Term
| Transfer Pricing's principal challenge |
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Definition
| devise a satisfactory method of accounting for the trasnfer of goods and services from one profit center to anther in companies that have a significant number of these transactions |
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Term
| Objectives of Transfer Pricing |
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Definition
| two or more profit centers are jointly responsible for product development, each should share in the revenue generated when the product is finally sold |
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Term
| Transfer price should be designed so that it accomplishes following objectives |
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Definition
- should provide each business unit with the relevant information it needs to determine optimum trade-off between company costs and revenues
- indluce goal congruent decisions; system should be designed so that decisions improve business unit profits will also improve company profits
- help measure economic performance of individual business units
- system should be simple to understand and easy to administer.
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Term
| Transfer of Pricing methods |
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Definition
- limit term trasnfer price to the value placed on a transfer of goods or services in transactions in which at least one of the two parties involved a profit center
- price typically includes a profit element because an independent company would normally not trasnfer goods or services to another independent company at cost or less
- exclude mechanisms for allocating costs in a cost accounting system; those costs don't include a profit element.
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Term
| Transfer Pricing Fundamental Principle |
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Definition
| 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 |
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Term
| When profit centers of a company buy and sell products to one another, two decisions must be made |
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Definition
- should the company produce the product inside or purchase it from outside? (sourcing decision)
- If produced inside, what price should the product be trasferred between profit centers? (transfer price decision)
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Term
| Market price based transfer price induces goal congruence if all of the following conditions exist (ideal situation) |
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Definition
- competent people
- good atmosophere
- market price
- freedom to source
- full information
- negotiation
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Term
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Definition
| managers should be interested in long-run as well as short-run performance of responsibilty center. Staff must want long-term as well. |
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Term
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Definition
| managers must regard profitability as an important goal and a significant consideration in the judgment of their performance. Perceive that transfer prices are just |
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Term
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Definition
| idea transfer price is based on a well-established normal market price for the identical product being trasnferred; a market price reflecting the same conditions (quantity, delivery time, and quality) as the product to which the transfer price applies. |
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Term
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Definition
| Alternatives for sourcing should exist, and managers should be permitted to choose the alternative that is in their best interest. |
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Term
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Definition
| managers must know about the available alternatives and the relevant costs and revenues of each |
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Term
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Definition
| smoothly working mechanism for negotiating "contracts" between business units. |
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Term
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Definition
- Buying manager should be free to make sourcing decisions
- Selling manager should be free to sell products in the most advantageous market
- in real life, freedom to source might not be feasible or might be constrained by corporate policy
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Term
| Situations where freedom to source may not be feasible |
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Definition
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Term
| Markets for buying and selling may be limited because |
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Definition
- existence of internal capacity might limit the development of external sales
- if a company is the sole producer of a differentiated product, no outside sources exist
- 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, which is not unusual
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Term
| How does a company find out what the competitive price is if it doesn't buy or sell the product in an outside market? |
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Definition
- if published market prices are available, they can be used to establish transfer prices
- market prices may be set by bids
- if production profit center sells similar products in the outisde markets, it is often possible to replicate a competitive price on the basis of outside price
- if buying profit center purchases similar products from the outside market, it may be possible to replicate competitive prices for proprietary products
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Term
| Excess or Shortage of Industry Capacity |
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Definition
- selling profit center can't sell to the outside market all it can produce (excess capacity)
- buying profit center can't obtain the product it requires from the outside while the selling profit center is selling to the outside (shortage capacity)
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Term
| Two decisions with Cost Based Transfer Prices |
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Definition
- how to define costs
- how to calculate profit mark-up
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Term
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Definition
| unit basis is standard cost; actual costs shouldn't be used because production inefficiencies wil lbe passed on to the buying center |
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Term
| Two Decisions for Profit Markup |
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Definition
- what the profit markup is based on
- the level of profit allowed
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Term
| Simplest and most widely used basis |
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Definition
| percentage of costs (no account is taken of capital required) |
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Term
| Two problems with percentage of costs |
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Definition
- conceptually better base is percentage of investment but calculating investment applicable to a given product could pose a problem
- amount of profit; management's perception of financial performance of a profit center will be affected by the profit it shows
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Term
| Upstream Fixed Costs and Profits |
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Definition
- transfer price can create problems in integrated companies
- profit center that sells to outside customers may not be aware of the amount of upstream fixed costs adn profits included in its internal purchase price
- even if profit center was aware of costs, it might be reluctant to reduce its own profits.
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Term
| Agreement Among Business Units |
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Definition
- Establish formal mechanism where representatives from the buying and selling units meet periodically to decide on outside selling prices and sharing of profits for products with significant upstream fixed costs and profits
- only works if the review process is limited to decisions involving a significant amount of business to at least one profit center otherwise the value of negotiations may not be worth the effort
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Term
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Definition
- establish a transfer price that includes two charges
- first: for each unit sold, a charge is made that is equal to the standard variable cost of the production
- periodic monthly charge is made that equals fixed costs associated with facilities reserved for buying unit.
- one or both units should include a profit margin
- two-step pricing corrects problem by transferring variable cost on a per-unit basis and trasferring fixed costs and profit on a lump sum basis
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Term
| Things to Consider about two-step pricing |
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Definition
- monthly charge for fixed costs and profit should be negotiated periodically and will depend on capacity reserved for buying unit
- questions may be rasied about accuracy of cost and investment allocation
- under pricing system, manufacturing unit's profit performance isn't affected by sales volume of final unit
- connflict between interest of manufacturing unit and those of the company
- similar to "take or pay" pricing that is used frequently by public utilities, pipelines and coal mining companies and in other long-term contracts
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Term
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Definition
| If two-step pricing isn't feasible, profit sharing system might be used to ensure congruence between business units and company interests |
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Term
| Profit sharing operates as follows |
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Definition
- product is transferred to marketing unit at standard variable cost
- after the product is sold, business units share the contributions earned, which is the selling price minus variable manufacturing and marketing costs
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Term
| Profit Sharing produces following problems |
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Definition
- arguments over the way contribution is divided between two profit centers and senior management might ahve to intervene to settle disputes
- costly and time consuming and works against a basic reason for decentralization; autonomy of business unit managers
- arbitrarily dividing profits between units doesn't give valid information on profitability of each unit
- since the contribution is not allocated until after the sale has been made, the manufacturing unit's contribution depends on marketing unit's ability to sell as well as the actual selling price
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Term
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Definition
- manufacturing unit's revenue is credited at the outside sales price and the buying unit is charged the total standard costs
- difference is charged to headquarters account and elminated when the business unit statement are consolidated
- transfer pricing method is sometimes used when there are frequent conflicts between buying and selling units that can't be resolved by other methods
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Term
| Disadvantages for two sets of Transfer Profits |
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Definition
- sum of business unit profits is greater than overall company profits
- system creates an illusive feeling that business units are making money, while in fact, the overal company might be losing money because of debits to headquarters
- system might motivate business units to concentrate more on internal trasnfers where they are assured of a good markup at expense of outside sales
- additional bookkeeping involved in first debiting the headquarters account every time a transfer is made and elminating account when statements are consolidated
- fact that conflicts between business units would be lessened under this system could be viewed as a weakness
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Term
| Pricing Corporate Services |
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Definition
- describe problem with charging business units for services furnished by corporate staff units.
- exclude cost of centreal service staff units over which business units have no control
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Term
| Two Types of Transfers remain: |
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Definition
- for central services that the receiving unit must accept but can at least partially control the amount used
- for central Services that business units can decide whether or not to use
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Term
| Control over Amount of Service |
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Definition
- Business units may be required to use company staffs for services such as information technology and R&D
- Business unit manager can't control efficiency with which these activities are performed but can control amount of services received.
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Term
| Three schools of thought about Service |
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Definition
- business unit should pay standard variable cost of discretionary services - if they pay less, it will be motivation to use more service than economically justified but if they pay more, they might not elect to use services senior management believes worthwhile
- buisness units should pay a price equal to the standard variable cost plus a fair share of standard fixed cost (full cost)
- business units should pay a price that is equivalent to the market price or standard full cost plus a profit margin
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Term
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Definition
- management may decide that business units can choose whether to use central service units.
- Business units may procure services from the outside, develop their own capabilities, or choose not to use the service at all.
- often found with activities such as information technology, internal consulting groups, and maintenance work.
- business unit managers control both the amount and efficiency of central services.
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Term
| Simplicty of the price mechanism |
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Definition
| 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. |
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Term
| Negotiating Transfer Prices |
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Definition
- business units negotiate transfer prices with each other; aren't set by central group
- establishing selling prices is one of the primary funcitons of line management
- many transfer prices require a degree of subjective judgment
- business units should neogtiate prices because they have the best information on markets and costs
- business units know ground rules iwthin transfer price negotiations should be conducted
- headquarters informs business units that they are free to deal with each other as they see fit, but if there is a tie, business must be kept inside.
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Term
| Arbitration and Conflict Resolution |
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Definition
- there may be instances where business units won't be able to agree on a price
- procedure should be put in place to arbitrate trasnfer price disputes
- one extreme is to have executives arbitrate dispute
- other extreme is committee
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Term
| Conflict resolution committee has responsibilities: |
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Definition
- settling transfer price disputes
- reviewing sourcing changes
- changing the transfer price rules when appropriate
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Term
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Definition
- extent and formailty of sourcing and transfer pricing rules depend to a largae extent on the number of intracompany transfers and the availability of markets and market prices
- greater are the number of intracompany transfers and availability of market prices, more formal and specific the rules must be
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Term
| Companies divide products into two main classes |
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Definition
- Class I: all products for which senior management wishes to control sourcing (large-volume products)
- Class II: all other products (produced outside the company)
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Term
| Souricing of Class I and II products |
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Definition
- sourcing of class I products can be changed only by permission of central management
- sourcing of class II products is determined by the business unit involved.
- Both buying and selling units are free to deal either inside or outside the company.
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