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5/19/2011


D.Prifit Split Method

Cases applicable: This would normally happen when transactions are very interrelated that they cannot be evaluated separately.

The method is based on the concept that profits earned in a controlled transaction should be equitably divided between associated parties involved in the transaction according to the functions performed.

Guideline mentioned 2 approaches to split profit which they are not necessarily exhaustive or mutually exclusive

(I)Residual profit split approach
- There are two stages of profit division under this approach. Firstly, the combined profit is apportioned according to basic returns assigned to each party to the transaction.
- The next stage involves the allocation of the remaining residual profit/loss.

(II)Contribution analysis approach

Under a contribution analysis, the combined profits would be divided between the associated enterprises based on the relative value of the functions (i.e. contribution) performed by each of the associated enterprises participating in the controlled transaction

Example 4

X, Y and Z are companies located in different countries. Company X
designs and manufactures the major components of a high quality
electrical product which it sells to its subsidiary Y. From these components,
Y further develops and manufactures them into the final product which it
exports to Z, an independent distributor.



The trading accounts of X and Y are as follows:



X
Y
Sales


100
300
Purchases

15
100
Manufacturing cost

20
35
Gross profit

65
165
R&D


20
15
Other operating expenses
15
10
Net profit

30
140



(I)Residual analysis of the group profit 

Step1.Calculation of total profit Net Profit (X) + Net Profit (Y) = 30 +140 = 170
Step2. Calculation of basic return
The mark-ups derived from external data will be used to calculate basic returns to X and Y.

Lets :
-       Transfer Price (TP)
-       Adjusted Transfer Price(ATP) = Arm’s Length Transfer Price
-       adjusted COGS_Y                 = COGS_Ya
-       COGS include TP from X      =  COGS_Yx

 Basic return to X      = 30% of (COGS_X + Other operating Expenses_X)
                                 = 30%(35+15)
                                 =15……<1>


Basic return to Y       =20% of (COGS_Y + Other operating Expenses_Y)……<2>

Since COGS of Y included the purchase price from associate X,

Thus, COGS_Ya = COGS_Yx - purchase price from X + ATP……<3>

Bring <3> into <2>:

Basic return to Y         =20% (COGS_Yx - purchase price from X + ATP  + Other operating Expenses_Y)
                                 = 20% (35 + 10 + ATP)
 = 9 + 0.2ATP……<4>



(II) Residual profit split:
Step3. Calculation of residual profit
(if you are good in Algebra, it is similar to the concept of  marginal error)

Residual profit           = Net profit - [(Return to X) + (Return to Y)]
                                  = 170 – (<1>+<4>)
  = 170 - (15+9+0.2ATP)……<5>


~Contribution analysis approach~
Assume that in this case R&D is a reliable indicator of X and Y's relative contribution
Step4.Get residual return :-

Total R&D                  = 20 + 15 = 35

Share for X                 =20/35 = 57%
Residual return to X  = 57% <5>
                                 =57% [170 - (15+9+0.2ATP)]
                                 =83.22 - 0.114ATP……<6>

Share for Y     =15/35 = 43%
Residual return to Y = 43% <5>
                                = 43%[170 - (15+9+0.2ATP)]
                                = 62.78 - 0.086ATP……<7>


Step5, Get Net profit :-
Net Profit for X         = Basic return to X + Residual return to X
                                 = <1> + <6>
                                 = 15 + 83.22 - 0.114ATP
                                 = 98.22 - 0.114ATP ……<8>

Net Profit for Y         = Basic return to Y + Residual return to Y
                                 = <4> + <7>
                                 = 9 + 0.2ATP + 62.78 - 0.086ATP
                                 =71.78 + 0.114ATP ……<9>



Step6, Finding unknown ATP:-
Setting formula with X

   ATP    = Total cost_X + Net Profit for X
                                   = (15+20+20+15) + <8>
   ATP    =70 + 98.22 - 0.114ATP
         ATP+0.114ATP   = 70 + 98.22
      1.114ATP    = 168.22
                          ATP   = 168.22/1.114
                          ATP   = 151.005386
                          ATP   ~ 151

or setting formula with Y

           Net Profit for Y  = Sales – Cost – ATP
                         <9>     = 300 – (35+15+10) – ATP
        71.78 + 0.114ATP = 300 – (60) – ATP
      0.114ATP + ATP = 240 – 71.78
                   1.114ATP  = 168.22
                            ATP = 168.22/1.114
                            ATP = 151.005386
                            ATP ~ 151

Thus solved unknown ATP = 151

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