Transfer Pricing Rectified

8/6/2019 Transfer Pricing Rectified

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22 - 12003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Transfer Pricing, and

Multinational Considerations


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Meaning of Transfer PricingMeaning of Transfer Pricing

A transfer price is the price one subunit charges

for a product or service supplied to anothersubunit of the same organization.

Intermediate products are the products

transferred between subunits of an organization.


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Objectives of Transfer PricingObjectives of Transfer Pricing

Help achieve a companys strategies and goals.

Foster Commercial attitude. Optimizing the profit of the Company.

Optimum use of Companys financial resources.

Evaluation of divisions performance.

Motivation to divisional Manager. Minimizing Tax Burden.


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Cost-Based Transfer

Prices

Cost-Based Transfer

PricesCost-based transfer pricing is a

method of setting prices when goodsare sold to divisions within the same

company.


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Cost-Based Transfer Pricing

Methods

Cost-Based Transfer Pricing

MethodsCost of Production Method Marginal Cost Method

Standard Cost Method

Cost of Sale Method

Cost plus normal mark-up

Opportunity cost Method


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Cost-Based Transfer

Prices Example

Cost-Based Transfer

Prices Example

The Refining Division of Lomas & Co. is

purchasing crude oil locally for $23 a barrel.

The Refining Division located an independent

producer in Alaska that is willing to sell 20,000

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


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Marginal Cost MethodMarginal Cost Method

Pricing is equal to Variable Cost.

Overall profitability of the company is the

main objective.

Used when capacity of selling unit is idle.

It leads to full utilization of Capacity.


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Cost-Based Transfer

Prices Example

Cost-Based Transfer

Prices Example

The Transportation Division has excess

capacity and can transport the crude oilat its variable costs of $2 per barrel.

Should Lomas purchase from the

independent supplier?

Yes.

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


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Standard CostStandard Cost It is pre-determined price.

Variance absorbed by the supplying unit.

Responsibility of performance is

centralized.

Profit performance of each unit cannot be

measured.


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Cost of SaleCost of Sale It is full cost.

It include all expenses.

Selling divisions Manager responsible for

profit

Measurement of divisional performance is

not possible.


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Cost plus a normal mark-upCost plus a normal mark-up Unit cost of production +some profit

margin.

Assumption supplying division selling to

outsiders & insiders.

Measurement of profit performance of each

unit.


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Opportunity CostOpportunity Cost It is maximum contribution forgone by the

suplying division.

Price equal to market value is treated as

opportunity Cost.

Opportunity cost is useful when evaluating

the cost and benefit of choices.

process of choosing one good or service

over another


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Cost-Based Transfer

Prices Example

Cost-Based Transfer

Prices Example

Alternative 1:

Buy 20,000 barrels from thelocal supplier at $23 per barrel.

The total cost to Lomas is:

20,000 $23 = $460,000


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Cost-Based Transfer

Prices Example

Cost-Based Transfer

Prices Example

Alternative 2:

Buy 20,000 barrels from the independentsupplier in Alaska at $17 per barrel and

transport it to Seattle at $2 per barrel.

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


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Cost-Based Transfer

Prices Example

Cost-Based Transfer

Prices Example

Suppose the Transportation Divisions

transfer price to the Refining Divisionis 112% of full cost.

What is the cost to the Refining Division?


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Cost-Based Transfer

Prices Example

Cost-Based Transfer

Prices Example

Purchase price of crude oil $17

Variable costs per barrel of crude oil 2Fixed costs per barrel of crude oil 3

Total $22

1.12 $22 = $24.64$24.64 20,000 = $492,800


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Cost-Based Transfer

Prices Example

Cost-Based Transfer

Prices Example

What is the maximum transfer price?

It is the price that the Refining Division can

pay in the local external market ($23).

What is the minimum transfer price?

The minimum transfer price is $19 per barrel.


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

Lomas & Co. has two divisions:

Transportation and Refining.

Transportation purchases

crude oil in Alaska and

sends it to Seattle.

Refining processes

crude oil

into gasoline.


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

External market price for supplying

crude oil per barrel: $13Transportation Division:

Variable cost per barrel of crude oil $ 2

Fixed cost per barrel of crude oil 3

Total $ 5

The pipeline can carry 35,000 barrels per day.


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Contribution based transfer pricesContribution based transfer prices

Determination of total contribution margin

earned after product sold externally.

Used when market price of a product is not

available.

Use of internal information for

determination of transfer price.

Used where several divisions contribute

work.


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Market based transfer pricingMarket based transfer pricing Determined by the forces of demand &

supply.

Profit will provide a good indicator of the

overall efficiency of the operating unit.

Allows both buying & selling division to

buy & sell their products anywhere theywant.


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Negotiated Transfer PricesNegotiated Transfer Prices

Negotiated transfer prices arise from the

outcome of a bargaining process betweenselling and buying divisions.


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Dual PricingDual Pricing Making use of two transfer prices.

Used to make a decision in one case &

performance evaluation in other case.

Used when there is conflict in interest of

buying profit centre & selling profit centre.


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Transfer-Pricing MethodsTransfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

External purchase price for

crude oil per barrel: $23Refining Division:

Variable cost per barrel of gasoline $ 8

Fixed cost per barrel of gasoline 4

Total $12

The division is buying 20,000 barrels per day.


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

The external market price to outside

parties is $60 per barrel.The Refining Division is operating

at 30,000 barrels capacity per day.


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

What is the market-based transfer price

from Transportation to Refining?

$23 per barrel

What is the cost-based transfer price

at 112% of full costs?


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

Purchase price of crude oil $13

Variable costs per barrel of crude oil 2Fixed costs per barrel of crude oil 3

Total $18

1.12 $18 = $20.16

What is the negotiated price?

Between $20.16 and $23.00 per barrel.


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods ExampleAssume that the Refining Division buys

1,000 barrels of crude oil from the

Transportation Division.

The Refining Division converts these 1,000

barrels of crude oil into 500 gallons of

gasoline and sells them.What is the Transportation Division operating

income using the market-based price?


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

Refining Division:

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

Transferred-in ($23 1,000) 23,000

Division variable ($8

500) 4,000Division fixed ($4 500) 2,000

Operating income $ 1,000


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

What is the operating income of both

divisions together?Transportation Division $5,000

Refining Division 1,000

Total $6,000


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods ExampleWhat is the Transportation Divisions operating

income using the 112% of full cost price?

Transportation Division:

Revenues: ($20.16 1,000) $20,160

Deduct costs: ($18.00 1,000) 18,000


What is the Refining Division operating

income using the full cost price?


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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

Refining Division:

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

Transferred-in ($20.16 1,000) 20,160

Division variable ($8.00

500) 4,000Division fixed ($4.00 500) 2,000



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Transfer-Pricing

Methods Example

Transfer-Pricing

Methods Example

What is the operating income of both

divisions together?Transportation Division $2,160

Refining Division 3,840

Total $6,000


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Learning Objective 5Learning Objective 5

Illustrate how market-based

transfer prices promote goal

congruence in perfectly

competitive markets.


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Market-Based Transfer PricesMarket-Based Transfer Prices

By using market-based transfer prices

in a perfectly competitive market, acompany can achieve the following:

Goal congruence

Management effortSubunit performance evaluation

Subunit autonomy


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Market prices also serve to evaluate the

economic viability and profitabilityof divisions individually.


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When supply outstrips demand, market prices

may drop well below their historical average.Distress prices are the drop in prices

expected to be temporary.


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Learning Objective 6Learning Objective 6

Avoid making suboptimal

decisions when transfer

prices are based on full

cost plus a markup.


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ProratingProrating

Lomas & Co. may choose a transfer price

that splits on some equitable basis thedifference between the maximum transfer

price and the minimum transfer price.

$23 $19 = $4Suppose that variable costs are chosen as

the basis to allocate this $4 difference.


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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


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Dual PricingDual Pricing

An example of dual pricing is for Lomas & Co.

to credit the Transportation Division with112% of the full cost transfer price of $24.64

per barrel of crude oil.

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


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Negotiated Transfer PricesNegotiated Transfer Prices

Negotiated transfer prices arise from the

outcome of a bargaining process betweenselling and buying divisions.


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Learning Objective 8


Construct a general guideline

for determining a minimum

transfer price.


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Comparison of MethodsComparison of Methods

Achieves Goal Congruence

Market Price: Yes, if markets competitive

Cost-Based: Often, but not always

Negotiated: Yes


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Useful for Evaluating Subunit Performance


Cost-Based:Difficult, unless transfer

price exceeds full cost

Negotiated: Yes


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Motivates Management Effort

Market Price: Yes

Cost-Based:

Yes, if based on budgeted

costs; less incentive if

based on actual cost

Negotiated: Yes


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Preserves Subunit Autonomy


Cost-Based: No, it is rule based

Negotiated: Yes


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Other Factors

Market Price: No market may exist

Cost-Based:Useful for determining

full-cost; easy to implement

Negotiated:Bargaining takes time and

may need to be reviewed


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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


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Assume a perfectly competitive market,

with no idle capacity.

Transportation Division can sell all the crude oil

it transports to the external market in Seattle

for $23 per barrel.


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


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Assume that an intermediate market exists

that is not perfectly competitive, and the

selling division has idle capacity.

If the Transportation Division has idle

capacity, its opportunity cost of transferring

the oil internally is zero.



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It would be $15 per barrel for oil purchased

under the long-term contract, or...$19 per barrel for oil purchased and

transported from the independent

supplier in Alaska.


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Incorporate income tax

considerations in

multinational

transfer pricing.


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Multinational Transfer PricingMultinational Transfer Pricing

IRC Section 482 requires that transfer prices forboth tangible and intangible property between a

company and its foreign division be set to equal

the price that would be charged by an unrelatedthird party in a comparable transaction.


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End of Chapter 22

Transfer Pricing Rectified

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