MCS UNS Linking Performance to Markets-Transfer Pricing
Chapter Review Notes
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Course Map Where are we?
Chps 13 Belief Systems Core Values Core Values Chps 12 & 13 Boundary Systems Risks to be Avoided
Organizing for Performance Chp 3
What to Control Chp 4
Building and Evaluating Budgets Chps 5, 6, 7 Measuring Performance Chps 8 & 9 Designing Employee Goals and Incentives 2 Chp 11
Business Strategy
Strategic Uncertainties Interactive Control Systems Chp 10 Chp 2 Chp 14
Internal Controls Chp 13
Todays Topic Critical Perf Variables Diagnostic Control Systems
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4 LEVERS OF CONTROL
Chp 10
Transfer Prices
Transfer
prices are the amounts charged by one segment of an organization for a product or service that it supplies to another segment of the same organization.
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Transfer Prices
An
internally set transaction price to account for the transfer of goods or services between divisions of the same firm. Very important to set correct transfer prices Impacts performance evaluations of divisions Impacts resource allocations Distortions impact managers willingness to do business with sister divisions
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Transfer Prices-Cont
Decentralized operating divisions or plants of the same company buy and sell among themselves
The sales price between these related divisions is called a transfer price Issue How do we decide the price?
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Transfer Prices Mechanism
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Objectives of Transfer Price
Provide
relevant information Induce goal congruent decisions Help measure the economic performance of each division Should be simple to understand and easy to administer
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Purpose of Transfer Pricing
Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.
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Objectives of Transfer Price-Cont
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Decisions about Transfer Prices
Sourcing
decision
Should the product be produced inside or outside the company?
Transfer
price decision
What price should be charged between responsibility centers?
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The Transfer Pricing Decision
A key assumption is that divisional managers can buy and sell products as they wish (decentralized) Thus, they have some control over the transfer price used for intra-divisional sales The problem Managers may make decisions that reduce the profit for the company as a whole
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Transfer Pricing Alternatives
How
should the transfer price policy be set so that managers acting in their own interest (i.e. their bonus) will also act in the best interest of the overall company?
Based
on Market Price Price based on internal cost data
Variable cost Full cost Full cost with profit
Negotiated
Price
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Market-Based Transfer Pricing
Using
Market Data optimum price
External market prices Must have an outside market
Specialized
goods
Must be able to determine market price Reflects opportunity cost Objective and simple Divisions appear as stand alone businesses with market transfer prices; can be evaluated as such
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Market-Based Transfer PricingCont
Operating
at full capacity
Market price is best Company wide income is only maximized when market price is charged If buying division can get a lower price outside, they should take it.
Operating
at less than full capacity
Other prices can be considered to optimize company wide income Internal costs are often used
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Market-Based Transfer PricingCont
The
problem raising with the approach is : Up Stream Fixed Cost and Profit How to resolve: Agreement Profit Sharing Two step Pricing Dual Pricing
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Internal Cost Data-Based Transfer Pricing
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Internal Cost Data-Based Transfer Pricing-Cont
Using
Internal Cost Data
What is internal cost? Should just variable or incremental costs be used?
This
is the lowest accounting-based transfer price. Standard costs often used so inefficiencies are not passed on to other divisions Buying division often very happy with these lower prices Selling division - no profit thus not motivated to sell to sister division and may provide poor service
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Internal Cost Data-Based Transfer Pricing-Cont
Using
Internal Cost Data
Variable costs If selling division at full capacity, may lose overall profitability Buying division may underprice finished products due to lower transfer price
Should fixed costs (full cost) be included?
Standard Simple Allows
costs often used
recovery of full costs Inaccuracies of cost allocations passed on
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Internal Cost Data-Based Transfer Pricing-Cont
Using
Internal Cost Data
Full costs Fixed costs of the selling division become variable costs of the buying division which may impact some decisions Still no profit
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Internal Cost Data-Based Transfer Pricing-Cont
Using
If
Internal Cost Data
Should a profit markup be included?
so, how much? Should return on investment percentage be used?
Two
sets of transfer prices
Market-based price for selling division Standard cost for buying division
Can
include separate charges for variable and fixed costs
Bookkeeping more complex but everybody is happy
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Negotiated Transfer Prices
Companies
heavily committed to segment autonomy often allow managers to negotiate transfer prices.
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Negotiated Transfer Pricing
Negotiated
Prices
Often reflect fairness Time-consuming Political Negotiation often part of line management Managers cannot blame poor profits on arbitrary transfer prices if they determined them Arbitration committees often set up when parties cannot agree to a price
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Activity Based-Transfer Pricing
Activity-Based
Transfer Prices
Unit-level and Batch-level costs charged based on unit volume and batches ran Product-based and Plant-level costs are charged annually based on planned levels of usage Buying division has reason to help selling division control activities
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Implication of Transfer Pricing
Managerial
Maximize
implications
Top managers
overall company profit Provide information for short-term and long-term decisions
Division managers
Maximize
their divisional performance Fairly represent their own performance
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Implication of Transfer Pricing
Managerial
Implications
Should divisions be forced to buy in-house? Are all divisions being evaluated as profit centers? If so, transfer prices must be established.
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Comparison of Different TransferPricing Methods
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Multinational Transfer Pricing Example
An
item is produced by Division A in a country with a 25% income tax rate. It is transferred to Division B in a country with a 50% income tax rate. An import duty equal to 20% of the price of the item is assessed. Full unit cost is $100, and variable cost is $60 (either transfer price could be chosen).
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Multinational Transfer Pricing Example
Which transfer price should be chosen?
$100
Why?
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Multinational Transfer Pricing Example
Income of A is $40 higher: 25% $40 = ($10) higher taxes Income of B is $40 lower: 50% $40 = $20 lower taxes Import duty paid by B: 20% $40 = ($8) Net savings = $2
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Domestic and Multinational Transfer Pricing Practice
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Corporate Services
Transfer
prices must be determined for corporate services used by sister divisions Corporate services: research and development, information technology, human resources, maintenance, legal services Must departments accept these in-house services or are they allowed to get outside help? If so, the departments can often control the amount of services used but not their efficiency.
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Corporate Services-Cont
Standard
variable costs are often used to entice departments to use the service Standard variable costs plus fixed costs represents long-run full costs Market price department must feel the service is worth the market cost or they will not use the in-house service which could be bad for the company
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Other Transfer Pricing Challenges Tax Planning & Minority Interest
What about where ownership % differs across subsidiaries? There are also tax planning issues to consider
Pricing if we produce in one tax jurisdiction and sell in another?
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