Transfer Pricing

Transfer Pricing

Transfer pricing

Objective:

  1. Goal congruence: companies work together to use its capacity which lower the total group costs.
  2. Performance measurement: allocate profits targets among divisions.

Methods to set transfer price:

1. Market based approach

When used: when an external market exists

Advantages:

  • Fair price
  • Buying divisions do not always buy at high price (not adversely affect their performance)

Disadvantages:

  • No external market price
  • Market price may not be stable
  • Adjusted market price may need to be calculated to include the costs saving elements such as advertising and delivery costs

2. Cost based approach

When used: when an external market does not exist

Which cost to include:

  1. 1. Based on standard cost not actual cost
  2. 2. Based on full cost: price may be too high, affected by under/over absorption of overheads
  3. 3. Based on variable cost: price may be too low
  4. 4. Should also consider opportunity cost when the selling division does not have spare capacity.

3. Negotiated price approach

When used: when market prices are volatile and change occurs constantly.

Optimal transfer price:

  • Selling division: minimum transfer price: relevant cost (incremental cost + opportunity cost if no spare capacity exists)
  • Buying division: maximum transfer price: lower of net marginal revenue of the buying division and the external purpose price

Exam technique:

  1. Draw the picture: what is the selling and buying division
  2. How does it work, ie, selling which product and its capacity

Common exam questions:

1. To maximise group’s profit:

If the buying division accepts the offer from the external supplier, what is the impact on company’s profit?

Say: A sells to B, A’s marginal cost is $100 and would like to sell at $165 to B. B can buy the component from the external supplier for $140.

To the group as a whole, the cost of the component if it is produced and transferred internally, is $100 whereas it would be $140 from the supplier. Therefore, if the component is not transferred internally, company’s total profits will decrease by $40.

Do watch out if there is any potential savings if the component is not transferred internally, such as the department in A is shut down – therefore, savings will need to be considered. – Question 14 from Sept 2016 Specimen paper (Revision note)

2. Calculate profits or losses of each divisions and the group:

Selling division:

Sales revenue from internal sales – at transfer price

-Costs of making the product – external cost

=Profits or losses

Buying division:

Sales revenue from external sales – to final customers

-Costs of buying from selling division – at transfer price

-Additional costs of processing the product – external costs

=Profits or losses

Group:

Sales revenue from external sales – to final customers

-Additional costs of processing the product – external costs

=Profits or losses

Task: Please do go back to Kaplan study text to go through TYUs in the transfer pricing session.

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