Introduction

1. Introduction One of the principal challenges in operating a decentralized system is to devise a satisfactory method of accounting for the transfer of goods and services from one profit center to another in companies that have a significant number of these transactions

2. Objectives of Transfer Pricing • The transfer price should be designed so that it accomplishes the following objectives : • It should provide each business unit with the relevant information it needs to determine the optimum trade off between company costs and revenue. • It should induce goal congruence decisions. • It should help measure the economic performance of the individual business units. • The system should be simple to understand and easy to administer.

3. Transfer Pricing Methods Transfer Priceis to refer to the amount used in accounting for any transfer of goods and services between responsibility centers.

4. Transfer Pricing Methods • Fundamental Principles • 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 • When profit centers of a company buy products from, and sell to, one another, two decisions must be made periodically for each product : • Should the company produce the product inside the company or purchase it from an outside vendor ?. This is the sourcing decision. • If produced inside, at what price should the product be transferred between profit centers ?. This is the transfer price decision.

5. Transfer Pricing Methods • The Ideal Situation • A market price based, transfer price will induce goal congruence if all the conditions listed below exist : • Competent People • Managers should be interested in long run as well as the short run performance of their responsibility centers. • b. Good Atmosphere • Managers must regard profitability as measured in their income statements, as an important goal.

6. Transfer Pricing Methods • The Ideal Situation • c. A Market Price • The ideal transfer price is based on a well established, normal market price for the identical product being transferred, a market price reflecting the same conditions (quantity, quality) as the product to which the transfer price applies. • d. Freedom to Source • Alternatives for sourcing should exist, and managers should be permitted to choose the alternative that is in their own best interests.

7. Transfer Pricing Methods If all of the conditions are exist, a transfer price system based on market prices would induce goals congruence decisions • The Ideal Situation • e. Full Information • Managers must know about the available alternatives and the relevant costs and revenues of each • f. Negotiation • There must be a smoothly working mechanism for negotiating “contracts” between business units

8. Transfer Pricing Methods • Constraints on Sourcing • Ideally, the buying manager should be free to make sourcing decisions. Similarly, the selling manager should be free to sell products in the most advantageous market • In real life, however, freedom to source might not be feasible or, if it is feasible, might be constraint by corporate policy.

9. Transfer Pricing Methods • Constraints on Sourcing • Limited Market In many companies, markets for the buying or selling profit centers may be limited, because of • The existence of internal capacity might limit the development of external sales. • If a company is the sole producer of a differentiated product, no outside source exists. • 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.

10. Transfer Pricing Methods • 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 ?. Here are some ways : • If published market prices are available, they can be used to establish transfer prices. • Market prices may be set by bids. This generally can be done only if the low bidder stands a reasonable chance of obtaining the business.

11. Transfer Pricing Methods • Constraints on Sourcing • 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 • If the buying profit center purchases similar products from the outside market, it may be possible to replicate competitive prices for its proprietary products.

12. Transfer Pricing Methods • Constraints on Sourcing Excess or Shortage of Industry Capacity • Some companies allow either the buying or selling profit center to appeal a sourcing decision to a central person or committee • If there are constraints on sourcing, the market price is the best transfer price. If the market price exists or can be approximated, use it. • However, if there is no way of approximating valid competitive prices, the other option is to develop cost based transfer prices.

13. Transfer Pricing Methods Cost Bases Transfer Prices If competitive prices are not available, transfer prices may be set on the basis of cost plus a profit, even though such transfer prices may be complex to calculate and the results less satisfactory than a market price. The two decisions must be made in a cost based transfer price system : How to define cost How to calculate the profit markup

14. Transfer Pricing Methods Cost Bases 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 standard costs are used, an incentive is needed to set tight standards and improve standards.

15. Transfer Pricing Methods • Cost Bases Transfer Prices The Profit Markup In calculating the profit markup, there also are two decisions : • 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 percentage of investment.

16. Transfer Pricing Methods • 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 of upstream fixed costs and profit included in its internal purchase price. Methods that companies use to mitigate this problem, are : • Agreement Among Business Units • Two Step Pricing • Profit Sharing • Two Sets of Prices

17. Transfer Pricing Methods Upstream Fixed Costs and Profits a. Agreement Among Business Units Some companies establish a formal mechanism whereby representatives from the buying and selling units meet periodically to decide on outside selling prices and the sharing of profits for products with significant upstream fixed costs and profit

18. Transfer Pricing Methods • Upstream Fixed Costs and Profits • b. Two Step Pricing • Establish a transfer price that includes two charges : • For each unit sold, a charge is made that is equal to the standard variable cost of production. • A periodic charge is made that is equal to the fixed costs associated with the facilities reserved for the buying unit.

19. Transfer Pricing Methods Business Unit X (manufacturer) Product A Expected monthly sales to business unit Y 5,000 units Variable cost per unit $ 5 Monthly fixed costs assigned to product 20,000 Investment in working capital and facilities 1,200,000 Competitive return on investment per year 10 % One way to transfer product A to business unit Y is at price per unit, calculated as follows : Transfer price for product A Variable cost per unit $ 5 Plus fixed cost per unit $ 4 Pus profit per unit $ 2 Transfer price per unit $ 11

20. Transfer Pricing Methods Correction by two step pricing : Transfer price for product “A” $ 5 + $ 20,000/month fixed cost + $ 10,000 per month for profit : $ 1,200,000 x 0.10 = 10,000 12 Unit “Y” will pay the variable cost of (5,000 unit x $ 5/unit) : $ 25,000 Plus fixed cost and profit : $ 30,000 Total $ 55,000 Unit “X” will pay $ 11/unit (5.000 unit x $ 11 = $ 55,000) If transfers in another month were 4,000 units, Unit “Y” would pay $ 50,000 [(4,000 unit x $ %) + $ 30,000], under two step pricing, compared with $ 44,000 ($ 11 x 4,000 unit). The difference is penalty for not using a portion of unit X’s capacity that it has reserved.

21. Transfer Pricing Methods • Upstream Fixed Costs and Profits • c. Profit Sharing • The system operates as follows : • The product is transferred to the marketing unit at standard variable cost • After the product is sold, the business units share the contribution earned, which is the selling price minus the variable manufacturing and marketing costs.

22. Transfer Pricing Methods Upstream Fixed Costs and Profits d. Two Sets of Prices The manufacturing unit’s revenue is credited at the outside sales price and the buying unit is charged the total standard costs. The difference is charged to a headquarters account and eliminated when the business unit statements are consolidated.

23. Pricing Corporate Services There remain two types of transfers : 1. For central services that the receiving unit must accept but can at least partially control the amount used. 2. For central services that the business unit can decide whether or not to use.

24. Pricing Corporate Services • Control Over Amount of Service • Business unit may be required to use company staffs for services such as IT and R&D. • There are three schools of thought about such services. • A business unit should pay the standard variable cost of the discretionary services. • A price equal to the standard variable cost plus a fair share of the standard fixed costs, that is, the full cost. • A price that is equivalent to the market price or to standard full cost plus a profit margin.

25. Pricing Corporate Services Optional Use of Services In some cases, management may decide that business units can be choose whether to use central service units. Business units may procure the service from outside, develop their own capability, or choose not to use the service at all.

26. Pricing Corporate Services Simplicity of the Price Mechanism The prices charged for corporate services will not accomplish their intended result unless the methods of calculating them are straightforward enough for business unit managers to understand them.

27. Administration of Transfer Prices Negotiation In most companies, business units negotiate transfer prices with each other, that is, transfer prices are not set by a central staff group. The most important reason for this is the belief that establishing selling prices and arriving at satisfactory purchase prices are among the primary functions of line management.

28. Administration of Transfer Prices • Arbitration and Conflict Resolution • A procedure should be in place for arbitrating transfer price disputes. • Example : • Arbitrating is assigned to single executive. • Set up a committee. • Usually such a committee will have three responsibilities : • Settling transfer price disputes • Reviewing sourcing changes • Changing the transfer price rules when appropriate.

29. Administration of Transfer Prices • Arbitration and Conflict Resolution • Arbitration can be conducted in a number of ways. With a formal system, both parties submit a written case to the arbitrator. The arbitrator reviews their positions and decides on the price. • There are four ways to resolve conflicts : • Forcing • Smoothing • Bargaining • Problem Solving

30. Administration of Transfer Prices • Product Classification • The extent and formality of the sourcing and transfer pricing rules depend to a large extent on the number of intra company transfers and the availability of markets and market prices. • Some companies divide products into two main classes : • Classes I, includes all products for which senior management wishes to control sourcing • Classes II, is all other products. In general, these are products that can be produced outside the company without any significant disruption to present operations.

31. General Considerations • Conditions for Delegating Profit Responsibility • Before delegate expense/revenue trade off decision to a lower level manager, two conditions should exists : • The manager should have access to the relevant information needed for making such a decision • There should be some way to measure the effectiveness of the trade offs the manager has made

32. General Considerations • Conditions for Delegating Profit Responsibility • Before delegate expense/revenue trade off decision to a lower level manager, two conditions should exists : • The manager should have access to the relevant information needed for making such a decision • There should be some way to measure the effectiveness of the trade offs the manager has made

33. General Considerations • Advantages of Profit Centers • The quality of decisions may improve because they are being made by managers closest to the point of decision. • The speed of operating decisions may be increased since they do not have to be referred to corporate headquarters. • Headquarters management, relieved of day to day decision making, can concentrate on broader issues. • Managers, subject to fewer corporate restraints, are freer to use their imagination and initiative.

34. General Considerations • Advantages of Profit Centers • Profit centers provide an excellent training ground for general management. • Profit consciousness is enhanced since managers who are responsible for profits will constantly seek ways to increase them. • Provide top management with ready made information on the profitability of the company’s individual components. • Because their output is so readily measured, profit centers are particularly responsive to pressures to improve their competitive performance.

35. General Considerations • Example • ABB (Asea Brown Boveri), a european multinational in the business of power generation, transmission and distribution, was organized into 4,500 small profit centers, each with profit and loss responsibility and meaningful autonomy. • Many Japanese companies use profit centers. The Kyocera Corporation, a technology company, divided itself into 800 small companies (nicknamed amoeba), which were expected to trade both internally and externally

36. General Considerations • Difficulties with Profit Centers • Decentralized decision making will force top management to rely more on management control reports than on personal knowledge of an operation. • If headquarters management is more capable than the average profit center manager, the quality of decisions made at the unit level may be reduced. • Friction may increase of arguments over the appropriate transfer price. • Competent general managers may not exist in a functional organization

37. General Considerations • Difficulties with Profit Centers • Organization units that once cooperated as functional units may now be in competition with one another. • Divisionalization may impose additional costs because of the additional management, staff personnel etc. • There is no completely satisfactory system for ensuring that optimizing the profits of each individual profit center will optimize the profits of the company as a whole. • There may be too much emphasis on short run profitability at the expense of long run profitability.

38. Business Unit as Profit Centers Most business units are created as profit centers since managers in charge of such units typically control product development, manufacturing and marketing resources.