In: Accounting
QUESTION TWO
A. In what situations should the transfer price be the external market price? (10 Marks)
B. How should the transfer price be established when there are diseconomies of scale and prices have to be lowered to increase sales volume? (10 Marks)
C. What is the ideal transfer price? (5 Marks)
D. In what circumstances should the transfer price be standard variable cost plus opportunity cost of making the transfer? (10 Marks)
E. Discuss the advantages and disadvantages of Market Price Based Transfer Prices and Cost Based Transfer Prices. Further, outline the main variants that exist under each method. (15 Marks)
Answer to question A
Globalization has both tremendous opportunities for business, but also significant challenges.
Determining the exact cost of transactions between related entities within a company — a process known as transfer pricing — is not only important for accurate accounting but mandatory for most multinationals to report. That’s because the Organization for Economic Cooperation and Development has developed transfer pricing guidelines and is bringing leading nations together to stop companies from evading taxes by shifting profits to low-tax jurisdictions.
Answer to question B
Diseconomies of scale happen when a company or business grows so large that the costs per unit increase. It takes place when economies of scale no longer function for a firm. With this principle, rather than experiencing continued decreasing costs and increasing output, a firm sees an increase in costs when output is increased.
External diseconomies of scale can arise due to constraints imposed by the environment within which a firm or industry operates. Essentially, diseconomies of scale are the result of the growing pains of a company after it's already realized the cost-reducing benefits of economies of scale.
Answer to question C
This is true, but there is one fairly straightforward principle which can be used to identify optimal transfer prices in many cases. This principle is as follows: The transfer price should be equal to the marginal cost of producing the transferred product or service, plus the opportunity cost of making the transfer.
Answer to question D
Although there are different approaches for establishing a transfer price, the general economic transfer pricing rule states the transfer price should be set at differential cost to the selling division (normally variable cost) plus the opportunity cost of making the sale internally
Answer to question E
Cost-based Transfer Pricing
In the absence of an established market price many companies base the
transfer price on the production cost of the supplying division. The most
common methods are:
• Full Cost
• Cost-plus
• Variable Cost plus Lump Sum charge
• Variable Cost plus Opportunity cost
• Dual Transfer Prices
Each of these methods is outlined below.
------Full Cost
A popular transfer price because of its clarity and convenience and
because it is often viewed as a satisfactory approximation of outside market
prices.
(i) Full actual costs can include inefficiencies; thus its usage for transfer
pricing often fails to provide an incentive to control such inefficien-
cies.
(ii) Use of full standard costs may minimize the inefficiencies mentioned
above.
---- Cost-plus
When transfers are made at full cost, the buying division takes all the
gains from trade while the supplying division receives none. To overcome
this problem the supplying division is frequently allowed to add a mark-up
in order to make a “reasonable” profit. The transfer price may then be
viewed as an approximate market price.
----- Variable Cost plus a Lump Sum Charge
In order to motivate the buying division to make appropriate purchasing
decisions, the transfer price could be set equal to (standard) variable cost
plus a lump-sum periodical charge covering the supplying division’s related
fixed costs.
Market based transfer pricing
A market-based transfer price is based on the fair market value of the good being transferred from the selling division to the buying division. When the selling division does not have excess (idle) capacity, the market price most closely approximates the opportunity cost of the resource.
Market-based prices are based on opportunity costs concepts. The opportunity cost approach signals that the correct transfer price is the market price. Since the selling division can sell all that it produces at the market price, transferring internally at a lower price would make the division worse off.