6.

Transfer Pricing

Transfer Pricing


An essential feature of decentralized firms is responsibility centres (e.g., cost, profit, revenue, or
investment centres). The performance of these responsibility centres is evaluated on the basis of various
accounting numbers, such as standard cost, divisional profit, or return on investment (as well as on the
basis of other non-accounting measures, like market share). One function of the management accounting
system therefore is to attach a dollar figure to transactions between different responsibility centres. The
transfer price is the price that one division of a company charges another division of the same company
for a product transferred between the two divisions. The basic purpose of transfer pricing is to induce
optimal decision making in a decentralized organization (i.e., in most cases, to maximize the profit of the
organization as a whole).

Purposes of Transfer Pricing

The main reasons for instituting a transfer pricing scheme are as follows:

Generate separate profit figures for each division and thereby evaluate the performance of each division
separately.

Help coordinate production, sales and pricing decisions of the different divisions (via an appropriate
choice of transfer prices). Transfer prices make managers aware of the value that goods and services
have for other segments of the farm.

Transfer pricing allows the company to generate profit (or cost) figures for each division separately.

The transfer price will affect not only the reported profit of each centre, but will also affect the allocation
of an organizations resources.

Mechanics of Transfer Pricing

No money need change hands between the two divisions. The transfer price might only be used for
internal record keeping.

(Transfer Price quantity of goods exchanged) is an expense for the purchasing centre and revenue for
the selling centre.


Accounting for Transfer Pricing

If intra-company transactions are accounted for at prices in excess of cost, appropriate elimination entries
should be made for external reporting purposes. Examples of items to be eliminated for consolidated
financial statements include:

Intracompany receivables and payables.
Intracompany sales and costs of goods sold.
Intracompany profits in inventories.

Market-based Transfer Pricing
When the outside market for the good is well-defined, competitive, and stable, firms often use the market
price as an upper bound for the transfer price.

Negotiated Transfer Pricing
Here, the firm does not specify rules for the determination of transfer prices. Divisional managers are
encouraged to negotiate a mutually agreeable transfer price. Negotiated transfer pricing is typically
combined with free sourcing. In some companies, though, headquarters reserves the right to mediate the
negotiation process and impose an arbitrated solution.

Cost-based Transfer Pricing
In the absence of an established market price many companies base the transfer price on the production
cost of the supplying division.


The most common methods are:
Full Cost
Cost-plus
Variable Cost plus Lump Sum charge
Variable Cost plus Opportunity cost
Dual Transfer Prices









4.Responsibility Centres
Responsibility Centres



A responsibility center is an organization unit that is headed by a manager who is responsible for its
activities and results. In Responsibility Accounting, revenues and costs information are collected and
reported by responsibility centers. A decentralized environment results in highly dispersed decision
making. As a result, it is imperative to monitor and judge the effectiveness of each manager.

Objectives of Responsibility Accounting:

Responsibility accounting is a method of dividing the organizational structure into various responsibility
centres to measure their performance. In other words responsibility accounting is a device to measure
divisional performance measurement may be stated as under:

1. To determine the contribution that a division as a sub-unit makes to the total
organization.
2. To provide a basis for evaluating the quality of the divisional managers
performance. Responsibility accounting is used to measure the performance of
managers and it therefore, influence the way the managers behave.
3. To motivate the divisional manager to operate his division in a manner consistent with the
basic goals of the organization as a whole.




There are four types of responsibility centres, according to the nature of the control over the inputs and
outputs:

1. Cost Center
A cost center is an organizational sub-unit such as department or division, whose manager is held
accountable for the costs incurred in that division. For example, a Power and Airco Department can can
be defined as a cost center within the Operation and Maintenance Department in United
Telecommunication Company. Manager of a cost center is responsible for controllable costs incurred in
the department, but is not responsible for revenue, profit or investment in that center. A cost center is
a responsibility center in which inputs, but not outputs are measured in monetary value.

2. Revenue Center
A manager of a revenue center is held accountable for the revenue attributed to the sub-unit. Revenue
centers are responsibility centers where managers are accountable only for financial outputs in the form
of generating sales revenue. A revenue center's manger may also be held accountable for selling
expenses such as sales persons' salaries, commissions, and order receiving costs.

3. Profit Center
Profits are the excess of revenue over the total expenses. Therefore, the manager of a profit center is
held accountable for the revenues, costs, and profits of the centre. A profit center is a responsibility center
in which inputs are measured in terms of expenses and outputs are measured in terms of revenues.

4. Investment Center
The manger of investment centre is held accountable for the division's profit and the invested capital used
by the centre to generate its profits. Investment centres consider not only costs and revenues but also the
assets used in the division. Performance of an investment centre are measured in terms of assets
turnover and return on the capital employed.

Problems in Responsibility Accounting

While implementing the system of responsibility accounting, the following difficulties are likely to be faced
by the management:

1. Classification of costs: For responsibility accounting system to be effective a proper classification
between controllable and non controllable costs is a prime requisite. But practical difficulties arise while
doing so on account of the complex nature and variety of costs.

2. Inter-departmental Conflicts: Separate departmental persuits may lead to inter-departmental rivalry and
it may be prejudicial to the interest of the enterprise as a whole. Managers may act in the best interests of
their own, but not in the best interests of the enterprise.

3. Delay in Reporting: Responsibility reports may be delayed. Each responsibility centre can take its own
time in preparing reports.

4. Overloading of Information: Responsibility accounting reports may be overloading with all available
information. This danger is inherent in the system but with clear instructions by management as to the
functioning of the system and preparation of reports, etc., only relevant information flow in.

5. Complete Reliance will be deceptive: Responsibility accounting cant be relied upon completely as a
tool of management control. It is a system just to direct the attention of management to those areas of
performance which required further investigation.