1. Transfer Pricing Chapter 6

2. A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organization. Transfer price is a value at which goods and Services are Transferred between divisions in a decentralized organizations . Intermediate products are the products transferred between subunits of an organization. 3. Transfer Pricing What is transfer pricing? It is a set of tools and methods used to attribute revenues earned by the organization to organization sub-units. 4. Objectives of Transfer Prices It should provide each Business Unit with relevant information so that Trade-off between company cost and revenue Decision that improve business unit profit will improve company profit so It should induce Goal Congruence decision Measure the economic performance of business unit Simple to understand, easy to administer 5. Fundamental Principle The Transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors Two decisions must be made periodically Sourcing decision Transfer price decision 6. Approaches to Transfer Pricing There are four approaches to transfer pricing: Market-Based Cost-Based Negotiated Administered 7. Approaches to Transfer Pricing Market-Based Transfer Pricing If a good external market exists for the transferred product or service, then market prices are the most appropriate basis for pricing. Unfortunately, these markets with well-defined prices seldom exist. 8. Approaches to Transfer Pricing Cost-Based Transfer Prices Variable cost plus a markup Full cost Full cost plus a markup 9. The Ideal Situation Competent people Good Atmosphere A Market price Freedom to Source Full information Negotiation 10. Constraints on Sourcing Limited Markets Existence of Internal capacity Sole producer of Differentiated products Companys investment in Fixed costExcess or shortage of Industry capacity 11. Cost based Transfer price Two decision must be made How to define cost How to calculate Profit Markup 12. Cost based Transfer price 1. The Cost Basis Standard cost is the base2.The Profit Markup What the profit markup is based on The level of profit allowed 13. Agreement among Business Unit Two Step Pricing Transfer price includes two charges Standard variable cost per unit Fixed cost associated with unit Take or pay pricing 14. Profit sharing The product is transferred to the Marketing Unit at Unit Variable cost After the product is sold, the Business units share the contribution Two sets of pricing Manufacturing units revenue is credited at outside sales price and buying unit is charged total standard cost The difference is charged to head quarters account and eliminated when Business unit statements are consolidated 15. Approaches to Transfer Pricing Negotiated Transfer Prices Supplying and receiving responsibility centers negotiate prices. Prices reflect both negotiating skills and economic considerations. Optimal transfer price is the the net realizable value of the last unit supplied for all units supplied. 16. Approaches to Transfer Pricing Negotiated Transfer PricesReflect the accountability and controllability principles underlying responsibility centers Can easily lead to decisions that do not provide the greatest economic benefits 17. Approaches to Transfer Pricing Administered Transfer Prices Prices set by a rule, policy, or an arbitrator Easy to administer Arbitrary Tend to violate the spirit of the responsibility approach 18. How does company set TP PUBLISHED MARKET PRICE BIDS SIMILAR PRODUCT OUT SIDE MARKET