1. Hilton • Maher • Selto

2. 19
Transfer Pricing

3. Transfer Pricing
Internal transfers of products create a need for a pricing mechanism between divisions to accurately reflect the costs and revenues of doing business.
A TRANSFER PRICE is the amount charged when one division of an organization sells goods or services to another division.

4. The Impact of Transfer Pricing on Organizations
Exh.
19-1
The Impact of Transfer Pricing on Organizations
Boundary
between the
organization
and outside parties
Sales of finished goods to customers outside the organization
Top
Management
Selling
division
Buying
Division
Goods
transferred at
a transfer price
Purchases
of productive
inputs from
vendors
outside the
organization
Assuming the transfer is made, the transfer price will not affect the company’s overall profit. However, it does affect the profit associated with each division. It can affect the decisions of autonomous division managers.

5. Goal and Behavioral Congruence
Divisions
Use of transfer price can affect the reported performance when evalutions use:
ROI, Residual Income, or EVA
. . . managers of profit centers and investment centers accepting or rejecting internal transfers based on the effect of the transfer price on their evaluation metric.
In Decentralized organizations, this can lead to . . .

6. General Transfer-Pricing Rule
A general rule that will ensure goal congruence:
Transfer price =
Additional outlay cost per unit incurred because goods are transferred +
Opportunity cost
per unit to the
organization
because of the
transfer
Includes the direct unit- level costs of the product/service & any other outlay costs that are incurred as a result of the transfer
An opportunity cost is a
benefit that is foregone
as a result of taking a
particular action

7. General Transfer-Pricing Rule
Koala Camp Gear Division
The Koala Camp Gear Division transfers some backpacks (RooPacks) to Outback’s retail and mail order divisions
The Koala Camp Gear
Division of Outback Outfitters manufactures
backpacks in its
Melbourne plant
The Koala Camp Gear Division transfers some backpacks to other companies under different labels
Suppose the Koala Camp Gear
Division can sell all the backpacks
it can produce to outside buyers at
a market price of $60 per backpack

8. General Transfer-Pricing Rule
Scenario 1: No excess capacity
Koala Camp Gear Division
Transfer price = Outlay cost + Opportunity cost
$ = $ $20.00
? = ? ?

9. General Transfer-Pricing Rule
Scenario 1: No excess capacity
Koala Camp Gear Division
Assuming that the backpacks can be sold on the wholesale market for $60 or on the retail market for $70, what is the best way for the Company to use its limited capacity?

10. General Transfer-Pricing Rule
Scenario 1: No excess capacity
Koala Camp Gear Division
All the backpacks should be transferred to the Retail Division to take advantage of the additional $10 contribution margin. The Camp Gear Division will not be hurt since the transfer price= the alternative wholesale price. +

11. General Transfer-Pricing Rule
Scenario 1: No excess capacity
Koala Camp Gear Division
What should the Company do if the Retail Division receives an offer to sell all its backpacks at $55 each? +

12. General Transfer-Pricing Rule
Scenario 1: No excess capacity
Koala Camp Gear Division
The Retail Division should reject the offer, because all the backpacks COULD be sold in the external market at $60, yielding a higher contribution margin of $20! +

13. General Transfer-Pricing Rule
Scenario 2: Excess capacity
Koala Camp Gear Division
Transfer price = Outlay cost + Opportunity cost
$ = $ $0
? = ? ?

14. General Transfer-Pricing Rule
Scenario 2: Excess capacity
Koala Camp Gear Division
Transfer price = Outlay cost + Opportunity cost
$ = $ $0
What should the Company do if the Retail Division receives an offer to sell all its backpacks at $55 each?

15. General Transfer-Pricing Rule
Scenario 2: Excess capacity
Koala Camp Gear Division
Transfer price = Outlay cost + Opportunity cost +
$ = $ $0
ACCEPT the offer. The Retail Division will realize a contribution margin of $15 on each backpack sold at the special price ($55 price - $40 transfer price).

16. Difficulty in Implementing the General Rule
Barriers to
Implementation
The opportunity cost may be difficult to measure.
The external market may not be perfectly competitive.
There may be no external market
The goods or services may be unique
Special equipment may be needed to
produce the transferred goods
Interdependencies among several transferred products or services

17. Transfers Based on the External Market Price
When the producing division has no excess capacity and
perfect competition prevails, the general transfer-pricing rule and the external market price yield the same transfer price.
The total contribution margin to the company is STILL $30!

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

19. Cost-Based Transfer Pricing
Cost-based transfer-pricing sets the transfer price on
the basis of the cost of the product or service transferred
Standard unit-level cost
Excess capacity
Transfer Price = the standard unit-level cost of $40 per backpack
- unit-level costs of $40
Contribution margin = 0
Unless the transferring division is allowed to realize a positive contribution margin, there is no positive incentive in this approach for the division to produce and transfer backpacks to the Retail Division.

20. Cost-Based Transfer Pricing
Absorption or Full Cost
Assigned higher-level costs
(batch-, product-, customer-,
and general- or facility-level)
Standard
unit-level
cost
Full cost = + +
$1,800,000 budgeted higher-level costs
100,000 budgeted units of production
= $
= $ = $58.00 per backpack
Possible dysfunctional decision-making behavior

21. Cost-Based Transfer Pricing
Absorption or Full Cost
= $ = $58.00 per backpack
They would reject it because they would incur a loss of $3 per unit.
What happens if the Retail Division receives a special order of $55?

22. Cost-Based Transfer Pricing
Absorption or Full Cost
= $ = $58.00 per backpack
What is in the best interest of the Company?
Accepting the order actually DOES provide $15 contribution margin.
So, Absorption Costing results in a dysfunctional decision!

23. Cost-Based Transfer PricingNO
Transfer prices should not be based on actual costs, but rather on standard costs.
ABC
Many companies use activity-based costing to improve the accuracy of numbers in its internal transfer of prices
If suppliers are not given a profit on the transaction, they are not motivated to transfer internally.
Use a cost center for internal transfers

24. Cost-Based Transfer Pricing
Koala Camp Gear Division
The manager
of Outback’s
Koala Camp Gear Division has excess
capacity but insists on a transfer price of $58.
The manager of the Retail Division has a special offer for backpacks of $55 per unit resulting in her divisional profit declining.
As company
manager, what
would YOU do?
Stay out
and lose the
contribution
margin for
the company
Intervene and
run the risk
of undermining
the authority
of the division
manager OR
But increased contribution margin for the company

25. Dual Transfer Pricing
The buying division is charged the cost of the transferred product.
The selling division is credited with the cost plus some profit allowance.
The difference is accounted for in a special account.
Other ways of encouraging internal transfers:
Recognize internal transfers and incorporate them in reward systems
Base part of the supplying manager’s bonus on the purchasing
center’s profit

26. Global Transfer-Pricing Practices
Research Insight 19-1

27. Global Transfer-Pricing Practices
In international transactions, transfer prices may affect tax liabilities, royalties, and other payments because of different laws in different countries (or states).
Companies have incentives to set transfer prices that will increase revenues (and profits) in low-tax countries and increase cost (thereby reducing profits) in high-tax countries
Nehru Jacket Corporation
Country S
(40% tax rate)
Country B
(70% tax rate)
Nehru’s facilities in Country B imports materials from the Country S facility.
Transfer of goods

28. Global Transfer-Pricing Practices
Exh.
19-2
Global Transfer-Pricing Practices
Nehru Jacket Corporation
Country S
(40% tax rate)
Country B
(70% tax rate)
Nehru’s facilities in Country B imports materials from the Country S facility.
Transfer of goods
Assume
$2,000,000
production
costs

29. Global Transfer-Pricing Practices
Exh.
19-3
Global Transfer-Pricing Practices
Nehru Jacket Corporation
Country S
(40% tax rate)
Country B
(70% tax rate)
Nehru’s facilities in Country B imports materials from the Country S facility.
Transfer of goods
The
transfer
price has
been
changed to
$10 million
This has reduced the tax liability by $2,100,000 ($10,900,000 - $8,800,000)

30. Segment Reporting and Transfer Pricing
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
FASB
If a company has significant foreign operations, it must disclose revenues, operating profits or losses, and identifiable assets by geographic region.
Principle items that must be disclosed about each segment
Segment revenue
Segment operating loss or profit
Identifiable segment assets
Depreciation and amortization
Capital expenditures
Certain specialized items
The accounting profession has
a preference for market-based
transfer pricing.

31. Now, this is my kind of transfer pricing!
End of Chapter 19
Now, this is my kind of transfer pricing!