Chapter 15

Transfer Pricing

McGraw-Hill/Irwin

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

Transfer Pricing
L.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 Setting
L.O. 2 Explain the general transfer pricing rules and
understand the underlying basis for them.

Padre Papers

Wood Division

Paper Division

Trees

Wood for making paper

Paper

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LO2

The Setting
Padre Papers Cost and Production Data
Wood Paper

Average units produced Average units sold Variable manufacturing cost per unit Variable finishing cost per unit Fixed divisional cost (unavoidable)

100,000 100,000 $ 20 $ 30 $2,000,000 $4,000,000

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LO2

The Setting
Padre Papers Resources Flow Wood Division (selling division) Variable cost = $20 Fixed cost = $2,000,000
Wood

Transfer price

Paper Division (buying division) Variable wood cost = ? Variable finishing cost = $30 Fixed cost = $4,000,000

Market for wood (intermediate market Price = ?

Market for paper (final market Price = ?

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LO2

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

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LO2

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.

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LO2

Padre Papers Example

Transfer Variable Lost contribution = + price cost (VC) margin (CM) If the Wood Division is working at capacity: If the Wood Division has idle capacity: Transfer = $20 + $40 price Transfer = $20 + price

$0

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LO2

Optimal Transfer Price

There is no intermediate 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).

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LO2

Perfect Intermediate Marked-Quality Differences

$ 20 $ 30

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

$120 $ 60 $ 50

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LO2

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 $5,000,000

Paper

$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
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LO2

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 $6,000,000

Paper

$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
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Managers Goals versus Firms Goals

L.O. 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

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LO3

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: The managers of the buying and selling divisions agree on a price.

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Multinational Transfer Pricing

L.O. 4 Explain the economic consequences
of multinational transfer prices.

International (or interstate) transfer pricing can affect tax liabilities, royalties, and other payments due to different laws in different countries 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 certain information about segments in order to provide a measure of performance for those segments that are significant to the company as a whole.

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End of Chapter 15

McGraw-Hill/Irwin

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