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The Kisha Company has several product divisions, each of which produces one product. Each of these divisions has its own manufacturing facilities and sells its output to both outside customers and other sister divisions. The company’s policy dictates that purchases and sales must be internal wherever possible and that transfer price are set at 112% of full manufacturing cost.
Division Omega buys all of its requirements of material X from division Alpha. However, a close substitute of material X can be acquired from outside sources at a unit price of TZS 1,150. Until recently, Division Omega required half of division Alpha’s output. Division Omega has just expanded its capacity and will require 90% of Division Alpha’s output in the future.
Division Omega is presently operating at full capacity, for technological reasons, current expansion plans cannot be implemented for another two years. The Manager of Division Alpha is very upset, because Division Omega’s new demand requirements will cause his return on investment to drop below the company’s require return of 12% based on invested capital at year end.
Division Omega’s product has a market price of TZS 3,500. Last years, the invested capital bases for Divisions Alpha and Omega were TZS 5,000,000 and TZS 9,000,000 respectively. Income statements for the last year for the two divisions are as follows: -
| Division Alpha | Division Omega | |||
|---|---|---|---|---|
| TZS | TZS | TZS | TZS | |
| Sales in units | 12,000 | 6,000 | ||
| Sales Revenue | 13,500,000 | 21,000,000 | ||
| Direct Materials | 4,890,000 | 9,300,000* | ||
| Direct Labour | 2,400,000 | 3,000,000 | ||
| Variable Manufacturing overhead | 1,320,000 | 1,500,000 | ||
| Fixed manufacturing overhead | 2,640,000 | 11,250,000 | 3,600,000 | 17,400,000 |
| Gross profit | 2,250,000 | 3,600,000 | ||
| Selling & Administrative expenses (all fixed) | 1,400,000 | 2,160,000 | ||
| Net Income | 850,000 | 1,440,000 | ||
*Includes Cost of Units transferred from Division Alpha.
Sales volume and costs for Division Alpha are estimated to remain unchanged.
Division Omega has just made an additional TZS 6,000,000 investment to the TZS 9,000,000 base to enable it expand to 10,800 units per year. Its material, labour and variable overhead costs per unit will remain the same as last year. Its total fixed manufacturing overhead is estimated at TZS 6,000,000 and selling and administrative expenses are estimated at TZS 3,700,000.
REQUIRED:
- Using the current transfer pricing policy and assuming that all output can be sold at last year’s prices, calculate the estimated Return On Investment (ROI) for both Division Alpha and Division Omega for the current year. (6 marks)
-
Now assume that the company’s policy allows division manager to negotiate transfer prices.
- what is the minimum transfer price that Division Alpha could accept and still earn a minimum ROI of 12%? (4 marks)
- what is the maximum transfer price that Division Omega could accept and still earn a minimum ROI of 12%? (4 marks)
- What are the 3 criteria for transfer pricing? (6 marks)
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In the evaluation of divisional performance in a decentralized environment, a number of approaches may be used including Rate of Return on Investment and the Residual Income Methods.
REQUIRED:
Discuss in point form the advantages and dis-advantages of the Rate of Return on Investment and Residual Income Methods in evaluating divisional performance. (4 marks)
-
Mr. Pekupeku having grasped some basic concepts of decentralization, could not help wondering how this concept could affect his company.
On coming back to office, Mr. Pekupeku summoned you, the Director of Finance of the company and directed you to prepare a Board paper on the decentralization of the ABC Company.
REQUIRED:
- Prepare the Board paper on the decentralization of the ABC Company. In the paper, outline the benefits and costs of decentralization. (10 marks)
- Outline three requirements that should be considered in setting transfer prices (6 marks)
- Describe two ways in which transfer prices may be determined and explain the extent to which and any conditions under which, each of them is useful or deficient for the purposes of: -
- Divisional performance measurement and
- Divisional decision making (9 marks)
Bumbire Products Limited Comprises two divisions, a manufacturing division (M) and a sales division (S).
Division M currently sales 1,000 tons of its monthly output to external customers for further processing and 600 tons per month to division S, which converts the product from division M into saleable units.
In January (the start of the budget year), division M agreed a transfer price with division S of TZS 10,000/= per ton, which represented the market price for their product at that time.
However, in May the market price fell to TZS 9,000/= per ton and the management at division S claimed that the internal transfer price should be reduced to this figure forthwith.
Division M disputed this, and pointed out that the price of TZS 10,000/= had been agreed at the beginning of the year. They further argued that, in the past, when prices had risen, division S had refused to accept any increase. Division S converts the product from division M at the rate of 100 units per ton, which it presently sells at TZS 200/= per unit. A further 40,000 units per month could be sold if the selling price were reduced to TZS 160/= per unit.
Other information relating to Bumbire Products Limited is as follows:
| Division M | Division S | |
|---|---|---|
| Production capacity per month | 2,000 tons | 120,000 units |
| Variable cost per ton (TZS) | 3,500 | 3,000 |
| Fixed costs per month (TZS) | 5,000,000 | 2,000,000 |
REQUIRED:
-
Prepare a profit statement for the month of June (the market price of TZS 9,000/= for external sales in force) for both divisions M and S and for Bumbire Products Limited as a whole, based on transfer prices of TZS 10,000/= per ton and TZS 9,000/= per ton, when production at division M is at:
- the current level of activity - 1,600 ton per month;
- division M's capacity of 2,000 tones, where its additional output is transferred to division S.
- Discuss the results of the statements prepared in (a) above, outlining the impact of the change in transfer price on both divisions and on Bumbire Products Limited. (2 marks)
-
State briefly:
- any weaknesses you detect in the transfer pricing system at Bumbire Products Limited; and
- some recommendation for improvement of the existing pricing system. (5 marks)
Lombalomba Limited is a large public company which is organised into autonomous divisions under which a substantial degree of decentralized decision-making takes place. For the purposes of managerial performance measurement, a return on capital employed (ROCE) is calculated by relating net profit to gross capital employed. This company interprets gross capital employed as current assets plus fixed assets at original cost. For external reporting purposes the company adopts the straight-line method of depreciation. The company estimates its cost of capital to be 15% per annum.
Extracts from the budgeted results for 2025 of division C and division D of the Lombalomba Limited are shown below:-
| Division C (TZS) |
Division D (TZS) |
|
|---|---|---|
| Net profit | 24,000,000 | 6,500,000 |
| Current assets | 28,000,000 | 20,000,000 |
| Fixed assets (at cost) | 92,000,000 | 110,000,000 |
There are two projects which are being considered by the division managers. Neither of them is included in the figures given above. They are:-
- Project X which was developed by the Central Marketing department. There is potential for an increase of TZS 30,000,000 annual sales by division C if they spend TZS 4,200,000 annually on an advertising campaign. It will also require the stock holding of the products involved to increase by TZS 10,000,000 on average. The contribution/sales ratio of these products is 20%.
- Project Y relates to some new manufacturing equipment which senior management considers necessary. New equipment costing TZS 25,000,000= can be purchased by division D in order to improve its manufacturing efficiency. Annual operating cash flows, before depreciation, could increase by TZS 8,000,000. The new equipment should last for five years.
REQUIRED:
-
Determine the budgeted return on capital employed (ROCE) for each division:-
- before the two projects are incorporated;
- assuming the managers adopt the projects available to their division and incorporate them in their budgets.
- Comment on the results produced in (a) above describing how the head office and division management would, on financial grounds, be likely to react to the projects.
- For the purposes of divisional ROCE, fixed assets may be valued at either their gross book value or net book value (after accumulated depreciation). Discuss briefly the implications of these alternatives.
A company reported the following results in Year 8:
| $000 | |
|---|---|
| Profit before interest and tax | 26,000 |
| Interest | 6,000 |
| Profit before tax | 20,000 |
| Tax at 25% | 5,000 |
| Profit after tax | 15,000 |
| Dividends paid | 7,000 |
| Retained profit | 8,000 |
The profit is after charging $3,000,000 for depreciation. However, it has been estimated that the economic cost of depreciation was $3,500,000.
The value of capital employed has been estimated as $120 million and the weighted average cost of capital is 9%.
REQUIRED:
Using this information, make the best estimate possible of economic value added in Year 8.
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