1. Transfer PricingChapter-6

2. There are several situations in which goods are bought andsold among various divisions and departments of an organization. 3. T.P. is defined as the value placed on transfer of goods orservices among two or more profit centers. It is a behavioral tool and not accounting tool. 4. For profit center selling the goods, T.P. will be the majordeterminant of its revenue. For buying profit center it will be major determinant of the expenses incurred. The price of inter-divisional sales affects the selling divisions sales and the buying divisions costs. 5. Objectives of transfer prices Should provide each segment with relevant informationrequired to determine the optimum trade off between costs and revenue. Should induce goal congruence Should help measure economic performance Should be simple and easy to operate. 6. Fixation of Transfer price A division may operate in two distinct situations: Completely independent of each other Divisions are inter dependent 7. Independent division Market price of the products manufactured are available T.P. is the current market price and divisional profitability ismeasured as if the division is an independent company. Decision making autonomy Co-ordination among divisions and conflicts are minimum. 8. Inter dependent divisions There may not be any outside source for the product. If the product is a key component, top management may notallow outsourcing. 9. Try to get information about market price If exact prices are not available, approximate market priceshould be estimated through appropriate market intelligence. M.P. is not available cost based transfer prices are used. 10. Selling divisions are allowed a profit margin over and abovethe cost of the product. A standard cost is developed and T.P. is based on it. This may be adjusted for price level changes in the prices of materials etc. 11. Idea of using standard costs is that the inefficiencies of theselling division should not be passed on to the buying divisions. 12. Cost based T.P. Increase in actual cost will not be considered for standardcost. There is no incentive for the selling division to reduce standard costs 13. How much profit margin should be allowed Selling division may be allowed a mark up % related to theassets employed in making the product. 14. In case if the division is selling exclusively to other divisionsand outside customer does not exist, the divisional manager principal responsibilities will be for control of costs, control of quality and production schedules. 15. The divisional manager has hardly any marketingresponsibility and his revenue is determined by the marketing decisions of the buying division. Since the volume of sales and hence pricing decisions are not within the control of the selling division, the profits of the selling division are not a true indicatior 16. Methods of calculating T.P. Fixed monthly charges (two-step pricing) Profit sharing system Two sets of prices 17. Profit sharing system Product is transferred to marketing unit at standard variablecost After the product is sold, business units share the contribution margin earned. 18. How to divide contribution margin Since the contribution is not allocated until after the sale hasbeen made, the manufacturing units contribution depends on the marketing units ability to sell and on the actual selling price. 19. Two sets of prices The manufacturing units revenue is credited at the outsidesales price. Buying unit is charged the total standard costs. Difference is charged to headquarters' account and eliminated when the business unit statements are consolidated. 20. When frequent conflicts are there this method is used 21. This method motivate business units to concentrate oninternal transfer Sum of the business unit profit is greater than overall company profits. It creates an illusive feelings that business is making profit. Additional bookkeeping involved in debiting headquarters' account 22. Administration of T.P. Negotiation Arbitration and conflict management 23. If control of pricing is left to the head quarters staff, linemanagements ability to affect profitability is reduced. A negotiated T.P. often is the result of compromises made by both buyer and seller If headquarters establish T.P. business units managers can argue that their low profits are due to arbitrariness. 24. Business units have the best information on markets and costsand so are best able to arrive at reasonable prices. They should know the ground rules within which these T.P. negotiations are to be conducted. 25. In a few co H.O. informs business units that they are free todeal with each other or with outsiders as they think fit, but if there is a tie the business must be kept inside. 26. Arbitration and conflict management No matter how specific the pricing rules are there may beinstances in which business units will not be able to agree on a price. Such disagreements are resolved by referring the decision to headquarters and seeking its arbitratrion. 27. Arbitration can be done in two ways Assigning a single executive To set up a committee