The Impact of Transfer Pricing on Decision Making and Control - Essay Example

Order 141717 Topic: The Impact of Transfer Pricing on Decision Making and Control: The Resolution of a Divisional Conflict Definition of transfer pricing To become aware how transfer pricing impacts on decision making and control in an organization as a whole we have to define what transfer pricing is. Transfer pricing is a term used to describe all aspects of inter-company pricing arrangements between related business entities, including transfers of intellectual property; transfers of tangible goods; services and loans and other financing transactions.1 Inter-company transactions across borders are growing rapidly and are becoming much more complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a complicated and time-consuming task. So, the question of fixing right transfer price becomes more and more important. As a rule transfer pricing refers to the pricing of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary, with the choice of the transfer price affecting the division of the total profit among the parts of the company.2 Transfer prices as usual differ from market ones. This kind of pricing is used by a company (as a rule by a multinational corporation) to avoid taxes, customs duty, and currency control, to increase share in joint ventures, and to keep back real profit of operations. 2. Factors of transfer pricing But how a multinational corporation can set the best transfer price? The matter is very difficult, and it depends on many elements. In practice a great many factors influence the transfer prices that are used by multinationals, including performance measurement, capabilities of accounting systems, import quotas, customs duties, VAT, taxes on profits, and (in many cases) simple lack of attention to the pricing. From marginal price determination theory3, we know that generally the optimum level of output is that where marginal costs equals marginal revenue. That is to say, a firm should expand its output as long as the marginal revenue from additional sales is greater than their marginal costs. In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. Mathematically, the marginal cost (MC) function is expressed as the derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume, and so at each level of production, the marginal cost is the cost of the next unit produced.4 A typical Marginal Cost Curve In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. Marginal Revenue is an important concept in basic microeconomics. Marginal revenue (MR) is the extra revenue that an additional unit of product will bring a firm. It can also be described as the change in total revenue/change in number of units sold. More formally, marginal revenue is equal to the change in total revenue over the change in quantity when the change in quantity is equal to one unit (or the change in output in the bracket where the change in revenue has occurred).5 This can also be represented as a derivative. (Total revenue) = (Price) times (Quantity) or . Thus, by the product rule: . For a firm facing perfectly competitive markets, price does not change with quantity sold (), so marginal revenue is equal to price. For a monopoly, the price received will decline with the quantity sold (), so marginal revenue is less than price. This means that the profit-maximizing quantity, for which marginal revenue is equal to marginal cost will be lower for a monopoly than for a competitive firm, while the profit-maximising price will be higher. When marginal revenue is positive, price elasticity of demand is elastic, and when it is negative, PED is inelastic. When marginal revenue is equal to zero, price elasticity of demand is equal to -1. The main thing in the transfer pricing is the policy of a corporation. There are different ways of pricing wich may be based on the market, costs or may be negotiated. A multinational has to take into account all these aspects and to choose the best alternative for it. 3. Transfer pricing at BBR group Every corporation tries to minimize its total costs, and uses the most appropriate techniques for doing it. But separate divisions of the whole group have not very often real power and influence on price fixing in their internal trade. A striking example of it is internal trade between two divisions of BBR: the Strewsbury plant and the Preston division. The current transfer pricing procedure of BBR is the following: Before the annual budgets are compiled, the divisional general managers enter into negotiations about fixing the transfer price. At the negotiation meeting, information provided by their respective management accountants and annual cost variances provided by the central purchasing officer of BBR are available. The Preston division provides cost data relating to standard variable and fixed costs traceable to the division, plus an apportionment for selling, administrative and distribution costs. Normally, these data provide a platform price for the negotiations. These forecasts given by the central purchasing officer are included in these cost estimates. The Preston subsidiary is unaware of the assumptions on which the purchasing forecasts are based, but nevertheless accepts them as relevant to the fixing of the transfer price. So from this we can draw a conclusion that Preston division doesn’t know the whole picture of the price forming. The group has right to offer its own purchasing forecasts, and provide the data of additional administrative costs the group has. So the group can offer a price it would prefer not taking into account real situation in the market and not paying much attention to the fact that the effectiveness of some divisions’ activity becomes very low. That is why at the meeting, which took place between John North, group finance director of BBR and Paul Giddings, divisional general manager of the Shrewsbury plant. Paul revealed that he did not believe, he was responsible for his division’s profitability. He claimed, it was due to the company’s transfer pricing policy. He argued that some divisions of the group get extra profits at the expense of other divisions. Historically, Paul’s division bought over 50% of its total input of rubber hose from a sister Preston division. This trade annually accounted for about 25-30% of the Preston division’s total output. Paul felt the transfer price was unfair, and hence his division’s reported profit was not a true reflection of his operational effectiveness. In the ensuing conversation both men agreed, in principle that, divisional general managers are delegated discretionary control over short-term strategy development, day-to-day operating decisions and capital expenditure decisions up to a prescribed limit. However Paul claimed that, in practice, other factors intervened to reduce the divisional manager’s degree of control and took, as an example, the inter-divisional trade in rubber hose. Paul Giddings feels that at the transfer price negotiating stage, he is always in a weak position. There are only two other domestic suppliers and three overseas who could supply the rubber hose in the volume he requires. Even then it is unlikely that any one of these five external suppliers would be willing to handle more than 20% of his division’s total needs. His input to the negotiations is based on volume discounts likely to be available from the external suppliers. In fact, he argues that the economies of scale Preston enjoys from the internal trade are being passed on in disproportionately lower prices to potential competitors of the Shrewsbury division! That is why he thinks that the price is of £12.50 is not fair and too high for internal trade. When we study cost data of Preston division (exhibit 1) we can reveal that if the output is small (100,000-200,000 meters of rubber hoses) the division has no profit at all, but when the sales are high and the quantity is big (from 400,000 meters), average costs decrease and profits grow. Taking into account the fact that Shrewbury divisions places its orders on a constant base, and that its input is always very high, we can state that profits of Preston division which it get as a result of selling to Shrewsbury divisions are high, and even more higher then by Preston’s rivals. So Paul Giddings thinks that Preston division should give a substantially better discount when he is buying internally because Preston avoids the problems of the settlements and payments, advertising and some transportation costs. It means that Preston profit even more then it is shown in its reports. On the other hand, we can also see from exhibit 1 that average external suppliers list price makes £14 per meter of rubber hose. This price is higher then Preston’s one, but the suppliers of Shrewsbury division offer it certain discounts, so in some cases (when the order is big) the price of competitors is even lower then the price of Preston division. Paul Griddings’ require to reduce the internal transfer price have real grounds. The transfer price is not a market one and it decreases the profitability and effectiveness of Strewsbury division. So, when buying rubber hoses at higher price Strewsbury division looses some profit, and hence it become more uncompetitive to compare with its rivals. On the other hand, Gridding has another alternative of placing his division’s orders. Although there are only 5 big external suppliers of rubber hoses who would be able to cover Strewsbury demand in this kind of products, but by undertaking certain efforts they have opportunity to place their orders by these external suppliers each of them is able to handle 20% of his division total needs. And in some respect it can result in bigger profit for Paul Griddings division, and hence for the whole group BBR. Exhibit 1 Cost Data Available for the Transfer Pricing Negotiations Preston Division Output (thousands metres of rubber hose) Average material cost (£ per metre) Average direct labour cost (£ per metre) Average total costs (£ per metre) 100 8.00 5.00 13.00 200 7.70 4.80 12.50 300 7.50 4.70 12.20 400 7.20 4.50 11.70 500 7.00 4.10 11.10 600 6.50 4.00 10.50 700 6.00 3.80 9.80 800 5.50 3.60 9.10 900 5.00 3.40 8.40 1000 4.50 3.20 7.70 Average total costs 10,6 Annual Budgeted Divisional Fixed costs £160,000 Annual Budgeted Allocation of Selling, Administration and Transportation Costs £40,000 Proposed Transfer Price £12.50 per metre Shrewsbury Division Buy-in order size (thousand metres of rubber hose) Average external Suppliers list price (£ per metre) Average discount (% per metre) Average discount (£ per metre) Average external suppliers prices with discounts (£ per metre) 100 14 nil - 14 200 14 3.57 0.50 13.5 300 14 7.15 1.00 13 400 14 11.60 1.60 12.4 500 14 15.00 2.10 11.9 The current transfer pricing procedure of BBR is based now on an overall strategy of the group. Fixing of a transfer price in the group depends on 3main factors: 1) Total costs of Preston Division. 2) Prices of Preston’s rivals. 3) Forecasts for the price for BBR. From the exhibit 1 it is clearly seen variable costs of the Preston division (it is cost for 1 meter of rubber horse manufacture). Annual fixed costs of the division make £160,000 plus administration and transportation costs in amount of £40,000. Variable costs can’t be changed, but the amount of profit depends directly on the amount of manufacture, but fixed costs are equally divided between the whole amount of manufactured products. So fixed costs, administration and transportation costs of the company can be classified as hidden ones. The total costs of the rubber hoses depend directly on the amount produced. The more the amount the less the sum of total costs. 4. Alternative transfer pricing One of the difficulties that have been experienced is that the range between the cost estimates at Preston and the competitor’s list prices at Shrewsbury can be vast. So much so that, the platform price exceeds the ceiling price. This may occur when excess supply is expected to characterize the external market. Hard-nosed negotiations can result in the ultimate transfer price being less than satisfactory to both parties, and thee is always the possibility for unrelated disputes to interfere with the unstructured negotiations on the transfer price. As we can see it from exhibit 1 average price for internal trade maybe be lower. There are some grounds for it. First, administration and transportation cost are reduced because of internal trade. Second, because of big orders the total costs of Preston divisions are low. That is why there is a real opportunity to reduce transfer price. At the negotiations on transfer price the Shrewsbury division also compiles standard cost data and, in addition, presents price list information with the likely allowable discounts it can hope to receive from alternative suppliers. Forecasts estimates of the BBR form the ceiling price for the negotiations on transfer price. The difference can definitely be seen from Calculation 1. The positive side of the price of £12.50 is that when buying small batches of the products Shrewsbury division may have certain advantages. For example if you buy only 100,000 meters of rubber hose youll pay 1,250 (thousand £). For comparison the total price of an external supplier will makes 14,000 (thousand £). But taking into consideration the fact that Shrewsbury division doesn’t place such small orders, and the total quantity of the products they need is known beforehand, the situation is quite opposite. If we compare total prices for rubber hoses for quantity of 500,000 we can find out very easily that Shrewsbury division bears losses. They may buy rubber horses of that quantity at an external supplier and pay for it 5,950 (thousand £). When doing the same buying at Preston division, it would pay 6,250 (thousand £), so it means that it would loose 300,000 (thousand £). Not very little!!! The diagram below also shows us that marginal costs of external suppliers is higher that Preston’s ones. The Preston division counters that the savings obtained by the large volume of internal sales enables it to be cost efficient and innovative in developing new production techniques. But it means that the can develop its manufacture at the expense of other divisions. And the financial results of their activity don’t reflect a real situation in the divisions’ activity. 5. Conclusion Transfer prices are used to plan and fulfill control; they are one of elements of multinationals’ policy. Transfer prices provide reaching of planned results of profit, decreasing of production costs and distribution costs at all stages of production process and moving goods to end users. So, transfer prices are one of the best ways to allocate resources and profit within the company. Transfer pricing procedures can differ according to purpose a company has. It can increase or decrease transfer prices in accordance with its policy and aims. In order the divisions of BBR group are competitive in the market they need to be most effective and efficient. So I think that transfer price must be suitable and fair for the both sides. It means that the parties have to review their approaches to transfer price forming. Preston division has to review all its costs and to do recalculation of them taking into account the economy it has because of minimizing transportation, selling, distribution, advertising and administrative costs. So the value of total costs of Preston division will decrease, and there is an opportunity to make transfer price lower. Of course by small orders Preston division must not to buy its production at a loss. But fulfilling big orders on the constant base of its internal customers Preston division may work out discounts schedule. According to the diagram we may state that Preston division costs are even less then these of its rivals. So it can help it to get additional profit and to develop its production process to do it more efficient. The group BBR has to realize that having a division, which is not competitive in the market, undermines the productivity and effectiveness of the whole group. And it results in worse financial figures of the group as a whole. Resources used: 1. Ackelsberg R., Yukl G. Negotiated transfer pricing and conflict resolution in organizations // Decision Sciences. 1979. №10. pp. 387-398 2. Anthony R.N., Dearden J. Management Control Systems. R.D. Irwin, 1984. p. 235 3. Eccles R.G. The transfer pricing problem: a theory for practice. Lexington, 1985. 4. Enzer H Static Theory of transfer pricing // Naval Research Logistic Quarterly. 1975. 22(2). p p. 375-89 5. Fremgen J. Transfer Pricing and management goals // Management Accounting. 1970. №52. p p. 25-31 6. Spicer B.H. Towards an organizational theory of the transfer pricing process // Accounting, Organization and Society. 1988. 13(3). p p. 303-321 7. Emmanuel C.R. Transfer Pricing: a diagnosis and possible solution to dysfunctional decision making in the divisionalised company // Management International Review. 1977. 17 (4). p p. 45-49 8. http://en.wikipedia.org/ 9. http://www.solbaram.org/articles/clm503.html 10. http://www.uic.edu/classes/actg/actg594/Readings/Transfer%20Prices/Transfer%20Pricing%20Summary.pdf Read More