Week 5 - Transfer Pricing Flashcards
What is transfer pricing?
- A transfer price is the price one subunit (segment, department, division) of an organisation changes for a product or service supplied to another subunit of the same organisation.
- high price and associated revenue for one division generated more revenue but at the expense of higher costs for the other division.
rationale for transfer pricing?
- so that subunit managers, when evaluating decisions, need only focus on how their actions will affect subunit performance without evaluating their impact on company-wide performance
- clash because subunit manager A wants as low a price as possible whilst other subunit manager wants to charge as much as possible
what is the purpose of transfer pricing? (Drury slides)
- to motivate managers to make good economic decisions (improve performance of own division and company as a whole)
- to provide information which can be used to evaluate the managerial and economic performance of the division
- to ensure divisional autonomy is not undermined - I.e managers able to make their own decisions
- to intentionally move profit between divisions for tax efficiency (different jurisdictions)
minimum transfer price =
maximum transfer price =
minimum (from perspective of selling division): marginal cost + opportunity cost
maximum (from perspective of buying division): market price - cost savings from internal transfer
Market based transfer pricing:
requires?
represents?
effect of selling expenses?
effect of other market imperfections?
- where there is free buying and selling and substitutes readily available
- internal or external price will be the same as its a perfect market
- requires a perfectly competitive market
- represents real economic contribution of division to total company profit
effect of selling expenses:
- not incurred on internal transfers
- market based TP = market price - avoidable selling and distribution expenses
- can pass on cost savings to other division as in interest of subunit and company
effect of other market imperfections:
- market unlikely to be perfectly competitive
- distress prices may cause incorrect decisions e.g. Brexit
- can make adjustments to reflect imperfections
marginal cost transfer pricing:
- Motivates profit maximising output when market is imperfect or non-existent
- positive impact for overall organisation but subunits may generate less profit
- short-term perspective
- not commonly used
full cost transfer pricing:
- Mangers able to recover all costs
- More widely used in practice
- long-term approach
Some problems with system:
- Difficult to allocate OH costs(year1), cannot trace or relate indirect costs conveniently e.g. depreciation, lighting costs = hard to trace to individual units.
- Which method you use to allocate costs will impact full cost you derive
- Drivers you use i.e. units/labour hours can change full cost — some costs not driven by no.o funits, cannot use just unit related absorption basis
- Can use ABC = more sophisticated . system — derives better full cost
cost-plus transfer pricing:
- Bonus incentive for manager
- attempt to align with performance evaluation
- can use variable cost or full cost
- doesn’t encourage optimal output
negotiated transfer pricing
divisional managers negotiate when they don’t agree on transfer price
arises as a result of the difficulty in establishing appropriate transfer prices
used where market imperfections exist
- outcome dependent on negotiating skills
- potential for conflict
- impact on divisional profitability
- time consuming
administered transfer pricing
- Where head office determines appropriate transfer price
- used where managers can’t agree
- maximes organisational profit
- undermines authority and autonomy
international transfer pricing
- problems associated with FX exchange risk, ability to repatriate funds, tax legislation
- multinationals will use transfer pricing for tax efficiency
Features of a good transfer pricing system
- provides information which motivates divisional managers to make decisions which are generally organisationally effective
- provide information which is useful for evaluating the managerial and economic performance of the division
- ensures divisional autonomy and authority is preserved
- evaluation of mangers based on what he can control (administered TP effects)
potential conflicts with transfer pricing
- decision making vs performance evaluation
- imposition vs autonomy
- organisational vs managerial performance
- distinguish what then mangers can and cannot control
transfer pricing and tax avoidance
ethical considerations with tax avoidance through transfer pricing…
should tax havens exist? why do they exisit?
google transfer pricing scandals
