Transfer pricing

The Rotech group comprises two companies, W Co and C Co.
W Co is a trading company with two divisions: The Design division, which designs wind turbines and supplies the
designs to customers under licences and the Gearbox division, which manufactures gearboxes for the car industry.
C Co manufactures components for gearboxes. It sells the components globally and also supplies W Co with
components for its Gearbox manufacturing division.
The financial results for the two companies for the year ended 31 May 2014 are as follows:
W Co C Co
Design division Gearbox division
$’000 $’000 $’000
External sales 14,300 25,535 8,010
Sales to Gearbox division 7,550
–––––––
15,560
–––––––
Cost of sales (4,900) (16,200)* (5,280)
Administration costs (3,400) (4,200) (2,600)
Distribution costs – (1,260) (670) ––––––– ––––––– –––––––
Operating profit 6,000 3,875 7,010 ––––––– ––––––– ––––––– ––––––– ––––––– –––––––
Capital employed 23,540 32,320 82,975
* Includes cost of components purchased from C Co.
Required:
(a) Discuss the performance of C Co and each division of W Co, calculating and using the following three
performance measures:
(i) Return on capital employed (ROCE)
(ii) Asset turnover
(iii) Operating profit margin
Note: There are 4·5 marks available for calculations and 5·5 marks available for discussion. (10 marks)
(b) C Co is currently working to full capacity. The Rotech group’s policy is that group companies and divisions must
always make internal sales first before selling outside the group. Similarly, purchases must be made from within
the group wherever possible. However, the group divisions and companies are allowed to negotiate their own
transfer prices without interference from Head Office.
C Co has always charged the same price to the Gearbox division as it does to its external customers. However,
after being offered a 5% lower price for similar components from an external supplier, the manager of the Gearbox
division feels strongly that the transfer price is too high and should be reduced. C Co currently satisfies 60% of
the external demand for its components. Its variable costs represent 40% of revenue.
Required:
Advise, using suitable calculations, the total transfer price or prices at which the components should be
supplied to the Gearbox division from C Co. (10 marks)
(20 marks)
.The Rotech group comprises two companies, W Co and C Co.
W Co is a trading company with two divisions: The Design division, which designs wind turbines and supplies the
designs to customers under licences and the Gearbox division, which manufactures gearboxes for the car industry.
C Co manufactures components for gearboxes. It sells the components globally and also supplies W Co with
components for its Gearbox manufacturing division.
The financial results for the two companies for the year ended 31 May 2014 are as follows:
W Co C Co
Design division Gearbox division
$’000 $’000 $’000
External sales 14,300 25,535 8,010
Sales to Gearbox division 7,550
–––––––
15,560
–––––––
Cost of sales (4,900) (16,200)* (5,280)
Administration costs (3,400) (4,200) (2,600)
Distribution costs – (1,260) (670) ––––––– ––––––– –––––––
Operating profit 6,000 3,875 7,010 ––––––– ––––––– ––––––– ––––––– ––––––– –––––––
Capital employed 23,540 32,320 82,975
* Includes cost of components purchased from C Co.
Required:
(a) Discuss the performance of C Co and each division of W Co, calculating and using the following three
performance measures:
(i) Return on capital employed (ROCE)
(ii) Asset turnover
(iii) Operating profit margin
Note: There are 4·5 marks available for calculations and 5·5 marks available for discussion. (10 marks)
(b) C Co is currently working to full capacity. The Rotech group’s policy is that group companies and divisions must
always make internal sales first before selling outside the group. Similarly, purchases must be made from within
the group wherever possible. However, the group divisions and companies are allowed to negotiate their own
transfer prices without interference from Head Office.
C Co has always charged the same price to the Gearbox division as it does to its external customers. However,
after being offered a 5% lower price for similar components from an external supplier, the manager of the Gearbox
division feels strongly that the transfer price is too high and should be reduced. C Co currently satisfies 60% of
the external demand for its components. Its variable costs represent 40% of revenue.
Required:
Advise, using suitable calculations, the total transfer price or prices at which the components should be
supplied to the Gearbox division from C Co. (10 marks)
(20 marks)
For the above question, how to know if is it asking for minimum transfer only or is it asking for minimum and maximum transfer prices.
I calculated the minimum transfer price to be 8544000. I calculated the marginal cost to be 3204000 by multiplying the external sales of 8010000 with the variable costs percentage of 40%. Then I calculated the contribution lost value of 5340000, i.e. the value of external demand not satisfied. I don’t understand where I went wrong
The maximum transfer price calculated is 7172500. Are the net marginal revenue figure of 16885000 and external purchase cost figure of 7172500 correct?
Also which costs out of cost of sales, administration costs and distribution costs should be considered as marginal costs.
When calculating the minimum transfer price, the marginal cost was calculated as 40% of revenue because the question mentioned that variable costs are 40% of revenue for C Co. whereas when calculating the net marginal revenue figure for the maximum transfer price, the adjusted cost of sales figure was used. There was no mention of variable cost percentage for gearbox division as was the case for C Co.