Transfer Pricing in a Multi-Product Environment

Savita A. Sahay
2014 Accounting and Finance Research  
This paper develops a simple model of a decentralized multi-product firm in which transfer pricing is used to co-ordinate the activities of its constituent divisions. Two goods are produced in a single facility and the accounting system provides the full cost for each based on a rule in which overhead costs are allocated in proportion to direct labor costs. The study compares the performance of some commonly used transfer pricing (TP) policies with respect to level as well as efficiency of
more » ... efficiency of production. The policies studied are Actual Cost-Based TP (ACTP), Standard Cost-Based TP (SCTP), and a hybrid TP policy based on both standard and actual costs. It is shown that under ACTP managers may have incentives to "pad" as well as misallocate costs deliberately to maximize their divisional incomes, while under SCTP there is over-reporting of costs leading to under-production. In general, neither policy achieves the first-best level of production or profit. ACTP yields higher profits to the firm than SCTP if the internally transferred good is the primary good produced by the firm. The hybrid policy eliminates some of the production inefficiencies associated with ACTP as well as the over-reporting problems associated with SCTP, resulting in a higher profit to the firm than can be achieved using either policy alone. and show that the resulting incentives created can significantly affect managers' decisions regarding the volume and efficiency of production that ultimately determine the firm's bottom line. Since a cost allocation system primarily affects the full cost of each product line, I restrict attention to full cost-based TP policies. (Note 8) (Note 9) Most firms that engage in cost-based TP use either standard costs or actual costs as the basis for setting the transfer price. (Note 10) Accordingly, the TP schemes analyzed in this paper are standard cost-based TP (SCTP), actual cost-based TP (ACTP) and a hybrid scheme (HCTP) in which the transfer price is set to the minimum of standard and actual costs. The term standard cost usually refers to a budgeted cost figure issued by the division responsible for producing the good (and hence, in the best position to estimate the production cost) before production is actually undertaken. The standard cost is used as the basis for making decisions about the quantity of goods to produce. Since a standard cost-based transfer price allocates the variance between standard and actual costs to the seller, it is expected that the seller will be motivated to keep actual costs down. To quote (Horngren, Datar and Foster, 2012): "[To] motivate the seller to produce efficiently, cost-based transfer prices should be based on budgeted rather than actual costs" (p. 870, original emphasis.) Such thinking, however, is based on a static view of costs that ignores the dynamic influence that the selling division may have on the formation of both standard and realized costs. The setting of appropriate standards, in particular, is a problematic issue. Ideally, standards should be determined by detailed engineering studies at the production site, and should be reviewed at the appropriate level. In practice, however, the informational requirements of such an approach are too stringent and production managers who are, after all, best informed about the cost environment often play a significant role in the standard-setting process. (Merchant, 1989) finds that profit center managers are often involved in setting and revising standards, and negotiate for budgets that are easier to meet. They like to forecast a pessimistic scenario even when they know better, especially when the information they provide is not easily verifiable. From their field study, Eccles and White (1988) conclude: "[by] setting standard costs he knew to be higher than what the actual costs would be, [the seller] ensured a positive variance [and] thereby contributed to the overall profitability of his division" (p. 28.) Actual cost, in contrast, refers to a post-production cost figure. If only a firm produces only one good, the actual cost incurred is observable after production. For multi-product firms, the formula for computing the actual cost of producing a good is more complicated. It usually involves the allocation of costs that are part of the overall production process but that cannot be traced to individual products. Foremost among such costs are manufacturing overhead costs such as power, indirect materials and labor, plant rent and insurance, property taxes and depreciation on plants, factory overhead costs and set-up and engineering costs. Manufacturing overheads are one of the most important cost categories in many companies. (Note 11) Other costs that need to be allocated among multiple goods are joint costs of a single production process that yields multiple products simultaneously. divisional performance evaluation and line of business reporting". Note 8. The paper excludes negotiated and market-based TP for several reasons: first, they are not as widely used as CTP; negotiated TP is difficult to analyze due to costs of conflict that are not easily quantified (see (Eccles1985) for a strong case against negotiated TP) while market-based TP policies are usually infeasible simply because there is no
doi:10.5430/afr.v3n4p132 fatcat:q75ps4o3o5dchpv63nialrn73q