Transfer Pricing This Master Class will cover; A consideration of the theory The importance of a transfer pricing system Understanding the optimum transfer price Understanding that optimum TP we will lead to goal congruency An examination question We will work through a difficult 25 mark question 1
The Transfer Price The Transfer Price is the internal charge used between two divisions when internal products/services are transferred. It is a notional charge that enables a company to set up a decentralised organisation. The TP facilitates each division to be run as a profit centre. The TP will represent; sales revenue for the selling division and a cost of sales for the buying division When the divisional accounts are reconciled to form group accounts, the internal debits and credits will be self balancing. Remember the TP is a notional charge that aims to; Facilitate divisions to be run as autonomous profit centres (business units) To ensure that divisional transfers are charged fairly Facilitate performance measurement Motivate staff PROBLEM When a TP is set to achieve the above objectives, we do not always end up with a charge that will encourage goal congruency. Goal congruency is where a decision made by a divisional manager is not only right for that division, it is also in the best interests of the group as a whole. 2
The Optimum Transfer Price The optimum transfer price is the internal charge that will ensure divisional managers make goal congruent decisions. Obtaining and using the optimum TP is a key aspect of transfer pricing in any Management Accounting examination we need a charge that will ultimately maximise the wealth of shareholders. Illustration An international accountancy college operates many regional education centres. Each regional college is treated as a profit centre. Lecturing staff are salaried and are contracted to teach 200 days per annum. Any teaching days over this are paid at the normal daily salary rate plus 50%. Each lecturer is based in one regional centre. On occasion, lecturers work in other centres. A standard daily charge out rate of $500 is used when lecturers deliver teaching resource outside of their own home centre. Using this scenario, consider the following situations... 3
The Process; The selling divisional manager sets the Transfer Price The manager of the buying division makes a decision accordingly Principle; As long as the Transfer Price reflects the RELEVANT COST of the internal transfer, the buying division will always make a goal congruent decision. So; OPTIMUM TRANSFER PRICE = RELEVANT COST OPT TP = MARGINAL PLUS OPPORTUNITY COST COST 4
Example Able and Baker (a) Explain the potential benefits of operating a transfer pricing system within a divisionalised company. (3 marks) (b) A company operates two divisions, Able and Baker. Able manufactures two products, X and Y. Product X is sold to external customers for $42 per unit. The only outlet for product Y is Baker. Baker supplies an external market and can obtain its semi-finished supplies (product Y) from either Able or an external source. Baker currently has the opportunity to purchase product Y from and external supplier for $38 per unit. The capacity of division Able is measured in units of output, irrespective of whether X or Y, or a combination of both are manufactured. The associated product costs are as follows: X Y Variable costs per unit ($) 32 35 Fixed overhead per unit ($) 5 5 Total unit costs ($) 37 40 Required; For each of the following conditions and using the information above, explain how optimum transfer prices will lead the manager of the Baker division to make goal congruent decisions; (i) When division Able has spare capacity and limited external demand for product X. (3 marks) (ii) When division Able is operating at full capacity with unsatisfied external demand for product X. (4 marks) (Total: 10 marks) 5
Suggested Answer - Able and Baker (a) Benefits of using transfer pricing within a divisionalised company; The TP can be set to reflect the relevant cost of the transfer price. This is called the optimum transfer price. The optimum transfer price will then encourage staff to make goal congruent decisions for the group as a whole. The TP is often used to ensure that the divisions are given a fair reward for their work and efforts. As the TP forms part of the divisional cost or revenue, it ensures that divisions are charged appropriately for internal transfers made. The TP may be used to promote autonomy within the divisionalised structure. Managers can run their divisions as separate business units as internal transfers are treated in a similar way to external (real) revenues and costs. (b)(i) If Able has spare capacity then the optimum transfer price will be the marginal cost of Product Y. ie $35. At this price the manager of Baker will decide to buy Product Y internally at $35, rather than from an external supplier at $38. This is goal congruent for the group, as it is cheaper to use spare capacity to make Y in-house at $35 per unit, rather than buy in the component for $38. (ii) Under this situation, in order to make Product Y, Able would have to reduce its production of Product X, thus losing the contribution from X. The optimum transfer price (relevant cost) of making Y is now; MC of Y PLUS contribution foregone from X i.e. $35 + $10 = $45 Now the manger of Baker is faced with buying Y internally at $45 or externally at $38. The manager will now choose to purchase Y from the external supplier. This is again the correct decision for the group (goal congruency has been achieved). If the company makes Y in-house it will spend $35 actually manufacturing Y, but in addition to this, the scarce resources required are removed from Product X, this leading to a sacrifice of contribution of $10 ($42 - $32). The cost to the business is a total of $45. At this point it is cheaper to buy in Y from the external supplier. 6