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.
 Transfer Pricing
Transfer pricing should help achieve
a company’s strategies and goals.

fit the organization’s structure

– promote goal congruence

– promotea sustained high level

of management effort
 Objectives of Transfer Pricing
• Providing relevant information to the profit centers
regarding the trade-off between costs and revenues
of the company.
• Inducing goal-congruent decisions, i.e., decisions
that improve the profits of business units and also
improve the profits of the company
• Helping to measure the economic performance of
profit centers.
• Minimizing tax liability.
Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices

 Opportunity cost of the
Outlay
Transfer price = + resource at the point of
cost
transfer
Centrally Established Transfer Pricing
Negotiated transfer
The managers of the buying and selling divisions
agree on a price.

Cost-based
Outlay cost to selling division plus forgone
contribution to company projects

Market price-based
Sets the transfer price at the market price or at a small
discount from the market price
Multinational Transfer Pricing

International (or interstate) transfer

pricing can affect tax liabilities, royalties
and other payments due to different laws
in different countries or states.

Company incentive

Increase profit in Decrease profit in

low-tax country high-tax country
https://www.youtube.com/watch?v=Y7iNOYCA3tY
(Intro to International Transfer Price)
 Example: Multinational Transfer Pricing
Diego Pharmaceuticals

Assume $20,000,000 transfer price

United States Puerto Rico

Revenues $ 20,000,00 $ 50,000,000
Third-party costs 0
20,000,00 5,000,000
Transferred goods costs 0 - 20,000,00
Taxable income - $025,000,00
Tax rate 35% 0 20%
Tax liability - $ 5,000,00
Total tax liability $ 5,000,00 0
0
Example: Multinational Transfer Pricing, Continued. . .
Diego Pharmaceuticals

Assume $45,000,000 transfer price

Segment Reporting

The FASB requires companies to report certain

information about segments in order to provide a
measure of performance for those segments that are
significant to the company as a whole.
 General Guideline

Minimum transfer price

= Incremental costs per unit incurred
up to the point of transfer
+ Opportunity costs per unit to the selling division
Let’s discuss some problems
Birch Paper Company Case
 Background
• Medium sized, partly integrated company
• Three product; white and Kraft papers and
paperboard
•Birch
•Southern

•Northern

•Thompson

•Division 4
•Division 4
 Working and Assessment
• Judgment based on the basis of its profit and
return on investment (ROI)
• Concept of decentralization-both authority
and responsibility
• Improvement attributed to above factor
 Situation
• Northern and Thompson division together
designed box for Northern division
• Thompson division was reimbursed by Northern
division for it’s designing and development
• After finalization, apart from Thompson’s bid it
also get offers from two outside companies
• Company policy where each division manager
had full freedom and discretion to buy from
anywhere
 Cont.
• Thompson’s most materials from within
company but sales mostly outsiders
• If Thompson gets bid materials to be procured
from Southern division
• 70% of out of pocket costs of $400 were above
materials
• This constituted 60% of selling price
The Northern division received bids on 1000
boxes
• From Thompson division - $480
• From West Paper Company - $430
• From Eire Paper Company - $432
 Birch Paper Company

Transfer Price Decision:

• Bids:
• 1) Thompson (internal) - $480.00 (20% profit)
– buys from Southern division (70% of $400 cost)
– Southern costs are 60% of transfer/selling price
• 2) West Paper Co. (external) - $430.00
• 3) Erie Papers Inc. (external) - $432.00
– Plus purchases i) $90 per box from Southern
– and ii) $30 from Thompson (25% is variable)
 Structure of the Problem
• Alternative A Alternative B Alternative C

Northern Div Northern Div Northern Div

$ 480 $432
$ 430
Thompson Div Eire papers ltd

West paper Co
$ 120 $ 280 $30 $90
Thompson Southern
Southern Div Div Div

$168 $25 $54

 Eire paper Company and dilemma
• It would buy outside linear board from Birch
with special printing (to be done by
Thompson) $90 (a thousand boxes) and $30
for printing.
• “Competitive market where higher costs
cannot be passed on, how can we buy own
supplies @10% higher than market rate.
 Other Factors
• Thompson division felt not received profit for
their development work, hence entitled to mark
up on production of box
• “Cost variable for one division could be largely
fixed for company as a whole”
• Without orders from top management Kenton
would accept the lowest bid
• Transaction involved only 5% of volume of
divisions involved
Which bid should Northern division accept that
is in best interest of the company?
• Thompson division
• In the calculation out the cost that Thompson
actually has the lowest costs associated with
them
 Cost involved
• Costs for Thompson are; Linear board and
corrugating medium: Cost
$400x70%x60%=$168 plus out of pocket:
$400x30%=$120, for a total cost $288
• Cost for West Paper would be a total $430
• Cost for Eire Papers would be $90x60%=$54
(Southern) plus $25 (Thompson), and their
supplies of $432-5-36=$391.
 Companies Overall Perspective
Thompson West Paper Eire Papers
Cost 480 430 432
Less-
• Southern Profit 36
(90*40%)
(280*40%) 112

• Thompson
Profit 5
• ( 30-25) 80
• (480-400)

Cost to Company 288 430 391

OR- Companies Overall Perspective
Should Mr. Kenton accept this bid?
• Mr. Kenton should not accept the bid from
West Paper because it is not in the best
interest of the company, but at the same time
with the transfer policy that exists, it is really
up to him what is in the best interest of his
division. Mr. Kenton should accept the bid
from Thompson because not only will result in
the lowest cost but also it will encourage
buying from within the company
 Vice president action
• Yes the vice president should take any action.
As if no orders come from top management
Kenton would accept the lowest bid
• The vice president of the Birch should take
action in order to remedy the overall
problems associated with this transfer pricing
policy
 Is transfer pricing system
dysfunctional?
• Yes
• The transfer price system is dysfunctional
because it focuses too much on individual
sectors making profit and return on
investment
• Some alternative should be present which
strikes a balance between both