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Int. Acc. MA LECT 8: CH 18 Decentralization and transfer pricing part 2:
Int. Acc. MA LECT 8: CH 18 Decentralization and transfer pricing part 2:
Transfer pricing methods (I)
: Different transfer-pricing methods produce different operating profits for individual subunits.
1 Market-based transfer price
Helpful in a perfectly competitive market
Setting the transfer price at the market price motivates division managers to deal internally and to take exactly the same actions as they would if they were dealing in the external market.
Transfer price is based on the price of a similar product or
service publicly listed
2 Cost-based transfer price
Transfer price is based on the costs of producing the
product
Helpful when market prices are unavailable, inappropriate or too costly to obtain
Many companies use transfer prices based on full costs.
To approximate market prices, cost-based transfer prices are sometimes set at full cost plus a margin
3 Negotiated transfer price
In some cases, the subunits of a company are free to negotiate the transfer price between themselves and then decide whether to buy and sell internally or deal with outside parties
Transfer pricing example slide 30-38/53
If the internal transfer takes place, the division of profit between the subunits is relevant.
Recognise when a transfer price may lead to suboptimal decisions
cost-based transfer prices
Example 39-45/53
Summary
As a profit centre, the Refining Division can maximise its short-run division operating profit by purchasing from the London supplier (£460,000 versus £492,800).
The transfer-pricing method has led the Refining Division to regard the fixed cost and the 12% mark-up of the Transportation Division as variable costs as well.
Transfer pricing rule: Minimum transfer price = Opportunity cost (£0)+ incremental cost (var. cost £2 + purchase price £17)
Understand the range over which two divisions generally negotiate the transfer price when there is unused capacity
Prorating (I)
Prorating: Allocating the difference between the maximum and the minimum transfer price to both divisions
Assumption:
Variable costs are the allocation basis.
Problem:
Prorating requires divisions to share information about their variable costs. Each division has an incentive to overstate its variable costs!
example 48-49/53
Comparison of Transfer Pricing Methods
Achieves Goal Congruence: Individuals and groups work towards achieving the organisation’s goals
Cost-Based: Often, but not always
Negotiated:Yes
Market Price:Yes, if markets competitive
Useful for Evaluating Subunit Performance
Cost-Based:Difficult, unless transfer price exceeds full cost in order to make a profit for the subunit
Negotiated: yes
Market Price:Yes, if markets are competitive
Comparison of Transfer Pricing Methods(II)
Motivates management effort
Negotiated:
Yes
Cost-Based: Yes, if based on budgeted costs; less incentive if based on actual cost
Market Price:Yes
Preserves subunit autonomy
Market Price: Yes, if markets competitive
Cost-Based: No, it is rule based
Negotiated: yes