Cost Accounting (17)

8/10/2019 Cost Accounting (17)

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Use of Learning Curve in cost

estimation


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Specific Learning Curves These are given names: such as 80% learning curve, 90% learning

curve etc.

The names are derived from the effect that learning has on average

production time when production time is doubled.

Eg ..If a worker takes 10 minutes to do first unit of a product and

takes 6 minutes to do the second unit of the same product, the

learning effect would be:

Average time to produce one unit ( ) 10 minutes

(when total production is 1 unit)

Average time to produce one unit

when production is doubled ( ) (10+6)/2 . 8 minutes

Therefore, learning effect = 8/10 = 80%

y

y


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17 - 3

Learning effect Approach

the Doubling approach

the equation approach


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the Doubling approach: The popular approach is to restrictoneself to doubling of production.

We take advantage of what we know about the relationship of

average production time and the doubling of production.

Assuming that 1000 direct labour hours are required to produce the

first unit, an 80% learning curve is given as follows:

An 80% learning curve implies that each at production doubling point,the cumulative average time required becomes 80% of what it was at theprevious doubling point. Hence, also known as cumulative average timeapproach.

Drawback: corresponds to doubling points only


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The Equation Approach

Studies have found that when the time spent on successive units is

graphed, it tend to follow an exponential curve, the functional form

of the curve is:

Defined by the equation Yx= Ax-b

where

Yx = average time to produce x units. (dependent variable)

A = time required to produce the 1st

unit of the productx = total no. of unit produced (independent variable)

b(beta)= coefficient that describes the amount of learning

that takes place

From the earlier table in earlier slide, y= 800; a=1000; and x=2 inabove equation we get : 800=(1000)(2)^-b; and to solve it, we use log

So, log 800 = log 1000b log 2

Or b = (log1000log 8000)/log 2 = (3-2.9031)/0.3010 =

0.0969/0.3010 = 0.3219


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Thus, value of b for 80% learning curve is 0.3219.

Such values may be derived for different learning curves.

General equation for the average time to produce a total of x units

at 80% learning curve is:

Y= (1000)(x)^-0.3219

Now, we can find out the value of y at any level of x units at 80%

learning curve on the assumptionthat it continues at the same

rate.

Eg. Y= 1000 * (4)^-0.3219 =640 hrs

Thus, the total time required to produce 4 units : 640*4=2560 hrs

Similarly, for 3 units: y = 1000 * 3^-0.3219 = 702 hrs and total time

= 702*3 = 2106 hrs

Now, time for the 4thunit = 2560-2106 = 454 hrs


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Transfer Pricing

Chapter 22


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Transfer pricing :

It is the determination of an exchange price for a

product or service when different business units within

a firm exchange it. The products can be final product or intermediate

products.

Transfer Price the price one subunit (department or division)

charges for a product or service supplied to another subunit of the

same organization

Management control systems use transfer prices to coordinate the

actions of subunits and to evaluate their performance

The transfer price creates revenues for the selling subunit and purchase

costs for the buyingsubunit affecting each subunitsoperating income


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Setting transfer prices is a difficult process because the price affects

centers profitability.

A high transfer price results in high profit for the selling center

and low profit for the buying center

A low transfer price results in low profit for the selling center and

high profit for the buying center

The price must be set to establish incentives for decentralized centermanagers to make decisions that support the overall goals of the

organization.

Arms Length Price OECD have prescribed guidelines on how Transfer Price could be

based on certain logical and reasonable methodscalling such a

price as Arms Length Price.


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Intermediate Product the product or service transferred between

subunits of an organization

Transfer pricing is one of the most strategic activities in strategicbusiness unit management.

It affects materials and parts sourcing decision, tax planning andpotentially, the marketing of the final and intermediate products.

Eg. A car manufacturer has a separate division that manufacturers

engines. The transfer price is the price the engine division chargeswhen it transfer engines to the car assembly division.

Importance

Transfer of products and services between business units is mostcommon in firms with a high degree of vertical integration.

Vertically integrated firm engage in a number of different value-creating activities in the value chain.

A computer manufacturer must determine transfer prices if it

manufacturers the chips, boards and other components andassembles the computer itself.


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Objective To provide an appropriate incentive for managers to make

decisions consistent with the firms goals.

To provide a basis for fairly rewarding manager. To minimize taxes locally and internationally.

By setting a high transfer price for goods shipped to a relatively hightaxed country, a firm can reduce its firm level tax liability. This would

increase cost and reduce the income of the purchasing unit in thehigh tax country, thereby minimize taxes there and higher profitsshown by the selling unit would be taxed at lower rates in the sellers

home country

To develop strategic partnership.

A high transfer price may induce internal unit to purchase fromexternal suppliers. The external suppliers might get assistance fromthe firm in its effort to supply quality materials to the firm. As a result,

newer or weaker unit becomes more healthy.


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International Objective

Tax issues Minimising custom charges,

Minimising currency restriction and

Minimising risk of expropriation by foreigngovernment.

Expropriation occurs, when a government takes

ownership and control of assets a foreigninvestor has invested in the country.


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Custom Charges

If custom charges are significant on the parts andcomponents imported, relatively low transfer price onthese imports would be beneficial to reduce the customcharges.

Currency Restriction

Repatriations of profits to the parent firm are restricted

in some countries. One way to deal in suchcircumstances, is to set the transfer price in such a waythat the profits become low and repatriations are easy.

Expropriation When risk of expropriation exists, transfer price may be

used as a devise to remove funds from the foreigncountry as quickly as possible.


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Market-based Transfer Prices

Cost-based Transfer Prices

Negotiated Transfer Prices

Three Transfer Pricing Methods

General Transfer-Pricing Rule

Transfer Price =Additional outlay cost per

unit incurred because

goods are transferred+

Opportunity cost per unitto the organization

because of the transfer


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Top management chooses to use the price of similar

product or service that is publicly available. Sources of

prices include trade associations, competitors, etc.

Lead to optimal decision-making when three conditions

are satisfied:

The market for the intermediate product is perfectly

competitive

Interdependencies of subunits are minimal

There are no additional costs or benefits to the

company as a whole from buying or selling in the

external market instead of transacting internally

Market-Based Transfer Prices


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Negotiated Transfer Price It is common for managers to negotiate transfer prices from the

external market price.

This can split the cost savings between both units, but can lead to

divisiveness and competition between investment centers.

Occasionally, subunits of a firm are free to negotiate the

transfer price between themselves and then to decide

whether to buy and sell internally or deal with externalparties

May or may not bear any resemblance to cost or market

data

Often used when market prices are volatile

Represent the outcome of a bargaining process between the

selling and buying subunits


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Negotiated Price Method

Therefore, involves negotiation, arbitration

between units to determine transfer price. It is a better method to avoid conflict and to

agree on an acceptable price.

The disadvantage of this method is that it may

reduce the desired autonomy of the units.

Firms commonly use two or more methods,called dual pricing. When numerous conflicts

exist between two units. standard full cost might be used as the buyerstransfer price, while the seller might use marketprice


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Top management chooses a transfer price based on the costs of

producing the intermediate product. Examples include:Variable Production Costs

Variable and Fixed Production Costs

Full Costs (including life-cycle costs)

One of the above, plus some markup Useful when market prices are unavailable, inappropriate, or too

costly to obtain

Prorating the difference between the maximum and minimum cost-

based transfer prices

Dual-Pricing using two separate transfer-pricing methods to price

each transfer from one subunit to another. Example: selling division

receives full cost pricing, and the buying division pays market pricing

Cost-Based Transfer Prices

Variable Cost


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Variable Cost

The biggest drawback with using variable cost is that when excess capacity

exists, the selling unit cant show contribution margin on the transferred goods.

This method sets the transfer price equal to the selling units variable cost

and used when objective is to satisfy the internal demand for the goods.

The relatively low price encourages buying internally.

This method is not suitable when selling unit is a profit unit.

Full Cost

The biggest drawback affects the buying units view of costs as fixed for thecompany as a whole

This method sets the transfer price equal to variable costs plus

selling units allocated fixed cost. The advantage is that the price is

well understood and information is readily available in accounting

records. Disadvantage is that the price includes fixed costs, which are some

time erroneous, because of improper uses of allocation bases.


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Comparison of Transfer-Pricing Methods


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Right Transfer Price

Three key factors are to be considered for

decision on right transfer price: Existence of outside supplier

Sellers variable cost less than market price

Selling unit operating at full capacity.


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Existence of outside supplier

If no outside supplier --- the best transfer price is on cost ornegotiated price.

If there is an outside supplier, market price should be considered inrelation to sellers variable cost

Sellers variable cost less than market price

If variable cost is more than market price , the buyer should buy

outside. If variable cost is less than the market price, the transfer priceshould be the market price.

Selling unit operating at Full Capacity

If internal buyer does not cause any disruption of sales opportunities

outside, the transfer price should be between variable cost andmarket price.

If internal buyer affects the sales opportunities, the transfer priceshould be the market price.

A l th i St d d


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Arms length price Standard

The standard calls for setting transfer prices to

reflect the price that unrelated parties acting

independently would have set. Three methods

are set : Comparable price method

Resale price method

Cost plus method.

Comparable Price Method It establishes arms length price by using the sales

prices of similar products made by unrelated firms.

Availability of comparable and unrelated price is

limitation of this method.


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TRANSFER PRICE FOR INTANGIBLES

Intangibles refer to the property having intellectual

contents like inventions, patents, design, trademark,

franchises, licenses, brand, etc

According to OECD guidelines the intangibles are

classified as

Trade and Market


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Trade intangiblesare created out of Research & Development like know-how,designs, etc.

There can be 3 types of such arrangements :

One enterprise does research and keeps the property rights.

One enterprise carries on research on behalf of other members as per acontract.

One enterprise carries on research on behalf of the group engaged in acommon activity and all share the ownership.

Market intangibles are trade names (brands including symbols, pictures, etc.)

This again can be owned by one enterprise or shared with others. Brand

valuation should be done taking into account all the variables like qualitycontrol and R&D, availability, success of promotion expenses, value of themarket, etc.


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Cost Accounting (17)