MANAGEMENT
AND COST
ACCOUNTING
SIXTH EDITION
COLIN DRURY
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2004 Colin Drury
Part Four:
Information for planning, control and performance
Chapter Twenty-one:
Transfer pricing in divisionalized companies
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.1a
Purposes of transfer pricing
1. To provide information that motivates divisional managers to make good
economic decisions.
2. To provide information that is useful for evaluating the managerial and
economic performance of the divisions.
3. To intentionally move profits between divisions or locations.
4. To ensure that divisional autonomy is not undermined.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.1b
Information for making good decisions
• Intermediate products = Goods transferred from the supplying to receiving
division.
• Final products = Products sold by the receiving division to the outside world
• Example
Incremental cost of making intermediate product
Incremental further processing costs in receiving division
Market price of final product
No external market for the intermediate product and spare
capacity
Cost-plus 50% transfer price
Business will be rejected if TP set at £150
= £100
= £60
= £200
= £150
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.1c
Evaluating managerial performance
• TP of £60 incremental cost of supplying division would motivate correct
decision but it does not form a basis for measuring the performance of the
supplying division.
• A conflict of objectives exists which can be difficult to resolve.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.2a
Alternative transfer pricing methods
1. Market-based
2. Marginal cost
3. Full cost
4. Cost-plus a mark-up
5. Negotiated transfer prices
Market-based transfer prices
• Where there is a perfectly competitive market for the intermediate
product,the current market price is the most suitable basis for setting the
transfer prices.
• TP ’s will motivate sound decisions and form a suitable basis for
performance evaluation (see Exhibit 21.2 in the text and Figure 21 A.1 slide 21.17)
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.2b
Marginal cost transfer prices
• Economic theory indicates TP based on the MC of producing the
intermediate product at the optimum output level for the company as a
whole will encourage total organizational optimality (see Figure 21.1 on
slide 21.3).
• Adopting a short-run perspective to derive MC results in MC = VC and
the assumption that MC is constant per unit throughout the relevant output
range.
• MC not widely used:
1. Provides poor information for performance evaluation
2. MC may not be constant over entire range of output
3. Measuring MC beyond short-term is difficult
4. Managers reject short-term perspective
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.3
Figure 21.1 An illustration of cost-based transfer prices
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.4a
Full cost transfer prices
• Widely used because managers require an estimate of long-run marginal
cost for decision-making.
• Traditional costing systems tend to provide poor estimates of long run
MC.
• Does not enable supplying division to report a profit on goods transferred.
Cost-plus a mark-up transfer prices
• Attempts to meet the performance evaluation purpose of transfer pricing
(profit allocated to the supplying division)
• Results in non-optimal decisions (See Figure 21.1 - slide 21.3) because
TP exceeds short-run or long-run MC.
• Enormous mark-ups can result when goods/services are transferred
between several divisions.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.4b
Negotiated transfer prices
• Most appropriate where there are market imperfections for the
intermediate product and managers have equal bargaining power.
• To be effective managers must understand how to use cost and revenue
information.
• Claimed behavioural advantages.
• Limitations:
1. Can lead to sub-optimal decisions
2. Time - consuming
3. Divisional profitability may be strongly influenced by the bargaining
skills and powers of the divisional managers.
4. Inappropriate in certain circumstances (e.g. no market for the
intermediate product or an imperfect market exists).
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.5
Marginal cost plus opportunity cost
• Often cited as a general rule that will lead to optimal decisions for the
company as a whole.
• Where there is no intermediate market the application of the rule leads to
TP = VC (assuming VC = MC
• Where there is a perfect market for the intermediate product the
application of the rule leads to TP = MP
(e.g. market price = £20 and VC = £5)
TP = £5VC + £15 opportunity cost = £20
• Rule tends to be a restatement of the general principles previously
established and it is also difficult to apply in more complex situations.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.6
Example
Oslo
Bergen
= Supplying division (No external market for the intermediate product)
= Receiving division (converts intermediate to final product)
Expected sales of the final product:
Net selling price
(£)
100
90
80
70
60
50
Quantity sold
Units
1 000
2 000
3 000
4 000
5 000
6 000
Oslo
(£)
11
Bergen
(£)
7
60 000
90 000
The costs of each division are:
Variable cost per unit
Fixed costs attributable to the
products
The transfer price of the intermediate product has been set at £35 based on a full cost plus
mark-up.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.7a
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.7b
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.7c
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.8a
• £35 TP does not motivate optimum output level for the company as a whole.
• To ensure overall company optimality the TP must be set at MC of the
intermediate product (i.e VC of £11 per unit or £11,000 per batch of 1,000 units).
• The receiving division will face the following net marginal revenue (NMR)
schedule:
Units
1 000
2 000
3 000
4 000
5 000
6 000
net marginal revenue (£)
93 000 (100 000 – 7000)
73 000 (80 000 – 7 000)
53 000 (60 000 – 7 000)
33 000 (40 000 – 7 000)
13 000 (20 000 – 7 000)
–7 000 (0 – 7 000)
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.8b
• At £11 TP receiving division will choose to expand output to 5,000 units.
• Consider a full cost TP without a mark-up (£23 if the denominator level to
compute unit fixed costs is 5,000 units)
The receiving division manager will choose to produce 4,000 units
• Negotiation:
1. No external market so supplying division manager has little bargaining power
.
2. Could avoid £60,000 fixed costs so would look for a TP of at least £23 per unit
(assuming a denominator level of 5,000 units is used).
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.9a
Resolving transfer pricing conflicts
• Two approaches advocated:
1.
2.
Adopt a dual rate TP system
Transfer at MC plus a lump sum fee
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.9b
Resolving transfer pricing conflicts (contd.)
Dual rate TP system
• Uses two transfer prices
1. Supplying division may receive full cost plus a mark-up so that it makes a
profit on inter-divisional transfers (e.g Oslo TP > £23).
2. Receiving division charged at MC of transfers thus motivating managers
to operate at the optimum output level for the company as a whole.
3. Profit on inter-group trading removed by an accounting adjustment.
• Not widely used because:
1. Use of two TP ’s causes confusion
2. Seen as artificial
3. Divisions protected from competition
4. Reported inter-divisional profits can be misleading
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.9c
Resolving transfer price conflicts (contd.)
Marginal cost plus a lump sum fee
• Intended to motivate receiving division to equate MC of transfers with its net
marginal revenue to determine optimum company profit maximizing output level.
• Enables supplying division to cover its fixed costs and earn a profit on interdivisional transfers through the fixed fee charged for the period.
• Motivates receiving division to consider full cost of providing intermediate
products/services (.TP = £11 MC plus £60,000 lump sum plus a profit contribution
in the example).
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.10a
Domestic TP conclusions/recommendations
• Competitive market for the intermediate product — Use market prices.
• No market for the intermediate product or an imperfect market — Transfer at MC
plus a lump sum or negotiation may be appropriate in certain circumstances.
• Use standard costs for cost-based TP ’s
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.10b
International transfer pricing
• Where divisions are located in different countries taxation implications become
important and TP has the potential to ensure that most of the profits on interdivisional transfers are allocated to the low taxation country.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.10c
Example
Supplying division in country A (Tax rate = 25%)
Receiving division in country B (Tax rate = 40%)
Motivation is to use highest possible TP so receiving division will have high costs
and low profits whereas supplying division will have high revenues and high
profits.
• Taxation authorities in most countries are wise to companies using TP to
manipulate profits and seek to apply OECD guidelines based on arm ’s length
pricing principles.
• TP can also have an impact on import duties and dividend repatriations.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.11a
ECONOMIC THEORY OF TRANSFER PRICING
No market for the intermediate product
1.
Correct TP is MC of producing the intermediate product at the optimal output
level for the company as a whole.
2.
The optimal output for the company as a whole is where:
• MC of supplying division + MC of receiving division
= MR of receiving division
• MC of supplying division = MR of receiving division
– MC of receiving division
• MC of supplying division = NMR of receiving division
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.11b
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.12
No market for the intermediate product (contd.)
3.
Optimal output = 7 000 units
4.
MC at 7 000 units = £4 000 (TP =£4 000 per 1 000 batch)
5.
At £4 000 TP the supplying division is motivated to transfer
7 000 units and the receiving division is motivated to buy
7 000 units.
6.
Note: optimum TP = VC where MC = VC.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.13
No market for the intermediate product (contd.)
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.14
Imperfect market for the intermediate product
Optimum transfer price for an imperfect intermediate market
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.15
Imperfect market for the intermediate product (contd.)
Allocation of output of supplying division between intermediate and external market
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.16
Imperfect market for the intermediate product (contd.)
1. Correct TP is the MC of producing the intermediate product at the
optimal output level (see tables on sheets 21.14 and 21.15).
2. To determine the optimum output level allocate the intermediate
product according to its most profitable use (see table on sheet 21.15).
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.17a
Imperfect market for the intermediate product (contd.)
3. Optimal output = 11 units (MC at this level =£27)
4. To be more precise,the optimal TP is where MCs and MR/NMR intersect between
£27 and £27.50.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.17b
Imperfect market for the intermediate product (contd.)
5. At a TP of £27.01 to £27.49
• the supplying division will choose to sell five units externally and
transfer six units internally
• the manager of the receiving division will choose to sell six units of
the final product.
6. If MC =VC the optimum TP =VC
7. Note the TP of £27.01 to 27.49 is only optimal where there are no
capacity constraints. If capacity constraints exist, the analysis must be
modified to reflect the constraint.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.18
Perfect external market for the intermediate product
• NMR for company as a whole =
BCDE
• MC for company as a whole = ADE
• Optimal output is where MC and NMR
for the company as a whole intersect
(point D at Q2)
• TP =OP
• At a TP of OP the receiving division
will require OQ1 and the supplying
division will wish to sell OQ2 (Q1Q2
externally if it supplies OQ1 internally).
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.19
No external market for the intermediate product
and a perfect market for the final product
Optimal output for the company as a
whole is where MCs + MCR equals
the MR for the company as a whole
(MRR) at OQ.
• MC of supplying division at the
optimal output level is OP and this is
the optimum TP.
• Supplying division will wish to
produce OQ at a TP of OP and the
receiving division will wish to produce
OQ at this TP.
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury
21.20
Imperfect market for the intermediate product
• The MC and MR schedules for
the company as a whole are MCs
and MRs +NMR.
• Optimal output is OQ3 and the
MC at this output level is OPT.
Therefore,optimal TP is OPT.
• At this TP the receiving division
will wish to purchase OQ2(where
TP =NMR).
• The supplying division faces a
MR schedule of BED and will sell
OQ1 externally and Q1Q3
internally giving a total output of
OQ3.(Note Q2Q3 = OQ1.)
Management and Cost Accounting, 6th edition, ISBN 1-84480-028-8
© 2000 Colin Drury
© 2004 Colin Drury