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Divisional cost restatement, in consolidation

A company makes Product X and sells to customers. The per unit cost / profit structure is as below.

Material cost Cy. 35
Add: Labour and other direct costs (Process A) Cy. 15
-----------
Cost of Process A output Cy. 50
Add: Labour and other direct costs (Process B) Cy. 20
Add: Overhead costs and profit Cy. 30
-----------
Selling price of finished product X Cy. 100
-----------

The company creates a new Division Z to cater to a certain geographical segment, and to save on outward transport cost.

The company transfers a part of its Process A output to Division Z at ten percent profit on cost, i.e., Cy. 50 + 10% = Cy. 55

Division Z's consequential per unit cost / profit structure is as below.

Material cost, transferred by Head office Cy. 55
Add: Labour and other direct costs (Process B) Cy. 20
Add: Overhead costs and profit Cy. 25
-----------
Selling price of finished product X Cy. 100
-----------

In consolidated profit and loss statement (and MIS), inter-unit transfer out / in are set-off. Unrealised profit in inventory carried by Division Z at end-of-period is also eliminated.
In standalone mode, Division Z's accounts should reflect material cost at Cy. 55.

However, my question is "in consolidation, should the material cost in Division Z's accounts be restated to have parity with 'true cost' at company level"?
To elaborate, the company's material cost is 35% of selling price, whereas Division Z reports material cost as 55% of selling price (for same finished product X).

In other words, should Division Z's "material cost" be split into "true company material cost Cy. 35", "labour and other direct costs Cy. 15", and "profit kept by company Cy. 5"?

This would show the correct revenue components at company level.

Please provide your views, for and against.

Answers

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

I'm a little confused. Is Division Z actually adding value (cost) to the product?

When you say transferred, is Division Z a SBU or just in another location (multi-location business). So is the inventory transferred or sold. Big big difference.

As far as adding a "cost" factor to Division Z. Are you using one overhead application assumption (at the end of the year, if you assumption was spot-on, that account would be zero). If you are transferring, you should be taking 10% away from other Divisions application rates and adding to Z.

If you are selling the units to Z, that is profit.

We won't get into transfer pricing where others here are far more technically adept on the subject.

Anonymous
(Independent Consultant) |

Thank you for the response.

Let me clarify. You ask whether Division Z is adding value. Yes, by serving a geographical segment (proximity to some customers, to support their JIT needs). Just to keep the example simple, I did not adjust for outward transport cost saving.

Division Z is an "unit", part of the company (legal entity). One could call it a non-SBU, as it cannot take profit centre decisions, and has to follow the Company's (headquarters) policy on pricing to customers / and transfer-in cost.
Inventory has to be "sold" between locations because of national tax rules, with VAT accounting involved. Skipped in the example again, to keep the core query distinct.

My basic query is only about restatement of Division cost, to provide "true" costs / margins information to, say, Top Management and Investors.

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