Transfer Price Evaluation
Under the proposed plan, Division A would have a cost reduction of $100,000, Division B. would have a cost reduction of $50,000, Division C. would have a profit reduction of $700,000, and the company would have an increase in profits of $80,000. If Division C. would drop their prices to meet market prices and the other divisions agree to them doing all the production, they would still loose the $700,000 in profits, but the company would have an increase in profits of $400,000. By doing this, Division C. would have a higher production, not have to lay off employees, and would still come out with $1,700,000 in profits. Under the proposed plan the production would be cut drastically, as well as the profits.
They could put more dollars in research and development and potentially improve existing products and have a flexible procurement that could supply variants as opportunity for change (Sahay, 2003). By spending more dollars for research and development, existing products could be improved for higher profits and new products could be implemented with a possible market to sell them. This way Division C. could have a chance of selling products in the market and not just in the company to be able to increase the price of existing products with the improvements. This would bring room for expansion.
Managers should concentrate on production efficiency and work to increase productivity per labor hour in order to maximize profits. Often times, it is not the profits that is the issue; it is the efficiency in making them. By working to get more production for each labor hour, costs are being cut in the long run and more profits are being made on the same labor hour. Looking for other costs that could be cut could also maximize profits and efficiency in the production process.
There are considerations that need to be made when selecting a transfer pricing policy (Feinschreiber). If the divisions are in different states, counties, or countries, taxes would bring consequences. Market position could create issues with transfer pricing of products. Inflation and deflation would cause market conditions to change and could cause problems with managers trying to reach targets. There are also administrative aspects that would affect the pricing, such as corporate goals and strategies, divisional control, corporate culture, frequency of transfer pricing change, technology and innovation of the products, market characteristics, general business conditions, and accounting systems.
Transfer pricing without regard to the costs of the selling division leads to unfair measurement (Sahay, 2003). Discretionary investments are needed to generate profits for efficiency in the production process. The selling division, Division C. In this case, needs profits for efficiency and research and development to improve products and implement new ones. Without the chance to implement improvements in existing products and implement new products the division would have no chance to be a profit center and maximize profits for the company.
Cost based approaches are used for products with no external market, or the market is an imperfect one (Abeysinghe, 2009). Actual costs will vary with volume, seasonal, and other factors, which can pass on any production efficiencies to the receiving divisions. The cost plus a mark-up will vary and can cause the frequency of transfer pricing changes to cause problems with the receiving units. Factors, such as material costs, volume, and market could cause fluctuations in the costs, therefore, creating problems with managers striving to reach goal targets. It can also be used to pass inefficiency on to another division without regard to Division C. working on any efficiency problems.
Standard cost plus a mark-up fails in giving fair revenue, reasonable costs, and the profit is distorted (Abeysinghe, 2009). As markets fluctuate, the material costs would also fluctuate causing profits and revenues to be stated falsely. The measurability of division performance would not be accurate using a standard cost. The differences between actual costs and standard costs cause variances, which can be favorable or unfavorable (Standard Costs). Standard costs distort the true profits because they are a standard and not actual.
When the entire production of Division C. is transferred internally, with no outside customers, and includes all variable, overhead, and labor costs, the incremental costs are not an appropriate measurement of the division’s performance (9). Any inefficiency that is present in production performance would not be a consideration and, therefore, would be passed on with the cost to another division. Often, managers with this situation feel they are working for someone else and have little initiative to work on efficiency of production. There are no profit targets or sales goals to look forward to in order to want to strive for growth of any kind.
The transfer price being negotiated by the managers may not solve the conflict, more especially with pressure to increase sales volume and profits are concerned. “The negotiated process favors executives with negotiation skills rather than executives that can produce goods efficiently (Feinschreiber). Negotiation of managers under pressure from the corporate office does not always work well. Managers that do not have good negotiation skills will often walk away resentful in the end, which will cause more conflict in the future. But, if managers are encouraged toward efficiency for increasing production per labor hour and looking for other costs that could be cut to maximize profits, it would relieve some of the pressure in order for negotiation to have a chance at working.
9, G. (n.d.). Transfer Pricing. Retrieved from Scribd: http://scribd.com/doc/6699410/Transfer-Pricing-Nitin
Abeysinghe, R.L. (2009, June 25). Cost Based Approaches to Transfer Pricing. Retrieved from Ezine Articles: http://ezinearticles.com/?Cost-Based-Approaches-to-Transfer-Pricing&id=2524966
Feinschreiber, R. (n.d.). Business Facets of Transfer Pricing. Retrieved from Anefac: http://www.anefac.org.mx/Docs/TrabajosInformacion/PreciosTransferencia/Word/Business%20Facets.htm
Sahay, S.A. (2003, Jan 1). Transfer pricing based on actual cost. Retrieved from High Beam Business: http://business.highbeam.com/6392/article-1G1-112905016/transfer-pricing-based-actual-cost
Standard Costs. (n.d.). Retrieved from Accouting Coach: http://accountingcoach.com/online-accounting-course-30Xpg01.html
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