2015 TUTORIAL QUESTIONS

E and E Ltd. manufacture 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 CDs, 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 $900 would be a suitable selling price
for the music player and that 60 000 units per annum would be sold at this price.
Variable selling costs would amount to $120 per unit sold.

The financial director has estimated that the new capital equipment required in
order to manufacture the music player would cost $30,000,000. 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 $550
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 1
Masango Investments is a small but growing engineering group. Corporate
guidelines indicate that no new product should be introduced to the
product range unless the anticipated rate of return over the product
lifecycle exceeds the company’s cost of capital.
Research and Development (R & D) staff at Masango investments recently
carried out design work on three proposed new products. Following
consultation between R & D and marketing staff, the following summary
information is available:

 Direct labour hours per unit of output: Product X Product Y

Product Z
2 7 5
 Production and sales quantities per month: Product X Product Y
Product Z
950 900
1100
 Total monthly overhead activity and costs in producing the three
products:
Cost per month Level of cost driver
activity
Cutting operations $12500 2500 per month
Materials movements $9600 160 per month
Production set-ups $7200 15 per month

A target costing team established by Masango investments reviewed the

data from the R & D staff. The marketing staff warned that none of the
three products will be adequately profitable, given the expected market
conditions and the cost of manufacturing the products using the proposed
design.

In an attempt to improve profitability, the target costing team

subsequently worked with the R & D staff to redesign Products Y and Z.
The marketing staff confirmed that these design modifications will have
no effect on demand for the finished products. The reductions in monthly
activity levels as a result of these design changes are expected to be as
follows: Effect of design changes: Effect of design changes:
Product Y Product
Z
Reduction in number of cutting operations 1,140
2,000
Reduction in number of materials movements 300
340
Reduction in number of production set-ups 20
10

It was found to be impossible to make any changes to the design of

Product X.

REQUIRED:
(a) Assume that the proposed design changes will be implemented.
Calculate the resulting reduction in the unit cost of each of the company’s
products in the following circumstances:
_ If all overheads are traced to products using activity-based costing.
_ If all overheads are allocated to products on a direct labour hour basis.
(12 marks)

(b) Explain (using the example of Masango investments to illustrate your

answer) why an activity based costing system is essential for the
implementation of target costing. (8 marks)
(c) A junior member of management at Masango Investments has
suggested that the company could expand its product range more quickly
by eliminating the requirement that no new product should be introduced
to the product range unless the anticipated rate of return over the product
lifecycle exceeds the company’s cost of capital.
Comment on this suggestion. (5 marks)
[Total: 25 marks]

Question 2
Delta 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:
Coke Beer
Division
Operating profit $1520 $720
Capital invested $16 000 $5
760
The cost of capital is 7% for both divisions. It can be assumed that there
are no intra company transfers between Divisions A and B.

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 Delta PLC.
(5 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 $230 but would require capital investment of $2 200? Are their
reactions in the best interests of the company’s shareholders? Justify your
answer. (5 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). (4 marks)
(d) Although there are no intra-company transfers between Divisions A
and B, there are a significant number of intra-company transfers between
other divisions of Tipp 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. (6 marks)
[Total: 20 marks]

Question 3
Cargill Ltd. is a divisionalised company. Each month the company’s
Clothing Division manufactures 60,000 tons of cloth which it sells to
external customers at a price of $200 per ton. The fixed costs of the
Clothing Division are $2,880 000 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 Blanket Division) buys 20,000 tons
of a very similar material from an external supplier each month at a price
of $150 per ton. However, the Clothing Division has sufficient spare
capacity to enable it to supply the monthly needs of the Blanket Division.
The transfer price which the Clothing Division would charge would be the
‘full cost per ton’ as calculated on the basis of the increased level of
output. The Blanket Division has indicated that this transfer price would
be acceptable.

REQUIRED:
a) Calculate the transfer price proposed by the Clothing Division, and
show that this transfers pricing arrangement will motivate both divisions
to act in a manner which is in the best interests of Cargill Ltd. as a whole.
(9 marks)
b) Assume now that the two divisions cannot agree on transfer pricing
arrangements for the 20,000 tons. Specifically, the Clothing Division will
not accept any price lower than $145 per ton but the Blanket Division will
not agree to pay any price higher than $95 per ton.
Discuss whether, in these circumstances, the board of directors of Cargill
Ltd. should intervene to order the divisions to make the transfer at the
price calculated in your answer to part (a). (10 marks)

(c) Assume now that the Blankets Division requires a further 5,000 tons
per month (in addition to the 20,000 tons), but that the Clothing Division
has no additional spare capacity and therefore these 5,000 tons could
only be provided to the Blankets Division if the Clothing Division were to
reduce sales to its external customers by an equivalent amount. Assume
also that the marginal cost to the
Clothing Division of supplying a ton to the Blankets 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 5,000 tons?
Explain your answer. (5 marks)
[Total: 25 marks]

Question 4

QUESTION 1

Target cost – Hunyani Furniture

Hunyani Furniture manufactures office chairs. It has been observed that

sales for the current year have fallen, compared to the previous year.
Therefore, Mudebhe, the marketing manager at Hunyani conducted a
market research to find out the reasons for the decrease. He discovered
that a competitor has started selling a set of 10 chairs at a lower price i.e.
$2,000. He estimated that in order to maintain the demand, the company
will need to rework the pricing decisions and cost structures.

Therefore, the directors asked the accounting team to compare Hunyani’s

cost accounting system with the competitors’ system. Mangwiro, the
accountant at Hunyani Furniture, analysed the competitors’ cost
accounting system. He determined that the competitor has adopted a
target costing approach for its product. Hence, the directors have decided
to implement target costing to manage costs and maintain the market
position.

However, Mangwiro is not aware of the target costing concept.

Required:

As a management accountant you are required to:

(a) Describe the target costing process that Hunyani Furniture should take
on.

(4 marks)

(b) Explain the implications of using target costing on cost control.

(4 marks)

Currently Hunyani Furniture sells a set of 10 chairs for $2275. In order to

meet the competition, Comfort’s management has decided to sell each
set for $2000. The management expects to maintain a 25% return on its
sales. It has budgeted the sale of 10,000 sets of chairs at $2000 per set
for the coming period. Due to fluctuations in the business volume,
Hunyani Furniture has more labour than what is required. Hunyani
Furniture’s cost department has estimated that 5% of the hourly rate is
paid to the carpenters for idle time.

The following is a cost structure for Hunyani Furniture

(i) Raw material i.e. wooden sheets required to make one set of chairs has
been purchased for $ 20 per sheet. 10 sheets are required to make one
set of 10 chairs.

(ii) Polish that is used to finish the chairs is purchased at $15 per bottle.
One complete bottle is required to polish one chair.

(iii) Other accessories used for the chair are brought in at the rate of $12
per chair.
(iv) 5 hours are needed to complete one chair. Carpenters are paid at the
rate of $5 per hour.

(v) Assembly workers are paid at the rate of $4 per hour for assembling
one chair. 30 minutes are needed to assemble one chair.

(vi) Overheads are absorbed on the basis of total labour hours worked on
carpentry work. Hunyani Furniture’s carpentry department generally
works for 80,000 hours per year.

The following data relates to the last two month’s production overheads:
Month Production Labour hours in Carpentry
Overheads department
1 $80,000 5000
2 $120,000 9000
Required:
(c) From the above cost data, calculate the expected cost per unit of each
set. Also identify the difference between the expected cost and the target
cost per unit of each set.
(12 marks)

(20marks)

Question 2

Divisional performance assessment and ROI- Matronics Ltd

Matronics Ltd is an electronics store that has a number of stores across

Zimbabwe. The manager of the company is an ambitious person, and is
looking to expand his activities, by continuously adding the number of
stores.

Matronics assesses the performance of each of their stores individually.

The expected return on investment (ROI) of Matronics is 10%. Some of the
stores have been able to achieve an ROI above this target.

The market for Matronics is rapidly increasing. The stores of the company,
at an average, have a gross profit ratio of around 40%.
Below is financial data given for two of Matronics Ltd’s stores for the last
year: Store A, Trafalgar court and Store B, Orr Street

Store A Store B

($'000) ($'000)

Sales 860 675

Gross profit 362 285

Net profit 75 50

Assets employed (investment) 585 360

Required:

(a) Discuss the past financial performance of store A and B using ROI and
any other measure you feel appropriate from the given data. Using your
findings discuss whether each of the measures you used correctly reflects
the stores’ actual performance. (13 marks)

(b) Discuss the disadvantages of comparing divisional performance. (7

marks)

(20 marks)

Question 3

Transfer pricing –

(a) The transfer pricing system operated by a divisional company has the
potential to make a significant contribution towards the achievement of
corporate financial objectives.

Required:

Explain the potential benefits of operating a transfer pricing system within

a divisionalised company. (6 marks)
(b) A company operates two divisions, Mango and Avo. Mango
manufactures two products X and Y. Product X are sold to external
customers for $42 per unit. The only outlet for product Y is Avo.

Mango supplies an external market and can obtain its semi finished
supplies (product Y) from either Avo or an external source. Mango
currently has the opportunity to purchase product Y from an external
supplier for $38 per unit. The capacity of division Avo is measured in units
of output, irrespective of whether product X, Y or a combination of both is
being manufactured. The associated product costs are as follows:

X Y

Variable costs per unit 32

35

Fixed overheads per unit 5

5

Total unit costs 37 40

Required:

Using the above information, provide advice on the determination of an

appropriate transfer price for the sale of product Y from division Avo to
division Mango under the following conditions:

(i) When division Avo has spare capacity and limited external demand for
product X;

(3 marks)

(ii) When division Able is operating at full capacity with unsatisfied

external demand for product X.

(4 marks)
(c) The design of an information system to support transfer pricing
decision making necessitates the inclusion of specific data. Identify the
data that needs to be collected and how you would expect it to be used.

(7 marks)

(20marks)

Question 4

First pack Ltd. manufactures advanced technical components for the

computer hardware industry.

The company’s Parts Division manufactures a special subcomponent at a

variable cost of $7 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 $10 each) while the remaining 1000 units are
transferred to the company’s IT Division at the same price.

The IT Division’s 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, IT Division uses one unit of the subcomponent purchased from
Parts Division and incurs additional variable costs of $9 per unit. The
selling price of IT Division’s product is $20 per unit. The IT 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
$18.50 per unit.

REQUIREMENT:

(a) Prepare calculations to indicate the increase in the monthly profits of

First pack 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

Parts Division and identify the maximum transfer prices which would be
acceptable to IT 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.

(7marks)

(20marks)

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]