ACCA_F5_KUPLAN教材_86

2  Transfer pricing



2.1  Introduction


A transfer price isthe price at which goods or services are transferred from one division toanother within the same organisation. The transfer price represents ‘revenueper unit’ to the profit centre ‘selling’ the good or service and ‘cost per unit’to the profit centre ‘buying’ the good or service.
Transfer pricing ispurely an internal bookkeeping exercise, which does not affect the overallprofitability of the organisation in the majority of circumstances, but allowsthe performance of each division to be evaluated on the basis of profit. If setcorrectly, it can also motivate divisional managers to improve performance. However,a poorly set transfer price can result in suboptimal decisions thus reducingoverall firm profitability.
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Illustration 5 – Transfer pricing[/td][/tr][tr][td=1,1,588]
Division A makescomponents, all of which are transferred to division B for use in making thefirm’s major product. At present there is no system of transfer pricing.
 
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DIV A

                     Components                    Finished goods     External
                                                                      market
 
Component on thecurrent system with respect to the following areas:
(a)  DivisionA’s performance appraisal.
(b)  DivisionB’s performance appraisal.
(c)  DivisionB’s decision making.
 
Solution
(a)  DivisionA has no external revenue so there is no problem treating it as a cost centreand assessing performance accordingly.
The lack of a transfer price does not causeissues for A
(b)  DivisionB has revenue and costs so should be treated as either a profit centre or aninvestment centre. Either way, profit will be a key measure of performance.
§    Under the current system division Beffectively receives the components for free, thus making it appear to bemore profitable than it deserves.
§    Also division B is not being heldresponsible for all factors under its control. For example, suppose employeesin B wasted some components due to carelessness – this will result in morecosts for A to make additional components but there is adverse impact on B’sprofit.
§    A transfer price should make B’s profitmore realistic and ensure better cost control.
Note: if, however,division A were to acquire external revenue streams (e.g. selling componentsto other firms), then it would also have to be treated as a profit centre. Todetermine a fair profit for division A the firm would have to introduce atransfer price so A has the cost of components made for B and somecorresponding revenue.
(c)  Thelack of transfer price means that B is not taking into account all of thecompany’s costs when making decisions. For example:
§    the price of the final product may be settoo low
§    new products may be developed that are notcommercially viable.[/td][/tr][/table]
 

2.2  Objectives of a transfer pricing system


§    Goal congruence
The decisions madeby each profit centre manager should be consistent with the objectives of theorganisation as a whole. A common feature of exam questions is that a transferprice is set that does result in sub-optimal behaviour.
§    Performance measurement
The performance ofeach division should be capable of being assessed and a good transfer pricewould enable each centre to be evaluated on the basis of profit.
§    Autonomy
The system used toset transfer prices should seek to maintain the autonomy of profit centremanagers. If autonomy is maintained, managers tend to be more highly motivatedbut sub-optimal decisions may be made.
§    Minimising the global tax liability
When adivisionalised company operates entirely within one tax regime the transferpricing policy will have a minimal impact on the corporate tax bill. Howevermultinational companies can and do use their transfer pricing policies to moveprofits around the world and thereby minimise their global tax liabilities.
§    Recording the movement of goods and services.
In practice, anextremely important function of the transfer pricing system is simply to assistin recording the movement of goods and services.
§    A fair allocation of profits betweendivisions.
Most of theadvantages claimed for divisionalisation are behavioural. Insofar as transferpricing has a material effect on divisional profit it is essential thatmanagers perceive the allocation of corporate profit as being fair if themotivational benefits are to be retained.
A number of theseobjectives can conflict with each other, and prove difficult to achieve inpractice. It is highly unlikely that any one method would meet all the firm’srequirements in all circumstances; the best that can be hoped for is areasonable compromise.

Test your understanding 6

Division A makescomponents, all of which are transferred to division B for use in making thefirm’s major products. The company isconsidering introducing a new product that will require a new component. Thefollowing data has been estimated for the new product: §    Variable cost of a new component indivision A = $10. §    Variable cost of making new product indivision B = $27 (excluding any transfer price). §    Final selling price = $50. Division Acurrently has spare capacity and fixed costs are not expected to rise as aresult of the new product. (a)  Isthe new product worth making from the company perspective? (b)  DivisionA has suggested a transfer price of $25. Comment. (c)  DivisionB has suggested a transfer price of $5. comment.

 

2.3  Theoretical transfer pricing


The general rule
The transfer priceshould be set at marginal cost plus opportunity cost.
This general rulehas certain implications.
§    When there is a perfectly competitive marketfor the intermediate product the transfer price should be set at market price. Themarket price represents marginal cost + opportunity cost.
§    When there is surplus capacity in theproducing division transfer price should be set at marginal cost as there is noopportunity cost.
§    When there are production constraints in theproducing division the transfer price should be set at marginal cost + theopportunity cost of using resources to produce for the internal market ratherthan the next best alternative.

Illustration 6 – Transfer pricing

Division A of theRobin Group makes a product A22, which it sells externally and to anotherdivision in the Robin Group, Division B. Division B uses product A22 as acomponent in product B46, which it sells externally. There is a perfectexternal market for both A22 and B46. Costs and salesprices are as follows:                                         DivisionA            Division B                                        Product A22           ProductB46 Variableproduction cost                $12 perunit Further variablecost                                         $15 per unit Fixed costs                             $200,000              $300,000 Sales price                             $20 perunit          $45 per unit Division A caneither sell product A22 externally for $20 or transfer the product internallyto Division B. Unless the transfer price is $20 or more, Division A willprefer to sell externally, in order to maximize its profit. Division B caneither buy product A22 from external suppliers at $20, or buy internally fromDivision A. If the transfer price exceeds $20, Division B will prefer to buyexternally, in order to minimise its costs and so maximise its profit. Conclusions: §    The only transfer price at which Division Aand Division B will be willing to trade with each other is $20, the externalmarket price. §    At a transfer price of $20, each divisionwould produce and sell up to its capacity. Each division would maximize itsprofit by making and selling as much as possible, and the total companyprofit would be maximised. Goal congruence would be achieved. §    In both Division A and B, the managershould be motivated to make and sell as much as possible, and to keep costsunder control, in order to maximise profit. §    This price would probably be negotiatedfreely between the managers of Divisions A and B, without head officeinterference. §    The performance of each profit centre wouldbe measured on a fair basis. §    If company policy is to encourageinter-divisional sales unless there is a good commercial reason for sellingor buying externally, the two divisions should trade internally up to theoutput capacity of the lower-capacity division. Another way ofstating the ideal transfer price is:                                                                      $ Marginal cost inDivision A                                          12 Opportunity cost: contributionforegone from external sales by transferring aunit to Division B ($20 -$12)                         8 Ideal transferprice (= market price)                                20 It can be seen that,in these circumstances, setting the transfer price as the market pricesatisfies all of the objectives of a transfer pricing system outlined above.

 

Test your understanding 7

A company has twoprofit centres, Centre A and Centre B. Centre A supplies Centre B with apart-finished product. Centre B completes the production and sells thefinished units in the market at $35 per unit. Budgeted data forthe year:                                                  Division A     Division B Number of units transferred/sold                    10,000         10,000                                                  $ per unit     $ per unit Materialscosts                                       8              2 Other variablecosts                                   2              3 Annual fixedcosts                                $60,000        $30,000 Calculate thebudgeted annual profit of each profit centre and the organisation as a wholeif the transfer price for components supplied by Division A to Division B is: (a)  $20. (b)  $25. (c)  Explainwhy it is necessary to set a transfer price. (d)  IfDivision A can sell the part-finished components to external customers at $23per unit, explain why this is the optimum transfer price.

2.5  Transfer pricing and dysfunctional decision making
A transfer price based on an absorbed total cost can lead to dysfunctional behaviour in the buying division. This is because, although the total cost is made up of fixed and variable cost elements relating to supplying division, the transfer price per unit is regarded by the receiving division manager as variable.
The receiving division manager, making decisions for his own area of responsibility and thinking primarily of optimising the profits of his own division, treats the transfer price as a variable item in the analysis. The danger is that in situations where the receiving division has spare production capacity, the manager may make the decision not to accept business at a lower selling price than usual, because it would apparently not make a profit or even a contribution for that division. However, for the company as a whole, the special price does exceed the variable costs and in the short-term it would be worth while to accept the business.
The solution to this problem may be to:
        set transfer prices at variable cost but this is unlikely to be acceptable to the selling division
        adopt two-part pricing.
The transfer price is marginal cost, but in addition a fixed sum is paid pa or per period to the supplying division to go at least part of the way towards covering its fixed costs and possibly even to generate a profit.
Test your understanding 10
Kwaree Inc, producing a range of minerals, is organised into two trading groups – one group handles wholesale business and the other deals with sales to retailers.
One of its products is a moulding clay. The wholesale group extracts the clay and sells it to external wholesale customers as well as to the retail group. The production capacity is 2,000 tonnes per month, but at present sales are limited to 1,000 tonnes wholesale and 600 tonnes retail.
The transfer price agreed is $180 per tonne, in line with the existing external wholesale trade price.
The retail group produces 100 bags of refined clay from each tonne of moulding clay, which it sells at $4 per bag. It would sell a further 40,000 bags if the retail trade price were reduced to $3.20 per bag.
Other data relevant to the operation:
                                       Wholesale group     Retail group
Variable cost per tonne                           $70              $60
Fixed cost per month                         $100,000          $40,000
You are required to prepare estimated profit statements for the current month for each group and for Kwaree Inc as a whole when producing at:
(a)        80% capacity
(b)        100% capacity, utilising the extra sales to supply the retail trade.
Comment on your results.
 
 

Test your understanding 9

Manuco Ltd hasbeen offered supplies of special ingredient Z at a transfer price of $15 perkg by Helpco Ltd, which is part of the same group of companies. Helpco Ltdprocesses and sells special ingredient Z to customers external to the groupat $15 per kg. Helpco Ltd bases its transfer price on total cost plus 25%profit mark-up. Total cost has been estimated as 75% variable and 25% fixed. Discuss the transfer prices at which Helpco Ltd shouldoffer to transfer special ingredient Z to Manuco Ltd in order that groupprofit maximising decisions may be taken on financial grounds in each of thefollowing situations: (i)     HelpcoLtd has an external market for all its production of special ingredient Z ata selling price of $15 per kg. Internal transfers to Manuco Ltd would enable$1.5 per kg of variable packing cost to be avoided. (ii)    Conditionsare as per (i) but Helpco Ltd has production capacity for 3,000kg of specialingredient Z for which no external market is available. (iii)  Conditionsare as per (ii) but Helpco Ltd has an alternative use for some of its spareproduction capacity. This alternative use is equivalent to 2,000kg of specialingredient Z and would earn a contribution of $6,000.

Test your understanding 8

A company operatestwo divisions, Able and Baker. Able manufactures two products, X and Y.Product X is sold to external customers for $42 per unit. The only outlet forproduct Y is Baker. Baker supplies anexternal market and can obtain its semi-finished supplies (product Y) fromeither Able or an external source. Baker currently has the opportunity topurchase product Y from an external supplier for $38 per unit. The capacityof division Able is measured in units of output, irrespective of whetherproduct X, Y or a combination of both are being manufactured. The associatedproduct costs are as follows:                                                 X                  Y                                                $                  $ Variable costs perunit                        32                 35 Fixed overheadsper unit                        5                  5 Total unitcosts                               37                 40   Using the aboveinformation, advise on the determination of an appropriate transfer price forthe sale of product Y from division Able to division Baker under thefollowing conditions: (i)      when division Able has spare capacity andlimited external demand for product X (ii)    when division Able is operating at fullcapacity with unsatisfied external demand for product X.

 

Illustration 8 – Transfer pricing

Continuing theArcher example in illustration 7: Discuss theimplications of setting the transfer cost at full cost plus. Solution There is anargument that the opportunity cost of transfer, in the absence of anintermediate market, is full cost. This assumes that,if the selling division decided against making any transfers at all, it wouldsave all costs, both marginal and fixed costs, by shutting down. In the aboveexample, the full cost for Division X of making component X8 is $7 ($5variable plus $2 fixed). At this price,Division X would want to sell as many units as possible to Division Y, andDivision Y would buy as many units as it could, subject to the limit oncapacity or sales demand. However, althoughfull cost represents the long-term opportunity cost to Division X oftransferring units of X8, it is not an ideal transfer price. §    At a transfer price of $7, Division X wouldmake $0 profit from each unit transferred. If output and sales are less thanthe budget of 20,000, Division X would make a loss due to the under-absorbedfixed overhead. If output and sales are more than the budget of 20,000,Division X would make a profit due to the over-absorbed fixed overheads. Theonly ways in which Division X could make a profit are therefore: -        tohope that sales demand exceeds the budgeted volume, and/or -        reduceits variable costs and fixed cost expenditures. §    It is unlikely that the manager of DivisionX would be prepared to negotiate this price with Division Y, and a decisionto set the transfer price at $7 would probably have to be made by head office. §    If Division X is set up as a profit centre,a transfer price at full cost would not provide a fair way of measuring andassessing the division’s performance. Transfer price = full cost plus If the transferprice is set at full cost plus a mark-up for profit, the manager of DivisionX would be motivated to maximise output, because this would maximise thedivision’s profit. As indicatedearlier, Division Y would want to buy as much as possible from Division Xprovided that the transfer price is no higher than $13. If a transferprice is set at full cost plus a mark-up for profit, the ‘ideal’ range ofprices lies anywhere between $7 and $13. The size of the mark-up would be amatter for negotiation. Presumable, the transfer price that is eventuallyagreed would be either: §    Imposed by head office, or §    Agreed by negotiation between the divisionmanagers, with the more powerful or skillful negotiator getting the betterdeal on the price.

2.4  Practical transfer pricing


In the real wordtransfer prices are set using the following techniques:
§    Market prices.
§    Production cost (either variable or full,possibly with a mark-up).
§    Negotiation.
Market prices
If there is a marketprice available then this is often seen as the optimum transfer price as allmanagers concerned with it view it as fair. However, there are many situationswhen it would be difficult to agree a market price.
Problems with market-based transfer prices
§    There may be no intermediate market price. Theproduct or service might not be readily available on the open market (anexample might be a partly-completed car being transferred from one division toanother).
§    The market price might not be independent. Thiswould occur if the transferring division was in the position of a monopolistboth within the company and in the outside market.
§    Difficulty in agreeing a source of marketprices. Debates will occur over the size, quality, timing and location ofinternal transfers compared with a range of published prices.
§    The need to adjust prices for differentvolumes. Prices quoted may well not relate to the levels of transfers that arelikely to take place. In the same way, the extent of reductions due to savedselling costs will be difficult to estimate.
§    Published prices may be fictitious. This is avariation on the previous problem but is typified by those products for whichit is customary for a seller to publish a price, then the buyer to negotiate alower figure.
Cost based transfer prices
If there is nomarket price then the transfer price is based on cost. It is generally arguedthat any transfer price based on cost should be based on standard cost ratherthan actual cost. A transfer cost based on actual cost would give thetransferring division no incentive to control costs as any cost overrun couldsimply be passed to the buying division.

Illustration 7 – Transfer pricing

Archer Group hastwo divisions, Division X and Division Y. Division X manufactures a componentX8 which is transferred to Division Y. Division Y uses component X8 to make afinished product Y14, which it sells for $20. There is no external market forcomponent X8. Costs are asfollows:                                       Division X        Division Y                                        ComponentX8      Product Y14 Variableproduction cost               $5 perunit       $3 per unit* Annual fixedcosts                      $40,000           $80,000 *Excluding thecost of transferred units of X8. The budgetedoutput and sales for Product Y14 is 20,000 units. One unit of component X8goes into the manufacture of one unit of Y14. The profit of thecompany as a whole will be maximised if Divisions X and Y produce up to theircapacity, or to the maximum volume of sales demand. For each extra unit sold,the marginal revenue is $20 and the marginal cost is $8 ($5 + $3); thereforethe additional contribution is $12 for each extra unit of Y14 made and sold. Since there is noexternal market for component X8, the transfer price will be cost-based. ‘Cost’might be marginal cost or full cost. The transfer price might also include amark-up on cost to allow a profit to Division X. The maximum transfer price that the buying divisionwill pay Division Y has amarginal cost of $3 per unit, and earns revenue of $20 for each unit sold. Intheory, Division Y should therefore be prepared to pay up to $17 ($20 - $3)for each unit of X8. It could beargued, however, that Division Y would not want to sell Product Y14 at all ifit made a loss. Division Y might therefore want to cover its fixed costs aswell as its variable costs. Fixed costs in Division Y, given a budget of20,000 units, are $4 per unit. The total cost in Division Y is $7($3 + $4). Onthis basis, the maximum transfer price that Division Y should be willing topay is $13($20 - $7). Transfer price =marginal cost The short-termopportunity cost to Division X of transferring units of X8 to Division Y isthe marginal cost of production, $5. At a transferprice of $5, Division X would be expected to sell as many units of X8 to DivisionY as Division Y would like to buy. However, althoughmarginal cost represents the opportunity cost to Division X of transferringunits of X8, it is not an ideal transfer price. §    At a transfer price of $5, Division X wouldmake $0 contribution from each unit transferred. The Division would thereforemake a loss of $40,000 (its fixed costs). §    This transfer price would not motivate themanager of Division X to maximise output. §    It is unlikely that the manager of DivisionX would be prepared to negotiate this price with Division Y, and a decisionto set the transfer price at $5 would probably have to be made by headoffice. §    If Division X is set up as a profit centre,a transfer price at marginal cost would not provide a fair way of measuringand assessing the division’s performance. Transfer price = marginal cost plus If transfer priceis set at marginal cost plus a mark-up for contribution, the manager ofDivision X would be motivated to maximise output, because this would maximisecontribution and profit (or minimise the loss). As indicatedearlier, Division Y would want to buy as much as possible from Division Xprovided that the transfer price is no higher than $17, or possibly $13. If a transferprice is set at marginal cost plus a mark-up for contribution, the ‘ideal’range of prices lies anywhere between $5 and $17. The size of the mark-upwould be a matter for negotiation. Presumably, the transfer price that iseventually agreed would be either: §    imposed by head office, or §    agreed by negotiation between thedivisional managers, with the more powerful or skillful negotiator gettingthe better deal on the price.