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TP
TRANSFER PRICING

Is the process of assigning prices on the intra-company transfer of goods or services.

TRANSFER PRICE (or price in a chargeback system)

Is the price charged when one segment of a company provides goods or services to another segment
of the same company.

Fundamental Objective in Setting Transfer Prices

To motivate the managers to act in the best interests of the overall company.

Suboptimization

It occurs when a decision is made that may be beneficial for a particular segment but not for the entire
company. So the overall level of profitability is less than what a company is capable of earning. In other
words, suboptimization is a condition in which individual managers work to achieve results that are in
their own and their segments’ best interests to the detriment of the overall company. Top managers must
guard against such behavior by subordinates when authority is delegated to them in a decentralized
setting. Suboptimization results from segment managers’ motivation to appear successful and gain
rewards and recognition. Sometimes, this motivation overrides the company’s best interests.

General Rule for Choosing a Transfer Price

UPPER LIMIT (or MAXIMUM TP) = Lowest purchase price @ w/c the buying segment can buy it from
an outside supplier.

If there is no idle capacity:

FLOOR LIMIT (or MINIMUM TP) = UVC for the internal transfer + lost UCM on outside sales or OC
of the internal transfer.

If it has idle or unused capacity:

FLOOR LIMIT (or MINIMUM TP) = UVC for the internal transfer

If there is unused capacity within the selling division, there are no opportunity costs involved for an
internal transfer. In this situation, the TP is likely to be in the lower range, covering only the outlay
costs of the selling segment.

Internal transfer should be made whenever the minimum TP of the selling division is less than
the maximum TP of the buying division.

Revenue from internal transfer of goods or service is recognized only for internal reporting purposes.
For external financial reporting purposes, a company cannot recognize internal sales because the
revenue has not been realized. Revenue, for financial reporting purposes is realized when goods or
services are sold to outside customers. Sales within the company are not "arms' length" transactions
(transactions entered into by unrelated parties). Without this restriction, companies could inflate sales &
income by engaging in numerous unnecessary internal sales transactions.

The difference between the upper & lower limit of the transfer pricing range is the corporate "profit" (or
savings) generated by producing internally rather than buying externally. The TP chosen acts to "divide
the corporate profit" between the buying & selling segments. For external statements, it is irrelevant
which segment shows the profits from transfers because such internal profit allocations are eliminated
in preparing these statements.

In transfer pricing, when the subunits are profit centers, the transferring unit would prefer a higher TP
since they count it as a revenue while the receiving unit would prefer it to be lower since they count it as
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a cost. A high TP results in high profit for the selling segment & low profit for the buying segment. The
transfer pricing policy can affect the incentives of autonomous division managers as they decide
whether to make the internal transfer or not. The TP should be chosen so that each division manager,
when striving to maximize his own division’s profit, makes the decision that maximizes the company’s
profit or strives to achieve the goals set by top management. Transfer prices should not be based on
actual costs but rather on standard costs because such practice would allow an inefficient producing
division to pass its excess production costs on to the buying division in the TP. When standard costs
are used in the transfer pricing formulas, the buying division is not forced to pick up the producer’s
inefficiency. Moreover, the producing division is given an incentive to control its costs, since any costs
of inefficiency cannot be passed on. Service entities & non-profit organizations also use transfer pricing
when services are transferred internally.

Assume that a product is available from external suppliers at a price below the lower limit of the transfer
pricing range. The immediate short-run decision might be that the selling division is to stop production
& allow the buying division to buy from outside supplier. This decision is reasonable because compared
with outside suppliers, the selling division does not appear to be cost efficient in its production activities.
Stopping production would release the facilities for other more profitable purposes. A long-run solution
is to have the selling division improve its efficiency and reduce the internal cost of making the product.

Segment managers in a decentralized firm often have competing vested interests if managerial
performance is evaluated on a competitive basis. Such internal competition could lead to
suboptimization which is a situation in which individual managers pursue goals & objectives that are in
their own and/or their segment's particular interests rather than in the company's best interests. If a
sub-unit is operated as a profit center, management should guard against suboptimization. It exists
when in the process of maximizing profit contribution of that sub-unit, the overall results of operations of
the company as a whole are adversely affected. For suboptimization to be limited or minimized, top
management must be aware that it can occur & should develop ways to avoid it like communicating
corporate goals to all organizational units and using appropriate transfer prices between units. The
appropriate TP should ensure optimal resource allocation and promote operating efficiency.

Criteria for Creating a Transfer Pricing System:

These 4 criteria should be prioritized when forming transfer pricing policies. TPs are evaluated based
on the firm’s:

1. GOAL CONGRUENCE exists when individuals & groups work toward the same goal (mutually
supportive & consistent) Will the TP encourage each manager to make decisions that will
maximize profits for the firm as a whole?

2. PERFORMANCE EVALUATION - Will the TP allow corporate level managers to measure the
financial performance of division managers in a fair manner?

3. AUTONOMY - Will the TP policy allow division managers to operate their division as if they were
independent businesses? If a division manager must ask for approval from some
higher level, the firm's policies have diluted the autonomy of its managers. If
autonomy is restricted greatly, the objectives of decentralization are defeated.

4. ADMINISTRATIVE COST - Is the transfer pricing system easy and inexpensive to operate? These
costs also include waiting for decisions, hours spent haggling and internal
divisiveness.

TRANSFER PRICING METHODS

Five (5) Basic Methods of Pricing Intracompany Transfers:
(1) cost-based; 2) market-based; (3) negotiated market; (4) arbitrary; and (5) dual.

No one method of setting a TP is best in all instances. Perhaps the best method is defined best for a
particular purpose. For decision-making purposes, what is important is to determine the differential cost
involved regardless of the TP method used. Transfer prices are not permanent; they are frequently
revised in relation to changes in costs, supply, demand, competitive forces & other factors. The TP that
provides the most benefit to the company as a whole is the 1 that should be chosen.
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Cost-Based TP

This is usually sufficient in situation where operations of the company is totally centralized. Aside from
being simple & easy to apply, it is widely used when there is no reliable market price that can be
used as a basis for TP or when the selling division has excess capacity. As such, the transferred
cost can readily be used to measure production efficiency by comparing actual figures with budgeted
figures. Likewise, it avoids the trouble of eliminating intra-company profits in consolidating financial
statements & for income tax. However because of its limitations, it is not applicable to decentralized
operations for it lacks the required factor, like margin, necessary to allow planning, motivation,
evaluation, and objectivity necessary for a good performance standards. In determining the TP based
on cost, the cost used may be the actual or standard, and may further be equal to total cost, total cost
plus markup, or marginal cost plus markup. Total cost plus markup approximates the market price,
considered a practical substitute & is better known as synthetic price. If cost only is used as a TP, the
selling unit cannot earn a profit. Another version of cost-based transfer pricing is variable cost. With VC
transfer prices, only variable production costs are transferred. It has the major advantage of
encouraging maximum profits for the entire firm when excess capacity exists.

Goal congruency can be achieved in many cases using cost-based transfer pricing. Transfers are
priced at cost when the transferring division is viewed as a cost center. However, if the transferor is a
profit center, MV or cost plus TP are typically used. Cost + TP is often used when a market price is not
available. In a sense, it is a surrogate for a market price.

Market-Based TP is the price at which the goods are sold on the open (intermediate) market.
Intermediate market means a market in which a transferred product or service is sold in its present form
to outside customers. This is the best TP for a firm which is highly decentralized in its operations
since it will maximize the profits of the company as a whole provided that: (1) a competitive MP exists
and (2) divisions are independent of each other.

It is very much useful in the process of performance evaluation for it reflects the reality of
competitiveness. However, the determination of the actual cost of the product becomes difficult due to
the presence of intra-company profit or loss for each transfer. The determination itself of the market
base to be used is not an easy task; it requires a well developed outside competitive market which is
unfortunately not always determinable for intermediate products. In determining the TP based on
market, the prevailing market price, current replacement cost or NRV, whenever clearly determinable,
serves as the ceiling for TP & may be reduced by the selling costs.

In conducting divisional performance, the market-based TP is considered the best because it attempts
to approximate an arm's length, bargained, open-market price. Goods & services transferred are priced
based on what is prevailing in an outside market or based on how much to pay the outsiders. From the
point of view of the transferor, it approximates its opportunity cost because the market price is the
amount of revenue it can realize from the sale of goods to outsiders. This method may be adopted
only when there is a perfectly competitive market for the intermediate product. In the absence
thereof, the "buying" and "selling" divisions may resort to negotiated TP, which is a refinement of the
market based TP.

Negotiated Market TP or bargained MP resulted from a bargaining process between the selling &
buying segments or that is the price agreed upon between the buying & selling division & used when
no intermediate MP exists for the product transferred. When excess capacity exists in the selling
division, the floor price is typically the selling division’s variable cost. The ceiling price is typically
the external market price. The final negotiated price will typically end up between the floor and ceiling
prices. In the absence of a clearly determinable market base for TP, the "buying" and "selling"
segments may negotiate & arrive at a mutually agreed price. The negotiation usually depends upon the
opportunity to buy from outsiders. Negotiated prices are helpful when:
1. Cost savings occur from selling and buying internally.
2. Additional internal sales fill previously unused capacity, allowing the buyer & seller to share any
incremental profit.

Even if a competitive market exist, the negotiated market TP demonstrate the authority & control of
managers over the profit of their respective unit. However, the procedure is time consuming & may
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even create conflict of opinion diverting the efforts of the managers to those affecting their end
results rather than the company as a whole. Besides, breakdown in negotiation may even involve
executive management to act as mediator only to arrive at an arbitrary price.

Arbitrary TP Neither the buying division nor the selling division controls the TP. Top management
sets the TP at a level considered best for the overall interests of the company. The use of an arbitrary
TP may indicate a step toward centralization & the inability of division managers to operate
smoothly on a decentralized basis. It hampers the autonomy and profit incentive of division
managers.

Dual TP To assist in meeting all the criteria set for transfer pricing, some firms will use dual pricing to
allow for each division to achieve the optimal value. Under this system, the transferor may value their
products or services in the same manner as they value the same when dealing with outside customers.
On the other hand, the transferee would value the goods & services received at a price that will clearly
reflect the actual cost & would not include an artificial profit for them to be aware of the total cost
implications.

Transfer Pricing in Make or Buy Decision Problems

Because a TP is revenue to one segment & a cost to the other segment, the price does not affect total
income for the firm unless a change in the TP induces the manager of some segment to make some
change in the operations of that segment.

Disadvantages of Transfer Pricing:

1. There can be (& most often is) disagreement among unit managers as to how the TP should be set.
2. Implementing transfer prices in the accounting system requires additional organization costs &
employee time.
3. Transfer prices do not work equally well for all departments or divisions.
4. The TP may cause dysfunctional behavior among segments or may induce certain services to be
under-or over-utilized.

Transfer Price for Services

Departments of many large organizations may sell services for customers & for each other internally.
For example, a company typically bill administrative services such as computer processing, accounting,
payroll & personnel to the departments they support. In each of the cases, equitable transfer prices
must be established to appraise the dept's performance for its own return on invested capital. The
following steps may be followed in setting TP for services:
1. Identify the different depts. contributing various services.
2. Evaluate the corresponding skill & experience of personnel involved in delivering services.
3. Estimate the cost involved in providing the service. Factors such as time requirements,
qualifications, cost of the facilities needed to provide the service should be considered.
4. Apply the appropriate transfer pricing method to use.

International Aspects of Transfer Pricing (or Multinational Transfer Pricing)

Transfer Pricing is used worldwide to control the flow of goods & services between segments of
organizations. However, the objective of transfer pricing change when a multinational corp. (MNC) is
involved & the goods and services being transferred must cross international orders. The objectives of
international transfer pricing focus on minimizing taxes, duties, and tariffs, forex risks along w/
enhancing a company's competitive position & improving its relation with foreign government.

It is possible to increase the overall after-tax profit of a multi-national corp. by adjusting transfer prices.
Corp. may change a TP that will reduce its total tax bill or that will strengthen a foreign subsidiary. For
example, a division in a high-income-tax rate country produces a subcomponent for another division in
a low-income-tax-rate country. By setting a low TP, the company will shift a portion of its income to a
country with a lower tax rate, so the overall company will have income tax savings. Most of the profit
from the production can be recognized in the low-income-tax-rate country, thereby minimizing taxes.
On the other hand, items manufactured by division in a low-income-tax-rate country & transferred to a
division in a high-income-tax-rate country should have a high TP to minimize taxes.
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The imposition of import duties or tariffs may offset income tax effects. Import duties or tariffs are the
fees charged to an importer, generally on the basis of the reported value of the goods being imported.
Usually import duties are based on the price paid for an item, whether bought from an outside company
or transferred to another division. Therefore, low transfer prices will be used to lessen the import duties,
thus maximizing the overall profit of the company as a whole. As in the case of taxation, countries
sometimes pass laws to limit a multinational firm’s flexibility in setting transfer prices for the purpose of
minimizing import duties. Managers should be sensitive to the geographic, political & economic
circumstances in w/c they are operating & set TP in such a way as to optimize total company
performance & at the same time conform with the laws in various countries where they operate.

A company has a plant in a high tax jurisdiction that produces products for a facility in a low tax
jurisdiction. What strategy (including transfer prices) will result in the lowest tax for the overall
corp.?

The overall corporate objective would be to report high costs and low revenue in the high tax
jurisdiction, and low costs and high revenue in the low tax jurisdiction. In this situation, a low TP from
the high tax jurisdiction facility will allocate more profit to the low tax jurisdiction. This will decrease total
taxes paid by the corporation.

I) SS Company manufactures pillows. The Cover Division makes covers and the Assembly Division
makes the finished products. The covers can be sold separately for P 5.00. The pillows sell for
P6.00. The information related to manufacturing for the most recent year is as follows:
Cover Division manufacturing costs ……………………………………….P 6,000,000
Sales of covers by Cover Division …………………………………………. 4,000,000
Market value of covers transferred to Assembly …………………………… 6,000,000
Sales of pillows by Assembly Division …………………………………….. 7,200,000
Additional manufacturing costs of Assembly Division …………………….. 1,500,000

Required: Compute the operating income for each division and the company as a whole. Use market
value as the TP. Are all managers happy with this concept? Explain.

II) SB Division makes top-of-the-line travel bags that are sold to external buyers and are also being
used by Sporting Goods Division as part of a complete tennis racket set. During the month just
ended, Sporting Goods acquired 2,000 bags from SB Division. SB's standard unit costs are.
Direct materials P 10 Fixed Factory Overhead 6
Direct labor 3 Variable Selling 2
Variable Factory Overhead 4 Fixed Selling and administrative 3
Sporting Goods can acquire comparable bags externally for P 40 each. Give the entries for each
division for the past month if the transfer is to be recorded.
1. at Sporting Good's external purchase price.
2. at a negotiated price of variable cost plus 15% of production cost.
3. by SB at Sporting Good's external price and by Sporting Goods at SB’s variable production cost.
4. at SB's absorption cost.

III) Clear Co. is operating 2 divisions, GG and MC. Product ZO is produced in division GG at a variable
cost of P15 per unit and 20,000 units is sold to the external market at P25 per unit and 10,000
units is transferred to division MC at variable cost plus 40% which is acceptable to division MC.
Fixed costs in division GG is P100,000. Division MC after processing further ZO turns out finished
product ZO7 which are sold in the external market at P35 per unit. Additional processing costs in
this division amounts to P80,000. All 10,000 units processed by division MC was sold. The annual
FC of this division was P50,000. No other costs are considered.
Required: 1. Prepare the income statement of the
a) two divisions b) company as a whole
2. Assume that only 5,000 of the 10,000 units processed by division MC were sold in the
external market, prepare:
a) Income statement for the two divisions.
b) Income statement for the company as a whole.

IV) Derek Products, Inc. has a North Division that manufactures and sells a standard valve as follows:
Capacity in units 100,000
Selling price to outside customers on the intermediate market P 30
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Variable costs per unit 16

Fixed costs per unit (based on capacity) 9

The company has a South Division that could use this valve in the manufacture of one of its pumps.
The South Division is currently purchasing 10,000 valves per year from an overseas supplier at a
cost of P29 per valve.

1. Assume that the North Division is selling all that it can produce to outside customers on the
intermediate market & that P3 of variable expenses can be avoided on intra-company sales, due to
reduced selling costs. What should be the TP between the two divisions?

2. Refer to the original data given above, assume that the South Division needs 20,000 special valves
per year that are to be supplied by the North Division. The North Division's variable costs to
manufacture & ship the special valve would be P20/ per unit. To produce these special valves, the
North Division would have to give up one half of its production of the regular valves (that is, cut its
production of the regular valves from 100,000 units per year to 50,000 units per year). You can
assume that the North Division is selling all of the regular valves that it can produce to outside
customers on the intermediate market. If the North Division decides to produce the special valves
for the South Division, what TP should it charge per valve?

“IT IS EASY TO MAKE DECISIONS ON MATTERS FOR WHICH YOU HAVE NO RESPONSIBILITY”