CIMA P3 Syllabus C. Internal controls - Transfer Pricing - Notes ^{4 / 10}

Transfer Pricing

So an organisation. say, has 2 divisions A and B

A sells goods to B

However A also sells to the external market

There will therefore be two sources of revenue for A.

• External Sales Revenue from the external market (at normal market prices)

• Internal Sales Revenue from division B (at the transfer price)

Aims of a Good Transfer Price

1. Division A and B have some autonomy

   Otherwise the managers of A and B will resent being told by head office which products they should make and sell and for how much

2. A and B Managers are Motivated

   So the transfer price allows them to perform well and make a profit

3. Ensure Goal Congruence

   Encourage divisions to make decisions which maximise group profits too

Practical Transfer Pricing

Transfer prices are set using the following techniques:

1. Market prices

2. Production Cost (of Division A) – this can be based on variable or full cost including a mark-up

3. Negotiation

The Advantages of Market Value Transfer Prices

• Divisional autonomy

  Division A has the freedom to sell on the open market, or with B

  Simply B can decide whether to buy from the open market or from A

  So autonomy is good using a market based transfer price

• Corporate Profit Maximisation

  Using market price, strangely you can still expect B to buy from A - as there should be a better quality of service, greater flexibility, and dependability of supply. 

  Division A will more likely sell to B than the open market due to cheaper costs of administration, selling and transport.

   A market price as the transfer price would therefore result in decisions which would be in the best interests of the group as a whole.

The Disadvantages Of Market Value Transfer Prices

• The market price may not be perfect - affected temporarily perhaps by adverse economic conditions, or dumping, or depend on the volume of output supplied to the external market 

  Similarly products may not be identical in the market

• A market price works better when Division A is at full capacity

  If Division A has spare capacity (it means no more demand from the external market) then charging a market price doesn't make sense

Marginal Cost-Based Transfer Prices

Here Division A just charges its variable costs to B

This means though, it does not cover its fixed costs - and so is demotivating for Division A - although it's great for Division B!

A has no incentive either to keep its variable costs low

• HOWEVER - it does mean B will get all it's products from A - and this will lead to goal congruence as their MC will be the same as the group as a whole

Full Cost-Based Transfer Prices

Under this approach, Division A charges the full cost (including fixed overheads absorbed) 

They would still not earn any profit - so sometimes a COST + profit approach is used

If a full cost plus approach is used, a profit margin is also included in this transfer price.

• If a full cost plus approach is used, a profit margin is also included in this transfer price. 

  So Division A gets some profit at the expense of Division B

• However Division A has no incentive to keep costs down -although using standard costs instead of actual costs would prevent this

• Also Divison B's variable costs include Division A's FC and profit - this can lead to dysfunctional decisions

Other Approaches to Transfer Pricing

There are two approaches to transfer pricing which try to preserve the economic information inherent in variable costs while permitting the transferring division to make profits, and allowing better performance valuation .

• Variable cost plus lump sum:

  Here transfers are made at variable cost but, periodically, a transfer is made between the two divisions to account for A's fixed costs and profit.

• Dual Pricing:

  Here, Division A transfers out at cost plus a mark up and the receiving division transfers in at variable cost.  

  Obviously, the divisional current accounts won’t agree, and some period-end adjustments will be needed to reconcile those and eliminate fictitious interdivisional profits.

In some cases, the divisions of a company are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with outside parties.

Negotiated transfer prices are often employed when market prices are volatile and change occurs constantly.

The negotiated transfer price is the outcome of a bargaining process between the supplying and receiving division.

Minimum and Maximum Transfer Prices

1. Minimum

   Division A will want its variable costs covered at least (when it has spare capacity)

   Division A will want its variable costs plus any contribution lost by not selling elsewhere (if it is at full capacity)

2. Maximum

   The maximum Division B will pay is the market price

Multinational transfer pricing is the process of deciding on appropriate prices for the goods and services sold intra­group across national borders.

When considering a multinational firm, additional objectives are to:

1. Pay lower taxes, duties, and tariffs

   Be aware that multinational firms will be keen to transfer profits if possible from high tax countries to low tax ones.

2. Repatriate funds from foreign subsidiary companies to head office

3. Be less exposed to foreign exchange risks

4. Build and maintain a better international competitive position

5. Enable foreign subsidiaries to match or undercut local competitors’ prices

6. have good relations with governments in the countries in which the multinational firm operates

Ethical issues in transfer pricing

There are a number of potential ethical issues for the multinational company to consider when formulating its transfer pricing strategy:

• Social responsibility, reducing amounts paid in customs duties and tax.

• Bypassing a country’s financial regulation via remittance of dividends.

• Not operating as a ‘responsible citizen’ in foreign country.

• Reputational loss.

• Bad publicity.

• Tax evasion.