Management Accounting: Transfer Pricing Methods and Approaches

This report explores the use of transfer pricing methods in management accounting. It discusses the benefits and limitations of market-based transfer pricing and cost-based transfer pricing. It also examines other approaches like negotiated transfer pricing and dual transfer pricing. The report highlights how transfer pricing affects divisional performance measurement and discusses the ethical issues involved. Additionally, it provides insights into optimal transfer pricing and the challenges of transfer pricing documentation.

Management Accounting
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Executive Summary
Management accounting is an important part of internal management which helps them to
formulate the policies and procedures for organization growth and development. This report
shows that the use of transfer pricing system in the organization that has so many departments
and depends upon each other. With the help of transfer pricing method, the organization can get
an optimal solution for the given problem.
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Table of Contents
Executive Summary...................................................................................................................... 2
Introduction................................................................................................................................... 4
Main Body.................................................................................................................................... 5
Conclusion.................................................................................................................................. 16
References................................................................................................................................. 17
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Introduction
Management accounting is an essential part of every business organization because it assists
the management in making the policies and plans for future business operations. It shows the
accounting information in an appropriate manner which helps the management to formulate day
to day activities for each and every department. This report is the case study about the Raven
Industries which manufactures carpets, furniture and cushions in three separate departments. In
this report, the transfer pricing methods are used in interdepartmental transfer between
departments. Market price method will use in this report which is the best pricing method for
transferor department. In this case study, another approach will be used to set transfer prices,
other than market price and manufacturing cost.
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Main Body
1. Transfer Price
Transfer price is the price at which organization departments transfer the labour, trade of
supplies, etc. with each other. Transfer prices are used in the organization when it has so many
departments or divisions. Transfer price is also called as transfer cost. It arises for the purpose
of accounting when the various departments of a multi-entity organization are in the
responsibility of their own profits. It generally does not fluctuate much from the market price and
if the price does change or fluctuate, then one department is at a disadvantage (Adler, 2013).
Transfer price = Opportunity cost per unit to the organization because of the transfer plus
Outlay cost per unit (additional) incurred because goods are transferred
Figure: Methods of transfer pricing
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T r a n s fe r P r ic in g Market Prices
Cost- Based Prices
Negotiated Prices
Dual Prices

There are a number of ways to derive transfer prices which are listed above and it helps to each
and every department of an organization to charge transfer prices on a transfer of raw materials,
labour, etc.
Objectives of transfer pricing:
1. Performance Evaluation: The transfer pricing system helps the top management in
determining the performance of an organization in an appropriate manner. It also determines the
contribution of each of the department towards organization profit (Cooper, et. al., 2017).
2. Autonomy: The transfer price system should seek to maintain the maximum department
autonomy so that the advantage of decentralization is achieved in an effective and efficient
manner. This means that the profit of one department should not be dependent on the action of
other departments in the organization. Both departments should work in an independent manner
which helps the organization to earn more and more profits (DRURY, 2013).
3. Goal congruency: The transfer pricing system of an organization should motivate each and
every department in decisions making the process which are beneficial for the whole
organization and its departments also. It does not motivate suboptimal decision making because
it maximizes the divisional goals rather than the corporate goals (Holtzman and Nagel, 2014).
So, it is beneficial for both department and organization to adopt the transfer pricing system in
their business operations whether it is operating inside or outside the country. With the help of
this system, the top management and departments are work together to achieve the goals and
objectives in an effective and efficient manner.
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a) Robert Cleveland is correct and it is beneficial for the Cushion Division to charge the market
price on the transfer of products or services to the other department of a company. It is the best
pricing method for the department which transfers goods or services to the other department.
Market- based transfer pricing is the easiest method of transfer pricing and it uses a usual
market rate that would be paid if the products or goods were purchased on the outside market.
With the help of this method of transfer pricing, the departments can earn a profit in transferring
the goods or services to the other department.
Market-Based Transfer Pricing
The market price refers to a price between independent sellers and markets in an intermediate
market. For the transferred product, when there is a competitive external market then the market
prices work well as transfer prices (John McKinley and CGMA, 2013). This price would meet all
of the objectives of a transfer price which are listed below:
 It maintains autonomy between the departments of a company
 It also achieves goal congruence
 It evaluates the realistic performance
Following are the benefits of market-based transfer pricing which are listed below:
 Department managers’ motivation increases because they have more control over the
products or services manufactured by its department.
 The top manager of the organization cannot be distracted by routine
 Market-based transfer pricing method is helpful to the department managers to preapare
decisions which are optimal for their own department.
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Cost-Based Transfer Pricing
Transfer pricing which are based on cost are normally practiced in the company when the
circumstances for setting ideal market price which does not exist in the market or the market
which does exist may be imperfect (Richardson, Taylor, and Lanis, 2013).
Limitations of cost-based transfer pricing
 It can lead to bad decisions because it does not include the opportunity costs from lost
sales.
 The department's autonomy would be affected
 The costs of inefficiencies which are incurred by the selling division would be passed on
the buying division of the company.
Conclusion:
It can be concluded that market-based transfer pricing method is an appropriate method to
adopt in the company. It is a suitable method for the transferor department which helps them to
generate profits from the interdepartmental transfer. Robert Cleveland is correct in his statement
that the market price method is suitable for his division and it helps them to check the
performance of his department.
b) Following are another approach of transfer pricing which is beneficial for the company
and its department:
Negotiated transfer pricing: This pricing method could be set by negotiation between the
selling and buying departments. It is generally a middle solution between cost-based prices and
market prices (Kaplan and Atkinson, 2015). The situations under which a negotiated transfer
price will involve the following successful points:
 Freedom to sell or buy outside
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 Sharing of all information on the market between the negotiators
 Top management occasional involvement and support
Following are the limitation of negotiated transfer pricing which is listed below:
 It is a process which is time-consuming for the departments’ managers which are
involved in it.
 If the negotiated price is more the opportunity cost of transferring the transferred goods
then it may lead to suboptimal level of output.
 Sometimes it may lead to conflicts between departments of the company.
 In the negotiating process the management efforts, resources, time are consumed in a
great manner.
Dual transfer pricing
Under this transfer pricing method, the selling department sells or transfer the goods or services
to the buyer department at a (a) cost plus some profit margin or (b) negotiated or market price.
But for the buying department, the transfer price is a cost-based amount which mostly includes
the variable costs of the transferor or selling department of the company (Otley and Emmanuel,
2013).
Characteristics of Dual transfer pricing
 In dual transfer pricing, the autonomy of decision-making division is at stake.
 Dual transfer pricing complicates the process of accounting for each and every
department.
 Buying division is not willing to purchase the goods or services to the selling department
because it charges the price which is too high for the buying department.
 Selling division is not willing to sell the goods or services at price offered by the buying
department.
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Different transfer pricing approaches
Particulars Performance
evaluation
Administrative
cost
Goal
Congruence
Autonomy
1. Cost- based
prices
Poor Poor Poor Very low
2. Market prices Very strong Low Good Very strong
3. Negotiated
prices
Strong High Strong Strong to poor
4. Dual prices Strong High Strong Poor
Conclusion:
The company can use the negotiated transfer pricing method to set the transfer prices for their
departments because this method is a middle solution for the selling department and buying
department. On the other hand, dual transfer pricing method is also an appropriate method
which also helpful for the selling department in fixing the prices of transfers goods for the buying
department of the company.
2. Transfer price based on the market price
Raven Industries
Profit & Loss Account
For the year ending, 31st December 2019
Particulars Carpet Division Furniture Division Cushion Division
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$ $ $
Sales Revenue 3,000,000 3,000,000 4,000,000
Less: Variable Costs
Direct Material
Direct Labour
Variable overhead
Administration
expenses (variable)
Selling and
distribution
expenses (variable)
500,000
500,000
750,000
85,000
480,000
1,000,000
2,00,000
50,000
140,000
480,000
1,000,000
1,000,000
1,000,000
40,000
400,000
Contribution (Sales
revenue – Variable
Costs)
685,000 11,30,000 15,60,000
Add: Variable Costs 23,15,000 18,70,000 34,40,000
Transfer price based
on Market price
30,00,000 30,00,000 50,00,000
Note: The transfer price of carpet, furniture, and cushion department is $30,00,000, $30,00,000
and $50,00,000. In the transfer pricing which is based on the market price, the variable cost is
added to the contribution to get transfer price for each department.
3. Report to the CEO
Transfer pricing is a manner of promoting autonomy of departments, ideally without discouraging
overall corporate profit maximisation or prejudicing the measurement of divisional performance.
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With the help of transfer pricing the management can attain their objectives and goals in an
effective and efficient manner. The transfer prices should be set at levels which make sure that
profits for the organisation as a whole are maximised. The change in transfer price can increase
the profit of a department or division, and then, on the other hand, it reduces the profit from other
departments or divisions within a company. But the top management of the company has to
keep control of the quantity and price decisions of goods or services which are transferred
between the departments (Klassen, Lisowsky, and Mescall, 2017).
Divisional performance measurement
Type of division Description Typical measures used to
check the performance
Cost centre Department has no revenue
stream but incurs costs.
Total cost and per unit cost
Variances of cost
NFPIs are related to
productivity, quality and
competence.
Profit center Departments have both
revenue and costs.
Manager of the department
does not have the authority to
change the investment level in
the department.
All of the above plus:
Profit
Working capital ratios
Total sales and share of the
market.
NFPIS are basically related to
productivity, quality and
satisfaction of the customer.
Investment center Department has both revenue
and costs
All of the above plus:
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The manager does have the
right to dispose of existing
assets or invest in new assets
ROI (return on investment)
RI
These measures are used to
verify the decisions of
investment which are made by
the managers of an
organization.
With the help of this transfer pricing, the company can able to distribute the profit to each and
every part of the department. It also improves the relationship and maintains the sustainability of
the relationship in the future for the company. The determine transfer price the market- based
transfer prices is the best method because it is used market price when there is a competitive
market for products or services that are internally transferred. This method has the benefit of
being able to offer a competitive price and describe the market indeed which is beneficial for the
transferor department. But this method also has a disadvantage associated with a market price
that is not always available in the market. The transfer pricing can be done between
departments within a company and between companies with special relationships within a
country. It also used for transactions within parties with special connections may be below or
above market price. The company should build appropriate and fair compensation policies to
motivate the manager of each department. There are two types of compensation a scheme
which has to be given by the top management in the company, first is the competitive
compensation scheme which is given on the basis of the profit of each department whereas a
cooperative compensation scheme is given to the manager on the basis of firm’s overall profit
(Dermine, 2013).
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Ethical issues in transfer pricing
When formulating the transfer pricing strategy, the company has to follow some potential ethical
issues which are listed as below:
 Evasion of tax
 Loss of reputation
 Bad reputation
Following are the approaches to transfer pricing which are discussed as below:
There are two approaches to transfer pricing which helps the department to preserve the
information in variable costs and also helps to the transferring departments to make profits.
Dual pricing: In this approach, the transferring department transfers at cost plus mark up and
the receiving department transfers in at variable cost.
Variable cost: The transfer is made in between the department at variable cost. The
transferring department transfers the goods at variable costs whereas the receiving department
paid on this basis to the supplying department.
Optimal transfer price for the department which is shown below:
Maximum (fixed by receiving department): The lower of net marginal revenue of the receiving
department and the external price of the purchase ≥ transfer price
Minimum (fixed by transferring department): Variable cost of transferring department plus
any lost contribution ≤ transfer price.
The main challenges faced by the company while making transfer pricing documentation
which may include the following points which are listed below:
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1. Whether the cost of maintaining and making the offsets documentation which associated the
risk with the transactions.
2. Selecting or finding similar transactions that are a niche or unique to the company’s business
operations.
3. Coordinating the finance, tax, supply chain, operations, and other departments to obtain
important information for purposes of benchmarking.
4. Procurement the required information which is useful to conduct functions, asset and risk
analysis of the transactions which are maintained by each department of the company.
5. Whether to maintain the document internally in the company or taking help of external
professional outside the company.
When the company have multiple business operations or having more two departments, the
transfer pricing is the best method for the company and its department. With the help of transfer
price both department i.e. transferring and receiving department transfer goods or services
inappropriate manner. While adopting the transfer pricing method, it motivates each and every
department of a company in generating profits from the receiving department (Rugman and
Eden, 2017).
Benefits of transfer pricing
1. For a company transfer pricing provides many benefits from a taxation perspective, although
most of the entities use the transfer pricing to evade taxes.
2. Transfer pricing takes benefits of different regimes of tax in various different countries. With
the help of this pricing, the company can save income from the tax and can do business
operations in a smooth manner.
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3. Transfer pricing helps the company to maintain the supply chain of raw materials owned by
the company.
4. It also allows the company to enter a new market and can establish a business empire, in this
regard to do monopoly in the competitive market. In transfer pricing, decentralization is done by
delegating responsibility to each division manager in which each manager understand the
information available in their respective segments.
5. The transfer pricing can result in a difference in profit between divisions or segments within
the company (Shunko, Debo, and Gavirneni, 2014)
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Conclusion
The above report concluded that the transfer pricing is an important method of management
accounting which offers various pricing method to the organization which helps them to
formulate price structure in the transfer of good or services between the departments. The
above report presents that the market-based transfer pricing method is an appropriate method
for the company when the market price available in the market. The report provides an idea and
advantage of the use of transfer pricing in the organization that has multiple business operations
in the domestic or international market. It helps the organization in tax relief and motivates each
and every department of an organization. Finally, Robert Cleveland who is the manager of the
cushion department is right in his suggestion that transfer price which is based on the market is
an appropriate method for his department.
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References
Adler, R., 2013. Management Accounting. Routledge.
Cooper, J., Fox, R., Loeprick, J. and Mohindra, K., 2017. Transfer pricing and developing
economies: A Handbook for policy makers and practitioners. The World Bank.
Dermine, J., 2013. Fund transfer pricing for deposits and loans, foundation and
advanced. Journal of Financial Perspectives, 1(1).
DRURY, C.M., 2013. Management and cost accounting. Springer.
Holtzman, Y. and Nagel, P., 2014. An introduction to transfer pricing. Journal of Management
Development, 33(1), pp.57-61.
John McKinley, C.P.A. and CGMA, J., 2013. Transfer pricing and its effect on financial
reporting. Journal of accountancy, 216(4), p.50.
Kaplan, R.S. and Atkinson, A.A., 2015. Advanced management accounting. PHI Learning.
Klassen, K.J., Lisowsky, P. and Mescall, D., 2017. Transfer pricing: Strategies, practices, and
tax minimization. Contemporary Accounting Research, 34(1), pp.455-493.
Otley, D. and Emmanuel, K.M.C., 2013. Readings in accounting for management control.
Springer.
Richardson, G., Taylor, G. and Lanis, R., 2013. Determinants of transfer pricing aggressiveness:
Empirical evidence from Australian firms. Journal of Contemporary Accounting &
Economics, 9(2), pp.136-150.
Rugman, A. and Eden, L., 2017. Multinationals and transfer pricing. Routledge.
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Shunko, M., Debo, L. and Gavirneni, S., 2014. Transfer pricing and sourcing strategies for
multinational firms. Production and Operations Management, 23(12), pp.2043-2057.
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