Transfer Pricing

Question 1

Transfer pricing - internal transactions

Answer 1

Purpose - (decentralized) co-ordinate actions between and evaluate peformance of divisions

Goal - motivate divisions to act in the best interest of its own, and ultmately for the organization as a whole

Question 2

General guideline - minimum TP

Answer 2

Selling division:
Minimum transfer price = Variable costs up to the point of transfer + Opportunity cost to the selling division *

*1) when there is no idle capacity AND market full competitve, oppotunity cost = CM foregon
2) when there is idle capacity OR no market, opportunity cost = 0

Buying division:
Minimum transfer price is ALWAYS equal or lower than the market price (arm’s length)

Question 3

Three common TP approaches

Answer 3

1) Cost-based TP
2) Market-based TP
3) Negotiated TP

Question 4

Cost-based TP

Answer 4

Most useful when market price is not available, inappropriate or costly to obtain
*full-cost + % markup (absorption cost)
*variable cost + % markup

Suboptimal approach
Pros: 1) simple
2) can be readily calculated using available accounting data
Cons: 1) may not be in the best interest of the company
2) unfair in profit distribution between seller and buyer
3) may encourage production inefficiency because cost is transferred to buyer

Question 5

Market-based TP

Answer 5

Based on makret price of suppliers or customers

Optimal decision-making if three conditions are met:
1) immediate market perfectly competitive and information readily available
2) minimal interdependencies between divisions/departments
3) no additional costs or benefits as a whole by choosing between market price and transacting internally

Pros：1) simple if market price is readily available
2) if no idle capacity for the seller, it only encourages transfer when it’s benefitial to company as a whole

Cons: 1) market price is not always available
2) suboptimal decisions may be made when seller has idle capacity

Question 6

Negotiated TP

Answer 6

Pros:
1) divisions maintain independence and control
2) divisions build relationship
3) TP arrived usually benefit the company as a whole

Question 7

International TP

Answer 7

Short-term decisions
1) irrelevant factors:
fixed costs - cannot be easily eliminated
sunk costs - already made and not retrievable
opportunity cost when there is idle capacity

2) relevant factors: opportunity costs when no idle capacity
incremental costs
decision-makers’ bias