As a manager, you may be tasked with making recommendations
As a manager, you may be tasked with making recommendations as to
how your organization should structure its transfer pricing. This is especially true in cases when both variable or full cost transfer pricing is acceptable, and the choice is not obvious.
For this Assignment, take a moment to review your course text. Reflect on the scenario presented and consider how transfer pricing decisions might apply to organizational decision making.
Phipps manufactures circuit boards in Division A, a country with a 30% income tax rate, and transfers them to Division B, a country with a 40% income tax. An import duty of 15% of the transfer price is paid on all imported products. The import duty is not deductible in computing taxable income. The circuit boards’ full cost is $1,000 and variable cost is $700; they are sold by Division B for $1,200. The tax authorities in both countries allow firms to use either variable cost or full cost as the transfer price.
The Assignment:
-Part 1:Analyze the effect of both full-cost and variable-cost transfer pricing methods on Phipps’ cash flows using a spreadsheet program such as Excel.
-Part 2:Make your recommendation as to how the organization should proceed, being sure to justify your recommendation with examples form this week’s resources, and/or additional research. Complete this aspect of the Assignment by using a word processing program such as Word.PLEASE USE WORK TO CITE AN REFERENCE YOUR WORK
22MANAGEMENT ACCOUNTING QUARTERL YWINTER 2010, VOL. 11, NO. 2Most companies now operate in an envi-ronment in which their products, mar-kets, customers, employees, andtechnology are constantly changing. Insuch circumstances, the appropriateorganizational form becomes important, and a decen-tralized organization is very common. The essence ofdecentralization is the freedom managers have at vari-ous levels to make decisions within their sphere ofresponsibility. This frequently involves determining atransfer price system within the company, which has thepotential to become the most important and possiblythe most interesting problem of management control.Decentralization can simulate market conditionswithin a company between autonomously acting sub-units—i.e., they reflect competition. Managers in suchsubunits or “business units” have different degrees ofautonomy and a range of company decisions for whichthey are responsible. The cost center manager is typi-cally responsible for costs, the profit center manager forcosts and revenues, and the investment center managerfor generating an adequate return on investment.Because of the decentralization of decision making,the role of performance measurement and performanceassessment within these responsibility centers becomesimportant. These issues lead to discussion and system-atic analysis of transfer price functions between seg-ments.1Companies often use transfer prices assubstitutes for market prices either because marketprices do not exist or because they do not facilitateinternal trading and the synergies it creates. Even ifsynergies exist for internal trade, it is possible that mar-ket prices may not encourage this to happen. Thus topmanagement often imposes a transfer price in order tobenefit from these synergies. An added complication,however, is that sharing the synergistic benefitsbetween responsibility centers is arbitrary, so the“correct” transfer price cannot exist. It is obvious thattransfer prices affect the profit reported in each respon-sibility center, and, more importantly, companies canuse transfer pricing to influence decision making.We will look at the functions and different types oftransfer prices and their possible behavioral conse-quences. The analysis, which is from a managerial pointTransfer Prices:Functions, Types,and BehavioralImplicationsTRANSFER PRICES AFFECT THE PROFIT REPORTED IN EACH RESPONSIBILITY CENTER OF ACOMPANY AND CAN BE USED TO INFLUENCE DECISION MAKING. SHOWING A VARIETY OFEXAMPLES,THE AUTHORS DESCRIBE THE FUNCTIONS AND TYPES OF TRANSFER PRICESAND DISCUSS THE POSSIBLE BEHAVIORAL CONSEQUENCES OF USING THEM.BYPETERSCHUSTER, PH.D.,ANDPETERCLARKE, PH.D.Winter2010VOL.11 NO.2Winter2010
23MANAGEMENT ACCOUNTING QUARTERL YWINTER 2010, VOL. 11, NO. 2of view, argues that neither a single “true” nor a “fair”price exists, but, rather, the transfer price is conditionalon the decision context. Our article also highlights pos-sible dysfunctional behavior. We outline some examplesand propose possible solutions that we assess in thelight of behavioral effects, highlighting how complex,difficult, and insolvable the issue of transfer pricing is inreality. In order to understand the effects resulting fromasymmetric information and finding suitable transferprices, we will first discuss the functions of transferprices.FUNCTIONS OFTRANSFERPRICESThe decentralized organization is a connection of partlyindependent business units. An important task for man-agement is the performance measurement and assess-ment of these units. This requires, for example, thatthe reported profit figure for, say, profit or investmentcenters for the relevant period, should be reliable andtrustworthy. Where these business units trade with eachother, the transfer pricing system has the potential todistort reported profit performance. Therefore, theinternal profit-allocation function and related perfor-mance measurement of business units are crucial ele-ments of transfer pricing.Transfer prices should also influence managerialdecision making because they should provide an incen-tive to maximize the business units’ profit targets. Werefer to this as the coordination function. If managerialdecisions lead to maximized profits within all theautonomous business units, then this should also maxi-mize the total company or, in the following “group,”profits, ignoring tax and foreign exchange considera-tions. Business unit managers’ decisions then are identi-cal to the decisions that the group’s top managers wouldmake if they had all the necessary information.There is a potential conflict between these two func-tions of transfer prices, namely the profit-allocationfunction (reliable and trustworthy prices and, thus,reported profits) and the coordination function (guidingbehavior of decentralized managers by using the trans-fer prices). One solution is to reduce the discretion ofsubunit managers in setting transfer prices. Thisapproach, however, partly defeats the original purposeof decentralization and reduces the validity of assessingsuch responsibility units on the basis of reported profitas it is no longer an aspect for which companies canhold them directly responsible.There are additional functions for transfer prices.Besides the primary functions of profit allocation andcoordination functions, transfer prices fulfill other tasks,such as complying with financial reporting regulationsin addition to tax considerations.2We will not discussthem here, however. Instead, we will concentrate onthe two primary functions of transfer prices togetherwith their behavioral consequences, which companiesoften do not understand.TYPES OFTRANSFERPRICES ANDTHEIRDETERMINATIONGenerally, companies can determine transfer pricesthree different ways: market-based transfer prices, cost-based transfer prices, and negotiated transfer prices.Although each method provides a different “answer,”their commonality is that transfer prices represent anintracompany market mechanism. We will now discusseach type of transfer price.Market-Based Transfer PricesMarket-based transfer prices represent market condi-tions and, therefore, simulate the market-within-the-company idea. Their advantage is that they support andimplement corporate strategy and allow performancemeasurement of responsibility centers using market-oriented data. A prerequisite for this method is a stan-dardized, existing market of the product or a substitute.Companies can determine a market-based transfer priceby comparing current prices if the business unit alsosells to the market. Alternatively, they can obtain trans-fer prices from the marketplace if a comparable com-petitive product exists. Problems do occur with thisapproach, however, if, for example, a company uses“marginal prices” in order to use idle capacity. In suchcircumstances, the short-term price may not be equiva-lent to the long-term price. Furthermore, should oneinclude special discounts? Another major problem withmarket-based prices is their trustworthiness, and thisraises questions such as:◆Who submits the information?◆Who decides which suppliers are asked for an offer,
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