Work book for Advanced Management Accounting

CHAPTER 7 – TRANSFER PRICING

Q.1) A Company fixes the inter-divisional transfer prices for its products on the basis of cost plus and
estimated return on investment in its divisions. The relevant portion of the budget for the
division A for the year 2009 – 10 is given below :

Fixed Assets Rs. 5,00,000

Current Assets (other than debtors) 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 of production per year (units) 4,00,000
Desired return on investment 28%

You are required to determine the transfer price for the Division A.

Q.2) Division A is a profit center, which produces three products X, Y and Z. Each product has an
external market.
Particulars X Y Z
External market price per unit Rs. 48 Rs. 46 Rs. 40
Variable cost of production in Division A Rs. 33 Rs. 24 Rs. 28
Labour hours required per unit in Division A 3 4 2
X Y Z
Product Y can be transferred to Division B, but the maximum quantity that might be required for
transfer is 300 units of Y.
X Y Z
The maximum external sales are : 800 units 500 Units 300 Units

Instead of receiving transfers of Product Y from Division A, Division B could buy similar product
in the open market as a slightly cheaper price of Rs. 45 per unit. What should the transfer price
be for each unit for 300 units of Y if the total labour hours available in Division A are : (a) 3800
hours ; (b) 5600 hours;

Q.3) Balaji Ltd. manufactures a product, which is obtained basically from a series of mixing operations.
The finished product is package in the company-made glass bottles and packed in attractive
cartons. The company is organized into two independent divisions’ viz. one for the manufacture

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of the end product and the other for the manufacture of glass bottles. The product manufacturing
division can buy all the bottle requirements from the bottle manufacturing division.

The General Manager of the bottle manufacturing division has obtained the following quotations
from the outside manufacturers for the empty bottles.
Volume empty bottles Total purchase values (Rs.)
8,00,000 14,00,000
12,00,000 20,00,000

A cost analysis of the bottle manufacturing division for the manufacture of empty bottle reveals
the following production costs :
Volume empty bottles Total cost
8,00,000 10,40,000
12,00,000 14,40,000

The production cost and sales value of the end product marketed by the product manufacturing
division are as under.
Volume (Bottle of Total Cost of Sales value (packed
end product) end product in bottles)
8,00,000 Rs. 64,80,000 Rs. 91,20,000
12,00,000 96,80,000 1,27,80,000

There has been considerable discussion at the corporate level to the use of proper price for
transfer of empty bottles from the bottle manufacturing division to product manufacturing
division. This interest is heightened because a significant portion of the Divisional Manager’s
salary is an incentive bonus based on profit centre results. As the corporate management
accountant responsible for defining the proper transfer prices for the supply of empty bottles by
the bottle manufacturing division to the product manufacturing division, you are required to
show for the two levels of volume of 8,00,000 and 12,00,000 bottles, the profitability by using (I)
market price and (ii) shared profit relative to the cost involved basis for the determination of
transfer prices. The profitability position should be furnished separately for the two divisions and
the company as a whole under each method. Discuss also the effect of these methods on the
profitability of the two divisions.

Q.4) An industrial group of companies includes two divisions, A and B. The output of division A is
product A, two units of which are used by division B for every one of its product B. Division B has

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first call on A’s output but there is a separate market outside the group for the balance of division
A’s output. All the output of division B is sold outside the group.

The maximum capacity of division A is 1,40,000 units of A and that of division B is 50,000 units of
B per annum. Each division maintains a stable level of stocks throughout the year. The group
would like to examine the results of using different basis of transfer pricing under different
scenarios (i.e., situation that would be expected to arise). The bases of transfer pricing are :
Absorbed standard cost (AS) , Market price (MP). Variable cost plus a lump sum of 80% of
division A’s fixed cost (VC)
The scenarios are :
Product A Product B
Scenario Market Demand Total Market Total
Number Price (Per Unit) units Price Demand
000’s (per unit) 000’s
15 Rs.30 100 Rs.100 40
23 25 70 90 30
29 35 130 90 30

Product A Product B
Variable cost per unit Rs. 20 Rs. 12 (exclusive of 2 units of
product (A)
Fixed Cost per unit 5 18
Budgeted volume in
Units per annum 1,00,000 40,000

(a) Calculate the profits shown by division A and by division B for the following situations:
Scenario Basis of transfer pricing
29 MP VC As
23 MP VC AS
15 MP VC AS

(b) Assume that division B receives an overseas order for 20,000 units of B that will in no way
influence its other clientele. As manager of division B state, with supporting calculations, whether
you would recommend acceptance of the order in the following two situations:
Scenario Price per unit Basis of transfer pricing
29 Rs.65 MP
23 Rs.55 AS

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(c) If you were managing director of the whole Group, State with very brief reasons, whether you
would recommend acceptance of the orders in (i) and (ii) above.

Q.5) A manufacture has three products A, B, C current sales, cost and selling price details and
processing time requirements are as follows:
Particulars Product A Product B Product C
Annual Sales (units) 6000 6000 750
Selling Price (Rs.) 20 31 39
Unit Cost (Rs.) 18 24 30
Processing time required per unit 1 1 2

The firm is working at full capacity (13,500 processing hours per year). Fixed manufacturing
overheads are absorbed into units’ costs by a charge of 200% of variable costs. This procedure
fully absorbs the fixed manufacturing overhead.

Assuming that : (i) Processing time can be switched from one product line into another. (ii) The
demand at current selling price is :
Product A Product B Product C
11,000 8,000 2,000

(iii) The selling prices are not to be altered, you are required to calculate the best production
programme for the next operating period and to indicate the increase in net profit that this
should yield. In addition identify the shadow price of processing hour.

Q.6) L Ltd. and M Ltd. are subsidiaries of the same group of companies. L Ltd. produces a branded
product sold in drums (10,000 in number) at a price of Rs. 20 per drum. Its direct product costs
per drum are: - Raw material from M Ltd. at a transfer price of Rs. 9 for 25 litres. Other
products and services from outside the group: at a cost of Rs.3.

L Ltd. fixed costs is Rs. 40,000 per month. These costs include process labour whose costs will not
alter until L LTD's output reaches twice its present level. A market research study has indicated
that L LTD's market could increase by 80% in volume if it were to reduce its price by 20%. M
LTD produces a fairly basic product, which can be converted into a wide range of end products. It
sells one third of its output to L Ltd. and the remainder to customers outside the group. M Ltd.
production capacity is 1,000 kilolitres per month, but competition is keen and it budgets to sell
not more than 750 kilolitres per month for the year 31 st December 2010. Its variable costs are
Rs. 200 per kilolitre and its fixed costs are Rs. 60,000 per month. The current policy of the group

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is to use market prices, where known as the transfer price between its subsidiaries. This is the
basis of the transfer price between M Ltd. and L Ltd. You are required to calculate the monthly
profit position for each of L Ltd. and M Ltd. if sales of L Ltd. are: At their present level, and at the
higher potential level indicated by the market research, subject to a cut in price of 20%.
(a) To explain why the use of market price as the transfer price produces difficulties under the
conditions outlined in (a)-(ii) above.(b) To recommend with supporting calculations, what
transfer price you would propose.

Q.7) P.H. Ltd has two manufacturing departments organised into separate profit centres known as the
Basic unit and Processing unit. The Basic unit has a production capacity of 4,000 tonnes per
month of Chemvax but at present its sales are limited to 2,000 tonnes to outside market and
1,200 tonnes to the Processing unit. This price has been fixed in line with the external wholesale
trade price to Rs. 360 per tonne with effect from 1st June 2010.

The Processing unit refines Chemvax and packs the output known as Colour-X in drums of 50 kgs
each. The selling price of Colour-X is Rs. 40 per drum. The Processing unit has a potential of
selling a further quantity of 16,000 drums of Colour-X provided that overall price is reduced to
Rs. 32 per drum. In that event it can buy the additional 800 tonnes of Chemvax from the basic unit
whose capacity can be fully utilised. The outside market will not however absorb more than the
present quantity of 2,000 tonnes. The cost data relevant to the operations are :

Basic unit Processing unit

Transfer Price
Raw materials/tonne Rs. 70
Variable cost/tonne 140 Rs. 170
Fixed costs/month 3,00,000 1,20,000
Required: (i) Prepare statements showing the estimated profitability for June 2010 for each unit
and the company as a whole on the following basis: At 80% capacity and 100% capacity
utilisation of the Basic unit at the market price and transfer to the Processing unit of Rs. 360 per
tonne. (ii) Comment on the effect of the company’s transfer pricing policy on the profitability of
the processing unit.

Q.8) Piranha Ltd has two divisions Sorty and Torty. Sorty transfers all its output to Torty which
finishes the work. Costs and revenues at various levels of capacity are as follows:

Output in units 600 700 800 900 1,000 1,100 1,200

Sorty’s Costs (Rs.) 600 700 840 1,000 1,200 1,450 1,800

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Torty’s net revenues 2,950 3,250 3,530 3,780 4,000 4,200 4,350
(i.e. Revenues less Costs
incurred in Torty) (Rs.)
Company’s Profit (Rs.) 2,350 2,550 2,690 2,780 2,800 2,750 2,550

The Company’s profits are maximised at Rs.2,800 with output of 1,000 units. If Piranha wish to select a
transfer price in order to establish Sorty and Torty as profit centres, what transfer price would motivate
the managers of the divisions to produce 1,000 units, no more and no less? Comment on this proposal.

Q.9) DHARA Ltd is engaged in the manufacture of edible oil. It has three divisions viz.,
(i) Harvesting whose function is production of oilseeds & transportation thereof to the oil mill,
(ii) Oil Mill, which processes oil seeds and manufacturers edible oil, (iii) Marketing Division,
which packs the edible oil in 2kg. containers for sale at Rs.150 per container.

The Oil Mill has a yield of 1000 kg of oil from 2000 ig of oil seeds during a period. The Marketing
Division has yield of 500 cans of edible oil of 2 kg each from every 1000 kg of oil. The net weight
per can is 2 kg of oil.
The cost data for each division for the period are as under:
Harvesting Division
Variable cost per kg. of oil seed Rs.2.50
Fixed cost per kg. of oil seed Rs. 5.00
Oil Mill Division
Variable cost of processed edible oil Rs.10.00 per kg
Fixed cost of processed edible oil Rs. 7.50 per kg
Marketing Division
Variable cost per can of 2 kg of oil Rs.3.75
Fixed cost per can of 2 kg of oil Rs.8.75

The fixed costs are calculated on the basis of the estimated quantity of 2000 kg of oil seeds
harvested, 1000 kg of processed oil and 500 cans of edible oil packed by the aforesaid divisions
respectively during the period under review. The other oil mills buy the oil seeds of same quality
at Rs.12.50 per kg in the market. The market price of edible oil processed by the oil mill, if sold
without being packed in the marketing division is Rs.62.50 per kg.

Compute the overall profit of the Company of harvesting 2000 kg of oil seeds, processing it into
edible oil and selling the same in 2 kg cans as estimated for the period under review. Compute the
transfer prices that will be used for internal transfers from (1) Harvesting Division to Oil Mill

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Division and (2) from Oil Mill Division to Marketing Division under the following pricing method
– (a) Shared Contribution in relation to variable costs and (b) Market Price. Which transfer
pricing method will each divisional manager prefer to use?

INTERNAL VS EXTERNAL PROCUREMENT – OPPORTUNITY COST IMPACT

Q.10) Ezee-Yuse Ltd. manufacturers of household articles are organised along decentralised lines with
each manufacturing division operating as a separate profit centre. Division Adrian normally
purchases one of its components from Division Electra at a unit price of Rs.175. Electra has
informed Division Adrian that the unit price will have to be increased to Rs.200. Adrian has
ascertained that it can still purchase an equivalent component from another outside
manufacturer for Rs.175 and has decided to change suppliers. Electra has appealed to the group
chairman against this decision. Data available are:

Adrian’s Annual purchase of Components 5,000 units

Electra’s variable cost per component Rs.140
Electra’s Fixed costs per component Rs.40

State with reasons, whether or not, in each of the following cases Adrian should purchase
externally: Assuming that there are no alternative uses for Electra’s internal facilities.
Assuming that there is no alternative use for Electra’s internal facilities and the price from
external suppliers drops a further Rs.40.

Assuming that by not producing the 5,000 components for Adrian the manufacturing facilities at
Electra should be used for other products so as to produce an annual contribution of Rs.1,70,000
Also suggest what transfer price(s) will lead to the correct decision in each of the above cases.

Q.11) A Company with two manufacturing divisions is organised on profit centre basis. Division ‘A’ is
the only source for the supply of a component that is used in Division B in the manufacture of a
product KLIM. One such part is used each unit of the product KLIM. As the demand for the
product is not steady, Division B can obtain orders for increased quantities only be spending
more on sales promotion and be reducing the selling prices. The Manager of Division B has
accordingly prepared the following forecast of sales quantities and selling prices.

Sales in units per day Average Selling Price per unit of KLIM
1,000 Rs.5.25
2,000 3.98
3,000 3.30
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4,000 2.78
5,000 2.40
6,000 2.01

The manufacturing cost of KLIM in Division B is Rs.3,750 first 1,000 units and Rs.750 per 1,000
units in excess of 1,000 units. Division A incurs a total cost of Rs.1,500 per day for an output up to
1,000 components and the total costs will increase by Rs.900 per day for every additional 1,000
components manufactured. The manager of Division A states that the operating results of his
Division will be optimised if the transfer price of the component is set at Rs.1.20 per unit and he
has accordingly set the aforesaid transfer price for his supplies of the component to Division A.
Required:

Prepare a schedule showing the profitability at each level of output for Division A and Division B.
(b). Find the profitability of the company as a whole at the output level at which
 Division A’s net profit is maximum.
 Division B’s net profit is maximum.

QUESTIONS ASKED IN LAST 10 EXAMS

Problem 1

XYZ Ltd. has two divisions, A and B. Division A makes and sells product A, which can be sold outside as well as
be used by B. A has a limitation on production capacity, that only 1,200 units can pass through its machining
operations in one month. On an average, about 10% of the units that A produces are defective. It may be
assumed that out of each lot that A supplies, 10% are defectives.
When A sells in the outside market, the defectives are not returned, since the transportation costs make it
uneconomical for the customer. Instead, A's customers sell the defectives in the outside market at a discount.
But, when B buys product A, it has to fix it into its product, which is reputed for its quality. Therefore, B
returns all the defective units to A. A can manually rework the defectives, incurring only variable labour cost
and sell them outside at Rs.150 and not having to incur any selling costs on reworked units. If A chooses not to
rework, it can only scrap the material at Rs.30 per unit. B can buy product A from outside at Rs.200 per unit,
but has to incur Rs.10 per unit as variable transport cost. B can insist to its outside suppliers also that it will
accept only good units.
A incurs a variable selling overhead only on units (other than reworked units) sold outside. The following
figures are given for the month:
Variable cost of production – Dept. A (Rs./unit) 120
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Variable selling overhead (Rs./u) 20

Selling price per unit in the outside market (Rs./u) 200
Current selling price to B (Rs./u) 190
Additional variable labour cost of reworking defectives (Rs./u) 100
Selling price of reworked defectives (Rs./u) 150
Fixed costs for the month (Rs.) 36,000
Maximum demand from B at present (no. of units) 630

The outside demand can be freely had upto 900units.

Given the demand and supply conditions, you are required to present appropriate calculations for the
following:
(i) Evaluation of the best strategy for A in the present condition.
(ii) If B can buy only upto 540 units and the outside demand is only 600 units, how much should A charge B to
maintain the same level of profit as in (i) above? (12 Marks) (June 2009)

Problem 2

Optically Ltd. makes two kinds of products, P (lenses) and Q (swimming goggles) in divisions P and Q
respectively. P is an input for Q and two units of P are needed to make one unit of Q.

The following data is given to you for a period:

If Q buys P from outside, it has the following costs:

For order quantity 2,499 or less Rs.90 per unit for the entire quantity ordered.
For order quantity 2,500 – 5,000 Rs.80 per unit for the entire quantity ordered.
For order quantity more than 5,000 Rs.70 per unit for the entire quantity ordered.
You are required to:
(i) Evaluate the best strategies for Division P and Q.
(ii) Briefly explain the concept of goal congruence. (12 Marks) (Nov 2009)

Problem 3
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Division Z is a profit center which produces four products A, B, C and D. Each product is sold in the
external market also. Data for the period is:

Particulars A B C D
Market price per unit (Rs.) 150 146 140 130
Variable cost of pdn. Per unit (Rs.) 130 100 90 85
Labour hours required per unit 3 4 2 3

Product D can be transferred to division Y, but the maximum quantity that may be required for transfer is
2,500 units of D.

The maximum sales in the external market are: A – 2,800 units , B- 2,500 units, C- 2,300 units, D- 1,600
units.

Division Y can purchase the same product at a price of Rs. 125 per unit from outside instead of receiving
transfer of product D from Division Z.

What should be the transfer price for each unit for 2,500 units of D, if the total labour hours available in
division Z are 20,000 hours?

Problem 4

A large business consultancy firm is organized in to several divisions. One of the divisions is the
Information Technology (IT) division which provides consultancy services to its clients as well as to the
other divisions of the firm. The consultants in the IT divisions always work in a team of three
professional consultants on each day of consulting assignment. The external clients are charged a fee at
the rate of Rs. 4,500 for each consulting day. The fee represents the cost plus 150% profit mark up. The
break up of cost involved in the consultancy fee is estimated at 80% as being variable and the balance is
fixed. The textiles division of the consultancy firm which has undertaken a big assignment requires the
services of two teams of IT consultants to work five days in a week for a period of 48 weeks. While the
director of the textiles division intends to negotiate the transfer price for the consultancy work, the
director of IT division proposes to charge the textiles division at Rs. 4,500 per consulting day. In respect
of the consulting work of the textiles division, IT division will be able to reduce the variable costs by Rs.
200 per consulting day. This is possible in all cases of internal consultations because of the use of
specialized equipment.

You are required to explain the implications and set transfer prices per consulting day at which the IT
division can provide consultancy services to the textiles division such that the profit of the business
consultancy firm as a whole is maximized in each of the following scenarios:

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(i) Every team of the IT division is fully engaged during the 48 week period in providing consultancy
services to external clients and that the IT division has no spare capacity of consultancy teams to take up
the textiles division assignment.

(ii) IT division will be able to spare only one team of consultants to provide services to the textiles
division during the 48 week period and all other teams are fully engaged in providing services to external
clients.

(iii) A new external client has come forward to pay IT division a total fee of Rs. 15,84,000 for engaging the
services of two teams of consultants during the aforesaid period of 48 weeks. (Nov 2008, 11
Marks)

Problem 5

Division Z is a profit center which produces four products A, B, C and D. Each product is sold in the
external market also. Data for the period is:

Particulars A B C D
Market price per unit (Rs.) 150 146 140 130
Variable cost of pdn. Per unit (Rs.) 130 100 90 85
Labour hours required per unit 3 4 2 3
Product D can be transferred to division Y, but the maximum quantity that may be required for
transfer is 2,500 units of D.

The maximum sales in the external market are:A - 2,800 units, B - 2,500 units C - 2,300 units

D -1,600 units

Division Y can purchase the same product at a price of Rs. 125 per unit from outside instead of
receiving transfer of product D from Division Z.

What should be the transfer price for each unit for 2,500 units of D, if the total labour hours
available in division Z are 20,000 hours?

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