TRANSFER PRICING

Transfer Pricing

General International transfer pricing

Rules * different tax rates
Objectives * Perfectly competitive market * Government action
* Surplus capacity * Managing cash flows
* Production constraints * Currency management

PERFORMANCE MEASUREMENT: BEHAVIOURAL CONSEQUENCIES

 When an organization is structured into profit centers or investment centers, authority is

delegated to the profit center or investment center managers
 These managers are given the authority to take decisions at a local level, without having to wait
for instructions from head office.
 Control is applied from head office through performance measurement: center managers are
held accountable for the profits or returns that they make
 The purpose of decentralization should
 to give autonomy to local center managers in decision – making
 to motivate center managers to improve performance at a profit center level, to achieve
better results for the organization as a whole.
 Decentralization can create tension between local center managers and head office
management
 The performance of the managers of profit center and investment centers will be assessed, and
the managers themselves will be awarded, on the basis of the results of their particular center.
 Profit center managers will therefore be motivated to optimize the results of their division,
regardless of other profit centers and regardless of the organization as a whole
 When head office management believe that a profit center manager is taking decisions that
improve the profit center performance, but are damaging for the interests of the organization as
whole, they might want to step in and either:
 Alter the decision that have been made at profit center level, or
 Make new decisions for the profit center
  However, if head office interferes in decision making at profit center level, local autonomy in
decision making is lost

TRANSFER PRICING:

 In an organization with profit centers and investment centers, there will almost certainly be
some inter-connection between different centers. Some profit centers will supply goods and
services to others
 When inter divisional (inter-company) trading takes place between profit centers, the center
providing the goods or services to the other will want to earn income from the transfer.
 Unless it receives income from the transfer, it will make a loss on the transaction.
 For example: If Division A provides items to Division B that cost $ 10 each to make. Division A
must earn at least $10 from the transfer; otherwise it will make a loss. If decision making is
delegated to profit center management, the manager of Division A would refuse to supply
Division B unless it is allowed to earn income of at least $10 for each unit.
 Inter-divisional transfers must therefore to be priced. The price of the transfer is the transfer
price.
 The transfer is treated as an internal sale and internal purchase within the organization.
It provides sales income to the supplying division and is a purchase cost for the
receiving division.
 The sale income of one division is offset by the purchase cost of the other division. The
transfer therefore affects the profits of the two divisions individually, but has no effect
on the profit of the organization as a whole.

SETTING A TRANSFTER PRICE: INTER-DIVISIONAL TRADIGN POLICY

 The transfer price for inter-divisional transactions is significant because

 It determines how the total profit is shared between the two divisions, and
 In some circumstances, it could affect decisions by the divisional managers about
whether they are willing to sell to or buy from the other division.

BOTH DIVISIONS MUST BENEFIT FROM THE TRANSACTION IF INTER-DIVISIOANL SALES ARE TO TAKE
PLACE.

 A selling division will not agree to sell items to another division unless it is profitable for the
selling division to do so
 Similarly, a buying division will not wish to purchase items from another division unless it is
profitable for the division
TRANSFER PRICE HAVE TO BE ESTABLISHED AND AGREED:

 They could be decided either centrally or locally.

 They could be imposed by Head office
 Alternatively, they could be decided by commercial negotiation between the profit
center managers
 If decentralization is to allow the power of decision making to profit center managers,
they should have the authority to agree transfer prices by discussion or negotiation
between themselves.
 Inter-divisional trading should take place within a broad company policy, that:
 for a ‘selling division’, given the choice between making a sale to an external customer
or supplying goods or services to another division within the group, the preference
should be to sell internally
 for a ‘buying division’, given the choice between purchasing from an external supplier or
from another division within the company, the preference should be to purchase
internally
 However, a division should be allowed to sell externally rather than transfer internally, or buy
externally rather than internally, if it has a good commercial reason. Good commercial reasons
would include an external customer offering a higher price or an external supplier offering a
lower price.

Example: 1: Inter-divisional trading

A company has two profit centers, Center A and Center B. Center A supplies Center B with a part –
finished product. Center B complete the production and sells the finished units in the market at
$35 per unit.

Budgeted data for the year:

Division A Division B
Number of units transferred/sold 10,000 10,000
Materials costs $8 per unit $2 per unit
Other variable costs $2 per unit $ 3 per unit
Annual fixed costs $60,000 $30,000
Required:
Calculate the budgeted annual profit of each profit center and the organization as a whole if the
transfer price or components supplied by Division A to Division B is:
(a) $20
(b) $25
SOLUTION:

(a) If the transfer price is $20

Division A Division B Company as a

whole
$000 $000 $000
External sales 0 350 350
Inter – divisional transfers 200 0 0
200 350 350
Costs
Inter divisional transfers 0 200 0
Other material costs 80 20 100
Other variable costs 20 30 50
Fixed costs 60 30 90
Total costs 160 280 240
Profit 40 70 110

(b) If the transfer price is $25

Division A Division B Company as a
whole
$000 $000 $000
External sales 0 350 350
Inter – divisional transfers 250 0 0
250 350 350
Costs
Inter divisional transfers 0 250 0
Other material costs 80 20 100
Other variable costs 20 30 50
Fixed costs 60 30 90
Total costs 160 330 240
Profit 90 20 110

Conclusions from the Example:

 The choice of transfer price does not affect the profit of the organization as a whole,
provided that there is agreement on the quantity of transfers
 However, the choice of transfer price affects the profitability of the individual profit
centers.

OBJECTIVES OF TRANSFER PRICING:

(1) Goal congruence:

 Within a divisionalised company, divisional managers will have responsibility for and
will be judged on their division’s performance
  They will act independently, autonomously and selfishly in the best interests of their
own division.
 They neither know nor care what is happening in other divisions:
 It is the task of the management accounting system in general and the transfer
pricing policy in particular to ensure that what is good for an individual division is
good for the company as a whole.
(2) Performance measurement:
 The transfer pricing system should result in a report of divisional profits that is a
reasonable measure of the managerial performance.
(3) Minimizing the global tax liability:
 When a divisional company operates entirely within one tax regime the transfer
pricing policy will have a minimal impact on the corporate tax bill. However
multinational companies can and do use their transfer pricing policies to move
profits around the world and thereby minimize their global tax liabilities.
(4) Recording the movement of goods and services:
 In practice, a extremely important function of the transferring pricing system is
simply to assist in recording the movement of goods and services
(5) A fair allocation of profits between divisions :
 Most of the advantages claimed for divisionalisation are behavioral. Insofar as
transfer pricing has a material effect on divisional profit it is essential that managers
perceive the allocation of corporate profit as being fair if the motivational benefits
are to be retained.

Needless to say that a number of these objectives can conflict with each other, and
prove difficult to achieve in practice. It is highly unlikely that any one method would
meet all the firm’s requirements in all circumstances the best that can be hoped for is a
reasonable compromise