Transfer Pricing: Coffee Makers International - Essay Example

? Transfer Pricing: Coffee Maker’s International Part If the proposal is enforced, the increase or decrease in profitsfor each division and for the company as a whole is shown in Tables 1, 2, 3 and 4. Division A - Part 101 Internal Purchase External Purchase Total Current Scenario:       Number of units 3,000 1,000 4,000 Cost per unit ($) 1,000 900   Total Cost 3,000,000 900,000 3,900,000 Proposal:       Number of units 2,000 2,000 4,000 Cost per unit ($) 1,000 900   Total Cost 2000000 1800000 3,800,000 Increase in profit for Division A     100,000 Table 1 – Change in Division A’s Profit if the Proposal is Accepted Table 1 indicates that Division A’s profit would increase by $100,000 if the proposal is accepted. However, the proposal will have a negative impact on Division C’s business and the company’s as a whole as shown in Tables 3 and 4. Division B - Part 201 Internal Purchase External Purchase Total Current Scenario:       Number of units purchased 1,000 1,000 2,000 Cost per unit ($) 2,000 1,900   Total Cost 2,000,000 1,900,000 3,900,000 Proposal:       Number of units 500 1,500 2,000 Cost per unit ($) 2,000 1,900   Total Cost 1000000 2850000 3,850,000 Increase in profit for Division B     50,000 Table 2 - Change in Division B’s Profit if the Proposal is Accepted The information in Table 2 indicates that Division B’s profit will increase by $50,000 if the proposal is accepted. The information in Table 3 below shows the impact that the proposal would have on Division C from which Division A and B purchases some of their supplies - Part 101 and Part 202 respectively. Division C - Manufacturer of Part 101 and Part 201 Division A Division B Total Current Scenario:       Number of units sold 3,000 1,000 4,000 Selling price per unit ($) 1,000 2,000   Total Earnings 3,000,000 2,000,000 5,000,000 Proposal:       Number of units sold 2,000 500 2,500 Selling price per unit ($) 1,000 2,000   Total Earnings 2000000 1000000 3,000,000 Reduction in profit for Division C     2,000,000 Table 3 – Change in Division C’s Profit if the Proposal is Accepted The information in Table 3 indicates that Division C’s profit would decrease by $2mn if the proposal is accepted. This is a very big reduction in profit for Division C and could effectively place the division in a loss position as well as have a negative impact on the company as a whole. In fact, the increase in profits for Division A and B cannot compensate for the loss of income to Division C. The impact of this proposal on the company as a whole is shown in Table 4. Effects of Proposal on the Company as a Whole Increase in Profit from Division A 100,000 Increase in Profit from Division B 50,000 Decrease in Profit from Division C (2,000,000) Reduction in profit for the Company (1,850,000) Table 4 – Change in profit on the company as a whole if the proposal is accepted The information in Table 4 consists of information taken form Tables 1, 2 and 3. This is an indication that whatever affects the individual parts will have an impact on the company as a whole. The information indicates that when taken together, the net impact on the company as a whole would be negative (- $1.85mn). This is a very large reduction in profit, and so this proposal should not be accepted as it will not be beneficial to the company. While the price charged may have a positive impact on the profitability of Divisions A and B, the ultimate effect will be on the company as a whole, and so it does not matter whether Division C charges $1,000 or $900 to Part 101 or $2,000 or $1,900 for Part 201. However, the market price is $900 and $1,900 respectively, and so it would make sense if Division C transfers the parts to Divisions A and B at the current market price. The quest for internal recognition should not be allowed to derail the company’s goal of profitability. In fact, Keat and Young (2006) indicate that if each profit center or division sets its price in the interest of maximizing its own profit, then the price of the end product may not meet the appropriate goal of maximizing the profit of the company as a whole. The aim of transfer pricing should be that of maximizing the total company profit and may therefore be determined from the top and not the level of the divisions (Keat & Young, 2006). Assessments of divisional performance should be based on improvements in efficiency. This will result in cost reductions which can be passed on in lower prices or help improve profitability. Therefore, divisions should seek to reduce their cost of production rather than seek to benefit solely from uncompetitive pricing of their products. A competitive market exists for both the purchase and sale of the products, and therefore, Division C should only produce the quantity at which the additional cost to produce an extra unit is equal to the additional revenue to be earned – that is, where marginal cost is equal to marginal revenue (Keat & Young, 2006). The difference should be purchased externally. However, Division C should be forced to reduce price to equate with that on the market since it cannot survive in a market where its prices are not competitive. Additionally, there are normally some common costs that divisions share, and so, when all divisions are contributing at their full potential, each division benefits. Part 2 Cost plus pricing is a very popular and widely used method of pricing products and services (Paleologo, 2004; Industry Week, 2008). It involves taking the cost of an item or service and adding a mark-up to achieve the particular margin required while ensuring that the firm or division makes a profit. In some cases, this may be at the expense of losing sales to other competitors. In this regard, Industry Week (2008) points out that some opportunities may be lost because firms may experience difficulties in capturing costs associated with manufacture, acquisition, sales and distribution of products. Therefore, when prices are set below market price, there is a risk that the true cost may not be covered. This pricing method is normally utilized by multinational enterprises (MNEs) in shifting profits from a high tax to a low tax jurisdiction. However, OECD guidelines suggests the use of arms length principle in establishing transfer prices (OECD, 2010; Feinschreiber & Kent, 2012; Rectenwald 2012). Failing this, the tax authorities will make the necessary adjustments in calculating the tax to be collected. In China, where a lot of MNEs have expanded there businesses, the appropriate transfer pricing methods include cost plus method and other methods that are in consistency with the arm’s length principle (Hoffman, 2009). Fair value pricing is one of the most acceptable ways of valuing products and services. Fair value is simply current market price. In fact, Holban (2011) indicates that businesses consider fair value in a number of cases including: i. Making decisions on the price to sell an asset; ii. Shopping around for the best price when making purchases; and iii. When taking competitor’s prices into consideration in order to set their own prices. Market price (fair value) provides a more reliable measure of income for Division C since such prices take demand and supply into consideration. Market prices would provide a good indication of how efficiently Division C is being operated. Division C should therefore consider taking competitor’s prices into consideration when setting prices. Chang et al. (2008) indicate that negotiation is a common approach in the determination of transfer prices. Negotiated transfer prices are based on discussions between managers of the buying and selling divisions. The aim of the discussion is normally to ensure that the selling division’s profit increases as much as the buying division also wants to ensure an increase in profit. This may not happen if the transfer is not beneficial to both parties. What should be sought in this scenario is obtaining at least the same price or a better price than that which can be obtained externally. However, if high volumes are involved and the distribution cost is lower than if sold to an external third party, the selling division may be obliged to reduce profits to facilitate the achievement of the overall goals of the company as a whole. Transfer pricing is a significant issue from both a financial and a managerial perspective because it affects the tax liability of the divisions and the incentives of divisional managers respectively (Hyde & Choe, 2005). However, the tax aspect only applies to MNEs with divisions in different tax jurisdictions. Where a supplying division exists in a high tax jurisdiction, MNEs tend to add a low market when supplies are being exported to a division in a low tax jurisdiction in order to reduce the tax. However, based on OECD guidelines, the arms length principle applies, and so the tax authorities would make the necessary adjustments as they see fit. References Chang, L., Cheng, M and Trotman, K.T. (2008). The effect of framing and negotiation partner’s objective on judgments about negotiated transfer prices. Accounting, Organizations and Society, 33(7-8), p. 704 - 717 Feinschreiber, R and Kent, M. (2012). Pricing Handbook: Guidance for the OECD Regulations. John Wiley & Sons, Inc Hoffman, R. (2009). China’s Transfer Pricing Measures. Beijing Review, June 2009, p. 36 Holban, I. (2011). Reflecting on the Fair Value under IFRS for SMEs: Challenges and Perspectives. Retrieved from http://www.wseas.us/e-library/conferences/2011/Iasi/AEBD/AEBD-31.pdf Hyde, C.E and Choe, C. (2005). Keeping Two Sets of Books: The Relationship Between Tax and Incentive Transfer Prices. Journal of Economics & Management Strategy, 14(1), p. 165 - 186 Industry Week. (2008). From Parts Unknown: How to identify what might be missing from your parts pricing strategy. April 2008. p. 39 Keat, P.G and Young, P.K.Y (2006). Managerial Economics: Economic Tools for Today’s Decision Makers. NJ: Pearson Prentice Hall OECD. (2010). OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2010. OECD Publishing Paleologo, G.A. (2004). Price-at-Risk: A methodology for pricing utility computing services. IBM Systems Journal, 43(1), p. 20 – 31 Rectenwald, G. (2012). A Proposed Framework for Resolving the Transfer Pricing Problem: Allocating the Tax Base of Multinational Entities Based on Real Economic Indicators of Benefit and Burden. Duke Journal of Comparative & International Law, 23(425), p 425 – 449 Charles E. Hyde* http://www.agsm.edu.au/bobm/cluster/IOWS/hyde1.pdf Read More