• Transfer pricing defined• Market-based transfer prices• Cost-based transfer prices• Negotiated transfer prices• Dual transfer prices• Transfer pricing and tax planning

ACTG 321Agenda for Lecture 18

Transfer PricingA transfer price is an “internal price”: what one

part of the company charges another part of the company for intermediate products.

Applies to companies that • are decentralized, especially companies that

are vertically integrated.or• are multinationals

Transfer Pricing

The “selling” division is sometimes called the upstream division.

The “buying” division is sometimes called the downstream division.

This is because product “flows” from upstream to downstream.

Shell Oil Company

Shell Oil Company

Shell Oil Company

Shell Oil Company

Transfer Pricing Options

• Market-Based Transfer Price

• Cost-Based Transfer Price

• Negotiated Transfer Price

Market-Based Transfer Price• Advantages:

– it is objective.

– in perfectly competitive markets, it will generally lead to optimal decisions.

• Disadvantages:

– many intermediate products are not traded in competitive markets, so no market price exists.

– some market prices fluctuate considerably.

Cost-Based Transfer Price• Can be variable cost or full cost.

• Whether variable or full, can be actual costs or budgeted costs.

• Whether variable or full, can include a “mark-up” to allow profit for the “selling” division.

• Major disadvantage: including fixed costs in the transfer price can lead to sub-optimal decisions.

Negotiated Transfer Price

• Advantage: provides greatest autonomy to divisions; requires least interference by headquarters.

• Disadvantages: outcome depends on the relative bargaining strengths and abilities of the Divisional Managers. May not be optimal for the company as a whole. May discourage cooperation among divisions.

DOMESTIC TRANSFER-DOMESTIC TRANSFER-PRICING METHODSPRICING METHODS

46% COST-BASED

37% MKT-BASED

16% NEGOTIATED

1% OTHER

DOMESTIC DOMESTIC COST-BASED TRANSFER COST-BASED TRANSFER

PRICING METHODSPRICING METHODS

89% FULL COST

9% VARIABLE COST

2% OTHER

MULTINATIONAL MULTINATIONAL TRANSFER-PRICING TRANSFER-PRICING

METHODSMETHODS

41% COST-BASED

46% MKT-BASED

13% NEGOTIATED

MULTINATIONAL MULTINATIONAL COST-BASED TRANSFER COST-BASED TRANSFER

PRICING METHODSPRICING METHODS

90% FULL

7% VARIABLE

3% OTHER

Dual Transfer Price• The “buying” division pays a different amount

than the “selling” division receives.

• Since this is a “paper” transaction, and no cash generally changes hands, the use of a “dual” transfer price is possible.

• In theory, dual transfer prices allow transfer pricing schemes that are optimal in terms of providing managers the appropriate incentives.

• However, dual transfer pricing is seldom used in practice.

Transfer Pricing and Taxes• Applies to multinational companies

• Tax treaties among nations attempt to tax all corporate income once, and only once.

• World-wide income of multinational companies is apportioned among tax jurisdictions.

• Companies have incentives to “shift” income from high tax countries to low tax countries.