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
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The SettingL.O. 2 Explain the general transfer pricing rules and
understand the underlying basis for them.
Padre Papers
Wood Division Paper Division
Trees PaperWood for
making paper
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The SettingLO2
Padre PapersCost and Production Data
Average units producedAverage units soldVariable manufacturing cost per unitVariable finishing cost per unitFixed divisional cost (unavoidable)
100,000
$ 20
$2,000,000
100,000
$ 30$4,000,000
Wood Paper
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The SettingLO2
Wood Division(selling division)
Variable cost = $20Fixed cost = $2,000,000
Paper Division(buying division)
Variable wood cost = ?Variable finishing cost = $30
Fixed cost = $4,000,000
Wood
Transferprice
Market for paper(final market
Price = ?
Market for wood(intermediate market
Price = ?
Padre Papers – Resources Flow
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Padre Papers ExampleLO2
• Assume the following data for the wood division:
Capacity in unitsSelling price to outsideVariable price per unitFixed price per unit (based on capacity)
100,000$ 60$ 20$ 20
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Padre Papers ExampleLO2
• The Paper Division is currently purchasing 100,000units from an outside supplier for $50, but wouldlike to purchase units from the Wood Division.
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Padre Papers ExampleLO2
Transferprice
Variablecost (VC)
Lost contributionmargin (CM)
= +
If the Wood Divisionhas idle capacity:
Transferprice
$20 $0= +
If the Wood Divisionis working at capacity:
Transferprice
$20 $40= +
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Optimal Transfer PriceLO2
• There is no intermediate market.
• In this case, the only outlet for the Wood Divisionis the Paper Division and the only source ofsupply for the Paper Division is the Wood Division.
• The optimal transfer price is the outlay cost forproducing the goods (generally the variable costs).
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Perfect IntermediateMarked-Quality Differences
LO2
Variable manufacturing cost (Wood Division) per unitVariable finishing cost (Paper Division) per unitOther data:
Final market (paper) priceIntermediate market (grade A wood) priceIntermediate market (grade B wood) price
$ 20$ 30
$120$ 60$ 50
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Quality Difference ExampleLO2
Sales:$ 50 × 100,000 (transfer)$120 × 100,000 (transfer)Variable costs:$ 20 × 100,000$ 50 × 100,000 (transfer)$ 30 × 100,000 (processing)Fixed costsOperating profitTotal company operating profit
$5,000,000
$2,000,000
$2,000,000$1,000,000
$12,000,000
$ 5,000,000 3,000,000 4,000,000$ -0-
Wood Paper
$1,000,000
• Grade B wood: $50 internal transfer price
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Quality Difference ExampleLO2
Sales:$ 60 × 100,000 (transfer)$120 × 100,000 (transfer)Variable costs:$ 20 × 100,000$ 60 × 100,000 (transfer)$ 30 × 100,000 (processing)Fixed costsOperating profitTotal company operating profit
$6,000,000
$2,000,000
$2,000,000$2,000,000
$12,000,000
$ 6,000,000 3,000,000 4,000,000$ (1,000,000)
Wood Paper
$1,000,000
• Grade A wood: $60 internal transfer price
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Managers’ Goals versus Firms’ Goals
L.O. 3 Identify the behavioral issues and incentive effectsof negotiated transfer prices, cost-based transferprices, 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
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Centrally EstablishedTransfer Price Policies
LO3
• Market price-based:Sets the transfer price at the market price orat a small discount from the market price
• Cost-based:Outlay cost to selling division plus forgonecontribution to company projects
• Negotiated transfer:The managers of the buying and sellingdivisions agree on a price.
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Multinational Transfer Pricing
L.O. 4 Explain the economic consequencesof multinational transfer prices.
• International (or interstate) transfer pricingcan affect tax liabilities, royalties, and otherpayments due to different laws in differentcountries or states.
• Company incentive:– Increase profit in low-tax country– Decrease profit in high-tax country
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Segment Reporting
L.O. 5 Describe the role of transfer prices in segment reporting.
• The FASB requires companies to report certaininformation about segments in order to providea measure of performance for those segmentsthat are significant to the company as a whole.
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End of Chapter 15
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin