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Transfer Pricing

Chapter 15

15-3

Learning ObjectivesLO 15-1 Explain the basic issues associated with transfer pricing.

LO 15-2 Explain the general transfer pricing rules and understand the underlying basis for them.

LO 15-3 Identify the behavioral issues and incentive effects of negotiated transfer prices, cost-based transfer prices, and market-based transfer.

LO 15-4 Explain the economic consequences of multinational transfer prices.

LO 15-5 Describe the role of transfer prices in segment reporting.

15-4

Transfer PricingLO 15-1 Explain the basic issues associated with transfer pricing.

Transfer Price The value or amount recorded in a firm’s accounting records when one business unit sells (transfers) a good or service to another business unit. The accounting records in the two units (responsibility centers) treat this transaction in exactly the same way as a sale to an outside customer.

Because the exchange takes place within the organization, however, the firm has considerable discretion in setting this transfer price.

LO 15-1

15-5

Transfer PricingLO

15-1

Because the managers of both the selling division and the buying division are evaluated on division profit, not company profit, they consider the effect of all sales, both internal and external, on their division, not company, profit.The optimal transfer price is the price that leads both division managers, each acting in his or her own self-interest, to make decisions that are in the firm’s best interest.

15-6

The SettingLO 15-2 Explain the general transfer pricing rules and

understand the underlying basis for them.

LO 15-2

15-7

The SettingPadre Papers

Cost and Production Data

LO 15-2

15-8

Determination ofOptimal Transfer Price

• Given the market prices and the costs in the firm,does firm profit increase?

• Given the transfer price, the intermediate marketprices, and the divisional costs, does the sellingdivision profit increase?

• Given the transfer price, the final market prices,and the divisional costs, does the buying divisionprofit increase?

LO 15-2

15-9

Padre Papers Example

Assume the following data for the wood division:

Capacity in unitsSelling price to outsideVariable price per unitFixed price per unit (based on capacity)

100,000$ 60$ 20$ 20

LO 15-2

15-10

Padre Papers ExampleLO

15-2

The Paper Division is currently purchasing 100,000 units from an outside supplier for $50, but would like to purchase units from the Wood Division.

The optimal transfer price in this case is clear: It is the only viable price, the intermediate market price. At any price lower than the intermediate market price, Wood Division will supply no output to Paper Division, and at any higher price, Paper will not purchase any wood from Wood.

15-11

Optimal Transfer PriceLO

15-2

Using the intermediate market price as the transfer price, the transfer price is set at $50. At these market prices, does Padre Papers (as a firm) want to sell paper? The company receives $120 for every unit sold. The total variable cost is $50 (= $20 Wood cost + $30 Paper cost). The firm wants to make the sale. Wood Division is indifferent between selling wood internally or on the intermediate market. Paper Division is indifferent between buying wood from Wood Division or the intermediate market. Therefore, the sale will be made and the source of wood to Paper Division does not affect firm profits.

15-12

Padre Papers ExampleTransfer

priceVariablecost (VC)

Lost contributionmargin (CM)= +

If the Wood Divisionhas idle capacity:

Transferprice $20 $0= +

If the Wood Divisionis working at capacity:

Transferprice $20 $40= +

LO 15-2

15-13

Optimal Transfer Price

Transferprice

Outlaycost

Opportunity cost of theresource at the point of transfer= +

LO 15-2

15-14

Optimal Transfer PriceTo restate the goal of each manager:

• Each division manager wants tomaximize his contribution margin.

• Each manager is indifferent aboutthe transfer price if it has no impact

on their contribution margin.

LO 15-2

15-15

Optimal Transfer Price:No Intermediate Market

• In this case, the only outlet for the Wood Division is the Paper Division and the only source of supply for the Paper Division is the Wood Division.

• The optimal transfer price is the outlay cost for producing the goods (generally the variable costs).

LO 15-2

Suppose that no intermediate market for wood exists or that, for whatever reason, the company has decided that it will not allow the divisions to buy or sell wood on the outside market.

15-16

Perfect IntermediateMarked-Quality Differences

Variable manufacturing cost (Wood Division) per unitVariable finishing cost (Paper Division) per unitOther data:

Final market (paper) priceIntermediate market (grade A wood) priceIntermediate market (grade B wood) price

$ 20$ 30

$120$ 60$ 50

LO 15-2

15-17

Quality Difference Example

Sales:$ 50 × 100,000 (transfer)$120 × 100,000 (transfer)Variable costs:$ 20 × 100,000$ 50 × 100,000 (transfer)$ 30 × 100,000 (processing)Fixed costsOperating profitTotal company operating profit

$5,000,000

$2,000,000

$2,000,000$1,000,000

$12,000,000

$ 5,000,000 3,000,000 4,000,000$ -0-

Wood Paper

$1,000,000

Grade B wood: $50 internal transfer price

LO 15-2

15-18

Quality Difference Example

Sales:$ 60 × 100,000 (transfer)$120 × 100,000 (transfer)Variable costs:$ 20 × 100,000$ 60 × 100,000 (transfer)$ 30 × 100,000 (processing)Fixed costsOperating profitTotal company operating profit

$6,000,000

$2,000,000

$2,000,000$2,000,000

$12,000,000

$ 6,000,000 3,000,000 4,000,000$ (1,000,000)

Wood Paper

$1,000,000

Grade A wood: $60 internal transfer price

LO 15-2

15-19

Managers’ Goals versus Firms’ Goals

LO 15-3 Identify the behavioral issues and incentive effects of negotiated transfer prices, cost-based transfer prices, and market-based transfer prices.

• Transfer price higher than market:Buying division will not buy

• Transfer price lower than market:Selling division will not sell

LO 15-3

15-20

Centrally EstablishedTransfer Price Policies

Market Price-BasedSets the transfer price at the market price orat a small discount from the market price

Cost-BasedOutlay cost to selling division plus forgonecontribution to company projects

Negotiated TransferManagers of the buying and sellingdivisions agree on a price

LO 15-3

15-21

Centrally EstablishedTransfer Price Policies

• Establishing a market price policy

• Establishing a cost-basis policy

LO 15-3

15-22

Alternative Cost MeasuresLO

15-3

Full Absorption Cost-Based TransfersAlthough the transfer pricing rule—differential outlay cost to the selling division plus the opportunity cost of making the internal transfer to the company—assumes that the company has a reliable estimate of differential or variable cost, this is not always the case. Consequently, manufacturing firms sometimes use full absorption cost as the transfer price.Cost-Plus TransfersWe also find companies using cost-plus transfer pricing based on either variable costs or full absorption costs. These methods generally apply a normal markup to costs as a surrogate for market prices when intermediate market prices are not available.Standard Costs or Actual CostsIf actual costs are used as the basis for the transfer, any variances or inefficiencies in the selling division are passed to the buying division. The problem of isolating the variances that have been transferred to the subsequent buying divisions becomes extremely complex. To promote responsibility in the selling division and to isolate variances within divisions, standard costs are generally used as a basis for transfer pricing in cost-based systems.

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Motivational Problems of Transfer Pricing

LO 15-3

A supplier whose transfers are almost all internal is usually organized as a cost center. The center manager is normally held responsible for costs, not revenues. Hence, the transfer price does not affect the manager’s performance measures.

In companies in which such a supplier is a profit center, the artificial nature of the transfer price should be considered when evaluating the results of that center’s operations.

15-24

Dual Transfer PricesLO

15-3

A dual transfer pricing system could be installed to provide the selling division with a profit but to charge the buying division only for costs. That is, the buyer could be charged the cost of the unit, however cost is determined, and the selling division could be credited for cost plus some profit allowance. The difference could be accounted for in a specialized centralized account.

15-25

Multinational Transfer PricingLO 15-4 Explain the economic consequences

of multinational transfer prices.

In international (or interstate) transactions, transfer prices can affect tax liabilities, royalties, and other payments because of different laws in different countries (or states or provinces). Because tax rates vary among countries, companies have incentives to set transfer prices that will increase revenues (and profits) in low-tax countries and increase costs (thereby reducing profits) in high-tax countries.

LO 15-4

15-26

Multinational Transfer PricingDiego Pharmaceuticals

Assume a $20,000,000 transfer price.

LO 15-4

15-27

Multinational Transfer PricingDiego Pharmaceuticals

Assume a $45,000,000 transfer price.

LO 15-4

15-28

Segment ReportingLO 15-5 Describe the role of transfer prices in segment reporting.

The Financial Accounting Standards Board (FASB) requires companies engaged in different lines of business to report certain information about segments that meet the FASB’s technical requirements. This reporting requirement is intended to provide a measure of performance for those segments that are significant to the company as a whole.

LO 15-5

15-29

Segment ReportingLO

15-5

The following are the principal items that must be disclosed about each segment:• Segment revenue, from both internal and external customers.• Interest revenue and expense.• Segment operating profit or loss.• Identifiable segment assets.• Depreciation and amortization.• Capital expenditures.• Certain specialized items.

15-30

End of Chapter 15