Question

An academic researcher at an accounting symposium once remarked: “A transfer pricing method is much more than simple choice of a price for the transfer of goods from one responsibility center to the other. The choice of a method, coupled with operating capacity of the unit, have at times serious implications for the goals set by the interested parties in the process…. Also, think of the firm’s total profit as a pie. Choice among transfer pricing methods not only changes how the pie is divided among responsibility centers, it also changes the size of the pie itself”.

Required:

Write a one-page essay commenting on the points raised by the researcher. Support your argument/s, wherever feasible, by constructing simple numerical examples.

Answer 1

Benefits of Transfer Pricing are as under :-

Investment appraisal
New investment should typically be evaluated using a method such as net present value. However, the cash inflows arising from an investment are almost certainly going to be affected by the transfer price, so capital investment decisions can depend on the transfer price.

Motivation to managers
Everyone likes to make a profit and this ambition certainly applies to the divisional managers. If a transfer price was such that one division found it impossible to make a profit, then the employees in that division would probably be demotivated. In contrast, the other division would have an easy ride as it would make profits easily, and it would not be motivated to work more efficiently.

Pay based on Performance
If there is a system of performance-related pay, the remuneration of employees in each division will be affected as profits change. If they feel that their remuneration is affected unfairly, employees’ morale will be damaged.

Evaluation of Performance
Success of each division will be changed whether measured by return on investment (ROI) or residual income (RI) . These measures might be interpreted as indicating that a division’s performance was unsatisfactory and could tempt management at head office to close it down.

Decisions relating to Make/abandon/buy-in

If the transfer price is very high, the receiving division might decide not to buy any components from the transferring division because it becomes impossible for it to make a positive contribution. That division might decide to abandon the product line or buy-in cheaper components from outside suppliers.

Further many amounts can be legitimately calculated in a number of different ways and can be correctly represented by a number of different values. For example, both marginal and total absorption cost can simultaneously give the correct cost of production, but which version of cost you should use depends on what you are trying to do.

Similarly, the basis on which fixed overheads are apportioned and absorbed into production can radically change perceived profitability. The danger is that decisions are often based on accounting figures, and if the figures themselves are somewhat arbitrary, so too will be the decisions based on them. You should, therefore, always be careful when using accounting information, not just because information could have been deliberately manipulated and presented in a way which misleads, but also because the information depends on the assumptions and the methodology used to create it. Transfer pricing provides excellent examples of the coexistence of alternative legitimate views, and illustrates how the use of inappropriate figures can create misconceptions and can lead to wrong decisions.

Transfer prices are almost inevitably needed whenever a business is divided into more than one department or division. Usually, goods or services will flow between the divisions and each will report its performance separately. The accounting system will usually record goods or services leaving one department and entering the next, and some monetary value must be used to record this. That monetary value is the transfer price. The transfer price negotiated between the divisions, or imposed by head office, can have a profound, but perhaps arbitrary, effect on the reported performance and subsequent decisions made. Example ;-

division A division B

transfer in price $ 0 $ 50

own cost $ 30 $ 20

divisional profit $ 20 $ 20

Transfer Price $ 50 $ 90

Here Division A makes components for a cost of $30, and these are transferred to Division B for $50 (shown as the transfer out price for Division A and the transfer in price for Division B). Division B buys the components in at $50, incurs own costs of $20, and then sells to outside customers for $90.

As things stand, each division makes a profit of $20/unit, and it should be easy to see that the group will make a profit of $40/unit. You can calculate this either by simply adding the two divisional profits together ($20 + $20 = $40) or subtracting both own costs from final revenue ($90 – $30 – $20 = $40).

You will appreciate that for every $1 increase in the transfer price, Division A will make $1 more profit, and Division B will make $1 less. Mathematically, the group will make the same profit, but these changing profits can result in each division making different decisions, and as a result of those decisions, group profits might be affected.

Consider the knock-on effects that different transfer prices and different profits might have on the divisions.