Paper P2 - Performance

ManagementBy KAPP Edge Solutions

Exam Pattern

Section A 50 marks Five compulsory medium

answer questions, each worth

ten marks.

Short scenarios may be given,

to which some or all questions

relate.

Section B 50 marks One or two compulsory

questions. Short scenarios

may be given, to

which questions relate.

Exam strategy

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Question requirements and presentation

Start a new page for each of the questions.

Layout your answers neatly and show all your workings.

Discussion answers must be broken down into small paragraphs with a space after each relevant point.

Make sure you present your answer in the format that is requested, e.g. report format.

Where questions require the use of a formula, write out the formula first and then insert the figures.

Make sure you read all the requirements before attempting the question.

Let the question requirement drive your headings.

Examine any information in the scenario (if provided) constantly to generate ideas.

Ensure you deal with all aspects to a question requirement, reread the question two or three times to ensure you have fully understood it.

Have a separate page for your workings and make sure your final answer makes reference to these.

If you get stuck on a certain part of the question, dont spend too long on that part.

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Syllabus structure

A: Pricing and Product Decisions (30%)

B. Cost Planning and Analysis for Competitive Advantage (30%)

C: Budgeting and Management Control (20%)

D: Control and Performance Measurement of

Responsibility Centres (20%)

Pricing and

Decision

Making

Budgeting and

Management

Control

Responsibility

Centres

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Important Topics

Pricing Decision

Decision Making

Transfer Pricing

Learning Curve

Budgeting

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Decision Making

Topics Covered

Relevant and non-relevant cost

Opportunity cost

Decision making

Relevant and Non-Relevant cost

Relevant cost- which changes as a direct result of decision taken.

o These are future costs.

o They are incremental/differential /avoidable costs.

o They are cash flows.

Note-variable costs are relevant cost.

Example, if I am deciding whether to buy a Toyota Camry or a Maruti Swift, and if my auto insurance will be

the same no matter which car I buy, my consideration of insurance costs will not affect my decision.

Non- Relevant cost- these are not relevant in decision making.

o Sunk costs

o Fixed costs

o Committed cost

o Depreciation

o Notional cost

Opportunity cost

Meaning-It is benefit sacrificed due to choosing one alternate .

Example:

K ltd has occupied the building itself . The market rent of such property is $ 2,000 p.m.

This $ 2,000 is an opportunity cost.

Relevant cost of Material

Relevant cost of Labor

Relevant cost of Overheads

Relevant cost of Non Current Assets

Current Replacement

Cost

If machinery is to be replaced at the end of its useful

life.

Higher of sale proceeds or

the net cash flow arising from

the use.

If machinery is not to be replaced at the end of its

useful life.

Decision making

Limiting factor decisions-

Limiting factor- which prevents a company from achieving the desired output or sales.

Situation1-single limiting factor

= Contribution per unit

Scarce resource

The product with highest contribution per scarce resource will be selected.

Decision making

Make or buy

Contribution per unit

Scarce resource

The product with highest contribution per scarce resource will be selected.

Any product which comes last in priority and cant not be allotted the scarce resources, will be purchased from outside.

Decision making

Accept or reject

Any order which gives highest contribution per unit/ contribution per scarce resource if any. Will be accepted.

Decision making

Shut down decision

Whether or not to close down a factory, department, product line or other activity, either because it is making losses or because it is too expensive to run.

If the decision is to shut down, whether the closure should be permanent or temporary. Shutdown decisions often involve long term considerations, and capital expenditures and revenues.

A shutdown should result in savings in annual operating costs for a number of years in the future.

Closure results in release of some fixed assets for sale.

Employees affected by the closure must be made redundant or relocated, perhaps even offered early retirement.

Minimum pricing Decision

Minimum price is equal to incremental cost plus opportunity cost.

Practice Questions

EXAMPLE

A summary of the cost estimates used for the purposes of arriving at the tender price is as follows:

Cost Estimates Grain Silo 000s

Direct Materials Steel 600

Direct Materials Wiring and ancillaries etc. 100

Direct Labour-Engineering-3000 hours@100 per hr. 300

Direct Labour - Unskilled 10000 hours @ 40 per hr. 400

Variable Overheads 150

Fixed Overheads Absorbed 150

Total Estimated Cost 1,700

K ltd. tendered at a price of 2.04 million by adding on a mark-up of 20% to the above costs. It has just been informed that its tender was unsuccessful.

engineering hours were in short supply and earn a contribution per hour of 10

due to the recent cancellation of an order the company expects to have available 6,000 idle unskilled hours available to work on the job. Any additional unskilled labour required is employed on a casual basis

the wiring was already in stock for the previous job that was cancelled. The wiring has no other use and was to be scrapped at a cost of 10,000.

fixed overheads represent an allocation of Ks central fixed overhead. The proposed tender would have incurred specific fixed costs of 20,000

Solution

K ltd.- Relevant Cost of Grain Silo:

Detail 000s Explanatory Note

Steel 250,000 Stock at replacement cost

Wiring etc. -10,000 Incremental cost saving

Engineering Hours 300,000 Cost of Hours

Engineering Hours 30,000 Opportunity Cost

Unskilled Hours (first 6000) 0 Committed cost, thus irrelevant

Unskilled Hours (last 4000) 160,000 Relevant as casual

Variable Overhead 150,000 Relevant as variable

Fixed Overheads

Central Apportionment 0 Irrelevant as non-incremental

Fixed Overheads - Specific 20,000 Relevant as incremental

TOTAL RELEVANT COST 900,000

Add:20% Mark Up 180,000

Pricing Decision

Topics Covered

Factors affecting profit

Price Elasticity of demand

Price Elasticity Graph

Factors affecting price elasticity

Perfectly Competitive Market

Imperfect Competition

Product Life Cycle

Pricing strategies

Factors affecting profit

Profit is the factor of three components:

Cost - volume -price

Cost

Higher volume reduces the cost per unit

Lower cost helps in lower prices

Volume

Volume increase- per unit cost decreases

Price

Lower cost helps in setting lower price

Price Elasticity of demand

The relative response of a change in quantity demanded to a change in price.

Price elasticity

An elastic demand means that the quantity demanded is relatively responsive to changes in price.

An inelastic demand means that the quantity demanded is not very responsive to changes in price.

Price Quantity

Price Elasticity of demand

Formula:

Price Elasticity of demand

=Percentage change in quantity demanded

Percentage change in price

Price Elasticity Graph

Inelastic Demand

Price Elasticity Graph

Elastic demand

Factors affecting price elasticity

1. Scope of the market

2. Information within the market

3. Availability of substitutes

4. Complementary products

5. Disposable Income

6. Necessities

7. Habit

Perfectly Competitive Market

All the firms and consumers are price takers.

They cannot affect the market price.

Assumptions

Many small firms,

Many individual buyers,

Perfect freedom of entry and exit from the industry.

Homogeneous products

Perfect knowledge

No externalities

Imperfect Competition

Monopoly

Oligopoly

Monopolistic Competition

Product Life Cycle

Introductory phase

Growth

Maturity

Decline

Marginal cost and Marginal Revenue

'Marginal Revenue - MR-The increase in revenue that results from the sale of one additional unit of output.

'Marginal Cost- MC- variable cost of production

Profit maximized

M = MR MC.

M= marginal profit

The firms profit-maximizing level of output occurs when the additional revenue from selling an

extra unit just equals the extra cost of producing it, that is, when MR = MC.

MR=MC

Profit Maximization

Price equation =p=a- bx

P= price

X=quantity

A and b are constants

MR =a-2bx

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Pricing strategies

Total cost plus

Marginal cost plus

Premium pricing

Market Skimming

Penetration Pricing

Loss leader pricing

Controlled Pricing

Transfer Pricing

Topics Covered

Meaning of Decentralization

Meaning of transfer pricing

Purpose

Basis of Transfer Pricing

Objective of Transfer Pricing

A Perfect Intermediate Market

Imperfect Intermediate Market

Decision making

TP and International Taxation

Meaning of Decentralization

Delegation of decision-making to the subunits of an organization.

It is a matter of degree.

The lower the level where decisions are made, the greater is the decentralization.

Decentralization is most effective in organizations where subunits are autonomous and costs and profits can be independently measured.

The benefits of decentralization include:

(1) decisions are made by those who have the most knowledge about local conditions;

(2) greater managerial input in decision- making has a desirable motivational effect; and

(3) managers have more control over results.

Meaning of Transfer Pricing

A transfer price is the price at which one company buys and sells goods or services or shares resources with a related affiliate in its supply chain.

A transfer price is what one part of a company charges another part of the same company for goods or services.

Purpose

Generate separate profit figures for each division and thereby evaluate

the performance of each division separately.

Help coordinate production, sales and pricing decisions of the different

divisions (via an appropriate choice of transfer prices).

Transfer prices make managers aware of the value that goods and services have for other segments of the firm.

Transfer pricing allows the company to generate profit (or cost) figures

for each division separately.

The transfer price will affect not only the reported profit of each centre,

but will also affect the allocation of an organizations resources.

Guidelines for transfer pricing

The Price Must be Similar to That Sold to Arm's-length Customers

An arm's-length transaction is one between two unrelated entities. If one division of a company normally sells products to companies that are unrelated to them, then that price should be used for a division that is related to them. "Related" means two companies that are legally part of the same corporation, LLC or other recognized business organization.

The Price Must be Similar to Prices Other Companies Charge Each Other

Examine the prices other companies charge each other for similar products. This is a good guideline for setting prices between divisions of your own company. Set the price near what the company-to-company market dictates.

Set Prices According to What You Have Paid Other Companies

The division acquiring the product may have purchased from outside sources in the past. Use the prices established in those transactions as a guide. Allow for inflation or other market changes, and set the price accordingly.

Basis of Transfer Pricing

There are three general methods for establishing transfer prices.

Market-based transfer price: In the presence of competitive and stable external markets for the transferred product, many firms use the external market price as the transfer price.

Cost-based transfer price: The transfer price is based on the production cost of the upstream division. A cost-based transfer price requires that the following criteria be specified:

Actual cost or budgeted (standard) cost.

Full cost or variable cost.

The amount of markup, if any, to allow the upstream division to earn a profit on the transferred product.

Negotiated transfer price: Senior management does not specify the transfer price. Rather, divisional managers negotiate a mutually-agreeable price.

Objective of Transfer Pricing

The independence of divisions.

The assessment of divisional performance.

The optimization of profits for the business.

The allocation of divisional resources.

Tax minimization

A Perfect Intermediate Market

Economists call a market perfect if buyers can buy and sellers can sell any quantity without affecting the price. This means, of course, that the product being

sold is not differentiated by quality, service, or other characteristics.

In perfect market, the marginal revenue is always the market price of the item because all output can be sold at the prevailing market price.

Transfer price can be set as per market price.

Imperfect Intermediate Market

A market is imperfect when the selling division is unable to sell its output externally at the same price.

In order to sell the product, the sales price needs to be reduced.

Marginal revenue is always lower than the market price as it is not possible to sell all output at the prevailing market price

Profit maximization

MR=MC

Decision making

Perfectly competitive market

Optimum TP =Market price + Any small Adjustments

Where there is surplus capacity

Optimum TP =Marginal Cost

Where there is production constraint

Optimum TP =Marginal Cost + shadow price (opportunity cost)

Dual Pricing

Selling price recorded by selling division is not same as buying price recorded by the buying division.

Buying division records at variable cost.

Selling division records at closer to market value.

The difference between two will be debited to group account called transfer price adjustment account.

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TP and International Taxation

In order to minimize the tax liability:

1. reduce the profitability of its subsidiaries in high tax countries.

2. Increase the profitability of its subsidiaries in low tax countries.

Thanks

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M-9871434852

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