Accounting, Strategy and Control

FAST National University

April 15, 2020

MBA (Morning and Evening)
Syed Kashif Saeed, PhD ACMA
Transfer Pricing
The price that is assumed to have been charged
by one part of the company for products and
services it provides to another part of the
company, in order to calculate each division’s
profit and loss separately. (i.e. Responsibility
Accounting)
Parent
Co.

Subsidiar Subsidiar Subsidiar

yA yB yC
Transfer Pricing
One
Company

Deptt A Deptt B Deptt C

Transfer Pricing
Aim:
Profits for each division
Autonomy
Goal congruence to maximize group and divisional
profits

Required for:
Accountability
Performance measurement
Transfer Pricing
Transfer pricing refers to establishing arm’s
length prices charged or paid upon the transfer
of physical goods and intangible property or
supply of services in transactions undertaken
between associated enterprises located in the
same or different tax jurisdictions.

Transfer Pricing is different than selling Prices.

Transfer Pricing
In case of Transfer price, we can say change of
location of goods within same business, hence
profit element in the transfer prices cannot be
realized in the hands of company.

Transfer price becomes revenue for the supplying

division and cost for the receiving division.

Transfer price is a notional price.

Transfer Pricing
Transfer prices and Transfer Pricing are neutral terms. To
regard them as describing solely mal-practices is
inappropriate / unhelpful. The assumption that the ‘transfer
prices’ charged in the intra-group transactions are necessarily
a device to divert profits to non-resident affiliates to avoid
taxation in purchaser’s country is a biased/inaccurate view of
the matter

Transfer prices in case of intra-group transactions, include

payments for intra-group services and intra-Group transfers
of technology e.g. in the pharmaceutical industry, such
payments are largely subsumed into the transfer prices for
drugs.
Transfer Pricing
Division A produces goods and transfer them to
Division B which packs and sells them to outside
customers. Division A has cost of $10 per unit,
and Division B has additional cost of $4 per unit.
Division B sells goods to external customers at
price of $20 per unit.

How to do it?
TP will be a price on which both parties
agree….
Transfer Pricing
Division A produces goods and transfer them to Division B
which packs and sells them to outside customers. Division
A has cost of $15 per unit, and Division B has additional
cost of $5 per unit.
Division B sells goods to external customers at price of $30
per unit. The Company has policy of setting transfer prices
at cost+20%.

Calculate:
1. The transfer price
2. Profit made by company overall
3. Profit made by each division
Transfer Pricing

Division A Division B
Transfer Price - 18
Cost incurred 15 5
Total Cost 15 23
Profit 3 7
Price Charged by the division 18 30
Transfer Pricing Methods
A. Pricing based on Cost
1. Actual Cost (FC+VC)
2. Cost plus (TC+Profit)
3. Standard Cost
4. Marginal Cost
B. Market prices as transfer price

C. Negotiated Pricing

D. Pricing based on Opportunity cost

Transfer Pricing Methods
Actual Cost:
Under this method, the actual cost of
production is taken as transfer price for inter-
divisional transfers.
Such actual cost may consist of variable cost or
sometimes total costs including fixed costs.
Transfer Pricing Methods
Cost plus:
Under this method, transfer price is fixed by
adding a reasonable return on capital employed
to the total cost. (Recall the idea of Residual
Income concept)
Thereby the measurement of profit becomes
easy.
Transfer Pricing Methods
Standard Cost :
Under this method, transfer price is fixed on the
basis of standard cost
The difference between the standard cost and
the actual cost being variance is absorbed by
transferring division.
This method is simple and easy to follow.
However the constant revision of standards is
necessary at regular interval.
Transfer Pricing Methods
Marginal Cost :
Under this method, transfer price is determined
on the basis of marginal cost
The reason being fixed cost is in any way
unavoidable and hence should not be charged
to the buying division.
That is why only marginal cost will be taken as
transfer price.
Transfer Pricing Methods
Market based transfer pricing :
When the outside market for the good is well
define, competitive and stable, then firm can
use market price as an upper bound for the
transfer price.
Negotiated Pricing

Pricing based on Opportunity cost

Question
Solution:
1-Transfer Price based on Marginal cost

Transfer Price (TP) = Rs 4 =

Less: Cost = Rs 4
Profit per unit = Rs 0

Increase in Profit = 0 x 2000 * 25 wk =0

There is no increase in profit of Transferor
Ltd.
Solution:
2-Transfer Price based on Marginal cost+25%

Transfer Price (TP) = Rs 4+ 25% of Rs 4

= Rs 4+1 = 5
Less: Cost = Rs 4
Profit per unit = Rs 1

Increase in Profit = 1 x 2000 * 25 wk

= Rs 50,000
Solution:
3-Transfer Price based on Marginal cost+15% RoCE

Transfer Price (TP) = Rs 4+ ((2000,000*15%)/2)/50,000

= Rs 4+3 = 7
Less: Cost = Rs 4
Profit per unit = Rs 3

Increase in Profit = 3 x 2000 * 25 wk

= Rs 150,000
Solution:
4-Transfer Price based on Existing Cost

Transfer Price (TP) = Rs 8

Less: Cost = Rs 4
Profit per unit = Rs 4

Increase in Profit = 4 x 2000 * 25 wk

= Rs 200,000
Solution:
5-Transfer Price based on Existing Cost plus

Transfer Price (TP) = Rs 8 + Profit

= Rs 8 + (8/12)*4 =10.67
Less: Cost = Rs 4
Profit per unit = Rs 6.67

Increase in Profit = 6.67 x 2000 * 25 wk

= Rs 333,500
Solution:
6-Transfer Price based on Market Price

Transfer Price (TP) = Rs 8.50

Less: Cost = Rs 4
Profit per unit = Rs 4.50

Increase in Profit = 4.50 x 2000 * 25 wk

= Rs 225,000
Academic Application: Dual Transfer Pricing System
Problem 1:
Tomato beetles, a major pest to the tomato crop, are now
being controlled by toxic pesticides. The firm BioScience
invested $5 million in R&D over the last five years to
produce a genetically engineered, patented microbe, MK-
23, which controls tomato beetles in an environmentally
safe way. BioScience built a plant with capacity to produce
10,000 pounds of MK-23 per month. The plant cost $12
million and has a 10-year life. MK-23 has a variable cost of
$3 per pound. Fixed costs are $50,000 per month for such
costs as plant management, insurance, taxes, and security.
Plant depreciation is not included in the $50,000 fixed cost.
MK-23 is sold for $30 per pound. BioScience is currently
selling 8,000 pounds per month to tomato farmers.
Problem 1: Contd…
Another division of BioScience, Home Life, wants to secure 1,000
pounds per month of MK-23 that it will process further into a
consumer product, Tomato Safe, for gardeners. Home Life is willing to
pay an internal transfer price of $5 per pound. Home Life will incur an
additional $4 of variable cost per pound of MK-23 in packaging and
reducing the potency of MK-23 to make Tomato Safe more
appropriate for home gardeners. Tomato Safe will sell for $20 per
pound of MK-23.
Problem 1: Contd…
Required:
a) Should the internal transfer be allowed?
b) What happens if the transfer price is set at full cost, $18? What
happens if the transfer price is set at variable cost, $3?
c) After deciding to use variable cost as the transfer price, new farm
orders for 2,000 pounds of MK-23 at $30 per pound per month are
received. Suppose plants come only in fixed sizes of 10,000-pound
capacities of $12 million each. Analyze the various options facing
BioScience.
d) What is the opportunity cost of the excess capacity prior to
producing MK-23 for Tomato Safe?
e) What happened to the $5 million R&D costs incurred to invent
MK-23?
Problem 1: Solution
a) Should the internal transfer be allowed?
The following table indicates that BioScience generates incremental
cash flow of $13 for every pound of MK-23 it transfers to Home Life
to be converted to Tomato Safe, assuming it does not forgo selling
this pound of MK-23 directly to farmers for $30 per pound.

Clearly, if BioScience has excess capacity of 2,000 pounds of MK-23

production per month, then transferring 1,000 pounds of MK-23
enhances overall firm profits.
Problem 1: Solution
b) What happens if the transfer price is set at full cost, $18?
What happens if the transfer price is set at variable cost, $3?

If a full-cost transfer price of $18 per pound is charged for MK-23,

Home Life will not accept the transfer because its total cost of $22
($18 transfer price plus $4 for further processing) is above the
market price of $20. If the firm has unused capacity, then
transferring at full cost causes it to forgo selling Tomato Safe and
receiving $13 per pound for its unused capacity. Transferring at
variable cost ($3) allows Tomato Safe to be produced. In the case
where the firm has unused excess capacity, full-cost transfer pricing
leads to the wrong decision.
If variable-cost transfer pricing is used, each month 1,000 pounds of
MK-23 are transferred to Home Life.
Problem 1: Solution
c) After deciding to use variable cost as the transfer price, new
farm orders for 2,000 pounds of MK-23 at $30 per pound per
month are received. Suppose plants come only in fixed sizes
of 10,000-pound capacities of $12 million each. Analyze the
various options facing BioScience.
Problem 1: Solution
Problem 1: Solution
d) What is the opportunity cost of the excess capacity prior to
producing MK-23 for Tomato Safe?

Prior to accepting the internal transfer of MK-23 to produce Tomato Safe,

BioScience has 2,000 pounds of unused capacity. If the demand for MK-23
is growing, then either consuming this capacity with an internal transfer
causes the firm to forgo the contribution margin on lost sales of MK-23 or
else the firm has to add capacity. The decision to permanently consume
fixed capacity should not be based on the short-run incremental cost of
the transfer unless it is highly likely that the internal transfer is the only
long-run use of the unused capacity. Full-cost transfer pricing includes an
estimate of the cost of adding capacity and reveals the past (historical)
cost of a unit of capacity. A new unit of capacity will cost more than
historical cost if there has been construction cost inflation. However, a
unit of capacity can cost less than the historic cost if adding a second
plant creates productivity enhancements or synergies.
Problem 1: Solution
e) What happened to the $5 million R&D costs incurred to invent
MK-23?

These R & D costs were not included in the manufacturing costs of

MK-23. The accounting system writes these costs off when
incurred. The firm has an unrecorded but real economic asset, the
patent on MK-23. The profit of $12 per pound of MK-23 ($30 - $18)
represents the firm’s return on this investment.