Topic 5: Transfer Pricing

Goliath
Goliath Corporation

• Three independent transactions are to be made:

1. Plastics to Metals
2. Electronics to Plastics
3. Metals to Electronics
• You are a part of two transactions. You are a profit centre manager
(what is your span of accountability/attention?)
• You needed to determine - Will you transact internally or not in each
case? Why or why not? If yes, what is the transaction price?
• Remember your CEO wants you to use a strict company transfer
pricing policy
1. Market-Based less 2% (as savings when dealing internally)
2. Cost Based: Actual Full Manufacturing Cost
3. Negotiated: Whatever price the two parties can agree on
4. Dual Selling receives 120% of full manufacturing costs
Buying pays 98% x market price

2
Apply opportunity cost approach: ‘General Rule’
• Transfer Price = Variable Cost + Opportunity Cost
o Opportunity cost relates to capacity
o If spare capacity exists; the opportunity cost is zero
o When opportunities are foregone (outside sales) that amount
is charged in the transfer price
o i.e. If no spare capacity; the opportunity cost = CM Foregone
(sales-VC) …..in other words TP = Market Price
• Note: this method is not always suitable
– Calculating idle capacity and opportunity loss changes
o might be highly variable in some organisations
o may take up too much valuable management time/effort
o Market prices might not be readily available
– This is why companies, like Goliath, sometimes put rigid transfer
pricing policies in place

3
Transaction 1: Plastics to Metals
Lets take the opportunity cost approach first:
• Buyer: 5,000 units @ $115 (ceiling price)
• Seller: VC [28+17+34] = $79 (floor price)
TP = VC + 0 = 79; Opportunity cost is zero as excess capacity
• Intuitively we can see from this method that it is in the best
interest for Goliath for the transfer to occur; the buyer should
purchase for $79 when idle capacity exists rather than
sending profits ($115 market price) outside Goliath. Yet when
we look at actual full costs ($124) – Goliath management
should be alerted to a potential issue with overhead costs.
Why so high. This could be a reason why Goliath have idle
capacity
• Note: ‘ceiling’ is highest price paid by buyer ($115); ‘floor’ is
the absolute lowest price the seller will sell for ($79)
4
Transaction 1: Plastics to Metals
• Market-Based policy: parties would transfer (idle cap)
Buyer pays $112.70 (2% less than market – note market is $115 not $174 );
Seller earns $33.70 (VC = $79; contribution above VC but does not cover full cost)

• Cost-Based policy: parties would not agree to transfer

Buyer refuses to pay more than $115 and actual full cost ($124) is greater than
market
Seller would be happy to transfer at $124 to cover fixed costs (issue for
management?)

• Negotiated policy: parties would transfer

Buyer and seller will negotiate a price between ceiling ($115) and floor ($79)

• Dual: parties would transfer

Buyer records $112.70 (happy as less than market);
Seller records $148.80 (happy as covering fixed costs and generating a profit)

5
Should Goliath management want the transfer?

• Transaction 1: Plastics sells cases to Metals

• Out-of-pocket costs:

o Inside:
o (5000 cases)(28+17+34) =$395,000

o Outside:
o (5000 cases)($115) =$575,000

• Is this transaction good for Goliath? Yes!

• All transfer policies work except for cost-based!

6
Transaction 2: Electronics to Plastics

• Buyer 2000 units @ $75 (ceiling price)

• Seller VC [ 20+9+14] = $43
No excess capacity; sales outside $80 (floor price)
TP = VC + opportunity cost = 43 + (80-43) = $80

• In this situation we have the buyer able to purchase outside

for $75 with Goliath (electronics) able to sell all they make for
$80 – why would we forgo $80 for a $75 transfer.
• Here we would recommend the buyer pay $75 elsewhere and
we maximise sales to outside customers willing to pay $80 for
our products

7
Transaction 2: Electronics to Plastics (no idle cap)
• Market-Based policy: parties would not transfer
Buyer would agree to pays $73.50 (less than ceiling $75);
Seller would not sell for less than $80 (floor)

• Cost-Based policy: parties would not transfer

Buyer would buy at $68 (full cost) because it is less than $75 (ceiling);
Seller would not transfer for less than $80 (floor)

• Negotiated policy: parties would not transfer

Buyer and Seller would not be able to negotiate a price as floor is greater than ceiling

• Dual: parties would transfer

Buyer records $ 73.50 (less than market of $75)
Seller records $81.60 (120% of full cost and more than outside sales)

8
Should Goliath management want the transfer?
• Transaction 2: Electronics sells sensors to Plastics

• Inside:
o Out-of pocket costs:2000 x $43 = 86,000
+ opportunity costs: 2000 (80-43) = 74,000
Total $160,000

• Outside:
o 2000 x $75 = $150,000
• Is this transaction good for Goliath? No! Better off selling
outside.
• The dysfunctional transfer pricing policy in this
case is the dual pricing policy (does this
matter?) 9
Transaction 3: Metals to Electronics

• Buyer – 8,000 units @ $40 (ceiling price)

• Seller – VC (18+7+24) = $49 (floor price)
Excess capacity; TP = VC + 0 = $49

Why would the company want to make for $49 VC when

they can buy outside for less? Intuitively we know this
transfer is not in the best interest of Goliath. A
manufacturing problem for Goliath to address?

Note: Transfer would only be achieved with the dual pricing policy
Complete the following blank slide to see if the transfer pricing
policies work in the best interest for Goliath

10
Transaction 3: Metals to Electronics (to complete)
• Market-Based policy: parties would/would not transfer
Buyer pays
Seller earns

• Cost-Based policy: parties would/would not transfer

Buyer;
Seller

• Negotiated policy: parties would/would not transfer

Buyer and seller

• Dual: parties would/would not transfer

Buyer records $
Seller records $

11
Should Goliath management want the transfer?

• Transaction 3: Metals sells brackets to Electronics

• Out-of-pocket costs:
o Inside:
o 8000 x $49 = $392,000

o Outside:
o 8000 x $40 = $320,000

• Is this transaction good for Goliath? No!

12