Chapter 25 Transfer Price 1 of 13

Management Control Systems

] A management control system (MCS) is a means of gathering and using information to aid and
coordinate the process of making planning and control decisions throughout the organization and to
guide employee behavior.
] Management control systems collect both financial data and nonfinancial data from within the
organization and from outside sources.
] Different levels of decision making require different information from the MCS.
] They have both formal and informal components. The management accounting and human resources
systems are formal components. Shared values, loyalties, mutual commitments among members of
the organization, and the unwritten norms about acceptable behavior comprise part of the informal
MCS.

Effective management control systems possess three main properties.

1 They are closely aligned to an organizations strategies and goals.
2 They are designed to fit the organization's structure and the decision- making responsibility of
individual managers.
3 They help to motivate managers and employees.

Organization Structure and Decentralization

Decentralization is the freedom for managers to make decisions at lower levels in the organization.
Benefits of Decentralization Costs of Decentralization
C Greater responsiveness to local needs D Suboptimal (dysfunctional) decision making
C Quicker decision making D Duplication of activities
C Increased motivation D Decreased loyalty toward organization as a whole
C Aids managerial development D Increased costs of gathering information
and learning
C Sharpens focus of managers

Comparison of Benefits and Costs

Managers often decide whether to centralize or decentralize decision making on a function-by-function
basis by examining the benefits vs. the costs.

Decentralization in Multinational Companies

T Organizations are often organized in a decentralized manner due to language, customs, cultures,
business practices, rules, laws and regulations that vary significantly between countries.
T Decentralization allows knowledge of local business conditions to be exploited by local managers.
T A major drawback of decentralizing in multinational companies is the lack of control. (Barings Bank
example)

Choices About Responsibility Centers

T Types include cost, revenue, profit, and investment centers.
T Caution is given not to automatically associate profit centers with decentralization and cost centers with
centralization. Profit centers may be in operation in centralized organizations and cost centers may be
present in decentralized ones.
Chapter 25 Transfer Price 2 of 13

Transfer Prices

Intermediate product (IP): a product transferred from one subunit to another subunit
Transfer price (TP) : the price one subunit charges for a product supplied to another subunit.

Supplying è Selling è Finished Product

Division Division Revenue
Makes boxes ê Sells Boxes Additional costs

Variable cost Margin

Fixed cost

Intermediate product market

for
for

Negotiated Transfer Prices

F Negotiated transfer prices result from a bargaining process between selling and buying divisions.
F When excess capacity exists in the selling division, the "floor" price is typically the selling division's
variable costs.
F The "ceiling" price is typically the external market price.
F The final negotiated price will typically end up between the floor and ceiling prices.

A General Guideline for Transfer-Pricing Situations

Minimum Additional incremental or + Opportunity costs per unit to the supplying division
=
transfer outlay costs per unit
price incurred up to the point of
transfer

" + Best Profit without Best Profit with transfer

transfer

where: outlay costs are the cash opportunity costs is the maximum profit
outflows that are directly foregone by the supplying division if the products or
associated with the services are transferred internally.
Chapter 25 Transfer Price 3 of 13

production and transfer of

the products and services.

Multinational Transfer Pricing and Tax Considerations

F Transfer pricing in an international setting requires consideration of international taxation and income
or dividend payment restrictions, tariffs
F Companies can attempt to minimize their global tax obligation by judiciously selecting transfer prices
for products transferred between countries. (See the Horizons Petroleum example on pages 914 and 915
of the text.)
F Taxing authorities have strict rules regarding acceptable transfer prices between operations in two
countries. In the U.S., Section 482 of the Internal Revenue Code restricts the price to that which
would be charged an unrelated third party.
F Additional factors that are present in international transfer pricing include tariffs and customs duties
levied on imports into a country.
F Sometimes transfer prices are influenced by restrictions that some countries place on payment of
income or dividends to parties outside their national borders.
V.Transfer Pricing

A.An intermediate product is a product transferred from one subunit to another

subunit of the same organization.

B.A transfer price is the price one subunit charges for a product or service supplied
to another subunit.

C.The transfer price represents revenue to the selling subunit and cost to the buying
subunit.

Objective 4
Identify three general methods for determining transfer prices.

D.Alternative Transfer-Pricing Methods

Ideally, the method used should lead each subunit manager to make optimal
decisions for the organization as a whole

1.Market-based

2.Cost-based - examples include variable manufacturing, manufacturing

(absorption) costs, and full product costs.

3.Negotiated

Do Multiple Choice 4.

Objective 5
Understand how a transfer-pricing method can affect the operating income of individual subunits.

VI.Illustration of Transfer Pricing

(Refer to Exhibits 25-1 and 25-2 on pages 906 and 907 for the Horizon Products transfer
pricing example.)

Objective 6
Illustrate how market-based transfer prices generally promote goal congruence in perfectly competitive
markets.

VII.Market-Based Transfer Prices

A.Market prices lead to optimal decisions when intermediate market is perfectly
competitive, subunit interdependencies are minimal, and no other costs or benefits
to the corporation as a whole in using the market versus internal sourcing.

Do Multiple Choice 5.

B.Distress prices occur when supply outstrips demand and prices drop well below
their historical average. When distress prices prevail, some companies use long-
run average cost as the transfer price.

1.If the distress price is used, the supplier division should meet the distress
price as long as it exceeds the incremental costs of supplying the product
or service; if not, the supplying division should stop producing and the
buying division should buy the product or service from an outside supplier.

Do Multiple Choice 6.

Objective 7
Recognize why a transfer price based on full cost plus a mark up may lead to suboptimal decisions.

VIII.Cost-Based Transfer Prices

A.Full-Cost Bases

1.Suboptimal decisions in the short run can result.

(Follow the Horizon Products refinery decision on pages 909 and 910.)

B.Prorating the Overall Contribution

1.This method imposes a variable-cost transfer price and prorate the

contribution to corporate operating income.

C.Dual Pricing

1.This method credits the selling division with full cost plus markup and
charges the buying division for variable cost. A debit to a corporate
account is made for the difference.

Do Multiple Choice 7.

Objective 8
Understand the range over which two divisions generally negotiate the transfer price when there is excess
capacity.

IX.Negotiated Transfer Prices

A.Negotiated transfer prices result from a bargaining process between selling and
buying divisions.

B.When excess capacity exists in the selling division, the "floor" price is typically
the selling division's variable costs.

C.The "ceiling" price is typically the external market price.

D.The final negotiated price will typically end up between the floor and ceiling
prices.

Objective 9
Present a general guideline for determining a minimum transfer price in transfer-pricing situations.

X.A General Guideline for Transfer-Pricing Situations

where:outlay costs are the cash outflows that are directly associated with the production
and transfer of the products and services.

opportunity costs is the maximum contribution foregone by the supplying

division if the products or services are transferred internally.

A.Examples of applying the general guidelines are given for three scenarios for the
Horizon Products example in the text on pages 913 and 914.

Do Multiple Choice 8, 9, and 10.

Objective 10
Recognize income tax considerations in transfer pricing.

XI.Multinational Transfer Pricing and Tax Considerations

A.Transfer pricing in an international setting requires consideration of international

taxation and income or dividend payment restrictions, tariffs

B.Companies can attempt to minimize their global tax obligation by judiciously

selecting transfer prices for products transferred between countries. (See the
Horizons Petroleum example on pages 914 and 915 of the text.)

C.Taxing authorities have strict rules regarding acceptable transfer prices between
operations in two countries. In the U.S., Section 482 of the Internal Revenue Code
restricts the price to that which would be charged an unrelated third party.

D.Additional factors that are present in international transfer pricing include tariffs
and customs duties levied on imports into a country.

E.Sometimes transfer prices are influenced by restrictions that some countries place
on payment of income or dividends to parties outside their national borders.

Chapter 25 Quiz/Demonstration Exercises_____________

1.Which of the following is not a benefit associated with decentralization?

a.Quicker decision making

b.Increased motivation of subunit managers
c.Greater responsiveness to local needs
d.Decreases costs of gathering information

2.Which of the following is a cost associated with decentralization?

a.Decreased loyalty toward the organization as a whole

b.Sharpens the focus of management
c.Slower decision making
d.a. and b.

3.Which of the following types of responsibility centers is synonymous with decentralization?

a.Cost center
b.Revenue center
c.Investment center
d.none of the above

4.According to the discussion presented in the text, which of the following is not one of the three main
methods for determining transfer prices?

a.Negotiated
b.Dictated
c.Cost-based
d.Market-based
5.When the intermediate market is perfectly competitive, subunit interdependencies are minimal and there are
no additional costs or benefits of the corporation as whole in using the market instead of transacting
internally, which transfer pricing method generally leads to optimal decisions from the firm's perspective?

a.Negotiated prices
b.Market-based transfer prices
c.Full variable costs
d.Full total costs

6.When supply outstrips demand and market prices drop well below their historical average, it is referred to as
a

a.suppliers price.
b.sellers price.
c.distress price.
d.famine price.

7.Reasons why companies do not often use a dual-pricing scheme (two separate transfer-pricing methods to
price each interdivision transaction) include the following:

a.The manager of the supplying division does not have sufficient incentives to control costs.
b.Dual-pricing reduces the incentives to gain knowledge about buying and selling markets.
c.It increases goal congruence problems associated with pure cost-plus based systems.
d.a. and b.

The following data apply to items 8-10.

The Santa Fe Manufacturing Company has two divisions in Illinois, the Sparland Division and the
Chillicothe Division. Currently, Chillicothe buys a part (3,000 units) from Sparland for $12.00 per unit.
Sparland wants to increase the price to Chillicothe to $15.00. The controller of Chillicothe claims that she
can not afford to go that high as it will decrease the division's profit to near zero. Chillicothe can buy the
part from an outside supplier for $14.00. The cost figures for Sparland are:

Direct Materials$3.25
Direct Labor 4.75
Variable Overhead .60
Fixed Overhead 1.20

8.If Sparland ceases to produce the parts for Chillicothe it will be able to avoid one-third of the fixed
manufacturing overhead. Sparland has no alternative uses for its facilities. Should Chillicothe continue to
buy from Sparland or start to buy from the outside supplier?
From the standpointFrom the standpoint
of Chillicothe Division of the company as a whole
a.Buy from outside supplierBuy from Sparland
b.Buy from outside supplierBuy from outside supplier
c.Buy from SparlandBuy from outside supplier
d.Buy from SparlandBuy from Sparland

9.Assume Sparland could use the facilities currently used to produce the 3,000 units for Chillicothe to make
3,000 units of a different product. The new product will sell for $16.00 and has the following costs:

Direct Materials$3.00
Direct Labor 4.30
Variable Overhead 5.40

What should be done from the point of view of

Sparland Division Chillicothe Division

a.Sell to Chillicothe DivisionBuy from outside
b.Sell to Chillicothe DivisionBuy from Sparland
c.Do not sell to Chillicothe and Buy from Sparland
produce the different product
d.Do not sell to Chillicothe andBuy from outside
produce the different product

10.What is the advantage (disadvantage) to Santa Fe Manufacturing as a whole if Chillicothe buys parts
internally from Sparland Division under the two assumptions above?

Sparland has no alternative Sparland can use the idle facilities

use of the idle facilities to produce a new product
a.$15,000$ 6,300
b.$16,200$ 300
c.$15,000 $ 6,300
d.$16,200$ 3,300

Solutions to Chapter 25 Quiz/Demonstration Exercises____

1.d

2.a

3.d
4.b

5.b

6.c

7.d

8.aSee the solution to question 10.

9.aSee solution to question 10.

10.c
Sparland has noSparland can use
alternativethe idle facilities
use for facilities to produce new product
Purchase costs if buying from Total Per Unit Total Per Unit
external supplier
(3,000•$14.00)$42,000 $14.00$42,000 $14.00

Outlay costs if buying from

Sparland Division
(3,000•$8.60)$25,800 $ 8.60$25,800 $ 8.60

Opportunity costs to Santa Fe

if buying from the
Sparland Division
(3,000•$0.40)$ 1,200 $ .40
(3,000•($16.00 - $12.70) $ 9,900 $ 3.30
Total relevant costs$27,000 $ 9.00$35,700 $11.90
Operating income advantage
(disadvantage) to
Santa Fe if buying
from the Sparland Division$15,000 $ 5.00$ 6,300 $ 2.10

The analysis above shows that from the firm's perspective (profitability objective) Sparland and Chillicothe
should be motivated towards an internal transfer. The "general guideline" discussed in the text for a
minimum price to be used as a "first step" in setting a transfer price is the "total relevant cost" figures above.
The range of prices that would result in both Sparland and Chillicothe opting to transfer is $9.00 - $14.00
when there is no alternative use of idle facilities and $11.90 to $14.00 when Sparland can produce a new
product. For prices less than the minimum figures ($9.00 and $11.90) Sparland would be better off without
a transfer. For prices greater than $14.00, Chillicothe would be better off using the outside source.

Suggested Readings__________________________________

1.Scarpo, J. A., Jr., "Auto Dealers Lag In Transfer Pricing," Management Accounting (July
1984), pp. 54-56.

2.Casey, M. P., "International Transfer Pricing," Management Accounting (October

1985), pp. 31-35.

3.Agami, A. M., "How To Choose Transfer Prices For FSCs," Management Accounting
(May 1986), pp. 48-50.

4.Eccles, R. G., "Analyzing Your Company's Transfer Pricing Practices," Journal of Cost
Management (Summer 1987), pp. 21-33.

5.Dearden, J., "Measuring Profit Center Managers," Harvard Business Review (September-
October 1987), pp. 84-88.

6.Lesser, F. E., "Does Your Transfer Pricing Make Cents?" Management Accounting
(December 1987), pp. 43-47.

7.Menssen, M. D., "A Contract Price Policy for Multinationals," Management Accounting
(October 1988), pp. 27-32.

8.Kovac, E. J. and H. P. Troy, "Getting Transfer Prices Right: What Bellcore Did,"
Harvard Business Review (September-October 1989), pp. 148-154.

9.von Simson, E. M., "The `Centrally Decentralized' IS Organization," Harvard Business

Review (July-August 1990), pp. 158-162.

10.Aranoff, G., "Transfer Pricing For Short-Run Profit Maximization In Manufacturing,"

Journal of Cost Management (Fall 1990), pp. 37-43.

11.Thomas, M., "A Matrix Approach to Transfer Pricing," Journal of Accounting Education
(1991), pp. 137-147.

12.Tang, R., "Transfer Pricing in the 1990's," Management Accounting (February 1992), pp.
22-26.

13.King, A. M., "The IRS's New Neutron Bomb," Management Accounting (December
1992), pp. 35-38.

14.Saltzman, M. I.,"Transfer Pricing Proposed Regulations Limit Reasonable Cause

Exception," Journal of Taxation (v79(4) 1993), pp. 252-257.

VIDEO
No Yen For Taxes
(15:54 Minutes)

SYNOPSIS: Commentator Sam Donaldson reports on a Prime Time investigation of Japanese

owned U.S. based subsidiaries' paying "almost nothing" in taxes. Over 70 percent of all foreign
firms do not pay taxes according to the Congressman J. J. Pickle of the Ways and Means
subcommittee that oversees tax law. According to congressional sources Japanese owned
corporations pay tax on only $0.46 for every $100.00 in sales in the U.S. compared to $5 to
$10.00 for U.S. owned firms. This adds up to a $30 billion shortfall per year!

This pattern of tax avoidance occurs when firms manipulate the transfer price charged when
goods produced in a foreign country are "sold" to a U.S. based subsidiary at a high cost, thus
reducing the taxable income generated by the U.S. subsidiary. This practice is illegal but
prosecuting foreign firms is almost impossible due to the difficulty in accessing tax records of
foreign firms.

Examples of how foreign firms evade U.S. taxes are detailed. The problem is in the lack of
enforcement by the I.R.S. Shirley Peterson, I.R.S. Commissioner, describes the game plan for
auditing these firms.

RELATED LEARNING OBJECTIVES:

_Define transfer prices and identify their purpose.

_Identify the factors affecting multinational transfer prices.

DISCUSSION QUESTIONS:

1.How do the purposes of transfer prices of domestic and multinational firms differ?

Domestic firms' transfer pricing policies have goal congruence and motivation as their
primary purposes, that is, to motivate managers at all levels within the firm to act in a
manner that is congruent with overall organizational goals. Multinational firms use
transfer prices for the same general purposes; however, since tax laws vary so
significantly between countries top management often overrides policy in order to
minimize total tax burdens. Another nonquantitative reason may be the tendency to
prefer paying taxes to a firm's country of ownership for nationalistic reasons.

When the direct cash flow consequences from outside entities such as taxing authorities
are material, then the purpose of "optimizing overall cash flow results from transfer
pricing policy" takes precedence over other purposes. Management must use prudence
when mandating these prices since they are subject to law. The Internal Revenue Code
Section 482 is the governing authority. The basic rule is that all sales should be made at
arm's length prices. It is even possible to negotiate in advance with the IRS an agreed
transfer price method. In January, 1993, new regulations on transfer pricing were issued
by the IRS. In general, the new rules are intended to pressure taxpayers to document
their transfer pricing and business decisions as they occur and to pursue Advance
Pricing Agreements.

Another example of when goal congruence and motivation purposes are superseded is
when a single stakeholder has a controlling or significant influence over operations of
two or more segments of a company and the percentage of ownership varies significantly.
In these circumstances profits may be shifted to the segment where the owner has the
largest ownership interest.

2.One of the purposes of transfer prices is to enable performance evaluation. Measures

used for performance evaluation include income and return on investment. What are the
implications for performance evaluation for multinational firms such as Toyota, Ford,
etc.?

When mandated transfer prices are imposed on subsidiaries for purposes of cash flow
management, the use of ROI or income measures is of dubious value. This is because of
the lack of controllability by the relevant manager.