Stage 3: Strategic Management Accounting

Marking schemes
Introduction

The following notes are guidelines for the completion of questions from previous examination papers.
Candidates are expected to illustrate the knowledge they have gained from the course materials,
additional reading and their experience. Questions can be categorised as either discussion questions
or numerical questions and the approach to each of these will obviously be different.

Hints and tips to answering questions

o Read the question carefully

o Ensure that you allocate the appropriate time to answering the question. If you run out of time
stop and move on to the next question. You will gain more marks by starting a new question.
o Each part of question will have marks allocated to it. Use this as a guide as to how much you
should do for each section.

Numerical Questions

o Ensure that you show all your workings when answering a question. Marks may be given for
workings even if the final answer is wrong.
o Do not be tempted to spend too long trying to get a question to balance, move on to the next
question.
o If you feel you have incomplete information for a question, make assumptions and state these
clearly on your examination script.

Discussion questions

o Read the question carefully to ensure you understand what is required

o Start your answer with an introduction if necessary to set the scene
o Your discussion should demonstrate your knowledge of the course materials, additional
reading and also your experience
o Give examples from your practical experience to illustrate the points you are making

The following marking grid is used to assess discussion questions:

Grade Comment
Distinction Outstanding work giving detailed responses to each of the points above.
Includes industry examples and reference to practical problems.
Illustrates reading beyond scope of course materials.
Merit Good to very good work, less detailed bullet point approach. Some
practical examples. Based mainly on course notes.
Pass Meets requirements but with some gaps - not all issues considered,
lacking in practical focus, some reference to course materials.
Fail Wholly inadequate
British Association of Hospitality Accountants
EDUCATION & TRAINING PROGRAMME

STRATEGIC STAGE –
MANAGEMENT ACCOUNTING
Date: 19 July 2001 Time: 09.30 – 12.30 hours

INSTRUCTIONS TO CANDIDATES:

 You are required to answer any four questions

 The paper is 3 hours in length
 All workings must be in ink or ball-point pen
 Non-programmable calculators may be used
 Discount tables are appended to the back of this paper
 Useful formula:

EOQ = √ 2Co D
Ch

Where:

EOQ = Economic Order Quantity

Co = Cost of ordering
D = Annual demand
Ch = Cost of holding stock

External Examiner Ms Helen Atkinson

 British Association of Hospitality Accountants

2
QUESTION 1 (25 MARKS)

The various stages of the Product Life Cycle raise a number of issues for the provision of
management accounting information. Describe each stage of the cycle and consider how
each of the following differs at each stage:

a) Cashflows

b) Level of operating expenses

c) Performance Measures
(25 marks)

QUESTION 2 (25 MARKS)

The Exclusive Club is considering adding fresh homebaked breads to its menu. However, an
oven that costs £30,000 will have to be purchased. It has an estimated seven-year life and the
owners have calculated that the club will sell £20,000 of breads annually with a food cost of
30% and a labour cost of 35%. The residual value of the machine at the end of seven years is
forecast to be £5,000.

The target return is 15% per annum.

You are required to:

a) Calculate the net present value for this investment. (5 marks)

b) Calculate the internal rate of return. (4 marks)

c) Comment on your findings. Do you think the machine should be purchased? (2 marks)

d) Describe the different capital investment appraisal techniques available and give the
strengths and weaknesses of each. Which method do you feel is the most effective and
why? (10 marks)

e) What is the 'cost of capital' and explain why it should be calculated with care? (4 marks)

3
QUESTION 3 (25 MARKS)

The Carmen Hotel has a bistro style restaurant which, due to growing demand, has recently
been extended. A summary of the current year results for the bistro are shown below:

Food Beverage
£ % £ %
Sales revenue 150,000 100 100,000 100
Cost of sales 45,000 30 25,000 25
Gross profit 105,000 70 75,000 75

With the extension now completed the following forecasts have been made for the coming
year:

i) Sales of food and beverage will increase to £200,000 and £150,000 respectively.
ii) The amount of stock to be held will be:
iii) Food - 10 days on average
iv) Beverage - 25 days on average
v) Of the total sales of food and beverage, 20% will be on credit and the debtors will be
on average 45 days.
vi) Food suppliers will give 30 days’ credit and beverage suppliers give 45 days.
vii) Advance booking deposits from parties will amount to 5% of four weeks food sales.

You are required to:

a) Prepare a statement analysing the average working capital requirements necessary to

fund the business during the coming year compared to the previous year. (15 marks)

b) Give illustrated examples of six key ratios which could be used to monitor the
effectiveness of a restaurant operation. (10 marks)

4
QUESTION 4 (25 MARKS)
A successful and expanding but fairly small private hotel company finds its rate of growth
restricted by lack of capital.

You are required to:

a) Describe the methods that the business might use to raise additional funds and
indicate, with reasons, your preferred method. (15 marks)

Assume such further facts as are necessary for your answer.

b) Explain what is meant by gearing and the implications of this measure on a business.
(10 marks)

5
 QUESTION 5 (25 MARKS)
Explain the purpose and difficulties of using ratio analysis. Suggest a range of financial and
non-financial measures which could be used to monitor a hospitality business using examples
drawn from both your study and your experience.
(25 marks)

QUESTION 6 (25 MARKS)

Part A

The Roasta Coffee Shop sells a particular brand of coffee and has the following
characteristics:

Sales 10 cases per week

Ordering costs £10 per order
Holding costs 30 per cent per year
Item cost £80 per case

You are required to calculate:

a) How many cases should be ordered at a time? (2 marks)

b) How often should the coffee be ordered? (2 marks)

c) What is the annual cost of ordering and holding coffee? (2 marks)

d) What factors might cause the coffee shop to order a larger or smaller amount than the
EOQ? (4 marks)

(Part A: 10 marks)

AND

Part B

a) Explain the role of a credit manager within a business. (8 marks)

b) Discuss the major factors a credit manager would consider when assessing the credit
worthiness of a particular customer. (7 marks)

(Part B: 15 marks)
END OF PAPER

6
Examination paper
July 2001

QUESTION 1

The discussion for this question should include a review of each stage of the product life cycle.
Candidates are expected to demonstrate their knowledge of the Product Life Cycle concept – a
drawing illustrating the concept is expected by the examiners.

The question requires candidates to review each stage - Launch, Growth, Maturity and Decline with
particular reference to the impact on:

 Cashflows – how will these vary at each stage, what precautions should the business take?
 Level of operating expenses – how will these vary at each stage?
 Performance measures – it is not appropriate to use say ROI throughout the project for example.
There should be a different emphasis on performance measures throughout the Product Life
Cycle.

Students should draw on examples from their practical experience.

QUESTION 2

a) Sales 20,000
Food cost 6,000
Labour cost 7,000

Therefore, the Cash flows to be generated are £ 7,000 per annum. The profit to be generated will
equate to the annual cash flow less depreciation.

Year DCF rate Cash flow Discounted

15% Cash
Flow
1 0.869 7000 6090
2 0.756 7000 5292
3 0.658 7000 4606
4 0.572 7000 4004
5 0.497 7000 3479
6 0.432 7000 3024
7 0.376 7000 2632

29127
Add Residual value 5000 1880
31007
Less initial investment 30000
NPV 1007

The positive NPV generated indicates that this project generates a return in excess of 15%.

7
b) In order to calculate the Internal Rate of Return another set of discounted figures are required. This
time we are discounting at 20%

Year DCF rate Cash flow Discounted

20% Cash
Flow
1 0.833 7000 5831
2 0.694 7000 4858
3 0.579 7000 4053
4 0.482 7000 3374
5 0.402 7000 2814
6 0.335 7000 2345
7 0.279 7000 1953

25228
Add Residual value 5000 1395
26623
Less initial investment 30000
NPV -3377

The negative net present value indicates that the project gives a return lower than 20%.

To calculate the IRR:

1. Look at the difference between NPV’s = 4384

2. Calculate the NPV per % change 4384 / 5 = 876.8

3. Calculate the % movement in NPV at 15% 1007 / 877 = 1.148

IRR is 15% + 1.148 = 16.148%

c) The project delivers a positive NPV at 15% and the IRR is in excess of 16%. The machine
should be purchased.

d) Answer to include reference to ARR, PI, NPV and IRR

ACCOUNTING RATE OF RETURN

INTRODUCTION
This is simply Return on Capital Employed by another name.

 It is an Historic Cost based procedure and uses the figures that are likely to appear in future Profit
& Loss Accounts and Balance Sheets in respect of the project.
 It is NOT a cashflow technique.
 It relates the AVERAGE Net Profit to the AVERAGE Book Value over the life of the project.
However, the AVERAGE Net Profit is often incorrectly related to the ORIGINAL Cost of the
Project. (If the project is subject to Straight Line Depreciation and has no Residual Value, the
AVERAGE Book Value will be half of the ORIGINAL cost).

ADVANTAGES
 Simple to calculate.
 Expressed as a % to enable projects to be ranked.
 Shows Profitability based on accepted accounting conventions of Historic Cost Accounting (HCR).
 Similar to Return on Capital Employed.

DISADVANTAGES
 Does NOT use cashflows.

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 Fails to consider the changing value of money through time. (It treats £1 received in the future as
being equal to £1 received now; but we can invest £1 received now so that it is worth more in the
future!).
 Shows only an average and ignores the timing of Profit or Cashflows and hence the time value of
money.

PAYBACK PERIOD

INTRODUCTION
 This IS a cash flow technique.
 It calculates the length of time it takes to recover the initial investment in cash.
 It is Liquidity rather than a Profitability technique.
 Note: Cash Flow is higher than Profits by the amount of Depreciation (and other non-cash
expenses).

ADVANTAGES
 Simple to calculate.
 Uses Cash Flows.
 As it emphasises Liquidity rather than Profitability, it is a SAFETY measure.

DISADVANTAGES
 Stresses the Payback Period rather than the useful life of the asset.
 Ignores Cash Flows after the Payback Period.
 Ignores timings of the Net Cash Inflows (and Out Flows) within the Payback Period. (This latter
limitation can be eliminated by the use of Discounted Payback).

NET PRESENT VALUE

INTRODUCTION
 This is a Discounted Cash Flow (DCF) technique.
 The total of the Present Value of future Cash Inflows is then compared with the Cost of the
project. The difference is called the Net Present Value (NPV).
 If the Discounted Inflows are less than the Cost of the project (negative NPV) a loss would occur
and hence the project should be rejected.
 The greater the excess of Discounted Inflows over the Cost of the project (positive NPV) the
greater the profit on the project.
 NPV shows Profitability and when WACC is used it is academically the best technique.
Sometimes a Target Rate of Return is used instead of, or as well as, WACC but only the use of
WACC as the discount rate indicates profitability.

ADVANTAGES
 A DCF technique
 The time value of money and the timing is taken into account on all Cash Flows
 Correct academically when WACC is used

DISADVANTAGES
 More difficult to calculate
 Difficult to rank projects as the size of the NPV is not related to the size of the original investment

INTERNAL RATE OF RETURN

INTRODUCTION
 This is also a Discounted Cash Flow (DCF) technique
 Instead of applying a rate to discount future Cash flows in order to obtain a NPV, this technique
calculates the rate that provides a Zero NPV of those cash flows. This rate is the Internal Rate of
Return (IRR)
 The calculations are done on a Trial & Error basis
 In practice, if two fairly close rates can be found, the actual rate can then be calculated by
Interpolation

9
  Modern computer spreadsheet Macros enable this to be done quickly and accurately

ADVANTAGES
 A DCF technique taking into account the time value of money and the timing of all cash flows
 Shows the result as a % which is popular for comparison with Money Market rates
 Enables projects of different sizes to be ranked

DISADVANTAGES
 More difficult to calculate
 Although it enables projects to be ranked, the technique assumes that surplus cash can be
reinvested at the IRR rate
 This is flawed when the IRR deviates from the Money Market rates
 Hence, it can give misleading results in certain circumstances

PROFITABILITY INDEX

INTRODUCTION
 This technique uses the Discounted Cash Flows prepared for the NPV calculation but separates
the discounted Inflows from the (discounted) Outflows.
 Unlike NPV which subtracts Outflows from Inflows, the Profitability Index (PI) divides the Inflows
by the Outflows to give an Index number.
 An Index number above 1.0 indicates a profitable project, whereas a number below 1.0 indicates
an unprofitable one.
 The discount rate used must be WACC.

ADVANTAGES
 A DCF technique based correctly on WACC.
 The Index number enables different sized projects to be ranked.

e) The WACC figure used in capital investment appraisal is calculated from weighted cost of
servicing the different forms of capital invested in the business and is crucial in determining
whether the project should go ahead or not. Too high and the project will be rejected, too low
and the project will be accepted.

QUESTION 3

a) In this question the student is required to forecast the forthcoming working capital requirements
based on the usage in the previous year. The figures for the coming year are likely to be, given
last years performance:

Food Beverage
£ % £ %
Sales 200,000 100 150,000 100
Cost of sales 60,000 30% 37,500 25
Gross profit 140,000 70 112,500 75

The day’s figures for each of the working capital items enables the cash value of the working capital
item to be calculated.

For example if the food holding is 10 days and the cost of food consumed is 45,000 then the food held
is:

45,000 x 10 = 450000 / 365 = £1233

Based on the stock holding formula of:

Stock holding (days) = (stock held / stock consumed) x 365

10
 Previous Budget
Stock:
Food 1233 1643
Beverage 1712 2568
Debtors 6164 8630
Cash 577 769
Less Creditors:
Food 3699 4931
Beverage 3082 4623
Total working capital 2905 4056

b) Students should give a range of ratios including some explanation for the workings and value for
each of the following:

o Gross profit
o Wage percentage
o Seat turnover
o Sales per employee
o Profit to sales %
o Return on capital employed
o Average spend per head (Food, beverage)

QUESTION 4

This question requires candidates to consider the funding available to a small private hotel.

From the course materials:

The definition of short-term finance is usually loans with a term of up to three years. Most financial
institutions prefer short term loans to be “self liquidating”, that is used for a purpose which will directly
generate profits out of which the loan interest and capital will be repaid. For example, a hotel might
seek short-term funds to purchase a bulk purchase of wine, which will be sold over a period of one or
two years.

Other uses include:

 purchasing plant and equipment with a short life

 acquiring cars
 financing working capital. For example, hotels with seasonal fluctuations in demand may require
short term finance in the low season

Main types of short-term finance include:

 bank overdraft which is normally obtained from the clearing banks and is the most common form
of short-term finance. Interest is calculated by reference to the bank base rate and is charged on
a day-to-day basis. Overdrafts are generally considered the most flexible and convenient external
finance but can be expensive. In theory, however, they are payable on demand, although they
are virtually never called in without reasonable warning
 Short-term bank loans are generally preferred by banks to an overdraft. This is particularly
where the credit is required for a specific purpose. The main difference to an overdraft is that a
fixed repayment schedule is determined and the interest rate may be fixed
 trading terms whereby extended credit from suppliers is used to provide short term funds. That
is to say creditors are not paid promptly. The business may also reduce working capital
requirements by ensuring debts are collected. Usually, extended credit can only be used to a
limited extent and will depend on a business’s “clout” as to how long it can delay credit and
whether it can even get credit from suppliers
 hire purchase and leasing. These two methods are very similar sources of finance for cars,
plant, equipment and furniture. The main difference being that at the end of a leasing term,
ownership does not automatically pass to the lessee, though an option to purchase can be

11
 acquired. In general, lease financing is more expensive than short term loans or overdrafts but
the rental charge is allowable for taxation

Medium term finance is generally defined as funds borrowed for between three and ten years.
Main uses are for acquisition of assets with a life within this range or for the partial funding of
longer life assets. For instance, it is not unusual for a hotel to be partially financed by such funds.

The main types of medium term finance include:

 Term loans which are the main source of medium term finance, where finance is made available
for a fixed period and repayments are normally in equal instalments over the life of the loan, with
interest payable on capital outstanding during the year. Variations include annuities, whereby
equal annual payments of capital and interest combined are paid, moratoriums where capital
repayments are deferred in the first year or so of the loan and balloon payments where capital
repayments are biased towards the end of the term. Term loans are generally provided by the
clearing banks, though sometimes by merchant banks and specialist banks.
 Supplier loans. Suppliers are sometimes prepared to provide finance in order to secure a
market for their products. In the hotel and catering industry, the brewing industry is a major
provider of such loans, particularly for improvements to bar facilities.

Long term finance is normally available for over ten years and is generally used to acquire
assets which have a long life, such as land and buildings.

The main types of long term finance include:

 Term loans as described above. These are generally difficult to secure since lenders prefer
loans to be secured
 Mortgages are loans which are secured on the property they are used to finance. Normally up to
65 per cent of the value of the property can be borrowed. The main sources of mortgages are
pension funds, insurance companies and some banks, though they are often organised and
arranged by a merchant bank. Note that building societies do not lend to companies
 Sale and lease back is where a business sells property to an institution, often an insurance
company or pension fund, and leases it back for a fixed term – usually 50 years or more. This
allows the company to realise the full asset value and perhaps re-invest more profitably, whereas,
if the property had been used as security for a loan, only a portion of the full value would have
been realised. This is a common method of financing in the hotel industry but the major
disadvantages include: the loss of right to modify the building; a high real cost particularly if there
are frequent rent reviews; contractual commitment to occupy the building for many years ahead
and a possible liability to capital gains tax on the sale of the property

Raising equity finance depends again on the type of business. In the case of the sole trader, the
owner may either retain profits or invest further personal funds. The partnership may in addition
to these options bring in a new partner, providing the partnership does not exceed twenty
persons. The partnership deed will obviously have to be altered to reflect any changes.

The methods of raising equity finance available to the limited company depend on the type of
company, whether it is a private or public and quoted or non quoted. The main characteristics of
these types of company are as follows:

 a private company restricts the right to transfer its shares and prohibits the public offer of shares
in its articles and memorandum of association. A private company is normally a family business
where shares are held by the directors and their family or a wholly owned subsidiary of another
company. Private company names are suffixed by ‘Ltd’
 a public company has greater scope for raising finance as shares are freely transferable. They
may be quoted on the Stock Exchange, which enables them to raise large amounts of equity
finance from the general public and institutions. The Stock Exchange is the market where the
shares can be bought and sold. Public company names are suffixed by ‘Plc’

Students should indicate a preferred method based on:

12
 Use of funding
 Cost of servicing
 Form of repayment
 Effect on gearing

b) From the course materials:

When a business borrows money, that money will be used to buy assets which will hopefully generate
more income than the cost of the loan. That is, the rate of return to the business will be greater than
the rate of interest it will have to pay. The difference will be kept as profit. Let’s illustrate this with
some examples.

Suppose a business employs £1,000,000 of assets and has a rate of return of 20%, giving a return of
£200,000. The management wishes to double the size of the firm and consider they can maintain the
same rate of return. If they borrow the additional £1,000,000 at, say, 12% interest, the profit position
will be as follows:

Total capital employed £2,000,000

Return at 20% 400,000
Less interest on £1m at 12% 120,000
Net profit remaining 280,000
Rate of return to £1m of equity 28%

By the use of relatively cheap loans, the rate of return to equity can be increased beyond the simple
rate of return. If the rate of return is improved to 21% the situation will be:

Return on £2m at 21% £420,000

Less interest on £1m at 12% 120,000
Net profit remaining 300,000
Rate of return to £1m of equity 30%

This magnifying effect of borrowed funds is the reason why borrowing is much resorted to by
businesses. Using borrowed funds in this way is known as gearing. A company with a high
percentage of borrowed funds is 'highly geared'. But the advantage all depends on the rate of return
being higher than the rate of interest. If it falls below the rate of interest, the advantage turns into a
disadvantage and may be fatal. This situation is known as reverse gearing. Suppose in the example
already shown, the company, having borrowed £1m at 12%, has poor results such that the rate of
return falls to 8%. The situation would then be:

Return on £2m at 8% £160,000

Less interest on £1m at 12% 120,000
Net profit remaining 40,000
Rate of return to £1m of 4%
equity

– and the situation can easily arise where the rate of return, though still a positive rate, can fall so far
below the rate of interest that the profit is wiped out and a loss is incurred, that is, a negative rate of
return to equity.

Gearing is an important matter of company finance both for profitability and for solvency. It is
essential when assessing a company to know its profit-making potential through gearing on the one
hand, and its vulnerability to insolvency through gearing on the other. A measure of gearing, the
gearing ratio, is calculated:

Gearing ratio = fixed interest funds

total funds

13
It would have been simpler to define the gearing ratio as "the proportion of borrowed funds to total
funds", and this would be correct for many companies.
What is the norm for a gearing ratio? As for many of the ratios we are studying, there is no answer to
this, but the question is even less appropriate in respect of gearing than for any of the other ratios. A
company with no gearing would be far safer than any other, but would be foregoing considerable profit
potential; a very highly geared company, with, say, a 70% gearing ratio, would have very high profit
potential for ordinary shareholders, but would be extremely vulnerable to a market downturn.

Another measure of gearing is the debt/equity ratio. This establishes the ratio of all fixed interest
capital to the equity capital.

Fixed interest loans and preference capital

Equity

A final word: the gearing ratio, like all the others, is only a guide or an indication. You must also bear
in mind the actual rates involved. Two companies might have the same gearing ratio, but is A's
borrowed funds have a lower rate of interest than B's, then A is in a better position. Further, the date
of redemption of the loans must be noted.

QUESTION 5

This is an open ended question and as a result has a range of possibilities appropriate for the
solution.

Students should discuss how ratios can be used to monitor business performance. The discussion
should include:

 Types of ratio
 How ratios can be used and the advantages
 Difficulties with ratios
 Range of non financial measures including possibly Balanced Scorecard

QUESTION 6

Part A

This question requires the use of the EOQ formula which is quoted on the front of the exam paper.

a)
√ 2Co D
EOQ
Ch
=

EOQ formula 2 x 10 x 520

24

Number of cases to order 21 cases.

b) Cases should be ordered every 15 days (365 / (520 / 21))

c) The annual cost of ordering the coffee is

D/EOQ x cost of placing order = £248
The annual cost of holding is
EOQ/2 x holding cost = £252

d) Seasonal variations
Delays in delivery
Inconsistent in supply
Length of time for delivery to be made.

14
Part B

a) The role of the credit manager should be discussed briefly but with sufficient detail to merit 8
marks.

o Establish a credit policy – discuss how briefly

o Assess customers credit worthiness – give how
o Establish effective administration of debtors - how
o Establish a policy on bad debts - examples

b) The major factors credit manager will look for:

o Customers accounts for signs of liquidity problems

o Monitor length of time to pay debts
o References from customers bank / other traders
o Credit checking agencies
o Volume of business
o Frequency of payment
o Overseas businesses

15
British Association of Hospitality Accountants
EDUCATION & TRAINING PROGRAMME

STRATEGIC STAGE –
MANAGEMENT ACCOUNTING

Date: 17 January 2002 Time: 09.30 – 12.40 hours

INSTRUCTIONS TO CANDIDATES

You are allowed 10 minutes reading time at the start of the examination, during
which time you are not permitted to write.

This paper examines Units 9, 10, 11 & 12.

You are required to answer any four questions.

All workings must be in ink or ball-point pen.

Non-programmable calculators may be used.

Discount tables are appended to this paper.

External Examiner Ms Helen Atkinson

© British Association of Hospitality Accountants

16
QUESTION ONE (25 MARKS)
A hospitality business is considering a capital project costing £755,000. The sales forecast
together with the forecast expenditure are shown below:

Year Sales Cost of sales Other Variable Fixed costs Depreciation

£ £ costs excluding £
£ depreciation £
1 400,000 150,000 50,000 60,000 150,000
2 500,000 180,000 60,000 60,000 150,000
3 600,000 220,000 70,000 60,000 150,000
4 600,000 220,000 70,000 60,000 150,000
5 600,000 220,000 70,000 60,000 150,000

YOU ARE REQUIRED TO:

i) Calculate the net present value at a cost of capital of 10%. (6 marks)

ii) Calculate the internal rate of return. (5 marks)

iii) Calculate the payback period. (3 marks)

iv) Calculate the accounting rate of return. (4 marks)

v) Discuss your results. (7 marks)

17
QUESTION TWO (25 MARKS)
The following figures are extracted from the accounts of a small catering company for the
year ended 31 December 2001. All customers are given credit payment terms:

£
Stocks 40,500
Debtors 70,200
Creditors 34,000
Sales 565,000
Cost of goods sold 142,500

YOU ARE REQUIRED TO:

i) Calculate the working capital cycle from the values in the accounts. (6 marks)

ii) Explain the result and discuss each of the component values. Give recommendations
where appropriate. (8 marks)

iii) List the reasons why it is important to manage the level of working capital. (4 marks)

iv) Discuss what you consider to be the most important factors that determine the
optimum level of stockholding for a business. (7 marks)

18
QUESTION THREE (25 MARKS)
COMPLETE PART A & PART B:

Part A:

Define each of the following ratios and explain the importance of the measure of
performance:

i) Return on Capital employed

ii) Net profit ratio
iii) Gross profit ratio
iv) Current ratio
v) Acid test ratio
vi) Rate of stock turnover
vii) Gearing ratio
viii) Earnings per share (16 marks)

AND

Part B:

A hotel operates three units. The information given below is for one month of trading:

Hotel Suisse Hotel Roma Hotel Paris

Number of rooms available 150 120 170
Guest capacity 280 200 300
Number of rooms occupied 90 80 120
Number of guests 150 150 200
Room sales £9,500 £8,750 £13,700
Food and beverage sales £2,500 £3,500 £3,800

Calculate a range of ratios to analyse the performance of the rooms division for each of the
hotels and discuss the significance of your results.
(9 marks)

19
QUESTION FOUR (25 MARKS)
A large hotel and catering company is considering additional finance to fund extensive
expansion plans. Describe the various forms of funding that are available to the business and
discuss the nature of each type of funding in terms of:

i) Risk
ii) Cost to the business
(25 MARKS)

QUESTION FIVE (25 MARKS)

Forest Caterers plc is a major hospitality company wishing to expand. Currently the
company has £500 million of long term capital and proposes to raise a further £100 million to
finance the expansion.

At present 60% of the Forest Caterers plc finance comes from equity and the rest from loan
stock. However, one of the Directors feels that more loan stocks could be introduced as these
are a cheaper form of finance than equity and suggests introducing additional loan finance so
that only 50% of funds are classified as equity after the additional finance has been raised.

However, a second Director argues that the best way to finance the project would be to use
retained profit as this represents a 'free' source of finance to the business.

Currently the shares, which have a nominal value of £0.50, are being traded at a market price
of £1.25. The dividend at present is £0.05 per share and recently has been increasing at a
compound rate of 10% per annum.

The average cost of the loan stock after taxation is 10%.

YOU ARE REQUIRED TO:

i) Calculate the Weighted Average Cost of Capital for Forest Caterers plc for each of the
scenarios described and comment on the remarks made by each of the Directors.
(10 marks)

ii) Calculate the amount of equity finance the Directors wish to raise and comment on
the business plan to increase the gearing of the business. (8 marks)

iii) Explain the term ‘Cost of Capital’ and discuss why a company should calculate its
cost of capital with care. (7 marks)

20
QUESTION 6 (25 MARKS)
Financial statement analysis

YOU ARE REQUIRED TO:

i) Identify the main user groups of accounting information and describe their common
needs in terms of financial analysis. (10 marks)

ii) What sources of information from outside the business are available to you as a
business operator to enable you to analyse the position of your business more
effectively? (9 marks)

iii) Explain briefly what is the difference between business risk and financial risk.
(6 marks)

END OF PAPER

21
Examination Paper
January 2002

QUESTION ONE

A hospitality business is considering a capital project costing £755,000. The sales forecast together
with the forecast expenditure are shown below. This calculation gives the cash flow generated. The
deduction of the depreciation expense provides the profit forecast.

Year Sales Cost of sales Other Variable Fixed costs Cash flow
£ £ costs excluding £
£ depreciation £
1 400,000 150,000 50,000 60,000 140,000
2 500,000 180,000 60,000 60,000 200,000
3 600,000 220,000 70,000 60,000 250,000
4 600,000 220,000 70,000 60,000 250,000
5 600,000 220,000 70,000 60,000 250,000

vi) Calculate the net present value at a cost of capital of 10%

Year Cash flow Discount rate Discounted

£ 10% cashflow
1 140,000 0.9091 127,274
2 200,000 0.8264 165,280
3 250,000 0.7513 187,825
4 250,000 0.6830 170,750
5 250,000 0.6209 155,225
Residual value 5,000 0.6209 3,105
Total cash 809,459
Less original 755,000
investment
Net present 54,459
value

vii) Calculate the internal rate of return. In order to do this it is necessary to discount at another
rate to give a second set of NPV figures.

Year Cash flow Discount rate Discounted

£ 20% cashflow
1 140,000 0.8333 116,662
2 200,000 0.6944 138,880
3 250,000 0.5787 144,675
4 250,000 0.4823 120,575
5 250,000 0.4019 100,475
Residual value 5,000 0.4019 2,010
Total cash 623,277
Less original 755,000
investment
Net present (131,723)
value

Difference in the present value = 54,459 + 131,723 = 186,182

Difference in discount rate = 20 -10 = 10

186,182 / 10 = 18,618

22
54,459 / 18,618 = 2.93

IRR = 10 + 2.93 approximately 13%

In order to prove this: (This calculation is not necessary in the examination)

Year Cash flow Discount rate Discounted cash

£ 13% flow
1 140,000 0.8850 123,900
2 200,000 0.7831 156,620
3 250,000 0.6931 173,275
4 250,000 0.6133 153,325
5 250,000 0.5428 135,700
Residual value 5,000 0.5428 2,714
Total cash 745,534
Less original 755,000
investment
Net present (9,466)
value

The value is not exactly zero NPV because the discount rate is not precisely 13%.

viii) Calculate the payback period (using discounted payback):

Year Cash flow Discount rate Discounted cash

£ 10% flow
1 140,000 0.9091 127,274
2 200,000 0.8264 165,280
3 250,000 0.7513 187,825
4 250,000 0.6830 170,750
5 250,000 0.6209 155,225
Total cash 806,354

Discounted payback occurs at 4.7 years.

ix) Calculate the accounting rate of return

Year Cash flow Depreciation Profit

£ £
1 140,000 150,000 (10,000)
2 200,000 150,000 50,000
3 250,000 150,000 100,000
4 250,000 150,000 100,000
5 250,000 150,000 100,000
Total 340,000

The five year average is 68,000

68,000 / 755,000 x 100 = 9%

x) Discuss your results: The discussion should include a summary of the results in tabular form.
The viability of the project should be discussed based on these results as well as a discussion
as to the viability of the methods used.

23
QUESTION TWO

The following figures are extracted from the accounts of a small catering company for the year ended
31 December 2001. All customers are given credit payment terms.

£
Stocks 40,500
Debtors 70,200
Creditors 34,000
Sales 565,000
Cost of goods sold 142,500

YOU ARE REQUIRED TO:

v) Calculate the working capital cycle from the values in the accounts.

These workings are performed using the standard ratios for working capital control.
Stock days 40,500 / 142,500 x 365 = 104
Debtor days 70,200 / 565,000 x 365 = 45
Creditor days 34,000 / 142,500 x 365 = (87)
Working capital cycle = 62

vi) Explain the result and discuss each of the component values. Give recommendations where
appropriate.

Stock days These are high at 104 days. In the hospitality industry it is
expected that the stock days reflect the nature of the goods which
are mostly perishable. This figure represents an average so some
items will have extremely low stock turnover values. 2 marks
Debtors days These figures reflect the length in days it takes on average for a
customer to pay their bill after departure or after a function. The
value of days is fairly high but is typical for many hotel operations.
2 marks
Creditor days These are fairly high days for the payment of suppliers. Typically
suppliers should be paid by 30 - 60 days but many companies take
longer. 2 marks
Recommendations To reduce stock turnover by examining all stock items and acting to
reduce the length of holding time. Review purchasing policy and
offer discounts to sell slow moving items. 2 marks

vii) List the reasons why it is important to manage the level of work capital.

 Finance is committed to funding working capital

 The cost of investing in current assets is an opportunity cost
 Sufficient levels of WC are required to keep the business operating.

Students should give detail and examples to illustrate each point.

viii) Discuss what you consider to be the most important factors that determine the optimum level
of stockholding for a business.

From the course materials:

The overall objective of inventory control is to minimise the costs associated with stock holding
without losing potential sales through not having sufficient stock available. The cost of stock

24
 comprises of three elements; the purchase price, the holding costs and the cost to the business of
being out of stock.
The cost of holding stock includes costs associated with:

 lost interest on money tied up in stock

 storage space
 staffing, insurance
 risk of obsolescence and pilferage
 purchasing costs

The cost of being out of stock is difficult to calculate accurately. It is not easy for us to quantify the
cost of the loss of customer goodwill and potential lost sales when insufficient stocks are available.
Other costs may be incurred where production is halted in other areas causing a delay in services,
through the loss of flexibility which exists when there is buffer stock and the administrative costs
incurred from placing lots of small orders.

The quantity of stock we order each time depends on the anticipated level of demand. We are
attempting to strike a balance between the costs of holding stock and the costs of a stock shortage,
that is the costs incurred when sales are lost.

Many models operate on the assumption that the stock levels fall evenly over time until the stock runs
out when it is replaced by a stock delivery,

QUESTION THREE

Part A:

Define each of the following ratios and explain the importance of the measure of performance.
ix) Return on Capital employed
x) Net profit ratio
xi) Gross profit ratio
xii) Current ratio
xiii) Acid test ratio
xiv) Rate of stock turnover
xv) Gearing ratio
xvi) Earnings per share

Each of the ratios should be defined (see courseware) and examples given of the measures and the
meaning.

Part B:

A hotel operates three units. The information given below is for one month of trading.

Hotel Suisse Hotel Roma Hotel Paris

No. of rooms available 150 120 170
Guest capacity 280 200 300
No. of rooms occupied 90 80 120
No. of guests 150 150 200
Room sales £9,500 £8,750 £13,700
Food and beverage sales £2,500 £3,500 £3,800

Calculate a range of ratios to analyse the performance of the rooms division for each of the hotels and
discuss the significance of your results.

25
 Hotel Suisse Hotel Roma Hotel Paris
Room occupancy % 60% 66.7% 70.6%
Guest occupancy % 53.6% 75% 66.7%
Average room rate £105.55 £109.38 £114.17
Average guest rate £63.33 £58.33 £68.50
REV PAR £63.33 £72.92 £80.59
Food and beverage sales £16.66 £23.33 £19.00
per guest
Food and beverage sales £27.77 £43.75 £31.67
per room occupied

Candidates are awarded 6 marks for the ratio calculation. Remember to show all your workings!
Marks are also given for interpretation of the results.

QUESTION FOUR

A large hotel and catering is considering additional finance to fund extensive expansion plans.
Describe the various forms of funding which are available to the business and discuss the nature of
each type of funding in terms of:

i) Risk
ii) Cost to the business

Student should describe the various forms of funding available. See model answer on page 8.

QUESTION FIVE

Forest Caterers plc is a major hospitality company wishing to expand. Currently the company has
£500 million of long term capital and proposes to raise a further £100 million to finance the expansion.

At present 60% of the Forest Caterers plc finance comes from equity and the rest from loan stock.
However, one of the Directors feels that more loan stocks could be introduced as these are a cheaper
form of finance than equity and suggests introducing additional loan finance so that only 50% of funds
are classified as equity after the additional finance has been raised.

However, a second Director argues that the best way to finance project would be to use retained profit
as this represents a 'free' source of finance to the business.

Currently the shares which have a nominal value of £0.50 are being traded at a market price of £1.25.
The dividend at present is £0.05 per share and recently has been increasing at a compound rate of
10% per annum.

The average cost of the loan stock after taxation is 10%.

You are required to:

i) Calculate the Weighted Average Cost of Capital for Forest Caterers plc for each of the
scenarios described and comment on the remarks made by each of the Directors.

The cost of equity is calculated using the dividend growth model:

£0.05
------- x 100 (+ 10%)
£1.25

= 14%

60% of funding at 14% and 40% at 10% gives a WACC of 12.4%

26
(60% x 14% = 8.4%) + (40% x 10% = 4%) = 12.4%

50% funding at 14% and 50% at 10% gives a WACC of 12%

Comment on the Directors comments. The important points are that:

o Loan capital does reduce cost of capital

o Retained profits are not a free source of finance.

ii) Calculate the amount of equity finance the Directors wish to raise and comment on the
business plan to increase the gearing of the business

The current equity / loan balance is:

Total funding £500,000,0000

Equity £300,000,0000
Loans £200,000,0000

The new funding structure is to be £600,000,000 from:

Equity £300,000,000
Loans £300,000,000

Students should discuss the nature of gearing and the impact on the shareholders of the business.
See diagram to illustrate relationship between gearing and cost of capital in the courseware.

iii) Explain the term ‘Cost of Capital’ and discuss why a company should calculate its cost of
capital with care.

The WACC figure used in capital investment appraisal is calculated from weighted cost of servicing
the different forms of capital invested in the business and is crucial in determining whether the project
should go ahead or not. Too high and the project will be rejected, too low and the project will be
accepted

QUESTION SIX

iv) Identify the main user groups of accounting information and describe their common needs in
terms of financial analysis.

Students should discuss the stakeholder as desscribed in the course materials. In each case they
should refer to the interests of each group and how this impacts on the strategy of the business. Good
answers will also make reference to conflict and possibly performance measures used by each group.

ii) What sources of information from outside the business are available to you as a business
operator to enable you to analyse the position your business more effectively?

From the courseware:

The problem with achieving effective competitor analysis lies in obtaining good, reliable and
meaningful information. It is not always necessary to obtain absolute values quite often relative
financial data that is data, relative to one's own business is sufficient. The management accountants
within the business should be sufficiently experienced to be able to apply their own knowledge of cost
structures to develop data drawn from the competition. The overall aim is to build up a
comprehensive database about the competition that is continually being updated. The information
contained within this can be drawn from a number of sources without in any way resorting to unethical
forms of industrial espionage. A varied range of sources are listed below:

27
 Library research - Annual reports
- Press/journal material
- Investment analysts reports
- Government reports
- Published market intelligence
- Company literature
- Company history
- Academic case studies
- Computer based information service
- Competitor advertising
Interviews - Journalists
- Academics
- Others with specialist knowledge
Direct contact - Visits to other establishments
- Physical observation
- Physical analysis of product
Conferences - Industry associations
Primary market research - Consumer surveys
- Industrial market research
Soft information - Own staff and management
- Mutual suppliers
- Mutual customers

ix) Explain briefly what the difference between business risk and financial risk is.
From the course materials:

The overall level of risk facing an organisation when it decides to launch a new idea is a combination
of two types of risk.

Financial risk is derived from the nature of the financing of the project and the cost structure of the
business. Financing risk occurs when the project is funded by debt capital rather than equity capital
with the risk arising from the fixed interest payments and the eventual need to repay the capital. Cost
structure refers to the nature of the costs experienced by the business. Costs that have to be paid
regardless of the level of trading are known as fixed costs and a high proportion of these renders a
business as high risk.

Business risk arises from the inherent nature of the product. A business will try to achieve a balance
by rejecting those projects with both high financial risk and high business risk. However, the
combination of low business risk and high financial risk could provide very favourable returns for
shareholders.

The stages of the product life cycle have different intrinsic levels of risk that the business has little
control over as these are created by the outside environment. The launch stage is obviously the stage
carrying greatest risk but the risk is also high in the development stage when the potential size of the
market is still not known. As the market matures the risk reduces and is concentrated on the length of
the maturity stage. The final stage is low risk as the demand for the product dies and the company's
strategy is tailored accordingly. Risk and return are invariably linked with a positive correlation in that
if risk increases so must the return. This basic economic principle is illustrated below:

28
 TABLE - RELATIONSHIP BETWEEN RETURN AND RISK

Risk premium
Risk

Risk free rate

Return

29
British Association Of Hospitality Accountants

EDUCATION & TRAINING PROGRAMME

STRATEGIC STAGE –
MANAGEMENT ACCOUNTING

Date: 16th July 2002 Time: 09.30 – 12.40 hours

INSTRUCTIONS TO CANDIDATES

You are required to answer any four questions.

The paper is 3 hours in length.

All workings must be in ink or ball-point pen.

Non-programmable calculators may be used.

Discount tables are appended to this paper.

External Examiner Ms Helen Atkinson

© British Association of Hospitality Accountants

30
QUESTION ONE (25 MARKS)

Analyse the strategic direction of a business with which you are familiar using a range of
strategic tools and models drawn from your studies (principally unit 9). You should describe
each tool you have selected to use and then try to analyse your own chosen business using the
key concepts you have described.

QUESTION TWO (25 MARKS)

x) Explain briefly what is meant by the term ‘working capital cycle’ (4 marks)

xi) The Blue Lagoon Restaurant offers a range of French style dishes, the demand for
which has been steadily increasing. As a result the restaurant plans to extend its
seating capacity. A summary of the current year results is shown below (These are
prior to the extension):

Food Beverages
£ % £ %
Sales 420,000 100 270,000 100
Less cost of sales 126,000 30 67,500 25
Gross profit 294,000 70 202,500 75

It is expected that with the extension completed the sales for food and beverage will
rise to £575,000 and £350,000 respectively.
Debtors are expected to increase from 5% to 10% of total sales. Debtors take to pay
on average 5 weeks.
The amount of stocks held will be on average:

 Food: 2 weeks supply

 Beverage: 4 weeks supply

Food and beverage suppliers will give 4 weeks credit.

YOU ARE REQUIRED TO:

Prepare a statement analysing the working capital requirements for food and beverage
for the coming year compared to the current year. You should assume that a year
comprises of 52 weeks. (18 marks)

xii) Discuss the implications for the business based on the figures you have calculated.
(3 marks)

31
QUESTION THREE (25 MARKS)
A medium-sized catering company has discovered that it is holding 20 days’ worth of dry
goods stock whilst its main competitor is holding only 10 days’ worth.

YOU ARE REQUIRED TO:

xi) Describe the costs and the benefits associated with holding stocks. (10 marks)

xii) Describe how the optimum stock level can be found. Explain how useful this
approach is in practice for the hospitality industry giving examples to illustrate your
explanation. (10 marks)

xiii) Consider how stock turnover might vary from industry to industry. Use your
knowledge of your own sector of industry in comparison with another of your choice.
(5 marks)

32
QUESTION FOUR (25 MARKS)

Bluebell Restaurants have been operating since 1990. The actual results for 2000 and 2001
are shown below:

Profit & Loss Accounts for the Year Ending 31 December

2000 2001
£000 £000 £000 £000
Sales:
Food 1,125 1,680
Beverage 900 870
Other 225 350
Total 2,250 2,900

Less:
Cost of sales:
Food 335 510
Beverage 225 220
Other 45 95
Total 605 825

Gross profit
Food 790 1170
Beverage 675 650
Other 180 255
Total 1,645 2,075

Less:
Operating expenses
Labour 565 815
Depreciation 225 290
Other expenses 56 79
Total 846 1,184

Less:
Fixed expenses
Depreciation 225 290
Other expenses (inc. interest) 279 421
Total 504 711

Net profit before tax 295 180

Less:
Corporation tax (20%) 59 36
Net profit after tax 236 144

Less:
Proposed Ordinary Share dividend 100 80

Retained profits for the year 136 64

(Please note that the annual interest charge is £36,000) Continued / …

33
Balance Sheets as at 31 December

2000 2001
£000 £000 £000 £000 £000 £000

Fixed Assets (net):

Freehold property 1,360 1,760
Equipment & furniture 480 400
1,840 2,160
Current Assets:
Stocks of food 40 45
Stocks of beverages 60 70
Cash at bank ---- 30
100 145

Less creditors:
(Amounts due within 1 year)
Creditors 55 75
Taxation 59 36
Proposed dividend 100 80
Bank overdraft 44 ----

Net Current Assets/(Liabilities) (258) (191)

1,682 2,114

Less creditors:
(Amounts due in more than 1 year)
10% Mortgage 2008 360 360
1,322 1,754

Financed by:
Ordinary Share Capital 759 1,127
Retained Profits 563 627
1,322 1,754

YOU ARE REQUIRED TO:

i) Use a range of ratios to compare the operational and financial performance from year
to year. (15 marks)

ii) Based on your calculations write a report commenting on the results with
recommendations for future actions and investigation. (10 marks)

34
QUESTION 5 (25 MARKS)
Capital investment appraisal

YOU ARE REQUIRED TO:

i) Explain the following methods of capital investment appraisal:

a) average accounting rate of return

b) payback method
c) net present value

Which method do you feel is the most effective and why? (11 marks)

ii) The Blue Skies Restaurant is considering purchasing a new food-processing machine
at a cost of £12,000, which is expected to save £4,000 per year in staff wages. The
estimated useful life of the machine is considered to be 5 years at the end of which it
is estimated it will have a value of £1,000.

a) Calculate the net present value at a cost of capital of 10% (4 marks)

b) Calculate the internal rate of return (4 marks)
c) Comment on your findings (2 marks)

iii) What is the 'cost of capital' value used in capital investment appraisal and explain why
it should be calculated with care? (4 marks)

QUESTION 6 (25 MARKS)

Financial statement analysis

YOU ARE REQUIRED TO:

In recent years a growing number of non-financial measures have been introduced to monitor
business performance in the hospitality industry. Explain the purpose of using ratio analysis
and discuss what alternative measures are available. How do these measures overcome the
weaknesses of ratios for monitoring performance? Use examples drawn from both your
study and your experience.

END OF PAPER

35
Examination paper
July 2002

QUESTION ONE

Candidates were required to analyse a business they were familiar with using a range of strategic
tools. In the response students were required to use at least one model described in unit 9 including:

o SWOT
o PEST
o Product life cycle
o Boston matrix
o Porters theories

The allocation of marks is judged as follows:

Criteria Distinction Pass Fail

Excellent Adequate Poor

Number of models 4 models 1 model 1 model

Explanation of models Clear and detailed Clear shallow Unclear

Depth of discussion Evaluative Descriptive little or none

References to industry
norms and practices Excellent Insight Clear Insight No real insight
demonstrates

Examples from real life Numerous Few examples None or

selective examples not useful

QUESTION TWO

i) Define the term working capital cycle:

From the course materials:

The exact amount of idle cash held can be managed effectively by understanding and controlling the
cash operating cycle. This specifies the period taken in days between the cash payment to suppliers
for goods and the cash being received from customers for sales. In the manufacturing industries,
taking the car industry as an example, a large portion of the cash cycle will focus on days required to
manufacture the finished product from the raw materials and the incomplete finished goods are known
as work in progress. As a result the usual cash operating cycle would comprise of the following:

Days raw materials held in stock x days

Days needed to produce goods x days

Days finished goods held in stock x days

Days debtors take to settle accounts on receipt of goods x days

LESS

Days taken to pay trade suppliers x days

EQUALS

36
 Cash operating cycle x days

The typical hotel operation requires stock for almost instant usage and the emphasis is on ensuring
that sufficient stocks are held for service without incurring the costs associated with overstocking.
The following diagram illustrates the working capital cycle in a service based operation:

Days raw materials held in stock x days

Days debtors take to settle accounts on receipt of goods x days

LESS

Days taken to pay suppliers x days

EQUALS

Cash operating cycle x days

We can see that whenever a business is able to gain credit from suppliers this in effect finances part
of the cash operating cycle. Consequently, large businesses such hotel chains can operate with
shorter operating cycles if they are able to secure better credit terms. Any delay in the time taken to
receive cash from outstanding customers or in the credit terms offered will increase the length of the
cycle. This will eventually lead to the running down of cash resources and may lead to liquidation.

v) This part of the question requires candidates to work out the working capital requirements for
the year.

Working capital Current year Coming year

Food stocks Stock = 2 x 126,000 Stock = 2 x 172,500
52 52
= 4,846 = 6,635
Beverage stocks Stock = 4 x 67,500 Stock = 4 x 87,500
52 52
= 5,192 = 6,731
Debtors Debtors = 5 x 34,500 Debtors = 5 x 92,500
52 52
= 3,317 = 8,894
Food creditors Creditors = 4 x 126,000 Creditors = 4 x 172,500
52 52
= 9,692 = 13,269
Beverage creditors Creditors = 4 x 67,500 Creditors = 4 x 87,500
52 52
=5,192 = 6,731

Working capital requirement –

Working capital Current year Coming year

Stock - Food 4,846 6,635
Stock – beverage 5,192 6,731
Debtors 3,317 8,894
Creditors – food (9,692) (13,269)
Creditors – beverage (5,192) (6,731)
Total (1,529) 2,260

iii) In the current year the current assets are funded by the creditors. However, in the coming year
because the sales are increasing and the debtor levels is increasing and further working capital will be
required. This could be funded from further investment or by extending credit from suppliers or by the
use of advanced booking deposits.

37
QUESTION THREE

i) From the course materials:

Stock or inventory may be defined as any current asset held for conversion into cash. In
manufacturing industries, stock holdings may account for almost half of the total assets employed and
consequently stock management will require careful planning and control. In these types of business
the stock is classified in to three types:
Raw materials. This is stock held in the state in which it was purchased without any work having
taken place

Work-in-progress. This is stock which has been partially converted in to the final state ands the
value is made up of raw material costs plus labour and expenses.

Finished goods. These are completed goods awaiting delivery to the customer.

Typically stock will comprise mainly of food and beverage both of which will be fairly fast moving,
however we may also hold significant levels of items such as disposables and stationery.

The overall objective of inventory control is to minimise the costs associated with stock holding
without losing potential sales through not having sufficient stock available. The cost of stock
comprises of three elements; the purchase price, the holding costs and the cost to the business of
being out of stock.

The cost of holding stock includes costs associated with:

 lost interest on money tied up in stock

 storage space
 staffing, insurance
 risk of obsolescence and pilferage
 purchasing costs

The cost of being out of stock is difficult to calculate accurately. It is not easy for us to quantify the
cost of the loss of customer goodwill and potential lost sales when insufficient stocks are available.
Other costs may be incurred where production is halted in other areas causing a delay in services,
through the loss of flexibility which exists when there is buffer stock and the administrative costs
incurred from placing lots of small orders.

ii) From the course materials:

Stock management can include the use of models where appropriate and also stock turnover ratios.
The use of these methods will depend on the nature of the stock. An effective stock control system
will not necessarily classify all stock items in the same way.

The Pareto principle is based on the condition that a small percentage of items comprise the greatest
value of stock. The principle works on the assumption that 80% of the value of the stock may be held
in only 20% of the items. This may well be close to reality in hotel operation where liquor stocks often
have the largest value per item.

Stock management models

The quantity of stock we order each time depends on the anticipated level of demand. We are
attempting to strike a balance between the costs of holding stock and the costs of a stock shortage
that is the costs incurred when sales are lost.

Many models operate on the assumption that the stock levels fall evenly over time until the stock runs
out when it is replaced by a stock delivery, as illustrated in the diagram below.

38
 A graph of the stock level against time for some item of stock

S E
t
o
c
k
E/2
L
e
v
e
l
0
Time
An amount (E) of stock is delivered at time 0. This is steadily used until the
stock level drops to 0, at which point a new consignment (amount E) arrives.
The average level of stock is E/2)

This is the basis of the Economic Order Quantity model (EOQ) which calculates the most efficient
order quantity for each item given the costs involved. The calculation is as follows:

√ 2Co D
EOQ =
Ch

Where:

EOQ = Economic Order Quantity

Co = Cost of ordering
D = Annual demand
Ch = Cost of holding stock

You may have already realised that models of this sort are limited in their application to the hotel and
catering industries. The model assumes that there is a known constant stock holding cost, a known
constant ordering cost, the rates of demand are known and that there is a known constant price per
unit.

The main problem arises from the seasonality of the hospitality industry, which, in many cases,
renders the model almost totally useless. However, the model may well have useful application in the
food production industries where production is constant.

iii) Discussions based on two types of industry say retail versus manufacturing.
The focus should be on:

o Value of stock held

o Type of stock held
o Conditions for holding stock
o How to hold deteriorating stocks.
o Stock turnover rates

39
 QUESTION FOUR

i) Candidates should show all workings for ratios.

2000 2001
ROCE 331/1682 x 100 = 19.68% 216/ 2114 x 100 = 10.22 %
295 + 36 = 331 where 36 =
interest paid
Return on sales 331 / 2250 x 100 = 14.7% 7.4%
Asset turnover 2250 / 1682 = 1.34:1 1.37:1
Stock days – Food 40 / 335 x 365 = 43.6 32.2
Stock days – Beverage 60 / 225 x 365 = 97 116
Current ratio 100/ 258 = 0.39:1 0.76:1
COS % Food 335 / 1125 x 100 = 29% 30.4%
COS % Beverage 225 / 900 x 100 = 25% 25%
COS % other 45 / 225 x 100 = 20% 27%
Labour % 565 / 2250 x 100 = 25% 28%
Operating expenses to sales 846 / 2250 x 100 = 37.6% 40.8%
Fixed expenses to sales 504 / 2250 x 100 = 22.4% 24.5%
Creditor days 55 / 605 x 365 = 33 33
Gearing 360 / 1682 x 100 = 21% 17%
Interest cover 331 / 36 = 9 times 6 times
Return on equity 236 / 1322 x 100 = 17.85% 8.2%

ii)
The report should include a review under the headings for example:

o Profitability
o Liquidity
o Asset usage
o Gearing
o Operational issues

The conclusions should pinpoint problems areas as well as strengths and include recommendations
for future action.

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QUESTION 5

i) For a full explanation of the capital investment appraisal methods – see the course notes unit
ten
ii) Calculations for NPV and IRR

Year Cashflow DCF 10% NPV

1 4,000 0.9091 3,636
2 4,000 0.8264 3.306
3 4,000 0.7513 3,005
4 4,000 0.6830 2,732
5 4,000 0.6209 2,484
5 1,000 0.6209 621
15,784
Original investment 12,000
Net present value 3,783
Year Cash flow DCF 20% NPV
1 4,000 0.8333 3,333
2 4,000 0.6944 2,778
3 4,000 0.5787 2,315
4 4,000 0.4823 1,929
5 4,000 0.4019 1,608
5 1,000 0.4019 402
12,365
Original investment 12,000
Net present value 365

To calculate the Internal Rate of return:

1. Calculate the difference in the two NPV figures = 3783 - 365 = 3420

2. Calculate the NPV per % point: 3420 divide by 10 = 342

3. Calculate the % point distance to zero 3783 / 342 = 11.06

IRR = 10 + 11.06 = 21.06

iii) Explanation of cost of capital

The WACC figure used in capital investment appraisal is calculated from weighted cost of
servicing the different forms of capital invested in the business and is crucial in determining
whether the project should go ahead or not. Too high and the project will be rejected, too low and
the project will be accepted

QUESTION 6

This question is based on materials in Unit 11 of the courseware. Students should discuss:

o Why we use ratios to monitor performance

o The types of measures commonly used
o Non financial measures commonly used in the hospitality industry
o Balanced score card approach
o Customer market profitability versus departmental profitability

All discussions should be illustrated with examples from the students own experience in the work
place.

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DISCOUNT TABLES

Present Value of £1

Discount Factor

Yea 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
r

0 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000

1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019

6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959 0.2791
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487 0.2326
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090 0.1938
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756 0.1615

11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476 0.1346
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240 0.1122
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042 0.0935
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413 0.1252 0.1110 0.0985 0.0876 0.0779
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229 0.1079 0.0949 0.0835 0.0736 0.0649

42