1. Transfer Pricing Management Control Systems Chapter 6 July 2014Iwan Pudjanegara SE., MM.1

2. Objectives of Transfer Prices  It should provide each business unit with the relevant information it needs to determine the optimum trade-off between company costs and revenues.  It should induce goal congruent decisions. The system should be designed so that decisions that improve business unit profits will also improve company profits. (induce = menyebabkan) July 2014Iwan Pudjanegara SE., MM.2

3. Objectives of Transfer Prices  It should help measure the economic performance of the individual business units.  The system should be simple to understand and easy to administer. July 2014Iwan Pudjanegara SE., MM.3

4. The Definition  The amount used in accounting for any transfer of goods and services between responsibility centers.  The value placed on a transfer of goods or services in transactions in which at least one of the two parties involved is a profit center. July 2014Iwan Pudjanegara SE., MM.4

5. Fundamental Principle  The Fundamental Principle is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors. July 2014Iwan Pudjanegara SE., MM.5

6. Fundamental Principle  When profit centers of a company buy products from, and sell to, one another, two decisions must be made periodically for each product: 1)The Sourcing Decision  should the company produce the product inside the company or purchase it from an outside vendor? 2)The Transfer Price Decision  if produced inside, at what price should the product be transferred between profit centers? July 2014Iwan Pudjanegara SE., MM.6

7. The Ideal Situation  The Competent People Ideally, managers should be interested in the long-run as well as the short-run performances of their RCs.  Good Atmosphere Managers must regard profitability as an important goal and a significant consideration of their performance. July 2014Iwan Pudjanegara SE., MM.7

8. The Ideal Situation  A Market Price The ideal transfer price is based on a well-established, a normal market price for the identical product being transferred  means a market price reflecting the same conditions (quantity, delivery time, quality) as the product to which the transfer price applies. July 2014Iwan Pudjanegara SE., MM.8

9. The Ideal Situation  Freedom to Source o Alternatives for sourcing should exist, and managers should be permitted to chose the best alternative. o The buying manager should be free to buy from the outside, and the selling manager should be free to sell outside. July 2014Iwan Pudjanegara SE., MM.9

10. The Ideal Situation  Full Information Managers must know about the available alternatives and the relevant costs and revenues of each.  Negotiation There must be a smoothly working merchanism for negotiating contracts between business units. July 2014Iwan Pudjanegara SE., MM.10

11. Constraints on Sourcing  Limited Markets Why markets for the buying or selling profit centers may be limited??? 1.The existence of internal capacity might limit the development of external sales. 2.If a company is the sole producer of a differentiated, no outside source. July 2014Iwan Pudjanegara SE., MM.11

12. Constraints on Sourcing 3.If a company has invested significantly in facilities, it is unlikely to use outside sources unless the outside selling price approaches the company’s variable cost, which is not usual. (Ex. Integrated Oil Companies). o The Competitive Price: the transfer price that best satisfies the requirements of a profit center system. July 2014Iwan Pudjanegara SE., MM.12

13. Constraints on Sourcing How does a company find out what the competitive price is if it does not buy or sell the product in an outside market??? 1.If published market prices are available, they can be used to establish transfer prices. 2.Market prices may be set by bids. July 2014Iwan Pudjanegara SE., MM.13

14. Constraints on Sourcing 3.If the production profit center sells similar products in outside markets, it is often possible to replicate a competitive price on the basis of the outside price. 4.If the buying profit center purchases similar products from the outside market, it may be possible to replicate competitive prices for its proprietary products. July 2014Iwan Pudjanegara SE., MM.14

15. Excess or Shortage of Industry Capacity  Excess Capacity : if the selling profit center cannot sell to the outside markets all it can produce.  Shortage Capacity : if the buying profit center cannot obtain the product it requires from the outside while the selling profit center is selling to the outside. July 2014Iwan Pudjanegara SE., MM.15

16. Cost-Based Transfer Prices When to use it??? If competitive prices are not available. Two decisions must be made : 1.How to define cost 2.How to calculate the profit markup. July 2014Iwan Pudjanegara SE., MM.16

17. Cost-Based Transfer Prices  The Cost Basis The usual basis is standard costs. Actual costs should not be used because production inefficiencies will be passed on to the buying profit center. If the standard costs are used, an incentive is needed to set tight standards and improve standards. July 2014Iwan Pudjanegara SE., MM.17

18. Cost-Based Transfer Prices  The Profit Markup Two decisions made in calculating the profit markup: What the profit markup is based on The level of profit allowed The simplest and most widely used base is a percentage of costs. A conceptually better base is a percentage of investment. July 2014Iwan Pudjanegara SE., MM.18

19. Upstream Fixed Costs and Profits  Transfer pricing can create a significant problem in integrated companies.  The profit center that finally sells to the outside customer may not even be aware of the amount upstream fixed costs and profits included in its internal purchase price. July 2014Iwan Pudjanegara SE., MM.19

20. Upstream Fixed Costs and Profits Methods that companies use to mitigate the problem are : 1)Agreement among Business Units 2)Two-Step Pricing 3)Profit Sharing 4)Two Sets of Price July 2014Iwan Pudjanegara SE., MM.20

21. Pricing Corporate Services  Control over Amount of Service  BUs may be required to use company staffs for services such as IT and R&D, but the BU Manager: cannot control the efficiency with which these activities are performed, can control the amount of the service received July 2014Iwan Pudjanegara SE., MM.21

22. Pricing Corporate Services  3 Opinions about such services: That a BU should pay the standard variable cost of the discretianory services That a price equal to the standard variable cost plus a fair share of the standard fixed costs = the full cost. That a price is equivalent to the market price, or to standard full cost plus a profit margin. July 2014Iwan Pudjanegara SE., MM.22

23. Pricing Corporate Services  Optional Use of Services  Whether to use central service units, or  Procure the service from outside, by develop their own capability, or  Choose not to use the service at all.  These service centers are independent and most often found for such activities as IT, Internal Consulting Group, and maintenance work. July 2014Iwan Pudjanegara SE., MM.23

24. Pricing Corporate Services Simplicity of the Price Mechanism The price charged for corporate services will not accomplish their intended results unless the methods of calculating them are straightforward enough for BU Managers to understand. July 2014Iwan Pudjanegara SE., MM.24

25. Administration of Transfer Prices  Negotiation  Compromises made by buyer and seller.  Because BUs have the best information on markets and costs, so they want to get reasonable prices.  Arbitration and Conflict Resolution 3 Responsibilities of Abritration Committe: (1) Settling transfer price disputer, (2) reviewing sourcing changes, (3) changing the transfer price rules when appropriate. July 2014Iwan Pudjanegara SE., MM.25

26. Administration of Transfer Prices (Product Classification) Class I All products for which Sr. management wishes to control sourcing. Large-volume products. Products for which no outside source exists Products over whose manufacturing. Class II All other products that can be produced outside the company without significant disruption to present operations. Relatively small volume. Produced with general- purpose equipment. July 2014Iwan Pudjanegara SE., MM.26

27. Administration of Transfer Prices (Product Classification) Class I For quality/secrecy reasons. Senior management wishes to maintain control. The sourcing of products can be changed only by permission of central management. Class II Products are transfered at market prices. The sourcing of products is determined by the Business Units involved. July 2014Iwan Pudjanegara SE., MM.27