BPP LEARNING MEDIA CIMA P2 Advanced Management Accounting For exams in 2016 江西财经大学会计学院 吉伟莉

BPP LEARNING MEDIA Chapter 7 Transfer pricing —The aims of transfer pricing —General rules —Setting transfer prices —Negotiated transfer prices

Aim —Maintain the right level of divisional autonomy —Ensure divisional performance is measured fairly —Ensure corporate profits are maximised The aims of transfer pricing 1

How —Transfer prices must be set to provide incentive and motivation —Although head office authority must ensure goal congruence and prevent dysfunctional decision making —Transfer prices must beat a fair commercial price to ensure appropriate behavioural decisions by divisional managers —The transfer price should encourage divisional managers to agree on the amount of goods transferred —This will also be at a level which is consistent with overall organisational aims such as maximising company profit The aims of transfer pricing 2

—Correctly-set transfer prices are therefore a way of promoting divisional autonomy —Ideally without prejudicing measurement of divisional performance or overall corporate profit maximisation The aims of transfer pricing 3

Limits within which transfer prices should fall The minimum —The sum of the supplying division’s marginal cost and the opportunity cost of the item transferred The maximum —The lowest market price at which the receiving division could purchase the goods or services externally, less any internal cost savings in packaging and delivery General rules 1

Opportunity cost —The opportunity cost included in determining the lower limit will be one of the following: —Maximum contribution foregone by the supplying division in transferring internally rather than selling externally or —Contribution foregone by not using the same facilities for their next best alternative use General rules 2

Example —Division A produces product D at a marginal cost of £350 —If a unit is transferred internally to division B, £70 contribution is lost on an external sale —The item can be purchased externally for £480 —Minimum - Division A’s minimum would be £( ) = £420 —Maximum - Division B’s maximum would be £480 —Savings from producing internally rather than buying externally = £60. General rules 3

—If there is no external market and no alternative uses for the facilities, transfer price = standard variable cost of production —If there is an external market and no alternative uses for the facilities, transfer price = market price General rules 4

Transfer prices based on market price —What is the ideal transfer price where a perfect external market exists? —External market price or —External market price less savings in selling costs —This applies whether or not variable costs and selling prices are constant Setting transfer prices 1

Merits of transfer prices based on market price Divisional autonomy —Profit centre managers have freedom to negotiate prices with each other as though independent companies —Market-based transfer prices will tend to result Divisional performance —Where a market price exists but the transfer price is a different amount —Divisional managers will argue about the volume of internal transfers Setting transfer prices 2

Merits continued Corporate profit maximisation —Such an approach results in decisions which are in the best interests of the organisation as a whole Setting transfer prices 3

Transfer prices based on cost – constant unit variable costs and selling prices —If there is an imperfect external market, the transfer price has to be based on cost Standard or actual cost? —The use of standard costs is fairer —If actual costs are used the supplying division has no incentive to control its costs —It can pass on its inefficiencies to the receiving division Setting transfer prices 4

Variable cost? —The supplying division does not cover its fixed costs —However this problem can be overcome by some form of dual pricing or two-part tariff system Full cost? —The supplying division makes no profit —As the transfer price increases, its effect on the receiving division could lead to organisational sub- optimisation problems Setting transfer prices 5

Full cost plus? —What margin will all parties perceive as fair? —If there is no external market for the item being transferred: —Goal congruent decisions will be made if the transfer price is ≥ variable cost in the supplying division —But also ≤ net marginal revenue in the receiving division Setting transfer prices 6

Transfer prices based on cost – changing unit variable costs and selling prices —When unit variable costs and/or unit selling prices are not constant, there will be a profit-maximising level of output —The ideal transfer price will only be found by careful analysis and sensible negotiation —Firstly establish the output and sales quantities that will optimise the profits of the company or group as a whole —Establish the transfer price at which both the supplying and receiving division would maximise their profits at this level Setting transfer prices 7

—Divisional and organisational profits will be maximised if: —The transfer price is ≥ marginal cost in the supplying division —But ≤ net marginal revenue in the receiving division Capacity constraints —If there is a capacity constraint resulting in a shortage of supplies of the product, a profit-maximising transfer price will be implemented as part of a centralised policy Setting transfer prices 8

Negotiated transfer prices —Transfer prices determined through negotiations may be a mix of accounting arithmetic, negotiation and compromise Possible transfer prices Market value —Elements to reflect internal nature of transaction (such as reduction in selling costs) Market value of end product —Amount for the finishing work in receiving division (used where receiving division is given non-finished goods) Negotiated transfer prices 1

Behavioural implications —Inter-departmental disputes —Head office intervention may be required which will reduce decentralisation of authority —Less decentralisation will reduce the effectiveness of the profit centre system’s ability to motivate divisional managers Negotiated transfer prices 2