Q11, May 2010, Shubham Enterprises, Transfer Pricing Two Divisions A and B of Shubham Enterprises operate as Profit Centres.

Div A normally purchases annually 10,000 units of required components from Div B; which has recently informed Div A that it will increase selling price per unit to Rs. 1,100. Div A decided to purchase the components from open market available at Rs. 1,000 per unit. Naturally, Div B is not happy and justifies its decision to increase prices due to inflation and added that overall company profitability will reduce and the decision will lead to excess capacity in Div B, whose variable and fixed costs per unit are Rs. 950 and Rs. 110. (a) Assume that no alternative use exists for excess capacity in Div B, will the company as a whole benefit if Div A buys from the market? (b) If tha market price reduces by Rs. 80 per unit, what would be the effect on the company (assuming Div B still has excess capacity) if Div A buys from the market. ( c ) If excess capacity of Div B could be used for alternative sales at yearly cost savings of Rs. 14.5 lacs, should Div A purchase from outside? Justify your answers with figures.

Q11, May 2010, Shubham Enterprises, Transfer Pricing Existing Situation Relevant points in the situation:

Situation (a)

Situation (b)

Situation (c)

1 2 3 4

Capacity on Div B Nos of units Price in the market Price sought by Div B Unit Costs of Div B variable cost fixed cost total cost Annual cost savings Unit annual cost savings Unit Contribution of Div B Unit Contribution of Div A Total Unit Contribution of Divs A and B Difference vis--vis Base decision

Div B sells 10,000 Div B has excess Div B has excess units to Div A unutilised capacity unutilised capacity 10000 10000 10000 1000 1000 920 1000 1100 950 110 1060 950 110 1060 950 110 1060

Div B can sell in the market 10000 1000

950 110 1060 1450000 145 145 UC(A)

50 UC(A)

0 UC(A)

0 UC(A) + 80

50+UC(A)

0+UC(A) -50

UC(A) + 80 30

UC(A) + 145 95

Decision

Retain Base Base decision: Buy decision:Buy from from Div B B

Change the Base decision:Buy from Change the Base Market and carry decision:Buy from out alternative Market sale.

Gain /(Loss) to Shubham from the decision vis--vis base decision (Rs) (Rs lacs)

(500000) (5)

300000 3

950000 9.5