(65)---TRANSFER PRICING (5).

Negotiated transfer prices.

A transfer price based on opportunity cost is often difficult to identify, for lack of suitable information about costs and revenues in individual divisions.
In this case it is likely that transfer prices will be set by means of negotiation. The agreed price may be finalized from a mixture of accounting arithmetic, polities and compromise.

• A negotiated price might be based on market value, but with some reductions to allow for the internal nature of the transaction, which savers external selling and distribution costs.
• Where one division receives near- finished goods from another, a negotiated price might be based on the market value of the end product. Minus an amount for the finishing work in the end product, minus an amount for the finish in work in the receiving division.

Behavioral implications.
Even so, inter-departmental disputes about transfer prices are likely to arise and these any need the intervention or mediation of head office to settle the problem. Head office management any then imposes a price which maximizes the profit of the company as a whole. On the other hand, head office management might restrict their intervention to the task of keeping negotiations in progress until a transfer price is eventually settled. The more head office has to impose its won decisions on profit centers, the less decentralization of authority there will be and the less effective the profit center system of accounting will be for motivating divisional managers.

Transfer pricing in a multinational company.

As we have seen the level at which a transfer price should be set is not a straight forward decision for organizations. The situation is even less clear cut for organizations operating in a number of counties, when even more factors need to be taken into consideration. Moreover, the manipulation of profit through the use of transfer pricing is a common area of confrontation between multinational organizations and host country governments.

Factors/explanations,

Exchange rate fluctuation -the value of a transfer to goods between profit centers in different countries could depend on fluctuations in the currency exchange rate.

Taxation in different countries- if taxation on profits is 20% of profits in country A and 50% on profits in country B, company will presumably try to ‘manipulate’ profits (by mans of raising or lower transfer prices or by invoicing the subsidiary in the high – tax country for “services” provided by the subsidiary for in low-tax country) so that profits are maximized for a subsidiary in country A by reducing profits for a subsidiary in country. Artificial attempts are reducing tax liabilities could, however, upset a country’s tax officials if they discover it and may lead to some form the penalty. Many tax authorities have the power to modify transfer prices in computing tariffs or taxes on profit, although a genuine arms-length market price should pass muster.

Import tariffs- suppose that country A imposes an important tariff of 20% on the value goods imported. Multi-national company has a subsidiary in country A which imports goods form a subsidiary in country B. in such a situation, the company would minimize costs by keeping the transfer price to a minimum value.

Exchange controls- if a country imposes restriction on the transfer of profits from domestic subsidiaries to foreign multinationals, the restrictions on the transfer can be overcome if head office provides some goods or services to the subsidiary and charges exorbitantly high prices, disguising the ‘ profits’ as sales revenue, and transferring them form one country to the other. The ethics of such an approach should, of course, be questioned.

Anti- dumping legislation- governments may take action to protect home industries by preventing companies form transferring goods cheaply into their countries. They may do this, for example, by insisting on the use of a fair market value for the transfer price.

Competitive- transfer pricing can be used to enable profit centers to match or undercut local competitors.

(64)---TRANSFER PRICING (4).

Transfer pricing when there is no external market for the transferred item.

If there is no similar item sold on an if the transferred item is a major product of the transferring division, there is a strong argument that profit center accounting is a waste of time. Profit centers cannot be judged on their commercial performance because there is no way of estimating what fair revenue for their work should be.

It wild be more appropriate, perhaps, to treat the transferring division as a cost center, and to judge performance on the basis of cost variances.

I profit centers are established, in the absence of a market price, the optimum Transfer price is likely to be on based on standard cost plus, but only provided that the variable cost per unit and selling price per unit are unchanged at all levels of output. A standard cost plus price would motivate divisional managers to increase output and to reduce expenditure levels.

Profit maximization with no external market and changing costs/prices.

Profit maximization general.
If cost behavior patterns change and the selling price to the external market are reduced at higher levels of output, there will be a profit- maximizing level of output to produce more than an ‘optimum’ amount would cause reductions in profitability.
Under such circumstances, the ideal transfer price is one which would motivate profit center managers to product at the optimum level of output, and neither below nor above this level.

Profit maximization with an external market and changing cost/prices.

Imperfect external market.

The approach is essentially the same.Expect that the supplying division may also have income, and so its marginal revenue needs to be taken into account.
Perfect external market.

The approach is the same as that used for an imperfect external market expect that marginal revenue for the supplying division is constant at the market price.

Transfer process based on opportunity costs.

It has been suggested that transfer price can be set using the following rule.
Transfer price per unit =standard variable cost in the producing division plus the opportunity cost to the organization as a whole for supplying the unit internally.
The opportunity cost will be one of the following
(a). The maximum contribution foregone by the supplying division in transferring internally rather than selling goods externally.
(b). The contribution foregone by not using the same facilities in the producing division for their nest best alternative use.
If there is no external market for the item being transferred, and no alternative use for the facilities, the transfer price = standard variable cost of production.
If there is no external market for the item being transferred, and no alternative, more profitable use for the facilities in that division, the transfer price=the market price.

Identifying the optimal transfer price.

Throughout the posts we have been leading up to the following guiding rules for identifying the optimal transfer price.

• The ideal transfer price should reflect the opportunity cost of sale to the supply division and the opportunity cost to the buying division unfortunately, full information about opportunity cost may not be easily obtainable in practice.
• Where a perfect external market price exists and unit variable costs and unit selling prices are constant, the opportunity cost of transfer will be external market price or external market price less savings in selling costs.
• In the absence of a perfect extent market price for the transferred item, but when unit variable cost are constant, and the sales price per unit of the end-product is constant, the ideal transfer price should reflect the opportunity cost of the resources consumed by the supply division to make and supply the item and so should be at standard variable cost + opportunity cost of making the transfer.
• When unit variable costs and/or unit selling prices are not constant, there will be a profit-maximization level of output and the ideal transfer price will only be found by sensible negotiation and careful analysis.

(1). Establish the output and sales quantities that will optimize the profits of the company or group as a whole.
(2). Establish the transfer price at which both profit centers would maximize their profits at this company optimization output level.

There may be a range of prices within which both profits centers can agree on the output level that would maximize their individual profits and the profits of the company as a whole. Any price within the range would then be “idle” .

(63)---COST BASED APPROACHES TO TRANSFER PRICING.

Cost-based approaches to transfer pricing.

Cost-based approaches to transfer pricing are often used in practice, because in practice the following conditions are common.

• There is no external market for the product that is being transferred.
• Alternatively, although there is an external market it is an imperfect one because the market price I affected by such factors as the amount that the company setting the transfer price supplies to it, or because there is only a limited external demand.

In either case there will not be a suitable market price upon which to base the transfer price.
Actual costs vary with volume, seasonal and other factors, seasonal and other factors. Moreover, if actual costs are used as a basis for transfer price, any inefficiency in the producing department will be passed on the receiving department in the form of an increased transfer price. The use of standard costs is therefore recommended.

Transfer prices based on full cost.Under this approach, unsurprisingly, the full cost (including fixed overheads absorbed) that has been incurred by the supplying division in making the intermediate product is charged to the receiving division. If a full cost plus approach is used a profit margin in also included in this transfer price.

The transfer price fails on all there criteria j(divisional autonomy, performance measurement and corporate profit measurement) for judgment.

• Arguably, the transfer price does not give fair revenue or charge b a reasonable cost, and so their profit performance is distorted. It would certainly be unfair, for example, to compare A’s profit with B’s profit.
• Given this unfairness it is likely that the autonomy of each of the divisional managers is under threat. If they cannot agree on what is a fair spilt of the external profit a decision will have to be imposed form above.
• It would seem to give an incentive to sell more goods externally and transfer less to B. THIS MAY OR MAY NOT BE IN THE best interest of the company as a whole.

Transfer prices based on Variable cost.A variable cost approach entails charging the variable cost that has been incurred by the supplying division to the receiving division.

(62)---TRANSFER PRICING.(2).

The use of market price as a basic for transfer prices

Market price as the transfer price.

If an external market price exists for transferred goods, profit center managers will be aware of the price they could obtain or the price they would have to pay for their goods on the external market, and they would inevitably compare this price with the transfer price.

Adjusted market price.
Internal transfers are often cheaper than external sales, with savings in selling and administration costs, bad debt risks and possibly transport/delivery costs. It would therefore seem reasonable for the buying division to expect discount on the external market price. The transfer price might be slight less than market price, so that A and B could share the cost savings from internal transfers compared with external sales. It should be possible to reach agreement on this price and on output levels with a minimum of intervention form head office.

The merits and disadvantages of market value transfer prices.
A market- based transfer price therefore seems to be the ideal transfer price because the buying division is likely to benefit from a better quality of service, greater flexibility, and dependability of supply. Both division may benefit from cheaper costs of administration, selling and transport. A market price as the transfer price would therefore result in divisions which would be in the best interest of the company or group as a whole.

Market value as a transfer price does have certain disadvantages.

• The market price may be a temporary one, induced by adverse economic conditions, or dumping, or the market price might depend on the volume of output supplied to the external market by the profit center.
• A transfer price at market value might, under some circumstances, act as a disincentive to use up any spare capacity in the divisions. A price based on incremental cost, in contrast, might provide an incentive to use up the spare resources in order to provide a marginal contribution to profit.
• Many products do not have an equivalent market price so that the price of a similar, but not identical, product might have to be chosen. In such circumstances, the option to sell or buy on the open market does not really exist.
• There might be an imperfect external market for the transferred item, so that is the transferring division tried to sell more externally, it would have to reduce its selling price.

(61)---TRANSFER PRICING.

Transfer pricing -The basic principles of transfer pricing.

A transfer price is the price is “the price at which goods or services are transferred form one process or department to another or form one member of a group to another ,
Transfer pricing is used when divisions of an organization need to charge other divisions of the organization for goods or services they provide to them.

Three problems with transfer pricing.
Divisional autonomy,

transfer prices are particularly appropriate for profit centers because if one profit center does work for another the size of the transfer price will affect the costs of one profit center and the revenues of another.
However, a danger with profit center accounting is that the business organization will divide into a number of self-interested segments, each acting at times against the wishes and interest of other segments. Decisions might be taken by a profit center manager in the best interests of his own part of the business, but against the best interest of other profit centers and possible the organization as a whole.
A task of head office is therefore to try to prevent dysfunctional decision making by individual profit centers. To do this, head office must reserve some power and authority for itself and so profit centers cannot be allowed to make entirely autonomous decision.
Just how much authority head office decides to keep for itself will vary according to individual circumstances. A balance ought to be kept between divisional autonomy to provide incentives and motivation, and retaining centralized authority to ensure that the organization’s profit centers are all working towards the same target, the benefit of the organization as a whole (in other words, retaining goal congruence among the organization’s separate divisions).

Divisional performance measurement.

profit centers managers tend to put their own profit performance above every this else. Since profit centers performance is measured according to the profit they earn, no profit center will want to do work for another an incur cost without being paid for it. Consequently, profit center managers are likely to dispute the size of transfer prices with each other, or disagree about whether one profit center should do work for another or not. Transfer prices affect behavior and decisions by profit center managers.

Corporate profit maximization.

When there are disagreements about how much work should be transferred between divisions, and how many sales the division should make to the external market, there is presumably a profit- maximizing level of output and sales for the organization as a whole. However, unless each profit center also maximizes
Its on profit at this same level of output , there will be inter divisional disagreements about output levels and the profit maximizing output will not be achieve.

The ideal solution.

Ideally a transfer price should be set at a level that overcomes these problems.

• The transfer price should provide an ‘artificial’ selling price that enables the transferring division to earn a return for its efforts. And the receiving division to incur a cost for benefits received.
• The a transfer price should be set at a level that enables profit center performance to be measured ‘commercially’. This means that the transfer price should be a fit commercial price.
• The transfer price, if possible, should encourage profit center managers to agree on the amount of goods and services to be transferred, which will also be at a level that I consistent with aims of the organization as a whole such as maximizing company profits.

In practice it is difficult to achieve all there aims

(60)---OTHER PRICING STRATEGIES-(2).

(3).Market skimming pricing

Market skimming pricing involves charging high prices when a product is first launched and spending heavily on advertising and sales promotion sales.
The aim of Market skimming is to gain high unit profits early in the product’s life. High unit prices make it more likely that competitors will enter the market than if lower prices were to be charged.

Such a policy may appropriate in the following circumstances

• Where the product is new and different, so that customers are prepared to pay high prices so as to be one up on other people who do not own it.
• Where the strength of demand and the sensitivity of demand to price are unknown it is better from the point of view of marketing to start by charging high prices and then reduce them if the demand for the product turns out to be price elastic than to start by charging low irises and then attempt to raise them substantially if demand appears to be insensitive to higher prices.
• Where high in the early stages of a product’s life might generate high initial cash flows. A firm with liquidity problems may prefer market-skimming for this reason.
• Where the firm can identify different market segments for the product, each prepared to pay progressively lower prices. If product differentiation can be introduced, it may be possible to continue to sell at higher prices to some market segments when lower prices are charged in others. This is discussed further below.
• Where products may have a short life cycle, and so need to recover their development costs and make a profit relatively quickly.

(4).Premium pricing.

This involves making a product appear ‘different’ so as to justify a premium price the product may be different in terms of, for example, quality , reliability , durability, after sales service or extended warranties. heavy advertising can establish brand loyalty which can help to sustain a premium and premium prices will always be paid by those customers whey blindly equate high price with high quality.

(5).Pricing to recover an investment.

An alternative pricing objective that is worth mentioning is to recover the investment in a new product or service as quickly as possible, that is to achieve a minimum payback period. The price is set so as to facilitate this. such an objective would tend to be used in the following conditions.

• The business is high risk
• Rapid changes in fashion or technology are expected.
• The innovator is short of cash

(59)---OTHER PRICING STRATEGIES-(1).

(1).Special orders

A special order is a one-off revenue earning opportunity. These may arise in the following situations.

• When a business has a regular source of income but also has some spare capacity allowing it to take on extra work if demanded. For example a brewery might have a capacity of 500,000 barrels per month but only be producing and selling 300,000 barrels per month. It could therefore consider special orders to use up some of its spare capacity.
• When a business has no regular source of income and relies exclusively on its ability to respond to demand. A building firm is a typical example as are many types of subcontractors. In the service sector consultants often work on this basis.

The reason for marking the distinction is that in the case of (a), a from would normally attempt to cover its longer-term running costs in its prices for its regular product. Pricing for special orders need therefore take no account of unavoidable fixed costs. This is clearly not the case for a firm in (b)’s position, where special orders are the only source of income for the foreseeable future.
The basic approach in both situations is to determine the price at which the firm would break even if it undertook the work, that is, the minimum price that it could afford to charge. It would have to cover the incremental costs of producing and selling the item and the opportunity costs of the resources consumed.

New products
A new strategy will depend largely on whether a company’s product or service is the first of its kind on the market.

• If the product is the first of its kind, there will be no competition yet, and the company, for a time at least , will be a monopolist. Monopolists have more influence over price and are able to set a price at which they think they can maximize their profits. A monopolist’s price is likely to be higher, and his profits bigger, than those of a company operating in a competitive market.
• If the new product being launched by a company is following a competitor’s product onto the market, the pricing strategy will be constrained by what the competitor is already doing. The new product could be given a higher price if its quality is better, it could be given a price which matches the competition. Undercutting the competitor’s price might result in a price war and a fall of the general price level in the market.

(2).Market penetration pricing.

Market penetration pricing is a policy of low prices when the product is first launched in order to obtain sufficient penetration into the market.
A penetration policy may be appropriate in the following circumstances.

• If the firm wishes to discourage new entrants in to the market.
• If the firm wishes to shorten the initial period of the product’s life cycle in order to enter the growth and maturity stages as quickly as possible.
• If there are significant economies of scale to be achieved from a high volume of output, so that quick penetration into the market is desirable in order to gain unit cost reductions.
• If demand is highly elastic and so would respond well to low prices.

Penetration prices are prices which aim to secure a substantial share in a substantial total market. a firm might therefore deliberately build excess production capacity and set its prices very low. As demand builds up the spare capacity will be used up gradually and unit costs will fall; the firm might even reduce prices further as unit costs fall. In this way, early losses will enable the firm to dominate the market and have the lowest costs.

(58)---PRICING-MARGINAL COST PLUS PRICE.

Marginal cost-plus pricing

Marginal cost-plus pricing/ mark- up pricing is a method of determining the sales price by adding a profit margin on to either marginal cost of production or marginal cost of sales.
Whereas a full cost- plus approach to pricing draws attention to net profit and the net profit margin, a variable cost-plus approach to pricing draws attention to gross profit and the gross profit margin, or contribution.

The advantages of a marginal cost-plus approach to pricing are as follows.

• It is a simple and easy method to use.
• The mark-up percentage can be varied, and so mark- up pricing can be adjusted to reflect demand conditions.
• It draws management attention to contribution, and the effects of higher or lower sales volumes on profit. In this way, it helps to create better awareness of the concepts and implications of marginal costing and cost –volume-profit analysis. For example, if a product costs Rs 10 per unit and a mark –up of 150 % is added to reach a price of Rs.25 per unit, management should be clearly aware that every additional Rs.1 of sales revenue would add 60 pence to contribution and profit.
• In practice, mark-up pricing is used in businesses where there is a readily identifiable basic variable cost. Retail industries are the most obvious example, and it is quite common for the prices of goods in shops to be fixed by adding a mark- up (20% or 33.3%,say ) to the purchase cost.

There are, of course, drawbacks to marginal cost- plus pricing ,

• Although the size of the mark-up can be varied in accordance with demand conditions, it does not ensure that sufficient attention is paid to demand conditions, competitors’ prices and profit maximization.
• It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently high to ensure that a profit is made after covering fixed costs.

Approach to pricing might be taken when a business is working at full capacity, and is restricted by a shortage of resources from expanding its output further. By deciding what target profit it would like to earn, it could establish a mark-up per unit of limiting factor.

(57)---PRICING STRATEGIES-FULL COST PLUS PRICING

FULL COST – PLUS PRICING

In practice cost is the most important influence on price. Many firms base price on simple cost-plus rules (costs are estimated and than a profit margin is added in order to set the price.) a study by Lancelot gave a number of reasons for the predominance of this method.

• Planning and use of scarce capital resources are easier.
• Assessment of divisional performance is easier
• It emulates the practice of successful large companies.
• Organizations fear government action against ‘excessive’ profits.
• There is a tradition of production rather than of marketing in many organizations.
• There is sometimes tacit collusion in industry to avoid competition.
• Adequate profits for shareholders are already made, giving no incentive to maximize profits.
• Cost-based pricing strategies based on internal data are easier to administer.
• Over time, cost-based pricing produces stability of pricing, production and employment.

Full cost –plus pricing is a method of determining the sales price by calculating the full cost of the product and adding a percentage mark- up for profit.
The full cost’ may be a fully absorbed production cost only, or it may include some absorbed administration, selling and distribution overhead.
A business might have an idea of the percentage profit margin it would like to earn. And so might decide on an average profit mark-up as a general guideline for pricing decisions
This would be particularly useful for businesses that carry out a large amount of contract work or jobbing work, for which individual job or contract prices must be quoted regularly to prospective customers. However, the percentage profit mark-up dose not have to be rigid and fixed, but can be varied to suit the circumstances. In particular, the percentage mark-up can be varied to suit demand conditions in the market.

Problems with and advantages of full cost-plus pricing .


There are several serious problems with relying on a full cost approach to pricing.

• It fails to recognize that since demand may be determining price, there will be a profit-maximizing combination of price and demand.
• There may be a need to adjust prices to market and demand conditions
• Budgeted output volume needs to be established. Output volume is a key factor in the overhead absorption rate.
• A suitable basis for overhead absorption must be selected, especially where a business produces more than one product.

(56)---THE OPTIMUM PRICING MODEL.

The optimum pricing model

Profit analysis.

• Micro economic theory suggests that as output increases, the marginal cost (MC) per unit might rise (due to the low of diminishing returns) and whenever the firm is faced with a downward sloping demand curve, the marginal revenue (MR) per unit will decline.
• Eventually, a level of output will be reached where the extra cost of marking one extra unit of output is greater than the extra revenue obtained from its sale. It would then be unprofitable to make and sell that extra unit
• Profits will continue to be maximized only up to the output level where (MC) has risen to be exactly equal to MR.
• Profit are maximized at the point where MC = MR, at a volume of Qn units.
• If we add a demand or average revenue curve to the graph we can see that an output level of Qn, the sales price per unit would be P n.
  
  
  Deriving demand curve
• When there is a linear relationship between demand and price, the equation for the demand curve is

P = a – BQ / Q

Where

p = the price
Q = the quantity demanded
A = the price at which demand would be nil
B = the amount by which the price changes for each stepped change in demand

Q = the stepped change in demandA=(current price)+(current quantity at current price/charge in quantity when price in charged by$)X$BThe demand function above shows how price (P) varies with quantity (Q).Alternatively you can always rearrange the equation to show how the quantity sold varies with the price charged.

Optimum pricing in practice .

The approach of optimal pricing with its prediction of a single predictable equilibrium price is important in economics. However in practice organizations rarely use the technique. The problems in applying optimal pricing occur for the following reasons.

• It assumes that the demand curve and total costs can be identified with certainty. This is unlikely to be so.
• It ignores the market research costs associated with acquiring knowledge of demand.
• It assumes the firm has no productive constraint which could mean that the equilibrium point between supply and demand cannot be reached.
• It assumes that the organization wishes to maximize profits. In fact it may have other objectives.
• It assumes that price is the only influence on quantity demanded . we have seen that this is for from the case.
  
  

(55)---FACTORS INFLUENCING THE PRICING DECISION.

Factors influencing the pricing decision

Markets.

The price that an organization can charge for its products will be determined to a greater or lesser degree by the market in which it operates. Here are some familiar terms that might feature as background for a question or that you might want to use in a written answer.
• Perfect competition-Many buyers and many sellers all dealing in an identical product. Neither producer nor user has any market power and both must accept the prevailing market price.
• Monopoly-One seller who dominates many buyers. The monopolists can use his market power to set a profit-maximizing price.
• Monopolistic competition-A large number of suppliers offer similar, but not identical products. The similarities ensure elastic demand whereas the slight differences give some monopolistic power to the supplier.
• Oligopoly-Where are relatively few competitive companies dominate the market whilst each large firm has the ability to influence market prices the unpredictable reaction from the other giants makes the final industry price in determinate. Cartels are often formed.

Other Factors

1. Prices Sensitivity.
2. Price Perception.
3. Compatibility with other Products.
4. Competitors.
5. Competition from substitute products.
6. Suppliers.

EXPLANATION/EXAMPLE.
Inflation-
in periods of inflation the organization may need to change prices to reflect increases in the prices of supplies and so on. Such changes may be needed to keep relative (real) prices unchanged.

Quality -
in the absence of other information, customers tend to judge quality by price. Thus a price change may send signals to customers concerning the quality of the product. A price rise may indicate improvements in quality, a price reduction may signal reduced quality, for example through the use of inferior components.

Incomes-
in times of rising incomes, price may become a less important marketing variable compared with product quality and convenience of access (distribution). When income levels are falling and /or unemployment levels rising, price will become a much more important marketing variable.

Ethics -
ethical considerations are a further factor, for example whether or not to exploit short-term shortages through higher prices.

CompetitionIf a rival cuts its prices in the expectation of increasing its market share, a firm has several options.

• It will maintain its existing prices if the expectation is that only a small market share would be lost, so that it is more profitable to keep prices at their existing level. Eventually, the rival firm may drop out of the market or be forced to raise its prices.
• It may maintain its prices but respond with a non-price counter-attack. This is a more-positive response, because the firms will besecuringor justifying its current prices with a product change, advertising, or better back-up services.
• It may reduce its prices. This should protect the firm’s market share so that the main beneficiary from the price reduction will be the consumer.
• It may raise its prices and respond with a non-price counter-attack.the extra revenue from the higher prices might be used to finance an advertising campaign or product design changes. A price increase would be based on a campaign to emphasize the quality difference between the firm’s own product and the rival’s product.