Arka Group - Transfer Pricing, Capacity and the ROI Behavioural Trap
Arka Group has two divisions. Division P makes a component in a plant with capacity of 20,000 units a year. Variable cost is ₹320 per unit and annual fixed cost is ₹12,00,000. P sells 15,000 units a year on the open market at ₹500. Division Q assembles the same component into a product selling for ₹1,400, with other variable costs of ₹700 per unit. Q needs 6,000 units next year. An overseas supplier has quoted ₹480 a unit delivered, with a ten-week lead time and a 1,000-unit minimum order.
Both divisional managers are assessed on divisional profit and on ROI against a 15% target. Last year P refused to supply Q below ₹500, Q bought abroad, and group profit fell. The group finance director wants a transfer pricing policy, and a worked example of the capacity logic, before the next budgeting round.
1. Determine the minimum transfer price for units supplied to Q and explain the capacity logic.
Read the worked answer
The general rule is: Minimum transfer price = outlay cost + opportunity cost per unit, where the opportunity cost is the contribution forgone by the supplying division.
- First 5,000 units. Capacity is 20,000 units and external demand is only 15,000, so 5,000 units are genuinely idle. Supplying Q loses no external sale, so opportunity cost is nil and the minimum is simply variable cost: ₹320.
- The 6,000th unit and beyond. P has no spare capacity, so each unit sold internally displaces one external sale earning ₹500 − ₹320 = ₹180 of contribution. Minimum = 320 + 180 = ₹500, i.e. market price.
The maximum Q will pay is its external quote, ₹480.
So the feasible bargaining range is ₹320 to ₹480 for the first 5,000 units, and there is no feasible range for the last 1,000 (minimum ₹500 exceeds maximum ₹480). That single comparison already answers the policy question: for the idle capacity the group wants the transfer to happen, and for the marginal units it does not. A blanket "market price or nothing" rule, which is what P applied last year, blocks the first 5,000 units and destroys group profit.
2. What is the group-optimal quantity to transfer, and how does group contribution compare with Q buying all 6,000 units abroad?
Read the worked answer
Evaluate at group level, cancelling the internal transfer price out.
Option 1 - transfer 5,000, buy 1,000 abroad P sells 15,000 externally: ₹75,00,000. P variable cost on 20,000 units: ₹64,00,000. Q sells 6,000 × ₹1,400 = ₹84,00,000; Q's other variable cost 6,000 × ₹700 = ₹42,00,000; overseas purchase 1,000 × ₹480 = ₹4,80,000. Group contribution = 75,00,000 + 84,00,000 − 64,00,000 − 42,00,000 − 4,80,000 = ₹48,20,000.
Option 2 - transfer all 6,000 (P's external sales fall to 14,000): 70,00,000 + 84,00,000 − 64,00,000 − 42,00,000 = ₹48,00,000.
Option 3 - buy all 6,000 abroad (P stays at 15,000 external): 75,00,000 + 84,00,000 − 48,00,000 − 42,00,000 − 28,80,000 = ₹40,20,000.
Option 1 is optimal at ₹48,20,000, which is ₹8,00,000 better than buying everything abroad and ₹20,000 better than transferring everything.
The ₹20,000 is worth commenting on: it is 0.04% of group contribution and well inside forecast error, while the overseas option carries a ten-week lead time and a 1,000-unit minimum. Practically, transferring all 6,000 at a negotiated price between ₹320 and ₹480 is the sensible policy - it secures supply and gives P an incentive to serve Q - and the group gives up almost nothing by doing so. Taking it also avoids rewarding P with a windfall: at any price above ₹320 on the idle-capacity block, P earns more than it would have done on the open market.
3. P's manager is offered a five-year contract to supply Q with 5,000 units a year at ₹350, requiring ₹8,00,000 of new tooling. P's current divisional profit is ₹15,00,000 on capital employed of ₹60,00,000. Show the ROI and residual income calculations and explain the behavioural problem.
Read the worked answer
The order uses only idle capacity, so no external sale is displaced. Incremental contribution = (₹350 − ₹320) × 5,000 = ₹1,50,000 a year.
ROI test
- Incremental ROI = 1,50,000 ÷ 8,00,000 = 18.75% - above the 15% target.
- Current divisional ROI = 15,00,000 ÷ 60,00,000 = 25.0%.
- ROI after accepting = (15,00,000 + 1,50,000) ÷ (60,00,000 + 8,00,000) = 16,50,000 ÷ 68,00,000 = 24.26%.
Residual income test (15% imputed charge)
- Before: 15,00,000 − (15% × 60,00,000) = ₹6,00,000.
- After: 16,50,000 − (15% × 68,00,000) = ₹6,30,000 - an increase of ₹30,000.
The behavioural problem: the contract is good for the group - contribution of ₹1,50,000 a year for five years against one-off tooling of ₹8,00,000 - and good for P in absolute profit. But a manager judged on divisional ROI sees the ratio fall from 25.0% to 24.26% and will rationally refuse. ROI rewards the manager who shrinks the asset base rather than the one who grows profit, so it can suboptimise. Residual income (or EVA) gives the correct signal here, because the ₹30,000 incremental RI is positive.
Policy recommendation: assess divisions on residual income with a 15% capital charge, give P explicit credit for internal sales in its profit figure, set the transfer price by negotiation within ₹320-₹480, and refer unresolved deadlocks to group head office - which is exactly the situation that cost the group money last year.