Transfer Pricing

Managerial Accounting

David Fender

1. Cost plus …2. Willingness to pay…

Possible pricing strategies

1. Identifying and adhering to both short-run and long-run pricing strategies

2. Maximizing profits3. Maintaining or gaining market share4. Setting socially responsible prices5. Maintaining a minimum rate of return on

investment6. Being customer focused

Objectives for pricing policy

Economic Pricing Concepts

Economic approach to pricingBased on microeconomic theory

Marginal Cost = Marginal Return

Profit will be maximized when the difference between total revenue and total costs is the greatest

Example of economic pricing concept

Organization and flow of goods within a company

One consequence of having different organizational units of a large company is the need

to have transfer prices for goods

Transfer PricingTransfer Price – the price one subunit

(department or division) charges for a product or service supplied to another subunit of the same organization

Transfer prices are used to coordinate the actions of subunits and to evaluate their performance

© 2009 Pearson Prentice Hall. All rights reserved.

Why are transfer prices a hot issue? They effect profits of divisions

EARNINGS!!! Power Compensation Pride – prestige Quality of employees

They effect the decision what a company manufactures PROFITABILITY!!!

TAXES!!!

The optimal transfer price allowseach division manager to make

decisions that maximize thecompany’s profit, while

attempting to maximize his/herown division’s profit.

The optimal transfer price allowseach division manager to make

decisions that maximize thecompany’s profit, while

attempting to maximize his/herown division’s profit.

What rule should a company apply?

© 2009 Pearson Prentice Hall. All rights reserved.

Drum roll …

General Rule

When the selling division is operating at capacity, the transfer price should be set at the market price.

Scenario I: No Excess Capacity

General Rule

When the selling division is operating below capacity, the minimum transfer price is the

variable cost per unit.So, the transfer price will be no lower

than variable cost, and no higher than (outside) market price.

Scenario II: Excess Capacity

Example

The Battery Division makes a standard 12-volt battery.Production capacity 300,000 unitsSelling price per battery $40 (to outsiders)Variable costs per battery $18Fixed costs per battery $7 (at 300,000 units)

The Battery division is currently selling 300,000 batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model.

Scenario I: No Excess Capacity

What is the appropriate transfer price?

Transferprice

Additional outlaycost per unit

incurred becausegoods aretransferred

Opportunity costper unit to theorganizationbecause ofthe transfer

= +

Transferprice = $18 variable

cost per battery +$22 Contribution

lost if outsidesales given up

Transferprice = $40 per battery

Scenario I: No Excess Capacity

Scenario I: No Excess Capacity

$40transfer

price

Auto division canpurchase 100,000batteries from anoutside supplier

for less than $40.

Auto division canpurchase 100,000batteries from anoutside supplier

for more than $40.

Transferwill notoccur.

Transferwill

occur.

The Battery Division makes a standard 12-volt battery.Production capacity 300,000 unitsSelling price per battery $40 (to outsiders)Variable costs per battery $18Fixed costs per battery $7 (at 300,000 units)

The Battery division is currently selling 150,000 batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model. It can purchase them for $38 from an outside supplier.

Scenario II: Excess Capacity

What is the appropriate transfer price?

Transferprice

Additional outlaycost per unit

incurred becausegoods aretransferred

Opportunity costper unit to theorganizationbecause ofthe transfer

= +

Transferprice = $18 variable

cost per battery +

Transferprice = $18 per battery

Scenario II: Excess Capacity

$0

General Rule

When the selling division is operating below capacity, the minimum transfer price is the

variable cost per unit.

So, the transfer price will be no lowerthan $18, and no higher than $38.

Scenario II: Excess Capacity

Scenario II: Excess Capacity

Transferwill

occur.

$18transfer

price

$38transfer

price

Transferwill notoccur.

Transferwill notoccur.