accounting 615 - module 17

8/3/2019 Accounting 615 - Module 17

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Accounting 615

Module 17

Transfer Pricing

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Transfer Pricing

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GeneralMotors

Chevrolet

Buick

Sell Engines(Transfer Price)

Selling price iscalled Transfer

Pricing


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Transfer Pricing

Increase Transfer Price

Increase ROA Decrease ROA

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ChevroletBuick

ChevroletBuick

ChevroletBuick


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Customer

Buick Ford

Buy Motors from FordResult: GM loses cash to

rival company

Increase Selling PriceResult: GM loses market

share


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What is object of Transfer Pricing?

The objective of transfer pricing is to set a price where:

Managers of both divisions are satisfied

Company output increases

Company profit increases

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Transfer Pricing Techniques

Variable cost

Actual full cost (VC + FC)

Actual full cost plus profit margin

Budgeted cost plus profit margin

Market price

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Objectives of Transfer Pricing

1.The transfer price should be seen as fair and equitable by both divisions

(selling and receiving division)

2. The transfer price should provide an incentive to increase company profit

3. The transfer price should provide an incentive to increase overall companyoutput.

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Problem one

The parts division of an organization sells parts to the assembly division of the

same organization. The cost of making parts is $10 per unit. At a cost of $4 perunit, the assembly division assembles the parts purchased from the parts divisionand sells the assembled product to another organization for $23 per unit.

Part one: Part a

What is the profit per unit of the two divisions if the part divisions cost of $10per unit was used as the transfer price between the part division and the assemblydivision?

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Solution: Part a

What is the profit per unit of the two divisions if the cost f $10 per unit in the

parts department is used as the transfer price?

Parts Division > Assembly Division$10

Part one: Part b

Do you see any problems with this technique?

Main Problem

The manager of the parts division will be disgruntled as the parts division is notrecording any profit.

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Revenue$10Cost$(10)Profit0 Revenue$23CostBuy

(10)Assembly(4)Profit9


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Solution? Set a technique that generates a profit to the parts division.

Problem one: Part c

What is the profit per unit of the two divisions if the parts division uses a transferprice of cost plus 20% profit margin as the Transfer Price?(Assume the cost is the same as before, namely, $10)

Part Division Assembly Division$12

Do you see any problem with this technique?

In order to understand the problems with this technique, (Please view the nextquestion)

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Revenue$12Cost$(10)Profit2

Revenue$23CostBuy(12)Assembly(4)Pro

fit7

The company profit is $9


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Problem one: Part d

Assume the parts division used the same transfer Price as in Part c (i.e cost plus

20% profit margin). If they (the parts division) are inefficient and the costincreases to $14 per unit, what is the profit per unit of the two divisions?

Part Division Assembly Division$16.8

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Revenue$16.80Cost$(14.00)Profit2.80 Revenue$23CostTransfer(16.80)Assembl

y(4.00)Profit2.20


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Problems with using cost plus profit margin

1. Inefficiency is transferred to other divisions

2. The division that is inefficient appears to be more profitable

3. When company profit declines it is difficult to pinpoint responsibility

Solution?

Instead of using actual cost, use a budgeted cost plus profit margin technique.

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Problem one: Part e

Assume the company decides to use budgeted cost plus 20 percent profit margin

as the transfer price of the parts division. Assume the budgeted cost of the partdivision is they work efficiently is $10 per unit. In this scenario, what the profit ofthe two division?

Solution of problem one: Part e

Parts Division Assembly Division

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fit7




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Problem one: Part f

Assume the company decides to use the budgeted cost of $10 plus 20 percent

profit margin. If the parts division is inefficient and the cost increases to $14 perunit is the profit of the two divisions?

Solution

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fit7

Revenue$12Cost$(14)Profit(2)



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Advantages of Budgeted Cost plus profit method

1. If company profit declines, it is easy to pinpoint responsibility to the

department that is responsible for the problem.

2. Any inefficiency is not transferred to other divisions.

Disadvantage of budgeted Cost plus profit method

1. The budgeted cost is estimated, the unions would want this cost to be high aspossible.

2. Management would want this cost to be as low as possible.

3. Hence, the use of this technique could result in confrontation betweenmanagement and unions.

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How can we overcome the problems associated with the budgeted cost plus

profit technique?

We need a technique that avoids confrontation. The best technique is using themarket price.

Problem one: Part g

Assume the company decides to use market price as the transfer price. They find

that the market price is $14 per unit. What is the per unit profit of the two divisionsif the parts division incurred cost of $10 per unit?

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fit7




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Problem one: Part h

Assume the same case as before. The company decides to use the market price of

$14 per unit. What is the profit of the two divisions if the parts division wasinefficient and incurred cost $14 per unit?

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fit5

Revenue$14Cost$(14)Profit0 Selling Price $14


fit5



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Advantage of Market Price as Transfer Price

Other price is not contentious and will not create friction.

The price is objective

The price results in equitable distribution of profits

Disadvantage f Market Price as Transfer Price

Not all items have a market price (for example unfinished products)

If Market Price declines the profit of the transferring division will decline. This isnot the transferring divisions fault. It is beyond their control.

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What have we learned so far?

We learned the different types of transfer prices that are used by companies. We

learned the advantages and disadvantages of each.

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Problem two

The restaurant division of a hotel provides a catering service for the hotels

convention center. It charges outside organizations $19 per person for catering.(The catering services comprise a plate of hot food, starters and wine).

The convention division of a hotel can buy the same catering services for whichthe going market rate is $21 per person. You are the boss of the hotel whichcomprises the restaurant and convention center.

Required:

What transfer price should be used between the restaurant division and theconvention center to encourage decentralized decision making that will maximize

profit for the hotel?

(Assume you have a choice between $18, 19, 20, 21 and 22).

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Restaurant > Convention Center?

Revenue $19 Cost $21

RestaurantConvention

Center18 No Yes

19 Indifferent Yes

20 Yes Yes

21 Yes Indifferent

22 Yes No

Now you have a range of prices that could work (19, 20 and 21). At which pricewould company profit be maximized?

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They can buy cheaperfrom outside

They do not care(they can buy forthe same price )

They do not care


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Solution

The answer is 19. When a series of transfer prices could work if you want to

maximize profit, always choose the lowest.

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Problem three

Kali Company has two divisions. Each year the paper division makes 10,000 tons of

paper that costs this division $1,000 per ton. It can either sell all of the paper in themarket for $1,500 per ton or transfer all of it to Kalis Printing Division whichconverts it into gift wrap at an additional cost of $4,000 per ton. The gift wrap can

be sold for $5,200 per ton.

Problem three: Question one

What is the companys profit if the paper is transferred to the printing division?

Assume the transfer price is at cost. Is the transfer price beneficial to the company?

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Solution

Paper Division Printing Division

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$10M

Revenue$52MCostTransfer(10M)Add.

Cost(40M)Profit$2M

Revenue$10MCost$(10M)Profit0

Company Profit 2M


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Problem 3: Question 2

What is the companys profit if the paper is transferred to the printing division, but

the transfer price is at current market price? Would the paper division approve thisand would it be beneficial to the company?

Paper Division Printing Division

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$15M

Revenue$52MCostTransfer(15M)Add.

Cost(40M)Loss$3M

Revenue$15MCost$(10M)Profit$5M

Company profit is $2M


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Question 3:

Can you suggest any other strategy that would maximize profit for the company?

What are the costs of this strategy (if any)?

Solution

The objective is to maximize profit for the company. Kali Company could decide todiscontinue the printing division. If so, the profit of the company would be 4%

million instead of 2 million. This is referred to as downsizing. The costs are thegolden handshakes that have to be paid to the employees.

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International Transfer Pricing

The objective of international transfer pricing is to reduce tax liability.

Assume you are an international manager of a corporation with the main companyin a high tax country and subsidiary in a low tax country.

If the objective is to reduce tax liability, should the transfer price be set high or low?

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Problem 4 (International Transfer Pricing)

Pepsi Company ships 5,000 units of syrup from the United States to a foreign

country subsidiary that adds carbonated water and cans and sells the mixture.Suppose the US income tax is 40% and the foreign countrys tax rate is 20%. Thecost to manufacture and ship is $14 per unit. It costs the foreign subsidiary $10 perunit to add the water, can, and sell the drink for $80 per unit. The following tablesummarizes the tax rates, final sales price, operating costs and units transferred.

USA ForeignSubsidiary

TaxRate

40% 20%

Unitstransferredand sold

5,000 5,000

Incrementalcosts

$14 %10

Selling Priceper unit

?? $80

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Question:

1. If Pepsi Company can select a unit transfer price of $16 or $ 18 and the

objective is to minimize its tax bill in both countries, what transfer priceshould it select?

2. How do countries prevent multinational corporations from reducing taxliability via transfer pricing scheme?

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Solution: Problem 4

USA (High tax) Foreign Countries

Sales (5,000 @ $16) 80,000 Sales (5,000 @ $80) 400,000Less: Cost (5,000@14) (70,000) Less: Cost (5,000@14) (80,000)

Profit $10,000 Additional (5,000 @10) (50,000)

Profit $270,000

Tax @ 40% $4,000 Tax @ 20% $54,000

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Total combined tax (both countries)= $58,000


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Sales (5,000 @ $18) 90,000 Sales (5,000 @ $80) 400,000

Less: Cost (5,000@14) (70,000) Less: Cost (5,000@18) (90,000)

Profit $20,000 Additional (5,000 @10) (50,000)Profit $260,000

Tax @ 40% $8,000 Tax @ 20% $52,000

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Total combined tax (both countries)= $60,000


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Transfer Pricing

The objective is to reduce tax bill

When transferring from high to low tax country, keep the transfer price as low aspossible.

When transferring from low tax to high tax country, keep the transfer prices ashigh as possible.

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accounting 615 - module 17

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