Topic: Executive compensation (Questions usually asked is short case study)

Discussion Questions 4
1. Cenderawasih Industries has two divisions: the Tan and Tin divisions. The
Tan Division produces a component that is used by the Tin Division.
Information about that component is as follows:

Sales RM200 per unit

Variable manufacturing costs RM80 per unit

Fixed manufacturing overhead RM50 per unit

Expected sales in units 12,000 units

The Tan Division can produce up to 15,000 components per year. The Tin Division
needs 1,500 units of the component for a product it manufactures.

Required:
Capacity: 15,000
Sales: 12,000
Needs: 1,500
= Excess capacity
Transfer price = 80 + 0
= RM80

a) Determine the minimum transfer price that the Tan Division would
accept.

Minimum Transfer Price = RM80

b) Determine the maximum transfer price that the Tin Division would pay.

Maximum Transfer Price = RM200

c) If the Tan Division produces and sells 15,000 units in a highly competitive
market, what would be the correct transfer price?

Capacity: 15,000
Sales: 15,000
Needs: 1,500
= no excess capacity

Transfer price = 80 + (200 – 120)

= RM200
2. Endang Industries is a decentralized company that evaluates its divisions
based on ROI. The Ban Division has the capacity to make 2,000 units of a
component. The Ban Division's variable costs are RM80 per unit.

The Bin Division can use the Ban component in the manufacturing of one of
its own products. The Bin Division would incur RM60 of variable costs to
convert the component into its own product, which sells for RM300.
(BUYING DIVISION provide more info, then TP need to recalculate)
The following requirements are independent of each other:

a) Assume the Ban Division can sell all of the components that it produces
for RM180 each. The Bin Division needs 100 units. What is the correct
transfer price?

Capacity: 2,000
Sales: sell all
Needs: 100
= no excess capacity

Transfer price = 80 + (180 – 80)

= RM180

b) Assume the Ban Division can sell 1,800 units at RM260. Any excess
capacity will be unused unless the units are purchased by the Bin
Division, which could use up to 100 units.

Capacity: 2,000
Sales: 1,800
Needs: 100
= have excess capacity
(i) Determine the minimum transfer price that the Ban Division would be
willing to accept.

Transfer price = RM80 which is the variable cost because it is below capacity
(have excess capacity)

(ii) Determine the maximum transfer price that the Bin Division would be
willing to pay. (recording)

Transfer price = RM240 (RM300 – RM60)

**Usually RM 260 is correct according to general rule

Without the internal transfer, Bin division (buying division) cannot sell their
end product, and cannot get the revenue of RM300. RM240 (RM300 –
RM60) is the contribution margin for buying division. When TP is set at
RM240 with internal transfer, the contribution margin for buying division is
RM0 (RM300 – 60 – 240). Contribution margin of RM0 and at TP of RM240
is the maximum TP that buying division willing to pay. If TP at RM260,
buying division will get contribution margin of -RM20 (RM300 – 60 –
260). Buying division will choose TP that give RM0 contribution margin.

Bin division
Revenue 300
Variable cost:
Incurred 60
Transferred in 260
Total 320
Contribution margin (20)

TP objective that buying division trying to meet: provide a basis for fairly
rewarding the managers, meet goal congruence

Profits matter to both division (optimise profits to determine good

performance)

Selling division – increase profit

Buying division – reduce cost

Additional question: Should the internal transfer be done in this case (at
TP of RM240) for the company?

Company’s viewpoint: it does not matter the TP is at what price because it

offset revenue in selling division and cost in buying division. Without internal
transfer, company as a whole cannot generate profit. (Assume Bin division
cannot produce products without the transfer, because Bin division cannot buy
from outside sources). The company is losing contribution margin of RM160
per unit (RM300 – 60 – 80). The transfer must be done to meet objective of
goal congruence. Company cares about transaction to outsider but not the
internal transfer.

Ban Division Bin Division Company

Revenue 240 300 300
VC
Incurred 80 60 140
Transferred in 240
Total 300
CM 160 0 160
 3. The ABC Division of Indonesian Car Company has offered to purchase
90,000 batteries from the XYZ Division for RM104 per unit. At a normal
volume of 250,000 batteries per year, production costs per battery are as
follows:
Direct materials RM 40
Direct manufacturing labor RM20
Variable factory overhead RM12
Fixed factory overhead RM40
Total RM112
The XYZ Division has been selling 250,000 batteries per year to outside buyers at
RM136 each; capacity is 350,000 batteries per year. The ABC Division has been
buying batteries from outside sources for RM130 each.
Required:
Capacity: 350,000
Sales: 250,000
Needs: 90,000
= Excess capacity
a) Should the XYZ Division manager accept the offer? Explain.
Sales RM104
Variable cost (40 + 20 + 12) (72)
Contribution margin RM32

**Put YES/NO, got mark

Yes, XYZ Division manager should accept the offer because it is above
variable costs. It is operated at excess capacity, the minimum TP is the
variable cost of RM72. It will generate a profit of RM2,880,000 (90,000 x
RM32). This is a gaining proposition in the short run and long run.

**If no excess capacity, the manager should not accept because contribution
margin decreases from (136 – 72 = RM64) to RM32.
b) From the company's perspective, will the internal sales be of any benefit?
Explain.

The company surely benefit from this transfer pricing as they will able to
reduce the price that is spent to buy these batteries from outside suppliers. As
mentioned in the question, the company spent RM 130 for each battery but if
they change their options by purchasing from XYZ division, they would only
spend RM 72 per battery. So from this, the company can save RM 58 per
battery if they apply transfer pricing. As a result, the company’s internal sales
will be increased by RM 5.22 million (RM 58 x 90,000 batteries) from the
incremental margin.
 4. Bestari Company recently acquired a palm oil processing company with an
annual capacity of 2,000,000 liters and processed and sold 1,400,000 liters
last year at a market price of RM8 per liter. The purpose of the acquisition
was to furnish oil for the Cooking Division. The Cooking Division needs
800,000 liters of oil per year. It has been purchasing oil from suppliers at
the market price RM8. Production costs at the capacity of the palm oil
company, now a division, are as follows:

Direct materials per liter RM2.00

Direct processing labor 1.00

Variable processing overhead 0.48

Fixed processing overhead 0.80

Total RM4.28

Management is trying to decide what transfer price to use for sales from the newly
acquired company to the Cooking Division. The manager of the Palm Oil Division
argues that RM8, the market price, is appropriate. The manager of the Cooking
Division argues that the cost of RM4.28 should be used, or perhaps a lower
price, since fixed overhead cost should be recomputed with the larger volume. Any
output of the Olive Oil Division not sold to the Cooking Division can be sold to
outsiders for RM8 per liter.

Required:

a) Compute the operating income for the Palm Oil Division using a
transfer price of RM8.

Palm Oil
Revenue
External [(2,000,000 – 800,000) x 8] 9,600,000
Internal (800,000 x 8) 6,400,000
16,000,000
Variable cost:
Incurred (2,000,000 x 3.48) 6,960,000
Transferred in 0
Total (6,960,000)
Contribution margin 9,040,000
Fixed costs (2,000,000 x 0.8) (1,600,000)
 Operating income 7,440,000

b) Compute the operating income for the Palm Oil Division using a
transfer price of RM4.28. (Full cost: combination of fixed and variable
cost, because include the fixed cost)

Type of TP: at full cost, variable cost (only VC), VC/FC cost plus mark up,
prorating, dual pricing
Palm Oil
Revenue
External [(2,000,000 – 800,000) x 8] 9,600,000
Internal (800,000 x 4.28) 3,424,000
13,024,000
Variable cost:
Incurred (2,000,000 x 3.48) 6,960,000
Transferred in 0
Total (6,960,000)
Contribution margin 6,064,000
Fixed costs (2,000,000 x 0.8) (1,600,000)
Operating income 4,464,000

c) What transfer price(s) do you recommend? Compute the operating

income for the Palm Oil Division using your recommendation.
Capacity: 2,000,000
Sales: 1,400,000
Needs: 800,000

Excess capacity = 600,000

TP should be RM4.28 for RM600,000
(General rule: when have excess capacity, TP is at variable cost RM3.48)
(Now use full cost because preparing income statement for selling
division, so TP higher at RM4.28 is better because it gives higher
revenue for the selling division as it will have additional revenue of RM
0.80 per unit)

*For BD, RM 4.28 is desirable? Is there any opportunity for BD to buy

from outsider?
Yes, it is desirable for BD to have internal sales, because compare to the
market price, which is RM 8, TP of RM4.28 is still lower (still advantage as
compared to RM8). Therefore, RM 4.28 still desirable and it is also can
achieve goal congruence of company as a whole. (min transfer price)

No excess capacity = 200,000

 TP should be RM 8 (market price) for 200,000 (general rule)
Palm Oil
Revenue
External [(2,000,000 – 800,000) x 8] 9,600,000
Internal (600,000 x RM4.28) + (200,000 x RM8) 4,168,000
13,768,000
Variable cost:
Incurred (2,000,000 x 3.48) 6,960,000
Transferred in 0
Total (6,960,000)
Contribution margin 6,808,000
Fixed costs (2,000,000 x 0.8) (1,600,000)
Operating income 5,208,000

5. Explain why it may not be desirable for head office management to

dictate transfer prices? Can you provide an example of a situation
where this may be appropriate?

Intervention by head office management to dictate the level of TP is not desirable

because it is considered to be inconsistent with the philosophy of decentralization. In
a decentralized organization, the managers of profit centres and investment centres
have considerable autonomy over setting and accepting TP. Hence, interfering in
dictating TP can undermine the autonomy of business unit managers.

The situation in which intervention by management is appropriate is when the TP that

are set by managers of business units may lead to decisions that are not in the best
interests of the organization as a whole. The selling unit insists to maximise the TP,
while the buying unit insists to minimize the TP whereby negotiation has failed and
consensus is not achieved.

In the case of dispute, intervention is appropriate. The head office can be the
mediator to advice managers.

PART 1:

It is generally not desirable for head office management to dictate transfer prices,
because such action would undermine the autonomy of business unit managers and go
against the philosophy of decentralization. However, if the transfer prices set by the
business managers are suboptimal and not in the best interest of the company, then
some might argue that head office management should intervene in the process.
Conflict of interest: Head office management may prioritize the overall performance
of the company rather than the performance of individual subsidiaries or divisions. In
such cases, transfer prices set by the head office may not adequately reflect the
individual performance or value contributions of different units. This can create
conflicts of interest among subsidiaries and hinder cooperation and collaboration.

Distorted performance evaluation: Transfer prices have a significant impact on the

performance evaluation of different business units within a company. If head office
management sets transfer prices arbitrarily, it can lead to distorted performance
measures for local managers, making it difficult to assess their true efficiency and
effectiveness. This can result in unfair incentives and demotivate local managers.

PART 2: Example of a situation where this may be appropriate:

For example, if a business unit is selling a product to another business unit within the
same company, it may be in the best interest of the company to set a transfer price that
is lower than the market price. This would allow the buying unit to purchase the
product at a lower cost and increase its profitability. However, if the selling unit is
setting a transfer price that is too low, it may not be covering its costs and may not be
profitable

One example of a situation where it may be appropriate for head office management
to dictate transfer prices is when there is a need for standardized pricing across
different subsidiaries or divisions within the company.

Consider a multinational corporation with several subsidiaries operating in different

countries. If the company wants to ensure consistency and uniformity in pricing for its
products or services across all regions, it may be necessary for head office
management to set transfer prices.

In industries where pricing is highly regulated or standardized, such as

pharmaceuticals or telecommunications, maintaining consistent pricing can be crucial.
This approach allows the company to present a unified pricing strategy to customers
and ensures that there is no significant price discrepancy between regions that may
lead to customer dissatisfaction or market distortions.

Additionally, when intellectual property or unique technologies are involved, head

office management may need to set transfer prices to protect the company's intangible
assets and maintain control over their value. By centralizing the pricing decisions, the
company can ensure that the appropriate value is attributed to the intellectual property
transferred between subsidiaries.

6. Why might some organizations use standard cost as the basis for their
transfer prices rather than actual cost? Provide an example to illustrate
 your answer

Standard costs are the estimated labor, material, and other production costs. Actual
costs are those during the period and compared at the end. If the actual cost is higher
than the standard, it creates an unfavorable variance. Some organizations use standard
cost as the basis for their transfer prices rather than actual cost due to some several
reasons:
a. Consistency and Predictability
 Standard costs provide a consistent and predictable basis for
calculating transfer prices across different departments or divisions
within an organization. By using predetermined standards for pricing,
organizations can establish a stable pricing structure that facilitates
planning, budgeting, and decision-making processes.
b. Performance Evaluation and Incentives
 Standard costs enable organizations to evaluate the performance of
different departments or divisions based on predetermined cost targets.
By comparing actual costs against standard costs, management can
assess the efficiency and effectiveness of each unit. This evaluation
can then be used to reward or incentivize high-performing units,
encouraging cost control and productivity improvements.
c. Encouraging Cost Control and Cost Planning
 Standard costs allow organizations to set cost benchmarks and plan
their operations accordingly. By establishing predetermined cost levels
for different inputs, organizations can assess the impact of cost
changes, optimize resource allocation, and identify areas for cost
reduction.
If use actual cost, it will be influenced by many factors which not reflect the true costs
of production. It is better to use standard cost

For example, let’s say that a company has two divisions: Division A and Division B.
Division A produces a product that is sold to Division B. The cost of producing the
product is $100 per unit. If Division A sells the product to Division B at $100 per unit
(actual cost), then there is no profit for either division. However, if Division A sells
the product to Division B at $120 per unit (standard cost), then there is a profit of $20
per unit for Division A and a loss of $20 per unit for Division B.

Basing transfer prices on actual costs allows an inefficient supplying unit to pass
excessive production costs on to the buying unit within the transfer price. Actual costs
can be influenced by various factors, such as inventory fluctuations, one-time
expenses or irregular events, which may not accurately reflect the true cost of
production. Hence, by using standards costs can help eliminate these temporary cost
distortions.

Moreover, when standard costs are used in transfer pricing formulas, the supplying
unit is given an incentive to control its costs. Since any actual cost inefficiencies
cannot be passed on in the transfer price. Organisations can promote cost-conscious
behaviour and encourage continuous improvement in operations.