transfer pricing

Performance Evaluation for Performance Evaluation for Decentralized OperationsDecentralized Operations

Over Under Budget Actual Budget Budget

Budget Performance ReportSupervisor, Department 1—Plant A

For the Month Ended October 31, 2006

Factory wages $ 58,100 $ 58,000 $100Materials 32,500 34,225 $1,725Supervisory salaries 6,400 6,400 Power and light 5,750 5,690 60Depreciation 4,000 4,000 Maintenance 2,000 1,990 10Insurance, taxes 975 975

$109,725 $111,280 $1,725 $170

Cost CentersCost Centers

$109,725$109,725 $111,280$111,280 $1,725$1,725 $170$170


Administration $ 17,500 $ 17,350 $150

Department 1 109,725 111,280 $1,555

Department 2 190,500 192,600 2,100

Department 3 149,750 149,100 650

$467,475 $470,330 $3,655 $800

Budget Performance ReportManager, Plant A



Department 1 109,725 111,280 $1,555 Department 1 109,725 111,280 $1,555

Administration $ 17,500 $ 17,350 $150

Department 1 109,725 111,280 $1,555

Department 2 190,500 192,600 2,100

Department 3 149,750 149,100 650

$467,475 $470,330 $3,655 $800


$467,475 $470,330 $3,655 $800$467,475 $470,330 $3,655 $800

Budget Performance ReportManager, Plant A



Budget Performance ReportVice-President, Production

For the Month Ended October 31, 2006Over Under

Budget Actual Budget Budget

Administration $ 19,500 $ 19,700 $ 200

Plant A 467,475 470,330 2,855

Plant B 395,225 394,300 $925

$882,200 $884,330 $3,055 $925


Plant APlant A 467,475467,475 470,330470,330 2,8552,855

Note that “Over Budget” is a net figure.Note that “Over Budget” is a net figure.

Budget Performance ReportVice-President, Production

For the Month Ended October 31, 2006Over Under

Budget Actual Budget Budget

Administration $ 19,500 $ 19,700 $ 200

Plant A 467,475 470,330 2,855

Plant B 395,225 394,300 $925

$882,200 $884,330 $3,055 $925

Each of the line items above is supported by a cost center report.Each of the line items above is

supported by a cost center report.


Responsibility Accounting for Profit Centers

Responsibility Accounting for Profit Centers

In a profit center, the unit manager has the responsibility and the authority to make

decisions that affect both costs and revenues.

Profit centers may be divisions, departments,

or products.

Profit centers may be divisions, departments,

or products.

Profit CentersProfit Centers

NEG, a diversified entertainment company, has two profit centers: the Theme Park

Division and the Movie Production Division.

NEG, a diversified entertainment company, has two profit centers: the Theme Park

Division and the Movie Production Division.

Theme Park Division

Movie Production Division

Revenues $6,000,000 $2,500,000Operating expenses 2,495,000 405,000

Charging Service Department Costs to Production Divisions


Purchasing Department: $400,000(Activity base: number of purchase requisitions)

Theme Park Division 25,000 purchase requisitions

Movie Production Division: 15,000 purchase requisitions

Total 40,000

$400,000

40,000 purchase requisitions$10 per purchase requisition

=




Payroll Accounting: $255,000(Activity base: number of payroll checks)

$255,000

15,000 payroll checks= $17 per payroll check

Theme Park Division 12,000 payroll checks

Movie Production Division: 3,000 payroll checks

Total 15,000




Legal Department: $250,000(Activity base: number of payroll checks)

$250,000

1,000 hours= $250 per hour

Theme Park Division 100 billed hours

Movie Production Division: 900 billed hours

Total 1,000


Nova Entertainment GroupService Department Charges to NEG Divisions

For the Year Ended December 31, 2006

Theme Movie Park Production

Service Department Division Division


Purchasing $250,000 $150,000

25,000 purchase 25,000 purchase requisitions x $10 requisitions x $10

per purchase per purchase requisitionrequisition







Purchasing $250,000 $150,000Payroll accounting 204,000 51,000

12,000 payroll 12,000 payroll checks x $17 per checks x $17 per

payroll checkpayroll check












Purchasing $250,000 $150,000Payroll accounting 204,000 51,000Legal 25,000 225,000






100 hours x $250 100 hours x $250 per hourper hour




Purchasing $250,000 $150,000Payroll accounting 204,000 51,000Legal 25,000 225,000Total service department charges $479,000 $426,000






Nova Entertainment GroupDivisional Income Statements


Theme Park Division Movie Production Division

Income from operations before service department charges.

Income from operations before service department charges.

Revenues $6,000,000 $2,500,000Operating expenses 2,495,000 405,000Income from operations $3,505,000 $2,095,000

Nova Entertainment GroupDivisional Income Statements


Theme Park Division Movie Production Division

Revenues $6,000,000 $2,500,000Operating expenses 2,495,000 405,000Income from operations $3,505,000 $2,095,000Less service dept. charges:

Purchasing $ 250,000$ 150,000Payroll accounting 204,00051,000Legal 25,000 225,000 Total service department charges $ 479,000 $ 426,000

Income from operations $3,026,000$1,669,000

Transfer PricingTransfer Pricing

Transfer PricingTransfer PricingTransfer PricingTransfer Pricing

When divisions transfer products or render services to each other, a

transfer pricing is used to charge for the products or services

When divisions transfer products or render services to each other, a

transfer pricing is used to charge for the products or services

Benefits of Transfer PricingBenefits of Transfer PricingBenefits of Transfer PricingBenefits of Transfer Pricing

1. Divisions can be evaluated as profit or investment centers.

2. Divisions are forced to control costs and operate competitively.

3. If divisions are permitted to buy component parts wherever they can find the best price (either internally or externally), transfer pricing will allow a company to maximize its profits.

MICS-HJB 22

Transfer Pricing

• Concept :-

– Transfer price is defined as the value placed on transfer of goods or services among two or more profit centers.

– For selling profit center, the transfer price is major determinant of its revenue and hence its profits.

– For buying profit center, the transfer price is major determinant of the expenses incurred and hence its profit.

– The price of inter divisional sales affects the selling divisional sales and buying divisional cost.

– Transfer price is fundamentally an attempt to simulate external market condition within the organization.

– Two divisions can be made completely independent of each other.

MICS-HJB 23

Transfer Pricing

Business Unit

Profit Centre

Input Output

Money Cost Money ProfitEC RC

Production Marketing

Input are related to Output

Selling costVariable costFixed costProfit margin

Buying costVariable costFixed cost

Buying cost Selling cost

MICS-HJB 24

Transfer Pricing

• Objectives :

– It should provide each segment with the relevant information required to determine the optimum trade – off between company cost and revenue.

– It should induce goal congruent decisions. ( Decisions regarding division and company )

– It should help measure the economic performance of individual profit centers.

– The system should be easy to administer.

MICS-HJB 25

Transfer Pricing

• Mechanism of Transfer Pricing :

– Transfer price, means the value placed on a transfer of goods or services in transaction.

– The FUNDAMENTAL PRINCIPLE is that the transfer price should be similar to the price that would be charged if the product were sold to out side customers or purchased from out side supplier.

– When profit center of an organization buy product from and sell to one other, two decision are to be carried out and reviewed periodically.

• Sourcing Decision : Should the company produce the product inside the company or purchase it from an out side vendor ?

• Transfer Price Decision : If produced inside, at what price should be the product transferred to next centre ?

– It starts from simple to extremely complex depending upon the nature of business.

MICS-HJB 26

Transfer Pricing

• The Ideal situation :– Transfer price will induce goal congruence if all the conditions listed

below exist.

– Competent People : Managers interested in long run and short run performance and staff involved in negotiation and arbitration of transfer price.

– Good Atmosphere : They should perceive that it is a mechanism.

– Market Price : It should based on well established market price, which reflects same conditions like quantity, quality, delivery time, etc.

– Freedom to Source : Buying manager should have freedom to buy from out side and selling manager should have freedom to sell out side.

– Full of Information : Managers must have all information about the alternatives and cost.

– Negotiation : Smooth mechanism for contract between business units.

MICS-HJB 27

Transfer Pricing

• The Constraints on Sourcing :– In actual all these conditions are not present the major short falls are :– Limited Market : Market for buying or selling is limited due to several

reasons.• Existence of internal capacity limit the development of external sales.• If company is sole producer of a differentiated product no out side

source exists.• If company has developed significant facilities, it does not allow to

use out side sources unless out side selling price approaches the company’s variable cost.

– Excess or Shortage of Capacity : • If selling unit can not sell all it can produce is excess capacity. The

profit can not be optimize if buying unit purchase from out side suppliers.

• If buying unit can not obtain product it requires from out side while selling unit is selling it out side is shortage of capacity. Out put of buying unit constrained.

MICS-HJB 28

Transfer Pricing

• Method of Calculating Transfer Prices :– By available Competitive Price :

– Published market price.

– Market price by “BID”

– If selling profit centre sells product in out side market, it can replicate the price.

– If buying profit centre purchase similar product from out side market, it can replicate the price.

– Cost Base Transfer Price :

– The Cost Basis – usual basis of standard cost.

– The Profit Mark up – consideration of profit.• Percentage of cost, no account of capital required.

• Batter base is percentage of investment but there are two problems, one is historical cost and other is level of profit. Standard cost is to be considered.

MICS-HJB 29

Transfer Pricing

• Method of Calculating Transfer Prices :

– Upstream Fixed Cost and Profit :

– Agreement Among Business Units

– Two – Step Pricing

– Profit Sharing

– Two Sets of Prices

MICS-HJB 30

Transfer Pricing

• Method of Calculating Transfer Prices :

– Upstream Fixed Cost and Profit :

• Transfer price can create a significant problem in an integrated company.

• The profit centre selling product out side may not aware about the upstream fixed cost and profit included.

• If aware, may be reluctant to reduce its own profit to company’s optimized profit.

– Agreement Among Business Units :

• A mechanism where representative of buying and selling unit meet to periodically and decide on the profit with significant upstream fixed cost.

MICS-HJB 31

Transfer Pricing

• Method of Calculating Transfer Prices :– Two – Step Pricing :

• Another way is, to include two charges, that is standard variable cost for each unit sold and periodic charges ( monthly ) which is equal to related with facilities reserved for the buying unit.

• Example : Unit - X is transferring product A to Unit – Y

Expected monthly sales to business unit Y 5000 units

Variable cost per unit 5 Rs

Monthly fixed cost assigned to product 20000 Rs

Investment in working capital and facilities 1200000 Rs

Competitive return on investment per year 10 %

Transfer price calculation :

Variable cost per unit 5 Rs

Fixed cost per unit ( 20000 / 5000 ) 4 Rs

Profit per unit (( 0.10 *(1200000 / 12 )) / 5000 ) 2 Rs

Total 11 Rs

MICS-HJB 32

Transfer Pricing

• Method of Calculating Transfer Prices :• If 5000 units are transferred amount is 11*5000 55000 Rs

• If 4000 units are transferred amount is 11*4000 44000 Rs

• If 6000 units are transferred amount is 11*6000 66000 Rs.

• This is normal calculation, two – step pricing method as doing some thing different.

• For 5000 unit– Monthly fixed cost 20000 Rs

– Return on investment ( 0.10*( 1200000 / 12 ) 10000 Rs

– Variable cost ( 5 * 5000 ) 25000 Rs

– Total 55000 Rs

• For 4000 unit– 30000 + ( 5 * 4000 ) 50000 Rs

• For 6000 unit– 30000 + ( 5 * 6000 ) 60000 Rs

MICS-HJB 33

Transfer Pricing

• Method of Calculating Transfer Prices :• Under two – step pricing method, company’s variable cost for

product - A is identical to Unit - Y. Unit – Y can take short - term corrective action. It is also having information of up stream fixed cost an profit relating to product – A which can be use for long – term action.

• The monthly charge for fixed coast and profit should negotiated periodically.

• Assigning cost to individual product is not difficult.

• Manufacturing unit performance is not affected by sales volume.

• There could be a conflict between the interest of manufacturing unit and company in case of capacity limited.

• Method is similar to “take or pay”

MICS-HJB 34

Transfer Pricing

• Method of Calculating Transfer Prices :– Profit Sharing :

• If two – step pricing method not feasible, a profit sharing is used.

• The product is transferred at standard variable cost.

• Profit is contributed after selling the product. ( Selling price – Variable manufacturing cost – Marketing cost )

• Applicable were demand is not steady.

– Two Sets of Prices :• It is used when there are frequent conflicts between buying and selling unit

and can not resolve by any other method.

• Manufacturing unit revenue is credited at the out side selling price.

• Buying unit charged to a total standard cost.

• Difference is charged to head office and eliminated at the time of business unit statement is consolidated.

1. Market price approach sets the price at which the product transferred could be sold to outside buyers.

2. Negotiated price approach allows decentralized managers to agree (negotiate) among themselves.

3. Cost price approach (variable or full) uses a variety of cost concepts for setting the transfer price.

Commonly Used Transfer PricesCommonly Used Transfer PricesCommonly Used Transfer PricesCommonly Used Transfer Prices

Variable Costper Unit $10

Market Priceper Unit $20

Full Costper Unit $13

Negotiated Price

Commonly Used Transfer PricesCommonly Used Transfer PricesCommonly Used Transfer PricesCommonly Used Transfer Prices

Transfer Pricing—Negotiated Price ApproachTransfer Pricing—Negotiated Price Approach

1.Division M produces a product with a variable cost of $10 per unit. Division M has unused capacity.

2.Division N purchases 20,000 units of the same product at $20 per unit from an outside source.

AssumptionsAssumptions

If the division managers agree on a price of $15 per unit, how much will each

division’s income increase?

If the division managers agree on a price of $15 per unit, how much will each

division’s income increase?

Responsibility Accounting for

Investment Centers

Responsibility Accounting for

Investment Centers

In an investment center, the unit manager has the responsibility and the authority to make decisions

that affect not only costs and revenues but also the assets invested in the center.

Datalink Inc.Divisional Income Statements


Northern Central SouthernDivision Division Division

Revenues $560,000 $672,000 $750,000Operating expenses 336,000 470,400 562,500Income from operations before service dept. charges $224,000 $201,600 $187,500Service department charges 154,000 117,600 112,500Income from operations $ 70,000 $ 84,000 $ 75,000

Invested assets $350,000 $700,000 $500,000Rate of return on investment 20% 12% 15%

Investment CentersInvestment Centers

20% 12% 15%20% 12% 15%

Revenues

Rate of Return on Investment (ROI)Rate of Return on Investment (ROI)Rate of Return on Investment (ROI)Rate of Return on Investment (ROI)

Investment Turnover

Profit Margin

Profit


The profit margin indicates the rate of profit

on each sales dollar.The

investment turnover indicates the rate of sales on

each dollar of invested

assets.

Profit Margin

Investment Turnover


Income from operation

Sales

Sales

Invested assetsxROI =

ROI =$ 70,000

$560,000x

$560,000

$350,000

ROI = 12.5% x 1.6 = 20%


Income from operation

Sales

Sales

Invested assetsxROI =


Profit Margin

Profit Margin

Inventory Turnover

Inventory Turnover

Northern Central SouthernDivision Division Division Profit MarginProfit Margin

Income from operations $ 70,000 $ 84,000 $ 75,000Revenues (Sales) $560,000 $672,000 $750,000

Profit margin 12.5% 12.5% 10.0%

Investment TurnoverInvestment Turnover

Revenues (Sales) $560,000 $672,000 $750,000Invested assets $350,000 $700,000 $500,000

Investment turnover 1.6 .96 1.5

Return on Investment (ROI)Return on Investment (ROI)

Income from operations $ 70,000 $ 84,000 $ 75,000Invested assets $350,000 $700,000 $500,000

Rate of return on investment 20% 12% 15%

Income from

Operations

Minimum Acceptable

Rate of Return on

Assets

– =Residual Residual IncomeIncome

Northern Central SouthernDivision Division Division

Baldwin CompanyDivisional Income Statements


Income from operations $70,000 $84,000 $75,000Minimum acceptable incomefrom operations as a percent of invested assets:

$350,000 x 10% 35,000

$700,000 x 10% 70,000

$500,000 x 10% 50,000

Residual income $35,000 $14,000 $25,000

The balance scorecard is a set of financial and nonfinancial measures

that reflect multiple performance dimensions of a business.

The balance scorecard is a set of financial and nonfinancial measures

that reflect multiple performance dimensions of a business.

Innovation and Learning

• R&D investment• R&D pipeline• Skills and training• Time to market

Innovation and Learning

• R&D investment• R&D pipeline• Skills and training• Time to market

Customer• Satisfaction• Loyalty• Perception

Customer• Satisfaction• Loyalty• Perception

• Efficiency• Quality• Time

• Efficiency• Quality• Time

Financial• ROI• Residual income• Profit• Cost• Sales

Financial• ROI• Residual income• Profit• Cost• Sales

Internal Process

The EndThe End

transfer pricing

Documents

budget actual budget

budget administration

profit centersin

profit centersneg

plant b

cost center report

performance evaluation

activity base