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On 24th February 2011, Australian Federal government announced a framework to implement a Carbon Tax from 1st July 2012. It is proposed to be implemented over 3-5 year period upon which it will switch to a cap and trade system. This would make Australia the first developed country in the world adopting a carbon tax scheme.
The carbon tax works by simply putting a tax on the carbon emissions of a company. It sets a price on the carbon emission. While the cap and trade system puts a cap on the aggregate emission of the whole market which limits the greenhouse gas emission of the overall economy. Specifically, a base-level of emissions allowances or credits is distributed at no cost or by auction. The number of allowances would be reduced over time and capped entities would be able to trade these allowances depending on the amount of emissions they generate. That is, a company that is able to reduce their emissions below the number of allowances they currently hold may sell their excess allowances to companies in need of more allowances for emissions levels that are above their cap.
Differences between carbon tax and cap and trade system
Theoretically, both of the carbon tax and the cap and trade system aim to achieve emission reductions. Both also set price on emissions. Under idealized conditions, they are equally effective, i.e. price of carbon permit = carbon tax rate (Betz 2009). However, the two approaches have significant differences as well.
The cap and trade system would generate additional revenue for the uncapped sectors when they trade their emission allowances, which would incentivize effective, short-term greenhouse gas emission reduction opportunities such as carbon sequestration. The cap and trade system would spur innovation in greenhouse gas mitigation opportunities from carbon offsets (Sands 2009).
On the other hand, it is held by Shapiro (2009) that the carbon tax is superior to the cap and trade system for six fundamental differences, which is also supported by Hennessey (2007)
1. The carbon tax brings the predictability to energy prices, whereas cap and trade systems will aggravate the price volatility that historically has discouraged investments in less carbon-intensive electricity generation, carbon-reducing energy efficiency and carbon-replacing renewable energy.
2. The carbon tax can be implemented much sooner than the more sophisticated cap and trade system.
3. The carbon tax is more transparent and easily understandable compared to the cap and trade system.
4. The carbon tax can be implemented with far less opportunity for manipulation by special interests, while a cap and trade system's complexity opens it to exploitation by special interests and perverse incentives that can undermine public confidence and undercut its effectiveness.
5. The carbon tax addresses emissions of carbon from every sector, whereas some cap and trade systems only put cap on some sectors including resources, energies, and so on while leave some sectors uncapped such as agriculture and forest sectors.
6. The carbon tax revenues would move to the government as the tax revenue which is usually redistributed to the public according to the government's fiscal requirements, while the costs of cap and trade systems are likely to become a hidden tax as dollars flow to market participants, lawyers and consultants.
The implication of the proposed carbon tax
The Australian Chamber of Commerce and Industry (ACCI 2011) says that the proposed carbon tax is a competitive blow to business and Australia should not be acting ahead of the rest of the world.
The resources sector has flagged another showdown with the Federal Government on the proposed carbon tax. It is reported that most resources companies are against the introduction of the carbon tax in Australia while the rest of the world are not doing so (AAP News 2011). The carbon tax levied on the resources companies will increase the companies cost and in turn reduce their global competitiveness. This is harmful to the companies global performance. Meanwhile, concerns have been expressed that the proposed carbon tax would eventually lead to mining companies looking overseas for exploration, resulting in a large downturn in the economy and high level of job losses in Australia. In addition, it is conceded by Elliott (Tasker 2011) that Australia's ability to attract foreign mining investors would be hit by the newly proposed carbon tax scheme. The tax will increase the uncertainty that a resource company need to face while the carbon pricing has not been known publicly. Investors do not like uncertainty and usually presume the worst case when making investment decision. As here, the worst scenario would be that they are not wishing to invest in Australian mining companies due to the uncertain but probably high cost of operations triggered by the proposed carbon tax.
Alternatively, the climate scientist Professor Bob Carter and Institute of Public Affairs (IPA) executive director John Roskam believe that a carbon tax would disproportionately impact Australia's future development and have a very negligible effect on reducing emissions (Grant 2011). They insist that it would be better to spend trillions of dollars on dealing with climate reality rather than the proposed carbon tax.
In general, it is expected that the electricity bill will increase by at least 25% after the introduction of this new carbon tax scheme. The small business owners will be forced to account for an extra $30,000 a year as part of the federal government's carbon tax policy, which will have significant influences on these small businesses (Matheson 2011). For some uncapped sectors, they are not able to make additional revenue from the trading of emission allowances as did under the cap and trade scheme, which implies that they do not benefit for innovations on emission reduction. This will in turn limit the overall emission reduction of the whole nation.
As a small pump manufacturing company in Australia, Outback Jack Pty Ltd suffered a loss in the second quarter of 2010 due to the unexpected price drop and increasing expenses during the past two years. Only one of its three product lines was profitable in this quarter. The management has to take measures to change the status quo and lead the company back to profit.
Seeing the situation, the managing director proposed three changes to current operations. To assist the managing director in making the appropriate decision, an analysis is conducted towards the company's current financial position as well as the costing system to identify the potential problems and figure out the possible solutions. A product line contribution margin income statement replaced the traditional one to offer the manager a more precise view on the company's cost structure and performance of each product line. Additionally, each course of act individually as well as combining as a whole operating plan is evaluated and compared to determine what actions should be taken by the management. Further discussion and recommendation is given to improve the
Current Reporting Metho
The company is currently using the traditional method to report its financial statement even for the internal use. As generally known, expenses are classified according to their functions in the traditional income statement, such as cost of goods sold , wages, utility expense, administrative expenses, etc.
However, this type of income statement is more likely prepared for the external users rather than the internal users as the information given in it cannot be directly applied by the manager for planning, controlling or evaluation of the performance. More information has to be collected through other sources in order for the managers to do analysis on the company's operations. For instance, before the managers are able to conduct variance analysis, one of the widely applied techniques in the management, they have to reclassify the information on activity basis, thereby comparing the actual operating results with the budget for control purposes.
Contribution Margin Method
In contrast to the traditional income statement approach, the contribution margin income statement is better suited for the managers in operating activities. A product line contribution margin income statement of the company is prepared (as shown in table 1) to illustrate the structure and usefulness of this type of income statement.
It is apparent that the contribution margin income statement clearly states the information categorised on activity basis for different product lines. Compared to the traditional income statement, it highlights the behaviours of controllable costs and indicates each product line's contribution to the company's profit and indirect fixed costs. Therefore, it is a very useful tool for managers to improve the operation efficiency, make budgeting and strategic plans, control the costs and operations, as well as evaluate the profitability of each product line.
Analysis on Proposed Actions
The managing director suggested three changes to the current operations to improve the company's financial performance.
a) Discontinue the S-pump product line immediately until the problems are solved.
b) Do promotion on R-pump by increasing the quarterly advertising by $100,000 to increase the sales volume by 15%.
c) Cut half of the production of the F-pump line and decrease the advertising and promotion expenses on this line to $20,000 annually (i.e. $5,000 quarterly).
Based on the product line contribution margin income statement outlined above, the potential influences caused by the proposed actions on the income statement of each product line are analysed to figure out the right decision for the manager in this case. Assume general selling and administrative expenses are allocated to the product lines in proportion to the sales volume.
Cost-benefit Analysis of the Proposed Actions
First of all, cost-benefit analysis is conducted to illustrate the potential benefits and required costs in each action as well as in the strategy to take all three actions as a whole. By comparison of the cost-benefit relationships among these four strategies as shown in table 2 (See appendix 1 for detailed product line contribution margin income statements for each strategy), the best strategy would be selected consequently.
Note: Action a, b and c are consistent with the ones mentioned above while combination denotes the strategy combined all three actions.
As shown in table 2 of all proposed strategies, strategy a, discontinuing S-pump, would generate the most benefit for the company. This is because the S-pump line had an initial contribution margin of zero, which implies that this line did not produce any profit for the company. Instead, it made the company suffer a big loss owing to its fixed cost. From another angle, the elimination of the S-pump line reduced the sales revenue to $2.5 million compared to the original $3.4 million, but the contribution margin remained the same and the fixed manufacturing costs declined as well. As a consequence, the net operating income increased to positive.
As for strategy b, the advertising cost was not covered by the revenue generated from the 15% increase in the sales volume and thus the situation became worse with a more negative income. It is interesting to note that strategy c led to the same net operating income as that in the initial situation. By cutting the production and advertising expenses of the F-pump line, both revenue and costs declined by the same amount and therefore the net operating income did not change. In addition, the combination strategy summed up the influences of the three strategies and increased the operating income as well, although not so much as the that in strategy a.
3.2 Elimination of S-pump
As discussed above, the company would be best off to discontinue the S-pump line since the elimination brought a dramatic increase in the company's profitability. Because the S-pump line has a contribution margin of zero, it can never make profit to the company. Additionally, it has no important link to the other two lines, which means that the elimination would not have significant impacts on the profitability of the other two lines.
3.3 Promotion on R-pump or F-pump
Assume the promotion was put on F-pump with an additional advertising expense of $100,000. If the sales volume increased as much as that of the R-pump in the proposed strategy b, then the net operating income of the company would be -$133,900, which was much worse than strategy b, even though they were both negative. A 53.9% increase in sales volume of F-pump is required to achieve the same results as in the case of putting promotion on R-pump. More precisely, if the management wished to turn the company's profitability into positive by this approach, an increase in sales volume of as high as 94.11% would be required. This seems irrational to happen. (See Appendix 2 for detailed computation)
Although the promotion on R-pump could get relatively better rewards, as discussed above, neither strategy could help the company out of the current situation.
Use of the Company's Capacity
A primary focus of management is that using the scare resources most efficiently to maximize the company's profit. In this case, the company has been operating at its full capacity for years but this does not necessarily mean that the company was making efficient use of its capacity.
As mentioned above, the S-pump line has a zero contribution margin and should be shut down accordingly. Assume the company's sales are not limited by demand but by the company's production. Then it would be reasonable to relocate the labour, raw materials (if possible) from the S-pump line to other product lines. If the relocation was feasible, the company's production would increase and thus the sales would be improved.
Assume the relocation is feasible in practice. If fully relocated to R-pump, the production would increase to 15,500 units. Otherwise, if fully relocated to F-pump, its production would rise to 24,700 units. Accordingly, the expected net operating income in both cases could be computed as shown in appendix 3. With the jump of sales volume, the net operating income in each case would be $601,000 and $325,000 respectively. It is also interesting to note that both lines would make profit if the resources of the S-pump line were fully relocated to the F-pump. Therefore, further information should be collected to determine whether this kind of relocation is possible.
Current Costing System
According to the stated information, the company's product costing system can be shown in the figure below (Figure 1).
The current costing system is a simple system, involving four types of direct costs and only two types of indirect costs. The general selling and administrative expenses are allocated in proportion to the sales volume of each production line. Allocation per unit is the same for each product.
Revised Costing System
Since the current costing system is not specific enough to provide accurate cost information for the management, a revision has to be conducted to get it improved. According to the evaluation results above, the costing system is modified in some aspects and the more detailed costing system is shown in Figure 2.
Unlike the current costing system, the improved one is a more sophisticated system which has multiple cost pools and cost drivers. This system covers all the relevant activities in the process of production. The costs are generally divided into five parts and then allocated to each product based on its contribution to the product. Allocation per unit depends on each product's use of cost drivers, not the same any more.
To develop such an elaborate costing system, further study must be conducted to determine the specific indirect cost allocation procedures, which is not covered in this report.
Breakeven analyses were conducted to identify the minimum operating levels under each situation. This also gave another view to the feasibility of each proposed strategy. Breakeven unit was computed in the predetermined five different situations under the current costing system (since the revised costing system has not been exactly established and the indirect cost allocation has not been specified) and the results are shown in table 3. Because the S-pump line has a zero contribution margin, the breakeven cannot be calculated.
It is crucial to understand that the breakeven analysis could get different results under different costing systems. Therefore, as we may discuss above, under the revised costing system, the breakeven analysis has to be redone because the indirect costs would be allocated on a different basis.
As seen from the computed results, in most cases, the R-pump line requires about one third of the minimum operating level of the F-pump line because it has relatively higher contribution margin per unit. So it is much easier for the R-pump line to make profit.
To summarise, instead of the traditional income statement, the company ought to adopt the product line contribution margin income statement in case of internal management and control use of the financial information because it provides a better views of the information essential for cost plan and control. As for the three proposed changes of the operations, it appears that action a took the dominant place among them but cautions have to be paid to this strategy because it does not make effective use of the company's capacity. In order to find out the minimum operating level required for each product line, breakeven analysis was performed and then profit could be estimated by comparison between the real sales and the breakeven volume. In addition, the current costing system was assessed, realising the existence of drawbacks. Therefore, a revised costing system was established but further development on the details has to be conducted to identify the indirect costs allocation.
As discussed above, the S-pump line should be discontinued immediately as it has a zero contribution margin. Alternatively, the resources that should have been utilised by S-pump line, such raw materials, labour, equipment and facilities, may be relocated to the other product lines to improve the efficiency of the use of the company's capacity. The management should do a further study on the feasibility of the relocation.
Once the revised costing system is finalised, it is strongly recommended that the management should do a new breakeven analysis based on this modified, more accurate and detailed costing system. This may lead to different results and therefore, different actions may be adopted by the management to maximize the company's profit.