Chapter 15 – Transfer Pricing
15–11
performance evaluation system used and the impact that alternative transfer prices will have on
managerial performance evaluation.
• Corporate managers have two economic bases on which to establish transfer price
policies: market prices and cost.
• Market price-based transfer pricing is a transfer pricing policy that sets the transfer
price at the market price or at a small discount from the market price.
• Two general guidelines for market price-based transfer pricing are:
(1) The transfer price is usually set at a discount from the cost to acquire the item on the
open market.
(2) The selling division may elect to transfer or to continue to sell to the outside.
• Externally based market prices are generally considered the best basis for transfer
pricing when a competitive market exists for the product and when market prices are
readily available.
• Usually, there are differences between products produced internally and those that can
be purchased from outsiders, such as costs, quality, or product characteristics.
• An advantage of market prices is that both the buying and selling divisions are
indifferent as to trading with each other or with outsiders, as long as the selling division
is not operating at capacity.
• When such advantages exist, it is in the company’s interest to create incentives for
internal transfer.
• A cost-based transfer pricing policy should adhere to the following rule:
Transfer at the differential outlay cost to the selling division (typically variable costs)
plus the foregone contribution to the company of making the internal transfers ($0 if the
seller has idle capacity; selling price minus the variable costs if the seller is operating at
capacity).
♦ The transfer pricing rule can be implemented as follows:
(1) A seller operating below capacity should transfer at the differential cost of production
(variable cost).
(2) A seller operating at capacity should transfer at the market price.
Chapter 15 – Transfer Pricing
15–12
• The general rule is optimal for the company, but it does not benefit the selling division
for an internal transfer in the below-capacity case.
• When a measure of differential or variable cost, or market price is not available,
companies usually use full absorption costs as the transfer price.
•Full-absorption costs are higher than variable costs, but probably less than the market
price.
• The use of full absorption costs does not necessarily lead to the profit-maximizing
solution for the company.
• Full absorption cost has some advantages:
(1) These costs are available in the company’s records.
(2) They provide the selling division with a contribution equal to the excess of full
absorption costs over the variable costs, which gives the selling division an incentive
to transfer internally.
(3) The full absorption cost can sometimes be a better measure of the differential costs of
transferring internally than the variable costs.
• Cost-plus transfer pricing is a transfer pricing policy based on a measure of cost (full
costing or variable costing, actual or standard cost) plus an allowance for profit.
• If actual costs are used as a basis for the transfer, any variances or inefficiencies in the
selling division are passed to the buying division.
• To promote responsibility in the selling division and to isolate variance within divisions,
standard costs are generally used as a basis for transfer pricing in cost-based systems.
♦ When the transfer pricing policy does not give the selling division a profit on the transfer:
(1) A selling division whose transfers are almost all internal is usually organized as a cost center.
(2) A selling division that does business with both internal and external customers may be set up
as a profit center for external business when the manager has price-setting power and as a
cost center for internal transfers when the manager does not have such power.
♦ Dual transfer pricing is a transfer pricing system that charges the buying division with costs
only and credits the selling division with cost plus some profit allowance. The difference could
be accounted for in a specialized centralized account.
Chapter 15 – Transfer Pricing
15–13
• This system would preserve the cost data for subsequent buyer divisions and would
encourage internal transfers by providing a profit on such transfers for the selling
divisions.
Example 4 (Revised from Example 1): It costs the selling division $20 to produce one
unit of a component which, if transferred to the buying division, requires additional
work costing $45 and can be sold to outside customers for $100 per unit of the finished
product.
To encourage internal transfers, the company decides to implement a dual transfer
pricing system in which the buying division is charged for the $20 cost while the
selling division is credited with a $3 profit allowance. On a per-unit basis,
Selling division’s profit (S) = ($20 + $3) – $20 = $3.
Buying division’s profit (B) = $100 – $20 – $45 = $35.
Total profit for the firm = $100 – $20 – $45 = $35 ≠ $3 + $35.
The sum of the two divisions’ profits ($38) is not equal to the firm’s total profit ($35).
The journal entries recorded by the two divisions tell the story.
Selling division:
A/R – Buying division
20
Intercompany sales in excess of assigned costs
3
Intercompany sales
23
Intercompany cost of goods sold
20
Finished goods
20
Buying division:
Inventory
20
A/P – Selling division
20
• Disadvantages of dual price system are:
(1) It reduces the value of the transfer price as a signal to division managers of the value
of the intermediate goods to the firm, and
(2) It also tends to remove some of the performance evaluation value because both
managers benefit and the difference in the central account is ignored.
♦ Negotiated transfer pricing is a system that arrives at the transfer prices through negotiation
between managers of buying and selling divisions.
Chapter 15 – Transfer Pricing
15–14
• The managers involved in negotiation should act in much the same way as the managers
of independent firms.
• The negotiated prices are generally between the market price at the upper limit and
some measure of cost at the lower limit.
• The major advantage to negotiated transfer pricing is that it preserves the autonomy of
the division managers.
• Two disadvantages of negotiated transfer pricing are:
(1) A great deal of management effort may be consumed in the negotiating process, and
(2) The final price and its implications for performance measurement could depend more
on the manager’s ability to negotiate than on what is best for the company.
======================
Demonstration Problem 2
(Revised from Demonstration Problem 1)
A manufacturing company has two divisions: Motor and Pump. The Motor Division produces an
intermediate good, motors, that can be used as an input for the Pump Division. The Pump
Division assembles the parts together to make water pumps which are sold to the consumers. The
Pump Division needs an average of 10,000 motors every year. The following information is
available.
Motor
Division
Pump
Division
Selling price
?
$80
Variable manufacturing cost
12
30
Transferred-in cost
?
Variable overhead
2
15
Fixed overhead
3
9
Required:
Calculate divisional operating income and total operating income given the following
independent transfer pricing policies.
1. Market-based transfer price of $20 per motor.
2. Cost-based transfer price at 105% of the full absorption cost per motor.
3. Negotiated transfer price of $18.5 per motor.
Chapter 15 – Transfer Pricing
15–15
4. The Motor Division receives the transfer price at 105% of the full absorption; the Pump
Division pays only the variable manufacturing cost.
Solution:
1.
2.
Motor
Division
Pump
Division
Revenuesa
$178,500
$800,000
Costs:
Variable manufacturing cost
120,000
300,000
Transferred-in cost
178,500
Variable overhead
20,000
150,000
Fixed overhead
30,000
90,000
Divisional operating income
$8,500
$81,500
Total operating income
$90,000
a Full absorption cost = $12 + $2 + $3 = $17.
Transfer price = $17 × 105% × 10,000 units = $178,500.
Motor
Division
Pump
Division
Revenues
$200,000
$800,000
Costs:
Variable manufacturing cost
120,000
300,000
Transferred-in cost
200,000
Variable overhead
20,000
150,000
Fixed overhead
30,000
90,000
Divisional operating income
$30,000
$60,000
Total operating income
$90,000
Chapter 15 – Transfer Pricing
15–16
3.
Motor
Division
Pump
Division
Revenues
$185,500
$800,000
Costs:
Variable manufacturing cost
120,000
300,000
Transferred-in cost
185,500
Variable overhead
20,000
150,000
Fixed overhead
30,000
90,000
Divisional operating income
$15,500
$74,500
Total operating income
$90,000
4.
Motor
Division
Pump
Division
Revenues
$178,500
$800,000
Costs:
Variable manufacturing cost
120,000
300,000
Transferred-in cost
120,000
Variable overhead
20,000
150,000
Fixed overhead
30,000
90,000
Divisional operating income
$8,500
$140,000
Total operating income
$90,000a
a Intracompany sales in excess of assigned cost = $178,500 – $120,000 = $58,500.
$8,500 + $140,000 – $58,500 = $90,000.
======================
♦ Management tends to settle for a transfer pricing system that seems to work reasonably well
when both the costs and benefits of the system are considered.
• In Exhibit 15.5, survey data showed that nearly 50 percent of the U.S. companies used a
cost-based transfer pricing system, 33 percent used a market price-based system, and 22
percent used a negotiated system.
• No transfer pricing policy applied in practice is likely to dominate all others.
Chapter 15 – Transfer Pricing
15–17
LO 15-4 Explain the economic consequences of multinational transfer
prices.
♦ In international (or interstate) transactions, transfer prices may affect tax liabilities, royalties,
and other payments because of different laws in different countries (or states or provinces).
• Management control considerations suggest that the transfer price reflect the value of
the goods or services being transferred.
• 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.
• International taxing authorities look closely at transfer prices when examining the
returns of companies engaged in related-party transactions that cross national boundaries.
• Companies must have adequate support to justify the use of the transfer price that they
have chosen.
======================
Demonstration Problem 3
(Revised from Demonstration Problem 2)
A manufacturing company has two divisions: Motor and Pump. The Motor Division is located in
a low tax country (Tax rate = 25%) and produces an intermediate good, motors, that can be used
as an input for the Pump Division. The Pump Division is located in a high tax country (Tax rate
= 40%) and assembles the parts together to make water pumps which are sold to the outside
customers. The Pump Division needs an average of 10,000 motors every year. The following
information is available.
Motor
Division
Pump
Division
Selling price
?
$80
Variable manufacturing cost
12
30
Transferred-in cost
?
Variable overhead
2
15
Fixed overhead
3
9
Required:
Calculate divisional operating income and total operating income and discuss tax
implications, given the following independent transfer pricing policies.
1. Market-based transfer price of $20 per motor.