FINAL EXAMINATION JUNE- 1995 PAPER 13:ADVANCED MANAGEMENT ACCOUNTING Techniques and application

Question 1.

(a) What do you understand by cost plus pricing? What are the advantages and disadvantage of the same ? (b) A manufacturing company, ABC Ltd. Has just completed a project with a capacity to manufacture 50,000 units per month and the same is ready for commercial production.

It has got an offer from another manufacturer to produce its products with Brand name by using the facility created. The Management is considering which of the two options, either to produce its own Brand or to manufacturer for others, it should accept.

The following Data are available:

(i)

Average selling price per unit Rs.3,500. (ii) Cost of material 75% of selling price. However, the company has engaged a firm to carry out Value Engineering and indications are that it may come down by 3% during 3 to 6 months next (iii) Power & Fuel-up to 15,000 units production/m. Rs.325 per unit; at 30,000 units production/m Rs.225 per unit (The Power & Fuel Cost per unit reduces on prorata basis with increase in production). (iv) (v) Indirect Material and consumables Rs.225 per unit. Fixed Cost per month:

(a) (b) (c)

Employment Cost Rs.50 lakhs Overheads (Administrative & Factory) Rs.15 lakhs. Overhead (Selling & Distb.) Rs.20 lakhs.

(vi) (vii) -

Variable Selling & Distribution Cost works out of 6% of Sale Price. Working Capital requirement @ 18% Interest. at level of production of 15,000 units/month Rs.10 crores. at level of production of 20,000 units/month Rs.12 crores. at level of production of 30,000 units/month Rs.20 crores.

The price offered by the manufacturer for carrying out conversion job is Rs.700 per unit. The other manufacturer would provide all Material other than an Indirect Material and consumables.

You are required to work out a Budget showing profitability under the two alternatives for three levels of production at 15,000 units/month, 20,000 units/month Bs, 30,000 units/month and find out the best course of action as a short term measure and as a long term measure.

Answer to Q. No. 1

(a) Cost Plus pricing In cost plus pricing all the costs variables and fixed are taken into account to fix the price. A standard mark up is determined which is then loaded to set the price.

Advantages (a) Simple and quick (b) Dose not require extensive analysis of cost behaviours (c) Provide transparent basis of price determination particularly when guided by outside control like B.I.C.P. for drug formulation etc.

Disadvantages

(a) Ignores market forces of competition (b) Ignores opportunity cost (c) Not sensitive to capacity bottlenecks.

A B C Ltd

in Rs. Lakh

Statement showing budgeted profitability at various levels / per month 15,000 Tyres Level Own Brand Manufacture conversion Sales value 210.00 Material Ind. Material / Consumables 7.50 3.75 3.75 50.00 48.75 5.00 50.00 58.00 5.00 50.00 58.00 7.50 50.00 67.50 525.00 393.75 105.00 -700.00 525.00 140.00 -1050.00 787.50 -Conversion Own Brand Conversion Own brand 20,000 Tyres Level 30,000 Tyres Level

Employment cost 50.00 50.00 Power & fuel 67.50 Other Fixed Overheads 15.00 Selling & Distri. Overheadsfixed 20.00 20.00 Variables 160.00 (37.75) Depreciation 40.00 Int. on working Capital Net Profit / (Loss) (10.00) (92.75) 15.00 40.00 31.50 562.75 15.00 48.75

15.00

15.00

15.00

15.00

20.00 -137.50 (32.50) 40.00

20.00 42.50 715.00 (15.00) 40.00

20.00 -148.00 (8.00) 40.00

20.00 63.00 1010.50 39.50 40.00 50.00 --

--

19.00

--

30.00

--

(72.50)

(74.00)

(48.00)

(30.50)

Comment: In the short run it would be beneficial to do the conversion job. But carrying out conversion job cannot be a long-term solution as then the unit would become dependent upon the other pray for supply of raw material. Moreover, it cannot built up its market demand for its own product.

But the level of operation must not fall below 20,000 level as there will be loss even by doing job work.

For own production even at 30,000 level, Depreciation could not be covered. Therefore, for own production the level would have to be higher to make the operation variable.

However, a separate working considering material as 72% which would change the scenario to some extent, as may be seen from below:

A B C Ltd.

(in Rs. lakh)

Statement showing Budgeted Profitability at various levels / per month (For own Brand Production Material Cost @ 72%) 15,000 Tyres/ P.M. Level Sales value Material Ind. Material /consumables Employment cost Power & Fuel Other Fixed overheads selling & Distribution Overheads Fixed Variables 15.00 20.00 31.50 547.00 (22.00) Depreciation Int. on Working Capital 40.00 15.00 15.00 20.00 42.00 694.00 6.00 40.00 19.00 15.00 20.000 63.00 979.00 71.00 40.00 30.00 525.00 378.00 3.75 50.00 48.75 20,000 Tyres/ P.M. Level 700.00 504.00 5.00 50.00 58.00 30,000 Tyres / P.M. Level 1050.00 756.00 7.50 50.00 67.50

Net Profit / (Loss) Corresponding position If only jobbing is done

(77.00)

(53.00)

1.00

(72.50)

(48.00)

10.00

But still it would be advantageous to be jobbing. In this context, as the gap is narrowing down a more detailed study of contribution per unit of different range (if it has a range of products) might be worthwhile to work out and a healthy mix of both own production and jobbing might be aimed at. ___________

Question 2.

Unique Products Ltd. is considering a proposal of whether to invest in a project which would need an immediate expenditure on capital equipment of Rs.40, 000.

The projected Sales from the project has been estimated as under:

2000 6000 8000 10000 14000 0.20 0.10

0.10 0.30 0.30

Once the sales are established at a certain volume in the first year they will continue at the same volume in subsequent years. The unit selling prices will be Rs.12, unit variable cost will rs.8. There will be additional fixed cost of Rs.20, 000 (all cash items).

The project will have a life of 6 years after which equipment could be sold for scrap at a price of Rs.3, 000.

You are required to find out:

(a) (b)

The expected value of the NPV of the project; The minimum volume of sales p.a. required to justify the project;

The cost of capital of the company is 10%. Discount factor of Re.1 per annum for 6 years at 10% is 4.355 and the Discount factor of Re.1 at the end of sixth year at 10% is 0.5645. Ignore Taxation.

Answer to Q. No. 2 (a) The expected value of sales volume per annum:-

Probability

Sales Vol. (Units)

Expected sales Volume (Units)

0.10 0.30 0.30 0.20 0.10

2,000 6,000 8,000 10,000 14,000

200 1,800 2,400 2,000 14,000 7,800

EV. Of contribution

= 7,800 x Rs. 4 (i.e. Rs. 12 Rs. 8) = Rs. 31,200

Less Add. Fixed cost = RS. 20,000 Ev. Of addl. Cash Profit = Rs. 11,200 each year

PV of Cash Flow Discount Factor Year 0 Cash Flow (Rs.) (40,000) @ 10% 1 PV of cash flow (40,000)

16 6

11,200 3,000

4.355 0.5645

48,766 1,634 -------------

Expected NVP

10,470 ------------

(b)

In order to Break Even, the NVP would be Zero.

Taking the cost of the equipment and it residual value, the minimum required PV of annual Cash Profit would be as under:Present Value (Rs.) PV. Of capital outlay PV. Of residual value PV. Of annual cash profit Required for NPV of 0 40,000 1,694 38,306

Discount factor of Rs. 1 p.a. for 6 years @ 10% = 4.355

38,306 Annual Cash Profit required = -------------- = Rs. 8,796 4.355 Rs. 20,000 Annual (cash) fixed costs = ------------------Rs. 28,736

Annual contribution reqd. for NVP 0 Contribution per unit Rs. 4/Rs. 28,796 Accordingly sellers required to Break Even -------------------- = 7,199units 4

_____________

Question 3.

(a)

Define and illustrate curvilinear Cost-Volume-Profit analysis.

(b) A Holiday Home operates for 300 weeks each year. The following financial data are available:

(i) It can accommodate minimum 6 guests and up to 15 guests at a charge of Rs.100 per week; (ii) Weekly variable cost amounts to Rs.43 per guest;

(iii) As long as 10 guests are accommodated, the fixed cost of supervision would be Rs.11,000 for 30 weeks. However, in case guests exceed 10 nos., additional fixed cost of Rs.200 per week will have to be incurred for the entire 30 week period; (iv) Rent charges is Rs.4,000 p.a. am Rs.1,000 p.a. is paid to outside contractor for general maintenance.

You are required to tabulate the figures too find out the Break Even Points.

Answer to Q. No. 3 (a) Curvilinear Analysis (CVP Analysis)

The traditional CVP Analysis is of theoretical importance and it takes into account:-

(a) Based on phenomenon of diminishing marginal productivity total cost line will not be straight line but will be of curvilinear shape (b) The additional units can be sold by a reduction in prices and as a result, the sales line will be concave to the base. (c) The decreasing sales line and the behaviour of cost line provides two Break Even points. The position can be represented graphically below.

A2 Loss

Total Revenue Total (Rs.)

A1 Total cost Loss points. A1 + A2 = 2 Break Even

Quantity

Holiday Home. Cost & Income Statement No. of Guests RS. (Note 1) 6 7 8 9 10 11 12 13 14 15 18,000 21,000 24,000 27,000 30,000 33,000 36,000 39,000 42,000 45,000 Income p.a Variable Cost RS. (Note 2) 7,740 9,030 10,320 11,610 12,900 14,190 15,480 16,770 18,060 19,350 10,260 11,970 13,680 15,390 17,100 18,810 20,520 22,230 23,940 25,650 Rs. Rs. (Note 3) 16,000 16,000 16,000 16,000 16,000 22,000 22,000 22,000 22,000 22,000 Contribution Fixed Cost Surplus (Deficit) Rs. (Note 4) (5,740) (4,030) (2,320) (610) 1,100 (3,190) (1,480) 230 1,940 3,650

Note 1: Calculation of Income has been made as 6 persons x 100 x 30 weeks = Rs. 18,000 and onwards.

Note 2: Variable Cost calculated as 6 persons x 43 x 30 weeks = Rs. 7,740 and onwards.

Note 3:

Fixed Costs Up to10 Nos.

Supervision Rent

Rs. 11,000 Rs. 4,000

Guests General Maintenance Rs. 1,000 Rs. 16,000

Beyond 10 Nos. Guests addl. Cost Rs. 200 x 30 = Rs. 6,000/- i.e. Rs. 22,000 Note 4: there are two Break Even points.

____________

Question 4.

Engineers Ltd. Plans to introduce two products A and B in the market. These will be manufactured in Department X, which will be treated as a Profit Centre.

Production volumes and costs are estimated as follows:

Product Annual Production (Units)

A 300000 Rs. Per Unit

B 500000

Direct Material cost Direct Labour cost (Rs.20 per hrs)

150 300

180 420

The proportion of overheads other than interest, chargeable to two products A & B are as under :

Factory Overheads (50% Fixed) 100% of Direct Wages.

Administration Overheads (100% Fixed) 10% of Factory Cost.

Selling and Distribution Overheads (50% Variable) Rs.30 and Rs.40 respectively per unit of products A and B.

The fixed Capital Investment in the Department will be Rs.2500 lakhs. The Working Capital requirement is equivalent to six months stock of cost of sales of both the products. To finance this project a term loan of 50% of working Capital required has been obtained from a Financial Institution at an interest rate of 18% p.a. Department X is expected to give a return a return of 20% on capital employed.

Required:

(a) Unit Selling Prices for products A and B, such that the contribution per labourhour (rounded up to the next higher integer), is the same for both the products. (b) Statement of overall profitability expected.

Answer to Q. No. 4 Unit Cost Sheet Product A Rs. Direct Material Direct Labour 150 300 --------Prime Cost 450 B Rs. 180 420 -------600

Factory Overheads Fixed Variable 150 150 -------750 210 210 ------1,020

Administrative Overheads Fixed 75 102

------Total 815 -------

-----1122 -------

Selling & Dist. Overheads Fixed Variable 15 15 ----------Total 855 ----------Total Marginal Cost Total Fixed Cost 615 240 ---------855 --------20 20 ---------1162 ---------830 332 --------1162 --------

Total Cost Sheet Product Units Marginal cost Fixed Cost A 3 Lakhs 1,845 720 ---------Total cost 2,565 ---------B 5 Lakhs 4,150 1,660 ----------5,810 ----------Total -5,995 2,380 -----------8,375 -----------

Capital Employed Rs. Fixed Capital Employed Working Capital (8,375 x 6 / 12) -------------6,687.50 ------------2500.00 4,187.50

Total Return @ 20% on the above

1,337.00 =========

Sales Value & contribution Total Cost Expected Return on Capital Employed Sales Less Marginal Cost 8,375.00 1337.00 9,712.50 5,995.00 -----------Contribution 3717.50 ------------

Total Labour Hours Product A 3 x 15 = 45 Lakh B 5 x 21 = 105 -------------150 Lakhs -----------------

Contribution per Labour Hour

Rs. 3717.50

Hrs. 150 = Rs. 24.78 = 25 /- Hour

(a) Price Fixation

Selling

Product

A Rs. / Unit

B Rs. / Unit 830

Marginal cost + Contribution (A Rs. 25 x 15 Hrs) (B Rs. 25 x 21 Hrs) Selling Price

615

375 990

525 1,355

(b) Statement of profitability

Rs. (Lakhs) Product Sales Less Variable Cost Contribution Less: Fixed Cost Less: interest on Working Capital Loan (18% on 50% of working Capital) Profit (376.875) 993.125 A 2,970 (1,845) 1,125 B 6,775 (4,150) 2,625 Total 9,745 (5,995) 3,750 (2,380)

___________ Question 5.

A processing company uses Standard Process Costing method. The Standard Process Cost Card is as follows :

Rs. Per Kg. Of Finished Product Direct Material-2 kgs. @ Rs.10 per kg Direct Labour-3 hrs. @ Rs.20 per hrs. Fixed Overheads (Recovered on labour hours) Total Budgeted output for the period is 1,000 kgs. Actual production and cost data for the period are as follows : Actual production Direct material Direct labour Fixed overheads Stocks: Opening W.I.P. 250 Kgs. Degree of completion Material 100%, Labour and overheads 60%. Closing W.I.P. 450 Kgs., Degree of completion Material 100%, Labour and over heads 20%. Finished stock 1200 Kgs. The company uses FIFO Method for evaluation of stocks. 950gs. 2900 kgs. 3300 kgs. At Rs.32,000 At Rs.68,000 Rs.1,00,000 20 60 90 170

Required:

(a) Computation of Cost variances in as much detail as possible and Process Cost Reconciliation Statement (b) Standard Process Account, showing the detailed variance analysis.

Answer to Q. No. 5. Statement Equivalent Production (Units) Degree of Output Completed Stock From Opg W.I.P. 250 -Nil 40% ---100 -100 Units Completion Material Labour Overheads

(Balance work to be done) Current Production Clg. W.I.P (To the extent of work Completed) -20% ---------Total 1,400 --------90 --------1,140 --------90 ---------1,140 ---------950 450 100% 100% 950 450 950 -950 --

Valuation of Opg. & Clg. W.I.P. (at standard cost)

Rate / Unit Material Labour Overheads Total Rs. 20 Rs. 60 Rs. 90

Opg. WIP (250 x 20) 5,000 (150 x 60) 9,000 (150 x 90) 13,500 Rs. 27,500

Clg. WIP (450 x 20) 9,000 (90 x 60) 5,400 (90 x 90) 8,100 Rs. 22,500

Material Cost Variance Analysis

Standard Qty. for actual output (11,400 x 2 kgs) = 2,800 kgs Actual Qty. Standard Cost rate Actual Cost 2,900 kgs Rs. 10 / kg Rs. 32,000

Material Price Variance

(Standard Price Actual Price) (29,000 32,000)

Actual Qty = 3,000

Material Usage Variance (Standard Qty. Actual Qty) (28,000 29,000) Material cost Variance Standard Price = 1,000 A = 3,000 A + 1,000 A = 4,000 A

Labour Cost Variance Analysis

Standard Hours For actual output (1,140 x 3) 3,420

Std. Wage Rate / Hour Rs. 20

Actual Hours 3,300

Actual Wage Cost Rs. 68,000

Labour rate Variance (Standard rate Actual Rate) (66,000 68,000) Actual Hours = 2,000 (A)

Labour time / Efficiency Variance

Standard Hours Actual Hours) (3,420 3,300) 20

Standard Rate = 2,400 F

Labour Cost Variance 2000 A + 2,400 F = 400 F

Fixed Overheads cost variance Budget Units Hours Cost 1,000 3,000 Rs. 90,000 Actual 1,140 3,300 Rs. 88,000

Budgeted Rate / Unit Rate / Hour Production Time ---Rs. 90 Rs. 30 3 Hours / Unit

Expenditure / Budget Variance (Budgeted Exp. Actual Exp.) 2,000 F

Volume Variance (Actual Budgeted Units) Budgeted Rate / Units (300 x 30) = 12,600 F

Capital Variance (Actual Hrs Budgeted Hrs) Budgeted Rate / Hours (300 x30) = 9,000 F

Efficiency Variance Standard Hours for Actual Productions Less Actual hours Budgeted Rate / Hr. (120 x 30) = 3,600 F

Standard Cost of Actual output Rs. Material Labour Overheads (1,400 x 20) (1,140 x 60) (1,140 x 90) 28,000 68,400 1,02,600 ------------Total 1,99,000 ________

Actual Cost Material Labour Overheads 32,000 68,000 88,000 ------------1,88,000 -------------

Rs.

Cost Reconciliation Statement Standard cost of actual output Variances + Direct material Cost

Rs. 1,99,000

Price Variance Usage Variance

3,000 A 1,000 A 4,000 A

Direct Labour Cost Variance Expenditure Variance 2,000 F

Volume Variance Capacity Variance Efficiency Variance 9,000 F 3,600 F 14,600 F -------------Actual Cost 1,88,000 -------------

Standard Process Account

To Opg. WIP Direct Material Actual Price Variance Usage Variance 1,32,000 3,000 A 1,000 A

27,500

By Finished Stock By Clg. WIP

2,04,000 22,500

28,000

Direct Labour Actual Rate Variance 68,000 2,000 A

Efficiency Variance 2,400 F 68,400 Fixed Overheads Actual Expenditure Variance 2,000 F 88,000

Capacity Variance 9,000 F Efficiency Variance 9,600 F 1,02,600 2,26,500 _______ 2,26,500

______________ Question 6.

ABC Ltd. is in the process of undertaking a contract which is represented below :

10

The numbers given are the normal expected completion time in days of the activities. Each separate activity costs Rs.200 per day and there is further charge of Rs.500 for everyday the project is in progress.

You are required to

(i) Compute the earliest expected starting time and the earliest expected finishing time for each activity. (ii) Indicate the critical path and the total cost.

(iii) Calculate the optimum plan for the project if the time of activities (b), (c) and (d) can be progressively reduced to one day at an extra cost as under :

Activity

Extra cost per day saved Rs.

.b .c .d

125 150 300

Answer to Q. No. 6.

Event

Time of activity Proceeding the event (days)

Earliest Starting Time (days) 0 10 16 0 0 4

Earliest Finishing Time (days) 0 + 10 = 10 10 + 10 = 10 16 + 4 = 20 0+6=6 0+4=4 4+4=8

d e f c b a

10 6 4 6 4 4 ----34

Critical path = 10 + 6 + 4 = 20 days

(b) Total cost of the Project: (i) 34 activities x Rs. 200 = Rs. 6,800 (ii) 20 days x Rs. 500 = Rs. 10,000

Rs. 16,800

(c) Effect on cost due to saving of time:-

Saving

Saving

Effect on Cost Extra Cost

Net Saving

1 day of d 1 day of c + d

Rs. 500 Rs. 500

- Rs. 300 - (Rs. 300 + Rs. 160)

= Rs. 200 = Rs. 50

1 day of b=c + d Rs. 500

- (Rs. 300 + Rs. 150 + Rs. 125) = (Rs. 75) Loss

Completion days

saving in days Activity

saving in Cost Rs. 200 400 600 800

Total Cost Rs. 16,800 200 = 16,600 16,800 400 = 16,400 16,800 600 = 16,200 16,800 800 = 16,000

19 18 17 16 15

1 day d 2 days d 3 days d 4 days cd 4 days of d and 1 day of d & c

850

16,800 850 = 15,950

14

4 days of d and 2 days of d & c 900 16,800 900 = 15,900

13

4 days of d and 3 days of d & c 950 16,800 950 = 15,850

12

4 days of d and 4 days of d & c 1,000 16,800 1,000 = 15,800

11

4 days of d + 4 days of d & c and 1day of d+c+b 925 16,800 925 = 15,875

(From this stage the Total Cost goes up so no further working is necessary) Therefore, the optimum plan will be 12 days as under: a = 4 days b = 4 days c = 4 days (6 4) d = 2 days (10 8) e = 6 days f = 4 days

This would entail a cost of Rs. 15,800/-

Question 7.

The operating results of AB Ltd. for the last three years were as under :

1992-93 Rs. lakh

1993-94 Rs. lakh

1994-95 Rs. lakh

Sales Material Consumed Wages Factory Expenses Administrative Expenses Selling Expenses Interest

50.00 20.00 20.00 6.00 2.50 0.50 -49.00.

63.00 26.40 24.00 7.00 3.20 2.00 0.60 63.20

69.30 30.36 28.80 7.50 3.50 2.50 1.00 73.66

Profit/(Loss)

1.00

(0.20)

(4.36)

The following index numbers have been worked out and are applicable to the whole of the year concerned:

1992-93 Sales Price Price of Raw Material Wages 100 100 100

1993-94 105 110 120

1994-95 105 120 144

You are required to analysis the figures and work out the efficiency at constant price. Offer your comments.

Answer to Q. No. 7

Statement showing efficiency in operation at constant prices:-

1992 93 Rs. lakhs Sales Material Wages Factory Exp. Adminst. Exp. Selling Exp. 50.00 20.00 20.00 6.00 2.50 0.50 --------49.00 Profit 1.00 ----------50.00

1993 94 Rs. lakhs

1994 95 Rs.- lakhs

100% 40% 40% 12% 5% 1% --------98% 2% --------100%

60.00 24.00 20.00 7.00 3.50 2.00 ----------56.20 3.80% -----------60.00

100% 40% 33.33% 11.67% 5.33% 3.33% --------93.66% 6.34% --------100%

60.00 25.30 20.00 7.50 3.50 2.50 --------58.80 7.20 --------66.00

100% 38.33% 30.30% 11.38% 5.30% 3.79% -----------89.10% 10.90% ---------100%

----------

---------

------------- -----------

---------

-------------

Working Notes: 1994 & 1995 figures at 1993 prices

1993 94 100 Sales 63 x ---------- = 60 105

1994 95 100 6,930 x ------- = 66 105

100 Material 26.40 x ------- = 24 110 100 Wages 24 x ------- = 20 120

100 30.36 x -------- = 25.30 120 100 2,880 x ------- = 20 144

Statement showing effect of price changes

(Rs. Lakh) 1993 94 1. Increase in selling Price 2. (a) Increase in material costs 3. (b) Increase in labour cost 3.00 2.40 4.00 ----------Total 6.40 ---------1994 95 3.30 2.06 8.80 ------------13.86 ------------

3. Loss duet to increase in cost 4. interest (extra payment) 5. Total Loss 6. Profit as per Statement (a) above 7. Loss as reported

3.40 0.60 4.00 3.80 0.20

10.56 1.00 11.56 7.20 4.36

Comment: It can be seen that although the overall cost has risen there has been no increase in selling price commensurate to cost increase. To effect the cost increase the selling price need to have enhanced by:-

1993 94 % Material (40 x 100% & 40 x 120%) Labour (40 x 120% & 40 x 144%) Factory Expenses Administrative Expenses Selling expenses 44.00 46.00 12.00 5.00 1.00 --------110.00 --------Profit (at 2% of selling price)

1994 95 % 48.00 57.60 12.00 5.00 1.00 ----------123.60 -----------

2.24 (2 / 98 x 100) 2.52(2 / 98 x 123.60) --------112.24 ------------------126.12 ----------26.12%

Increase in selling price

12.24%

___________

Question 8.

Discuss about the various approaches in setting transfer prices. Now there is no problem. 18

Answer to Q. No. 8

Transfer pricing

In decentralised organisations very often goods and services which are the outputs of one division would be transferred to another division as inputs. It may be (i) from one plant or factory to another under the same company or (ii) from one division or sector of a plant to another division. In such cases, there is a need to set price for the goods or services sold / transferred. Such a price which applies solely to sales between divisions within an organisation is called Transfer Price.

As explained Transfer Price becomes cost to the Unit receiving the goods / services and revenue to the unit providing the goods / services. It is, therefore, obvious that the profitability of the two units involved would be dependent upon the Transfer Price.

The approaches to setting transfer price are:-

(a) Market based transfer pricing (b) Cost based transfer pricing (c) Negotiated transfer pricing

Market based transfer pricing

Market based transfer prices could be applied in a perfectly competitive market for the product or service, when there is very little differentiation in the product and the market prices are readily available. This is the rational method which is based on the principles of opportunity cost. The consignee receives the product at the price which it would have paid if purchased from outside. For the consignor, Market price represents the earning, which it has lost by the transfer.

This method has the advantage as consignor gets the market value and if it can operate at optimum efficiency it would show reasonable result. On the other hand, the consignee is not required to pay anything extra. This is also a simple method as far as determining the transfer price is concerned.

However, in case, the market price is not easily available and the market price fluctuates very frequently this system of transfer pricing becomes difficult to apply. Moreover, in some case while fixing transfer price based on market price it might be necessary to delete the elements of post manufacturing costs of selling and distribution like commission, advertising etc. Sometimes , it might so happen that an outside firm may quote a lower rate to start with in order to take an entry and this would vitiate the market price.

Cost based transfer pricing

Under this method transfers are priced at full absorption cost which may be actual cost or standard cost. In the latter case, unfavorable variances arising out of inefficiencies are not transferred to the consignee but remain charged to the consignor.

Cost based transfer pricing used when (a) Market price is not available as in case of semi finished / specialised product. (b) Difficulty in determining the market price. (c) Product manufactured is of secret nature.

The transfer can also be made at variable costs. As fixed costs do not come into the picture, this method is very useful for making short term decisions.

The problems with setting variable cost as the transfer prices are -- The setting division will earn no profit and will not have any incentive for the transfer

-- If marginal cost is not the same over the range of outputs, the setting divisions will have to prepare a schedule of marginal cost as transfer price to the buying division. This becomes even more complicated if there are more than one buyer and the output is determined by the joint demands of all buyer.

-- There may be difficulty to ascertain and apply marginal cost in situation of full capacity utilisation and the tendency to overstate the marginal cost by the setting division.

Negotiated Transfer Pricing

BY negotiated settlement of transfer pricing there will be no post disputes as the Managers of both divisions would freely discuss all relevant points before arriving at a Negotiated Price. However, if the negotiated ability of the Managers of the respective Managers differ widely then there may be difficulty later.

___________