EXTRA QUESTIONS FOR CHAPTER 7 TO 13

QUESTION 1

Environmental management Accounting [EMA] has received considerable attention in recent

years as the monetary consequences of corporate environmental impacts and incidents have
grown. EMA is principally concerned with the generation, analysis and use of financial and
non-financial information in order to evaluate and control the environmental aspects of an
organisation.

Required:

(a) Explain FOUR (4) categories of environmental cost

(b) Explain the main issues involved in defining and controlling environmental costs.
(c) Explain the role that can be played by the management accountant for the successful
implementation of an environmental management system within an organization.

ANSWER FOR QUESTION 1

(a)
 Environmental prevention costs: the costs of activities undertaken to prevent the
production of waste.
 Environmental detection costs: costs incurred to ensure that the organisation complies
with regulations and voluntary standards.
 Environmental internal failure costs: costs incurred from performing activities that
have produced contaminants and waste that have not been discharged into the
environment.
 Environmental external failure costs: costs incurred on activities performed after
discharging waste into the environment.

(b)
 Some of the costs are difficult to separate out and identify.
 The costs need to be controlled but this can only be done if they have been correctly
identified in the first place.
 Identifying environmental costs could be a lengthy process, particularly in a large
organisation. The fact that environmental costs are often ‘hidden’ in general
overheads makes it difficult for management to identify opportunities to cut
environmental costs.

(c)
 Establishing the framework for EMA system
 Recognition of need to rethink cost classifications lead by the management accountant
 Application of relevant MA techniques to identify and control environmental costs.
 Actively involved in implementation of EMA system, reporting and monitoring
performance.

EQ C7 TO 13-1
QUESTION 2

Wearmore Plc is currently designing a new product that has an estimated life cycle of three
years. The project manager of the product has provided you with all the information relating
to the new product but has asked you to prepare the financial evaluation as he does not have
the required experience to do this. The organisation has a maximum production of 750,000
units.

The initial cost of the equipment needed for production is RM19,750,000, this is payable at
the beginning of the project. The residual value of the equipment is estimated at RM475,000.

The total market size for this product is predicted to be as follows: Year 1: 3,000,000 units;
Year 2: 4,500,000 units; Year 3: 2,250,000 units

Wearmore Plc have estimated the sales of the new product using a price / demand function
which is as follows: P = 200 – 0.20Q where P represents the price and Q represents the sales
in 000 units.

The sales/marketing department have stated that the year one sales will determine the sales in
years 2 and 3. The sales in Wearmore Plc will increase in proportion from year one in the
same pattern that the total market size increases from year 1 to year 2 and from year 2 to year
3. This will be restricted to the company production capacity.

The prices in year’s 2 and 3 will be determined using the price /demand function as above
and the demand which is calculated above.

There will be a marketing campaign for the product based on the following: Year 0:
RM1,500,000; Year 1: RM1,250,000 and Year 2: RM750,000

The variable cost of the product will remain constant throughout the production process at
RM70 per unit.

Fixed costs relating to the new product (in addition to the marketing costs above) are
calculated to be RM2,500,000 every year.

The launch price for this product will be RM180.

For the purpose of this question, you can ignore taxation and inflation.

Required:

(a) Calculate life cycle cost per unit.

(b) Calculate average net cash flow per unit for whole product life cycle.

EQ C7 TO 13-2
ANSWER FOR QUESTION 2

(a)
Year 0 Year 1 Year 2 Year 3 Total
(RM) (RM) (RM) (RM) (RM)
Initial cost 19,750,000 19,750,000
Variable cost (100,000 × (150,000 × (75,000 × 22,750,000
RM70) RM70) RM70)
7,000,000 10,500,000 5,250,000
Marketing 1,500,000 1,250,000 750,000 3,500,000
cost
Fixed cost 2,500,000 2,500,000 2,500,000 7,500,000
Total life 53,500,000
cycle cost

(W1)
Quantity for Year 1
P = 200 – 0.2Q
RM180 = 200 – 0.2Q
Q = 100 = 100,000 units

Quantity for Year 2

= 100,000 units × 4,500,000 / 3,000,000
= 150,000 units

Quantity for Year 3

= 150,000 units × 2,250,000 / 4,500,000
= 75,000 units

(W2)
Price for Year 1 = RM180

Price for Year 2

P = 200 – 0.2Q
P = 200 – 0.2(150)
P = RM170

Price for Year 3

P = 200 – 0.2Q
P = 200 – 0.2(75)
P = RM185

Life cycle cost per unit

= RM53,500,000 / (100,000 + 150,000 + 75,000) units
= RM164.62

EQ C7 TO 13-3
(b)
Year 0 Year 1 Year 2 Year 3 Total
(RM) (RM) (RM) (RM) (RM)
Sales (100,000 × (150,000 × (75,000 × 57,375,000
RM180) RM170) RM185)
= 18,000,000 = 25,500,000 13,875,000
Residual 475,000 475,000
value
Total cash 57,850,000
inflow

Cash inflow per unit

= RM57,850,000 / (100,000 + 150,000 + 75,000) units
= RM178

Net cash flow per unit

= RM178 - RM164.62
= RM13.38

EQ C7 TO 13-4
QUESTION 3

A newly formed engineering company has just completed its first three months of trading.
The company manufactures only one type of product. The external accountant for the
company has produced the following statement to present at a meeting to review performance
for the first quarter.

Performance report for the quarter ending 31 October 20X2

Budget Actual Variance

Sales units 12,000 13,000 1,000
Production units 14,000 13,500 (500)
RM’000 RM’000 RM’000 RM’000 RM’000
Sales 360 385 25
Direct materials 70 69 1
Direct labour 140 132 8
Variable production overhead 42 43 (1)
Fixed production overhead 84 85 (1)
Inventory adjustment (48) (12) (36)
Cost of sales 288 317 (29)
Gross profit 72 68 (4)

The external accountant has stated that he values inventory at the budgeted total production
cost per unit.

Required:

(a) Produce an amended statement for the quarter ending 31 October 20X2 that is based on a
flexed budget.

(b) Explain ONE benefit and ONE limitation of the statement you have produced.

EQ C7 TO 13-5
ANSWER FOR QUESTION 3

Inventory
= [(RM70,000 + RM140,000 + RM42,000 + RM84,000) ÷ 14,000 units] × 2,000 units
= RM24 per units × 2,000 units
= RM48,000[check answer]

(a)

Original Flexible Budget

Budget Actual Variance
Sales units 12,000 13,000 13,000
Production units 14,000 13,500 13,500
RM’000 RM’000 RM’000 RM’000 RM’000 RM’000 RM000
Sales 360 390(W1) 385 5(A)
Direct materials 70 67.5(W2) 69 1.5(A)
Direct labour 140 135 132 3(F)
Variable production 40.5
overhead 42 43 2.5(A)
Fixed production 84
overhead 84 85 1(A)
Inventory adjustment (48) (12)(W3) (12) 0
Cost of sales 288 315 317 2(A)
Gross profit 72 75 68 7(A)

(W1)
=RM360,000/12,000 x 13,000
=RM390,000

(W2)
=RM70,000/14,000 x 13,500
=RM67,500

(W3)
= RM24 per unit x (13,500-13,000) units
=RM24 per unit x 500units

(b)
Benefit
The figures are compared on a 'like for like' basis to reveal more effective performance
review and control. (enable fair comparison)

Limitation
The flexible budget does not offer enough detail for responsibility and control. The variances
are in 'total' variances. (e.g. Material cost variance of RM1,500 (A) could be caused by
“price” or the “usage”)

EQ C7 TO 13-6
QUESTION 4

S Sdn. Bhd. was formed over 20 years ago to manufacture numerous types of electrical and
electronic products to sell directly to individual consumers and industrial users. The electrical
and electronic products market in these recent years is increasingly competitive, with
overseas companies entering the market. S Sdn. Bhd.’s customers have responded to this by
demanding lower prices and better quality products from S Sdn. Bhd. As the electrical and
electronic products market is technologically innovative, there is also a requirement to
continually develop new products or enhance existing ones.

The sales manager has revealed his sales team figures for the year ended 31 December 2020
and is excited to announce that the team has exceeded sales volume targets. However, his
enthusiasm is not shared by the financial controller, who has written a report to the chief
executive officer suggesting that there are fundamental performance problems in the
company.

An extract of her report is given below:

Financial performance
‘In a period of increased competition and growing product ranges, we are failing to keep
control of the profitability of our business. The following statement is a summary of our
performance for the year ended 31 December 2020, showing problems with our pricing
and/or our cost control. This has definitely affected our profitability.

Budget Actual
Sales units 486,000 540,000

RM’000 RM’000
Sales revenue 72,900 72,900
Direct materials (31,590) (37,260)
Direct labour (6,804) (9,450)
Fixed overheads (16,500) (22,900)
Operating profit 18,006 3,290

Required:

EQ C7 TO 13-7
It is clear that the financial controller and the sales manager have different opinions about the
current performance of the company.

(a) Produce a revised statement that is based on a flexed budget and calculate the relevant
variances to analyse the data shown in the statement above for the year ended 31 December
2020.

(b) Refer to your answer in part (a), comment on the performance why it may not be as
positive as that portrayed by the sales manager.

ANSWER FOR QUESTION 4

(a)
Flexible Budget Actual Variance
Sales units 540,000 540,000

RM’000 RM’000 RM’000

Sales revenue 81,000 72,900 8,100 (A)
Direct materials (35,100) (37,260) 2,160 (A)
Direct labour (7,560) (9,450) 1,890 (A)
Fixed overheads (16,500) (22,900) 6,400 (A)
Operating profit 21,840 3,290 18,550 (A)

(b)
From the above, it can be seen that all calculated variances are adverse when considered
against the flexed budget. The operating profit variance is RM18,500,000 adverse.

Sales revenue showed an adverse variance of RM8,100,000. Although the actual sales
revenue is the same as budgeted, this is from a much higher sales volume. The selling price
per unit was budgeted at RM150 [RM72,900,000/ 486,000units], but the actual selling price
per unit was RM135 [RM72,900,000/ 540,000 units], a decrease of 10%. It could be that the
price was necessarily reduced in order to cope with increased competition.

Direct materials showed an adverse materials variance of RM2.16m may either be due to the
price or quantity of materials used. It was stated that customers wanted more quality
products, which may have led to more advanced component parts, thus increasing costs.

Direct labour has also shown an adverse variance of RM1.89m. This may be due to either the
rate paid, or the hours worked on products. As the quantity produced has exceeded the
budget, this may have required overtime, which could affect the labour rate variance causing
it to be higher due to enhanced overtime payments.

Fixed overheads show a RM6.4m adverse variance, which is 39% higher than budgeted,
suggesting that either the standard absorption rate of overheads is incorrect, or that overheads

EQ C7 TO 13-8
have not been controlled throughout the year. The focus on meeting increased orders may
have distracted management attention from overhead control, thus leading to inefficiencies
related to these costs.

QUESTION 5

You have been provided with the following operating statement, which represents an attempt
to compare the actual performance for the quarter which has just ended with the budget:

Budget Actual Variance

Number of units sold (000s) 640 720 80

RM’ 000 RM’ 000 RM’ 000

Sales 1,024 1,071 47
Cost of sales (all variable)
Material 168 144
Labour 240 288
Overheads 32 36
440 468 (28)

Fixed labour cost 100 94 6

Selling & distribution costs:

Fixed 72 83 (11)
Variable 144 153 (9)

Administration costs:
Fixed 184 176 8
Variable 48 54 (6)
548 560 (12)
Net profit 36 43 7

Required:

(a) Using a flexible budgeting approach, re-draft the operating statement so as to provide a
more realistic indication of the variances and comment briefly on the possible reasons (other
than inflation) why they have occurred.

EQ C7 TO 13-9
(b) Explain why the original operating statement was of little use to management.

(c) Discuss the problems associated with the forecasting of figures which are to be used in
flexible budgeting.

EQ C7 TO 13-10
ANSWER FOR QUESTION 5

Flexible Actual Variance

Budget
Number of units sold (000s) 720 720
RM’ 000 RM’ 000 RM’ 000
Sales 1,152 1,071 81 (A)
Cost of sales (all variable)
Material 189 144 45 (F)
Labour 270 288 18 (A)
Overheads 36 36 0
495 468 27 (F)

Fixed labour cost 100 94 6(F)

Selling & distribution costs:

Fixed 72 83 11 (A)
Variable 162 153 9 (F)

Administration costs:
Fixed 184 176 8 (F)
Variable 54 54 0
572 560 12 (F)
Net profit 85 43 42 (A)

Possible reasons:

Actual sales volume exceeds budgeted sales volume thus generating revenues in excess of
budgets.

However, actual selling price was less than budgeted selling price (due to discount allowed
for customers) thus it actually created an adverse result on sales variance of RM81,000.

Favourable materials variance of RM45,000 may be due to cheaper price (due to discount
from supplier) or more efficient use of materials.

Adverse labour variance of RM18,000 may due to poor quality of material consumption that
lead to over time consumed or higher wages rate (employed more experienced labour).

Favourable fixed labour cost variance of RM6,000 was due to leaving of employees that no
replacement incurred.

Adverse fixed S&D costs variance of RM11,000 maybe due to an increase in advertising cost
while favourable variable S&D costs of RM9,000 may arise due to more efficient distribution
method that reduce costs.

Favourable fixed admin cost of RM8,000 may due to cheaper rental costs or reduction of
staff.

EQ C7 TO 13-11
From the above, it can be seen that adverse variances are more than favourable variances
when considered against the flexed budget. The net profit variance is RM42,000 adverse.

(b) Original operating statement was based on 640,000 units while actual result was based on
sales volume of 720,000 units, thus all sales revenue and variable costs in original statement
did not show the true picture to the management in term of performance by comparing
UNDERSTATED budgeted figure with actual result.

(c)
 Flexible budgeting assumes all variable cost per unit are constant.
 Assumes all fixed costs are constant, but it might be stepped fixed costs.
 Past information is used to predict future costs. All historical cost behaviour did not
provide the reliable guide in future.

EQ C7 TO 13-12
QUESTION 6

The following information relates to budget period 1 for Leysel Co:

Budget Budget Actual for period

(60,000 units) (90,000 units) (80,000 units)
Sales (RM) 900,000 1,350,000 1,240,000
Raw materials (RM) 450,000 675,000 632,400
Labour (RM) 155,000 207,500 165,200
Production 190,000 235,000 238,000
overheads (RM)

Actual production and sales in budget period 1 were 80,000 units. Actual labour costs for the
period included RM50,000 of fixed labour costs. Actual production overheads for the period
included RM110,000 of fixed production overheads.

Required:

(a) Using a marginal costing approach, prepare a flexed budget for the period and calculate
appropriate variances in as much detail as allowed by the information provided above.

(b) Explain how budgeting can help organisations to achieve their objectives.

ANSWER FOR QUESTION 6

(W1) High Low Method [Labour]

Step 1
Variable cost per unit = Changes in cost / Changes in unit
= (RM207,500 – RM155,000) / (90,000 – 60,000)
= RM1.75

Step 2
Total cost = Fixed cost + Variable cost

Let say for 60,000 units….

RM155,000 = Fixed cost + (RM1.75 × 60,000 units)
RM155,000 = Fixed cost + RM105,000

Fixed cost = RM155,000 – RM105,000

= RM50,000

(W1) High Low Method [Production overheads]

Step 1

EQ C7 TO 13-13
Variable cost per unit = Changes in cost / Changes in unit
= (RM235,000 – RM190,000) / (90,000 – 60,000)
= RM1.50

Step 2
Total cost = Fixed cost + Variable cost

Let say for 60,000 units….

RM190,000 = Fixed cost + (RM1.50 × 60,000 units)
RM190,000 = Fixed cost + RM90,000

Fixed cost = RM190,000 – RM90,000

= RM100,000

(a)
Flexible Budget Actual Variance
Quantity (units) 80,000 80,000

RM RM RM

Sales RM15 x 80,000 = 1,240,000 40,000 (F)

1,200,000
(-) Variable costs
Raw materials RM7.5 x 80,000 = 632,400 32,400 (A)
600,000
Labour RM1.75 x 80,000 = 115,200 24,800 (F)
140,000
Production RM1.50 x 80,000 = 128,000 8,000 (A)
overheads 120,000

Contribution 340,000 364,400 24,400 (F)

(-) Fixed costs

Labour 50,000 50,000 0
Production 100,000 110,000 10,000 (A)
overheads

Profit 190,000 204,400 14,400 (F)

(b)
Organisations formulate plans in order to achieve their objectives. Corporate or strategic
planning is concerned with determining the direction in which the organisation is expected to
move and with setting objectives to support this. Achievement of longer-term objectives is
supported in the shorter term by the budgetary planning process, which gives rise to the short-
term financial plan known as a budget. Annual budgets, therefore, are the means by which
organisations implement their long-term or strategic plan.

EQ C7 TO 13-14
Budgetary planning requires the identification of the principal budget factor, which is the
limiting factor as far as the organisation’s activities are concerned. This limiting factor is
usually sales volume in commercial organisations and so budget preparation would begin
with formulating the sales budget.

Where some other factor is limiting the organisation’s activities, such as production capacity,
achievement of strategic plans may call for financial investment in new machinery in order to
remove this limiting factor. Once the principal budget factor and its associated budget have
been prepared, functional budgets and the master budget can be prepared. In a large
organisation the preparation of these budgets will require planning and co-ordination between
different aspects or areas of the business, since otherwise the budget might contain elements
that are unrealistic or not achievable.

In supporting planning and co-ordination, the budgetary planning process also supports
communication between different areas of the organisation. Each area will become aware of
the long-term objectives of the organisation, the role that it is expected to play in achieving
those objectives in the short-term through the annual budget, and the way in which different
areas of the organisation need to work together during the budget period.

While annual budgets give structure and direction to organisational activity, regular
monitoring of actual performance is needed in order to determine whether planned
performance is being achieved. The detailed comparison of planned with actual performance
can indicate where the organisation needs to take action in order to ensure that the annual
budget is achieved. By achieving the annual budget, the organisation will be meeting its long-
term objectives. Although it is possible that changes in the environment of the organisation
may mean that some elements of the budget are no longer appropriate, the budgetary control
process can accommodate these environmental changes by amending the budget in order to
support the continuing achievement of organisational objectives.

Another way in which budgetary planning and control can help organisations to achieve their
objectives is by motivating employees to achieve those objectives. This motivation can arise
through participation in the budgetary planning process, through setting budget targets which
have a motivational effect on employees, through employee satisfaction at meeting periodic
budget targets, and by using performance against budget as the basis for employee rewards.
An organisation will also expect that managers do not perform poorly in the organisational
areas for which they are responsible, since this undermines the achievement of both short-
term and long-term organisational objectives, and managerial performance can be evaluated
against agreed budget targets in order to identify such managers.

EQ C7 TO 13-15
QUESTION 7

It is argued that the budgetary control systems have behavioural problems.

It can lead to a lack of goal congruence, budget slacks and non-acceptance of budget targets.

Required:

Briefly explain the above stated THREE (3) behavioural problems.

ANSWER FOR QUESTION 7

Lack of goal congruence

There is goal congruence in an organisation if employees are motivated to engage in
behaviour that is compatible with the goals of the organization. However, when there are
budgets set, employees may try to achieve the budget at all costs even if this results in actions
that are not in the best interests of the organisation.

Budget slacks
Owing to pressure to meet the budget, employees may manipulate the data by putting in
budget slacks. Budget slacks relates to the process by which managers seek to obtain budget
targets that can be easily achieved by understating revenues and/or overstating costs.

Non-acceptance of budget targets

Non-acceptance of budget targets because the targets set are considered too difficult and
employees are held responsible for outcomes over which they have little control e.g. the
increase in price of raw material.

EQ C7 TO 13-16
QUESTION 8

In recent years, criticisms of traditional budgeting have attracted much publicity. The major
criticism is that the annual budgeting process is incapable of meeting the demands of the
competitive environment in today’s information age.

Required:

(a) Describe the limitations of incremental budgeting.

(b) Explain the alternative budgeting method called zero-based budgeting and how it differs
from incremental budgeting.

(c) Discuss the applicability of zero-based budgeting to profit-oriented organizations.

ANSWER FOR QUESTION 8

(a) With incremental budgeting, indirect costs and support activities are prepared on an
incremental basis. This means that existing operations and the current budgeted allowance for
existing activities are taken as the starting point for preparing the next annual budget. The
base is then adjusted for changes which are expected to occur during the new budget period.
When this approach is adopted, the concern is mainly with the increment in operations or
expenditure that will occur during the forthcoming budget period. The major disadvantage of
the incremental approach is that the majority of expenditure, which is associated with the
‘base level’ of activity, remains unchanged. Thus, past inefficiencies and waste inherent in
the current way of doing things are perpetuated.

(b) Zero-based budgeting emerged as an attempt to overcome the limitations of incremental

budgets. ZBB is a method of budgeting that is mainly used in non-profit organizations but it
can also be applied to discretionary costs and support activities in profit organizations. This
approach requires that projected expenditure for existing activities should start from base zero
rather than last year’s budget. In other words, managers are required to justify all budgeted
expenditure rather than just the changes from the previous year.

(c) In profit orientated organizations, those costs which are of a discretionary nature such as
service and support activities are appropriate candidates for zero-base budgeting. Examples
of departments which fall into this category include personnel, research and development and
data processing.

EQ C7 TO 13-17
QUESTION 9

Describe THREE (3) essential elements of an effective budgetary control systems.

ANSWER FOR QUESTION 9

There must be a system of responsibility accounting. In responsibility accounting, costs and

revenues for each individual centre/department are accumulated so that managers are aware
of their responsibilities and authorities. A centre for which an individual budget is drawn up
is called a budget centre. Each budget centre will have its own budget and a manager will be
responsible for managing the budget centre and ensuring that the budget is met.

Performance reports must be produced at frequent intervals to compare actual result and
budget. Variances should be investigated, causes found and remedial action taken as soon as
possible but not all variances should be investigated. There must be clear rules to establish
whether a variance should be investigated or not. The business environment is always
changing. Therefore, budgets should be frequently reviewed and revised in order to ensure
that actual results are compared with appropriate budgets.

The managers should participate in the setting of budgets to take into account the aspiration
levels of the managers. When managers are actively involved in setting their own budgets,
the targets are more likely to be accepted by them. However, when managers are able to
influence their budgets there is a possibility that they will attempt to introduce budgetary
slack or easily achievable targets.

EQ C7 TO 13-18
QUESTION 10

Describe the influence of participation in the budgeting process.

ANSWER FOR QUESTION 10

Participation relates to the extent to which budgetees are able to influence the figures that are
incorporated in their budgets or targets. Allowing individuals to participate in the setting of
performance targets results in individuals being more likely to accept the targets and be
committed to achieving them. Participation, however, is subject to the limitation that
performance is measured by precisely the same standard that the budgetee has been involved
in setting. Participation must be used selectively; but if it is used in the right circumstances, it
has an enormous potential for encouraging the commitment to organizational goals.

EQ C7 TO 13-19
QUESTION 11

A specialized machinery company is preparing its budget for next year. In previous years, the
director of the company has prepared the company budget without the participation of senior
staff and presented it to the company board for approval. Last year, the company board
criticized the director over the lack of participation of his senior staff in the preparation of the
budget and requested that for next year’s budget the senior staff were to be involved.

Required:

Discuss the potential impacts to the company of involving the senior staff in the budget
preparation process.

ANSWER FOR QUESTION 11

The positive motivational impact arising from staff feeling that they are being respected
because of their knowledge and experience relating to running the company.

The following additional disadvantages could also arise:

 Senior staff may spend a great deal of time arguing with each other and top
management relating to the content and level of difficulty of the budget
 The participative process can be very time-consuming
 Senior staff may be excellent in their chosen area but lack the knowledge and skills to
engage in the management of the budget process.

EQ C7 TO 13-20
QUESTION 12

Describe the FOUR (4) different types of responsibility centres.

ANSWER FOR QUESTION 12

A responsibility centre may be defined as a unit of a firm where an individual manager is

held accountable for the unit’s performance. There are four types of responsibility centre cost
or expense centres, revenue centres, profit centres and investment centres.

Cost or expense responsibility centres are those centres whose managers are normally
accountable for only those costs or expenses that are under their control. It is necessary to
distinguish between standard cost centres, whose output can be measured and the input
required to produce each unit of output can be specified and discretionary expense centres,
where there are no clearly observable relationships between inputs and the outputs.

Revenue responsibility centres are those centres whose managers are mainly accountable
for financial outputs in the form of generating sales revenues.

Units within an organization whose managers are accountable for both revenues and costs are
called profit responsibility centres. Managers are therefore free to set selling prices, choose
which markets to sell in, make product mix and select suppliers.

Investment responsibility centres are centres whose managers are responsible for both sales
revenues and costs and, in addition, have responsibility and authority to make working capital
and capital investment decisions.

EQ C7 TO 13-21
QUESTION 13

Responsibility accounting is based on the application of the controllability principle.

Required:

Explain the ‘controllability’ principle and why its application is difficult in practice.

ANSWER FOR QUESTION 13

Responsibility accounting is based on the application of the controllability principle, which

means that it is appropriate to assign only those costs to responsibility centres that can be
significantly influenced by the manager of that responsibility centre. The controllability
principle can be implemented by either eliminating the uncontrollable items from the areas
for which managers are held accountable or calculating their effects so that the reports
distinguish between controllable and uncontrollable items.

Applying the controllability principle is difficult in practice because many areas do not fit
neatly into either controllable and uncontrollable categories. Instead, they are partially
controllable. Even when outcomes are affected by occurrences outside a manager’s control,
such as competitors’ actions, price changes and supply shortages, a competent manager can
take action to reduce their adverse effects.

EQ C7 TO 13-22
QUESTION 14

Discuss the extent to which the incidence of budgetary slack is likely to be affected by the
use of each of the techniques listed in below:

(a) Rolling budget

(b) Flexible budget
(c) Zero-based budget
(d) Incremental budget

ANSWER FOR QUESTION 14

(a) Rolling budget

The continuous nature of rolling budgets and the fact that the budget will be reviewed at
frequent intervals may reduce the need for budgetees to protect themselves against the
uncertainties inherent in the annual budgeting process.

Alternatively, if rolling budgets seek to incorporate a continuous improvement, or if a good

performance in the previous period is reflected by a more demanding budget, then rolling
budgets might be seen as an additional short-term threat and thus encourage the need to build
in slack.

(b) Flexible budget

Without flexible budgets, managers might restrict activity in order to ensure that actual
expenditure will be lower than budget (purely because of the lower level of activity). At the
budget setting stage, flexible budgets are unlikely to have much impact on budget slack.

(c) Zero-based budget

With zero-based budgeting, each expenditure item must be justified for the new budget
period. Zero-based budgeting focuses the budgeting process on the objectives of the
organisation by linking decision packages to organisational objectives. With intention of
seeking better resource allocation and lower costs, it is unlikely to have impact on budget
slack.

(d) Incremental budget

This method assumes a slight change in budgetary allocations froms prior period, it assumes
that method of working shall remain the same. Incremental budgeting may cause
management to lead into a scenario called as budgetary slack, whereby managers tend to
build lower revenue growth and higher expense growth so as to have favourable variances.

EQ C7 TO 13-23
QUESTION 15

A system of responsibility accounting and standard costing was introduced in SLOWY

Berhad to promote effective control of expenditure.

The basic principles underlying the responsibility cost control system included:
(1) setting cost and profit targets
(2) assigning target costs to various levels of responsibility centre;
(3) evaluating performance based on fulfilment of the responsibility targets;
(4) implementing a reward scheme with built-in incentive mechanisms.

If a responsibility centre or individual worker fails to meet the cost targets specified in the
responsibility contracts, all bonus and other benefits relating to the responsibility unit or
worker will be forfeited.

Required:

Explain the limitations of linking bonuses to meeting cost targets in SLOWY Berhad.

ANSWER FOR QUESTION 15

There may be several limitations of linking the bonus to meeting cost targets:
 The cost information may be manipulated to achieve the target, and thus the bonus.
 If the focus on meeting costs is too severe, quality may suffer.
 Based on the information given, if seems all bonuses and benefits are forfeited if cost
targets are not met. This could affect staff motivation.
 Do staff have control over all elements of cost? For example, material prices are
driven by market forces of which staff has no control.

EQ C7 TO 13-24
QUESTION 16

EQ C7 TO 13-25
ANSWER FOR QUESTION 16

EQ C7 TO 13-26
QUESTION 17

EQ C7 TO 13-27
ANSWER FOR QUESTION 17

EQ C7 TO 13-28
EQ C7 TO 13-29
QUESTION 18

Bedtime Bedding Company manufactures pillows. The Cover Division makes covers and the
Assembly Division makes the finished products. The covers can be sold separately for
RM5.00. The pillows sell for RM6.00. The information related to manufacturing for the
most recent year is as follows:

RM
Cover Division manufacturing costs 6,000,000
Sales of covers by Cover Division (external sales) 4,000,000
Market value of covers transferred to Assembly (internal sales) 6,000,000
Sales of pillows by Assembly Division (external sales) 7,200,000
Additional manufacturing costs of Assembly Division 1,500,000

Required:

EQ C7 TO 13-30
(a) Compute the operating income for each division and the company as a whole. Use market
value as the transfer price.

(b) Explain whether all managers are satisfied with this concept.

ANSWER FOR QUESTION 18

Cover Division Assembly Division Company

RM’000 RM’000 RM’000 RM’000 RM’000
External sales 4,000 7,200 11,200
Transfer to Assembly 6,000
Total sales 10,000 7,200
Transfer cost 6,000
Cost of production 6,000 1,500 (7,500)
(6,000) (7,500)
Profit 4,000 (300) 3,700

(b) The Assembly manager is probably not happy because the division is showing a loss. The
manager would probably argue for a transfer price at something less than market price.
However, since the market is open and competitive, the market price can be justified. The
division needs to either increase its price or reduce its costs if it expects to show a profit.

QUESTION 19

Croydon BHD is a large manufacturing company with divisional performance assessed on the
basis of profitability. Division A of this company produces a single product. Currently 60%
of the output is sold externally and 40% is transferred within the company to Division B
which incorporates this product into another product (Division B uses 1 product from
Division A to make 1 product). Both divisions are currently operating significantly below full
capacity.

Division A’s costs per unit of product are (based on current total output of 25,000 units):

RM
Direct Materials 200 Total variable costs:
Direct Labour 250 RM800 x 25,000 units
Variable Manufacturing Overhead 350 = RM20,000,000
Fixed Manufacturing Overhead 500

EQ C7 TO 13-31
Selling and Distribution Costs* 150
Total Cost 1,450

Note
*
- these costs are variable and apply to EXTERNAL sales only

Division A sells the external output at a price of RM2,000 per unit. Internal transfers to
Division B are made at a transfer price of RM1,850 per unit (reflecting the saving in selling
and distribution costs).

In producing its final product, Division B incurs further direct costs of RM500 per unit and
overhead of RM700 per unit (60% of this figure is the fixed overhead per unit at current
output level and the remainder is variable overhead)(RM500 + RM700 x 40% = RM780
variable OH).

Division B’s management believe the transfer price is too high and claim Division A could
not anyway sell more externally at its current price. Both divisions are concerned with
maximising profits and Division B argues that a transfer price of RM1,400 would be
beneficial to the company and still allow a good contribution margin for Division A.

Estimated demand for the external products is shown below:

Division A
Price RM1,700 RM2,000 RM2,300
Demand 20,000 15,000 10,000

Division B
Price RM3,000 RM3,500 RM4,000
Demand 20,000 15,000 10,000

Required:

(a) Calculate the contribution of both divisions and of the company overall in the current
situation.

(b) Calculate the contribution of both divisions and of the company overall using the transfer
price proposed by Division B.

(c) Would the change in transfer price be likely to affect overall company profits?

(d) Briefly explain the problem being caused by the transfer pricing system in this specific
situation.

(e) Discuss whether it is advisable for central management to act to reduce such problems
arising from transfer pricing systems.

ANSWER FOR QUESTION 19

(a)

EQ C7 TO 13-32
(W1) Division A

Quantity (units) for external sale = 25,000 units × 60% = 15,000 units
Quantity (units) for internal sale = 25,000 units × 40% = 10,000 units

Division A Division B Company

RM’000 RM’000 RM’000 RM’000 RM’000
External sales @RM2,00 30,000 10k units 40,000 70,000
0
Transfer to B @RM1,85 18,500
0
Total sales 48,500 40,000
Transfer cost 18,500
Selling and distribution 2,250 (2,250)
costs (@RM150)
Variable production cost 20,000 7,800 (27,800)
(22,250) (26,300)
Contribution 26,250 13,700 39,950

(b)
Since Division B would like to maximise its profit, if the transfer price is RM1,400, Division
B would buy 15,000 units from Division A (as it has the most contribution).

Demand 20,000 15,000 10,000

RM’000 RM’000 RM’000

External sales 60,000 52,500 40,000

Transfer cost @RM1,400 (28,000) (21,000) (14,000)
Variable production cost (15,600) (11,700) (7,800)

Contribution 16,400 19,800 18,200

(W2) Division A

Quantity (units) for external sale = 15,000 units (remained the same)
Quantity (units) for internal sale = 15,000 units

Division A Division B Company

RM’000 RM’000 RM’000 RM’000 RM’000
External sales 30,000 15k units 52,500 82,500
Transfer to B @RM1,40 21,000
0
Total sales 51,000 52,500
Transfer cost 21,000
Selling and distribution 2,250 (2,250)
costs

EQ C7 TO 13-33
 Variable production cost 24,000 11,700 (35,700)
(26,250) (32,700)
Contribution 24,750 19,800 44,550

(c)
Overall profit level for company is increased by around RM4,600,000 if both divisions
willing or agree with transfer price of RM1,400.

(d)
The main problem occurred here is transfer price in current situation is treated as variable
cost by division B. In fact, it contained fixed cost elements and certain profit margin
elements. Thus, both division and company might have different measures of contribution
and division A and B will definitely choose the TP where maximize their own profit.

(e)
One solution is to arrange a negotiation between divisions. Such solution might waste some
time and human resources. It will depend on the size of the problem. Since the loss of profit
arising from the current high TP (RM1,850) is very significant, the central management will
attempt to influence the division A to reduce the TP to acceptable level. The base of the
problem is that the optimum TP is the marginal cost of transferring division of management's
resources but this conflicts with their desire to make profits. By definition the division would
make a loss equal to fixed cost at that price.

Another idea is to split costs into unit cost and charge certain agreed amount of annual
charges for the TP. This would ensure that unit cost (marginal cost) is used for decision
marking but that the annual transfer reflected the requirement for the transferring divisions to
cover fixed costs and make profit.

EQ C7 TO 13-34