19
Transfer Pricing
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
19-2
Transfer Price
The amount charged when one division of an
organization sells goods or services to another
division. The exchange is internal and does not
affect the organization’s total sales or profit.
Battery Division
Auto Division
19-3
Learning Objective 1
19-4
Impact of Transfer Pricing on
Organizations
If the divisions are evaluated on profitability, the
transfer price can have an impact on the reported
performance of each division.
Battery Division
The higher the
transfer price to
the auto division, Auto Division
the . . .
greater is the
profit of the
battery division.
19-5
Setting Transfer Prices
The value placed on the goods being transferred
between divisions should encourage the
divisions to complete the transfers, if that is in
the organization’s best interest – while
allowing them to retain their autonomy.
19-6
Goal and Behavioral Congruence
In a decentralized organization, the managers
of profit centers and investment centers often
have considerable autonomy in deciding
whether to accept or reject orders and whether
to buy from inside or outside the organization.
The goal in setting the transfer price is to provide
incentives for each division manager to act in the
company’s best interests.
19-7
Learning Objective 2
19-8
General Transfer-Pricing Rule
Transfer
price
=
Additional
outlay cost per
unit incurred
because of the
transfer
+
Opportunity
cost per unit to
the organization
because of the
transfer
19-9
Setting Transfer Prices
Let’s consider the following two conditions
to show how they affect the setting of
transfer prices.
I.
The company has no excess capacity.
II.
The company has excess capacity.
19-10
Scenario I: No Excess Capacity

The Battery Division of Wills Company makes a standard
12-volt battery. The division is currently producing at its
capacity of 300,000 batteries, and sells each battery to
outside companies for $60. The company has no excess
capacity. The Vehicle Division offers to purchase 100,000
batteries for $45 each.
19-11
Scenario I: No Excess Capacity
Battery
Division
Transfer price = Outlay cost + Opportunity cost
$60
=
$40
+
$20
Vehicle
Division
19-12
Scenario I: No Excess Capacity
The offer of $45 per battery by the Vehicle Division
will not be accepted by the Battery Division.
Battery
Division
Transfer price = Outlay cost + Opportunity cost
$60
=
$40
+
$20
Vehicle
Division
19-13
Scenario II: Excess Capacity

The Battery Division of Wills Company makes a standard 12volt battery. The division is currently producing 200,000
batteries. Full capacity for the Division is 300,000 batteries. The
Division currently sells all batteries to outside companies for
$60 each. The Vehicle Division offers to purchase 100,000
batteries for $45 each.
Transfer price = Outlay cost + Opportunity cost
$40
=
$40
+
$0
The offer of $45 per battery by the Vehicle Division
will be accepted by the Battery Division. Each battery
sold to the Vehicle Division will produce $5 in
contribution to the Battery Division.
19-14
Difficulty in Implementing the General
Rule
1. The general rule is often difficult or impossible to
implement due to the difficulty of measuring
opportunity costs.
2. Under imperfect competition, a single producer
can affect the market price by varying the
amount of product available in the market.
3. Transfer pricing can be quite complex when
selling and buying divisions cannot sell and buy
all they want in perfectly competitive markets.
19-15
Learning Objective 3
19-16
Transfers Based on the External
Market Price
General rule when the producing division has no
excess capacity and perfect competition
prevails:
Transfer price = Outlay cost
+ Opportunity cost
(which is the market price)
19-17
Transfers Based on the External Market
Price
The producing division has excess capacity or
the external market is imperfectly competitive
1. If the transfer price is set at market price, the
producing division should have the option to
either produce goods for internal transfer or sell
in the external market.
2. The buying division should be required to
purchase goods from inside its organization if the
producing division’s goods meet the product
specifications.
19-18
Transfers Based on the External Market
Price
Distress Market Prices
Occasionally an industry experiences a period of
significant excess capacity and extremely low
prices.
Basing transfer
prices on market
Producing division
prices can lead to
managers might prefer to
decisions that are
move the division to a
more profitable product
not in the best
line.
interests of the
overall company.
19-19
Negotiated Transfer Prices
In some companies, division managers
negotiate the price at which transfers will be
made.
Negotiations can
lead to divisiveness
and competition
between
participating division
managers.
Although negotiating
skill is a valuable
managerial skill, it
should not be the
sole or dominant
factor in evaluating a
division.
19-20
Cost-Based Transfer Prices
When a company does not use market prices or
negotiated prices to determine transfer price, it
usually turns to cost-based transfer-pricing.
The cost-based transfer price may be based
upon:
1. Unit-level cost
2. Absorption cost
19-21
Using Standard Unit-Level Cost
When using this approach, the producing division
is not allowed to show any contribution margin on
the transferred products or services.
Under such conditions, the producing division has
no positive incentive to produce and transfer
products or services efficiently.
Some companies avoid these problems
by setting the transfer price at standard
unit-level cost plus a markup.
19-22
Using Absorption Cost
Absorption cost is equal to the product’s unit-level
cost plus an assigned portion of the higher-level
costs (batch-level, product-line-level, customerlevel, and facility-level costs.
The Battery Division has
unit-level costs of $40
and assigned higherlevel costs of $3,600,000.
The Division expects to
produce 200,000
batteries during the
period.
19-23
Dysfunctional Decision Making


The Battery Division has excess capacity of
100,000 units and uses the absorption cost
method to set a transfer price of $58 per
battery.
The Vehicles Division offers to purchase
100,000 batteries (the excess capacity) at a
price of $55 per battery).
Will the offer be accepted?
19-24
Dysfunctional Decision-Making
Per unit offer from Vehicle Division
Transfer price of Battery Division
Loss per unit
$ 55
58
$ (3)
It appears the offer will be rejected.
Per unit offer from Vehicle Division
Unit-level cost to Battery Division
Contribution to company as a whole
$ 55
40
$ 15
(even though the transfer is a benefit
to the company as a whole)
19-25
Standard versus Actual Costs
Transfer prices should not be based on actual
costs because such a practice would allow an
inefficient producing division to pass its excess
production costs on to the buying division via
the transfer price.
19-26
Remedying Motivational Problems of
Transfer Pricing Policies
If the selling division stands to make very little
profit on an exchange, the division manager
has no motivation to accept the transfer.
How to remedy this impasse for the good of the
company?
-- Consider treating the selling division as a
cost center.
-- Consider treating the selling division as a
profit center for external sales and a cost
center for internal transfers.
-- Use these criteria when evaluating division
performance.
19-27
Undermining Divisional Autonomy
Top management may become swamped with
pricing disputes causing division
managers to lose autonomy.
You really
don’t have any
choice!
I just won’t
pay $58 for
that battery!
19-28
Undermining Divisional Autonomy
Top management may become swamped with
pricing disputes causing division
managers to lose autonomy.
Now, here is what the two
of you are going to do.
19-29
Dual Transfer Prices
A dual transfer-pricing system charges the
buying division for the cost of the
transferred product (however the cost
might be determined) and credits the
selling division with the cost plus some
profit allowance.
19-30
Learning Objective 4
19-31
Multinational Transfer Pricing
Since tax rates are different in different
countries, companies have incentives to set
transfer prices that will increase revenues in
low-tax countries and increase costs in hightax countries.
19-32
Multinational Transfer Pricing
Country A imports materials from the
company’s Country B facility. The tax rate
in Country A is 70 percent and in Country B
is 40 percent
Country A
(40% tax rate)
Country B
(70% tax rate)
19-33
Multinational Transfer Pricing
Country A can use a transfer price of $3,000,000 or
$10,000,000. Let’s see the impact of this pricing.
$3,000,000 transfer price
Country A
$
3,000,000
(2,000,000)
Revenue
Third-party costs
Transferred goods cost
Taxable income
Income tax rate
Tax liability
$
1,000,000
40%
400,000
Country B
$
24,000,000
(6,000,000)
(3,000,000)
15,000,000
70%
$
10,500,000
Total
$
10,900,000
$10,000,000 transfer price
Country A
$ 10,000,000
(2,000,000)
Revenue
Third-party costs
Transferred goods cost
Taxable income
8,000,000
Income tax rate
40%
Tax liability
$ 3,200,000
Country B
$ 24,000,000
(6,000,000)
(10,000,000)
8,000,000
70%
$ 5,600,000
Total
$ 8,800,000
19-34
Learning Objective 5
19-35
Segment Reporting
Companies engaged in different lines of
business are required to report
certain information about segments:
o
o
o
o
o
o
Revenue.
Operating profits or losses.
Identifiable segment assets.
Depreciation and amortization.
Capital expenditures.
Certain specialized items.
19-36
Segment Reporting
If a company has significant foreign
operations, it must disclose . . .
o Revenues.
o Operating profits or losses.
o Identifiable assets by geographic region.
For purposes of external financial reporting,
the transfer prices for exchanges among
a company’s segments should be marketbased if possible.
19-37
Transfer Pricing in the Service Industry
Service industry firms and nonprofit
organizations use transfer pricing when
services are transferred between
responsibility centers.
19-38
End of Chapter 19