Professional Documents
Culture Documents
MANAGEMENT
ADVISORY
SERVICE
Pre-Finals
Table of Contents
Pricing Policies and Profitability Analysis......................................................4
1. Factors Influencing the Price of a Product...........................................6
2. Markets................................................................................................7
3. Price and Demand Relationship...........................................................7
4. Price Elasticity of Demand...................................................................8
5. Profit Maximization............................................................................10
6. Pricing Strategies..............................................................................13
7. Profitability Analysis..........................................................................18
Divisional Performance Measures..............................................................25
1. Objectives.........................................................................................25
2. Centralization and Decentralization..................................................26
3. Concepts of Responsibility Centres...................................................27
4. Financial Performance Measures of Investment Centre.....................27
5. Transfer Pricing..................................................................................34
Transfer Pricing Methods............................................................................42
1. The Need for Transfer Pricing............................................................44
2. Transfer Pricing Methods...................................................................45
Divisional Performance Measures..............................................................55
1. Objectives.........................................................................................55
2. Centralization and Decentralization..................................................56
3. Concepts of Responsibility Centres...................................................57
4. Financial Performance Measures of Investment Centre.....................58
5. Transfer Pricing..................................................................................64
Segment Performance Measurements.......................................................73
1. Allocation of Costs and Segment Report...........................................74
2. General Aspects in Performance Measurements...............................75
Chapter 11 Strategic Management Accounting and Processes..................79
1. What is Strategy?..............................................................................80
2. Levels of Strategy.............................................................................81
Example 1 Levels of strategy..................................................................81
3. Mission, Goals and Objectives...........................................................81
4. Corporate Appraisal: Environmental Analysis...................................82
5. Corporate Appraisal: Position Audit...................................................87
6. Other Strategic Cost Management Techniques.................................95
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Page 2
Page 3
Page 4
F a c to rs
In flu e n c in g
th e P ric e
T ypes of
M a r k e ts
in E c o n o m ic s
P ric e a n d
D em and
R e l a t i o n s h ip
P ric e
E l a s t i c i ty
of D em and
P ro fit
M a x im iz a tio n
(M R = M C )
P ric in g
S tra te g ie s
F u ll C o s t-p lu s
P ric in g
B y P ro d u c t
M a rg in a l
C o s t-p lu s
P ric in g
B y C u s to m e rs
M a rk et
S k im m in g
P ric in g
M a rk et
P e n e tra tio n
P ric in g
C o m p le m e n ta ry
P ro d u c t
P ric in g
P ric e
D is c rim in a tio n
M a rk e t-b a s e d
P ric in g
T a rg et
P ric in g
E th ic a l
P ric in g
Page 5
P r o f i t a b il ity
A n a l y s is
1.1
(Dec 11)
Several factors underlie all pricing decisions and effective decisions will be based on a
careful consideration of the following.
Influence
Price sensitivity
Price perception
Quality
Intermediaries
Competitors
Suppliers
Inflation
Newness
Incomes
Product range
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Explanation/Example
Sensitivity to price levels will vary amongst purchasers. Those
that can pass on the cost of purchases will be the least sensitive
and will therefore respond more to other elements of perceived
value. For example, a business traveller will be more
concerned about the level of service in looking for an hotel
than price, provided that it fits the corporate budget. In
contrast, a family on holiday are likely to be very price
sensitive when choosing an overnight stay.
Price perception is the way customers react to prices. For
example, customers may react to a price increase by buying
more. This could be because they expect further price
increases to follow (they are 'stocking up').
This is an aspect of price perception. In the absence of other
information, customers tend to judge quality by price. Thus a
price rise may indicate improvements in quality, a price
reduction may signal reduced quality.
If an organisation distributes products or services to the market
through independent intermediaries, such intermediaries are
likely to deal with a range of suppliers and their aims concern
their own profits rather than those of suppliers.
In some industries (such as petrol retailing) pricing moves in
unison; in others, price changes by one supplier may initiate a
price war. Competition is discussed in more detail below.
If an organisation's suppliers notice a price rise for the
organisation's products, they may seek a rise in the price for
their supplies to the organisation.
In periods of inflation the organisation may need to change
prices to reflect increases in the prices of supplies, labour, rent
and so on.
When a new product is introduced for the first time there are
no existing reference points such as customer or competitor
behaviour; pricing decisions are most difficult to make in such
circumstances. It may be possible to seek alternative reference
points, such as the price in another market where the new
product has already been launched, or the price set by a
competitor.
If incomes are rising, price may be a less important marketing
variable than product quality and convenience of access
(distribution). When income levels are falling and/or
unemployment levels rising, price will be more important.
Products are often interrelated, being complements to each
Page 6
2.
Markets
2.1
The price that an organization can charge for its products will be determined to a
greater or lesser degree by the market in which it operates.
Perfect competition many buyers and many sellers all dealing in an identical
product. Neither producer nor user has any market power and both must accept the
prevailing market price.
Monopoly one seller who dominates many buyers. The monopolist can use his
market power to set a profit-maximising price.
Monopolistic competition a large number of suppliers offer similar, but not
identical, products. The similarities ensure elastic demand whereas the slight
differences give some monopolistic power to the supplier.
Oligopoly where relatively few competitive companies dominate the market. Whilst
each large firm has the ability to influence market prices, the unpredictable reaction
from the other giants makes the final industry price indeterminate. Cartels are often
formed.
2.2
2.3
2.4
2.5
3.
3.1
You know from your personal experience as a consumer that the theory of demand is
essentially true, the higher the price of a good, the less will be demanded.
3.2
If you think about how you decide which goods to buy, you will realize that there are
many factors entering into the decision.
Influence
Explanation/Example
Price
This is probably the most significant factor. For each of the goods,
the higher the price, the less likely people are to buy it.
Income
In general, the more people earn, the more they will buy. The
demand for most goods increases as income rises, and these goods
are known as normal goods.
This does not apply to inferior goods, such as low quality foodstuffs.
These are cheap goods which people might buy when on a low
income, but as their incomes rises, they switch to more attractive
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4.1
4.1.1
(b)
4.1.2
Example 1
The price of a good is $1.20 per unit and annual demand is 800,000 units. Market
research indicates that an increase in price of 10 cents per unit will result in a fall in
annual demand of 75,000 units. What is the price elasticity of demand?
Solution:
% change in demand = (75,000 / 800,000) x 100% = 9.375%
% change in price = (0.1 / 1.20) 100% = 8.333%
Price elasticity of demand = (9.375/8.333) = 1.125
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(b)
4.3
4.3.1
When demand is elastic, total revenue rises as price falls and vice versa.
This is because the quantity demanded in very responsive to price changes.
When demand is inelastic, total revenue falls as price falls because a fall in
price causes a less than proportionate rise in quantity demanded.
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Profit Maximization
5.1
Profit maximization
Profits are maximized using marginalist theory when marginal cost (MC) =
marginal revenue (MR). The optimal selling price can be determined using
equations. The optimum selling price can also be determined using tabulation.
5.2
In economics, profit maximisation is the process by which a firm determines the price
and output level that returns the greatest profit. There are two common approaches to
this problem.
(a)
The Total revenue (TR) Total cost (TC) method is based on the fact that
profit equals revenue minus cost.
(b)
The Marginal revenue (MR) Marginal cost (MC) method is based on the
fact that total profit in a perfect market reaches its maximum point where
marginal revenue equals marginal cost.
5.3
From the graph above it is evident that the difference between total costs and total
revenue is greatest at point Q. This is the profit maximising output quantity.
5.4
Example 2
AB has used market research to determine that if a price of $250 is charged for
product G, demand will be 12,000 units. It has also been established that demand will
rise or fall by 5 units for every $1 fall/rise in the selling price. The marginal cost of
product G is $80.
Required:
If marginal revenue (MR) = a 2bQ when the selling price (P) = a bQ, calculate
the profit-maximising selling price for product G.
Solution:
b = change in price / change in quantity = $1 / 5 = 0.2
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The optimum selling price can also be determined using tabulation. To determine the
profit-maximising selling price:
(a)
Work out the demand curve and hence the price and the total revenue (P
Q) at various levels of demand.
(b)
Calculate total cost and hence marginal cost at each level of demand.
(c)
Finally calculate profit at each level of demand, thereby determining the price
and level of demand at which profits are maximized.
Question 1
An organisation operates in a market where there is imperfect competition, so that to sell
more units of output, it must reduce the sales price of all the units it sells. The following data
is available for prices and costs.
Total output
Units
0
1
2
3
4
5
6
7
8
9
10
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Price
Total
revenue
Margina
l
revenue
$
Total
cost
Margina
l cost
Profit
0
1
2
3
4
5
6
7
8
9
10
6.
Pricing Strategies
6.1
Cost-plus pricing
(Dec 09, Jun 10, Dec 10, Dec 11, Jun 12, Dec 14)
6.1.1
Cost-plus pricing
Full cost-plus pricing is a method of determining the sales price by calculating the
full cost of the product and adding a percentage mark-up for profit.
6.1.2 In practice cost is one of the most important influences on price. Many firms base
price on simple cost-plus rules (costs are estimated and then a profit margin is added in
order to set the price).
6.1.3 The 'full cost' may be a fully absorbed production cost only, or it may include some
absorbed administration, selling and distribution overhead.
6.1.4 A business might have an idea of the percentage profit margin it would like to earn,
and so might decide on an average profit mark-up as a general guideline for pricing
decisions.
6.1.5 Advantages of full cost-plus pricing
(a)
It is a quick, simple and cheap method of pricing which can be delegated to
junior managers.
(b)
Since the size of the profit margin can be varied, a decision based on a price in
excess of full cost should ensure that a company working at normal capacity
will cover all of its fixed costs and make a profit.
6.1.6 Disadvantages of full cost-plus pricing
(a)
It fails to recognise that since demand may be determining price, there will
be a profit-maximising combination of price and demand.
(b)
There may be a need to adjust prices to market and demand conditions.
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Example 3
A company budgets to make 20,000 units which have a variable cost of production of
$4 per unit. Fixed production costs are $60,000 per annum. If the selling price is to
be 40% higher than full cost, what is the selling price of the product using the full
cost-plus method?
Solution:
Full cost per unit = variable cost + fixed cost
Variable cost = $4 per unit
Fixed cost = $60,000/20,000 = $3 per unit
Full cost per unit = $4 + $3 = $7
Selling price using full cost-plus pricing method = $7 140% = $9.80
6.2
6.2.1
6.2.2 Whereas a full cost-plus approach to pricing draws attention to net profit and the net
profit margin, a variable cost-plus approach to pricing draws attention to gross profit
and the gross profit margin, or contribution.
6.2.3
Example 4
A product has the following costs.
$
5
3
7
Direct materials
Direct labour
Variable overheads
Fixed overheads are $10,000 per month. Budgeted sales per month are 400 units to
allow the product to breakeven.
Required:
Determine the profit margin which needs to be added to marginal cost to allow the
product to break even.
Solution:
Breakeven point is when total contribution equals fixed costs.
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6.3.1
6.3.2
The aim of market skimming is to gain high unit profits early in the product's life.
High unit prices make it more likely that competitors will enter the market than if
lower prices were to be charged.
6.3.3
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6.3.4
6.4
6.4.1
6.4.2
6.5
6.5.1
Complementary products are goods that tend to be bought and used together.
Complementary products are sold separately but are connected and dependant
on each other for sales, for example, an electric toothbrush and replacement
toothbrush heads. The electric toothbrush may be priced competitively to
attract demand but the replacement heads can be relatively expensive.
6.5.2
A loss leader is when a company sets a very low price for one product intending to
make consumers buy other products in the range which carry higher profit margins.
Another example is selling razors at very low prices whilst selling the blades for them
at a higher profit margin. People will buy many of the high profit items but only one
of the low profit items yet they are 'locked in' to the former by the latter. This can
also be described as captive product pricing.
6.6
Price discrimination
Page 15
Price discrimination
The use of price discrimination means that the same product can be sold at
different prices to different customers. This can be very difficult to implement in
practice because it relies for success upon the continued existence of certain market
conditions.
6.6.2
There are a number of bases on which such discriminating prices can be set.
(a)
By market segment. A cross-channel ferry company would market its services
at different prices in England and France, for example. Services such as
cinemas and hairdressers are often available at lower prices to old age
pensioners and/or juveniles.
(b)
By product version. Many car models have 'add on' extras which enable one
brand to appeal to a wider cross-section of customers. The final price need not
reflect the cost price of the add on extras directly: usually the top of the range
model would carry a price much in excess of the cost of provision of the
extras, as a prestige appeal.
(c)
By place. Theatre seats are usually sold according to their location so that
patrons pay different prices for the same performance according to the seat
type they occupy.
(d)
By time. This is perhaps the most popular type of price discrimination. Offpeak travel bargains, hotel prices and telephone charges are all attempts to
increase sales revenue by covering variable but not necessarily average cost of
provision. Railway companies are successful price discriminators, charging
more to rush hour rail commuters whose demand is inelastic at certain times of
the day.
6.7
Market-based pricing
(Jun 12, Dec 14)
6.7.1
Market-based pricing
Prices are determined in an attempt to capture market share.
6.8
Target pricing
(Dec 10, Jun 12)
6.8.1
Target pricing
Target pricing is the price at which a seller projects that a buyer will buy a
product. Target costing determines the cost of a product or service according to the
target price that a customer is willing to pay and it is an estimated long-run cost.
6.9
Ethical pricing
(Dec 09)
6.9.1
Ethical pricing
Sometimes pricing policy should be based on certain ethical principles. Business
without ethics is a sin. While setting the prices, some moral standards are to be
followed. The pricing policy has to secure reasonable amount of profits to a firm to
Page 16
7.
Profitability Analysis
7.1
Introduction
7.1.1
7.1.2
7.2
7.2.1
Product and supplier profitability analysis allow the management to identify the true
costs associated with their products and supplies.
Normally, it takes into account those initial costs (such as purchase, transport,
receiving and reject cost), on going costs (such as storage and overheads), finance and
customer return costs for different product or product groups.
7.2.2
7.2.3
Example 5
In general, it can be elaborated as follows (assuming two products groups);
Product A
Product B
Total
$
$
$
Sales
150,000
250,000
400,000
(37.5%)
(62.5%)
(100%)
Expenses
Variable costs
Materials & supplies
15,000
22,000
37,000
(% of revenue)
(10%)
(8.8%)
(9.25%)
Labour
2,000
3,500
5,500
(% of revenue)
(1.33%)
(1.4%)
(1.38%)
Distribution
3,000
5,000
8,000
(% of revenue)
(2%)
(2%)
(2%)
Marketing
12,000
10,000
22,000
(% of revenue)
(8%)
(4%)
(5.5%)
Other
5,000
5,000
(% of revenue)
(2%)
(1.25%)
Total variable costs
32,000
45,500
77,500
(21.3%)
(18.2%)
(19.4%)
Fixed costs
Location
10,000
Page 17
10,000
20,000
(6.67%)
5,000
(3.33%)
3,000
(2%)
2,000
(1.33%)
20,000
(13.3%)
98,000
65%
34.9%
(4%)
6,000
(2.4%)
3,000
(1.2%)
3,000
(1.2%)
22,000
(8.8%)
182,500
73%
65.1%
(5%)
11,000
(2.75%)
6,000
(1.5%)
5,000
(1.25%)
42,000
(10.5%)
280,500
70.1%
100%
When management considers the resource allocation and strategy formulation, it can
determine whether the company should put more emphasis on a particular product or
whether they would allocate the costs differently to get a better margin for the
product group.
7.3
7.3.1
7.3.2
Example 6
A simple CPA can be conducted as follow:
Customer A
$
Sales
150,000
(37.5%)
Cost of sales
Ongoing service & support
17,000
Other direct customer costs
15,000
Total cost of sales
11,800
(78.7%)
Other costs
Customer acquisition
10,000
Customer marketing
5,000
Customer termination
5,000
Total other customer costs
20,000
Profit by customer groups
98,000
(34.9%)
Page 18
Customer B
$
250,000
(62.5%)
Total
$
400,000
(100%)
25,500
20,000
204,500
(81.8%)
42,500
35,000
322,500
(80.6%)
10,000
6,000
6,000
22,000
20,000
11,000
11,000
42,000
182,500
(65.1%)
280,500
(100%)
Page 19
Page 20
REQUIRED:
(a)
(b)
(c)
Determine the profitability of each customer type using the traditional approach of
assigning customer-related activity costs in proportion to the sales revenue earned by
each customer type. Discuss the problems of this measure of customer profitability.
(5 marks)
By using the activity rates to assign customer-related activity costs to each customer
type, re-calculate the profitability of each customer category. Discuss how you, as a
manager, would use this information.
(11 marks)
Describe briefly the nature of value-added and non-value-added activities and give an
example of each type of activity.
(4 marks)
(Total 20 marks)
(HKIAAT PBE II Management Accounting December 2007 Q3)
Page 21
Objectives
1.1
1.2
1.3
1.4
1.5
1.6
1.7
D iv is io n a l
P e rfo rm a n c e
M e a su re s
C e n t r a liz a t io n
and
D e c e n t r a liz a t io n
A d v a n ta g e s
and
D is a d v a n t a g e s
R e s p o n s ib ilit y
C e n tre s
F in a n c ia l
P e rfo rm a n c e
M e a su re s
1 . C o st c e n tre
1. R O I
2. R I
3. EVA
2 . R e v e n u e c e n tre
A d v a n ta g e s
and
D is a d v a n t a g e s
T ra n sfe r
P r ic in g
M e th o d s
1 . M a rk e t-b a se d
3 . P r o f it c e n t r e
3 . N e g o tia te d
P r ic in g
4 . In v e stm e n t c e n tre
4 . D u a l- r a t e
P r ic in g
Page 22
2.1
Definitions
(a)
(b)
2.2
Advantages of decentralization
(a)
(b)
(c)
(d)
(e)
2.3
Disadvantages of decentralization
(a)
(b)
(c)
Lack of goal congruence the danger arises that divisional managers will
make decisions which, whilst in the best interests of their divisions, are not in
the best interest of the company as a whole. This leads to sub-optimal or
dysfunctional decisions.
Cost It is claimed that the costs of activities that are common to all
divisions such as running the accounting department may be greater for a
divisionalised structure that for a centralized structure.
Loss of central control top management may not aware what is going on
in the division. An effective system of divisional reporting should
overcome this problem. The reporting system should produce the key figures
to monitor divisional performance and motivate the staff.
Page 23
3.
3.1
Nowadays, most sizable organizations are decentralizing as their operations are getting
more complex while they have operations globally. Geographical and complicated
operations make management more difficult to control and thus managers of business
units are responsible for a range of decisions considered by the head office.
3.2
Definitions
(a)
(b)
(c)
(d)
3.3
The following table shows the principal performance measures for each centre:
Types of
responsibility
Cost centre
Revenue centre
Profit centre
Investment centre
4.
(A)
4.1
ROI
Principal performance
measures
Variance analysis
Efficiency measures
Revenues
Profit
Return on investment
Residual income
Other financial ratios
ROI shows how much profit has been made in relation to the amount of capital
invested and is calculated as (profit/capital employed) x 100%.
Page 24
Example 1
Suppose that a company has two investment centres A and B, which show results for
the year as follows.
A
B
$
$
Profit
60,000
30,000
Capital employed
400,000
120,000
ROI
15%
25%
Investment centre A has made double the profits of investment centre B, and in terms
of profits alone has therefore been more 'successful'. However, B has achieved its
profits with a much lower capital investment, and so has earned a much higher ROI.
This suggests that B has been a more successful investment than A.
4.3
(a)
4.4
This is probably the most common method, but it does present a problem. If an
investment centre maintains the same annual profit, and keeps the same assets without
a policy of regular replacement of non-current assets, its ROI will increase year by
year as the assets get older. This can give a false impression of improving
performance over time.
4.5
Example 2
For example, the results of investment centre X, with a policy of straight-line
depreciation of assets over a 5-year period, might be as follows.
Profit before depreciation
Depreciation
Net profit
NBV Equipment
ROI
Year 1
4,000
(1,000)
3,000
Year 2
4,000
(1,000)
3,000
Year 3
4,000
(1,000)
3,000
5,000
60%
4,000
75%
3,000
100%
This table of figures is intended to show that an investment centre can improve its
ROI year by year, simply by allowing its non-current assets to depreciate, and
there could be a disincentive to investment centre managers to reinvest in new or
replacement assets, because the centre's ROI would probably fall.
4.6
Example 3
A further disadvantage of measuring ROI as profit divided by net assets is that, for
similar reasons, it is not easy to compare fairly the performance of investment
Page 25
$
20,000
230,000
170,000
Profit
ROI
$
20,000
230,000
10,000
60,000
80,000
220,000
240,000
24,000
30%
24,000
10%
Investment centres P and Q have the same amount of working capital, the same value
of non-current assets at cost, and the same profit. But P's non-current assets have
been depreciated by a much bigger amount (presumably P's non-current assets are
much older than Q's) and so P's ROI is three times the size of Q's ROI. The
conclusion might therefore be that P has performed much better than Q. This
comparison, however, would not be 'fair', because the difference in performance
might be entirely attributable to the age of their non-current assets.
4.7
The arguments for using net book values for calculating ROI
(a)
It is the 'normally accepted' method of calculating ROI.
(b)
Organisations are continually buying new non-current assets to replace old
ones that wear out, and so on the whole, the total net book value of all noncurrent assets together will remain fairly constant (assuming nil inflation and
nil growth).
(b)
4.8
4.9
Example 4
If a company acquired a non-current asset costing $40,000, which it intends to
depreciate by $10,000 pa for 4 years, and if the asset earns a profit of $8,000 pa after
depreciation, ROI might be calculated on net book values or gross values, as follows.
Year
Profit
NBV
ROI based
Gross
ROI based
(mid-year
on NBV
value
on gross
value)
value
$
$
$
1
8,000
35,000
22.9%
40,000
20%
2
8,000
25,000
32.0%
40,000
20%
3
8,000
15,000
53.3%
40,000
20%
4
8,000
5,000
160.0%
40,000
20%
Page 26
Advantages of ROI
(a)
(b)
(c)
4.11
Disadvantages of ROI
(a)
(b)
(c)
(d)
4.12
(B)
Page 27
RI
RI is a measure of the centres profits after deducting a notional or imputed
interest cost or cost of capital charge.
(a)
The centres profit is after deducting depreciation on capital equipment.
(b)
The imputed cost of capital might be the organizations cost of borrowing or
its weighted average cost of capital (WACC).
4.14
Example 6 RI calculation
A division with capital employed of $400,000 currently earns an ROI of 22%. It can
make an additional investment of $50,000 for a five-year life with nil residual value.
The average net profit from this investment would be $12,000 after depreciation. The
divisions cost of capital is 14%.
What are the residual incomes before and after the investment?
Solution:
(b)
56,000
32,000
63,000
37,000
Disadvantages of RI
(a)
(b)
(C)
After
investment
$
100,000
Advantages of RI
(a)
4.16
Before
investment
$
88,000
Page 28
EVA
EVA is an alternative absolute performance measure. It is similar to RI and is
calculated as follows:
EVA = net operating profit after tax (NOPAT) less capital charge
Capital charge = WACC x net assets
4.18
4.19
4.20
4.21
Economic value added (EVA) is a registered trade mark owned by Stern Stewart &
Co. It is a specific type of residual income (RI). However, there are differences as
follows:
(a)
The profit figures are calculated differently. EVA is based on an economic
profit which is derived by making a series of adjustments to the accounting
profit.
(b)
The notional capital charges use different bases for net assets. The
replacement cost of net assets is usually used in the calculation of EVA.
There are also differences in the way that NOPAT is calculated compared with the
profit figure that is used for RI, as follows:
(a)
Costs which would normally be treated as expenses, but which are considered
within an EVA calculation as investments building for the future, are added
back to NOPAT to derive a figure for 'economic profit'. These costs are
included instead as assets in the figure for net assets employed, ie as
investments for the future. Costs treated in this way include items such as
goodwill, research and development expenditure and advertising costs.
(b)
Adjustments are sometimes made to the depreciation charge, whereby
accounting depreciation is added back to the profit figures, and economic
depreciation is subtracted instead to arrive at NOPAT. Economic depreciation
is a charge for the fall in asset value due to wear and tear or obsolescence.
(c)
Any lease charges are excluded from NOPAT and added in as a part of
capital employed.
Another point to note about the calculation of NOPAT, which is the same as the
calculation of the profit figure for RI, is that interest is excluded from NOPAT
because interest costs are taken into account in the capital charge.
Example 7 EVA calculation
An investment centre has reported operating profits of $21 million. This was after
charging $4 million for the development and launch costs of a new product that is
expected to generate profits for four years. Taxation is paid at the rate of 25 per cent
of the operating profit.
The company has a risk adjusted weighted average cost of capital of 12 per cent per
annum and is paying interest at 9 per cent per annum on a substantial long term loan.
The investment centre's non-current asset value is $50 million and the net current
assets have a value of $22 million. The replacement cost of the non-current assets is
estimated to be $64 million.
Required:
Calculate the investment centre's EVA for the period.
Page 29
$m
21
4
(1)
24
(6)
18
$m
86
3
89
Calculation of EVA
The capital charge is based on the WACC, which takes into account of the cost of
share capital as well as the cost of loan capital. Therefore the correct interest rate is
12%.
$m
NOPAT
18.00
Capital charge (12% x $89m)
10.68
EVA
7.32
4.22
Advantages of EVA
(a)
(b)
(c)
(d)
4.23
Disadvantages of EVA
(a)
(b)
Page 30
5.
Transfer Pricing
5.1
5.2
Transfer pricing
Transfer prices are a way of promoting divisional autonomy, ideally without
prejudicing the measurement of divisional performance or discouraging overall
corporate profit maximisation.
Transfer prices should be set at a level which ensures that profits for the
organisation as a whole are maximised.
5.3
5.4
General rules
The limits within which transfer prices should fall are as follows.
(a)
The minimum. The sum of the supplying divisions marginal cost and
opportunity cost of the item transferred.
(b)
The maximum. The lowest market price at which the receiving division
could purchase the goods or services externally, less any internal cost
Page 31
The minimum results from the fact that the supplying division will not agree to
transfer if the transfer price is less than the marginal cost + opportunity cost of the
item transferred (because if it were the division would incur a loss).
The maximum results from the fact that the receiving division will buy the item at the
cheapest price possible.
Example 8
Division X produces product L at a marginal cost per unit of $100. If a unit is
transferred internally to division Y, $25 contribution is foregone on an external sales.
The item can be purchased externally for $150.
The minimum. Division X will not agree to a transfer price of less than $(100 +
25) = $125 per unit.
The maximum. Division Y will not agree to a transfer price in excess of $150.
The difference between the two results ($25) represents the savings from producing
internally as opposed to buying externally.
5.8
(A)
5.8.1 If an external market price exists for transferred goods, profit centre managers will
be aware of the price they could obtain or the price they would have to pay for their
goods on the external market, and they would inevitably compare this price with the
transfer price.
5.8.2 Advantages:
(a)
Divisional autonomy In a decentralised company, divisional managers
should have the autonomy to make output, selling and buying decisions which
appear to be in the best interests of the division's performance. (If every
division optimises its performance, the company as a whole must inevitably
achieve optimal results.)
(b)
Corporate profit maximization In most cases where the transfer price is at
market price, internal transfers should be expected, because the buying
division is likely to benefit from a better quality of service, greater
flexibility, and dependability of supply. Both divisions may benefit from
cheaper costs of administration, selling and transport. A market price as the
transfer price would therefore result in decisions which would be in the best
interests of the company or group as a whole.
5.8.3 Disadvantages:
(a)
The market price may be a temporary one, induced by adverse economic
conditions, or dumping, or the market price might depend on the volume of
output supplied to the external market by the profit centre.
(b)
A transfer price at market value might, under some circumstances, act as a
Arth Vince Malaca
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(c)
(d)
(B)
Cost-based approach
5.8.4 Cost-based approaches to transfer pricing are often used in practice, because in
practice the following conditions are common.
(a)
There is no external market for the product that is being transferred.
(b)
Alternatively, although there is an external market it is an imperfect one
because the market price is affected by such factors as the amount that the
company setting the transfer price supplies to it, or because there is only a
limited external demand.
5.8.5 Disadvantages:
(a)
It can lead to bad decisions, for example, they dont include opportunity costs
from lost sales.
(b)
The only division that will show any profit on the transaction is the one that
makes the final sale to an outside party.
(c)
It provide no incentive for control of costs unless transfers are made at
standard cost.
(a)
5.8.6
(b)
5.8.7
(C)
5.8.8
Page 33
Page 34
Discuss the past financial performance of store W using ROI and any other measure you
feel appropriate and, using your findings, discuss whether the ROI correctly reflects
Store Ws actual performance.
(8 marks)
Explain how a manager in store W might have been able to manipulate the results so as
to gain bonuses more frequently.
(4 marks)
PC has another store (store S) about to open in the south of the country. It has asked you for
help in calculating the gross profit, net profit and ROI it can expect over each of the next four
years. The following information is provided:
Sales volume in the first year will be 18,000 units. Sales volume will grow at the rate of 10%
for years two and three but no further growth is expected in year 4. Sales price will start at
$12 per unit for the first two years but then reduce by 5% per annum for each of the next two
years.
Gross profit will start at 40% but will reduce as the sales price reduces. All purchase prices on
goods for resale will remain constant for the four years.
Overheads, including depreciation, will be $70,000 for the first two years rising to $80,000 in
years three and four.
Store S requires an investment of $100,000 at the start of its first year of trading.
PC depreciates non-current assets at the rate of 25% of cost. No residual value is expected on
these assets.
Required:
(c)
(d)
Calculate (in columnar form) the revenue, gross profit, net profit and ROI of store S
over each of its first four years.
(9 marks)
Calculate the minimum sales volume required in year 4 (assuming all other variables
remain unchanged) to earn the manager of S a bonus in that year.
(4 marks)
(Total 25 marks)
(ACCA F5 Performance Management December 2008 Q1)
Page 35
Calculate the price that Nail would charge for the garden shears under the existing
policy of variable cost plus 30%.
(6 marks)
Calculate the increase or decrease in price if the pricing policy switched to total cost
plus 10%.
(4 marks)
Discuss whether or not including fixed costs in a transfer price is a sensible policy.
(4 marks)
Discuss whether the retail stores should be allowed to buy in from outside suppliers if
the prices are cheaper than those charged by Nail.
(6 marks)
(20 marks)
(ACCA F5 Performance Management June 2010 Q4)
Page 36
Understand how transfer pricing methods affect the performance of independent units.
Explain the different transfer pricing methods.
Determine the optimal transfer price between the selling division and buying division.
Page 37
Transfer
Pricing
Methods
Need for
Transfer
pricing
Marketbased
Methods
Cost-based
Full-cost
Variable cost
Page 38
Negotiated
pricing
Dual-rate
pricing
1.1
1.2
Transfer pricing
Transfer prices are a way of promoting divisional autonomy, ideally without
prejudicing the measurement of divisional performance or discouraging overall
corporate profit maximisation.
Transfer prices should be set at a level which ensures that profits for the
organisation as a whole are maximised.
1.3
1.4
General rules
(Dec 09)
The limits within which transfer prices should fall are as follows.
(a)
The minimum. The sum of the supplying divisions marginal cost and
opportunity cost of the item transferred.
(b)
The maximum. The lowest market price at which the receiving division
could purchase the goods or services externally, less any internal cost
savings in packaging and delivery.
1.5
1.6
The minimum results from the fact that the supplying division will not agree to
transfer if the transfer price is less than the marginal cost + opportunity cost of the
item transferred (because if it were the division would incur a loss).
The maximum results from the fact that the receiving division will buy the item at the
cheapest price possible.
Page 39
Example 1
Division X produces product L at a marginal cost per unit of $100. If a unit is
transferred internally to division Y, $25 contribution is foregone on an external sales.
The item can be purchased externally for $150.
The minimum. Division X will not agree to a transfer price of less than $(100 +
25) = $125 per unit.
The maximum. Division Y will not agree to a transfer price in excess of $150.
The difference between the two results ($25) represents the savings from producing
internally as opposed to buying externally.
2.
2.1
Market-based approach
(Jun 10)
2.1.1 If an external market price exists for transferred goods, profit centre managers will
be aware of the price they could obtain or the price they would have to pay for their
goods on the external market, and they would inevitably compare this price with the
transfer price.
2.1.2 Advantages:
(a)
Divisional autonomy In a decentralised company, divisional managers
should have the autonomy to make output, selling and buying decisions which
appear to be in the best interests of the division's performance. (If every
division optimises its performance, the company as a whole must inevitably
achieve optimal results.)
(b)
Corporate profit maximization In most cases where the transfer price is at
market price, internal transfers should be expected, because the buying
division is likely to benefit from a better quality of service, greater
flexibility, and dependability of supply. Both divisions may benefit from
cheaper costs of administration, selling and transport. A market price as the
transfer price would therefore result in decisions which would be in the best
interests of the company or group as a whole.
2.1.3 Disadvantages:
(a)
The market price may be a temporary one, induced by adverse economic
conditions, or dumping, or the market price might depend on the volume of
output supplied to the external market by the profit centre.
(b)
A transfer price at market value might, under some circumstances, act as a
disincentive to use up any spare capacity in the divisions. A price based on
incremental cost, in contrast, might provide an incentive to use up the spare
resources in order to provide a marginal contribution to profit.
(c)
Many products do not have an equivalent market price so that the price of a
similar, but not identical, product might have to be chosen. In such
circumstances, the option to sell or buy on the open market does not really
exist.
(d)
There might be an imperfect external market for the transferred item, so that
if the transferring division tried to sell more externally, it would have to reduce
Arth Vince Malaca
Page 40
Cost-based approach
2.2.1 Cost-based approaches to transfer pricing are often used in practice, because in
practice the following conditions are common.
(a)
There is no external market for the product that is being transferred.
(b)
Alternatively, although there is an external market it is an imperfect one
because the market price is affected by such factors as the amount that the
company setting the transfer price supplies to it, or because there is only a
limited external demand.
2.2.2 Disadvantages:
(a)
It can lead to bad decisions, for example, they dont include opportunity costs
from lost sales.
(b)
The only division that will show any profit on the transaction is the one that
makes the final sale to an outside party.
(c)
It provide no incentive for control of costs unless transfers are made at
standard cost.
(a)
2.2.3
(b)
2.2.4
2.3
2.3.1
2.3.2 Advantages:
(a)
Encourage the management of the selling division to be more conscious of
cost control.
(b)
Benefit the buying division by purchasing the product at a lower cost than
Arth Vince Malaca
Page 41
2.4
2.4.1
Question 1 Determination of the range of transfer price and disadvantages of costbased and market-based transfer pricing methods
Page 42
Page 43
Page 44
Page 45
Page 46
Page 47
Objectives
1.1
1.2
1.3
1.4
1.5
1.6
1.7
D iv is io n a l
P e rfo rm a n c e
M e a su re s
C e n t r a liz a t io n
and
D e c e n t r a liz a t io n
A d v a n ta g e s
and
D is a d v a n t a g e s
R e s p o n s ib ilit y
C e n tre s
F in a n c ia l
P e rfo rm a n c e
M e a su re s
1 . C o st c e n tre
1. R O I
2. R I
3. EVA
2 . R e v e n u e c e n tre
A d v a n ta g e s
and
D is a d v a n t a g e s
T ra n sfe r
P r ic in g
M e th o d s
1 . M a rk e t-b a se d
3 . P r o f it c e n t r e
3 . N e g o tia te d
P r ic in g
4 . In v e stm e n t c e n tre
4 . D u a l- r a t e
P r ic in g
Page 48
2.1
Definitions
(a)
(b)
2.2
Advantages of decentralization
(a)
(b)
(c)
(d)
(e)
2.3
Disadvantages of decentralization
(a)
(b)
(c)
Lack of goal congruence the danger arises that divisional managers will
make decisions which, whilst in the best interests of their divisions, are not in
the best interest of the company as a whole. This leads to sub-optimal or
dysfunctional decisions.
Cost It is claimed that the costs of activities that are common to all
divisions such as running the accounting department may be greater for a
divisionalised structure that for a centralized structure.
Loss of central control top management may not aware what is going on
in the division. An effective system of divisional reporting should
overcome this problem. The reporting system should produce the key figures
to monitor divisional performance and motivate the staff.
Page 49
3.
3.1
Nowadays, most sizable organizations are decentralizing as their operations are getting
more complex while they have operations globally. Geographical and complicated
operations make management more difficult to control and thus managers of business
units are responsible for a range of decisions considered by the head office.
3.2
Definitions
(a)
(b)
(c)
(d)
3.3
The following table shows the principal performance measures for each centre:
Types of
responsibility
Cost centre
Revenue centre
Profit centre
Investment centre
4.
(A)
4.1
ROI
Principal performance
measures
Variance analysis
Efficiency measures
Revenues
Profit
Return on investment
Residual income
Other financial ratios
ROI shows how much profit has been made in relation to the amount of capital
invested and is calculated as (profit/capital employed) x 100%.
Page 50
Example 1
Suppose that a company has two investment centres A and B, which show results for
the year as follows.
A
B
$
$
Profit
60,000
30,000
Capital employed
400,000
120,000
ROI
15%
25%
Investment centre A has made double the profits of investment centre B, and in terms
of profits alone has therefore been more 'successful'. However, B has achieved its
profits with a much lower capital investment, and so has earned a much higher ROI.
This suggests that B has been a more successful investment than A.
4.3
(a)
4.4
This is probably the most common method, but it does present a problem. If an
investment centre maintains the same annual profit, and keeps the same assets without
a policy of regular replacement of non-current assets, its ROI will increase year by
year as the assets get older. This can give a false impression of improving
performance over time.
4.5
Example 2
For example, the results of investment centre X, with a policy of straight-line
depreciation of assets over a 5-year period, might be as follows.
Profit before depreciation
Depreciation
Net profit
NBV Equipment
ROI
Year 1
4,000
(1,000)
3,000
Year 2
4,000
(1,000)
3,000
Year 3
4,000
(1,000)
3,000
5,000
60%
4,000
75%
3,000
100%
This table of figures is intended to show that an investment centre can improve its
ROI year by year, simply by allowing its non-current assets to depreciate, and
there could be a disincentive to investment centre managers to reinvest in new or
replacement assets, because the centre's ROI would probably fall.
4.6
Example 3
A further disadvantage of measuring ROI as profit divided by net assets is that, for
similar reasons, it is not easy to compare fairly the performance of investment
centres.
Page 51
$
20,000
230,000
170,000
Profit
ROI
$
20,000
230,000
10,000
60,000
80,000
220,000
240,000
24,000
30%
24,000
10%
Investment centres P and Q have the same amount of working capital, the same value
of non-current assets at cost, and the same profit. But P's non-current assets have
been depreciated by a much bigger amount (presumably P's non-current assets are
much older than Q's) and so P's ROI is three times the size of Q's ROI. The
conclusion might therefore be that P has performed much better than Q. This
comparison, however, would not be 'fair', because the difference in performance
might be entirely attributable to the age of their non-current assets.
4.7
The arguments for using net book values for calculating ROI
(a)
It is the 'normally accepted' method of calculating ROI.
(b)
Organisations are continually buying new non-current assets to replace old
ones that wear out, and so on the whole, the total net book value of all noncurrent assets together will remain fairly constant (assuming nil inflation and
nil growth).
(b)
4.8
4.9
Example 4
If a company acquired a non-current asset costing $40,000, which it intends to
depreciate by $10,000 pa for 4 years, and if the asset earns a profit of $8,000 pa after
depreciation, ROI might be calculated on net book values or gross values, as follows.
Year
Profit
NBV
ROI based
Gross
ROI based
(mid-year
on NBV
value
on gross
value)
value
$
$
$
1
8,000
35,000
22.9%
40,000
20%
2
8,000
25,000
32.0%
40,000
20%
3
8,000
15,000
53.3%
40,000
20%
4
8,000
5,000
160.0%
40,000
20%
The ROI based on net book value shows an increasing trend over time, simply
Page 52
Advantages of ROI
(a)
(b)
(c)
4.11
Disadvantages of ROI
(a)
(b)
(c)
(d)
4.12
(B)
Page 53
RI
RI is a measure of the centres profits after deducting a notional or imputed
interest cost or cost of capital charge.
(a)
The centres profit is after deducting depreciation on capital equipment.
(b)
The imputed cost of capital might be the organizations cost of borrowing or
its weighted average cost of capital (WACC).
4.14
Example 6 RI calculation
A division with capital employed of $400,000 currently earns an ROI of 22%. It can
make an additional investment of $50,000 for a five-year life with nil residual value.
The average net profit from this investment would be $12,000 after depreciation. The
divisions cost of capital is 14%.
What are the residual incomes before and after the investment?
Solution:
After
investment
$
100,000
56,000
32,000
63,000
37,000
Advantages of RI
(a)
(b)
4.16
Before
investment
$
88,000
Disadvantages of RI
(a)
(b)
(C)
4.17
EVA
Page 54
4.19
4.20
4.21
Economic value added (EVA) is a registered trade mark owned by Stern Stewart &
Co. It is a specific type of residual income (RI). However, there are differences as
follows:
(a)
The profit figures are calculated differently. EVA is based on an economic
profit which is derived by making a series of adjustments to the accounting
profit.
(b)
The notional capital charges use different bases for net assets. The
replacement cost of net assets is usually used in the calculation of EVA.
There are also differences in the way that NOPAT is calculated compared with the
profit figure that is used for RI, as follows:
(a)
Costs which would normally be treated as expenses, but which are considered
within an EVA calculation as investments building for the future, are added
back to NOPAT to derive a figure for 'economic profit'. These costs are
included instead as assets in the figure for net assets employed, ie as
investments for the future. Costs treated in this way include items such as
goodwill, research and development expenditure and advertising costs.
(b)
Adjustments are sometimes made to the depreciation charge, whereby
accounting depreciation is added back to the profit figures, and economic
depreciation is subtracted instead to arrive at NOPAT. Economic depreciation
is a charge for the fall in asset value due to wear and tear or obsolescence.
(c)
Any lease charges are excluded from NOPAT and added in as a part of
capital employed.
Another point to note about the calculation of NOPAT, which is the same as the
calculation of the profit figure for RI, is that interest is excluded from NOPAT
because interest costs are taken into account in the capital charge.
Example 7 EVA calculation
An investment centre has reported operating profits of $21 million. This was after
charging $4 million for the development and launch costs of a new product that is
expected to generate profits for four years. Taxation is paid at the rate of 25 per cent
of the operating profit.
The company has a risk adjusted weighted average cost of capital of 12 per cent per
annum and is paying interest at 9 per cent per annum on a substantial long term loan.
The investment centre's non-current asset value is $50 million and the net current
assets have a value of $22 million. The replacement cost of the non-current assets is
estimated to be $64 million.
Required:
Calculate the investment centre's EVA for the period.
Page 55
$m
21
4
(1)
24
(6)
18
$m
86
3
89
Calculation of EVA
The capital charge is based on the WACC, which takes into account of the cost of
share capital as well as the cost of loan capital. Therefore the correct interest rate is
12%.
$m
NOPAT
18.00
Capital charge (12% x $89m)
10.68
EVA
7.32
4.22
Advantages of EVA
(a)
(b)
(c)
(d)
4.23
Disadvantages of EVA
(a)
(b)
Page 56
(c)
(d)
5.
Transfer Pricing
5.1
5.2
Transfer pricing
Transfer prices are a way of promoting divisional autonomy, ideally without
prejudicing the measurement of divisional performance or discouraging overall
corporate profit maximisation.
Transfer prices should be set at a level which ensures that profits for the
organisation as a whole are maximised.
5.3
5.4
General rules
The limits within which transfer prices should fall are as follows.
(a)
The minimum. The sum of the supplying divisions marginal cost and
opportunity cost of the item transferred.
(b)
The maximum. The lowest market price at which the receiving division
Page 57
The minimum results from the fact that the supplying division will not agree to
transfer if the transfer price is less than the marginal cost + opportunity cost of the
item transferred (because if it were the division would incur a loss).
The maximum results from the fact that the receiving division will buy the item at the
cheapest price possible.
Example 8
Division X produces product L at a marginal cost per unit of $100. If a unit is
transferred internally to division Y, $25 contribution is foregone on an external sales.
The item can be purchased externally for $150.
The minimum. Division X will not agree to a transfer price of less than $(100 +
25) = $125 per unit.
The maximum. Division Y will not agree to a transfer price in excess of $150.
The difference between the two results ($25) represents the savings from producing
internally as opposed to buying externally.
5.8
(A)
Market-based approach
5.8.1 If an external market price exists for transferred goods, profit centre managers will
be aware of the price they could obtain or the price they would have to pay for their
goods on the external market, and they would inevitably compare this price with the
transfer price.
5.8.2 Advantages:
(a)
Divisional autonomy In a decentralised company, divisional managers
should have the autonomy to make output, selling and buying decisions which
appear to be in the best interests of the division's performance. (If every
division optimises its performance, the company as a whole must inevitably
achieve optimal results.)
(b)
Corporate profit maximization In most cases where the transfer price is at
market price, internal transfers should be expected, because the buying
division is likely to benefit from a better quality of service, greater
flexibility, and dependability of supply. Both divisions may benefit from
cheaper costs of administration, selling and transport. A market price as the
transfer price would therefore result in decisions which would be in the best
interests of the company or group as a whole.
5.8.3 Disadvantages:
(a)
The market price may be a temporary one, induced by adverse economic
conditions, or dumping, or the market price might depend on the volume of
output supplied to the external market by the profit centre.
(b)
A transfer price at market value might, under some circumstances, act as a
Arth Vince Malaca
Page 58
(c)
(d)
(B)
Cost-based approach
5.8.4 Cost-based approaches to transfer pricing are often used in practice, because in
practice the following conditions are common.
(a)
There is no external market for the product that is being transferred.
(b)
Alternatively, although there is an external market it is an imperfect one
because the market price is affected by such factors as the amount that the
company setting the transfer price supplies to it, or because there is only a
limited external demand.
5.8.5 Disadvantages:
(a)
It can lead to bad decisions, for example, they dont include opportunity costs
from lost sales.
(b)
The only division that will show any profit on the transaction is the one that
makes the final sale to an outside party.
(c)
It provide no incentive for control of costs unless transfers are made at
standard cost.
(a)
5.8.6
(b)
5.8.7
(C)
5.8.8
Page 59
Page 60
Discuss the past financial performance of store W using ROI and any other measure you
feel appropriate and, using your findings, discuss whether the ROI correctly reflects
Store Ws actual performance.
(8 marks)
Explain how a manager in store W might have been able to manipulate the results so as
to gain bonuses more frequently.
(4 marks)
PC has another store (store S) about to open in the south of the country. It has asked you for
help in calculating the gross profit, net profit and ROI it can expect over each of the next four
years. The following information is provided:
Sales volume in the first year will be 18,000 units. Sales volume will grow at the rate of 10%
for years two and three but no further growth is expected in year 4. Sales price will start at
$12 per unit for the first two years but then reduce by 5% per annum for each of the next two
years.
Gross profit will start at 40% but will reduce as the sales price reduces. All purchase prices on
goods for resale will remain constant for the four years.
Overheads, including depreciation, will be $70,000 for the first two years rising to $80,000 in
years three and four.
Store S requires an investment of $100,000 at the start of its first year of trading.
PC depreciates non-current assets at the rate of 25% of cost. No residual value is expected on
these assets.
Required:
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Calculate (in columnar form) the revenue, gross profit, net profit and ROI of store S
over each of its first four years.
(9 marks)
Calculate the minimum sales volume required in year 4 (assuming all other variables
remain unchanged) to earn the manager of S a bonus in that year.
(4 marks)
(Total 25 marks)
(ACCA F5 Performance Management December 2008 Q1)
Calculate the price that Nail would charge for the garden shears under the existing
policy of variable cost plus 30%.
(6 marks)
Calculate the increase or decrease in price if the pricing policy switched to total cost
plus 10%.
(4 marks)
Discuss whether or not including fixed costs in a transfer price is a sensible policy.
(4 marks)
Discuss whether the retail stores should be allowed to buy in from outside suppliers if
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(6 marks)
(20 marks)
(ACCA F5 Performance Management June 2010 Q4)
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Segment
Performance
Measurements
Definitions
Prepare
Segment
Report
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General aspects
in Performance
Measurements
1.1
Definitions
(a)
(b)
(c)
(d)
(e)
1.2
Example 1
To illustrate how it works, here is an example:
Segments
Revenue
Less: Variable expenses
Variable cost of goods sold
Other variable expenses
Total variable expenses
Contribution margin
Less: Traceable fixed costs
Divisional segment margin
Less: Common fixed expenses not
traceable to individual divisions
Net operating income
1.3
Total
$
500
Division A
$
300
Division B
$
200
(180)
(50)
(230)
270
(170)
100
(120)
(30)
(150)
150
(90)
60
(60)
(20)
(80)
120
(80)
40
(85)
15
In order to utilize segment reporting for achieving its purposes, costs must be properly
allocated to segments properly. If the purpose is to determine the profits being
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1.5
2.
2.1
2.2
2.3
The areas of performance criteria will vary. Some of the criteria, and control and
measurement used, are as follows:
Financial performance
Competitiveness
Activity
Productivity
Cost
Profitability
Liquidity
Budget variance analysis
Capital structure
Market ratios
Level of bad debts
Return on capital employed
Sales growth by product or service
Measures of customer base
Relative market share and position
Sales units
Labour / machine hours
No. of passengers carried
No. of material requisitions serviced
Efficiency measurements of resources planned
against consumed
Measurements of resources available against
those used
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Quality of service
Customer satisfaction
Innovation
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3G
5,000
$3,000
$600
$6,000,000
$300
$300,000
$3,480,000
4G
3,000
$6,000
$1,200
$9,000,000
$360
$450,000
$3,600,000
Required:
(a)
(b)
(c)
(d)
Prepare a segmented income statement for the first quarter, showing columns for
the company as a whole and for each product.
(8 marks)
Explain why segment reporting is an extension of responsibility accounting. Use the
data from part (a), point out the item(s) which is/are relevant for responsibility
accounting.
(3 marks)
The director of the 3G product is responsible for its production and marketing.
What are the advantages of such decentalised structure?
(4 marks)
What are the THREE levels of responsibility to which decentalised companies
divide their segments? Describe briefly and indicate which level the 3G business
belongs to.
(5 marks)
(HKIAAT PBE Paper II Management Accounting and Finance June 2011 Q4)
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S tra te g ic
M anagem ent
A c c o u n tin g &
P ro c e s s e s
S tra te g y
P u rp o s e o f
S tra te g ic
M anagem ent
L e v e ls o f
S tra te g y
1.
2.
3.
Fu
M is s io n ,
G o a ls &
O b je c tiv e s
C o rp o ra te L e v e l
B u s in e s s L e v e l
O p e ra tio n a l o r
n c tio n a l L e v e l
PEST EL
S te p s in
F o rm u la tin g
S tra te g ie s
E n v iro n m e n ta l
A n a ly s is
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P o s itio n
A u d it
1 . S W O T A n a ly s is
2 . V a lu e C h a in A n a ly s is
3 . B e n c h m a rk in g
O th e r S tra te g ic
C ost M anagem ent
T e c h n iq u e s
1 . J IT
2. TQ M
3 . Q u a lity C o s tin g
What is Strategy?
1.1
Definition of strategy
1.1.1
Definitions
(a)
(b)
1.2
Strategy is the direction and scope of an organization over the long term,
which achieves competitive advantage in a changing environment through
its configuration of resources and competencies with the aim of fulfilling
stakeholder expectations.
Strategic management is a process that management use strategies to
achieve objective, goal and performance of a company.
Levels of Strategy
2.1
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2.2
Example 1 Levels of strategy
ABC Ltd is a company selling widgets. The finance director says: 'We plan to issue
more shares to raise money for new plant capacity we don't want loan finance
which will enable us to compete better in the vital and growing widget markets of
Latin America. After we've promised the shareholders 5 per cent profit growth this
year, and trading is tough.
What are the corporate, business and functional strategies in the above statement?
The corporate strategy is the decision that entering new markets, rather than
producing new products will achieve this.
The business strategy suggests that those markets include Latin America.
3.
3.1
Definitions
(a)
(b)
(c)
3.2
1.
2.
Mission broad, general statements that tell why your organization exists.
These do not usually change from year to year.
For example:
3M To solve unsolved problems innovatively
Walt Disney To make people happy
Goals statements describing what your organization wishes to
accomplish, stemming from your mission. Goals are the ends toward which
your efforts will be directed and often change from semester to semester and
year to year, depending on the organization.
Objectives Descriptions of exactly what is to be done, derived from the
goals; clear specific statements of measurable tasks that will be
accomplished as steps toward reaching your goals. Objectives are short-term
and have deadlines.
Example 2 Mission, Goals and Objectives: Restaurant Example
Mission: Provide to our valued customers prompt and high quality food and
service in a friendly and courteous manner.
Goals:
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3.
4.
4.
4.1
4.1.1 The environment may be divided for convenience into three concentric layers:
(a)
Macro-environment
(b)
Industry or sector
(c)
Competitors and markets
4.2
PESTEL
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4.2.2 The acronym PESTEL is sometimes replaced by PESTE, in which the legal aspect is
incorporated with political; SLEPT, in which the environmental protection aspect is
folded into the other five; or even by STEEPLE, where the extra 'E' stands for ethics.
4.2.3 Remember, though, that PESTEL is only concerned with the external environment,
not the internal capabilities of an organisation.
(a)
Political environment
4.2.4 Government policy affects the whole economy, and governments are responsible for
enforcing and creating a stable framework in which business can be done. A report
by the World Bank indicated that the quality of government policy is important in
providing three things:
(a)
Physical infrastructure (for example, transport)
(b)
Social infrastructure (education, a welfare safety net, law enforcement, equal
opportunities)
(c)
Market infrastructure (enforceable contracts, policing corruption)
4.2.5 The political risk in a decision is the risk that political factors will invalidate the
strategy and perhaps severely damage the firm. Examples are wars, political chaos,
corruption and nationalisation.
(b)
Economic environment
4.2.6 The economic environment affects firms at national and international level, both in the
general level of economic activity and in particular variables, such as exchange rates,
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4.2.7
(c)
Potential impacts
Increased/decreased demand for goods (for example,
dishwashers) and services (for example, holidays)
Type of industry in the area, office/factory rents, labour
rates, property prices
How much it costs to borrow money affects cash flow,
some companies carry a high level of debt, consumer
spending is affected by rises in interest rates
Corporate tax affects how much firms can invest or return
to shareholders, income tax affects how much consumers
have to spend therefore demand
Corporate tax affects how much firms can invest or return
to shareholders, income tax affects how much consumers
have to spend therefore demand
Suppliers to the government (for example, construction
firms) are affected by spending
Economic activity is always punctuated by periods of
growth followed by decline, simply because of the nature
of trade. Government policy can cause, exacerbate or
mitigate such trends, but cannot abolish the business cycle.
(Industries that prosper when others are declining are
called counter-cyclical industries.)
Potential impacts
Cost of imports, selling prices and value of exports; cost of
hedging against fluctuations
Desirable overseas markets (demand) or sources of supply
(cheap imports?)
Generally, advanced economies accept that supply and
demand set the value of their currencies, using interest
rates only to control inflation
MNCs have huge turnovers and significant political
influence because of governments' desire to attract capital
investment
Cost of barriers to trade, effect on supplier interests of free
trade, erection of reciprocal barriers, possibility of
dumping
Socio-cultural environment
4.2.8 The social and cultural environment features long-term social trends and people's
beliefs and attitudes.
Factors
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Comment
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Technological environment
4.2.9 Technology contributes to overall economic growth. There are three ways in which
technology can increase total output:
(a)
Gains in productivity (more output per units of input)
(b)
Reduced costs (for example, transportation technology)
(c)
New types of product
(e)
Environmental protection
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Legal environment
4.2.12 The following list highlights possible legal factors affecting all companies:
Factors
General legal
framework: contract,
tort, agency
Criminal law
Company law
Employment law
Health and safety
Data protection
Marketing and sales
Environment
Tax law
Competition law
Example
Basic ways of doing business, negligence proceedings,
ownership, rights and responsibilities, property
Theft, insider dealing; bribery, deception, industrial
espionage
Directors and their duties, reporting requirements, takeover
proceedings, shareholders' rights, insolvency
Trade Union recognition, minimum wage, unfair dismissal,
redundancy, maternity
Fire precautions, safety procedures
Use of information about employees and customers
Laws to protect consumers (for example, refunds and
replacement, 'cooling off' period after credit agreements),
what is or isn't allowed in advertising
Pollution control, waste disposal
Corporate tax payment, collection of income tax
General illegality of cartels
5.
5.1
SWOT analysis
5.1.1
SWOT analysis
SWOT analysis is a systematic method for detailing the strengths, weaknesses,
opportunities and threats to an organisation. It attempts to provide a picture of the
organisation's position relative to the impact of important internal and external
factors and is therefore a useful part of the first step in formulating strategies.
5.1.2 How can we start a SWOT analysis? One approach is to follow these four steps:
Step 1: List the key factors for success
Step 2: Outline the major outside influences and their impact on our business
Step 3: Give an assessment of our company versus our competitors. Highlight the
differential strengths and weaknesses
Step 4: Give an explanation for good or bad performance
5.1.3 A potential problem with SWOT analysis is the development of a long list of
unweighted factors. If the situation review is to be of assistance to strategic planning,
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5.1.4
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5.1.6
Example 3 SWOT
The Hong Kong Jockey Club is one of the largest racing organisations in the world.
Horse racing is the most popular spectator sport in Hong Kong and through its
subsidiaries, the Club is the only authorised operator of horse racing. It also operates
the Mark Six lottery and under Government authority offers betting on football
matches held outside Hong Kong.
The Club is the largest single taxpayer in Hong Kong HK$12,976 million in
2008/09, or about 6.8 per cent of all taxes collected by the Government's Inland
Revenue Department. A unique feature of the Club, much admired worldwide, is its
not-for-profit business model whereby its surplus goes to charity. Over the past
decade, the Club has donated an average of one billion Hong Kong dollars every year
to hundreds of charities and community projects. Today, the Club ranks alongside
organisations such as the Rockefeller Foundation as one of the biggest charity donors
in the world.
The Club is also one of the largest employers in Hong Kong, with some 5,300 fulltime and 21,000 part-time staff.
The racing arm of the Hong Kong Jockey Club operates two thoroughbred race
tracks in Hong Kong at Happy Valley and Sha Tin. Racing is held at Happy Valley
on Wednesdays mostly in the evenings, and at Sha Tin on Sundays mostly in the
daytime.
Racing facilities in Hong Kong are among the finest in the world. Happy Valley's
historic race track at Happy Valley, with its spectacular cityscape setting, offers
racegoers a truly electric atmosphere, especially during night meetings.
Sha Tin Racecourse, opened in 1978, boasts some of the world's most sophisticated
racing facilities and plays host to Hong Kong's major international events. Its highresolution diamond vision screen is the longest TV display in the world, while the
recently-opened covered Parade Ring sets new standards of comfort and access for
racing fans with its unique, retractable paddock roof.
Required:
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and
this
that
that
Solution:
1.
2.
SWOT analysis
Strengths (internal)
Very strong brand recognition as one of the premier thoroughbred racing
organisations in the world.
Strong financial position, although the 2008-2009 season experienced a 2
per cent fall in the dollar gross margin.
Excellent race track, especially at Sha Tin.
Attracts high quality horses, trainers, jockeys and administrators from
overseas.
Strong government support, enhanced by high tax revenues for
government.
Recognised as largest charity donor in Hong Kong.
Weaknesses (internal)
Reliance on overseas horse stocks that is, there is no local breeding
operation, due to environmental and climatic conditions.
Heavy reliance on overseas trainers and jockeys.
Limited land for expansion none at Happy Valley.
As a corollary of limited land, there is pressure on training facilities.
Opportunities (external)
Expansion of racing product into Mainland China.
Expansion of wagering to casino operations in Hong Kong, as a
challenge to Macau.
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Threats (external)
Alternative forms of wagering (eg Macau casinos).
Political interference, either overtly or in the form of increased taxation
of wagering.
Equine disease this happened in Australia in 2008-2009 and curtailed
racing in a major market for six months.
Erosion of wagering income due to rise in popularity of other forms of
gambling,
Lack of clarity about who are the primary stakeholders of the Club.
5.2
5.2.1
5.2.2
Michael Porter grouped the various activities of an organization into a value chain.
5.2.3 The margin is the excess the customer is prepared to pay over the cost to the firm
of obtaining resource inputs and providing value activities. It represents the value
created by the value activities themselves and by the management of the linkages
between them.
5.2.4 Primary activities are directly related to production, sales, marketing, delivery and
service.
(Jun 11)
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Comment
Receiving, handling and storing inputs to the production
system: warehousing, transport, stock control and so on
Converting resource inputs into a final product: resource
inputs are not only materials. People are a resource,
especially in service industries
Storing the product and its distribution to customers:
packaging, testing, delivery and so on; for service
industries, this activity may be more concerned with
bringing customers to the place where the service is
available; an example would be front of house management
in a theatre
Informing customers about the product, persuading them to
buy it, and enabling them to do so: advertising, promotion
and so on
Installing products, repairing them, upgrading them,
providing spare parts and so forth
5.2.5 Support activities provide purchased inputs, human resources, technology and
infrastructural functions to support the primary activities. It may seem an obvious
point that support activities need to support the primary activities, but do not overlook
it. For example, staff recruitment and training need to be appropriate for the product
being produced in the operations.
(Dec 09, Jun 11)
Activity
Comment
Procurement
All of the processes involved in acquiring the resource
inputs to the primary activities (for example, purchase of
materials, subcomponents equipment)
Technology
Product design, improving processes and resource
development
utilization
Human resource
Recruiting, training, managing, developing and rewarding
management
people; this activity takes place in all parts of the
organisation, not just in the HRM department
Firm infrastructure
Planning, finance, quality control, the structures and
routines that make up the organisation's culture
5.2.6 Linkages connect the activities of the value chain.
(a)
Activities in the value chain affect one another. For example, more costly
product design or better quality production might reduce the need for aftersales service.
(b)
Linkages require co-ordination. For example, Just In Time requires smooth
functioning of operations, outbound logistics and service activities such as
installation.
5.3
Benchmarking
5.3.1
Benchmarking
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Example 4 Benchmarking
A typical example of benchmarking can be done by:
(a)
Comparison with previous years (i.e. inter-year fluctuation)
(b)
Comparison between industry sectors
(c)
Comparison with international competitors
(a)
Inter-year comparison
Company A
% change
Sales
10% increase
Cost of sales
9% increase
Gross profit
0.4% increase
Less: operating
expenses
32% increase
Net profit
(3.6%) decrease
(b)
2010
110,000
(43,600)
66,400 (60.4%)
2009
100,000
(40,000)
60,000 (60%)
(26,400)
40,000 (36.4%)
(20,000)
40,000 (40%)
Industry comparison
Company A
110,000
(43,600)
66,400 (60.4%)
(26,400)
40,000 (36.4%)
Sales
COS
Gross profit
Less: operating expenses
Net profit
International comparison
Company A
(HK based)
Sales
110,000
Cost of sales
(43,600)
Gross profit
66,400 (60.4%)
Less: operating
expenses
(26,400)
Net profit
40,000 (36.4%)
Company B
130,000
(50,000)
80,000 (61.5%)
(22,000)
58,000 (44.6%)
(c)
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Company B
(US based)
200,000
(70,000)
130,000 (65%)
Company K
(UK based)
180,000
(60,000)
120,000 (66.7%)
(50,000)
80,000 (40%)
(48,000)
72,000 (40%)
6.1
Just-in-Time (JIT)
(Dec 12)
6.1.1
JIT
JIT system is a system in inventory management by which materials ordered are
received just as they are needed and so avoiding the need to carry any materials
or components inventory. It is generally known as demand driven as production
and delivery are done immediately after the order is made.
6.1.2 There are two aspects to JIT systems, namely, JIT purchasing and JIT production.
6.1.3 JIT purchasing seeks to match the usage of materials with delivery from outside
suppliers and keeping stocks at nearly zero level. It requires:
(a)
Confidence that suppliers will deliver exactly on time.
(b)
Delivery of 100% quality materials by suppliers with no rejects, no returns
and no production delays.
As a result, a close working relationship with the suppliers is necessary and the
reliability of suppliers is important.
6.1.4 JIT production is a demand-pull concept and tends to eliminate waste and
avoiding production bottlenecks. Such improvements are necessary for the
introduction of advanced manufacturing technology (AMT) and total quality
management (TQM).
6.1.5
Benefits of JIT
(a)
(b)
(c)
(d)
(e)
(f)
(g)
6.2
6.2.1
TQM
TQM is an organization-wide effort to seek continuous improvement in all aspects
of operations. It suggests that products should be of zero defects and do right in
the first time.
The characteristics of TQM are:
(a)
TQM necessitates an internal managerial system of planning, controlling
and decision-making.
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6.3
Quality costing
(Dec 12)
6.3.1
Quality costing
It describes the cost that incurred for product or service failures as the company
cannot deliver its normal level of service or product quality to its clients and it may
include the lost of revenue and cost of bad publicity, etc.
6.3.2 When considering the quality costing, a cost of quality report is vital as management
has to consider the relative importance of each component of total quality cost as a
percentage of sales revenue.
Page 85
(c)
What is PEST? Describe briefly what the PEST headings stand for.
(6 marks)
Distinguish among revenue centre, profit centre, cost centre and investment centre.
Which category would you assign to a government funded hospital organization with
annual funding of over $30 million? Can it be treated as a profit centre? Explain
briefly.
(10 marks)
What is the main rationale behind responsibility accounting?
(4 marks)
(HKIAAT PBE II Management Accounting and Finance June 2009 Q6)
Question 2
Sunshine Watch Ltd produces watches and related products. The company is a recognized
leader in the industry for quality products. In recent months, the directors have become
interested in trying to quantify the costs of quality in the company. As an initial effort, the
company was able to identify the following costs for the year ended 30 June 2004, by
categories that are associated with quality:
$
150,000
65,000
180,000
95,000
21,000
500,000
140,000
90,000
320,000
76,000
Quality training
Scrap and waste
Quality inspections
Warranty handling
Waste disposal
Quality technology
Test equipment
Procedure verifications
Quality circles
Customer reimbursement/returns
Managers were also aware that in the above, 250 of the 8,000 watches that were produced had
to be sold as scrap. As a result, each of the 250 watches earned $800 less in profit than good
watches. Also, the company incurred $60,000 rework costs that were necessary in order to sell
200 other watches through regular market channels.
Required:
(a)
(b)
Prepare a quality cost report for the year ended 30 June 2004 showing clearly the four
major categories of quality costs.
(12 marks)
Assuming that the company intends to extend the warranty period from one year to
two years, describe the impact of this intended change on quality costs.
(3 marks)
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Briefly describe the characteristics of total quality management (TQM) and explain
why it is important to all kinds of organizations.
(5 marks)
(HKIAAT PBE II Management Accounting December 2004 Q4)
Question 3
What is a value chain and what are the four support activities in the value chain?
(2 marks)
(HKIAAT PBE II Management Accounting and Finance December 2009 Q2(c))
Question 4
Define a value chain and point out the activities in a value chain.
(5 marks)
(HKIAAT PBE II Management Accounting and Finance June 2011 Q1(d))
Question 5
State THREE techniques commonly used by management accountants in the strategic
management accounting framework.
(5 marks)
(HKIAAT PBE II Management Accounting and Finance December 2012 Q1(e))
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