Management Accounting & Decisions II N12401

Lecture 8

Transfer Pricing

by Hung Woan-Ting

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Learning Objectives

1. To understand the main issues of transfer pricing in decentralized organizations

2. To be aware of the different types of transfer pricing models and understand their suitability and management implications

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1.0 Decentralized organization

Delegation of decision making authority down the organization hierarchy

Many advantages

Frees top management (strategic level planning and decisions)

Quality and timely decisions from the floor

Managerial motivation

etc.

Task control Results control

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1.1 Responsibility centres

Operation units as separate responsibility centres

Partly autonomous Manager made responsible Goal congruence (no sub-optimal decisions)

Centre Company Centre

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1.1 Responsibility centres

Types of responsibility centres:

Cost Centre

Profit Centre

Investment Centre

Concept of controllability

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1.1 Responsibility centres

Responsibility flow

and accounting flow within the organisation

Concept of controllability

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1.2 Controllability

Key issue in applying the controllability principle:

Revenues and costs are jointly earned/incurred in many organisations

(sequential and interdependent activities/centres)

Management to measure the performance of each of these centres (performance evaluation; financial control; etc.)

Choice of the performance measure may influence decision-making behavior

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Example:

A firm faced the problem of developing performance standards in an environment of continuously rising costs

Raw materials costs, which were 60% - 90% of the final costs, were market determined

Should the evaluation of the managers depend on their ability to control the quantity of raw materials used rather than the cost?

Senior management announced that it would

evaluate managers on their ability to control total costs

The managers quickly discovered that one way to control raw materials costs was through long-term fixed price contracts for raw materials

Contracts led to declining raw materials costs

The company could project product costs several quarters into the future, thereby achieving lower costs and stability in planning and product pricing

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1.3 Segmental reporting

Profit measure is comprehensive and pervasive To treat units as Profit Centers Segment margin reports

Profit center accounting systems must reflect interactions between the various profit center

Dividing revenue among all the responsibility

centers that contribute to earning it (transfer pricing issue)

Allocations may be quite arbitrary

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1.4 Transfer pricing (TP)

The set of rules an organization uses to allocate jointly earned revenue among responsibility centers

Typical TP decisions:

Sourcing decision (should the company produce the product inside the company or purchase it from an outside

vendor?) Apply the concept of relevance in cost/revenue

Pricing decision (if produced within, at what price should the product be transferred between the centres?)

Assess the likelihood: 1. Div A willing to

supply internally?

2. Div B willing to buy internally?

3. Company ME benefits from the internal transfer?

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1.5 A sourcing decision

Example:

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1.6 A pricing decision

An internal price charged by the Supplying Centre to the Receiving Centre for an internally produced and consumed commodity

Fundamental principle: TP = Market Price

Would this promote goal congruence??

Motivation to set TP at a level which ensures profits maximisation for the organization as a whole

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Market-based pricing

Cost-based pricing

Marginal Cost;

Full Cost

Cost plus mark-up, Cost plus fixed fee, etc.

Negotiated pricing

2.0 Types of transfer price model

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Negotiated pricing

From sellers perspective:

Transfer price >= Variable cost per unit + Opportunity costs

(if any)

From purchasers perspective:

Transfer price

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2.1 Choice of TP

The best TP model?

Rule of thumb?

Market based Negotiation Cost-based (fair evaluation in place)

Goal congruence

Divisional autonomy

Management effort

vs. vs.

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2.2 Practice adoption

Borkowski (1990) Environmental and Organizational Factors Affecting Transfer Pricing: A Survey, Journal of Management Accounting Research, Fall: 87.

Basis of Transfer Price %

Market price 33

Negotiated 23

Full cost plus profit 17

Full cost 23

Variable costs 4

100

Similar findings in Elliott & Emmanuel (2000) International Transfer Pricing: A Study of Cross Border Transactions, CIMA.

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2.3 Benefits of TP mechanism

Allocate the jointly earned revenue among centres

Evaluate performance of supplying & receiving centres

Maintain divisional autonomy

Motivate sound decisions (for division & company)

Allocate resources and coordinate activities among centres

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Readings & Exe.

1.Read the following chapters in the prescribed textbooks

D Ch20

GNBCY Ch13

2.Attempt the Question Sets attached at the back of

this handout (indicative solutions in Moodle for self-checking)

End of Lecture