Divisional Performance And Transfer Pricing Issues

DIVISIONAL STRUCTURE AND PERFORMANCE MEASURES

In this section we look at three performance measures relevant in a divisionalised structure.

These are Return on Investment, Residual Income and Economic Value Added .

Return on Investment (ROI) and Residual Income (RI) were discussed previously when we considered the scope of strategic performance measures in the private sector.  In this chapter we will just pick out the salient features that apply to their use in divisionalised structures.

Divisional performance: return on investment (ROI)

Return on investment (ROI) is a form of ROCE and is calculated as:

Profit before Interest and Tax x 100

Operations Management Capital Employed

ROI is normally applied  to investment centres or profit centres. These normally reflect the existing organisation structure of the business.

Evaluation of ROI

You may like to consider the following factors when evaluating the use of ROI as a divisional performance measure.

  • Comparisons. It permits comparisons to be drawn between investment centres that differ in their absolute size.
  • Aggregation. ROI is a very convenient method of measuring the performance for a division or company as an entire unit.
  • Using an identical target return. This may not be suitable for many divisions or investment centres as it makes no allowance for the different risk of each investment centre.
  • Misleading impression of improved performance. If an investment centre maintains the same annual profit, and keeps the same assets without a policy of regular non-current asset replacement, its ROI will increase year by year as the assets get older. This can give a false impression of improving ‘real’ performance over time.
  • Valuation and classification of assets. Many of the criticisms of ROI arise from the valuation of assets used in the denominator. Refer back to Chapter 12 for a full explanation of the problems in measuring asset values. Chapter 12 also refers to the tricky decision of when to classify expenditure as assets.
  • Short-term perspective. Since managers will be judged on the basis of the ROI that their centre earns each year, they are likely to be motivated into taking those decisions, which increase their centre’s short-term ROI. So, in the short term, a desire to increase ROI might lead to projects being taken on without due regard to their risk
  • Lack of goal congruence. An investment might be desirable from the group’s point of view, but would not be in the individual investment centre’s ‘best interest’ to undertake. Furthermore, any decisions which benefit the company in the long term but which reduce the ROI in the immediate short term would reflect badly on the manager’s reported performance.

Divisional performance: residual income (RI)

Residual income is a measure of the centre’s profits after deducting a notional or imputed interest cost.

Its use highlights the finance charge associated with funding.

Evaluation of RI

You may like to consider the following factors when evaluating the use of RI. Think about how it compares to ROI as a possible divisional performance measure.

Usefulness in decision-making. Residual income increases in the following circumstances.

    • Investments earning above the cost of capital are undertaken
    • Investments earning below the cost of capital are eliminated

Thus it leads managers to make the correct investment decision to benefit the company as a whole.

  • Flexibility compared to ROI since a different cost of capital can be applied to investments with different risk characteristics.
  • Does not allow comparisons between investment centres. RI cannot be used to make comparisons between investment centres as it is an absolute measure of performance.
  • Difficulty in deciding on an appropriate and accurate measure of the capital employed. As we discussed above, there can be some difficulty in knowing what values to place on assets.
  • Does not relate the size of a centre’s income to the size of the investment, other than indirectly through the interest charge.

Divisional performance: Economic Value Added (EVA®)

EVA ® is an alternative absolute performance measure. It is similar to RI and is calculated as follows.

EVA = net operating profit after tax (NOPAT) less capital charge where the capital charge = weighted average cost of capital × net assets

® Economic value added (EVA) is a registered trade mark owned by Stern Stewart & Co. It is a specific type of residual income (RI) calculated as follows.

EVA = net operating profit after tax (NOPAT) less capital charge

where the capital charge = weighted average cost of capital x net assets

You can see from the formula that the calculation of EVA is very similar to the calculation of RI.

EVA and RI are similar because both result in an absolute figure, which is calculated by subtracting an imputed interest charge from the profit earned by the investment centre. However there are differences as follows.

  • The profit figures are calculated differently. EVA is based on an ‘economic profit‘ which is derived by making a series of adjustments to the accounting profit.
  • The notional capital charges use different bases for net assets. The replacement cost of net assets is usually used in the calculation of EVA.

 

The calculation of EVA is different from RI because the net assets used as the basis of the imputed interest charge are usually valued at their replacement cost and are increased by any costs that have been capitalised (see below).

There are also differences in the way that NOPAT is calculated compared with the profit figure that is used for RI, as follows.

 

  • Costs which would normally be treated as expenses, but which are considered within an EVA calculation as investments building for the future, are added back to NOPAT to derive a figure for ‘economic profit’. These costs are included instead as assets in the figure for net assets employed, i.e. as investments for the future. Costs treated in this way include items such as goodwill, research and development expenditure and advertising costs.
  • Adjustments are sometimes made to the depreciation charge, whereby accounting depreciation is added back to the profit figures, and economic depreciation is subtracted instead to arrive at NOPAT. Economic depreciation is a charge for the fall in asset value due to wear and tear or obsolescence.
  • Any lease charges are excluded from NOPAT and added in as a part of capital employed.

 

Another point to note about the calculation of NOPAT, which is the same as the calculation of the profit figure for RI, is that interest is excluded from NOPAT because interest costs are taken into account in the capital charge.

Evaluation of EVA

The advantages of EVA include the following.

  • Real wealth for shareholders. Maximisation of EVA will create real wealth for the shareholders.
  • Less distortion by accounting policies. The adjustments within the calculation of EVA mean that the measure is based on figures that are closer to cash flows than accounting profits.
  • An absolute value. The EVA measure is an absolute value, which is easily understood by non-financial managers.
  • Treatment of certain costs as investments thereby encouraging expenditure. If management are assessed using performance measures based on traditional accounting policies they may be unwilling to invest in areas such as advertising and development for the future because such costs will immediately reduce the current year’s accounting profit. EVA recognises such costs as investments for the future and thus they do not immediately reduce the EVA in the year of expenditure.

 

EVA does have some drawbacks.

 

  • Focus on short-term performance. It is still a relatively short-term measure, which can encourage managers to focus on short term performance.
  • Dependency on historical data. EVA is based on historical accounts, which may be of limited use as a guide to the future. In practice, the influences of accounting policies on the starting profit figure may not be completely negated by the adjustments made to it in the EVA model.
  • Number of adjustments needed to measure EVA. Making the necessary adjustments can be problematic as sometimes a large number of adjustments are required.
  • Comparison of like with like. Investment centres, which are larger in size, may have larger EVA figures for this reason. Allowance for relative size must be made when comparing the relative performance of investment centres.

 

MEASURING PERFORMANCE

One of the problems of measuring managerial performance is segregating managerial performance from the economic performance of their department or division.

Managerial performance

The distinction between the manager’s performance and that of the division is very important. C. T. Horngren provides a good illustration .

‘The most skilful divisional manager is often put in charge of the sickest division in an attempt to change its fortunes. Such an attempt may take years, not months. Furthermore the manager’s efforts may merely result in bringing the division up to a minimum acceptable ROI. The division may continue to be a poor profit performer in comparison with other divisions. If top management relied solely on the absolute ROI to judge management, the skilful manager would be foolish to accept such a troubleshooting assignment.’

It is difficult to devise performance measures that relate specifically to a manager to judge his or her performance as a manager. It is possible to calculate statistics to assess the manager as an employee like any other employee (days absent, professional qualifications obtained, personability and so on), but this is not the point. As soon as the issue of ability as a manager arises it is necessary to consider him or her in relation to his/her area of responsibility. If we want to know how good a manager is at marketing the only information there is to go on is the marketing performance of their division (which may or may not be traceable to his/her own efforts).

In summary then, managers should only be assessed on results within their control.

Divisional performance should be based on total economic performance to provide an assessment of the measure of the worth of the division to the organisation.

 

Profit statement

A possible profit statement for a division might look as follows:

    RWF
Sales revenue    X
Variable costs    (X)
Contribution   X
Controllable fixed costs   (X)
Controllable profit   X
Non-controllable fixed costs    (X)
Divisional profit   X

 

Contribution should be an acceptable measure of managerial performance unless it contains imposed transfers and transfer prices.

Controllable profit may be a more appropriate measure of managerial performance where managers can make decisions about equipment rental or labour costs. It is more acceptable when managers are free to secure services either in house or from third parties. Deprecation is likely to be included and this will only be controllable to the extent that managers control investment decisions.

Divisional profit is unlikely to be an acceptable managerial measure. It is suitable for assessing the economic performance of the divisions provided the allocation of fixed costs is reasonable.

WHEN TRANSFER PRICING IS REQUIRED

It is necessary for control purposes that some record of the market in inter-divisional goods or services should be kept. One way of doing this is through the accounting system. Interdivisional work  can be given a cost or a charge: a transfer price.

Introduction to transfer pricing

Where there are transfers of goods or services between divisions of an organisation, the transfers could be made ‘free’ or ‘as a favour’ to the division receiving the benefit. For example, if a garage and car showroom has two divisions, one for car repairs and servicing and the other for car sales, the servicing division will be required to service cars before they are sold and delivered to customers. There is no requirement for this service work to be charged for: the servicing division could do its work for the car sales division without making any record of the work done.

Unless the cost or value of such work is recorded, however, management cannot keep a proper check on the amount of resources (such as labour time) being used up on new car servicing. It is necessary for control purposes that some record of the inter-divisional services should be kept, and one way of doing this is through the accounting system. Interdivisional work can be given a cost or charge: a transfer price.

A transfer price is the price at which goods or services are transferred from one department to another, or from one member of a group to another.

Criteria for design of a transfer pricing policy

Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing divisional performance measurement or discouraging overall corporate profit maximisation.

Divisional autonomy

Transfer prices are particularly appropriate for profit centres because if one profit centre does work for another the size of the transfer price will affect the costs of one profit centre and the revenues of another.

However, a danger with profit centre accounting is that the business organisation will divide into a number of self-interested segments, each acting at times against the wishes and interests of other segments. A profit centre manager might take decisions in the best interests of his own part of the business, but against the best interests of other profit centres and possibly the organisation as a whole.

A task of head office is therefore to try to prevent dysfunctional decision making by individual profit centres. To do this, it must reserve some power and authority for itself and so profit centres cannot be allowed to make entirely autonomous decisions.

Just how much authority head office decides to keep for itself will vary according to individual circumstances. A balance ought to be kept between divisional autonomy to provide incentives and motivation, and retaining centralised authority to ensure that the organisation’s profit centres are all working towards the same target, the benefit of the organisation as a whole (in other words, retaining goal congruence among the organisation’s separate divisions).

Divisional profit maximisation

Profit centre managers tend to put their own profit performance above everything else. Since profit centre performance is measured according to the profit they earn, no profit centre will want to do work for another and incur costs without being paid for it. Consequently, profit centre managers are likely to dispute the size of transfer prices with each other, or disagree about whether one profit centre should do work for another or not. Transfer prices affect behaviour and decisions by profit centre managers.

Corporate profit maximisation

When there are disagreements about how much work should be transferred between divisions, and how many sales the division should make to the external market, there is presumably a profit-maximising level of output and sales for the organisation as a whole. However, unless each profit centre also maximises its own profit at this same level of output, there will be inter-divisional disagreements about output levels and the profit-maximising output will not be achieved.

The ideal solution

Ideally a transfer price should be set at a level that overcomes these problems.

  • The transfer price should provide an ‘artificial’ selling price that enables the transferring division to earn a return for its efforts, and the receiving division to incur a cost for benefits received.
  • The transfer price should be set at a level that enables profit centre performance to be measured ‘commercially’ (that is, it should be a fair commercial price).
  • The transfer price, if possible, should encourage profit centre managers to agree on the amount of goods and services to be transferred, which will also be at a level that is consistent with the organisation’s aims as a whole such as maximising company profits

In practice it is very difficult to achieve all three aims.

THE ‘GENERAL RULE’

We shall see eventually that the ideal transfer price should reflect the opportunity cost of sale to the supplying division and the opportunity cost to the buying division. However, this ‘general rule’ requires extensive qualification, and you will need to work through the rest of this chapter before we return to it and you fully appreciate what it means. In the meantime, be content with Horngren’s formulation of the problem:

‘Is there an all-pervasive rule for transfer pricing that leads toward optimal decisions for the organisation as a whole? No. Why? Because the three criteria of goal congruence, managerial effort, and sub-unit autonomy must all be considered simultaneously.’

THE USE OF MARKET PRICE

Transfer prices may be based on market price (or an adjusted market price) where there is an external market for the item being transferred.

Market price as the transfer price

If an external market price exists for transferred goods, profit centre managers will be aware of the price they could charge or the price they would have to pay for their goods on the external market, and so will compare this price with the internal transfer price.

Adjusted market price

However, internal transfers are often cheaper than external sales, with savings in selling and administration costs, bad debt risks and possibly transport/delivery costs. It would therefore seem reasonable for the buying division to expect a discount on the external market price.

The transfer price might be slightly less than market price, so that A and B could share the cost savings from internal transfers compared with external sales. It should be possible to reach agreement on this price and on output levels with a minimum of intervention from head office.

The merits of market value transfer prices

Divisional autonomy

In a decentralised company, divisional managers should have the autonomy to make output, selling and buying decisions, which appear to be in the best interests of the division’s performance. (If every division optimises its performance, the company as a whole must inevitably achieve optimal results.) Thus a transferor division should be given the freedom to sell output on the open market, rather than to transfer it within the company.

‘Arm’s length’ transfer prices, which give profit centre managers the freedom to negotiate prices with other profit centres as though they were independent companies, will tend to result in a market-based transfer price. 

Corporate profit maximisation

In most cases where the transfer price is at market price, internal transfers should be expected, because the buying division is likely to benefit from a better quality of service, greater flexibility, and dependability of supply. Both divisions may benefit from cheaper costs of administration, selling and transport. A market price as the transfer price would therefore result in decisions, which would be in the best interests of the company or group as a whole.

 

Divisional performance measurement

Where a market price exists, but the transfer price is a different amount (say, at standard cost plus), divisional managers will argue about the volume of internal transfers.

For example, if division X is expected to sell output to division Y at a transfer price of Rwf8 per unit when the open market price is Rwf10, its manager will decide to sell all output on the open market. The manager of division Y would resent the loss of his cheap supply from X, and would be reluctant to buy on the open market. A wasteful situation would arise where X sells on the open market at Rwf10, where Y buys at Rwf10, so that administration, selling and distribution costs would have been saved if X had sold directly to Y at Rwf10, the market price.

The disadvantages of market value transfer prices

Market value as a transfer price does have certain disadvantages.

  • The market price may be a temporary one, induced by adverse economic conditions, or dumping, or the market price might depend on the volume of output supplied to the external market by the profit centre.
  • A transfer price at market value might, under some circumstances, act as a disincentive to use up any spare capacity in the divisions. A price based on incremental cost, in contrast, might provide an incentive to use up the spare resources in order to provide a marginal contribution to profit.
  • Many products do not have an equivalent market price so that the price of a similar, but not identical, product might have to be chosen. In such circumstances, the option to sell or buy on the open market does not really exist.
  • The external market for the transferred item might be imperfect, so that if the transferring division wanted to sell more externally, it would have to reduce its price.

 

COST-BASED APPROACHES TO TRANSFER PRICING

Problems arise with the use of cost-based transfer prices because one party or the other is liable to perceive them as unfair.

Cost-based approaches to transfer pricing are often used in practice, because in practice the following conditions are common.

  • There is no external market for the product that is being transferred.
  • Alternatively, although there is an external market it is an imperfect one because the market price is affected by such factors as the amount that the company setting the transfer price supplies to it, or because there is only a limited external demand.

 

In either case there will not be a suitable market price upon which to base the transfer price.

Transfer prices based on full cost

Under this approach, the full cost (including fixed overheads absorbed) incurred by the supplying division in making the ‘intermediate’ product is charged to the receiving division. If a full cost plus approach is used a profit margin is also included in this transfer price. An intermediate product is one that is used as a component of another product, for example car headlights or food additives.

Divisional autonomy, divisional performance measurement and corporate   profit maximisation

In the above case the transfer price fails on all three criteria for judgement.

  • Arguably, it does not give A fair revenue or charge B a reasonable cost, and so their profit performance is distorted. It would certainly be unfair, for example, to compare A’s profit with B’s profit.
  • Given this unfairness it is likely that the autonomy of each of the divisional managers is under threat. If they cannot agree on what is a fair split of the external profit a decision will have to be imposed from above.
  • It would seem to give A an incentive to sell more goods externally and transfer less to B. This may or may not be in the best interests of the company as a whole.

Divisional autonomy, divisional performance measurement and corporate profit maximisation

  • This result is deeply unsatisfactory for the manager of division A who could make an additional RWF4,400 (RWF(8,000 – 3,600)) profit if no goods were transferred to division B.
  • Given that the manager of division A would prefer to transfer externally, head office are likely to have to insist that internal transfers are made.
  • For the company overall, external transfers only would cause a large fall in profit, because division B could make no sales at all.

 

The problem is that with a transfer price at marginal cost the supplying division does not cover its fixed costs.

 

FIXED COST AND TRANSFER PRICING

Fixed costs in the supplying division can be accounted for in a number of ways to ensure that it at least breaks even.

There are a number of ways in which this problem could be overcome.

Sharing contribution

Each division can be given a share of the overall contribution earned by the organisation, but it is probably necessary to decide centrally what the shares should be, undermining divisional autonomy. Alternatively central management could impose a range within which the transfer price should fall, and allow divisional managers to negotiate what they felt was a fair price between themselves.

Two-part charging system

Transfer prices are set at variable cost and once a year there is a transfer of a fixed fee to the supplying division, representing an allowance for its fixed costs. Care is needed with this approach. It risks sending the message to the supplying division that it need not control its fixed costs because the company will subsidise any inefficiencies. On the other hand, if fixed costs are incurred because spare capacity is kept available for the needs of other divisions it is reasonable to expect those other divisions to pay a fee if they ‘booked’ that capacity in advance but later failed to utilise it. The main problem with this approach once more is that it is likely to conflict with divisional autonomy.      

Dual pricing

Be careful not to confuse this term with ‘two-part’ transfer pricing. Dual pricing means that two separate transfer prices are used.

  • For the transfer of goods from the supplying division to the receiving division the transfer price is set at variable cost. This ensures that the receiving division makes optimal decisions and it leads to corporate profit maximisation.
  • For the purposes of reporting results the transfer price is based on the total costs of the transferring division, thus avoiding the possibility of reporting a loss.

This method is not widely used in practice.

Addressing organisational structure

One final possibility that may be worth mentioning. Given that the problems are caused by the divisional structure, might it not be better to address the structure, for example by merging the two divisions, or ceasing to treat the transferring division as a profit centre. This may not be practical. Some would argue that the benefits of decentralisation in terms of motivation outweigh any costs that might arise due to slight inefficiencies.

STANDARD COST VERSUS ACTUAL COST

Standard costs should be used for transfer prices to avoid encouraging inefficiency in the supplying division.

When a transfer price is based on cost, standard cost should be used, not actual cost. A transfer of actual cost would give no incentive to control costs, because they could all be passed on. Actual cost-plus transfer prices might even encourage the manager of A to overspend, because this would increase the divisional profit, even though the company as a whole (and division B) suffers.

COST-BASED APPROACHES WITH NO EXTERNAL MARKET

With no external market, the transfer price should be set in the range where variable cost in the supplying division net marginal revenue in the receiving division.

Unlimited capacity and no external market

So far we have considered the use of cost-based approaches where the following factors applied.

  • There was a limit on the maximum output of the supplying division.
  • There was a limit to the amount that could be sold in the intermediate market.

 

We found that a marginal cost based approach led to the best decisions for the organisation overall, but that this was beset with problems in maintaining divisional autonomy and measuring divisional performance fairly.

We shall now consider whether this finding changes in different conditions. We shall remove the limit on output and demand for the final product, but assume that there is no intermediate market at all.

Example: unlimited capacity and no intermediate market

Motivate Ltd has two profit centres, P and Q. P transfers all its output to Q. The variable cost of output from P is RWF5,000 per unit, and fixed costs are RWF1,200,000 per month. Additional processing costs in Q are RWF4,000 per unit for variable costs, plus fixed costs of

RWF800k. Budgeted production is 400 units per month, and the output of Q sells for RWF15k per unit. The transfer price is to be based on standard full cost plus. From what range of prices should the transfer price be selected, in order to motivate the managers of both profit centres to both increase output and reduce costs?

Summary

To summarise the transfer price should be set in the range where:

Variable cost in supplying Selling price minus variable costs (net division marginal revenue) in the receiving

division

In fact, if there is no external market, and if the transferred item is the major product of the transferring division, there is a strong argument for suggesting that profit centre accounting is a waste of time.

Profit centres cannot be judged on their commercial performance because there is no way of gauging what a fair revenue for their work should be. It would be more appropriate, perhaps, to treat the transferring ‘division’ as a cost centre, and to judge performance on the basis of cost variances.

OPPORTUNITY COSTS AND TRANSFER PRICES

If a profit-maximising output level has been established, the transfer price should be set such that there is not a more profitable opportunity for individual divisions. In other words transfer prices should include opportunity costs of transfer.

The ideal transfer price

Ideally, a transfer price should be set that enables the individual divisions to maximise their profits at a level of output that maximises profit for the company as a whole. The transfer price which achieves this is unlikely to be a market-based transfer price (if there is one) and is also unlikely to be a simple cost plus based price.

An opportunity cost approach

If optimum decisions are to be taken transfer prices should reflect opportunity costs.

  • If profit centre managers are given sufficient autonomy to make their own output and selling decisions, and at the same time their performance is judged by the company according to the profits they earn, they will be keenly aware of all the commercial opportunities.
  • If transfers are made for the good of the company as a whole, the commercial benefits to the company ought to be shared between the participating divisions.

 

Transfer prices can therefore be reached by:

  • Recognising the levels of output, external sales and internal transfers that are best for the company as a whole, and
  • Arriving at a transfer price that ensures that all divisions maximise their profits at this same level of output. The transfer price should therefore be such that there is not a more profitable opportunity for individual divisions. This in turn means that the opportunity costs of transfer should be covered by the transfer price.

         

BLANK

TRANSFER PRICING WHEN INTERMEDIATE PRODUCTS ARE IN SHORT SUPPLY

When an intermediate resource is in short supply and acts as a limiting factor on production in the supplying division, the cost of transferring an item is the variable cost of production plus the contribution obtainable from using the scarce resource in its next most profitable way.

Central information

The only way to be sure that a profit-maximising transfer policy will be implemented is to dictate the policy from the centre. This means that the following information must be available centrally.

  • A precise breakdown of costs in each division at all levels of output
  • Market information for each market, indicating the level of demand at a range of prices
  • Perhaps most vitally, knowledge of the likely reaction of divisional managers to a centrally imposed policy that undermines their autonomy and divisional profits

 

Why not try to explain in your own words why transfer prices should reflect opportunity costs?

If you cannot do so, start reading this section again. You probably would not be able to do a Paper P5 transfer pricing question unless you can give this explanation.

Optimal transfer prices: an extended example

A group of highly integrated divisions wishes to be advised as to how it should set transfer prices for the following inter-divisional transactions:

  • Division L sells all its output of product LX to Division M. To one kilogram of LX, Division M adds other direct materials and processes it to produce two kilograms of product MX which it sells outside the group. The price of MX is influenced by volume offered and the following cost and revenue data are available:

Division L

TRANSFER PRICING AND A RANGE OF LIMITING FACTORS

If a supplying division is subject to a range of limiting factors, the optimum production plan can be derived using a linear programming model.

In practice, as you probably remember, where there are more than two variables in the objective function and more than a few constraints a computer software package is needed.

The output from the model will show how many sachets of X and Y should be produced and how many litres, if any, of B should be sold externally. The output also provides a means of calculating the ideal transfer price, because it indicates the shadow price of scarce resources.

 

SHADOW PRICE AND TRANSFER PRICES

Shadow prices replace opportunity costs when determining transfer prices if there are constraints on production.

The shadow price is the maximum extra amount that it would be worth paying to obtain one extra unit of a scarce resource. To put it another way, the shadow price is the opportunity cost of the scarce resource, the amount of benefit forgone by not having the availability of the extra resources.

NEGOTIATED TRANSFER PRICES

In practice, negotiated transfer prices, market-based transfer prices and full cost-based transfer prices are the methods normally used.

A transfer price based on opportunity cost is often difficult to identify, for lack of suitable information about costs and revenues in individual divisions. In this case it is likely that transfer prices will be set by means of negotiation. The agreed price may be finalised from a mixture of accounting arithmetic, politics and compromise.

The process of negotiation will be improved if adequate information about each division’s costs and revenues are made available to the other division involved in the negotiation. By having a free flow of cost and revenue information, it will be easier for divisional managers to identify opportunities for improving profits, to the benefit of both divisions involved in the transfer.

A negotiating system that might enable goal congruent plans to be agreed between profit centres is as follows.

  • Profit centres submit plans for output and sales to head office, as a preliminary step in preparing the annual budget.
  • Head office reviews these plans, together with any other information it may obtain. Amendments to divisional plans might be discussed with the divisional managers.
  • Once divisional plans are acceptable to head office and consistent with each other, head office might let the divisional managers arrange budgeted transfers and transfer prices.
  • Where divisional plans are inconsistent with each other, head office might try to establish a plan that would maximise the profits of the company as a whole. Divisional managers would then be asked to negotiate budgeted transfers and transfer prices on this basis.
  • If divisional managers fail to agree a transfer price between themselves, a head office ‘arbitration’ manager or team would be referred to for an opinion or a decision.
  • Divisions finalise their budgets within the framework of agreed transfer prices and resource constraints.
  • Head office monitors the profit performance of each division.

         

MULTINATIONAL TRANSFER PRICING

Multinational transfer pricing needs to take account of a range of factors.

  • Exchange rate fluctuations
  • Anti-dumping legislation
  • Exchange controls
  • Taxation in different countries
  • Competitive pressures
  • Import tariffs
  • Repatriation of funds

 

Globalisation, the rise of the multinational corporation and the fact that more than 60% of world trade takes place within multinational organisations mean that international transfer pricing is very important.

Factors to consider when setting multinational transfer prices

The level at which a transfer price should be set is even less clear cut for organisations operating in a number of countries, when even more factors need to be taken into consideration. Moreover, the manipulation of profits through the use of transfer pricing is a common area of confrontation between multinational organisations and host country governments.

 

 

Factors to consider Explanation
Exchange rate fluctuation The value of a transfer of goods between profit centres in different countries could depend on fluctuations in the currency exchange rate.
Taxation in different countries If taxation on profits is 20% of profits in Country A and 50% on profits in Country B, a company will presumably try to ‘manipulate’ profits (by means of raising or lowering transfer prices or by invoicing the subsidiary in the high-tax country for ‘services’ provided by the subsidiary in the lowtax country) so that profits are maximised for a subsidiary in Country A, by reducing profits for a subsidiary in Country B.

Some multinationals set up marketing subsidiaries in countries with low tax rates and transfer products to them at a relatively low transfer price. When the products are sold to the final customer, a low rate of tax will be paid on the difference between the two prices.

Import tariffs Suppose that Country A imposes an import tariff of 20% on the value of goods imported. A multi-national company has a subsidiary in Country A which imports goods from a subsidiary in Country B. In such a situation, the company would minimise costs by keeping the transfer price to a minimum value.
Exchange controls If a country imposes restrictions on the transfer of profits from domestic subsidiaries to foreign multinationals, the restrictions on the transfer can be overcome if head office provides some goods or services to the subsidiary and charges exorbitantly high prices, disguising the ‘profits’ as sales revenue, and transferring them from one country to the other. The ethics of such an approach should, of course, be questioned.
Antidumping

legislation

Governments may take action to protect home industries by preventing companies from transferring goods cheaply into their countries. They may do this, for example, by insisting on the use of a fair market value for the transfer price.
Competitive pressures Transfer pricing can be used to enable profit centres to match or undercut local competitors.
Repatriation of funds By inflating transfer prices for goods sold to subsidiaries in countries where inflation is high, the subsidiaries’ profits are reduced and funds repatriated, thereby saving their value.

Transfer prices and tax

Tax authorities obviously recognise the incentive to set transfer prices to minimise taxes and import tariffs. Many tax authorities have the power to modify transfer prices in computing tariffs or taxes on profit, although a genuine arms-length market price should be acceptable.

  • For instance, UK government legislation restricts how far companies can declare their profits in a low taxation country. Some scope for profit apportionment between divisions clearly exists, however. HM Revenue and Customs has the power to adjust the taxable income of the UK party to a cross-border transaction to the figure that would have resulted if the prices actually used had been between two unrelated parties (‘arm’s length’ price).
  • And in the USA, multinational organisations must follow an Internal Revenue Service Code specifying that transfers must be priced at ‘arm’s length’ market values, or at the values that would be used if the divisions were independent companies. Even with this rule, companies have some leeway in deciding an appropriate ‘arm’s length’ price.

 

To meet the multiple objectives of transfer pricing, companies may choose to maintain two sets of accounting records, one for tax reporting and one for internal management reporting. The tax authorities may interpret the use of two sets of records as suggestive of profit manipulation, however.

Double taxation agreements between countries mean that companies pay tax on specific transactions in one country only. If a company sets an unrealistically low transfer price, however, the company will pay tax in both countries (double taxation) if it is spotted by the tax authorities.

Most countries now accept the Organisation for Economic Co-operation and Development (OECD) 1995 guidelines. These aim to standardise national approaches to transfer pricing and provide guidance on the application of the ‘arm’s length’ price. This can be determined in three main ways.

  • Comparable uncontrolled price method is the most widely used and involves setting the arm’s length price on the basis of the externally verified prices of similar products. In other words, the market price or an approximation to one is used. It can be difficult to make meaningful comparisons, however, as most international trade is carried out between related companies.
  • Resale price method involves deducting a percentage from the selling price of the final product to allow for profit.
  • Cost-plus method. This method is used where there is no market price and so the comparable uncontrolled price method cannot be used.

 

These methods are of little use in determining arm’s length prices for intangible assets such as a trade name, however, and much of the information required is not in the public domain. Setting transfer prices is therefore not straightforward.

Many countries are tightening their regulations in response to the OECD guidelines. In the UK, for example, it used to be up to the tax authorities to detect cases of inappropriate transfer pricing. Under self-assessment, it is now the duty of the tax payer to provide the correct information. A penalty of 100% of any tax adjustment is payable for failing to demonstrate a reasonable attempt at using an arm’s length price in a tax return. The taxpayer may enter into an Advanced Pricing Agreement (APA) with the two tax authorities involved. This is done in advance to avoid dispute, double taxation and penalties.

The pros and cons of different transfer pricing bases

  • A transfer price at market value is usually encouraged by the tax and customs authorities of both host and home countries as they will receive a fair share of the profits made but there are problems with its use.
    • Prices for the same product may vary considerably from one country to another.
    • Changes in exchange rates, local taxes and so on can result in large variations in selling price.
    • A division will want to set its prices in relation to the supply and demand conditions present in the country in question to ensure that it can compete in that country.
  • A transfer price at full cost is usually acceptable to tax and customs authorities since it provides some indication that the transfer price approximates to the real cost of supplying the item and because it indicates that they will therefore receive a fair share of tax and tariff revenues.
  • Transfer prices at variable cost are unlikely to be acceptable to the tax authorities of the country in which the supplying division is based as all the profits are allocated to the receiving division and the supplying division makes a loss equal to the fixed costs incurred.
  • In a multinational organisation, negotiated transfer prices may result in overall suboptimisation because no account is taken of factors such as differences in tax and tariff rates between countries.

 

CHAPTER ROUNDUP

  • EVA ® is an alternative absolute performance measure. It is similar to RI and is calculated as follows.

EVA = net operating profit after tax (NOPAT) less capital charge  where the capital charge = weighted average cost of capital × net assets

  • EVA and RI are similar because both result in an absolute figure, which is calculated by subtracting an imputed interest charge from the profit earned by the investment centre. However there are differences as follows.
    1. The profit figures are calculated differently. EVA is based on an ‘economic profit‘ which is derived by making a series of adjustments to the accounting profit.
    2. The notional capital charges use different bases for net assets. The replacement cost of net assets is usually used in the calculation of EVA.
  • One of the problems of measuring managerial performance is segregating managerial performance from the economic performance of their department or division.
  • It is necessary for control purposes that some record of the market in interdivisional goods or services should be kept. One way of doing this is through the accounting system. Inter-divisional work can be given a cost or a charge: a transfer price.
  • Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing divisional performance measurement or discouraging overall corporate profit maximisation.
  • Transfer prices may be based on market price (or an adjusted market price) where there is an external market for the item being transferred.
  • Problems arise with cost-based transfer prices because one party or the other is liable to perceive them as unfair.
  • Fixed costs in the supplying division can be accounted for in a number of ways to ensure that it at least breaks even.
  • Standard costs should be used for transfer prices to avoid encouraging inefficiency in the supplying division.
  • With no external market, the transfer price should be set in the range where variable cost in the supplying division net marginal revenue in the receiving division.
  • If a profit-maximising output level has been established, the transfer price should be set such that there is not a more profitable opportunity for individual divisions. In other words transfer prices should include opportunity costs of transfer.
  • When an intermediate resource is in short supply and acts as a limiting factor on production in the supplying division, the cost of transferring an item is the variable cost of production plus the contribution obtainable from using the scarce resource in its next most profitable way.
  • If a supplying division is subject to a range of limiting factors, the optimum production plan can be derived using a linear programming model.
  • Shadow prices replace opportunity costs when determining transfer prices if there are constraints on production.
  • In practice, negotiated transfer prices, market-based transfer prices and full costbased transfer prices are the methods normally used.
  • Multinational transfer pricing needs to take account of a range of factors.

− Exchange rate fluctuations

− Anti-dumping legislation

− Taxation in different countries

− Competitive pressures

− Import tariffs

− Repatriation of funds

− Exchange controls

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