Transfer Pricing

Key Concepts/DefinitionsA transfer price is the price charged when one segment of a company provides goods or services to another segment of the company.The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company.

Transfer PricingThe amount charged when one division sells goods or services to another divisionBattery DivisionAuto Division

Three Primary ApproachesThere are three primary approaches to setting transfer prices: Negotiated transfer prices;Transfers at the cost to the selling division; andTransfers at market price.

Negotiated Transfer PricesA negotiated transfer price results from discussions between the selling and buying divisions.

Barker Company An ExampleAssume the information as shown with respect to The Battery Division and Vehicle Division (both Divisions are owned by Barker Company).

Sheet1

Pipe Products

9-Inch12-Inch18-InchTotal

Warehouse sq. ft.1,0004,0005,00010,000

Lease price per sq. ft.$4$4$4$4

Total lease cost$4,000$16,000$20,000$40,000

Acquisition cost

Less: Accumulated depreciation

Net book value

Residual income=Net operating income-Average operating assetsMinimum required rate of return

Sheet2

Battery Division:

Production Capacity (Number of Batteries)300,000

Variable cost per battery18

Fixed costs per month2,100,000

Selling price per battery to outsiders40

Vehicle Division:

Purchase price per battery from outside supplier39

Monthly comsumption of batteries50,000

Sheet3

Barker Company Scenario 1Suppose that the Battery Division is operating at capacity. What is the lowest acceptable transfer price from the viewpoint of the Battery Division?What is the highest acceptable transfer price from the viewpoint of the Vehicle Division? Will a transfer take place?

General Guideline for Determininga Minimum Transfer PriceMinimum transfer price= Incremental costs per unit incurredup to the point of transfer+ Opportunity costs per unit to the selling division

Barker Company Scenario 1The Vehicle Divisions acceptable transfer price is calculated as:

Sheet1

Pipe Products

9-Inch12-Inch18-InchTotal

Warehouse sq. ft.1,0004,0005,00010,000

Lease price per sq. ft.$4$4$4$4

Total lease cost$4,000$16,000$20,000$40,000

Acquisition cost

Less: Accumulated depreciation

Net book value

Residual income=Net operating income-Average operating assetsMinimum required rate of return

Sheet2

Imperial Beverages:

Ginger beer production capactiy per month10,000barrels

Variable cost per barrel of ginger beer8per barrel

Fixed costs per month70,000

Selling price of Imperial Beverages ginger beer on the outside market20per barrel

Pizza Maven:

Purchase price of regular brand of ginger beer18per barrel

Monthly comsumption of ginger beer2,000barrels

Transfer PriceVariable cost+Total contribution margin on lost salesTransfer PriceCost of buying from outside supplier

per unitNumber of units transferred

Sheet3

Barker Company Scenario 1If Battery Division has no idle capacity (0 batteries) and must sacrifice other customer orders (50,000 batteries) to meet Vehicle Divisions demands (50,000 barrels), then the lowest and highest possible transfer prices are computed as follows:

Barker Company Scenario 2

Refer to the original data. Assume that the Battery Division has enough idle capacity to supply the Vehicle Divisions needs without diverting batteries from the outside market.

What is the lowest acceptable transfer price from the viewpoint of the Battery Division? In what price range will a transfer take place?

Barker Company Scenario 3

Refer to the original data. Suppose the Battery Division is selling 275,000 batteries per month on the outside market. The Vehicle Division can put only one kind of batteries in its vehicles. It cannot buy 25,000 batteries from an outside supplier and 25,000 batteries from the Battery Division: it must buy all of its batteries from one source. The Battery Division must sacrifice some outside customer orders to meet the Vehicle Divisions demands.

What is the lowest acceptable transfer price from the viewpoint of the Battery Division? In what price range will a transfer take place? Is this transfer goal-congruent for the Company (Barker)?

An ExampleMaterials used by the Truck Division of Structure Motors are currently purchased from outside suppliers at a cost of $260 per unit. However, the same materials are available from the Component Division. The Component Division has unused capacity and can produce the materials needed by the Truck Division at a variable cost of $190 per unit.

If a transfer price of $230 per unit is established and 40,000 units of material are transferred with no reduction in the Component Divisions current sales, how much would Structure Motors total income from operations increase?

How much would the Truck Divisions income from operations increase?

How much would the Component Divisions income from operations increase?

Lets change the transfer price to $250. Recalculate a, b and c above. What additional insights can we gain?

Evaluation of Negotiated Transfer PricesIf a transfer within a company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer.

Cost-Based Transfer PricesSome companies use the following measures of cost to establish transfer prices . . .

Variable cost (18 for the Battery Division). The selling division will never show a profit on any internal transfer.

Full absorption cost (25 for the Battery Division)Will the Battery Division transfer at Full Cost if it has no capacity?What happens if the Battery Division has capacity and the Auto Division can sell batteries at 23 in a foreign country?

Mark-up (e.g. 120% of full cost, or 30 per battery).

Transfers at Market PriceA market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.Note:

1. A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. In the Battery Division example, the price would be set at 40.

2. A market price approach does not work well when the selling division has idle capacity. What happens if the Battery Division has excess capacity? Will it prefer to sell at a price below 40?

An International Perspective Since tax rates are different in different countries, companies have incentives to set transfer prices that will: Increase revenues in low-tax countries.Increase costs in high-tax countries.

Appendix 12A: Transfer Pricing.A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. While domestic transfer prices have no direct effect on the entire companys reported profit, they can have a dramatic effect on the reported profitability of a division.The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. Suboptimization occurs when managers do not act in the best interests of the overall company or even their own divisions.There are three primary approaches to setting transfer prices, namely negotiated transfer prices, transfers at the cost to the selling division, and transfers at market price.

*A negotiated transfer price results from discussions between the selling and buying divisions. Negotiated transfer prices have two advantages.

First, they preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

Second, the range of acceptable transfer prices is the range of transfer prices within which the profits of both divisions participating in the transfer would increase. The lower limit is determined by the selling division. The upper limit is determined by the buying division.

*Assume the information as shown with respect to Imperial Beverages and Pizza Maven (both companies are owned by Harris and Louder).

*The selling divisions (Imperial Beverages) lowest acceptable transfer price is calculated as shown.

The buying divisions (Pizza Maven) highest acceptable transfer price is calculated as shown.

If Pizza Maven had no outside supplier for ginger beer, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the ginger beer, net of its own expenses.

Lets calculate the lowest and highest acceptable transfer prices under three scenarios.

*The selling divisions (Imperial Beverages) lowest acceptable transfer price is calculated as shown.

The buying divisions (Pizza Maven) highest acceptable transfer price is calculated as shown.

If Pizza Maven had no outside supplier for ginger beer, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the ginger beer, net of its own expenses.

Lets calculate the lowest and highest acceptable transfer prices under three scenarios.

*Part IIf Imperial Beverages has no idle capacity and must sacrifice other customer orders (two thousand barrels) to meet the demands of Pizza Maven (two thousand barrels), then the lowest and highest possible transfer prices will be computed as shown.

Part IIThe lowest acceptable transfer price, as determined by the seller, is twenty pounds.

Part IIIThe highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, there is no range of acceptable transfer prices. This is a desirable outcome for Harris Louder because it would be illogical to give up sales of twenty pounds to save costs of eighteen pounds. *Part IIf Imperial Beverages has sufficient idle capacity (three thousand barrels) to satisfy Pizza Mavens demands (two thousand barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as shown.

Part IIThe lowest acceptable transfer price, as determined by the seller, is eight pounds.

Part IIIThe highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, the range of acceptable transfer prices is eight pounds to eighteen pounds.

*Part IIf Imperial Beverages has sufficient idle capacity (three thousand barrels) to satisfy Pizza Mavens demands (two thousand barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as shown.

Part IIThe lowest acceptable transfer price, as determined by the seller, is eight pounds.

Part IIIThe highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, the range of acceptable transfer prices is eight pounds to eighteen pounds.

*Part IIf Imperial Beverages has sufficient idle capacity (three thousand barrels) to satisfy Pizza Mavens demands (two thousand barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as shown.

Part IIThe lowest acceptable transfer price, as determined by the seller, is eight pounds.

Part IIIThe highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, the range of acceptable transfer prices is eight pounds to eighteen pounds.

If a transfer within the company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer. Nonetheless, if managers are pitted against each other rather than against their past performance or reasonable benchmarks, a noncooperative atmosphere is almost guaranteed. Thus, negotiations often break down even though it would be in both parties best interests to agree to a transfer price. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices.

*35*A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.It works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity.With no idle capacity the real cost of the transfer from the companys perspective is the opportunity cost of the lost revenue on the outside sale.

It does not work well when the selling division has idle capacity. In this case, market-based transfer prices are likely to be higher than the variable cost per unit of the selling division. Consequently, the buying division may make pricing and other decisions based on incorrect, market-based cost information rather than the true variable cost incurred by the company as a whole. *40