- 20 Marks
MA – L2 – Q70 – Performance analysis
Question
Kumasi Ventures Ltd manufactures and sells a single product. Its budget for the next financial year is as follows:
| Sales (80,000 units at GH₵600 per unit) | GH₵000 |
|---|---|
| 48,000 | |
| Production costs: materials and labour | 16,000 |
| Other production costs | 8,000 |
| Marketing and distribution costs | 12,000 |
| Administration costs | 10,000 |
| Total costs | 46,000 |
| Profit | 2,000 |
Materials and labour costs in production are 100% variable, and 25% of other production costs are variable. All administration costs are fixed costs and two-thirds of marketing and distribution costs are also fixed.
The directors of Kumasi Ventures Ltd are dissatisfied with the budgeted profit, and believe that annual profits should be at least double the size of the budgeted profit.
Three strategies have been proposed to improve profitability.
(1) Strategy 1. Increase sales by opening a new sales office in a neighbouring country. It is expected that this would increase annual sales by 5,000 units, but would add GH₵1.2 million to annual fixed costs.
(2) Strategy 2. Re-design the product by adding several additional features that should add value for the customer. This would have no effect on annual sales volume in units, but the company would be able to raise the sales price to GH₵625. The additional costs of producing the new product design would be GH₵1.5 million each year (all fixed costs).
(3) Strategy 3. Implement a cost reduction exercise throughout the company. It is expected that the planned exercise would reduce all variable costs by 20%, but would add to annual fixed costs by GH₵3.5 million.
Required:
(a) Calculate the effect of each individual strategy on annual profit, assuming that the strategy is implemented on its own, without the other two strategies.
(b) Show whether the three strategies, if they are all introduced together, will close the profit gap between the budgeted profit and the target profit that the directors would like to achieve.
Answer
(A)
Strategy 1
Increase in sales (units): 5,000
Increase in total annual contribution (GH₵325 × 5,000): GH₵1,625,000
Increase in annual fixed costs: GH₵1,200,000
Increase in annual profit: GH₵425,000
Strategy 2
Increase in sales price and unit contribution: GH₵25
Increase in total annual contribution (GH₵25 × 80,000 units): GH₵2,000,000
Increase in annual fixed costs: GH₵1,500,000
Increase in annual profit: GH₵500,000
Strategy 3
Reduction in variable cost per unit (20% × GH₵275): GH₵55
Therefore increase in unit contribution: GH₵55
Increase in total annual contribution (GH₵55 × 80,000 units): GH₵4,400,000
Increase in annual fixed costs: GH₵3,500,000
Increase in annual profit: GH₵900,000
(b)
Taking all three strategies together
| Sales (85,000 units at GH₵625 per unit) | GH₵000 |
|---|---|
| 53,125 | |
| Variable costs (85,000 × GH₵220 per unit) | 18,700 |
| Total contribution | 34,425 |
| Fixed costs | |
| In the original budget | 24,000 |
| Extra fixed costs of strategies 1, 2 and 3 | 6,200 |
| 30,200 | |
| Profit | 4,225 |
| Profit taking all three strategies together | GH₵000 |
|---|---|
| 4,225 | |
| Original budget profit | 2,000 |
| Difference | 2,225 |
| Extra profit from Strategy 1 only | 425 |
| Extra profit from Strategy 2 only | 500 |
| Extra profit from Strategy 3 only | 900 |
| Balancing figure | 400 |
The balancing figure comes from the combination of the three strategies.
The company will sell 5,000 units more than in the original budget, and the contribution per unit will be GH₵80 per unit higher (GH₵25 per unit from strategy 2 and GH₵55 per unit from strategy 3).
5,000 extra units of sale × GH₵80 extra contribution per unit = Extra total contribution of GH₵400,000.
Gap analysis
Target profit: GH₵4,000,000
Original budget profit: GH₵2,000,000
Profit gap: GH₵2,000,000
| Extra profit from Strategy 1 only | 425,000 |
| Extra profit from Strategy 2 only | 500,000 |
| Extra profit from Strategy 3 only | 900,000 |
| Extra profit from combination of three strategies | 400,000 |
| Profit in excess of the ‘gap’ | 225,000 |
Conclusion: Strategies 1, 2 and 3 together will successfully close the profit gap, if the targets for each of the strategies can be achieved.
- Topic: Performance Analysis
- Uploader: Salamat Hamid