Cambridge VCE Accounting Units 3 & 4 Teacher CD-ROM

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1 Exercise 18.1 Cheltenham Hi Fi An assessment of profitability requires that profit is expressed in relation to another measure (like sales, assets or owner s investment) so that differences between firms are accounted for. Base 1 Base 2 Level of assets / sales Owner s investment Simmons, Hardy 2006 Cambridge University Press 1

2 Exercise 18.2 Karl s Kites ROI = Net profit 100 Average Owner s equity = $ $ Return on Owner s investment % ROI = Net profit 100 Average Owner s equity = $ $ Return on Owner s investment % Although Net profit decreased (from $ to $14 400, or 4%), Owner s equity decreased by proportionately more ($ to $ , or 20%), meaning the owner is earning a greater return on a smaller investment. Reason 1 His ROI has increased (from 10% in 2010 to 12% in 2011). Reason 2 His ROI is higher than the return on the alternative investment (8% on the property trust). Reason The firm s Net profit has decreased (from $ in 2010 to $ in 2011): the only reason for the increase in ROI is the (larger) reduction in Owner s equity. Simmons, Hardy 2006 Cambridge University Press 2

3 Exercise 18.3 Legends Guitars / Axeman s Heaven ROA measures how profitably the firm s assets have been used / the amount of profit generated per dollar of assets controlled by the business ROA = Net profit 100 Average Total Assets = $ $ Return on assets Legends Guitars 10 % ROA = Net profit 100 Average Total Assets = $ $ Return on assets Axeman s Heaven 8 % More profitable firm Axeman s Heaven Justification ROI is higher (the owner has earned the same profit with a much lower investment of capital). More profitable firm Legends Guitars Justification ROA is higher (the business has earned the same profit using less assets) e. Because its Owner s equity will always be lower than its assets (due to its liabilities) (The extent to which they differ will depend on the level of liabilities, and Gearing.) Simmons, Hardy 2006 Cambridge University Press 3

4 f. Indicator ATO / Net profit rate To assess how effectively the firm is using its assets to generate revenue OR To assess how much of each dollar of sales is retained as Net profit Both will allow the owner to identify whether they should focus on revenue generation, or expense control. Simmons, Hardy 2006 Cambridge University Press 4

5 Exercise 18.4 Only Bikes ATO measures how effectively the firm s assets have been used to generate revenue / the amount of revenue generated per dollar of assets controlled by the business. ATO = Average Total Assets = $ $ Asset Turnover times ROA = Average Total Assets = $ $ Asset Turnover times increased (from $ to $ , or almost 50%), which was a proportionately bigger increase than the increase in Average total assets (which increased by $80 000, or 40%), indicating an improved ability to use assets to earn revenue. Although ATO increased (indicating an improved ability to generate revenue), ROA actually decreased (indicating worsening profitability). Given that revenue increased, the only reason for a lower Return on Assets is poorer expense control. e. Strategy 1 Strategy 2 Cheaper supplier Reduce stock loss / Better control over advertising, wages Simmons, Hardy 2006 Cambridge University Press 5

6 Exercise 18.5 Filmore Fittings Reason 1 Asset Turnover is lower than the industry average (indicating it is not using its assets as effectively to earn revenue). Reason 2 Net Profit Rate is lower than the industry average (indicating it is retaining less of every dollar of sales revenue as Net profit). Benchmark 1 Benchmark 2 The ROA from a previous period The budgeted ROA Strategy 1 Strategy 2 Increase advertising Reduce selling prices Some expenses (like Cost of sales and possibly wages) are variable, and must increase in line with sales volume. If these expenses increase in proportion to (or less than) Sales, it indicates satisfactory expense control. Simmons, Hardy 2006 Cambridge University Press 6

7 Exercise 18.6 All The Weights Indicator ATO has decreased Reason Average total assets increased by (proportionately) more than the increase in Sales. Net Profit Rate measures the percentage of every dollar of sales revenue that is retained as Net profit. NPR = = Net profit $8 500 $ Net Profit Rate % NPR = = Net profit $ $ Net Profit Rate % e. Although the ATO has decreased, the Net Profit Rate has increased by proportionately more. This improvement in expense control has meant that even though the assets have not been used as productively to generate revenue, more of each dollar of sales is retained as Net profit. Simmons, Hardy 2006 Cambridge University Press 7

8 Exercise 18.7 Holly s Golf Gear Gross Profit Rate measures the percentage of every dollar of sales revenue that is retained as Gross profit GPR = Gross profit = $ $ Gross Profit Rate 62.5 % Strategy 1 Strategy 2 Decrease cost prices by finding a cheaper supplier / finding a cheaper delivery company Increase selling prices (Any strategy which would increase the average mark-up) A higher selling price will increase the average mark-up, and thus increase the Gross Profit Rate. However, customers may be unwilling to pay the higher prices, leading to a decrease in the volume / quantity of sales i.e. more profit per sale may be offset by fewer sales e. Adj. GPR = = Adjusted Gross profit $ $ Adjusted Gross Profit Rate 60 % f. Strategy 1 Strategy 2 Use of security measures to reduce theft / Staff training to reduce damage Careful checking of sales/purchases against invoice (Any strategy to reduce stock loss) Simmons, Hardy 2006 Cambridge University Press 8

9 Exercise 18.8 Campbell Paints Reason 1 Increase in cost prices Reason 2 Decrease in selling prices (Any reason which would cause a decrease in the average mark-up) This strategy (of increasing advertising) will not change the average mark-up; it may generate greater sales volume, but it will not affect the Gross profit earned per sale as it does not affect selling prices or cost prices. Strategy Decrease cost prices by finding a cheaper supplier / finding a cheaper delivery company The Net Profit Rate will increase if Sales increases proportionately more than advertising. The Net Profit Rate will decrease if Sales increases proportionately less than advertising. e. Accept any two of three Information 1 The number of sales returns The number of purchase returns Information 2 The number of customer complaints f. Accept any one of two Limitation It reflects the average mark-up; individual mark-ups may vary. It relies on historical data which may not be replicate Simmons, Hardy 2006 Cambridge University Press 9

10 Exercise 18.9 Woolly Good Reason 1 Increase in advertising (from $ to $13 200) Reason 2 Reason 3 Decrease in selling prices (as indicated by the decrease in the Gross Profit Rate) (Different) Stock that is in higher demand Better / Worse Justification Worse The Net Profit Rate has decreased (from 15% to 14%), indicating less of every dollar of is retained as Net profit. A lower Gross Profit Rate possibly due to a lower selling price has generated greater sales volume, leading to higher and higher Net profit (in dollar terms). Reason 1 Adjusted Gross Profit has increased in dollar terms. Reason 2 The gap between the Gross Profit Rate and the Adjusted Gross Profit rate has actually decreased, indicating better management of stock loss. e. Strategy 1 Better assessment of number of staff required Strategy 2 Better training to improve staff productivity / service levels f. Accept any one of two Reason Signed a new lease at a higher rate Moved to more expensive premises g. Yes although advertising has increased, it has increased by proportionately less than sales have increase As a consequence, it has actually decreased as a percentage of sales from 13% to 11%. Simmons, Hardy 2006 Cambridge University Press 10

11 h. Information 1 Staff turnover / Average length of employment Information 2 Number of days lost due to sick leave /Iindustrial action Simmons, Hardy 2006 Cambridge University Press 11