Management Accounting
Transfer Pricing
It is the notional value
of goods and services transferred from one division to other division. In other
words, when internal exchange of goods and services
take place between the different divisions of a firm, they have to be expressed
in monetary terms. The monetary amount for those inter divisional exchanges is
called as ‘transfer price’. The determination of transfer prices is an
extremely difficult and delicate task as lot of complicated issues are involved
in the same. Inter division conflicts are also possible. There are several
methods of fixation of ‘Transfer Price’. They are discussed below.
1. Cost-based
transfer pricing
(a)
Actual cost/Absorption cost method
(b)
Cost plus method
(c)
Standard cost method
(d)
Marginal cost method
2. Market
price based transfer pricing
3. Negotiated
transfer pricing
4. Opportunity
cost based transfer pricing
1. Cost-based
transfer pricing: - In these methods, ‘cost’ is the base and the following
methods fall under this category.
(a) Actual
Cost Method: - Under this method the actual cost of production is taken as
transfer price for inter divisional transfers. Such actual cost may consist of
variable cost or sometimes total costs including fixed costs.
(b) Cost
Plus Method: - Under this method, transfer price is fixed by adding a
reasonable return on capital employed to the total cost. Thereby the
measurement of profit becomes easy.
(c) Standard
Cost Method: - Under this method, transfer price is fixed on the basis of
standard cost. The difference between the standard cost and the actual cost
being variance is absorbed by transferring division. This method is simple and
easy to follow, but the constant revision of standards is necessary at regular
intervals.
(d) Marginal Cost Method: - Under this method,
the transfer price is determined on the basis of marginal cost. The reason
being fixed cost is in any case unavoidable and hence should not be charged to
the buying division. That is why only marginal cost will be taken as transfer
price
2. Market price based transfer pricing: - Under this method, the transfer
price will be determined according to the market price prevailing in the
market. It acts as a good incentive for efficient production to the selling
division and any inefficiency in production and abnormal costs will not be
borne by the buying division. The logic used in this method is that if the
buying division would have purchased the goods/services from the open market,
they would have paid the market price and hence the same price should be paid
to the selling division. One of the variation of this method is that from the
market price, selling and distribution overheads should be deducted and price
thus arrived should be charged as transfer price. The reason behind this is
that no selling efforts are required to sale the goods/services to the buying
division and therefore these costs should not be charged to the buying
division. Market price based transfer price has the following advantages:
1.
Actual costs are fluctuating and
hence difficult to ascertain. On the other hand market prices can be easily
ascertained.
2.
Profits resulting from market price
based transfer prices are good parameters for performance evaluation of selling
and buying divisions.
3.
It avoids extensive arbitration
system in fixing the transfer prices between the divisions.
However, the market price based
transfer pricing has the following limitations:
1.
There may be resistance from the
buying division. They may question buying from the selling division if in any
way they have to pay the market prices.
2.
Like cost based prices, market prices
may also be fluctuating and hence there may be difficulties in fixation of
these prices.
3.
Market price is a rather vague term
as such prices may be ex-factory price, wholesale price, retail price etc.
4.
Market prices may not be available
for intermediate products, as these products may not have any market.
5.
This method may be difficult to
operate if the intermediate product is for captive consumption.
6.
Market price may change frequently.
7.
Market prices may not be ascertained
easily.
3. Negotiated
Transfer Pricing: - Under this
method, the transfer prices may be fixed through negotiations between the
selling and the buying division. Sometimes it may happen that the concerned
product may be available in the market at a cheaper price than charged by the
selling division. In this situation the buying division may be tempted to
purchase the product from outside sellers rather than the selling division.
Alternatively the selling division may notice that in the outside market, the
product is sold at a higher price but the buying division is not ready to pay
the market price. Here, the selling division may be reluctant to sell the
product to the buying division at a price, which is less than the market price.
In all these conflicts, the overall profitability of the firm may be affected
adversely. Therefore it becomes beneficial for both the divisions to negotiate
the prices and arrive at a price, which is mutually beneficial to both the
divisions. Such prices are called as ‘Negotiated Prices’. In order to make
these prices effective care should be taken that both, the buyers and sellers
should have access to the available data including about the alternatives
available if any. Similarly buyers and sellers should be free to deal outside
the company, but care should be taken that the overall interest of the
organisation is not affected.
The main
limitations of this method are:
1)
Lot of time is spent by both the
negotiating parties in fixation of the negotiated prices.
2)
Negotiating skills are required for
the managers for arriving at a mutually acceptable price; otherwise there is a
possibility of conflicts between the divisions.
4. Opportunity cost based transfer pricing: - This pricing recognizes the minimum
price that the selling division is ready to accept and the maximum price that
the buying division is ready to pay. The final transfer price may be based on
these minimum expectations of both the divisions. The most ideal situation will
be when the minimum price expected by the selling division is less than the
maximum price accepted by the buying division. However in practice, it may
happen very rarely and there is possibility of conflicts over the opportunity
cost.
It is very clear that fixation of transfer
prices is a very delicate decision. There might be clash of interests between
the selling and buying division and hence while fixing the transfer price,
overall interests of the organisation should be taken into consideration and
overall ‘Goal Congruence’ should be given utmost importance rather than
interests of the selling or buying division.
Part B
Management Accounting
Transfer Pricing
Selected Problems and Solutions
Illustration: 1
A company has two divisions, X and Y. Division X
manufactures a component which is used by Division Y to produce a finished
product. For the next period, output and costs have been budgeted as follows:
|
Particulars |
Division
X |
Division
Y |
|
Component
units |
50,000 |
– |
|
Finished
units |
– |
50,000 |
|
Total
variable costs (Rs) |
2,50,000 |
6,00,000 |
|
Fixed
costs (Rs) |
1,50,000 |
2,00,000 |
The fixed costs are
separable for each division. You are required to advise on the transfer price
to be fixed for Division X’s component under the following circumstances.
(i)
Division X can sell the component in
a competitive market for Rs 10 per unit. Division Y can also purchase the
component from the open market at that price.
(ii)
Along with the situation mentioned in
(i) above further assume that Division Y currently buys the component from an
external supplier at the market price of Rs 10 and there is a reciprocal
agreement between the external supplier and Division X. Under this agreement,
the external supplier agrees to buy one unit of component from Division X at a profit
of Rs 4 per unit to Division X, for every component which Division Y buys from
the external supplier.
Illustration: 2
A company fixes the inter-divisional
transfer prices for its products on the basis of cost plus an estimated return
on investment in its divisions. The relevant portion of the budget for the
Division X for the year 2015 -16 is given below:
|
Particulars |
Rs |
|
Fixed assets |
5,00,000 |
|
Current assets (other than debtors) |
3,00,000 |
|
Debtors |
2,00,000 |
|
Annual fixed costs for the division |
8,00,000 |
|
Variable costs per unit of product |
10 |
|
Budgeted volume of production per year (units) |
4,00,000 |
|
Desired rate of return on investment |
28% |
You are required to determine the
transfer price for Division X.
Illustration: 3
XYZ Ltd which has a system of
assessment of Divisional Performance on the basis of residual income has two Divisions,
Alfa and Beta. Alfa has annual capacity to manufacture 15, 00,000 numbers of a
special component that it sells to outside customers, but has idle capacity.
The budgeted residual income of Beta is Rs 1, 20, 00,000 while that of Alfa is
Rs 1, 00, 00,000. Other relevant details extracted from the budget of Alfa for
the current year were as follows:
|
Particulars |
|
|
Sale (outsider customers) |
12 Lakh units @ Rs 180 p.u. |
|
Variable costs per unit |
Rs 160 |
|
Divisional fixed costs |
Rs 80 Lakh |
|
Capital employed |
Rs 750 Lakh |
|
Cost of capital |
12% |
Beta has just received a special
order for which it requires components similar to the ones made by Alfa. Fully
aware of the idle capacity of Alfa, Beta has asked Alfa to quote for
manufacture and supply of 3, 00,000 numbers of the
components with a slight modification during final processing. Alfa and Beta
agree that this will involve an extra variable cost of Rs 5 per unit.
You are required to calculate the
transfer price which Alfa should quote to Beta to achieve its budgeted residual
income.
Illustration: 4
Transferor Ltd. has two processes –
Preparing and Finishing. The normal output per week is 7,500 units (completed)
at a capacity of 75%.
Transferee Ltd. had production
problems in preparing and requires 2,000 units per week of prepared material
for their finishing process.
The existing cost structure of one
prepared unit of Transferor Ltd. at the existing capacity is as follows.
|
Material: |
Rs 2.00 (variable 100%) |
|
Labour: |
Rs 2.00 (variable 50%) |
|
Overheads: |
Rs 4.00 (variable 25%) |
The sale price of a completed unit of
Transferor Ltd. is Rs 16 with a profit of Rs 4 per unit.
Contrast the effect on the profits of
Transferor Ltd. for 6 months (25 weeks) of supplying units to Transferee Ltd.
with the following alternative transfer prices per unit.
(i)
Marginal Cost
(ii)
Marginal Cost + 25%
(iii)
Marginal cost + 15% return on capital
employed. (Assume capital employed Rs 20 lakhs)
(iv)
Existing Cost
(v)
Existing Cost + a portion of profit on
the basis of [(preparing cost ÷ total cost) × unit profit]
(vi)
At an agreed market price of Rs 8.50.
Assume no increase in the fixed
costs.
Illustration: 5
Division A is a profit centre that
produces three products X, Y and Z and each product has an external market.
The relevant data is as follows:
|
Particulars |
X |
Y |
Z |
|
External market price per unit (Rs) |
48 |
46 |
40 |
|
Variable costs of production
(Division A) (Rs) |
33 |
24 |
28 |
|
Labour hours per unit (Division A) |
3 |
4 |
2 |
|
Maximum external sales units |
800 |
500 |
300 |
Up to 300 units of Y can
be transferred to an internal division B. Division B has also the option of
purchasing externally at a price of Rs 45 per unit.
Determine the transfer price for Y,
if the total labour hours available in division A is:
(a)
3,800 hours
(b)
5,600 hours
Illustration: 6
Arthur C
Doyle & Company is a multidivisional company and its managers have been
delegated full profit responsibility and autonomy to accept or reject transfers
from other divisions.
Division X
produces a sub-assembly with a ready competitive market. This sub-assembly is
currently used by Division Y for a final product that is sold outside at Rs
1,200. Division X charges Division Y market price for the sub-assembly which is
Rs 700 per unit. Variable costs are Rs 520 and Rs 600 for Division X and Y
respectively.
The manager
of Division Y feels that Division X should transfer the sub-assembly at a lower
price than the market price because at this price Division Y is unable to make
profit.
Required:
1.
Compute
Division Y’s contribution margin if transfers are made at the market price and
also the total contribution margin of the company as a whole.
2.
Assume that
Division X can sell all its production in the open market. Should Division X transfer
the goods to Division Y? If yes, at what price?
3.
Assume that
Division X can sell in the open market only 500 units at Rs 700 per unit out of
1,000 units that it can produce every month and that a 20% reduction in price
is necessary to sell at full capacity. Should transfers be made? If yes, how
many units should be transferred and at what price? Submit a schedule showing
comparisons of contribution margins under the three different alternatives to
support your decision.
Illustration: 7
The WEBEL
Ltd. manufactures and sells television sets. The Assembly Division assembles
the television sets. It buys the picture tubes for the television sets from the
Picture Tubes Division. The Picture Tubes Division is operating at capacity.
The incremental cost of manufacturing the picture tubes is Rs 700 per unit. The
Picture Tubes Division can sell as many picture tubes as it wants in the
outside market at a price of Rs 1,100 per picture tube. If it sells picture
tubes in the outside market, the Picture Tubes Division will incur variable
marketing and distribution costs of Rs 40 per unit. Similarly, if the Assembly
Division purchases picture tubes from outside suppliers, it will incur variable
purchasing costs of Rs 20 per screen.
Required:
1.
Using the general
guideline on transfer pricing policy what is the minimum transfer price at
which the Picture Tubes Division will sell picture tubes to the Assembly
Division?
2.
Suppose
division managers act autonomously to maximise their own division’s operating
income, either by transacting internally or by buying and selling in the
market. If the two division managers were to negotiate a transfer price, what
is the range of acceptable transfer prices?
Illustration: 8
Division A
is a profit centre, which produces four products P, Q, R and S. Each product is
sold in the external market also. Data for the period is as follows:
|
Particulars |
P |
Q |
R |
S |
|
Market
price p.u. (Rs) |
350 |
345 |
280 |
230 |
|
Variable
cost of production p.u. (Rs) |
330 |
310 |
180 |
185 |
|
Labour
hours required p.u. |
3 |
4 |
2 |
3 |
Product S
can be transferred to Division B but the maximum quantity that might be
required for transfer is 2,000 units of S.
The maximum
sales in the external market are:
|
P |
3,000
units |
|
Q |
3,500
units |
|
R |
2,800
units |
|
S |
1,800
units |
Division B can
purchase the product S from the market at a slightly cheaper price of Rs 225
per unit instead of receiving transfers of the same product from Division A.
What should
be the transfer price for each unit of 2,000 units of S, if the total labour
hours available in Division A are?
(i)
24,000 hours?
(ii)
32,000 hours?
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