PM REVISION QUESTIONS 2

Question 1 – Transfer pricing

A manufacturing company, Man Co, has two divisions: Division L and Division M. Both divisions make a single
standardised product. Division L makes component L, which is supplied to both Division M and external customers.
Division M makes product M using one unit of component L and other materials. It then sells the completed product M
to external customers. To date, Division M has always bought component L from Division L.
The following information is available:
Component L Product M
$ $
Selling price 40 96
Direct materials:
Component L (40)
Other (12) (17)
Direct labour (6) (9)
Variable overheads (2) (3)
Selling and distribution costs (4) (1)
Contribution per unit before fixed costs 16 26
Annual fixed costs $500,000 $200,000
Annual external demand (units) 160,000 120,000
Capacity of plant 300,000 130,000
Division L charges the same price for component L to both Division M and external customers. However, it does not
incur the selling and distribution costs when transferring internally.
Division M has just been approached by a new supplier who has offered to supply it with component L for $37 per unit.
Prior to this offer, the cheapest price which Division M could have bought component L for from outside the group was
$42 per unit.
It is head office policy to let the divisions operate autonomously without interference at all.
Required:
(a) Calculate the incremental profit/(loss) per component for the group if Division M accepts the new
supplier’s offer and recommend how many components Division L should sell to Division M if group profits
are to be maximised. (3 marks)

(b) Using the quantities calculated in (a) and the current transfer price, calculate the total annual profits of
each division and the group as a whole. (6 marks)

(c) Discuss the problems which will arise if the transfer price remains unchanged and advise the divisions on a
suitable alternative transfer price for component L. (6 marks)
Answer for (c)
The problem is that the current transfer price of $40 per unit is now too high. Whilst this has not been a problem before
since external suppliers were charging $42 per unit, it is a problem now that Division M has been offered component L
for $37 per unit. If Division M now acts in its own interests rather than the interests of the group as a whole, it will buy
component L from the external supplier rather than from Division L. This will mean that the profits of the group will fall
substantially and Division L will have significant unused capacity.
Consequently, Division L needs to reduce its price. The current price does not reflect the fact that there are no selling
and distribution costs associated with transferring internally, i.e. the cost of selling internally is $4 less for Division L than
selling externally. So, it could reduce the price to $36 and still make the same profit on these sales as on its external sales.
This would therefore be the suggested transfer price so that Division M is still saving $1 per unit compared to the
external price.
A transfer price of $37 would also presumably be acceptable to Division M since this is the same as the external supplier
is offering.
Question 2 – Transfer pricing
Mobe Co manufactures electronic mobility scooters. The company is split into two divisions: the scooter division
(Division S) and the motor division (Division M). Division M supplies electronic motors to both Division S and to
external customers. The two divisions run as autonomously as possible, subject to the group’s current policy that
Division M must make internal sales first before selling outside the group; and that Division S must always buy its motors
from Division M. However, this company policy, together with the transfer price which Division M charges Division S,
is currently under review.
Details of the two divisions are given below.
Division S
Division S’s budget for the coming year shows that 35,000 electronic motors will be needed. An external supplier could
supply these to Division S for $800 each.
Division M
Division M has the capacity to produce a total of 60,000 electronic motors per year. Details of Division M’s budget,
which has just been prepared for the forthcoming year, are as follows:
Budgeted sales volume (units) 60,000
Selling price per unit for external sales of motors $850
Variable costs per unit for external sales of motors $770
The variable cost per unit for motors sold to Division S is $30 per unit lower due to cost savings on distribution and
packaging.
Maximum external demand for the motors is 30,000 units per year.
Required:
Assuming that the group’s current policy could be changed, advise, using suitable calculations, the number of
motors which Division M should supply to Division S in order to maximise group profits. Recommend the
transfer price or prices at which these internal sales should take place.
Note: All relevant workings must be shown. (10 marks)

Answer for question 2

From the group’s perspective
For every motor sold externally, Division M generates a profit of $80 ($850 – $770) for the group as a whole. For every
motor which Division S has to buy from outside of the group, there is an incremental cost of $60 per unit ($800 – [$770
– $30]).
Therefore, from a group perspective, as many external sales should be made as possible before any internal sales are
made.
Consequently, the group’s current policy will need to be changed. This does, however, assume that the quality of the
motors bought from outside the group is the same as the quality of the motors made by Division M.
Division M’s total capacity is 60,000 units. Given that it can make external sales of 30,000 units, it can only supply 30,000
of Division S’s demand for 35,000 motors. These 30,000 units should be bought from Division M since, from a group
perspective, the cost of supplying these internally is $60 per unit cheaper than buying externally. The remaining 5,000
motors required by Division S should then be bought in from the external supplier at $800 per unit. .
In order to work out the transfer price which should be set for the internal sales of 30,000 motors, the perspective of
both divisions must be considered.

From Division M’s perspective

Division M’s only buyer for these 30,000 motors is Division S, so the lowest price it would be prepared to charge is the
marginal cost of making these units, which is $740 per unit. However, it would ideally want to make some profit on these
motors too and would consequently expect a significantly higher price than this.
From Division S’s perspective Division S knows that it can buy as many external motors as it needs from outside the
group at a price of $800 per unit. Therefore, this will be the maximum price which it is prepared to pay.

Overall
Therefore, the transfer price should be set somewhere between $740 and $800. From the perspective of the group, the
total group profit will be the same irrespective of where in this range the transfer price is set. However, it is important
that divisional managers and staff remain motivated. Given the external sales price which Division M can achieve and the
fact that Division S would have to pay $800 for each motor bought from outside the group, the transfer price should
probably be at the higher end of the range.
Question 3 – Pricing decisions
TR Co is a pharmaceutical company which researches, develops and manufactures a wide range of drugs. One of these
drugs, ‘Parapain’, is a pain relief drug used for the treatment of headaches and until last month TR Co had a patent on
Parapain which prevented other companies from manufacturing it. The patent has now expired and several competitors
have already entered the market with similar versions of Parapain, which are made using the same active ingredients.
TR Co is reviewing its pricing policy in light of the changing market. It has carried out some market research in an
attempt to establish an optimum price for Parapain. The research has established that for every $2 decrease in price,
demand would be expected to increase by 5,000 batches, with maximum demand for Parapain being one million batches.
Each batch of Parapain is currently made using the following materials:
Material Z: 500 grams at $0·10 per gram
Material Y: 300 grams at $0·50 per gram
Each batch of Parapain requires 20 minutes of machine time to make and the variable running costs for machine time are
$6 per hour. The fixed production overhead cost is expected to be $2 per batch for the period, based on a budgeted
production level of 250,000 batches.
The skilled workers who have been working on Parapain until now are being moved onto the production of TR Co’s
new and unique anti-malaria drug which cost millions of dollars to develop. TR Co has obtained a patent for this
revolutionary drug and it is expected to save millions of lives. No other similar drug exists and, whilst demand levels are
unknown, the launch of the drug is eagerly anticipated all over the world.
Agency staff, who are completely new to the production of Parapain and cost $18 per hour, will be brought in to produce
Parapain for the foreseeable future. Experience has shown there will be a significant learning curve involved in making
Parapain as it is extremely difficult to handle. The first batch of Parapain made using one of the agency workers took 5
hours to make. However, it is believed that an 80% learning curve exists, in relation to production of the drug, and this
will continue until the first 1,000 batches have been completed. TR Co’s management has said that any pricing decisions
about Parapain should be based on the time it takes to make the 1,000th batch of the drug.
Note: The learning co-efficient, b = –0·321928
Required:
(a) Calculate the optimum (profit-maximising) selling price for Parapain and the resulting annual profit which
TR Co will make from charging this price. Note: If P = a – bQ, then MR = a – 2bQ (12 marks)

(b) Discuss and recommend whether market penetration or market skimming would be the most suitable
pricing strategy for TR Co when launching the new anti-malaria drug. (8 marks)
Answer for (b)
Market penetration pricing
With penetration pricing, a low price would initially be charged for the anti-malaria drug. The ideology behind this is that
the price will make the product accessible to a larger number of buyers and therefore the high sales will compensate for
the lower prices being charged. The anti-malaria drug would rapidly become accepted as the only drug worth buying, i.e.
it would gain rapid acceptance in the marketplace.
The circumstances which would favour a penetration pricing policy are:
– Highly elastic demand for the anti-malaria drug, i.e. the lower the price, the higher the demand. There is no evidence
that this is the case.
– If significant economies of scale could be achieved by TR Co so that higher sales volumes would result in sizeable
reductions in costs. It cannot be determined if this is the case here.
– If TR Co was actively trying to discourage new entrants into the market, however in this case, new entrants cannot
enter the market anyway due to the patent.
– If TR Co wished to shorten the initial period of the drug’s life-cycle so as to enter the growth and maturity stages
quickly but there is no evidence the company wish to do this.

Market skimming pricing

With market skimming, high charges would initially be charged for the anti-malaria drug rather than low prices. This
would enable TR Co to take advantage of the unique nature of the product.
The most suitable conditions for this strategy are:
– The product has a short life cycle and high development costs which need to be recovered. There is no information
about the drug’s life cycle but development costs have been high.
– Since high prices attract competitors, there needs to be barriers to entry if competitors are to be deterred. In TR Co’s
case it has a patent for the drug and also the high development costs could act as a barrier.
– Where high prices in the early stages of a product’s life cycle are expected to generate high initial cash flows, this will
help TR Co recover the high development costs it has incurred.

Recommendation
Given the unique nature of the drug and the barriers to entry, a market skimming pricing strategy would appear to be the
far more suitable pricing strategy. Also, whilst there is demand curve data, it is unknown how reliable this data is, in
which case a skimming strategy may be the safer option.

Question 4 – Performance measurement

The following ratios have been calculated for a company:
Gross profit margin 42%
Operating profit margin 28%
Gearing (debt/equity) 40%
Asset turnover 65%
What is the return on capital employed for the company?
A 27·3%
B 18·2%
C 11·2%
D 16·8%

Question 5 – Time series and regression

M uses time series analysis and regression techniques to estimate future sales demand. Using these techniques, it has
derived the following trend equation:
y = 10,000 + 4,200x Where y is the total sales units and x is the time period.
It has also derived the following seasonal variation index values for each of the quarters using the multiplicative
(proportional) seasonal variation model:
Quarter Index value
1 120
2 80
3 95
4 105
The transport costs incurred by M have been found to be represented by the formula:
t = $7,000 + $0.5v Where t is the total transport cost and v is the volume of sales in units.
What is the total transport cost for time period 33, which is the first quarter of year 9, to the nearest $1,000?
A $68,000
B $69,000
C $96,000
D $97,000

Question 6 – Sales quantity variance

The following budgeted data for a particular period was available for a company selling two products:
Sales price per unit Variable cost per unit Sales volume in units
Product A $20 $8 15,840
Product B $24 $11 10,560
The actual results for the period were as follows:
Sales price per unit Variable cost per unit Sales volume in units
Product A $22 $8 14,200
Product B $26 $11 12,500
What is the total sales quantity contribution variance for the period?
A $3,720 F
B $3,720 A
C $4,320 F
D $4,320 A
Question 7 – Sales planning variances
Caf Co budgeted to sell 10,000 units of a new product in the period at a budgeted selling price of $5 per unit. Actual sales
volumes in the period were as budgeted but the actual sales price achieved was only $4 per unit. This was because a
competitor launched a similar product at the same time. Caf Co had been unaware that this was going to happen when it
prepared its budget and, had it known this, it would have revised its expected selling price to $3·80 per unit, which was
the price of the competitor’s product.
What is the sales price planning variance?
A $12,000 A
B $12,000 F
C $2,000 F
D $2,000 A

The following scenario relates to questions 8 to 12 – Planning and operational variances

Marcus manages the production and sales departments for product MN at Grayshott Co. Marcus has been asked to
attend a meeting with Grayshott Co’s finance director to explain the results for product MN in the last quarter.
Budgeted and actual results for product MN were as follows:
Budget Actual
Sales volume (units) 40,000 38,000
$’000 $’000
Revenue ($65 per unit) 2,600 2,394
Material (5·2 kg at $4 per kg) (832) (836)
Labour (2 hours at $8 per hour) (640) (798)
Variable overheads (2 hours at $4 per hour) (320) (399)
Fixed overheads (220) (220)
Profit 588 141
There was no opening and closing inventory in the last quarter. Grayshott Co operates a marginal costing system.
Marcus is angry about having to attend the meeting as he has no involvement in setting the original budget and he
believes that the adverse results are due to the following circumstances which were beyond his control:
(1) A decision by Grayshott Co’s board to increase wages meant that the actual labour rate per hour was 25% higher than
budgeted. This decision was made in response to a request by the production department to enable it to meet a large,
one-off customer order in the last quarter.
(2) Due to the closure of a key supplier, Grayshott Co agreed to a contract with an alternative supplier to pay 6% more
per kg than the budgeted price for material. The actual cost per kg of material was $4·40.
(3) Difficult economic conditions meant that market demand for product MN was lower by 10%.
At present Grayshott Co does not operate a system of planning and operational variances and Marcus believes it
should do so.

8 What was the market share variance for product MN for the last quarter?
A $40,400 Favourable
B $80,800 Adverse
C $29,400 Favourable
D $38,000 Adverse

9 What was the adverse materials price planning variance for product MN for the last quarter?
A $30,400
B $76,000
C $45,600
D $49,920

10 What was the labour rate operational variance for product MN for the last quarter?
A $159,600 Favourable
B $159,600 Adverse
C $160,000 Favourable
D $160,000 Adverse
11 Which of the following would explain a labour efficiency planning variance?
(1) A change in employment legislation requiring staff to take longer rest periods
(2) Customers demanding higher quality products leading to a change in product design
(3) The learning effect for labour being estimated incorrectly in the production budget
A 1 and 2 only
B 2 and 3 only
C 3 only
D 1, 2 and 3

12 Which of the following statements regarding the problems of introducing a system of planning and
operational variances is/are true?
(1) Operational managers may argue that variances are due to the original budget being unrealistic
(2) Operational managers may seek to blame uncontrollable external factors for the variances
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2

Question 13 – Zero based budgeting

Lesting Regional Authority (LRA) is responsible for the provision of a wide range of services in the Lesting region, which
is based in the south of the country ‘Alaia’. These services include, amongst other things, responsibility for residents’
welfare, schools, housing, hospitals, roads and waste management.
Over recent months the Lesting region experienced the hottest temperatures on record, resulting in several forest fires,
which caused damage to several schools and some local roads. Unfortunately, these hot temperatures were then followed
by flooding, which left a number of residents without homes and saw higher than usual numbers of admissions to
hospitals due to the outbreak of disease. These hospitals were full and some patients were treated in tents. Residents have
been complaining for some years that a new hospital is needed in the area.
Prior to these events, the LRA was proudly leading the way in a new approach to waste management, with the
introduction of its new ‘Waste Recycling Scheme.’ Two years ago, it began phase 1 of the scheme and half of its residents
were issued with different coloured waste bins for different types of waste. The final phase was due to begin in one
month’s time. The cost of providing the new waste bins is significant but LRA’s focus has always been on the long-term
savings both to the environment and in terms of reduced waste disposal costs.
The LRA is about to begin preparing its budget for the coming financial year, which starts in one month’s time. Over
recent years, zero-based budgeting (ZBB) has been introduced at a number of regional authorities in Alaia and, given the
demand on resources which LRA faces this year, it is considering whether now would be a good time to introduce it.
Required:
(a) Describe the main steps involved in preparing a zero-based budget. (3 marks)
Answer for (a)
1. Activities are identified by managers. Managers are then forced to consider different ways of performing the activities.
These activities are then described in what is called a ‘decision package’, which:
– analyses the cost of the activity;
– states its purpose;
– identifies alternative methods of achieving the same purpose;
– establishes performance measures for the activity;
– assesses the consequence of not performing the activity at all or of performing it at different levels.
As regards this last point, the decision package may be prepared at the base level, representing the minimum level of
service or support needed to achieve the organisation’s objectives. Further incremental packages may then be prepared to
reflect a higher level of service or support.

2. Management will then rank all the packages in the order of decreasing benefits to the organisation. This will help
management decide what to spend and where to spend it. This ranking of the decision packages happens at numerous
levels of the organisation.

3. The resources are then allocated based on order of priority up to the spending level available.
(b) Discuss the problems which the Lesting Regional Authority (LRA) may encounter if it decides to introduce
and use ZBB to prepare its budget for the coming financial year. (9 marks)
Answer for (b)
At present, the LRA finds itself facing particularly difficult circumstances. The fires and the floods have meant that
urgent expenditure is now needed on schools, roads and hospitals which would not have been required if these
environmental problems had not occurred. Lesting is facing a crisis situation and the main question is therefore whether
this is a good time to introduce anything new at the LRA when it already faces so many challenges.

The introduction of ZBB in any organisation is difficult at any time because of the fact that the process requires far more
skills than, for example, incremental budgeting. Managers would definitely need some specialist training as they simply
will not have the skills which they would need in order to construct decision packages. This then would have further
implications in terms of time and cost, and, at the moment, both of these are more limited than ever for the LRA. When
so many costs are being faced by the LRA, can it really consider spending money on training staff to prepare and evaluate
decision packages?

Given that the budget needs preparing imminently as the new financial year is approaching, it is really too late to start
training staff. With ZBB, the whole budgeting process becomes a lot more cumbersome as it has to be started from
scratch. There is a lot of paperwork involved and the whole process of identifying decision packages and determining
their costs and benefits is extremely time-consuming. There are often too many decision packages to evaluate and there is
frequently insufficient information for them to be ranked. The LRA provides a wide range of services and it is therefore
obvious that this would be a really lengthy and costly process to introduce. At the moment, some residents are homeless
and several schools have been damaged by fire. How can one rank one as more important than the other when both are
equally important for the community? Sometimes, the information needed in order to rank them simply will not be
available, or managers will not feel able to assimilate it properly.

Another problem with ZBB is that it can cause conflict to arise as departments compete for the resources available. Since
expenditure is urgently required for schools, roads and hospitals, it is likely that these would be ranked above expenditure
on the recycling scheme. In fact, the final phase of the scheme may well be postponed. This is likely to cause conflict
between departments as those staff and managers involved in the recycling scheme will be disappointed if the final phase
has to be postponed.

(c) Outline THREE potential benefits of introducing zero-based budgeting at the LRA. (3 marks)
Answer for (c)
– ZBB will respond to changes in the economic environment since the budget starts from scratch each year and takes
into account the environment at that time. This is particularly relevant this year after the fires and the floods. Without
ZBB, adequate consideration may not be given to whether the waste management scheme should continue but, if ZBB
is used, the scheme will probably be postponed as it is unlikely to rank as high as expenditure needed for schools,
housing and hospitals.
– If any of the activities or operations at LRA are wasteful, ZBB should be able to identify these and remove them. This
is particularly important now when the LRA faces so many demands on its resources.
– Managers may become more motivated as they have had a key role in putting the budget together.
– It encourages a more questioning attitude rather than just accepting the status quo.
– Overall, it leads to a more efficient allocation of resources.
– All of the organisations activities and operations are reviewed in depth.
– ZBB focuses attention on outputs in relation to value for money. This is particularly important in the public sector
where the 3 Es (economy, efficiency and effectiveness) are often used to measure performance.
Note: Only three were required.