Transfer pricing is a methodology of deciding the price for some transactions which occurred between different divisions of an organization or between different entities which get controlled by the same entity.
The price which gets determined under this methodology is not totally based on the cost of the transaction rather it includes some profit elements also but normally it falls below the market price.In the present case P Company manufactures circuit boards and the applicable tax rate on that division L of the company is 30% and after manufacturing the circuit they get transferred to division H and its income tax rate is 40%.
Prepare a schedule to compute the taxable income and total taxes under full and variable cost transfer pricing methods using MS Excel, which will be shown as follows:
The result of above will be as follows:
Under full cost approach, the total cost of division L gets charged from division H as transfer price which eliminates the taxes of L division and put the whole burden of taxation on H which amounts to $230.
Under variable cost approach, the only variable cost of division L get charged from division H as transfer price which results in a refund of taxes of L division for $90 and the burden of taxation on H is $305 but the overall taxes amount to $215 only.
The resultant amount after reducing all expenses of the company weather direct or indirect for the period from all revenues is termed as net income.Cost and Expenses:
Cost is the amount expended to any particular product or amount related to any particular product. Whereas, expenses means cost incurred in order to earn income. Prepaid Expense and Outstanding Expense are its two types. It is shown on the debit side of profit and loss Account.
The points that shall be considered while discussing the topic of transfer pricing and the same are as follows:
The concept of transfer pricing is keen towards transferring the profits on one division of the company into another division but this concept affects the entire profit of the company as a whole because the units or goods that are sold during such transfer of profits is ignored.
The transfer price which is used for the transfer of goods from one unit to another is manipulated because the profit of transferring division is included in the transfer price hence the division which is buying those units tends to purchase lesser units because of the inflated price.3.
The transfer price which is used for transfer shall be computed by taking into consideration the opportunity costs of the products.
The costs of producing the products and selling them to another division will increase the costs because these costs include the profit margin of the transferring division and such thing happens due to the ignorance of opportunity costs.
In the company, if there is the availability of spare capacity i.e. the company has enough margin left for producing extra units then its normal capacity at the same vary cost then it shall transfer the units to other division at the variable costs.
Return on assets (ROA)
Return on assets is calculated as percentage of operating income earned on the total invested assets of company. Higher return on assets indicates higher profitability of company while lower return on assets indicates lower profitability.
Formula to calculate return on assets
a.In the given case profits would be operating profit before taxes and thus interest expense would be added back to the net income before taxes.
Calculate S's ROA last year as shown below
Thus, S's return on assets last year is
b.Calculate revised ROA of S after purchase of new complex as shown below
Thus, revised ROA is
The ROA after purchase of new complex is above before weighted average cost of capital of 15% however below the last year's ROA of 26.25% and thus managers of S would reject the purchase.c.Calculate ROA of only V's complex as shown below
Thus, ROA is 20.05%
This, ROA is higher than S's weighted average cost of capital of 15% shareholders would allow the acquisition as it is profitable for them.
d.The method used to compensate managers of S is not correct. This is because managers would then see the investment benefit from their point of view rather than from company's view. In part (b) even though the complex purchase is profitable it is rejected due to lower ROA. Management should therefore compensate based on residual income rather than ROa.
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