Strategy Performance Management: Transfer pricing

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CO5126 – Strategy Performance Management

TABLE CONTENT

INTRODUCTION

OVERVIEW ABOUT TRANSFER PRICING

1.Transfer pricing objectives

2.Alternative transfer price policies

DECENTRALIZATION AND THE TRANSFER-PRICE PROBLEM

TRANSFER PRICING CASE OF GENERAL APPLIANCE CORP

1.Company overview

2.The Stovetop Problem - involving the Chrome Products Division and the Electric Stove division.

3.Comments on the Stovetop Problem

RECOMMENDATION & CONCLUSION

LIST OF REFERENCE

INTRODUCTION

Transfer pricing is one of the most efficient management accounting tools that deals with the pricing of goods and services transferred between branches, divisions, companies, and other legal entities inside and/or outside the country in which a company’s headquarters is located. Transfer prices have been defined as the monetary values assigned to goods and services transferred between the units of the same company (Oyelere & Emmanuel, 1999). The term “transfer pricing” is often used in Australia business to refer to price charged for international transfer of goods and services between business units, and this is of interest to specialists in income tax. Business often used term “internal service charge” to refer to domestic transfer pricing (Langfield, 2009). The transfer prices are effectively internal selling prices used within the decentralization of companies — the creation of the responsibility canters and responsibility accounting and the issues of transfer pricing in accounting are closely related to these entities in which goods and services are often transferred between investment centres and profit centres. This paper will examine some problem when implement transfer pricing as a concept of domestic transfer in decentralization organizations and analysis a specific case in General Appliance Corp Pty Ltd which manufactures consumer durables and is a decentralized, divisional organization.

OVERVIEW ABOUT TRANSFER PRICING

1. Transfer pricing objectives

The following are the most dominant objectives of domestic transfer pricing:

  • Making good economic decisions that maximize total company profits.
  • Performance evaluation.
  • Management motivation.
  • Goal congruence.
  • Ensuring that divisional autonomy is not undermined.
  • Simplicity and cost of administration.
  • To intentionally move profits between divisions.

In practice, transfer prices can be used when:

  • Semi-product is transferred to the next stage of the production process, or is sold in the market;
  • The company has plants located in various cities or regions, and these plants constitute autonomous organizational units;
  • There exist departments assisting production in the company, whose products or services can be sold outside (for instance, workshops, canteens);
  • The related (interdependent) companies are based in the same country, but in different cities; and
  • Plants of multinational companies are situated in the territories of various countries.

2. Alternative transfer price policies

The following important aspects should be taken into account when establishing transfer prices (Ronen, 1970):

  • Transfer prices should lead to goal congruence among individual responsibility centres and the company as a whole;
  • Transfer prices should motivate appropriate decision making;
  • Transfer prices should not limit the autonomy of individual units;
  • Transfer prices should be used to assess the activities of managers administering individual responsibility centres; and
  • It must be recognized that there is no single best transfer price for all situations.

According to the particular criterion chosen as a basis for pricing, the following transfer prices can be distinguished:

  • Prices based on the market prices: These can be the prices that a unit achieves upon the external sale of its products, or can be market prices used by other companies.
  • Prices based on costs: These can be actual, planned, or normative costs of production at the level of variable, full costs; or can be prices such as ‘cost plus margin’, ‘cost plus opportunity cost’, ‘marginal cost’.
  • Negotiated prices: These are established on the basis of negotiations among individual, independent units.
  • Dual prices: These are set on different levels for the supplier and the purchaser.

Most attention will be devoted to the use of market-base transfer prices and that is the best meet the needs of the total organization in Australia. In one variant of this system, profit centres are given authority to test as use the outside market. They can buy and sell inside the firm or outside, depending on where the greatest profit for the profit centre is.

DECENTRALIZATION AND THE TRANSFER-PRICE PROBLEM

The trend toward decentralization with its multiplicity of internal “profit centre” has given rise to the thorny problem of setting prices for transactions within a company (Cook, 1995). This is that a company, in decentralizing, expect to increase its profitability by giving direct profit incentives and evaluations to more people in management; if this is to be successful, the company must insure that one profit centre is not led to increase its profits by reducing the profits of the company as a whole. Other side of this problem is that the possibilities for an intelligent transfer price system tend to show the extent to which a company can decentralize successfully and the form which decentralization should take. It also is the limitations of decentralization and it is most likely that decentralization is successful if one of the following conditions is satisfied:

  • “It is undertaken on a divisional basis, so that transfers are minimized; this could be accomplished by either a product diversion organization where productive facilities are separate or by a geographical decentralization.
  • There are fairly well-developed markets which can be tested or used as reference points in setting transfer prices”

The limit of decentralization might be beyond these two conditions. After these conditions it is usual that a further decentralization of a profit centre would increase the profit of the specific profit centre, but unfortunately this would result in a lower profit for the company as a whole. Overall, every transfer pricing method has its advantages and disadvantages. This applies for the matter of decentralization as well. Until a certain point it can be advantageous for a company, but after that point it might only be an advantage for a certain part, department or unit of a company, but not for the company as a whole. In the purpose of making this matter more clear, this paper will analysis a specific case of General Appliance Corp Pty Ltd, which is a decentralized company that apply the market-base method for internal transfer pricing.

TRANSFER PRICING CASE OF GENERAL APPLIANCE CORP

1. Company overview

General Appliance Corp Pty Ltd is a private company categorized under Non-Bank Holding Companies and located in Burnie, TAS, Australia; manufactures consumer durables and is a decentralized, divisional organization made up of 4 Product divisions, 4 Manufacturing divisions and 6 staff offices (Shulman, 1968).

The Product divisions are responsible for the design, engineering, assembly and sale of a variety of home appliances. They manufacture very few component parts and as a result look to either the manufacturing divisions or outside suppliers for stocks of these parts. The parts made by the manufacturing divisions, about 75% of which are sold to the product divisions, are produced to specifications provided by the product divisions, who are responsible for the designs.

Company policy states that the divisions are expected to deal with one another, as though they were independent companies. However, in many instances, this policy could not be observed because the product division involved did not have the power to decide whether to buy from the manufacturing division within the company or from an outside supplier.

Transfers prices for the parts are arrived at by negotiation between the divisions, are usually based on the prices paid to outside suppliers for comparable parts and are also adjusted to reflect differences in the design of the outside part compared with that being produced within the organization. Where the divisions cannot agree a price, they can submit the dispute to the finance staff for arbitration.

2. The Stovetop Problem - involving the Chrome Products Division and the Electric Stove division.

Owing to complaints from customers and dealers relating to the quality of the company's products, John Smith - the head of the production staff office found down that the appearance of a chrome-plated stovetop, made by the Chrome products division for the Electric stove division but formerly manufactured by an outside supplier was not satisfactory.

He therefore increased the minimum acceptable quality level for these Stovetops by making the best of a particular batch the standard, and as a result, rejects increased to more than 80% of the quantity being produced. In turn, this high rejection level led to a study of the manufacturing process by the Chrome products division and the production staff, following which additional processes (copper plating and buffing) at the beginning and end of the manufacturing cycle was included. Whilst these additional processes had the effect of cutting the rejection rate to less than one per cent, they increased the Chrome products division costs by 40 cents per unit.

During the month following the changes in the manufacturing cycle, the Chrome products division proposed that the transfer price to the Electric Stove division be increased from $5.00 a unit to $5.45 to cover the cost of the additional operations and profit. On the other hand, this price increase was opposed by the Electric stove division; on the grounds that there had been no change in engineering specifications so they felt that should not give the supplying division the right to increase the price. Further, they contended that they had not requested or consulted for improvement in quality, and in any case they were doubtful if their customers would notice the difference in quality standards before and after the change in the manufacturing cycle. It was argued that the improvement in quality only brought the part up to the level previously attained by the outside manufacturer, so that the cost was included in the $5.00 transfer price.

Finally, the Electric Stove division stated that if 45 cents was to be added to the cost of the stove, they could add features which would have a much more significant effect on its marketability than this quality improvement. The argument of the manager of the Chrome Products division for the increase in price was based on the fact that the production staff had required him to add operations to his manufacturing process, that these operations had resulted in improved quality that could benefit only the Electric stove division and that had the outside supplier been required to meet the new quality standard, the price would have been increased by 45 cents.

The dispute was submitted to the finance staff for arbitration. During the review by the finance staff, the engineering department of the production staff stated that the costs proposed by the Chrome Products division were reasonable and represented efficient processing. Similarly, the quality control department of the manufacturing staff when approached by the finance staff stated that the quality was improved and that the new parts were of superior quality to the parts previously supplied by the outside manufacturer.

3. Comments on the Stovetop Problem

An important point to emerge from this problem is that it demonstrates one of the advantages of decentralized profit control. If profit control had been operated on a centralized basis, none of the participants in the dispute would have been greatly concerned about the extra cost of the improvement in quality. The head of type production staff would have achieved his aim of improving quality, the works manager would have obtained budget authorization to offset the increased costs plus improved quality which no doubt would have improved his relationship with quality control, and the sales force would be marketing a product whose appearance had improved. Even if any of the above personnel was fully aware of the fact that the company was wasting money, in a centralized profit control situation there would be little incentive for any of them to take steps to cut cost.

RECOMMENDATION & CONCLUSION

In conclusion, the paper concentrates to define the transfer pricing as a concept of internal transfer prices. There are several ways of setting transfer prices namely market-based, cost-based, negotiation and so on. In Australia, the market-based method is the most popular with more than 50 percentage of decentralization organizations rely in domestic transfer. However, there is a significant matter that rises in implementing this method is, in decentralizing, the profit of one centre can be led to increase by reducing the profits of the company as a whole. Therefore, one of the most attentions for decision making in internal transfer pricing is setting a reasonable transfer prices to ensure the profit of the company as a whole.

LIST OF REFERENCE

Cook (1995). Decentralization and the transfer price problem. Retrieved on 5 January, 2014 from

http://www.jstor.org/discover/10.2307/2350901?uid=3737496&uid=2&uid=4&sid=21103341667713

Langfield (2009) Management accounting, 5e, Mc Graw Hil, page 613

Oyelere & Emmanuel (1999). Environmental factors affecting the international transfer pricing decisions of multinational enterprises: a foreign-controlled versus UK-controlled companies’ comparison. Retrieved on 5 January, 2014 from

http://www.asu.edu.jo/TestWeb/userfiles/file/HumanitiesSeries-pdf/Volume-11-2008/Number-2/Transfer Pricing in Jordanian Manufacturing Companies..pdf.

Shulman (1968). Transfer pricing in the multinational firm. Retrieved on 15 January, 2014 from https://dspace.mit.edu/bitstream/handle/1721.1/49304/transferpricingi00shul.pdf?sequence=1

Ronen (1970). Transfer Pricing for Divisional Autonomy. Journal of Accounting Research, Spring, 8 (1), pp. 89-112.

Transfer pricing 1

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