CHAPTER ELEVEN TRANSFER PRICING NATURE AND EFFECTS TRANSFER PRICING - is the exchange value assigned a product or sérvice that one it of organization provides another unit of the same organization. organization. The choice of a transfer pricing policy (i.c., which type of transfer price to 82) is normally decided by top management. ‘OBJECTIVES OF TRANSFER PRICING - “A great deal of intra-company buying and selling occurs in many companies, which necessitates transfer prices. ‘Transfer prices are important because they are revenues to the ‘welling division and costs to the buying division and” therefore affect divisional Performance. The objectives of Transfer Pricing are: cee when the interest of both ‘the division and the ‘total company 2. Perth i Bvakalind ~ the performance credit of the selling division for its transfer “of goods and services to the buying division. 3: Motivation - the’ iricentive for a division manager to act in the best interest of the division and the company. 4. “Autonomy - the right of division managers to self-govem their own divisions. q ES OF “4. ‘To establish the amounts for which the manager of the buying division has’ assumed responsibility and. the-mimiager of the. supplying division ‘tas been: reticved of responsibility. 2 To determine foreach division manager the profitability of individual traisactions and classes of transactions in whith the intermediate products figure. 3. ‘To: measure, for internal accountability and reporting, inventories of intermediate products or other products manufactured from them, 4. To measure the flow of resources from one division to another, for use in calculations to be made by individuals or organizations outside the company.‘Transfer Pricing : Chapter Eleven” Crr TO BE MET IN_A TRANSFER PRICING SYS divisional profit center in terms of its separate contribution to the total company profit. Motivate the divisional manager to pursue the division's own profit goal in a manner conducive to the success of the company as a while. Stimulate the manager's efficiency without losing the division's autonomy as a profit center. TRANSFER PRICING METHODS (BASES) COST - When used in transfer pricing, it may mean full cost (absorption), standard, « 1. or variable cost. Cost-based transfer price-is ¢asy to understand and convenient to use. - Allow central management to judge’ as ‘accurately as possible the performance of the - ‘The variable cost-based transfer price-has.an advantage over the full cost method _ because in the short run it may tend to ensure the best unitilization of the overall company’s. resources. COST PLUS - The established cost phis a percentage mark-up on cost. ., MARKET PRICE - The price at which a division may buy or sell the units outside and is based en an arm's length transaction in an open market. It is the best transfer price in the sense that it will maximize the profits of the company as a whole if there exists a competitive market price and divisions are independent of each other. NEGOTIATED PRICE - The transfer price arrived at in negotiations between the buying and selling divisions. It is generally used when there is no intermediate outside market price exists forthe product. transferred and the, selling division is assured of a normal profit. . ARBITRARY PRICE - A price established by interaction between buying and ® selling divisions and is at a level considered best for overall company interests, with .) neither the buying nor selling divisions having any control over the final decision. . DUAL PRICING - A method, of transfer pricing where the transferor division. uses. ‘one price, and the transferee division uses another price. This method allows the company for the selling and buying divisions to reflect a transfer price that will better. measure their division performance. abu‘Pricing : ‘Chapter Eleven MPLE PROBLEM 1 .» The TP Company has two divisions, D1-and D2. D1 produces a part that is used in be finished product-of D2. The costs of producing each part are: Materials P4.00 Labor 2.00 Variable overhead 2.00 Fixed costs 2.00 ‘The partis sold in the highly competitive market for P12 each. D2 is buying 60% of the output of D1 currently at a negotiated price of P11 cach. ‘Due to emphasis on divisional welfare rather than company welfare, a new transfer price “must be developed. The suggestion -was to add 40% to the total costs of the part when transferring to D2.. Another proposal “was: to. use the’ variable costs of P8 per part in _ Striving at a transfer price. D1 transferred 1,000 parts to D2. Pertinent data of D2 follow: In addition to the transfer price of each part, there are additional processing and marketing coats of PS and P4 per unit, respectively. ‘The selling price of the finished product of D2 is P26. REQUIRED: Using the abjve information and suggestions, determine the gross profit per Ete jprovie paseo the flowing tes picng 1: .. Cost method . Cost plus tfiethod Market price.method ‘Negotiated price method Dual pricing method . poose 2. Journal entries in the books of D1 and D2 under the Cost plus method.“Traneter Pricing SOLUTION - EXAMPLE PROBLEM 1 4. ¥ a. Cost Method Selling’price P26.00 Less: Transfér price: : Materials P 4.00 Labor 2.00 Variable overhead _ 2.00 Variable Cost* - Transfer price 8.00 Processing costs 6.00 | Marketing costs: 4.00, 18,00 Gross Profit b. Cost Plus Method Selling price : Less: Transfer price: Materials P 4.00 Labor ‘2.00 Variable overhead 2.00 - ‘Fixed costs 2.00 Total Costs - -P10.00 Markup. (40%)'~ __4.00 Transfer price. P14.00., Processing costs. 6.00 Marketing costs __4.00 | _24.00 Gross Profit P-2:00 Selling price P26.00 Less: Transfer price: ‘Negotiated price P11.00 Processing costs: 6.00 Marketing costs. - __ 4.00 21.00 Gross Profit P 5.00 e. Dual Price Method Selling price P26.00 Less: ‘Transfer price: Variable Cost* ©“ P 8.00 Processing costs 6.00. | . Marketing costs 4.00 _18.00 Gross'Profit ~: P 8.00 Note to Dual Pricing: D1 could have assigned another transfer price to suit its division 2, Jourtal Entries Books of D1: ‘Accounts receivable, D2.. 14,000 Sales to D2 14,000 Cost of goods sold 10,000 Inventory, DI 10,000 Joutial Entries - Books of D2: D2: 14,000 ‘Accounts payable, DI. 14,000‘Transfer Pricing (Ceapter Eleven EXAMPLE PROBLEM 2 ‘rans Company is operating two divisions, TX and TY: ‘Product ZM is produced in TX drision aes vatlable tae of PIS per at Of the 30,000 units being produced by TX, 20,000 units are sold in the external. market at P25 per unit and 10,000 units are transferred to TY division at variable cost plus 40% mark-up which is acceptable to TY. Fixed costs in TX division are P100,000. :. TY Division turns out finished product ZO7 after processing further ZM, which are sold in the external market at P35 per unit. Additional processing costs ‘in TY division amounts to P80,000. All 10.000. units processed by TY were sold, The annual fixed costs of this division are P50,000. No other costs are considered. REQUIRED: os Prepare income statements forthe TX and TY divisions. 2.’ Prepare an income statement for the company asa whole, 3. Assuming that only 5,000 of the 10,000 units processed by TY division were:sold in the external market, prepare b... Income statement of the Trans Company-as a whole. SOLUTION - EXAMPLE PROBLEM 2 _ ‘ : 1, ‘TRANS COMPANY 2 TRANS COMPANY: * and *** [(P15 x 40%) + P25] x 10,000 -P210,000 ** 30,000 units x P15 = P450,000 Note: Divisional sales or transfer should not be incorporated in the income statement of the company as a whole and therefore transfer costs (price) are also excluded.‘Tremater Pricing Chapter Kleven 3a. TRANS COMPANY 3b. TRANS COMPANY Income Statement ©.” Income Statement rs TX Division TY Division by esr te " Sales-Exterhal P500,000 P175,000 —Sales-TX Division 500,000 -TY Division* 210,000 -TY Division _175,000 P675,000 Total Sales P710,000 175.000 Variable costs: Variable costs** . P450,000- P - (25,000 x P15) -.P375,000 ‘Transfer price*** : 105,000 Processing costs: on Processing costs - 40,000. > -TY Division _40,000 415,000. Total 450,000 “P145,000 » ‘Cont: Margin’ P260,000 Cont. Margin P260,000 P_ 30;000 Fixed costs: Fixed costs 100,000 + 50,000 TX Division _P100,000 Division Profits P 160,000. P( 20,000) TY Division 50,000- .150,000 Gross Margin P110,000 Note: Gross margin of the company as a whole of P110,000-does not equal the combined division profits (loss) of TX and TY amounting to P140,000 because intra-company profits (transfer) is not ‘considered profits to the company as a whole until such time "transfers (5,000 unsold) are sold to outside customers. 4 EXAMPLE PROBLEM 3 ‘Using the same data i in Example Problem 2, assume that Trans Company uses the dual transfer’ price system. TX division charges TY division at variable costs plus 40%, while TY division takes up the.transfer price only at vatiable cost.- All other information in Problem ai Temains the same. °.« REQUIRED: 1... Prepare income statements of TX and TY Divisions. 2. Prepare an income statement of Trans Company as a whole. 4‘Transfer Pricing SOLUTION - EXAMPLE PROBLEM. 3 1. TRANS COMPANY Income Statement Sales-External 500,000 -TY Division _ 210,000 Total Sales P710.000 0 Variable costs P450,000 PP - Transfer price * - 150,000 ” Processing costs 2 80,000 Total 450,000 _P230,000 Cont. Margin P260,000 .P120,000 Fixed costs 100,000 50,000 P 160,000 Division Profits + P 70,000 2. TRANS COMPANY Income Statement Sales-TX Division P500,000_ -TY Djvision _350,000 P850,000 Variable costs: TX Division P450,000 Processing costs: : TY Division 80,000 _$30:000 Cont. Margin P320,000 Fixed costs: . TX Division P100,000 TY Division 50,000. _ 150,000 Gross Margin P170,000 Note: The gross margin of the company as a whole is lower than the combined division profits of TX and TY. The difference of P60,000 is dué to the difference in dual pricing, (P210,000 - P150,000) not recognized as company profit EXAMPLE PROBLEM 4 MAR Company has two decentralized divisions, X and Y. Division X has always purchased certain units from Division Y at P120 per unit. Because Division ¥ plans to raise the price to P150 per unit, Division X desires to purchase these units be outside suppliers at P120 per unit. Division Y's costs follow: Y's variable cost pet unit ‘Y's annual fixed costs ‘Y's annual production © for X Division’ P100 P50,000 2,000 units If Division X buys from an outside supplier, the facilities of Division Y used to manufacture these units would remain idle. What would beth result if MAR enforces a transfer price of PISO per imt between Division X and Y? * SOLUTION - Cost to purchase from outside suppliers (2,000 x P120) Variable cost to make in Division Y (2,000 x P100) Net Advantage to the Company EXAMPLE PROBLEM 4 -P240,000 200,000 P 40,000