Transfer Pricing Flashcards
Define transfer price
-> internal price charged by one segment of a firm for a product or service supplied to another segment of the same firm
Objectives/purposes of transfer pricing
- To provide information that motives divisional managers to make decisions that maximise overall corporate profit (goal congruence)
- To provide information that is useful for evaluating the managerial and economic performance of divisions
- To ensure that divisional autonomy is not undermined
Market based transfer prices
-> based on the listed price of an identical or similar product or service, the actual price the supplying division sells the product to external customers, or the price a competitor is offering
-> assumes there is a perfectly competitive market for the product to base the current market price off
-> market based transfer prices will motivate sound decisions and form a basis for performance evaluation
Problems with the market based transfer prices
- the market is unlikely to be perfectly competitive
- market price only appropriate when quality, delivery, discounts, and back up services are identical
- receiving division will expect a discount to reflect lower selling costs
-> suppliers in the external market temporarily willing to sell at a loss
Marginal cost transfer prices
-> transfer price based on incremental or relevant cost of production (excludes fixed costs)
-> imperfect or non existent market for intermediate product
-> short term assumption that marginal cost is consistent per unit throughout the output range and equivalent to short term variable costs
Problems with marginal cost transfer price
- it creates poor information for evaluating the supply and receiving divisions
- supplying divisions will report losses as fixed costs are not covered
- receiving division will report over stated profits
- no incentive for supplying division to make cost savings
- marginal cost may not be consistent
Full cost transfer prices
- widely used in practice
- managers view product related decisions as long run decisions and therefore require a measure of long run marginal costs
Problems with full cost transfer pricing
- some research suggest ABC should be used to establish full cost transfer prices
- supplying division will not make a profit (not motivated to reduce costs)
- potentially good for the reviving division if transfer prices less than market price
- does not promote goal congruence
Cost plus a mark up transfer price
- supplying division would not make any profit on cost based prices
- they are not suitable for performance measurement
- mark up added so they make a profit
Problems with cost plus a mark up transfer pricing
- Potential to result in inflated prices if sequential divisions are involved and there is no cap put on the mark up
- Issues around agreeing the level of mark up
- Potentially results in sub optimal decisions with no incentive for the receiving division to buy internally if the transfer price is greater than the market price
Negotiated transfer price
- appropriate when there are different selling costs
- appropriate where several mark prices exist
- when there are such imperfections in the market, the divisional managers must have the freedom to buy and sell outside the company to enable them to engage in a bargaining process
- for negotiation to work effectively it is important that managers have equal bargaining power
Problems with negotiated transfer prices
- time consuming
- leads to conflict
- imposed transfer prices will:
1. Impact performance evaluation
2. Weaken decentralised profit responsibility
3. Motivation and morale
Marginal cost plus a lump sum fee (two part tariff)
- Intended to motivate receiving division to equate marginal cost of transfers with its net marginal revenue to determine optimum company profit maximising output levels
- Enables supplying division to cover its fixed costs and earn a profit on inter divisional transfer through the fixed changed for the period
- Motivates receiving division to consider full cost of providing intermediate products/services
- Should stimulate planning, communication, and coordination amongst divisions mainly because they have to agree on capacity requirements in order to determine the basis for the lump sum (fixed fee)
Advise on the appropriateness of the present transfer system (always put in part a)
-market price will encourage correct decisions on output
-the overall group profit will not be reduced or limited by the current system
-each division will be in the same position as they would if they were stand alone companies (autonomy)
-however, manager of company 2 is demotivated by the present system
Why might the chief exec be reluctant to intervene
- divisional manager has complete responsibility for activities of their decisions
- if chief imposes a transfer price system then in evaluating the performance of the divisional managers it will be necessary to bear in mind that part of their results will be affected by decisions they did not make
- intervention will weaken decentralised profit responsibility and move towards centralised decision making
- possible effect on morale/motivation
