Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 19 Transfer Pricing

19-2 Transfer Price The amount charged when one division of an organization sells goods or services to another division. The exchange is internal and does not affect the organization’s total sales or profit. Battery Division Auto Division

19-3 Learning Objective 1

19-4 Impact of Transfer Pricing on Organizations If the divisions are evaluated on profitability, the transfer price can have an impact on the reported performance of each division. Battery Division Auto Division The higher the transfer price to the auto division, the... greater is the profit of the battery division.

19-5 Setting Transfer Prices The value placed on the goods being transferred between divisions should encourage the divisions to complete the transfers, if that is in the organization’s best interest – while allowing them toretain their autonomy The value placed on the goods being transferred between divisions should encourage the divisions to complete the transfers, if that is in the organization’s best interest – while allowing them to retain their autonomy.

19-6 Goal and Behavioral Congruence In a decentralized organization, the managers of profit centers and investment centers often have considerable autonomy in deciding whether to accept or reject orders and whether to buy from inside or outside the organization. The goal in setting the transfer price is to provide incentives for each division manager to act in the company’s best interests.

19-7 Learning Objective 2

19-8 General Transfer-Pricing Rule Transfer price Additional outlay cost per unit incurred because of the transfer Opportunity cost per unit to the organization because of the transfer =+

19-9 Setting Transfer Prices Let’s consider the following two conditions to show how they affect the setting of transfer prices. I.The company has no excess capacity. II.The company has excess capacity.

19-10 Scenario I: No Excess Capacity The Battery Division of Wills Company makes a standard 12-volt battery. The division is currently producing at its capacity of 300,000 batteries, and sells each battery to outside companies for $60. The company has no excess capacity. The Vehicle Division offers to purchase 100,000 batteries for $45 each. The Battery Division of Wills Company makes a standard 12-volt battery. The division is currently producing at its capacity of 300,000 batteries, and sells each battery to outside companies for $60. The company has no excess capacity. The Vehicle Division offers to purchase 100,000 batteries for $45 each.

19-11 Scenario I: No Excess Capacity Battery Division Battery Division Vehicle Division Vehicle Division Transfer price = Outlay cost + Opportunity cost $60=$40+$20

19-12 Scenario I: No Excess Capacity Battery Division Battery Division Vehicle Division Vehicle Division Transfer price = Outlay cost + Opportunity cost $60=$40+$20 will not The offer of $45 per battery by the Vehicle Division will not be accepted by the Battery Division.

19-13 Scenario II: Excess Capacity The Battery Division of Wills Company makes a standard 12- volt battery. The division is currently producing 200,000 batteries. Full capacity for the Division is 300,000 batteries. The Division currently sells all batteries to outside companies for $60 each. The Vehicle Division offers to purchase 100,000 batteries for $45 each. The Battery Division of Wills Company makes a standard 12- volt battery. The division is currently producing 200,000 batteries. Full capacity for the Division is 300,000 batteries. The Division currently sells all batteries to outside companies for $60 each. The Vehicle Division offers to purchase 100,000 batteries for $45 each. Transfer price = Outlay cost + Opportunity cost$40=$40+$0 will The offer of $45 per battery by the Vehicle Division will be accepted by the Battery Division. Each battery sold to the Vehicle Division will produce $5 in contribution to the Battery Division.

19-14 Difficulty in Implementing the General Rule 1.The general rule is often difficult or impossible to implement due to the difficulty of measuring opportunity costs. 2.Under imperfect competition, a single producer can affect the market price by varying the amount of product available in the market. 3.Transfer pricing can be quite complex when selling and buying divisions cannot sell and buy all they want in perfectly competitive markets. 1.The general rule is often difficult or impossible to implement due to the difficulty of measuring opportunity costs. 2.Under imperfect competition, a single producer can affect the market price by varying the amount of product available in the market. 3.Transfer pricing can be quite complex when selling and buying divisions cannot sell and buy all they want in perfectly competitive markets.

19-15 Learning Objective 3

19-16 Transfers Based on the External Market Price General rule when the producing division has no excess capacity and perfect competition prevails: Transfer price = Outlay cost + Opportunity cost (which is the market price)

19-17 Transfers Based on the External Market Price The producing division has excess capacity or the external market is imperfectly competitive option 1.If the transfer price is set at market price, the producing division should have the option to either produce goods for internal transfer or sell in the external market. required inside 2.The buying division should be required to purchase goods from inside its organization if the producing division’s goods meet the product specifications.

19-18 Transfers Based on the External Market Price Distress Market Prices Distress Market Prices Occasionally an industry experiences a period of significant excess capacity and extremely low prices. Producing division managers might prefer to move the division to a more profitable product line. Basing transfer prices on market prices can lead to decisions that are not in the best interests of the overall company.

19-19 Negotiated Transfer Prices In some companies, division managers negotiate the price at which transfers will be made. Negotiations can lead to divisiveness and competition between participating division managers. Although negotiating skill is a valuable managerial skill, it should not be the sole or dominant factor in evaluating a division.

19-20 Cost-Based Transfer Prices When a company does not use market prices or negotiated prices to determine transfer price, it usually turns to cost-based transfer-pricing. The cost-based transfer price may be based upon: 1.Unit-level cost 2.Absorption cost The cost-based transfer price may be based upon: 1.Unit-level cost 2.Absorption cost

19-21 Using Standard Unit-Level Cost When using this approach, the producing division is not allowed to show any contribution margin on the transferred products or services. Under such conditions, the producing division has no positive incentive to produce and transfer products or services efficiently. Some companies avoid these problems by setting the transfer price at standard unit-level cost plus a markup.

19-22 Using Absorption Cost Absorption cost is equal to the product’s unit-level cost plus an assigned portion of the higher-level costs (batch-level, product-line-level, customer- level, and facility-level costs. The Battery Division has unit-level costs of $40 and assigned higher- level costs of $3,600,000. The Division expects to produce 200,000 batteries during the period.

19-23 Dysfunctional Decision Making The Battery Division has excess capacity of 100,000 units and uses the absorption cost method to set a transfer price of $58 per battery. The Vehicles Division offers to purchase 100,000 batteries (the excess capacity) at a price of $55 per battery). Will the offer be accepted?

19-24 Dysfunctional Decision-Making It appears the offer will be rejected. (even though the transfer is a benefit to the company as a whole)

19-25 Standard versus Actual Costs Transfer prices should not be based on actual costs because such a practice would allow an inefficient producing division to pass its excess production costs on to the buying division via the transfer price.

19-26 Remedying Motivational Problems of Transfer Pricing Policies If the selling division stands to make very little profit on an exchange, the division manager has no motivation to accept the transfer. How to remedy this impasse for the good of the company? -- Consider treating the selling division as a cost center. -- Consider treating the selling division as a profit center for external sales and a cost center for internal transfers. -- Use these criteria when evaluating division performance.

19-27 Undermining Divisional Autonomy Top management may become swamped with pricing disputes causing division managers to lose autonomy. I just won’t pay $58 for that battery! You really don’t have any choice!

19-28 Undermining Divisional Autonomy Now, here is what the two of you are going to do. Top management may become swamped with pricing disputes causing division managers to lose autonomy.

19-29 Dual Transfer Prices A dual transfer-pricing system charges the buying division for the cost of the transferred product (however the cost might be determined) and credits the selling division with the cost plus some profit allowance.

19-30 Learning Objective 4

19-31 Multinational Transfer Pricing low-taxhigh- tax Since tax rates are different in different countries, companies have incentives to set transfer prices that will increase revenues in low-tax countries and increase costs in high- tax countries.

19-32 Multinational Transfer Pricing Country A imports materials from the company’s Country B facility. The tax rate in Country A is 70 percent and in Country B is 40 percent Country A (40% tax rate) Country B (70% tax rate)

19-33 Multinational Transfer Pricing Country A can use a transfer price of $3,000,000 or $10,000,000. Let’s see the impact of this pricing.

19-34 Learning Objective 5

19-35 Segment Reporting Companies engaged in different lines of business are required to report certain information about segments: oRevenue. oOperating profits or losses. oIdentifiable segment assets. oDepreciation and amortization. oCapital expenditures. oCertain specialized items.

19-36 Segment Reporting If a company has significant foreign operations, it must disclose... oRevenues. oOperating profits or losses. oIdentifiable assets by geographic region. For purposes of external financial reporting, the transfer prices for exchanges among a company’s segments should be market- based if possible.

19-37 Transfer Pricing in the Service Industry Service industry firms and nonprofit organizations use transfer pricing when services are transferred between responsibility centers.

19-38 End of Chapter 19