Q11, Nov 2011, Omega Omega Company has divisions M and N.

Products required by Div N are currently being outsourced at Rs. 20 per unit. Div M also makes this product and and can sell either to Div N or to outside markets. Current capacity of Div M is 50,000 units. Div N sells its products at Rs. 40 per unit in the market. Income statement for both the divisions and the company is as under: (Figures in Rs. lacs) Div M Div N Omega Co. Sales Units (Nos) 50000 Price (Rs/unit) 20 10 10 Units (Nos) 20000 Price (Rs/unit) 40 8 8 Total 10 8 18 Expenses Variable Units (Nos) 50000 Cost (Rs/unit) 10 5 5 Units (Nos) 20000 Cost (Rs/unit) 30 6 6 Fixed 3 1 4 Total Expense 8 7 15 Gross Income 2 1 3 Div M is in a position to create an additional capacity of 20000 units at no extra fixed expenses. However, it can only continue to sell 50000 in the market. (a) What should be done by the company as a whole? (b) What would be the approach of managers of Div M and N towards the possible capacity increase? What should it be?Why? ( c) If you recommend inter unit sale, what could be the recommended price? Why?

Q11, Nov 2011, Omega current situation 1. Product reqd by Div N outsourced from market at Rs. 20/unit 2. Current cap of 50,000 units of Div M sold in market at Rs. 20/unit 3. Div N sells its product at Rs. 40 / unit 4. Unit Variable Cost of Div N is Rs. 30/unit incl.Rs. 20/unit for outsourced product Div M Div N Omega Co. units (nos.) 50000 20000 unit price (Rs/unit) 20 40 unit vc (Rs/unit) 10 30 Unit Contribution (Rs/unit) 10 10 Revenue(Rs lacs) Less: VC (Rs lacs) Contribution (Rs lacs) Less: Fixed Costs Profit (Rs lacs) % Profit of Div 10 5 5 3 2 66.67% 8 6 2 1 1 33.33% 18 11 7 4 3 100.00%

proposed situation 1. Div M will have capacity of 70,000 units; of this, 20,000 units will be sold to Div N, and 50,000 units sold in market as before. 2. Current cap of 50,000 units of Div M sold in market at Rs. 20/unit 3. Div N sells its product at Rs. 40 / unit 4. Unit Variable Cost of Div N is Rs. 30/unit incl.Rs. 20/unit for outsourced product A. Sale in market: units (nos.) unit price (Rs/unit) unit vc (Rs/unit) Unit Contribution (Rs/unit) Revenue(Rs lacs) Less: VC (Rs lacs) Contribution (Rs lacs) B. Transferred to Div N at Transfer Price of Rs. 20/unit: units (nos.) unit price (Rs/unit) unit vc (Rs/unit) Unit Contribution (Rs/unit) Revenue(Rs lacs) Less: VC (Rs lacs) Contribution (Rs lacs) Total of A & B: units (nos.) Revenue(Rs lacs) Less: VC (Rs lacs) Div M 50000 20 10 10 10 5 5 Div M 20000 20 10 10 4 2 2 Div N Omega Co. 0

0 10 0 5 0 5 Div N Omega Co. 20000 40 30 10 8 6 2 12 8 4

70000 14 7

20000 8 6

22 13

Contribution (Rs lacs) Less: Fixed Costs Profit (Rs lacs)

7 3 4

2 1 1

9 4 5

proposed situation without a Transfer Price: 1. Div M will have capacity of 70,000 units; of this, 20,000 units will be sold to Div N, and 50,000 units sold in market as before. 2. Current cap of 50,000 units of Div M sold in market at Rs. 20/unit 3. Div N sells its product at Rs. 40 / unit 4. Unit Variable Cost of Div N is Rs. 30/unit incl.Rs. 20/unit for outsourced product A. Sale in market: units (nos.) unit price (Rs/unit) unit vc (Rs/unit) Unit Contribution (Rs/unit) Revenue(Rs lacs) Less: VC (Rs lacs) Contribution (Rs lacs) B. Transferred to Div N at Zero Transfer Price units (nos.) unit price (Rs/unit) unit vc (Rs/unit) Unit Contribution (Rs/unit) Revenue(Rs lacs) Less: VC (Rs lacs) Contribution (Rs lacs) Total of A & B: units (nos.) Revenue(Rs lacs) Less: VC (Rs lacs) Contribution (Rs lacs) Less: Fixed Costs Profit (Rs lacs) Div M 50000 20 10 10 10 5 5 Div M 20000 0 10 -10 0 2 -2 Div N Omega Co. 0

0 10 0 5 0 5 Div N Omega Co. 20000 40 10 30 8 2 6 8 4 4

70000 10 7 3 3 0

20000 8 2 6 1 5

18 9 9 4 5

Comments: WITHOUT EXPANSION Revenue(Rs lacs) Less: VC (Rs lacs) Contribution (Rs lacs) Less: Fixed Costs Profit (Rs lacs) % Profit of Div

Div M 10 5 5 3 2 67%

Div N Omega Co. 8 6 2 1 1 33% 18 11 7 4 3 100%

WITH EXPANSION With Rs 20 transfer price: Total of A & B: Revenue(Rs lacs) Less: VC (Rs lacs) Contribution (Rs lacs) Less: Fixed Costs Profit (Rs lacs) % Profit of Div With Rs zero transfer price: Revenue(Rs lacs) Less: VC (Rs lacs) Contribution (Rs lacs) Less: Fixed Costs Profit (Rs lacs) % Profit of Div

14 7 7 3 4 80%

8 6 2 1 1 20%

18 13 9 4 5 100%

10 7 3 3 0 0%

8 2 6 1 5 100%

18 9 9 4 5 100%

Ans: (a) Company should go ahead with creation of additional capacity since the company's profit increases by Rs. 2 lacs (i.e. increase by 67% (2/3)). (b) Managers of Div M should realise that because of Div N buying from Div M his contribution has gone up by Rs. 2 lacs Thus, the % profit of Div M and Div N which was 66.67% and 33.33% has changed in favour of Div M and is now 80% and 20%. Also manager of Div N should realise that although his contribution of Rs. 2 lacs remains the same whether it outsources or buys from Div M, the contribution and hence the profit of the company has gone up by Rs. 2 lacs. (Goal Congruence) (c ) Since there is a clear market price available, Div M deserves a transfer price which is equal to the market price of Rs. 20/unit.