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Transfer prices: functions, types, and behavioral implications.

Most companies now operate in an environment in which their products, markets, customers, employees, and technology are constantly changing. In such circumstances, the appropriate organizational form becomes important, and a decentralized de·cen·tral·ize  
v. de·cen·tral·ized, de·cen·tral·iz·ing, de·cen·tral·iz·es

v.tr.
1. To distribute the administrative functions or powers of (a central authority) among several local authorities.
 organization is very common. The essence of decentralization de·cen·tral·ize  
v. de·cen·tral·ized, de·cen·tral·iz·ing, de·cen·tral·iz·es

v.tr.
1. To distribute the administrative functions or powers of (a central authority) among several local authorities.
 is the freedom managers have at various levels to make decisions within their sphere of responsibility. This frequently involves determining a transfer price system within the company, which has the potential to become the most important and possibly the most interesting problem of management control.

Decentralization can simulate simulate - simulation  market conditions within a company between autonomously acting subunits--i.e., they reflect competition. Managers in such subunits or "business units" have different degrees of autonomy and a range of company decisions for which they are responsible. The cost center manager is typically responsible for costs, the profit center manager for costs and revenues, and the investment center manager for generating an adequate return on investment.

Because of the decentralization of decision making, the role of performance measurement and performance assessment within these responsibility centers becomes important. These issues lead to discussion and systematic analysis of transfer price functions between segments. (1) Companies often use transfer prices as substitutes for market prices either because market prices do not exist or because they do not facilitate internal trading and the synergies it creates. Even if synergies exist for internal trade, it is possible that market prices may not encourage this to happen. Thus top management often imposes a transfer price in order to benefit from these synergies. An added complication complication /com·pli·ca·tion/ (kom?pli-ka´shun)
1. disease(s) concurrent with another disease.

2. occurrence of several diseases in the same patient.


com·pli·ca·tion
n.
, however, is that sharing the synergistic synergistic /syn·er·gis·tic/ (sin?er-jis´tik)
1. acting together.

2. enhancing the effect of another force or agent.


syn·er·gis·tic
adj.
1.
 benefits between responsibility centers is arbitrary, so the "correct" transfer price cannot exist. It is obvious that transfer prices affect the profit reported in each responsibility center, and, more importantly, companies can use transfer pricing to influence decision making.

We will look at the functions and different types of transfer prices and their possible behavioral consequences. The analysis, which is from a managerial point of view, argues that neither a single "true" nor a "fair" price exists, but, rather, the transfer price is conditional on the decision context. Our article also highlights possible dysfunctional dys·func·tion also dis·func·tion  
n.
Abnormal or impaired functioning, especially of a bodily system or social group.



dys·func
 behavior. We outline some examples and propose possible solutions that we assess in the light of behavioral effects, highlighting how complex, difficult, and insolvable the issue of transfer pricing is in reality. In order to understand the effects resulting from asymmetric information Asymmetric Information

Information available to some people but not others.

Notes:
In other words, the asymmetric information is held by only one side, meaning someone is keeping a secret.
 and finding suitable transfer prices, we will first discuss the functions of transfer prices.

Functions of Transfer Prices

The decentralized organization is a connection of partly independent business units. An important task for management is the performance measurement and assessment of these units. This requires, for example, that the reported profit figure for, say, profit or investment centers for the relevant period, should be reliable and trustworthy. Where these business units trade with each other, the transfer pricing system Noun 1. pricing system - a system for setting prices on goods or services
system - a procedure or process for obtaining an objective; "they had to devise a system that did not depend on cooperation"
 has the potential to distort reported profit performance. Therefore, the internal profit-allocation function and related performance measurement of business units are crucial elements of transfer pricing.

Transfer prices should also influence managerial decision making because they should provide an incentive to maximize the business units' profit targets. We refer to this as the coordination function. If managerial decisions Managerial decisions

Decisions concerning the operation of the firm, such as the choice of firm size, firm growth rates, and employee compensation.
 lead to maximized profits within all the autonomous business units, then this should also maximize the total company or, in the following "group," profits, ignoring tax and foreign exchange considerations. Business unit managers' decisions then are identical to the decisions that the group's top managers would make if they had all the necessary information.

There is a potential conflict between these two functions of transfer prices, namely the profit-allocation function (reliable and trustworthy prices and, thus, reported profits) and the coordination function (guiding behavior of decentralized managers by using the transfer prices). One solution is to reduce the discretion of subunit sub·u·nit  
n.
A subdivision of a larger unit.

Noun 1. subunit - a monetary unit that is valued at a fraction (usually one hundredth) of the basic monetary unit
fractional monetary unit
 managers in setting transfer prices. This approach, however, partly defeats the original purpose of decentralization and reduces the validity of assessing such responsibility units on the basis of reported profit as it is no longer an aspect for which companies can hold them directly responsible.

There are additional functions for transfer prices. Besides the primary functions of profit allocation and coordination functions, transfer prices fulfill ful·fill also ful·fil  
tr.v. ful·filled, ful·fill·ing, ful·fills also ful·fils
1. To bring into actuality; effect: fulfilled their promises.

2.
 other tasks, such as complying with financial reporting regulations in addition to tax considerations. (2) We will not discuss them here, however. Instead, we will concentrate on the two primary functions of transfer prices together with their behavioral consequences, which companies often do not understand.

Types of Transfer Prices and Their Determination

Generally, companies can determine transfer prices three different ways: market-based transfer prices, cost-based transfer prices, and negotiated transfer prices. Although each method provides a different "answer," their commonality is that transfer prices represent an intracompany in·tra·com·pa·ny  
adj.
Occurring within or between the branches of a company: an intracompany network. 
 market mechanism. We will now discuss each type of transfer price.

Market-Based Transfer Prices

Market-based transfer prices represent market conditions and, therefore, simulate the market-within-the-company idea. Their advantage is that they support and implement corporate strategy and allow performance measurement of responsibility centers using market-oriented data. A prerequisite pre·req·ui·site  
adj.
Required or necessary as a prior condition: Competence is prerequisite to promotion.

n.
 for this method is a standardized, existing market of the product or a substitute. Companies can determine a market-based transfer price by comparing current prices if the business unit also sells to the market. Alternatively, they can obtain transfer prices from the marketplace if a comparable competitive product exists. Problems do occur with this approach, however, if, for example, a company uses "marginal prices" in order to use idle capacity. In such circumstances, the short-term price may not be equivalent to the long-term price. Furthermore, should one include special discounts? Another major problem with market-based prices is their trustworthiness trustworthiness Ethics A principle in which a person both deserves the trust of others and does not violate that trust , and this raises questions such as:

* Who submits the information?

* Who decides which suppliers are asked for an offer, and how often should the information be requested?

* Should there be a "favored" clause for intracompany trading compared to market suppliers?

[FIGURE 1 OMITTED]

Figure 1 shows a case of two responsibility units in the situation of a perfect market. (3) The costs of the business units remain unaffected by their decisions whether to purchase externally in the marketplace or to engage in intracompany trading. The example shows that under normal circumstances subunit 1 produces an intermediate product and can sell it in the market at $125 or to subunit 2 for an agreed transfer price that the company will determine. Subunit 2 transforms this into a final product that it sells on the market at a normal price of $300. A supplier, however, has offered $240 for subunit 2's product, and this subunit has idle capacity to produce the product.

Managers should base suggested transfer prices on how well they fulfill the two functions of "profit allocation" and "coordination." In this example, the reported profits of both subunits are reliable and trustworthy because the company bases them on a transfer price equal to the market price of the intermediate product ($125). The selling division (subunit 1) always has the incentive to sell internally because the market-based transfer prices mirror current market conditions. Equally, the buying division (subunit 2) does not overpay o·ver·pay  
v. o·ver·paid , o·ver·pay·ing, o·ver·pays

v.tr.
1. To pay (a party) too much.

2. To pay an amount in excess of (a sum due).

v.intr.
To pay too much.
 for the intermediate product. Table 1 summarizes the decisions and profits of the two subunits. Both subunits have the incentive to trade internally using market prices to determine the transfer price and the overall group benefits accordingly.

We now adapt this example to case 2, where the processing costs of subunit 2 are $120 per unit rather than $80 (see Figure 2).

In case 2, subunit 2 still has the incentive to trade internally, but, with a transfer price of $125, subunit 2 will reject the supplementary offer. Table 2 summarizes the alternatives. By selling the product to the market, the market-based transfer price leads to subunit 1's profit of $25. In contrast, internal trading would result in an accounting loss of $5. Subunit 2 will not produce the final product, so subunit 2 will sell the intermediate product on the market. This, then, is also the profit-maximizing decision from the group perspective because it generates a total profit of $25 ($125-$100) compared to only $20 ($240-$100-$120) for a supplementary order.

Figures 1 and 2 illustrate the fulfillment ful·fill also ful·fil  
tr.v. ful·filled, ful·fill·ing, ful·fills also ful·fils
1. To bring into actuality; effect: fulfilled their promises.

2.
 of the profit-allocation function as there is an obvious homogenous homogenous - homogeneous  market price that can be the transfer price. Additionally, both subunits make the same decision as would top centralized cen·tral·ize  
v. cen·tral·ized, cen·tral·iz·ing, cen·tral·iz·es

v.tr.
1. To draw into or toward a center; consolidate.

2.
 management if they possessed all available information. This is highlighted by the decision about a one-off supplementary offer for an additional customer for a price of $240: In case 1, both subunits independently decide to trade internally, and top management would approve this in the company headquarters as the supplementary order increases company profit by $60. A variation of this, case 2, in which subunit 2 has production costs of $120, shows that it is preferable to sell the intermediate product in the market. Thus the subunits do not trade with each other when they use the market-based transfer price. This decision leads to an overall profit of $25. If interdivisional trading took place at a transfer price of $125, it would lead to additional group profit of only $20. Thus this also fulfills the coordination function. Top management would have made this decision if they had access to all the information.

[FIGURE 2 OMITTED]

We can further adapt the previous example. Figure 3 indicates that subunit 1 incurs costs of $100 per unit when selling internally and costs of $116 when selling to the market. The incidence of selling and distribution costs distribution costs distribute nplVertriebskosten pl  could explain this phenomenon. In case 3, the production costs of subunit 2 are $120, which are the same as in case 2, and the necessary intermediate product is bought internally from subunit 1. This example builds on the previous example with one exception: the existence of synergies, represented by a different cost situation when subunit 1 sells its product internally or to the market and when subunit 2 buys internally or from the market.

This proves that the market-based transfer price will not fulfill the profit allocation and the coordination function when synergies exist. That is to say, the obvious solution for a transfer price of a decentralized organization will not work in the real world where synergies exist. As shown in the example, the two functions are not fulfilled because neither the "correct" profit can be reported by the use of the transfer price nor are the subunit's decisions in the best interests of the company as a whole. Yet synergies can be seen as a reason for the existence of companies because companies then can produce something better and cheaper, i.e., in principle favorable fa·vor·a·ble  
adj.
1. Advantageous; helpful: favorable winds.

2. Encouraging; propitious: a favorable diagnosis.

3.
 to customers.

Despite the fact that there is an obvious homogenous market price, the profit-allocation function is not fulfilled anymore because of synergies represented by the lower internal costs of subunit 1 when avoiding the use of the market--i.e., when selling the intermediate product to subunit 2 rather than to the market--and by the additional costs of subunit 2 when utilizing the market. The synergies, therefore, comprise $16 (subunit 1) and $15 (subunit), which equals $31, symbolized by increased cost functions of both business units (e.g., for higher marketing costs of business unit 1 or higher quality-control costs of business unit 2). The reporting of the "correct" profit supposedly shows the correct division of the synergies, but any division of these advantages is arbitrary.

[FIGURE 3 OMITTED]

So who should benefit from synergy The enhanced result of two or more people, groups or organizations working together. In other words, one and one equals three! It comes from the Greek "synergia," which means joint work and cooperative action.  when subunit 1 produces the intermediate product that it sells to subunit 2, who processes it into the final product sold as the supplementary order at the price of $240? For example, at a price of $110 for the intermediate product, both subunits end up with a profit of $10 each: Subunit 1 is $110 - $100 = $10; subunit 2 is $240 - $120 - $110 = $10. Both share the maximum achievable profit, which equals $20 for an intracompany solution of the supplementary order versus a profit of $9 when subunit 1 sells the intermediate product to the market and when the supplementary order is rejected. At that price, both subunits report a profit, even though the amounts are arbitrary and not in accordance Accordance is Bible Study Software for Macintosh developed by OakTree Software, Inc.[]

As well as a standalone program, it is the base software packaged by Zondervan in their Bible Study suites for Macintosh.
 with the market price of the intermediate product but $15 lower.

An analysis of the next function, the coordination function, reveals that the company's decision is not identical to the subunits' decisions: A company can achieve maximum profit by producing the supplementary order at a profit of $20 per product. Subunit 1 also prefers the profit of $25, but subunit 2 rejects this because of a loss of $5, so the only business consists of selling the intermediate product to the market with a combined profit of $9 for subunit 1 and the company. Because of synergistic effects, the market-based transfer price in the example is too high for both subunits to decide to accept the one-time order. A price that would lead both business units to decide positively about the order is in the range of $109 and $120. At a price of $109, subunit 1 earns a contribution margin internally in the amount of $9, which is identical to the amount it could earn at the market price. It is the minimum price it would ask for in case of internal business. At a price of $120, subunit 2 starts to earn a positive contribution margin--i.e., it is the maximum price subunit 2 is willing to pay. The rejection of the supplementary order cuts the possible company profit from $20 to $9, so the market-based transfer price does not support independent decisions in the company's best interests.

In summary, the main advantage of market-based transfer prices is that they are objective and unbiased measures, although they might fluctuate because of market conditions over time. Further, they are difficult to manipulate. As case 3 shows, market-based transfer prices perform the profit-allocation function except when synergies and interdependencies exist. When an imperfect market Imperfect market

Economic environment in which the costs of labor and other resources used for production encourage firms to use substitute inputs that less costly.
 exists, a company may not fulfill the coordination function. Further questions remain, such as:

* What if the market price cannot be determined?

* How often are market prices measured?

* Will they be based on short-term single-production-run offers or long-term high-volume offers?

These questions indicate that using market-based transfer prices presents practical difficulties.

Cost-Based Transfer Prices

Depending on one's definition of cost, cost-based transfer prices can provide a variety of figures for determining intracompany trading. Cost-based prices are the most common type in practice, and they represent an alternative if a market price does not exist. In accounting terms, "cost" can be defined in a variety of ways, including actual versus budget (or standard); marginal versus absorbed (full) cost; and whether one uses pure cost or cost-plus to determine transfer prices. The first classification, actual versus standard costs, concerns the issue of who will take the risk of cost deviations and variances. Using actual costs--i.e., ex-post price determination--transfers the risk associated with cost deviations to the purchasing subunit. In contrast, standard costs require the ex-ante determination of the prices and shift the risk to the supplying subunit.

Marginal versus full cost represents the next category. Marginal costs fulfill the function of coordination because the marginal-cost-based transfer price leads to "optimal" decisions of the purchasing subunits, and the independence of the subunits remains unchanged. As a result, the supplying subunit makes an accounting loss by approximating the fixed costs fixed costs,
n.pl the costs that do not change to meet fluctuations in enrollment or in use of services (e.g., salaries, rent, business license fees, and depreciation).
 per unit, assuming linearity of cost behavior. The purchasing subunit regularly earns high profits, and the issue of profit allocation is unresolved Not completed; not finished; not linked together. See resolve. .

This model, known as the Hirshleifer model, is the next example: The business units' decisions are identical to the decisions of corporate headquarters if headquarters had all the information. It supports the academic logic of management accounting in which only marginal costs are relevant in the short-term view. To analyze this point and shed some light on the specific problems of it, we introduce a new example where the cost functions of subunits 1 and 2 are simple linear equations as follows: [C.sub.1] = 100 + 0.3x and [C.sub.2] = 30 + x. The demand curve for the final product is given as: p(x) = 31 - 1.2x. Based on profit-maximization theory, which equates marginal cost Marginal cost

The increase or decrease in a firm's total cost of production as a result of changing production by one unit.


marginal cost

The additional cost needed to produce or purchase one more unit of a good or service.
 with marginal revenue Marginal revenue

The change in total revenue as a result of producing one additional unit of output.


marginal revenue

The extra revenue generated by selling one additional unit of a good or service.
, the optimal solution is an output of 12,375 units and a loss of $100 (subunit 1) and $153.77 (subunit 2). Table 4 summarizes profit functions and decisions.

We assumed linear cost functions in the example. In a modification of the previous example, now we assume a nonlinear A system in which the output is not a uniform relationship to the input.

nonlinear - (Scientific computation) A property of a system whose output is not proportional to its input.
 cost function of subunit 1 because this shows that the described solution of the Hirshleifer model will not work anymore. The cost function of the supplying business unit changes to [C.sub.1] = 100 + 0.3 * [x.sup.2], and this Hirshleifer model proves that marginal-cost-based transfer prices, while seemingly seem·ing  
adj.
Apparent; ostensible.

n.
Outward appearance; semblance.



seeming·ly adv.
 supporting the coordination function, provide an apparent solution. This is so because the company headquarters has to announce the transfer price (where TP = $6 (for [x.sub.opt] = 10); profit subunit 1 (2) = -$70 ($90)). In the case of a nonlinear cost function, this requires the knowledge of x, the amounts of product units. Marginal costs of subunit 1 are 0.6 * x; i.e., x remains unknown, and, therefore, [x.sub.optimum] must be known to determine [x.sub.optimum], and, with it, a circularity problem exists, and headquarters can find a solution by announcing the transfer price after determining [x.sub.optimum]. In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke"
put differently
, only an apparent solution is found because independent subunits are not independent anymore as headquarters must know x and use it for presenting the transfer price. This problem is only linked to nonlinear cost functions. Therefore, the example started with a linear cost function [C.sub.1], and we then modified it to a nonlinear function to illustrate the unsuitability un·suit·a·ble  
adj.
Not appropriate: unsuitable attire.



un·suit
 of transfer prices based on marginal costs.

Another problem is that profit allocation is not performed because there is an arbitrary split of the profits between the business units that typically favors the purchasing business units.

Table 5 shows the profits of both subunits, summarizes their decisions, and represents the subunits' decisions (decentralized decisions) in comparison to the company's perspective as a whole (centralized decision). The decisions are identical in each case ([x.sub.opt]=10).

In regard to behavioral effects, two problems become obvious: First, from the viewpoint of the supplying business unit, the unit probably will end up with a loss. The loss in the previous example is $70. Understanding the procedure, the subunit can gain advantages by reporting a distorted cost function by, for instance, increasing the reported variable costs that lead to higher marginal costs and, thus, transfer price. In this example, the distortion to a cost function of [C.sub.1] = 100 + 0.4 * [x.sup.2] changes the company's and business units' decisions and reduces the loss from $70 to $64.84 (TP=$7.50, [x.sub.opt] = 9.375). The total company profit falls by about 47% from $20 to $10.63 (by 88% for [C.sub.1] = 100 + 0.5 * [x.sup.2], etc.). Second, from the viewpoint of the purchasing business unit, understanding the procedure changes the unit's profit function because the business unit realizes that the transfer price is not independent of the amount of products. The transfer price is a function of x and therefore maximizes the following profit function using the initial cost function: [C.sub.1] = 100 + 0.3 * [x.sup.2]: [Profit.sub.2] = p(x) x - TP(x) x - [K.sub.2](x) = (31 - 1.2x) x - 0.6[x.sup.2] - 30 - x. As a result, a different optimum amount of units produced arises and is not consistent with the initial solution (x = 8.33 versus x = 10). The profit of subunit 2 rises from $90 to $95, exemplifying ex·em·pli·fy  
tr.v. ex·em·pli·fied, ex·em·pli·fy·ing, ex·em·pli·fies
1.
a. To illustrate by example: exemplify an argument.

b.
 the dysfunctional incentive.

[FIGURE 4 OMITTED]

Marginal-cost-based transfer prices cause other dysfunctional behavior. The supplying business unit has an incentive for untruthful reporting and, in general, to qualify the highest possible portion of the costs as being variable. Further, supplying business units will oppose investments that will lead to smaller variable and higher fixed costs, known in literature as the hold-up problem of investments. (4)

This example shows that the theoretical view of solutions--the optimum achieved by applying marginal costs--may not work in company practice because of other considerations, such as behavioral effects. Theory, however, does provide insights for issues highly relevant in practice.

In summary, using marginal-cost-based transfer prices leads to the central optimum in the short-term view, i.e., the fulfillment of the coordination function. This may only be an apparent solution and does not work in the case of nonlinear cost functions. The profit-allocation function is not fulfilled, and the supplying business unit usually ends up with a loss. This might be overcome by multitier schemes we will describe.

The capacity limit of the marginal costs is the point that includes opportunity costs Opportunity costs

The difference in the actual performance of a particular investment and some other desired investment adjusted for fixed costs and execution costs. It often refers to the most valuable alternative that is given up.
. Opportunity costs increase with higher volume, and, in principle, this leads to an approximation approximation /ap·prox·i·ma·tion/ (ah-prok?si-ma´shun)
1. the act or process of bringing into proximity or apposition.

2. a numerical value of limited accuracy.
 toward the market-based transfer prices.

As an alternative to marginal costs, companies can use fully absorbed cost-based transfer prices. The basic idea is that the supplying subunit should be able to meet all of its costs and should not incur an accounting loss on the internal transaction. Certain variations of costs exist, such as using production costs or, alternatively, total costs to include a portion of selling, distribution, and administrative overheads.

A major problem of this type of transfer price is the distortion of the group's cost structure. The reason is we can regard the transfer price from the viewpoint of the purchasing unit, and it regards the transfer price as a variable cost even though it includes an element of fixed cost. Therefore, decisions made seemingly on variable cost actually include fixed-cost portions, and this distortion leads to suboptimal Suboptimal
A solution is called suboptimal if a part of the solution has been optimized without regards to the overall objective.
 decisions. The problem that full cost includes irrelevant parts for short-term decisions highlights the problem that the allocation of fixed overhead costs overhead costs

see fixed costs.
 is always arbitrary. The distortion intensifies if we use cost-plus transfer prices that include a surcharge An overcharge or additional cost.

A surcharge is an added liability imposed on something that is already due, such as a tax on tax. It also refers to the penalty a court can impose on a fiduciary for breaching a duty.
, such as a percentage of full costs, the required return on capital employed Return on capital employed (ROCE)

Indicator of profitability of the firm's capital investments. Determined by dividing Earnings Before Interest and Taxes by (capital employed plus short-term loans minus intangible assets).
 (ROCE ROCE

See: Return on capital employed
), or the return on investment (ROI (Return On Investment) The monetary benefits derived from having spent money on developing or revising a system. In the IT world, there are more ways to compute ROI than Carter has liver pills (and for those of you who never heard of that expression, it means a lot). ).

A step toward a solution may be the multitier transfer price. Figure 5 shows a two-tier scheme: a single periodic amount for reserving capacity as an equivalent to the fixed costs this capacity level causes and current products the company will buy at marginal (variable) costs.

Effects arising from this two-tier scheme are that the supplying subunit is reimbursed for its full costs and can possibly even earn a profit and that the periodic payment does not affect short-term decisions about single product orders that are made based solely on marginal costs. The two-tier scheme achieves the coordination function. Yet problems arise for capacity planning Determining the required future configuration of hardware and software for a network, datacenter or Web site. There are numerous capacity planning tools on the market used to monitor and analyze the performance of the current hardware and software.  because several questions come up, such as:

* What happens with idle capacity?

* What type of fixed costs will we use to determine the single payment--actual capacity use (known ex-post only), former average capacity use, or reported planned capacity use?

* When will the payment be renegotiated--periodically or when the capacity is adjusted?

[FIGURE 5 OMITTED]

[FIGURE 6 OMITTED]

Another version of a cost-based transfer price is a dual transfer price. Its main idea is that two different transfer prices will be used--one for the supplying unit and another for the purchasing subunit. The example in Figure 6 suggests that the supplying subunit receives the average net margin of the purchasing subunit and that the purchasing subunit pays only the average full costs of the supplying subunit. As a result, the head office subsidizes the supplying subunit.

One effect of negotiated transfer prices is that the subunits' profits and the company's profits become identical. Therefore, the transfer prices fulfill the coordination function because the subunits maximize identical profit functions and will come to identical decisions, the decisions that headquarters would also come to if it had all the necessary information. The following example illustrates this with the data from Figure 6.

Through maximizing the total profit, the central solution leads to an output volume of 10 units and a profit of $20. The transfer price, TP1, as the sales price of the supplying subunit, is deducted de·duct  
v. de·duct·ed, de·duct·ing, de·ducts

v.tr.
1. To take away (a quantity) from another; subtract.

2. To derive by deduction; deduce.

v.intr.
 from the average net margin of the purchasing subunit, and, in the example, [TP.sub.1] is: -1.2x + 30 - 30/x. The maximized profit, [P.sub.1], is identical to the company's total profit and, therefore, leads to an identical decision about units produced and sold. The transfer price, [TP.sub.2], as the average full cost of the supplying subunit in this example, is 0.3x + 100/x, and the profit function, [P.sub.2], is also identical to the previous profit functions, as are the decisions.

This procedure is characterized char·ac·ter·ize  
tr.v. character·ized, character·iz·ing, character·iz·es
1. To describe the qualities or peculiarities of: characterized the warden as ruthless.

2.
 by a subsidization sub·si·dize  
tr.v. sub·si·dized, sub·si·diz·ing, sub·si·diz·es
1. To assist or support with a subsidy.

2. To secure the assistance of by granting a subsidy.
 of the supplying subunit. Because of increased subsidization, an untruthful reporting of cost functions can be beneficial to all subunits, provided that a collusive col·lu·sive  
adj.
Acting in secret to achieve a fraudulent, illegal, or deceitful goal.



col·lusive·ly adv.
 agreement between the subunits on combined "distorted" cost functions is made. In other words, the untruthfully reported cost functions relate to each other, with both subunits calculating identical unit numbers produced and sold.

In summary, several problems arise with the dual transfer prices. The subunits' profits appear to be too high because headquarters subsidizes them. There is a strong incentive to do internal business because headquarters pays a subsidy to each unit to increase the subunit's profits. Both subunits report the same profit, which means the profit-allocation function is not achieved. Besides that, in general there is low acceptability because it is not obvious what the "real" or "correct" transfer price is. This type of transfer price involves a number of organizational efforts.

Negotiated Transfer Prices

Finally, one can determine transfer prices by way of negotiation. Negotiated transfer prices simulate the "market within the company." These prices can be determined in a situation that is characterized by highly autonomous and independent subunits. It implies that responsible managers have the option to refuse internal "business," and the process is similar to negotiations with regular customers. Headquarters can have different ways of influencing decisions, such as requiring approval, having the right to reject, having veto rights, and establishing procedural rules.

As a result, it is difficult to assess whether negotiated transfer prices fulfill the coordination and/or profit-allocation function because they depend on the negotiating power and negotiating skills of the individuals involved. Results of negotiations, which top management can influence, depend on the alternatives available. If no market prices exist, it is especially challenging to find a workable way. (5) Negotiations can be time-consuming and may lead to intracompany conflicts. Based on alternatives, these negotiated transfer prices typically fluctuate between marginal cost and market prices. Therefore, they will not generally fulfill the primary functions of transfer prices.

Further Thoughts

Decentralized organizations, such as those made up of a number of independent profit centers designed to improve the entrepreneurial conduct of managers, lead to increased motivation and better decision making. This leads to a consideration of transfer pricing. We argue, however, that there is no such thing as an ideal solution for transfer prices, nor even a "correct" or "fair" transfer price, as long as a perfect market condition applies.

How should management accountants deal with this issue if none of the characteristics exists? We argue that the main point is to see that, despite company practices, demand is high for it, and there cannot be one solution for a transfer price system. So it is essential to understand that different functions require different, even contradictory, transfer prices.

To determine a transfer price type, a company must consider the primary functions, namely profit allocation and coordination. Depending on the prioritized role, companies prefer certain transfer price types. Yet the possible dysfunctional behavioral effects arising from the transfer prices indicate how complex, difficult, and insolvable the issue of transfer pricing is in reality. Typically, a theoretical view presents a clear solution as a suggestion to practice; here it does not. This might be confusing con·fuse  
v. con·fused, con·fus·ing, con·fus·es

v.tr.
1.
a. To cause to be unable to think with clarity or act with intelligence or understanding; throw off.

b.
, but it also shows how highly relevant the theoretical reasoning can be. At least with the perspective on prioritized functions, we showed some solutions, including the dangers that arise from including behavioral effects.

References

Regina M. Anctil and Sunil Dutta Sunil Dutta is an author, social activist, scholar of music and poetry.

He was a scientist before he decided to join the police. He is a scholar of Urdu mystical poetry and an Indian classical music form called Dhrupad. Dutta was born and raised in Jaipur, India.
, "Negotiated Transfer Pricing and Divisional vs. Firm-Wide Performance Evaluation Performance evaluation

The assessment of a manager's results, which involves, first, determining whether the money manager added value by outperforming the established benchmark (performance measurement) and, second, determining how the money manager achieved the calculated return
," The Accounting Review, January 1999, pp. 87-104.

Bala V. Balachandran, Lode Li, and Robert P. Magee, "On the Allocation of Fixed and Variable Costs from Service Departments," Contemporary Accounting Research, Autumn 1987, pp. 164-185.

Tim Baldenius, Nahum D. Melumad, and Stefan Reichelstein, "Integrating Managerial and Tax Objectives in Transfer Pricing," The Accounting Review, July 2004, pp. 591-615.

Joseph M. Cheng, "A Breakthrough in Transfer Prices: The Renegotiate-Any-Time System," Management Accounting Quarterly, Winter 2002, pp. 1-8.

Paul W. Cook, "Decentralization and the Transfer-Price Problem," The Journal of Business, January 1955, pp. 87-94.

Robert G. Eccles, "Control with Fairness in Transfer Pricing," Harvard Business Review Harvard Business Review is a general management magazine published since 1922 by Harvard Business School Publishing, owned by the Harvard Business School. A monthly research-based magazine written for business practitioners, it claims a high ranking business readership and , November/December 1983, pp. 146161; The Transfer Pricing Problem, Lexington Books, Lexington, Mass., 1985; "The Performance Measurement Manifesto MANIFESTO. A solemn declaration, by the constituted authorities of a nation, which contains the reasons for its public acts towards another.
     2. On the declaration of war, a manifesto is usually issued in which the nation declaring the war, states the reasons
," Harvard Business Review, January/February 1991, pp. 13-137.

Ralf Ewert, Alfred Wagenhofer, and Peter Schuster, Management Accounting, Springer-Verlag, Berlin, Germany, 2010.

Robert Feinschreiber and Margaret Kent, "A Guide to Global Transfer Pricing Strategy," Journal of Corporate Accounting & Finance, September/October 2001, pp. 29-34.

Jack Hirshleifer Jack Hirshleifer (August 26, 1925 – July 26, 2005) was an American economist and long-time professor at the University of California, Los Angeles.

He received a B.S. from Harvard University in 1945 and a Ph.D. in 1950.
, "On the Economics of Transfer Pricing," The Journal of Business, January 1956, pp. 172-184, and "Economics of the Divisionalized Firm," The Journal of Business, January 1957, pp. 96-108.

Robert P. Magee, Advanced Managerial Accounting Managerial Accounting

The process of identifying, measuring, analyzing, interpreting, and communicating information for the pursuit of an organization's goals.

Notes:
, John Wiley John Wiley may refer to:
  • John Wiley & Sons, publishing company
  • John C. Wiley, American ambassador
  • John D. Wiley, Chancellor of the University of Wisconsin-Madison
  • John M. Wiley (1846–1912), U.S.
 & Sons, New York New York, state, United States
New York, Middle Atlantic state of the United States. It is bordered by Vermont, Massachusetts, Connecticut, and the Atlantic Ocean (E), New Jersey and Pennsylvania (S), Lakes Erie and Ontario and the Canadian province of
, N.Y., 1986.

Jeltje van der Meer-Kooistra, "The Coordination of Internal Transactions: The Functioning of Transfer Pricing Systems in the Organizational Context," Management Accounting Research, June 1994, pp.123-152.

Peter Schuster, "Verrechnungspreise bei Profit Center-Organization," in Handbuch Marktorientiertes Kostenmanagement, edited by Werner Pepels and Hilmar J. Vollmuth, Renningen, Germany, 2003, pp. 71-80.

Barry H. Spicer and Van Ballew, "Management Accounting Systems and the Economics of Internal Organization," Accounting, Organizations and Society, Vol. 8, Issue 1, pp. 73-96.

Barry H. Spicer, "Towards an Organizational Theory of the Transfer Pricing Process," Accounting, Organizations and Society, Vol. 13, Issue 3, pp. 303-322.

Williard E. Stone, "Intracompany Pricing," The Accounting Review, October 1956, pp. 625-627.

Endnotes

(1) Transfer prices have received a great deal of attention at all times, and research on them goes back to the 1950s. See Jack Hirshleifer, "On the Economics of Transfer Pricing," The Journal of Business, January 1956, pp. 172-184, and "Economics of the Divisionalized Firm," The Journal of Business, January 1957, pp. 96-108. Also see Paul W. Cook, "Decentralization and the Transfer-Price Problem," The Journal of Business, January 1955, pp. 87-94, and Williard E. Stone, "Intracompany Pricing," The Accounting Review, October 1956, pp. 625-627. Eugen Schmalenbach, one of the founding researchers of management accounting in Germany, started his research as early as 1903.

(2) For information on tax objectives, see, for example, Tim Baldenius, Nahum D. Melumad, and Stefan Reichelstein, "Integrating Managerial and Tax Objectives in Transfer Pricing," The Accounting Review, July 2004, pp. 591-615.

(3) Examples are adapted from Ralf Ewert, Alfred Wagenhofer, and Peter Schuster, Management Accounting, Springer-Verlag, Berlin, Germany, 2010.

(4) Regina M. Anctil and Sunil Dutta, "Negotiated Transfer Pricing and Divisional vs. Firm-Wide Performance Evaluation," The Accounting Review, January 1999, pp. 87-104.

(5) For a suggestion in this situation in the form of a "Renegotiate-Any-Time" system, see Joseph M. Cheng, "A Breakthrough in Transfer Prices: The Renegotiate-Any-Time System," Management Accounting Quarterly, Winter 2002, pp. 1-8.

Peter Schuster, Ph.D., is a professor of management accounting and management control at Schmalkalden University of Applied Sciences in Schmalkalden, Germany. You can reach Peter at (0049) 3683 688 - 3112 or Schuster@Fh-Schmalkalden.de.

Peter Clarke, Ph.D., is an associate professor of accountancy and director of the academic centre-accouting/taxation research at University College in Dublin, Ireland. You can reach Peter at (00353)1 7164700 or Peter.Clarke@ucd.ie.
Table 1: Decisions and Profits of the Subunits in Case 1

CASE      PROFIT SUBUNIT 1     DECISION SUBUNIT 1

Case 1    125 - 100 = 25       Produce and sell
                               intermediate product
                               (to subunit 2)

CASE      PROFIT SUBUNIT 2    DECISION SUBUNIT 2     PROFIT GROUP

Case 1    240 - 125 -         Buy intermediate       240 - 100 -
          80 = 35             product and produce    80 = 60
                              and sell
                              supplementary order

Table 2: Decisions and Profits of the Subunits in Case 2

CASE     PROFIT SUBUNIT 1     DECISION SUBUNIT 1

Case 2   125 - 100 = 25       Produce and sell
                              intermediate product
                              (to market)

CASE     PROFIT SUBUNIT 2    DECISION SUBUNIT 2    PROFIT GROUP

Case 2   240 - 125 -         Decline               125 - 100 = 25
         120 = -5            supplementary order   (for intermediate
                                                   product only)

Table 3: Decisions and Profits of the Subunits in Case 3

                PROFIT SUBUNIT 1    DECISION SUBUNIT 1

Intracompany    125 - 100 = 25      Intracompany
Market          125 - 116 = 9       preferred

                PROFIT SUBUNIT 2         DECISION SUBUNIT 2

Intracompany    240 - 125 - 120 = -5     Reject
Market          240 - 135 - 125 = -20    supplementary order

                PROFIT COMPANY

Intracompany    240 - 100 - 120 = 20
Market          125 - 116 = 9

Table 4: Decisions and Profits of the Subunits Based on a
Marginal-Cost-Based Transfer Price with Linear Cost Functions

PROFIT SUBUNIT 1       0.3 * x - 100 - 0.3 * x = - 100

DECISION SUBUNIT 1     Irrelevant, as marginal costs = variable costs
                       and thus profit always = a loss in the amount
                       of the fixed costs

PROFIT SUBUNIT 2       31 * x - 1.2 * [x.sup.2] - 0.3 * x - 30 - x =
                       - 1.2 * [x.sup.2] + 29.7 * x -30

DECISION SUBUNIT 2     x opt = 29.7/2.4 = 12.375 ([Profit.sub.max] =
                       153.77)

PROFIT GROUP           31 * x - 1.2 * [x.sup.2] - 100 - 0.3 * x - 30 -
                       x = - 1.2 * [x.sup.2] + 29.7 * x - 130

DECISION GROUP         Identical to Subunit 2 (Profitmax = 53.77)

Table 5: Decisions and Profits of the Subunits
Based on a Marginal-Cost-Based Transfer Price
with Nonlinear Cost Functions

PROFIT SUBUNIT 1      TP * x - 100 - 0.3 * [x.sup.2]

DECISION SUBUNIT 1    Because of nonlinear cost function,
                      headquarters has to set transfer price at 0.6 x
                      (knowing x!): TP=6 (Profit = -70) [x.sub.opt] =
                      10

PROFIT SUBUNIT 2      31 * x - 1.2 * [x.sup.2] - 6 * x - 30 - x =
                      -1.2 * [x.sup.2] + 24 * x - 30

DECISION SUBUNIT 2    [x.sub.opt] = 24/10 = 10 ([Profit.sub.max] = 90)

PROFIT COMPANY        31 * x - 1.2 * [x.sup.2] - 100 - 0.3 *
                      [x.sup.2] - 30 - x = -1.5 * [x.sup.2] + 30 * x
                      - 130

DECISION COMPANY      [x.sub.opt] = 10 ([Profit.sub.max] = 20)
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Author:Schuster, Peter; Clarke, Peter
Publication:Management Accounting Quarterly
Geographic Code:1USA
Date:Jan 1, 2010
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