PM – Nov 2014 – L2 – Q1 – Divisional Performance Measurement

Analyze transfer pricing impact on divisional performance and group profitability with tax implications for cross-border divisions.

Question

Naijax Group Limited has been in operation since 1980, playing a leading role in the automobile industry.

Division “X,” which is part of the group, manufactures only “265 by 16’’ Rim tyre, which it sells to external customers and also to Division “Y,” another member of the group. Naijax Group’s policy is that:

Divisions have the freedom to set transfer prices and choose their suppliers.
It uses Residual Income (RI) for performance appraisals.
The group’s cost of capital is 12% per annum.

The two divisions’ operating data are as follows:

Division X
Budgeted information for the coming year:
Maximum capacity	150,000 tyres
External sales	110,000 tyres
External selling price	N35,000 per tyre
Variable cost	N22,000 per tyre
Fixed costs	N1,080,000,000
Capital employed	N3,200,000,000
Target residual income	N180,000,000

Division Y has found two other companies willing to supply tyres:

Adex Limited could supply at N28,000 per tyre, but only for annual orders in excess of 50,000 tyres.
Banaxa Limited could supply at N33,000 per tyre for any quantity ordered.

Required:

(a) If Division Y provisionally requests a quotation for 60,000 tyres from Division X for the coming year:

i. Determine the transfer price per tyre that Division X should quote in order to meet its residual income target. (9 Marks)

ii. Calculate the TWO prices that Division X would have to quote to Division Y if it becomes the group’s policy to quote transfer prices based on opportunity costs. (2 Marks)

(b) Evaluate the impact of the group’s current and proposed policies on the profits of Divisions X and Y and on group profit. (4 Marks)

c. Assume that Divisions X and Y are based in different countries and consequently pay taxes at different rates: Division X at 55% and Division Y at 25%. If Division X has now quoted a transfer price of N30,000 per tyre for 60,000 tyres, you are required to determine whether it is better for the group if Division Y purchases
60,000 tyres from Division X or from Adex Limited. (15 Marks)

Answer

NAIJAX GROUP LIMITED

(a) Calculation of transfer price per tyre that Division X should quote in order to meet its residual income target:

(aii) Selling price to division Y on an opportunity cost basis:

40,000 tyres at N22,000 marginal cost and
20,000 tyres at N35,000 external selling price

(b) Because of the present policy of judging performance on the single measure of
profitability, there is the possibility of sub-optimality.

Y could purchase tyres at 28,000 from Adex Ltd instead of N29,900 from
company X, and if X cannot sell the 40,000 tyres externally, the group’s profit
would fall.

To optimise group profit, goods should be transferred at marginal cost but
divisional performance assessment becomes meaningless and motivation would
fall.

(c)(i) Buying from company X Strategy A