1. © 2012 Pearson Prentice Hall. All rights reserved. Financial Control Chapter 11 – Transfer Pricing

2. © 2012 Pearson Prentice Hall. All rights reserved. Transfer Pricing Transfer pricing is the set of rules an organization uses to allocate jointly earned revenue among responsibility centers To understand the issues and problems associated with allocating revenues in a simple organization, consider the activities that occur when a customer purchases a new car at a dealership:

3. © 2012 Pearson Prentice Hall. All rights reserved. Transfer Pricing – The new car department sells the new car and takes in a used car as a trade – The used car is transferred to the used car department – There, it may undergo repairs and service to make it ready for sale, or may be sold externally on the wholesale market The value placed on the used car transferred between the new and used car departments is critical in determining the profits of both departments:

4. © 2012 Pearson Prentice Hall. All rights reserved. Transfer Pricing – The new car department would like the value assigned to the used car to be as high as possible to increase revenue – The used car department would like the value to be as low as possible because that makes its reported costs lower The same considerations apply for any product or service transfer between any two departments in the same organization

5. © 2012 Pearson Prentice Hall. All rights reserved. Approaches to Transfer Pricing Organizations choose among four main approaches to transfer pricing: – Market-based transfer prices – Cost-based transfer prices – Negotiated transfer prices – Administered transfer prices

6. © 2012 Pearson Prentice Hall. All rights reserved. Market-Based Transfer Price If external markets exist for the intermediate (transferred) product or service, then market prices are the most appropriate basis for pricing the transferred good or service between responsibility centers The market price provides an independent valuation of the transferred product or service, and of how much each profit center has contributed to the total profit earned by the organization on the transaction

7. © 2012 Pearson Prentice Hall. All rights reserved. Cost-Based Transfer Price Some common cost-based transfer prices are: – Variable cost – Variable cost plus a percent markup on variable cost – Full cost – Full cost plus a percent markup on full cost Economists argue that any cost-based transfer price other than marginal cost leads organization members to choose a lower than optimal level of transactions

8. © 2012 Pearson Prentice Hall. All rights reserved. Problems with Cost-Based Transfer Price The selling division will never show a profit on any internal transfer. Transfer prices based on actual costs provide no incentive to the supplying division to control costs, because the supplier can always recover its costs

9. © 2012 Pearson Prentice Hall. All rights reserved. Problems with Cost-Based Transfer Price Cost-based pricing does not provide the proper economic guidance when operations are capacity constrained – Production decisions near full capacity should reflect the most profitable use of the capacity, not only cost considerations – The transfer price should be the sum of the marginal cost and the opportunity cost of capacity, where opportunity cost reflects the profit of the best alternative use of the capacity

10. © 2012 Pearson Prentice Hall. All rights reserved. Negotiated Transfer Price Some organizations allow supplying and receiving responsibility centers to negotiate transfer prices between themselves Negotiated transfer prices reflect the controllability perspective inherent in responsibility centers, because each division is ultimately responsible for the transfer price that it negotiates – Negotiated transfer prices and therefore production decisions may reflect the relative negotiating skills of the two parties rather than economic considerations

11. © 2012 Pearson Prentice Hall. All rights reserved. Problems with Negotiated Transfer Price Problems arise when negotiating transfer prices because the bilateral bargaining situation causes: – The supplying division to want a higher than optimal price – The receiving division to want a lower than optimal price When the actual transfer price is different from the optimal transfer price, the organization as a whole suffers

12. Negotiated TP Rules The selling division’s lowest acceptable transfer price is calculated as: The buying division’s highest acceptable transfer price is calculated as: Let’s calculate the lowest and highest acceptable transfer prices under three scenarios. If an outside supplier does not exist, the highest acceptable transfer price is calculated as:

13. © 2012 Pearson Prentice Hall. All rights reserved. Administered Transfer Price An arbitrator or a manager applies some policy to set administered transfer prices – Organizations often use administered transfer prices when a particular transaction occurs frequently Such prices reflect neither pure economic considerations, as do market-based or cost-based transfer prices, nor accountability considerations, as negotiated transfer prices do

14. © 2012 Pearson Prentice Hall. All rights reserved. Transfer Prices Based on Equity Considerations Administered transfer prices are usually based on cost Sometimes administered transfer prices are based on equity considerations: – Relative cost method – Base the allocation of cost on the profits that each manager derives from using the asset – Assign each manager an equal share of the asset’s cost