17 _Transfer_Pricing_Spring2014.ppt - Objectives for today...

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ACCY 302 (Fanning) Class 17 1 Objectives for today and next class Overview of transfer pricing Establishing a transfer pricing policy what does management at headquarters, divisions want? constraint Computing transfer prices methods and their limitations underlying principle of all methods general guidelines for choosing a method
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ACCY 302 (Fanning) Class 17 2 The setting for Transfer Pricing A decentralized organization in which the work flows of the divisions within it are interdependent * . Managers are evaluated based on divisional performance. * Within the same organization, the outputs of one division are the inputs of another.
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ACCY 302 (Fanning) Class 17 3 Why do we care ? Frequency of Internal Transfer: A study of 400 large US companies in 1990s reported that 15% of the firms have in excess of 10% of their sales in internal transfers.
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ACCY 302 (Fanning) Class 17 4 The problems Example: Illini Lumber Co. has two divisions: Raw Lumber (RL), which can either: sell its product to FL, where it can be processed further sell its product to outside customers Finished Lumber (FL), which can sell its product to outside customers
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ACCY 302 (Fanning) Class 17 5 The problems (continued) Illini Lumber Company Raw Lumber (RL) Division Finished Lumber (FL) Division outside customers who want to buy boards outside customers who want to buy paneling
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ACCY 302 (Fanning) Class 17 6 The problems (continued) What problems arise? 1) Measuring performance is problematic The organization as a whole needs to place a value on interdependent work flows so management can determine whether value is being created But because this is an internal market: transactions are not at arms-length the prices placed on those work flows are distorted
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ACCY 302 (Fanning) Class 17 7 The problems (continued) What problems arise? 1) Measuring performance is problematic - Example If the selling division is receiving too little revenue from the buying division relative to the "true" value of the product/service, then: - the selling division's profit will be too low - the buying division's profit will be too high
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ACCY 302 (Fanning) Class 17 8 The problems (continued) What problems arise? (continued) : 2) In response, resource allocation decisions will change Because the divisions and their managers are evaluated based on divisional performance.. ..the managers have no incentive to work together, and will adjust their decisions in response to the distortions created by their performance evaluation.. ..even if those decisions are not in the best interest of the organization as a whole ( a moral hazard problem )!
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ACCY 302 (Fanning) Class 17 9 Divisional Manager’ s Perspective
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ACCY 302 (Fanning) Class 17 10 The problems (continued) What problems arise?
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