CHAPTER 19

Transfer Pricing

Chapter Outline

A.

Cost Management Challenges Chapter 19 provides four cost management challenges.

1.

2.

3.

4.

What is the primary purpose of establishing a transfer price policy?

What are four methods for setting transfer prices?

What is the significance of excess capacity in the transferring division, and what impact does that have on the transfer price?

Why might income-tax laws affect the transfer-pricing policies of multinational companies?

Learning Objectives This chapter has five learning objectives.

B.

1.

2.

3.

4.

5.

The chapter discusses the effects of transfer pricing on segment reporting. A transfer price represents the amount charged when one division sells goods or services to another division within an organization. Transfer pricing is a challenge for cost managers because it represents an economic event that must be recorded in the accounting system. Deciding what the transfer price should be is the challenge. Transfer of goods and services within an organization do not impact the organizations profits as a whole organization. However, the buying and selling divisions profits are affected by transfer prices charged. A high transfer price increases profits for the selling division and increases costs for the buying division.

C.

Chapter 19 explains the purpose and role of transfer pricing.

The chapter explains how to use a general economic rule to set an optimal transfer price.

It explains how to base a transfer price on market prices, costs, or negotiations.

It discusses the implications of transfer pricing in a multinational company.

It discusses the effects of transfer pricing on segment reporting.

If divisions are evaluated using ROI, residual income, or economic value added, then the transfer price can affect the performance of each division. This fact may motivate managers to pursue strategies for transfer pricing that are not congruent with organizational goals.

1.

In a highly decentralized organization, managers are given the autonomy to decide whether to accept or reject orders and whether to buy from inside the organization or from outside. The goal in setting transfer prices is not to motivate managers to buy internally. It is to motivate managers to make decisions that support the overall goals of the organization. Thus, the transfer price chosen should allow each division manager to maximize his or her own profits, while also maximizing the companys profit.

2.

There is a general transfer-pricing rule that ensures goal congruence. It is:

Transfer price = Additional outlay cost per unit incurred because goods are transferred + Opportunity cost per unit to the organization because of the transfer.

a.

b.

This general rule separates the transfer price into two pieces. The first piece is just the additional costs incurred to manufacture the product (or provide the service), plus any applicable costs that are directly related to the transaction to transfer goods internally.

The second piece of the transfer price, the opportunity, represents the amount of contribution margin given up to make the sale internally. In other words, if a sale could be made to an outside buyer, the difference between the outside buyers price and the additional outlay costs per unit equals the opportunity cost. The opportunity cost of selling internally depends on whether the selling division has excess capacity or not.

Assume the selling division has no excess capacity. This means that all production

capacity is currently being used to sell product at the market price. The transfer price is the outlay cost plus foregone contribution margin. This is just the existing market price. That is the case, because for every unit sold internally, one less unit can be sold to external customers.

3.

a.

b.

Given the case that the selling division has no excess capacity, how can the general transfer-pricing rule be used to promote goal or behavioral congruence? One should next look at the buying divisions situation. Suppose the transfer price for a part is $40. Suppose the buying division can obtain the same item from another supplier for $35. The buying division should buy from the other supplier. Why? Because the selling division can sell the product to external customers instead of selling internally. The buying division can buy externally at $5 less than it could if the item was purchased internally. This will increase profits for the company as a whole.

Suppose the selling division has no excess capacity, its transfer price is $40, and other suppliers charge $45. In this case, it is better for the buying division to buy internally. The selling division should be indifferent since the transfer price is the same amount that would have been charged to external buyers.

4.

Now, consider the case where the selling division has excess capacity. In this case, the general rule for a transfer price would assume that opportunity costs are zero. All demand for external sales can be met, and excess capacity can be used to satisfy internal demand. Now, suppose again that the price charged to external customers is $40. Suppose further that this $40 price included contribution margin of $14. The opportunity cost of $14 becomes $0 when there is excess capacity. In this case, the transfer price is $26.

a.

Suppose, as described earlier, that the buying division could buy an item for $35 from another supplier. In the case where the selling division could sell the item for $40, it would be better not to transfer the item internally. In the case of excess capacity where the transfer price is now $26, it makes sense for the selling division to accept the internal order, and it makes sense for the buying division to buy internally. In this case, it is unlikely that the buying division could find the

item externally for less than the transfer price.

5.

Theoretically, the general rule for transfer pricing should work well and should promote goal or behavioral congruence. In reality, there are some challenges associated with

setting the transfer price, outlined below.

a.

b.

c.

d.

e.

The external market may not be perfectly competitive, so the opportunity cost is not always easy to determine. In a perfect competitive market, the market price does not depend on the quantity sold by any one producer. Under imperfect competition, a single producer can effect the market price by varying the amount of product available in the market. This makes the opportunity cost variable because it depends on decisions about the amount available to external buyers.

Another complication arises when there is no outside market for the item to be sold internally. In the most extreme of these cases, the company may even combine the buying and selling divisions, so the transfers occur without a need to set transfer prices.

A third complication arises when the goods being transferred are unique or when

special equipment must be acquired to produce the items being transferred. These special situations could be viewed as opportunity costs since the producing division could have used those resources for more profitable activities.

A fourth complication arises when the selling manager has excess capacity and has no opportunity cost. It is to the advantage of the organization for the selling division to manufacture and sell the product to the buying division using excess capacity. Yet, the selling manager is evaluated based on the profitability of his or her division. If items are produced and sold (transferred) without any contribution margin, the selling managers profitability will not increase as a result.

Because of the complexities encountered in real transfer pricing situations, the general rule for transfer pricing is sometimes modified, as described below.

6.

In the simplest case, the transfer price equals the external market price. This occurs when the market is perfectly competitive and the selling division has no excess capacity.

There may be occasions where an industry experiences a period of significant excess capacity and extremely low prices. Under such extreme conditions, transfer price cannot equal market price. In this unusual case, the transfer price should be based on the longrun external market price instead of the current, artificially low market price.

7.

8.

Many companies use negotiated transfer prices. Division managers may start at the external market price and seek reductions based on savings that may occur because the internal transfer may involve less cost than external sales. For instance, sales commissions are not necessary, and transportation and shipping costs may be less if the two divisions share facilities. Negotiated transfer prices may also be used when there is no external market.

Negotiated transfer prices have two drawbacks. Negotiations can cause divisiveness and competition between division managers. This can undermine cooperation and cohesiveness.

a.

A second drawback is that negotiating skill can erroneously become an evaluating mechanism for managers. If, for instance, the selling division manager is very effective at negotiating the transfer price, the selling division may look better simply because of the selling managers negotiating ability.

b.

9.

10.

11.

12.

An alternative to a market-based or negotiated transfer price is a cost-based transfer price.

In general, when making a transfer pricing decision, the transfer price should be based on standard costs instead of actual costs. If actual costs were used, the costs of any inefficiencies would be passed on to the buying division.

Cost-based transfer pricing can be improved by adopting activity-based costing. This would improve the accuracy of costs used to determine transfer price.

When the producing division is not provided with financial motivation for selling product internally, motivational problems can arise. There are several remedies to this problem.

A supplying division whose transfers are almost all internal could be organized as a cost center. Then the manager is not responsible for generating profit, and the managers performance is not based on profit measures.

a.

13.

14.

b.

A supplying division who sells externally could be structured so that external sales activity is treated as profit center activity, and internal sales activity could be treated as part of cost center activity.

A tempting solution to disputes between managers regarding transfer price disagreements is to have upper management intervene. Once a company establishes a transfer pricing policy and gives managers autonomy to accept or reject orders or transfer prices, it is best not to intervene directly.

In the case where the transfer price could cause the buying and selling managers to reject internal transfers when they should not, a dual transfer pricing system could be set up. Using this approach, the buying division is charged with only the cost of the transferred product, while the selling division is given credit for some profit.

D.

The transfer pricing issue becomes much more complex and controversial in a global environment. This is true because of tax laws, royalties, and other laws related to definition of cost and transfer of profits outside of a country. Since tax rates vary among countries, companies

are motivated to set transfer prices that will increase revenues in low-tax countries and increase costs in high-tax countries.

1.

2.

International tax authorities look closely at transfer prices when examining tax returns of companies engaged in related-party transactions that cross national boundaries. Companies often are required to provide support for the transfer prices they use.

In addition to the tax effects on transfer pricing decisions, import duties may influence the transfer prices chosen by companies. Import duties, or tariffs, are fees charged to

importers that are based on the value of the goods being imported. If there are import tariffs, a company will be motivated to set the transfer price low in order to minimize the amount of import tariffs assessed.

E.

The Financial Accounting Standards Board (FASB) requires companies engaged in different lines of business to report certain information about segments. This includes segmented reporting of revenue, profit or loss, assets, depreciation and amortization, capital expenditures, and certain specialized items. International organizations must also report segmented information by geographic region. The FASB promotes the use of market-based transfer prices for financial

(external) reporting purposes. The determination of market price is not always feasible, as has been discussed earlier in this chapter. Companies usually are forced to estimate market price of items for which a market price is not readily available.

F.

Although most of the discussion in Chapter 19 revolves around the transfer pricing issue for a manufacturing firm, it is also used in service sector firms and in non-profit organizations.