locos Region, Differentiate the arms length transactions from the related yeu Reuter ce party transactions. Pee ela + Explain the importance of transfer pricing to segment reporting. + Identify the various transfer prices, their proper applications, and explain their importance to segment evaluation. + Evaluate various multinational transfer pricing options for the overall corporate objective.CHAPTER 9 TRANSFER PRICING 426, Transfer Pri Related parties transfer pricing happens wher i PecenEA Dy Niayienper N two or more legally independent but related companies The related companies may be a wh purpose entity, or a business enterpris ‘commercial and other activities, holly-owned company, subsidiary, affiliate, special however created having legal existence to conduct Fig. 9.1. The Related Parties Parent Company Fax ; A Company ; B Company (affiliate) (subsidiary) sk VS Ge [ee 1 C Company D Company E Company F Company (subsidiary) (subsidiary) (effiliate) (wholly-owned entity) Any transaction entered into by the parent company with any of its related entities or entered into by any two or more of its related parties is defined as related-party transaction. The issue of transfer pricing occurs when an independent unit sells to or buys from another independent unit within the same business conglomerate. This is anissue of interdependence. Since independent business unit managers have the authority to decide on how they run their iness operations, they deal with external suppliers and customers and also with affiliated divisions (e.g,, internally independent business units) as well. Selling division, buying division, and parent company Wheney i interdivisional transaction, there are at least three (3) independent but aeons affected thereto; the selling division, the buying division, and the parent Company. i n (parent company) has several related companies operating paca oe ee of its related companies are the Packaging Company and the Consumer Products Company. The Packaging Company (eating Gila) sells Packaging materials to Consumer Products Company (buying division). The central issue is: What transfer price is to be used in the interdivisional transaction?Negotated pice Ee” =i i‘é‘ el CHAPTER 9 427 TRANSFER PRICING Fig. 9.2. The Transfer Price Environment 7 ee aad “pte lg the 2c Corey Merri euaag AT WHAT TRANSFER PRICE? fatten ane yer : (Selling Division) Goal congruence and suboptimization Another issue on transfer pricing arises when the entity goal of the transacting dvison center runs in conflict with the overall goal of the organization. When the overall goal of the organization prevails over that of the divisional goals, it is called goal congruence. When the entity goal of the division prevails over the overall organization's goals, itis called suboptimization. Managerial effort is the extent to which a manager attempts to accomplish a goal. Goal congruence and managerial effort are managerial motivation. Motivation is the desire to attain a specific goal (goal congruence) and the commitment to accomplish the goal (managerial effort), Transfer Prices Transfer price is an artificial price used to record interdivisional transactions of goods or services and correspondingly evaluate divisional performance inline with the overall objective of the enterprise. Transfer pricing may be a market-based pricing, cost-based pricin, rcp aia itor Pricing, negotiated pricing, arbitrary The best transfer price is market price. Because individual busi ine: to.compete with the rest ofthe world they have to beat or conform with, Ran ee price to stay competitive. They have to follow the market rules in the oanrshere eh a free enterprise system, capitalistic model of Acost-based transfer price equals cost plus alum, either be standerd or actual cost. Standard costfne fan atte Actual costs give the selling division a little incentive to contra transfer pricing does not promote long-term manufacturing effi transfer pricing does rt give motivation on the part ofthe by incurred by the selling division may not reflect the best possi which is adversely transferred to the buying division : Ip percentage. Cost may 19€ Of isolating variances ‘Ol costs. Actual cost-based iclencies. Also, the cost-based uying division since the costs ble performance in the market Negotiated transfer price may occur when segm which they buy and sell internally. itis especially appren are free to torapid fluctuations, Itreflects the best bargain price anew, determine the prices at 'arket prices are subject rice acceptable to the selling and biaCHAPTER 9 TRANSFER PRICING be divisions without adversely sacrificing their respective interests. arbitrary transfer pricing/s set by the management in the corporate headquarters. Its strength ‘Arpivary pce ig anchored on the premise that the entire corporate organization has to promote its overall ~~" goals (optimization) over and above that of the division's goals (suboptimization). On the contrary, it does not jibe well with the very principle of decentralization where authority Is given to division managers to make decisions with regard to their operations. Dual pricing is used when the selling and buying divisions, use two (2) different prices in “Sutprcing recording their inter-company transfers. For example, the selling division records the transfer atmarket prices as if the sale is made to outside customers, while the buying division records the purchases at variable cost of production. Each division's performance would improve using the dual pricing scheme. Ina sense, the variable costs would be the relevant price for decision-making purposes but the segment's performance is evaluated based on market prices. In this pricing model, the sum of the profits of the individual divisions would be greater than the overall profit of the orcanization. This model reduces managerial efforts fo Control costs. The seller is assured of a high price, and the buyer is assured of an artificially low price This model is rarely used in practice because division managers are assured of a good segment performance and may not exert much effort to report higher segment margin. Sample Problem 9.1. Basic Transfer Prices Great Flowers Holdings, Inc., has two: independent divisions, Asian Enterprises and Malayan Corporation, that conduct business inthe same country, Asian Enterprises prodluces prodict "Cute" of which Malayan Corporation buys from an external supplier at P80 per piece. The relevant production data of Asian Enterprises is as follows: Variable production costs P66 Allocated factory overhead 15 Required: Determine the profit for Asian Enterprises, Malayan Corporation, and Great Flowers, ihe if an interdvisional transfer of goods ocourred under each ofthe folowing transfer pices: 1. Market price of P80. 2. Vatiable production costs of P66. 2 3. Negotiated price of P73. 4. Dual pricing. Solutions/Discussions: + The profit of the concerned companies is computed as follows: ¥CHAPTER 9. 429 TRANSFER PRICING t PBO. | 1. Transfer price is market price a a0 Market price Transfer price P80 Market price Var. aly Goer > 2 Lak y(- Trenate poe || La” 9/sVetepree. Coste | Profit Bia Profit Peace 2. Transfer price is variable production costs of P66. : Transfer price 66 Market price BOuny Markee PyICe | , 5; 66 - Var. prod. Costs ‘Var. prod.cost. _66 —_~ Transfer price Profit _. Profit ele eae 3. Transfer price is negotiated price of P73. | Transfer price 73 Market price 80 Market price | Var. prod. cost 66 —- Transfer price _73 — -Var. prod. Costs | Profit 2 Profit ogee ye, Profan, ia 4. Transfer price is dual prices. Transfer price 80 Market price 80 Market price 80) - Var.prod.cost. _66 —_- Transfer price 66 -Var.prod. Costs. _66 Profit EARLS Petite yt St ran If the transfer price is the market price, the selling division reports all the profit of P14 and thereupon reports higher return on investment, or residual income, or EVA. The selling division manager has a higher chance of getting more rewards suich as job bonuses, bonuses, and other perks and privileges, assuming all things are the same in all divisions. : + If the transfer price is based on costs, the buying division register fi c costs, all the profit of P14, reports higher return on investment, or residual income, or EVA, enh wa buying division manager would have a higher chance of getting more renner recognition, assuming all things are the same on all divisions, ca + If the transfer price is based on negotiated pricing, divisions have share on the transaction Profit, report residual income, or EVA, and have an equal chance of b oF promotions or giving of rewards, assuming all things both the selling and the buying higher return on investment, © ing considered in the next round arethe same among the divisions. If the transfer price is based on dual pricing, bath the eel record profitat P14, report much higher return on mena ma ae buying divisions and have an equal chance of being considered in the next mri ual income, oF EVA, of rewards, assuming all things are the same among the ngag rom otions or giving + The allocated factory overhead is not considered in for performance purposes because it is not reetne or neater Givisional prof : “ le performancece. CHAPTER 9 TRANSFER PRICING ae * and it does not change regardless of the option to buy the product from an outside supplier or from a relative division Performance Report Profit itshould had been immediately noticed the transfer price is notrelevantin the perspective Center Manager ofthe parent company. First, because the divisions are in the same country and therefore —— covered by the same taxation laws and regulations. Second, the transfer price is an input cost and a revenue invciving the same amount, therefore is only a transfer payment, and has no impact on the overall performance of the parent company. If in case, the trensacting divisions are covered by different set of tax rules and regulations, although located in the same country “owever have varying tax impacts, the change in the tax effects should be consideres in the analysis in the parent company. Overall, the profit of Great Flowers Holdings, Inc., remains the same at P14, despite the differences in the transfer price used by the transacting divisions. Following the doctrine of goal congruence, a holding company should continue advising its buying division to buy the goods from its selling division as long as the incremental costs of producing the goods is lower than the cost of buying the same from an outside supplier. This decision would produce overa' savings, regardless of the transfer price used in recording the interdivisional transaction, and would be beneficial for the overall operations of the holdings company. Minimum transfer prices The transfer pricing policy is normajly set by the top management. The segment's goal is also relevant but the overall goal of the organization is paramount. The other factors that ate considered in setting the transfer price are excess capacity, opportunity cost of the « transfer transaction, international tax issues (e.g., income taxes, sales taxes, value-added taxes, inventory and payroll taxes, and other governmental charges), and other international issues such as foreign exchange rate fluctuations and limitations on transfers of profits outside the host country. The challenge in setting the minimum transfer price is of interest both to the selling and Buying divisions. In the perspective of the selling division, the minimum transfer price (MTP) \Sas follows: with excess capacity 4 without excess capacity feoular incremental costs include that of variable production costs, incremental fixed head, and regular marketing, selling, and administration expenses. Other incremental sts pertain to those aside from the regular incremental costs.ransfer price st costs of Pl to the buying 4s if the regul roduction and sales, fixed division, and regular lar sales are sacrificed minimum ti jar incremental .d and charged unity Cost When there is no excess capacity, the price which already includes the regu! overhead which should be transferre’ contribution margin which becomes an opport in lieu of accepting the order of the buying division Sample Problem 9.2 Minimum Transfer Price nut brooms that are used in ices ‘bales” of coco! Coco Division of Lubi Corporation produ is sell for an average of P20 each and Coco ie gs per month, consumer Producte Division each month in its production Coco Division at its present various commercial applications. The bal Division has the capacity to produce 10,00 of Lubi Corporation uses approximately 2,000 b: of various household gadgets. The operating int level of operations (8,000 bales per month) follows jales of brooms formation for Sales (all external) P160,000 Variable costs per bale: Production 2 Selling Fi General and administrative expenses Fixed costs per bale (based on a 10,000 unit capacity) Production 2 Selling 3 4 General and administrative expenses Consumer Products Division currently pays P15 per bale for coconut brooms obtained from its external supplier. Required: Determine the following: 1. Minimum transfer price. 2. Minimum transfer price, assuming the Consumer Products Division needs 3,500 bales 3. Minimum transfer price, assuming the Consumer Products Division needs 4,400 bales but is willing to pick up the goods from the factory resulting to a saving in selling expenses of P1.30 per bale. Solutions / Discussions: 1. with excess capacity Min. Transfer Price = Incremental costs + Opportunity costs - Savings = P8.00 The incremental costs include variable production and expenses (e.g,, P5 + P2 + P1) with no excess capacity Min. Transfer Price = Regular sales price + Other incremental costs Oppotunity costs - Savings ie = P20+P0.8571 = CHAPTER ell TRANSFER PRICING arts from the regular sales a\PTER 9 CHA TRANSFER PRICING 432 The opportunity cost is the k 3,500 units - 2,000 units) x would be P0.8571 per unit lost contribution Pas Pacoey margin on regular sales P3,000 (e.g., and if spread over the 3,500 units ordered 3, Min. Transfer Price =“(P20-1.30)+P1.20 = pia.ag ibution margin on regular sales P3,000 (e.g., }00), and if spread over the 4,000 units ordered The opportunity cost is the lost contrit 4,400 units - 2,000 units) x P2 = p4, 8 would be P1.20 per unit ‘ Multinational Transfer Pricing Multinational transfer pricing applies when the transacting divisions are addressed or located indifferent countries of operations, ie Moltinational ‘ transfer pricing Inmultinational transfer pricing, the objectives of the holdings company govern to minimize reduces taxes paid costs and maximize profit. Costs are minimized if the internal costs of producing the goods are lower than the costs of Acquiring the goods externally. A special focus of multinational transfer pricing is the analysis on international tax effects incurred or paid by the parent or holding company to the host countries. The holding company would endeavor to reduce the overall tax payments by striking the best transfer price that would result to the lowest total tax payments to be made. Also, to record the shippine expenses in the country having lower applicable tax rates. Sample Problem 9.3. Multinational Transfer Pricing World Holdings, inc., has two international divisions, one operating in the Philippines and the other is operating in China. The China Division produces product "22n4” which is a material used by the Philippines Division. The divisions are operating independently and below are the selected data on their operations: China Philippines Unit sales price P300 P580. Unit variable production costs = 120 80 Domestic price of material “22n4 250 Tax rate 60% 30% World Holdings, Inc., is entertaining the possibility of the China Division supplying the product “22n4" needs of the Philippine Division. The China Division has enough capacity to accommodate the possible demand of the Philippine Division,and its local and other international market would not be affected by its contemplated sales to the Philippine Division. if ever the transfer pushes through, shipping charges, freight, custom duties. and other incremental and similar costs of transactions would be P40 per unit. Required: Determine the overall profit of World Holdings, Inc,, if the transfer price and the "cording of the shipping and related costs, are as follows:CHAPTER 9 433 TRANSFER PRICING Its. the / other commen Options Transfer price Shipping casts to be recorded PY ue P300 China Division 2 P300 Philippine Division 3. P120 Philippine Division 4 P120 China division 5. P250 Philippine Division é he materials locally and the China The 6th option is for the Philippine Divisions buys t Division sells the goods in the domestic marker Solutions / Discussions: follows: The computations of the consolidated net profit shall be as j 2k Consolicated profit before tax (P580 ~ P120 - P40 -P80) p340 P340 P340 P340 P340 ae (P300 - P120) + (P580 - P80 - P250) China taxpaid _________ (P300 ~ P120 = P40) 60% (84) (P300 - P120 ) 60% (108) (P120 - P120) 60% 0 (P120 — P120 — P40) 60% 24 (P250 — P120) 60% (78) (P300 — P120) 60% (108) Philippine tax paid —____ (P580 ~ P30 ~ P80) 30% (60) (P580 ~ P300 - P40 - PBO) 30% (48) (P580 ~ P120 ~ P40- P80) 30% (102) (P580 ~ P120- P80) 30% (114) (P580 ~ P250 ~ P40 - P80) 30% (63) (P580 — P250 ~ P80) 30% (eb Consolidated profit 2196 Pigg p38 8 p75q we P1994 p747 @ Based on the analysis above, the best transfer of the enterprise is option no. 3 which would re: 250.00. Thats, set the transfer price at P12 the cost of shipping and related expenses, Price for the overall goal congruence sult to the highest profit after taxes of 0 and the China Division would absorb The field of multinational transfer pricing has alread agencies, international standard-setting firms, and e1 wisdom of recording transactions on a pure arm's-le ly attracted the attention of regulatory tities articulati ing the advantages and ngth transactions basis. Quality management measurements Feedback and performance evaluation are im ort regarding managerial performance may, take the form onan ee managing __ Feedback that may be internally and externally generated. Some cariates haninancia measures nancial and externalCHAPTER 9 TRANSFER PRICING oy sures are pein f ae ear a ota average on return on equity, return on assets, return oF eee es ity ratio, and price-earnings ratio, Examples of internal and financial mea: variances, return on investment, residual income, breakeven point, breakeven time, retum on sales, and other financial ratios. Breakeven time is the point where the cumulative discounted cash inflows from investment equals the cost of investment Nonfinancial measures are important in a modern, quality-oriented organizations. Emphasis. is made on kaizen or continuous improvement, value-chain analysis, process innovation (or reengineering), process mapping where standards are geared towards process analyses and not on absolute costs benchmarks. Examples of ‘external nonfinancial measures are customer satisfaction, market share, number of sales returns, delivery performances, and competitive rank, Examples of internal nonfinancial measures are set UP time, retooling, rework, outgoing product quality, new product development time, manufacturing cycle time, and productivity rate. product development time pertains to the period where the product is conceptualized, designed, approved, and the prototype made and readied for commercial production. As customer tastes, preferences, needs, and wants change now more frequently, product life cycle shortens and the quickness of addressing customer wants, etc. becomes a critical factor in a business growth and relevance. Manufacturing cycle time refers to a period where the materials from suppliers are received, stocked, checked, processed, and prepared for delivery to customers. To improve manufacturing cycle time, non-value-added activities should be eliminated, therefore, production gets faster, costs diminishes, and customers will be served on time. Partial Productivity rate is a measure of output (finished goods) over process input (e.g., materials, labor hours) ‘asures in determining as to whether a manager is Balanced scorecard uses multiple me achieving objectives at the expense of others. The scorecard approach is a goal congruence tool that informs managers about the factors ‘that top management believes tobe important. For example, the value of improving operating results at the expense of new product development could be evaluated using the scorecard approach. A typical scorecard includes measures in four categories: t » earning and growth perspectives) | internal business processes perspectives; + customer satisfaction perspectives; and + financial perspectives: