Management Accounting: Transfer Pricing Practice

Discuss about the Management Accounting for Transfer Pricing Practice.

Introduction 

Transfer pricing is a tool set by the management for the purpose of calculating the price which is required to sale goods among its own divisions or branches in the same country or may be in another country. The important feature is that the decentralized firms to operate as responsible profit centres through Cost, Profit, Revenue, Investment motives. The idea of transfer pricing is to reduce the bad decisions and make the optimal decision. The transfer pricing is the price that one division charges the other division in the same company for a product transferred from one division to another (Ey, 2016). 

Purpose of Transfer Pricing

Transfer pricing done by a company to generate more profit or cost for each division as profit centres.

Generation of respective divisional profits and to help evaluate the performance of each division separately.

To help create better coordination among various divisions like production, sales and pricing decision makers (Taxjustice, 2016). 

The Transfer Pricing Mechanism is Like—

The transfer pricing among divisions are used mainly for record keeping and thus involves no physical movement of money or fund.

The transfer price when multiplied by quantity of goods exchanged between the divisions becomes an expense for the division purchasing and becomes profit generator for the division selling. 

Accounting for transfer pricing—when an intra company transfer pricing is affected then appropriate elimination entries are to make for covering prices in excess of costs. Eliminations are to be done for;

-Intra Company cost of goods sold and sales.

Intra company inventories related profits.

Intra Company payable and receivables.

Methods for Transfer Pricing are—

Cost based transfer pricing—when the market price is not available then the company bases transfer price on the production cost of the division supplying. The most used methods are

Full cost.

Cost plus.

Dual transfer prices.

Variable cost with opportunity cost.

Variable cost with lump-sum charge.

Negotiated transfer pricing—Negotiated transfer pricing is typically combines with free sourcing. The divisional managers do always make negotiations to find a mutually agreeable transfer price for the said method. In some companies the Headquarters control the negotiation for all divisions for better control (Pwc, 2016).

Market based transfer pricing—the competitive and stable market price is used for pricing foe upper bound transfer but when the market is in bad condition.  

1. There are various types of Transfer Pricing. The actual total cost based transfer pricing are not appropriate as the basis for divisional performance management. To understand this we need to study in details.

The main areas where the said method is not the right method for performance measurement can be easily understood from the adjustment needed to be done if Cost plus method is applied. Gross profit margin needs to be kept stable by making following adjustments--

1. Cost structures of assets which are very old.
2. Management efficiency.
3. Contractual terms like warranties provided, purchase or sales volumes, credit terms, transport terms, etc.
4. The manufacturing or assembling operations.
5. Working capital like debtors, creditors, inventories, etc.
6. The activities to be controlled like purchasing, procurement, and inventory control (Imfacademy, 2016).

The main difficulties of this method is stated herby—

1. The most important difficulty in applying Cost Plus method is that extensive details are required for cost based for usage in the mark ups of the controlled and the uncontrolled transactions for getting the actual results.
2. It is difficult to make appropriate adjustments in market conditions, management efficiency, exclusive rights, economies rights, etc.
3. Cost plus method gets doubtful when there are too much intangibles and very high risk involvement (Lanewala, 2012).  

Conclusion:

The biggest disadvantage of Cost plus method is that all elements of product costs of the selling division will be transferred to the buying division. The measurement of any incentive is very difficult and also all inefficiencies or actual costs any variance will be passed on to the purchasing division. The problem of variance isolation thus passed to the buying division becomes very difficult thus making it vulnerable to make impractical cost management. 

2. The assessment process would include assessment effective capability of each unit in profit making. According to transfer pricing mechanism various departments showcase their capacity to cost control and profit maximization. The assessment based on contribution will indicate profitability of the organization. It is well known that higher contribution margin is the indication of higher profitability as fixed cost is constant even for higher capacity of production.  The formula for calculation of contribution margin is;

Contribution Margin

Sales-Variable Cost

Sales

According to the given problem, selling price for cleaning and scrapping division would be $95 per unit and for processing division it would be $160. If cleaning and scrapping division sells goods in open market then it incur variable selling cost of $5 per unit. Therefore during the calculation of contribution per unit variable selling cost of $5 per unit is to be considered as part of the variable cost, as the transfer pricing concept suggests that sales price is to be assumed at the arms’ length (Managementstudyguide, 2015). 

Particulars	Cleaning and Scraping  Division	Processing Division
Sales	$                  95.00	$      160.00
Units	400,000	400,000
Direct material	$                        18	$                5
Direct labour	$                        12	$              10
Manufacturing overhead	$                        40	$              25
Variable Cost
Direct material	$                        18	$                5
Direct labour	$                        12	$              10
Manufacturing overhead	$                        30	$              10
Selling cost	$                          5
Vaiable Cost	$                        65	$              25
Fixed Cost	$          4,000,000	$6,000,000
Contribution Margin
Sales-Variable Cost	31.58%	84.38%
Sales

3. The negotiation method is generally accepted principle when all the buying and selling divisions and its headquarters agrees to make mutually agreed pricing for making transfers effective between various divisions and units.. Negotiated pricing is the mid way between the cost plus method and market based method. The divisional managers in buying and selling divisions act like the managers of separate companies and not like from Intra Company managers. The strategies followed for negotiation will be like trading with outside parties. In case of output of the selling division cannot be sold to the external market the negotiation price will be the basis and total margin will be thus shared by all divisions (Kpmg, 2016). 

In this case The Complete Mining and Manufacturing Company can easily follow the negotiation transfer pricing by

1. It gives freedom to sell or buy outside by making proper bargaining in the open market.
2. Both the divisions should be making proper negotiations by sharing all market information among them so that the negotiated transfer price thus derived is close or nearer to opportunity market open cost.
3. The strength and skill of the divisional managers in negotiations of the transfer pricing could vary extensively and also avoids the bilateral monopoly stage.
4.  Top management must also get involved in the negotiation of transfer pricing procedure among various divisions so that a transparent method is followed and the divisions should function in a healthy manner as also in friendly manner as all of them form the inner part of the same organization ultimately. The negotiated price helps to avoid mistrust, bad and hurt feelings, unaccepted bargaining hardships and it also promotes accurate performance evaluation, opportunity to achieve the target set, and goal congruent atmosphere (OECD, 2016). 

But the divisions as well as the top management needs to be very serious and keep note of bad areas of negotiated pricing are

1. The efforts thus put in by divisions and management including time, resource and efforts can be wasted if not reached at right point.
2. The entire process depends on the divisional manager; if any factor is not taken care of then the divisional performance will be highly affected.
3. To avoid any conflict and infighting among divisions.
4. One divisional manager having some secret information may take undue advantage on other.
5. If the opportunity cost of supplying the goods transferred is lower than the negotiated price then it affects the suboptimal output level.

4. Cleaning and Scraping division wants to have lowest transfer price by general transfer pricing rule.

Let us see general rule specifies the transfer price as a sum of two components.

1. They are output cost incurred being the first component for goods & services transferred. Output cost includes any transfer cost & direct variable costs of the goods and services transferred.
2. The other component in the general transfer rule is opportunity cost which is a benefit that is not considered sometimes as a result of some action and it also is incurred as a result of transfer thus affected.

In broad sense, transfer price is additional outlay cost per unit incurred transferred including opportunity cost per unit to the company for goods transferred respectively (Akmglobal, 2016).

References: 

Akmglobal, 2016. Introduction to Transfer Pricing. [Online] www.akmglobal.com Available at: http://www.akmglobal.com/transfer-pricing.html [Accessed 10 September 2016].

Ey, 2016. Transfer Pricing Advisory & Operating Model Effectiveness. [Online] www.ey.com Available at: http://www.ey.com/IN/en/Services/Tax/Transfer-Pricing-and-Operating-Model-Effectiveness [Accessed 10 September 2016].

Imfacademy, 2016. Transfer Pricing. [Online] www.imfacademy.com Available at: http://www.imfacademy.com/areasofexpertise/tax/Transfer_Pricing.php [Accessed 10 September 2016].

Kpmg, 2016. Transfer Pricing. [Online] home.kpmg.com Available at: https://home.kpmg.com/in/en/home/services/tax/transfer-pricing.html [Accessed 10 September 2016].

Lanewala, M., 2012. Cost & Management Accounting & Performance Management. [Online] Available at: http://managementaccounting.accasupport.com/2012/08/types-of-transfer-pricing-for-measuring.html [Accessed 13 September 2016].

Managementstudyguide, 2015. Financial Management - Meaning, Objectives and Functions. [Online] Available at: http://www.managementstudyguide.com/financial-management.htm [Accessed 29 February 2016].

OECD, 2016. Transfer pricing. [Online] www.oecd.org Available at: http://www.oecd.org/ctp/transfer-pricing/ [Accessed 10 September 2016].

Pwc, 2016. Transfer pricing. [Online] www.pwc.com Available at: http://www.pwc.com/gx/en/services/tax/transfer-pricing.html [Accessed 10 September 2016].

Taxjustice, 2016. Transfer Pricing. [Online] www.taxjustice.net Available at: http://www.taxjustice.net/topics/corporate-tax/transfer-pricing/ [Accessed 10 September 2016]. 

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