1. Transfer Pricing Chapter 15
We saw in Chapter 12 that a decentralized firm delegates decision-making authority to subordinates. With this delegation of authority comes the risk of managers making decisions based on their individual goals that can be sub-optimal for the organization as a whole. One example of dysfunctional decision-making occurs when business units or divisions within the organization buy goods and services from one another and each unit or division manager is evaluated on reported profits.
In this chapter we address this potential problem.
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Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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2. Transfer Pricing
L.O. 1 Explain the basic issues associated with transfer pricing.
Transfer price:
The value assigned to the goods or services sold or rented
(transferred) from one unit of an organization to another.
Treatment is the same as a sale to an outside customer.
– Revenue to the selling unit
– Cost to the buying unit
When business units or divisions within the organization buy goods and services from one another, the value or amount recorded in a firm’s accounting records as revenue to the selling unit and cost to the buying unit is called the transfer price. Although this is recorded as revenue to one unit and cost to another unit, both units are part of the organization and the transfer has no impact on the firm. Because the exchange takes place within the organization, the firm has considerable discretion in setting the transfer price. And, of course, the question is: What price is optimal?
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3. The Setting L.O. 2 Explain the general transfer pricing rules and
understand the underlying basis for them.
Padre Papers
Wood Division
Paper Division
Trees
Paper
Wood for
making paper
Let’s use Padre Papers to study transfer-pricing rules. Suppose Padre Papers has two divisions, the Wood Division that processes
trees and sells wood and the Paper Division that buys wood for manufacturing paper.
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4. Cost and Production Data
LO2
The Setting
Padre Papers
Cost and Production Data
Wood
Paper
Average units produced
Average units sold
Variable manufacturing cost per unit
Variable finishing cost per unit
Fixed divisional cost (unavoidable)
100,000 $
$2,000,000
100,000 $
$4,000,000
Here is the cost data for Padre Papers. The Wood Division produces 100,000 units that has a variable manufacturing cost of $20 per
unit and has fixed divisional costs of $2,000,000. The Paper Division sells 100,000 units that has a variable manufacturing cost of $30 per unit and has fixed divisional costs of $4,000,000. The Wood Division can sell wood to the Paper Division or on the outside market. The Paper Division can buy wood from the Wood Division or on the outside market.
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5. The Setting Padre Papers – Resources Flow Wood Division
(selling division)
Variable cost = $20
Fixed cost = $2,000,000
Paper Division
(buying division)
Variable wood cost = ?
Variable finishing cost = $30
Fixed cost = $4,000,000
Wood
Transfer
price
Market for wood
(intermediate market
Price = ?
Market for paper
(final market
Price = ?
Given the market prices and the costs in the firm, does firm profit increase if the transfer takes place? In determining the optimal transfer price, the important issue is the nature of the market for the good being transferred: in the case of Padre Papers, this is wood.
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6. Padre Papers Example Assume the following data for the wood division:
Capacity in units
Selling price to outside
Variable price per unit
Fixed price per unit (based on capacity)
100,000 $ $
Assume that the Wood Division has the capacity to produce 100,000 units and the units are sold to the outside market for $60 per unit. Recall, the variable cost per unit is $20 and fixed costs are $2,000,000. Producing 100,000 units results in a fixed cost per unit of $20.
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7. LO2
Padre Papers Example
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.
Also assume that the Paper Division is currently purchasing from the outside market 100,000 units for $50 per unit. So, the Wood Division sells the product for $60 per unit and the Paper Division buys the product for $50 per unit. What is the optimal transfer price? Of course, immediately you think, the Wood Division would be unwilling to sell to the Paper Division for less than $60 per unit. Additionally, the Paper Division would not want to pay any more than $50 per unit.
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8. is working at capacity:
LO2
Padre Papers Example
Transfer
price
Variable
cost (VC)
Lost contribution
margin (CM) = +
If the Wood Division
is working at capacity:
Transfer
price
$20
$40 = +
If the Wood Division
has idle capacity:
Transfer
price
$20 $0 = +
Let’s start with an assumption that the Wood Division is currently producing at full capacity, 100,000 units, and selling all 100,000 units for $60. Of course, the Wood Division will not give up sales at $60 a unit to sell for anything less than $60. Variable cost for the Wood Division is $20 per unit. Sales price of $60 minus variable cost of $20 leaves a contribution margin of $40. Wood will not sell for any less than the outlay cost of $20 per unit plus the opportunity cost of $40 per unit lost contribution margin. The minimum transfer price the Wood Division would be willing to sell to the Paper Division is $60. Now, assume there is idle capacity in the Wood Division. Idle capacity means the division is not selling 100,000 units even though the capacity exists to produce 100,000 units. Suppose the Wood Division isn’t selling any units. In that case, there is no lost contribution margin or opportunity cost and the minimum transfer price is the variable cost of $20 per unit. Remember, the $2,000,000 fixed costs is irrelevant. Wood Division will incur the fixed costs whether it sells to the Paper Division or not.
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9. Optimal Transfer Price
LO2
Optimal Transfer Price
There is 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).
If there is no intermediate market, the optimal transfer price is the outlay cost.
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10. Perfect Intermediate Marked-Quality Differences
LO2
Perfect Intermediate Marked-Quality Differences
Variable manufacturing cost (Wood Division) per unit
Variable finishing cost (Paper Division) per unit Other data:
Final market (paper) price
Intermediate market (grade A wood) price
Intermediate market (grade B wood) price
$ 20
$ 30
$120
$ 60
$ 50
The intermediate market for grade A wood is $60, and the intermediate market price for grade B wood is $50. What is the optimal market price?

11. Quality Difference Example
LO2
Quality Difference Example
Grade B wood: $50 internal transfer price
Alternative 1:
Sales:
$ 50 × 100,000 (transfer)
$120 × 100,000 (transfer)
Variable costs:
$ 20 × 100,000
$ 30 × 100,000 (processing)
Fixed costs
Operating profit
Total company operating profit
$5,000,000
$2,000,000
$1,000,000
$12,000,000
$ 5,000,000
3,000,000
4,000,000 $
Wood
Paper
At a sales price of $50, operating profit for Wood is $1,000,000 and $-0-for Paper. Again, net operating profit for Padre Papers is $1,000,000.

12. Quality Difference Example
LO2
Quality Difference Example
Grade A wood: $60 internal transfer price
Alternative 2:
Sales:
$ 60 × 100,000 (transfer)
$120 × 100,000 (transfer)
Variable costs:
$ 20 × 100,000
$ 30 × 100,000 (processing)
Fixed costs
Operating profit
Total company operating profit
$6,000,000
$2,000,000
$12,000,000
$ 6,000,000
3,000,000
4,000,000
$ (1,000,000)
Wood
Paper
$1,000,000
Whether the transfer price is set at $60 or at $50, Padre Paper is indifferent. At a sales price of $60, operating profit for Wood is $2,000,000 and for Paper a loss of $1,000,000. Net operating profit for Padre Papers is $1,000,000.

13. Managers’ Goals versus Firms’ Goals
L.O. 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
The firm needs to be cognizant of the behavioral issues related to negotiated transfer prices and manager performance evaluation based on transfer prices. We stated earlier that if the transfer price were higher than the market price, the buying division would not buy. If the transfer price is lower than the market price, the selling division will not sell. If it is in the interest of the firm for the transfer to take place, the reward system must be structured so that the transfer takes place. We will see in a minute why, in fact, the firm may want to set the transfer price at a certain amount. Transfer pricing will work as long as a managers are evaluated on items only under their control. (Remember, responsibility accounting?)

14. Centrally Established Transfer Price Policies
LO3
Centrally Established Transfer Price Policies
Market price-based:
Sets the transfer price at the market price or
at a small discount from the market price
Cost-based:
Outlay cost to selling division plus forgone
contribution to company projects
Alternative transfer prices include negotiated, cost-based, and market price-based. Negotiated prices occur when the buying and selling managers agree on a transfer price. Cost-based prices use the outlay cost to selling division plus any forgone contribution margin. Market price-based sets the transfer price at the market price or at a small discount from the market price.
Negotiated transfer:
The managers of the buying and selling
divisions agree on a price.

15. Multinational Transfer Pricing
L.O. 4 Explain the economic consequences
of multinational transfer prices.
International (or interstate) transfer pricing
can affect tax liabilities, royalties, and other
payments due to different laws in different
countries or states.
Company incentive:
– Increase profit in low-tax country
– Decrease profit in high-tax country
We said earlier we would see why, in fact, the firm might want to set the transfer price at a certain amount. A company may have economic incentives to set a certain transfer price. Because the transfer price is revenue to the selling division and cost to the buying division, a company can affect tax liabilities, royalties, and other costs by the transfer price. For example, a company would set the transfer price to increase operating profits in a low-tax country and decrease profits in a high-tax country. Let’s look at Diego Pharmaceuticals.

16. Segment Reporting
L.O. 5 Describe the role of transfer prices in segment reporting.
The FASB requires companies to report certain
information about segments in order to provide
a measure of performance for those segments
that are significant to the company as a whole.
The FASB requires companies to report certain information about segments which are significant to the company as a whole. The principle items that must be disclosed about each segment are: 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, and certain specialized items. In addition, if a company has significant foreign operations it must disclose revenues, operating profits or losses, and identifiable assets by geographical region.

17. End of Chapter 15 McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.