TRADITIONAL ABSORPTION V ACTIVITY BASED COSTING

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1 TRADITIONAL ABSORPTION V ACTIVITY BASED COSTING A company manufactures two products: X and Y. Information is available as follows: (a) Product Total production Labour time per unit X 1, hours Y hour Total overhead: $16,500 Calculate the overhead content of each product using traditional absorption methods. (b) The total overhead has now been broken down into: Materials handling 4,800 Production scheduling 6,500 Machine-related 5,200 Product X Product Y Number of purchase orders received (total) 8 4 Number of production runs (total) 3 2 Number of machine operations (per unit) 2 6 Recalculate the overhead content of each product using an activity-based costing approach.

2 ACTIVITY BASED COSTING * Gives fairer valuation of cost per unit Identifies cost driver for each overhead rather than absorb all at one arbitrary rate * Focuses attention on cost drivers Leads to better control of overheads BUT: * time - consuming to identify cost drivers * not always possible to identify a cost driver

3 THROUGHPUT ACCOUNTING A company produces 3 products, details of which are given below: A B C Selling price Materials Labour Variable overheads Fixed overheads Profit p.u Machine hours p.u. 1 hr 2 hrs 2 hrs Maximum demand 500u 500u 500u The machine time is limited to 1,800 hours. Determine the optimum production plan and calculate the maximum profit (a) using key factor analysis (b) using throughput accounting Main assumptions of throughput accounting: * in the short term, all costs except materials are fixed * inventory levels are kept to a minimum, ideally zero.

4 LIFE CYCLE COSTING Consider costs and revenues over the estimated entire life of a product. Phases of life cycle: * Development * Introduction * Growth * Maturity * Decline For example, might plan to have high selling price initially (high development/introduction costs, low competition), and then to have lower prices during the maturity phase (higher volume of sales, lower costs, more competition) and plan for eventual withdrawal of product (and replacement with new product) towards end of life cycle.

5 TARGET COSTING 1. Determine a realistic / competitive selling price. 2. Determine the profit required (e.g. required profit margin) 3. Calculate the maximum cost p.u. in order to achieve the required profit. 4. This is the target cost 5. Compare the estimated actual cost with the target cost. If higher, look for ways of achieving the target cost.

6 PRICING Full cost plus: Take full cost (i.e. including fixed overheads) and add on a percentage Example variable cost of production budgeted fixed costs budgeted production $5 p.u. $60,000 p.a. 20,000 units p.a. mark-up of 30% fixed costs p.u. = 60,000/20,000 = $3 full cost = = $8 p.u. selling price = $8 + 30% x $8 = $10.40 p.u. Ensures that company covers fixed costs, BUT how to budget the level of Takes no account of the effect of the selling price on demand. production? Marginal cost plus: Take marginal (variable cost) and add on a percentage Example Variable cost of production budgeted fixed costs budgeted production $5 p.u. $60,000 p.a. 20,000 units p.a. mark-up of 50% marginal cost = $5 p.u. selling price = $5 + 50% x $5 = $7.50 p.u. Avoids the problems of absorbing fixed overheads, BUT what percentage to add in order to ensure that fixed overheads are covered? Takes no account of the effect of the selling price on demand.

7 THEORETICAL PRICING 1. At a selling price of $80 p.u., the demand will be 50,000 units p.a.. For every $5 change in the selling price, the demand will change by 2,000 units. Derive the price/demand equation. 2. At a selling price of $100 p.u., the demand will be 80,000 units p.a.. For every $10 change in the selling price, the demand will change by 5,000 units. Derive the price/demand equation. 3. At a selling price of $200, the demand will be 100,000 units p.a.. The demand will change by 10,000 units for every $30 change in the selling price. The total costs will be 60, Q What should be the selling price p.u. to achieve maximum profit p.a.?

8 RELEVANT COSTING * Suitable for one-off contracts. * Calculate the future, incremental (i.e. extra), cash flows which will result from doing the contract. Sunk costs: Opportunity costs: Fixed costs: costs already incurred - not relevant lost income as a result of doing the contract - are relevant only relevant if the total changes as a result of doing the contract Examples: 1. Contract requires 200 kg of material X. Company has 500 kg in stock, which originally cost $6 per kg.. Material X has no other use, and if not used in the contract will be scrapped for $2 per kg.. 2. Contract requires 300 kg of material Y. Company has 600 kg in stock, which originally cost $10 per kg.. Material Y is in regular use by the company has the current purchase price is $12 per kg.. 3. Contract requires 50 hours of skilled labour. The company pays skilled labour $5 per hour, and there is currently plenty of idle time. 4. Contract requires 80 hours of skilled labour. Labour is paid $5 per hour. There is no spare time, and the contract would have to be done in overtime. Overtime is paid at normal rate plus 50%. 5. Contract requires 100 hours of skilled labour. Labour is paid $5 per hour. Labour is currently fully occupied making another product which is generating a contribution of $8 p.u. Each unit of the other product requires 2 hours of skilled labour.

9 UNCERTAINTY Sales per week Sales (units) Probability Selling price: Cost: $20 p.u. $10 p.u. Any unsold units must be sold as scrap for $1 p.u. The company can contract to purchase 10, 20 or 30 units each week. How many units should they contract for? (a) Expected Values (b) Maximax (c) Maximin (d) Minimax Regret

10 BUDGETING (1) Incremental budgeting Take last years figures and adjust for growth and inflation. Easiest and most common approach, but assumes that we continue to do things the same way. (For example, if we make our products by hand, we will budget to continue to make them by hand and ignore the fact that maybe there are now machines capable of producing them.) Zero based budgeting Ignore what currently happens. Instead, identify different solutions available, cost them out, and budget on adopting the best solution. For example, if our product can be made by hand or made by machine, then cost out both approaches, see which is the cheaper, and budget on that basis. Although zero based is in principle a much better approach, it is time-consuming and requires expertise. A realistic way of using a zero based approach is to apply it to one area of the business each year, and budget the other areas using an incremental approach. Activity based budgeting Use an activity based costing approach. Budget the costs for each activity and how each activity is being used, in an attempt to ensure that each activity is being used efficiently.

11 BUDGETING (2) Top-down budgeting Budget is prepared centrally and then imposed on the managers of each department Bottom-up budgeting Each manager produces his/her budget. It is the job of central management to make sure the budgets are challenged and that different departments budgets coordinate with each other. Bottom-up budgeting is regarded as being more motivational for managers. However the budgets do need to be challenged well otherwise there is the danger of managers introducing slack into their budgets.

12 BUDGETING (3) Fixed budget The original budget based on the originally estimated levels of sales and production. The original budget profit remains the overall target of the company. Flexed budget The budget is adjusted (or flexed) for the actual levels of sales and production. This is usually done monthly and is used for the purpose of control (compare the actual results with the flexed budget. i.e. variance analysis) Rolling budget (continuous budgeting) Update the budget each month and always have a budget for the next 12 months

13 FORECASTING HIGH LOW METHOD Month Sales (units) Month Units High Low Difference Change per month: 4400 / 11 = 400 Forecast for next month: = units

14 FORECASTING REGRESSION x y xy x 2 Month Sales (units) Σx = 78 Σy = Σxy = Σ x 2 = 650 n = number of pairs of observations = 12 b = a = nσxy ΣxΣy = 12 x x = nσx 2 (Σx) 2 12 x x Σy bσx x 78 = = n n = y = x Forecast for month 13 = x 13 = units

15 FORECASTING TIME SERIES Sales (units) Moving Average Centred Average Seasonal Variation Seasonal Variation (Additive) (Multiplicative) 2005 qtr qtr qtr qtr qtr qtr qtr qtr qtr qtr qtr qtr

16 LEARNING CURVES As cumulative output doubles, the cumulative average time (labour cost) per unit falls to a fixed percentage of the previous average time (labour cost) Example 1 First batch takes 100 hours to produce. There is a 75% learning effect. How long will it take to produce another 7 batches. Example 2 First batch takes 60 hours to produce. There is an 80% learning effect. How long will it take to produce the 7 th batch? Learning curve formula: y = ax b y = average time per batch a = time for initial batch x = number of batches b = learning factor b = log r log 2

17 OPERATING STATEMENT (ABSORPTION COSTING) Sales Volume Variance Actual sales Budgeted sales Sales Price Variance Actual sales at actual S.P. Actual sales at standard S.P Materials Expenditure Variance Actual purchases at actual cost Actual purchases at standard cost units Original Budget Profit units Standard profit p.u. Materials Usage Variance Actual usage Standard usage for actual production Labour Rate of Pay Variance Actual hours paid at actual cost kg kg Standard cost Actual hours paid at standard cost Labour Idle Time Variance Actual hours paid Actual hours worked Labour Efficiency Variance Actual hours worked Standard hours for actual production Variable Expenditure Variance Actual hours worked at actual cost hours hours Standard cost Standard cost Actual hours worked at standard cost Variable Efficiency Variance Actual hours worked Standard hours for actual production Fixed Overhead Expenditure Variance Actual total hours Standard cost Budget Total Fixed Overhead Volume Variance Actual production Budget production units Standard cost per unit Actual Profit

18 OPERATING STATEMENT (MARGINAL COSTING) Sales Volume Variance Actual sales Budget sales Sales Price Variance Actual sales at actual S.P. units Original Budget Profit units Standard contribution p.u. Actual sales at standard S.P Materials Expenditure Variance Actual purchases at actual cost Actual purchases at standard cost Materials Usage Variance Actual usage Standard usage for actual production Labour Rate of Pay Variance Actual hours paid at actual cost kg kg Standard cost Actual hours paid at standard cost Labour Idle Time Variance Actual hours paid Actual hours worked Labour Efficiency Variance Actual hours worked Standard hours for actual production Variable Expenditure Variance Actual hours worked at actual cost hours hours Standard cost Standard cost Actual hours worked at standard cost Variable Efficiency Variance Actual hours worked Standard hours for actual production Fixed Overhead Expenditure Variance Actual total hours Standard cost Budget Total Actual Profit

19 VARIANCE ANALYSIS Budget sales and production of Product X are 600,000 units p.a. at a standard selling price of $100 p.u. The original standard costs of production were: Materials: 2 $20 per kg Labour: 1.5 $2 per hr Variable overheads: 1.5 $6 per hr Fixed overheads were budgeted at $10.8M for the year. Actual results for January were as follows: Sales: 53,000 $95 p.u. Production costs for 55,000 units produced: Materials (110,000 kg) $2,300,000 Labour (85,000 hrs) $180,000 Variable Overheads $502,000 Fixed Overheads $935,000 (a) Prepare an operating statement, reconciling actual profit with budget profit. (Note: the company s policy is to use marginal costing) Since preparation of the budget, the suppliers of the materials had announced a permanent price increase of 10%. As a result the manufacturing process was examined and ways were found of reducing material usage by 5% without affecting the quality of finished goods. (b) Using the additional information, analyse the total materials variance into Planning and Operational Variances.

20 VARIANCES 1. Always marginal costing in exam unless told otherwise, but check carefully. 2. Always show standard cost per unit (cost card) unless given in question. (Make sure you still get the marks even if you have misread something). 3. Examiner sometimes uses the word cost variance to mean total variance. (e.g. calculate for materials the cost, expenditure, and usage variances. Means expenditure and usage as normal + total variance. Do not calculate total separately, it is simply the total of expenditure + usage). 4. If more than one material, do NOT calculate mix & yield variances unless asked for. (or unless he says the materials are substitutable but he is unlikely to use these words). 5. Remember: for cost variances we are always comparing actual costs with standard cost for actual level of production. It is worth writing down the actual level of production if you have misread, it is then obvious what you were trying to do. 6. Planning and Operational Variances (a) Planning (or Revision) Variances This variance cannot be corrected (or controlled) but when it is identified that it is going to occur company may decide to change plans for the future ie. feed-forward control. (b) Operational Variances Normally calculated monthly. It is too late to do anything about the period under review, but can use information to attempt to correct (or control) any problems for the future. ie. feedback control.

21 FIXED OVERHEAD VARIANCES A company uses absorption costing. The standard cost card is as follows: Materials (2 kg at $30 per kg) Labour ( 4 hours at $5 per hour) Fixed overheads (4 hours at $4 per hour) $96.00 Standard selling price $ Budget production and sales: Actual production and sales: 50,000 units 60,000 units All sales were made at the standard selling price, and materials usage and cost were as per the standard cost card. 230,000 labour hours were paid and worked, at a cost of $ 1,150,000 Actual expenditure on fixed overheads was $ 1,000,000

22 LABOUR VARIANCES - EXCESS IDLE TIME The standard costs of labour are as follows: 5 hours (paid) at $3.60 per hour = $18 p.u. It is budgeted that there will be 10% idle time. The actual production is 10,000 units and the actual labour costs are as follows: $185,000 was paid for 48,000 hours, of which 46,000 were actually worked.

23 MIX & YIELD VARIANCES Standard cost for every 8 kg of output: A 6 $8 48 B 3 $ Actual results: Materials input A 99,000 kg at a total cost of $800,000 B 36,000 kg at a total cost of $140,000 Actual production: 13,000 kg

24 COST-VOLUME-PROFIT ANALYSIS MULTIPLE PRODUCTS A company produces and sells three products: A, B and C. The budget information for the coming year is as follows: A B C Sales (units) 5,000 6,000 8,000 Selling price (p.u.) $10 $12 $15 Variable cost (p.u.) $5 $8 $6 Contribution (p.u.) $5 $4 $9 The total budgeted fixed overheads for the year are $50,000 (a) (b) (c) (d) Calculate the CS ratio for each product individually Calculate the average CS ratio (assuming that the budget mix of production remains unchanged) Calculate the breakeven revenue (assuming that the budget mix of production remains unchanged) Construct a PV chart (assuming that the budget mix of production remains unchanged) Assuming that the products are produced in order of their CS ratios, contruct a table showing the cumulative revenue and cumulative profits (e) (f) Calculate the breakeven sales revenue on this basis Add the information to the P/V chart already produced

25 ENVIRONMENTAL MANAGEMENT ACCOUNTING Note: there can be no calculations on this in the exam, and there will be a maximum of 8 marks for it as one part of a question. Environmental costs comprise such things as electricity, water, and the disposal of waste. In addition there is the effect on the image of the company of not being environmentally friendly, although this is much harder to quantify. For the exam you should be able to write briefly about four techniques that may be useful: Inflow / Outflow analysis This approach balances the quantity of resources input with the quantity that is output (either as production or as waste). Resources include not just raw materials, but also ones such as electricity. Measuring these in physical quantities and in monetary terms forces the business to focus on environmental costs. Flow cost accounting This is really inflow / outflow analysis, but concentrates on material flows in each of three categories: Material: the resources used in storing raw materials and in production System: the resources used in storing finished goods and in quality control Delivery & disposal: the resources used in delivering to the customer and in disposing of any waste. Life-cycle costing Ensuring that environmental costs such as the disposal of waste are included in the life-cycle costs. It may be possible to design-out these costs before the product is launched. Environmental Activity Based Costing Environmental costs should be allocated to their own cost centres rather than simply being included in general overheads. As with ABC in general, this focuses more attention on these costs and potentially leads to greater efficiency and cost reduction.

26 LIFE-CYCLE COSTING / TARGET COSTING William plc is planning to commence production of a new product the Kate. It is expected that demand for Kate s will last for 6 years and that they will sell 1,000 units in the first year; 3,000 units in the second year; and 6,000 units per year thereafter. The selling price will be $15 per unit, and the company wishes to achieve a mark-up of 50% on cost. The following costs have been estimated: Design and development: $40,000 Variable production costs: $7 per unit Additional fixed production costs: $4,000 per year End of life costs: $10,000 You are required to: (a) calculate the target cost per unit for production of Kate s (b) (c) calculate the actual full production cost per unit for the first year and comment as to whether or not there is a cost gap calculate the lifecycle cost per unit and comment as to whether or not there is a cost gap

27 DECISION TREES Charming plc have to make a decision as to which, if either, of two machines to buy machine A or machine B. Machine A will cost $10,000 and will last for 10 years, generating $2,000 a year if demand for the product is high, but only $1,000 a year if demand is low. If demand is low, they will be able after 5 years to scrap the machine for $1,000 or, alternatively, to invest an additional $5,000 in which case it will generate $1,500 a year for the remaining 5 years. Machine B will cost $15,000 and will also last for 10 years, generating $4,000 a year if demand is high, or $1,000 a year if demand is low. Neither machine has any scrap value at the end of 10 years. For both machines, the probability of demand being high is 0.6. Charming intend to make the decision using expected values, based on the expected net cash receipts over the life of the machines. Which (if either) of the two machines should they buy?

28 PERFORMANCE INDICATORS RETURN ON CAPITAL Profit before interest & tax Long term capital (ie Equity + Long Term debt) 100% OPERATING PROFIT MARGIN Operating Profit Sales 100% CURRENT RATIO Current Assets Current liabilities QUICK RATIO Current Assets Inventory Current liabilities EARNINGS PER SHARE (E.P.S.) Profit after interest & tax Number of shares P / E ratio Market value per share Earnings per share

29 RETURN ON INVESTMENT V RESIDUAL INCOME Division X of Y plc is currently reporting profits of $100,000 p.a. on capital employed of $800,000 A new project is being considered which will cost $100,000 and is expected to generate profits of $15,000 p.a. The target return of Y plc is 16% (a) (b) Should Y plc accept or reject the project? Will the manager of Division X be motivated to accept the project if his performance is measured (i) on Return on Investment? (ii) on Residual Income?

30 DIVISIONAL PERFORMANCE MEASUREMENT Type of responsibility centre: Cost centre: Manager has authority for decisions over costs (but not revenue) Revenue centre: Manager has authority for decisions over revenue (but not costs) Profit centre: Manager has authority for decisions over costs and revenues (but not capital investment decisions) Investment centre: Manager has authority for decisions over costs, revenues, and new capital investment. Controllable factors: The manager should only be assessed over those items over which he has control. For example, if a manager is given authority to make decisions over everything except salary increases which are dictated by central management, then it would be unfair to include salaries in his performance measurement. If (for example) it is a profit centre, then for the purposes of measuring his performance the profit of the division should be calculated ignoring salaries.

31 TRANSFER PRICING OBJECTIVES: * Goal congruence * Performance appraisal * Divisional autonomy OVERALL: * Must maximise group profit PRACTICAL: * T.P. often fixed by Head Office * Problem loss of autonomy possibility of dysfunctional decisions APPROACH: Allow individual managers to negotiate the transfer price Selling division: Minimum T.P. = Marginal cost + opportunity cost Receiving division: Maximum T.P. is lower of (a) external purchase price (on intermediate market) and (b) net marginal revenue (selling price less costs of receiving division)

32 TRANSFER PRICING [S = selling division; R= receiving division] S R 1. Variable production cost 15 8 Final selling price $30 2. As (1), but intermediate market exists. S can sell intermediate market at $18; R can buy on intermediate market at $20 (a) S has unlimited production capacity and there is limited demand on the intermediate market (b) S has limited production capacity and there is unlimited demand on the intermediate market 3. S has restricted capacity to make A and B R wants product A. A B S s Variable production cost per unit S s Intermediate market price per unit

33 NON-FINANCIAL PERFORMANCE MEASURES Quality Flexibility Efficiency (Resource utilisation) Innovation Competitiveness

34 FIXED OVERHEAD VARIANCES - ABSORPTION COSTING Total Variance Actual total fixed overheads Standard cost for actual production Analysis of Total Variance Expenditure Variance Actual Total Budget Total Volume Variance Actual Production Budget Production units Standard cost per unit = Analysis of Volume Variance Capacity Variance Actual hours worked Budget hours Efficiency Variance Actual hours worked Standard hours for actual production hours hours Standard cost per hour = Standard cost per hour = Summary Expenditure Variance Capacity Variance Efficiency Variance Note: Analysis of Volume Variance into capacity and efficiency variances assumes that budget production was limited by labour hours available. Therefore we can only produce more than budget if a) we have more hours available (capacity) and/or b) workers work faster (efficiency)

35 VARIANCES - DIFFERENCES BETWEEN MARGINAL AND ABSORPTION COSTING All the variances are the same in both cases, except: Sales Volume Variance: Take difference in units between budget and actual sales, and cost out at: Marginal costing: Standard contribution per unit Absorption costing: Standard profit per unit Fixed Overheads Variances Marginal costing: Absorption costing: Only expenditure variance Expenditure variance and volume variance (Volume Variance can be analysed into capacity and efficiency - see separate sheet)

36 ORIGINAL BUDGET Standard cost of materials: 8kg at $4 per kg = $32 per unit Budget production: 20,000 units Actual results: Production 24,000 units Materials: 190,000kg for $769,500 Since preparation of the budget, the price per kg had increased to $4.10 and the usage had been revised to 7.5 kg per unit. Calculate the planning and operational variances, and analyse each into expenditure and usage variances

37 Flexed original budget (for 24,000 units produced): 24,000 units x $32 = $768,000 Revised budget (for 24,000 units produced): 24,000 units x $30.75 = $738,000 Planning $30,000 (F) Actual results (for 24,000 units produced): $769,500 Operational $31,500 (A) Analysis Planning variances Expenditure 24,000u x 7.5 kg = 180,000 kg x $4.10 = 738, ,000 kg x $4 = 720,000 $18,000 (A) Usage: kg Revised 180,000 Flexed budget (24,000u x 8 kg 192,000 12,000 x $4 = $48,000 (F) Operational variances Expenditure Actual 190,000 kg 769,500 Revised 190,000 kg x $4.10 = 779,000 $9,500 (F) Usage: kg Actual 190,000 Revised (24,000 x 7.5 kg) 180,000 10,000 x $4.10 = $41,000 (A)

38 USAGE VARIANCES Original budget: Standard cost of materials: Budget production: Actual results: Production Materials 10 kg at 5 per kg = $50 per unit 10,000 units 11,000 units 108,900kg at $4.75 per kg Since preparation of the budget the price per kg has changed to $4.85 and the usage to 9.5kg per unit Calculate the planning and operational variances, and analyse each into expenditure and usage variances

39 USAGE VARIANCES Flexed original budget (for 11,000 units produced): 11,000 units x $50 = $550,000 Revised budget (for 11,000 units produced): 11,000 units x $ = $506,825 Actual results (for 11,000 units produced): 108,900 kg x $4.75 = $517,275 Planning $43,175 (F) Operational $10,450 (A) Analysis Planning variances Expenditure 11,000u x 9.5 kg = 104,500 kg x $4.85 = 506, ,500 kg x $5 = 522,500 $15,675 (F) Usage: kg Revised 104,500 Flexed budget (11,000 x 10kg) 110,000 5,500kg x $5 = $27,500 (F) Operational variances Expenditure Actual 108,900 kg x $4.75 = 517,275 Revised 108,900 kg x $4.85 = 528,165 $10,890 (F) Usage: kg Actual 108,900 Revised (11,000 x 9.5 kg) 104,500 4,400kg x $4.85 = $21,340 (A)

40 HOW TO PASS ACCA EXAMS!!!! 1 Attempt every question 2 Attempt every part of every question (attempt does not mean finish even just copying a relevant formula from the formula sheet will get a mark and could make the difference between 49 and 50) 3 Help the marker start each new question on a new sheet of paper 4 Start each part of a question on a new sheet of paper. If you can only write one line for part (a) of a question, leave the rest of the page blank you might think of something else later to add. 5 Help the marker be neat! You will get marks for the correct approach even if your calculations are wrong provided the marker can see what you have done. 6 Always write something for a written part never write nothing! Anything sensible will almost certainly get you 1 mark, which could be the difference between passing and failing. There is no negative marking, and so even if you are wrong you will not lose marks. 7 Allocate your time between questions and parts of questions. Spending an hour on one part of one question will certainly mean you will fail because you will not have enough time for other questions. 8 In a calculation question, no one figure can be worth more than 3 or 4 marks (if it is it will be a separate part of the question). If you find yourself spending too long on one figure then leave it there will be plenty more marks available in the same time. 9 Help the marker in essay parts of questions put each separate point on a new line. If you string points one after the other, there is the danger of the marker missing some of them. Do make each point into a sentence never write one-word answers. 10 Read the requirements first do not start worrying about the figures in the body of the question until you know what it is you are trying to do! 11 Remember the pass mark is 50%. Aim to get 50% on every part of every question as fast as you can by going for the easy bits first. Once you feel you have got half the marks then you can spend more time on the harder bits. 12 Allocate your time and attempt every part of every question. 13 Allocate your time and attempt every part of every question.

41 BUSINESS SOLUTIONS Business Solutions is a firm of management consultants which experienced considerable business growth during the last decade. By 2000 the firm s senior managers were beginning to experience difficulties in managing the business. During 2001 the firm was reorganised and a regional divisional structure was introduced with individual profit targets being set for each of the semi-autonomous profit centres. Although North division has its own customer base that is distinct from that of its sister division South, it does occasionally call upon the services of a South consultant to assist with its projects. North has to pay a cross charge to South per consulting day. The amount of the charge is determined by HQ. North is free to choose whether it employs a South consultant or subcontracts the project to an external consultant. The manager of North division believes that the quality of the external consultant and the one from South division are identical and on this basis will always employ the one who is prepared to work for the lower fee. The following information is also available: North division is very busy and it charges its clients $1,200 per consulting day North division pays its external consultant $500 per consulting day The variable cost per internal consulting day is $100 Required: (a) Determine a possible optimal daily cross charge that should be paid by North for the services of a consultant from South in the scenarios outlined below. The charges that you select must induce both divisional managers to arrive at the same decision independently. Explain how you have determined your cross charges and state any assumptions that you think necessary. Scenario (i) South division has spare consulting capacity. Scenario (ii) South division is fully occupied earning fees of $400 per consulting day. Scenario (iii) South division is fully occupied earning fees of $700 per consulting day. (10 marks) (b) Identify the possible factors that may have prompted the senior management to introduce a divisional structure in 2001 and suggest some potential problems that may arise. (10 marks) (20 marks)

42 BUSINESS SOLUTIONS (a) Scenario (i) If North uses the external consultant, the daily contribution to the company is $1,200 $500 = $700. If North uses a consultant from South the daily contribution to the company is $1,200 $100 = $1,100. Therefore the cross charge rate should be set on a level where both North and South will perceive that they will benefit above $100 and below $500 say $300. Scenario (ii) If North uses the external consultant, the total contribution for one day s consultancy in both North and South divisions would be: Income VC North 1, South , = $1,000 If the South consultant goes to North, then the total contribution would be: $1200 $100 = $1,100 Therefore it is best if North employs the South consultant by setting the cross charge above $400 and below $500, say $450, both parties will benefit and agree to the transaction. Scenario (iii) If the North uses the South Consultant, the total contribution will be: $1200 $100 = $1,100 If North employs the external consultant, the total contribution will be: Income VC North 1, South , = $1,300 The lost contribution of the work in South ($600) exceeds the incremental cost ($400) of the external consultant undertaking the work. The company therefore needs to set a cross charge that discourages a consultant going North i.e. above $500 but below $700 (b) Assumptions: the objective of the company is to maximise contribution in the short run (not long run considerations) the long term business consequences of rejecting work in the South (Scenario ii) can be ignored the divisional managers behaviour and responses determined only by short term sectional (divisional) financial performance measurement. access to all the decision making data that the separate divisions use. Reasons for re-organisation the need to have local knowledge applied specifically to local decisions a divisional company offers the opportunity to make decentralised speedy decisions especially with a rapidly changing environment it permits senior managers to concentrate on global strategic issues detailed operational activities are dealt with separately by those most suitable it permits junior managers to experience broader decision making and can be used as part of their development programme local semi-autonomous decision making is likely to be a motivating factor for managers (less central control) a divisional structure may reduce the complexity and cost of the communication systems within an unitary hierarchical structure Suggested problems the senior management may have difficulty in letting go permitting decision to be made locally senior management may become involved in resolving disputes between the divisions the divisions might eventually compete against each other to the detriment of the entire company some divisional decisions may not be in the best interests of the entire company (problems of local optimality v global optimality) ensuring goal congruence the potential waste from the duplication of functions