Transfer Pricing
Objectives:
To understand the concept of Transfer Pricing.
To analyze the Transfer Pricing methods.
To understand the problems of corporate services pricing.
How is the administration of Transfer Pricing in the organization?
What is Transfer Price?:
A transfer price is the price one subunit of an organization charges for a product or service supplied to another subunit of the same organization. The two segments can be cost centers, profit centers, or investment centers. For example, the allocation of service department costs to production departments that are set up as either cost centers or investment centers is an example of transfer pricing.
Objectives of Transfer Pricing: (Why Transfer Pricing ?)
If two or more profit centers are jointly responsible for product development, for example manufacturing and marketing, each should share in the revenue generated when the product is finally sold. The transfer price is the mechanism for distributing this revenue.
The transfer prices should be designed to accomplish different objectives like:
· It should provide each business unit with the relevant information it needs to determine the optimum trade-off between company costs and revenue.
· It should induce goal congruent decisions – means the decisions which can improve business unit profit will also improve company profits.
· It should help measure the economic performance of the individual business units
· It should motivate management effort
- It should preserve a high level of subunit autonomy in decision making.
· The system should be simple to understand and easy to administer.
Factors that are conducive for fixing an optimum Transfer Price:
The ideal situation to implement the Transfer Pricing in the organization should have following components:
· Competent People
· Good atmostpher
· A Market Price
· Freedom to source
· Full Information
· Negotiation
Factors that are detrimental:
The determination of a fair Transfer Price may be adversely affected by constraints placed on sourcing either because of the corporate policies or due to certain constraints it is not feasible to source for the purchase and sales department. Limited Markets and
Excess or shortage of industry capacity w ill also affect the determination of a fair transfer price.
Methods of determining Transfer Price:
The three general methods for determining transfer prices are:
1. Market-based transfer prices
2. Cost-based transfer prices
3. Negotiated transfer prices
Significance of alternative transfer-pricing methods:
Alternative transfer-pricing methods can result in sizable differences in the reported operating income of divisions in different income tax jurisdictions. If these jurisdictions have different tax rates or deductions, the net income of the company as a whole can be affected by the choice of the transfer-pricing method.
Market-based transfer prices:
The transfer pricing issue is actually about pricing in general, modified slightly to take into account factors that are unique to internal transactions. For instance the transfer of an intermediate product between divisions.
The fundamental principle is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors. This is what is referred to as the “arms length” principle, to denote a distance that closely held firms or divisions with a firm should maintain in Pricing decisions. This is relevant in the matters of Taxation especially with reference to Multinational firms, which span across more than one country and thereby having tax implications involving several countries.
Transferring products or services at market prices generally leads to optimal decisions when (a) the market for the intermediate product market is perfectly competitive, for instance the transferred product may have special characteristics that differentiate it from the products that are available in the market. (b) interdependencies of subunits are minimal, and (c) there are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally.
Minimum Transfer Price & Idle capacity:
The general transfer-pricing guideline specifies that the minimum transfer price equals the additional outlay costs (Marginal Cost ) per unit incurred up to the point of transfer plus the opportunity costs per unit to the supplying division.
When the supplying division has idle capacity, its opportunity costs are zero; when the supplying division has no idle capacity, its opportunity costs are positive. Hence, the minimum transfer price will vary depending on whether the supplying division has idle capacity or not.
Cost-based transfer prices
Sometimes Market prices are unavailable. Even if the market prices were available, it may be considered as being too costly an exercise, to incorporate into a routine Pricing decision, and hence not feasible. Under such circumstances the alternatives of using cost based pricing is resorted to. Whatever be the justification for the use of cost-based Transfer price, it will always be less satisfactory than the Market Price.
Usually in this cost-based transfer pricing, the two issues that need to be resolved are:
i) What costs are to be included ?(Full , Standard or Marginal costs ?) and
ii) What is the basis for the mark-up? (is it an approximation of outside market price or one that is based on the cost of capital?)
Full Costs Plus Markup:
One potential limitation of full-cost-based transfer prices is that they can lead to suboptimal decisions for the company as a whole. An example of a conflict between divisional action and overall company profitability resulting from an inappropriate transfer-pricing policy is buying products or services outside the company when it is beneficial to overall company profitability to source them internally. This situation often arises where full-cost-based transfer prices are used. This situation can make the fixed costs of the supplying division appear to be variable costs of the purchasing division. Another limitation is that the supplying division may not have sufficient incentives to control costs if the full-cost-based transfer price uses actual costs rather than standard costs.
The purchasing division sources externally if market prices are lower than full costs. From the viewpoint of the company as a whole, the purchasing division should source from outside only if market prices are less than variable costs of production, not full costs of production.
Standard Costs:
Under the full cost approach the supplying division could potentially pass on the inefficiencies of the division to the receiving division. In order to overcome this limitation
the use of Standard Costs is proposed. Standard Costs are scientifically pre-determined cost of production. This control checks for the efficiency of the supplying division and motivates it to contain costs.
Marginal Costs Plus mark-up: Under this approach only the variable costs are considered on the contention that fixed costs have already been sunk or committed irrespective of the receiving division’s purchase decision. Inasmuch as this does not allow the Supplying Division to recover its Fixed Costs, it de-motivates the Supplying Division. This approach would however be valid if the supplying division has spare capacity that is lying idle for want of outside demand.
Negotiated transfer prices:
Cost and market price information are often useful starting points in the negotiation process. Costs, particularly variable costs of the "selling" division, serve as a "floor" below which the selling division would be unwilling to sell. Prices that the "buying" division would pay to purchase products from the outside market serves as a "ceiling" above which the buying division would be unwilling to buy. The price negotiated by the two divisions will, in general, have no specific relationship to either costs or prices. But the negotiated price will generally fall between the variable costs-based floor and the market price-based ceiling.
Two-Step Pricing:
Under this approach the transfer Price includes two charges. First for each unit sold , a charge is made that is equal to the standard variable cost of production. Second a periodic (Usually monthly) charge is made that is equal to the fixed cost associated with the facilities reserved for the buying unit. One or both these components should include a profit margin.
The scenario reproduced below illustrates the concept.
Illustration
Business Unit X ( Manufacturer) Product A
Expected monthly sales to Y 5000 Units
Variable Cost per Unit Rs. 5
Monthly Fixed Cost assigned to the product 20,000
Investment in working Capital & Facilities 12,00,000
Competitive return on Investment per year 10%
One way to transfer Product A to Business Unit Y is at a price per unit ,calculated as follows:
Transfer Price for
Product A
Variable Cost per unit 5
Plus: Fixed Cost per Unit 4
Plus: Profit Per Unit 2*
-------------------
Transfer Price Per Unit Rs. 11
-------------------
*
ROI per Year = 12,00,000 * 10 % = 1.20,000. Annual Production = 5000 units/PM * 12 = 60,000 Hence ROI per Unit = 1,20,000/60,000 =
In this method the Transfer price of Rs. 11 is a variable cost for Unit Y. The Company’s Variable cost, on the other hand is only Rs. 5. Per unit. Thus Unit does not have the right information to make appropriate short- term marketing decisions. If, for instance, unit Y knew that the Company’s variable cost was only Rs.5/ unit, under certain circumstances, it could safely accept business at less than the its normal price. That is, as long as the price covers the variable cost and is contributing to the partial recovery of fixed cost, though not resulting in profit.
The two step pricing method correct this problem by transferring variable cost on a per unit basis, and transferring fixed cost and profit on a lump sum basis.
Under this method the transfer price for product A would be Rs.5 for each unit that unit Y purchases plus Rs.20000 per month for fixed cost. Plus Rs.10000 per month for profit:
If transfer of product A in a certain month are at the expected amount 5000 units then under the two step method unit y will pay the variable cost of Rs.25000 ( 5000 units * Rs.5 per unit) plus Rs.30000 ,on a monthly basis, for the fixed cost and profit--- a total of Rs.55000 .This is the same amount as the amount it would pay unit x if the Transfer Price were Rs.11 per unit ( 5000 *11= Rs.55,000)
if the transfers in another month is less than 5000 units say 4000 units, unit y would pay Rs.50,000 [ 4000 units * Rs 5 + Rs 30,000] under the two step methods compared with the Rs.44000 it would pay if the transfer price were Rs.11 per unit. The difference is their penalty for not using a portion of unit X’s capacity that it has reserved.
Conversely, Unit Y would pay less under the 2 step-method if the transfers were more than 5,000 units in a given month. This represents the savings Unit X would have because it could produce the additional units without having to incur additional Fixed Costs.
Note that under two step method the company variable cost for product A is identifiable to unit Y’s variable cost for the product, and unit Y will make the correct short term marketing decisions. Unit Y also has information on upstream fixed costs and profit related to product A and it can use these data for long term decision.
The fixed cost calculation in the two step pricing method is based on the capacity that is reserved for the production of product A that is sold to unit Y. The investment represented by this capacity is allocated to product A. The return on investment that unit X earns on competitive ( and, if possible comparable) products is calculated and multiplied by the investment assigned to the product.
In the example we calculated the profit allowance as a fixed monthly amount. It would be appropriate under some circumstance to divide the investment into variable( Receivable & Inventory) and fixed ( Plant & Machinery) components. Then, a profit allowance based on a return on investment on variable assets would be added to the standard variable cost for each unit sold.
Following are some points to consider about the two-step pricing method:
1. The Monthly charge for Fixed Costs and Profit should be negotiated periodically and will depend on the capacity reserved for the buying unit.
2. How much capacity to reserve for various products is an issue under this method of pricing
3. Under this method the manufacturing units profit performance is not affected by the sales volume of the final unit.
4. There could be a conflict of interest between manufacturing unit and those of the company. If capacity is limited the unit may have an opportunity to increase its profit by using its limited capacity to cater to external demand in preference to internal demand. This is mitigated by firm level involvement, by stipulating that the marketing unit has first claim.
5. This method is similar to “Take or Pay” pricing that is frequently used by public utilities, mining, pipelines and Long-term contracts
Profit sharing:
If the two step pricing system just described is not feasible, a profit sharing system might be used to ensure congruence of business unit interest with company interest. This system operates as follows.
1. The product is transferred to the marketing unit at standard variable cost.
2. After the product is sold, the business units share the contribution earned which is selling price minus the Company’svariable manufacturing and marketing costs.
This method of pricing may be appropriate if the demand for the manufactured product is not steady enough to warrant the permanent assignment of facilities as in the two step method. In general, this method does make the marketing unit’s interest congruent with that of the company.
There are several practical problems in implementing such profit sharing system. First, there can be arguments over the way contribution is divided between the two profit centers. Senior Management may have to intervene to settle the dispute. This is costly & time consuming and works against a basic reason for decentralization, namely autonomy of the business units mangers. Second, arbitrarily dividing up the profits between units does not give valid information on the profitability of each unit.
Third since the contribution is not allocated until after the sale has been made the manufacturing units contribution depends upon the marketing unit’s ability to sell and on the actual selling price. Manufacturing units may perceive this situation to be unfair
Two set of price:
In this method, the manufacturing unit’s revenue is credited at the outside sales price, and the buying unit is charged the total standard costs. The difference is charged to a headquarter account and eliminated when the business unit statement are consolidated. This transfer pricing method is sometimes used when there are frequent conflicts between the buying and selling units that cannot be resolved by one of the other method. both the buying and selling units benefit under this method.
There are several disadvantages to the system of having two set of transfer prices. First the sum of the business unit profits is greater than overall company profits. Senior management must be aware of this situation when approving budgets for the business units and subsequently evaluating performance against these budgets. Secondly, this system create an illusive feeling that business units are making money while in fact the overall company might be losing after taking account of the debits to headquarters. Thirdly this system might motivate business unit to concentrate more on internal transfers at the expense of outside sales. Fourthly, there is additional bookkeeping involved in first debiting headquarters every time a transfer is made and then eliminating this account when the Financial Statements are consolidated.
Finally the fact, that the conflict between the business units would be lessened under this system could be viewed as a weakness. Sometime, it is better for the headquarter to be aware of the conflict arising out of transfer prices because such conflict may signal problem in either the organizational structure or in other management systems. Under the two sets of prices method these conflicts are smoothed over thereby not alerting senior management to these problems.
Numericals:
Output & sales Selling price Marginal cost Fixed Costs
(all to external customers) (= variable cost)
40,000 tons Rs.120 per ton Rs.65 per ton Rs.720,000 P/A
The company also has a Glass Bottles Division, which needs 10,000 tons of molten glass per annum in order to manufacture its bottles. At present, however, the Glass Bottles Division buys all of its molten glass from an external supplier at a price of Rs. 105 per ton.
Determine the transfer Price in the following 3 scenarios
Scenario 1: No spare capacity in the Molten Glass Division
Scenario 2: Spare capacity in the Molten Glass Division
and there is no demand from external customers for these potential additional tons.
Scenario 3:LIMITED Spare capacity in the Molten Glass Division
Suppose, for example, that the maximum production capacity of the Molten Glass Division is 45,000 tons per annum. Since there is demand from external customers for 40,000 tons, this means that spare capacity is just 5,000 tons.
Remember that the Glass Bottles Division needs 10,000 tons per annum
Scenario 4:Assume that the transfer Price is based on the Full Cost Method
Solution:
Scenario 1: No spare capacity in the Molten Glass Division
If any tons of molten glass are sold to the Glass Bottles Division, then there will have to be a corresponding reduction in the quantity sold to external customers. Applying the commonly used principle, the Molten Glass Division will want to set the transfer price as follows:
`
Variable cost of Production 65
Plus Contribution Lost
Selling Price 120
Less Variable costs: 65 55
Production Costs ------ ----------------
Minimum TP= 120
__________
Scenario 2: Spare capacity in the Molten Glass Division
And there is no demand from external customers for these potential additional tons.
This means that it is now possible to produce some extra molten glass for sale to the Glass Bottles Division without any reduction in the quantity sold to external customers. In other words, where spare capacity exists, there is no opportunity cost associated with making the transfer.
Variable cost of Production 65
Plus Contribution Lost
Selling Price 0
Variable costs: 0 0
Production Costs------ -----------------
Minimum TP= 65
-----------------
In line with the principle of divisional autonomy, it is appropriate to leave it to the two division managers to negotiate the precise transfer price within the range between 65 & 105
Scenario 3: LIMITED Spare capacity in the Molten Glass Division
Only half of BD's needs (5,000 tons) can be produced using spare capacity, and these transferred tons should be priced in accordance with Scenario 2.
As regards units which could not be produced using spare capacity, but would instead reduce the number of units available for sale to external customers, in accordance with the logic of Scenario 1, the transfer price should be €120 (the price charged to external customers whom these transfers would displace).
Scenario 4: Assume that the transfer Price is based on the Full Cost Merthod
Full Cost is calculated as follows:
Marginal cost per ton (= variable cost ton) | Fixed cost per ton | Full cost per ton |
Rs.65 | Rs.18 (Rs720,000 / 40,000 tons) | Rs.83 (Rs.65 + Rs.18) |
If we consider Scenario 1, it is clear that the full cost transfer price (€83 per ton) would be too low where no spare capacity exists. However, in Scenario 2 (where spare capacity exists) it is clear that the full cost transfer price of €83 per ton would lead to optimal decision-making in these circumstances (and, in fact, would split the incremental profit reasonably equitably between the two divisions).
Numerical 2
.
Required 1:
If Division could sell 125000 units @ Rs 100 each in the open market----
What Transfer Price the central Management would prefer in order to provide proper motivation to y Division ?
Required 2:
As Management Accountant would you advice Division Y to Buy the product at the Transfer Price determined in 1 above ?
Required 3:
If Sales of Division Y's product drops to Rs. 200, whether the TP of 98 will be acceptable ?
Required 4:
Assume that Division X 's product did not have an outside demand in excess of one lakh units and its total Fixed Manufacturing Costs could be reduced by 10 %, if the Volume of the Production were reduced to 100,000 units, What is the appropriate Transfer Price ?
Required 5:
Suppose that X division 's maximum outside demand is 1,10,000 units at Rs. 100 and there is no usage for the capacity . What Transfer Price should the Company Management prefer ?
Solution:
Required 1:
If Division could sell 125000 units @ Rs 100 each in the open market----
Soln:
Variable cost of Production 84
Plus Contribution Lost
Selling Price 100
Variable costs: 84
Production Costs
Selling Costs 2 86 14
-------------------------------------------
Minimum TP= 98
-------------------------------------------
Required 2:
As Management Accountant would you advice Division Y to Buy the product at the Transfer Price determined in 1 above ?
Soln:
Yes, obviously the Contribution earned by Division Y would be more if the Internal Transfer price is lesser than the external purchase price.
Required 3:
If Sales of Division Y's product drops to Rs. 200, whether the TP of 98 will be acceptable ?
Soln:
Approach:
Examine Perspective of Y Division
Examine Perspective of Firm
1 Whether to Transfer to Y ?
2 Whether to sell the produce of X externally ?
Perspective of Division Y
Y Purchaes from X at TP 98
Contribution
Selling Price 200
Variable costs:
Production Costs 100
Bought Out Item 98
Selling Costs 6 204
---------------------------------------------
Contribution (4.00)
----------------------------------------------
The Contribution is Negative . Division Y will be de-motivated
Perspective of the Firm:
The Contribution earned by the firm when it sells the product of X externally is more than when it is transferred to Y and the final product is sold by Y. If the firm is not strategically affected by this decision, it would be better to sell product of X externally, at least in the short term, till the time, the price of the product of Division Y is sufficiently revived.
Required 4:
Assume that Division X 's product did not have an outside demand in excess of one lakh units and its total Fixed Manufacturing Costs could be reduced by 10 %, if the Volume of the production were reduced to 100,000 units, What is the appropriate Transfer Price ?
Required 5:
Suppose that X division 's maximum outside demand is 1,10,000 units at Rs. 100 and there is no usage for the capacity . What Transfer Price should the Company Management prefer ?
Soln:
For 10,000 units Rs 98
For 15000 units with Nil Opportunity Costs, the minimum Transfer Price will beRs.84. The actual Transfer price, however, will be settled by negotiation, at a level above this minimum.
Return on Investment:
Q.1) A)Explain the concept of ROI. What are its advantages?
Return on investment (ROI) is the ratio of profit before tax to the gross investment.
ROI is calculated with the help of the following formula:
ROI = (Pre-Tax Profit/Sales) X (Sales/Net Assets) or (Pre-Tax Profits/Net Assets)
The numerator is profit before tax as reported in the P&L account. The profit should include only the profits arising out of the normal activities of the division. Unusual items of receipts and expenses should be excluded from the profit figure. One should also ignore windfalls and income from investments not related to the operations of the division. Tax is excluded from the numerator because the marginal of the SBU is not responsible for or in control of the tax paid.
Capital employed can be ascertained from the balance sheet by including fixed and current assets. Assets not currently put to divisional use should be excluded from the investment base. One also needs to exclude their relative earnings if any. The company should also exclude intangible assets like goodwill, deferred revenue expenses, preliminary expenses, etc.
ROI can be improved by:
Increasing the profit margin on sales.
Increasing the capital turnover
Increasing both profit margin and capital turnover.
Reducing cost as that adds to the total earnings of the firm.
Increasing the profits by expanding present operations or developing new product line, increasing market share, etc.
Diversifying, introducing productivity imporevement measures, expansion, replacement of old equipments
Advantages of ROI
ROI relates return to the level of investment and not sales as the rate of return is more realistic.
ROI can be decomposed into other variables as shown. These variables have tremendous analytical value.
ROI is an effective tool for inter-firm comparison.
Question 1 (b):
Many experts regard EVA as a concept superior to ROI and yet in certain cases, EVA does not do justice to the evaluation of investment center. Explain this phenomenon with as illustration.
EVA does not solve all the problems of measuring profitability in an investment center. In particular, it does not solve the problem of accounting for fixed assets discussed above unless annuity depreciation is also used, and this is rarely done in practice. If gross book value is used, a business unit can increase its EVA by taking actions contrary to the interests of the company, as shown in Exhibit 7-3. If net book value is used, EVA will increase simply due to the passage of time. Furthermore, EVA will be temporarily depressed by new in¬vestments because of the high net book value in the early years. EVA does solve the problem created by differing profit potentials. All business units, regardless of profitability, will be motivated to increase investments if the rate of return from a potential investment exceeds the required rate prescribed by the mea¬surement system.
Moreover, some assets may be undervalued when they are capitalized, and others when they are expensed. Although the purchase cost of fixed assets is ordinarily capitalized, a substantial amount of investment in start-up costs, new product development, dealer organization, and so forth may be written off as expenses, and, therefore, not appear in the investment base. This situation applies especially in marketing units. In these units the investment amount may be limited to inventories, receivables, and office furniture and equipment. When a group of units with varying degrees of marketing responsibility are ranked, the unit with the relatively larger marketing operations will tend to have the highest EVA.
In view of all these problems, some companies have decided to exclude fixed assets from the investment base. These companies make an interest charge for controllable assets only, and they control fixed assets by separate devices. Con¬trollable assets are, essentially, receivables and inventory. Business unit man¬agement can make day-to-day decisions that affect the level of these assets. If these decisions are wrong, serious consequences can occur-quickly. For exam¬ple, if inventories are too high, unnecessary capital is tied up, and the risk of obsolescence is increased; whereas, if inventories are too low, production inter¬ruptions or lost customer business can result from the stockouts. To focus atten¬tion on these important controllable items, some companies, such as Quaker Oats, 17 include a capital charge for the items as an element of cost in the busi¬ness unit income statement. This acts both to motivate business unit manage¬ment properly and also to measure the real cost of resources committed to these items.
Investments in fixed assets are controlled by the capital budgeting process before the fact and by post completion audits to determine whether the antici¬pated cash flows, in fact, materialized. This is far from being completely satis-factory because actual savings or revenues from a fixed asset acquisition may not be identifiable. For example, if a new machine produces a variety of prod¬ucts, the cost accounting system usually will not identify the savings attribut¬able to each product.
The argument for evaluating profits and capital investments separately is that this often is consistent with what senior management wants the business unit manager to accomplish; namely, to obtain the maximum long-run cash flow from the capital investments the business unit manager controls and to add capital investments only when they will provide a net return in excess of the company's cost of funding that investment. Investment decisions, then, are controlled at the point where these decisions are made. Consequently, the capi¬tal investment analysis procedure is of primary importance in investment con¬trol. Once the investment has been made, it is largely a sunk cost and should not influence future decisions. Nevertheless, management wants to know when capital investment decisions have been made incorrectly, not only because some action may be appropriate with respect to the person responsible for the mistakes but also because safeguards to prevent a recurrence may be appropriate.
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