1.

Explain the basic issues associated with transfer

pricing.
2. Explain the general transfer pricing rules and
understand the underlying basis for them.
3. Identify the behavioral issues and incentive effects
of negotiated transfer prices, cost-based transfer
prices, and market-based transfer prices.
4. Explain the economic consequences of
multinational transfer prices.
5. Describe the role of transfer prices in segment
reporting.

Transfer Price the price one subunit

(department or division) charges for a
product or service supplied to another
subunit of the same organization

Management control systems use

transfer prices to coordinate the
actions of subunits and to evaluate
their performance

The product or service transferred

between subunits of an organization

The transfer price creates revenues

for the selling subunit and purchase
costs for the buying subunit - affecting each subunits operating
income

Transfer
Theprice
value assigned to the goods or
services sold or rented (transferred) from
oen unit of an organization to another.
Treated the same as a sale to
an outside customer
Revenue to
the selling
unit

Cost to the
buying unit

Price that leads both division managers,

who act in their own self-interest, to make
the best decisions for the firm.
Managers are evaluated
on performance and both
division managers want to
maximize revenues and
minimize costs.

Promote goal congruence

Make performance evaluation
among segments more comparable
Transform a cost center into a
profit center
For better internal reporting

Maximum - no greater than the

lowest market price

Minimum - no less than the sum of

selling segments incremental costs, and
the opportunity cost of the facilities used

Managers should understand how to

compute and evaluate the transfer
price

Paperhaus, Inc.
Wood Division
Trees

Paper Division

Wood for
manufacturing paper

Paper

Example 1: It costs the selling division $20 to

produce one unit of a part which, if transferred to
the buying division, requires additional work
costing $45 and can be sold to outside customers
for $100 per unit of the finished product. Assume
that the transfer price in question is TP. Then
Selling divisions profit (S) = TP - $20.
Buying divisions profit (B) = $100 TP - $45.

Total profit for the firm = (TP - $20) + ($100 TP $45) = $35.

If TP = $20, then S = $0 and B = $35.

The selling division gets nothing while the
buying division reaps all the profit.
If TP = $55, then S = $35 and B = $0. The
situation is reversed.
If TP is somewhere between $20 and $55,
both divisions benefit while sharing the
profit of $35.

Example 2 (Revised from Example 1): It costs the

selling division $60 to produce one unit of a part
which, if transferred to the buying division, requires
additional work costing $45 and can be sold to outside
customers for $100 per unit of the finished product.
Assume that the transfer price in question is TP. Then

Selling divisions profit (S) = TP - $60.

Buying divisions profit (B) = $100 TP - $45.
Total profit for the firm = (TP - $60) + ($100 TP $45) = -$5.
Whatever the transfer price is, the firm will suffer a loss
of $5 per unit. The internal transfer is off.

Cost Production Data

Wood
Division
Average units produced
Average units sold
Variable manufacturing cost per unit
Variable finishing cost per unit
Fixed divisional costs (unavoidable)

Paper
Division

100,000
100,000
$

20

$ 2,000,000

$
30
$ 4,000,000

Resource
Flows
Wood Division
(selling division)
Variable cost = $20
Fixed cost = $2,000,000

Market for wood

(intermediate market) Price
=?

Paper Division
(buying division)
Variable cost = $30
Fixed cost = $4,000,000

Market for paper

(final market) Price
=?

Assume the following data for the wood

division

Capacity in units
Selling price to outside
Variable cost per unit
Fixed costs per unit (based on capacity)

100,000
$
$
$

60
20
20

Paper Division is currently purchasing

100,000 units from an outside supplier
for $50, but would like to purchase units
from the Wood Division.

1. Given the market prices and the costs

in the firm, does firm profit increase?
2. Given the transfer price, the
intermediate market prices, and the
divisional costs, does the selling
division profit increase?
3. Given the transfer price, the final
market prices, and the divisional
costs, does the buying division profit
increase?

Transfer
price

Opportunity cost of
Outlay
=
+ the resource at the
cost
point of transfer

A perfect intermediate market: product not

differentiated by quality or service
Optimal transfer price is market
price
Transfer price
higher than
market

Transfer price
lower than
market

Buying
division will
not buy
Selling
division will
not sell

Transfer
price

Variable
Lost
=
+
cost
contribution
margin
VC

CM

Wood Division has

idle capacity

$2
0

Wood Division is
working at capacity

$2
0

+ $40

To restate the goal of each manager:

Each division manager wants to
maximize his contribution margin.

Each manager is indifferent

about the transfer price if the
resulting contribution margin is
zero.

Grade B wood

$50 internal transfer

price
Wood

Sales
$ 50 x 100,000
$ 120 x 100,000
Variable costs
$ 20 x 100,000
$ 50 x 100,000
$ 30 x 100,000
Fixed costs

(transfer)
(transfer)

Paper

$ 5,000,000
$ 12,000,000
$ 2,000,000

(transfer)
(processing)

Operating profit
Total company operating profit

$ 2,000,000

$
$
$

5,000,000
3,000,000
4,000,000

$ 1,000,000

-0-

$ 1,000,000

Grade A wood

$60 internal transfer

price

Transfer price higher

than market
Buying
division will
not buy

Transfer price lower

than market
Selling
division will
not sell

The minimum transfer price in many

situations should be:

Incremental cost is the additional cost of

producing and transferring the product or

service
Opportunity cost is the maximum
contribution margin forgone by the selling
subunit if the product or service is
transferred internally

If an intermediate market exists, the

optimal transfer price is the market
price.

If no intermediate market exists, the

optimal transfer price should be the
cost outlay (or incremental cost) for
the producing the goods (i.e.,
generally, the variable costs)

Cost-based prices

Market-based prices

Negotiated prices

Negotiated
transfer
The
managers of the buying and selling
divisions agree on a price.
Cost-based
Outlay cost to selling division plus forgone
contribution to company projects
Market price-based
Sets the transfer price at the market price
or at a small discount from the market
price

Definition of cost
variable cost vs. absorption cost
actual vs. standard

Standard cost is superior to actual

cost
actual costs vary according to season
actual costs vary according to production

volume
variances are attributed to selling division
standard costs are stable measures of
production costs

Market-Based Transfer Prices

Potential problems when the market

determines transfer price
No exact counterpart in the external

market
Ignores internal cost savings
Market price varies
current depressed price v.s. long-run market price

Different prices, discounts, and credit

terms for different buyers

Negotiated Transfer Prices

Below market purchase price

Above the incremental and
opportunity costs of the selling unit
If negotiation fails
managers can purchase on the

market
arbitration by top management

Dual Pricing

Seller transfers at market or negotiated

price
Buyer records transfer at cost-based
amount
Eliminates need to artificially divide profits
Provides relevant information for decision
making and performance evaluation
Promotes goal congruency
Eases tension between segments

Transfer Pricing System

Permits evaluation of segment

performance
Allows for rational acquisition of
goods and services between
corporate divisions
Is flexible to respond to changes
Encourages and rewards goal
congruence

Service Transfer Prices

Allocate service costs using direct, step, or
algebraic method, or
Sell service costs using transfer price
Transfer price useful when distinct,
measurable benefits are provided
Transfer price useful when services provided
have a specific cause-and-effect
relationship
Transfer price depends on
cost and volume of service
comparable substitutes

Market-based - common, standardized

services that are high-cost, high volume

Negotiated transfer price customized services that are high-cost,

high volume

Cost-based or dual - low-cost, low

volume

Advantages

Encourage involvement between

service departments and their users

Promote cost consciousness and

elimination of waste

Provide information for performance

evaluations - controllable service
department cost

Service Transfer Prices

Disadvantages
Disagreement among unit managers
about transfer price
Implementation requires additional costs
and employee time
Does not work equally well for all
segments
May cause dysfunctional behavior or
cause some services to be under- or
overutilized
Complex tax regulations

Transfer Pricing in
Multinational Settings
Differences in
Tax systems
Customs duties
Freight and insurance costs
Import/export regulations
Foreign-exchange controls

Internal Objectives
Better goal
congruence
Better performance
evaluations
More motivated
managers
Better cash
management

External
Objectives
Less taxes and
tariffs
Less foreign
exchange risks
Better competitive
positions
Better relations
with government