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4.2 Question Bank Solutions (TP) (2) Transfer Pricing Honours

The document provides suggested solutions for transfer pricing and incremental cash flow analysis for two companies, Digilens and Sunny Furnishers. It discusses optimal transfer prices, contribution margins, and the impact of production capacity on profitability. Additionally, it outlines considerations for management regarding product discontinuation and market strategy.

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0% found this document useful (0 votes)
39 views34 pages

4.2 Question Bank Solutions (TP) (2) Transfer Pricing Honours

The document provides suggested solutions for transfer pricing and incremental cash flow analysis for two companies, Digilens and Sunny Furnishers. It discusses optimal transfer prices, contribution margins, and the impact of production capacity on profitability. Additionally, it outlines considerations for management regarding product discontinuation and market strategy.

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rossvdh20
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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DEPARTMENT

OF

FINANCIAL

MANAGEMENT

2020 FBS 705: TP - Suggested Solutions


SUGGESTED SOLUTION QUESTION 1:

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.

Digilens’s perspective (supplier)

Demand (units) 60 000 40 000 20 000


R R R
Selling price 550 650 750
Less: Variable costs 234 234 234
Material (104) (104) (104)
Labour (5) (5) (5)
Variable overheads (100) (100) (100)
Selling/distribution (25) (25) (25)
Contribution per unit 316 416 516

Total contribution (R’000) 18 960 16 640 10 320

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:

Cellcom demand Lost sales Digilens Contribution lost Opportunity cost pu


30 000 30 000 N1 18 960-12 480=6480’ 6480/30 000 = R216
20 000 20 000 18 960-16 640= 2320’ 2320’/20 000 = R116
10 000 10 000 N2 18 960-15 800 =3160’ 3160’/10 000 = R316

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

1
The incremental cash flow from the group’s perspective for the respective demand levels
would be –

Demand (units) 30 000 20 000 10 000


R R R
Selling price 2 500 3 000 3 500
Less costs 1 855 1 755 1 955
Variable cost A 209 209 209
Variable cost B 1430 1430 1430
Opportunity cost* 216 116 316
Incremental per unit 645 1 245 1 545

Total contribution (R’000) 19 350 24 900 15 450

Ideally the group would want to sell 20 000 units of the M3000 to optimise profits.

The management of Digilens (seller) would be satisfied however, if they yield a


contribution of R18 960 000 on the sale of 40 000 units to the open market and a transfer
of 20 000 to Cellcom (that would put them in the same position).

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.

The minimum transfer price will be –


R
Opportunity cost – lost contribution 116
Variable costs (R234 - R25 saving) 209
Transfer price per unit 325

2
SUGGESTED SOLUTION: QUESTION 2 (EXAM 2007) (40 MARKS)

SUNNY FURNISHERS (PTY) LIMITED

(a) Optimum output level of Umbrella division:

20 000 units 14 000 units 7 500 units


Selling price R500 R700 R1 000
Variable costs (330) (330) (330)
Contribution per unit 170 370 670
Total contribution R3 400 000 R5 180 000 R5 025 000

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:

3 000 units 2 500 units 2 000 units


Selling price R2 840 R3 020 R3 200
Variable costs – wood division (1 400) (1 400) (1 400)
Variable costs – umbrella division (300) (300) (300)
Contribution per set 1 140 1 320 1 500
Total contribution R3 420 000 R3 300 000 R3 000 000

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.

If transfer price is R300 3 000 units 2 500 units 2 000 units


(see previously)

3
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:

3 000 (R1 440 – TP) = 2 500 (1 620 – TP)


R4 320 000 – 3 000 TP = R4 050 000 – 2 500TP
500TP = R270 000
TP = R540

(b) Wooden garden furniture division: margin of safety prior to the acquisition:

Optimum profitability level:


3 000 units 2 500 units 2 000 units
Selling price R2 840 R3 020 R3 200
Variable costs – wood (2 100) (2 100) (2 100)
division
Contribution per set 740 920 1 100
Total contribution R2 220 000 R2 300 000 R2 200 000

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%

(c) Fixed costs of the Poolbrella division (prior to acquisition):

20 000 units 14 000 units 7 500 units


Selling price R500 R700 R1 000
Variable costs (330) (330) (330)
Contribution per unit 170 370 670
Total contribution R3 400 000 R5 180 000 R5 025 000

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

Hence the fixed costs of the division amount to R2 072 000

4
Margin of safety post acquisition of Poolbrellas’

Wooden garden furniture division:


Contribution per unit (see part (a) R1 140.00
Break-even point (R687 500 / 1 140) = 603.07 units
Margin of safety (3 000 – 603.07) / 3 000 = 79.9%

Garden umbrella division:

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.

5
QUESTION 3
GARD-ROO LIMITED (‘GR’ LIMITED) (50 marks)
PART A

(a) (i) Number of bottles of MIS from 5 000kg:


5 000 / (R38.40 / R480) = 62 500 bottles
(ii) XG (1 750 x 12 = 21 000 litres) of generic syrup:
21 000 x 0.625 = 13 125kg

(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:

OPTION 1 OPTION 2 OPTION 3


Inflow
Sales
– XG/MIS 5 000 x 300 1 500 000 62 500 x 3 750 000 –
60.00
– Generic 21 000 x 560 11 760 000 12 250 x 560 6 860 000 21 000 x 560 11 760 000
Total inflow 13 260 000 10 610 000 11 760 000
Incremental outflows (11 650 000) (7 337 500) (8 550 000)
Delivery (100 000) - -
XG 13 125 x 600 (7 875 000) 7 656.25 x (4 593 750) 8 125 x 600 (4 875 000)
600
Other variable 21 000 x 175 (3 675 000) 62 500 x (350 000) 21 000 x 175 (3 675 000)
5.60
12 250 x 175 (2 143 750)
Net inflow 1 610 000 3 522 500 3 210 000

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:

1 Total litres of generic per annum: 1 750 x 12 = 21 000 litres


2 Number of months to make generic for option 2: 12 – (62 500/12 500) =
7 months
3 Generic litres in 7 months: 7 x 1 750 = 12 250 litres
4 XG required for option 2: 7 x 1 750 x 0.625 = 7 656.25 kg
5 Other variable cost per bottle MIS: R44.00 – R38.40 = R5.60
6 XG required for option 3: 13 125kg – 5 000kg = 8 125kg

6
(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:

OPTION 1 OPTION 2 OPTION 3


Inflow
Sales
– EBlast (EB) 200000 x 162 32 400 000 32 400 000 32 400 000
– MIS (as per A) 0 62 500 x 60.00 3 750 000 0
–Generic 3 000 x 560 1 680 000 7 x 140 000 980 000 1 680 000
– XG 1 500 000 0 0
Total inflow 35 580 000 37 130 000 34 080 000
Incremental outflows (16 510 000) (18 697 500) (13 410 000)
Delivery charge (100 000) 0 -
Purchases – XG 13 125kg (7 875 000) 7 656.25kg (4 593 750) 8 125kg (4 875 000)
Coverting costs @175 21 000ℓ (3 675 000) 12 250ℓ (2 143 750) 21 000ℓ (3 675 000)
Other Variable 0 62 500 x 5.60 (350 000) 0
Variable costs - EB 3 600’ x 1.35 (4 860 000) (4 860 000) (4 860 000)
Purchase of Esiup 7 500 x (6 750 000) 0
4.5/0.005
Net inflow 19 070 000 18 432 500 20 670 000

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.

7
(b) The range of prices top management would consider are as follows:

Minimum price:

Incremental cost of food division to carry out option 3:

Purchases of XG (8 125kg x R600) R4 875 000


Conversion cost – 21 000 liters @ R175 p. ℓ 3 675 000
Total incremental costs 8 550 000
Opportunity (see Part A) 3 522 500
Total revenue required R12 072 500
Received from external sales (1 680 000)
Required from units transferred R10 392 500
Units transferred 18 000 liters
Minimum transfer price per litre R577.36
Maximum price R4.50 / 0.005 R900

Range of transfer prices: R577.36 and R900

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:

- No consideration was given to the risks associated by each division. The


riskier the division, the bigger the benefit required from the transfer price.
- No consideration was given to the size of the investment required to yield
the the profits of the respective divisions. The bigger the investment, the
bigger the benefit required from the transfer price.
- No consideration was given to the current profit margins obtained on the
other products in the respective divisions. This offers a leeway to
management in determining where to peg the transfer price.
- No consideration was given to performance measures implemented by
management. How are the divisions ultimately measured and did the
transfer price account for this equitably?
- Any other valid comment

8
SUGGESTED SOLUTION: QUESTION 4 (YEAR TEST 2009) (25 marks)

MULTIPLEX LTD.

LETTERHEAD

TO: HUB Multiplex Ltd.


FROM: Consultant
DATE: Today

Advice on suitable transfer price

Based on the information provided to me by your company I have calculated the group
optimum position as follows:

Source Volume Cost to Note Net Extra Total


company marginal contribution contribution
revenue in p/unit R’000
TD Not required Not required
Spare capacity 40 000 R64,00 1 R118 R54,00 2 160 (2)
Chinese exporter 20 000 R93,50 2 R118 R24,50 490 (2)
Sacrifice external 10 000 R114,50 2&3 R118 R3,50 35 (2)
70 000 2 685

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

9
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.

10
(b) We should now consider whether the two suggested transfer prices would lead to
this optimum result during the next 12 months:

1. Normal selling price

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.

With a transfer price of R120, TD would purchase as much as possible (½)


externally at a price of R93,50 per unit as it is cheaper. This is however
limited to the 20 000 units available from China. (1)

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)

2. Standard variable manufacturing cost plus 10% mark-up

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)

A transfer price of R70,40 (R64 x 1,1) would be acceptable to both SCD


and TD for the first 40 000 (½)
units as it is more than SCD’s incremental manufacturing costs and lower
than TD’s optional external purchase price of R93,50. (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)

11
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)

12
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

13
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.

14
SUGGESTED SOLUTION: QUESTION 5 (45 marks)

(BUDTRA (PTY) LIMITED)

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:

Division 1 2 500 2 500 2 500 2 500 10 000

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:

PV = R5 400 000, n = 60, i = 1%, FV = 0 Comp monthly PMT = R120 120

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.

c) ACCEPTANCE OF THE CONTRACT:

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:

Benefit to company on every motor transferred (R960- R425) = R535


Benefit from Division 2 selling externally = R300

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.

Acceptance of the contract should be made as follows:


As the company would insist on transferring (see above) the decision to accept the
contract will result in the following:

Incremental sales (6 000 x R300) = R1 800 000


Cost to obtain = (1 250 000)
Benefit to company in accepting the contract during first 6 months = R550 000

ALTERNATIVE CALCULATION
(Accept 66 000 units (transfer 15 000) OR Reject 60 000 units 15 000 transferred)

If the contract is accepted:


External sales – motors: 51 000 units x R300 = R15 300 000
Foreign contract 6 000 units = (1 250 000)
Production of linear motors (60 000 x R145) = (8 700 000)
Total contribution if contract is accepted = R5 350 000

If the contract is rejected:


Total external sale of linear motors 45 000 x R300 = R13 500 000
Production of linear motors 60 000 x R145 = (8 700 000)
R4 800 000

Benefit to company in accepting the contract during first 6 months = R550 000

16
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.

The total contribution if all


production is sold to the external
market will be: 54 000 units x (R300 – 145) = R8 370 000

The minimum transfer price will be determined as follows:

Sales - external 51 000 units x R300 = R15 300 000


Foreign contract (1 250 000)
Production cost (6 x 10 000 x 145) = (8 700 000)
Total contribution (before receipt of TP revenue) = R5 350 000
Hence required from transfer price to ‘re-instate’ contribution = R3 020 000
Total contribution (as per before management instruction) = R8 370 000

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%

The maximum price will be determined by benchmarking it against the measurement


used by management to evaluate performance i.e. 12% return on sales:

Total sales 15 000 x R960 = R14 400 000


12% of sales = R1 728 000

Hence maximum transfer price will be:


Sales = R14 400 000
Less: Required profit = (1 728 000)
Production costs 6 x R1 062 500 = (6 375 000)
Fixed costs 6 x R540 000 = (3 240 000)
Maximum that Division 1 will be willing to pay R3 057 000

Maximum transfer price per motor R3 057 000 / 15 000 = R203.80

17
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

Internal resources perspective:


- Timeous delivery and facilitation of printer production process
- Storage space etc. depending delivery of the contract (will 1 000 units be
delivered at once or in stages?)

Learning / alternatives’ perspective:


- Any other appropriate suppliers
- Hiring / acquisition of machines to supplement the capacity shortages

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).

18
SUGGESTED SOLUTION: QUESTION 6 (40 marks)

(TRANSBRI-X (PTY) LIMITED)

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

iii) The fuel consumption rate of the existing trucks is as follows:


Gross revenue R862 207 200
- From delivery fee R1 250 x 36 000 45 000 000
- From bricks @ standard 810 000 000
- Hence from diesel 7 207 200

Hence cost of diesel ÷ 1.10 = R6 552 000


Hence annual litres used ÷ R7.00 = 936 000 litres

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

Other data (not required per question)


A single truck will:
In 300 days complete (300/2); (300/3) 150 trips 100 trips
Travel in a year (150 x 600); (100 x 750) 90 000km 75 000km
Deliveries made (150 x 3); (100 x 5) 450 500
Total km travelled for all trips (12 000 x 600); (7 680 x 750) 7 200 000 5 760 000

b) Report layout

i) Annual demand 720 000m3 / 750 x 800 768 000m3


Supplied by Wi-Rock 350 000m3 / 80% 437 500m3
Hence purchased from regular suppliers 330 500m3

Total cost of these bricks R813 441 563


- Wi-Rock division 437 500 X (0.975 x R363 125)/350 442 558 594
- @ Standard price 330 500 x 95% x R1 125 353 221 875
- @ Discount price 353 211 875 x 5% 17 661 094
Average cost of bricks per m3 R813 441 463/768 000 = R1 059.17

19
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.

ii) Per truck, the contribution per annum is:


Total revenue R11 964 719
- Bricks R810”/720’ x (20m3 x 5) x 100 R11 250 000
- Delivery fee (100 x 5) x R1 250 625 000
- Fuel (13+1.5) x R7.50 x 1.10 x 75 000 / 100 89 719
Total variable costs R10 850 763
- Fuel R89 719 ÷ 1.10 81 563
- Drivers fees R300 x 300 days 90 000
- Marketing commission R70 x 500 deliveries 35 000
- Accommodation & meals R525 x 100 trips 52 500
Cost of bricks R1059.17 x 100m3 x 100 trips 10 591 700

Contribution per truck per annum R1 113 956


Break-even point (trucks)
Fixed costs for 2012
- Existing operations 24 920 000
- Wi-Rock division (30 000 – 7 500) 22 500 000
R47 420 000
Break-even point R47 420 000 ÷ R1 113 956 = 42.569 say 43 trucks

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).

iii) Factors to consider before implementing the logistical changes

- 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

- Impact of reduction in driver / job opportunities, as the number of trips /


trucks will be reduced

20
- 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

- Driver exhaustion over the longer trips that need to be travelled

- Potential of fines if trucks are overloaded

- Impact of change in diesel prices on the company’s demand (sensitivity


analysis)

- 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

- Any other valid comment

c) The minimum transfer price will be determined as follows:

Division’s existing profit R8 500 000


Fixed costs R22 500 000
Total variable costs (R363 125 000 x 0.975) ÷ 350 x 437.5 R442 558 594
Total to be recovered from TP R473 558 594

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.

21
SUGGESTED SOLUTION: QUESTION 7 (50 marks)

(U-WEAR LIMITED)

A suggestion is to determine the period for the last six months as follows:

First six For the first Data for last


months year 6 months
Rands Rands Rands
Sales 45 000 000 99 000 000 54 000 000
Raw materials 11 250 000 26 370 000 15 120 000
Labour 6 990 000 15 570 000 8 580 000
Overheads 13 867 500 28 185 000 14 317 500
Administration 1 650 000 3 300 000 1 650 000
Selling expenses 3 000 000 6 600 000 3 600 000
Net profit 8 242 500 18 975 000 10 732 500
Taxation (28%) (2 307 900) (5 313 000) (3 005 100)
Net profit after tax 5 934 600 13 662 000 7 727 400

a) Calculation (‘000) First six months Last six months


Total costs 45 000-8 242.5; 99 000 – 18 975 R36 757 500 R80 025 000
Cost per unit R98.02 R97.00
Budget volumes 375 000 825 000
Units in 1st six months (375 000)
Total units per six month period 375 000 450 000
Sales units per month (÷ 6) = 62 500 75 000

b) The following is provided as an ‘overview’:

TOTAL COST
R80 025 000
375 units 450 units
FIRST 6 MONTHS LAST 6 MONTHS
R36 757 500 R43 267 500

PRODUCT PERIOD PRODUCT PERIOD


R’000 R’000 R’000 R’000
Variable Fixed Variable Fixed Variable Fixed Variable Fixed TOTAL
Raw materials R11 250 R15 120 R26 370
Labour R6 750 R240.0 R8 100 R480.0 R15 570
Overheads R2 250 R11 617.5 R2 700 R11 617.5 R28 185
Admin R1 650 R1 650 R3 300
Selling R3 000 R3 000 R6 600
TOTAL R20 250 R11 857.5 R3 000 R1 650 R25 920 R12 097.5 R3 600 R1 650 R80 025

22
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:

Budgeted recovery rate per unit:

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

Total product cost for first 6 months R29.036 + R54.00 = R83.04


Units sold during first four month 80% x 375 000/6 = 50 000 u
Units produced during first four months 90% x 375 000/6 = 56 250 u

Inventory accumulated after 4 months (56 250 – 50 000) x 4 = 25 000 u

Actual fixed costs incurred during first 4 months:

Production: (R11 617 500/6 x 4) + 4 x R40 000 = R7 905 000


Period: R1 650 000/6 x 4 = R1 100 000

23
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)

The fixed costs are irrelevant to this decision.

d) Total units required:


For external sales 2 x 62 500 + 75 000 = 200 000 u
For transfers 3 x 40 000 = 120 000 u
Total required 320 000 u

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

Produce 93 750 units per month.

24
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

f) In creating a competitive advantage the company has to perform some aspect of


its business perceptibly better or more effectively than its competitors perform. (1)

U-Wear Limited creates competitive advantage as follows:

• The company differentiates itself from its competitors by designing,


manufacturing and marketing a range of clothing which is uniquely
different from those it’s competitors, in terms of their design (special
features which my U-Wear’s products different such as the V neck on the
back of the jersey). (2)

• U-Wear however also focuses on a specific segment of the market –


namely the teenage and 18 – 25 groups. U-Wear’s products would be
specifically designed around the tastes of these groups. (2)

• Given the above it can be said that U-Wear implements a differentiation-


focus strategy in creating competitive advantage. (1)

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)

Logical argumentation (1)


Presentation (1)

25
26
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

Tonnage levels - Richards Bay


Production tonnage +5% 350 000 367 500
Sales Tonnage – Phosphuric Acid No change 350 000 350 000
Closing inventory 0 17 500

Sales – Gypsum Particles 50/350 x 50 000 52 500


367 500

Calculation – Fixed cost Richards Bay

Total figure for FJ2013 R22 656 000


Variable – shifts 472 x R27 360 = (R12 913 920)
Depreciation (R4 871 040)
Fixed cost attributable to employees R4 871 040
Variable to number of employees 45/43 x R4 871 040 = R5 097 600
Adjust for increase R5 097 600 x 1.07 = R5 454 432
Per unit R5 454 432 / 350 000 t = R15.58

Calculation - Standard Inventory Values

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

Closing inventory R514.49 x 17 500 = R9 003 625

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,

20 000x + 20 000(x – 5) + 20 000(x -10) + 15 000(x -15) = R72 x 75 000


Solving for x, the price for the first 20 000 tonnes was R79. Every additional 20 000
tons was, therefore, purchased at R5 less per tonne.

BSR/29S15.94

27
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:

If total rock mined at Phalaborwa is 1.6m tons 1.3m tons


Produce internally – transfer to Mauritius [50’/350’ x Rock mined/4] 57 143 46 429
Purchase tonnes – externally 17 857 28 571
Annual demand (in tonnes) required 75 000 75 000

The cost to the company thereof is as follows:

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.

Establish supplying division’s perspective (minimum price):

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

Establish receiving division’s perspective (maximum price):

Currently the receiving division incurs (must not be exceeded)


75 000 x R72 = R5 400 000
Transfer price (the balancing ?
figure)
Cost to transport 50 000 x R7.50 = R375 000
External purchases 20 000 x R79 + 5 000 x R74 = R1 950 000
Maximum outflow acceptable R5 400 000
Maximum to be charged on transfer = R3 075 000
Per tonne = R61.50

The range of acceptable transfer prices will be between R48.50 and R61.50

28
ZIPPY ELECTRIX (PTY) LIMITED

(a) Divisional break-even (POWBAT)

POWBAT’s divisional break-even has already been determined as 10 000 units at a


price of R435, however, it’s total required sales will have to exceed 10 000 units in
order to contribute towards the company’s common fixed costs of R9 500 000.

The division’s cost structure is presently as follows:

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:

Selling price Contribution Break-even point

R425 R185 10 541 units


R410 R170 11 471 units
R375 R135 14 444 units

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.

Divisional break-even (ZOOT-SCOOT)


Annual fixed costs (12 x R750 000) R9 000 000
Contribution per unit:
Selling price R3 000
Variable costs (R1 000)
Battery (have indicated that this is price they are paying) (R375)
R1 625

Divisional break-even point is (R9 000 000/1 625) = 5 539 units

Company break-even point

Fixed costs R9 500 000

Division’s to contribute as follows:

ZOOT-SCOOT: 14 scooters will contribute R22 750.

29
POWBAT : Depending on the sales price the alternate break-even levels can be
summarized as follows:

Selling Contribution Weighted Break-even Break-even


price for 24 contribution batteries scooters

R425 R4 440 R27 190 8 386 4 892


R410 R4 080 R26 830 8 498 4 958
R375 R3 240 R25 990 8 773 5 118

The combined batteries would thus be:

If selling price is R425: (10 541 + 8 386) = 18 927


If selling price is R410: (11 471 + 8 498) = 19 969
If selling price is R375: (14 444 + 8 773) = 23 217

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).

Hence the company’s minimum break-even point will be:

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:

30
• 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

• Consider the controllability of this expenditure and ensure that respective


management is “charged” with an accountable portion of the head office
expenditure.

c) POWBAT would, by ignoring any transfers, consider it’s alternatives as follows:

Please note, within each range the maximum number of units will yield the highest
contribution.

Batteries Sales Variable cost Contribution


Units R R R
10 000 4 350 000 2 400 000 1 950 000
14 000 5 950 000 3 360 000 2 590 000
20 000 8 200 000 4 800 000 3 400 000 ✓
24 000 9 000 000 5 760 000 3 240 000

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.

(d) List the objectives of transfer pricing

• Reliable transfer pricing system should motivate divisional managers, assisted by


reliable information provided by the transfer price, in making responsible
decisions.
• Encourages divisional managers to maximize divisional contribution which at the
same time will maximize company profits, achieve goal congruence

31
• 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:

Option 1: Sell 10 000 externally and transfer 14 000


Option 2: Sell 14 000 externally and transfer 10 000
Option 3: Sell 20 000 externally and transfer 4 000

The company’s potential profit for each of it’s options above will be:

Option Option 2 Option 3


1
R’000 R’000 R’000
External
sales
ZOOT- 14 000 x 42 000 42 000 42 000
3000
SCOOT
POWBAT 10 000 x 4 350 14 000 x 5 950 20 000 x 410 8 200
435 425
46 350 47 950 50 200
Variable
costs
ZOOT- 14 000 x (14 000) (15 500) (17 750)
1 000
SCOOT
POWBAT 24 000 x (5 760) 24 000 x (5 760) 24 000 x 240 (5 760)
240 240
Contribution 26 590 26 690 26 690
Fixed costs
ZOOT 750 000 x (9 000) (9 000) (9 000)
12
SCOOT
POWBAT Calc in (a) (1 950) (1 950) (1 950)
HEAD 9500 000 - (8 300) (9 500) (9 500)
500 000-
OFFICE 700 000

NET 7 340 6 240 6 240


PROFIT

(f) Minimum transfer price: from POWBAT’s perspective


R’000

Variable costs incurred 5 760

32
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

Maximum transfer price: from ZOOT-SCOOT’s perspective

Contribution before transfer price (2 000 x 14 000) 28 000


Current contribution (1 625 x 14 000) (22 750)
Maximum prepared to pay for transfer of batteries 5 250

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.

However, if the saving is directly attributable to ZOOT-SCOOT, the maximum transfer


price can be increased by R85.71 i.e R460.71 per unit. This however, exceeds the
current external price of R375 and if applied will not lead to goal congruency within the
company.

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.

33
(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:

POWBAT ZOOT-SCOOT TOTAL


Investment R4 000 000 R30 000 000
Required return R1 600 000 R12 000 000 R13 600 000

(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:

POWBAT ZOOT-SCOOT TOTAL


Required return R1 840 000 R13 800 000 R15 640 000
Return on assets 46% 46%

(iii) To ensure a return of R1 840 000 for POWBAT, the required transfer price would have
to be:

Required profit R1 840 000


Add: fixed costs R1 950 000
Total contribution R3 790 000
Add: variable costs R5 760 000
Sales required R9 550 000
External sales (R4 350 000)
Transfer sales required R5 200 000

Transfer price per unit R371.43

Proof (not required):


ZOOT-SCOOT will return profits of:
Sales R42 000 000
Variable costs – other (14 000 000)
- transfer price (5 200 000)
Contribution 22 800 000
Fixed costs (9 000 000)
Return before HO costs 13 800 000
(which represents 46% return)

34

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