978-0077733773 Chapter 19 Cases Part 4

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Chapter 19 – Strategic Performance Measurement: Investment Centers

correct incentive, from the standpoint of the organization as a whole: subunit 2 will reject the

special (supplemental) offer of $240 per unit from an external buyer. As such, subunit 1 would

sell in the external market. Both it and the firm as a whole are better off by $25/unit (i.e., $125

– $100).

Figure 3 illustrates a situation where there are internal cost savings (here, $16 of selling &

distribution cost savings per unit) when subunit 1 sells internally rather than externally;

unit, rather than the external market price, would in fact induce the correct economic decision

5. Finally, market prices may fluctuate significantly and continually over time (because of market

conditions—by definition), thereby requiring the organization to constantly reevaluate its

decisions (sell internally or sell externally).

Disadvantages

1. An established market price may not exist for an intermediate good/service.

2. May, in the short run, induce suboptimal decision-making (particularly when excess [i.e., idle]

market price, etc.

Cost-Based Transfer Prices

Advantages

2. Some might argue that cost information is “objective.”

Disadvantages

1. There is no singular, best definition of “cost.” Cost can be defined as: variable (or, incremental)

or full, standard or actual, and pure cost versus cost-plus.

economic decisions, but if used in its pure form would not provide any profit or mark-up to the

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Chapter 19 – Strategic Performance Measurement: Investment Centers

nonlinear cost functions makes the problem intractable.

5. If marginal costing is used to set transfer prices, there may be disincentives for

6. The use of full-cost transfer prices may avoid some of incentive problems associated with the

use of marginal (variable) costs. However, when this is the case, suboptimal decisions can

arise when the buying/purchasing subunit treats such costs as incremental—which we know

scheme.

Negotiated Transfer Prices

In some sense, and this is true particularly when divisions (subunits) within an organization operate

autonomously and independently, allowing divisions to negotiate a transfer price creates a “market

within the company.” That is, it produces results that approximate the financial results that would be

can more reflect the negotiating skills of the parties rather than optimum resource allocation and

decision making. These problems are intensified to the extent that market prices do not exist for the

goods or services transferred internally.

Summary: as can be seen from the discussion in the article, and the comments above, transfer prices

serve different purposes: profit allocation (among subunits)—a feedback or control purpose, and

providing incentives for sub-unit managers to make decisions that are in the best interest of the

organization as a whole—a decision-making purpose. Further, transfer prices affect cash flows because

of income tax considerations, which are particularly pertinent in an international context. Finally, a

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Chapter 19 – Strategic Performance Measurement: Investment Centers

19-7: “Multinational Transfer Pricing: Management Accounting Theory

versus Practice,” by Laurel Adams and Ralph Drtina, Management Accounting

Quarterly (Fall 2010), pp. 20-31.

Management accounting has traditionally used a theoretical, economics-based approach for determining

transfer prices. Nevertheless, international tax law requires that transfer prices be based on an arm’s-

length standard. This article compares the consequences of setting transfer prices under these two

approaches, which are dependent on whether the selling division is operating at or below full capacity. To

ensure that tax compliance obligations are considered when establishing transfer prices, we recommend

that the theoretical approach be modified such that there is no adjustment for capacity utilization. This

represents a significant shift in the traditional approach to teaching transfer pricing.

Discussion Questions

1. Provide an overview of the primary thesis (argument) raised by the authors of this manuscript.

This article points to a possible inconsistency in terms of the setting of transfer prices in theory (i.e., in

the literature of management accounting) versus actual practice (i.e., based on international tax law).

In terms of the former, transfer prices should be set to maximize economic efficiency; as such, we can

characterize this as an economics-based approach. In terms of the latter, tax authorities (increasingly

that the theory-based approach be modified to ignore the issue of capacity utilization.

2. How, specifically, does the issue of capacity utilization affect the theoretically appropriate

transfer price (i.e., the transfer price that leads to economic efficiency for the firm as a whole)?

The basic model is that the relevant transfer price for short-term decision-making is equal to the

“general model” shown in Chapter 19 of the text: incremental (i.e., out-of-pocket) costs + opportunity

cost, if any. (Also as noted in the text, this general model establishes the floor for the appropriate

transfer price. That is, it establishes the minimum transfer price that would help ensure profit

maximization for the firm as a whole.)

Selling/Producing Division is Operating at Less than Capacity

In this case, by definition “opportunity costs” of the selling division are zero. Thus, the minimum

transfer price would be incremental cost (which is usually, but not necessarily, the variable cost

incurred by the producing division). Of course, at this minimum price the producing division would

Selling/Producing Division is Operating at Capacity

In this case, the market price provides both the correct “signal” for economic decision making and

maintains decision-making authority on the part of subunits. If there are internal cost savings

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Chapter 19 – Strategic Performance Measurement: Investment Centers

3. Provide an overview of legal imperatives regarding transfer pricing in an international context.

Because of differential income-tax rates across countries, opportunities for minimizing world-wide

taxes (and maximizing both after-tax income and cash flow for an organization) exist through the

transfer-pricing mechanism. Essentially, the goal (from a planning, and tax, standpoint) is to attempt to

“relocate” profits of the firm to low-tax jurisdictions. (High transfer prices to a purchasing/buying unit

in Tables 1 and 2 of the article provide background information for this discussion. Table 1 assumes a

situation where the selling division is operating at capacity, while Table 2 provides data for the

situation where the selling division has excess (i.e., idle) capacity.

Taken together, these two tables lead to four possible outcomes (explored in Tables 1-4—see question

4 below). The issue then addressed by the authors is “whether the management accounting

(conceptual) approach results in transfer prices that satisfy international tax law.”

4. Provide a summary of the analysis of data reported in Tables 1, 2, 3, and 4 of the article.

Table 1 (i.e., selling division is operating at capacity): if there are no synergies (interdependencies)

between selling and buying divisions, and an external market price exists, then the economic-based

In Table 2 (i.e., selling division has excess capacity): under the economic-based approach, the selling

division would charge at a minimum a transfer price equal to its relevant cost (same as was discussed

in Chapter 11): out-of-pocket cost ($650) + Opportunity cost ($0, by definition). The maximum

transfer is allocated to the buying division.) The primary point, however, is that an arm’s length

transaction would dictate a transfer price equal to the external market price of $1,000. Anything lower

would violate the spirit if not the requirements of international tax law.

Table 3 assumes that the selling division is operating at capacity but that the circumstances for internal

versus external sales are not comparable. Here, “noncomparable” relates not to differential costs

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Chapter 19 – Strategic Performance Measurement: Investment Centers

Further, the authors suggest that this ability “to adjust for risk permits a wider range of (acceptable)

prices than used under the traditional (managerial accounting) approach where the emphasis is on

reported costs.” The example of how this ability can be used to “shift profit from a high-tax to a low-

tax jurisdiction while still satisfying the arm’s-length standard.” (See Table 3 in the article.)

Comments:

1. It is not clear what the source of this recommendation by the authors is. For example, is it the

opinion of the authors? Is it statutorily backed?

2. The choice of the $50 amount as the example offered by the authors is interesting. Might it (that is,

the low dollar amount) suggest that the leeway under the authors’ recommendation is rather limited

in terms of its impact on world-wide taxes paid?

3. It is also interesting that in discussing Table 3 the authors do not state explicitly that internal cost

savings realized because of internal transfers (i.e., situations where there are synergies associated

with internal transfers), these cost reductions can be used for tax purposes to justify a transfer price

below external market price. This possibility is not raised until later in the article when the authors

state: “As discussed in case 3, tax law allows transfer-price differences based on avoidable costs,

such as bad debts.”

In Table 4, the authors examine the situation where (similar to the case illustrated in Table 2) the

selling division is operating at less than capacity, and (similar to the case illustrated in Table 3) there

are non-comparable circumstances regarding internal versus external transfers. According to the

authors, the opportunity that exists in this context is basically the same as the case 3 (above).

A summary analysis by the authors is presented in Table 5 in the article.

5. What recommendation do the authors offer on the basis of the analysis contained in Tables 1-5

and the accompany discussion?

Table 5 indicates that in four of six situations, the theoretical (marginal costing) or managerial

accounting recommendation for setting transfer prices is inconsistent with the arm’s-length

requirement for international tax purposes. When the selling division has idle capacity, transfer prices

Given the summary in Table 5, the authors recommend that “all transfer prices be set as if the firm

were operating a fully capacity” (i.e., as if idle capacity were zero). Two justifications of this

recommendation are offered by the authors: