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Chapter 15 - Transfer Pricing

Chapter 15
Transfer Pricing
Learning Objectives
1. Explain the basic issues associated ith transfer pricing.
!. Explain the general transfer pricing rules and understand the underl"ing basis for the#.
$. %dentif" the behavioral issues and incentive effects of negotiated transfer prices& cost-
based transfer prices& and #ar'et-based transfer prices.
(. Explain the econo#ic conse)uences of #ultinational transfer prices.
5. *escribe the role of transfer prices in seg#ent reporting.
Chapter Outline
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%%. *ETE/4%0%02 T,E OPT%4-L T/-0.1E/ P/%CE
-. The setting
6. *eter#ining hether a transfer price is opti#al
1. Case 17 - perfect inter#ediate #ar'et for +ood
!. Case !7 0o inter#ediate #ar'et
%%%. OPT%4-L T/-0.1E/ P/%CE7 - 2E0E/-L P/%0C%PLE
8 Other #ar'et conditions
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9%%. CE0T/-LL3 E.T-6L%.,E* T/-0.1E/ P/%C%02 POL%C%E.
-. Establishing a #ar'et price polic"
6. Establishing a cost-basis polic"
C. -lternative cost #easures
1. 1ull absorption cost-based transfers
!. Cost-plus transfers
$. .tandard costs or actual costs
*. /e#ed"ing #otivational proble#s of transfer pricing policies
< *ual transfer prices
9%%%. 0E2OT%-T%02 T,E T/-0.1E/ P/%CE
%=. %4PE/1ECT 4-/>ET.
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Chapter 15 - Transfer Pricing
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>e" Concepts
LO 15-1 Explain the basic issues associated with transfer pricing.
8 *ecentraliAation in the fir# is often beneficial because it loers infor#ation costs associated
ith atte#pting to #a'e decisions centrall" and because the organiAation benefits fro# using
#anagers; local 'noledge.
< /ecall that decentraliAation is the delegation of decision-#a'ing authorit" to
subordinates.
< -long ith the benefits of decentraliAation co#e the costs of d"sfunctional decision
#a'ing that occur hen local #anagers& #a'ing decisions based on local interests& #a'e
choices that are subopti#al for the organiAation as a hole.
< - co##on d"sfunctional behavior arises hen business units EdivisionsF ithin the
organiAation bu" goods and services fro# one another and hen each is treated as a
profit center Ei.e.& hen each unit #anager is evaluated on reported unit profitF.
< The accounting s"ste#s in the to divisions record the transaction as if it ere an
ordinar" sale EpurchaseF to Efro#F an external custo#er EsupplierF.
< Transfer price is the value assigned to the goods or services sold or rented EtransferredF
fro# one unit of an organiAation to another. Transfer price is the price at hich the
transaction beteen the divisions is recorded.
< 6ecause the exchange ta'es place ithin the organiAation& the fir# has considerable
discretion in setting the transfer price.
< Transfer prices are idel" used for decision #a'ing& product costing& and perfor#ance
evaluation. %t is i#portant to consider alternative transfer pricing #ethods and their
advantages and disadvantages.
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Chapter 15 - Transfer Pricing
< The profit on the sale that accrues to the selling division is the transfer price less the
cost of goods sold.
< The profit that ill accrue to the bu"ing division hen the ite# is sold to an external
custo#er is the revenue fro# the external sale less the transfer price and an" additional
cost incurred b" the bu"ing division to co#plete the product.
< 1ro# the corporation;s viepoint& the total profit associated ith the ite# being
transferred is si#pl" the price paid b" the external custo#er less the costs incurred b" the
selling division and the additional cost incurred b" the bu"ing division before the ite# is
sold.
< The transfer price is not a factor in the calculation of total profit for the fir# and&
therefore& does not affect corporate profit if the transaction occurs.
< The folloing diagra# illustrates the relation beteen a selling division and a bu"ing
division ithin the sa#e organiAation hen goods or services are exchanged internall".
The total profit calculation does not involve the transfer price usedG the selling division;s
revenue fro# the transfer is cancelled out b" the bu"ing division;s cost for the
transaction.
.elling *ivision
2oods or services
6u"ing *ivision
Transfer price
Transfer price Price paid b" external custo#er
- Cost of goods sold - Transfer price
- -dditional costs
H .elling *ivision;s profit H 6u"ing *ivision;s profit
.elling *ivision;s /O% or E9- 6u"ing *ivision;s /O% or E9-
Total profit H .elling *ivision;s profit I 6u"ing *ivision;s profit
H Price paid b" the external custo#er C Cost of goods sold E.elling *ivisionF
C -dditional costs E6u"ing *ivisionF.
< +hat #a'es the transfer price i#portant is that it affects the division #anagers;
decision about hether to engage in the transaction.
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Chapter 15 - Transfer Pricing
< 6ecause the #anagers of both the selling division and bu"ing division are evaluated on
division profit& the" consider the effect of all sales& not just sales to custo#ers outside the
co#pan"& on their division& not co#pan" profit.
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Chapter 15 - Transfer Pricing
< The definition of the transfer price can affect corporate profitabilit".
<The opti#al transfer price is the price that leads both division #anagers& each acting in
his or her on self-interest& to #a'e decisions that are in the fir#;s interest.
< %f a transaction ould increase fir# profits& it #ust be profitable for both divisions&
given the transfer price& to #a'e the transaction& or the selected transfer price cannot be
the opti#al price.
< %f a transaction is not profitable for the corporation& the transfer price& to be opti#al&
#ust #a'e the sale unprofitable for at least one of the to transacting divisions.
< %f business unit profitabilit" is used to #easure perfor#ance& b" return on invest#ent
E/O%F or econo#ic value added EE9-F& the transfer price ill affect the evaluation of
the unit and the unit #anager.
< The higher the transfer price is& the loer ill be the profit Eand /O% or E9-F in the
bu"ing division and the higher the profit ill be in the selling division& all other things
being e)ual. /efer to the previous diagra# for infor#ation.
Exa#ple 17 %t costs the selling division J!@ to produce one unit of a co#ponent hich&
if transferred to the bu"ing division& re)uires additional or' costing J(5 and can be
sold to outside custo#ers for J1@@ per unit of the finished product. -ssu#e that the
transfer price in )uestion is TP. Then
.elling division;s profit E.F H TP - J!@.
6u"ing division;s profit E6F H J1@@ C TP - J(5.
Total profit for the fir# H ETP - J!@F I EJ1@@ C TP - J(5F H J$5.
%f TP H J!@& then . H J@ and 6 H J$5. The selling division gets nothing hile the
bu"ing division reaps all the profit.
%f TP H J55& then . H J$5 and 6 H J@. The situation is reversed.
%f TP is set so#ehere beteen J!@ and J55& both divisions Eand the co#pan"F ill
benefit fro# the transfer hile sharing the profit of J$5. 1or exa#ple& if TP H J(@& then
. H J!@ and 6 H J15. The issue no is ho to deter#ine the transfer price acceptable
b" both divisions.

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Chapter 15 - Transfer Pricing
LO 15-2 Explain the general transfer pricing rules and understand the
underlying basis for them.
8 The transfer price is a device to #otivate #anagers to act in the best interests of the co#pan".
< >eeping separate accounting records and using transfer prices to record exchanges
a#ong divisions allo fir#s to delegate decisions to local #anagers hile holding the#
responsible for divisional perfor#ance.
< There #a" be an intermediate market for the 'ind of outputs delivered b" the selling
division. The bu"ing division #a" also purchase these ite#s fro# the inter#ediate
#ar'et& but it sells its products in the final #ar'et& as shon in Exhibit 15.!.
.elling *ivision
2oods or services
6u"ing *ivision
1inal 4ar'et
Transfer price
%nter#ediate
4ar'et
< There is a si#ple test& an application of the differential profitabilit" anal"sis discussed
in Chapter (& to deter#ine hether the calculated transfer price is opti#al.
E1F 2iven the #ar'et prices and the costs in the fir#& does the transfer increase fir#
profit5
E!F 2iven the transfer price& the inter#ediate #ar'et prices& and the divisional costs& does
the transfer increase the selling division profit5
E$F 2iven the transfer price& the final #ar'et prices& and the divisional costs& does the
transfer increase the bu"ing division profit5
< %f the anser to the first )uestion is K"es&L the ansers to )uestions ! and $ #ust also be
K"esL or the transfer price is not opti#al. %f the anser to the first )uestion is Kno&L the
anser to either )uestion ! or $ Eor bothF #ust be KnoL or the transfer price is not
opti#al.
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Chapter 15 - Transfer Pricing
Exa#ple ! E/evised fro# Exa#ple 1F7 %t costs the selling division JM@ to produce one
unit of a co#ponent hich& if transferred to the bu"ing division& re)uires additional
or' costing J(5 and can be sold to outside custo#ers for J1@@ per unit of the finished
product. -ssu#e that the transfer price in )uestion is TP. Then
.elling division;s profit E.F H TP - JM@.
6u"ing division;s profit E6F H J1@@ C TP - J(5.
Total profit for the fir# H ETP - JM@F I EJ1@@ C TP - J(5F H -J5.
+hatever the transfer price is& the fir# ill suffer a loss of J5 per unit. The internal
transfer is better called off since the anser to the first )uestion above is Kno.L

< %n deter#ining the opti#al transfer price& the i#portant issue is the nature of the
inter#ediate #ar'et here the goods are being transferred. To cases are considered7
E1F - perfect inter#ediate #ar'et& and
E!F 0o inter#ediate #ar'et.
8 - #ar'et is perfect if bu"ers can bu" and sellers can sell an" )uantit" ithout affecting the
price.
< The product being sold in a perfect #ar'et is not differentiated b" )ualit"& service& or
other characteristics.
< The parties in a perfect #ar'et are Kprice ta'ers.L
< The opti#al transfer price in a perfect inter#ediate #ar'et is the Einter#ediateF #ar'et
price.
< -t an" price loer than the inter#ediate #ar'et price& the selling division ill suppl"
no output to the bu"ing division. -t an" higher price& the bu"ing division ill not
purchase an" output fro# the selling division.
< 2iven the opti#al transfer price& the to division #anagers acting independentl" ill
#a'e the transfer that the corporate staff ould set if it had all the infor#ation that the
division #anagers have.
< +ith an efficient transfer pricing s"ste# li'e this& hen external #ar'ets Eboth
inter#ediate and finalF change& there is no need to change the transfer price polic".
8 %f there is no inter#ediate #ar'et for the goods being transferred& or the co#pan" has decided
that it ill not allo the divisions to bu" or sell the ite#s externall"& then the onl" outlet for the
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Chapter 15 - Transfer Pricing
selling division is the bu"ing division& and the onl" source of suppl" for the bu"ing division is
the selling division.
< -t an" transfer price belo the variable cost in the selling division& no transfers ill
ta'e place because the selling division ill lose #one" on each unit sold.
< -t an" transfer price above the final #ar'et price less the EotherF variable cost of the
bu"ing division& no transfers ill ta'e place.
< To be the opti#al transfer price in general& it cannot depend on the current external
price.
< %n this case& the onl" price that ill or'& for all possible external #ar'et prices& is the
variable cost of the selling division& assu#ing it is not operating at capacit".
< The fixed costs of the selling division ill be incurred Ei.e.& unavoidableF regardless of
hether the transfer is #ade& and is irrelevant for the decision.
Exa#ple $ E/evised fro# Exa#ple 1F7 %t costs the selling division J!@ Evariable cost
onl"F to produce one unit of a co#ponent hich& if transferred to the bu"ing division&
re)uires additional or' costing J(5 and can be sold to outside custo#ers for J1@@ per
unit of the finished product. There is no inter#ediate #ar'et for the co#ponent in
)uestion.
The selling division;s fixed cost is not a factor because it is unavoidable Etherefore not
differentialF. The selling division ill not accept a transfer price belo J!@& the
variable cost per unit.
2iven the final #ar'et price of J1@@ and the additional cost of J(5 to #a'e the
co#ponent salable& the bu"ing division ill not pa" #ore than J55 for the part.
%f the final #ar'et price drops to JM5 EH selling division;s variable cost of J!@ I bu"ing
division;s additional cost of J(5F or loer& no internal transfer should ta'e place as the
fir# ill suffer a loss.
+ith a final #ar'et price of JM5 or #ore& the internal transfer benefits the fir#. The
opti#al transfer price should be set at the variable cost of the selling division to ensure
stead" exchanges beteen the to divisions.

8 The transfer price that is opti#al represents the value of the goods being transferred to the
bu"ing division at the transfer point.
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Chapter 15 - Transfer Pricing
< - general principle on setting the transfer price that leads #anagers to #a'e decisions
in the fir#;s best interests is7
Transfer
price
H Outla"
cost
a
I Opportunit" cost of the resource
at the point of transfer.
b
a
The incre#ental cost to produce the good being transferred and bring it to the point of
transfer.
b
The opportunit" cost of choosing to transfer internall" and not sell it on the outside
Einter#ediateF #ar'et.
< %n the case of a perfect inter#ediate #ar'et& the value to the bu"ing division is e)ual to
hat it can be sold for in the inter#ediate #ar'et Ei.e.& inter#ediate #ar'et priceF.
< %f there is no inter#ediate #ar'et& there is no opportunit" cost and the onl" cost is the
variable& or outla" cost. The transfer price should be set accordingl".
< %f the selling division is operating at capacit" and there is a #ar'et for the goods being
transferred& the #ar'et price of the goods should be used.
< %f the selling division is operating at capacit" and there is no inter#ediate #ar'et& then
the opportunit" cost depends on the cost of adding capacit".
< %f the inter#ediate #ar'et is i#perfect& the opti#al transfer price is still the outla" cost
plus the opportunit" cost. ,oever& in this case the opportunit" cost is less than the
current inter#ediate #ar'et price less the outla" cost.
8 The general principle can be easil" applied ith the folloing to general rules hen
establishing a transfer price.
E1F %f an inter#ediate #ar'et exists& the opti#al transfer price is the #ar'et price.
E!F %f no inter#ediate #ar'et exists& the opti#al transfer price should be the outla" cost
for producing the goods Egenerall"& the variable costsF.
< This transfer price ensures that if the #anagers #a'e the correct decision for their
divisions& the result Etransfer or no transferF ill also be the correct decision for the fir#.
HHHHHHHHHHHHHHHHHHHHHH
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Chapter 15 - Transfer Pricing
*e#onstration Proble# 1
- #anufacturing co#pan" has to divisions7 4otor and Pu#p. The 4otor *ivision produces an
inter#ediate good& #otors& that can be used as an input for the Pu#p *ivision. The 4otor
*ivision also sells the #otors in the open #ar'et. The Pu#p *ivision secures the #otors fro#
either the 4otor *ivision or an outside supplier and asse#bles the parts together to #a'e ater
pu#ps hich are sold to the consu#ers. The Pu#p *ivision needs an average of 1@&@@@ #otors
ever" "ear. The folloing infor#ation is available.
otor
!i"ision
#ump
!i"ision
.elling price J!@ .elling price JO@
9ariable cost 1! 9ariable cost Eother than the #otorF $@
Contribution #argin JO
9ariable cost of the #otor
Epurchased fro# an outside supplierF 1P
Contribution #argin J$1
/e)uired7
*iscuss the possible transfer prices under each of the folloing independent situations.
1. The 4otor *ivision sells all it can produce EO@&@@@ #otorsF to the outside custo#ers.
!. The 4otor *ivision can produce O@&@@@ #otors but sells onl" M5&@@@ #otors to the
outsider custo#ers.
$. The Pu#p *ivision re)uires a custo#iAed version of the #otors that onl" the 4otor
*ivision can suppl". The variable cost for the 4otor *ivision ould be J!! per #otor.
The 4otor *ivision is running at capacit".
(. The Pu#p *ivision re)uires a custo#iAed version of the #otors that onl" the 4otor
*ivision can suppl". The variable cost for the 4otor *ivision ould be J!! per #otor.
The 4otor *ivision has the excess capacit" to handle the Pu#p *ivision;s de#and.
.olution7
1. .ince the 4otor *ivision is operating at capacit"& the onl" transfer price that is
acceptable is the inter#ediate #ar'et price of J!@& hich is the su# of the outla" cost
EJ1!F and the opportunit" cost at the point of transfer EJO& the contribution #argin lost
due to internal transferF. The Pu#p *ivision& on the other hand& gets its #otors fro# an
outsider supplier for J1P per unit and is not li'el" to give up the source. There ill be no
transfers beteen the 4otor *ivision and the Pu#p *ivision.
!. .ince the 4otor *ivision has excess capacit"& it ill accept a price that at least covers the
variable cost of J1! per #otor. There is no opportunit" cost in this situation. The Pu#p
*ivision currentl" pa"s J1P per #otor fro# an outsider supplier. .o a transfer price
beteen J1! and J1P ill benefit both divisions.
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Chapter 15 - Transfer Pricing
$. .ince the 4otor *ivision is operating at capacit"& it ill not accept an" price less than
J$@& hich is the su# of the outla" cost EJ!!F and the opportunit" cost at the point of
transfer EJO& the contribution #argin lost due to internal transferF. The Pu#p *ivision
ill have to pa" at least J$@ each as this is the onl" source for the custo#iAed #otors.
(. .ince the 4otor *ivision has excess capacit"& it ill accept a price that at least covers the
variable cost of J!! per #otor. There is no opportunit" cost in this situation. The Pu#p
*ivision #a" even pa" a nor#al #ar'up just to secure these pu#ps.
HHHHHHHHHHHHHHHHHHHHHH
LO 15-$ %dentify the beha"ioral issues and incenti"e effects of negotiated
transfer prices& cost-based transfer prices& and mar'et-based
transfer prices.
8 - conflict can occur beteen a co#pan";s interests and the divisional #anager;s interests
hen transfer price-based perfor#ance #easures are used.
< The general transfer pricing rules are eas" to state but difficult to appl" in practice.
< There are three general approaches to this t"pe of proble# in a decentraliAed
organiAation7
E1F *irect intervention b" top #anage#ent&
E!F Centrall" established transfer price policies& and
E$F 0egotiated transfer prices.
8 %f the transfer is an extraordinaril" large order& or if internal transfers are rare& direct
intervention could be the best solution to the proble#.
< The disadvantages of direct intervention are that
E1F top #anage#ent #a" beco#e sa#ped ith pricing disputes& and
E!F individual division #anagers ill lose the flexibilit" and other advantages of
autono#ous decision #a'ing& the benefits fro# decentraliAation.
< -s long as transfer pricing proble#s are infre)uent& the benefits of direct intervention
could outeigh the costs.
8 - transfer pricing polic" should allo divisional autono#" "et encourage #anagers to pursue
corporate goals consistent ith their division goals. The polic" should also consider the
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Chapter 15 - Transfer Pricing
perfor#ance evaluation s"ste# used and the i#pact that alternative transfer prices ill have on
#anagerial perfor#ance evaluation.
< Corporate #anagers have to econo#ic bases on hich to establish transfer price
policies7 #ar'et prices and cost.
< ar'et price-based transfer pricing is a transfer pricing polic" that sets the transfer
price at the #ar'et price or at a s#all discount fro# the #ar'et price.
< To general guidelines for #ar'et price-based transfer pricing are7
E1F The transfer price is usuall" set at a discount fro# the cost to ac)uire the ite# on the
open #ar'et.
E!F The selling division #a" elect to transfer or to continue to sell to the outside.
< Externall" based #ar'et prices are generall" considered the best basis for transfer
pricing hen a co#petitive #ar'et exists for the product and hen #ar'et prices are
readil" available.
< Bsuall"& there are differences beteen products produced internall" and those that can
be purchased fro# outsiders& such as costs& )ualit"& or product characteristics.
< -n advantage of #ar'et prices is that both the bu"ing and selling divisions are
indifferent as to trading ith each other or ith outsiders& as long as the selling division
is not operating at capacit".
< +hen such advantages exist& it is in the co#pan";s interest to create incentives for
internal transfer.
< - cost-based transfer pricing polic" should adhere to the folloing rule7
Transfer at the differential outla" cost to the selling division Et"picall" variable costsF
plus the foregone contribution to the co#pan" of #a'ing the internal transfers EJ@ if the
seller has idle capacit"G selling price #inus the variable costs if the seller is operating at
capacit"F.
8 The transfer pricing rule can be i#ple#ented as follos7
E1F - seller operating belo capacit" should transfer at the differential cost of production
Evariable costF.
E!F - seller operating at capacit" should transfer at the #ar'et price.
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Chapter 15 - Transfer Pricing
< The general rule is opti#al for the co#pan"& but it does not benefit the selling division
for an internal transfer in the belo-capacit" case.
< +hen a #easure of differential or variable cost& or #ar'et price is not available&
co#panies usuall" use full absorption costs as the transfer price.
<1ull-absorption costs are higher than variable costs& but probabl" less than the #ar'et
price.
< The use of full absorption costs does not necessaril" lead to the profit-#axi#iAing
solution for the co#pan".
< 1ull absorption cost has so#e advantages7
E1F These costs are available in the co#pan";s records.
E!F The" provide the selling division ith a contribution e)ual to the excess of full
absorption costs over the variable costs& hich gives the selling division an incentive
to transfer internall".
E$F The full absorption cost can so#eti#es be a better #easure of the differential costs of
transferring internall" than the variable costs.
< (ost-plus transfer pricing is a transfer pricing polic" based on a #easure of cost Efull
costing or variable costing& actual or standard costF plus an alloance for profit.
< %f actual costs are used as a basis for the transfer& an" variances or inefficiencies in the
selling division are passed to the bu"ing division.
< To pro#ote responsibilit" in the selling division and to isolate variance ithin
divisions& standard costs are generall" used as a basis for transfer pricing in cost-based
s"ste#s.
8 +hen the transfer pricing polic" does not give the selling division a profit on the transfer7
E1F - selling division hose transfers are al#ost all internal is usuall" organiAed as a cost center.
E!F - selling division that does business ith both internal and external custo#ers #a" be set up
as a profit center for external business hen the #anager has price-setting poer and as a
cost center for internal transfers hen the #anager does not have such poer.
8 !ual transfer pricing is a transfer pricing s"ste# that charges the bu"ing division ith costs
onl" and credits the selling division ith cost plus so#e profit alloance. The difference could
be accounted for in a specialiAed centraliAed account.
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Chapter 15 - Transfer Pricing
< This s"ste# ould preserve the cost data for subse)uent bu"er divisions and ould
encourage internal transfers b" providing a profit on such transfers for the selling
divisions.
Exa#ple ( E/evised fro# Exa#ple 1F7 %t costs the selling division J!@ to produce one
unit of a co#ponent hich& if transferred to the bu"ing division& re)uires additional
or' costing J(5 and can be sold to outside custo#ers for J1@@ per unit of the finished
product.
To encourage internal transfers& the co#pan" decides to i#ple#ent a dual transfer
pricing s"ste# in hich the bu"ing division is charged for the J!@ cost hile the
selling division is credited ith a J$ profit alloance. On a per-unit basis&
.elling division;s profit E.F H EJ!@ I J$F - J!@ H J$.
6u"ing division;s profit E6F H J1@@ - J!@ - J(5 H J$5.
Total profit for the fir# H J1@@ - J!@ - J(5 H J$5 Q J$ I J$5.
The su# of the to divisions; profits EJ$OF is not e)ual to the fir#;s total profit EJ$5F.
The journal entries recorded b" the to divisions tell the stor".
)elling di"ision*
-R/ C 6u"ing division !@
%nterco#pan" sales in excess of assigned costs $
%nterco#pan" sales !$
%nterco#pan" cost of goods sold !@
1inished goods !@
+uying di"ision*
%nventor" !@
-RP C .elling division !@

< *isadvantages of dual price s"ste# are7
E1F %t reduces the value of the transfer price as a signal to division #anagers of the value
of the inter#ediate goods to the fir#& and
E!F %t also tends to re#ove so#e of the perfor#ance evaluation value because both
#anagers benefit and the difference in the central account is ignored.
8 ,egotiated transfer pricing is a s"ste# that arrives at the transfer prices through negotiation
beteen #anagers of bu"ing and selling divisions.
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hole or part.
Chapter 15 - Transfer Pricing
< The #anagers involved in negotiation should act in #uch the sa#e a" as the #anagers
of independent fir#s.
< The negotiated prices are generall" beteen the #ar'et price at the upper li#it and
so#e #easure of cost at the loer li#it.
< The #ajor advantage to negotiated transfer pricing is that it preserves the autono#" of
the division #anagers.
< To disadvantages of negotiated transfer pricing are7
E1F - great deal of #anage#ent effort #a" be consu#ed in the negotiating process& and
E!F The final price and its i#plications for perfor#ance #easure#ent could depend #ore
on the #anager;s abilit" to negotiate than on hat is best for the co#pan".
HHHHHHHHHHHHHHHHHHHHHH
*e#onstration Proble# !
E/evised fro# *e#onstration Proble# 1F
- #anufacturing co#pan" has to divisions7 4otor and Pu#p. The 4otor *ivision produces an
inter#ediate good& #otors& that can be used as an input for the Pu#p *ivision. The Pu#p
*ivision asse#bles the parts together to #a'e ater pu#ps hich are sold to the consu#ers. The
Pu#p *ivision needs an average of 1@&@@@ #otors ever" "ear. The folloing infor#ation is
available.
otor
!i"ision
#ump
!i"ision
.elling price 5 JO@
9ariable #anufacturing cost 1! $@
Transferred-in cost 5
9ariable overhead ! 15
1ixed overhead $ P
/e)uired7
Calculate divisional operating inco#e and total operating inco#e given the folloing
independent transfer pricing policies.
1. 4ar'et-based transfer price of J!@ per #otor.
!. Cost-based transfer price at 1@5S of the full absorption cost per #otor.
$. 0egotiated transfer price of J1O.5 per #otor.
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Chapter 15 - Transfer Pricing
(. The 4otor *ivision receives the transfer price at 1@5S of the full absorptionG the Pu#p
*ivision pa"s onl" the variable #anufacturing cost.
.olution7
1.
!.
otor
!i"ision
#ump
!i"ision
/evenues
a
J1NO&5@@ JO@@&@@@
Costs7
9ariable #anufacturing cost 1!@&@@@ $@@&@@@
Transferred-in cost 1NO&5@@
9ariable overhead !@&@@@ 15@&@@@
1ixed overhead $@&@@@ P@&@@@
*ivisional operating inco#e JO&5@@ JO1&5@@
Total operating inco#e JP@&@@@
a
1ull absorption cost H J1! I J! I J$ H J1N.
Transfer price H J1N T 1@5S T 1@&@@@ units H J1NO&5@@.
15-1M
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hole or part.
otor
!i"ision
#ump
!i"ision
/evenues J!@@&@@@ JO@@&@@@
Costs7
9ariable #anufacturing cost 1!@&@@@ $@@&@@@
Transferred-in cost !@@&@@@
9ariable overhead !@&@@@ 15@&@@@
1ixed overhead $@&@@@ P@&@@@
*ivisional operating inco#e J$@&@@@ JM@&@@@
Total operating inco#e JP@&@@@
Chapter 15 - Transfer Pricing
$.
otor
!i"ision
#ump
!i"ision
/evenues J1O5&5@@ JO@@&@@@
Costs7
9ariable #anufacturing cost 1!@&@@@ $@@&@@@
Transferred-in cost 1O5&5@@
9ariable overhead !@&@@@ 15@&@@@
1ixed overhead $@&@@@ P@&@@@
*ivisional operating inco#e J15&5@@ JN(&5@@
Total operating inco#e JP@&@@@
(.
otor
!i"ision
#ump
!i"ision
/evenues J1NO&5@@ JO@@&@@@
Costs7
9ariable #anufacturing cost 1!@&@@@ $@@&@@@
Transferred-in cost 1!@&@@@
9ariable overhead !@&@@@ 15@&@@@
1ixed overhead $@&@@@ P@&@@@
*ivisional operating inco#e JO&5@@ J1(@&@@@
Total operating inco#e JP@&@@@
a
a
%ntraco#pan" sales in excess of assigned cost H J1NO&5@@ - J1!@&@@@ H J5O&5@@.
JO&5@@ I J1(@&@@@ C J5O&5@@ H JP@&@@@.
HHHHHHHHHHHHHHHHHHHHHH
8 4anage#ent tends to settle for a transfer pricing s"ste# that see#s to or' reasonabl" ell
hen both the costs and benefits of the s"ste# are considered.
< %n Exhibit 15.5& surve" data shoed that nearl" 5@ percent of the B... co#panies used a
cost-based transfer pricing s"ste#& $$ percent used a #ar'et price-based s"ste#& and !!
percent used a negotiated s"ste#.
< 0o transfer pricing polic" applied in practice is li'el" to do#inate all others.
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hole or part.
Chapter 15 - Transfer Pricing
LO 15-- Explain the economic conse.uences of multinational transfer
prices.
8 %n international Eor interstateF transactions& transfer prices #a" affect tax liabilities& ro"alties&
and other pa"#ents because of different las in different countries Eor states or provincesF.
< 4anage#ent control considerations suggest that the transfer price reflect the value of
the goods or services being transferred.
< Co#panies have incentives to set transfer prices that ill increase revenues Eand profitsF
in lo-tax countries and increase costs Ethereb" reducing profitsF in high-tax countries.
< %nternational taxing authorities loo' closel" at transfer prices hen exa#ining the
returns of co#panies engaged in related-part" transactions that cross national boundaries.
< Co#panies #ust have ade)uate support to justif" the use of the transfer price that the"
have chosen.
HHHHHHHHHHHHHHHHHHHHHH
*e#onstration Proble# $
E/evised fro# *e#onstration Proble# !F
- #anufacturing co#pan" has to divisions7 4otor and Pu#p. The 4otor *ivision is located in
a lo tax countr" ETax rate H !5SF and produces an inter#ediate good& #otors& that can be used
as an input for the Pu#p *ivision. The Pu#p *ivision is located in a high tax countr" ETax rate
H (@SF and asse#bles the parts together to #a'e ater pu#ps hich are sold to the outside
custo#ers. The Pu#p *ivision needs an average of 1@&@@@ #otors ever" "ear. The folloing
infor#ation is available.
otor
!i"ision
#ump
!i"ision
.elling price 5 JO@
9ariable #anufacturing cost 1! $@
Transferred-in cost 5
9ariable overhead ! 15
1ixed overhead $ P
/e)uired7
Calculate divisional operating inco#e and total operating inco#e and discuss tax
i#plications& given the folloing independent transfer pricing policies.
1. 4ar'et-based transfer price of J!@ per #otor.
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hole or part.
Chapter 15 - Transfer Pricing
!. Cost-based transfer price at 1@5S of the full absorption cost per #otor.
$. 0egotiated transfer price of J1O.5 per #otor.
.olution7
ar'et-based
transfer price
/ 021
(ost-based
transfer price
/ 012.35
,egotiated
transfer price
/ 013.5
otor !i"ision
/evenues $200,000 $178,500 $185,500
Costs7
9ariable #anufacturing cost 1!@&@@@ 1!@&@@@ 1!@&@@@
9ariable overhead !@&@@@ !@&@@@ !@&@@@
1ixed overhead $@&@@@ $@&@@@ $@&@@@
*ivisional inco#e before tax J$@&@@@ JO&5@@ J15&5@@
%nco#e tax E!5SF N&5@@ !&1!5 $&ON5
*ivisional inco#e J!!&5@@ JM&$N5 J11&M!5
ar'et-based
transfer price
/ 021
(ost-based
transfer price
/ 012.35
,egotiated
transfer price
/ 013.5
#ump !i"ision
/evenues JO@@&@@@ JO@@&@@@ JO@@&@@@
Costs7
9ariable #anufacturing cost $@@&@@@ $@@&@@@ $@@&@@@
Transferred-in cost 200,000 178,500 185,500
9ariable overhead 15@&@@@ 15@&@@@ 15@&@@@
1ixed overhead P@&@@@ P@&@@@ P@&@@@
*ivisional inco#e before tax JM@&@@@ JO1&5@@ JN(&5@@
%nco#e tax E(@SF !(&@@@ $!&M@@ !P&O@@
*ivisional inco#e J$M&@@@ J(O&P@@ J((&N@@
Total inco#e J5O&5@@ J55&!N5 J5M&$!5
%f the selling division is located in a lo-tax countr" Erelative to the bu"ing divisionF& the
#anage#ent has the incentive to set the transfer price high to increase revenue of the selling
division hile reducing the tax burden of the bu"ing division.
On the other hand& if the selling division is located in a high-tax countr" Erelative to the
bu"ing divisionF& then the #anage#ent ill loer the transfer price to reduce the tax burden
in the selling division hile increasing the profit of the bu"ing division.
HHHHHHHHHHHHHHHHHHHHHH
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Chapter 15 - Transfer Pricing
LO 15-5 !escribe the role of transfer prices in segment reporting.
8 The 1-.6 re)uires co#panies engaged in different lines of business to report certain
infor#ation about seg#ents that #eet 1-.6;s technical re)uire#ents EStatement of Financial
Accounting Standards No.131& K*isclosure about seg#ent of an enterprise and related
infor#ationLF.
< The principal ite#s that #ust be disclosed about each seg#ent include7
E1F .eg#ent revenue& fro# both internal and external custo#ers&
E!F %nterest revenue and expense&
E$F .eg#ent operating profit or loss&
E(F %dentifiable seg#ent assets&
E5F *epreciation and a#ortiAation&
EMF Capital expenditures& and
ENF Certain specialiAed ite#s.
< %n addition& if a co#pan" has significant foreign operations& it #ust disclose revenues&
operating profit or loss& and identifiable assets b" geographical region.
< The financial reporting of internal transactions re)uires that fir#s report seg#ent profits
as co#puted for use b" the chief operating decision #a'er in assessing seg#ent
perfor#ance.
< The transfer pricing #ethod used for perfor#ance evaluation ill be reflected in
reported seg#ent inco#e and can be either cost or #ar'et based.
< -ccounting for external reporting& in rare occasions& recogniAes differences in the a"
fir#s use financial infor#ation for internal decision #a'ing.

4ppendix* (ase 1a #erfect intermediate mar'ets 5 6uality differences
8 The case of perfect inter#ediate #ar'ets is not interesting because there is reall" little
opportunit" for #anagerial discretion.
< - change in the transfer price does not change the total co#pan" operating profit but
does i#pact division perfor#ance.
< -lloing the #anagers to decide here to trade& the co#pan" can increase its profits
because the opti#al transfer price is sending the correct signal for the #anagers to act
accordingl".
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hole or part.
Chapter 15 - Transfer Pricing
Exa#ple 5 E/evised fro# Exa#ple 1F7 %t costs the selling division J!@ to produce one
unit of a co#ponent hich& if transferred to the bu"ing division& re)uires additional
or' costing J(5 and can be sold to outside custo#ers for J1@@ per unit of the finished
product.
The co#ponent in )uestion has to grades& grade % EbetterF and grade %%. -ssu#e that
either grade is suitable for the bu"ing division and that there are perfect #ar'ets for the
to different grades. The inter#ediate #ar'et price for grade % is J5@ and the
inter#ediate #ar'et price for grade %% is J(@ per unit. The selling division specialiAes in
grade % co#ponents.
%f the division #anagers are alloed to choose here to bu" and sell the co#ponents&
the selling division ill sell its outputs on the inter#ediate Egrade %F #ar'et for J5@&
and the bu"ing division ill bu" its co#ponents needed on the inter#ediate Egrade %%F
#ar'et for J(@. 0o transfers ill be #ade since the opti#al transfer price in this case is
J5@& and the co#pan" benefits fro# the #anagers; independent decisions.

4atching
-. Cost-plus transfer pricing
6. *ual transfer pricing
C. 4ar'et price-based transfer pricing
*. 0egotiated transfer pricing
E. Transfer price
UUUUU 1. The value assigned to the goods or services sold or rented EtransferredF fro# one unit
of an organiAation to another.
UUUUU !. - s"ste# that arrives at the transfer prices through negotiation beteen #anagers of
bu"ing and selling divisions.
UUUUU $. - transfer pricing s"ste# that charges the bu"ing division ith costs onl" and credits
the selling division ith cost plus so#e profit alloance.
UUUUU (. - transfer pricing polic" that sets the transfer price at the #ar'et price or at a s#all
discount fro# the #ar'et price.
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Chapter 15 - Transfer Pricing
UUUUU 5. - transfer pricing polic" based on a #easure of cost Efull costing or variable costing&
actual or standard costF plus an alloance for profit.
-nsers
1. E
!. *
$. 6
(. C
5. -
4ultiple Choice

1. Transfer price
a. %s the value assigned to the goods or services sold fro# one unit of an
organiAation to another.
b. /epresents a cost to the selling division.
c. +ill affect the co#pan";s total profits.
d. %s the sa#e as the #ar'et price.
!. - #ar'et is perfect if
a. The bu"ers can bu" at an" )uantit" ithout affecting the price.
b. The sellers can sell at an" )uantit" ithout affecting the price.
c. The parties in the #ar'et are price ta'ers.
d. -ll of the above.
$. +hich of the folloing state#ents is incorrect5
a. %f an inter#ediate #ar'et exists& the opti#al transfer price is the #ar'et price.
b. %f no inter#ediate #ar'et exists& the opti#al transfer price should be the outla" cost for
producing the goods.
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Chapter 15 - Transfer Pricing
c. %f the selling division is operating at capacit" and there is a #ar'et for the goods being
transferred& the variable cost of the goods should be used.
d. %f the selling division is operating at capacit" and there is no inter#ediate #ar'et& then
the opportunit" cost depends on the cost of adding capacit".
(. +hen should the top #anage#ent intervene in setting the transfer price5
a. The transfer is an extraordinaril" large order.
b. %nternal transfers are rare.
c. %nternal transfer benefits the co#pan" but the division #anagers cannot agree on a price.
d. -ll of the above.
5. The selling division sells all it can produce at J1O per unit. The contribution #argin lost
due to internal transfer is JM per unit. +hat is the outla" cost per unit5
a. J!(.
b. J1O.
c. JM.
d. J1!.
The folloing infor#ation is for )uestions M C N.
The selling incurs variable cost of J! per unit. The bu"ing division incurs additional J5 per unit
and sells the final product for J15 per unit.
M. %f there is no inter#ediate #ar'et and the selling division is not operating at capacit"&
hat is the opti#al transfer price5
a. J15.
b. JN.
c. J5.
d. J!.
N. +hat is the co#pan";s profit per unit5
a. J1!.
b. JO.
c. JN.
d. J5.
The folloing infor#ation is for )uestions O C P.
- #anufacturing co#pan" has to divisions7 4otor and Pu#p. The 4otor *ivision produces an
inter#ediate good& a #otor& that can be used as an input for the Pu#p *ivision. The 4otor
*ivision also sells the #otors in the open #ar'et. The Pu#p *ivision asse#bles the parts
together to #a'e ater pu#ps hich are sold to the consu#ers. The Pu#p *ivision needs an
average of 1@&@@@ #otors ever" "ear. - transfer price based on the variable cost is #andated.
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hole or part.
Chapter 15 - Transfer Pricing
otor
!i"ision
#ump
!i"ision
4ar'et selling price J!@ .elling price JO@
9ariable cost 1! 9ariable cost Eother than the #otorF $@
Contribution #argin JO
9ariable cost of the #otor
Epurchased fro# an outside supplierF 1P
Contribution #argin J$1
O. %f the 4otor *ivision has no excess capacit"& hat is the net result of the variable cost-
based transfer pricing polic"5
a. - gain of J! per unit.
b. - loss of J1 per unit.
c. J@.
d. There is not enough infor#ation to go on.
P. %f the 4otor *ivision has available capacit" to handle the Pu#p *ivision;s de#and& hat
is the net result of the variable cost-based transfer pricing polic"5
a. - gain of JN per unit.
b. - gain of J( per unit.
c. - loss of JN per unit.
d. - loss of J! per unit.
1@. .eg#ent reporting
a. %s re)uired b" 1-.6.
b. 4ust disclose seg#ent revenue& interest revenue and expense& seg#ent operating profit or
loss& identifiable seg#ent assets& and so on.
c. -pplies to foreign operations.
d. -ll of the above.
11. +hich of the folloing is suitable to deal ith proble#s as a result of transfer price-
based perfor#ance #easures being adopted5
a. *irect intervention b" top #anage#ent.
b. Centrall" established transfer price polic".
c. 0egotiated transfer prices.
d. -ll of the above.
1!. +hich of the folloing state#ents is incorrect5
a. - transfer pricing polic" should allo divisional autono#".
b. 4ar'et prices& if available& are considered the best basis for transfer pricing.
c. - seller operating at capacit" should transfer at the differential cost of production.
d. 1ull-absorption costs are higher than variable costs.
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hole or part.
Chapter 15 - Transfer Pricing
-nsers
1. a LO1
!. d LO!
$. c LO!
(. d LO$
5. d LO!
J1O - JM H J1!.
M. d LO!
N. b LO!
J15 - J! - J5 H JO.
O. b LO!
The 4otor *ivision losses the contribution #argin of JO per unit hile the Pu#p *ivision
gains JN per unit fro# internal transfer EH J1P - J1!F. The net loss is J1 per unit.
P. a LO!
+ith excess capacit"& the 4otor *ivision does not suffer fro# an" contribution #argin lost
hile the Pu#p *ivision benefits fro# internal transfer b" JN. The net result is a gain of JN
per unit.
1@. d LO5
11. d LO$
1!. c LO$
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