module preparation seminar (part i) for module b on ... · module preparation seminar (part i) for...

Module Preparation Seminar (Part I)

for

Module B on Corporate Financing

Speaker

Mr. Ted Chan

18 October 2013

Table of Contents QPB Corporate Financing Dec 2013

Prepared by Ted Chan, CPA, CFA 1 Copyright © Kaplan Financial 2013

HKICPA QPB Seminar

Table of Contents

1. Introduction

P.2

2. LP 5: Performance Measurement

P.5

3. LP 6: Performance Measurement for Organisational Units

P.34

4. LP 4 : Costing

P.58

5. LP 1, 2: Strategy and Ethics

P.79

Introduction QPB Corporate Financing Dec 2013


Exam No. Exam

B Financial Management 783 67% Feb-2005 B Financial Management 1,323 64% Sep-2005 B Financial Management 1,738 62% May-2006 B Financial Management 1,722 50% Feb-2007 B Financial Management 2,182 60% Sep-2007 B Financial Management 2,400 65% May-2008 B Financial Management 2,287 56% Feb-2009 B Financial Management 2,447 62% Sep-2009 B Financial Management 2,592 74% May-2010 B Corporate Financing 265 65% Dec-2010 B Corporate Financing 1,410 51% Jun-2011 B Corporate Financing 1,609 48% Dec-2011

B Corporate Financing 1,609 50% Jun-2012 B Corporate Financing 2,025 50% Dec-2012 B Corporate Financing 2,396 46% Jun-2013

45%

50%

55%

60%

65%

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75%

Feb

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Oct

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QPB

QPB



Past Paper Analysis

LP Dec-2010 Jun-2011 Dec-2011 Jun-2012 Dec-2012 Jun-2013

1 Q4 (7) Q3 (7) Q3 (12) Q3 (13) Q2 (12)

2 Q1 (14) Q1 (7)

3 Q2 (15)

4 Q2 (10) Q1 (20) Q1 (38)

5 Q1 (10) Q1 (22)

6 Q2 (23)

7

8 Q4 (7) Q2 (6) Q5 (2)

9 Q4 (8),

Q6 (10) Q4 (5) Q4 (5) Q5 (14) Q4 (20)

10 Q5 (18) Q5 (20)

11 Q6 (24),

Q7 (8) Q4 (15) Q6 (15) Q4 (18) Q5 (15)

12 Q5 (16) Q3 (16) Q1, Q2

(32)

13 Q6 (10) Q1, Q3

(18)

14

15

16

17 Q4 (10) Q6 (15)

18 Q5 (20) Q2 (15)

19 Q4 (9)

20

Out Q2 (19)



Key points:

1. The exam consists of half calculations and half discussions, and quite often the discussion

questions come after the calculations, so it is important for you to understand and practice as many

calculations as possible

2. QPB emphasises on application, so it is important that you understand in details the theories

discussed in the class. It is an open-book exam, but it relies very little on the notes because the

marking scheme rarely accepts material copied from your notes.

LP 5: Performance Measurement QPB Corporate Financing Dec 2013


Overall Performance Measures (LP 5.2) Characteristics of a good performance measurement system 1. Support corporate strategy, its communication and implementation 2. Measure performance from a financial, non-financial, quantitative and qualitative perspective 3. Attuned to the needs of decision makers and their activities 4. Reporting is produced at sufficient regularity to properly support decision-making 5. Attention to the accuracy of data and calculation of measures is important for trust in the

information (LP 5.2.3) Meaningful Comparison 1. Budget 2. Competitors 3. Other time periods 4. Other measures of performance

a. Don‟t just focus on a very limited number of measurement 5. Other industries Disadvantages of Ratio Analysis



(LP 5.3.1) Profitability

Advantages Disadvantages

Simple to calculate No direct relationship between profitability and shareholder value

Information are readily available Need to ensure like is compared with like. Different companies may calculate profitability measurements based on different methods

Measure how well a business is utilising the funds invested in it

Subject to manipulation using the flexibility in accounting policies

Commonly used by many analyst May lead management to focus on short term only, and ignore long term best interest

Gross margin = Gross Profit

Sales

Return on investment (ROI) = Net profit after tax

Total asset

Residual Income (RI) = Net profit - [capital charge x total assets]

Return on Equity (ROE) =

Operating profit

Equity

Gross profit margin =

Sales - COS x 100%

Sales

Net profit margin = Net profit

x 100% Sales



Return on Capital Employed (ROCE)

=

Operating Profit Capital Employed

/ ( = Total assets – Current liabilities) / ( = Shareholders' equity + Non-current liabilities)

= Profit Margin x Asset Turnover

=

Operating Profit x

Sales

Sales Capital Employed

Note: Be careful of the exact formula used in exams!!! For example if in the exam, you are given your competitors‟ ROE calculated as net profit after tax dividend by equity, you should also calculate your company‟s ROE using the same formula. Don‟t just rely on the formula stated in LP or other notes.



Example of Profitability

Solution



(LP 5.3.4) Liquidity – Short Term

Current Ratio = Current Assets

Current Liabilities

Quick Ratio = Current Assets – Inventory

Current Liabilities Note: The quick ratio is the more stringent than current ratio. Out of all current assets, inventory is the most difficult to be converted into cash and is therefore is excluded Note: The higher the ratios, the better liquidity of the company The easier for the company to meet its liabilities

Receivables Period = AR

x 365 Credit Sales

Payables Period = AP

x 365 Cost of sales / CreditPurchase

Inventory Period = Inventory

x 365 Cost of sales

Cash operating cycle = Inventory Period + Receivables Period – Payables Period Note: The balance sheet figures (AR, AP, Inventory) can be ending, beginning or average figures. Therefore you need to pay attention to what is required in the exams What does cash operating cycle mean? Purchases Sales Debtors Pay Inventory Period AR Period AP Period DAYS Pay Creditors Cash Operating Cycle 1. It measures the time from payment of inventory to receipt of money from customers 2. Shorter cash operating cycle can mean

a. Low balance sheet figures. For example, if a company keeps very low inventory level, it seems that its inventory can be sold fast

b. Higher P&L figures



What is the optimal duration of cash operating cycle? 1. Depends on the balance between liquidity and profitability 2. Depends on three factors

a. The industry you are in i. For example, construction industry has much longer cash operating cycle than

retail industry b. Management attitude

i. Within the same industry, some management may be more aggressive and so it tries to keep low inventory level, leading to short cash operating cycle. However, some management may be more prudent and so it tries to keep high inventory level, leading to long cash operating cycle

c. Efficiency of operation i. Big companies, with better IT system, should be able to control its inventory level

better, manage its AR and AP better Should attain short cash operating cycle

(LP 5.3.2) Financial Gearing – Long Term

Financial Gearing = Total Debt

Total Equity Note: There are many ways to calculate the gearing, so please pay attention to what is given and required in the exams Note: The higher proportion of debt The higher the financial gearing The higher the financial risk because the company may find it difficult to repay the debt and interest The higher the chance of being forced into liquidation

Interest Coverage = Profit before Interest and Tax

Interest Expense Note: It measures how many times the operating profit can cover the interest expense Note: The higher interest coverage, the better ability to support interest payment the less likely the company will default on interest payment financially healthier



(LP 5.3.3.2) Operational Gearing – Long Term

Operational Gearing = Fixed Costs

Total costs Alternatively,

Operational Gearing = Contribution

Operating Profit Contribution = Revenue – Variable Cost of Sales Operating Profit = Contribution – Fixed Costs Note: There are many ways to calculate the gearing, so please pay attention to what is given and required in the exams Note: The higher proportion of fixed cost / contribution

The higher the operational gearing

The more volatile the operating profit because if sales changes, operating profit changes by a

larger percentage if the proportion of fixed cost is high

Example of Operating Gearing

High gearing Low gearing $ per unit $ per unit Selling price $100 $100 Variable costs ($40) ($60) Contribution per unit $60 $40 ___ ___ Total sales 4,000 units 4,000 units $ $ Total sales revenue $400,000 $400,000 Total variable costs ($160,000) ($240,000) Total fixed costs ($180,000) ($100,000) Operating profit $60,000 $60,000 Breakeven sales 3,000 units 2,500 units Operating profit @ 3,500 units $30,000(-50%) $40,000 (-33%) Operating profit @ 5,000 units $120,000 (+100%) $100,000 (+67%) This illustrates that the business with the higher gearing has the greater upside potential ($60k $120k, +100%), but greater downside risk ($60k $30k, -50%).



(LP 5.3.5) Cash Flow Why is cash important? 1. Profitability

a. Cash can earn profit by buying inventory, investment, etc 2. Liquidity

a. Cash can prevent closure of business by meeting short-term cash disbursement requirements

What is optimal cash balance? 1. Take a balance between profitability and liquidity

a. (Liquidity) Make sure enough cash is kept on hand to meet short term cash outflow requirements

b. (Profitability) Make sure not have too much idle cash Marginal cash flow (MCF)

MCF = Contribution margin (i.e. sales – variable costs) – change in working capital (increase only)

MCF = Contribution margin (i.e. sales – variable costs) + change in working capital (decrease only) Operating cash flow (OCF)

OCF = EBIT – Change in net operating assets Net cash flow (NCF)

NCF = Change in borrowings Advantages of Cash flow Measurement 1. Difficult to be manipulated Disadvantages of Cash Flow Measurement 1. More difficult to prepare when compared to profitability measurement Growth

Sustainable Growth % = Retained income

x (Dividend

Retention %) Opening equity

Dividend Retention % = 1 – Dividend Payout %

Dividend Payout % = Dividend Paid

Net Profit



(LP 5.4) Non-financial Measures

Features of Non-financial Measures

Examples of Non-financial Measures



Advantages of Non-financial Measures



(LP 5.6) The Balanced Scorecard (Read Example 3) What is Balanced Scorecard? 1. A comprehensive framework that translates the organisation‟s vision and strategy into a coherent

set of performance measures 2. Include financial and non-financial performance

Steps in Implementing the Balanced Scorecard 1. Make the strategy explicit

a. Low-cost producer? Maintain market share? b. Can interact with LP 2 Strategies

2. Choose the measures a. The measures should support the achievement of strategies

3. Define and refine a. Clearly define the exact requirement under each measurement

4. Deal with people a. Limit the number of measures b. Career progression and remuneration should be appropriately linked to the scorecard

measures



Advantages of the Balanced Scorecard 1. Consensus on organisation priorities 2. Clearer communication / team working

a. The implementation of balanced scorecard involves almost all sub units in the company 3. Alignment of strategic goals with shorter term actions

a. The measurements are a comprehensive representation of the goals Disadvantages of the Balanced Scorecard



(LP 5.10.3.2) Agency Theory

What is an agency relationship?

What are the conflicts between shareholders (the principal) and the management (the agent)?

1. Remuneration

a. Management wants more, but shareholders don‟t

2. Takeover bids

a. Management doesn‟t want the company to be taken over because it may lose its job

b. Shareholders may want to sell the company at good price

3. Risky business decisions

a. Management may want to undertake risky projects in order to earn big bonus

b. Shareholders want the company to develop healthily

How to solve the agency conflicts?

What compensation scheme can solve the agency conflicts?

1. Executive share option scheme

a. Advantages

i. Since management‟s bonus is linked to the share price

Goal alignment is achieved between the management and shareholders

ii. This scheme usually takes several year

Prevent management from focusing on short term only

b. Disadvantages

i. Share price may not be under control of management all the time

Unfair performance measurement to management

ii. Cannot avoid the possibility of profit manipulation which then improve share price



Example 1 on Ratio Analysis (Source: HKICPA Learn Pack May 2010 P.9-25)



Answers to Example 1 on Ratio Analysis



Example 2 on Cash Flow Preparation (Source: HKICPA Learn Pack May 2010 P.9-28)



Answer to Example 2 on Cash Flow Preparation



Example 3 on Performance Measurement



Answers to Example 3 on Performance Measurement



Example 4 on Performance Measurement

Scotia Health Consultants Ltd provides advice to clients in medical, dietary and fitness matters by offering consultation with specialist staff.

The budget information for the year ended 31 May 20X2 is as follows:

(i) Quantitative data as per Appendix.

(ii) Clients are charged a fee per consultation at the rate of: medical $75; dietary $50 and fitness $50.

(iii) Health foods are recommended and provided only to dietary clients at an average cost to the company of $10 per consultation. Clients are charged for such health foods at cost plus 100% mark-up.

(iv) Each customer enquiry incurs a variable cost of $3, whether or not it is converted into a consultation.

(v) Consultants are EACH paid a fixed annual salary as follows: medical $40,000; dietary $28,000; fitness $25,000.

(vi) Sundry other fixed cost: $300,000.

Actual results for the year to 31 May 20X2 incorporate the following additional information:

(i) Quantitative data as per Appendix.

(ii) A reduction of 10% in health food costs to the company per consultation was achieved through a rationalisation of the range of foods made available.

(iii) Medical salary costs were altered through dispensing with the services of two full-time consultants and sub-contracting outside specialists as required. A total of 1,900 consultations were sub-contracted to outside specialists who were paid $50 per consultation.

(iv) Fitness costs were increased by $80,000 through the hire of equipment to allow sophisticated cardio-vascular testing of clients.

(v) New computer software has been installed to provide detailed records and scheduling of all client enquiries and consultations. This software has an annual operating cost (including depreciation) of $50,000.

Required:

(a) Prepare a statement showing the financial results for the year to 31 May 20X2 in tabular format. This should show:

(i) the budget and actual gross margin for each type of consultation and for the company

(ii) the actual net profit for the company

(iii) the budget and actual margin ($) per consultation for each type of consultation.

(Expenditure for each expense heading should be shown in (i) and (ii) as relevant) (15 marks)



(b) Suggest ways in which each of the undernoted performance measures (1 to 5) could be used to supplement the financial results calculated in (a). You should include relevant quantitative analysis from Appendix for each performance measure:

(1) Competitiveness;

(2) Flexibility;

(3) Resource utilisation;

(4) Quality;

(5) Innovation.

(20 marks)

(Total: 35 marks)

Appendix Statistics relating to the year ended 31 May 20X2

Budget Actual Total client enquiries:

- new business 50,000 80,000 - repeat business 30,000 20,000

Number of client consultations:

- new business 15,000 20,000 - repeat business 12,000 10,000

Mix of client consultations:

- medical 6,000 5,500 (note 1) - dietary 12,000 10,000 - fitness 9,000 14,500

Number of consultants employed:

- medical 6 4 (note 1) - dietary 12 12 - fitness 9 12

Number of client complaints:

270

600

Note: Client consultations INCLUDE those carried out by outside specialists. There are now 4 full-

time consultants carrying out the remainder of client consultations.



Answers to Example 4 on Performance Measurement

(a)

Scotia Health Consultants Ltd Operating statement for the year ended 31 May 20X2

Medical Dietary Fitness Total $000 $000 $000 $000 Budget: Client fees 450.0 600.0 450.0 1,500.0

Healthfood mark-up (cost 100%) 120.0 120.0

Salaries (240.0) (336.0) (225.0) (801.0)

______ ______ ______ ______

Budget gross margin 210.0 384.0 225.0 819.0

______ ______ ______ ______

Variances: Fee income gain/(loss) (37.5) (100.0) 275.0 137.5 Healthfood mark-up loss (30.0) (30.0) Salaries increase (15.0) (75.0) (90.0) Extra fitness equipment (80.0) (80.0)

______ ______ ______ ______

Actual gross margin 157.5 254.0 345.0 756.5

______ ______ ______ ______

Less: company costs: Enquiry costs -budget (240.0)

- variance (60.0) General fixed costs (300.0) Software systems cost (50.0) ______

Actual net profit 106.5 ______

Budget margin per consultation ($) 35.00 32.00 25.00 Actual margin per consultation ($) 28.64 25.40 23.79

(b)

Competitiveness may be measured in terms of the relative success/failure in obtaining business from enquiries from customers. The percentages are as follows:

Budget Actual

Uptake from enquiries:

- new business 30% 25%

- repeat business 40% 50%

Repeat business suggests customer loyalty. The new business figures are disappointing, being below the budgeted level of uptake.

In absolute terms, however, new business is 5,000 consultations ABOVE budget whereas repeat business is 2,000 consultations BELOW budget.

There are variations within the types of consultation. Medical and dietary are DOWN on budget by approximately 8% and 16% respectively. Fitness is UP on budget by approximately 60%.

Flexibility may relate to the company being able to cope with flexibility of volume, delivery speed and job specification. Examples of each may be taken from the information in the Appendix.

Additional fitness staff have been employed to cope with the extra volume of clients in this area of business.

Medical staff levels have been reorganised to include the use of external specialists. This provides flexibility where the type of advice required (the job specification) is wider than expected and may improve delivery speed in arranging a consultation more quickly for a client.

Dietary staff numbers are unchanged even though the number of consultations has fallen by 16% from budget. This may indicate a lack of flexibility. It may be argued that the fall in consultations



would warrant a reduction in consultant numbers from 12 to 11. This could cause future flexibility problems, however, if there was an upturn in this aspect of the business.

Resource utilisation measures the ratio of output achieved from input resources. In this case the average consultations per consultant may be used as a guide.

Average consultations per consultant

Budget Actual Rise() or fall()

Medical (full-time only) 1,000 900 10%

Dietary 1,000 833 16.7%

Fitness 1,000 1,208 20.8%

These figures show that:

(1) Medical consultants are being under-utilised. Could this be due to a lack of administrative control? Are too many cases being referred to the outside specialists? This may, however, be viewed as a consequence of flexibility - in the use of specialists as required.

(2) Dietary consultants are being under-utilised. Perhaps there should be a reduction in the number of consultants from 12 to 11 as suggested above.

(3) Fitness consultants are carrying out considerably more consultations (20.8%) than budgeted. There are potential problems if the quality is decreasing. Overall complaints from clients are up by 120%. How many relate to fitness clients?

It may be, however, that the new cardio-vascular testing equipment is helping both throughput rates and the overall level of business from fitness clients.

Quality of service is the totality of features and characteristics of the service package that bear upon its ability to satisfy client needs. Flexibility and innovation in service provision may be key quality factors.

The high level of complaints from clients (up from 1% to 2% of all clients) indicates quality problems which should be investigated.

Quality of service may be improving. For example the new cardio-vascular testing equipment may be attracting extra clients because of the quality of information which it provides. Quality may also be aided through better management of client appointments and records following the introduction of the new software systems.

Innovation may be viewed in terms of the performance of a specific innovation. For example, whether the new computer software improved the quality of appointment scheduling and hence resource utilisation; improved competitiveness in following up enquiries and hence financial performance; improved flexibility in allowing better forward planning of consultant/client matching.

Innovation may also be viewed in terms of the effectiveness of the process itself. Are staff adequately

trained in its use? Does the new software provide the data analysis which is required?

LP 6: Performance Measurement for Organisational Units QPB Corporate Financing Dec 2013


LP 6.1: Divisionalisation Advantages of Divisionalisation (LP 6.1.2) 1. Great responsiveness to local needs

2. Faster decision making

3. Improve motivation and job satisfaction

a. Divisional managers can make their own decisions

4. Improve training

a. Divisional managers are responsible for the performance of their own divisions

Provide better training to improve performance

5. Remove operational control responsibility from top management

a. Top management can then focus on strategic issues

Disadvantages of Divisionalisation (LP 6.1.3)

1. Divisional goals may be different from organisational goals

a. It is reasonable for a divisional manager to make decisions in the best interests of his

division, and ignore the best interest of the whole organisation

b. To prevent dysfuncational decision making, the top management should retain centain

centralised authority

2. Competition among divisions

3. Duplicate divisions

a. Lead to higher cost for the organisation

b. For example, all divisions run its own accounting and HR department

4. Top management loses control

a. To avoid losing control over the whole organisation, the top management should set up a

good system of performance evaluation and upward reporting

Design of Performance Measurement Characteristics of performance indicators

1. Aligned to the organisation‟s strategic goals

2. Measurable

a. If the indicators are not measureable / vague, there is a lack of objective measuring

standards

3. Controllable

a. It is unfair to judge a sub-division‟s performance using indicators that are out of the

control of the sub-division‟s managers

4. Relevant

5. Few in number



LP 6.2 : Return on investment (ROI) / Return on assets (ROA) (Read Example 4) ROI shows how much profit has been made in relation to the amount of capital invested

Advantages of using ROI (Overall)

1. Widely used

2. As a relative measure in %, it enables comparison for sub-units of different size

3. % is easy to understand

4. Can be broken down into two secondary ratios (Profit margin + Asset turnover)



Problems of using ROI (Profits)

1. Profit is subject to manipulation

a. Choice of accounting policies is subjective

2. Profit does not necessarily lead to cash inflow

3. Choice of profit is subjective

a. Operating profit before interest, taxes, and extraordinary items is often used because it

measures only operating items which are under control of the sub-unit managers

4. Some profits or costs are common to more than one sub-unit

Subjective sharing of profit is needed

Problems of using ROI (Capital Employed)

1. Choice of asset is subjective

a. Total assets

b. Total assets minus total liabilities (ie the equity)

c. Fixed assets at net book value plus working capital

i. The best choice of assets

ii. Because it encourages sub-unit managers to use effectively fixed assets and

working capital

2. Valuation of fixed assets is subjective

a. Net book value

not appropriate because net book value may be quite different from the market value

b. Gross historical cost

as bad as net book value

c. Current replacement cost

the best!

3. Treatment of shared assets

4. Treatment of off-balance sheet asset

a. For example leased assets under operating lease

5. Timing of asset

a. Beginning? Ending? Average?

6. Choice of accounting policies is subjective

a. Mainly about depreciation methods

Problems of using ROI (Overall)

1. This is a measure in %, but not in absolute amount of profits

a. Unreasonable to give big bonus to a small sub-unit with high ROI but low profits, and

small bonus to a big sub-unit with low ROI but high profits

2. Behavioural problem 1

a. If bonus is paid to sub-units based on ROI only

sub-unit managers only accept projects with ROI higher than its current ROI (in order

to keep a high sub-unit ROI)

More and more difficult to find projects with very high ROI as time goes by

b. If bonus is paid to sub-units based on ROI only

sub-unit managers reject projects with ROI lower than its current ROI (in order to keep

a high sub-unit ROI)

reject projects with low ROI but profitable

c. Solution: Use discounted cash flow techniques (NPV, RI, etc)


a. Encourage sub-unit managers to focus on only short term results



b. For example, lower investment in fixed assets

Lower assets used

Higher ROI

c. For example, lower investments in R&D

Lower expenses

Higher profits

Higher ROI


a. ROI increases with age of assets if net book values are used

encourage managers not to replace old, inefficient assets

Example of Behavioural Problem 3 Company X earns $100 each year with a machine that was bought at cost $1,000 with useful life 5 years. If X calculates its ROI using the mid-year NBV of the machine, ROI Year 1 = $100 ÷ $900 = 11.1% ROI Year 2 = $100 ÷ $700 = 14.3% ROI Year 3 = $100 ÷ $500 = 20% ROI Year 4 = $100 ÷ $300 = 33.3% ROI Year 5 = $100 ÷ $100 = 100% The management of X has an incentive not to replace the machine because as the machine ages the ROI will become higher and higher The ROI improvement from Year 1 to Year 5 is actually fake As a result of not replacing the old machine, Company X will have low productivity with compared to its competitors that keep buying good machine A better method is to calculate ROI using the gross amount of asset ROI for all years = $100 ÷ $1,000 = 10%



Example of Behavioural Problem 1 of using ROI (Source: HKICPA Candidate Learning Pack May 2010 P.8-11)



LP 6.3: Residual Income (RI)

Residual income is a measure of the division‟s profit after deducting a notional or imputed interest cost RI = Net profit – Imputed interest on capital employed = Net profit – (Capital charge x Total assets) Advantages of using RI (LP 6.3.1)

1. It is an absolute measurement in amount, not a %

Better than ROI because RI is more consistent with the objective of maximising total profits

Behavioural problem 1 in ROI is solved

2. The selection is simple

If RI > $0 = acceptable

3. RI is more flexible because the capital charge can be changed when a project of different risk is

considered

4. Encourage the managers to pay attention to cost of financing (imputed interest)

a. Cost of financing is the minimum return required

Problems of using RI (LP 6.3.1) 1. Difficult to determine the values of total assets (Same as ROI)

2. Distorted by accounting policies (Same as ROI)

3. Encourage short term focus (Same as ROI Behaviour problem 2)

4. Does not facilitate comparison of organisations in different size

a. Some divisions are larger so their RIs are reasonably higher

5. Choice of capital charge rate is subjective

a. Firm‟s WACC

b. Average ROI

c. Firm‟s borrowing rate



Example of ROI and RI Company X has the following profit, capital employed and an imputed interest charge of 11% on operating assets Operating profit $33,000 Operating assets $100,000 Imputed interest (11%) ($11,000) RI $22,000 ROI 33% Suppose now that an additional investment of $11k is proposed, which will increase operating income in X by $1,400. The effect of the investment would be: Operating profit $34,400 Operating assets $111,000 Imputed interest (11%) ($12,210) RI $22,190 ROI 31% If the head office judges X based on ROI, X would reject the new project because the ROI will decrease from 33% to 31% In fact, X rejects all projects with ROI less than 33% because the overall ROI must decrease if X accepts a project with ROI less than 33% If the head office judges X based on RI, X would accept the project because X can earn $190 more after accepting the new project



LP 6.4 : Economic Value Added (EVA) EVA is a specific type of RI EVA = Net operating profit after tax (NOPAT*) – Capital Charge = NOPAT – (WACC x Net Asset**) * Interest is EXCLUDED from NOPAT ** Net asset should be measured at replacement cost EVA is based on economic profit which is derived by making adjustments to the accounting profit RI is based on accounting profit Advantages of using EVA (LP 6.4.2)

1. It is an absolute measurement in amount, not a %

Better than ROI because EVA is more consistent with the objective of maximising wealth of

shareholders

Behavioural problem 1 in ROI is solved

2. Less distortion by accounting policies. EVA is more like a measurement of cash flow, but not profit

3. Selection is simple. If EVA > $0 = acceptable

4. EVA encourages capital expenditure

ROI Behavioural Problem 2 is solved

a. Some items like advertising are expensed in ROI and RI but capitalised as asset in EVA

Such items do not immediately reduce the value of EVA

Does not affect the performance evaluation of a company

Problems of using EVA (LP 6.4.2) 1. Encourage short term focus

a. Even the ROI Behavioural Problem 2 is solved, EVA is still a short-term measurement

2. Too many adjustments are needed

3. Does not facilitate comparison of organisations in different size

a. Some divisions are larger so their EVA are reasonably higher



Example 1 of EVA (Source: HKICPA Learning Pack Dec 2010 P.238)

An investment centre has reported operating profits of $21m. This was after charging $4m for the development and launch costs of a new product that is expected to generate profits for 4 years. Taxation is paid at the rate of 25% of the operating profit The company has a risk adjusted WACC of 12% per annum and is paying interest at 9% per annum on a substantial long term loan The investment centre‟s non-current asset value is $50m and the net current assets have a value of $22m. The replacement cost of the non-current assets is estimated to be $64m Required Calculate the investment centre‟s EVA for the period Solution Operating profit $21m Development cost $4m Amortisation ($1m) $24m Taxation at 25% ($6m) NOPAT $18m Replacement cost of net asset $86m [$22m + $64m] Investment in new product $3m Net assets $89m NOPAT $18m Capital Charge ($10.68m) ($89m x 12%) EVA $7.32m



Example 2 of EVA (Source: HKICPA Learning Pack Dec 2010 P.239)

B division of Z co has operating profits and assets as below: $‟000 Gross profit 156 Non-cash expense (8) Amortisation of goodwill (5) Interest @ 10% (15) PBT 128 Tax @ 30% (38) Net profit 90 Total equity 350 Long-term debt 150 500 Z Co has a target capital structure of 25% debt and 75% equity. The cost of equity is estimated at 15%. The capital employed at the start of the period amounted to $450k. The division had non-capitalised leased of $20k throughout the period. Goodwill previously written off against reserves in acquisitions in previous years amounted to $40k Required Calculate EVA for B division and comment on your results Solution $‟000 Net profit 90 Non-cash expense 8 Amortisation of goodwill 5 Interest 10.5 [$15k x (1 – 30%)] NOPAT 113.5 $‟000 Beginning assets 450 Non-capitalised leases 20 Amortised goodwill 40 Adjusted assets 510 WACC = [25% x 10% x (1 – 30%)] + [75% x 15%] = 13% $‟000 NOPAT 113.5 Capital charge (66.3) [$510 x 13%] EVA 47.2 $‟000 Net profit 90 Capital charge (65) [$500 x 13%] RI 25



The EVA for B division is $47.2k, higher than its RI. This is despite the higher net asset value and is caused by treating expenses, such as amortisation, in line with economic, not accountancy, principles The business is creating value as its return (however calculated) is greater than the group‟s WACC. The division‟s ROI is 18% [$90 † $500] and WACC 13% (based on target not actual capital structure) Its „economic ROI‟ is 22.3% [$113.5 † $510]



LP 6.5: Transfer Pricing (LP 6.5.1) Definition of Transfer Pricing A transfer price is “the price charged for transfer of goods or services from one department to another” The transfer price is the revenue of the supplier division, or cost of the receiver divisions, or both Transfer pricing allows performance of each division to be evaluated on the basis of profit (LP 6.10.2) Range of Transfer Price Variable Cost in Selling Division ≤ Transfer Price ≤ Selling Price – Variable Cost in

Receiving Division (LP 6.5.2) Objectives of Transfer Pricing

1. Minimise tax liabilities

2. Fair measures of performance

3. Goal Congruence

a. Decisions made by each sub-unit manager should be consistent with the objectives of the

organisation

4. Maintain decentralised managers‟ autonomy

a. If no autonomy, sub-unit managers lose the motivation to work hard



(LP 6.11) Opportunity Cost Approach to Transfer Pricing (Read Example 1 & 2)

1. Transfer price should reflect the real (“opportunity”) cost of transferring the goods

2. Transfer price = Cost incurred + opportunity cost for the firm

3. Disadvantages

a. If the selling sub-unit is not operating at full capacity

Calculation of opportunity cost becomes difficult Practical measurement problems

Example of Opportunity Cost Approach (Source: HKICPA Learning Pack Dec 2010 P.253) Suppose, for example, that Division A is a profit centre that produces three items, X, Y and Z. Each item has an external market X Y Z External market price per unit $48 $46 $40 Variable cost of production in Division A $33 $24 $28 Labour hours required per unit in Division A 3 4 2 Product Y can be transferred to Division B, but the maximum quantity that might be required for transfer is 300 units of Y The maximum external sales are 800 units of X, 500 units of Y and 300 units of Z Instead of receiving transfers of product Y from Division A, Division B could buy similar units of product Y on the open market at a slightly cheaper price of $45 per unit What should be transfer price be for each unit if the total labour hours available in Division A are 3,800 hours or 5,600 hours? Solution Hours required to meet maximum demand: Hours External sales X 2,400 [3 x 800] External sales Y 2,000 [4 x 500] External sales Z 600 [2 x 300] 5,000 Transfer of Y 1,200 [4 x 300] Total 6,200 Contribution from external sales: X Y Z Contribution per unit $15 $22 $12 Labour hours per unit 3 hrs 4 hrs 2 hrs Contribution per labour hour $5 $5.5 $6 Priority for selling 3

rd 2

nd 1

st

Total hours needed 2,400 2,000 600

Examinable!



(a) If only 3,800 hours of labour are available, Division A would choose, ignoring transfers to B, to sell: Hours 300 Z (maximum) 600 500 Y (maximum) 2,000 2,600 400 X (balance) 1,200 Total 3,800 To transfer 300 units of Y to division B would involve forgoing the sale of 400 units of X because 1,200 hours would be needed to make the transferred units Opportunity cost of transferring units of Y, and the appropriate transfer price $ per unit Variable cost of making Y 24 Opportunity cost (contribution Of $5 per hour available from Selling X externally): benefit Forgone (4 hours x $5) 20 Transfer price for Y 44 The transfer price for Y should, in this case, be less than the external market price (b) If 5,600 hours are available, there is enough time to meet the full demand for external sales (5,000 hours) and still have 600 hours of spare capacity, before consideration of transfers However, 1,200 hours are needed to produce the full amount of Y for transfer (300 units), and so 600 hours need to be devoted to producing Y for transfer instead of producing X for external sale This means that the opportunity cost of transfer is (i) The variable cost of 150 units of Y produced in the 600 „spare‟ hours ($24 per unit) (ii) The variable cost of production of the remaining 150 units of Y ($24 per unit), plus the contribution forgone from the external sales of X that could have been produced in the 600 hours now devoted to producing Y for transfer ($5 per labour hour). An average transfer price per unit could be negotiated for the transfer of the full 300 units, which works out at $34 per unit $ 150 units x $24 3,600 150 units x $24 3,600 600 hours x $5 3,000 Total for 300 units 10,200 In both cases, the opportunity cost of receiving transfers for division B is the price it would have to pay to purchase Y externally – $45 per unit. Therefore: Maximum labour hours in A Opp. Cost to A of transfer Opp. Cost to B of transfer $ $ 3,800 44 45 5,600 34 (average) 45 In each case any price between the two opportunity costs would be sufficient to persuade B to order 300 units of Y from division A and for division A to agree to transfer them



(LP 6.6) Market Based Transfer Pricing (Read Example 3)

1. If a perfectly competitive market exists for the product, the market price is the best transfer price

a. Rare that such a market exists for intermediate products

2. Advantages (LP 6.6.3)

a. Internal policy does not significantly affect the evaluation of the divisions

Maintain divisional autonomy

i. Because transfer price is the same as external market price

b. Fair to managers of buying divisions and selling divisions

i. Selling divisions will receive the same amount for internal and external sales

ii. Buying divisions will pay the same for products if they buy internally or externally

c. Encourage internal transfers

Buying divisions may benefit from better quality of service, greater flexibility and

dependability of supply. The whole company can benefit from lower cost of administration

d. Closure of production divisions does not affect receiving divisions

3. Disadvantages (LP 6.6.4)

a. The external market may not exist

No market price exists

b. The external market may be imperfect

If the selling division wants to sell more externally, it would have to reduce its price

c. The external market may not be stable

i. Price may be influenced by unusual factors such as adverse economic conditions

d. Adjustments to market prices may be needed

i. Savings may be made from transferring the goods internally. For example,

delivery costs will be saved. These savings should be deducted from the external

market price in order to compromise a transfer price



(LP 6.7.2) Variable Cost Based Transfer Pricing

1. Rarely used in practice

2. Assumptions (all limiting)

a. Only two divisions

b. Only one product

c. Technological independence

d. Variable costs are readily determinable

e. Management in each division is autonomous

3. Disadvantages

a. If the selling division transfers at variable cost, losses will be suffered

impact badly on the selling sub-unit‟s profit performance

i. Because fixed cost is not covered

How to cover the fixed cost in the selling division if a system of marginal cost transfer price is used? 1. Sharing contribution

a. Each division can share a proportion of the overall contribution earned by the whole organisation

2. Two-part charging system a. Transfer price is set at variable cost, but there is a transfer of a fixed fee from the buying

division to the selling division

(LP 6.7.1) Full Cost Based Transfer Pricing Can be transferred at full cost / full cost plus a profit margin

1. Widely used in practice

2. Disadvantages

a. May lead to sub-optimal decision making

i. May lead to overpricing in the external market

b. Allocation of fixed costs is arbitrary

c. Imply a tendency to incorporate inefficiencies that may be passed to the next divisions

and finally the consumers

i. If consumers don‟t want to pay for the higher prices, profit of the whole

organisation is harmed

d. Discourage managers to look for better productivity and technology

i. Less costs within the department

Lower revenue received from the next divisions (Read the example below)

e. The fixed percentage mark-up

Unfair performance measurement

i. The benefits of improvement made by the selling division all go to the buying

division (Read the example below)



Example of Problems in Full Cost Based Transfer Pricing Assume a company has two departments Mark-up = 10% Full cost to manufacturing division (Division 1) = $100 External selling price of receiving division (Division 2) = $200 Total selling costs of Division 2 = $50 Quantity sold = 1,000 The transfer price is therefore = $100 x (1 + 10%) = $110 The profit of Division 2 = ($200 – $50 – $110) x 1,000 = $40,000 The profit of Division 1 = ($110 – $100) x 1,000 = $10,000 Total company profit = $40,000 + $10,000 = $50,000 Suppose now Division 1 has achieved a breakthrough in the manufacturing process and successfully reduced its cost by 40% The transfer price is therefore = $100 x 60% x (1 + 10%) = $66 The profit of Division 2 = ($200 – $50 – $66) x 1,000 = $84,000 The profit of Division 1 = ($66 – $60) x 1,000 = $6,000 Total company profit = $84,000 + $6,000 = $90,000 The total company profit has increased by $40,000 but all the benefits go to Division 2. Why? It‟s because the percentage mark-up for Division 1 is fixed at 10%. As a result, Division 2 gets all the benefits of Division 1‟s cost-reduction improvements Division 2 mark-up is not fixed because it charges what the market can bear Division 1 will have low motivation to innovate and improve because all the cost it saves becomes the benefits of Division 2 An alternative way is to allow Division 1 to impose a higher mark-up after it has improved its manufacturing process

3. Better ways to solve the problem

a. Use the standard full cost

i. Any cost over-runs become the responsibility of the selling sub-unit

Encourages the selling divisions to control costs

ii. The buying divisions can know the cost in advance, and can therefore plan ahead

b. Profit mark-up is negotiated by the two units

i. For example, based on the example above, if Division 1 on the above example

has made some improvements in cost savings, it can increase the % of mark-up

so that the benefits don‟t just go to Division 2



Example of Full Cost Plus Approach (Source: HKICPA Learning Pack Dec 2010 P.251)

Motivate Ltd has two profit centers, P and Q. P transfers all its output to Q. The variable cost of output from P is $5 per unit, and fixed costs are $1,200 per month. Additional processing costs in Q are $4 per unit for variable costs, plus fixed costs of $800. Budgeted production is 400 units per month, and the output of Q sells for $15 per unit The transfer price is to be based on standard full cost plus From what range of prices should the transfer price be selected, in order to motivate the managers of both profit centers to both increase output and reduce costs? Solution Any transfer price based on standard cost plus will motivate managers to cut costs, because favourable variances between standard costs and actual costs will be credited to the division‟s profit Managers of each division will also be willing to increase output above the budget of 400 units provided that it is profitable to do so; that is in: (a) P, provided that the transfer price exceeds the variable cost of $5 per unit (b) Q, provided that the transfer price is less than the difference between the fixed selling price ($15) and the variable costs in Q itself ($4). This amount of $11 ($15 – $4) is sometimes called net marginal revenue The range of prices is therefore between $5.01 and $10.99 Suppose the transfer price is $9. Let‟s find out the effect of divisional and organisational profits when the output and sales have increased from 400 units to 500 units At 400 units P Q Total $ $ $ External Sales 6,000 6,000 Internal Sales 3,600 3,600 Internal Costs (3,600) (3,600) External Costs (3,200) (2,400) (5,600) Profit 0 0 0 At 500 units P Q Total $ $ $ External Sales 7,500 7,500 Internal Sales 4,500 4,500 Internal Costs (4,500) (4,500) External Costs (3,700) (2,800) (6,500) Profit 800 200 1,000



(LP 6.14) Negotiated Transfer Pricing

1. Best used when a small, less than perfect external market exists for the intermediate product

2. 3 factors to consider

a. The negotiation will decide on adjustments to price for factors like reduced freight,

marketing costs, etc. on internal sales

b. The negotiated price should be close to the opportunity cost of one or preferably both

divisions

c. Each divisional manager has the right to accept or reject the offer

3. Advantages

a. Can settle conflicts by negotiation

Good for the whole company‟s morale

4. Disadvantages

a. Negotiated transfer prices depend highly on negotiating skills of management

Performance evaluation is clouded

b. Company-wide optimal decision making is questionable without central office intervention

(LP 6.15) International Transfer Pricing

1. Primary objective: Reduce tax payment

2. Transfers are not at arm‟s length

Raise issues about whether the transfer price is accepted by the tax authorities

3. Dysfunctional behavioural effects

a. Divisions in the regions of high tax rates earn very little profit

Low motivation to work hard because all profits will be shifted to regions of low tax

rates

4. Factors to consider when setting international transfer prices

Tax rates in different countries Shift profits to subsidiaries located in low-tax countries

Save tax for the whole group

Exchange Rate Fluctuation Fluctuations in exchange rates affect the profit booked in

divisions in different regions

Import tariffs Goods that enter into a country with import tariffs should be

transferred at low prices to avoid the import tariffs

Anti-dumping legislation Some countries do not import goods that are unreasonably

cheap in order to protect the domestic industries

As a result, the international transfer price may be forced to be

set at the fair price, or even more

Competitive pressures If the transfer prices are too high, the buying divisions may find

it difficult to sell and compete locally

If the transfer prices are too low, the profits cannot be shifted to

the selling divisions



Example of Tax in International Transfer Pricing (Source: HKICPA Learning Pack Dec 2010 P.262)

Division A produces product B in a country where the income tax rate is 30% and transfers it to Division C, which operates in a country with a 40% rate of income tax. An import duty equal to 25% of the price of product B is also assessed. The full cost per unit is $290, the variable cost $160 The tax authorities allow either variable or full cost transfer prices. Determine which should be chosen Solution Effect of transferring at $290 instead of $160 Income of A is $130 higher, so A pays more income tax ($39) [$130 x 30%] Income of C is $130 lower, so C pays less income tax $52 [$130 x 40%] Additional import duty paid by C ($32.5) [$130 x 25%] Net cost of transferring at $290 instead of $160 ($19.5) Should choose to transfer at $160 because $19.5 tax can be saved



Example 1 on Transfer Pricing



Answers to Example 1 on Transfer Pricing

(i)



Example 2 on Transfer Pricing



Answers to Example 2 on Transfer Pricing

LP 4: Costing QPB Corporate Financing Dec 2013


Importance of Costing 1. Inventory valuation in the statement of financial position 2. To record costs in the income statement 3. To price products 4. Decision making What are costs? 1. Direct costs (LP 4.2.1)

a. Can be traced to a product easily b. Example: direct materials, direct labour c. Note: Treatment of direct costs is the same in ALL costing methods

2. Indirect costs (LP 4.2.2)

a. Cannot be traced to a product easily b. Need to allocate it to a cost object using a driver (for example machine hours for

electricity) c. Example: electricity expenses

3. Overhead costs (LP 4.2.3)

a. Cannot be traced to a particular product b. More difficult than indirect costs to be traced to a product c. Need to allocate it using a driver

i. A subjective process (Please refer to Example 1 to see how the subjective allocation of overhead costs can affect the final valuations of inventory)

d. Example: factory rent



(LP 4.2.4) Activity Based Costing (ABC)

What is ABC?

1. A management accounting information system that identifies the various activities performed

2. Collect costs based on underlying nature + extent of those activities

Assign costs to products

3. Focus on activities as the fundamental cost objects

4. Can facilitate customer profitability analysis (LP 4.8) and ABM (LP 4.2.4.8)

Aims of ABC

1. To provide more accurate costs of products

a. To avoid the subjective allocation of overhead costs suffered in absorption costing

2. To improve the quality of management accounting information

Activities (LP 4.2.4)

1. Activities are major tasks performed

2. All activities consume resources

3. 4 kinds of activities

a. Unit level activities

i. Performed each time a unit is produced

ii. The more units produced, the more unit level activities performed

iii. Example: Machining

b. Batch level activities

i. Performed each time a batch of goods is processed

ii. The more batch of production, the more batch level activities performed

iii. Example: Machine set up, Delivery

c. Product-sustaining activities

i. Performed to enable individual products to be produced and sold

ii. The more kinds of products, the more product-sustaining activities

iii. Example: Marketing

d. Facility-sustaining activities

i. Performed to operate the organisation, but are not used by any particular product

ii. Treated as period expense

1. Because unrelated to the volume and mix of products

iii. Example: salary cost of accounting department

Implementation of ABC (LP 4.2.4.7)

1. Identify the activities performed Create an activity dictionary

2. Costs are attributed to products

Overhead absorption rate = Overhead costs

Level of activity



When to use ABC?

1. Overheads are high with compared to direct costs

a. If direct costs are very low, it is meaningless to allocate overhead costs based on direct

costs driver

2. Great diversity of products

a. Difficult to use one cost driver to well allocate the overhead costs to numerous kinds of

products

3. Great diversity of overhead inputs

4. Consumption of overheads is not driven by volume

5. Examples: Manufacturing of electrical products

Benefits of ABC

1. More accurate costs of products

a. Because of more detailed allocation of fixed costs

2. Flexible to analyse costs by cost objects

3. Reliable indication of long-run variable costs

a. Study the past trends of costs

Predict the future trend

4. Provide financial (overhead absorption rates) and non-financial information (cost driver volumes)

5. Understand cost behaviour

a. Breakdown costs into fixed and variable

b. Identify when fixed costs will increase

c. Helpful in other areas

i. Expansion of business

ii. Prepare budget with detailed cost allocations

Limitations of ABC

1. ABC may not improve profitability

a. Costly and time-consuming to locate activities and study cost behavior

2. Over reliance on historical and internal cost information

a. Do not contribute to future strategic decisions

3. Cannot avoid the subjective selection of cost drivers

4. Updating is difficult

5. Late reporting may arise

a. Because of complicated calculations of costs



(LP 4.2.11) Time-driven Activity Based Costing (TDABC) What is TDABC?

1. An improved form of ABC

2. Use time as the cost driver

Benefits of TDABC

1. Easier and faster to build an accurate cost model

2. Highlight the existence of costs of unused capacity

3. Easier to update

4. Timely reporting

(LP 4.8) Customer Profitability Analysis (CPA) What is CPA? Place a value on customers by identifying expected future cash flows from them 1. Identify revenues earned from customers

2. Identify costs incurred to earn those revenues

a. Can be facilitated by ABC

3. Focus on those customers making large contribution

a. Don‟t just focus on financial considerations. Do consider non-financial reasons.

Limitations of CPA

1. Provide historical, few period values of customers

a. Historical trend may not repeat in the future

2. Consider only financial factors

Non-financial considerations in CPA

1. Well-known customers

2. Customers with potential growth

3. Customer loyalty

4. Opportunities to learn from customers



(LP 4.2.6) Traditional Absorption Costing Absorption costing (sometimes called full costing), includes fixed overhead into the cost of a product Accepted by financial reporting standards Note: Compare it with variable costing to which does not capitalise fixed overhead into the cost of a product Note: Suitable for organisation with one or a few kinds of products, or a simple costing system Disadvantages of Absorption Costing (Read Example 1 to understand more about the disadvantages) 1. The subjective allocation of overhead Inaccurate cost of products

2. Not applicable in a one-off project a. Variable costing can help

Example: an organisation tendering for a one-off contract using this method may not win the contract even though a lower price would have been sufficient to cover all incremental costs and opportunity costs. In addition, different overhead allocation methods can result in very different price for products

3. Cannot be used in companies where a. High complexity of operation b. High proportion of overhead costs c. Less volume related costs



(LP 4.2.5) Variable Costing Not accepted by financial reporting standards Contribution – The difference between sales revenue and the marginal cost of sales. It may be thought as short for “Contribution towards covering fixed costs and making a profit”. Key relationship to remember:

Sales revenue - Variable cost = Contribution = Fixed cost + Profit

PER UNIT IN TOTAL

unit per nContribu

Cost Fixed (units) point even-Break

tio

ratio on/SalesContributi

Costs Fixed revenue) (sales point even-Break

Sales volume to achieve a target profit = unit per onContributi

profit Required cost Fixed

Example – Breakeven Analysis Selling price $10 per unit Variable cost $6 per unit Fixed costs are $20,000 per month Required: Calculate the break-even point in units and in terms of sales revenue, and the level of sales required to achieve a profit of $8,000 per month.

BEP (units) = 000,5)610(

000,20

BEP (revenue) = 000,50$

104

000,20

To make a profit of $8,000 per month, sales units = 000,74

000,8000,20



Example – Limiting Factor Analysis Stewart Ltd produces two products using the same machinery. The hours available on this machine are limited to 5,000. Information regarding the two products is detailed below: Products (per unit data) M N Selling price ($) 40 30 Variable cost ($) (16) (15) Fixed cost ($) (10) (8) Profit ($) 14 7 Machine hours per unit 8 3 Budgeted sales (units) 600 500 Note: Fixed costs are absorbed on a per unit basis calculated at the budgeted sales levels above. Required Calculate the maximum profit that may be earned. Answers M N Selling price ($) 40 30 Variable cost ($) 16 15 Unit contribution ($) 24 15 Machine hours per unit 8 3 Contribution per machine hour $3 $5 Ranking 2

nd 1

st

Product Units Hours used

Hours left Total contribution ($)

N 500 1,500 3,500 7,500 M 437(W1)

3,496 4 10,488

17,988 Fixed Costs (W2) 10,000 Profit 7,988

(W1) 3,500 ÷ 8 (W2) 10 x 600 + 8 x 500 = 10,000



Example – Limiting Factor Analysis Lauda Ltd operates a joint process from which four products arise. The products may be sold at the separation point of the process or can be refined further and be sold at a premium. Information regarding the products and the refining process can be found below:

Products E F G H

Selling prices per litre ($)

At separation point 12 16 15 18

After refining 20 23 25 22

Costs ($)

Joint process 8 8 8 8

(per litre)

Refining process:

Variable ($ per litre) 5 5 5 5

Specific fixed ($ in total) 1,000 2,000 3,000 4,000

Budgeted litres 2,000 500 5,000 6,000

The general fixed overheads in the refining process amount to $20,000.

Required:

(a) Determine which products should be further processed.

(b) Would your decision in (a) change if the general fixed overheads were $30,000?

Answers (a)

E F G H Incremental Revenue per litre 8 7 10 4 Variable cost of refining (5) (5) (5) (5) Additional contribution from refining 3 2 5 (1) Sell at split-off Litres 2,000 500 5,000

Additional total contribution($) 6,000 1,000 25,000 Specific fixed costs (1,000) (2,000) (3,000) Additional profit from refining 5,000 (1,000) 22,000 Refine Sell at split-off Refine Total relevant profit from refining is $27,000 General fixed costs of refining are 20,000 Total profit from refining $ 7,000 Thus, further process E and G, sell F and H at the split-off point. (b) If the general fixed overheads were $30,000 it would not be worth running the refining process

since it would make a $3,000 loss. In this case all products should be sold at the split-off point.



Example 1 on Overhead Allocation A company makes 2 products in 3 departments. Relevant product information is: Product A Product B Direct material cost ($) 15 25 Direct labour cost in Department 1 ($) 12 18 Direct labour cost in Department 2 ($) 15 15 Direct labour cost in Department 3 ($) 6 0* Budgeted number of units 10,000 8,000 * Product B does not pass through Department 3. The labour rate is $6 per hour in each department. The Budgeted Departmental Overheads are: Department 1 $55,000 Department 2 $27,000 Department 3 $200,000 Required (a) Calculate the cost per unit of A & B using a blanket (plantwide) overhead absorption rate,

based on labour hours

(b) Calculate the cost per unit of A & B using individual departmental overhead absorption rates, based on labour hours

(c) Which method is more appropriate?

[10 marks]



Answer to example 1 on Overhead Allocation (a) Blanket Rates

Blanket OAR = 000,99

000,200$000,27$000,55$ = $2.85 per hour

Unit Cost Product A

$ Product B

$ Direct Material 15 25 Direct Labour 33 33 Overheads 15.68 15.68 63.68 73.68 (b) Departmental Rates

Product A Product B Hours in Department 1 2 3 Hours in Department 2 2.5 2.5 Hours in Department 3 1 0 TOTAL 5.5 5.5 Total Hours in Department 1: 2 x 10,000 + 3 x 8,000 = 44,000 Total Hours in Department 2: 2.5 x 10,000 + 2.5 x 8,000 = 45,000 Total Hours in Department 3: 1 x 10,000 = 10,000 99,000

Department 1 – OAR = 000,44

000,55$ = $1.25 per hour


000,27$ = $0.6 per hour


000,200$ = $20 per hour

Unit Cost Product A

$ Product B

$ Direct Material 15 25 Direct Labour 33 33 Overheads - Department 1 2.5 3.75 Department 2 1.5 1.5 Department 3 20 0 72 63.25



(c) Appropriateness

Department 3 has much higher overhead costs than Department 1 and Department 2, and hence the allocation of overhead costs incurred in Department 3 has a very material impact to the final unit cost of Product A and Product B. Product B does not pass through Department 3, so it should not absorb any overhead cost incurred in Department 3. Therefore, using a blanket overhead absorption rate is not appropriate because it charges some overhead cost of Department 3 into Product B. Using individual departmental overhead absorption rate is a lot more appropriate because this detailed method does not charge any overhead cost incurred in Department 3 into Product B. This reflects better the actual cost incurred in both products.



Example 2 on ABC The following budgeted information relates to Money Ltd for the forthcoming period. Products

A (000)

B (000)

C (000)

Sales and production (units) 50 40 30

$ $ $

Selling Price (per unit) 45 95 73 Prime cost (per units) 32 84 65

Hours Hours Hours

Machine department (machine hours per unit) 2 5 4 Assembly department (direct labour hours per unit) 7 3 2 Overheads allocated and apportioned to production departments (including service cost centre costs) were to be recovered in product costs as follows.

Machine department at $1.20 per machine hour

Assembly department at $0.825 per direct labour hour You ascertain that the above overheads could be re-analysed into 'cost pools' as follows: Cost pool $000 Cost driver Quantity for the period

Machining services 357 Machine hours 420,000 Assembly services 318 Direct labour hours 530,000 Set-up costs 26 Set-ups 520 Order processing 156 Customer orders 32,000 Purchasing 84 Suppliers' orders 11,200 941 You have also been provided with the following estimates for the period: Products A B C

Number of set-ups 120 200 200 Customer orders 8,000 8,000 16,000 Suppliers' orders 3,000 4,000 4,200

Required (a) Prepare and present profit statements using:

(i) traditional absorption costing, and (ii) activity based costing

(b) Comment on why activity based costing is considered to present a fairer valuation of the product cost per unit.



Answers to Example 2 on ABC (a) (i) Absorption Costing

A B C Total

Volume (000) 50 40 30

$000 $000 $000 $000

Sales 2,250 3,800 2,190 Prime Cost (1,600) (3,360) (1,950) Overheads: Machinery at $1.20 per hour (120) (240) (144) Assembly at $0.825 per hour (289) (99) (49)

241 101 47 389

(ii) Activity Based Costing A B C Total

Volume (000) 50 40 30

$000 $000 $000 $000

Sales 2,250 3,800 2,190 Prime Cost (1,600) (3,360) (1,950) Overheads(Workings): Machining: $0.85 per hour (85) (170) (102) Assembly: $0.6 per hour (210) (72) (36) Setups: $50 per setup (6) (10) (10) Ordering: $4.875 per order (39) (39) (78) Purchasing: $7.5 per order (23) (30) (31)

Profit 287 119 (17) 389

Workings: Cost Pool Machining Assembly Setups Ordering Purchasing

$000 357 318 26 156 84 Driver Quantity 420,000 530,000 520 32,000 11,200

Rate $0.85 /hr $0.6 / hr $50 / setup $4.875/order $7.5/order

(b) Absorption costing is flawed in that it is a very subjective process. Overheads are first allocated

to cost centres and many will then have to be apportioned across the centres on an arbitrary basis. This arbitrary apportionment may then be repeated if there are any service centres needing reapportionment. The entire overhead for each department is then absorbed on a single basis (e.g. machine hours) with little regard to whether, for example, machine hours is a reasonable driver of that department's overheads.

ABC attempts to address the situation by linking the overheads to demand by the products for

the 'drivers' which cause the overhead in the first place. As in part (a) the total overhead is split into individual activities or 'cost pools'. For each pool a 'cost driver' is identified as being the action causing the overhead. The cost drivers are then linked to individual products.

The approach is thought to give a fairer idea of product cost and has implications in a wide range of areas such as pricing, budgeting and cost management.



Example 3 on Customer Profitability Analysis Happy Ltd is a distributor of mobile phones. Its ABC system has five activities: Activity Cost Driver Rate in 2010

1. Order processing $40 per order 2. Accessories $3 per line item 3. Deliveries $50 per store delivery 4. Carton deliveries $1 per carton 5. Shelf-stocking $16 per stocking-hour

Tommy, the Financial Controller of Happy Ltd, wants to use this ABC system to examine individual customer profitability. Two customers operating retail stores of mobile phone are used to exemplify the insights available with the ABC approach. Data pertaining to these two customers in 2009 are as follows: Park Ltd Garden Ltd Total orders 12 10 Average accessories items per order 10 18 Total deliveries 6 25 Average cartons shipped per store delivery 24 20 Average hours of stocking per order 0 0.5 Average revenue per order $2,450 $1,850 Average cost of goods sold per order $2,080 $1,620 Park Ltd is a well-established retailer of mobile phone, specialising the retails of low-end phones. It has been ordering from Happy Ltd for more than 10 years and its volume of ordering has been stable for the past few years. Garden Ltd is a new customer which was listed three months ago. Required Use the ABC information to compute the operating income of each customer in 2010. Comment on the results.



Answers to Example 3 on Customer Profitability Analysis Park Ltd Garden Ltd $ $ Revenue 29,400 18,500 Cost of goods sold (24,960) (16,200) Cost of order processing (480) (400) Cost of line items (360) (540) Cost of deliveries (300) (1,250) Cost of carton deliveries (144) (500) Cost of stocking - (80)

Operating income/(loss) 3,156 (470)

Park contributes higher operating income in 2009 while Garden contributes only operating loss, so from a financial point of view, Hello Ltd should pay more attention and put more resources to Park, and at the same time terminate the relationships with Garden. However, Hello Ltd should not ignore other non-financial considerations. First, the negative contributions from Garden in 2009 may not repeat in the future. Second, Garden, which was just listed, may have a big plan about gaining market share in the retailing of mobile phone. This may imply that there is a potential growth of profits earned from Garden if after several years of operation Garden is satisfied about the quality of mobile phones delivered by Happy Ltd. On the other hand, Park, being a well-established company in a niche market of low-end phones retailing, may contribute only stable profits to Happy Ltd in the foreseeable future. In additions, Park has been ordering from Happy Ltd for more than 10 years, suggesting that Park is a very loyal customer, so Happy Ltd should devote some resources towards Garden without worrying Park will stop ordering.



Example 4 on Time-driven ABC (Source: HKICPA Learning Pack May 2010 P.11-19)



Example 4 on Variable Costing Trevor Payne has been asked to quote for a contract which is larger than he would normally consider. The contractor would like to obtain the job as he does have surplus capacity. The estimating and design department has spent 200 hours in preparing drawings and the following cost estimate:

COST ESTIMATE $ $ Direct materials 3,000 units of X at $10 per unit (original cost) - see note 1 30,000 100 units of Y (charged out using FIFO): - see note 2 50 units at $100 per unit 5,000 50 units at $125 per unit 6,250 ───── 11,250 Direct material to be bought in - see note 3 12,000 Direct labour: skilled staff: 2,720 hours at $16 per hour - see note 4 43,520 trainees: 1,250 hours at $ 8 per hour - see note 5 10,000 Depreciation on curing press - see note 6 Annual depreciation (straight line): $12,000 One month's depreciation 1,000 Subcontract work - see note 7 20,000 Supervisory staff - see note 8 6,150 Estimating and design department - see note 9 200 hours at $10 per hour 2,000 Overtime premium for 50 hours 500 ───── 2,500 ─────── 136,420 Administration overhead at 5% of above costs - see note 10 6,821 ─────── $143,241 ─────── The following notes maybe relevant. (1) A sufficient stock of raw material X is held in stores. It is the residue of a quantity bought

some ten years ago. If this stock is not used on the prospective contract it is unlikely that it will be used in the foreseeable future. The net resale value is thought to be $20,000.

(2) Material Y is regularly used by the contractor on a variety of jobs. The current replacement

cost of the material is $130 per unit. (3) This is the standard cost of the required material. (4) Staff are always paid for a standard 40 hour week. The labour hour rate includes a charge of

100% of the wage rate to cover labour related overhead costs. It is estimated that, with this contract, 80% of the overheads are variable. It is considered that one extra worker will be re-quired temporarily for three months if the contract is obtained. His salary will be $500 per week.

(5) No additional trainees would be taken on. The trainees' wage rate is $4 per hour but their

time is charged out at $8 to allow for labour related overhead on the same basis as in note 4. (6) The curing press is normally fully occupied. If it is not being used by the contractor's own

workforce it is being hired out at $500 per week.



(7) This is the estimated cost for the work. (8) It is not considered that it would be necessary to employ any additional supervisory staff. The

estimated cost of $6,150 includes an allowance of $1,000 for overtime which it may be necessary to pay the supervisors.

(9) The expense of this department is predominately fixed but the overtime payments were

specifically incurred to get the drawings and plans out in time.

(10) The administrative expense is a fixed cost. This is the established method of allocating the cost to specific contracts.

It is considered that any quotation higher than $100,000 will be unsuccessful. Required: Prepare a revised cost estimate using an opportunity cost approach, indicating any reasoning or assumptions you make. State whether you consider that the revised calculations can provide support for a quotation below $100,000.



Answers to Example 4 on Variable Costing

REVISED COST ESTIMATE Opportunity cost approach

$ Direct materials 3,000 units of X - see note 1 20,000 100 units of Y at $130 per unit - see note 2 13,000 Direct material to be bought in - see note 3 12,000 Direct labour: skilled staff: 2,720 hours at $6.40 per hour - see note 4 17,408 trainees: 1,250 hours at $3.20 per hour - see note 5 4,000 extra worker - see note 6 6,000 Curing press - see note 7 2,000 Subcontract work - see note 8 20,000 Supervisory staff - see note 9 1,000 Estimating and design department - see note 10 0 Administration overhead - see note 11 0 ────── $95,408 ────── The following notes indicate the reasoning and assumptions upon which the above revised estimate is based. Note 1 Direct material X: The material has no alternative use in the company and therefore the contract has been charged at its net resale value of $20,000. Note 2 Direct material Y: The material has alternative uses within the company and therefore the contract is charged at its current replacement cost of $130 per unit.

Note 3 Direct material to be bought in: The entire cost of $12,000 is relevant to the contract. Note 4 Skilled staff The skilled staff are paid on a time basis and therefore will be paid regardless of whether the contract is worked or not. There is an indication that one additional staff member is required (and this is dealt with in note 6 below), but no indication that overtime is required. The only relevant charge to the

contract is the variable overhead associated with the skilled labour: 2,720 hours (0.8 0.5 $16.00) = $17,408. Note 5 Trainees The trainee staff are paid on a time basis and therefore will be paid regardless of whether the contract is worked or not. There is no indication that additional staff or overtime is required. The only relevant

charge to the contract is the variable overhead associated with the trainee staff: 1,250 hours (0.8

0.5 $8.00) = $4,000.



Note 6 Extra worker The cost of the extra staff member is directly attributable to the contract, and is therefore relevant. It

is assumed that the contract involves 12 weeks. Hence the contract is charged: 12 $500 = $6,000 Note 7 Curing press Depreciation is a sunk cost and is not relevant. However if the contract is undertaken external sales

of $500 per week would be foregone. This lost income of $500 4 weeks (one month) = $2,000 of opportunity cost. Note 8 Subcontract work The cost of the subcontract work ($20,000) is attributable to the contract, and is therefore a relevant cost. Note 9 Supervisory staff The overtime cost of $1,000 is attributable to the contract and is a relevant cost. Note 10 Estimating and design department The work performed by this department is already completed and hence the cost represents a sunk cost. Any past cost is not relevant to establishing an opportunity future cost. No charge is made to the contract. Note 11 Administration overhead Apportioned costs are not directly attributable, and therefore do not represent a relevant cost to the contract. No charge is made to the contract. CONCLUSION Based on the above figures, there is justification for the proposition that the contractor should tender for the contract, quoting at any figure between $95,409 and $100,000. However the contractor should be advised that there are other considerations. Will the contract cause cash flow problems? Would a movement in interest rates affect the contractor's decision to tender? These two questions represent the depth of appraisal required for a contract of this nature.

LP 1, 2: Strategy and Ethics QPB Corporate Financing Dec 2013


LP 2: Strategic Formulate and Choice

1. Environment

analysis

2. Corporate

mission 1a. SWOT (LP 2.9.1)

- Strength (internal)

- Weakness (internal)

- Opportunities (external)

- Threats (external)

1b. Porter’s five-forces

(LP 2.7)

- Threat of new entrants

- Level of industry rivalry

- Threat of possible

substitute products

- Customer negotiating

power

- Supplier negotiation

power

3a. BCG Matrix (LP 2.10.2)

3. Long-term

objectives

1c. PESTE

- Political

- Economic

- Societal

- Technological

- Environmental

Question Mark

(Build / Phase Out)

Dog

(Divest)

Cash Cow

(Harvest)

4a. Ansoff Matrix (LP 2.11)

Market penetration

strategy

Product development

strategy

Diversification

(Related / Unrelated)

Market development

strategy

4. Strategies

4b. Porter’s Generic Strategies (LP

2.12)

- Low Cost leadership

- Differentiation

- Focus

How to

compete?

Where to

compete?

Star

(Hold)

1d. Critical

Success Factors

(LP 2.9.4)

3b. GEM Matrix

LP 1, 2 : Strategy and Ethics QPB Corporate Financing Dec 2013




Ansoff Matrix (LP 2.11.2)

1. Market penetration

a. Maintain / Increase share of current market with current products

i. Example: Competitive pricing / advertising / promotion

b. Secure dominance of growth markets

c. Restructure a mature market by driving out competitors

d. Increase usage by existing customers

i. Example: Loyalty cards / membership

e. Acquire smaller competitors

2. Market development

a. Export to new geographical markets

b. New distribution channels

i. Example: selling organic food in supermarkets, not just specialist shops

c. Differential pricing policies to attract different types of customer and create new

market segments

i. Example: Airline companies charge customers in different ways according

to the time of booking

3. Product development

a. Launch of new products to existing markets

b. Advantages

i. Can use existing marketing arrangements to promote the new products

Low costs to use current promotional methods / distribution channels

ii. Already have good knowledge of customers

Well understand their wants and habits

Easier to launch the new products

iii. Cost of entry to the market will go up because the company has

successfully created new products

c. Disadvantages

i. Riskier than market penetration and market development because it

requires major investment in the new product development process

4. Diversification

a. Objective 1: Growth

i. New products and new markets should be selected which offer prospects

for growth, which the existing product-market mix does not

b. Objective 2: Investing surplus funds

i. Diversification becomes a high-risk strategy

c. Objective 3: Synergy

i. Diversification is justified

5. Withdrawal strategy

a. Withdrawal may be an appropriate strategy in the following situations

i. Products may disappear when they reach the end of the life cycles

ii. Underperforming products

iii. Sales of assets to raise funds



b. Exit barriers make withdrawal difficult

i. Too much costs (redundancy costs, difficult to sell assets, etc)

ii. Managers hate to admit failure

iii. Political barriers (government attitudes)

iv. Market considerations may delay withdrawal (a loss-making product may

not be worth terminating if it can contribute to the company‟s reputation)

6. Divestment, demerger and privatisation (also in LP 19)

a. Can allow market valuation to reflect growth and income prospects



Porter’s Generic Strategies (LP 2.12)

1. Cost leadership

a. Being the lowest-cost producer in the industry

2. Differentiation

a. A differentiation strategy assumes that competitive advantage can be gained

through particular characteristics of a firm‟s products

i. Breakthrough products

A radical performance advantage over competition, perhaps at a lower

price

ii. Improved products

Not radically different from their competitors but are obviously superior

in terms of better performance at a competitive price

iii. Competitive products

Derive their appeal from a particular compromise of cost and

performance

b. How to differentiate

i. Build up a brand name

ii. Give the products special features

iii. Exploit other activities of the value chain

3. Focus

a. Cost focus

Being the cost leader for a particular segment

b. Differentiation focus

Pursue differentiation for a chosen segment



Product Life Cycle (LP 2.10.1)

1. Introduction

a. A loss-making stage

b. A new product takes time to find acceptance by would-be purchases

There is a slow growth in sales

c. Unit costs are high because of low output and expensive sales promotion

2. Growth

a. Start to make profits

b. If the new product gains market acceptance, sales will eventually rise more

sharply

c. Competitors are attracted

d. Unit costs fall because sales and production rise

3. Maturity

a. Profits are maintained

b. Sales grow slower

c. This is the longest period of successful products

4. Decline

a. Sales and profit begin to decline

b. Producers trying to search for new market segments to prolong the product life

c. Some producers leave the market because of falling profits



Industry Life Cycle (LP 2.13)



External factors to consider about when forming strategies (Hints about what you can

write in your exam regarding strategies!!)

1. Customers

a. Stable taste vs changing taste

b. Easy to accept price change?

2. Suppliers

a. Stability of supply

b. Quality of supply

3. Competitors

a. Monopoly vs many competitors

4. Government

a. Political stability

b. Tax policy

c. Labour regulations

d. Environmental regulations

5. Industry life cycle

a. Introduction

b. Growth

c. Maturity

d. Decline

6. Economy

a. Inflation

b. Exchange rate

c. Interest rate

7. Product life cycle

a. Introduction

b. Growth

c. Mature

d. Declining

Internal factors to consider about when forming strategies

1. Finance

a. Where to get finance for the operation? Equity? Loan? Retained Earnings?

2. Human Resources

a. Relevant skills

b. Enough employees?

3. Shareholders

a. Effect to share price

b. Effect to dividend policy



Ethics (LP 1)

HKICPA Code of Ethics for Professional Accountants (LP 1.2)

5 Fundamental Principles (LP 1.2.3.1)

1. Integrity

a. Straightforward, honest and fair dealing

2. Objectivity

a. No bias

b. No conflict of interest

c. No influence of others to override professional or business judgements

3. Professional Competence and Due Care

a. Maintain professional knowledge

b. Act diligently in accordance with applicable technical and professional standards

4. Confidentiality

a. Not disclose confidential information without proper and specific authority, unless

required by law or professional duty

b. Not use confidential information for personal advantage

5. Professional Behaviour

a. Comply with laws and regulations

b. Avoid action that discredits the profession

c. The minimum requirement

Threats and Safeguards (LP 1.2.3.2)

1. Self-interest threats

a. Occur as a result of the financial / other interests of an accountant

b. Example: Providing financial advice for a client in which the accountant hold

some shares

The accountant tend to incorporate more positive information

2. Self-review threats

a. Occur when an accountant reviews works/judgements done by him

3. Advocacy threats

a. Occur when an accountant promotes a position or opinion to the point that

subsequent objectivity may be compromised

b. Example: An accountant promoting an IPO for his client while he at the same

time works in the accounting department of the client

The accountant tend to promote his own company

4. Familiarity threats

a. Occur when an accountant becomes too sympathetic to the interests of others

because of a close relationship

b. Example: An accountant providing financial advice to a client which he has

served for long time

May ignore some details just because the accountant thinks he is very familiar

with the client



5. Intimidation threats

a. Occur when an accountant may be deterred from acting objectively by threats

(actual or perceived)

b. Example: An accountant providing financial advice to a loss-making client

If the decision is not good, the accountant may get fired

The accountant may try to provide fake or over optimistic information

Solving Ethical Dilemma

AAA 7-step model (LP 1.5)

1. Determine the facts

2. Define the ethical issue

3. Identify the major principles, rules and values

4. Specify the alternatives

5. Compare values and alternatives – see if the decision is clear

6. Access the consequences

7. Make your decision

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