Management Accounting For Company Transit Division: Transfer Pricing Methods And Contribution Margin Computation

Part-A: Transfer Pricing Methods

Discuss about the Management Accounting for Company Transit Division.

Transfer pricing can be defined as the price at which the division of the company transact with each other, for example supply trade or labour between the departments. Transfer pricing are used when business entities of a larger multinational firm are treated and measured as separate business entities (Kaplan and Atkinson 2015). A transfer price is also known as the transfer cost. This method is useful in the computation of income tax implications under distinct areas of jurisdiction. In addition to this, it is advantageous in improving the efficiency level of numerous departments in the purchase and sale for decision-making purpose.

Cost base transfer pricing:

Organisations using transfer base costing approach to identify the sales from international entities contribute to corporate profitability through economies of scale in domestic manufacturing companies. The transfer cost at base helps in reduces the duties of company (Deegan 2013). It should be mentioned that companies using this approach have no profit anticipations on transfer sales.

Cost plus pricing:

Companies, which follow the cost plus transfer pricing method are undertaking the profitability position, to reflect at any stage of production, the cost of processing in the form of transfer price. Under the cost plus pricing systems use this process, add the profitability margin on the sum total of manufacturing cost to sell the product in the market (Kamala et al. 2015). Under this operating profit cannot be generated by the intermediate department.

Transfer price at market rate:

This pricing method is derived from the transfer of price based on market rate. Under transfer pricing method, business firms compute the transfer price in accordance with the policies and other factors.

Negotiated transfer price:

Business entities on most of the occasion decide the transfer pricing after negotiating with the other branches of the organisation. Hence, this is known as negotiated transfer pricing (Needles et al. 2013).

It is evident there are numerous business units which adopts certain different methods of adopting transfer pricing in order to suit their daily operations. Therefore, selecting the most appropriate method involves various aspects, which are as follows;

Cost base method is widely used for its simplicity in order to assess the appropriate cost of the final goods produced.

Cost plus methods adopted is adopted to distribute the total amount of profit at different level of production in order to bring out desired level of performance from the organisation (Warren et al. 2013).

Cost Base Transfer Pricing

On the other hand, the management usually prefers the market rate of transfer pricing in order to distribute the units produced at the original market price. This helps in the computation of unit produced in accordance with the prevailing rate of price in the market.

It should also be noted that the prevailing market rate of products also constitute risk related to cost which includes, bad debts, insurance and abnormal loss from damages. Therefore, the above stated expenses incurred are not considered for transferring the sub units in to another branch of the company. The adjusted market rate is undertaken to reduce or eliminate the unnecessary expenses and implement more precise rate of market transfer price (Drury 2013).

Negotiated pricing methods is used to introduce a pricing method which is acceptable by both the upstream and downstream departments in order to equally benefit the department.

The objective of transfer prices are as follows;

If an organisation has numerous processing units in order to suit different tax jurisdiction, transfer-pricing methodology can be beneficial for the business unit to compute the taxes under different head more precisely (Braun et al. 2013). In addition to this, if the selling heads are under the higher side of the tax zone then the business unit has to bear the tax liability on the sale of product. On the occurrence of such event profits are distributed under different heads of the tax zone to lower the tax liability of the company.

The objective of transferring pricing is to decide whether sub units of prices to be transferred in to the next department or can be sold externally to earn high margin of profit (Horngren et al. 2013). The management has the authority to make decision whether subunits should be transferred from previous branches in order to lower down the expenses.

Operating profit arising out of each branch, work as an additional motivating factor for employees and management to perform better. It can be assumed that transfer-costing method is an effective tool for the management to measure the degree of efficiency for each individual branch.

Determination of transfer price under cost base transfer pricing method is easy and simple to compute. Therefore, such methods cannot be used in the measurement of divisional performance (Fullerton et al. 2014). Perhaps if the transfer price is based on the cost of processing, then such measurement does not show the actual value of the transferred product.

Cost Plus Pricing

The fair value of the product can be ascertained if the cost of processing is drawn for comparing the prevailing market rate with the sub units. This helps the management to assess whether the actual cost incurred in processing is higher or is in accordance with the current market rate. Therefore, if the current market rate or negotiated transfer pricing method are employed, then the upstream will be under obligation to deliver the unit produce in accordance with the price fixed by the management (Otley and Emmanuel 2013). Under such circumstances, if the organisation suffers loss or is unable to attain the budgeted amount of profit, then the performance will be considered below the satisfactory level.

On the other hand, if the product is delivered at a higher price and the possibilities of estimated profit is achieved, then in such a case the performance will be considered as favourable. Furthermore the downward department also receives the product at stipulated rate in order maintain the operating profit level at divisional level. However, if it considerably fails to achieve the targeted profit, then in such circumstances, it will be considered as under-performing division.

Computation of Contribution Margin:-
	Cleaning & Scraping Division	Processing Division
Particulars	Amount	Amount
Sale Price Per/Unit	95	160
Less: Variable Costs Per/Unit
Transfer Price		-95
Direct Material	-18	-5
Direct Labour	-12	-10
Manufacturing Overheads	-30	-10
Contribution Margin Per/Unit	35	40

 

It is noteworthy to denote that the business unit should fix the negotiated transfer price at a range where both the units employed can yield equivalent operating margin. Under the cost base transfer pricing method, the cleaning and scrapping department can make an earning of only 9% of the operating margin, while on the other hand, the processing division generates 27% operating margin of profit (Ward 2012). Under such circumstances, if a market rate is applied then the upstream division will make a profit of 26% but the margin of profitability relating to other division will fall to 16%. On the occurrence of such event, the negotiated price should be fixed at $87.75, which enables both the division to yield a profitability margin of 20%.

Below listed are the calculations:

	Cost-Base Transfer	Market-Base Transfer	Negotiated Transfer
Particulars	Amount	Amount	Amount
Cleaning & Scraping Division:
Revenue per unit	77	95	87.75
Direct Labour	-12	-12	-12
Direct Material	-18	-18	-18
Manufacturing Overhead:
Fixed overhead  – 25%	-10	-10	-10
Variable Overhead – 75%	-30	-30	-30
Divisional Operating Profit	7	25	17.75
Operating Profitability Margin	9%	26%	20%
Processing Division:
Revenue	160	160	160
Cost of Direct material	-5	-5	-5
Cost of Direct Labour	-10	-10	-10
Cost of Transfer	-77	-95	-87.75
Manufacturing Overhead:
Fixed Overhead – 60%	-15	-15	-15
Variable Overhead – 40%	-10	-10	-10
Divisional Operating Profit	43	25	32.25
Operating Profit Margin	27%	16%	20%
Total Operating Profit	50	50	50

 

The lowest amount of transfer price, which will be acceptable, by the cleaning and scrapping unit will be based on the total value per unit of Cruden, which is $70. At this rate, the division would neither earn profit nor will it incur loss. It will be considered as cost base transfer pricing for Cruden. However, it must be noted that this will not be acceptable by the managers since they will prefer the product to be in accordance with the cost plus transfer pricing having minimum range of profitability attached with the product.

Reference List:

Braun, K.W., Tietz, W.M. and Harrison, W.T., 2013. Managerial accounting. Pearson.

Brewer, P., Garrison, R. and Noreen, E., 2014. Course ACCT 21011 Principles of Managerial Accounting (3). Cell, 314, pp.698-6582.

Deegan, C., 2013. Financial accounting theory. McGraw-Hill Education Australia.

Delia, D., Adriana, P. and Coman, D.D., 2014. THE ROLE AND THE IMPORTANCE IN CHOOSING THE PROPER MANAGERIAL ACCOUNTING CONCEPTS REGARDING THE NEED FOR INFORMATION ON THE DECISION MAKING FACTORS. Studia Universitatis Vasile GoldiÅŸ, Arad-Seria ÅžtiinÅ£e Economice, (1), pp.122-130.

DRURY, C.M., 2013. Management and cost accounting. Springer.

Fullerton, R.R., Kennedy, F.A. and Widener, S.K., 2014. Lean manufacturing and firm performance: The incremental contribution of lean management accounting practices. Journal of Operations Management, 32(7), pp.414-428

Hiromoto, T. and Hiki, F., 2015. Cost Accounting. Theory and Practice 3th Edition, CHUOKEIZAI-SHA HOLDINGS.

Horngren, C.T., Sundem, G.L., Schatzberg, J.O. and Burgstahler, D., 2013. Introduction to management accounting. Pearson Higher Ed.

Kamala, P., Struwig, J., Bornman, M., Boersman, R., Vermaak, M., McGill, M., Jordaan-Marais, J., Matthew, J., Hurter, C. and Taylor, P., 2015.Principles of Cost Accounting. Oxford University Press.

Kaplan, R.S. and Atkinson, A.A., 2015. Advanced management accounting. PHI Learning.

Keller, W.D., 2015. Cost and Managerial Accounting II Essentials (Vol. 2). Research & Education Assoc..

Needles, B.E., Powers, M. and Crosson, S.V., 2013. Financial and managerial accounting. Nelson Education.

Otley, D. and Emmanuel, K.M.C., 2013. Readings in accounting for management control. Springer

Peng, L. and Röell, A., 2014. Managerial incentives and stock price manipulation. The Journal of Finance, 69(2), pp.487-526.

Ward, K., 2012. Strategic management accounting. Routledge

Warren, C.S., Reeve, J.M. and Duchac, J., 2013. Financial & managerial accounting. Cengage Learning.