Alflonnso is a large producer of industrial chemicals, with divisions in 25 countries. The agrochemicals division produces a chemical pesticide, known internally as ‘ALF’, to control pests in a crop which is of worldwide significance, economically and for food production. Pesticides such as ALF only remain effective for a limited time, after which pests become resistant to them and a replacement product needs to be found. A scientific study has shown that the current variant, ALF6, is becoming ineffective in controlling pests and in some places, it has accumulated in the soil to levels which may significantly reduce crop yields in the future if it is continued to be used. The agrochemicals division is evaluating three new products to find one replacement for ALF6.

ALF7
ALF7 is produced by a small chemical modification to the existing product and requires little research and development (R&D) resources to develop it. As it is closely related to the current variant, it is only expected to remain effective, and in use, for three years. It is unclear whether ALF7 will accumulate in the soil in the same way as ALF6 does.

Red
Red is a new type of pesticide which will incur large amounts of R&D expenditure to develop a commercial version.

In addition, the agrochemicals division will have to fund a long-term scientific study into the effect of Red on the environment at a cost of $4m for each of the 15 years that the product will be in use, and for five years afterwards.

Production of Red generates large amounts of toxic by-products which must be treated in the division’s waste treatment facility. The production plant used to produce Red must also be decommissioned for cleaning, at an estimated cost of $45m, at the end of the life of the product.

Green
Green is a form of a naturally occurring chemical, thought to be safe and not to accumulate in the environment. It is expected to remain in use for eight years. Production of Green requires relatively large amounts of energy. Significant R&D expenditure is also needed to produce an effective version, as Green remains active in the environment for only a short time. Because of this, Green is unsuitable for use in climates where crop production is already difficult.

The Global Food Production Organisation (GFPO) is a non-governmental organisation which funds new ways to increase global crop production, especially in regions where food for human consumption is already scarce. The GFPO has agreed to make a significant contribution to the R&D costs of producing a replacement for ALF6, but will be unwilling to contribute to the R&D costs for Green because it cannot be used in every region. Similarly, a number of governments, in countries where Alflonnso has licences to operate its other chemical businesses, have warned the
company of the potential public disapproval should the agrochemical division choose to replace ALF6 with a product unsuitable for use in areas where food production is scarce.

The newly appointed chief financial officer (CFO) for the agrochemicals division has asked you as a performance management consultant for your advice. ‘One of our analysts in the agrochemicals division’, she said, ‘has produced a single period statement of profit or loss (Appendix 1) to show the profitability of the three new products we are considering as replacements for ALF6.’

‘I think the analyst’s calculations are too simplistic’, she continued. ‘The costs of the waste treatment are apportioned based on the expected revenue of the new products. This is consistent with Alflonnso’s traditional group accounting policy, but I don’t think this gives an accurate costing for the new products. Also, I watched a presentation recently about the use of lifecycle costing and also how environmental management accounting (EMA) can help reduce costs in the categories of conventional, contingent and reputation costs and as a result improve performance.’

Appendix 1
Single period statement of profit or loss for the replacement products for ALF61

Notes to the statement of profit or loss:

1 – All figures exclude the contribution from the GFPO towards the R&D costs of the new product.

2 – Waste treatment is an overhead cost incurred in the division’s waste treatment facility. Currently, costs of waste treatment are apportioned to products according to expected revenue. The total annual cost of the waste treatment facility, which processes a total of 55m litres of waste each year, is $300m. Any waste treatment capacity not used by any of the three new products can be used to treat waste created during the manufacture of other products in the division. One litre of waste by-product is produced for every 12·5 litres of ALF7 produced, for every 2·5 litres of Red produced and for every 100 litres of Green.

3 – R&D costs are incurred in the division’s R&D facility. In accordance with the group’s accounting policy, R&D expenditure is not currently apportioned to individual products. The annual cost of the R&D facility is $60m and has a total of 30,400 R&D hours available, of which 800 hours would be required to develop ALF7, 8,500 hours to develop Red, and 4,000 hours to develop Green.

Required:

(b) Using your answers from part (a) (ii), calculate the average net profit per litre of each of the three alternative new products over their expected lifecycles and comment on the results. (9 marks)