Transfer Pricing

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

 GREEN FIEND

Transfer Pricing
 In decentralized organizations, the output of one
division is used as the input of another.
 The value of the transferred good is revenue to the
selling division and cost to the buying division.
 This value, or internal price, is called the transfer
price.
 Transfer price is the price charged for a component by
the selling division to the buying division of the same
company.

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Impact of Transfer Pricing on
Divisions and the Firm as a Whole
 When one division of a company sells to
another division, both divisions as well as the
company as a whole are affected.
 The price charged for the transferred good
affects both
 the costs of the buying division
 the revenues of the selling division
 Thus, the profits of both divisions, as well as the
evaluation and compensation of their
managers, are affected by the transfer price.
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Impact of Transfer Pricing on Divisions
and the Firm as a Whole (cont.)

 Since profit-based performance measures of

the two divisions are affected, transfer pricing
often can be an emotionally charged issue.
 The next exhibit illustrates the effect of the
transfer price on two divisions of a company.
 Division A wants the transfer price to be as
high as possible while Division C prefers it to
be as low a as possible.

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Impact of Transfer Pricing on Divisions
and the Firm as a Whole (cont.)

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 GREEN FIEND
Transfer Pricing Policies
• Several transfer pricing policies are used in
practice, including:
– market price
– cost-based transfer prices
– negotiated transfer prices

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 GREEN FIEND
Transfer Pricing Policies:
Market Price
• If there is a competitive outside market for the
transferred product, then the best transfer price is
the market price.
• Divisional managers’ actions will simultaneously
optimize divisional profits and firm-wide profits.
• No division can benefit at the expense of another. In
this setting, top management will not be tempted to
intervene.
• The market price, if available, is the best approach to
transfer pricing.

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Transfer Pricing Policies:
Cost-Based Transfer Prices
• Frequently, there is no good outside market price.
• The lack of a market price occurs because the transferred
product uses patented designs owned by the parent
company.
• A company might use a cost-based transfer pricing
approach.
• A transfer price at cost does not allow for any profit for
the selling division, top management may define cost as
‘‘cost plus, ’’ which allows a certain percentage to be
tacked onto the cost.

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 GREEN FIEND
Transfer Pricing Policies:
Negotiated Transfer Prices
• Top management may allow the selling and buying
division managers to negotiate a transfer price.
• This approach is useful in cases with market
imperfections, such as an in-house division to avoid
selling and distribution costs that external market
participants would have to incur.
• Using a negotiated transfer price then allows the two
divisions to share any cost savings resulting from
avoided costs.

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Negotiated Transfer Prices:
Bargaining Range
• When using negotiated transfer prices, a bargaining range exists.
– Minimum Transfer Price (Floor): The transfer price that would
leave the selling division no worse off if the good were sold to
an internal division than if the good were sold to an external
party. This is the ‘‘floor’’ of the bargaining range.
– Maximum Transfer Price (Ceiling): The transfer price that would
leave the buying division no worse off if an input were
purchased from an internal division than if the same good were
purchased externally. This is the ‘‘ceiling’’ of the bargaining
range.

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 Cornerstone 12.4 GREEN FIEND

Calculating Transfer Price

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 Cornerstone 12.4 GREEN FIEND

Calculating Transfer Price

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 Transfer Pricing

Internal
Internaltransfers
transfers of of products
products create
createaaneed
need for
for aa
pricing
pricingmechanism
mechanismbetween
betweendivisions
divisionsto
to
accurately
accuratelyreflect
reflect the
thecosts
costsand
andrevenues
revenuesofofdoing
doing
business.
business.

AATRANSFER
TRANSFERPRICEPRICEis isthe
the
amount
amountcharged
chargedwhen
whenoneone
division
divisionof
ofan
anorganization
organization
sells
sellsgoods
goodsor
orservices
servicesto to
another
anotherdivision.
division.

.
 The Impact of Transfer
Boundary
Pricing on Organizations
between the Sales
Salesof
of
organization finished
finished
and outside Top
Top goods
goodsto to
parties Management
Management customers
customers
outside
outsidethe
the
Goods organization
Purchases
Purchases organization
transferred at
of
ofproductive
productive a transfer price
inputs
inputsfrom
from
venders
venders Selling Buying
outside Selling Buying
outsidethe
the division
division Division
Division
organization
organization

Assuming
Assumingthe thetransfer
transferisismade,
made,thethetransfer
transfer
price
pricewill
willnot
notaffect
affectthethecompany’s
company’soverall
overallprofit.
profit.
However,
However,ititdoes
doesaffect
affectthetheprofit
profitassociated
associatedwith
with
each
eachdivision.
division. ItItcan
canaffect
affectthe
thedecisions
decisionsof of
autonomous
autonomousdivision
divisionmanagers.
managers.
.
 Goal and Behavioral
Congruence
Divisions
Divisions
Use
Useof
oftransfer
transferprice
pricecan
can
affect
affect the
thereported
reported
performance
performancewhen whenevalutions
evalutions
use:
use: ......managers
ROI, managersof of
ROI,Residual
ResidualIncome,
Income, or
orEVA
EVA profit
profitcenters
centersand and
investment
investmentcenters
centers
accepting
acceptingor or
rejecting
rejectinginternal
internal
transfers
transfersbasedbasedon on
In
InDecentralized
Decentralized the
theeffect
effectofofthe
the
organizations,
organizations,thisthis transfer
transferpricepriceonontheir
their
can
canlead
leadto
to...... evaluation
evaluationmetric.
metric.

.
 General Transfer-Pricing Rule

AAgeneral
general rule
rule that
thatwill
will ensure
ensure goal
goal congruence:
congruence:

Additional Opportunity cost

outlay cost per per unit to the
Transfer
= unit incurred + organization
price
because goods because of the
are transferred transfer

Includes
Includesthe thedirect
directunit-
unit-level
level
costs
costsofofthe
theproduct/service
product/service An
Anopportunity
opportunitycost
costis
isaa
&&any
anyother
otheroutlay
outlaycosts
coststhat
that benefit
benefitthat
thatis
isforegone
foregone
are
are incurred
incurredas asaaresult
resultofof as
asaaresult
resultof
oftaking
takingaa
the
thetransfer
transfer particular
particularaction
action
.
 General Transfer-Pricing Rule
Koala
KoalaCamp
CampGear
GearDivision
Division
The
TheKoala
KoalaCamp
CampGear
GearDivision
Division
transfers
transferssome
somebackpacks
backpacks
The (RooPacks)
(RooPacks) to toOutback’s
Outback’sretail
retail
TheKoala
KoalaCamp
CampGear
Gear and
Division
Divisionof
ofOutback
Outback andmail
mailorder
orderdivisions
divisions
Outfitters
Outfittersmanufactures
manufactures
backpacks
backpacksininits
its The
Melbourne TheKoala
KoalaCamp
CampGear
GearDivision
Division
Melbourneplant
plant transfers
transferssome
somebackpacks
backpacks to to
other
othercompanies
companiesunder
under
different
differentlabels
labels

Suppose
Supposethe
theKoala
KoalaCamp
CampGear
Gear
Division
Divisioncan
cansell
sellall
allthe
thebackpacks
backpacks
ititcan
can produce to outsidebuyers
produce to outside buyersat
at
aamarket
marketprice
priceof
of$60
$60per
perbackpack
backpack

.
 General Transfer-Pricing Rule
Scenario
Scenario1:
1:No
Noexcess
excesscapacity
capacity
Koala
KoalaCamp
CampGear
GearDivision
Division

Transfer
Transfer price
price == Outlay
Outlay cost
cost ++ Opportunity
Opportunity cost
cost

$60.00
??
$60.00 == $40.00
??
$40.00 ++++ $20.00
??
$20.00

.
 General Transfer-Pricing Rule
Scenario
Scenario1:
1:No
Noexcess
excesscapacity
capacity
Koala
KoalaCamp
CampGear
GearDivision
Division

Assuming
Assumingthat
thatthe
thebackpacks
backpackscan
canbebesold
soldononthe
the
wholesale
wholesalemarket
marketfor
for$60
$60ororon
onthe
theretail
retailmarket
marketforfor$70,
$70,
what
whatis
isthe
thebest
bestway
wayfor
forthe
theCompany
Companyto touse
useits
itslimited
limited
capacity?
capacity?

.
 General Transfer-Pricing Rule
Scenario
Scenario1:
1:No
Noexcess
excesscapacity
capacity
Koala
KoalaCamp
CampGear
GearDivision
Division

All
Allthe
thebackpacks
backpacksshould
shouldbebetransferred
transferredtotothe
theRetail
Retail
Division
Divisiontototake
takeadvantage
advantageof ofthe +
theadditional
additional $10
$10
contribution
contributionmargin.
margin. The
TheCamp
CampGearGearDivision
Divisionwill
willnot
notbe
be
hurt
hurtsince
sincethe
thetransfer
transferprice=
price=the
thealternative
alternativewholesale
wholesale
price.
price.
.
 General Transfer-Pricing Rule
Scenario
Scenario1:
1:No
Noexcess
excesscapacity
capacity
Koala
KoalaCamp
CampGear
GearDivision
Division

What
What should
shouldthe
theCompany
Companydo do ifif+the
the Retail
Retail
Division
Divisionreceives
receivesan
anoffer
offerto
tosell
sellall
allits
its
backpacks
backpacksat
at$55
$55each?
each?

.
 General Transfer-Pricing Rule
Scenario
Scenario1:
1:No
Noexcess
excesscapacity
capacity
Koala
KoalaCamp
CampGear
GearDivision
Division

The
TheRetail
RetailDivision
Divisionshould
shouldreject
rejectthe
theoffer,
offer,
because all the backpacks COULD +be sold in the
because all the backpacks COULD be sold in the
external
externalmarket
marketat
at$60,
$60,yielding
yieldingaahigher
higher
contribution
contributionmargin
marginof of$20!
$20!
.
 General Transfer-Pricing Rule
Scenario
Scenario2:
2:Excess
Excesscapacity
capacity
Koala
KoalaCamp
CampGear
GearDivision
Division

Transfer
Transfer price
price == Outlay
Outlay cost
cost ++ Opportunity
Opportunity cost
cost

$40.00
??
$40.00 == $40.00
??
$40.00 ++++ $0
$0??

.
 General Transfer-Pricing Rule
Scenario
Scenario2:
2:Excess
Excesscapacity
capacity
Koala
KoalaCamp
CampGear
GearDivision
Division

Transfer
Transfer price
price == Outlay
Outlay cost
cost ++ Opportunity
Opportunity cost
cost

$40.00
$40.00 == $40.00
$40.00 ++ $0
$0

What
What should
shouldthe
theCompany
Companydo doififthe
theRetail
Retail
Division
Division receives
receivesan
an offer
offer to
to sell
sellall
all its
its
backpacks
backpacksatat $55
$55 each?
each?

.
 General Transfer-Pricing Rule
Scenario
Scenario2:
2:Excess
Excesscapacity
capacity
Koala
KoalaCamp
CampGear
GearDivision
Division

Transfer
Transfer price
price == Outlay
Outlay cost
cost ++ Opportunity
Opportunity
+
cost
cost

$40.00
$40.00 == $40.00
$40.00 ++ $0
$0

ACCEPT
ACCEPTthe theoffer.
offer. The
TheRetail
RetailDivision
Divisionwill
will
realize
realizeaacontribution
contributionmargin
marginofof $15
$15on
oneach
each
backpack
backpacksoldsoldat
atthe
thespecial
specialprice
price($55
($55price
price--
$40
$40transfer
transferprice).
price).

.
 Difficulty in Implementing the
General Rule
The
Theopportunity
opportunitycost
costmay
maybe
bedifficult
difficult
Barriers
Barriersto
to to
tomeasure.
measure.
Implementation
Implementation
The
Theexternal
externalmarket
marketmay
maynotnotbe
be
perfectly
perfectlycompetitive.
competitive.

There
Theremay
maybe
beno
noexternal
externalmarket
market

The
Thegoods
goodsor
orservices
servicesmay
maybe
beunique
unique

Special
Specialequipment
equipmentmaymaybe
beneeded
neededto
to
produce
producethe
thetransferred
transferredgoods
goods

Interdependencies
Interdependenciesamong
amongseveral
several
transferred
transferredproducts
productsor
orservices
services
.
 Transfers Based on the
External Market Price
Whenthe
When theproducing
producingdivision
divisionhashasno
noexcess
excesscapacity
capacityand
and
perfectcompetition
perfect competitionprevails,
prevails,the
thegeneral
generaltransfer-pricing
transfer-pricingrule
ruleand
andthe
the
externalmarket
external marketprice
priceyield
yieldthe
thesame
sametransfer
transferprice.
price.

The
Thetotal
total contribution
contributionmargin
margin to
to the
thecompany
companyis
is
STILL
STILL$30!
$30!

.
 Negotiated Transfer Prices

Division
Divisionmanagers
managersor or their
theirrepresentatives
representativesactually
actually
negotiate
negotiate the
theprice
priceat
atwhich
which transfers
transferswill
willbe
bemade.
made.

Drawbacks
Drawbacks
Negotiations
Negotiationscan
canlead
leadto
to divisiveness
divisiveness
and
andcompetition
competitionbetween
betweenparticipating
participating
division
divisionmanagers.
managers.
Although
Althoughnegotiating
negotiatingskill
skillis isaa
valuable
valuablemanagerial
managerialtalent,
talent, ititshould
should
not
not be
bethe
thesole
soleorordominant
dominantfactor
factorin
in
evaluating
evaluating aa division
division manager.
manager.
.
 Cost-Based Transfer Pricing
Cost-based
Cost-basedtransfer-pricing
transfer-pricingsets
setsthe
thetransfer
transferprice
priceon
on
the
thebasis
basisof
ofthe
thecost
costof
ofthe
theproduct
productororservice
servicetransferred
transferred

Standard
Standardunit-level
unit-levelcost
cost Excess
Excesscapacity
capacity

Transfer
TransferPrice
Price== the
thestandard
standardunit-level
unit-levelcost
costof
of$40
$40per
perbackpack
backpack
--unit-level
unit-levelcosts
costsof
of$40
$40
Contribution
Contributionmargin
margin==00

Unless
Unlessthe thetransferring
transferringdivision
divisionis
isallowed
allowed
to
torealize
realizeaapositive
positivecontribution
contributionmargin,
margin,
there
thereisisno
nopositive
positiveincentive
incentiveininthis
this
approach
approachfor forthe
thedivision
divisiontotoproduce
produceandand
transfer
transferbackpacks
backpacksto tothe
theRetail
RetailDivision.
Division.

.
 Cost-Based Transfer Pricing

Absorption
Absorptionor
orFull
FullCost
Cost
Standard
Standard Assigned
Assignedhigher-level
higher-levelcosts
costs
+
Full
Fullcost
cost == unit-level
unit-level (batch-,
(batch-,product-,
product-,customer-,
customer-,
cost
+ and general- or facility-level)
cost and general- or facility-level)

$1,800,000
$1,800,000budgeted
budgetedhigher-level
higher-levelcosts
costs
== $40.00
$40.00 ++
100,000
100,000budgeted
budgetedunits
unitsof
ofproduction
production

== $40.00
$40.00 ++ 18
18 == $58.00
$58.00per
perbackpack
backpack

Possible
Possibledysfunctional
dysfunctionaldecision-making
decision-making
behavior
behavior
.
 Cost-Based Transfer Pricing

Absorption
Absorption or
or Full
FullCost
Cost

== $40.00
$40.00 ++ 18
18 == $58.00
$58.00per
perbackpack
backpack

They
Theywould
wouldreject
reject
What
Whathappens
happensifif ititbecause
becausethey
they
the
theRetail
RetailDivision would
Division wouldincur
incuraaloss
loss
receives
receivesaaspecial of
special of$3
$3per
perunit.
unit.
order
orderof
of$55?
$55?

.
 Cost-Based Transfer Pricing

Absorption
Absorption or
or Full
FullCost
Cost

== $40.00
$40.00 ++ 18
18 == $58.00
$58.00per
perbackpack
backpack

What
Whatisisin
inthe
the
Accepting
Acceptingthe
theorder best
order bestinterest
interestofof
actually
actuallyDOES the
DOES theCompany?
Company?
provide
provide$15
$15 So,
So,Absorption
Absorption
contribution
contribution Costing
Costingresults
resultsin
in
margin.
margin. aadysfunctional
dysfunctional
decision!
decision!

.
 Cost-Based Transfer Pricing
Transfer
Transferprices
pricesshould
shouldnot
notbe
bebased
basedon
onactual
actual
NO costs.
costs.

Many
Manycompanies
companiesuse use activity-based
activity-based
costing
costingto
toimprove
improvethetheaccuracy
accuracyof of
numbers
numbersininits
itsinternal
internal transfer
transferof
of prices
prices

IfIf suppliers
suppliersare
arenot
notgiven
givenaaprofit
profiton
onthe
the
transaction,
transaction,they
theyare
arenot
notmotivated
motivatedtoto
transfer
transferinternally.
internally.

Use
Useaacost
costcenter
centerfor
for internal
internal transfers
transfers
.
 Cost-Based Transfer Pricing
Koala
KoalaCamp
Camp Gear
Gear Division
Division
The
Themanager
managerof ofthe
the
The
Themanager
manager Retail
RetailDivision
Divisionhas
hasaa
of
ofOutback’s
Outback’s special
specialoffer
offerfor
for
Koala
KoalaCamp
Camp backpacks
backpacksof of$55
$55 As company
Gear
Gear per
perunit
unitresulting
resultingin in manager, what
Division her
herdivisional
divisionalprofit
Divisionhas
has profit would YOU do?
excess declining.
declining.
excess
capacity
capacitybutbut
Intervene
Interveneand
insists
insistson
onaa Stay
Stayout
out
and
run
runthe
therisk
risk
transfer But and
andlose
losethe
transfer price
price But
increased
the
contribution OR of
ofundermining
undermining
of increased contribution
of$58.
$58. contribution margin
marginfor
for
the
theauthority
authority
contribution ofofthe
thedivision
division
margin the
thecompany
marginfor
for company manager
manager
the
thecompany
company
.
.