Lecture 7- Transfer pricing

Transfer pricing- Amount [blank_start]charged[blank_end] when one business [blank_start]unit[blank_end] sells goods or services to another business [blank_start]unit[blank_end] (effectively [blank_start]internal[blank_end] selling prices). It is key accounting method that is important for measuring [blank_start]performance[blank_end] within [blank_start]highly decentralised[blank_end] organisations

One purpose of transfer pricing system is to provide information that [blank_start]motivates[blank_end] divisional managers to make good [blank_start]economic decisions[blank_end]. This will occur when [blank_start]actions[blank_end] that divisional managers take to [blank_start]improve[blank_end] reported profit of their [blank_start]divisions[blank_end] also improves profit of [blank_start]company[blank_end] as whole

Another purpose of transfer pricing system is to provide information that is [blank_start]useful[blank_end] for evaluating [blank_start]managerial[blank_end] & [blank_start]economic[blank_end] performance of [blank_start]division[blank_end]

Third purpose of transfer pricing system is to ensure that [blank_start]divisional autonomy[blank_end] is not undermined

Fourth purpose of transfer pricing system is to intentionally move [blank_start]profits[blank_end] between divisions or locations for shifting [blank_start]taxable profits[blank_end] to divisions located in [blank_start]different[blank_end] countries

Minimum transfer price = [blank_start]Outlay cost + Opportunity cost[blank_end]

Outlay cost- Costs incurred by [blank_start]supplying[blank_end] unit to [blank_start]produce[blank_end] & [blank_start]supply[blank_end] goods or services to be [blank_start]transferred[blank_end]

Opportunity cost- Profit [blank_start]forgone[blank_end] by [blank_start]supplying[blank_end] unit to [blank_start]produce[blank_end] & [blank_start]supply[blank_end] product for [blank_start]internal[blank_end] transfer

One transfer pricing method is [blank_start]market-based[blank_end] transfer prices. In determining this, management may choose to use [blank_start]price[blank_end] of [blank_start]similar[blank_end] product or service [blank_start]publicly[blank_end] listed. If there are competitive external [blank_start]markets[blank_end] for product, then [blank_start]market prices[blank_end] are generally recommended transfer price

Another transfer pricing method is [blank_start]cost plus mark-up[blank_end] transfer prices. Two cases for adopting this are: when [blank_start]transferred[blank_end] goods do not have [blank_start]reliable[blank_end] external [blank_start]market prices[blank_end] & when supplying unit has [blank_start]spare capacity[blank_end]

Third transfer pricing method is [blank_start]negotiated[blank_end] transfer prices. In determining this, [blank_start]subunits[blank_end] of company are free to [blank_start]negotiate[blank_end] transfer price between [blank_start]themselves[blank_end] & then to decide whether to [blank_start]buy[blank_end] & [blank_start]sell[blank_end] internally or deal with outside parties. Managers [blank_start]negotiate[blank_end] price at which transfers will be made

Fourth transfer pricing method is [blank_start]marginal cost[blank_end] transfer prices

Fifth transfer pricing method is [blank_start]full cost[blank_end] transfer prices

Advantage of using market-based transfer prices is that leads to calculation of ‘[blank_start]realistic[blank_end]’ divisional [blank_start]profits[blank_end] that can be [blank_start]compared[blank_end] to [blank_start]competitive industry[blank_end] benchmarks

Disadvantage of using market-based transfer prices is that it will not always encourage [blank_start]goal-congruent[blank_end] behaviour

Advantage of using negotiated transfer prices is that there is full [blank_start]independence[blank_end] of [blank_start]buying[blank_end] & [blank_start]selling[blank_end] divisions

Disadvantage of using negotiated transfer prices is that there can be [blank_start]disagreement[blank_end] & [blank_start]competition[blank_end] between [blank_start]managers[blank_end] of divisions involved

When there is perfectly competitive market for intermediate product correct transfer price is [blank_start]external market[blank_end] price

Cost-plus transfer prices will not result in [blank_start]optimum[blank_end] output being [blank_start]achieved[blank_end]

In decentralised organisation, managers of [blank_start]profit centres[blank_end] & [blank_start]investment centres[blank_end] usually have considerable [blank_start]autonomy[blank_end] over setting & accepting transfer prices. Direct intervention by [blank_start]corporate management[blank_end] is usually considered to be inconsistent with [blank_start]philosophy[blank_end] of decentralisation