What is the Bangladesh standard on Audit(BSA-300) ? Describes in details

Transfer pricing? Kinds of transfer pricing

Question-01

What is Transfer pricing?

ANS:

Transfer pricing is the determination of prices at which goods, services and intangible property are transacted between related parties.

The term ‘transfer price’ refers to the price at which a division/subsidiary of a company transact with each another division/subsidiary for goods or services. 

It takes place when two related companies, such as a parent company and a subsidiary, or two subsidiaries controlled by a common parent, engage in international trade with each other for goods and services.

Question-02

What is the transfer pricing problem?

Ans:

The transfer pricing problem arises where corporations are divisional and have responsibility centers operating as strategic business units, a situation that presents challenges in determining suitable prices for intro-group transactions. 

The transfer pricing problem becomes even more critical where a company has subsidiaries spread throughout the world, in countries that have varying tax rates.

Question-03

Explain how transfer prices can impact performance measures, Firm wide profit, and the decision to decentralize decision making?

Ans:

Transfer prices impact the revenues of the transfer division and the cost of the buying division and thus, the profit of both division .A transfer price can affect the profits of the firm because it can affect the output decision of the buying division. 

If the price is set too high (low) , then the output of the buying division may be too low(high)since the transfer price can affect firm wide profitability, higher management may be tempted to interfere with the autonomy of a division and dictate the price (rather than letting the divisional manager make the pricing decision).

Question-04

Method of transfer pricing

There are three broad categories of method for determining transfer pricing, such as-

01. Market based transfer pricing

In the market base transfer pricing, management may choose market price for transferring to the desire department of the similar product or service internally. Transferring product or service at market prices generally leads to optimal decisions when three conditions are satisfied-

01.  The market for the intermediate product or service is perfectly competitively,

02.  Inter dependencies of sub units are minimal and

03.  There is no additional cost or benefits to the company as whole from buying or selling in the external market instead of transacting internally.

02. Cost based transfer pricing

The top management may choose a transfer price base on cost of producing the product.

Cost based transfer prices are helpful when market price is unavailable, inappropriate  & where

The market is not perfectly competitive.

Some time, cost base transfer price includes a markup or profit margin that represents a return on sub unit investment.

                                                                  Formula

                                                          Variable production cost ****

                                                              Fixed production cost ****

                                     Result creates product cost per unit ****

    Add: (R&D +Designed +Marketing+ distribution cost) ****      

                          Result creates full production cost per unit ****

                                               Add: desire profit % on full cost ****

                            Result creates Cost based transfer pricing ****

03. Hybrid or, Negotiable Transfer pricing :

Hybrid transfer pricing takes into account both cost and market information. Top of the management may administer such prices. For example by specifying a transfer price that is average of the cost of producing and transporting the product internally and the market price comparable products. 

The most common  form if hybrid transfer arise via negotiation- the sub units of a company  are asked to negotiate the transfer price between them and  to decide  whether  to buy and sell internally or deal with  external  parties.

             Here are the some general guidelines for transfer pricing

 (1. ) Minimum transfer pricing:

                                                 Incremental cost/Marginal cost per unit (M+L+FOH)   = ****                        

           Add: Opportunity cost [when there is no exist excess capacity  ]  = ****

              Total cost per unit applicable for Minimum transfer pricing    = ****

 ***Only variable cost are relevant for the minimum transfer price if, transfer division has excess capacity, but when there is no exist excess capacity ] Add: Opportunity cost in addition on variable cost.

(2. )Maximum transfer pricing:

                                Outside supplier or external market price = ****

    (Less): (If any) internal cost saving in packaging & delivery = (****)

           ***When transfer division operating at capacity ,there must consider minimum & maximum transfer pricing are hold the same price.  since cost to the company is the same where or not transfer take place***

            (3.) When internal transfer take place or not? Why or why not?

Here, we must calculate  minimum transfer price, i mean ,Marginal cost (M+L+FOH) +opportunity cost if any ,of the transfer division, that are compare negotiation price/Internal user offered price,If  the the negotiation price/Internal users offered price is "lower "than the minimum transfer price their not to be possible to internal transfer because of ,the transfer division ultimately will be logger  for every per unit transfer.

On other hand, negotiation price/Internal users offered price is "higher "than the minimum transfer price, their should an internal transfer  because of ,the transfer division ultimately will be gain  for  every per unit transfer.

Say for example,

There are two division  components part division or production goods division ,components part division cost data are as follows-

                         Particular                                          Cost per unit(Tk.)

                 Direct material cost                                         10.00

                              Direct labor                                           2.00

                   Variable over head                                          3.00

                        Fixed overhead*                                          5.00

                                  Total cost                                            20.00

 *Base on a practical volume of 2,00,000 parts

 

Additional information:

Components part division  external regular sale  price is Tk.29.00 where as production goods division has been buying the same part from an external supplier for Tk.28.00 per units .The manager of production goods division  has offered to buy 50,000 units from the components part division for Tk.18.00 per unit.

Here ,Minimum transfer price is -

                    Particular                                          Cost per unit(Tk.)

                 Direct material cost                                         10.00

                              Direct labor                                           2.00

                   Variable over head                                          3.00

           Minimum transfer price                                         15.00

Here, we see that,

                                         Production goods division  has offered price   = Tk.18.00

                       Less: Minimum transfer price Components part division =Tk.15.00

That  result create Earning per unit of Components part division(18-15) =Tk.3.00

Total earning for internal transfer-(50,000 units@Tk.3.00)=Tk.1,50,000.00

Also Joint benefit, however,(13*50,000)=Tk.6,50,000.00

H ere,Rate is-(15-18)=3+(28-18)=10 sub Total rate=13.00

Comment:

The Components part division  should an internal transfer  because of ,the division ultimately will be gain  (50,000 units@Tk.3.00)=Tk.1,50,000.00.

 ***I think so you better understand  from this Example***

Noted that,

01.  The transfer division will not agree to transfer units if the transfer price is setting at lower than the marginal cost (M+L+FOH) /minimum transfer price plus opportunity cos (if any).

02.  The transferee  division will not accept internally transferred units if it can buy them for lower cost from an outside supplier.

Say for example:

 If the marginal cost (M+L+FOH) of a units Tk.5.00 & contribution of Tk. 3.00  from an outside sale is lost through using that unit for an internal transfer, then the transferor division will no agree to transfer for lower  than Tk.8.00, (5+3) , if such units can bought from an outside supplier for TK.9.00, then the transferee division will not accept an internally transferred units at any price greater than TK.9.00. So, in this case the lower and upper limits of the transfer price are TK.8.00 and Tk.9.00 respectively.

 The difference between the two limits represents the saving money that made by producing internally as opposed to buying in from outside supplier.

 

 Journal entries for inter company  Transfer

 say for transfer division  prediction cost Tk.56  & inter-company selling price Tk.85 assume sales for 600000 units

  Journal entries for(transfer division)

Account receivable (600000Units@Tk.56)        = TK.3,36,00,000

Inter-company profit(85-56)=29*6,00,000 units =TK.1,74,00000

                                    Inter-company Sales(85*6,00,000 units) =TK.5,10,00,000

 

Inter-company cost of goods sold (6,00,000 units@56) =TK.3,36,00,000

                                                     Finished goods (6,00,000 units@56) =TK.3,36,00,000

  Journal entries for(Buying  division)

                     Inventory (6,00,000 units@56) =TK.3,36,00,000

                                           Accounts payable  (6,00,000 units@56) =TK.3,36,00,000

Calculate transfer price whether two division are equally profitable  =(Lower limit+upper limit) /02

Let,s start  with some practical Example:-

     Practical Example -01

Max Ltd. Produces kitchen tools, and operates several divisions as profit centers. Division M produces a product that it sells to other companies for $16 per unit. 

 It is currently operating at its full capacity of 45,000 units per year. Variable manufacturing cost is $9 per unit, and variable marketing cost is $3 per unit.

The company wishes to create a new division, namely Division "N", to produce an innovative new tool that requires the use of Division B's product (or one very similar). 

Division N wills produce 30,000 units. Currently, Division N can purchase a product equivalent to Division M's from other Company X for $15 per unit. However, Max Ltd. is considering transferring the necessary product from Division M.

Required

1)      Assume the transfer price is $12 per unit. how would this affect the profits of Division M? & How would this affect the purchasing costs of Division N? How would this affect Max Ltd. as a whole?

2.) What if the transfer price was $13 per unit?

Ans:

1)      Division N needs 30,000 units. Outsourced, this would cost $450,000 ($15 x 30,000). Purchased from Division M, this would cost $360,000 ($12 x 30,000). 

      Transferring would save $90,000. Division M is operating at capacity. They currently make $4 per unit ($16 - $9 - $3) sold to outside customers. 

       This means they make $180,000 ($4 x 45,000) per year. If they transferred 30,000 units to Division N, they would only make a margin of $ 3 (12-9) per unit, and lose $30,000 {(4-3)=1*(10,000 units)} per year. As a whole, the company would save $80,000 ($90,000 - $10,000) if transfer pricing @ $12  per unit was used.

2)      Purchased from Division M, this would cost (30000 units@13) =$390,000. Transferring would save Division N (15-13)*30,000 units) $ 60,000.  

 At $13, the new transfer profit margin would be (13-9) =$4 per unit. This is the same as the profit margin  for selling to outside customers ( 16-12)=$4 per unit , so Division M would be indifferent about selling to outside customers versus transferring to Division N.

As a whole, transferring pricing @ $13 per unit would save Max Ltd. (15-13)*30,000 units) = $ 60,000.

Practical Example -02

Old Castle Vineyard produces premium wine. Its success in the industry is due to its quality, although all of its customers, wine shops and specialty grocery stores, are very cost conscious and negotiate for price cuts on all large orders. 

Noting that the wine industry is becoming increasingly competitive, Old Castle is looking for a way to meet the challenge. It is negotiating with Eastern Seasons, a regional specialty grocery store, to purchase a large order of wine. Old Castle is currently producing at under-capacity and would like to keep its production facilities gain better economies of scale by increasing production.

Eastern Seasons has agreed to a large order but only at a price of $25 per bottle. The special order can be purchased in one batch with available capacity. Old Castle prepared these data:  Next month's operating information (per unit, for 10,000 units, made in 10 batches of 1,000 each)

Other information

   Sales price                                                                   =    45.00

  Variable manufacturing costs                                    =  19.00

 Batch-level costs                                                            =    5.00

 Fixed manufacturing costs                                           =  5.00

 Variable marketing costs                                              =   8.00

 Fixed marketing costs                                                   =   2.00

 Special order information Sales                                   =   2,000

 Sales price per unit                                                        =  $3.00

No variable marketing costs are associated with this order, but Old Castle has spent $2,500 during the past two months trying to get Eastern Seasons to purchase the special order.

Additional information:( with Regular customers)

      Price per bottle                                                                  = $45.00

 

Current production & sales (in units)                                    = 10,000

 

Variable manufacturing costs per unit                                  = $19.00

 

Costs per batch 5,000 per bottle* 1,000 bottles per batch     = $5

 

Number of batches for special order                                       =  01

 

Batch level costs/unit  $5,000/2,000                                          =  $2.50                              

 

Special Order Price                                                                    =  $35

 

 Bottles                                                                                         =  2,000

Plant Capacity:

Plant capacity is available and no other uses for the plant capacity are expected

 Requirement:

1. How much wills the special order change Old Castle’s total operating income?

Solution

 Total relevant manufacturing costs (variable costs per unit plus batch costs per unit) 19 + $2.50 = $21.50 Accept the offer. The price paid is greater than the cost to manufacture. $35 >$21.50

The special order will increase operating income by $27,000 = 2,000 x ($35 - $21.50) or 2,000 x ($35 - $19) - $5,000

Note that this answer relies on the availability of production capacity. The answer might be different if Old Castle is at full capacity and the sale of the special order would require Old Castle to lose some amount of current sales. 

For a good in-class assignment, ask the class to answer the question again, assuming Old Castle is at full capacity. We now assume that a total of $10,000 units will be produced (full capacity) and that 10 batches will be used, as before; thus, batch level costs will be the same, with or without the special order, so batch level costs are now irrelevant and can be ignored.

Contribution of special order     2000 ($35-$19)                                        =  $32000

Less: Lost contribution on loss of regular sales  2000($45-$19-$8)          = 36000

Net loss of the special order under full capacity                                        = ($4000)         

Practical Example-03

The Home Office Company makes all types of office desks. The Computer Desk Division is currently producing 10,000 desks per year with a capacity of 15,000. 

The variable costs assigned to each desk are $300 and annual fixed costs of the division are $900,000. The computer desk sells for $400. The Executive Division wants to buy 5,000 desks at $280 for its custom office design business. 

The Computer Desk manager refused the order because the price is below variable cost. The executive manager argues that the order should be accepted because it will lower the fixed cost per desk from $90 to $60 and will take the division to its capacity, thereby causing operations to be at their most efficient level.

Required:

a. Should the order from the Executive Division be accepted by the Computer Desk Division? Why?

  b. From the perspective of the Computer Desk Division and the company, should the order be accepted if the Executive Division plans on selling the desks in the outside market for $420 after incurring additional costs of $100 per desk?

 c. What action should the company president take?

Answer:

                  a).                       Sales                       = $280

                               Variable costs                       = 300

                     Contribution margin                     = $ (20)

The manager should not accept the order because it is below variable costs. It will generate a loss of $100,000 [5,000 units x $(20)]. This is a losing proposition in both the short run and long run.

  Answer:

b.) What the Executive Division does with the desks after receiving them is of no consequence to the Computer Desk Division. However, the division will still object to the transfer price of $280. 

The company, on the other hand, will encourage the offer because it increases total company operating income by $1,00,000 = 5,000 x [$420 - ($300 + $100)].

 Answer:

 c.) If the company president wants the Executive Division to have the new business, it should arrange a dual-pricing system or else have negotiated prices between divisions. 

Dual pricing would allow the selling division to get a market value for the transfer and the buying division to get some type of cost-plus transfer price. The negotiated price would allow the buying and selling divisions to feel like they had a part in the final pricing decision.

Practical Example-04

Sportswear Company manufactures socks. The Athletic Division sells its socks for $6 a  pair to outsiders. Socks have manufacturing costs of $2.50 each for variable and $1.50 for fixed. The division's total fixed manufacturing costs are $1,05,000 at the normal volume of 70,000 units. 

 

The European Division has offered to buy 15,000 socks at the full cost of $4. The Athletic Division has excess capacity and the 15,000 units can be produced without interfering with the current outside sales of 70,000. The 85,000 volume is within the division's relevant operating range.

Requirement:

Explain whether the Athletic Division should accept the offer.

 Answer:

                Sales                                                              =    $4.00

                Variable costs                                               =    2.50

                Contribution margin                                   =    $1.50

The proposal should be accepted because it makes a contribution to fixed costs and profits of $1.50 per unit. This would increase the division's operating income by $22,500 ($1.50 x 15,000 units)

Practical Example-05

Better Food Company recently acquired an olive oil processing company that has an annual capacity of 20,00,000 liters and that processed and sold 14,00,000 liters last year at a market price of $4 per liter.

The purpose of the acquisition was to furnish oil for the Cooking Division. The Cooking Division needs 8,00,000 liters of oil per year. It has been purchasing oil from suppliers at the market price. Production costs at capacity of the olive oil company,

Now a division, are as follows:

  Direct materials per liter                                          = $1.00

  

  Direct processing labor                                           =  0.50

  

 Variable processing overhead                                  =  0.24

   

  Fixed processing overhead                                       =  0.4                   

                                   Total                                            =  2.14

 

Management is trying to decide what transfer price to use for sales from the newly acquired company to the Cooking Division. The manager of the Olive Oil Division argues that $4, the market price, is appropriate.

 

The manager of the Cooking Division argues that the cost of $2.14 should be used, or perhaps a lower price, since fixed overhead cost should be recomputed with the larger volume. Any output of the Olive Oil Division not sold to the Cooking Division can be sold to outsiders for $4 per liter.

Required:

a. Compute the operating income for the Olive Oil Division using a transfer price of $4.  

 

b. Compute the operating income for the Olive Oil Division using a transfer price of $2.14.

 

c. What transfer price(s) do you recommend? Compute the operating income for the Olive Oil Division using your recommendation.

Answer: a

Sales:

External (1,200,000 x $4) =$48,00,000

 

 Internal  (800,000 x $4)  = 32,00,000                                        =   $80,00,000

  Cost of goods sold:

   Variable (20,00,000 x $1.74)   $34,80,000

 

  Fixed (20,00,000 x $0.40) 8,00,000                                         = 42,80,000

   

 Operating income                                                                    =  $37,20,000

Answer: b.

Sales:

External (1,200,000 x $4) $4,800,000

 

Internal (800,000 x $2.14) 1,712,000                                          =  $65,12,000

Cost of goods sold:

Variable (20,00,000 x $1.74) $34,80,000

  

Fixed (20,00,000 x $0.40) 8,00,000                                             =  42,80,000

 

 Operating income                                                                       =  $22,32,000

Answer: c.

Due to current demand in excess of the capacity, the Olive Oil Division should not be penalized by having to sell inside. All sales equivalents to the current external demand of 14,00,000 should be at the market price.

    Current external demand                                                               = 14,00,000

    

   Current internal demand                                                                =  8,00,000

    

Total demand                                                                                    = 22,00,000              

    

  Capacity                                                                                             = 20,00,000

   

 Excess demand                                                                                   = 2,00,000             

  

  Internal demand                                                                                = 8,00,000

   Noncompetitive internal demand  (20,00,000 -14,00,000)              = 6,00,000

   Sales: External (12,00,000 x $4)                                                        = $48,00,000

  

 Internal (2,00,000 x $4)                                                                       = 8,00,000

  

  Internal (600,000 x $2.14)                                                                  = 1,284,000                                              

                                   Total sales                                                            =  $68,84,000

   Cost of goods sold:

   Variable (20,00,000 x $1.74) $34,80,000

  

 Fixed (20,00,000 x $0.40)  $ 800,000                                                   =  42,80,000

  

 Operating income                                                                                 =  $26,04,000

Practical Example-06

The Mill Flow Company has two divisions. The Cutting Division prepares timber at its sawmills. The Assembly Division prepares the cut lumber into finished wood for the furniture industry.

 

 No inventories exist in either division at the beginning of 20x3. During the year, the Cutting Division prepared 60,000 cords of wood at a cost of $6,60,000. All the lumber was transferred to the Assembly Division, where additional operating costs of $6 per cord were incurred. The 6,00,000 board feet of finished wood were sold for $25,00,000

Required:

a.       Determine the operating income for each division if the transfer price from Cutting to Assembly is at cost, $11 a cord.

 

b. Determine the operating income for each division if the transfer price is $9 per cord.

 

 c. Since the Cutting Division sells all of its wood internally to the Assembly Division, does the manager care what price is selected? Why? Should the Cutting Division be a cost center or a profit center under the circumstances?

Answer:

a).

                                    Cutting Assembly                      Cutting Assembly

 

Revenue                           =  $6,60,000*                                 =  $25,00,000

Cost of services:

 Incurred                          =  $ 6,60,000                                  =  $ 3,60,000

Transferred-in                 =  0                                                 =  $ 6,60,000

  Total                                =   $ 6,60,000                                 =  $10,20,000

 Operating income          =  $ 0                                             =  $14,80,000

 

* 60,000 cords x $11 = $660,000

 

 b.                                   Cutting                                                   Assembly

             Revenue         = $5,40,000*                                              =   $2,500,000

 Cost of service

Incurred $                  =  6,60,000                                                 =  $ 3,60,000

 

Transferred-in           =   0                                                            =  5,40,000

 

 Total $                       = 6,60,000                                                   = $ 9,00,000

Operating income     = $(1,20,000)                                               =  $16,00,000

* 60,000 cords x $9    = $5,40,000

c. The manager of Cutting cares about the transfer price if the division is a profit center but not if it is a cost center. Under the circumstances, the division probably should be a cost center and not worry about the profit it pretends to make by selling to another division.

 Practical Example-07 (CMA- September-2022) ( Try yourselves)

The corporate practice bd LTD has two division component division & goods division . the components division produce  a parts that is used by goods  division.

The cost of manufacturing the parts is as follows-

Direct material  = $10

Direct Labor       = $2

Variable OH          =3 

Fixed MOH          = 5 (based on practical volume of 2,00,000 parts)

          Total cost  = $20

Others cost incurred  by the components Division are as follows

Fixed selling & Admin Expense $ 5,00,000

Variable selling $1 per unit

The part usually sell for Between $28 and $30 in the external market. currently components division is selling it to External customers  for $29  . the division is capable  of producing 2,00,000 units  of the parts per year. because week economy  only 1,50,000 parts  are expected  to be sold during the coming year . the variable selling  expense are avoidable if the parts is sold  internally..the goods division has been  buying the same part from an external supplier for $ 28 .it expected to use 50,000 units  of the part during  the coming year.

The manager of the goods division has offered to buy 50,000 units from the components division  for $18 per unit.

Requirement:

1. Determining the minimum transfer pricing that the components division would accept.

2. Determining the maximum transfer pricing that the manager of good  division would pay.

3.Should internal transfer  take place  ?why why not .if you were the manager of the components division ,would you sale the 50,000 components for $.18 each? Explain

4.suppose that the average  operating asset  of the components division total $10 million.Compute ROI  for the coming year , assuming that the 50,000 units are transferred to the Goods division for $21 each.