Transfer Pricing

22 - 1©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Management Control Systems,Transfer Pricing, and

Multinational Considerations

Management Control Systems,Transfer Pricing, and

Multinational Considerations

Chapter 22


Learning Objective 1Learning Objective 1

Describe a management

control system and its

three key properties.


Management Control SystemsManagement Control Systems

A management control system is a meansof gathering and using information.

It guides the behavior of managers and employees.


Management Control SystemsManagement Control Systems

Financial data

Formal control system

Nonfinancial data

Informal control system


Evaluating ManagementControl Systems

Evaluating ManagementControl Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary Nonmonetary



Describe the benefits and

costs of decentralization.


Organization StructureOrganization Structure

Total decentralization

Total centralization


Benefits of DecentralizationBenefits of Decentralization

Creates greater responsiveness to local needs

Leads to gains from quicker decision making

Increases motivation of subunit managers

Assists management development and learning

Sharpens the focus of subunit managers


Costs of DecentralizationCosts of Decentralization

Suboptimal decision making may occur

Focuses the manager’s attention on the subunitrather than the organization as a whole

Increases the costs of gathering information

Results in duplication of activities


Decentralization inMultinational Companies

Decentralization inMultinational Companies

Decentralization enables country managers tomake decisions that exploit their knowledge

of local business and political conditions.

Multinational corporations often rotatemanagers between foreign locations

and corporate headquarters.


Responsibility CentersResponsibility Centers

Costcenter

Revenuecenter

Investmentcenter

Profitcenter



Explain transfer prices and four

criteria used to evaluate them.


Transfer PricingTransfer Pricing

A transfer price is the price one subunit chargesfor a product or service supplied to another

subunit of the same organization.

Intermediate products are the productstransferred between subunits of an organization.


Transfer PricingTransfer Pricing

Transfer pricing should help achievea company’s strategies and goals.

– fit the organization’s structure

– promote goal congruence

– promote a sustained high levelof management effort



Calculate transfer prices using

three different methods.


Transfer-Pricing MethodsTransfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices


Transfer-PricingMethods ExampleTransfer-Pricing

Methods Example

Lomas & Co. has two divisions:Transportation and Refining.

Transportation purchasescrude oil in Alaska and

sends it to Seattle.

Refining processescrude oil

into gasoline.



Methods Example

External market price for supplyingcrude oil per barrel: $13

Transportation Division:Variable cost per barrel of crude oil $ 2Fixed cost per barrel of crude oil 3Total $ 5

The pipeline can carry 35,000 barrels per day.



Methods Example

External purchase price forcrude oil per barrel: $23

Refining Division:Variable cost per barrel of gasoline $ 8Fixed cost per barrel of gasoline 4Total $12

The division is buying 20,000 barrels per day.



Methods Example

The external market price to outsideparties is $60 per barrel.

The Refining Division is operatingat 30,000 barrels capacity per day.



Methods Example

What is the market-based transfer pricefrom Transportation to Refining?

$23 per barrel

What is the cost-based transfer priceat 112% of full costs?



Methods Example

Purchase price of crude oil $13Variable costs per barrel of crude oil 2Fixed costs per barrel of crude oil 3Total $18

1.12 × $18 = $20.16

What is the negotiated price?

Between $20.16 and $23.00 per barrel.



Methods Example

Assume that the Refining Division buys1,000 barrels of crude oil from the

Transportation Division.

The Refining Division converts these 1,000barrels of crude oil into 500 gallons of

gasoline and sells them.

What is the Transportation Division operatingincome using the market-based price?



Methods Example

Transportation Division:Revenues: ($23 × 1,000) $23,000Deduct costs: ($18 × 1,000) 18,000Operating income $ 5,000

What is the Refining Division’s operatingincome using the market-based price?



Methods Example

Refining Division:Revenues: ($60 × 500) $30,000Deduct costs:

Transferred-in ($23 × 1,000) 23,000Division variable ($8 × 500) 4,000Division fixed ($4 × 500) 2,000

Operating income $ 1,000



Methods Example

What is the operating income of bothdivisions together?

Transportation Division $5,000Refining Division 1,000Total $6,000



Methods Example

What is the Transportation Division’s operatingincome using the 112% of full cost price?

Transportation Division:Revenues: ($20.16 × 1,000) $20,160Deduct costs: ($18.00 × 1,000) 18,000Operating income $ 2,160

What is the Refining Division operatingincome using the full cost price?



Methods Example

Refining Division:Revenues ($60 × 500) $30,000Deduct costs:

Transferred-in ($20.16 × 1,000) 20,160Division variable ($8.00 × 500) 4,000Division fixed ($4.00 × 500) 2,000

Operating income $ 3,840



Methods Example

What is the operating income of bothdivisions together?

Transportation Division $2,160Refining Division 3,840Total $6,000



Illustrate how market-based

transfer prices promote goal

congruence in perfectly

competitive markets.


Market-Based Transfer PricesMarket-Based Transfer Prices

By using market-based transfer pricesin a perfectly competitive market, acompany can achieve the following:

Goal congruence

Management effort

Subunit performance evaluation

Subunit autonomy



Market prices also serve to evaluate theeconomic viability and profitability

of divisions individually.



When supply outstrips demand, market pricesmay drop well below their historical average.

Distress prices are the drop in pricesexpected to be temporary.



Avoid making suboptimal

decisions when transfer

prices are based on full

cost plus a markup.


Cost-Based TransferPrices Example


The Refining Division of Lomas & Co. ispurchasing crude oil locally for $23 a barrel.

The Refining Division located an independentproducer in Alaska that is willing to sell 20,000

barrels of crude oil per day at $17 per barreldelivered to the pipeline (Transportation Division).




The Transportation Division has excesscapacity and can transport the crude oil

at its variable costs of $2 per barrel.

Should Lomas purchase from theindependent supplier?

Yes.

There is a reduction in total costs of $80,000.




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




Alternative 2:Buy 20,000 barrels from the independentsupplier in Alaska at $17 per barrel andtransport it to Seattle at $2 per barrel.

The total cost to Lomas is:20,000 × $19 = $380,000




Suppose the Transportation Division’stransfer price to the Refining Division

is 112% of full cost.

What is the cost to the Refining Division?




Purchase price of crude oil $17Variable costs per barrel of crude oil 2Fixed costs per barrel of crude oil 3Total $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 canpay in the local external market ($23).

What is the minimum transfer price?

The minimum transfer price is $19 per barrel.



Understand the range over

which two divisions negotiate

the transfer price when

there is unused capacity.


ProratingProrating

Lomas & Co. may choose a transfer pricethat splits on some equitable basis the

difference between the maximum transferprice and the minimum transfer price.

$23 – $19 = $4

Suppose that variable costs are chosen asthe basis to allocate this $4 difference.


ProratingProrating

The Transportation Division’s variablecosts are $2 × 1,000 = $2,000.

The Refining Division’s variable costs torefine 1,000 of crude oil into 500 barrels

of gasoline are $8 × 500 = $4,000.


ProratingProrating

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 theTransportation Division?

$17.00 + $2.00 + $1.33 = $20.33


Dual PricingDual Pricing

An example of dual pricing is for Lomas & Co.to credit the Transportation Division with

112% of the full cost transfer price of $24.64per barrel of crude oil.

Debit the Refining Division with the market-basedtransfer price of $23 per barrel of crude oil.


Negotiated Transfer PricesNegotiated Transfer Prices

Negotiated transfer prices arise from theoutcome of a bargaining process between

selling and buying divisions.



Construct a general guideline

for determining a minimum

transfer price.


Comparison of MethodsComparison of Methods

Achieves Goal Congruence

Market Price: Yes, if markets competitive

Cost-Based: Often, but not always

Negotiated: Yes



Useful for Evaluating Subunit Performance


Cost-Based:Difficult, unless transferprice exceeds full cost

Negotiated: Yes



Motivates Management Effort

Market Price: Yes

Cost-Based:Yes, if based on budgetedcosts; less incentive ifbased on actual cost

Negotiated: Yes



Preserves Subunit Autonomy


Cost-Based: No, it is rule based

Negotiated: Yes



Other Factors

Market Price: No market may exist

Cost-Based:Useful for determiningfull-cost; easy to implement

Negotiated:Bargaining takes time andmay need to be reviewed


General GuidelineGeneral Guideline

Minimum transfer price= Incremental costs per unit incurred

up to the point of transfer+ Opportunity costs per unit to the selling division



Assume a perfectly competitive market,with no idle capacity.

Transportation Division can sell all the crude oilit transports to the external market in Seattle

for $23 per barrel.


($19 + $4) or ($13 + $2 + $8) = $23 = Market price



Assume that an intermediate market existsthat is not perfectly competitive, and the

selling division has idle capacity.

If the Transportation Division has idlecapacity, its opportunity cost of transferring

the oil internally is zero.




It would be $15 per barrel for oil purchasedunder the long-term contract, or...

$19 per barrel for oil purchased andtransported from the independent

supplier in Alaska.



Incorporate income tax

considerations in

multinational

transfer pricing.


Multinational Transfer PricingMultinational Transfer Pricing

IRC Section 482 requires that transfer prices forboth tangible and intangible property between acompany and its foreign division be set to equalthe price that would be charged by an unrelated

third party in a comparable transaction.


End of Chapter 22End of Chapter 22

Transfer Pricing

Documents

cost accounting

variable cost

barrel of gasoline fixed

barrel of crude oil

knowledge of local business

barrel of crude oil

barrel of gasoline total

management development