Transfer Pricing (I)

Key points(I)
In decentralized organizations, subunits often supply goods or services (intermediate products) to one
another.
In that case, top management uses transfer prices to coordinate the actions of the subunits and to
evaluate the performance of their managers.
Transfer price—the price one subunit (department or division) charges for a product or service
supplied to another subunit of the same organization.
The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit
affecting each subunit’s operating income.
The operating incomes can be used to evaluate the subunits’ performances and to motivate their
managers.

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 Key points (II)

Transfer prices needing to be set at a level that:

◦ maximizes company profits,
◦ is compliant with tax laws,
◦ allows for fair performance evaluation of both divisions and staff/managers
 Criteria for evaluating
transfer prices

To help a company achieve its goals, transfer prices should :

1. Promote goal congruence.
2. Induce managers to exert a high level of effort.
3. Help top managers evaluate the performance of individual subunits.
4. Preserve autonomy of subunits
5. Fulfill local and global tax guidelines

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 Transfer Pricing Methods

1. Market-based transfer prices.

2. Cost-based transfer prices.

3. Hybrid transfer prices.

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 Market-Based Transfer Prices (I)

Transferring products or services at market prices allows firms to:

achieve goal congruence

motivate managers
evaluate subunit performance evaluations
preserve subunit autonomy

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 Market-Based Transfer Prices (II)

It leads to optimal decisions when three conditions are satisfied:

1. A market for the intermediate product exists and is perfectly competitive.
2. The interdependencies of subunits are minimal.
3. There are no additional costs or benefits to the company as a whole from buying or
selling in the external market instead of transacting internally.

Not appropriate if the market is currently in a state of “distress pricing”.

when a company chooses to mark down the

price it charges for an item or service instead of
discontinuing the product altogether.

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 Cost-Based Transfer Prices (I)

Mostly appropriate when:

o prices are unavailable (markets do not exist), inappropriate, or too costly to obtain
o the internal product is different from the products available externally.
o markets are not perfectly competitive,
o the product is specialized

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 Cost-Based Transfer Prices (II)

In the absence of an established market price, the transfer price is based on the production cost
of the supplying division.

Alternative methods of transfer prices based on costs:

o Based on variable production costs.
o Based on fixed and variable production costs,
o Based on full costs (including life-cycle costs).
o Any of the above including a margin.

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 Transfer Prices based
on Variable Costs

The transfer price based on variable costs is the minimum transfer price that achieves
organizational congruence.
However there are some issues to consider:
◦ To the extent that margins are included at this price goal congruence may be at risk
◦ If only variable costs are included, the supplying sub-unit can only be analyzed as a cost
center since it has no revenues to analyze.
◦ The results of the receiving sub-unit will be overestimated by including only variable costs.
 Transfer Prices
Based on Full
Costs (I)

Popular because of its simplicity and clarity but it may raise the following issues:
o For transfers at full (absorption) cost the receiving division takes all the gains from trade. To
overcome this problem the supplying division is frequently allowed to add a markup to make a
"reasonable" profit.
o By including fixed costs and a margin on them, prices on total costs can exceed the market
price being incongruent prices that do not motivate managers.
o Transfer price must fall between the minimum transfer price and the maximum transfer price
range.
o Prices outside this range will benefit one subunit in excess and penalize the alternative subunit
in the same proportion.
 Minimum Transfer Price
The minimum transfer price is calculated as:

Incremental cost per unit

Minimum incurred up to the point of Opportunity Cost per unit
Transfer Price = transfer + to the selling subunit

 Incremental cost is the additional cost of producing and transferring the product
or service.

 Opportunity cost is the maximum contribution margin forgone by the selling

subunit if the product or service is transferred internally.

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 Transfer Prices Based
on Full Costs (II)
Other questions related to the use of full costs as bases are:
How are the subunit’s indirect costs allocated to products?
Have the correct activities, cost pools and cost-allocation bases been identified?
Should the chosen fixed-cost rates be actual or budgeted?

Despite its limitations, managers generally prefer to use full-cost-based transfer prices because:
They represent relevant costs for long-run decisions.
They facilitate external pricing based on variable and fixed costs.
They are the least costly to administer.
 Hybrid Transfer Prices

Takes into account both cost and market information.

Top management may set the prices by specifying a transfer price that is an average of the cost of
producing and transporting the product internally and the market price for comparable products.
Types of hybrid transfer prices:
1. Negotiated pricing (most common hybrid type)
2. Prorating between maximum and minimum transfer prices.
3. Dual pricing (using two separate transfer-pricing methods to price each transfer from one
subunit to another. Example: selling division receives full cost pricing, and the buying
division pays market pricing).

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 Negotiated Transfer Prices
Occasionally, subunits of a firm are free to negotiate the transfer price between themselves and
then to decide whether to buy and sell internally or deal with external parties.

The negotiation process depends on:

The negotiating capacity of the subunits
The cost information that each subunit has over the other subunit

The resulting prices:

May or may not bear any resemblance to cost or market data.
Often used when market prices are volatile.
Represent the outcome of a bargaining process between the selling and buying subunits.
 Prorating between Min and Max
Transfer Prices

Once the minimum transfer price (variable costs) and the maximum transfer price (market
price) have been identified, their difference can be prorated by considering which sub-unit
should be motivated.

This type of transfer price solves some of the problems of the transfer price on variable costs
as it:
◦ minimizes the overvalued profits of the receiving sub-unit.
◦ includes a kind of mark-up on variable costs for the transferring sub-unit.
 Dual Transfer Prices (I)

Very rarely is there a cost transfer price that simultaneously achieves all four objectives
(consistency, effort, evaluation and autonomy) for the two subunits involved.
One solution to this problem is to use two different transfer prices for each subunit. This is
what we call Dual Transfer Pricing.

Example:
Transfer price Full Cost + margin for the supplying sub-unit.
Transfer price on variable costs without margin for the receiving sub-unit
 Dual Transfer Prices (II)

From a theoretical point of view, it solves the problems that could be caused by a single
transfer price for the two subunits, but it also suffers from certain problems:
It generates problems in calculating taxes if the subunits are in different constituencies.
The ceding subunit has no incentive to control its costs with a dual system since the ceding
division records revenues based on current costs.
This system isolates the manager from the market, since it is affected by costs and not by
actual prices. There is a loss of contact with reality.
 Comparison of Transfer-
Pricing Methods

Frequency of Use:
1. Full Cost
2. Market Based
3. Negotiated

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22-19
 Multinationals and
Transfer Pricing (I)

In companies based in more than one country with divisions trading with each other, the
price that one division charges the other will affect the profit that each of those divisions
makes.
As tax is based on profits, a division will pay more or less tax depending on the transfer
prices that have been set and the tax regimes that apply in each country.
Governments are aware of the risk that multinationals will use transfer pricing to avoid
paying income and other taxes and publish specific guidelines.

payroll taxes, customs duties, tariffs, sales taxes,

value-added taxes, environment-related taxes
Multinationals and
Transfer Pricing (II)
 Exercise 22.20

Transfer pricing methods, goal congruence.

British Columbia Lumber has a Raw Lumber Division and a Finished Lumber Division.

The variable costs are:

•Raw Lumber Division: $100 per 100 board-feet of raw lumber
•Finished Lumber Division: $125 per 100 board-feet of finished lumber

Assume that there is no board-feet loss in processing raw lumber into finished lumber.
Raw lumber can be sold at $200 per 100 board-feet and finished lumber can be sold at $275 per
100 board-feet.

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Required:

1. Should British Columbia Lumber process raw lumber into finished lumber?
2. Assume that internal transfers are made at 110% of variable cost. Will each division
maximize its division operating income contribution by adopting the action that is in the
best interest of British Columbia Lumber as a whole?
3. Assume that the internal transfers are made at market prices. Will each division
maximize its division operating income contribution by adopting the action that is in the
best interest of British Columbia Lumber as a whole?
Req 1_22_20
Req 3_22_20
 Exercise 22-23

Multinational transfer pricing, global tax minimization.

The Mornay Company manufactures telecommunications equipment at its plant in Toledo,

Ohio. The company has marketing divisions throughout the world. A Mornay marketing
division in Vienna, Austria, imports 10,000 units of Product 4A36 from the United States.
The following information is available:

US income tax rate on the US divison´s Operating Income 35%

Austrian income tax rate on the Austrian división´s operating income 40%
Austrian Import Duty 15%
Variable manufacturing cost per unit of 4A36 $550
Full manufacturing cost per unit of 4ª36 $800
Selling Price (net of marketing and distribution costs) in Austria $1,150

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Suppose that:
The U.S. and Austrian tax authorities only allow transfer prices that are
between the full manufacturing cost per unit of $800 and a market price of
$950, based on comparable imports into Austria.
The Austrian import duty is charged on the price at which the product is
transferred into Austria.
Any import duty paid to the Austrian authorities is a deductible expense for
calculating Austrian income taxes due.
Income taxes are not included in the computation of the cost-based
transfer prices.

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Required:
1. Calculate the after-tax operating income earned by the U.S. and Austrian divisions from
transferring 10,000 units of Product 4A36
(a) at full manufacturing cost per unit and
(b) at market price of comparable imports.

2. Which transfer price should the Mornay Company select to minimize the total of
company import duties and income taxes?
Remember that the transfer price must be between the full manufacturing cost per unit of $800
and the market price of $950 of comparable imports into Austria.
 Req 1_22_23

IF units are transfered at Market

Price the suppling division gets a
positive Income, otherwise no

It is the difference in the

trasferred in costs that
causes the overall diference
on the Operating Income of
the receiving division
 Req 2_Ex 22_23

Mornay Company will minimize import duties and income taxes by

setting the transfer price at its minimum level of $800, the full
manufacturing cost.
 $ 60,000

If the transfer price changes from $800 to $950, the net effect is an increase in import duty and tax
payments of ($950 - $800) × $0.04 = $6 per unit.

Across 10,000 units, this implies a decrease in total profits of (10,000) × $6 = $60,000, which
corresponds exactly to the $60,000 difference in total after-tax operating incomes.
 Ex 22_24

Using the information of Ex. 22_23 now suppose that the US división could sell in the US market as
many units of product 4A36 as it makes at $900 per unit, net of all marketing and distribution costs.

Required:
1. From the view point of the Company as a whole, would after tax operating income be maximized if
the 10,000 units were sold in the US or in Austria?
2. Suppose división managers act autonomously to maximize the after tax profits of their división.
Would transferring at the full manufacturing cost lead the US division manager to make decisions
that are best for the company as a whole?
3. What is the mínimum transfer price that the US división manager would agree to? Does this Price
result in the Company paying more import duty and taxes than in Ex 22_23? If so, how much more?
Req 1_Ex 22_24
 Req 2_Ex 22_24

Transferring Product 4A36 at the full manufacturing cost of the U.S. Division minimizes import duties
and taxes (Exercise 22-23, requirement 2), but creates zero operating income for the U.S Division.

Acting autonomously, the U.S. Division manager would maximize division operating income by selling
Product 4A36 in the U.S. market, which results in $650,000 in after-tax division operating income as
calculated in requirement 1, rather than by transferring Product 4A36 to the Austrian division at full
manufacturing cost.

Thus, the transfer price calculated in requirement 2 of Exercise 22-23 will not result in actions that are
optimal for Mornay Company as a whole.
 Req 3_Ex 22_24

The minimum transfer price at which the U.S. division manager acting autonomously will agree to
transfer Product 4A36 to the Austrian division is $900 per unit. Any transfer price less than $900 will
leave the U.S. Division's performance worse than selling directly in the U.S. market.
Because the U.S. Division can sell as many units as it makes of Product 4A36 in the U.S. market, there
is an opportunity cost of transferring the product internally equal to $350 (selling price $900 −
variable manufacturing costs, $550).
Total import duties and income taxes at transfer prices of $800 and $900 per unit for 10,000 units
of Product 4A36 are:

The minimum transfer price that the U.S. division manager acting autonomously would agree
to results in Mornay Company paying $40,000 in additional import duties and income taxes.
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