Hilton • Maher • Selto

19 Transfer Pricing

Transfer Pricing Internal transfers of products create a need for a pricing mechanism between divisions to accurately reflect the costs and revenues of doing business. A TRANSFER PRICE is the amount charged when one division of an organization sells goods or services to another division.

The Impact of Transfer Pricing on Organizations Exh. 19-1 The Impact of Transfer Pricing on Organizations Boundary between the organization and outside parties Sales of finished goods to customers outside the organization Top Management Selling division Buying Division Goods transferred at a transfer price Purchases of productive inputs from vendors outside the organization Assuming the transfer is made, the transfer price will not affect the company’s overall profit. However, it does affect the profit associated with each division. It can affect the decisions of autonomous division managers.

Goal and Behavioral Congruence Divisions Use of transfer price can affect the reported performance when evalutions use: ROI, Residual Income, or EVA . . . managers of profit centers and investment centers accepting or rejecting internal transfers based on the effect of the transfer price on their evaluation metric. In Decentralized organizations, this can lead to . . .

General Transfer-Pricing Rule A general rule that will ensure goal congruence: Transfer price = Additional outlay cost per unit incurred because goods are transferred + Opportunity cost per unit to the organization because of the transfer Includes the direct unit- level costs of the product/service & any other outlay costs that are incurred as a result of the transfer An opportunity cost is a benefit that is foregone as a result of taking a particular action

General Transfer-Pricing Rule Koala Camp Gear Division The Koala Camp Gear Division transfers some backpacks (RooPacks) to Outback’s retail and mail order divisions The Koala Camp Gear Division of Outback Outfitters manufactures backpacks in its Melbourne plant The Koala Camp Gear Division transfers some backpacks to other companies under different labels Suppose the Koala Camp Gear Division can sell all the backpacks it can produce to outside buyers at a market price of $60 per backpack

General Transfer-Pricing Rule Scenario 1: No excess capacity Koala Camp Gear Division Transfer price = Outlay cost + Opportunity cost $60.00 = $40.00 + $20.00 ? = ? + ?

General Transfer-Pricing Rule Scenario 1: No excess capacity Koala Camp Gear Division Assuming that the backpacks can be sold on the wholesale market for $60 or on the retail market for $70, what is the best way for the Company to use its limited capacity?

General Transfer-Pricing Rule Scenario 1: No excess capacity Koala Camp Gear Division All the backpacks should be transferred to the Retail Division to take advantage of the additional $10 contribution margin. The Camp Gear Division will not be hurt since the transfer price= the alternative wholesale price. +

General Transfer-Pricing Rule Scenario 1: No excess capacity Koala Camp Gear Division What should the Company do if the Retail Division receives an offer to sell all its backpacks at $55 each? +

General Transfer-Pricing Rule Scenario 1: No excess capacity Koala Camp Gear Division The Retail Division should reject the offer, because all the backpacks COULD be sold in the external market at $60, yielding a higher contribution margin of $20! +

General Transfer-Pricing Rule Scenario 2: Excess capacity Koala Camp Gear Division Transfer price = Outlay cost + Opportunity cost $40.00 = $40.00 + $0 ? = ? + ?

General Transfer-Pricing Rule Scenario 2: Excess capacity Koala Camp Gear Division Transfer price = Outlay cost + Opportunity cost $40.00 = $40.00 + $0 What should the Company do if the Retail Division receives an offer to sell all its backpacks at $55 each?

General Transfer-Pricing Rule Scenario 2: Excess capacity Koala Camp Gear Division Transfer price = Outlay cost + Opportunity cost + $40.00 = $40.00 + $0 ACCEPT the offer. The Retail Division will realize a contribution margin of $15 on each backpack sold at the special price ($55 price - $40 transfer price).

Difficulty in Implementing the General Rule Barriers to Implementation The opportunity cost may be difficult to measure. The external market may not be perfectly competitive. There may be no external market The goods or services may be unique Special equipment may be needed to produce the transferred goods Interdependencies among several transferred products or services

Transfers Based on the External Market Price When the producing division has no excess capacity and perfect competition prevails, the general transfer-pricing rule and the external market price yield the same transfer price. The total contribution margin to the company is STILL $30!

Negotiated Transfer Prices Division managers or their representatives actually negotiate the price at which transfers will be made. Drawbacks Negotiations can lead to divisiveness and competition between participating division managers. Although negotiating skill is a valuable managerial talent, it should not be the sole or dominant factor in evaluating a division manager.

Cost-Based Transfer Pricing Cost-based transfer-pricing sets the transfer price on the basis of the cost of the product or service transferred Standard unit-level cost Excess capacity Transfer Price = the standard unit-level cost of $40 per backpack - unit-level costs of $40 Contribution margin = 0 Unless the transferring division is allowed to realize a positive contribution margin, there is no positive incentive in this approach for the division to produce and transfer backpacks to the Retail Division.

Cost-Based Transfer Pricing Absorption or Full Cost Assigned higher-level costs (batch-, product-, customer-, and general- or facility-level) Standard unit-level cost Full cost = + + $1,800,000 budgeted higher-level costs 100,000 budgeted units of production = $40.00 + = $40.00 + 18 = $58.00 per backpack Possible dysfunctional decision-making behavior

Cost-Based Transfer Pricing Absorption or Full Cost = $40.00 + 18 = $58.00 per backpack They would reject it because they would incur a loss of $3 per unit. What happens if the Retail Division receives a special order of $55?

Cost-Based Transfer Pricing Absorption or Full Cost = $40.00 + 18 = $58.00 per backpack What is in the best interest of the Company? Accepting the order actually DOES provide $15 contribution margin. So, Absorption Costing results in a dysfunctional decision!

Cost-Based Transfer Pricing NO Transfer prices should not be based on actual costs, but rather on standard costs. ABC Many companies use activity-based costing to improve the accuracy of numbers in its internal transfer of prices If suppliers are not given a profit on the transaction, they are not motivated to transfer internally. Use a cost center for internal transfers

Cost-Based Transfer Pricing Koala Camp Gear Division The manager of Outback’s Koala Camp Gear Division has excess capacity but insists on a transfer price of $58. The manager of the Retail Division has a special offer for backpacks of $55 per unit resulting in her divisional profit declining. As company manager, what would YOU do? Stay out and lose the contribution margin for the company Intervene and run the risk of undermining the authority of the division manager OR But increased contribution margin for the company

Dual Transfer Pricing The buying division is charged the cost of the transferred product. The selling division is credited with the cost plus some profit allowance. The difference is accounted for in a special account. Other ways of encouraging internal transfers: Recognize internal transfers and incorporate them in reward systems Base part of the supplying manager’s bonus on the purchasing center’s profit

Global Transfer-Pricing Practices Research Insight 19-1

Global Transfer-Pricing Practices In international transactions, transfer prices may affect tax liabilities, royalties, and other payments because of different laws in different countries (or states). Companies have incentives to set transfer prices that will increase revenues (and profits) in low-tax countries and increase cost (thereby reducing profits) in high-tax countries Nehru Jacket Corporation Country S (40% tax rate) Country B (70% tax rate) Nehru’s facilities in Country B imports materials from the Country S facility. Transfer of goods

Global Transfer-Pricing Practices Exh. 19-2 Global Transfer-Pricing Practices Nehru Jacket Corporation Country S (40% tax rate) Country B (70% tax rate) Nehru’s facilities in Country B imports materials from the Country S facility. Transfer of goods Assume $2,000,000 production costs

Global Transfer-Pricing Practices Exh. 19-3 Global Transfer-Pricing Practices Nehru Jacket Corporation Country S (40% tax rate) Country B (70% tax rate) Nehru’s facilities in Country B imports materials from the Country S facility. Transfer of goods The transfer price has been changed to $10 million This has reduced the tax liability by $2,100,000 ($10,900,000 - $8,800,000)

Segment Reporting and Transfer Pricing The Financial Accounting Standards Board (FASB) requires companies engaged in different lines of business to report certain information about segments that meet the FASB’s technical requirements FASB If a company has significant foreign operations, it must disclose revenues, operating profits or losses, and identifiable assets by geographic region. Principle items that must be disclosed about each segment Segment revenue Segment operating loss or profit Identifiable segment assets Depreciation and amortization Capital expenditures Certain specialized items The accounting profession has a preference for market-based transfer pricing.

Now, this is my kind of transfer pricing! End of Chapter 19 Now, this is my kind of transfer pricing!