Basic Of Transfer Pricing And How It Works Research Assignment (Essay Sample)

Part B
Transfer Pricing and Performance in an Organization
Introduction
Transfer pricing is used by an organization when the price of the goods and services being provided by the company is controlled or connected between the different legal entities between which it is traded. This process takes place within the organization itself and as the goods and services are being sold within the organization, it is the responsibility of the company itself to be able to set the price at which the goods are traded. For example, when a good is sold by the subsidiary to its own parent company, the sale has to be booked on the accounts of the subsidiary and then the parent as well (Kaplan & Atkinson, 2015). The cost of goods at which the goods are sold to the parent are known as the transfer price and legal entities like a branch or department which is operating under the umbrella of the parent company is considered for transfer pricing.
Transfer pricing is used for profit allocation in order to attribute the profit earned from a sale to the subsidiary and allows the company to set the prices based on the divisions which exist under the parent company (Sikka & Willmott, 2010). The mechanism for setting the transfer pricing uses the arm’s length method where the price is one that a customer would pay to an independent supplier what they would get in the market or one an arm’s length customer would be willing to pay in the market.
Use of transfer pricing
Transfer pricing is primarily used in organizations of companies whose operations are divided into smaller departments or divisions which have a certain amount of autonomy over their functionality. Transfer pricing is used in accounting as there is a need to value the goods and services used by the company. There is a need to record all amounts and legitimate methods for calculation of value are needed to correctly represent the values involved (Perron et al., 2010). Fair value is one of the most basic measure of value where any good or service is measured based on what it would cost or would be sold for in the market which has a sufficient number of buyers and sellers.
Goods and services being traded between two divisions or departments within a company cannot be measured in terms of their value to one department or another but an accounting requirement is to book it as a sale for one division while it is considered a purchase for the other department. This is needed in order to present a true and fair picture of cost and sales of both departments and the company in the end. Transfer pricing is used for that purpose as it is the value at which division A is able to sale the good to the other division and allows associating a numerical value to the transaction being carried out.
Transfer price is able to allow both companies to determine their revenue and profitability in a more efficient and realistic manner. Accounting figures are mostly used for decision making by managers and these figures need to capture and encompass all the operations of a company. Without transfer pricing, the revenues and profitability of a division will not present the right picture and might distort the accounting figures (Zimmerman & Yahya-Zadeh, 2011). Based on the assumptions being used by the accountants or ones interpreting the financial information, accounting data might be used to present a disfigured picture of the company or its branches which need to be corrected before any sort of decisions are made on them.
Application of transfer pricing
Transfer pricing is always used when an organization is divided into multiple departments or divisions and there is a constant of flow of goods and services being traded between all the divisions. There is a need for the divisions to be able to report their sales and performance separately. The accounting system being used at the organization will look to make sure that the goods and services leaving their department are considered as being as the sales for their own department. In order to record them properly, they will need a monetary value for the transaction (Pfeiffer et al., 2011). This monetary value is negotiated between the two departments or can be determined by the head office of the company itself in order to allow the departments or the divisions to be able to report their earnings and profits.
Quantitative measurement of performance
Transfer pricing is key in order to determine the performance of the company. Once the revenue or profit has been determined, the success of the division can be determined in a much better manner. In the most basic manner, the company can look at the absolute and relative profit that the division is earning. This can be considered one of the most basic measures as it shows how much profit a division is earning and whether it is profitable to the company or not. This is a very robust measure to show profitability of a division but can be developed further (Grant, 2011; Lohse et al., 2012). The relative performance can be measured by looking at the return on investment (ROI) of the company itself. This is the amount of profit the division is able to earn based on the investment that has been made in that division. This allows the company to know based on their investment, how much has been earned by the division itself.
This can be used as comparable measure between the departments and lets the company determine if future profits can be expected based on the investment being carried out. In simple terms, it can be seen how much the company is able to get for each dollar it is spending. This can also show if the performance of a division was unsatisfactory for the company and whether the continuity of the division will be good for the company in the long run. Similarly, the residual value added by the project can be evaluated. Residual value is another measure which uses the context of profit being earned by the division above its cost of capital. Even though return on investment can be used as a measure to monitor the performance of the company, residual income is able to bring each division further into context by matching the profits to the cost of capital of the division itself (Cristea & Nguyen, 2014).
This shows whether the capital being employed by the company is earning enough profits and based on the capital mix at the company; the profitability is able to match compared to other departments. The last measurement of performance in terms of numerical values is economic value added. This last measure is able to see the profitability of the division above the required return of the shareholders. This is the most stringent measure as it able to see if the division is able to meet the needs and required return of the shareholders as well. Divisions which exceed this return will be considered the best performing in the company. These divisions can be used to balance out certain divisions which are not seen as being well performing but necessary for the company to maintain. These measures can be used to measure the performance of the company in numerical terms. By the use of transfer pricing, a division will be able to determine the revenue and profitability of the company which can then be used to evaluate the performance of the divisions individually (Drucker, 2010).
Qualitative measures of performance
In addition to the quantitative measures, there are also certain qualitative measures which can be used in order to measure the performance of the company. The decision to abandon or continue a division within the company uses transfer pricing in order to see how well the division is performing. For divisions which are proving to be a drain for the company, the company might decide to buy in those products from a third party rather than make them in house as it will prove to be cheaper...