COST AND MANAGEMENT ACCOUNTING 2(CUAC 203)

ABC, INVESTMENT APPRAISAL & DIVISIONAL PERFORMANCE QUESTIONS

A: ACTIVITY BASED COSTING

1. Mutambi Ltd-TUTORIAL QUESTION 1
Mutambi Ltd is engaged in the production of different types of cooling systems. It manufactures
and sells cooling systems using almost the same production methods and equipment for each
system. It also specialises in processing and replacing old parts of systems. Mutambi Ltd
traditionally determines its prices by adding a 10% mark-up to the budgeted full cost of the
system. The fixed overheads are absorbed on the basis of machine hours using a predetermined
rate.

Mutambi Ltd Operating and Financial Data for 2012

Mist Cooling Water mist Total
Average hours 3 hours 3,6 hours
per unit
Number of 996 1 270 2 266
systems
produced(units)
Variable cost $1 450 $1 254
per system
Total costs $14 376 780

Required:
(a) Calculate the cost per unit and the prices that Mutambi would have charged for each system
using the traditional system of allocation. (4 marks)

Tawanda is a new management accountant appointed this year. He reviewed the cost accounting
system and found that irrelevant overheads were allocated to the system. The inappropriate
allocation of overheads had a direct impact on the cost and prices of the systems. Therefore, he
has recommended activity based costing (ABC) for allocation of the overhead costs to the
systems. However, directors are not aware of the activity based costing (ABC) system.
Therefore, they are worried about the impact of switching to an activity based costing (ABC)
system to assign overheads to the system. Tawanda has gathered the following additional
information after analyzing the cost accounting records maintained by the organisation:
Activity Cost Driver Mist Water Fixed
Cooling Mist Overheads($)
Set ups Number of set ups 3 000 2 000 8 780 000
Material Number of movements of 6 200 6 200 1 500 400
handling materials
Inspection costs Number of inspections 7 860 23 580 1 059 600
Total 11 340 000
Overheads

Required:
(b) Explain the concept of activity based costing and also discuss the benefits that may arise from
introducing the ABC for the allocation of overhead costs. (6 marks)
(c) Calculate the cost per unit and the prices that Mutambi would have charged for each system
using the ABC to assign overhead costs. (7 marks)
(d) Compare the results of your calculated prices in (a) and (c) and suggest with reasons what
pricing decisions you would recommend to the organisation. (3 marks)
(20 marks)
SUGGESTED SOLUTION

1. Mutambi Ltd
This question requires students to calculate the prices under both the traditional method and the
activity based costing system. It also asks you to compare the results obtained under both
methods.
Don’t forget to add a 10% mark up on cost while calculating the prices under both methods.
In part (b), explain how cost, prices, revenue etc would be affected by the use of an ABC system.
Calculate cost driver rate for each activity and allocate the fixed overheads to each system.

(a) Calculation of the prices for mist cooling and water mist system

Mist cooling Water mist

$ $
Variable costs 1,450 1,254
Add: Absorbed fixed overhead (W1) 4,500 5,400
5,950 6,654
Add: 10% mark-up 595 665.4
Price 6,545 7,319

Working
W1
Total machine hours are calculated as under
Machine hours = (996 units x 3 hrs) + (1,270 units x 3.6 hrs) = 7,560 hrs
1 mark
Fixed overheads are calculated as under:

$ $
Total costs 14,376,780
Less: Variable costs
Mist cooling ($1,450 x 996 units) 1,444,200
Water mist ($1,254 x 1,270 units) 1,592,580
Total variable costs (3,036,780)
Fixed overheads 11,340,000

Under the traditional system, the overhead cost is allocated on machine hour basis. Therefore,
overhead absorption rate per hour = Total fixed cost / total machine hours
= $11,340,000 / 7,560 hours
= $1,500
Mist cooling system = 3 hours x $1,500 = $4,500
Water mist system = 3.6 hours x $1,500 = $5,400

(b) Activity-based costing is an approach to costing that identifies individual activities as

fundamental cost objects. It uses the costs of these activities as the basis for assigning costs to
ultimate cost objects such as products or services.

The following are the benefits that may arise for Mutambi from the introduction of the
ABC:
While allocating the overheads under activity based costing, activity consumed by each product
is taken into consideration. A one-to-one relationship is identified between the cost and cost
drivers. Therefore, the origin of the costs could be identified more clearly. All relevant cost
drivers are provided by Mutambi.
1 mark
Activity-based costing also reveals the appropriate cost of each activity consumed in the
organisation. Activity-based costing can help Mutambi to control costs by giving importance to
the activities that generate them. For example, set up costs are the most important cost and are
higher than other overheads. Proper training could be given to the staff to reduce the set up costs.
Therefore, activity based costing is a means of cost control.
1 mark
Activity-based costing calculates the costs of each activity and assigns the activity cost to
products on the basis of activity consumption. It encourages optimum pricing. Therefore, it is
more useful in determining the minimum price that Mutambi would have charged for each
system. 1 mark
Under activity-based costing, the overheads are allocated to the products on the basis of the
activity consumption (cost driver). This means that all cost is considered and assigned on a more
realistic basis. Therefore, it helps when deciding the more profitable product or services.
1 mark
Activity-based costing also provides accurate information about costs to help with decision-
making. This would further help the managers to make correct decisions in key areas such as
product pricing and cost control.
1 mark
Maximum marks 6

(c) Calculation of the prices of each system under an activity based costing

Mist cooling Water mist Marks

$ $
Total overhead cost (W1) (a) 6,283,100 5,056,900 0.5
No. of systems (b) 996 1,270 0.5
Overhead per system (a / b) 6,308.33 3,981.81 0.5
Variable cost 1,450.00 1,254.00 0.5
Total cost per system 7,758.33 5,235.81 0.5
Add: 10% mark up 775.83 523.58 1
Price 8,534.16 5,759.39

Workings
W1 Overhead allocation to the operation on the basis of ABC

Activity Cost driver Total overheads Total activity consumption Cost/driver

$ $
Set ups Number of set ups 8,780,000 5,000 1,756.00
Materials Number of mvents 1 500 400 12 400 121.00
handling
Inspection costs Number of inspections 1,059,600 31,440 33.70
Total overheads 11,340,000

W2 Total overhead consumed by each system

Set up costs
Mist cooling = Cost per driver x activity consumption
= $1,756 x 3,000
= $5,268,000
Water mist = $1,756 x 2,000
= $3,512,000 1 mark
Materials handling costs
Mist cooling = Cost per driver x activity consumption
= $121 x 6,200 = $750,200
Water mist = $121 x 6,200 = $750,200
1 mark
Inspection costs
Mist cooling = Cost per driver x activity consumption
= $33.70 x 7,860 = $264,900
Water mist = $33.70 x 23,580 = $794,700
1 mark
Maximum marks 7
(d) The traditional pricing method that is based on machine hours does not take into
consideration the activities that drive costs. The cost drivers are identified from activity based
information. The cost of manufacturing the mist cooling system has risen to $7,758.33 under
ABC whereas the cost of the water mist system has fallen to $5,235.81 per system.
1 mark

The price of $7,319 charged for a water mist system under the traditional method exceeds the
costs of $5,235.81 calculated using ABC. In fact, it is possible that the company is losing sales
opportunities for the water mist system, as their prices are very high compared to the prices
calculated using ABC, and are therefore uncompetitive. The company needs to take into
consideration the prices that are charged by the competitors before making a final decision on
pricing. On the basis of the information currently available, the company should decrease the
price of their water mist system and increase the price of the mist cooling system.
2 marks
Maximum marks 3

QUESTION 2: TUTORIAL QUESTION 2

Apex Design Ltd manufactures an exclusive range of high quality office chairs. Using a modern,
streamlined production process the company produces three types of luxury chairs: The Classic,
Prestige and Ultra. There are two main production departments, the forming department, which
is highly mechanised and the finishing department, which is labour intensive.

The company has been in operation for ten years and every year sales have increased. In recent
years a greater choice of design features has been offered to customers such that the finished
chair, especially the Ultra, is highly bespoke. The current selling price of the chairs was
established two years ago based on a markup of approximately 30% on product cost.

For the first time since it commenced trading, profits last year were lower than expected and
management were concerned that this may be a continuing trend. An initial investigation raised
questions regarding the overhead costing system used by the company. Currently, the company
uses a traditional overhead costing approach, absorbing overheads based on either machine hours
or labour hours as appropriate. Details relating to the current year are provided below:

Classic Prestige Ultra

Selling price per chair $875 $1,050 $1,200
Direct materials per chair $225 $270 $315
Direct labour per chair $115 $138 $161
Direct labour hours per chair 5 6 7
Machine hours per chair 10 11 13
Total chairs produced 1,750 1,000 600

Forming Finishing Total

$ $ $
Production overhead costs 828,729 400,982 1,229,711

In an attempt to curb the reduction in profits, the company is considering changing to an activity
based costing approach for absorbing overheads and has compiled the following information:

Cost Driver Volumes

Activity Cost Driver Cost $ Classic Prestige Ultra Total
Purchasing No. of requisitions 125,175 240 225 285 750
Set up costs No. of set ups 512,120 150 300 350 800
Machining No. of machine hours 205,095 17,500 11,000 7,800 36,300
Quality control No. of inspections 387,321 3,000 2,450 2,800 8,250
Total 1,229,711

REQUIREMENT:
(a) Calculate the total product cost for each of the three types of office chair using:
(i) The costing approach currently used by Apex Design Ltd; (8 marks)
(ii) Activity based costing. (10 marks)
(b) Compare and comment on your answers in (i) and (ii) above, providing recommendations to
improve the profitability of Apex Design Ltd. (7 marks)
[Total: 25 Marks]

Solution 1

SOLUTION 1
(a)
(i) Total product cost using traditional overhead costing approach
W1 Calculation of total direct labour hours
Classic : 1,750 chairs X 5 hours each 8,750
Prestige: 1,000 chairs X 6 hours each 6,000
Ultra: 600 chairs X 7 hours each 4,200
Total direct labour hours 18,950

W2 Calculation of production overhead absorption rate

Forming Finishing
Total production overhead $828,729 $400,982
Overhead absorption base
- Machine hours 36,300
- Direct labour hours (W1) 18,950
Production overhead absorption rate (OAR) $22.83 $21.16
Per machine Per direct labour
hour hour
Calculation of total product cost
Classic Prestige Ultra
$ $ $
Direct materials 225.00 270.00 315.00
Direct labour 115.00 138.00 161.00
Production overhead
- Forming dept (machine hrs x OAR) 228.30 251.13 296.79
- Finishing dept (direct labour hrs x OAR) 105.80 126.96 148.12
Total product cost 674.10 786.09 920.91
(8 marks)
(ii) Total product cost using traditional overhead costing approach
W3 Calculation of cost per driver
Activity Cost driver Cost Total of drivers Cost per driver
$ $
Purchasing Requisitions 125,175 750 166.900
Set up costs Set ups 512,120 800 640.150
Machining Machine hours 205,095 36,300 5.650
Quality control Inspections 387,321 8,250 46.948
1,229,711

W4 Calculation of total and unit production overhead cost

Classic Prestige Ultra Total
$ $ $ $
Purchasing 40,056.00 37,552.50 47,566.50 125,175.00
Set up costs 96,022.50 192,045.00 224,052.50 512,120.00
Machining 98,875.00 62,150.00 44,070.00 205,095.00
Quality control 140,844.00 115,022.60 131,454.40 387,321.00
Total production overhead cost A 375,797.50 406,770.10 447,143.40 1,229,711.00
Units produced B 1,750 1,000 6,00
Production overhead cost per unit A/B $214.74 $406.77 $745.24

Calculation of total product cost Classic Prestige Ultra

$ $ $
Direct materials 225.00 270.00 315.00
Direct labour 115.00 138.00 161.00
Production overhead 214.74 406.77 745.24
Total product cost 554.74 814.77 1221.24
(10 marks)

(b) Comparison of Product costs

Product cost per chair
Traditional/ ABC approach Difference Selling price
Existing approach per chair
$ $ $ $
- Classic 674.10 554.74 119.36 875.00
- Prestige 786.09 814.77 -28.68 1,050.00
- Ultra 920.91 1,221.24 -300.33 1,200.00

Comments & recommendations

Comments
ABC is a more accurate method of absorbing overheads onto products. In relation to the 3 chairs
being produced:

Classic
The classic chair is currently overcosted by $119.36 - too much overhead is being absorbed as
part of the product cost. This chair is produced in greater quantity than the others and under the
existing costing system is being incorrectly allocated a greater share of production overheads. It
is subsidising the two other types of chairs which are creating more costs for the company. The
company is charging $875 for each chair sold and is actually generating a higher markup than the
30% or so expected. It is generating almost 58% mark up on cost ($320.26/ $554.75).

Prestige
From the analysis above, the prestige chair is being undercosted by $28.68, i.e. Under the
existing overhead costing system there is not enough production overhead being included as part
of the product cost.
For the prestige chair the company is charging $1,050 and is generating approximately 29%
mark up ($235.23/$814.77) rather than the 30% or so expected mark up.

Ultra
This type of chair is undercosted by almost 33% ($300.33/$920.91) based on the existing costing
system. As can be seen from W4, this product consumes $447,143.40 or 36% of production
overheads but accounts for only 18% of total production. The existing system was subsidising
the cost of this product by allocating more overheads to the classic and the prestige chairs. As the
analysis above shows, the selling price of this chair is less than the production cost and the
company is making a loss of $21.24 per chair.

Any other reasonable comments

Recommendations
- Apex Design Ltd should adopt the activity based costing approach to improve the accuracy of
its product costs.
- The selling price of the Ultra chair should be increased to cover its cost and secure a profit. If
this is not possible, based on the market situation, the company should examine the overhead
costs, especially the set up and quality control costs, to see if these can be reduced.
- For the prestige chair, the company should increase its selling price slightly to ensure that it is
generating a mark up of 30%. Again, if this is not possible then the company should examine its
costs, particularly set up and quality control costs to see if these can be reduced.
- As the classic chair is earning more than the required 30% mark up, the company might
consider reducing the selling price. Even a slight decrease may boost sales, however, as the
company is producing for the luxury market a price reduction may have an adverse affect on
sales.
- Any other reasonable recommendation.
(7 marks)

QUESTION 3-IN-CLASS TEST 2

Question 2

Trimake Ltd makes three main products, using broadly the same production methods and
equipment for each. A conventional product costing system is used at present, although an
activity based costing (ABC) system is being considered. Details of the three products for a
typical period are:

Labour hrs per unit Machine hrs per unit Material cost per unit Volume (units)

Product X ½ 1½ $20 750

Product Y 1½ 1 $12 1,250
Product Z 1 3 $25 7,000

Direct labour costs $6 per hour and production overheads are absorbed on a machine hour basis.
The rate for the period is $28 per machine hour.

Required
(a) Calculate the cost per unit for each product using conventional methods. (5 marks)
Further analysis shows that the total of production overheads can be divided as follows:
%
Costs relating to set-ups 35
Costs relating to machinery 20
Costs relating to materials handling 15
Costs relating to inspection 30
___
Total production overhead 100
___

The following total activity volumes are associated with the product line for the period as a
whole.
Number of set ups Number of movements of materials Number of inspections
Product X 75 12 150
Product Y 115 21 180
Product Z 480 87 670
___ ___ _____
670 120 1,000
___ ___ _____

Required
(b) Calculate the cost per unit for each product using ABC principles; (15 marks)
(c) Comment on the reasons for any differences in the costs in your answers to (a) and (b).
(5 marks)
(Total: 25 marks)

Solution 2
(a)
A conventional system would use a machine hour rate of overhead absorption.

Product X Y Z
$ $ $
Direct materials 20 12 25
Direct labour 3 9 6
Production overhead 42 28 84
Total 65 49 115

Part (b)
Total production overhead equals the total machine hours multiplied by $28 per hour:-
Product X: 750 units X1 ½ hours = 1,125 hours
Product Y: 1,250 units X1 hour = 1,250 hours
Product Z: 7,000 units X3 hours = 21,000 hours
_____
23,375 hours
_____
23,375 hours X$28 per hour = $654,500.

Cost Driver Rates:-

Set-ups
($654,500 X 35%)/670 set-ups
= $341.90 per set up
Material movements
($654,500 X 15%)/120 movements
= $818.125 per material movement

Inspections
($654,500 X 30%)/1,000 inspections
= $196.35 per inspection

Machinery (based on machine hours)

($654,500 X 20%)/23,375 machine hours
= $5.60 per machine hour

Production overhead attributed to product lines for the period:

Product X Y Z
Set-ups 25,642.50 39,318.50 164,112.00
Material movements 9,817.50 17,180.63 71,176.88
Inspections 29,452.50 35,343.00 131,554.50
Machinery 6,300.00 7,000.00 117,600.00
________ ________ _________
Total 71,212.50 98,842.13 484,443.38
________ ________ _________
(Note: Due to roundings there is a small difference in the total, but this does not significantly
affect unit values).
Unit costs:
Product X Y Z
Direct materials 20 12 25
Direct labour 3 9 6
Production overhead 95 79 69
___ ___ ___
Total 118 100 100
___ ___ ___
Part (c)
The most significant differences between the unit costs calculated in parts (a) and (b) above can
be seen to be in relation to products X and Y.
The unit cost of product X is greatly increased because of the small number of product units and
its consumption of overhead resources.

A similar pattern applies to product Y.

Product Z’s unit costs are reduced slightly due to primarily the high number of product units.

B: INVESTMENT APPRAISSAL

QUESTION 1-TUTORIAL

PV Co is evaluating an investment proposal to manufacture Product W33, which has performed

well in test marketing trials conducted recently by the company’s research and development
division. The following information relating to this investment proposal has now been prepared.

Initial investment $2 million

Selling price (current price terms) $20 per unit
Expected selling price inflation 3% per year
Variable operating costs (current price terms) $8 per unit
Fixed operating costs (current price terms) $170,000 per year
Expected operating cost inflation 4% per year

The research and development division has prepared the following demand forecast as a result of
its test marketing trials. The forecast reflects expected technological change and its effect on the
anticipated life-cycle of Product W33.

Year 1 2 3 4
Demand (units) 60,000 70,000 120,000 45,000

It is expected that all units of Product W33 produced will be sold, in line with the company’s
policy of keeping no inventory of finished goods. No terminal value or machinery scrap value is
expected at the end of four years, when production of Product W33 is planned to end. For
investment appraisal purposes, PV Co uses a nominal (money) discount rate of 10% per year and
a target return on capital employed of 30% per year. Ignore taxation.
Required:
(a) Identify and explain the key stages in the capital investment decision-making process, and the
role of investment appraisal in this process. (7 marks)
(b) Calculate the following values for the investment proposal:
(i) net present value;
(ii) internal rate of return;
(iii) return on capital employed (accounting rate of return) based on average investment; and
(iv) discounted payback period. (13 marks)
(c) Discuss your findings in each section of (b) above and advise whether the investment
proposal is financially acceptable. (5 marks)
(25 marks)

Solution 1

(a) The key stages in the capital investment decision-making process are identifying investment
opportunities, screening investment proposals, analysing and evaluating investment proposals,
approving investment proposals, and implementing, monitoring and reviewing investments.

Identifying investment opportunities

Investment opportunities or proposals could arise from analysis of strategic choices, analysis of
the business environment, research and development, or legal requirements. The key requirement
is that investment proposals should support the achievement of organisational objectives.
1.5 marks
Screening investment proposals
In the real world, capital markets are imperfect, so it is usual for companies to be restricted in the
amount of finance available for capital investment. Companies therefore need to choose between
competing investment proposals and select those with the best strategic fit and the most
appropriate use of economic resources. 1.5 marks

Analysing and evaluating investment proposals

Candidate investment proposals need to be analysed in depth and evaluated to determine which
offer the most attractive opportunities to achieve organisational objectives, for example to
increase shareholder wealth. This is the stage where investment appraisal plays a key role,
indicating for example which investment proposals have the highest net present value.1.5 marks

Approving investment proposals

The most suitable investment proposals are passed to the relevant level of authority for
consideration and approval. Very large proposals may require approval by the board of directors,
while smaller proposals may be approved at divisional level, and so on. Once approval has been
given, implementation can begin. 1.5 marks

Implementing, monitoring and reviewing investments

The time required to implement the investment proposal or project will depend on its size and
complexity, and is likely to be several months. Following implementation, the investment project
must be monitored to ensure that the expected results are being achieved and the performance is
as expected. The whole of the investment decision-making process should also be reviewed in
order to facilitate organisational learning and to improve future investment decisions.1.5 marks
Maximum marks 7

(b)
(i) Calculation of NPV
Year 0 1 2 3 4
Investment (2,000,000)
Income 1,236,000 1,485,400 2,622,000 1,012,950
Operating costs 676,000 789,372 1,271,227 620,076
Net cash flow (2,000,000) 560,000 696,028 1,350,773 392,874
Discount at 10% 1·000 0·909 0·826 0·751 0·683
Present values (2,000,000) 509,040 574,919 1,014,430 268,333
Net present value $366,722
2 marks
Workings
Calculation of income
Year 1 2 3 4
Inflated selling price($/unit) 20·60 21·22 21·85 22·51
Demand (units/year) 60,000 70,000 120,000 45,000
Income ($/year) 1,236,000 1,485,400 2,622,000 1,012,950
1 mark
Calculation of operating costs
Year 1 2 3 4
Inflated variable cost ($/unit) 8·32 8·65 9·00 9·36
Demand (units/year) 60,000 70,000 120,000 45,000
Variable costs ($/year) 499,200 605,500 1,080,000 421,200
Inflated fixed costs ($/year) 176,800 183,872 191,227 198,876
Operating costs ($/year) 676,000 789,372 1,271,227 620,076
1 mark

Alternative calculation of operating costs

Year 1 2 3 4
Variable cost ($/unit) 8 8 8 8
Demand (units/year) 60,000 70,000 120,000 45,000
Variable costs ($/year) 480,000 560,000 960,000 360,000
Fixed costs ($/year) 170,000 170,000 170,000 170,000
Operating costs ($/year) 650,000 730,000 1,130,000 530,000
Inflated costs ($/year) 676,000 789,568 1,271,096 620,025
1 mark

(ii) Calculation of internal rate of return

Year 0 1 2 3 4

Net cash
Flow (2,000,000) 560,000 696,028 1,350,773 392,874
Discount at
20% 1·000 0·833 0·694 0·579 0·482
Present
Values (2,000,000) 466,480 483,043 782,098 189,365
2 marks
Net present value ($79,014)

Internal rate of return = 10 + ((20 – 10) x 366,722)/(366,722 + 79,014) = 10 + 8·2 = 18·2%

2 marks

(iii) Calculation of return on capital employed

Total cash inflow = 560,000 + 696,028 + 1,350,773 + 392,874 = $2,999,675
Total depreciation and initial investment are same, as there is no scrap value
Total accounting profit = 2,999,675 – 2,000,000 = $999,675
Average annual accounting profit = 999,675/4 = $249,919
Average investment = 2,000,000/2 = $1,000,000
Return on capital employed = 100 x 249,919/1,000,000 = 25%
2 marks
(iv) Calculation of discounted payback
Year 0 1 2 3 4
PV of cash
Flows (2,000,000) 509,040 574,919 1,014,430 268,333
Cumulative
PV (2,000,000) (1,490,960) (916,041) 98,389 366,722
Discounted payback period = 2 + (916,041/1,014,430) = 2 + 0·9 = 2·9 years 2 marks
Maximum marks 13

(c) The investment proposal has a positive net present value (NPV) of $366,722 and is therefore
financially acceptable. The results of the other investment appraisal methods do not alter this
financial acceptability, as the NPV decision rule will always offer the correct investment advice.
1 mark
The internal rate of return (IRR) method also recommends accepting the investment proposal,
since the IRR of 18·2% is greater than the 10% return required by PV Co. If the advice offered
by the IRR method differed from that offered by the NPV method, the advice offered by the
NPV method would be preferred. 1 mark
The calculated return on capital employed of 25% is less than the target return of 30%, but as
indicated earlier, the investment proposal is financially acceptable as it has a positive NPV. The
reason why PV Co has a target return on capital employed of 30% should be investigated. This
may be an out-of-date hurdle rate that has not been updated for changed economic
circumstances. 1.5 marks
The discounted payback period of 2·9 years is a significant proportion of the forecast life of the
investment proposal of four years, a time period which the information provided suggests is
limited by technological change. The sensitivity of the investment proposal to changes in
demand and life-cycle period should be analysed, since an earlier onset of technological
obsolescence may have a significant impact on its financial acceptability. 1.5 marks
 Maximum marks 5

QUESTION 2. Paradise Ltd-TUTORIAL

Paradise Ltd is a large company specialising in luxury holidays for the rich and famous. It has
recently purchased an uninhabited island, close to the popular resort of Luca, at a cost of $2
million. The company has already spent $1·5 million on preparing the land for construction
work.

Over the next year it plans to develop the island extensively, with the aim of making it one of the
most exclusive holiday locations in the region. An offer has just been made to buy the land for
$5 million. Paradise Ltd has therefore decided to reappraise the project in order to decide
whether they should still proceed with the project, or should instead accept the offer to sell the
land. If they decide to accept the offer, the sale will take place immediately, incurring legal fees
of $20,000.

If they reject the offer, development will continue and accommodation will be available for rent
after one year. The company’s project accountant has provided estimates of costs and revenues
for the next five years as set out below.

1. Total construction costs for the seven hotels on the island are $37 million. Of the total, $2
million has already been spent in the form of down payments to several construction firms.
These down payments are irrecoverable.
2. Total construction costs for the forty luxury self-catering lodges that will be attached to the
hotels are $24 million. A down payment of $4 million is required immediately.
3. The cost of furnishing the hotels and lodges is estimated at $3,2 million.
4. Each lodge will have its own private swimming pool. The cost of each pool is expected to be
$12,000.
5. Six restaurants will be built on the island at a cost of $15 million. Paradise Ltd has already had
to commit to $3 million of these costs in order to attract the chefs it requires. Although these
monies have not yet been paid over, Paradise Ltd is contractually bound to pay them, irrespective
of whether the project now proceeds.
6. A small parade of shops will be developed at a cost of $4 million.
7. Annual cash overheads are expected to be $2 million for the hotels. Revenues for the hotels
are estimated at $13 million per annum.
8. Maintenance costs for each of the lodges will be $7,000 per annum, compared to rental
income of $390,000 per annum, per lodge.
9. Depreciation totalling $1,5 million per annum will be charged in Paradise Ltd’s accounts for
the hotels, lodges, restaurants and shops.
10. The restaurant and shops are expected to generate net income of $4,73 million per annum, in
total.

All the set-up costs will occur within the next year, before the resort is open. The annual
revenues and overheads relate to the four years following the first year of development. Assume
that all cash flows occur at the end of each year, unless otherwise stated, and that there are no
terminal values to consider at the end of the four years.
The company’s cost of capital is 10% per annum.
Required:
(a) Explain the main principles used to differentiate between relevant and irrelevant costs for
investment appraisal, using the information in the question to illustrate your points. (4 marks)
(b) Calculate the project’s net present value (NPV) at the company’s required rate of return.
Conclude as to whether the company should accept the offer or continue with the project, giving
a reason for your conclusion. (16 marks)
(c) Calculate the IRR of the project (5 marks)

Total (20 marks)

Solution 2

(a) Relevant costs

The following principles should be applied when identifying costs that are relevant to a period.
1. Relevant costs are future costs
A relevant cost is a future cost that arises as a direct result of a decision. Therefore, any costs
arising as a result of a past decision should be ignored. Such past costs are known as ‘sunk
costs’.

In the case of Paradise Ltd, the cost of $1·5 million that is already spent for preparing the land
for construction and the $2 million down payment to construction firms are examples of sunk
costs. Hence, these costs should not be considered when calculating the net present value of the
project.

2. Relevant costs are cash flows

Relevant costing works on the assumption that profits earn cash. Hence, only those future costs
which are in the form of cash should be included. Therefore, non-cash costs should be ignored
for the purpose of decision-making. In the case of Paradise Ltd, the depreciation of $1·5 million
should be ignored for the calculation of NPV.

3. Relevant costs are opportunity costs

An opportunity cost is the value of a benefit foregone as a result of choosing a particular course
of action. Such a cost will always be a relevant cost. The sale proceeds foregone $ 4.98million
(5.0 million-0.020million) is considered as relevant cost.

4. Other non-relevant costs

Certain other costs such as ‘committed costs’ and ‘finance costs’ will also be irrelevant to any
decision that is being made in the present. Committed costs are future cash outflows that will be
incurred regardless of whatever decision is taken. In the case of Paradise Ltd, the $3 million
restaurant costs represent such committed costs. Hence these should be ignored for the decision-
making process. The interest costs of $2·5 million per annum are also ignored. This is because
interest has already been taken into account in the discounting process.
1.25 marks for each correctly explained principle
Maximum marks 5

(b) Net present value

Years Marks
0 1 2 3 4 5 Total
$’000 $’000 $’000 $’000 $’000 $’000 $’000
Sale proceeds
foregone
(net of legal fees) (4,980) (4,980) 1
Hotel building costs
($37m - $2m) (35,000) (35,000) 1
Lodge construction
costs (4,000) (20,000) (24,000) 2
Furnishing costs (3,200) (3,200) 0.5
Cost of swimming
pools
($12,000 x 40) (480) (480) 0.5
Restaurants
($15m - $3m) (12,000) (12,000) 1
Cost of developing
shops (4,000) (4,000) 1
Annual cash
overheads (2,000) (2,000) (2,000) (2,000) (8,000) 1
Annual hotel revenues 13,000 13,000 13,000 13,000 52,000 1
Rental income –
lodges
($390,000 x 40) 15,60015,600 15,600 15,600 62,4001
Maintenance costs of
lodge
($7,000 x 40) (280) (280) (280) (280) (1,120)1
Restaurant / shop
income 4,730 4,730 4,730 4,730 18,920 1
Net relevant costs (8,980) (74,680) 31,050 31,050 31,050 31,050 40,540 1
10% discount factors 1·000 0·909 0·826 0·751 0·683 0·621 1
Discounted cash flow (8,980) (67,884) 25,647 23,319 21,207 19,282 12,591 1

Since the project has a positive NPV of $12·591 million, Paradise Ltd should accept the
project.(1 mark)
Maximum marks 16

(c) Internal rate of return

IRR = a +A/(A-B)X(b-a)%
Where
a is lower of two rates of return used
b is higher of two rates used
A is NPV obtained using rate a
B is NPV obtained using rate b

Using 20% as the discounting rate, the NPV can be calculated as follows:

Years
0 1 2 3 4 5 Total
$’000 $’000 $’000 $’000 $’000 $’000 $’000
Net relevant costs (8,980) (74,680) 31,050 31,050 31,050 31,050 40,540
20% discount factors 1·000 0·833 0·694 0·579 0·482 0·402
Discounted cash flow (8,980) (62,208) 21,549 17,978 14,966 12,482 (4,214)

Net present value at 20% = – $4·214 million(2 marks)

IRR = 17% (2 marks)-show working
Maximum marks 4

QUESTION 3: Assignment 1

Chamu Ltd, a software company, has developed a new game, ‘Ferrari’, which it plans to launch
in the near future. Sales of the new game are expected to be very strong, following a favourable
review by a popular PC magazine. Chamu Ltd has been informed that the review will give the
game a ‘Best Buy’ recommendation. Sales volumes, production volumes and selling prices for
‘Ferrari’ over its four-year life are expected to be as follows.

Year 1 2 3 4
Sales and production (units) 150,000 70,000 60,000 60,000
Selling price ($ per game) 25 24 23 22

Financial information on ‘Ferrari’ for the first year of production is as follows:

$
Direct material cost 5.40 per game
Other variable production cost 6.00 per game
Fixed costs 4.00 per game

Advertising costs to stimulate demand are expected to be $650,000 in the first year of production
and $100,000 in the second year of production. No advertising costs are expected in the third and
fourth years of production.

Fixed costs represent incremental cash fixed production overheads. ‘Ferrari’ will be produced on
a new production machine costing $800,000. Although this production machine is expected to
have a useful life of up to ten years, government legislation allows Chamu Ltd to claim the
capital cost of the machine against the manufacture of a single product. Capital allowances will
therefore be claimed on a straight-line basis over four years.
Chamu Ltd pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in
which they arise. Chamu Ltd uses an after-tax discount rate of 10% when appraising new capital
investments. Ignore inflation.

Required:
(a) Calculate the net present value of the proposed investment and comment on your findings.
(11 marks)
(b) Calculate the internal rate of return of the proposed investment and comment on your
findings. (5 marks)
(c) Discuss the reasons why the net present value investment appraisal method is preferred to
other investment appraisal methods such as payback, return on capital employed and internal rate
of return.
Tip: Discuss the strengths of the NPV method against the weaknesses of the other methods
(9 marks)
(25 marks)

SOLUTION

(a) Calculation of NPV of 'Ferrari' investment project

Year 1 2 3 4 Marks
$ $ $ $
Sales revenue 3,750,000 1,680,000 1,380,000 1,320,000 1
Direct material costs (810,000) (378,000) (324,000) (324,000) 1
Variable production costs (900,000) (420,000) (360,000) (360,000) 1
Advertising costs (650,000) (100,000) 1
Fixed costs (W1) (600,000) (600,000) (600,000) (600,000) 1
Taxable cash flow 790,000 182,000 96,000 36,000
Taxation 30% (237,000) (54,600) (28,800) (10,800)
CA tax benefits (W2) 60,000 60,000 60,000 60,000 1
Net cash flow 613,000 187,400 127,200 85,200 1
Discount at 10% 0.909 0.826 0.751 0.683
Present values 557,217 154,792 95,527 58,192 1
PV of cash flows 865,728 1
Initial investment (800,000)
Net present value 65,728 1

Workings
W1
Fixed costs in year 1 = 150,000 x 4 = $600,000 .You are informed that fixed costs represent
incremental cash fixed production overheads. These are the fixed costs in subsequent years as
well.
W2
Annual capital allowance (CA) tax benefits = (800,000/4) x 0.3 = $60,000 per year

Conclusion
Since the NPV of $65,728 is positive, the company may accept the proposed investment.
However, the positive .NPV is primarily dependent on the revenue generated in the first year.
Variation in the sales for this year may adversely impact the NPV.
1 mark
Maximum marks 11
SECTION D
(b) Calculation of IRR of 'Ferari' investment project
The NPV based on 10% discount rate is $65,728 approx.

The NPV based on 20% discount rate can be calculated as follows:

Year 1 2 3 4 Marks
Net cash flow ($) 613,000 187,000 127,000 85,200 1
Discount at 20% 0.833 0.694 0.579 0.482
Present values ($) 510,629 129,778 73,533 41,066
$
Present value of future benefits 755,006
Initial investment (800,000)
Net present value (44,994)

IRR= Internal rate of return

= 16% approx. (show working) 3 marks

Conclusion
Since the internal rate of return is greater than the discount rate used to appraise new
investments, the company may accept the proposed investment. 1 mark
Maximum marks 5

(c) The superiority of the Net Present Value (NPV) method with reference to the other
investment appraisal methods is outlined in the following aspects:

(i) NPV can be used to appraise projects with non-conventional cash flows. A project has non-
conventional cash flows when negative cash flows occur during the life of the project. A project
with non-conventional cash flows will have more than one IRR. Due to this technical limitation,
IRR cannot be used to appraise projects with non-conventional cash flows.

(ii) NPV assumes that intermediate cash flows can be re-invested at the company’s cost of
capital. In contrast, the internal rate of return method assumes that the cash flows are re-invested
at the internal rate of return. This investment rate is not available in practice.
(iii) NPV can accommodate changes in the discount rate. However, the IRR ignores any changes
in the discount rate since it is independent of the cost of capital in all time periods.

(iv) While choosing between mutually exclusive projects, NPV always indicates which project
should be selected in order to achieve the maximum return on investment. However, the IRR
offers incorrect advice at discount rates which are less than the internal rate of return of the
incremental cash flows

(v) NPV is directly related to the objective of maximising shareholders’ wealth since a project
with positive NPV increases the market value of a company. Other techniques of investment
appraisal are not directly related to the objective of maximising shareholders’ wealth.

(vi) Unlike IRR or ROCE, NPV is an absolute measure of return. It is therefore able to reflect the
absolute increase in the corporate value.

(vii) NPV considers the time value of money. Money has a time value i.e. the same amount of
money has different value at different time. NPV and IRR consider the time value of money
while appraising investment projects. Payback period and ROCE do not consider the time value
of money while appraising investment projects.

(viii) ROCE compares average annual accounting profit with initial or average capital invested.
NPV considers cash flows to accounting profit. Financial management, unlike accounting,
considers cash flows to be more effective as accounting profits can be manipulated.

(ix) The Payback method ignores all the cash flows beyond the payback period. This could lead
to rejecting several financially viable projects which fall outside the acceptable payback period.
The NPV method is superior to the Payback method as it considers all the cash flows involved in
2 marks for each point explained
Maximum marks 9

DIVISIONAL PERFORMANCE MEASUREMENT

QUESTION 1: TUTORIAL QUESTION 1

FP sells and repairs photocopiers. The company has operated for many years with 2 departments,
the Sales Department and the Service department, but the departments had no autonomy. The
company is now thinking of restructuring so that the two departments will become profit centres.

The Sales Department

This department sells new photocopiers. The department sells 2000 copiers per year. Included in
the selling price is $60 for a one-year guarantee.All customers pay this fee.This means that during
the first year of ownership , if the photocopier needs to be repaired , then the repair costs are not
charged to the customer.On average 500 photocopiers per year need to be repaired under the
guarantee.The repair work is carried out by the Service Department who, under the proposed
changes, would charge the sales department for the repairs.It is estimated that on average the
repairs take 3 hours each and that the charge by the Service Department will be $136 500 for the
500 repairs.

The Service Department

This department has 2 sources of work; the work needed to satisfy the guarantees for the Sales
Department and the repair work for external customers. Customers are charged at full cost plus
40%. The details of the budget for the next year for the Service Department revealed the
following standard costs.

Labour $15 per hour

Variable Overheads $10 per labour hour

Fixed Overheads $22 per labour hour

The calculation of these standards is based on the estimated maximum market demand and
includes the expected 500 repairs for the Sales Department. The average cost of the parts needed
for a repair is $54 per part. This means that the charge to the Sales Department for the repair work
, including the 40% mark up , will be $136 500.

Proposed Change

It has now been suggested that FP should be structured so that the 2 departments become profit
centres and that the managers of the departments are given autonomy. The individual salaries of
the managers would be linked to the profits of their respective departments.

Budgets have been produced for each department on the assumption that the Service Department
will repair 500 photocopiers for the Sales department and that the transfer price for this work will
be calculated in the same way as the price charged to external customers.

However the manager of the Sales Department has now stated that he intends to have the repairs
done by another company, RS, because they have offered to carry out the work for a fixed fee of
$180 per repair and this is less than the price that the Service Department would charge.

Required

a) Calculate the individual profits of the Sales Department and the Service Department, and of
FP as a whole from the guarantee scheme if :

(i)The repairs are carried out by the Service Department and are charged at full cost plus 40%.

(ii)The repairs are carried out by the Service Department and are charged at marginal cost.

(iii)The repairs are carried out by RS [8]

b) (i)Explain, with reasons, why a ‘full cost plus’ transfer pricing model may not be appropriate
for FP [3]
(ii)Comment on other issues that the managers of FP should consider if they decide to allow
RS to carry out the repairs. [4]
c) Briefly explain the advantages and disadvantages of structuring the departments as profit
centres [5]

Total 20marks

Solution

a)
Calculation of transfer $ per Total cost for 500
price repair repairs($)
Parts 54
Labour 45
Variable cost 30
Marginal cost 129 64 500
Fixed Overhead 66 33 000
Total cost 195 97 500
Mark up (40%) 78 39 000
Selling price 273 136 500

(i)Transfers @ 40% mark up

Sales Depart.($) Service Depart($) FP($)

Sales 120 000 136 500 120 000

Costs 136 500 97 500 97 500

Profit/(Loss) (16 500) 39 000 22 500

(ii) Transfer @ marginal cost

Sales Depart.($) Service Depart($) FP($)

Sales 120 000 64 500 120 000

Costs 64 500 97 500 97 500

Profit/(Loss) 55 500 (33 000) 22 500

(iii) Repairs carried out by RS\

Sales Depart.($) Service Depart($) FP($)

Sales 120 000 0 120 000

Costs 90 000 33 000 123 000

Profit/(Loss) 30 000 (33 000) (3 000)

b(i) The full cost transfer price is encouraging the manager of the sales department to contract the
repairs out at cost per repair of $180 because the transfer price has been set at $273 per repair.FP
is worse off as a result of the transfers as shown by a loss of $3 000.

-Other shortcomings of full cost plus transfer pricing can be discussed.

(ii)Issues to be considered in outsourcing include;

-Quality of the repairs carried out by RS

-The duration of the contract, The extent to which other suppliers are available(otherwise FP may
be at the mercy of the supplier).

-The extent to which the fixed costs of the service department are avoidable and the alternative
uses of the released capacity.

c) Advantages and disadvantages of Divisionalisation.

QUESTION 2: TUTORIAL QUESTION 2

In High Tech Computers, a manufacturer of digital watches, there are two divisions i.e. the
manufacturing unit (division M) and the Del-chip unit (division D). Division M can purchase
chips either from division D unit or from the external market. On the other hand, division D can
sell inside or outside the firm.

Division D unit is working at full capacity (160,000 units).

One Del-chip is needed for each computer manufactured by High Tech.

Other information $
Sales price of an HTC computer (per unit) 910
Variable manufacturing cost of the computer (per unit, excluding Delchip) 680
Variable Del-chip manufacturing cost for HTC’s division D (per unit) 70
Price of Del-chip from outside supplier, to division M (per unit) 90
Selling price of Del-chip (HTC’s division D) 100
Required
Compare the profitability of the buying division under both the situations i.e. when purchased
from the external market or internally (at market price).

Solution
In the given question, both the departments will enjoy the autonomy of taking decisions about
whether to sell / buy the intermediate product from the other department or not.
Here, variable cost to division D is $70 and one Del-chip is available in the market at $90. This
means the variable cost of the department is less than the market price.

It is given that division D is working at full capacity implying that there is no additional capacity.
Therefore we need to calculate the contribution to High Tech Computers as a whole from both
the options.
Calculation of the contribution
When purchased from Outside
Division M$’000 Division D$’000 Total$’000
Sales revenue (@ $910, $100) 145,600 16,000 161,600
Less: Variable costs
Del-chip ($90 x 160,000 units)) (14,400) (14,400)
Manufacturing cost
($680 x 160,000 units) (108,800) (108,800)
Manufacturing cost
($70 x 160,000 units) (11,200) (11,200)
Contribution margin 22,400 4,800 27,200

Purchases from inside at market price

Division M Division D Total
$000 $000 $000
Sales revenue (@ $910, $100) 145,600 16,000 161,600
Less: Variable costs
Del-chip ($100) (16,000) (16,000)
Manufacturing cost
($680 x 160,000 units) (108,800) (108,800)
Manufacturing cost
($70 x 160,000 units) (11,200) (11,200)
Contribution margin 20,800 4,800 25,600
As the overall contribution margin is greater if Del-chips are purchased from outside, it is a
better option to purchase from the external market.

TUTORIAL QUESTION 3
Afro-products Ltd is a chemical division of a large industrial corporation. Jim, the divisional
General Manager, is choosing which of two plants, Namibia or South Africa, to use for the
production of a new product. Both have the same capacity and an expected life of four years,
with different capital costs and expected net cash flows. The following information is provided:
 Namibia South Africa
$ $
Initial capital investment 4,800,000 3,900,000
Net cash flows (before tax)
2014 1,800,000 1,950,000
2015 1,800,000 1,650,000
2016 1,800,000 1,125,000
2017 1,800,000 750,000
Both plants have negligible residual value. Jim is expected to generate a before-tax return on his
divisional investment in excess of 14% p.a. which he is currently achieving. As his bonus is
linked to his performance, he will not take up a project with a return of less than 14%. For
calculating returns, divisional assets are valued at net book values at the beginning of the year.
Depreciation is charged on a straight line basis.
Required:
Evaluate both the plants using Residual Income as well as Return on Investment to arrive at a
decision whether to take up the new project or not.
Solution
The annual ROI and residual income calculations for each plant are as follows
2014 2015 2016 2017 Total
Namibia $m $m $m $m $m
I. Net cash flow 1.800 1.800 1.800 1.800 7.2
II. Depreciation (1.200) (1.200) (1.200) (1.200)
III. Profit 0.600 0.600 0.600 0.600 2.4
IV. Cost of capital 14% of (VI) (0.672) (0.504) (0.336) (0.168)
V. Residual income (W1) (0.72) 0.096 0.264 0.432
VI. Opening WDV of asset 4.800 3.600 2.400 1.200
VII. ROI (W2) 12.50% 16.67% 25% 50%
South Africa
I. Net cash flow 1.950 1.650 1.125 0.750 5.475
II. Depreciation (0.975) (0.975) (0.975) (0.975)
III. Profit 0.975 0.675 0.150 (0.225) 1.575
IV. Cost of capital 14% of (VI) (0.546) (0.410) (0.273) (0.137)
V. Residual income (W1) 0.429 0.265 (0.123) (0.362)
VI. Opening WDV of asset 3.900 2.925 1.950 0.975
VII. ROI (W2) 25% 23% 7.7% -23%
Workings
W1 Residual income (RI) for Newcastle and Sheffield
RI = Income – Charged on investment
Charged on investment = Investment x Rate of return
W2 Return on investment (ROI) for Newcastle and Sheffield
ROI = Return on sales x Assets turnover i.e. Profit/Opening WDV of assets

From the above calculations it is found that the Namibia plant will give a higher return in the
later period and the South Africa plant will provide higher return in the earlier period during the
life of the plant. As shown by the calculations, accepting Namibia is a better option as it will give
a higher return than the South Africa, but this will involve Jim having to part with his
performance bonus. As bonus is linked to performance, there is the chance that managers may
devise sub-optimal plans. Therefore, in this case, it is possible that Jim will choose to go for
South Africa. This will mean that the organisation as a whole will fail to achieve goal
congruence.
0