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Divisional Transfer Pricing (Transfer Pricing Methods (Cost Based (Methods…
Divisional Transfer Pricing
Transfer Pricing
Utility of Transfer Pricing
Employee agreement and compensation
Resource allocation
Performance evaluation
Taxation and profit remittance
A Question of Fair Value
Transfer Pricing Methods
Cost Based
Methods
Standard cost based transfer price
Advantages = Performance evaluation can be done agaist budgeted cost targets
Disadvantages = Profit performance measurement is centralized and cannot be measured for individual divisions
Full cost based transfer price
Advantages = Full cost of goods transferred is recovered hence the supplying division will not show a loss
Disadvantages = Since mark-up cannot be charged on internal transfers, the supplying division does not record any profit on theses sales. This is a disincentive for the supplying division
Cost plus a mark-up based transfer price
Advantage = Since the supplying division makes a profit, this method address the distinctive problem discussed above in the full cost method
Since the transfer price under this method closely approximates its market price, the purchasing division may bear a share of the selling expenses although none was incurred for such internal sales
Marginal cost based transfer price
Advantage = Useful when the supplying has excess capacity. The method ensures that the supplying division recoups the cost of internal transfer, while the purchasing division enjoys the benefit of a lower price compared to the market
Disadvantage = No fixed cost or mark-up is allowed to be charged to the purchasing division. Each unit of internal sale will hence result in a loss at approximately fixed cost per unit
Advantages
Performance can be benchmarked to internal cost targets (bbudgets)
Information is more easily available as compared to market price
Disadvantages
The cost on which transfer pricing is used can be subjective since there can be multiple ways of interpreting costs
Since cost is passed on to another division, there may be instances when managers of he supply division may find little incentive to lower the cost of production by adopting cost efficient methods
Negotiation based transfer price
Advantages = Managers are given autonomy to decide whether to purchase (or sell) from its sister unit or source then from (or to) external market
This method requires sufficient external information to be available regarding the external market price, terms of trade etc. Internal cost information must also be shared in order to negotiate a reasonable price
Market Based
Disadvantages
May not be suitable when market prices can fluctuate widely or quickly
Market price may not be completely unbiased, if a competitive environment does not exist
Goods that are transferred may be at an intermediate stage in the production process. At times market price may not be available for such intermediate goods
Methods
Shared profit relative to cost based transfer price method
Market price and shared contribution method
Advantages
Market prices are less ambiguous compared to cost-based pricing. They cannot be manipulated
Since the pricing is competitive, divisional performance can be linked more objectively to its contribution to the company's overall profits
Since demand and supply determine market price, it is likely to be unbiased
Transfer pricing and goal congruence
Range of transfer price that promotes goal congruence
Minimum Transfer Price (Determined by Supplying Divisionz0
= Additional outlay cost per unit + Opportunity cost per unit
Where,
Additional Outlay Cost = Marginal cost + Any additional incidental costs incurred by the supplying division; and
Opportunity Cost is the benefit foregone from selling internally rather than externally
Maximum Transfer Price (Determined by Purchasing Division)
= Lower of net marginal revenue and the External buy-in price
Where
Net Marginal Revenue = Marginal Revenue (i.e. Selling price p.u.) - Marginal cost to purchasing division
Transfer Pricing Decisions under Different Circumstances
Different Capacity Levels
Where the supplying division has excess capacity
Minimum Transfer Price = Marginal Cost Per Unit
Maximum Transfer Price = Lower of Net Marginal Revenue and External Buy-in Price
Where the supplying division operates at full capacity
Minimum Transfer Price = Marginal Cost Per Unit + Opportunity Cost Per Unit
Maximum Transfer Price = Lower of Net Marginal Revenue and External Buy-in Price
Different Demand Levels
Same as in different capacity levels
Proposals for Resolving Transfer Pricing Conflict
Dual Rate Transfer Pricing
Drawbacks
It can complicate the records, thereby may result in errors in the company's overall records
Profits shown by the divisions are artificial and need to be used only for internal evaluations
Two Part Transfer Pricing System
International Transfer Pricing
Driving factors of Business Models of MNCs
Availability of raw materials in a specific country
Availability of low cost labour with specialized skills
Demand for its final products
International Transfer Pricing and Currency Management