Candidates should answer all three Questions in Section A and
two Questions from Section B. All Questions carry equal marks. SMA TABLES ARE PROVIDED TIME ALLOWED: 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. STRATEGIC MANAGEMENT ACCOUNTING PROFESSIONAL 1 EXAMINATION - AUGUST 2007 The Institute of Certified Public Accountants in Ireland, 9 Ely Place, Dublin 2. THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND STRATEGIC MANAGEMENT ACCOUNTING PROFESSIONAL 1 EXAMINATION - AUGUST 2007 Time Allowed: 3.5 hours, plus 10 minutes to read the paper. Answer all three Questions from Section A and any two Questions from Section B. Section A - Questions 1, 2 and 3 are all compulsory 1. Cavan Ltd. manufactures two models of heavy-duty cooking rack suitable for use in restaurant kitchens and similar commercial environments. Both models use the same types of raw materials and direct labour. No stocks are held. The sales budget for the first quarter of this year was as follows: Model A Model B Budget sales units 1,800 600 Budget selling prices 150 per unit 105 per unit This sales budget was based on an assumption that Cavan Ltd.s total sales units would amount to a 40% share of the market in which it operates. The company operates a standard variable costing system, and the following is a calculation of the standard variable cost of each product: Model A Model B Raw materials 4 kg. @ 15 per kg. = 60 3kg. @ 15 per kg. = 45 Direct labour 2 hours @ 12 per hour = 24 1hour @ 12 per hour = 12 Variable overheads 2 direct labour hours @ 10 1 direct labour hour @ 10 per hour = 20 per hour = 10 Totals: 104 67 The actual results for the quarter were as follows: Model A Model B Sales 1,320 units @ 150 per unit 880 units @ 105 per unit = 198,000 = 92,400 Raw materials 5,500 kg. @ 15 per kg. 2,700 kg. @ 15 per kg. = 82,500 = 40,500 Direct labour 2,600 hours @ 12.50 per hour 900 hours @ 12.50 per hour = 32,500 = 11,250 Variable overheads 36,000 6,350 Contribution 47,000 34,300 Published industry data indicated that, in the first quarter of this year, a total of 5,400 heavy-duty cooking racks were sold in the market in which Cavan Ltd. operates. Page 1 REQUIREMENT: (a) Calculate the following variances: G Sales mix variance. G Sales quantity variance. G Market share variance. G Market size variance. (8 marks) (b) Using your answer to part (a), and such additional variance calculations as you consider necessary, present a reconciliation of the budgeted and actual total company contribution. (A breakdown by product is not required). (6 marks) (c) Provide clear explanations of the significance of each of the four variances which you calculated in your answer to part (a). (6 marks) [Total: 20 marks] Page 2 2. Down Ltd. plans to open a new factory where two products (A and B )will be manufactured using a single set of production facilities. Engineers have estimated that the inputs required to manufacture a unit of product in respect of A and B will be as follows: Product A Product B Direct labour hours 4 7 Machine hours 16 12 Raw materials 50 60 The factory manager estimates that, during the first month of production, the average time elapsing between production and sale of each unit of product will be 10 days in the case of Product A and 15 days in the case of Product B. She also estimates that 40% of units of Product Aand 20% of units of Product B will fail quality control tests at the end of the production process and will therefore need to be immediately repaired. The inputs required to repair a unit of each product will be: Product A Product B Direct labour hours 3 5 Machine hours 6 4 Raw materials 20 25 Output in the first month will be 20,000 units of Product A and 25,000 units of Product B, and the factorys machine capacity will be fully utilised at this level of output. The factorys energy costs are variable in proportion to the number of machine hours worked and are estimated at 550,400 per month when the factory is operating at full capacity. Direct labour is available in any desired quantity at a wage rate of 10 per hour. Storage of products between production and sale is subcontracted to a local warehouse which charges Down Ltd. in accordance with the quantity and duration of goods stored. Down Ltd. estimates that it will incur storage charges of 345,000 during the first month of production. Selling prices per unit are 200 per unit for Product A and 230 per unit of Product B. REQUIREMENT: (a) For each of the two products, calculate the contribution per unit of output during the first month of production. (9 marks) (b) Senior management at Down Ltd. are committed to implementing Just-In-Time production (JIT) and Total Quality Management (TQM) insofar as possible. To this end, the company expects that in the second month of production the average times elapsing between production and sale of units of each product will be only half of the corresponding times in the first month. It is also expected that, in the second month of production, 15% of the output of each product will fail quality control tests at the end of the production process. In the second month, the factory will produce at least 20,000 units of product A and 25,000 units of product B (i.e. the same quantities in the previous month). However, there is substantial unfulfilled demand for both products and any additional machine hours which become available as a result of the decrease in the rate of quality control failures will be used in the most profitable way possible. Calculate the increase in total monthly contribution (i.e. between the first and second months) which will result from the implementation of these changes. (7 marks) (c) In the context of quality management, give two examples of appraisal costs and discuss the likely trend in appraisal costs during the implementation of a total quality management programme. (4 marks) [Total: 20 marks] Page 3 3. Donegal Ltd. manufactures a wide variety of products at its factory in Letterkenny. The company operates an activity based costing system, and has made the following estimates of the factorys overhead costs (and related cost driver activities) for next month: Cost pool Cost driver activity Total costs in pool Production line set-up 400 set-ups 336,000 Product & equipment testing 5,000 tests 1,000,000 Customer order processing & deliveries 6,000 customer orders 1,440,000 Fixed factory overhead NONE 906,000 Because no cost driver activity can be identified for fixed factory overhead, this cost is allocated to products on a direct labour hour basis. Total direct labour hours in the factory next month are estimated at 300,000. One of the companys products (Pro-1) is manufactured in batches of 500 units per production run. A total of 3 tests are carried out during each production run to ensure that quality standards are achieved. It is estimated that, next month, the company will receive a total of 2,000 customer orders for Pro-1 (consisting of 800 orders for 100 units per order and a further 1,200 orders for 40 units per order).Production of a unit of Pro-1 requires raw materials costing 2.50 as well as one and a half hours of direct labour. All direct labour in Donegal Ltd. is paid at a rate of 9 per hour. The selling price of each product is calculated as the full cost of production (including all overhead allocations) plus a 25% markup. The company operates a just-in-time system. Therefore, no stocks are held and all goods are produced in response to customer orders and are immediately delivered to customers. REQUIREMENT: (a) Calculate the unit cost of Pro-1 (in accordance with Donegal Ltd.s costing system) and the selling price per unit. (10 marks) (b) Estimate the incremental contribution which Donegal Ltd. would earn from each of the following opportunities: G 250 extra orders for 40 units of Pro-1 per order. G 100 extra orders for 100 units of Pro-1 per order. N.B.: In answering this part, take each of these two opportunities separately. Assume that the selling price per unit would be the same as in part (a). (5 marks) (c) Explain what is meant by Customer Profitability Analysis, and discuss why an activity based costing system is necessary in order to implement meaningful customer profitability analysis. (5 marks) [Total: 20 marks] Page 4 Section B - Answer any two Questions 4. Fermanagh Manufacturing PLC is a divisionalised company. Jack Maguire is the manager of the companys Textiles Division and he is considering the introduction of a new product line. This would require an immediate investment of 1,000,000 in new fixed assets plus 500,000 in additional working capital. The fixed assets would have a useful life of four years, and the product line would be discontinued at the end of that time. During each of the four years, 150,000 units of the product would be produced and sold at a price of 18 each. Variable costs of production would be 12 per unit and fixed costs (other than depreciation) would amount to 500,000 per annum. It is believed that a cash sum of 200,000 would be received when the fixed assets are sold for scrap at the end of their four year life. However, in accordance with the companys standard accounting practices, the full purchase cost of the fixed assets would be depreciated on a straight line basis over their useful life (i.e. a zero residual value would be assumed in the calculation of the annual depreciation charge). The working capital investment would be recovered in full at the end of the projects life. The performance of the Textiles Division is measured each year on the basis of Return On Investment (ROI). For this purpose, profit is defined to include any gains or losses on fixed asset disposals and the investment base is defined as working capital investment plus the net book value of fixed assets at the beginning of the year. Jack Maguire is paid a bonus each year which is linked to the extent by which his divisions actual ROI exceeds the divisions required (or target) ROI. The required rate of return for the Textiles Division is 10% per annum, and this is also the divisions cost of capital. Jacks own financial forecasts indicate that (in the absence of the proposed investment in the new product line) the Textiles Division will earn a ROI of 15% per annum for the next five years. Jack plans to leave his current employment within the next two to three years and set up in business as a consultant to manufacturing companies who could benefit from his experience and advice. REQUIREMENT: Note: Present value and annuity tables are available with this paper. (a) Calculate the ROI of the proposed investment in each of the next four years. Then, explain whether or not Jack is likely to accept this proposed investment, assuming that he acts to maximise his own self- interest. (10 marks) (b) Calculate the net present value of the proposed investment. (4 marks) (c) The use of ROI as a performance measure does not necessarily ensure that a division manager will take decisions which are in shareholders best interests. Give three examples of why this so, using the case of Fermanagh Manufacturing PLC to illustrate. (6 marks) [Total: 20 marks] Page 5 5. Monaghan Ltd. manufactures advanced technical components for the computer hardware industry. The companys Unu Division manufactures a special subcomponent at a variable cost of 70 per unit. This divisions maximum monthly production capacity is 27,000 units, but its actual production each month is 25,000 units. Of this actual monthly production, 15,000 units are sold to external customers (at a price of 100 each) while the remaining 10,000 units are transferred to the companys Du Division at the same price. The Du Divisions maximum production capacity is 13,500 units per month. However, market demand for the divisions product is only 10,000 units and therefore production is carried out at this level. In producing one unit of its product, Du Division uses one unit of the subcomponent purchased from Unu Division and incurs additional variable costs of 90 per unit. The selling price of Du Divisions product is 200 per unit. The Du Division recently received an enquiry from a new customer, who has offered to purchase 3,000 units of that divisions product each month at a price of 185 per unit. REQUIREMENT: (a) Prepare calculations to indicate the increase in the monthly profits of Monaghan Ltd., if the new customers offer is accepted. (7 marks) (b) Prepare calculations to indicate whether the existing transfer pricing arrangements would motivate each of the two divisions to cooperate in transferring the 3,000 subcomponents needed in order to manufacture the new customers order. (6 marks) (c) Identify the minimum transfer prices which would be acceptable to Unu Division and identify the maximum transfer prices which would be acceptable to Du Division. Then, suggest a transfer price per unit for the 3,000 subcomponents which would achieve the following: G The incremental profits from doing business with the new customer are to be shared equally between the two divisions. G The same transfer price per unit is to apply to all units transferred. (7 marks) [Total: 20 marks] Page 6 6. Tyrone Ltd. manufactures specialised engineering products. The items produced are of high quality but are fragile by nature and therefore the packaging process must be carried out with some care. The companys product development staff recently completed design work on a new product (the TLX). Comparison with competitors products indicates that 20 per unit is a realistic selling price for the TLX. The company requires a 35% margin on selling price from all products in order to ensure an adequate company- wide return on investment. Production and sales of TLX are estimated at 13,000 units per annum. According to the design specifications, the TLX is to be produced in batches of 500 units and packaged in batches of 25 units. Overhead costs amount to 2,000 for each batch of 500 units produced and a further 125 for each batch of 25 units packaged. The design specifications also indicate that the manufacture of each unit of TLX will require 3 units of Component #1 and 5 units of Component #2. Component #1 is a new item which Tyrone Ltd. will have to manufacture at a cost of 0.20 (variable) each plus 4,000 for each batch of 10,000 units of this component. Component #2 is used regularly by the company and can be purchased in any desired quantity from a reliable supplier for 0.55 each. The labour cost of fitting these components in the manufacture of TLX is estimated at 0.45 per unit of Component #1 and 0.15 per unit of Component #2. REQUIREMENT: (a) Prepare calculations to indicate whether Tyrone Ltd. will achieve the target cost for the TLX on the basis of the data provided. (8 marks) (b) Now assume that a target costing task force has suggested the following changes in order to help reduce the cost of the TLX: G Increase the production batch size so that each years total output of TLX would be produced in just 24 batches; G Increase the packaging batch size to 75 units of TLX; G Modify the design of the TLX, such that 2 units of Component #1 would be replaced by the same number of units of Component #2 in each TLX. Calculate the total annual cost savings if all of these changes are implemented, and indicate whether the target cost would be achieved. (8 marks) (c) The Managing Director points out that no consideration has been given to the cost of delivering the product to customers. Discuss whether the company needs to give consideration to delivery costs as part of the target costing exercise. (N.B. Calculations are not required in your answer to this part). (4 marks) [Total: 20 marks] END OF PAPER Page 7 STRATEGIC MANAGEMENT ACCOUNTING PROFESSIONAL 1 EXAMINATION - AUGUST 2007 Solution 1: Cavan Ltd. (a) Sales mix variance AQ in AM AQ in SM Standard Contribution Variance A 1,320 1,650 46 15,180 U B 880 550 38 12,540 F 2,200 2,200 2,640 U Sales quantity variance G Weighted average contribution per unit = (75% * 46) + (25% * 38) = 44. G SQV = (2,200 2,400) * 44 = 8,800 U. Market size variance G Actual market size = 5,400 units. G Budget market size = 2,400 / 40% = 6,000 units. G MSZV = (5,400 6,000) * 40% * 44 = 10,560 U. Market share variance G Actual sales = 2,200 units. G Standard share of actual market = 5,400 * 40% = 2,160 units. G MSHV = (2,200 2,160) * 44 = 1,760 F. (b) Materials use variance G Actual quantity = 5,500 + 2,700 = 8,200 kg. G Standard quantity = (1,320 * 4) + (880 * 3) = 7,920 kg. G MUV = (8,200 7,920) * 15 = 4,200 U. Labour efficiency variance G Actual hours = 2,600 + 900 = 3,500. G Standard hours = (1,320 * 2) + (880 * 1) = 3,520. G LEV = (3,500 3,520) * 12 = 240 F. Labour rate variance = 3,500 * (12.50 - 12) = 1,750 U. Variable overhead efficiency variance = (3,500 LH 3,520 LH) * 10 = 200 F. Variable overhead spending variance G Actual VO expenditure = 36,000 + 6,350 = 42,350. G Standard VO expenditure for actual labour hours = (3,500 * 10) = 35,000 G VOSV = 42,350 - 35,000 = 7,350 U. Page 8 SUGGESTED SOLUTIONS RECONCILIATION Budget profit: (1,800 * 46) + (600 * 38) 105,600 Sales mix variance 2,640 U Market size variance 10,560 U Market share variance 1,760 F Sales quantity variance ------------ 8,800 U Materials use variance 4,200 U Labour efficiency variance 240 F Labour rate variance 1,750 U Variable overhead efficiency variance 200 F Variable overhead spending variance 7,350 U Actual profit: 47,000 + 34,300 81,300 (c) G The cause of the unfavourable sales mix variance is that the product with the higher contribution per unit (Model A, at 46) actually accounted for a lower proportion of sales units (60%) than budgeted (75%). Conversely, in the case of the higher-contribution product (Model B), its actual sales quantities accounted for a higher percentage of sales units (40%) than budgeted (25%). G The unfavourable sales quantity variance shows the decrease in total contribution resulting from the increase in total sales quantity from 2,400 to 2,200, ignoring the changing in the sales mix (i.e., holding the sales mix constant at its budgeted 75%:25% level). G Together, the market share and market size variances make up the sales quantity variance (1,760 F + 10,560 U = 8,800 U). G The unfavourable market size variance of 10,560 is the loss of contribution which Cavan Ltd. would have suffered because of the increase in the total market size from 6,000 to 5,400 units, if the company had achieved only a 40% market share as budgeted. G The favourable market share variance of 1,760 is the amount of additional contribution earned by Cavan Ltd. as a result of increasing its market share from a budgeted 40% to an actual 44.4%. Tutorial notes: G Purpose of question: To test candidates ability to calculate and explain advanced sales and marketing variances, including advanced materials variances, and to identify which other variances are also necessary in order to complete a variance reconciliation. (Topic 3). G Links: None. G Options: Textbooks (and therefore candidates) are likely to differ somewhat in the precise methods used to calculate variances in parts (a) and (b), although all should arrive at the same answer. G Essential components: Candidates need to be able to perform the calculations required for parts (a) and (b), and to identify which variances are required for part (b). In part (c), candidates are expected to provide a thorough (and not merely superficial) explanation of the meanings of the variances. Page 9 Solution 2: Down Ltd. (a) G Energy costs per MH: Total MH = (20,000 * 16) + (25,000 * 12) + (20,000 * 40% * 6) + (25,000 * 20% * 4) = 688,000. Energy cost per MH = 550,400 / 688,000 = 0.80 per MH. G Storage costs per day: Total storage days = (20,000 * 10) + (25,000 * 15) = 575,000. Storage cost per day = 345,000 / 575,000 = 0.60 per day. G Average cost per unit: Product A Product B Production: labour 4 * 10 = 40 7 * 10 = 70 Production: energy 16 * 0.80 = 12.80 12 * 0.80 = 9.60 Production: materials 50 60 Storage 10 days * 0.60 = 6 15 days * 0.60 = 9 Repair: labour 40% * 3 * 10 = 12 20% * 5 * 10 = 10 Repair: energy 40% * 6 * 0.80 = 1.92 20% * 4 * 0.80 = 0.64 Repair: materials 40% * 20 = 8 20% * 25 = 5 Total cost per unit 130.72 164.24 G Contribution per unit: Product A Product B 200 - 130.72 = 69.28 230 - 164.24 = 65.76 (b) G Extra MH available = (40% - 15% * 20,000 * 6) + (20% - 15% * 25,000 * 4) = 35,000 MH. G Revised costs per unit: Product A Product B Production: labour (as before) 40 70 Production: energy (as before) 12.80 9.60 Production: materials (as before) 50 60 Storage 5 days * 0.60 = 3 7.5 days * 0.60 = 4.50 Repair: labour 15% * 3 * 10 = 4.50 15% * 5 * 10 = 7.50 Repair: energy 15% * 6 * 0.80 = 0.72 15% * 4 * 0.80 = 0.48 Repair: materials 15% * 20 = 3 15% * 25 = 3.75 Total cost per unit 114.02 155.83 G Contribution per unit of scarce resource (MH): Product A Product B Contribution per unit 200 - 114.02 = 85.98 230 - 155.83 = 74.17 Average MH per unit 16 + (15% * 6) = 16.9 MH 12 + (15% * 4) = 12.6 MH Contribution per MH 5.09 5.89 G Hence: Optimal use of additional hours is to increase production of B by (35.000 MH / 12.6 MH) = 2,777 units. Page 10 G Change in total contribution: Contribution (Month 2) (20,000 * 85.98) + (27,777 * 74.17) = 3,779,820 Contribution (Month 1) (20,000 * 69.28) + (25,000 * 65.76) = 3,029,600 Increase in contribution 750,220 (c) G Example 1: Costs of quality control sampling at the end of the production staff (e.g., salaries paid to quality control inspectors). G Example 2: Costs of periodic testing of production equipment, to determine whether it is calibrated with sufficient accuracy. G In the earliest stages of a total quality management (TQM) programme, appraisal costs often increase as management take steps to identify any defective output produced by existing production facilities and prevent if from leaving the factory. In the longer term, however, it is a fundamental tenet of TQM that quality should be designed in and not inspected out. For example, by increasing its expenditure on preventive maintenance and staff training, a manufacturing firm can significantly reduce the probability of defective output being produced. In these circumstances, appraisal becomes less necessary and therefore appraisal costs can be expected to decrease. Tutorial notes: G Purpose of question: To test candidates ability to identify and calculate relevant information for decision- making including the effect of a limiting factor (Topic 2), and to prepare calculations and explanations in the context of cost of quality management (Topic 5). G Links: One effect of part (b) is to highlight the high opportunity cost (Topic 2) of low quality levels. G Options: There are many valid examples which could be given in answer to part (c). In parts (a) and (b), the precise sequence of calculations may vary somewhat although candidates should ultimately arrive at the answers presented here. G Essential components: Candidates need to be able to identify and calculate relevant costs in parts (a) and (b), not forgetting about the significant impact of repair costs. Also, candidates must know how to identify the optimal use of a single limiting factor in part (b). Finally, in part (c), candidates must understand appraisal costs including their likely trend in the context of TQM. Page 11 Solution 3: Donegal Ltd. (a) G Cost driver rates: Set-up: 336,000 / 400 = 840 per set-up. Testing: 1,000,000 / 5,000 = 200 per test. Customer order processing & delivery: 480,000 / 2,000 = 240 per order. G Fixed overhead allocation rate: 906,000 / 300,000= 3.02 per DLH. G Activity levels for Pro-1: Total output = (800 * 100) + (1200 * 40) = 128,000 units. Number of set-ups = 128,000 / 500 = 256. Number of tests = 256 * 3 = 768. Number of customer orders = 800 + 1,200 = 2,000. G Activity-based overhead cost levels for Pro-1: Set-up 256 * 840 = 215,040 Test 768 * 200 = 153,600 Customer order processing 2,000 * 240 = 480,000 Total 848,640 G Cost and selling price per unit: Raw materials 2.50 Direct labour 1.5 DLH * 9 = 13.50 Activity based overheads 848,640 / 128,000 = 6.63 Fixed factory overhead 1.5 DLH * 3.02 = 4.53 Total cost per unit 27.16 Selling price 27.16 plus 25% = 33.95 (b) G Activity levels for Opportunity #1: Total output = (250 * 40) = 10,000 units. Number of set-ups = 10,000 / 500 = 20. Number of tests = 20 * 3 = 60. Number of customer orders = 250. G Incremental costs & contribution for Opportunity #1: Set-up 20 * 840 = 16,800 Test 60 * 200 = 12,000 Customer order processing 250 * 240 = 60,000 Raw materials 10,000 * 2.50 = 25,000 Direct labour 10,000 * 13.50 = 135,000 Total costs 233,680 Total sales 10,000 * 33.95 = 339,500 Total incremental contribution 90,700 G Activity levels for Opportunity #2: Total output = (100 * 100) = 10,000 units, i.e., the same as Opportunity #1. Hence, activity & incremental costs are the same as for Opportunity #1, except that: - Number of customer orders = 100 - Hence, cost of order processing = 100 * 240 = 24,000. Page 12 G Hence: Incremental contribution for Opportunity #2: Incremental contribution for Opportunity #1 90.700 Saving in customer order processing costs 60K - 24K = 36K Incremental contribution for Opportunity #2 126,700 (c) G Customer profitability analysis typically involves calculating the profit which a firm earns from its relationships with each of its major customers. The objective is to identify the most profitable customers so that the relationship can be carefully nurtured and maintained, and also to identify unprofitable customers so that steps can be taken to improve the profitability of such relationships. G Activity based costing is essential for meaningful customer profitability analysis. Without ABC, it would not be possible to trace costs accurately to individual customers to identify their profitability. For example, customers can be expensive to serve because they order in small quantities (as the example in part (b) illustrates) or require a lot of pre- or post-sales support. G Customers often differ in the mix of products which they buy. Therefore, the profit calculation for each customer should include an accurate, activity-based figure for the cost of goods sold to that customer. This requires that product costs have been calculated using activity based costing insofar as possible. Tutorial notes: G Purpose of question: To test candidates to perform and interpret activity-based costing calculations (Topic 1). G Links: Part (b) involves a relevant cost calculation (Topic 2). G Options: In part (c) there are several possible examples to explaining why ABC information is a prerequisite for customer profitability analysis. G Essential components: Part (a) requires an ability to accurately perform ABC and cost-based pricing calculations. Part (b) requires an ability to distinguish between incremental and non-incremental costs. In part (c) candidates need to explain what customer profitability analysis is and why ABC is essential for its implementation. Page 13 Solution 4: Fermanagh Manufacturing PLC (a) Profit: Y1, Y2, Y3 Y4 Sales: 150,000 @ 18 2,700,000 2,700,000 VC: 150,000 @ 12 1,800,000 1,800,000 FC (excl. depreciation) 500,000 500,000 Depreciation: 1,000,000 / 4 250,000 250,000 Gain on disposal 200,000 Profit 150,000 350,000 Investment base: Y1 Y2 Y3 Y4 FA @ beginning of year 1,000,000 750,000 500,000 250,000 Working capital 500,000 500,000 500,000 500,000 Total 1,500,000 1,250,000 1,000,000 750,000 ROI: Y1 Y2 Y3 Y4 10% 12% 15% 46.7% Jack is unlikely to accept the proposed investment. His division earns 15% without it, so acceptance will reduce the average ROI during the timeframe of Jacks intended remaining employment with the company, and thus adversely affect his bonus. (b) Cash flows: Y) Y1, Y2, Y3 Y4 Operating cash flows (2.7M - 1.8M - 0.5M) 400,000 400,000 Purchase and sale of fixed assets (1,000,000) 200,000 Working capital (500,000) 500,000 Net cash flow (1,500,000) 400,000 1,100,000 NPV @ 10% = - 1.5M + (400K * 2.487) + (1.1M * 0.683) = 246,000. (c) Examples: 1. ROI includes a depreciation charge. NPV calculations do not, because depreciation is not a cash flow. 2. ROI is a year-by-year calculation, so the managers reaction to it depends on his time horizon (e.g., Jack does not plan to stay long enough with Fermanagh Manufacturing for the high ROI in Year 4 to be of any benefit to him). By contrast, NPV involves evaluating a project over its whole life. 3. NPV calculations enable a project to be judged in isolation. It is possible to see whether (as in this case) the project would increase shareholders wealth. By contrast, managers tend to react to the ROI of an individual project in terms of how it will affect their division average ROI and this can lead to dysfunctional decisions (e.g., Jack is unlikely to accept this project because it would reduce his existing high average ROI). Page 14 Tutorial notes: G Purpose of question: To test candidates ability to calculate ROI (Topic 4) and NPV (Topic 3) and their ability to identify how the performance evaluation method used is likely to affect a managers reaction to a project (Topic 4). G Links: Part (b) requires an ability to identify incremental cash flows (Topic 2). G Options: In part (c) there is scope for variation, as candidates are free to use any three valid examples. G Essential components: In part (a) candidates need to be able to calculate ROI and assess the managers likely reaction to the situation. Part (b) requires the ability to identify and discount incremental cash flows. To answer part (c), candidates must give examples as to why the use of ROI as a performance measure does not necessarily guarantee goal congruence. Page 15 Solution 5: Monaghan Ltd. (a) G Spare capacity in Unu Division = (27,000 15,000 10,000) = 2,000 units. G Spare capacity in Du Division = (13,500 10,000) = 3,500 units. G Effect on profits of accepting the new order: Price paid by customer 3,000 * 185 = 555,000 Lost external sales in Unu (3,000 2,000 = 1,000 units) * 100 = 100,000 Incremental variable costs in Unu 2,000 * 70 = 140,000 Incremental variable costs in Du 3,000 * 90 = 270,000 Incremental profit 45,000 (b) G Unu Division: - First 2,000 units: In favour. Incremental profit on units transferred = (100 - 70) * 2,000 = 60,000. - Next 1,000 units: Indifferent, as internal transfer is at the same price as the displaced external sale (100). G Du Division: - Unwilling to accept the transfer. Incremental loss on units transferred = (185 - 100 - 90 = 5 per unit) * 3,000) = 15,000. G Hence, although Unu would be willing to make the transfer, it will not take place because it is unacceptable to Du. (c) G Minimum prices acceptable to Unu: - First 2,000 units: 70 (i.e., marginal cost). - Next 1,000 units: 100 (i.e., external market price). G Maximum prices acceptable to Du: - All units: 185 - 90 = 95 per unit. G Transfer price in accordance with criteria: - At transfer price of 95 per unit, Dus profit is nil (see above). - To give Du half of the total incremental profit, decrease this transfer price by: Half of total profit Decrease in transfer price per unit 45,000 / 2 = 22,500 22,500 / 3,000 = 7.50 - Hence: transfer price of 95 - 7.50 = 87.50 per unit. - Dus incremental profit = 3,000 * (185 - 90 - 87.50) = 22,500. - Unus incremental profit = (3,000 * 87.50) (1,000 * 100) (2,000 * 70) = 22,500. Page 16 Tutorial notes: G Purpose of question: To test candidates ability to appraise and identify transfer pricing arrangements which will motivate goal congruent behaviour. (Topic 4). G Links: The question asks candidates to identify goal congruent transfer pricing arrangements, and this necessitates (especially in part (a)) an ability to identify the relevant costs and revenue for decision- making (Topic 2) from shareholders perspective. G Options: The scope for variation in answers is limited. However, it should be noted that the solution to part (c) above is slightly longer than strictly necessary. Specifically, the question does not ask candidates to prove that the proposed transfer pricing scheme gives equal profits (22,500) to each division. G Essential components: In all three parts, candidates need to be able to perform the calculations as required. Some explanations would help the flow of the answers in most parts, but is not strictly necessary given the wording of the question. Page 17 Solution 6: Tyrone Ltd. (a) G Target cost = 20 less 35% = 13. G Component costs: - To buy & fit one unit of Component #1: 0.20 + (4,000 / 10,000 = 0.40) + 0.45 = 1.05. - To buy & fit one unit of Component #2: 0.55 + 0.15 = 0.70. G Expected cost per unit of TLX: Component #1: 3 units @ 1.05 3.15 Component #2: 5 units @ 0.70 3.50 Production overheads: 2,000 / 500 units 4.00 Packaging overheads: 125 / 25 units 5.00 TOTAL 15.65 G Hence, on this basis, the target cost will not be achieved. (b) G Reduction in numbers of batches: - Production: (13,000 / 500 = 26) 24 = 2. - Packaging: (13,000 / 25 = 520) - (13,000 / 75 = 173.33) = 346.67. G Annual expected cost savings: Production overheads: 2 * 2,000 4,000 Packaging overheads: 346.67 * 125 43,333 Substitution of components: 13,000 * 2 * (1.05 - 0.70) 9,100 TOTAL COST SAVINGS 56,433 (c) G The question of whether delivery cost needs to be considered hinges on whether or not customers expect the product price charged to include the cost of delivery. G If competitive conditions are such that customers expect the cost of delivery to be included in the product price, then the target costing group should allow for delivery costs in their calculations as to whether or not the target cost will be achieved. In addition, the search for cost reduction ideas should include ways of reducing delivery costs (e.g., by redesigning the product to make it lighter or otherwise easier to transport), since such cost savings directly benefit the company. G On the other hand, if competitive conditions are such that customers expect to be charged separately for delivery, then the target costing group will pay less attention to these costs as they are not borne by the company. Nevertheless, it should be remembered that the companys products will enjoy a competitive advantage if they are designed so that the cost to customers of transporting them is low. Tutorial notes: G Purpose of question: To test candidates ability to apply their knowledge of target costing, including both the calculation aspects and the identification of cost reduction opportunities. (Syllabus topic 2). G Links: The question also involves some very basic cost driver calculations. G Options: There is scope for variation in the sequence of calculations in parts (a) and (b), and in the precise points made in part (c). G Essential components: Candidates need to be able to perform the calculations required for parts (a) and (b) accurately. In part (c) candidates need to address both sides of the delivery costs issue (i.e., the relevance of these costs depends on whether or not they are included in the price charged to the customer). Page 18