Transfer pricing Flashcards
3 main aims of transfer pricing
- Goal congruence
- Fair measurement of performance
- Divisional autonomy
Golden rule: Supplying division
Variable cost + opportunity cost (CM lost) + marginal increase in fixed cost - saving
Golden rule: Receiving division
External market = market price
No external market:
NMR = contribution(sp-vc)
Marginal cost = vc/unit + additional FC per unit
Steps when asked to give your opinion on the transfer price
- calculate the optimal company profit and corresponding unit sales
- Calculate the min TP
- Calc max TP
- Give your opinion on the fair TP (Based on whether it meets any of the 3 goals of TP)
When will it be beneficial for division A to transfer?
If they are able to do 2 things:
1. Cover their incremental costs
2. Cover the opportunity cost
Market price: TP method
- The external market is not strong.
- MP would be automatically adjusted for the change in the market
- MP is usually below full cost therefore, would be unsatisfactory to the divisions individually
- It would result in unrealised profits in inventory
- We would be able to correctly reflect the value added.
Negotiated price: TP method
- Method is time consuming
- The bargaining power between the divisions may not be equal
- Complicated/too much effort for entitiesYY
Goal congruence
Encourages divisional managers to take decisions which are not only beneficial to the divisions but to the group as a whole.
The group profits increase by R…
The TP results in B incurring losses on the product and unless A is prepared to lower the price B may choose to buy from alternative supplier at a cheaper cost or reject offer (if special order is made).
It’s unlikely that the external market will sell the item at lower than the A’s variable cost.
This action will benefit B but will decrease group profits. Thus GC will not be achieved.
Fair measure of performance
TP should result in the reported profit from the transactions being a fair measure of the divisions performance.
The market price does/doesn’t achieve this goal because the division A makes a significant profit whilst division B incurs a loss.
This is fair/not because…
Divisional autonomy
The TP should promote autonomy of the indivisual divisions because this s one of the key motivators for decentralising operations.
In a perfect market, the TP based on the established market price will encourage autonomy because the supplying and receiving divisions will accept that the price charged is fair.
As a perfect market does not exist, the price suggested may lead to disputes and head office may have to intervene to ensure that group profits is maximized and that a fair allocation of the profit occurs.xs
Recommend a TP for the divisions
- Determine A’s spare capacity
- Alternative use for A’s capacity (opportunity cost)
- No alternative use (Meet A’s marginal cost) –> but transferring components at this cost means 0 profit for A and all profit for B
- Range of TP (min vs max)
Limitations of ROCE as a performance indicator
- Encourages divisional managers to use their existing ROCE as a base line
- If existing ROCE > WACC, divisional managers are encounraged to ignore investments whre the ROCE > WACC but < previous ROCE
Economic value added (EVA)
Adjusts conventional accounting profits to economic value which is in line with shareholder value.
Key factors to consider when outsourcing a service
- Retrenchment costs and other costs involved with closing a department
- Reputation of the brand will be linked to the service company we’re outsourcing to thus could impact current repeat customers
- Increased lead times
- Able to reach wider customers that we didn’t have access to before
- Less time will be spent on staff training
- Risk that we’re exposed to the other companies business failing
- Our company losing control over the service. –> quality of the service provided.
ROI
Operating profit after tax/Net assets (Total assets - current liabilities)
