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2021 SCM S16 Transfer Pricing
2021 SCM S16 Transfer Pricing
Cost Management
SESSIONS: 16
MANAGEMENT LEVEL CONTROL:
STRATEGIC PERFORMANCE
MEASUREMENT
‐ TRANSFER PRICING
Learning Goals
Explain the basic concepts and general principle of transfer
pricing
Describe the advantages and disadvantages of various transfer
pricing alternatives
Understand important international issues that arise in transfer
pricing
References:
BSJS Chapter 19
Problems: 19‐52,53, 54 Add: 19‐49, 51
Cases : Birch Paper
HDR Chapter 22
Transfer Pricing
3
Transfer Pricing
Transfer price: Price charged when one division (subunit) provides goods or services to another
division (subunit) of the same company.
Or, Price one subunit charges for a product or service supplied to another subunit of the same
organization.
Objective :
• To promote goal congruence,
• To motivate high level of management effort,
• To facilitate performance evaluation of subunits, and
• To promote high degree of subunit autonomy in decisions
Optimal Transfer Price : leads division managers to make decisions in the best interests of the
company as a whole
Three Primary Approaches:
1. Negotiated Transfer Price
2. Market based Transfer Price
3. Cost based Transfer Price
4
Negotiated Price
Results from discussions between the selling and buying divisions
Advantages: Disadvantages:
• Preserve the autonomy of the divisions – consistent • Compromise between buyer and seller
with decentralisation theory • Non‐cooperative atmosphere if managers
• Managers negotiating are likely to have much better pitted against each other ‐ dysfunctional
information about the potential costs & benefits of • Disputes and Appeals costly arbitrations
transfer – most practical when significant conflict • Might not be considered arm’s length
exists
Acceptable Range ‐ within which the profits of both divisions increase
– Min TP: Lower limit (lowest acceptable price) determined by seller
– Max TP: Upper limit (Highest acceptable price) is determined by buyer
Minimum Transfer Price (seller would be willing to sell at)
= Incremental cost per unit up to the point of transfer
+ Opportunity cost per unit to the selling unit
Often boils down to:
Total contribution margin of lost sales Range of Acceptable Transfer Prices
Transfer price Variable cost +
Total number of units transferred Upper limit is
determined by the
buying division.
Maximum Transfer Price (buyer would be willing to pay)
Transfer price ≤ Cost of buying from outside supplier Lower limit is
determined by the
5
Multinationals use transfer pricing to minimize their taxes selling division.
Negotiated Price – Acceptable Range
1. A transfer makes sense from the standpoint of the company if:
• Here, profits of both divisions will increase if
Variable + Total contribution margin of lost sales Transfer Cost of purchasing
cost Total number of units transferred price from outside supplier
• Here, it is impossible to satisfy both the selling division and the buying
division
6
Market based transfer price
Market Price – the price charged in the open market
Often regarded as the best transfer price
Works best
– When the item being transferred has an active, perfectly competitive outside market
– Seller division has no idle capacity
– The interdependencies of subunits are minimal
– 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.
Advantages ‐
– Helps preserve subunit autonomy
– Provide for the selling unit to be competitive with outside suppliers
– Has arm’s‐length standard desired by international taxing authorities
Disadvantages
Might lead to suboptimal decision by buyer if selling division has idle capacity ‐ Can lead to
short‐term sub‐optimization
Often intermediate products have no market price
Should be adjusted for cost savings such as reduced selling costs, no commissions, etc.
7
Cost based transfer price
Should be used only when
– market prices are not available, or too costly to obtain such as when markets are not
perfectly competitive, or
– When internal product is different from the products available externally
Transfer Price can be based on:
Variable Cost or, Full cost (absorption costing) + markup if any
Advantages:
– Easy to understood & implement; convenient & less costly to use; Negotiation not needed
– VC: Relatively low transfer price encourages buying internally (the correct decision from
the overall firm’s standpoint when there is excess capacity)
Disadvantages:
1. Suboptimal decision ‐ Includes irrelevant fixed costs, Ignores Opportunity Costs
• on Full cost (Includes irrelevant fixed costs, how are indirect costs allocated)
• on Variable Cost (if no idle capacity‐Ignores Opportunity costs from lost sales)
2. Unfair to Selling Division‐ No selling division other than the one making final sales will
show profits
3. No cost control incentive unless standards costs are used 8
Other Methods ‐ Hybrid
• Two step Pricing
– VC per unit * Units transferred
+ Fixed cost charged periodically for capacity reserved by selling division to cater to
buying division needs
(5*2000 +10,000 =20,000)
– Challenge : Estimating the demand of buying division
• Profit Sharing Method
– Total contribution is distributed among the division on pro‐rata basis
– Challenge: Distribution of contribution – Fairness, Intervention
• Dual Pricing Method
Firms can use two or more methods, called dual pricing, one method for the buying unit
and a different one for the selling unit
– Selling division credited at market price (selling division receives full cost pricing)
– Buying division charged at standard cost (buying division pays market pricing)
– Difference between transfer price charged to corporate account
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Example: Transfer Pricing
Imperial Beverages:
Ginger beer production capactiy per month 10,000 barrels
Variable cost per barrel of ginger beer £8 per barrel
Fixed costs per month £70,000
Selling price of Imperial Beverages ginger beer
on the outside market £20 per barrel
Pizza Maven:
Purchase price of regular brand of ginger beer £18 per barrel
Monthly comsumption of ginger beer 2,000 barrels
The selling division’s (Imperial Beverages) lowest acceptable transfer price is:
Variable cost Total contribution margin on lost sales
Transfer Price +
per unit Number of units transferred
The buying division’s (Pizza Maven) highest acceptable transfer price is:
Transfer Price Cost of buying from outside supplier
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A) If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfy Pizza
Maven’s demands (2,000 barrels), without sacrificing sales to other customers, then the
lowest and highest possible transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
£0 Therefore, the range of
Transfer Price £8 + = £8
2,000 acceptable transfer price
is £8 – £18.
Buying division’s highest possible transfer price:
Transfer Price Cost of buying from outside supplier = £18
B) If Imperial Beverages has no idle capacity (0 barrels) and must sacrifice other
customer orders (2,000 barrels) to meet Pizza Maven’s demands (2,000 barrels), then the
lowest and highest possible transfer prices are computed as follows:
Therefore, there
Selling division’s lowest possible transfer price:
is no range of
( £20 - £8) × 2,000
Transfer Price £8 + = £20 acceptable
2,000 transfer prices.
Buying division’s highest possible transfer price:
Transfer Price Cost of buying from outside supplier = £18
Example: Transfer Pricing
C) If Imperial Beverages has some idle capacity (1,000 barrels) and must sacrifice other
customer orders (1,000 barrels) to meet Pizza Maven’s demands (2,000 barrels), then the
lowest and highest possible transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
NO Buy Inside
Is there an outside
@ Cost/ Negotiated price
supplier?
Is the seller’s variable NO Buy from outside,
YES cost (VC) <
No Transfer Price
Market price (MP)?
General Transfer Pricing Rule:
NO Cost savings of NO Buy from outside,
Minimum Transfer Price = internal buyer > No Transfer Price
Incremental (i.e., out‐of‐pocket) cost Cost of lost sales to
of the producing division + the seller division
opportunity cost to the organization
as a whole, if any, for an internal YES Buy Inside @ Market Price
transfer 13
Transfer Pricing Another Example (from Text) : High Value Computer (HVC)
x‐chip unit is at full capacity (150,000 units)
Bought from outside seller @ $85
Sold to outside VC to make it compatible $5
purchaser @ $95
TP, if bought
Internal Division
Internal Division internally ? (computer manufacturing Final
(x‐chip unit – seller) unit [CMU]‐ buyer) SP=
$850 Consumer
Variable Mfg cost $60 Variable Mfg cost (other
Variable Selling cost $ 2 than x‐chip) $650 Whether CMU should buy internally from x‐chip unit ?
Option 1: X‐Chip Unit Sells to Outside Supplier
x‐chip unit Computer manufacturing unit Total
1. Is there an outside supplier?
• Yes , so we must compare the inside seller’s variable costs ($60) to the outside
seller’s price or Market Price ($85+$5)
2. Is the seller’s variable cost less than the market price?
• Yes, so we must consider the utilization of capacity in the inside selling unit
3. Does the selling unit have excess capacity ?
• No, so we must consider the contribution of the selling unit’s outside sales
(lost if transferred internlly) ($4,950) relative to the savings from selling inside
($21,000‐16,500= $4,500)
• Again, for HVC, the contribution lost of the selling unit’s outside sales is $33
(=95‐62) per unit, which is higher than the savings of selling inside i.e. $30
(=90‐60),
– so from the standpoint of the company as a whole, the selling unit
should choose outside sales (Option 1) and make no internal transfers
Minimum Transfer Price = Incremental (i.e., out‐of‐pocket) cost of the producing division +
opportunity cost to the organization as a whole, if any, for an internal transfer
= $60 + (95 ‐ 6233) = $93
So, Manufacturing unit will be willing to buy externally at $90. HVC as a whole will generate a
higher contribution $21,450 (option1) vs. 21,000 (option 2)
15
HVC Unit and Total Operating Income (000s omitted) Under Alternative Transfer Prices
Internal Transfer
TRANSFER PRICING TRANSFER PRICING
TRANSFER PRICING OPTIONS:
Volume = 150,000 units OPTIONS: Market Price OPTIONS: Variable Cost
Negotiated Price ($72.50/unit)
($85.00/unit) ($60.00/unit)
Revenues
$ 12,750 $ 9,000 $ 10,875
Costs:
Variable costs ($60/unit)
Revenues ($850/unit)
Transfer Pricing
Objectives
Domestic International
•Greater divisional autonomy • Less taxes, duties, and tariffs
•Greater motivation for managers • Less foreign exchange risks
•Better performance evaluation • Better competitive position
•Better goal congruence • Better governmental relations
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Source: HDR
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