Transfer Pricing Managerial Accounting David Fender Midterm 1 Next week – instructions online for cases Changed some homework problems – correct assignment is on connect Today we will learn about ABC Do the Bozo exercise What are criteria High correlation between resource usage and cost allocation (usefulness) Traded off with cost and timeliness Managerial Accounting David Fender

Possible pricing strategies Cost plus … Willingness to pay…

Objectives for pricing policy Identifying and adhering to both short-run and long-run pricing strategies Maximizing profits Maintaining or gaining market share Setting socially responsible prices Maintaining a minimum rate of return on investment Being customer focused Keep in mind that maximizing profit is not always the only objective

Economic Pricing Concepts Economic approach to pricing Based on microeconomic theory Marginal Cost = Marginal Return Profit will be maximized when the difference between total revenue and total costs is the greatest Why profit maximal when MC = MR?

Example of economic pricing concept Show that when MC and MR equal each other that profit is largest

Organization and flow of goods within a company One consequence of having different organizational units of a large company is the need to have transfer prices for goods

Transfer Pricing Transfer Price – the price one subunit (department or division) charges for a product or service supplied to another subunit of the same organization Transfer prices are used to coordinate the actions of subunits and to evaluate their performance © 2009 Pearson Prentice Hall. All rights reserved.

Why are transfer prices a hot issue? They effect profits of divisions EARNINGS!!! Power Compensation Pride – prestige Quality of employees They effect the decision what a company manufactures PROFITABILITY!!! TAXES!!!

The optimal transfer price allows each division manager to make decisions that maximize the company’s profit, while attempting to maximize his/her own division’s profit.

What rule should a company apply?

Drum roll … © 2009 Pearson Prentice Hall. All rights reserved.

Scenario I: No Excess Capacity General Rule When the selling division is operating at capacity, the transfer price should be set at the market price. 17

Scenario II: Excess Capacity General Rule When the selling division is operating below capacity, the minimum transfer price is the variable cost per unit. So, the transfer price will be no lower than variable cost, and no higher than (outside) market price. 14

Example

Scenario I: No Excess Capacity The Battery Division makes a standard 12-volt battery. Production capacity 300,000 units Selling price per battery $40 (to outsiders) Variable costs per battery $18 Fixed costs per battery $7 (at 300,000 units) The Battery division is currently selling 300,000 batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model. What is the appropriate transfer price? 9

Scenario I: No Excess Capacity Additional outlay cost per unit incurred because goods are transferred Opportunity cost per unit to the organization because of the transfer Transfer price = + $22 Contribution lost if outside sales given up Transfer price $18 variable cost per battery = + Transfer price = $40 per battery

Scenario I: No Excess Capacity Auto division can purchase 100,000 batteries from an outside supplier for less than $40. Auto division can purchase 100,000 batteries from an outside supplier for more than $40. Transfer will not occur. Transfer will occur. $40 transfer price 10

Scenario II: Excess Capacity The Battery Division makes a standard 12-volt battery. Production capacity 300,000 units Selling price per battery $40 (to outsiders) Variable costs per battery $18 Fixed costs per battery $7 (at 300,000 units) The Battery division is currently selling 150,000 batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model. It can purchase them for $38 from an outside supplier. What is the appropriate transfer price? 9

Scenario II: Excess Capacity Additional outlay cost per unit incurred because goods are transferred Opportunity cost per unit to the organization because of the transfer Transfer price = + Transfer price $18 variable cost per battery = + $0 Transfer price = $18 per battery

Scenario II: Excess Capacity General Rule When the selling division is operating below capacity, the minimum transfer price is the variable cost per unit. So, the transfer price will be no lower than $18, and no higher than $38. 14

Scenario II: Excess Capacity Transfer will not occur. Transfer will occur. Transfer will not occur. $18 transfer price $38 transfer price 10