Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury MANAGEMENT AND COST ACCOUNTING SIXTH EDITION COLIN DRURY

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury Part Four: Information for planning, control and performance Chapter Twenty-one: Transfer pricing in divisionalized companies

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.1a © 2000 Colin Drury 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 intentionally move profits between divisions or locations. 4. To ensure that divisional autonomy is not undermined.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.1b © 2000 Colin Drury Information for making good decisions Intermediate products = Goods transferred from the supplying to receiving division. Final products = Products sold by the receiving division to the outside world Example Incremental cost of making intermediate product = £100 Incremental further processing costs in receiving division = £60 Market price of final product = £200 No external market for the intermediate product and spare capacity Cost-plus 50% transfer price = £150 Business will be rejected if TP set at £150

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.1c © 2000 Colin Drury Evaluating managerial performance TP of £60 incremental cost of supplying division would motivate correct decision but it does not form a basis for measuring the performance of the supplying division. A conflict of objectives exists which can be difficult to resolve.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.2a © 2000 Colin Drury Alternative transfer pricing methods 1. Market-based 2. Marginal cost 3. Full cost 4. Cost-plus a mark-up 5. Negotiated transfer prices Market-based transfer prices Where there is a perfectly competitive market for the intermediate product,the current market price is the most suitable basis for setting the transfer prices. TP ’s will motivate sound decisions and form a suitable basis for performance evaluation (see Exhibit 21.2 in the text and Figure 21 A.1 - slide 21.17)

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.2b © 2000 Colin Drury Marginal cost transfer prices Economic theory indicates TP based on the MC of producing the intermediate product at the optimum output level for the company as a whole will encourage total organizational optimality (see Figure 21.1 on slide 21.3). Adopting a short-run perspective to derive MC results in MC = VC and the assumption that MC is constant per unit throughout the relevant output range. MC not widely used: 1. Provides poor information for performance evaluation 2. MC may not be constant over entire range of output 3. Measuring MC beyond short-term is difficult 4. Managers reject short-term perspective

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.3 © 2000 Colin Drury Figure 21.1 An illustration of cost-based transfer prices

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.4a © 2000 Colin Drury Full cost transfer prices Widely used because managers require an estimate of long-run marginal cost for decision-making. Traditional costing systems tend to provide poor estimates of long run MC. Does not enable supplying division to report a profit on goods transferred. Cost-plus a mark-up transfer prices Attempts to meet the performance evaluation purpose of transfer pricing (profit allocated to the supplying division) Results in non-optimal decisions (See Figure slide 21.3) because TP exceeds short-run or long-run MC. Enormous mark-ups can result when goods/services are transferred between several divisions.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.4b © 2000 Colin Drury Negotiated transfer prices Most appropriate where there are market imperfections for the intermediate product and managers have equal bargaining power. To be effective managers must understand how to use cost and revenue information. Claimed behavioural advantages. Limitations: 1.Can lead to sub-optimal decisions 2.Time - consuming 3.Divisional profitability may be strongly influenced by the bargaining skills and powers of the divisional managers. 4.Inappropriate in certain circumstances (e.g. no market for the intermediate product or an imperfect market exists).

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.5 © 2000 Colin Drury Marginal cost plus opportunity cost Often cited as a general rule that will lead to optimal decisions for the company as a whole. Where there is no intermediate market the application of the rule leads to TP = VC (assuming VC = MC Where there is a perfect market for the intermediate product the application of the rule leads to TP = MP (e.g. market price = £20 and VC = £5) TP = £5VC + £15 opportunity cost = £20 Rule tends to be a restatement of the general principles previously established and it is also difficult to apply in more complex situations.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.6 © 2000 Colin Drury Example Oslo = Supplying division (No external market for the intermediate product) Bergen = Receiving division (converts intermediate to final product) Expected sales of the final product: Net selling price Quantity sold (£)Units The costs of each division are: Oslo Bergen (£) (£) Variable cost per unit 11 7 Fixed costs attributable to the products The transfer price of the intermediate product has been set at £35 based on a full cost plus mark-up.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.7a © 2000 Colin Drury

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.7b © 2000 Colin Drury

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.7c © 2000 Colin Drury

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.8a © 2000 Colin Drury £35 TP does not motivate optimum output level for the company as a whole. To ensure overall company optimality the TP must be set at MC of the intermediate product (i.e VC of £11 per unit or £11,000 per batch of 1,000 units). The receiving division will face the following net marginal revenue (NMR) schedule: Units net marginal revenue (£) ( – 7000) ( – 7 000) ( – 7 000) ( – 7 000) ( – 7 000) –7 000 (0 – 7 000)

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.8b © 2000 Colin Drury At £11 TP receiving division will choose to expand output to 5,000 units. Consider a full cost TP without a mark-up (£23 if the denominator level to compute unit fixed costs is 5,000 units) The receiving division manager will choose to produce 4,000 units Negotiation: 1.No external market so supplying division manager has little bargaining power. 2.Could avoid £60,000 fixed costs so would look for a TP of at least £23 per unit (assuming a denominator level of 5,000 units is used).

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.9a © 2000 Colin Drury Resolving transfer pricing conflicts Two approaches advocated: 1.Adopt a dual rate TP system 2.Transfer at MC plus a lump sum fee

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.9b © 2000 Colin Drury Resolving transfer pricing conflicts (contd.) Dual rate TP system Uses two transfer prices 1.Supplying division may receive full cost plus a mark-up so that it makes a profit on inter-divisional transfers (e.g Oslo TP > £23). 2.Receiving division charged at MC of transfers thus motivating managers to operate at the optimum output level for the company as a whole. 3.Profit on inter-group trading removed by an accounting adjustment. Not widely used because: 1.Use of two TP ’s causes confusion 2.Seen as artificial 3.Divisions protected from competition 4.Reported inter-divisional profits can be misleading

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.9c © 2000 Colin Drury Resolving transfer price conflicts (contd.) Marginal cost plus a lump sum fee Intended to motivate receiving division to equate MC of transfers with its net marginal revenue to determine optimum company profit maximizing output level. Enables supplying division to cover its fixed costs and earn a profit on inter- divisional transfers through the fixed fee charged for the period. Motivates receiving division to consider full cost of providing intermediate products/services (.TP = £11 MC plus £60,000 lump sum plus a profit contribution in the example).

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.10a © 2000 Colin Drury Domestic TP conclusions/recommendations Competitive market for the intermediate product — Use market prices. No market for the intermediate product or an imperfect market — Transfer at MC plus a lump sum or negotiation may be appropriate in certain circumstances. Use standard costs for cost-based TP ’s

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.10b © 2000 Colin Drury International transfer pricing Where divisions are located in different countries taxation implications become important and TP has the potential to ensure that most of the profits on inter- divisional transfers are allocated to the low taxation country.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.10c © 2000 Colin Drury Example Supplying division in country A (Tax rate = 25%) Receiving division in country B (Tax rate = 40%) Motivation is to use highest possible TP so receiving division will have high costs and low profits whereas supplying division will have high revenues and high profits. Taxation authorities in most countries are wise to companies using TP to manipulate profits and seek to apply OECD guidelines based on arm ’s length pricing principles. TP can also have an impact on import duties and dividend repatriations.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.11a © 2000 Colin Drury ECONOMIC THEORY OF TRANSFER PRICING No market for the intermediate product 1.Correct TP is MC of producing the intermediate product at the optimal output level for the company as a whole. 2.The optimal output for the company as a whole is where: MC of supplying division + MC of receiving division = MR of receiving division MC of supplying division = MR of receiving division – MC of receiving division MC of supplying division = NMR of receiving division

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.11b © 2000 Colin Drury

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury No market for the intermediate product (contd.) 3.Optimal output = units 4.MC at units = £4 000 (TP =£4 000 per batch) 5.At £4 000 TP the supplying division is motivated to transfer units and the receiving division is motivated to buy units. 6.Note: optimum TP = VC where MC = VC.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury No market for the intermediate product (contd.)

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury Imperfect market for the intermediate product Optimum transfer price for an imperfect intermediate market

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury Imperfect market for the intermediate product (contd.) Allocation of output of supplying division between intermediate and external market

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury Imperfect market for the intermediate product (contd.) 1. Correct TP is the MC of producing the intermediate product at the optimal output level (see tables on sheets and 21.15). 2. To determine the optimum output level allocate the intermediate product according to its most profitable use (see table on sheet 21.15).

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.17a © 2000 Colin Drury Imperfect market for the intermediate product (contd.) 3. Optimal output = 11 units (MC at this level =£27) 4. To be more precise,the optimal TP is where MCs and MR/NMR intersect between £27 and £27.50.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury 21.17b © 2000 Colin Drury Imperfect market for the intermediate product (contd.) 5. At a TP of £27.01 to £27.49 the supplying division will choose to sell five units externally and transfer six units internally the manager of the receiving division will choose to sell six units of the final product. 6. If MC =VC the optimum TP =VC 7. Note the TP of £27.01 to is only optimal where there are no capacity constraints. If capacity constraints exist, the analysis must be modified to reflect the constraint.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury NMR for company as a whole = BCDE MC for company as a whole = ADE Optimal output is where MC and NMR for the company as a whole intersect (point D at Q2) TP =OP At a TP of OP the receiving division will require OQ1 and the supplying division will wish to sell OQ2 (Q1Q2 externally if it supplies OQ1 internally). Perfect external market for the intermediate product

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury No external market for the intermediate product and a perfect market for the final product Optimal output for the company as a whole is where MCs + MCR equals the MR for the company as a whole (MR R ) at OQ. MC of supplying division at the optimal output level is OP and this is the optimum TP. Supplying division will wish to produce OQ at a TP of OP and the receiving division will wish to produce OQ at this TP.

Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury © 2000 Colin Drury Imperfect market for the intermediate product The MC and MR schedules for the company as a whole are MCs and MRs +NMR. Optimal output is OQ3 and the MC at this output level is OP T. Therefore,optimal TP is OP T. At this TP the receiving division will wish to purchase OQ2(where TP =NMR). The supplying division faces a MR schedule of BED and will sell OQ1 externally and Q1Q3 internally giving a total output of OQ3.(Note Q2Q3 = OQ1.)