Transfer Pricing

Chapter 15

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Transfer PricingL.O. 1 Explain the basic issues associated with transfer pricing.

• Transfer price:The value assigned to the goods or services sold or rented(transferred) from one unit of an organization to another.

• Treatment is the same as a sale to an outside customer.– Revenue to the selling unit– Cost to the buying unit

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The SettingL.O. 2 Explain the general transfer pricing rules and

understand the underlying basis for them.

Padre Papers

Wood Division Paper Division

Trees PaperWood for

making paper

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The SettingLO2

Padre PapersCost and Production Data

Average units producedAverage units soldVariable manufacturing cost per unitVariable finishing cost per unitFixed divisional cost (unavoidable)

100,000

$ 20

$2,000,000

100,000

$ 30$4,000,000

Wood Paper

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The SettingLO2

Wood Division(selling division)

Variable cost = $20Fixed cost = $2,000,000

Paper Division(buying division)

Variable wood cost = ?Variable finishing cost = $30

Fixed cost = $4,000,000

Wood

Transferprice

Market for paper(final market

Price = ?

Market for wood(intermediate market

Price = ?

Padre Papers – Resources Flow

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Padre Papers ExampleLO2

• Assume the following data for the wood division:

Capacity in unitsSelling price to outsideVariable price per unitFixed price per unit (based on capacity)

100,000$ 60$ 20$ 20

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Padre Papers ExampleLO2

• The Paper Division is currently purchasing 100,000units from an outside supplier for $50, but wouldlike to purchase units from the Wood Division.

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Padre Papers ExampleLO2

Transferprice

Variablecost (VC)

Lost contributionmargin (CM)= +

If the Wood Divisionhas idle capacity:

Transferprice $20 $0= +

If the Wood Divisionis working at capacity:

Transferprice $20 $40= +

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Optimal Transfer PriceLO2

• There is no intermediate market.

• In this case, the only outlet for the Wood Divisionis the Paper Division and the only source ofsupply for the Paper Division is the Wood Division.

• The optimal transfer price is the outlay cost forproducing the goods (generally the variable costs).

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Perfect IntermediateMarked-Quality Differences

LO2

Variable manufacturing cost (Wood Division) per unitVariable finishing cost (Paper Division) per unitOther data:

Final market (paper) priceIntermediate market (grade A wood) priceIntermediate market (grade B wood) price

$ 20$ 30

$120$ 60$ 50

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Quality Difference ExampleLO2

Sales:$ 50 × 100,000 (transfer)$120 × 100,000 (transfer)Variable costs:$ 20 × 100,000$ 50 × 100,000 (transfer)$ 30 × 100,000 (processing)Fixed costsOperating profitTotal company operating profit

$5,000,000

$2,000,000

$2,000,000$1,000,000

$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

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Quality Difference ExampleLO2

Sales:$ 60 × 100,000 (transfer)$120 × 100,000 (transfer)Variable costs:$ 20 × 100,000$ 60 × 100,000 (transfer)$ 30 × 100,000 (processing)Fixed costsOperating profitTotal company operating profit

$6,000,000

$2,000,000

$2,000,000$2,000,000

$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

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Managers’ Goals versus Firms’ Goals

L.O. 3 Identify the behavioral issues and incentive effectsof negotiated transfer prices, cost-based transferprices, 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

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Centrally EstablishedTransfer Price Policies

LO3

• Market price-based:Sets the transfer price at the market price orat a small discount from the market price

• Cost-based:Outlay cost to selling division plus forgonecontribution to company projects

• Negotiated transfer:The managers of the buying and sellingdivisions agree on a price.

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Multinational Transfer PricingL.O. 4 Explain the economic consequences

of multinational transfer prices.

• International (or interstate) transfer pricingcan affect tax liabilities, royalties, and otherpayments due to different laws in differentcountries or states.

• Company incentive:– Increase profit in low-tax country– Decrease profit in high-tax country

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Segment Reporting

L.O. 5 Describe the role of transfer prices in segment reporting.

• The FASB requires companies to report certaininformation about segments in order to providea measure of performance for those segmentsthat are significant to the company as a whole.

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End of Chapter 15

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin