AF09101

ACCOUNTING FOR DECISION

MAKING

TOPIC 6
RESPONSIBILITY ACCOUNTING AND
TRANSFER PRICING

BLOCK I – 2019/20

MTC - JANUARY 2020

 Coverage:

1. Meaning of responsibility accounting

2. Responsibility centres: Cost, Profit, and

investment centres
3. Objectives and significance of Responsibility
Centres

4. Transfer price for decision making

 Meaning of Responsibility Accounting

• RA is an accounting system that collects,

summarizes, and reports accounting data relating
to the responsibilities of individual managers.
• RA is a management control system which is based
on the principles of delegating and allocating
responsibility to different managers.
• The basic premise of RA is that managers should be
held accountable for variables or activities they
control
 Introduction
The concept of Control
The term control refers to
– Authority to influence and to measure results .
– Control can be absolute or relative.
Absolute Control:
- Full control over an item or activity that managers are
held responsible for
Relative control:
- Control over most of the factors that influence a given
budget item.
• RA is based on information relating to inputs and
outputs under relative control of a particular
center manager
 Reasons for Evaluation

• A company evaluates subunits in order to

decide if it should expand or contract them
or change their operations
• A company evaluates subunit managers in
order to motivate them to take actions that
maximize the value of the firm
• Reasons for evaluating subunit managers:
– Identifies successful operations and areas
needing improvement
– Influences the behavior of managers
 Requirements for Implementing RA
1. The business must be organized so that
responsibilities are assignable to individual
managers.
2. Managers and their lines of responsibility should
be fully defined in the organization chart
3. Responsibility centers should be established
• A responsibility center is an organizational unit headed by a
manager, who is responsible for its activities and results.
• In responsibility accounting; revenues and cost information is
collected and reported on by responsibility centers
 Functional and Devisionalized Organisation
Structure
• To implement responsibility accounting in a
decentralized organization, costs and revenues are
traced to the organizational level where they can be
controlled
• Functional organisation structure
– Activities of similar type are placed under one
departmental head to control them
– e.g. marketing function, production function, purchasing
function
• Divisionalized Organisation Structure
– Organisation is split according to produced products or
geographical location.
 Responsibility Centres.
There are four types of responsibility
centers:
1. Cost or expense centre.
2. Revenues centre
3. Profit centre.
4. Investment centre.
 RESPONSIBILITY CENTERS

Extractions Management
Investment
Division (Cost)

Account Division. - Profit

Crude oil
900,000 l

Retailing Division
(Revenue)
Refining
Division (cost)
 Responsibility Centres.
1. Cost or Expense Centres
– The center for incurring only expense (cost) items.
– The accounting system records only the cost
incurred (inputs) and exclude revenues outputs)
– The performance of managers are measured in
terms of expenses/costs
– The center is responsible for minimizing costs
– Managers are held responsible only for specified
expense items
– The comparison (variance) between budgeted or
standard costs with actual costs variance would be
an indicator of the efficiency of the division.
 Responsibility Centres.
2.Revenue Centres
– In Revenue Centres, managers are held accountable only
for financial output in the form of generating revenue;
that is managers are held responsible for revenues (sales).
– Managers are evaluated solely on the basis of sales
revenue.
– There is a danger that managers responsible for revenue
may concentrate on maximizing sales at the expense of
profit.
– Managers can increase volume of sales by promoting low-
profit products through lowering selling price.
– Managers of such centres may also be responsible for
controlling selling expenses such as salesperson salaries,
 Responsibility Centres.
3.Profit Centres
– Profit centre is a centre in which both the inputs and
outputs are measured in monetary terms.
– Both costs and revenues of the centre are accounted for.
– Financial measures of the outputs and of inputs enable
profit analysis that can be used as a base for evaluating
the performance of divisional manager.
– The performance of the managers is measured by profit.
– The problem with profit centers may relate to the
measure of certain type of expenses which have to be
involved in the computation of profit centres.
• There are different opinions relating to the treatment
of those types of expenses which are not traceable or
attributable.
 Responsibility Centres.
Profit Centres...
• While evaluating Profit Centres, the Goal is to
maximize profit for the division
• Performance can be evaluated in terms of
profitability
• A variety of methods are used to evaluate
profitability
– Current income compared to budgeted income
– Current income compared to past income
– Comparison with other profit centres, called relative
performance evaluation
 Responsibility Centres.
4. Investment Centres
– Investment Centres are responsibility centres whose
managers are responsible for both sales revenue, costs,
and profit
– Managers also have responsibility and autonomy to
influence working capital and capital investment decisions.
– Investment centres represent the highest level of
managerial autonomy and they include company as a
whole, operating subsidiaries, operating groups and
divisions.
– It is a centre in which assets employed are measured. In
the investment centre, inputs are accounted for in terms
of costs and outputs are accounted for in terms of
revenues and assets employed in terms of values.
 Responsibility Centres.

Investment Centres…
• Investment centre is the broadest center, its performance
is measured not only in terms of profits but also in terms
of assets employed to generate profits.
• An investment centre differs from a profit centre in that
investment centre is evaluated on the basis of the rate
of return earned on the assets invested while a profit
centre is evaluated on the basis of excess revenue over
expenses for the period.
• Common Investment Centre Performance Measures
– Return on Investment
– Residual Income
– Economic Value Added
 Responsibility Centres.
4. Investment Centres..
The most popular approach for evaluating the performance of such a centre
are:
ROI (return on investment (ROI) and residual income (RI):
ROI measures the net operating income generated per dollar of investment in
operating assets
ROI = Margin  Turnover

ROI = Net operating income x Sales

Sales Average Assets
Example 1: ROI of Cool Company
Cool Company reports the following:
Net operating income TZS 30,000,000
Average operating assets TZS 200,000,000
Sales TZS 500,000,000
Operating expenses TZS 470,000,000
What is Cool Company’s ROI?
 Alternative definitions of investment

• Total Assets Available- all assets

• Total Assets Employed-total assets
available less any idle assets or assets
purchased for expansion in the future
• Total Assets Employed minus Current
Liabilities
• Common approach is Total assets less non-
interest-bearing current liabilities
• Stockholders’ Equity – But, is it gross or
net?
 Responsibility Centres
• There are number of ways income can be
determined
– Net income after tax
– Operating income
– Income before tax
• Most common one is net operating income after
tax
– To get this, add back non-operating items to net
income then adjust tax expense accordingly
• It is the operating profit before interest and tax
then less tax specific for this i.e. interest expense
and its saving implication are ignored
 Responsibility Centres
• Invested capital is typically based on historical
costs
– Fully depreciated assets lead to a low invested capital
number resulting in high ROI
– Makes comparison of investment centres using ROI
difficult
• May discourage Managers to purchase of new
equipment
– May result into underinvestment
– In contrast, using profit as a measure may result into
overinvestment because managers may be motivated
to make investments that earn a return that is less
than the cost of capital
 Responsibility Centres
Residual Income (RI): measures the net operating income
earned in excess of a required return on operating assets.
• RI = Net operating income – Required return on operating
assets
Example 2: RI of ABC Corporation:
One division of AB Corp. has average operating assets of TZS
200m. The required rate of return for the division is 20%.
The division has recently reported a net operating income
of TZS 50m.
Required
• Calculate the division’s residual income.
• Indicate whether AB Corp. should keep or discontinue the
division.
 Responsibility Centres
Residual Income…
Solution:
Required return on assets = 200x20% = 40m
• RI = TZS 50m – TZS 40m = TZS10m
• AB Corp should keep the division because is
has positive RI.
 Responsibility Centres
• EVA is residual income adjusted for accounting
distortions that arise from GAAP
• A performance measure approach to solving
overinvestment and underinvestment problems
• Advantage is that managers are less tempted to
cut those costs that distort income under GAAP
• For example, under GAAP research and
development costs are expensed, but these costs
benefits future periods
• Thus, under EVA research and development is
capitalized and amortized over future periods
 Responsibility Centres
• EVA is a specific type of residual income
calculation that has gained popularity
EVA=Conventional Divisional Profit+ Accounting
Adjustments - Cost of Capital Charge on Divisional
Assets
EVA = After-tax
Operating Income { Weighted-Average
Cost of Capital X( Total
Assets
Current
Liabilities )}
• Weighted-average cost of capital is the after-tax
average cost of all long-term funds in use
 Activity- Adopted from Horngren pg. 848
• Consider the following data for the two geographical divisions of
the BCBG Company that operates as profit centers:-
Atlantic Devision Pacific Division
Total Assets $ 1,000,000 $ 5,000,000
Current Liabilities 250,000 1,500,000
Operating Income 200,000 750,000
• Required:
i. Calculate the ROI for each division using operating income as a
measure of income and using total assets as a measure of
investments
ii. The company has used RI as a measure of management
performance, the variable the manager is required to maximise.
Using this criteria, which divisional manager has performed better
than the other if the required rate of return on investment is 12%?
 Activity- Adopted from Horngren pg. 848
iii) The company has two sources of funds, which are
the long term debt with market value of $ 3,500,000
and an interest rate of 10%, and equity capital with
market value of $ 3,500,000 at a cost of capital of
14%. Both divisions face similar risks, hence the
same weighted average cost of capital applies to all
of them. The corporate tax rate applicable to the
company is 40%. Calculate EVA for each division
iv. Which of the performance measures in i, ii and iii
above would you recommend to the company and
why?
 Steps Involved in Responsibility Accounting

Responsibility accounting is used as a control device. The

following steps are necessary to effect control through
the Responsibility Accounting:
1. The organization is divided into various responsibility
centres. Each responsibility centre is put under the
charge of a responsibility manager.
2. The targets or budgets of each responsibility centre are
set in consultation with the manager of responsibility
centre, so that the manager of responsibility center
should know as what is expected of him
3. Managers are charged over the items which they can
exercise a significant degree of direct control.
Steps Involved in Responsibility Accounting
….
4. Goals defined for each area of responsibility
should be attainable with efficient and
effective performance.
5. The actual performance is communicated to
the managers concerned.
6. The performance reports for each center
should be prepared highlighting the variances
and items requiring management's attention.
 Objectives of Responsibility Accounting
RA is a device to measure divisional manager’s
performance so that:
• To determine the contribution that a division as a
sub-unit makes to the total organization.
• To provide a basis for evaluating the quality of
the divisional managers performance.
• To motivate the divisional manager to operate in
a manner consistent with the basic goals of the
organization as a whole
 Significance of Responsibility Accounting

The significance of responsibility accounting to

management can be explained in the following ways:
• Easy Identification of manager’s performance: RA
enables the identification of individual managers
responsible for satisfactory or unsatisfactory
performance of a particular responsibility centre.
• Motivational Benefits: If a system of responsibility
accounting is implemented, considerable motivational
benefits are assured.
• Ready-hand Information: Relevant and up to date
information is made available which can be used to
estimate future costs and or revenues and to fix up
standards for departmental budgets
 Significance of Responsibility Accounting
• Planning and Decision Making: Responsibility
accounting helps not only in control but also in
planning and decision making too.
• Delegation and Control: The twin objectives of
management; delegating responsibility and control
can be achieved by adoption of responsibility
accounting system.
Principles of responsibility Accounting: The main
features of responsibility accounting are that it
collects and reports planned and actual accounting
information about the inputs and outputs of
responsibility accounting
 Problems with Responsibility Accounting
Difficulties in implementing responsibility accounting,
system
1. Classification of controllable and un-controllable
costs is difficulty
2. Inter-departmental Conflicts: Separate
departmental responsibilities may lead to inter-
departmental rivalry. Managers may act in the best
interests of their own, but not in the best interests of
the enterprise.
3. Delay in Reporting: Responsibility reports may be
delayed. Each responsibility centre can take its own
time in preparing reports.
Problems with Responsibility Accounting
4. Overloading of Information: Responsibility
accounting reports may be overloading with
all available information.
5. Complete Reliance may be deceptive:
Responsibility accounting can’t be relied
upon completely as a tool of management
control. It is a system just to direct the
attention of management to those areas of
performance which required further
investigation.
TRANSFER
PRICING
 OBJECTIVES

1. Explain the concept of decentralization and

transfer pricing
2. Apply transfer pricing in making decision
3. Calculate Transfer price using general rule of
transfer pricing and other approaches
4. Explain and discuss benefits and problems
of transfer pricing
 The Concept of Decentralization
• Decentralisation refers to a form of organisation
in which subunit managers are given authority to
make substantive decisions (make choice among
alternatives)
• An essential feature of decentralized firms is
responsibility centers (e.g., cost, profit, revenue,
or investment-centers)
 The Concept of Decentralization

• Advantages of Decentralisation:
– Utilisation of specialised knowledge and skills
of managers
– Relief of top management from day-to-day
activities
– Creates greater responsiveness to local needs
– Leads to gains from quicker decision making
– Increases motivation of subunit managers
– Sharpens the focus of subunit managers
– Assists management development and learning
 The Concept of Decentralization
• Disadvantages of decentralization
– Lack of goal congruence among managers in
different division of the organization
– Insufficient information available to top
management; increased costs of obtaining
detailed information.
– Lack of coordination among managers in
different divisions
Transfer Pricing and Decentralization
• Under decentralisation, one sub-unit can
produce a product or a service which then
transfer it to another sub-unit at a price
• The price at which the products or the services
are transferred is called transfer price.
Decentralization and Transfer pricing
Extractions
Division (Cost)

Crude oil
Profit
900,000 l

Retailing Division
(Revenue)
Refining
Division (cost)
 Transfer Pricing and Decentralization

What is transfer price

 Amount charged by one division selling goods/services to
another division
 The value assigned to the goods or services sold or rented
(transferred) from one unit of an organization to another
 Is the price at which products or services are transferred
between two divisions in an organization
Challenge of Decentralization:
 Difficult to achieve goal congruence among organizational
autonomous managers - one of the solution to this
challenge is establishment of transfer pricing
 When TP is needed?
• A transfer pricing policy is needed when
– An organization has been decentralized into
divisions and
– Inter-divisional trading of goods or services
occurs
• Transfers between divisions must be recorded in
monetary terms as revenue for selling division
and costs for buying division
• Transfer price bring no effect on profitability of
the whole firm, but have a large effect on the
behaviour of divisional managers.
 Purposes of Transfer pricing

• Help coordinate production, sales and pricing

decisions of the different divisions (via an
appropriate choice of transfer prices). This
motivates divisional managers to make good
economic decisions
• To encourage goal congruence among division
managers
• Generate separate profit figures for each division
and thereby evaluate managerial and economic
performance of each division.
 Purposes of Transfer pricing
• TP makes managers aware of the value that
goods and services have for other segments of
the company.
• To intentionally move or reallocate profits
between divisions for taxation relief
• The transfer price will affect not only the
reported profit of each division, but will also
affect the allocation of organization’s resources
• To ensure that divisional autonomy is not
undermined.
 General Rule of Transfer Pricing

• Top management objective in setting TP is to encourage goal

congruence among division managers
• As a general rule, TP is set using economic rules as given
below
– The minimum transfer price is that which covers the marginal
(variable) cost plus the opportunity cost of making the
goods/services to be transferred
• Min. TP = (Variable cost + opportunity cost)
• Transfer price ≥ marginal cost of transferring division + any lost
contribution
– (Min. PT is fixed by selling division)
– The Maximum transfer price acceptable to selling division would
be lower of the external market price and the net marginal
revenue to the buying division
• Transfer price ≤ the lower of net marginal revenue of transfer-in division
and the external purchase price
 General Rule of Transfer Pricing
• Criteria for determining TP include:
– TP should help in accurate valuation of divisional
performance
– TP should motivate divisional managers to maximize
profitability of their division and the company
– TP should ensure preservation of divisional manger
authority and autonomy
– TP should allow goal congruence to take place
– TP should ensure minimum tax burden
• General rule of TP distinguishes two scenarios that an
organization can have:
– Absence of excess capacity
– Presence of excess capacity
 General Rule of Transfer Pricing
• Generally, if there is a perfectly
competitive external market for the
intermediate product, the market price is
the optimal transfer price.
• But, if there is no market for the
intermediate product, transfers should be
made at the variable cost per unit of
output of the intermediate product.
 ACTIVITY 6.1
• Division BQ requires some components for its
electronic games console. Division BP has some
spare capacity and could make the components
for a variable cost of TZS 60,000 each
– Required
a) Calculate the minimum TP acceptable to the Div. BP
(Sell division)
b) State what will happen if Div. BQ (buy division) buy
externally the product for TZS 55,000
c) Conclude whether the action of Div. BQ in part b)
leads to goal congruence
 Activity 1 - Solution
a) Minimum TP acceptable to the Div. BQ
• TP = (Variable cost + opportunity cost)
• TP = TZS 60,000 + 0 = TZS 60,000
• Opportunity cost is zero because the selling division
have spare capacity to produce
b) If Div. BP buys externally for TZS 55,000; there
will be no transfer taking place
c) Both divisions are acting to the best interest of
the over all company. Division BQ is saving the
company TZS 5,000 per component, since the
cost of making the component is TZS 60,000
 Activity 6.2
• Red division makes product Y and Z, the maximum capacity
of the factory is 5,000 units per month in total. This capacity
can be used to make either 5000 units of Y or 2500 units of Z
or any combination of the two.
Details Y in TZS Z in TZS
Selling Price 12,000 16,000
Variable Costs 10,000 13,000
Time used to produce a unit of 20min. 40min
Contribution 2,000 3,000
REQUIRED
a) Determine which product would Red division make
b) Blue division has asked Red division to supply product Y. Determine the
minimum TP to be accepted by Red division
c) Blue division now informed red division that it can buy product Y from
external at TZS 11,000 unit, and is not prepared to accept price above this.
Explain what would happen if the divisions have full autonomy. Comment
whether this will benefit the company
a) The Red division will make product Y as its
contribution margin per limited resources is
higher this will lead to maximum profit TZS
See workings below
Details Y Z
Time used to produce a unit 20min 40min
Contribution Margin 2,000 3,000
Contribution margin per minutes 100 75
Ranking 1 2
 Activity 2 - Solution
a) The minimum TP acceptable to Red Division will
be
Min. TP = (Variable cost + opportunity cost)
Min. TP = TZS 10,000 + 2,000 = TZS 12,000
b) Red division would refuse to sell for less than TZS
12,000 (min. PT). So Blue will buy from external
c) Both divisions are acting for the good of the
company
d) By buying from external for TZS 11,000, Blue is
saving the company TZS 1,000 per unit
 Transfer Pricing Approaches
• A transfer pricing policy defines rules for
calculating the transfer price.
• In addition, a transfer price policy has to specify
sourcing rules (i.e., either mandate internal
transactions or allow divisions discretion in
choosing whether to buy/sell externally).
• The most common transfer pricing methods
– Market-based transfer pricing (MTP),
– cost-based transfer pricing (CTP), and
– negotiated transfer pricing (NTP)
 Transfer Pricing Approaches - MTP
• When the outside market for a product or a
service is well-defined, competitive, and stable,
firms often use the market price as an upper
bound for the transfer price.
• MTP is based on the listed price of an identical
or similar products or services.
• MTP equal to the price in the external market
 MTP
• Question: How would you argue that market price is the
"correct" TP if the external market is perfectly competitive?
TIPS
– Advantages
• MTP allows divisional performance to represent real
economic contribution of a division on the overall
performance of the firm.
• MTP allows divisional performance be compared with
that of external firms operating in similar business
• It is a simple and easily understood method
• Minimises the complications for performance evaluation
• Reduces point of conflict between various divisions
• Usually are consistent with the environment outside the
organisation (market)
 Market Transfer Pricing
Drilling Division
Fixed Costs $100,000
Variable costs $30,000
Produce 900,000 litres of crude
Market price $150,000 Sales $850,000
Fixed Costs 215,000
Crude oil Variable Costs 140,000
900,000 l Profit 495,000

Refining Division
Fixed Costs $70,000
Variable costs $70,000
Produce 850,000 litres of petrol
Market price = $250,000
Retailing Division
Fixed Costs $45,000
Variable costs $40,000
Sell 850,000 litres of petrol @ $1 a
litre
The table below indicate, how the divisions of the Shell
company can be evaluated (figures in $)
Remember that TP DO NOT affect the overall profit of the
firm, but affects Divisional Profits
DD RFD RTD SHELL COY
Sales 150,000 250,000 850,000 850,000
Variable (30,000) (70,000) (40,000) (140,000)
Transfer (150,000) (250,000) -
Cont. Margin 120,000 30,000 660,000 710,000
Fixed (100,000) (70,000) (45,000) (215,000)
Profit 20,000 (40,000) 515,000 495,000

TASK: Choose any Market Transfer Price and evaluated

performance of The divisions and the whole company.
Comment on the reactions of division managers on the
“new” TP as compared to the “old”
 Transfer Pricing Approaches - MTP
• Question: How would you argue that market
price is “not correct" TP if the external market is
not perfectly competitive? TIPS (disadvantages)
– Under certain conditions, there may be deviations from
market-based TP.
– Some causes for the deviation are as follows
• Where the products involved are highly specialised.
Market-price determination is difficult
• Where it is necessary to take advantage of economies.
• When it is necessary to shift resources from low priority
to high priority division
• When considerations of tax advantages are important
 Transfer Pricing Approaches - NTP
• When, a firm does not specify rules for the
determination of transfer prices. Divisional
managers are encouraged to negotiate a
mutually agreeable transfer price.
• Division managers actually negotiate the price
at which transfers will be made
• Question for discussion:
– What do you perceive to be the major
advantages/disadvantages of negotiated transfer
pricing?
 Transfer Pricing Approaches - NTP
• Question for discussion – some solutions:
– What do you perceive to be the major
advantages/disadvantages of negotiated
transfer pricing?
• Advantages of NTP
– Such price avoids mistrust, conflicts, and
undesirable bargaining interest among divisional
managers
– It provides opportunities for goal congruence,
autonomy and accurate performance evaluation
 Transfer Pricing Approaches - NTP
• NTP may have some limitations as follows
– Great deal of management effort, time, and resources
maybe consumed
– Such a price may also depend upon the skill and
ability of managers concerned
– NTP may lead to divisiveness and competition
between divisional managers
– One division manager may take advantage of having
some private information which the other managers
may not possess as a result, the negotiated price may
not be accurate
 Transfer Pricing Approaches - CTP
• In the absence of an established market price many
companies base the transfer price on the production
cost of the supplying division. The most common
methods are:
– Full cost: TP is equal to product’s variable cot plus an
allocated portion of fixed cost. When TP is made at full
cost, the buying division takes all the gains from trade
while the supplying division receives none.
– Variable Cost plus: To overcome the problem of full cost
the supplying division is frequently allowed to add a
mark-up in order to make a “reasonable” profit.
– The transfer price may then be viewed as an
approximate market price.
 Cost-based Transfer Pricing
Drilling Division
Fixed Costs $100,000
Variable costs $30,000
Produce 900,000 litres of crude
Sales $850,000
Full Cost TP $130,000 Fixed Costs 215,000
Variable Costs 140,000
Crude oil Profit 495,000
900,000 l

Retailing Division
Fixed Costs $45,000
Variable costs $40,000
Sell 850,000 litres of petrol @ $1 a litre
Refining Division
Fixed Costs $70,000
Variable costs $70,000
Produce 850,000 litres of petrol
Full cost TP = $270,000
The table below indicate, how the divisions of the Shell
company can be evaluated using CTP (Full Cost TP)
DD RFD RTD SHELL COY
Sales 130,000 270,000 850,000 850,000
Variable (30,000) (70,000) (40,000) (140,000)
Transfer (130,000) (270,000) -
Cont. Margin 100,000 70,000 540,000 710,000
Fixed (100,000) (70,000) (45,000) (215,000)
Profit 0 0 495,000 495,000

TASK: Determine Cost plus Transfer Price for Shell Company

and evaluated performance of the divisions and the
company.
Comment on possible conflicting interests of divisional
managers on the CTP as compared to the MTP discussed above
 International Transfer Pricing

• Multinational companies (MNC) may operate in

countries with different tax rates, import duties,
interest rates, currencies etc
• It is common for MNC to minimize profits of
divisions in high-tax rate countries and maximize
profit of divisions in low-tax countries:
• Applied Practices
– Use High transfer price if buyer division is in a higher-
tax country than the seller division
– Use low TP if the seller division is in higher tax rate
country than the buyer.
– See example below
 QUESTION
You are the Manager of NST Oil and Gas Company that operates in three countries
with three main divisions as indicated in the table. The CEO of the company
requested your skills to ensure the company pays as small tax as possible. The TP
policy of the company is to use negotiated price of $ 200 per unit and or market
price $350 per unit. TP of refined oil are $ 400 and $ 550 negotiated and market
price per unit respectively. 1,000 units is the full capacity in every division. How do
you advice the CEO of NST to ensure less tax is paid?
Division Country ($ ‘000’) Tax Rate
Drilling and Extraction Norway: 60%
Variable costs: 80
Fixed cost: 60
Refinery Scotland 30%
Variable costs: 100
Fixed cost: 70
Retail Tanzania 40%
Sales external mkt 1,200
Variable costs: 5
Fixed cost: 20
Basing on the rules (see slide 30), which require to use high transfer
price if buyer division is in a higher-tax country than the seller division
otherwise the opposite is true.
NORWAY SCOTLAND TANZANIA NOSCTA PLC.
Sales $200,000 $550,000 1,200,000 1,200,000
Variable (80,000) (100,000) (5,000) 185,000
Transfer (200,000) (550,000)
Cont. Margin 120,000 250,000 645,000 1,015,000
Fixed (60,000) (70,000) (20,000) (150,000)
PBT 60,000 180,000 625,000 865,000
TAX 60% = (36,000) 30% =(54,000) 40%=(250,000) 39%=(340,000)
PAT 24,000 126,000 375,000 525,000

TASK:
Use the other alternatives and determine which of them lead to lower
tax.
 International Transfer Pricing
• Problems with International TP arise:
– Where corporations are divisionalised and there
responsibility centres operate as strategic business units
– Where subsidiaries spread throughout countries that have
varying tax rates. It is common for multinational
corporations to attempt to minimise their tax liabilities by
shifting profits from higher tax countries to lower tax
regimes
– Generally TP is seen by most government as a way for tax
evade
• To avoid these problems countries/government do establish
regulations to deal with TP problems
• In Tanzania Income Tax Act has been used to deal with the
problems (see section 33 of Income Tax Act)
 Dealing with International TP: Tanzania
• On 7 February 2014 the Tanzania Government
published The Income Tax (Transfer Pricing)
Regulations under the Income Tax Act through
Government Notice No. 27.
• The Act, requires that the TP should be
consistent with the arm’s length principle
 International Transfer Pricing: Tanzania

• To comply with arm’s length principle, the

Income tax (transfer price) regulations, 2014
specify the following TP methods
– Comparable Uncontrolled Price (CUP) method
– Resale price method
– Cost plus method
– Profit split method
– Any other method prescribed by the
commissioner.
 International Transfer Pricing: Tanzania
• CUP: method compares the price charged for
products or services transferred in uncontrolled
transaction to the price charged for products or
services transferred in a comparable circumstances-
Arm’s Length Principle
• The Resale Price Method: The resale price method
begins with the price at which a product that has
been purchased from an associated enterprise is
resold to an independent enterprise. “Resale price
margin”,
• The Cost Plus Method: begins with the costs incurred
by the supplier of products or services then add an
appropriate mark-up.
 International Transfer Pricing: Tanzania
• Transaction Net Margin Method: examines a net
profit indicator, i.e. a ratio of net profit relative to
an appropriate base (e.g. costs, sales, assets).
• Profit Split Method: first identifies the combined
profits to be split for the associated enterprises
from the controlled transactions in which the
associated enterprises are engaged. then splits
the combined profits between the associated
enterprises on an economically valid basis
 Ways of Resolving Transfer Pricing Conflicts

• Despite the methods and approaches used in

determining transfer prices so as to prevent
dispute - conflicts are still common.
• The resolution of such conflicts can be considered
under two main approaches
– proactive and
– reactive approach
 Resolving Transfer Pricing Conflicts: Proactive Measures

• Advance Pricing Agreements (APA):

– the MNC will propose and negotiate with the
authorities the procedure it would use in determining
its transfer prices
• Simultaneous Examination Procedure (SEP):
– is a simultaneous process of conducting a tax audit of
the accounts of a MNC by two or more tax authorities
legally authorized to carry out such examination. After
the conclusion of the independent audits, notes are
then exchanged and compared by the different tax
authorities.
– The agreed outcome is then used to prepare efficient,
effective and satisfactory transfer prices
 Resolving Transfer Pricing Conflicts: Proactive Measures
• Proper Documentation:
– Documentation is one of the most important issues in the
conflict resolution process.
– Failure to maintain a proper and concise documentation policy
according to the arm’s length or other agreed standard will
expose a MNC to the risk of transfer pricing non-compliance
and penalties.
• Maintaining proper Transfer Pricing Policies and Risk Assessment:
– Proper transfer pricing policy and risk assessment is a must for
every MNC which must take care in determining which
jurisdiction and transaction exposes it to unbearable high risks.
– The risk assessment would then be used to develop proper
documentation policies which are consistent with the transfer
pricing methods adopted in such jurisdiction
 Resolving Transfer Pricing Conflicts: Reactive Measures
• Arbitration/negotiation:
– This dispute resolution mechanism is fast gaining
recognition as a way of settling bi-lateral and
multilateral tax disputes.
– A good example is the European Union Arbitration
Convention which provides that whenever the
competent authorities of the two countries fail to
reach an agreement to eliminate double taxation
arising out of transfer pricing within two years, same
shall be referred to an advisory commission.
• Litigation: legal action as a means of dispute settlement
has been the traditional approach of resolving tax
disputes
4
 Review Question one
• Private Systems Company’s Microprocessor Division sells
computer module to the company’s Guidance Assembly
Division which assembles completed guidance systems. The
microprocessor division has no excess capacity. The
computer module costs TZS 1,000,000 to manufacture, and
it can be sold to external market at TZS 1,350,000.
a) Compute the transfer price for the computer module using the
general transfer price rule
b) Assume that the two division negotiated transfer price to be
1,400,000 per computer module and the microprocessor
division’s production capacity is limited to produce 200
computer modules. The external market demand is limited to
150 units while the internal market require 200 units. Discuss
what the Microprocessor Division manager is likely to do to
maximize profitability of the Private Systems Company.
 Review Question Two
• Explain the economic consequences of
multinational transfer prices.

• Discuss current practices used in Tanzania

to deal with profit repatriation in
multinational companies trough transfer
prices
– Consider applicable laws and practices while outlining
examples.