- 20 Marks
MA – L2 – Q65 – Transfer Pricing
Question
Kumasi Construction Materials Ltd is organised into two trading divisions. Division A makes materials that are used to manufacture special bricks. It transfers some of these materials to Division B and sells some of the materials externally to other brick manufacturers. Division B makes special bricks from the materials and sells them to traders in building materials.
The production capacity of Division A is 2,000 tonnes per month. At present, sales are limited to 1,000 tonnes to external customers and 600 tonnes to Division B.
The transfer price was agreed at GH₵200 per tonne in line with the external sales trade price at 1st July which was the beginning of the budget year. From 1st December, however, strong competition in the market has reduced the market price for the materials to GH₵180 per tonne.
The manager of Division B is now saying that the transfer price for the materials from Division A should be the same as for external customers. The manager of Division A rejects this argument on the basis that the original budget established the transfer price for the entire financial year.
From each tonne of materials, Division B produces 1,000 bricks, which it sells at GH₵0.40 per brick. It would sell a further 400,000 bricks if the price were reduced to GH₵0.32 per brick.
Other data relevant are given below:
| Division A | Division B |
|---|---|
| GH₵ | GH₵ |
| Variable cost per tonne | 70 |
| Fixed cost per month | 100,000 |
The variable costs of Division B exclude the transfer price of materials from Division A.
Required:
(a) Prepare estimated profit statements for the month of December for each division and for Kumasi Construction Materials Ltd as a whole, based on transfer prices of GH₵200 per tonne and of GH₵180 per tonne, when producing at
(i) 80% capacity
(ii) 100% capacity, on the assumption that Division B reduces the selling price to GH₵0.32.
(b) Comment on the effect that might result from a change in the transfer price from GH₵200 to GH₵180.
(c) Suggest an alternative transfer price that would provide an incentive for Division B to reduce the selling price and increase sales by 400,000 bricks a month.
Answer
Profit Statements
(i) Operating at 80% capacity
Transfer price GH₵200
| Division A (GH₵) | Division B (GH₵) | Company (GH₵) | |
|---|---|---|---|
| Sales Revenue | |||
| External (1,000t × 180) | 180,000 | 180,000 | |
| External (600,000 bricks × 0.40) | 240,000 | 240,000 | |
| Transfers (600t × 200) | 120,000 | ||
| Total Revenue | 300,000 | 240,000 | 420,000 |
| Variable Costs | |||
| Production (1,600t × 70) | 112,000 | 112,000 | |
| Production (600t × 60) | 36,000 | 36,000 | |
| Transfers (600t × 200) | 120,000 | ||
| Total Variable Costs | 112,000 | 156,000 | 148,000 |
| Contribution | 188,000 | 84,000 | 272,000 |
| Fixed Costs | 100,000 | 100,000 | 200,000 |
| Profit | 88,000 | (16,000) | 72,000 |
Transfer price GH₵180
| Division A (GH₵) | Division B (GH₵) | Company (GH₵) | |
|---|---|---|---|
| Sales Revenue | |||
| External (1,000t × 180) | 180,000 | 180,000 | |
| External (600,000 bricks × 0.40) | 240,000 | 240,000 | |
| Transfers (600t × 180) | 108,000 | ||
| Total Revenue | 288,000 | 240,000 | 420,000 |
| Variable Costs | |||
| Production (1,600t × 70) | 112,000 | 112,000 | |
| Production (600t × 60) | 36,000 | 36,000 | |
| Transfers (600t × 180) | 108,000 | ||
| Total Variable Costs | 112,000 | 144,000 | 148,000 |
| Contribution | 176,000 | 96,000 | 272,000 |
| Fixed Costs | 100,000 | 100,000 | 200,000 |
| Profit | 76,000 | (4,000) | 72,000 |
(ii) Operating at 100% capacity (Division B selling price GH₵0.32)
Transfer price GH₵200
| Division A (GH₵) | Division B (GH₵) | Company (GH₵) | |
|---|---|---|---|
| Sales Revenue | |||
| External (1,000t × 180) | 180,000 | 180,000 | |
| External (1,000,000 bricks × 0.32) | 320,000 | 320,000 | |
| Transfers (1,000t × 200) | 200,000 | ||
| Total Revenue | 380,000 | 320,000 | 500,000 |
| Variable Costs | |||
| Production (2,000t × 70) | 140,000 | 140,000 | |
| Production (1,000t × 60) | 60,000 | 60,000 | |
| Transfers (1,000t × 200) | 200,000 | ||
| Total Variable Costs | 140,000 | 260,000 | 200,000 |
| Contribution | 240,000 | 60,000 | 300,000 |
| Fixed Costs | 100,000 | 100,000 | 200,000 |
| Profit | 140,000 | (40,000) | 100,000 |
Transfer price GH₵180
| Division A (GH₵) | Division B (GH₵) | Company (GH₵) | |
|---|---|---|---|
| Sales Revenue | |||
| External (1,000t × 180) | 180,000 | 180,000 | |
| External (1,000,000 bricks × 0.32) | 320,000 | 320,000 | |
| Transfers (1,000t × 180) | 180,000 | ||
| Total Revenue | 360,000 | 320,000 | 500,000 |
| Variable Costs | |||
| Production (2,000t × 70) | 140,000 | 140,000 | |
| Production (1,000t × 60) | 60,000 | 60,000 | |
| Transfers (1,000t × 180) | 180,000 | ||
| Total Variable Costs | 140,000 | 240,000 | 200,000 |
| Contribution | 220,000 | 80,000 | 300,000 |
| Fixed Costs | 100,000 | 100,000 | 200,000 |
| Profit | 120,000 | (20,000) | 100,000 |
(B)
The effect of a change in the transfer price from GH₵200 to GH₵180 will result in lower profit for Division A and higher profit for Division B, but the total profit for the company as a whole will be unaffected.
A reduction in the transfer price to GH₵180 (or possibly lower) is recommended, because this is the price at which Division B can buy the materials externally. At any price above GH₵180, Division B will want to buy externally, and this would not be in the interests of the company as a whole.
Significantly, at a transfer price of both GH₵200 and GH₵180, Division B would suffer a fall in its divisional profit if it reduced the selling price of bricks to GH₵0.32 and increased capacity by 400,000 bricks each month. A reduction in price would be in the best interests of the company as a whole, because total profit would rise from GH₵72,000 per month to GH₵100,000. (C)
Ignoring the transfer price, the effect on Division B of reducing the sale price of bricks to GH₵0.32 would be to increase external sales by GH₵80,000 and variable costs in Division B by GH₵24,000 (400 Tonnes × GH₵60). Cash flows would therefore improve by GH₵56,000 per month. To persuade Division B to take the extra 400 Tonnes, the transfer price should not exceed GH₵140 (GH₵56,000 / 400). This is below the current external market price, although there is strong price competition in the market.
The transfer price for Division A should not be less than the variable cost of production in Division A, which is GH₵70 per tone.
However, if the transfer price is reduced to GH₵140 per tone or less, Division A might try to sell more materials in the external market, by reducing the selling price.
It would appear that although the ideal transfer price might be GH₵140 or below, this will not be easily negotiated between the division managers. An imposed settlement may be necessary. Intervention by head office might be needed to impose a transfer price, and require Division B to reduce its sales price to GH₵0.32.
- Uploader: Salamat Hamid