There is no doubt that transfer pricing is an area that candidates find difficult.It’s not surprising,then,that when it
There is no doubt that transfer pricing is an area that candidates find difficult.It’s not surprising,then,that when it was examined in June 2014’s Performance Management exam,answers were not always very good.
The purpose of this article is to strip transfer pricing back to the basics and consider,first,why transfer pricing is important;secondly,the general principles that should be applied when setting a transfer price;and thirdly,an approach to tackle exam questions in this area,specifically the question from June 2014’s exam.We will talk about transfer pricing here in terms of two divisions trading with each other.However,don’t forget that these principles apply equally to two companies within the same group trading with each other.
This article assumes that transfer prices will be negotiated between the two parties.It does not look at alternative methods such as dual pricing,for example.This is because,in Performance Management,the primary focus is on working out a sensible transfer price or range of transfer prices,rather than different techniques to setting transfer prices.
Why transfer pricing is important
It is essential to understand that transfer prices are only important in so far as they encourage divisions to trade in a way that maximises profits for the company as a whole.The fact is that the effects of inter-divisional trading are wiped out on consolidation anyway.Hence,all that really matters is the total value of external sales compared to the total costs of the company.So,while getting transfer prices right is important,the actual transfer price itself doesn’t matter since the selling division’s sales(a credit in the company accounts)will be cancelled out by the buying division’s purchases(a debit in the company accounts)and both figures will disappear altogether.All that will be left will be the profit,which is merely the external selling price less any cost incurred by both divisions in producing the goods,irrespective of which division they were incurred in.
As well as transfer prices needing to be set at a level that maximises company profits,they also need to be set in a way that is compliant with tax laws,allows for performance evaluation of both divisions and staff/managers,and is fair and therefore motivational.A little more detail is given on each of these points below:
If your company is based in more than one country and it has divisions in different countries that are trading with each other,the price that one division charges the other will affect the profit that each of those divisions makes.In turn,given that tax is based on profits,a division will pay more or less tax depending on the transfer prices that have been set.While you don’t need to worry about the detail of this for the Performance Management exam,it’s such an important point that it’s simply impossible not to mention it when discussing why transfer pricing is important.
From bullet point 1,you can see that the transfer price set affects the profit that a division makes.In turn,the profit that a division makes is often a key figure used when assessing the performance of a division.This will certainly be the case if return on investment(ROI)or residual income(RI)is used to measure performance.Consequently,a division may,for example,be told by head office that it has to buy components from another division,even though that division charges a higher price than an external company.This will lead to lower profits and make the buying division’s performance look poorer than it would otherwise be.The selling division,on the other hand,will appear to be performing better.This may lead to poor decisions being made by the company.
If this is the case,the manager and staff of that division are going to become unhappy.Often,their pay will be linked to the performance of the division.If divisional performance is poor because of something that the manager and staff cannot control,and they are consequently paid a smaller bonus for example,they are going to become frustrated and lack the motivation required to do the job well.This will then have a knock-on effect to the real performance of the division.As well as being seen not to do well because of the impact of high transfer prices on ROI and RI,the division really will perform less well.
The impact of transfer prices could be considered further but these points are sufficient for the level of understanding needed for the Performance Management exam.Let us now go on to consider the general principles that you should understand about transfer pricing.Again,more detail could be given here and these are,to some extent,oversimplified.However,this level of detail is sufficient for the Performance Management exam.
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