Evaluating Transfer Pricing and Financial Performance Indicators

This document presents solutions to a finance assignment. The assignment addresses two key questions: the advantages and disadvantages of negotiation and market-based transfer pricing methods, and explanations of return on capital employed (ROCE), residual income, and economic value added (EVA). The solution provides a comparative analysis of the transfer pricing methods, highlighting the benefits and drawbacks of each. Additionally, it defines and discusses the significance of ROCE, residual income, and EVA as financial performance indicators, covering their applications and limitations. References to relevant academic sources are also included. This assignment provides a comprehensive understanding of transfer pricing and financial performance metrics.

2 Questions

Table of Contents
Q3. Advantage and disadvantage of two methods of transfer pricing........................................1
Q4. Explain the following points................................................................................................2
A) Return on capital employed ..............................................................................................2
B) Residual income................................................................................................................2
C) Economic value added.......................................................................................................2
REFERENCES................................................................................................................................3

Q3. Advantage and disadvantage of two methods of transfer pricing
Transfer pricing refers to the monetary value which is being attached with the product or
services that are transferred between two unit of organisations that are situated at different
geographical location. Following are the types of transfer pricing:
Negotiation transfer pricing:- It refers to a type of transfer pricing where negotiation
happens between market and cost based price. It is beneficial when each division is consider as
an independent and individual unit. This method is also helpful to manager in determining
appropriate transfer price that will satisfy the requirement of division (Dufo-López, 2015). But it
is time consuming process as it require more effort and time to settle the price. Apart from this,
negotiation transfer price depend more over manager skills and ability to bargain.
Market based transfer price:- It refers to a transfer price method where company uses
external market price for transferring goods to another department in stable as well as
competitive external market (Advantages of Market based pricing, 2018). Once the deal get final
in competitive market then it lead to optimal decision formation. It is most appropriate decision
when external market is well defined, stable and competitive, at that time firm can set upper
bound as a transfer price. But apart from this some intermediate products are generally not traded
in competitive market, hence no market price exists. In addition to this it is more riskier approach
as market price fluctuates more often that may result in heavier loss.
So, from the above analysis it has been found that negotiation transfer pricing is more
appropriate option as compare to market based transfer price. This is because in negotiation
pricing the manager have an option to negotiate cost in their deal which beneficial to both the
department. In case of market based price there is always a risk of price fluctuation that
sometimes result in loss.
Q4. Explain the following points
A) Return on capital employed
It refers to a financial ratio which measures company's efficiency as well as profitability
with which the capital of firm is employed. Return on capital employed help in measuring how
efficiently a firm can generate profit over its employed capital by performing a comparison
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between capital employed and net operating profit (DRURY, 2013). ROCE is helpful in
comparing the company's performance in capital intensive sector like telecoms. Major issue with
Return on capital employed is that unlike payback there is not any method present that can
modified to take time value of money in account.
B) Residual income
It refers to the type of payment or stream which is being received after the product or
services provided to final user. Residual income is generally associated with entertainment
industry where revenue is generate after the movie or music get released (What is Residual
income, 2018). The benefit of residual income is that it attract new investment. Main problem
with residual income is that it is based on accounting measure of capital employed and profit that
may result in manipulation.
C) Economic value added
It is basically a measure to calculate company's financial performance which is based on
residual wealth which is find out after deducting cost of capital from operating profit and
adjusted for taxes on the bases of cash (Kerans, Vo and et. al., 2011). Main advantage of
economic value added method is that it supplement financial data through several methods of
business assessment and valuation. Major problem with economic value added is that it cannot
evaluate the return over expenses such as research and development has a potential to yield
future earning which is not measured by EVA.
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REFERENCES
Books and Journals
DRURY, C. M., 2013. Management and cost accounting. Springer.
Dufo-López, R., 2015. Optimisation of size and control of grid-connected storage under real
time electricity pricing conditions. Applied Energy. 140. pp.395-408.
Kerans, A., Vo, D., and et. al., 2011, May. Pricing of spectrum based on physical criteria. In New
Frontiers in Dynamic Spectrum Access Networks (DySPAN), 2011 IEEE Symposium
on (pp. 223-230). IEEE.
Online
Advantages of Market based pricing. 2018 [Online] Available through
<https://smallbusiness.chron.com/market-based-pricing-strategy-5121.html>
What is Residual income. 2018 [Online] Available through
<https://www.readyratios.com/reference/analysis/residual_income_ri.html>
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