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GN51395_Revised/GN51395_Revised.docx
MANAGERIAL ACCOUNTING
Table of Contents
Introduction    3
Discussion    3
Conclusion    6
References    7
Appendices    8
Appendix 1: Base and Revised Case Scenario    8
Appendix 2: Proposed Case Scenario    9
Appendix 3: Key Details of Division D1 and Division D2    10
Introduction
The significance of transfer pricing in determining divisional performance is one of the most discussed topics in the study of Management Accounting as the concept of transfer pricing is considerably impactful in the profitability and performance standards of a business unit, department, division, etc. In this paper, the researcher has discussed the issue of transfer pricing as provided in the given case study and also the ideal transfer pricing policy with respect to the investment and divisional profit in the backdrop of the given case study scenario. Based on the discussion, the researcher has finally provided the recommendation before wrapping up the paper by way of concluding notes.
Discussion
The importance of transfer pricing largely depends upon the business strategy and the operational framework of the business in terms of divisional profit and scaling-up strategy of the firm (https://kfknowledgebank.kaplan.co.uk, 2020). A business may have separate departments or divisions where each of the divisions may be treated as a profit or revenue center. In such a case, it becomes critical for the respective departmental managers to fix such a transfer pricing strategy that may contribute towards the overall profitability position of the business. In short, the transfer pricing policy of a business should be guided from a holistic viewpoint and not from an individual department perspective (https://kfknowledgebank.kaplan.co.uk, 2020).
In the given case study, it has been observed that the company CLUK has two divisions namely division D1 and division D2. The production is being performed in D1 and the final output of D1 is then transferred to D2 at a predetermined transfer price. In D2, the product is further processed before selling it to the final customers. On the other hand, D1 also sells its product to external customers after fulfilling the total demand for D2. Respective data set are being provided in the given case study and based on which the calculations with respect to the contribution, profitability and ROI has been performed in this paper.
The existing scenario shows that business earns profit from both D1 and D2 by way of selling its products externally. Also, the margin on transfer pricing performed by the D1 while transferring goods to D2 may be considered as part of the total business profit position. The figures in the appendices show that the existing EBIT of D1 may stand at $2,440,000 with an ROI of 61%. ROI has been calculated with reference to the total asset base of $4,000,000 and notional interest has been calculated on the same asset base considering the cost of capital of 7% as given in the case study. Therefore, the residual income may be computed to be $2,160,000 after deducting a notional interest of $280,000 from EBIT. Similarly, for D2, EBIT stands at $1,410,000 with ROI of 11.15% and residual income of $524,500, after adjusting notional interest of $885,500. Combining both the situations, the existing profitability position of the business, as a whole, may be shown in the figure below.
Figure 1: Existing Profitability Position of the Business
(Source: As provided in the case study)
In this context, it is to be noted that the individual ROI figure is radically different from the standard set by the organization at 25%. The departmental manager of D1 will be able to get a bonus on the ground that the divisional ROI has been able to meet the target ROI which will not be available to the departmental manager of D2. This difference may primarily be attributable to the inefficient transfer pricing policy of the business as the same is based on the strategy of full cost plus a markup.
The theory of transfer pricing suggests many different ways out in this situation out of which the opportunity cost proposition may be helpful here. Since D1 sells its product at $0.13 per unit to the external customer, the transfer pricing value based on such opportunity cost will not change the overall profit position of the business but increase the ROI of D2 substantially to 21%.
In addition, the residual income of D2 will also increase more than a hundred percent to $1,764,500. In this context, it is important to analyze the irrelevance of ROI and the importance of residual income. ROI largely depends upon the net asset base of the business and such depreciable asset base may not be treated as a fair basis for computing profitability especially in the backdrop of a long-term project where the net asset base of the business will gradually decrease without corresponding implication in the bottom line of the...