Q162

a) Discuss the managing director's pricing strategy in the

circumstances described above. (5 marks)
Ans:
Managing director’s pricing strategy:
the managing director has adopted what is known as a full cost-plus pricing
strategy, which means that a profit margin (in this case, of 50%) is added to
the budgeted full cost of the product.
Given the information in the question, the selling price used by RB Co is
calculated as follows:
$
Full cost 400
50% markup 200
Selling price 600
Disadvantages of this pricing strategy:
 Its focus is internal- internal costs and internal targets. It therefore takes
no account of the market conditions faced by RB Co, which is why the
company’s selling price bears little resemblance to those of its
competitors’ pricing decisions.
 Absorption basis used when calculating the full cost are decided
arbitrarily. The current basis of absorption is based on the budgeted
level of production, which is lower than the current capacity. Depending
on the absorption basis used in the calculation of total cost, the strategy
can produce different selling prices.
Advantages of this pricing strategy:
 It is quick, cheap and relatively easy to apply. Pricing can therefore be
delegated to more junior management if necessary.
  It ensures that all costs are covered and that the organisation makes a
profit, provided budget figures used in the pricing calculation are
reasonably accurate. This was the case in the first two years for RB Co.
The costs of collection market information on demand and competitor activity are
avoided.

b) Suggest and explain two alternative strategies that could have

been implemented at the launch of the packages. (4 marks)
Ans: Alternative pricing strategies:
1. Market penetration pricing
Market penetration pricing is a policy of low prices when a
product is first launched in order to achieve high sales
volumes and hence gain a significant market share. If RB Co
had adopted this strategy it might have discouraged
competitors from entering the market.
2. Market skimming
This pricing strategy involves charging high prices when a
product is first launched and spending heavily on advertising
and promotion to obtain sales so as to exploit any price
insensitivity in the market. Such an approach would have
been particularly suitable for RB’s circumstances: demand for
the software would have been particularly inelastic,
customers being prepared to pay high prices for the software
given its novelty appeal. As the product moves onto the later
stages of its life cycle, prices can be reduced in order to
remain competitive.
c) P=a-bq
a= $750
b= 10/1000=0.01
P= 750-0.01Q
d) RB's total costs (TC) can be modelled by the equation TC =
1,200,000 + 320Q. Explain the meaning of this equation. (3 marks)
 Ans: Cost behavior can be modelled using a simple linear equation of the
form y=a+bx where ‘a’ represents the fixed costs, which for RB are
$1,200,000 (15000x$80) and ‘b’ represents the variable costs per unit, i.e.
$320(400-80) per unit for RB.
This cost model assumes fixed costs remain unchanged over all ranges of
output and a constant unit variable cost.

e) Explain what is meant by price elasticity of demand and explain

the implications of elasticity for RB's pricing strategy. (5 marks)

Ans: Price elasticity of demand is a measure of the extent of change in

market demand for a good in response to a change in its price. It is
measured as:
The change in quantity demanded, as a % of demand ÷ the change in price,
as a % of the price
Since the demand goes up when the price falls, and goes down when the
price rises, the elasticity has a negative value, but it is usual to ignore the
minus sign. The value of demand elasticity may be anything from zero to
infinity.
Demand is referred to as inelastic if the absolute value is less than 1. Where
the demand is inelastic, the quantity demanded falls by a smaller
percentage than the percentage increase in price.
Where demand is inelastic, demand falls by a larger percentage than the
percentage rise in price. The absolute value is greater than 1.
An awareness of the concept of elasticity can assist management with
pricing decisions.
In circumstances of inelastic demand, prices should be increased because
revenues will increase, and total costs will reduce (because quantity sold
will reduce).
In circumstances of elastic demand, increases in prices will bring decreases
in revenue and decreases in prices will bring increases in revenues.
Management therefore have to decide whether the increase/decrease in
costs will be less than/greater the increase/decrease in revenue.
 In situation of very elastic demand, overpricing can lead to a massive drop
in quantity sold and hence a massive drop in profits; whereas underpricing
can lead to costly stockouts and, again, a massive drop in profits. Elasticity
must be therefore reduced by creating a customer preference which is
unrelated to price (through advertising and promotional activities).
In situations of very inelastic demand, customers are not sensitive to price.
Quality, service, product mix and location are therefore more important to
a firm’s pricing strategy.
Cost-plus pricing is based on the assumption that demand for the
company’s software is inelastic and prices should be increased in order to
increase revenue and hence profit. The market research information for RB
Co does not support this view. It suggests that increasing prices will lead to
a drop in demand and hence a reduction in profit.

Q163
(a) Calculate the incremental cash flows, for the month of January
(31 days), if Belton Park
Resort decides to keep open:
(i) the hotel;
(ii) the water park.
In each case, state whether it should remain open or should close. (15
marks)
Ans: (i) Hotel
Incremental revenue and contribution
$
Total room revenue(120x31x0.5x$70) 130,200
Total 'extras' contribution(1860x12) 22,320
 $
Total cash inflows 152,520
Incremental running costs:
Staff costs(120,000-2500-2000) (115,500)
50% normal hours (57,750)
50% at reduced hours x 50/90 (32,083)
Maintenance costs:
If open (14,600)
If closed (4,000)
Power costs:
Electric -
Gas – fixed charge -
Gas – variable (20,000–(8000+2200)x1·50 (14,700)
Security -
Water (6,450)
Total incremental cash flows 30,937

(ii) Water park

Incremental revenue and contribution
$
Admission revenue(5760x16.8) 96,768
Total contribution(5760x7.2) 41,472
Total cash inflows 138,240
Incremental running costs
Staff costs:
Other staff (75600–2,000)x0.48 (35,328)
Maintenance costs:
If open (6,000)
 $
If closed 2,000
Power costs:
Gas–variable(18000-(7000+1500))x1·5 (14250)
Water (12100)
Total incremental cash flows 72,562

Conclusion: should keep both open, positive cash inflows.

b) Discuss any other factors which Belton Park Resort should consider
when making the decision in part (a). (5 marks)

Ans: As regards the estimates calculated, these are based on very limited data
and should be approached with caution. The calculations are based on the first
two months’ of opening only and, consequently, it is difficult to say how accurate
they are likely to be. In addition, the basis of estimating the revised occupancy
rate for the hotel, for example, has not been given. If these estimates are too
optimistic, the actual results could be far worse.
The figures suggest that both the waterpark and the hotel should stay open.
Given that this a new business and therefore it is still building up its customer
base, this would seem like a wise decision anyway, even if calculations shown that
the estimated incremental cashflow were not as positive as this.
Similarly, if Belton park were to close either the hotel or the water park, they
would invariably lose some valuable staff who might seek out other the closure.
These staff might not be available again when the hotel and the water park
reopen in February.
The interdependency of the two sets of projections has not been taken to taken
into account in the calculations either. Since the incremental cashflows suggest
that both the hotel and the water park should stay open, it is not a big problem.
However, if they had shown, for example, if the water park alone had closed
down, the affect it would have on hotel visitors would also need to be taken into
account. Many visitors may be attracted to the hotel because it has a water park.
Q164

(c) Discuss the non-financial factors that Robber Co should consider

when making a decision about outsourcing the manufacture of keypads
and display screens. (5 marks)

Ans: Robber Co should consider the following non-financial factors when making
a decision about outsourcing the manufacture of keypads and display screens:
 Supplier performance- Rubber Co would need to establish whether the
supplier is reliable in meeting delivery dates and delivering components of
a high quality.
If the components delivered are not of the required quality Robber Co risks
damaging its reputation and losing sales as well as incurring high repair
costs for control panel under warranty. This is particularly significant given
that supplier is based overseas - Robber therefore has less control over
quality and continuity of supply than if it were dealing with a locally based
supplier.
Information to support the supplier’s record in meeting delivery dates may
be hard to come by, especially as the supplier is a newly established
company. Late delivery of components could disrupt Robber Co’s
production schedule and its ability to supply control panels to meet market
demand.
 New company- The potential supplier is a newly formed company. There is
no guarantee that the company will be able to operate at the level required
to supply the desired level of components at the right quality.
Robber Co should consider whether there are any other potential suppliers
of the components. This would enable Robber Co to compare prices and
get the best deal. It could also provide the company with an alternative
supplier should the new supplier go out of business.
 Pricing- The new supplier has only guaranteed the current price for two
years. After this, the supplier should increase prices significantly. Robber Co
should negotiate a fixed price for a longer period of time as a part of the
agreement or seek out alternative suppliers to ensure that the company’s
not forced to accept a significant increase in component prices at the end
of the two-year period.
 Q165

(c) Briefly explain the maximin decision rule and identify which
price should be chosen by management if they use this rule to
decide which price should be charged. (3 marks)

Ans: the maximin decision rules involves choosing the outcome that offers
the least unattractive worst outcome, in this instance choosing the
outcome that maximizes the minimum profit. Management would therefor
choose a selling price of $35, which has the lowest possible profit of
$742,000. This is better than the worst possible outcome from a selling
price of $30, providing a profit of $740,000.

(d) Discuss the factors which may give rise to uncertainty when
setting budgets. (6 marks)

Ans: Uncertainty arises largely because of changes in the external environment

over which a company will sometimes have little control. Reasons include:
 Customers may decide to buy more or less goods or services than originally
forecast. For example, if a major customer goes into liquidation, this has a
huge effect on the company and also cause them to go into liquidation.
 Competitors may strengthen and emerge and may take some business
away from a company. On the other hand, a competitor’s position may
weaken leading to increased business for a particular company.
 Technological advances may take place which lead a company’s products or
services to become outdated and therefore less desirable.
 The workforce may not perform as well as expected, perhaps because of a
time off due to illness or simply because of lack of motivation.
 Materials may increase in price because of global changes in commodity
prices.
 If a company imports or exports goods or services, changes in exchange
rates can cause prices to change.
 Machines may fail to meet production schedules due to breakdown.
 Social/political unrest could affect productivity, e.g. the workforce goes on
strike.
Q166
(d) Explain what would happen to the breakeven point if the
products were sold in order of the most profitable products first.
(2 marks)

Ans: If the more profitable products are sold first, this means the fixed costs will
be covered more quickly. Consequently, the breakeven will be reached earlier, i.e.
fewer sales will need to be made to breakeven, so the breakeven point will be
lower.

(e) Explain the limitations of cost volume profit (CVP) analysis. (5

marks)

Ans: The limitations of CVP analysis are the unrealistic assumptions required.
i) It is assumed that fixed costs are the same in total and variable costs are
the same per unit at all levels of output. This assumption is a great
simplification.
(a) Fixed cost will change if output falls or increases substantially
(most fixed costs are step costs).
(b) The variable cost per unit will decrease where economies of scales
are made with higher volume of outputs, but the variable cost per
unit will also eventually rise when diseconomies of scale begin to
appear at even higher output volumes.

The assumption is only correct within a normal range or relevant range of

output. It is generally assumed that both the budgeted output and the
breakeven point lie within this relevant range.
ii) It is assumed that sales price will be constant at all levels of activity. This
may not be true, especially at higher volumes of output, where the price
may have to be reduced to win extra sales.
iii) Production and sales are assumed to be the same, so the consequences
of any increase in inventory levels or destocking are ignored.
iv) Uncertainty in the estimates of fixed costs and unit variable costs is
often ignored.
Q167

(b) Discuss and recommend whether market penetration or

market skimming would be the most suitable pricing strategy for
TR Co when launching the new anti-malaria drug. (8 marks)
Ans:
i) Market penetration pricing- with penetration pricing, a low price would
initially be charged for the anti-malaria drug. The ideology behind this is
that the price will make the product accessible to a larger number of
buyers and therefore high sales will compensate for the lower prices
being charged. The anti-malaria drug would rapidly become accepted as
the only drug worth buying, i.e. it would gain rapid acceptance in the
marketplace.
The circumstances which would favor a penetration pricing policy are:
(a) Highly elastic demand for the anti-malaria drug , i.e. the lower the
price, the higher the demand. However, there is no evidence that
this is the case.
(b) If the significant economies of scale could be achieved by TR Co so
that the higher sales volumes would result in sizeable reduction in
costs. It cannot be determined if this is the case here.
(c) If TR Co was actively trying to discourage new entrants into the
market, however in this case, new entrants cannot enter the
market anyway due to the patent.
(d) If TR Co wished to shorten the initial period off the drug’s life
cycle so as to enter the growth and maturity stages quickly but
there is no evidence that the company wishes to do this.
ii) Market skimming pricing- with market skimming pricing, high charges
would initially be charged for the anti-malaria drug rather than low
prices. Thus, would enable TR Co to take advantage of the unique nature
of the product. The most suitable strategy for this strategy are:
(a) The product has a short life cycle and high development costs
which need to be recovered. There is no information about the
drug’s life cycle, but the development cost have been high.
(b) Since high prices attract competitors, there needs to be barriers
to entry if competitors are to be deterred. In TR Co’s case it has
 patent for the drug and also the high development costs should
act as a barrier.
(c) Where high prices in early stage of a product’s life cycle are
expected to generate high initial cash flows, this will help TR Co
recover high development costs it has incurred.
Recommendation: Given the unique nature of the drug and the
barriers to entry, a market skimming pricing strategy would appear
to be the far more suitable pricing strategy. Also, whilst there is
demand curve data, it is unknown how reliable this data is, in which a
skimming pricing strategy may be the safer option.

Q168
(d) Using the graph, quantify and comment upon the
financial effect of Project 2 on the Alka Hotel. (8 marks)
Ans: Project 2 will cause the fixed costs of the hotel to rise from $600,000
per annum to $800,000 per annum for the hotel and restaurant combined.
This is an annual increase of $200,000.
Revenue per occupied room will increase from $180 to $250
($2,000,000/8,000 rooms) which reflects the extra guest expenditure in the
restaurant.
The total cost predicted at a level of 8,000 occupied rooms is $1,560,000
which means the variable cost must be $760,000 ($1,560,000-$800,000).
This is a variable cost of per occupied room of $95 which is an increase of
$35. This reflects the variable costs of the restaurant.
As a result of these changes, the breakeven point has increased from 5,000
to 5,161 occupied rooms so the hotel needs to sell more room nights to
cover costs.
However, budgeted occupancy is now 7,300 occupied room nights which
gives 80% occupancy (7,300/9,125). This gives a margin of safety of 2,139
occupied rooms per night or 29%. This is an increase on the current
position and hotel’s position appears safer. At 7,300 occupied room nights
the Alka hotel’s budgeted profit is $331,500 ((7,300x(250-95))-800,000).

Q169
 (c) Explain the use of expected values and sensitivity analysis and
suggest how HMF Co could make use of such techniques. (6
marks)
Ans:
- Expected values: where probabilities are assigned to different outcomes,
we can evaluate the worth of a decision as the expected value, or weighted
average, of these outcomes. He expected value is calculated as the
probability of the outcome multiplied by the outcome. The principle is that
when there are a number of alternative decisions, each with a range of
possible outcomes, the optimum decision will be the one which gives the
highest expected value. However, the expected value may never occur.
Expected values are more valuable as a guide to decision making where
they refer to outcomes which will occur many times over. Examples would
include the probability that so many customers per day will buy a loaf of
bread, the probability that a customer services assistant will receive so
many phone calls per hour and so on.
We have not been given information on probabilities of each demand
occurring for HMF Co’s scooters and it is unlikely that demand will be
sufficiently predictable to use this technique successfully.
- Sensitivity analysis: sensitivity analysis can be used in any situation so long
as the relationships between the key variables can be established. Typically,
this involves changing the value of a variable and seeing how the results are
affected.
For example, HMF Co could use sensitivity analysis to estimate by how
much costs and revenues would need to differ from their estimated values
before the decision would change or to estimate whether a decision would
change if estimated costs were x% higher than estimated or, revenues y%
lower than estimated.
Sensitivity analysis can help to concentrate management attention on the
most important factors and can be particularly useful when launching a
new product.
Q170

Q251
(a) Calculate the actual total monthly labor costs for producing
the microphones for each of the five months from July to
November. (9 marks)
Ans: To begin with, every time that output doubles, the average
production time is 88% of what it was before. As stated in the question, the
learning curve effect comes to an end in October. This does not relate to
the month of November where average time taken to produce is equivalent
of the time required to produce the eighth batch in October.
Tabular approach:
Month Cumulativ Cumulative Cumulativ Increment Labor cost
e number average e total al time (at
of time per time (hours) $12/hour)
batches batch (hours)
(hours)
July 1 200 200 200 2400
(200x1) (200-0) (200x12)

August 2 176 352 152 1824

(200x.88) (2x176) (352-200) (152x12)

Septemb 4 154.88 619.52 267.52 3210

er (176x.88) (4x154.88) (619.52- (267.52x12)
352)
 October 8 136.294 1090.352 470.832 5650
(154.88x.8 (8x136.29 (1090.352- (470.832x1
8) 4) 619.52) 2)

Algebraic approach:
Average time to produce first 8 batches: 200 x 8^-0.1844245=136.29
Total time for first 8 batches: 8 x 136.29= 1090.35
Average time to produce first 7 batches: 200x 7^-0.1844245=139.69
Total time for first 7 batches: 7 x 139.69= 977.85
Time taken to make the 8th batch: 1090.35-977.85=112.50 hours
Total labor cost (November): $12 x 112.50 hours x 8 batches=$10800

(b) Discuss the implications of the learning effect coming to an end for
Mic Co, with regard to costing, budgeting and production. (4 marks)
Ans: The learning effect coming to an end indicates that the time taken to
produce each batch in November would be constant. Therefore, in future,
Mic Co should base its decisions on the time taken to produce the 8th batch,
which was the last batch to be produced before the learning effect came to
an end, when it is related to allocating its resources and putting a cost to its
products.
As stated in the question, Mic Co uses cost plus pricing to set a price of its
products, however it has not been proven beneficial as its sales were not
up to the expectations. This can be justified as the learning effect of 88%
was not taken into consideration when setting prices and therefore prices
were set too high.
In the first few months, the average time per batch was 200 hours which
had fallen to 122.50 hours, post-learning effect of 88%. Hence, when
budgeting for labor cost and labor time, learning effect has a crucial
contribution to it.
(c) Discuss the potential advantages and disadvantages of involving
senior staff at Mic Co in the budget-setting process, rather than the
managing director simply imposing budgets on them. (7 marks)
Ans: involvement of senior management in budget setting process is used
where top-level management’s confidence is needed by its juniors. Like
every budgeting process, this process has advantages and some
disadvantages.

Advantages:
 Knowledge is being shared between different areas of the
organisation, this can help in increasing morale of Mic Co’s staff, as
they feel their work is appreciated and acknowledged.
 The staff will also feel motivated as they are trusted enough to give
this responsibility, which can help in lessening the production
manager’s grudge of lack of involvement.
 There may be improved coordination, as many departments are
involved. Since the departments who know the most about their area
of work are involved, the accuracy level could be increased.

Disadvantages:
 Due to high level of involvement, this process can be highly time
consuming and costly.
 The process may have to be started earlier than a-non participative
one. This would again waste time of the staff.
 The time spent on preparing budgets could be spent on other
process of Mic Co. resulting in opportunity cost.

Q252
(a) Discuss the particular difficulties encountered when budgeting
in public sector organisations compared with budgeting in private
sector organisations, drawing comparisons between the two types
of organisation. (5 marks)
Ans: The budgeting process is an essential component of management
control systems, as it provides a system of planning, coordination and
control of management. It is often a demanding process.
In the public sector, the budgeting process can be even more difficult, since
the objectives of the organisation are more difficult to define in a
quantifiable way than the objectives of a private company. A private
company’s main objective may be to maximize profit, to achieve that a
budget can be set out aiming for an increase in sales or cutting out
operating costs. On the other side, when budgeting for a public sector
organisation, such as a hospital, the objectives are highly qualitative,
ensuring number of patients treated are given another appointment post
treatment. This is difficult to define in a quantifiable way, and how to
achieve it is even more tricky to calculate.
This leads to another reason why budgeting is difficult in public sector. Not
only the objectives are difficult to interpret, even the outputs are tricky to
define. It is difficult to define a quantifiable relationship between inputs
and outputs. In a hospital, what is easier to compare is the relationship
between how much cash available for a certain department and how much
is required. Therefore, this indicates public sector budgeting naturally
focuses naturally focuses on inputs, rather than the relationship between
inputs and outputs.

(b) Explain the terms 'incremental budgeting' and 'zero-based

budgeting'. (4 marks)
Ans: Incremental budgeting is the traditional budgeting method whereby a
budget is made with current year’s actual or budgeted performance as
base, with incremental amounts added up for the next budget period.
Zero-based budgeting is where the budgeting process starts with zero as a
base, with no relation to the previous period’s performance. Every function
is then reviewed comprehensively, with all expenditure requiring approval.

(c) State the main stages involved in preparing zero-based

budgets. (3 marks)
Ans: there is a 3-step approach to implementing a zero-based budgeting
1. Define decision packages- at the first stage, management
identify the key activities withing the organisation. These
activities are described within a decision package. There are
two types of decision packages. A mutually exclusive
package, which contain alternative ways of getting the
same job done. Incremental packages, which divide one
aspect of an activity into different levels of effort.
2. Evaluate and rank each activity- management ranks each
activity on the basis of its benefit to the organisation. High
priority is given to minimum work requirements and work
that meets legal obligation. This helps management decide
what to spend and where to spend it.
3. Allocate resources- at the final stage, management will
allocate resources according to funds available and the
ranking and evaluation of the packages.

(d) Discuss the view that 'there is no longer a place for

incremental budgeting in any organisation, particularly public
sector ones', highlighting any drawbacks of zero-based budgeting
that need to be considered. (8 marks)
Ans: