P2 Notes

Greater the cost differentiations, the better ABC will be.

Residual income method does not enables simple comparison between different investment
centres. It is an absolute measure, so comparisons between different investment centres of
different sizes may be misleading. RI and ROI both suffer from the same problems of
determining capital employed. The profit figures used in both measures may be subject to
manipulation.

Dual pricing system, the transfer price is set at variable cost for the purposes of the transfer
and is set at total cost for the purposes of reporting results.

The manager of a profit centre must have control over fixed operational costs.

Directors can prolong the introduction phase of aproducts life cycle by lowering its price so
that it is cheaper than the price that competitors are expected to charge., The directors can
prolong the introduction phase of the products life cycle by maintaining its price but
introducing new features that competitors products will not have. T he maturity stage is the
best time to make short-term one-off offers.

What is the tax saving or charge in relation to the investment in year 5: The correct answer
is: $15000

The simple payback method does not take into account the time value of money and it does
not consider cashflows over the investments lifetime. It is a measure of time, not cash flow
amounts.The correct answer is: It is based on cash flows, not profits, It is a helpful guide if
the company is looking for rapid cash inflows from new investments.
Under product bundling, the principal product is sold at a low price, the extras at a high price.

In making comparisons between the performance of two divisions based in different

countries it may be difficult to establish realistic local standards for each country.
Just in time: Small, frequent deliveries against bulk order supply contracts with few
suppliers, Continual products & processes simplification. Felxible workers.

In balanced scorecard Quality team participation is innovation & learning perspective.

A process of incremental budgeting, involving preparing budgets from scratch, will help
eliminate slack. This is a description of zero-based budgeting, not incremental budgeting.
Incremental budgeting encourages slack by basing the budget on the previous budget plus
an increment.

Minimax regret means minimising the maximum regret from choosing wrongly and the
choice made may not be the choice that maximises the minimum achievable profit. A
risk-averse investor may choose the highest risk option if it has a high enough return, a
risk-neutral investor may choose it if it has the highest expected value, which is the key
information required to determine a risk-neutral investors choice.

BN has a specialist components division that manufactures electronic components as well

as a products division that manufactures a range of electronic goods.
The specialist components division sells components to external customers and to the
product division. It typically sells components for $12.00. It incurs a variable manufacturing
cost of $4.00 and a shipping charge of $2.80 on external sales and $1.10 on sales to the
products division. The products division can buy elements from external suppliers for $10.50.
Currently the specialist components department has no spare capacity, but its managers are
anticipating a fall in demand. The correct answer is: Both divisions are likely to prefer to
trade internally because internal delivery charges are lower than external delivery charges.,
The minimum transfer price that will satisfy the specialist components division is $10.30.,
There is a range of prices within which a transfer price can be set that will satisfy both
divisions., If the specialist components department did have spare capacity, the best transfer
price from the companys viewpoint would be marginal cost.

As a non-financial performance, Customer visits = marketing performance measure.

Machine maintenance, which is an example of a unit-level cost.

Inventory storage costs, Inventory financing costs, Labour storage area costs, Purchase
price of the good are indirect costs that would be included in direct product profitability
analysis. Costs of special orders from customers are part of customer profitability analysis.

Quality control investigation of poor output = internal failure costs.

Set-up of quality control equipment = Appraisal costs.
Quality audits = appraisal.

New systems should free up staff from routine tasks & allow closer relationships with other
stakeholders.
Discounted payback period will increase (ie get longer), if the companys cost of capital
increases.

EVA: development costs incurred at end of current year means not depreciated in current
year and should be added in their entirety to profits and non-current assets figures.
EVA:

Training for quality staff = prevention cost.

Discounted payback method of investment appraisal does

not tell you what to decide by itself, it needs to be compared with the
pre-determined acceptable payback period.

IRR is not an absolute measure, but this is considered a disadvantage. The

results it gives will NOT be consistent with the results that the NPV method
gives therefore decisions indicated by NPV and IRR may conflict.

An investment centre can be defined as a centre in which inputs are

measured in terms of expenditure and outputs are measured in
terms of revenue, the excess of revenue over expenditure then being
related to assets.

In terms of balanced scorecard perspective: Length of time tutors are

employed by the organisation = learning & growth.
Attendance levels at new training courses = customer.
Attendance by tutors at professional development courses = learning &
growth.

To assist the introduction of beyond budgeting, There needs to be clear

definition of management responsibilities, but within that framework
managers need to have the freedom to make decisions. Management
targets should be linked to shareholder value. Front line teams being
responsible for relationships with customers and suppliers, Strong total
quality management programme.

The cost of the item on the external market is a market-based system. The
buying divisions purchasing cost has to be established by a particular cost
method.

Materials requirement planning (MRP1) A system that converts a

production schedule into a listing of the materials and components required
to meet that schedule, so that adequate inventory levels are maintained
and items are available when needed.
Enterprise resource planning = An accounting-oriented information system
which aids in identifying and planning the resources over the whole
organisation needed to resource, make, account for and deliver customer
orders .

An advantage of using market value as the basis for transfer pricing is fair
to the managers of the selling division, since it gives them the autonomy to
make decisions that are in their divisions best interests NOT an incentive
to use up spare capacity. An incremental price may be a better incentive to
use spare capacity.

The amount of risk that an organisation can bear is a definition of risk

capacity.

The following would be included in the calculation of controllable profits by

a subsidiary: Divisional fixed costs, Profits on sale of non-current assets,
Sales to other divisions. HOWEVER Head office will determine the
allocation of its fixed costs so this is not calculated as controllable and the
dividend paid to the parent will be decided by the parent.

If question says divisions are treated as investment centres then profit is

after apportioned central costs, for ROI.
When assessing the profit figure that would most influence the decision of a
risk-seeking investor, use the best (non-EVd) outcome for the revenue and
cost figures.

Labour hours worked is a non-financial performance measure.

Profitability index method of investment selection can only be used if the

projects are divisible. It assumes complete certainty about the outcome
of investments, so that risk is ignored.

Head office salaries could be an indicator under the internal business

perspective, as could the time taken to claim back tax.

Value Analysis: car acceleration = use. Petrol Consumption = use.

Controllable divisional profit includes sales to other divisions.

Ratios advantages as performance measure: can compare performance

over time; can be sued to related different items in account to each other;
can be used as performance target CAN NOT be used to compare gross
levels of profit.

When comparing companies return on capital allowances should be made

for items that aree obviously different due to systemic/ fundamental
differences in business (eg see ques 183).

[Apparently] benchmarking CAN be used to overcome resistance to

change.

Market skimming pricing: suitable for short life-cycle products, eg smart

phones, to quickly get big profits before next generation of phone arrives.

For annuities including inflation: work out real rate, then divide annual sum
required by real rate.

For PV of annuities starting in n years time: (annuity / cost of capital %) *

n-1 DF
Shareholder rejection of alternate project = NOT OPPORTUNITY cost

The rejection of a project with a positive net present value because of

funding constraints = opportunity cost. NOT The rejection of a project with a
higher positive net present value because it has been decided to invest the available funds
in a different project.

A disadvantage of capital spending limits = shareholders unhappy that too

few investments made.

IRR considers time-value of money; easy to use (although not so easy to

understand); looks at entire project; DOES NOT tell whether to accept/
reject therefore cannot be used to choose between projects. Does not
measure increase in shareholder wealth.

Do not use IRR to rank mutually exclusive projects as IRR makes the
assumption that any cash flows released during the life of an investment
project will be reinvested at the IRR which distorts results. Net present
value (NPV) is better as it makes the more realistic assumption that any
cash flows released during the life of an investment project will be
reinvested at the required rate of return.

Beyond budgeting = There will be less scope for budget slack. But can decrease
coordination.

NOV of cash flows in perpetuity from year n: (Investment) + NPV of inflows

in yrs prior to yr n + (cash flows in yr n 1/cost of capital DF @ n yrs)

Lifecycle costing: allocates development costs to individual products. But

does NOT assess costs on an accounting period basis.

Value analysis: Prestige ownership = esteem value.

Value analysis vs functional costing analysis: VA generally production
processes, aiming to reduce costs without losing value [can still focus on
quality though]. FCA = prior to production with focus on increasing profits
cia product features that customers prepared to pay for. Therefore VA =
cost reduction FCA = value ot customer.

Value analysis = cost value; exchange value (price); use value (function/
purpose); Esteem value (prestige).

Customer profitability analysis: rank products by customer specific costs

only (ie not general costs like admin O/Hs) and no need to divide by units
sold of each item; they should be ranked by total profit).

Learning curve = occurs with new; complex; labour intensive products

produced with continuous production.

In porters value chain, quality management activities are support function.

Value activities focus = external to organisation. Activities are
interdependent. Value chain = one of a number of value chains that make
up a value system.

Optimised production technology = related to throughput accounting. Aim is

to maximise throughput while simultaneously maintaining or decreasing
inventory & operating costs.

Manufacturing resources planning (MRPII): A system that converst a

production shecdule into a listing of materials and components required to
meet the schedule so that items are available when needed. IS integrated.

Manufacturing Requirements Planning (MRPI) NOT integrated.

Computer Integrated manufacturing (CIM) = advanced technology and

quality control into single, computerised coherent system.

Enterprise Resource Planning (ERP) are often accounting orientated and

aid in identifying planning resource allocation.

Benefits from an improved information system are often intangible.

Just in Time: Machines should be grouped by product or component
instead of by type of work performed [think flexibility].

Backflush accounting: At trigger point of sale: Dr Cost of Goods Sold

account: i) Difference between conversion costs incurred vs conversion
costs allocated. ii) Finished goods sold.

Backflush accounting may require complex production controls to keep

production costs to a minimum.

Risk management: greater upside risk in safer/ more stable country

[maybe w/ more compliance challenges], where doing business is also
likely to be in public interest.

Relevance > precision with good information.

Big data problems = ownership; too present/past focused, not future

focused enough.

In attainable vs target cost questions: answers only positive.

Backflush accounting: costs attached when output completed or sold. NOT

reflect flow of work through production process.

JIT manufacturing costs may increase for some procurement and

production tasks not really for sales and distribution.

In TQM environment: the purchase of quality control equipment =

prevention cost. Goods inwards inspection = appraisal.

Total time for nth batch = (time for 1st batch n n LearningIndex) (time
for 1st batch n-1 n-1 LearningIndex)

To calculate Learning Rate: total time for nth unit/ n = average time for unit
@ nth level of production = time for 1st unit LRy [y = number of times
doubled to get to that number of batches/ units]

Learning Index = (log LR) / (log2) [LR as % figure eg 0.85]

Profitability index = NPV / Initial Investment

Optimum replacement cycle = NPV/ annuity factor [which is CDF]

A project's equivalent annual cost = NPV/ annuity factor [which is CDF]

MIRR = investment (1 + MIRR)n = terminal value [which is PV of cash

flows but does not include initial investment]
MIRR = (n (terminal value/ initial investment)) - 1 OR find via DF
table

Accounting rate of return = average annual profit / average investment

average profits = net inflows (ie not incl scrap) less depn (ie investement -
scrap value) divided by number of years
Average investment = investment + resale value / 2
Note: read question to determine whether residual value within final years
cash flow figure (as this will be excluded from av profit e.g. increase in
cash flow vs post tax cash flow).

Return on Investment (ROI) = profit [always before interest and tax. Before
head office allocations most of the time, but this could be included for
divisions] / investment [less depn]

Residual Income = Profit - (investment cost of capital)

Asset turnover ratio [not a % figure] = turnover / [average] capital

employed

[note: w/ profit margin calculation no need to add back interest to profits,

this is only for ROI)

Economic Value Added (EVA):

Provision for bad debts: Add original to profit add increased ammount to
asset
Interest payable: Add for profit only
Development Costs: Add for both
Development Costs Depreciated: Remove for both
Advertising: Add for both
Old Depn: Add for profit
New Depn: Remove for profit (and for assets only if ques specifies that not
yet depd)
Leasing Charges: Add for both

Note: watch out for if it says investment figure already adjusted.

Note: If assets have impairment review ignore this as it will be taken into
account by depn & replacement value.

Standard deviation: (x- EV)2P

For investment cost of capital % change sensitivity analysis: Find IRR then IRRa% - 1
turn to %

For sensitivity of profit to change in Learning Rate: (actual LR - expected LR) expected
learning rate

For changes in selling price [sensitivity analysis] when profit is post tax: sales price figures
need to be adjusted to be post tax.

For sensitivity analysis of change in the annual sales volume: only volume related revenue
and cost figures need to be used (ie not fixed costs). So effectively this means NPV / PV of
contribution cash flows

An insurance company deciding which risks to accept for insurance = minimax regret.

When assessing a risk averse investors choices, the NPV more important than standard
deviation.

Transfer Pricing: dysfunctional behaviour = Divisions going external when there is capacity
for transfer, because the selling division wanted a higher price than a competitor is charging.
This is dysfunctional because the money paid to the external company is an extra cost to the
that did not need to be spent. If the spare capacity had been used then there would have
been no extra cost. The dysfunctional behaviour arises from the division providing good/
service focusing solely on their own divisions revenue performance which, in this case, is
detrimental to the business as a whole.
It would not be dysfunctional for the seller to offer a transfer price between marginal cost and
external market price.

When there are delivery savings it is better for the company to transfer internally. Buying
division will be prepared to accept a transfer less than external price. If seller has sufficient
capacity, theyll be prepared to transfer at any price greater than marginal cost as this will
increase their profits. Not the case if they are at full capacity as they will be forgoing higher
contribution from external market.

[Good probability PV question to practice: C, a ferry company, is considering leasing a car ferry to service a new route. The
project will run for three years.

This initial setup costs are $150,000 if C uses ferry X. Alternatively, C could pay more to secure the use of ferry Y.

The annual total running and leasing costs will be $300,000 for either ferry.
Ticket sales are difficult to predict, but C believes that the first year's ticket sales would be replicated in each of second and
third years. Annual sales will be $250,000 or $750,000, with each possibility being equally likely.
The project will be abandoned in the event that the first year's sales are $250,000.
If C leases ferry X then the contract will require the lease payments to be made in years 2 and 3, even if the project is
abandoned. If C leases ferry Y then it will be possible to cancel the lease at the end of year 1 without penalty.
C's required rate of return on this project is 10%.
Calculate the maximum setup costs that C should be willing to pay in order to secure the use of ferry Y.
Give your answer to the nearest thousand dollars.
ANSWER: The answers that are acceptable here are either 3 86 or 387 (thousand dollars). This range reflects the fact that,
depending on how the calculation is performed, there may be rounding involved in determining the present values of future
cash flows and credit is given for any answer where the rounding is carried out in a reasonable way.
Here is the calculation which gives one of these correct answers: 387 (thousand dollars). Note that it is only necessary to type
in the number 387 because the dollar sign and 000 are already provided in the question. Moreover, this calculation uses
CIMAs present value and cumulative present value tables where the factors are rounded to three decimal places.
The maximum acceptable setup costs for ferry Y can be determined by equating the net present value (NPV) of using ferry Y
with that of ferry X. These NPVs take into account the probabilities of the different levels of ticket sales and the impact of the
project being abandoned.
The NPV of using ferry X is:

(((250,000x0.909)-(300,000x2.487))x0.5) + ((750,000-300,000)x2.487x0.5)-150,000 = $150,150

The NPV of using ferry Y, excluding the setup costs, is:

((250,000-300,000x0.909)x0.5) + ((750,000-300,000)x2.487x0.5) = $536,850
Equating the two NPVs:
536,850-Ysetup = 150,150, so Ysetup = $386,700.]

Transfer pricing & fairness: G has two divisions, one of which manufactures paint and
another which manufactures painted furniture. The paint division sells paint to external
customers and to G's furniture division.

The management teams of the two divisions have agreed that the transfer price of the paint
should be based on marginal production cost plus 15%. This transfer price is less than the
market price of paint charged by the paint division to external customers and the paint
division currently has sufficient capacity to meet all internal and external demand. The
following arguments in support of this negotiated arrangement were offered at the time the
agreement was reached:
1. Transfers at the market price charged to external customers would give the paint division
an unfair share of total profit because the cost of making and servicing sales to internal
customers is lower. = CORRECT

2. Transfers at the opportunity cost would not be fair to the furniture division.

3. Transfers at marginal cost would give the furniture division an unfair share of total profit. =
CORRECT

4. This arrangement will prevent any dysfunctional behaviour by either of the divisions.

When asked for net relevant cash flow for year 2 that will be used in the NPV calculation
no need to discount figure.

Note: when comparing companies simply in terms of which is more profitable (ie not ROCE
or RI) then whichever has a greater absolute profit is more profitable.

TQM & JIT are very compatible as they are both largely focused on customer satisfaction.

When working out RI on competing investments: incremental profit [which is incremental

contribution - incremental depreciation] - incremental investment * cost of capital %

When asked what combination of available investments will maximise ROI, its not just a
case of selecting the investments that lead to an increase on the current ROI. It is about the
combination that will increase the ROI % to the highest possible level. Will be a case of
checking the ROI for each of the options available through trial & error.

For long-term variable overhead costs, the cost driver will be the volume of activity.

Inventory held at bottleneck resource not a feature of JIT, its throughput . Machine cells is a
feature of JIT

ROI results in dysfunctional behaviour but RI resolves this. Only ROI, not RI, encourages
divisions to hold onto assets. Together both encourage manipulation of profit and capital
employed figures.

Performance measurement, goal congruence, autonomy and recording the movement of

goods and services are all goals of a transfer pricing system.

For value of perfect information questions when there are two options. Work out EV of both
options, choose best EV. Then, depending on which option is better for each scenario
combine the EVs for that option at each scenario. The value of perfect information is then
the difference b/w the option with the best EV and the best combo of EVs chosen from b/w
each option at each of the different scenarios.

ARR places equal value on all cash flows throughout a project. NPV places less value on
later cash flows.

Max price a firm will pay for a component currently produced internally = contribution from
switching to a new product plus saving on marginal costs incurred making the component in
the past.