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, ln ;:.decentralised_ organization there arelJarious profit centers; :r;\eSe profit cent~rsm?ny times have to deal with each other. One of the most difficult things in such organizations istt~e setting up of transfer prices among the profit centers.

when two or more profit centers are jointly responsible for product development, manufacturing and marketirg, each one of them has to get a share in the profit generated when the product is sold, The Transfer Price is the mechanism for distributing these profits among all Lhe centers involved. Transfer price is not only an accounting tool, but is also a behavioral tool, that will help motivate the manager to make right decisions. The main objectives of transfer price should be as follows:

• It should provide each segment with the relevant information required to determine the optimum trade-ott between company costs and revenues,

• It should induce goal congruent decisions that mean that the system should be so designed that decisions that improve business unit profits will also improve company profits. What it means is that a transfer price decision would he ,.orrect only if It helps increase the overall profitability of tile company and not only that of theprofit center.

It -should help measure the economic performance of the individual profit centers.

The tran~fer price system hasJ10 be simple to understand ~nd should be eaSy' to' ' administer. The managers shour~volve a complicated transfer pricing mechanism, which will require a lot of time to implement and operate.

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uesigning a good transfer pricing system is a big challenge that is faced by most ' organizations.

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Mana,!c!llcnt Control Systems

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Transfc;: priceis defineo in two ways. It is defined as the amount used in accounting for a.0Y transfer of goods and services. between responsibility centers. Anthony and Govindrajan use a narrower definition. They limit the .terrn transfer price to the value placed on a transfer of goods or services in transactions in which at ieast one of the two parties involved is a profit center, Transfer price should include an element of profit, the logic being that no compa.ny will

. transfer qood or services to another company at cost. The independent profit centers are therefore required to make a profit even while transferring the goods or services to another business unit of their own company.

Ti1e fundamental principle of transfer pricing mechanism is that the transfer price should be similar to (_I'c~ uic:.e that would be charged if the product were sold to outside customers or purcnased from outside vendors. This principle is not very easy to apply in the actual practice. :;0rn~ people. believe that there should be no element of profit in the transfer price, and the transfer p~i::~ ~hQu!d be set on marqinal costs. However in' the corporate world transfer price

"Vnen (credit ':f~rlU:i'S c)ra companv buy .and sell from and to each other, they are required to make tVIO decisions with regard to the product made by one and said to the other unit.

The first decision is known as the Sourcing Decision. The decision is also known as Make or Buy decision. The company has to decide ;f it should produce the product by itself or buy it from outside.'

The second decision is the transfer pricing decision. The decision to be made is if the prcduct is to be produced inside then at what price should it be transfer-eo between the profit. centers? This is [;lemost crucial and dirtlcult decision.

Let us now discuss the ideal situation necessary to exist in a company for the transfer price to be goai congruent. Only if these conditions prevail then the goal congruence will be acnieved.

The first isthat the people who arc going to make the transfer pricing deos.ons should be competent, ii! the sense that thcv must understand the short-term and long-term performance . or the.responsib.litvcenter. The')' also have to be good in the art of neootiation .

. The mar'9,;rs must understand their responsibility towards profitability a? an Important goal and the me,':150[ measurement of their performance. They shouto perceive transfer price as JUst.

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The idea: transfer price should be equal to the market-once of tne Identical product that I'> being transierred between units. This market price should reflect the same conditions regarding the quality of the orocuct. delivery time etc. However in practice the transfer price would have to be scaled downwards due to the sa·.;ings that will accrue from making the product msrde the company. The transfer PflC~ does not have to be factored With sale's promotion expense". advertrsmo expenses or risk premium for 'lad debts. The transfer once Vlill be bereft of exc r.c cuties and sales tax (is Viell. if 111(/ orooucts are bought from anotl1el umt of tile same cornoauv

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i under differen name t en the taxes may be applicable. As long as Reliance Industries and

t. Relia ce Petro - • 'ere di ere t companies, Reliance Industries for its purchases from Reliance

Pe axes. O'Ne e-r"ari:er the merger uf tuese twu comoantes, tiie tax

case in ndia excise duty on most products is covered under the re refundable. Also whenever VAT will be introduced, the problem of

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i:.s recards Ireedon I lo S0l.iI·Cc ;:; i='i"ufit center ",oOlo9c~ :;hould be free to sell t"1_ls products o lsi e e company, while the manager of the buying division should be free to buy (rom an outside source. This has to be so because the managers are responsible for the profit performance of the profit center. If such a situation really exists, then the market would determine the transfer price. The transfer price quoted by the selling division will be compared against the quotes received from the outside suppliers. This will involve negotiations between the buying and selling division. If the selling division is unable to match or improve upon the price of the outside supplier, then the buying division manager will be free to source his requirements from the outside market.

The, market price is the opportunity cost to the seller, because if he could not sell it inside the company, he has a ready market outside. Market price works well when the selling unit is not dependent only on the inside buyer and when the buying division has the option to procure from the outside market. From the company's point of view the market price is relevant cost of the product, because that will be the amount of cash that will be foregone by selling inside.

The managers before deciding the transfer price must have ful! information available, on the possible alternatives and the costs. thereof.

A smooth mechanism for negotiation between the buying and selling unit must exist for this method of transfer pricing to work effectively safeguarding the interests of both the uniits and the company as a whole.

Let us now take a look at the possible constraints that may exist in the way of the smooth functioninq of this method of transfer priCing mechanism.

The first is whether the buying unit manager will have the real freedom in the field of Sourcing? This freedom in reality may either not be feasible or may be constrained by the corporate pOlicy of the company .

One constraint that is possible is that selling or buying from outside may not be possible due to limited markets. If a company is normally sourcing internally, then outside capacity may not even exist. This will put limitations on outsourcing such components. Even if some capacity is available it may not be possible to source (rom there if the demand is not regular.

Secondly if the company is the sole producer of a differentiated product, no outside

capacity exists.

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Management Control Systems

72

Transfer Pnc1r::g_

If a company has made Investments in facilities to produce the components required, then it will not buy from outside, even If the capacity exists. However if the market price is close to the company's variable cost then the company can be interested, though this kind of a situation will he difficult to find.

The next point that needs to be looked at is how to find out the competitive prices especially when the company is neither selling or buying from outside.

One way is that if published price list of the products is available then that can be used. The price wilt have to found out for bulk quantity, 2S many times the published price could be the price for a single unit. The price that a supplier will Quote will depend on the quantity required, payment terms etc.

In case published prices are not available then they have to be found cut through the bidding process. This means that the company should float the inqulry for the product and. ask the interested vendors to quote their prices. However serious bidding will take place only if the vendors are confident that the company will actually give them orders for the supply of these components.

If the units of the company are selling part of their production outside, or buying part of their requirements from outside then the market price will be known.

When the selling profit center cannot utilise its full capacity, it affects the profitability of the company. In such a case it will make no sense if the buying unit. is partially buying its requirements from the outside market. On the other hand if the buying profit center is unable to buy from outslde.while selling profit center is selling part of its production to outside market, the company will not be able to optimise its profitability.

when itracompany buying or selling is small or temporary,· then the. matter will be left entirely to the buying and selling profit centers. In most companies there is a mechanism in the form of intervention from the top management in cases where there is a dispute between the buying and selling profit center. For example if the selling profit center has excess capacity and the buying profit center still buys from outside, the selling profit center will appeal to the·higher . managemehfto intervene and force the buying profit center to procure its requirements from

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, them. In the same the buying profit center can appeal if selling profit center sells outside when

buying centers requirements are not fully met. There can also be disputes related to the pricing ..

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These transfer prices are difficult and complex to set. But if market prices are not available then this method has to be used. In this type two crucial decisions have to be made a) How to oeiine costs? And b) What should be the profit mark-up?

The usual baSIS used (or setting these prices IS Stancard Costs, Actual costs ·,re «ot considered because they tend to pass on the production inefficiencies to the buyer:· I

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In determining the profit mark-up t>.'-IO dedstons need to be made. a) On what is the profit

._ ~2f!.:1.!~ to based? ,)_What ts the level of profit allowed?

The most po~ lar ethod used is, the markup is done as a percentage of costs, In ;1his - :s

e ui ement of capital. ts not considered. Another way Is to add a percentage of

_ is <:; ery difficult, as it Is not easy to calculate the Investment (or each product. markup should be near to the rate of return that would be earned, if the unit we~e an - epen ent cornpanysellinq to outsiders •

• any a time the profit center that sells the final product outside may not be aware of the I -

pstream costs and the profit markup In its internal purchases. Even when it is aware of this It

will be reluctant to reduce its own profitability to optimise the company's profitability.

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Two Step Transfer Prlcing :

In this the transfer price includes two charges. The first charge is the standard variable cost. of production of the unit. Then a periodic charge is made that Is equal to the fixed costs associated with the facilities reserved for the buying unit. The profit margin is to be factored in

either or both these components of the price. This method transfer the variable cost on a per

unit basis, and the fixed costs and profit is transferred on a lump sum basis.

lliustratlon of Two Step Transfer Pricing

Product A Sooo units

The manufacturing unit X Expected monthly sale to unit Y Variable cost per unit

Monthly fixed cost for product

Rs. 5 Rs.2CXXO -

Invest nent in working capital and Rs.12CXXXXl/fadllti~

ROI required per year

The calculation of transfer price:

Variable cost per unit + Fixed cost per unit + Profit per unit Transfer price per unit C;, :culation of profit:

Investment Rs .. -1200000

10%

Rs.5 Rs.4 Rs.2

Rs. 11 per unit.

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However let us now see what happens to the transfer price if the buying division buys only 4000 units in one month.

The variable cost 4000 x 5 Rs.20000
Fixed cost per month Rs.200C<l
ROI requirement per month Rs.1oooo
(As per the calculation above)
Total cost Rs. 5Ot.XX.)
Cost per unit 50000/4000 Rs. 12.50 per unit. So in case in a month in which the buying unit buys less than 'the agreed quantity they will pay a higher price per unit. In the same way if the buying unit buys more quantity then it will effectively pay lesser price per unit in that month. However it should be kept in mind that the fixed cost and the investment requirement is based on the basis of the quantity that is agreed upon between the two units.

In two step transfer pricing following points need to be considered.

• The monthly charge on account of fixed charges need to be negotiated periodically, and it will depend upon the number of units that agreed upon.

• The accuracy of the cost and investment allocation can be questioned. Some times there is a lot of difficulty in assig~ing costs and investments to a particutar product.

Under this system of arriving at the transfer price the sales volumes of the other unitoc not affect the manufacturing unit's profitability

• There can be conflict of interest between the manufacturing unit and the interest of the

. company. If the c(~jpacity is limited the manufacturing unit may wish to increase its profits by se!Jing in the outside market. However the management must make It clear that the buying unit will always have preference and Its needs have to be fulfilled before selling to outside customers.

Pr-ofit Sharing Method of Transfer Pricing

This system operates as follows:

The product is transferred ~o the marketing diVISion at the standard variable cost.

Mter the product IS sold the bus.ness unit's ~'lare of the contribution e.irned. which IS the Selling price nunus the vanablemanufacturing and marketing costs.

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ThiS method can create some problems, which may require the intervention from time to time, which is time consuming and is against the principle of decentralisation. Firstly there can be serious disagreement as to how to divide the contribution in the two units. This method divides profits arbitrarily and hence accurate information on profitability of each unit is not available. Since the contribution can be divided only after the sale, the manufacturing unilis completely dependent on the marketing division's ability to sell and on the actual selling price.

Two Sets of Prices Method of Transfer Pricing : In this method the manufacturing unit's revenue is credited at the outside sales price, and the buying urut IS chargee the i.ui.di standard costs. The difference is charged to a H.O. account and eliminated when business unit's financial statements are conso!idated. This is not a fair way of setting transfer price. The individuai unit's profitability cannot be measured in this system.

Transfer Price for Corporate Services: We had briefly discussed in the chapter on Profit Center that there is a problem that is associated with the charging the business units for the services that are provided to them by the corporate office. When these cnarqes are charged to the business units they do not include any profit margin. This therefore is not a transfer price. However there are two types of transfers:

1. For central services that the receiving unit must accept, but for which the amount of the service is at least partially controllable by the unit.

2. For central services that the business unit has the discretion of using or not using, Business unit are likely to use corporate staff for services like MIS and Rand D. Here the units cannot have any control on the efficiency of these services, but can seek to control the amount of service that he wishes to receive.

There are various arguments about these issues and the way these services should be priced.

One suggestion is that the business unit should pay the. :·~.ndard variable cost of the discretionary services. The argument is that if at least this cost is not paid then the business unit may be tempted to use these services uneconomically and indiscnrnnatelv. On the other hand if these units are charged more than the variable costs, then they I av choose not to use these services even though the management may actually want them to use such ;,_:-vices.

The other alternative suggested is that a price equal to the standard variable cost plus a fair share of the standard fixed costs, which is the full cost, but such cost shouid not be more than (he market price. The argument is that if the business units do not believe that these prices are not worth this amount then these services are either are not of qood quality or the efficiency of these services is not good.

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The thirci argument is that these services must be at the market prices if thev are available or

they should be priced at standard full cost plus a profit margin. The profit margin is return on . investment that the corporate has to make to provide the service. The rationale is that if the

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corporate office did not make these services available, the business unit will have to make investments on their own to have these services. Also the capital employed by a service unit should earn a return just like the- capital employed by a manufacturing unit must,

At times the ma'1agement may decide to give the freedom to the busrness units to d~itje as to whether they may use such services offered by the central service units. The business units are free to outsource such services, may develop their own capabilities or not use the service at all. This type of freedom can be given for activities like information processing or maintenance. The service providing units within the organization are independent and must stand on their own feet in any case.

Today we find many companies are outsourcing many services such as pay roll work or customer services through Call Centers. Companies like TELCO are outsourcing even logistic activities from outside parties. Outsourcing itself is becoming a very popular way with many a corporate. Many companies from the U. S and Europe are outsourcing services like invoicing, follow up of payments etc. from many a Indian companies. Before the outsourcing became the norm, these services were obviously provided by the service units within the organization. With cost cutting possibilities being enormous through outsourcing, companies are willing to outsource many a services to make' substantial savings. It is also clear that since many services are now outsourced, the service centers providing these services have to be closec.i down.

In India we have a classic case of charging corporate services, which was introduced in Tata Group by the group Chairman, Mr. Ratan Tata. Mr. Tata decided some years back that all companies in the Tata Group have to contribute 5% of their after tax profits towards the corporate services and should be paid to Tata Sons. His argument is that the group companies get a preferential treatment in the market because they belonged to the Tata Group. He also argues that the funds such collected will be used for these companies in many ways ultimately. Tata group has used these funds to consolidate the holdinrs in the group companies where the holding was less.

Many a Tata group CEOs like Mr Ajit Kerkar the then Chairman of Indian Hotels were very unhappy with this proposal and actually got into a conflict with the group Chairman on thiS issue. However Mr. Tatas wish ultimately prevailed and Mr. Kerkar had to leave the Tata group.

Let us now take a look at how the decided transfer price needs to be implemented It has already been seen that lot of negotiations are necessary between the business unit managers before deciding the transfer prices. What needs to be clearly soelt out. as a pohcv IS the degree - of negotiation allowed, in setting the transfer prices, and methods of resclvmc the conflicts associated with transfer price mechanism.

In most cornoarues the transfer prices are set through the method of negotiations between the business unit managers without the Interference of the central office. In .:; decentlallsed organization It IS the respons.buuv of the manger of the busmess unit to cec.oe ~he seillnt] and purchase prices A negotiated transfer price represents a compromise l)e::,cen the two

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concerned manaqers. If the central office decides the transfer prices then they will be' blamed in case the profit performance of any of the two divisions is not as required. The concerned units are also likely to ore aware on the markets and the costs and are thus best suitable to decide the

transfer .pnce ...

In many companies managers are free to deal with each other or the outsiders. as they may deem proper.

iviallY tiiltE ir.:;~ite cf lay:ng aU procedures there will be times when there will be a contlict among business units while fixing the transfer prices. To resolve such conflicts an Arbitration mechanism has to be evolved and put in place. Arbitration can be through a single person. or through a committee constituted for this purpose. Such a committee needs to have three responsibilities:

1. To settle the transfer price disputes.

2. To review the sourcing decision.

3. To change the transfer price rules when necessary.

It is necessary that only few disputes should reach the stage of arbitration. If business unit managers are unable toresolve conflicts at their own level it would mean many things. For one the competency of these managers would be questioned. It will also mean .that the existing, procedure laid down by the senior management is inadequate and not clear. Arbitration by itself is a very time consuming exercise and will cause unnecessary delay in decision making. It is the experience of many companies the arbitration award many times leaves both the parties unsatisfied, because the arbitration would result essentially in a compromise.

The arbitration route should be kept open, because otherwise legitimate grievances may Got have a platform. Absence of arbitration will also hide the fact that there are problems with the transfer price system.

One example of setting transfer prices was recently reported in Hindustan Lever. Hindustan Lever is to supply bagged tea to its parent Unilever. HLL won this contract through internal biduing by many units of Unilever. This is an interesting way of setting transfer price within a group.

Such system will not work say in companies like Reliance for example. Refiance witnesses a lot of inter unit transfers. because the company is fully integrated. But there are no competing units here as they are in the case of Unilever.

Numerical Problems on Transfer Pricing

Illustration 1 :

Hummer Sewing r-tachine Company is a decentralized manufacturing company in which all the major component parts are made by separate divisions that are operated as profit centers.

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The motors for the sewing machines are made by the r"1TO division of the company. The MTO division has more capacity-than required to satisfy production needs for the company's sewing

200 each and the rest were sold to the assembly division of the Hummer Sewing l-1achine Company. The industry average for the marketing and distribution costs of this type of molar is 20% of selling price.

The MTO division made 25,000. motors during 2002 and incurred the following total standard manufacturing costs and actual operating expenses -

Direct: Material

Direct Labour

Manufacturing Overheads Total Production Cost variance

Rs. 15,00,000 Rs. 10,00,000 Rs. 8,00,000

Rs. 4,00,000 Unfavourable

Operating Expenses - Selling and Distribution Administration

Rs. 2,00,000 Rs. 8,00,000

Evaluation of the production standards I· .s led to lhe decision to increase production standard costs by 100/0 for the coming year. Market clI.:lysis indicates a 6% price increase is logical for motors. With the new standard costs, management of Division MTO expects variances from standards will average S% Unfavourable. No changes are expected in selling and distribution expenses or administration expenses. Production and sales quantities are expected to be the same as in 2002.

Ca .ulate the transfer price for the sewing machine motors for each of the following 'independent asscrnptions. The transfer price should -

(a) based on 2002 standard product cost (b) based on 2002 actual product cost

(c) be based on 2003 standard product cost (d) be based all 2003 actual product cost (e) be based on 2003 market price

(f) be based on 2003 market price modified for marketing and distribution costs (g) provide a 6% profit in 200 3 on expected total costs

(h) prepare a schedule stl0wtng the MTO ijlvlSlon'S net Income for ('(j(11 of tne 2003 base transfer price alternatives.

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The calculation of cost for the years 2002 and 2003 will be as below:

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Particulars 2002 (Rs) 2003 (Rs)
---- -- -------- -- .
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lO,OO,CXXl l1,OO,(XX)
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Standard Production Overheads 8,OO,CXXl '8,SC,COO
Standard Production Cost 33,OO,CXXl -~-.
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Production Cost Variance (Unfavourable) 4,OO,CXX) 1,81,500
Actual Production Cost 37,00,000 38,11,500
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Administration Expenses 8,OO,CXXl 8,OJ,em
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Selling and Distribution Expenses 2,OO,CXXl :.2,00,(0)
Actual Total Cost 47,00,000 48,11,500 Calculation of Transfer Price on the basis of various .. Iternatives -

(a) Based on 2002 Standard Production Cost Rs. 33,00,000 I 25,000 Units = Rs. 132 Per Unit (b) Based on 2002 Actual Production Cost

Rs. 37,00,000 125,000 Units = Rs .. 148 Per Unit (c) Based on 2003 Standard Production Cost Rs. 36,30,000 I 25,000 Units = Rs_ 145_20 Per Unit (d) Based on 2003 Actual Production Cost

Rs. 38,11,500 125,000 Units = Rs_ 152.46 Per Unit

(e) Based on 2003 Market Price

r'1arket Price for 2003 is higher by 6% over Market Price of 2002

As !'1arket Price of 2002 is Rs. 200 Per Unit, Transfer Price will be 106% of Rs. 200 i.e. Rs. 212 Per Unit

(f) Based on 2003 Market Price modified for marketing and distribution costs r'1;;rket Price for 2003 is Rs. 212 Per Unit and Selling and Distribution expenses are 20% of the r-tarket Price. k, such, Transfer Price will be 80% of Rs. 212 i.e. Rs. 169.60 Per Unit

(g) At a profit of GO/o on 2G03 Expected Tota! Cost

2003 Total Cost is Rs. 48,11,500 + 6% Profrt: i.e. 2,88,690 ::: Rs. 51,00,190

Hence, transfer Price will be Rs. 51,00,190/ 25,000 Units::: Rs. 204 Per Unit

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. . Transfer PrlCI~

Profit abif ity Statement of MTD division when 2003 Transfer Price is Oil the basis specified above

Part:CU!3:--$ c I d I ~ I f I 9 I
Sales
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7,500 Units Rs. 212 per unit 1590,OXl 1590,000 1590,OOJ 1590,(0) 1590,(0)
17,500 Units at the 2541,OXl 2668,050 3710,OOJ 2968,(0) 3570,(0)
calculated transfer price
Expected Total Sales 4131,CXXl 4258,050 SJOO,OOJ 4558,OCO 5160,(0)
Expected Total Cost 4811,500 4811,500 4811,500 4811,500 '1811,500
I Expected profit (-)680,500 (-)553,450 488,500 {-)253,SOO 348,500 Illustration 2 :

Faster Limited is having production shops reckor.ed as cost centers. Each shop charges other shops for material supplied and services rendered. .

The shops are motivated through goal congruence, autonomy and management efforts. Fasters Limited is having a welding shop and a panting shop. The weidingshop welds annually 75,000 purchased items and other 1,50,000 shop made parts into 12})OO assemblies. The assemblies have variable cost of Rs. 9_50 each and are sold in the market at Rs. 12 per assembly. Out of the total production, 80% is divested to the painting shop at the same price ruling in the market. Welding shop incurs a fixed cost of Rs. 25,000 per annum. The painting shop is having fixed cost of Rs. 30,000 and its cost of painting including transfer price from welding shop comes to Rs. 20 per unit. This shop sells all the units transferred to it by welding shop at Rs. 20 per assembly. -IOU are required to-

(a) Find out the- profit of individual cost centers and overall profitability of the concern.

(b) Recommended course of action if painting shop wishes to purchase Its full requirement (at market price which is Rs. 10 per assembly) either (rom open market or (rom welding shop at market price of Rs. 10 per assemblv. Give reasons for your recommendations

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Solution:

(Profitability Statement - Welding Shop)

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t=,.~ Rs. I Rs. I
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Variable Cost 12/XX) 950 1, 14,CXXl
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Contribution 250 30,CXXJ
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Fixed Cost 25,COJ
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Profit 5,COJ Profitability Statement - Painting Shop

Particulars No. of Units Per Unit
Rs.
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Sales 9~600 25.00
Variable Cost 9,600 20_00 I
Contribution 5.00
Fixed Cost
Profit Total I

Rs. !

_ _ J

i

2,4D,CXX) I

- 1, 92,CXX) I

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48,roJ I

- ~g,00J j

lS,OX)

Hence, the total profit of the company as a whole will be Rs. is.coo

Proposal I - Painting Shop purchases its entire requirement from open market Profitability Statement - Welding Shop

- ---- -- --.--- .. _-_.'_ ... - 1
Particulars No. of Units Per Unit
Rs_ j
Sales 2,400 12.00 I
Variable Cost 2,400 9.50 I
Contribution 2.50 I
I
Fixed Cost I
I
--
Profit I
--_. .-------_---- ... ~ Total

Rs.

28,800 22,800

6,0X)

2S,CXXl

(-)19,CXX)

Managcmcnt Control_ Sy_s_k_ln_s _

82

Transfer Prtctng_

Profitability Statement- Painting Shop

Particulars No. of Units Per Unit - Total
Rs. Rs.
Sales 9,600 25.00 2,40,(X))
Variable Cost
Purchased Components 9,600 10.00 96,(X))
In-house Variable Cost 9,600 8.00 76,800
--- ------ -----_
I
Total Variable Cost 18,00 1,72,800 I

Contribution 7,00 67,200
----_
Fixed Cost 30,(X))
Profit 37,200 Total profits of the company as a whole will be Rs. 18,200 i.e. Profit of Rs. 37,200 of painting shop less loss of Rs. 19,000 of Welding Shop.

Proposal II - Painting Shop purchases its entire requirement from Welding Shop at the market price

Profitability Statement- Welding Shop

Sale

No. of Units

Per Unit Rs.

Particulars

Total Rs.

~ __ O_p_e_n _m_a_r_ke_t + ' _2,_400 -1 1_2_.00_. __ I ._ ~8_,_800 ~

Paint Shop 9,600 10.00 96,(X)) i

1------'----------+----·----1---·- -----1---------:

12,roJ

I-------------j---------- ----.-------- .--- ... ---.-------,

I

12,roJ

1,24,800

Total Sales

25,CXXl

9.50

Variable Cost

1,14,CXXl

1---------------1---------1------- ----- .. ------ ---- ..

Contribution

2.50

10,800

_----- -------j- -----_.- --.- -.-

Fixed Cost

L ..

(-)14,200

Profit

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Trans~cr Prlcllll.!

Profitability Statement - Painting Shop

Particulars ------ I No. of Units -- ---;e-;Unit--i--Total

____ -+- -+- __ . __ Rs.. _J Rs __ . __ ~

.~:~~~~f:~weldm9~hOD-j-~~': ~_~- ~~~.~:.: =~~I~~: 2,::

------ ------- --------- ---------- -- - .. _- ----- ------

In-house Variable Cost 9,600 - 8.00 76,800

:rotal Variable Cost 18.00 1,72,800

------+--------1--- ----- ---------

Contribution 7.00 67,200

----------------1----- - -------- -- ----------'------j

Fixed Cost

30,OX)

~------ --- ------4------------------- .. --- ---- -----'----,

37,200

------------------'---------'---------------- -- ---- - ------'

Profit

Total profits of the company as a whole will be Rs. 23,000 i.e. Profit of Rs. 37,200 of painting shop less loss of Rs. 14,200 of Welding Shop.

Note: At present, total variable cost per unit of painting shop is Rs. 20 which includes Rs. 12 per unit being the transfer price of the welding shop. It means that the variable cost incurred by the painting shop in-house is Rs. 8 per unit

Conclusion: The effect on the profitability of the various possible situations can be summarized as below:

Situation Welding Shop Painting Shop Total
Existing .s.coo B,OC() 13,cro -
Proposal I (-)19,000 37,200 18,200
Proposal II (-)14,200 37,200 zs.o» Illustration 3 :

The AS Company has two divisions X and Y. One of the part produced by division X is used in the manufacture of a product that is assembles at division Y_ n-:, part is not unique and there is readily defined market so that X can sell outside the firm and Y can buy from outside.

o

Following details are available in respect of division X -

Capadtv to produce the part 1,25,000 units

External sales at Rs. 100 per unit 1,00,000 units

Transfer to division Y 25,000 units

Variable production cost per unit Rs. 84

Variable selling cost per unit (only on external sales and not on transfers) Rs_ 2

Fixed production costs per unit (based on 1,25,000 units) Rs_ 6

Fixed selling costs per unit (based on 1,00,000 units) Re. 1

ManagcmcntControl Systc~_._

The division Y represents the following data on the assumption of a volume of 25,000 units (one part is needed for each unit of its own production)

Variable production cost per unit (excluding transfer price or outside

Rs.100

purchase price)

Variable selling cost per unit Fixed production cost per unit Fixed selling ccst per unit Sel!lng price of finished product

You are required to make the following calculations:

(a) If division X could sell 1,25,000 units at Rs. 100 each in the outside market, what transfer price the central management would prefer in order to provide proper motivation to division Y.

Rs. 6

Rs.10

Rs. 4

Rs. 240

(b) As management accountant, would you advise division Y to buy at the transfer price determined in "a" above.

(c) Assume transfer price determined as .in "au above. If. selling price drops to Rs. 200, should division Y buy at that price I Would this be advisable from the point of view of the firm and why?

(d) Assume that division x's product did not have an outside demand in excess of 1,00,000 uni::- and its total fixed production cost could be reduced by 10%, if the volume of production were reduced to 1,00,000 units, what is the appropriate transfer price?

(e) Suppose thatdivision X's maximum outside demand is 1;10,000 units at Rs. 100 and there is no other usage for the capacity. What transfer price should t:.c company management prefer)

Cf) Suppose that the unit selling price of division Y's product is Rs. 180, one of its customers is also the customer of division of X, division Y refuses to buy the part from the outside market at Rs. 100 since the selling price of Rs. 180 would not cover the variable costs, it division X does not cover the transfer price, division Y will not sell to this customer who in turn will probably cancel the usual order of 50,000 units to division X, there is no other demand for the product and no other usage of X's capacity, fixed costs would not change at either division. What is the lowest transfer price that the division X would be advised to accept) Support the recommendations with computation.

Solution:

(a) If Division A can sell the entire production of 1,25,000 units in the outside market, it can generate contribution of P-s. 14 per unit i.e.

Selling price per unit

Variable production cost per unit Variable selling cost per unit Contnbut Ion per un it

Rs. 100 Rs. 84 Ks. 2 Rs. 14

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85

Transfer of 25,000 units to Division 8 will result into the loss of contribution of Rs. 14 per unit. Hence, the ideal transfer price should be

Variable production cost per unit loss of contribution per unit

Rs.B4 Rs. 14 Rs. 98

Transfer Price per unit

(u J 11 uivi::,iull a buys at the transfer price stateci In "a" above, the profitability statement of Division 8 per unit wil! be as below -

Particulars Rs. Rs.
Selling Price per unit 240
Variable Co st
Variable Production Cost 100
Transfer Price of Oivision A ss
Variable Selling Cost per unit 6 I
Total Variable Cost per unit ! 204
Contribution per unit 36 As Division B generates th,= contribution of Rs. 36 per unit, the transfer price of Rs. 98 per unit is justifiable.

(c) If Division B buysat th-e transfer price stated in "a" above but the selling price per unit drop S to Rs. 200 per unit, the p.rofltability statement of Division B per unit will be as below -

I particulars: -+ Rs_. __ t-I Rs_. __ ----j

Selling Price per unit 200

Variable Cost

,

_J ~ ~ )~.

------------_._-----------j---------j-------------

Variable Production Cost

100

Transfer Price of Division A ~ I

----------------.----- --------"1------i------

6

Variable Selling Cost per unit

201

Total Variable Cost per unit ------T--------+--------------j

Contribution per unit

As Division B generates the ne gative contribution of Rs. 4 per unit, the transfer price of Rs.

C7P

98 per unit is not justifiabte.

, .

Management Contra! Systems

86

Illustration 4 :

A company is organized on decentralized lines with each manufacturing division operating as a separate profit center. Each division manager has ful! authority to decide on sale of the division's output to outsiders and to other divisioes.

Division C has always purchased its requirements of a component from Division A. But when informed that Division A was increasing its selling price to Rs. iSO, the manager of Division C decided to look at outside suppliers.

Division C can buy the component from an outside supplier for Rs. 135. But Division A refuses to lewer its price in view of its need to maintain its return on investment.

The top management has the fallowing information - Cs annual purchases of the component - 1,000 units

- Rs, 120 Rs. 20

-Rs.120

- Rs. 20

A's variable cost per unit A's fixed cost per uni Required :

(a) Will the company as whole benefit, if Division C bought the component at Rs. 135 from

an outside supplier.

(b) If A did not produce the material for C, it coula usc the facilities for other activities resulting in a cash operating savings of KS. 18,000. Should C then purchase (rom outside sources?

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(c) Suppose there is no alternative use of A's facilities and the market price per unit for the component droops by Rs. 20, should C buy from outside?

Solution:

Situation r - Division C buys the component from outside supplier-

Purchase Price per component 1000 units @Rs. 135 per unit

Less: Reduction in variable cost for A @Rs. 120 per unit Effective cost for the company as a whole

ns. 1,35,000

Rs. 1,20,000 Rs. 15,000

Conclusion - As the proposal to buy from the outside supplier does not result in the 'saving for the company, the company should not go for it.

Situation " - Decision to buy from outside supplier results in cash savings-

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Purchase Price per component 1000 units @Rs. 135 per unit Less: Reduction in variable cost for A @Rs. 120 per unit Cash Savings

Rs. 1,3S,CXXl Rs. 1,20,CXXl Rs. 18,CXXl Rs. 1,38,CXXl

Total reduction In cost

Effective saving for the company as .ll'Ihole

R..s. 3,CXXl

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Conclusion - As the proposal to buy from outside supplier results in net saving for the company, the company should go for it.

Situation III - Division C buys the component fr0mnutslde'S(fpplre'~ at' the ;ed'uced ~rice -

Purchase Price per component 1000 units @Rs. 115 per unit Less: Reduction in variable cost for A @Rs. 120 per unit Effective saving for the company as a whole

Rs.l,15,OCO Rs. 1,20,000 Rs.5,OOO

Conclusion - As the proposal to buy from outside supplier results in net saving for the company, the company should go far it.

Illustration 5 :

Division A of Better t-1argins Limited has been given a budoeted target of selling 2,00,000 components of CoM21, it manufactures at a price which would fetch a return of 25%00 the average assets employed by it. The following figures are relevant -

Fixed Overheads variable Cost

Rs. 4,00,000

Re. 1 per unit

Average Assets - Debtors

Stocks

Plant and Other Assets

ss.z.co.coo Rs. 6,00,000 Rs.4,OO,OOO

However, the marketing department of the company finds out by a survey that the maximum number of CoM21, tf ~ market can take at the proposed price is only 1,40,000 units.

Fortunately, Division B is willi,.; to nllrchase the balance 60,000 units. The manager of A is wiliing to sell to Division B at a concessional price of Rs. 4 per unit. But the rnanaqer of Division B is ready to pay Rs. 2.25 per unit, as he feels he can make CoM21 in his division at that price.

Rather than selling to Division Bat Rs. 2.25 per unit, manager of division A feels that he will restrict the activity to his division to manufacture and sale of 1,40,000 components only. Gy this he can reduce Rs. 80,000 in stocks, Rs. 1,20,000 of plant and other assets and Rs. 40,000 in selling and administration expenses.

As management accountant, do you agree with the proposition of manager of Division A to restrict the activities to 1,40,000 components, from the overall interest of the organization. Give detailed workings.

Solution:

Considering the target given to Division A, the budgeted profitability stater.:\r 2,00,000

units will be as below : ~

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Manap;cll\cnt Con trot Systems

88· Transfer Pr1clr~i?:

.. _-----_._---_._._--_._._-- -- -.-~

Particulars Rs I
variable Cost @Re. 1 per unit 2,00,~1
,
fixed CNerheads 4,00,000
Expected profit @25% on Rs. 12,00,000 3,00,000
Hence, Budgeted Sales 9,00,000
- As the budgeted sales for 2,00,000 units are Rs. 9,00,000; per unit selling price will be Rs. 4.50 i.e. Rs. 9,00,000/2,00,000 units.

Following two proposals are to be considered -

Proposal! - Selling 1,40,000 units to outside parties @Rs. 4.50 per unit and 60,000 units to Division B @Rs. 2.25 per unit.

Proposal II - Selling 1.40,000 units to outside parties @Rs. 4.50 per unit Profitability Statement under the above two proposals will be as below -

I Particulars I Proposal I-Rs ; Proposal II-Rs

Sales i I
1,40,000 units @Rs. 4.50 per unit I 6,30,CXXl I 6,30,000
I
60,000 units @Rs. 2.25 per unit I 1,35,CXXl ; Nil
Total Sales I 7,65,CXXl I 6,30,000
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Variable Cost @Re. 1 per unit I 2,OO,CXXl I 1,40,000
I I
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Contribution 5,65,CXXl I 4,90,000
Fixed Overheads 4,OO,CXXl i 3,60,000
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- I
Profit I 1,65,CXXl I 1,30,000
I I
Investment in Assets i 12,OO,CXXl i 10,00,000 J
I I I
__ _l_ -_. -- ·_·--1
Return on Assets in Percentage , 13.75 1300 ,
._---------------------- ---- .---- - Conclusion :

I As the proposal to make the sales only to outside parties @Rs. 4.50 per units reduces lhe

II,'

\ Return on Assets, the proposal will not be acceptable.

I (lustra tion G :

SV Limited manufactures a product which IS obtained basicauv from J ser.es of mIXIng operations. TIle flnislled product IS pack<1ged in tile company rr.ace glass bottle'; and ~aclt"d In thc auracuve cartons.

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The company is orqanized into two independent divisions viz. one for the manufacture of the end product and the other for the manufacturing of [l Lakhs bottles. The product manufacturing division can buy all the bottle requirements from the bottle manufacturing division.

The General Manager of the bottle manufacturing division has obtained the following Quotations from the outside manufacturers for the supply of emoty bottles -

I No. of empty bottles Total Purchase Value (Rs.)
8,00,000 14,00,(0)
-_._-----_._-- ----. - . ._--_._--- - ... ----
12,00,(0) 20,00,(0) A cost analysis of the bottle manufacturing division for the manufacturinq of empty bottles reveals the following production costs -

No. of empty bottles Total Cost (Rs.)
8,00,000 10,40,000
12,00,000 14,40,CXXl The production cost and sales value of the end product marketed by the product manufacturing division are as under -

-r----· - -- -- -- .. -.-. -- - I
Volume Total Cost of end product Sales Value
(Bottles of end product) (Excluding cost of empty (Packed in bottles) I
bottles) Rs.
Rs.
8,00,CXXl 64,80,CXXl 91,20,000
12,00,000 96,80,(0) 1,27,80,000 I

I.'

There has been considerable discussion at the corporate level as to the use of proper price for transfer of ernp v bottles from the bottle manufacturing division to product rnanufacturinq division. This interest 'J hei"htened because a significant portion of the Divisional General Manager is in incentive bonus based on profit center results.

As the corporate management accountant responsible for defining proper transfer prices for the supply of empty bottles by the bottle manufacturing division to the product manutacturino division, you are required to show for the two levels of volumes of 8 Lakh and 12 Lakh bottles, the profitability by using (a) market price and (b) shared profit relative to the costs involved basis for the determination of transfer prices, The profitability portion should be furnished separately for the two divisions and the company as a whole under each method. Also

I

discuss the effect of these methods on the profitability of two divisions.

90

Solution:

Profitability Statement of the two divisions if transfer price Is based- on the market price-

Bottle Manufacturing Division -

---------- ----- - _ .. ------- _------- .- ,--------- .. _.-
Particulars
Volume - Number of Bottles 8,OO,roJ 12,OO,o::xJ
Sales - Rs. 14,00,00J 20,00,o::xJ
---------- ------------ -~------ ----- ._._--_---
Cost - Rs. 10,4D,OCD 14,4D,00J
Profit 3,60,OCD 5,60,COJ Product Manufacturing Division -

-- --------_.- -.------ --.--------- - .. - ---------_-
Particulars
-
Volume - Number of Botties 8,OO,CXXl 12,00,CXXl
Sales - Rs. 91,20,CXXl 1,27,BO,CXXl
Cost- Rs.
Incurred in division 64,BO,CXXl 96,BO,CXXl
Transfer price of the bottles 14,00,00J 20,00,CXXl
.. - --- .. ---- -_--. --- . - --_.------ . - ----"_-- -_---_ .. _--_ . -._._- - _ .. _-
Total Cost - Rs. 78,BO,00J 1,16,BO,CXXl
Profit 12,40,00J 1l,00,CXXl As such, the total profits of the company as a whole will be -

For 8 Lakhs bottles - Rs. 3,60,000 + Rs. 12,40,000 := Rs. 16,00,000 For 12 Lakhs bottles - Rs. 5,60,000 + Rs. 11,00,000 := Rs.16,60,000

Profitability Statement of the cornp anv if transfer price is based on the shared profit relative to the costs -

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________ ~3_O,CXXl l'3~,8g_'_CX!?1

-- ---- ----1- . '-1

:~,:',CXXlCXXl"-'- _j 96,80.CXXl I 14. 4{). COJ I

- - -- 1

7S.20.CXXl ,

,

Sales - Rs. Cost - Rs.

Particulars

Volume - Number of eottles

I J

Incurred in product manufacturing div.sion Cost of the bottle l1lanu(actwlf19 divrsron Total Cost - Rs.

1,l1.20.0c0 ;

16.00,CXXl :

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71

Trnn sfcr ('rlc:l1!!

i under differen name t en the taxes may be applicable. As long as Reliance Industries and

t. Relia ce Petro - • 'ere di ere t companies, Reliance Industries for its purchases from Reliance

Pe axes. O'Ne e-r"ari:er the merger uf tuese twu comoantes, tiie tax

case in ndia excise duty on most products is covered under the re refundable. Also whenever VAT will be introduced, the problem of

c

i:.s recards Ireedon I lo S0l.iI·Cc ;:; i='i"ufit center ",oOlo9c~ :;hould be free to sell t"1_ls products o lsi e e company, while the manager of the buying division should be free to buy (rom an outside source. This has to be so because the managers are responsible for the profit performance of the profit center. If such a situation really exists, then the market would determine the transfer price. The transfer price quoted by the selling division will be compared against the quotes received from the outside suppliers. This will involve negotiations between the buying and selling division. If the selling division is unable to match or improve upon the price of the outside supplier, then the buying division manager will be free to source his requirements from the outside market.

The, market price is the opportunity cost to the seller, because if he could not sell it inside the company, he has a ready market outside. Market price works well when the selling unit is not dependent only on the inside buyer and when the buying division has the option to procure from the outside market. From the company's point of view the market price is relevant cost of the product, because that will be the amount of cash that will be foregone by selling inside.

The managers before deciding the transfer price must have ful! information available, on the possible alternatives and the costs. thereof.

A smooth mechanism for negotiation between the buying and selling unit must exist for this method of transfer pricing to work effectively safeguarding the interests of both the uniits and the company as a whole.

Let us now take a look at the possible constraints that may exist in the way of the smooth functioninq of this method of transfer priCing mechanism.

The first is whether the buying unit manager will have the real freedom in the field of Sourcing? This freedom in reality may either not be feasible or may be constrained by the corporate pOlicy of the company .

One constraint that is possible is that selling or buying from outside may not be possible due to limited markets. If a company is normally sourcing internally, then outside capacity may not even exist. This will put limitations on outsourcing such components. Even if some capacity is available it may not be possible to source (rom there if the demand is not regular.

Secondly if the company is the sole producer of a differentiated product, no outside

capacity exists.

·{

Management Control Systems

72

Transfer Pnc1r::g_

If a company has made Investments in facilities to produce the components required, then it will not buy from outside, even If the capacity exists. However if the market price is close to the company's variable cost then the company can be interested, though this kind of a situation will he difficult to find.

The next point that needs to be looked at is how to find out the competitive prices especially when the company is neither selling or buying from outside.

One way is that if published price list of the products is available then that can be used. The price wilt have to found out for bulk quantity, 2S many times the published price could be the price for a single unit. The price that a supplier will Quote will depend on the quantity required, payment terms etc.

In case published prices are not available then they have to be found cut through the bidding process. This means that the company should float the inqulry for the product and. ask the interested vendors to quote their prices. However serious bidding will take place only if the vendors are confident that the company will actually give them orders for the supply of these components.

If the units of the company are selling part of their production outside, or buying part of their requirements from outside then the market price will be known.

When the selling profit center cannot utilise its full capacity, it affects the profitability of the company. In such a case it will make no sense if the buying unit. is partially buying its requirements from the outside market. On the other hand if the buying profit center is unable to buy from outslde.while selling profit center is selling part of its production to outside market, the company will not be able to optimise its profitability.

when itracompany buying or selling is small or temporary,· then the. matter will be left entirely to the buying and selling profit centers. In most companies there is a mechanism in the form of intervention from the top management in cases where there is a dispute between the buying and selling profit center. For example if the selling profit center has excess capacity and the buying profit center still buys from outside, the selling profit center will appeal to the·higher . managemehfto intervene and force the buying profit center to procure its requirements from

~ .

, them. In the same the buying profit center can appeal if selling profit center sells outside when

buying centers requirements are not fully met. There can also be disputes related to the pricing ..

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These transfer prices are difficult and complex to set. But if market prices are not available then this method has to be used. In this type two crucial decisions have to be made a) How to oeiine costs? And b) What should be the profit mark-up?

The usual baSIS used (or setting these prices IS Stancard Costs, Actual costs ·,re «ot considered because they tend to pass on the production inefficiencies to the buyer:· I

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~_ " Management Control SystCl1\~ __ ... _. __

;,t-' The Profit Mark-Up:

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73

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In determining the profit mark-up t>.'-IO dedstons need to be made. a) On what is the profit

._ ~2f!.:1.!~ to based? ,)_What ts the level of profit allowed?

The most po~ lar ethod used is, the markup is done as a percentage of costs, In ;1his - :s

e ui ement of capital. ts not considered. Another way Is to add a percentage of

_ is <:; ery difficult, as it Is not easy to calculate the Investment (or each product. markup should be near to the rate of return that would be earned, if the unit we~e an - epen ent cornpanysellinq to outsiders •

• any a time the profit center that sells the final product outside may not be aware of the I -

pstream costs and the profit markup In its internal purchases. Even when it is aware of this It

will be reluctant to reduce its own profitability to optimise the company's profitability.

y

Two Step Transfer Prlcing :

In this the transfer price includes two charges. The first charge is the standard variable cost. of production of the unit. Then a periodic charge is made that Is equal to the fixed costs associated with the facilities reserved for the buying unit. The profit margin is to be factored in

either or both these components of the price. This method transfer the variable cost on a per

unit basis, and the fixed costs and profit is transferred on a lump sum basis.

lliustratlon of Two Step Transfer Pricing

Product A Sooo units

The manufacturing unit X Expected monthly sale to unit Y Variable cost per unit

Monthly fixed cost for product

Rs. 5 Rs.2CXXO -

Invest nent in working capital and Rs.12CXXXXl/fadllti~

ROI required per year

The calculation of transfer price:

Variable cost per unit + Fixed cost per unit + Profit per unit Transfer price per unit C;, :culation of profit:

Investment Rs .. -1200000

10%

Rs.5 Rs.4 Rs.2

Rs. 11 per unit.

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120000

Monthly profit Rs. -u = Rs.ICXXXl

Profit per unit = = units

= Rs. 2 per unit

However let us now see what happens to the transfer price if the buying division buys only 4000 units in one month.

The variable cost 4000 x 5 Rs.20000
Fixed cost per month Rs.200C<l
ROI requirement per month Rs.1oooo
(As per the calculation above)
Total cost Rs. 5Ot.XX.)
Cost per unit 50000/4000 Rs. 12.50 per unit. So in case in a month in which the buying unit buys less than 'the agreed quantity they will pay a higher price per unit. In the same way if the buying unit buys more quantity then it will effectively pay lesser price per unit in that month. However it should be kept in mind that the fixed cost and the investment requirement is based on the basis of the quantity that is agreed upon between the two units.

In two step transfer pricing following points need to be considered.

• The monthly charge on account of fixed charges need to be negotiated periodically, and it will depend upon the number of units that agreed upon.

• The accuracy of the cost and investment allocation can be questioned. Some times there is a lot of difficulty in assig~ing costs and investments to a particutar product.

Under this system of arriving at the transfer price the sales volumes of the other unitoc not affect the manufacturing unit's profitability

• There can be conflict of interest between the manufacturing unit and the interest of the

. company. If the c(~jpacity is limited the manufacturing unit may wish to increase its profits by se!Jing in the outside market. However the management must make It clear that the buying unit will always have preference and Its needs have to be fulfilled before selling to outside customers.

Pr-ofit Sharing Method of Transfer Pricing

This system operates as follows:

The product is transferred ~o the marketing diVISion at the standard variable cost.

Mter the product IS sold the bus.ness unit's ~'lare of the contribution e.irned. which IS the Selling price nunus the vanablemanufacturing and marketing costs.

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ThiS method can create some problems, which may require the intervention from time to time, which is time consuming and is against the principle of decentralisation. Firstly there can be serious disagreement as to how to divide the contribution in the two units. This method divides profits arbitrarily and hence accurate information on profitability of each unit is not available. Since the contribution can be divided only after the sale, the manufacturing unilis completely dependent on the marketing division's ability to sell and on the actual selling price.

Two Sets of Prices Method of Transfer Pricing : In this method the manufacturing unit's revenue is credited at the outside sales price, and the buying urut IS chargee the i.ui.di standard costs. The difference is charged to a H.O. account and eliminated when business unit's financial statements are conso!idated. This is not a fair way of setting transfer price. The individuai unit's profitability cannot be measured in this system.

Transfer Price for Corporate Services: We had briefly discussed in the chapter on Profit Center that there is a problem that is associated with the charging the business units for the services that are provided to them by the corporate office. When these cnarqes are charged to the business units they do not include any profit margin. This therefore is not a transfer price. However there are two types of transfers:

1. For central services that the receiving unit must accept, but for which the amount of the service is at least partially controllable by the unit.

2. For central services that the business unit has the discretion of using or not using, Business unit are likely to use corporate staff for services like MIS and Rand D. Here the units cannot have any control on the efficiency of these services, but can seek to control the amount of service that he wishes to receive.

There are various arguments about these issues and the way these services should be priced.

One suggestion is that the business unit should pay the. :·~.ndard variable cost of the discretionary services. The argument is that if at least this cost is not paid then the business unit may be tempted to use these services uneconomically and indiscnrnnatelv. On the other hand if these units are charged more than the variable costs, then they I av choose not to use these services even though the management may actually want them to use such ;,_:-vices.

The other alternative suggested is that a price equal to the standard variable cost plus a fair share of the standard fixed costs, which is the full cost, but such cost shouid not be more than (he market price. The argument is that if the business units do not believe that these prices are not worth this amount then these services are either are not of qood quality or the efficiency of these services is not good.

-

The thirci argument is that these services must be at the market prices if thev are available or

they should be priced at standard full cost plus a profit margin. The profit margin is return on . investment that the corporate has to make to provide the service. The rationale is that if the

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corporate office did not make these services available, the business unit will have to make investments on their own to have these services. Also the capital employed by a service unit should earn a return just like the- capital employed by a manufacturing unit must,

At times the ma'1agement may decide to give the freedom to the busrness units to d~itje as to whether they may use such services offered by the central service units. The business units are free to outsource such services, may develop their own capabilities or not use the service at all. This type of freedom can be given for activities like information processing or maintenance. The service providing units within the organization are independent and must stand on their own feet in any case.

Today we find many companies are outsourcing many services such as pay roll work or customer services through Call Centers. Companies like TELCO are outsourcing even logistic activities from outside parties. Outsourcing itself is becoming a very popular way with many a corporate. Many companies from the U. S and Europe are outsourcing services like invoicing, follow up of payments etc. from many a Indian companies. Before the outsourcing became the norm, these services were obviously provided by the service units within the organization. With cost cutting possibilities being enormous through outsourcing, companies are willing to outsource many a services to make' substantial savings. It is also clear that since many services are now outsourced, the service centers providing these services have to be closec.i down.

In India we have a classic case of charging corporate services, which was introduced in Tata Group by the group Chairman, Mr. Ratan Tata. Mr. Tata decided some years back that all companies in the Tata Group have to contribute 5% of their after tax profits towards the corporate services and should be paid to Tata Sons. His argument is that the group companies get a preferential treatment in the market because they belonged to the Tata Group. He also argues that the funds such collected will be used for these companies in many ways ultimately. Tata group has used these funds to consolidate the holdinrs in the group companies where the holding was less.

Many a Tata group CEOs like Mr Ajit Kerkar the then Chairman of Indian Hotels were very unhappy with this proposal and actually got into a conflict with the group Chairman on thiS issue. However Mr. Tatas wish ultimately prevailed and Mr. Kerkar had to leave the Tata group.

Let us now take a look at how the decided transfer price needs to be implemented It has already been seen that lot of negotiations are necessary between the business unit managers before deciding the transfer prices. What needs to be clearly soelt out. as a pohcv IS the degree - of negotiation allowed, in setting the transfer prices, and methods of resclvmc the conflicts associated with transfer price mechanism.

In most cornoarues the transfer prices are set through the method of negotiations between the business unit managers without the Interference of the central office. In .:; decentlallsed organization It IS the respons.buuv of the manger of the busmess unit to cec.oe ~he seillnt] and purchase prices A negotiated transfer price represents a compromise l)e::,cen the two

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concerned manaqers. If the central office decides the transfer prices then they will be' blamed in case the profit performance of any of the two divisions is not as required. The concerned units are also likely to ore aware on the markets and the costs and are thus best suitable to decide the

transfer .pnce ...

In many companies managers are free to deal with each other or the outsiders. as they may deem proper.

iviallY tiiltE ir.:;~ite cf lay:ng aU procedures there will be times when there will be a contlict among business units while fixing the transfer prices. To resolve such conflicts an Arbitration mechanism has to be evolved and put in place. Arbitration can be through a single person. or through a committee constituted for this purpose. Such a committee needs to have three responsibilities:

1. To settle the transfer price disputes.

2. To review the sourcing decision.

3. To change the transfer price rules when necessary.

It is necessary that only few disputes should reach the stage of arbitration. If business unit managers are unable toresolve conflicts at their own level it would mean many things. For one the competency of these managers would be questioned. It will also mean .that the existing, procedure laid down by the senior management is inadequate and not clear. Arbitration by itself is a very time consuming exercise and will cause unnecessary delay in decision making. It is the experience of many companies the arbitration award many times leaves both the parties unsatisfied, because the arbitration would result essentially in a compromise.

The arbitration route should be kept open, because otherwise legitimate grievances may Got have a platform. Absence of arbitration will also hide the fact that there are problems with the transfer price system.

One example of setting transfer prices was recently reported in Hindustan Lever. Hindustan Lever is to supply bagged tea to its parent Unilever. HLL won this contract through internal biduing by many units of Unilever. This is an interesting way of setting transfer price within a group.

Such system will not work say in companies like Reliance for example. Refiance witnesses a lot of inter unit transfers. because the company is fully integrated. But there are no competing units here as they are in the case of Unilever.

Numerical Problems on Transfer Pricing

Illustration 1 :

Hummer Sewing r-tachine Company is a decentralized manufacturing company in which all the major component parts are made by separate divisions that are operated as profit centers.

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The motors for the sewing machines are made by the r"1TO division of the company. The MTO division has more capacity-than required to satisfy production needs for the company's sewing

200 each and the rest were sold to the assembly division of the Hummer Sewing l-1achine Company. The industry average for the marketing and distribution costs of this type of molar is 20% of selling price.

The MTO division made 25,000. motors during 2002 and incurred the following total standard manufacturing costs and actual operating expenses -

Direct: Material

Direct Labour

Manufacturing Overheads Total Production Cost variance

Rs. 15,00,000 Rs. 10,00,000 Rs. 8,00,000

Rs. 4,00,000 Unfavourable

Operating Expenses - Selling and Distribution Administration

Rs. 2,00,000 Rs. 8,00,000

Evaluation of the production standards I· .s led to lhe decision to increase production standard costs by 100/0 for the coming year. Market clI.:lysis indicates a 6% price increase is logical for motors. With the new standard costs, management of Division MTO expects variances from standards will average S% Unfavourable. No changes are expected in selling and distribution expenses or administration expenses. Production and sales quantities are expected to be the same as in 2002.

Ca .ulate the transfer price for the sewing machine motors for each of the following 'independent asscrnptions. The transfer price should -

(a) based on 2002 standard product cost (b) based on 2002 actual product cost

(c) be based on 2003 standard product cost (d) be based all 2003 actual product cost (e) be based on 2003 market price

(f) be based on 2003 market price modified for marketing and distribution costs (g) provide a 6% profit in 200 3 on expected total costs

(h) prepare a schedule stl0wtng the MTO ijlvlSlon'S net Income for ('(j(11 of tne 2003 base transfer price alternatives.

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Solution:

The calculation of cost for the years 2002 and 2003 will be as below:

~--- --- -- ---I----------- -- -----
Particulars 2002 (Rs) 2003 (Rs)
---- -- -------- -- .
I :;:~:::: ~::: ::::I~~~ • _~ 15,00,000 16,50,000
lO,OO,CXXl l1,OO,(XX)
-
Standard Production Overheads 8,OO,CXXl '8,SC,COO
Standard Production Cost 33,OO,CXXl -~-.
-_. ~- ... - _,_ -- -- _. .- _--.----_ - - .-- - ---_. - . ----- -- . . _. -- - -- --- .. - .. - .
Production Cost Variance (Unfavourable) 4,OO,CXX) 1,81,500
Actual Production Cost 37,00,000 38,11,500
, ,
Administration Expenses 8,OO,CXXl 8,OJ,em
-- ---_ .. _- . --- --- .. ---- .. -.------------- ---.----- --_ - _.- ----_--_. _. - --- --_.--
Selling and Distribution Expenses 2,OO,CXXl :.2,00,(0)
Actual Total Cost 47,00,000 48,11,500 Calculation of Transfer Price on the basis of various .. Iternatives -

(a) Based on 2002 Standard Production Cost Rs. 33,00,000 I 25,000 Units = Rs. 132 Per Unit (b) Based on 2002 Actual Production Cost

Rs. 37,00,000 125,000 Units = Rs .. 148 Per Unit (c) Based on 2003 Standard Production Cost Rs. 36,30,000 I 25,000 Units = Rs_ 145_20 Per Unit (d) Based on 2003 Actual Production Cost

Rs. 38,11,500 125,000 Units = Rs_ 152.46 Per Unit

(e) Based on 2003 Market Price

r'1arket Price for 2003 is higher by 6% over Market Price of 2002

As !'1arket Price of 2002 is Rs. 200 Per Unit, Transfer Price will be 106% of Rs. 200 i.e. Rs. 212 Per Unit

(f) Based on 2003 Market Price modified for marketing and distribution costs r'1;;rket Price for 2003 is Rs. 212 Per Unit and Selling and Distribution expenses are 20% of the r-tarket Price. k, such, Transfer Price will be 80% of Rs. 212 i.e. Rs. 169.60 Per Unit

(g) At a profit of GO/o on 2G03 Expected Tota! Cost

2003 Total Cost is Rs. 48,11,500 + 6% Profrt: i.e. 2,88,690 ::: Rs. 51,00,190

Hence, transfer Price will be Rs. 51,00,190/ 25,000 Units::: Rs. 204 Per Unit

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. . Transfer PrlCI~

Profit abif ity Statement of MTD division when 2003 Transfer Price is Oil the basis specified above

Part:CU!3:--$ c I d I ~ I f I 9 I
Sales
f-.
7,500 Units Rs. 212 per unit 1590,OXl 1590,000 1590,OOJ 1590,(0) 1590,(0)
17,500 Units at the 2541,OXl 2668,050 3710,OOJ 2968,(0) 3570,(0)
calculated transfer price
Expected Total Sales 4131,CXXl 4258,050 SJOO,OOJ 4558,OCO 5160,(0)
Expected Total Cost 4811,500 4811,500 4811,500 4811,500 '1811,500
I Expected profit (-)680,500 (-)553,450 488,500 {-)253,SOO 348,500 Illustration 2 :

Faster Limited is having production shops reckor.ed as cost centers. Each shop charges other shops for material supplied and services rendered. .

The shops are motivated through goal congruence, autonomy and management efforts. Fasters Limited is having a welding shop and a panting shop. The weidingshop welds annually 75,000 purchased items and other 1,50,000 shop made parts into 12})OO assemblies. The assemblies have variable cost of Rs. 9_50 each and are sold in the market at Rs. 12 per assembly. Out of the total production, 80% is divested to the painting shop at the same price ruling in the market. Welding shop incurs a fixed cost of Rs. 25,000 per annum. The painting shop is having fixed cost of Rs. 30,000 and its cost of painting including transfer price from welding shop comes to Rs. 20 per unit. This shop sells all the units transferred to it by welding shop at Rs. 20 per assembly. -IOU are required to-

(a) Find out the- profit of individual cost centers and overall profitability of the concern.

(b) Recommended course of action if painting shop wishes to purchase Its full requirement (at market price which is Rs. 10 per assembly) either (rom open market or (rom welding shop at market price of Rs. 10 per assemblv. Give reasons for your recommendations

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Solution:

(Profitability Statement - Welding Shop)

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Particulars - .. No. of Units; Per Unit . ,.' Total':
t=,.~ Rs. I Rs. I
--- f----- --- -------.-~
Sales
, Open n1"1rket .-. "'" l~-- .. 28,80j i
__ , tVV .l..L.tJ\J
, Paint Shop 9,600 12.00 t 1,15,200'
---+----
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Total Sales 12,()(X) 1,44,CXXJ
Variable Cost 12/XX) 950 1, 14,CXXl
I
Contribution 250 30,CXXJ
-- -_. I
Fixed Cost 25,COJ
-
Profit 5,COJ Profitability Statement - Painting Shop

Particulars No. of Units Per Unit
Rs.
-- _. __ ... _---
Sales 9~600 25.00
Variable Cost 9,600 20_00 I
Contribution 5.00
Fixed Cost
Profit Total I

Rs. !

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- 1, 92,CXX) I

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Hence, the total profit of the company as a whole will be Rs. is.coo

Proposal I - Painting Shop purchases its entire requirement from open market Profitability Statement - Welding Shop

- ---- -- --.--- .. _-_.'_ ... - 1
Particulars No. of Units Per Unit
Rs_ j
Sales 2,400 12.00 I
Variable Cost 2,400 9.50 I
Contribution 2.50 I
I
Fixed Cost I
I
--
Profit I
--_. .-------_---- ... ~ Total

Rs.

28,800 22,800

6,0X)

2S,CXXl

(-)19,CXX)

Managcmcnt Control_ Sy_s_k_ln_s _

82

Transfer Prtctng_

Profitability Statement- Painting Shop

Particulars No. of Units Per Unit - Total
Rs. Rs.
Sales 9,600 25.00 2,40,(X))
Variable Cost
Purchased Components 9,600 10.00 96,(X))
In-house Variable Cost 9,600 8.00 76,800
--- ------ -----_
I
Total Variable Cost 18,00 1,72,800 I

Contribution 7,00 67,200
----_
Fixed Cost 30,(X))
Profit 37,200 Total profits of the company as a whole will be Rs. 18,200 i.e. Profit of Rs. 37,200 of painting shop less loss of Rs. 19,000 of Welding Shop.

Proposal II - Painting Shop purchases its entire requirement from Welding Shop at the market price

Profitability Statement- Welding Shop

Sale

No. of Units

Per Unit Rs.

Particulars

Total Rs.

~ __ O_p_e_n _m_a_r_ke_t + ' _2,_400 -1 1_2_.00_. __ I ._ ~8_,_800 ~

Paint Shop 9,600 10.00 96,(X)) i

1------'----------+----·----1---·- -----1---------:

12,roJ

I-------------j---------- ----.-------- .--- ... ---.-------,

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12,roJ

1,24,800

Total Sales

25,CXXl

9.50

Variable Cost

1,14,CXXl

1---------------1---------1------- ----- .. ------ ---- ..

Contribution

2.50

10,800

_----- -------j- -----_.- --.- -.-

Fixed Cost

L ..

(-)14,200

Profit

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Profitability Statement - Painting Shop

Particulars ------ I No. of Units -- ---;e-;Unit--i--Total

____ -+- -+- __ . __ Rs.. _J Rs __ . __ ~

.~:~~~~f:~weldm9~hOD-j-~~': ~_~- ~~~.~:.: =~~I~~: 2,::

------ ------- --------- ---------- -- - .. _- ----- ------

In-house Variable Cost 9,600 - 8.00 76,800

:rotal Variable Cost 18.00 1,72,800

------+--------1--- ----- ---------

Contribution 7.00 67,200

----------------1----- - -------- -- ----------'------j

Fixed Cost

30,OX)

~------ --- ------4------------------- .. --- ---- -----'----,

37,200

------------------'---------'---------------- -- ---- - ------'

Profit

Total profits of the company as a whole will be Rs. 23,000 i.e. Profit of Rs. 37,200 of painting shop less loss of Rs. 14,200 of Welding Shop.

Note: At present, total variable cost per unit of painting shop is Rs. 20 which includes Rs. 12 per unit being the transfer price of the welding shop. It means that the variable cost incurred by the painting shop in-house is Rs. 8 per unit

Conclusion: The effect on the profitability of the various possible situations can be summarized as below:

Situation Welding Shop Painting Shop Total
Existing .s.coo B,OC() 13,cro -
Proposal I (-)19,000 37,200 18,200
Proposal II (-)14,200 37,200 zs.o» Illustration 3 :

The AS Company has two divisions X and Y. One of the part produced by division X is used in the manufacture of a product that is assembles at division Y_ n-:, part is not unique and there is readily defined market so that X can sell outside the firm and Y can buy from outside.

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Following details are available in respect of division X -

Capadtv to produce the part 1,25,000 units

External sales at Rs. 100 per unit 1,00,000 units

Transfer to division Y 25,000 units

Variable production cost per unit Rs. 84

Variable selling cost per unit (only on external sales and not on transfers) Rs_ 2

Fixed production costs per unit (based on 1,25,000 units) Rs_ 6

Fixed selling costs per unit (based on 1,00,000 units) Re. 1

ManagcmcntControl Systc~_._

The division Y represents the following data on the assumption of a volume of 25,000 units (one part is needed for each unit of its own production)

Variable production cost per unit (excluding transfer price or outside

Rs.100

purchase price)

Variable selling cost per unit Fixed production cost per unit Fixed selling ccst per unit Sel!lng price of finished product

You are required to make the following calculations:

(a) If division X could sell 1,25,000 units at Rs. 100 each in the outside market, what transfer price the central management would prefer in order to provide proper motivation to division Y.

Rs. 6

Rs.10

Rs. 4

Rs. 240

(b) As management accountant, would you advise division Y to buy at the transfer price determined in "a" above.

(c) Assume transfer price determined as .in "au above. If. selling price drops to Rs. 200, should division Y buy at that price I Would this be advisable from the point of view of the firm and why?

(d) Assume that division x's product did not have an outside demand in excess of 1,00,000 uni::- and its total fixed production cost could be reduced by 10%, if the volume of production were reduced to 1,00,000 units, what is the appropriate transfer price?

(e) Suppose thatdivision X's maximum outside demand is 1;10,000 units at Rs. 100 and there is no other usage for the capacity. What transfer price should t:.c company management prefer)

Cf) Suppose that the unit selling price of division Y's product is Rs. 180, one of its customers is also the customer of division of X, division Y refuses to buy the part from the outside market at Rs. 100 since the selling price of Rs. 180 would not cover the variable costs, it division X does not cover the transfer price, division Y will not sell to this customer who in turn will probably cancel the usual order of 50,000 units to division X, there is no other demand for the product and no other usage of X's capacity, fixed costs would not change at either division. What is the lowest transfer price that the division X would be advised to accept) Support the recommendations with computation.

Solution:

(a) If Division A can sell the entire production of 1,25,000 units in the outside market, it can generate contribution of P-s. 14 per unit i.e.

Selling price per unit

Variable production cost per unit Variable selling cost per unit Contnbut Ion per un it

Rs. 100 Rs. 84 Ks. 2 Rs. 14

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Transfer of 25,000 units to Division 8 will result into the loss of contribution of Rs. 14 per unit. Hence, the ideal transfer price should be

Variable production cost per unit loss of contribution per unit

Rs.B4 Rs. 14 Rs. 98

Transfer Price per unit

(u J 11 uivi::,iull a buys at the transfer price stateci In "a" above, the profitability statement of Division 8 per unit wil! be as below -

Particulars Rs. Rs.
Selling Price per unit 240
Variable Co st
Variable Production Cost 100
Transfer Price of Oivision A ss
Variable Selling Cost per unit 6 I
Total Variable Cost per unit ! 204
Contribution per unit 36 As Division B generates th,= contribution of Rs. 36 per unit, the transfer price of Rs. 98 per unit is justifiable.

(c) If Division B buysat th-e transfer price stated in "a" above but the selling price per unit drop S to Rs. 200 per unit, the p.rofltability statement of Division B per unit will be as below -

I particulars: -+ Rs_. __ t-I Rs_. __ ----j

Selling Price per unit 200

Variable Cost

,

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------------_._-----------j---------j-------------

Variable Production Cost

100

Transfer Price of Division A ~ I

----------------.----- --------"1------i------

6

Variable Selling Cost per unit

201

Total Variable Cost per unit ------T--------+--------------j

Contribution per unit

As Division B generates the ne gative contribution of Rs. 4 per unit, the transfer price of Rs.

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98 per unit is not justifiabte.

, .

Management Contra! Systems

86

Illustration 4 :

A company is organized on decentralized lines with each manufacturing division operating as a separate profit center. Each division manager has ful! authority to decide on sale of the division's output to outsiders and to other divisioes.

Division C has always purchased its requirements of a component from Division A. But when informed that Division A was increasing its selling price to Rs. iSO, the manager of Division C decided to look at outside suppliers.

Division C can buy the component from an outside supplier for Rs. 135. But Division A refuses to lewer its price in view of its need to maintain its return on investment.

The top management has the fallowing information - Cs annual purchases of the component - 1,000 units

- Rs, 120 Rs. 20

-Rs.120

- Rs. 20

A's variable cost per unit A's fixed cost per uni Required :

(a) Will the company as whole benefit, if Division C bought the component at Rs. 135 from

an outside supplier.

(b) If A did not produce the material for C, it coula usc the facilities for other activities resulting in a cash operating savings of KS. 18,000. Should C then purchase (rom outside sources?

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(c) Suppose there is no alternative use of A's facilities and the market price per unit for the component droops by Rs. 20, should C buy from outside?

Solution:

Situation r - Division C buys the component from outside supplier-

Purchase Price per component 1000 units @Rs. 135 per unit

Less: Reduction in variable cost for A @Rs. 120 per unit Effective cost for the company as a whole

ns. 1,35,000

Rs. 1,20,000 Rs. 15,000

Conclusion - As the proposal to buy from the outside supplier does not result in the 'saving for the company, the company should not go for it.

Situation " - Decision to buy from outside supplier results in cash savings-

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Purchase Price per component 1000 units @Rs. 135 per unit Less: Reduction in variable cost for A @Rs. 120 per unit Cash Savings

Rs. 1,3S,CXXl Rs. 1,20,CXXl Rs. 18,CXXl Rs. 1,38,CXXl

Total reduction In cost

Effective saving for the company as .ll'Ihole

R..s. 3,CXXl

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Conclusion - As the proposal to buy from outside supplier results in net saving for the company, the company should go for it.

Situation III - Division C buys the component fr0mnutslde'S(fpplre'~ at' the ;ed'uced ~rice -

Purchase Price per component 1000 units @Rs. 115 per unit Less: Reduction in variable cost for A @Rs. 120 per unit Effective saving for the company as a whole

Rs.l,15,OCO Rs. 1,20,000 Rs.5,OOO

Conclusion - As the proposal to buy from outside supplier results in net saving for the company, the company should go far it.

Illustration 5 :

Division A of Better t-1argins Limited has been given a budoeted target of selling 2,00,000 components of CoM21, it manufactures at a price which would fetch a return of 25%00 the average assets employed by it. The following figures are relevant -

Fixed Overheads variable Cost

Rs. 4,00,000

Re. 1 per unit

Average Assets - Debtors

Stocks

Plant and Other Assets

ss.z.co.coo Rs. 6,00,000 Rs.4,OO,OOO

However, the marketing department of the company finds out by a survey that the maximum number of CoM21, tf ~ market can take at the proposed price is only 1,40,000 units.

Fortunately, Division B is willi,.; to nllrchase the balance 60,000 units. The manager of A is wiliing to sell to Division B at a concessional price of Rs. 4 per unit. But the rnanaqer of Division B is ready to pay Rs. 2.25 per unit, as he feels he can make CoM21 in his division at that price.

Rather than selling to Division Bat Rs. 2.25 per unit, manager of division A feels that he will restrict the activity to his division to manufacture and sale of 1,40,000 components only. Gy this he can reduce Rs. 80,000 in stocks, Rs. 1,20,000 of plant and other assets and Rs. 40,000 in selling and administration expenses.

As management accountant, do you agree with the proposition of manager of Division A to restrict the activities to 1,40,000 components, from the overall interest of the organization. Give detailed workings.

Solution:

Considering the target given to Division A, the budgeted profitability stater.:\r 2,00,000

units will be as below : ~

j

I

I

f ~

~

Manap;cll\cnt Con trot Systems

88· Transfer Pr1clr~i?:

.. _-----_._---_._._--_._._-- -- -.-~

Particulars Rs I
variable Cost @Re. 1 per unit 2,00,~1
,
fixed CNerheads 4,00,000
Expected profit @25% on Rs. 12,00,000 3,00,000
Hence, Budgeted Sales 9,00,000
- As the budgeted sales for 2,00,000 units are Rs. 9,00,000; per unit selling price will be Rs. 4.50 i.e. Rs. 9,00,000/2,00,000 units.

Following two proposals are to be considered -

Proposal! - Selling 1,40,000 units to outside parties @Rs. 4.50 per unit and 60,000 units to Division B @Rs. 2.25 per unit.

Proposal II - Selling 1.40,000 units to outside parties @Rs. 4.50 per unit Profitability Statement under the above two proposals will be as below -

I Particulars I Proposal I-Rs ; Proposal II-Rs

Sales i I
1,40,000 units @Rs. 4.50 per unit I 6,30,CXXl I 6,30,000
I
60,000 units @Rs. 2.25 per unit I 1,35,CXXl ; Nil
Total Sales I 7,65,CXXl I 6,30,000
I
I
Variable Cost @Re. 1 per unit I 2,OO,CXXl I 1,40,000
I I
I I
Contribution 5,65,CXXl I 4,90,000
Fixed Overheads 4,OO,CXXl i 3,60,000
I
- I
Profit I 1,65,CXXl I 1,30,000
I I
Investment in Assets i 12,OO,CXXl i 10,00,000 J
I I I
__ _l_ -_. -- ·_·--1
Return on Assets in Percentage , 13.75 1300 ,
._---------------------- ---- .---- - Conclusion :

I As the proposal to make the sales only to outside parties @Rs. 4.50 per units reduces lhe

II,'

\ Return on Assets, the proposal will not be acceptable.

I (lustra tion G :

SV Limited manufactures a product which IS obtained basicauv from J ser.es of mIXIng operations. TIle flnislled product IS pack<1ged in tile company rr.ace glass bottle'; and ~aclt"d In thc auracuve cartons.

!

r

I
t. i
. ,
d~, I
.' 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The company is orqanized into two independent divisions viz. one for the manufacture of the end product and the other for the manufacturing of [l Lakhs bottles. The product manufacturing division can buy all the bottle requirements from the bottle manufacturing division.

The General Manager of the bottle manufacturing division has obtained the following Quotations from the outside manufacturers for the supply of emoty bottles -

I No. of empty bottles Total Purchase Value (Rs.)
8,00,000 14,00,(0)
-_._-----_._-- ----. - . ._--_._--- - ... ----
12,00,(0) 20,00,(0) A cost analysis of the bottle manufacturing division for the manufacturinq of empty bottles reveals the following production costs -

No. of empty bottles Total Cost (Rs.)
8,00,000 10,40,000
12,00,000 14,40,CXXl The production cost and sales value of the end product marketed by the product manufacturing division are as under -

-r----· - -- -- -- .. -.-. -- - I
Volume Total Cost of end product Sales Value
(Bottles of end product) (Excluding cost of empty (Packed in bottles) I
bottles) Rs.
Rs.
8,00,CXXl 64,80,CXXl 91,20,000
12,00,000 96,80,(0) 1,27,80,000 I

I.'

There has been considerable discussion at the corporate level as to the use of proper price for transfer of ernp v bottles from the bottle manufacturing division to product rnanufacturinq division. This interest 'J hei"htened because a significant portion of the Divisional General Manager is in incentive bonus based on profit center results.

As the corporate management accountant responsible for defining proper transfer prices for the supply of empty bottles by the bottle manufacturing division to the product manutacturino division, you are required to show for the two levels of volumes of 8 Lakh and 12 Lakh bottles, the profitability by using (a) market price and (b) shared profit relative to the costs involved basis for the determination of transfer prices, The profitability portion should be furnished separately for the two divisions and the company as a whole under each method. Also

I

discuss the effect of these methods on the profitability of two divisions.

90

Solution:

Profitability Statement of the two divisions if transfer price Is based- on the market price-

Bottle Manufacturing Division -

---------- ----- - _ .. ------- _------- .- ,--------- .. _.-
Particulars
Volume - Number of Bottles 8,OO,roJ 12,OO,o::xJ
Sales - Rs. 14,00,00J 20,00,o::xJ
---------- ------------ -~------ ----- ._._--_---
Cost - Rs. 10,4D,OCD 14,4D,00J
Profit 3,60,OCD 5,60,COJ Product Manufacturing Division -

-- --------_.- -.------ --.--------- - .. - ---------_-
Particulars
-
Volume - Number of Botties 8,OO,CXXl 12,00,CXXl
Sales - Rs. 91,20,CXXl 1,27,BO,CXXl
Cost- Rs.
Incurred in division 64,BO,CXXl 96,BO,CXXl
Transfer price of the bottles 14,00,00J 20,00,CXXl
.. - --- .. ---- -_--. --- . - --_.------ . - ----"_-- -_---_ .. _--_ . -._._- - _ .. _-
Total Cost - Rs. 78,BO,00J 1,16,BO,CXXl
Profit 12,40,00J 1l,00,CXXl As such, the total profits of the company as a whole will be -

For 8 Lakhs bottles - Rs. 3,60,000 + Rs. 12,40,000 := Rs. 16,00,000 For 12 Lakhs bottles - Rs. 5,60,000 + Rs. 11,00,000 := Rs.16,60,000

Profitability Statement of the cornp anv if transfer price is based on the shared profit relative to the costs -

I

i'

--- - "'1 12~CXl,~-1

I

________ ~3_O,CXXl l'3~,8g_'_CX!?1

-- ---- ----1- . '-1

:~,:',CXXlCXXl"-'- _j 96,80.CXXl I 14. 4{). COJ I

- - -- 1

7S.20.CXXl ,

,

Sales - Rs. Cost - Rs.

Particulars

Volume - Number of eottles

I J

Incurred in product manufacturing div.sion Cost of the bottle l1lanu(actwlf19 divrsron Total Cost - Rs.

1,l1.20.0c0 ;

16.00,CXXl :

16.GO,OjJ

f

P '5 as (r allsf. O/us a (Ile !fa y

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.i,

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