Management Control and Transfer Pricing Chapter 22 ACCTG 312 Week 11 B

Learning Objectives At the end of this chapter you should be able to Explain the purpose and role of transfer pricing (e.g. performance measurement, profits of segments). Explain how to use a general economic rule to set an optimal transfer price (e.g. variable costing, full costing) Explain how to base a transfer price on market prices, costs, or negotiations (with or without spare capacity). Discuss the implications of transfer pricing in a multinational company (e.g. tax impact)

Management Control Systems Management Control Systems are a means of gathering and using information to aid and coordinate the planning and control decisions throughout an organization and to guide the behaviour of its managers and other employees

Management Control Systems Consist of Formal and Informal control systems: Formal systems include explicit rules, procedures, performance measures, and incentive plans that guide the behaviour of its managers and other employees Informal systems include shared values, loyalties, and mutual commitments among members of the company, corporate culture, and unwritten norms about acceptable behaviour

Management Control Systems & Transfer Pricing One of the objectives of MCS is to improve the performance of organisations by making sure that appropriate practices/procedures are in place. Transfer pricing is an important factor which could influence the performance of units/divisions within an organisation.

Transfer Pricing Transfer Price – the price one subunit (department or division) charges for a product or service supplied to another subunit of the same organization Management control systems use transfer prices to coordinate the actions of subunits and to evaluate their performance

Management Control Systems & Responsibility Centres Transfer pricing is particularly appropriate when some centres/divisions within an organisation are selling products/services to each other.

Transfer Pricing The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit affecting each subunit’s operating income Intermediate Product – the product or service transferred between subunits of an organization

Transfer Pricing Internal transfers of products create a need for a pricing mechanism between divisions to accurately reflect the costs and revenues of doing business.

Transfer Pricing Battery Division Auto Division The amount charged when one division of an organization sells goods or services to another division. Auto Division Battery Division Transfer pricing is the process of deciding the amount to charge one division of an organization of a product or service offered by another division. In the example on your screen, a company has a automobile division that manufactures cars and trucks and a battery division. The auto division uses a battery for each unit manufactured. The battery division may be able to provide that battery. The question is, what price should be charged for the battery sold to the auto division. 3

Impact of Transfer Pricing on Organizations If the divisions are evaluated on profitability, the transfer price can have an impact on the performance of each division. The higher the transfer price to the Auto Division, the . . . Greater the profits of the Battery Division. Battery Division Auto Division Obviously, the higher the price charged for the battery sold to the Auto Division the greater the profits of the Battery Division. Is charging a high price in the best interest of the company as a whole? 4

The Impact of Transfer Pricing on Organizations Sales of finished goods to customers outside the organization Top Management Selling division Buying Division Goods transferred at a transfer price Purchases of productive inputs from venders outside the organization Assuming the transfer is made, the transfer price will not affect the company’s overall profit. However, it does affect the profit associated with each division. It can affect the decisions of autonomous division managers.

Transfer Pricing Goal In a decentralized organization, the managers of units (e.g. profit centers and investment centers) often have considerable autonomy in deciding whether to accept or reject orders and whether to buy from inside or outside the organization. The goal in setting the transfer price is to provide incentives for each division manager to act in the company’s best interests. We want the transfer price to be set so there are incentives for the managers of all divisions involved.

Three Transfer Pricing Methods Market-based Transfer Prices Cost-based Transfer Prices Negotiated Transfer Prices

Market-Based Transfer Prices (what price what source?) Top management chooses to use the price of similar product or service that is publicly available. Sources of prices include trade associations, competitors, etc.

Market-Based Transfer Prices (why and when it is appropriate?) Lead to optimal decision-making when three conditions are satisfied: The market for the intermediate product is perfectly competitive Interdependencies of subunits are minimal There are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally (e.g. No special tax if sell or buy to or from outside market)

Market-Based Transfer Prices (why and when it is appropriate?) A perfectly competitive market exists when there is a homogeneous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actions Motivating management effort, subunit performance evaluations, and subunit autonomy Perhaps should not be used if the market is currently in a state of “distress pricing” (e.g. Extra capacity and not covering fixed costs)

Cost-Based Transfer Prices Top management chooses a transfer price based on the costs of producing the intermediate product. Examples include: Variable Production Costs Variable and Fixed Production Costs Full Costs (including life-cycle costs) One of the above, plus some mark-up

Negotiated Transfer Prices Occasionally, subunits of a firm are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties May or may not bear any resemblance to cost or market data Often used when market prices are volatile Represent the outcome of a bargaining process between the selling and buying subunits

Transfer Pricing Illustration

Transfer Pricing Illustration

Comparison of Transfer-Pricing Methods

Minimum Transfer Price The minimum transfer price in many situations should be: Incremental cost is the additional cost of producing and transferring the product or service Opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally

General Transfer-Pricing Rule A general rule that will ensure goal congruence: Opportunity cost per unit to the organization because of the transfer Additional outlay cost per unit incurred because goods are transferred Transfer price = + Includes the direct unit- level costs of the product/service & any other outlay costs that are incurred as a result of the transfer An opportunity cost is a benefit that is foregone as a result of taking a particular action

Setting Transfer Prices Let’s consider two different examples of setting transfer prices. The company has no excess capacity. The company has excess capacity. Before we can determine an appropriate transfer price we must know if the selling division has excess, or unused, capacity or not. The transfer price will depending upon the capacity utilization of the selling division. 8

Scenario 1: No Excess Capacity The Battery Division of Wills Company makes a standard 12-volt battery. The division is currently producing at capacity of 300,000 batteries, and sells each battery to outside companies for $60. The company has no excess capacity. The Vehicle Division offers to purchase 100,000 batteries for $45 each. Let’s assume the Battery Division is operating at full capacity of three hundred thousand batteries. It is currently sell all its production to outside companies for sixty dollars per unit. The vehicle division offers to purchase one hundred thousand batteries at forty five dollars each. The outlay cost for each battery in the Battery Division is forty dollars, so the contribution margin of each battery sold to outside companies is twenty dollars. Do you think the Battery Division will accept the offer from the Vehicle Division? 9

Scenario 1: No Excess Capacity Battery Division Transfer price = Outlay cost + Opportunity cost $60 = $40 + $20 Vehicle Division Our general model shows that the transfer price should be sixty dollars. Forty dollars for outlay costs plus the lost contribution margin if the offer is accepted of twenty dollars per battery. 10

Scenario 1: No Excess Capacity The offer of $45 per battery by the Vehicle Division will not be accepted by the Battery Division. Battery Division Transfer price = Outlay cost + Opportunity cost $60 = $40 + $20 Vehicle Division The forty five dollar per battery will not be accepted because it is less than the appropriate transfer price when the Battery Division is operating at full capacity. 11

Scenario II: Excess Capacity The Battery Division of Wills Company makes a standard 12-volt battery. The division is currently producing 200,000 batteries. Full capacity for the division is 300,000 batteries. The division currently sells all batteries to outside companies for $60 each. The Vehicle Division offers to purchase 100,000 batteries for $45 each. Transfer price = Outlay cost + Opportunity cost The offer of $45 per battery by the Vehicle Division will be accepted by the Battery Division. Each battery sold to the Vehicle Division will produce $5 in contribution to the Battery Division. Part I Now let’s assume that the Battery Division is producing two hundred thousand batteries and still has a full capacity of three hundred thousand batteries. All two hundred thousand batteries are being sold to outside companies for sixty dollars each. Part II The proper transfer price is forty dollars. There is no lost contribution margin if the offer is accepted and the Battery Division sells one hundred thousand batteries to the Auto Division. Part III The forty five dollar per battery will be accepted and it will produce a contribution margin of five dollars be battery to the Battery Division. 12

Difficulty in Implementing the General Rule Barriers to Implementation The opportunity cost may be difficult to measure. The external market may not be perfectly competitive. There may be no external market The goods or services may be unique

Cost-Based Transfer Pricing and motivation How to encourage motivation when you are using cost-based transfer pricing? Dual-Pricing – using two separate transfer-pricing methods to price each transfer from one subunit to another. Example: selling division receives full cost pricing, and the buying division pays market pricing

Dual Transfer Pricing The selling division is credited with the cost plus some profit allowance. The buying division is charged the cost of the transferred product. The difference is accounted for in a special account. Other ways of encouraging internal transfers: Recognize internal transfers and incorporate them in reward systems Base part of the supplying manager’s bonus on the purchasing center’s profit

Global Transfer-Pricing Practices Companies have incentives to set transfer prices that will increase revenues (and profits) in low-tax countries and increase cost (thereby reducing profits) in high-tax countries Country S (40% tax rate) Country B (70% tax rate) Transfer of goods

Global Transfer-Pricing Practices SS Corporation Country S (40% tax rate) Country B (70% tax rate) BB Corporation in Country B imports products from SS in the Country S Transfer of goods Assume $2,000,000 production costs

Global Transfer-Pricing Practices SS Corporation Country S (40% tax rate) Country B (70% tax rate) BB Corporation in Country B imports products from SS in the Country S Transfer of goods The transfer price has been changed to $10 million This has reduced the tax liability by $2,100,000 ($10,900,000 - $8,800,000)

Exercise 22-20 Transfer-pricing methods, goal congruence. British Columbia Lumber has a Raw Lumber Division and a Finished Lumber Division. The variable costs are: ■ Raw Lumber Division: $100 per 100 board-feet of raw lumber ■ Finished Lumber Division: $125 per 100 board-feet of finished lumber Assume that there is no board-feet loss in processing raw lumber into finished lumber. Raw lumber can be sold at $200 per 100 board-feet. Finished lumber can be sold at $275 per 100 board-feet. © 2009 Pearson Prentice Hall. All rights reserved.

1. Should British Columbia Lumber process raw lumber into its finished form? 2. Assume that internal transfers are made at 110% of variable cost. Will each division maximize division operating-income by adopting the action that is in the best interest of British Columbia Lumber as a whole? 3. Assume that internal transfers are made at market prices. Will each division maximize its operating-income contribution by adopting the action that is in the best interest of British Columbia Lumber as a whole? © 2009 Pearson Prentice Hall. All rights reserved.

Exercise 22-23 Multinational transfer pricing, global tax minimization. The Mornay Company manufactures telecommunications equipment at its plant in Toledo, Ohio. The company has marketing divisions throughout the world. A Mornay marketing division in Vienna, Austria, imports 1,000 units of Product 4A36 from the United States. The following information is available: © 2009 Pearson Prentice Hall. All rights reserved.

Suppose the U.S. and Austrian tax authorities only allow transfer prices that are between the full manufacturing cost per unit of $500 and a market price of $650, based on comparable imports into Austria. The Austrian import duty is charged on the price at which the product is transferred into Austria. Any import duty paid to the Austrian authorities is a deductible expense for calculating Austrian income taxes due. 1. Calculate the after-tax operating income earned by the U.S. and Austrian divisions from transferring 1,000 units of Product 4A36 (a) at full manufacturing cost per unit and (b) at market price of comparable imports. (Income taxes are not included in the computation of the cost-based transfer prices. © 2009 Pearson Prentice Hall. All rights reserved.

Consider what happens every time the transfer price is increased by $1 over, say, the full manufacturing cost of $500. What would be the results? © 2009 Pearson Prentice Hall. All rights reserved.