Week 3 | Internal Transfer Pricing

Question 1

What is transfer pricing? Could you describe a real life instance of it being used

Answer 1

A price that provides:
- People with information they need to make decisions that are coherent (unified)
- Motivation to act on those decisions

Transfer prices value and co-ordinate the workflows of interdependent units; in turn, prices affect allocation of profit

Acts as a demand and supply system to determine price

Question 2

How can manager work unit performance be measured from transfer pricing?

Answer 2

The transfer price set determines the revenue that the supplying and buying managers receive.
Managers ideally want to maximize their profit and the price they receive will determine the amount of revenue they get. This affects an entire work unit as well.
This is how manager and work unit performance are measured.

Question 3

What elements does transfer pricing policy consist of?

Answer 3

1. Sourcing autonomy (ability for managers to source internally or externally)
2. The transfer pricing method

Question 4

What are the 2 transfer pricing methods that do not require negotiation?

Answer 4

1. Cost based transfer prices:
   Consist of variable cost, full cost [cost plus mark up]
   Transfer price based on the costs of producing the products in question. Used when market data is not readily available.

• Reduces incentive for supplying division to manage cost effectively
• May result in unfair distribution of profits between divisions
• If external market exist for the transferred product, cost based internal pricing will be difficult to sustain

2. Market-based transfer prices (aligns with sourcing autonomy more)
   - Transfer recorded at external price
   - selling division records normal sale
   - purchase division record arms length purchase
   - discounts may apply in internal sale

Question 5

What is the formula for transfer pricing?

Answer 5

transfer price = variable cost + cost forgone

Question 6

What is a real world application of managerial conflict arising?

Answer 6

When unit managers ideally should make decisions with goal of maximizing value of firm as a whole
In reality, they often make decisions with goal of maximizing unit’s performance

Question 7

How does transfer pricing relate to the previous (or future) topics?

Answer 7

• silo effect
• decentralization
• flamholtz system
• simon lever control system
• performance metrics

Question 8

What are the two non-negotiated transfer pricing methods?

Answer 8

1. Negotiated transfer price alternative:
   - often used to ensure equity between divisions
   - market based price used as a starting point
   - used when market price unavailable or production cost unstable
   - managers work out overall profit
   - supports decentralization and autonomous decision making
2. Dual Transfer pricing
   - using 2 separate transfer pricing methods to price each inter-divisional transaction
   i.e., selling and purchasing division record transactions at different values

• The difference between 2 transfer prices is recorded in corporate cost account and borne by company
• Less likely to observe as part of a transfer pricing policy - useful in dispute resolution

Question 9

How does available capacity affect transfer pricing?

Answer 9

It affects transfer pricing as the supply division will have to charge the purchasing division external market price if they run out of capacity to supply purchasing division demands