CIMA - Chartered Institute of Management Accountants



-3411950200OPERATIONAL CASE STUDY August 2018 EXAM ANSWERSVariant 5SECTION 1- INTERPRETATION OF BUTLER ESTATES DIRECT LABOUR VARIANCESRate variance:The rate variances show that the hourly rate paid to the trainee workers was lower than the standard rate. The business took on additional trainees at the start of the month because of losing two experienced staff and these trainees will have been paid at the lowest trainee rate. This will have resulted in a reduction in the average rate paid to trainees. In addition, the hourly rate paid to senior grade workers was higher than was expected. This could be because the Butler brothers had to persuade one of their senior grade workers to stay with the business: perhaps a pay increase was offered to entice them to stay. Junior grade staff were paid at the same rate as was expected. Idle time:Butler Estates budgets for idle time and the budgeted idle time is the difference between the expected productive hours and paid hours. The adverse variances for trainee and senior grade workers indicate that the actual amount of idle time was greater than budget. This is likely due to the initial training of the trainees by the senior grade workers which meant that neither grade of worker was being productive. The scale of the variance for trainee time compared to senior grade workers indicates that this might not be the only reason. Possibly, new trainees are initially not productive for less than 90% of the time that they work.The favourable variance for junior grade workers shows that there was less idle time than budgeted, probably due to them not being involved in training and therefore completing work that they would not normally be expected to do.Mix variance:Both trainee and junior grade standard hourly rates are lower than the weighted average of D$23.20. The favourable mix variances must mean that the actual mix of worker hours included a greater proportion of both trainee and junior grade hours than budgeted. The favourable senior grade worker mix variance is because a lesser proportion than budgeted of a more than average rate resource has been used. This corresponds with expensive senior grade workers being replaced with relatively inexpensive trainees. The overall impact is that D$6,432 of the efficiency variance is the result of this change in mix and is not a reflection of how efficient the workers have been in achieving the level of actual output. Productivity variance:The favourable productivity variance tells us that based on the original standard mix of workers, the business used less productive hours than was originally budgeted to produce the actual output. Perhaps due to the idle time incurred as a result of training, when workers were being productive, they were able to achieve more in the time because they had to, which indicates that perhaps there is some slack in the 10% idle time standard.FINANCIAL REPORTING IMPLICATIONS OF POTENTIAL INVESTMENTConsolidated financial statements:If we acquire an 80% controlling interest in Butler Estates, we will be acquiring a subsidiary and as such will need to prepare consolidated financial statements for the first time. The investment will be a subsidiary because our 80% interest will give us control: meaning the right to variable returns and the power to direct the activities of the business.To prepare the consolidated financial statements we need to treat the group (Thomas Fine Teas as parent and Butler Estates as subsidiary) as if it were one entity. In the consolidated statement of financial position 100% of the assets and liabilities of Butler Estates will be added to our assets and liabilities: we add in 100%, even though we only own 80% of the business, because we control those assets and liabilities. In the consolidated statement of profit or loss we add 100% of the revenue and expenses of Butler Estates to ours, although in the year of acquisition this will be pro-rated to reflect our period of ownership.The consolidated statement of financial position will also include a figure for goodwill, which is the difference between what we pay for our interest in Butler Estates and the fair value of the net assets that we will acquire. Goodwill is discussed further below. To reflect the fact that we will only own 80% we will need to make further adjustments for non-controlling interest. Non-controlling interest will represent the Butler brothers remaining interest in the business and will be valued at the date of acquisition either at fair value or at 20% of the fair value of the net assets of the business on that date. At the year-end in our consolidated statement of financial position we will include non-controlling interest as a credit balance under equity; its value will be the value at acquisition plus 20% of the profit of Butler Estates for the period. In the consolidated statement of profit or loss we will show the non-controlling interest share of Butler Estates profit for the period since acquisition.Impact of paying too much for the goodwill:The amount that we end up paying for our investment in Butler Estates will directly affect the amount of goodwill that we will include on our consolidated statement of financial position: goodwill is treated as an asset. If in years to come, we find that we have paid too much for our investment then this will lead to an impairment in the value of the goodwill that we recorded at the date of acquisition. In any event we will need to test the goodwill for impairment at the end of each financial year, irrespective of any indications of impairment.To determine whether goodwill is impaired we will need to identify the cash generating unit to which it belongs. A cash generating unit is the smallest identifiable group of assets for which independent cash flows are available: this will be the net assets of our subsidiary plus the goodwill. The impairment review will compare the recoverable amount (higher of value in use and net realisable value) against the carrying value of the cash generating unit. If the recoverable amount is lower than carrying value an impairment needs to be recorded.Any impairment in the cash generating unit will first be allocated against the value of goodwill in the consolidated statement of financial position and then to all other assets in the cash generating unit on a pro-rata basis. This will also represent a loss in the consolidated statement of profit or loss.SECTION 2ORGANISATION STRUCTURE FOR THE COMBINED BUSINESSBenefits of running Butler Estates autonomously:A benefit of running Butler Estates completely separately from Thomas Fine Teas is that it will help to keep the integrity of the Butler Estates brand. The reputation and brand of Butler Estates are based on products which are pure unblended loose leaf tea, harvested and carefully processed by hand in Deeland and then sold as a niche tea at the quality end of the market: this is very different to our products which, although are high quality, are mass market blended teas. Autonomy will allow management to focus on that is important to the Butler Estates brands, without distraction.Another benefit is that we will need to retain a certain amount of independence anyway, because we will not own 100% of the business. The Butler brothers will retain 20% and will expect returns on their investment in the form of dividends. By keeping the business independent and autonomously run it will be easier to allow them to understand how their investment is being managed.Butler Estates staff may end up feeling isolated if management is from afar and therefore keeping management local might help with staff morale. It will also ensure that quality standards do not slip.Benefits of incorporating Butler Estates into our existing organisation structure:We currently have a functional organisation structure as we have separate departments for the key areas of the business including products, production and finance. A significant benefit of incorporating the management of Butler Estates into this existing structure is cost. There will be no duplication of resources across the two sites which reduces the overall cost of management across the combined business and allows us to take advantage of economies of scale.In addition, it will allow us to pool expertise and to recruit experts in the field for say product development or marketing. It will also allow us to have a more co-ordinated approach to the business as a whole: for example, there could be options in the future for development of new blends using tea grown on the Butler Estate. Even though the two end products are different there is potentially a lot that can be learned on both sides of the combined business. The Butler Estates operation might benefit from management from our factory being involved to make suggestions about production efficiencies. Similarly, our sales people and product development people might benefit from being involved with Butler Estates to understand a market that we have not really tapped into yet. TIME SERIES ANALYSISThe Trend:A series of trend data is established from the source data by calculating, at each quarter point in the period, an average of sales for the quarter based on the previous four quarters sales. This series of moving average can then then be plotted on a graph to establish the trend in sales over the five years. For premium unblended loose-leaf tea, we are likely to see an upward trend over the period as we know from industry and press reports that sales have grown for such products: consumers have become much more critical of food miles and are actively seeking to source local produce; they are also prepared to pay a premium price for this.Seasonal variations:Seasonal variations are fluctuations in or movements from the trend that are specific to a time of year. We will be able to identify this by comparing the moving average (which represents the trend) to actual demand at that point of the period. The variation will be seasonal if it reoccurs at the same point of time in each year. We will expect there to be seasonal variations in the summer and winter periods with higher sales in the summer and lower sales in the winter. This is because industry and press reports show that unblended teas are particularly popular with consumers when the weather is hot because they are more refreshing than standard tea.Appropriateness of this approach:This is potentially a sensible way in which to at least start to forecast future sales of Butler Estates teas because the source data is specifically for premium unblended loose-leaf teas (of which Butler Estates is one example). However, the following limitations need to be considered:The source data is historic and therefore it is entirely possible that what has happened in the past will not continue to happen in the future. The hot beverage market is highly competitive and new products such as infusions are being launched all the time which might affect demand for tea, even a premium branded tea.The source data is for the loose-leaf premium tea industry as a whole and hence will not take the specific characteristics of Butler Estates teas into account; that being the fact that it is the only tea grown in Deeland.Time series assumes that the trend can be established as a linear relationship between sales and time and that seasonal variations are proportional to the trend. In reality a linear relationship might not exist, and it could be that cyclical or random factors (such as economic recession or an excessive hot summer) cause variations from trend which make it much harder to predict the future.There could be many factors which affect future demand for Butler Estates tea including competitors, health crazes and environmental changes. SECTION 3BUTLER ESTATES BUDGETThe table of breakeven and sensitivity information:Based on budgeted selling price and costs we need to sell 448,235 units to breakeven: this is the point where neither a profit or a loss is budgeted to be made. Budgeted sales are 500,000 and this would have to drop by 10.4% in order to reach this breakeven point (this is known as the margin of safety). The sensitivities measure by how much each element needs to change before we will make a loss. For example, sales price would need to fall by 5.5% to generate a loss and fixed costs would need to increase by 21.4% to generate a loss.Usefulness of this analysis:Sensitivity analysis allows us to see the degree to which a variable such as sales price or marketing spend could change before it turns a profit into a loss (or vice versa). This is useful where there is some uncertainty concerning elements of the budget. For example, we do not know how much we will end up paying for the marketing campaign, although the sensitivity analysis does tell us that it could be 25% higher than D$350,000 before we turn a profit to a loss.Sensitivity analysis gives us an idea about the elements of the budget that are most sensitive and therefore are the riskiest. For example, sales price per unit only needs to fall by 5.5% before the business starts making a loss: this is the most sensitive element for this budget. Knowing this means that we can focus on maintaining sales prices.However, in this analysis we change only one variable at a time which limits its usefulness. In reality it is unlikely that only sales price will change: it could be say that packaging costs increase and wage rates rise which then leads to a price rise: sensitivity analysis cannot capture the effect of this. It could be that increasing the marketing spend, increases volumes or allows us to charge higher prices.The analysis in this schedule is also skewed because the one-off marketing campaign cost has been included in full. The benefits of this campaign are likely to cover more than the three-month period considered here. Also, inclusion of this one-off cost, increases the break-even point specific to this period: breakeven will be significantly lower in future periods. Therefore, it would be incorrect to base decisions that affect future period solely on this analysis. MARKETING MIX FOR BUTLER TEA COMPARED TO EVERYDAY BLENDProduct:Butler Tea and Everyday Blend are essentially the same core product: consumers gain the same main benefit from drinking each product which is to satisfy thirst. However, what consumers expect from each of the teas is very different and hence the expected product is different. Everyday Blend is a blended tea designed to be drunk regularly and has mass appeal. Whilst consumers expect good quality from us, the most important aspect of this tea is that a cup of tea today tastes the same as a cup of tea last week: it is the consistency of the blend that consumers expect. There are different expectations for Butler Tea which is an unblended artisan tea. Consumers will expect the taste to change slightly as the tea is produced at different times of the year: they expect luxury and it is likely that consumers view Butler Tea as more of a treat than a necessity.Price:All of our Thomas Fine Tea products are priced at above average retail prices to consumers to reflect our reputation for quality blends. Butler Tea is likely to be priced at even more of a premium given that it is sold in luxury department stores, sold as an artisan product and is the only tea available which is grown and processed in Deeland. The market clearly accepts the price for Butler Tea and therefore there is probably little scope or need to change the pricing strategy.Place:Where the products are sold is quite different. Everyday Tea is sold directly to all of the major supermarkets and to wholesalers who service chains of convenience stores. This means that Everyday Blend is available to buy in every city, town and probably village throughout Deeland and consumers will not be able to avoid seeing the blend alongside our competitors’ offerings.Butler Tea on the other hand is sold in the food halls of exclusive high-end department stores at the luxury end of the market. This means it has reduced visibility in the market place. Having said that, Butler Estates does appear to have a thriving on-line business with a loyal base of customers that buy directly from them, which is something Thomas Fine Teas does not have at present.Promotion:How the two products have been promoted in the past is also different. Butler Estates has a social media presence and an active on-line sales website, both of which are being used to promote the brand. We currently do not use digital media for marketing purposes, instead relying on more traditional television and media advertising to the mass market. It’s possible that we can learn from Butler Estates and start using digital media ourselves as a way to reach an even wider audience.SECTION 4From: Finance OfficerTo: Jack Ford, Head of FinanceSubject: RE: Butler Estates: one-off contract and receivables management RELEVANT COSTS FOR ONE-OFF CONTRACTMaterials:The purchase cost of black tea leaves that we import from Kenya will be a relevant cost, as will any costs to be incurred in obtained those tea leaves such as air freight charges and import duties. These costs will only be incurred if we accept the contract and are therefore incremental to the decision.Any additional costs of blending these tea leaves should also be included, although we need to take care that these are truly incremental costs. If our tasters and blenders have spare capacity and we are already committed to pay their wages, this cost will be nil. If, however, we pay overtime this will be included. We would also only include additional overhead costs, however, given the scale of this contract these are unlikely to change.We will be using Butler tea leaves from normal production. The relevant cost will be the standard cost of producing these leaves (excluding any fixed overheads). We might also need to include an opportunity cost for lost contribution if we end up losing sales because of using these leaves on the contract.The purchase cost for the metal caddies that we need to purchase will be a relevant cost as this in incremental to the decision. If the caddies already in inventory have no alternative use in the business, then the relevant cost of these will be nil. However, given that they were only purchased last month it is possible that there is still a plan to use them in future production and as such the relevant cost of these caddies will be replacement cost.We will need to buy in the presentation boxes and the relevant cost will be the full cost of 10,000 boxes even though we only need 8,000. This is the future cash flow that will arise.Machinery:We will have to hire a filling and sealing machine for a period of a month and the full cost of this is a relevant cost to the contract.Labour:There is spare capacity and therefore we should only include the cost of the overtime hours that the two staff will work, which is above the hours that we are contracted to pay them.Management time:The management time already spent negotiating the contract is a sunk cost because it has already happened. In addition, the cost of any additional time to be spent supervising the two staff is not relevant because management are paid salaries which are a committed cost of the business. FACTORING OF RECEIVABLES BALANCES OF BUTLER ESTATES SMALL INDEPENDENT BUSINESS CUSTOMERSPotential benefits:The main benefit of factoring the receivables balances of the small independent business customers is that we will receive the cash from sales to these customers more quickly than if we do not factor. Typically, factors advance around 80% of the invoice value on the raising of the invoice, with the remainder received a little later. This could be a huge benefit for us because, even after only two months, we know that this type of customer is slow at paying which is because they are small probably owner-managed businesses where cash flow is very tight. We are used to dealing with large supermarkets and wholesalers.Another benefit is that if we use a non-recourse arrangement, we can transfer the risk of irrecoverable debts to the factor. The ability to do this is potentially very beneficial for this type of customer. Small independent retail businesses are far more likely to cease trading than our normal supermarkets and wholesalers.Another benefit is that a factor will be an expert in credit control and in dealing with customers like this. They will have set procedures and will promptly chase outstanding amounts. As mentioned above this is a different type of customer than either the Butler Estates or Thomas Fine Teas finance departments are used to. Indeed, given the rapid growth in this customer base it is unlikely that we have the resource to manage the credit control function effectively without taking on and training new staff.Potential drawbacks:The main drawback of factoring is its cost. A factor will charge an administrative fee of a percentage of sales revenue. This is a cost against gross profit and will affect our margin. In addition, the factor will charge a finance fee on the monies advanced, which will affect our net profit. Given the nature of these customers and the relatively high risk of non-payment, it is likely that any factor willing to over us a service will expect a high level of fees in compensation.Another drawback is that our customers might not be happy about the arrangement. With factoring, unlike invoice discounting, the customer will be fully aware of the arrangement because they will receive correspondence with the factor. Customers might feel that they have lost their link to Butler Estates and that we do not value their business, especially if the factor is aggressive in chasing for payment. The potential loss of business needs to be carefully considered. ................
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