, showing one statistic for visitors who have come from the online magazine and one for those who have not. This would help clarify the position. Website availability
Rather than improving after the work completed by Web Co’s IT department, the website’s availability has stayed the same. This means that the IT department’s changes to the website have not corrected the problem. Lack of availability is not good for business, although its exact impact is difficult to ascertain. It may be that visitors have been part of the way through making a purchase only to find that the website then becomes
unavailable. More information would need to be available about aborted purchases, for example, before any further conclusions could be drawn. Subscribers to online newsletter
These have increased by a massive 159%. It is not clear what impact this has had on the business as we do not know whether the level of repeat customers has increased. This information is needed. Surprisingly, it seems that there has not been an increased cost associated with providing Fast Track delivery, as the whole fall in net profit has been
accounted for, so one can only assume that Web Co managed to offer this service without incurring any additional cost itself. Conclusion
With the exception of the work carried out to make the system more available, all of the other measures seem to have increased sales or, in the case of Incentive 1, increased subscribers. More information is needed in relation to a couple of areas, as noted above. The business has therefore been responsive to changes made and incentives
implemented but the cost of the advertising was so high that, overall, profits have declined substantially. This expenditure seems too high in relation to the corresponding increase in sales volumes. Workings
1. Increase in sales revenue $2·75m – $2·2m/$2·2m = 25% increase. 2. NPM: 25% x $2·2m = $550,000 profit in quarter 1. 16·7% x $2·75m = $459,250 profit in quarter 2.
3. No. of visits to website: increase = 141,714 – 101,589/101,589 = 39·5%. 4. Increase in orders = 49,600 – 40,636/40,636 = 22%.
5. Customers accessing website through magazine line = 141,714 x 19·9% = 28,201. 6. Increase in subscribers to newsletter = 11,900 – 4,600/4,600 = 159%.
The rolling budget outlined for Designit would be a budget covering a 12-month period and would be updated monthly. However, instead of the 12-month period remaining static, it would always roll forward by one month. This means that, as soon as one month has elapsed, a budget is prepared for the corresponding month one year later. For example, Designit would begin by preparing a budget for the 12 months from 1 December 2012 to 30 November 2013, to correspond with its year end. Then, at the end of December 2012, a budget would be prepared for the month December 2013, so that the unexpired period covered by the budget is always 12 months.
When the budget is initially prepared for the year ending 30 November 2013, the first
month is prepared in detail, with much less detail being given to later months, where there is a greater uncertainty about the future. Then, when this first month has elapsed and the budget for the month of December 2013 is prepared, it is also necessary to revisit and revise the budget for January 2013, which will now be done in more detail.
Note: This answer gives more level of detail than would be required to gain full marks. (b) Problems
Designit only has one part-qualified accountant. He is already overworked and probably has neither the time nor the experience to prepare rolling budgets every month. One would only expect to see monthly rolling budgets of this nature in businesses which face rapid change. There is no evidence that this is the case for Designit. If it did decide to introduce rolling budgets, it would probably be sufficient if they were updated on a quarterly rather than a monthly basis. If this monthly rolling budget is going to be
introduced, it is going to require a lot of input from many of the staff, meaning that they will have less time to dedicate to other things. The sales managers may react badly to the new budgeting and incentive system. They are used to having been set targets that are easily achievable. With the new system, they will have to work hard all year round. They are also likely to become frustrated with the fact that they do not know the target for the whole year in advance. Once they have hit their target for the month, they may then also be tempted to hold back further work and let it run into the next month, so that they increase the chances of meeting next month’s target. This would not be good for the business.
(c) Alternative incentive scheme
The issue with the current bonus scheme is that the reward system is stepped, rather than being a percentage of sales. The first $1·5 million fee income target is too easy to reach and the second $1·5 million target is too hard to reach. Therefore, managers are not motivated to earn additional fees once the initial $1·5 million target has been reached. A series of constantly rising bonus rates ranging over a narrower rate of sales could be used. For example, every $500,000 of fee income could be rewarded with an additional bonus equivalent to 5% of salary. Alternatively, the bonus could be replaced by commission, giving the managers a reward as a percentage of the fee income rather than a percentage of salary. Currently, the company is paying out $30,000 in bonus to each of its managers each year. This is 2% of $1·5 million. Therefore, the bonus could be that each manager earns 2% commission on all sales.
(d) Using spreadsheets
If spreadsheets are used for budgeting, the part-qualified accountant could be rekeying large amounts of data taken from the company’s systems. It would be very easy for him to make a mistake when he is entering his data, especially without someone else to check his work. Similarly, if there is any error in any of the formulae, all the numbers in the budget will be wrong. Whilst this risk already exists because fixed budgets are being prepared on spreadsheets, the rolling budgets will be far more complex, which increases the risk of error in the design of the model or any of the formulae. A model can become easily corrupted simply by putting a number in the wrong cell. The accountant is unlikely to spot this due to his lack of experience and the time pressure on him. When spreadsheets are used, there is no audit trail that can be followed in order to check the numbers.
(b) With perfect information:
If membership numbers were 6,000: EV = $3·42m x 3 = $10·26m Less costs of $360k = $9.9m
Therefore, with these membership numbers, GB would choose option 1 instead. If membership numbers were 6,500:
EV = $3·705 x 3 = $11·115m Less costs of $360k = $10·755m
In this instance, GB would choose option 2.
So, if membership numbers are 6,000, of which there is a 0·4 probability, EV will be $10·08m (option 1) and if membership numbers are 6,500, of which there is a 0·6 probability, then EV will be $10·755m (option 2). Therefore EV with perfect information = (0·4 x $10·08m) + (0·6 x $10·755) = $10·485m. Without perfect information the EV is $10·413m, therefore the value of it is $72k ($10·485m – $10·413m). This represents the maximum price that GB should be prepared to pay for the information.
(c) The expansion decision is a one-off decision, rather than a decision that will be
repeated many times. Expected values, on the other hand, give us a long run average of the outcome that would be expected if a decision was to be repeated many times. The actual outcome may not be very close to the expected value calculated and the technique is therefore not really very useful here.
Also, estimating accurate probabilities is difficult because this exact situation has not arisen before.
The expected value criterion for decision-making is useful where the attitude of the
investor is risk neutral. We do not know what the management of Gym Bunnies’ attitude to risk is, which makes it difficult to say whether this criterion is a good one to use. In a
decision such as this one, it would be useful to see what the worst case scenario and best case scenario resultswould be too, in order to assist decision-making.