Transfer Pricing

Question 1

What are the three main approaches of transfer pricing?

Answer 1

Market based prices
Cost based prices
Negotiated prices

Question 2

What is the purpose of transfer pricing?

Answer 2

1. To provide information that will encourage divisional managers to make good economic decisions. Happens when actions that divisional managers take to improve the reported profit of their division also improves the profit of the company as a whole.
2. To provide information that is useful for evaluating the managerial and economic performance of the divisions.
3. To ensure that divisional autonomy is not undermined.
4. To intentionally move profits between divisions or locations.

Question 3

What is transfer pricing?

Answer 3

A division’s output is sold to another division.

How should they be priced?
The pricing of transfers represents sales for the selling division.
The pricing of transfers represent a variable cost or the buying division.

Question 4

What does the choice of a certain transfer price influence?

Answer 4

The profitability of A, the profitability of B and the profitability of the organisation overall.

The input and output decisions of each division.

Question 5

What are the critical aspects in the choice of transfer prices?

Answer 5

• Transfer prices are used in the evaluation of the profitability of both the selling division and the buying division.
• Different transfer prices may deceive top management into believing that individual divisions are more or less profitable that is actually the case.
• Different divisional profit figures may lead to different degrees of motivation of divisional management which could result in an underachievement of targets.
• Problems of goal congruence between headquarter and divisions.

Question 6

MARKET BASED PRICE APPROACH

Answer 6

Pre-requisite: the existence of a competitive outside market in the transferred goods.

If so, the market price can be used for pricing internal transfers.

OPERATING CONDITIONS:
Individual divisions have the freedom to act independently (i.e. selling/buying either externally or internally)
Adjust for transaction costs.

Question 7

CRITICISMS OF MARKET BASED PRICING.

Answer 7

If substitute products are not perfect substitutes the conditions for applying the price do not hold.

It may create unused capacity in the selling division.

Question 8

COST-BASED PRICES

Answer 8

When a market for the intermediate product is non existent or imperfect, a cost configuration can be used.

Marginal/variable cost:

• Motivates the supplying and receiving divisions to operate at output levels that maximise the overall company performance.
• Variable cost is poor measure of divisional performance.

Full cost:

• Based on the calculation of a fixed overhead rate to be added to variable costs.
• It can also consider a profit mark-up to be added to full cost.

Question 9

CRITICISMS OF COST-BASED APPROACH

Answer 9

• Including fixed costs may create unused capacity in the selling division.
• The approach does not encourage behaviours which are in the best interest of the organisation.

Question 10

NEGOTIATED PRICES

Answer 10

Top management act as an arbiter in fixing interdivisional prices:

• Negotiated prices are flexible but artificial.
• Top management can consider strategic issues such as taxation, motivational issues, etc.
• Their use makes divisional performance more difficult to measure realistically and independently.

Question 11

TWO PART TARIFF PRICES

Answer 11

Charge the receiving division with the variable cost per unit plus an annual “block” charge to cover approved fixed costs and eventually a small margin for profit contribution.