You should never accept without question any accounting information you are given.
This scepticism is why users of financial statements want them to have been audited, but it extends to other accounting areas also such as tax calculations, cash flow projections and management accounting reports. You should be sceptical not just
because information could have been deliberately manipulated and presented in a way which misleads, but also because the information depends on the assumptions lying behind it and the methodology used to create it.
Indeed, there can be more than one legitimate view of which numbers best represent truth. For example, both marginal and total absorption cost can simultaneously give the correct cost of production. Which version of cost you should use depends on what you are trying to
do. Transfer pricing provided excellent examples of how assumptions and methodologies can create misconceptions and also lead to wrong decisions.
Transfer prices are almost inevitably needed whenever a business is divided into more than on department or division, each department reports its performance separately and goods or services flow between them.
The accounting system will usually record the goods leaving one department and entering the next, and some
monetary value must be used to record this. That monetary value is the transfer price of the goods. We will see that it could be the actual cost of the goods at the point of transfer, their standard cost, or a price above cost. It is easy to see that transfer price
Take the following scenario in which Division A makes components for a cost of $30 which are transferred to Division B for $50. Division B buys the components in at $50, incurs own costs of $20 and then sells to outside customers for $90.
As things stand, each division makes a profit of $20/unit. It should be easy to see that the group will make a profit of $40/unit. You can calculate this either by simply adding the two divisional profit together ($20 + $20 = $40) or subtracting own cost from final
revenue ($90 – $30 – $20 = $40).
You will easily appreciate that for every $1 the transfer price is increased, Division A will make $1 more profit, Division B will make $1 less. Mathematically, the group will make the some profit, but we will soon see that these changing profits can make
each division make different decisions and as a result of those decisions, group profits might be affected.
For now, just consider the knock-on effects that different transfer prices and different
profits might have on the divisions:
1. Performance evaluation. The success of each division, whether measures by
Return on Investment or Residual Income will be changed. These measures
could indicate that a division’s performance was unsatisfactory and tempt
management to close it down.
2. If there is performance-related pay, the remuneration of employees in each
division will be affected. If they feel that their remuneration is unfair,
employees’ morale will be adversely affected.
3. Motivation. Everyone likes to make a profit and this ambition applies to
managers in divisions. If a transfer price were to be set so that one division
found it impossible to make a profit, employees there would probably be
demotivated. In contrast the other division would have an easy ride as it
would make profits easily, and would not be motivated to work more efficiently.
4. New investment should typically be evaluated using a method such as net
present value, but the cash inflows arising the investment are almost certainly
going to be affected by the transfer price, so capital investment decisions can
depend on the transfer price.
5. Taxation and profit remittance. If the divisions are in different countries, the
profits earned in each country will depend on transfer prices. This could affect
the overall tax burden of the group and could affect the amount of profits that
need to be remitted to head office.