CUACM 413 Tutorial Questions

Question 1

Triple E Ltd. manufactures a range of electronics products. Technical staff recently developed
a design for a new type of in-car music player which can be used to play DVDs, digital
downloads, and cassette tapes. The board of the company has asked the marketing, financial,
and production directors to evaluate the design before a decision is made as to whether to begin
production of the music player.

The marketing director has suggested that $90.00 would be a suitable selling price for the music
player and that 600 units per annum would be sold at this price. Variable selling costs would
amount to $10 per unit sold.

The financial director has estimated that the new capital equipment required in order to
manufacture the music player would cost $300 000. The company requires an annual return on
investment (ROI) of 8% on all capital investments.

The production director has not yet finalized her estimate of the cost of manufacturing the
music player.

However she has commented that the design has certain features which are likely to add to the
complexity and cost of the manufacturing process without significantly enhancing the
attractiveness of the product to potential customers.

REQUIRED:

(a) Using the data provided above, calculate the target cost of manufacturing the music player,
and explain fully the significance of this figure.

(10 marks)

(b) Assume now that the production director has estimated the cost of manufacturing the music
player (using the recently-developed design) at $60,00 per unit and has suggested that the
company should accept a reduced ROI if necessary. Calculate the ROI if this suggestion is
accepted and comment on the production director’s suggestion. (7 marks)

(c) It is often stated that target costing is most likely to be effective when products are still at
the design stage (i.e., before any production begins) and when comprehensive information
about cost driver rates is available from the company’s accounting system. Explain why this is
so. (8 marks)

[Total: 25 marks]

Question 2

Taiseki Engineering Ltd. manufactures specialized engineering products. The items produced
are of high quality but are fragile by nature and therefore the packaging process must be carried
out with some care.

The company’s product development staff recently completed design work on a new product
(the Pump). Comparison with competitors’ products indicates that $20 per unit is a realistic
selling price for the Pump. The company requires a 35% margin on selling price from all
products in order to ensure an adequate companywide return on investment. Production and
sales of Pump are estimated at 13,000 units per annum.
According to the design specifications, the Pump is to be produced in batches of 500 units and
packaged in batches of 25 units. Overhead costs amount to $2000 for each batch of 500 units
produced and a further $125 for each batch of 25 units packaged.

The design specifications also indicate that the manufacture of each unit of Pump will require
3 units of Component 1 and 5 units of Component 2. Component 1 is a new item which Taiseki
Engineering Ltd. will have to manufacture at a cost of $0.20 (variable) each plus $4,000 for
each batch of 10,000 units of this component.

Component 2 is used regularly by the company and can be purchased in any desired quantity
from a reliable supplier for $0.55 each. The labour cost of fitting these components in the
manufacture of Pump is estimated at $0.45 per unit of Component 1 and $0.15 per unit of
Component 2.

REQUIREMENT:
(a) Prepare calculations to indicate whether Taiseki Engineering Ltd. will achieve the target
cost for the Pump on the basis of the data provided. (9 marks)
(b) Now assume that a “target costing task force” has suggested the following changes in order
to help reduce the cost of the Pump:
_ Increase the production batch size so that each year’s total output of Pump would be produced
in just 24 batches;
_ Increase the packaging batch size to 75 units of Pump;
_ Modify the design of the Pump, such that 2 units of Component 1 would be replaced by the
same number of units of Component 2 in each Pump.
Calculate the total annual cost savings if all of these changes are implemented, and indicate
whether the target cost would be achieved. (10 marks)
(c) The Managing Director points out that no consideration has been given to the cost of
delivering the product to customers. Discuss whether the company needs to give consideration
to delivery costs as part of the target costing exercise. (N.B. Calculations are not required in
your answer to this part). (6 marks)
[Total: 25 marks]
Question 3
The Parirenyatwa Group Hospital (PGH) provides the entire healthcare service to residents in
Zimbabwe. The PGH is funded centrally through revenues from taxpayers. However, the
government is not involved in the day-to-day running of the PGH, which is largely managed
regionally by a number of self-governing trusts, such as the Pari Trust. The Pari Trust runs one
hospital in Harare and, like other trusts in Zimbabwe, receives 70% of its income largely from
the PGH’ ‘payments by results’ scheme, which was established two years ago. Under this
scheme, the trust receives a pre-set tariff (fee income) for each service it provides. If the Trust
manages to provide any of its services at a lower cost than the pre-set tariff, it is allowed to use
the surplus as it wishes. Similarly, it has to bear the cost of any deficits itself.

Currently, the Trust knows that a number of its services simply cannot be provided at the tariff
paid and accepts that these always lead to a deficit. Similarly, other services always seem to
create a surplus. This is partly because different trusts define their services and account for
overheads differently. Also, it is partly due to regional differences in costs, which are not taken
into account by the scheme, which operates on the basis that ‘one tariff fits all’. The remaining
30% of the Trust’s income comes from transplant and heart operations. Since these are not
covered by the scheme, the payment the Trust receives is based on the actual costs it incurs in
providing the operations. However, the Trust is not allowed to exceed the total budget provided
for these operations in any one year.
Over recent years, the Trust’s board of directors has become increasingly dissatisfied with the
financial performance of the Trust and has blamed it on poor costing systems, leading to an
inability to control costs. As a result, the finance director and his second in command – the
financial controller – have now been replaced. The board of directors has taken this decision
after complaining that ‘the Trust simply cannot sustain the big deficit between income and
spending’. The new financial controller comes from a manufacturing background and is a great
advocate of target costing, believing that the introduction of a target costing system at the Pari
Trust is the answer to all of its problems. The new financial director is unconvinced, believing
target costing to be only really suitable in manufacturing companies.

Required:
(a) Explain the main steps involved in developing a target price and target cost for a product
in a typical manufacturing company. (6 marks)
(b) Explain four key characteristics that distinguish services from manufacturing. (4 marks)
(c) Describe how the Pari Trust is likely, in the current circumstances, to try to derive: (i) a
target cost for the services that it provides under the ‘payment by results’ scheme; and (2
marks) (ii) a target cost for transplants and heart operations. (2 marks)
(d) Discuss THREE of the particular difficulties that the Pari Trust may find in using target
costing in its service provision. (6 marks)

Question 4

Fit Co specialises in the manufacture of a small range of hi-tech products for the fitness market.
They are currently considering the development of a new type of fitness monitor, which would
be the first of its kind in the market. It would take one year to develop, with sales then
commencing at the beginning of the second year. The product is expected to have a life cycle
of two years, before it is replaced with a technologically superior product. The following cost
estimates have been made.
Year 1 Year 2 Year3

Units manufactured and sold 100,000 200,000

 Research and development costs $160,000
Product design costs $800,000
Marketing costs $1,200,000 $1,000,000 $1,750,000
Manufacturing costs: Variable cost per unit $40 $42
Fixed production costs $650,000 $1,290,000
Distribution costs: Variable cost per unit $4 $4·50
Fixed distribution costs $120,000 $120,000
Selling costs: Variable cost per unit $3 $3·20
Fixed selling costs $180,000 $180,000
Administration costs $200,000 $900,000 $1,500,000

Note: You should ignore the time value of money.

Required:
(a) Calculate the life cycle cost per unit. (6 marks)
(b) After preparing the cost estimates above, the company realises that it has not taken into
account the effect of the learning curve on the production process. The variable manufacturing
cost per unit above, of $40 in year 2 and $42 in year 3, includes a cost for 0·5 hours of labour.
The remainder of the variable manufacturing cost is not driven by labour hours. The year 2 cost
per hour for labour is $24 and the year 3 cost is $26 per hour. Subsequently, it has now been
estimated that, although the first unit is expected to take 0·5 hours, a learning curve of 95% is
expected to occur until the 100th unit has been completed.

Calculate the revised life cycle cost per unit, taking into account the effect of the learning curve.
Note: the value of the learning co-efficient, b, is –0·0740005. (10 marks)
(c) Discuss the benefits of life cycle costing. (4 marks)
(20 marks)

Question 5
Makudo Co manufactures webcams, devices which can provide live video and audio streams
via personal computers. It has recently been suffering from liquidity problems and hopes that
these will be eased by the launch of its new webcam, which has revolutionary audio sound and
visual quality. The webcam is expected to have a product life cycle of two years. Market
research has already been carried out to establish a target selling price and projected lifetime
sales volumes for the product. Cost estimates have also been prepared, based on the current
proposed product specification. Makudo Co uses life cycle costing to work out the target costs
for its products, believing it to be more accurate to use an average cost across the whole lifetime
of a product, rather than potentially different costs for different years. You are provided with
the following relevant information for the webcam:

Projected lifetime sales volume 50,000 units

Target selling price per unit $200
Target profit margin (35% selling price) $70
Target cost per unit $130
Estimated lifetime cost per unit (see note below for detailed breakdown) $160

Note: Estimated lifetime cost per unit:

$ $

Manufacturing costs Direct material (bought in parts)

40
Direct labour
26
Machine costs
21
Quality control costs
10
Rework costs 100
3
Non-manufacturing costs
Product development costs
25
 Marketing costs 60
35
Estimated lifetime cost per unit 160
The average market price for a webcam is currently
$150.
The company needs to close the cost gap of $30 between the target cost and the estimated
lifetime cost.
The following information has been identified as relevant:
1. Direct material cost: all of the parts currently proposed for the webcam are bespoke parts.
However, most of these can actually be replaced with standard parts costing 55% less.
However, three of the bespoke parts, which currently account for 20% of the estimated direct
material cost, cannot be replaced, although an alternative supplier charging 10% less has been
sourced for these parts.
2. Direct labour cost: the webcam uses 45 minutes of direct labour, which costs $34·67 per
hour. The use of more standard parts, however, will mean that whilst the first unit would still
be expected to take 45 minutes, there will now be an expected rate of learning of 90% (where
‘b’ = –0·152). This will end after the first 100 units have been completed.
3. Rework cost: this is the average rework cost per webcam and is based on an estimate of
15% of webcams requiring rework at a cost of $20 per rework. With the use of more standard
parts, the rate of reworks will fall to 10% and the cost of each rework will fall to $18.

Required:
(a) Recalculate the estimated lifetime cost per unit for the webcam after taking into account
points 1 to 3 above. (12 marks)
(b) Explain the ‘market skimming’ (also known as ‘price skimming’) pricing strategy and
discuss, as far as the information allows, whether this strategy may be more appropriate for
Makudo Co than charging one price throughout the webcam’s entire life. (8 marks)
(20 marks)

Question 6
Renco Ltd. manufactures a range of products, most of which have short product lifecycles.
Research and development staff recently designed three new products which would be
manufactured in a single production cell of the company’s factory. The combined monthly
manufacturing overhead costs of the three products are summarized as follows:

Production set-ups (10 per month) $2000

Materials movements (400 per month) $18000
Repairs (4000 per month) $30000
Total manufacturing overheads per month _50000

The following information is available concerning the three new products:

Product A Product B Product C
Production & sales, per month 2,000 units 5,000 units 1,000 units
Direct labour hours per unit 6 4 8

The company’s target costing task group expressed the view that the new products would not
be profitable given the likely market prices and the cost of manufacturing the products using
the proposed design. In response, the product designers indicated that no design changes were
possible in relation to Products A or B, but that changes in the design of Product C would bring
about the following reductions in the amount of monthly activity involved in manufacturing
that product without compromising either the quality or quantity of output:

Production set-ups Materials movements Repairs

2 per month 100 per month 1,000 per
month
REQUIRED:
(a) Calculate the reduction in the cost per unit of each of the three products which would
occur as a result of the design changes to Product C, in each of the following
circumstances:

 If manufacturing overheads are traced to products using activity-based costing (ABC);

 If manufacturing overheads are allocated to products on a direct labour hour basis.
(10 marks)
(b) Discuss the view that an ABC system is essential for the implementation of target costing,
using Renco Ltd. Case illustrate your answer.
(5 marks)
Question 7

Makudo ltd assembles three models of a bicycle at the same factory: the Kid Mountain, The
Lady Mountain and The Male Mountain, It sells the bicycles throughout the world. In response
to market pressures Makudo ltd has invested heavily in new manufacturing technology in
recent years and, as a result, has significantly reduced the size of its workforce.

Historically, the company has allocated all overhead costs using traditional total direct labour
hours, but is now considering introducing Activity Based Costing (ABC). Makudo ltd’s
accountant has produced the following analysis:

Annual output Annual direct Selling price Raw material

(units) labour hours ($ per unit) cost ($ per unit)

The Kid Mountain 2000 200 000 4000 400

The Lady Mountain 1600 220 000 6000 600
The Male Mountain 400 80 000 8 000 900
The three cost drivers that generate overheads are:

Deliveries to retailers – the number of deliveries of Bicycles to retail showrooms;

Set-ups – the number of times the assembly line process is re-set to accommodate a production
run of a different model of Bicycles;

Purchase orders – the number of purchase orders.

The annual cost driver volumes relating to each activity and for each model of motorcycle are
as follows:

Number of Number of set- Number of purchase

deliveries to retailers ups orders
The Kid Mountain 100 35 400
The Lady Mountain 80 40 300
The Male Mountain 70 25 100
The annual overhead costs relating to these activities are as follows:
 $000

Deliveries to retailers 2,400

Set-up costs 6,000

Purchase orders 3,600

All direct labour is paid at $5 per hour. The company holds no inventory.

Required:

(a) Calculate the total profit on each of Makudo Ltd.’s three models using the existing method
of allocating overheads based on labour hours. (5 marks)

(b) Recalculate the total profit on each of Makudo Ltd’s three models using activity based
costing. (10 marks)

(c) Evaluate the labour hours and the activity based costing methods in the circumstances of
Makudo Ltd (5 marks)

(20 marks)

Question 8

E and E Co produces three products, X, Y and Z, all made from the same material. Until now,
it has used traditional absorption costing using labour hours to allocate overheads to its
products.

The company is now considering an activity based costing system in the hope that it will
improve profitability. Information for the three products for the last year is as follows:

X Y Z
Production and sales volumes (units) 15000 12000 18000
Selling price per unit $ 7.50 12 13
Raw material usage (kg) per unit 2 3 4
Direct labour hours per unit 0.1 0.15 0.2
Machine hours per unit 0.5 0.7 0.9
Number of production runs per annum 16 12 8
Number of purchase orders per annum 24 28 42
 Number of deliveries to retailers per annum 48 30 62
The price for raw materials remained constant throughout the year at $1·20 per kg. Similarly,
the direct labour cost for the whole workforce was $14·80 per hour. The annual overhead costs
have been analyzed by activity as follows:

Machine set up costs 26,550

Machine running costs 66,400

Procurement costs 48,000

Delivery costs 54,320

Required:

(a) Calculate the full cost per unit for products A, B and C under traditional absorption costing,
using direct labour hours as the basis for apportionment. (5 marks)

(b) Calculate the full cost per unit of each product using activity based costing. (9 marks)

(c) Using the information given and your calculation from (a) and (b) above, explain how
activity based costing may help Gadget Co improve the profitability of each product. (6 marks)

(20 marks)

Question 9

Triple E Investments experience difficulty in its budgeting process because it finds it necessary
to qualify the learning effect as new products are introduced. Substantial product changes occur
and result in the need for retraining.
An order for 30 units of a new product has been received by Triple E Investments so far, 14
units have been completed: the first unit required 40 direct labour hours and a total of 240 direct
labour hours has been recorded for the 14units. The Production Manager expects an 80%
learning effect for this type of work.

The company uses standard absorption costing. The direct costs attributed to the centre in
which the unit is manufactured and its direct materials costs are as follows:
 $
Direct material 30.00
Direct labour 6.00
Variable overhead 0.50 per direct hour
Fixed overhead $6000 per four –week operating period.

There are ten (10) direct labour employees working a five day week, eight (8) hours per day.
Personal and other down time allowances account for 25% of total available time. The company
usually quotes a four –week delivery period for orders.

You are required to:

a) Determine whether the assumption of an 80% learning effect isMmmmmmm

a reasonable one in this case
by using the standard formula: Y = aXb

where:
Y = the cumulative average time (or cost) per unit.
X = the cumulative number of units produced.
a = time (or cost) required to produce the first unit.
b = slope of the function when plotted on log-log paper.
= log of the learning rate/log of 2. (5marks)

b) Calculate the number of direct labour hours likely to be required for an expected second
order of 20 units. (5marks)

c) Use the cost data given, to produce an estimated product cost for the initial order, Examine
the problems which may be created for budgeting by the presence of the learning effect
(8marks)

d) Factors such as peer pressure, union-imposed constraints, and the state of management-
worker relationships can affect productivity and limit learning. Discuss this statement with the
aid of examples. (7marks)

Question 10
A company wishes to determine the price it should charge a customer for a special order .The
customer has requested a quotation for 10machines but might subsequently place another order
for a further 10 .Material costs are $30 per machine. It is estimated that the first batch of 10
machines will take 100hours to manufacture and an 80% learning curve is expected to apply.
Labour plus variable overhead costs amount to $3 per hour. Set -up costs are $1000 regardless
of the number of machines made.

a) What is the minimum price the company should quote for the initial order if there is no
guarantee of further orders?
b) That is the minimum price for the following order?
c) What would be the minimum price if both orders were placed together?
d)Having completed the initial orders for the a total of 20 machines (price at the minimum
levels recommended in (a)and (b) the company thinks that there would be a ready market for
this type of machine if its unit selling price is brought to $45.
e) At this price, what would be the profit on the first (1) 140 mass production models (that is
after the first 20 machines) assuming that marketing costs totaled $250?

Question 11
Three E Plc produces microphones for mobile phones and operates a standard costing system.
Before production commenced, the standard labour time per batch for its latest microphone
was estimated to be 200 hours. The standard labour cost per hour is $12 and resource allocation
and cost data were therefore initially prepared on this basis. Production of the microphone
started in July and the number of batches assembled and sold each month was as follows:
Month No of batches assembled and sold
July 1
August 1
September 2
October 4
November 8

The first batch took 200 hours to make, as anticipated, but, during the first four months of
production, a learning effect of 88% was observed, although this finished at the end of October.
The learning formula is shown on the formula sheet and at the 88% learning rate the value of
b is –0·1844245. Three E Plc uses ‘cost plus’ pricing to establish selling prices for all its
products. Sales of its new microphone in the first five months have been disappointing. The
sales manager has blamed the production department for getting the labour cost so wrong, as
this, in turn, caused the price to be too high. The production manager has disclaimed all
responsibility, saying that, ‘as usual, the managing director prepared the budgets alone and
didn’t consult me and, had he bothered to do so, I would have told him that a learning curve
was expected.’

Required:
(a) Calculate the actual total monthly labour costs for producing the microphones for each of
the five months from July to November. (9 marks)
(b) Discuss the implications of the learning effect coming to an end for Three E Plc, with regard
to costing, budgeting and production. (4 marks)
(c) Discuss the potential advantages and disadvantages of involving senior staff at Three E Plc
in the budget setting process, rather than the managing director simply imposing the budgets
on them. (7 marks)
(20 marks

Question 12
Tsoko (pvt) experience difficulty in its budgeting process because it finds it necessary to
qualify the learning effect as new products are introduced. Substantial product changes occur
and result in the need for retraining.
An order for 30 units of a new product has been received by Tsoko (pvt so far, 14 units have
been completed: the first unit required 40 direct labour hours and a total of 240 direct labour
hours has been recorded for the 14units. The Production Manager expects an 80% learning
effect for this type of work.

The company uses standard absorption costing. The direct costs attributed to the centre in
which the unit is manufactured and its direct materials costs are as follows:
$
Direct material 20.00
Direct labour 5.00
Variable overhead 0.80 per direct hour
Fixed overhead $8000 per four –week operating period.
There are ten (12) direct labour employees working a six day week, eight (8) hours per day.
Personal and other down time allowances account for 20% of total available time. The company
usually quotes a four –week delivery period for orders.

You are required to:

a) Determine whether the assumption of an 80% learning effect is a reasonable one in this case
by using the standard formula: Y = axb

(5marks)

b) Calculate the number of direct labour hours likely to be required for an expected second
order of 20 units.

c) Use the cost data given, to produce an estimated product cost for the initial order, examine
the problems which may be created for budgeting by the presence of the learning effect

Makudo Ltd. is a divisionalised company. Each month the company’s Industrial Division
manufactures 600 tons of a product which it sells to external customers at a price of $20 per
ton. The fixed costs of the Industrial Division are $28 800 per month and the marginal costs of
production and sale amount to $9 per ton. An absorption costing system is used to work out a
‘full cost per ton’ on the basis of this level of cost and activity.

Another division of the company (the Consumer Division) buys 200 tons of a very similar
chemical component from an external supplier each month at a price of $15 per ton. However,
the Industrial Division has sufficient spare capacity to enable it to supply the monthly needs of
the Consumer Division. The transfer price which the Industrial Division would charge would
be the ‘full cost per ton’ as calculated on the basis of the increased level of output. The
Consumer Division has indicated that this transfer price would be acceptable.

REQUIRED:
(a) Calculate the transfer price proposed by the Industrial Division, and show that this transfers
pricing arrangement will motivate both divisions to act in a manner which is in the best interests
of Makudo Ltd. as a whole.
(7 marks)
(b) Assume now that the two divisions cannot agree on transfer pricing arrangements for the
200 tons. Specifically, the Industrial Division will not accept any price lower than $14,50 per
ton but the Consumer Division will not agree to pay any price higher than $9,50 per ton.

Discuss whether, in these circumstances, the board of directors of Makudo Ltd. should
intervene to order the divisions to make the transfer at the price calculated in your answer to
part (a). (9 marks)

(c) Assume now that the Consumer Division requires a further 50 tons per month (in addition
to the 200 tons), but that the Industrial Division has no additional spare capacity and therefore
these 50 tons could only be provided to the Consumer Division if the Industrial Division were
to reduce sales to its external customers by an equivalent amount.
Assume also that the marginal cost to the Industrial Division of supplying a ton to the Consumer
Division is $0, 30 lower than the cost of supplying a ton to an external customer. What is the
appropriate transfer price per ton for these 50 tons? Explain your answer.
(4 marks)
[Total: 25 marks]

Question 13

Mangwiro Ltd. manufactures advanced technical components for the computer hardware
industry. The company’s Uhuru Division manufactures a special subcomponent at a variable
cost of $70 per unit. This division’s maximum monthly production capacity is 2700 units, but
its actual production each month is 2500 units. Of this actual monthly production, 1500 units
are sold to external customers (at a price of $100 each) while the remaining 1000 units are
transferred to the company’s Chopa Division at the same price.

The Chopa Divisions’ maximum production capacity is 1350 units per month. However,
market demand for the division’s product is only 1000 units and therefore production is carried
out at this level. In producing one unit of its product, Chopa Division uses one unit of the
subcomponent purchased from Uhuru Division and incurs additional variable costs of $90 per
unit. The selling price of Chopa Division’s product is $200 per unit.
The Chopa Division recently received an enquiry from a new customer, who has offered to
purchase 300 units of that division’s product each month at a price of $185 per unit.
REQUIREMENT:

(a) Prepare calculations to indicate the increase in the monthly profits of Mangwiro Ltd., if the
new customer’s offer is accepted.
(7 marks)

(b) Prepare calculations to indicate whether the existing transfer pricing arrangements would
motivate each of the two divisions to cooperate in transferring the 300 subcomponents needed
in order to manufacture the new customer’s order. (6 marks)
(c) Identify the minimum transfer prices which would be acceptable to Uhuru Division and
identify the maximum transfer prices which would be acceptable to Chopa Division. Then,
suggest a transfer price per unit for the 300 subcomponents which would achieve the following:

_ the incremental profits from doing business with the new customer are to be shared equally
between the two divisions.
_ The same transfer price per unit is to apply to all units transferred.
(7 marks)

Question 14
Rungano Ltd. manufactures a wide range of specialized electrical products. The company is
structured along divisional lines.
“Division X” manufactures a specialized motor. Monthly production is 3000 units and the
marginal cost of production is $140 per unit. Half of all output is sold to external customers at
a price of $200 per unit. The remaining output is sold within Rungano Ltd. to “Division Y”.
In accordance with the company’s rules, these internal transfers are made at the same price per
unit as sales to external customers (i.e. $200).
“Division Y” uses the motor as a component in the manufacture of an industrial heater, which
is sold to external customers at a price of $350 per unit. (One motor is required for each heater).
“Division Y” incurs a marginal cost of $100 per unit, in addition to the transfer price paid for
the motor.
A potential new customer (Kwangu Ltd.) has offered to purchase 750 units per month of the
industrial heater from “Division y” at a special contract price of $275 each. “Division Y” has
sufficient spare production capacity to produce these additional heaters.
REQUIRED:
(a) Assume that “Division X” has sufficient spare production capacity to enable it to produce
the additional motors required by “Division Y” to enable it to fulfill the Kwangu Ltd. contract.
In these circumstances, explain:
i) Whether it would be in the best interests of Rungano Ltd. to accept the Kwangu Ltd. contract,
and
ii) Whether the existing transfer pricing arrangements motivate the division managers to take
the decisions which are in the best interests of Rungano Ltd. as a whole.
(10 marks)

(b) Now assume that “Division X” has no spare production capacity. If “Division X” were to
produce the additional motors required by “Division Y” to enable it to fulfill the Kwangu Ltd.
contract, then “Division X” would reduce its sales of motors to external customers.
Explain how your answer to part (a) would differ in these circumstances.
(7 marks)

(c) Critically evaluate the transfer pricing arrangements in Rungano Ltd., using your answers
to parts (a) and (b) to illustrate your answer.
(8marks)

(Total 25marks)

Question 15

Bamaco Company is a company specializing in the manufacture and sale of kitchen sink. Each
sink consist of a main unit plus a set of kitchen fittings. The company is split into two divisions
C and D. Division C manufactures the sink and Division D manufactures set of kitchen fittings.
Currently, all of Division C’s sales are made externally. Division D, however, sells to Division
C as well as to external customers. Both of the divisions are profit centers.

The following data is available for both divisions.

Division C
Current selling price for each sink $450.00
Cost per sink
Fittings from Division C $75.00
Other materials from external suppliers $200.00
Labour costs $45.00
Annual fixed overheads $7 440 000
Annual production on sales of sink (units) 80 000
Maximum annual market demand for sink (units) 80 000

Division C
Current external selling price per set of fittings $80
Current price for sales to Division A $75

Costs per set of fittings:

Materials $5
Labour costs $15
Annual fixed overheads $4 400 000
Maximum annual production on sales of set of fitting (units) (including 200 000
Internal and External sales)
Maximum annual external demand for sets of Fittings (units) 180 000
Maximum annual internal demand for sets of fittings (units) 80 000

The transfer price charged by Division D to Division C was negotiated some years ago between
the previous divisional managers, who have now both been replaced by new managers. Head
Office only allows Division C to purchase its fittings from Division D, although the new
manager of Division C believes that he could obtains fittings of the same quality and
appearance for $65 per set. If he was given autonomy to purchase from outside the company,
Division D makes no cost savings from supplying internally to Division C rather than selling
externally.

Required
1. Under the current transfer pricing system, prepare a profit statement showing the profit for
each of the divisions and for Bamco Company as whole. Your sales and costs figures should
be split into external sales and inter-divisional transfers, where appropriate. [6 marks].

1. Head office is considering changing the transfer pricing policy to ensure maximization
of company profits without demotivating either of the divisional managers. Division C
will be given autonomy to buy from external suppliers and Division D to supply
external customers in priority to supplying to Division C. [6 marks]

Calculate the maximum profit that could be earned by Bamco Company if transfer pricing is
optimized.[8 marks]

2. Discuss the issues of encouraging divisional managers to take decisions in the interest
of the company as a whole, where transfer pricing is used. Provide a reasoned
recommendation of a policy Bamco Company should adopt. [6 marks]

Question 16

E and E investments consists of several stand alone divisions, including "Potato-Division" and
"Maize Division". Each month "Potato-Division" purchases 50,000 kilograms of a chemical
product ("Fertiliser") from an outside supplier at a price of $7.80 per kilogram. "Potato-
Division" uses the Fertiliser as a raw material in the production of one of its products.

E and E investment’s managing director is aware that "Maize-Division" manufactures

"Fertiliser" for sale to external customers.
The following is a summary of the typical monthly activities of "Maize-Division":

Production and sales selling price Marginal cost Fixed costs to external
(=variablecost) Customers ]
$9 per kg. $6 per kg. $120,000 per month 200,000 kg.

The managing director believes that it might benefit the company as a whole if "Maize-
Division" were to sell some output to "Potato-Division", thus reducing the amount which
"Potato-Division" would need to purchase from its outside supplier. He has asked the two
division managers to try to agree possible transfer pricing arrangements.
REQUIRED:
N.B.: Answer each of the following three requirements separately.
(a) If the maximum monthly capacity of "Maize-Division" is 200,000 kg., will the two divisions
be able to agree on a transfer price? Is this outcome in the best interests of E and E investments
as a whole? Explain your answer fully.
(6 marks)

(b) Assume now that the maximum capacity of "Potato-Division" is 260,000 kg. Per month but
that demand from external customers is just 200,000 kg per month.
· Discuss whether, in this situation, it will be possible for the two divisions to agree on a transfer
price.
· If the two divisions can agree on a transfer price, by how much will the monthly profits of E
and E investments as a whole be increased? (8 marks)
(c) Assume now that the maximum capacity of "Maize-Division" is 220,000 kg per month but
that demand from external customers is just 200,000 kg per month.
In this situation, suggest a transfer pricing arrangement which would increase the profits of
each of the two divisions and would be optimal for E and E investments as a whole. Support
your answer with appropriate calculations and explanations.
(6 marks)
d) Discuss the variants of costing method as a transfer price giving examples in each case.
(5marks)
Total marks 25MARKS

Question 17

Makudo ltd has a production capacity of 12000 batches of paper per month. Costs are $17 per
batch (variable) and $60000 per month (fixed). At present all sales are made to unconnected
third-party customers at a price of $30 per batch.
The Director has noticed that another of Makudo ltd’s subsidiaries Tsoko purchases 2000
batches of paper each month for its newspaper printing business from an unconnected local
supplier. Tsoko’s reason for buying from its local supplier rather than from Makudo ltd is that
the local supplier charges a much lower price ($24 per batch).
The Director suspects that the Makudo ltd and Tsoko operations may each be trying to
maximise its own profits rather than acting in the best interests of Mhuka Ltd. as a whole. He
has decided that the possibility of Tsoko obtaining its monthly paper needs through transfers
from Makudo ltd (rather than continuing to buy from its local supplier) should be actively
considered.
REQUIRED:
(a) Assume that Makudo can sell 12000 batches per month to unconnected third-party
customers. In these circumstances:
i) Explain whether Makudo and Tsoko will be able to voluntarily agree on a transfer price, and
whether this situation is in the best interests of Mhuka Ltd. as a whole. (4 marks)
ii) If Makudo were to agree to make transfers to Tsoko at the price charged by the latter’s local
supplier, what would be the effect on the profits of Makudo, Tsoko, and Mhuka Ltd. as a
whole? (3 marks)
(b) Now assume that, because of limited market demand, Makudo can sell only 8500 batches
per month to unconnected third-party customers. In these circumstances:
i) Discuss whether Makudo and Tsoko will be able to voluntarily agree on a transfer price.
(4 marks)
ii) If Tsoko’s local supplier were to reduce its price to $20 per batch, should Makudo agree to
reduce the transfer price to the same figure? Consider this question from the viewpoints of
Tsoko, Makudo, and Mhuka Ltd. as a whole. (3 marks)
iii) Following a refusal by Tsoko to agree to transfers at the $20 price, The Director is
considering the possibility of issuing a directive that Tsoko must purchase its monthly paper
requirements from Makudo at $30 transfer price. Advise The Director as to the merits (or
otherwise) of this proposal.(5marks/)

Question 18

At the request of Makondo, Shiri ltd recently purchased 100% of the share capital of Marko
Ltd. This request was made to ensure a steady supply of Cotton wool jackets to Makondo in
Kadoma, where they are an extremely popular item, but Shiri has no plans to sell the jackets in
Chinhoyi.
Following the acquisition, Marko Ltd. retained its existing profit centre structure. Division A
manufactures lengths of wool and operates at its full capacity of 6,000 lengths per month. Of
this amount, 25% is sold to Division B (which produces one Cotton wool jacket from each
length of wool) and the other 75% is sold to other Chinhoyi Cotton wool garment
manufacturers. Variable costs in Division A are $24 per length, and variable costs in Division
B are $28 per jacket (plus the transfer price paid to Division A for the length of cotton wool).
Fixed costs per month are $30,000 in Division A and $25,000 per month in Division B.
Division B sells all of its output to Makondo for $80 per jacket. At present it purchases all of
its lengths of wool from Division A, but it has recently been approached by an external supplier
which has offered to supply lengths of cotton wool of the same quality at a price of $44 each.
Division A has been approached by another garment manufacturer which has offered to
purchase (under a long-term supply arrangement) the 1,500 lengths of wool which are at
present sold to Division B. The price offered by this garment manufacturer is $50 per length,
although the manager of Division A estimates that the incremental cost of transporting these
lengths of tweed to the garment manufacturer would be $10 each (payable by Division A).

REQUIRED:
(a) In terms of maximising Makondo’s Wool monthly profits, is it preferable that Division B
should continue to source its lengths of wool from Division A? Explain your answer fully.
(4 marks)
(b) Calculate the “optimal transfer price” and show that this will motivate the two Division
Managers to engage in behaviour which is goal congruent from Makondo’s point of view.
(5 marks)
(c) Assume that the price which you calculated in part (b) is used for transfers between the two
divisions. Show how much of the net profit (after deduction of fixed costs) from the sale of
1,500 jackets would be included in each division’s monthly performance report.
(6 marks)
(d) Comment on whether the results in your answer to part (c) provide a fair reflection of the
performance of each division, and respond to the suggestion that Division B should be closed
down. (6 marks)
[Total: 20

The budget serves as a vehicle through which actions of different parts of an organization
Nhongo Ltd. is a divisionalised company. Each month the company’s Chemicals Division
manufactures 6000 tons of a product which it sells to external customers at a price of _$200
per ton. The fixed costs of the Chemicals Division are _$288 000 per month and the marginal
costs of production and sale amount to $90 per ton. An absorption costing system is used to
work out a ‘full cost per ton’ on the basis of this level of cost and activity.
Another division of the company (the Detergents Division) buys 2000 tons of a very similar
chemical from an external supplier each month at a price of _$150 per ton. However, the
Chemicals Division has sufficient spare capacity to enable it to supply the monthly needs of
the Detergents Division. The transfer price which the Chemicals Division would charge would
be the ‘full cost per ton’ as calculated on the basis of the increased level of output. The
Detergents Division has indicated that this transfer price would be acceptable.

REQUIRED:
(a) Calculate the transfer price proposed by the Chemicals Division, and show that this transfers
pricing arrangement will motivate both divisions to act in a manner which is in the best interests
of Nhongo Ltd. as a whole.
(7 marks)

(b) Assume now that the two divisions cannot agree on transfer pricing arrangements for the
2000 tons. Specifically, the Chemicals Division will not accept any price lower than _$145 per
ton but the Detergents Division will not agree to pay any price higher than $95 per ton.

Discuss whether, in these circumstances, the board of directors of Nhongo Ltd. should
intervene to order the divisions to make the transfer at the price calculated in your answer to
part (a). (9 marks)

(c) Assume now that the Detergents Division requires a further 500 tons per month (in addition
to the 2000 tons), but that the Chemicals Division has no additional spare capacity and therefore
these 500 tons could only be provided to the Detergents Division if the Chemicals Division
were to reduce sales to its external customers by an equivalent amount.

Assume also that the marginal cost to the Chemicals Division of supplying a ton to the
Detergents Division is $3 lower than the cost of supplying a ton to an external customer.
What is the appropriate transfer price per ton for these 500 tons? Explain your answer.
(4 marks)
[Total: 25 marks]
Question 19

E and E Investments manufactures product pipe. At the moment, when customers complain
that there is one or more defects in the product they have bought, the company repairs the
product, at its own cost. Management is now considering a new policy , whereby the company
will accept no liability at all for any defects in the product , but will reduce the sales price by
$6.00 per unit.

 The estimates of defects in each product, and cost of repairs each defect, have been
estimated from historical records as follows:

 Number of defects probability cost probability

per product of repairs

0 0.99 20 .20

1 0.007 30 .50

2 0.002 40 . 30

3 0.001 -

The company makes and sells 10000units of product pipe each month. Would it be cheaper to
continue repairing faulty products, or would it be more profitable to reduce the sales price by
$6.00 per unit for all units of the product?

Pay off Table

A profit table (pay-off table) can be a useful way to represent and analyse a scenario where
there is a range of possible outcomes and a variety of possible responses. A pay off table simply
illustrates all possible profits/ losses and as such is often used in decision making under
uncertainty.

Example
Mamie runs a kitchen that provides food for various canteens throughout a large organisation.
A particular salad is sold to the canteen for $10.00 and costs $8.00 to prepare. The contribution
per salad in this case is $2.00. Based upon past demands, it is expected that during the 250day
working year, the canteens will require the following daily quantities:

 On 25days of the year 40 salads

 On 50days of the year 50 salads
 On 100days of the year 60salads
 On 75days 70 salads.
The kitchen must prepare the salads in batches of 10 meals in advance. The manager has asked
you to help decide how many salads the kitchen should supply for each of the fourth coming
year.

Constructing a Payoff able

If 40 salads will be required on 25days of the 250day year the probability that demand is
40salads can be represented as:

Probability of 40salads is = P (Demand of 40) = 25days /250 =0.1 likewise:

P(demand 50) = 0.20

P(demand 60) = 0.40

P(demand 70) = 0.30

Different Profit values

For example if 40 salads are supplied and all are sold, our profit amount to 40 *$2.00
contribution =$80.00.

If however we supply 50 salads and 40 are sold out profit is 40*2 =80-(10 unsold salads *$8unit
cost) =80 contribution – 80 cost ($8*10) =0.

The full table can be as follows:

Daily Probability 40 50 60 70
supply
 Daily 40 0,1 80 0 (80) (160)
demand
50 0,20 80 100 20 (60)
60 0,40 80 100 120 40
70 0,30 80 100 120 140

Decision making

This involves making a choice out of the many available alternatives. Decision making under
uncertainty may fall under three categories namely:

Maximax

The maxi max rule involves selecting the alternative that maximises the maximum payoff
available. This approach would be suitable for an optimist or risk seeking investor who seeks
to achieve the best results if the best happens. The manager who employs the maxi max
criterion is assuming that whatever action is taken, the best will happen: he/she is a risk taker.
So how many salads should Mamie decide to supply?

From the payoff table the highest maximum possible pay-off is $140. This means 70 salads can
be supplied every day.

Maxi min

The maximin rule involves selecting the alternative that maximises the minimum pay-off
achievable. The investor would at the worst possible outcome at each supply level, and then
selects the highest one of these. The decision maker therefore chooses the outcome which is
guaranteed to minimise his losses. In the process, he loses out on the opportunity of making
big profits. This approach would be appropriate for a pessimistic who seeks to achieve the best
results if the worst happens. So, how many salads will Mamie decide to supply?

From the payoff table:

If 40 salads are supplied minimum payoff is $80.00

50 salads are supplied minimum payoff is $0.00

60 salads are supplied minimum payoff is ($80.00)

 70 salads are supplied minimum payoff is ($160).

The highest minimum payoff arises from supplying 40 salads. This ensures that the worst
possible scenario still results in a gain of at least $80.00

Mini max regret

This is the decision that minimises the maximum regret. It is useful for a risk –neutral decision
maker. This is the technique for a risk neutral decision maker. This is the technique for a “sore
loser” who does not wish to make the wrong decision. Regret is defined as the opportunity loss
through having made the wrong decision. To solve this table showing the size of regret needs
to be constructed. This means we need to find the biggest payoff for each demand row then
subtract all other numbers in this row from the largest number.

For example, if the demand is 40 salads, we will make a maximum profit of $80.00 if they sell.
If we had decided to supply 50 salads we would achieve a nil profit. The difference or regret
between that nil profit and the maximum of $80 achievable is $80.00.

The minimax regret criterion focuses on avoiding the worst possible consequences that could
result when making a decision. It views actual losses and missed apportunities as equally
comparable.

Regert can be tabled as follows:

Daily supply
(salads) 40 50 60 70
Daily 40 0 80 160 240
demand
50 20 0 80 160
60 40 20 0 80
70 60 40 20 0

The maximum regrets for each choice are thus as follows (reading down the column)
If supply is 40 salads the maximum regret is $60.00

50 salads the maximum regret is $80.00

60 salads the maximum regret is $160.00

70 salads the maximum regret is $240.00

A manager employing the minimax regret criterion would wait to minimize that maximum
regret, and therefore supply 40 salads only.

Question 20

Fanago Manufacturing PLC is a divisionalised company. Maguire is the manager of the

Company’s Textiles Division and he is considering the introduction of a new product line. This
would require an immediate investment of $100000 in new fixed assets plus $50000 in
additional working capital.
The fixed assets would have a useful life of four years, and the product line would be
discontinued at the end of that time.
During each of the four years, 15000 units of the product would be produced and sold at a price
of $18 each. Variable costs of production would be $12 per unit and fixed costs (other than
depreciation) would amount to $50000 per annum. It is believed that a cash sum of $20000
would be received when the fixed assets are sold for scrap at the end of their four year life.
However, in accordance with the company’s standard accounting practices, the full purchase
cost of the fixed assets would be depreciated on a straight-line basis over their useful life (i.e.
a zero residual value would be assumed in the calculation of the annual depreciation charge).
The working capital investment would be recovered in full at the end of the projects life.

The performance of the Textiles Division is measured each year on the basis of Return on
Investment (ROI).
For this purpose, profit is defined to include any gains or losses on fixed asset disposals and
the investment base is defined as working capital investment plus the net book value of fixed
assets at the beginning of the year.
Maguire is paid a bonus each year which is linked to the extent by which his divisions actual
ROI exceeds the divisions required (or target) ROI. The required rate of return for the Textiles
Division is 10% per annum, and this is also the divisions cost of capital. Maguire’s own
financial forecasts indicate that (in the absence of the proposed investment in the new product
line) the Textiles Division will earn a ROI of 15% per annum for the next five years.
Maquire plans to leave his current employment within the next two to three years and set up in
business as a consultant to manufacturing companies who could benefit from his experience
and advice.
REQUIREMENT:
(a) Calculate the ROI of the proposed investment in each of the next four years. Then, explain
whether or not Maguire is likely to accept this proposed investment, assuming that he acts to
maximize his own self interest.
(10 marks)
(b) Calculate the net present value of the proposed investment.
(4 marks)
(c) The use of ROI as a performance measure does not necessarily ensure that a division
manager will take decisions which are in shareholders’ best interests. Give three examples of
why this so, using the case of Fanago Manufacturing PLC to illustrate.
(6 marks)
[Total: 20 marks]
Question 21
Sunset PLC, a large multinational company, is undertaking a review of its organizational
structure. Top management is concerned that the methods used for divisional performance
evaluation and transfer pricing may be encouraging dysfunctional behaviour by division
managers.
The following sample data is available concerning two of the company’s divisions for last year:
Beverages Hardware
Operating profit $15 200 $7 200
Capital invested $160 000 $57 600

The cost of capital is 7% for both divisions. It can be assumed that there are no intra company
transfers between Divisions B and H.

REQUIRED:
(a) Calculate the Return on Investment (ROI) and residual income for each division. Explain
which of these two measures (ROI or residual income) gives the clearer indication of divisional
contribution to the overall success of Sunset PLC.
(6 marks)
(b) Assume that ROI is used for divisional performance evaluation purposes. How would each
of the two division managers react to an additional investment opportunity which would
increase operating profit by $2300 but would require capital investment of $22 000? Are their
reactions in the best interests of the company’s shareholders? Justify your answer. (6 marks)
(c) At what cost of capital would the two divisions have the same residual income? (In
answering this part, ignore the additional investment opportunity in part (b) above). (6 marks)
(d) Although there are no intra-company transfers between Divisions B and H, there are a
significant number of intra-company transfers between other divisions of Sunset PLC. Discuss
the circumstances in which it is feasible and appropriate to use external market prices as the
basis for setting transfer prices in such cases. (7 marks)
[Total: 25 marks]

QUESTION 22

You have recently been appointed as an assistant management accountant in large company,
Delta Beverages. When you meet the production manager, you overhear him speaking to one
of his staff, saying: “Budgeting is a waste of time. I don’t see the point of it. It tells us what we
can’t afford but it doesn’t keep us from buying it. It simply makes us invent new ways of
manipulating figures. If all levels of management aren’t involved in the setting of the budget,
they might as well not bother preparing one.

Required

3. Identify and explain six objectives of a budgeting control system. [13 marks]

4. Discuss the concept of a participative style of budgeting in terms of the six objectives
identified in past (a). [12 marks]