Megatrends in the profession

Megatrends in the profession

MAFHH An Institution: What challenges may face by small conglomerate org...

MAFHH An Institution: What challenges may face by small conglomerate org...:   Query:  What challenges may face by small conglomerate organisations during an up-gradation of an existing information system? Solution: T...

Importance of Transfer Pricing within the organisation

 

Query no.1

What is transfer pricing in order to assess the performance of the divisions under decentralized structure of the organisation?

Solution:

Transfer pricing is a price where selling division charge price to the buying  division against goods or services delivered within the organizations.

 

Query no.2:

What discrepancy can arise on charging transfer price within the organization?

Solution:

If actual cost is charged by selling division then buying division can claim that, selling division has charged poor cost control within the transfer price. In that situation, discrepancies can be arisen in order to settle transfer price.

Query no.3:

How to assess whether transfer price is within the best of interest of the organization as a whole?

Solution:

Although there are some problems with transfer price but if following five goals are met then it can be said that transfer price is in the best of interest of the organization as a whole such as below:

1. Goal congruence
2. Equitable performance measurement
3. Retained divisional autonomy
4. Motivated divisional managers
5. Optimum resource allocation

Query no.4:

What are the problems with transfer pricing?

Solution:

Maintaining the right level of divisional autonomy:

Self-interest is one of the important element which is difficult to maintain within the organization because people have different level of wishes and their interests. It might possible that divisional managers take their decision in their best of interest rather than organization as a whole.

Ensuring divisional performance is measured fairly:

Transfer price affect behaviour and decisions made by profit centre managers. Because profit centre performance is measured according to the profit they earned. In this situation, no profit centre will want to do work for another without being paid for it. Resultantly, profit centre managers would not be agreed to work for another.

Ensuring organization profits are maximized:

If selling division is capable to sell goods in the external market at higher price as compare to internally transfer at a lower price then selling division would not be willing to transfer goods inside.

Query No.5:

What are the solutions of transfer pricing?

Solutions:

Transfer price should provide an arbitrary selling price that enable transferring division to earn a return for its efforts and receiving division to incur a cost for benefits received.

Additionally, the transfer price should be set at a level that enables profit centre performance to be measured commercially which means transfer price should be a fair commercial price.

Similarly, if it is possible transfer price should encourage profit centre managers to agree on the amount of goods and services to be transferred which will also be at a level that is consistent with the aims of the organization as a whole such as maximizing company profits.

Accounting for our planet – a global conversation on COP26

Accounting for our planet – a global conversation on COP26

Climate resilience: Emergency treatments

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Throughput accounting emphasis over cost control and to minimise inventory level.

What is Throughput Accounting (TA)?

TA is based on theory of constraints which means that throughput of the factory will be determined by the speed of bottleneck process. TA is very similar to marginal costing but here throughput is relevant rather than contribution analysis. TA assumes that only variable cost is material cost and all other factory cost is fixed in the short run along with labour cost. It is more appropriate to use Just-in-time (JIT) environment because of emphasis on minimising inventory and cost control.

Throughput = Sales - Material Costs.

In a JIT environment, production only for building inventory is a bad thing. Products should not be made unless there is a customer for them. This mean that accepting some idle time in non-bottleneck operations. Work In Progress (WIP) should be valued at material cost only so that no value is added to profit until sale in made.

Profit is determined by the rate at which throughput can be generated i.e. how quickly raw material can be turned into sales to generate cash. Producing for the sole purpose of increasing inventory creates no profit and so should not be encouraged.

Traditional costing	Throughput accounting
Labour costs and variable overheads are treated as variable costs.	All costs other than material are seen as fixed in the short run.
Inventory is valued at total production cost.	Inventory is valued at material cost only.
Value is added when an item is produced.	Value is added when an item is sold.
Product profitability can be determined by deducting a product cost from selling price.	Profitability is determined by the rate at which money is earned.

TPAR = Return per factory hour / Cost per factory hour. Return per  factory hour = (Sales revenue – material purchases) / Time on bottleneck resources. Cost per factory hour = Total factory costs / Time on bottleneck resource. Total factory costs = Fixed production costs including labour.

How to interpret TPAR?

Total throughput should exceed total factory costs otherwise organisation will make a loss. This means that TPAR should exceed 1.0

How can business improve TPAR?

• Increase throughput per bottleneck hour or decrease cost per factory hour.
• Increase selling price of the product. This will increase throughput per unit and so will increase throughput per unit of bottleneck resource.
• Reduce material cost per unit. This will increase throughput per unit and so will increase throughput per unit of bottleneck resource.
• Reduce expenditure on factory costs (operating costs). This will reduce operating cost per unit of bottleneck resource.
• Improve efficiency and increase no. of units or products that are made in each bottleneck hour. This would increase total throughput per hour. The operating costs per hour would be unaffected therefore TPAR would increase.
• Elevate bottleneck so that there are more hours available of the bottleneck resource. Throughput per unit of bottleneck resource would be unaffected but operating costs are fixed costs and there are more bottleneck hours available, the operating cost per bottleneck hour would fall and the TPAR would increase.

However there may be adverse consequences from some of these measures.

Measures	Consequences
Increase sales price per unit	Demand for the product may fall
Reduce material cost per unit, eg change materials or suppliers	Quality may fall and bulk discounts may be lost
Reduce operating expenses	Quality may fall or errors may increase

How throughput accounting can help to make effective growth in a business?

 

How effective growth in a business can be achieved by Throughput Accounting (TA)?

Throughput accounting (TA) can help to make an effective growth in a business because  it is essential to know that what you should produce for effective utilisation of your resources. TA is an approach to production management where aim is to maximise throughput contribution while also reducing inventory & operational expenses.

TA is a management accounting technique which is based on Theory of Constraint ( ToC ) and is consistent with the use of just in time production method.

What is the Basic concept of TA?

Under TA organisation should seek to maximise throughput by identifying and eliminating bottlenecks. All operational expenses except materials are assumed to be fixed costs.

How to calculate throughput?

throughput = Sales revenue - Direct material cost.

 What is Theory of Constraint ( ToC ) ?

ToC is a production system where key financial concept is to maximise throughput while keeping conversion & investment costs to a minimum. Five steps of ToC has been mentioned in the image above.

It is an approach of production management & optimising production performance that was developed by Goldratt & Cox in 1986. Its key role to turn material into sales as quickly as possible.

ToC also states that at all times there will be a bottleneck resource and it can be sales demand in theory but it is more likely to be a resource that an organisation uses.

Bottleneck resource / binding constraint is a process which has lower capacity than preceding or subsequent activities, thereby limiting throughput.

In the above diagram, Process 2 is bottleneck because this process is slow as only 50 units per hour can be processed as compare to the Process 1 & Process 3 as 100 units per hour can be processed. So Process 2 is bottleneck.

Note: Once the capacity of Process 2 is increased then Other Processes may become bottleneck resource.

Example 
Cat Co makes a product using three machines – X, Y and Z. The capacity of each machine is as follows:

The demand for the product is 1,000 units per week. For every additional unit sold per week, net present value increases by $50,000. Cat Co is considering the following possible purchases (they are not mutually exclusive):

Purchase 1: Replace machine X with a newer model. This will increase capacity to 1,100 units per week and costs $6m.

Purchase 2: Invest in a second machine Y, increasing capacity by 550 units per week. The cost of this machine would be $6.8m.

Purchase 3: Upgrade machine Z at a cost of $7.5m, thereby increasing capacity to 1,050 units.

Required:
Which is Cat Co’s best course of action?

Solution:
First, it is necessary to identify the system’s bottleneck resource. Clearly, this is machine Z, which only has the capacity to produce 500 units per week. Purchase 3 is therefore the starting point when considering the logical choices that face Cat Co. It would never be logical to consider either Purchase 1 or 2 in isolation because of the fact that neither machines X nor machine Y is the starting bottleneck. Let’s have a look at how the capacity of the business increases with the choices that are available to it.

From the table above, it can be seen that once a bottleneck is elevated, it is then replaced by another bottleneck until ultimately market demand constrains production. At this point, it would be necessary to look beyond production and consider how to increase market demand by, for example, increasing advertising of the product.

In order to make a decision as to which of the machines should be purchased, if any, the financial viability of the three options should be calculated.

The company should therefore invest in all three machines if it has enough cash to do so.

The example of Cat Co demonstrates the fact that, as one bottleneck is elevated, another one appears. It also shows that elevating a bottleneck is not always financially viable. If Cat Co was only able to afford machine Z, it would be better off making no investment at all because if Z alone is invested in, another bottleneck appears too quickly for the initial investment cost to be recouped.

How desirable profitability can be achieved under Product Life Cycle Costing (LCC)?

 

Query no.1: What is product Life Cycle Costing?

Solution: LCC is a whole life costing of the product from the beginning to an end. It is an accumulation of all costs over the entire life of the product.

Query no.2: What is the aim and objective of product LCC?

Solution: The aim is to maximise return over the entire life of the product and objective is to minimise costs. This means that, Products that are not expected to be profitable after allowing for design & development costs or clean up costs should not be considered for commercial development. All costs related to a product including research & development are associated with the product. This enables true assessment of a product's profitability.

Query no.3: Why LCC is modern costing technique?

Solution: LCC is a modern costing technique because in the past, costs & revenues of a product are assessed on a financial year on year basis or period basis. But life cycle costing change this phenomenon since it tracks and accumulates actual costs & revenue attributable to each product over the entire product life cycle. 

Query no.4: How many stages, sales volume & costs in product LCC?

Solution: In a table below:

Stages	Sales Volume	Costs
Development	None	Research & development
Introduction	Very low level	Very high fixed cost i.e. non-current assets & advertisement
Growth	Rapid increase	Increase in variable cost some fixed cost may increase i.e. Increased no. of factories
Maturity	Stable	Primary variable cost
Decline	Falling	Primary variable cost (Now decreasing some fixed cost) i.e. Decommissioning cost

 

Query no.5: What type of costs spent in research & development costs?

Solution: Design cost, Cost of making a prototype, Testing costs, Production process and Equipment development & investment.

Query no.6: What other costs over product life cycle?

Solution: In the bullets below:

• Cost of purchasing any technical data required i.e. purchasing the right from another organisation to use a patent.
• Training costs. including initial operator training & skills updating.
• Production cost when product is eventually launched int he market.
• Distribution costs including transportation & handling costs.
• Marketing & Advertising i.e. Customer service, Field maintenance & Brand promotion.
• Inventory costs including  spare parts, warehousing & so on.
• Retirement & disposal costs i.e. costs occuring at the end of the product's life which may include costs of cleaning up a contaminated site.

Some of above costs such as design cost are once-only costs. Others would be incurred throughout the product's life but vary with production & sales volume.   

Query no.7: How to maximise return over the product life cycle?

Solution: In the bullets below:

• Design out cost of product: Approximately 70% to 90% costs can be determined by decision made early in the life cycle at the design & development stage.
• Minimise time to market: A company should get a product to the marketplace very quickly since it will give the product as long a span as possible without competitors' rival product in the market.and this mean that market share is increased in the long run.
• Minimise breakeven time: Pricing strategy can affect both contribution & volume generated. A short breakeven time is very important for liquidity purposes.
• Extend the length of the life cycle itself i.e. Product development, finding other uses of products or launch in the other relevant markets.

Query no.8: What are the implications to calculate LCC?

Solution: Looking at the product life cycle, It is clear that product will make a loss initially. Viewing profitability on a period basis can put unnecessary pressure on management because of the visibility of the loss which can lead to incorrect decision making.

It would not be appropriate to set one price for the product's entire life since there will be different level of demand for a product over its expected life.

Query no.9: What can be the advantages of LCC?

Solution: In the bullets below:

• It helps management to assess profitability over the entire life of a product which in turns helps management to decide whether to develop the product or continue making the product. 
• It can be very useful for organisations that continually develop products with a relatively short life, where it may be possible to estimate sales volume & prices with reasonable accuracy.
• The life cycle concept results in earlier actions to generate more revenue or lower costs.
• Better decision making should follow from more accurate & realistic assessment of revenues & costs at least with in a particular life cycle stage.
• It encourages longer-term thinking and forward-planning and may provide more useful information than traditional reports of historical costs & profits in each accounting period.