A transfer pricing system should satisfy three objectives: accurate performance evaluation, goal congruence, and preservation of divisional autonomy.Accurate performance evaluation means that no one divisional manager should benefit at the expense of another (in the sense that one division is made better off while the other is made worse off). Goal congruence means that divisional managers select actions that maximize firmwide profits. Autonomy means that central management should not interfere with the decision-making freedom of divisional managers. The transfer pricing problem concerns finding a system that simultaneously satisfies all three objectives.
We can evaluate the degree to which a transfer price satisfies the objectives of a transfer pricing system by considering the opportunity cost of the goods transferred. The opportunity cost approach can be used to describe a wide variety of transfer pricing practices. Under certain conditions, this approach is compatible with the objectives of performance evaluation, goal congruence, and autonomy. The opportunity cost approach identifies the minimum price that a selling division would be willing to accept and the maximum price that the buying division woul be willing to pay. These minimum and maximum prices correspond to the opportunitycosts of transferring internally. They are defined for each division as follows:
We can evaluate the degree to which a transfer price satisfies the objectives of a transfer pricing system by considering the opportunity cost of the goods transferred. The opportunity cost approach can be used to describe a wide variety of transfer pricing practices. Under certain conditions, this approach is compatible with the objectives of performance evaluation, goal congruence, and autonomy. The opportunity cost approach identifies the minimum price that a selling division would be willing to accept and the maximum price that the buying division woul be willing to pay. These minimum and maximum prices correspond to the opportunitycosts of transferring internally. They are defined for each division as follows:
- The minimum transfer price, or floor, is the transfer price that would leave the selling division no worse off if the good is sold to an internal division.
- The maximum transfer price, or ceiling, is the transfer price that would leave the buying division no worse off if an input is purchased from an internal division. The opportunity cost rule signals when it is possible to increase firmwide profits through internal transfers. Specifically, a good should be transferred internally whenever the opportunity cost (minimum price) of the selling division is less than the opportunity cost (maximum price) of the buying division. By its very definition, this approach ensures that the divisional manager of either division is no worse off by transferring internally. This means that total divisional profits are not decreased by the interna transfer.
Rarely does central management set specific transfer prices. Instead, most companies develop some general policies that divisions must follow. Three commonly used policies are market-based transfer pricing, negotiated transfer pricing, and cost-based transfer pricing. Each of these can be evaluated according to the opportunity cost approach.
Market Price
If there is an outside market for the intermediate product (the good to be transferred) and that outside market is perfectly competitive, the correct transfer price is the market price. In such a case, divisional managers’ actions will simultaneously optimize divisional profits and firmwide profits. Furthermore, no division can benefit at the expense of another division. In this setting, central management will not be tempted to intervene.The opportunity cost approach also signals that the correct transfer price is the marketprice. Since the selling division can sell all that it produces at the market price, transferring internally at a lower price would make that division worse off. Similarly, the buying division can always acquire the intermediate good at the market price, so it would be unwilling to pay more for an internally transferred good. Since the minimum transfer price for the selling division is the market price and since the maximum price for the buying division is also the market price, the only possible transfer price is the market price. In fact, moving away from the market price will decrease the overall profitability of the firm. This principle can be used to resolve divisional conflicts that may occur, as the following example illustrates.
Read negotiated transfer prices
Yarrow Manufacturers is a large, privately held corporation that produces small appliances. The company has adopted a decentralized organizational structure. The Parts Division, which is at capacity, produces parts that are used by the Motor Division. The parts can also be sold to other manufacturers and to wholesalers at a market price of $8. For all practical purposes, the market for the parts is perfectly competitive. Suppose that the Motor Division, operating at 70 percent capacity, receives a special order for 100,000 motors at a price of $30. Full manufacturing cost of the motors is $31, broken down as follows
Notice that the motor includes a part transferred in from the Parts Division at a marketbased transfer price of $8. Should the Parts Division lower the transfer price to allow the Motor Division to accept the special order? We can use the opportunity cost approach to answer this question. Since the Parts Division can sell all that it produces, the minimum transfer price is the market price of $8. Any lower price would make the Parts Division worse off. For the Motor Division, identifying the maximum transfer price that can be paid so that it is no worse off is a bit more complex.
Since the Motor Division is under capacity, the fixed overhead portion of the motor’s cost is not relevant. The relevant costs are those additional costs that will be incurred if the order is accepted. These costs, excluding for the moment the cost of the transferred-in component, equal $13 ($10 + $2 +$1). Thus, the contribution to profits before considering the cost of the transferred-in component is $17 ($30 - $13). The division could pay as much as $17 for the component and still break even on the special order. However, since the component can always be purchased from an outside supplier for $8, the maximum price that the division should pay internally is $8. As a result, the market price is the best transfer price.
Since the Motor Division is under capacity, the fixed overhead portion of the motor’s cost is not relevant. The relevant costs are those additional costs that will be incurred if the order is accepted. These costs, excluding for the moment the cost of the transferred-in component, equal $13 ($10 + $2 +$1). Thus, the contribution to profits before considering the cost of the transferred-in component is $17 ($30 - $13). The division could pay as much as $17 for the component and still break even on the special order. However, since the component can always be purchased from an outside supplier for $8, the maximum price that the division should pay internally is $8. As a result, the market price is the best transfer price.
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