the risk of not fully understanding customer needs in the new market. Cost overruns in A would be passed on to B. The division would not accept the investment since it would reduce the division's ROI. Discuss the transfer prices at which Helpco Ltd should offer totransfer special ingredient Z to Manuco Ltd in order that group profitmaximising decisions may be taken on financial grounds in each of thefollowing situations. This is the wrong decision from the companyperspective as the project ROI of 20% beats the company hurdle of 18%. Bakercurrently has the opportunity to purchase product Y from an externalsupplier for $38 per unit. The buying division will pay the same for goods if they buy them internally or externally. Management accounting and finance (LM340) Uploaded by. The logical thrust here is that, if you enjoy a high market share,then you will probably have a strong position because of low unitproduction cost and a high market profile. There are two main approaches to setting transfer prices – market based approach and cost based approach. (i)The transfer price should be setbetween $35 and $38. Helpco Ltd has an external market for allits production of special ingredient Z at a selling price of $15 per kg.Internal transfers to Manuco Ltd would enable $1.50 per kg of variablepacking cost to be avoided. [Robert B Williams; Warwick N Funnell] Accountants (IESBA), published by the International Federation of Accountants (IFAC) in December 2012 and is used with permission of IFAC. Trout Inc had non-capitalised leases valued at $10 million in each year. Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the measurement of divisional performance or discouraging overall corporate profit maximisation. Other management ratios Ã¢â¬â this could include measures such as sales per employee or square foot as well as industry specific ratios such as transport costs per mile, brewing costs per barrel, overheads per chargeable hour. On this basis, the maximum transferprice that Division Y should be willing to pay is $13 ($20 Ã¢â¬â $7). Determine which should be chosen. This transfer price would not motivate the manager of Division X to maximise output. The general point this model makes is that current period cash flowis not an unambiguous statement on the performance of a product orbusiness sector. Investment centre managers who make investment decisions on thebasis of short-term performance will want to undertake any investmentsthat add to RI, i.e. 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 $7 would probably have to be made by head office. This may give a poor indication of future potential performance. a division with a current ROI of 30% would not wish to accept a project offering a ROI of 25%, as this would dilute its current figure. Ansoff's matrix is used to analyse the possible strategic directions that a division can follow. The capacity of division Able is measured inunits of output, irrespective of whether product X, Y or a combinationof both are being manufactured. Copyright 2020. Identify the data that needs to be collected and how youwould expect it to be used. The balance ofits spare capacity (1,000kg) has no opportunity cost and should still beoffered at marginal cost. The second component in the general transfer-pricing rule is the opportunity cost incurred by the organization as a whole because of the transfer. 15. Test your understanding 7 - Opportunity cost approach. The external market price may not be stable. ROI might be measured as: $28,000/$142,000 = 19.7%. Test your understanding 2 - Disadvantages of ROI. Food for thought has a dog and a problem child that both require immediate attention. “Divisional Performance Measurement and Transfer Pricing for Intangible Assets.” Review of Accounting Studies 11(3): 339-365. Explain the relationship between EVA and NPV. Care must be taken in identifying the controllability of, and responsibility for, each variance. In the above example, the full cost for Division X of making component X8 is $7 ($5 variable plus $2 fixed). 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. (5 marks) Test your understanding 8 - Additional example. The size of the mark-up would be a matter for negotiation.Presumably, the transfer price that is eventually agreed would beeither: Discuss the implications of setting the transfer cost at full cost plus. Manuco company has been offered supplies of special ingredient Z ata transfer price of $15 per kg by Helpco company, which is part of thesame group of companies. If theprice is set above $38, Baker will be encouraged to buy outside thegroup, decreasing group profit by $3 per unit. 1—Divisional management if ROI is used to evaluate divisional performance? A transfer price set equal to the variable cost of the transferring division produces very good economic decisions. This discussion aims to disentangle these features so as to highlight those that are the key drivers of the results. 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. Thisalternative use is equivalent to 2,000kg of special ingredient Z andwould earn a contribution of $6,000. 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. (a) The transfer pricing method used for the transfer of an intermediate product between two divisions in a group has been agreed at standard cost plus 30% profit markup. If this assumption is used, ROI would be $28,000/$112,000 = 25.0%. It may lead to dysfunctional decision making, e.g. The transfer price should be setbetween $35 and $38. if the RI is positive. Each division is expected to generate a rate of return of at least 14 percent on its operating assets. Transfer pricing Within a decentralised organisation there may be a division which makes units that are then transferred to another division. The notional cost of capital is 12%. (10 marks) 2. There is no external market for Division A's goods and the profit will be $110,000 regardless of the transfer price set. 2,000kg at $7.50 + $3 = $10.50 per kg; 1,000kg at $7.50per kg (= MC). Example 1 suggested a transfer price between $18 and $80, but exactly where the transfer price is set in that range vastly alters the perceived profitability and performance of each division. The strength of such capabilities will have to be monitored carefully. At a transfer price of $5, Division X would make $0 contribution from each unit transferred. Additional example on international issues. Interest expense was $4 million in 20X7 and $6 million in 20X8. As a relative measure it enables comparisons to be made with divisions or companies of different sizes. Manuco Ltd has been offered supplies of special ingredient Z at atransfer price of $15 per kg by Helpco Ltd, which is part of the samegroup of companies. Review questions; Divisional performance. marginal cost). The market price should be adjusted for costs not incurred on an internal transfer, e.g. (Base your calculations on opening book values).Would the investment centre manager wish to undertake the investment ifperformance is judged on ROI? Division B is basedin Southland, a country with a tax rate of 20%. Lutchmee Murchoyea it may take time to achieve the required critical mass and the associated economies of scale. The division would accept the investment since it generates an increase in RI of $1,000. 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. Alternatively, if a perfectly competitive market does not exist for the product, the transfer price can be set at. An investment centre has net assets of $800,000, and made profitsbefore interest and tax of $160,000. Acommon feature of exam questions is that a transfer price is set thatresults in sub-optimal behaviour. Helpco bases itstransfer price on full cost plus 25% profit mark-up. Conditions are as per (i) but Helpco Ltd hasproduction capacity for 3,000kg of special ingredient Z for which noexternal market is available. The transfer price may be altered after taking into consideration the planning and operational variance analysis at the transferor division. RI = Controllable profit Ã¢â¬â Notional interest on capital, Test your understanding 3 - RI calculation. Productivity â€“ suppose some staff in division A are ill, slowing down the supply of components to division B. the transfer price is $13.50 per kg. The company's post tax cost of debt was 5.85% in 20X7 and 6.5% in 20X8. This isvariable cost less packing costs avoided = $9 â€“ $1.50 = $7.50 per kg(note. What decisions will be made bymanagement if they act in the best interests of their division (and inthe best interests of their bonus)? This gives them a profit of $160,000 compared with a profit of $94,000 if the full cost transfer price is used. Using the BCG matrix assess the competitive position of Food For Thought Ltd. Where products stand within the BCG matrix. There is an argument that the opportunity cost of transfer, in the absence of an intermediate market, is full cost. A division earning a high ROI may do so because assets are old and fully depreciated. Industrial Company operates its divisions as autonomous units, giving its divisional manager great discretion in pricing and other decisions. Learn faster with spaced repetition. Kaplan Financial Limited. 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. The project would have a four-year life, and would makeprofits of $15,000 each year. Estimate the Economic Value Added (EVA) for Trout Inc for both 20X7 and 20X8. in order to obtain a bonus payment. Division A is based inNorthland, a country with a tax rate of 50%. The investment centre manager will want to undertake the investmentbecause it will increase RI. Use of BCG analysis as a performance management tool. In this situation Helpco has no alternativeopportunity for 3,000kg of its special ingredient Z. These frameworks can also be used for assessing performance management issues in divisionalised businesses. P5-Chapter-9- Divisional- Performance- Appraisal-AND- Transfer- Pricing. What would be the ROI with andwithout the investment? the transfer price is $13.50 per kg. If a standard cost is used, the buying division will know the cost in advance and can therefore put plans in place. dual pricing - the selling division records one transfer price (e.g. making payments to the parent company in the form of: charging the subsidiary company additional head office overheads. Helpco Ltd bases itstransfer price on total cost-plus 25% profit mark-up. So long as the bought-in external price of Y to Baker isless than $45, Baker should buy from that external source. As far as the problemchild is concerned, the management need to devise appropriate strategiesto convert them into stars. Divisional managers will be demotivated if this is notachieved. This decision is in the best interests of the company. (b)Conditions are as per (i) but Helpco Ltd hasproduction capacity for 3,000kg of special ingredient Z for which noexternal market is available. Question focus: now attempt question 15 from chapter 13. If the price is setabove $38, Baker will be encouraged to buy outside the group, decreasinggroup profit by $3 per unit. The matrices of Ansoff and the Boston Consulting Group (BCG) were met in paper P3 where they were used for strategic portfolio analysis. Other information Ã¢â¬â such as staff turnover, market share, new customers gained, innovative products or services developed. TRANSFER PRICING FOR DIVISIONAL AUTONOMY 101 situations where suboptimal transfer prices result.6 The question is whether an optimal transfer price system which ensures corporate as well as divisional profit maximization can at the same time preserve the operating autonomy of the divisional manager. This will be adjusted to allowfor the $1.50 per kg avoided on internal transfers due to packing costsnot required, i.e. Evaluation of ROI as a performance measure. This would give them a budgeted profit of $16,000, compared to a loss of $50,000 when the marginal cost transfer price is used. In theory, Division Y should therefore beprepared to pay up to $17 ($20 Ã¢â¬â $3) for each unit of X8. If the transfer price is set at marginal cost plus a mark-up forcontribution, the manager of Division X would be motivated to maximiseoutput, because this would maximise contribution and profit (or minimisethe loss). 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 will slow down division B as well, unless adequate inventories are held. Product pricing Divisional performance Transfer pricing PM 1 Cost classification Overhead costing Labour costing Example Download. quality, delivery terms, etc.). (b)The design of an information system tosupport transfer pricing decision making necessitates the inclusion ofspecific data. Left to their owndevices then the managers would end up accepting the project giving only$12,000. At this price, Division X would want to sell as many units aspossible to Division Y, and Division Y would buy as many units as itcould, subject to the limit on capacity or sales demand. Baker supplies an external market and can obtain its semi-finishedsupplies (product Y) from either Able or an external source. since his performance will be judged as havingdeteriorated. There is no external market for component X8. If autonomy is maintained, managerstend to be more highly motivated but sub-optimal decisions may be made. Divisional performance can be compared in many ways. Will new products be based on extending existing capabilities or will new capabilities have to be created / acquired first? It may encourage the manipulation of profit and capital employed figures to improve results, e.g. One projectgives a profit of $20,000 and the other $12,000. 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. 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