In the previous lecture we identified a number of alternative financial measures for examining divisional performance. However, all of the financial measure outcomes will be affected when divisions transfer goods and services to each other. The transfer price (TP) set by the transferring (or supplying) division (TD) for goods to be transferred to the receiving division (RD) is a revenue for the TD and a cost to the RD. This means that the value at which the TP is set will affect the profitability of each division. It will also affect production and sales levels for each division, and therefore the overall profitability of the company as a whole.
In this lecture we will look at a number of approaches that can be adopted to arrive at a transfer price for sales between divisions. To illustrate the principles, we will only consider a company which has two divisions, a TD and an RD. We will also assume that the TD manufactures an intermediate product. The intermediate product (which can at times be sold on an external market) is sold to the RD at a transfer price, which is set by the TD. The RD then uses the intermediate product as a component of a final product manufactured by the RD, which is sold on an external market.
Transfer Pricing in Divisionalized Companies
Division (TD) Division (RD)
A TP system can be used for the following purposes:
- To provide information that motivates divisional managers to make good economic decisions. This will happen when the actions of divisional managers, taken to improve the profitability of their individual divisions, also improve the profit of the company as a whole.
- To provide information that is useful for evaluating the managerial and economic performance of the division.
- To intentionally move profits between divisions or locations.
- To ensure that divisional independence is not undermined
Conflict of Objectives
No single TP is likely to achieve all four of the above-mentioned objectives. Because many companies try to allow their divisional managers as much freedom as possible when it comes to decision-making (and also expect them to achieve certain financial targets), conflicts often arise when it comes to the setting of TP’s. This can require divisional managers to make compromises. Also, in cases where divisional managers cannot reach agreement on TP’s, the corporate Head Office may have to get involved. However, this can have a negative effect on the motivation and morale of divisional managers and can also undermine their authority.
The Alternative Bases for Transfer Pricing
- Marginal Cost
- Full Cost
- Cost plus a Mark-Up
- Negotiated Transfer Prices
Market-based Transfer Prices
If there is an external market for the intermediate product, and the transferring division can sell all of its production in that market, then the TP should be set at the selling price of the intermediate product in that market. If the TP is set at a level which is lower than the market price, then it is unfair to the transferring division as it loses the opportunity of maximizing its profits.
However, if the transferring division has spare capacity, it can transfer its spare capacity to the receiving division at less than the market price for the intermediate product.
TP equal to marginal cost
When there is no external market for the intermediate product, a transfer price equal to the marginal (i.e. variable) cost of the intermediate division allows the organization as a whole to maximize its profits. (This will be illustrated in a later example). However, it is likely to be demotivating for the manager of the transferring division, as the transferring division does not make any profits, or even any contribution towards its fixed costs.
TP equal to Full Cost
This means that the transferring division will charge a TP equal to marginal costs, plus fixed manufacturing overheads. This is more attractive to the transferring division, as it does cover its total manufacturing costs, but it still does not allow for a profit margin for the transferring division. For this reason it may be turned down by the transferring division, which will lead to the organization as a whole not maximizing its profits.
TP equal to Cost plus a mark-up
This allows the transferring division to make a contribution towards fixed costs (if variable cost is used as the cost base), or to make a profit (if full cost is used as the cost base). The problem with this transfer pricing system is that it can also lead to the organization as a whole making less than the maximum possible profits.
Negotiated Transfer Prices
It is argued that divisional managers should be able to negotiate transfer prices, as this may help each manager to achieve their divisional aims, and may also help the organization as a whole to maximize profits.
Range of negotiated transfer prices
If it is assumed that each division acts in its own best interests, then it is possible to predict a range of transfer prices within which the TD and RD would negotiate. To illustrate this, we will assume the following:
Variable cost per unit £8 £15
Annual fixed costs attributable to the products £50,000 £90,000
External selling price per unit £50
Maximum production and sales (units) 10,000 10,000
Scenario 1: There is no external market for TD’s product
In this case, TD would wish to transfer its products at the highest TP possible, but at least above its variable cost per unit. In this way, it is guaranteed at least some contribution towards its fixed costs.
RD, in turn, would wish to pay the lowest price possible, and certainly less than its contribution margin per unit excluding the TP, as in this way it is guaranteed some contribution towards its fixed costs. The range in which the TP would be negotiated would then be:
TP range : >£8<£35 (£35 = £50 – £15 in RD)
Scenario 2: TD can sell 2,000 units in an external market at £20 per unit
In this case, if RD still wished to purchase 10,000 units from TD, the ranges of TP’s would be:
1 – 2,000 units: =>£20<£35
(It is unlikely that RD would agree to a TP above £20, being TD’s opportunity cost of selling its first 2,000 units internally rather than on the external market).
2,001 – 10,000 units: >£8<£35
If, for instance, Scenario 2 applied, but TD had a production capacity of 12,000 units, then the TP for the 10,000 units required by RD would again be in the range:
In this case TD would not have to give up its external sales to supply RD, so that no opportunity cost would apply for the first 2,000 units.
Setting Transfer Prices in Multi-National Companies
It can happen that different countries have different rates of company tax, and transfer prices are often designed to take advantage of this fact. For instance, if Country A has a company tax rate of 30%, and Country B has a tax rate of 40%, then it can be advantageous to transfer profits from a company operating in Country B to a company operating in Country A.
For example, if a low transfer price is used in Country B (i.e. a low selling price for the transfers), then the profit will be lower for the company in Country B, and the amount of tax paid will also be lower.
A low TP means that the company in Country A will pay a lower price for the intermediate product, and will therefore make higher profits. These higher profits will be taxed at the lower rate, which will allow the group as a whole to make greater total profits.
However, a number of measures have been put in place by countries to stamp out this practice.
An illustration of transfer pricing (Source: Drury 6th edition, example 21.1 as adapted).
The Oslo and Bergen divisions are divisions within the Baltic Company. The Oslo division manufactures a number of products, one of which is an intermediate product for which there is no external market. The intermediate product is transferred to the Bergen division, where it forms part of a final product which is sold on the external market. (One unit of intermediate product is used in every one unit of final product).
The costs of each division are as follows:
Variable cost per unit £11 £7
Annual fixed costs attributable to the products £60,000 £90,000
The TP of the intermediate product has been set at £35, based on Oslo’s full production capacity of 6,000 units per year. The TP has been calculated as full cost plus a mark-up of 66.67%, i.e. (([6,000 x £11] + £60,000]) / 6,000) x 1.667 = £21 x 1.667 = £35.
The final product sold by Bergen is price sensitive. The expected units of the final product which the Bergen division estimates it can sell, at various selling prices, are as follows:
Net Selling Price per Unit Units Sold
£ 90 2,000
£ 80 3,000
£ 70 4,000
£ 60 5,000
£ 50 6,000
(The selling prices represent the average selling price at each level of activity. In other words, if Bergen wishes to sell 1,000 units it will achieve an average price of £100 for each of the 1,000 units. However, if it wishes to sell 2,000 units, the average price achieved for all 2,000 will be £90 per unit, and so on).
- Does a TP of £35 maximize profits for the Baltic Company?
- If not, determine a TP at which the company does maximize its profits.
- Is the profit-maximizing TP likely to be satisfactory to the Oslo (TD) division?
- If the profit-maximizing TP is not likely to satisfy the Oslo division, how can a compromise be reached?
- Profits of each division at a TP of £35
Oslo Division (TD)
|Output (Units)||TP Revenues ( £35 / unit)||Var.Costs (£11 / unit)||Fixed costs||Profit (Loss)|
Bergen Division (RD)
|Output (Units)||Total Revenues||Var.Costs (£7/unit)||Transfer In Costs (£35 / unit)||Fixed Costs||Total Profit / (Loss)|
As can be seen, the TD will maximize its profit at an output level of 6,000 units, whereas the RD maximizes profits at an output level of 3,000 units. The RD will therefore only order and purchase 3,000 units from the TD. The question that arises, though, is whether the output level of 3,000 units maximizes profits for the company as a whole?
To test this, we can examine company profits as a whole, ignoring the TD’s TP revenue and the RD’s transfer-in costs, and just looking at the total incremental costs of producing and selling the final product on the open market:
Company as a Whole
|Output (Units)||Total External Market Revenues||Var.Costs (£11 + £7 per unit)||Company Fixed Costs||Profit (Loss)|
You will note that the total company profit at each level of output is equal to the sum of the profits of the two divisions for that same level of output. It can also be seen that the company maximizes its profits at an output and sales level of 5,000 units. This is a clear indication that the TP of £35 per unit does not lead to the maximization of profits for the company.
How can the profit-maximizing TP be determined? It can be stated as follows:
Profit-maximizing TP = Variable cost per unit of TD + Opportunity cost per unit of TD
[Where the opportunity cost of the TD is defined as the contribution margin foregone (given up) by supplying the intermediate product internally (to the RD), instead of selling it on the open market].
The general effect of this rule is that, where there is an external market for the intermediate product, the TP is the same as the external market price for the intermediate product. Where there is no external market, the TP is equal to the variable cost of the intermediate product.
In the Baltic Company example, as there is no external market for the intermediate product the profit maximizing TP is equal to the variable cost per unit of the TD = £11 per unit. If we apply this TP to the Baltic example, we should arrive at the profit-maximizing output of 5,000 units:
Oslo Division (TD) (TP = £11)
|Output (Units)||TP Revenues ( £11 / unit)||Var.Costs (£11 / unit)||Fixed costs||Profit (Loss)|
Bergen Division (RD)
|Output (Units)||Total Revenues||Var.Costs (£7/unit)||Transfer In Costs (£11 / unit)||Fixed Costs||Total Profit / (Loss)|
As can be seen, the Bergen Division maximizes its profits at a level of 5,000 units. If the revised profit figures for the Bergen Division are added to the revised loss figures for the Oslo Division, it is apparent that the total company profits at each level of sales is the same as at a TP of £35.
However, at all levels the TD makes a loss of £60,000 (Equal to its total fixed costs). This is a problem as at a TP of £11 the TD will not be motivated to supply any units to the RD.
At present, the manager of the TD does not have much of a choice in the short run. There is no external market for the intermediate product, and in the short run it may not be possible to reduce the fixed costs of £60,000. So, if the TD manager could obtain a TP which is even slightly above £11 per unit, he or she may be forced to accept it, as any price above £11 will at least provide a contribution towards fixed costs.
However, in the long run, by not producing the intermediate product the TD manager may be able to save (avoid) the full £60,000 of fixed costs. In this case the TD would stop production of the intermediate product, and the RD (and the company) would miss out on the profits from the final product.
What is the solution? The TD and RD managers could try to negotiate a TP. If we use 5,000 units of output, the level at which company profits are maximized, we can calculate the TP at which the TD covers all of its costs. Any price above this would allow the TD to make a profit, so it may be assumed that the TP could be negotiated at a level above full cost for the TD.
The full cost of the TD at 5,000 units is:
(5,000 x £11) + £60,000 = £115,000
And £115,000 / 5,000 units = £23 per unit.
A TP of £23 would therefore cover all of the TD’s costs, and any amount above this figure would allow the TD to make profits.
How would a TP of £23 appeal to the RD? The RD will always buy additional units from the TD as long as the marginal revenue made is greater than the marginal cost of making the additional units.
This can be illustrated as follows:
|Output (Units)||Total Revenue||Total Variable Costs
(£7 + £23) per unit
|Marginal revenue||Marginal costs|
At an output level of 4,000 units, marginal revenue is still greater than marginal costs, but above this level of output marginal costs exceed marginal revenue. At a TP of £23, the RD will therefore only purchase 4,000 units from the TD. This is below the company’s optimum level of 5,000 units, and will also not please the TD. At 4,000 units, profits for the TD are:
(4,000 x £23) – (4,000 x £11) – £60,000 = (£12,000) loss
Profits for the TD would be: (4,000 x £70) – (4,000 x [£7 + £23]) – £90,000 = £70,000 profit.
Profits for the company as a whole would be £70,000 – (£12,000) = £58,000, which is below the optimum profits of £60,000.
Resolving TP conflicts
Two methods have been suggested for resolving TP conflicts:
- A dual-rate transfer pricing system;
- Transferring at TP = marginal cost, plus a fixed lump-sum fee.
A dual-rate transfer pricing system
When this system is used, two different TP’s are used. For instance, the TD in our example above might be allowed to transfer at a price of £25, for instance. The RD, on the other hand, may be allowed to receive the transfers at a TP of £11. In this way the TD is encouraged to supply the RD, and the RD has the benefit of a TP which will maximise overall company profits. The loss resulting from the difference in TP’s of (£25 – £11 = £6) per unit is held in the corporate office books.
Dual rate TP systems are not widely used, for three reasons:
- The use of different TP’s can cause confusion, especially when more than two divisions are concerned;
- The system is regarded as being artificial;
- These systems reduce divisional incentives to compete effectively.
Marginal Costs plus a Lump-Sum Fee
When this approach is used, the TP is set at the TD’s variable cost per unit, thereby effectively maximising group profits. The RD then pays a fixed lump-sum amount to the TD each year (or half-year, or quarter, as agreed). This lump sum is intended to cover the TD’s fixed costs and provide it with an acceptable level of profit as well.
In our example, this would involve the TD transferring all of its output to the RD at £11 per unit, and receiving a lump-sum payment of £60,000 plus a further amount from the RD, to cover the TD’s fixed costs and also provide the TD with an acceptable return on its invested capital.
In this way both divisions make acceptable profits, and the overall profitability of the company is also maximized.
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MA360: Transfer Pricing: – Practical Question