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C.2. Transfer Pricing Essay

The document discusses transfer pricing, including defining it, objectives, and methods for determining transfer prices. It recommends using market-based transfer prices for the company described. It also notes how tariffs and taxes can affect transfer pricing and performance evaluation, and identifies four types of responsibility centers.

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Kondreddi Saku
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52 views7 pages

C.2. Transfer Pricing Essay

The document discusses transfer pricing, including defining it, objectives, and methods for determining transfer prices. It recommends using market-based transfer prices for the company described. It also notes how tariffs and taxes can affect transfer pricing and performance evaluation, and identifies four types of responsibility centers.

Uploaded by

Kondreddi Saku
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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1- Define transfer pricing.

2- Identify the objectives of transfer pricing.


3- Identify the methods for determining transfer prices.

 Explain the advantages and disadvantages of each method.


 Based on the scenario, which method should this company select? Explain
your answer.

4- How could tariffs, customs duties, or taxes affect transfer pricing and related
performance evaluation in this multinational company?
5- Identify and explain the four different types of responsibility centers.
1-

Explanation

Transfer pricing is the price one subunit, department, or division charges for a product or service
supplied to another subunit of the same organization.
2-

Explanation

The objectives of transfer pricing are to focus managers' attention on their own subunits and to
plan and coordinate actions across different subunits to maximize operating income for the
company as a whole. Transfer prices should help achieve a company's strategies and goals and fit
its organizational structure. They should promote goal congruence and a sustained high level of
management effort. The transfer price should also help top management evaluate the
performance of individual subunits and their managers.
3-

Explanation

1. The three main ways to determine transfer prices are as follows:


o Market-based transfer prices: Top management may choose to use the price of a
similar product or service publicly listed, for example in a trade association
website. Also, top management may select, for the internal price, the external
price that a subunit charges to outside customers.
o Cost-based transfer prices: Top management may choose a transfer price based on
the cost of producing the product in question. Examples include variable
production cost, variable and fixed production costs, and full cost of the product.
Full cost of the product includes all production costs plus costs from other
business functions (R&D, design, marketing, distribution, and customer service).
The cost used in cost-based transfer prices can be actual cost or budgeted cost.
Sometimes, the cost-based transfer price includes a markup or profit margin that
represents a return on subunit investment.
o Negotiated transfer prices. In some cases, the subunits of a company are free to
negotiate the transfer price between themselves and then to decide whether to buy
and sell internally or deal with external parties. Subunits may use information
about costs and market prices in these negotiations, but there is no requirement
that the chosen transfer price bear any specific relationship to either cost or
market price data. Negotiated transfer prices are often employed when market
prices are volatile and change constantly. The negotiated transfer price is the
outcome of a bargaining process between selling and buying subunits.

2. The advantages and disadvantages to each method are as follows:


o Market-based transfer prices generally lead to optimal decisions when three
conditions are satisfied. The market for intermediate product is perfectly
competitive, interdependencies of subunits are minimal, and there are no
additional costs or benefits to the company as a whole from buying or selling in
the external market instead of transactions internally.
 Achieves goal congruence when markets are competitive.
 Is useful for evaluating subunit performance when markets are
competitive.
 Motivates management effort.
 Preserves subunit autonomy when markets are competitive.
 However, a market may or may not exist, or markets may be imperfect or
in distress.
o Cost-based transfer prices are helpful when market prices are unavailable,
inappropriate, or too costly to obtain—for example, when the product is
specialized or when the internal product is different from the products available
externally in terms of quality and customer service.
 It often, but not always, achieves goal congruence.
 It is difficult unless transfer prices exceed full cost and even then is
somewhat arbitrary for evaluating subunit performance.
 It motivates management effort when based on budgeted costs; less
incentive to control costs if transfers are based on actual costs.
 Does not preserve subunit autonomy because it is rule-based.
 It is useful for determining full cost of products and services and it is easy
to implement.
o Negotiated transfer prices result from a bargaining process and preserve division
autonomy because the transfer price is the outcome of negotiations. Each division
manager is motivated to put forth effort to increase division operating income but
has a disadvantage of the time and energy spent on the negotiation.
 Achieves goal congruence.
 It is useful for evaluating subunit performance but transfer prices are
affected by bargaining strengths of the buying and selling divisions.
 It motivates management effort.
 It preserves subunit autonomy because it is based on negotiations between
subunits.
 Bargains and negotiations take time and may need to be reviewed
repeatedly as conditions change.

3. This company should use market-based transfer prices, as the market for the products is
competitive, interdependencies of subunits are minimal, and there are no benefits to the
company as a whole from buying or selling in the external market instead of transactions
internally.
4-

Explanation

Because management is often evaluated on the basis of subunit profits, it often cares deeply
about how transfer prices are set. Transfer prices can reduce income tax payments by reporting
more income in low-tax-rate countries and less income in high-tax-rate countries. However, the
tax regulations of different countries restrict the transfer prices that companies can use. Tariffs
and customs duties levied on imports can create similar issues. Companies have incentives to
lower transfer prices for products imported into a country to reduce tariffs and customs duties.
5-

Explanation

The four types of responsibilities centers are:

1. Cost center: The manager is accountable for costs only.


2. Revenue center: The manager is accountable for revenues only.
3. Profit center: The manager is accountable for revenues and costs.
4. Investment center: The manager is accountable for investments, revenues, and costs.

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