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CHAPTER 8

Transfer Pricing

Transfer Pricing Transfer Pricing


Transfer price - price used to value internal transfers of goods or services Subunits of a company sell goods or services to other subunits within the same company Must determine the price to use for internal transfers

Transfer Pricing Objectives Transfer Pricing Objectives

General Transfer-Pricing Rule General Transfer-Pricing Rule


VC + OC Transfer Price Market Price
The minimum price should be no less than the sum of the selling segments incremental costs (VC) associated with the goods or services plus the opportunity cost (OC) of the forgone production of the seller per unit (lost contribution margin). The maximum price should be no greater than the lowest market price at which the buying segment can acquire the goods or services externally.

Methods of Setting the Transfer Methods of Setting the Transfer Price Price
Pricing alternatives:
Market price Cost-based price Negotiated price Arbitrary price Dual Pricing

Market Price Market Price


The price at which the division may buy or sell the units outside and is based on arms length transaction in an open market. The best transfer price in the sense that it will maximize the profits of the company as a whole, if it meets the following two conditions:
- There exists a competitive market price. - Divisions are independent of each other.

Cost-Based Transfer Price Cost-Based Transfer Price


Variable or Full Cost Actual or Standard Cost
*Actual costs may vary according to the season, production
volume, and other factors, whereas standard costs can be specified in advance and are stable measures of efficient production costs. For these two reasons, standard costs provide a superior basis for transfer pricing.

Negotiated Price Negotiated Price


The transfer price arrived at in negotiations between the buying and selling divisions. Such price is typically below the normal market purchase price of the buying unit, but above the sum of the selling units incremental and opportunity costs. A negotiated price meeting these specifications falls within the range limits of the transfer pricing rules.

Arbitrary Price Arbitrary Price


A price established by interaction between buying and selling divisions and is at a level considered best for overall company interests, with neither the buying nor the selling divisions having any control over the final decisions. This is due to such extensive autonomy that leads to dysfunctional behavior and suboptimization, top management may provide a means of arbitrating a price in the event that the units cannot agree.

Dual Pricing Dual Pricing


A method where both the selling and buying divisions record the transactions at different prices. Such an arrangement lets the selling division record the transfer of goods or services at a market or negotiated market price and the buying division to record the transfer at a costbased amount and provides a profit margin on the goods transferred and thus reflects a profit for the selling division and also provide a minimal cost to the buying division.

Journal Entries Journal Entries


Assum that 1,000 units of product are transferred fromthe Evergreen Division to the Marine Biochem e ical Division: Variable cost (1,000 x P 0.40) =P400 Full production cost (1,000 x P0.45) =P450 External selling price (1,000 x P0.72) =P720

S UAT IT ION
Transfer Price at Variable Cost

E R E N(E VE GR E )
A/R - Division MB Intracom pany Sales Intracom pany CGS Finished Goods A/R - Division MB Intracom pany Sales Intracom pany CGS Finished Goods A/R - Division MB Intracom pany Sales Intracom pany CGS Finished Goods 400 400 450 450 450 450 450 450 720 720 450 450

MAR B H MICAL(MB INE IOC E )


Inventory A/P - Division E 400 400

Transfer Price at Full Production Cost

Inventory A/P - Division E

450 450

Transfer Price at Market Price

Inventory A/P - Division E

720 720

Transfer Price at Dual Price Market Price for selling division & Full Prod Cost for buying division

A/R - Division MB 450 Intracom pany Sales in excess of Assigned Cost 270 Intracom pany Sales Intracom pany CGS 450 Finished Goods

Inventory A/P - Division E 720 450

450 450

NOTE: Entries for negotiated transfer prices would be similar to those at full production cost, except that the negotiated transfer price would be shown for first entry for the selling division and the purchase entry for the buyingdivision.

Sample Problem Sample Problem


Assuming Estimated sales to outside entities: 4,000 units Estimated intra-company transfers: 1,000 units Total standard cost per unit of P0.52 in Evergreen division

Sales: External (4,000 x 0.72) Internal (1,000 x 0.45) Costs (5,000 x 0.52) Income before tax

P2,880 450 P3,330 2,600 P 730

Suppose the Marine Biochemical Division of Scott Company can purchase evergreen units externally from United Company for P0.44 and that the externally purchased units are of the same quality and specifications as those produced internally. Thus, although the buying segment manager appears to save P0.01 per unit, the company would be better off by P4,000 if the units were purchased internally rather than externally: Unit cost to Marine Biochemical Division to purchase externally P0.44 Unit cost to produce in Evergreen Division (out-of-pocket costs) 0.40 Net advantage of company to produce per unit P0.04 Multiplied by number of units transferred 1,000 Total savings to produce internally P4,000
*These facts assume that the Evergreen Division does not have an opportunity cost of more than P0.04 per evergreen unit. Under the above circumstances, the general transfer pricing rules also would have yielded the decision not to make the internal transfer. The sum of the P0.40 incremental cost to produce and the P0.32 opportunity cost of additional contribution on external sales is P0.72, which exceeds the upper limit of the P0.44 market price. Scott Company should not make the transfer as long as the Marine Biochemical Division can purchase the units externally for a price less than P0.72.