Looking at transfer pricing

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The price which one division of an organization charges for good or service to deliver it to another division of same organization is known as Transfer Price. Among transfer pricing shifting of physical goods and intangible property and providing services to related parties takes place. Transfer pricing is a vital aspect for the controlling party as it helps them to reduce tax rate and also becomes valuable for transactions happening across different tax jurisdictions. Since there being no external market for the products being transported, Cost Based approach to transfer pricing is suggested. This cost approach of transfer price employed in the organization has a major impact on the financial production of other divisions and has substantial influence on the income, expenditure and profit of responsibility centers. Therefore Cost Based transfer pricing is suitable when accounting is to be applied for the aim of divisional performance measurement. Another approach of transfer pricing is based on Full Cost. Under this approach full cost (comprising fixed overhead costs) is charged to receiving division which does not give true picture of cost and revenue being charged which distorts their profit performance. Therefore full cost based transfer pricing is not appropriate for divisional measurement. Transfer prices are also based on Cost plus a Normal Mark-up price. Under this approach an additional profit or mark-up is included in cost of production. It aims to meet the performance estimation grounds of transfer pricing by providing a profit to selling divisions for the products and services being transferred. This makes cost plus a normal mark up transfer price an appropriate measurement of divisional performance.

After taking market price as the transfer price contribution margin for division A and B are £190000 and £720000 respectively. (Appendix 1)

Since division B manager is unhappy selling entire output at manufacturing cost of 110 per cent. So after having negotiations they have come up with a price range that neither reduces the profit of division B nor give a benefit to division A. After resolving the prices mutually they have decided the price range of Alpha would be somewhere between £76 - £80 which would be accepted by both divisions and would allow them to sell and buy on the open market.

Company can transfer their products and services on the basis of three transfer prices: - cost based, market based and negotiated transfer price. Looking at the present situation of Pvaslgun plc it can be perceived that Division B manager is unhappy transferring the entire output of 20,000 units of Alpha to Division A at manufacturing cost of 110 percent. So for the satisfaction of both the divisions their managers have to deal on the basis of negotiated pricing. Negotiated pricing refers to the method in which prices are settled between the managers of receiving and supplying division through negotiations. Primary advantage of this process is that a price mutually is decided which is beneficial for both the divisions. This technique can be mostly used in circumstances where receiving division has the preference of suppliers and selling division has the preference of consumers or when there are imperfections in the market such as existing of different market prices. This gives the managers liberty to get engage in a bargain process outside the company by selling and buying. Through this bargain method misallocating the resources is eliminated and decisions are made that could well maximize the company's total profits. Therefore Negotiated transfer pricing is most likely to be used to extract desirable management behaviour at Pvaslgun and for the benefit of the overall business both the divisions should crop up with a price lying between £76 - £80.

PART B

In measuring the financial performance of an organization the following features are evaluated:-

Residual Income

The net operating income that a company receives above the minimum required return on their working assets is known as Residual Income. Residual income is one of the method through which the performance of divisional manager is evaluated. Many companies have recently adopted Economic Value Added (EVA) as an assumption of residual income. Under EVA, companies frequently adjust their accounting values. Nowadays companies are executing residual income for performance measurement reasons.

Strengths of residual income model include:

Residual income boosts itself when investments producing beyond the cost of capital are accepted and investment producing lower than the cost of capital is eliminated. Residual income raises if a new investment comes up which makes profit in surplus of interest rate charged on the cost of the assets purchased.

It can evaluate stocks that do not have steady cash flows

Also Residual income plays a vital role in encouraging goal congruence

Concentrates more on money-spinning, rather than productivity

Weakness of this model includes:

Focuses more on accounting data (that can be manipulated)

May need modification based on accounting system, mostly in cases of dirty surplus

It ignores the time value of money as is done in case of multiyear projects

Return on Investment

Another approach used to examine the performance of investment centre is Return on Investment (ROI). Return on investment (also known as rate of return) is an operation measure used to estimate the effectiveness of an investment or to evaluate the efficiency of number of distinctive investments. It is a generally considered key measure for a company because of its simplicity and flexibility. Other features that make ROI preferable and distinctive are:-

It links directly with the accounting process and can be easily recognized from the balance sheet (profit and loss account)

Its importance can also be seen as it being the only measure of performance existing through which ROI of company with single enter unit can be calculated

Advantages:-

Managers are provoked to make acceptable decisions as it can be used as measure for the betterment of the company's overall execution

It is more suitable to be compared with other financial measures

It is also preferred over RI as it being a ratio can be used for comparing within the divisions and firms

However there are certain weaknesses of ROI as well:

While evaluating divisional managerial performance it persuades the managers to exploit the ratio which can lead to suboptimal decisions

While calculating ROI age factor is not taken into consideration which means no significant difference between old and fresh assets

For proper running of old assets repair cost is required which reduces the profitability of investment centre which overall reduces the ROI

Technological change and inflation also play a major part in altering the cost as with the span of time price changes and with new technology coming up it may vary the ROI of an investment centre

Net Present Value (NPV):-

NPV plays a vital role in production investment decisions. Net present Value (NPV) is measured as value of future cash inflows (or net benefits) minus the cost of investment and cost of associated future outflows. NPV with positive value is considered as profitable and is taken into account and NPV with negative value is ignored.

Advantages:-

As it considers time value of money, it permits significance of things like interest rates, cost of capital and investment opportunity cost

It is specially suitable for lasting projects

Disadvantages:-

Calculation of NPV is responsive of discount rate so a minor change in discount rate may lead to a major change in NPV

Unlike accounting systems NPV looks at cash flows, not losses and profits

Comparison of absolute levels is not done by NPV while ranking investments

3. Part C

3.1 Decision making under Risk and Uncertainty

The features that help in the decision making and can be used as decision making under Risk and Uncertainty are:

Decision tree

Organization consistently faces situation in which painful divisions must be made. In some situations, complexity may be that, even after alternative options being there, the penalties of those options are not visible. In these cases the need of decision tree has been considered. Decision tree is a graphical chart that can sustain management in decision making. Major benefit of decision tree is that they are valuable for clarifying alternative route of action and their possible outcome and provide visual representation of options faced by the manager.

Advantages:-

It presents a clear signal of which areas are most essential for classification and prediction

They execute classification without involving much calculation

They are capable of holding categorical and continuous variables mutually

However there are certain limitations of model as well:

To know how precise is the data used in the building of the tree

How dependent are the estimate of the probabilities

The data used may be historical and is not related to valid time

Regret Criterion

Regret criterion is a method of decision making under conditions of risk and uncertainty under which the opportunity cost (or regret) linked with each probable course of action and their possible outcome is measured and the decision maker chooses the activity which diminishes the maximum regret or loss. Regret refers to the distinction between the worst and best possible payoff for each decision. The major advantage of this is that its importance can be seen in situations where information to be attach to each criterion is not available. The limitation of this method is that it does not take into account the features of every approach apart from the most extreme and overlook any comparative value of criteria which the decision maker desires to enforce.

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