CHAPTER 6-Transfer-Pricing Advanced Management Accounting).pptx

Transfer Pricing
Advanced Management Accounting: Chapter 6

Learning
Objectives
Basic Concepts in Transfer
Pricing
Methods of Transfer Pricing
2

Definition
A transfer price is the price
charged when one segment
of a company provides
goods or services to
another segment of the
company.
The fundamental objective
in setting transfer prices is
to motivate managers to
act in the best interests of
the overall company.

Transfer Pricing
The amount charged when one division sells
goods or services to another division
Battery Division Auto Division
Batteries

Concep
t
Several divisions in an organisation
Performance of each division measured in terms of profit
Manager of the division responsible for its performance/
profits
When goods are transferred, income of the supplying division is
the cost of the receiving division
Thus Transfer price fixed will affect the profitability of both
divisions
4

Objective
s
Emphasis
on
Profits
Maximum
Utilisation of
plant
capacity
Optimise
allocation
of
financial
resources
5

Methods of Transfer
Pricing
Pricing at bargained or negotiated
price
Pricing at Market
Price
Pricing at Cost or variants of cost
method
Actual
Manufacturing
Cost
Standard Cost Full Cost Full Cost + Markup
6

Various
Methods
I. Pricing at
Cost
7

Actual Manufacturing
Cost
8
Goods or services are transferred at their actual
cost of production
Useful for those units where the responsibility of
profit performance is centralised
Difficult to measure the performance of each
profit centre

Standard
Cost
Transfers of goods and services are made at their standard cost
Any difference between actual and standard cost viz., variances
are usually absorbed by the supplying unit. Occasionally,
variances are transferred to the user unit
This will result in the inventory being carried at identical standard
cost by both the supplying and receiving units
Here also the profit performance responsibility is centralised and
thus it cannot be measured for individual units involved
9

Full Cost
Pricing
Full cost means cost of production plus expenses like
selling and distribution, administration, research and
development cost etc
In this method, the supplying unit is not allowed to make
any profit on transfers to other units. But it is free to
earn profit on outside sale
One good thing about this method is that the supplying
unit is allowed to recover the full cost of the
goods/services transferred
10

Full Cost + Markup
Pricing
Supplying unit transfers goods and services at full cost plus some mark-up
The markup added to full cost is either expressed as a percentage of full cost
or of capital employed
Selling expenses here are recovered by the supplying unit without incurring
them, especially when the goods/services are transferred internally
Due to this defect the use of full cost plus method is not appreciated by the
internal receiving units
To overcome this defect either the use of standard cost plus or actual cost
plus are preferred
Use of either of the preceding method facilitates the task of measuring
profit performance and efficiency of the units involved
11

An
Introduction.
II. Pricing at Market
Price
12

Objectiv
e
Transfer prices of
goods/services
transferred to other
units/divisions are
based on market
prices
In a competitive
market
goods/services
cannot be
transferred to its
users at a higher
price.
Such a competitive
market provides
an incentive to
efficient
production
Since market prices
will, by and large be
determined by
demand and supply in
the long run, it is
claimed that profits
which results under
this method, will
provide a good
indicator of the
overall efficiency of
the various units
Competitive market
prices provide
reliable measures of
divisional income
because these prices
are established
independently rather
than by individuals
who have an interest
in the results
13

Market Pricing -
Limitations
Difficulty in obtaining market
prices
Difficulty in determining the elements
of selling and distribution expenses
such as commission, discounts,
advertisement and sales promotion
etc., so that necessary adjustment may
be made in the market price to provide
benefit of these expenses, to the profit
centre, receiving the goods.
14

III. Pricing at Bargained
Price
23

Methodolog
y
Under this method each decentralised unit is considered as an independent
unit and such units decide the transfer price by negotiations or bargaining
Divisional managers have full freedom to purchase their requirement
from outside if the prices quoted by the outside party is lower
A system of negotiated prices develops business like attitude
amongst divisions of the company
To avoid any reduction in overall profits of the company, top management
may impose restriction on the external purchase/sale of goods
24

Intra-Company
Transfer
In order to have an effective system of intra-company
transfer pricing the following points should be kept in
view:
Prices of all transfers in and out of a profit
centre should be determined by negotiation
between the buyer and the seller
Negotiations should have access to full data on
alternative sources and markets and to public
and private information about market prices
Buyers and sellers should be completely free to
deal outside the company
25

Problem
Statement
34
Products X Y Z
Rs. Rs. Rs.
External mkt price p.u. 48 46 40
Variable cost of prodn in Divn A 33 24 28
Labour hrs reqd p.u. in divn A 3 4 2
 Division A is a profit centre which produces three
products X, Y and Z. Each product has an external
market.

Problem
Statement
What should the transfer price be for each unit for 300 units of Y, if the total labour
hours
available in Division A are:
3,800 hours 5,600 hours
Instead of receiving transfers of product Y from Division A, Division B could buy
similar product in the open market at slightly cheaper price of Rs. 45
p.u.
The maximum external sales
are:
X: 800 units; Y: 500 units; Z: 300 units
Product Y can be transferred to Division B, but the maximum quantity that
might be required for transfer is 300 units of Y.
35

Solution: (i) Hours required
to meet maximum demand
36
External sales Hours reqd p.u. Total Hrs
(i) (ii) (iii)=(i) x (ii)
X 800 units 3 2,400
Y 500 units 4 2,000
Z 300 units 2 600
Total 5,000

Contribution Per
Unit
37
Product X Y Z
Rs. Rs. Rs.
Selling Price 48 46 40
Less: Variable cost 33 24 28
Contribution p.u. (A) 15 22 12
Labour hrs reqd p.u.(B) 3 4 2
Contb p. hr (A)/ (B) 5 5.5 6
Ranking III II I

3,800
Hours
(a) If only 3,800 hours are available in Division A:
300 units of Z (maximum), which will
take 500 units of Y (maximum), which
will take 400 units of X to use
remaining hrs.
 600 hrs.
2,000 hrs.
1,200 hrs.
3,800 hrs.


Transfer price
 (i) Variable cost of
Y
24.00
Opportunity cost
 (ii) Contribution relating to ‘X’ forgone for
producing additional units of Y (4 hrs × Rs. 5*) 20.00
44.00
*Y takes 4 hours and in each hour production of X would have generated contribution of
Rs. 5.
38

5,600
Hours
(b) If 5,600 hours are available
 Maximum time required to meet external sales
(Refer to Working note 1)
 Hours now available
 It means 600 hrs can be easily used for the production of Y and
transfer price will be variable cost only i.e. (600 hrs. ÷ 4 hrs) × Rs.
24
Note: Y takes 4 hours per unit
5,000
hrs.
5,600
hrs.
Rs. 3,600
 For producing additional 150 units, production of X will be
disturbed.
Variable costs
 (i) 150 units of X @ Rs. 24
Opportunity cost
Rs. 3,600
 (ii) Contribution of ‘X’ units forgone (600 hrs. × Rs. 5) Rs. 3,000* 6,600
 Total price for 300 units 10,200
 Thus, Average transfer price should be Rs. 34 per unit
*Contribution per hr. of X foregone
39

Division and Company
Conflict
40

Conflict
s
Where profitability is used as a criteria for evaluating the
performance of each division, conflict arises between a division
of the company and company as a whole
Under decentralisation it is expected that the top management
should not interfere with the decision making process of its
subordinates heading different units
The management of such companies also expects that each
division should not only achieve its own objective necessary for
evaluating the performance but should also achieve the objective
of goal congruence.
41

Conflict
s
If a division fails to achieve the objective of ‘goal congruence’
the management of the company may dictate their ‘transfer
price’
Such interference of management of the company is usually the
main basis of conflict between a division and the company as a
whole
Conflict is aggravated if management advocates transfer of goods
and services at cost
The profitability of the transferring division will not be known
by the use of such a transfer price
42

Multinational Transfer
Pricing
43

Multinational transfer
pricing
Multinational
companies may use
transfer prices to
minimize worldwide
income taxes, import
duties, and tariffs.
For example, an MNC
might prefer to make its
profits in a country,
where maximum
corporate tax rate is
28%, rather than in
some other place where
the rate is 35%
44

pricing
Suppose a division in a high-income-tax-rate country
produces a sub-assembly for another division in a low-
income-tax-rate country.
By setting a low transfer price, the company can recognize
most of the profit from the production in the low-income-
tax-rate country, thereby minimizing taxes.
Likewise, items produced by divisions in a low-income-tax-
rate country and transferred to a division in a high-
income-tax-rate country should have a high transfer price
to minimize taxes.
45

pricing
Sometimes import
duties offset income
tax effects
Most countries base
import duties on the
price paid for an item,
whether bought from
an outside company or
transferred from
another division.
Therefore, low
transfer prices
generally lead to low
import duties.
46

pricing
Suppose the full unit cost of the item is Rs. 100, and the variable
cost is Rs. 60. If tax authorities allow either variable- or full-cost
transfer prices, which should ABC Ltd choose?
In addition, suppose India imposes an import duty equal to 20% of
the price of the item and that ABC Ltd cannot deduct this import
duty for tax purposes.
Consider a item manufactured by ABC Ltd. (Switzerland) with an 8%
income tax rate and transferred to a division in India with a 40%
income tax rate.
47

By transferring @ Rs.100 in
place of Rs. 60, Co gains Rs.
4.80 p.u.
Income of the Swiss division is Rs. 40 higher; therefore it pays
8% x Rs. 40 more income taxes (Rs. 3.20)
Income of the Indian division is Rs. 40 lower; therefore it
pays 40% x Rs. 40 less income taxes (Rs.16.00)
Import duty is paid by the India division on an additional
Rs.100 – Rs.60 = Rs.40; therefore it pays 20% x Rs.40 more
duty (Rs. 8)
Net saving from transferring at Rs. 100 instead of Rs. 60 Rs. 4.80
48

pricing
Financial
restrictions
imposed by some
governments may
be avoided by an
effective use of
transfer price
In case a country
restricts the
amount of
dividend paid to
foreign owners, it
may be easier for
a company to get
cash from a
foreign division in
form of payments
for product
transferred rather
than cash
dividend
Transfer pricing
is more complex
in a
multinational
company than it
is in a domestic
company.
MNCs try to
achieve more
objectives through
transfer pricing
policies
49

Illustration-
4C Ltd consists of the Semi-conductor Division and the
Minicomputer Division each of which operates as an independent
profit centre. Semi- conductor Division employs craftsmen, who
produce two different electronic components, the new-high
performance Super-chip and an older product called Okay-chip.
These two products have the following cost characteristics:
Super Chip Okay Chip
Material Parts Rs.20 Parts Rs.10
Labour 2 hours x Rs.
140
Rs.280 ½ hour
x
Rs.140
Rs.70
Annual Overhead in Semi-conductor Division is Rs. 40,00,000 all
fixed. Owing to high skill level necessary for the craftsmen, the
Semi-conductor Division’s capacity is set at 50,000 hours per year.
51

Illustration-
4
 To date, only one customer has developed a product utilising
super- chip, and this customer orders a maximum of 15,000
super-chips per year at a price of Rs. 600 per chip. If C cannot
meet his entire demand, the customer curtails his own
production. The rest of the semiconductor’s capacity is devoted to
Okay-chips, for which there is unlimited demand at Rs. 120 per
chip.
 The Mini-computer Division produces only one product, a process
control unit, which requires a complex circuit board imported at a
price of Rs. 600. The control unit’s costs are:
Material Circuit board Rs.600
Other Parts Rs.80
Labour 5 hours @ Rs.100 Rs.500
52

Illustration-
4
53
 The Mini-Computer Division is composed of only a small assembly plant and all
overhead is fixed at a total of Rs. 8,00,000 per year. The current market price for
the control unit is Rs. 1,400 p.u.
 A joint research project has just revealed that with minor modifications, a
single super-chip could be substituted for the circuit board currently used
by the Mini- computer division. The modification would require an extra
one hour of labour by Mini-computer’s staff, for a total of 6 hours per unit.
 Mini-computer has therefore asked Semi-conductor division to declare a
transfer price at which Semi-conductor division would sell super-chip
internally.
 Required :
 Mini-computer expects to sell 5,000 control units this year. From the overall view
point of C, how many super-chips should be transferred to Mini-computer
Division to replace circuit boards ?
 If the demand for the control unit is sure to be 5,000 units, but its price is
uncertain, what should be the transfer price of super-chip to ensure proper
decisions ? (All other data unchanged)
 If demand for the control unit rises to 12,000 units at a price of Rs. 1,400 per
unit, how many of 12,000 units should be built using Super-chip ?

Solutio
n
54
1. Contribution per hour of Super-chips and Okay-
chips:
Super-Chips Okay-Chips
Selling price p.u. (Rs.) 600 120
Less: Variable cost p.u. (Rs.) 200 80
Contribution p.u. (Rs.) 300 40
Hours reqd p.u. 2 0.5
Contb per hr 150 80
(Rs.300/2 hrs) (Rs.40/0.5 hrs)
2 . Details of hours utilised in meeting the demand of 15,000 units of Super-chips
and utilising the remaining hours for Okay-chips out of available hours of 50,000
per annum:
Hours utilised for 15,000 units of Super-chips (15,000 units × 2
hours)= Hours utilised for 40,000 units of Okay-chips (40,000 units ×
0.5 hours)=
30,000
20,000
50,000

Solutio
n
Incremental contribution per unit of a process control unit, when instead of using imported
complex circuit board Super-chip is used : Rs. 200 (Rs. 420 – Rs. 220)
55
3 . Contribution of process control unit (using imported complex circuit board): Rs.
 Selling price per unit : (A) 1,400
Variable costs :
 Circuit board (Imported) 600
 Other parts 80
 Labour cost (5 hours × Rs. 100) 500
 Total variable cost : (B) 1,180
 Contribution per unit (Rs.) {(A) – (B)} 220
4 . Contribution of a process control unit (using a Super chip) :
 Selling price per unit : (A) 1,400
Variable costs :
 Super chip (Material + Labour costs) 300
 Other parts 80
 Labour cost (6 hours × Rs. 100) 600
 Total variable cost : (B) 980
 Contribution per unit : {(A) – (B)} 420

Solutio
n
56
(i) Super-chip to be transferred to Mini Computer Division to replace Circuit Boards:
 Out of 50,000 available hours 30,000 hours are utilised for meeting the demand of
15,000 units of Super-chips, the rest 20,000 hours may be used for manufacturing
40,000 Okay- chips, which yields a contribution of Rs. 40 per unit for Rs. 80/- per
hour or a contribution of Rs. 160 per two-equivalent hours.
 In case the company decides to forego the manufacturing of 20,000 units of Okay-
chips in favour of 5,000 additional units of Super-chips to be used by Mini-Computer
Division (instead of complex imported Circuit Board) for manufacturing process
control units. This decision would increase the existing contribution of Mini-
Computer Division by Rs. 200/- per two-equivalent hours
 After taking into account the profit foregone of Okay-chips, the existing
contribution of Mini-Computer Division of C would increase by Rs. 40 per two
equivalent hours.
 Hence the entire requirement of 5,000 units of Super-chips be produced and
transferred to Mini-Computer Division.

Solutio
n
(ii) Minimum transfer price of Super-chip to Mini Computer Division :
 = Variable cost of a Super-chip + Opportunity cost of foregoing the
production of an Okay-chip and using the craftsman time for
Super-chip
= Rs. 300 + 2 hours × Rs. 80
= Rs. 460
(iii)Super-chips to be produced for the production of 12,000 units of
process control units:
 After meeting out the order of 15,000 Super-chips per year, the
concern is left out with 20,000 hours. Use of Super-chips for control
units production would increase the existing contribution of Mini-
Computer Division by Rs. 200/- per unit.
 Out of the remaining 20,000 craftsmen hours, 10,000 units of Super-
chips can be made, which may be used for the production of 10,000
process control units.
57

Multiple Choice
Question-1
 In the case of standard cost based transfer pricing, if there is
a variance between the standard and actual cost, how is the
same dealt with?
 A. Variances if any are ignored
 B. Variances are usually absorbed by the supplying unit
and occasionally transferred to the user unit.
 C. Variances cannot arise as the standard cost will be equal to
the actual cost
 D. If actual cost if more than standard cost, the transfer is
made at actual cost. If actual is less, it is made at standard
cost.
 Answer:
59

Multiple Choice
Question-2
 Transfer pricing helps in efficient
allocation of financial resources:
 True
 False
 Answer:
60

Multiple Choice
Question-3
 Full cost plus markup pricing suffers from the following
defect:
 A. Arbitrary markup percentage can be prejudicial to
the receiving division
 B. Selling expenses are recovered by the supplying
unit without incurring them
 C. It is unclear whether standard cost or actual cost is to
be used
 D. Creates conflicts between the division and the company
as a whole
 Answer:
61

Multiple Choice
Question-4
 Under Bargained method of transfer
pricing, divisional managers have freedom
to purchase their requirement from outside
if the prices quoted by outside party is
lower.
 True
 False
 Answer:
62

Multiple Choice
Question-5
 The main objective of multinational
transfer pricing is not to motivate
divisional managers.
 True
 False
 Answer:
63

Multiple Choice
Question-6
 “Goal congruence” refers to the alignment
of the divisional objective with the objective
of the company as a whole in intra-
company transfer pricing.
 True
 False
 Answer:
64

Multiple Choice
Question-7
 If a division in a high income tax rate country produces and
transfers a product to a low income tax rate country, the
transfer price should be:
 A. High. Then the multinational company can recognise most
of the profit in the low income tax rate country, thereby
minimising taxes
 B. Same. In the overall worldwide tax calculations, it will not
have any effect.
 C. Low. Then the multinational company can recognise most of
the profit in the low income tax rate country, thereby
minimising taxes
 D. High. Then the multinational company can recognise less of
the profit in the high income tax rate country, thereby
minimising taxes
 Answer
65

Multiple Choice
Question-8
 Transfer pricing can be achieved in a
service organisation with one division.
 True
 False
 Answer:
66

Multiple Choice
Question-9
 Transfer pricing based on actual cost alone is:
 Fair and achieves the objectives of transfer
pricing
 Not useful in motivating managers to
perform better
 Reflective of the high efficiency of the
division
 None of the above
 Answer:
67

Multiple Choice Question-
10
 If the external market for the transferred good is
not reasonably competitive and there is no idle
capacity:
 Incremental cost should be deducted from outlay
costs for determining the maximum transfer price
 Opportunity cost should be added to outlay costs
for determining minimum transfer price
 Incremental cost should be added to outlay costs
for determining minimum transfer price
 Opportunity cost should be deducted from outlay
costs for determining the maximum transfer price
 Answer:
68

Lesson
Summary
69
We appreciated that in a transfer price scenario, the income of the
supplying division is cost of the receiving division. Hence profitability of
both divisions is affected.
Various methods of transfer pricing can be broadly categorised
under: cost or variant of cost method, market price method and
negotiated price method. Cost method has several sub methods like
actual manufacturing cost, standard cost, full cost and full cost
plus mark up.
Market price based pricing is faced with the difficulty of obtaining market
prices.

Lesson
Summary
70
Negotiated/ Bargained price method develops business like attitude
amongst divisions of the company
Where profitability is used as a criteria for evaluating performance of
each division conflict may arise between the division and the
company as a whole. Goal congruence is essential in intra-company
transfer pricing.
Multinational transfer pricing is driven by factors other than motivating
managers. Here the objective is often to minimize worldwide income
taxes, import duties, and tariffs.

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