6. transfer pricing

6. Transfer Pricing 1

6. Transfer Pricing


Transfer Pricing

A transfer price is the price one subunit chargesfor a product or service supplied to another

subunit of the same organization.

Intermediate products are the productstransferred between subunits of an organization.


Objectives of Transfer Pricing• Two or more Profit Centers are jointly involved in manufacturing,

product development & marketing, they should share the revenue generated (when the product is finally sold). The transfer price mechanism must distribute this revenue to achieve the following objectives:

– Provide each unit with information for an optimum trade-off between company costs & revenues.

• The company maximizes it’s profits when Marginal costs = Marginal Revenue

– Introduce Goal Congruence – i.e. decisions that improve the business unit’s profits also improve the company’s profits.

– Should measure Economic Performance of the units– Should be simple to understand and easy to administer


Transfer Pricing

Transfer pricing should help achievea company’s strategies and goals.– fit the organization’s structure

– promote goal congruence– promote a sustained high level

of management effort


Transfer-Pricing Methods

Market-based transfer prices. The market price represents the opportunity cost, of selling internally.

Cost-based transfer prices.Standard Costs, used. Profit Mark-up usually at rate of return like anindependent company (say > WACC)

Negotiated transfer prices.Whether internal or external, today everyone must make the “value-chain”competitive

Fundamental Principle: A Transfer price should be similar to the price, as if soldto an outside customer.• Help the company arrive at correct Sourcing decision (make in-house, or buy?)•If made in-house, the transfer price should be optimum:

• The unit does not sell at a loss (i.e. at least recover variable costs)• The unit attempts to maximize contribution, , by accounting for opportunity costs.


The Ideal Situation for Market-based transfer pricing

• Market based transfer pricing will induce goal congruence if all the following conditions exist:

– People must be competent – i.e. they can manage on their own.

– Good atmosphere – i.e. all perceive transfer prices as just.

– Transfer price must actually represent market price less benefits accruing out of dealing internally (for e.g. bad debt expense, advertising costs, selling costs hardly exist when selling internally).

– Freedom to source – the selling divisions and buying units, both have freedom sell or buy in their own self interest. This way the open market establishes the correct “transfer price”. The market cost represents a selling unit’s opportunity cost of selling internally. It is also an opportunity cost for the company.

– Full information – available alternatives, their costs and revenues must be known accurately (i.e. assuming a perfect market.

– Negotiation – the processes for negotiation, arbitration, dispute resolution, etc must be smooth.


Real life constraints on sourcing from open markets• Though full freedom is “ideally”

desired, in reality it is not feasible:– Limited markets – even if

outside capacity exists, it may not be available to an internal unit:

• Because the unit doesn’t use this capacity regularly, especially as an internal unit exists

• If the internal unit is “sole” producer, no outside supplier exists

• The company has invested significantly in facilities. Hence, it will not permit the use outside sources, unless outside selling price approaches it’s variable cost (which is unlikely). The internal capacity must be utilized.

• The might be shortages in the market

– Even in limited markets, as above, a “competitive” transfer price should be set.

• A competitive price is as if no internal capacity is available, and inputs (for e.g. crude) must be purchased from outside at “market” conditions.

• And still, both units must ensure a positive contribution to company’s profits.

• A “competitive” price helps measure the performance of the unit vis-a-vis competition.

– Ways of determining “competitive” price:• Published market prices – for conditions

similar to within the company. • Bids – valid bidders will make a serious low

bid , only they have an assurance that you will buy, if they bid the lowest (even below your own company)

• Production profit center – the price it sells to outside market.

• Buying profit center – i.e. purchases from outside market as well


Cost-Based Transfer Prices Two Issues of fixing cost-based

transfer prices:

• How to define costs– Usual basis is “standard” costs. And

the selling unit must make an attempt to “improve” standards.

• How to calculate the mark-up– What is the basis for profit mark-up

• Most commonly % of cost is used as a basis. Sometimes % of investment

• The level of profit allowed (profit allowance)

• Generally it should approximate, as far as possible, the rate of return if business unit would have earned as an independent unit, selling to the outside market

Issues of Upstream fixed costs & Profits.

The profit center that finally sells to the customer must be competitive, and hence have control & full knowledge of the upstream costs & profits. Else the whole value chain will be pushed out of the market.

Even if it knew all upstream costs, it may “insist” on making an uncompetitive” profit, which would jeopardize the business (i.e. loosing the customer)

Methods to overcome the above problems:• Agreement among Business Units.

– All units jointly decide on selling price and profit sharing. This is reviewed as frequently as is necessary

• Two-Step Pricing– Two charges

• Standard variable cost of production• Associated Fixed Costs – for

facilities reserved for the subsequent division


Cost-based pricing …contd.

• An example of two-step pricing

• Say Unit Y buys Product X at transfer price from X.

• One way is to transfer (FULL COST) at $11 (incl. All costs I.e. variable, fixed & competitive ROI (i.e. $5, $4 & $2). But at this price, Unit Y does not know the costs & profits of Unit X.

• Two Step Pricing : Variable per unit $5 plus FIXED $30,000 every month end.

– If X picks up less than 5000 units, it still pays the agreed FIXED costs.

– It gains if it sells more than 5000 units

• Profit Sharing method :– Sometimes Two-Step method is

not feasible. Then a profit-sharing system can be employed:

• The product is transferred to the marketing unit at variable cost.

• After the product is sold the business units share the contribution earned (Selling Price – variable mfg & marketing costs).

• Two Sets of Prices– In this method the manufacturing unit

gets credit at market prices. The buying unit is charged at TOTAL STANDARD costs. The difference is charged to HQ account.

– This method benefits both units. Is most useful if there are conflicting situations.

Unit X (manufacturer) Product AExp. Monthly sales to Unit Y 5000 unitsVariable cost/unit $ 5Monthly Fixed cost (assigned) $20,000Capital invested $1,200,000Competitive ROI per year 10%

Various types of Cost-based transfer price – Full cost plus mark-up, Two-step, Profit Sharing…


Pricing Corporate Services• Only those corporate services are charged to units, on which the units have

“some” control.

• Non-controllable (by unit) corporate expenses may be “allocated” to the units, but they do not constitute transfer prices. Corporate Communication services such as PR, corporate advertising, are such services.

• Transfer prices for corporate services can be made, under the following conditions:– The receiving unit can at least partially control the amount used ( e.g. in

Siemens, SAP seats can be somewhat controlled). In such cases (i.e. IT services, R&D, the unit may not be able to control the efficiency, but they can control the amount.

• There are various of pricing such services i.e. standard variable cost, standard full cost, standard full cost plus profit margin or market price

– The unit can decide whether to use or not (e.g. CRM package, )• In such cases, the buying unit may choose to get outside services. In short the

selling unit must be competitive


Administration of Transfer Prices• Negotiating transfer prices:

– Not set by HQ, but after mutual negotiation– Compromises by both sides required. It makes sense to work as members of the

same “value chain”. Too much time must not be spent on “internal” negotiation.

• Arbitration & Conflict Resolution– Normally the CFO is the arbitrator.

• Product Classification.– The availability of “market” price information, is crucial for transfer price

arbitration.– Products tend to classified as:

• CLASS I – where senior management controls sourcing. These products may have “customized” rules for transfer pricing, based on strategic objectives. For e.g. a strategically important product may be transferred at an “aggressive” price (and subsidized by HQ)

• CLASS II – Generally can be produced outside the company / outsourced. These are transferred at market prices.


Transfer-PricingMethods Example

Lomas & Co. has two divisions:Transportation and Refining.

Transportation purchasescrude oil in Alaska and

sends it to Seattle.

Refining processescrude oil

into gasoline.



External market price (in Alaska) forcrude oil per barrel: $13

Transportation Division:Variable cost per barrel of crude oil $ 2Fixed cost per barrel of crude oil 3*Total $ 5

The pipeline can carry 35,000 barrels per day.*Per unit Fixed Costs are based on a planned / standard volume



External purchase price (in Seattle) forcrude oil per barrel: $23

Refining Division:Variable cost per barrel of gasoline $ 8Fixed cost per barrel of gasoline 4**Total $12

The division is buying 20,000 barrels per day.**Per unit Fixed Costs are based on a planned / standard volume.

The refining division is operating at 30,000 barrels per day



The external market price to outsideparties is $60 per barrel.

The Refining Division is operatingat 30,000 barrels capacity per day.



What is the market-based transfer pricefrom Transportation to Refining?

$23 per barrel

What is the cost-based transfer priceat 112% of full costs?



Purchase price of crude oil $13Variable costs per barrel of crude oil 2Fixed costs per barrel of crude oil 3Total $18

1.12 × $18 = $20.16

What could be the negotiated price?

Between $20.16 and $23.00 per barrel.If transportation division’s capacity is lying idle, it may be willing to

negotiate anything more than variable cost i.e. $15. (i.e. between $15 to $23)



Assume that the Refining Division buys1,000 barrels of crude oil from the

Transportation Division (at market price).

The Refining Division converts these 1,000barrels of crude oil into 500 gallons of

gasoline and sells them.

What is the Transportation Division operatingincome using the market-based price?



Transportation Division:Revenues: ($23 × 1,000) $23,000Deduct costs: ($18 × 1,000) 18,000Operating income $ 5,000

What is the Refining Division’s operatingincome using the market-based price?



Refining Division:Revenues: ($60 × 500) $30,000Deduct costs:

Transferred-in ($23 × 1,000) 23,000Division variable ($8 × 500) 4,000Division fixed ($4 × 500) 2,000

Operating income $ 1,000



What is the operating income of bothdivisions together?

Transportation Division $5,000Refining Division 1,000Total $6,000



What is the Transportation Division’s operatingincome using the 112% of full cost price?

Transportation Division:Revenues: ($20.16 × 1,000) $20,160Deduct costs: ($18.00 × 1,000) 18,000Operating income $ 2,160

What is the Refining Division operatingincome using the full cost price?



Refining Division:Revenues ($60 × 500) $30,000Deduct costs:

Transferred-in ($20.16 × 1,000) 20,160Division variable ($8.00 × 500) 4,000Division fixed ($4.00 × 500) 2,000

Operating income $ 3,840



What is the operating income of bothdivisions together?

Transportation Division $2,160Refining Division 3,840Total $6,000


Learning Objective

Illustrate how market-basedtransfer prices promote goal

congruence in perfectlycompetitive markets.


Market-Based Transfer PricesBy using market-based transfer pricesin a perfectly competitive market, acompany can achieve the following:

Goal congruence

Management effort

Subunit performance evaluation

Subunit autonomy


Market-Based Transfer Prices

Market prices also serve to evaluate theeconomic viability and profitability

of divisions individually.


Market-Based Transfer Prices

When supply outstrips demand, market pricesmay drop well below their historical average.

Distress prices are the drop in pricesexpected to be temporary.


Learning Objective

Avoid making suboptimaldecisions when transferprices are based on full

cost plus a markup.


Cost-Based TransferPrices Example

The Refining Division of Lomas & Co. ispurchasing crude oil locally for $23 a barrel.

The Refining Division located an independentproducer in Alaska that is willing to sell 20,000

barrels of crude oil per day at $17 per barreldelivered to the pipeline (Transportation Division).



The Transportation Division has excesscapacity and can transport the crude oil

at its variable costs of $2 per barrel.

Should Lomas purchase from theindependent supplier?

Yes.

There is a reduction in total costs of $80,000.



Alternative 1:Buy 20,000 barrels from the

local supplier at $23 per barrel.

The total cost to Lomas is:20,000 × $23 = $460,000



Alternative 2:Buy 20,000 barrels from the independentsupplier in Alaska at $17 per barrel andtransport it to Seattle at $2 per barrel.

The total cost to Lomas is:20,000 × $19 = $380,000



Suppose the Transportation Division’stransfer price to the Refining Division

is 112% of full cost.

What is the cost to the Refining Division?



Purchase price of crude oil $17Variable costs per barrel of crude oil 2Fixed costs per barrel of crude oil 3Total $22

1.12 × $22 = $24.64

$24.64 × 20,000 = $492,800



What is the maximum transfer price?

It is the price that the Refining Division canpay in the local external market ($23).

What is the minimum transfer price?

The minimum transfer price is $19 per barrel.The Range for negotiation (with Transportation) is between the

maximum & minimum available from the market


Learning Objective

Understand the range overwhich two divisions negotiate

the transfer price whenthere is unused capacity.


Prorating

Lomas & Co. may choose a transfer pricethat splits on some equitable basis the

difference between the maximum transferprice and the minimum transfer price.

$23 – $19 = $4

Suppose that variable costs are chosen asthe basis to allocate this $4 difference.


Prorating

The Transportation Division’s variablecosts are $2 × 1,000 = $2,000.

The Refining Division’s variable costs torefine 1,000 of crude oil into 500 barrels

of gasoline are $8 × 500 = $4,000.


ProratingThe Transportation Division gets to keep

$2,000 ÷ $6,000 × $4 = $1.33.

The Refining Division gets to keep$4,000 ÷ $6,000 × $4 = $2.67.

What is the transfer price from theTransportation Division?

$17.00 + $2.00 + $1.33 = $20.33


Dual PricingAn example of dual pricing is for Lomas & Co.

to credit the Transportation Division with112% of the full cost transfer price of $24.64

per barrel of crude oil.

Debit the Refining Division with the market-basedtransfer price of $23 per barrel of crude oil. $1.64

Debited to HQDISCUSSION: The Pros & Cons of this transfer pricing. Will this promote efficiencyin the transportation division?


Negotiated Transfer Prices

Negotiated transfer prices arise from theoutcome of a bargaining process between

selling and buying divisions.


Learning Objective

Construct a general guidelinefor determining a minimum

transfer price.


Comparison of Methods

Achieves Goal Congruence

Market Price: Yes, if markets competitiveCost-Based: Often, but not alwaysNegotiated: Yes



Useful for Evaluating Subunit Performance

Market Price: Yes, if markets competitive

Cost-Based: Difficult, unless transferprice exceeds full cost

Negotiated: Yes



Motivates Management Effort

Market Price: Yes

Cost-Based:Yes, if based on budgetedcosts; less incentive ifbased on actual cost

Negotiated: Yes



Preserves Subunit Autonomy

Market Price: Yes, if markets competitiveCost-Based: No, it is rule basedNegotiated: Yes



Other Factors

Market Price: No market may exist

Cost-Based: Useful for determiningfull-cost; easy to implement

Negotiated: Bargaining takes time andmay need to be reviewed


General Guideline

Minimum transfer price= Incremental costs per unit incurred

up to the point of transfer+ *Opportunity costs per unit to the selling division

*Opportunity cost varies with circumstances. •Supply > Demand : i.e. if idle capacity available, only variable cost•Demand > Supply : highest bidder’s price


General GuidelineAssume a perfectly competitive market,

with no idle capacity.

Transportation Division can sell all the crude oilit transports to the external market in Seattle

for $23 per barrel.


($19 + $4) or ($13 + $2 + $8) = $23 = Market price

Contribution


General GuidelineAssume that an intermediate market existsthat is not perfectly competitive, and the

selling division has idle capacity.

If the Transportation Division has idlecapacity, its opportunity cost of transferring

the oil internally is zero.



General GuidelineIt would be $15 per barrel for oil purchased

under the long-term contract, or... i.e. $13 is crude procurement

and $2 is variable. Anything more is contribution*

$19 per barrel for oil purchased andtransported from the independent

supplier in Alaska.*A profit center tries to maximize contribution in a way that it first recovers fixed

costs. Then goes for maximizing NOPAT


Learning Objective

Incorporate income taxconsiderations in

multinationaltransfer pricing.


Multinational Transfer Pricing

Generally, all countries require that transfer prices forboth tangible and intangible property between acompany and its foreign division be set to equalthe price that would be charged by an unrelated

third party in a comparable transaction.

Divisions operate at ARM’S LENGTH with each other


A Sample Problem in transfer pricing:Part 1- Calculate FULL COST Transfer Price(s) & Std Cost

1. Division A of company L, manufactures Product A, which is sold to Division B as a component of Product Y. Product Y is sold to Div C, as a component of it’s Product Z, which is sold to the external market. The intra-company transfer price rule is to transfer at Standard Cost plus a 10% return on inventories & fixed costs.

Q1. From the information above calculate the transfer price for Products X & Y and the standard cost of Product Z.

Standard Cost Per Unit (in Rs) Product X

Product Y Product Z

Material purchased from outside

2 3 1

Direct Labour 1 1 2

Variable Overhead 1 1 2

Fixed Overhead / unit 3 4 1

Standard Volume 10,000 10,000 10,000

Inventories (average) 70,000 15,000 30,000

Fixed Assets (Net) 30,000 45,000 16,000

Cost item (in Rs) TP of X

TP of Y

Std Cost of Z

Transfer in cost 0 8 17.6

Variable Cost / unit 4 5 5

Total Variable (input) costs 4 13 22.6

Direct Fixed Cost / unit 3 4 1

Total Cost (Direct) 7 17 23.6

Add: Charge (of 10%) on assets – Fixed & Inventory per unit

1 0.6 0.46

Transfer Price 8 17.6 24.06

SOLUTION to Q1

NOTES:• Direct = directly proportional to no. of units• Std Cost per unit of a division is all direct costs per unit.• Transfer Price is like Selling Price.

• It varies between variable cost to total cost.• For e.g. if capacity is idle, you will utilize capacity to first defray fixed costs, and then earn profits


A Sample Problem in transfer pricing:Part 2- Calculate Transfer Price (Two-Step method)…contd

Q2. Using the information in Q1, if TP rule is TP is variable cost per unit plus monthly charge. This charge is equal to fixed charge assigned to the product plus 10% return on avg. inventories & fixed assets, calculate TP for X & Y and unit std. cost for Y & Z

Cost item (in Rs) TP of X TP of Y Std Cost of Z

Transfer in variable cost 4 9

Variable Cost / unit 4 5 5

Total Variable (input) costs 4 9 14

• Fixed cost passed in from previous division 40000 86000

•Direct Fixed Cost (per unit X no. of units) of current division 30000 40000 10000

•Fixed Asset Charge (of 10%) on assets of current division – Fixed & Inventory per unit

10000 6000 4600

Total Monthly Charge passed on to next division (All fixed costs so far)

40000 86000 100600

Std. Unit Cost in current division (at 10,000 std vol) 8 17.6 24.06

Notes:• Variable costs vary as per no. of units. • Fixed costs are converted to unit cost, based on volume. Std costs are based on std. volume.• Subsequent divisions, can reduce their per unit cost by exceeding std. volume. Conversely, their per unit costs exceed std. costs if they fall below std. volume.


Example of relationship between Transfer Price (total costs) & Contribution

Question A) Given TP as in 1. above, i.e. FULL COSTS, should Division C, maintain it’s price Rs. 28, or follow competition:

• The present selling price of Product Z is Rs. 28. Competition is contemplating price reductions, and their impact on sales volume of product Z are estimated as below:

Possible competition’s price (in Rs) 27 26 25 23 22

Sales volume, if Product Z’s price is maintained at Rs. 28 9000 7000 5000 2000 0

Sales Volume if Product Z matches competitions price 10000 10000 10000 10000 10000

Competitive Price

Competitive Price 27 26 25 23 22

Variable Cost 22.6 22.6 22.6 22.6 22.6

Contribution/unit 4.4 3.4 2.4 0.4 (-) 0.6

Sales Quantity 10000 10000 10000 10000 10000

Total Contribution 44000 34000 24000 4000 (-) 6000

Maintain the price

Maintain the price 28 28 28 28 28

Variable cost 22.6 22.6 22.6 22.6 22.6

Contribution/unit 5.4 5.4 5.4 5.4 5.4

Sales Quantity 9000 7000 5000 2000 0

Total Contribution 48600 37800 27000 10800 0

• Maintaining the price is the better option, because it gives higher contribution.

• BUT, this decision based on FULL COST TP, may not be the best for the company. The best decision is one which maximizes Sum of Contributions made by all divisions, i.e. by the whole company.

•NOTE: CONTRIBUTION is (Selling Price) less (Variable Costs). It “contributes” to

•covering Fixed costs at various levels, i.e. division, corporate, etc; •overheads such as management salaries, etc; •and finally to profits


Example of relationship between Transfer Price (two-step) & Contribution

Question B) Given TP as in 2. above, i.e. TWO-STEP COSTS, should Division C, maintain it’s price Rs. 28, or follow competition:

SOLUTION to Q B (See Table alongside):• In this case, i.e. when two-step method is used for

TP, then recommended approach is to follow the competition, because Total Contribution is higher.

• NOTE: Maximizing CONTRIBUTION is the key objective of divisions.

• As you would observe, different methods of transfer pricing, induces different behavior by the divisions. BUT, which is the best method?

• The profits of the whole company must be maximized.

Competitive Price

Competitive Price 27 26 25 23 22

Variable Cost 14 14 14 14 14

Contribution/unit 13 12 11 9 8

Sales Quantity 10000 10000 10000 10000 10000


Maintain the price

Maintain the price 28 28 28 28 28

Variable cost 14 14 14 14 14

Contribution/unit 14 14 14 14 14

Sales Quantity 9000 7000 5000 2000 0


QUESTION C: Which TP method is in the best economic interest of the Company?

ANSWER : Total Variable Cost (not Full Cost)• Upstream visibility of costs available. The selling unit can act to maximize overall contribution. In the FULL COST method, marginal costs (variable) from previous divisions are not visible• Economic theory : Company profits are maximized when Marginal cost = Marginal Revenue. So as long as there is spare capacity aim to maximize capacity utilization, by selling at the highest price attainable, above the variable cost.


The cost of a faulty Transfer Price PolicyQUESTION D: Using the TP based on Total Cost As in case 1, is the manager making a

decision, contrary to the best interest of the company? If so, what is the opportunity loss to the company in each of the competitive pricing actions?

As seen earlier, when FULL COST TP was used, Division chose to Maintain price at Rs. 28. When Two-step TP was implemented, Division C, chose to follow the competitive price.

Various pricing scenarios by competition (Rs) 27 26 25 23 22

When Full Cost TP was used

Total Contribution, when Selling Price was maintained at Rs. 28 48600 37800 27000 10800 0

Less: Fixed Price of Division C & Capital Charge. All other costs (fixed of earlier divisions + all variable) already taken.

14600 14600 14600 14600 14600

Company’s Profit 34000 23200 12400 (-) 3800 (-) 14000

When Two-step TP was used

Total Contribution, when Selling Price was competitive 130000 120000 110000 90000 80000

Less: Fixed Cost & Capital Charge of Total Company. = 10000 X (3 + 4 +1). + 10% of Rs. 206,000/-

100600 100600 100600 100600 100600

Company’s Profit 29,400 19400 9400 (-) 10600 (-) 20600

Opportunity Loss (-) (due to using the incorrect TP method). NO LOSS MADE . FULL COST IS BEST!

4600 3800 3000 6800 6600

( -)


Faulty TP policy can cause faulty investment decisionsQUESTION 4: Division wishes to invest in TV advertising to increase it’s sales. A marketing survey

reveals the impact of advertising, on increase in sales, as below:

ANSWER to Q 4:

Advertising Exp (in Rs.) 100000 200000 300000 400000 500000

Sales Volume of Z, at diff levels of ad spend 10000 19000 27000 34000 40000

When FULL COST TP used. The contribution of Division C per unit was Rs. 5.40 (Rs 28 – 22.60)



Incremental contribution on added volume (5.4 X vol incr.)

54000 102600 145800 183600 216000

Net Contribution ( Contribution less Exp) -46000 -97400 -154200 -216000 -284000

When Two-Step method used. Assumed that selling price is Rs. 28 and & contribution is Rs. 14. Ad. spend increases sales volume at the given Selling price of Rs. 28



Incremental contribution on added volume (14 X X vol incr.)

140000 266000 378000 476000 560000

Net Contribution ( Contribution less Exp) 40000 66000 78000 76000 60000

The best decision. • Two-step TP• Invest Rs. 300000 in TV ads

Because of –ve contribution, Div C says no TV Ads.

If a faulty TP policy (FULL COST) was used, Division C would loose an opportunity to contribute 78K to the company


University Questions1. A company fixes the inter divisional transfer prices for its product on the basis of

cost plus estimated return on investment in its divisions. The relevant portion of the budget for division' A' for year 2007-08 is given below: Fixed Assets Rs.5, 00,000 Assets (other than debtors) Rs. 3, 00,000 Debtors Rs.2, 00,000 Annual fixed cost of division Rs.8, 00,000 Variable cost per unit of product Rs.10Budgeted volume of production per year (units) 4,00,000 desired return on

investment 28%. You are required to determine transfer price for division 'A'. [10]

Division 'A' and 'B' are both considering an outlay on new investment projects.

Div A Div BInvestment outlay Rs. 1,00,000 Rs. 1,00,0000

Return on new Rs. 16,000 Rs. 11,000

Current ROI 18% 11%

The company’s Cost of Capital is 13%. Should the project be accepted or rejected ?[6]


Univ Qs2. In a typical organization one can observe goal conflicts arising out of different roles its people

play/assume i.e. an individual, hierarchical, functional, organizational. How one can resolve this conflict? Explain with suitable example." [18] ch 6 – transfer pricing arbitration – pg 256-7

3. ABC Ltd is a multidivision integrated company. One of its division "A" produces a product, which is being sold in open market entirely. However in view of demand from division "B", "A" supplies part of its produce to 'B'. To keep motivated both the divisions, company has established a transfer pricing policy such that' B' shall pay actual full cost plus 50% of profit division 'A' would have made, if it would have sold the product in open market. Given below the sales and cost data for division' A'.

Volume per annum 10,000 unitsExternal sales @ Rs.150 per unit. 6,000 units Internal transfer as per TP policy 4,000 units (?).Variable cost Rs.80 per unit Fixed cost Rs.20 per unit. Required:• Compute the transfer price per unit need to be born by division 'B' in the present circumstances.• Incase demand from division B goes up from 4,000 to 6,000 units and division agrees to pay 60% of

profit instead of 50% agreed earlier. Compute transfer price in this situation.• Compute profitability of division' A', in case of situations discussed in 1 & 2 above.• Given selling price of final product by 'B' is Rs.250 per unit, variable cost of Rs.30 per unit

(excluding transfer price) and fixed cost ofRs.20 per unit (based on volume of 4,800 units).compute profitability of division 'B' in both the above discussed situations'- 1 & 2. Offer your comments on suitability of approach. [16]

4. Write short notes on any THREE – Market based and cost based transfer pricing. {ch 6 pg 245-249


Univ Q’s

5. M/s. Mittal Ltd has two divisions M & N. Division M sales two third of its produce to division N and rest in the open market. Cost and revenue of these divisions and that of company for year 2,000 is given as under:

(Amt.in Rs.) M N

Company Sales (outside only) 16,000 8,000 Cost of manufacturing 24,000 20,000 (Internal + outside sales)

Profit 44,000 20,000There is no opening or closing stock. You are required to find out profit of each division and that of company under following options of transfer prices-

.~ a) at cost. b) at cost plus a margin of25%. c) at cost plus a margin of 25% ; but there is overspending in division M by Rs.3,000. d) at market price.

[16]


Univ Q’s6. The Allison-Chambers Corporation, manufacturer of tractors and other heavy farm equipment,

is organized along decentralized lines, with each manufacturing division operating as a separate profit center. Each division manager has been delegated full authority on a11 decisions involving the sale of that division's output both to outsiders and to other divisions of Allison-Chambers. Division C has in the past always purchased its requirement of a particular tractor engine component from Division A. However, when informed that Division A is increasing its selling price to $150, Division C' s manager decides to purchase the engine component from outside suppliers.

Division C can purchase the component for $135 on the open market. Division A insists that, because of the recent installation of some highly specialized equipment and the resulting high depreciation charges, it will not be able to earn an adequate return on its investment unless it raises its price. Division A's manager appeals to top management of Allison-Chambers for support in the dispute with Division C and supplies the following operating data: C's annual purchases of tractor-engine component 1,000 unitsA's variable costs per unit of tractor-engine component $120A's fixed costs per unit of tractor-engine component $20

REQUIRED [16]I. Assume that there are no alternative uses for internal facilities. Determine whether the company as a whole will benefit if Division C purchases the component from outside suppliers for $135 per unit.2. Assume that internal facilities of Division A would not otherwise be idle. By not producing the 1,000 units for Division C, Division A's equipment and other facilities would be used for other production operations that would result in annual cash-operating savings of$18,000. Should Division C purchase from outside suppliers?3) Assume that there are no alternative uses for Division A's internal facilities and that the price from outsiders drops $20. Should Division C purchase from outside suppliers?


Univ Q’s 7. Case no. 1 {ch 6}

Division A of a large divisionalized organization manufactures a single standardzid product. Some of the output is sold externally whilst the remainder is transferred to Division B where it is a subassembly in the manufacture of that division’s product. The unit cost of Division A’s product are as follows:

($)Direct material 4Direct labour 2Direct expenses 2Variable manufacturing overheads 2 Fixed manufacturing overheads 4 Selling and packing expense variable � 1 15

Annually 10000 units of the product are sold externally at the standard

price of $30.In addition to the external sales, 5000 units are transferred annually to

Division B at an internal transfer charge of $29 per unit. This transfer price is obtained by deducting variable selling and packing expense from the external price since this expense is not incurred for internal transfers.

Division B incorporates the transferred-in goods into a more advanced product. The unit costs of this product are as follows.

($)Transferred-in item (from Division A) 29Direct material and components 23Direct labour 3Variable overheads 12Fixed overheads 12Selling and packing expense variable � 1Total Costs 80

Division B’s manager disagrees with the basis used to set the transfer price. He argues that the transfers should be made at variable cost plus an agreed (minimal) mark-up since he claimed that division is taking output that Division A would be unable to sell at the price of $30.

Customer demand at various selling prices:

Division ASelling Price $20 $30 $40Demand 15000 10000 5000

Division BSelling price $80 $90 $100Demand 7200 5000 2800

The manager of Division B claims that this study supports his case. He suggests that a transfer price of $12 would give Division A a reasonable contribution to its fixed overheads while allowing Division B to earn a reasonable profit. He also believed that it would lead to an increase of output and an improvement in the overall level of company profits.

You are required:• to calculate the effect hat the transfer pricing system has had

on the company s profits, and�• to establish the likely effect on profit of the suggestion by the

manager of Division B of a transfer price of $12.


Univ Q’s

8. Case no. 2 {ch 6}Fastner International Ltd. is having production shops reckoned as profit centres. Each shop is allowed to charge other shops for materials supplied and services rendered. The shops are motivated through goal congruence, autonomy and management efforts.The company has a welding shop as well as a painting shop. The welding shop welds annually 72,000 purchased items with other 1,56,000 shop made parts in to 12,000 assemblies. Total cost of this assembly for the welding shop works out to Rs. 24,000 p.a. for this level of operations.Out of the total production, 80% is diverted to painting shop at the same price i.e. Rs. 12 per assembly and remaining sold in the market.The printing shop’s cost of painting including transfer price from welding shop comes to Rs. 20 each. Painting shop sells all the assemblies duly painted at a price of Rs. 25 each. Painting shop’s fixed costs are Rs. 30,000 p.a.The manager of the welding shop has ascertained from the market that of latent demand for the welded (unpainted) assembly has increased substantially and this situation is expected to continue for another 6 to 8 months. This has resulted in an increase in the market price from present Rs. 12 each to Rs. 14 each. He, therefore, proposes to increase the transfer price for supplies to painting shop.Manager of the painting shop refuses to accept the new transfer price of Rs. 14 each on the ground that his profitability will be adversely affected.Welding shop manager, therefore, proposes that, since supplying assemblies to painting shop at existing transfer price he is loosing Rs. 2 per assembly he should at least be allowed to sell in the external market extra quantity of 20% of his total present production in order to partially compensate him for the loss. He is then prepared to continue with the present transfer price for the balance quantity of painted assemblies to the extent of only the quantities received from welding shop.Will this proposal benefit him? What will be the effect of it on the profitability of the painting shop as well as the total company?Justify your answer with appropriate and detailed calculations.


Univ Q’s

Case No. 1 Division A of a large divisionalized organization manufactures a single standardized product. Some of the output is sold externally whilst the remainder is transferred to Division B where it is a subassembly in the manufacture of that division’s product. The unit costs of Division A’s Product are as follows:Direct material

4Direct labour 2Direct expense

2Variable manufacturing overheads

2Fixed manufacturing overhead

4Selling and packing expense - variable 1

-------------------- 15

Annually 10000 units of the product are sold externally at the standard price of L 30.

In addition to the external sales, 5000 units are transferred annually to Division B at an internal transfer charge of L 29 per unit. This transfer price is obtained by deducting variable selling and packing expense from the external price since this expense is not incurred for internal transfers.Division B incorporates the transferred in goods into a more advanced product. The unit cost of this product are as follows.Transferred in item (from Division A) 29Direct material and components 23

Direct labour 3Variable overhead 12Fixed overhead 12Selling and packing expense variable 1� TOTAL 80

Division B’s manager disagrees with the basis used to set the transfer price. He argues that the transfer should be made at variable cost plus an agreed (minimal) mark-up since he claimed that his division is taking output that Division A would be unable to sell at the price of L 30.

Do you agree with Division B? Why or why not?

6. transfer pricing

Documents

competitive transfer

correct transfer price

transfer price mechanism

objectives of transfer

marketbased transfer

selling price

market cost

competitive price