Q1. Matthews Ltd is a small company operating in the pottery industry.

Its board of
directors believes that managers are best motivated by financial incentives. The
company pays a monthly bonus of 10% of profit earned in their respective divisions
to the divisional managers. Managers are given autonomy over production and sales
matters.
The company is split into four divisions. The Eastern division has faced a steady
demand for its product with some seasonal variation. The manager of the Eastern
division, however, has reported significantly increased profits in May 2004. The board
of directors is now questioning the size of her bonus payment, particularly as she has
already resigned and will leave the company in June 2004.
Eastern division profit and loss accounts for the last two months are shown below.
Matthews Ltd uses an absorption costing system.
Profit and Loss Account for the month ended

The following information is also available

1. Selling price per case of finished product was £350 in both months
2. Variable production cost was £200 per case in both months
3. Fixed production overheads are recovered on the basis of budgeted monthly
production of 1,000 cases
4. Actual fixed production overheads were £100,000 in each month, exactly as
budgeted.
Required:
(a) Calculate the number of cases produced and the number of cases sold
per month in both April and May 2004.
(4 marks)
(b) Redraft the above profit and loss accounts on a marginal costing basis
for both April and May 2004 and calculate the bonus to be paid to the
Eastern division manager in each month if the bonus was set at 10% of
marginal costing profit. (12 marks)
(c) Write a report to the board of directors of Matthews Ltd which will
(i) explain, with supporting figures, any differences between the net of
bonus profit figures in (b) and those in the absorption costing statements;
(ii) discuss any apparent problems associated with the performance of the
Eastern division in May 2004 even though its absorption costing profit has
improved;
(iii) discuss the wisdom of basing bonus payments on profits calculated on
an absorption costing basis; and (iv) suggest and justify two alternative
bonus schemes which might be improvements on that currently operated.
(15 marks)

To: Board of directors Matthews Ltd

From: A Certified Accounting Technician
Subject: Profit measurement and bonus scheme
Date: Today

Differences in profit Figures

The difference in net profit figures for May 2004 is due to a change in costing
principle. Absorption costing values finished goods closing stock at full production
cost (fixed and variable cost). In a period where finished goods stocks increase some
fixed overheads are carried forward to the next period in the finished goods closing
stock valuation.
Marginal costing values finished goods closing stock at variable production cost only.
Fixed production costs are written off against profit in the period they are incurred.
Thus in a period where production is greater than sales, as in May 2004, absorption
costing will show a higher profit figure as a large proportion of May’s fixed production
cost is carried forward in the closing stock valuation.
The statement below reconciles the two profit figures.
£000
Absorption costing profit 91·80
Less
Stock increase in cases x £100 per case
1,200 cases x £100 (120·00)
Plus
Difference in bonus payments 10·20
Marginal costing profit (18·00)

Problems with the performance of eastern division

Although the Eastern division has increased its reported profit (under absorption
costing principles) two problems have occurred. Firstly its sales have fallen leading to
less contribution, and secondly the ‘profit’ has been generated by building up large
stocks of finished goods. The holding costs of these goods could be high, and given
Eastern’s static market there seems little reason to carry them.
Bonus systems based upon absorption costing principles
The danger of basing bonus schemes on absorption costing profit is that managers
are effectively rewarded for increasing stocks. In May the manager of the Eastern
division increased the reported profit figure (and her bonus) although her
contribution to the financial well-being of the company is questionable. If managers
are given autonomy over production levels there is a danger that they ‘play the
system’ to manipulate profits and boost their earnings.
Improved Bonus Systems
Many alternative bonus schemes could be adopted, examples include
– Basing bonus upon contribution or marginal cost net profit. This would result in
bonus varying with sales and costs, not production levels.
– Bonus payments based upon non financial indicators of performance such as a
balanced scorecard approach. This would focus manager’s attention on the long term
success of their operations rather than short term financial performance.
– Bonus payments could be based upon measures such as return on investment or
residual income. This would focus managers’ attention upon capital invested as well
as profit earned.

Q2. AZ Transport Group operates a fleet of eight vehicles on four different routes in Ceetown.
Each vehicle has a capacity of 30 passengers. There are two vehicles assigned to each route,
and each vehicle completes five return journeys per day, for six days each week, for 52 weeks
per year.
AZ Buses is considering its plans for year ending 31 December. Data in respect of each route is
as follows:
Route Route Route Route
W X Y Z
Return travel distance (km) 42 36 44 38
Average passengers per journey:
Adults 15 10 25 20
Children 10 8 5 10
Return journey fares:
Adults £3.00 £6.00 £4.50 £2.20
Children £1.50 £3.00 £2.25 £1.10
The following cost estimates have been made:
Fuel and repairs per kilometre £0.1875
Drivers’ wages per vehicle per work day £120
Vehicle fixed cost per annum £2,000
General fixed cost per annum £300,000
Requirements:
(a) Prepare a statement showing the planned contribution of each route and the total contribution
of each route and the total contribution and profit of the AZ Buses division for the year ending 31
December. (8 marks)
(b) (i) Calculate the effect on the contribution of route W of increasing the adult fare to £3.75 per
return journey if this reduces the number of adult passengers using this route by 20%, and
assuming that the ratio of adult to child passengers remains the same. (Assume no change in the
child fare.) (4 marks)
[12 marks]