Deliverable 4 - Costing and Decision Making

Costing Methods

Production costing methods not only impact the actual cost assigned to a product but can also have effects on how inventory is valued, how transfer pricing is determined as well as tax implications. Let’s examine these issues:

Transfer Prices and Taxes

PRICES AND TAXES

Transfer price is simply what one related entity charges another for a product. In other words what on division of a company charges another division for a product. While these types of transactions are eliminated during the consolidation process in preparing the audited financial statements, so they have no impact, there can still be tax consequences particular in multinational companies. Tax rates can vary from Country to Country so that these multinational companies have an incentive to show their profits in the Country with the lowest tax rate.

TAX RATE EXAMPLES

For example, Corporation A has two divisions, Division B and Division C. The tax rate in the Country where Division B is located is 25% and the tax rate where Division C is located is 50%. For simplicity sake, let's assume Corporation A makes and sells widgets and there are no laws or restrictions on transfer pricing. The selling price is $1,000 and the cost to make a widget is $600. Therefore the company makes a profit of $400 per widget. Widgets are produced in Division B and in sold by Division C and sold in the Country that division C is located.

PROFITS AND TAXES

If Division C "buys" the widgets from Division B for $900. Division B then sells them for $1,000 and reports a profit of $100 ($1,000 - $900) and pays tax of $50 ($100 x 50%). Division B reports a profit of $300 ($900 - $600) and pays tax of $75 ($300 x 25%). So the total tax paid in this example is $125 ($50 + $75) which is well below the $200 ($400 x 50%) they would have had to pay if the entire transaction would have taken place in Division C's home Country. For the Corporation in total there is no difference in the total amount of profit, just the amount of tax paid.

The above example is for illustrative purposes of how taxes could be manipulated by a multinational corporation and does not reflect reality. In the United States, the IRS takes a close look at transfer pricing policies in multinational corporations.

Sec. 482 of the US Tax Code gives the IRS the authority to adjust taxable income between two related divisions to more accurately reflect the income earned by each division. The IRS will apply their standard to determine the true taxable income of a controlled division. Their standard basically tries to determine the transfer price of an open market transaction of unrelated companies.

Inventory Costing

The method in which inventory is costed affects how a production company’s inventoried is valued. Most companies use one of the following inventory costing methods:

1. First-In First-Out (FIFO)

2. Last-In First-Out (LIFO)

3. Weighted Average

4. Specific Identification

These inventory costing methods determine the how the inventory is valued each time new inventory is added or taken out of the inventory pool. Production companies maintain three inventory accounts (pools): raw materials, work in process and finished goods. Costs will flow through these inventory accounts until the product is sold. The costs are then transferred from the balance sheet (credit to finished goods inventory) to the income statement (debit cost of goods sold) to match expenses with revenues (matching principle).

First-In First-Out moves the oldest cost of inventory from one inventory account to the next or to cost of goods sold in the case of finished goods. This is the most common method used.

Last-In First-Out moves the newest cost of inventory from one inventory account to the next or to cost of goods sold in the case of finished goods.

Average or Weighted Average essentially establishes a new average cost after every purchase. It is this average cost that is used when items are removed from inventory.

Specific Identification assigns each inventory item a specific cost and when it is sold or used in production, the specific cost of the item is moved to the next inventory account or cost of goods sold, as appropriate. This method is used if you are producing items that are individually produced and they are expensive.