Transfer Pricing

CHAPTER 5

MR. LAMIN DAMPHA

 Introduction
A transfer price is the price at which goods or
services are transferred from one division to
another within the same organisation.
 Objectives
1. Goal congruence
The decisions made by each profit centre manager
should be consistent with the objectives of the
organisation as a whole, i.e. the transfer price
should assist in maximising overall company
profits. A common feature of exam questions is
that a transfer price is set that results in suboptimal
behaviour.
 Objectives
2. Performance measurement
The buying and selling divisions will be treated as
profit centres. The transfer price should allow the
performance of each division to be assessed fairly.
Divisional managers will be demotivated if this is
not achieved.
 Objectives
3. Autonomy
The system used to set transfer prices should seek
to maintain the autonomy of profit centre
managers. If autonomy is maintained, managers
tend to be more highly motivated but suboptimal
decisions may be made.
 Objectives
4. Recording the movement of goods and services
In practice, an extremely important function of
the transfer pricing system is simply to assist in
recording the movement of goods and services.
 Setting the Transfer Price
There are two main methods available:
 Method 1: Market Based
Approach
If an external market exists for the transferred
goods then the transfer price could be set at the
external market price.
 Method 2: Cost Based Approach
The transferring division would supply the goods
at cost plus a % profit.
A standard cost should be used rather than the
actual cost since:
 Actual costs do not encourage the selling
division to control costs.
 If a standard cost is used, the buying division
will know the cost in advance and can therefore
put plans in place.
 Cost Based Approach
There are a number of different standard costs
that could be used:
 Full cost

 Marginal (variable) cost

 Opportunity cost.

Each of these will be reviewed.

EXERCISE ON FULL COST &
MARGINAL COST
FULL & MARGINAL COST
Full & Marginal Cost
SOLUTION
SOLUTION
SOLUTION
SOLUTION
Exercise on Opportunity Cost
Approach
Opportunity Cost Approach
Opportunity Cost Approach
 A company has two profit centres, A and B. A
sells half of its output on the open market and
transfers the other half to B. Costs and external
revenues in an accounting period are as follows.
 A B Total

$ $ $

External sales 8,000 24,000 32,000

Costs of production 12,000 10,000 22,000

Company profit 10,000

 What are the consequences of setting a transfer
price at market value?
SOLUTION
Target Costing

CHAPTER 6

MR. LAMIN DAMPHA

 History
 Target costing was invented by Toyota in 1965
Reasons:
 80-90% of the life cycle cost is determined at the
design phase of the product (Tanaka)
 continuous improvement, “cost kaizen”, inevitably
lead to fewer opportunities to cut costs (Tanaka)

SOLUTION: actual costs -> predetermined costs

 Definition

 Target Costing is defined as a cost

management tool for reducing the
overall cost of a product over its
entire life-cycle with the help of
production, engineering, research
and design.
 TARGET-COSTING PRINCIPLES

1. price-led costing.
2. focus on customers.
3. focus on design.
4. cross-functional involvement.
5. value-chain involvement.
6. a life-cycle orientation..
 Target costing objectives

 To identify the cost at which the product must

be manufactured if it's to earn its target profit
margin at its expected or target selling price.
 To decompose the production process and then
to set cost targets for each product element.
 Approaches to target costing
 Price-based targeting
 Cost-based targeting
 Value-based targeting

 A target cost is the maximum amount of cost

that can be incurred on a product.
 Target Cost = Market Price – Expected Margin
 Price-based targeting

 Sets target cost for the product through

comparison with that of competitors
 This means setting the price of the product by
observing what the market will bear, then
deducting the desired profit margin from the
price, and thereby obtaining the target cost.
 Cost-based targeting
 It sets the cost 1st, then the desired profit
margin is derived at the price of the product.
 This method requires the suppliers to reveal the
very details of their cost structure and will sour
the buyer-supplier relationships so itsn’t good
for the long run.
 Value-based targeting
 It sets the price by what it thinks the market will
‘value’ the product
 After that, the producer sets the desired profit
margin and then tries all ways to keep the cost
below that of the target cost.
 Benefits

 Delivering the optimal value proposition to

end customers.
 Minimizing product-line complexity.
 Selecting appropriate product and process
technologies.
 Lowering product design late in the innovation
process.
 Eliminating cost overruns.
 Negative points
 possible misuse of the technique.
Producers might make use of cost-based target costing to
squeeze the profit margins of suppliers, thereby getting
materials at the lowest cost possible.
 the stress on the design team of companies using target
costing
 disadvantage to the company.

Product development time might be lengthen as product

is repeatedly designed to bring cost below that of
target.
Three main elements of the target costing process
by Cooper & Slagmulder
 Implementation
1. Price-led costing ~ market prices are used to
determine target costs

2. Focus on customers ~ value to the customer

must be greater than the cost of the product
itself

3. Focus on design ~ cost control must occur

before production
4. Cross-functional involvement ~ interfunctional
product and process teams

5. Value-chain involvement ~ all members of the

value chain included

6. Life-cycle orientation ~ minimizing total life-

cycle costs
 Control Points

Top management in case of establishing a new product

Cost estimating group decomposing the preset value

Cross-functional target costing teams analysing the

production process
 Similar approach to the target
costing by Caterpillar
 The main aim: to reduce costs by 5.4%

 The cost of the comparable model is based on

current manufacturing capabilities
 Similar approach to the target
costing by Caterpillar
 cross-functional organizational team
 emphasize cost reduction during the new
product development cycle
 reduce costs through efficiency improvements

Caterpillar
 Similar approach to the target
costing by Caterpillar
A few areas of reduction:
 Assembly
 Cab
 Engine
 Hydraulics
 Power Train
 Structures
 Linkage
 Other
 Target costing prospectives
 Target costing which has been widely used by
Japanese firms since 1970s now is spread all over
the world
 Main industries: transportation and heavy
equipment industries (Intensive competition,
extensive supply chains, and relatively long
product development cycles)
 EXAMPLE 1
 Packard plc are considering whether or not to
launch a new product. The sales department
have determined that a realistic selling price will
be $20 per unit.
 Packard have a requirement that all products
generate a gross profit of 40% of selling price.
 Calculate the target cost.
 EXAMPLE 1 SOLUTION
 Selling price = $20 p.u.
 Target return = 40% of selling price
 Target Cost = $12 p.u.
 EXAMPLE 2
 Hewlett plc is about to launch a new product on
which it requires a pre-tax ROI of 30% p.a.
 Buildings and equipment needed for production
will cost $5,000,000.
 The expected sales are 40,000 units p.a. at a
selling price of $67.50 p.u.
 Calculate the target cost.
 ANSWER TO EXAMPLE 2

Target return = 30% × 5M = $1.5M p.u.

Expected revenue = 40,000 × $67.50 = $2.7M
 The Use of the Target Cost
Once the target cost has been determined, it will
be compared with the estimated actual cost of
production. The excess of the actual cost over the
target cost is known as the target cost gap, and the
company will then be looking for ways of closing
this gap.
 Target Costing in Service
Organisation
Target costing is as relevant to the service sector as
the manufacturing sector. Key issues are similar in
both: the needs of the market need to be
identified and understood as well as its customers
and users; and financial performance at a given
cost or price (which does not exceed the target
cost when resources are limited) needs to be
ensured.
 Problems with target costing in
service industries
(1) The intangibility of what is provided means
that it is difficult to define the ‘service’ and
attribute costs;
(2) ) Inseparability/simultaneity of production and
consumption: although the manufacturer of a
tangible good may never see the actual
customer, customer often must be present
during the production of a service, and cannot
take the service home.
 Problems with target costing in
service industries (Cont.)
3. Heterogeneity – The quality and consistency
varies, because of an absence of standards or
benchmarks to assess services against.
4. Perishability – the unused service capacity from
one time period cannot be stored for future use.
5. No transfer of ownership – Services do not
result in the transfer of property. The purchase of
a service only confers on the customer access to or
a right to use a facility.
 EXERCISE
A company has the capacity of production of
80,000 units and presently sells 20,000 units at
GMD100 each. The demand is sensitive to selling
price and it has been observed that every
reduction of GMD10 in selling price the demand
is doubled. What should be the target cost at full
capacity if profit margin on sale is taken as 25%?
 SOLUTION
Maximum capacity 80,000 units
Presented sales 20,000 units @ GMD100 p.u.
 SOLUTION
(b) At present
Variable cost/unit = 40% of cost i.e. 75 = Rs. 30
Fixed cost/unit = 100 –25% = 75
Thank you for attention