ACA 212 Strategic Cost Management

Lesson 6: Transfer Pricing

Learning Outcomes:
a. Explain why transfer prices are used.
b. Describe the types of transfer prices.
c. Explain the difficulties that multinational companies may encounter when using transfer
prices.

Transfer Pricing
1. Transfer prices in general.
a. Transfer prices are internal charges established for the exchange of goods or
services between organizational units of the same company.
b. A pseudo-profit center is created when one responsibility center uses a transfer
price to artificially “sell” goods or services to another responsibility center: The
selling center has artificial revenues and profits, and the buying center has an
artificially inflated product or service cost.
c. The appropriate transfer price should be one that ensures optimal resource
allocation and promotes operating efficiency. Transfer prices may be established to
promote goal congruence, make performance evaluation among segments more
comparable, and/or “transform” a cost center into a profit center.
d. The general rules for choosing a transfer price are:
i. The maximum price should be no higher than the lowest market price at which
the buying segment can acquire the goods or services externally.
ii. The minimum price should be no less than the sum of the selling segment’s
incremental costs associated with the goods or services plus the opportunity cost
of the facilities used.

2. The three traditional methods for determining transfer prices are:

a. A cost-based transfer price is equal to total unit absorption cost, variable cost, or
modified variable and/or absorption cost.
b. A market-based transfer price is believed to be an objective measure of value and
simulates the selling price that would exist if the segments were independent
companies.
c. A negotiated transfer price is an intracompany charge for goods or services that has
been set through a process of negotiation between the selling and purchasing unit
managers.

3. A dual pricing arrangement is a transfer pricing system that allows the selling division to
record the transfer of goods or services at a market or negotiated market price and the
buying division to record the transfer at a cost-based amount.

4. Selecting a transfer pricing system.

a. The final determination of what transfer pricing system to use should reflect the
circumstances of the organizational units and corporate goals; no one method of
setting a transfer price is best in all instances.
b. Transfer prices are not permanent; they are frequently revised in relation to changes
in costs, supply, demand, competitive forces, and other factors.
 5. A thoughtfully set transfer price, regardless of the method used, will provide the
following advantages:
a. an appropriate basis for the calculation and evaluation of segment performance;
b. the rational acquisition or use of goods and services between corporate divisions;
c. the flexibility to respond to changes in demand or market conditions; and
d. a means of motivation to encourage and reward goal congruence by managers in
decentralized operations.

6. In contrast, transfer prices can also have the following potential problems:
a. Disagreement between organizational unit managers as to how the transfer price
should be set.
b. Additional organizational costs and employee time.
c. The inability to work equally well for all departments or divisions. For example,
service departments that do not provide measurable benefits or cannot show a
distinct cause-and-effect relationship between cost behavior and service use by
other departments should not attempt to use transfer prices.
d. Dysfunctional behavior among organizational units or underutilization or
overutilization of services.
e. Complicated tax planning in multinational companies.

B. Transfer Prices in Multinational Settings

1. The setting of transfer prices for products and services becomes quite difficult when the
company is engaged in multinational operations due to differences in tax systems,
customs duties, freight and insurance costs, import/export regulations, and foreign
exchange controls.
2. The general test of reasonableness is that a transfer price should reflect an arm’s-length
transaction.
3. Multinational enterprises (MNEs) have transfer pricing policies with internal and
external objectives that differ, so there is no simple answer to setting transfer prices.
4. More countries are adopting transfer pricing legislation and, as MNEs begin doing
business in a new country, they must comply with that country’s tax requirements
relative to transfer pricing.

5. Advance pricing agreements (APAs) is a binding contract between a company and one
or more national tax authorities that provides details of how a transfer price is to be set
and establishes that no adjustments or penalties will be made if the agreed-upon
methodology is used.
a. These agreements usually run for three to five years and may be renewed if no
major changes occur.
b. APAs also help eliminate the possibility of double taxation on the exchange of goods
or services.
c. One disadvantage of seeking an APA is that several years typically pass before it
acquires approval from the IRS.

6. Multi-state firms can also employ transfer pricing strategies to move profits from state
to state.
a. Firms can take advantage of not only different income tax rates across states.
b. Firms also can take advantage of the fact that a few states impose no income taxes
at all.

*End of Lesson 6 Lecture Notes*