PROFIT PERFORMANCE MEASUREMENTINTRA COMPANY TRANSFER PRICINGPRODUCT 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 % 2 20 %

8 % 2.5 20

6 % 3.3 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%

Residual income

1 77 480 96 (19)

2 77 320 64 13

3 77 160 32 45

Present value of residual income

19.25

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

Management’s 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 department’s 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 department’s 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 department’s final product

cost = Rs.60 but wants to sell at Market

price Rs.100 Sewing department ‘s raw material

wants to purchase at =Rs.60Negotiated 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 department’s final product

cost = Rs.60 but wants to sell at Market

price Rs.100 Sewing department ‘s raw material

wants to purchase at =Rs.60Price by top management = Rs.85

Dual Transfer Pricing

Different price for consuming &

producing division

Eliminate all encountered Problems

Example

Chenab textile Weaving department’s 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

VCper unit

FC Profit

16 60000 960000 420000 300000 240000

14 80000 1120000 560000 300000 260000

12 100000 1200000 700000 300000 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 x 20% =80%

5000000

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 Product A Product B

DM $6 $3

DL 2 4

FOH 1 2

TMC $9 $9

Sale Price 10 10

Gross Profit $1 $1

Other methods

Contribution Margin Price approach

to Pricing

Standard Cost for Pricing

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