Transfer Pricing Rectified

Transfer Pricing, and Multinational Considerations
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Meaning of Transfer Pricing

A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organization. Intermediate products are the products transferred between subunits of an organization.
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Objectives of Transfer Pricing

Help achieve a companys strategies and goals. Foster Commercial attitude. Optimizing the profit of the Company. Optimum use of Companys financial resources. Evaluation of divisions performance. Motivation to divisional Manager. Minimizing Tax Burden.
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Cost-Based Transfer Prices

Cost-based transfer pricing is a method of setting prices when goods are sold to divisions within the same company.
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Cost-Based Transfer Pricing Methods

Cost of Production Method Marginal Cost Method
Standard Cost Method Cost of Sale Method Cost plus normal mark-up Opportunity cost Method
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 22 - 5
Cost of Production Method

Transfer price is equal to the cost Price. Pricing based on divisions unit cost of production. Profit performance is centralised. Simplest method
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Cost-Based Transfer Prices Example

The Refining Division of Lomas & Co. is purchasing crude oil locally for $23 a barrel. The Refining Division located an independent producer in Alaska that is willing to sell 20,000 barrels of crude oil per day at $17 per barrel delivered to the pipeline (Transportation Division).
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Marginal Cost Method

Pricing is equal to Variable Cost. Overall profitability of the company is the main objective. Used when capacity of selling unit is idle. It leads to full utilization of Capacity.

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The Transportation Division has excess capacity and can transport the crude oil at its variable costs of $2 per barrel. Should Lomas purchase from the independent supplier? Yes. There is a reduction in total costs of $80,000.
Standard Cost
It is pre-determined price. Variance absorbed by the supplying unit. Responsibility of performance is centralized. Profit performance of each unit cannot be measured.

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Cost of Sale
It is full cost. It include all expenses. Selling divisions Manager responsible for profit Measurement of divisional performance is not possible.

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Cost plus a normal mark-up

Unit cost of production + some profit margin. Assumption supplying division selling to outsiders & insiders. Measurement of profit performance of each unit.

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Opportunity Cost
It is maximum contribution forgone by the suplying division. Price equal to market value is treated as opportunity Cost. Opportunity cost is useful when evaluating the cost and benefit of choices. process of choosing one good or service over another


Alternative 1: Buy 20,000 barrels from the local supplier at $23 per barrel. The total cost to Lomas is: 20,000 $23 = $460,000
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Alternative 2: Buy 20,000 barrels from the independent supplier in Alaska at $17 per barrel and transport it to Seattle at $2 per barrel. The total cost to Lomas is: 20,000 $19 = $380,000

Suppose the Transportation Divisions transfer price to the Refining Division is 112% of full cost. What is the cost to the Refining Division?
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Purchase price of crude oil $17 Variable costs per barrel of crude oil 2 Fixed costs per barrel of crude oil 3 Total $22 1.12 $22 = $24.64 $24.64 20,000 = $492,800

What is the maximum transfer price? It is the price that the Refining Division can pay in the local external market ($23). What is the minimum transfer price? The minimum transfer price is $19 per barrel.
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Transfer-Pricing Methods Example

Lomas & Co. has two divisions: Transportation and Refining. Transportation purchases crude oil in Alaska and sends it to Seattle. Refining processes crude oil into gasoline.
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External market price for supplying crude oil per barrel: Transportation Division: Variable cost per barrel of crude oil Fixed cost per barrel of crude oil Total $13 $ 2 3 $ 5
The pipeline can carry 35,000 barrels per day.

Contribution based transfer prices

Determination of total contribution margin earned after product sold externally. Used when market price of a product is not available. Use of internal information for determination of transfer price. Used where several divisions contribute work.

Market based transfer pricing

Determined by the forces of demand & supply. Profit will provide a good indicator of the overall efficiency of the operating unit. Allows both buying & selling division to buy & sell their products anywhere they want.
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Negotiated Transfer Prices

Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.
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Dual Pricing
Making use of two transfer prices. Used to make a decision in one case & performance evaluation in other case. Used when there is conflict in interest of buying profit centre & selling profit centre.

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Dual Pricing
An example of dual pricing is for Lomas & Co. to credit the Transportation Division with 112% of the full cost transfer price of $24.64 per barrel of crude oil. Debit the Refining Division with the market-based transfer price of $23 per barrel of crude oil.
Transfer-Pricing Methods
Market-based transfer prices Cost-based transfer prices Negotiated transfer prices

External purchase price for crude oil per barrel: Refining Division: Variable cost per barrel of gasoline Fixed cost per barrel of gasoline Total $23 $ 8 4 $12
The division is buying 20,000 barrels per day.


The external market price to outside parties is $60 per barrel. The Refining Division is operating at 30,000 barrels capacity per day.
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What is the market-based transfer price from Transportation to Refining? $23 per barrel What is the cost-based transfer price at 112% of full costs?

Purchase price of crude oil Variable costs per barrel of crude oil Fixed costs per barrel of crude oil Total 1.12 $18 = $20.16 What is the negotiated price? Between $20.16 and $23.00 per barrel.
$13 2 3 $18

Assume that the Refining Division buys 1,000 barrels of crude oil from the Transportation Division. The Refining Division converts these 1,000 barrels of crude oil into 500 gallons of gasoline and sells them. What is the Transportation Division operating income using the market-based price?

Transportation Division: Revenues: ($23 1,000) $23,000 Deduct costs: ($18 1,000) 18,000 Operating income $ 5,000 What is the Refining Divisions operating income using the market-based price?

Refining Division: Revenues: ($60 500) $30,000 Deduct costs: Transferred-in ($23 1,000) 23,000 Division variable ($8 500) 4,000 Division fixed ($4 500) 2,000 Operating income $ 1,000

What is the operating income of both divisions together? Transportation Division Refining Division Total $5,000 1,000 $6,000
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What is the Transportation Divisions operating income using the 112% of full cost price? Transportation Division: Revenues: ($20.16 1,000) Deduct costs: ($18.00 1,000) Operating income $20,160 18,000 $ 2,160
What is the Refining Division operating income using the full cost price?

Refining Division: Revenues ($60 500) Deduct costs: Transferred-in ($20.16 1,000) Division variable ($8.00 500) Division fixed ($4.00 500) Operating income $30,000 20,160 4,000 2,000 $ 3,840
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What is the operating income of both divisions together? Transportation Division Refining Division Total $2,160 3,840 $6,000
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Learning Objective 5 Illustrate how market-based transfer prices promote goal congruence in perfectly competitive markets.
Market-Based Transfer Prices

By using market-based transfer prices in a perfectly competitive market, a company can achieve the following: Goal congruence Management effort Subunit performance evaluation Subunit autonomy

Market prices also serve to evaluate the economic viability and profitability of divisions individually.
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When supply outstrips demand, market prices may drop well below their historical average. Distress prices are the drop in prices expected to be temporary.
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Learning Objective 6 Avoid making suboptimal decisions when transfer prices are based on full cost plus a markup.
Learning Objective 7 Understand the range over which two divisions negotiate the transfer price when there is unused capacity.
Prorating
Lomas & Co. may choose a transfer price that splits on some equitable basis the difference between the maximum transfer price and the minimum transfer price. $23 $19 = $4 Suppose that variable costs are chosen as the basis to allocate this $4 difference.
Prorating
The Transportation Divisions variable costs are $2 1,000 = $2,000. The Refining Divisions variable costs to refine 1,000 of crude oil into 500 barrels of gasoline are $8 500 = $4,000.
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Prorating
The Transportation Division gets to keep $2,000 $6,000 $4 = $1.33. The Refining Division gets to keep $4,000 $6,000 $4 = $2.67. What is the transfer price from the Transportation Division? $17.00 + $2.00 + $1.33 = $20.33
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Dual Pricing
An example of dual pricing is for Lomas & Co. to credit the Transportation Division with 112% of the full cost transfer price of $24.64 per barrel of crude oil. Debit the Refining Division with the market-based transfer price of $23 per barrel of crude oil.
Negotiated Transfer Prices

Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.
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Learning Objective 8 Construct a general guideline for determining a minimum transfer price.
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Comparison of Methods
Achieves Goal Congruence Market Price: Yes, if markets competitive Cost-Based: Negotiated: Often, but not always Yes
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Useful for Evaluating Subunit Performance Market Price: Yes, if markets competitive Cost-Based: Negotiated: Difficult, unless transfer price exceeds full cost Yes
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Motivates Management Effort Market Price: Yes Cost-Based: Negotiated: Yes, if based on budgeted costs; less incentive if based on actual cost Yes
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Preserves Subunit Autonomy Market Price: Yes, if markets competitive Cost-Based: Negotiated: No, it is rule based Yes
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Other Factors Market Price: No market may exist Cost-Based: Negotiated: Useful for determining full-cost; easy to implement Bargaining takes time and may need to be reviewed
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General Guideline
Minimum transfer price = Incremental costs per unit incurred up to the point of transfer + Opportunity costs per unit to the selling division
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General Guideline
Assume a perfectly competitive market, with no idle capacity. Transportation Division can sell all the crude oil it transports to the external market in Seattle for $23 per barrel. What is the minimum transfer price? ($19 + $4) or ($13 + $2 + $8) = $23 = Market price
General Guideline
Assume that an intermediate market exists that is not perfectly competitive, and the selling division has idle capacity. If the Transportation Division has idle capacity, its opportunity cost of transferring the oil internally is zero. What is the minimum transfer price?
General Guideline
It would be $15 per barrel for oil purchased under the long-term contract, or... $19 per barrel for oil purchased and transported from the independent supplier in Alaska.
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Learning Objective 9 Incorporate income tax considerations in multinational transfer pricing.

Multinational Transfer Pricing
IRC Section 482 requires that transfer prices for both tangible and intangible property between a company and its foreign division be set to equal the price that would be charged by an unrelated third party in a comparable transaction.
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End of Chapter 22
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Transfer Pricing, and Multinational Considerations

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Meaning of Transfer Pricing

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Objectives of Transfer Pricing

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Cost-Based Transfer Prices

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Cost-Based Transfer Pricing Methods

Cost of Production Method

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Cost-Based Transfer Prices Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Marginal Cost Method

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Cost-Based Transfer Prices Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Cost plus a normal mark-up

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Cost-Based Transfer Prices Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Cost-Based Transfer Prices Example

Cost-Based Transfer Prices Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Cost-Based Transfer Prices Example

Cost-Based Transfer Prices Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Transfer-Pricing Methods Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Transfer-Pricing Methods Example

The pipeline can carry 35,000 barrels per day.

Contribution based transfer prices

Market based transfer pricing

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Negotiated Transfer Prices

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Transfer-Pricing Methods Example

The division is buying 20,000 barrels per day.

Transfer-Pricing Methods Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Transfer-Pricing Methods Example

Transfer-Pricing Methods Example

Transfer-Pricing Methods Example

Transfer-Pricing Methods Example

Transfer-Pricing Methods Example

Transfer-Pricing Methods Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Transfer-Pricing Methods Example

Transfer-Pricing Methods Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Transfer-Pricing Methods Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Market-Based Transfer Prices

Market-Based Transfer Prices

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Market-Based Transfer Prices

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster