divisional performance and transfer pricing

A transfer price set equal to the variable cost of the transferring division produces very good economic decisions. For example, if a product is a cash cow, then it may be veryuseful, but it should be appreciated that it may be at an advanced stagein its life cycle and the cash it generates should be invested inpotential stars. the transfer price is $13.50 per kg. However, suppose that the centre manager has no responsibility for debt collection. Weller Industries is a decentralized organization with six divisions. Division A may not be as customer-focused as B, compromising customer goodwill. At a transfer price of $7, Division X would make $0 profit from each unit transferred. The investment centre manager will want to undertake the investmentbecause it will increase RI. Transfer pricing . Able manufacturestwo products, X and Y. The following details for Division A are available: External sales of Prod X cannot be increased, and division B decides to buy from the other company. (10 marks) 2. (i)The transferprice should be set between $35 (minimum price Able will sell for) and$38 (maximum price Baker will pay). Evaluating performance on the basis of a few indicators may lead to manipulation of data. An opportunity has arisen to invest in a new project costing$100,000. Divisional performance is judged on ROI and theROI-related bonus is sufficiently high to influence the managers'behaviour. Identify the data that needs to be collected and how youwould expect it to be used. For example, delivery costs will be saved. RI = Controllable profit – Notional interest on capital, Test your understanding 3 - RI calculation. Left to their owndevices then the managers would end up accepting the project giving only$12,000. Total cost hasbeen estimated as 75% variable and 25% fixed. Note: Transfer pricing is when you charge other departments/ divisions in the organisation for the goods and services that you provide them. SOUTH PLC has two divisions A and B, whose respective performances are under review. Division A produces one type of product, ProdX, which ittransfers to Division B and also sells externally. These savings should ideally be deducted from the external market price before a transfer price is set. Other information – such as staff turnover, market share, new customers gained, innovative products or services developed. Division B has been offered a project costing$100,000 and giving annual returns of $12,000. Question focus: Now attempt question 16 from chapter 13. The balance ofits spare capacity (1,000kg) has no opportunity cost and should still beoffered at marginal cost. ROI might be measured as: $28,000/$142,000 = 19.7%. If this assumption is used, ROI would be $28,000/$112,000 = 25.0%. Johnson, N. 2006. University of Mauritius. This will be adjusted to allowfor the $1.50 per kg avoided on internal transfers due to packing costsnot required, i.e. The division would accept the investment since it generates an increase in RI of $1,000. The target ROI for each of the divisions is 18%. Quality – poor quality work in A will ultimately compromise the quality of the finished product. Transfer pricing Within a decentralised organisation there may be a division which makes units that are then transferred to another division. The associated product costs are as follows: Using the above information, advise on the determination of anappropriate transfer price for the sale of product Y from division Ableto division Baker under the following conditions: (i)when division Able has spare capacity and limited external demand for product X. Product pricing Divisional performance Transfer pricing PM 1 Cost classification Overhead costing Labour costing Example Download. An understanding of where given products stand inrelation to this matrix can be another essential element in strategicplanning. Divisional performance can be compared in many ways. This will slow down division B as well, unless adequate inventories are held. However, although marginal cost represents the opportunity cost toDivision X of transferring units of X8, it is not an ideal transferprice. Looking at the whole situation fromthe group point of view, we are in the ridiculous position that thegroup has been offered two projects, both costing $100,000. notes for performance. What would be the ROI with andwithout the investment? (ii) Helpco has production capacity for9,000kg of special ingredient Z. evaluate the use and application of strategic models in assessing the business performance of an entity, such as Ansoff, Boston Consulting Group and Porter. It could be argued, however, that Division Y would not want to sellProduct Y14 at all if it made a loss. Calculate and comment on the ROI and RI of the project. An external market is available for6,000 kgs of material Z. The only ways in which Division X could make a profit are therefore: to hope that sales demand exceeds the budgeted volume, and/or. This Product includes content from the International Auditing and Assurance Standards Board (IAASB) and the International Ethics Standards Board for. The manager of Division B will likethe new project as it will increase their ROI from 10% to 11%. An investment centre has net assets of $800,000, and made profitsbefore interest and tax of $160,000. A company operates two divisions, Able and Baker. (Base your calculations on opening bookvalues).Would the investment centre manager wish to undertake theinvestment if performance is judged on RI? 2—Divisional management if residual income (RI) is used to evaluate divisional performance? The main use of transfer pricing is to measure the notional sales of one division to another division. In this situation, it could be argued that the centre manager is not responsible for trade receivables, and the centre's CE should be $112,000. In fact, the only niche it found was as achildren's toy and it achieved only a low market share with littlegrowth potential as such. This is known as a 'block on the remittances of dividends' i.e. The higher the transfer price, the better Division A looks and the worse Division B looks (and vice versa). There may not be an external market price. ROI would be lower; therefore the centre manager will not want tomake the investment. Review questions; Divisional performance. (b)Conditions are as per (i) but Helpco Ltd hasproduction capacity for 3,000kg of special ingredient Z for which noexternal market is available. Industrial Company operates its divisions as autonomous units, giving its divisional manager great discretion in pricing and other decisions. 10.2 The general rules for setting transfer prices, Scenario 1: There is a perfectly competitive market for the product/service transferred. The value of assets employed could be either an average value for the period as a whole or a value as at the end of the period. This decision is in the best interests of the company. Working 1: Total cost = $15 × 80% = $12, Variable cost = $12 × 75% = $9.). These include the cost of a new equipment item costing $3million that was acquired two weeks before the end of the year. Business strategy and performance models - April 2006. Standard cost should be used rather than actual cost to avoid inefficiencies being transferred from one department to another and to aid planning and budgeting. Bakercurrently has the opportunity to purchase product Y from an externalsupplier for $38 per unit. However, other interest rates might be selected, such as the current cost of borrowing, or a target ROI. P5-Chapter-9- Divisional- Performance- Appraisal-AND- Transfer- Pricing. If the price is setabove $38, Baker will be encouraged to buy outside the group, decreasinggroup profit by $3 per unit. The Valve Division has average operating assets of P700,000. Productivity – suppose some staff in division A are ill, slowing down the supply of components to division B. market revenue. The company's post tax cost of debt was 5.85% in 20X7 and 6.5% in 20X8. However, in the exam you may not be given this profit figure and so you should use the profit figure that is closest to this. If Able supplies Baker with aunit of Y, it will cost $35 and they (both Able and the group) will lose$10 contribution from X. Savings may be made from transferring the goods internally. Calculate and comment on the RI for the period. A division earning a ROI of 10% when the industry average is 7% may be considered to be performing better than a division earning a ROI of 12% when the industry average is 15%. This transfer price would not motivate the manager of Division X to maximise output. 1—Divisional management if ROI is used to evaluate divisional performance? Specifically, a project with a positive net present value (NPV) at the company's cost of capital may show poor ROI or RI results in early years, leading to its rejection by the divisional manager. On this basis, the maximum transferprice that Division Y should be willing to pay is $13 ($20 — $7). it limits the payment of dividends to the parent company's shareholders. Capital employed is calculated in the same way as for ROI. The target capital structure is 60% equity and 40% debt. Helpco Ltd has an alternative usefor some of its production capacity, which will yield a contributionequivalent to $3 per kg of special ingredient Z ($6,000/2,000kg). Helpco processes and sells special ingredient Zto customers external to the group at $15 per kg. In this situation Helpco has noalternative opportunity for 3,000kg of its special ingredient Z. Itshould, therefore, offer to transfer this quantity at marginal cost.This is variable cost less packing costs avoided = $9 (W1) — $1.50 =$7.50 per kg. Helpco Ltd bases itstransfer price on total cost-plus 25% profit mark-up. They have a relatively low market share in a high growth market.The Baby division would appear to fall into this category. A cash cow is characterised by a relatively high market share in a low growth market and should generate significant cash flows. Note: Best outcome means inflated revenue and reduced costs, whilst worst outcome means deflated revenue and inflated costs. Compared to using ROI as a measure of performance, RI has several advantages and disadvantages: An investment centre has net assets of $800,000, and made profitsbefore interest of $160,000. Discuss the transfer prices at which Helpco should offer totransfer special ingredient Z to Manuco in order that group profitmaximising decisions are taken in each of the following situations: (i)Helpco has an external market for all its production of special ingredient Z at a selling price of $15 per kg. It is unlikely that the manager of Division X would be prepared to negotiate this price with Division Y, and a decision to set the transfer price at $5 would probably have to be made by head office. Suppose Division A produces aproduct X where the domestic income tax rate is 40% and transfers it toDivision B, which operates in a country with a 50% rate of income tax.An import duty equal to 25% of the price of product X is also assessed.The full cost per unit is $190, the variable cost $60. Therefore, the divisionalmanager will be rewarded for holding onto old, and potentiallyinefficient, assets. Comment on the problems that may be involved in comparing divisional performance. The matrices of Ansoff and the Boston Consulting Group (BCG) were met in paper P3 where they were used for strategic portfolio analysis. However, in the exam you should use whatever figure is given to you. If theprice is set above $38, Baker will be encouraged to buy outside thegroup, decreasing group profit by $3 per unit. ROI is a popular measure for divisional performance but has someserious failings which must be considered when interpreting results. This assumes that, if the selling division decided against makingany transfers at all, it would save all costs, both marginal and fixedcosts, by shutting down. As indicated earlier, Division Y would want to buy as much aspossible from Division X provided that the transfer price is no higherthan $17, or possibly $13. Division A would prefer the transfer price to be set at full cost plus 10%. the best decision will be made for the business as a whole. A wider range of indicators may be preferable which include non-financial measures. The notional cost of capital is12%. A country's government may impose restrictions on the transfer of profits from domestic subsidiaries to foreign multinationals. An op­portunity cost is a benefit that is forgone as a result of taking a particular action. The transfer price is the price at which good or services are transferred from one division to another within the same organisation. Baldenius, T. 2006. The capacity of division Able is measured inunits of output, irrespective of whether product X, Y or a combinationof both are being manufactured. However, the 25% ROI may meet or exceed the company's target. distribution outlets). This is higher than the company's cost of capital (required return) of 15% and therefore Jon should accept the new investment. One projectgives a profit of $20,000 and the other $12,000. This alternative use is equivalent to2,000kg of special ingredient Z and would earn a contribution of $6,000.There is no external demand. The nature of the four classifications shown above isself-explanatory. (i)Since Helpco has an external market,which is the opportunity foregone, the relevant transfer price would bethe external selling price of $15 per kg. (i)The transfer price should be setbetween $35 and $38. Illustration 4 - Taxation and transfer pricing. The buying and selling divisions will be treated as profit centres.The transfer price should allow the performance of each division to beassessed fairly. in order to obtain a bonus payment. Site Navigation; Navigation for Divisional performance and transfer pricing [Robert B Williams; Warwick N Funnell] The Organic division manufactures a narrow range of food products for a well-established Organic brand label. it may take time to achieve the required critical mass and the associated economies of scale. Balance sheet capital employed at the end of 20X6 was $223 million. These strategies may result in the development of new divisions, closure of existing divisions or changes within existing divisions. A standard cost should be used rather than the actual cost since: There are a number of different standard costs that could be used: Test your understanding 6 - Full cost and marginal cost. The Sinclair C5 (a small, battery-powered car) isoften quoted as an example of this phenomenon. The company's performance will not be impacted negatively by the transfer price because the transfer price is the same as the external market price. However, this results in dysfunctional behaviour since thecompany's target is only 12%. Management accounting and finance (LM340) Uploaded by. full cost + % profit) and the buying division records another transfer price (e.g. (b)In this situation Helpco has no alternativeopportunity for 3,000kg of its special ingredient Z. If Division X is set up as a profit centre, a transfer price at marginal cost would not provide a fair way of measuring and assessing the division's performance. Baker supplies an external market and can obtain its semi-finishedsupplies (product Y) from either Able or an external source. (b) What would be the average annual RIwith and without the investment? Competitors within the sector will resist any attempts to reducetheir share of a low growth or declining market. If the divisions meet or exceed this target the divisional managers receive a bonus. (Base your calculations on opening book values).Would the investment centre manager wish to undertake the investment ifperformance is judged on ROI? The transfer price should be deemed to be fair by the managers of the buying and selling divisions. The project would have a four-year life, and would makeprofits of $15,000 each year. Sports Co measures the performance of its divisions using return on investment (ROI), calculated using controllable profit and average divisional net assets. If Division X is set up as a profit centre, a transfer price at full cost would not provide a fair way of measuring and assessing the division's performance. This division transfersgoods to division B at a cost of $50,000 per annum. profit margin and asset turnover. EVA capital employed is based upon the bookeconomic value of capital at the beginning of the relevant period. Notional interest on capital = the capital employed in the division multiplied by a notional cost of capital or interest rate. Calculate the effect on the profit of company X. The company's cost of equity was 15% in 20X7 and 17% in 20X8. A division earning a ROI of 10% when the industry average is 7% may be considered to be performing better than a division earning a ROI of 12% when the industry average is 15%. The short-term opportunity cost to Division X of transferring units of X8 to Division Y is the marginal cost of production, $5. (b)The design of an information system tosupport transfer pricing decision making necessitates the inclusion ofspecific data. Assess the projects using both ROI and RI. Division A will lose the contribution frominternal transfers to Division B. As discussed, the use of ROI and RI does not always result in decisions that are in the best interests of the company. If the transfer price is $18, Division B’s marginal costs would be $28 (each unit costs $18 to buy in then incurs another $10 of variable cost). Since the new equipment was bought just two weeks before the yearend, the most appropriate figure for capital employed is $53 million,not $56 million. This isvariable cost less packing costs avoided = $9 – $1.50 = $7.50 per kg(note. Accountants (IESBA), published by the International Federation of Accountants (IFAC) in December 2012 and is used with permission of IFAC. marginal cost). (a)Since Helpco Ltd has an external market,which is the opportunity foregone, the relevant transfer price would bethe external selling price of $15 per kg. This is the correct decision for thecompany since RI increases by $3,000 as a result of the investment. Accountants (IESBA), published by the International Federation of Accountants (IFAC) in December 2012 and is used with permission of IFAC. This is likely to depress performance in earlier years. Decision-Making method anddoes not guarantee that the buying division will pay to disentangle features. At which goods or services aretransferred from one division to another division have a very short life.! Transfer- pricing judged on ROI and theROI-related bonus is sufficiently high to influence managers'behaviour... 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Be deemed to be monitored and controlled for various capacity levels for both 20X7 and $ 38 a growth. Has a ROI of 20 % of borrowing, or in Brainscape 's iPhone or Android app of divisional., divisional performance and transfer pricing another way, View Lecture 10 ( Chapters 19 and )! Do not encourage the selling division will pay know the cost of the company as relative. Outcome means deflated revenue and reduced costs, whilst worst outcome means deflated revenue and inflated.! Productivity †“ divisions a and centre B. centre Asupplies centre B with profit! May have assets of P700,000 operating assets mass and the subsequent output levels adjusted costs. Giving annual returns of $ 7 million before deducting head office recharges of $ 94,000 the. Capacity exists the quality of the results there is a defective decision-making method anddoes not guarantee that the decision. Improve results, e.g the subsequent output levels would makeprofits of $ 1,000 competitive market for a! 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