Transfer pricing - Examples

1. Del Norte Paper Company

The problem: John Powell, general manager - International Operations of Del Norte Papers Container Division, is faced with the question of what, if anything, should be done about the reluctance of Frank Duffy, his Italian subsidiary manager, to use linerboard manufactured by a Del Norte Paper Company mill in the United States. The Italian subsidiary, the German subsidiary and 20 outside firms have recently submitted bids to an African firm for a contract involving the manufacture of a large quantity of corrugated boxes. DNP-Italia won the contract with a bid of $400 per ton. The winning bid was based on the premise that the linerboard would be purchased in the European Spot market

In order to more clearly understand the entities involved in the case look at the diagram 1

Del Norte Paper Company

The question to be resolved in the case analysis is what course of action would have been best for the overall corporation. The numerical analysis are shown in the tables 1 and 2, that determine the same result
Diagram 1

African Company 340 to 550

550

(460)

400 (325)

Twenty Outside Firms

DNP Deutschland

DNP Italia

Tables 1
Table 1: Transfer pricing matrix

Transfer price range Maximum price (by DNP Italia) Minimum price (by DNP American mill) Net profit/loss (overall company) $235 represents the linerboard cost per ton of corrugated box sold. The actual cost per ton of linerboard used was $220. Thus the relevant ratio is (235/220)=1,07 $251 represents the internal variable costs for DNP American mill ($190*1,07+$45*1,07)

Available capacity $235 $251 ($16)

Tables 2
Table 2: Make or buy analysis
Spot $400 ($325) DNP Italia KEA $400 ($475) DNP Deutschland Spot KEA $400 $400 ($310) ($460)

European subsidiary: Sales revenue Direct costs DNP American mill Contribution All figures are computed on the basis of one ton of corrugated box output The sales revenue amount for DNP Deutschland is set at $400, as this was the price in the winning bid $475= $385+$90; $385 is the KEA price for corrugated box ($360*1,07); $90 is the conversion cost ($325-$235) $310=$235+$75; $235 is the price in the spot market; $75 is the conversion cost ($460-$385) $134=$385 less direct costs ($203, or $190*1,07) and freight cost ($48, or $45*1,07)

$134 $75 $59 $90

$134 $74

Remarks
As can be seen in these two tables it is unlikely that Frank Duffys decision has cost the firm any lost contribution in this particular instance. The Spot alternative shows $16 more contribution. The interesting discovery is that the German subsidiary would have contributed the most, by buying Spot and selling at the $400 price. This allows the student to raise the question as to why the German subsidiary manager bid is so high. Three possibilities, at least, come to mind here. 1. First the manager is German and, thus, follows the rules. That is to say, the corporation wants KEA-priced and DNP-produced linerboard used and thats exactly what hell do 2. A second possible reason is that the German subsidiary, like the Italian one, is viewed and measured as a profit center. Thus, the manager may simply not wish to show a negative profit contribution on each ton shipped. As can be seen below, both subsidiaries would show a loss if they used KEA-priced linerboard
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Remarks

DNP Italia Sales revenue (per ton) $400 Direct costs, at KEA invoiced prices ($475) Contribution ($75)

DNP Deutschland $400 ($460) ($60)

3. Finally, is the hypothesis that the German manager full well knows what hes doing. He may simply not want this business. He is quite possibly either at or near capacity, or believes that he will be at such a position before the order could be filled.

Remarks
The possibility exists that Powells real concern is that he wanted Duffy to use KEA-priced and DNP-produced linerboard for tax evasion (in Italy) purposes. If the linerboard is invoiced at $385 per ton, as opposed to $235 per ton, $150 per ton of taxable income is, in effect, transferred out of Italy. This is done via the route of having a higher cost-of-goods-sold figure. Thus, while the overall contribution to the corporation may be marginally lower using KEA linerboard, the firms after-tax contribution might be higher. This would be true if Italys marginal tax rate exceeded that in the United States.

2. Burger Rama
The problem: Jane Garton has to evaluate the convenience for the overall company of internal transfer rather than external purchasing As in the Del Norte Paper Company case, its possible to resolve the problem defining the Transfer pricing matrix or using the make or buy analysis As shown in the following tables, the internal transfer generates a net convenience of $1320 Table 1: Transfer pricing matrix
Transfer price range Maximum price (by Cape drive-in) Minimum price (by ice-cream manager) Net profit/loss (overall company) Total profit $3,3 represents the price from outside supplier $2,10 represents the internal variable cost $0,32=$480/1500 represents the differential fixed cost for unit generated by the internal transfer Available capacity $3,3 $2,10 + $0,32 $0,88 $0,88*1500=$1320

Burger Rama
Table 2: Make or buy analysis
Selling unit (ice-cream unit) Revenue: $4*1500=$6000 Variable costs: ($2,10*1500)=($3150) Fixed costs: ($5000) Overall company ($8150) Selling unit (ice-cream unit) Fixed costs: ($4520) Overall company ($9470) Buying unit Costs: ($4*1500)=($6000) 1. Internal transfer

Buying unit 2. External purchasing ($3,3*1500)=($4950)

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3. Mason Corporation
The problem: the president of the company has to evaluate the convenience for the overall company of internal transfer rather than external purchasing As in the Del Norte Paper Company case, its possible to resolve the problem defining the Transfer pricing matrix or using the make or buy analysis We assume that the fixed costs ($60000) are not differential costs generated by the internal transfer, because its not possible to save them in the case of external purchasing In addition, try to resolve the problem assuming that fixed costs are differential elements

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Table 1: transfer pricing matrix

Transfer price range Maximum price (by Pacific) Minimum price (by Southern) Net profit/loss (overall company) Total profit/loss $300 represents the price from outside supplier $285 represents the internal variable cost $330-$285-$12= $33 represents the contribution margin lost if Southern doesn't sell to other customers Question 1 $300 Question 2 $270 Question 3 $300 $285 + ($330$285-$12)=$318 ($18) (18*2000=$36000)

$285 $285 $15 ($15) $15*2000=$30000 ($15*2000=$30000)

The external The internal transfer The external purchasing purchasing is is convenient is convenient convenient
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Table 2: make or buy analysis

1 question Selling unit (Southern unit) Revenue: $330*2000=$660000 Variable costs: ($285*2000)=($570000) Overall company ($570000) Selling unit (Southern unit) Overall company ($600000) It's convenient the internal transfer
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Buying unit (Pacific) 1. Internal transfer Costs: ($330*2000)=($660000)

Buying unit (Pacific) 2. External purchasing ($300*2000)=($600000)

Table 2: make or buy analysis

2 question Selling unit (Southern unit) Revenue: $330*2000=$660000 Variable costs: ($285*2000)=($570000) Overall company ($570000) Selling unit (Southern unit) Overall company ($540000) It's convenient the external purchasing
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Buying unit (Pacific) 1. Internal transfer Costs: ($330*2000)=($660000)

Buying unit (Pacific) 2. External purchasing ($270*2000)=($540000)

Table 2: make or buy analysis

3 question Selling unit (Southern unit) Revenue: $330*2000=$660000 Variable costs: ($285*2000)=($570000) Overall company ($570000) Selling unit (Southern unit) Revenue: $330*2000=$660000 Variable costs: ($285+$12)*2000=($594000) Overall company ($534000) It's convenient the external purchasing Buying unit (Pacific) 2. External purchasing ($300*2000)=($600000) Buying unit (Pacific) 1. Internal transfer Costs: ($330*2000)=($660000)

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