Numericals:
The company also has a Glass Bottles Division, which needs 10,000 tons of molten glass per annum in order to manufacture its bottles. At present, however, the Glass Bottles Division buys all of its molten glass from an external supplier at a price of Rs. 105 per Ton.
Determine the transfer Price in the following 4 scenarios
Scenario 1: No spare capacity in the Molten Glass Division
Scenario 2: Spare capacity in the Molten Glass Division
and there is no demand from external customers for these potential additional tons.
Scenario 3: LIMITED Spare capacity in the Molten Glass Division
Suppose, for example, that the maximum production capacity of the Molten Glass Division is 45,000 tons per annum. Since there is demand from external customers for 40,000 tons, this means that spare capacity is just 5,000 tons.
Remember that the Glass Bottles Division needs 10,000 tons per annum
Scenario 4:Assume that the Tr Price is based on the Full Cost method
Solution:
Scenario 1: No spare capacity in the Molten Glass Division
If any tons of molten glass are sold to the Glass Bottles Division, then there will have to be a corresponding reduction in the quantity sold to external customers. Applying the commonly used principle, the Molten Glass Division will want to set the transfer price as follows:
`
Scenario 2: Spare capacity in the Molten Glass Division
And there is no demand from external customers for these potential additional tons.
This means that it is now possible to produce some extra molten glass for sale to the Glass Bottles Division without any reduction in the quantity sold to external customers.
In other words, where spare capacity exists, there is no opportunity cost associated with making the transfer.
And there is no demand from external customers for these potential additional tons.
This means that it is now possible to produce some extra molten glass for sale to the Glass Bottles Division without any reduction in the quantity sold to external customers.
In other words, where spare capacity exists, there is no opportunity cost associated with making the transfer.
In line with the principle of divisional autonomy, it is appropriate to leave it to the two division managers to negotiate the precise transfer price within the range between 65 & 105
Scenario 3: LIMITED Spare capacity in the Molten Glass Division
Only half of BD's needs(5,000 tons) can be produced using spare capacity, and these transferred tons should be priced in accordance with Scenario 2 .
As regards units which could not be produced using spare capacity, but would instead reduce the number of units available for sale to external customers, in accordance with the logic of Scenario 1, the transfer price should be €120 (the price charged to external customers whom these transfers would displace).
Scenario 4: Assume that the transfer Price is based on the Full Cost Merthod
Full Cost is calculated as follows:
Marginal cost per ton
(= variable cost ton)
|
Fixed cost per ton
|
Full cost per ton
|
Rs.65
|
Rs.18
(Rs720,000 / 40,000 tons)
|
Rs.83
(Rs.65 + Rs.18)
|
If we consider Scenario 1, it is clear that the full cost transfer price (€83 per ton) would be too low where no spare capacity exists. However, in Scenario 2 (where spare capacity exists) it is clear that the full cost transfer price of €83 per ton would lead to optimal decision-making in these circumstances (and, in fact, would split the incremental profit reasonably equitably between the two divisions).
Numerical 2
Required 1:
If Division could sell 125000 units @ Rs 100 each in the open market----
What Transfer Price the central Management would prefer in order to provide proper motivation to y Division ?
Required 2:
As Management Accountant would you advice Division Y to Buy the product at the Transfer Price determined in 1 above ?
Required 3:
If Sales of Division Y's product drops to Rs. 200, whether the TP of 98 will be acceptable ?
Required 4:
Assume that Division X 's product did not have an outside demand in excess of one lakh units and its total Fixed Manufacturing Costs could be reduced by 10 %, if the Volume of the Production were reduced to 100,000 units, What is the appropriate Transfer Price ?
Required 5:
Suppose that X division 's maximum outside demand is 1,10,000 units at Rs. 100 and there is no usage for the capacity .
What Transfer Price should the Company Management prefer?
What Transfer Price should the Company Management prefer?
Solution:
Required 1:
If Division could sell 125000 units @ Rs 100 each in the open market----
Soln:
Variable cost of Production 84
Plus Contribution Lost
Selling Price 100
Variable costs: 84
Production Costs
Selling Costs 2 86 14
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Minimum TP= 98
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Required 2:
As Management Accountant would you advice Division Y to Buy the product at the Transfer Price determined in 1 above ?
Soln:
Yes, obviously the Contribution earned by Division Y would be more if the Internal Transfer price is lesser than the external purchase price.
Required 3:
If Sales of Division Y's product drops to Rs. 200, whether the TP of 98 will be acceptable ?
Soln:
Approach:
Examine Perspective of Y Division
Examine Perspective of Firm
1 Whether to Transfer to Y ?
2 Whether to sell the produce of X externally ?
Perspective of Division Y
Y Purchaes from X at TP 98
Contribution
Selling Price 200
Variable costs:
Production Costs 100
Bought Out Item 98
Selling Costs 6 204
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Contribution (4.00)
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The Contribution is Negative . Division Y will be de-motivated
Perspective of the Firm:
The Contribution earned by the firm when it sells the product of X externally is more than when it is transferred to Y and the final product is sold by Y. If the firm is not strategically affected by this decision, it would be better to sell product of X externally, at least in the short term, till the time, the price of the product of Division Y is sufficiently revived.
Required 4:
Assume that Division X 's product did not have an outside demand in excess of one lakh units and its total Fixed Manufacturing Costs could be reduced by 10 %, if the Volume of the production were reduced to 100,000 units, What is the appropriate Transfer Price ?
Soln:
Required 5:
Suppose that X division 's maximum outside demand is 1,10,000 units at Rs. 100 and there is no usage for the capacity . What Transfer Price should the Company Management prefer ?
Soln:
For 10,000 units Rs 98
For 15000 units with Nil Opportunity Costs, the minimum Transfer Price will be Rs.84. The actual Transfer price, however, will be settled by negotiation, at a level above this minimum.
Return on Investment:
Q.1) A)Explain the concept of ROI. What are its advantages?
Return on investment (ROI) is the ratio of profit before tax to the gross investment.
ROI is calculated with the help of the following formula:
ROI = (Pre-Tax Profit/Sales) X (Sales/Net Assets) or (Pre-Tax Profits/Net Assets)
The numerator is profit before tax as reported in the P&L account. The profit should include only the profits arising out of the normal activities of the division. Unusual items of receipts and expenses should be excluded from the profit figure. One should also ignore windfalls and income from investments not related to the operations of the division. Tax is excluded from the numerator because the marginal of the SBU is not responsible for or in control of the tax paid.
Capital employed can be ascertained from the balance sheet by including fixed and current assets. Assets not currently put to divisional use should be excluded from the investment base. One also needs to exclude their relative earnings if any. The company should also exclude intangible assets like goodwill, deferred revenue expenses, preliminary expenses, etc.
ROI can be improved by:
Increasing the profit margin on sales.
Increasing the capital turnover
Increasing both profit margin and capital turnover.
Reducing cost as that adds to the total earnings of the firm.
Increasing the profits by expanding present operations or developing new product line, increasing market share, etc.
Diversifying, introducing productivity improvement measures, expansion, replacement of old equipments
Advantages of ROI
ROI relates return to the level of investment and not sales as the rate of return is more realistic.
ROI can be decomposed into other variables as shown. These variables have tremendous analytical value.
ROI is an effective tool for inter-firm comparison.
Question 1 (b):
Many experts regard EVA as a concept superior to ROI and yet in certain cases, EVA does not do justice to the evaluation of investment center. Explain this phenomenon with as illustration.
EVA does not solve all the problems of measuring profitability in an investment center. In particular, it does not solve the problem of accounting for fixed assets discussed above unless annuity depreciation is also used, and this is rarely done in practice. If gross book value is used, a business unit can increase its EVA by taking actions contrary to the interests of the company, as shown in Exhibit 7-3. If net book value is used, EVA will increase simply due to the passage of time. Furthermore, EVA will be temporarily depressed by new investments because of the high net book value in the early years. EVA does solve the problem created by differing profit potentials. All business units, regardless of profitability, will be motivated to increase investments if the rate of return from a potential investment exceeds the required rate prescribed by the measurement system.
Moreover, some assets may be undervalued when they are capitalized, and others when they are expensed. Although the purchase cost of fixed assets is ordinarily capitalized, a substantial amount of investment in start-up costs, new product development, dealer organization, and so forth may be written off as expenses, and, therefore, not appear in the investment base. This situation applies especially in marketing units. In these units the investment amount may be limited to inventories, receivables, and office furniture and equipment. When a group of units with varying degrees of marketing responsibility are ranked, the unit with the relatively larger marketing operations will tend to have the highest EVA.
In view of all these problems, some companies have decided to exclude fixed assets from the investment base. These companies make an interest charge for controllable assets only, and they control fixed assets by separate devices. Controllable assets are, essentially, receivables and inventory. Business unit management can make day-to-day decisions that affect the level of these assets. If these decisions are wrong, serious consequences can occur-quickly. For example, if inventories are too high, unnecessary capital is tied up, and the risk of obsolescence is increased; whereas, if inventories are too low, production interruptions or lost customer business can result from the stockouts. To focus attention on these important controllable items, some companies, such as Quaker Oats, 17 include a capital charge for the items as an element of cost in the business unit income statement. This acts both to motivate business unit management properly and also to measure the real cost of resources committed to these items.
Investments in fixed assets are controlled by the capital budgeting process before the fact and by post completion audits to determine whether the anticipated cash flows, in fact, materialized. This is far from being completely satisfactory because actual savings or revenues from a fixed asset acquisition may not be identifiable. For example, if a new machine produces a variety of products, the cost accounting system usually will not identify the savings attributable to each product.
The argument for evaluating profits and capital investments separately is that this often is consistent with what senior management wants the business unit manager to accomplish; namely, to obtain the maximum long-run cash flow from the capital investments the business unit manager controls and to add capital investments only when they will provide a net return in excess of the company's cost of funding that investment. Investment decisions, then, are controlled at the point where these decisions are made. Consequently, the capital investment analysis procedure is of primary importance in investment control. Once the investment has been made, it is largely a sunk cost and should not influence future decisions. Nevertheless, management wants to know when capital investment decisions have been made incorrectly, not only because some action may be appropriate with respect to the person responsible for the mistakes but also because safeguards to prevent a recurrence may be appropriate.
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