Accounting Costing 3 Prof. Clive Vlieland-Boddy Academic Year 2009-2010

Dr. Clive Vlieland-Boddy FCA FCCA MBA Costing 3 Dr. Clive Vlieland-Boddy FCA FCCA MBA

Management use it Effectively Costing & How Management use it Effectively

The Functions of Management Strategy Evaluation Forecasting Planning – Choosing goals and deciding how to achieve them Acting – carry out plan Controlling – evaluating results by comparing the actual results to the plan. You work for Baskin Robins – one of its goals is to increase operating income How do you do it? Incr sales price Incr sales volume Lower costs The accounting system, by tracking costs, helps managers evaluate performance Feedback

Objectives Make, Buy & Sell Decisions Transfer Pricing Balanced Score Card The Value Chain Management Motivation

Make Buy or Sell

Decision Making Sunk - irrelevant Opportunity Costs Incremental / Differential

DECISIONS Make or buy decisions Close department Accept or reject order Conversion cost pricing

Transfer Pricing

What is transfer pricing? Transfer pricing is a set of rules an organisation uses to assign prices to products transferred between internal responsibility centres. A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company.

Transfer Pricing Fundamental Objective: Setting transfer prices to motivate the managers to act in the “best interest of the overall company”

Three Common Approaches: Managers negotiate their own transfer price Set transfer price using either: 1. Variable Cost, or 2. Full (Absorption) Cost Set transfer price at market price

Transfer Pricing When division managers work well together, a negotiated transfer price is an excellent solution to the transfer pricing problem. The following formula, representing the minimum transfer price, provides a good starting point in determining the appropriate transfer price: Transfer Price = Variable cost per unit + Lost contribution margin on outside sales

Transfer Pricing EXAMPLE: The battery division of a company makes a standard 12-volt battery. Production capacity 300,000 batteries Selling price to outsiders $40 Variable cost per battery $18 Fixed costs per battery $ 7 (based on capacity) The company’s vehicle division could use this battery in its forklift trucks. The vehicle division is now buying 100,000 batteries per year from an outside supplier at $39 per battery.

Transfer Pricing Battery Transfer Price? Vehicle Division Division $39 $40 Outside Suppliers Outside Customers

Transfer Pricing Situation 1: The battery division operates at full capacity (i.e., sells presently 300,000 batteries to outside customers). Transfer Price = $18 + ($40 - $18) = $40 No transfer will happen since the vehicle division can buy batteries for $39 on the outside market.

Transfer Pricing Situation 2: The battery division operates at full capacity (i.e., sells presently 300,000 batteries to outsider customers), but can avoid $4 in variable costs (e.g., sales commissions) on sales to the vehicle division. Transfer Price = ($18 - $4) + ($40 - $18) = $36 Transfer will happen if the transfer price is set between $36 and $39.

So the price set will affect the profitability of each division! What is the effect on divisional profitability of transfer prices for goods or services that are transferred from one division to another? The ‘transfer price’ will be: A cost to the receiving division, and A revenue to the supplying division So the price set will affect the profitability of each division!

What about the overall company? The ‘transfer price’ will have: No direct effect on the entire company’s reported profit. It is like taking money out of one pocket and putting it into the other. So the price set will NOT affect the profitability of overall company!

What are the 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 ensure that divisional autonomy is not undermined. 4. To intentionally move profits between divisions or locations.

Basic Principle in Setting Transfer Prices: How do we price goods or services that are transferred from one division to another? (contd…) Basic Principle in Setting Transfer Prices: Motivate the divisional managers to act in the best interests of the overall company. If not, sub-optimization can occur.

Market-based Transfer Price (Contd…) Market price works well when there is no idle capacity. However, it is more difficult to apply when there is idle capacity.

3. Negotiated Transfer Prices A negotiated transfer price is a transfer price that is agreed on between the supplying and receiving divisions. Generally speaking, we cannot predict the exact transfer they will agree to. For any given proposed transfer, the transfer price has both: A lower limit (determined by the situation of the supplying division), and An upper limit (determined by the situation of the receiving division). These limits determine the range of acceptable transfer prices.

3. Negotiated Transfer Prices (contd…) Range of Acceptable Transfer Prices The Actual Transfer Price falls anywhere between the Lower and Higher Limit Lowest Limit (Seller’s Perspective) – Supplying Division Transfer Price ³ Variable Cost + Total Cont. Margin on lost sales Number of units transferred Highest Limit (Purchaser's Perspective)- Receiving Division Transfer Price £ Cost of buying from outside supplier

Negotiated transfer prices Advantages Autonomy  Decentralisation Better information about costs and benefits • Most appropriate where there are market imperfections for the intermediate product and when managers have equal bargaining power. • To be effective managers must understand how to use cost and revenue information. • Limitations: Can lead to sub-optimal decisions Time - consuming Divisional profitability may be strongly influenced by the bargaining skills and powers of the divisional managers.

Tax and transfer pricing International companies can make use of tax havens to strip out profit by transfer pricing. However, most governments are well aware of this.

Question 1 An investment center is responsible for: Answer: Investing in long term assets Controlling costs Generating revenues All of the above Answer: d. All of the above

Question 1 An investment center is responsible for: Answer: Investing in long term assets Controlling costs Generating revenues All of the above Answer: d. All of the above

Question 1 An investment center is responsible for: Answer: Investing in long term assets Controlling costs Generating revenues All of the above Answer: d. All of the above

Question 1 An investment center is responsible for: Answer: Investing in long term assets Controlling costs Generating revenues All of the above Answer: d. All of the above

Question 1 An investment center is responsible for: Answer: Investing in long term assets Controlling costs Generating revenues All of the above Answer: d. All of the above