A transfer price may be:
(a) Market based (i) full market price
(ii) discounted market price (b) Cost based
(i) marginal cost (ii) full cost
(iii) cost-plus (based on either marginal or full cost with a profit margin) (c) Negotiated
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Key chapter points
• JIT aims for zero inventory and perfect quality and operates by demand-pull. It consists of JIT purchasing and JIT production and results in lower investment requirements, space savings, greater customer satisfaction and increased flexibility.
• JIT aims to eliminate all non-value-added costs.
• Inventory costs include purchase costs, holding costs, ordering costs and costs of running out inventory.
• Inventory control levels can be calculated in order to maintain inventories at the optimum level.
The three critical control levels are reorder level, minimum level and maximum level.
• The economic order quantity (EOQ) is the order quantity which minimises inventory costs.
The EOQ can be calculated using a table, graph or formula.
• There are a number of other systems of stores control and reordering, such as order cycling, two- bin, classification and Pareto distribution.
– Under the order cycling method, quantities on hand of each stores item are reviewed periodically.
– The two-bin system of stores control, or visual method of control, is one whereby each stores item is kept in two storage bins.
– Materials items may be classified as expensive, inexpensive or in a middle-cost range.
– Pareto (80/20) distribution which is based on the finding that in many stores, 80% of the value of stores is accounted for by only 20% of the stores items.
• Many firms base price on simple cost-plus rules.
– Full cost-plus pricing is a method of determining the sales price by calculating the full cost of the product and adding a percentage mark-up for profit.
– Marginal cost-plus pricing/mark-up pricing is a method of determining the sales price by adding a profit margin on to either marginal cost of production or marginal cost of sales.
• Many firms base price on what consumers demand rather than simple cost-plus rules.
• Target costing requires managers to change the way they think about the relationship between cost, price and profit. The traditional approach is to develop a product, determine the expected standard production cost of that product and then set a selling price (probably based on cost), with a resulting profit or loss.
• The target costing approach is to develop a product concept and then to determine the price customers would be willing to pay for that concept. The desired profit margin is deducted from the price, leaving a figure that represents total cost. This is the target cost.
• Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the divisional performance measurement or discouraging overall corporate profit maximisation.
• Transfer prices may be based on market price where there is a market.
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Quick revision questions
1 Features of a Just-in-Time production system include:
A longer production runs
B producing only to meet known customer demand C more movement of materials within the production area D less preventive maintenance work
2 Which of the following may be reasons for holding inventory?
(I) To take advantage of bulk purchase discounts
(II) To smooth out production volumes when sales demand is seasonal (III) When the production process is very long.
A (I) and (II) only B (I) and (III) only C (II) and (III) only D (I), (II) and (III)
3 A company determines its order quantity for a raw material by using the Economic Order Quantity (EOQ) model.
What would be the effects on the EOQ and the total annual holding cost of a decrease in the cost of ordering a batch of raw material?
EOQ Total annual holding cost
A Higher Lower
B Higher Higher
C Lower Lower
D Lower Higher
4 Which one of the following statements is correct?
A For differential pricing to succeed, it must be possible to keep the different price markets segregated.
B Cost plus pricing is a pricing method to ensure maximum profits.
C Marginal cost plus pricing is more appropriate when marginal costs are a small proportion of total costs.
D Market skimming pricing is appropriate if a small cut in the selling price of the product will lead to a large increase in the quantity demanded.
5 At which stage of a product’s life cycle are profits the lowest?
A Introduction B Growth
C Saturation and decline D It could be any of these.
11: Inventory and pricing decisions 313 6 Which of the following statements regarding transfer pricing is/are correct?
I Negotiated transfer prices will always maximise total profit.
II Market based transfer prices will always encourage internal transfers.
A I only
B II only
C I and II
D Neither I nor II
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Answers to quick revision questions
1 B Features of JIT production systems are shorter production runs, more preventive
maintenance work (to prevent production hold-ups) and less movement of materials within the production area (with production based around work cells). The organisation produces only to meet known customer demand.
2 D To take advantage of bulk purchase discounts, it may be necessary to buy larger quantities, but the cost of holding more inventory is justified by the saving in purchase costs. When sales demand is seasonal, a manufacturer may schedule even production flows through the year (to reduce overtime costs, avoid excessive production capacity, etc) and this means building up inventories during the low sales seasons. When the production process is long, for example in wine-making, it is necessary to hold large quantities of work-in-progress.
3 C If there is a decrease in the cost of ordering a batch of raw material, then the EOQ will also be lower (as the numerator in the EOQ equation will be lower). If the EOQ is lower, then average inventory held (EOQ/2) with also be lower and therefore the total annual holding costs will also be lower.
4 A Market skimming pricing is appropriate when customers will pay high prices to own a new product. Cost plus pricing cannot ensure maximum profits, because profitability depends on sales demand. Marginal cost plus pricing is more appropriate when marginal costs are a large proportion of total costs, for example in retailing. For differential pricing to succeed, it must be possible to keep the different price markets segregated: for example separate prices for children and people over 70. Unless the markets can be kept segregated, customers will buy in the lower-priced market and re-sell in the higher-priced market, or will move to the lower- priced market to buy the product or service.
5 D Net profits are revenues minus costs. In the introductory stage, high prices can be charged, but fixed costs may be high and development costs may be charged against profits. In the growth phase, sales volume is rising, but prices are falling and additional capital investment may add to total costs. In the saturation and decline phase, sales volumes and probably also prices are falling, and losses may be incurred. So for a given product, any of these phases of the life cycle could be the least profitable.
6 D Negotiated transfer prices may result in maximum profit and market-based transfer prices may encourage internal transfers, but not ‘always’.
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Answers to chapter questions
1 B Revision of stock controls levels would not be necessary (I) because the control level system would be abandoned completely. Parts and raw materials would be purchased in small frequent deliveries against bulk contracts.
II is not correct because the number of suppliers would be reduced in a JIT environment.
There may be a long-term commitment to a single supplier.
III is correct. Suppliers may be chosen because of their close proximity so that they can respond quickly to changes in the company’s demands.
IV is correct. Accurate forecasting of demand reduces the need for inventories.
V is correct. Production management will aim to eliminate the occurrence of rejects and defective materials since these situations stop the flow of production.
2 C The other activities are non-value-adding activities.
3 B All are potential limitations of JIT systems. Smaller batch sizes mean more batch production runs. This results in higher set-up costs, administration costs and materials handling costs.
There is also more non-productive time spent getting ready for the next batch; therefore an opportunity cost of productive labour is also incurred.
4 (a) C Maximum inventory level = reorder level + reorder quantity – (min usage × min lead time)
= 6 300 + 6 500 – (180 × 11) = 10 820
Using good MCQ technique, if you were resorting to a guess you should have eliminated option A. The maximum inventory level cannot be less than the reorder quantity.
(b) D Buffer inventory = minimum level
Minimum level = reorder level – (average usage × average lead time)
= 6 300 – (350 × 13) = 1 750
Option A could again be easily eliminated. With minimum usage of 180 per day, a buffer inventory of only 200 would not be much of a buffer!
5 A Average inventory = safety inventory + ẵ reorder quantity
= 500 + (0.5 × 3 000)
= 2 000
6 Average inventory = Buffer inventory + EOQ/2
Total holding costs = [Buffer inventory + (EOQ/2)] x Annual holding cost per component
EOQ =
$6.40 000 25
$32
2× ×
= 250000
= 500 units
7 C [Buffer inventory + (EOQ/2)] x Annual holding cost per component
= [500 + (2 000/2)] x $2
= $3 000 8 $7.99 ($4.70 × 170%)
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Selling price 20 $
Marginal (variable) cost (5 + 3 + 7 + 2) 17
3 Mark up =
cost Marginal
Profit × 100%
= 3
17 × 100%
= 17.6%
Note that the fixed overheads are not included in marginal cost.
9 B
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Chapter 12
Performance measurement and evaluation
Topic list
1 Responsibility centres 2 Investigating variances 3 Control action
4 Performance measures 5 The balanced scorecard 6 Reward systems
Learning objectives Reference
Performance measurement and evaluation LO12
Explain the characteristics and purpose of performance measurement systems LO12.2 Analyse the different types of financial performance measures and their limitations LO12.3 Describe the key characteristics of the Balanced Scorecard and its advantages over
traditional performance measurement systems
LO12.4 Outline the characteristics of reward systems and the circumstances in which they
can be tied to performance measures
LO12.5
Internal control LO1
Identify and explain appropriate internal controls for management and accounting systems in a range of situations
LO1.7
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Introduction
In Chapter 9 we learnt the mechanics of calculating variances and preparing operating statements. But, for the purposes of operating a budgetary control system, this is not the end of the matter. The information must be given to the people responsible for the parts of the organisation that are experiencing variances, so that they can take action to bring the situation under control. A system which gives this responsibility to managers is known as responsibility accounting.
Variances provide one way of highlighting a possible problem area to managers, and is therefore a type of performance indicator. We will have a look at other performance indicators, which can be used to monitor the performance of individual departments in the organisation and the organisation as a whole.
The chapter then moves on to a discussion about the key characteristics of the balanced scorecard and its advantages over traditional performance measurement systems.
Finally, we consider reward systems.
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Before you begin
If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the study manual.
1 What is a responsibility centre? (Section 1)
2 What factors should be considered when deciding whether or not (Section 2) to investigate the reasons for the occurrence of a particular variance?
3 Why might a variance arise? (Section 3)
4 Give examples of performance measures (Section 4.1)
5 Explain how indices can be used to measure activity within an organisation? (Section 4.4.3) 6 Outline performance measures for an investment centre (Section 4.10) 7 What are the four perspectives of the balanced scorecard? (Section 5.1) 8 What are the limitations of using the balanced scorecard? (Section 5.2)
9 Define the term ‘reward’. (Section 6)
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1 Responsibility centres
Section overview
• Responsibility accounting is a system of accounting that segregates revenue and costs into areas of personal responsibility in order to monitor and assess the performance of each part of an
organisation.
• A responsibility centre is a function or department of an organisation that is headed by a manager who has direct responsibility for its performance.
There are a number of different bases for control:
– A cost centre is any unit of an organisation to which costs can be separately attributed.
– A profit centre is any unit of an organisation to which both revenues and costs are assigned, so that the profitability of the unit may be measured.
– An investment centre is a profit centre whose performance is measured by its return on capital employed.
Definitions
Responsibility accounting is a system of accounting that makes revenues, costs and assets the responsibility of particular managers so that the performance of each part of the organisation can be monitored and assessed.
A responsibility centre is a section of an organisation that is headed by a manager who has direct responsibility for its performance.
A budget will be prepared for each responsibility centre, and its manager will be responsible for achieving the budget targets of that centre. The performance of the centre will be monitored, and the manger will be expected to take appropriate action if there are significant variances or other targets are not met.
Responsibility centres are usually divided into different categories. Here we shall describe cost (expense), revenue, profit and investment centres.