chapter 9 transfer pricing - practice tests academy · 12/15/2018 · transfer price for the...

P2 – Advanced Management Accounting CH9 – Transfer pricing

Chapter 9 Transfer pricing Chapter learning objectives: Lead Component Indicative syllabus content

B.3 Evaluate issues arising from the division of the organisation into responsibility centres.

(a) Discuss the likely behavioural consequences of performance measurement within an organisation.

• The behavioural consequences of performance management and control in responsibility centres.

• The behavioural consequences arising from divisional structures: internal competition and internal trading.

(b) Discuss transfer pricing systems.

• The theory of transfer pricing, including perfect, imperfect and no market for the intermediate good.

• Negotiated, market, cost plus and variable cost-based transfer prices. Dual transfer prices and lump sum payments as means of addressing some of the issues that arise.

(c) Evaluate the effects of transfer prices.

• The motivation of divisional management.

• Divisional and group profitability.

• The autonomy of individual divisions.


1. Transfer pricing • Inter-divisional transfers must be priced.

• The price of the transfer is the transfer price.

• The sales income of the division is offset by the purchase cost of the other division.

• The transfer affects the profits of the two divisions individually.

• It has no effect on the profit of the organisation as a whole.

Setting a transfer price: inter-divisional trading policy The transfer price of the inter-divisional transactions is significant because:

• It determines how the total profit is shared between the two divisions.

• It could affect decisions by the divisional managers about whether they are willing to sell or buy from the other division.

Both divisions must benefit from the transaction:

• A selling division will not agree to sell items to another division unless it is profitable for the selling division to do so.

• A receiving division will not buy an item from elsewhere unless it is profitable for the division.

Transfer prices have to be established and agreed:

• They could be imposed by the head office.

• They could be decided by commercial negotiation between the profit centre managers.


Inter-divisional trading should take place within a broad company policy that:

• For a selling division, given a choice between making a sale to an external customer or supplying goods and services to another division within the group, the preference should be to sell internally.

• For a buying division, given a choice between purchasing from an external supplier or from another division within the company, the preference should be to purchase internally.

Test Your Understanding 1: Set up a transfer price A company has two profit centres, A and B. Centre A supplies Centre B with a part-finished product. Centre B completes the product and sells the finished item to the market at $40 per unit.

Budgeted data for the year is as follows:

Centre A Centre B

Number of units transferred/sold 10,000 10,000

Material cost $8 per unit $4 per unit

Other variable costs $3 per unit $6 per unit

Annual fixed costs $50,000 $25,000

Required:

Calculate the budgeted annual profit of each profit centre and the organisation as a whole if the transfer price for the components supplied by Centre A to Centre B is $20.

2. Objectives of transfer pricing • Goal congruence

• Performance measurement

• Maintaining divisional autonomy

• Minimising the global tax liability

• Recording the movement of goods and services

• A fair allocation of profits between divisions


BASIS FOR SETTING A TRANSFER PRICE

Market-based prices • The price for the item in external.

Seller Buyer

Earns the same level of profit on internal sales as on external sales

Happy to accept transfer (cannot buy cheaper elsewhere)

Happy to transfer unless at full capacity making other units that have a greater contribution

• If savings are made by selling internally, then this may be reflected in the transfer price, e.g. by offering a discount equivalent to saved transport costs.

Cost-based transfer price • Similar to those involved in manufacturing accounts.

• Supplying division – manufacturing costs are covered + a small markup (to encourage the transfer).

• When a transfer price is based on cost, it could be actual cost or budgeted cost. The most suitable bases would be budgeted cost or standard cost.

Actual cost vs standard cost

Use of actual costs would result in:

• all inefficiencies being passed on to the buying division

• no encouragement for cost control in the selling division

• the buying division not knowing in advance what price it will be paying

• performance measurement therefore being difficult

• the seller wanting to transfer, but the buying division not wanting to transfer

Using standard costs overcomes all of these problems.


Standard cost: Full versus Variable

The intermediate market The intermediate market for the products and services of a selling division could be perfect or imperfect.

Perfect market Imperfect market

• All suppliers to the market are able to sell their output at the prevailing market rate.

• There are no restrictions on the sales demand at that price.

• No individual supplier dominates the market.

With a perfect market, the selling division would be able to:

• Sell its output on the external market at the market price

• Provided that it can sell at a price above its marginal cost

• The only limitation on profitability from external sales is the output capacity of the division

• The selling division is unable to sell its output externally at the same market price.

• This happens when the division is a dominant influence in the market, and monopoly or oligopoly conditions apply.

• The division is required to reduce its selling price.


The demand curve

• The total market demand for an item varies with the sales price.

• If the relationship between sales price and sales demand is linear, a demand curve could be expressed by:

P = a + bQ

where:

P = sales price of an item

Q = quantity of the item sold

Value can be established for “a” and “b”. When the price is “a”, Q should be zero.

Marginal revenue

• The extra revenue that will be earned by selling one additional unit in the market.

• In the perfect market, the marginal revenue for a company is always the market price of the item.

• This is because all of the output is sold at the prevailing market price.

• In an imperfect market, the marginal revenue is lower than the market price.

A quick view:

• The demand curve gives “P”: P = a + bQ

• Total revenue = aQ + bQ2

• Marginal revenue (MR) = a + 2bQ

Test Your Understanding 2: Demand curve The demand curve for a product, A, is: P = 100 – 0.008Q

Total revenue (TR) from selling Product A = (100 – 0.008Q) ×Q

TR = 100Q – 0.008Q2

What is the marginal revenue for Product A?

Maximising profit:

In an imperfect market:

Profits are maximised by selling the output to a volume where marginal revenue = marginal cost.


3. Transfer pricing - decision-making General rule: all goods and services should be transferred at opportunity cost.

THREE POSSIBLE SITUATIONS

Case 1: A perfect competitive market for an intermediate product Optimum transfer price (DM) = Market price + any small adjustments

Illustration Division A of a company makes a product, Z, that it sells externally and to another division, B, in the company. Division B uses Product Z as a component in Product X, which it sells externally. There is a perfect external market for both of the products.

Costs and sales prices are as follows:

Division A can either sell Product Z externally for $20 or transfer to Division B internally. Unless the transfer price is $20 or more, Division A would prefer to sell externally in order to maximise profit.

Division B can buy Product Z from external suppliers at $20 or buy internally from Division A. If the transfer price exceeds $20, Division B would prefer to buy it from external suppliers in order to minimise its costs and so maximise the profit.

Conclusion: The only transfer price at which A and B would agree to trade is $20, the external market price.

An alternative way to state the ideal transfer price:

$

Marginal cost in Division A 12

Opportunity cost: Contribution forgone from external sale by transferring a unit to Division B ($20 - $12)

8

Ideal transfer price = market price 20

Division A Division B Product Z Product X

Variable production cost $12 per unit

Further variable costs $15 per unit

Fixed costs $200,000 $300,000

Sales price $20 per unit $45 per unit


Case 2: A perfect intermediate market but with variable selling costs If there are variable selling or buying costs in the intermediate market:

• It will cost the selling division more to sell externally than to transfer internally, or

• It will cost the buying division more to purchase from an external supplier than to buy internally.

It is therefore cheaper and more profitable to transfer internally than to buy or sell externally. The cost savings can be reflected in an adjustment to the transfer price so that both divisions share the benefits.

Illustration Division A of a company makes a product, Z, that it sells externally and to another division, B, in the company. Division B uses Product Z as a component in Product X, which it sells externally. There is a perfect external market for both of the products.

Costs and sales prices are as follows:

Division A Division B Product Z Product X

Variable production cost $12 per unit

Variable selling cost in the external market

$3

Further variable costs $15 per unit

Fixed costs $200,000 $300,000

Sales price $20 per unit $45 per unit

Division A can either sell Product Z externally for $20 to earn a contribution of $5 per unit ($20 - $15) or transfer to Division B internally and earn a contribution of $8. The manager of Division A would prefer to sell to Division B because it is cheaper and more profitable. The lowest transfer price that Division A would expect is $17, i.e. ($20 - $3), external selling price – external selling costs.

Division B can buy Product Z from external suppliers at $20 or buy internally from Division A. If the transfer price exceeds $20, Division B would prefer to buy it from external suppliers in order to minimise its costs and so maximise the profit.

Case 2: Case 3:

Where there is surplus capacity Where there are production constraints

Optimum transfer price = marginal cost Optimum transfer price = marginal cost + shadow price


4. Performance evaluation 1. When there is a perfectly competitive market for an intermediate product

Optimum transfer price = Market price + any small adjustments

This is fair, no solution required.

2. When there is surplus capacity

Optimum transfer price = Marginal cost

The problem is that transferring at marginal cost is unlikely to be fair to the supplying division.

POSSIBLE SOLUTIONS: (i) Two-part tariff

The 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.

Illustration Georgia Group has two divisions, A & B. Division A manufactures a component, X, that is transferred to Division B. Division B uses this component to make a finished product, Y, which it sells for $20. There is no external market for Component X.

Costs are as follows:

Division A Division B

Component X Product Y

Variable production cost $5 per unit $3 per unit*

Annual fixed costs $40,000 $80,000

Note *: excludes the cost of transferred units of Component X

Under the two-part tariff transfer pricing arrangement, Division A would pay:

1) A fixed fee of $40,000 each year plus possibly a negotiated markup for profit, plus

2) $5 for each unit of Component X transferred.


(ii) Cost plus pricing

• The transfer price is the marginal cost or full cost plus markup.

(iii) Dual pricing

• In a dual pricing system, different prices are used by different divisions.

• The selling division is credited with a price that will enable them to earn an appropriate profit (often the external market price, if one exists).

• The buying division is debited with the variable or marginal cost only.

• The ‘balancing figure’ between the two will be debited to a group account and, at the end of the year, incorporated to consolidate out the difference and arrive at the correct group profit.

SELLER BUYER

Receives external market price Pays variable cost

Will want to transfer Happy to accept transfer

3. Where there are production constraints Optimum transfer price = marginal cost + shadow price

The problem is that the optimum transfer price is unfair to the buying division.

Solutions:

• Two-part tariff

• Cost plus pricing

• Dual pricing


5. Opportunity cost-based approach to transfer pricing An opportunity cost-based approach is the optimum approach to setting transfer prices.

Minimum transfer price Maximum transfer price

• Where the supplying division has spare capacity, the opportunity cost of transferring units internally is zero.

• Where the supplying division is at full capacity, the opportunity cost will be the lost contribution from the other sales (the shadow price).

• Opportunity cost-based approaches should always result in goal-congruent behaviour, with both buyer and seller happy to transfer when it is in the group's best interest to do so.

Test Your Understanding 3: Min and max transfer price Division X produces three products, Microphone A, Microphone B and Microphone C. Each microphone has an external market, but Microphone B can also be transferred to Division Y.

After incurring extra costs of $60, Division Y then sells the unit for $300.

The maximum quantity that might be required for transfer is 150 units of Microphone B.

Information on the products is as follows.

Microphone A Microphone B Microphone C

External market price per unit $150 $200 $140

Variable production cost per unit $86 $95 $83

Labour hours required per unit 4 6 3

Maximum external sales, in units 2,000 1,250 2,400


In the current period, labour hours in the profit centre are limited to 20,000, and this is insufficient to satisfy maximum external demand.

Therefore, using limiting factor analysis, the optimal production plan has been calculated as:

Microphone A Microphone B Microphone C

Contribution per unit $64 $105 $57

Labour hours required 4 6 3

Contribution per hour $16 $17.50 $19

Ranking 3rd 2nd 1st Optimal production plan

Microphone Units Hours / unit Hours

C 2,400 3 7,200

B 1.250 6 7,500

A (balance) 1.325 4 5,300

20,000 Given that Division X is operating at full capacity, what are the minimum and maximum transfer prices that could be used for Microphone B?

6. Solutions to Test Your Understanding

Test Your Understanding 1: Set up a transfer price Centre A Centre B Company as a whole

External sales 0 400 400

Inter-divisional transfer 200

Total sales 200 400 400

Costs

Inter-divisional transfer 0 200 0

Other material costs 80 40 120

Other variable costs 30 60 90

Fixed costs 50 25 75


Total costs (160) (325) (285)

Profit 40 75 115

Test Your Understanding 2: Demand curve The marginal revenue from selling each extra unit of Product A is:

MR = 100 – (2*0.008)Q

MR = 100 – 0.016Q

Test Your Understanding 3: Min and max transfer price Optimal production plan:

Microphone Units Hours

C 2,400 7,200

B 1.250 7,500

A (balance) 1.325 5,300

20,000

If labour is diverted for the transfer, hours will come from Microphone A, which is earning a contribution of $16 per hour.

Minimum transfer price should be $

Variable unit cost 95

Opportunity cost 6 hrs x $16 96

Therefore, minimum transfer price is 191

Maximum transfer price should be $

Lower of External market price 200

Divisional net revenue 240

Therefore, max transfer price 200

The transfer price should be between $191 and $200.


7. Chapter summary

chapter 9 transfer pricing - practice tests academy · 12/15/2018 · transfer price for the...

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