Chapter 15 – Transfer Pricing
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2. Cost-based transfer price at 105% of the full absorption cost per motor.
3. Negotiated transfer price of $18.5 per motor.
Solution:
Market-based
transfer price
@ $20
Cost-based
transfer price
@ $17.85
Negotiated
transfer price
@ $18.5
Motor Division
Revenues
$200,000
$178,500
$185,500
Costs:
Variable manufacturing cost
120,000
120,000
120,000
Variable overhead
20,000
20,000
20,000
Fixed overhead
30,000
30,000
30,000
Divisional income before tax
$30,000
$8,500
$15,500
Income tax (25%)
7,500
2,125
3,875
Divisional income
$22,500
$6,375
$11,625
Market-based
transfer price
@ $20
Cost-based
transfer price
@ $17.85
Negotiated
transfer price
@ $18.5
Pump Division
Revenues
$800,000
$800,000
$800,000
Costs:
Variable manufacturing cost
300,000
300,000
300,000
Transferred-in cost
200,000
178,500
185,500
Variable overhead
150,000
150,000
150,000
Fixed overhead
90,000
90,000
90,000
Divisional income before tax
$60,000
$81,500
$74,500
Income tax (40%)
24,000
32,600
29,800
Divisional income
$36,000
$48,900
$44,700
Total income
$58,500
$55,275
$56,325
If the selling division is located in a low-tax country (relative to the buying division), the
management has the incentive to set the transfer price high to increase revenue of the selling
division while reducing the tax burden of the buying division.
On the other hand, if the selling division is located in a high-tax country (relative to the
buying division), then the management will lower the transfer price to reduce the tax burden
in the selling division while increasing the profit of the buying division.
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Chapter 15 – Transfer Pricing
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LO 15-5 Describe the role of transfer prices in segment reporting.
♦ The FASB requires companies engaged in different lines of business to report certain
information about segments that meet FASB’s technical requirements (Statement of Financial
Accounting Standards No.131, “Disclosure about segment of an enterprise and related
information”).
• The principal items that must be disclosed about each segment include:
(1) Segment revenue, from both internal and external customers,
(2) Interest revenue and expense,
(3) Segment operating profit or loss,
(4) Identifiable segment assets,
(5) Depreciation and amortization,
(6) Capital expenditures, and
(7) Certain specialized items.
• In addition, if a company has significant foreign operations, it must disclose revenues,
operating profit or loss, and identifiable assets by geographical region.
• The financial reporting of internal transactions requires that firms report segment profits
as computed for use by the chief operating decision maker in assessing segment
performance.
• The transfer pricing method used for performance evaluation will be reflected in
reported segment income and can be either cost or market based.
• Accounting for external reporting, in rare occasions, recognizes differences in the way
firms use financial information for internal decision making.
Appendix: Case 1a Perfect intermediate markets – Quality differences
♦ The case of perfect intermediate markets is not interesting because there is really little
opportunity for managerial discretion.
• A change in the transfer price does not change the total company operating profit but
does impact division performance.
• Allowing the managers to decide where to trade, the company can increase its profits
because the optimal transfer price is sending the correct signal for the managers to act
accordingly.
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Example 5 (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.
The component in question has two grades, grade I (better) and grade II. Assume that
either grade is suitable for the buying division and that there are perfect markets for the
two different grades. The intermediate market price for grade I is $50 and the
intermediate market price for grade II is $40 per unit. The selling division specializes
in grade I components.
If the division managers are allowed to choose where to buy and sell the components,
the selling division will sell its outputs on the intermediate (grade I) market for $50,
and the buying division will buy its components needed on the intermediate (grade II)
market for $40. No transfers will be made since the optimal transfer price in this case is
$50, and the company benefits from the managers’ independent decisions.
Matching
A.
Cost-plus transfer pricing
B.
Dual transfer pricing
C.
Market price-based transfer pricing
D.
Negotiated transfer pricing
E.
Transfer price
_____ 1. The value assigned to the goods or services sold or rented (transferred) from one unit
of an organization to another.
_____ 2. A system that arrives at the transfer prices through negotiation between managers of
buying and selling divisions.
_____ 3. A transfer pricing system that charges the buying division with costs only and credits
the selling division with cost plus some profit allowance.
_____ 4. A transfer pricing policy that sets the transfer price at the market price or at a small
discount from the market price.
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_____ 5. A transfer pricing policy based on a measure of cost (full costing or variable costing,
actual or standard cost) plus an allowance for profit.
Answers
Multiple Choice
1. Transfer price
a. Is the value assigned to the goods or services sold from one unit of an organization to
another.
b. Represents a cost to the selling division.
c. Will affect the company’s total profits.
d. Is the same as the market price.
2. A market is perfect if
a. The buyers can buy at any quantity without affecting the price.
b. The sellers can sell at any quantity without affecting the price.
c. The parties in the market are price takers.
d. All of the above.
3. Which of the following statements is incorrect?
a. If an intermediate market exists, the optimal transfer price is the market price.
b. If no intermediate market exists, the optimal transfer price should be the outlay cost for
producing the goods.
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c. If the selling division is operating at capacity and there is a market for the goods being
transferred, the variable cost of the goods should be used.
d. If the selling division is operating at capacity and there is no intermediate market, then
the opportunity cost depends on the cost of adding capacity.
4. When should the top management intervene in setting the transfer price?
a. The transfer is an extraordinarily large order.
b. Internal transfers are rare.
c. Internal transfer benefits the company but the division managers cannot agree on a price.
d. All of the above.
5. The selling division sells all it can produce at $18 per unit. The contribution margin lost due
to internal transfer is $6 per unit. What is the outlay cost per unit?
a. $24.
b. $18.
c. $6.
d. $12.
The following information is for questions 6 – 7.
The selling incurs variable cost of $2 per unit. The buying division incurs additional $5 per unit
and sells the final product for $15 per unit.
6. If there is no intermediate market and the selling division is not operating at capacity, what is
the optimal transfer price?
a. $15.
b. $7.
c. $5.
d. $2.
7. What is the company’s profit per unit?
a. $12.
b. $8.
c. $7.
d. $5.
The following information is for questions 8 – 9.
A manufacturing company has two divisions: Motor and Pump. The Motor Division produces an
intermediate good, a motor, that can be used as an input for the Pump Division. The Motor
Division also sells the motors in the open market. 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. A transfer price based on the variable cost is mandated.
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Motor
Division
Pump
Division
Market selling price
$20
Selling price
$80
Variable cost
12
Variable cost (other than the motor)
30
Contribution margin
$8
Variable cost of the motor
(purchased from an outside supplier)
19
Contribution margin
$31
8. If the Motor Division has no excess capacity, what is the net result of the variable cost-based
transfer pricing policy?
a. A gain of $2 per unit.
b. A loss of $1 per unit.
c. $0.
d. There is not enough information to go on.
9. If the Motor Division has available capacity to handle the Pump Division’s demand, what is
the net result of the variable cost-based transfer pricing policy?
a. A gain of $7 per unit.
b. A gain of $4 per unit.
c. A loss of $7 per unit.
d. A loss of $2 per unit.
10. Segment reporting
a. Is required by FASB.
b. Must disclose segment revenue, interest revenue and expense, segment operating profit or
loss, identifiable segment assets, and so on.
c. Applies to foreign operations.
d. All of the above.
11. Which of the following is suitable to deal with problems as a result of transfer price-based
performance measures being adopted?
a. Direct intervention by top management.
b. Centrally established transfer price policy.
c. Negotiated transfer prices.
d. All of the above.
12. Which of the following statements is incorrect?
a. A transfer pricing policy should allow divisional autonomy.
b. Market prices, if available, are considered the best basis for transfer pricing.
c. A seller operating at capacity should transfer at the differential cost of production.
d. Full-absorption costs are higher than variable costs.
Chapter 15 – Transfer Pricing
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Answers