Page 22 - DCOM202_COST_ACCOUNTING_I

Cost Accounting – I

Notes are still reported as a single line item on the profit and loss statement. However, for internal
accounting purposes, salary and wage costs from cultivating the sugar cane are allocated to
one of several cost pools: land preparation, planting, post-harvest management, fertilizing,
weed control, pest & disease control, ripening, irrigating, canal construction, drainage
sub-surface, or drainage maintenance. Those cost pools are reported clearly on Mhlume’s
internal profit and loss statements, allowing managers to see clearly how much cost was
incurred in each area. Costs are allocated to the pools on the basis of labor hours.
Product Pricing and Cost Control
As mentioned previously, Mhlume introduced ABC to give managers better control over
their costs. Cost control is critical in Mhlume’s operation, as they have very little control
over product pricing in their markets. Sugar is traded on the world commodity markets,
much like soybeans and pork bellies. The world market, then, determines the price based
on supply and demand factors. Any individual company, therefore, cannot influence the
world price of sugar in any significant way. Mhlume operates in the Kingdom of Swaziland.
Situated in south-eastern Africa, Swaziland is surrounded on three sides by South Africa;
it also shares a border with Mozambique. As a developing nation, Swaziland receives
a special concession when it sells sugar to external markets. Specifically, Swazi sugar is
sold on the world market at three times the established world price for sugar; that is, if
sugar is sold on the world market at $5 per ton, Swazi sugar is sold for $15 per ton. One
of the main factors influencing the world price for sugar is its supply in the world market.
Each sugar producing company in Swaziland receives a quota (allowance) for sugar
production each year. For production up to the quota, Mhlume receives a fixed price. For
production over the quota, Mhlume receives a price which is always less than the “quota”
price. The two types of revenue are reported separately on Mhlume’s internal profit and
loss statement as “unsegregated” (amounts up to the quota) and “segregated” (amounts
over the quota).
Transfer Pricing

Mhlume’s operation also raises some interesting transfer pricing issues. Basically, transfer
pricing is concerned with setting prices for purely internal transactions where market
rules and constraints do not apply. Transfer pricing was pioneered by the U.S. automobile
manufacturer General Motors when its divisions had to do business with one another.
Normal laws of supply and demand do not apply to purely internal transactions, and much
has been written about the options for establishing transfer prices and the consequences of
the various options.

Mhlume confronts transfer pricing issues for two of its major inputs: sugar cane and water.
Mhlume does not actually own most of the fields where its sugar cane is grown. Rather,
the fields are owned by private individuals, who agree to sell all their output to Mhlume
at a fixed price. In return, Mhlume assists the individual farmers with crop maintenance.
Since the farmers have no option but to sell their output to Mhlume, and since Mhlume
must buy all the farmers’ output, a transfer price must be set which satisfies both parties.
In this particular case, the transfer pricing problem is somewhat alleviated by Mhlume’s
participation in the cultivation and harvesting of the grain.
Water is one of the principal indirect materials used in processing sugar. All of Mhlume’s
water comes from IYSIS, a firm which has many common shareholders with Mhlume. Thus,
IYSIS has a lot of control over the price Mhlume pays for water. With no external market
forces governing the price, IYSIS could potentially raise the price of water to an exorbitant
level, creating severe cost control problems for Mhlume’s overall operation. In this case,
however, the strong relationship between the two firms alleviates the potential problem,
and IYSIS basically passes on its direct costs to Mhlume in the transfer price.

Contd…

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