Transfer pricing among divisions
Decrease/ increase in profits in the three divisions.
Division A’s increase in profits is $100,000.
When the new agreement is enforced, division A will report a decrease in the cost of materials by $100,000. It will make the division’s profit increase by the same amount. Boyd (2010) explains that it is necessary to consider the opportunity cost when determining transfer prices under excess capacity. In this case, the price has been negotiated. The opportunity cost for division A is the benefit it would get by purchasing ‘Part 101’ from external suppliers. Division A would lose $100 per unit for a total of 2000 units. The amount lost when the opportunity is not used is $200,000. It is obtained by multiplying the two values. The profitability will increase by $100,000 in the new agreement.
Division B’s increase in profits is $50,000.
Division B’s profitability will increase by $50,000 because the cost of raw materials has decreased. The decrease in material costs will be reflected as a decrease in cost of goods sold which increases profits. The lost opportunity in the new agreement amounts to $50,000. It has a value of $100 per unit.
Division C’s decline in profits is $2,427,000 when opportunity cost is considered.
Division C’s revenue will decline by $2,000,000 as a result of the new agreement. It sells its product above the market price. It is unlikely to find new customers for the products. The mark-up is the additional charge that the division charges above the cost of production. The mark-up and the number of units when multiplied give the net income that the division is likely to generate. Division C would have generated $1,700,000 of taxable income in the old agreement and $1,000,000 in the new agreement. Stuart (2009) elaborates that the Federal government is aggressive in raising income through transfer pricing. It is almost impossible for a company to avoid taxation when its subsidiaries sell products to each other. Walther (2012) explains that budgets should provide adequate details about the expected revenues and cost. Corporate tax is one of the costs that division C expects. Division C would have incurred a corporate tax of $663,000 in the old agreement. According to the federal corporate tax table (KNV, 2013), the income bracket $335,001 to $10,000,000 is charged a tax rate of 39%. In the new agreement, the division will have a decline in corporate tax amounting to $273,000. Decline in tax is considered as an increase in net income. Low taxes would make the earnings after taxes increase relative to the previous amount. Following the argument, it is deducted from the value that shows decrease in profitability which is ‘decline in mark-up’.
Decrease in income for the entire company is $2,277,000.
The decrease in profitability in the entire company is calculated by adding the values from the three divisions. The decrease in profitability from division C surpasses the increases from divisions A and B. The firm’s profit would decline by $2,277,000 when the new agreement is enforced. Walther (2012) discusses that “successful managers understand that their individual needs are subservient to the large organizations goals” (para. 16). The managers in divisions A and B are under pressure to lower their operations cost. However, as the calculations indicate, the entire firm will lose much more compared to individualized benefits at the divisional level. The overall decrease in profitability indicates that the company should continue using the old agreement until it can find new customers for its products or a more efficient technology. Boyd (2010) explains that when there is an opportunity cost associated with transfer pricing, the market price should be used. Considering that the company has no plans to use market prices, the lost opportunity in the new agreement is $250,000. It includes $200,000 from division A, and $50,000 from division C. It is not large enough to surpass the decline in net income from division C. It shows that the old agreement is still better than gains from divisions A and B when they purchase all materials from external suppliers.
Implication for different transfer pricing policies
Cost plus mark-up pricing involves a subsidiary selling products to other subsidiaries after creating a profit margin in addition to the cost of production. Cost plus a mark-up price enables the supplying division to generate operating profits. Different divisions have their own objectives of maximizing profit (Walther, 2012). It may allow divisions that have not gained competitiveness to operate before they can incorporate more efficient means. It may be inefficient at the divisional level when the mark-up price exceeds the market price. Stuart (2009) indicates that it may be a difficult methodology to defend considering IRS (Internal Revenue Service) aggressive policy towards transfer pricing.
Fair market pricing is a method in which managers use the market price of similar products to sell products to each other (Slideshare, n.d.). Fair market value pressurizes divisional managers to seek more efficient methods that will lower their costs. The Federal government prefers fair market pricing for the sake of taxation. It reduces chances of being penalized for using an inappropriate methodology (Slideshare, n.d.). The method may easily get approval from the IRS.
Negotiated transfer price is decided by an agreement between subsidiaries (Slideshare, n.d.). The price negotiated by managers may incur penalties for using a methodology that does not clearly illustrate the methodology (Stuart, 2009). The firm may use the negotiated price to lower corporate tax for the overall company. Negotiated price may allow divisions to select a price that gives them competitive advantage when it is lower than the market price.
Significance of transfer pricing
Transfer pricing has become more significant to multinationals because countries across the globe are modifying taxation requirements (Stuart, 2009). They intend to capture more corporate taxes by targeting transfer pricing. It is necessary to develop the right procedures to avoid high penalties charged on tax misappropriation. There is need to have documents that support the method used for transfer pricing (Secular, 2014)
Transfer pricing is significant in determining the cost associated with different options that a firm may choose (Secular, 2014). The firm would like to increase profitability by choosing transfer options that increase profitability of the whole firm (Walther, 2012).
Transfer pricing has become more significant because of the increase in the number of mergers and acquisitions (Secular, 2014). Companies would like to know how to share resources, such as intellectual property, without increasing the overall cost of their operations. Companies that engage in research and development programs would like to know how to share the cost of the projects.
References
Boyd, K. (2010,). Management Accounting 16: Transfer Pricing [Video file]. Web.
KNV (2013). U.S. Federal Corporate Tax Rate Table. Web.
Secular, L. (2014). Why Transfer Pricing is Key to Decision Making and Strategic Reviews. Web.
Slideshare (n.d.). Global Management Accounting. Web.
Stuart, A. (2009). Transfer Pricing: A World of Pain. CFO. Web.
Walther, I. (2012). Chapter Twenty-One. Budgeting: Planning for Success. Web.