Considerations/Issues in TP

Taxation – tax heavens, double taxations

Govt. Regulations – Arms length price (in absence of
which BU can set TP to minimize the tax liability)
Tariffs – They are certain % of import value,
therefore lower the TP lower will be the tariffs.
Foreign Exchange Control – e.g. limit on FE
spending for import.
Shifting of funds to desired location.
Joint Ventures – May enforce the specific TP.
Transaction, Operation and Economic exposure to
ER.
Problem on cost based transfer pricing –
ABC Co Ltd has received an enquiry for the supply of 1000 units steel
chairs. Company’s division A has got capacity to produce these many
chairs, but it has to incur fixed investment of Rs 400000 and working
capacity to the extent of 25% of the sale value will be required if the
job is undertaken. The costs are estimated as follows –
Raw material 11000 Kg @ Rs20 per Kg
Direct wages 1000 hours @ Rs 10 per hour
Variable Overheads - Factory Rs 15 per labor hour
Selling & Distribution Rs 20000
Fixed Overheads - Factory Rs 10000
Selling & Distribution Rs 45000
Prepare a statement showing the price to be fixed under –
• Total cost method using i. 30% on the total cost and ii. 20% on S. Price
• b. Conversion cost method – 200% conversion cost as profit
c. Marginal cost method assuming a P/V ratio of 35%
d. Return on investment method with an expected return of 20% on the
capital employed
Solution – a. Total cost method –
For 1000 units Per unit
Direct Material (11000*20) 220000 220
Direct Wages (1000*10) 10000 10
Prime Cost 230000 230
Factory O/H(1000*15 +
10000) 25000 25
Cost of Mfg. 255000 255
Selling & Distri. O/H 65000 65
Total Cost 320000 320
Profit(30% on total cost) 96000 96
Sale 416000 416
i. When the profit is 30% on the total cost, price will be Rs 416 per unit
ii. When profit is 20% on sales, i.e. profit is 25 of cost, hence
Selling Price = 320 + (320 * 25%)
b. Conversion Cost method –
Conversion Cost = Direct wages + Factory O/H
= 10 + 25 = 35
Profit to be charged = Conversion Cost * 2
= 35 * 2 = 70
Selling Price = Total Cost + Profit
= 320 + 70 = 390
c. Marginal Cost Method –
Marginal Cost Statement
Direct Material Cost 220000
Direct Wages 10000
Variable O/H
Factory - 15000
Selling & Distri. 20000
Marginal Cost 265000
Marginal Cost Per Unit = 265000/1000 = 265

P/V Ratio expected is 35%

V/S = 1 – P/V ratio = 1- 0.35 = 0.65

Hence Sales = V/ 0.65 = 265 / 0.65 = Rs 408

d. Return on Investment Method
Sales = Total Cost + ROI in Rupee value
= 320000 + 20% * (Additional Fixed Investment
PLUS Additional Working
capital requirement)

= 320000 + 20% ( 400000 + Sales * 25%)

= 320000 + 80000 + (SALES * 5%)

Sales – 0.05 Sales = 400000

0.95 Sales = 400000
Sales = 400000/0.95
= 421053 (for 1000 unit)
Sales Price per unit Rs 421.05
Numerical/Case Illustration No 17 in my book
ABC Company has two divisions Relay Division (RD) and Motor
Division (MD).
RD can manufacture 50,000 relays per year at a variable cost of Rs 12
per unit and sale at Rs 20 per unit. Each relay unit requires one labor
hour to complete.
MD has developed a new model of motor for which a new model of
relay is required. The annual requirement is 50,000 units. There are
two options available to procure this new model of relay –
To buy from external supplier at Rs 15 per unit
To get it manufactured at RD, for which it has to give up its entire
present business.
The variable cost of manufacturing a new relay model is Rs 10 per unit.
The MD also has to incur Rs 25 per unit as variable cost and shall get
selling price of Rs 60 per unit.
Advice whether the RD should give up its existing business to
manufacture new model of relay for MD? OR
The MD should procure it from the open market?
From RD’s point of view, what should be the transfer price, if decided so
Numerical/Case – Illustration No27 in my book
A large auto-mobile company, Jay Auto follows a pricing policy,
whereby normal or standard activity is used as base. That is the prices
are set on the basis of long run annual volume predictions. They are
then rarely changed, except for notable changes in wage rates or
material prices. You are given following data about company’s
working:
Material, Wages & Other Variable Costs Rs 1320 per unit
Fixed Cost Rs 3,00,000 per
annum
Desirable ROR on invested capital 20%
Normal Volume 1000 units
Invested Capital Rs 9,00,000
Find –
What net income % based on rupee sales is needed to attain the desired
rate of return?
What rate of return on invested capital will be earned on sales volume of
1500 and 500 units?
Numerical/Case – Big Burger Co has two stores Central BB and Western
BB. Company is considering expanding menus at these stores to
include pizza. Installation of necessary ovens and purchase of
equipments would cost Rs 1,80,000 per store.
The current investment in Central BB totals Rs 8,90,000. Store revenues
are Rs 11,00,500 and expenses are Rs 9,24,420. Expansion of Central
BB’s menu should increase profits by 30,600.
The current investment in Western BB totals Rs 17,40,000. The stores
revenues are Rs 17,60,800 and expenses are Es 14,96,680. Expansion
of Western BB’s menu should increase its profits by Rs 30,600.
Big Burger Co evaluates its managers based on return on investment.
Managers of individual stores have decision rights over the pizza
expansion.
Calculate the return on investment for both stores before expansion, only
for pizza project and after expansion.
Assuming 14% cost of capital, calculate residual income for both stores
before expansion, only for pizza project and after expansion.
Will the stores choose to expand? How would the answer change, if the
stores were franchised units?
Solution – Computation of Return on Investment
Before Central Western After Central Western
Expansion BB BB Expansion BB BB
Current Curt. Invest
Investment 890000 1740000 +180000 1070000 1920000
Revenue 1100500 1760800 Revenue 1100500 1760800
Expenses 924420 1496680 Expenses 924420 1496680
Profit 176080 264120 Profit +30600 206680 294720
ROR 19.78 15.18 ROR 19.32 15.35
For Central BB with expansion its ROR decreases hence he won't
accept the company's proposal to expand.
However for Western BB with expansion its ROR increases hence he
will welcome the expansion project
But whether Central BB is acting in the interest of the Big Burger??
Solution – Computation of EVA or Residual Income
Before Central Western After Central Western
Expansion BB BB Expansion BB BB
Current Curt. Invest.
Investment 890000 1740000 +180000 1070000 1920000
Revenue 1100500 1760800 Revenue 1100500 1760800
Expenses 924420 1496680 Expenses 924420 1496680
Profit 176080 264120 Profit+30600 206680 294720
Capital
Charge-14% 124600 243600 149800 268800
RESIDUAL
INCOME 51480 20520 56880 25920
In view +ve EVA both the divisions would accept the expansion project
If Central BB and Western BB were the franchised units, then both
would have accepted the expansion proposal, without any hitch as the
ROR of the project is higher that cost of capital (prj ROR 17%, CC 14%)
Numerical/Case –
A company is having two independent divisions Div S and Div B. Div B
buys certain component from Div S at an agreed upon transfer price
of Rs 95 per unit. After further value addition to it, Div B sells the
final product in the market. The cost structure of the two divisions is
given as under:
Div S Div B
Fixed Cost (Rs) 15000 10000
Variable Cost (Rs) per unit 10 20
It is further given that the demand for final product is a function of
selling price as shown below –
Demand (Units) 100 200 300 400 500 600
Selling Price (per unit) 200 180 150 130 120 104
Based on above data find at which operating levels Div B, Div S and
Company maximizes profit. Support your answer with necessary
calculations.
Being a management controller of the company which transfer price
would you advice and why?
Solution -

Div S

Selling Variable Fixed

Demand Price TP Revenue Cost Cost Total Cost Profit

100 200 95 9500 1000 15000 16000 -6500

200 180 95 19000 2000 15000 17000 2000

300 150 95 28500 3000 15000 18000 10500

400 130 95 38000 4000 15000 19000 19000

500 120 95 47500 5000 15000 20000 27500

600 104 95 57000 6000 15000 21000 36000

Div S is making profit of Rs 2000 at output level of 200 units and can
make more if Div B buys more from him.
 Div B Variable Cost

VC-
Selling Further Fixed Total
Demand Price Revenue TP Proc Cost Cost Profit

100 200 20000 9500 2000 10000 21500 -1500

200 180 36000 19000 4000 10000 33000 3000

300 150 45000 28500 6000 10000 44500 500

400 130 52000 38000 8000 10000 56000 -4000

500 120 60000 47500 10000 10000 67500 -7500

600 104 62400 57000 12000 10000 79000 -16600

At 200 units Div B maximizes profit i.e. Rs 3000 and at any other level
of output reduces Div B's profit.
Company maximizes profit at output level of 500 units as under –
Company maximizes profit at output level of 500 units as under –

Selling Div S's Div B's Company's Co's

Demand Price Cost Own Cost Total Cost Revenue Profit
100 200 16000 12000 28000 20000 -8000
200 180 17000 14000 31000 36000 5000
300 150 18000 16000 34000 45000 11000
400 130 19000 18000 37000 52000 15000
500 120 20000 20000 40000 60000 20000
600 104 21000 22000 43000 62400 19400

Company’s profit raises from Rs 5000 to 20000 if output level increases

from 200 to 500 units Therefore the correct TP at this situation is
variable cost only, because for more than this TP the Div B shall be
discouraged to buy from Div S