M/A - Transfer Pricing Overview & In-depth

Question 1

What is the objective of the transfer price

Answer 1

Transfer price - price that is charged internally by one component of an organization
Ex. DEpt, division, subsidiary, or another component in product or service
- Best for internal reporting
Ex. Large telecommunication provider operating in several divisions including wholesale supplier
- The manufacturing department will move goods from dept to another

Question 2

What are the two organizational structure

Answer 2

1. Centralized - The organization contain one person who makes the key decisions for the organization, such as a resource organization contains one person who makes key decision
2. Decentralized - no one main person makes decisions, decisions are made at various levels of the organization
   - Transfer prices are often used to co-ordinariate action between evaluating performance

Question 3

What are the interpersonal conflicts with transfer pricing
And what is the main purpose of the transfer price

Answer 3

• Divisions are operating as profit centers, they are focused on evaluates based on profit maximization
  Cost center - A division of an organization’s total profit being reduced: Lack of goal congruence

The main goal of transfer pricing is that it would be to motivate the division to act in the best interest

Question 4

What are the relevant and irrelevant factors of transfer pricing

Answer 4

Relevant factors - opportunity cost, incremental cost, decision-maker bias
Irrelevant factor - opportunity cost when there is idle capacity, fixed cost, and sunk cost

• opportunity cost is the loss on CM for the selling company to the internal purchasing company in which they will not be able to sell units externally

Qualitative consideration - Lost from the customer, CM lost.

Question 5

What are the three types of transfer pricing methods

Answer 5

1. Cost-based pricing
2. Market based pricing
3. Negotiated based pricing

Question 6

What is the minimum transfer price

Answer 6

Minimum transfer price = Variable cost up to point of transfer + opportunity cost of the selling division

• If the selling division has idle capacity and no market exists = transfer price = variable cost

Question 7

What are the two methods of cost-based pricing

Answer 7

1. Full cost based - measure full absorption cost of the product transfer plus mark up
2. Variable cost - measure the variable cost of the product being transferred plus the markup

Advantage of cost-based pricing - It is simple and readily available, useful when the market price is unknown to costly to obtain
- Cab be appropriate to transfer the price when the selling price updated at cost centre

Disadvantage - can be led to suboptimal decision
- are not acting in the best interest of the organization
Encourages production inefficiencies because costs are passed to the buyer

Question 8

Explain how market-based pricing is used and the advantages and disadvantage

Answer 8

• Transfer price is used from external market condition
• Generally leads to optimal decision-making making three considering satisfied
  
  • Immediate market must be perfectly competitive and information readily available
  • Interdependencies between the department must be minimal
    -There must be no additional cost or benefit to the organization in using the external market instead of transacting internally

Advan - Simple for external market price are readily available, selling division is operating at full capacity it will encourage transfer only is benefit able to organization
Disadvan - External market price may not be readily available, suboptimal decision

Question 9

Explain how negotiated transfer price is used

Answer 9

• Seller and buyer work together to come up with an internal transfer price for the product or service
• Two must work together, the negotiation process can be time-consuming

Operating at full capacity - Minimum transfer price for the seller - Variable cost + opportunity cost
Max transfer price for the buyer: Market price
Excess capacity: minimum transfer price - Variable cost
Maximum transfer price for buyer - Market price

Question 10

What are the several factors that can lead to an organization sourcing cheaper input from a supplier

Answer 10

• Geographical location, this reduces transportation cost
• Locked in contract and subsequent market fluctuation
• Competitors going out of business and needing to liquidate their products quickly

Question 11

What are three other method of determining transfer pricing

Answer 11

1. Administered transfer price
   - Transfer price set by senior management.
2. Profit splitting approach - Total return earned by the various departments is split among the departments using the formula
3. Dual rate approach -transfer price received by the selling is the NRV of the product, while the price paid by the buying division is the incremental cost to date of the product
   Provides cost and revenue in a transfer pricing system that reflects economic theory.