TRANSFER PRICING

PERFORMANCE MANAGEME
 INTRODUCTION

❖ When a company has a divisionalised structure subsidiaries, some of the subsidiaries or

divisions might supply goods or services to other divisions in the same company.

❖ If we are measuring the performance of each division separately then it becomes important
that divisions are able to charge each other for goods or services supplied

• What is Transfer Pricing

• A transfer price is the price at which goods or services are sold by one division (selling
division) within a company to another division (buying division) in the same company.
Internal sales are referred to as transfers, so the internal selling and buying price is the
transfer price.

❖ In accounting, when goods are sold or transferred by one division to another within the same
organisation, the sale for one division is matched by the purchase by the other division, and
total profit of the company as a whole is unaffected.

❖ However, for effective performance measurement, a decision has to be made regarding what
the transfer price should be.
 TRANSFER PRICING METHODS

• Two broad approaches to transfer pricing:

▪ the cost of the item (to the selling division); or

▪ a price that is higher than the cost to the selling division, which may be cost plus a
profit margin or related to the external market price of the item transferred.

❑ It is important to note that transfer prices are only important in so far as they
encourage divisions to trade in a way that maximises profits for the company as a
whole
 GENERAL PRINCIPLES ON TRANSFER PRICING

1. Where there is an external market for the product being transferred

• a). Minimum transfer price (Seller’s Perspective)

•
We consider transfer pricing from the point of view of the selling subsidiary or
division. The question we ask is: what is the minimum selling price that the selling
division would be prepared to sell for? This may not always be the same as the
price that the selling division would be happy to sell for, although, if it does not
have spare capacity, it is the same.

• The minimum transfer price that should ever be set if the selling division is to be
happy is: marginal cost + opportunity cost.

• Opportunity cost is defined as the 'value of the best alternative that is foregone
when a particular course of action is undertaken'. Given that there will only be an
opportunity cost if the seller does not have any spare capacity, the first question to
ask is therefore: does the seller have spare capacity?
 GENERAL PRINCIPLES ON TRANSFER PRICING

• Spare capacity
If there is spare capacity, then, for any sales that are made by using that spare capacity, the
opportunity cost is zero. This is because workers and machines are not fully utilised. So, where a
selling division has spare capacity the minimum transfer price is effectively just marginal cost (i.e,
variable costing). However, this minimum transfer price will result in a loss equal to the division’s
Fixed Cost and the division manager may probably seek to negotiate transfer price.
• No spare capacity
If the seller doesn’t have any spare capacity, or it doesn’t have enough spare capacity to meet all
external demand and internal demand, then the next question to consider is: how can the
opportunity cost be calculated? Given that opportunity cost represents contribution foregone, it
will be the amount required in order to put the selling division in the same position as they would
have been in had they sold outside of the group.
❑ Logically, the buying division must be charged the same price as the external buyer would pay, less
any reduction for cost savings that result from supplying internally. These reductions might reflect,
for example, packaging and delivery costs that are not incurred if the product is supplied internally
to another division.
❑ The steps:
(i) Determine the price to sell the product to external parties
(ii) determine any cost savings from selling internally.
• (iii) deduct (ii) from (i) to arrive at the minimum transfer price.
 GENERAL PRINCIPLES ON TRANSFER PRICING

• Maximum transfer price (Buyer’s Perspective)

❖
When we consider the maximum transfer price, we are looking at transfer pricing
from the point of view of the buying division. The question we are asking is: what is
the maximum price that the buying division would be prepared to pay for the
product? The answer to this question is very simple and the maximum price will be
one that the buying division is also happy to pay.

❖ The maximum price that the buying division will want to pay is the market price for
the product – ie whatever they would have to pay an external supplier for it.

❖ If this is the same as the selling division sells the product externally for, the buyer
might reasonably expect a reduction to reflect costs saved by trading internally.
This would be negotiated by the divisions and is called an adjusted market price
 GENERAL PRINCIPLES ON TRANSFER PRICING

• 2. Where there is no external market for the product being transferred

• Sometimes, there will be no external market at all for the product being supplied by the selling
division; perhaps it is a particular type of component being made for a specific company product. In
this situation, it is not really appropriate to adopt the approach above. In reality, in such a situation,
the selling division may well just be a cost centre, with its performance being judged on the basis of
cost variances. This is because the division cannot really be judged on its commercial performance,
so it doesn’t make much sense to make it a profit centre. Options here are to use a cost based
approach to transfer pricing but these also have their advantages and disadvantages.

• Cost based approaches

• a). Variable cost

A transfer price set equal to the variable cost that the transferring division produces very good or
item sold.

• The draw back with this that the transferring division will make a loss equal to its Fixed Cost which
can be demotivating, while the buying division gets an easy ride as it is not charged enough to
cover all costs of manufacture. Therefore, if marginal cost is going to be used as a transfer price, it
at least should be standard marginal cost, so that efficiencies and inefficiencies stay within the
divisions responsible for them.
 GENERAL PRINCIPLES ON TRANSFER PRICING

• b). Full cost : Fixed Cost + Variable Cost

• c). Full cost plus – Adding a mark up to the full cost

• d). Variable cost plus

• The difficulty with full cost, full cost plus and variable cost plus is that they
all result in fixed costs and profits being perceived as marginal costs.
Therefore divisions will have the wrong data to enable it to make good
economic decisions for the group – even if it wanted to. In fact, once you
get away from a transfer price equal to the variable cost in the transferring
division, there is always the risk of dysfunctional decisions being made
unless an upper limit – equal to the net marginal revenue in the receiving
division – is also imposed.
 TRANSFER PRICING

• The objectives of transfer pricing

• In most organizations, transfer prices are decided by management.

However, when authority is delegated to divisional managers, the
managers of the selling and buying divisions should be given the authority
to negotiate and agree the transfer prices for any goods or services ‘sold’
by one division to the other.

• The objectives of transfer pricing should be to make it possible for

divisionalisation to operate successfully within a company, and:

❑ give autonomy (freedom to make decisions) to the managers of the profit

centres or investment centres; and

❑ enable the company to measure the performance of each division in a fair

way.
 TRANSFER PRICING

• In addressing transfer pricing questions, an alternative approach is to follow the steps below:

❑ Step 1. Begin by identifying the arrangement for transferring goods internally that would maximise
the profits of the company as a whole. In other words, what solution is best for the company?

❑ Step 2. Having identified the plan that is in the best interests of the company as a whole, identify
the transfer price, or range of transfer prices, that will make the manager of the buying division
want to work towards this plan. The transfer price must ensure that, given this transfer price, the
profits of the division will be maximised by doing what is in the best interests of the company as a
whole.

❑ Step 3. In the same way, having identified the plan that is in the best interests of the company as a
whole, identify the transfer price, or range of transfer prices, that will make the manager of the
selling division want to work towards the same plan. Again, the transfer price must ensure that,
given the transfer price, the profits of the division will be maximised by doing what is in the best
interests of the company as a whole.
 TRANSFER PRICING STRATEGY BY MULTINATIONAL FIRMS

• When considering a multinational firm, additional objectives are to:

1. Pay lower taxes, duties, and tariffs Be aware that multinational firms will be keen
to transfer profits if possible from high tax countries to low tax ones.

2. Repatriate funds from foreign subsidiary companies to head office

3. Be less exposed to foreign exchange risks

4. Build and maintain a better international competitive position

5. Enable foreign subsidiaries to match or undercut local competitors’ prices

6. have good relations with governments in the countries in which the multinational
firm operates
 QUALITIES OF A GOOD TRANSFER PRICING SYSTEM.

• 1.Preserve divisional autonomy: divisionalisation is accompanied by a degree of decentralisation in

decision making so that specific managers and teams are put in charge of each division and must
run it to the best of their ability. Divisional managers are therefore likely to resent being told by
head office which products they should make and sell. Ideally, divisions should be given a simple,
understandable objective such as maximising divisional profit

• 2.Maintain motivation for managers Be perceived as being fair for the purposes of performance
evaluation and investment decisions.

• 3.Assess divisional performance objectively Permit each division to make a profit: profits are
motivating and allow divisional performance to be measured using positive ROI or positive RI

• 4.Ensure goal congruence Encourage divisions to make decisions which maximise group profits: the
transfer price will achieve this if the decisions which maximise divisional profit also happen to
maximise group profit – this is known as goal congruence. Furthermore, all divisions must want to
do the same thing. There’s no point transferring out if the next division doesn’t want to transfer in.
In practice it is difficult to achieve all four aims.
 PRACTICE QUESTION 1
A company has two divisions, Division A and Division B.
Division A makes a component X which is transferred to Division B. Division B uses component X
to make end-product Y.
Both divisions are profit centres within the company. Details of costs and selling price are as
follows:
Division A ₦
Cost of component X Variable cost 100
Fixed cost 80
Total cost 180

Division B
Further processing costs Variable cost 40
Fixed cost 70
Total Cos t 110
Selling price per unit of product Y 400

The further processing costs of Division B do not include the cost of buying component X from
Division A. One unit of component X goes into the production of one unit of Product Y. Fixed
costs in both divisions will be the same, regardless of the volume of production and sales.
Required
What is the ideal transfer price, or what is a range of prices that would be ideal for the transfer
price assuming there is no market for the product?
 PRACTICE QUESTION – NOV. 2020

Adeb Nigeria Limited has two divisions, Eastern and Northern divisions. Eastern division makes
materials that are used to manufacture special blocks. It transfers some of these materials to the
Northern division and sells some of the materials externally to other block manufacturers. Northern
division makes special blocks from the materials and sells them to traders in building materials.

The production capacity of Eastern division is 10,000 tonnes per month. At present, sales are limited
to 5,000 tonnes to external customers and 3,000 tonnes to Northern division.

The transfer price was agreed at ₦200 per tonne in line with the external sales trade price at 1st July
which was the beginning of the budget year. From 1st December, however, strong competition in the
market has reduced the market price for the materials to ₦180 per tonne.
The manager of the Northern division has suggested that the transfer price for the materials from
Eastern division should be the same as for external customers. The manager of Eastern division
rejected this suggestion on the basis that the original budget established the transfer price for the
entire financial year.
From each tonne of materials, Northern division produces 10 blocks, which it sells at ₦40 per blocks.
It would sell a further 20,000 blocks if the price were reduced to ₦32 per block.
 PRACTICE QUESTION – NOV. 2020

Other relevant data are given below: Eastern division Northern division
N N
Variable cost per tonne 70 60
Fixed cost per month 150,000 60,000

The variable costs of Northern division exclude the transfer price of materials from Eastern division

Required:
a. Prepare estimated profit statements for the month of December for each division and for Adeb
Nigeria Limited as a whole, based on transfer prices of ₦200 per tonne and of ₦180 per tonne, when
producing at
i. 80% capacity
ii. 100% capacity, on the assumption that Northern division reduces the selling price to ₦32. (10
Marks)
b. Comment on the effect that might result from a change in the transfer price from ₦200 to ₦180. (5
Marks)
c. Suggest an alternative transfer price that would provide an incentive for Northern division to
reduce the selling price and increase sales by 20,000 blocks a month. (5 Marks) (Total 20 Marks
PRACTICE QUESTION 3
PRACTICE QUESTION 3
 PRACTICE QUESTION 4

A company consists of two divisions, Division A and Division B. Division A is operating at full
capacity making Product X, for which there is an external market.

The variable cost of making one unit of Product X is ₦700, and the sale price of Product X in
the external market is ₦1,000 per unit.

Division B needs one unit of Product X to manufacture another product, Product Y. The
variable conversion costs and further processing costs in Division B are ₦290 per unit of
Product Y. The external selling price of Product Y is ₦1,400 per unit.
An external supplier has offered to sell units of Product Y to Division B for
₦1,030 per unit.

Required
(a) Identify the ideal transfer price.
(b) Calculate the contribution per unit for each Division and for the company as a whole if this
transfer price is used.
(c) Suggest with reasons whether this transfer price provides a fair measure of divisional
performance.
 PRACTICE QUESTION 5 / MARCH-JUNE 2020

Olascom Nigeria Limited has two operating divisions, Western

division and Eastern division that are treated as profit centres
for the purpose of performance reporting.

Western division makes two products, Tot and Tal. Tot is sold to
external customers for ₦310 per unit. Tal is a part-finished
item that is sold only to Eastern division.

Eastern division can obtain the part-finished item from either

Western division or from an external supplier. The external
supplier charges a price of ₦275 per unit
PRACTICE QUESTION 5 / MARCH-JUNE 2020
QUESTION?