Transfer Pricing

Question 1

what is a transfer price- definition, assumption

Answer 1

in a divisional structure,, one division may sell to another division.
Manufacturing division may sell to retail division e.g. assets goods and people can be transferred.

Assumptions - you must accept
1. The divisions are autonomous
2. The divisions are profit centres

It is better to set up a transfer price that is goal congruent

Question 2

Theory V Practice

Answer 2

Th theory is rock solid, if the rules are broken it would lead to problems and group profit will suffer.

In practice there are problems and a simplifying policy is needed.

Autonomy suffers with H/O dictating terms on transfer price to divisions

Theory
1. consider from group position - what is groups objective - buy/sell externally or internally, calculate contribution to decide
2. Group sets transfer prices to meet groups objective - the price must be within a minimum and maximum range - minimum should be external price and maximum is the amount of internal contribution
3. Divisions can then be left to make their decisions

Objective
1. achieve goal congruence
2. maximise group profit
3. maintain divisional autonomy
4. Being fair to all divisions

Question 3

when transfer prices breaks theoretical rules/limits

Answer 3

Group can make less profit if internal contribution is higher than external

Question 4

problems with theory

Answer 4

1. market prices and costs vary all the time, TP can become obsolete fast
2. in complex and diverse group, it may be perform theoretical calculations
3. International tax rates may get in the way, transfer price may be adjusted to ensure high profits in low tax countries

Question 5

Practical policies

Answer 5

If theoretical limits are broken by a practical policy, this will lead to goal incongruence.

H/O can step in and instruct branches to buy/sell internally which may damage morale and harmony.

Practical options
1. Transfer at cost of cost+ -issues include
- Manufacturer makes little to no profit
- which cost to use - actual v standard, total v variable.

Standard cost should be used so manufacturer is not passing all inefficiencies unto buyer and there is little incentive to control costs. standard costs should be used.

Total cost seems fairer as manufacturer can make profit however the fixed costs of manufacturer turns to variable costs of buyer and could lead to poor decision making since non relevant cost will now be allowed.

A two part TP policy can be an option here -
1. Transfer at standard variable cost initially
2. Then add fixed cost contribution as lump sum.

Drawbacks
- market values change all the time
- market values are hidden behind discounts and rebates so are hard to identify
- should adjust for cost savings if selling internally