16 Transfer Pricing

Question 1

What is the need for a transfer price

Answer 1

• Important consideration in decentralised companies where there are different business units with managers with decision making capabilities
• The price of the components that is transferred to division B will be responsible for the profits for division A
• Therefore, the performance of manager A will depend on what he can sell to division B at
  o Unless it’s a cost centre
• But division B also wants more profits and the buy in price is a cost of production to them so they want to minimise
  o Creates conflict
• If the price is too high then B will buy fewer units and prevents goal concurrency as it will be hurting the larger group

Question 2

What is a transfer price

Answer 2

The transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organisation

Question 3

What are intermediate products

Answer 3

Intermediate products are the products transferred between subunits, also known as responsibility centres, of an organisation

Question 4

How does transfer pricing work in organisations

Answer 4

• Most important when the organisation is divided into profit and investment centres which have significant decision making autonomy
• The transfer price creates revenues for the selling subunit and purchase cost for the buying subunit
  o Affecting subunits operating income
  o Which performance is evaluated
• Can be arbitrary when a high degree of interaction exists among individual responsibility centres
• Don’t want set price too low selling division doesn’t want to sell as they cant make a profit
• Don’t want it set too high or the buying unit will not buy many as cannot supply many units to the outside world

Question 5

What are the 4 criteria used to evaluate transfer prices

Answer 5

1. Promote goal congruence between subunits and total firm
   a. The overall well-being of the firm is most important
2. Induce managers to exert a high level of management effort
3. Help top management evaluate performance of individual subunits
4. Promote a high degree of subunit authority, if top management favours a high degree of decentralisation

Question 6

What are the 4 main approaches to transfer prices

Answer 6

Four main approaches to transfer pricing:
1. Market based transfer prices
a. Mainly with profit and investment centres
2. Cost based transfer prices
3. Negotiated transfer prices
a. When excess capacity exists for profit and investment centres
4. Administered transfer prices
Transfer prices serve different purposes; however, the goal of using transfer prices is always to motivate the decision maker to act in the organisations best interest

Question 7

What is the market based approach to transfer pricing

Answer 7

• Only applicable when there is an external market for the intermediate product
  o Selling subunit doesn’t have to sell to buying subunit as there is an external market they can sell too
  o Equally buying unit doesn’t have to buy from selling subunit
• If so, then that price is used to transfer the goods or services between responsibility centres
• The market price provides an independent valuation of the transferred product or service, and of how much each profit centre has contributed to the total profit earned by the organisation on the transaction
  o Means price is not open to manipulation
• Allows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations and subunit autonomy

Question 8

What are market based transfer prices

Answer 8

• Transferring products or services at market prices generally leads to optimal decisions when three conditions are satisfied:
  o The market for the intermediate product is perfectly competitive
  o Interdependencies of subunits are minimal
  o There are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transferring internally
• If the market is not fair, monopoly exists, price will often be inflated

Question 9

What is a perfectly competitive market

Answer 9

Exists when there is a homogeneous product with buying prices equal to selling prices and no individual buyers or sellers can affect those prices by their own actions

Question 10

What is imperfect competition

Answer 10

• When the market for the intermediate good is imperfectly competitive, the transfer price must generally be set below the external market price (but above the selling division’s variable cost) in order to induce efficient transfers
• Due to an imbalance in power between parties can charge more money

Question 11

What is the cost based approach to transfer pricing

Answer 11

• Top management chooses a transfer price based on the costs of producing the intermediate product
• When the transferred good or service does not have a well defined market price, on alternative to consider is a transfer price on cost
• Some common cost-based transfer prices are:
  o Variable cost
  o Variable cost + % mark up
  o Full cost
  o Full cost + % mark up
• Adding in mark up allows the subunit to create contribution to the business

Question 12

What are the problems with cost based transfer pricing

Answer 12

• Transfer prices based on actual costs provide no incentives to the supplying division to control costs, since the supplier can aways recover costs
  o One solution is to use a standard cost as the transfer price
  o Will promote good practice in the supplying division
• Developing and operating accurate costing systems is quite challenging
  o People are likely to complain and come frustrated if they believe the organisation is using inaccurate costing systems for transfer pricing purposes in a way that will adversely affect the measure of their performance
  o Can be manipulated by management to their goals

Question 13

What is dual pricing

Answer 13

• Dual pricing is a solution to the problems with the standard “price + % margin” formula for mark up
• The receiving division is charged only for the variable costs of producing the unit supplied
• The supplying division is credited with the net realisable value of the unit supplied
• This has the desirable effect of letting marginal cost influence the decisions of the buying division while giving the selling division credit for an imputed profit on the transferred good or service

Question 14

What is the negotiated approach to transfer pricing

Answer 14

• Some organisations allow supplying and receiving responsibility centres to negotiate transfer prices between themselves
  o In the absence of market prices
  o Given the drawbacks of cost based pricing
• Negotiated transfer prices reflect the controllability perspective inherent in responsibility centres, such as each division is ultimately responsible for the transfer price it negotiates
  o However, negotiated transfer prices and therefore production decisions may reflect the relative negotiating skills of the two parties rather than economic considerations

Question 15

What is the possible range for negotiated transfer prices

Answer 15

• The buying division will not pay more than the price that they would have to pay on a competitive market
• The selling division will not accept less than its variable costs.
• Where the price is finalised will depend upon the negotiating power of each division
  o If the supplying division is operating near full capacity it will be reluctant to accept much less than the market price if it can sell externally.

Question 16

What determines the negotiated position of transfer prices

Answer 16

• For both the supplying division and the buying division the transfer price achieved will depend mainly upon
  o Excess capacity of the supplying division
  o Access to external markets
  o Nature of the responsibility allowed divisions, whether highly autonomous or given little control
• If supplying division cannot sell outside the firm then it is captive to the buying division. It will be a cost centre and the transfer price will be the variable cost unless higher management allow a higher transfer price.
• If supplying division can sell also on the external market the transfer price will depend on division’s excess capacity. If operating at full capacity the transfer price will be the market price for the intermediate product, unless told to sell to the buying division.
• If supplying division is operating at less than full capacity the transfer price will be negotiated

Question 17

What are the general guidelines on optimal negotiated transfer prices

Answer 17

Minimum transfer price
= Incremental costs per unit incurred
up to the point of transfer
+ Opportunity costs per unit to the selling division
* If no external market the opportunity cost = 0. If the selling division can sell all the intermediate product on the outside market for ₤ 10 and its variable (incremental) costs are ₤ 4 then the minimum transfer price that it would accept will be:
o Opportunity cost (profit foregone) (₤ 10-₤ 4) + incremental costs (₤ 4)= ₤ 10= market price.

Question 18

What are the problems with negotiated transfer prices

Answer 18

• Problems arise when negotiating transfer prices, because the bilateral bargaining situation causes:
  o The supplying division to want a higher than optimal price
  o The receiving division to want a lower than optimal price
• When the actual transfer price is different from the optimal transfer price, the organisation as a whole suffers
  o It results in the transfer of a smaller than optimal number of units between the two divisions

Question 19

What is the administered approach to transfer pricing

Answer 19

• An arbitrator or a manager applies some policy to set administered transfer prices
  o Organisations often used administered transfer prices when a particular transaction occurs frequently

Question 20

How can transfer prices be based on equity considerations

Answer 20

• Administered transfer prices are usually based on cost
  o i.e., the transfer price is cost plus markup
• Sometimes administered transfer prices are based on equity considerations
  o Designed around some definition of a reasonable division of a jointly earned revenue or a jointly incurred cost
• Possible alternatives include:
• Base the allocation of cost on the profits that each manager derives from using the asset
  o Reflects the equity criterion of ability to pay
• Still another approach is to assign each manager an equal share of the asset’s cost
  o Reflects the equity criterion of equal division