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Transfer pricing
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  1. Transfer pricing 6 maggio 2008

  2. Horizontal dimension at the business unit level • Business units as independent units which have the responsibility on one product/market • To evaluate the economic behavior of BU the top management has to solve the following problems: • the definition of partial Profit/Loss statements for Business Unit; • the evaluation of possible internal trade (goods/services) between business units (transfer pricing determination).

  3. Transfers within the company • A transfer is referred to the movement of goods from a responsibility center to another, within the same company • Different types of responsibility center, belonging to different organizational levels, are involved in the transfers

  4. Transfers within the company: the profit centers • If the manager of a responsibility center is allowed to sell the produced part (intermediate product) also to outside customers (he is not obliged to sell the part exclusively to another company center), its responsibility center is a profit center (the manager has the responsibility both on costs and revenues) • The manager of a profit center must choose between the alternative of selling outside or transferring the part within the company (which customer, external or internal, is giving the higher price?) • The manager which uses the intermediate product must choose between the alternative of purchasing it from outside supplier or from an internal unit (which supplier, internal or external, is giving the lower cost?) • If the transfer is not obliged (from a profit center) its value is called “transfer pricing” • The problem is: how transfer prices should be defined?

  5. Transfers within the company: top management and division managers • Top management wants to have information about the transfers between profit centers because he wants to have the maximum overall company profit; • Due to the fact that “transfer pricing” provides a rule for sharing transfer extra-profit between division managers, these managers are interested in its definition • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result is obtainable through the application of the make-or-buy data analysis

  6. Optional transfers between profit centers: which transfer price? • We use the following example: Yard Equipment Company and its responsibility centers: Braxton and Clipper units • 1° case: Braxton produces engines. It is a profit center: it is not obliged to transfer engines to Clipper division and can sell engines outside in the market; Clipper division is a profit center as well. • The question is: which is the value used for the transfer? External customers Engines Finished product (grass-cutting machine) Braxton Ouside market of finished product Clipper External customers

  7. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Optional transfers between profit centers: which transfer price? • Transfer price is an internal price for optional transfers of an intermediate product from a profit center to another profit center • Both the managers of the selling unit and the buying unit must agree on the transfer • Anyway, the transfer is convenient only if the overall company profits are increasing • Three are the studied situations: 1. Braxton has available capacity in excess to realize the internal transfer to Clipper 2. Braxton has not capacity in excess 3. Differential fixed costs are generated by the internal transfer

  8. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis 1. Optional transfers from profit centers: available capacity • Braxton is selling 100 engines to outside customers at price per unit=$300 • Braxton has capacity of producing 150 engines monthly • Clipper manager wants to buy 50 engines and not more, so that Braxton capacity is sufficient to realize the transfer to Clipper without abandoning the external sales • The Braxton and Clipper data are the following:

  9. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis 1. Optional transfers from profit centers: available capacity • Braxton is saving variable sale costs for $15 if it transfers engines to Clipper • Clipper manager has two alternatives: to buy engines from the outside supplier at $275 or to buy engines from Braxton. He wants to obtain the lower cost engine, so that his superior limit of price for the internal transferis $275 (he obviously accepts any lower price) • Braxton manager wants an internal price so that he can maintain his already achieved contribution margin. If Braxton has capacity in excess the alternatives are: to sell 50 engines to Clipper or not to produce these engines due to the fact that there are not any other external customers. Consequently, the internal transfer price must cover at least the internal standard variable costs ($175). Obviously, Braxton manager accepts any other higher price. Anyway, $175 isthe inferior limit of price for the internal transfer • Yard Equipment Company wants to obtain the engines at the lower costs. The overall company has two alternatives: to produce 50 extra engines in the Braxton division or to buy these motors for Clipper division from an outside supplier at $275. Obviously the overall company prefers the internal transfer because it manages to save $100 per engine

  10. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis 1. Optional transfers from profit centers: available capacity • The convenience (extra-profit or cost saving) for Yard Equipment Company is obtainable from the difference between the maximum price (determined by Clipper) and the minimum price (determined by Braxton) • GENERAL RULE: a transfer price range is so existing, acceptable for both the managers. If the superior limit (max price for buying division) is higher than the inferior limit (min price for selling division), Yard Equipment Company has got always extra-profit from the transfer, if the selling division has capacity in excess. Both the managers should agree to realize the transfer

  11. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis 2. Optional transfers from profit centers: not available capacity • Braxton is saturating his capacity with the external sales (150 engines, all sold to external customers). Its inferior limit is different because its alternatives are different: to sell all the engines to outside customers or to transfer a part of them (50) to Clipper. In this case, achieving the break-even means maintaining the same contribution margin obtainable by the external sales • Inferior limit=$175+$110=$285 • Alternatively we can derive the Inferior limit if the capacity is saturated (by selling division) as= Normal Selling price ($300) - Normal Variable costs saved with the internal transfer ($15)= $285

  12. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis 2. Optional transfers from profit centers: not available capacity • Clipper division has again a superior limit of price of $275 (engine price from external supplier). It is not influenced by the level of Braxton capacity • Yard Equipment Company saves costs of $100 (internal production, $175, respect to external purchasing price, $275), but it loses a contribution margin of $110 for each engine not sold to outside customers. Consequently, Yard has a net loss of $10 for each transferred engine. In fact, the different between the superior limit of price (by buying division), $275, and the inferior limit of price (by selling division), $285, is negative, -$10

  13. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Optional transfers from profit centers: the transfer pricing matrix • To compare the two situations the tool is the Transfer pricing Matrix. It gives to the managers the relevant information to decide about the internal transfer

  14. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis 3. Optional transfers from profit centers: differential fixed costs • Suppose that Braxton has to occur additional fixed costs to produce engines for Clipper because Clipper wants 20 engines with specific features (ex. with a particular name printed above). Braxton has to buy a specific printing machine for $1000, not usable for normal engines. The internal transfer generates differential fixed costs. The transfer pricing matrix is so modified (fixed costs as a total):

  15. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis 3. Optional transfers from profit centers: how is modified the transfer pricing matrix with differential fixed costs • fixed costs as amount per unit:

  16. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Optional transfers from profit centers: the choose of the transfer pricing and the sharing of the profits • Use of the superior limit of price (transfer price=$275) considering the situation of capacity in excess, all the transfer extra-profits $100 are associated to Braxton division (Transfer pricing $275 - Internal variable costs $175=$100); Clipper manager is indifferent respect the external or internal buying • Use of the inferior limit of price (transfer price=$175) all the transfer profits are associated to Clipper division • Use of the average point in the interval (transfer price=$225) the transfer profits are shared in equal parts between the two division ($225-$175=$50 for Braxton; $275-$225=$50 for Clipper)

  17. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Optional transfers from profit centers: not available capacity and incremental fixed cost • GENERAL FORMULA for Inferior limit (by selling division) is as follows: Ivc= Variable internal costs Cmu= Contribution margin per unit of product, lost due to the fact the selling division has not sold to outside customers Dfc= Differential fixed cost for unit of product, if it exists, generated by the internal transfer (look at the 3° situation) Inferior limit of price=Ivc+Cmu+Dfc

  18. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Optional transfers from profit centers: the choose of the transfer pricing and the sharing of the profits • Transfer pricing is only a rule for sharing transfer extra-profit between division managers; any transfer price is at the end chosen, the overall company extra-profit derived from the transfer does not change • The transfer overall profit is equal to the difference between the superior limit of price (by buying division) and inferior limit of price (by selling division). Each price is fixed, in fact, the sum of division profits is always equal to the company overall profit derived by the transfer

  19. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Optional transfers from profit centers: who should decide the transfer pricing? • If managers of divisions are not evaluated and rewarded on the base of the transfer extra-profit, there is no real conflict in the transfer pricing fixing. The controller can decide the level of transfer pricing without particular conflicts • If managers are evaluated and rewarded on the base of the profit derived by internal transfer, there is a potential great conflict related to the transfer price fixing. The internal transfer can be compromised even if the overall company profit is increasing because managers of divisions do not agree about the profit sharing. Different options can be followed by controller: - fixing a transfer price, declaring the sharing of profit. The established price is sometimes useful to save taxes at the overall company level moving profits from higher tax rate countries to lower tax rate countries - requiring the transfer, but not fixing a transfer price, asking that the managers negotiate it (long time could be necessary in this case, but the managers “accept” the transfer) • anyway, you realize that the transfer pricing problem is very hard in the modern management control systems

  20. Obliged transfers from cost centers • 2° case: Braxton unit is a cost center (it is obliged to transfer engines to Clipper division that is a profit center. Braxton cannot sell engines outside) • The question is: which is the value used for the transfer? Other division Engine Finished product (grass-cutting machine) Braxton Ouside market of finished product Clipper Other division

  21. Obliged transfers from cost centers: alternative value options 1. Transfer at cost: which cost? (actual/standard, full/variable) 2. Transfer at market price

  22. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Obliged transfers from cost centers: which cost? • Braxton shows a negative variance both in the variable costs ($10 per engine) and in the fixed costs ($10 per engine) for a total negative variance of $20 per engine ($20*100 engines=$2000 total) • If the actual cost is used as transfer cost, overall Yard Equipment Company could have problems in terms of: 1. Braxton manager has not incentive to control costs because he realizes that any actual cost will be transfer to the Clipper Division ($20 are hidden in the grass-cutting machine costs) 2. It could be difficult to evaluate each manager performance. Obviously, Clipper manager is not available to accept the variance in his evaluation of performance. If other components are transferred on the base of actual cost, the total cost of finished product includes all the variances. Consequently it is very difficult to find the responsibilities and to evaluate the performances 3. Clipper manager has problems in forecasting his costs. In fact, he knows the engine cost only at the actual transfer moment. It could be late for changing the final price of the product to take into consideration the major engine cost

  23. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Obliged transfers from cost centers: which cost? • If the standard cost is used as transfer cost ($18000=transferred costs, $2000=variance at the Braxton cost center): 1. Braxton manager has incentive to control costs because his evaluation is based on the obtained variances 2. Clipper manager is able to do better forecasting about his production costs • Standard cost: variable or full? 1. If full cost is used as transfer price, it is possible to determine a more appropriate selling price for the finished product (cost + mark-up). In addition, the variance about fixed costs is correctly associated to the Braxton manager(“right evaluation”). 2. If variable cost is used, the fixed costs are not included in the transfer costing of the engine. The fixed costs will be charged to the cost of sold goods as an overall sum. In this way the referring to the cost centers responsible for the variances is lost.

  24. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Obliged transfers from cost centers: which cost? • If outside suppliers are existing and Clipper division can buy from them, a market price is available as transfer costing • Market price represents the “opportunity cost” to obtain the engines, but it does not represent a real cost. In fact, if the market price is used as transfer price, the cost of grass-cutting machine could be over-evaluated in the case the engine cost of Braxton is lower than the market price (=$250)

  25. Top management wants to have information about the transfers between profit centers because wants to have the maximum overall company profit • A specific tool is available to have the relevant information about internal transfer. The tool is called “Transfer Pricing Matrix” • The same result, as we’ll realize through a set of examples, is obtainable through the application of the make-or-buy data analysis Obliged transfers from cost centers: which cost? • Yard Equipment Company saves costs due to the fact Braxton division produces engines ($250 -$200)*100 engines=$5000 • But, since Braxton division cannot sell engines to outside customers, the positive variance is only an unreal profit (a “dummy profit”) for Braxton division and a major cost for Clipper division • In the reality, a market price is sometimes used, creating an unreal profit in the statement of the supplier-division. Possible reasons are the following: 1. Taxes implications for the multinational companies. If, for example, the engine cost production is lower in Mexico than in California (lower costs of labor), and the Braxton production is consequently made in Mexico, the resulting cost of grass-cutting machine in California should be lower and the taxes on income higher. If the California tax-rate is major than Mexico tax-rate, it is convenient to use the $250 market price to bring the $5000 profit to Braxton division in Mexico. This profit moving allows Yard Equipment Company to really save costs for taxes. 2. Creation of a responsibility on profit. As a first step towards the transformation of a cost center into a profit center