ACCA F5 Performance Management - 2010 - Study text

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Chapter 14: Transfer pricing

Required

What is the ideal transfer price or range of transfer prices?

Answer

Step 1

What is in the best interests of the company as a whole?

This is stated in the example. The company wants to make and sell as many units of

the end product of Division B as possible. It is not clear, however, whether it is

better for Division B to buy Product Y externally or to buy internally from Division

If Division A does not make Product Y, it can make and sell Product Z instead.

Product Z earns a higher contribution per unit of machine time, the limiting factor

in Division A.

Step 2

What would motivate the buying division to buy as many units of Product Y as

possible from Division A?

Division B will be prepared to buy Product Y from Division A as long as it is not

more expensive than buying in the external market from another supplier.

Division B will be willing to buy Product Y internally if the transfer price is $15 or

less.

Step 3

What would motivate the selling division to make and transfer as many units of

Product Y as possible?

The selling division will only be willing to make Product Y instead of Product Z if it

earns at least as much contribution as it would from making Z and selling it

externally. (In this situation, the division can make as many units of Z as it can make

of Y, and Product Z earns a higher contribution).

Product Y $

Variable cost of making Product Y (the variable cost of sale is

not relevant for internal transfers)

Opportunity cost of lost external sale of Product Z (17 – 7 – 2) 8

Total cost = minimum transfer price 18

Ideal transfer price/ideal production and selling plan

Division B will not want to pay more than $15 for transfers of Product Y; otherwise

it will buy Product Y externally.

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Division A will want to receive at least $18 for transfers of Product Y; otherwise it

will prefer to make and sell Product Z, not Product Y.

The ideal solution is for Division B to buy Product Y externally at $15 and for

Division A to make and sell Product Z.

Example

A company consists of two divisions, Division A and Division B. Division A is

operating at full capacity making Product X, for which there is an external market.

The variable cost of making one unit of Product X is $70, and the sale price of

Product X in the external market is $100 per unit.

Division B needs one unit of Product X to manufacture another product, Product Y.

The variable conversion costs and further processing costs in Division B are $29 per

unit of Product Y. The external selling price of Product Y is $140 per unit.

An external supplier has offered to sell units of Product Y to Division B for $103 per

unit.

Required

(a) Identify the ideal transfer price.

(b) Calculate the contribution per unit for each Division and for the company as a

whole if this transfer price is used.

divisional performance.

Answer

Step 1

What is in the best interests of the company as a whole?

 For each additional unit of Product Y that Division B makes and sells, the

additional contribution for the company is $41 ($140 – $70 – $29).

 The contribution from selling one unit of Product Y in the intermediate market is

$30 ($100 – $70).

The company therefore makes more contribution and profit from making and

selling Product Y than from selling Product X externally.

The production plan that will optimise the profit for the company as a whole is for

Division A to make units of Product X and transfer them to Division B.

Step 2

What would motivate the buying division to buy as many units of Product X as

possible from Division A?

Division B will not want to pay more to Division A for Product X than the price it

has been offered by an external supplier, $103. However, Division B can presumably

Chapter 14: Transfer pricing

find another supplier who is willing to offer the current market price of $100, and

the maximum price that Division B should pay ought to be $100.

Step 3

What would motivate the selling division to make and transfer as many units of

Product X as possible?

Product Y $

Variable cost 70

Opportunity cost of lost external sale (100 – 70) 30

Total cost = minimum transfer price 100

Ideal transfer price

The ideal transfer price is $100 per unit of Product X.

Contribution per unit

Division

Entity as

a whole

$/unit

External sale -

140

Internal sale 100

Sales revenue 100

140

Transfer: purchase cost -

100

Other variable costs 70

Total variable costs 70

129

Contribution per unit 30

Comment

The contribution per unit for each division is a fair representation of the economic

contribution of each division to the profitability of the company as a whole.

The transfer price therefore provides an appropriate measurement of divisional

performance.

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Transfer pricing in practice

 Transfer price at market price

 Transfer price at full cost plus

 Transfer price at variable cost plus or incremental cost plus

 Two-part transfer prices

 Dual pricing

 Negotiated transfer prices

 Transfer pricing in multinational groups

3 Transfer pricing in practice

Transfer prices might be decided by head office and imposed on each division.

Alternatively, the managers of each division might have the autonomy to negotiate

transfer prices with each other.

In practice, transfer prices may be agreed and expressed in one of the following

ways.

3.1 Transfer price at market price

A transfer price may be the external selling/buying price for the item in an external

intermediate market. This price is only possible when an external market exists.

If the selling division would incur some extra costs if it sold its output externally

rather than transferred it internally to another division, the transfer price may be

reduced below market price, to allow for the variable costs that would be saved by

the selling division. This is very common as the selling division may save costs of

packaging and warranties or guarantees. Distribution costs may also be cheaper and

there will be no need for advertising.

Advantages of market price as the transfer price

Market price is the ideal transfer price when there is an external market. A transfer

price below this amount will make the manager of the selling division want to sell

externally, and a price above this amount will make the manager of the buying

division want to buy externally.

Transferring at market price also encourages efficiency in the supplying division,

which must compete with the external competition.

Chapter 14: Transfer pricing

Disadvantages of market price as the transfer price

The current market price is not appropriate as a transfer price when:

 the current market price is only temporary, and caused by short-term conditions

in the market, or

 the selling price in the external market would fall if the selling division sold

more of its output into the market. The opportunity cost of transferring output

internally would not be the current market price, because the selling price would

have to be reduced in order to sell the extra units.

It may also be difficult to identify exactly what the external market price is. Products

from rival companies may be different in quality, availability may not be so certain

and there may be different levels of service back-up.

3.2 Transfer price at full cost plus

A transfer price may be the full cost of production plus a margin for profit for the

selling division.

Standard full costs should be used, not actual full costs. This will prevent the

selling division from increasing its profit by incurring higher costs per unit.

Full cost plus might be suitable when there is no external intermediate market.

However, there are disadvantages in using full cost rather than variable cost to

decide a transfer price.

 The fixed costs of the selling division become variable costs in the transfer price

of the buying division. This might lead to decisions by the buying division

manager that are against the best interests of the company as a whole. This is

because a higher variable cost may lead to the buying division choosing to set

price at a higher level which would lose sales volume.

 The size of the profit margin or mark-up is likely to be arbitrary.

3.3 Transfer price at variable cost plus or incremental cost plus

A transfer price might be expressed as the variable cost of production plus a margin

for profit for the selling division.

Standard variable costs should be used, not actual variable costs. This will prevent

the selling division from increasing its profit by incurring higher variable costs per

unit.

Variable cost plus might be suitable when there is no external intermediate market.

It is probably more suitable in these circumstances than full cost plus, because

variable cost is a better measure of opportunity cost. However, as stated earlier,

when transfers are at cot, the transferring division should be a cost centre, and not a

profit centre.

Other methods that may be used to agree transfer prices include:

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 Two-part transfer prices

 Dual pricing

3.4 Two-part transfer prices

With two-part transfer prices, the selling division charges the buying division for

units transferred in two ways:

 a standard variable cost per unit transferred, plus

 a fixed charge in each period.

The fixed charge is a lump sum charge at the end of each period. The fixed charge

would represent a share of the contribution from selling the end product, which the

selling/transferring division has helped to earn. Alternatively, the charge could be

seen as a charge to the buying division for a share of the fixed costs of the selling

division in the period.

The fixed charge could be set at an amount that provides a ‘fair’ profit for each

division, although it is an arbitrary amount.

3.5 Dual pricing

In some situations, two divisions may not be able to agree a transfer price, because

there is no transfer price at which the selling division will want to transfer internally

or the buying division will want to buy internally. However, the profits of the entity

as a whole would be increased if transfers did occur.

These situations are rare. However, when they occur, head office might find a

solution to the problem by agreeing to dual transfer prices.

 the selling division sells at one transfer price, and

 the buying division buys at a lower transfer price.

There are two different transfer prices. The transfer price for the selling division

should be high enough to motivate the divisional manager to transfer more units to

the buying division. Similarly, the transfer price for the buying division should be

low enough to motivate the divisional manager to buy more units from the selling

division.

In the accounts of the company, the transferred goods are:

 sold by the selling division to head office and

 bought by the buying division from head office.

The loss from the dual pricing is a cost for head office, and treated as a head office

overhead expense.

However, dual pricing can be complicated and confusing. It also requires the

intervention of head office and therefore detracts from divisional autonomy.

Chapter 14: Transfer pricing

3.6 Negotiated transfer prices

A negotiated transfer price is a price that is negotiated between the managers of the

profit centres.

The divisional managers are given the autonomy to agree on transfer prices.

Negotiation might be a method of identifying the ideal transfer price in situations

where an external intermediate market does not exist.

An advantage of negotiation is that if the negotiations are honest and fair, the

divisions should be willing to trade with each other on the basis of the transfer price

they have agreed.

Disadvantages of negotiation are as follows:

 The divisional managers might be unable to reach agreement. When this

happens, management from head office will have to act as judge or arbitrator in

the case.

 The transfer prices that are negotiated might not be fair, but a reflection of the

bargaining strength or bargaining skills of each divisional manager.

Paper F5: Performance management

Paper F5

Performancemanagement

CHAPTER

Performance analysis in

not-for-profit organisations

and the public sector

Contents

1 Performance measurement in not-for-profit

organisations

2 Value for money

Paper F5: Performance management

Performance measurement in not-for-profit organisations and the

public sector

 The special characteristics of not-for-profit organisations and the public sector

 The need for performance measurement

 Identifying performance targets in not-for-profit and public sector

organisations

 Problems with measuring performance in this sector

1 Performance measurement in not-for-profit

organisations and the public sector

1.1 The special characteristics of not-for-profit organisations and the

public sector

The public sector refers to the sector of the economy that is owned or controlled by

the government in the interests of the general public. It includes all government

departments and government-financed bodies, including nationalised industries. In

the UK, this includes the national health service, state-owned schools, the police and

fire services, and so on.

Not-for-profit organisations are entities that are not government-owned or in the

public sector, but which are not in existence to make a profit. They include

charitable organisations and professional bodies.

A common feature of public sector organisations and not-for-profit organisations is

that their main objective is not financial. The main objective of any such

organisation depends on the purpose for which it exists: to administer the country

(government departments), to provide education (schools and universities), provide

medical care (hospitals), do charitable work, and so on.

A not-for-profit organisation will nevertheless have some financial objectives:

 State-owned organisations must operate within their spending budget.

 Charitable organisations may have an objective of keeping running costs within

a certain limit, and of raising as much funding as possible for their charity work.

1.2 The need for performance measurement

Although the main objective of not-for-profit and public sector organisations is not

financial, they need good management, and their performance should be measured

and monitored. In many countries, including the UK, public sector organisations are

given a range of performance targets, against which actual performance is

compared.

 The directors of a company are accountable to their shareholders for the

performance of the company. This is a function of the annual report and

accounts, although accountability is also achieved in other ways, such as general

meetings of the company.

ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing

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