Transfer Pricing

Management Accounting Systems Variance Analysis Cost Accounting Systems Budgeting Systems Transfer Pricing Performance Measurement Systems

Agenda Describe the issue of transfer pricing Transfer price setting Objectives of transfer price Develop the “optimal” transfer pricing rule Takeaway

Transfer Pricing Setting In many organizations, divisions transfer products and services to each other The copying division transfers xeroxed copies to Ross Executive MBA program The copying division reports lots of costs The Executive MBA program reports lots of revenue Can Ross management reward the Executive MBA program for its revenue and penalize the copy center for its costs? No, because the two divisions are interlinked.

Transfer Pricing Definition How to recognize such interconnections among the divisions? Set an “internal” price for xeroxing services The “price” at which the goods or services are exchanged across divisions within an organization is called the “transfer price” The transfer price represents revenue for the selling unit (Copy center) And cost for the buying unit (Executive MBA program)

Transfer Prices Objective Why does the transfer price matter? For a given transfer price, the effect on firm profits is zero (The cost to the buying unit are offset by the revenues to the selling unit) Objectives of the transfer pricing system: Provide information for capital resource allocation decisions Provide information for the evaluation of the manager and the business unit This information can impact profits How you split the pie changes the size of the pie

Agenda Describe the issue of transfer pricing Transfer price setting Objectives of transfer price Develop the “optimal” transfer pricing rule Takeaway

Current System Division A creates and transfers an intermediate good to Division B, who processes it further and sells it. Final Market Price is $20 Division A Incremental cost per unit = $6 Division B Own cost per unit = $2 Profit = – $6 Profit = $20 – $2 = $18

Optimal Transfer Price Suppose the market for the intermediate good is “perfect” Optimal transfer price = market price per unit Final Market Price is $20 Selling Division Incremental cost per unit = $6 Buying Division Own cost per unit = $2 Intermediate market price = $11

Optimal Transfer Price The transfer price is the market price for the intermediate good, namely $11 Selling division profit: Transfer price – Own cost $11 – $6 = $5 Buying division profit: Final price – Own cost – Transfer price $20 – $2 – $11 = $7

Optimal Transfer Price Suppose there is no market for the intermediate good Optimal transfer price = selling division’s incremental cost per unit Final Market Price is $20 Selling Division Incremental cost per unit= $6 Buying Division Own cost = $2 No intermediate market

Optimal Transfer Price The transfer price is the production cost for the intermediate good, namely $6 Selling division profit: Transfer price – Own cost $6 – $6 = $0 (This division is thus a cost center) Buying division profit: Final price – Own cost – Transfer price $20 – $2 – $6 = $12

Optimal Transfer Price The “general rule” of transfer pricing If a perfect market for the transferred product exists Transfer price = Market Price In the previous example, the market price was $11 If no intermediate market exists Transfer price = Incremental (Marginal) Cost of the Selling Division In the previous example, this cost was $6

Measuring Incremental Costs In some instances, producing an extra unit Requires investment in long-term “chunky” capacity How to compute incremental (marginal) costs in such a situation? A suggested solution is a two-step transfer pricing scheme Charge a fixed fee every quarter or year (to cover for capacity costs) Charge variable fee based on the budgeted incremental unit cost

Takeaway The definition of a transfer price A price charged by one unit of an organization to another unit for a product or service Transfer price impacts divisional profits and provides information for: Capital resource allocation to divisions Divisional manager performance evaluation Formulas exist but must be applied with judgment Can we change TP often when outside market is highly volatile?