Transfer pricing

Question 1

Why transfer pricing?

Answer 1

A tool for performance measurement

• Enable the evaluation of the profitability of separate units (RCs) or activities
• How are we doing?

A tool for pricing
- Give information about costs to guide decentralised decision-making on prices, products, quantities

Motivate managers selling internally (co-operation)

Question 2

Pros of profit centres?

Answer 2

• Greater responsiveness to comp challenges
• Better information
• Timeliness (free up time for top management)
• Training ground
• Business sense - profit consciousness
• Increased measurement possibilities

Question 3

How? - Two interrelated decisions

Answer 3

1. Sourcing decision: Freedom to source internally or externally?
2. The pricing decision: If internally - which price?

Question 4

Different perspectives on setting transfer prices?

Answer 4

• Unit level - Profit of individual units
• Company level - Best for company as an entity

Achieve goal congruence!

Question 5

Which are the four transfer pricing approaches?

Answer 5

1. Cost-based
2. Market-based
3. Negotiated
4. Special cases
   - Two step pricing
   - Profit sharing
   - Dual pricing

Question 6

Describe cost-based in more detail

Answer 6

• Product decisions reflect long-run commitments and should therefore be based on full costs rather than variable costs
• Common basis is standard costs: actual costs inappropriate as production inefficiencies will be passed on to buying profit centre
• Ultimately, top management decides

Question 7

Describe market-based in more detail

Answer 7

• If commodity - compare with price of the same good
• If not “true market price” - make adjustments
• A discount on market price may be used since no transport or selling costs internally
• Ultimately, top management decides

Question 8

Describe negotiated in more detail

Answer 8

• Mandate for negotiating delegated to supplier and buyer
• Intention to duplicate external market relationship
• Use full cost as a floor (when no excess capacity, otherwise vc) and market price as ceiling

Question 9

Two-step pricing

Answer 9

• Takes upstream costs (i.e profits and fc from other units) into account
• Provides proper information to make short-term selling/marketing decisions
• Pays in two steps: TP per unit = vc and lumpsum = fc + profit
• Dont forget any reserved capacity!

Question 10

Profit sharing

Answer 10

1. Purchasing unit pays standard variable cost and sells to outside customer
2. The profit is shared (selling price less vc in both units)

Question 11

Problems with profit sharing?

Answer 11

1. Conflict over sharing
2. Gives no information about the profitability of the different units
3. Contribution is allocated after the sale
   - Unfair since selling unit is dependent on sales unit’s ability to sale/set prices

Question 12

Two sets of prices (dual pricing)

Answer 12

1. Selling price: Outside sales price
2. Buying price: Standard cost
3. Difference is charged centrally

Question 13

Problems with dual pricing?

Answer 13

1. Sum of BU profit greater than overall profit
2. Creates illusion of BU making money when company is losing money
3. Motivate managers to focus on internal transactions
4. Sometimes you want conflicts - can be creative or signal problems. Entrepreneurial spirit

Question 14

What to think of generally when deciding transfer prices?

Answer 14

• Performance measurements (which standards, when well or not well?)
• Organizational structure
• Management philosophy (decentralized)
• Strategy: emphasize integration and look at interfaces between units
• Behavioral consequences (how will employees be affected, motivated etc.)