Tp Mcs Full222

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About MeAbout Me Prof. Mahesh Halale B.Sc. M.B.A. M.C.A.

Worked with Maharashtra State Financial Corporation, from 1985 to 2003

Working with

Vishwakarma Institute of Management since 2003 as an Assistant Professor (Approved by UoP)

Written books on

Management Control Systems – Everest, Pune

Management Information System – HPH, Mumbai

Every year conduct a days workshop on Case Studies in MIS and MCS for all MBA students

Completed about 50 consultancy assignments of projects of finance

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Essence of MCS -Essence of MCS - ““However laudable strategic intentions However laudable strategic intentions

may be, if they do not become reality, they may be, if they do not become reality, they usually are not worth the paper on which usually are not worth the paper on which they are written”they are written”

““Conversely, High performing companies Conversely, High performing companies excel at execution”excel at execution”

Anthony & GovindrajanAnthony & Govindrajan

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AgendaAgenda

Topic - Transfer PricingTopic - Transfer Pricing Concept Relevance of TP in MCS Significance of TP Methods of TP

Market Price Based TP Cost Based TP

General Rule for TP

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Transfer Pricing – The ConceptTransfer Pricing – The Concept

Division ADivision A

Transfer Pricing is applicable when …. • Company is an Integrated Company• Company follows “Profit Center” strategy to

manage its divisions/business unitsThen…..• Transfer Price is a Value charged by Div A to Div B • Transfer Pricing - Method followed to set TP

ABC Co Ltd.

Division BDivision B

Division CDivision C

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Why Transfer Pricing in MCSWhy Transfer Pricing in MCS

A well-set TP acts as a Management Control Tool in itself.

MCS aims at evaluating & if needed control the managerial actions/decisions

Usually Profit is best performance measure & it is a prime function of Price

Inappropriate/Discriminatory Pricing draws wrong performance picture

Appropriate Pricing policy ensures realistic assessment of performance

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Methods of Transfer PriceMethods of Transfer PriceI) Market Price Based TP: -

A) Market Price as TP:

● Essentials -* Div A’s product having open market.

* Market forces determine the PRICE. * Then MP is best TP.● Advantages - * Div A can not pass its inefficiencies to Div B* Acceptable to Div A and Div B.* It is opportunity cost for Div A.

* Creates competitive environment.

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Methods of Transfer PriceMethods of Transfer PriceI) Market Price Based TP: -

B) Modified Market Price (MMP): -

● TP less/greater than MP may be set to compensate various factors such as –

* Saving on selling and transportation costs. * Guaranteed take off by Div B. * Quantity, Quality and Delivery aspects

of transfer.An unbiased negotiation may lead to acceptable TP by both divisions. Thus TP becomes an agreed upon price between them.

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Methods of Transfer PriceMethods of Transfer PriceI) Market Price Based TP: -

C) TP Lower than MP: -

WHEN - ● Div A is not able to sale its product at MP.Div B is able to get it below MP.

Establishment of TP in such situation depends on the amount of IDLE capacity Div A is having…..

If Div A operating at its full capacity- No question of reducing MP.If Div A running with idle capacity – Opportunity cost of Div A is zero, and whatever it can earn over and above its VC is well and good. (Below BEP it FC recovery and above BEP it is profit)& Non reduction of MP in such situation leads to reduction of firms profits.

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Methods of Transfer PriceMethods of Transfer PriceII ) Cost Based TP: -

A) Variable Cost as TP: -

● TP be set at Variable cost of production of Div A * Rational – This is the cost below which Division A

Shall be unwilling to sell, as it leads to net losses.And after all FC is a sunk cost for Div A, irrespective ofWhether Division produce & sale at it has to incur this cost .

This TP forces Div A to not to earn any profit but also not to recover its operating cost too.

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Methods of Transfer PriceMethods of Transfer PriceII ) Cost Based TP: -

B) Full Cost/Absorption Cost: -

● TP is set at VC + FC of production of Div A.

* In this approach FC of Div A acts as VC of Div B,In a broader perspective of firm it is wrong conception.

* Such conception may leads to incorrect decision on the part of Div B and subverts the firm’s goal.* Do not provide any incentive for cost control.

(since actual cost = TP).

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Methods of Transfer PriceMethods of Transfer PriceII ) Cost Based TP: -

C) Standard Cost as TP: -

● Actual Cost as TP leads to passinginefficiencies of Div A to Div B therefore …….

* Scientifically Predetermined product cost would be a better yard stick to control actual cost.

* Ensures operating efficiency of Div A by motivating it to contain its actual cost in predetermined limit.

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Methods of Transfer PriceMethods of Transfer PriceII ) Cost Based TP: -

D) Modified Cost as TP: - ● Mere recovery of Cost does not provide any profit

perspective to Div A. It lacks motivation for Div A to earn profit.Therefore TP can be set as:-

TP = Cost + Mark up {Markup = Certain % of cost or lump sum amount}

•-However taking cost as actual cost again introducesits inherent drawback.

•Therefore best approach would be TP = Std. Cost + Markup

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General Rule for TPGeneral Rule for TP

● This makes Div A indifferent as to the sale to outsider or inter divisional transfer

Minimum TP = VC per unit + Contribution lost per unit Div A must recover its entire VC and also the

Contribution lost.

(to the extent that Div A would otherwise have recovered by way of outside sales)

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Conclusion on Transfer PricingConclusion on Transfer Pricing

* Highest TP = Market PriceHighest TP = Market Price

* Lowest TP = Variable CostLowest TP = Variable Cost

Both the divisions must settle for optimal TP i.e.***********************************

Optimal TP = VC p.u + Contribution Lost p.u.Optimal TP = VC p.u + Contribution Lost p.u.******************************************************************************************

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Problem on Transfer Pricing ( appeared in PU MBA-II, Exam 2003)Problem on Transfer Pricing ( appeared in PU MBA-II, Exam 2003)The Top Company Ltd has two divisions X & Y. One of the parts produced by 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 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 unique and there is readily defined market such that X can sell to outside firms and Y can buy from outside.firms and Y can buy from outside.

The following data is available in respect of division X:The following data is available in respect of division X:Capacity to Produce the part Capacity to Produce the part 125000 units125000 unitsExternal Sales at Rs 100 per unitExternal Sales at Rs 100 per unit 100000 units100000 unitsTransfer to division YTransfer to division Y 2500025000

Costs:Costs:Variable Manufacturing cost per unitVariable Manufacturing cost per unit Rs 84Rs 84Variable Selling Cost per unitVariable Selling Cost per unit Rs 2Rs 2(on external sales only but not incurred on internal transfer)(on external sales only but not incurred on internal transfer)Fixed Manufacturing Cost (based on 125000 units)Fixed Manufacturing Cost (based on 125000 units) Rs 6Rs 6Fixed Selling Cost (based on 100000 units)Fixed Selling Cost (based on 100000 units) Rs 1Rs 1

The division Y represents the following data on the assumption of volume of The division Y represents the following data on the assumption of volume of 25000 units.25000 units.Variable manufacturing expenses per unitVariable manufacturing expenses per unit Rs 100Rs 100(excluding internal transfer price/outside purchase)(excluding internal transfer price/outside purchase)Variable Selling Expenses per unitVariable Selling Expenses per unit Rs 6Rs 6Fixed manufacturing costFixed manufacturing cost Rs 10Rs 10Fixed selling expensesFixed selling expenses Rs 4Rs 4Selling price per unitSelling price per unit Rs 240Rs 240

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Top Company – Problem – contd… Required –Required –1.1.If division X could sell 125000 units at Rs 100 If division X could sell 125000 units at Rs 100

each in the open market what transfer price, the each in the open market what transfer price, the central management would prefer in order to central management would prefer in order to provide proper motivation to division Y?provide proper motivation to division Y?

2.2.As a management accountant would you As a management accountant would you advise division Y to buy the product at the advise division Y to buy the product at the transfer price determined in 1 above?transfer price determined in 1 above?

3.3.Assume transfer price as in 1 above and if Assume transfer price as in 1 above and if selling price for division Y’s product drops to Rs selling price for division Y’s product drops to Rs 200 should you buy at that price? Would this be 200 should you buy at that price? Would this be desirable from the point of the firm, why?desirable from the point of the firm, why?

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Top Company – Solution

1.) X selling the product to outsiders at Rs.100

Selling Price 100-Variable Cost (Prodn) 84-Variable Cost (Selling) 2Contribution 14-Fixed Cost (Prodn) 6-Fixed Cost (Selling) 1Profit 7

TP = Variable Cost + Contribution Lost

= 84 + 14

= 98

Justification for TP = 98To supply the product to Div Y, X must get VC of Production - 84

also it must get its FC of Production - +6even It must recover its FC of selling - +1and X must earn the profit +7

Therefore X must charge a TP of 98

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Top Company – Solution – contd…2. As a management accountant of Division Y would you advise the purchase at TP of 98

Y Purchases from X at TP 98

Y Purchases from outside at Rs

100Selling Price 240 240

-Variable Cost (Production) 100 100

-Variable Cost ( Bought Out Item)

98 100

-Variable Cost (Selling) 6 6

Contribution 36 34

Since the option to purchase the item from X at TP of 98 gives better contribution, division Y should go for this transaction.

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Top Company – Solution – contd…3. If sales price of division Y’s product drops to Rs 200, whether the TP of 98 will be acceptable

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.

Co. uses product of X in division

Y

Co opts to sell the Product of X in Open market at

100Selling Price 200 100

-Variable Cost (Production) 100 84

-Variable Cost (Bought Out Item)

84

-Variable Cost (Selling) 6 2

Contribution 10 14

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Que 6 2007 Backlog New- PUMBAThe Allison-Chambers Corporation, manufacturer of tractors and other heavy farm equipments, is organized along decentralized lines, with each manufacturing division operating as a separate profit center. Each division manager has been delegated full authority on all 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 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 the 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 1000 units A's variable costs per unit of tractor engine component $ 120 A's fixed costs per unit of tractor engine component $ 20

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Que 6 2007 Backlog New- PUMBAThe Allison-Chambers Corporation…Required -1. Assume that there are no alternative uses for internal facilities.

Determine whether the company as 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 1000 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 $ 18000. 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?

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Que 6 2007 Backlog New- PUMBAThe Allison-Chambers Corporation…Solution – Given for Division A - Expects a increase in price for its tractor engine

component to $ 150, so that it earns adequate return on its investment in view of its acquisition of highly sophisticated specialized machine.

Division C - Expects the price for the component be set at $ 135, as the said component is available in open market at that price.

1.Cost to the Company if no alternative usage of facilities of Division A

Company's OptionsCompany's Options Optuon-1 Optuon-1 Option-2 Option-2

Buy from A Buy from A Buy from Outside Buy from Outside

Variable Costs p.u. Variable Costs p.u. 120120 135 (Price Being Paid)135 (Price Being Paid)

Fixed Costs p.u. Fixed Costs p.u. 2020 20 #20 #

Total Cost Total Cost 140140 155155

# Since the facilities of Division A remaining idle, irrespective of A producing anything or not , Co & A has to carry/bare the FC of $20 .In this situation buying from outside is not beneficial from Co's point of view, since the option is costlier by $15

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Que 6 2007 Backlog New- PUMBAThe Allison-Chambers Corporation…Solution – 2. If Division A discontinues the production of engine component and

uses the facilities for other production operations, which shall lead to annual cash savings (net inflow) of $ 18000

Division C's Division C's OptionsOptions

Optuon-1 Optuon-1 Option-2 Option-2 Buy from Outside, Buy from Outside, Use facility for other Use facility for other production production

Buy from A Buy from A

Variable Costs Variable Costs p.u. p.u.

120120 Total Cash Outflow Total Cash Outflow 135000135000

Fixed Costs p.u. Fixed Costs p.u. 2020 Total Cash Total Cash Inflow/Savings Inflow/Savings

- 18000- 18000

Total Cost Total Cost 140140 Net Cash Outflow Net Cash Outflow 117000117000Net Cash Outflow is $ 117 p.u. as against $ 140Here buying from outside provides the net cash savings and thereby the net cash outgo on the engine component reduces to 117 instead of 140, when the Division A manufactures and supplies the same to Division C.Here Division C can get this component at lesser price than Division A's variable cost .

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Que 6 2007 Backlog New- PUMBAThe Allison-Chambers Corporation…Solution – 3. In case there is no alternative usage of Division A's facilities and

outside price drops by $20

Division C's Division C's OptionsOptions

Optuon-1 Optuon-1 Option-2 Option-2

Buy from A Buy from A Buy from Outside AT A REDUCED Buy from Outside AT A REDUCED PRICE OF 115 i.e. (135-20) PRICE OF 115 i.e. (135-20)

Variable Costs p.u. Variable Costs p.u. 120120 115115

Fixed Costs p.u. Fixed Costs p.u. 2020 20 (there is no use of facility at A)20 (there is no use of facility at A)

Total Cost Total Cost 140140 135135

For Division C this alternative is attractive if the outside price reduces to 115, Division C should purchase from outside however; From Company's point of view this is not beneficial, because – Company by compelling Division A to produce the component and selling it to Division C at price of $115, can at least recover the fixed cost at Division A to the extent of $15

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Thanks Thanks

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● ● I)I) Market Price Based TP: -Market Price Based TP: -A) Advantages -

2. MP are easily available. 3. Performance of both the divisions is continuously harnessed.

1. True representation of opportunity cost.

1. Div A has no outside market.2. No competitive market for Div A’s product. (Div A is price leader)

4. Sales price variance gives a better control data.A) Limitations of MP as TP –

4. What is right MP? Ex-factory/ Wholesalers/Customers 5. MP includes selling and distribution cost. (which is absent in TP.)

3. Wide fluctuations in MP. ( leads to inconsistent results)

7. After sales service do matters in MP.6. Quantity discounts/special discount plays important role in MP.

8. Dumping price can be anything (when Div A builds idle stock)

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Significance of TPSignificance of TP

Measure realistic performance of the division.

Grant full autonomy to divisional functioning without subverting firm’s goal

Achieve Goal Congruence

Motivate all concerned divisions

Ensure cost control at all divisions