H manufactures perfumes and cosmetics by mixing various ingredients in different processes, before the items are packaged and sold to wholesalers. H uses a divisional structure with each process being regarded as a separate division with its own manager who is set performance targets at the start of each financial year which begins on 1 January.
Performance is measured using Return on Investment (ROI) based on net book value of capital equipment at the start of the year. The company depreciates its capital equipment at the rate of 20% per annum on a reducing balance basis. The annual depreciation is calculated at the start of the financial year and one-twelfth of this annual amount is included as monthly depreciation in the fixed overhead costs of each process. Output transferred from one process to another is valued using transfer prices based on the total budgeted costs of
the process plus a mark-up of 15%.
Process B
This is the first process. Raw materials are blended to produce three different outputs, two of which are transferred to Processes C and D respectively. The third output is accounted for as a by-product and sold in the external market without further processing. The equipment used to operate this process originally cost $800,000 on 1January 2005.
The Process B account for April 2010 was as follows:
• Litres $ Litres $
• Opening WIP NIL NIL Normal Loss 3,000 3,000
• Material W 10,000 25,000 By-product 5,000 5,000
• Material X 5,000 10,000 Output to C 9,000 82,800
• Material Y 12,000 24,000 Output to D 10,000 92,000
• Direct labour 30,000 Closing WIP NIL NIL
• Overhead 75,000
• Profit & Loss 18,800
• Totals 27,000 182,800 Totals 27,000 182,800
The material costs are variable per unit of input and direct labour costs are fixed in the short term because employees' contracts provide them with a six month notice period. Overhead costs include a share of Head Office costs, and of the remaining overhead costs some vary
with the input volume of the process. The level of activity in April 2010 was typical of the monthly volumes processed by the company.
Process C
This process receives input from Process B to which is added further materials to produce a finished product that is sold in the external market at the budgeted selling price of $20 per litre. The equipment used to operate this process originally cost $500,000 on 1 January 2008.
The Process C account for April 2010 was as follows:
• Litres $ Litres $
• Opening WIP 1,000 11,200 Normal Loss 3,000 1,500
• Input from B 9,000 82,800 Abnormal Loss 1,500 750
• Material Z 3,000 15,000 Output 7,500 150,000
• Direct labour 20,000 Closing WIP 1,000 11,200
• Overhead 50,000
• Profit & Loss 15,550
• Totals 13,000 179,000 Totals 13,000 179,000
The material costs are variable per unit of input and direct labour costs are fixed in the short term because employees' contracts provide them with a six month notice period. Overhead costs include a share of Head Office costs, and of the remaining overhead costs some vary
with the input volume of the process. The level of activity that occurred in April 2010 was typical of the monthly volumes processed by the company, and the opening and closing work in process are identical in every respect. The process is regarded as an investment centre
and completed output and losses are valued at their selling prices. The manager of Process C is concerned at the level of output achieved from the input volume and is considering Performance Management 10 May 2010investing in new equipment that should eliminate the abnormal loss. This would involve investing $1,000,000 in new processing equipment on 1 January 2011; the existing equipment would be sold on the same date at a price equal to its net book value.
Process D
This process receives input from Process B which is further processed to produce a finished product that is sold in the external market at the budgeted selling price of $16 per litre. The equipment used to operate this process originally cost $300,000 on 1 January 2000.
The Process D account for April 2010 was as follows:
• Litres $ Litres $
• Opening WIP 1,000 5,500 Normal Loss 1,000 3,000
• Input from B 10,000 92,000 Output 9,000 144,000
• Direct labour 30,000 Closing WIP 1,000 5,500
• Overhead 30,000 Profit & Loss 5,000
• Totals 11,000 157,500 Totals 11,000 157,500
Direct labour costs are fixed in the short term because employees' contracts provide them with a six month notice period. Overhead costs include a share of Head Office costs, and of the remaining overhead costs some vary with the input volume of the process. The level of
activity in April 2010 was typical of the monthly volumes processed by the company, and the opening and closing work in process are identical in every respect. The process is regarded as an investment centre and completed output and losses are valued at their selling prices.
The manager of Process D believes that the transfer price from Process B is unfair because the equivalent material could be purchased in the open market at a cost of $7·50 per litre.
Required
(a) (i) Calculate the annualised Return on Investment (ROI) achieved by each of the process divisions during April 2010.
(ii) Discuss the suitability of this performance measure in the context of the data provided for each process division.
(b) (i) Calculate the effect on the annualised Return on Investment in 2011 of Process Division C investing in new capital equipment.
(ii) Discuss the conflict that may arise between the use of NPV and ROI in this investment decision.
(c) Discuss the transfer pricing policy being used by H from the viewpoints of the managers of Process Division B and Process Division D.