AC303 AUTUMN 200809 ADVANCED MANAGEMENT ACCOUNTING

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AC303 - AUTUMN 2008/09ADVANCED MANAGEMENT
ACCOUNTING

• Lecture (10)
• Divisionalised Organisations and Transfer Pricing
  II

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Last Lecture Summary

• From the standpoint of the company as a whole,
  the transfer price has no effect on aggregate
  income (other than perhaps from tax effects
  when divisions are in different states or
  countries).
• What is counted as revenue to one division is a
  cost to the other and is eliminated in the
  consolidation process.
• From an economic perspective, it is like taking
  money out of one division and putting it into
  the other.
• What matters is how the transfer price affects
  the decisions made by the segment managers, as
  these will affect input and output decisions
  and thus overall company profits.
• In companies in which divisionalisation is
  really practised, segment managers are given
  a lot of latitude in dealing with
• each other.

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• Domestic Transfer Pricing
• Conclusions/recommendations
• If a competitive market exists for the
  intermediate product, use market prices.
• If there is no market for the intermediate
  product or an imperfect market, TPs may be
• Costbased or
• Negotiated
• Demonstrated that only MC results in optimal
  activity level for organisation as a whole
• Recommended to use standard costs for
  cost-based TP

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Todays Lecture

• Resolving TP conflicts.
• International transfer pricing taxation
  implications

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Transfer pricing issues Resolving TP conflicts

• Transfers at marginal (variable) cost
• Motivate decisions that are optimal from the
  overall companys perspective.
• Are unsuitable for performance evaluation because
  they do not contain a profit margin for the
  supplying division.
• Transfers at cost-plus a mark-up
• Meet the performance evaluation requirement
• But will not induce managers to make optimal
  decisions.

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Resolving transfer pricing conflicts Two
approaches advocated 1. Adopt a dual rate TP
system 2. Transfer at MC plus a lump sum fee
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• Resolving transfer pricing conflicts
• Dual rate TP system
• Uses two transfer prices
• Supplying division may receive full cost plus a
  mark-up so that it makes a profit on
  inter-divisional transfers.
• Receiving division charged at MC of transfers
  thus motivating managers to operate at the
  optimum output level for the company as a whole.
• Profit on inter-group trading removed by an
  accounting adjustment.

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Example of Dual-Rate Transfer Price (Drury, 2004)
MC/VC 50
MC/ VC
Company Profit 5million - 4 million
1million
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Resolving transfer pricing conflicts Dual rate
TP system (cont.) Not widely used because 1. Use
of two TPs causes confusion 2. Seen as
artificial 3. Divisions protected from
competition 4. Reported divisional profits can be
misleading
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Resolving transfer price conflicts Marginal cost
plus a lump sum fee (two-part transfer pricing
system It is intended to motivate receiving
division to equate MC of transfers with its net
marginal revenue to determine optimum company
profit maximizing output level. Enables
supplying division to cover its fixed costs and
earn a profit on inter-divisional transfers
through the fixed fee charged for the period.
Motivates receiving division to consider full
cost of providing intermediate products/services.
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Remember From Last Weeks Example To ensure
overall company optimality the TP must be set at
MC of the intermediate product (i.e VC of 11 per
unit or 11,000 per batch of 1,000 units).
The receiving division will face the following
net marginal revenue (NMR) schedule Units
net marginal revenue () 1 000
93 000 (100 000 7000) 2 000 73 000 (80 000
7 000) 3 000 53 000 (60 000 7 000) 4 000
33 000 (40 000 7 000) 5 000 13 000 (20
000 7 000) 6 000 7 000 (0 7 000)
NMR (13000) gt Transfer price (11000)
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Domestic and International Transfer
McGraw-Hill Co
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International transfer pricing Where divisions
are located in different countries taxation
implications become important and TP has the
potential to ensure that most of the profits on
inter-divisional transfers are allocated to the
low taxation country.
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International transfer pricing
Example Supplying division in country A (Tax
rate 25) Receiving division in country B (Tax
rate 40) The motivation is to use highest
possible TP so receiving division will have high
costs and low profits, whereas supplying division
will have high revenues and high profits.
Taxation authorities in most countries are wise
to companies using TP to manipulate profits and
seek to apply OECD guidelines based on arm s
length pricing principles. TP can also have an
impact on import duties and dividend
repatriations.
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International transfer pricing OECD Guidelines
(1)

• Organisation for Economic Co-operation and
  Development
• Issued a guideline statement in 1995
• Attempt to provide a world-wide consensus on the
  pricing of international intra-firm transactions
• Tax authorities in most countries use this as
  basis for regulating TP behaviour.
• Based on the arms length principle
• The price which would have resulted if the prices
  actually used had been between two unrelated
  parties.

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International transfer pricing OECD Guidelines
(2)

• Arms Length Principle can be implemented using
  one of the following methods
• The comparable uncontrolled price method (which
  uses externally verified prices of similar
  transactions involving unrelated parties)
• The resale price method (which deducts a
  percentage of the selling price from the final
  product to allow for profit)
• The cost-plus method

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International transfer pricing OECD Guidelines
(3)

• OECD guidelines state that
• whenever possible, the comparable uncontrolled
  price should be used
• And if no market price, preference should be
  given to cost-plus.

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International Transfer Pricing

• Considerable variations in costing methods, may
  provide some flexibility in reducing tax burden
  when determining cost-plus TP
• Would appear multinational companies should use
  two TP systems
• One for internal purposes, and
• One for taxation purposes!

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International Transfer Pricing

• TP can also have an impact on import duties and
  dividend repatriation.
• Import duties can be minimised by transferring
  products at low prices to a division in a country
  with high import duties.
• Some countries restrict the repatriation of
  income and dividends
• By increasing the TP, possible to increase the
  funds repatriated without appearing to violate
  dividend restrictions.

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Summaryof TP issues

• Domestic context aim is to set transfer prices
  to maximise profit for the company as a whole
• Market price where possible
• In absence of external market ? short run MC
  fixed fee
• Market imperfections ? Negotiated transfer price
• International context aims include
• Minimise taxation laibilities
• Facilitate repatriation of income
• OECD guidelines apply

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Workshop (10)

• See Exercise P16-20 (Seal et al.).

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Articles

• Adler, R. W. (1996), Transfer Pricing for
  World-Class Manufacturing, Long Range Planning,
  Vol. 29, No. 1, pp. 69-75.
• Borkowski, S. C. (1997), Factors Motivating
  Transfer Pricing Choices of Japanese and United
  States Trans-national Corporations, Journal of
  International Accounting, Auditing Taxation,
  Vol. 6, No. 1, pp. 25-47.