CIMA P2
Advanced Management Accounting
For exams in 2016
江西财经大学会计学院 吉伟莉
[email protected]
BPP LEARNING MEDIA
Chapter 7
Transfer pricing
—The aims of transfer pricing
—General rules
—Setting transfer prices
—Negotiated transfer prices
BPP LEARNING MEDIA
The aims of transfer pricing 1
Aim
— Maintain the right level of divisional autonomy
— Ensure divisional performance is measured fairly
— Ensure corporate profits are maximised
The aims of transfer pricing 2
How
— Transfer prices must be set to provide incentive and
motivation
— Although head office authority must ensure goal
congruence and prevent dysfunctional decision making
— Transfer prices must beat a fair commercial price to ensure
appropriate behavioural decisions by divisional managers
— The transfer price should encourage divisional managers to
agree on the amount of goods transferred
— This will also be at a level which is consistent with overall
organisational aims such as maximising company profit
The aims of transfer pricing 3
— Correctly-set transfer prices are therefore a way of
promoting divisional autonomy
— Ideally without prejudicing measurement of divisional
performance or overall corporate profit maximisation
General rules 1
Limits within which transfer prices should fall
The minimum
— The sum of the supplying division’s marginal cost and
the opportunity cost of the item transferred
The maximum
— The lowest market price at which the receiving division
could purchase the goods or services externally, less
any internal cost savings in packaging and delivery
General rules 2
Opportunity cost
— The opportunity cost included in determining the lower
limit will be one of the following:
— Maximum contribution foregone by the supplying
division in transferring internally rather than selling
externally
or
— Contribution foregone by not using the same facilities
for their next best alternative use
General rules 3
Example
— Division A produces product D at a marginal cost of
£350
— If a unit is transferred internally to division B, £70
contribution is lost on an external sale
— The item can be purchased externally for £480
— Minimum - Division A’s minimum would be £(350 + 70)
= £420
— Maximum - Division B’s maximum would be £480
— Savings from producing internally rather than buying
externally = £60.
General rules 4
— If there is no external market and no alternative uses
for the facilities, transfer price = standard variable cost
of production
— If there is an external market and no alternative uses for
the facilities, transfer price = market price
Setting transfer prices 1
Transfer prices based on market price
— What is the ideal transfer price where a perfect
external market exists?
— External market price
or
— External market price less savings in selling costs
— This applies whether or not variable costs and selling
prices are constant
Setting transfer prices 2
Merits of transfer prices based on market price
Divisional autonomy
— Profit centre managers have freedom to negotiate
prices with each other as though independent
companies
— Market-based transfer prices will tend to result
Divisional performance
— Where a market price exists but the transfer price is a
different amount
— Divisional managers will argue about the volume of
internal transfers
Setting transfer prices 3
Merits continued
Corporate profit maximisation
— Such an approach results in decisions which are in the
best interests of the organisation as a whole
Setting transfer prices 4
Transfer prices based on cost – constant unit variable
costs and selling prices
— If there is an imperfect external market, the transfer
price has to be based on cost
Standard or actual cost?
— The use of standard costs is fairer
— If actual costs are used the supplying division has no
incentive to control its costs
— It can pass on its inefficiencies to the receiving division
Setting transfer prices 5
Variable cost?
— The supplying division does not cover its fixed costs
— However this problem can be overcome by some form
of dual pricing or two-part tariff system
Full cost?
— The supplying division makes no profit
— As the transfer price increases, its effect on the
receiving division could lead to organisational suboptimisation problems
Setting transfer prices 6
Full cost plus?
— What margin will all parties perceive as fair?
— If there is no external market for the item being
transferred:
— Goal congruent decisions will be made if the transfer
price is ≥ variable cost in the supplying division
— But also ≤ net marginal revenue in the receiving
division
Setting transfer prices 7
Transfer prices based on cost – changing unit variable
costs and selling prices
— When unit variable costs and/or unit selling prices are
not constant, there will be a profit-maximising level of
output
— The ideal transfer price will only be found by careful
analysis and sensible negotiation
— Firstly establish the output and sales quantities that will
optimise the profits of the company or group as a whole
— Establish the transfer price at which both the supplying
and receiving division would maximise their profits at
this level
Setting transfer prices 8
— Divisional and organisational profits will be maximised
if:
— The transfer price is ≥ marginal cost in the supplying
division
— But ≤ net marginal revenue in the receiving division
Capacity constraints
— If there is a capacity constraint resulting in a shortage of
supplies of the product, a profit-maximising transfer
price will be implemented as part of a centralised policy
Negotiated transfer prices 1
Negotiated transfer prices
— Transfer prices determined through negotiations may be
a mix of accounting arithmetic, negotiation and
compromise
Possible transfer prices
Market value
— Elements to reflect internal nature of transaction (such
as reduction in selling costs)
Market value of end product
— Amount for the finishing work in receiving division (used
where receiving division is given non-finished goods)
Negotiated transfer prices 2
Behavioural implications
— Inter-departmental disputes
— Head office intervention may be required which will
reduce decentralisation of authority
— Less decentralisation will reduce the effectiveness of
the profit centre system’s ability to motivate divisional
managers