10 Chapter Transfer Pricing - PowerPoint Presentation

1. 10ChapterTransfer Pricing

2. Transfer Pricing Learning OutcomeLead C3: Analyse the performance of responsibility centres and prepare reportsComponent C3): Explain:Behavioural issuesUse and ethics of transfer pricingInternal Competition & Internal trading.Transfer pricing for intermediate goods where market exist & where no market exist.Types of transfer prices & when to use them.Effect of transfer pricing on autonomy, & motivation of managers of responsibility centre.Effect of transfer pricing on responsibility centre & group profitability.

3. Chapter ContentDecision MakingPerformance EvaluationTransfer Pricing

4. Objectives of Transfer PricingGoal congruencePerformance measurementMaintaining divisional autonomyMinimising global tax liabilityRecording the movement of goods and servicesFair allocation of profits between divisions

5. Bases for setting transfer pricesMarket based Cost basedNegotiated

6. Selecting a transfer priceIf there is an external market the market price will be the ideal price (less any selling expenses)If there is no external market then - the selling division should accept a minimum price of marginal cost plus any opportunity cost. - the buying division should accept any transfer price which will allow contribution to be made (positive net marginal revenue) - there may be a range of acceptable prices which will be subject to negotiation

7. Example 1A company has two profit centres, Centre A and Centre B. Centre A supplies Centre B with a part-finished product. Centre B completes the production and sells the finished units in the market at $35 per unit.Budgeted data for the year: Division A Division BNumber of units transferred/sold  10,000   10,000Materials costs $8 per unit $2 per unitOther variable costs $2 per unit $3 per unitAnnual Fixed Costs $60,000 $30,000Required:Calculate the budgeted annual profit of each profit centre and the organisation as a whole if the transfer price for components supplied by Division A to Division B is:1. $20 2. $25

8. Decision MakingThe general rule for decision-making is that all goods and services should be transferred at opportunity costThere are 3 possible situationsWhere there is a perfectly competitive market for an intermediate productOPTIMUM TP (DM) = MARKET PRICE + ANY SMALL ADJUSTMENTS2. Where there is surplus capacityOPTIMUM TP (DM) = MARGINAL COST3. Where there are production constraintsOPTIMUM TP (DM) = MARGINAL COST + SHADOW PRICE

9. Example 2AB Ltd has two Divisions – A and B. Division A manufactures a product called the aye and Division B manufactures a product called the bee. Each bee uses a single aye as a component. A is the only manufacturer of the aye and supplies both B and outside customers. Details of A’s and B’s operations for the coming period are as follows: Division A Division BFixed Costs $7,500,000 $18,000,000Variable Costs per unit $280 $590 (*)Capacity – Units 30,000 18,000* Note: exclude transfer costsMarket research has indicated that demand for AB Ltd’s products from outside customers will be as follows in the coming period:the aye: at unit price $1,000 no ayes will be demanded but demand will increase by 25 ayes with every $1 that the unit price is reduced below $1,000;the bee: at unit price $4,000 no bees will be demanded, but demand will increase by 10 bees with every $1 that the unit price is reduced below $4,000;

10. Example 2 ( Cont….)Required:Calculate the unit selling price of the bee (accurate to the nearest $) that will maximise AB Ltd’s profit in the coming period. Calculate the unit selling price of the bee (accurate to the nearest $) that is likely to emerge if the Divisional Managers of A and B both set selling prices calculated to maximise Divisional profit from sales to outside customers and the transfer price of ayes going from A to B is set at ‘market selling price’.Explain why your answers to parts (a) and (b) are different, and propose changes to the system of transfer pricing in order to ensure that AB Ltd is charging its customers at optimum prices.

11. Decision Making2. Where there is surplus capacityOPTIMUM TP (DM) = MARGINAL COSTPossible Solutions- 2 part tariffThe transfer price is marginal cost, but in addition a fixed sum is paid per annum 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.Cost-plus pricingThe transfer price is the marginal cost or full cost plus a markup.Dual pricingDual pricing is where one transfer price is recorded by the supplying division and a different transfer price is recorded by the buying division.

12. Decision Making3. Where there are production constraintsOPTIMUM TP (DM) = MARGINAL COST + SHADOW PRICEThere are 2 possibilities:Where internal demand has to be met by foregoing external sales of another product, the shadow prices reflect contribution foregone on that other product. The resulting TP (DM) is also suitable for performance evaluation.(ii) Where the supplying division makes only one product which is only sold internally, the shadow price must now reflect contribution from the final production. The TP (DM) builds that contribution into the supplying division's revenue.Therefore all contribution will appear in the supplying division's books (and none in the buying division's).The problem is that the optimum TP (DM) is unfair to the buying division.

13. Example 3Pool Group has two divisions that operate as profit centres. Each centre sells similar products, but to different segments of the market:Division P makes product P29 which it sells to external customers for $150. Variable costs of production are $45 per unit. The maximum annual sales demand for P29 is 5,000 units, although Division P has capacity for 7,000 units. Increasing output from 5,000 to 7,000 each year would result in additional fixed cost expenditure of $8,000.The manager of Division L has seen an opportunity to sell an amended version of Product P29 to its own customers, and is interested in buying 2,000 units each year to resell externally at $90 per unit. The costs of amending Product P29, for sale as Product L77, would be $25 per unit. However, the manager of Division L will not pay more than $40 per unit of Product P29. He argues that Division P will benefit from lower fixed costs per unit by working at full capacity. The manager of Division P refuses to sell at a price that does not cover the division’s incremental costs.Required:Suggest a dual transfer pricing arrangement that might overcome the disagreement between the two divisional managers.