Transfer Pricing Chapter 15 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Transfer Pricing L.O. 1 Explain the basic issues associated with transfer pricing. Transfer price: The value assigned to the goods or services sold or rented (transferred) from one unit of an organization to another. Treatment is the same as a sale to an outside customer. – Revenue to the selling unit – Cost to the buying unit

The Setting L.O. 2 Explain the general transfer pricing rules and understand the underlying basis for them. Padre Papers Wood DivisionPaper Division TreesPaper Wood for making paper

The Setting LO2 Padre Papers Cost and Production Data Average units produced Average units sold Variable manufacturing cost per unit Variable finishing cost per unit Fixed divisional cost (unavoidable) 100,000 $ 20 $2,000, ,000 $ 30 $4,000,000 WoodPaper

The Setting LO2 Wood Division (selling division) Variable cost = $20 Fixed cost = $2,000,000 Paper Division (buying division) Variable wood cost = ? Variable finishing cost = $30 Fixed cost = $4,000,000 Wood Transfer price Market for paper (final market Price = ? Market for wood (intermediate market Price = ? Padre Papers – Resources Flow

Padre Papers Example LO2 Assume the following data for the wood division: Capacity in units Selling price to outside Variable price per unit Fixed price per unit (based on capacity) 100,000 $ 60 $

Padre Papers Example LO2 The Paper Division is currently purchasing 100,000 units from an outside supplier for $50, but would like to purchase units from the Wood Division

Padre Papers Example LO2 Transfer price Variable cost (VC) Lost contribution margin (CM) =+ If the Wood Division has idle capacity: Transfer price $20$0=+ If the Wood Division is working at capacity: Transfer price $20$40=

Optimal Transfer Price LO2 There is no intermediate market. In this case, the only outlet for the Wood Division is the Paper Division and the only source of supply for the Paper Division is the Wood Division. The optimal transfer price is the outlay cost for producing the goods (generally the variable costs)

Perfect Intermediate Marked-Quality Differences LO2 Variable manufacturing cost (Wood Division) per unit Variable finishing cost (Paper Division) per unit Other data: Final market (paper) price Intermediate market (grade A wood) price Intermediate market (grade B wood) price $ 20 $ 30 $120 $ 60 $

Quality Difference Example LO2 Sales: $ 50 × 100,000 (transfer) $120 × 100,000 (transfer) Variable costs: $ 20 × 100,000 $ 50 × 100,000 (transfer) $ 30 × 100,000 (processing) Fixed costs Operating profit Total company operating profit $5,000,000 $2,000,000 $1,000,000 $12,000,000 $ 5,000,000 3,000,000 4,000,000 $ -0- WoodPaper $1,000,000 Grade B wood: $50 internal transfer price

Quality Difference Example LO2 Sales: $ 60 × 100,000 (transfer) $120 × 100,000 (transfer) Variable costs: $ 20 × 100,000 $ 60 × 100,000 (transfer) $ 30 × 100,000 (processing) Fixed costs Operating profit Total company operating profit $6,000,000 $2,000,000 $12,000,000 $ 6,000,000 3,000,000 4,000,000 $ (1,000,000) WoodPaper $1,000,000 Grade A wood: $60 internal transfer price

Managers’ Goals versus Firms’ Goals L.O. 3 Identify the behavioral issues and incentive effects of negotiated transfer prices, cost-based transfer prices, and market-based transfer prices. Transfer price higher than market: Buying division will not buy Transfer price lower than market: Selling division will not sell

Centrally Established Transfer Price Policies LO3 Market price-based: Sets the transfer price at the market price or at a small discount from the market price Cost-based: Outlay cost to selling division plus forgone contribution to company projects Negotiated transfer: The managers of the buying and selling divisions agree on a price

Multinational Transfer Pricing L.O. 4 Explain the economic consequences of multinational transfer prices. International (or interstate) transfer pricing can affect tax liabilities, royalties, and other payments due to different laws in different countries or states. Company incentive: – Increase profit in low-tax country – Decrease profit in high-tax country

Segment Reporting L.O. 5 Describe the role of transfer prices in segment reporting. The FASB requires companies to report certain information about segments in order to provide a measure of performance for those segments that are significant to the company as a whole

End of Chapter 15 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin