Jun 06 Mock Exam suggested answers

QUESTION 1
1 (a) Estimated NPV £000
Year 0 1 2 3 4 5 6
Outlay 1500
Sales 3000 3000 3000 3000 3000 3000
Variable costs 2385 2385 2385 2385 2385 2385
____ ____ ____ ____ ____ ____
Taxable cash flow 615 615 615 615 615 615
Taxtion (35%) 215 215 215 215 215 215
____ ____ ____ ____ ____ ____ ____
Net cash flow (1500) 400 400 400 400 400 400

Discounting at 8% the expected NPV is :

(1500) + (400 x 4.623) = 349.2 or £349.200
Where 4.623 is the present value of an annuity of one FOR six years at 8%.
Notes:
(i) Variable cost per unit is £3.95 x 20% (copyright) plus £1.50 x 40%
(purchases from supplier) plus £0.20 (additional variable cost) =
£1.59.
(ii) Market research is a sunk cost.
(iii) The financing cost is encompassed within the discount rate. The
use of 8% as the discount rate discussed in part (b).

(b) Assuming the company wishes to retain its existing capital structure the
cost of finance of any project, no matter whether the actual source of
finance can be identified, is best regarded as the cost of a ‘pool’ of debt
and equity weighted by their market proportions. The minimum
acceptable return is the weighted average cost of debt and equity. In this
question the weighted average used is the real cost of capital as the cash
flows have not been adjusted for rising prices or cost (‘inflation’) during the
six year period. The use of 18% as a discount rate would produce an
incorrect solution as real cash flows would be discounted by a nominal
cost of capital.

The 8% discount rate is unlikely to be satisfactory because:

(i) The project might have a different systematic risk to Tigwood’s
normal activities, in which case the discount rate should reflect the
different risk
(ii) During the six years of the agreement prices and cost might
increase at different rates. The effect of these differential price
changes is not reflected by discounting real cash flows by a real
discount rate. Discounting ‘inflation’ – adjusted nominal cash flows
at a nominal rate, is recommended, and is likely to result in a
different estimated net present value.

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Jun 06 Mock Exam suggested answers

(c) In sensitivity analysis all variable except the one under consideration are held
constant, and an estimate is made of the value for the variable under
consideration that produces a net present value of zero.

Initial outlay: As the present value of net cash inflows is 1849.2, the value of the
initial outlay would have to be 1849.2 to result in a zero NPV.
349.2
This represents a change of 1500 x 100% = 23.28%

Contribution: The zero NPV annual contribution can be estimated by solving the
following equation for x (the zero contribution)

- 1500 + 4.623 x – (.35x) 4.623 = 0

N.B. –(.35x) 4.623 is the annual tax charge which is dependent upon the
unknown contribution.

Solving 3.005x = 1500, x = 499.16

The present annual contribution is 615, this represents a charge of

115.84
615 X 100% = 18.83%

Agreement life: The zero NPV life has a present value of annuity factor at 8% of
–1500 + 400x = 0, x = 3.75

From the annuity table:

PV annuity for four years is 3.312
PV annuity for five years is 3.993

Extrapolating, the zero NPV life is

3.75 - 3.312 x 1 year = 4.643 years
4 years + 3.993 – 3.312

This is a reduction of 1.35 years of 22.61 %

Discount rate : The zero NPV rate is where the present value of a six year
annuity of 400 is zero.
Solving – 1500 + 400 x = 0, where x is the required rate = 3.75
From the present value of annuity table 15% has a PV annuity factor of 3.784,
and 16% 3.685.

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Jun 06 Mock Exam suggested answers

Extrapolating, the zero NPV rate is

3.784 – 3.75
15% + 3.784 – 3.685 x 1% = 15.34 %

7.34
This represents a change of ------ = 91.75%
8

These estimates suggest, not surprisingly, that the decision is most sensitive to
a change in the annual contribution. The analysis does not, however, establish
how sensitive the decision is to the sales price alone, or any of the elements of
variable cost (assuming their relationship to sales price alters) Such information
might be useful to the decision maker.

Sensitivity analysis has several limitations:

(i) It treats variables as if they are independent and does not consider the
inter- relationships that might exist between variables.
(ii) There is no measure of the probability of changes in any of the variables
occurring.
(iii) There is no automatic decision rule implied for managers. Managers do
not know whether their decisions should be altered because of the level of
sensitivity of a variable.

(d) Information might include:

(i) What relationship (if any) does Tigwood Ltd have with the suppliers of the
microfiche readers? The success of the project is dependent upon the
availability and sale of readers. What price are they to be sold at? How
are they to be marketed? Would it be better for the project to be a joint
venture between Tigwood and the manufacturer of microfiche readers
(and possibly the photographic company that supplies the microfiche).
(ii) How accurate are the estimated cash flows? What is the effect of inflation
on the cash flows?
(iii) What is the systematic risk of the project?
(iv) Is the agreement likely to be renewed after six years?
(v) If the project is successful is it possible to extend it to more books?
(vi) How secure is the market from competitors ? Is it possible to obtain patent
protection on the microbooks?

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Jun 06 Mock Exam suggested answers

QUESTION 2
(a) Benefit to Comfylot will be measured by the incremental effects of the
proposed changes, initially during the next year.

Domestic sales are £11.2m in total, £8.96 on credit.

Export sales are £4.8m, £4.08m on credit (net of the 15% initial
deposit).

(i) Incremental effects

£ £
Administration: Savings 85,000
Factor cost – credit sales of
£8.96m x 1.5% (134,000)
------------- (49,400)
Financing:
Existing cost:

£8.96m x 57 x 15% 209,885

365

Cost with factor:

£8.96m x 57 x .8 x 15.5% (173,505)
365

£8.96m x 57 x .2 x 15% ( 41,977)

365 ------------ (5,597)
Redundancy payment (15,000)
Saving in bad debts (as the factor is non-recourse)
£8.96m x 0.75% 67,200
------------

(2,797)

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Jun 06 Mock Exam suggested answers

Although the incremental effect of using the factor appears to be unfavourable, the
redundancy payment is a one-off cost which will not be repeated in future years. If the other
net savings are maintained after year one, the use of the factor is likely to result in savings of
approximately £12,200 per year.

(ii) £ £

Cash discount:
Current finance costs 209,885

Costs with discount of customers not taking

the discount

£8.96m x .6 x 57 x 15% (125,931)

365

Plus customers taking the discount

£8.96m x .4 x .985 x 7 x 15% (10,155)

365

Financing saving from the discount 73,799

Cost of offering the discount £8.96m x .4 x 0.15 (53,760)
Administration cost (25,000)
Saving on bad debts £8.96 x .25% (22,400)
-----------

17,439

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Jun 06 Mock Exam suggested answers

This saving is larger than the saving from using the factor. If the discount and the
factor cannot both be used then the discount offers the higher financial again.
However, other considerations might influence the decision such as the automatic
increase in finance that is provided by the factor as sales increase, which could
prevent overtrading.

(iii) Export sales

Although it is possible to estimate the expected increase in export sales (25.5%) and
to calculate the incremental costs and benefits of this expected increase, it is more
useful for the company to quantify the effects of all three stated sales increases.

Export sales are currently £4.8 million, £4.08m on credit after deducting the initial
deposit.

The finance cost of these sales is

£4.08m x 75 x 15% = £125,753

365
Bad debts are £4.08m x 1.25% = £51,000

20% sales increase Change in costs (£)

New credit sales are £4.896m

Finance costs £4.896m x 80 x 15% = £160,964 35,211

365

Bad debts £4.896m x 1.5% = £73,440 22,440

Contribution from extra sales

(£5.76m - £4.8m) x .35 = £336,000 - £30,000(admin) (306,000)

Overall effect (248,349)

25% sales increase

New credit sales £5.1m

Finance costs £5.1m x 80 x 15% = £167,671 41,918
365

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Jun 06 Mock Exam suggested answers

Bad debts £5.1m x 1.5% = £76,500 25,500

Extra contribution
(£6m - £4.8m) x 3.5 = £420,000 - £40,000 (380,000)
Overall effect (312,582)
30% sales in increase
New credit sales £5.304m

Finance costs £5.304m x 80 x 15% = £174,378 48,625

365
Bad debts £5.304m x 1.5% = £79,560 28,560

Extra contribution
(£6.24m - £4.8m) x .35 = £504,000 - £50,000 (454,000)
-------------
Overall effect (376,815)

Advertising costs £300,000. If sales increase by either 25% or 30%, the incremental
benefits from increased sales are large enough to cover the cost of advertising. There
is an 80% chance of this occurring. If sales increase by 20% the cost of advertising
exceeds the expected benefits by £51,651. However, if the benefits of advertising last
beyond the first year (without similar repeat advertising being necessary), then it is
likely to be beneficial to undertake the advertising campaign even with a 20% sales
increase.

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Jun 06 Mock Exam suggested answers

Question 3
(a) Financial gearing is the ratio between ordinary share capital and interest
bearing plus fixed dividend bearing securities (including preference
shares).

Financial gearing might be important to a company because:

(i) It affects the income risk of shareholders and the providers of interest
bearing and fixed dividend bearing finance. The higher the financial
gearing the greater the interest payments a company must make before
the ordinary shareholders and preference shareholders receive dividend
payments. It profits fall and cash flow is limited high financial gearing
might result in reduced dividends or no dividends and cause a fall in
share price. Increased financial gearing also increases the probability of
default on interest payments and increases income risk for providers of
debt finance.
(ii) It affects the capital risk for providers of funds. Increased financial
gearing is likely to increase bankruptcy cost, agency costs and lead to a
higher probability of corporate failure as there is a greater chance of
default on payments on interest and principal.
(iii) The level of financial gearing influences a company’s ability to raise new
finance, and the type of finance that might be available. A company with
high gearing could experience difficulty in raising new debt finance or
have to pay a higher price for both new debt and equity because of the
higher financial risk.
(iv) Financial gearing affects the company’s cost capital. Initially the use of
debt in the capital structure might reduce the weighted average cost of
funds, but as financial risk increase and the required return on both debt
and equity increases the weighted average cost of funds will increase.

(b) Factors that might limit the amount of debt finance include:
(i) Security. The amount and quality of assets, guarantees or other forms
of security that are available to lenders. Companies with a high
proportion of easily realisable fixed assets are likely to use more long-
term debt than companies whose assets are primarily in the form of
debtors and stock.
(ii) Limitations imposed in the company’s articles of association.

(iii) The existing level of financial gearing. A company with high gearing
might experience difficulty in raising further debt finance because of the
extra risk to both shareholders and prospective lenders. Lenders (e.g.
banks) might have perceptions of ‘acceptable’ levels of gearing and be
unwilling to lend beyond these levels. Additionally a company might

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Jun 06 Mock Exam suggested answers

have some desired ‘target’ capital structure which approximately

minimiss the weighted average cost of capital and maximises the
market value of the company (assuming operating income is
independent of capital structure). The relationship between the existing
gearing level and the desired ‘optimal’ gearing is likely to influence the
decision of how much debt finance to use.
(iv) Cash flow available to meet payments of interest and principal Most
lenders will need to be convinced that future cash flows will safely meet
these obligations. Alternatively accounting ratios such as estimated
interest cover may be examined to see how high earnings before tax and
interest are relative to forecast interest payments.
(v) Stability and growth of profits and sales. Stability of sales and profits
mear companies can incur interest charges on debt with less risk than
when sales and profits are volatile.
(vi) The relative costs of debt and equity, particularly any tax advantages to
either form of financing (it may be argued that in an efficient market debt
and equity would be correctly priced according to their systematic risk).
(vii) Covenants on existing debt restricting further debt financing.
(viii) The attitude of the company’s management towards risk and control.
Raising new equity might affect the control and voting position of some
companies (especially small companies) in which case debt finance
might be favoured rather than equity finance. Risk averse management
may deliberately limit debt financing to a substantially lower amount than
a less risk averse management team operating in similar financial
circumstances.

(c) All of the three managers have used some form of the ratio.

debt
-------- in their estimates of financial gearing
equity

Mr Y has used book values, and has only included medium and long-term debt
in his estimate
5,600 + 1,800
Hence ------------------- = 89%
8,330

Mr Z has also used book values but has included short-term loans and
overdraft in addition to long-term debt.

7,400 + 1,000 + 2,800

------------------------------ = 134%
8,330

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Jun 06 Mock Exam suggested answers

Mr R has used market values with both short and long-term loans and overdraft

5,600 + 1,944 + 980 + 2,800

---------------------------------------- = 55%
20,680

Mr Y might argue that many financial institutions measure financial gearing by

relating the book value of medium and long-term debt to the book value of
shareholders’ funds, and that Engot should use the same measure as such
institutions, which might include potential lenders to the company. He might
reject gearing based on market values because:
(i) Market values, especially of equity can be volatile and make it difficult for
a company to identify its ‘optimal’ gearing (or range of gearing)
(ii) Security is often based upon balance sheet values of fixed assets. (N.B.
Balance sheet values often include revalued fixed assets.)
Mr Z could extend Mr Y’s arguments by pointing out that the company has
a substantial amount of short-term loans and overdraft, which increase cash
outflows on interest payments, and affect the company’s interest cover and
financial risk. Unless short-term loans and overdrafts are expected to be
eliminated in the near future a gearing measure which does not take such loans
into account would be incomplete and inaccurate.

Mr R could argue that book values often bear little relationship to the
current value to the business of assets and liabilities, especially fixed assets
and should therefore, not be used to measure gearing. Financial decisions
should be taken based upon market values rather than largely historic cost-
based book values. For these reasons gearing based upon market values is
preferred.

(d) Report on financing the proposed expansion

Dear Sirs,
Your choice of financing will be influenced by several factors including
(i) Risk.
(ii) Taxation and cost of alternative sources of finance.
(iii) Likely efect on share price and earnings per share.
(iv) Security available.
If debentures are used financial gearing and financial risk will be increased.
Gearing based upon book values of all loans and overdraft related to
shareholders’ funds will initially increase to
11,200 + 5,000 = 194%
8,330
i.e loans are almost twice as high as shareholders’ funds
Using market value gearing increases to (assuming no change in market
prices)
11,324 + 5,000 = 79%
20,680

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Jun 06 Mock Exam suggested answers

If a rights issue is used gearing, based upon the same measures, initially falls
to

11,200 11,324
--------- = 84% and ---------- = 44% respectively
13,330 25,680

These appear to be quite high when debt finance is used especially for a
company with potentially volatile sales and profits, However, no details are
available of comparative gearing levels of other companies in the industry or
the nature and current values of the company’s assets (e.g. whether they are
easily realisable at book value or higher).

The expected profits are:

£000 £000 £000 £000 £000

Sales 56,000 72,000 90,000 108,000 120,000
Variable costs 42,000 54,000 67,500 81,000 90,000
Fixed costs 8,000 8,000 8,000 8,000 8,000
---------- ---------- --------- ---------- ----------
EBIT 6,000 10,000 14,500 19,000 22,000
At the lowest expected sales level interest cover using the debenture is

6,000
--------- = 3.63 times
1,654

(existing interest assumed constant, plus new interest payable). Although the
minimum acceptable level is likely to differ between companies, a cover of 3.63
times (at worst) is likely to be acceptable to the providers of finance.

The effects of the two financing sources on earnings per share are:

Debentures £000 £000 £000 £000 £000

EBIT 6,000 10,000 14,500 19,000 22,000
Interest 1,654 1,654 1,654 1,654 1,654
-------- --------- ---------- ---------- ----------
Taxable 4,346 8,346 12,846 17,346 20,346
Taxation 1,521 2,921 4,496 6,071 7,121
--------- --------- ---------- ---------- ----------
Available to shareholders 2,825 5,425 8,350 11,275 13,225
-------- --------- ---------- ---------- ---------
EPS (22m shares) 12.8p 24.7p 38.0p 51.2p 60.1p

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Jun 06 Mock Exam suggested answers

Rights issue
£5m at a 15% discount or approximately 80p per share requires the issue of
6,250,000 new shares.

£000 £000 £000 £000 £000

EBIT 6,000 10,000 14,500 19,000 22,000
Interest 1,154 1,154 1,154 1,154 1,154
-------- --------- ---------- ---------- ----------
Taxable 4,846 8,846 13,346 17,846 20,846
Taxation 1,696 3,096 4,671 6,246 7,296
--------- --------- ---------- ---------- ----------
Available to shareholders 3,150 5,750 8,676 11,600 13,560
-------- --------- ---------- ---------- ---------
EPS (28.25m shares) 11.2p 20.4p 30.7p 41.1p 48.0p

At all sales levels use of the debenture results in higher expected EPS. The
level of sales at which the shareholders might be indifferent based on EPS is
found by equating for both the rights issue and debenture issue.

(Sales – variable cost – fixed costs – interest) (1 -- tax)

--------------------------------------------------------------------------
Number of shares
or
(S - .75S – 8 – 1.154) (.65) (S - .75S – 8 – 1.654) (65)
------------------------------------ = ------------------------------------
28.25 22

Solving S = 45.66 million

Sales would have to fall to approximately £45.66 million before shareholders
became indifferent, based upon EPS, between the rights issue and debentures.
At all levels above this (assuming linear relationships) debentures would be
preferred.
The book value of fixed assets is currently £16.7 million. This figure should
increase with the proposed expansion. Taking into account the current level of
overdrafts and loans adequate security should be available for a £5 million
debenture issue.
It would be useful to know what effect the two methods of financing would
have on share price, in particular any relevant effects of changes in bankruptcy
costs and agency costs on share price. However, it is difficult to quantify such
factors.

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Jun 06 Mock Exam suggested answers

Although a debenture issue appears to offer financial advantages, the

decision on the financing choice must depend also upon management attitude
to risk, the target gearing of the company, and the effect that the financing
choice now will have on the company’s long-term investment and financing
plans.

Yours sincerely

C.O.D. & Co. Accountants

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Jun 06 Mock Exam suggested answers

Question 4

Painting and Decorating Cost Budget 20X1 to 20X3

20X1 20X2 20X3
£ £ £
Direct material 20,250 21,263 22,326
Direct labour 72,900 78,003 83,463
Variable overhead 25,515 27,046 28,669
Fixed overhead:
Avoidable 15,430 16,356 17,337
Depreciation 10,287 10,287 10,287
Head office 25,718 27,261 28,897
Total relevant cost 134,095 142,668 151,795
(excluding depreciation and
head office costs) £428,558

Painting 20X1
Working notes: £
Overhead absorbed per house:
20% on material cost 15
100% on labour cost 270
285
Variable overhead element:
30% of material related 4.5
33⅓% of labour related 90
____

Total variable overhead per house 94.5

_____
Fixed overhead per house £190.5
=====

Budgeted fixed overhead for year

= (150 + 120 ) x £190.5 = £51,435
The cost is compiled by multiplying the cost per house for material, labour
and overhead by the number of houses budgeted to be painted each year ( 150
+ 120 = 270 ).
The fixed overhead is analysed into its component categories: avoidable,
depreciation and head office costs.
The 19X2 and 19X3 cost budgets are then compiled by multiplying by the
appropriate cost factors given in the question:
materials + 5%; labour + 7%; overhead + 6%

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Jun 06 Mock Exam suggested answers

Painting and Decorating Cash Budget

20X1 20X2 20X3
£ £ £

Material payments:
Prior year creditors 2,100 1,823 1,914
Current year credit 16,402 17,223 18,084
Cash purchases 2,025 2,126 2,233
Labour payments:
Prior year accruals 2,800 2,916 3,120
Current year 69,984 74,883 80,124
Variable overhead:
Current year 24,664 26,144 27,713
Prior year creditors 600 851 902
Fixed overhead:
Avoidable 15,430 16,356 17,337
Head office 25,718 27,261 28,897
_____ ______ ______
Total cash flows 159,723 169,583 180,324

The cash budget is compiled using the cost budget data calculated above,
together with the information regarding balances at 31 December 20X0 and the
timing forecasts for payments in respect of materials, labour and overhead
given in the question. Note that depreciation is omitted since it does not
constitute a cash flow.

(b) (i) The total relevant costs of operating the painting and decorating
squad for the three year period are £428,558 as calculated above.
The outside company quotation is for 3 x £135,000 = £405,000.
The outside company offer should, therefore, be accepted on financial
grounds.
(ii) Points in favour of the proposal include:

1. Cost. The projected relevant costs for the maintenance

department for the period 20X1 to 20X3 are £428,557.
The outside company quotation is for £405,000 i.e. a saving of
£23,557.

2. Any cash received on sale of residual stocks of paint, plumbing

spares and electrical spares will further increase the savings to
be made from the change.

3. It may be possible to sub-let premises e.g. stores and

workshops which are no longer required and hence generate
additional income.

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Jun 06 Mock Exam suggested answers

4. The current internal operating costs may be understated. The

cost budget in part (a) of the answer includes labour cost based on
the 19X1 cost of £270 per house. The cost per house assumes that
labour is a wholly variable cost which will be available at the times
when individual houses require to be repainted. It may be necessary
to consider labour as a semi-variable cost whereby a small team are
employed permanently all year round with additional employees being
recruited to cope with peaks of painting and decorating activity e.g.
when the weather is particularly favourable. This strategy would mean
an overall increase in labour cost from that stated in the cost budget.

Points against the proposed closure:

1. Redundancy payments to employees may be considerable

hence reducing the savings to be made from the change.

2. The housing association management may wish to employ

inspectors to check that the work done by the outside contractor is of
an acceptable standard. The salaries payable to such inspectors will
reduce the savings to be made from the change.

3. The quality of work may be poorer than at present and cause

dissatisfaction amongst tenants.

4. What happens after the three year period? Will the outside
firm negotiate another contract? Would it be difficult to re-
establish an internal maintenance function.

The apparent savings from the proposal will also be affected by the
accuracy of the estimates of maintenance cost per house. If the
estimates are overstated the external quotation may be considerably
higher than the costs which would be incurred by an internal
maintenance provision. If the cost increase estimates used in compiling
the 1992 and 1993 costs are inaccurate this will further distort the
information being used in the cost comparison.

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Jun 06 Mock Exam suggested answers

Question 5

a) The standard product cost

Standard Standard Standard

Quantity Price Cost
£ £
Direct materials
WALS 15 60 900
LOPS 8 75 600
--------
1500
Direct labour 60 hours at £10.50 per hour 630

Standard prime cost 2,130

Production overheads £504,000/2,400 Wallops 210
--------
2,340
Standard profit (by deduction) £2,800 - £2,340 460
--------
Standard sales price £504,000/180 Wallops = 2,800
=====

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Jun 06 Mock Exam suggested answers

(b) (i) Materials price variance

£
WALS (SP – AP) x Quantity used
(£60 - £57) x 2,850 * = 8,550 Fav
LOPS (£75 - £81) X 1,470 ** = 8,820 Ad
--------
270 Ad
--------

Materials usage variance £

WALS opening stock 600
Purchases 3,000
--------
3,600
Closing stock 750
---------
Quantity used = 2,850 *
Standard 180 x 15 = 2,700
--------
Ad = 150 x £60 = 9,000Ad
Standard Price
LOPS Opening stock 920
Purchases 1,000
--------
1,920
Closing stock 450
--------
Quantity used = 1,470 **
Standard 180 x 8 = 1,440
--------
Ad = 30 x £75 = 2,250Ad
Standard Price
--------
11,250 Ad

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Jun 06 Mock Exam suggested answers

---------
(ii) Direct labour rate variance
(SR – AR) X hours worked
£112,320
(£10.50 - ------------ = £9.60/hour
11,700 hours = 10,530 Fav
- £0.9 x 11,700 hours
Direct wages efficiency variance
(SH – AH) X Std wage rate
(180 x 60) – 11,700) x £10.50
(10,800 – 11,700) x £10.50 = 9,450 Ad
---------
= 1,080 Fav
---------

(iii) Fixed production overhead expenditure variance

(Budgeted overhead – Actual overhead)
£504,000
------------- --- £42,600
12 months
= £42,000 - £42,600 = 600 Ad
Fixed production overhead volume variance
(Budgeted volume – Actual volume) x Overhead absorption rate per unit
£42,000
(200 – 180) x ---------- = £210/unit
200
(20) x £210 = 4,200 Ad
Underabsorbed overhead (i.e. 20 units x £210)

(c) Reconciliation statement standard gross profit and actual gross profit

£
Sales 180 at £2,800 standard price 504,000
Standard cost of sales (a) 180 at £2,340 421,200
-----------
Standard gross profit 82,800

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Jun 06 Mock Exam suggested answers

Variances:

Fav Ad
Material price 270
Material usage 11,250
Direct wages rate 10,530
Direct wages efficiency 9,450
Fixed overheads:
Expenditure 600
Volume 4,200
---------- ---------
10,530 25,770
10,530 = 15,240 Ad
---------
Actual gross profit = 67,560
=====

(d) To: Mr Jones – for presentation to the board of directors

From:
Management accountant………………………….
Date:
Subject: Reconciliation statement of standard gross profit and actual gross profit
Taken alone, the reconciliation statement between the standard gross profit and the
actual gross profit as shown in (c) above is of little value for the board of directors. It is
the causes and the significance of the variances which are of much more importance than
the figures themselves.
Variance reports/statement should initiate the required action and this will depend on
whether the reported variances are controllable or non-controllable – for example:
(1) Material price variance might be unavoidable because of general price rises
whereas material usage variances may have resulted from the excessive waste of
materials due to inefficiency of labour/condition(s) of machines/machinery.
(2) Reduced quality of labour may have led to labour rate savings, but the inadequate
quality/standard of skill(s) cause excessive efficiency variance (s) or is it that the
equipment is outdated and is causing workers to take longer to meet the required
level of satisfactory output.

I recommend that as soon as possible the company implements a system which

requires that all managers prepare for you a detailed report as to the causes and the
implications of any variances for their respective departments.

Signed: ……………………….

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