Explain advantages and disadvantages of two step transfer pricing and profit sharing methods
Transfer pricing
If two or more profit center is jointly responsible for product development manufacturing and marketing each should share in the revenue that is generated when the product is finally sold. The transfer price is not primarily an accounting tool; rather, it is a behavioral tool that motivates manager to make the right decisions. In particular the transfer price should be designed so that it accomplishes the following objective:It should provide each segment with the relevant information required to determine the optimum trade off between company cost and revenues. It should induce goal congruent decisions that is the system should be so designed that decision improve business unit to earn more profit. It should help measure the economic performance of the individual profit center.Two step pricing
First, a charge is made for each unit sold that is equal to the standard variable cost of production.Second a periodic charge is made for the buying unit. One or both of these components should include a profit margin.The two step pricing method correct this problem by transferring variable cost on a per unit basis, and transferring fixed cost and profit on a lump sum basis under this method the transfer price for product A would be 5$ for each unit that unit Y purchases plus $20000 per month for fixed cost. Plus $10000 per month for profit: if transfer of product A in a certain month are at the expected amount 5000 units then under the two step method unit y will pay the variable cost of $25000 plus $30000 for the fixed cost and profit a total of $55000 .this is the same amount as the amount it would pay unit x if the transfer price is less than 5000 units say 4000 units. Unit y would pay $50000 under the two step methods compared with the $44000 it would pay if the transfer price were $11 per unit. The difference is their transfer prices were for not using a portion of unit X capacity that it has reserved. Note that under two step method the company variable cost for product A is identifiable to unit Y variable cost for the product, and unit Y will make the correct short term marketing decisions. Unit Y also has information on upstream fixed costs and profit related to product A and it can use these data for long term decision.The fixed cost calculation in the two step pricing method is based on the capacity that is reserved for the production of product A that is sold to unit Y the investment represented by this capacity is allocated to product A. The return on investment that unit X earns on competitive product is calculated and multiplied by the investment assigned to the product.In the example we calculated the profit allowance as a fixed monthly amount. It would be appropriate under some circumstance to divide the investment into variable and fixed component. Then, a profit allowance based on a return on investment on variable assets would be added to the standard variable cost for each unit sold.
Profit sharing
If the two step pricing system just described is not feasible, a profit sharing system might be used to ensure congruence of business unit interest with company interest. This system operates somewhat as follows.1.The product is transferred to the marketing unit at standard variable cost.2.After the product is sold, the business units share the contribution earned which is selling price minus the variable manufacturing and marketing costs.
This method of pricing may be appropriate if the demand for the manufactured product is not steady enough to warrant the permanent assignment of facilities as in the two step method. In general, this method accomplished the purpose of making the marketing unit’s interest congruent with the companies. There are several practical problems in implementing such profit sharing system. First,there can be arguments over the way contribution is divided between the two profit centers. Which is costly, time consuming and work against basic reason for decentralization namely autonomy of the business units mangers. Second, arbitrarily divided up the profit between units does not give valid information on the profitability of each segment of the organization.Third since the contribution is not allocated until after the sale has been made the manufacturing units contribution depends upon the marketing unit’s ability to sell and on the actual selling price.Manufacturing units may perceive this situation to be unfair.
Two set of price
In this method, the manufacturing unit’s revenue is credited at the outside sales price, and the buying unit is charged the total standard costs. The difference is changed to a headquarter account and eliminated when the business unit statement are consolidated, this transfer pricing method is sometimes used when there are frequent conflict between the buying and selling units that cannot be resolved by one of the other method both the buying and selling.
There are several disadvantages to the system of having two set of transaction prices,however
the sum of the business unit profit is greater than overall company profits, senior management must be aware of this situation in approved budget for the business units and in subsequent evaluation of performance against these budget. Also, this system create an illusion feeling that business units are making money while in fact the overall company might be losing after taking account of the debits to headquarter. Further this system might motivate business unit to concentrate more on internal transfers at the expense of outside sales.
The fact that the conflict between the business units would be lessened under this system could be viewed as a weakness.
Sometime, it is better for the headquarter to be aware of the conflict arising out of transfer prices because such conflict may signal problem in either the organizational structure or In other management systems. Under the two sets of prices method these conflicts are smoothed over thereby not alerting senior management to these problems.