Strategic Management Accounting Transfer Pricing PDF

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Theeoratial concept on transfer pricing problems for divisional perforformanc...

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Responsibility accounting is an arrangement under which managers are given decision making authority and are made responsible for their area of assigned activity occurring within a specific department/division of the company. “Responsibility accounting is a system of accounting that recognizes various responsibility centers throughout the organization and reflects the plans and actions of each of these centers by assigning particular revenues and cost to the one having the pertinent responsibility. It is also called profitability accounting and activity accounting.” – Charles T Horngren Requirements of Responsibility Accounting  A sound and well designed organization structure with strictly defined authority and responsibility should exist.  The organization should be divided into various defined responsibility centers.  Development of accurate and effective budgets keeping in mind the opinions the concerned managers and requirements as well.  The responsibility accounting system so adopted ought to have full support from the higher authorities of the organization.  The system so designed and implemented should be understood be the managers fully and thus should provide support as well for its effective operation.  A conducive organizational environment and progressive management attitude should exist. Benefits of Responsibility Accounting  Clarity of goals  Assists in setting realistic plans and budgets  Improves quality  Cost control  Objective evaluation  Decentralization decision making Limitations of Responsibility Accounting  Failure of support of top management  Unorganized structure of the organization  Unrealistic goals  Defective reporting system  Impact of behavioral system Types of Responsibility Centers A responsibility centre is sub unit of an organization under the control of a manager. A small firm can possibly be managed by an individual in the past but in today’s era, a large firm is necessarily divided into appropriate segments or departments for ensuring efficient managerial control. The main criterion in the creation of this centre is that the sub unit of the organization should be separable and identifiable for operating performance. Cost Centre: Cost centre is a smaller segment of activities of responsibility for which cost can be accumulated. In other words, the manager is held accountable only for costs incurred in their respective responsibility centre. A distinctive feature of this centre is that the inputs and not the outputs are measured in terms of money. The performance of the manager is evaluated by comparing the cost incurred with the budgeted costs. The management focuses on the cost variances for ensuring proper control. Revenue Centre: The Revenue centre is the small segment in which the manager or any person, to whom the duty is assigned, is responsible for generation of revenues. A distinctive feature of this centre is that the outputs and not the inputs are measured in terms of money. The manager here has no control over the investments in assets or the cost of manufacturing a product but might exercise the control over distribution expenses. Profit Centre: A profit centre is that segment of the organization which is concerned with both revenues as well as costs. The main aim of profit centre is to maximize the profits by either controlling costs or increasing revenues. Investment Centre: A Responsibility centre is called an investment centre, when its manager is responsible for costs and revenue as well as for the investment in assets used by his centre. The return on investment (ROI) is used as the performance evaluation criterion in an investment centre. Key Issues of Responsibility Accounting  Segment Reporting  Transfer Pricing  Performance Appraisal Segment Reporting: A segment can be defined in many ways, but one prevailing view is that it is a discrete business unit for which separate financial information is prepared and evaluated by an operating decision maker within the organization. This decision maker usually has authority to allocate resources and judge performance of the unit, and typically relies upon the segment’s financial reports in making those calls. Thus, it is quite important that segmented data be prepared in ways that facilitate thoughtful and correct decisions. Keys to segmented income statements: Md. Mizanur Rahman, Cell: 01914384538

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A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. Traceable fixed costs arise because of existence of a particular segment and would disappear over time if the segment itself disappeared. Common fixed costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. Traceable costs can become common costs: it is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. e.g. the landing fee paid to land an airplane at an airport is traceable to the particular flight, but it is not traceable to first class, business class, and economy class passengers. Segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment. Transfer Pricing Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided. It is the rates or prices that are used when selling goods or services between company divisions and departments, or between a parent company and a subsidiary. Transfer pricing allows for the establishment of prices for the goods and services exchanged between a subsidiary, an affiliate, or commonly controlled companies that are part of the same larger enterprise. Transfer pricing can lead to tax savings for corporations, though tax authorities may contest their claims. Characteristics of a good transfer price 1) Goal congruence: the transfer price that is negotiated and agreed upon by the buying and selling divisions should be in the best interests of the company overall. 2) Fairness: the divisions must perceive the transfer price to be fair since the transfer price set will impact divisional profit and hence performance evaluation. 3) Autonomy: the system used to set the transfer price should seek to maintain the autonomy of the divisional managers. This autonomy will improve managerial motivation. 4) Bookkeeping: the transfer price chosen should make it straightforward to record the movement of goods or services between divisions. 5) Minimize global tax liability: multinational companies can use their transfer pricing policies to move profits around the world and thereby minimize their global tax liability. When considering a multinational firm, additional objectives are to:  Pay lower taxes, duties, and tariffs  Be aware that multinational firms will be keen to transfer profits if possible from high tax countries to low tax ones.  Repatriate funds from foreign subsidiary companies to head office  Be less exposed to foreign exchange risks / reduce foreign exchange risks  Build and maintain a better international competitive position  Enable foreign subsidiaries to match or undercut local competitors’ prices  have good relations with governments in the countries in which the multinational firm operates Transfer pricing is not simply buying and selling products between divisions. The term is also used to cover:  head office general management charges to subsidiaries for various services  specific charges made to subsidiaries by, for example, head office human resource or information technology functions  royalty payments  between parent company and subsidiaries  among subsidiaries.  interest rate on borrowings between group companies. Objectives of transfer pricing: A good transfer price should have the following characteristics  Preserve divisional autonomy  Maintain motivation for managers  Assess divisional performance objectively  Ensure goal congruence Transfer Pricing Methods: (i) Cost-Based Transfer Prices: Cost-based transfer pricing is a method of setting prices when goods are sold to divisions within the same company. Several factors affect the price, including production costs, managers' reviews, international taxation and competitors' pricing. There are different methods of selecting the cost-based transfer price. In the absence of an established market price many companies base the transfer price on the production cost of the supplying division. The most common methods are: 1. Full Cost 2. Cost-plus 3. Variable Cost plus Lump Sum charge Md. Mizanur Rahman, Cell: 01914384538

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4. Variable Cost plus Opportunity cost also known as the Minimum Transfer Price For internal decision making purposes, a transfer price should be at least as large as the sum of:  cash outflows that are directly associated with the production of the transferred goods; and,  the contribution margin foregone by the firm as a whole if the goods are transferred internally. (ii) Market price: Transfer price = external market price. If a perfectly competitive market exists for a product, then the external market price is the optimum transfer price if the supplying division is operating at full capacity. Market conditions which are appropriate for adoption • Are generally appropriate in a perfect market, where there is homogeneous product with only one price for both sellers and buyers and no buying or selling costs. • In a perfect market, Selling Division will be operating at full capacity and can sell whatever quantity of intermediate product it can produce in the external market. In this situation, internal transfers will result in a need to sacrifice external sales. The benefit forgone that is the contribution lost (opportunity cost) from sacrificing external sales should be included in the transfer price. Thus in this situation TP=MP will be consistent with the general TP rule. • TP=MC+OC = MP • In a perfect market, the minimum TP is also the maximum TP. Thus, both Selling Division and Buying Division will be happy with a transfer price set as the market price. • The adoption of market-based transfer price in a perfectly competitive market meet the criteria of a good transfer price that is it will promote goal congruent decisions, preserve divisional autonomy and provide an equitable basis for performance evaluation. Limitations (i) As a result of product differentiation, ther may be no comparable product or a single market price. (ii) Market price may vary because of over-supply or under-supply, promotions, or ‘product dumping’ by foreign competitors. (iii) Bargained or negotiated prices: Transfer prices may be set on the basis of negotiations among the division managers. Here, the firm does not specify rules for the determination of transfer prices. Divisional managers are encouraged to negotiate a mutually agreeable transfer price. Negotiated transfer pricing is typically combined with free sourcing. In some companies, though, headquarters reserves the right to mediate the negotiation process and impose an “arbitrated” solution. Subunits negotiate the transfer price themselves. Disadvantages: Time-consuming, Increases conflicts between subunits, Outcome often depends on the bargaining power of subunits. (iv) Dual pricing: Different price used for receiving and supplying division. The practice of setting prices at different levels depending on the currency used to make the purchase. Dual pricing may be used to accomplish a variety of goals, such as to gain entry into a foreign market by offering unusually low prices to buyers using the foreign currency, or as a method of price discrimination. Dual pricing can also take place in different markets that use the same currency. This is closer to price discrimination than when dual pricing is implemented in foreign markets and different currencies. Dual pricing is not necessarily an illegal pricing tactic; in fact, it is a legitimate pricing option in some industries. However, dual pricing, if done with the intent of dumping in a foreign market, can be considered illegal. General principles about transfer pricing Selling Unit’s Minimum Acceptable Transfer Price: A transfer price generally has two parts: the outlay costs and the opportunity cost. The outlay cost is the cost of making or obtaining the product. The opportunity cost is the profit the division could make by selling the product in the marketplace, as opposed to selling the product internally. Transfer price ≥ Variable cost per unit + Total Contribution margin on lost sales Number of units transferred Marginal Cost or additional outlay cost or incremental costs + Opportunity Cost. Outlay cost = direct material + direct labor + variable overhead Opportunity Cost is the contribution margin that the seller would earn if the product could be sold on the outside market. Opportunity cost = forgone contribution margin from outside sale on open market = Market Price - Additional Outlay Cost Transfer price = additional outlay costs incurred because goods are transferred + opportunity costs to the organization because of the transfer. • If there is spare or excess capacity i.e. the seller cannot sell additional units on the outside market, then for any sales that are made by using that spare capacity, the opportunity cost is zero. • If the seller doesn’t have any spare capacity, or it doesn’t have enough spare capacity to meet all external demand and internal demand, then the next question to consider is: how can the opportunity cost be calculated? Minimum Price = Additional outlay cost, i.e., differential cost.

Md. Mizanur Rahman, Cell: 01914384538

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For example, consider a division that makes hats. The cost of making one hat is $20. That division can sell the hat in the marketplace for the market price of $50. Therefore, the opportunity cost of selling the hat internally instead of externally is $30. The transfer price would then be $50 ( $20+ $30). – Transfer price ≥ marginal cost of transfer out division + any lost contribution Minimum acceptable transfer price

=

additional outlay costs incurred because goods are transferred

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opportunity cost to the organization because of the transfer

When tax rates differ, companies should strive to generate less income in high tax-rate countries, and vice versa. When alternatives are available, this can be accomplished by a careful determination of the transfer price. Maximum transfer price (what is the maximum price that the buying division would be prepared to pay for the product?)  The maximum price that the buying division will want to pay is the market price for the product  Transfer price ≤ the lower of net marginal revenue of transfer-in division and the external purchase price  Maximum Price = Market Price Where there is no external market for the product being transferred, it is not really appropriate to adopt the approach above. In reality, in such a situation, the selling division may well just be a cost centre, with its performance being judged on the basis of cost variances. Options here are to use a cost based approach to transfer pricing but these also have their advantages and disadvantages. Two situations should be considered. a. A transfer makes sense from the standpoint of the company if the item can be made inside the company (including opportunity costs) for less that it costs to buy the item from the outside. In algebraic form:      Variable costs +  ≤ Cost of purchasing from outside supplier.     

In this case, any transfer price within the following range will increase the profits of both divisions:      Variable costs +  ≤ Transfer price ≤ Cost of purchasing from outside supplier.     

b. A transfer does not make sense from the standpoint of the company if the item can be purchased from an outside supplier for less than it costs to make inside the company (including opportunity costs). In algebraic form:      ≥ Cost of purchasing from outside supplier. Variable costs +       In this case, it is impossible to satisfy both the selling division and the buying division and no transfer will be made voluntarily. And, of course, no transfer should be forced on the managers since a transfer would not be in the best interests of the entire company. Choosing the Right Transfer Pricing Method A business that is engaged in the process of selecting one or more transfer pricing methods should consider a number of external variables in selecting such a method, whether this decision applies to intercompany transactions or to intracompany transactions. The following are 10 of the most important external variables that affect the selection of a transfer pricing method: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Income tax considerations Re-zonal income and property tax considerations Taxation imposed by a foreign entity Market position, including oligopoly or oligopsony Customs duties and enforcement Inflation or deflation Production capacity, including plant efficiency Currency fluctuation and hedging costs Currency control mechanisms and their effectiveness Relationships with the aforementioned governments

The relative importance of each of these external variables varies between one business and another. Weighing these factors a priori would be counterproductive. Moreover, a business should change the list of variables or the priorities within these variables over time as conditions change and choose the right transfer pricing method. Transfer price for Service Departments Divisions of a company often supply goods and services to other divisions of the same company. The cost of these goods and services can be allocated with the company. Alternatively, the goods and services can be "sold" by one department to another department within the same company. When individual divisions of the company are evaluated on their own individual profit, a price must be established for the goods and services which are "sold" between departments. This necessitates the establishment of a transfer price. A transfer price can be defined as an internal charge established for the exchange of goods or services between responsibility centers with a company. But, these prices are eliminated for external reporting purposes. A general rule with regard to transfer prices as follows: • The maximum price should be no higher than the lowest market price at which the good of service can be acquired. Md. Mizanur Rahman, Cell: 01914384538

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• The minimum price should be no less than the sum of the selling segment's incremental costs for the good or service plus any opportunity costs. Multinational Transfer pricing International business transactions have increased dramatically over the years. Investment has increasingly expanded at an unprecedented rate in many countries. These international business activities have led to the formation of a group of companies with mutual interests which are known as “multinational companies”. Companies within the MNC may trade goods or services with one another by means of “Transfer Pricing”. Transfer Pricing is the price set between related contracting parties for goods or services which may deviate from the market price. For a multinational company where products are produced by a segment in one country and sold to a segment in another country, there are additional transfer price considerations. These considerations arise because of the differences in taxes, tariffs, freight charges, foreign exchange currency controls, etc. 1. Taxes rates in different countries. The firm's strategy is to shift income from the high tax country to the low tax country. If the buying division is in a low tax country, then transfers would be made at the lowest cost possible. If the seller is in a low tax country transfers...