ACCA PM考点：Tackling a transfer pricing question

Tackling a transfer pricing question

Thus far,we have only talked in terms of principles and,while it is important to understand these,it is equally as important to be able to apply them.The following question came up in June 2014’s exam.It was actually a 20-mark question with the first 10 marks in part(a)examining divisional performance measurement and the second 10 marks in part(b)examining transfer pricing.Parts of the question that were only relevant to part(a)have been omitted here however the full question can be found on ACCA’s website.The question read as follows:

Reproduction of exam question

Relevant extracts from part(a)

The Rotech group comprises two companies,W Co and C Co.

W Co is a trading company with two divisions:the design division,which designs wind turbines and supplies the designs to customers under licences and the Gearbox division,which manufactures gearboxes for the car industry.

C Co manufactures components for gearboxes.It sells the components globally and also supplies W Co with components for its Gearbox manufacturing division.

The financial results for the two companies for the year ended 31 May 2014 are as follows:

(b)C Co is currently working to full capacity.The Rotech group’s policy is that group companies and divisions must always make internal sales first before selling outside of the group.Similarly,purchases must be made from within the group wherever possible.However,the group divisions and companies are allowed to negotiate their own transfer prices without interference from head office.

C Co has always charged the same price to the Gearbox division as it does to its external customers.However,after being offered a 5%lower price for the similar components from an external supplier,the manager of the Gearbox division feels strongly that the transfer price is too high and should be reduced.C Co currently satisfies 60%of the external demand for its components.Its variable costs represent 40%of the total revenue for the internal sales of the components.

Required:

Advise,using suitable calculations,the total transfer price or prices at which the components should be supplied to the Gearbox division from C Co.

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Approach

As always,you should begin by reading the requirement.In this case,it is very specific as it asks you to‘advise,using suitable calculations…’In a question like this,it would actually be impossible to‘advise’without using calculations anyway and your answer would score very few marks.However,this wording has been added in to provide assistance.In transfer pricing questions,you will sometimes be asked to calculate a transfer price/range of transfer prices for one unit of a product.However,in this case,you are being asked to calculate the total transfer price for the internal sales.You don’t have enough information to work out a price per unit.

Allocate your time.Given that this is a 10-mark question then,since it is a three-hour exam,the total time that should be spent on this question is 18 minutes.

Work through the scenario,highlighting or underlining key points as you go through.When tackling part(a)you would already have noted that C Co makes$7.55m of sales to the Gearbox Division(and you should have noted who the buying division was and who the selling division was).Then,in part(b),the first sentence tells you that C Co is currently working to full capacity.Highlight this;it’s a key point,as you should be able to tell now.Next,you are told that the two divisions must trade with each other before trading outside the group.Again,this is a key point as it tells you that,unless the company is considering changing this policy,C Co is going to meet all of the Gearbox division’s needs.

Next,you are told that the divisions can negotiate their own transfer prices,so you know that the price(s)you should suggest will be based purely on negotiation.

Finally,you are given information to help you to work out maximum and minimum transfer prices.You are told that the Gearbox division can buy the components from an external supplier for 5%cheaper than C Co sells them for.Therefore,you can work out the maximum price that the division will want to pay for the components.Then,you are given information about the marginal cost of making gearboxes,the level of external demand for them and the price they can be sold for to external customers.You have to work all of these figures out but the calculations are quite basic.These figures will enable you to calculate the minimum prices that C Co will want to sell its gearboxes for;there are two separate prices as,when you work the figures through,it becomes clear that,if C Co sold purely to the external market,it would still have some spare capacity to sell to the Gearbox division.So,the opportunity cost for some of the sales is zero,but not for the other portion of them.

Having actively read through the scenario,you are now ready to begin writing your answer.You should work through in a logical order.Consider the transfer from both C Co’s perspective(the minimum transfer price),then Gearbox division’s perspective(the maximum transfer price),although it doesn’t matter which one you deal with first.Head up your paragraphs so that your answer does not simply become a sea of words.Also,by heading up each one separately,it helps you to remain focused on fully discussing that perspective first.Finally,consider the overall position,which in this case is to suggest a sensible range of transfer prices for the sale.There is no single definitive answer but,as is often the case,a range of prices that would be acceptable.

The suggested solution is shown below.

Always remember that you should only show calculations that actually have some relevance to the answer.In this exam,many candidates actually worked out figures that were of no relevance to anything.Such calculations did not score marks.

Reproduction of answer

From C Co’s perspective:

C Co transfers components to the Gearbox division at the same price as it sells components to the external market.However,if C Co were not making internal sales then,given that it already satisfies 60%of external demand,it would not be able to sell all of its current production to the external market.External sales are$8,010,000,therefore unsatisfied external demand is([$8,010,000/0.6]–$8,010,000)=$5,340,000.

From C Co’s perspective,of the current internal sales of$7,550,000,$5,340,000 could be sold externally if they were not sold to the Gearbox division.Therefore,in order for C Co not to be any worse off from selling internally,these sales should be made at the current price of$5,340,000,less any reduction in costs that C Co saves from not having to sell outside the group(perhaps lower administrative and distribution costs).

As regards the remaining internal sales of$2,210,000($7,550,000–$5,340,000),C Co effectively has spare capacity to meet these sales.Therefore,the minimum transfer price should be the marginal cost of producing these goods.Given that variable costs represent 40%of revenue,this means that the marginal cost for these sales is$884,000.This is,therefore,the minimum price which C Co should charge for these sales.

In total,therefore,C Co will want to charge at least$6,224,000 for its sales to the Gearbox division.

From the Gearbox division’s perspective:

The Gearbox division will not want to pay more for the components than it could purchase them for externally.Given that it can purchase them all for 95%of the current price,this means a maximum purchase price of$7,172,500.

Overall:

Taking into account all of the above,the transfer price for the sales should be somewhere between$6,224,000 and$7,172,500.

Summary

The level of detail given in this article reflects the level of knowledge required for Performance Management as regards transfer pricing questions of this nature.It’s important to understand why transfer pricing both does and doesn’t matter and it is important to be able to work out a reasonable transfer price/range of transfer prices.

The thing to remember is that transfer pricing is actually mostly about common sense.You don’t really need to learn any of the specific principles if you understand what it is trying to achieve:the trading of divisions with each other for the benefit of the company as a whole.If the scenario in a question was different,you may have to consider how transfer prices should be set to optimise the profits of the group overall.Here,it was not an issue as group policy was that the two divisions had to trade with each other,so whether this was actually the best thing for the company was not called into question.In some questions,however it could be,so bear in mind that this would be a slightly different requirement.Always read the requirement carefully to see exactly what you are being asked to do.

Written by a member of the Performance Management examining team

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