OPERATIONAL CASE STUDY FEBRUARY 2017 EXAM ANSWERS

Variant 1

The February 2017 exam can be viewed at:

https://connect.cimaglobal.com/resources/february-2017-operational-case-study-
variant-1

SECTION 1

COUSINS STRATEGIC SUPPLY WHEEL

Competences and skills

We at Mavis Venderby are skilful at producing and retailing wooden hives. However our
knowledge of polystyrene hives is limited, therefore in our search for the right supplier we
need to recognise our need to fill our knowledge gap with external experts. The supplier
chosen will need to have good communication skills as we will need to work collaboratively
to produce the best design and manage future supply chain issues.

Performance measures

These are the metrics by which we monitor the success of the supply strategy. At Mavis
Venderby we already have in place a number of tactical measures, such as lead time and
reject rate. As with all agency transactions the need to build trust is paramount. We would
need to find further appropriate quality control checks to ensure our brand and reputation are
not tarnished by sub-standard poly hives.

Cost / benefit

In choosing a new supplier our primary concern must be quality and expertise. Therefore we
need to focus on the benefits a specialist manufacturer will bring to our portfolio. The cost is
a secondary concern, however, it must be calculated and a viability study performed to
ensure the long term success of our business.

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Relationships

This symbiotic relationship between us and the manufacturer means in Cousins term our
relationship would need to be collaborate rather than competitive. We would need to see
our suppliers as partners, working together to achieve long term success. We already have a
great long term working relationship with our wood suppliers, however this time we would
have to go even further and collaborate on the design and manufacture stages.

Organisational structure

It is important that supply management can work cross functionally as a team. At Mavis
Venderby it is important that we do not become stuck in our functional silos to the detriment
of the success of our overall strategy. For example, consideration of suppliers from a
financial perspective may prefer a particular supplier whereas Tracey may prefer to
purchase from a supplier that will despatch a special order quickly. The decision to choose a
sole supplier of poly hives will require a project like approach.

FORECASTING

The trend line

The regression line Y = 17, 000 - 700Q, is the trend line for Petroc Hives. It is based on
observations of past sales to model the relationship between Y, the total number of wooden
hives sold and Q, the time period (which in this case is quarters).

17,000 represents the number of wooden box hives sold in the base year, that is, the year
before Petroc Hives sold poly hives. This represents a size of demand close to our own at
Mavis Venderby, which suggests that we can expect similar results.

-700Q means that for every three month period (quarter) that Petroc Hives traded, the
demand for wooden hives fell, on average, by 700 hives.

Given the similarity of our businesses, we can use this relationship to forecast what will
happen to our wooden hives sales once we start to sell poly hives.

Seasonal variation

We are a seasonal business and make most of our sales in March, April, May June and July.
Therefore in addition to our trend line, which is at its most simple, just an average sales
figure, we need to adjust for differences due to the time of year.

Q1 is the first quarter of the financial year and sales are likely to be 60% above the average
(trend). As Q2, the second quarter of the financial year, is less busy sales are only 40%
above the average (trend).

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For our business the multiplicative method is more useful that the additive as our seasonal
variation is proportionate to our total sales. So for example, if our annual sales are down due
to, for example, poor weather, the proportion of seasonal variation is likely to remain
constant.

Limitations

The simple regression assumes linearity, in that there is a linear relationship between time
and the fall in volume sales of wooden box hives. Using this assumption we will sell no
wooden box hives at all after approximately six years of poly hive sales. While this is
possible, it is unlikely.

Linear regression is based on past sales. The assumption is that the trend will continue in
the future as it has in the past. This is not a safe assumption particularly as we are basing
the trend on only two years sales data.

We are also assuming that the buying pattern of beekeepers in the North Republic will be
replicated by the beekeepers of Tucland and also that data that is 15 years old is still
relevant. This may not be the case as perhaps the climate in the North Republic is colder
than in Tucland or the technology that produces poly hives may have advanced and become
more desirable.

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SECTION 2

ASSESSMENT OF THE SIX POTENTIAL SUPPLIERS

Financial stability

We have only two indicators of financial stability: the size of the revenue and the time that
the supplier has been trading. The revenue of each of the suppliers can indicate an ability to
survive in the short to medium term. The revenue of Supplier A is the smallest of all the
suppliers under consideration. The smaller the revenue, the greater proportion of their
business will be taken up by our orders. On this basis, Supplier A is by far the riskiest
choice.

The most likely time for a business to cease trading is in the months following start-up. In
this category it is once again Supplier A that would be the least stable as they have only
been trading for a little over a year. Supplier F has also only traded for a short period of time.

Location and currency

From a financial perspective it is easier to trade with suppliers A, D and F as they operate
within Tucland which means that we will receive and pay invoices in T$. Suppliers B, C and
E will invoice in their own currency and we will have to consider the currency risk of using
them as suppliers. In addition it will be less easy to pay suppliers in a foreign currency, which
could lead to problems with payment and additional administration.

Different locations also have implications for lead times. The closer a supplier is to us the
easier it is to manage inventory and to limit the amount of environmental damage caused by
transporting goods. Furthermore, if we import from a country outside of Tucland, we may
have to pay import duties or higher delivery charges which would increase the cost of the
goods.

Credit terms

The schedule shows that Supplier A is offering the best terms at 60 days, however we
should be wary of choosing Supplier A for the reasons already listed. The second best are
Suppliers D and F and, although 40 days is much shorter than we currently receive from our
wood supplier, they are the best available. Supplier D would appear the best option of the
two as they have slightly larger revenues and have been trading for longer. We should also
consider though whether there are prompt payment discounts on offer; as this will reduce
these standard terms potentially.

Similarly there may be bulk discounts available for larger orders. Although larger orders will
increase our inventory holding costs (such as the cost of financing inventory, insurance, and
store management) as a seasonal business we might find that a bulk discount benefit could
outweigh the cost. The availability of discounts needs further investigation.

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THE MARKETING MIX

Product

Obviously our products are hives but we need to consider the features of a poly hive that
makes it more attractive to our customers. The extract from the Honeypot Beekeepers
Forum was probably written by a commercial beekeeper (given the volume of hives ordered)
who will value a product where honey bees will enjoy an ideal environment for producing as
high a honey yield as possible. The poly hive is made from a material that, due to its
insulating properties, makes it easier for the bees to regulate the internal temperature, is less
draughty and is waterproof. In other words, better for honey yield than wooden hives. In
addition, the poly hive will not rot, which will mean less time and expense spent on
maintenance. This will mean a better financial yield.

It is also important that the poly hive is designed in order that the parts are interchangeable
with the wooden hives that we sell. Few beekeepers (hobby or commercial) will want to
replace their entire hive stock in one go.

Price

We have always priced our hives using a cost plus approach. However in the minds of our
customers the price of a poly hive will have as a benchmark, the price of a wooden hive. In
effect it is likely that if the price of a poly hive rises then the customer will switch to a wooden
hive and vice versa. To this extent the price that we charge for a poly hive will be anchored
with the price of a wooden hive. As our market is quite competitive, the prices that we charge
for a poly hive are probably going to be influenced by what our competitors are charging.
The going rate price will influence our price to some extent but if we can differentiate our
poly hives, in terms of a superior design or brand we will be able to sell at a higher price.

We have been able to charge a premium price for our wooden hives because of our strong
brand name. It is likely that we will be able to charge a premium price for our poly hive for
the same reason. I believe that the brand prestige will extend to the poly hive. As usual,
commercial beekeepers are likely to buy in bulk and suitable discount will be available to
them for this.

Promotion

We will promote the poly hive in the same way that the wooden hives are promoted, via the
national beekeeping magazines, through local beekeeping and bee farming associations, at
trade shows and of course through the website. The poly hive is a new product, with different
attributes to the wooden hives. In the early months of the lifecycle of the poly hive,
customers are likely to need more help and guidance than they need for the established
wooden versions. Our sales staff must be able to give this advice.

Place

Our poly hives will be sold via the website and also through our shop. In the shop they will
need to be displayed assembled at the side of our wooden hives. At our premises we have a
number of bee colonies. The presence of a poly hive and the resulting evidence of a bumper
honey crop will aid promotion. We will also need to ensure that the poly hives have
prominence on our web-site.

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SECTION 3

VARIANCES

Materials

The cedar price variance is marginally favourable which means that we bought cedar at
less per metre than the original standard set in February 2017. However as the world price
for cedar has fallen by almost a third since this standard was set, a much more favourable
variance could be expected. In effect, the world cedar price drop masked an adverse
variance. This operational variance may be a result of the lack of contact between Tracey
and the suppliers during the time that she had to work almost exclusively with the poly hive
supplier, it is possible lower prices need negotiating.

This pine price variance is adverse as we paid more for a metre than standard. This is
probably due to the loss of bulk purchase discounts as we will buy less wood if we are
making less hives.

Usage is adverse for both the pine and the cedar hives, which means that we are using
more wood for each hive built than standard. The pine usage can be explained by the fact
that all of the new trainees have been working on the pine box production and they are more
likely to make mistakes and errors. The adverse usage on the cedar hives is likely to be due
to the poor staff motivation. The cutting staff may be worried about the possibility of losing
their jobs as it is obvious that the demand for wooden hives is falling.

Labour

The pine rate variance is favourable as this is where we employed the trainees. All trainees
are paid a basic T$9 per hour not the full T$17 per hour until they complete their six month
probationary period. The weighted average hourly will have reduced as the lower paid
trainees have replaced the more expensive experienced staff on the pine box hives. The
cedar rate variance is less favourable than the pine and is probably due to the fact that the
annual pay rise has not yet been awarded.

The pine labour efficiency variance is due to the high proportion of trainee workers working
on this product. As they are not yet fully trained they take longer than standard to
manufacture a hive and they are more likely to make sub-standard hives. The reason for the
cedar box hive for the adverse efficiency variance is less clear, but possibly due to the
motivational issues as discussed above.

PLANNING AND OPERATIONAL VARIANCES

A planning variance is caused by differences between the revised standard cost of actual
output and the original standard cost of actual output, whereas the operational variance is
caused by differences between the actual costs and the revised standard cost of actual
output.

Standards are usually based on the environment which are anticipated when they are set.
We produced the current standard cost card during January and February this year, using
the information available to us at that point in time. We could not have anticipated the world
cedar price fall that has happened since. If we split our variances into planning and

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operational, this price fall would be categorised as a planning variance. Splitting the
variances is useful when factors in the environment change unexpectedly.

The information used in setting the ex-post standards can be used in future budget periods,
making them more accurate and therefore more useful for performance appraisal and
control. For example, the material price variance was calculated on a standard price that
assumed that demand for wooden hives, required more wood to be purchased than the
previous year. In fact the volume of wood purchased is likely to be lower than the previous
year and so it is likely that bulk purchase discounts will be lost and the price of wood higher.
Therefore the standard does not reflect true performance. When we set the standard for the
next year we will factor this into the standard rate we establish.

The division of variances into planning and operational elements can be subjective. The mix
of trainees during this quarter could be argued to be a normal variation with our usual
operations or an abnormal blip caused by the garden furniture manufacturer paying much
higher wages. Managers will want to argue this point depending on their perspective, and
this can lead to conflicts within the business.

Finally the re-working of variances into their planning and operational elements is a time
consuming process, which will rely on good analysis skills. Within our business we have
limited resources within the finance function with which to calculate the variances.

MANAGEMENT PERFORMANCE

Managers should only be held responsible for factors that are within their control. As our
managers had no control over the reduced demand for wooden hives it is unfair to appraise
their performance on the fact that they have produced less hives. In this case splitting the
variances into the planning and operational elements would have been useful. In fact not
splitting them out was misleading, as detailed above

When actual performance is compared with a standard that is up to date and takes account
of any changed conditions, it provides a more meaningful measure of managerial
performance. This can mean that a manager is not blamed or indeed praised for factors that
they have not influenced. For example Tracey should not be rewarded for a favourable cedar
price variance. This means that these variances are more motivational as they are more
equitable.

The use of planning variances will allow us to assess how effective our planning process has
been. Where a revision of standards is required due to environmental changes that were not
foreseeable at the time the budget was prepared, the planning variances are uncontrollable.
However standards that failed to anticipate known market trends when they were set will
reflect faulty standard setting. As the standards were set not long before the start of the new
financial year in March, perhaps the fall in world cedar price should have been anticipated.

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SECTION 4

BREAKEVEN

Breakeven point

The break-even point is higher when poly hives are included, meaning that we need a higher
level of sales to cover our fixed costs in order to break-even. The reason that the break-
even point is higher is because the weighted average C/S ratio has fallen as a result of
increasing the sales of poly hives.

The weighted average C/S ratio with the inclusion of the poly hives is lower because we will
be making a higher contribution margin on those products that we make-in house than we do
with the poly hive which we buy in. It is reasonable to expect a lower contribution margin for
the poly hives as all of the costs are variable costs whereas the wooden hives have a high
proportion of fixed costs. We are adding less value to the poly hive than we do to the raw
materials that we purchase.

It is also possible that our weighted average C/S ratio is lower with the inclusion of poly hives
because we will make less wooden hives which means that we buy less materials and may
lose any bulk purchase discount. This will increase our cost and reduce the contribution
margin.

Margin of safety

The margin of safety is higher with the inclusion of poly hives, meaning that the gap between
our budgeted sales and break-even sales is bigger than without poly hives. This is because
of our overall sales increase. In effect we gain more customers (sales) overall if we sell poly
hives.

Business implications

Overall the increase the breakeven point increases our business risk as we have to make
more sales to cover our fixed costs. However the is risk offset to some extent by the
increased margin of safety, as this shows that we are achieving higher levels of sales.

The poly hive business is purely variable cost based and it could be useful for us to
investigate other outsourcing opportunities. As there is no additional fixed cost incurred in
the purchase and sale of poly hives, every additional poly hive that we sell will generate
contribution and therefore profit. However, in reality it is likely that the sale of poly hives will
have some incremental fixed costs.

CUSTOMER IN LIQUIDATION

IAS 10: Events after the reporting date, states that where there is evidence that a condition
existed at the reporting period date and the financial statements have not yet been approved
by the director, those financial statements should be adjusted to reflect the change.

Although the customer was not declared insolvent until many months after the reporting
period date of 28 February 2017, the debt owed relates to sales made in the year leading up
to that date. Within our draft financial statements for the year ended 28 February 2017 there

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is a receivable balance for this customer (the conditions) and we now have evidence that
this money is not going to be collected. In accordance with IAS 10 this is an adjusting event.

In terms of the impact on our financial statements we will need to reduce the receivables
balance by the amount that the customer owes and debit the irrecoverable debt expense in
the statement of profit or loss (which will increase administrative expenses).

The implication of this for our receivables management is that we need to ensure that we
review all receivables balances (both at 28 February 2017 and now) for any other amounts
that might not be recovered. This debt has been outstanding for many months and it would
appear that it was a surprise that had not been paid. Possibly as a result of all the changes
to the business and the increased workload regarding credit customers, monitoring of
receivables balances has been ignored. We need to ensure that an aged receivables report
is prepared, reviewed and acted on regularly.

CHANGING INVENTORY VALUATION METHOD

IAS 2: Inventories allows the weighted average and FIFO methods to value inventory but not
LIFO.

IAS 8: Accounting Policies, Changes in Accounting Estimates and Errors, states that a
change of this nature is a change in accounting policy, which if allowed would require a
retrospective adjustment to the financial statements. This means that we would have to
restate the inventory value using the weighted average or FIFO method for the comparatives
in the financial statements as well as the opening position in retained earnings.

The impact of changing to the FIFO method of valuation on the financial statements would
be to increase the recorded value of the inventory at the year end. The weighted average
method of valuation is likely to give a similar recorded value to the standard cost. The impact
on profit will depend upon the opening inventory position (as this will also change). In any
event any profit differences are only temporary as the closing inventory for this February
2017 will be the opening inventory for the year ended 28 February 2018. In the long term
there is no tax benefit.

Changes in accounting policy are only permitted if required by a standard or if it results in the
financial statements providing more reliable and more relevant information. We will need to
assess if this is the case. Currently we use standard costs to value inventory in our financial
statements and in accordance with IAS 2 these will need to be adjusted by a share of the
variances at the year end to give an approximation of cost. If either FIFO or weighted
average give us a better approximation for cost then it is possible that the auditors will agree
this change.

One final point is that it is not ethical to manipulate profits in order to pay less taxation. Even
if there was a tax benefit (which in the long term there isnt) this could be seen as tax
avoidance, which although not illegal, is viewed negatively.

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