MANAGEMENT CONTROL SYSTEMS

UNIVERSITY QUESTION - ANSWERS

Year 2001 to 2008

Q5. What is the concept of free cash flow as applied to organization. Explain process of computation? We define net cash flow as net income plus non cash adjustment which typically means net income plus depreciation though that cash flows cannot be maintained over time unless depreciated fixed assets are replaced. So management is not completely free to use its cash flows 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 the company has made all the investment in fixed assets and working capital necessary to sustain ongoing operation. When we studied income statement in accounting the emphasis was probably on the firms net income, which is accounting profit. However the value of companys operation is determined by the stream of cash flows that the operations will generate now and in the future. To be more specific, the value of operation depends on all the future expected free cash flows, defined as after- tax operating profit minus the amount of new 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 their free cash flow. Uses of FCF: 1. Pay interest to debt holders, keeping in mind that the net cost to the company is the after 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 equal to FCF. For example, a company might pay interest and dividends, issue new debts, also sell some 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 non cash charge which is $100million then its operating cash flow in 2001 would be NOPAT plus any non cash adjustment on the statement of cash flows. Operating cash flow =NOPAT +depreciation (non cash adjustment) = $17.03 + $100 = $270.3

Company has $1,455million operating assets, at the end of 2000, but $1,800 at the end of 2001.it made a net investment in operating assets of $18, 00 - $1,455 = $345million If net fixed assets rose from $870million to $1000million however company reported $100million of depreciation. So its gross investment in fixed assets would be Gross investment = net investment + depreciation = $130 + $100 = $230million Company free cash flows in 2001 was FCF = operating cash flow gross investment in operating assets = $270.3 - $445 = - $174.7million An algebraically equivalent equation is FCF = NOPAT - Net investment in operating assets = $170.3- $345 = - $174.7million Even though company had a positive NOPAT, its very high investment in operating assets resulted in a negative free cash flow. Because free cash flow is what is available for distribution to investor, not only was there nothing for investors, but investor actually had to provide additional money to keep the business ongoing. A negative current FCF not necessarily bad provided it is due to the high growth or to support the growth. There is nothing wrong with profitable growth; even it causes negative free cash flow in the short term

Q7)

Girish Engineering (MCS-2004) Numerical

Responsibility budgeting was introduced in a medium sized organization Girish Engineering. Monthly report (in part) for an expense centre in factory is: All figures in Rs. Lacs Actual Variance Direct Labour 100.13 0.21 (Favourable) Indirect Labour 66.34 8.10 (Unfavourable) Total Controllable Costs 168.47 8.50 (Unfavourable) Department Fixed Costs 38.82 -------Allocated Costs 53.62 -------Questions: 1. Why no variance is shown in two items? Is this correct approach in performance reporting? 2. Should overhead expenses mentioned above be included in Controllable Costs? Why? Why not? Solution (a): Variances between actual and budgeted departmental fixed costs are obtained simply by subtraction, since these costs are not affected by either the volume of sales or the volume of production. Thats why no variance is shown for departmental fixed costs. Allocated costs are a share of the costs of a resource used by a project, where the same resource is also used by other activities. These are different to the Incurred costs because these costs are not exclusively related to any individual project. However, the cost of the resource still needs to be recovered, and making a fair and reasonable charge 2

to all projects using the resource does this. The key difference between costs and Allocated costs is that the latter will be charged based upon an estimate, rather than actual cash values. Thus as it is charged based upon an estimate the budgeted figure is the same as the actual figure and hence no variances. Solution (b): Overhead Expenses mentioned above should not be included in controllable costs because some costs are uncontrollable like fixed costs. . They don't vary with the change in short run managerial decisions and output. And some costs are controllable i.e. they can be managed and changed with the managerial decisions and output. As the above overhead expenses would have certain portion of fixed expenses this is hard to control. So, these should not be a part of controllable cost. Q8. ABC ltd. (MCS-2008) Numerical Particulars ROI Sales Investment EBIT Division X (Rs.) 28% 100 Lacs 25 lacs 7 Lacs Division Y (Rs.) 26% 500 lacs 100 Lacs 26 lacs

Analyze and comment upon performances of both the divisions Solution: Division X ROI Profit Profit margin Turnover of investments = = = = = = = = = = = = = = = = = = (Profit / investment)* 100 (28/100)*25lacs 7lacs (Profit/sales)*100 (7/100)*100 7lacs (Sales/investment)*100 (100/25)*100 4 times (Profit / investment)* 100 (26/100)*100lacs 26lacs (Profit/sales)*100 (26/500)*100 5.2lacs (Sales/investment)*100 (500/100)*100 5 times

Division Y ROI Profit Profit margin Turnover of investments

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

Q9: Kiran Company (MCS-2004) Numerical Budget versus Actual comparison for div Z of Kiran company is as follows:

Budget Actual Sales and other income Variable expenses Fixed expenses Sales promotional expenses Operating profit Net working capital Fixed assets 800 480 120 40 160 400 160 740 436 120 28 156 412 148

Actual better (worse) than budget (60) 44 0 12 4 12 (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 budgeted operating profit and actual operating profit. In order to analyze the variances, we need to understand the key causal factors that affect profit, namely, revenues and cost structure. The profit 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 this expectation. Revenue variances, that is a negative Rs 60 lakhs, could be a result of selling price variance, mixed variance and/or volume variance. A combination of above three factors must have been unfavorable that is either the volume of sales must have been below the budgeted volumes ( this must be particularly true since actual variable expenses are less than budgeted) and/or the selling price must have been below expectation and/or the proportion of products 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 beyond the managements control and largely dependent on the state of economy. Variable expenses are directly proportional to volumes and hence as is evident are less than 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 working capital is more than budgeted which indicates capital block in higher inventory. Another issue is that the fixed assets are lower than the budget by Rs 12 lakhs which may indicate slower capacity 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 that estimates the as realistic as possible. Given the estimates are correct, in that case depending upon the above analysis, the management needs to take corrective action areas needing improvement, sales volume could be improved by better marketing, quality standards and promotional efforts, product mix could be improved by selling more of higher contribution products. Better sales will ensure a higher inventory turnover. Better credit management to recover receivables, will ensure improve cash flow situation since less capital will be tied up in working capital. 4

Q10 : Shandilya Ltd. (MCS-2008) Numerical Shandilya Ltd. has adopted Economic Value Added (EVA) technique for the appraisal of performance 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 :Div A Div B Div C Total Particulars
Budgete d Actua l Budgete d Actua l Budgete d Actua l Budgete d Actua l

Profit Current Assets Fixed Assets Solution: Particulars

360 400

320 360

220 800

240 760

200 1200

200 1400

780 2400

760 2520

1600

1600

1600

1800

2000

2200

5200

5600

Div A Budgete d Actua l

Div B Budgete d Actua l

Div C Budgete d Actua l

Total Budgete d Actua l

ROA EVA

18% 208

16% 170.4

9% 44

9% 50.4

6% -32

6% -60

10% 220

9% 160.8

b) Comment upon both methods, based on results. There are three apparent benefits of an ROA measure. First, it is a comprehensive measure in that anything that effects the financial statements is reflected in this ratio. Secondly, ROA is easy to calculate, easy to understand, and meaningful in absolute sense. Finally, it is a common denominator that may be applied to any organizational units responsible for profitability, no matter what its size or what business it practices. The performance of different units may be compared directly to each other. Also, ROI data is available for competitors that can be used as a basis for comparison. Nevertheless, the EVA approach has some inherent advantages over ROA. There are three compelling reasons to use EVA over ROI. First, with EVA all business units have the same profit objective for comparable investments. The ROI approach, on the other 5

hand, provides different incentives for investment across business units. For example, a business unit that is currently achieving 30% ROA would be most reluctant to expand unless it is able to earn a ROI of 30% or more on additional assets. Second, decision that increase a centres ROI may decrease its overall profits. Third advantage of EVA is that different interest rates may be used for different types of assets. For example, a relatively low rate May be used 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 Budgeted Actual Actual (Rs. Per (Total in Rs.) (Rs. Per (Total in For 20,000 Units For 19,600 Units Unit) Unit) Rs.) 20 4,00,000 20 3,92,000

Direct and Variable Labour Cost Material Cost Fixed Overheads Total Cost Transfer Price Profit Investment ROI = Profit/Investment

60 20 100 120 20 20

12,00,000 4,00,000 20,00,000 24,00,000 4,00,000 20,00,000 20%

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11,17,200 4,00,000 19,09,200 23,49,200 4,40,000 22,00,000 20%

119.86

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 6

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

Therefore, Div A should purchase from outside. Particulars Total Purchase Cost Total outlay if transferred inside Total opportunity cost if transferred Total relevant cost Net advantage/disadvantage to company as a whole if it buys from inside 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 of its Product C (sold to outside market). Intra company transactions rule: standard cost plus a 10 percent return on fixed assets and inventory, to be paid by the buying division. Standard Cost per Unit *Purchase of outside material Direct. Labour Variable overhead *Fixed overhead per unit. Average Inventory Net Fixed Assets Standard Production (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Units) Product A 40 20 20 60 14 lacs 6 lacs 2 lacs Product B 60 20 20 60 3 lacs 9 lacs 2 lacs Product C 20 40 40 20 6 lacs 3.2 lacs 2 lacs Option A Amount 1,00,00,000 95,00,000 95,00,000 5,00,000 Option B Amount 92,00,000 95,00,000 92,00,000 (3,00,000) Option C Amount 1,00,00,000 95,00,000 14,50,000 1,00,00,000 (9,50,000)

(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) Direct Labour (20 * 2 lac units) Variable O.H. (20 * 2 lac units) + 10% on (FA + Inventory) i.e. 10% on 20 lacs

80,00,000 40,00,000 40,00,000 1,60,00,000 2,00,000 1,62,00,000

Transfer Price for Product A = 1,62,00,000 = 81 2,00,000 Standard Cost of Product B Outside material (60 * 2 lac units) Direct Labour (20 * 2 lac units) Variable O.H. (20 * 2 lac units) + 10% on (FA + Inventory) i.e. 10% on 12 lacs

1,20,00,000 40,00,000 40,00,000 2,00,00,000 1,20,000 8

2,01,20,000 Transfer Price for Product A = 2,01,20,000 = 100.6 2,00,000 Standard Cost of Product C Outside material (20 * 2 lac units) Direct Labour (40 * 2 lac units) Variable O.H. (40 * 2 lac units) Fixed O.H. (20 * 2 lac units) 40,00,000 80,00,000 80,00,000 20,00,000 2,20,00,000

(b): While arriving at the cost of Product C, margins of Product A, which become an input to Product B, and Product B, which in turn become an input to Product C, are added. So when it is sold to outside market, it suffers a disadvantage from its competitors as far as pricing is concerned, as its price will normally be high compared to products of similar category. So it might become uncompetitive. But in the long run, customers will distinguish between a good product and a bad product and the one with the best quality will survive. So if the quality of product C is better than its competitors 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 then come out with Product C with a lower price tag on it. This may do well to the product by making higher revenues and capturing the market share.

Q33. Ananya & Company comprises of five divisions A, B, C, D and E and the present performance. metric is return on assets. However, the controller has suggested management to 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 A B C ________ D E Profit 300 220 100 110 180 Fixed Assets 800 400 600 400 200 Current Assets -160 ---1600 1000 800 800

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, 9

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 lakhs B = 220 (0.10*400) + (0.05*1600) = 100 lakhs C = 100 (0.10*600) + (0.05*1000) = -10 lakhs D = 110 (0.10*400) + (0.05*800) = 30 lakhs E = 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) 212 100 -10 30 120

A 31.25% B 11.00% C 6.25% D 9.17% E 18.00% 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 which is the least among the five divisions. 5. The above reason holds true for the poor performance of divisions C and D as can be seen that they have a huge amount invested in current assets which does not indicate good signs about their operational efficiency. 6. A company which is into an expansion and overall growth mode primarily invests into fixed assets and this is also one of the major reasons why the performance of division A is the best amongst all. 7. Though division C has also invested a huge amount in fixed assets the advantage is offset due 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 it has 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 up either in debtors or inventory or rather it is holding a large amount of cash which is not a good 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, Black and White, spare parts(SP) and servicing (SG) each headed by manager BTV in addition to BVTV sales; also sells old TV exchanged (under scheme) by customer while purchasing new TV . in one particular instance a new TV was sold for 14150(financed by cash rs2000, Bank loan 7350and Rs 4800;exchange price for old TV agreed by CTV manager )cost of new TV was Rs 11420. Shivangi Manager of BTV, examined the old TV (valued at Rs 3500 by TV trade 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 to BTV by SP and SG are at market rates Rs235 for parts by SP and Rs 470 for services by SG. 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 Rs 835;BTV Rs 665;SP RS 32 ;SG Rs 114. Compute the profitability of the transaction assuming sales commission of $250 for the trade in 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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Particulars Sales Selling commission Gross profit Overhead

New TV 14150 0 2730 835

OLD TV 5000 250 -505 665 470 -1640

Service 470 0 470 114 0 591

Parts 235 0 235 32 0 123

Servicing 0 Net profit before common exp 1895 If the trade-in is recorded @ $3500

Particulars Sales Selling commission Gross profit Overhead Servicing

New TV 14150 0 2730 835 0

OLD TV 5000 250 1045 665 470

Service 470 0 470 114 0

Parts 235 0 235 32 0

Net profit before common exp

1895

-340

356

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 B Divisional sales 4000000 9600000 Divisional Investment 2000000 3200000 Profit 400000 640000 Analyse and comment on divisional performance of each. ANSWER As Profit Margin = Profit *100 Sales 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 Profit centers. Div A normally purchases annually 10000 nos. of required components from Div 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 at Rs.1000 p.u Div B is not happy and justified its decision to increase price due to inflation and added that the overall company profitability will reduce and decision will lead to excess capacity in Div B, whose V.C and Fixed cost p.u. are Rs. 950 and Rs.1100. 1. Assuming that no alternate use exists for excess capacity in Div B, will company 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 the company (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 yearly costs savings of Rs. 14.5 lacs, should Div A purchase from outside? Justify your answers with figures ANSWER 1) Division A action BUY OUTSIDE (Rs.) Total Purchase 10,00,000 Cost Total Outlay Cost Nil Net Cash Outflow To The Company As A Whole 10,00,000 (Rs.) Nil 9,50,000 9,50,000 BUY INSIDE

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 action BUY OUTSIDE (Rs.) Total Purchase 9,20,000 Cost Total Outlay Cost Nil Net Cash Outflow To The Company As A Whole 9,20,000 (Rs.) BUY INSIDE Nil 9,50,000 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 of Rs. 14.5 lakhs

Division A action 14

BUY OUTSIDE (Rs.) Total Purchase Cost Total Outlay Cost Revenue From Using These Facilities Net Cash Outflow To The Company As A Whole 10,00,000 Nil 1,45,000 8,55,000 Nil

(Rs.) BUY INSIDE

9,50,000

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 Cost of critical component for division X Cost of other material Fixed & processing costs Total cost for division X Selling price of final product Net loss for division X Desired profit for division X Amount (Rs./unit) 220 500 290 1010 1000 10 60 Amount (Rs./unit)

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 Cash inflow (a) Cash outlay: Variable cost for division Y 5 (Working note) Amount (Rs. Lakh) Amount (Rs. Lakh) 50 (5000 Rs.1000/unit) units *

Material bought by division X 25 (5000 units * Rs.500/unit) from outside Total cash outlay (b) Net cash inflow to Company as a whole [(a)- (b)] 30 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:16

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 Selling price p.u. Variable Cost p.u. Contribution p.u. Contribution p.u. 24 24 24 Expected sales (no. of units) 2000 3000 6000 Amount(Rs.) 35 11 24 Total contribution 48000 72000 144000 Total Fixed cost Net profit (Rs.) (Rs.) 60000 (12000) 60000 12000 60000 84000

ii) Profitability statement of Division B:Total Contribution Expected variable p.u. sales (no. cost p.u. of units) 90 42 48 2000 80 42 38 3000 50 42 8 6000 [Note: Total Variable cost p.u. = Variable cost p.u. product (Rs.35)] Selling p.u. Total Fixed cost (Rs.) 96000 90000 114000 90000 48000 90000 (Rs.7) + Transfer price of Total contribution Net profit (Rs.) 6000 24000 (42000) intermediate

iii) Profitability statement of Company as a whole:Expected sales 2000 3000 6000 Net profit of division Net profit of Division Total Net profit A (Rs.) B (Rs.) (12000) 6000 (6000) 12000 24000 36000 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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