Transfer Pricing

Performance Evaluation for
Decentralized Operations
Cost Centers
Budget Performance Report
Supervisor, Department 1—Plant A
For the Month Ended October 31, 2006
Over Under
Budget Actual Budget Budget
Factory wages $ 58,100 $ 58,000 $100
Materials 32,500 34,225 $1,725
Supervisory salaries 6,400 6,400
Power and light 5,750 5,690 60
Depreciation 4,000 4,000
Maintenance 2,000 1,990 10
Insurance, taxes 975 975
$109,725 $111,280 $1,725
$1,725 $170
Cost Centers
Manager, Plant A
Over Under
Administration $ 17,500 $ 17,350 $150

Department
Department 11 109,725
109,725 111,280
111,280 $1,555
$1,555
Department 2 190,500 192,600 2,100
Department 3 149,750 149,100 650
$467,475 $470,330 $3,655 $800
Cost Centers
Manager, Plant A
Over Under
Administration $ 17,500 $ 17,350 $150

Department 1 109,725 111,280 $1,555
Department 2 190,500 192,600 2,100
Department 3 149,750 149,100 650
$467,475 $470,330
$470,330 $3,655
$3,655 $800
$800
Cost Centers
Vice-President, Production
Over Under
Administration $ 19,500 $ 19,700 $ 200
Plant
Plant A
A 467,475
467,475 470,330
470,330 2,855
2,855
Plant B 395,225 394,300 $925
$882,200 $884,330 $3,055 $925
Note that “Over Budget” is a net figure.

Cost Centers
Vice-President, Production
Over Under
Administration $ 19,500 $ 19,700 $ 200
Plant A 467,475 470,330 2,855
Plant B 395,225 394,300 $925
$882,200 $884,330 $3,055 $925
Each of the line items above is

supported by a cost center report.
Responsibility
Accounting for
Profit Centers
In a profit center, the unit manager has the

responsibility and the authority to make
decisions that affect both costs and revenues.
Profit centers may be
divisions, departments,
or products.
Profit Centers
NEG, a diversified entertainment company,

has two profit centers: the Theme Park
Division and the Movie Production Division.
Theme Park Movie Production

Division Division
Revenues $6,000,000 $2,500,000
Operating expenses 2,495,000 405,000
Profit Centers
Charging Service Department Costs
to Production Divisions
Purchasing Department: $400,000
(Activity base: number of purchase requisitions)
Theme Park Division 25,000 purchase requisitions
Movie Production Division: 15,000 purchase requisitions
Total 40,000
$400,000
= $10 per purchase
40,000 purchase requisitions requisition
Profit Centers
Payroll Accounting: $255,000
(Activity base: number of payroll checks)
Theme Park Division 12,000 payroll checks
Movie Production Division: 3,000 payroll checks
Total 15,000
$255,000
= $17 per payroll check
15,000 payroll checks
Profit Centers
Legal Department: $250,000
(Activity base: number of payroll checks)
Theme Park Division 100 billed hours
Movie Production Division: 900 billed hours
Total 1,000
$250,000
= $250 per hour
1,000 hours
Profit Centers
Nova Entertainment Group
Service Department Charges to NEG Divisions
For the Year Ended December 31, 2006
Theme Movie
Park Production
Service Department Division Division
Purchasing $250,000 $150,000
25,000 purchase
15,000 purchase
requisitions xrequisitions
$10 x $10
per purchaseper purchase
requisition requisition
Profit Centers
Theme Movie
Park Production
Purchasing $250,000 $150,000
Payroll accounting 204,000 51,000
12,000 payroll3,000 payroll

checks x $17 checks
per x $17 per
payroll checkpayroll check
Profit Centers
Theme Movie
Park Production
Purchasing $250,000 $150,000
Legal 25,000 225,000
100 hours x $250

900 hours x $250
per hour per hour
Profit Centers
Theme Movie
Park Production
Purchasing $250,000 $150,000
Legal 25,000 225,000
Total service department charges $479,000 $426,000
Divisional Income Statements
Theme Park Division Movie Production Division
Revenues $6,000,000 $2,500,000
Income from operations $3,505,000 $2,095,000
Income from operations before

service department charges.
Theme Park Division Movie Production Division
Revenues $6,000,000 $2,500,000
Less service dept. charges:
Purchasing $ 250,000 $ 150,000
Legal 25,000 225,000
Total service department
charges $ 479,000 $ 426,000
Transfer Pricing
Transfer Pricing
When divisions transfer products or
render services to each other, a
transfer pricing is used to charge for
the products or services
Benefits of Transfer Pricing
1. Divisions can be evaluated as profit or
investment centers.
2. Divisions are forced to control costs and
operate competitively.
3. If divisions are permitted to buy component
parts wherever they can find the best price
(either internally or externally), transfer
pricing will allow a company to maximize
its profits.
Transfer Pricing
• Concept :-
– Transfer price is defined as the value placed on transfer of
goods or services among two or more profit centers.
– For selling profit center, the transfer price is major
determinant of its revenue and hence its profits.
– For buying profit center, the transfer price is major
determinant of the expenses incurred and hence its profit.
– The price of inter divisional sales affects the selling
divisional sales and buying divisional cost.
– Transfer price is fundamentally an attempt to simulate
external market condition within the organization.
– Two divisions can be made completely independent of each
other.
MICS-HJB 22
Transfer Pricing
Profit Centre Input are related to Output
Input Output
EC RC
Money Cost Money Profit
Production Marketing Business Unit
Buying cost Selling cost

Selling cost Buying cost
Variable cost Variable cost
Fixed cost Fixed cost
Profit margin
MICS-HJB 23
Transfer Pricing
• Objectives :
– It should provide each segment with the relevant
information required to determine the optimum trade – off
between company cost and revenue.
– It should induce goal congruent decisions. ( Decisions
regarding division and company )
– It should help measure the economic performance of
individual profit centers.
– The system should be easy to administer.
MICS-HJB 24
Transfer Pricing
• Mechanism of Transfer Pricing :
– Transfer price, means the value placed on a transfer of goods or services
in transaction.
– The FUNDAMENTAL PRINCIPLE is that the transfer price should be
similar to the price that would be charged if the product were sold to out
side customers or purchased from out side supplier.
– When profit center of an organization buy product from and sell to one
other, two decision are to be carried out and reviewed periodically.
• Sourcing Decision : Should the company produce the product inside
the company or purchase it from an out side vendor ?
• Transfer Price Decision : If produced inside, at what price should be
the product transferred to next centre ?
– It starts from simple to extremely complex depending upon the nature of
business.
MICS-HJB 25
Transfer Pricing
• The Ideal situation :
– Transfer price will induce goal congruence if all the conditions listed
below exist.
– Competent People : Managers interested in long run and short run
performance and staff involved in negotiation and arbitration of
transfer price.
– Good Atmosphere : They should perceive that it is a mechanism.
– Market Price : It should based on well established market price, which
reflects same conditions like quantity, quality, delivery time, etc.
– Freedom to Source : Buying manager should have freedom to buy from
out side and selling manager should have freedom to sell out side.
– Full of Information : Managers must have all information about the
alternatives and cost.
– Negotiation : Smooth mechanism for contract between business units.
MICS-HJB 26
Transfer Pricing
• The Constraints on Sourcing :
– In actual all these conditions are not present the major short falls are :
– Limited Market : Market for buying or selling is limited due to several
reasons.
• Existence of internal capacity limit the development of external sales.
• If company is sole producer of a differentiated product no out side
source exists.
• If company has developed significant facilities, it does not allow to
use out side sources unless out side selling price approaches the
company’s variable cost.
– Excess or Shortage of Capacity :
• If selling unit can not sell all it can produce is excess capacity. The
profit can not be optimize if buying unit purchase from out side
suppliers.
• If buying unit can not obtain product it requires from out side while
selling unit is selling it out side is shortage of capacity. Out put of
buying unit constrained.
MICS-HJB 27
Transfer Pricing
• Method of Calculating Transfer Prices :
– By available Competitive Price :
– Published market price.
– Market price by “BID”
– If selling profit centre sells product in out side market, it can replicate
the price.
– If buying profit centre purchase similar product from out side market, it
can replicate the price.
– Cost Base Transfer Price :
– The Cost Basis – usual basis of standard cost.
– The Profit Mark up – consideration of profit.
• Percentage of cost, no account of capital required.
• Batter base is percentage of investment but there are two problems, one is
historical cost and other is level of profit. Standard cost is to be considered.
MICS-HJB 28
Transfer Pricing
– Upstream Fixed Cost and Profit :
– Agreement Among Business Units
– Two – Step Pricing
– Profit Sharing
– Two Sets of Prices
MICS-HJB 29
Transfer Pricing
– Upstream Fixed Cost and Profit :
• Transfer price can create a significant problem in an
integrated company.
• The profit centre selling product out side may not aware
about the upstream fixed cost and profit included.
• If aware, may be reluctant to reduce its own profit to
company’s optimized profit.
– Agreement Among Business Units :

• A mechanism where representative of buying and selling
unit meet to periodically and decide on the profit with
significant upstream fixed cost.
MICS-HJB 30
Transfer Pricing
– Two – Step Pricing :
• Another way is, to include two charges, that is standard variable cost for
each unit sold and periodic charges ( monthly ) which is equal to related with
facilities reserved for the buying unit.
• Example : Unit - X is transferring product A to Unit – Y
Expected monthly sales to business unit Y 5000 units
Variable cost per unit 5 Rs
Monthly fixed cost assigned to product 20000 Rs
Investment in working capital and facilities 1200000 Rs
Competitive return on investment per year 10 %
Transfer price calculation :
Variable cost per unit 5 Rs
Fixed cost per unit ( 20000 / 5000 ) 4 Rs
Profit per unit (( 0.10 *(1200000 / 12 )) / 5000 ) 2 Rs
Total 11 Rs
MICS-HJB 31
Transfer Pricing
• If 5000 units are transferred amount is 11*5000 55000 Rs
• If 4000 units are transferred amount is 11*4000 44000 Rs
• If 6000 units are transferred amount is 11*6000 66000 Rs.
• This is normal calculation, two – step pricing method as doing some thing
different.
• For 5000 unit
– Monthly fixed cost 20000 Rs
– Return on investment ( 0.10*( 1200000 / 12 ) 10000 Rs
– Variable cost ( 5 * 5000 ) 25000 Rs
– Total 55000 Rs
• For 4000 unit
– 30000 + ( 5 * 4000 ) 50000 Rs
• For 6000 unit
– 30000 + ( 5 * 6000 ) 60000 Rs
MICS-HJB 32
Transfer Pricing
• Under two – step pricing method, company’s variable cost for
product - A is identical to Unit - Y. Unit – Y can take short - term
corrective action. It is also having information of up stream fixed
cost an profit relating to product – A which can be use for long –
term action.
• The monthly charge for fixed coast and profit should negotiated
periodically.
• Assigning cost to individual product is not difficult.
• Manufacturing unit performance is not affected by sales volume.
• There could be a conflict between the interest of manufacturing unit
and company in case of capacity limited.
• Method is similar to “take or pay”
MICS-HJB 33
Transfer Pricing
– Profit Sharing :
• If two – step pricing method not feasible, a profit sharing is used.
• The product is transferred at standard variable cost.
• Profit is contributed after selling the product. ( Selling price – Variable
manufacturing cost – Marketing cost )
• Applicable were demand is not steady.
– Two Sets of Prices :

• It is used when there are frequent conflicts between buying and selling unit
and can not resolve by any other method.
• Manufacturing unit revenue is credited at the out side selling price.
• Buying unit charged to a total standard cost.
• Difference is charged to head office and eliminated at the time of business
unit statement is consolidated.
MICS-HJB 34
Commonly Used Transfer Prices
1. Market price approach sets the price at which
the product transferred could be sold to outside
buyers.
2. Negotiated price approach allows decentralized
managers to agree (negotiate) among
themselves.
3. Cost price approach (variable or full) uses a
variety of cost concepts for setting the transfer
price.
Commonly Used Transfer Prices
Variable Cost Full Cost Market Price

per Unit $10 per Unit $13 per Unit $20
Negotiated Price
Transfer Pricing—Negotiated Price Approach
Assumptions
1.Division M produces a product with a variable
cost of $10 per unit. Division M has unused
capacity.
2.Division N purchases 20,000 units of the same
product at $20 per unit from an outside source.
If the division managers agree on a price of

$15 per unit, how much will each
division’s income increase?
Responsibility
Accounting for
Investment Centers
In an investment center, the unit manager has the
responsibility and the authority to make decisions
that affect not only costs and revenues but also
the assets invested in the center.
Investment Centers
Datalink Inc.
Northern Central Southern
Division Division Division
Revenues $560,000 $672,000 $750,000
Operating expenses 336,000 470,400 562,500
Income from operations
before service dept. charges $224,000 $201,600 $187,500
Service department charges 154,000 117,600 112,500
Income from operations $ 70,000 $ 84,000 $ 75,000
Invested assets $350,000 $700,000 $500,000
Rate of return on investment 20%
20% 12%
12% 15%
15%
Rate of Return on Investment (ROI)
Revenues
Profit
Profit
Margin
Investment
Turnover
The profit margin
indicates the rate of profit
on each sales dollar.
The
investment
turnover
indicates
the rate of
sales on Profit
each dollar Investment
Margin
of invested Turnover
assets.
ROI = Income from operation x Sales

Sales Invested assets
$ 70,000 $560,000
ROI = x
$560,000 $350,000
ROI = 12.5% x 1.6 = 20%
ROI = Income from operation x Sales

Sales Invested assets
Profit Inventory
Margin Turnover
Profit Margin Division Division Division
Revenues (Sales) $560,000 $672,000 $750,000
Profit margin 12.5% 12.5% 10.0%
Investment Turnover
Revenues (Sales) $560,000 $672,000 $750,000
Invested assets $350,000 $700,000 $500,000
Investment turnover 1.6 .96 1.5
Return on Investment (ROI)
Invested assets $350,000 $700,000 $500,000
Rate of return on investment 20% 12% 15%
Minimum
Income Acceptable
– Residual
from Rate of =
Income
Operations Return on
Assets
Baldwin Company

Division Division Division
Income from operations $70,000 $84,000 $75,000
Minimum acceptable income
from operations as a percent
of invested assets:
$350,000 x 10% 35,000
$700,000 x 10% 70,000
$500,000 x 10% 50,000
Residual income $35,000 $14,000 $25,000
The balance scorecard is a set of
financial and nonfinancial measures
that reflect multiple performance
dimensions of a business.
Innovation and
Learning
• R&D investment
• R&D pipeline
• Skills and training
• Time to market
Customer Internal
• Satisfaction Process
• Loyalty • Efficiency
• Perception • Quality
• Time
Financial
• ROI
• Residual income
• Profit
• Cost
• Sales
The End

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Performance Evaluation for

Administration $ 17,500 $ 17,350 $150

Administration $ 17,500 $ 17,350 $150

Note that “Over Budget” is a net figure.

Each of the line items above is

In a profit center, the unit manager has the

NEG, a diversified entertainment company,

Theme Park Movie Production

12,000 payroll3,000 payroll

100 hours x $250

Income from operations before

Profit Centre Input are related to Output

Production Marketing Business Unit

Buying cost Selling cost

– Agreement Among Business Units :

– Two Sets of Prices :

Variable Cost Full Cost Market Price

If the division managers agree on a price of

ROI = Income from operation x Sales

ROI = Income from operation x Sales

Northern Central Southern

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