For NYANYA only - Revision

Transfer pricing

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Course

Transfer pricing

PART A

Transfer price is the price charged on a sub-unit, department or division for products or services supplied to it by another department within the same organisation. The transferring department treats the transfer price as an income while the receiving department treats it as a cost (Horngren, Datar, & Rajan, 2015).

Different types of transfer pricing

1. Market based transfer pricing- In this method the management opts to use prices of similar products or services available in the market and in public domain such as trade associations website or the external prices the specific department charges outside customers.

2. Under the cost-based transfer method, the transfer price is calculated based on the cost of producing the product being transferred. The cost include product cost, production cost, fixed and variable costs, or the full cost that includes Research and Development , design, marketing, distribution and customer service costs. Either budgeted costs of full cost can be used. It can also include a mark-up or margin of the costs, which represents a return on investment for the department’s investment.

3. Hybrid transfer pricing takes into account both cost and market information. It includes the average cost of producing and transporting the product internally and the market price of comparer able products. It is unique in that it sometimes allows the buying department to report a different cost than the revenue recognised by the selling unit. This method commonly occurs through negotiations between departmental heads where they decide whether to buy and sell internal or deal with external parties especially when the prices are very volatile

Reasons why this transfer pricing methods are used

1. Market based transfer pricing is used when products operate in a perfectly competitive market, where there is low dependencies between departments and lastly where there are no additional costs or benefits to the company as a whole from buying or selling to the external markets (Horngren, Datar, & Rajan, 2015).

2. Cost based transfer pricing is used where market prices are unavailable, inappropriate or too costly to obtain. This mainly occurs in an imperfect market

3. Hybrid transfer pricing is used when there is excess capacity in one of the departments and it would be more profitable for the organisation as a whole if the buying department obtains its products from the other department rather than from the external market

Purpose of using transfer pricing

1. Promote goal congruence between subunits and the whole company. Departmental managers will act in their best own interests and their actions will assist the top management to achieve their goals too

2. Managers will be encouraged to exert a high level of effort. Selling units will be motivated to hold down their costs while buying units will be motivated to acquire and use inputs efficiently.

3. It helps evaluate performance of individual sub units

4. It preserve autonomy of subunits especially where the top management favours decentralization such that individual units have the freedom to transact with other sub units or with external parties.

Part B

(A) Explain why transfer prices based on total actual costs are not appropriate as the basis for divisional performance measurement

1. They can lead to suboptimal decisions where a reduction in on subunits as a way of improving costs will result to an increase in the other department’s costs resulting to suboptimal decisions especially if the subunits are interdependent (Kinney & Raiborn, 2012).

2. There will be no incentive to reduce costs since all costs from other departments are transferred fully to the buying department. In fact, an increase in cost will result in a higher margin for the selling department.

3. This will hide some inefficiencies in the departments and the management will not have a true picture of the actual department’s performance since there is no comparison with the market prices.

b.	cleaning and scraping	processing division
selling price	95	160
variable costs
transfer price		95
direct material	18	5
direct labor	12	10
Variable manu. Overheads	30	10
total variable per unit	60	120
contribution per unit	35	40
total contribution (400,000 units )	14000000	16000000
margin	0.37	0.25

c) The cleaning and scraping division would prefer selling to the processing department for the market price of $95. However, it would also be willing to sell at $90 per unit in order to avoid the $5 variable selling cost. The processing division would prefer buying at the negotiated $77 but if the, cleaning and scrapping division does not sell to it. It will be forced to buy it from the market at $95.

A negotiated range of $90-$95 would be the most appropriate for both divisions and would benefit the company as a whole.

d) In this above case there is no excess capacity in the cleaning and scraping division. Therefore, in such a case under the general transferring rules the lowest transfer price is the market price since it can sell all its products in the market. That would be $95-$5=$90.

Yes, this would be the price that the cleaning and scraping division manager would prefer since it is higher than the current transfer price of $77 and thus increases his departmental profits.

References

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost accounting: A managerial emphasis (15 ed.). Boston: Pearson.

Kinney, M., & Raiborn, C. (2012). Cost Accounting: Foundations and Evolutions. Cengage Learning.