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    Cost Accounting

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    Nitin Rajotia
    1. Learning curves are used to estimate production costs and are defined by equations that model how unit production time decreases with cumulative production volume. 2. Common learning curves are named after the percentage reduction in production time when volume doubles (e.g. 80%, 90%). 3. Transfer pricing refers to the price charged for goods/services exchanged between business units within a firm and impacts each unit's profits. Firms consider market prices, costs, and negotiations to set appropriate transfer prices.

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    Cost Accounting

    Uploaded by

    Nitin Rajotia
    25 views29 pages
    1. Learning curves are used to estimate production costs and are defined by equations that model how unit production time decreases with cumulative production volume. 2. Common learning curves are named after the percentage reduction in production time when volume doubles (e.g. 80%, 90%). 3. Transfer pricing refers to the price charged for goods/services exchanged between business units within a firm and impacts each unit's profits. Firms consider market prices, costs, and negotiations to set appropriate transfer prices.

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    Cost Accounting (17)

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    1. Learning curves are used to estimate production costs and are defined by equations that model how unit production time decreases with cumulative production volume. 2. Common learning curves are named after the percentage reduction in production time when volume doubles (e.g. 80%, 90%). 3. Transfer pricing refers to the price charged for goods/services exchanged between business units within a firm and impacts each unit's profits. Firms consider market prices, costs, and negotiations to set appropriate transfer prices.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    25 views29 pages

    Cost Accounting

    Uploaded by

    Nitin Rajotia
    1. Learning curves are used to estimate production costs and are defined by equations that model how unit production time decreases with cumulative production volume. 2. Common learning curves are named after the percentage reduction in production time when volume doubles (e.g. 80%, 90%). 3. Transfer pricing refers to the price charged for goods/services exchanged between business units within a firm and impacts each unit's profits. Firms consider market prices, costs, and negotiations to set appropriate transfer prices.

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    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 29

    Use of Learning Curve in cost

    estimation

    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 ( y ) 10 minutes
    (when total production is 1 unit)
    Average time to produce one unit
    when production is doubled ( y ) (10+6)/2 . 8 minutes
    Therefore, learning effect = 8/10 = 80%

    Learning effect Approach


    the Doubling approach
    the equation approach

    17 - 3

    the Doubling approach: The popular approach is to restrict


    oneself 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 the
    previous doubling point. Hence, also known as cumulative average time
    approach.
    Drawback: corresponds to doubling points only

    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 product
    x
    = 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 in
    above equation we get : 800=(1000)(2)^-b; and to solve it, we use log
    So, log 800 = log 1000 b log 2
    Or b = (log1000 log 8000)/log 2 = (3-2.9031)/0.3010 =
    0.0969/0.3010 = 0.3219

    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 assumption that 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 4th unit = 2560-2106 = 454 hrs

    1.
    2.
    3.
    4.

    Relevance:
    Used for planning and decision making
    Preparation of Direct labour budgets
    Preparation of variable overheads budgets
    Setting standard costs
    Pricing decision

    Transfer Pricing
    Chapter 22

    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 buying subunit affecting each subunits operating income

    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 center


    managers 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 methods calling such a
    price as Arms Length Price.

    Intermediate Product the product or service transferred between


    subunits of an organization

    Transfer pricing is one of the most strategic activities in strategic


    business unit management.
    It affects materials and parts sourcing decision, tax planning and
    potentially, 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 charges
    when it transfer engines to the car assembly division.

    Importance
    Transfer of products and services between business units is most
    common in firms with a high degree of vertical integration.
    Vertically integrated firm engage in a number of different valuecreating activities in the value chain.
    A computer manufacturer must determine transfer prices if it
    manufacturers the chips, boards and other components and
    assembles the computer itself.

    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 high
    taxed country, a firm can reduce its firm level tax liability. This would
    increase cost and reduce the income of the purchasing unit in the
    high tax country, thereby minimize taxes there and higher profits
    shown 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 from
    external suppliers. The external suppliers might get assistance from
    the firm in its effort to supply quality materials to the firm. As a result,
    newer or weaker unit becomes more healthy.

    International Objective

    Tax issues
    Minimising custom charges,
    Minimising currency restriction and
    Minimising risk of expropriation by foreign
    government.
    Expropriation occurs, when a government takes
    ownership and control of assets a foreign
    investor has invested in the country.

    Custom Charges
    If custom charges are significant on the parts and
    components imported, relatively low transfer price on
    these imports would be beneficial to reduce the custom
    charges.
    Currency Restriction
    Repatriations of profits to the parent firm are restricted
    in some countries. One way to deal in such
    circumstances, is to set the transfer price in such a way
    that 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 foreign
    country as quickly as possible.

    Three Transfer Pricing Methods


    Market-based Transfer Prices
    Cost-based Transfer Prices
    Negotiated Transfer Prices

    General Transfer-Pricing Rule


    Transfer Price

    Additional outlay cost per


    =
    unit incurred because
    goods are transferred

    Opportunity cost per unit


    to the organization
    +
    because of the transfer

    Market-Based Transfer Prices


    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


    Allows a firm to achieve goal congruence, motivating
    management effort, subunit performance evaluations,

    and subunit autonomy


    Perhaps should not be used if the market is currently
    in a state of distress pricing

    Therefore, Market Price Use if the selling unit has no excess capacity and perfect competition exists.
    Here, the general transfer rule and the external market price are equal
    The long-run average external market price should be used, because distressed
    market prices can severely affect transfer pricing profitability.

    The disadvantage is that the market price for


    intermediate products, may not always be
    available.

    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 external

    parties
    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

    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 buyers
    transfer price, while the seller might use market
    price

    Cost-Based Transfer Prices


    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 costbased 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

    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 the
    company 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.

    Comparison of Transfer-Pricing Methods

    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.

    Existence of outside supplier


    If no outside supplier --- the best transfer price is on cost or
    negotiated price.
    If there is an outside supplier, market price should be considered in
    relation 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 price
    should 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 and
    market price.
    If internal buyer affects the sales opportunities, the transfer price
    should be the market price.

    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.

    Resale Price Method


    This is a transfer price set for distributors and
    marketing units when little value is added and
    no significant manufacturing operations exist.
    The price is based on mark up on gross profits
    of unrelated firms selling similar products.
    Cost plus Price Method
    This price is set based on sellers costs plus a
    percentage of gross profit determined by
    comparing the sellers sales to those of
    unrelated parties or to unrelated parties sales
    to those of other unrelated parties.

    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

    Trade intangibles are 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 a


    contract.

    One enterprise carries on research on behalf of the group engaged in a


    common 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 quality
    control and R&D, availability, success of promotion expenses, value of the
    market, etc.

    Arms Length Price is applicable for


    intangibles. It is a difficult exercise and it is
    difficult to establish or prescribe any
    standard or guidelines for the legal and
    economic ownership of the marketing
    intangible.
    ALP for Intangibles :
    The utility of the property is an important
    criterion while determining comparability
    of intangible properties.

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