Theory of Constraints by jolinmilioncherie


									ACCY 122 – Fall 2010             Transfer Pricing and Cost Allocation
Transfer pricing refers to the pricing of goods and services within a multi-divisional organization,
particularly in regard to cross-border transactions. For example, goods from the production division may
be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary,
with the choice of the transfer price affecting the division of the total profit among the parts of the
company as well as the company’s total profit.
Responsibility Accounting
       Domain                  Decision Rights         Performance Measures          Typically Used When
     Cost Center

   Revenue Center

     Profit Center

  Investment Center

Transfer Pricing Issues
   1. International Tax Issues
IRS Accepts Settlement Offer in Largest Transfer Pricing Dispute - September, 2006
Under the settlement agreement, GSK will pay the Internal Revenue Service approximately $3.4 billion,
and will abandon its claim seeking a refund of $1.8 billion in overpaid income taxes, as part of an
agreement to resolve the parties' long-running transfer pricing dispute for the tax years 1989 through
The agreement between GSK and the IRS brings to a conclusion a dispute dating back to the 1980s and
involves adjustments to GSK's tax years from 1989 through 2000. The Tax Court case concerns "transfer
pricing," an accounting method requiring that related parties engage in transactions at arm's length to
ensure the proper reporting of taxable income.
The Tax Court dispute for years 1989-2000 involves intercompany transactions between GSK and certain
of its foreign affiliates relating to various GSK "heritage" pharmaceutical products. Specifically at issue is
the level of U.S. profits reported by GSK after making intercompany payments that took into account:
        product intangibles developed by and trademarks owned by its U.K. parent,
        and other activities outside the U.S.,
        and the value of GSK's marketing and other contributions in the U.S.
GSK's $3.4 billion payment to the IRS (which includes interest) is the largest single payment made to the
IRS to resolve a tax dispute, bringing the company current with respect to its transfer pricing of the
"heritage" products through 2005.
IRS Chief Counsel Donald Korb praised the extraordinary efforts of the Manhattan-based trial team
handling the case in bringing about such an outstanding result for the Government. "I am often asked the
question," Mr. Korb said, "whether the Chief Counsel lawyers are being constantly outgunned by the
large law firms they face in the big dollar cases in the Tax Court. During my tenure as Chief Counsel it
has become quite evident to me that our lawyers can go up against the best firms the private tax bar has to
offer in the Tax Court and achieve quite successful results."
“We have consistently said that transfer pricing is one of the most significant challenges for us in the area
of corporate tax administration,” said Mark W. Everson
This settlement exemplifies the IRS’s continuing commitment to resolve transfer pricing disputes through
responsible and innovative agreements that embody the arm's length standard for related-party
transactions — or through litigation when necessary.

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ACCY 122 – Fall 2010                   Transfer Pricing and Cost Allocation
"Transfer pricing that allocates an appropriate return to the U.S. affiliates of multinational groups is a key
focus for the IRS," said Mr. Korb. "
Our decision to accept GSK's settlement offer reflects our commitment to resolving transfer pricing
controversies without litigation, provided that our ultimate goal of compliance is not compromised.
    2. How Transfer Pricing is Organized
         a. Tax Methods:
              Tax Court
              APA – Advanced Pricing Agreements
         b. Common Accounting Methods:
              Market based
              Variable-costing
              Full-costing
              Negotiated agreements

So What Costs Are To Be Transferred and How Do We Allocate?
This is a cost allocation issue:
 Direct material and direct labor and in some cases direct overhead1 are traced to cost objects
 Other indirect costs are allocated
 Together cost tracing and cost allocation result in cost assignment to the cost object – often called the
    cost structure of the cost object:
   1. For economic decisions
   2. For motivation of managers, employers, and owners
   3. For cost reimbursement
   4. For measuring income and assets

Problem: how to allocate costs:
   1. Cause an effect
   2. Benefits received
   3. Fairness

 For example, say we have a license to use a design technology for a unit of the printer for HP and pay the patent holder
$0.25 per printer. This similar to direct material but is managed as an indirect purchase.

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ACCY 122 – Fall 2010              Transfer Pricing and Cost Allocation
   4. Ability to bear the costs

Methods – remember we are only allocating indirect costs:
    1. Full costing or absorption costing – both fixed and variable costs:
            a. ABC
            b. Direct allocation with indirect rates
            c. Direct allocation with allocation rates such as a step-down method
    2. Variable costing only using the above three methods.
    3. May or may not include all the costs in the value chain
    4. May or may not include all the costs in the product life cycle
    5. Additional complications with joint products and by-products
            a. Sales value
            b. Net-realizable value
            c. Go back to the “Cost Allocation” topic above
Problem with Corporate Overhead
    1. Visible amount both from the business and community
    2. Cost hierarchy method – a little arbitrary
            a. Enterprise related
            b. Market related
            c. Channel
            d. Customer
            e. Order
            f. Parts and services
    3. Cost include
            a. Pension and benefits administration
            b. Losses
            c. Corporate costs
            d. Advertising
            e. Financing costs
Problem – Step Down Method: Gotham University offers only high-tech graduate-level programs.
Gotham has two principal operating departments, Engineering and Computer Sciences, and two support
departments, Facility and Technology Maintenance and Enrollment Services. The base used to allocate
facility and technology maintenance is budgeted total maintenance hours. The base used to allocate
enrollment services is number of credit hours for a department. The Facility and Technology Maintenance
budget is $350,000, while the Enrollment Services budget is $950,000. The following chart summarizes
budgeted amounts and allocation-base amounts used by each department:

                                                        Services Provided: (Annually)
                                                        Computer             F&T        Enrollment
                           Budget       Engineering      Sciences        Maintenance     Service
                           $350,000        1,000          2,000             Zero          5,000
  Maintenance (in hours)
  Enrollment Service
                           $950,000       24,000         36,000             2,000         Zero
  (in credit hrs)

Required: Prepare a schedule which allocates service department costs using the step-down method
with the sequence of allocation based on the highest-percentage support concept. Compute the total
amount of support costs allocated to each of the two principal operating departments, Engineering
and Computer Sciences.

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