Responsibility

TRANSFER PRICING Accounting

and Transfer
Pricing
 TRANSFER PRICING

 One of the problems encounters in successfully and meaning-

fully evaluating the performance of the different segments of
an organization is caused by the transfer of goods and
services between or among segments.
 Transfer price is the monetary value or the price charged by
one segment of a firm for the goods and services it supplies
to another segment of the same firm.
 Transfer price is an internal price- it is the amount charged by
one responsibility center to another responsibility center for
goods and services.
 TRANSFER PRICING METHODS

 There are different methods of setting transfer prices. The

selection of method appropriate is based on the reporting
needs of an organization.
 The most commonly used transfer pricing methods are:
1) Market Price
2) Modified market price
3) Transfer price based on full cost
4) Transfer price based on variable cost
5) Negotiated transfer price
6) Dual transfer pricing method
 1. MARKET PRICE (T RA N SF E R P R I C I N G M E T HO D )

 If a perfectly competitive market exists for the products to be

transferred between departments, the ideal transfer price is
the prevailing market price.
 When the market price is used for intra-company transfers,
such transfer price is acceptable to all the segments
concerned , because the price is set as if the segments are
dealing at arm’s length with one another.
 2. MODIFIED MARKET PRICE

 The interdivisional transfers, the selling division incurs less

selling costs than it would incur if the goods were delivered to
outside consumers. Because of these cost savings, it is but fair
that the market price be adjusted downward so that the buying
division could also be benefited by such savings. In this case, an
adjusted or modified market price is used as the transfer price.
 If there is no existing outside market for a product that is
subject to interdivisional transfers, the modified transfer price
can still be used provided that the market price to be used will
be based in a substitute product that is similar (not identical) to
the division’s product. Furthermore, some adjustments on the
market price should be made to provide allowance for the
differences in type of materials used, durability of the product,
etc.
 3. TRANSFER PRICE BASED ON FULL
COST
 When no outside market exists for either identical product or
a close substitute for the division’s product, the firm shall
consider alternative bases of transfer price other than market
price.
 One of these bases is the full cost to produce the product. In
some cases, a certain amount of mark-up is added to full cost
to enable the selling division to earn profit from
interdivisional transaction.
 3. TRANSFER PRICE BASED ON FULL
COST
 Example:
 Division 1 incurs full cost of 12 to produce a product that is
transferred to Division 2. If the transfer price is set at full cost of 12,
division generates sales of 12 per unit for each transfer and reports
zero profit. Division 2 on the other hand will incur a cost of 12
whenever a unit is transferred from Division1.
 Assume however, that the transfer price in the preceding example is
set at full cot plus 50% mark-up, the transfer price will amount to 18
( 12+ (50% of 12))
4. TRANSFER PRICE BASED ON VARIABLE
COST
 Some companies use only the variable costs as the basis in
establishing transfer prices.
 Under this method, fixed cost is considered irrelevant because
if alternatives exists whether to transfer the goods to another
division within the firm or sell them to the external market,
fixed cost will not change.
 To motivate division managers to transfer goods to other
divisions despite the use of variable cost as the base for
transfer prices, the transfer pricing policy wherein certain
amount of mark-up may be added to the variable cost may be
formulated. This mechanism is called variable cost-plus
method.
4. TRANSFER PRICE BASED ON VARIABLE
COST
 Example
 Assume that Division 1 produces a product at a cost of 20 of which 5
is fixed. Division 2 wants to buy the products from Division 1 at a
price of 17. Should Division 1 transfer the goods to Division 2?
 Using the Transfer Price based on variable cost, the contribution
margin would be 2 per unit computed as follows:
Transfer price 17.00
Less: Variable Cost (20-5) 15.00
Contribution Margin 2.00
 Assume however that the transfer price in the preceding example is
set at variable cost plus 40% mark-up, the transfer price will amount
to 21 ( 15+ (40% of 15))
 5. NEGOTIATED TRANSFER PRICE

 A negotiated transfer price is determined by bargaining

between the buying and selling divisions. In this case, the
divisions are treated as if they are indeed separate entities.
 This method, however, is applicable only when any of the
divisions can actually buy from or sell to the external market.
This is so because if no external market exists, the bargaining
process might just end up to misunderstanding between
division managers when in the end, they will have no other
choice but to transact with each other.
 6. DUAL TRANSFER PRICING

 A transfer price may be acceptable to one division but

unacceptable to another division depending on the effect of
such transfer price to each division’s profit position.
 To remedy this situation, a dual transfer pricing system may
be applied.
 6. DUAL TRANSFER PRICING

 For instance, Division 1, which produces a product at a cost of 10.00

per unit may be allowed to sell to Division2 at a transfer price of
15.00. Division 2, on the other hand, may be allowed to record the
purchase of goods from Division 1 at a transfer price (purchase cost)
of P10.00. If Division 2 incurs additional 4.00 to process each unit
received from Division 1 and sells it at 18.00, the results will be as
follows:
STANDARD COST IN TRANSFER PRICING

 When a firm uses the standard cost accounting system, it is

advisable to use standard costs instead of actual costs in the
determination of transfer prices. This is to avoid the passing
or transfer on to another division the inefficiencies or
efficiencies (variances) in the manufacturing operations of
the selling division.
 For instance, assume that Division 1 produces a product at a
standard cost of 10.00. Accounting data during a certain period
revealed that actual costs incurred to produce the product amounted
to 13.00. Based on the investigations made, it was found out that the
unfavorable variance of 3.00 was due to inefficient use of materials
in Division 1.
 ACCOUNTING TREATMENT FOR INTRA-
COMPANY TRANSFERS
 Assume that Landrace Company has two divisions, R and S.
Division R produces a product at a cost of 10.00 and transfers
the same to Division S at a transfer price of 15.00. To take up
the transfer of goods, the following entries are recorded:
 ACCOUNTING TREATMENT FOR INTRA-
COMPANY TRANSFERS
 At the end of the accounting period, when consolidated
statements are prepared for the Landrace company as a
whole, entries for all intra-company transactions are
eliminated, leaving only the accounts with outside parties.
QUESTIONS? CLARIFICATIONS?
 REFERENCES

 Roque , Management Advisory Services

Thank you!