Chapter 14: Pricing Decisions(Transfer Price) Flashcards
(14 cards)
What are the costs and benefits of decentralization?
-Decentralization refers to delegating decision-making authority from top executives to lower level managers in individual decisions, branches or departments.
Benefits include: Greater responsiveness to local needs, quicker decision-making, increased motivation of subunit managers, improved management development and learning, and it sharpens the focus of subunit managers.
Costs include: Sup-optimal decision-making and goal incongruence, decreased loyalty towards the organization, increased costs of gathering information, and duplicated activities.
What are responsibility centres, and what are the key types of responsibility centres?
-Responsibility centres are used to measure performance of a subunit in organizations, and are also often used in centralized or decentralized organizations.
-There are four types of responsibility centres:
1) Cost Center: manager accountable for costs only
2) Revenue Center: manager accountable for revenue only
3) Profit Center: manager accountable for costs and revenue
4) Investment Center: manager accountable for investment, revenue, and costs.
What is transfer pricing? What are the goals and methods of transfer pricing?
-Transfer pricing is the pricing that one subunit division or department within a company charges another subunit for goods and services.
-The goods involved in transfer pricing are often intermediate products, not sold to outside customers yet.
-Transfer pricing should do the following things:
1) Promote goal congruence: Ensure both divisions act in the best interest of the entire company, not just themselves
2) Promote sustained effort: Motivate managers to perform well, knowing their results are being measured fairly.
3) Evaluate subunit and manager performance: A fair transfer price ensures that one division doesn’t appear to perform better or worse just because of biased pricing.
4) Promote autonomy in decision making: Let managers operate their units like businesses with enough freedom to make decisions, while still aligning company goals.
-Without fair transfer pricing, a selling division may overcharge a buying division making one look great, and the other one may seem to underperform. It may also lead to conflict, dysfunctional decisions, or goal incongruence.
-The main methods are:
1) Using market-based transfer prices
2) Using cost-based transfer prices
3) Using negotiated transfer prices
What is a fair transfer price between two divisions within the same company?
-Min<=Transfer Price(TP(<=Max
-Min=VC+Incremental Cost+Opportunity cost(on the side of the seller).
-Max=Prie the buyer could pay to an outside vendor.
How does idle capacity affect the minimum transfer price, and what is the optimal transfer pricing range when idle capacity exists?
-Idle capacity means that the selling division (supplier) has unused production capacity–resources like labor, machinery, or time that aren’t being used to produce goods for external customers.
-From the sellers perspective, as long as they didn’t lose external revenue, there is no opportunity cost. In that case, the only cost is the variable cost (VC) to make the unit.
-It may also include incremental costs such as for extra setup, packaging, and labor.
-So the minimum acceptable price is Transfer Price>=VC+Incremental Cost
-From the buyer’s perspective, Transfer Price<=Market Price
How does no idle capacity affect the transfer price, and what is the minimum transfer price?
-No idle capacity means the selling division is fully utilizing its resources, and it must give up external sales to fulfill internal demand.
-Minimum Transfer Price=VC+Incremental Cost+Opportunity Costs
-Maximum Transfer price will be market price.
What is the transfer pricing rule when the selling division has some idle capacity?
-Some idle capacity means the selling division can fulfill some internal demand without giving up external sales, and we must sacrifice external sales for the rest.
-Minimum Transfer Price=VC+Incremental Cost+Partial Opportunity Cost.
-Maximum Transfer Price is market price.
What happens when there are no external suppliers?
The buyer is willing to pay as high as the amount expected to earn, after paying all expenses.
What are the pros and cons of market based pricing?
-Market based pricing can lead to the optimal decision if:
1) The intermediate market is perfectly competitive.
2) Independencies of subunits are minimal
3) There are no additional costs to benefits to the corporation
-Market based pricing can help to treat each division like an independent business.
-Cons are:
1) Distressed Price May be greater than normal market price: In tough market conditions such as economic downturn, the market price may drop to unusually low levels, called distress prices.
2) Distress Price May be Needed to be Used: Sometimes the only available “market price” is distress price, and you’re forced to use it temporarily.
3) Use Distress Price Only if>Incremental Costs+Variable Costs. If not, then the selling division loses money per unit, and the company as a whole may be worse off with the transfer than without it.
What is full cost based transfer pricing? What are the pros and cons of it?
-Full cost based transfer pricing is based on the concept that Full Cost=Variable Cost+Fixed Cost
-The pros of full-cost based pricing are as follows:
1) Yields Relevant Costs for Long-Run Decision-Making
-Full cost includes all resources used, not just variable costs.
-Full cost reflects what the company spends overall, making it good for evaluating long-term product viability and pricing.
2) Facilitates External Pricing Based on VC+FC
3) Least Costly to Administer
-The cons of full-cost based pricing include:
1) May Lead to Suboptimal Decisions: The buying division may buy externally because it’s cheaper, even though buying internally would help the company overall.
2) Buyers May Confuse FC+Markup as Variable Cost
3) Can Undermine Incentives
-If selling divisions are forced to transfer at cost with no markup, they earn no profit, making them less motivated to control costs, accept internal orders, and treat internal buyers as “real customers.”
What is variable-cost based transfer pricing? What are the pros and cons of it?
-Variable cost based transfer pricing sets the transfer price as equal to the variable cost.
-That means that the internal buyer pays just the marginal cost of production, and the selling division does not recover any fixed costs or earn profit on the transfer.
-The pros of variable-cost based pricing are:
1) Can Acheive Goal Congruence: For short-term decisions (where fixed costs are sunk), using VC ensures decisions are based on marginal benefit to the company.
2) Buyers Report Large Profit(if paying less than full cost)
-Buying division gets a low transfer price, which leads to a higher profit.
-This encourages the internal use of idle capacity.
3) FC Problem Can Be Addressed with Lump-Sum Transfer Payments.
-The cons of variable-cost based pricing are:
1) Seller reports a loss
2) Managers are Not Motivated to Exert Effort: If the seller earns no profit, there’s no incentive to accept internal order, manage costs, or improve quality.
What is prorating the difference transfer pricing? What are it’s pros and cons?
-Prorating the difference means splitting the gap between the minimum price the selling division is willing to accept, and the maximum price the buying division is willing to pay.
-Sharing information will increase goal congruence.
-We want to make sure that we never prorate outside the acceptable range.
-Another con is that subunit managers may overstate its VC to receive a more favorable transfer price.
What is dual pricing transfer pricing? What are the pros and cons?
-Dual pricing means that the selling division and the buying division record different transfer prices for the same internal transaction.
-This achieves goal congruence, enables each division to show realistic performance, and reduces conflict between divisions.
-The seller records the transfer at market price(full cost+markup), and the buyer records the transfer at variable cost(or a lower agreed upon price). The difference between the two prices would be absorbed by head office, or a corporate-level adjustment account.
-The cons of dual pricing are:
1) Requires Head Office Intervention: Someone has to record the adjustment difference.
2) Distorts Company Wide Profit Totals: Since the transaction is booked at two different values, the company’s internal profit numbers no longer reconcile cleanly.
3) Not Acceptable for External Financial Reporting: For financial accounting, a single value must be used, and dual pricing can be for internal use only.
What are negotiated prices? What are the pros and cons of negotiated prices?
-Negotiated pricing means the selling and buying divisions agree on a transfer price through direct negotiation, rather than using a preset market or cost based formula.
-Negotiated pricing is not fixed, and depends on the relative bargaining power of each division.
-This gives autonomy to both divisions, encourages divisino managers to think like entrepreneurs, and reflects real-life negotiation, similar to how businesses interact with external suppliers or customers.
-The advantages of negotiated pricing are that it preserves subunit autonomy, promotes high effort from both parties, encourages information sharing, and can reflect complex market realities.
-The disadvantages of negotiated pricing are that it’s time consuming(and negotiation is often a zero-sum game), it’s not always goal congruent, and it may create internal conflict.
