Transfer Pricing

6. Transfer Pricing


Transfer Pricing
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.

6. Transfer Pricing


Objectives of Transfer Pricing
‡ Two or more Profit Centers are jointly involved in manufacturing, product development & marketing, they should share the revenue generated (when the product is finally sold). The transfer price mechanism must distribute this revenue to achieve the following objectives: ± Provide each unit with information for an optimum trade-off between company costs & revenues.
‡ The company maximizes it¶s profits when Marginal costs = Marginal Revenue

± ± ±

Introduce Goal Congruence ± i.e. decisions that improve the business unit¶s profits also improve the company¶s profits. Should measure Economic Performance of the units Should be simple to understand and easy to administer

6. Transfer Pricing


Transfer Pricing Transfer pricing should help achieve a company¶s strategies and goals. Transfer Pricing 4 . ± fit the organization¶s structure ± promote goal congruence ± promote a sustained high level of management effort 6.

or buy?) ‡If made in-house. at least recover variable costs) ‡ The unit attempts to maximize contribution. . Profit Mark-up usually at rate of return like an independent company (say > WACC) Negotiated transfer prices. used.e. Whether internal or external.Transfer-Pricing Methods Fundamental Principle: A Transfer price should be similar to the price. Cost-based transfer prices. Standard Costs. of selling internally. by accounting for opportunity costs. the transfer price should be optimum: ‡ The unit does not sell at a loss (i. ‡ Market-based transfer prices. The market price represents the opportunity cost. today everyone must make the ³value-chain´ competitive 6. as if sold to an outside customer. Transfer Pricing 5 . Help the company arrive at correct Sourcing decision (make in-house.

all perceive transfer prices as just. advertising costs. ± Good atmosphere ± i. they can manage on their own. arbitration. ± Full information ± available alternatives.The Ideal Situation for Market-based transfer pricing ‡ Market based transfer pricing will induce goal congruence if all the following conditions exist: ± People must be competent ± i.e. selling costs hardly exist when selling internally). Transfer Pricing 6 . their costs and revenues must be known accurately (i. The market cost represents a selling unit¶s opportunity cost of selling internally. dispute resolution. ± Transfer price must actually represent market price less benefits accruing out of dealing internally (for e. bad debt expense. etc must be smooth.e.g. ± Negotiation ± the processes for negotiation. This way the open market establishes the correct ³transfer price´.e. 6. assuming a perfect market. It is also an opportunity cost for the company. ± Freedom to source ± the selling divisions and buying units. both have freedom sell or buy in their own self interest.

Real life constraints on sourcing from open markets
‡ Though full freedom is ³ideally´ desired, in reality it is not feasible: ± Limited markets ± even if outside capacity exists, it may not be available to an internal unit: ‡ Because the unit doesn¶t use this capacity regularly, especially as an internal unit exists ‡ If the internal unit is ³sole´ producer, no outside supplier exists ‡ The company has invested significantly in facilities. Hence, it will not permit the use outside sources, unless outside selling price approaches it¶s variable cost (which is unlikely). The internal capacity must be utilized. ‡ The might be shortages in the market ± Even in limited markets, as above, a ³competitive´ transfer price should be set. ‡ A competitive price is as if no internal capacity is available, and inputs (for e.g. crude) must be purchased from outside at ³market´ conditions. ‡ And still, both units must ensure a positive contribution to company¶s profits. ‡ A ³competitive´ price helps measure the performance of the unit vis-a-vis competition.

± Ways of determining ³competitive´ price: ‡ Published market prices ± for conditions similar to within the company. ‡ Bids ± valid bidders will make a serious low bid , only they have an assurance that you will buy, if they bid the lowest (even below your own company) ‡ Production profit center ± the price it sells to outside market. ‡ Buying profit center ± i.e. purchases from 6. Transfer Pricing 7 outside market as well

Cost-Based Transfer Prices
Two Issues of fixing cost-based transfer prices:
‡ How to define costs ± Usual basis is ³standard´ costs. And the selling unit must make an attempt to ³improve´ standards. How to calculate the mark-up ± What is the basis for profit mark-up ‡ Most commonly % of cost is used as a basis. Sometimes % of investment ‡ The level of profit allowed (profit allowance) ‡ Generally it should approximate, as far as possible, the rate of return if business unit would have earned as an independent unit, selling to the outside market

Issues of Upstream fixed costs & Profits.
The profit center that finally sells to the customer must be competitive, and hence have control & full knowledge of the upstream costs & profits. Else the whole value chain will be pushed out of the market. Even if it knew all upstream costs, it may ³insist´ on making an uncompetitive´ profit, which would jeopardize the business (i.e. loosing the customer) Methods to overcome the above problems: ‡ Agreement among Business Units. ± All units jointly decide on selling price and profit sharing. This is reviewed as frequently as is necessary ‡ Two-Step Pricing ± Two charges ‡ Standard variable cost of production ‡ Associated Fixed Costs ± for facilities reserved for the subsequent division


6. Transfer Pricing

Cost-based pricing «contd.
‡ An example of two-step pricing Product A
5000 units $5 $20,000 $1,200,000 10%


Unit X (manufacturer)
Exp. Monthly sales to Unit Y Variable cost/unit Monthly Fixed cost (assigned) Capital invested Competitive ROI per year

Profit Sharing method : ± Sometimes Two-Step method is not feasible. Then a profit-sharing system can be employed:
‡ The product is transferred to the marketing unit at variable cost. ‡ After the product is sold the business units share the contribution earned (Selling Price ± variable mfg & marketing costs).

‡ ‡


Say Unit Y buys Product X at transfer price from X. One way is to transfer (FULL COST) at $11 (incl. All costs I.e. variable, fixed & competitive ROI (i.e. $5, $4 & $2). But at this price, Unit Y does not know the costs & profits of Unit X. Two Step Pricing : Variable per unit $5 plus FIXED $30,000 every month end. ± If X picks up less than 5000 units, it still pays the agreed FIXED costs. ± It gains if it sells more than 5000 units


Two Sets of Prices
± In this method the manufacturing unit gets credit at market prices. The buying unit is charged at TOTAL STANDARD costs. The difference is charged to HQ account. This method benefits both units. Is most useful if there are conflicting situations.


Various types of Cost-based transfer price ± Full cost plus mark-up, Two-step, Profit Sharing«
6. Transfer Pricing 9

the buying unit may choose to get outside services. on which the units have ³some´ control. ‡ There are various of pricing such services i. IT services. ) ‡ In such cases. Non-controllable (by unit) corporate expenses may be ³allocated´ to the units. are such services. corporate advertising. CRM package. Transfer prices for corporate services can be made. In short the selling unit must be competitive 6. Transfer Pricing 10 . standard full cost plus profit margin or market price ‡ ‡ ± The unit can decide whether to use or not (e.e. standard full cost. In such cases (i. but they can control the amount. R&D. the unit may not be able to control the efficiency. in Siemens. standard variable cost.g. but they do not constitute transfer prices.e. Corporate Communication services such as PR.g.Pricing Corporate Services ‡ Only those corporate services are charged to units. under the following conditions: ± The receiving unit can at least partially control the amount used ( e. SAP seats can be somewhat controlled).

For e. is crucial for transfer price arbitration. These are transferred at market prices. Transfer Pricing 11 . ± Products tend to classified as: ‡ CLASS I ± where senior management controls sourcing. a strategically important product may be transferred at an ³aggressive´ price (and subsidized by HQ) ‡ CLASS II ± Generally can be produced outside the company / outsourced.Administration of Transfer Prices ‡ Negotiating transfer prices: ± Not set by HQ. These products may have ³customized´ rules for transfer pricing. ‡ Arbitration & Conflict Resolution ± Normally the CFO is the arbitrator. Too much time must not be spent on ³internal´ negotiation. based on strategic objectives. but after mutual negotiation ± Compromises by both sides required. ‡ Product Classification. ± The availability of ³market´ price information. It makes sense to work as members of the same ³value chain´.g. 6.

Transfer-Pricing Methods Example Lomas & Co. Transportation purchases crude oil in Alaska and sends it to Seattle. has two divisions: Transportation and Refining. Refining processes crude oil into gasoline. Transfer Pricing 12 . 6.

*Per unit Fixed Costs are based on a planned / standard volume 6.Transfer-Pricing Methods Example External market price (in Alaska) for crude oil per barrel: Transportation Division: Variable cost per barrel of crude oil Fixed cost per barrel of crude oil Total $13 $ 2 3* $ 5 The pipeline can carry 35. Transfer Pricing 13 .000 barrels per day.

**Per unit Fixed Costs are based on a planned / standard volume.Transfer-Pricing Methods Example External purchase price (in Seattle) for crude oil per barrel: Refining Division: Variable cost per barrel of gasoline Fixed cost per barrel of gasoline Total $23 $ 8 4** $12 The division is buying 20.000 barrels per day 6.000 barrels per day. The refining division is operating at 30. Transfer Pricing 14 .

6. Transfer Pricing 15 .Transfer-Pricing Methods Example The external market price to outside parties is $60 per barrel.000 barrels capacity per day. The Refining Division is operating at 30.

Transfer-Pricing Methods Example What is the market-based transfer price from Transportation to Refining? $23 per barrel What is the cost-based transfer price at 112% of full costs? 6. Transfer Pricing 16 .

(i.12 × $18 = $20. it may be willing to negotiate anything more than variable cost i. If transportation division¶s capacity is lying idle.16 What could be the negotiated price? Between $20. Transfer Pricing 17 $13 2 3 $18 .e.e. between $15 to $23) 6. $15.Transfer-Pricing Methods Example Purchase price of crude oil Variable costs per barrel of crude oil Fixed costs per barrel of crude oil Total 1.00 per barrel.16 and $23.

000 barrels of crude oil into 500 gallons of gasoline and sells them. Transfer Pricing 18 .Transfer-Pricing Methods Example Assume that the Refining Division buys 1. The Refining Division converts these 1. What is the Transportation Division operating income using the market-based price? 6.000 barrels of crude oil from the Transportation Division (at market price).

000 Operating income $ 5. Transfer Pricing 19 .000) $23.000) 18.000 What is the Refining Division¶s operating income using the market-based price? 6.000 Deduct costs: ($18 × 1.Transfer-Pricing Methods Example Transportation Division: Revenues: ($23 × 1.

000 6.000 Operating income $ 1.Transfer-Pricing Methods Example Refining Division: Revenues: ($60 × 500) $30.000 Division fixed ($4 × 500) 2.000 Deduct costs: Transferred-in ($23 × 1.000 Division variable ($8 × 500) 4.000) 23. Transfer Pricing 20 .

000 $6.000 1.Transfer-Pricing Methods Example What is the operating income of both divisions together? Transportation Division Refining Division Total $5.000 6. Transfer Pricing 21 .

Transfer Pricing 22 .Transfer-Pricing Methods Example What is the Transportation Division¶s operating income using the 112% of full cost price? Transportation Division: Revenues: ($20.000 $ 2.160 18.000) Operating income $20.160 What is the Refining Division operating income using the full cost price? 6.16 × 1.000) Deduct costs: ($18.00 × 1.

000 2. Transfer Pricing $30.00 × 500) Division fixed ($4.00 × 500) Operating income 6.160 4.Transfer-Pricing Methods Example Refining Division: Revenues ($60 × 500) Deduct costs: Transferred-in ($20.000) Division variable ($8.000 $ 3.000 20.840 23 .16 × 1.

160 3. Transfer Pricing 24 .840 $6.Transfer-Pricing Methods Example What is the operating income of both divisions together? Transportation Division Refining Division Total $2.000 6.

Learning Objective Illustrate how market-based transfer prices promote goal congruence in perfectly competitive markets. Transfer Pricing 25 . 6.

Transfer Pricing 26 . a company can achieve the following: Goal congruence Management effort Subunit performance evaluation Subunit autonomy 6.Market-Based Transfer Prices By using market-based transfer prices in a perfectly competitive market.

Transfer Pricing 27 .Market-Based Transfer Prices Market prices also serve to evaluate the economic viability and profitability of divisions individually. 6.

6.Market-Based Transfer Prices When supply outstrips demand. market prices may drop well below their historical average. Distress prices are the drop in prices expected to be temporary. Transfer Pricing 28 .

Learning Objective Avoid making suboptimal decisions when transfer prices are based on full cost plus a markup. 6. Transfer Pricing 29 .

is purchasing crude oil locally for $23 a barrel.Cost-Based Transfer Prices Example The Refining Division of Lomas & Co. Transfer Pricing 30 . The Refining Division located an independent producer in Alaska that is willing to sell 20.000 barrels of crude oil per day at $17 per barrel delivered to the pipeline (Transportation Division). 6.

Cost-Based Transfer Prices Example The Transportation Division has excess capacity and can transport the crude oil at its variable costs of $2 per barrel.000. 6. There is a reduction in total costs of $80. Should Lomas purchase from the independent supplier? Yes. Transfer Pricing 31 .

000 barrels from the local supplier at $23 per barrel.Cost-Based Transfer Prices Example Alternative 1: Buy 20.000 × $23 = $460. The total cost to Lomas is: 20.000 6. Transfer Pricing 32 .

000 barrels from the independent supplier in Alaska at $17 per barrel and transport it to Seattle at $2 per barrel. Transfer Pricing 33 . The total cost to Lomas is: 20.Cost-Based Transfer Prices Example Alternative 2: Buy 20.000 6.000 × $19 = $380.

Transfer Pricing 34 . What is the cost to the Refining Division? 6.Cost-Based Transfer Prices Example Suppose the Transportation Division¶s transfer price to the Refining Division is 112% of full cost.

800 6.Cost-Based Transfer Prices Example Purchase price of crude oil $17 Variable costs per barrel of crude oil 2 Fixed costs per barrel of crude oil 3 Total $22 1.64 $24.12 × $22 = $24.000 = $492. Transfer Pricing 35 .64 × 20.

The Range for negotiation (with Transportation) is between the maximum & minimum available from the market 6.Cost-Based Transfer Prices Example What is the maximum transfer price? It is the price that the Refining Division can pay in the local external market ($23). Transfer Pricing 36 . What is the minimum transfer price? The minimum transfer price is $19 per barrel.

6. Transfer Pricing 37 .Learning Objective Understand the range over which two divisions negotiate the transfer price when there is unused capacity.

Transfer Pricing 38 .Prorating Lomas & Co. 6. may choose a transfer price that splits on some equitable basis the difference between the maximum transfer price and the minimum transfer price. $23 ± $19 = $4 Suppose that variable costs are chosen as the basis to allocate this $4 difference.

000 of crude oil into 500 barrels of gasoline are $8 × 500 = $4. The Refining Division¶s variable costs to refine 1. Transfer Pricing 39 .Prorating The Transportation Division¶s variable costs are $2 × 1. 6.000.000 = $2.000.

Transfer Pricing 40 .Prorating The Transportation Division gets to keep $2.00 + $2.33 ÷ $6. What is the transfer price from the Transportation Division? $17.00 + $1. The Refining Division gets to keep $4.33 = $20.000 × $4 = $2.000 ÷ $6.000 × $4 = $1.

64 Debited to HQ DISCUSSION: The Pros & Cons of this transfer pricing. to credit the Transportation Division with 112% of the full cost transfer price of $24.64 per barrel of crude oil. Will this promote efficiency in the transportation division? 6.Dual Pricing An example of dual pricing is for Lomas & Co. Transfer Pricing 41 . $1. Debit the Refining Division with the market-based transfer price of $23 per barrel of crude oil.

6. Transfer Pricing 42 .Negotiated Transfer Prices Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.

6.Learning Objective Construct a general guideline for determining a minimum transfer price. Transfer Pricing 43 .

Comparison of Methods Achieves Goal Congruence Market Price: Yes. but not always Yes 6. Transfer Pricing 44 . if markets competitive Cost-Based: Negotiated: Often.

unless transfer price exceeds full cost Yes 6. if markets competitive Cost-Based: Negotiated: Difficult.Comparison of Methods Useful for Evaluating Subunit Performance Market Price: Yes. Transfer Pricing 45 .

if based on budgeted costs. less incentive if based on actual cost Yes 6. Transfer Pricing 46 .Comparison of Methods Motivates Management Effort Market Price: Yes Cost-Based: Negotiated: Yes.

Transfer Pricing 47 . it is rule based Yes 6.Comparison of Methods Preserves Subunit Autonomy Market Price: Yes. if markets competitive Cost-Based: Negotiated: No.

easy to implement Bargaining takes time and may need to be reviewed 6.Comparison of Methods Other Factors Market Price: No market may exist Cost-Based: Negotiated: Useful for determining full-cost. Transfer Pricing 48 .

‡Supply > Demand : i. if idle capacity available. only variable cost ‡Demand > Supply : highest bidder¶s price 6.General Guideline Minimum transfer price = Incremental costs per unit incurred up to the point of transfer + *Opportunity costs per unit to the selling division *Opportunity cost varies with circumstances.e. Transfer Pricing 49 .

General Guideline Assume a perfectly competitive market. with no idle capacity. Transfer Pricing 50 . Transportation Division can sell all the crude oil it transports to the external market in Seattle for $23 per barrel. What is the minimum transfer price? ($19 + $4) or ($13 + $2 + $8) = $23 = Market price Contribution 6.

and the selling division has idle capacity.General Guideline Assume that an intermediate market exists that is not perfectly competitive. If the Transportation Division has idle capacity. What is the minimum transfer price? 6. Transfer Pricing 51 . its opportunity cost of transferring the oil internally is zero.

*A profit center tries to maximize contribution in a way that it first recovers fixed costs. $13 is crude procurement and $2 is variable..General Guideline It would be $15 per barrel for oil purchased under the long-term contract. i. or..e. Then goes for maximizing NOPAT 6. Transfer Pricing 52 . Anything more is contribution* $19 per barrel for oil purchased and transported from the independent supplier in Alaska.

Learning Objective Incorporate income tax considerations in multinational transfer pricing. 6. Transfer Pricing 53 .

Transfer Pricing 54 .Multinational Transfer Pricing Generally. Divisions operate at ARM¶S LENGTH with each other 6. all countries require that transfer prices for both tangible and intangible property between a company and its foreign division be set to equal the price that would be charged by an unrelated third party in a comparable transaction.

of units ‡ Std Cost per unit of a division is all direct costs per unit.000 15.000 45. The intra-company transfer price rule is to transfer at Standard Cost plus a 10% return on inventories & fixed costs. Cost item (in Rs) TP of X 0 4 4 3 7 1 8 TP of Y 8 5 13 4 17 0. Division A of company L.000 Product Y 3 1 1 4 10. manufactures Product A.06 Transfer in cost Variable Cost / unit Standard Cost Per Unit (in Rs) Material purchased from outside Direct Labour Variable Overhead Fixed Overhead / unit Standard Volume Inventories (average) Fixed Assets (Net) Product X 2 1 1 3 10. if capacity is idle.Calculate FULL COST Transfer Price(s) & Std Cost SOLUTION to Q1 1. as a component of it¶s Product Z. ‡ It varies between variable cost to total cost.46 24. NOTES: ‡ Direct = directly proportional to no. ‡ For e. which is sold to Division B as a component of Product Y.000 30. you will utilize capacity to first defray fixed costs.6 0.6 5 22.000 16. Transfer Pricing 55 . which is sold to the external market.g. From the information above calculate the transfer price for Products X & Y and the standard cost of Product Z.000 70.6 1 23.6 Std Cost of Z 17. Product Y is sold to Div C. and then earn profits 6. ‡ Transfer Price is like Selling Price.000 Produ ct Z 1 2 2 1 10.000 Total Variable (input) costs Direct Fixed Cost / unit Total Cost (Direct) Add: Charge (of 10%) on assets ± Fixed & Inventory per unit Transfer Price Q1.6 17.000 30.A Sample Problem in transfer pricing: Part 1.

volume. ‡ Subsequent divisions.A Sample Problem in transfer pricing: Part 2. ‡ Fixed costs are converted to unit cost. their per unit costs exceed std.6 Std Cost of Z 9 5 14 86000 10000 4600 100600 24.Calculate Transfer Price (Two-Step method)«contd Q2. calculate TP for X & Y and unit std. volume. volume. cost for Y & Z Cost item (in Rs) Transfer in variable cost Variable Cost / unit Total Variable (input) costs ‡ Fixed cost passed in from previous division ‡Direct Fixed Cost (per unit X no. Unit Cost in current division (at 10. can reduce their per unit cost by exceeding std. inventories & fixed assets. of units. costs if they fall below std. Using the information in Q1.06 Notes: ‡ Variable costs vary as per no. of units) of current division ‡Fixed Asset Charge (of 10%) on assets of current division ± Fixed & Inventory per unit Total Monthly Charge passed on to next division (All fixed costs so far) Std. based on volume. This charge is equal to fixed charge assigned to the product plus 10% return on avg. Transfer Pricing 56 .000 std vol) 30000 10000 40000 8 4 4 TP of X TP of Y 4 5 9 40000 40000 6000 86000 17. Std costs are based on std. if TP rule is TP is variable cost per unit plus monthly charge. Conversely. 6.

‡NOTE: CONTRIBUTION is (Selling Price) less (Variable Costs). ‡and finally to profits Maintain the price Maintain the price Variable cost Contribution/unit Sales Quantity Total Contribution 28 22.4 10000 24000 23 22. FULL COSTS. 28 Sales Volume if Product Z matches competitions price 27 9000 10000 26 7000 10000 25 5000 10000 23 2000 10000 22 0 10000 Question A) Given TP as in 1.Example of relationship between Transfer Price (total costs) & Contribution ‡ The present selling price of Product Z is Rs.6 5. this decision based on FULL COST TP. should Division C. Transfer Pricing 57 .4 5000 27000 28 22.4 2000 10800 28 22. i.6 5. may not be the best for the company.4 10000 44000 26 22. or follow competition: Competitive Price Competitive Price Variable Cost Contribution/unit Sales Quantity Total Contribution 27 22.6 (-) 0. corporate.6 5.6 5. It ³contributes´ to ‡covering Fixed costs at various levels. 28. Competition is contemplating price reductions. ‡overheads such as management salaries.6 5. because it gives higher contribution.4 0 0 6.e. ‡ BUT. etc.e. i. The best decision is one which maximizes Sum of Contributions made by all divisions. and their impact on sales volume of product Z are estimated as below: Possible competition¶s price (in Rs) Sales volume.4 7000 37800 28 22.4 10000 4000 22 22. above.6 0. division. maintain it¶s price Rs.6 4. etc.6 10000 (-) 6000 ‡ Maintaining the price is the better option. 28.4 9000 48600 28 22. i. if Product Z¶s price is maintained at Rs.e.4 10000 34000 25 22.6 2.6 3. by the whole company.

maintain it¶s price Rs.Example of relationship between Transfer Price (two-step) & Contribution Question B) Given TP as in 2. or follow competition: SOLUTION to Q B (See Table alongside): ‡ In this case. As you would observe. The selling unit can act to maximize overall contribution. Transfer Pricing 58 . Competitive Price Competitive Price Variable Cost Contribution/unit Sales Quantity Total Contribution Maintain the price Variable cost Contribution/unit Sales Quantity Total Contribution 27 14 13 10000 130000 26 14 12 10000 120000 25 14 11 10000 110000 23 14 9 10000 90000 22 14 8 10000 80000 Maintain the price 28 14 14 9000 126000 28 14 14 7000 98000 28 14 14 5000 70000 28 14 14 2000 28000 28 14 14 0 0 ‡ ‡ ‡ QUESTION C: Which TP method is in the best economic interest of the Company? ANSWER : Total Variable Cost (not Full Cost) ‡ Upstream visibility of costs available. different methods of transfer pricing. i. above the variable cost. 28. So as long as there is spare capacity aim to maximize capacity utilization. NOTE: Maximizing CONTRIBUTION is the key objective of divisions. marginal costs (variable) from previous divisions are not visible ‡ Economic theory : Company profits are maximized when Marginal cost = Marginal Revenue. when two-step method is used for TP. by selling at the highest price attainable. because Total Contribution is higher. TWO-STEP COSTS. i. In the FULL COST method. BUT.e. induces different behavior by the divisions. above. 6. should Division C.e. then recommended approach is to follow the competition. which is the best method? The profits of the whole company must be maximized.

27 26 25 23 22 48600 14600 37800 14600 27000 14600 10800 14600 0 14600 Company¶s Profit When Two-step TP was used Total Contribution. chose to follow the competitive price. contrary to the best interest of the company? If so.000/- 34000 23200 12400 (-) 3800 (-) 14000 ( -) 130000 100600 29. Division chose to Maintain price at Rs. All other costs (fixed of earlier divisions + all variable) already taken. Transfer Pricing method). FULL COST IS BEST! 59 . Division C. when Selling Price was competitive Less: Fixed Cost & Capital Charge of Total Company. when FULL COST TP was used. 28. NO LOSS MADE . When Two-step TP was implemented. Various pricing scenarios by competition (Rs) When Full Cost TP was used Total Contribution. when Selling Price was maintained at Rs. what is the opportunity loss to the company in each of the competitive pricing actions? As seen earlier. 28 Less: Fixed Price of Division C & Capital Charge.The cost of a faulty Transfer Price Policy QUESTION D: Using the TP based on Total Cost As in case 1. = 10000 X (3 + 4 +1).400 120000 100600 19400 3800 110000 100600 9400 3000 90000 100600 (-) 10600 6800 80000 100600 (-) 20600 6600 Company¶s Profit 4600 Opportunity Loss (-) (due to using the incorrect TP 6. 206. is the manager making a decision. + 10% of Rs.

) Because of ±ve contribution. 28 and & contribution is Rs. Div C says no TV Ads. Division C would loose an opportunity to contribute 78K to the company 6. at diff levels of ad spend 100000 10000 200000 19000 300000 27000 400000 34000 500000 40000 ANSWER to Q 4: When FULL COST TP used. A marketing survey reveals the impact of advertising. as below: Advertising Exp (in Rs.4 X vol incr. The contribution of Division C per unit was Rs. 100000 10000 54000 -46000 200000 19000 102600 -97400 300000 27000 145800 -154200 400000 34000 183600 -216000 500000 40000 216000 -284000 Net Contribution ( Contribution less Exp) When Two-Step method used. spend increases sales volume at the given Selling price of Rs.) Sales Volume of Z.60) Advertising Exp (in Rs.) Sales Volume of Z. 5. at diff levels of ad spend Incremental contribution on added volume (14 X X vol incr.) 100000 10000 140000 40000 200000 19000 266000 66000 300000 27000 378000 78000 400000 34000 476000 76000 500000 40000 560000 60000 Net Contribution ( Contribution less Exp) If a faulty TP policy (FULL COST) was used. at diff levels of ad spend Incremental contribution on added volume (5. 14. ‡ Two-step TP ‡ Invest Rs. on increase in sales. 300000 in TV ads 60 . Ad. Transfer Pricing The best decision. Assumed that selling price is Rs.Faulty TP policy can cause faulty investment decisions QUESTION 4: Division wishes to invest in TV advertising to increase it¶s sales.40 (Rs 28 ± 22.) Sales Volume of Z. 28 Advertising Exp (in Rs.

3.5.000 Assets (other than debtors) Rs.00. 1. A company fixes the inter divisional transfer prices for its product on the basis of cost plus estimated return on investment in its divisions.000 Rs. 00. 11. 16. The relevant portion of the budget for division' A' for year 2007-08 is given below: Fixed Assets Rs.10 Budgeted volume of production per year (units) 4.000 Variable cost per unit of product Rs. 00.000 18% Div B Rs. 1.000 Annual fixed cost of division Rs.0000 Rs.000 desired return on investment 28%. 00.00.000 11% The company¶s Cost of Capital is 13%. Transfer Pricing 61 . Should the project be accepted or rejected ? [6] 6.000 Debtors Rs.University Questions 1. You are required to determine transfer price for division 'A'. [10] Division 'A' and 'B' are both considering an outlay on new investment projects. Div A Investment outlay Return on new Current ROI Rs.

20 per unit. Transfer Pricing 62 . if it would have sold the product in open market. 4.000 units and division agrees to pay 60% of profit instead of 50% agreed earlier.000 units (?). {ch 6 pg 245-249 6. 6. in case of situations discussed in 1 & 2 above. Required: ‡ Compute the transfer price per unit need to be born by division 'B' in the present circumstances. Volume per annum 10. functional. company has established a transfer pricing policy such that' B' shall pay actual full cost plus 50% of profit division 'A' would have made. "A" supplies part of its produce to 'B'. Compute transfer price in this situation. How one can resolve this conflict? Explain with suitable example. hierarchical.800 units). an individual. organizational.000 units Internal transfer as per TP policy 4. Offer your comments on suitability of approach. variable cost of Rs. To keep motivated both the divisions. Given below the sales and cost data for division' A'. ‡ Incase demand from division B goes up from 4. ± Write short notes on any THREE Market based and cost based transfer pricing. [16] 3. Variable cost Rs." [18] ch 6 ± transfer pricing arbitration ± pg 256-7 ABC Ltd is a multidivision integrated company.20 per unit (based on volume of 4.30 per unit (excluding transfer price) and fixed cost ofRs.80 per unit Fixed cost Rs. However in view of demand from division "B".150 per unit. which is being sold in open market entirely.000 units External sales @ Rs.250 per unit. In a typical organization one can observe goal conflicts arising out of different roles its people play/assume i.1 & 2. ‡ Compute profitability of division' A'. ‡ Given selling price of final product by 'B' is Rs.000 to 6.e.compute profitability of division 'B' in both the above discussed situations'.Univ Qs 2. One of its division "A" produces a product.

Division M sales two third of its produce to division N and rest in the open market. Mittal Ltd has two divisions M & N.000 8.) M N Company Sales (outside only) 16. b) at cost plus a margin of25%.000 20.in Rs. but there is overspending in division M by Rs.~ a) at cost.000 20. [16] 6.000 (Internal + outside sales) Profit 44. d) at market price.000 There is no opening or closing stock. Transfer Pricing 63 .Univ Q¶s 5. Cost and revenue of these divisions and that of company for year 2.000 is given as under: (Amt.3. c) at cost plus a margin of 25% . M/s. You are required to find out profit of each division and that of company under following options of transfer prices.000.000 Cost of manufacturing 24.

Determine whether the company as a whole will benefit if Division C purchases the component from outside suppliers for $135 per unit. Should Division C purchase from outside suppliers? [16] 6. because of the recent installation of some highly specialized equipment and the resulting high depreciation charges. Division A insists that. Each division manager has been delegated full authority on a11 decisions involving the sale of that division's output both to outsiders and to other divisions of Allison-Chambers. Division C has in the past always purchased its requirement of a particular tractor engine component from Division A. 2. By not producing the 1. it will not be able to earn an adequate return on its investment unless it raises its price. Transfer Pricing 64 . However. with each manufacturing division operating as a separate profit center. when informed that Division A is increasing its selling price to $150. The Allison-Chambers Corporation. Assume that there are no alternative uses for internal facilities. is organized along decentralized lines. Division A's manager appeals to top management of Allison-Chambers for support in the dispute with Division C and supplies the following operating data: C's annual purchases of tractor-engine component 1.Univ Q¶s 6. Should Division C purchase from outside suppliers? 3) Assume that there are no alternative uses for Division A's internal facilities and that the price from outsiders drops $20. Division C can purchase the component for $135 on the open market. Division A's equipment and other facilities would be used for other production operations that would result in annual cash-operating savings of$18. manufacturer of tractors and other heavy farm equipment.000 units A's variable costs per unit of tractor-engine component $120 A's fixed costs per unit of tractor-engine component $20 REQUIRED I. Assume that internal facilities of Division A would not otherwise be idle.000 units for Division C.000. Division C' s manager decides to purchase the engine component from outside suppliers.

1 {ch 6} Univ Q¶s Division B¶s manager disagrees with the basis used to set the transfer price. Transfer Pricing 65 . 6. Division B incorporates the transferred-in goods into a more advanced product. In addition to the external sales. You are required: ‡ to calculate the effect hat the transfer pricing system has had on the company s profits. ($) Transferred-in item (from Division A) 29 Direct material and components 23 Direct labour 3 Variable overheads 12 Fixed overheads 12 Selling and packing expense variable 1 Total Costs 80 $30 10000 $40 5000 $80 7200 $90 5000 $100 2800 The manager of Division B claims that this study supports his case. He suggests that a transfer price of $12 would give Division A a reasonable contribution to its fixed overheads while allowing Division B to earn a reasonable profit. This transfer price is obtained by deducting variable selling and packing expense from the external price since this expense is not incurred for internal transfers.7. The unit cost of Division A¶s product are as follows: ($) Direct material 4 Direct labour 2 Direct expenses 2 Variable manufacturing overheads 2 Fixed manufacturing overheads 4 Selling and packing expense variable 1 15 Annually 10000 units of the product are sold externally at the standard price of $30. Customer demand at various selling prices: Division A Selling Price $20 Demand 15000 Division B Selling price Demand Division A of a large divisionalized organization manufactures a single standardzid product. Some of the output is sold externally whilst the remainder is transferred to Division B where it is a subassembly in the manufacture of that division¶s product. and ‡ to establish the likely effect on profit of the suggestion by the manager of Division B of a transfer price of $12. 5000 units are transferred annually to Division B at an internal transfer charge of $29 per unit. The unit costs of this product are as follows. He argues that the transfers should be made at variable cost plus an agreed (minimal) mark-up since he claimed that division is taking output that Division A would be unable to sell at the price of $30. Case no. He also believed that it would lead to an increase of output and an improvement in the overall level of company profits.

000 p. 14 each. 2 per assembly he should at least be allowed to sell in the external market extra quantity of 20% of his total present production in order to partially compensate him for the loss. 6.a. Painting shop¶s fixed costs are Rs. 25 each.56. proposes to increase the transfer price for supplies to painting shop. Out of the total production. The company has a welding shop as well as a painting shop. 30. Welding shop manager. The shops are motivated through goal congruence. 12 each to Rs. The manager of the welding shop has ascertained from the market that of latent demand for the welded (unpainted) assembly has increased substantially and this situation is expected to continue for another 6 to 8 months. The printing shop¶s cost of painting including transfer price from welding shop comes to Rs. Transfer Pricing 66 . 80% is diverted to painting shop at the same price i. He is then prepared to continue with the present transfer price for the balance quantity of painted assemblies to the extent of only the quantities received from welding shop. proposes that.a. since supplying assemblies to painting shop at existing transfer price he is loosing Rs. 24. therefore. 2 {ch 6} Fastner International Ltd. autonomy and management efforts. Will this proposal benefit him? What will be the effect of it on the profitability of the painting shop as well as the total company? Justify your answer with appropriate and detailed calculations.Univ Q¶s 8. 14 each on the ground that his profitability will be adversely affected.e. 20 each. 12 per assembly and remaining sold in the market.000 assemblies. for this level of operations. He. The welding shop welds annually 72. Case no. Painting shop sells all the assemblies duly painted at a price of Rs.000 shop made parts in to 12. therefore. Rs. is having production shops reckoned as profit centres.000 purchased items with other 1. This has resulted in an increase in the market price from present Rs. Manager of the painting shop refuses to accept the new transfer price of Rs.000 p. Total cost of this assembly for the welding shop works out to Rs. Each shop is allowed to charge other shops for materials supplied and services rendered.

The unit cost of this product are as follows. 1 Division A of a large divisionalized organization manufactures a single standardized product. Transferred in item (from Division A) 29 Direct material and components 23 Direct labour 3 Variable overhead 12 Fixed overhead 12 Selling and packing expense variable 1 TOTAL 80 Division B¶s manager disagrees with the basis used to set the transfer price. The unit costs of Division A¶s Product are as follows: Direct material 4 Direct labour 2 Direct expense 2 Variable manufacturing overheads 2 Fixed manufacturing overhead 4 Selling and packing expense .Univ Q¶s Case No. Do you agree with Division B? Why or why not? 6.variable 1 -------------------15 Annually 10000 units of the product are sold externally at the standard price of L 30. In addition to the external sales. 5000 units are transferred annually to Division B at an internal transfer charge of L 29 per unit. This transfer price is obtained by deducting variable selling and packing expense from the external price since this expense is not incurred for internal transfers. Some of the output is sold externally whilst the remainder is transferred to Division B where it is a subassembly in the manufacture of that division¶s product. He argues that the transfer should be made at variable cost plus an agreed (minimal) mark-up since he claimed that his division is taking output that Division A would be unable to sell at the price of L 30. Transfer Pricing 67 . Division B incorporates the transferred in goods into a more advanced product.

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