Lecture 3: Transfer Pricing Flashcards
Why do we need transfer pricing?
Since units deliver things to each other, we need transfer prices on these internal transactions. For evaluation of managers and decentralised decisions.
What is transfer pricing about?
How to devise a satisfactory method of accounting for the transfer of goods and services from one profit center to another in organizations that have a significant number of these transactions.
What objectives should the transfer price be designed to accomplish?
- Provide each responsibility center with the relevant information it needs to determine the optimum tradeoff between company costs and revenues.
- Induce goal-congruent decisions: designed so that decisions that improve responsibility center profits will also improve company profits.
- Help measure the financial performance of the individual responsibility centers.
- Simple to understand and easy to administer.
- Acceptable to the tax authorities if the two responsibility centers are located in two different tax jurisdictions.
What is a transfer price?
The price one unit of a firm or organization charges for a product or service supplied to another unit of the same firm or organization.
- Creates revenue for the selling unit and cost for the purchasing unit.
What two things can transfer pricing be a tool for?
- Tool for performance measurement. Enable the evaluation of the profitability of separate units (responsibility centers) or activities. How are we doing?
- Tool for pricing. Give information on costs to guide decentralized decision-making on prices, choice of products, quantities. What is the appropriate price to an external buyer? Motivate managers selling to internal users (cooperation).
How can we transfer functional units into profit centers?
By introducing transfer prices between units. For example, for a marketing department, the transfer priced charged may be the standard cost of the products sold (not actual cost, to separate from the manufacturing department’s performance).
What are two interrelated decisions that must be made for the transfer price of each product?
- The sourcing decision: freedom to source internally or externally? Should the company produce the product inside the company or purchase it from an outside vendor?
- The pricing decision: if internal transfers - which price? If produced inside, at what price should the product be transferred between profit/investment centers?
What are some possible constraints on the sourcing decision?
- Limited (outside) markets. If a company is the sole producer of a differentiated product, no outside source exists.
- If a company has invested significantly in facilities, it is unlikely to use outside sources unless the outside selling price approaches the company’s variable cost, which is unusual.
- Excess or shortage of industry capacity. E.g. can’t buy from outside while the selling unit is selling to the outside. → not optimal company profits.
What are two different perspectives to consider when setting the transfer price?
- Unit level. Profit of the individual units?
- Company level. What is best for the company as an entirety? Same or different rules for all units?
What are the four overarching categories of transfer pricing approaches?
- Cost-based transfer pricing
- Market-based transfer pricing
- Negotiated transfer pricing
- Special cases
What is cost-based transfer pricing?
Two components:
- The cost basis
- Product decisions reflect long-run commitments and should therefore be based on full costs (rather than variable costs).
- Common basis is standard costs; actual costs are inappropriate as production inefficiencies will be passed on to the buying profit center.
- Ultimately, top management decides. - A profit markup
- Keep managers more motivated.
- Often based upon a percentage of costs.
What is market-based transfer pricing?
Using the price of the same good to compare with.
- If there is no “true market price” then an adjusted market price of similar goods could be used as a starting point for internal pricing discussions.
- A discount on the market price may be used since internal trading saves transport or selling costs.
- Ultimately, top management decides (market, product).
What 6 factors induce goal congruence in the market price-based transfer pricing (rarely in practice)?
- Competent people: negotiation, interested in both long-run and short-run performance
- Good atmosphere: regard profitability as an important goal and significant consideration in performance judgment.
- A market price: the ideal transfer price is based on a well-established, normal market price reflecting the same conditions as the product the transfer price considers. May be adjusted to reflect savings accruing to the selling unit from dealing inside the company.
- Freedom to source: alternatives for sourcing should exist, and managers should be permitted to choose the alternative that is in their own best interest.
- Full information: must know about the available alternatives.
- Negotiation: a smoothly working mechanism for negotiating “contracts” between responsibility centers.
What is negotiated transfer pricing?
Mandate for negotiation delegated to supplier and buyer, with the intention to duplicate external market relationships.
- If market prices exist, these will be a starting point for negotiations.
- If there are no market prices, cost would be a normal starting point.
Usually somewhere in between cost and market price. The exact price matters for who it benefits, so we want it to align with evaluation targets.
What is the problem that the special cases transfer pricing methods solve?
Dividing profits between units while addressing upstream fixed costs and profits. The profit center that finally sells to outside customers may not be aware of the amount of upstream fixed costs and profit included in its internal purchase price. Even if they are aware, they might be reluctant to reduce its own profit to optimize company profit.
