Chapter 15

Transfer Pricing

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Transfer Pricing
L.O. 1 Explain the basic issues associated with transfer pricing.

Transfer price:
The value assigned to the goods or services sold or rented
(transferred) from one unit of an organization to another.
Treatment is the same as a sale to an outside customer.
Revenue to the selling unit
Cost to the buying unit

15 - 2

The Setting
L.O. 2 Explain the general transfer pricing rules and
understand the underlying basis for them.

Padre Papers

Wood Division

Trees

Paper Division

Wood for
making paper

Paper

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LO2

The Setting
Padre Papers
Cost and Production Data
Wood

Average units produced

Average units sold
Variable manufacturing cost per unit
Variable finishing cost per unit
Fixed divisional cost (unavoidable)

Paper

100,000
100,000
$

20

$
30
$2,000,000 $4,000,000

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LO2

The Setting
Padre Papers Resources Flow
Wood Division
(selling division)
Variable cost = $20
Fixed cost = $2,000,000

Wood

Transfer
price

Market for wood

(intermediate market
Price = ?

Paper Division
(buying division)
Variable wood cost = ?
Variable finishing cost = $30
Fixed cost = $4,000,000

Market for paper

(final market
Price = ?
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LO2

Padre Papers Example

Assume the following data for the wood division:
Capacity in units
100,000
Selling price to outside
$
60
Variable price per unit
$
20
Fixed price per unit (based on capacity) $
20

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LO2

Padre Papers Example

The Paper Division is currently purchasing 100,000
units from an outside supplier for $50, but would
like to purchase units from the Wood Division.

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LO2

Padre Papers Example

Transfer
Variable
Lost contribution
=
+
price
cost (VC)
margin (CM)
If the Wood Division
is working at capacity:
If the Wood Division
has idle capacity:

Transfer
= $20 + $40
price
Transfer
= $20 +
price

$0

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LO2

Optimal Transfer Price

There is no intermediate market.
In this case, the only outlet for the Wood Division
is the Paper Division and the only source of
supply for the Paper Division is the Wood Division.
The optimal transfer price is the outlay cost for
producing the goods (generally the variable costs).

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LO2

Perfect Intermediate
Marked-Quality Differences

Variable manufacturing cost (Wood Division) per unit

Variable finishing cost (Paper Division) per unit
Other data:
Final market (paper) price
Intermediate market (grade A wood) price
Intermediate market (grade B wood) price

$ 20
$ 30

$120
$ 60
$ 50

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LO2

Quality Difference Example

Grade B wood: $50 internal transfer price

Wood
Sales:
$ 50 100,000 (transfer)
$120 100,000 (transfer)
Variable costs:
$ 20 100,000
$ 50 100,000 (transfer)
$ 30 100,000 (processing)
Fixed costs
Operating profit
Total company operating profit

Paper

$5,000,000
$12,000,000
$2,000,000
$ 5,000,000
3,000,000
4,000,000
$
-0-

$2,000,000
$1,000,000

$1,000,000
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LO2

Quality Difference Example

Grade A wood: $60 internal transfer price

Wood
Sales:
$ 60 100,000 (transfer)
$120 100,000 (transfer)
Variable costs:
$ 20 100,000
$ 60 100,000 (transfer)
$ 30 100,000 (processing)
Fixed costs
Operating profit
Total company operating profit

Paper

$6,000,000
$12,000,000
$2,000,000
$ 6,000,000
3,000,000
4,000,000
$ (1,000,000)

$2,000,000
$2,000,000

$1,000,000
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Managers Goals versus Firms Goals

L.O. 3 Identify the behavioral issues and incentive effects
of negotiated transfer prices, cost-based transfer
prices, and market-based transfer prices.

Transfer price higher than market:

Buying division will not buy
Transfer price lower than market:
Selling division will not sell

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LO3

Centrally Established
Transfer Price Policies
Market price-based:
Sets the transfer price at the market price or
at a small discount from the market price
Cost-based:
Outlay cost to selling division plus forgone
contribution to company projects
Negotiated transfer:
The managers of the buying and selling
divisions agree on a price.

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Multinational Transfer Pricing

L.O. 4 Explain the economic consequences
of multinational transfer prices.

International (or interstate) transfer pricing

can affect tax liabilities, royalties, and other
payments due to different laws in different
countries or states.
Company incentive:
Increase profit in low-tax country
Decrease profit in high-tax country

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Segment Reporting
L.O. 5 Describe the role of transfer prices in segment reporting.
The FASB requires companies to report certain
information about segments in order to provide
a measure of performance for those segments
that are significant to the company as a whole.

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End of Chapter 15

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.