ACC80008

Managerial Accounting
Lecture 10: Performance Evaluation in
Decentralized Firm Transfer Pricing
Lecturer: Dr. Eva Elijido-Ten
Reference: Chap.22 (Horngren et al)
Swinburne University of Technology
2
Lec t ur e 10
Lear ni ng Obj ec t i ves
After working through this topic, you will be able to:
Describe the role of transfer pricing in the
decentralised firm
Define and describe methods of transfer pricing
Evaluate the benefits and costs of transfer pricing
Calculate possible transfer prices in specific
situations
Swinburne University of Technology
3
Responsibility Centre:
sub-unit in firm whose manager is held accountable for specified
financial and non-financial results of the sub-units activities
Cost
Centre
Revenue
Centre
Profit
Centre
Investment
Centre
RESPONSIBILITY
CENTRES
Responsibility Centres Review
Performance evaluation of responsibility centres
Many measures of performance
Only on the costs/revenues that you have control over
Difficult in practice due to uncontrollability of some costs and
revenues and level of investment.
Activities in businesses are highly interdependent
Swinburne University of Technology
4
In decentralised
organizations,
managers of profit
centers and investment
centers often have
considerable autonomy
in decision making.
Autonomous
managers can
accept or reject
orders and can
decide whether
to buy from the
outside.
The transfer pricing context
Swinburne University of Technology
5
The transfer pricing context
What price should A charge B for product X?
Division A Division B
A sells to B
Product X
Sell outside Sell outside
Swinburne University of Technology
6
Air Con
lower profits for
the building division
The transfer price affects the profit measure for both the selling
division and the buying division.
Building Division
Air Con Division
Transfer Pricing
A higher transfer
price for air conditioning
unit means . . .
greater profits for
the aircon division
Swinburne University of Technology
7
Transfer between divisions: Effect on business as a whole
Revenue to A from sale/transfer of product affects profit and
therefore performance: high revenue
Costs paid by B affect profit and therefore performance: low cost
Division A sells 100 units to Division B

Price Division
A
Division
B
Company
as a whole
(A+B)
Revenue Expense
$100 10,000 10,000 0
$200 20,000 20,000 0

Swinburne University of Technology
8
Transfer Pricing
Amount charged when one division sells goods or services
to another division
Internal transfer decisions
Creates a need for a pricing decisions
Does price reflects the costs and revenues of doing business?
Although it does not affect overall total profit
Transfer prices affect profits of buying and selling divisions
Who wins, who loses?
Swinburne University of Technology
9
The problem
What price?
Division A wants to sell at
a price as high as
possible: high price =
increased profits =>
increased ROI or EVA
Division B wants to buy at
a price as low as
possible: low costs =
increased profits =>
increased ROI or EVA
Preservation of divisional
autonomy
Mimics competitive market
Goal congruence
Actions maximise firm-wide
profits
Accurate performance
evaluation
Includes all revenues and
costs
Aims of transfer
pricing
Swinburne University of Technology
10
Transfer prices impact on
Divisional performance
measures
Higher price increases profit
for selling division and
reduces profit for buying
division and vice versa
Managerial performance
incentives
Higher profit higher
bonuses and the converse
Firm-wide profits
Maximising divisional profits
may reduce firm-wide profits
e.g. sell component outside
lack of components for
buying division
Business unit autonomy
If dispute occurs, senior
management may intervene
to set price loss of
managerial autonomy
Swinburne University of Technology
11
Goal and Behavioural Congruence
The transfer price
should be chosen so
that each division
manager makes
decisions that maximise
the companys profit
The goal in setting the
transfer price is to provide
incentives for each of the
division managers to act in
the companys best
interest
Swinburne University of Technology
12
General Transfer-Pricing Rule:
Optimal Transfer Price
Includes the direct unit-
level costs of the product +
any other costs incurred as
a result of the transfer
Transfer
Pri ce
=
Addi ti onal outl ay
cost per uni t
i ncurred because
goods are
transferred
+
Opportuni ty cost
per uni t to the
organi sati on
because of the
transfer
An opportunity cost is a
benefit that is foregone
as a result of taking a
particular action
Swinburne University of Technology
13
Transfer-Pricing Methods
Market-based transfer prices
Cost-based transfer prices
Negotiated transfer prices
Swinburne University of Technology
14
Transfer Prices -Example
A & R Ltd owns fast food restaurants and beverage manufacturers. One of its
restaurants, Petes Pizzas, is known for serving a wide variety of soft drinks with
its pizzas. One of the beverages is ginger beer which is served on tap. A & R
Ltd has just purchased a new division, GB Beverages, that produces ginger beer.
The managing director of GB Beverages has approached Pete of Petes Pizzas
about purchasing GBs ginger beer rather than its usual brand. Pete is happy
with the quality of GBs ginger beer - it is just a question of price. GB can sell
their ginger beer to other customers for $20 per barrel. Basic data follow:
GB Beverages:
Ginger beer production capacity per month 10,000 barrels
Variable cost per barrel of ginger beer $8 per barrel
Fixed costs per month $70,000
Petes Pizzas:
Purchase price of regular brand of ginger beer $18 per barrel
Monthly consumption of ginger beer 2,000 barrels
Swinburne University of Technology
15
Transfer price = Incremental cost + Opportunity cost
Unit-level cost of Foregone
= production and + contribution margin
transportation of an external sale
When producing division has no excess capacity and
perfect competition prevails, the general transfer-pricing
guideline and market price yield the same transfer price
Market Price
Transfer price = $8 + $12 = $20
Swinburne University of Technology
16
With no excess capacity
Selling divisions lowest
acceptable transfer price
Variable costs + Opportunity cost
$8 + $12 = $20
Buying divisions highest
acceptable transfer price
cost of buying from supplier
$18
IF Minimum > Maximum
THEN No transfer
With excess
capacity
Selling divisions lowest
acceptable transfer price
Variable costs
$8
Buying divisions highest
acceptable transfer price
cost of buying from supplier
$18
IF Minimum < Maximum, i.e.
$8Transfer Price $18
THEN should transfer
Swinburne University of Technology
17
Market-Based Transfer Prices
If external markets exist for the intermediate
(transferred) product or service, then market prices are
the most appropriate basis for pricing the transferred
good or service between responsibility centers
The market price provides an independent valuation of
the transferred product or service, and of how much
each profit center has contributed to the total profit
earned by the organization on the transaction
Unfortunately, such competitive markets with well-
defined prices seldom exist
Swinburne University of Technology
18
Cost-Based Transfer Pricing Issues
Full Cost vs Variable Cost
Full cost - can result in dysfunctional
decisions in buying division
-No incentive to cut down cost (WHY? Can
pass inefficiencies to buying division)
One solution is to use a standard cost as the transfer price
- Developing and operating accurate costing systems is quite a
challenge
=>People are likely to complain and become frustrated if they
believe the organization is using an inaccurate costing
system for transfer-pricing purposes
Swinburne University of Technology
19
$8 Transfer Price $18
Full cost = $8 + $7 = $15
Full cost + mark-up (assume 30%)
$15 x 130% = $19.50
outside supplier can supply for < $19.50
no transfer as Pete can buy cheaper from supplier
however optimal for firm to supply Pete when GB has excess capacity
Variable cost + mark-up
VC =>$8 + ??% = $ 19.50
$8 + $11.50 = $ 19.50
$8 + 143.75%VC = $19.50
Swinburne University of Technology
20
Negotiated Transfer Price
Some organizations allow supplying and receiving
responsibility centers (divisions) to negotiate transfer
prices between themselves
In the absence of market prices
Given the drawbacks of cost-based transfer pricing
Negotiated transfer prices reflect the controllability
perspective inherent in responsibility centers, since each
division is ultimately responsible for the transfer price that
it negotiates
However, negotiated transfer prices and therefore production
decisions may reflect the relative negotiating skills of the two
parties rather than economic considerations
Swinburne University of Technology
21
Negotiated Transfer Prices
Division managers actually negotiate the price at
which transfers will be made
Drawbacks
divisiveness and competition
private information may bias outcome
performance distorted by negotiating skills
costly - time and resources
goal congruence
autonomy
performance evaluation
Swinburne University of Technology
22
Other ways of encouraging internal transfers:
Recognise internal transfers and incorporate in reward system
Base part of supply managers bonus on purchasing centres profit
Dual Transfer Pricing
The buying division is
charged the cost of
the transferred
product
The selling division
is credited with the
cost plus some profit
allowance
The difference
is accounted for in a
special account
Swinburne University of Technology
23
Scenario 1
Outlay/incremental price = $800
Opportunity cost
External price $ 1000
Var. prodn cost 800
Opportunity cost 200
Transfer price =
$800 + 200 = $1000
If sales expense of $5 not incurred
TP = $795 + $200
= $995
Scenario 2
Outlay cost $800
Opportunity cost 0
Transfer price $800
Negotiate to share profit?
If 4Mtons @$1000 and 1M
tons $800
TP = WAP
=($4000+$800)/5
=$960
Lecture Illustration 1: (See Lecture Handout)
Swinburne University of Technology
24
Scenario 3
Sell externally $
Selling price 1000
Variable costs 800
Contribution margin 200
Transfer to smelting
Selling price 1700
Variable costs 800
350 1150
Contribution margin 550
TP should be at Market Price =>$1000
Alumina could negotiate to share profits, eg. $250: $300 (instead of
$200:$350)
Lecture Illustration 1: (See Lecture Handout)
Swinburne University of Technology
25
Multi-national transfers and tax
Income tax
Multinational Companies may take advantage of country-specific
corporate tax rates
To maximise profitabitability
Company is likely to report high costs and low revenue in the high
tax jurisdiction, and low costs and high revenue in the low tax
jurisdiction.
In practice: market based more popular - easier to justify to tax
authorities
Other Tax issues
Sales taxes and GST
Tariffs and customs duties
Swinburne University of Technology
26
Illustrative Example 2:Past Exam Qs
Forever Diamonds Incorporated (FDI)
It is useful to draw a diagram: show the flows of resources,
products and services both internally and externally
South
Africa
U.S.
Raw diamonds
ZAR 3,150
Raw diamonds
Polished
Diamonds
US$5,000
Swinburne University of Technology
27
Dealing with Foreign
Currency Translation:
Summary data in U.S. dollars:
7 ZAR =$1 U.S
South Africa Mining Division
Variable costs: 560 ZAR 7 =
$80 per lb. of raw diamonds
Fixed costs: 1,540 ZAR 7 =
$220 per lb. of raw diamonds
Market price: 3,150 ZAR 7 =
$450 per lb. of raw diamonds
U.S. Processing Division
Variable costs = $150 per lb. of
polished industrial diamonds
Fixed costs = $700 per lb. of
polished industrial diamonds
Market price = $5,000 per lb. of
polished industrial diamonds
1. The transfer prices are:
a. 200% of full costs
Mining Division to
Processing Division
= 2.0 ($80 + $220) =
$600 per lb. of raw
diamonds
b. Market price
Mining Division to
Processing Division
= $450 per lb. of
raw diamonds
Requirement 1:
Swinburne University of Technology
28
Requirement 1 (Contd):
200% of
Full Cost
Market
Price
South Africa Mining Division
Division revenues, $600, $450 2,000
Costs
Division variable costs, $80 2,000
Division fixed costs, $220 2,000
Total division costs
Division operating income
Income tax at 18%
Division after-tax operating income

U.S. Processing Division
Division revenues, $5,000 1,000
Costs
Transferred-in costs, $600, $450 2,000
Division variable cost, $150 1,000
Division fixed costs, $700 1,000
Total division costs
Division operating income
Income tax at 30%
Division after-tax operating income

$1,200,000

160,000
440,000
600,000
600,000
___108,000
_$__492,000


$5,000,000

1,200,000
150,000
700,000
2,050,000
$2,950,000
__885,000
$2,065,000

$ 900,000
160,000
440,000
600,000
300,000
___54,000
_$_246,000
$5,000,000
900,000
150,000
700,000
1,750,000
$3,250,000
___975,000
$2,275,000

Swinburne University of Technology
29
Requirements 2 & 3:
200% of
Full Cost
Market
Price
South Africa Mining Division:
After-tax operating income
U.S. Processing Division:
After-tax operating income
FDI Overall:
After-tax operating income

$ 492,000

2,065,000

$2,557,000

$ 246,000

2,275,000

$2,521,000

The South Africa Mining Division manager will prefer the higher
transfer price of 200% of full cost and the U.S. Processing Division
manager will prefer the lower transfer price equal to market price. FDI
will maximize companywide net income by using the 200% of full cost
transfer-pricing method. This method sources more of the total income
in South Africa, the country with the lower income tax rate.
Swinburne University of Technology
30
THE END