Transfer Pricing Disputes
Current
Profit Inc./Dec
Costs
Costs
Division A
Internal @ $1,000
3,000,000
2,000,000
1,800,000
Total Costs
3,900,000
3,800,000
Division B
Internal @ $2,000
2,000,000
1,000,000
External @ $1,900
1,900,000
2,850,000
Total Costs
3,900,000
3,850,000
Inc 50,000
Division C
Part 101 @ $1,000
3,000,000
2,000,000
Part 201 @ $2,000
2,000,000
Total Sales
2,100,000
1,400,000
Part 201 @ $1,200
1,200,000
Total Costs
3,300,000
2,000,000
Profit
1,700,000
Company as a whole (100,000 + 50,000) — 700,000 = 550,000 loss
To enforce the proposed plan would cause a $550,000 loss for the company as a whole. The increases in profits for division A and B, $100,000 and $50,000 respectively, are not enough to cover the $700,000 loss from division C. This is especially if the selling prices of the finished products of division A and B. are the same as the company would take the loss as a whole. If division C. dropped their prices to market prices, they would still experience a $400,000 loss, still creating a $250,000 loss for the company.
Where there are no other customers likely to be found for the parts, other strategy needs to be considered. Putting more dollars into research and development could potentially improve existing products and create a flexible procurement that could supply variants for opportunity to change (Sahay, 2003). Existing products can be improved for higher profits or new products can be developed for market expansion. This would create an expansion opportunity for division C. For higher profits on existing products being sold to external customers or new products that can be sold externally. Either way, it could create a market share for division C.
With the entire production of division C. being transferred internally, the incremental costs are not an appropriate measurement of its performance (9, n.d.). Inefficiencies are passed on without consideration of wasted costs. Often, managers with this situation feel they are working for someone else and have little initiative to work on efficiency of production standards. There are no profit targets or sales goals to look forward to in order to have the drive for growth of any kind. Research and development can change a situation like this by creating a market expansion opportunity to sell to external customers and create initiative within division C. For higher profit and sales goals. The goals could create a bigger incentive to work for production efficiency to cut wasted costs.
Managers in divisions A and B. should also concentrate on production efficiency and work to increase productivity per labor hour to maximize profits and cut waste in costs. There are too many times when waste in the production process reduces profits unnecessarily. Working on production efficiency can bring about higher profits per labor hour in the long run. Looking for other waste in costs can also maximize profits and efficiency in the production process.
Considerations need to be made when selecting transfer pricing policy (Feinschrieber, n.d.). Divisions across state, county, and country boundaries can bring tax and other legal consequences. Market positions change with inflation and deflation that cause problems with reaching targeted goals. Corporate goals and strategies, divisional control, corporate culture, frequency of transfer pricing change, technology and innovation of products, market characteristics, general business conditions, and accounting systems also affect transfer pricing.
Cost based approaches are good for products with no external market, or the market is imperfect (Abeysingh, 2009). Actual costs will vary with volume, seasonal, and other factors that can pass production inefficiency to other divisions. The cost plus mark-up will vary and can cause frequency of transfer pricing changes that cause problems. Factors, such as material costs, volume, and market can cause cost fluctuations that create problems with goal targets.
Standard cost plus a mark-up fails in giving fair revenue, reasonable costs, and the profit is distorted (Abeysingh, 2009). Material costs fluctuate in market fluctuations that cause revenues to be stated falsely. Differences between actual and standard costs cause variances, favorable or unfavorable, that distort true profits.
The transfer pricing being negotiated between division managers may not solve the conflict, more especially with pressure to increase sales volume and profits are concerned. “The negotiated process favors executives with negotiation skills rather than executives that can produce goods efficiently (Feinschrieber, n.d.). When managers are under pressure from corporate, negotiation does not always work well. Managers that do not have good negotiation skills often walk away resentful, which causes problems. If managers are instead encouraged toward production efficiency and other cost cutting measures, negotiation has a better chance.
References
9, G. (n.d.). Transfer Pricing. Retrieved from Scribd: http://scribd.com/doc/6699410/Transfer-Pricing-Nitin
Abeysingh, R. (2009, June 25). Cost Based Approaches to Transfer Pricing. Retrieved from Ezine Articles: http://ezinearticles.com/?Cost-Based-Approaches-to-Transfer-Pricing&id=2524966
Feinschrieber, R. (n.d.). Business Facets of Transfer Pricing. Retrieved from Anefac: http://www.anefac.org.mx.Docs/TrabajosInformacion/PreciosTransferencia/Word/Business%20Facets.htm
Sahay, S. (2003, Jan 1). Transfer pricing based on actual cost. Retrieved from High Beam Business: http://business.highbeam.com/6392/article-1G1-1129056016/transfer-pricing-based-actual-cost
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