MANAGEMENT CONTROL SYSTEM PAPER ASSIGNMENT

Case Study Chapter 6

“Medoc Company”

Lecturer:
Ayu Chairina Laksmi, SE., M.App.Com., M.Res., Ph.D, Ak., CA.

By:
Vega Agnitya Eka Pangesti
17312053

DEPARTMENT OF ACCOUNTING INTERNATIONAL PROGRAM

FACULTY OF ECONOMICS
UNIVERSITAS ISLAM INDONESIA
2020
COMPANY BACKGROUND

Medoc Company is a company engaged in wheat processing. The company has two
division units:
1. Milling Division
2. Consumer Product Division

The product output was distributed as follows:

1. Approximately 70 percent (by weight) was transferred to the Consumer Products
Division and marketed by this division through retail stores. The Consumer Products
Division was responsible for these items from the time of packaging; that is, it
handled warehousing, shipping, billing, and collections as well as advertising and
other sales promotion efforts.

2. Approximately 20 percent was sold by the Milling Division as flour to large industrial
users.

3. Approximately 10 percent was flour transferred to the Consumer Products Division

and sold by that division to industrial users, but in different industries than those
serviced directly by the Milling Division.

The Milling Division and Consumer Products Division were 2 of 15 investment centers in
the Medoc Company. Products were transferred from the Milling Division to the Consumer
Products Division at a unit price that corresponded to actual cost.

Counting each size and pack as one unit, there were several hundred products in the line
marketed by the Consumer Products Division. The gross margin percentage on these products
was considerably higher than that on flour sold to industrial users.

Wheat was purchased by the Grain Department, which was separate from the Milling
Division. The price of wheat fluctuated widely and frequently. Other ingredients and supplies
were purchased by the Milling Division.
 There was a variation among products, but on the average, this cost included elements in
the following approximate proportions:

Also, 75 percent of the Milling Division's investment was charged to the Consumer
Products Division in computing the latter's return on investment. This investment consisted of
property, plant, equipment, and inventory, all of which were "owned and operated" by the
Milling Division.

This transfer price resulted in friction between the Milling Division and the Consumer
Products Division, primarily for three reasons.

1. As in many process industries, unit costs were significantly lower when the plant
operated at capacity. Indeed, the principal reason for accepting the low-margin
industrial business was to permit capacity operations. There was general agreement that
acceptance of such business at a low margin, or even at something less than full-cost,
was preferable to operating at less than capacity. In recent years, the Milling Division
had operated at no less than 98 percent of capacity.

The Milling Division alleged that the Consumer Products Division was not aggressive
enough in seeking this capacity-filling volume. The Milling Division believed that the
Consumer Products Division could increase the volume of consumer sales by
increasing its marketing efforts and by offering more attractive special deals and that it
could do more to obtain industrial business at a price which, although not profitable,
nevertheless would result in a smaller loss than what the Milling Division incurred from
sales made to the industry it served. This additional volume would benefit the company,
even though it reduced the average profit margin of the Consumer Products Division.
The Consumer Products Division admitted that there was some validity in this
 argument, but pointed out that it had little incentive to seek such business when it was
charged full cost for every unit is sold.

2. The Consumer Products Division complained that although it was charged for 75
percent of the investment in the Milling Division, it did not participate in any of the
decisions regarding the acquisition of new equipment, inventory levels, etc. It admitted,
however, that the people in the Milling Division were technically more competent to
make these decisions.

3. The Consumer Products Division complained that since products were charged to it at
actual cost, it must automatically pay for production inefficiencies that were the
responsibility of the Milling Division.

A careful study had been made of the possibility of relating the transfer price either to
a market price or to the price charged by the Milling Division to its industrial customers.
Because of differences in product composition, however, this possibility definitely had been
ruled out.

The Consumer Products Division currently earned about 20 percent pre-tax return on
investment, and the Milling Division earned about 6 percent.

Top management of the Medoc Company was convinced that some way or other, the
profit performance of the Milling Division and the Consumer Products Division should be
measured separately; that is, it ruled out the simple solution of combining the two divisions
for
profit-reporting purposes.

One proposal for solving the problem was that the transfer price should consist of two
elements: (a) a standard monthly charge representing the Consumer Products Division's fair
share of the non-variable overhead, plus (b) a per-unit charge equivalent to the actual
material, labour, and variable overhead costs applied to each unit billed. The investment
would no longer be allocated to the Consumer Products Division. Instead, a standard profit
would be included in computing the fixed monthly charge.
 The monthly non-variable overhead charge would be set annually. It would consist of
two parts:
1. A fraction of the budgeted non-variable overhead cost of the Milling Division,
corresponding to the fraction of products that was estimated would be transferred to
the Consumer Products Division (about 80 percent). This amount would be changed
only if there were changes in wage rates or other significant noncontrollable items
during the year.

2. A return of 10 percent on the same fraction of the Milling Division's investment. This
was higher than the return that the Milling Division earned on sales to industrial users.
The selection of 10 percent was arbitrary because there was no way of determining a
"true" return on products sold by the Consumer Products Division.
DISCUSSION QUESTIONS

1. What would you recommend given the organizational structure constraints in the case?

Since Milling Division is supplying at actual cost, Consumer Product Division could
purchase the surplus capacity of 2%. The Consumer Product Division could increase the
volume of consumer sales by increasing its marketing efforts. For instance, providing
solutions for the Consumer Product Division to develop new products and offering more
attractive special deals.

Then, It could also do more to obtain industrial business at a price which, although
not profitable, would still result in a smaller loss than what the Milling division currently
incurred. This additional volume would benefit the company even though it reduced the
average profit margin of the Consumer Product Division.

2. What would you recommend if there were no organizational structure constraints on your
options?

If there were no organizational structure constraints, the transfer price could be

revised either to market price or the price charged by the Milling Division to its
industrial customers and could also sell anywhere. Meanwhile, the consumer product
division can buy raw materials from the market