MCS

MAY22_AUG22:
P2 APPLIED
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1 2 3
Project Transfer Responsibility
appraisal pricing centers

4 5
Pricing Wrap-up
strategies

AGENDA
1. PROJECT APPRAISAL
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PROJECT APPRAISAL

> Time value of money: Discount cashflows because

money received now is worth more than money
received later
> Payback period: Amount of time it takes to recoup
initial investment
> NPV: Discount cashflows and subtract the initial
investment cost
– Choose projects with the highest NPV

> IRR: The discount rate at which NPV = 0.

– Choose projects that have an IRR > cost of capital

> ARR: Average annual profit before interest and tax

divided by the initial investment
– Choose projects with an ARR > target ARR
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NET PRESENT VALUE

> Net present value or NPV is a popular project appraisal tool

> In the MCS, questions frequently come up relating to the difficulties that an
organisation may face when calculating the NPV of a project
> Alternatively, you may be asked to present the challenges in getting the
present value of cash flows
> When answering these questions, consider the following:

NATURE OF PROJECT COST OF CAPITAL TIMELINE

> The nature of the project > The cost of capital might be > The period over which cash
may make the related cash hard to obtain, especially if flows will be incurred might
flows difficult to estimate the company is unquoted be hard to predict
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SENSITIVITY ANALYSIS

> Sensitivity analysis can be used in conjunction with

investment appraisal techniques

> Shows the maximum amount by which a variable

can change before a project becomes non-viable

> Can be used to assess the required change in a

single variable before a project becomes non-viable
(NPV of zero)

𝑁𝑃𝑉 𝑜𝑓 𝑃𝑟𝑜𝑗𝑒𝑐𝑡
> Sensitivity % = × 100
𝑁𝑃𝑉 𝑜𝑓 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒

> The lower the sensitivity margin, the more sensitive

the project is to this variable
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PROJECT APPRAISAL

> Project appraisal techniques could be applied in

numerous different scenarios

> Piping’s board may approve the creation of a new

product (line of infusions, iced tea etc.)

> This would result in inflows from sales but also outflows
for new machinery, staff, advertising etc.

> Project appraisal techniques could be used to assess if

the project to launch a new product is worthwhile
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PROJECT APPRAISAL

> Project appraisal techniques may also be applied if

Piping’s board is assessing acquisitions

> Consider the challenges that Piping may face when

trying to calculate the NPV in some of these scenarios

> Remember that the WACC will not be an appropriate

cost of capital to use for project appraisal if:
– The investment carries a different business risk profile
– The new investment changes Ke or Kd materially
– The capital structure changes significantly as a result of the
investment
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POTENTIAL SCENARIO

Question Answer
> It is 1 July 2022. You receive an email from Channa de Silva,
Challenges
Senior Financial Manager.
> Channa tells you that Piping’s board has been offered the ability • Determining the income from the patent could be difficult
to purchase a patent for new weather resistant tea seeds.
• Piping has no experience in the seed market, so estimates may
> The seeds were specifically designed to reduce common causes
of crop failure and are 80% more weather resistant than the
be inaccurate as there is no track record to base them off
dominant strain of tea grown across the world.
• Plantations may also have no interest in the seeds, preferring to
> The board believes that the patent could be useful, as it would instead use the seeds that they are able to source cheaply in
allow Piping to sell seeds to plantations, which would generate their own countries
revenues for the company.
> Selling the seeds would also help prevent crop failure, which • Additionally, Piping will have to be careful to not be seen as
would reduce the risk of supply chain issues. being exploitative when dealing with the plantations
> The patent is for 25 years and would allow Piping to be the only • This risk of reputational damage may prevent Piping from
company in the world with the ability to produce these seeds.
charging high prices for the seeds
> Channa asks you to:
• The benefit of reducing the risk of crop failure (and, therefore,
A. Identify and explain the challenges we would face when trying to
determine the net present value (NPV) of acquiring and using
supply chain issues) may be hard to quantify as well
the patents (sub-task (a) = 52%)
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POTENTIAL SCENARIO

Question Answer
> It is 1 July 2022. You receive an email from Channa de Silva,
Challenges
Senior Financial Manager.
> Channa tells you that Piping’s board has been offered the ability • Costs associated with the patent are uncertain
to purchase a patent for new weather resistant tea seeds.
• Firstly, there will need to be a negotiation to purchase the patent
> The seeds were specifically designed to reduce common causes
of crop failure and are 80% more weather resistant than the • In addition, costs will need to be incurred to replicate and
dominant strain of tea grown across the world.
manufacture the seeds
> The board believes that the patent could be useful, as it would
allow Piping to sell seeds to plantations, which would generate • As Piping is completely new to this line of business, the
revenues for the company. anticipated costs of manufacturing the seeds is uncertain
> Selling the seeds would also help prevent crop failure, which
would reduce the risk of supply chain issues.
• The patent does however have a time period, which gives us a
period over which we can calculate the NPV
> The patent is for 25 years and would allow Piping to be the only
company in the world with the ability to produce these seeds.
> Channa asks you to:
A. Identify and explain the challenges we would face when trying to
determine the net present value (NPV) of acquiring and using
the patents (sub-task (a) = 52%)
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POTENTIAL SCENARIO

Question Answer
> It is 1 July 2022. You receive an email from Channa de Silva,
Challenges
Senior Financial Manager.
> Channa tells you that Piping’s board has been offered the ability • The cost of capital used to discount cashflows may be difficult to
to purchase a patent for new weather resistant tea seeds. determine
> The seeds were specifically designed to reduce common causes
of crop failure and are 80% more weather resistant than the
• Piping cannot use its weighted average cost of capital (WACC)
dominant strain of tea grown across the world. because the business risk profile of this project is different to
that of Piping’s main line of business
> The board believes that the patent could be useful, as it would
allow Piping to sell seeds to plantations, which would generate • This issue could be overcome by finding the cost of capital for a
revenues for the company.
quoted company that specialises in seed production
> Selling the seeds would also help prevent crop failure, which
would reduce the risk of supply chain issues. • As this is a niche area though, it may be difficult to find such an
> The patent is for 25 years and would allow Piping to be the only
organisation
company in the world with the ability to produce these seeds.
> Channa asks you to:
A. Identify and explain the challenges we would face when trying to
determine the net present value (NPV) of acquiring and using
the patents (sub-task (a) = 52%)
2. TRANSFER PRICING
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TRANSFER PRICING OBJECTIVES

GOAL CONGRUENCE EVALUATION AUTONOMY

> Ensuring alignment between > Should allow an > An effective transfer pricing
divisional and overall organisation to measure a policy will encourage
company performance divisional manager’s decentralisation
performance

MINIMISES TAX LIABILITY ALLOCATION RECORDING

> This is possible when > A transfer pricing policy > A transfer pricing policy
divisions operate in different should result in a fair assists in recording goods
tax regimes allocation of profits among and services movements
divisions
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TRANSFER PRICING APPROACHES

A market-based approach is when the market price of a product or service is

used to determine its transfer price
> When an organisation is below capacity, the supplying division is likely to accept the
prevailing market price
> When an organisation is at or above capacity, the supplying division will require the
opportunity cost of internal transfer to be factored into the transfer price

A cost-based approach is when the cost of a product or service is used to

determine its transfer price – Below are some examples
> Marginal cost – May provide no incentive for the supplier
> Cost plus – The ‘plus’ element is added onto the marginal cost, often arbitrary
> Full cost – Full cost means marginal costs plus overhead, these costs can be excessively high
> Actual cost – Using actual costs will pass on inefficiencies to the buying division
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ALTERNATIVE TRANSFER PRICING
APPROACHES

TWO-PART TARIFF DUAL PRICING

> Transfer price set at marginal cost > One transfer price is recorded by
> Fixed sum is paid to the supplying the buying division
division to go towards fixed costs > A different transfer price is recorded
> Can distort divisional performance by the supplying division

> Often requires a lengthy negotiation > The difference between the two is
process recorded in a head office balancing
account (written off at year-end)
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TRANSFER PRICING

> Piping’s board may decide to purchase a tea plantation

in an effort to control supply and raw material prices

> If they proceed with this, there will be a need to set a

transfer price for the tea

> Setting a transfer price could be difficult as the price of

tea often fluctuates in the market

> At times, tea from a different plantation in another

country could be cheaper to purchase, therefore there
could be an opportunity cost of purchasing internally
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TRANSFER PRICING

> Transfer prices may also be required when valuing the

time that staff spend assisting departments

> For example, the marketing and distribution department

may be required to assist the product development
department if a new product is launched

> A transfer price will need to be set to compensate the

marketing and distribution department for their time

> Remember that each department is ran as a cost

centre, except for marketing & distribution (profit centre)
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POTENTIAL SCENARIO

Question Answer
> It is 1 st October 2022. You are sent an email from Channa de
Challenges
Silva, Senior Financial Manager.
> Channa tells you that the board is eager for Piping to launch a • Will be hard to quantify the opportunity cost of seconding
line of infusions to sell in supermarkets and retailers. managers for five days per month
> Launching a new infusions range would require a considerable
amount of effort. As a result, the board is considering the
• Once posted to the team, each manager’s work will likely be
creation of a new team which will be responsible for absorbed by their department, and thus the opportunity cost
investigating the feasibility of creating a new infusions range, could be minimal
along with the logistics and financial implications of doing so.
• Additionally, it could be difficult to use each manager’s salary as
> A manager from each of Piping’s departments will be
the basis for setting the transfer price
represented on the team for five days per month.
> The team is supporting the product development department, so • If salaries are unequal, this could cause friction within the team
a realistic transfer price must be determined which represents
the opportunity cost of transferring managers from other • Managers who have higher transfer prices (salaries) may feel
departments in support of the product development department. that their opinion is more valid, thus causing issues within the
> Channa asks you to: team
A. Identify the challenges associated with determining a transfer
price to compensate for seconding managers and suggest how
those challenges might be overcome. (sub-task (a) = 52%)

POTENTIAL SCENARIO
Question
> It is 1 st October 2022. You are sent an email from Channa de
Silva, Senior Financial Manager.
> Channa tells you that the board is eager for Piping to launch a
line of infusions to sell in supermarkets and retailers.
> Launching a new infusions range would require a considerable
amount of effort. As a result, the board is considering the
creation of a new team which will be responsible for
investigating the feasibility of creating a new infusions range,
along with the logistics and financial implications of doing so.
> A manager from each of Piping’s departments will be
represented on the team for five days per month.
> The team is supporting the product development department, so
a realistic transfer price must be determined which represents
the opportunity cost of transferring managers from other
departments in support of the product development department.
> Channa asks you to:
A. Identify the challenges associated with determining a transfer
price to compensate for seconding managers and suggest how
those challenges might be overcome. (sub-task (a) = 52%)
27
Answer
Challenges
• It could also be argued that some managers represent
departments which are more value-added to the team than
others
• For example – The manager representing the HR department
may have limited input unless the creation of the new infusions
range requires new employees
• It might be difficult to charge a different transfer price for each
manager depending on how ‘useful’ they are to the team, this
could also create friction in the team
• It is also hard to determine a fair transfer price because each
department ultimately benefits from the team
• For example – If the new range has been investigated properly,
this will make the operations, marketing and distribution
processes for the new range much easier

POTENTIAL SCENARIO
Question
> It is 1 st October 2022. You are sent an email from Channa de
Silva, Senior Financial Manager.
> Channa tells you that the board is eager for Piping to launch a
line of infusions to sell in supermarkets and retailers.
> Launching a new infusions range would require a considerable
amount of effort. As a result, the board is considering the
creation of a new team which will be responsible for
investigating the feasibility of creating a new infusions range,
along with the logistics and financial implications of doing so.
> A manager from each of Piping’s departments will be
represented on the team for five days per month.
> The team is supporting the product development department, so
a realistic transfer price must be determined which represents
the opportunity cost of transferring managers from other
departments in support of the product development department.
> Channa asks you to:
A. Identify the challenges associated with determining a transfer
price to compensate for seconding managers and suggest how
those challenges might be overcome. (sub-task (a) = 52%)
28
Answer
Overcoming challenges
• One way to overcome these issues is to create a new cost
centre specifically for the project
• This would reduce potential conflict between the product
development department and the other departments
• It could be argued that setting a transfer price of nil is acceptable
because managers can reallocate their work to their
subordinates and each department will ultimately benefit from
the work being done
• If managers are at capacity, a transfer price based on the
external cost of hiring a contractor, which would be expected to
perform the same role on the team, would be a fair basis for
setting a transfer price
• The day rate set should be the same for each manager on the
team
3. RESPONSIBILITY CENTRES
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RESPONSIBILITY CENTRES

A responsibility centre is an area of an organisation that a manager is directly

responsible for
> Managers of responsibility centres are accountable for the centres' performance
> Responsibility accounting involves segregating costs and revenues into areas of
responsibility to control performance
> The controllability principle states that a manager should only ever be responsible for
that which they have influence over

Types of centres:

Revenue centre Cost centre Profit centre Investment centre


RESPONSIBILITY COST CENTRES
CENTRE KPIS > Managers held responsible
for costs only
> KPIs could include cost
variances, total cost and
cost per unit
PROFIT CENTRES
> Managers held responsible
for costs and revenues
> KPIs could include gross
profit or operating profit
margins, overall profit, cost
per unit and revenue growth
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REVENUE CENTRES
> Managers held responsible
for revenues only
> KPIs could include revenue
per unit, revenue growth or
total revenue
INVESTMENT CENTRES
> Managers held responsible
for costs, revenues and
capital
> KPIs could include all prior
metrics plus ROI, EVA and
residual income (RI)
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INVESTMENT CENTRE KPIS

ROI
ROI = (controllable operating profit / capital employed) x 100%
+ Relative measure, which facilitates comparisons
- Can encourage dysfunctional behaviour

Residual income
RI = controllable operating profit – (capital employed x cost of capital)
+ Simple interpretation
- Absolute measure, so is not useful for comparisons

EVA
EVA = adjusted NOPAT after tax – (adjusted capital employed x cost of capital)
+ Encourages managers to take a long-term view on performance
- Difficult to calculate and may be too complex to explain to managers
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RESPONSIBILITY CENTRES

> Piping’s structure is as follows; Five functional

departments, all of which are cost centres with the
exception of marketing and distribution

> The company may decide to create a new department

(such as IT) and you may be asked which type of
responsibility centre would be most appropriate

> Additionally, the acquisition of another business will

create new responsibility centres – The choice of centre
will depend on the circumstances
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RESPONSIBILITY CENTRES

> In the exam, there may be disagreements which stem

from Piping’s structure

> For example, if the company incurs legal costs as a

result of misleading advertising, a conflict may occur
regarding which centre is to take the cost

> You may also be asked to recommend KPIs for new or

existing responsibility centres

> Remember that a manager should only ever be

responsible for that which they have influence over
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POTENTIAL SCENARIO

Question Answer
> It is 1 October 2022. You are sent an email from Channa de
Evaluation of the claim
Silva, Senior Financial Manager.
> Channa tells you that legal action was taken against Piping. • There is some validity to Than Pale’s claim
> Earlier in the year, Piping made health claims on an • The legal costs associated with defending the case are outside
advertisement that related to a new brand of infusions that was
developed to aid sleep.
of the control of Than Pale

> The Northlandia Advertising Agency has launched a legal case • Holding him responsible for these costs is unfair, as his ability to
against the company for making unsubstantiated health claims. influence them is very limited
> The legal costs associated with defending the case have been
charged to the marketing & distribution department.
• However, it could also be argued that the marketing &
distribution department did not do adequate due diligence when
> Than Pale, Marketing & Distribution Director, claims that the making the health claims
costs should be charged to the product development department
because they assured the marketing team that the health claims • Than notes that the product development department advised
were verified and checked by a reputable third party.
that the claims were OK to make
> Channa asks you to:
• Realistically, this should have been cleared by a legal consultant
> Evaluate Than Pale’s claim that the legal costs should be
charged to the product development department (sub-task (a) =
rather than the product development department
33%)
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POTENTIAL SCENARIO

Question Answer
> It is 1 October 2022. You are sent an email from Channa de
Evaluation of the claim
Silva, Senior Financial Manager.
> Channa tells you that legal action was taken against Piping. • It might be a good idea to charge this as a ‘head office cost’ so
> Earlier in the year, Piping made health claims on an
that it is not being charged to the marketing & distribution or
advertisement that related to a new brand of infusions that was product development department
developed to aid sleep.
• However, Than Pale, should be aware of the cost
> The Northlandia Advertising Agency has launched a legal case
against the company for making unsubstantiated health claims. • If, Piping wins the case, reimbursed legal costs should not be
> The legal costs associated with defending the case have been charged to marketing & distribution
charged to the marketing & distribution department.
• The case has not yet been concluded, and so it could be argued
> Than Pale, Marketing & Distribution Director, claims that the that the marketing & distribution department may have prepared
costs should be charged to the product development department
because they assured the marketing team that the health claims
the advertisement in line with the law
were verified and checked by a reputable third party.
• Ultimately though, Than Pale has little ability to control the costs
> Channa asks you to: and should probably not be responsible for them as a result
> Evaluate Than Pale’s claim that the legal costs should be
charged to the product development department (sub-task (a) =
33%)
4. PRICING STRATEGIES
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PRICING STRATEGIES

> Selecting a pricing strategy is a hugely

important business decision

> Influences on pricing strategies could include:

– Competitor actions and prices

– Costs

– Elasticity of demand

– Nature of product or service being sold

– Overall market factors

> Let’s look at some pricing strategies

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PRICING STRATEGIES

COST PLUS PRICING PENETRATION PRICING MARKET SKIMMING

> Involves getting the > Setting a low initial price in > Setting a high initial price
expected cost of the product order to gain market share but dropping that price as
and adding a mark-up the product moves through
the product life cycle

PRICE DISCRIMINATION PREMIUM PRICING

> Involves charging a different > Differentiating a product so

price to different groups of a high price can be justified
buyers
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PRICING STRATEGIES

PRODUCT BUNDLING PRICING WITH OPTIONAL EXTRAS LOSS LEADER PRICING

> Selling a bundle of products > Charging higher prices for > Setting a very low price for
at a reduced price additional features one product or service to
entice customers

PRODUCT LINE PRICING DISCOUNT PRICING

> Having an array of related > Using discounts or price

products offered at different reductions to stimulate
prices demand
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PRICING STRATEGIES

> From the pre-seen, it appears that Piping adopts a

premium pricing strategy

> The strategy is supported through Piping’s high-quality

offering, along with its strong brand name

> It might be harder for Piping to justify premium prices in

markets outside of Northlandia as the brand name may
be less well-known and alternative high-quality brands
may be cheaper
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PRICING STRATEGIES

> When pricing a new product, such as a new herbal

infusion or a cold iced tea beverage, the pricing
strategy will be very important

> The board will need to consider competitors in the

market, whilst also considering the power of Piping’s
brand name (particularly in Northlandia)

> It is unlikely that excessive discounting or loss-leader

pricing will be appropriate for Piping’s products because
such pricing strategies may lower the perception of the
brand’s quality

POTENTIAL SCENARIO
Question
> It is 1 September 2022. You have a conversation with Channa
de Silva, Senior Financial Manager.
> Channa informs you that the board has just approved the
creation of a joint venture between Piping and Filton, a large
beverage company based in Northlandia.
> The joint venture has been created for the sole purpose of
creating a new iced tea beverage that will be developed by
Piping but manufactured by Filton.
> The iced tea market is highly competitive in Northlandia, but the
board believes that Piping could take market share by branding
the iced tea drink as being a Piping product.
> Additionally, high quality tea will be used when creating the
product, which should create a distinct flavour.
> Channa asks you to:
> Discuss the problems that we will face in choosing a pricing
approach to setting a recommended retail price for the new iced
tea beverage and recommend, with reasons, the approach that
we should adopt. (sub-task (a) = 40%)
51
Answer
Problems
• The product is completely new, so it may be difficult to
accurately determine the demand for it
• Customers for this product may be very different to customers
who purchase Piping’s tea products
• While Piping is a well-known brand, iced tea customers are
different to conventional tea customers
• As a result of this, Piping’s brand may not be strong enough to
justify higher than average prices in this market
• Pricing is also complicated by the fact that Piping is a premium
brand, and so excessive discounting might not be appropriate as
it could hurt the company’s overall brand image
• The iced tea industry is also highly competitive, which means
that if Piping’s prices are excessive, customers may choose
cheaper alternatives
 52

POTENTIAL SCENARIO

Question Answer
> It is 1 September 2022. You have a conversation with Channa
Pricing strategy
de Silva, Senior Financial Manager.
> Channa informs you that the board has just approved the • Despite its risks, premium pricing should be used for the new
creation of a joint venture between Piping and Filton, a large iced tea product
beverage company based in Northlandia.
> The joint venture has been created for the sole purpose of
• Discounting could potentially ruin the perception of quality that
creating a new iced tea beverage that will be developed by Piping is known for
Piping but manufactured by Filton.
• The drink is being marketed as a somewhat higher quality
> The iced tea market is highly competitive in Northlandia, but the offering, and so the price should match this
board believes that Piping could take market share by branding
the iced tea drink as being a Piping product. • Otherwise, customers may perceive the drink to be low quality
> Additionally, high quality tea will be used when creating the
product, which should create a distinct flavour. • The use of premium pricing may also be a way to stand out in
this competitive market
> Channa asks you to:
> Discuss the problems that we will face in choosing a pricing
approach to setting a recommended retail price for the new iced
tea beverage and recommend, with reasons, the approach that
we should adopt. (sub-task (a) = 40%)
 53

WRAP UP

Closing notes

> We have covered a lot, but not everything

> Technical knowledge is not enough to pass

> You need to apply this information!

Examiner’s feedback

> Try to incorporate information given to you

in the question, and where applicable,
incorporate the pre-seen too

> Application is the key to achieving top

level marks
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