PROFIT PERFORMANCE MEASUREMENT INTRA COMPANY TRANSFER PRICING PRODUCT PRICING METHOD

Capital employed
Rate of Return on Capital Employed Based on

% age of profit to sales capital employed turnover

Rate of Return on Capital Employed

NPM

TATO

Rate of Return

10 %
8% 6%

2
2.5 3.3

20 %
20 20

Types of Profits
Gross profit

sales COGS Operating Profit GP-operating expenses Income Before tax Operating profit - interest Net income EBT-Tax

Departmental Rates of Return

Allocation of sales

Allocation of cost
Allocation of assets

Divisional Rate of Return On Capital Employed

Return on capital employed

Residual income figure

Calculation
Year Net Income Investment Cost of capital at 20%
96 64 32

Residual income
(19) 13 45 19.25

1 2 3

77 77 77

480 320 160 Present value of residual income

Importance of Rate of Return on Capital Employed

For internal profit measurement Internal control As a tool for planning Measuring operational profitability Cooperative efforts of divisions for profit Establishing Budgets

Advantages
Managements attention upon the earning

the best profit possible on the capital Measures management efficiency and effectiveness Tie- financial planning, sales objectives, cost control and profit goal Comparison of results Develop sense of responsibility

Limitations
Lack of agreement

Valuation of assets
Danger to long run interest

Neglect desirable activities

MULTIPLE PERFORMANCE MEASUREMENT

Previous years

Budget

Intra Company Transfer Pricing

Transfer price is a value assign to goods and services sold or rented from one unit of an organization to another.

Fundamental Criteria of Transfer Pricing

Helps management to judge the profit accurately division

wise

Motivate the divisional manager

Increase management efficiency

Methods of Intra Company Transfer Pricing

Transfer Pricing based on Cost Market based Transfer Pricing Negotiated Transfer Pricing Arbitrary Transfer Pricing Dual Transfer Pricing

Transfer Pricing Based on Cost

Useful for centralized firm

Measuring management performance

Simplicity

Not suitable for decentralized company

Example
Chenab textile Weaving departments final product cost

= Rs.60 Sewing department s raw material =Rs.60

Market based Transfer Pricing

Best for profitability and performance measurement

Reflects a product profitability

Used in competitive markets

But it is difficult to calculate actual cost

Example
Chenab textile Weaving departments final product cost

= Rs.60 Sewing department s raw material =Rs.100

Negotiated Transfer Pricing

Setting of price by negotiation.

Diverts Company welfare

Time consuming

Stress to unit managers

Example
Chenab textile Weaving departments final product cost

= Rs.60 but wants to sell at Market price Rs.100 Sewing department s raw material wants to purchase at =Rs.60 Negotiated Price = Rs.80

Arbitrary Transfer Pricing

Setting of price by negotiation but final decision by top

management
De motivation to unit managers

Hampers profit objective

Example
Chenab textile Weaving departments final product cost

= Rs.60 but wants to sell at Market price Rs.100 Sewing department s raw material wants to purchase at =Rs.60 Price by top management = Rs.85

Dual Transfer Pricing

Different price for consuming & producing

division

Eliminate all encountered Problems

Example
Chenab textile Weaving departments final product cost

= Rs.60 but records the sale at Market price Rs.100 Sewing department s raw material records at Rs. 60

Product Pricing Methods

Pricing is a complex job

Coordination &cooperation of economists,

statisticians, market specialists,etc is required

Cost-starting point of price determination

.contd
Price setting

an art Prices are influenced by Competitors Customers willingness Governmental regulations

Methods of price determination

Profit Maximization
Sale price per unit No. of uints to be sold Total sales volume VC per unit FC Profit

16 14 12

60000 80000 100000

960000 1120000 1200000

420000 560000 700000

300000 300000 300000

240000 260000 200000

Pricing based on return on capital

%age markup=capital employed x desired rate of return on capital employed total annual cost %age markup= 20000000 5000000 x 20% =80%

Sale volume = total annual cost +(%age markup x total annual cost) = 5000000+ (80% x 5000000) =9000000

. contd
price = total cost+ (desired rate of return x total capital employed) sale volume in units

=$210000+(20% x 2000000) 50000 =$5

Conversion cost pricing

Conversion cost = DL + FOH
Item of cost DM DL FOH TMC Sale Price Gross Profit Product A $6 2 1 $9 10 $1 Product B $3 4 2 $9 10 $1

Other methods
Contribution Margin Price approach to

Pricing
Standard Cost for Pricing

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QUESTIONS

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