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Transfer Pricing
Chapter 15

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin

Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

LO
15-1

Transfer Pricing
LO 15-1

Explain the basic issues associated with transfer pricing

Transfer Price
The value or amount recorded in a firms accounting re
when one business unit sells (transfers) a good or serv
another business unit. The accounting records in the t
(responsibility centers) treat this transaction in exactly
same way as a sale to an outside customer.
Because the exchange takes place within the
organization, however, the firm has considerable
discretion in setting this transfer price.
15-3

LO
15-1

Transfer Pricing
Because the managers of both the selling division
and the buying division are evaluated on division
profit, not company profit, they consider the
effect of all sales, both internal and external, on
their division, not company, profit.
The optimal transfer price is the price that leads
both division managers, each acting in his or her
own self-interest, to make decisions that are in
the firms best interest.

15-4

LO
15-2

Determination of
Optimal Transfer Price
Given the market prices and the costs in the firm,
does firm profit increase?
Given the transfer price, the intermediate market
prices, and the divisional costs, does the selling
division profit increase?
Given the transfer price, the final market prices,
and the divisional costs, does the buying division
profit increase?
15-5

LO
15-2

Optimal Transfer Price

Transfer
Outlay
Opportunity cost of the
+
=
price
cost
resource at the point of transfer

15-6

LO
15-2

Optimal Transfer Price

To restate the goal of each manager:
Each division manager wants to
maximize his contribution margin.
Each manager is indifferent about
the transfer price if it has no impact
on their contribution margin.

15-7

LO
15-2

Optimal Transfer Price:

No Intermediate Market

Suppose that no intermediate market for wood exists or that,

for whatever reason, the company has decided that it will not
allow the divisions to buy or sell wood on the outside 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).

15-8

LO
15-3

Managers Goals versus Firms

Goals
LO 15-3

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

15-9

LO
15-3

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
Managers of the buying and selling
divisions agree on a price

15-10

LO
15-3

Alternative Cost Measures

Full
Full Absorption
Absorption Cost-Based
Cost-Based Transfers
Transfers
Although
Although the
the transfer
transfer pricing
pricing ruledifferential
ruledifferential outlay
outlay cost
cost to
to the
the
selling
selling division
division plus
plus the
the opportunity
opportunity cost
cost of
of making
making the
the internal
internal
transfer
transfer to
to the
the companyassumes
companyassumes that
that the
the company
company has
has aa reliable
reliable
estimate
estimate of
of differential
differential or
or variable
variable cost,
cost, this
this is
is not
not always
always the
the case.
case.
Consequently,
Consequently, manufacturing
manufacturing firms
firms sometimes
sometimes use
use full
full absorption
absorption
cost
cost as
as the
the transfer
transfer price.
price.
Cost-Plus
Transfers
Cost-Plus Transfers
We
We also
also find
find companies
companies using
using cost-plus
cost-plus transfer
transfer pricing
pricing based
based on
on
either
either variable
variable costs
costs or
or full
full absorption
absorption costs.
costs. These
These methods
methods generally
generally
apply
apply aa normal
normal markup
markup to
to costs
costs as
as aa surrogate
surrogate for
for market
market prices
prices when
when
intermediate
intermediate market
market prices
prices are
are not
not available.
available.

Standard
Standard Costs
Costs or
or Actual
Actual Costs
Costs
If
If actual
actual costs
costs are
are used
used as
as the
the basis
basis for
for the
the transfer,
transfer, any
any variances
variances or
or
inefficiencies
inefficiencies in
in the
the selling
selling division
division are
are passed
passed to
to the
the buying
buying division.
division.
The
The problem
problem of
of isolating
isolating the
the variances
variances that
that have
have been
been transferred
transferred to
to
the
the subsequent
subsequent buying
buying divisions
divisions becomes
becomes extremely
extremely complex.
complex. To
To
promote
promote responsibility
responsibility in
in the
the selling
selling division
division and
and to
to isolate
isolate variances
variances
within
within divisions,
divisions, standard
standard costs
costs are
are generally
generally used
used as
as aa basis
basis for
for
transfer
transfer pricing
pricing in
in cost-based
cost-based systems.
systems.

15-11

LO
15-3

Motivational Problems of
Transfer Pricing
A
A supplier
supplier whose
whose transfers
transfers are
are almost
almost all
all internal
internal is
is usually
usually organized
organized
as
as aa cost
cost center.
center. The
The center
center manager
manager is
is normally
normally held
held responsible
responsible for
for
costs,
costs, not
not revenues.
revenues. Hence,
Hence, the
the transfer
transfer price
price does
does not
not affect
affect the
the
managers
managers performance
performance measures.
measures.
In
In companies
companies in
in which
which such
such aa supplier
supplier is
is aa profit
profit center,
center, the
the artificial
artificial
nature
nature of
of the
the transfer
transfer price
price should
should be
be considered
considered when
when evaluating
evaluating the
the
results
results of
of that
that centers
centers operations.
operations.

15-12

LO
15-3

Dual Transfer Prices

A dual transfer pricing system could be installed to
provide the selling division with a profit but to charge the
buying division only for costs. That is, the buyer could be
charged the cost of the unit, however cost is determined,
and the selling division could be credited for cost plus
some profit allowance. The difference could be accounted
for in a specialized centralized account.

15-13

LO
15-4

Multinational Transfer Pricing

LO 15-4

Explain the economic consequences

of multinational transfer prices.

In international (or interstate) transactions, transfer prices

can affect tax liabilities, royalties, and other payments
because of different laws in different countries (or states or
provinces). Because tax rates vary among countries,
companies have incentives to set transfer prices that will
increase revenues (and profits) in low-tax countries and
increase costs (thereby reducing profits) in high-tax
countries.

15-14

LO
15-5

Segment Reporting
LO 15-5

Describe the role of transfer prices in segment reportin

The Financial Accounting Standards Board (FASB) requires

companies engaged in different lines of business to report
certain information about segments that meet the FASBs
technical requirements. This reporting requirement is
intended to provide a measure of performance for those
segments that are significant to the company as a whole.

15-15

LO
15-5

Segment Reporting
The following are the principal items that must be
disclosed about each segment:
Segment revenue, from both internal and external
customers.
Interest revenue and expense.
Segment operating profit or loss.
Identifiable segment assets.
Depreciation and amortization.
Capital expenditures.
Certain specialized items.

15-16

End of Chapter 15

15-17