Transfer pricing Flashcards
Considerations: Fair transfer price
-Transfer price should meet the group optimum objective and ensures that autonomous divisional managers act in their own best interest (i.e. goal congruence)
- The minimum price, set as high as possible for the supplying division, is the incremental costs of all transferred plus lost opportunity (VC as a minimum)
-The maximum transfer price should be set as low as possible for the supplying division: this being the market price plus the relevant cost (e.g. delivery costs avoided). It will result in a competitive edge for effectively selling at below market.
-A transfer price could be negotiated such that both divisional managers are incentivized for aiming for group maximum profits & acting in their own best interest
-Various inequalities that exist between the two divisions needs to be appropriately considered to achieve fairness in the performance evaluation of the respective division’s.
-Transfer prices should be based on budgeted (standard cost) so as to avoid unfairly transferring inefficiencies/efficiencies of the respective divisions when applying actual costs
-Inequalities in negotiating power considered
-Based on standard costs (avoid transfer inefficiencies)
-Transfers will allow unused capacity to be utilized
Negotiated to incentives PE
- Inequalities which impact on the fairness of the pricing includes, amongst other, the following:
Different operating conditions/risks – processing division is operating at 100% capacity – impact on breakdowns etc., while weaving division has surplus capacity
Difference in the degree of operating leverage – weaving division is sensitive to volume
The imbalance (and hence potential unfairness) of the weaving department’s profitability being dependent on the efficiency of the processing department should be considered.
The transfer price should meet the group optimum objective and ensures that autonomous
divisional managers act in their own best interest (i.e. goal congruence discussion).
The minimum price, set as high as possible for the supplying division, is the incremental
costs, not full cost
sold externally as well different contribution lost in respect of unutilized capacity.
The maximum transfer price should be set as low as possible for the supplying division: this
being the market price plus the relevant cost (e.g. delivery costs avoided). It will result in a
competitive edge for effectively selling at below market.
A transfer price could be negotiated such that both divisional managers are incentivized for
aiming for group maximum profits & acting in their own best interest (performance evaluation discussion)
Various inequalities that exist between the three divisions needs to be appropriately considered to
achieve fairness in the performance evaluation of the respective division’s.
Transfer prices should be based on budgeted (standard cost) so as to avoid unfairly transferring
inefficiencies/efficiencies of the respective divisions when applying actual costs.
Group as a whole perspective:
Purely financial perspective
1. There appears to be a negative consequence on the Data Analytics division with the current negotiation
Sales have declined in spite of the non financial signals showing positive.
2. The company’s spare hours capacity would be better used, particularly the software and data analyics.
3. The Harware and software are arguably gateways to the most important offring, Analytics.
but at present are damaging this market with high prices.
4. Potential savings/more revenue for the group (bulk purchasing, better profile in market)
Qualitative factors
5. A longer term view and consideration of the market should be considered, where firm heading.
6. Using firm hardware would possibly make software and analytics more compatible. Whole package stability.
7. Future changing capacities and expansions should be considered.
8. Divisions are very different, product vs service, different risks, the intracacies should be borne in mind.
9. Difference in the degree of operating leverage – Data Analytics is at a sensitive volume stage. Perhaps subsidise to get volume.
10. The imbalance (and hence potential unfairness) of the Hardware department’s profitability.
The transfer price should meet the group optimum objective and ensures that autonomous
divisional managers act in their own best interest (i.e. goal congruence discussion).
Marginal costs
-Imperfect market or where there is no external market for a product
-Transfer price should be set where MC=MR
It is not widely used because:
-Provides poor performance evaluation
-May not be constant over relevant range
-Measuring beyond short term may be difficult
-Managers reject short term perspective
- Marginal cost transfer price will ensure that the optimal decision from a company perspective is made, but will not be appropriate to evaluate the performance of the two divisions.
- The market based measure is not appropriate as the market is not perfectly competitive, and therefore the market price will change depending on the level of assembled chairs that are demanded.
Full cost (used a lot in practice)
-Managers view pricing decisions as long term decisions
Bad stuff:
- Derived from traditional costing system
- Prices do not include a profit mark up
Cost plus markup (used a lot in practice)
-Attempts to meet PE purpose
Bad stuff:
- Profit would cause the inter divisional transfers to be less than the optimal
- The compounding effect of mark-up may cause TP to be enormous
Negotiated
- Used when market imperfections when there are different selling costs
- Best approach to setting the transfer price in the current context of an imperfect market would be a negotiated transfer price
Bad stuff:
- Can lead to sub optimal decisions
- Time consuming
- Bargaining skills and powers of divisional managers
General notes on transfer pricing:
- Transfer at MV
- In perfect market: Transfer at marginal cost
- MC plus a fixed lump sum fee: Motivates receiving division to equate MC of transfers with net MR to determine optimum company profit maximizing output level
Consider in deciding upon a fair transfer price
-Transfer pricing is just trying to allocate resources the most efficiently for the company.
-The transfer price should meet the group optimum objective and ensures that autonomous.
-Divisional managers will act in their own best interest (i.e. goal congruence discussion).
-The minimum price, set as high as possible for the supplying division, is the incremental costs of colorant transferred plus lost opportunity not being able to get market price in external sale.
-Only if lack of capacity. If enough capacity then only incremental cost of colorant.
-Any delivery or packing cost avoided should reduce the transfer price, as a opportunity gain.
-A transfer price could be negotiated such that both divisional managers are incentivized for as performance
evaluation is important as a motivator.
-Should consider the negotiation powers of the divisions, the family member may have extra power.
-The transfer price must be based on standard cost, so as not to pass on inefficiencies in the colourant division.
-Any unutilised capacity can yield more profit for the company if covers variable costs.
-Must consider future growth as well, if likely to grow, then excess capacity only short term.
-Transfer price may therefore be different in the longer term.
-Qualitative aspects, such as straw division securing the best ink, and getting competitive advantage.
- Simple and easy to understand,
-A revenue-based royalty may be unfair,
-There may be an under- or over-recovery of all
the shared service division costs
-There will be a time lag between R&D expenditure and its impact on revenue.
-An arbitrary allocation may lead to incorrect
resource allocation decisions - Profit is shifted from low to high tax jurisdiction for..
-. The current system does not incentivise the shared service center to minimise costs.
-The royalty fee of 12.5% comprises a significant contribution of revenue
-The managers are assessed on a basket of measures, which also includes the net profit percentage. An unfair allocation of costs from a shared services division
-Should use standard costs (or budgeted) for allocations to
avoid inefficiencies being passed onto divisions if costs are exceeded.
-Use an allocation basis such as activity based costing to
correctly allocate the costs - Impact on the movement of profits between the territories may result in transfer pricing consequences with the tax authorities, with resulting implications. Could be challenged under the general anti avoidance provisions under GAAR, to the extent not at market value.
