Session 1: the cost-volume-profit model.

Short-term decision making using variable costing.

« Eat Differently » Restaurant

Before opening her organic and zero waste restaurant, Claire the owner of "eat differently"
had to convince her bank to participate in the financing of her project. For this, she had to
provide elements relating to the expected development of its turnover as well as expenses
associated with this level of activity. For the year 2019, here are the elements presented:

Average price for one meal 18 euros

Number of customers / year 25 000
Food cost / meal 7 euros
Waiter cost / meal 1 euros
Fixed Costs 150 000 euros

Questions

1. Based on this business plan what would be the expected operating income of the "eat
differently" restaurant at the end of 2019?

2. According to these assumptions, when will the break-even point would be reached?

3. What are the security index and operating leverage of this project.

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 Travel and Co.

Travel and Co. operates three bus lines between Paris and 3 European cities

L1 : Paris - Bruxelles
L2 : Paris - Strasbourg
L3 : Paris - Luxembourg

Its leader wondered about the profitability of the different lines. Below are the information
about the past year.

L1 L2 L3
Average price for one way ticket 26 22 24
Number of one way 672 558 250
Number of one way tickets sold 15 640 14 354 2 503
VC per passenger * 4 4 4
Specific costs per way ** 230 280 252
Indirect Fixed Costs *** 240 000

*VC per passenger : ticket issue cost + transaction cost + free bottle of water
**Specific costs : bus maintenance + bus depreciation cost + driver wage + petrol
+ toll
***Indirect Fixed Costs : headquarters costs + internet website + HR service and
communication spending.

Questions

1. According to this information, what are, per bus line

- the VCM : Variable Contribution Margin ?
- the Margin on Specific Costs ?
- and therefore the Income ?

2. According to your latest results calculate the Profitability Threshold on Specific Fixed
Cost in unit (one way ticket sold) for each line.

3. What would be the way(s) to improve Travel and Co.’s profitability?

Hotel Nosy Ba

Located on a wonderful island in Mauritius, the Nosy Ba hotel goes through a difficult
economic period linked to the high financial targets set by its shareholders. Ms Naty, its
General Director, asks you to help her define her commercial strategy based on the hotel’s
cost analysis.

The hotel has 100 rooms available 360 days a year. All clients have a full-package (including
breakfast, lunch and dinner) and costs are based on a two-person-per-room basis. As this
hotel is part of a wider network, royalties (commissions) have to be paid against company
services.

In 2017, the forecasted level of activity is the following one: 25,000 booking nights at 120
USD. Budgeted costs are:

 Variable costs:

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 o Commissions paid to travel agencies: 20% of all revenues
o Company’s fees (variable part): 5% of turnover
o Cleaning staff: 10 USD per booking night

 Fixed costs
o Maintenance team: 80,000 USD per year
o Management staff: 150,000 USD per year
o Rent: 800,000 USD per year
o Company’s fees (fixed part): 40,000 USD per year

On top of these costs, catering costs have to be added to them. They are split into fixed and
variable costs:
o Variable (food): 20 USD per booking night
o Fixed (staff): 100,000 USD per year.

1) Calculate the financial result of this hotel for the forecasted level of activity. Determine,
the total revenue, the variable costs, the contribution margin, the fixed costs and the profit
for this level of activity (25,000 booking nights).

2) Calculate the breakeven point of this hotel in sales value, number of booking nights and
occupancy rate.

3) In order to simplify the management of the catering service, Ms Naty would like to work
with a third party and get rid of the internal activity. The third-party would charge 26 USD
per room and per day. Is this proposal interesting? Discuss the minimum number of
meals to be achieved that would make this proposal interesting for the hotel.

4) In order to improve the profit made by this hotel, advise what could be done from a
pricing strategy to boost global sales.

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 The Kart Company

The Kart company operates a kart renting business and organizes team building seminars
for companies. Organizing a seminar means that between two and 10 teams of participants
will compete during 4 hours. Every team has 4 people in it. Every tour lasts 10 minutes and
there is a change of driver after every tour meaning one driver completes 6 tours of 10
minutes during a 4-hour seminar.

The following pieces of information are given for a seminar when 10 teams compete.

Sales

 The price of a seminar is 155 euros excluding VAT. VAT rate is 20%.

Resources’ consumption of a kart

 On the average, a kart consumes 5 litres of gasoline during a 4-hour seminar.

 The price of one litre of gasoline amounts to 1,16 euros (excluding VAT).

Staff requirement

o For a 4-hour seminar, 4 workers are affected to deal with helping clients embark and
disembark and to guarantee safety. Every worker starts working 30 minutes before
the seminar starts (preparation) and ends 30 minutes after it ends (cleaning).

o One worker is specifically dedicated to manage the bar. He starts 30 minutes before
the seminar starts and ends 90 minutes after its endings.

o The gross labour rates per hour are as follows for the staff.

Worker Gross labour rate per hour Mission

N°1 9,15 Karting track
N°2 6,42 Karting track
N°3 6,42 Karting track
N°4 6,86 Karting track
N°5 6,42 bar

o Extra social security expenses of 40% have to be added back to the gross rates.

Other expenses

 The winning team gets a trophy worth 45,75 euros (excluding VAT).
 Fixed costs amount to 130 euros (excluding VAT).

Kart maintenance

 Maintenance costs of karts are proportional to the number of tours made. It is

estimated to 0,60 euros per tour (for 10 minutes of use and excluding VAT).

Required:

1) Calculate the profit made when organizing a 10-team-seminar.

2) Determine the breakeven point

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 Dental Health Partnership

The Dental Health Partnership was established in 1992 and provides dentistry and other
related services to the population of Blaintopia, a country in which the public health service is
partially funded by the Government. Additional information relating to the Dental Health
Partnership for the year ended 31 December 2019 is as follows:

1. The partnership was open for 5 days per week during 48 weeks of the year

2. Each dentist treated on average 20 patients per day. The maximum number of
patients that could have been treated by a dentist on any working day was 24
patients.

3. (i) The partnership received a payment from the government each time any patient
was consulted as shown in the following table:

Category of treatment Payments from

government ($)
No treatment required (routine check visit) 12
Minor treatment 50
Major treatment 100

(ii) In addition, adult patients paid a fee for each consultation which was equal to the amount
of the payment shown per category of treatment in the above table. Children and senior
citizens were not required to pay a fee for any dental consultation.

4. The partnership received an annual fee of 20,880 $ from a well-known manufacturer

of dental products under a fixed-term contract of three years’ duration. The contract
commenced on 1st January 2019 and relates to the promotion of the products of the
manufacturers.

5. The total of material and consumable costs (which are 100% variable) during the year
ended 31 December 2019 amounted to $ 446,400.

6. Staff costs were paid as follows:

Category of employee Basic salary/ annum per

employee
Dentist 60,000
Dental assistant 20,000
Administrator 16,000

Note: a fixed bonus payment amounting to 4% of their basic salary was paid to each dental
Assistant and Administrator.

7. Establishment costs and other operating costs amounted to 85,000$ and 75,000*
respectively during the year ended 31 December 2019.

8. All costs other than materials and consumables costs incurred by the Dental Health
Partnership are subject to contracts and are therefore to be treated as fixed costs.

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 9. A table of non-financial information relating to the Dental Health Partnership for the
year ended 31 December 2019 is as follows:

Number of dentists 6
Dental Assistants 7
Administrators 2
Patient ‘mix’ (%)
 Adults 50
 Children 40
 Senior citizens 10
Mix of patient appointments (%)
 No treatment required 70
 Minor treatment 20
 Major treatment 10

Required:

1. Calculate the variable and fixed revenues of the Dental Health Partnership for the
year ended 31 December 2019.

2. Calculate the variable and fixed costs of the Dental Health Partnership for the year
ended 31 December 2019.

3. Determine the profit for 2019, the contribution margin in $ and per patient visit

4. Determine the breakeven point in number of annual visits and in number of daily
patients per dentist.

5. Determine the operating leverage of this business.

6. What would be the profit variation if the process redesign of this dental service makes
it possible to serve 21 instead of 20 patients per day per dentist?

7. Discuss the different ways in which Dr Bekett has redesigned the process in her
dental office to improve its performance

Lutukka Oy

Lutukka Oy owns the rights to extract minerals from beach sands in Enare Lappmark.
Lutukka has costs in three areas:

1) Payment to a mining subcontractor who charges 80 € per tonne of beach sand mined and
returned to the beach (after being processed on the Mainland to extract three minerals:
ilmenite, rutile and zircon.

2) Payment of a government mining and environmental tax of €50 per tonne of beach sand
mined

3) Payment to a barge operator. This operator charges €150 000 per month to transport each
batch of beach sand – up to 100 tonnes per batch per day – to the Mainland and then return

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to Enare Lappmark (that is, 0-100 tonnes per day = € 150000 per month; 101-200 tonnes =
€300 000 per month and so on..). Each barge operates 25 days per month. The €150 000
monthly charge must be paid even if less than 100 tonnes is transported on any day and
even if Lutukka requires fewer than 25 days of barge transportation in that month.

Required:

1. What is the variable cost per tonne of beach sand mined? What is the fixed cost to
Lutukka per month?

2. Plot one graph of the variable cost and another graph of the fixed costs of Lutukka

3. What is the unit cost per tonne of beach sand mines (a) if 180 tonnes are mined each
day, or (b) if 220 tonnes are mined each day? Explain the difference in the unit-cost
figures.

ABACUS Inc.

1) Abacus Inc. is a small one-product firm which plans to make and sell 1,000 ornamental
abacuses a year at a price of €250 each. How much profit does Abacus expect to make
in a year if the standard cost of one abacus is as follows?

€/unit
Materials 100
Direct Labour 25
Variable overheads 20
Variable cost 145
Fixed cost (based on a budget of 1,000 units) 75
Total cost 220

2) An export order is received for 200 abacuses modified by the addition of some semi-
precious stones. The effect of this is a 30% increase in the cost of materials and a 40%
increase in the cost of direct labour. Also, special export insurance will cost €5 for each
modified abacus shipped. However, the customer is not willing to pay more than €44,000
in total for this large order. Should Abacus Inc accept this order?

Make or Buy ?

Vendco manufactures a variety of vending machines which have a number of common

components. As part of a cost review, Vnedco has found an external supplier who will supply
it with one of these parts (which has a standard cost of €90) for €75.

€/unit
Direct labour 25
Direct materials 30
Variable overheads 5
Fixed overhead (based on a budget of 1,000 units) 30
Standard cost 90

Advise Vendco whether it should continue to make this part or to buy it in at €75.

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 Scarce resource

Jean-Paul Cie (J-P) is a world-famous haute-couture fashion house based in Paris. It also
manufactures a range of perfumes, all made from secret recipes. Only one ingredient called
‘maylarnge’, a mixing agent, is used in all their products. Maylarnge is obtained from SML
Laboratoire in Brussels and the quantity used varies with the particular perfume recipe.

Due to temporary processing difficulties, SML has informed J-P that it can supply only $
13,100 worth of maylarnge over the next three months.

The budget below relates to the quarter in question under normal circumstances. The
shortage of the mixing agent means that the budget will have to be revised.

Passion Entice Magique Exotique

Sales volume (50 ml bottles) 6,000 5,500 6,500 4,500
Maylarnge ingredients per 1$ 0.8 $ 1.2 $ 0.6 $
unit (as per recipe)
Other variable cost per unit 2$ 3.1 $ 2.6 $ 1.9 $
Selling price per unit $ 12.9 $ 15.7 $ 16.1 $ 14.5 $

Fixed costs for the quarter amount to $ 133,300 (including all wages and salaries).
Tasks:
1. What would the quarter’s profit be if there was no shortage of maylarnge?
2. Calculate the profit for this period of shortage if the perfumes were manufactured in
the order of their contribution per bottle until they ran out of maylarnge.
3. Calculate the revised sales budget and profit assuming J-P wishes to maximize its
profit for this period of shortage.

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 Session 2 :
Driving performance in service industries

 Balancing demand and capacity in capacity-constraint service industries.

 Yield Management: revenues maximization under capacity constraints in service

industries

 Redesigning processes in services

Cases:

 Case Accra Beach (see separate file)

 Case Gondolas of Venice (see separate file)

Flic-en-Flac Hotel

Flic-En-Flac is a village located on the west coast of Mauritius. Famous for its luxurious
hotels, this place attracts many tourists from all over the world for its diversity and its
landscape. Flic-En-Flac is part of the Black River district and its one and a half kilometer long
beach of white sand is one of the most beautiful beaches in Mauritius. It is a famous site for
scuba diving with its numerous caves and wrecks. Flic en Flac is the second most important
tourist site in Mauritius, after Grand Bay which is located in the north of the island.

The Flic-En-Flac hotel is one of the rather luxurious resorts bordering this heavenly beach
and offers an opening on the white sand, turquoise waters and memorable sunsets. In
addition to a tropical garden, several palm-lined pools, and numerous bars and restaurants
offering different types of cuisine, this modern hotel was designed to be integrated into its
surroundings, making it a popular spot for travelers seeking tranquility. The hotel is used to
serving a diverse clientele - business and leisure, regional and international - and has
developed a full range of services to meet the needs and expectations of these different
segments of clientele - spa with thermal, beauty and wellness treatments, yoga, gym, water
sports, excursions etc.

Newly hired as a management controller for this hotel, the director of the establishment and
the marketing manager of the establishment have requested your assistance in producing
analyses to support decisions relating to three ongoing projects.
Monetary data is expressed in the country's currency, the Mauritian Rupee (MUR). The
exchange rate is 1 Euro = 40 MUR.

Part I: Analysis of the breakfast activity

The Flic-En-Flac hotel has 150 rooms and bungalows. Guests can book stays with half or full
board. Breakfast is charged at MUR 575 per person, including VAT, and consists of a vast
and varied self-service buffet. The VAT rate is 15%. Breakfast service is provided between
7:00 and 10:00 each morning. The average occupancy rate for rooms and bungalows in the
first quarter of N was 92%. There was an average of 1.9 people per room during this period.
100% of travelers eat breakfast.

Breakfast service is provided by a team of 15 staff divided between kitchen activities (5 staff)
and food-serving service activities (10 staff). The staff starts working 0.5 hours before

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breakfast opens and stays 1.5 hours after closing to tidy, clean and prepare tables for
breakfast.
Headcount Gross hourly wage
Kitchen Staff 5 100 MUR / hour
Food-serving staff 10 80 MUR / hour

The employer's social security charges are 10% of the gross salary.

In the first quarter of N, purchases of ingredients and raw materials for the preparation of
breakfasts amounted to MUR 2,397,600 excluding VAT. The management control
department indicates that the cost of using the breakfast room - including the building's share
of depreciation, cleaning, electricity, water and maintenance expenses - amounted to MUR
6,000,000 exclusive of tax for the first quarter N.

The Flic-En-Flac hotel's purchasing manager has also negotiated a contract with producers
offering high quality local products such as artisanal whole fruit jam, freshly squeezed fruit
juices, COCO candies or local drinks. In exchange for the display and promotion of their
products and brands at the breakfast served at the hotel, these producers pay for this service
on the basis of a contract. This contract has a duration of 6 years and started in N-3. The
global and fixed amount of these contracts represents a quarterly income of MUR 250,000
excluding tax for the hotel for a duration of 6 years.
For the analysis, we will consider months of 30 days.

Required:

1) Draw up the income statement for the "breakfast" activity corresponding to the level of
activity recorded in the first quarter of N. (Split fixed, variable costs and calculate
contribution margin).

2) Calculate the break-even point in terms of quantity, occupancy rate and turnover.
Calculate the margin of safety, the safety index and the operating leverage of the "breakfast"
activity for the first quarter. Comment on these results and suggest some ideas for the hotel's
management.

3) What would be the increase in profit for the first quarter N if the number of breakfasts was
increased by 10%?

4) What should be the price of a breakfast including VAT in order to make a profit of 30% on
the turnover, taking into account the level of activity of the first quarter of N?

5) Briefly explain the main limitations of the cost-volume-profit model. Contextualize your
answer.

Part 2: Analysis of the Seychelles Sports Team Accommodation Request

The Indian Ocean Games (IOG) is a sporting event usually organized every four years. The
Republic of Mauritius will host the tenth edition of the Indian Ocean Games in July N+1,
according to the decision of the International Council of the Games (ICG). This tenth edition
coincides with the 40th anniversary of these Games, which include seven islands of the
Indian Ocean, namely Madagascar, Reunion, Seychelles, Maldives, Comoros, Mayotte and
Mauritius. The Flic-En-Flac hotel has received a request for accommodation from a team of
Seychelles athletes to occupy 42 rooms for two periods: 8 nights in June for training sessions
and 17 nights in July covering the period when the Games will take place. The marketing
manager wishes to study all the dimensions of this decision, starting with the financial impact
of accepting this order.

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Required:

Answer the following questions and use the information contained in Appendix 1 along with
the calculation methodology recommended in Appendix 2

1) Carry out the calculation of the four steps of the methodology proposed in Appendix 2.
Conclude on the financial interest of this one-time hosting request.

2) Comment on the assumption made in Appendix 2 for the calculation of the opportunity
cost.

3) For this hotel business, are the conditions met to apply a revenue management
approach? Is it desirable to increase the price of the rooms still available for customers
other than Seychelles athletes during the island games? Justify your answer.

4) What are the advantages and disadvantages of serving different customer segments?

5) What are the other dimensions - other than financial - that should be considered in
making this decision?

Appendix 1:

General data concerning the hotel

Mauritius enjoys a very favorable climate all year round and there are two periods:
- The southern summer is hot and humid and lasts from November to April depending on the
year. Temperatures are generally between 27°C and 34°C. It is an ideal period to discover
Mauritius during the Christmas period or at the beginning of the year when it is very cold in
France.
- The southern winter is drier and a little less hot. It lasts from May to October in general. We
can count on temperatures between 17°C and 26°C. It is an ideal period for people who do
not tolerate humidity and heat.

The following table 1 shows the average monthly occupancy rate of the Flic-En-Flac hotel
over the last three years:
Year N-2 Rate N-2 Year N-1 Rate N-1 Year N Rate N
January 96.5% January 98% January 97.1%
February 92.5% February 94% February 92.8%
March 87.3% March 87% March 86.1%
April 80% April 82.1% April 81.4%
May 79% May 80.1% May 80.7%
June 78.5% June 79.2% June 80%
July 82% July 83.1% July 82.5%
August 85% August 86.5% August 85.5%
September 85.2% September 86.1% September 86.2%
October 87.6% October 88.3% October 88.2%
November 89.2% November 90.2% November 89.3%
December 97.2% December 98.6% December 96.5%

Data concerning the accommodation request of the Seychelles sports team

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The Seychelles sports team wishes to reserve 42 rooms for 8 nights in June and 17 nights in
July N+1. These two periods correspond to a training session and to the dates of the Islands
Games. The Flic-En-Flac hotel has never in the past welcomed groups of this size for such a
long period. The hotel's clientele is traditionally composed of individual tourists and the rate
of loyalty of this demanding clientele is high. The hotel is also visited by mainly regional
businessmen and women in the course of their professional activities. The amount charged
per night for this atypical request of the Seychelles team is MUR 4,000 excluding VAT. This
amount corresponds to the price of the bungalow and the breakfast is offered. This is a
unique price. In addition, the Seychelles team requests the hotel's laundry service free of
charge on a daily basis.

The marketing manager also prepared a report showing the number of nights that had been
sold last year in N for the same days as those requested by the Seychelles team in N+1.

This is table 2:

Booking nights N Booking nights N

June N Day 5 140

Day 120 Day 6 125
Day 2 125 Day 7 127
Day 3 123 Day 8 120
Day 4 117 Day 9 118
Day 5 108 Day 10 118
Day 6 122 Day 11 117
Day 7 119 Day 12 116
Day 8 107 Day 13 110
July N Day 14 112
Day 1 135 Day 15 120
Day 2 150 Day 16 122
Day 3 150 Day 17 120
Day 4 143

The marketing manager also hypothesizes that the Seychelles team's sportsmen and women
will behave differently than other traditional hotel guests. In particular, she considers that the
Seychelles team athletes will not stay all day at the hotel and that they will spend less on
extras - for example, drinks at the bar, dinners or participation in paid excursions that
generate income for the hotel, laundry service, margins on dinners, etc. - than other guests.
It summarizes the main differences in behavior between the Seychelles sports team and the
hotel's traditional guests.

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 Traditional guests Seychelles team
athletes
Number of guests per room 2 1
Price of one booking night (without 5 000 MUR without 4 000 MUR without
VAT) VAT VAT
% of customers having breakfast 100% 80%

Price of one breakfast per 575 MUR including Free

customer VAT
Variable costs of one breakfast 100 MUR without VAT 100 MUR without VAT
Margin on extras per customer per 1000 MUR without 200 MUR without VAT
day VAT
VAT rate on breakfast 15% 15%
Daily cost of laundry service 50 MUR without VAT
per player.

The hotel's cost structure is mostly fixed and indirect (security, front desk, maintenance,
beach monitoring, pool maintenance, gardening, bar staff, spa, gym, restaurants etc.). In
addition, variable and direct costs related to room maintenance will be considered negligible
in the financial analysis.

Appendix 2 - Methodology for Calculating the Financial Impact of Accommodation

Demand

To determine the financial impact of the Seychelles team's accommodation request, a four-
step process will be used:

1. Determine the revenue directly related to this demand, which is the overnight stays of
the Seychelles team.

2. Determine the costs directly related to this accommodation request, which are limited
to the cost of breakfast and laundry service.

3. At this stage of the calculation, the margin on the extras directly generated by the
Seychelles sports team will be taken into account.

4. The opportunity cost of accepting this accommodation request will be determined. By

allocating the 42 rooms to the Seychelles sports team, the hotel is unlikely to be able
to accommodate all requests from other traditional guests due to capacity constraints.
The opportunity cost therefore measures the loss of profit on these reservation
requests that cannot be satisfied due to lack of available capacity. To do this, we
assume that the number of rooms requested by traditional customers at this hotel in
N+1 is the same as in N. This is shown in Table 2.

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 Performance Measurement Systems
Counting the seconds – Performance measurement of frontline employees

Retailers have come under tremendous pressure to cut costs, and labor is their biggest
controllable expense. It is no wonder then that business is booming for the Operations
Workforce Optimization (OWO) unit that was recently acquired by Accenture, the global
consulting firm. The consulting and software company adapted time-motion concepts
developed for manufacturing operations to service businesses, where it breaks down tasks
such as working a cash register in a supermarket into quantifiable units and develops
standard times to complete each unit or task. The firm then implements software to help its
clients to monitor employee performance.

A spokesperson of a large retailer explained that “they expect employees to be at 100%

performance to the standards, but we do not begin any formal counseling process until the
performance falls below 95%”. If a staff falls below 95% of the baseline score too many
times, he or she is likely to be bounced to a lower-paying job or be fired. Employee
responses to this approach can be negative. Interviews with cashiers of that large retailer
suggest that the system has spurred many to hurry up and experience increased stress
levels. Hanning, 25 years old, took a job as cashier in one of the chain’s stores in Michigan
for $7.15 per hour in July 2007. She said she was “written up” three or four times for scores
below 95% and was told that she had to move to another department at a lower pay if her
performance did not improve. She recalled being told, “make sure you’re just scanning,
grabbing, bagging”. She resigned after almost one year on the job.

The customer’s experience can also be negatively affected. Gunter, 22 years old, says he
recently told a longtime customer that he could not chat with her anymore as he was being
timed. He said “I was told to get people in and out.” Other cashiers said that they avoided
eye contact with shoppers and hurried along those customers who may take longer to unload
carts or make payment. A customer reported, “Everybody is under stress. They are not as
friendly. I know elderly people have a hard time making change because you lose your ability
to feel. They’re so rushed at checkout that they don’t want to come here”.

Required:
 Explain in detail the logic of this performance measurement system. Why does it have
negative side effects?

 What recommendations would you make to make it more effective?

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 Session 3: Transfer pricing policies

The ARENAL Company

The firm « High-End ARENAL » produces and sells high-end pieces of jewellery through a
dedicated network of retailers. So far the company had performed very well as 500.000
pieces of jewellery were sold every year and there was no inventory. The selling price per
unit is 450 euros and the full amount of cost is 195 Millions (out of which 50 Millions are fixed
costs).

Question 1: Calculate the profit made by the company and the contribution margin per unit
and in euros.

Unfortunately a major economic crisis unfolded and sales went down to only 350,000 pieces
of jewellery a year. The company decided to open a second channel of distribution and to
sell low-end products to retail companies such as Carrefour and Tesco. A subsidiary was
founded to market these new low-end products under a different name to differentiate these
products for marketing purposes. This new legal entity « Low-End » (owned at 100% by the
ARENAL group) purchases the raw material from the « High-End ARENAL » branch at the
transfer price of 329 euros per unit. On top of that, « Low-End Arenal » has 1,8 Millions of
fixed costs and 15 euros per unit of variable cost. They sell 100,000 pieces of low-end
jewellery at the price of 400 euros per unit.

Question 2: Calculate the sales revenues, contribution margin, fixed costs and profit of the
branch « High-End Arenal » under these assumptions

Question 3: Calculate the sales revenues, contribution margin, fixed costs and profit of the
branch « Low-End Arenal » under these assumptions

Question 4: Calculate the sales revenues, contribution margin, fixed costs and profit of the
global company ARENAL under these assumptions

However, a fight opposing the two managers of the two branches has been more and more
acute. The manager of « High-End ARENAL » refusing to sell its raw materials to « Low-End
ARENAL » at a price below 329 euros. But the manager of « Low-End ARENAL » has just
found an external supplier willing to deliver the same quality of raw material at a price of 300
euros per unit.

Question 5: Calculate the sales revenues, contribution margin, fixed costs and profit of the
branch « High-End Arenal » under these assumptions

Question 6: Calculate the sales revenues, contribution margin, fixed costs and profit of the
branch « Low-End Arenal » under these assumptions

Question 7: Calculate the sales revenues, contribution margin, fixed costs and profit of the
global company ARENAL under these assumptions.
Question 8: What should management do? Which transfer prices do you think could be
acceptable?

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 DATA MECA

DATA MECA is an industrial firm that, in order to face the evolutions of its market,
has decided to reorganize its activities around two divisions that have become profit
centres located in two distinct towns:

 The Lyons division that manufactures spare parts (ALPHA)

 The Marseilles division that takes care of the production of motors (BETA)

The Lyon division has a capacity of 10 000 units; the variable unit cost is of 800
Euros and the fixed unit cost of 400 Euros (on the basis of a normal activity of 10 000
units, which means the fixed costs amount to 4,000,000 euros). These are the
assumptions made when calculating the standard full cost per unit and its budget
target.

Unfortunately, the Lyon division has a current level of activity that is well below its
budget target as it produces and sells only 8,000 units instead of 10,000 units. The
breakdown of its actual sales is as follows: 6000 units on the external market
(national market) at 1500 Euros, 2000 units at the Marseilles division. Costs were
under control however as there was no significant drift between actual and budgeted
costs for Lyon. The volume gap between actual and budget is due to a drop in the
external demand and there was no volume gap with Marseilles. The transfer price
used to value the sales made to Marseilles is equal to 112,5% of the full standard
cost. This Transfer price was set when making the budget of both divisions and was
based on the volume assumption at the time (e.g. 10,000 units). It was then applied
as such.

The Marseilles division manufactures the BETA product, product with strong added
value in the following conditions: variable unit cost 150 Euros and fixed unit cost 200
Euros (for an activity level of 2000 units). This product is sold on the market at 3 500
Euros. There was no gap at all between actual and forecast volumes and costs for
Marseilles.

Work to be done:

Q1: What is a standard cost? What are the benefits of using standard costing to
value internal transactions within a company?

Q2: Calculate the forecasted result for Lyon and Marseilles.

Q3: Calculate the actual result for Lyon, Marseilles and the Company as a whole.

Q4: Comment on these results

Q5. Would this result be different if the transfer price was equal to the price on the
market reduced by 4%? What are the economic reasons that can justify a transfer
price defined as a market price?

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 E-Card

The managers of E-Card have decided to transform the company's responsibility

centers into profit centers. E-Card has two divisions: CP and CE. Within the
company, the CP division manufactures smart cards referenced as CP5. It currently
sells 900,000 of these cards per year at a price of €1 (excluding tax) to industrial
customers who use them mainly for telephony and bank cards. CP’s fixed costs are
€500,000 per year for an annual production capacity of 1,000,000 CP5 cards.
Material costs and other variable expenses amounted to €0.20 per card.

The CE division manufactures one model of electronic cards, CE8, which is sold to
household appliance manufacturers. The director of the CE division has identified a
market opportunity to sell a CB1 bank card to an online bank that would be
manufactured in his division (CE) using CP5 chips supplied by the CP division.
Therefore, there will be a new internal transaction between the CP and CE divisions.

This new product, CB1, would be sold at €4 per unit, excluding tax. The manufacture
of CB1 cards would generate €70,000 in additional fixed costs for CE and a
production capacity of 100,000 CB1. The variable costs of manufacturing this new
product would amount to €2.50 for CE. Given the promising commercial prospects,
the sale of 100,000 CB1 cards to the online bank is entirely possible. The director of
the CP division proposes to the director of the CE division to sell the 100,000 CP5 at
the market price of €1 each.

Work to be done

1) What is the current profit of the CP division (without the new deal with the CE
division)?
2) What would be the profit of the CP division with the new deal? Is it in the
interest of the CP Division to manufacture the CB1 product?
3) By how much would the profit of the CE division increase (or decrease) with
the new deal? Is it in the interest of the CE Division to manufacture product
CB1?
4) By how much would the profit of the global company increase (or decrease)
with the new deal? Is it in the interest of the company as a whole to market
product CB1?
5) What do you conclude about the transfer price proposed by the head of the
CP Division?
6) Determine the boundaries of the transfer price that will make it acceptable to
CP
7) Determine the boundaries of the transfer price that will make it acceptable to
CE

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 Session 4:
Under which conditions does a budgeting process add value to an organization?

NEW DREAMS COMPANY

NEW DREAMS COMPANY is a newly-formed company that designs customised computer

programs for its clients. The capital needed to fund the company will be provided by a
venture capitalist who will invest 150 000 Euros on January 2019 in exchange for shares in
NEW DREAMS.

The Directors are currently gathering the information needed to help in the preparation of the
cash budget for the first three months of 2019. The information that they have is given below.

Budget details

The budgeted sales (that is, the value of the contracts signed) for the first quarter of 2019 are
expected to be 200 000 Euros. However, as the company will only just have commenced
trading, it is thought that sales will need time to grow. It is therefore expected that 15% of the
first quarter’s sales will be achieved in January, 30% in February and the remainder in
March. It is expected that sales for the year ending December 2019 will reach 1 000 000
Euros.

Clients must pay a deposit of 5% of the value of the computer program when they sign the
contract for the program to be designed. Payments of 45% and 50% of the value are then
paid one and two months later respectively. No bad debts are anticipated in the first quarter.

There are six people employed by the company, each earning an annual gross salary of
45 000 Euros including 40% of social charges. The net salary is paid on the last day of each
month whereas the social charges are paid on the 15th of the following month.

Computer hardware and software will be purchase for 100 000 Euros. A deposit of 25% is
payable on placing the order for the computer hardware and software, with the remaining
balance being paid in equal amounts in February and March. The capital outlay will be
depreciated on a straight-line basis over three years, assuming no residual value.

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The company has decided to rent offices that will require an initial deposit of 13 000 Euros
and an ongoing cost of 6 500 Euros per month payable in advance. These offices are fully
services and the rent is inclusive of all fixed overhead costs.

Variable production costs are paid in the month in which they are incurred and are budgeted
as follows:

 January: 1 200 Euros

 February: 4 200 Euros
 March: 8 000 Euros

A marketing and advertising campaign will be launched in January at a cost of 10 000 Euros
with a further campaign in March for 5 000 Euros, both amounts being payable as they are
incurred.

Administration overhead is budgeted to be 500 Euros each month: 60% to be paid in the
month of usage and the balance one month later.

Tax and interest charges can be ignored

Required:

1. Prepare the cash budget by month and in total for the first quarter on 2019
2. Identify and comment on those areas of the cash budget that you wish to draw to the
attention of the Directors of NEW DREAMS, and recommend action to improve cash flow.
3. Prepare the Net income budget by month and in total for the first quarter on 2019
4. Why do net income and cash budgets differ so much?

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 ALPHA Limited

ALPHA Limited is a plastic bottle manufacturing company. You have been asked to assist
the company by preparing some budgets for the first three months of 2016.

The following information is available

1. The expected sales volumes in 2016

January February March April May June

Units Units Units Units Units Units
8,000 15,500 11,000 14,000 16,500 18,000

2. The selling price per bottle will be $4 in 2016. As in previous years, it is expected that
20% of customers will pay in the month of sales, 40% will pay in the month following
sale and the remainder will pay in the month after that. Receipts of $50,000 and
$25,000 respectively will arise in January and February 2016 regarding sales
generated in 2015.

3. At each month end, the company typically maintains a stock (inventory) of finished
goods that equals 70% of the next month’s sales. Opening stock inventory of finished
goods will be 7,000 units on 1 January 2016.

4. The raw materials required to manufacture plastic bottle will cost 1,90$ per bottle.
Closing stock (inventory) of raw materials valued at $8,000 is available on 1 January
2015 and the company requires the maintenance of this stock (inventory) level at the
end of each month. The company will pay for raw materials as follows:

 40% in the month purchase

 60% in the month following

At the end of December 2015, $5,300 was due to creditors for purchase of raw materials.

Required:

Prepare for ALPHA: for each of the three month of 2016 the following:

1. A sales revenue budget

2. A schedule for the receipts from debtors
3. A production budget for finished products
4. A purchase budget for raw materials
5. A schedule of payments for purchase of raw materials
6. Explain THREE ways in which you think that ALPHA might accelerate its cash
collection from customers.

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 Budget in a manufacturing context – the Chikin Corporation

The Chikin Corporation produces surfboards. Its sales have been 300 a month for the last
few months – in February and March - but it is about to launch an expansion strategy aimed
at increasing sales by 50% over the next four months, April to July. Sales in April are
expected to still be 300 boards but to increase by 50 units a month until 450 units are sold in
July and each subsequent month.

The selling price of the boards is $50 units a month and half the customers pay in the month
following purchase. One-quarter take two months to pay and the other quarter pay cash on
delivery, taking advantage of a 5% cash discount.

Chinkin has planned an advertising campaign for the months of April, May and June, costing
a total $40,000. Half this amount is payable in April and the remainder in two equal
instalments in May and June.

To facilitate the increase in production, new plant and equipment costing 18,000$ have been
ordered for delivery in April, with payment in three equal monthly instalments, commencing in
May.

To lessen the impact of acquiring these fixed assets, Chinkin plans to arrange a three-month
loan of $20,000 from its bank and expects to pay interest at the rate of 10% per annum. The
interest will be paid in one amount on the same day as the capital sum is repaid. The money
is to be transferred into the account on 3 April.

Raw materials cost $20 a unit and are paid for one month after purchase.
Chinkin plans to have a monthly opening stock of raw materials equal to each month’s
production requirements. Similarly, its policy regarding stocks of finished boards is to have a
monthly opening stock equal to each month’s total sales.

Monthly fixed costs for the period April-July, including depreciation of $600, total $6,200 and
are paid for in the month incurred. The amount of depreciation includes the depreciation of
the new equipment.

The opening bank balance for April is expected to be $11,400 positive. Chinkin’s current
overdraft limit is $ 25,000.

Requested:

1) Elaborate the income statement for the months April to July (cumulated)
2) Calculate volume of production of finished products taking into account the stock
policy for finished products.
3) Calculate purchase of material taking into account the stock policy for raw materials
4) Calculate monthly cash flows for operating activities (April to July)
5) Calculate monthly cash flows for investing activities (April to July)
6) Calculate monthly cash flows for financing activities (April to July)
7) Comment on the cash situation at the end of July

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 T-Shirt Company

You plan to start up a business on January the 1st 2018. The idea is to buy unprinted T-Shirts
and to print or plaster them according to your clients’ wishes.

There is no inventory as you run your business on a just-in-time approach.

The following pieces of information are used to elaborate the income and cash flow
statements for the first quarter of 2018 and the balance sheet as of March 31st 2018.

A) Sales Forecasts:

A monthly amount of sales representing 1,600 T-shirts for the first quarter of 2018 is
expected. The price per unit is 30$. You forecast 20% of the sales to happen in January,
40% in February and 40% in March.

B) Payment of sales: the sales made in a month are paid the next month (30 days).

C) Purchase of unprinted T-Shirts from suppliers: 10 $ per unit.

D) Payment of purchase of T-Shirts: 50% the month of the sales and 50% the following
month

E) Other external services purchased

They are estimated at 2,000 $ per month and are fixed costs.

F) Payment of other external services: 40% the month of purchase and 60% the following
month.

G) Acquisition of a printing machine

This new equipment will be operational on January the 1st 2018 and is worth 10,000 $. The
company uses the straight-line depreciation method over 5 years. This equipment is paid in
two instalments: 50% on January the 1st and 50% on June the 1st 2018.

E) Headcount and social charges

A monthly 1,440 $ amount of labour costs are expected and paid the same month.

To this amount, social charges must be added and account for 60% of the total labour costs
and are paid the following month.

F) Corporate tax amounts to 40% of net income and will be paid in 2019.

G) VAT is not considered.

Additional Data

H) Also common stock will be issued in exchange for shares for 40,000 on January the 1rst
2018.

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M) The company plans to take a bank loan worth 10,000 $ on February the 1rst and the
whole amount will be paid back on February the next year. The yearly interest rate is 2%.

Required:

1) Calculate the budgeted income statement for the first three months of 2018 and the
first quarter of 2018.

2) Determine the cash flow statement for the first quarter. You need to differentiate
between operating, investing and funding activities.

3) Elaborate the Balance Sheet at the end of March 2018.

4) What is the breakeven point in number of T-Shirts for the first quarter?

5) Comment on these results

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 Freeshire Hospital Trust

In common with the rest of the National Health Service, Freeshire Hospital Trust is having to
cope with considerable constraints on resources. To address this, a new accountant was
appointed two years ago to introduce a decentralized budgetary control system to make
managers more accountable for their actions. The new system gave managers full
responsibility for their costs. The central overhead support costs are devolved to the
departments which buy in these central services. However, the introduction of the new
budgetary control system has not gone well. The chief executive, whose skills lie in the area
of managing people rather than in financial control, is perplexed by the performance of the
various departments. Last year’s adverse variances produced by the orthopaedics
department are typical of the situation (see below).

Actual outcome compared with fixed budget (Orthopaedics)

Actual Budget Variance

Annual patient days 10,000 9,000 1,000

Variable costs ($)

Pharmacy 144,000 99,000 45,000

Laboratory 109,000 108,000 1,000
Meals 54,000 49,500 4,500
Laundry 40,000 36,000 4,000

Fixed costs ($)

Staff 310,000 300,000 10,000

Other 465,000 460,000 5,000

Total 1,122,000 1,052,500 69,500

The chief executive is outraged that every variable cost variance is adverse and is, in his
view, a demonstration of completely ineffective cost control. Moreover, he is becoming
increasingly concerned, not only about the failure to keep with previous budgets, but also by
the new budgets for next year which are being proposed by the department managers.
Mindful of his lack of financial expertise, the chief executive has decided to bring in a new
financial director. The latter has been recruited to investigate with the newly decentralized
system and to put forward some proposals on future development. In his initial meetings with
senior staff the new financial director obtained the following quotes:

Chief executive:

I don’t understand it. I didn’t have thse problems in my last organizations. People understood
the system and its objectives. People didn’t play games, they didn’t build “fudge factors” in
their budgets. I don’t see any budget reductions made in the light of our cost-saving
information technology investment programme. As for the new budget reports, I never know
if the variances are real or just a matter of poor phasing of expenditure across the year. I also
need more warning of how the year is developing. I want realistic budget figures with a little
to stretch people and we have got to have a budget which fits our corporate objectives. Or
maybe we should scrap the budget altogether and put one of these new balanced
scorecards in its place?

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Department manager:

I’m not going to put another brave budget forward after last year. Last year they published a
league table of performance against budget and I came bottom. This year I will be giving
myself plenty of slack. Next year’s budget is this year’s plus 15 per cent. I am sure they will
knock 5 per cent off straight away even without looking at the budget submission. As for the
forms, reports and budget procedure, they just take too long. Every month I have to fill this
massive form covering what I have spent and even what bills I am going to pay in the future.
This is a system designed by accountants for accountants. I’ve got real work to do. In any
case, I never get any feedback on the figures until months later.

Chief accountant:

We produce monthly reports with actual spend against budget and never get any credible
responses explaining the variances. All we seem to get is complaints about the way we have
phased the budgets. They don’t understand it’s not down to us that their budgets are cut –
not that it makes any difference, they never know if they are overspent or not. All levels of
management have poor budgetary discipline, the budget is there to be complied with.
They’re always being creative; it’s amazing what gets classed as training when that line is
underspent ! How can I stop them from messing around with my accounts? Most managers
aren’t rigorous enough in defining their budget assumptions, especially the board; I keep
telling them it’s to protect them, especially when things go wrong.

A clinical Director:

I am fed up with this budgetary control system, it just gives me a headache. Firstly, it’s too
complex. Secondly, I get the analysis of my expenditure five or six weeks after the month
end. Thirdly, I get no explanation of the variances! My staff have also become adept at
beating the system. I found one spending her budget on non-essentials just so it wouldn’t get
cut next year. Another overspent manager negotiated with a local supplier to post-date an
invoice into next year. Where will it end?

Tasks:
1. Discuss the chief executive’s opinion that the orthopaedics budget is indicative of a
complete lack of control. Show the calculations of any figures you use to substantiate
your argument.

2. Explain what you understand by “budget games”. Using the Freeshire case where
possible, give examples of these games.

3. Why do you think it is more difficult in a non-profit context like an hospital than in a
for-profit business to focus on budget targets and Performance measurement
system?

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 Session 5:
Management and cost accounting fundamentals – The traditional full absorbing
costing method

Spring Distribution

Spring Distribution has decided to analyse the profitability of three customers. It buys
bottled water at $0.50 per bottle and this constitutes the cost of goods sold.

These bottles are then sold to wholesale customers at a list selling price of $0.60 per bottle.
The difference between the list selling price and the actual selling price refers to the amount
of invoice discount granted to each customer. Data pertaining to three customers are:

Customer A Customer B Customer C

Bottles sold (units) 1,460,000 764,000 94,000

List selling price $0.6 $0.6 $0.6

Actual selling price $0.55 $0.58 $0.54

Number of purchase orders 30 25 30

Number of sales visits 6 2 3

Number of deliveries 60 40 20

Kilometres travelled per delivery 3 8 40

Number of expedited deliveries 0 0 1

Its five cost-pools and their Overheads Absorption Rate are:

Cost-pools OAR
Order taking $ 100 per purchase order
Sales visits $ 80 per sales visit
Delivery vehicles $ 2 per delivery kilometre travelled
Product handling $ 0.02 per bottle sold
Expedited deliveries $ 300 per expedited delivery

1. Calculate the operating profit of each of the three customers

2. What insights are gained by reporting the list selling price and the actual selling price
for each customer?

3. What factors should Spring Distribution consider in deciding whether to drop one or
more customers?

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 The K Company

K makes many products, one of which is Product Z. K is considering an activity-based

costing approach for setting its budget, in place of the current practice of absorbing
overheads using direct labour hours.

The main budget categories and cost driver details for the whole company for October are
set out below, excluding direct material costs:

budget category € Cost driver details

Direct labour 128 000 8,000 direct labour hours
,Set-up costs 22 000 88 set-ups each month
Quality testing costs*** 34 000 40 test each month
Other overhead costs 32 000 Absorbed by direct labour hours

*** A quality test is performed after every 75 units produced

The following data for Product Z is provided:

Direct materials budgeted cost of € 21.5 per unit

Direct labour budgeted at 0,3 hours per unit
Batch size 30 units
Set-ups 2 set-ups per batch
Budgeted volume for October 150 units

Requires:

1) Calculate the budgeted unit cost of product Z for October assuming that a direct
labour-based absorption method was used for all overheads.

2) Calculate the budgeted unit cost of product Z for October using an activity-based
costing approach.

3) Explain in less that 100 words why the costs absorbed by a product using an activity-
based costing approach could be higher than those absorbed is a traditional labour-
based absorption system were used, and identify two implications for management.

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 Session 6: Investment decisions

BARCO COMPANY

BARCO Ltd manufactures and sells a consumer good product mainly distributed through
Hypermarkets chains.

A market study has shown that there is a potential for a significant turnover increase.
However, an investment has to be made to adjust the production capacity of the factory to
this new target.

Data have been gathered in order to allow you to make an appraisal on this investment
proposal and you are requested to analyse the cash flows linked to this project and to
calculate the Net Present Value.

Appendix

 The acquisition of new machines will cost an estimated 500 000 Euros.

 The increase in turnover is expected to be 300 000 Euros on a yearly basis.

 The new machines will be operational on January the first of the year N.

 Depreciation: Straight-line depreciation method on a 5 year period will be used. No

residual book value at the end of the 5 year period is expected.

 Additional production costs

Variable costs : 40% of turnover

Fixed costs (excluding depreciation charges) are estimated 20 000 Euros per year

 Corporate tax rate: 40% of the taxable profit.

 Barco’s cost of capital is estimated at 12 %

 The cash flows are to be studied for a 5 year period.

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 East Tacoma Works

Context

In late July 2017, Dick Sutter, of Ryan industries’ project appraisal group (PAG), was
again trying to decide what course of action to recommend on a capital-expenditure proposal
submitted by the East Tacoma Works Division for a specially designed 100-ton overhead
crane to be operational in January 2018. The crane would be used to move subassemblies
around the shop floor and to transport finished products to temporary storage in the dry end
or to the flatbed bays. Similar crane projects had been rejected for economic reasons in past
years. In June Sutter had not recommended approval of this year’s first proposal because he
believed the expected savings to be generated by the crane were not enough to warrant its
purchase.

East Tacoma fabricated heating and air conditioning components for large
commercial buildings. The parts and subassemblies were move along the various shops by
lift trucks or, in the case of large or heavy items, on a fleet of ingenious four-axled steerable
dollies that were pushed about by lift trucks. In the case of these heavy items, a jib crane
was used to lift the finished product onto flatbed trucks. The proposed new crane would
replace the existing method of transporting heavy items within the factory.

After the first review, the East Tacoma proposers of the crane project agreed with
Sutter that the estimated annual savings did not meet the minimum return requirements of
Ryan Industries. They argued, however, that a number of other issues made the project
attractive and, therefore, the proposed project should not be judged by Ryan’s normal
criteria.

One focus of the proposers’ argument was against the company’s requirement for
“committal of savings”. Savings were said to be “committed” when those responsible for
managing the proposed project and achieving the projected savings were willing to “put it on
the line” by having their future performance measured against the “committed savings”. The
proposers’ premise was that the crane project was already suitably attractive and the
committal to more savings was mere “window dressing”. For the crane project, the East
Tacoma Division had committed to only what it considered a reasonable amount of savings,
with the result that the projected internal rate of return was slightly below Ryan’s minimum.
Although the division thought that additional savings from improved production efficiencies
were possible, even probable, it preferred not to commit to savings about which the amounts
were uncertain.

Another point made by the proposers was that, unlike the crane project, many of
Ryan’s capital budgeting projects were for manufacturing facilities to produce new products
or expand the production of existing ones. The success of these projects depended, to a
great extent, on uncontrollable market factors. Accordingly, the crane proposers argued that
the financial success of the production projects was much more uncertain than for the crane
project. In fact, it seemed to them unlikely that the actual savings would fluctuate much from
their projected values and that the project was only a “banker’s risk”.

Ryan’s capital-budgeting procedure

Ryan’s capital budgeting was controlled by headquarters, but administered by the operating
divisions. Each division requested funds annually on a project basis. The company had been
able to finance all acceptable projects submitted by its divisions; although the total amount of
funds available for capital expenditures was something of a limiting factor, the company

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 usually had been able to supplement internally generated cash with public offerings. On its
issues of long-term bonds, the company’s favourable credit standing had permitted it to
secure such funds for 8-10 percent.

Each division’s estimates for capital spending were presented in two reports prepared
annually:

(1) A formal two-year forecast of capital expenditures. This report gave a list of proposed
projects, their approximate internal rate of return, and the capital investment needed.
Although the projects listed at this stage had not been formally reviewed by the PAG at
headquarters, the total of the funds shown in this report was taken as the division’s estimate
of its needs for the year.

(2) An informal, long-term forecast of divisional activity. This report was concerned primarily with
the “types of activity” in which each division planned to engage in the future. The report was
quite general in nature and listed specific projects only when major expenditures were
required.

Any capital expenditure that did not exceed $100K and was within the normal activity of the
division could be given approval by a division manager. If he gross fixed investment
exceeded $100K, approval of the company’s administrative committee was needed. These
proposals were written in a standard form used by all divisions. (The board of directors’
approval was required for any project over $1 million).

The capital-spending request

For a project requiring administrative committee approval, a capital spending request, a

lengthy, formal report, was prepared by the division seeking approval. The purpose of the
request was:

 To explain and justify the project as a good investment in a clear, understandable document
 To establish a basis for later performance review

The capital spending request had the following four sections:

 Summary of highlights of the project

 Description of the premises upon which internal rate of return was calculated
 Tabular work showing internal rate of return
 Details dealing with all aspects of the project and its effect on the division and the company

The request was first sent to the project appraisal group (PAG) to give the administrative
committee a candid, unbiased review. The group would then recommend the committee
accept or reject the project. The PAG based its recommendation on the project’s financial
acceptability, the premises upon which the internal rate of return and payout were calculated,
the company’s long-range plans, and other pertinent information about the project. Although
this recommendation did not represent approval or rejection, it was usually a major factor in
the committee’s decision. The PAG was also responsible for recommending changing any
financial requirements for projects. Thus East Tacoma’s question of different standards for
this project was of importance to the members of the group.

Financial standards

The financial standards used by members of management as guidelines for judging a project
were as follows:

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1. The after-tax internal rate of return must exceed 12 percent in not more than eight years.

2. The time required to return cash investment to the company should not exceed four years.

In 2017, these standards were used for all divisions of the company for all types of projects.
One of the tangential issues raised in the east Tacoma Works request was whether these
standards should be more lenient for a “low-risk” project.

The crane project

The review of the crane project by the PAG began in June 2017. After this first review, the
PAG did not recommend to the administrative committee that the project be accepted. One
of the members of the review group commented about the request:
“We felt that the project had some potential. The main problem was that the East Tacoma
Division would not commit itself to an acceptable return and payout. What we suggested was
that they redraft the request and include the additional savings which they had mentioned as
possible. But, as written, the return was not acceptable in my mind”.

After the initial comments about the project, the division redrafted the capital spending
request. This time, in the section of the report concerning the premises upon which the return
was calculated, several paragraphs explained the savings more fully than in the previous
report, but additional savings were again not committed savings as excerpted below:

The new crane would cost about $850,000. Modifications to the plant, including wiring for the
crane power supply, were estimated to be $130,000. Allowing for shipping, installation, and
testing, the total cost of the crane was expected to be close to $1 million, all of which would
be capitalized and depreciated for tax purposes assuming a 7-year life, using the modified
accelerated cost recovery system (MACRS). Somewhat offsetting this capital expenditure
would be the proceeds from the sale of the trucks and scrapping of the dollies. The six lift
trucks together had originally cost $70,000, against which $22,000 of depreciation had
already been charged; total depreciation of these trucks had been averaging $8,000
annually. East Tacoma had received a bid of $25,000 for the six trucks but estimated the
dollies might cost more to dismantle than the value of resulting scrap. Still outstanding was
$35,000 on the 10 percent bank note used to finance the trucks. The dollies had never been
depreciated because they were built at East Tacoma from scrap, and, thus, had been
assigned no cost. The jib crane would be unaffected. The reduced shop-floor traffic resulting
from the overhead crane was seen as a real plus.
The new crane required two skilled operators (one per shift) at $17 per hour including
fringes, a contract maintenance of $12,000 per year, and additional power and
miscellaneous costs of $6,000 annually. One year represents a potential of 2,080 hours that
could be worked by an individual.

The lift trucks required six men per shift or 12 in total at only $10 per hour, the equivalent of
three maintenance men in total at $8 per hour, plus maintenance supplies of about $5,000
per year. Lift trucks each burned approximately $3,600 per year of propane and might last
indefinitely with proper maintenance. In addition to these savings in labour and fuel, the
crane was also expected to generate savings of about $12,000 annually due to an improved
level of safety in the factory. These savings included reduced insurance premiums and out-
of-pocket medical costs. The company’s effective tax rate was 35 percent.

During the period following the second submission, the members of the PAG talked about
the project among themselves. Some were in favour of the project; others opposed. One
member of the committee said that he still was not pleased with the return and payout:

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 “I know the crane seems like a good project. The savings committed to still don’t meet our
standards, though. I know the division says the crane will pay for itself in time and yield a
good return. But if they won’t commit the additional savings, I wonder just how sure they are
of getting them. I don’t go for this low-risk business. If the profit isn’t there, we shouldn’t go
into it”.

Another member of the group disagreed:

“I think that the low-risk aspect should be considered. After all, these savings are a sure thing
and we should use a different standard to judge a low-risk project like this. In addition,
remember that over 30 percent of the East Tacoma Works floor space is taken up with extra-
wide aisles to accommodate the dollies. With the overhead crane’s modernization of the
factory, almost half (approximately 1000 square feet) of this space would be available for
other purposes”.

Required:

1. How does this company organize the investment decision process? Why is it the decision-
making process so centralized?

2. Identify the total project cash-flows using the MACRS tax-depreciation method.

3. Calculate the Present Value and the Net Present Value of this project. Does it meet the
standards of the company?

4. Which limitations do you see in the way this investment proposal is being analysed? Which
recommendations would you make?

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