CMA (Homework week 6) PDF

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Contemporary Management Accounting Week 6 Homework 12.29 General transfer pricing rule: manufacture 1. If the Assembly Division has spare capacity, there is no opportunity cost associated with a transfer Transfer price = outlay cost + opportunity cost = $450 + 0 = $450 2. Transfer price = outlay cost + opportunity cost = $450 + $120 = $570 Opportunity cost = forgone contribution margin = $570 - $450 = $80 3. If the Assembly Division has spare capacity and no outside market exists for the transferred component, the transfer price should be based on the variable cost per unit, $450, plus a small profit margin to provide an incentive for the Assembly Division to manufacture and transfer the component to the Electrical Division. 12.30 Cost-based transfer pricing: manufacturer 1. The Electrical Division’s manager is likely to reject the special offer because the Electrical Division’s incremental cost on the special order exceeds the division’s incremental revenue: Incremental revenue per unit of the special order

$697.50

Incremental cost per unit to the Electrical Division per unit for the special order: Transfer price

$561.00

Additional variable cost

150.00

Total incremental cost

711.00

Loss per unit in special order for the Electrical Division

$ (13.50)

2. The Electrical Division manager’s decision to reject the special order is not in the best interests of the company as a whole, since the company’s incremental revenue on the special order exceeds the company’s incremental cost. Incremental revenue per unit in special order $697.50 Incremental cost to company per unit in special order: Unit variable cost incurred in Assembly Division $450.00 Unit variable cost incurred in Electrical Division 150.00 Total unit variable cost 600.00

Profit per unit in special order for the company as a whole $ 97.50 3. The transfer price could be set in accordance with the general rule, as follows: Transfer price = outlay cost + opportunity cost = $450 + 0* = $450 * Opportunity cost is zero, since the Assembly Division has spare capacity. The Assembly Division will want to make a profit on the transfer, so that transfer price will be $450 plus a profit margin. The Electrical Division manager will have an incentive to accept the special order since the Electrical Division’s incremental revenue on the special order exceeds the incremental cost. Any transfer price that is between $450 and $697.50will allow the Electrical Division to make a profit. 12.31 Responsibility accounting; budgetary participation; behavioural issues: service firm 1 Responsibility accounting system (a) Two potential behavioural advantages if Reliable’s managers accept the philosophy of responsibility accounting are as follows:  They may be motivated to plan ahead and promote goal congruence.  They may be pleased to be responsible only for those items they can control. (b) Two potential problems that could arise if the managers do not accept the change in philosophy are as follows:  They could dislike being measured on an individual basis, since they may be responsible for costs over which they have no control.  They could focus too much on their own department’s goals to the possible detriment to the organisation as a whole (suboptimisation). (c) If the managers support the new system, and most of the disadvantages pointed out above are avoided, the responsibility centre system will enhance the alignment of organisational and personal goals. Since Commercial Maintenance Ltd (CML) took the time to fully explain and communicate the system to Reliable’s managers, by pointing out the advantages and encouraging their participation, organisational and personal goals will likely become aligned. 2

Participatory budgeting system (a) Two potential behavioural benefits are the following:  Reliable’s managers are likely to accept the system and be motivated to attain the budget targets, since they were actively involved in setting the goals and understand what is expected of them.  Communication and group cohesiveness may be improved, because the managers would feel part of a team. (b) Two potential problems that could arise are as follows:  The managers could be motivated to ‘pad’ their budgets, building slack into the plan to ensure that they will meet the targets.  An overemphasis on departmental goals could hurt cross-departmental employee relations. (c) Participatory budgeting can contribute to an organisation’s goals by encouraging buy-in to the resulting budget and performance evaluation by the organisation’s employees. There is no reason to believe that such an approach would not be beneficial for Reliable if the new system is communicated well and introduced in a supportive manner.

12.39 Transfer pricing problem: manufacturer 1 (a) Transfer price = outlay cost + opportunity cost = $195 + $45 = $240 (b) Transfer price = standard variable cost + (10%)(standard variable cost) = $195 + (10%)($195) = $214.50 Note that the Frame Division manager would be likely to refuse to transfer at this price. 2 (a) Transfer price = outlay cost + opportunity cost = $195 + 0 = $195 (b) When there is no spare capacity, the opportunity cost is the forgone contribution margin on an external sale when a frame is transferred to the Glass Division. The contribution margin equals $45 (i.e. $240 – $195). When there is spare capacity in the Frame Division, there is no opportunity cost associated with a transfer. Students should not be formula bound here but understand the rationale: when there is no spare capacity this manager can sell all output for $240. Hence, they would not be willing to transfer at $214.50. When there is spare capacity anything over $195 will increase their profit. This argument is reflected in the use of the opportunity cost. (c) Fixed overhead per frame (125%)($60) = $75 Transfer price = variable cost + fixed overhead per frame + (10%)(variable cost + fixed overhead per frame) = $195 + $75 + [(10%)($195 + $75)] = $297 (d) Incremental revenue per window

$465

Incremental cost per window Direct material (Frame Division)

$45

Direct labour (Frame Division)

60

Variable overhead (Frame Division)

90

Direct material (Glass Division)

90

Direct labour (Glass Division)

45

Variable overhead (Glass Division)

90

Total variable (incremental) cost

420

Incremental contribution per window in special order for Clear Windows Company $45 From the perspective of the company as a whole, the special order should be accepted because the incremental revenue exceeds the incremental cost. (e) Incremental revenue per window

$465

Incremental cost per window, for the Glass Division: Transfer price for frame [from requirement 2(c)]

$297

Direct material (Glass Division)

90

Direct labour (Glass Division)

45

Variable overhead (Glass Division)

90

Total incremental cost

522

Incremental loss per window in special order for Glass Division

$ (57)

The Glass Division manager has an incentive to reject the special order because the Glass Division’s reported net profit would be reduced by $57 for every window in the order. 3

The price to transfer 200 units from the Frame Division to the Glass Division is $285 per unit. Minimum transfer price = incremental cost per unit + opportunity cost per unit = [(200 x $195) + (150 x $120)]/200 = $57 000 / 200 = $285 per unit

This transfer price will not change the profits of the Frame Division. If the units are transferred then the Frame Division may also add a profit margin to make the transfer worthwhile. Note that the Frame Division only has sufficient capacity to manufacture 100 of the total 200 units required by the Glass Division. The opportunity cost in this calculation relates to the forgone profit of $120 per unit for the 150 units that could not be manufactured and sold to external customers if the extra 100 units are manufactured and transferred to the Glass Division. The Frame Division must consider any impact on regular external customers if the Frame Division cannot supply them with their usual product. This could result in a decrease in the company’s reputation, and loss of future external sales as disappointed customers seek out other suppliers. The manager of the Frame Division could transfer the 200 units at an average price of $285 per unit, or it could transfer 100 units at anything above the variable cost of $195 per unit to utilise its spare capacity. The manager of the Glass Division will not find the price of $285 per unit for 200 units attractive, as it is higher than the market price of $240 per unit. Thus, the manager would prefer to purchase 100 units at a price less than the market price of $240 from the Frame Division and the remaining 100 units at $240 from the external market. If the manager of the Glass Division does not want to manage two suppliers or if the Glass Division insists on charging the market price, then the Glass Division may end up purchasing all of the 200 units from the outside supplier. Chapter 12 Performance measurement system is the system which helps to evaluate the performance of employees in the organization. By this process, the organization is able to form uniformity between the goals of the employees and the goal of the organization as a whole.

Purpose of Performance measurement system:

1. To make a manager communicate the plans and strategies to employees so that the employees also strive to achieve the goals. 2. To enable the manager to track their own performance and comparing with their past performance or with the budgeted performance. This would help to take corrective action so that mistakes would not be repeated in the future. 3. To enable managers to develop realistic and effective targets for the future so that long term goal can be achieved 4. To enable the managers for evaluating and measuring the performance of employees It is important to establish a performance measurement system which is effective. Performance target should be links to the strategies and goals. The system should recognize controllability, embraces participation and empowerment. It should have predetermined benchmark based on which the performance of managers would be evaluated. Also, there should rewards for the managers who exceed their performance. This would motivate the manager to perform at their best level.

Structuring for control decentralization: 1. Decentralization: is the process by which the activities of an organization, particularly those regarding planning and decision making, are distributed or delegated away from a central, authoritative location or group. The main objectives which a decentralized system of organization seeks to achieve: To relieve the burden of work on the chief executive. To develop the managerial faculties. To motivate the lower level of workers. The cost would narrowing focus on own unit’s goal and would be unnecessary duplication 2. Goal congruence is a situation in which people in multiple levels of an organization share the same goal. A well-thought-out organizational design causes goal congruence and results in an organization being able to work together to accomplish a strategy. 3. Responsibility accounting refers to an accounting system that collects, summarizes, and reports accounting data relating to the responsibilities of individual managers. It involves the internal accounting and budgeting for each responsibility centre within a company. The objective of responsibility accounting is to assist in the planning and control of a company's responsibility centres.

Four common types of responsibility centres: 1. Cost centre: A cost or expense centre is a segment of an organisation in which the managers are held responsible for the cost incurred in that segment but not for revenues. Responsibility in a cost centre is restricted to cost. For planning purposes, the budget estimates are cost estimates; for control purposes, performance evaluation is guided by a cost variance equal to the difference between the actual and budgeted costs for a given period. 2. Revenue centre: A revenue centre is a segment of the organisation which is primarily responsible for generating sales revenue. A revenue centre manager does not possess control over cost, investment in assets, but usually has control over some of the expense of the marketing

department. The performance of a revenue centre is evaluated by comparing the actual revenue with budgeted revenue, and actual marketing expenses with budgeted marketing expenses. 3. Profit centre: A profit centre is a segment of an organisation whose manager is responsible for both revenues and costs. In a profit centre, the manager has the responsibility and the authority to make decisions that affect both costs and revenues (and thus profits) for the department or division. 4. Investment centre: An investment centre is responsible for both profits and investments. The investment centre manager has control over revenues, expenses and the amounts invested in the centre’s assets.

The financial performance report shows the key financial results appropriate for the type of responsibility centre, it segmented profit statements and contribution margin format. It highlights variances between budgeted and actual.

Transfer pricing should result in units’ profit that are reliable and accurate, it preserved and encourage autonomy as well as goal congruent behaviour. Managers of profit centre and investment centre may have considerable autonomy. Corporate management intervention is contrary to decentralisation philosophy, they may develop general policies to govern transfer pricing practices. There are 3 transfer pricing methods as market- based prices; cost-plus prices and separate capacity. Transfer pricing under different scenarios Scenario 1 – There is an external market and excess capacity in the supplying division - This usually means that the internal department doing the supplying benefits from the trade as they wouldn’t have made those profits otherwise. Hence the transfer price is a negotiated price under market price Scenario 2 – there is an external market but no excess capacity - If there is no excess capacity then the supplying division has to take into account the opportunity cost of lost profits on sale due to transfer Scenario 3 – there is an external market but there is limited capacity in the supplying division - If capacity is limited, then an opportunity cost (partial) needs to be accounted for in the transfer price Scenario 4 – there is no external market and there is excess capacity in the supplying division - As there is no opportunity cost with the transfer, the transfer is based on cost-plus mark-up Scenario 5 – there is no external market and no excess capacity in the supplying division - The transfer price will need to account for the opportunity cost on lost sales in other products due to the transfer...