1. TRANSFER PRICING CHAPTER 22 MANAGEMENT SYSTEMS TRANSFER PRICING

2. MANAGEMENT SYSTEMS THERE ARE TWO GENERAL MANAGEMENT SYTEMS CENTRALIZED DECENTRALIZED

3. PROS OF CENTRALIZATION SHOULD LEAD TO OPTIMAL DECISION MAKING FOR THE ORGANIZATION FOCUSES MANAMENTS ATTENTION ON THE COMPANY AS-A-WHOLE REDUCES DATA GATHERING COSTS REDUCES DUPLICATION OF ACTIVITIES

4. PROS OF DECENTRALIZATION GREATER RESPONSES TO LOCAL NEEDS FASTER DECISION MAKING MORE MOTIVATED SUBUNIT MANAGERS IMPROVES MANAGEMENT DEVELOPMENT TOP MANAGEMENT CAN SPEND MORE TIME ON STRATEGIC PLANNING

5. TYPES OF RESPONSIBILITY CENTERS THERE ARE FOUR TYPES OF CENTERS: REVENUE CENTERS – ONLY REVENUE IS MEASURED COST CENTERS – ONLY COST IS MEASURED PROFIT CENTERS -- BOTH REVENUE AND COST ARE MEASURED INVESTMENT CENTERS - PROFITS ARE MEASURED IN RELATION TO THE INVESTMENTS IN THE CENTERS WE WILL VISIT THESE AGAIN IN THE NEXT CHAPTER AND TAKE A CLOSER LOOK AT INVESTMENT CENTERS

6. EXAMPLE OF COST CENTER AND PROFIT CENTER WHEN I HAVE EXAMS DUPLICATED, I CAN HAVE THEM DUPLICATED IN THE COLLEGE OF BUSINESS’ WORD PROCESSING CENTER OR I CAN HAVE THEM DUPLICATED IN THE UNIVERSITY’S REPROGRAPHICS CENTER

7. DESCRIPTION OF EACH UNIT THE COLLEGE’S WORD PROCESSING CENTER IS A COST CENTER. IT ONLY ACCUMULATES COST. THE UNIVERSITY’S REPROGRAPHIC CENTER IS A PROFIT CENTER. THE CHARGE TO THE ACCY. DEPT. IS REVENUE TO THE REPRO. CENTER AND THE COST OF THE PAPER IS THE COST TO THE REPRO. CENTER.

8. COLLEGE OF BUSINESS IF I HAVE THE WORD PROCESSING CENTER DUPLICATE THE EXAMS, THE ACCY. DEPT. IS NOT CHARGED ANYTHING. THE COLLEGE ALLOCATES A BUDGET TO THE WORD PROCESSING CENTER. IF I HAVE THE REPROGRAPHICS CENTER DUPLICATE THE EXAMS, THE ACCY. DEPT. IS CHARGED FOR EACH COPY.

9. MANAGEMENT EFFICIENCIES IF THE DEPT THAT USES THE SERVICES OF ANOTHER DEPT. IS NOT CHARGED FOR THOSE SERVICES, THEY WILL TEND TO USE THEM INEFFICIENTLY.

10. PROFIT CENTERS FROM ACCOUNTING WE KNOW THAT PROFITS REQUIRE TWO THINGS REVENUES AND COSTS COSTS ARE OBTAINED FROM OUR RECORDS NOW WE NEED REVENUES

11. REVENUES TRANSACTIONS WITH OUTSIDERS DOES NOT POSE A PROBLEM FOR US BUT TRANSACTIONS WITH OTHER SUBUNITS IN THE SAME ORGANIZATION ARE A PROBLEM. HOW DO WE MEASURE THE REVENUE.

12. INTERNAL REVENUES REVENUES FROM INTERNAL EXCHANGES ARE CALLED THE TRANSFER PRICE

13. WHAT IS A TRANSFER PRICE? THE “PRICE” ASSIGNED TO GOODS OR SERVICES TRANSFERRED BETWEEN UNITS OF AN ENTITY. FOR EXAMPLE: A GENERAL MOTORS SUBSIDIARY MAY SELL WHEELS TO THE BUICK DIVISION

14. PURPOSE OF TRANSFER PRICE TRANSFER PRICES HAVE MANY PURPOSES PROFIT CENTERS MANAGEMENT EFFICIENCIES UNION CONTRACT ASPECTS TAX ASPECTS

15. MANAGEMENT ASPECTS MANAGEMENT DOES NOT HAVE TO EXERCISE AS MUCH SUPERVISION OF THEIR EMPLOYEES BECAUSE THE USES OF THE SERVICES WILL BE SUPERVISED BY THE USER (BUYER).

16. UNION CONTRACT ASPECTS MANAGEMENT MAY AGREE TO GIVE THE HIGHER WAGE DEMANDED BY THE UNION BUT EXPLAIN THAT A CERTAIN NUMBER OF THE EMPLOYEES (UNION MEMBERS) WILL HAVE TO BE RELEASED BECAUSE THE TRANSFER PRICE WILL BE INCREASED AND THUS DEMAND FOR THE SERVICES WILL BE REDUCED.

17. TAX ASPECTS THE TRANSFER PRICE DETERMINES WHERE PROFITS WILL BE REPORTED. MANAGEMENT WILL TEND TO TRANSFER PROFITS TO LOWER TAX JURISDICTIONS CALIFORNIA DEALT WITH THIS ISSUE BY ESTABLISHING A “UNITARY” TAX SYSTEM. A PORTION OF A COMPANY’S WORLD-WIDE PROFITS IS TAXED IN CALIFORNIA. THE TRANSFER PRICE DETERMINES THE CUSTOM’S TAX ON IMPORTS.

18. HOW TO SET THE TRANSFER PRICE COST BASED MARKET BASED NEGOTIATED DUAL PRICING ECONOMIC BASED

19. COST BASED THE TRANSFER PRICE CAN BE A PERCENTAGE OF VARIABLE COSTS (E.G., 190%) OR FULL COST (E.G. 120%) PRO: INFORMATION IS READILY AVAILABLE CON: DOES NOT ENCOURAGE EFFICIENCY IN PRODUCTION BECAUSE THE COSTS ARE TRANSFERRED TO THE BUYING DIVISION.

20. MARKET BASED ESTIMATE THE MARKET PRICE AND SET THE TRANSFER PRICE ACCORDINGLY. PRESUMABLY, THE TRANSFER PRICE WILL BE LESS THAN THE MARKET PRICE BECAUSE THERE ARE EFFICIENCES FROM TRANFERRING INTERNALLY, E.G., NO CREDIT DEPT. COSTS. PRO: ENCOURAGES EFFICIENCIES IN PRODUCTION CON: INFORMATION IS NOT READILY AVAILABLE

21. NEGOTIATED THE BUYER AND SELLER GET TOGETHER AND AGREE ON A PRICE PRO: EACH SIDE IS INVOLED IN THE PROCESS AND THEREFORE SHOULD BE SATISFIED WITH THE RESULT. CON: MAY MEASURE NEGOTIATING ABILITY AS MUCH AS MANAGEMENT ABILITY

22. DUAL TRANSFER PRICE SET ONE PRICE TO BE RECORDED AS REVENUE FOR THE SELLING UNIT AND A “LOWER” PRICE FOR THE BUYING UNIT. THIS WILL ENCOURAGE MORE TRANSFERS BETWEEN UNITS.

23. ECONOMIC MANAGEMENT ESTIMATES THE TRASFER PRICE THAT WILL MAXIMIZE PROFITS FOR THE FIRM AS A WHOLE. I CALL THIS A “DICTATED” TRANSFER PRICE PRO: PRESUMABLE THE TRANSFER PRICE WILL OPTIMIZE THE FIRMS PROFITS CON: BOTH SIDES WILL PROBABLY BE DISSATISFIED BECAUSE IT IS NOT CLEAR HOW THE TRANSFER PRICE WAS SET.

24. A NOTE IN USING A TRANSFER PRICE, BUYERS SHOULD GENERALLY HAVE THE RIGHT TO PURCHASE FROM OUTSIDE AND THE SELLING UNIT SHOULD HAVE THE RIGHT TO SELL TO OTHERS INSTEAD OF INSIDERS.

25. DETERMINE THE QUANTITY THAT HEADQUARTERS WANTS TRANSFERRED FROM MICRO-ECONOMICS WE KNOW THAT THE OPTIMAL QUANTITY IS THAT QUANTITY THAT RESULTS IN MARGINAL COSTS EQUAL TO MARGINAL REVENUE MC = MR

26. APPLYING ECONOMIC ANALYSIS ASSUME: PERFECT COMPETITION FOR THE FINAL PRODUCT. THUS, THE PRICE OF THE FINAL PRODUCT IS SET. SO, MR FOR THE FIRM IS SET. THIS IS NOT NECESSARY BUT IT SIMPLIFIES OUR ANALYSIS. WE ARE CONCERNED ONLY WITH THE PRICE ON GOODS (OR SERVICES) TRANSFERRED BETWEEN UNITS INTERNALLY. WE HAVE ESTIMATES OF THE MARGINAL COSTS OF EACH SUB-UNIT

27. GRAPHICALLY, FOR THE FIRM MC FOR FIRM $ PRICE OF FINAL PRODUCT MARGINAL REVENUE MC S MC B OPTIMAL ACTIVITY LEVEL UNITS PRODUCED

28. WHAT DO WE KNOW NOW? WE KNOW THE QUANTITY OF GOODS THAT TOP MANAGEMENT SHOULD WANT TRANSFERRED BETWEEN THE SUB-UNITS NOW WE NEED TO DETERMINE THE TRANSFER PRICE

29. LET’S LOOK AT THE BUYER DIVISION THE BUYING DIVISION CAN PAY, AS A TRANSFER PRICE, AN AMOUNT UP TO THE PRICE OF THE FINAL PRODUCT LESS THE BUYING DIVISION’S MARGINAL COST (MC B ) LET’S CALL THIS FUNCTION THE “NET MARGINAL REVENUE” (NMR) THE NMR FUNCTION IS THE DEMAND FUNCTION TO THE SELLING DIVISION

30. GRAPHICALLY, FOR THE SELLER $ PRICE OF FINAL PRODUCT MARGINAL REVENUE MC S MC B TP NMR OPTIMAL ACTIVITY LEVEL UNITS PRODUCED

31. HOW DO WE GET THE SELLING DIVISION TO PRODUCE THE QUANTITY WANTED? NOTE THAT THE TRANSFER PRICE IS THE MARGINAL REVENUE (MR S ) FOR THE SELLING DIVISION. SO, WHEN THE TRANSFER PRICE EQUALS THE MARGINAL COST OF THE SELLING DIVISION (MC S ) WE HAVE THE LEVEL OF ACTIVITY THAT THE SELLING DIVISION WOULD BE WILLING TO PRODUCE. THIS IS ALSO THE DESIRED LEVEL OF ACTIVITY

32. GRAPHICALLY, FOR THE SELLER $ PRICE OF FINAL PRODUCT MARGINAL COST OF SELLER TRANSFER PRICE AT WHICH THE MC OF THE SELLER = MR OF THE SELLER OPTIMAL ACTIVITY LEVEL UNITS PRODUCED

33. OBSERVE OPTIMAL TRANSFER PRICE NOTE THAT THE OPTIMAL TRANSFER PRICE IS AT THE INTERSECTION OF THE MR S AND THE MC S.

34. ALGEBRAIC EXAMPLE THE PRICE OF THE FINAL PRODUCT IS $50 AND DIV. A SELLS TO DIV. B THE COST FUNCTIONS ARE: DIV. A: 10 + 6Q + ½ Q 2, THUS MCA = 6 + Q DIV. B: 8 + 4Q + 2Q 2, THUS MCB = 4 + 4Q

35. DETERMINE OPTIMAL QUANTITY TO BE EXCHANGED MR FOR FIRM = $50 MC A + MC B = $50 $6 + Q + $4 + 4Q = 50 Q = 8

36. DETERMINE OPTIMAL TRANSFER PRICE DETERMINE THE NMR NMR = $50 - $4 – $4 Q AT Q = 8 TP = $46 – ($4 X 8) TP = 14 DOES THIS WORK WITH MCA? MC A = $6 + $Q = $14

37. EXERCISE PRICE OF FINAL PRODUCT = $428 MARGINAL COST OF SELLING DIV. 5 + 1.1 Q MARGINAL COST OF BUYING DIV. 3 + Q

38. OPTIMAL ACTIVITY LEVEL FOR FIRM 428 = 5 + 1.1 Q + 3 + Q Q = 200

39. OPTIMAL TRANSFER PRICE TP = 428 – 3 – Q WHERE Q = 200 TP = 428 – 3 – 200 TP = 225

40. CHECK ON CALCULATION MC S = 5 + 1.1 Q AT Q = 200 MC S = 5 + (1.1 X 200) MC S = 225, THE TRANSFER PRICE