Syllabus Requirement:
Transfer Pricing (Market based and Cost Based) - Related numerical problems - Return
on Investment, Economic Value Added, Capital Budgeting and Ratio Analysis as a
tool to management performance measurement
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’s
variable 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.
.
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