- 20 Marks
MA – L2 – Q54 – Transfer pricing
Question
Zora Shoes Ltd sells 5,000 pairs of shoes each month through its Production/Sales department. 25% of the shoes (by number) sold require repairs which are carried out by the company’s Repairs department. The Production/Sales department collects an additional GH¢5 for each pair of shoe requiring repairs as an anticipated repair charge when the shoes are sold to customers. The following additional information is available:
| GH¢ | |
|---|---|
| Material | 2.50 |
| Labour | 1.5 per Labour hour |
| Variable Overheads | 0.5 per Labour hour |
| Fixed Overheads | 1.15 per Labour hour |
Each repair takes 2 labour hours and the Repairs department processes 1,250 repairs each month (5,000 pairs × 25%). The Production/Sales department sells each pair of shoe for GH¢22.
Required:
(i) Calculate the individual profits of the Production/Sales department, Repairs department and Zora Ventures if repairs are done by the repairs department of Zora Ventures at either full cost plus 20% margin on sales or at marginal cost. (8 marks)
(ii) Lee Shoe Repairs has offered to repair each pair of shoe for Zora Ventures at GH¢10.00, a price which is cheaper than what the repairs department is offering. Should Zora Ventures accept this offer? (5 marks)
(iii) Identify THREE other factors Zora Ventures should consider in finalizing the decision in (ii) above? (3 marks)
(iv) Explain TWO principles of a good transfer pricing method.
Answer
Alternative Solution: Assuming the company collects the anticipated repair charge on all pairs of shoes upfront.
Full Cost plus 20% profit on sales
| Pdn/Sales Dept | Repairs Dept. | Zora Ventures | |
|---|---|---|---|
| GH¢ | GH¢ | GH¢ | |
| Sales | 110,000 | 27,500 | 110,000 |
| Cost | 27,500 | 22,000 | 22,000 |
| 82,500 | 5,500 | 88,000 |
Marginal Costing Method
| Pdn/Sales Dept | Repairs Dept. | Zora Ventures | |
|---|---|---|---|
| GH¢ | GH¢ | GH¢ | |
| Sales | 110,000 | 16,250 | 110,000 |
| Cost | 16,250 | 22,000 | 22,000 |
| 93,750 | (5,750) | 88,000 |
(ii) If Lee’s offer is accepted
| Pdn/Sales Dept | Repairs Dept. | Zora Ventures | |
|---|---|---|---|
| GH¢ | GH¢ | GH¢ | |
| Sales | 110,000 | 0 | 110,000 |
| Cost | 25,000 | 5,750 | 30,750 |
| 85,000 | (5,750) | 79,250 |
No, Zora Ventures should not accept Uncle Lee’s offer because the entire organisation would be worse off. Loss of overall profit would be GH¢8,750 (GH¢88,000 – GH¢79,250).
(iii) The following additional factors should be considered by Zora Ventures
- Lee Ventures’ ability to meet the quality standards of Zora Ventures
- Timely delivery of after-sales repair services
- Probable closure of the repairs department of Zora Ventures due to reduced numbers
- Uncertain customer response if they get to know that the repair works are outsourced
Principles of good transfer pricing method
- Goal Congruence: it should lead to optimal decision of the whole organisation and not just a section of it.
- It should lead to a sustained high level of management effort. Sellers should be motivated to keep cost down whilst buyers are motivated to acquire and use inputs efficiently.
- Subunit autonomy: If decentralisation is favoured in the organisation, then the transfer pricing method should support that.
- Topic: Transfer pricing
- Uploader: Salamat Hamid