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MOCK EXAM PAPER

Main Examination Period

BUSM107  FINANCIAL ANALYSIS AND MANAGEMENT ACCOUNTING

PART A (Mandatory)

Answer only ONE Question from this Section

QUESTION 1 [60 marks]

Permaclean Products is an old-established firm, located in Dunstable, manufacturing a compre-hensive range of domestic cleaning materials. It has a sound reputation and a well-known brand name, which has made it a market leader in a wide range of products designed for home use. Although Permaclean has several competitors, the total sales of each are small in comparison with those of Permaclean, mainly because none offers such a complete product range. In 2016 the price of one of Permaclean’s major products, Permashine – a mini-bottled bath cleaner, was raised from 75p per bottle to 99p when the product was repackaged in a newly designed bottle; however, the contents were identical to the previous pack, both in formulation and quantity. During the following two years sales fell by 27%. At 75p per bottle Permashine had been competitively priced but when its price was increased manufacturers of similar products had not followed. In the period from 2014 to 2017 the price of competing products had been raised by only 5p. Prices were fixed once a year, to come into force on 1 February, before the annual peak demand which occurred in the spring. In January 2018, John Williams, the marketing manager, met with Andrew Dutton, the chief accountant, to review the company’s pricing policy for the coming year.

Permashine

Permashine is a proprietary cleaning product for bathrooms and in 2014 had accounted for over 10% of the company’s sales. Although there are a variety of competing products that are mini-bottled on the market, Permashine has special properties which make it especially suitable for cleaning baths made of acrylic materials. Such baths are becoming increasingly common, but great care has to be taken to avoid scratching them when they are being cleaned. Permashine contains no abrasive materials yet is able to clean acrylic surfaces with great efficiency, giving a surface shine that is very durable. No competing product appears to have this combination of advantages. The process used in the manufacture of Permashine involves a hazardous chemical reaction that has to be precisely controlled. Production therefore takes place in a separate building on the same site as the main factory where the other products are made but some distance from it. This production unit, which was constructed in 2010 for safety reasons, is not capable of being adapted for the manufacture of other Permaclean products without substantial expenditure. Although the manufacture of Permashine is potentially hazardous, no serious accidents have occurred dur-ing the 15 years in which it has been produced and the final product is itself completely harmless. In early 2015, Andrew Dutton had installed an improved cost accounting system which allowed product costs to be determined and product profitability to be reviewed. With regard to Permashine, this took into account the new packaging costs, as well as the overhead costs that were separately attributable to the production unit. His analysis, shown in Exhibit 201.1, indi-cated that the total cost of Permashine was greater than the current selling price of 75p. As a result, at the annual pricing review in 2016 the selling price was increased to 99p. Although total industry sales continued to rise during 2016 and 2017, Permashine suffered a reduction in both its market share and its total sales, as shown in Exhibit 201.2. The 2018 pricing review Both Mr Williams and Mr Dutton were concerned to improve the profitability of Permashine, as it was one of the company’s major products. Mr Williams had joined the company in 2010 and had introduced a number of changes in the firm’s marketing methods. One of his major suc-cesses had been his decision to replace wholesalers with a team of salaried sales representativeswho sold the company’s full product range direct to retailers. Mr Dutton had been appointed in 2014, following the retirement of the previous chief accountant, and had been responsible for installing a modern computer-based accounting system. Mr Williams pressed for a return to the previous price of 75p for Permashine; at this price he was confident that the market share of the product could be increased to 20% in 2018. He thought that total industry sales would continue to increase to at least 3 million bottles in 2018, and that Permashine was capable of regaining its previous position, provided that it was competitively priced. Because Permaclean had a modern production facility and a manufacturing output greater than any competitor, he was confident that factory production costs were the lowest in the industry. He therefore supported a policy of reducing the price so that other firms would find it uneconomic to continue to compete. Mr Williams was convinced that sales would continue to fall if the price were to be maintained at 99p, although he believed that there would always be a premium market for Permashine because of its unique qualities. He thought that annual sales were unlikely to fall below 250 000 bottles even at the current price. Mr Dutton replied that he was well aware of the problems being experienced in selling the higher-priced product. Nevertheless, his analysis showed that the 99p price covered the costs of the product, even at the lowest volume envisaged. If the price were reduced to 75p costs would fail to be covered, even if sales volume rose to the 800 000 bottles which represented the maxi-mum practical capacity of the plant. He referred to his detailed costings (Exhibit 201.1) to support his argument. These figures, he stated, were based on actual data from past years; where data were not available, he had made what he regarded as realistic assumptions.

Required: What price would you recommend for Permashine? Support your recommendation with detailed calculations, making the underlying assumptions on which your analysis is based as clear as possible.

Note: Exhibits follow on the next page.

SECTION B

Answer only ONE Question from this Section

QUESTION 2 [40 marks]

A tenth of oil production may become uneconomic.

 WoodMackenzie warns crude at 17-year lows could force industry to shut-in projects.

At least 10 per cent of global oil production could become uneconomic if crude prices hold at 17-year lows, piling pressure on energy companies to lower production or “shut-in” projects as they battle to survive.  Should Brent crude remain around the $25 a barrel level, revenue from 10m barrels a day of global supply will not cover the cost of production and payments to governments, according to a report from consultancy WoodMackenzie. 

 “If prices don’t rebound, the taps will inevitably be turned off or strategically choked back in some areas,” analysts at the group said. “The industry’s ability to keep higher-cost barrels flowing will be severely tested.”  Oil prices can swing dramatically even with small shifts in supply and demand. Global supply stood at about 100m b/d in February, according to the International Energy Agency. The coronavirus outbreak, which has shut down whole countries and halted travel, has hit global consumption of crude and caused turmoil in international oil and financial markets. At the same time, Saudi Arabia and Russia are unleashing more barrels on to the market as they engage in a price war. Brent crude, which fell to its lowest level since 2003 on Wednesday, taking prices down by half in the past 10 days, rebounded slightly to $27 on Friday.  Heavier oil production in Venezuela and Mexico, which requires crude prices above $55 a barrel, is most vulnerable.

Canadian oil sands projects require $45 a barrel. Saudi Arabia and Russia, meanwhile, are among the lowest-cost producers in the world at $10 a barrel or under. Yet even these countries rely on oil revenues to fill government coffers and balance their budgets. After oil prices crashed in 2014, production largely continued to flow as turning off the taps incurs additional costs and reservoir productivity losses. “Operators usually try every other tool in the box first,” said WoodMackenzie. “But, the current trifecta of oversupply, demand evaporation and global behemoths fighting for market share, may require immediate and dramatic action.” “Production shut-ins [the implementation of a production cap that is set lower than the available output of a specific site] may be substantial,” they added. Apart from reducing activity, companies will also seek to extract more efficiencies by producing as much as they can for lower levels of investment.

 They are also likely to defer the sanctioning of new projects. Italy’s Eni, UK energy major BP, Norway’s Equinor and Chevron and ExxonMobil have all warned of drastic spending cuts. Shale operators in the US will probably take the biggest hit because of the shorter nature of their production cycles and more flexible budgets versus other types of conventional projects. EnQuest, a UK energy company, said on Thursday it would shut-in or restrict output. Personnel issues related to the coronavirus will also hit activity as companies minimise the number of people on-site to prevent spreading the illness. “There will be logistical challenges to get crew and equipment in and out,” said Audun Martinsen, head of oilfield services research at Rystad Energy. Given the costs associated with restarting more mature fields, a fair chunk of this supply may never return to the market, oil analysts say. This will hearten environmentalists who have lobbied heavily for divestment from fossil fuels and see the pandemic as a chance to set the world on the path to decarbonisation.

Required: You are the financial advisor of British Airways. Consider the effect of the cost of the crude oil for your company. Which factors can play a role in your judgements concerning the future price of oil? How would the estimation about the price of oil affect the company’s budget for 2021? (word count: 750 words +/-10%)

QUESTION 3 [40 marks]

Qantas set to break even, emerge from pandemic stronger says chief executive Seat capacity to reach half of pre-virus levels by Christmas as Australian state borders reopen

 Qantas chief executive Alan Joyce expects Australia's largest carrier to stop burning through cash and restore seat capacity to at least half its pre-virus levels by Christmas, a rare note of optimism from an airline industry devastated by the coronavirus pandemic. Australia's adept handling of the Covid-19 crisis and tough calls made by the carrier's management will allow Qantas to come out of the pandemic ahead of its rivals, Mr Joyce told the Financial Times. As state borders reopen in a nation on the brink of eliminating local transmission of the virus, Qantas should be able to achieve cash breakeven, begin rebuilding its balance sheet and target opportunities following the worst crisis in aviation history, he said. “We are very optimistic. When we open up borders we’re seeing this massive surge in pent up demand,” said Mr Joyce, who on Monday will launch Qantas’ centenary celebrations in Sydney.

Mr Joyce said passenger numbers for European, US and Middle Eastern carriers were dropping due to surging Covid-19 cases while domestic rival Virgin Australia is still recovering from administration. The re-opening of Australia, which contributes two thirds of Qantas’ profit, should enable the carrier to claim 70 per cent of the domestic market, up 10 percentage points on pre-Covid-19 levels, he said. “We think we could be way over our 50 per cent [seat capacity] target by the time we get to Christmas, and that by far is one of the leading amounts of capacity being added anywhere in the world at the moment,” Mr Joyce added. Qantas has been hit hard by the virus, which prompted Australia to close its international borders to non-residents and restrict travel between states. In May the airline revealed it was burning A$40m ($29m) per week and that most international routes would remain closed until mid-2021.

Until last month, 70 per cent of domestic travel was either banned or subject to hotel quarantine, which meant capacity ran at just 25 per cent of pre-Covid levels — the lowest in the developed world, according to UBS. The restrictions have prompted the carrier to implement A$1bn cost cuts: furloughing 18,000 staff; raising A$3.5bn from shareholders and debt markets; and slashing 8,000 jobs. Trade unions accuse Mr Joyce of using Covid-19 as an excuse to downgrade working conditions. Mr Joyce said management had to act decisively during the crisis, otherwise Qantas could be among the 40 per cent of airlines that some analysts have warned could go bust.

“Qantas has survived for 100 years because it adapts it evolves, it changes its model when it has to, and it takes the necessary action,” said Mr Joyce. Latest coronavirus news Follow FT's live coverage and analysis of the global pandemic and the rapidly evolving economic crisis here. He said low prices would tempt passengers back to air travel and downplayed concerns fear of the virus would stop people flying.

A study by the International Air Transport Association detected just 44 cases of inflight transmission of the virus among 1.2bn travellers, he said. “The risk is 1 in 27m people,” said Mr Joyce, who opposes implementing social distancing on flights, a move that dents profitability, and says pre-flight testing in Australia is not needed due to low case numbers. He added that in a post-Covid world, more international passengers would embrace direct ultra-long haul routes, which could allow Qantas to reboot its delayed “Project Sunrise” strategy of launching direct flights from Sydney to New York and London.

Required: Consider the effect of Cost Volume Profit Analysis in the case of Qantas. Which factors do you consider important in this analysis and why? Explain (word count 750 words +/-10%)