L15 L16 Problems On Tp

Considerations/Issues in TP Taxation – tax heavens, double taxations Govt. Regulations – Arms length price (in absence of which BU can set TP to minimize the tax liability) Tariffs – They are certain % of import value, therefore lower the TP lower will be the tariffs. Foreign Exchange Control – e.g. limit on FE spending for import. Shifting of funds to desired location. Joint Ventures – May enforce the specific TP. Transaction, Operation and Economic exposure to ER.

Problem on cost based transfer pricing – ABC Co Ltd has received an enquiry for the supply of 1000 units steel chairs. Company’s division A has got capacity to produce these many chairs, but it has to incur fixed investment of Rs 400000 and working capacity to the extent of 25% of the sale value will be required if the job is undertaken. The costs are estimated as follows – Raw material 11000 Kg @ Rs20 per Kg Direct wages 1000 hours @ Rs 10 per hour Variable Overheads Factory Rs 15 per labor hour Selling & Distribution Rs 20000 Fixed Overheads Factory Rs 10000 Selling & Distribution Rs 45000 Prepare a statement showing the price to be fixed under – • Total cost method using i. 30% on the total cost and ii. 20% on S. Price • b. Conversion cost method – 200% conversion cost as profit c. Marginal cost method assuming a P/V ratio of 35% d. Return on investment method with an expected return of 20% on the capital employed

Solution – a. Total cost method –

Direct Material (11000*20) Direct Wages (1000*10) Prime Cost Factory O/H(1000*15 + 10000) Cost of Mfg. Selling & Distri. O/H Total Cost Profit(30% on total cost) Sale

For 1000 units Per unit 220000 220 10000 10 230000 230 25000 255000 65000 320000 96000 416000

25 255 65 320 96 416

i. When the profit is 30% on the total cost, price will be Rs 416 per unit ii. When profit is 20% on sales, i.e. profit is 25 of cost, hence Selling Price = 320 + (320 * 25%)

b. Conversion Cost method – Conversion Cost = Direct wages + Factory O/H = 10 + 25 = 35 Profit to be charged = Conversion Cost * 2 = 35 * 2 = 70 Selling Price = Total Cost + Profit = 320 + 70 = 390

c. Marginal Cost Method – Marginal Cost Statement Direct Material Cost Direct Wages Variable O/H Factory Selling & Distri. Marginal Cost

220000 10000 15000 20000 265000

Marginal Cost Per Unit = 265000/1000 = 265 P/V Ratio expected is 35% V/S = 1 – P/V ratio = 1- 0.35 = 0.65 Hence Sales = V/ 0.65 = 265 / 0.65 = Rs 408

d. Return on Investment Method Sales = Total Cost + ROI in Rupee value = 320000 + 20% * (Additional Fixed Investment PLUS Additional Working capital requirement) = 320000 + 20% ( 400000 + Sales * 25%) = 320000 + 80000 + (SALES * 5%) Sales – 0.05 Sales = 400000 0.95 Sales = 400000 Sales = 400000/0.95 = 421053 Sales Price per unit Rs 421.05

(for 1000 unit)

Numerical/Case Illustration No 17 in my book ABC Company has two divisions Relay Division (RD) and Motor Division (MD). RD can manufacture 50,000 relays per year at a variable cost of Rs 12 per unit and sale at Rs 20 per unit. Each relay unit requires one labor hour to complete. MD has developed a new model of motor for which a new model of relay is required. The annual requirement is 50,000 units. There are two options available to procure this new model of relay – To buy from external supplier at Rs 15 per unit To get it manufactured at RD, for which it has to give up its entire present business. The variable cost of manufacturing a new relay model is Rs 10 per unit. The MD also has to incur Rs 25 per unit as variable cost and shall get selling price of Rs 60 per unit. Advice whether the RD should give up its existing business to manufacture new model of relay for MD? OR The MD should procure it from the open market? From RD’s point of view, what should be the transfer price, if decided so

Numerical/Case – Illustration No27 in my book A large auto-mobile company, Jay Auto follows a pricing policy, whereby normal or standard activity is used as base. That is the prices are set on the basis of long run annual volume predictions. They are then rarely changed, except for notable changes in wage rates or material prices. You are given following data about company’s working: Material, Wages & Other Variable Costs Rs 1320 per unit Fixed Cost Rs 3,00,000 per annum Desirable ROR on invested capital 20% Normal Volume 1000 units Invested Capital Rs 9,00,000 Find – What net income % based on rupee sales is needed to attain the desired rate of return? What rate of return on invested capital will be earned on sales volume of 1500 and 500 units?

Numerical/Case – Big Burger Co has two stores Central BB and Western BB. Company is considering expanding menus at these stores to include pizza. Installation of necessary ovens and purchase of equipments would cost Rs 1,80,000 per store. The current investment in Central BB totals Rs 8,90,000. Store revenues are Rs 11,00,500 and expenses are Rs 9,24,420. Expansion of Central BB’s menu should increase profits by 30,600. The current investment in Western BB totals Rs 17,40,000. The stores revenues are Rs 17,60,800 and expenses are Es 14,96,680. Expansion of Western BB’s menu should increase its profits by Rs 30,600. Big Burger Co evaluates its managers based on return on investment. Managers of individual stores have decision rights over the pizza expansion. Calculate the return on investment for both stores before expansion, only for pizza project and after expansion. Assuming 14% cost of capital, calculate residual income for both stores before expansion, only for pizza project and after expansion. Will the stores choose to expand? How would the answer change, if the stores were franchised units?

Solution – Computation of Return on Investment Before Expansion Current Investment Revenue Expenses Profit ROR

Central BB 890000 1100500 924420 176080 19.78

Western After BB Expansion Curt. Invest 1740000 +180000 1760800 Revenue 1496680 Expenses 264120 Profit +30600 15.18 ROR

Central Western BB BB 1070000 1920000 1100500 1760800 924420 1496680 206680 19.32

294720 15.35

For Central BB with expansion its ROR decreases hence he won't accept the company's proposal to expand. However for Western BB with expansion its ROR increases hence he will welcome the expansion project But whether Central BB is acting in the interest of the Big Burger??

Solution – Computation of EVA or Residual Income Before Expansion Current Investment Revenue Expenses Profit Capital Charge-14% RESIDUAL INCOME

Central BB

Western BB

890000 1740000 1100500 1760800 924420 1496680 176080 264120

After Expansion Curt. Invest. +180000 Revenue Expenses Profit+30600

Central BB

Western BB

1070000 1100500 924420 206680

1920000 1760800 1496680 294720

124600

243600

149800

268800

51480

20520

56880

25920

In view +ve EVA both the divisions would accept the expansion project If Central BB and Western BB were the franchised units, then both would have accepted the expansion proposal, without any hitch as the ROR of the project is higher that cost of capital (prj ROR 17%, CC 14%)

Numerical/Case – A company is having two independent divisions Div S and Div B. Div B buys certain component from Div S at an agreed upon transfer price of Rs 95 per unit. After further value addition to it, Div B sells the final product in the market. The cost structure of the two divisions is given as under: Div S Div B Fixed Cost (Rs) 15000 10000 Variable Cost (Rs) per unit 10 20 It is further given that the demand for final product is a function of selling price as shown below – Demand (Units) 100 200 300 400 500 600 Selling Price (per unit) 200 180 150 130 120 104 Based on above data find at which operating levels Div B, Div S and Company maximizes profit. Support your answer with necessary calculations. Being a management controller of the company which transfer price would you advice and why?

Solution Div S Selling Demand Price

TP

Variable Fixed Revenue Cost Cost Total Cost Profit

100

200

95

9500

1000

15000

16000

-6500

200

180

95

19000

2000

15000

17000

2000

300

150

95

28500

3000

15000

18000

10500

400

130

95

38000

4000

15000

19000

19000

500

120

95

47500

5000

15000

20000

27500

600

104

95

57000

6000

15000

21000

36000

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

Div B

Variable Cost

Selling Demand Price

Revenue TP

VCFurther Fixed Proc Cost

Total Cost

Profit

100

200

20000

9500

2000

10000

21500

-1500

200

180

36000 19000

4000

10000

33000

3000

300

150

45000 28500

6000

10000

44500

500

400

130

52000 38000

8000

10000

56000

-4000

500

120

60000 47500

10000

10000

67500

-7500

600

104

62400 57000

12000

10000

79000 -16600

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

Company maximizes profit at output level of 500 units as under – Selling Div S's Demand Price Cost

Div B's Own Cost

Company's Co's Total Cost Revenue Profit

100

200

16000

12000

28000

20000

-8000

200

180

17000

14000

31000

36000

5000

300

150

18000

16000

34000

45000

11000

400

130

19000

18000

37000

52000

15000

500

120

20000

20000

40000

60000

20000

600

104

21000

22000

43000

62400

19400

Company’s profit raises from Rs 5000 to 20000 if output level increases from 200 to 500 units Therefore the correct TP at this situation is variable cost only, because for more than this TP the Div B shall be discouraged to buy from Div S