Management Control

System
S4, MBA
GIMS

UNIT III

Syllabus Topics To Cover

Transfer Pricing (Market based and

Cost Based) - Related numerical
problems
Return on Investment, Economic
Value Added
Capital Budgeting and Ratio Analysis
as a tool to management
performance measurement

Transfer Pricing
Definition
A transfer price is defined as the price that is
assumed to have been charged by one
department of a company for products and
services it provides to another department of the
same company, in order to calculate each
departments profit and loss separately.

A transfer price is the price one

subunit charges for a product or
service supplied to another subunit of
the same organization.
Transfer price is a value at which
goods and Services are Transferred
between divisions in a decentralized
organizations .
Intermediate products are the
products transferred between
subunits of an organization.

Concept
TP is aimed at simulating the
external market conditions within
the company so that the managers
get motivated and try to perform
well.
TP does not have any direct impact
on the organizations Profits as a
whole (because its effect on one
departments revenue is exactly

Objectives of TP
To distribute properly, the revenue between
profit centres when they are responsible jointly
for product development and marketing.
To provide relevant information to the profit
centres regarding the trade off between costs
and revenues of the company.
To induce goal congruent decisions to improve
the profits of the department and the whole
company also.
To measure the economic performance of profit
centres.

Fundamental Principle
The transfer price should be similar to
the price which would be charged if
products were sold to outside
customers or purchased from outside
vendors.
Two decisions must be made
periodically
I. Sourcing Decision
II. Transfer Price Decision

Goal congruence

There should be goal congruence between

profit centres and parent organization.
The pre requisites for achieving goal
congruence are as follows: or

IDEAL SITUATION
a. Competent people
b. Good organizational atmosphere
c. Details of market price.
d. Freedom to source
e. Availability of information
f. Scope of negotiation.

Constraints on sourcing in TP
Sometimes, it becomes difficult to find an
ideal situation for the operation of a
transfer pricing mechanism.
Due to corporate policy being exercised
in the company, the profit centre
managers may not have enough freedom
to make a sourcing decision.
Following are the general constraints
i. Limited Markets
ii. Excess or shortage of industry capacity.
iii. Sourcing constraints

1. Limited Markets
Reasons for limited Markets
In many companies the exercise of excess
internal capacity forces the buying department
not to go for outside purchase.
In highly integrated companies, there tends to
be a little independent production capacity for
the intermediate products
If the company is a sole producer of a product,
outside capacity does not exist.
If a company makes a significant investment in
facilities, then it cannot buy the goods from
outside sources through the outside capacity
exists

2. Excess or shortage of Industry capacity

i. In situation of excess capacity in the

industry , the selling department does
not sell in the outside market, where as
the buying department may buy from
outside vendors , though inside capacity
is available in the company.
ii. The situation is reversed in time of
shortage of industry capacity
However, in either situation, the company
as a whole may not optimise its profits

3. Sourcing constraints
A company may allow its buying
department to buy goods from market if
the department gets a better deal in
terms of Quality, Price and service.
A selling department may be allowed to
sell its products in the open market if it
gets a better profit there.
Therefore, the management should take
appropriate decisions to optimise the
companys profit

USEFULNESS OF TP
a. To identify unit contribution to the total
profit
b. To encourage profit consciousness
c. To measure management performance
d. To maximise operating unit profitability
e. To locate profits to minimise tax
f. To facilitate decentralised decision making
g. To motivate divisional managers, towards
goal congruence
h. To serve as a tool for control

Disadvantages of TP
a. Unit managers tend to prefer
divisional profits over corporate
b. Lengthy disagreements on prices
c. Extra administrative costs
d. Need for conventions, if no market
prices are available
e. Arguments over disposition of
variances
f. Prices to minimise tax liabilities
g. Task of eliminating book profits
arising from interdivisional profits

Approaches to TP
1.Market Based TP
If a good external market exists for the
transferred product or service, then
market prices are the most appropriate
basis for pricing.
Unfortunately, these markets with welldefined prices seldom exist

Advantages
a. Divisional managers are assured of
independence in respect of sourcing
decisions.
b. Market prices represent true
opportunity costs
c. MP provide incentive for efficient
production because excessive cost
cannot be passed on to the buyers.

Disadvantages

a. It can be applied only to fairly standard

products under stable market conditions
b. It breaks down when there is excess capacity
c. Low initial prices are often quoted to get a
foothold in the market
d. There are problems of quality differential's
between outsiders products and the
companys own standards

2.

Cost Based TP

Two decisions must be made

How to define cost?
How to calculate Profit Mark-up?

 The concept of cost is subject to varied

interpretations.

Various alternatives are

Variable cost, direct cost, Full cost, Full cost plus
profit.etc

MaterialPurchase costs vary from consignment to consignment

Control price Vs Market Prices
FIFO LIFO average or derived from specific
consignment.

Labour
Level of activity adopted
Efficiency Variables
Abnormal items

Overhead Basis of OvH allocations

3. Negotiated TP
In theory, a TP is based on negotiations
between buying and selling divisions
would be more acceptable.
This presupposes that the divisional
managers and those who are involved in
determining TPs have adequate
information and market situation and
product costs. This will enable them to
arrive at TPs which are fair to both
parties
In practice , negotiations do not always
result in harmonious relations

4.Dual pricing Method

Under this method, the supplying
department charges a higher TP,
whereas the buying department gets
the goods at a lower price / cost price.

General principle
Minimum TP = Incremental Cost p.u (+)
Opportunity cost p.u

In the absence of a market for intermediate

products or in the case of availability of idle
capacity of the supplying department,
opportunity cost may be taken as zero.
In such situation
Minimum TP may be taken as Incremental or
Marginal Cost

Transfer Pricing problems in the public sector

Recently, public sector industries are also

charged with the task of earning adequate
return on capital.
Problems peculiar to the public sector
i. Social objectives Vs Profit Objectives.
ii. Divisional managers do not have full
control over his resources
iii. Large turn over of divisional managers.

Example 1

V Company fixes the inter divisional TP for its

products on the basis of cost plus a return on
investment in the division. The budget for division A
for 2004-05 appears as under:

Investment in division A:
Fixed Assets 5,00,000
Current Assets 3,00,000
Debtors 2,00,000
Annual Fixed cost of the division 8,00,000
Variable cost per unit of product 10
Budgeted Volume - 4,00,000units per year
Desired ROI - 28%
Determine the transfer price for Division A

 Investment in Division A :
RS

Fixed Assets, current Assets & Debtors

Desired Return on Investment (ROI)
28% on 10,00,000
2,80,000

10,00,000

Variable Cost (4,00,000*10)

40,00,000
Annual Fixed Cost of the Div A
8,00,000
48,00,000
Add Return on investment
2,80,000
50,80,000
Inter divisional TP = 50,80,000 = Rs. 12.70Per Unit
40,00,000

Example NO. 2
Transferor Ltd have two process preparing
and finishing. The normal output per week is
7500units (Completed) at a capacity of 75%
Transferee Ltd. Had production problems in
preparing and require 2000units per week of
prepared material for their finishing process
The existing cost structure of one prepared
unit of transferor Ltd at existing capacity :
Material Rs. 2 (Variable 100%)
Labour Rs.2 (Variable 50%)
OVH RSRs 4 (Variable 25%)

 The sales price of a completed units of

Transferor Ltd is Rs 16 with a profit of Rs.
4 Per Unit
Contrast the effect on the profits of
transferor Ltd. For six months (25weeks)
of supplying units of Transferee Ltd., with
the following alternative TPs per unit

a. Marginal cost
b. Marginal cost +25%
c. MC+15% Return on capital (assume
capital employed Rs. 20Lakh)
d. Existing cost
e. Existing cost + a portion of profit on the
basis of
Preparing Cost * Unit Profit
Total cost
f. At an agreed market price of Rs 8.50
Assume no increase in fixed cost.

Existing profits of Transferor Ltd based on

75% capacity are
RS
Sales price per unit
16
Profit per unit
4
Profit per week = 4*7500
30,000
Profit for 6months (25weeks) 7,50,000
(30,000*25=7,50,000)

a. Marginal Cost (P.U)

Rs
Material
2
Labour
1
Overhead
1
Transfer Price
4
since no additional fixed costs are incurred then the
cost of the additional output is the VC

b. Marginal cost + 25%

Rs

Marginal cost per unit

4
Profit @25%
1
TP
5
Profit per week Rs 1 *2000units = 2000
Profit for six months 2,000*25weeks = 50,000

c. Marginal cost + 15% Return on

capital
Capital employed Rs 20 Lakhs
Return
15% per annum
Profit = 15*6*20,00,000 = 1,50,000
100*12
d. Existing Cost
Rs
Marginal cost per unit
4
Profit
4
Transfer Price
8
Profit per week (2000*4)
8,000
Profit for six months (25 weeks)

e. Existing cost + a portion of profits on the

basis of
Preparing Cost *Profit
Total cost
Rs
Marginal cost per unit
4
TP 8+(8/12*4)
10.66
Profit
6.6
Profit per week
13,200
Profit for 6months (25weeks)3,30,000

At an agreed Market Price of Rs 8.50

Marginal cost per Unit Rs. 4
Transfer Price Rs. 8.50
Profit Rs. 4.5
Profit per week 9000
Profit for 6months 2,25,000
In this problem the additional profit in the 6months
25weeks can vary from nil for the marginal cost
transfer pricing policy to 3,30,000for the existing
standard cost a portion of profit
The choice of a transfer pricing systems should be
fair and equitable to both transferor and transferee
divisions

Problem No. 3
A manufacturing company has two
divisions X and Y. The output of X, which
may be sold in the market at Rs. 300 per
unit, is also used as a component by Y for
manufacturing a product.
Y requires one unit of the component from
X for producing every one unit of the final
products which is sold in the market at Rs.
500per unit.
The budgeted production for X and Y are
3,000 and 1,000 units respectively. The
cost data for the budgeted level of

Materials P.U
Wages P.U
Variable OVH
P.U
Fixed OVH P.U

Div. X (RS.)

Div. Y
(RS.)

100
60
40

?
50
30

50

40

Show the divisional profits and the profits of the

company in case of the following TP Policies:
i. Market Price Method
ii. 110% of full cost Method, and
iii. Negotiated price of Rs. 290 per unit.

Market price based TP Method

Statement showing the divisional profits and the
profits
ofDivision
the company
Division
X
Y (RS.)
Compan
(RS.)
y
Sales
9,00,000
5,00,000 14,00,00
(3000*Rs 300)
(1,000*Rs300)
0
Less
6,00,000 Transfer in costs
costs
(3000*Rs 300) (1,000*Rs.
Variab
300)3,00,000 +
le
Other V.C
Costs
9,80,000
(1,000*80)
80,000
3,80,000
FC

1,50,000
(3,000*Rs50)

40,000 1,90,000
(1,000*40)