Managerial Accounting

Session 14 – Revision and exam preparation

INSEAD MBA Program – Asia Campus 2023

Prof. Hami Amiraslani

Office: INSEAD Asia Campus, Office 528
Email: hami.amiraslani@insead.edu
 Session 9 – Responsibility accounting
Responsibility accounting systems:
Role creation and allocation of decision Benefits of decentralization:
rights (centralized vs. decentralized Better information concerning local conditions
decision making) Frees up central managers’ time to deal with
Processes for information flow (think the strategy
telephone game) Contributes to employee motivation
Accountability for decisions made
(responsibility centers) Costs of decentralization:
Decisions may not be aligned with the firm’s
Agency frictions arise because of: interests
Information asymmetries between local and Ideas might not be shared across BUs
central managers Duplication of efforts
Misalignment of local and central managers’ Evaluating BUs requires costly systems
incentives and objectives Transfer pricing is a time-consuming process
Four levers of control within organizations:
• Diagnostic controls: are primarily focused on Feedback control. Performance is measured
against a target and management acts on the variance.
• Interactive controls: typically focuses on one issue. The benefit of using interactive controls is
that it creates real focus on a single issue.
• Boundary systems: statements of what the company is not going to do. This ensures that
people don't spend time on new opportunities that the company is never going to pursue.
• Belief systems: they communicate the vision, mission and values of the business.

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 Session 10 – Transfer pricing
General rule Negotiated
Transfer price= Outlay cost + Opportunity cost Preserves autonomy and replicates the market
Transfer price is the sum of: conditions, but can be time-consuming, and
Marginal (outlay) cost per unit incurred up to lead to conflicting incentives (BU vs. the firm)
the point of transfer (i.e., variable cost to the
supplying division) and Why is TP relevant?
Opportunity cost per unit forgone by the firm Transfer prices affect the revenues and costs
from transferring internally (i.e., external market of internal divisions; this matters for two
price – variable cost= CM) reasons:
Transfer pricing methods: Where is the firm recognizing profits that
Market-based, cost-based (full or are subject to corporate taxes?
variable cost), or negotiated How are the division managers’ incentives
affected as a result of the transfer prices?
Market-based
Ignores synergies and interdependencies In a perfect world without taxes and without
Ignores the benefits from quality control, timely agency costs, transfer pricing wouldn’t matter
supply, or better protection of trade secrets in terms of firm profits; but these assumptions
Remedy: a discount that reflects cost savings do not conform to the way the world actually
Cost-based works
Useful when market prices are unavailable,
avoids disputes, but allows the selling division
to transfer its cost inefficiencies to the buying
division, and creates incentives for redefining
what is fixed and what is variable
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 Session 11 – Performance evaluation
Objective performance evaluation relies on
quantifiable KPIs, but what if:
KPIs should be: Objective KPIs are not available, or…
Specific (accepted definition) KPIs are less controllable (i.e., affected by
Measurable (quantifiable) things agents can’t influence)
Achievable (if they work hard)
Relevant (link to value creation)
Subjective performance evaluation can be
Time-bound (horizon) used to balance the weaknesses of objective KPIs
Evaluate dimensions of performance that cannot
Financial KPIs: be measured objectively
NOPAT Revenue Subjectively filter out uncontrollable events
ROIC= Revenue × Invested capital Make adjustments for employee gaming of
objective KPIs
Not conducive to value creation
Misalignment with firms’ interests Bias in subjective performance evaluation
Ignores the cost of capital Idiosyncratic rater effect: Ratings influenced by
age, gender, race, …
Residual Income (RI) Favoritism: Higher ratings for buddies, affairs, …
Leniency bias: Everybody is above average’
RI= NOPAT – Capital charge Centrality bias: Avoid extreme performance ratings
RI= (ROIC × Invested capital) Recency bias: Only most recent performance
– (CoC × Invested capital)
RI= (ROIC – CoC) × Invested capital Use multiple raters in so-called 360 degree
evaluations, apply forced rankings conduct more
frequent evaluations, use calibration committees
and ask the raters to justify their ratings
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 Session 12 – Balanced scorecard
The Balanced Scorecard tells the firm’s story by…
Translating strategy into a small set of KPIs Four dimensions in the BSC
Quantifying the economic links among KPIs Customer Perspective
Quantifying the economic links between KPIs and Financial Perspective
value creation Business Processes
The Balanced Scorecard balances… Learning & Growth
Financial and nonfinancial KPIs Emerging dimension: ESG (e.g.,
Backward-looking and forward-looking KPIs gender pay gap, diversity on the board,
‘Outcome’ measures and ‘value drivers’ waste control and recycling, emissions in
the manufacturing process, etc.)
Features of a good balanced scorecard
• Developed based on strategy
• Causal effects of ‘value drivers’ on value creation are tested rigorously
• KPIs are ‘actionable’
Employees know which activities will lead to value creation and have
ability to execute those activities (‘controllable’)
• KPIs capture value drivers reliably
• Targets are challenging but achievable (balance between KPIs and OKRs)

Ittner & Larcker (HBR 2003): identify several shortcomings:

• KPIs are not linked to strategy
• Links between KPIs and value creation are not validated
• Different business units measure the same KPI in different ways
• Setting the wrong targets

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 Session 13 – Internal controls and risk

Elements of an ERM: COSO on internal controls:

Risk appetite (risk-return tradeoffs) Control environment (setting the tone at
Risk identification the top)
Risk assessment (likelihood and impact) Risk environment (identify, assess and
Risk reporting (risk report card linked to report)
the BSc) Control activities (admin controls and
Risk-based decisions (preventable, accounting controls)
strategy-related and external) Information and communication
Risk response (controls) (feedback effects)
Internal controls Monitoring

Elements of the fraud triangle and fraud diamond

Pressure (Financial and emotional force pushing towards fraud)
Opportunity (Lack of supervision or adequate internal controls)
Rationalization (Personal justification of dishonest actions)
Capability (Ability to execute fraudulent activity without being caught)

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 Saratoga Company - TDABC
Saratoga manufactures jobs to customer specifications. The company is conducting a TDABC study
in its Purchasing Department to understand how labor resources are consumed by jobs. The
company provided the following data regarding its Purchasing Department and three of its many jobs:
Number of employees 16
Average salary per employee $25,000
Weeks of employment per year 52
Hours worked per week 40
Practical capacity percentage 85%
Requisition Processing Bid Evaluation Inspection
Minutes per unit of the activity 15 45 30

Job X Job Y Job Z

Number of requisitions processed 10 7 6
Number of bid evaluations 4 3 5
Number of inspections 7 3 7

In addition, assume that Saratoga Company provided the following activity data for all jobs produced
during the year:
Requisition Processing Bid Evaluation Inspection
Activity demands for all jobs 10,100 12,050 14,100

Required:
1. Calculate Saratoga’s used capacity in minutes. (4 points)
2. Calculate Saratoga’s unused capacity in minutes. (4 points)
3. Calculate Saratoga’s unused capacity in number of employees. (Round your answer to 2
decimal places.) (3 points)
4. Calculate the impact on expenses of matching capacity with demand. (Be sure to round
down your potential adjustment in the number of employees to a whole number. Negative
amounts should be indicated by a minus sign.) (3 points)
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 Saratoga Company - TDABC
Saratoga’s used capacity in minutes
Requisition Bid
Inspection Total
Processing Evaluation
Customer demand for each activity (a) 10,100 12,050 14,100
Purchasing minutes required per unit of each activity (b) 15 45 30
Purchasing minutes used to meet demand (a) × (b) 151,500 542,250 423,000 1,116,750

Saratoga’s unused capacity in minutes

Total purchasing minutes available to meet demand (a) 1,697,280
Total purchasing minutes used to meet demand (b) 1,116,750
Unused capacity in minutes (a) − (b) 580,530
Available capacity: 16 workers × 52 weeks × 40 hours × 60 minutes × 85% practical capacity
Available capacity: 1,697,280 minutes
Saratoga’s unused capacity in number of employees
Unused capacity in minutes (a) 580,530
Practical capacity per employee (in minutes) (b) 106,080
Unused capacity in number of employees (a) ÷ (b) 5.47

Practical capacity per employee: 1,697,280 minutes ÷ 16 employees = 106,080 minutes

Impact on expenses of matching capacity with demand

Potential adjustment in number of employees (rounded) (a) (5.00)
Average salary per employee (b) $25,000
Impact on expenses of matching capacity with demand (a) × (b) $(125,000)

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 Absorption vs variable costing
Mr. Whippy, Inc. produces nonfat frozen yogurt. The product is sold in five-gallon containers,
which have the following price and variable costs.
Sales price £15
Direct material 5
Direct labor 2
Variable overhead 3
Budgeted fixed overhead in 2017, the company’s first year of operations, was £300,000. Budgeted
and actual production was 150,000 five-gallon containers, of which 125,000 were sold. Mr. Whippy,
Inc. incurred the following selling and administrative expenses.
Fixed £50,000 for the year
Variable £1 per container sold

1. Compute the product cost per container of frozen yogurt under (a) variable costing and (b)
absorption costing. (4 points)
2. Prepare operating income statements for 2017 using (a) absorption costing and (b) variable
costing. (6 points)
3. Reconcile reported operating income under the two methods; what is the main reason for the
difference in the reported income numbers? (2 points)
4. What are the main arguments for and against using absorption and variable costing for
inventory valuation and income measurement? What are some of the remedies that
companies can use to mitigate the consequences of using absorption costing information for
decision-making and performance evaluation? (2 points)

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 Absorption vs variable costing
1. Calculation of predetermined fixed overhead rate:
Fixed overhead rate= (Budgeted fixed overhead)/(Budgeted production)
= £300,000/150,000= £2 per unit
Direct material £ 5
Direct labor 2
Variable overhead 3
a. Cost per unit under variable costing £10
Fixed overhead per unit under absorption costing 2
b. Cost per unit under absorption costing £12
2.
Absorption costing income statement
Sales revenue (125,000 units sold at £15 per unit) £1,875,000
Less: Cost of goods sold (at absorption cost of £12 per unit) 1,500,000
Gross margin £ 375,000
Less: Selling and administrative expenses:
Variable (at £1 per unit) 125,000
Fixed 50,000
Operating income £ 200,000
Variable costing income statement
Sales revenue (125,000 units sold at £15 per unit) £1,875,000
Less: Variable expenses:
Variable manufacturing costs (at variable cost of £10 per unit) 1,250,000
Variable selling and administrative costs (at £1 per unit) 125,000
Contribution margin £ 500,000
Less: Fixed expenses:
Fixed manufacturing overhead 300,000
Fixed selling and administrative expenses 50,000
Operating income £ 150,000
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Absorption vs variable costing
3. Cost of goods sold under absorption costing £1,500,000
Less: Variable manufacturing costs under variable costing 1,250,000
Subtotal £ 250,000
Less: Fixed manufacturing overhead as period expense under variable costing 300,000
Total £ (50,000)

Operating income under variable costing £ 150,000

Less: Operating income under absorption costing 200,000
Difference in operating income £ (50,000)

4. Absorption costing versus variable costing

(a) Absorption costing creates incentives for overproduction, yet it is a legal and widely-used method: in
fact, it is required under U.S. GAAP (ARB 43, par.5 and SFAS 151, par.1) and under IFRS (IAS 2,
par.10)
(b) Tax rules in many countries also require that absorption costing is used for purposes of corporate
taxation
(c) For internal decision-making, absorption costing produces numbers that are far from useful in CVP
analysis
(d) Absorption costing can lead to inappropriate pricing decisions (assuming cost-plus pricing) and
dropping products that are in fact profitable

5. Some potential remedies:

(a) Do not allocate costs of excess capacity (i.e., unutilized fixed overhead resources) to
products/services
(b) For performance evaluation and incentive system design, incorporate an inventory carrying charge
into the KPIs

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 Practice questions
HMA, Inc. reported a return on investment of 12%, a capital turnover of 5, and income of $180,000.
Based on this information, the company's invested capital was:
(A) $300,000. (B) $900,000. (C) $1,500,000. (D) $7,500,000. (E) None of the answers is correct.

ROIC= 12%, Revenue/Investment= 5, and NOPAT= $180,000

Solution:
NOPAT Revenue
ROIC= ×
Revenue Invested capital
$180,000
12%= × 5 therefore, Revenue= $7,500,000 and invested capital= $1,500,000 (C)
Revenue

Jamison Company had sales revenue and operating expenses of $5,000,000 and $4,200,000,
respectively, for the year just ended. If invested capital amounted to $6,000,000, the firm's ROIC
was:
(A) 13.33%. (B) 83.33%. (C) 120.00%. (D) 750.00%. (E) None of the answers is correct.

NOPAT= $5,000,000 – $4,200,000= $800,000 and Invested capital= $6,000,000

Solution:
NOPAT Revenue
ROIC= ×
Revenue Invested capital
$800,000 $5,000,000
ROIC= × therefore, ROIC= 13.33% (A)
$5,000,000 $6,000,000

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 Practice questions
Which of the following describes the goal that should be pursued when setting transfer prices?
(A) Maximize profits of the buying division.
(B) Maximize profits of the selling division.
(C) Minimize opportunity costs.
(D) Allow top management to become actively involved when calculating the proper dollar
amounts.
(E) Establish incentives for autonomous division managers to make decisions that are in the
overall organization's best interests.
Solution: An objective to transfer pricing policies is establish goal congruence, that is to
incentivize managers to take actions and make decisions that aligned with the interests of the
organization as whole (E)

One of the main challenges in making a decentralized organization function effectively is:
(A) earning maximum profits through fair practices.
(B) minimizing losses.
(C) taking advantage of the specialized knowledge and skills of highly talented managers.
(D) obtaining goal congruence among division managers.
(E) developing an adequate budgetary control system.

Solution: An objective to transfer pricing policies is establish goal congruence, that is to

incentivize managers to take actions and make decisions that aligned with the interests of the
organization as whole (D)

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 Practice questions
Coral Co.’s Mumbai Division is currently purchasing a part from an outside supplier. The
company's Delhi Division, which has excess capacity, makes and sells this part for external
customers at a variable cost of ₹22,000 and price of ₹34,000. If Delhi begins sales to Mumbai, it
(a) will use the general transfer-pricing rule and (b) will be able to reduce variable costs on
internal transfers by ₹4,000. If sales to outsiders are not affected, Delhi would establish a
transfer price of:
(A) ₹18,000. (B) ₹22,000. (C) ₹30,000. (D) ₹34,000. (E) None of the answers is correct.

Solution: Selling division (i.e., Delhi) has excess capacity, so internal transfers should not attract
any opportunity costs associated with foregone contribution margins. Out-of-pocket (variable)
costs: 22K which will be reduced by 4K for internal transfers; therefore, the transfer price can be
set at ₹22,000 – ₹4,000= ₹18,000 (A)

The information that follows relates to KJ103 Corporation:

Sales margin: 7.5%, Capital turnover: 2, Invested capital: $20,000,000
Based on this information, the company's sales revenue is:
(A) $1,500,000. (B) $40,000,000. (C) $10,000,000. (D) $3,000,000. (E) None of the answers is
correct.

Solution: Capital turnover= Sales revenue/Invested capital

Therefore: Revenue= 2 × $20,000,000 = $40,000,000 (B)

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 Practice questions
The Nashville Division of Country Classics currently reports a profit of $3.6 million. Divisional
invested capital totals $9.5 million; the imputed cost of capital is 12%. Based on this information,
Nashville’s residual income is:
(A) $432,000. (B) $708,000. (C) $1,140,000. (D) $2,460,000. (E) None of the answers is correct.

Solution: RI= ROIC – Cost of capital

RI = [(3.6/9.5) – 0.12] × 9,500,000 = $2,460,000 (D)

For the period just ended, Global Industries’ Western Division reported profit of $31.9 million and
invested capital of $220 million. Assuming an imputed interest rate of 12%, which of the following
choices correctly denotes Western’s return on investment (ROI) and residual income?
ROI Residual Income
(A) 12.0% $(5.5 million)
(B) 12.0% $5.5 million
(C) 14.5% $(5.5 million)
(D) 14.5% $5.5 million
(E) 14.5% $26.4 million

Solution: ROIC = (31.9/220) × 100 = 14.5%

RI = (ROIC – Cost of capital) × Invested capital = (0.145 – 0.12) × $220,000,000 = $5,500,000 (D)

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 Practice questions
Which of the following is not a component of good internal controls based on the COSO report?
(A) Setting the tone at the top about internal controls.
(B) Implementing administrative and accounting controls
(C) Assigning decision rights, communicating goals, and providing adequate training
(D) Regularly monitoring and updating the internal controls
(E) Capturing industry-specific factors that influence risk-taking incentives
Solution: The framework involves: (a) control environment (setting the tone at the top of the
organization), (b) control activities (admin controls and accounting controls), (C) risk
environment (identify, assess and report), (d) information and communication (feedback effects),
and (e) monitoring. Industry-specific factors that affect risk might be part of the process through
which risks are identified and assessed, but they are not one of the general components of good
internal control systems. (E)

Ben Corp. has excess capacity. If the firm desires to implement the general transfer-pricing rule,
opportunity cost would be equal to:
(A) zero
(B) the direct out-of-pocket expenses incurred in producing the goods.
(C) the total difference in the cost of production between two divisions.
(D) the contribution margin forgone from the lost external sale.
(E) the summation of variable cost plus fixed cost.
Solution: Note that the question is asking for the opportunity cost from the standpoint of the firm
as a whole, not the selling division; given that excess capacity exists, the only cost incurred is the
variable costs of the selling division, which will be recovered through the TP, hence the overall
opportunity cost for the firm is zero. (A)
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