Exam Practice

Sample Questions for AMA Final Exam

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Advanced Management Accounting Sample Questions for Final Exam Question One You have been offered employment over the summer break by your uncle, who operates Flower Power, a large fresh flower delivery service. Flower Power makes about 400 deliveries per day, often to corporate customers. The company is currently evaluating the monthly performance of each of its divisions using return on investment. You are employed at the main depot and over the past few weeks you have noticed that there appears to be a fair degree of wastage occurring. The business has been running at a loss, and customer complaints have been increasing. You have suggested to your uncle that one way of managing this problem would be to design a new performance measurement system. To assist you in your task, you have been told that the critical success factors of Flower Power are product quality, customer responsiveness and a wide product range. The managers believe that if these factors are focused on, sales revenue and profit will follow. Required:

(a) For each of the critical success factors, describe two performance measures that could be used. Make sure that your measures suit the particular products and operations of Flower Power.

(6 marks) (b) Non- financial performance measures are better suited for monitoring the

operations of a business and provide a more effective way of improving performance, compared with financial measures.

(i) Explain why some people believe the above statement. (3 marks)

(ii) What are the arguments against claim? (3 marks)

(c) Explain the positive and negative effects associated with using return on

investment for evaluating divisional performance. (6 marks)

(Total marks =18 marks)


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Question Two Continental Industries is a diversified corporation with separate operating divisions. Each division’s performance is evaluated on the basis of profit and return on investment. The Air Comfort Division manufactures and sells air-conditioner units. The coming year’s budgeted income statement, which follows, is based upon a sales volume of 15,000 units. AIR COMFORT DIVISION Budgeted Income Statement (In thousands) Total Per Unit (,000) Sales revenue…………………………………..….. $12,000 $800 Manufacturing costs: Compressor…………………………………..… $ 2,100 $140 Other direct material…………………………… 1,110 74 Direct labour…………………………………… 900 60 Variable overhead……………………………… 1,350 90 Fixed overhead………………………………… 960 64 Total manufacturing cost…………………… $ 6,420 $428 Gross margin…………………………………… $5,580 $372 Operating expenses: Variable selling………………………………… $ 540 $ 36 Fixed selling…………………………………… 570 38 Fixed administrative…………………………… 1,140 76 Total operating expenses…………………… $2,250 $150 Net income before taxes…………………………… $3,330 $222 Air Comfort’s division manager believes sales can be increased if the price of the air-conditioners is reduced. A market research study by an independent firm indicates that a 5 percent reduction in the selling price would increase sales volume 16 percent or 2,400 units. The division has sufficient production capacity to manage this increased volume with no increase in fixed costs. The Air Comfort Division uses a compressor in its units, which it purchases from an outside supplier at a cost of $140 per compressor. The Air Comfort Division manager has asked the manager of the Compressor Division about selling compressor units to Air Comfort. The Compressor Division currently manufactures and sells a unit to outside firms which is similar to the unit used by the Air Comfort Division. The specifications of the Air Comfort Division compressor are slightly different, which would reduce the Compressor Division’s direct material cost by $3 per unit. In addition, the Compressor Division would not incur any variable selling costs in the units sold to the Air Comfort Division. The manager of the Air Comfort Division wants all of the compressors it uses to come from one supplier and has offered to pay $100 for each compressor unit.


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The Compressor Division has the capacity to produce 75,000 units. Its budgeted income statement for the coming year, which follows, is based on sales volume of 64,000 units without considering Air Comfort’s proposal.

COMPRESSOR DIVISION Budgeted Income Statement (In thousands) Total Per Unit (,000) Sales Revenue…………………………………………… $12,800 $200 Manufacturing costs: Direct material……………………………… $ 1,536 $ 24

Direct labour……………………………….. 1,024 16 Variable overhead………………………….. 1,280 20 Fixed overhead…………………………….. 1,408 22 Total manufacturing costs……… $ 5,248 $ 82 Gross Margin…………………………………………... $ 7,552 $118 Operating expenses: Variable selling…………………………….. $ 768 $ 12 Fixed selling……………………………….. 512 8 Fixed administrative……………………….. 896 14 Total operating expenses………. $ 2,176 $ 34 Net income before taxes……………………………….. $ 5,376 $ 84

REQUIRED: A. Should the Air Comfort Division institute the 5 percent price reduction on its

air-conditioner units even if it cannot acquire the compressors internally for $100 each? Support your conclusion with appropriate calculations.

(7 marks) B. Independently of your answer to requirement (A), assume the Air Comfort

Division needs 17,400 units. Should the Compressor Division be willing to supply the compressor units for $100 each? Support your conclusions with appropriate calculations.

(7 marks) C. Independently of your answer to requirement (A), assume Air Comfort needs

17,400 units. Suppose Continental’s top management has specified a transfer price of $100. Would it be in the best interest of Continental Industries for the Compressor Division to supply the compressor units at $100 each to the Air Comfort Division? Support your conclusions with appropriate calculations.

(6 marks) D. Is $100 a goal-congruent transfer price? Why?

(5 marks)

(Total: 25 marks)


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Question Three Devonport Inc is a large business organized on divisional lines. Two typical divisions are Asia-Pacific and Europe. They are engaged in broadly similar activities and, therefore, central management compares their results in order to make judgments on managerial performance. Both divisions are regarded as investment centres. A summary of last year’s financial results of the two divisions is as follows:

Asia-Pacific Europe $,000 $,000 $,000 $,000Capital Employed 2,500 500Sales 1,000 400Manufacturing cost: Direct 300 212 Indirect 220 48 Selling and distribution cost 180 700 40 300Divisional profit 300 100Apportionment of uncontrollable central overhead cost 50 20Net profit 250 80

At the beginning of last year, Asia-Pacific division incurred substantial expenditure on automated production lines and new equipment. Europe has quite old plant. Approximately 50% of the sales of Europe are internal transfers to other divisions within the business. These transfers are based on unadjusted prevailing market price. The inter-divisional transfers of Asia-Pacific are minimal. Management of the business focuses on return on investment as a major performance indicator. The required minimum rate of return is the business’ cost of capital of 10%. REQUIRED: A. Compute the following: i. Residual income. ii. Return on investments based on net profit. iii. Return on investment based on divisional profit.

(6 marks) B. Comment on the performance of the two divisions, making reference to any

matters that give cause for concern when comparing the divisions or in divisional performance generally.

(8 marks)

(Total: 14 marks)


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Question Four Lynsar Corporation started as a single plant to produce its major components and then assembled its main product into electric motors. Lynsar later expanded by developing outside markets for some components used in motors. Eventually, the company reorganised into four manufacturing divisions: bearing, casing, switch, and motor. Each manufacturing division operates as an autonomous unit, and divisional performance is the basis for year-end bonuses. Lynsar’s transfer pricing policy permits the manufacturing divisions to sell either externally or internally. The price for goods transferred between divisions is negotiated between the buying and selling divisions without any interference from top management. Lynsar’s profits for the current year have dropped although sales have increased, and the decreased profits can be traced almost entirely to the motor division. Jere Feldon, Lynsar’s chief financial officer, has learned that the current motor division purchased switches for its motors from an outside supplier during the current year rather than buying them from the switch division, which is at capacity and has refused to sell to the motor division. It can sell them to outside customers at a price higher than the actual full (absorption) manufacturing cost that has always been negotiated in the past with the motor division. When the motor division refused to meet the price that the switch division was receiving from its outside buyer, the motor division had to purchase the switches from an outside supplier at an even higher price. Jere is reviewing Lynsar’s transfer pricing policy because he believes that suboptimisation has occurred. Although the switch division made the correct decision to maximise its division profit by not transferring the switches at actual full manufacturing cost, this was not necessarily in Lynsar’s best interest because of the price the motor division paid for them. The motor division has always been Lynsar’s largest division and has tended to dominate the smaller divisions. Jere has learned that the casing and bearing divisions are also resisting the motor division’s expectation to use the actual full manufacturing cost as the negotiated price. Jere has requested that the corporate accounting department study alternative transfer pricing methods to promote overall goal congruence, motivate divisional management performance, and optimise overall company performance. Three transfer pricing methods being considered follow. The one selected will be applied uniformly across all divisions.

• Standard full manufacturing costs plus mark-up. • Market selling price of the products being transferred. • Outlay (out-of-pocket) costs incurred to the point of transfer plus opportunity

cost to the seller, per unit.


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REQUIRED: A. Discuss the following:

i. The positive and negative motivational implication of employing a negotiated transfer price system for the goods exchange between divisions.

(4 marks)

ii. The motivational problems that can result from using actual full (absorption) manufacturing costs as a transfer price.

(4marks) B. Discuss the motivational issues that could arise if Lynsar Corporation decides

to change from its current policy of covering the transfer of goods between divisions to a revised transfer pricing policy that would apply uniformly to all divisions.

(7 marks)

C. Discuss the likely behaviour of both buying and selling divisional managers for each transfer pricing method listed earlier, if it were adopted by Lynsar.

(10 marks)

(Total: 25 marks)


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Suggested solutions: Question One (a) Critical Success Factor Measure Product quality No. customer complaints No. customer returns Turnover of flowers (hours) No. orders returned to supplier Quantity flowers destroyed due to poor quality Customer responsiveness Delivery time to customers Time between order and delivery Time taken to respond to customer complaints Response time to customer suggestions Wide product range No. of different types of flowers ordered each

day No. new varieties introduced each month No. of varieties of flowers compared to competitors (1 mark for each performance measure x 6 – only if it suits the products and operations of flower Power. Generic lists get 0 marks. Max for 2(a): 6 marks) (b) (i) Reasons in support of non- financial measures: - easier to control at operational level compared to financials - are actionable ( easy to improve directly) - easier to understand, usually relate closely to operations - they drive future financial performance - they highlight the causes of problems (1/2 mark for each supportive reason – as long as it is logical, max. for 2(b)(i): 3 marks)

(ii) Arguments against non- financial measures: - not as objective as financials

- difficult to choose which ones to measure - may be difficult to see how they relate to achieving profit - we want to maximise profits, and profit should be the focus - costly to develop systems to collect non- financial data (½ mark for each argument – as long as it is logical, max. for 2(b)(ii): 3 marks)


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(c) Positive effects of ROI: - motivates managers to maximise profits, while holding asset balances

low - can be used to compare divisions of different size - easy to understand - widely- accepted in practice Negative effects of ROI: - creates disincentive to invest in new assets - incentive to hold on to old outdated assets - incentive to manipulate profits

reduce R & D, training expenditure - causes managers to focus on short- term performance at the expense of the

long term - can cause managers to focus too narrowly on their own division’s

performance, at the expense of the rest of company - can provide misleading signals of performance - can cause managers to reject projects which benefit the company, but

lower divisional ROI. (1/2 mark (max 2 marks) for each positive effect; ½ mark (max 4 marks) for

each negative effect. Max. for Part 2(c): 6 marks)

(Total for Question Two: 18 marks)


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Question Two

A. Yes, Air Division should institute the 5% price reduction on its air conditioner units because net profit would increase by $264,000. Supporting calculations follow.

Before 5% After 5% Price Reduction Price Reduction Total Per Total Per Total Difference Unit (in thousands) Unit (in thousands) (in thousands) ___________________________________________________________________________

Sales revenue $800 $12,000 $760 $13,224.0 $1,224.0 Variable costs Compressor $ 140 $2,100 $ 140 $2,436.0 $336.0 Other direct materials 74 1,110 74 1,287.6 177.6 Direct labour 60 900 60 1,044.0 144.0 Variable overhead 90 1,350 90 1,566.0 216.0 Variable selling 36 540 36 626.4 86.4 Total variable costs $400 $6,000 $400 $6,960.0 $960.0 Contribution margin $400 $6,000 $360 $6,264.0 $264.0

Summarised presentation:

Contribution margin of sales increase ($360 × 2,400) $864,000 (4marks) Loss in contribution margin on original volume arising from decrease in selling price ($40 × 15,000) 600,000 (3 marks) Increase in net profit before taxes $264,000

(Total: 7 marks)

B. No, the Compressor Division should not sell all 17,400 units to Air Division for $100. If the

Compressor Division does sell all 17,400 units to Air Division, Compressor Division will only be able to sell 57,600 units to outside customers instead of 64,000 units due to the capacity restrictions. This would decrease Compressor Division’s net profit before taxes by $71,000. Compressor Division would be willing to accept any orders from Air Comfort above the 64,000 unit level at $100 per unit because there would be a positive contribution margin of $43. Supporting calculations follow.

Outside WindAir Sales Sales _________________________________________________________________________________________ Selling price $200 $100.00 Variable costs Raw materials $ 24 $21.00 Direct labour 16 16.00 Variable overhead 20 20.00 Variable selling expenses 12 – Total variable costs $ 72 $57.00 Contribution margin $ 128 (2 marks) $43.00 (2 mks) Capacity calculation in units: Total capacity 75,000 Sales to WindAir 17,400 Balance 57,600 Projected sales to outsiders 64,000 Lost sales to outsiders 6,400 (1 mk)


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Solution: _____________________________________________________________________________ Contribution from sales to WindAir ($43.00 × 17,400) $748,200 (1 mark) Loss in contribution from loss of sales to outsiders ($128 × 6,400) 819,200 (1mark) Decrease in net profit before taxes $ 71,000

(Total: 7 marks) C. Yes, it would be in the best interests of National Industries for the Compressor Division to sell

the units to the Air Division at $100 each. The net advantage to National Industries is $625,000 as shown in the following analysis. The net advantage is the result of the cost savings from purchasing the compressor unit internally and the contribution margin lost from the 6,400 units that the compressor division otherwise would sell to outside customers.

Cost savings by using compressor unit from Compressor Division:

Outside purchase price $ 140.00 (1 mark) Compressor Division’s variable cost to produce (see requirement 2) 57.00 (1 mark) Savings per unit $ 83.00 Number of units 17,400 Total cost savings $1,444,200 (2 marks) Compressor Division’s loss in contribution from loss of sales to outsiders (See requirement 2): $128 × 6,400 819,200 (2 marks) Increase in net profit before taxes for National Industries $625,000

(Total: 6 marks) D. As the answers to requirements (2) and (3) show, $100 is not a goal-congruent transfer price (1

mark). Although a transfer is in the best interests of National Industries as a whole (2 marks), a transfer of $100 will not be perceived by the Compressor Division’s Management as in that division’s best interests (2 marks).

(Total: 5 marks)


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Question Three A. i. Residual Income. Asia-Pacific = 300,000 - (2,500,000 x 0.1) = 50,000 Europe = 100,000 - (500,000 x 0.1) = 50,000 ii ROI based on net profit AP = 250,000 ÷ 2,500,000 = 10% Europe = 80,000 ÷ 500,000 = 16% iii. ROI based on divisional profit AP = 300,000 ÷ 2,500,000 = 12% Europe = 100,000 ÷ 500,000 = 20%

(Total: 6 marks) B. The ROIs indicate that Europe is the better performing division (1 mark).

However, we are told in the question that Europe has older plant (1/2 mark) than Asia-Pacific, which has recently modernised its production lines (1/2 mark). This difference in the age of the plant is likely to mean that the ROI of Europe is higher due, at least in part, to the fact that the plant has been substantially written down (1 mark). Some common base is required for comparison basis (eg unadjusted historical cost) (1/2 mark).

We are told that ROI is used as a basis for evaluating performance. We can see

that, whichever measure of ROI is used, the two divisions meet the minimum returns required (1/2 mark). If ROI is being used to assess managerial performance, then the divisional profit rather than net profit figure should be used in the calculation (1 mark). This is because the net profit figure is calculated after non-controllable central overheads have been deducted (2 marks).

The business should consider the use of RI as another measure of divisional

performance. This measure reveals the same level of performance for the current year from each division (1 mark).

(Total: 8 marks)


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Question Four A. i. The positive and negative motivational implications arising from employing

a negotiated transfer price system for goods exchanged between divisions include the following: Positive • Both the buying and selling divisions have participated in the negotiations

and are likely to believe they have agreed on the best deal possible. (1 mark)

• Negotiating and determining transfer prices will enhance the autonomy/independence of the divisions. (1 mark)

Negative • The result of a negotiated transfer price between divisions may not be

optimal for the firm as a whole and therefore will not be goal congruent. (1 mark)

• The negotiating process may cause harsh feelings and conflicts between divisions. (1 mark)

ii. The motivational problems which can arise from using actual full (absorption) manufacturing costs as a transfer price include the following.

• Full-cost transfer pricing is not suitable for a decentralized structure where the autonomous divisions are measured on profitability as the selling unit is unable to realize a profit. (2 marks)

• This method can lead to decisions that are not goal congruent if the buying unit decides to buy outside at a price less than the full-cost of the selling unit. If the selling unit is not operating at full capacity, it should reduce the transfer price to the market price if this would allow the recovery of variable costs plus a portion of the fixed costs. This price reduction would optimize overall company performance. (2 marks)

B. The motivational problems that could arise if Lynsar Corporation decides to change its transfer pricing policy to one that would apply uniformly to all divisions include the following:

• A change in policy may be interpreted by the divisional managers as an

attempt to decrease their freedom to make decisions and reduce their autonomy. This perception could lead to reduced motivation. (2 marks)

• If managers lose control of transfer prices and thus, some control over profitability, they will be unwilling to accept the change to uniform prices. (2 marks)

• Selling divisions will be motivated to sell outside if the transfer price is lower than market as this behavior is likely to increase profitability and bonuses. (3 marks)


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C. The likely behavior of both buying and selling divisional managers, for each of the following transfer pricing methods being considered by Lynsar Corporation, include the following: a. Standard full manufacturing costs plus a markup.

• The selling divisions will be motivated to control costs because any costs over standard cannot be passed on to the buying division and will reduce the profit of the selling division. (2 marks)

• The buying divisions may be pleased with this transfer price. However, if the market price is lower and the buying divisions are forced to take the transfer price, the managers of the buying divisions will be unhappy. (2 marks)

b. Market selling price of the product being transferred. • Creates a fair and equal chance for the buying and selling divisions to make

the most profit they can and should promote cost control, motivate divisional management, and optimize overall company performance. Since both parties are aware of the market price, there will be no distrust between the parties, and both should be willing to enter into the transaction. (2 marks)

c. Outlay (out-of-pocket) costs incurred to the point of transfer plus opportunity cost per unit.

• This method is the same as market price when there is an established market price and the seller is at full capacity. At any level below full capacity, the transfer price is the outlay cost only (as there is no opportunity cost) which would approximate the variable costs of the good being transferred. (2 marks)

• Both buyers and sellers should be willing to transfer under this method because the price is the best either party should be able to realize for the product under the circumstances. This method should promote overall goal congruence between managers and the firm, motivate managers, and optimize overall company profits. (2 marks)

(Total: 25 marks)

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