Paper P2 - Performance

Management
By KAPP Edge Solutions
Exam Pattern
Section A 50 marks Five compulsory medium
answer questions, each worth
ten marks.
Short scenarios may be given,
to which some or all questions
relate.
Section B 50 marks One or two compulsory
questions. Short scenarios
may be given, to
which questions relate.
Exam strategy
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Question requirements and presentation
Start a new page for each of the questions.
Layout your answers neatly and show all your workings.
Discussion answers must be broken down into small paragraphs with a space after each relevant
point.
Make sure you present your answer in the format that is requested, e.g. report format.
Where questions require the use of a formula, write out the formula first and then insert the figures.
Make sure you read all the requirements before attempting the question.
Let the question requirement drive your headings.
Examine any information in the scenario (if provided) constantly to generate ideas.
Ensure you deal with all aspects to a question requirement, reread the question two or three times to
ensure you have fully understood it.
Have a separate page for your workings and make sure your final answer makes reference to these.
If you get stuck on a certain part of the question, dont spend too long on that part.
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Syllabus structure
A: Pricing and Product Decisions (30%)
B. Cost Planning and Analysis for Competitive
Advantage (30%)
C: Budgeting and Management Control (20%)
D: Control and Performance Measurement of
Responsibility Centres (20%)
Pricing and
Decision
Making
Budgeting and
Management
Control
Responsibility
Centres
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Important Topics
Pricing Decision
Decision Making
Transfer Pricing
Learning Curve
Budgeting
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Decision Making
Topics Covered
Relevant and non-relevant cost
Opportunity cost
Decision making
Relevant and Non-Relevant cost
Relevant cost- which changes as a direct result of decision taken.
o These are future costs.
o They are incremental/differential /avoidable costs.
o They are cash flows.
Note-variable costs are relevant cost.
Example, if I am deciding whether to buy a Toyota Camry or a Maruti Swift, and if my auto insurance will be
the same no matter which car I buy, my consideration of insurance costs will not affect my decision.
Non- Relevant cost- these are not relevant in decision making.
o Sunk costs
o Fixed costs
o Committed cost
o Depreciation
o Notional cost
Opportunity cost
Meaning-It is benefit sacrificed due to choosing one alternate .
Example:
K ltd has occupied the building itself . The market rent of such property is $ 2,000
p.m.
This $ 2,000 is an opportunity cost.
Relevant cost of Material
Relevant cost of Labor
Relevant cost of Overheads
Relevant cost of Non Current Assets
Current Replacement
Cost
If machinery is to
be replaced at the
end of its useful
life.
Higher of sale proceeds or
the net cash flow
arising from
the use.
If machinery is
not to be replaced
at the end of its
useful life.
Decision making
Limiting factor decisions-
Limiting factor- which prevents a company from achieving the desired output or
sales.
Situation1-single limiting factor
= Contribution per unit
Scarce resource
The product with highest contribution per scarce resource will be selected.
Decision making
Make or buy
Contribution per unit
Scarce resource
The product with highest contribution per scarce resource will be selected.
Any product which comes last in priority and cant not be allotted the scarce
resources, will be purchased from outside.
Decision making
Accept or reject
Any order which gives highest contribution per unit/ contribution per scarce
resource if any. Will be accepted.
Decision making
Shut down decision
Whether or not to close down a factory, department, product line or other activity,
either because it is making losses or because it is too expensive to run.
If the decision is to shut down, whether the closure should be permanent or
temporary. Shutdown decisions often involve long term considerations, and capital
expenditures and revenues.
A shutdown should result in savings in annual operating costs for a number of years in
the future.
Closure results in release of some fixed assets for sale.
Employees affected by the closure must be made redundant or relocated, perhaps even
offered early retirement.
Minimum pricing Decision
Minimum price is equal to incremental cost plus opportunity cost.
Practice Questions
EXAMPLE
A summary of the cost estimates used for the purposes of arriving at the tender price is as follows:
Cost Estimates Grain Silo 000s
Direct Materials Steel 600
Direct Materials Wiring and ancillaries etc. 100
Direct Labour-Engineering-3000 hours@100 per hr. 300
Direct Labour - Unskilled 10000 hours @ 40 per hr. 400
Variable Overheads 150
Fixed Overheads Absorbed 150
Total Estimated Cost 1,700
K ltd. tendered at a price of 2.04 million by adding on a mark-up of 20% to the above costs. It has just
been informed that its tender was unsuccessful.
engineering hours were in short supply and earn a contribution per hour of 10
due to the recent cancellation of an order the company expects to have available 6,000 idle unskilled hours
available to work on the job. Any additional unskilled labour required is employed on a casual basis
the wiring was already in stock for the previous job that was cancelled. The wiring has no other use and was
to be scrapped at a cost of 10,000.
fixed overheads represent an allocation of Ks central fixed overhead. The proposed tender would have
incurred specific fixed costs of 20,000
Solution
K ltd.- Relevant Cost of Grain Silo:

Detail 000s Explanatory Note

Steel 250,000 Stock at replacement cost
Wiring etc. -10,000 Incremental cost saving
Engineering Hours 300,000 Cost of Hours
Engineering Hours 30,000 Opportunity Cost
Unskilled Hours (first 6000) 0 Committed cost, thus irrelevant
Unskilled Hours (last 4000) 160,000 Relevant as casual
Variable Overhead 150,000 Relevant as variable
Fixed Overheads
Central Apportionment 0 Irrelevant as non-incremental
Fixed Overheads - Specific 20,000 Relevant as incremental
TOTAL RELEVANT COST 900,000
Add:20% Mark Up 180,000
Pricing Decision
Topics Covered
Factors affecting profit
Price Elasticity of demand
Price Elasticity Graph
Factors affecting price elasticity
Perfectly Competitive Market
Imperfect Competition
Product Life Cycle
Pricing strategies
Factors affecting profit
Profit is the factor of three components:
Cost - volume -price
Cost
Higher
volume
reduces the
cost per unit
Lower cost
helps in
lower prices
Volume
Volume
increase- per
unit cost
decreases
Price
Lower cost
helps in
setting lower
price
Price Elasticity of demand
The relative response of a change in quantity demanded to a change in price.
Price elasticity
An elastic demand means that the quantity demanded is relatively responsive to changes in price.
An inelastic demand means that the quantity demanded is not very responsive to changes in
price.
Price Quantity
Price Elasticity of demand
Formula:
Price Elasticity of demand
=Percentage change in quantity demanded
Percentage change in price
Price Elasticity Graph
Inelastic Demand
Price Elasticity Graph
Elastic demand
Factors affecting price elasticity
1. Scope of the market
2. Information within the market
3. Availability of substitutes
4. Complementary products
5. Disposable Income
6. Necessities
7. Habit
Perfectly Competitive Market
All the firms and consumers are price takers.
They cannot affect the market price.
Assumptions
Many small firms,
Many individual buyers,
Perfect freedom of entry and exit from the industry.
Homogeneous products
Perfect knowledge
No externalities
Imperfect Competition
Monopoly
Oligopoly
Monopolistic Competition
Product Life Cycle
Introductory phase
Growth
Maturity
Decline
Marginal cost and Marginal Revenue
'Marginal Revenue - MR-The increase in revenue that results from the sale of one
additional unit of output.
'Marginal Cost- MC- variable cost of production
Profit maximized
M = MR MC.
M= marginal profit
The firms profit-maximizing level of output occurs when the additional revenue from selling an
extra unit just equals the extra cost of producing it, that is, when MR = MC.
MR=MC
Profit Maximization
Price equation =p=a- bx
P= price
X=quantity
A and b are constants
MR =a-2bx
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Pricing strategies
Total cost plus
Marginal cost plus
Premium pricing
Market Skimming
Penetration Pricing
Loss leader pricing
Controlled Pricing
Transfer Pricing
Topics Covered
Meaning of Decentralization
Meaning of transfer pricing
Purpose
Basis of Transfer Pricing
Objective of Transfer Pricing
A Perfect Intermediate Market
Imperfect Intermediate Market
Decision making
TP and International Taxation
Meaning of Decentralization
Delegation of decision-making to the subunits of an organization.
It is a matter of degree.
The lower the level where decisions are made, the greater is the decentralization.
Decentralization is most effective in organizations where subunits are autonomous and
costs and profits can be independently measured.
The benefits of decentralization include:
(1) decisions are made by those who have the most knowledge about local conditions;
(2) greater managerial input in decision- making has a desirable motivational effect; and
(3) managers have more control over results.
Meaning of Transfer Pricing
A transfer price is the price at which one company buys and sells goods or
services or shares resources with a related affiliate in its supply chain.
A transfer price is what one part of a company charges another part of the same
company for goods or services.
Purpose
Generate separate profit figures for each division and thereby evaluate
the performance of each division separately.
Help coordinate production, sales and pricing decisions of the different
divisions (via an appropriate choice of transfer prices).
Transfer prices make managers aware of the value that goods and services
have for other segments of the firm.
Transfer pricing allows the company to generate profit (or cost) figures
for each division separately.
The transfer price will affect not only the reported profit of each centre,
but will also affect the allocation of an organizations resources.
Guidelines for transfer pricing
The Price Must be Similar to That Sold to Arm's-length Customers
An arm's-length transaction is one between two unrelated entities. If one division of a company
normally sells products to companies that are unrelated to them, then that price should be used for a
division that is related to them. "Related" means two companies that are legally part of the same
corporation, LLC or other recognized business organization.
The Price Must be Similar to Prices Other Companies Charge Each Other
Examine the prices other companies charge each other for similar products. This is a good guideline
for setting prices between divisions of your own company. Set the price near what the company-to-
company market dictates.
Set Prices According to What You Have Paid Other Companies
The division acquiring the product may have purchased from outside sources in the past. Use the
prices established in those transactions as a guide. Allow for inflation or other market changes, and
set the price accordingly.
Basis of Transfer Pricing
There are three general methods for establishing transfer prices.
Market-based transfer price: In the presence of competitive and stable external
markets for the transferred product, many firms use the external market price as the
transfer price.
Cost-based transfer price: The transfer price is based on the production cost of the
upstream division. A cost-based transfer price requires that the following criteria be
specified:
Actual cost or budgeted (standard) cost.
Full cost or variable cost.
The amount of markup, if any, to allow the upstream division to earn a profit on the transferred product.
Negotiated transfer price: Senior management does not specify the transfer price.
Rather, divisional managers negotiate a mutually-agreeable price.
Objective of Transfer Pricing
The independence of
divisions.
The assessment of
divisional performance.
The optimization of profits
for the business.
The allocation of
divisional resources.
Tax minimization
A Perfect Intermediate Market
Economists call a market perfect if buyers can buy and sellers can sell any
quantity without affecting the price. This means, of course, that the product being
sold is not differentiated by quality, service, or other characteristics.
In perfect market, the marginal revenue is always the market price of the item
because all output can be sold at the prevailing market price.
Transfer price can be set as per market price.
Imperfect Intermediate Market
A market is imperfect when the selling division is unable to sell its output
externally at the same price.
In order to sell the product, the sales price needs to be reduced.
Marginal revenue is always lower than the market price as it is not possible to sell
all output at the prevailing market price
Profit maximization
MR=MC
Decision making
Perfectly competitive market
Optimum TP =Market price + Any small Adjustments
Where there is surplus capacity
Optimum TP =Marginal Cost
Where there is production constraint
Optimum TP =Marginal Cost + shadow price (opportunity cost)
Dual Pricing
Selling price recorded by selling division is not same as buying price recorded by the
buying division.
Buying division records at variable cost.
Selling division records at closer to market value.
The difference between two will be debited to group account called transfer price
adjustment account.
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TP and International Taxation
In order to minimize the tax liability:
1. reduce the profitability of its subsidiaries in high tax countries.
2. Increase the profitability of its subsidiaries in low tax countries.
Thanks
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KAPP Edge Solutions
www.onlineglobalcareer.com
M-9871434852
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