«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»
An important issue in establishing a transfer price is the motivational effect that this may have on managers of both the buying and selling business units, who may prefer to buy and sell on the open market. However, in the increasingly globalized business world, manufacturing, assembly and selling operations may take place in different countries. In these cases, transfer prices are often set to ensure that reported proﬁts are earned in countries where lower corporation tax is payable to maximize the after-tax earnings of the multinational corporation. Transfer pricing is discussed in more detail in Chapter 13.
Segmental proﬁtability As well as being price-makers or price-takers, businesses also adopt marketskimming or market-penetration strategies at different phases of the product/service lifecycle (see Chapter 9). A common marketing strategy is differential pricing, where prices vary between each market segment.
Where products/services are sold in different market segments at different
prices, the price can be considered in different ways:
ž A minimum short-term price taking into account only marginal, i.e. usually variable, costs.
ž A minimum long-term price that covers the full product/service cost.
ž A target long-term price that takes into account the return on investment necessary to increase shareholder value.
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As we will see in Chapter 11, major assumptions are involved in how costs are allocated within a business. However, for the purposes of the present chapter, we will separate ﬁxed costs into unavoidable business-wide costs and avoidable segment-speciﬁc costs. Unavoidable costs are allocated by an often arbitrary method to each business unit or market segment, although these costs are only able to be inﬂuenced at the corporate level. Avoidable costs are identiﬁable with and are able to be inﬂuenced by decisions made at the business unit level.
As this chapter has already shown, provided that the selling price exceeds variable costs, there is a contribution from the sales of products/services towards covering ﬁxed costs and towards proﬁtability. This position is confused when ﬁnancial reports include an allocation of unavoidable business-wide costs and those reports need to be analysed more carefully.
An example is an accounting practice that prepares tax returns on behalf of clients. The clients are grouped into three market segments: business (where the practice also carries out accounting services); business (where the practice only completes the tax return); and personal returns. The practice thinks that personal returns may be unproﬁtable and a partner has produced the data in Table 8.3.
As the example in Table 8.3 shows, despite the loss made by the personal tax returns market segment, these clients contribute £7,000 in the period towards the unavoidable overhead. If this segment were discontinued, the proﬁt of the practice would fall by £7,000 to £18,000. This is because, even though the ﬁxed costs for administrative support would be saved if the segment were discontinued, the whole of the unavoidable costs of £50,000 would continue.
The following case study illustrates segmental proﬁtability.
Proﬁtability of business segments for an accounting practice Table 8.3
Case study: Retail Stores PLC – the loss-making division Retail Stores has three segments, producing the results in Table 8.4. The contribution as a percentage of sales, assuming a constant sales mix, is 70.6% (£600,000/£850,000).
The company’s breakeven point in sales is calculated as:
280,000 + 255,000 ﬁxed costs 535,000 = = unit contribution as a % of sales 0.706 0.706 or £758,000.
Current sales of £850,000 represent a margin of safety of:
expected sales − breakeven sales £850,000 − £758,000 × 100 = expected sales £850,000 or 10.8%.
Management is considering dropping the Toys segment due to its reported loss after deducting avoidable segment-speciﬁc ﬁxed costs and unavoidable businesswide costs, which are allocated as a percentage of sales revenue.
However, an understanding of cost behaviour helps to identify that each segment is making a positive contribution to business-wide costs after deducting the segment-speciﬁc ﬁxed costs, as the modiﬁcation to the reported proﬁts in Table 8.5 demonstrates.
Based on the ﬁgures in Table 8.5, despite the Toys segment making a loss, it makes a positive contribution of £30,000 to allocated business-wide costs.
If the Toys segment was discontinued, total proﬁt would fall by £30,000, as Table 8.6 shows.
This is because the loss of the contribution by the Toys segment to business-wide costs and proﬁts amounts to £30,000 (after deducting avoidable segment-speciﬁc ﬁxed costs). The business-wide costs of £255,000 are reallocated over the two remaining business segments in proportion to sales revenue, which in turn makes the Electrical segment appear only marginally proﬁtable.
If the Toys division were discontinued, the impact would be to reduce costs by £60,000 and a new, higher contribution as a percentage of sales
expected sales − breakeven sales £700,000 − £652,000 × 100 = expected sales £700,000 Segmental proﬁtability is the result of avoidable variable costs and ﬁxed costs that are segment-speciﬁc and an allocation of unavoidable business-wide ﬁxed costs.
It is important to differentiate these costs in decision-making. We will return to the cost allocation problem in Chapter 11.
The following case study shows how an understanding of ﬁnancial information can assist more directly in carrying out the marketing function.
Case study: SuperTech – using accounting information to win sales One of Global Enterprises’ target customers is SuperTech, a high-technology company involved in making semiconductors for advanced manufacturing capabilities. SuperTech has grown rapidly and its sales are £35 million per annum.
Variable costs consume about 60% of sales and ﬁxed selling, distribution and administrative expenses are about £10 million, leaving a proﬁt of £4 million. The challenge facing SuperTech is to continue to grow while maintaining proﬁtability.
It plans to achieve this by continuing to re-engineer its production processes to reduce the lead time between order and delivery and improve the yield from its production by improving quality.
Global sees SuperTech as a major customer for its services. However, it operates in a highly price-competitive industry. Global is unwilling to reduce its pricing because it has a premium brand image and believes that it should be able to use its customer knowledge, including published ﬁnancial information, to increase sales and justify the prices being charged. Global believes that its services can contribute to SuperTech’s strategy of reducing lead time and improving yield.
Global has been able to ascertain the following information from the published
accounts of SuperTech:
ž Its cost of sales last year was £21 million and its inventory was £17.5 million.
This is because the equipment made by SuperTech is highly technical and requires long production lead times.
ž Employment-related costs for the 250 employees were £8 million, 25% of the total business costs of £31 million.
ž The company has borrowings of £14.5 million, its gearing being 90%, and interest costs last year were £787,000.
We need to make a number of assumptions about the business, but these are acceptable in order to estimate the kind of savings that Global’s services might obtain for SuperTech.
We can calculate that the company’s cost of production, assuming 240 working days per year, as £90,000 per day (£21.6 million/240). Given the low number of employees and the knowledge that many of these are employed in non-production roles, the vast majority (over 80%) of production costs are believed to be material costs. Using the inventory days ratio (see Chapter 7), we can calculate that the
ACCOUNTING FOR MANAGERSyear-end inventory holding is 194 days (£17.5 million/£90,000), equivalent to 81% of working days (194/240).
Global’s services will increase the production costs because of its premium pricing, and expects the price differential to be £250,000 per annum. However, Global’s services will generate savings for SuperTech. First, the service will reduce the lead time in manufacture by 10 days. The company’s interest cost of £787,000 is 5.4% of its borrowings of £14.5 million. This is a very rough estimate as borrowings increased during the year and the company most likely had different interest rates in operation. However, it is useful as a guide. If Global’s services can reduce SuperTech’s lead time by 10 days, that will reduce the level of inventory by £900,000 (£90,000 per day × 10), which can be used to reduce debt, resulting in an interest saving of £48,600 (£900,000 @ 5.4%).
Second, Global also believes that its services will increase the yield from existing production because of the higher quality achieved. Global estimates that this yield improvement will lower the cost of sales from 60% to 59%. This 1% saving on sales of £35 million is equivalent to £350,000 per annum.
Global’s business proposal (which of course needs to demonstrate how these gains can be achieved from a technical perspective) can contain the following ﬁnancial justiﬁcation:
Interest savings on reduced lead time £48,600 Yield improvements £350,000
Conclusion This chapter has introduced various cost concepts, including cost behaviour, cost–volume–proﬁt analysis, alternative approaches to pricing and understanding segmental proﬁtability. While marketing is critical to business success, so is the fulﬁlment of the promises made by marketing, which is the subject of the next chapter.
References Doyle, P. (1998). Marketing Management and Strategy. (2nd edn). London: Prentice Hall Europe.
Porter, M. E. (1980). Competitive Strategy: Techniques for Analyzing Industries and Competitors.
New York, NY: Free Press.
Porter, M. E. (1985). Competitive Advantage: Creating and Sustaining Superior Performance.
New York, NY: Free Press.
This chapter introduces the operations function through the value chain and contrasts the different operating decisions faced by manufacturing and service businesses. Operational decisions are considered, in particular capacity utilization, the cost of spare capacity and the product/service mix under capacity constraints. Relevant costs are considered in relation to the make versus buy decision, equipment replacement and the relevant cost of materials. Other costing approaches such as lifecycle, target and kaizen costing and the cost of quality are also introduced.
The operations function Operations is the function that produces the goods or services to satisfy demand from customers. This function, interpreted broadly, includes all aspects of purchasing, manufacturing, distribution and logistics, whatever those may be called in particular industries. While purchasing and logistics may be common to all industries, manufacturing will only be relevant to a manufacturing business. There will also be different emphases such as distribution for a retail business and the separation of ‘front ofﬁce’ (or customer-facing) functions from ‘back ofﬁce’ (or support) functions for a ﬁnancial institution.
Irrespective of whether the business is in manufacturing, retailing or services, we can consider operations as the all-encompassing processes that produce the goods or services that satisfy customer demand. In simple terms, operations is concerned with the conversion process between resources (materials, facilities and equipment, people etc.) and the products/services that are sold to customers.
There are four aspects of the operations function: quality, speed, dependability and ﬂexibility (Slack et al., 1995). Each of these has cost implications and the lower the cost of producing goods and services, the lower can be the price to the customer.
Lower prices tend to increase volume, leading to economies of scale such that proﬁts should increase (as we saw in Chapter 8).
A useful analytical tool for understanding the conversion process is the value chain developed by Porter (1985) and shown in Figure 9.1. According to Porter
every business is:
a collection of activities that are performed to design, produce, market, deliver, and support its product... A ﬁrm’s value chain and the way it
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Figure 9.1 Porter’s value chain Reprinted from Porter, M.
E. (1985). Competitive Advantage: Creating and Sustaining Superior Performance.
New York, NY: Free Press.
performs individual activities are a reﬂection of its history, its strategy, its approach to implementing its strategy, and the underlying economics of the activities themselves. (Porter, 1985, p. 36) Porter separated these activities into primary and secondary activities.
This approach has similarities to the business process re-engineering approach of Hammer and Champy (1993, p. 32). Their emphasis on processes was on ‘a collection of activities that takes one or more kinds of input and creates an output that is of value to the customer’ (p. 35).