1. Transfer Pricing, Evaluating and Managing Performance19
Transfer Pricing, Evaluating and Managing Performance

2. Transfer Pricing
The amount charged when one division of an organization sells goods or services to another division.
Battery Division
Auto Division

3. Impact of Transfer Pricing on Organizations
If the divisions are evaluated on profitability, the transfer price can have an impact on the performance of each division.
The higher the
transfer price to
the auto division,
the . . .
Greater the
profits of the
battery division.
Battery Division
Auto Division

4. Setting Transfer Prices
The value placed on transfer goods is used to make it possible to transfer goods between divisions while allowing them to retain their autonomy.

5. 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.

6. General Transfer-Pricing Rule
Transfer Price
Additional outlay cost per unit incurred because goods are transferred
Opportunity cost per unit to the organization because of the transfer = +

7. Setting Transfer Prices
Let’s consider two different examples of setting transfer prices.
The company has no excess capacity.
The company has excess capacity.

8. Scenario 1: No Excess Capacity
The Battery Division of Wills Company makes a standard 12-volt battery. The division is currently producing at 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.

9. Scenario 1: No Excess Capacity
Battery
Division
Transfer price = Outlay cost + Opportunity cost
$60 =
$40 +
$20
Vehicle
Division

10. Scenario 1: No Excess Capacity
The offer of $45 per battery by the Vehicle Division will not be accepted by the Battery Division.
Battery
Division
Transfer price = Outlay cost + Opportunity cost
$60 =
$40 +
$20
Vehicle
Division

11. 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.
Transfer price = Outlay cost + Opportunity cost
$40 = + $0
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.

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

13. Transfers Based on the External Market Price
General Rule When Producing Division Has No Excess Capacity and Perfect Competition Prevails
Transfer price = Outlay cost + Opportunity cost Transfer price = Market price

14. Transfers Based on the External Market Price
The Producing Division Has Excess Capacity or the External Market is Imperfectly Competitive
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.
The buying division should be required to purchase goods from inside its organization if the producing division’s goods meet the product specifications.

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

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

17. 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:
Unit-level cost.
Absorption cost.

18. 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.
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. 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.

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

21. Dysfunctional Decision-Making
It appears the offer will be rejected.
The transfer is a benefit to the company as a whole.

22. 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.

23. Remedying Motivational Problems of Transfer-Pricing Policies
If profits of the selling division are too low, the manager has no motivation to make internal transfer.
Consider treating the selling division as a cost center.
Consider a profit center for external sales and a cost center for internal transfers.

24. 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!

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

26. 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.

27. Multinational Transfer Pricing
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.

28. 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)

29. 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.

30. Segment Reporting
Companies engaged in different lines of business are required to report certain information about segments.
Revenue.
Operating profits or losses.
Identifiable segment assets.
Depreciation and amortization.
Capital expenditures.
Certain specialized items.

31. Segment Reporting
If a company has significant foreign operations, it must disclose . . .
Revenues.
Operating profits or losses.
Identifiable assets by geographic region.

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

33. End of Chapter 19