Transfer Pricing

What is transfer pricing?

This could be an extension of a make or buy decision. When a company contemplates to make products or render service within itself, the department that provides the product or service (transferor) has to decide on which price it must charge the department that uses the product or service (transferee). The price charged is called the transfer price.

Application of Relevant Cost Analysis to Transfer Pricing

EZ Company manufactures and sells various computer products and has two decentralized divisions: Production and Marketing. Marketing has always purchased a particular mouse from Production at P60 per unit. However, Production sells it for P70 each to outside buyers. Assume that the Production Divisions costs related to mouse production are as follows: Variable costs per unit: P50 and Monthly fixed costs: P10,000 Marketing handles the promotion and distribution of the mouse it purchases from Production and sells each mouse for P100. Marketing incurs monthly fixed costs of P5,000. Marketing sells 1,500 units per month. Marketing is able to procure the mouse from outside at P60 each. Assumption 1: When production division has no outside customers, should marketing buy from production or from outside? Assumption 2: When production division is capable of producing 1,500 units and sales to outside customers is 1,500 units, should marketing buy from production or from outside? Assumption 3: When production division is capable of producing 2,000 units and sales to outside customers is 1,000 units, should marketing buy from production or from outside?

Transfer price
As explained in the previous slide, transfer price is used to charge for the product or service when divisions in a company transfer products or services to each other. These may be used for cost, revenue, profit , and investment centers.
Cost center
A distinctly identifiable department, division, or unit of a firm whose managers are responsible for all of its associated costs and for ensuring adherence to its cost budgets. Eg: Production department of a manufacturing company, marketing department, R&D department, help desks, customer service or contact center.

Revenue center
A distinctly identifiable department, division, or unit of a firm that generates revenue through the sale of goods and services. Eg: Rooms department and F&B department of a hotel.

Profit center
A distinctly identifiable department, division, or unit of a firm that contributes to the overall financial results of the firm. These centers are given the responsibility to target certain percentages of the total revenue and are given adequate authority to control their costs to achieve those targets. Eg: An independent branch/segment; manufacturing units that produce and sell products.

Investment center
A profit center where management also makes capital investment decisions.

Transfer price
Danger of transfer price: the department that provides the product or service may misuse the setting up of transfer price and the overall company benefit may suffer. The main thrust of setting transfer price: to motivate managers to behave in a manner that will increase the overall company income (profit maximizing viewpoint) while allowing divisional autonomy and responsibility. Objectives for setting transfer price:
Motivate a high level of effort on the part of subunit managers (extent to which a particular transfer pricing method maintains divisional autonomy). Goal congruency achieving consistency between decisions made by managers and goals of top mangers Reward managers fairly for their effort and skills and for the effectiveness of the decisions they make.

Common approaches to transfer pricing

Market price approach
The transfer price is the price at which the product or service transferred could be sold to outside buyers. This is most appropriate when the product or service provider is operating at full capacity (no idle capacity) where it is able to sell all of its products and services to outside buyers. This approaches does not work well when the selling division has idle capacity. Its key advantage is objectivity. However, for intermediate products, market price may be unavailable Transfer price = Market price (or current price of the product in the external market)

Common approaches to transfer pricing

Cost price approach
This is most appropriate when responsibility centers are organized as cost centers. If responsibility centers are organized as profit or investment centers, the cost price approach is normally not used. Categories of cost price approach:
Variable cost approach
This is desirable when the selling division has excess capacity and the transfer prices chief objective is to satisfy internal demand for the goods. TP = UVC; however, to encourage internal transfer, TP = UVC + markup for profit.

Full cost approach

This method is well understood and information is readily available in accounting records. However, since it includes fixed cost, it may cause improper decision taking. TP = UVC + allocated share of the selling divisions fixed cost + markup for profit, if any.

Common approaches to transfer pricing

Negotiated price approach
This approach allows managers to agree among themselves on a transfer price. Senior management does not specify the transfer price. The upper limit is determined by the buying division and the lower limit is determined by the selling division. This is most appropriate when the product or service provider has unused or excess capacity when it sells only to outside buyers. It is also desirable if the units have a history of significant conflict and negotiation can result in an agreed-upon price. Advantages of negotiated transfer prices:
They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company. They control their own destiny.

Disadvantage of negotiated transfer prices:

It can reduce desired autonomy of the units. It may be costly and time consuming.

Common approaches to transfer pricing

Negotiated price approach
Evaluation of negotiated transfer price:
If a transfer within a company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer. If managers are pitted against each other rather than against their past performance or reasonable benchmarks, a no cooperative atmosphere is almost guaranteed. Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices. Lost CM must be accounted pro-rata for in the transfer price, if the selling division does not have excess capacity. (Variable costs per unit + (TCM of lost sales / Total number of units transferred) < or = Transfer price < or = Market price.) *Dual pricing involves the use of multiple prices for an internal transfer. (When numerous conflicts occur, the buying division may use cost price approach while the selling division may use market price approach.

Common approaches to transfer pricing

Advantages of the common approaches to transfer pricing:

METHOD Market price approach ADVANTAGES: Helps preserve unit autonomy. Provides incentive for the selling division to be competitive with outside suppliers. Has arms length standard desired by taxing authorities. Provides proper motivation for the manager to make the correct short-term decision, in which the sellers fixed costs are not expected to change. When the sellers variable cost < buyers outside price, the variable cost TP will cause internal sourcing, the correct decision. Easy to understand and intuitive. Appropriate for long-term decision making in which fixed costs are relevant, and prices must cover fixed as well as variable costs. Can be the most practical when significant conflict exists. Consistent with the theory of decentralization.

Variable cost approach

Full cost approach

Negotiated cost approach

Limitations of the common approaches to transfer pricing:

METHOD Market price approach Variable cost approach

DISADVANTAGES:
Intermediate products often have no market price. Should be adjusted for any cost savings associated with an internal transfer (eg: reduced selling costs if any) Inappropriate for long-term decision making in which fixed costs are also relevant, but ignored. Unfair to the selling division if the selling division is a profit or investment center.

Full cost approach

Irrelevance of fixed cost in short-term decision making. Fixed costs should be ignored in the buyers choice of whether to buy inside or outside the firm. If used, should be standard rather than actual cost (so buyer will know cost in advance and prevents seller from passing on the inefficiencies.
Negotiation rule/arbitration procedure can reduce autonomy. Can be costly and time-consuming to implement. Potential tax problems as it might not be considered arms length. Resulting profitability measures (ROI, RI) are partly a function of the managers negotiating skills rather than the operational performance of the business unit.

Negotiated cost approach

Choosing the right transfer price:

Decision to transfer
Is there an outside supplier?

Transfer price
Cost or negotiated price

No

Buy inside

Yes
Is the sellers VC < Outside price?

No

Buy outside

No transfer price

Yes
Is the selling unit operating at full capacity?

No

Buy inside

Low: Variable cost High: Market price

Opportunity cost of selling units lost sales outside > Cost savings of inside purchase Opportunity cost of selling units lost sales outside < Cost savings of inside purchase

Yes

Buy outside

No transfer price

Buy inside

Market price

Sample Problem 1
Espadrille Shoes has two divisions: Production and Marketing. Production produces Espadrille shoes which it sells to both the Marketing division and to outside retailers. Marketing operates several small shoe stores in shopping centers. Marketing sells both Espadrille and other brands. Production is operating far below capacity. Relevant facts for Production are as follows: Sales price to outsiders P2,850 per pair Variable cost to produce P1,800 per pair Fixed costs P10 million per month Marketing is also operating far below capacity. The following data pertain to the shoes of Espadrille shoes by Marketing: Sales price P4,000 per pair Variable marketing costs P100 per pair The companys variable manufacturing and marketing costs are differential to this decision, while fixed manufacturing and marketing costs are not.

Sample Problem 1
Required: 1. What is the minimum price that can be charged by the Marketing Division for the shoes and still cover the companys differential manufacturing and marketing costs? 2. What is the appropriate transfer price for this decision? 3. If the transfer price is set at P2,850, what effect will this have on the minimum price set by the Marketing manager? 4. How would your answer to Requirement 2 change if the Production Division was operating at full capacity?

Sample Problem 2
Assume the information as shown with respect to Imperial Beverages and Pizza Maven (both companies are owned by Harris and Louder). Imperial Beverages Ginger beer production capacity per month Variable cost per barrel of ginger beer Fixed costs per month Outside Selling price of Imperial ginger beer

10,000 barrels P 800 per barrel P 70,000 P 2,000 per barrel

Pizza Maven Monthly consumption of ginger beer Selling price Fixed costs per month

2,000 barrels P 2,500 per barrel P 10,000

Sample Problem 2
Requirements:
1. Suppose that Imperial Beverages is currently selling 7,000 barrels to outside customers, and that the purchase price of a regular brand of ginger beer outside costs P1,800, calculate the highest and lowest acceptable transfer price. 2. Suppose that Imperial Beverages is currently selling 10,000 barrels to outside customers, and that there is no other supplier other than Pizza Maven, calculate the highest and lowest acceptable transfer price. 3. Suppose that Imperial Beverages is currently selling 9,000 barrels to outside customers, and that purchase price of a regular brand of ginger beer outside costs P1,800, calculate the highest and lowest acceptable transfer price. 4. Suppose that Imperial Beverages is currently selling 10,000 barrels to outside customers, and that purchase price of a regular brand of ginger beer outside costs P1,800, calculate the highest and lowest acceptable transfer price.

International/Multinational Transfer Pricing

Objectives:
Less taxes, duties, and tariffs. Less foreign exchange risk. Better competitive position. Better governmental relations.

Features of international or multinational transfer pricing:

Guidelines must be developed that are followed on a consistent basis. Transfer prices should be set that reflect an arms length transaction. Firms must be prepared to undergo transfer pricing audits. Firms may consider Advanced Pricing Agreements binding contracts between a company and taxing authorities that set an acceptable transfer pricing methodology.

Sample Problem 3 (International or Multinational Transfer Pricing)

La Plue Corporation is US Company which has operations in Maldives. Product V is manufactured in the US where the tax rate is 35% and sold in Maldives for P1,500 per unit where tax rate is 45%. 10,000 units of Product V are transferred monthly from the US to Maldives. Assume that the US and Maldives divisions variable costs per unit are P200 and P150 (excluding the transfer price), respectively. Further assume that the US and Maldives divisions incur P1,000,000 and P5,000,000 of monthly fixed costs respectively. The Maldives division determined that transfer price should be P500 per unit. However, the US division begged to differ and insisted that the transfer price should be P800 per unit. Because both divisions could not reach a decision, management is called on to set an arbitrary transfer price. How should the manager set the transfer price?

Pricing Internal Services

Service departments in a company do not directly engage in operating activities. Instead, they provide support to operating departments. This service must be quantified to know whether the service department is efficient in carry out its task to support the company. The service department charges can be viewed as a transfer price that is charged for services provided by service departments to operating departments Whenever possible, variable and fixed service department costs should be charged separately.

Charging Service Costs by Behavior:

Variable service department costs should be charged to consuming departments according to whatever activity causes the incurrence of the cost. Fixed service department costs should be charged to consuming departments in predetermined lump-sum amounts that are based on the consuming departments peak-period or long-run average servicing needs.
Based on amounts of capacity each consuming department requires. Should not vary from period to period.

Budgeted, not actual variable and fixed service department costs should be charged to operating departments using a predetermined rate applied to actual services consumed.
Variable costs at the beginning of the year shall be allocated using planned hours. (Assumption, if problem is silent) Variable costs at the end of the year shall be allocated using actual hours.

Reasons for charging service department costs:

To encourage operating departments to wisely use service department resources. To provide operating departments with more complete cost data for making decisions. To help measure the profitability of operating departments. To create an incentive for service departments to operate efficiently.

Sample Problem 4 (Pricing Internal Services)

XYZ Inc. has a maintenance department and two operating departments: cutting and assembly. Variable maintenance costs are budgeted at P0.60 per machine hour. Fixed maintenance costs are budgeted at P200,000 per year. Data relating to the current year are:
Operating Departments Cutting Assembly Total Hours Percent of Peak-Period 60% 40% 100% Hours Planned 75,000 50,000 125,000 Hours Used 80,000 40,000 120,000

Requirement: Allocate maintenance costs to the two operating departments assuming: 1. Allocation is done at the beginning of the year (Assumption, if problem is silent). 2. Allocation is done at the end of the year.