1. Transfer Pricing

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

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

4. 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.

5. 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)

6. 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

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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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?