Causes of mix variance: substituting one input for another

Yield variance: failure to follow standard procedure, higher/lower input than expected quality,
interrelated with mix variance

Criticisms of Traditional Budgeting

1. Inflexibility: Traditional budgets are often rigid and fixed for the fiscal year,
which can limit managers' ability to respond to changes and unforeseen events.
This rigidity makes it difficult for companies to adapt quickly to market dynamics
or operational demands.
2. Time-Consuming: The process of creating budgets can be very time-consuming,
involving detailed negotiations and iterations. This extensive time commitment
can detract from other strategic activities.
3. Encourages Short-Term Thinking: Because traditional budgets are typically
annual, they can encourage a focus on short-term results at the expense of long-
term strategy. Managers might manipulate or "game" the numbers to meet
budget targets rather than thinking about what's best for the organization in the
long run.
4. Can Lead to Unhealthy Behavior: Budgets can create unhealthy competition
between departments, encouraging managers to overstate needs or hoard
resources. It can also lead to spending surges at the end of a budget period to
use up allocated funds, regardless of whether the expenditures are necessary.
5. Cost Focused, Not Value Focused: Traditional budgeting often focuses more on
cost control than on value creation. This approach can stifle innovation and risk-
taking, which are crucial for development and growth.
6. Disconnection from Reality: Budgets are often prepared based on past data
and predictive assumptions, which may not hold true. This can lead to strategies
and plans that are out of touch with the actual business environment.

Beyond Budgeting: A Response to Traditional Budgeting's

Shortfalls

The Beyond Budgeting model emerged as a response to these criticisms, proposing a

more flexible, decentralized approach to managing company resources. The key
principles of Beyond Budgeting include:
 1. Decentralization: Empowering managers by decentralizing decision-making
authority, which allows those closest to the market and daily operations to make
decisions quickly and responsively.
2. Adaptive Processes: Moving away from fixed annual budgets to rolling forecasts
and continuous planning that can adjust to changing conditions throughout the
year.
3. Performance Evaluation: Shifting from evaluating performance based strictly on
meeting budget targets to using relative performance indicators that compare
results with peers or market standards, which encourages continual improvement.
4. Strategic Focus: Encouraging a focus on strategy and value creation over mere
cost control, supporting innovation and long-term growth.
5. Organizational Alignment: Creating alignment through shared goals and values
rather than through detailed rules and budgets, fostering a culture of trust and
accountability.
6. Customer Focus: Prioritizing customer satisfaction and market alignment,
ensuring that business decisions directly respond to customer needs and market
opportunities.

Qualitative factors to consider when evaluating contracts for decision making problems:

- Brand reputation and alignment with strategic goals/flexibility

- Service quality and customer satisfaction
- Supplier reliability and partnership opportunities
- Employee consideration: workforce impact and skills development
- Market dynamics and competitive advantage

(quantitative: cash flow/ must occur in the future/ cause extra incremental costs as a result)
Volume and non-volume based cost drivers. Cost distortion: non-volume related overheads and
product diversity. ABC non-output volume based derivers, traditional: cost drivers that vary
directly with volume. ABC establishes a separate cost driver rate for support activities and assign
their costs directly to products and services rather than apportioning them.

Reconciliation: compares actual with flexed data. Reports price and usage variance rather
than total. Will give a different message (favorable/adverse). Highlights major areas where
investigation is required.
If products go through a similar
process then it is simplest to have
an overall or factory wide or
blanket rate. If we have low
product diversity an average rate
can be cost effective.
(blanket overhead absorption: add overhead and allocation bases of all departments together)
• If products make different
demands on different
departments then a departmental
rate may be more appropriate to
reflect the resources consumed
and capture overhead intensive
processes. This is more accurate
but more time consuming and
costly to do.
(calculate a separate OAR for each department depending on departmental overheads)

1. Job Costing vs. Process Costing

Job Costing:
  Applicability: Used when products are distinct and custom-made.
 Costing Approach: Costs are tracked per job or batch.
 Industries: Common in construction, special orders in manufacturing, or any
industry where products are made to order.
 Cost Variability: Costs can vary significantly from one job to another based on
specifications.

Process Costing:

 Applicability: Used when products are homogeneous and produced in a

continuous process.
 Costing Approach: Costs are averaged over all units produced in a period.
 Industries: Chemical manufacturing, oil refining, and food production are typical
examples.
 Cost Variability: Costs are relatively uniform across all units produced.

2. Activity-Based Costing (ABC) vs. Traditional Costing

Activity-Based Costing (ABC):

 Cost Drivers: Uses multiple cost drivers to allocate indirect costs based on actual
activities that drive costs.
 Accuracy: Provides more accurate product costing, particularly in complex
environments with diverse products and indirect costs.
 Complexity: More complex and expensive to implement due to the need to
identify and track numerous activities and cost drivers.

Traditional Costing:

 Cost Drivers: Typically uses a single cost driver like labor hours, machine hours,
or units produced.
 Accuracy: Can result in cost distortion, especially in diversified operations where
not all products consume resources at the same rate.
 Complexity: Simpler and less costly to implement, making it suitable for smaller
or less complex operations.

3. Marginal Costing vs. Absorption Costing

Marginal Costing:
  Costs Included: Only variable costs are charged to cost units; fixed costs are
treated as period costs and written off against contribution.
 Profitability Analysis: Useful for decision-making as it highlights contribution
margin.
 Financial Reporting: Not typically used for external financial reporting due to
not capitalizing fixed manufacturing costs.

Absorption Costing:

 Costs Included: All manufacturing costs (both fixed and variable) are absorbed
into the cost of production.
 Profitability Analysis: Can obscure the impact of fixed costs on profitability
because fixed costs are spread across units produced.
 Financial Reporting: Required by GAAP for external reporting as it ensures all
costs of production are captured in inventory and cost of goods sold.

4. Linear Programming vs. Traditional Decision-Making

Linear Programming:

 Focus: Optimizes resource allocation to maximize or minimize a particular

objective (e.g., maximizing profit or minimizing costs).
 Applicability: Useful in handling complex decision-making scenarios involving
multiple constraints and objectives.
 Requirements: Requires clear, linear relationships and quantifiable objectives
and constraints.

Traditional Decision-Making:

 Focus: Often based on rule of thumb or simplified cost considerations without

explicitly optimizing resource use.
 Applicability: Can be applied more quickly and with less data than linear
programming.
 Requirements: Less rigorous, relying more on managerial judgment and
experience.

These methodologies provide a toolkit for management accountants, each suited to

different types of decision contexts and information needs within organizations.
1. Traditional management costing v strategic cost management

Traditional Strategic
• Focus on comparing actuals against • Focus on cost reduction, added value
pre-set standards, identifying variances and continuous improvement
and taking remedial action
• Based on the preservation of the • Applied on an ad hoc basis when an
status quo opportunity for cost reduction arises
• Applied on a routine basis • Cost Management approaches do not
necessarily involve accounting
techniques
• Emphasis on cost containment, rather • Process improvements → efficiency;
than cost reduction quality; cost reduction
 Life-cycle costing considers all costs incurred, before and after manufacturing. Differentiates
between costs incurred and costs committed
Target costing decides on a price then walks back to cost
Activity-based management is an extension of ABC, not only assigns costs, but analyze,
categorize into value-adding and non-value-adding, prioritize activities that need to be looked at
more closely.
Kaizen: incremental improvements towards cost reduction rather than large innovations
JIT: receive goods on time to reduce inventory costs
TQM: zero defects
Value-chain activities: higher efficient and lower costs in both primary and support activities
Benchmarking: compares to industry best practices
2. Objectives of absorption costing

3. Explain the choice of overhead absorption rate

4. Explain why the overhead account showed a credit balance

5. Explain differences in profit calculated in variable costing and absorption costing

Write reconciliation: difference in profit vs difference in inventory
Costs are stored in inventory until sold
6. Problems associated with standard costing
7. Contracts standard and target cost
Standard costs are derived from a study of internal operations whereas target costs
are market-driven, based on market information and target profit margins.
Standard costs are internally focused and established after production has begun
with the emphasis being on cost control. In contrast, target costs are externally
focused and are established before production commences. With target costing the emphasis is
on cost reduction rather than seeking to ensure that costs adhere to some
predetermined standard.
8. Advantages and disadvantages of variable costing

--- dis

--- adv
 9. Why relevant costs calculations won’t give the same profit figure as the financial statement

Ansoff's Matrix, also known as the Product/Market Expansion Grid, was developed by Igor Ansoff and
first published in 1957 in the Harvard Business Review. It has been widely used since then to help
companies decide their product and market growth strategy. Ansoff's Matrix suggests that a business'
attempts to grow depend on whether it markets new or existing products in new or existing markets. The
matrix outlines four possible growth strategies:

Market Penetration: Increase market share within existing markets with current products. This can be
achieved through competitive pricing strategies, advertising, sales promotions, or other initiatives to
increase product usage by existing customers.

Product Development: Offer new products or services to the current market. This involves research and
development and being innovative to meet existing customer needs or to attract new customers within
the same market.

Market Development: Enter new markets with existing products. This can be geographic expansion,
targeting new segments, or using different channels, in markets not previously served.

Diversification: Introduce new products to new markets. This can be related diversification (where the
new business has a logical connection with the company’s existing business lines) or unrelated
diversification (which does not have such connections).

10. Porter (1985) suggests that an organization has a choice of three generic strategies to
achieve a sustainable competitive advantage. Identify and explain each of Porter’s three
generic strategies, illustrating your answer with a real-world example for each

1. Cost Leadership

Description: The cost leadership strategy aims for a firm to become the lowest cost producer in its
industry. The sources of cost advantage are varied and include economies of scale, proprietary
technology, preferential access to raw materials, and other factors. By producing at lower costs, the firm
can offer its products at lower prices than competitors or maintain average industry prices to earn a
higher profit margin.

Example: Walmart is a prime example of cost leadership. The company leverages its immense buying
power to achieve economies of scale, which allows it to purchase goods at lower prices. Walmart also
utilizes sophisticated supply chain management technology and distribution efficiencies to minimize costs,
enabling it to offer lower prices that attract a large customer base and maintain its market leadership
position.

2. Differentiation

Description: This strategy involves creating products and services that are perceived as being unique
industry-wide. Differentiation can be achieved through innovation, high quality, unique features, superior
service, or a strong brand reputation. The goal is to create something that customers perceive as distinct
enough to pay a premium price.

Example: Apple exemplifies the differentiation strategy. The company focuses on delivering innovative
products with distinctive designs and functionalities, combined with a high level of customer service and
an ecosystem that integrates hardware, software, and services. The brand loyalty is strong enough that
customers are willing to pay higher prices for Apple products, distinguishing Apple from competitors in
the tech industry.

3. Focus

Description: The focus strategy is concentrated on a narrow segment and within that segment attempts
to achieve either a cost advantage or differentiation. The premise is that by focusing on certain segments
in the market, the company will be able to achieve better service for that specific kind of customer than
competitors who target broader groups. Focus can be divided into two variants: cost focus and
differentiation focus.

Example: Rolex employs a focus differentiation strategy by concentrating on the luxury watch segment.
The company targets consumers who seek prestige and status, offering high-quality watches that are
symbols of luxury. Rolex’s focus on this narrow market segment allows it to command premium prices
and maintain a distinctive image.

11.Identify and explain the four perspectives of Kaplan and Norton’s Balanced Scorecard.

The Balanced Scorecard, developed by Robert Kaplan and David Norton in the early 1990s, is a strategic
management tool that enables organizations to translate a company’s vision and strategy into a coherent
set of performance measures. Unlike traditional financial performance metrics, the Balanced Scorecard
offers a more ‘balanced’ view by providing a framework that adds strategic non-financial performance
measures to traditional financial metrics. This approach provides managers and executives with a more
comprehensive view of organizational performance. The Balanced Scorecard consists of four
interconnected perspectives:
1. Financial Perspective

Description: The financial perspective focuses on the financial objectives of an organization and enables
managers to track financial success and shareholder value. This perspective answers the question, "How
do we look to our shareholders?" Key performance indicators (KPIs) typically include measures such as
return on capital employed, net profit, cash flow, and operating income.

Example: A company might track return on investment (ROI) to gauge overall financial efficiency or
monitor revenue growth rates to assess business expansion success.

2. Customer Perspective

Description: This perspective measures the organization’s performance as seen through the eyes of its
customers and clients. It focuses on customer satisfaction and market share goals. The core question it
addresses is, "How do customers see us?" Typical metrics include customer satisfaction rates, customer
retention rates, and the number of new customers acquired.

Example: A business may use customer satisfaction surveys to gauge satisfaction levels, track customer
retention rates annually, or measure the percentage of market share compared to competitors.

3. Internal Process Perspective

Description: This perspective focuses on the internal operational goals of the organization, looking at the
key processes necessary to deliver the customer objectives. It asks, "What must we excel at?" This involves
measuring the efficiency and effectiveness of internal processes and often includes innovation,
production, and logistical processes.

Example: A manufacturing firm might measure the efficiency of its production processes through metrics
like throughput time, waste percentage, or the rate of return of defective goods.

4. Learning and Growth Perspective

Description: Also known as the "innovation and learning" perspective, this dimension focuses on the
intangible assets of an organization, primarily the skills, knowledge, and capabilities of the employees. The
core question here is, "How can we continue to improve and create value?" Metrics might include
employee training completion rates, employee satisfaction, and retention rates, as well as measures of
technological innovation.

Example: A tech company might track the number of new patents filed, the percentage of revenue from
new products, or employee turnover rates as indicators of performance in this area.

12. Rosborough School is a private high school in the north of England. The school’s mission
statement is as follows: -
‘Rosborough School seeks to create a challenging learning environment that encourages
high expectations for success through first class teaching that allows for individual
 differences and learning styles. Our school promotes a safe, orderly, caring, and supportive
environment. We stress the total development of each child: spiritual, moral, intellectual,
social, emotional, and physical. We strive to have our parents, teachers and community
members actively involved in our students’ learning.’
Given the school’s mission statement, identify two goals and two corresponding measures
for the school for each perspective of the Balanced Scorecard (I.e., eight goals and
corresponding measures in total).

Critically 13. Key points to interpret the result of the transfer price:
- Internal and external financial reporting (affect on individual and overall profit)
- Tax compliance: similar to unrelated parties to reduce overall tax burden
- Affect on managers incentives and performance
- Managerial decisions in terms of allocating resources in more profitable divisions
- Inter-departmental conflicts affect overall organizations effectiveness
- How is it being negotiated within the company: market-based and cost-plus pricing

13. Discuss whether ROI is providing a fair basis for calculating the manager's bonuses and the
problems arising at the company from it’s use
14. Discuss performance according to ROI and RI
In theory RI is a better measure than ROI since it evaluates short term financial performance in
terms of the capital employed in each division, thus treating divisions as if they were
independent companies that raise finance themselves
Consider appropriateness of cost of capital, this assumes that divisions belong
Calculate both with and without allocated costs and compare
Discuss effect of depreciation according to life or project
15. Discuss why switching to a performance management model is better
 16. Identify the main weaknesses usually associated with the traditional absorption costing
methodology

In its simplest form (blanket overhead absorption rates) it is inappropriate if products do not
consume department overheads in uniform proportions
- It tends to use arbitrary bases of apportionment and absorption, where no cause and effect
relationship exists
- It gets involved in the arbitrary re-apportionment of service department overheads
- It tends to assume that all overheads are directly related to volume of production
- In its calculations it tends to rely on broad averages and to ignore the controllability principle
- It has proved less than appropriate in service environments where prime cost is not the majority
element of cost (when overhead rates are applied on labor hours and direct materials)
- It is based on an underlying assumption that overheads are directly linked to departmental
structure, which is by no means true in many cases
- Its use of budgeted overhead absorption rates creates the complexity of under/over-absorption of
overheads.

17. Compare answers from absorption costing method and activity-based costing

Traditional absorption overhead allocation methods, based on volume (eg. direct labor
hours) are of limited use when the product or service being costed is unique. Increased
product and service diversity (arising from products consuming resources in different
proportions) favours a more sophisticated costing system, because increased diversity
results in increased distortion based on traditional absorption costing methods. Activity-
based costing emphasizes the need to understand how activities cause overheads. It is a
model of resource consumption rather than spending and, therefore, provides a more
effective mechanism for managing overhead costs.
Another answer
The overhead charges calculated in (c) may support the idea of a change to ABC, since the
departmental approach could well mask the usage of resources on different contracts. For
example, the existing absorption method cannot explicitly or with any reasonable accuracy
absorb overhead in a way that recognises the fact (important to the laundry part of the
company’s operation) that the dry weight per cost unit for the Hillsmere contract is twice that of
the Goreton contract. ABC, however, charges the Hillsmere contract twice as much Laundry
overhead as the Goreton contract because the importance of cost units’ dry weight as a cost
driver is recognised. On the face of it, changing to ABC would appear beneficial to the company.
This assumes that the cost drivers have been correctly identified and quantified and that the
activities specified in the question are, in fact, the main ones constituting the company’s
operation. The potential cost of changing to, and operating, the new system should also be
borne in mind.

17. Briefly describe the main steps involved in deriving a target cost.

Deriving a target cost:

Step 1: A product or service is developed which is perceived to be needed by customers and
therefore will attract adequate sales volumes.
Step 2: A target price is then set based on the customers’ perceived value of the product. This will
therefore be a market based price.
Step 3: The required target operating profit per unit is then calculated. This may be based on either
return on sales or return on investment.
Step 4: The target cost is derived by subtracting the target profit from the target price.
Step 5: If there is a cost gap, attempts will be made to close the gap. Techniques such as value
engineering may be performed, which looks at every aspect of the value chain business functions
with an objective of reducing costs while satisfying customer needs.
Step 6: Negotiation with customers may take place before deciding whether to go ahead with the
project.

18. Explain any difficulties which may be encountered and any benefits which may arise when
implementing target costing at C Co

Difficulties in implementation:
– C Co is a service company and in service companies, it is often more difficult to find a precise
definition for some of the services. In order for target costing to be useful, it is necessary to define
the service being provided. C Co actually provides a range of services to clients including specialist
care wards at hospitals. This means that the definition of the services being provided will vary.
Different target costs will need to be derived for the different services provided.
– C Co has two types of clients: regular clients and one-off clients. Since the service for regular
clients is being repeated, it should be relatively easy to set a target cost for these jobs. However, for
the one-off jobs, there may not be any comparative data available and therefore setting the target
cost will be difficult.
– Similarly, some of the work available is very specialist. For example, cleaning restaurants and
kitchens after an outbreak of food poisoning will require specialist techniques and adherence to a
set of regulations with which C Co may not be familiar. It may be difficult to establish the market
price for a service like this, thus making it difficult to derive a target cost.
Benefits to C Co
– Target costing is useful in competitive markets where a company is not dominant in the market
and therefore has to accept a market price for their products. C Co is operating in a competitive
market and whilst the service offered by C Co is more specialist, it is clear from the recent drop in
sales that price increases do lead to loss of customers. C Co cannot therefore ignore the market
price for cleaning services and simply pass on cost increases as it has done. Target costing would
therefore help C Co to focus on the market price of similar services provided by competitors, where
this information is available.
– If after calculating a target cost C Co finds that a cost gap exists, it will then be forced to examine
its internal processes and costs more closely. It should establish why the prices of the products it
uses have increased in the first place. If it cannot achieve any reduction in these prices, it should
consider whether it can source cheaper non-chemical products from alternative suppliers. So, target
costing will benefit C Co by helping it to focus on cost reduction and consequently customer
retention

19. arguments put forward for marginal costing:

 Quicker and easier to calculate
 Avoids arbitrary fixed cost allocations
 More useful information for short-term decision-making
 Avoids overheads being capitalized in unsaleable inventory
 Avoids fictitious profits by removing the effect of inventory level changes from profit
 Treats fixed costs as a period cost by viewing fixed production costs as ‘capacity costs’ the
benefit of which expires at the end of the period
 Profit is a function of sales, not a function of a build up of inventory
 By reporting fixed costs as period costs, this may force managers to pay more attention to
them – their impact on profit is emphasized
Arguments put forward for absorption costing:
 Complies with SSAP 9 for external reporting purposes
 Avoids fictitious losses being reported by deferring fixed overheads in periods of slack sales
(an application of the ‘matching’ principle)
 Recognises the need to meet fixed costs in the long run
 Provides full product costs useful for both pricing and inventory valuation purposes
 Recognises that fixed costs are incurred for the benefit of production and are, therefore, a
product cost rather than a period cost.

ISSUES IN BUDGETING

a) Explain how the BB philosophy could be applied to Vita GmbH

- Explanation of BB: what is it?
- Movement away from 'traditional' budgeting, with its emphasis on bureaucracy and control
- Rethinking the way today's organisations are managed
- Removal of resource constraints
- Focus on team goals
- Focus on transparency and openness
- Flexible and adaptable to ongoing change
- Allow creativity, independence, and freedom for employees
- Applying BB: BB is a management approach; applying BB in practice means that management
needs to adopt a new way of thinking and a modern style of management for the organisation.
Analyse the ways in which BB could benefit the organisation (suggestions for current problems
which
BB can help to address)
1. A significant amount of management time is currently taken up with budgeting and control
2. Managers are currently operating a ‘spend-it-or-lose-it’ mentality.
3. Managers are ‘detached’ from the customer and have little awareness or understanding of
customer priorities.
4. In terms of organisational performance, there appears to be a focus on financial measures of
performance.
5. The organisation has layers and layers of bureaucracy.
6. Extremely low (or non-existent) staff motivation (majority of workforce = care centre staff).
7. Dysfunctional and unethical staff behaviour.
8. Lack of innovation.
9. Financial resources are not being allocated efficiently. For example, an investment in data
systems now would save money in the long run; a failure to invest in data systems now could
have damaging long-term implications (e.g., if patient data is incorrect this could lead to
patients being given the wrong care or medication).
10. Lack of diversity and fresh thinking at Board level.
11. Responsibility concentrated at Board level (top-down management structure).
For each of the above ‘issues’ you need to: (i) explain the issue; (ii) explain why it is a problem for
the
organisation (or why it could lead to problems in the future) and (iii) identify the aspects of BB which
could
help with the issue, for example:
- Motivation (employee empowerment)
- Teamwork
- Customer-focus
- Creativity and innovation
- Faster transfer of information
- Responsibilities and values are highlighted
- Recognition of 'bigger picture' achievements rather than time-wasting
b) Why the Board of Directors of Vita GmbH may have reacted negatively to Mary’s suggestion; why
might the Board be resistant to change and reluctant to implement new ‘management’ approaches?
 They may see the suggestion as a direct criticism of their performance
 They may not yet have confidence in Mary as she was only appointed recently
 They may have concerns about the financial costs of implementation
 They may have concerns about the time commitment needed for planning, preparing and
implementation
 They may be fearful of ‘losing control’ (e.g., by delegating responsibility, as is necessary for
BB)
 They may lack confidence in their employees’ ability to take on more responsibilit
 i. Briefly explain what the adverse materials mix and favorable materials yield
variances indicate about production at Safe Soap Co in October.
ii. Discuss whether the sales manager could be justified in claiming that the change in
the materials mix has caused an adverse sales volume variance in October.

19. What arguments would Arturo Tuzon, manager of the Mining Division, make to support the
transfer-pricing method that he prefers?

Arturo Tuzón, the manager of the Mining Division will appeal to the existence of a competitive
market to price transfers at market prices. Using market prices for transfers in these conditions leads
to goal congruence. Division managers acting in their own best interests make decisions that are
also in the best interests of the company as a whole.
Tuzón will further argue that setting transfer prices based on cost will cause him to pay no attention
to controlling costs since all costs incurred will be recovered from the Metals Division at 110% of full
costs.
20. Would you recommend that Escuelas allow the divisions to buy and sell toldine in the open
market, and to negotiate transfer prices between themselves? Explain your answer.
 Encourage the management of the Mining Division to be more conscious of cost control.
 Provide a more realistic measure of divisional performance while motivating actions that are
in the best interests of Escuelas as a whole.
 Save transactions costs for the divisions and the company.
 Perhaps provide toldine to the Metals Division at a cost lower than the price its competitors
would pay for toldine. Of course, where in the range between €85 and €93 per unit, the
transfer price will eventually end up depends on the bargaining powers of the two divisions.

21. What non-financial factors need to be considered as part of the decision-making process of
buying from an external supplier?
Using full cost plus gives the service department no incentive to control costs.
This means it appears to the sales department that external supplies are cheaper.
Making this decision in the interests of the sales department is at odds with the interests of the
company overall.
How long will this external price hold for? How reliable are they? How quickly do they respond?
Will customers notice any change in quality?
Transfer pricing:

- If manufacturing division has surplus capacity, it should accept any offer in excess of it’s
variable manufacturing cost
 - If internal supply is required in excess of it’s capacity, minimum transfer price should be
revenue less savings on variable selling and distribution costs
- Cost plus pricing will only lead to maximization of group profits if it is equal to the
external market price
- Since cost-plus is based on actual costs, division will not be motivated to control costs.
Transfer price should be on standard costs
- To give supplying division motive to reject external market offers, receiving division
should offer to pay their percentage of fixed costs on top of variable costs

No external market: Supplying division variable costs (higher so that there is incentive for the
manager) ≤ Transfer price ≤ Receiving division contribution (incentive)

There is an external market and spare capacity: supplying division should accept transfer price
equal to variable cost
External market and insufficient capacity: internal transfer price take into account supplying
division lost contribution through external sales

Discuss the problems with the current system of

calculating and reporting variances for assessing the
performance of the production manager.

- The raw material price variances included in the report are

probably outside the production manager’s control, and are
more the responsibility of the purchasing manager.

- Furthermore, the production manager has no participation in

setting the standard mix. Holding managers accountable for
variances they cannot control is demotivating.

- There appears to be no use of planning variances. Prices and

quality of the three materials are volatile and using ex ante
prices and usage standards can give a distorted view of mix
and yield variances. Failing to isolate non-controllable planning
variances can be demotivating.

- The standard mix for the product has not changed in five years
despite changes in the quality and price of ingredients. It can
also lead the production manager to attempt control action
based on variances which are calculated based on standards
which are out of date.
- As Kappa Co does not currently give feedback or commentary,
a true picture is lacking as to the production manager’s
performance. There is also no follow up on the variances
calculated.

- As Kappa Co does not appear to place much importance on

the variances, the production manager will not be motivated to
control costs and could become complacent which could
adversely impact Kappa Co overall.

- This can be illustrated by looking at the overall usage variance

reported which shows a $580 favourable variance, so the
production manager could assume good performance.
However, if the usage variance is considered in more detail,
through the mix and yield calculations, it can be seen that it
was driven by a change in the mix.

- There is a direct relationship between the materials mix

variance and the materials yield variance and by using a mix of
materials which was different from standard, it has resulted in
a saving of $913·33; however, it has led to a significantly lower
yield than Kappa Co would have got had the standard mix of
materials been adhered to.

- Also changing the mix could impact quality and as a result

sales and there is no information about this.
- Problems with current transfer price and suggested
alternative
The problem is that the current transfer price of $40 per
unit is now too high. Whilst this has not been a problem
before since external suppliers were charging $42 per unit,
it is a problem now that Division M has been offered
component L for $37 per unit.
- If Division M now acts in its own interests rather than the
interests of the group as a whole, it will buy component L
from the external supplier rather than from Division L.
 - This will mean that the profits of the group will fall
substantially and Division L will have significant unused
capacity.

- Consequently, Division L needs to reduce its price. The

current price does not reflect the fact that there are no
selling and distribution costs associated with transferring
internally, i.e. the cost of selling internally is $4 less for
Division L than selling externally.

- So, it could reduce the price to $36 and still make the
same profit on these sales as on its external sales.

- This would therefore be the suggested transfer price so

that Division M is still saving $1 per unit compared to the
external price.

- A transfer price of $37 would also presumably be

acceptable to Division M since this is the same as the
external supplier is offering.

From the group’s perspective

For every motor sold externally, Division M generates a profit of
$80 ($850 – $770) for the group as a whole. For every motor
which Division S has to buy from outside of the group, there is
an incremental cost of $60 per unit ($800 – [$770 – $30]).

Therefore, from a group perspective, as many external sales

should be made as possible before any internal sales are made.

Consequently, the group’s current policy will need to be

changed. This does, however, assume that the quality of the
motors bought from outside the group is the same as the quality
of the motors made by Division M.
Division M’s total capacity is 60,000 units. Given that it can
make external sales of 30,000 units, it can only supply 30,000
of Division S’s demand for 35,000 motors.

These 30,000 units should be bought from Division M since,

from a group perspective, the cost of supplying these internally
is $60 per unit cheaper than buying externally. The remaining
5,000 motors required by Division S should then be bought in
from the external supplier at $800 per unit.

In order to work out the transfer price which should be set for
the internal sales of 30,000 motors, the perspective of both
divisions must be considered.

From Division M’s perspective

Division M’s only buyer for these 30,000 motors is Division S,
so the lowest price it would be prepared to charge is the
marginal cost of making these units, which is $740 per unit.

However, it would ideally want to make some profit on these

motors too and would consequently expect a significantly higher
price than this.

From Division S’s perspective

Division S knows that it can buy as many external motors as it
needs from outside the group at a price of $800 per unit.
Therefore, this will be the maximum price which it is prepared to
pay.

Overall
Therefore, the transfer price should be set somewhere between
$740 and $800. From the perspective of the group, the total
group profit will be the same irrespective of where in this range
the transfer price is set.

However, it is important that divisional managers and staff

remain motivated. Given the external sales price which Division
M can achieve and the fact that Division S would have to pay
$800 for each motor bought from outside the group, the transfer
price should probably be at the higher end of the range.

Should u reapportion service overheads to production departments?

Reapportioning production service department costs is necessary to compute product costs for
stock valuation purposes in order to meet the financial accounting requirements. However, it is
questionable whether arbitrary apportionments of fixed overhead costs provides useful
information for decision-making. Such apportionments are made to meet stock valuation
requirements, and they are inappropriate for decision-making, cost control and performance
reporting. An alternative treatment would be to adopt a variable costing system and treat fixed
overheads as period costs. This would eliminate the need to reapportion service department
fixed costs. A more Materials handling (£) 100,000 (100,000) 135,000 — 781 recent suggestion is
to trace support/service department costs to products using an activity-based costing system
(ABCS).