4.2 Question Bank Solutions (TP) (2) Transfer Pricing Honours
4.2 Question Bank Solutions (TP) (2) Transfer Pricing Honours
OF
FINANCIAL
MANAGEMENT
PART A
(a) In determining the optimal transfer price, the decision must be considered from the
perspective of the group as a whole, the supplier and buyer.
Ideally Digilens would want to sell 60 000 units of the lens to optimise profits. Production
capacity will however not facilitate this as a maximum of 60 000 lenses can be
manufactured and depending how many should be delivered to Cellcom, only the
remaining units can be supplied to the market. If we consider the demand levels of the
final product (M3000), Digilens lost sales (opportunity cost) would be:
N1 - Digilens can now only sell 30 000 units at a contribution of R416 = R12 480 000
N2 - Digilens can now only sell 50 000 units at a contribution of R316 = R15 800 000
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The incremental cash flow from the group’s perspective for the respective demand levels
would be –
Ideally the group would want to sell 20 000 units of the M3000 to optimise profits.
Since there is an external market for the lenses, the supplying department will
determine the minimum transfer price. This transfer price should place the supplying
department in at least the same position that it would be if it were to sell all its lenses
externally.
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SUGGESTED SOLUTION: QUESTION 2 (EXAM 2007) (40 MARKS)
Consequently the umbrella division will want to operate at 14 000 units, leaving 6 000
units available to transfer to the wooden furniture division.
Optimum output level from the company (as a whole) perspective in respect of garden
furniture:
The company would insist on the sale of 3 000 garden sets, of which the 3 000
umbrellas required would be obtained from the spare capacity of 6 000 umbrellas in the
Poolbrellas’ division. The wooden garden division realises that the optimum transfer
price payable in respect of the umbrellas would be between R300 (the variable cost of
producing it) and R700 (the price it is currently paying).
At these respective prices the contribution of wooden garden furniture division will be:
If transfer price is R700 3 000 units 2 500 units 2 000 units
Selling price R2 840 R3 020 R3 200
Variable costs – wood (1 400) (1 400) (1 400)
division
Transfer price (700) (700) (700)
Contribution per set 740 920 1 100
Total contribution R2 220 000 R2 300 000 R2 200 000
At which point the wooden garden division would insist on selling only 2 500 units, which
is not the objective of the company.
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Total contribution R3 420 000 R3 300 000 R3 000 000
At which point the wooden garden division would share the objectives of the company.
The optimum point is thus where the wooden garden furniture division is indifferent as to
selling either 2 500 or 3 000 units. This would thus be the point where the contribution
for either level of sales is the same. The optimum transfer price is thus:
(b) Wooden garden furniture division: margin of safety prior to the acquisition:
Prior to the acquisition the company would have opted to sell only 2 500 garden sets.
Hence the fixed costs for the year 2 500 x R275 = R687 500
are:
Break-even sales R687 500 / R920 = 747.28 units
Margin of safety (2 500-747.28) / 2 500 = 70.1088%
Breakeven sales volume is 5 600 units and the optimum point is 14 000 units (part a).
Thus the margin of safety is 60% ((14 000 – 5600)/14 000)).
The total contribution at this level will be 5 600 x R370 = R2 072 000
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Margin of safety post acquisition of Poolbrellas’
As this division has two different ‘products’ a weighted average contribution should be
determined to measure the break-even point of this division.
Products External Transferred
Sales price R700.00 R540.00
Variable costs (R330.00) (R300.00)
Contribution per unit R370.00 R240.00
Weighting of units 14 000 3 000
(or simplified) 4.66667 1
For each 4.6667 units sold externally, 1 unit is transferred. Sales take place in this ratio
as a batch.
Weighted average contribution (4.66667 x R370 + 240) = R1 966.67
Fixed costs (R2 072 000 – 450 000) = R1 622 000
Break-even point (R1 622 000 / 1 966.667) = 824.75
batches
(4,6667 + 1)
units per batch
i.e. No of transferred units required to break-even = 824.75
No of external units required (824.75 x 4.66667) = 3 848.81 units
Total units = 4 673.56 units
Margin of safety (17 000 – 4 673.56) / 17 000 = 72.51%
Conclusion:
The managers of both division’s will benefit from the merger as their margin of safety
improves from the position prior the acquisition. In the case of the Wooden garden
furniture division the improvement has been effected by an increase in contribution per
unit, whereas in the case of the Poolbrellas’ division the improvement is a consequence
of a reduction in fixed costs.
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QUESTION 3
GARD-ROO LIMITED (‘GR’ LIMITED) (50 marks)
PART A
(a) The incremental cash-flows the food division will be faced with in the next year for
each of the three alternatives is as follows:
From a purely financial perspective the management of the food condiment division
would want to continue with the production of MIS until the existing XG is
completed and then to purchase the more expensive XG to produce the generic
syrup. Consequently the MIS should be discontinued at the end of 5 months i.e.
31 March 2009.
Calculations:
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(c) Before going ahead with this decision management may wish to consider:
- How this decision may impact on the decision of the company and other
existing products. Ending the product may lead to a decline in other
existing brands.
- The impact on competitors and market share. The decision may open the
door for competitors to gain market share etc
- The impact on other internal factors such as will it lead to staff redundancy
or other spare unutilised capacity. Severance packages etc.
- Alternative marketing strategies, smaller bottles of MIS etc which may
have a very positive impact on the sales of the product
- The quality of the generic, which as promised by management, would be
of good quality. How certain can they be, why are others producing volatile
output?
- Any other valid comment.
PART B
(a) The incremental cash-flows the company will be faced with in the next year for
each of the three alternatives is as follows:
From a purely financial perspective top management of the company would want to
implement option 3, i.e. immediately commence with the production of the generic syrup
in the food division and have the requirements of the beverage division transferred.
Consequently top management would want to discontinue the production of MIS
immediately.
Calculations:
1 Option 2: Only for the last 7 months will the excess generic be sold externally i.e.
7 x (1 750 – 1 500) = 250 litres x R560 = R140 000
2 During the 5 months that MIS is being produced, the company will have to
purchase Epius. Total requirement = 5 x 1 500 = 7 500 litres.
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(b) The range of prices top management would consider are as follows:
Minimum price:
Although this exceeds the current market price of R560 per litre, the company policy
is not to acquire the generic hence a comparison should not be made against this
price as it is not an option.
(c) The following factors have not been considered at all and consequently will affect
the equitability of the advice given by the junior management accountant:
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SUGGESTED SOLUTION: QUESTION 4 (YEAR TEST 2009) (25 marks)
MULTIPLEX LTD.
LETTERHEAD
Based on the information provided to me by your company I have calculated the group
optimum position as follows:
One mark was awarded for identifying the source and quantity, and another mark for
determining the cost of that purchase.
The optimum position for the group would therefore be to transfer 50 000 units and buy
20 000 units from the Chinese exporter, thereby selling 70 000 units in the final market.
Notes
1 SCD currently have spare capacity of 40 000 units as its own market is satisfied.
The TD’s net marginal revenue of R118 is greater than the incremental cost of R64
((R11 800’ + R800’ + R200’) / 200’) and Multiplex Ltd should therefore
manufacture the additional 40 000 units.
2 Once SCD is running at full capacity, Multiplex Ltd should consider the
opportunity cost from not selling into the intermediate market, but transferring
batteries to TD. This is the net of the R120 external selling price foregone and the
saving in selling and distribution costs of R5,50 ((R600’ + R500’)/200’) equalling
R114,50. (This is equal to the variable cost of R64 + R50,50 opportunity cost.)
Multiplex Ltd should then decide between buying the next units at either R93,50
from the Chinese supplier or the R114,50 opportunity cost of SCD. It is therefore
cheaper to buy the next 20 000 units from China.
3 Multiplex Ltd then still needs 10 000 units to satisfy the drill market demand.
Multiplex Ltd has the choice of selling 10 000 batteries from the SCD and earning
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a net revenue of R114,50 or selling the batteries to TD and earn net marginal
revenue of R118. The latter is greater and therefore it would increase cash flow
the most to sacrifice the 10 000 units from the intermediate market and rather
transfer it to be sold in the final market.
Examiners comments:
• Many students did not even attempt to answer the question in report format, as requested. The
mark was only awarded if it looked more or less like a report.
• A number of students also included fixed costs with the variable cost calculation of R64. Students
lost a mark for it (marked negatively).
• The R20 000 legal expenses is already built into the SCD’s projected income statement. It therefore
does not relate to the acceptance or not of the transfers and cannot be brought into the calculation
of the transfer price as an incremental cost. Furthermore, it is already committed and thus not a
future cash flow which takes place as a result of the transfers. Remember that with relevant costing
decision making not every future cash flow necessarily arises as a result of the options under
consideration.
• No information was given in the question that the packaging costs would be saved if batteries
were transferred internally. Packaging in this case is part of the product (ensuring quality) and
does not occur with despatching.
• Many students forgot about the option to import 20 000 units from the Chinese supplier and has
assumed that the SCD was the only source.
• Others again did not understand that the supply from China was limited to 20 000 batteries. They
did their calculations with 30 000 or even 70 000 batteries.
• The price of R93,50 for the Chinese product is not representative of a market price in a perfect
market. It is a stress price because it is supplied from excess stock and only for a limited number
of units and timeframe.
• Savings on internal transfers were not always taken into account in the calculation of the lost
contribution on external sales sacrificed.
• The minimum cost from the company’s (group’s) perspective is not equal to the transfer price. Thus,
it cannot be used as the cost for the company when calculation the profit for the company as a
whole (in other words to determine how many units should be transferred internally for optimum
profitability). The transfer price has no effect on the company as a whole’s profits (income for one,
expense for the other). It can only result in the individual division taking the wrong decision which
is detremental for the company as a whole.
• 200 000 batteries is not 65% of capacity for SCD. 65% was the utilised capacity for the past few
months (since the product was launched) and 200 000 is the expected capacity utilisation for the
next twelve months.
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(b) We should now consider whether the two suggested transfer prices would lead to
this optimum result during the next 12 months:
At R120 per battery (R240 000 / 200 000), SCD will supply any quantity to
TD as it equals SCD’s external selling price. They would actually prefer
selling to TD as they would be saving R5,50 in selling and distribution costs.
As this transfer price proposed by SCD (R120) exceeds the net marginal
revenue of R118 of TD, TD will not purchase any other units internally
from SCD. (1)
SCD would therefore not increase their own profitability as they as still left
with the spare capacity of 40 000 units. (1)
The transfer price proposed by SCD would therefore not lead to goal
congruence as Multiplex will only sell 20 000 drills instead of 70 000 drills.
(1)
In the next 12 months SCD has 40 000 units surplus capacity on which it is
currently earning no profit. Therefore any price in excess of its variable
manufacturing cost of R64,00 per unit will be acceptable to the manager of
SCD. (1)
Although a price of R70,40 includes a R6,40 profit per unit, this leads to
only a 9% profit on sales which is lower than the target of 15%. From a
performance measurement perspective, SCD might still reject it. (1)
Orders in excess of 40 000 units will result in lost sales on the external
market for SCD. The minimum transfer price acceptable for internal
transfers in excess of 40 000 units is SCD’s opportunity cost of R114,50.
(1)
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This transfer price of R70,40 will thus definitely not be acceptable to SCD for
demand in excess of 40 000 units as they could be earning R114,50 net. TD
would be forced to buy as much as it can externally at R93,50. The latter is
limited to 20 000 units. (1)
Multiplex Ltd would therefore only be selling 60 000 drills and not 70 000 – this
does not result in goal congruency. (1)
Maximum (8)
Examiners comments:
• Students do not understand the concept goal congruency. It means that the divisions’
individual decisions i.t.o. the transfer price as well as the volumes, agree with the decisions
which are best for the company as a whole i.t.o. the transfer price and volumes. Therefore,
goal congruency cannot be reached from the view point of SCD or TD alone. It is either
achieved or not achieved for the company as a whole.
• In this case, both suggested transfer prices would result in the company not selling 70 000
drills. In part (a) it was calculated that it is the best for the company as a whole to sell 70
000 drills (and not less). Therefore, goal congruency is not achieved.
• Students don’t formulate proper statements and conclusions. It is not made clear which
division will buy or sell batteries (and how many) and many marks were forfeited as a result.
• Both transfer prices had to be discussed from both the buyer (TD) and the seller’s (SCD)
viewpoints. Many students did not do it like this.
c) I would suggest the following transfer price policy, which should satisfy the
objectives of efficient transfer price determination:
A negotiated transfer price should be used to bring about goal congruency based on the
incremental manufacturing (and other, if any) cost plus opportunity cost of the supplying
division, as the floor or minimum price. This represents the minimum cash outflow for
the group as a whole. (1)
The incremental costs should be based on standard costs and not actual costs to
prevent the supplying division from passing on their inefficiencies to the buying division.
(1)
The opportunity cost is derived from the sum of the incremental cost of the supplying
division from meeting the internal demand plus any lost contribution when sacrificing
external sales. Alternatively this can be derived as the external selling price achievable
less savings in selling and distribution (and (1) other, if any) as result of the transfers.
From this minimum price (floor), both parties can negotiate an acceptable profit mark-up
in order to also satisfy performance measurement targets. (1)
This marked-up price would always be constrained by the maximum which the buying
division is prepared to pay, which is the lowest of the external price available for similar
quality products (if any) or the net marginal revenue generated by the buying division.
(1)
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Both parties should also negotiate how the savings (in selling and distribution costs,
etc.) are going to be split between them. (1)
Whilst SCD has spare capacity (the first 40 000 units), the resulting minimum transfer
price will be R64,00 (R64,00 + zero lost contribution). (1)
With the R64,00 transfer price, TD would purchase from SCD, but SCD would be
indifferent about transferring goods to TD. (1)
Any negotiation ought to lead to a transfer price between R64,00 and R93,50 for the first
40 000 units capacity in order to satisfy SCD’s performance measurement target as
well. (1)
If SCD is to achieve its target of 15% profit, the negotiated price should amount to
R64/85% = R75,29. This is still below the external purchase price of R93,50 or the net
marginal revenue of R118, and should therefore also be acceptable to TD. (1)
Insufficient information was given regarding TD’s selling price to enable us to determine
whether a profit of R42,81 (R118 – R75.29) would also satisfy their 15% profit target. (1)
For demand in excess of 40 000 units the resulting transfer price will be R114,50
(R64,00 incremental cost + R50,50 lost contribution). (Lost contribution = net selling
price R114,50 less R64,00 variable manufacturing cost.) (1)
With a R114,50 transfer price, TD would buy first buy 20 000 units from the Chinese
supplier at R93,50 as it is cheaper. (1)
TD would then buy the last 10 000 from SCD at the price of R114,50 as the purchase
price is lower than TD’s net marginal revenue of R118. This is the correct decision if
SCD is operating at full capacity. (1)
Alternatively: an average transfer price of R74,10 per unit could be charged for the
50 000 unite order (40 000 x R64)+(10 000 x R114,50)/50 000. (1)
This would lead TD to buy 50 000 units from SCD as it is lower than the Chinese price
of R93,50 and the R118 net marginal revenue. (1)
Additional units would be quoted at R114,50 (being units in excess of 10 000, sacrificed
in the external market) which would lead to TD to buy from the Chinese supplier at
R93,50. (1)
This would lead to the same optimal result, namely 50 000 units to be transferred
internally and 20 000 to be bought externally. (1)
Setting the transfer price based on negotiations and opportunity cost would enable the
divisions to make the correct decision, which would be in agreement with the best
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position for the group (goal congruency). The objective of autonomy is therefore also
satisfied. (1)
Further provisos:
Both buyer and seller must have access to the correct information to make decisions in
the interest of the group and they should know how to use the information. (1)
In the interest of obtaining goal congruency for the group, Head Office might have to
relent on performance targets if a transfer that is beneficial for the group detrimentally
affects one of both of the divisions’ performance. (1)
Maximum (9)
SIGNED
CONSULTANT
Setting an average transfer price for 70 000 units would lead to the incorrect decision for
the group. A price of (40 000 x R64)+(30 000 x R114,50)/70 000 = R85,64 (OR (70 000
x R64)+(30 000 x R50,50)/70 000) would lead TD to buy all their requirements from
SCD. Group profits will be as follows:
R
Sales (70 000 x R118) 8 260 000
Incremental costs (70 000 x R64) (4 480 000)
Opportunity cost (30 000 x R50,50) (1 515 000)
Net profit 2 265 000
This is less than the profit achieved if only 50 000 units is transferred, as in (a), of
R2 685 000.
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SUGGESTED SOLUTION: QUESTION 5 (45 marks)
M0 M1 M2 M3 M4 Total
R’000 R’000 R’000 R’000 R’000 R’000
Opening balance 0 (250) 217.38 984.76 1 677.14 0
Add receipts: 4 500 4 800 5 100 5 400 19 800
Sales – Printers 2 400 2 400 2 400 2 400 9 600
Sales – Motors 2 100 2 400 2 700 3 000 10 200
Less: payments (250) (4 032.62) (4 032.62) (4 407.62) (4 032.62) (16 755.48)
Production printers (1 062.5) (1 062.5) (1 062.5) (1 062.5) (4 250)
Production motors (1 450) (1 450) (1 450) (1 450) (5 800)
Foreign Contract (250) (375) (625)
Fixed Costs (1 400) (1 400) (1 400) (1 400) (5 600)
Loan repayments (120,12) (120,12) (120,12) (120,12) (480.48)
Closing balance (250) 217.38 984.76 1 677.14 3 044.52 3 044.52
Explanatory note:
Acquiring the contract will effectively increase available monthly capacity for division two
to 11 000 linear motors (10 000 production plus 1 000 units purchased). Since there is an
external market for the motors that exceed the production capacity after taking into
account the internal transfer (from month two onwards), it can be assumed that the full
maximum capacity (10 000) will be produced from month 1 to make provision for future
market demand as well as supplies.
CALCULATIONS
The unit sales and production schedule for the linear motors will be as follows:
M1 M2 M3 M4 Total
Sales - external 9 500 10 500 11 500 11 000 44 000
Division 1 2 500 2 500 2 500 2 500 10 000
Division 2 7 000 8 000 9 000 10 000 34 000
Acquisitions 11 000 11 000 11 000 11 000 44 000
Production – Division 2 9 500 10 000 10 000 10 000 39 500
Production future shortage 500 500
Contract 1 000 1 000 1 000 1 000 4 000
The unit sales and production schedule for the printers will be as follows:
Monthly fixed costs: [(R540 000 – R480 000/12) + (R950 000 – R600 000/12)]
= R1 400 000
15
Monthly loan instalments:
Total loans raised: R480 000 + R600 000 = R1 080 000 x 5 = R5 400 000
Monthly Repayment:
b) From the above it is clear funding must be applied for the initial R250 000. Given
the favourable increase in the cash position during these 4 months, a short-term
loan or an overdraft would be an appropriate facility to apply for.
The following relevant data applies: There is clearly no doubt that the company would
insist on the transfer of motors from Division 2 to Division 1 for the following reasons:
From a goal congruence/ maximising profits perspective, the 15 000 motors should be
transferred (to maximise profits), and acceptance of the foreign contract is therefore
limited to the benefit received from selling these motors externally i.e. at R300 each.
ALTERNATIVE CALCULATION
(Accept 66 000 units (transfer 15 000) OR Reject 60 000 units 15 000 transferred)
Benefit to company in accepting the contract during first 6 months = R550 000
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RANGE OF TRANSFER PRICES:
Explanatory note:
The supplying division (Division 2) could sell all its production of 54 000 units (7 000 +
8 000 + 9 000 + 10 000 + 10 000 + 10 000) for the six month period externally. The
supplying department would require a transfer price that at least returns the same profit if
all units are sold externally. Should the contract be concluded by top management, the
following contribution will be reported by the division, based on internal transfers of 15 000
units (2 500 x 6) and the balance of the units of 51 000 ((10 000 x 6) + (1 000 x 6) – (2 500
x 6)) sold externally.
Minimum transfer price per unit (R3 020 000 / 15 000) = R201.33
This will also yield a return on sales of (8370 – 6 x 950)/(15300 + 3020) = 14.57%
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d) Shareholders’ perpective:
- Dependency on the foreign supplier / providing foreign suppliers with ideas
that may limit their future markets etc
- Reliability / credentials / track record of the foreign supplier
Clients’ perspective:
- Quality of the product
- Policy in respect of faulty workmanship regarding the foreign motors
Other:
- Exposure exchange risk etc
- Embargos / relations / political environment, sovereignty of foreign country
e) Sales shortage for the 5 year period 5 x 12 x 2 500 x R300 = R45 000 000
Profit required 12% x R45 million = (5 400 000)
Variable costs to be incurred R145 x 12 x 5 x 2 500 = (21 750 000)
Maximum investment to consider for investment = R17 850 000
(Note: this decision should ultimately based on capital budgeting principles, but if funds
had no cost and inflation did not exist, the decision would be made as above).
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SUGGESTED SOLUTION: QUESTION 6 (40 marks)
a) Actual Forecast
2011 2012
i) Total customers 750 800
Customers serviced per trip 3 5
Therefore trips required to deliver to each customer once 250 160
Hence total trips required for 48 deliveries per customer 12 000 7 680
Hence annual deliveries 36 000 38 400
ii) Average delivery size per delivery (720 000m3)÷ 36 000 20m3 20m3
Consumption rate per 100km 936 000 / 72 000 = 13 litres per 100km
Final answer: Consumption rate for 2011 = 13 litres/100km
Consumption rate for = 2012 = 14.5 litres/100km
b) Report layout
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Explanatory note:
Question (b)(i) required you to calculate the variable cost per cubic metre of the bricks.
Only costs that are variable with regards to the number of cubic metres of bricks
bought/produced should have been taken into account. Many students incorrectly
included costs that are variable with regards to the number of deliveries or trips.
Explanatory note:
As every truck can complete 100 trips per year, the break-even point could have been
calculated based on trips or trucks. In order to calculate a break-even point, you need
a contribution per unit (or contribution percentage) as well as the amount of fixed costs
for a specific period. In this case the relevant units are trips (or trucks) and the variable
costs used to calculate the contribution are the costs that vary per trip (compare this to
the cost calculated in part i).
- Current market conditions for the sale of trucks. It may not be the most
suitable time to sell off the trucks (including tax position) and the company
forfeit future opportunities
- Clients may wait longer for their deliveries, which may affect their attitude
and loyalty to the company
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- Are there any other suppliers in the areas covered by Transbri-X with whom
a strategic alliance can be formed to optimise deliveries and the logistics
thereof
- The increased capacity utilisation per trip (100%) may have a negative
impact on operations if there are road works / strikes by drivers etc
- Any other alternatives for the excess capacity of the trucks (diversify
operations?) instead of selling trucks
Minimum transfer price per m3 R473 558 594 ÷ 437 500m3 = R1 082.42
The maximum price will be the price of R1 125/m3 from their existing regular suppliers
(or less 5% in times when suppliers are offering the discounted price), as it can be
assumed that they will not experience shortages due to Transbri-X shift in purchases.
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SUGGESTED SOLUTION: QUESTION 7 (50 marks)
(U-WEAR LIMITED)
A suggestion is to determine the period for the last six months as follows:
TOTAL COST
R80 025 000
375 units 450 units
FIRST 6 MONTHS LAST 6 MONTHS
R36 757 500 R43 267 500
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Analysis of individual cost items:
1st Period 2nd Period
Raw materials (variable only):
Cost per unit (R11 250/375; R15 120/450) = R30.00 R33.60
Labour
Fixed (6 x R40 000; R80 000) = R240 000 R480 000
Variable (R6 990-240)/375; (R8 580-480)/450 = R18.00 R18.00
Overheads
High 450 000u R14 317 500
Low 375 000u R13 867 500
75 000u R450 000
Fixed [R28 185 000-(825 000x6)]/2 = R11 617 500 R11 617 500
Variable per unit R450 000/75 000u = R6.00 R6.00
Administration (all fixed) R1 650 000 R1 650 000
Selling expenses (all variable)
– per unit R6 600 000/825 000u = R8.00 R8.00
Summary:
Product cost per unit – variable (R30 + 18 + 6; R33.60 + 18 + 6) = R54.00 R57.60
Period cost per unit – variable = R8.00 R8.00
Fixed product cost – total = R11 857 500 R12 097 500
Fixed period cost = R1 650 000 R1 650 000
Further calculations:
Total budgeted fixed overhead per annum (R11 857.5 + 12 097.5)’000 = R23 955 000
Total units per annum 375 000 + 450 000 = 825 000 units
Recovery rate per unit = R29.036
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Summarised actual results – Absorption approach R
Sales 4/6 x 80% x R45 000 000 = 24 000 000
Cost of sales (16 608 000)
Cost of production 4 x 56 250 x R83.04 = 18 684 000
Closing inventory 25 000 x 83.04 = (2 076 000)
Gross profit 7 392 000
Under-recovery of overheads R7 905 000 – (225 000 x R29.04) = (1 371 000)
Period costs R1 100 000 + (200 000 x R8) = (2 700 000)
Net profit 3 321 000
c) The relevant cash-flows for the 3-month period (months 5 to 7) will be:
Cash in - Sales (2 x 62 500 + 75 000) = 200 000 u x R120 = R24 000 000
Cash out:
Production –
labour and overheads (62 500 x 2) + (75 000 – 25 000*) = 175 000 u x (R18 + 6) = (R4 200 000)
Production –
raw materials (125 000 u x R30 + 50 000** u x 33.60) = (R5 430 000)
Non-production 200 000 x R8 = (R1 600 000)
Maximum change in cash position at the end of month 7 R12 770 000
For the 3 months ahead, this also represents the maximum opportunity Division V
has.
*The 25 000 units on hand at the end of month 4 will be utilised to make sales during
periods 5 to 7
**Given the increase in raw materials in month 7, profits will optimised by purchasing as
much raw material as possible prior to the increase (without increasing inventory levels)
Available:
Opening inventory 25 000 u
Maximum capacity 75 000/0.8 x 3 = 281 250 u
Total available 306 750 u
Shortage of 13 750 u
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e) Minimum transfer price
Sales external (200 000 – 13 750) = 186 250 u x R120 = R22 350 000
Transfer sales 120 000 x R65 = 7 800 000
Less:
Appointment of supervisor in month 5 and 6 2 x R40 000 = (80 000)
Raw materials: month 5 and 6 2 x 93 750 x R30 = (5 625 000)
Month 7 93 750 x R33.60 = (3 150 000)
Other production costs 3 x 93 750 x (R18 + 6) = (6 750 000)
Selling commission 186 250 u x R8 = (1 490 000)
Profit achieved 13 055 000
This exceeds Division V’s alternative determined in c) above, hence from a purely
financial perspective the transfer price would be acceptable.
Minimum transfer price per unit (not required) R62.625
U-Wear can only create competitive advantage in the market for a limited period
of time using approaches such as the V neck at the back, since fashion trends
have a limited life span, and competitors can react by designing unique attributes
in turn to their products, reducing the demand for U-Wear’s products. (2)
The impact of the above on the pricing strategy is that, given the differentiation
strategy followed, the company could factor a premium into the price charged for
its products – in other words charge the market for the unique differentiating
factor built into their product. Essentially this would entail applying a price
skimming pricing strategy. (2)
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a) Calculations BUDGET STANDARD
Tonnage levels - Phalaborwa Tonnes Tonnes
Production tonnage +10% 1 400 000 1 540 000
Tonnage transferred +5% 1 400 000 1 470 000
Closing inventory 0 70 000
Phosphuric Concentrate
Total cost to produce R4 950 000 + R126 557 750 = R131 507 750
Per ton R131 507 750 / 1 540 000 = 85.39
Closing inventory R85.39 x 70 000 (Of 17 500 x R341.58) = R5 977 625
Phosphuric Acid
Total cost to produce R180 072 502
Per ton R180 072 502 / 350 000 = R514.49
b) Note 2: The price paid for gypsum particles, at different intervals, needs to be
determined. Based on the information in the example provided (note: the example
data cannot yield an average price of R72), this can be established as follows:
Let the price for the first 20 000 tonnes = ‘x’ per ton,
BSR/29S15.94
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Establish group perspective:
The company’s objective will be to source the 75 000 tonne of gypsum particles in the
most cost effective manner. The (range of) options facing the company to source its
requirement of gypsum particles thus lies between the following ranges:
Opportunity cost
(lost contribution) (R50 – R1.50) x 57 143; x 46 429 = (R2 771 436) (R2 251 807)
Transport cost 57 143 x 7.50; 46 429 x 7.50 = (428 573) (348 218)
External purchases 17 857 x R79; 20 000 x R79 + 8 571 x R74 = (1 410 703) (2 214 254)
Purchase costs avoided 75 000 x R72 = R5 400 000 R5 400 000
Overall cash inflow (saving to company by transferring) R789 288 R585 721
Given the present conditions the group will be better off by at least R585 721 per
annum by transferring. Hence the transfer will be enforced.
c) Note 3: All joint costs will be unavoidable and therefore irrelevant to any decisions
regarding the byproduct. All production costs will have to be incurred, irrespective of
what Crushtide decide to with the gypsum particles , hence the packaging cost (to
preserve it) is also irrelevant.
Currently the supplying division’s opportunity is 50 000 x (R50 – 1.50) = R2425 000
(all product costs are irrelevant)
Minimum price per ton R2 425 000 / 50 000 tonnes = R48.50
The range of acceptable transfer prices will be between R48.50 and R61.50
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ZIPPY ELECTRIX (PTY) LIMITED
Calculation
Units 10 000 24 000 Change
Total costs (9000 – 1290)’000 R4 350 000 R7 710 000 R3 360 000
Hence variable cost per battery is (R3 360/14) = R240 per unit
Fixed costs are thus R4 350 000 – (10 000 x 240) = R1 950 000
The different break-even points (depending on sales value) will therefore be:
Hence the divisional break-even point at this point, due to the reduced sales price
(which will drop after 10 000 units) is 10 541 units. This may change depending on how
many units are required to contribute to the company’s head office fixed costs.
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POWBAT : Depending on the sales price the alternate break-even levels can be
summarized as follows:
The first point i.e. 18 927 is not possible as the selling price will have changed to
R410 (when sales exceed 14 000 units).
Batteries 19 969
Scooters (5 539 + 4 958) 10 497
(b) These costs are incurred by head office simply as a means of reducing the overall
costs of the company and to prevent a duplication of costs. The respective divisions
should therefore be assigned an appropriate portion of these costs.
The allocation of common fixed head office costs on the basis appears to be an
unacceptable basis, basically because:
• It penalizes a division that generates high sales values and that could lead to
dysfunctional management decisions
• Not all the head office costs are caused by sales i.e. sales driven, hence the
allocation of the costs could lead to distorted allocations
• It ignores relevant information such as the variable costs associated with the
revenue, the production volumes (i.e. production values are more associated
with certain costs) etc.
• It does not recognize components of the total costs which may specifically
attributable to either of the two divisions eg. the salary of someone in
administration may be solely for the POWBAT division as the person is only
involved in transactions relating to the POWBAT division
Issues that should be considered in allocating these costs include amongst others,
the following:
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• Consider what these costs were before and after the acquisition of the division as
any change in these costs could be viewed as directly attributable to the new
division
• Determine the cause and nature of the R1 200 000 potential savings in the these
costs if the transfer between the divisions is to be implemented, as this again
could be indicative as to which division these costs should be apportioned
• Consider alternative basis of allocation, for example an ABC basis, in allocating
these costs to the respective divisions, which would represent a more
representative basis for the cause of the costs incurred.
• Establish suitable cost drivers for each of the individual costs which comprise
head office costs and allocate the costs on this basis
• Apply the sound allocation principles, which basically incorporate the following
principles:
- establish the causal factor (cost driver) for the cost
- ensure that each element of the cost driver is ‘equivalent’ (the same) and
accommodate for any differences by means of measure of weighting
Please note, within each range the maximum number of units will yield the highest
contribution.
From the above it is clear that POWBAT would only be interested in selling 20 000
batteries @ R410 each. As the variable as well as revenue structure of ZOOT-COOT
is linear, this division would opt to produce and sell as many units as possible i.e. 14
000 per annum.
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• The contribution achieved by these means should also represent a fair
measurement of the manager’s performance in the division
• It shouldn’t undermine divisional autonomy, which would be in contrast with the
objectives of decentralization
• Minimising global tax liability applies to multinational companies
• Recording the movement of goods and services simply to assist in the accounting
function
• any other valid comment
(e) As any transfer price should exceed the incremental costs thereof, they would be
interested in transferring batteries. The sales/transfer combinations available can thus
be summed up as follows:
The company’s potential profit for each of it’s options above will be:
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Contribution required 3 400
Total revenue required 9 160
From sale of 10 000 units (4 350)
Hence minimum required from transfer price 4 810
Hence minimum transfer price per battery (R4 810 000/14 000) = R343.57
Hence maximum transfer price per battery (R5 250 000/14 000) = R375.00
It is not clear from the question as to why the R1.2 million in distribution, marketing and
advertising costs will be saved. If the saving is directly attributable to POWBAT (which
is more likely) the minimum price of R343.57 can be decreased by (R1.2 m/14k) R85.71
per unit i.e R257.86. However, as the minimum price of R343.57 is below the minimum
external market price it is unlikely that the minimum price will be adjusted with the head
office saving.
The conclusion from the above is that only the minimum price should be reduced with
an appropriate portion of the saving in head office costs obtained. The head office
should, however, credit the applicable division with the relevant amount of R1.2 million
to ensure that the target profit of the division is obtained.
In all likelihood the total saving of R1 200 000 will resort with head office and simply
imply that head office costs have been reduced by means of reduction in their
expenditure.
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(g)
(i) If the respective divisions performance will be measured at 40% return on their
controllable assets, the respective managers would require a return of:
(ii) The company’s overall profit before head office costs at the moment is:
R’000
Optimum profit as determined in (d) above 7 340
Reduced head office costs (9 500 – 1 200) 8 300
Total profit before head office costs 15 640
As the company anticipated profits before head office costs exceeds R13.6 million, the
respective managers would expect a return (on an equitable basis) as follows:
(iii) To ensure a return of R1 840 000 for POWBAT, the required transfer price would have
to be:
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