Question 1
Residual income (RI) is calculated as the difference between the operating income and the minimum return on the assets. RI = Accounting income – (min rate of return (%) × average operating assets). If RI > 0, then the company is earning more than the hurdle rate (minimum rate of return), thus the proposed project is desirable. Value Added (EVA) is a special case of RI, calculated as the difference between net income (operating income after tax) and the cost of capital per annum. Therefore, unlike RI, EVA calculates the actual cost of capital, instead of the minimum rate of return and considers after-tax operating profit. It is a monetary value, while RI is represented a as percentage. EVA is often preferred by the investors, as it gives an opportunity to relate the amount of resources needed for the project to the potential profit.
Question 2
Target costing is the method, which calculates the difference between the target product price in the market and the desired profit per unit, in order to determine the optimal price of the product. The current product/service price can be then compared to the target price, adjusting the former through processes and product features optimization. However, target costing is associated with a number of challenges. Firstly, it is very difficult to estimate precisely the selling price, as market conditions are changing over time, due to new competition, technological advancement and volatile consumer preferences. Secondly, the estimated profit margin is derived from the shareholders’ expectations and not on the market potential. Moreover, target cost should also incorporate such aspects as quality management, delivery reliability, process design and continuous improvement, which often cannot be estimated in advance. It is also crucial to determine in advance how overheads are being. If the overheads are included into the target cost, then it is necessary to predict the production volume as well. Lastly, achieving the target cost is highly cross-functional task, which requires extensive coordination.
Question 3
Balanced scorecard is a tool used in strategic decision-making. Its main advantage is the “balanced” perspective on the company’s performance, using both financial and non-financial criteria. The original components of the balanced scorecard, proposed by Kaplan and Norton, were financial, customer, internal business processes and learning/growth. It helps to identify and clarify organization’s vision and objectives and to determine the steps to achieve them. It allows not only determining the cost of the conducted activities, but also identifying strategic process and products, emphasizing the quality aspect and identifying long-term development opportunities, rather than a short-term cost reduction and growth. One of the major criticisms of the balanced scorecard implementation is its inability to provide a summarized view on the problem, instead presenting a list of criteria and performance indicators. Secondly, in order to evaluate future orientation, measurements used for the balanced scorecard cannot be outdated. This poses a challenge, since the assumptions and measurements used for the scorecard design might not be relevant or true at the time of the future strategy implementation. Lastly, the generic structure of the scorecard may not fit every organization. In order to determine a successful strategic path, each company should identify own characteristics and measurements, relevant for its future competitiveness.
Question 4
Transfer pricing usually refers to the price setting and analysis for the transactions between related entities or organization components, for services, products, intangibles etc, to allocate profit and resources. Most of the countries in the world adopt certain regulations for transfer pricing, in order to avoid tax evasion due to profit shift. There are several parameters to be considered when setting a transfer price. Firstly, it is the related legislation. Secondly, the nature of service/goods, risks and additional services by the seller and the actual terms of sale (e.g. quantity). Moreover market conditions should be taken into account, including outside prices, fixed, variable and marginal cost of service/goods provision.
Question 5
Just-in-Time (JIT) is a part of the lean strategy, which aims to improve business performance by optimizing processes and reducing inventory and associated costs. JIT principle pursues several objectives. Firstly, it reduces inventories both at the workstations and in the warehouse, due to synchronized delivery and production processes. It assures more flexible and multifunctional workforce. Using JIT, higher quality is assured due to immediate error detection, prevention and correction. It assures operation flexibility, reducing set up time for new order fulfilment.
Question 6
(i) Management by exception refers to the practice of investigating only the cases, which resulted in a significant deviation of the planned results from the actual ones. It is believed to provide time savings for the management, allowing concentrating on the strategic objectives definition, rather than operational issues. Project managers have to meet only to discuss key decisions, instead of conducting regular meetings. The leaderships style, associated with the management by exception, is usually based on criticism, negative reinforcement and feedback.
(ii) Kaizen costing is based on the continuous reduction of the cost for manufacturing of the existing products. Budgeted expectations for the current period according to the kaizen system should always exceed the results of the previous one. Kaizen standards are changed every period, based on the previous accomplishments, ensuring continuous improvement.
(iii) Limiting constraints is the one factor, identified at a particular point of time, which is preventing business from becoming more profitable and achieving higher performance. Such factor can be the shortage of capacity, lack of demand etc. Once identified, the impact of the constraint should be reduced in order to improve business activity. In the following step, company’s situation is analyzed again, identifying a new limiting constraint, thus continuously improving business operations.
Question 7
(i) Profit contribution of each unit of Alpha and Stigma camcorder models can be calculated as the difference between the selling price and total cost per unit. It is therefore equal to 425-270 = £155 for Alpha and 740 – 446 = £294 for Stigma. Based on this, it is possible to derive a profit maximization equation, where a – number of Alpha units and s – number of Stigma units: 155a + 294s max. The limiting conditions can be deduced from the problem. Since producing one Alpha camcorder requires 5h (£75/£15per hour) and producing 1 Stigma takes 6 hours (£90/£15 per hour), while the total number of hours available is 1700, we can set limiting condition: 5a + 6s ≤ 1700. Moreover, considering the existing demand, it is not appropriate to produce more than consumer request. Therefore, a ≤ 500, and s ≤ 250.
Combining all the conditions, the product mix, maximising the profit can be established at 250 units of Stigma camcorders and 40 units of Alpha, leading to the profit amount of 250×294+155×40 = £79,700
(ii) Let us assume that Toshiba Plc takes the order. As there is no excess of Stigma camcorders, it will then have to increase their production by 30, using 30×6=180 more hours. As labour capacity cannot be changed in the short run, Alpha production will be reduced by 180/5 = 36 camcorders. The per unit profit for the additional 30 Stigma camcorders will be 680 - 446 = £234. The profit from this product combination can be calculated as:
294×250+234×30+155×4 = £81, 140. Since, £81, 140 > £79,700, the order should be taken.
(iii) As the main constraint is labour for Toshiba Plc., management of the company should take steps to eliminate this bottleneck. Although in the short – run hiring more skilled labour is not feasible, in the long run Toshiba should consider this option, especially if the demand for camcorders (in particular for Stigma model) will continue to grow. Depending on the nature of work, it is also possible to hire temporary and low skilled worker, in order to fulfil the demand. This will be less expensive for company’s budget, would allow higher capacity flexibility, as well as reduce hiring time/effort, which would allow faster implementation.
Question 8
Material Price Variance = standard cost - actual cost of material used or purchased = £8×2400 - £21600 = 19,200 – 21600 = £2400
Material usage variance = (standard quantity of materials - actual quantity of materials) × standard cost per unit = (300×10 – 2400) ×£8 = £4800
Total material cost variance = actual cost of actual number of units - budgeted material cost = = Material usage variance - Material Price Variance = £4800 – £2400 = £ 2400
Labour rate variance = (actual labour rate - standard labour rate) x actual number of hours = (£9 -£9) * 11,100 = £0
Labour idle time variance = idle time × standard rate = 1500 × £9 = £13,500
Labour efficiency variance = (standard labour time - the actual labour) × standard rate = (2400 – 11000) × £9 = £77400
Total labour cost variance = standard labour cost - actual labour costs = 300 × 8 × $9 – £99900 = £ 78300
(b) The variances related both to the material and labour cost suggest problems in the planning. The variances are especially big in budgeting labour costs. The deviation could have occurred if prices of material changed. Labour variance could arise from overtime payment, which was larger than the standard rate. However, as the labour rate variance is 0, workers were not paid above the budgeted value. Idle time also significantly contributes to the deviation, as it means paying people without utilizing their potential. Variances in both material and labour can also appear due to inefficient processes in production, which required higher input usage.
Question 9
Book value of the investment can be calculated as the cost of investment, adjusted to the depreciation. As the depreciation method used is straight line depreciation over 3 years, and the residual value is 0, then the following table can be constructed:
The revenue from the investment is equal to 11,000,000 – 2,000,000 – 800,000 = £9,200,000. When it is accounted for depreciation, then the profit value per annum is going to be equal to £9,200,000 - £5,000,000 = £4,200,000
Therefore, ROI can be calculated as the (profit / investment book value) ×100%, thus
Year 1
(4,200,000/15,000,000) ×100% = 28%
Year 2
(4,200,000/10,000,000) ×100% = 42%
Year 3
(4,200,000/5,000,000) ×100% = 84%
As ROI for all 3 years exceeds both the average investment ROI of 15% for the company as well as the cost of capital of 10%, the investment should be undertaken.
RI = Revenue - (Cost of capital × Assets)
As the Residual Income value is positive, the company has earned enough to cover the capital charge of the investment. Therefore, the investment should be undertaken even based on the RI valuation.
