SANJAYAGGARWAL

SOLUTIONS OF TRANSFER PRICING

Question1:- XYZ Ltd. Has two divisions, A and B. Division A makes and sells product A, which can be sold outside as well as be used by B. A has a limitation on production capacity, that only 1200 units can pass through its machining operations in one month. On an average about 10% of the units that A produces are defective. It may be assumed that out of each lot that A supplies, 10% are defectives. When A sells in the outside market, the defectives are not returned, since the transportation costs make it uneconomical for the customer. Instead, As customers sell the defectives in the outside market at a discount. But, when B buys product A, it has to fix it into its product, which is reputed for its quality. Therefore B returns all the defective units to A. A can manually rework the defectives, incurring only variable labour cost and sell them outside at Rs. 150 and not having to incur any selling costs on reworked units. If a chooses not to rework, it can only scrap the material at Rs. 30 per unit. B can buy product A from outside at Rs. 200 per unit, but has to incur Rs. 10 per unit as variable transport cost. B can insist to its outside suppliers also that it will accept only good units. A incurs a variable selling overhead only on units(other than reworked units) sold outside. The following figures are given for the month: Variable cost of production-Dept. A (Rs./unit) 120 Variable selling overhead(Rs./u) 20 Selling price per unit in the outside market(Rs./u) 200 Current selling price to B(Rs./u) 190 Additional variable labour cost of reworking defectives(Rs./u) 100 Selling price of reworked defectives(Rs./u) 150 Fixed costs for the month(Rs.) 36,000 Maximum demand from B at present (no. of units) 630 The outside demand can be freely had up to 900 units Given the demand and supply condition, you are required to present appropriate calculations for the following: 1:- Evaluation of the best strategy for A in the present condition. 2:- If B can buy up to 540 units and the outside demand is only 600 units, how much should A charge B to maintain the same level of profit as in (1) above? Solution:- a (i) Contribution per unit against sale to outside =Rs.(200-120-20) = Rs. 60 In case of transfer, good units and rejected units are in proportion of 9:1. In case of Transfer , contribution per good unit = Rs. (190-120) = Rs.70 In case of transfer, contribution per rejected unit = Rs (150-120-100) = Rs. -70. Thus effective contribution per unit of transfer = Rs. (70X0.9-70X0.1)= Rs.56 As contribution per unit against outside sale is higher, the best strategy should be to sell maximum number of unit to outside marker. Contribution from outside market from sale of 900 units = Rs. 54.000 Rs. (900X 60)
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Contribution from transfer of 300 units to B = Rs. 16,800. Rs. (300X56) Total contribution from best strategy = Rs. 70,800. (i) If Bs demand is 540 unit, total production required = 600 units (540/0.9) Taking outside market demand of 600, it is within production capacity of 1200 units. Now contribution from 600 units of outside sale = Rs. 36,000 Rs/ (600 X 60) Contribution from rejected 60 units = Rs. (4,200) Rs. (60X -70) = Rs. 31,800 To keep same level of contribution as in (i) the contribution required from transfer of 540 unit to B = Rs. 39,000 (RS 70,800 31,800) Thus, contribution required per unit = Rs. 72.22 Hence price to be charged per unit against transfer to B=Rs. 192.20 Rs. (120 + 72.22) Alternative Solution: Let X be the number of units sold outside and y be the number of units sold to B, before B returns 10% as defectives. Then X+Y =1200 is the limitation on production capacity of A. Department A Outside To B Rs. Rs. Selling Prices 200 190 Variable Cost-Production 120 120 Variable Cost-Sale 20 Total Variable Cost 140 120 Contribution 60 70 Contribution on X units sold outside = 60X. Out of y units to B, 10%= IF A reworks and sells. It gets 150 -100 = 50/unit Decision to reworks all defectives i.e. (.1) (y) Contribution on good units of B = 0.9y X 70 = 63y Contribution on reworked units of B = (.1) (y) X 50 = 5y Amount of material lost on manufacture of defectives to B = 12y (.1) (y) X 120 Contribution on y gross units transferred to B = 56y 63y + 5y -12y Total contribution earned by A = 60x + 56y Where x + y =1200 To maximize contribution , maximize units sold outside. 900 units sell outside. Balance

units (gross transfer to B, of which B gives back 30 defectives)

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Contribution : Rs. 60(900) + Rs. 56(300) = Rs. 54,000 + Rs. 16,800. Contribution = Rs. 70,800 Fixed Cost = Rs. 36,000 (i) Profit = Rs. 34,800. (ii) Outside demand = 600 units Contribution = 600 X Rs. 60 = Rs/ 36,000 Balance to be got = Rs. 34,800 = Rs. 70,800. Out of Rs .34,800 defectives of B will give Rs.3000 60X50 Rs. 31,800 Charge to B for 540 units. Contribution to be obtained from 540 units of B = Rs. 31,800 Add: Production cost of 600 units @ 120/= Rs. 72,000 Amount changed for 540 units = Rs/ 1,03,800. Price to be changed to B= =192.22 Per good unit transferred to maintain the same level of profit as in (a). ----------------------------------------------------------------------------------------------------Question2:- A Company is organized on decentralized lines with each manufacturing division operating as a separate profit centre. Each division manager has full authority to decide on sale of divisions output to outsiders or to other divisions. Division AB manufactures a single standardized product. Some output is sold externally and remaining is transferred to division XY where it is a subassembly in the manufacture of the division product. The unit cost of division AB product and division XY is s follows: Division AB(Rs.) Division X Transfer from division AB to XY 42.00 Direct Material 6.00 35.00 Direct Labour 3.00 4.50 Direct Expenses 3.00 Variable Manufacturing Overheads 3.00 18.00 Fixed manufacturing overheads 6.00 18.00 Variable selling and packing expenses 3.00 2.50 24.00 120.00 Division AB sold 40,000 units annually at the standard price of Rs. 45 in external market. In addition to the external sales, 10,000 units are transferred annually to division XY at internal price of Rupee 42 per unit. Variable selling and packing expenses are not incurred by supplying division for the internal transfer of the product. Division XY incorporates the transferred goods into more advance product. The manager of division XY disagrees with the basis used to set the transfer price. He argues that transfer price should be made at variable cost since he claims that his division is taking output that division AB should be unable to sell at price Rs. 45. He also submitted a report of the relationship between selling price and demand to support of his disagreement. The report of customer demand at various selling prices for division AB and for division XY is as follows: Division AB Selling Price per unit(RS.) 30 45 60 Demand (units) 60,000 40,000 20,000
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Division XY Selling price per unit(Rs.) 120 135 150 Demand (Units) 15,000 10,000 5,000 The Company has sufficient capacity to meet demand at various selling prices. Internal transfer demanded units will be decided by XY division. Required:- To Calculate divisional profitability and overall profitability of company if division AB transfer demanded units to XY at price of Rs. 42. (i) To calculate divisional profitability and overall profitability of company if division AB transfers demanded units to XY at variable cost. (ii) In place of internal transfers, AB division can sell 10,000 units of their product in new external market without effecting existing market, at price Rs. 32 per unit arid XY division can purchase these units at the rate of Rs. 31 in open market. Calculate companys profit by following above strategies. Solution:- AB sells product at external market Selling price(Rs.) 30 45 60 Less variable cost 18 18 18 Contribution(per unit) 12 27 42 Demands(units) 60,000 40,000 20,000 Total Contribution 7,20,000 10,80,000 8,40,000 Optimal output is 40,000 units at a selling price of Rs. 45. AB transfer at RS. 42 to XY division then contribution of XY Selling price(Rs.) 120 135 150 Less Variable cost V + 102 102 102 TP(42+60) Contribution (per unit) 18 33 48 Demands(units) 15,000 10,000 5,000 Total Contribution 2,70,000 3,30,000 2,40,000 Manager will choose out put level 10,000 units at a selling price of Rs. 135. Overall profit when transfer made at Rs. 42 Division AB Contribution on 10,000 units (42-(18-3)} = 2,70,000 Division XY contribution 10,000 (135 102) = 3,30,000 Total Contribution = 6,00,000 Division AB contribution from external market sale = 10,80,000 Total profit = 16,80,000 (i) AB transfer at variable cost Selling price(Rs.) 120 135 150 Less variable Cost ( 15 + 60) 75 75 75 Contribution (per unit) 45 60 75 Demands (units) 15,000 10,000 5,000 Total contribution 6,75,000 6,00,000 3,75,000 Optimal is 15,000 units at the rate of 120 per unit. If AB transfer at variable cost (Rs. 15 ) then no contribution will be generated by AB division. XY division choose 15,000 units level gives contribution 15,000 X 45 = 6,75,000 Division AB contribution from external market sale = 10,80,000
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= 17,55,000 (ii) Contribution AB division by selling 10,000 units to new external market at Rs. 32 and XY division purchasing at Rs. 31. Contribution (32 18) X 10,000 = 1,40,000 XY Contribution ({135-{31+60)}) = 4,40,000 Division AB contribution from external market sale = 10,80,000 Total contribution = 16,60,000 ----------------------------------------------------------------------------------------------------Question3:- L Ltd. And M Ltd. Are subsidiaries of the same group of companies L Ltd. Produces a branded product sold in drums at a price of Rs. 20 per drum. Its direct product costs per drum are: Raw material from M Ltd: At a transfer price of Rs. 9 for 25 Kiloliters. Other products and services from outside the group: At a cost of Rs. 3. L ltds fixed costs are Rs. 40,000 per month. These costs include process labour whose costs will not alter until L Ltds output reaches twice its present level. A market research study has indicated that L Ltds market could increase by 80% in volume if it were to reduce its price by 20%. M Ltd produces a fairly basic product, which can be converted into a wide range of end products. IT sells one third of its output to L Ltd. And the remainder to customers outside the group. M Ltds production capacity is 10,00,000 kilolitres per month, but competition is keen and it budgets to sell no more than 7,50,000 kilolitres per month for the year ending 31 December. Its variable costs are Rs. 0.20 per kilolitre and its fixed costs are Rs. 60,000 per month. The current policy of the group is to use market prices, where known as the transfer price between its subsidiaries. This is the basis of the transfer prices between M Ltd. and L Ltd. You are required to calculate (a) The monthly profit position for each of L Ltd. and M Ltd. if the sales of L Ltd. are (i) at their present level, and (ii) at the higher potential level indicated by the market research, subject to a cut in price of 20%. (b) (i) Explain why the use of a market price as the transfer price produces difficulties under the conditions outlined in (a) (ii) above. (iii)Explain briefly, as chief Accountant of the group, What factors you would consider in arriving at a proposal to overcome these difficulties. SOLUTION:- A (i) Monthly profits at present level of L & M Ltd. (Rs. 000) L Ltd:- Sales(10,000 drums@ Rs. 20 per drum) 200 Less: Costs: Raw materials@ Rs. 9 per drum 90 Other costs @ Rs. 3 per drum 30 Contribution 80 Less: Fixed costs 40 Profit 40 M Ltd: Sales (7,50,000 kilolitres at Rs. 9 per 25 liters) 270
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Total contribution

Less: Costs: Variable (@ Rs. 0.20 per Kilolitre) 150 Contribution 120 Less: Fixed Costs 60 Profit 60 Note:- Sales of L Ltd = (2,50,000 kilolitres internal transfers/ 25 liters per drum) = 10,000 drums (ii) Monthly profits at higher sales level (Rs. 000) L Ltd.: Sales(18,000 drum at Rs. 16 per drum) 288 Less Costs: Raw materials ( Rs. 9 per drum) 162 Other expenses (Rs. 3 per drum) 54 Contribution 72 Less: Fixed costs 40 Profit 32 M Ltd Sales (9,50,000 Kilolitres at Rs. 9 per 25 342 Liters) Costs : Variable @ Rs. 20 per Kilolitre 190 Contribution 152 Less: Fixed costs 60 Profit 92

Note:- Internal transfers (18,000 drums of Rs. Liters per drum) plus 5,00,000 kilolitres external sales.
(c) (i) The use of a market price as the transfer price produces difficulties because L Ltd. is not motivate4d to reduce the selling price. In order to increase volume, because its profit declines from Rs. 40,000 to Rs. 32,000. However the profits of M Ltd increase from Rs. 60,000 to Rs. 92,000. Thus the profits for the company as a whole increase by Rs. 24,000. Hence the transfer price does not encourage goal congurance in this particular situation. (ii) In order to overcome the above difficulties, there is a need to offer some inducement to L Ltd. such that its profits will increase as a result of lowering the selling price in order to increase volume. Factors to consider are the following: A:- The significance of the loss in profits arising from the difference between profits at the optimum output level and profits based on the output using the current transfer pricing system. B:- Savings in selling and distribution costs arising from internal transfers compared with external sales. The savings per unit should be deducted from the market price. --------------------------------------------------------------------------------------------------------------------------------------Question 4: A Company has two manufacturing divisions A and B Division: A has a capacity of 96,000 hours per annum. It manufactures two products X and Y as per the following details: X Y

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Direct materials Variable costs @ 80 per hour Selling price Maximum sales units

Rs. 300 Rs. 320 Rs. 800 15,000

60 80 160 Unlimited

Division B produces product Z whose particulars are as under: Imported components Direct materials Variable costs @ Rs. 40 per hour Selling price Rs. 800 120 400 1450

The fixed overheads amount to Rs. 30 lacs and Rs 5 lacs per annum respectively for Division A and B. With a view to minimizing the dependence on imported component, the company explored the possibility of the Division B using the product X as substitutes for imported component. This is possible provided Division B spends two machine hour entailing an additional expenditure of Rs.80 per component on modification of the product X to fit into the product Z. The production of Z Division B is 5000 units per annum.Div. B seeks a discount of Rs.80.So that the transfer price of product X can be set at Rs.720 each. You are required to present division wise profitability and the profitability of the company as a whole on the basis of the following conditions: 1. Division B imports its requirement of components. 2. Division B stops importing the component and obtain 5,000 units of product X for being used as substitute from Division A at the latters usual market price of Rs. 800 per unit. 3. Same condition as (ii) above but Division B gets a relief of ` 80 per unit of product X in that case the transfer price has been set by Division A at Rs. 720 per unit. [RTP, Nov. 2009]

Solution:Products X Y Z Selling price per unit: (Rs) 800 160 1,450 Less: Variable Costs: (Rs) 620 140 1,320 Contribution per unit: (RS.) 180 20 130 Hours required per unit 4 1 Contribution per hour: (Rs.) 45 20 Demand in units 15,000 Hours required to meet the units demanded 60,000 36,000 (i) When division B imports its component requirements: Division A Rs. Division B Contribution Contribution X 15,000 units X Rs. 180 27,00,000 (5,000 units X Rs. 130) Y- 36,000 units X Rs. 20 7,20,000 Less: Fixed Cost Total Contribution: 34,20,000

Rs. 6,50,000 5,00,000

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Less: Fixed costs 30,00,000 Profit 4,20,000 Profits The profit of the company as a whole is Rs. 5,70,000. (ii) When division B buys 5,000 units of product X at Rs. 800 per unit: Division A Contribution Rs. X- 20,000 units X Rs. 180 36,00,000 Sales revenue(5,000 units X 1450) Y- 16,000 units X Rs. 20 3,20,000 Less: variable cost (5,000 units X Rs. 1,320) Total Contribution 39,20,000 Less: Additional cost (5000 units X Rs. 80) Less: Fixed costs 30,00,000 Contribution Profit 9,20,000 Less: Fixed costs Loss Profit of the company as a whole in this case would be Rs. 6,70,000/(iii)Division B gets a product X at a transfer price Rs. 720 from Division A. Profit of Division A Profit for Division B Contribution X-15,000 units X RS. 180 X- 5,000 units X RS. 100(For Division B) Y -16,000 units X Rs.20 Total contribution Less: Fixed costs Profit Rs. 27,00,000 5,00,000 3,20,000 35,20,000 30,00,000 5,20,000

1,50,000

Division B Rs. 72,50,000 66,00,000 4,00,000 2,50,000 5,00,000 (2,50,000)

Variable cost of material X Direct materials

Product Z Cost per unit Rs. 720 120

Variable overheads 400 Additional Cost 80 Total Cost: (A) 1,320 Selling price: (B) 1,450 Contribution (per unit) : {B- A} 130 Total contribution(5,000 units X Rs. 6,50,000 130) Less: Fixed costs 5,00,000 Profit of Division B 1,50,000 Total profit of the company as a whole is Rs. 6,70,000. --------------------------------------------------------------------------------------------------------------------------------------KEY FACTOR Question5: An agro-products producer company is planning its production for next year. The following information is relating to the current year: Products/Crops X1 X2 Y1 Y2 Area occupied (acres) 250 200 300 250 Yield per acre(ton) 50 40 45 60 Selling price per ton(Rs.) 200 250 300 270 Variable Cost per acre (Rs.) Seeds 300 250 450 400
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Pesticides 150 200 300 250 Fertilizers 125 75 100 125 Cultivations 125 75 100 125 Direct wages 4,000 4,500 5,000 5,700 Fixed overhead per annum (Rs.) 53,76,000. The land that is being used for the production of Y1 and Y2 can be used for either crop, but not for Xl and X2. The land that is being used for X1 and X2 can be used for either crop, but not for Y1 and Y2. In order to provide adequate market service, the company must produce each year at least 2,000 tons each of Xl and X2 and 1,800 tons each of Y1 and Y2. Required (i) Prepare a statement of the profit for the current year. (ii) Profit for the production mix by fulfilling market commitment. (iii) Assuming that the land could be cultivated to produce any of the four products and there was no market commitment, calculate: Profit; amount of most profitable crop and break- even point of most profitable crop in terms of acres and sales value. (Nov. 2009) Solution:- (i) Calculation of Selling price and Contribution per acre: X1 X2 Y1 Y2 Products Total Yield per acre in (tones) 50 40 45 60 Selling price per tones(Rs.) 200 250 300 270 Sales revenue per acre(Rs.) 10,000 10,000 13,500 16,200 Variable Cost per acre(Rs.) 4,700 5,100 5,950 6,600 Contribution per acre(Rs.) 5,300 4,900 7,550 9,600 Area (Acres) 2,50 200 300 250 Total Contribution(Rs.) 13,25,000 9,80,000 22,65,000 24,00,000 69,70,000 Less: Fixed Cost 53,76,000 Profit(Rs.) 15,94,000 (iii) Profit Statement for recommended mix X1 X2 Y1 Y2 Products Total Contribution per acre 5300 4900 7550 9600 Rank 1 2 2 1 Minimum Sales Requirements in acres 2000/40 = 50 1800/45=40 Recommended Mix ( in Acres) 400 50 40 510 Total Contribution (Rs.) 21,20,000 2,45,000 3,02,000 48,96,000 75,63,000 Less: Fixed Cost 53,76,000 Profit 21,87,000 Most profitable Crop: Production should be concentrated on Y2 which gives highest contribution per acres Rs. 9,600. Overall contribution if complete land is used for Y2 (1,000 X 9,600) = Rs.96,00,000 Less: Fixed cost = Rs. 53,76,000 Profit: = Rs. 42,24,000 Break even point in acres for B2 = 5376000 / 9600 = 560 acres Break even point in sales value = 560 X (270 X60) = Rs. 90,72,000.
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