MCS Mayur Shah

Transfer Pricing At Hindustan Petroleum

EX.1
Hindustan Petroleum has two divisions. Each operates as a profit center. The transportation
division purchases crude oil in Ankleshwar, Gujarat. It operates a pipeline that transports crude
oil from Ankleshwar to Mathura, U.P. the Refining Division manages a refinery at Mathura that
processes crude oil into gasoline (petrol). It takes two barrels of crude oil to yield one barrel of
gasoline.

Variable costs in each division are variable with respect to a single cost driver in each division:
barrels of crude transported by the Transportation Division, and barrels of gasoline produced by
the Refining Division. Fixed costs per unit are based on the budgeted annual out put of crude oil
to be transported and the budgeted annual output of gasoline to be produced.
• The transportation Division has obtained the rights certain oilfields in the ankleshwar
area. It has a long term contract to purchase crude oil produced from these fields at Rs.
120 per barrel. Division transports the oil to Mathura and then “sells” it to the Refining
Division. The pipeline from Ankleshwar to Mathura has the capacity to carry 40,000
barrels of crude oil per day.
• The refining division has been operating at capacity (30000 barrels of crude oil a day),
using oil supplied by HP’s transportation Division (an average of 10000 barrels per day)
and oil bought from other producers and delivered to the Mathura Refinery (an average of
20000 barrels per day at 210 per barrel).
• The refining division sells the gasoline it produces at Rs. 580 per barrel.

External market:
Transportation division
Contract price Variable cost per barrel of crude oil Rs. 10
for supplying crude Fixed cost per barrel Rs. 30
oil = Rs. 120 per barrel

Refining division
External Market: Variable cost per barrel of gasoline Rs. 80
Market price of outside Fixed cost per barrel of gasoline Rs. 60
Supplies to Mathura
Refinery = Rs. 210
per barrel

Calculate Transfer prices from transportation Division to Refining Division under each of the
three methods are: (Take 100 barrels as base.)
• Method A: market based transfer price of Rs. 210 per barrel of crude oil based on the
competitive market price in Mathura

• Method B: cost based transfer prices at, say , 110% of full costs, when full cost are the
costs of the crude oil purchased plus the Transportation Division’s own variable and
fixed costs: 1.1 X (Rs. 120 + Rs. 10 + Rs. 30) = Rs. 176

• Method C: negotiated transfer price of Rs. 192.5 barrel of crude oil, which is between the
market-based and cost-based transfer prices.
Find out operating income (per 100 barrels). Which division will favour which method of transfer
price based on operating income?

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MULTINATIONAL TRANSFER PRICING AND TAXATION
EX.2
Anita corporation, headquartered in India, manufactures state of the art milling machines in India.
It has two marketing subsidiaries, one in brazil and one in Switzerland, that sells its products.
Anita is building one new machine, at a cost of Rs. 5,00,000. there is no market for equipment in
India. The equipment can be sold in brazil for Rs. 10,00,000, but the Brazilian subsidiary would
incur transportation and modification costs of Rs. 2,00,000. Alternatively, the Equipment can be
sold in Switzerland for Rs. 9,50,000, but the Swiss subsidiary would incur transportation and
modification costs of Rs. 2,50,000. the Indian company can sell the equipment to either its
Brazilian or its Swiss subsidiary, but not to both. The Anita Corporation and its subsidiary
companies operate in a very decentralized manner. Mangers in each company have considerable
autonomy, with managers interested in maximizing their own company’s income.

Required:
1. From the viewpoint of Anita and its subsidiaries taken together, should the Anita
corporation manufacture the equipment? If it does, where should it sell the equipment to
maximize total operating income? What would the operating income? For Anita and its
subsidiaries be from the sale? Ignore any income tax effects.
2. what range of transfer prices will be optimal for brazil and swiss subsidiary as per
requirement 1 ? Explain.
3. The effective income tax rates are as follows: 40 % in India, 60% in brazil, 15% in
Switzerland. The tax authorities are uncertain about the cost of intermediate product and
will allow any transfer price between Rs. 5,00,000 and Rs. 7,00,000. if Anita and its
subsidiaries want to maximize after tax operating income, (a) should the equipment be
manufactured, and (b) where and at what price should it be transferred and sold? Show
your computations.

EX.3
User Friendly computer inc., with headquarters in San Francisco, manufactures and sells desktop
computers. User friendly has three divisions, each of which is located in a different country:
a. China division – manufactures memory devices and key boards.
b. South Korea division – assembles desktop computers using internally manufactured parts
and memory devices and keyboards from the China division
c. US division – packages and distributes desktop computers.

Each division is run as a profit center. The costs for the work done in each division for a single
desktop computer are as follows:

China division: variable costs = 1000 yuan

Fixed costs = 1800 yuan

South korea division: variable costs = 3,60,000 won

Fixed costs = 4,80,000 won

U.S. division: variable costs = $ 100

Fixed costs = $ 200.
Chinese income tax rate on China division’s operating income: 40 %
South Korean income tax rate on south Korean division: 20 %
U.S. income tax rate on US division’s income: 30 %
Each desktop is sold to retail outlets in US for $ 3200. Assume that the current fireign exchange
rates are:
8 yuan = $ 1 US
1200 won = $ 1 US

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Both the china and south korea divisions sells part of their production under a private label. The
china division sells the comparable memory / keyboard used in each User friendly computer to a
Chinese manufacturer for 3600 yuan. The south korea division sells the comparable desktop
computer to a south Korean distributor for 1560000 won.

(1). Calculate the after tax operating income per unit earned by each division under the following
transfer pricing methods: (a) market price. (b) 200 % of full costs, and (c) 300 % of variable costs
(2). Which transfer pricing method will maximize net income per unit of User Friendly Inc.?

Ex.4
Better Food Company recently acquired an Olive oil processing company that has an annual
capacity of 2,000,000 liters and that processed and sold 1,400,000 liters last year at a
market price of Rs.4 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. Production costs at capacity of the olive
oil company, now a division, are as follows:

Direct materials per liter Rs.1.00

Direct processing labor 0.50
Variable processing overhead 0.24
Fixed processing overhead 0.40
Total Rs.2.14

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 Olive Oil Division argues that Rs.4,
the market price, is appropriate. The manager of the Cooking Division argues that the cost
of Rs.2.14 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 Rs.4 per liter.

Required:
a. Compute the operating income for the Olive Oil Division using a transfer price of
Rs.4.
b. Compute the operating income for the Olive Oil Division using a transfer price of
Rs.2.14.
c. What transfer price(s) do you recommend? Compute the operating income for the
Olive Oil Division using your recommendation.

TRUE/FALSE (relate with chapter theory)

1. The goal of a management control system is to improve the collective decisions in an

organization in an economically feasible way.

Answer: True Difficulty: 1 Objective: 1

2. Management control systems reflect only financial data.

Answer: False Difficulty: 1 Objective: 1

Management control systems also reflect non financial data.

3. Information in a management control system report at the individual-facility level would

include information on employee absenteeism.

Answer: True Difficulty: 1 Objective: 1

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4. Presenting financial and nonfinancial information in a single report is called the unified
reporting method.

Answer: False Difficulty: 1 Objective: 1

This is called the balanced scorecard.

5. Motivation is the desire to attain a selected goal combined with the resulting drive or
pursuit towards that goal.

Answer: True Difficulty: 1 Objective: 1

6. The essence of decentralization is the freedom for managers at lower levels of the
organization to make decisions.

Answer: True Difficulty: 1 Objective: 1

7. Suboptimal decision making is also called congruent decision making.

Answer: False Difficulty: 2 Objective: 2

It’s also called incongruent decision making.

8. Surveys indicate that decisions made most frequently at the corporate level are related to
sources of supplies and products to manufacture.

Answer: False Difficulty: 2 Objective: 2

These decisions are made at a decentralized level.
9. An important advantage of decentralized operations is that it improves corporate control.

Answer: False Difficulty: 1 Objective: 2

Decentralized operations weaken controls.

10. Products transferred between subunits within an organization are considered intermediate
products.

Answer: True Difficulty: 1 Objective: 3

11. The costs used in cost-based transfer prices can only be actual costs.

Answer: False Difficulty: 2 Objective: 4

The costs can also be budgeted costs.

12. The choice of a transfer-pricing method has minimal effect on the allocation of company-
wide operating income among divisions.

Answer: False Difficulty: 2 Objective: 3

The choice of a transfer-pricing method has a large effect.

13. No matter how low the transfer price, the manager of the selling division should sell the
division's product to other company divisions in the interests of overall company
profitability.

Answer: False