Management Accounting For Various Product Divisions: Transfer Pricing Methods And Use

Transfer price Meaning

Describe about the Management Accounting for Various Product Divisions.

The companies and large business entities with multiple divisions transfer products among various divisions. The products are transferred at a price, which is known as transfer price. The transfer price is useful and serves various important purposes. There are different types of transfer pricing methods. In this report, an attempt is made to discuss the meaning of transfer price, different types of transfer price, use and purpose of transfer price (DRURY 2013).

The price at which divisions within the company transacts with each other is known as Transfer price. For example, supply of labor or stock from one department to another at a particular price is an example of transfer price. The transfer prices are mostly used by entities that has large and diverse operating units and each units run as a separate entity. Transfer prices are also known as transfer cost (Weygandt et al. 2015).

In case of multi unit entities, each division is responsible for their own profit. In managerial accounting the return on invested capital for each division are calculated so it is important that when divisors transacts with each other a transfer price is established to determine the cost (Ward 2012). A close proximity is maintained between transfer price and market price because huge difference in price will adversely affect the performance of the transferor division whereas transferee division will gain. This will not reflect the actual performance of the divisions.

The various types of transfer price that can be used are given below:

The simplest method of determining transfer price is to use the market rate. The market based transfer price is not suitable in case of product that have unique nature. It is also possible that the division can earn highest possible profits rather than being subject to mandated pricing schemes (Soin and Collier 2013).

If the direct application of market rate as transfer price is not appropriate then necessary adjustments should be made in the market price. This adjusted market price then can be used as transfer price.

If the market price is not readily available then in such cases the divisions should negotiate the transfer price. This can happen for products that have very small market or the product is highly customized. The price is determined the negotiating skills of the respective divisions (Otley and Emmanuel 2013).

If there is no available market price then the transfer price could be determined by based on the contribution margin of the component.

Types of transfer pricing

The transfer price could be determined based on the component of cost that is to transferred. The procedure to determine the transfer price under this method is to add all the component of costs and then a profit is margin is added with the cost. It is useful for deterring transfer price where there is no available market price (Taipaleenmäki and Ikäheimo 2013).

When one division transfers product to another division at costs then it is referred to as cost based transfer pricing. Under this method, the final division that sells the goods to the customer will recognize the entire profit (Bessis and O’Kelly 2015).

The above discussion shows that there are different types of transfer pricing methods. In order to determine the most appropriate method the following criteria is used:

The transfer price should be determined objectively;

The transfer price should appropriately reflect the value of the transferred product;

The transferring division should be appropriately compensated;

The transfer should be compatible with the overall company goals and policy;

There are different types of transfer price that are used so that the company can choose the appropriate method by fulfilling the above criteria.

The most essential functions and use of transfer price are:

The transfer price is useful in profit allocation among various divisions. This helps to assess the performance of the various departments.

The transfer price is useful for coordination and guidance if the division.

The transfer pricing is useful in determining cost that is used for decision-making and justification of price.

The transfer price is also useful for external regulatory purpose especially for income statement and balance sheet.

The transfer price because of its simplification is used for determining budget.

The transfer price serves various purposes as given below:

The transfer prices are necessary for determining divisional profits when the product are transferred from one division to another in a decentralized entity.

The transfer price helps to evaluate the performance of the divisions.

In case of companies where the managers have the authority to purchase product externally or internally then in such cases the transfer price helps to evaluate the performance of the managers. It also helps to determine whether the performance incentives of the managers are in line with that of the company (Collier 2015).

The transfer price becomes relevant in calculating income tax if multinational companies transfer the products across international borders.

Conclusion

The discussion above has highlighted the importance of transfer price. It can be concluded that transfer-pricing system serves an important purpose in the multi divisional entities and multinational corporations.

Use of different types of transfer price

The Transfer prices are the prices charged by one division for transferring product to another division of the same organization. There are various methods for determining transfer price and one of such method is to base the transfer price on actual costs. It is not appropriate to use the actual cost as transfer price because the inefficiencies of the production department might be transferred to receiving departments (Braun et al. 2013). As the products are transferred at cost, so the production department will not have any incentives to reduce such inefficiencies. The goals of an organization are to achieve efficiency in operation and the use of transfer price based on actual costs does not helps the organization to achieve this objective. The cost based transfer price does not motivate management, as there are no incentives for controlling costs.  The cost-based transfer pricing does not help in maintaining sub unit autonomy as the transfer price are rule based (Warren et al. 2013). Therefore based on the above discussion it can be concluded that total actual cost, as transfer price is not appropriate because the performance of the divisions cannot be evaluated effectively.

Statement showing Contribution Margin
Particulars	Cleaning & Scraping Division	Processing Division
Units	400000	400000
Market Price	$                                 95.00	$                   160.00
Sales	$                38,000,000.00	$     64,000,000.00
Less: Variable costs
Direct Material	$                (7,200,000.00)	$     (2,000,000.00)
Inter Divisional Transfer		$  (38,000,000.00)
Direct labor	$                (4,800,000.00)	$     (4,000,000.00)
selling cost	$                (2,000,000.00)	$                            –
Manufacturing Overhead	$              (12,000,000.00)	$     (4,000,000.00)
contribution	$                12,000,000.00	$     16,000,000.00
Less: Fixed Costs
manufacturing overhead	$                (4,000,000.00)	$     (6,000,000.00)
Net profit	$                  8,000,000.00	$     10,000,000.00
Contribution Per unit	$                                 30.00	$                     40.00
Net profit per unit	$                                 20.00	$                     25.00

In the negotiated transfer price, the price is determined by informed bargaining by the divisions. The negotiated transfer price provides autonomy to the divisions. This system provides better information about the costs and benefits. In order to determine the transfer price under this method it is important to ascertain the acceptable transfer price of both the selling and buying division (Seuring and Goldbach 2013).

If the transfer price is below the costs incurred by the selling division then the selling division will incur loss. In such case the selling division will not agree to transfer product and if the transferring division is required to transfer product at such price in accordance with the company policy (Demski 2013). Then such method will promote inefficiency among the selling division as there as there will be no incentive for controlling costs. Further, as the product can be sold in the open market if the buying department does not give the market price or higher then transferor division will sell the product in the open market. The acceptable transfer price for selling division will be the price that includes all the variable costs, fixed costs and opportunity costs. In this case, the acceptable transfer price for cleaning and scraping division will be market price less the selling cost of the product (Maher et al. 2012). The selling price of the product is $95.00 and variable selling expenses is $5.00 so $90.00 will be appropriate transfer for selling division. Therefore, the acceptable price range for selling division is $90.00 to $95.00.

Use/ Function of transfer price

If the transfer price is set too high by the selling division then for the buying division earning profit will be difficult. The buying division will always look for purchasing at lower price so that it can increase its profitability. If the transfer set by the selling department is more than the market price then the buying department will purchase it from the market (Maher et al. 2012).  Therefore, the acceptable transfer price range for the buying division will be market price of $95.00 or less.

d.

The company that has multiple divisions and transfers product from one division to another is required to establish a transfer price. The objective of the management is to set a transfer price that encourages goal congruence among all the mangers of the divisions that are involved in the transfer. In order to maximize the overall profit of the company the guideline for each divisions are provided in the general transfer-pricing rule. The general transfer-pricing rule is to add opportunity cost with the variable cost of the product. Two scenarios are possible with the general transfer-pricing rule this are when there is excess capacity and when there is no excess capacity (Gray 2014). In case where there is excess capacity there is no opportunity cost so the transfer price will be variable cost of the division. Where there is no excess capacity in that scenario opportunity cost is added with the variable cost in order to determine the transfer price. The opportunity costs are revenue that is for gone for internal transfer of the product. The general transfer price rule is applicable when there is available market price. The calculation of transfer under two scenarios is given below:

Calculation of Transfer price
Particular	Excess capacity	No excess Capacity
Total variable Costs	$                                 60.00	$                         60.00
opportunity Costs	$                                 30.00
Transfer price	$                                 95.00	$                         60.00

The minimum transfer price that is acceptable is $60.00.

The management of the Cleaning and scraping division will not prefer this as the transfer price as the company will lose an opportunity cost of $30.00. The management will prefer the market price or the price of $90.00 after deducting variable costs on sales. The management will prefer higher price because it will affect the profitability of the division. The performance and the cost control measure that are undertaken by the company in order to compete in the market will not be reflected in the transfer price (Kinney et al. 2012). This will adversely affect the performance of the division as they will be not be motivated to reduce costs. As a result, the management will not prefer the transfer price that is below market price.

Reference

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