Calculate the increase or decrease in profits for the three divisions and the company

 

Cost & Management Accounting

 

 

Calculate the increase or decrease in profits for the three divisions and the company

 

Case 1 – Greenwich plc

 

Topic: Transfer Pricing, Negotiated Transfer Prices, Divisional Autonomy

A mediator has been appointed by the head office of Greenwich plc to agree the purchasing of products X and X100. The original agreement was for the North Division to purchase X and the Essex Division to purchase X100 and the level of purchases to remain the same as the previous year.

The mediator appointed by head office has only recently joined the company and is recently qualified. He has worked for the management accountant at the North Division at another company but does not believe this helped him to get the job. Apparently this is the first time that a manager from head office has been asked to mediate in a dispute between divisions.    

 

Initially the mediator talked to the two purchasing divisions separately. The managers at the North Division gave details of current market prices for product X and argued that Swansea was not lowering its prices in line with other suppliers. North Division also complained about the new profit targets that have been set been set by head office. Managers’ were convinced that they must have the freedom to buy and sell outside the company.

The managers at the Essex Division told a similar story. They gave details of how market prices had fluctuated in the last 6 months. Their conclusion was that market prices would continue to fall and therefore the Swansea Division must reduce its prices. Again managers also argued that they must have the freedom to buy and sell outside the company.

Finally a meeting with the Swansea Division was held. The managers did not accept any of the points raised by the two purchasing divisions and argued that the current arrangement had worked well and did not need changing.

After returning to the head office the mediator wrote a short report summarising the details of the original agreement. 

 

Details of the original agreement

The North Division purchases 3,000 units of product X from Swansea (the supplying division) and another 1,000 units from an external supplier.  The market price for product X is  £900 per unit.

The Essex Division purchases 1,000 units of product X100 from Swansea and another 1,000 units from an external supplier.

Details of the revised agreement

Swansea will continue to produce products X and X100. All of its production will be sold to the North and Essex Divisions. No other customers are likely to found for these products in the short term given that supply is greater than demand in the market.

The mediator carefully considered the issues raised by the managers and suggested the following compromise. He gave all of the divisions 7 days in which to comment.

Swansea will manufacture 2,000 units of X for the North Division and 500 units of product X100 for the Essex Division.

North will buy 2,000 units of X from Swansea and 2,000 units from an external supplier at £900 per unit.

Essex will buy 500 units of X100 from Swansea and 1,500 units from an external supplier at £1,900 per unit.

 

Swansea Division  Data 1999

 

Data based on original agreement

 

Product

X

X100

Direct materials

£200

£300

Direct labour

£200

£300

Variable overhead

£300

£600

Transfer price

£1,000

£2,000

Annual Volume

3,000 units

1,000 units

Questions

Question 1

Calculate the increase or decrease in profits for the three divisions and the company if the      head office agreement is imposed on managers. Discuss the problems faced by mediator in this situation.

Question 2

Evaluate the implications of the following transfer pricing policies:

            Transfer price = cost plus a mark-up for the selling division

            Transfer price = standard cost plus a mark-up for the selling division.

            Transfer price = incremental cost

            Transfer price = price negotiated by the managers

Case 2 – Customer Profitability at Stoke plc

 

Introduction

Managers at Stoke plc have been using various teams to collect activity-based data since 2000. Each team has consisted of one or more management accountants working closely with department managers. The teams typically work for 3-6 months on data collection and developing spreadsheets. To date the teams have mainly focused on product costing. Recently two teams have been set up to collect data to improve the company’s understanding of customer-related costs and profitability. One team has looked at distribution costs and the second at order related costs. 

Only 3 customers were included in the analysis. Theses 3 customers represent 10`% of total sales. The company has approximately 250 customers in total. Finally the teams only considered labour related costs and direct costs for the cost pools.

The first objective for each team was to estimate the total annual overhead cost and annual volume for each cost driver. As the company only focused on three customers the data was quickly estimated.  The second objective was to estimate the percentage of each cost driver per customer.

Collecting Data

The management accept that a ‘cost sampling’ or snapshot’ approach is the best way to identify key activities and their costs.  This technique helps the department to develop estimates of how much time is devoted to different activities. Then by using an average hourly rate for all staff managers will be able to estimate the total annual cost of an activity. The decision to use an average hourly rate for all staff will save time.

Managers decided that between 4 to 8 activities should to be identified by each team.  The possibility of identifying 20-30 activities was considered but this was rejected because there was very little time to do the work. For the whole exercise it was felt that the information must not take too long to collect and interpret.

Most of the managers involved with the new teams have little experience of collecting data regarding activities and cost drivers. With some activities several cost drivers were discussed. This confused some managers who felt unclear why a cost driver was rejected or accepted. The management accountants believed these problems would not affect the accuracy of the data.

ABC data

Team 1 – Order related overheads

(Data based on 3 customers)

Activity cost pool

Cost driver

Annual overhead cost for the 3 customers

Annual volume for the 3 customers

Changes to orders

Number of order amendments 

£50,000

3,000

Pre-sales support

Number of hours of pre-sales support

£100,000

3,800

Post-sales support

Number of hours of post-sales support

£100,000

2,200

Delayed payments

Number of delayed payments over 3 months

£70,000

1,250

Order processing

Number of orders

£60,000

20,000

Invoicing

Number of invoices

£25,000

22,500

Team 2 Distribution costs

(Data based on 3 customers)

Distribution related overhead costs

Cost driver

Annual overhead cost for the 3 customers

Annual volume for the 3 customers

Storage expenses

Average cartons in stock

£12,000

5,000

Requisition handling

Number of requisitions

£8,500

10,000

Standard deliveries

Number of standard deliveries

£5,000

3,000

Special deliveries

Number of special deliveries

£12,800

500

Customer sales and activity analysis

 

Customer

North

South

East

Annual Sales

£175,000

£178,000

£173,000

The following table summarises the percentage of each cost driver per customer.

Customer

North

South

East

Total

%

%

%

%

Number of order amendments 

20

2

20

100

Number of hours of pre-sales support

16

10

30

100

Number of hours of post-sales support

10

15

20

100

Number of delayed payments

10

12

10

100

Number of orders

10

30

30

100

Number of invoices

20

30

50

100

Average cartons in stock

40

30

30

100

Number of requisitions

30

30

40

100

Number of standard deliveries

10

40

50

100

Number of special deliveries

20

60

20

100

Questions

Question 1

Calculate the profit for each customer based on the ABC data and discuss what steps the company should consider to improve the profitability of individual customers.

Question 2

Assume that the company has a complete analysis of all customer-related revenues and costs. Discuss why such data is needed and how it can be used to help a company compete profitably.

Case 3 – Wanstead Engineering

 

The annual bonus for senior managers at Wanstead Engineering was first agreed in 1998. Since then the company has seen no need to make any changes to the way in which the bonus is calculated. Both shareholders and managers agree the bonus is important, as it is a major factor in motivating and rewarding managers to maximize the agreed corporate objectives. The bonus scheme has also helped the company to retain senior managers.  Shareholders want to see a steady improvement in the share price for a given level of risk and the directors are responsible for designing the remuneration systems.

Details of bonus calculation

 

The original forecast presented by managers was prepared on the assumption that no funds were available for investment in new products. Investments that have already been approved are considered essential to maintain current production capacity.  

Original forecast – no funds available for investment in new products

Year

2001

2002

2003

*Profit

£6 million

£5 million

£4 million

Capital employed (at beginning of year)

£77 million

£79 million

£81 million

*Profit is calculated before tax and interest

The bonus is calculated by multiplying the ROI percentage by £1,000 if the capital employed is below £80 million and by £1,100 if the capital employed is greater than £80 million.

The group ignores tax and depreciation when calculating bonuses and the capital employed is the opening balance at the start of each year and excludes cash balances which are held in a group account

Example:       Capital employed = £50,000,000

ROI = 7.143%                       

Bonus = 7.143 X £1,000 = £7,143

Investment in new products

After receiving the forecast above senior managers were asked to identify three investments in new products. The company has been asked to only consider projects with cash inflows in 2002 and 2003. Although the senior managers were asked to identify 3 projects only 1 would be accepted.

Cost of capital is 10%

Project 1

Year

2001

2002

2003

Cash flow

-£5 million

£4.5 million

£1.5 million

Net present value

£330,579

Project 2

Year

2001

2002

2003

Cash flow

-£2 million

£0.1 million

£3 million

Net present value

£570,248

Project 3

Year

2001

2002

2003

Cash flow

-£0.5 million

Nil

£1 million

Net present value

£326,446

Questions

 

Question 1

 

Discuss why the bonus scheme could result in poor decisions and cause conflict between shareholders and senior managers.

 

Question 2

 

What changes would you like to see to the way in which bonus is calculated? Discuss why strategy is important when identifying financial objectives for a business unit.

SECTION II – SOLVE ANY 4 QUESTIONS OUT OF 6.

 

  1. “Management accounting is a mid-way between financial and cost accounting.” Elucidate.

  1. What is the major revenue recognition criterion?

  1. What is a trading account? What are its major constituents? What is its major outcome?

  1. The cash flow statement is as useful to shareholders and lenders as to management. Explain.

  1. (a) “All future costs are relevant.” Do you agree? Why?

(b) “Fixed costs are really variable. The more you produce the less they become.”                                  

                    Do you agree? Explain.

  1. In connection with inventory ordering and control, certain terms are basic. Explain the meaning of each of the following:

    1. Economic order quantity

    2. Re-order point

    3. Lead time

    4. Safety stock

 

Calculate the increase or decrease in profits for the three divisions and the company

 

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