Transfer Pricing - Essay Example

?INTRODUCTION Transfer price mechanism is process that provides opportunity to attach prices of goods and services of two divisions of same company. It is the process where the negotiated price is arrived between two sections of similar divisions (Robertson , 1996, 2). It is usually applied when bodies are separate entities and are individually responsible for their profitability and divisions are accountable for their own profits (Jensen and Meckling, 1976, 315). Since transfer pricing is an agreement between two divisions of same group there is greater chance of conflict of interest as both buying and selling side try to transfer to counter party resulting increased benefit to its division (Chan, Landry, and Jalbert , 2004, 39). This report will also analyze a case between Millwall Company and Reading Company as both these companies are interested in buying and selling with each other and both of these companies belong to the same group of companies. EFEFCTOF EACH PROPOSED PRICE ON MANAGEMENT OF READING The transfer price mechanism is the source of revenue for selling division which in this case is Reading Company and cost for buying division which in mentioned case is Millwall Company. Former aims to get it maximum revenue from deal and latter tries to get supply at minimum cost. The best option can, therefore, be negotiated at point where both firms are given autonomy as finally they will be held responsible for the profitability of the respective divisions (Grubert and Joel Slemrod , 1998, 368). Considering the fact that Reading Company is already performing under capacity, therefore, it can serve Millwall Company without reducing its supply to other external suppliers and so no opportunity cost would be involved in this scenario. With these assumptions, standard variable cost and opportunity cost would be the total cost that it has to incur. Since opportunity cost is nil in this case then standard variable cost constitutes main component of cost and any point above this would be the profit. Using its spare capacity, selling at any price over and above the average variable price would increase the profit for Reading Company by same amount. For instance, Profit for Reading company = (selling price – average variable price) * quantity In the given case price demanded by Reading Company is inclusive of fixed cost as well and only selling and distribution cost is foregone. It is in due alignment with the need of Reading Company as it has to keep profitability improved with its operation under capacity. Offer from Millwall Company is true on its part as it is well calculated from buyer’s current condition of operating under capacity and it would like to pay minimum or at least less than what it would pay to an external supplier to improve its profitability. But management of Reading Company would surely not like this scenario as it would not benefit the profitability of the company as selling the same product to an external buyer give the company revenue of $ 13per unit. Supplying on the price given by Millwall Company would only then improve the profitability of Millwall Company and this can raise an intra-company conflict of interest and reduction in its revenue will reduce its profit. The best Reading Company is ready to forego its profit by $1.20, which is the market selling price less price offered to Millwall Company. For the price offered by management is less than the one asked by Reading company. This price has already covered the cost and the margin that is suggested to be foregone and it is higher than the Reading’s acceptable price. This price is also not considered suitable for overall profitability of group as it would yield a profit of $ 3 per unit (price: $13 – cost $10) if sold to outsider and this management’s suggested price would reduce the profit of overall group by $2.88 (13- 10.12) and loss in profit is $1.68 (11.80- 10.12) above than profit Reading company is ready to forego. In point of ROI comparison Reading company would finally be held for less profitability overall. To mention, this analysis is based on condition that Reading Company is performing under capacity and supplying to Millwall Company can also be performed within its existing capacity and no external customer has been to be ignored. NEGOTIATION BETWEEN THE TWO DIVISIONS Involvement of the two divisions directly in negotiations is not advisable for several reasons. As in the end both divisions will be accounted for the profitability of their respective divisions and this transfer price will no longer hold in any of income or cost in the income statement then profitability less than regular sales with hold them questioned (Christopher, 1994, 45-47). Though there is always a range available for the parties between which the transfer price can be decided but the point at which two parties shall coincide is a critical question. Both parties being part of the same group would prefer to show its higher profitability in front of top management and the party would try to get it transfer price which is favorable to its own division. This situation has also happened in the given case. Reading company is not ready to forge its profit margin below certain range even in case when it is performing under capacity. Also Millwall Company is not willing to pay more than variable cost and certain margin. In such situations there are higher chances that negotiation fails between the two divisions. To resort it is advisable that top management shall hire a neutral agent that conducts negotiation between two divisions. An informed agent about the necessary cost as well as market price details would be the best in interest of both (Currie , 3). An agent neutral to the profitability of both parties would arrive at middle price based on single and straight forward principle. The price coordinator arrangement will benefit the firm in some ways are as follows: The continued need for and ability to measure each division under profit center parameters; The vehicle for a settlement of interdivisional disputes over pricing where cost plus and market-oriented pricing systems have proven costly or inappropriate; Forcing divisional management to continue seek their production or operational efficiencies (Duft , 1) INVOLVEMENT OF TOP MANAGEMENT IN TRANSFER PRICE MECHANISM In such cases some suggest that top management shall involve in decision making and make relevant suggestions as done in this case however it was rejected by both divisions with reason of grossly unfair. It is merely not advisable for the top management to get involved for; first, it will affect the divisional autonomy as suggestion from top management will be to considered obligatory and this way divisions cannot be hold accountable for their profitability as their autonomy has been breached (Brauner , 2008, 3). Secondly, in case divisions fail to agree on certain price in strict attempt to hold price transfer in their favor and negotiation fails then they would deprive their divisions from the profit in terms of reduced cost for buyer and less but some profit in revenue for seller. This deprivation will bring bigger loss to them individually as well as overall firm (Stoughton and Talmor , 1994, 145-146). For instance, Reading Company by agreeing on price which is above its cost and less than its demand would have benefitted it with some utilization of its underutilized capacity and some profit in its treasury. This agreement would have benefitted to Millwall Company also, only in case the offered price by Reading Company is below than what its external supplier would offer, and benefit of both would have brought benefit to overall company than bringing no revenue or profit in treasury. Detrimental affect of such attitude to individual firms’ as well overall company would give top management chance to question on reduced profitability only in case top management had no contribution or involvement in entire decision making. Hence, to reduce chances of such losses it is suggested that top management shall hire third party who can negotiate price in best interest of two divisions as well as overall group. CONCLUSION Transfer price mechanism, an option practiced to benefit the two divisions of same company (one buying division and other selling division) with price of goods and services negotiated so to retain the benefits of both the divisions at centre point that is acceptable by both divisions. Usually this technique is applied with the mutual consent of both the divisions and without the interference of top management from group to maintain the status of autonomous body with both divisions. Many factors impact the decision making as happened in the given cases where Reading Company was not ready to sell at the proposed price by Millwall Company as well as its top management as it had realization that undergoing profit for its group concern will though benefit the other company but would not keep the division safe as it would reduce its profitability and top management would question about the profitability in term end. Autonomous bodies of a group get more considerate in such cases as overall benefit of transfer price reduces profitability results in detrimental impact on its overall position among other division when profitability is compared. To retain the autonomous position of divisions it is suggested that top management refrain from self interference and shall appoint neutral mediator between two groups to reap long term benefits. Bibliography Brauner, Yariv. 2008. Value in the Eye of the Beholder: The Valuation of Intangibles for Transfer Pricing Purposes. http://scholarship.law.ufl.edu/facultypub/18 Chan, Canri, Steven P. Landry, and Terrance Jalbert. 2004. “Effects of Exchange Rates in International Transfer Pricing Decisions.” International Business and Economics Research Journal 3(3): 35-48. Christopher, Pass. 1994. “Transfer Pricing in Multinational Companies”, Management Accounting – London 72(8): 44-50. Currie, John. “Transfer Pricing”. Department of Accountancy & Finance, National University of Ireland Galway. http://www.cpaireland.ie/UserFiles/File/students/Articles/Transfer_Pricing_Article_by_John_Currie1.pdf Duft, Ken. “When You Buy From Yourself, How Much Should It Cost?.” AgriBusiness Management. Washington State University & U.S. Department of Agriculture Cooperating. http://www.agribusiness-mgmt.wsu.edu/ExtensionNewsletters/price-cost/buy_cost.pdf Grubert, Harry and Joel Slemrod. 1998. “The Effect of Taxes on Investment and Income Shifting into Puerto Rico.” Review of Economics and Statistics 75: 365-373. Jensen, Michaell and William Meckling. 1976. “Theory of the Firm: ‘Managerial Behavior, Agency Costs and Capital Structure’.” Journal of Financial Economics 3: 305-360. Robertson, Sandra. 1996. “Transfer Pricing Solutions in the Global Economy.” Annual Survey of International & Comparative Law 3(1): 1-16. http://digitalcommons.law.ggu.edu/annlsurvey/vol3/iss1/8 Stoughton, Neal, and Eli Talmor. 1994. “A Mechanism Design Approach to Transfer Pricing by the Multinational Firm.” European Economic Review 38(1): 143-170. Read More