L16 Problem On Transfer Pricing

Problem on Transfer Pricing (appeared in PU MBA-II, Exam 2003) Problem 1. (pg59) Taken on 6/9/04 9.15-10.30 The Top Company Ltd has two divisions X & Y. One of the parts produced by X is being used by Division Y in its manufacturing process. This part is not unique and there is readily defined market such that X can sell to outside firms and Y can buy from outside. The following data is available in respect of division X: Capacity to Produce the part 125000 units External Sales at Rs 100 per unit 100000 units Transfer to division Y 25000 Costs: Variable Manufacturing cost per unit Rs 84 Variable Selling Cost per unit Rs 2 (on external sales only but not incurred on internal transfer) Fixed Manufacturing Cost (based on 125000 units) Rs 6 Fixed Selling Cost (based on 100000 units) Rs 1 The division Y represents the following data on the assumption of volume of 25000 units. Variable manufacturing expenses per unit Rs 100 (excluding internal transfer price/outside purchase) Variable Selling Expenses per unit Rs 6 Fixed manufacturing cost Rs 10 Fixed selling expenses Rs 4 Selling price per unit Rs 240 Required – 1. If division X could sell 125000 units at Rs 100 each in the open market what transfer price, the central management would prefer in order to provide proper motivation to division Y? 2. As a management accountant would you advise division Y to buy the product at the transfer price determined in 1 above? 3. Assume transfer price as in 1 above and if selling price for division Y’s product drops to Rs 200 should you buy at that price? Would this be desirable from the point of the firm, why? Solution – 1.) X selling the product to outsiders at Rs.100 Selling Price 100 -Variable Cost (Prodn) 84 -Variable Cost (Selling) 2 Contribution 14 -Fixed Cost (Prodn) 6 -Fixed Cost (Selling) 1 Profit 7 Minimum Transfer Price Could be = Variable Cost Of production + Contribution Lost = 84 + 14 = 98 (Justification) For transferring the product X must get its VC of Production 84 It must get its FC of Production +6 It must get its FC of selling +1 X must earn the profit +7 ---------------X must charge a TP of 98 .

2. As a management accountant of Division Y would you advise the purchase at TP of 98

Selling Price -Variable Cost (Production) -Variable Cost ( Bought Out Item) -Variable Cost (Selling) Contribution

Y Purchases from X at TP 98 240 100 98 6 36

Y Purchases from outside at Rs 100 240 100 100 6 34

Since the option to purchase the item from X at TP of 98 gives better contribution, division Y should go for this transaction. 3. If sales price of division Y’s product drops to Rs 200, whether the TP of 98 will be acceptable Co. uses product of X in division Y Selling Price -Variable Cost (Production) -Variable Cost (Bought Out Item) -Variable Cost (Selling) Contribution

200 100 84 6 10

Co opts to sell the Product of X in Open market at 100 100 84 2 14

Since from company’s point of view selling the product of division X to outside buyer gives better contribution than transferring it to division Y. (Taken on 6/9/04 9.15-10.30) ===================================== Problem 2: - PUMBA Taken on 8/9/04 11.00-12.15 Geo Ltd. Producing a range of minerals is organized in 2 divisions, one Manufacturing Division and the other Trading Division. Both are profit centers. Manufacturing Division sells to external traders as well as to Internal Trading Division (ITD). In turn the ITD repacks the bulk minerals received from Manufacturing Division (MD) and sells them to the end-users in the pack of 10 Kg. One of the minerals produced is moulding clay and the total production capacity is 2000 Tons per month. At present the monthly sales are limited to 1000 Tons to external traders and 600 Tons to ITD. The transfer price to the ITD was agreed at Rs. 2000 per ton in line with the price charged to external traders from 1st APRIL i.e. beginning of new budget year. As from 1st October, however, competitive pressure has forced the price to the external traders down to Rs. 1800 per ton. The head of the ITD contends that the transfer price to tyhem should be less than that for the external traders. The M(fg)D refutes the argument on the basis that the original budget established the transfer price for the whole year. (Transfer price proposed by ITD now Rs. 1700 per ton). Existing price to the end users charged by the ITD is Rs. 40/- per pack of 10 Kg. ITD also argues that with reduced transfer price they would be able to reduce their price to the end-users to Rs.32/- per pack of 10 Kg. And sell additional 40,000 packs of 10 Kg. Per month. Relevant cost data for moulded clay is as follows –

Mfg.D. Rs. 700 Rs. 960000

Variable Cost per ton Fixed cost per month

ITD Rs.600 (Cost of re-packing) Rs. 480000

A) As a management consultant of the company will you accept the proposal of ITD to reduce transfer price to Rs. 1700 per ton with additional sales volume as proposed by ITD and make recommendation to the MD of the company accordingly? B) What will be the reaction of Mfg.D. if decision is taken to reduce the transfer price? C) Can you modify ITD’s proposal regarding transfer price reduction to Rs. 1700 per ton to avoid internal conflict and achieve goal congruence? Substantiate your recommendation with relevant calculation. Solution – A) Option I: - TP of Rs. 1800/- per ton

Mfg Div

Add

Less

Sales (External) 1000T @ 1800 Sales (to ITD ) 600 T @ 1800

1800000 Sales 600T (@ 40 per 1080000 pack of 10 kg) @ 4000 PT

Total sales

2880000

Variable Cost @ 700 PT

1120000 Cost of Purchase VC @ 600 PT (Repacking) 1760000 Contribution

Contribution Less

ITD 2400000

1080000 360000 960000

Fixed Cost

960000 Fixed Cost

480000

Profit

800000 Profit

480000

Company's Profit = 800000 + 480000 =

1280000

Option IITP of Rs. 1700/- per ton

Mfg Div

Add

Less

Less

ITD

Sales (External) 1000T @ 1800 Sales (to ITD ) 1000 T @ 1700

1800000

Total sales

3500000

Variable Cost @ 700 PT Contribution Fixed Cost Profit

Sales 1000T (@ 32 per pack of 10 kg) @ 3200 PT

3200000

1400000

Cost of Purchase VC @ 600 PT

1700000 600000

2100000

Contribution

900000

Fixed Cost

480000

Profit

420000

1700000

960000 1140000

Company's Profit = 1140000 + 420000 =

1560000

TP MD ITD Company Rs.1800 8,00,000 4,80,000 12,80,000 RS. 1700 11,40,000 4,20,000 15,60,000

A) The reduction in the transfer price from 1800/- to 1700/ i) Though there is increase in sales volume of ITD, the decrease in selling price degrades its performance. i.e. its profits goes down from 480000 to 420000 ii) The performance of MD gets uplift. i.e. profits go up by 800000 to 1140000 iii) However the performance of the company as whole improves a significantly. Thus from the company’s (Being the consultant of the company) point of accepting ITD’s proposal of reducing the TP from 1800 to 1700 is acceptable. B) For the Mfg. Division, it should not have any problem in accepting the reduced price. The only contention of MD is that TP (of Rs.1800/- ) is finalized in the beginning of the budgeting year. He may have objection as to the enhancement of production targets. But since the move enhances the company’s performance as well company need to pursued the MD to go for reduced TP and increased volume. (else the company will on the ground of underutilization of capacity) C) There is sound economic reason to reduce the TP from 1800 to 1700. The only hitch in this decision is that the ITD do not have any motivation to go for such reduced TP as its profit level drops after reduction of TP. Therefore to keep him contended and motivated Company must introduce certain plan to share the ADDITIONAL profits of (15.60 – 12.80 = 2.80 ) ================================================== Problem 5: Case-III PUMBA – [2475]-302 Q-5 Case III Taken on 8/9/04 11.00-12.15 A large company organized into several manufacturing divisions. The policy of the company is to allow the Divisional Managers to choose their sources of supply and buying from or selling to sister divisions, to negotiate the prices just as they will for outside purchases or sales. Division X buys all of its requirements of its main raw material R from division Y. the full manufacturing cost of R for division Y is Rs.88 per Kg at normal volume. Till recently, Division Y was willing to supply R to division X at a transfer price of Rs. 80 per kg. The incremental cost of R for division Y is Rs. 76 per Kg. Since division Y is now operating at its full capacity, it is unable to meet the outside customers’ demand for R at its market price of Rs. 100 per Kg. Division Y therefore threatened to cut off supplies to division X unless the latter agrees to pay the market price for R. Division X is resisting the pressure because its budget based on the comsumption of 100000 Kg per month at a price of Rs. 80 per Kg is expected to yield a profit of Rs.20,00,000 per month and so a price increase to 100 per kg will bring the division X close to break even point. Division X has even found an outside source for a substitute material at a price of Rs. 95 per Kg. Although the substitute material is slightly different from R, it would meet the needs of division X. alternatively, division X is prepared to pay division Y even the manufacturing cost of Rs. 88 per Kg. Required – 1. Using each of the transfer price of Rs. 80, 88, 95, 100 show with supporting calculations, the financial results as projected by the a) Manager of division X b) Manager of division Y and c) Company

2. Comment on the effect of each transfer price of the performance of the Managers’ of Division X and Y 3. If you were to make a decision in the matter without regard to the views of the individual Divisional Managers, where should Division X obtain its material from and at what price? Solution – 1. a ) Financial Results of Division Y Transfer Price Less Incremental Cost Contribution Less Fixed Cost Profit

80 76 4 12 -8

88 76 12 12 0

95 76 19 12 7

100 76 24 12 12

17 88

10 95

5 100

17

17

17

95

100 Worst Best

b) Financial Results of Division X Profit 25 Based on VC i.e. Transfer Price of

80

c) Financial Results of Division X Profit

17

2. Effect of each TP on division X & Y’s performance 80 Div X Div Y

88 Best Worst

4. Being a controller at corporate office a). Division Y’s product R has got outside market at Rs.100 Selling Price 100 -Variable Cost 76 Contribution 24 - Fixed Cost 12 Profit 12 b) Division X should get a substitute material at Rs. 95 from outside so that it will be beneficial decision than buying from division Y at 100. This option will profit of Rs.10 (based on cost of 95) And note company’s profit position will be 12 + 10 = 22 which is better than any of the TP option which gives maximum profit og 17 only. XX c) Let division Y supply the R to division X at mere VC of 76, due to which Div Y will be incurring loss of Rs.12 and Div. X would earn profit of Rs.29. Taken together the company will be earning profit of Rs.17 (29-12) ===================================== Problem 3 – (pg 89)

At the transfer point from division S to division P, a products variable cost is Rs 1 and its market price is Rs 2. Division P’s variable cost of processing the product further is Rs.1.25 and the selling price of the final product id Rs.2.75. Find – 1. prepare a tabulation of the contribution margin per unit for division P’s performance and overall performance under two alternatives a) processing further & b) selling to outsiders at the transfer point. 2. as division P’s manager , what alternative would you use? Explain. Solutions – 1) Coputation of Contribution Margin Div P Div S Processing Further S's Selling the Product Product Outside Selling Price Less V.C. (Purchase at TP of 2) V.C.(Processing)

2.75

Company's Point of View

2.00

2.00 1.25 -0.50

1.00 1.00

2.75 VC at P

1.25

VC at S

1.00 0.50

2. From division P’s processing further the product of S, which is beging bought at Rs. 2.00 (TP) is not advisable. From division S’s point of view selling its product in open market is most profitable decision even as compared with Company’s point of view. ======================================= Problem 4. The Power Lite division manufactures batteries that it sells primarily to the Lantern division for inclusion with that division’s main product. Last year 20% of the batteries were sold to the other companies at a price of Rs.10 each. The remaining batteries went to the Lantern division. Cost data for the year are presented for Power Lite is as under – Units Produced Manufacturing Cost (Rs.) Marketing Cost (Rs.) Administrative Costs (Rs.)

5,00,000 30,00,000 1,00,000 8,00,000

Required – A. What will be the transfer price of batteries if the company uses 1. Market price? 2. Market price less marketing costs 3. A transfer price that will yield a net income of 10% on sales for Power Lite? B. Prepare a schedule showing the Power-Lite divisions net income for each of the transfer pricing alternatives computed. Solution – Given Units Produced

Power Lite Division 5,00,000

20% Units Sols Outside 80% Units Sold to Latern Div. Market Price Production Cost 30,00,000/5,00,000 Marketing Cost 1,00,000/5,00,000 Administration Cost 8,00,000/5,00,000 A)

1,00,000 4,00,000 @ Rs 10.00 @ Rs. 6.00 @ Rs. 0.20 @ Rs. 1.60

i) TP as MP = Rs 10.00 ii) TP = MP - Marketing Cost = 10.00 – 0.20 = 9.80 iii) Set TP such that it should give 10% profit on sales price Production Cost Marketing Cost Administration Cost Total Cost Profit Selling Price i.e. TP

6.00 0.20 1.60 7.80 0.87 8.67

B) PLD’s Net Income under various options of TP Transfer Price @ Rs.10.00 Sales 5,00,000@ 10

50,00,00 0

Transfer Price @ Rs. 9.80 Sales 1,00,000 @ 10 4,00,000 @9.8

Total Sales

50,00,00 0 Total [email protected] 39,00,00 0 Profit 11,00,000

10,00,00 0 39,20,00 0 49,20,00 0 39,00,00 0 10,20,00 0

Transfer Price @ Rs. 8.67 Sales 1,00,000 @ 10 10,00,000 4,00,000 @8.67

34,68,000 44,68,000 39,00,000 5,68,000

================================== Problem 6: ABC Co Ltd. has two divisions Relay Division (RD) and Motor Division (MD). Other information given is – RD – It can manufacture 50,000 Relays (a kind of switch) per year at a variable cost of Rs,12 per unit and selling price is Rs. 20 per unit. Each relay requires one labour hour to complete. MD – It has developed a new model of Motor for which a new model of Relay is required. There are two options to procure this new model of Relay: a. To buy from an external supplier @ Rs 15 per unit (Annual requirement 50,000 units) b. To be manufactured by RD which has to give up its entire present business. The variable cost of manufacturing a new model is Rs.10 per unit. The MD also has to incure Rs.25 as variable cost and the selling price per unit is Rs.60. Advise whether the RD should give up its existence business to manufacture a new model of relay for MD OR The latter should procure the new model from the market?

Solution: 1. Option I – Develop new relay model in RD and transfer it to MD Relay Division (RD) Sales 50,000 @ 10 TP (Treating VC as TP) Variable Cost @10

Motor Division (MD)

5,00,000

Sales 50,000 @ 60

30,00,000

5,00,000

VC (Purchase cost from RD @ 10) VC @ 25 (Production cost)

5,00,000

Contribution NIL

Total

12,50,000 12,50,000

12,50,000

2. Option II – Let MD procure from outside supplier & RD continue the production of old model relays Relay Division (RD) Motor Division (MD) Total Sales 50,000 @ 20 MP

10,00,000

Sales 50,000 @ 60

30,00,000

Variable Cost @12

6,00,000

VC (Ext. Purchase cost @ 15) VC @ 25 (Production cost)

7,50,000

Contribution 4,00,000

12,50,000 10,00,000

14,00,000

The above table option II show that if MD procures its new model of relays from outside supplier it leads to earning better contribution i.e. 14,00,000 to the company. This also entails RD to sell outside and run profitably. However with Option I company’s contribution gets reduced by 1,50,000. Therefore transfer transaction should not be made. From RD’s point of view the Minimum TP should be equal to VC + Contribution lost, which comes out to be Rs.18 {10 + (20-12)}. But as the MD is able to procure the relay at Rs.15 this TP may not advisable to MD. ========================================== Problem 7: Amit Industries has two divisions A & B. Division A has a capacity of manufacturing 1,00,000 boxes per year. The selling price is Rs.30 whereas the variable cost is Rs.16 per unit and fixed cost is 9,00,000 per year. Division B is also using the same box but it is purchasing 10,000 units per year at a cost of Rs.29 per unit. Find out the transfer price in following cases: a. If division A has sufficient idle capacity to handle requirement of division B. b. If there is no idle capacity in division A, should there be any transfer at this price? c. If there is no idle capacity in division A, however Rs.3 in variable cost can be avoided on interdivision sales, due to reduced selling costs. Solution: a. Option I- Division A has idle capacity i.e. it can produce more but can not sell the additional produce. In this situation whatever it can sell to division B over

above the variable cost is acceptable to it. Division A’s opportunity cost is Zero i.e. it is not loosing any contribution on account of transfer. Contribution Lost per unit = ZERO Therefore Minimum TP = VC per unit + Contribution Lost per unit = 16 + 0 = 16 But to provide motivate division A, by carrying negotiations, TP may be set any where between Rs.16 to 29. (as division B is in a position to get the said product from open market at Rs.29) b. Option I – Division A has NO IDLE capacity i.e. whatever it can produce it can sell. Therefore in this situation division A need not reduce its transfer price below the market price. And any such transfer required to be made must compensate for the total contribution lost by A on account of such transfer. Contribution Lost per unit = Rs14 {30-16} Therefore Minimum TP = VC per unit + Contribution Lost per unit = 16 + 14 = 30 However note that division B is also able to get its requirement at Rs.29, therefore no transfer is possible between the divisions. c. Division A has no idle capacity, but it can save variable cost of Rs.3 on internal transfer to division B on account of reduced selling cost. Therefore in this situation Varibale Cost of Div. A = 16-3 = 13 Minimum TP = VC per unit + Contribution Lost per unit = 13 + 14 = 27 Again here to provide proper motivation to division A, TP mat be set between Rs.27 to 29. ====================================== Problem 8: There are two divisions in a firm, the Valve Division (VD) and a Pump Division (PD). The PD’s requirement is 20,000 units of a special type of valves which can be supplied by VD. Presently, the VD is producing 1,00,000 valves of other models at its full capacity (i.e. HAVING NO IDLE CAPACITY), at variable cost of Rs.16 and selling price of Rs.30 per unit. In order to produce special type of valve, as required by PD, the VD has to give up 50% of its regular production and need to incur additional variable cost of Rs.4 per unit. If the VD decides to produce the special type of valve for PD, what transfer price should it charge to PD? Solution – In order to produce 20,000 units of special type of valves, the VD need to cut its regular production by half i.e. by 50,000 units. And in this case the contribution lost would be Contribution Lost per unit = 50,000 (30 – 16) = Rs.7,00,000 And it needs to recover this loss from the production of special type of valve. It is required to produce 20,000 special type of valves. Therefore the lost contribution per special valve comes out to be Rs. 35 ( Rs.7,00,000 / 20,000) And based on this lost contribution per unit transfer price be set as under

Minimum TP = VC per unit + Contribution Lost per unit = 20 + 35 = Rs.55 Thus VD should charge minimum transfer price of Rs.55 to PD so as to compensate the switchover in production. =================================== Consider if Required =================================== Problem 9: - (pg 60) A company is organized on a decentralized line, with each manufacturing division operating as a separate profit center. Each division manager has full authority to decide on the sale of the division’s output to outsiders and to other divisions. Division C has always purchased its requirement of component from division A. but when informed that division A was increasing its selling price to Rs.150/-, 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 lower its prices in view of its need to maintain its return on investment. The top management has following information. C’s annual purchase of the component 1000 units A’s variable cost per unit Rs 120/A’s fixed cost per unit Rs.20/Find i. Will the company as a whole benefit, if division C bought the component at Rs. 135/- from an outside buyer. (No) ii. If A did not produce the material for C, it could use the facilities for other activities resulting in a cash operating savings of Rs.18000/-. Should C then purchase from outside sources?(yes) iii. Suppose there is no alternative use of A’s facilities and the market price per unit for the component drops by Rs.20, should C buy from outside?(yes) Solution :i) Div C Buys from outside parties at Rs 135 SP per unit VC per unit Contribution per unit

135 120 15

Here if the division C buys the product at Rs 135 from the outside parties instead of division A, the company as whole will be loosing the contribution otherwise would have been earned of Rs.15, because it can produce the said item at variable cost of 120 only. Therefore division should not buy the product from outside at Rs.135/ii) C’s annual requirement is 1000 components If A produce this requirement and transfer it to C it is incurring the additional cost of Rs.18000, in other words it save on this cost if it does not produce the C required stock. i.e. per unit of this produce leads to cost of 18000/1000 i.e. Rs 18 per unit So instead of producing and earing Rs 15 as contribution it can save Rs18 per unit by choosing not to produce.

Therefore in this situation division C should go for purchase of the component fron outside parties at Rs135/Purchase cost 1000*135 135000 Less Saving on VC 1000*120 120000 Less Saving of A if its 18000 capacity used for other activities ---------Net Cost (benefit) to the company (3000) iii) If the selling price for A’s product drops by Rs 20, the new selling price will be Rs.115 per unit. Price drops from 135 to 115 SP per unit VC per unit Contribution per unit

115 120 (5)

In this situation the revised prices reduces the division A’s contribution and it becomes -5 per unit, it will better if division C goes for outside purchase because to produce the component division A has to incur variable cost of Rs.120/ but the said component is available at less than that so from A’s as well as from company’s point of view it is advisable for C to go for outside purchase. ================================= Problem 3: - (pg - 74) S V Ltd. manufactures a product, which is obtained basically from a series of mixing operations. The finished product is packaged in the company made glass bottles and packed in attractive cartons. The company is organized into two independent divisions viz. one for the manufacture of end product and other for manufacture of 800000 glass bottles. The product manufacturing division can buy all the bottle requirements from the bottle manufacturing division. The general manager of the bottle division has obtained the following data from the outside manufacturers for the supply of empty bottles – No of empty bottles Total Purchase value (Rs.) 800000 1400000 1200000 2000000 a cost analysis of the bottle manufacturing division for the manufacturing of empty bottles reveals the following production costs – No of empty bottles 800000 1200000

Total Purchase value (Rs.) 1040000 1440000

the production cost and sales value of the end product marketed by the product manufacturing division are as under – Volume Total cost of end product Sales Value (Bottles of end product) (excluding cost of bottles) (packed in Bottles) 800000 6480000 9120000 1200000 9680000 12780000 there has been considerable discussion at the corporate level as to the use of proper price for transfer of empty bottles from the bottle manufacturing division to product

manufacturing division. This interest is heightened because a significant portion of the Divisional General Managers salary is in incentive bonus based on profit center results. As a company management accountant responsible for defining the proper transfer prices for the supply of empty bottles by bottle manufacturing division to product manufacturing division, you are required to show for the two levels of volumes 800000 and 1200000 bottles, the profitability by using a. market price 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 whole under each method. Discuss also the effect of these methods on the profitability of the two divisions. Solution – 1) Statement showing the profit at two volumes 800000 & 1200000 at market price Pariculars Sales of Bottle mfg. Division (Treated outside prevailing price as TP) Less Production Cost

Vol. 8000000

Vol. 1200000

1,400,000

2,000,000

1,040,000

1,440,000

360,000

560,000

Sales of product Mfg. Division Less Cost of Production Less Cost of Bottles (as above)

9,120,000 6,480,000 1,400,000

12,780,000 9,680,000 2,000,000

b) Profit of Product Division

1,240,000

1,100,000

a+b) Profit of the SV Ltd

1,600,000

1,660,000

a) Profit Bottle mfg. Division

2) Statement of Showing determination of Transfer Price (Based on sharing the profits on Total Cost) Cost of Bottle Mfg Div. 1,040,000 Add Cost of Product Div. 6,480,000 Total Cost 7,520,000 Share of Bottle Mfg. Div. In Profits 1040000 * 1600000 & 1440000 * 1660000 7520000 11120000 Share of Product Mfg. Div. In Profits (Total Profits less Share of Bottle Div.) Cost of Bottle Mfg. Div Add Its Share of Profit TRANSFER PRICE BY BOTTLE Mfg. Div

1,440,000 9,680,000 11,120,000

221,276

214,964

1,378,724

1,445,036

1,040,000 221,276 1,261,276

1,440,000 214,964 1,654,964

3) Based on the above transfer price Profit Calculation of both division -

Sales of Bottle mfg. Division (Treated outside prevailing price as TP) Less Production Cost a) Profit Bottle mfg. Division

1,261,276

1,654,964

1,040,000

1,440,000

221,276

214,964

Sales of product Mfg. Division Less Cost of Production Less Cost of Bottles (as above)

9,120,000 6,480,000 1,261,276

12,780,000 9,680,000 1,654,964

b) Profit of Product Division

1,378,724

1,445,036

a+b) Profit of the SV Ltd

1,600,000

1,660,000

It can be seen that taking market price as transfer price is more appealing to Bottle Mfg. Div rather than TP based on sharing the profits on the costs basis. Problem 4: - (pg – 75) Fasters Ltd. is having production shops reckoned 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 Ltd is having a Welding Shop and a Painting Shop. The WS welds annually 75000 purchased items and other 150000 shop made parts in to 12000 assemblies. The assemblies are having variable cost of Rs. 9.50 each and are sold in market at Rs. 12 per assembly. Out of its total production of 12000, 80% is divested to PS at same price ruling in the market. WS incurs a fixed cost of Rs. 25000 per annum. The PS is having fixed cost of Rs.30000 and its cost of painting including transfer price from welding shop comes to Rs. 20 per unit. This shop sells all units transferred to it by welding shop at Rs. 25 per assembly. You are required to – a. find out profit of individual cost centers and overall profitability of the concern. b. Recommend course of action if painting shop wishes to purchase its full requirement (at market price which is Rs.10 per assembly) either from open market or from WS at market price of Rs10 per assembly. Give reasons for your recommendations. (find profit for each option i.e. open market as well as internal transfer separately) Tabulate profits under each option and Compare them Solution – a) Profitability of Welding Shop , Painting Shop and Company as whole Particular Sale in Open Market Transfer to Painting Shop Total Less V.C. Contribution Less Fixed Cost

Welding Shop Qty. Rate 2400 12 9600 12 12000 @ 9.50

Value 28800 115200 144000 114000 30000 25000

Qty.

Painting Shop Rate Value

9600 25 9600 @ 20.00

240000 240000 192000 48000 30000

Profit 5000 18000 Company as whole the profits would be 23000 b) i) When Paint shop purchases its entire requirement from OPEN market @ Rs. 10 (Welding shop doesn’t have any other option than to curtail the production to 2400 units.) Particular Sale in Open Market Transfer to Painting Shop

Welding Shop Qty. Rate 2400 12 9600 12

Value 28800 115200

Painting Shop Qty. Rate Value 9600 25 240000

Less V.C.

@ 9.50

22800

@ (20 – 12) = 8 Outside Buying cost @ 10

76800 96000

Contribution Less Fixed Cost

6000 25000

67200 30000

Profit

(19000)

37200

Company as whole the profits would be (19000) + 37200 = 18200 ii) When Paint shop purchases its entire requirement (i.e. 9600 units) from Welding shop at TP @ Rs. 10 (and welding shop can then as usual sell its rest of produce of 1200 in open market at MP of 12) Particular Sale in Open Market Transfer to Painting Shop Less V.C.

Welding Shop Qty. Rate 2400 12 9600 10 @ 9.50

Value 28800 96000 114000

Painting Shop Rate Value 25 240000

Qty. 9600

@ (20 – 12) = 8 Buying cost @ 10 (from WS)

76800

Contribution Less Fixed Cost

10800 25000

96000 67200 30000

Profit

(14200)

37200

Company as whole the profits would be (14200) + 37200 = 23000 Out of all options above b) ii) appears to be quite reasonable on account of Goal Congruence, maximum autonomy to both the Divisions, motivation to both the divisions. Both have been treated as cost center rather than mere profit centers.(Reduction in cost of paint shop) ===================================== Problem 5: - (pg85) Division A of Better Margins Ltd. has been given a budgeted target of selling 200000 components COM1, it manufactures at a price which would fetch a return of 25% on the average assets employed by it. The following figures are relavent: Fixed Overheads Rs. Varibale Costs Rs. Average Assest Sales Debtors Stocks Plant and other Assets

400000 1 per unit 200000 600000 400000

However the marketing department of the company finds out by a survey that the maximum number of COM1, the market can take at the proposed price is only 140000 units. Fortunately division B is willing to purchase the balance 60000 units. The manager of division A is willing to sell to division B at a concessional price of Rs 4 per unit. But the

manager of division B is ready to pay Rs2.25 per unit, as he feels he can himself make COM1 in his division at that price. Rather than selling to division B at rate Rs2.25 per unit, manager of division A feels that he will restrict the activity of his division to the manufacture and sale of 140000 components only. By this he can reduce Rs.80000 in stocks, Rs 120000 of plant and other assets and Rs. 40000 in selling and administrative expenses. As a management accountant do you agree with the proportion of maanger of division A to restrict the activities to 140000 componenets, from the overall interest of company. Give detail workings. (Find selling price for given ROI, with transfer to B at 2.25 and reduce activity –find profitability of both.) ===================================== Problem 6:- (pg 87) Hummer Sewing machine company is a decentralized manufacturing company in which all major component parts are made by separate divisions that are operated as profit centers. The motors for the sewing machines are made MTR division of the company. The MTR division has more capacity than required to satisfy production needs for the company’s sewing machines. During 1998 the division sold 30% of its motors to other companies at aprice of Rs 200 each and rest were sold to the assembly division of the Delux Sewing machine co. the industry average for the marketing and distribution costs of this type of motor is 20% of selling price. The MTR division made 25000 motors during 1998 and incurred the following expenses Direct Material Direct Labor Manufacturing O/H Total Production cost variance Operating Expenses Selling and Distribution Administrative

1500000 1000000 800000 400000(Unfavorable) 200000 800000

Evaluation of production standards has led toi the decision to increase production standard cots by 10% for the coming year. Market analysis indicate a 6% price increase is logical for motors. With the new standard costs, management of division MTR expects variance from standard will average 5% unfavorable. Production ab\nd sales quantities are expected to be the same as in 1998. Find – Compute the transfer price for the sewing machine motors for each of the following independent assumptions. 1. 2. 3. 4. 5. 6.

TP based on 1998 standard product cost. TP based on 1998 actual product cost. TP based on 1999 standard product cost. TP based on 1999 expected actual product cost. TP based on 1999 market price. TP based on 1999 market price modified for lower marketing and distribution costs. 7. Provide a 6% profit in 1999 expected total costs. 8. Prepare a schedule showing the MTR divisions net income for each of the 1999 base transfer pricing alternatives. (product cost and production ) ======================================

Example 8:- ( pg – 91) Paradise State park has been plagued by vandalism recently. There are no funds available to hire permanent security officers to patrol the park. However there is a general contingency fund with enough resources to hire temporary security people to patrol the park for a while until the vandalism controlled. Private security firms have bid for the job, with a low bid of Rs.250 per patrol hour, including patrol vehicles. The State Police have heard of the situation and offered to patrol the park. In return the park must pay the State Police out of the special contingency fund. State Police cost and activity data for the year as follows – Police Hours State Police in total 1000000 Stae Police Patrol Div.400000

Cost (Rs.) 150000000 72000000

Of the patrol division’s cost, 60% is variable. Required – A) Compute the transfer price for the state patrol service, if 1. Park officials can convince the State Police that full cost for the State Police activities in general is the appropriate transfer price. 2. State Police can convince park official that full cost for the patrol division is the appropriate TP. 3.State Police can convince park official that outside market price less a normal profit of 20% is the appropriate TP. 4.Park official can convince the State Police that the appropriate TP is the variable part of the patrol division cost plus an incentive of 20% of the variable cost. A) If the contingency fund can provide Rs.270000 for this project, how many patrol hours can the aprk purchase using each of the TPs’ computed above? ======================================== Problem9: Two of the divisions of C Corporation Ltd. are the Intermediate Division (ID)and Final Division(FD). The ID produces three products A, B & C. Normally these products are sold both to outsiders and to FD. The FD uses products A, B & C in manufacturing of X, Y & Z respectively. In recent weeks, the supply of products A,B,C has tightened to such an extent that the FD has been operating considerably below capacity. With the result, the ID has been told to sell all its products to FD. The financial facts about these products are as follows – Intermediate Division Transfer Price (Rs) Variable Mfg. Cost per unit Contribution per unit Fixed Costs (Total)

Product A 10 3 7 50,000

Product B 10 6 4 100,000

Product C 15 5 10 75,000

The ID has a monthly capacity of 50000 units. The processing constraints are such that capacity production can be obtained only by producing at least 10000 units of each product. The remaining capacity can be used to produce 20000 units of any combination of the three products. The ID cannot exceed the capacity of 50000 units. Final Division

Selling Price (Rs) Variable Mfg. Cost per unit Inside purchases Other VC Total VC Contribution per unit Fixed Costs (Total)

Product X 28

Product Y 30

Product Z 30

10 5 15 13

10 5 15 15

15 8 23 7

100,000

100,000

200,000

The FD has sufficient capacity to produce about 40% more than it is now producing, because the availability of products A, B & C is limiting production. Also the FD can sell all the products that it can produce at the price indicated above. Find B) a. If you were manager of the ID, what products would you sell to the FD? What is the amount of profit that you would earn on these sales? b. If you were the manager of FD, what products would you order from the ID, assuming that the ID must sell all its production to you? What profits would you earn? c. What production pattern optimizes total company profit? How does this affect the profits of the ID? If you were the Executive V P of C Corporation Ltd. and prescribed this optimum pattern, how would you distribute the profit between two divisions? (With minimum capacity compute contribution , allot rest of the excess capacity to product giving maximum contribution, compute profit if ID, FD, Company) B. How, if at all, would your answer to (A) change if there were no outside buyer for products A, B & C. (vague answer) C. The company has determined that capacity can be increased in excess of 50000 units, but these increases require an out of pocket cost penalty. These penalties are as follows – Volume in excess of Cost Penalty (Rs.) Present capacity (units) Product A Product B Product C 1000 10000 12000 10000 2000 25000 24000 20000 3000 50000 50000 35000 4000 80000 80000 50000 Each of the above increases is independent i.e increase of production of product A do not affect the costs of increasing the production of B or C. Change can be made only in quantities of 100 units with maximum of 4000. Find i. What would be the ID’s production pattern, assuming that it can charge all penalty costs to the FD? (ID can hike capacity to maximum for a product which gives max contribution) ii. The FD’s optimum production pattern, assuming that it is required to accept the penalty costs? (for each level excess output , find when contribution margin – penalty cost will be max. that is the max capacity FD can afford ) iii. The optimum company production pattern. (for each product and each volume hike find Net Conti = conti – penalty) Solution A-a,b,c

Intermediate Division Contribution PU

A

B

C

7

4

10

Minimum Vol. Consn.

10000

10000

10000 20000

Total Contribution Fixed Cost Profit

70000 50000 20000

40000 100000 -60000

300000 75000 225000

Final Division Contribution PU Minimum Vol. Consn.

X

Y

185000

Z

13

15

7

10000

10000

10000

20000 Total Contribution Fixed Cost Profit

130000 100000 30000

450000 100000 350000

70000 200000 -130000

28

30

30

3 5

6 5

5 8

20 10000

19 10000 20000 570000 100000 100000 370000

17 10000

250000

Company as Whole Selling Price Variable cost VC Attached at ID VC Attached at FD Contribution

Total contribution FC at ID FC at FD Profit

200000 50000 100000 50000

170000 75000 200000 -105000

315000

Profit sharing will be based on the product volume decided on the basisi of Company’s optimal mix. It works out to as under Contribution at ID Volume as per Co's Mix Toatl Contribution FC at ID Profit to ID Contribution at FD Volume as per Co's Mix FC at FD Profit to FD

7 30000 210000 50000 160000 13 30000 390000 100000 290000

4 10000 40000 100000 -60000 15 10000 150000 100000 50000

10 10000 100000 75000 25000 7 10000 70000 200000 -130000

21 50000 350000 225000 125000 35 50000 610000 400000 210000

B Since the products do not have external market TP has to be fixed based on motivation and goal congruemce i.e. total cost and some margin.

C i ) Since ID can charge all its penalty to FD , it will go for maximum increases of 4000 units and specially for such product which gives highest contribution. i..e product C C ii)Since FD will accept all penalty costs, we will go for that vol hike which gives the maximum after penalty contribution Prod A VC per unit at ID FC at ID Penalty Cost to Increase vol by 1000 Penalty Cost to Increase vol by 2000 Penalty Cost to Increase vol by 3000 Penalty Cost to Increase vol by 4000 Penalty Cost per unit

Prod C

6 4 12000 24000 50000 80000 12 12 16.7 20

5 10 10000 20000 35000 50000 10 10 11.7 12.5

13

15

7

3 1000

3 2000

0

Contribution at FD Contri After Penalty(Max) (Select the vol which gives max contri after penalty)

Prod B

3 7 10000 25000 50000 80000 10 12.5 16.7 20

Thus company should go for increase in capacity of product A by 1000 units and product B by 2000 units. C c) Optimum Company production based on penalty cost Product X 20

Product Y 19

Product Z 17

20000 10000 10000

19000 12000 7000

17000 10000 7000

Total contribution for 2000 units Cost penalty Net Contribution

40000.0 25000 15000.0

38000.0 24000 14000.0

34000.0 20000 14000.0

Total contribution for 3000 units Cost penalty Net Contribution

60000 50000 10000

57000 50000 7000

51000 35000 16000

Total contribution for 5000 units Cost penalty Net Contribution

80000 80000 0

76000 80000 -4000

68000 50000 18000

Contribution Per Unit Total contribution for 1000 units Cost penalty Net Contribution

Thus maximum after penalty contribution is possible in product Z i.e. production of product C. ====================================