Transfer Pricing

transfer price - variable cost: the amount of profit or loss that the company incurs from the
transfer of the product from one party to another.

market price - variable cost: the amount of profit or loss that the company incurs from its sale of
the product on the open market.

market price - transfer price: the amount of profit or loss that the company incurs from the
transfer of the product to another party at a negotiated or lower price than the open market price.

To calculate the profit or loss, multiply the difference by the units transferred.

Ex 24.17/18
Ziegler Inc. market price of $1,350 per unit.
Components Division market price of $1,350 per unit.
Instruments Division variable cost of $900 per unit.
transfer price of $1000 per unit
75000 material transferred

- Ziegler Inc.'s how much increase?

market price - variable cost x units transfer

- Instrument Division's how much increase?

market price - transfer price x units transferred.

- Components Division’s income?

transfer price - variable cost x units transferred.

Product cost method of product costing

Cost-plus methods

normal selling price = amount per unit + markup

Product cost method

manufacturing costs (product costs) + Markup (operating ex / desired profit)

normal selling price = product cost + markup per unit

Product cost method of product costing

1. desired profit amount = profit equal % x invested assets

2. product cost per unit = product cost / units
product cost = (direct material + direct labor + variable factory overhead) x units + fixed
factory overhead
3. markup % = (desired profit + variable operating ex per unit x units + fixed operating
ex)/nr2
4. selling price = cost per unit + mark up (cost per unit x markup %)

Total product costing

1. desired profit amount = profit equal % x invested assets
2. product cost per unit = (variable x units + fixed cost) / units
3. mark up %= desired profit / nr 2
4. $ total = $ unit + mark up = $ unit + $unit x nr 3
Variable costing method
1. desired profit amount = profit equal % x invested assets
2. product cost = variable cost x units
3. mark up %= (desired profit + fixed cost) / variable ex
4. $total = $ unit + mark up = $ unit + $unit x nr 3

contribution margin
unit contribution margin = selling – variable

contribution margin rate = (selling – variable)/selling

operating income = sales – variable – fixed – operating ex

Chapter 24 & 25 Evaluating Decentralized Operations & Differential Analyses and Product Pricing

Obj. 1: Describe and illustrate how the market price, negotiated price, and cost price approaches to
transfer pricing may be used by decentralized segments of a business.

Obj. 2: Determine the selling price of a product, using the product cost method.

Transfer Pricing

• The objective of setting a transfer price is to motivate managers to behave in a manner that will
increase the overall company income.

• Transfer prices can be set as low as the variable cost per unit or as high as the market price.

- Often, transfer prices are negotiated at some point between the two.
Market Price Approach

• Using the market price approach, the transfer price is the price at which the product or service
transferred could be sold to outside buyers.

• If an outside market exists for the product or service transferred, the current market price may
be a proper transfer price.

Negotiated Price Approach

• The negotiated price approach allows the managers to agree (negotiate) among themselves on a
transfer price.

• The only constraint is that the transfer price be less than the market price but greater than the
supplying division’s variable costs per unit, as follows:

Variable Costs per Unit < Transfer Price < Market Price

Cost Price Approach

• Under the cost price approach, cost is used to set transfer prices.

• A variety of costs may be used in this approach, including:

- Total product cost per unit

◦ Direct materials, direct labor, and factory overhead are included in the transfer
price.

- Variable product cost per unit

◦ The fixed factory overhead cost is excluded from the transfer price.

• Actual costs or standard (budgeted) costs may be used in applying the cost price approach.

- If actual costs are used, inefficiencies of the producing (supplying) division are
transferred to the purchasing division.
 ◦ Thus, there is little incentive for the producing (supplying) division to control
costs.

• Most companies use standard costs in the cost price approach.

• In this way, differences between actual and standard costs remain with
the producing (supplying) division for cost control purposes.

• The cost price approach is most often used when the responsibility centers are organized as cost
centers.

• When the responsibility centers are organized as profit or investment centers, the cost price
approach is normally not used.

Setting Normal Product Selling Prices

• Managers can use one of two market methods to determine selling price.

- Demand-based method

◦ The demand-based method sets the price according to the demand for the
product.

• If there is high demand for the product, then the price is set high.

• Likewise, if there is low demand for the product, then the price is set
low.

- Competition-based method

◦ The competition-based method sets the price according to the price offered by
competitors.

• For example, if a competitor reduces the price, then management

adjusts the price to meet the competition
Cost-Plus Methods

• Cost-plus methods determine the normal selling price by estimating a cost amount per unit and
adding a markup, computed as follows:

- Management determines the markup based on the desired profit for the product.

- The markup should be sufficient to earn the desired profit plus cover any costs and
expenses that are not included in the cost amount.

Product Cost Method

• The product cost method is applied using the following steps:

- Step 1: Estimate the total product cost as follows:

- Step 2: Estimate the total selling and administrative expenses.

 - Step 3: Divide the total product cost by the number of units expected to be produced
and sold to determine the total product cost per unit, computed as follows:

- Step 4: Compute the markup percentage as follows:

◦ The desired profit is normally computed based on a rate of return on assets as

follows:

- Step 5: Determine the markup per unit by multiplying the markup percentage times the
product cost per unit as follows:

- Step 6: Determine the normal selling price by adding the markup per unit to the product
cost per unit as follows:

Total Cost Method

• The total cost method is applied using the following steps:

- Step 1: Estimate the total manufacturing cost as follows:

- Step 2: Estimate the total selling and administrative expenses.

- Step 3: Estimate the total cost as follows:

- Step 4: Divide the total cost by the number of units expected to be produced and sold to
determine the total cost per unit, as follows:

- Step 5: Compute the markup percentage as follows:

◦ The desired profit is normally computed based on a rate of return on assets as

follows:
 - Step 6: Determine the markup per unit by multiplying the markup percentage times the
total cost per unit as follows:

- Step 7: Determine the normal selling price by adding the markup per unit to the total
cost per unit as follows:

Target Costing Method

• Target costing is a method of setting prices that combines market-based pricing with a cost-
reduction emphasis.

• Under target costing, a future selling price is anticipated, using the demand-based or the
competition-based methods.

• The target cost is then determined by subtracting a desired profit from the expected selling
price, computed as follows:

• Target costing tries to reduce costs.

Variable Cost Method

• The variable cost method is applied using the following steps:

- Step 1: Estimate the total variable product cost as follows:

- Step 2: Estimate the total variable selling and administrative expenses.

- Step 3: Determine the total variable cost as follows:

- Step 4: Compute the variable cost per unit as follows:

- Step 5: Compute the markup percentage as follows:

◦ The desired profit is normally computed based on a rate of return on assets as

follows:

- Step 6: Determine the markup per unit by multiplying the markup percentage times the
variable cost per unit as follows:
 - Step 7: Determine the normal selling price by adding the markup per unit to the variable
cost per unit as follows:

Target Costing Method

• The target cost is normally less than the current cost.

• Managers must try to reduce costs from the design and manufacture of the product.

- The planned cost reduction is sometimes referred to as the cost drift.

- Costs can be reduced in a variety of ways such as the following:

◦ Simplifying the design

◦ Reducing the cost of direct materials

◦ Reducing the direct labor costs

◦ Eliminating waste