Question & Answer

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CVP Single product   (LO3)

SmallScale Publishing has just commenced business and will sell only one title, “New to Business”. Market analysis has indicated that sales for the next 6 months should be 5 000 copies. The accountant has provided information that shows variable costs are $100 per title with fixed costs expected to be $200 000. The book is expected to sell for $150.

Required

(a) Calculate the breakeven number of books to be sold.

(b)           Calculate the estimated profit for the first six months.

 Identify an industry that would have a high level of operating leverage. Briefly comment on your selection.

 Give an example of how a business can reduce variable costs by increasing fixed costs.

How do different cost structures affect the breakeven point and operating leverage?

Under what circumstances will managers want sensitivity analysis results relating to a CVP analysis?

Explain how CVP analysis can be used to make decisions about increases in advertising costs.

          Describe three uses for CVP analysis.

  Can the margin of safety ever be negative? Explain your answer.

How are CVP analysis and breakeven analysis related? 

    Explain the term sales mix in your own words. How does sales mix affect the contribution margin?

How do volume discounts from suppliers affect our assumption that the cost function is linear? Explain how we incorporate this type of cost into a CVP analysis.

Explain the relationship between margin of safety percentage and degree of operating leverage. 

To estimate revenues, costs and profits across a range of activity, we usually assume that the cost and revenue functions are linear. What are the specific underlying assumptions for linear cost and revenue functions, and how reasonable are these assumptions?

What is the effect on an entity’s breakeven point of a lower income tax rate?

An organisation experiences a 20 per cent increase in pre-tax profits when revenues increase 20 per cent. Assuming linearity, what do you know about the organisation’s cost function?

Explain how to calculate a weighted average contribution margin per unit.

If an entity has a mixed cost function, a 10 per cent increase in sales volume should increase income by more than 10 per cent. Explain why.

            Transfer pricing

Georgina Chan is the chief financial officer of Colorado Pty Ltd, which has three interdependent divisions where, on average, about 30 per cent of the output of one division is transferred to one of the other divisions. She is currently dealing with a dispute within the accounting office about the best way to treat transfer pricing within the company. The chief executive officer has advised that any change to the policy should not compromise what is best for the company overall. Senior accountant Andy Chan says ‘as we are a highly decentralised firm, the only way to go is to use market price as the key method and allow sourcing autonomy’. Meanwhile, graduate accountant Roger Singh says ‘I disagree. If we go with full cost plus a 15 per cent mark-up and no sourcing autonomy, that would be best’.

Required

State one advantage and one disadvantage of each proposed policy and advise which policy you think would serve the company best. Briefly explain.

            Choice of transfer price

The following information relates to a new computer chip that Hand Held has developed for its new mobile phone that contains a personal organiser:

The variable costs of the mobile phone division will be incurred whether it buys from the chip division or from an outside supplier.

Required

(a)        What is the highest price that the managers of the mobile phone division would want to pay the chip division for the chip? Explain.

(b)        If the chip division is working at full capacity and cannot produce additional units, what transfer price for the chip would be best for the entity as a whole? Explain.

(c)        If the chip division is not operating at capacity and has no prospect of reaching capacity, what is the lowest price its managers would typically be willing to sell chips to the mobile phone division?

Transfer price; sale to outside versus inside customer

The Enviro division of Solar Sun produces electric motors, 20 per cent of which are sold to the Energy Plus division of Solar Sun and the remainder to outside customers. Solar Sun treats its divisions as profit centres and allows division managers to choose their sources of sale and supply. Corporate policy requires that all interdivisional sales and purchases be recorded at variable cost as transfer price. Enviro division’s estimated sales and standard cost data for 2017, based on its full capacity of 100 000 units are as follows:

Enviro has an opportunity to sell the 20 000 units to an outside customer at a price of $75 per unit on a continuing basis. Energy Plus can purchase its requirements from an outside supplier for $85 per unit.

Required

Assuming that Enviro division desires to maximise its gross margin, should Enviro accept the new customer and drop its sales to Energy Plus for 2019? Why?

            ROI; transfer prices; taxes; employee motivation

Fowler Electronics produces colour plasma screens in its Bien Hoa plant in Vietnam. The screens are then shipped to the entity’s plant in Sturt, South Australia, where they are incorporated into finished televisions. Although the Bien Hoa plant never sells plasma screens to any other assembler, the market for them is competitive. The market price is $750 per screen.

Variable costs to manufacture the screens are $350. Fixed costs at the Windsor plant are $2 000 000 per period. The plant typically manufactures and ships 10 000 screens per period to the Sturt plant. Taxes in Vietnam amount to 30 per cent, of pre-tax income. The Windsor plant has total assets of $20 000 000.

The Sturt plant incurs variable costs to complete the televisions of $110 per set (in addition to the cost of the screens). The Sturt plant’s fixed costs amount to $4 000 000 per period. The 10 000 sets produced each period are sold for an average of $2500 each. For Sturt, the tax rate is 45 per cent of pre-tax income. The Sturt plant has total assets of $30 000 000.

Required

(a)        Determine the return on investment for each plant if the screens are transferred at variable cost.

(b)        Determine the return on investment for each plant if the screens are transferred at market price.

(c)        To reduce taxes, will Fowler prefer a transfer price based on cost or market price? Explain.

(d)        Will the top managers in each plant prefer to use cost or market price as the transfer price? Explain.

(e)        How would you resolve potential conflict over the transfer price policy?

Lease versus buy decision; ROI; residual income; EVA; manager          incentives

Refer to the information in Problem 18.21. The manager of Sandy Point Construction is considering a new project. She can buy or lease equipment that will reprocess tailings from old mines to remove any traces of gold left behind by the original separating processes. The purchase price of the equipment is $150 000. The cost to lease is $2000 per month. She estimates the return (incremental revenues minus incremental expenses, including lease cost) to be $40 000 per year. She knows that purchasing the equipment will increase the value of average operating assets. If she leases the equipment, expenses will increase, but not assets. (In other words, the lease will be accounted for as an operating lease.) Although it is more cost effective to purchase the equipment, she has decided to lease it.

Required

(a)     Calculate the new ROI if the equipment is (i) purchased or (ii) leased.

(b)     Calculate the new residual income if the equipment is (i) purchased, or (ii) leased.

(c)     One of the adjustments that can be made using EVA is to treat all operating lease costs as if they were purchases — in other words, to capitalise the lease. If Sandy Point Construction used EVA with this adjustment, how might the manager’s incentives and behaviour change? Explain.

            ROI; residual income; explaining the better measure

The following financial data are for the evaluation of performance for Sandy Point Construction:

Sandy Point Construction currently uses return on investment to evaluate investment centre managers. An accounting intern from the local university suggested to the controller that residual income may be a better performance measure.

Required

(a)     Calculate ROI for Sandy Point Construction.

(b)     Calculate residual income for Sandy Point Construction.

(c)     Write a brief memo to the controller explaining why residual income is a better performance measure.

            ROI, EVA, residual income

Senior management at Harriot Industries, an Italian-based fashion house and cosmetics company, have been engaged in a debate around the best key financial measure relevant to evaluate the performance of senior executives and divisional managers. Currently, the performance of senior managers and divisional managers is based on return on investment (ROI), which forms the basis of the bonus payments, provided ROI increases are achieved each year.

The main source of tension seems to be that some of the accounting staff are pushing for the use of economic value added (EVA) or, at the very least, residual income (RI) to be used at both the senior executive and divisional levels.

You have been asked to contribute some views. On a recent visit to the head office of Harriot Industries you were able to access details on a printout from a digital whiteboard that represented a discussion about performance measures and a potential investment project in the Logistics Division. Some of this material is provided below.

Required

Using the information provided in the table, demonstrate (perhaps including calculations) the key arguments that might be put forward to support the view that the sole use of return on investment (ROI) may be inappropriate, particularly at the divisional level.