© 2012 Pearson Prentice Hall. All rights reserved. Financial Control Chapter 11 – Transfer...

© 2012 Pearson Prentice Hall. All rights reserved.

Financial ControlFinancial Control

Chapter 11 – Transfer Pricing


Transfer Pricing Transfer Pricing Transfer pricing is the set of rules an organization

uses to allocate jointly earned revenue among responsibility centers

To understand the issues and problems associated with allocating revenues in a simple organization, consider the activities that occur when a customer purchases a new car at a dealership:


Transfer PricingTransfer Pricing– The new car department sells the new car and takes

in a used car as a trade– The used car is transferred to the used car

department– There, it may undergo repairs and service to make

it ready for sale, or may be sold externally on the wholesale market

The value placed on the used car transferred between the new and used car departments is critical in determining the profits of both departments:


Transfer PricingTransfer Pricing– The new car department would like the value

assigned to the used car to be as high as possible to increase revenue

– The used car department would like the value to be as low as possible because that makes its reported costs lower

The same considerations apply for any product or service transfer between any two departments in the same organization


Approaches to Approaches to Transfer PricingTransfer Pricing

Organizations choose among four main approaches to transfer pricing:– Market-based transfer prices– Cost-based transfer prices– Negotiated transfer prices– Administered transfer prices


Market-Based Transfer PriceMarket-Based Transfer Price If external markets exist for the intermediate

(transferred) product or service, then market prices are the most appropriate basis for pricing the transferred good or service between responsibility centers

The market price provides an independent valuation of the transferred product or service, and of how much each profit center has contributed to the total profit earned by the organization on the transaction


Cost-Based Transfer PriceCost-Based Transfer Price Some common cost-based transfer prices are:

– Variable cost– Variable cost plus a percent markup on variable

cost– Full cost– Full cost plus a percent markup on full cost

Economists argue that any cost-based transfer price other than marginal cost leads organization members to choose a lower than optimal level of transactions


Problems with Cost-Based Problems with Cost-Based Transfer PriceTransfer Price

The selling division will never show a profit on any internal transfer.

Transfer prices based on actual costs provide no incentive to the supplying division to control costs, because the supplier can always recover its costs


Problems with Cost-Based Problems with Cost-Based Transfer PriceTransfer Price

Cost-based pricing does not provide the proper economic guidance when operations are capacity constrained– Production decisions near full capacity should

reflect the most profitable use of the capacity, not only cost considerations

– The transfer price should be the sum of the marginal cost and the opportunity cost of capacity, where opportunity cost reflects the profit of the best alternative use of the capacity


Negotiated Transfer Price Negotiated Transfer Price Some organizations allow supplying and receiving

responsibility centers to negotiate transfer prices between themselves

Negotiated transfer prices reflect the controllability perspective inherent in responsibility centers, because each division is ultimately responsible for the transfer price that it negotiates– Negotiated transfer prices and therefore production

decisions may reflect the relative negotiating skills of the two parties rather than economic considerations


Problems with Negotiated Problems with Negotiated Transfer PriceTransfer Price

Problems arise when negotiating transfer prices because the bilateral bargaining situation causes:– The supplying division to want a higher than

optimal price– The receiving division to want a lower than

optimal price When the actual transfer price is different from the

optimal transfer price, the organization as a whole suffers

Negotiated TP RulesNegotiated TP RulesThe selling division’s lowest acceptable transfer price is calculated as:

Variable cost Total contribution margin on lost salesper unit Number of units transferredTransfer Price +

Transfer Price Cost of buying from outside supplier

The buying division’s highest acceptable transfer price is calculated as:

Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.

Transfer Price Profit to be earned per unit sold (not including the transfer price)

If an outside supplier does not exist, the highest acceptable transfer price is calculated as:


Administered Transfer Price Administered Transfer Price An arbitrator or a manager applies some policy to

set administered transfer prices– Organizations often use administered transfer

prices when a particular transaction occurs frequently

Such prices reflect neither pure economic considerations, as do market-based or cost-based transfer prices, nor accountability considerations, as negotiated transfer prices do


Transfer Prices BasedTransfer Prices Basedon Equity Considerationson Equity Considerations

Administered transfer prices are usually based on cost

Sometimes administered transfer prices are based on equity considerations:– Relative cost method– Base the allocation of cost on the profits that each

manager derives from using the asset– Assign each manager an equal share of the asset’s

cost

© 2012 Pearson Prentice Hall. All rights reserved. Financial Control Chapter 11 – Transfer...

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