MCS-Transfer Pricing - Final
MCS-Transfer Pricing - Final
By Vinit Arondekar M1101 Nirvisha Bhuta M1105 Shariq Qureshi M1146 Poorva Saurkar M1150 Gauri Sawant M1152
Lead to rewards
Monetary
Nonmonetary
Benefits of Decentralization
Creates greater responsiveness to local needs Leads to gains from quicker decision making Increases motivation of subunit managers Assists management development and learning Sharpens the focus of subunit managers
Costs of Decentralization
Suboptimal decision making may occur Focuses the managers attention on the subunit rather than the organization as a whole
Multinational corporations often rotate managers between foreign locations and corporate headquarters.
Transfer Pricing
A transfer price is the price one subunit of a corporation charges for a product or service supplied to another subunit of the same organization. Management control systems use transfer prices to coordinate the actions of subunits and to evaluate their performance.
Transfer Pricing
The transfer price creates revenues for the selling subunits and purchasing cost for the buying subunits, affecting each subunits operating income. The product or service transferred between subunits is called the intermediate product.
Transfer-Pricing Methods
$13
$ 2 3 $ 5
$23
$ 8 4 $12
$23 per barrel What is the cost-based transfer price at 112% of full costs?
$13 2 3 $18
What is the Refining Division operating income using the full cost price?
Comparison of Methods
Achievement of Goal Congruence Market Price: Yes, if markets competitive Cost-Based: Often, but not always Negotiated: Yes
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Comparison of Methods
Usefulness for Evaluating Subunit Performance Market Price: Yes, if markets competitive Cost-Based: Difficult, unless transfer price exceeds full cost Negotiated: Yes
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Comparison of Methods
Motivating Management Effort
Market Price: Yes Cost-Based: Yes, if based on budgeted costs; less incentive if based on actual cost Negotiated: Yes
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Comparison of Methods
Preserving Subunit Autonomy
Market Price: Yes, if markets competitive Cost-Based: No, it is rule based Negotiated: Yes
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Comparison of Methods
Other Factors to Consider
Market Price: Cost-Based: Negotiated: No market may exist Useful for determining fullcost; easy to implement Bargaining takes time and may need to be reviewed
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Problem 1
User Friendly Computer with headquarters in San Francisco, manufactures and sells a desktop computer. The company has three divisions each of which is located in a different country.
Three Divisions
China Division manufactures memory devices and keyboards. South Korean Division assembles desktop computers using internally manufactured parts and memory devices and keyboards from the China division. US Division packages and distributes desktop computers.
Additional Information
Each division is run as a profit center. The cost for work done in each division for a single desktop computer is as follows.
China Division South Korea Division United States Division Variable costs = Fixed cost = Variable cost = 1000 yuan 1800 yuan 360,000 won
Fix cost =
Variable cost = Fixed costs =
480,000 won
$100 $200
Additional Information
Chinese income tax rate is 40%. A South Korean income tax rate is 20%. United States income tax rate is 30%. Exchange rates:
8 yuan = $1.00 US dollar 1,200 won = $1.00 US dollar
Additional Information
Each desktop computer is sold through retail outlets in the United States for $3200.
Additional Information
Both China and South Korea sell part of their production under a private label. The Chinese division sells a comparable memory/keyboard package to a Chinese manufacturer for 3600 yuan. The South Korea division sells a comparable desktop computer to a South Korean distributor for 1,560,000 won
Question
Calculate the after tax operating income per unit earned by each division under the following transfer pricing methods: (a) market price, ( b) 200% of full costs, and (c) 300% of variable costs. Income taxes are not included in the computation of cost based transfer prices.
Analysis
This is a three-country, three-division transfer pricing problem with three alternative transfer pricing methods.
Analysis
Lets take this approach in solving the problem: First begin by summarizing the costs in US dollars. Then organize this data into transfer price alternatives. Then prepare income statements for each division using each transfer price method, summing to see the total corporate net income under each alternative.
Transfer Prices
Market Price as a transfer price: China to South Korea = $450 per subunit South Korea to U.S. Plant = $1,300 per unit
Transfer Prices
200% of Full Cost as a transfer price China to South Korea: 2.0 ($125 + $225) = $700 per subunit South Korea to U.S. Plant: 2.0 ($700 + $300 + $400) = $2,800 per unit
Where does this come from?
It is the transfer price of the memory devices and keyboards from China
Transfer Prices
300% of Variable Costs: China to South Korea: 3.0 $125 = $375 per subunit South Korea to U.S. Plant: 3.0 ($375 + $300) = $2,025 per unit
Lets Start in China which makes the memory devices and keyboards.
Method A Internal Transfers at Market Price 1. China Division Division revenue per unit Cost per unit: Division variable cost per unit Division fixed cost per unit Total division cost per unit Div income per unit Income tax at 40% Division net income per unit Method B Internal Transfers at 200% of Full Costs Method C Internal Transfers at 300% of Variable Costs
Method A Internal Transfers at Market Price 1. China Division Division revenue per unit Cost per unit: Division variable cost per unit Division fixed cost per unit Total division cost per unit Division income per unit Income tax at 40% Division net income per unit
These are the costs transferred from China under each transfer pricing assumption.
Method A Internal Transfers at Market Price 2. So. Korea Division Division revenue per unit Cost per unit: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 20% Division net income per unit
These costs will be transferred to the United States under each pricing assumption.
Method A Internal Transfers at Market Price 3. US Division Division revenue per unit Cost per unit: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 30% Division net income per unit $3,200 1,300 100 200 1,600 1,600 480 $1,120
Method B Internal Transfers at 200% of Full Costs $3,200 2,800 100 200 3,100 100 30 $ 70
Method C Internal Transfers at 300% of Variable Costs $3,200 2,025 100 200 2,325 875 262.5 $ 612.5
So what transfer pricing scheme gives the company the greatest profit?
Division Net Income China Division So. Korea Division US Division User Friendly Computer, Inc.
The company will maximize its net income by using 200% of full costs as the transfer price. This is because method B sources the largest proportion of income in S. Korea, the country with the lowest income rate.
Problem 2
Crango Products is a cranberry cooperative with two divisions: Harvesting and Processing. Currently all output is converted into cranberry juice by Processing and sold to large companies. The Processing Division has a yield of 500 gallons of juice per 1,000 pounds of cranberries.
Problem 2
Cost information is given below:
Harvesting Division Variable cost per pound of cranberries Fixed cost per pound of cranberries Selling price per pound of cranberries in outside market Processing Division $0.10 Variable processing cost per gallon of juice produced $0.25 Fixed cost per gallon of juice produced $0.60 Selling price per gallon of juice $0.20 $0.40 $2.10
Question
Compute Crangos operating income from harvesting 500,000 pounds of cranberries during June 2006 and processing them into juice.
Pounds of cranberries harvested Gallons of juice processed (500 gals per 1,000 lbs.) Revenues (250,000 gals. $2.10 per gal.) Costs Harvesting Division Variable costs (500,000 lbs. $0.10 per lb.) Fixed costs (500,000 lbs. $0.25 per lb.) Total Harvesting Division costs Processing Division Variable costs (250,000 gals. $0.20 per gal.) Fixed costs (250,000 gals. $0.40 per gal.) Total Processing Division costs Total costs Operating income 500,000 250,000 $525,000
Question
Crango rewards its division managers with a bonus equal to 5% of operating income. Compute the bonus earned by each manager for each of the following transfer pricing methods:
200% of full cost Market price
Answer
Transfer price per pound (($0.10 + $0.25) 2; $0.60) 1. Harvesting Division Revenues (500,000 lbs. $0.70; $0.60) Costs Division variable costs (500,000 lbs. $0.10 per lb.) Division fixed costs (500,000 lbs. $0.25 per lb.) Total division costs Division operating income Harvesting Division manager's bonus (5% of operating income) 2. Processing Division Revenues (250,000 gals. $2.10 per gal.) Costs Transferred-in costs Division variable costs (250,000 gals. $0.20 per gal.) Division fixed costs (250,000 gals. $0.40 per gal.) Total division costs Division operating income Processing Division managers bonus (5% of operating income)
Question
Which transfer pricing method will each division manager prefer? The Harvesting Division manager will prefer to transfer at 200% of full costs because this method gives a higher bonus. The Processing Division manager will prefer transfer at market price for its higher resulting bonus.
Question
How might Crango resolve any conflicts that may arise on the issue of transfer pricing?
Basing division managers bonuses on overall Crango profits in addition to division operating income. This will motivate each manager to consider what is best for Crango overall and not be concerned with the transfer price alone. Letting the two divisions negotiate the transfer price between themselves. However, this may result in constant re-negotiation between the two managers each accounting period.
Problem 3
Industrial Diamonds has two divisions:
South African Mining Division which polishes raw diamonds for use in industrial polishing tools. US Processing Division which polishes raw diamonds for use in industrial cutting tools.
Problem 3
The Processing Divisions yield is 50%. It takes two pounds of raw diamonds to produce 1 pound of top-quality polished industrial diamonds. Although all of the Mining Divisions annual output of 2,000 pounds of raw diamonds is sent for processing to the United States, there is also an active market for raw diamonds in South Africa.
Problem 3
The foreign exchange rate is 7 ZAR (South African Rands) = $1.00 US Dollar. The information shown on the following slide is for the two divisions.
1,540
3,150 18%
ZAR
ZAR
Question
Compute the annual pre-tax operating income, in US dollars, of each division using 200% of full cost and market price transfer pricing methods. Then calculate after-tax income using same methods.
$1,200,000
160,000 440,000 600,000 $ 600,000 $5,000,000 1,200,000 150,000 700,000 2,050,000 $2,950,000
$ 900,000
160,000 440,000 600,000 $ 300,000 $5,000,000 900,000 150,000 700,000 1,750,000 $3,250,000
AnswerAfter-Tax Income
200% of Full Cost Market Price
Mining Division Division operating income Income tax at 18% Division after-tax operating income Processing Division Division operating income Income tax at 30% Division after-tax operating income
The Mining Division manager would prefer 200% of full cost for the purpose of calculating a bonus. The Processing Division manager, however, would prefer market price.
Question
In addition to tax minimization, what other factors might Industrial Diamonds consider in choosing a transfer-pricing method?
Performance evaluation Management motivation Pricing and product emphasis External market recognition
Overall income of the company Income or dividend repatriation restrictions Competitive position of subsidiaries in their respective markets
AnswerAfter-Tax Income
200% of Full Cost Market Price
Mining Division Division operating income Income tax at 18% Division after-tax operating income Processing Division Division operating income Income tax at 30% Division after-tax operating income
Due to differing tax rates, the company will pay less tax and keep more profit if they use 200% of full cost as the transfer price.