MCS Numerics

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MANAGEMENT CONTROL SYSTEMS

UNIVERSITY QUESTION - ANSWERS

Year 2001 to 2008

Q5. What is the concept of free cash flow as applied to organization. Explainprocess of computation?

We define net cash flow as net income plus non cash adjustment which typically means netincome plus depreciation though that cash flows cannot be maintained over time unlessdepreciated fixed assets are replaced. So management is not completely free to use its cashflows however it chooses. Therefore we define the term free cash flows.Free cash flow is the cash flow actually available for distribution to investor after thecompany has made all the investment in fixed assets and working capital necessary tosustain ongoing operation. When we studied income statement in accounting the emphasiswas probably on the firms net income, which is accounting profit. However the value ofcompanys operation is determined by the stream of cash flows that the operations willgenerate now and in the future. To be more specific, the value of operation depends on allthe future expected free cash flows, defined as after- tax operating profit minus the amount ofnew investment in working capital and fixed assets necessary to sustain the business.

Therefore the way for managers to make their companies more valuable is to increase theirfree cash flow.Uses of FCF:

1. Pay interest to debt holders, keeping in mind that the net cost to the company is theafter tax interest expense.

2. Repay debt holders, that is, pay off some of debt.3. Pay dividends to shareholders.4. Repurchase stock from shareholders.5. Buy marketable securities or other non operating assets.In practice, most companies combine these five uses in such a way that the net total is equalto FCF. For example, a company might pay interest and dividends, issue new debts, also sellsome of its marketable securities. Some of these activities are cash outflows (paying interest

and dividends) and some are cash inflows (issuing debt and selling marketable securities),but the net cash flow from these five activities is equal to free cash flows.

Computation of free cash flows:Eg:Suppose the company had a 2001 NOPAT of $170.3million and depreciation is only the noncash charge which is $100million then its operating cash flow in 2001 would be NOPAT plusany non cash adjustment on the statement of cash flows.

Operating cash flow =NOPAT +depreciation (non cash adjustment)= $17.03 + $100= $270.3

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to all projects using the resource does this. The key difference between costs andAllocated costs is that the latter will be charged based upon an estimate, rather thanactual cash values. Thus as it is charged based upon an estimate the budgeted figure isthe same as the actual figure and hence no variances.

Solution (b):Overhead Expenses mentioned above should not be included in controllable costsbecause some costs are uncontrollable like fixed costs. . They don't vary with the changein short run managerial decisions and output. And some costs are controllable i.e. theycan be managed and changed with the managerial decisions and output.As the above overhead expenses would have certain portion of fixed expenses this ishard to control. So, these should not be a part of controllable cost .

Q8. ABC ltd. (MCS-2008) Numerical

Particulars Division X (Rs.) Division Y (Rs.)ROI 28% 26%

Sales 100 Lacs 500 lacsInvestment 25 lacs 100 LacsEBIT 7 Lacs 26 lacs

Analyze and comment upon performances of both the divisionsSolution:

Division XROI = (Profit / investment)* 100Profit = (28/100)*25lacs

= 7lacsProfit margin = (Profit/sales)*100

= (7/100)*100= 7lacs

Turnover of investments = (Sales/investment)*100= (100/25)*100= 4 times

Division YROI = (Profit / investment)* 100Profit = (26/100)*100lacs

= 26lacsProfit margin = (Profit/sales)*100

= (26/500)*100

= 5.2lacsTurnover of investments = (Sales/investment)*100

= (500/100)*100= 5 times

Profit margin of X is better than profit margin of division Y. Turnover of investment of divisionY is better than Division X. Hence cost management of Division X is better than Division Y.

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Q9: Kiran Company (MCS-2004) Numerical

Budget versus Actual comparison for div Z of Kiran company is as follows:

Budget Actual Actual better (worse) than budgetSales and other income 800 740 (60)

Variable expenses 480 436 44

Fixed expenses 120 120 0

Sales promotional expenses 40 28 12

Operating profit 160 156 4

Net working capital 400 412 12

Fixed assets 160 148 (12)

(a) Carry out and overall performance analysis to decide areas needing investigation.

From the given data, we see that there is a certain amount of variance between the budgetedoperating profit and actual operating profit. In order to analyze the variances, we need tounderstand the key causal factors that affect profit, namely, revenues and cost structure. Theprofit budget has embedded in it certain expectations about the state of total industry,companys market share, selling prices and cost structure. Results from variance

computation are actionable if changes in actual results are analyzed against each of thisexpectation.Revenue variances, that is a negative Rs 60 lakhs, could be a result of selling pricevariance, mixed variance and/or volume variance. A combination of above three factors musthave been unfavorable that is either the volume of sales must have been below the budgetedvolumes ( this must be particularly true since actual variable expenses are less thanbudgeted) and/or the selling price must have been below expectation and/or the proportion ofproducts sold with a higher contribution must have been less than budgeted.One more factor could have been the overall industry volume. However, this factor is beyondthe managements control and largely dependent on the state of economy.Variable expenses are directly proportional to volumes and hence as is evident are lessthan budgeted. Sales promotional expenses also show a negative variance which could be a

cause of lower sales volumes.A cause of concern is that despite lower sales, the net workingcapital is more than budgeted which indicates capital block in higher inventory. Another issueis that the fixed assets are lower than the budget by Rs 12 lakhs which may indicate slowercapacity expansion then expected or distressed sale of assets to tide over cash flow.

(b) What are the remedial measures if any would you suggest based on analysis?The budgeted estimates may be too optimistic and far from reality, one needs to ensure thatestimates the as realistic as possible. Given the estimates are correct, in that casedepending upon the above analysis, the management needs to take corrective action areasneeding improvement, sales volume could be improved by better marketing, qualitystandards and promotional efforts, product mix could be improved by selling more of highercontribution products. Better sales will ensure a higher inventory turnover. Better creditmanagement to recover receivables, will ensure improve cash flow situation since lesscapital will be tied up in working capital.

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Q10 : Shandilya Ltd. (MCS-2008) Numerical

Shandilya Ltd. has adopted Economic Value Added (EVA) technique for the appraisal ofperformance of its three divisions A,B and C. Company charges 6% for current assets and 8% for Fixed Assets, while computing EVA relevant data are given below :-Particulars Div A Div B Div C Total

Budgete

d

Actua

l

Budgete

d

Actua

l

Budgete

d

Actua

l

Budgete

d

Actua

l

Profit 360 320 220 240 200 200 780 760

Current

Assets

400 360 800 760 1200 1400 2400 2520

Fixed Assets 1600 1600 1600 1800 2000 2200 5200 5600

Solution:

Particulars Div A Div B Div C Total

Budgete

d

Actua

l

Budgete

d

Actua

l

Budgete

d

Actua

l

Budgete

d

Actua

l

ROA 18% 16% 9% 9% 6% 6% 10% 9%

EVA 208 170.4 44 50.4 -32 -60 220 160.8

b) Comment upon both methods, based on results.

There are three apparent benefits of an ROA measure. First, it is a comprehensive measurein that anything that effects the financial statements is reflected in this ratio. Secondly, ROAis easy to calculate, easy to understand, and meaningful in absolute sense. Finally, it is acommon denominator that may be applied to any organizational units responsible forprofitability, no matter what its size or what business it practices. The performance ofdifferent units may be compared directly to each other. Also, ROI data is available forcompetitors that can be used as a basis for comparison. Nevertheless, the EVA approachhas some inherent advantages over ROA.

There are three compelling reasons to use EVA over ROI. First, with EVA all business unitshave the same profit objective for comparable investments. The ROI approach, on the other

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hand, provides different incentives for investment across business units. For example, abusiness unit that is currently achieving 30% ROA would be most reluctant to expand unlessit is able to earn a ROI of 30% or more on additional assets. Second, decision that increase acentres ROI may decrease its overall profits. Third advantage of EVA is that different interestrates may be used for different types of assets. For example, a relatively low rate May beused for inventories while a higher rate may be used for different types of fixed assets.

(Numerical) MCS 2004

Q 16. Division B of Shayana company contracted to buy from Div. A, 20,000

units of a components which goes into the final product made by Div. B. The

transfer price for this internal transaction was set at Rs. 120 per unit by mutual

agreement. This comprises of (per unit) Direct and Variable labour cost of Rs.

20; Material Cost of Rs.60; Fixed overheads of Rs.20 (lumpsum Rs.4 lacs) and

Rs.20 lacs that Div. A would require for this additional activity. During the year,

actual off take of Div. B from Div. A was 19,600 units. Div. A was able to reduce

material consumption by 5% but its budgeted investment overshot by 10%.

a) As Financial controller of Div. A, compare Actual Vs Budgetred

Performance

b) Its implications for Management Control?

Solution:

a)

Particulars Budgeted(Rs. Per

Unit)

Budgeted(Total in Rs.)

Actual(Rs. Per

Unit)

Actual(Total in

Rs.)Direct and

Variable Labour

Cost

20 4,00,000 20 3,92,000

Material Cost 60 12,00,000 57 11,17,200

Fixed Overheads 20 4,00,000 4,00,000

Total Cost 100 20,00,000 19,09,200

Transfer Price 120 24,00,000 119.86 23,49,200

Profit 20 4,00,000 4,40,000

Investment 20 20,00,000 22,00,000

ROI =

Profit/Investment

20% 20%

b) Despite of increase in investment by 10%, there is negligible difference in transfer

price. Also the sales have decreased by 400 units. Therefore we can say that

additional investment has not achieved any positive results.

MCS 2007

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Q 17. Two Divisions A and B of Satyam Enterprises operate as Profit centers.

Division A normally purchases annually 10,000 nos. of required components

from Div. B; which has recently informed Div. A that it will increase selling price

per unit to Rs.1,100. Div. A decided to purchase the components from open

market available at Rs. 1000 per unit. Naturally, Div. B is not happy and justified

its decision to increase price due to inflation and added that overall company

profitability will reduce and the decision will lead to excess capacity in Div. B,

whose variable and fixed costs per unit are respectively Rs. 950 and Rs. 1,100.

a) Assuming that no alternate use exists for excess capacity in Div. B, will

company as a whole benefit if div A buys from the market.

b) If the market price reduces by Rs. 80 per unit. What would be the effect on

the company (assuming Div. B still has excess capacity) if A buys from the

market

c) If excess capacity of Div. B could be used for alternative sales at yearlycost savings of Rs. 14.5 lacs, should Div. A purchase from outside?

Justify your answers with figures.

Solution

a) Option A ( Div A buys from outside)

Total Purchase Cost = 10,000 Units * Rs. 1000 = Rs. 1,00,00,000

Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000

Since total outlay if transferred inside is lesser than total purchase cost if bought

from outside, relevant cost is the lesser one i.e. Rs. 95,00,000 and overall benefitfor the company would be Rs. 5,00,000

b) Option B ( if the market price is reduced by Rs. 80 per unit and A buys

from the market)

Total Purchase Cost = 10,000 Units * Rs. 920 = Rs. 92,00,000


Since total purchase cost is lesser than the total outlay if transferred inside,

relevant cost is the lesser one i.e. 92,00,000 and overall benefit for the company

would be Rs. 3,00,000

c) Option C ( if excess capacity of Div B could be used for alternative sales

at yearly cost savings of Rs 14.5 lacs, should Div A purchase from outside)

Total Purchase Cost = 10,000 Units * Rs. 1,000 = Rs. 1,00,00,000


Total opportunity cost if transferred inside = Rs. 14,50,000

Total relevant cost becomes Rs. 1,00,00,000

If Div A purchase from outside, overall benefit for the company would be Rs.

9,50,000.

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Therefore, Div A should purchase from outside.

Particulars Option A

Amount

Option B

Amount

Option C

AmountTotal Purchase Cost 1,00,00,000 92,00,000 1,00,00,000

Total outlay if transferred inside 95,00,000 95,00,000 95,00,000

Total opportunity cost if transferred - - 14,50,000Total relevant cost 95,00,000 92,00,000 1,00,00,000Net advantage/disadvantage to

company as a whole if it buys from

5,00,000 (3,00,000) (9,50,000)

Question 25.

Division of Aparna Company manufactures Product A, which is sold to another division

as a component of its product B; which then is sold to third division to be used as part ofits Product C (sold to outside market). Intra company transactions rule: standard costplus a 10 percent return on fixed assets and inventory, to be paid by the buying division.

Standard Cost per Unit Product A Product B Product C

*Purchase of outside material (Rs.) 40 60 20Direct. Labour (Rs.) 20 20 40Variable overhead (Rs.) 20 20 40*Fixed overhead per unit. (Rs.) 60 60 20Average Inventory (Rs.) 14 lacs 3 lacs 6 lacsNet Fixed Assets (Rs.) 6 lacs 9 lacs 3.2 lacsStandard Production (Units) 2 lacs 2 lacs 2 lacs

(a) Determine from above data, transfer prices for A, B and Standard Cost of C.(b) Product C could become uncompetitive since upstream margins are added.

Comment.

Answer(a): Standard Cost of Product A

Outside material (40 * 2 lac units) 80,00,000Direct Labour (20 * 2 lac units) 40,00,000Variable O.H. (20 * 2 lac units) 40,00,000

1,60,00,000+ 10% on (FA + Inventory)

i.e. 10% on 20 lacs 2,00,000

1,62,00,000

Transfer Price for Product A = 1,62,00,000 = 812,00,000

Standard Cost of Product BOutside material (60 * 2 lac units) 1,20,00,000Direct Labour (20 * 2 lac units) 40,00,000Variable O.H. (20 * 2 lac units) 40,00,000

2,00,00,000+ 10% on (FA + Inventory)

i.e. 10% on 12 lacs 1,20,000

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2,01,20,000

Transfer Price for Product A = 2,01,20,000 = 100.62,00,000

Standard Cost of Product COutside material (20 * 2 lac units) 40,00,000Direct Labour (40 * 2 lac units) 80,00,000Variable O.H. (40 * 2 lac units) 80,00,000Fixed O.H. (20 * 2 lac units) 20,00,000

2,20,00,000

(b): While arriving at the cost of Product C, margins of Product A, which become an input toProduct B, and Product B, which in turn become an input to Product C, are added. So when itis sold to outside market, it suffers a disadvantage from its competitors as far as pricing isconcerned, as its price will normally be high compared to products of similar category. So itmight become uncompetitive.But in the long run, customers will distinguish between a good product and a bad product andthe one with the best quality will survive. So if the quality of product C is better than itscompetitors than only it can survive in this competitive market.Another strategy for the company is to cut the margins added by Products A and B, and thencome out with Product C with a lower price tag on it. This may do well to the product bymaking higher revenues and capturing the market share.

Q33. Ananya & Company comprises of five divisions A, B, C, D and E and the presentperformance. metric is return on assets. However, the controller has suggested managementto switch over to economic value added (EVA) as the criterion rather than return on assets.Compute and tabulate both return on assets and EVA on the basis of following information(Rs. lakhs) and comment on divisional performance. Controller feels corporate finance rates

on current assets and.fixed assets should be 5% and 10% respectively.Division Profit Fixed Assets Current Assets

--A 300 800 160

----B 220 400 1600C 100 600 1000

________D 110 400 800

E 180 200 800

Solution:Return on Assets = Profit * 100

Total Assets

A = 300/960*100 = 31.25%B = 220/2000*100 = 11%C = 100/1600*100 = 6.25%D = 110/1200*100 = 9.17%E = 180/1000*100 = 18%

Economic Value Added (EVA) = Profit (W.A.C.C.* Capital Employed)In this case,

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EVA = Profit (W.A.C.C. on Fixed Assets * Total Fixed Assets) + (W.A.C.C. on Current

Assets * Total Current Assets)

A = 300 (0.10*800) + (0.05*160) = 212 lakhsB = 220 (0.10*400) + (0.05*1600) = 100 lakhs

C = 100 (0.10*600) + (0.05*1000) = -10 lakhsD = 110 (0.10*400) + (0.05*800) = 30 lakhsE = 180 (0.10*200) + (0.05*800) = 120 lakhs

Summary

Division Return on Assets (R.O.A.) Economic Value Added (E.V.A.)(Rs. lakhs)

A 31.25% 212B 11.00% 100

C 6.25% -10D 9.17% 30E 18.00% 120

Comments:1. It appears from the above analysis that division A has performed the best among the five

divisions.2. Also, it can be clearly noticed that divisions C and D seem to be in trouble.3. Division A has performed the best when seen in terms of return on assets and economic

value added.4. The reason why division A has performed the best is that it has the best working capital

management that can be reflected in the total amount invested in current assets and whichis the least among the five divisions.

5. The above reason holds true for the poor performance of divisions C and D as can be seenthat they have a huge amount invested in current assets which does not indicate goodsigns about their operational efficiency.

6. A company which is into an expansion and overall growth mode primarily invests into fixedassets and this is also one of the major reasons why the performance of division A is thebest amongst all.

7. Though division C has also invested a huge amount in fixed assets the advantage is offsetdue to the fact that it perhaps has a larger investment in current assets.

8. Division E is the second best both in terms of R.O.A. as well as E.V.A.9. Though division E has the same amount invested in current assets as that of division D and

perhaps a lesser amount invested in fixed assets its profitability is much better and hence ithas delivered a better performance.

10. Division B is a better performer than divisions C and D in terms of R.O.A. as well as E.V.A.but the major problem with this division is that it has a terrible working capital management.Its current assets are the highest and this reflects that it has huge sums of money held upeither in debtors or inventory or rather it is holding a large amount of cash which is not agood sign.

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Q:48. Veena Television (VT) Problem December 2005

A TV dealership Veena Television (VT) is organized into four profit centers. colour TV, Blackand White, spare parts(SP) and servicing (SG) each headed by manager BTV in addition toBVTV sales; also sells old TV exchanged (under scheme) by customer while purchasing newTV . in one particular instance a new TV was sold for 14150(financed by cash rs2000, Bankloan 7350and Rs 4800;exchange price for old TV agreed by CTV manager )cost of new TVwas Rs 11420. Shivangi Manager of BTV, examined the old TV (valued at Rs 3500 by TVtrade magazine) and felt that she could get Rs 5000 for that TV offer repairing cabinet,resulting and servicing for which she would use services of SP and SG price chargeable toBTV by SP and SG are at market rates Rs235 for parts by SP and Rs 470 for services bySG. Market price are arrived at after marking up cost by 3.5 times SG and 1.4 times SP.BTV pays a service commission of Rs 250 per TV sold .overhead fixed per sale are CTV Rs835;BTV Rs 665;SP RS 32 ;SG Rs 114.

Compute the profitability of the transaction assuming sales commission of $250 for the tradein on a selling price of $5000

Compute at market price & at cost price,

Gross and net profit of each profit center.

SOLUTION:

SP of New TV by CTV = $14150.

Original cost= $11420

($14150= $2000 cash down payment + $4800 trade in allowance + $7350 bank

loan)

Guide Book Value =$3500

Ms. Shivangi of BTV Dept, believed that she could sell the trade in at $5000

Other Cost: Rs235 for parts by SP and Rs 470 for services by SG

When trade-in is recorded @ $4800

4800+470+235=5505; 5000-5505= (-505)

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If the trade-in is recorded @ $3500

Particulars New TV OLD TV Service Parts

Sales 14150 5000 470 235

Selling commission 0 250 0 0

Gross profit 2730 1045 470 235

Overhead 835 665 114 32

Servicing 0 470 0 0

Net profit before common exp 1895 -340 356 123

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Particulars New TV OLD TV Service Parts

Sales 14150 5000 470 235

Selling commission 0 250 0 0

Gross profit 2730 -505 470 235

Overhead 835 665 114 32

Servicing 0 470 0 0

Net profit before commonexp 1895 -1640 591 123


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Q 50. Soniya Company has two Divisions: A & B. Return on Investment for both

divisions is 20%. Details are given below:-

Particulars Div A Div BDivisional sales 4000000 9600000

Divisional Investment 2000000 3200000Profit 400000 640000Analyse and comment on divisional performance of each.

ANSWER

As Profit Margin = Profit *100Sales

Profit Margin for Division A= 4,00,000 /40,00,000 *100 = 10%

Profit Margin for Division B = 6,40,000/ 96,00,000 *100 = 6.6%

Turnover of Investment = Sales * 100

Investment

Turnover of Investment for Division A = 40,00,000/20,00,000 = 2 times

Turnover of Investment for Division B = 96,00,000/32,00,000 = 3 times

As Return on investment for both Divisions A and B is 20%.

COMMENTS:-

Division A Although A has more profit margin than Division B that is 10% as compared

to 6.6% of B, so it has more profitability but inspite of it, division A has lower turnover of

investment that its assets management is bad than Division B, it can be improved by

increased sales or reducing investment.

Division B Needs to improve profit margin by increasing sales and reduce variable cost

and sales at same price or by reducing salesprice and increase the volume of sales so that

its profit would improve. As it has good assets management shown by its turnoverof Division

B that is 3 times which is better than Division A. So it can become profitable organisation

by improving Profit Margin.

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Q 51) 2006: sum(11) - Two divisions A and B of Sonali enterprises operate Profitcenters. Div A normally purchases annually 10000 nos. of required components fromDiv B, which has recently informed Div A that it will increase selling price p.u to Rs.1100. Div A decided to purchase the components from open market available atRs.1000 p.u Div B is not happy and justified its decision to increase price due toinflation and added that the overall company profitability will reduce and decision willlead to excess capacity in Div B, whose V.C and Fixed cost p.u. are Rs. 950 andRs.1100.

1. Assuming that no alternate use exists for excess capacity in Div B, willcompany benefit as a whole if Div A buys from the market.2. If the market price reduces by Rs.80 p.u. What would be the effect on thecompany (assuming Div B has still excess capacity) if A buys from market.3. If excess capacity of Div B could be use for alternative sales at yearlycosts savings of Rs. 14.5 lacs, should Div A purchase from outside?

Justify your answers with figuresANSWER

1) Division A actionBUY OUTSIDE (Rs.) (Rs.) BUY INSIDE

Total PurchaseCost

10,00,000 Nil

Total Outlay Cost Nil 9,50,000

Net Cash OutflowTo The CompanyAs A Whole

10,00,000 9,50,000

The Company as a whole will benefit if Division A buys inside from Division B.

2) If the market price reduces by Rs.80 p.u

Division A actionBUY OUTSIDE (Rs.) (Rs.) BUY INSIDE

Total PurchaseCost

9,20,000 Nil



9,20,000 9,50,000

The Company as a whole benefit if A buys from outside supplier at Rs. (1000-80) =

920

3) If excess capacity of Div B could be use for alternative sales at yearly costs savings ofRs. 14.5 lakhs

Division A action

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BUY OUTSIDE (Rs.) (Rs.) BUY INSIDE

Total PurchaseCost

10,00,000 Nil


Revenue FromUsing TheseFacilities

1,45,000


8,55,000 9,50,000

Yes, without cloud of doubt Company should purchase from outside.

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Q.52 Girish Engineering Ltd. (Numerical) (MCS-2006)

(1) On the basis of costing, will the manager be interested in accepting the market

offer?

Solution:

Particulars Amount (Rs./unit) Amount (Rs./unit)

Cost of critical component for

division X

220

Cost of other material 500

Fixed & processing costs 290

Total cost for division X 1010

Selling price of final product 1000

Net loss for division X 10

Desired profit for division X 60

Thus on the basis of full actual cost incurred by division X, it would suffer a loss of Rs.10/unit

if it accepts the market offer whereas its target profit margin is Rs.60/unit. So, division X

would not accept the market offer.

(2) Is this offer beneficial to the company as a whole? Justify with figures.

Particulars Amount (Rs. Lakh) Amount (Rs. Lakh)

Cash inflow (a) 50 (5000 units *

Rs.1000/unit)

Cash outlay:

Variable cost for division Y 5 (Working note)

Material bought by division X

from outside

25 (5000 units * Rs.500/unit)

Total cash outlay (b) 30

Net cash inflow to Company

as a whole [(a)- (b)]

20

Thus, the Company as an entity would receive cash inflow of Rs.20 lakh. So, the offer is

beneficial to the company as a whole.

Working notes:-

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Variable cost for division Y:

Desired RoI =10% of Rs.2.4 Cr. p.a. = Rs.24 lakh p.a. i.e. Rs.2 lakh per month

Fixed cost assigned to division X = Rs.4 lakh per month

Fixed cost p.u. = 400000/5000 = Rs.80

Contribution per month = Rs.6 lakh

Total sales value for division Y = 220 * 5000 = Rs.11 lakh per month

So, total Variable cost per month for division Y = 11 lakh 6 lakh = Rs.5 lakh

Variable cost p.u. for division Y = 500000/5000 = Rs.100

An annual investment of Rs2.4 Cr. is assigned by division Y to division X but it

does not imply that a special investment of Rs.2.4 Cr. is made by division Y

exclusively to produce the component required by division X. Therefore, cash

outflow associated with this investment is not relevant for the above concerned

decision regarding accept the market offer.

(3) If yes, how should the company organize its transfer pricing

mechanism? Illustrate.

Solution: Currently, Girish Engineering Ltd. is following 2 step transfer pricing

method wherein the selling division charges actual variable cost along with profit

mark-up & separately allocates a particular amount of fixed costs per month to the

buying division. However, in the case of division X (buying division) & division Y(selling division), this method of transfer pricing is not feasible as division X would

suffer loss if it accepts the market offer under this scenario. So, divisions X & Y can

negotiate a transfer price by taking into account full actual variable cost (Rs.100 p.u.)

& half of fixed costs incurred by division Y that is assigned to division X (Rs.40 p.u.) &

add a mark-up of say Rs.10/unit. Taking into consideration only half of the fixed costs

of selling division i.e. division Y prevents shifting of any operational inefficiencies from

selling division to buying division i.e. division X, which would unnecessarily increase

the costs for division X and thereby eat up its profit margin. In this case, division Xs

total costs would turn out to Rs.940 (500 + 290 + 150) & would earn a profit margin of

Rs.60 p.u. (desired profit margin). Also, contribution p.u. for division Y would be

Rs.50 (150 100). Thus, total contribution for division Y would be Rs.250000

resulting in RoI of 12.5% (250000/2000000) which is more than the desired RoI of

10%.

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Q. 53 Suresh Ltd. (Numerical) (MCS-2007)

(a) Define profit in this case and prepare a statement for both divisions and overall

company.

Solution:

i) Profitability statement of Division A:-

Particulars Amount(Rs.)Selling price p.u. 35Variable Cost p.u. 11Contribution p.u. 24

Contribution p.u. Expected sales(no. of units) Totalcontribution Total Fixed cost(Rs.) Net profit (Rs.)

24 2000 48000 60000 (12000)24 3000 72000 60000 1200024 6000 144000 60000 84000

ii) Profitability statement of Division B:-

Sellingp.u.

Totalvariablecost p.u.

Contributionp.u.

Expectedsales (no.of units)

Totalcontribution

TotalFixed cost(Rs.)

Net profit(Rs.)

90 42 48 2000 96000 90000 600080 42 38 3000 114000 90000 2400050 42 8 6000 48000 90000 (42000)[Note: Total Variable cost p.u. = Variable cost p.u. (Rs.7) + Transfer price of intermediate

product (Rs.35)]

iii) Profitability statement of Company as a whole:-

Expected sales Net profit of divisionA (Rs.)

Net profit of DivisionB (Rs.)

Total Net profit

2000 (12000) 6000 (6000)3000 12000 24000 360006000 84000 (42000) 42000

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(b) State the selling price which maximizes profits for division B and company as a

whole. Comment on why the latter price is unlikely to be selected by division B.

Solution:

As per the calculation in part (a), selling price p.u. of Rs.80 maximizes profit for division B

whereas selling price p.u. of Rs.50 maximizes profit for the Company as a whole.

However, if Division B opts for selling price p.u. of Rs.50 in order to maximize Companys

profit, it would suffer a loss of Rs.42000. Therefore, Division B would not select Selling

price p.u. of Rs.50.

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MCS Numerics