Problem on Transfer Pricing (appeared in PU MBA-II, Exam 2003)

Problem 1. (pg59) Taken on 6/9/04 9.15-10.30

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 unique and there
is readily defined market such that X can sell to outside firms and Y can buy from
outside.
The following data is available in respect of division X:
Capacity to Produce the part 125000 units
External Sales at Rs 100 per unit 100000 units
Transfer to division Y 25000
Costs:
Variable Manufacturing cost per unit Rs 84
Variable Selling Cost per unit Rs 2
(on external sales only but not incurred on internal transfer)
Fixed Manufacturing Cost (based on 125000 units) Rs 6
Fixed Selling Cost (based on 100000 units) Rs 1
The division Y represents the following data on the assumption of volume of 25000 units.
Variable manufacturing expenses per unit Rs 100
(excluding internal transfer price/outside purchase)
Variable Selling Expenses per unit Rs 6
Fixed manufacturing cost Rs 10
Fixed selling expenses Rs 4
Selling price per unit Rs 240

Required –
1. If division X could sell 125000 units at Rs 100 each in the open market what
transfer price, the central management would prefer in order to provide proper motivation
to division Y?
2. As a management accountant would you advise division Y to buy the product at
the transfer price determined in 1 above?
3. Assume transfer price as in 1 above and if selling price for division Y’s product
drops to Rs 200 should you buy at that price? Would this be desirable from the point of
the firm, why?
Solution – 1.) X selling the product to outsiders at Rs.100

Selling Price 100

-Variable Cost (Prodn) 84
-Variable Cost (Selling) 2
Contribution 14
-Fixed Cost (Prodn) 6
-Fixed Cost (Selling) 1
Profit 7
Minimum Transfer Price Could be = Variable Cost Of production +
Contribution Lost
= 84 + 14
= 98
(Justification)
For transferring the product X must get its VC of Production - 84
It must get its FC of Production - +6
It must get its FC of selling - +1
X must earn the profit - +7
----------------
X must charge a TP of 98 .
2. As a management accountant of Division Y would you advise the purchase at TP of 98

Y Purchases Y Purchases from

from X at outside at Rs 100
TP 98
Selling 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.

3. If sales price of division Y’s product drops to Rs 200, whether the TP of 98 will be
acceptable

Co. uses Co opts to sell the

product of X Product of X in
in division Y Open market at
100
Selling Price 200 100
-Variable Cost (Production) 100 84
-Variable Cost (Bought Out Item) 84
-Variable Cost (Selling) 6 2
Contribution 10 14

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.
(Taken on 6/9/04 9.15-10.30)
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Problem 2: - PUMBA Taken on 8/9/04 11.00-12.15

Geo Ltd. Producing a range of minerals is organized in 2 divisions, one Manufacturing

Division and the other Trading Division. Both are profit centers.
Manufacturing Division sells to external traders as well as to Internal Trading
Division (ITD). In turn the ITD repacks the bulk minerals received from Manufacturing
Division (MD) and sells them to the end-users in the pack of 10 Kg.
One of the minerals produced is moulding clay and the total production capacity
is 2000 Tons per month.
At present the monthly sales are limited to 1000 Tons to external traders and 600 Tons
to ITD. The transfer price to the ITD was agreed at Rs. 2000 per ton in line with the price
charged to external traders from 1st APRIL i.e. beginning of new budget year. As from 1st
October, however, competitive pressure has forced the price to the external traders down
to Rs. 1800 per ton. The head of the ITD contends that the transfer price to tyhem should
be less than that for the external traders. The M(fg)D refutes the argument on the basis
that the original budget established the transfer price for the whole year. (Transfer price
proposed by ITD now Rs. 1700 per ton).
Existing price to the end users charged by the ITD is Rs. 40/- per pack of 10 Kg.
ITD also argues that with reduced transfer price they would be able to reduce their price
to the end-users to Rs.32/- per pack of 10 Kg. And sell additional 40,000 packs of 10 Kg.
Per month. Relevant cost data for moulded clay is as follows –
 Mfg.D. ITD
Variable Cost per ton Rs. 700 Rs.600 (Cost of re-packing)
Fixed cost per month Rs. 960000 Rs. 480000

A) As a management consultant of the company will you accept the proposal of ITD
to reduce transfer price to Rs. 1700 per ton with additional sales volume as
proposed by ITD and make recommendation to the MD of the company
accordingly?
B) What will be the reaction of Mfg.D. if decision is taken to reduce the transfer
price?
C) Can you modify ITD’s proposal regarding transfer price reduction to Rs. 1700 per
ton to avoid internal conflict and achieve goal congruence?
Substantiate your recommendation with relevant calculation.
Solution –

A)
Option I: - TP of Rs. 1800/- per ton
Mfg Div ITD
Sales (External) 1800000 Sales 600T 2400000
1000T @ 1800 (@ 40 per
Add Sales (to ITD ) 1080000 pack of 10 kg)
600 T @ 1800 @ 4000 PT

Total sales 2880000

Less Variable Cost 1120000 Cost of Purchase 1080000

@ 700 PT VC @ 600 PT 360000
(Repacking)
Contribution 1760000 Contribution 960000

Less Fixed Cost 960000 Fixed Cost 480000

Profit 800000 Profit 480000

Company's Profit = 800000 + 480000 = 1280000

Option IITP of Rs. 1700/- per ton

Mfg Div ITD
Sales (External) 1800000 Sales 1000T 3200000
1000T @ 1800 (@ 32 per
Add Sales (to ITD ) 1700000 pack of 10 kg)
1000 T @ 1700 @ 3200 PT

Total sales 3500000

Less Variable Cost 1400000 Cost of Purchase 1700000

@ 700 PT VC @ 600 PT 600000

Contribution 2100000 Contribution 900000

Less Fixed Cost 960000 Fixed Cost 480000

Profit 1140000 Profit 420000

Company's Profit = 1140000 + 420000 = 1560000

 TP MD ITD Company
Rs.1800 8,00,000 4,80,000 12,80,000
RS. 1700 11,40,000 4,20,000 15,60,000

A) The reduction in the transfer price from 1800/- to 1700/ -

i) Though there is increase in sales volume of ITD, the decrease in
selling price degrades its performance. i.e. its profits goes down from
480000 to 420000
ii) The performance of MD gets uplift. i.e. profits go up by 800000 to
1140000
iii) However the performance of the company as whole improves a
significantly.
Thus from the company’s (Being the consultant of the company) point of
accepting ITD’s proposal of reducing the TP from 1800 to 1700 is acceptable.

B) For the Mfg. Division, it should not have any problem in accepting the reduced
price. The only contention of MD is that TP (of Rs.1800/- ) is finalized in the
beginning of the budgeting year. He may have objection as to the enhancement of
production targets. But since the move enhances the company’s performance as
well company need to pursued the MD to go for reduced TP and increased
volume. (else the company will on the ground of underutilization of capacity)

C) There is sound economic reason to reduce the TP from 1800 to 1700. The only
hitch in this decision is that the ITD do not have any motivation to go for such
reduced TP as its profit level drops after reduction of TP. Therefore to keep him
contended and motivated Company must introduce certain plan to share the
ADDITIONAL profits of (15.60 – 12.80 = 2.80 )
==================================================
Problem 5: -
Case-III PUMBA – [2475]-302 Q-5 Case III Taken on 8/9/04 11.00-12.15

A large company organized into several manufacturing divisions. The policy of the
company is to allow the Divisional Managers to choose their sources of supply and
buying from or selling to sister divisions, to negotiate the prices just as they will for
outside purchases or sales.
Division X buys all of its requirements of its main raw material R from division Y. the
full manufacturing cost of R for division Y is Rs.88 per Kg at normal volume.
Till recently, Division Y was willing to supply R to division X at a transfer price of Rs. 80
per kg. The incremental cost of R for division Y is Rs. 76 per Kg. Since division Y is now
operating at its full capacity, it is unable to meet the outside customers’ demand for R at
its market price of Rs. 100 per Kg. Division Y therefore threatened to cut off supplies to
division X unless the latter agrees to pay the market price for R.
Division X is resisting the pressure because its budget based on the comsumption of
100000 Kg per month at a price of Rs. 80 per Kg is expected to yield a profit of
Rs.20,00,000 per month and so a price increase to 100 per kg will bring the division X
close to break even point.
Division X has even found an outside source for a substitute material at a price of Rs. 95
per Kg. Although the substitute material is slightly different from R, it would meet the
needs of division X. alternatively, division X is prepared to pay division Y even the
manufacturing cost of Rs. 88 per Kg.

Required –
1. Using each of the transfer price of Rs. 80, 88, 95, 100 show with supporting
calculations, the financial results as projected by the a) Manager of division X
b) Manager of division Y and c) Company
2. Comment on the effect of each transfer price of the performance of the Managers’ of
Division X and Y
3. If you were to make a decision in the matter without regard to the views of the
individual Divisional Managers, where should Division X obtain its material from
and at what price?

Solution –
1. a ) Financial Results of Division Y

Transfer Price 80 88 95 100

Less Incremental Cost 76 76 76 76
Contribution 4 12 19 24
Less Fixed Cost 12 12 12 12
Profit -8 0 7 12

b) Financial Results of Division X

Profit 25 17 10 5
Based on VC i.e. Transfer 80 88 95 100
Price of

c) Financial Results of Division X

Profit 17 17 17 17

2. Effect of each TP on division X & Y’s performance

80 88 95 100
Div X Best Worst
Div Y Worst Best

4. Being a controller at corporate office

a). Division Y’s product R has got outside market at Rs.100
Selling Price 100
-Variable Cost 76
Contribution 24
- Fixed Cost 12
Profit 12

b) Division X should get a substitute material at Rs. 95 from outside so that it will
be beneficial decision than buying from division Y at 100. This option will profit of
Rs.10 (based on cost of 95)
And note company’s profit position will be 12 + 10 = 22 which is better than any of the
TP option which gives maximum profit og 17 only.

XX c) Let division Y supply the R to division X at mere VC of 76, due to which Div Y
will be incurring loss of Rs.12 and Div. X would earn profit of Rs.29. Taken together the
company will be earning profit of Rs.17 (29-12)

=====================================

Problem 3 – (pg 89)

At the transfer point from division S to division P, a products variable cost is Rs 1 and its
market price is Rs 2. Division P’s variable cost of processing the product further is
Rs.1.25 and the selling price of the final product id Rs.2.75.

Find –
1. prepare a tabulation of the contribution margin per unit for division P’s
performance and overall performance under two alternatives a) processing
further & b) selling to outsiders at the transfer point.
2. as division P’s manager , what alternative would you use? Explain.

Solutions –
1) Coputation of Contribution Margin -
Div P Div S Company's
Processing Further S's Selling the Product Point of
Product Outside View

Selling Price 2.75 2.00 2.75

Less
V.C. (Purchase 2.00 VC at P 1.25
at TP of 2)
V.C.(Processing) 1.25 1.00 VC at S 1.00
-0.50 1.00 0.50

2. From division P’s processing further the product of S, which is beging bought at Rs.
2.00 (TP) is not advisable.

From division S’s point of view selling its product in open market is most profitable
decision even as compared with Company’s point of view.

=======================================
Problem 4.
The Power Lite division manufactures batteries that it sells primarily to the Lantern
division for inclusion with that division’s main product. Last year 20% of the batteries
were sold to the other companies at a price of Rs.10 each. The remaining batteries went
to the Lantern division. Cost data for the year are presented for Power Lite is as under –

Units Produced 5,00,000

Manufacturing Cost (Rs.) 30,00,000
Marketing Cost (Rs.) 1,00,000
Administrative Costs (Rs.) 8,00,000

Required – A. What will be the transfer price of batteries if the company uses
1. Market price?
2. Market price less marketing costs
3. A transfer price that will yield a net income of 10% on sales for Power Lite?
B. Prepare a schedule showing the Power-Lite divisions net income for
each of the transfer pricing alternatives computed.

Solution –
Given
Power Lite Division
Units Produced 5,00,000
 20% Units Sols Outside 1,00,000
80% Units Sold to Latern Div. 4,00,000
Market Price @ Rs 10.00
Production Cost 30,00,000/5,00,000 @ Rs. 6.00
Marketing Cost 1,00,000/5,00,000 @ Rs. 0.20
Administration Cost @ Rs. 1.60
8,00,000/5,00,000

A) i) TP as MP = Rs 10.00
ii) TP = MP - Marketing Cost = 10.00 – 0.20 = 9.80
iii) Set TP such that it should give 10% profit on sales price

Production Cost 6.00

Marketing Cost 0.20
Administration Cost 1.60
Total Cost 7.80
Profit 0.87
Selling Price i.e. TP 8.67

B) PLD’s Net Income under various options of TP

Transfer Price @ Rs.10.00 Transfer Price @ Rs. 9.80 Transfer Price @ Rs.
8.67
Sales Sales Sales
5,00,000@ 10 50,00,00 1,00,000 @ 10 10,00,00 1,00,000 @ 10 10,00,000
0 0
4,00,000 @9.8 39,20,00 4,00,000 @8.67 34,68,000
0
Total Sales 50,00,00 49,20,00 44,68,000
0 0
Total Cost@7.8 39,00,00 39,00,00 39,00,000
0 0
Profit 11,00,000 10,20,00 5,68,000
0

==================================

Problem 6: -
ABC Co Ltd. has two divisions Relay Division (RD) and Motor Division (MD). Other
information given is –
RD – It can manufacture 50,000 Relays (a kind of switch) per year at a variable cost of
Rs,12 per unit and selling price is Rs. 20 per unit. Each relay requires one labour hour to
complete.
MD – It has developed a new model of Motor for which a new model of Relay is
required. There are two options to procure this new model of Relay:
a. To buy from an external supplier @ Rs 15 per unit (Annual requirement
50,000 units)
b. To be manufactured by RD which has to give up its entire present business.
The variable cost of manufacturing a new model is Rs.10 per unit.
The MD also has to incure Rs.25 as variable cost and the selling price per unit is Rs.60.
Advise whether the RD should give up its existence business to manufacture a new model
of relay for MD OR
The latter should procure the new model from the market?
 Solution: -
1. Option I – Develop new relay model in RD and transfer it to MD

Relay Division (RD) Motor Division (MD) Total

Sales 50,000 @ 10 TP 5,00,000 Sales 50,000 @ 60 30,00,000

(Treating VC as TP)
Variable Cost @10 5,00,000 VC (Purchase cost 5,00,000
from RD @ 10)
VC @ 25 12,50,000
(Production cost)
Contribution NIL 12,50,000 12,50,000

2. Option II – Let MD procure from outside supplier & RD continue the production
of old model relays
Relay Division (RD) Motor Division (MD) Total

Sales 50,000 @ 20 MP 10,00,000 Sales 50,000 @ 60 30,00,000

Variable Cost @12 6,00,000 VC (Ext. Purchase 7,50,000

cost @ 15)
VC @ 25 12,50,000
(Production cost)
Contribution 4,00,000 10,00,000 14,00,000

The above table option II show that if MD procures its new model of relays from outside
supplier it leads to earning better contribution i.e. 14,00,000 to the company. This also
entails RD to sell outside and run profitably.
However with Option I company’s contribution gets reduced by 1,50,000. Therefore
transfer transaction should not be made.

From RD’s point of view the Minimum TP should be equal to VC + Contribution lost,
which comes out to be Rs.18 {10 + (20-12)}. But as the MD is able to procure the relay
at Rs.15 this TP may not advisable to MD.

==========================================
Problem 7: -
Amit Industries has two divisions A & B. Division A has a capacity of manufacturing
1,00,000 boxes per year. The selling price is Rs.30 whereas the variable cost is Rs.16 per
unit and fixed cost is 9,00,000 per year. Division B is also using the same box but it is
purchasing 10,000 units per year at a cost of Rs.29 per unit.
Find out the transfer price in following cases:
a. If division A has sufficient idle capacity to handle requirement of division B.
b. If there is no idle capacity in division A, should there be any transfer at this
price?
c. If there is no idle capacity in division A, however Rs.3 in variable cost can be
avoided on interdivision sales, due to reduced selling costs.

Solution: -
a. Option I- Division A has idle capacity i.e. it can produce more but can not sell
the additional produce. In this situation whatever it can sell to division B over
 above the variable cost is acceptable to it. Division A’s opportunity cost is
Zero i.e. it is not loosing any contribution on account of transfer.
Contribution Lost per unit = ZERO
Therefore
Minimum TP = VC per unit + Contribution Lost per unit
= 16 + 0
= 16

But to provide motivate division A, by carrying negotiations, TP may be

set any where between Rs.16 to 29. (as division B is in a position to get the said
product from open market at Rs.29)

b. Option I – Division A has NO IDLE capacity i.e. whatever it can produce it

can sell. Therefore in this situation division A need not reduce its transfer price below
the market price. And any such transfer required to be made must compensate for the
total contribution lost by A on account of such transfer.
Contribution Lost per unit = Rs14 {30-16}
Therefore
Minimum TP = VC per unit + Contribution Lost per unit
= 16 + 14
= 30
However note that division B is also able to get its requirement at Rs.29, therefore
no transfer is possible between the divisions.

c. Division A has no idle capacity, but it can save variable cost of Rs.3 on internal transfer
to division B on account of reduced selling cost.

Therefore in this situation Varibale Cost of Div. A = 16-3 = 13

Minimum TP = VC per unit + Contribution Lost per unit

= 13 + 14
= 27

Again here to provide proper motivation to division A, TP mat be set between

Rs.27 to 29.
======================================
Problem 8: -
There are two divisions in a firm, the Valve Division (VD) and a Pump Division (PD).
The PD’s requirement is 20,000 units of a special type of valves which can be supplied
by VD.
Presently, the VD is producing 1,00,000 valves of other models at its full capacity (i.e.
HAVING NO IDLE CAPACITY), at variable cost of Rs.16 and selling price of Rs.30 per
unit. In order to produce special type of valve, as required by PD, the VD has to give up
50% of its regular production and need to incur additional variable cost of Rs.4 per unit.
If the VD decides to produce the special type of valve for PD, what transfer price should
it charge to PD?

Solution –
In order to produce 20,000 units of special type of valves, the VD need to cut its regular
production by half i.e. by 50,000 units. And in this case the contribution lost would be
Contribution Lost per unit = 50,000 (30 – 16)
= Rs.7,00,000
And it needs to recover this loss from the production of special type of valve. It is
required to produce 20,000 special type of valves. Therefore the lost contribution per
special valve comes out to be Rs. 35 ( Rs.7,00,000 / 20,000)
And based on this lost contribution per unit transfer price be set as under
 Minimum TP = VC per unit + Contribution Lost per unit
= 20 + 35
= Rs.55

Thus VD should charge minimum transfer price of Rs.55 to PD so as to compensate the

switchover in production.
===================================
Consider if Required
===================================

Problem 9: - (pg 60)

A company is organized on a decentralized line, with each manufacturing division
operating as a separate profit center. Each division manager has full authority to decide
on the sale of the division’s output to outsiders and to other divisions.
Division C has always purchased its requirement of component from division A. but
when informed that division A was increasing its selling price to Rs.150/-, the manager of
division C decided to look at outside suppliers.
Division C can buy the component from an outside supplier for Rs.135/-. But division A
refuses to lower its prices in view of its need to maintain its return on investment.
The top management has following information.

C’s annual purchase of the component 1000 units

A’s variable cost per unit Rs 120/-
A’s fixed cost per unit Rs.20/-
Find
i. Will the company as a whole benefit, if division C bought the component at
Rs. 135/- from an outside buyer. (No)
ii. If A did not produce the material for C, it could use the facilities for other
activities resulting in a cash operating savings of Rs.18000/-. Should C then
purchase from outside sources?(yes)
iii. Suppose there is no alternative use of A’s facilities and the market price per
unit for the component drops by Rs.20, should C buy from outside?(yes)

Solution :-
i)
Div C Buys from outside parties at Rs 135

SP per unit 135

VC per unit 120
Contribution per unit 15

Here if the division C buys the product at Rs 135 from the outside parties instead of
division A, the company as whole will be loosing the contribution otherwise would have
been earned of Rs.15, because it can produce the said item at variable cost of 120 only.
Therefore division should not buy the product from outside at Rs.135/-

ii)
C’s annual requirement is 1000 components
If A produce this requirement and transfer it to C it is incurring the additional cost of
Rs.18000, in other words it save on this cost if it does not produce the C required stock.

i.e. per unit of this produce leads to cost of 18000/1000 i.e. Rs 18 per unit
So instead of producing and earing Rs 15 as contribution it can save Rs18 per unit by
choosing not to produce.
Therefore in this situation division C should go for purchase of the component fron
outside parties at Rs135/-
Purchase cost 1000*135 135000
Less Saving on VC 1000*120 120000
Less Saving of A if its 18000
capacity used for
other activities
----------
Net Cost (benefit) to the company (3000)

iii) If the selling price for A’s product drops by Rs 20, the new selling price will be
Rs.115 per unit.
Price drops from 135 to 115

SP per unit 115

VC per unit 120
Contribution per unit (5)
In this situation the revised prices reduces the division A’s contribution and it becomes -5
per unit, it will better if division C goes for outside purchase because to produce the
component division A has to incur variable cost of Rs.120/ but the said component is
available at less than that so from A’s as well as from company’s point of view it is
advisable for C to go for outside purchase.
=================================

Problem 3: - (pg - 74)

S V Ltd. manufactures a product, which is obtained basically from a series of mixing
operations. The finished product is packaged in the company made glass bottles and
packed in attractive cartons.
The company is organized into two independent divisions viz. one for the manufacture of
end product and other for manufacture of 800000 glass bottles. The product
manufacturing division can buy all the bottle requirements from the bottle manufacturing
division.
The general manager of the bottle division has obtained the following data from the
outside manufacturers for the supply of empty bottles –

No of empty bottles Total Purchase value (Rs.)

800000 1400000
1200000 2000000
a cost analysis of the bottle manufacturing division for the manufacturing of empty
bottles reveals the following production costs –

No of empty bottles Total Purchase value (Rs.)

800000 1040000
1200000 1440000

the production cost and sales value of the end product marketed by the product
manufacturing division are as under –
Volume Total cost of end product Sales Value
(Bottles of end product) (excluding cost of bottles) (packed in Bottles)
800000 6480000 9120000
1200000 9680000 12780000

there has been considerable discussion at the corporate level as to the use of proper price
for transfer of empty bottles from the bottle manufacturing division to product
manufacturing division. This interest is heightened because a significant portion of the
Divisional General Managers salary is in incentive bonus based on profit center results.

As a company management accountant responsible for defining the proper transfer prices
for the supply of empty bottles by bottle manufacturing division to product
manufacturing division, you are required to show for the two levels of volumes 800000
and 1200000 bottles, the profitability by using
a. market price
b. Shared profit relative to the costs involved basis for the determination of transfer
prices.
The profitability portion should be furnished separately for the two divisions and the
company as whole under each method.
Discuss also the effect of these methods on the profitability of the two divisions.

Solution –
1) Statement showing the profit at two volumes 800000 & 1200000 at market
price

Pariculars Vol. 8000000 Vol. 1200000

Sales of Bottle mfg. Division 1,400,000 2,000,000

(Treated outside prevailing price as TP)
Less Production Cost 1,040,000 1,440,000

a) Profit Bottle mfg. Division 360,000 560,000

Sales of product Mfg. Division 9,120,000 12,780,000

Less Cost of Production 6,480,000 9,680,000
Less Cost of Bottles (as above) 1,400,000 2,000,000

b) Profit of Product Division 1,240,000 1,100,000

a+b) Profit of the SV Ltd 1,600,000 1,660,000

2) Statement of Showing determination of Transfer Price

(Based on sharing the profits on Total Cost)
Cost of Bottle Mfg Div. 1,040,000 1,440,000
Add Cost of Product Div. 6,480,000 9,680,000
Total Cost 7,520,000 11,120,000

Share of Bottle Mfg. Div. In Profits

1040000 * 1600000 & 1440000 * 1660000 221,276 214,964
7520000 11120000
Share of Product Mfg. Div. In Profits 1,378,724 1,445,036
(Total Profits less Share of Bottle Div.)
Cost of Bottle Mfg. Div 1,040,000 1,440,000
Add Its Share of Profit 221,276 214,964
TRANSFER PRICE BY BOTTLE Mfg. Div 1,261,276 1,654,964

3) Based on the above transfer price Profit Calculation of both division -

Sales of Bottle mfg. Division 1,261,276 1,654,964

(Treated outside prevailing price as TP)
Less Production Cost 1,040,000 1,440,000

a) Profit Bottle mfg. Division 221,276 214,964

Sales of product Mfg. Division 9,120,000 12,780,000
Less Cost of Production 6,480,000 9,680,000
Less Cost of Bottles (as above) 1,261,276 1,654,964

b) Profit of Product Division 1,378,724 1,445,036

a+b) Profit of the SV Ltd 1,600,000 1,660,000

It can be seen that taking market price as transfer price is more appealing to Bottle Mfg.
Div rather than TP based on sharing the profits on the costs basis.

Problem 4: - (pg – 75)

Fasters Ltd. is having production shops reckoned as cost centers. Each shop charges other
shops for material supplied and services rendered.
The shops are motivated through goal congruence, autonomy and management efforts.
Fasters Ltd is having a Welding Shop and a Painting Shop.
The WS welds annually 75000 purchased items and other 150000 shop made parts in to
12000 assemblies. The assemblies are having variable cost of Rs. 9.50 each and are sold
in market at Rs. 12 per assembly. Out of its total production of 12000, 80% is divested to
PS at same price ruling in the market. WS incurs a fixed cost of Rs. 25000 per annum.
The PS is having fixed cost of Rs.30000 and its cost of painting including transfer price
from welding shop comes to Rs. 20 per unit. This shop sells all units transferred to it by
welding shop at Rs. 25 per assembly.
You are required to –
a. find out profit of individual cost centers and overall profitability of the concern.
b. Recommend course of action if painting shop wishes to purchase its full
requirement (at market price which is Rs.10 per assembly) either from open
market or from WS at market price of Rs10 per assembly. Give reasons for your
recommendations.
(find profit for each option i.e. open market as well as internal transfer separately)
Tabulate profits under each option and Compare them

Solution –
a) Profitability of Welding Shop , Painting Shop and Company as whole

Particular Welding Shop Painting Shop

Qty. Rate Value Qty. Rate Value
Sale in Open Market 2400 12 28800
Transfer to Painting Shop 9600 12 115200 9600 25 240000
Total 12000 144000 9600 240000
Less V.C. @ 9.50 114000 @ 20.00 192000
Contribution 30000 48000
Less Fixed Cost 25000 30000
Profit 5000 18000
Company as whole the profits would be 23000
b)
i) When Paint shop purchases its entire requirement from OPEN market @ Rs. 10
(Welding shop doesn’t have any other option than to curtail the production to 2400 units.)

Particular Welding Shop Painting Shop

Qty. Rate Value Qty. Rate Value
Sale in Open Market 2400 12 28800 9600 25 240000
Transfer to Painting Shop 9600 12 115200
Less V.C. @ 9.50 22800 @ (20 – 12) = 8 76800
Outside Buying
cost @ 10 96000

Contribution 6000 67200

Less Fixed Cost 25000 30000
Profit (19000) 37200

Company as whole the profits would be (19000) + 37200 = 18200

ii) When Paint shop purchases its entire requirement (i.e. 9600 units) from Welding shop
at TP @ Rs. 10 (and welding shop can then as usual sell its rest of produce of 1200 in
open market at MP of 12)

Particular Welding Shop Painting Shop

Qty. Rate Value Qty. Rate Value
Sale in Open Market 2400 12 28800 9600 25 240000
Transfer to Painting Shop 9600 10 96000
Less V.C. @ 9.50 114000 @ (20 – 12) = 8 76800
Buying cost @
10 (from WS) 96000
Contribution 10800 67200
Less Fixed Cost 25000 30000
Profit (14200) 37200

Company as whole the profits would be (14200) + 37200 = 23000

Out of all options above b) ii) appears to be quite reasonable on account of Goal
Congruence, maximum autonomy to both the Divisions, motivation to both the divisions.
Both have been treated as cost center rather than mere profit centers.(Reduction in cost of
paint shop)
=====================================

Problem 5: - (pg85)
Division A of Better Margins Ltd. has been given a budgeted target of selling 200000
components COM1, it manufactures at a price which would fetch a return of 25% on the
average assets employed by it. The following figures are relavent:

Fixed
Overheads Rs. 400000
Varibale Costs Rs. 1 per unit
Average Assest
Sales Debtors 200000
Stocks 600000
Plant and other Assets 400000

However the marketing department of the company finds out by a survey that the
maximum number of COM1, the market can take at the proposed price is only 140000
units.
Fortunately division B is willing to purchase the balance 60000 units. The manager of
division A is willing to sell to division B at a concessional price of Rs 4 per unit. But the
manager of division B is ready to pay Rs2.25 per unit, as he feels he can himself make
COM1 in his division at that price.
Rather than selling to division B at rate Rs2.25 per unit, manager of division A feels that
he will restrict the activity of his division to the manufacture and sale of 140000
components only. By this he can reduce Rs.80000 in stocks, Rs 120000 of plant and other
assets and Rs. 40000 in selling and administrative expenses.
As a management accountant do you agree with the proportion of maanger of division A
to restrict the activities to 140000 componenets, from the overall interest of company.
Give detail workings.
(Find selling price for given ROI, with transfer to B at 2.25 and reduce activity –find
profitability of both.)

=====================================

Problem 6:- (pg 87)

Hummer Sewing machine company is a decentralized manufacturing company in which

all major component parts are made by separate divisions that are operated as profit
centers. The motors for the sewing machines are made MTR division of the company.
The MTR division has more capacity than required to satisfy production needs for the
company’s sewing machines. During 1998 the division sold 30% of its motors to other
companies at aprice of Rs 200 each and rest were sold to the assembly division of the
Delux Sewing machine co. the industry average for the marketing and distribution costs
of this type of motor is 20% of selling price.
The MTR division made 25000 motors during 1998 and incurred the following expenses

Direct Material 1500000

Direct Labor 1000000
Manufacturing O/H 800000
Total Production cost variance 400000(Unfavorable)
Operating Expenses
Selling and Distribution 200000
Administrative 800000

Evaluation of production standards has led toi the decision to increase production
standard cots by 10% for the coming year. Market analysis indicate a 6% price increase is
logical for motors. With the new standard costs, management of division MTR expects
variance from standard will average 5% unfavorable. Production ab\nd sales quantities
are expected to be the same as in 1998.

Find – Compute the transfer price for the sewing machine motors for each of the
following independent assumptions.

1. TP based on 1998 standard product cost.

2. TP based on 1998 actual product cost.
3. TP based on 1999 standard product cost.
4. TP based on 1999 expected actual product cost.
5. TP based on 1999 market price.
6. TP based on 1999 market price modified for lower marketing and distribution
costs.
7. Provide a 6% profit in 1999 expected total costs.
8. Prepare a schedule showing the MTR divisions net income for each of the
1999 base transfer pricing alternatives.
(product cost and production )

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Example 8:- ( pg – 91)
Paradise State park has been plagued by vandalism recently. There are no funds available
to hire permanent security officers to patrol the park. However there is a general
contingency fund with enough resources to hire temporary security people to patrol the
park for a while until the vandalism controlled. Private security firms have bid for the
job, with a low bid of Rs.250 per patrol hour, including patrol vehicles. The State Police
have heard of the situation and offered to patrol the park. In return the park must pay the
State Police out of the special contingency fund. State Police cost and activity data for the
year as follows –

Police Hours Cost (Rs.)

State Police in total 1000000 150000000
Stae Police Patrol Div.400000 72000000

Of the patrol division’s cost, 60% is variable.

Required –
A) Compute the transfer price for the state patrol service, if
1. Park officials can convince the State Police that full cost for the State Police
activities in general is the appropriate transfer price.
2. State Police can convince park official that full cost for the patrol division
is the appropriate TP.
3.State Police can convince park official that outside market price less a normal
profit of 20% is the appropriate TP.
4.Park official can convince the State Police that the appropriate TP is the variable
part of the patrol division cost plus an incentive of 20% of the variable cost.

A) If the contingency fund can provide Rs.270000 for this project, how many patrol
hours can the aprk purchase using each of the TPs’ computed above?
========================================

Problem9: -
Two of the divisions of C Corporation Ltd. are the Intermediate Division (ID)and Final
Division(FD). The ID produces three products A, B & C. Normally these products are
sold both to outsiders and to FD. The FD uses products A, B & C in manufacturing of X,
Y & Z respectively. In recent weeks, the supply of products A,B,C has tightened to such
an extent that the FD has been operating considerably below capacity. With the result, the
ID has been told to sell all its products to FD. The financial facts about these products are
as follows –

Intermediate Division
Product A Product B Product C
Transfer Price (Rs) 10 10 15
Variable Mfg. Cost per unit 3 6 5
Contribution per unit 7 4 10
Fixed Costs (Total) 50,000 100,000 75,000

The ID has a monthly capacity of 50000 units. The processing constraints are such that
capacity production can be obtained only by producing at least 10000 units of each
product. The remaining capacity can be used to produce 20000 units of any combination
of the three products. The ID cannot exceed the capacity of 50000 units.

Final Division
 Product X Product Y Product Z
Selling Price (Rs) 28 30 30
Variable Mfg. Cost per unit
Inside purchases 10 10 15
Other VC 5 5 8
Total VC 15 15 23
Contribution per unit 13 15 7

Fixed Costs (Total) 100,000 100,000 200,000

The FD has sufficient capacity to produce about 40% more than it is now producing,
because the availability of products A, B & C is limiting production. Also the FD can sell
all the products that it can produce at the price indicated above.
Find
B) a. If you were manager of the ID, what products would you sell to the FD? What
is the amount of profit that you would earn on these sales?
b. If you were the manager of FD, what products would you order from the ID,
assuming that the ID must sell all its production to you? What profits would you
earn?

c. What production pattern optimizes total company profit? How does this affect
the profits of the ID? If you were the Executive V P of C Corporation Ltd. and
prescribed this optimum pattern, how would you distribute the profit between two
divisions?
(With minimum capacity compute contribution , allot rest of the excess capacity to
product giving maximum contribution, compute profit if ID, FD, Company)

B. How, if at all, would your answer to (A) change if there were no outside buyer for
products A, B & C.
(vague answer)

C. The company has determined that capacity can be increased in excess of 50000 units,
but these increases require an out of pocket cost penalty. These penalties are as follows –
Volume in excess of Cost Penalty (Rs.)
Present capacity (units) Product A Product B Product C
1000 10000 12000 10000
2000 25000 24000 20000
3000 50000 50000 35000
4000 80000 80000 50000
Each of the above increases is independent i.e increase of production of product A do not
affect the costs of increasing the production of B or C. Change can be made only in
quantities of 100 units with maximum of 4000.
Find -
i. What would be the ID’s production pattern, assuming that it can charge all
penalty costs to the FD?
(ID can hike capacity to maximum for a product which gives max
contribution)
ii. The FD’s optimum production pattern, assuming that it is required to
accept the penalty costs?
(for each level excess output , find when contribution margin – penalty
cost will be max. that is the max capacity FD can afford )
iii. The optimum company production pattern.
(for each product and each volume hike find Net Conti = conti – penalty)

Solution A-a,b,c
 Intermediate Division A B C
Contribution PU 7 4 10
Minimum Vol. Consn. 10000 10000 10000
20000
Total Contribution 70000 40000 300000
Fixed Cost 50000 100000 75000
Profit 20000 -60000 225000 185000

Final Division X Y Z
Contribution PU 13 15 7
Minimum Vol. Consn. 10000 10000 10000
20000
Total Contribution 130000 450000 70000
Fixed Cost 100000 100000 200000
Profit 30000 350000 -130000 250000

Company as Whole

Selling Price 28 30 30
Variable cost
VC Attached at ID 3 6 5
VC Attached at FD 5 5 8

Contribution 20 19 17
10000 10000 10000
20000
Total contribution 200000 570000 170000
FC at ID 50000 100000 75000
FC at FD 100000 100000 200000
Profit 50000 370000 -105000 315000

Profit sharing will be based on the product volume decided on the basisi of
Company’s optimal mix. It works out to as under

Contribution at ID 7 4 10 21
Volume as per Co's Mix 30000 10000 10000 50000
Toatl Contribution 210000 40000 100000 350000
FC at ID 50000 100000 75000 225000
Profit to ID 160000 -60000 25000 125000

Contribution at FD 13 15 7 35
Volume as per Co's Mix 30000 10000 10000 50000
390000 150000 70000 610000
FC at FD 100000 100000 200000 400000
Profit to FD 290000 50000 -130000 210000

B Since the products do not have external market TP has to be fixed based on motivation
and goal congruemce i.e. total cost and some margin.
C i ) Since ID can charge all its penalty to FD , it will go for maximum increases of 4000
units and specially for such product which gives highest contribution. i..e product C

C ii)Since FD will accept all penalty costs, we will go for that vol hike which gives the
maximum after penalty contribution

Prod
A Prod B Prod C
VC per unit at ID 3 6 5
FC at ID 7 4 10
Penalty Cost to Increase vol by 1000 10000 12000 10000
Penalty Cost to Increase vol by 2000 25000 24000 20000
Penalty Cost to Increase vol by 3000 50000 50000 35000
Penalty Cost to Increase vol by 4000 80000 80000 50000
Penalty Cost per unit 10 12 10
12.5 12 10
16.7 16.7 11.7
20 20 12.5

Contribution at FD 13 15 7
Contri After Penalty(Max) 3 3 -
(Select the vol which gives max contri 1000 2000 0
after penalty)

Thus company should go for increase in capacity of product A by 1000 units and product
B by 2000 units.

C c) Optimum Company production based on penalty cost

Product Product Product

X Y Z
Contribution Per Unit 20 19 17
Total contribution for 1000
units 20000 19000 17000
Cost penalty 10000 12000 10000
Net Contribution 10000 7000 7000

Total contribution for 2000

units 40000.0 38000.0 34000.0
Cost penalty 25000 24000 20000
Net Contribution 15000.0 14000.0 14000.0

Total contribution for 3000

units 60000 57000 51000
Cost penalty 50000 50000 35000
Net Contribution 10000 7000 16000

Total contribution for 5000

units 80000 76000 68000
Cost penalty 80000 80000 50000
Net Contribution 0 -4000 18000

Thus maximum after penalty contribution is possible in product Z i.e. production of

product C.

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