Transfer pricing

Transfer pricing is a popular topic in management accounting. It is concerned with the price when one department (the selling department) provides goods or services to another department (the buying department). That is, one department generates revenue from the sales of goods or services and the other department incurs expenses from the purchases of goods or services. Transfer pricing is closely related to responsibility accounting in which each department is responsible for its cost, revenue, expense or investment return depending on the type of centre it is. Thus, transfer pricing effectiveness is essential to the success of the overall company. The related key issue is the determination of a transfer price which brings goal congruence to the company, and to the buying and the selling departments, as all parties want to make a profit. A department like the sales department which purchases goods and services may compare the prices of similar products in the external market before making its purchasing decision. If external prices are more attractive than internal prices, it may purchase from outside rather than from an internal department like the production department. Similarly, the production department may refer to prices of similar products before it decides to sell to the sales department since selling to the external market may be more attractive. This is the basic idea of market-based transfer prices. Market-based transfer prices generally result in optimal decisions provided that there is a perfectly competitive market for the intermediate product being transferred and there is minimal interdependence between subunits. Also, there are no additional costs or benefits from buying or selling to the external market instead of selling the items internally. In cost-based transfer pricing, the transfer price is decided by the cost of goods or services concerned. The cost calculation formula may involve variable costs, fixed costs, full costs or some other variation. Cost-based transfer pricing models are appropriate when market prices are not available or are inappropriate or are even costly to get. This could be the case when the intermediate product being sold is unique or differs from the products available externally. In fact, many companies use transfer prices based on full cost or full cost plus a markup to approximate market price. The use of cost-based transfer prices can result in sub-optimal decisions because the full-cost transfer price is higher than the external product price, so the departmental operating 2 profit is maximized by purchasing the product externally. However, purchasing the product from external sources results in a lower total company profit because the other divisions still incur fixed costs included in the full-cost transfer price, and the external price is higher than the variable cost of producing the product. Cost calculation is also somewhat subjective. Dual pricing is used to describe the situation in which the selling and buying departments use different transfer pricing methods. For example, the selling department may use full cost pricing while the buying department may use market pricing. Another common transfer pricing method is the negotiated transfer price. In this method, departments negotiate between themselves to arrive at a transfer price. Quite often this involves some form of bargaining. For example, a powerful department may be able to get a better price from a small department. Consider the following example. Suppose AAT is a company producing chairs. The company’s production department produces 100,000 chairs a year and its annual capacity is 150,000. The variable cost of each chair is $300 and the annual fixed cost for the production plant is $9,000,000. The chair can be sold for $400 in the open market. Within the company, the administration department plans to buy 50,000 chairs at $280 from the production department, but the production department refuses this order as the offered price is below the variable cost, as can be seen by calculating the contribution margin: . Sales price $280 Variable cost ($300) Contribution margin ($20) The minimum transfer price should therefore equal the variable or incremental costs incurred by the transferring department plus the opportunity costs resulting from transferring the products or service internally instead of selling them to external customers. Transfer price >= variable cost per unit + unit contribution margin on lost sales Unused capacity within the selling department affects the opportunity cost of an internal transfer. If there is unused capacity within the selling department, no opportunity costs are involved in an internal transfer price. The transfer price will likely be in the lower range, covering only the variable cost involved in the production of the product but not the fixed cost, 3 because the fixed cost will be incurred regardless of the production volume. The transfer price must be great than or equal to $300 or otherwise the selling department (in this case, the production department) incurs a loss. If there is limited capacity, say 100,000 chairs, acceptance of the order from the administration department means that the production department needs to reduce its production volume from 100,000 to 50,000 chairs. The unit contribution is $100 ($400 - $300). An ideal transfer price is at least equal to the variable cost per unit + unit contribution margin on lost sales = $300 + $100 = $400. Back to the unlimited capacity case, the administration department’s manager thinks that the order could bring the fixed cost per desk from $90 to $60. In addition, it also takes the production department to its maximum capacity of 150,000. This case can be strengthened by the fact that the department is able to sell the chair at $420 though an additional cost of $100 per chair is incurred. From the company’s perspective, the transfer price of $280 is acceptable because the overall profit of the company is increased by $1,000,000 [50,000 chairs x ($420 - $300 - $100)]. A possible way to solve this situation is to either a dual pricing system to allow the production department to gain the market transfer price and to allow the administration department to pay a cost-based price. Another solution is to have the two departments to negotiate an agreed transfer price. In another example, PBE Ltd is a chain store cake business. It produces cakes and it has two departments: the production department and the sales department. The variable costs of the production and sales departments are $3 and $10 respectively, and the fixed costs $2 and $12. Due to refrigeration issues, the sales department has a daily capacity of 40,000 cakes; it usually purchases 25,000 cakes from the production department and 15,000 cakes from other vendors for $20 each. Now, if the formula of 180% of variable cost is used as the transfer price from the production department to the sales department, the transfer price between departments is $5.40 ($3 x 180%). If management decides to use another formula, 110% of the full cost, the transfer price would become $5.5 [($3+$2) x110%]. This is a good deal as the price is much lower than the price of $20 paid to external vendor. 4 Now assume that 200 cakes are transferred from the production department to the sales department at a transfer price of $6 per cake. The sales department sells the 200 cakes at a price of $40 each to customers. This would bring the profit of both divisions up to $2,600. Per unit Production Per unit Sales Revenue $6 $1,200 $40 $8,000 Expenses - Variable 3 600 16 3,200 Fixed 2 400 12 2,400 Profit 200 2,400 Many factors affect transfer pricing. Management efforts, especially between the departmental and senior level; departmental performance; and autonomy all need to be taken into consideration as well as calculations. Transfer prices often have tax issues when the intermediate product is being sold or transferred between departments operating under different tax jurisdictions. The company’s total profit will be maximized when the transfer price results in the departments with the lowest tax rate realizing the largest profits. Many tax regulatory bodies restrict companies “shifting” profit from locations with higher tax rates to locations with lower tax rates. Thus companies need to be aware of the impact of tax rates and transfer prices on total company profits.

Decentralization, Segment Reporting and Transfer Pricing:PART 1

Decentralization and Segment Reporting: When an organization grows beyond a few people, it becomes impossible for the top manager to make decisions about everything. Managers have to delegate decisions to some degree to those who are at lower levels in the organization. However the degree to which decisions are delegated varies from organization to organization. Decentralization in Organizations: A decentralized organization is one in which decision making is not confined to a few top executives but rather is throughout the organization, with managers at various levels making key operating decisions relating to their sphere of responsibility. Decentralization is a matter of degree, since all organizations are decentralized to some extent out of necessity. At one extreme, a strongly decentralized organization is one in which even the lowest-level managers and employees are empowered to make decisions. At the other extreme, in a strongly decentralized organization, lower-level managers have little freedom to make decisions. Although most organizations fall somewhere between these two extremes, there is a pronounced trend toward more and more decentralization. Advantages/Benefits of Decentralization: Decentralization has many advantages/benefits, including: Top management is relieved of much day-to-day problem solving and is left free to concentrate on strategy, on higher level decision making, and coordinating activities. Decentralization provides lower level managers with vital experience in making decisions. Without such experience, they would be ill-prepared to make decisions when they are promoted into higher level positions. Added responsibility and decision making authority often result in increased job satisfaction. Responsibility and the authority, that goes with it makes the job more interesting and provides greater incentives for people to put out their best efforts. Lower level managers generally have more detailed and up to date information about local conditions than top managers. Therefore the decisions of lower level management are often based on better information. It is difficult to evaluate a manager's performance if the manager is not given much latitude in what he or she can do. Disadvantages of Decentralization: Decentralization has four major disadvantages: Lower level managers may make decisions without fully understanding the "big picture." While top level managers typically have less detailed information about local operations than the lower level managers, they usually have more information about the company as a whole and should have a better understanding of the company's strategy. In a truly decentralized organization, there may be a lack of coordination among autonomous managers. This problem can be reduced by clearly defining the company's strategy and communicating it effectively throughout the organization. Lower-level managers may have objectives that are different from the objectives of the entire organization. For example, some managers may be more interested in increasing the sizes of their departments than in increasing the profits of the company. To some degree, this problem can be overcome by designing performance evaluation system that motivate managers to make decisions that are in the best interests of the organization. In a strongly decentralized organization, it may be more difficult to effectively spread innovative ideas. Someone in one part of the organization may have a traffic idea that would benefit other parts of the organizations, but without strong central direction the idea may not be shared with, and adopted by other parts of the organization. Definition and Explanation of Segment: A segment is a part or activity of an organization about which managers would like cost, revenue or profit data. Examples of segments include divisions of a company, sales territories, individual stores, service centers, manufacturing plants, marketing departments, individual customers and product lines. Effective decentralization requires segment reporting. In addition to the companywide income statement, reports are needed for individual segments of the organizations. These segmented income statements are useful in analyzing the profitability of segments and measuring the performance of segment managers. These reports have been discussed in more detail on our segment reporting and profitability analysis page. Cost, profit and investment centers: Decentralized companies typically categorize their business segments into cost centers, profit centers, and investment centers--depending on the responsibility of the segment managers of the segment. Cost center: A cost center is a business segment whose manager has control over costs but not over revenue or investment funds. Service departments such as accounting, finance, general administration, legal, personnel and so on, are usually considered to be cost centers. In addition, manufacturing facilities are often considered to be cost centers. The managers of cost centers are usually expected to minimize the costs while providing the level of services or the amount of products demanded by the other parts of the organization. For example, the manager of a production facility would be evaluated at least in part by comparing actual costs to how much costs should have been for the actual number of good units produced during the period. Standard costing and variance analysis page deals this evaluation of the performance of cost centers in detail. Profit center: A profit center is any business segment whose manager has control over both cost and revenue. Like a cost center, a profit center generally does not have control over investment funds. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit. Segmented income statements should be used to evaluate the performance of profit center managers. Investment center: An investment center is any segment of an organization whose manager has control over cost, revenue and investments in operating assets. Investment centers are usually evaluated using return on investment or residual income measures. Responsibility Center: Responsibility center is broadly defined as any part of an organization whose manager has control over cost, revenue, or investment funds. Cost centers, profit centers and investment centers are all known as responsibility centers.

O-LEVEL'S HUB: Accounting concepts and conventions

O-LEVEL'S HUB: Accounting concepts and conventions

Steps to the Accounting Cycle

Steps to the Accounting Cycle The term, accounting cycle, refers to the steps involved in accounting for all of the business activities during an accounting period. These steps are repeated each reporting period. There are ten steps to the accounting cycle. We will go through each one in detail later. But let’s review the basics. Step one begins with analyze transactions. Step two – journalize. Step three – Post. Step four – prepare unadjusted trial balance. Step five – adjust. Step six – prepare adjusted trial balance. Seven – prepare financial statements. Step eight – close. Step nine – Prepare a post-closing trial balance and Step Ten – Reverse. It’s important that you realize when the steps occur. Steps 1 through 3 occur often throughout the accounting time period. Steps four through 10 occur only at the end of the accounting period. The accounting process begins with analyzing transactions. The company first looks at the source documents which describe the transactions and events. Source documents can be either hard copy or electronic. Some examples of source documents include bank statements, checks, and purchase orders. After analyzing the transactions, events and source documents, the company is now ready to complete step 2, journalize. When the company journalizes the accountant applies the rules of double-entry accounting. Remember that double-entry accounting means that each transaction must be recorded in at least two accounts or that the debits must equal the credits. After applying the rules of debits and credits, the accountant should then record the transactions in a journal, or journalize. A journal is a complete record of each transaction. It’s easy to remember, because journal entry has the word journal in it! The third step in the accounting cycle is to post. This sounds complicated but it’s actually very easy. Posting involves transferring information from the journal to the ledger. A ledger is simply a collection of all accounts – it shows all of the number detail about a company’s accounts. In this posting example, notice how the journal entry that includes a debit to cash and credit to common stock is posted to the ledger with a debit of $25,000 in the cash account and a credit of $25,000 in the common stock account. When we post, we are simply transferring the debits and credits from the journal to the ledger. To verify that the companies debits equals the credits, an unadjusted trial balance is prepared. A trial balance is a list of all accounts and their balances at a point in time. This is the fourth step of the accounting cycle. The information used in a trial balance comes from the ledger. The account balances from the ledger is used to create the trial balance. We call this trial balance an unadjusted trial balance because it is prepared before the adjusting entries. Here’s an example of the trial balance, notice how the account balances are listed in the appropriate debit and credit column. The purpose of the trial balance is to verify that the debits equal the credits. It does not guarantee that no errors were made. The fifth step in the accounting cycle is to prepare adjusting entries. Adjusting entries involve bringing an asset or liability account balance to its proper amount and updating the corresponding revenue or expense account. Adjusting entries are recorded in the general journal and then posted to the ledger. All adjusting entries are made at the end of the accounting time period. After the adjusting entries have been posted, the accountant prepares another trial balance. This trial balance is called the adjusted trial balance because it is prepared AFTER the adjusting entries. This trial balance is used to verify that the debits equal the credits and also is used to prepare the financial statements. Now that the adjusted trial balance has been prepared the next step is to prepare the financial statements. The financial statements must be prepared in a very specific order. The order for the financial statements is: income statement, statement of retained earnings, balance sheet, and then statement of cash flows. This order is important because information provided in the income statement is used in the statement of retained earnings, and information from the statement of retained earnings is used in the balance sheet. Step eight in the accounting cycle is to prepare the closing entries. Closing entries are prepared after the financial statements are completed. The purpose of closing entries is to prepare the accounts for recording transactions and events for the next period. The accountant is now getting the books ready for next year! Step nine, and for many companies the last step in the accounting cycle, is to prepare a post-closing trial balance. A post-closing trial balance should only contain the debit and credit balance for permanent accounts, because these are the only accounts that are remaining after the closing process. Once again the purpose of this trial balance is to ensure that the debits equal the credits and that all temporary accounts have a zero balance. For many companies this is the last step in the accounting cycle, the company is now ready to start the new accounting period. However, some companies, complete one more step in the accounting cycle, step 10, or reversing entries. Reversing entries are optional. These entries reverse certain adjustments in the next period. For most of you, reversing entries will not be covered by your accounting instructor. We have now gone through and discussed each of the steps to the accounting cycle. Remember, that there are ten steps to the accounting cycle. Step one begins with analyze transactions. Step two – journalize. Step three – Post. Step four – prepare unadjusted trial balance. Step five – adjust. Step six – prepare adjusted trial balance. Seven – prepare financial statements. Step eight – close. Step nine – Prepare a post-closing trial balance and Step Ten – Reverse.