Module 6: Transfer pricing

(1)

Module 6: Transfer pricing

Overview

Module 6 focuses on decentralization and the impact of transfer pricing on decision making and costs within organizations. The self-test for the module asks you to apply your understanding to determine transfer prices using a range of pricing measures.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.

Learning objectives

6.1 Organizational structure and decentralization

Learning objective

Describe the benefits and drawbacks of decentralization. (Level 2)

Required reading

Chapter 23, pages 884-887

LEVEL 2

All organizations exist on a continuum between fully centralized, where all decisions that affect day-to-day operations are made by top management, to fully decentralized, where managers at lower levels make day-to-day and, in some cases strategic, decisions without senior management approval. There are advocates for and against decentralization, as the success of this management structure often depends on the corporate culture and overall structure of the organization.

6.1 Describe the benefits and drawbacks of decentralization. (Level 2) 6.2 Determine the impact of transfer pricing policies on profits. (Level 1)

6.3 Determine transfer prices using market-based, cost-based, and negotiated transfer pricing measures. (Level 1)

6.4

Determine the minimum transfer price under varying levels of production capacity. (Level 1) 6.5

(2)

Advocates of decentralization consider that managers at lower levels can have a better understanding of the local conditions and concerns than senior managers, and that lower level managers are therefore in a better position to make certain types of decisions. In this view, decentralization can

create greater responsiveness to local needs lead to quicker decision-making

increase motivation

aid management development and learning, and sharpen the focus of managers.

Arguments against decentralization suggest that some decisions are too important to leave to lower-level managers. Depending on how they are compensated, managers at this level are sometimes encouraged to make decisions counterproductive to the goals and strategies of the organization, and may also be tempted to make decisions in their own best interests rather than the company’s. In this view, decentralization can

lead to suboptimal decision making (goal incongruence) result in duplication of duties

decrease loyalty toward the organization as a whole, and increase costs of gathering information.

Degrees of decentralization

Managers decide on the degree of decentralization to set up for different purposes. For example, top

management might consider that centralization of income tax structures would allow the company to lower overall taxes with a centrally coordinated strategy, while leaving other areas of the business, such as budget preparation, decentralized. Such a structure allows managers to have more say in the budgeting process and can therefore increase buy-in on company goals and objectives. In multinational companies, a certain degree of decentralization is necessary as local languages, customs, business practices, and government regulations are best known and navigated by the managers in each country.

Responsibility centres

As noted earlier, a common concern with decentralization is managers having authority to make decisions that may or may not be in the best interest of the overall organization. Controlling the range of decisions or actions of managers through the establishment of responsibility centres may therefore be necessary. As studied in your earlier management accounting courses, there are four types of responsibility centres:

Cost centres — Managers are accountable only for incurring and controlling costs. An example of a

cost centre is the logging division in a large integrated lumber and paper company. The logging division provides the raw material for the other divisions, and is therefore a cost centre.

Revenue centres — Managers are accountable for the incurrence of revenues. Although these centres

do incur costs, their main function is to produce revenues for the firm. A sales department is an example of a revenue centre.

Profit centres — Managers are accountable for both controlling costs and generating revenues. A

Wal-Mart store in any city is an example of a profit centre for Wal-Wal-Mart Stores Inc.

Investment centres — Managers are accountable not only for profit generation, but also for making

capital investment decisions, and are therefore responsible for generating a return on investment. An example of an investment centre is Jazz Airlines, which must control capital budgeting and profit

(3)

6.2 Transfer pricing policies

Determine the impact of transfer pricing policies on profits. (Level 1)

LEVEL 1

In many organizations, intermediate products or services are transferred from one subunit to another within the organization. The price at which the product or service is transferred determines the profitability of the particular subunit. This in turn can affect management compensation, and may be used for performance measurement evaluations through the company’s management control system.

The management accounting themes of cost behaviour (variable to fixed) and time frame (short-term to long-term) are particularly important in this topic, as transfer pricing is based on a straightforward distinction between variable and fixed costs. Cost definitions are also important because variable costs are taken as proxy for marginal product costs, and opportunity costs are considered in setting transfer prices.

Transfer pricing helps manage the flow of goods and services in companies that are divided into

responsibility centres. Although transfer prices are usually set between profit and investment centres, in practice transfer pricing can take the form of transferring costs from cost centres to other divisions. There is no single pricing policy to cover all transfer situations. Here are the three main general methods:

1. Market-based transfer prices — Available in the general market to third-party outside buyers and sellers, market-based transfer prices are used to determine internal transfer prices.

2. Cost-based transfer prices — Based on the cost (either budget or actual) of producing the specific product. Cost can be defined as either straight variable cost, manufacturing (absorption) cost, or full cost (production plus other costs such as distribution, marketing, and so on).

3. Negotiated transfer prices — In some decentralized organizations, managers are allowed to negotiate their own transfer prices and are given the autonomy (degree of freedom to make choices) to buy from, or sell to, a subunit. Some managers feel this is a good training ground in negotiation.

Transfer prices should lead to goal congruence with the overall strategy of the organization, and help to sustain high performance levels by management.

Example 6.2-1: Transfer pricing problem at Miliken

Miliken Inc. is a manufacturer of heart diagnostic equipment. The TA24 machine is manufactured at the company’s plant in Vancouver and distributed across North America. Miliken sells 3,000 TA24 machines in a typical year. Parts for the machine are either outsourced or manufactured at the company’s Winnipeg division plant. The pump is one such component. The Winnipeg division receives input material for the pumps from various sources across Canada.

(4)

Winnipeg Division: The Winnipeg division receives inputs at an accumulated cost of $140 per pump. The additional cost of manufacturing the pump is $70 variable cost and $90 fixed cost per pump. The goods are then shipped to the Vancouver plant at a cost of $5 per pump.

Vancouver Division : The received pumps are assembled along with other parts. The other parts have a combined cost of $450 per pump variable cost, and $900 fixed cost. The assembled TA24 machine is then sold for a price of $2,500 per pump. The Vancouver division also knows that a Toronto-based company is willing to sell heart pumps to Miliken at a price of $425 per pump. Following are the three methods for transfer prices that can be considered in this scenario:

1. Market-based — Vancouver can buy the pumps at an outside price of $425.

2. Cost-based — The company senior management considers a cost-based transfer price should be at 125% of full absorption cost. The cost of production is $140 + $70 + 90 = $300 x 1.25 = $375

3. Negotiated — This is negotiated between cost ($375) and market ($425). Assume management splits the difference at $400.

These choices are illustrated in the following exhibit. Exhibit 6.2-1: Transfer pricing at Miliken — Pumps

(5)

The transfer prices serve to split the profits for the corporation between the two internal divisions. Now look at a situation of information asymmetry and transfer pricing in the following computer illustration.

Computer illustration 6.2-1: Transfer pricing and information asymmetry

Solution a Solution b Solution c

6.2 Transfer pricing policies - Content Links

Computer illustration 6.2-1: Transfer pricing and information asymmetry

Cobb Industries, a division of Firefly Inc., makes and sells toy trucks. Mudderville Ltd., also a division of Firefly Inc., produces and sells an intermediate product — electric motors for use in Cobb’s toy trucks — to Cobb Industries. Since both divisions are profit centres, the managers are evaluated on profit making; profit maximization is the key issue for the managers of the two divisions.

(6)

Mudderville has fixed costs of $300 per day and variable costs of $0.20 per unit. Cobb has fixed costs of $200 per day in the relevant range of 100 to 800 units per day and variable costs of $0.40 per unit in the same relevant range. Cobb has a downward-sloping demand curve for the toy trucks with the following price-quantity relationship.

The transfer price is set at $1.80 per unit and 200 units are transferred. The $1.80 is set by taking

Mudderville’s variable cost of $0.20 per unit and adding $1.50 ($300/200 units) in fixed costs plus $0.10 for profits. At this transfer price, Mudderville’s profit is 200 units x $0.10 = $20.

Using the electric motors transferred from Mudderville, Cobb Industries produces 200 toy trucks, for a profit of $260.

Material provided

File MA2M6P1, containing the worksheets M6P1, M6P1S Part A and M6P1S Part B in your MA2 data folder.

Required

a. Using the information provided, calculate the divisional profit for both Cobb Industries and Mudderville Ltd., as well as Total Corporate profit.

b. Given a transfer price of $1.90, what level of output, within the range presented in the data table, would be optimal for Cobb Industries? What level of output would maximize Total Corporate profit? c. What effect would asymmetric information have on the choice of transfer price?

(7)

Procedure

1. Open file MA2M6P1.

2. Click sheet tab M6P1 and observe the layout of the worksheet. Rows 5 to 20 comprise the data table, using the data provided above. Cell B23 contains the output level of the Cobb Industries and cell B25 contains the transfer price data $1.80. The range A29 to B33 is where you calculate Cobb Industries profit, the range D29 to E31 is for Mudderville Ltd. profit calculation and G29 to H31 is for

calculating Total Corporate profit. Formulas in cells B33, E31, and H31 have been pre-entered for you.

Part A – Profit calculations

1. Enter the formula to calculate Cobb Industries divisional revenues in cell B29, referencing the data table values. You should use the VLOOKUP function to determine the selling price from the demand information in the data table. For more information on how to use the VLOOKUP, refer to CT2. 2. Enter the formula to calculate Cobb Industries manufacturing costs in cell B30, referencing the values

in the data table where appropriate.

3. Enter the formula to calculate the transfer cost incurred by Cobb Industries from purchasing the electric motors from Mudderville in cell B32.

4. Enter the formulas in the appropriate cells to calculate the profits for Mudderville. 5. Enter the formulas in the appropriate cells to calculate the Total Corporate profits. Part B: Total firm profit maximization and output level

1. Return to your completed worksheet from Part A or click the sheet tab M6P1S Part A if you had difficulty obtaining the correct results for Part A.

2. Change the value in cell B25 to $1.90.

3. Enter the value 100 in cell B23 and observe the value of Cobb Industries, Mudderville Ltd., and Total Corporate profit. Increase the output of Cobb Industries in units by 100 increments, up to 800 units, as specified in the relevant range information given above. Record the resulting profits for Cobb

Industries, Mudderville Ltd., and Total Corporate profit to use as a reference in this table:

(8)

Computer illustration 6.2-1 Solution a

Save your completed worksheet. You should have obtained the following results:

If you did not obtain these results, click sheet tab M6P1S Part A and compare it with your worksheet.

Computer illustration 6.2-1 Solution b

You should have observed that the Total Corporate profit is maximized at 800 units (using a transfer price of $1.90) and results in a profit of $924. Cobb Industries profit is maximized at $240 with 200 units produced. Mudderville Ltd. earns a profit of $40 at 200 units, although it could earn $1,060 at a volume of 800 units. Thus, the transfer price does more than just divide firm profits into two amounts of $(136) and $1,060. If you did not obtain these results, click the M6PIS Part B tab and compare it with your worksheet.

Computer illustration 6.2-1 Solution c

Note the importance of sharing information for this scenario. To maximize the return to shareholders, Cobb Industries division manager is encouraged to make a production decision that would not make sense without the shared information.

6.3 Transfer pricing measures

Determine transfer prices using market-based, cost-based, and negotiated transfer pricing measures.

(9)

LEVEL 1

Market-based

Using market-based transfer prices generally leads to the most optimal pricing decision for a company. Under conditions of perfectly competitive markets — when there are homogeneous products where neither buyer nor seller can influence the pricing structure of the market — interdependence between subunits is minimal, and there are no additional costs or benefits of using market prices.The objectives of goal

congruence, evaluation of management effort, optimal subunit performance, and subunit autonomy can be achieved using market-based transfer prices.

In Example 6.2-1, the market price was $425 to purchase the pump from the supplier in Toronto. If

management wanted to ensure internal transfers to maintain quality, a transfer price of less than $425 would motivate the Vancouver division to purchase internally but, if both units had autonomy to do so, the

Winnipeg division would be motivated to sell externally to another company. Setting the price at the market price ensures both divisions act in the best interests of the company as a whole.

When market prices fluctuate greatly, companies may opt to use long-run average prices, rather than market-based prices.

Cost-based

When market-based prices are not readily available, such as with specialty or unique products, internal cost-based transfer prices may be an alternative. Companies can choose a variety of cost-cost-based transfer prices including variable cost, absorption cost, or cost-plus pricing (with a markup over either variable or full-absorption costing), or opt for a dual-pricing transfer cost strategy.

Full-costing may lead to sub-optimal decisions for the company. In Example 6.2-1, fixed costs are treated as a variable cost. Assume that the prices for the inputs to the Winnipeg division for the price increased to $190 per pump from the current $140 per pump. The price per pump using cost-based pricing would be ($190 + $70 + 90) x 125% + $5 (transportation) = $442.50. The Vancouver division would now reject the Winnipeg pump in favour of the Toronto pump, which it can purchase for $425.

Using variable costing, however, would maintain goal-congruence for the overall company. In this case, variable costing would provide a cost of ($190 + $70 + $5) x 125% = $331.25, and the Vancouver division would be willing to continue to buy from Winnipeg rather than from the external Toronto supplier.

To achieve goal congruence, the minimum transfer price that should be accepted by the Winnipeg division is the variable cost of production. Below this price, they would lose money. The maximum amount the

Vancouver division is willing to pay is the market price that they can purchase from the outside ($425). Some companies may wish to prorate the difference between the minimum and maximum amounts to

determine a transfer price. One such method is to prorate the percentage of variable cost of production of the supplying division over the difference in costs.

Dual pricing is also an alternative. In this case, the selling division would use a cost-based pricing strategy to determine its own profitability, while the buying division would use market prices in determining its profitability. Dual pricing is not widely used in practice.

(10)

Negotiated

Negotiated transfer prices are used as a training ground for managers. The ability of each manager to negotiate, in addition to the relative bargaining strengths of the buying and selling division, are used to determine a transfer price between the minimum variable cost for the selling division and the market price for the buying division.

Negotiating transfer prices can sometimes lead to conflicts between managers, especially when management compensation is based on profitability of the divisions. In such cases, the senior management can either step in or have an arbitration hearing to hear both sides. Exhibit 23-3 on page 898 provides a summary of the three methods for determining transfer prices.

6.4 Determining minimum transfer price

Determine the minimum transfer price under varying levels of production capacity. (Level 1 )

LEVEL 1

As a general guideline in starting the transfer pricing decision, some companies use the following rule. However, in some situations, the three criteria of goal-congruence may require changes to the transfer price described here.

This formula can also be considered as follows:

Minimum transfer price = Variable cost + Lost contribution margin on an outside unit of sales.

The minimum transfer price then depends on whether the selling division has excess capacity, is at full capacity or has partial capacity. The maximum transfer price would be the market price at which the buying division could purchase from an outside source.

Refer to Example 6.2-1. Assume that the Winnipeg division has capacity to produce 4,000 heart pumps and can also sell to the outside market at a price of $445 per unit. Currently, it is selling all 4,000 units to the outside market. The Winnipeg division must also incur the $5 shipping cost to an outside sale and pay a commission to the sales department of $10 per machine. This commission could be eliminated on an inside sale to the Vancouver division.

Minimum transfer price = ($140 + $70 + $5) + ($445 – $225) = $435

The minimum transfer price that would be charged to the Vancouver division is $435. Since the Vancouver division could purchase the heart pump from the Toronto supplier for $425, the maximum transfer price the Minimum transfer

price =

Additional incremental or outlay costs per unit incurred up to transfer point

+

Opportunity costs per unit to the supplying division

(11)

Vancouver division would be willing to pay is $425. In this case, no transfer would take place.

In this formula, the variable cost excludes the commission. The commission is included in the external market price, so the lost contribution margin per unit does include the commission, as this would have to be paid on an outside sale.

Now assume that the Winnipeg division is currently selling only 1,000 units to the outside market. Minimum transfer price = ($140 + $70 + $5) + $0 = $215

The Winnipeg division has enough idle capacity to provide all the units to the Vancouver division without giving up any outside sales.

Partial capacity occurs when a company can use idle capacity to provide part of the requested amounts to the buying division, but to provide the remainder would require giving up outside sales. The lost contribution margin (CM) on the outside sales must be considered. Use the following steps to determine lost CM,

assuming 2,500 units are currently sold to the outside markets.

Step 2: Allocate total lost CM to the units requested (3,000) Lost CM per unit = $330,000 / 3,000 units = $110 per unit Step 3: Determine minimum transfer price

Transfer price = ($140 + $70 + $5) + $110 = $325

Transfer price range = $325 to $425 (market price that Vancouver can buy)

6.5 Multinational companies and transfer pricing

Describe transfer pricing issues facing multinational corporations. (Level 2)

LEVEL 2

Multinational companies engage in inter-country transfer of products. Because nations derive a portion of their tax income from collecting corporate income tax, as well as customs and duties, the transfer pricing used for inter-country transfer of products affects more than the corporate bottom line. These transfer prices affect the tax base of the two nations involved and the cash flows of the company. The two nations involved in the transaction have a vested interest in the process.

Step 1: Determine total lost CM on outside sales

First 1,500 units (idle capacity), no lost C/M $0

Next 1,500 units ($445 – $225) $330,000

(12)

Effect of tax rates

The transfer price charged between divisions of a company operating in different countries seems to create an opportunity for companies to take advantage of differing tax rates around the world by “shifting” profits from high-tax countries to low-tax countries based on the transfer price charged. However, both the

Canadian and U.S. governments have taken aggressive action against companies they consider to be evading taxes through these mechanisms. Section 247 of the Income Tax Act sets the guidelines for transfer pricing. Ensuring that companies do not use transfer pricing to avoid paying taxes is an important part of many countries’ tax legislation. Such transfers have a very real impact on corporate cash flows. If a company can transfer goods from a location with low tax rates into a country with high tax rates at a transfer price that leaves the majority of the income in the low-tax country, then the company keeps more of its cash. (Work through Self-test question 5 to get a feel for the impact that multinational transfer pricing can have on a company’s taxes.)

Other factors

There are some other factors that multinational companies need to consider in designing their transfer pricing systems:

Currency restrictions — Some countries limit the amount and/or timing of transfering accumulated

profits.

Risk of expropriation — Managers should consider the likelihood that local government might take

ownership and control over foreign subsidiaries.

Country risk — Managers should also consider the level of economic risk of the country in which the

subsidiaries are located.

Module 6 summary

Describe the benefits and drawbacks of decentralization

Benefits:

Greater responsiveness to local needs Quicker decision making

Increased motivation

(13)

Sharpens the focus of management

Drawbacks:

Suboptimal decisions making (goal incongruence) Duplication of duties

Decreased loyalty to the organization as a whole Increased costs of gathering information

Determine the impact of transfer pricing policies on profits

Transfer prices determine the profitability of subunits, potentially affecting management compensation and performance measurement evaluations.

Transfer pricing affects the flow of goods and services in organizations that are divided into responsibility centres. Three main transfer pricing methods are:

Market based — if a general market is available

Cost-based — may be straight variable, absorption, or full cost

Negotiated — determined by the negotiating skills of the units’ managers

The main problem is ensuring that the transfer price used optimizes the organization's returns and leads to goal congruence.

Determine transfer prices using market-based, cost-based, and negotiated transfer pricing

measures

Market-based:

Generally leads to optimal pricing for the entire organization in conditions of perfect competition

where interdependence between subunits is minimal, and there are no additional costs or benefits to the company.

When prices fluctuate greatly, long-run average prices can be used.

Cost-based:

Minimum transfer pricing should be the variable cost of production in the selling unit. Maximum transfer pricing should be market price.

Prorating between these amounts is an option.

Dual pricing can be used where the selling division uses cost-based transfer pricing and the buying

division uses market-based. Negotiated:

Managers are allowed to negotiate their own transfer prices and are given the autonomy to buy from,

(14)

This method aids in management training.

Determine the minimum transfer price under varying levels of production capacity

General guidelines for transfer pricing are:

Minimum TP = Additional incremental outlay or outlay costs per unit to point of transfer +

opportunity costs per unit to the supplying division.

Minimum TP = Variable cost + lost contribution margin on outside unit of sale.

Guideline when intermediate markets exist that are not perfectly competitive and the selling division has unused capacity:

Minimum TP = incremental cost.

General guideline kicks in when all unused capacity has been used.

Guideline when no market exists for intermediate product:

Opportunity cost would be zero, so minimum TP = incremental costs.

Describe the transfer pricing issues facing multinational corporations

National legislation often restricts transfer prices that a multinational corporation can use.

Transfer prices paid between divisions across national borders affects the amount of taxes that the

company pays.

Module 6 self-test

Question 1

Exercise 23-18, page 908

Solution (To view the content from this link you must go on-line.)

Question 2

Exercise 23-20, pages 908-909

Question 3

Problem 23-27, pages 911-912

(15)

Question 4

Exercise 23-23, pages 909-910

Question 5

Exercise 23-24, page 910

Solution (To view the content from this link you must go on-line.) Use the following data to answer questions 6 to 10

Sprig Inc. has 2 divisions. The supply division produces a motor that is used in the production of lawn mowers in the production division. For the supply division, the variable cost of the motor is $200. The fixed cost is $100 per unit. The supply division also sells the motor to the outside market for $400. The supply division has a capacity of 40,000 motors. The lawn mower division can buy motors from an outside company for $380. The lawn mower division uses the motor plus other parts totalling $200 in production and has a fixed cost of $100 per unit. The lawn mower is sold for $900.

Question 6

Using market-based transfer prices, determine the transfer price that should be charged from the motor division to the lawn mower division.

Solution (To view the content from this link, go to end of document.)

Question 7

Using cost-based transfer price of full absorption cost plus 50%, determine the transfer price that should be charged from the motor division to the lawn mower division.

Question 8

Assume that the motor division is currently selling 10,000 units externally to the market and the lawn mower division requires 20,000 units. Calculate the minimum and maximum transfer prices and determine if a transfer should take place.

Question 9

Assume that the motor division is currently selling all 40,000 units externally to the market and the lawn mower division requires 20,000 units. Calculate the minimum and maximum transfer prices and determine if a transfer should take place.

(16)

Question 10

Assume that the motor division is currently selling 30,000 units externally to the market and the lawn mower division requires 20,000 units. Calculate the minimum and maximum transfer prices and determine if a transfer should take place.

(17)

Self-test 6 Solution 6

Minimum transfer price = $380 (market price of buying division)

Minimum transfer price = ($200 + $100) x 150% = $450.

Idle capacity:

Minimum transfer price = Variable cost + Lost contribution margin on outside sale = $200 + $0

= $200

Maximum transfer price = $380 (market price for buying division) A transfer should take place.

Full capacity:

Minimum transfer price = Variable cost + Lost contribution margin on outside sale = $200 + ($400 – $200)

= $400

Maximum transfer price = $380 (market price for buying division) No transfer should take place.

(18)

Partial capacity:

Lost contribution margin: First 10,000 units $0

Next 10,000 units ($400 – $200) $2,000,000 Total lost contribution margin $2,000,000

Divided by number of units required 20,000 Contribution margin lost per unit $100

Minimum transfer price = Variable cost + Lost contribution margin on outside sale = $200 + $100

= $300

Maximum transfer price = $380 (market price for buying division) A transfer should take place.