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Transfer Pricing
Chapter 15
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
LO 15-1
Explain the basic issues associated with transfer pricing.
LO 15-2
Explain the general transfer pricing rules and understand
the underlying basis for them.
LO 15-3
Identify the behavioral issues and incentive effects of
negotiated transfer prices, cost-based transfer prices,
and market-based transfer.
LO 15-4
Explain the economic consequences of multinational
transfer prices.
LO 15-5
Describe the role of transfer prices in segment reporting.
15-3
LO
15-1
Transfer Pricing
LO 15-1
Explain the basic issues associated with transfer pricing.
Transfer Price
The value or amount recorded in a firm’s accounting records
when one business unit sells (transfers) a good or service to
another business unit. The accounting records in the two units
(responsibility centers) treat this transaction in exactly the
same way as a sale to an outside customer.
Because the exchange takes place within the organization,
however, the firm has considerable discretion in setting this
transfer price.
15-4
LO
15-1
Transfer Pricing
Because the managers of both the selling division and the
buying division are evaluated on division profit, not company
profit, they consider the effect of all sales, both internal and
external, on their division, not company, profit.
The optimal transfer price is the price that leads both division
managers, each acting in his or her own self-interest, to make
decisions that are in the firm’s best interest.
15-5
LO
15-2
The Setting
LO 15-2
Explain the general transfer pricing rules and
understand the underlying basis for them.
15-6
LO
15-2
The Setting
Padre Papers
Cost and Production Data
15-7
LO
15-2
Determination of
Optimal Transfer Price
• Given the market prices and the costs in the firm,
does firm profit increase?
• Given the transfer price, the intermediate market
prices, and the divisional costs, does the selling
division profit increase?
• Given the transfer price, the final market prices,
and the divisional costs, does the buying division
profit increase?
15-8
LO
15-2
Padre Papers Example
Assume the following data for the wood division:
Capacity in units
100,000
Selling price to outside
$
60
Variable price per unit
$
20
Fixed price per unit (based on capacity) $
20
15-9
LO
15-2
Padre Papers Example
The Paper Division is currently purchasing 100,000 units from an
outside supplier for $50, but would like to purchase units from
the Wood Division.
The optimal transfer price in this case is clear: It is the only viable
price, the intermediate market price. At any price lower than the
intermediate market price, Wood Division will supply no output to
Paper Division, and at any higher price, Paper will not purchase any
wood from Wood.
15-10
LO
15-2
Optimal Transfer Price
Using the intermediate market price as the transfer price, the transfer
price is set at $50. At these market prices, does Padre Papers (as a
firm) want to sell paper? The company receives $120 for every unit
sold. The total variable cost is $50 (= $20 Wood cost + $30 Paper
cost). The firm wants to make the sale. Wood Division is indifferent
between selling wood internally or on the intermediate market. Paper
Division is indifferent between buying wood from Wood Division or the
intermediate market. Therefore, the sale will be made and the source
of wood to Paper Division does not affect firm profits.
15-11
LO
15-2
Padre Papers Example
Transfer
Variable
Lost contribution
=
+
price
cost (VC)
margin (CM)
If the Wood Division
is working at capacity:
Transfer
= $20 + $40
price
If the Wood Division
has idle capacity:
Transfer
= $20 +
price
$0
15-12
LO
15-2
Optimal Transfer Price
Transfer
Outlay
Opportunity cost of the
=
+
price
cost
resource at the point of transfer
15-13
LO
15-2
Optimal Transfer Price
To restate the goal of each manager:
• Each division manager wants to
maximize his contribution margin.
• Each manager is indifferent about
the transfer price if it has no impact
on their contribution margin.
15-14
LO
15-2
Optimal Transfer Price:
No Intermediate Market
Suppose that no intermediate market for wood exists or that, for whatever
reason, the company has decided that it will not allow the divisions to buy or
sell wood on the outside market.
• In this case, the only outlet for the Wood Division is the
Paper Division and the only source of supply for the Paper
Division is the Wood Division.
• The optimal transfer price is the outlay cost for producing the
goods (generally the variable costs).
15-15
LO
15-2
Perfect Intermediate
Marked-Quality Differences
Variable manufacturing cost (Wood Division) per unit
Variable finishing cost (Paper Division) per unit
Other data:
Final market (paper) price
Intermediate market (grade A wood) price
Intermediate market (grade B wood) price
$ 20
$ 30
$120
$ 60
$ 50
15-16
LO
15-2
Quality Difference Example
Grade B wood: $50 internal transfer price
Wood
Sales:
$ 50 × 100,000 (transfer)
$120 × 100,000 (transfer)
Variable costs:
$ 20 × 100,000
$ 50 × 100,000 (transfer)
$ 30 × 100,000 (processing)
Fixed costs
Operating profit
Total company operating profit
Paper
$5,000,000
$12,000,000
$2,000,000
$ 5,000,000
3,000,000
4,000,000
$
-0-
$2,000,000
$1,000,000
$1,000,000
15-17
LO
15-2
Quality Difference Example
Grade A wood: $60 internal transfer price
Wood
Sales:
$ 60 × 100,000 (transfer)
$120 × 100,000 (transfer)
Variable costs:
$ 20 × 100,000
$ 60 × 100,000 (transfer)
$ 30 × 100,000 (processing)
Fixed costs
Operating profit
Total company operating profit
Paper
$6,000,000
$12,000,000
$2,000,000
$ 6,000,000
3,000,000
4,000,000
$ (1,000,000)
$2,000,000
$2,000,000
$1,000,000
15-18
LO
15-3
Managers’ Goals versus Firms’
Goals
LO 15-3
Identify the behavioral issues and incentive effects
of negotiated transfer prices, cost-based transfer
prices, 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
15-19
LO
15-3
Centrally Established
Transfer Price Policies
Market Price-Based
Sets the transfer price at the market price or
at a small discount from the market price
Cost-Based
Outlay cost to selling division plus forgone
contribution to company projects
Negotiated Transfer
Managers of the buying and selling
divisions agree on a price
15-20
LO
15-3
Centrally Established
Transfer Price Policies
• Establishing a market price policy
• Establishing a cost-basis policy
15-21
LO
15-3
Alternative Cost Measures
Full Absorption Cost-Based Transfers
Although the transfer pricing rule—differential outlay cost to the selling division plus
the opportunity cost of making the internal transfer to the company—assumes that
the company has a reliable estimate of differential or variable cost, this is not always
the case. Consequently, manufacturing firms sometimes use full absorption cost as the
transfer price.
Cost-Plus Transfers
We also find companies using cost-plus transfer pricing based on either variable costs
or full absorption costs. These methods generally apply a normal markup to costs as a
surrogate for market prices when intermediate market prices are not available.
Standard Costs or Actual Costs
If actual costs are used as the basis for the transfer, any variances or inefficiencies in
the selling division are passed to the buying division. The problem of isolating the
variances that have been transferred to the subsequent buying divisions becomes
extremely complex. To promote responsibility in the selling division and to isolate
variances within divisions, standard costs are generally used as a basis for transfer
pricing in cost-based systems.
15-22
LO
15-3
Motivational Problems of
Transfer Pricing
A supplier whose transfers are almost all internal is usually organized as a cost center.
The center manager is normally held responsible for costs, not revenues. Hence, the
transfer price does not affect the manager’s performance measures.
In companies in which such a supplier is a profit center, the artificial nature of the
transfer price should be considered when evaluating the results of that center’s
operations.
15-23
LO
15-3
Dual Transfer Prices
A dual transfer pricing system could be installed to provide the selling
division with a profit but to charge the buying division only for costs. That
is, the buyer could be charged the cost of the unit, however cost is
determined, and the selling division could be credited for cost plus some
profit allowance. The difference could be accounted for in a specialized
centralized account.
15-24
LO
15-4
Multinational Transfer Pricing
LO 15-4
Explain the economic consequences
of multinational transfer prices.
In international (or interstate) transactions, transfer prices can affect tax
liabilities, royalties, and other payments because of different laws in
different countries (or states or provinces). Because tax rates vary among
countries, companies have incentives to set transfer prices that will
increase revenues (and profits) in low-tax countries and increase costs
(thereby reducing profits) in high-tax countries.
15-25
LO
15-4
Multinational Transfer Pricing
Diego Pharmaceuticals
Assume a $20,000,000 transfer price.
15-26
LO
15-4
Multinational Transfer Pricing
Diego Pharmaceuticals
Assume a $45,000,000 transfer price.
15-27
LO
15-5
Segment Reporting
LO 15-5
Describe the role of transfer prices in segment reporting.
The Financial Accounting Standards Board (FASB) requires companies
engaged in different lines of business to report certain information about
segments that meet the FASB’s technical requirements. This reporting
requirement is intended to provide a measure of performance for those
segments that are significant to the company as a whole.
15-28
LO
15-5
Segment Reporting
The following are the principal items that must be disclosed about
each segment:
• Segment revenue, from both internal and external customers.
• Interest revenue and expense.
• Segment operating profit or loss.
• Identifiable segment assets.
• Depreciation and amortization.
• Capital expenditures.
• Certain specialized items.
15-29
End of Chapter 15
15-30