Sundaram Auto Components: Transfer Price, Spare Capacity and a Competing Export Enquiry
Sundaram Auto Components Ltd runs two divisions. The Components Division can machine 90,000 sensor housings a year; it currently sells 72,000 units externally at ₹2,600 each, with variable cost of ₹1,780 and fixed overhead of ₹7.2 crore absorbed at normal capacity. The Assembly Division buys 24,000 identical housings from an outside vendor at ₹2,520 delivered and has asked for internal supply at ₹2,300, the price used for inter-division quotes. Division managers are appraised on divisional ROI, and transfers are recorded at the quoted price. Separately, an export enquiry seeks 15,000 units at ₹2,050; the export specification adds ₹90 per unit of variable cost and one-time tooling of ₹36 lakh. The single five-axis machining centre is already loaded to 88%, and the buyer has slipped delivery on similar orders roughly one time in four; the export contract carries a ₹20 lakh delay penalty. The Components manager has refused the internal order and wants the export order instead, arguing that both 'use up idle capacity'.
1. Compute the group-optimal quantity of internal supply, the defensible transfer price range, and the group benefit at the optimal quantity. Is the Components manager's refusal rational for his own division?
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Capacity and unit economics
- Spare capacity = 90,000 − 72,000 = 18,000 units.
- External contribution forgone per unit displaced = 2,600 − 1,780 = ₹820.
- Group saving per unit transferred = 2,520 (external purchase price avoided) − 1,780 (own variable cost) = ₹740.
Decision rule. Transfer internally only while the per-unit saving (₹740) exceeds the contribution displaced (₹820). Since ₹740 < ₹820, internal supply must never displace an external sale.
Optimal quantity = 18,000 units (spare capacity only). Group benefit = 18,000 × 740 = ₹1,32,60,000.
If the division supplied the full 24,000, it would displace 6,000 external units: benefit = (24,000 × 740) − (6,000 × 820) = 1,77,60,000 − 49,20,000 = ₹1,28,40,000 - lower by ₹4,20,000. The full order is therefore value-destroying at the margin.
Price range. Floor = ₹1,780 (variable cost, no opportunity cost on spare capacity); ceiling = ₹2,520 (the Assembly Division's avoidable outside cost). Any price inside the range merely splits the ₹1.33 crore of group gain and is a negotiation and performance-measurement question, not an economic one.
Is the refusal rational? For his own division, each of the 18,000 spare units earns contribution of (TP − 1,780). At ₹2,300 that is ₹520 per unit, or ₹93.6 lakh - better than idle capacity. Refusal is defensible only if he genuinely expects to fill those 18,000 units at above ₹2,300 in the spot market, or fears the internal price anchoring future market quotes. Otherwise it is price signalling that destroys both divisional and group profit.
2. Evaluate the 15,000-unit export enquiry, allowing for the capacity it consumes, and rank the three feasible capacity allocations.
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Stand-alone relevant cost of the export order
| Item | ₹ |
|---|---|
| Revenue: 15,000 × 2,050 | 3,07,50,000 |
| Variable cost: 15,000 × (1,780 + 90) | (2,80,50,000) |
| One-time tooling | (36,00,000) |
| Expected delay penalty: 0.25 × 20,00,000 | (5,00,000) |
| Net | (14,00,000) |
The order fails on its own numbers even before capacity is priced, because contribution per unit is only ₹180 against ₹36 lakh of tooling. It is not a 'use up idle capacity' order at all - it is a loss order.
Capacity comparison (group position)
- Internal supply 18,000, no export: 18,000 × 740 = ₹1,32,60,000.
- Internal 24,000, no export: ₹1,28,40,000 (as above).
- Export 15,000 plus internal 3,000: (3,000 × 740) + (−14,00,000) = 22,20,000 − 14,00,000 = ₹8,20,000.
Ranking: option 1 > option 2 > option 3. The export order should be rejected; it consumes 15,000 units of the scarce machining hours for a negative return and removes ₹1.24 crore of value relative to the best allocation.
Risk caveat. The 25% delay probability rests on one machine already loaded to 88%, so the penalty is more likely than history suggests; the ₹20 lakh penalty also excludes reputational and expediting costs. A sensitivity at a 40% delay probability gives expected penalty of ₹8 lakh and a net loss of ₹17 lakh.
3. The CFO wants a transfer pricing policy that prevents a recurrence. Set out the design features and flag any tax or GST consequences of the policy.
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Why the current policy fails. Divisional ROI with market-price transfers gives the selling division the full ₹820 external contribution as its benchmark, so any internal price below ₹2,600 looks like a loss to the manager even where the group gains. The appraisal metric, not the manager, is the problem.
Design features
- Capacity-based floor price. Minimum transfer price = variable cost + opportunity cost of the capacity consumed, computed from the current capacity register. Here the floor is ₹1,780 on the 18,000 spare units and ₹2,600 on any unit that displaces external sales.
- Dual pricing or a two-part tariff. Credit the selling division at market (₹2,600) and charge the buying division at variable cost plus a fixed capacity fee, with the difference eliminated at group level. Goal congruence is achieved without penalising the seller's ROI.
- Group capacity committee. Allocate scarce machine hours centrally between internal and external demand, with monthly visibility of bookings, so that the sales team cannot commit capacity twice.
- Separate appraisal of capacity utilisation from margin, so a manager is rewarded for absorbing idle capacity even at a below-market internal price.
Tax and GST consequences
- Domestic related-party transfer pricing under section 92 was withdrawn (section 92BA omitted), so no Form 3CEB is triggered by an internal transfer price.
- If the two divisions hold separate GST registrations in different States, they are 'distinct persons' and stock transfers are supplies under Schedule I; valuation then follows Rule 28 (open market value), so a purely internal price of ₹1,780 can create a GST demand. Align the documented policy price with the Rule 28 valuation to avoid a conflict between the costing policy and the GST return.