P2 Chapter 10

• Profit managers


  May start looking at their own interests and take decisions that amplify their own profits but may not be beneficial to the organisation on a whole
• Head office interference


  Hurts the local autonomy
• Transfer pricing


  Interdependence between various departments or profit/ investment centres in terms of exchanging goods and services
• Profit centres


  Want to earn income from the transfers to maintain their performance
• Transfer price


  The price at which goods are sold internally
• Transfer price


  Causes sales income for the selling centre and purchase cost for the buying centre
• The two costs cancel each other out at the central level. Thus, profit is generated at the individual profit centres but no effect is made on the overall profits of the company on a whole
• Rules to remember for transfer pricing

  • Both divisions must have some benefit from the transaction or else they will not participate in it
  • The transfer price can be imposed by the head office, decided by commercial negotiation, decided amongst the managers themselves
  • For the selling division, the preference should be to sell internally and for the purchasing division, the preference should be to buy internally
  • However, if there is a commercial reason (availability of better prices externally) then the managers should have the option to buy/ sell from/ to an external party
• Purposes of decentralisation


  • Give autonomy to local centre managers in decision making
  • Motivate centre managers to improve performance
  • Through performance enhancement at a profit center level, to achieve better results for the whole organisation
• Budgeted data for a company with two profit centres, Centre A and Centre B, where Centre A supplies Centre B with a part-finished product
• Objectives of transfer pricing

  • Goal congruence
  • Performance measurement
  • Maintaining divisional autonomy
  • Minimising global tax liability
  • Recording movement of goods and services
  • Fair allocation of profits between divisions
• Basis for setting transfer prices

  • Market based prices
  • Cost based prices
  • Negotiated prices
• Perfect market

  All the produce can be sold in the market for existing market price. Thus market price approach in transfer pricing is appropriate
• Imperfect market


  In an imperfect market, pricing products is more difficult and profit maximisation model should be used (MR = MC)
• Non-existent market


  Since there is no market for the product, cost model should be used for transfer prices
• All goods and services should be transferred for opportunity cost
• Optimum transfer price with a competitive market for intermediate product


  Market price + any small adjustments
• Division A won't sell to division B if they are paying anything less than $20, since they can then easily sell the product outside for $20. Division B won't buy for a price higher than $20 because they can buy it from outside at $20. Hence optimum transfer price is the market price
• Optimum transfer price when there is a variable selling cost

  Market price - selling cost
• Optimum transfer price when selling division has surplus capacity

  Marginal cost
• Shadow price


  The opportunity cost of the lost contribution from the other product or it is the extra contribution that would be earned if more of the scarce resource were available
• Optimum transfer price with production constraints and no surplus capacity

  Marginal cost + shadow price
• Optimum transfer price for widget is $42 (market price of $45 less selling cost of $3)
• Possible solutions for transfer pricing when selling division has no surplus capacity

  • 2 part tariff
  • Cost plus pricing
  • Dual pricing
• 2 part tariff


  The transfer price is marginal cost, Additionally, a fixed sum is paid per period to the supplying division to cover fixed costs, and generate a profit
• Cost plus pricing


  A markup is added to the total or marginal standard cost. Actual cost is not used so that manager is motivated to keep the costs within standard limit
• Dual pricing


  If no common ground can be reached, one price is recorded by selling division and another by purchasing dept and the difference is recorded in HQ's books. This is not desirable for the overall welfare of the company
• International transfer pricing


  MNCs can have cross border transfers that lead to tax implications. MNCs try to minimise tax implications through cross-border transfers by reducing profits in high tax area and increasing profits in low tax area
• Calculation of after tax profits of a group with two subsidiaries, UKD in the UK and GD in Germany, where UKD makes and sells Product S99 and GD in Germany buys 400 units of S99 from UKD each year, adapts them for the German market, and sells them
• Government action on transfer pricing

  Government knows that MNCs try to minimise taxes. Many countries require justification for transfer prices. MNCs can be required to apply 'arm's length prices' which are market based prices. Countries that want to attract business may also have lax rules and maybe called 'tax haven'
• Features of tax havens

  • Low rate of tax
  • Low withholding tax on dividends paid to foreign companies
  • Tax treaties with other companies
  • No exchange control
  • Stable economy
  • Good communication systems
  • Well-developed legal framework
• Transfer pricing to manage cash flows

  Some governments might place legal restrictions on dividend payments by companies to foreign parent companies. In this situation, multinationals may sell goods or services to a subsidiary in the country concerned from other divisions in other countries, and charge very high transfer prices as a means of getting cash out of the country. However, if there are rules to maintain arm's length prices, this is not possible
• International transfer pricing and currency management

  When inter-divisional transfers are between subsidiaries in different countries or currency zones, a decision has to be made about the currency to select for transfer pricing. Exchange rates are volatile and can lead to forex profits/ losses
• Implications of international transfer pricing and currency management

  • Exposure to forex losses
  • When one subsidiary makes a loss on an adverse exchange rate movement, the other will make a profit
  • Management of exposures to currency risks might be the responsibility of either the profit centre managers or a treasury department
  • When it is fairly certain which way an exchange rate might move in the future, a multinational company might be tempted to set transfer prices in a currency such that any currency losses arise in the subsidiary in the high-tax country, and currency profits arise in the country with the lower tax rate