Transfer pricing in divisionalized

companies

Question IM 21.1 (a) Outline and discuss the main objectives of a transfer pricing system. (5 marks)
Advanced (b) Consider the advantages and disadvantages of
(i) market price-based transfer prices; and
(ii) cost-based transfer prices.
Outline the main variants that exist under each heading. (9 marks)
(c) Discuss the relevance of linear programming to the setting of transfer prices.
(3 marks)
(Total 17 marks)
ACCA Level 2 Management Accounting

Question IM 21.2 Exel Division is part of the Supeer Group. It produces a basic fabric which is then
Advanced converted in other divisions within the group. The fabric is also produced in other
divisions within the Supeer Group and a limited quantity can be purchased from
outside the group. The fabric is currently charged out by Exel Division at total
actual cost plus 20% profit mark-up.
(a) Explain why the current transfer pricing method used by Exel Division is
unlikely to lead to:
(i) maximization of group profit and
(ii) effective divisional performance measurement. (6 marks)
(b) If the supply of basic fabric is insufficient to meet the needs of the divisions
who convert it for sale outside the group, explain a procedure which should
lead to a transfer pricing and deployment policy for the basic fabric for group
profit maximization. (6 marks)
(c) Show how the procedure explained in (b) may be in conflict with other
objectives of transfer pricing and suggest how this conflict may be overcome.
(5 marks)
(Total 17 marks)
ACCA Level 2 – Cost and Management Accounting II

Question IM 21.3 Fabri Division is part of the Multo Group. Fabri Division produces a single product
Advanced: for which it has an external market which utilizes 70% of its production capacity.
Discussion of Gini Division, which is also part of the Multo Group requires units of the product
transfer price available from Fabri Division which it will then convert and sell to an external cus-
where there is an tomer. Gini Division’s requirements are equal to 50% of Fabri Division’s production
external market capacity. Gini Division has a potential source of supply from outside the Multo
for the Group. It is not yet known if this source is willing to supply on the basis of (i) only
intermediate supplying all of Gini Division’s requirements or (ii) supplying any part of Gini
product Division’s requirements as requested.
(a) Discuss the transfer pricing method by which Fabri Division should offer to
transfer its product to Gini Division in order that group profit maximization is
likely to follow.
You may illustrate your answer with figures of your choice. (14 marks)
(b) Explain ways in which (i) the degree of divisional autonomy allowed and (ii)
the divisional performance measure in use by Multo Group may affect the
transfer pricing policy of Fabri Division. (6 marks)
(Total 20 marks)
ACCA Level 2 Cost and Management Accounting II
160 TRANSFER PRICING IN DIVISIONALIZED COMPANIES
(a) Spiro Division is part of a vertically integrated group of divisions allocated in Question IM 21.4
one country. All divisions sell externally and also transfer goods to other divi- Advanced
sions within the group. Spiro Division performance is measured using profit
before tax as a performance measure.
(i) Prepare an outline statement which shows the costs and revenue elements
which should be included in the calculation of divisional profit before tax.
(4 marks)
(ii) The degree of autonomy which is allowed to divisions may affect the
absolute value of profit reported.
Discuss the statement in relation to Spiro Division. (6 marks)
(b) Discuss the pricing basis on which divisions should offer to transfer goods in
order that corporate profit maximising decisions should take place. (5 marks)
(Total 15 marks)
ACCA Paper 9 Information for Control and Decision Making

(a) The transfer pricing method used for the transfer of an intermediate product Question IM 21.5
between two divisions in a group has been agreed at standard cost plus 30% Advanced
profit markup. The transfer price may be altered after taking into consideration
the planning and operational variance analysis at the transferor division.
Discuss the acceptability of this transfer pricing method to the transferor and
transferee divisions. (5 marks)
(b) Division A has an external market for product X which fully utilises its
production capacity.
Explain the circumstances in which division A should be willing to transfer
product X to division B of the same group at a price which is less than the
existing market price. (5 marks)
(c) An intermediate product which is converted in divisions L, M and N of a group
is available in limited quantities from other divisions within the group and
from an external source. The total available quantity of the intermediate
product is insufficient to satisfy demand.
Explain the procedure which should lead to a transfer pricing and
deployment policy resulting in group profit maximisation. (5 marks)
(Total 15 marks)
ACCA Paper 9 Information for Control and Decision Making

Alton division (A) and Birmingham division (B) are two manufacturing divisions of Question IM 21.6
Conglom plc. Both of these divisions make a single standardized product; A makes Advanced:
product I and B makes product J. Every unit of J requires one unit of I. The required Resolving a
input of I is normally purchased from division A but sometimes it is purchased transfer price
from an outside source. conflict
The following table gives details of selling price and cost for each product:
Product I Product J
(£) (£)

Established selling price 30 50

Variable costs
Direct material 8 5
Transfers from A — 30
Direct labour 5 3
Variable overhead 02 02
15 40
Divisional fixed cost (per annum) £500 000 £225 000

Annual outside demand with current selling

prices (units) 100 000 25 000
Capacity of plant (units) 130 000 30 000
Investment in division £6 625 000 £1 250 000
TRANSFER PRICING IN DIVISIONALIZED COMPANIES 161
 Division B is currently achieving a rate of return well below the target set by the
central office. Its manager blames this situation on the high transfer price of prod-
uct I. Division A charges division B for the transfers of I at the outside supply price
of £30. The manager of division A claims that this is appropriate since this is the
price ‘determined by market forces’. The manager of B has consistently argued that
intra group transfers should be charged at a lower price based on the costs of the
producing division plus a ‘reasonable’ mark-up.
The board of Conglom plc is concerned about B’s low rate of return and the divi-
sional manager has been asked to submit proposals for improving the situation.
The board has now received a report from B’s manager in which he asks the board
to intervene to reduce the transfer price charged for product I. The manager of B
also informs the board that he is considering the possibility of opening a branch
office in rented premises in a nearby town, which should enlarge the market for
product J by 5000 units per year at the existing price. He estimates that the branch
office establishment costs would be £50 000 per annum.
You have been asked to write a report advising the board on the response that it
should make to the plans and proposals put forward by the manager of division B.
Incorporate in your report a calculation of the rates of return currently being
earned on the capital employed by each division and the changes to these that
should follow from an implementation of any proposals that you would
recommend. (22 marks)
ACCA Level 2 Management Accounting

Question IM 21.7 AB Limited which buys and sells machinery has three departments:
Advanced: New machines (manager, Newman)
Apportionment of Second-hand machines (manager, Handley)
company profit to Repair workshops (manager, Walker)
various
departments In selling new machines Newman is often asked to accept an old machine in part
exchange. In such cases the old machine is disposed of by Handley.
The workshops do work both for outside customers and also for the other two
departments. Walker charges his outside customers for materials at cost and for
labour time at £8 per hour. This £8 is made up as follows:

Per hour (£)

Fixed costs 2.00 (10 000 budgeted hours per annum)

Variable costs 4.50
Profit 01.50
£8.00

AB Limited wishes to go over to a profit centre basis of calculations so as to be able

to reward its three managers according to their results. It wishes to assess the situa-
tion in the context of the following transaction:
Newman sold to PQ Limited a new machine at list price of £16 000, the cost of
which to AB Limited was £12 000.
To make the sale, however, Newman had to allow PQ Limited £5000 for its old
machine in part exchange.
PQ Limiteds old machine was in need of repair before it could be re-sold and
Newman and Handley were agreed in their estimate of those repairs as £50 in
materials and 100 hours of workshop’s labour time. That estimate was proved to be
correct when the workshops undertook the repair.
At the time of taking PQ Limited’s machine in part exchange Handley would
have been able to buy a similar machine from other dealers for £3700 without the
need for any repair. When the machine had been repaired he sold it to ST Limited
for £4200.

162 TRANSFER PRICING IN DIVISIONALIZED COMPANIES

You are required to:
(a) show how you would calculate the profit contribution for each of the three
departments from the above transaction.
(b) re-calculate the profit contribution for each department if there were the
following alternative changes of circumstances:
(i) When the workshops came to repair the old machine they found that they
required an extra 50 hours of labour time because of a fault not previously
noticed.
(ii) Before deciding on the figure he would allow PQ Limited for their old
machine, Newman asks Walker to estimate the cost of repairs. This esti-
mate is £50 in materials and 100 hours of workshops labour time. When,
however, workshops came to repair the old machine, it took them 50%
longer than estimated.
(c) recommend briefly how to deal with the following situations in the context of
profit centre calculation:
(i) The manufacturer of the new machines allows AB Limited £200 per
machine for which AB Limited undertakes to do all warranty repairs. Over
the year the total cost of repairs under warranty exceeds the amount
allowed by the supplier.
(ii) Although 4000 hours of workshop time were budgeted to be reserved for
the other two departments, their load increases over the year by 20% (at
standard efficiency). The load from outside customers, however, stays as
budgeted. (25 marks)
CIMA P3 Management Accounting

English Allied Traders plc has a wide range of manufacturing activities, principally Question IM 21.8
within the UK. The company operates on the divisionalized basis with each divi- Advanced:
sion being responsible for its own manufacturing, sales and marketing, and work- Computation of
ing capital management. Divisional chief executives are expected to achieve a three different
target 20% return on sales. transfer prices
A disagreement has arisen between two divisions which operate on adjacent and the extent to
sites. The Office Products Division (OPD) has the opportunity to manufacture a which each price
printer using a new linear motor which has recently been developed by the Electric encourages goal
Motor Division (EMD). Currently there is no other source of supply for an equiva- congruence
lent motor in the required quantity of 30 000 units a year, although a foreign manu-
facturer has offered to supply up to 10 000 units in the coming year at a price of £9
each. EMD’s current selling price for the motor is £12. Although EMD’s production
line for this motor is currently operating at only 50% of its capacity, sales are
encouraging and EMD confidently expects to sell 100 000 units in 2001, and its max-
imum output of 120 000 units in 2002.
EMD has offered to supply OPD’s requirements for 2001 at a transfer price equal
to the normal selling price, less the variable selling and distribution costs that it
would not incur on this internal order. OPD responded by offering an alternative
transfer price of the standard variable manufacturing cost plus a 20% profit margin.
The two divisions have been unable to agree, so the corporate operations director
has suggested a third transfer price equal to the standard full manufacturing cost
plus 15%. However, neither divisional chief executive regards such a price as fair.

TRANSFER PRICING IN DIVISIONALIZED COMPANIES 163

 EMD’s 2001 budget for the production and sale of motors, based on its standard
costs for the forecast 100 000 units sales, but excluding the possible sales to OPD, is
as follows:
(£000)

Sales Revenue (100 000 units at £12.00 each) 1200

Direct Manufacturing Costs
Bought-in materials 360
Labour 230
Packaging 40
Indirect Manufacturing Costs
Variable overheads 10
Line production managers 30
Depreciation
Capital equipment 150
Capitalized development costs 0060
Total manufacturing costs 880
Sales and Distribution Costs
Salaries of sales force 50
Carriage 20
General Overhead 0050
Total costs 1000
Profit 0200

Notes
(1) The costs of the sales force and indirect production staff are not expected to
increase up to the current production capacity.
(2) General overhead includes allocations of divisional administrative expenses
and corporate charges of £20 000 specifically related to this product.
(3) Depreciation for all assets is charged on a straight line basis using a five year
life and no residual value.
(4) Carriage is provided by an outside contractor.
Requirements
(a) Calculate each of the three proposed transfer prices and comment on how each
might affect the willingness of EMD’s chief executive to engage in inter-
divisional trade. (10 marks)
(b) Outline an alternative method of setting transfer prices which you consider to
be appropriate for this situation, and explain why it is an improvement on the
other proposals. (5 marks)
(Total 15 marks)
ICAEW P2 Management Accounting and Financial Management 2

Question IM 21.9 Engcorp and Flotilla are UK divisions of Griffin plc, a multinational company. Both
Advanced: divisions have a wide range of activities. You are an accountant employed by
Optimal output Griffin plc and the Finance Director has asked you to investigate a transfer pricing
and transfer price problem.
where the market Engcorp makes an engine, the Z80, which it has been selling to external cus-
for the tomers at £1350 per unit. Flotilla wanted to buy Z80 engines to use in its own pro-
intermediate duction of dories; each dory requires one engine. Engcorp would only sell if Flotilla
product is paid £1350 per unit. The managing director of Engcorp commented:
imperfect ‘We have developed a good market for this engine and £1350 is the current mar-
ket price. Just because Flotilla is not efficient enough to make a profit is no reason
for us to give a subsidy.’
Flotilla has now found that engines suitable for its purpose can be bought for
£1300 per unit from another manufacturer. Flotilla is preparing to buy engines from
this source.

164 TRANSFER PRICING IN DIVISIONALIZED COMPANIES

 From information supplied by the divisions you have derived the following pro-
duction and revenue schedules which are applicable over the capacity range of the
two divisions:

Engcorp’s data for Z80 engines Flotilla’s data for dories

Total Total cost Total

revenue of producing revenue
Total from dories from
Annual manufacturing outside excluding sales
number cost sales engine costs of dories
of units (£000) (£000) (£000) (£000)

100 115 204 570 703

200 185 362 1120 1375
300 261 486 1670 2036
400 344 598 2220 2676
500 435 703 2770 3305
600 535 803 3320 3923
700 645 898 3870 4530
800 766 988 4420 5126
Requirements
(a) Ignoring the possibility that Flotilla could buy engines from another
manufacturer, calculate to the nearest 100 units:
(i) the quantity of Z80 production that would maximize profits for Griffin plc,
and
(ii) the consequent quantity of Z80 units that would be sold to external cus-
tomers and the quantity that would be transferred to Flotilla. (8 marks)
(b) Explain the issues raised by the problems of transfer pricing between Engcorp
and Flotilla, and discuss the advantages and disadvantages of the courses of
action which could be taken. (10 marks)
(c) Discuss the major considerations in setting transfer prices for a profit-
maximizing international group. (7 marks)
(Total 25 marks)
ICAEW P2 Management Accounting

HKI plc has an Engineering Division and a Motorcycle Division. The Engineering Question IM 21.10
Division produces engines which it sells to ‘outside’ customers and transfers to the Advanced:
Motorcycle Division. The Motorcycle Division produces a powerful motorbike Calculation of
called the ‘Beast’ which incorporates an HKI engine in its design. optimum selling
The Divisional Managers have full control over the commercial policy of their price using
respective Divisions and are each paid 1% of the profit that is earned by their calculus as the
Divisions as an incentive bonus. effect of using the
Details of the Engineering Division’s production operation for the next year are imperfect market
expected to be as follows: price as the
Annual fixed costs £3 000 000 transfer price
Variable cost per engine £350

Details of the Motorcycle Division’s production operation for the next year are
expected to be as follows:
Annual fixed costs £50 000
Variable cost per Beast £700*
*Note: this figure excludes transfer costs

Both Divisions have significant surplus capacity.

TRANSFER PRICING IN DIVISIONALIZED COMPANIES 165

 Market research has indicated that demand from ‘outside’ customers for HKI
plcs products is as follows:
• 9000 engines are sold at a unit selling price of £700; sales change by an average of
10 engines for each £1 change in the selling price per engine;
• 1000 Beasts are sold at a unit selling price of £2200; sales change by an average of
125 Beasts for each £100 change in the selling price per Beast.
It is established practice for the Engineering Division to transfer engines to the
Motorcycle Division at ‘market selling price’.
You are required
(a) to calculate the unit selling price of the Beast (accurate to the nearest penny)
that should be set in order to maximize HKI plc’s profit; (7 marks)
(b) to calculate the selling price of the Beast (accurate to the nearest penny) that is
likely to emerge if the Engineering Division Manager sets a market selling price
for the engine which is calculated to maximize profit from engine sales to
outside customers. You may assume that both Divisional Managers are aware
of the information given above. Explain your reasoning and show your
workings; (8 marks)
(c) to explain why you agree or disagree with the following statement made by
the Financial Director of HKI plc:

‘Pricing policy is a difficult area which offers considerable scope for dysfunc-
tional behaviour. Decisions about selling prices should be removed from the
control of Divisional Managers and made the responsibility of a Head Office
department.’
(12 marks)
(Total 27 marks)
CIMA Stage 4 Management Accounting – Decision Making

Question IM 21.11 Scenario

Advanced: Chambers plc produces motor components and a vehicle called the Rambler. The
Various aspects company is split into three operating divisions – Engines, Transmissions and
of divisional Assembly. The Rambler is produced in the Assembly division. Each Rambler incor-
performance porates an engine produced in the Engines division and a transmission system
evaluation and produced in the Transmissions division.
transfer pricing Each operating division is both a profit and an investment centre, with the per-
involving the formance of divisional managers assessed on return on capital employed (ROCE)
algebraic achieved. In addition to their salary, each manager is paid a bonus each year linked
manipulation of to ROCE achieved in the current year. Chambers plc is financed by various means
figures to identify and has an average cost of capital of 7% per annum.
likely outcomes Relevant details concerning the three operating divisions in the coming year are
as follows:

Engines division:
• The variable cost of engine production is £600 per unit.
• Annual demand from outside customers for engines varies with price: it is 5000
units at unit price £1000 and changes by 5 units with each £1 change in unit
price.
• Fixed costs are £5 000 000 per year, and capital employed is £5 200 000.

Transmissions division:
• The variable cost of transmission unit production is £350 per unit.
• Annual demand from outside customers for transmission units varies with price:
it is 2500 units at unit price £1200 and changes by 5 units with each £2 change in
unit price.
• Fixed costs are £5 200 000 per year, and capital employed is £8 100 000.

166 TRANSFER PRICING IN DIVISIONALIZED COMPANIES

Assembly division:
• The variable cost (excluding transfer charges) of Rambler production is £1500 per
unit.
• Annual demand for ramblers varies with price: it is 4000 units at a unit price of
£6000 and changes by 2 units with each £1 change in unit price.
• Fixed costs are £5 800 000 per year, and capital employed is £10 200 000.
There are no capacity constraints in any of the divisions.
Chambers plc’s transfer pricing policy is that goods transferred between divi-
sions should be at the price charged to outside customers for the relevant units. In
setting selling prices to outside customers, the Engines and Transmissions divisions
must ignore the effect of transfers to the Assembly division. The manager of the
Assembly division treats transfer prices for units received as variable costs.
An investment in new equipment (having a life of 5 years and a residual value of
nil) is being considered by the management of the Transmissions division. The
equipment would cost £850 000 and would reduce the variable cost per transmis-
sion unit by £30.

Part One
Requirements:
(a) Calculate for each division the output, product price, profit and ROCE that is
likely to emerge, given the existing transfer pricing system and assuming that
each divisional manager will act to maximise the ROCE of his/her own
division.
Ignore the investment in new equipment. (7 marks)
(b) Determine and state the optimum output level and selling price for each
division from the point of view of Chambers plc as a whole.
Prepare a statement showing the resultant profit and ROCE of each division,
assuming that the existing transfer policy system remains in place.
Ignore the investment in new equipment. (7 marks)
(c) Prepare a financial analysis to show the impact of the investment in new
equipment on the profit and ROCE of the three divisions, given the existing
transfer pricing and performance appraisal systems. State whether or not the
management of the Transmissions division is likely to adopt the proposed new
investment. (6 marks)
(d) State whether or not the proposed new investment is to the advantage of
Chambers plc as a whole, assuming that decisions concerning output, etc.
continue to be determined by the existing transfer pricing and performance
appraisal systems.
Support your answer with a discounted cash flow analysis. (5 marks)
Note: The following information is given to illustrate a methodology that might be
used to solve the requirements of the question:
• The demand function for sales by the Engines division to outside customers may
be represented by the following equation, where y = unit selling price and x =
demand:
y = 2000 − x
5
• The corresponding marginal revenue function may be represented by:

y = 2000 − x
2.5
(Total 25 marks)
Part Two
The concept of divisional organisation is to place divisional managers in the same
risk/reward position as independent entrepreneurs. In theory, this induces divisional

TRANSFER PRICING IN DIVISIONALIZED COMPANIES 167

 managers to act in a manner calculated to maximise the wealth of the company’s
shareholders. This may or may not work in practice but you may be sure of one thing
– divisional organisation creates a lot of employment for chartered management
accountants.
Requirements:
Having regard to the above statement,
(a) explain how the divisional performance appraisal and transfer pricing systems
at Chambers plc might contribute to maximising the wealth of shareholders;
(7 marks)
(b) explain the limitations of ROCE as a divisional performance indicator, and
suggest alternative measures that might be more effective; (7 marks)
(c) explain why and how the concept behind divisional organisation might be
extended into many areas of government/public service; (5 marks)
(d) explain why divisional organisation generates work for management
accountants, and suggest actions which might be taken to make such work
cost-effective. (6 marks)
(Total 25 marks)

Part Three
An effective transfer pricing system in the context of a divisional organisation has
to satisfy several basic criteria. The problem is that nobody has yet invented a sys-
tem of transfer pricing that is capable of doing this with perfection.
Requirements:
Having regard to the above statement,
(a) explain what criteria an effective system of transfer pricing has to satisfy;
(7 marks)
(b) state how far the system used by Chambers plc meets the criteria you have
identified in your answer to (a); advise Chambers plc on how it might modify
its transfer pricing system in order to make it more effective. (9 marks)
(c) explain the features of transfer pricing systems based on
(i) marginal cost,
(ii) opportunity cost, and
(iii) cost plus;
state how far each of these systems meets the criteria you have identified in
your answer to requirement (a). (9 marks)
(Total 25 marks)
CIMA Stage 3 Management Accounting Applications

168 TRANSFER PRICING IN DIVISIONALIZED COMPANIES