Transfer Pricing

Question 1

Organisational structure and decentralisation

What are organisations always in?
Organisational processes are never ________
What is the essence of decentralisation?

Answer 1

• Organisations are in a constant state of flux in terms of markets, customers, workers, technology, etc.
• Organisational processes are never static.
• The essence of decentralisation is the freedom for managers at lower levels of the organisation to make decisions.

Question 2

Decentralisation vs Centralisation

Basic difference?
Most companies’ structures?

Answer 2

Decentralisation:

• minimum constraints and maximum freedom.

Centralisation:

• maximum constraints and minimum freedom.

Most companies’ structures fall somewhere between these two extremes.

Question 3

Transfer pricing

What happens in decentralised organisations?
The management control system often…to…?

What is an intermediate product?
What is a transfer price?

Answer 3

• In decentralised organisations, individual subunits act as separate units. The management control system often use transfer prices to coordinate actions and to evaluate performance of the subunits.
• An intermediate product is a product transferred from one subunit to another subunit.
• A transfer price is the price one subunit (segment, department, division, etc) charges for a product or service supplied to another subunit of the same organisation.

Question 4

Motivations for employing transfer pricing in a decentralised organisation

To (4)?

Answer 4

• To strategically move profits between divisions or locations – e.g. from a high to a low tax jurisdiction – high profile cases in the EU include Apple, Starbucks, amazon, Fiat.
• To provide information that motivates divisional managers to make good economic decisions – i.e. important for planning.
• To provide information that is useful for evaluating the managerial and economic performance of the divisions – i.e. important for control.
• To ensure that divisional autonomy is not undermined in the decentralised organisation.

Question 5

Alternative transfer-pricing methods

3 methods?
What does transfer price promote? (3)

Answer 5

• Market-based transfer prices.
• Cost-based transfer prices. (e.g. variable manufacturing costs, manufacturing absorption costs, full product costs)
• Negotiated transfer prices.

Transfer price should promote goal congruence, management effort and subunit autonomy.

Question 6

Goal Congruence

What is it?

Answer 6

‘On the same page’: transfer price should allow the manager to maximize overall company profit- while attempting to maximize profit in their own segment.

Question 7

Advantages and disadvantages of the transfer pricing methods

The following table refers to a Manufacturing Division that manufactures and sells an intermediate product to a Distribution Division, who then may process the product further before it is sold externally.

4 methods - advantages and disadvantages (3,2/2,3/2,2/1,2)

Answer 7

Question 8

An illustration of transfer pricing

Example:

• S-Oil has 3 ______________. Each operates as a __________ _________.
• The ______________ Division manages the production of crude oil from a petroleum field near Heimberg.
• The _________________ Division manages the operation of a pipeline that transports crude oil from the Heimberg area to Nordstad.
• The ___________ Division manages a refinery at Nordstad that processes crude oil into petrol. (petrol is the only saleable product the refinery makes)

Answer 8

Example:

• S-Oil has 3 divisions. Each operates as a profit centre.
• The production Division manages the production of crude oil from a petroleum field near Heimberg.
• The transportation Division manages the operation of a pipeline that transports crude oil from the Heimberg area to Nordstad.
• The refining Division manages a refinery at Nordstad that processes crude oil into petrol. (petrol is the only saleable product the refinery makes)

Question 9

Market-based transfer price

Requirement?
Transfer products or services at market prices generally lead to ___________ _________ based on 3 conditions:

What does the requirement allow a company to do?

What do market prices also serve to?

Distress prices

When is it needed?
What can companies use?
In the short-run?
In the long run?

Answer 9

• In perfectly competitive market:
• Transfer products or services at market prices generally lead to optimal decisions based on 3 conditions:
  
  • a) perfectly competitive intermediate market;
  • b) minimal inter-dependencies of subunits;
  • c) no additional costs or benefits to the corporation in using market instead of transacting internally.

By using market-based transfer prices in perfectly competitive markets, a company can meet the criteria of goal congruence, management effort and (if desired) subunit autonomy.
Market prices also serve to evaluate the economic performance and profitability of each division individually.

Distress prices

• When supply outstrips demand, market prices may drop below the historical average.
• Some companies use distress prices, others use long-run average prices or normal market prices.
• In the short run, as long as the distress price exceeds the incremental costs, the supplier division should meet the distress price.
• In the long run, if prices remain low, the supplier division must decide whether to dispose of some manufacturing facilities or shut down.

Question 10

Transfer prices at full costs

What can it lead to?
When are they helpful?
What do surveys indicate?

Answer 10

• In practice, many companies use transfer prices based on full costs. These prices, however, can lead to suboptimal decisions.
• Cost-based transfer prices are helpful when market prices are unavailable, inappropriate, or too costly to obtain.
• Surveys indicate that managers prefer to use full-cost transfer pricing because it yields relevant costs for long-run decisions and because it facilitates pricing on the basis of full product costs

Question 11

Transfer prices at Cost+

Why is profit produced?
What does the system reward?

If transfer price=cost +10%, what would be the transfer price and profit for £10 and £15?

2 issues?

Answer 11

• Profit is produced so supply centre can be evaluated using ROCE.
• System rewards inefficiency by making profit a proportion of cost.

If transfer price=cost +10%
Cost £10, transfer price £11, profit £1
Cost £15, transfer price £16.5, profit £1.5

Issues

• Mark up (over-statement of buyers cost may lead to dysfunctional consequences)
• Arbitrary nature of establishing mark up

Question 12

Dual pricing

Why is it used?
What is it?

Answer 12

• There is rarely a single transfer price that simultaneously meets the criteria of goal congruence, management effort and subunit autonomy.
• Some companies use two separate transfer-pricing methods to price each interdivisional transaction.

Question 13

Negotiated transfer price

What does it depend on?
Is there an all-pervasive rule for transfer pricing that leads towards optimal decisions for the organisation as a whole?

Answer 13

• Negotiated transfer price depends on the bargaining strengths between selling and buying divisions.
• Is there an all-pervasive rule for transfer pricing that leads towards optimal decisions for the organisation as a whole? No.

Question 14

General guideline for transfer-pricing situations

3 scenarios

Answer 14

Three scenarios:

1. Market-based transfer prices are ideal in perfectly competitive markets when there is no idle capacity.
2. In markets that are not perfectly competitive, capacity utilisation can be increased only by cutting prices.
3. No market exists for the intermediate product.

Question 15

The potential issues that transfer pricing may cause in multi-divisional firms

Where ______________ _______________ exists, transfer pricing can lead to ______________ ____________ and _____ in ____________ _______, for example: (5)

Answer 15

Where asymmetric information exists, transfer pricing can lead to dysfunctional behaviour and loss in company value, for example:

• Serious disputes between divisional managers as they fight over internal prices. Such disputes can be time-consuming and costly for the organisation.
• Divisional manager of one unit taking advantage of managers of another unit – e.g. if first manager has information that can be exploited to their advantage when setting prices.
• Mismanagement/misrepresentation of costs – e.g. for variable cost transfer pricing, the manager of the manufacturing division may have a motivation not to manage fixed costs, or to report fixed costs as variable.
• Inefficiencies being passed on (e.g. if full-cost pricing is used).
• Incentives for managers to behave in ways that maximise their division’s profits, to the detriment of managers of other divisions and the firm.

Question 16

Possible solutions to the transfer pricing problems:

(2/3,1+1eg)

Answer 16

Negotiated prices:

• Manufacturing division may receive full cost plus a mark-up so that it makes a profit on inter-divisional transfers
• Distribution division charged at opportunity cost of transfers thus motivating managers to operate at the optimum output level for the company as a whole
• Profit on inter-divisional trading removed by an accounting adjustment

Reorganisation of firm:

• If transfer pricing becomes sufficiently dysfunctional, the firm may be reorganised – organisational architecture is changed (e.g. decision rights, performance evaluation and/or rewards)
• For example – divisions could be combined, reorganised as cost centres, performance and rewards could be linked to company profits (not unit profits)

Question 17

Transfer pricing and tax considerations

Transfer prices often have tax implications. Tax factors include: (8)

What is our aim?

Answer 17

Transfer prices often have tax implications. Tax factors include:

• income taxes,
• payroll taxes,
• customs duties,
• tariffs,
• sales taxes,
• value added taxes,
• environment-related taxes
• and other government levies on organisations.

Our aim here is to highlight tax factors and in particular, income taxes as an important consideration in transfer-pricing decisions.