You are required to answer all three questions in this section. .... The company's
Management Accountant consulted extensively in the organisation in order to ...
STRATEGIC MANAGEMENT ACCOUNTING PROFESSIONAL 1 EXAMINATION - AUGUST 2009
NOTES:
Section A You are required to answer all three questions in this section. Section B You are required to answer any two questions from this section. (If you provide answers to more questions than required in this section, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first two answers to hand for these three questions will be marked).
All questions carry equal marks.
TIME ALLOWED:
SMA TABLES ARE PROVIDED
3.5 hours, plus 10 minutes to read the paper.
INSTRUCTIONS:
During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page.
You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted.
Page 7 The Institute of Certified Public Accountants in Ireland, 17 Harcourt Street, Dublin 2.
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
STRATEGIC MANAGEMENT ACCOUNTING PROFESSIONAL 1 EXAMINATION - AUGUST 2009
Time Allowed: 3.5 hours, plus 10 minutes to read the paper.
1.
Answer all three questions from Section A and any two questions from Section B.
Section A - Questions 1, 2 and 3 are all compulsory.
Aragon Ltd. is one of several Irish companies which manufacture a special type of synthetic fabric.
In preparing its budget for 2008, Aragon Ltd. assumed that the total Irish market for the synthetic fabric would amount to 400,000 bales and that Aragon Ltd.’s share of that market would be 80,000 bales at a selling price of €12 each. The only variable cost is raw materials, and the standard variable cost for 50 bales of output was as follows: Raw material – Type A Raw material – Type B Raw material – Type C Total input Less: normal loss Output
Number of bales 12 15 33 60 10 50
Price per bale €10 €8 €5
At the end of 2008, Aragon Ltd. was pleased that its actual sales for the year had amounted to 86,000 bales at a selling price of €12.40. Furthermore, the actual prices paid per bale of raw materials were exactly as budgeted. The quantities of raw materials used were 21,000 bales of Type A, 26,000 of Type B, and 60,000 of Type C. No stocks of raw materials or finished goods were held at the beginning or end of the year.
The CEO of Aragon Ltd. has expressed the opinion that the company’s success in 2008 was caused by a combination of good luck and good strategic management. Both the company and its competitors benefited from the fact that, because of changing consumer preferences, the total Irish market for the synthetic fabric amounted to 500,000 bales (rather than the 400,000 bales assumed when the budget was being prepared). In response to this strong demand, Aragon Ltd. increased the selling price per bale more rapidly than its competitors, and also changed to using a slightly cheaper mix of raw materials even though this had the effect of slightly reducing product quality.
REQUIRED:
(a)
(b) (c)
Calculate Aragon Ltd.’s budget and actual total contribution for 2008.
(3 marks)
Prepare variance analysis calculations to reconcile budget and actual contribution in as much detail as is possible from the information provided. Your answer should include market share and market size variances. (12 marks)
Critically evaluate the company’s performance and the strategic choices made, supporting your answer by reference to the results of your variance calculations. (5 marks) [Total : 20 marks]
Page 1
2.
Galicia Ltd. manufactures two high-quality components which it sells to car manufacturers. Both components are manufactured using a single set of production equipment which can be programmed to manufacture units of either component as necessary. The equipment operates at full capacity at present, fulfilling regular demand from the company’s established customers. The fixed costs of operating the equipment amount to €507,840 per month, and these are allocated to products on a machine hour basis. The following is a summary of the monthly output: Production and sales Selling price Raw materials cost Direct labour cost Machine hours (MH) First pass yield
Product A 6,000 units €170 per unit €40 per unit of output €25 per unit of output 4.25 MH per unit of output 65%
Product B 3,000 units €230 per unit €30 per unit of output €20 per unit of output 8.7 MH per unit of output 75%
Product A €20 per unit repaired €10 per unit repaired 1 MH per unit repaired
Product B €12 per unit repaired €5 per unit repaired 2 MH per unit repaired
The following additional inputs are used in repairing those units which fail the company’s quality control tests and therefore have to be repaired before sale:
REQUIRED:
(a) (b)
(c)
Raw materials cost Direct labour cost Machine hours
Calculate the profit per unit on each of the two products and calculate Galicia Ltd.’s total profit per month. (7 marks)
Now assume that Galicia Ltd. has been approached by a potential new customer which would be interested in purchasing up to 300 units of Product A and / or 400 units of Product B if the company could supply them. The company’s Chief Executive has noted that Galicia Ltd. is already working at full machine capacity and would not be willing to disappoint any of its established customers. She has therefore determined that the only way to obtain the machine capacity necessary to meet at least some of the demand from the potential new customer is to increase the first pass yield. Assuming that the first pass yield could be increased to 95% for each product, present calculations to indicate what mix of products should be manufactured each month for the potential new customer and what increase in monthly profits would result. (7 marks)
Explain clearly what is meant by each of the four categories of cost in a Cost of Quality report. Use examples to illustrate your answer. (6 marks) [Total: 20 marks]
Page 2
3.
Castilla Ltd. manufactures and sells several types of consumer products. Competition is intense and product lifecycles are short, so it is important for the company to make the right decisions when considering the introduction of possible new products. The company’s research and development (R & D) staff recently identified two new product ideas. Following consultation between R & D, Production and Marketing staff, the following estimates of production times and quantities were arrived at: Production and sales, per month Machine hours (MH), per unit of output
Product X 25,000 units 5 MH
Product Y
10,000 units 2 MH
Product Z
20,000 units 10 MH
The company’s Management Accountant consulted extensively in the organisation in order to arrive at estimates of the activity levels and overhead costs associated with the production of the above outputs. It was estimated that monthly production would involve a total of 1,000 production set-ups (at a total cost of €1,200,000) and 8,000 materials movements (at a total cost of €600,000). In addition, the electricity consumed in running the production equipment was estimated to cost €2 per MH.
A target costing task force, consisting of representatives of all of the functional management departments in the company as well as several accounting staff, determined that none of the three products was likely to be adequately profitable given the expected market conditions and the cost information presented above.
Consequently, the target costing task force asked the R & D staff whether changes to the designs of any products could be made which would have the effect of simplifying the production process without adversely affecting the usefulness and attractiveness to the customer of the finished product. The following is a summary of the reductions in the activity levels associated with each product as a result of the design changes which the R & D staff proposed: Reduction in number of production set-ups, per month Reduction in number of materials movements, per month Reduction in MH, per unit of product
Product X
Product Y
Product Z
200 None
80 None
None 0.25
20
15
None
REQUIRED:
(a)
Calculate the total reduction in total monthly costs from implementing the design changes proposed by the R & D staff. (8 marks)
(b)
Assuming that the proposed design changes are implemented, calculate the reduction in the unit cost of each of the three products in each of the following circumstances: ●
●
(c)
If overheads are traced to products using activity-based costing (ABC).
If overheads are allocated to products on the basis of the number of units of output.
(6 marks)
Now assume that the company’s Chief Executive has decided that each product should be introduced only if the changes proposed by the R & D staff would lead to cost savings of at least the following magnitudes: Product X: €1.40 per unit
Product Y: €2.00 per unit
Product Z: €1.00 per unit
Using this additional information, and the results of your calculations in part (b), explain why it is essential for Castilla Ltd. to use ABC when applying target costing analysis to decisions about whether or not to introduce new products. (6 marks)
[Total: 20 marks]
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Section B - Answer any two of Questions 4,5 and 6.
4.
(If you provide answers to more questions than required in this section, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first two questions to hand will be marked) Several companies, which had engaged in significant amounts of trade with each other for over a decade, merged to form Canarias Group Ltd. in early 2009. Each company within the group operates as an autonomous profit centre and, because of the significant amount of intra-group transactions, the Group’s Financial Controller is anxious to devise appropriate rules governing the transfer prices attached to such transactions.
REQUIRED: (a)
Explain the consequences for Canarias Group Ltd. of requiring transfer prices to be based on the full cost of goods transferred plus a mark-up. Use the following example of a possible transaction between two of the companies within the group to illustrate your answer: •
• •
(b)
Lanzarote Ltd. has spare production capacity which could be used to manufacture 12,500 units of a component (which cannot be bought or sold outside Canarias Group Ltd.) each month. The variable cost of production would be €27 per unit, and Lanzarote Ltd. estimates that the fixed costs associated with this production capacity amount to €100,000 per month.
By using one unit of the component produced by Lanzarote Ltd. and incurring additional variable costs of €15 per unit, Tenerife Ltd. could manufacture a product which it could sell for €60 per unit. Tenerife Ltd. has plenty of spare production capacity. Lanzarote Ltd. argues that the transfer price of components sold to other companies within the Canarias Group Ltd. should be calculated as full cost of production plus a 40% mark-up, which is the formula applied in determining selling prices of products sold to external customers. (6 marks)
Assume now that the Financial Controller of Canarias Group Ltd. is considering introducing a rule that transfer price should be based on the marginal cost of production up to the point of making the transfer plus the opportunity cost associated with making the transfer. Using the above example of Lanzarote Ltd. and Tenerife Ltd., explain why this rule would not necessarily result in behaviour by those two companies which is optimal for Canarias Group Ltd. as a whole. (4 marks)
(c)
Outline two other transfer pricing rules and explain why they may be more satisfactory for Canarias Group Ltd. than the rules applied in your answers to the previous parts of this question. Your answer to this part should include explanations of the advantages and disadvantages of these two other transfer pricing rules, and indications of the steps which Canarias Group Ltd. could take in order to minimise the impact of the disadvantages. (10 marks) [Total: 20 marks]
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5.
Navarre Ltd. is a divisionalised company. Decisions about bonuses and promotions for Divisional Managers are at the discretion of the company’s Directors, but are significantly influenced by each division’s return on investment (ROI). For the purposes of ROI calculations, fixed assets are measured at their net book value at the end of the financial year. The following forecasts are available for the company’s three divisions for the year ended 31st December 2010: Division A: Division B: Division C:
Sales €600,000 €500,000 €200,000
Net profit €125,000 €80,000 €37,000
Capital at 31st December €1,100,000 €900,000 €210,000
After the above forecasts were prepared, one possible extra project was identified for each division. These projects would commence on 1st January 2010, and each Divisional Manager must decide by that date as to whether or not to accept his or her division’s possible extra project. Details of these possible extra projects (which would continue for several years if accepted) are as follows: •
•
•
REQUIRED:
(a)
Division A could increase its market share. This would result in extra sales of €160,000 in 2010 and €200,000 in each subsequent year. The profit margin on sales would be 19%. The only additional investment required would be an increase of €225,000 in the division’s working capital for the duration of the project.
Division B could invest €200,000 in new technology which would improve the productivity of the division’s manufacturing facilities. This extra investment would be depreciated on a straight-line basis over an 8-year life, and an additional investment of €60,000 in the division’s working capital would also be required for the duration of the project. The productivity improvement would result in increased sales of €130,000 in 2010 and €140,000 in each year thereafter. The profit margin on sales would be 30%, before taking account of depreciation. Division C could invest €40,000 in a new delivery vehicle, which would be depreciated at a rate of 30% per annum on a diminishing balance basis. Annual sales would increase by €64,000, and the profit margin on sales would be 25% before depreciation. An additional working capital investment of €10,000 would also be required.
For 2010, calculate each of the following:
•
•
The ROI for each division, and for Navarre Ltd. as a whole, assuming that the extra projects are not accepted. The expected ROI for each of the three extra projects.
(8 marks)
(b)
Calculate the ROI of each extra project for 2011.
(6 marks)
(c)
Explain whether each Divisional Manager is likely to accept his or her division’s proposed extra project and what decision would be in the best interests of the company’s shareholders in each case, insofar as is possible from the information available. (Indicate any reservations which you may have about the comprehensiveness of the information available). (6 marks) [Total: 20 marks]
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6.
Catalunya Ltd. operates a visitor centre in a major tourist area. The normal admission price is €20 per person, but a reduced rate applies of €12 applies to senior citizens (who make up 25% of the centre’s visitors). Total visitor numbers per month are 24,000.
The fixed costs of operating the centre are €360,000 per month. This does not include the fixed costs of the centre’s shop and café, which are €50,000 and €70,000 respectively. The average spend per visitor in the shop and café are as follows: Normal-price visitor Senior citizen
Shop €10 €8
Café €10 €3
Contribution margins in the shop and café are 25% and 30% respectively.
REQUIRED:
(a)
(b)
(c)
(d)
Calculate the monthly breakeven point (in terms of number of visitors to the centre) for each of the following: -
The shop; The café; The visitor centre as a whole.
(6 marks)
A nationwide catering chain has offered to take over the running of the café. The chain would pay all fixed and variable costs of the café, and would also pay the centre a monthly fee of €5,000 for use of the café space in the visitor centre. Identify and present the financial analysis which the visitor centre should carry out in relation to this offer. (6 marks)
The Marketing Manager of the centre has suggested that the admission price for senior citizens should be increased by €5. This price increase would be accompanied by an advertising campaign (in magazines read by senior citizens) costing €3,500, but would nevertheless result in a 25% reduction in the number of senior citizens visiting the centre.
Calculate the effect on monthly profit of implementing this proposal. (In answering this part, assume that the proposal at part (b) above is also implemented). (4 marks) Identify two factors (other than the results of the financial analysis which you have conducted) which should be considered by the visitor centre in making decisions about the proposals at parts (b) and (c) above. (4 marks)
[Total: 20 marks] END OF PAPER
Page 6
SUGGESTED SOLUTIONS
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND
STRATEGIC MANAGEMENT ACCOUNTING Solution 1: Aragon Ltd.
PROFESSIONAL 1 EXAMINATION - AUGUST 2009
Part (a):
Budget contribution: • • • •
Selling price = €12. Variable cost per bale = [(12*€10) + (15*€8) + (33*€5)] / 50 = €8.10. Contribution per bale = €3.90. Total contribution = 80,000 * €3.90 = €312,000.
Actual contribution:
Sales: 86,000 * €12.40 = Raw material A: 21,000 * €10 Raw material B: 26,000 * €8 Raw material C: 60,000 * €5 Actual contribution €348,400
€1,066,400 €210,000 €208,000 €300,000
Part (b):
Materials mix variance: •
Standard raw materials mix:
•
Variance:
A B C Total
A 12 / 60 = 20%
Actual quantity 21,000 26,000 60,000 107,000
B 15 / 60 = 25% Actual quantity in standard mix 21,400 26,750 58,850 107,000
Materials yield variance: • • •
Actual yield = 86,000. Standard yield = 107,000 * (50 / 60) = 89,167. Variance = (86,000 – 89,167) * €8.10 = €25,650 U.
Selling price variance:
•
Variance = (€12.40 - €12) * 86,000 = €34,400 F.
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C 33 / 60 = 55% Standard price €10 €8 €5
Variance €4,000 F €6,000 F €5,750 U €4,250 F
Market size variance: • • • •
Change in market size = 500,000 – 400,000 = 100,000. Standard market size % = 80 / 400 = 20%. Budget contribution per bale = €3.90. Variance = 100,000 * 20% * €3.90 = €78,000 F.
Market share variance: • • • •
Actual quantity = 86,000. Standard share of actual market = 20% * 500,000 = 100,000 bales. Budget contribution per bale = €3.90. Variance = (86,000 - 100,000) * €3.90 = €54,600 U.
Reconciliation:
Budgeted contribution Materials mix variance Materials yield variance Selling price variance Market size variance Market share variance Sales volume variance Actual contribution
€78,000 F €54,600 U
€312,000 €4,250 F €25,650 U €34,400 F €23,400 F €348,400
Part (c):
•
• •
•
Although the company’s actual contribution is significantly higher than the budget contribution, this seems to be entirely due to the single “good luck factor” of the increased market size. If this good luck factor had been fully reflected in the company’s performance, actual contribution would have been €78,000 more than budget. In fact, the improvement in performance was much more modest, and this appears to be due to the negative effect of bad strategic choices.
The change in materials mix led to a modest cost saving of €4,250, but there were apparently two adverse knockon effects. First, there was a very poor yield from the raw materials, leading to a costly unfavourable yield variance of €25,650. Second, customers seem to have noticed the difference in product quality and switched to competitors’ products. The evidence of this is the unfavourable market share variance, which reflects the fact that although sales volumes increased in absolute terms (from 80,000 to 86,000 bales) this disguises the fact that the company’s percentage share of the market decreased significantly (a decrease which cost the company €54,600).
Another factor leading to the loss of market share was the fact that Aragon Ltd. increased its selling price more rapidly than competitors. Although this resulted in a favourable selling price variance, the benefit was more than offset by the adverse effect on market share.
Tutorial notes
•
•
•
•
Purpose of question: To test candidates’ ability to calculate and interpret advanced variances. (Syllabus topic 3).
Links: None.
Options: In the first two parts, the sequence and layout of calculations could vary somewhat from the solution presented here, although the end results should be the same. In the last part, there is of course scope for candidates to bring their own interpretation to the figures, although there is a clear trend of the effects of good luck being offset by bad decisions and this needs to be brought out.
Essential components: Candidates need to be able to perform the calculations required for parts (a) and (b). The third part requires candidates to be able to identify the causes of variances in a way which recognises that there are significant interrelationships between them. Page 8
SOLUTION 2: Galicia Ltd. Part (a): •
Average MH per unit of each product:
•
Total MH capacity = (6,000 * 4.6) + (3,000 * 9.2) = 55,200 MH.
•
•
•
-
Product A: 4.25 + (35% * 1) = 4.6 MH. Product B: 8.7 + (25% * 2) = 9.2 MH.
Fixed overhead allocation rate = €507,840 / 55,200 = €9.20 per MH. Profit per unit:
Product A €170 €40 + (35% * €20) = €47 €25 + (35% * €10) = €28.50 4.6 MH * €9.20 = €42.32 €52.18
Selling price Raw materials Direct labour Fixed overheads Profit
Total profit = (6,000 * €52.18) + (3,000 * €91.11) = €586,410.
Product B €230 €30 + (25% * €12) = €33 €20 + (25% * €5) = €21.25 9.2 MH * €9.20 = €84.64 €91.11
Part (b):
•
Revised average MH per unit of each product:
•
Available extra capacity:
•
•
-
Product A: 4.25 + (5% * 1) = 4.3 MH. Product B: 8.7 + (5% * 2) = 8.8 MH.
Total capacity Time needed for existing work Available extra capacity
Time needed to meet new customer’s order in full:
(300 * 4.3) + (400 * 8.8) = 4,810 MH
This is more than the available extra capacity ⇒ need to prioritise. Contribution per machine hour, on work for new customer:
Product A €170 €40 + (5% * €20) = €41 €25 + (5% * €10) = €25.50 €103.50
Product B €230 €30 + (5% * €12) = €30.60 €20 + (5% * €5) = €20.25 €179.15
Units MH used Product A 300 300 * 4.3 = 1,290 Product B 194.3 units 1,710 MH / 8.8 MH = 194.3 units Total increase in contribution (and profit)
Contribution 300 * €103.50 = €31,050 194.3 * €179.15 = €34,812 €65,862
Selling price Raw materials Direct labour Contribution per unit •
55,200 MH (6,000 * 4.3) + (3,000 * 8.8) = 52,200 MH 3,000 MH
Contribution per MH
Hence: Optimal production plan:
€103.50 / 4.3 = €24.07
Page 9
€179.15 / 8.8 = €20.36
Part (c):
Prevention costs Appraisal costs
Internal failure costs External failure costs
– –
– –
to stop quality problems before they occur. incurred during production to detect, and eliminate, defective production. where the product defect is detected “in house” by the producer. where the product defect is detected by the customer.
Examples within each category: CATEGORIES
Prevention costs. Appraisal costs. Internal failure costs. External failure costs.
EXAMPLES
1. Simplification of product designs. 2. Supplier evaluation & certification. 3. Staff training.
1. Inspection of RM, WIP & FG stocks. 2. Maintenance of testing equipment. 1. Cost of re-work/repair. 2. Scrapped materials.
Same as costs of ‘internal’ failure, PLUS: 1. Cost of processing warranty claims. 2. “Product liability” payments.
Tutorial notes
•
•
•
•
Purpose of question: To test candidates’ ability to measure costs and benefits for decision-making, with an application to the specific area of the costs associated with quality management. (Syllabus topics 2 and 5). Links: None.
Options: The greatest scope for variation is in the third part of the question, where candidates will of course be given credit for any worthwhile and valid examples under each of the four headings in a COQ report. In the first two parts, the scope for variation is largely limit to changes in the detailed sequence of calculations, although the end results should be the same as presented here. Essential components: Candidates need to be able to perform the calculations required for parts (a) and (b). For part (c), candidates need to know and be able to explain (with proper examples) the four different cost categories in a COQ report.
Page 10
SOLUTION 3: Castilla Ltd. Part (a):
Cost driver rates: • Production set-up: €1,200,000 / 1,000 = €1,200 per set-up. • Materials movements: €600,000 / 8,000 = €75 per movement. • Machine running costs [given in question] = €2 per MH. Savings from design changes:
Product X: Production set-ups Product X: Materials movements Product Y: Production set-ups Product Y: Materials movements Product Z: Machine running costs Total savings €73,000
20 * €1,200 = €24,000 200 * €75 = €15,000 15 * €1,200 = €18,000 80 * €75 = €6,000 0.25 MH * 20,000 * €2 = €10,000
Part (b):
Reduction in unit costs, if overheads traced using ABC: • • •
Product X: (€24,000 + €15,000) / 25,000 = €1.56 per unit. Product Y: (€18,000 + €6,000) / 10,000 = €2.40 per unit. Product Z: 0.25MH * €2 = €0.50 per MH.
• • •
Total cost savings (above) = €73,000. Total units = 25,000 + 10,000 + 20,000 = 55,000 units. Hence: Cost reduction for ANY product = €73,000 / 55,000 = €1.33 per unit.
Reduction in unit costs, if overheads traced using non-ABC costing:
Part (c): •
• • •
•
When the expected cost of manufacturing a product is so high that the product would not provide Galicia Ltd. with its required rate of return, a target for cost reductions must be set and achieved before a decision can be made to begin manufacturing the product. These cost reductions can be brought about by design changes to the product.
An ABC system is essential in order to ensure that any cost savings made as a result of changing the design of any product are fully reflected in the reported cost of that product, instead of being unfairly spread over several products.
In part (b), we see that if overheads are allocated to all units on the basis of units of output, then it appears that the design changes have resulted in the costs of a unit of each product (X, Y or Z) having been reduced by €1.33.
ABC analysis is required in order to show that the cost savings resulting from the design changes differ substantially as between the three products. The impact of the design changes on the cost of Product Z is more modest than suggested by the non-ABC data, because all that has happened is a 0.25-hour reduction in machine time giving rise to a €0.50 reduction in product costs. Similarly, the ABC data is necessary to reveal the full impact of the activity reductions on the unit cost of Products X and Y (whose costs are reduced by substantially more than the €1.33 which is the amount indicated by the non-ABC allocation).
To illustrate this point, consider the cost reductions which the chief executive requires before a product can be launched. The ABC analysis in part (b) shows that the design changes have resulted in these targets having been achieved for Products X and Y (but not Z), and therefore only X and Y are economically worthwhile. From part (b), it can also be seen that if the decision had been based on the non-ABC data, precisely the opposite (and wrong) decision would have been made.
Page 11
Part (d): •
• •
In highly competitive product markets, such as those in which Castilla Ltd. operates, selling price is a “given” over which individual sellers have little real control. This is the reverse of the logic in traditional costplus pricing, which implicitly assumes that a seller can somehow rely on customers accepting whatever price is necessary to cover the seller’s costs and provide an adequate profit margin. Target costing is an acknowledgement of economic reality. Customers will go elsewhere if Castilla’s prices are higher than those of competitors for products of similar quality and functionality.
Therefore, to earn an “adequate” profit on a product → product cost must be brought below a certain level: Anticipated selling price
minus
Required profit
=
Target cost
Tutorial notes
•
•
•
•
Purpose of question: To test candidates’ ability on the use of activity based costing information (Syllabus topics 1 and 5), with a particular application of ABC to target costing (Syllabus topic 2). Links: None.
Options: There is scope for variation in the specific points made in the discursive parts of the question. To a lesser extent, there is also scope for variation in the sequence of calculations with parts (a) and (b) of the question.
Essential components: Candidates need to be able to perform simple calculations of cost driver rates and to use these to estimate the cost savings from the proposed design changes. They also need to be able to perform ABC and non-ABC calculations for part (b), and to be able to explain convincingly why the ABC information is more appropriate for decision-making in the specific scenario presented in the question. For part (d), they need to be able to explain the limitations of full-cost pricing as a means of achieving adequate product profitability.
Page 12
Solution 4: Canarias Group Ltd.
Part (a): • •
Full cost per unit in Lanzarote Ltd. = €27 + (€100,000 / 12,500) = €35 per unit. Transfer price = €35 * 140% = €49.
• • •
Lanzarote would agree to the transfer: €49 > €27. The transfer would benefit Canarias Group Ltd.: €60 > (€27 + €15). However, Tenerife would not agree to the transfer: €45 < €49.
•
• •
Net revenue to Tenerife Ltd. (before cost of transfer) = €60 - €15 = €45.
The proposed transfer pricing rule can allow sub-optimisation, since the divisions are autonomous and are therefore free to reject transfers which would impact negatively on their reported profits. In this case, the transfer would benefit Canarias Group Ltd. However, the transfer will not take place because Tenerife Ltd. will reject it.
Part (b):
• • •
• • •
Marginal cost up to the point of transfer = €27. Opportunity cost of making the point of transfer = NIL. Hence: Transfer price = €27.
Tenerife would agree to the transfer: €45 > €27. As shown in part (a), the transfer would benefit Canarias Group Ltd.: €60 > (€27 + €15). However, the problem is that Lanzarote Ltd. would be indifferent to the transfer and therefore could not be relied upon to take part in it. The price offered would only equal the marginal cost.
Part (c):
One possible solution is “two-step” transfer pricing: -
-
-
-
-
Step 1: For each unit transferred, the buying division pays a transfer price to the selling division equal to the standard marginal cost of production).
Step 2: Each month, the buying division pays a lump sum to the selling division to cover A’s a constant fair share of the latter’s fixed costs (e.g., €100,000 in the case of the transfer in part [a]) plus a profit element. This two-step transfer pricing system is likely to be goal congruent, since the buying division has an incentive to request transfers. The marginal cost of the transferred item to the buying division is the same as the marginal cost of the transferred item to Canarias Group Ltd. as a whole, so there is a significant likelihood of goal congruence. Also, the buying division will recognize that, to earn a profit, it must earn sufficient net revenues to cover all fixed costs (including fixed costs transferred to it from the selling division).
The selling division is able to make a profit through its markup on the monthly fixed costs transfer.
The proportion of the selling division’s capacity which is reserved for meeting the buying division’s needs must be fixed. Otherwise, it would be impossible to arrive at the applicable fixed costs figure for Step 2 above.
Page 13
A second possible solution is “dual-rate transfer pricing”: •
Description: The selling division is credited with the external selling price of the finished product; -
•
•
-
The buying division is charged with the standard cost of the transferred product;
The difference is eliminated on consolidation in preparing the company financial statements.
Advantages: Ensures that the division managers take goal-congruent decisions about whether to make transfers. -
Provides proper information for performance evaluation purposes.
Disadvantages: Company Profits < Combined Business Unit Profits ⇒ division managers must be told that their reported division profit significantly overstates how much profit they are earning for the company as a whole. -
Business units can come to regard internal transfers as “sheltered markets”, instead of focusing on doing business in the real world. For performance evaluation purposes, one solution is to use a composite performance measure in which each €1 of profits from external transactions is weighted more heavily than €1 of profits from intra-company sales.
Tutorial notes
•
• • •
Purpose of question: To test candidates’ knowledge of the objectives and methods of transfer pricing (Syllabus topic 4). Links: None.
Options: There is considerable scope for variation, both in the methods suggested in part (c) and in the structure of the answers to parts (a) and (b). Essential components: In parts (a) and (b), candidates need to perform the calculations to indicate how these transfer pricing mechanisms would function in this case. They also need to be able to explain the results (calculations alone are not sufficient). In part (c), candidates need to be able to explain two valid methods, to make a significant case as to why they would be reasonably satisfactory, and to identify the extent of their limitations.
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Solution 5: Navarre Ltd.
Part (a): •
•
•
Existing divisional ROI :
-
Division A : €125K / €1.1M = 11.36%. Division B : €80K / €900K = 8.89%. Division C : €37K / €210K = 17.6%.
-
Total profit : €125K + €80K + €37K = €242K. Total investment : €1.1M + €900K + €210K = €2.21M Corporate ROI : €242K / €2.21M = 11.0%.
Existing corporate ROI :
New project ROIs for 2010 :
Profit before depreciation Depreciation Profit
Working capital Book value of fixed assets at 31st December Total
Project ROI
Division A 19% * €160K = €30,400 Nil €30,400 €225,000
Nil €225,000
Division B Division C 30% * €130K = €39,000 25% * €64K = €16,000 €200K / 8 = €25,000 €40,000 * 30% = €12,000 €14,000 €4,000 €60,000
€200K - €25K = €175K €235,000
13.5%
6.0%
€10,000
€40K - €12K = €28K €38,000 10.5%
Part (b):
•
New project ROIs for 2011 : Profit before depreciation Depreciation Profit
Working capital
Book value of fixed assets at 31st December Total
Project ROI
Division A 19% * €200K = €38,000 Nil €38,000
Same as 2010 ⇒ €225,000 Same as 2010 ⇒Nil €225,000 16.9%
Division B Division C 30% * €140K = €42,000 Same as 2010 ⇒ €16,000 Same as 2010 €28,000 * 30% ⇒ €25,000 = €8,400 €17,000 €7,600 Same as 2010 ⇒ €60,000 €175K - €25K = €150K €210,000 8.1%
Same as 2010 ⇒ €10,000 €28K - €8,400 = €19,600 €29,600 25.7%
Part (c):
Division A extra project
• •
Likely to be accepted by the divisional manager. In both 2010 and 2011, this project has a return higher than the division’s existing projected ROI, and would thus increase average divisional ROI.
To determine whether this decision would be in the shareholders’ interests, we would need to know the company’s cost of capital. However, assuming that the company’s existing ROI (11%) equals or exceeds the cost of capital, this investment seems to be in the shareholders’ interests. Page 15
Division B extra project •
•
Likely to be rejected by the divisional manager, since in both 2010 and 2011 this project has a return less than the division’s existing projected ROI (and would thus reduce average divisional ROI). However, the effect of the depreciation will be to increase ROI further in future years, so if the divisional manager has a very decisionmaking long time horizon then he may wish to accept the project. As with Division A’s project, to determine whether this decision would be in the shareholders’ interests, we would need to know the company’s cost of capital.
Division C extra project •
•
This has an ROI which is substantially below the division’s existing ROI in 2010 and substantially above it in 2011 (and subsequent years) because of the effect of the diminishing balance depreciation. Hence, the divisional manager’s decision is likely to depend on his time horizon – e.g., if he plans to leave his existing job before the end of 2011 then he is unlikely to accept the project.
As with Division A and B’s projects, to determine whether this decision would be in the shareholders’ interests, we would need to know the company’s cost of capital.
Tutorial notes
•
•
• •
Purpose of question: To test candidates’ ability to implement and analyse measures of divisional profitability for purposes of investment centre management control (Syllabus topics 3 and 4). Links: None.
Options: There is scope for variation in the points made in part (c), especially as to the comprehensiveness of the information available. There is no significant scope for variation in parts (a) and (b) apart from the layout of calculations.
Essential components: Candidates need to be able to perform the ROI calculations in parts (a) and (b), and to interpret the results in the specific context of Navarre Ltd. in part (c). For purposes of part (c) it is also essential that candidates should be able to assess the adequacy (for purposes of answering the question) of the available information.
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Solution 6: Catalunya Ltd. Part (a): •
Weighted average contributions:
•
Fixed costs:
•
Breakeven :
Shop 25% * [(75% * €10) + (25% * €8)] = €2.375
Café 30% * [(75% * €10) + (25% * €3)] = €2.475
Visitor centre (75% * €20) + (25% * €12) = €18 + €2.375 + €2.475 = €22.85
Shop €50K
Café €70K
Visitor centre €50K + €70K + €360K = €480K
Shop 21,053
Café 28,283
Visitor centre 21,007
Part (b):
•
Effect on monthly profit (based on current visitor numbers):
•
At what level of visitor numbers would subcontracting the café be less profitable than the current arrangement?
Fixed costs avoided Fee income Lost contribution: €2.475 * 24,000
Contribution per visitor Fixed costs Hence:
With subcontracting €20.375 €410K
+ €70,000 + €5,000 - €59,400 + €15,600
Without subcontracting €22.85 €480K
20.375X – 410,000 < 22.85X – 480,000 ⇒ 70,000 < 2.475X ⇒ 28,283 < X. Part (c):
•
Effect on monthly profit:
Loss of 25% of senior citizens ticket sales: (24,000 * 25% = 6,000 * 25% = 1,500 * €12) Price increase for remaining senior citizens tickets: (6,000 * 75% = 4,500 * €5) Cost of advertising Loss of shop margin: 1,500 * (€8 * 25%) Decrease in monthly profit
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- €18,000 + €22,500 - €3,500 - €3,000 - €2,000
Part (d):
Examples of valid points:
•
•
Would decreases in senior citizen numbers also affect sales of full-price tickets? It is likely that they would, since senior citizens often travel with their families and therefore sales of full-price tickets might also be adversely affected by the proposal in (c).
In (b), the fact that the subcontractor is a nationwide chain would be an advantage if the chain’s reputation is a positive one. Although customers would not buy tickets for the centre just to visit the chain, nevertheless the fact that the centre has reputable catering facilities would enhance customers’ willingness to visit the centre.
Tutorial notes
•
•
•
•
Purpose of question: To test candidates’ ability to identify relevant costs for decisions, including the application of cost-volume-profit analysis (Syllabus topic 2). Links: None.
Options: There is considerable scope for variation in the points made in answer to part (d).
Essential components: Candidates need to be able to perform the CVP calculations in part (a); to identify and perform the relevant calculations in part (b); to calculate the effect on profit in part (c), and to identify two valid points in part (d).
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