BBMC4023 ADVANCED PERFORMANCE MANAGEMENT 4RAC

Week 2 Tutorial Answers

CTC

(i) Format of the statement of product profitability should distinguish between:

(Select any answers below that are applicable)
 Sales (in dollars) of each product and in total
 Cost of sales of each product and in total
 Gross profit of each product and in total
 Contribution of each product and in total
 Operating expenses of each product and in total
 Fixed overheads of each product and in total
 Other fixed overheads of each product and in total
 Other fixed overheads in total only

(ii) The verb “comment” means to explain about:

(Select FOUR answers below to earn FOUR marks)
 Percentage of total sales decrease for each product from 2008 to 2009
 Percentage of contribution to sales ratio for each product from 2008 to 2009
 Percentage of fixed overheads increase/decrease for each product from 2008 to 2009
 Percentage of profit margin for each product and in total, comparing between 2008 to 2009
 Percentage of annual capacity utilisation, comparing between 2008 to 2009
 Conclusion about the overall state of affairs
 Suggestion to management about the appropriate future action plans

 From to 2008 to 2009, Bruno and Kong are forecast to suffer decrease in sales of 33% and
68% respectively. Despite the forecast increase in Leo’s sales by 20%, it is not substantial
enough to offset the decrease in Bruno and Kong, making total company sales to decrease by
37%.
 Even though contribution to sales ratio will remain unchanged in 2008 and 2009, savings in
product-specific fixed overheads will increase Bruno’s profit margin slightly from 17% to
20% but not for Kong’s profit margin which will decrease from 33% to 9%. Leo’s profit
margin will increase from 3% to 11% (due to higher sales revenue despite maintaining the
same fixed overheads), but total company profit margin will decrease from 11.9% to 0.19
 Total annual capacity utilisation in 2008 is 97.5% and will decrease to 60% in 2009. This is
reflected by the rapid decline in the sales of Bruno and Kong. CTC could try to increase sales
by utilising the spare capacity with variable costing in setting selling prices.
 Conclusion: CTC is facing a severe decline in sales, and its efforts to cut fixed overheads are
not adequate to reduce the negative impact on profitability. If this trend continues, CTC will
soon be reporting a loss because its product contributions are not able to cover fixed
overheads (i.e. below the breakeven point).

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BBMC4023 ADVANCED PERFORMANCE MANAGEMENT 4RAC
Week 2 Tutorial Answers

(iii) To “identify” an alternative strategy, the possible root causes of current state of affairs are:
(Select any answers below that are applicable)
 Zero-inflation economy is not able to enjoy growth in consumer wealth
 Tax-exempt status for children toys has attracted many new entrants to this industry
 CTC have not been investing in newer toys because no tax allowances are available
 CTC’s production capacity is limited to 400,000 units only
 Competitive and substitute toys/gadgets have captured the market share of CTC
 CTC’s toys are old and have not been updated/replaced with newer toys
 CTC is unable to reduce costs in order to increase profitability

Identify appropriate strategies for each root cause selected above:

 Explore new markets (i.e. market development)
 Create new toys
 Improve the existing toys with new features (i.e. product development)
 Outsource to cheaper manufacturing location

Select ONE strategy: elaborate and root cause to earn TWO marks:
 Explore new markets (i.e. market development) in order to grow revenue. The tax-exempt
status for children toys could have attracted many new entrants to this industry, causing
intense competition and selling prices have to be reduced.
 Create new toys in order to differentiate against competitors and sell at higher pricing. CTC
may not be investing in newer toys because no tax allowances are available, resulting in high
risks and costs of creating new toys.
 Improve the existing toys with new features (i.e. product development) in order to extend their
lifecycles. The existing toys may be too old and have not been updated/replaced.
 Outsource to cheaper manufacturing location such as third world countries like Vietnam,
Cambodia or Bangladesh, because the CTC is unable to reduce costs in order to increase
profitability. CTC is probably located in a developed country with high labour costs, as
indicated by the zero-inflation economy, which is normally faced by developed countries.

The verb “discuss” means to argue about:

(Select only ONE correct answer)
 Reason for selecting the strategy above
 Advantage and disadvantage of selecting the strategy above
 How the strategy above can improve CTC’s future profitability

Write TWO answers to “discuss” (to earn TWO marks):

 With intense competition domestically, it is necessary for CTC to export to new markets in
order to grow revenue, such as exporting to less developed countries.
 However, CTC may not have the expertise/skills in the new markets. Joint ventures or
strategic alliances may be helpful.
 Even though no tax allowances are available for creating new toys, CTC should consider the
long-term benefits because innovation will differentiate CTC from competitors.
 However, the costs involved may be excessive and there is high risk that the new toys created
are not appealing to customers’ preferences.
 New features will attract new customers or retain the loyalty of existing customers, who may
buy for their next generation.
 CTC may find it difficult/challenging to improve with new features because these features
may also be available in the competing/substitute products, hence, no differentiation.
 Outsourcing to cheaper manufacturing location will reduce production costs, hence improve
CTC’s profitability, which is a common practice by multinational corporations.
 However, CTC may face difficulty in controlling the quality of finished goods and managing
the performance of the overseas manufacturing location due to differences in work practices,
culture and government regulations.

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Week 2 Tutorial Answers

Zorro Company

(a) To decide on financial grounds requires calculation of (to earn FOUR marks):
(Select only ONE correct answer)
 Gross profit for each product line
 Contribution for each product line
 Net profit of each product line

W X Y Z
£000 £000 £000 £000
Sales 2,000 2,500 1,000 500
Less variable costs:
Materials (300) (400) (200) (40)
Labour (500) (600) (400) (100)
Factory overhead (240) (320) (200) (40)
Selling overhead (100) (125) (50) (25)
Contribution 860 1,055 150 295

To answer “should Y be withdrawn”, “explain” (elaborate) to earn ONE mark:

 Y should not be withdrawn because it is earning a contribution of £150,000 towards paying
the fixed overheads. If Y is withdrawn, the savings of fixed overheads is £100,000 compared
to the loss of contribution of £150,000, therefore, Zorro’s overall profit decreases by £50,000.

The verb “qualify” means to argue:

(Select only ONE correct answer)
 Under what circumstances the answer “should Y be withdrawn” above will change
 Pros and cons of the answer “should Y be withdrawn” above

Write TWO answers to “qualify” (to earn TWO marks):

 In order to justify that Y is contributing positively towards fixed overheads, the breakdown
between variable and fixed costs must be accurate. Any error that will change the amount of
contribution may no longer justify it.
 In order to justify that Y should not be withdrawn, there is no potential for changes in the
selling price or fixed overheads in the future. Any reduction in selling price or increase in
fixed overheads in future may no longer justify it.

(b) In the long run, is it profitable to keep Y?

(Select any answers below that are applicable)
 As long as Y is making a contribution, it will always be profitable to keep Y
 As long as Zorro is operating at below capacity, it will always be profitable to keep Y
 If Y is necessary to be offered as part of a range of products to attract/retain customers
 If production of Y enables synergies to be achieved together with other products

In what circumstances would it be appropriate to drop Y?

(Select any answers below that are applicable)
 When Zorro is operating at full capacity  because Y is still contributing positively
 When the fixed cost saved from dropping Y exceeds its contribution
 When new products with higher contribution are introduced
 When significant capital expenditure needs to be spent to maintain Y

To earn SIX marks, elaborate SIX answers:

 As long as Zorro is operating at below capacity, it will always be profitable to keep Y because
of the contribution towards fixed overheads, which would otherwise be under-utilised.
 If Y is necessary to be offered as part of a range of products to attract/retain customers, Y
should be retained, otherwise, sales of other products will be negatively affected.
 If production of Y enables synergies to be achieved together with other products, Y should be
retained in order to derive these benefits (e.g. cost-savings, training, continuous production)

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BBMC4023 ADVANCED PERFORMANCE MANAGEMENT 4RAC
Week 2 Tutorial Answers

 When the fixed cost saved from dropping Y exceeds its contribution, Y should be dropped
because the incremental costs outweigh the incremental benefits.
 When new products with higher contribution are introduced, and if Zorro’s capacity are at or
near full utilisation, Y should be dropped to make the capacity available for other products.
 When significant capital expenditure needs to be spent to maintain Y, e.g. the cost of replacing
the machinery will deprive Zorro of other capital expenditure that will generate higher
contribution.

(c) SIX marks for the calculations of the THREE scenarios.

To answer “should product Y be continued, withdrawn completely or continued as a service”,
“explain” (elaborate) to earn ONE mark.

If Y were to be continued: £000

Product W contribution 860
Product X contribution 1,055
Product Y contribution 150
Product Z contribution 295
Total contribution 2,360
Fixed costs (1,800)
Net profit 560

If Y were to be withdrawn: £000

Product W contribution Less: 10% x £860,000 774
Product X contribution Unchanged 1,055
Product Y contribution Withdrawn -
Product Z contribution Add: £300,000 x 59% 472
Total contribution 2,301
Fixed costs Less: £100,000 (1,700)
Net profit 601

If Y were to be retained to service W’s customers: £000

Product W contribution Unchanged 860
Product X contribution Unchanged 1,055
Product Y contribution Only 20% x £150,000 30
Product Z contribution Add: £300,000 x 59% 472
Total contribution 2,417
Fixed costs Less: £50,000 (1,750)
Net profit 667

The best option is for Zorro to retain Y for the service of W’s customers as it gives the highest net
profit. Even though Y is the least profitable product, dropping Y completely will lose some sales
of W, which is a higher incremental cost (£86,000) than the incremental savings of fixed costs
(£50,000).