Transfer Pricing and Responsibility Centers
Because both divisions wanted to reduce their production costs and increase profitability, both of them proposed an alternative proposal on the process of purchasing units from their internal and external suppliers. The current pattern is that Division A purchases 3,000 units of product part 101 from Division C (the supplying division) and another 1,000 units from an external supplier. The total market price offered by their internal supplier is $1700. On the other hand, Division B purchases 1,000 units of Part 201 from Division C and another 500 units from an external supplier. The total market price offered by their internal supplier is $2200.
Since Divisions A and B needed the supplies from both the internal source and an external source at the same time, they thought of decreasing the units from their internal supplier. Division A divided it in 50%, while Division B cut it for about 30%, from the total number of units to be purchased. From 3,000 units, Division A proposed to only purchase 2,000 from Division C (internal supplier) at the same price (i.e. $1,700). Then the remaining 2,000 will be purchase from an external supplier for $900. From $6,000,000, the cost will only be $5,200,000. Hence, Division A can save $800,000. On the other hand, Division B proposed to purchase only 500 units from Division C and the remaining 1,500 units from an external supplier for $1,900. From $3,150,000, the cost will reduce to $3,000,000. Thus, Division B will save $150,000.
With these proposals, Division C will lost $1,700,000 from Division A, and $400,000 from Division B. This also means that Division A saves $800 in each unit, whereas Division B saves $300 in each unit.
From each proposal, it will be better that each division shall have a modest cost of
Deduction. This means that the amount for each unit may be reduced by 20% and up to a maximum of only 30%. Immediate increases on the amount may result in longevity of a non-deduction proposal. It is recommended for Division A to target only a modest deduction.
Implications of Transfer Pricing Policies
Cost Plus is a major factor in the issuance of price. As the selling division, Division C, has the responsibility of marking its products with the right price. Usually, this is a result of quality and function description of the products they sell. The policy of “fair market value” can be achieved by the modest proposal of profit from each trading parties. Thus, fair market value is the guiding price for traders to offer reasonable prices. Lastly, the policy of price negotiated by the managers also has a determining factor in profitability. Since managers knew the progress and regression of its area, they decide whether an increase or a deduction shall be implemented.
Because of these policies that affect transfer pricing, financial and managerial perspective look at transfer pricing an important issue. Mainly, because principal processes such as production and marketing decisions are to be conducted by the subsidiaries, which involve taxation, financial reporting and management accounting (Martini, 2008).
Division A has a greater proposal than Division B. It targeted a higher amount that is twice larger than of Division B. It can be said that Division A really wants to make profit, while Division B is only targeting a modest deduction on its units purchase. Although, profit should be a major factor to businesses, fair monetary trade must be considered. Consequently, Division A may hit its target profitability faster than Division B. However, Division A may have a hard time decreasing the unit price after two years. Yet, Division B may do so, because it only reduces the cost for about 30%.
Martini, J. (2008). Managerial versus financial transfer pricing.German Economic Association of Business Administration, 1-27. Retrieved September 01, 2015 from http://www.ww.uni-magdeburg.de/bizecon/teaching/WT_0910/BizEcon_papers/Martini(2008) _Transfer%20pricing_GEABA.pdf