chapter 22 transfer pricing

TRANSFER PRICINGrights reserved.

Class Announcements Service Learning Assignment:

Schedule a meeting with Danika Leblanc ([email protected]) prior to contacting your organization

See Service Learning Project on-line See M Oxner if not assigned to a project

Next class – In lieu of class (both sections) – Leadership Forum at 2:15pm in SCHW 110. Speaker – Richard Peddie, Former CEO Maple Leaf Sports and Entertainment

Assignment #2 due February 10, available on-line Midterm February 19th (Wednesday)- discussed at end of class Office hours on Wednesday 9:00am-12:00noon Business Banquet - April 2nd – 5:45-8pm, Catering - Gabrieau's

Bistro; Keynote Speaker - Annette Verschuren, Past President of Home Depot for Canada and Asia

mailto:[email protected]

Class Objectives1. Understanding transfer pricing as an

internal pricing mechanism2. Understanding transfer pricing as a

means for evaluation3. Consider the implications of transfer

pricing on behaviour

Transfer Pricing When evaluations are based on profit, etc. we need

to establish price for internal transfers “Transfer price is the price one subunit

(department or division) charges for a product or service supplied to another subunit of the same organization.” p. 780

Transfer prices can have a dramatic effect on the reported profitability of a division but not on overall profit

In a well designed transfer pricing system a manager focuses on optimizing subunit performance and in doing so optimizes the performance of the whole company.

© 2012 Pearson Prentice Hall. Aill rights reserved.i

Transfer Pricing: Internal Price Management control systems use transfer prices

to coordinate the actions of subunits and to evaluate their performance.

The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit affecting each subunit’s operating income.

When segments sell to one another, a benefit to one segment may have a negative impact on another segment (internal transfer)

Transfer price becomes a cost to the buying division and revenue to the selling division.


Transfer Pricing: Purposes 1) Promote goal congruence 2) To guide managers to decide whether to buy

internally or externally a good transfer price is one that induces division

managers to do whatever is in the best interest of the entire company otherwise sub optimization (i.e. each division manager makes a decision to maximizes the company’s profit).

3) To evaluate segment performance 4) To minimize taxes, duties & tariffs for

multinationals 5) Preserve autonomy

Transfer Pricing: Rule Transfer Price = Incremental Cost+

Opportunity Cost Incremental cost is additional cost of producing ad

transferring a product or service Opportunity cost is the maximum contribution

margin foregone by selling if product or service is transferred internally.

Transfer price depends on capacity Excess capacity – TP=Incremental Cost No excess capacity – TP= Incremental Cost+ Opp

Cost

Transfer Pricing: MethodsDifficulty in implementing this rule yielded three approaches to determining transfer price.1.Market-based transfer prices2.Cost-based transfer prices3.Hybrid transfer prices

i. Prorated transfer pricesii. Dual transfer pricesiii. Negotiated transfer prices


Transfer Pricing: 1.Market-Based

Top management chooses to use the price of similar product or service that is publicly available. Sources of prices include trade associations,

competitors, and so on. Lead to optimal decision-making when three

conditions are satisfied:1. The market for the intermediate product is perfectly

competitive.2. Interdependencies of subunits are minimal.3. There are no additional costs or benefits to the company

as a whole from buying or selling in the external market instead of transacting internally.



A perfectly competitive market exists when there is a homogeneous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actions.

Allows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations, and subunit autonomy.

Perhaps should not be used if the market is currently in a state of “distress pricing.”

Because not based on costs, motivates each division manager to exert management effort to maximize his or her own division’s operating income (cost management)



Advantages: i) avoids routinely bogging down negotiations ii) if no idle capacity, market price is the

perfect choice iii) external segmented reporting using market

price Disadvantages:

i) market prices are not always known ii) may reduce possibility of generating benefits

through cooperation

Transfer Pricing: 2.Cost-Based Top management chooses a transfer price

based on the costs of producing the intermediate product. Examples include: Variable production costs Variable and fixed production costs Full costs (including life-cycle costs)/absorption

costing One of the above, plus some markup

Useful when market prices are unavailable, inappropriate, or too costly to obtain


Transfer Pricing: 2.Cost-Based Advantages:

i) commonly used in practice ii) easily understood and convenient to use

Disadvantages: i) distinction between fixed and variable

costs are blurred (absorption cost leads to dysfunctional behavior)

ii) since inefficiencies are passed on, lacks incentive to control expenditures/assets (standards avoid this)

Transfer Pricing: 3.Hybrid Takes into account both cost and market

information Types of hybrid transfer prices:

Prorating the difference between maximum and minimum transfer prices

Dual pricing Negotiated pricing (most common)


Transfer Pricing: 3.Hybrid Dual-pricing transfer prices

charge the buying division for the cost of the transferred product (however the cost might be determined) and credits the selling division with the cost plus some profit allowance.

using two separate transfer-pricing methods to price each transfer from one subunit to another.

not used much in practice example: selling division receives full cost

pricing, and the buying division pays market pricing.


Transfer Pricing: 3.Hybrid Negotiated transfer prices:

Occasionally, subunits of a firm are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties.

May or may not bear any resemblance to cost or market data.

Often used when market prices are volatile. Represent the outcome of a bargaining process

between the selling and buying subunits. Promotes autonomy


Transfer Pricing: 3.Hybrid Disadvantages of Negotiated Transfer Price:

i) time consuming ii) may lead to bad “blood” between mangers of

different subunit; Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices.

iii) If managers are pitted against each other rather than against their past performance or reasonable benchmarks, a non-cooperative atmosphere is almost guaranteed.

Note: The principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally, even is this may occasionally result in suboptimal decisions.

Transfer Pricing: Method Comparison


Transfer Pricing: International

Transfer Pricing Objectives

Domestic• Greater divisional autonomy• Greater motivation for managers• Better performance evaluation• Better goal congruence

International• Less taxes, duties, and tariffs• Less foreign exchange risks• Better competitive position• Better governmental relations

Friday, Wednesday February19th(in-class) Worth: 30% Coverage: Chpts. 6, 7, 8 , 22 (p. 780-791), 23 (p.

808-814) Format:

Short answer questions with multiple parts No – multiple choice, journal entries, ethics Answer for only THREE of the four questions; each

question is worth 25 points. Preparation:

Problems On-line Lecture Notes On-line Additional Office Hours:

Tuesday 18th – 11:00am – 1:00pm (normally none) Wednesday 19th – 9:00am – 2:00pm (normally 11:00am –

2:00pm)

Midterm

chapter 22 transfer pricing

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