Question
Section B
This section of the exam contains two questions.
Each question is worth25 marksand is compulsory.
This exam section is worth50 marks in total.

1. Company information
Vaa is a manufacturer of electronic consumer goods. It is made up of two divisions, R division and S division, and a head office which provides the overall management of Vaa. Both the divisions and head office are based in Essland, where they manufacture all goods and where there is currently an economic recession. The corporation tax rate in Essland is 25%.
A large proportion of the electronic goods（电子产品）manufactured by R division use a key component which R division transfers in from S division. There are several companies throughout the world who manufacture a component which fulfils the same function as the component produced by S division. The component produced by S division, however, has much lower energy consumption（低能耗）than those of its competitors.
Both R and S divisions are profit centres. Both have the autonomy to be able to negotiate the price at which the key component is transferred between the two divisions and to be able to choose whether to purchase or sell the key component externally.

2. Transfer pricing
Head office is concerned about the amount of time divisional managers spend arguing about a suitable transfer price, when their efforts would be better focused on other important areas of the business, such as finding ways to utilise spare capacity.
There is also concern from the head office that the divisions negotiate in a self-interested（自私自利的）way, so that head office often has to intervene and impose a transfer price which maximises the performance of Vaa as a whole. Head office is considering setting up a formal transfer pricing policy.
R division managers have proposed that the components be transferred at the market price in future, because they believe that R division should have a share of the cost savings which S division would make compared to if S division sold externally, such as administration costs and bad debts.
Head office understands the potential benefits of this approach but not the disadvantages.

3. International acquisition
Vaa is considering acquiring a subsidiary in the country of Teeland, which would be known as T division and would also be managed as a profit centre. Teeland is one of the largest producers of electronic consumer goods in the world and uses a different currency to Essland.
The Teeland government is concerned about the level of competition to local manufacturers from imported goods and is considering introducing a range of protectionist measures, for example, the introduction of import tariffs, to deal with this. The corporation tax rate in Teeland is 16%.
Vaa plans to use the key component manufactured by S division in T division’s products and has asked for advice on the factors which it should consider when setting international transfer prices, assuming the acquisition goes ahead.

Requirements (25 marks)
It is now 1 September 20X5.
(a) Advise Vaa on the criteria for designing a formal transfer pricing policy for its two divisions in Essland. (9 marks)
So, in summation, the best way to answer this part would have been to:
a) Identify and explain the main criteria in transfer pricing (probably four)
b) Assess individually why each of those criteria is desirable
c) Relate/apply each of those criteria to Vaa’s specific situation

2 (a) Criteria for the design of a transfer pricing policy
Divisional autonomy
A transfer pricing policy should allow divisional autonomy for managers to negotiate transfer prices. This ensures management is motivated to act in the best interest of their divisions. Both R and S divisions already have the autonomy to negotiate the price at which the key component is transferred between them and to choose from whom to purchase and to sell to in the external market.
Both divisions must want to transfer internally if this is to take place. There is no point, for example, in R trying to purchase the key component from S, if S does not want to sell to it.
Goal congruence
As profit centres, R and S divisions will seek to act in their own interests, which may not be in the interests of the other division, or of Vaa as a whole. This does seem to be the case, as Vaa head office often has to intervene in the negotiations between the divisions in order to impose a transfer price which maximises the performance of Vaa as a whole.
For this reason, the transfer pricing policy needs to allow head office to retain some control over the transfer price to ensure that the divisions are pursuing goals which are congruent to those of the organisation as a whole.

Divisional performance evaluation
As profit centres, R and S divisions’ performance will be measured according to divisional profits and managers will prioritise the profits of their own division. The transfer pricing policy should ensure that divisional managers see the transfer price as fair because the transfer prices will affect the profits of the divisions and hence the evaluation of their own performance.
Recently, R has only broken even, whereas S has made substantial profits. It has been suggested that this is due to high transfer prices charged by S. Though the basis on which the transfer price is negotiated is unknown, this suggests that S division may have the stronger negotiating position, perhaps because the component produced by S division has much lower energy consumption than those of its competitors. The current system may not be fair and therefore may not allow a meaningful evaluation of divisional performance.
The transfer price should allow each division to earn a fair return for the work it has done, otherwise managers will not be motivated to improve performance. For the same reason, the basis of determining the price should be clearly understood by divisional managers. The transfer pricing policy should allow transfer prices to be easily calculated and recorded to minimise the amount of time and resource spent doing this.

Profit maximisation of Vaa
There are concerns about the amount of time divisional managers spend arguing about a suitable transfer price. A transfer price policy should be designed so that less time is spent doing this and so that managers can focus on improving performance in other areas, such as finding ways to utilise spare capacity.
The transfer price should be set to maximise Vaa’s overall profits rather than the profits of the divisions themselves. The policy should set a transfer price which reflects the true cost to the organisation.

(b) Explain the disadvantages for Vaa of using market-based transfer prices. (8 marks)
So, in summation, the best way to answer this part would have been to:
a) Identify some of the main disadvantages of market-based transfer pricing
b) Express why the area identified is a disadvantage
c) Explain how that disadvantage would specifically affect Vaa’s situation
(b) Disadvantages of market-based transfer prices
Setting a market-based transfer price may be difficult because the market price may be only temporary. There is currently an economic recession in Essland, which may temporarily lower the demand for, and hence the price of, electronic consumer goods. These products will also be subject to rapid changes in technology. This may lead to falling market prices for components as they are superseded by newer versions.

There may be no equivalent product on which to set a market value price. There are other companies which manufacture a component which fulfils the same function as that produced by S division, so it appears that it would be possible to set a market value for this.
The key component produced by S division, however, has lower energy consumption than competitors’ products, and so in some sense may be unique. It is unclear how significant this energy saving is relative to that of the finished product, but the fact that it is in some degree unique, suggests that the price charged by S may be higher than the market price. The use of average market price of other components may be inappropriate, as this would put S at a disadvantage. This may be unfair and could reduce motivation in S division.
Market price may discourage divisions from utilising spare capacity in the selling division, for example, because the buying division can purchase more cheaply from the open market. There is said to be spare capacity in Vaa, but it is unclear in what division(s) or whether this has anything to do with the component’s transfer price.

If a market-based transfer price is used, this may increase the amount of any spare capacity in S as the price charged by S is likely to exceed the market price. This would encourage R to purchase from the external market. A market-based transfer price may not therefore maximise Vaa’s overall profit and so would be a disadvantage in using it.
In reality, any market-based transfer price is likely to be an adjusted market price. This is due to that fact that internal transfers do not incur as many costs to the selling division, such as administration and bad debt costs, as external transfers do. Establishing the extent of these costs may be complicated and time consuming and may need to change over time.
In the end, the adjusted market price would also have to be negotiated between the divisions. S division may need to share cost information with R division, so that the negotiation can be done on a fair basis, which it may be unwilling to do so. Given the difficulties the two divisions have in negotiating a transfer price, it seems likely head office would also have to intervene to impose an adjusted market price, which detracts from the benefits of using this basis.

(c) Advise Vaa on the factors it should consider when setting international transfer prices in relation to the potential acquisition in Teeland. (8 marks)
So, in summation, the best way to answer this part would have been to:
a) Identify the relevant factors
b) Explain why each factor is relevant
c) Advise as to how the individual factors are likely to affect Vaa (this is likely to be the longest section of the answer)

(c) Factors to consider when setting international transfer prices
Tax
The corporation tax rate in Teeland is lower than that in Essland. This gives Vaa the opportunity and incentive to minimise its overall tax liabilities by charging a low transfer price for the key component. This would increase profits in T division, where the tax rate is 16% and decrease profits in Essland where the tax rate is 25%.
Vaa should consider whether trying to minimise its tax liabilities in this way would be legal or ethical. Whatever transfer price is charged, the tax authorities in Essland and Teeland may tax Vaa as if the components transferred from S division to T division had been transferred between unrelated parties at an arm’s length price.
Import tariffs and anti-dumping legislation
Teeland is one of the largest producers of electronic consumer goods in the world. There may be many competitors there supplying the key component. In order to be competitive, Vaa may have to reduce the costs to T division by charging a lower transfer price.

However, the Teeland government is considering introducing a range of protectionist measures to protect local manufacturers from competition from imported electronic consumer goods. Import tariffs imposed on the value of imported components would increase Vaa’s costs. Vaa could consider charging a low transfer price to reduce this cost of the import tariff, again subject to legal and ethical considerations. The Teeland government may require all transfers to be at arm’s length value to try to protect local manufacturers by restricting companies from importing goods to Teeland.
If Vaa were to charge a lower transfer price to T division, the Teeland government may perceive this as unfair competition with local manufacturers and be more likely to use protectionist measures such as anti-dumping legislation.

Exchange rates
The transfer price of the components would vary over time according to the movements in exchange rate between the currencies in Essland and Teeland, which could make planning and budgeting more difficult. Exchange rate movements could also change the price of the component in the external market, which could affect each division’s decision to buy from or sell to the external market.
The transfer price would have to be adjusted to reflect exchange rate movements. Otherwise divisional managers could become de-motivated if their performance was evaluated based on factors outside of their control. This would make calculating and recording the transfer price more complex and may make it harder for managers to understand.

1. Company information
Breac is a sports clothing（运动装）goods company which operates globally（全球地）. It purchases sports clothing goods which have already been partly（部分地）manufactured, completes the manufacture of the goods and then sells these goods through its global retail outlets（零售店）. Breac’s mission（使命）is to be the best sports clothing goods company in the world. Breac has 25,000 employees and a turnover of $8 billion approximately. Each country of operation is classed（看作）as an individual strategic business unit (SBU).

2. Manufacturing agreement
Breac has agreed with Gowan, a large global manufacturing company, that Gowan will manufacture the major part of all sports clothing goods for Breac. Breac will then complete the manufacture of these clothing goods. This completion work includes Breac adding（添加）its own brand name, specialist climate cool（冷却）material and synthetic waterproof fabrics（防水布料）. Breac will then despatch（发送）the clothing goods to its retail outlets.
Breac’s manufacturing departments have highlighted（强调）that the clothing goods received from Gowan are often neither up to the required standard nor delivered on time. Problems have also been identified in both the retail outlets and by the end-user which have been attributed to（归因于）the poor quality of material supplied by Gowan. Specific（具体的）quality problems have included stitching（针脚）disintegrating（解体）, poor quality of material and clothing goods being incorrectly（错误地）sized（大小调整）.
Breac and Gowan each have their own individual information systems. Breac’s is an advanced computerised system whereas Gowan’s is more basic and parts of it are manual（手工的）. The two companies’ systems are unable to communicate with each other.
Breac’s staff at various levels in the organisation have suggested that a formal service level agreement (SLA)（服务水平协议）with Gowan is required if the agreement is to continue.