Transfer price mechanism is process that provides opportunity to attach prices of goods and services of two divisions of same company. It is the process where the negotiated price is arrived between two sections of similar divisions…
It is usually applied when bodies are separate entities and are individually responsible for their profitability and divisions are accountable for their own profits (Jensen and Meckling, 1976, 315). Since transfer pricing is an agreement between two divisions of same group there is greater chance of conflict of interest as both buying and selling side try to transfer to counter party resulting increased benefit to its division (Chan, Landry, and Jalbert , 2004, 39). This report will also analyze a case between Millwall Company and Reading Company as both these companies are interested in buying and selling with each other and both of these companies belong to the same group of companies. EFEFCTOF EACH PROPOSED PRICE ON MANAGEMENT OF READING The transfer price mechanism is the source of revenue for selling division which in this case is Reading Company and cost for buying division which in mentioned case is Millwall Company. Former aims to get it maximum revenue from deal and latter tries to get supply at minimum cost. The best option can, therefore, be negotiated at point where both firms are given autonomy as finally they will be held responsible for the profitability of the respective divisions (Grubert and Joel Slemrod , 1998, 368). Considering the fact that Reading Company is already performing under capacity, therefore, it can serve Millwall Company without reducing its supply to other external suppliers and so no opportunity cost would be involved in this scenario. With these assumptions, standard variable cost and opportunity cost would be the total cost that it has to incur. Since opportunity cost is nil in this case then standard variable cost constitutes main component of cost and any point above this would be the profit. Using its spare capacity, selling at any price over and above the average variable price would increase the profit for Reading Company by same amount. For instance, Profit for Reading company = (selling price – average variable price) * quantity In the given case price demanded by Reading Company is inclusive of fixed cost as well and only selling and distribution cost is foregone. It is in due alignment with the need of Reading Company as it has to keep profitability improved with its operation under capacity. Offer from Millwall Company is true on its part as it is well calculated from buyer’s current condition of operating under capacity and it would like to pay minimum or at least less than what it would pay to an external supplier to improve its profitability. But management of Reading Company would surely not like this scenario as it would not benefit the profitability of the company as selling the same product to an external buyer give the company revenue of $ 13per unit. Supplying on the price given by Millwall Company would only then improve the profitability of Millwall Company and this can raise an intra-company conflict of interest and reduction in its revenue will reduce its profit. The best Reading Company is ready to forego its profit by $1.20, which is the market selling price less price offered to Millwall Company. For the price offered by management is less than the one asked by Reading company. This price has already covered the cost and the margin that is suggested to be foregone and it is higher than the Reading’s acceptable price. This price is also not considered suitable for overall profitability of group as it would yield a profit of $ 3 per unit (price: $13 – cost $10) if sold to outsider and this management’s suggested price would reduce the profit of overall group by $2.88 (13- 10.12) and loss in profit is $1.68 (11.80- 10.12) above than profit Reading company is ready to forego. In point of ROI comparison Reading company would finally be held for less profitability overall. ...
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