The essential feature of decentralization in large firms is the creation of responsibility centers (e.g. cost, profit, or investment centers). The performance of these responsibility centers is evaluated on the basis of various accounting numbers, such as standard and actual cost, divisional profit or return on investment. A central role of the management accounting system therefore is to evaluate (i.e. attach a dollar figure to) the transactions between the different responsibility centers. Under the subject cost allocation we studied alternative methods to charge user departments for the services rendered by service departments (frequently cost ...view middle of the document...
9. The use of transfer prices allows the company to generate separate profit figures for each divisions and thereby to evaluate the performance of each division separately.
Alternative Methods of Transfer Pricing
Transfer pricing policies specify the rules that are being used to calculate the TP. In addition, a TP policy has to be specific about the sourcing question, i.e., are divisions free to buy/sell externally or is it the case that internal transfers are mandated.
1. Market-based Transfer Pricing
In the presence of competitive and stable external markets, many firms take the external market price as a benchmark for their internal transfer price. Generally, the external market price provides a ceiling not to be exceeded by the internal transfer price.
Question: How would you argue that market price is the "correct" TP if the external market is perfectly competitive?
Issues with market-based TP:
• Imperfect Competition
• Distress Prices
-Protecting "infant" segments
2. Negotiated Transfer Pricing
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, H.Q. reserves the right to interfere in the negotiation process and impose an "arbitrated" solution.
Question: What do you perceive to be the major advantages/disadvantages of negotiated transfer pricing?
3. Cost-based Transfer Pricing
In the absence of an established market price many companies base the TP on the production cost of the supplying division.
1. Full (absorption) cost; either standard or actual. Popular because of its simplicity and clarity.
2. Cost-plus For transfers at full cost the buying division takes all the gains from trade while the supplying division receives none. To overcome this problem the supplying division is frequently allowed to add a mark-up in order to make a "reasonable" profit. The transfer price may then be viewed as an approximate market price.
EXAMPLE: The following example, however, illustrates potential problems with this TP method. The ABC company consists of two divisions: A and B. Division A's output is an intermediate product that is completed and marketed by the B division. The following cost and revenue information applies:
Division A: Fixed Cost : $4000
Variable Cost : $2 per unit
Division B: Fixed Cost : $3,000
Variable Cost : $10 per unit
Each unit of the final product requires one unit of the intermediate product plus certain other inputs (provided by Division B) leading to a variable cost of 10. For the final product y Division B estimates that the market demand curve is given by: P = 19 B .001 * y. Suppose that the supplying division is entitled to a mark-up of 25%...