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ACF303

2nd SEMESTER 2020/21 Final EXAM

Advanced Management Accounting

Question 1

The pet industry in China is booming. Chinese shoppers are set to spend 46.3 billion yuan ($7 billion) on their pets by 2022, up from 17.5 billion yuan this year as the market grows at around an annual 20 percent, according to estimates from Euromonitor. The U.S. market may be much bigger with an estimated $44.4 billion in sales in 2019 but it is only growing around 2 percent a year. Even though the market for pets and pet supplies is significant, the success rate varies greatly on such factors as location, community participation, and how well the business is run.

A group of private investors are considering whether to open a pet store (structured as a corporation) near a new condominium complex in the wealthy Shanghai Pudong New Area. The condominium complex is large. 1,500 families are currently living in the complex and an additional 1,000 families are expected to move in by the end of 2020. The pet shop will sell different kinds of animals to the public, as well as a variety of animal supplies and pet accessories, including food, treats, toys, collars, leashes, cat litter, cages and aquariums. Hygienic care (such as pet cleaning) and aesthetic services (such as cat and dog grooming) will also be provided. Currently, getting to the nearest pet store for residents in this condominium complex takes about 40 minutes’ drive. Some residents order pet accessories online. By setting up a store near the complex, the investors expect that their store will capture 40% of this area’s pet market. The investors are concerned that Petland, a large pet franchise, may open a store nearby and reduce their store’s market share and profitability. The investors believe that there is a 60% chance that Petland may decide to locate nearby. They do not believe that the existence of their store will affect Petland’s decision. The investors are considering wait for one year to see whether Petland decides to locate nearby. In case Petland opens a store nearby, the investors may terminate their investment and sell the store after the first year of operation. The following table contains data that are relevant to this investment decision.

  First year’s market, RMB
  5 million
  Annual market growth
  3%
  Market share without Petland competition
  40%
  Market share with Petland competition
  20%
  Gross profit margin ratio without Petland competition
  25%
  Gross profit margin ratio with Petland competition
  19%
  Discount rate
  8%
  Investment cost, RMB
  210,000
  Investment life
  4 years
  Salvage value at the end of investment life
  0
  Corporate tax rate in China
  25%
  Depreciation (straight line), RMB
  52,500
  Staff costs, RMB
  150,000
  Other operating costs, RMB
  260,000
  Probability of Petland entry
  60%
  Sale on early termination, RMB
  100,000
  Reinvestment cost (to extend 1 year), RMB
  20,000

Required:

1. Suppose that the investors decide to wait one year, what is the expected value of the best decision? Show your calculations. (5 marks)

2. Suppose the investors decide to invest now, what is the expected value of the best decision? Show your calculations. (5 marks)

3. Based on the real option analysis, should the investors act now or wait? Up to what amount would the investors be willing to pay for an option on this pet store? Show your calculations. (5 marks)

(Total marks: 15)

Question 2

Cochlear is the global leader in medical hearing devices, holding a 70 per cent market share. The company is based in Sydney and has operations in more than 100 countries. It employs approximately 2,500 employees around the world. The long-term vision of the company is to help the hearing impaired.

In the 1960s, the company’s founder Graeme Clark (an ear, nose and throat doctor) began research into the possibility of an electronic, implantable hearing device. He persevered despite the resistance of his colleagues.

The idea of a bionic ear evolved gradually through the integration of research from numerous disciplines. Apart from audiology and surgery, these included biology, psychophysics, speech science and electrochemistry. Clark strengthened his research after being appointed professor and chairman of the Department of Otolaryngology at the University of Melbourne. He established partnerships with a leading expert in sound quality and a small local company conducting pioneering research on heart pacemakers.

The critical contribution to the progress was made by engineers Jim Patrick and Ian Foster who designed the circuit diagram for the Mastermos silicon chip to provide circuitry for one of the ten stimulus channels of the first bionic ear. The first Cochlear implant from multichannel research as developed in 1978. The lengthy delay was due largely to the indifference of the medical community and the lack of financial support. Fundraising continued to be a major obstacle and the leading Australian research institutions repeatedly rejected Clark’s applications for research grants.

The first major breakthrough came in 1974 when Clark persuaded the proprietor of a new television channel to conduct fund-raising ‘Telethon’, which provided the finance to produce a prototype. A year later, Clark began partnering with a group of medical equipment manufacturers who had offered to commercially develop the bionic ear. In 1982 Cochlear was listed on the stock exchange and became a public company. This was the turning point for Cochlear and the company became engaged in a significant development process. At that stage, obtaining the support of surgeons and hearing aid professionals around the world was a formidable challenge.

Cochlear has been twice named the most innovative company in Australia. The company today is well renowned worldwide with approximately 16,300 recipients of its main product – Nucleus – and 260 Nucleus clinics in the Asia-Pacific region as well as 27,000 Nucleus recipients and more than 500 Nucleus clinics in the United States. In Europe, there are more than 21,000 Nucleus recipients and more than 260 clinics. As part of its services, it provides support for both medical professionals and implant recipients.

The company invests a significant portion of its revenue (roughly double the industry average) into research and development. Cochlear is involved with over 100 collaborative research programs focused on implantable hearing solutions and part of its research investment is geared towards redesigning its products so that they can be scaled up to mass production.

Developing and strengthening strategic alliances is important for Cochlear. In November 2019, Cochlear and GN Hearing agreed to further strengthen their technology and commercial alliance to develop best-in-class integrated hearing solutions. The deepening of this relationship includes joint R&D, shared technology and a strengthened global Smart Hearing Alliance collaboration between Cochlear and GN Hearing, the hearing aid division of the GN Group.

Cochlear has also made sound progress in the development of its new manufacturing facility in Chengdu, China. The manufacturing facility in Chengdu will raise Cochlear's global cochlear implant production by at least 50 percent. The hearing devices manufactured in Chengdu will mainly serve the Chinese market, and are expected to lower the overall price of these products in China. Cochlear will also collaborate with the Sichuan Innovation and Entrepreneurship Promotion Association to promote a Sino-Australia International Hearing Hub in Chengdu, which will conduct research on cochlear implant technology and develop hearing-loss solutions tailored for the Chinese market.

Cochlear’s management believes that training, development and engagement with employees is vital for the firm to thrive into the future. Cochlear is a fast-growing organisation and there have been over 900 people hired or promoted in the 2019 financial year (FY), up 26% on FY18. Training and development have both been strengthened with the implementation of globally consistent leadership programs, with Cochlear recognised by the Association for Talent Development as a ‘Best Learning Organisation’.

Cochlear’s vision is to connect the hearing impaired to a world of sound by offering life-enhancing hearing solutions. Cochlear aims to meet or exceed customer expectations by actively seeking to understand their requirements, responding to their needs in a timely manner and continuously improving its processes and offerings.

Cochlear’s strategic priorities are:

- Retain market leadership

- Grow the hearing implant market

- Deliver consistent revenue and earnings growth

(1) What do you think are the strategic capabilities of Cochlear? Identify one capability for each of the following functional areas: Corporate, Research and development, Operations, Marketing, Sales and distribution. (5 marks)

(2) Identify the main elements of Cochlear’s competitive advantage. (5 marks)

(3) You are a management consultant, assisting the senior management in developing a balanced scorecard for Cochlear. Identify two performance measures that are driven by the vision and strategic objectives of the firm for each of the four performance dimensions (i.e., financial, market, internal business processes and learning & growth). (8 marks)

(4) Suppose the new manufacturing plant in Chengdu commences production in 2022. The operational costs for the first 64 hearing devices are as follows:

  Number of hearing devices produced
  Cumulative average cost (RMB)
  1
  1,200
  2
  960
  4
  806
  8
  710
  16
  653
  32
  614
  64
  589

What are the total operational costs of the first 100 hearing devices produced? (5 marks)

(5) Continuing from the previous question, suppose the manufacturing plant in Chengdu receives an order for the delivery of a total of 32 hearing devices starting from Device 33 (i.e., from Device 33 to Device 64) from a local hearing clinic. The variable overhead costs are RMB 150 per device and the fixed overhead costs are RMB 9,500. The company wants to earn a margin of 25% of the sales. The hearing clinic is willing to pay a fixed amount of RMB 45,000 for the whole order of 32 hearing devices. Should the company agree to the listed price? Show your calculations. (7 marks)

(Total marks: 30)

Question 3

A firm consists of two profit centres, Production and Distribution. Production produces a single computer software product which may be sold on the open market for £200 per unit. The Distribution division adds a step-by-step ‘Teach yourself’ manual to the software and packages them in an attractive box, then sells the package for £240. The teach-yourself guide is an optional extra, as the software already has a basic users’ guide.

The total cost functions of the two divisions are:

Production Division: Cp(q) = 14000 + 40q + 0.1q2

Distribution Division: Cd(q) = 1200 + 20q + 0.1q2

The management of the firm wishes to set a transfer price which will induce both divisions to act simultaneously in the best interests of the firm as a whole

Required:

1. Show that, in order to maximise overall firm profit, the Production division should produce 800 units, 100 of which should be transferred to the Distribution division for further processing. (6 marks)

2. State what transfer price should be set for the Production division’s output. Explain why you would set this price. (4 marks)

3. Prepare summary profit and loss accounts for each division and for the firm as a whole. (4 marks)

4. Should the Distribution division be closed? (2 marks)

5. What are the main limitations of the economic transfer pricing model in practice? (4 marks)

(Total marks: 20)

Question 4

The board of directors of XYZ Ltd plans to implement bonus compensation plans for the firm’s senior executives, who have been compensated by salary only. The proposed plan for each member of the four-person C-suite executive team has the following parameters based on annual operating profit reported to shareholders:

  Bonus rate
  Operating profit
  Bonus compensation
  0%
  €0
  €10,000
  0%
  €100,000
  €10,000
  10%
  €100,001
  €10,000.1
  10%
  €500,000
  €50,000
  0%
  €500,001
  €50,000
  0%
  €600,000
  €50,000

The proposed bonus plan is graphically shown below:

Required:

1. The CEO’s responsibilities include major sales contracts. Close to the end of the fiscal year, the company’s operating profit was €90,000. At that time, the CEO was negotiating sales with a new customer that could earn an operating profit of €25,000. Discuss the CEO’s incentives as to whether to ask the CFO to recognise the sales revenue as earned during the current fiscal year given the bonus plan. (3 marks)

2. Suppose close to the end of the fiscal year, current operating profit was €485,000. The CEO was in the process of completing the negotiation of sales with an existing customer for products that are in stock. The expected operating profit from the sales is €60,000. Should the CEO defer completion of the sales to the next fiscal year? Why, or why not? (3 marks)

3. Discuss the strengths and weaknesses of extending a similar bonus plan to all employees of XYZ Ltd. (4 marks)

(Total marks: 10)

Question 5

A company considers an improvement of its washing machine to make it smarter and more acceptable by the younger generation. Two alternative improvements are considered: 1) a basic improvement by adding the remote-control function, and 2) a high value improvement by making it smart home compatible with smart assistants such as Amazon Alexa or Google Assistant.

If the firm adopts the basic improvement strategy, the marketing department estimate the net income in the first year of sales to be $1,500,000 if the market is price sensitive and $1,200,000 if the market is price insensitive. If the firm follows the high value improvement strategy, the marketing department estimate the net income in the first year of sales to be $1,100,000 if the market is price sensitive and $1,600,000 if the market is price insensitive.

The company does not know how price sensitive the consumers are: are they willing to pay a higher price for the high value improvement or is a basic remote-control improvement more optimal?

Required:

1. Suppose the management of the company is pessimistic, which strategy should the management prefer? Explain your answer. (3 marks)

Suppose the marketing department estimate a 45% chance that the business market is price sensitive and 55% that the market is price insensitive.

Required:

2. Calculate the expected value (EV) of each alternative. (6 marks)

3. Calculate the expected value of perfect information. (3 marks)

The company is considering whether to hire a consulting firm to conduct a market research examining whether the market is price sensitive or price insensitive. Suppose the consulting firm was 85% of the cases successful in predicting a price sensitive market and in 75% successful in predicting a price insensitive market.

Required:

4. Calculate the expected value of sample information. (10 marks)

5. The consulting firm charges $80,000 for the report. Would the company be willing to ask the consulting firm to do the research? (3 marks)

(Total marks: 25)