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.
(4 marks)
(ii) Discuss the suitability of this performance measure in the context of the
data provided for each process division.
(4 marks)
(b)
(i) Calculate the effect on the annualised Return on Investment in 2011 of
Process Division C investing in new capital equipment.
(4 marks)
(ii) Discuss the conflict that may arise between the use of NPV and ROI in
this investment decision.
(4 marks)
(c) Discuss the transfer pricing policy being used by H from the viewpoints of
the managers of Process Division B and Process Division D.
(9 marks)