Transfer pricing is the method used to sell a product from one subsidiary to another within a company. It impacts the purchasing behavior of the subsidiaries, and may have income tax implications for the company as a whole.
Required:
Describe any THREE methods of transfer pricing and discuss their limitations. (6 marks)
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Market-based transfer prices:
Under this method, transfer prices are based on readily determinable and available market prices. The method is particularly applicable under competitive and efficient market conditions. This is applicable where there is an open market for the intermediate product of the selling division.
Limitations
1. Appropriate Market Price may not Exist:
2. Excess Production Capacity
Marginal cost transfer prices:
Under this method, transfer prices are based on variable costs. This is applicable under short term and in cases of one-off transactions and where the division is purely a cost centre.
Limitations
1. Long-term pricing. The method is completely unacceptable for long-term price setting, since it will result in prices that do not capture a company’s fixed expenses.
2. Ignores market prices. Marginal cost pricing sets prices at their absolute minimum. Any company routinely using this methodology to determine its prices may be giving away an enormous amount of margin that it could have earned if it had instead set prices at or near the market rate.
3. Customer loss. If a company routinely engages in marginal cost pricing and then attempts to raise its prices, it may find that it was selling to customers who are extremely sensitive to price changes, and who will abandon it at once.
Full cost transfer prices (Absorption costing):
Full costs transfer prices are based on total costs; fixed and variable costs. This method is suitable when dealing with purely cost centres and for costing routine transactions. The method is also used when the entity is operating under the long run.
Limitations
1. Ignores competition. A company may set a product price based on the full cost plus formula and then be surprised when it finds that competitors are charging substantially different prices.
2. Ignores price elasticity. The company may be pricing too high or too low in comparison to what buyers are willing to pay. Thus, it either ends up pricing too low and giving away potential profits, or pricing too high and achieving minor revenues.
3. Product cost overruns. Under this method, the engineering department has no incentive to prudently design a product that has the appropriate feature set and design characteristics for its target market (see the target costing method). Instead, the department simply designs what it wants and launches the product.
Cost-plus a mark-up transfer prices:
Cost-plus mark-up based prices are based on costs and a profit element. This method is applicable when dealing with profit centres where in addition to the recovery of costs, divisional profitability is a prime objective.
Limitations
1. Product cost overruns. Under this method, the engineering department has no incentive to prudently design a product that has the appropriate feature set and design characteristics for its target market (see the target costing method). Instead, the department simply designs what it wants and launches the product.
2. Contract cost overruns. From the perspective of any government entity that hires a supplier under a cost plus pricing arrangement, the supplier has no incentive to curtail its expenditures – on the contrary, it will likely include as many costs as possible in the contract so that it can be reimbursed. Thus, a contractual arrangement should include cost-reduction incentives for the supplier.
3. Ignores replacement costs. The method is based on historical costs, which may have changed. The most immediate replacement cost is more representative of the costs incurred by the entity.
Negotiated Transfer Price:
This is a price that is established as a result of discussions between the buying and selling divisions. Here, selling and buying divisions will only agree to the transfer price only if the profits of their respective divisions increase as a result of the transfer. This method of determining prices has various advantages: First, divisional autonomy is maintained. Second, managers of divisions have better cost versus benefit information. Where idle capacity exists for the selling division.
Limitations
1. Sub-optimal: The agreed transfer price may depend on the negotiating skills and bargaining powers of the managers involved. The final result may not always be optimal
2. Conflicts: Rather than agreement on transfer prices, negotiations can lead to conflict between divisions and may require top-management mediation.
3. Defeat of Performance evaluation criteria: Transfer prices dependent on Manager’s negotiations skill will defeat the very purpose of performance evaluation.
4. Time and Cost: Negotiations are time consuming for the managers involved, particularly when the number of transactions and interdependencies are large.
(3 marks for Explanation, 3 marks for Limitations)