Transfer Pricing

Performance Evaluation for Decentralized Operations

Cost Centers Budget Performance Report Supervisor, Department 1—Plant A For the Month Ended October 31, 2006

Factory wages Materials Supervisory salaries Power and light Depreciation Maintenance Insurance, taxes

Budget

Actual

$ 58,100 32,500 6,400 5,750 4,000 2,000 975 $109,725

$ 58,000 34,225 6,400 5,690 4,000 1,990 975 $111,280

Over Budget

Under Budget

$100 $1,725 60 10 $1,725 $1,725

$170

Cost Centers Budget Performance Report Manager, Plant A For the Month Ended October 31, 2006

Administration Department Department 11 Department 2 Department 3

Budget

Actual

$ 17,500 109,725 109,725 190,500 149,750 $467,475

$ 17,350 111,280 111,280 192,600 149,100 $470,330

Over Budget

Under Budget

$150 $1,555 $1,555 2,100 $3,655

650 $800

Cost Centers Budget Performance Report Manager, Plant A For the Month Ended October 31, 2006 Budget

Administration Department 1 Department 2 Department 3

$ 17,500 109,725 190,500 149,750 $467,475

Actual

$ 17,350 111,280 192,600 149,100 $470,330 $470,330

Over Budget

Under Budget

$150 $1,555 2,100 $3,655 $3,655

650 $800 $800

Cost Centers Budget Performance Report Vice-President, Production For the Month Ended October 31, 2006 Over Budget Actual Budget

Administration Plant Plant A A Plant B

$ 19,500 467,475 467,475 395,225 $882,200

$ 19,700 470,330 470,330 394,300 $884,330

Under Budget

$ 200 2,855 2,855 $3,055

Note that “Over Budget” is a net figure.

$925 $925

Cost Centers Budget Performance Report Vice-President, Production For the Month Ended October 31, 2006 Over Budget Actual Budget

Administration Plant A Plant B

$ 19,500 467,475 395,225 $882,200

$ 19,700 470,330 394,300 $884,330

Under Budget

$ 200 2,855 $3,055

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

$925 $925

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 NEG, a diversified entertainment company, has two profit centers: the Theme Park Division and the Movie Production Division.

Revenues Operating expenses

Theme Park Movie Production Division Division $6,000,000 $2,500,000 2,495,000 405,000

Profit Centers Charging Service Department Costs to Production Divisions Purchasing Department: $400,000 (Activity base: number of purchase requisitions) Theme Park Division Movie Production Division: Total

$400,000

25,000 purchase requisitions 15,000 purchase requisitions 40,000

= $10 per purchase requisition 40,000 purchase requisitions

Profit Centers Charging Service Department Costs to Production Divisions Payroll Accounting: $255,000 (Activity base: number of payroll checks) Theme Park Division Movie Production Division: Total

$255,000 15,000 payroll checks

12,000 payroll checks 3,000 payroll checks 15,000

= $17 per payroll check

Profit Centers Charging Service Department Costs to Production Divisions Legal Department: $250,000 (Activity base: number of payroll checks) Theme Park Division 100 billed hours Movie Production Division: 900 billed hours Total 1,000

$250,000 1,000 hours

= $250 per hour

Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006

Service Department

Purchasing

Theme Park Division

$250,000

Movie Production Division

$150,000

25,000 purchase 15,000 purchase requisitions xrequisitions $10 x $10 per purchaseper purchase requisition requisition

Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006

Service Department

Purchasing Payroll accounting

Theme Park Division

$250,000 204,000

Movie Production Division

$150,000 51,000

12,000 payroll3,000 payroll checks x $17 checks per x $17 per payroll checkpayroll check

Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006

Service Department

Purchasing Payroll accounting Legal

Theme Park Division

$250,000 204,000 25,000

Movie Production Division

$150,000 51,000 225,000

100 hours x $250 900 hours x $250 per hour per hour

Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006

Service Department

Purchasing Payroll accounting Legal Total service department charges

Theme Park Division

$250,000 204,000 25,000 $479,000

Movie Production Division

$150,000 51,000 225,000 $426,000

Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2006 Theme Park Division

Revenues Operating expenses Income from operations

$6,000,000 2,495,000 $3,505,000

Income from operations before service department charges.

Movie Production Division

$2,500,000 405,000 $2,095,000

Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2006 Theme Park Division

Revenues $6,000,000 Operating expenses 2,495,000 Income from operations $3,505,000 Less service dept. charges: Purchasing $ 250,000 Payroll accounting 204,000 Legal 25,000 Total service department charges $ 479,000 Income from operations $3,026,000

Movie Production Division

$2,500,000 405,000 $2,095,000 $ 150,000 51,000 225,000 $ 426,000 $1,669,000

Transfer Pricing

Transfer Pricing 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 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.

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

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Transfer Pricing Profit Centre

Input are related to Output

Input Money Cost

Output EC

RC

Production

Buying cost

Money Profit

Marketing

Business Unit

Selling cost Selling cost Variable cost Fixed cost Profit margin

Buying cost Variable cost Fixed cost

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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.

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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.

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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.

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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.

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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

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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

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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

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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

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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 Return on investment ( 0.10*( 1200000 / 12 ) Variable cost ( 5 * 5000 ) Total

20000 Rs 10000 Rs 25000 Rs 55000 Rs

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

50000 Rs

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

60000 Rs

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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”

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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. MICS-HJB

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Commonly Used Transfer Prices 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 Prices

Variable Cost per Unit $10

Full Cost per Unit $13

Negotiated Price

Market Price per Unit $20

Transfer Pricing—Negotiated Price Approach Assumptions 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. 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 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.

Investment Centers Datalink Inc. Divisional Income Statements For the Year Ended December 31, 2006 Northern Division

Central Division

Southern Division

Revenues Operating expenses Income from operations before service dept. charges Service department charges Income from operations

$560,000 336,000

$672,000 470,400

$750,000 562,500

$224,000 154,000 $ 70,000

$201,600 117,600 $ 84,000

$187,500 112,500 $ 75,000

Invested assets Rate of return on investment

$350,000 $700,000 $500,000 20% 12% 15% 20% 12% 15%

Rate of Return on Investment (ROI) Revenues

Rate of Return on Investment (ROI)

Profit

Investment Turnover

Profit Margin

Rate of Return on Investment (ROI)

The investment turnover indicates the rate of sales on each dollar of invested assets.

The profit margin indicates the rate of profit on each sales dollar.

Investment Turnover

Profit Margin

Rate of Return on Investment (ROI)

Sales ROI = Income from operation x Sales Invested assets ROI =

$ 70,000 $560,000

x

$560,000 $350,000

ROI = 12.5% x 1.6 = 20%

Rate of Return on Investment (ROI)

Sales ROI = Income from operation x Sales Invested assets

Profit Margin

Inventory Turnover

Profit Margin Income from operations Revenues (Sales) Profit margin

Northern Division

Central Division

Southern Division

$ 70,000 $560,000 12.5%

$ 84,000 $672,000 12.5%

$ 75,000 $750,000 10.0%

Revenues (Sales) Invested assets Investment turnover

$560,000 $350,000 1.6

$672,000 $700,000 .96

$750,000 $500,000 1.5

Return on Investment (ROI) Income from operations Invested assets

$ 70,000 $350,000

$ 84,000 $700,000

$ 75,000 $500,000

Investment Turnover

Rate of return on investment

20%

12%

15%

Income from Operations

–

Minimum Acceptable Rate of Return on Assets

=

Residual Income

Baldwin Company Divisional Income Statements For the Year Ended December 31, 2006 Northern Division

Income from operations Minimum acceptable income from operations as a percent of invested assets: $350,000 x 10% $700,000 x 10% $500,000 x 10% Residual income

Central Division

Southern Division

$70,000 $84,000 $75,000

35,000 70,000 50,000 $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.

Innovation and Learning • • • •

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

Internal Process

Customer • Satisfaction • Loyalty • Perception

Financial • • • • •

ROI Residual income Profit Cost Sales

• Efficiency • Quality • Time

The End