1. © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

2. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Transfer Pricing Chapter 15

3. 15-3 Learning Objectives LO 15-1 Explain the basic issues associated with transfer pricing. LO 15-2 Explain the general transfer pricing rules and understand the underlying basis for them. LO 15-3 Identify the behavioral issues and incentive effects of negotiated transfer prices, cost-based transfer prices, and market-based transfer. LO 15-4 Explain the economic consequences of multinational transfer prices. LO 15-5 Describe the role of transfer prices in segment reporting.

4. 15-4 Transfer Pricing LO 15-1 Explain the basic issues associated with transfer pricing. Transfer Price The value or amount recorded in a firm’s accounting records when one business unit sells (transfers) a good or service to another business unit. The accounting records in the two units (responsibility centers) treat this transaction in exactly the same way as a sale to an outside customer. Transfer Price The value or amount recorded in a firm’s accounting records when one business unit sells (transfers) a good or service to another business unit. The accounting records in the two units (responsibility centers) treat this transaction in exactly the same way as a sale to an outside customer. Because the exchange takes place within the organization, however, the firm has considerable discretion in setting this transfer price. LO 15-1

5. 15-5 Transfer Pricing LO 15-1 Because the managers of both the selling division and the buying division are evaluated on division profit, not company profit, they consider the effect of all sales, both internal and external, on their division, not company, profit. The optimal transfer price is the price that leads both division managers, each acting in his or her own self-interest, to make decisions that are in the firm’s best interest.

6. 15-6 The Setting LO 15-2 Explain the general transfer pricing rules and understand the underlying basis for them. LO 15-2

7. 15-7 The Setting Padre Papers Cost and Production Data LO 15-2

8. 15-8 Determination of Optimal Transfer Price Given the market prices and the costs in the firm, does firm profit increase? Given the transfer price, the intermediate market prices, and the divisional costs, does the selling division profit increase? Given the transfer price, the final market prices, and the divisional costs, does the buying division profit increase? LO 15-2

9. 15-9 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) Capacity in units Selling price to outside Variable price per unit Fixed price per unit (based on capacity) 100,000 $ 60 $ 20 100,000 $ 60 $ 20 LO 15-2

10. 15-10 Padre Papers Example LO 15-2 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. The optimal transfer price in this case is clear: It is the only viable price, the intermediate market price. At any price lower than the intermediate market price, Wood Division will supply no output to Paper Division, and at any higher price, Paper will not purchase any wood from Wood.

11. 15-11 Optimal Transfer Price LO 15-2 Using the intermediate market price as the transfer price, the transfer price is set at $50. At these market prices, does Padre Papers (as a firm) want to sell paper? The company receives $120 for every unit sold. The total variable cost is $50 (= $20 Wood cost + $30 Paper cost). The firm wants to make the sale. Wood Division is indifferent between selling wood internally or on the intermediate market. Paper Division is indifferent between buying wood from Wood Division or the intermediate market. Therefore, the sale will be made and the source of wood to Paper Division does not affect firm profits.

12. 15-12 Padre Papers Example Transfer price Transfer price Variable cost (VC) Variable cost (VC) Lost contribution margin (CM) Lost contribution margin (CM) = = + + If the Wood Division has idle capacity: If the Wood Division has idle capacity: Transfer price Transfer price $20 $0 = = + + If the Wood Division is working at capacity: If the Wood Division is working at capacity: Transfer price Transfer price $20 $40 = = + + LO 15-2

13. 15-13 Optimal Transfer Price Transfer price Transfer price Outlay cost Outlay cost Opportunity cost of the resource at the point of transfer Opportunity cost of the resource at the point of transfer = = + + LO 15-2

14. 15-14 Optimal Transfer Price To restate the goal of each manager: Each division manager wants to maximize his contribution margin. Each manager is indifferent about the transfer price if it has no impact on their contribution margin. LO 15-2

15. 15-15 Optimal Transfer Price: 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. 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). The optimal transfer price is the outlay cost for producing the goods (generally the variable costs). LO 15-2 Suppose that no intermediate market for wood exists or that, for whatever reason, the company has decided that it will not allow the divisions to buy or sell wood on the outside market.

16. 15-16 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 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 $ 20 $ 30 $120 $ 60 $ 50 LO 15-2

17. 15-17 Quality Difference Example Sales: $ 50 × 100,000 (transfer) $120 × 100,000 (transfer) Variable costs: $ 20 × 100,000 $ 50 × 100,000 (transfer) $ 30 × 100,000 (processing) Fixed costs Operating profit Total company operating profit Sales: $ 50 × 100,000 (transfer) $120 × 100,000 (transfer) Variable costs: $ 20 × 100,000 $ 50 × 100,000 (transfer) $ 30 × 100,000 (processing) Fixed costs Operating profit Total company operating profit $5,000,000 $2,000,000 $1,000,000 $5,000,000 $2,000,000 $1,000,000 $12,000,000 $ 5,000,000 3,000,000 4,000,000 $ -0- $12,000,000 $ 5,000,000 3,000,000 4,000,000 $ -0- Wood Paper $1,000,000 Grade B wood: $50 internal transfer price LO 15-2

18. 15-18 Quality Difference Example Sales: $ 60 × 100,000 (transfer) $120 × 100,000 (transfer) Variable costs: $ 20 × 100,000 $ 60 × 100,000 (transfer) $ 30 × 100,000 (processing) Fixed costs Operating profit Total company operating profit Sales: $ 60 × 100,000 (transfer) $120 × 100,000 (transfer) Variable costs: $ 20 × 100,000 $ 60 × 100,000 (transfer) $ 30 × 100,000 (processing) Fixed costs Operating profit Total company operating profit $6,000,000 $2,000,000 $6,000,000 $2,000,000 $12,000,000 $ 6,000,000 3,000,000 4,000,000 $ (1,000,000) $12,000,000 $ 6,000,000 3,000,000 4,000,000 $ (1,000,000) Wood Paper $1,000,000 Grade A wood: $60 internal transfer price LO 15-2

19. 15-19 Managers’ Goals versus Firms’ Goals LO 15-3 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 LO 15-3

20. 15-20 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 Negotiated Transfer Managers of the buying and selling divisions agree on a price LO 15-3

21. 15-21 Centrally Established Transfer Price Policies Establishing a market price policy Establishing a cost-basis policy LO 15-3

22. 15-22 Alternative Cost Measures LO 15-3 Full Absorption Cost-Based Transfers Although the transfer pricing rule—differential outlay cost to the selling division plus the opportunity cost of making the internal transfer to the company—assumes that the company has a reliable estimate of differential or variable cost, this is not always the case. Consequently, manufacturing firms sometimes use full absorption cost as the transfer price. Full Absorption Cost-Based Transfers Although the transfer pricing rule—differential outlay cost to the selling division plus the opportunity cost of making the internal transfer to the company—assumes that the company has a reliable estimate of differential or variable cost, this is not always the case. Consequently, manufacturing firms sometimes use full absorption cost as the transfer price. Cost-Plus Transfers We also find companies using cost-plus transfer pricing based on either variable costs or full absorption costs. These methods generally apply a normal markup to costs as a surrogate for market prices when intermediate market prices are not available. Cost-Plus Transfers We also find companies using cost-plus transfer pricing based on either variable costs or full absorption costs. These methods generally apply a normal markup to costs as a surrogate for market prices when intermediate market prices are not available. Standard Costs or Actual Costs If actual costs are used as the basis for the transfer, any variances or inefficiencies in the selling division are passed to the buying division. The problem of isolating the variances that have been transferred to the subsequent buying divisions becomes extremely complex. To promote responsibility in the selling division and to isolate variances within divisions, standard costs are generally used as a basis for transfer pricing in cost-based systems. Standard Costs or Actual Costs If actual costs are used as the basis for the transfer, any variances or inefficiencies in the selling division are passed to the buying division. The problem of isolating the variances that have been transferred to the subsequent buying divisions becomes extremely complex. To promote responsibility in the selling division and to isolate variances within divisions, standard costs are generally used as a basis for transfer pricing in cost-based systems.

23. 15-23 Motivational Problems of Transfer Pricing LO 15-3 A supplier whose transfers are almost all internal is usually organized as a cost center. The center manager is normally held responsible for costs, not revenues. Hence, the transfer price does not affect the manager’s performance measures. In companies in which such a supplier is a profit center, the artificial nature of the transfer price should be considered when evaluating the results of that center’s operations.

24. 15-24 Dual Transfer Prices LO 15-3 A dual transfer pricing system could be installed to provide the selling division with a profit but to charge the buying division only for costs. That is, the buyer could be charged the cost of the unit, however cost is determined, and the selling division could be credited for cost plus some profit allowance. The difference could be accounted for in a specialized centralized account.

25. 15-25 Multinational Transfer Pricing LO 15-4 Explain the economic consequences of multinational transfer prices. In international (or interstate) transactions, transfer prices can affect tax liabilities, royalties, and other payments because of different laws in different countries (or states or provinces). Because tax rates vary among countries, companies have incentives to set transfer prices that will increase revenues (and profits) in low-tax countries and increase costs (thereby reducing profits) in high-tax countries. LO 15-4

26. 15-26 Multinational Transfer Pricing Diego Pharmaceuticals Assume a $20,000,000 transfer price. LO 15-4

27. 15-27 Multinational Transfer Pricing Diego Pharmaceuticals Assume a $45,000,000 transfer price. LO 15-4

28. 15-28 Segment Reporting LO 15-5 Describe the role of transfer prices in segment reporting. 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. This reporting requirement is intended to provide a measure of performance for those segments that are significant to the company as a whole. LO 15-5

29. 15-29 Segment Reporting LO 15-5 The following are the principal items that must be disclosed about each segment: 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. Certain specialized items. The following are the principal items that must be disclosed about each segment: 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. Certain specialized items.

30. 15-30 End of Chapter 15