Question

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Question 4: Explain the effect on transfer prices on:

1. The performance evaluation of buying and selling divisions.
2. The selling division managers’ incentives to sell goods either internally or externally.

Answer 1

Trasfer pricing is the accounting procedure in which a high earning division of the company, called upstream, diverts its earnings towards the low earning division of the company, called downstream in order to decrease the tax burden on the company. In this managerial accounting technique, the upstream division purchases the goods and services from the downstream division in order to save cost. This thechnique is largely used in big corporations having more than one branches all over the world. Is is mainly done to save tax and other costs assosiated with the working of the downstream division. The companies charge high prices for the divisions in high taxed countries while charges low charges for division in low taxed countries, hereby reducing the cost of downstream division. Example of companies doing transfer pricing is Facebook, Colca- cola, etc.

(i) The transaction of goods and services totally depends on the proftability of the goods or services rendered. This affects the cost and revenue of the transacting division. If the product is priced at a low price, the upstream division get low profit on the product rendered, but the downstream division gets quality product at lower price. This affects the performance of the divisions in a negative way. This is the reason that the upstream divisions mark their products as if they are selling it to the external customer.

(ii) If the upstream division is providing the downstream division with the products they have produced, and the other customer for the same product is providing more price than the downstream division, then the upstream division may reject the internal sales offer and go with the sales of goods to the other customer, because at the end of the day, the main motive of the divisions set up in other country is to earn more. Whether they sale the product to internal customer or to the external customer, the idea is to earn more. If we think on a large scale, this will affect the overall productivity of the organization. Because of this idea, the downstream division will have to face hard time controlling their cost and this will affect the profitability of the whole organization.