Transfer Pricing

Management Control Systems

 Management control systems are a means of gathering
and using information to aid and coordinate the
planning and control decisions throughout an
organization and to guide the behavior of its managers
and other employees.
Management Control Systems
 Many management control systems contain some or
all of the balanced scorecard perspectives:
1. Financial
2. Customer
3. Internal business process
4. Learning and growth
Management Control Systems
 Consist of formal and informal control systems:
 Formal systems include explicit rules, procedures,
performance measures, and incentive plans that guide
the behavior of its managers and other employees.
 Informal systems include shared values, loyalties, and
mutual commitments among members of the company,
corporate culture, and unwritten norms about
acceptable behavior.
Evaluating Management Control Systems
 To be effective, management control systems should
be closely aligned to the firm’s strategies and goals.
 Systems should be designed to fit the company’s
structure and decision-making responsibility of
individual managers.
Evaluating Management Control Systems
 Effective management control systems should also
motivate managers and their employees.
 Motivation is the desire to attain a selected goal (goal-
congruence) combined with the resulting pursuit of
that goal (effort).
Two Aspects of Motivation
 Goal congruence exists when individuals and groups
work toward achieving the organization’s goals—
managers working in their own best interest take
actions that align with the overall goals of top
management.
 Effort is exertions toward reaching a goal, including
both physical and mental actions.
Organization Structure and Decentralization
 Decentralization is the freedom for managers at lower
levels of the organization to make decisions.
 Autonomy is the degree of freedom to make decisions.
The greater the freedom, the greater the autonomy.
Decentralization vs. Centralization
 Total decentralization means minimum constraints
and maximum freedom for managers at the lowest
levels of an organization to make decisions.
 Total centralization means maximum constraints
and minimum freedom for managers at the lowest
levels of an organization to make decisions.
 Companies’ structures generally fall somewhere in
between these two extremes, as each has benefits
and costs. Structure chosen cost vs. benefit analysis.
Benefits of Decentralization
 Creates greater responsiveness to subunit’s customers,
suppliers, and employees
 Leads to gains from faster decision making
 Increases motivation of subunit managers
 Assists management development and learning
 Sharpens the focus of subunit managers
Costs of Decentralization
 Leads to suboptimal decision making, which arises
when a decision’s benefit to one subunit is more than
offset by the costs or loss of benefits to the
organization as a whole.
 Also called incongruent decision making or
dysfunctional decision making
Costs of Decentralization
 Focuses manger’s attention on the subunit rather than
the company as a whole
 Results in duplication of output
 Results in duplication of activities
Decentralization and
Multinational Firms
 Multinational firms, companies that operate in multiple
countries, are often decentralized because centralized
control of a company with subunits around the world is
often physically and practically impossible.
 Decentralization enables managers in different countries
to make decisions that exploit their knowledge of local
business and political conditions and to deal with
uncertainties in their individual environments.
 Biggest drawback to international decentralization: loss
or lack of control.
Choices about
Responsibility Centers
 Regardless of the degree of decentralization,
management control systems use one or a mix of the
four types of responsibility centers:
 Cost center
 Revenue center
 Profit center
 Investment center
Transfer Pricing
 Transfer price—the price one subunit (department or
division) charges for a product or service supplied to
another subunit of the same organization.
 Management control systems use transfer prices to
coordinate the actions of subunits and to evaluate
their performance.
Transfer Pricing
 The transfer price creates revenues for the selling
subunit and purchase costs for the buying subunit
affecting each subunit’s operating income.
 Intermediate product—the product or service
transferred between subunits of an organization.
 Transfer Pricing
The amount charged when one division sells
goods or services to another division

Batteries

Battery Division Auto Division

 Transfer Pricing
The transfer price affects the profit measure for both the
selling division and the buying division.

A higher transfer
price for batteries
means . . .

greater
Battery Division profits for the Auto Division
battery division.
 Transfer Pricing
The transfer price affects the profit measure for both the
selling division and the buying division.

A higher transfer
price for batteries
means . . .

lower profits
Battery Division for the Auto Division
auto division.
Goal Congruence
The ideal transfer price allows
each division manager to make
decisions that maximize the
company’s profit, while
attempting to maximize his/her
own division’s profit.
 General-Transfer-Pricing Rule
Additional outlay Opportunity cost
cost per unit per unit to the
incurred because organization
Transfer goods are because of
price = transferred + the transfer
 Scenario I: No Excess Capacity
 The Battery Division makes a standard 12-volt
battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
 The Battery division is currently selling 300,000
batteries to outsiders at $40. The Auto Division can
use 100,000 of these batteries in its X-7 model.

What is the appropriate transfer price?

 Scenario I: No Excess Capacity
Additional outlay Opportunity cost
cost per unit per unit to the
Transfer incurred because organization
goods are because of
price = transferred + the transfer

$22 Contribution
Transfer $18 variable lost if outside
price = cost per battery + sales given up

Transfer
price = $40 per battery
Scenario I: No Excess Capacity
Auto division can
purchase 100,000
batteries from an
outside supplier
for less than $40.
Auto division can
purchase 100,000
batteries from an
outside supplier
for more than $40.

Transfer Transfer
will not will
occur. $40 occur.
transfer
price
Scenario I: No Excess Capacity
General Rule
When the selling division is operating
at capacity, the transfer price should
be
set at the market price.
Scenario II: Excess Capacity
 The Battery Division makes a standard 12-volt
battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
 The Battery division is currently selling 150,000
batteries to outsiders at $40. The Auto Division can
use 100,000 of these batteries in its X-7 model. It can
purchase them for $39 from an outside supplier.

What is the appropriate transfer price?

Scenario II: Excess Capacity
Additional outlay Opportunity cost
cost per unit per unit to the
Transfer incurred because organization
goods are because of
price = transferred + the transfer

Transfer $18 variable

price = cost per battery + $0

Transfer
price = $18 per battery
Scenario II: Excess Capacity
General Rule
When the selling division is
operating below capacity, the
minimum transfer price is the
variable cost per unit.

So, the transfer price will be no lower

than $18, and no higher than $39.
Scenario II: Excess Capacity
Transfer Transfer Transfer
will not will will not
occur. occur. occur.

$18 $39
transfer transfer
price price
Setting Transfer Prices
The value placed on transfer goods is used to make it
possible to transfer goods between divisions while
allowing them to retain their autonomy.
Goal Congruence
Conflicts may arise between the company’s
interests and an individual manager’s interests
when transfer-price-based performance measures
are used.
Three Transfer Pricing Methods
1. Market-based transfer prices
2. Cost-based transfer prices
3. Hybrid transfer prices
Market-Based Transfer Prices
 Top management chooses to use the price of similar
product or service that is publicly available. Sources of
prices include trade associations, competitors, and so
on.
Market-Based Transfer Prices
 Lead to optimal decision-making when three
conditions are satisfied:
1. The market for the intermediate product is perfectly
competitive.
2. Interdependencies of subunits are minimal.
3. There are no additional costs or benefits to the
company as a whole from buying or selling in the
external market instead of transacting internally.
Market-Based Transfer Prices
 A perfectly competitive market exists when there is a
homogeneous product with buying prices equal to
selling prices and no individual buyer or seller can
affect those prices by their own actions.
 Allows a firm to achieve goal congruence, motivating
management effort, subunit performance
evaluations, and subunit autonomy.
 Perhaps should not be used if the market is currently
in a state of “distress pricing.”
Cost-Based Transfer Prices
 Top management chooses a transfer price based on
the costs of producing the intermediate product.
Examples include:
 Variable production costs
 Variable and fixed production costs
 Full costs (including life-cycle costs)
 One of the above, plus some markup

 Useful when market prices are unavailable,

inappropriate, or too costly to obtain
Hybrid Transfer Prices
 Takes into account both cost and market information
 Types of hybrid transfer prices:
 Prorating the difference between maximum and
minimum transfer prices
 Dual pricing
 Negotiated pricing
Hybrid Transfer Pricing
 Prorating the difference between the maximum and
minimum cost-based transfer prices.
 Dual-pricing—using two separate transfer-pricing
methods to price each transfer from one subunit to
another. Example: selling division receives full cost
pricing, and the buying division pays market pricing.
Negotiated Transfer Prices
 Occasionally, subunits of a firm are free to negotiate
the transfer price between themselves and then to
decide whether to buy and sell internally or deal
with external parties.
 May or may not bear any resemblance to cost or
market data.
 Often used when market prices are volatile.
 Represent the outcome of a bargaining process
between the selling and buying subunits.
Comparison of Transfer-Pricing
Methods
Transfer Pricing Illustration
Transfer Pricing Example A
Minimum Transfer Price
 The minimum transfer price in many situations should
be:

Incremental cost per unit

Minimum incurred up to the point of Opportunity Cost per unit
Transfer Price = transfer + to the selling subunit

 Incremental cost is the additional cost of producing and

transferring the product or service.
 Opportunity cost is the maximum contribution margin
forgone by the selling subunit if the product or service is
transferred internally.
Multinational Transfer Pricing and Tax
Considerations
 Transfer prices often have tax implications.
 Tax factors include income taxes, payroll taxes,
customs duties, tariffs, sales taxes, value-added taxes,
environment-related taxes, and other government
levies.
Multinational Transfer Pricing and Tax
Considerations
 Section 482 of the U.S. Internal Revenue Code governs
taxation of multinational transfer pricing.
 Section 482 requires that transfer prices between a
company and its foreign division or subsidiary equal
the price that would be charged by an unrelated third
party in a comparable transaction.
 Transfer price could be market-based or “cost-plus” based.