Transfer Pricing

Key Concepts/Definitions

A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company.

The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company .

Transfer Pricing The amount charged when one division sells goods or services to another division Batteries

Battery Division Auto Division

Three Primary Approaches

There are three primary approaches to setting transfer prices: 1. Negotiated transfer prices; 2. Transfers at the cost to the selling division; and 3. Transfers at market price.

Negotiated Transfer Prices

A negotiated transfer price results from discussions between the selling and buying divisions.

Range of Acceptable Transfer Prices Upper limit is determined by the buying division.

Lower limit is determined by the selling division.

Barker Company – An Example Assume the information as shown with respect to The Battery Division and Vehicle Division (both Division’s are owned by Barker Company).

Battery Division:

Production Capacity (Number of Batteries) Variable cost per battery Fixed costs per month Selling price per battery to outsiders

Vehicle Division:

Purchase price per battery from outside supplier Monthly comsumption of batteries 300,000 £18 £2,100,000 £40 £39 50,000

Barker Company –Scenario 1 Suppose that the Battery Division is operating at capacity. What is the lowest acceptable transfer price from the viewpoint of the Battery Division?

What is the highest acceptable transfer price from the viewpoint of the Vehicle Division?

Will a transfer take place?

General Guideline for Determining a Minimum Transfer Price

Minimum transfer price = Incremental costs per unit incurred up to the point of transfer + Opportunity costs per unit to the selling division

Barker Company – Scenario 1 As indicated, the Battery Division is operating at capacity. The Battery Division’s acceptable transfer price is calculated as: Transfer Price

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Variable cost per unit + Total contribution margin on lost sales Number of units transferred The Vehicle Division’s acceptable transfer price is calculated as: Transfer Price

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Cost of buying from outside supplier

Barker Company – Scenario 1 If Battery Division has no idle capacity (0 batteries) and must sacrifice other customer orders (50,000 batteries) to meet Vehicle Division’s demands (50,000 barrels), then the lowest and highest possible transfer prices are computed as follows: Selling division’s lowest possible transfer price: Transfer Price

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£18 + ( £40 - £18) × 50,000 50,000 = £40 Buying division’s highest possible transfer price: Transfer Price

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Cost of buying from outside supplier = £39 Therefore, there is no range of acceptable transfer prices.

Barker Company – Scenario 2 Refer to the original data. Assume that the Battery Division has enough idle capacity to supply the Vehicle Division’s needs without diverting batteries from the outside market.

What is the lowest acceptable transfer price from the viewpoint of the Battery Division? In what price range will a transfer take place?

Barker Company – Scenario 3 Refer to the original data. Suppose the Battery Division is selling 275,000 batteries per month on the outside market. The Vehicle Division can put only one kind of batteries in its vehicles. It cannot buy 25,000 batteries from an outside supplier and 25,000 batteries from the Battery Division: it must buy all of its batteries from one source. The Battery Division must sacrifice some outside customer orders to meet the Vehicle Division’s demands. What is the lowest acceptable transfer price from the viewpoint of the Battery Division? In what price range will a transfer take place? Is this transfer “goal-congruent” for the Company (Barker)?

An Example Materials used by the Truck Division of Structure Motors are currently purchased from outside suppliers at a cost of $260 per unit. However, the same materials are available from the Component Division. The Component Division has unused capacity and can produce the materials needed by the Truck Division at a variable cost of $190 per unit.

If a transfer price of $230 per unit is established and 40,000 units of material are transferred with no reduction in the Component Division’s current sales, how much would Structure Motors’ total income from operations increase?

How much would the Truck Division’s income from operations increase?

How much would the Component Division’s income from operations increase?

Let’s change the transfer price to $250. Recalculate a, b and c above. What additional insights can we gain?

Evaluation of Negotiated Transfer Prices

If a transfer within a company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer.

Cost-Based Transfer Prices Some companies use the following measures of cost to establish transfer prices . . .

Variable cost (₤18 for the Battery Division). The selling division will never show a profit on any internal transfer. Full absorption cost (₤25 for the Battery Division)

Will the Battery Division transfer at Full Cost if it has no capacity?

What happens if the Battery Division has capacity and the Auto Division can sell batteries at ₤23 in a foreign country?

Mark-up (e.g. 120% of full cost, or ₤30 per battery).

Transfers at Market Price A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.

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Note: 1. A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. In the Battery Division example, the price would be set at ₤40 .

2. A market price approach does not work well when the selling division has idle capacity. What happens if the Battery Division has excess capacity? Will it prefer to sell at a price below ₤40?

An International Perspective

Since tax rates are different in different countries, companies have incentives to set transfer prices that will: • Increase revenues in low-tax countries.

• Increase costs in high-tax countries.