Class Meeting 12

TRANSFER PRICING

Riwayadi
 DEFINISI
Ekternal Market price
Price
Internal Transfer price

• Transfer price is a price that is set for

interdivision in the organization
 PT ABC
Selling Division Buying Division
$?
(Producing (Producing
Plastic Bottle) mineral water)
Capacity: 10.000 units Capacity 8.000 units

Plastic bottle selling price $ 30/unit

Sales: 6.000 units
Variable Cost $ 24 Plastic bottle buying price $ 28/unit
Sales: 8.000 units

Market
APPLICATION OF TRANSFER PRICE

• Transfer price can only be applied to

the company that has a profit center or
investment center in which output of
one division is used as input of other
division
• Value of the transferred goods is
revenue to the selling division, and cost
to the buying division.
• In a profit center or an investment center,
division’s manager performance will be
evaluated based on profit (profit center) or
ROI/RI/EVA (investment center).
• Ideally, to achieve the optimum profit,
selling division can sell their products to
other division or to market (which is
higher) and buying division can also buy
their input from other division or from
market (which is lower).
 PRINCIPLES OF TRANFER
PRICING
• Each divisin has arm’s length
transctions (each division is assumed as
independent business units)
IMPACT OF TRANSFER PRICE ON DIVISION

• Manager from one division may take

advantages at the expense of
another even though the company
performance as a whole is not
affected
 PT AMIA
SELLING DIVISION
• Producing plastic bottles
and transferring to Buying
Division at a transfer price
$ 30 per unit
• Transfer Price = $ 30 per
unit
• Revenue to Selling
Division
• Increase in net income
• Increase in ROI
BUYING DIVISION
• Buying plastic bottles from
Selling Division at a transfer price
$ 30 per unit and using them to
package mineral water
• Transfer price = $ 30 per unit
• Cost to Buying Division
• Decrease in net income
• Decrease in ROI

Transfer
TransferPrice
PriceRevenue
Revenue==Transfer
Transfer Price
PriceCost
Cost
Zero
ZeroImpact
Impacton
onPT
PTAMIA
AMIA
 IMPACT OF TRANSFER PRICE ON
FIRM-WIDE PROFIT
1. Divisional manager, acting
independently, may set transfer price
that maximize divisional profit, but
adversely affect firm-wide profit. For
example, the Buying Division may decide
to purchase the goods from an outside
party because the outside price is lower
than the transfer price, when in reality,
the cost of producing the goods internally
is much lower than the transfer price.
ILLUSTRATION
• Assuming cost of Plastic Bottles $ 24 per unit. If
Buying Division can buy Plastic Bottles from
market for $ 28 per unit, it wll refuse to buy from
Selling Division for $ 30 per unit because Buying
Division will save the cost for $ 2 per unit ($ 30 -
$ 28).
• If Selling Division can not replace the internal
sales with external sales, the company as a
whole will be worse of by $ 4 per unit ($ 28 - $
24). If the selling division has idle capacity of
4.000 units, the company profit will be worse by
4.000 units x $ 4 =$ 16.000.
2. Transfer pricing can affect overall
corporate income taxes, specially for
multinational corporations. More revenue
or less cost will be assigned to divisions
in low-tax countries, and more cost or
less revenue is assigned to divisions in
high-tax countries.
 Setting Transfer Prices

12
 IMPACT OF TRANSFER PRICE
ON DIVISIONAL AUTONOMY
• Because transfer pricing can affect firm-
wide profitability, top management is often
tempted to intervene and dictate desirable
transfer price. It may effectively
abandoned decentralization and all of its
advantages. Intervention by central
management to reduce this cost may
actually prove to be more expensive in the
long-run than nonintervention.
OBJECTIVES OF TRANSFER PRICE

1. To make an accurate performance

evaluation. No one divisional manager
should benefit at the expense of another.
2. To create goal congruence. Divisional
manager selects actions that maximize
firm-wide profit.
3. To create the autonomy. Central
management should not interfere with
the decision-making freedom of
divisional managers.
Problem:
Problem: how
how to to set
set transfer
transfer price
price that
that can
can
meet
meet all
all three
three objectives?
objectives?

Opportunity
Opportunity cost cost approach
approach can can bebe used
used toto
achieve
achieve these
these objectives
objectives by by identifying
identifying the
the
minimum
minimum priceprice that
that aa selling
selling division
division would
would
be
be willing
willing toto accept
accept (floor
(floor of
of bargaining
bargaining
range)
range) and
and thethe maximum
maximum price price that
that the
the
buying
buying division
division would
would be be willing
willing toto pay
pay
(ceiling
(ceiling of
of the
the bergaining
bergaining range).
range).
 TRANSFER PRICING METHODS
1. Market price based transfer
pricing This is the
• Perfectly competitive market best transfer
price pricing
• Selling division is able to sell method
all of their product at capacity because it is
• Since minimum transfer price
for the Selling Division is the
suitable for
market price, and the autonomy
maximum transfer price for
the Buying Division is also
market price, the only
possible transfer price is the
market price.
2. Negotiated transfer price
• No perfectly competitive market price exist)
• Selling Division has idle capacity
• Minimum transfer price for Selling Division is
variable production cost, and maximum
transfer price for Buying Division is market
price
Maximum transfer price for Mineral Water Division is $
28, while minimum transfer price for Plastic Bottle is
$ 24. Transfer price can be set between maximum
and minimum price. Ideal Transfer price:
24 + ((28 – 24) / 2) = $ 26
Disadvantages of negotiated transfer price
• A divisional manager who has private
information may take advantage of other
divisional manager
• Performance measures may be distorted by
the negotiating skills of managers
• Negotiation can consume considerable time
and resources.
Advantage of negotiated transfer price
• Negotiated transfer prices offer some hope of
complying with three objectives (accurate
performance evaluation, goal congruence, and
autonomy)
3. Cost based transfer price
• This method will be used if there is no
market price, especially for semi-
finished product.
• Full cost transfer price
• DM + DL + FOH V and portion of
fixed FOH
• Disadvantage: can provide perverse
(bad) incentives and distort
performance measures.
• Full cost plus mark-up (percentage).
This method may be used if fixed cost
can not be covered by outside selling
revenues.
• Variable cost plus fixed fee. This
method may be used if there is idle
capacity (whether produce or not, fixed
cost still incurs.
 Illustration: Avoidable Transportation Costs
SALES AND PRODUCTION DATA
BOARD DIVISION GAME DIVISION
Units sold:
Per day 1.000 350
Per year (260 days) 260.000 91.000
Unit Data:
Selling price $ 22 $ 45
Variable costs:
Manufacturing $ 12 $ 32
Selling $ 2 $ 3
Annual fixed cost $ 1.480.000 $ 610.000
The $ 2 distribution cost is avoided if the board is sold
internally.
• Minimum transfer price is $ 20 and
maximum transfer price is $ 22 (assuming
that game division can buy board from
market at $ 22), and set the limits of the
negotiated price. Assuming the
concession price is $ 21,10 per unit, so
Board Division will increase profit by $ 385
per day ((21.10 – 20) x 350 units)), and
Game Division will increase profit by $ 315
per day ((22 – 21.10) x 350 units) or $
81.900 per year ($ 0.90 x 91.000 units).
 BEFORE NEGOTIATION: ALL SALES TO EXTERNAL

    Board Division   Game Division Total

Sales 260.000 x $ 22 5,720,000 91.000 x $ 45 4,095,000 9,815,000

       
COGS 260.000 x $ 12 (3,120,000) 91.000 x $ 32 (2,912,000) (6,032,000)
Selling Exp 260.000 x $ 2 (520,000) 91.000 x $ 3 (273,000) (793,000)

Total VC (3,640,000) (3,185,000) (6,825,000)

CM 2,080,000 910,000 2,990,000

FC (1,480,000) (610,000) (2,090,000)

Net Income 600,000 300,000 900,000

           
 AFTER NEGOTIATION: INTERNAL TRANSFER PRICE @ $ 21,10

    Board Division   Game Division Total

Sales - External 169.000 x $ 22 3,718,000 91.000 x $ 45 4,095,000 9,733,100

Internal 91.000 x $ 21.1 1,920,100    

  5,638,100    
COGS 260.000 x $ 12 (3,120,000) 91.000 x $ 31.10 (2,830,100) (5,950,100)
Selling Exp 169.000 x $ 2 (338,000) 91.000 x $ 3 (273,000) (611,000)

Total VC (3,458,000) (3,103,100) (6,561,100)

CM 2,180,100 991,900 3,172,000

FC (1,480,000) (610,000) (2,090,000)

Net Income 700,100 381,900 1,082,000

Net Income before Negotiation 600,000 300,000 900,000

Change in Net Income 100,100   81,900 182,000
 Illustration: Excess Capacity

Pharmaceuticals Plastics
•Units sold 250.000 units
•Variable cost per
•Selling price $ 0.85 per bottle
bottle $ 0.15
•Variable cost $ 0.60 per unit, not
including the cost of the plastic •Has excess capacity
bottle
(fixed cost will not
•Cost of bottle $ 0.40 per bottle change whether to
•Loss $ 0.15 per bottle (0.85 – (0.6 make the bottle or
+ 0.4) or total $ 37.500 ($ 0.15 x
250.000) not)
• The minimum transfer price for Plastic
Division is $ 0.15 (only variable cost is
relevant to the decision because of excess
capacity). The maximum transfer price for
Pharmaceuticals Division is $ 0.25, so
total cost will be $ 0.85 ($ 0.60 + $ 0.25).
Better transfer price is between the
minimum and maximum price, in this case
$ 0.20. Each division will have the same
CM.
 TRANSFER PRICE OF $ 0.40
Pharmaceutical Plastics Total
Sales $ 212.500 $ 100.000 $ 312.500
Variable exp. (250.000) (37.500) (287.500)
CM (37.500) 62.500 25.000

TRANSFER PRICE OF $ 0.25

Pharmaceutical Plastics Total
Sales $ 212.500 $ 62.500 $ 275.000
Variable exp. (212.500) (37.500) (250.000)
CM 0 25.000 25.000
 TRANSFER PRICE OF $ 0.20
Pharmaceutical Plastics Total
Sales $ 212.500 $ 50.000 $ 262.500
Variable exp. (200.000) (37.500) (237.500)
CM 12.500 12.500 25.000

TRANSFER PRICE OF $ 0.15

Pharmaceutical Plastics Total
Sales $ 212.500 $ 37.500 $ 250.000
Variable exp. (187.500) (37.500) (225.000)
CM 25.000 0 25.000