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A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organization.
Intermediate products are the products transferred between subunits of an organization. AB Company Ltd C Company Ltd
Firm with vertical integration, having different value-creating activities in the value chain
Division A TP = Variable cost + Lost contribution per unit per unit on outside sales
A buys from B at mutually agreed transfer Price
A buys from company C at prevailing market price
Market-based Transfer Prices Cost-based Transfer Prices Negotiated Transfer Prices .
no outside source exists.•A common approach is to set the transfer price equal to the price in the external market •Market price is best transfer price as it represents the opportunity cost from point of view of both the division are concerned. freedom to outsource Capacity shortage / excess Market price is easily available What is right market price ? Ex -factory / Wholesalers / Customers . •Market prices also serve to evaluate the economic viability and profitability of divisions individually. Essentials profit is the performance measure Constraints For differentiated products.
• When transfer prices are based on full cost plus a markup. • • • .Determine the cost of products -----To set up the profit mark up About half of the major companies in the world transfer items at cost. suboptimal decisions can result. Cost based transfer price are used when there is no outside buyer available It involves two tasks: ---.
or as a method of price discrimination . such as to gain entry into a foreign market by offering unusually low prices to buyers using the foreign currency. Dual pricing may be used to accomplish a variety of goals. The problem with this approach is that the producing division is not allowed to show and contribution on the transferred goods. Minimum Transfer Price = Incremental Cost + Opportunity Cost. Variable cost: under this approach variable cost is set as the transfer price. This happens because the buying division perceives the fixed cost to the company as a whole as variable cost to the buying division . even if it has excess capacity Under this method transfer price is equal to variable cost of Variable costs the product plus an allocated portion of the fixed overheads.Variable cost Full cost Dual Pricing Dual Transfer Prices • selling product at different prices in different markets the practice of setting different prices for the same product in the different markets in which it is sold The practice of setting prices at different levels depending on the currency used to make the purchase. Transfer price based on full cost run the risk of causing dysfunctional decision making behavior.
This method is used sometimes when no external market exists for the product. • Two drawbacks of this method are -divisiveness and competition between division managers and undue weight age to negotiating skills of a manager in appraising his performance .• • • • Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions Division managers actually negotiate the price at which the transfer will be made. Sometimes they start with market price and make adjustments for various reasons.
Virtually any type of transfer pricing policy can lead to dysfunctional behavior – actions taken in conflict with organizational goals. .
and tariffs .1Goal Congruence 2 Subunit Performance Evaluation 3 Autonomy to division without subverting the firm’s goals 4 Motivation to all concerned division 5 Ensure the cost control at every division 6 Multinational companies use transfer pricing to minimize their worldwide taxes. duties.
Factor Influencing Transfer pricing Nature of Industry Culture Prevailed Organization Structure Role of Corporate Office .
Extend of negotiation Capacity utilization Type of manufacturing process Buyer’s or seller’s market .
but not always Yes .Comparison of Methods Achieves Goal Congruence Market Price: Yes. if markets competitive Cost-Based: Negotiated: Often.
if markets competitive Cost-Based: Negotiated: Difficult.Comparison of Methods Useful for Evaluating Subunit Performance Market Price: Yes. unless transfer price exceeds full cost Yes .
if based on budgeted costs. less incentive if based on actual cost Negotiated: Yes .Comparison of Methods Motivates Management Effort Market Price: Yes Cost-Based: Yes.
it is rule based Yes .Comparison of Methods Preserves Subunit Autonomy Market Price: Yes. if markets competitive Cost-Based: Negotiated: No.
easy to implement Negotiated: Bargaining takes time and may need to be reviewed .Comparison of Methods Other Factors Market Price: No market may exist Cost-Based: Useful for determining full-cost.
Market price 3. Negotiated market price Transfer price = Variable cost per unit + Lost contribution per unit on outside sales This relationship identifies the minimum and maximum transfer prices . Cost-based approach – – Variable cost Full (absorption cost) 2.Transfer Pricing Approaches 1.
.000 units per year from an outside source at a cost of $14.A Transfer Pricing Problem Assume the following data for division A: Capacity in units 50.000 Selling price to outside $15 Variable cost per unit 8 Fixed costs per unit (based on capacity) 5 Division B would like to purchase units for division A. Division B is currently purchasing 5.
Assume division A has idle capacity in excess of 10.000 units: Minimum transfer price = Variable cost + Lost contribution margin = $8 + $0 = $8 2. Assume division A is working at capacity: Transfer Price = Variable cost + Lost contribution margin = $8 + $7 = $15 (market price) 3. Assume division A is working at capacity. but a negotiated $2 in variable costs can be avoided on intercompany sales: Transfer Price = Variable cost + Lost contribution margin = $6 + $7 = $13 (negotiated price) .A Transfer Problem Example (Continued) 1.
Strategic Factors International Transfer Pricing Consideration Tax Rate.minimize taxes locally as well internationally Exchange Rate Custom Charges Risk of expropriation Currency Restriction Strategic relationship Assist bayside division to grow Gain entrance in the new country Supplier’s quality or name .
but not always Negotiated Yes Useful for Evaluating Subunit Performance Yes. but transfer prices are affected by bargaining strengths of the buying and selling divisions 21 .Comparison of Transfer-Pricing Methods Criteria Achieves Goal Congruence MarketBased Yes. when markets are competitive Difficult unless transfer price exceeds full cost and even then is somewhat arbitrary Yes. when markets are competitive CostBased Often.
because it is based on negotiations between subunits 22 . because it is rule-based Yes. less incentive to control costs if transfers are based on actual costs Negotiated Yes Preserves Subunit Autonomy Yes.Comparison of Transfer-Pricing Methods Criteria Motivates Management Effort MarketBased Yes CostBased Yes. when based on budgeted costs. when markets are competitive No.
Comparison of Transfer-Pricing Methods Criteria Other Factors MarketBased CostBased Negotiated No market may Useful for Bargaining and exist or determining negotiations markets may full cost of take time and be imperfect or products. easy may need to be in distress to implement reviewed repeatedly as conditions change 23 .
Transfer Pricing Implementation • Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers Internal accounting data are often used to set transfer prices. firms may reorganize by combining interdependent segments or spinning off some segments as separate firms • • • 24 . even when external market prices are available Classifying costs as fixed or variable can influence transfer prices determined by internal accounting data To reduce transfer pricing disputes.
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