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Transfer Pricing Problems Emas Ltd Emas Ltd is a decentralised organisation with four divisions. Each division operates as an investment centre and evaluated on the basis of Return on Investment (ROI) – calculated as annual profit divided by investment in division. An annual target ROI of 20% is set for all divisions. Two of the divisions: Atlantic and Pacific, each make a single product line. Atlantic makes component X, which currently sells on the external market for £25 each. Component X is also one of the key components used by Pacific to make its own final product, i.e., product Y. Every unit of product Y – which sells for £80 each, requires two (2) units of component X. Pacific usually acquires component X from Atlantic but sometimes a compatible component is purchased from an outside supplier. The following table provides cost and other details for each product and division: Atlantic Division (Supplying) Component X

Pacific Division (Receiving/Buying ) Product Y (each needs 2 Components X)

Variable costs Direct material Transfers from Atlantic division at £25 each Direct labour Variable overhead Total variable costs per unit Divisional fixed cost (per annum) Annual demand from outside customers at current selling prices (units)

Capacity of plant (units)

Investment in division

£ 10 -

£ 15 50

2 2 £ 14

4 3 £ 72

40% x £300,000

£250,000

120,000 +80,000(pacific) = 200,000 units Comp X PACIFIC=80/200k =40% of operation

40,000 (80,000 Comp X units in total)

220,000

50,000 (100,000 Comp X units neeed)

£4,000,000

£2,500,000

Minimum to Seller = Marginal Cost + Lost Contribution The board of Emas Ltd is concerned about Pacific division’s performance and has asked the division’s manager, Harry West to provide an explanation. Harry argues that the current transfer price set by Atlantic division is too high and does not allow his division a fair chance to meet the performance target set by the board. He has also had an unsuccessful attempt to re-negotiate the price with the Atlantic division’s manager who insisted that transfers between divisions should only happen at a price that is “determined by market forces”. Harry has now asked the board of Emas Ltd to intervene in order to reduce the transfer price charged by Atlantic division for Component X. He suggests that the price should instead be set on the basis of Atlantic division’s marginal production cost plus a ‘reasonable’ annual lump-sum payment to partially cover Atlantic’s divisional fixed costs. Required: Write a report advising the board of Emas Ltd on the response that it should make to the proposal put forward by the manager of Pacific division. Include in your report: a) a calculation of divisional profits and return on investment (ROI) based on current demand and transfer price arrangement; Divisional Profits = Revenue – Cost of Transfer (this is only for the receiving division) – Variable Costs – Fixed Costs

ROI for Atlantic = 47.5% ROI for Pacific = 2.8% b) a discussion of the relative merits and disadvantages of the current transfer price and the pricing approach suggested by Pacific division’s manager; Looking back at the lecture, it is not wrong to use the market price. In fact, it would be fair to use it. But it does show the specific division generating very poor performance which makes the divisional managers very unhappy.

c) a revised calculation of divisional profits and return on investment (ROI), assuming that the proposed change to transfer price is implemented; and

ROI for Atlantic = 28.5% ROI for Pacific = 33.2%

d) your recommendation, with reasons. *A wide range of conclusion would be acceptable. For example, it should state why a transfer price of 14 marginal or variable cost plus a lump sum payment is recommended/acceptable by discussing the impact on ROI and divisional manager’s motivation.*

Notes to attempt the question Identify which is the buying and selling division. One is supporting market price. But to keep both managers happy, we have to look at a different approach.

Minimum to Seller = Marginal Cost + Lost Contribution

Ringring plc Ringring plc produces components for the mobile telephone market. The production process follows two stages. In the first stage, the lithography department prints circuits on silicon chips. In the second stage, the coating department embeds the silicon chips in robust plastic cases. The coated printed silicon chips are Ringring’s final product. Ringring’s top management requires that all uncoated printed silicon chips are transferredin from the lithography department to the coating department. The departmental managers are responsible for their department’s operating income and receive a monthly bonus calculated as a percentage of the departmental operating income. At an activity level of 10,000 units of uncoated silicon chips per month, the lithography department’s variable costs for the plastic modules are £5,000 and fixed costs are £1,000 per month. At the same activity level, the coating department’s variable costs for the plastic modules are £500 per month and fixed costs are £400 per month. The price of the finished product is £0.80 per unit. There is an established market for uncoated silicon chips, where unlimited amounts of this product can be bought and sold at £0.71 per unit. Required: a) Calculate the monthly operating income of both departments using the following transfer pricing approaches: i. Transfers at 110% of full costs ii. Transfers at the market price iii. Dual pricing method, whereby the lithography department sells the uncoated printed silicon chips at the published price estimate, and the coating department pays for them at 110% of the lithography department’s full costs. b) Which of the three transfer pricing approaches considered above would you recommend to Ringring? Consider their implications on managerial incentives and profitability in your answer. c) Briefly explain the circumstances under which organisations might choose to adopt negotiated transfer prices? What are the disadvantages of this approach?

Cornish Minerals

Required: a) Prepare estimated profit statements for the month of May 2018 for each division

and for Cornish Minerals plc as a whole, based on transfer prices of £2,000 per tonne and of £1,800 per tonne when producing at: i) 80% capacity ii) 100% capacity, utilising the extra sales to supply the retail trade. Revenue – Cost of Transfer – Variable Cost – Fixed Cost

b) Discuss the results achieved under part a).

c) Present a reasoned recommendation of an alternative transfer price which would

provide greater incentive to increase company profits, indicating any problems that might be encountered....