2646 – Strategic Costing
Class 3 – Transfer Pricing
Information for Decision-Making - Transfer pricing
• Responsibility Centres
• Measuring Performance in Investment Centres
• Alternative transfer pricing methods
1. Market-based
2. Cost-based
3. Negotiated transfer prices
Transfer pricing
Objectives:
1. To define the different types of responsibility centres
2. To discuss the advantages and disadvantages of divisionalisation
3. Compute an investment centre’s ROI, RI and EVA
4. To identify and describe the different transfer pricing methods
What is a Responsibility Centre?
A responsibility centre is a unit of a firm where an individual manager is held
responsible for the unit’s performance.
▪ It is virtually impossible for most firms to be controlled centrally due to the
complexity of the environment in which they operate
▪ Thus, organizations decentralize by creating responsibility centres
▪ Responsibility centres enable accountability for results to be allocated to
individuals throughout the organization
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Cost Revenue Profit Investment
centres centres Centres centres
Their managers Their Their managers Their managers
are accountable managers are are accountable are responsible
for only those accountable for for both for investments,
costs under revenues only revenues and revenues and
their control costs costs
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Responsibility accounting assigns differences from the targeted performance to the individual who is
accountable for the responsibility centre.
Responsibility Accounting involves:
1. Setting performance targets.
2. Measuring performance.
3. Comparing performance against target.
4. Analysing variances and taking remedial actions.
Issues that must be addressed by responsibility accounting include:
1. Distinguishing between controllable and non-controllable factors (i.e. the controllability principle).
2. Determining how challenging the targets should be.
3. Determining how much influence managers should have in the setting of targets.
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Responsibility-accounting systems can influence behaviour significantly. Whether the behavioural
effects are positive or negative, depends on how responsibility accounting is implemented.
Information versus Blame
The focus of a responsibility accounting system is Information. The system should identify the
individual in the organization who is best positioned to explain each particular event or financial
result. The emphasis should be on providing that individual and higher-level managers with
information to help them understand the reasons behind the organizations’ performance.
Motivating desired behaviour
Management often uses the responsibility accounting system to motivate actions they consider
desirable. It can also be used to resolve behavioural problems, e.g. rushed orders impact on sales and
production managers.
Controllability
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The controllability principle advocates that it is appropriate to charge to a responsibility centre only
those costs/revenues that can be influenced by the manager of the responsibility centre.
Distinguish between controllable and uncontrollable factors.
Examples of uncontrollable factors: (1) Competitors’ actions; (2) Supply shortages; (3) Acts of nature
But applying the controllability principle is difficult in practice because many items do not fit into
either controllable and uncontrollable categories
So, how can organizations distinguish between controllable and uncontrollable items?
‘Hold managers accountable for the performance areas the organization wants managers to
pay attention to.’
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• In a functional structure only the organization as a whole is an investment centre and below this level a
functional structure applies throughout.
• A functional structure is where all activities of a similar type are placed under the control of a
departmental head.
• In a functional structure all centres below the chief executive or corporate level are cost centres or
revenue centres.
• In a divisionalised structure the organization is divided into separate investment or profit centres and a
functional structure applies below this level.
• In a divisionalized structure divisions tend to be either investment centres or profit centres but within
each division there are multiple cost and revenue centres
Divisionalised structures generally lead to a decentralization of the decision-making process whereas
managers in a functional structure will tend to have less independence.
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Advantages
Advantages of
of divisionalisation
divisionalisation
• Improved quality of decisions
• Speedier decisions
• Increases managerial motivation
• Enables top management to devote more time to strategic issues
Disadvantages of divisionalisation
Advantages of divisionalisation
• Sub-optimisation and may promote a lack of goal congruence
• More costly to operate a divisionalised structure
• Loss of control by top management
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Prerequisites for successful divisionalization
• More appropriate for companies with diversified activities.
• Relations between divisions need to be regulated so that no division to prevent any division from
harming the company's overall profitability in pursuit of its own gain.
Read Siemens
example on moodle
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• The primary goals of any profit-making enterprise include maximizing its profitability and using its
invested capital as effectively as possible.
• Managerial accountants use three different measures to evaluate the performance of investment
centres:
▪ Return on Investment (ROI)
▪ Residual Income (RI)
▪ Economic Value Added (EVA®)
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Division A Division B
Profit £10m £20m
Investment £40m £200m
ROI 25% 10%
• Division B earns higher profits, but A is more profitable.
• ROI is a relative measure of performance that can be compared with other investments. It also
provides a useful summary measure of the ex post return on capital employed.
• A major disadvantage of ROI is that managers may be motivated to make decisions that make the
company worse off.
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Division X Division Y
Investment project available £10 million £10 million
Controllable contribution £2 million £1.3 million
Return on the proposed project 20% 13%
ROI of divisions at present 25% 9%
The overall cost of capital for the company is 15%.
The manager of X would be motivated not to invest and the manager of Y would be motivated to invest.
ROI may also motivate managers to make incorrect asset disposal decisions.
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• Controllable residual income = Controllable profit less a cost of capital charge on the
investment controllable by the manager.
• It is claimed that RI is more likely to encourage goal congruence
Division X (£m) Division Y (£m)
Proposed investment 10 10
Controllable profit 2 1.3
Cost of capital charge (15%) 1.5 1.5
Residual income +0.5 –0.2
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• The manager of division X is motivated to invest, and the manager of division Y is motivated
not to invest.
• RI also enables different cost of capital percentages to be applied to different investments
that have different levels of risk.
• If RI is used it should be compared with budgeted/target levels which reflect the size of the
divisional investment.
• Empirical evidence indicates that RI is not widely used.
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• Financial performance measures can encourage managers to become short-term oriented and seek to
boost short-term profits at the expense of long-term profits.
• Approaches for reducing the short-term orientation:
• Divisional performance evaluated on the basis of economic income.
• Adopt EVA( ) incorporating many accounting adjustments.
• Lengthen the measurement period.
• Do not rely excessively on financial measures
• Incorporate non-financial measures that measure those factors that are critical to the long-term
success of the organization.
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• To provide information that motivates divisional managers to make good
economic decisions.
• To provide information that is useful for evaluating the managerial and economic
performance of the divisions.
• To intentionally move profits between divisions or locations.
• To ensure that divisional autonomy is not undermined.
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Is the price (value) that one unit (department or division) charges for a product or service supplied to
another unit of the same organization
The established transfer price is a cost to the buying unit and a revenue to the selling/supplying unit
Goods transferred from a supplying division to a receiving division are known as intermediate
products.
The products sold by a receiving division to the outside world are known as final products.
The objective of the receiving division is to subject the intermediate product to further processing
before it is sold as a final product in the outside market.
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1. Market-based 2. Cost-based 3. Negotiated
transfer prices transfer prices transfer prices
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1. Market-based transfer prices
• Usually based on the listed price of a similar product or service; can also be the
external price charged by the supplying unit to outside customers, or the price a
competitor is offering
• Where there is a perfectly competitive market for the intermediate product,
the current market price is the most suitable basis for setting the transfer prices
• Transfer prices will motivate sound decisions and form a suitable basis for
performance evaluation
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2. Cost-based transfer prices
Where there is an imperfect or non-existent competitive market for the
intermediate product, or if the selling unit has spare capacity, transfer price is
usually based on the costs of producing the transferred product:
•Variable (marginal) cost transfer price
•Full cost transfer price
•Cost-plus a mark-up transfer price
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3. Negotiated transfer prices
• Most appropriate where there are market imperfections for the intermediate
product and managers have equal bargaining power
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General rule for setting the transfer
price (TP)
TP = variable cost (VC) per unit transferred + opportunity cost
Where
Opportunity cost = contribution forgone by the supplying unit from
transferring internally the intermediate product
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Setting the transfer price
• Where there is a perfectly competitive market for the intermediate product and supplying unit
has no spare capacity:
TP = VC + Opportunity cost = VC + (MP – VC) = MP
where MP = Market price
• Where supplying unit has temporary spare capacity:
TP = VC + Opportunity cost = VC + 0 = VC
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The following details for Division A are available:
Capacity………………………………………………………50.000 units
External selling price………………………………….…15 €
Variable cost per unit…………………………………... 8 €
Fixed costs per unit (based on capacity)…….... 5 €
Division B wishes to purchase from Division A, as Division B is currently buying 5.000 units per year in the
market at 14 € per unit.
Which TP should be set up?
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Assuming that Division A has a spare capacity of 10.000 units:
TP = VC + Opportunity cost =
TP = 8 € + 0 = 8 €
Assuming that Division A has no spare capacity :
TP = VC + Opportunity cost = VC + (MP – VC) =
TP = 8 + (15 – 8) = 15 €
Assuming that Division A has no spare capacity, but, as a result of negotiation between the
managers of the two divisions, a 2 € of variable cost per unit can be avoidable in internal sales:
TP = VC + Opportunity cost = VC + (MP – VC) =
TP = 6 + (15 – 8) = 13 € (negotiated transfer price)
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International transfer pricing
Where divisions are located in different countries taxation implications become important and
TP has the potential to ensure that most of the profits on inter-divisional transfers are allocated
to the low taxation country.
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Supplying division in country A (Tax rate = 25%)
Receiving division in country B (Tax rate = 40%)
Motivation is to use highest possible TP so receiving division will have high costs and low profits
whereas supplying division will have high revenues and high profits.
• Taxation authorities in most countries are wise to companies using TP to manipulate profits and seek
to apply OECD guidelines based on arm ’s length pricing principles.
• TP can also have an impact on import duties and dividend repatriations.
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Objectives of transfer pricing
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What is: arm ’s length
pricing principles ??
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