CHAPTER 8CHAPTER 8CHAPTER 8CHAPTER 8

Transfer PricingTransfer PricingTransfer PricingTransfer Pricing

Transfer PricingTransfer PricingTransfer PricingTransfer Pricing

Transfer price - price used to value internal transfers of goods or services

Subunits of a company sell goods or services to other subunits within the same company

Must determine the price to use for internal transfers

Transfer Pricing ObjectivesTransfer Pricing ObjectivesTransfer Pricing ObjectivesTransfer Pricing Objectives

General Transfer-Pricing RuleGeneral Transfer-Pricing RuleGeneral Transfer-Pricing RuleGeneral Transfer-Pricing Rule

VC + OC ≤ Transfer Price ≤ Market Price

The minimum price should be no less than the sum of the selling segment’s incremental costs (VC) associated with the goods or services plus the opportunity cost (OC) of the forgone production of the seller per unit (lost contribution margin).

The maximum price should be no greater than the lowest market price at which the buying segment can acquire the goods or services externally.

Methods of Setting the Methods of Setting the Transfer PriceTransfer Price

Methods of Setting the Methods of Setting the Transfer PriceTransfer Price

Pricing alternatives:

Market price Cost-based price Negotiated price Arbitrary price Dual Pricing

Market PriceMarket PriceMarket PriceMarket Price

The price at which the division may buy or sell the units outside and is based on arm’s length transaction in an open market.

The best transfer price in the sense that it will maximize the profits of the company as a whole, if it meets the following two conditions:- There exists a competitive market price.- Divisions are independent of each other.

Cost-Based Transfer PriceCost-Based Transfer PriceCost-Based Transfer PriceCost-Based Transfer Price

Variable or Full Cost Actual or Standard Cost

*Actual costs may vary according to the season, production volume, and other factors, whereas standard costs can be specified in advance and are stable measures of efficient production costs. For these two reasons, standard costs provide a superior basis for transfer pricing.

Negotiated PriceNegotiated PriceNegotiated PriceNegotiated Price The transfer price arrived at in negotiations

between the buying and selling divisions.

Such price is typically below the normal market purchase price of the buying unit, but above the sum of the selling unit’s incremental and opportunity costs. A negotiated price meeting these specifications falls within the range limits of the transfer pricing rules.

Arbitrary PriceArbitrary PriceArbitrary PriceArbitrary Price A price established by interaction between

buying and selling divisions and is at a level considered best for overall company interests, with neither the buying nor the selling divisions having any control over the final decisions.

This is due to such extensive autonomy that leads to dysfunctional behavior and sub-optimization, top management may provide a means of arbitrating a price in the event that the units cannot agree.

Dual PricingDual PricingDual PricingDual Pricing A method where both the selling and buying

divisions record the transactions at different prices.

Such an arrangement lets the selling division record the transfer of goods or services at a market or negotiated market price and the buying division to record the transfer at a cost-based amount and provides a profit margin on the goods transferred and thus reflects a “profit” for the selling division and also provide a minimal cost to the buying division.

Journal EntriesJournal EntriesJournal EntriesJournal EntriesAssume that 1,000 units of product are transferred from the Evergreen Division to the Marine Biochemical Division:Variable cost (1,000 x P 0.40) = P400Full production cost (1,000 x P0.45) = P450External sell ing price (1,000 x P0.72) = P720

SITUATION EVERGREEN (E) MARINE BIOCHEMICAL (MB)Transfer Price at Variable Cost A/R - Division MB 400 Inventory 400

Intracompany Sales 400 A/P - Division E 400Intracompany CGS 450

Finished Goods 450

Transfer Price at Full Production A/R - Division MB 450 Inventory 450Cost Intracompany Sales 450 A/P - Division E 450

Intracompany CGS 450Finished Goods 450

Transfer Price at Market Price A/R - Division MB 720 Inventory 720Intracompany Sales 720 A/P - Division E 720

Intracompany CGS 450Finished Goods 450

Transfer Price at Dual Price A/R - Division MB 450 Inventory 450Market Price for sell ing division & Intracompany Sales in excess A/P - Division E 450Full Prod Cost for buying division of Assigned Cost 270

Intracompany Sales 720Intracompany CGS 450

Finished Goods 450NOTE: Entries for negotiated transfer prices would be similar to those at full production cost, except that the negotiated transfer price would be shown for first entry for the selling division and the purchase entry for the buying division.

Sample ProblemSample ProblemSample ProblemSample ProblemAssuming Estimated sales to outside entities: 4,000 units Estimated intra-company transfers: 1,000 units Total standard cost per unit of P0.52 in Evergreen divisionSales:

External (4,000 x 0.72) P2,880Internal (1,000 x 0.45) 450 P3,330

Costs (5,000 x 0.52) 2,600Income before tax P 730 Suppose the Marine Biochemical Division of Scott Company can purchase evergreen units

externally from United Company for P0.44 and that the externally purchased units are of the same quality and specifications as those produced internally. Thus, although the buying segment manager appears to “save” P0.01 per unit, the company would be better off by P4,000 if the units were purchased internally rather than externally:

Unit cost to Marine Biochemical Division to purchase externally P0.44Unit cost to produce in Evergreen Division (out-of-pocket costs) 0.40Net advantage of company to produce per unit P0.04Multiplied by number of units transferred 1,000Total savings to produce internally P4,000

*These facts assume that the Evergreen Division does not have an opportunity cost of more than P0.04 per evergreen unit. Under the above circumstances, the general transfer pricing rules also would have yielded the decision not to make the internal transfer. The sum of the P0.40 incremental cost to produce and the P0.32 opportunity cost of additional contribution on external sales is P0.72, which exceeds the upper limit of the P0.44 market price. Scott Company should not make the transfer as long as the Marine Biochemical Division can purchase the units externally for a price less than P0.72.