Management Accounting 101: Performance Measurement and Control Transfer Pricing Marketbased Costbased Negotiated Goal Congruence Taxation

What This Is

Transfer pricing is the process of setting prices for goods or services sold between different departments or divisions within a company. This matters for managers as it affects profitability, resource allocation, and decision-making. For example, Toyota sets prices for components sold between its manufacturing divisions to ensure efficient production and minimize costs.

Key Frameworks & Metrics

• Market-based Transfer Pricing: uses market prices as a benchmark to set transfer prices between divisions. This framework is useful when divisions operate in competitive markets and prices are readily available.
• Cost-based Transfer Pricing: uses the costs incurred by the selling division to set transfer prices. This framework is useful when divisions operate in non-competitive markets or when costs are difficult to measure.
• Negotiated Transfer Pricing: involves negotiations between divisions to set transfer prices. This framework is useful when divisions have different goals or priorities.
• Goal Congruence: ensures that transfer prices align with the goals and objectives of each division. This metric is useful for evaluating the effectiveness of transfer pricing.
• Taxation: considers the tax implications of transfer pricing. This metric is useful for minimizing tax liabilities.
• Transfer Price Variance (TPV): measures the difference between the transfer price and the market price. This metric is useful for evaluating the effectiveness of transfer pricing.
• Residual Income (RI): measures the profit earned by a division after charging for the cost of capital. This metric is useful for evaluating the profitability of divisions.
• Economic Value Added (EVA): measures the true economic profit earned by a division after charging for the cost of capital. This metric is useful for evaluating the profitability of divisions.
• Break-even Point (BEP): measures the point at which a division breaks even in terms of costs and revenues. This metric is useful for evaluating the viability of a division.

Step-by-Step Process

1. Identify the goals and objectives of each division: Determine the goals and objectives of each division to ensure that transfer prices align with their priorities.
2. Determine the transfer pricing method: Choose a transfer pricing method (market-based, cost-based, or negotiated) based on the specific needs of the divisions.
3. Set transfer prices: Set transfer prices based on the chosen method, considering factors such as market prices, costs, and tax implications.
4. Monitor and evaluate transfer prices: Regularly monitor and evaluate transfer prices to ensure they remain aligned with the goals and objectives of each division.
5. Make adjustments as needed: Make adjustments to transfer prices as needed to ensure they remain effective and efficient.
6. Consider tax implications: Consider the tax implications of transfer pricing and make adjustments as needed to minimize tax liabilities.

Common Mistakes

• Mistake: Treating all costs as relevant when setting transfer prices.
• Correction: Only consider avoidable costs when setting transfer prices, as they directly impact the profitability of divisions.
• Mistake: Ignoring qualitative factors in make-or-buy decisions.
• Correction: Consider both quantitative and qualitative factors when making make-or-buy decisions, such as strategic fit, risk, and flexibility.
• Mistake: Using ROI alone without considering residual income or EVA.
• Correction: Use a combination of metrics, such as ROI, residual income, and EVA, to evaluate the profitability of divisions.

Decision-Making Tips

• When faced with a make-or-buy decision, always isolate avoidable costs and consider strategic, not just quantitative, factors.
• When evaluating transfer prices, consider the goals and objectives of each division and the tax implications of transfer pricing.
• When making adjustments to transfer prices, consider the impact on the profitability of divisions and the overall organization.

Quick Practice Scenario

A division rejects a project because its ROI would drop from 18% to 17%. By how much would residual income change if the project cost is $1M and the required rate of return is 12%?

Answer: Residual income would increase by $80,000 ($1M x 8%).

Last-Minute Cram Sheet

• Transfer pricing is the process of setting prices for goods or services sold between different departments or divisions within a company.
• Market-based transfer pricing uses market prices as a benchmark to set transfer prices.
• ⚠️ Fixed costs are only fixed in the short run within a relevant range – outside that range, they can change.
• Cost-based transfer pricing uses the costs incurred by the selling division to set transfer prices.
• Negotiated transfer pricing involves negotiations between divisions to set transfer prices.
• Goal congruence ensures that transfer prices align with the goals and objectives of each division.
• Taxation considers the tax implications of transfer pricing.
• Transfer price variance measures the difference between the transfer price and the market price.
• Residual income measures the profit earned by a division after charging for the cost of capital.
• Economic value added measures the true economic profit earned by a division after charging for the cost of capital.
• Break-even point measures the point at which a division breaks even in terms of costs and revenues.